The Start of the Beginning

April 7, 2019

by Steve Stofka

In 1971 former President Nixon announced that the U.S. was abandoning the gold standard of fixed exchange that had existed for almost thirty years. Within a short time, other leading nations followed suit. Each nation’s currency simply traded against each other on a global currency, or FX, market.

Since oil was priced in dollars and the world ran on oil, the U.S. dollar became the world’s reserve currency. Each second of every day, millions of US dollars are traded on the international FX markets. The demand for US dollars is strong because we are a productive economy. The euro, yen and British pound are secondary currency benchmarks.

When the U.S. wants to borrow money from the rest of the world, the U.S. Treasury sells notes and bills collectively called “Treasuries” to large domestic and foreign banks who “park” them in their savings accounts at the Federal Reserve (Fed), the U.S. central bank (Note #1). The phrase “printing money” refers to a process where the Federal Reserve, an independent branch of the Federal Government, buys Treasury debt on the secondary market. It may surprise many to learn that the Fed owns the same percentage of U.S. debt as it did in 1980. The debt in real dollars has grown seven times, but the percentage held by the Fed is the same. That is a powerful testament to the global hunger for U.S. debt. Here’s the chart from the Fed’s FRED database.

FedResHoldTreasPctDebt

In 1835, President Andrew Jackson paid off the Federal debt, the one and only time the debt has been erased. It left the country’s banking system in such a weak state that subsequent events caused a panic and recession that lasted for almost a decade (Note #2). Government debt is the private economy’s asset. Paying down that debt reduces those assets.

About a third of the debt of the U.S. is traded around the world like gold. It is better than gold because it pays interest and there are no storage costs. Foreign businesses who borrow in dollars must be careful, however. They suffer when their local currency depreciates against the dollar. They must earn even greater profits to convert their local currency to dollars to make payments on those dollar-denominated loans.

Each auction of Treasury debt is oversubscribed. There isn’t enough debt to meet demand. In a world of uncertainty, the U.S. government has a long history of respect for its monetary obligations. As the reserve currency of the world, the U.S. government can spend at will. Even if there were no longer a line of domestic and foreign buyers for Treasuries, the Federal Reserve could “purchase” the Treasuries, i.e. print money. Let’s look at the difference between borrowing from the private sector and printing money.

When the private sector buys Treasuries, it is effectively trading in old capital that cannot be put to more productive use. That old capital represents the exchange of real goods at some time in the past. In contrast, when the government spends by buying its own debt, i.e. printing money, it is using up the current production of the private sector. This puts upward pressure on prices. Let’s look at a recent example.

Quantitative Easing (QE) was a Fed euphemism for printing money. During the three phases of QE that began in 2009, the Fed bought Treasury debt. That was an inflationary policy that countered price deflation as a result of the Financial Crisis. In August 2009, inflation sank as low as -.8% (Note #3). It was even worse, but inflation measures do not include the dividend yield on money. To many households, inflation felt like -2% (Note #4). The Fed’s first round of QE did provide a jolt that helped drive prices up by 3% and out of the deflationary zone.

During the five years of QE programs, the Fed continued to fight itself. The QE programs pushed prices upwards. Near zero interest rates produced a deflationary counterbalance to the inflationary pressures of printing money. Because inflation measures do not include the yield on money, the Fed could not read the true change in the prices of real goods in the private sector. The economy continues to fall below the Fed’s goal of 2% inflation. There are still too many idle resources.

Leading proponents of Modern Monetary Theory (MMT) remind people that yes, the U.S. can spend at will, but that it must base its borrowing on policy rules to avoid inflation. A key component of MMT is a Job Guarantee (JG) program ensuring employment to anyone who wants a job. A JG program may remind some of the WPA work programs during the Great Depression. Visitors to popular tourist attractions, from Yellowstone Park in Wyoming to Carlsbad Caverns in New Mexico, use facilities built by WPA work crews. Today’s JG program would be quite different. It would be locally administered and targeted toward smaller public works so that the program was flexible.

The U.S. government has borrowed freely to go to war and has never paid that debt back. Proponents of MMT recommend that the U.S. do the same during those times when the private economy cannot support full employment. That policy goal was given to the Fed in the 1970s, but it has never been able to meet the task of full employment through crude monetary tools. With an active program of full employment, the Fed would be left with only one goal – guarding against inflation.

There are two approaches to inflation control: monetary and fiscal. Monetary policy is controlled by the Fed and includes the setting of interest rates. If the Fed’s mandate was reduced to fighting inflation, it could more readily adopt the Taylor rule to set interest rates (Note #4).

Fiscal policy is controlled by Congress. Because taxation drains spending power from the economy, it has a powerful control on inflation. However, changes in tax policy are difficult to implement because taxes arouse passions. We are familiar with the arguments because they are repeated so often. Everyone should pay their “fair share,” whatever that is. Some want a flat tax like a head tax that cities like Denver have enacted. Others want a flat tax rate like some states tax incomes. Others want even more progressive income taxes so that the rich pay more and the middle class pay less. Some claim that income taxes are a government invasion of private property rights.

Because tax changes are difficult to enact, Congress would be slow to respond to changes in inflation. The Fed’s control of interest rates is the more responsive instrument. The JG program would provide stability to the economy and reduce the need for corrective monetary action by the Fed. The program would help uplift those in marginal communities and provide much needed assistance to cities and towns which had to delay public works projects and infrastructure repair because of the Financial Crisis. As sidewalks and streets get fixed and graffiti cleaned, those who live in those areas will take more pride in their town, in their communities, in their families and themselves. This makes not just good economic sense but good spiritual sense. We can start small, but we must start.

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Notes:

1. Twenty to twenty-five times each month, the Treasury auctions U.S. government debt. Many refer to the various forms of bills and notes as “treasuries.” A page on the debt
2. The Panic of 1837
3. The Federal Reserve’s preferred measure of inflation is the Personal Consumption Expenditure Index, PCEPI series.
4. The annual change in the 10-Year Constant Maturity Treasury fell below -1% at the start of the recession in December 2007 and remained below -1% until July 2009. FRED series DGS10. John Maynard Keynes had recommended the inclusion of money’s yield in any index of consumer demand. In his seminal work Foundations of Economic Analysis (1947), economist Paul Samuelson discussed the issue but discarded it (p. 164-5). Later economists did the same.
5. The Taylor rule utility at the Atlanta Federal Reserve.

 

Green Debt

March 17, 2019

by Steve Stofka

Imagine a world where, each year, the U.S. government (USG) gave $1000 to each of it’s approximately 300 million citizens (Note #1). The annual cost of the program would be $300 billion, about $120 billion more than the 2017 tax cuts (Note #2). As it does every year, the USG would borrow the money and issue Treasury bills, which are traded around the world. Although there is more than $23 trillion of Treasury debt – a plentiful supply – there is not enough to meet world demand.

Let’s say that the American people spent 80% of that $300 billion each year and saved the rest (Note #3). Let’s also calculate a multiplier of 1.5 so that the extra $240 billion of spending generates $360 billion of GDP (Note #4), about 1.7% of last year’s GDP. The increase in GDP would return about $60 billion to the USG in tax revenues (Note #5). The net cost to the USG is $300 billion less $60 billion in additional tax revenue = $240 billion.

Will the slight increase in GDP each year generate higher inflation? Inflation occurs when too much money chases too few goods and resources. Efficiencies in world production of goods and services has caused a continuing deflation in developed economies. Against those headwinds, inflationary pressures will be modest.

At the end of ten years, this program would create an additional $3.5 trillion in U.S. debt, the same amount of debt that the Federal Reserve accumulated in 2008 to protect the jobs and bonuses of Wall St. bankers. The Fed still owns most of that debt (Note #6). Which is fairer? A program to distribute money equally to everyone or a program to distribute the same amount to a select few?

Implementation of such a program is unlikely but illustrates the lack of a moral rudder in our Congress. Self-branded fiscal conservatives in both parties promote the fiction that the Social Security and Medicare funds will “run out of money” at a certain date in the future. These funds are part of the Federal government and are nothing more than bookkeeping entries on the Federal government’s books. The Social Security Administration explains this: “[the funds] provide 1) an accounting mechanism for tracking all income to and disbursements from the trust funds, and (2) they hold the accumulated assets. These accumulated assets provide automatic spending authority to pay benefits” [my emphasis] (Note #7). The accumulated assets are paper IOUs from the government to itself so that Social Security benefits are beyond the reach of Congressional infighting and debate each year. When it was created, President Roosevelt called Social Security an insurance program because it was insured against Congressional tampering.

Republicans propose to privatize Social Security while Democrats propose additional taxes to “fully fund” Social Security. These schemes are built on accounting fictions and sold to the general public as prudent solutions. Will the trust funds run out of money? Congress can change this with a stroke of a pen. Just as they “borrowed” from the funds, they can “loan” to the funds (Note #8). Both parties are trying to convince voters that big changes must be made because Congress is too incompetent to make a small legislative change. Will voters buy this nonsense and let them keep their jobs?

Around the world, the value of US Treasury debt is more trusted than gold. It is more than a bond because it trades among commercial banks like currency. The U.S. enjoys a unique position. Its debt is a trusted part of the world’s savings. This country has worked hard and prudently to make the U.S. dollar the world’s money. Over the past century, the U.S. has managed its economy and debt better than other large developed countries. Let us take advantage of that position. Let’s stop the political ploys around Social Security and other federal entitlement programs. Let’s have a serious discussion about investing in building new schools and transportation solutions, as well as needed infrastructure repairs. Let’s stop posturing like buffoons and start behaving like the leader we are.

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Notes:

1. Census Quick Facts
2. Annual loss of tax revenue about $180 billion times 10 years = $1.8 trillion per CBO estimate 
3. Americans usually save about 5% of income.
4. More on fiscal multipliers. 1.5 is an average of various multipliers.
5. USG revenues average 17% of GDP.
6. Fed’s balance sheet over time. The Fed buys Treasury debt in the secondary market from large banks that buy the debt at Treasury auctions. The Fed continues to hold $1.6 trillion of mortgage-backed securities, the same kind of debt that led to the Financial Crisis. Current balance sheet.
7. Social Security Administration FAQ #1 on the nature of the funds . Also, see their page debunking SS myths promoted on the Internet
8. The Federal government pays below market interest rates for the money that it “borrowed” from the SSA funds. Decades ago, the interest rate was set at approx. the five-year average for funds “borrowed” for several decades. If 20 or 30 year rates had been used, the SS funds would be much larger. There would be no “crisis” to argue about.

The Big Picture

May 19, 2018

by Steve Stofka

Here is a simple and elegant animation model of the economy in a thirty-minute video from Bridgewater Associates, the world’s largest hedge fund. The video illustrates the spending – income – credit cycle in easy to understand terms. The video includes an insight first noted eighty years ago by the economist John Maynard Keynes, who pointed out that one person’s spending is another person’s income. Sounds obvious, doesn’t it?  I spend money on a pizza which increases the income of the pizza store.

When Keynes explored this simple idea, he revealed a glitch in the traditional model of savings and investment. In a simplified version, money not spent is saved in a bank. The bank loans out those savings to a business.  A business invests that loan into production for future spending. When economists model the whole economy, Savings = Investment. It is an accounting identity like a mathematical definition. The financial industry transforms one into the other.

During the Depression, something was obviously broken, and economists debated various aspects of their models. Keynes asked a question: what happens to the merchant where the money was not spent? Let’s say the Jones family decides not to buy a new TV and puts the money in a savings account at the Acme Bank.  The local Bigg TV store sells one less TV and has a corresponding decline in its income. Because Bigg had less income, they must withdraw money from their Acme Bank savings account to meet payroll. The money that the family saves is withdrawn by the business. The money Saved never makes it to the Investment side of the equation.  There is no increase in investment.

Most of the time, those who are saving and those who are spending funds from saving balances out. But there were times, Keynes proposed, when everyone is saving. Keynes attributed the phenomenon to “animal spirits.” As incomes fall, people start using up their savings to make up for the lost income.

During a crisis like this, Keynes proposed that government increase its spending, even if it needed to borrow, to boost incomes and break the vicious cycle. When the crisis was over, the government could raise taxes to pay back the money it borrowed. In Keynes’ model, government spending acted as a balancing force to the animal spirits of the capitalist economy. In the real world, politicians win votes by spending money but find that raising taxes does not win them favor with voters. Without legislative debt controls, government borrowing to counterbalance declines in income only produces greater government debt.

Turning from government debt to personal debt, the average credit card rate has risen to 15.3%, an eighteen year record. As an economy continues to expand and credit is extended to those with marginal creditworthiness, the default rate grows. The percent of credit card balances that have been charged off in default has risen from 1.5% several years ago to 3.6% in the 4th quarter of 2017.

Mortgage rates have risen to about 4.9% on thirty-year loans, and about a half percent less on fifteen-year loans. That half percent difference is close to the average for the past twenty-five years and adds up to an extra $1.60 in interest paid during the life of the loan on every $100 of mortgage principal. The graph below shows the difference between the two rates.

MortRatesDiff

Because shorter-term mortgages require higher monthly payments, they are more feasible for those with stable financial situations and above average incomes. When the difference in rates is less than average, there is a smaller advantage to getting a short-term mortgage.  At such times, the mortgage industry is reaching out to expand home ownership to lower income homeowners. When the difference is more than average, as it has been since the recession, the finance industry is cautious and not actively reaching out to lower income families.

Mortgages are secured by a physical asset, the house. U.S. Treasury bonds are secured by an intangible asset, the full faith and credit of the country. Just like us, the Treasury usually pays a higher interest rate for a longer-term loan.

A benchmark is the difference between a 10-year Treasury bond and a 2-year bond. As this difference declines toward zero, economists call it a “flattening of the yield curve.” At zero, there is no reward for loaning the government money for a longer term. Knowing only that, a casual investor would sense that something is wrong, and they are right. Periods when this difference falls below zero usually occur about a year before a recession starts. In the graph below, I’ve shaded in pink those negative periods. In gray are the ensuing recessions.

10YRLess2Yr

Before that negative pink period comes another phenomenon. Above was the 10 year – 2 year difference in interest rates. Let’s call that the medium difference. There’s also the difference between two long term periods, the 20-year minus 10-year difference. I’ll call that the long difference. When we subtract the medium difference from the long, we get a difference in long term outlook. In a healthy economy, that difference should be positive, meaning that investors are being paid for taking risks over a longer period. When that difference turns negative, it shows that there are underlying distortions in the risks and rewards of loaning money. That distortion will show first before the flattening of the yield curve.

DiffRates1995-2018

As you can see, the difference today is positive, a welcome sign that a recession is not likely within the year.

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Tidbits

The actuaries for Social Security and Medicare use an assumption that our average life expectancy will increase .77% per year (Reuters article)  If you are expected to live till 85 this year, then that expectation will grow to 85 years and eight months next year. That’s a nice birthday present!

U.S. lumber mills can supply only two-thirds of the lumber needed by homebuilders. The other third comes from Canada. Recent import tariffs now add about $6300 to the price of a new home (Albuquerque Journal).

Guessing the Future

April 23, 2017

Human beings have an ability to foretell the future, or at least some people think so.  A more accurate description is that we predict the likelihood of future events based on past patterns.  Index funds average the predictions of buyers and sellers in a particular market.

During the recovery most active fund managers have underperformed their benchmark indexes. Standard & Poors, the creator and publisher of many indexes, provides a quick summary in their SPIVA spotlight. In the past five years, 88% of active fund managers have underperformed the SP500.  In a random world, I would expect that 50% of active fund managers would beat the index, and 50% of managers would underperform the index because the index is an average of all those buy sell decisions.

The 1% higher fees charged by active fund managers contribute mightily to this underperformance. Using long term averages, we expect that a third of active fund managers would beat their benchmark index.  The current percentage is only 12%. It is likely that the law of averages will eventually exert its pull.

Index funds mechanically rebalance regularly. Let’s look at a real life example.  The pharmaceutical giant Johnson and Johnson is a member of both the SP500 and the smaller group of core stocks that make up the Dow Jones index.  This week the company  reported first quarter revenues that were below expectations, and sellers promptly knocked 3% off the stock price.  Because most SP500 index funds are market weighted, index funds that mimic the weighting of the stocks in the index would buy and sell stocks in the index to capture these changes.

Because index funds are averaging the decisions of all stock investors, they should underperform. After all, the index funds are buying those companies that everyone else is buying, and selling companies that everyone else is selling.  Index funds are buying high and selling low, creating a drag on performance that is overcome by the lower fees charged by these funds.

In an article last fall in the Kiplinger newsletter, Steven Goldberg makes the case for a mix of both index and active funds.  Research shows that active fund mangers do better when an index does poorly.  It’s worth a read.

The index fund giant Vanguard is featured in a NY times article. John Bogle founded Vanguard based on his thesis that a passive approach to investing and low fees would reward most investors over the long term.

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Correlation, not Causation

When the stock market crashed in 1929, the unemployment rate was less than 3%.  A booming economy during the 1920s lifted demand for labor, while severe immigration restrictions enacted in 1924 reduced the supply of workers.

Unemploy1929-1942

The unemployment rate was 6% when the market crashed in October 1987 and again in September 2008. There seems to be a weak connection between unemployment and severe market crashes.  However, there is a consistent correlation between the change in number of unemployed and the start of recessions.

UnemployChange

A yearly increase in the number of unemployed on a percentage basis indicates a fundamental weakness in the economy.  Sometimes, the change reverses as it did in early 1996, at the start of the dot com boom, or in the mid-eighties after a downturn in oil and housing exposed a banking scandal. These two periods are circled in blue in the graph above.

Often the economy continues to weaken, more people lose their jobs, GDP falters and the economy slides into depression.

Because we cannot rely on just one indicator as a warning signal, we can chart the amount of production generated by each person in the labor force.  The civilian labor force includes both those who are working and those who are actively looking for work.  A growth rate below 1% indicates some weakness.  Using both the change in unemployment and the change in production helps filter out some of the noise.

While production growth may be faltering, the current unemployment level is not worrying.

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Pay Attention to the Pros

Institutional buyers and sellers of Treasury bonds will usually let the rest of us know when they are worried about a recession.  In a middling to healthy economy, Treasury buyers will demand a higher interest rate for a longer dated bond.  Subtracting the interest rate on a shorter term two year bond from a long term ten year bond should be positive.  In a “normal” environment, a 10 year bond might have an interest rate of 3% and a two year bond an interest rate of 1%.  The difference of 2% would be expected.  However, a negative result indicates that buyers want more interest from short term bonds because they are more concerned about short term risks.  As we can see in the chart below, a negative result precedes a recession by 12 to 18 months.  The current difference shows no indication of concern.

Guessing the future is not divination, nor is it perfect.  Retail investors may not have the time or expertise to estimate future risk, but we can study those who make it their business to manage risk.

Dance of Debt

April 9th, 2017

Last week I wrote about the dance of household, corporate and government debt. When the growth of one member of this trinity is flat, the other two increase. Since the financial crisis the federal debt has increased by $10 trillion. Let’s look at the annual interest rate that the Federal government has paid on its marketable debt of Treasuries. This doesn’t include what is called interagency debt where one part of the government borrows from another. Social Security funds is the major example.

In 2016, the Federal government paid $240 billion in interest, an average rate of 1.7% on $14 trillion in publicly held debt. Only during WW2 has the Federal government paid an effective interest rate that is as low as it today. World War 2 was an extraordinary circumstance that justified an enormous debt. Following the war, politicians increased taxes on households and businesses to reduce the debt. Here is a graph of the net interest rate paid by the Federal government since 1940.

InterestRate

In 2008, before the run up in debt, the interest rate on the debt was 4.8%. If we were to pay that rate in 2017, the interest would total $672 billion, more than the defense budget. Even at a measly 3%, the interest would be $420 billion.  That is $180 billion greater than the interest paid in 2016.  That money can’t be spent on households, or highways, or education or scientific research.

The early 1990s were filled with political arguments about the debt because the interest paid each year was crippling so many other programs. Presidential candidate Ross Perot made the debt his central platform and took 20% of the vote, more than any independent candidate since Teddy Roosevelt eighty years earlier. Debt matters. In 1994, Republicans took over Congress after 40 years of Democratic rule on the promise that Republicans would be more fiscally responsible. In the chart below, we can see the interest expense each year as a percent of federal expenses.

PctFedExp

Let’s turn again to corporate debt. As I showed last week, corporate debt has doubled in the past ten years.

CorpDebt2016

In December, the analytics company FactSet reported (PDF) that the net debt to earnings ratio of the SP500 (ex-financials) had set another all time high of 1.88. Debt is almost twice the amount of earnings before interest, taxes, debt and amortization (EBITDA). Some financial reporters (here, for example ) use the debt-to-earnings ratio for the entire SP500, including financial companies. Financial companies were highly leveraged with debt before the crisis. In the aftermath and bailout, deleveraging in the financial industry effectively hides the growth of debt by non-financial companies.

What does that tell us? Unable to grow profits at a rate that will satisfy stockholders, corporations have borrowed money to buy back shares. Profits are divided among fewer shares so that the earnings per share increases and the price to earnings (profit), or P/E ratio, looks lower. Corporations have traded stockholder equity for debt, one of the many incidental results of the Fed’s zero interest rate policy for the past eight years.

Encouraged by low interest rates, corporations have gorged on debt. In 2010, the pharmaceutical giant Johnson and Johnson was able to borrow money at a cheaper rate than the Federal government, a sign of the greater trust that investors had in Johnson and Johnson at that time.

Other financial leverage ratios are flashing caution signals, prompting a subdued comment in the latest Federal Reserve minutes ( PDF ) “some standard measures of valuations [are] above historical norms.” Doesn’t sound too concerning, does it?

Each period of optimistic valuation is marked by a belief in some idea. When the bedrock of that idea cracks, doubts grow then form a chasm which swallows trillions of dollars of marketable value.

The belief could be this: passively managed index funds inevitably outperform actively managed funds. What is the difference? Here’s  a one-page comparison table. In 1991, William Sharpe, creator of the Sharpe ratio used to evaluate stocks, made a simple, short case for the assertion that passive will outperform active.

During the post-crisis recovery, passive funds have clearly outperformed active funds. Investors continue to transfer money from active funds and ETFs into index funds and ETFs. What happens when a smaller pool of active managers make buy and sell decisions on stocks, and an ever larger pool of index funds simply copy those decisions? The decisions of those active managers are leveraged by the index funds. Will this be the bedrock belief that implodes? I have no idea.

Market tensions are a normal state of affairs. What is a market tension? A conflict in pricing and risk that makes investors hesitate as though the market had posed a riddle. Perhaps the easiest way to explain these tensions is to give a few examples.

1. Stocks are overvalued but bond prices are likely to go down as interest rates rise. The latest minutes from the Fed indicated that they will start winding down their portfolio of bonds. What this means is that when a Treasury bond matures, they will no longer buy another bond to replace the maturing bond. That lack of bond purchasing will dampen bond prices. Stocks, bonds or cash? Tension.

2. Are there other alternatives? Gold (GLD) is down 50% from its highs several years ago. Inflation in most of the developing world looks rather tame so there is unlikely to be an upsurge in demand for gold. However, a lot of political unrest in the Eurozone could drive investors into gold as a protection against a decline in the euro. Tension.

3. What about real estate? After a run up in 2014, prices in a broad basket (VNQ) of real estate companies has been flat for two years. A consolidation before another surge? However, there is a lot of debt which will put pressure on profits as interest rates go up. Tension.

In the aftermath of the financial crisis, we discovered that financial companies, banks, mortgage brokers and ordinary people resolved market tensions through fraud, a lack of caution, and magical thinking. Investors can only hope that there is enough oversight now, that the memories of the crisis are still fresh enough that plain old good sense will prevail.

During the present seven year recovery there have been four price corrections in the Sp500 (Yardeni PDF). A correction is a drop in price of 10 – 20%. The last one was in the beginning of 2016. Contrast this current bull market with the one in the 2000s, when there was only one correction. That one occurred almost immediately after the bear market ended in the fall of 2002. It was really just a part of the bear market. From early 2003 till the fall of 2007, a period of 4-1/2 years, there was no correction, no relief valve for market tensions.

Despite the four corrections and six mini-corrections (5 – 10%) during this recovery, the inflation adjusted price of the SP500 is 50% higher than the index in the beginning of 2007, near the height of the market.  Inflation adjusted sales per share have stayed rather stable and that can be a key metric in the late stages of a bull market. The current price to sales (P/S) ratio is almost as high as at the peak of the dot com boom in 2000 and that ratio may prove to be the better guide. In a December 2007 report, Hussman Funds sounded a warning based on P/S ratios.  Nine years later, this report will help a reader wanting to understand the valuation cycles of the past sixty years.

Election Volatility

November 13, 2016

Sometimes the hardest thing an investor can do is nothing.  That’s pretty much what a casual investor with a balanced portfolio should do in response to the election results.  With a portfolio of 57% stocks and 43% bonds and cash, my total portfolio has risen 1/2% this week, or much ado about nothing.  Let’s dig into this week’s election results and the market’s reaction.

Donald Trump, the President-elect, has long maintained that his campaign was a movement and was proved right this past Tuesday.  White voters from rural districts around the country rallied in strong numbers to Trump’s promise to straighten up Washington.

Voters generally want a change of direction after one party has occupied the White House for two terms and this election proved to be no different. In the modern era of politics, only H.W. Bush was able to gain a 3rd Presidential term for the Republican party in 1988 after two terms of Ronald Reagan.  Countering the emotion and momentum of the Trump movement on the right were the voters on the left who passionately turned out for Bernie Sanders in the Democratic primaries.  Voters and superdelegates chose the establisment candidate, Hillary Clinton.  Some say that the process and the rules favored Clinton over Sanders.  His supporters are convinced that Sanders could have beat Trump.  Movement against movement.

In the past decade, voters have expressed a preference for rallying cries, for mantras of momentum like “Si se puede!” (Obama), “Build the wall!” (Trump) and “Medicare for all!” (Sanders).  Candidates must learn to condense their message into a short slogan that can be easily waved.  McCain, Romney and Clinton never found a verbal cadence that would act as a catalyst for voters to enthusiastically join the parade.  Sarah Palin, McCain’s Vice-Presidential candidate in 2008, understood the need for slogans.

 Note to future Presidential candidates who would like to actually win:  criticize the candidate, not that candidate’s supporters.  Hillary Clinton made the same mistake that Romney made in the 2012 election – disparaging their opponent’s voters.

Election night.  As a Trump victory became increasingly probable, global markets began to sell risk (stocks) and buy safety (bonds).  In the early morning hours after the polls closed, the networks called the state of Wisconsin for Donald Trump and put him over the threshold of 270 votes in the Electoral College.  Several  minutes later, about 2:45 AM on Nov. 9th, we learned that Hillary Clinton  had called Donald Trump to concede and wish him luck.  Dow Futures were down about 4% at that point.  Japan’s stock market was down 5.5%.  The yield on the 10 year Treasury note was down 7.22%, meaning that the price was up about 8% as investors in world markets were seeking the safety of U.S. debt.  Emerging markets fell in anticipation of protectionist trade policies under a Trump administration.

About 3 A.M.  President-elect Trump began to give a sedate and rational acceptance speech that began with a gracious nod to Hillary Clinton’s fight.  He spoke of unity, healing and more importantly, infrastructure spending and tax cuts.  With control of the Congress and Presidency in Republican hands, there was real hope that Washington could end the years of stalemate and finally implement fiscal policy to rescue a economy that had been kept afloat by an exhausted monetary policy for six years.

The overseas markets began to turn around.  By the time U.S. markets opened more than six hours later, stocks and Treasuries had reversed.  Stocks were now off less than 1/2% and Treasury prices were down severely.  TLT, a popular ETF for long term Treasuries, opened about 2% lower, a price swing of 10%.  EEM, a composite of Emerging Market stocks, opened up almost 3% down and lost ground during the trading session.  By week’s end the SP500 had risen 3.8% for the week, and EEM had fallen by that same percentage.

This week’s action in the bond market was a good example of the mechanics of bond pricing so let’s look at the price action and what it says about the future guesses of the direction and extent of interest rates.  First, bond prices move inversely to interest rates.   The extent that these prices move is measured by a bond’s duration.  Here is a link to the iShares page for the TLT ETF on long term Treasuries.  I have captured a section of the page with the duration highlighted.

If you have a bond fund, the mutual fund company will state the bond duration as well.  What does this tell you?  Leverage.  Duration tells you the approximate change in price for a 1% change in interest rates.  In this case, a 1% increase in interest rates will generate about a 17% decrease in price.  Because TLT is a composite of long term Treasuries, its price is more sensitive to changes in interest rates, or the consensus on interest rates six months to a year in the future.  The price of TLT fell 7.4% this week as traders repriced future interest rates.  With some grade school math, we can calculate what traders are guessing interest rates will be a half year to a year from now.

The Fed last raised rates at the end of 2015, putting them at approximately 1/4% – 1/2%.  In July, the price of this ETF was about $142.  It closed this week at $122, a decline of 14% from the summer high. Now we divide the 14% by the bond’s duration of 17.41% to get a ratio of .80.  This is the new guess of how much interest rates are likely to rise – approximately 3/4% – 1%.  By the fall of 2017, traders are betting that the benchmark Fed interest rate will be about 1.25% to 1.5%.

Let’s look at a more balanced composite bond ETF that financial advisors might recommend for casual investors.  Vanguard has a more conservative composite ETF whose ticker symbol is BND, with a duration of 5.8, about a third of the TLT ETF. (Spec Sheet here)  This week BND lost almost 2% and is down almost 4% from its summer high.  When we divide 4% by 5.8% (the duration in percentage terms) we get a guess of about a .7% raise in interest rates.  Because BND contains shorter term bonds, this guess is slightly below that of TLT.

Why are traders betting on more aggressive interest rate increases after Donald Trump was elected?  He has spoken about infrastructure spending and tax cuts, two fiscal stimulus programs that will likely spur inflation upward.  With a Republican party that has control of the Presidency and both houses of Congress, these measures are likely to be passed in some form.  Some sectors of the economy will likely benefit from more infrastructure spending so they rose this week.  Shares in technology giants like Apple and Google fell as traders switched money among sectors but are still up by healthy margins since February lows.

Let’s say that next March comes and the Trump White House and the House Budget Committee can not come to terms on either of these programs.  Investors would likely reprice interest rate expectations and lower them, causing the price of bond ETFs or mutual funds to rise.

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Miscellaneous Election Notes

I’ll share a distinction that NPR’s David Folkenflik made this week.  Those on the left took Donald Trump literally, but not seriously.  Those who voted for him took him seriously, but not literally.

During Thursday’s trading the Mexican peso fell to 15.83 per dollar, the lowest since 1993 when Mexico reset their currency. Why the big drop?  Trump has repeatedly said that he would cancel the NAFTA agreement that binds Mexico, Canada and the U.S.  The NAFTA agreeement requires only a 6 month notification before termination.  There is some disagreement whether the White House would need Congressional approval to cancel NAFTA which might delay the action.  Some in the Republican party like free trade agreements and are likely to put up a fight.  Some analysts think that the devaluation of the peso could lead to a recession in Mexico, which was already under economic pressure due to falling oil prices.

131 out of 231 million registered voters cast their vote in this election, slightly below the voter total in the 2008 election. (538)  Trump and Clinton each took 26% of registered voters.

The Trump White House can reverse Obama’s executive action on the Keystone pipeline and re-initiate construction.  It will likely amend or repeal tentative proposals to mitigate climate change.

Why did pre-election polls get it so wrong?  According to Pew Research, more than a third of households would respond to a survey a few decades ago.  Now it is only 9%.  Statisticians must tweak this rather small sample to make it more representative of the population as a whole.  A particular demographic constituent in the sample – say white working class men – might be underrepresented in the survey.  Survey methodology then gives the opinion of relatively few sample respondents more weight than it actually has in the general voter population.

Some statisticians recommend using economic and demographic algorithms to gauge future election results based on actual past voting records.

Of the 700 counties that voted for Obama in 2012, a third of those voted for Trump in 2016.  Polls indicated that Hillary Clinton would capture the majority of the white college-educated vote for the first time in decades but she failed to do so.  More white voters voted for Obama than Hillary.

A third of Democrats in the House come from just three states:  California, New York and Massachusetts.  This concentration may answer to the concerns of those states but indicates that the party has become out of touch with the voters in many states.

Each time a Democratic candidate is elected President, unfounded rumors circulate that the new President will take away people’s guns.  People rush out to buy guns.  Trump’s surprise win caused the stock of gun maker Smith and Wesson to decline 22% in a couple of days.

On the other hand, many women feared that Trump and a Republican Congress would restrict birth control and stocked up in the days after the election. Here is a map of abortion regulations in the states before the 1972 Supreme Court’s decision in Roe v. Wade.  Abortion was more permitted in the southern states than the northeast states.

Here‘s a state-by-state breakdown of the vote from NPR.

Which Way Sideways?

August 9, 2015

As we all sat around the Thanksgiving table last November, the SP500 was about the same level as it closed this week.  Investors have pulled off the road and are checking their maps to the future.  After forming a base of good growth in the past few months, July’s CWPI reading surged upwards.

Despite years of purchasing managers (PMI) surveys showing expanding economic activity, GDP growth remains lackluster.  Every summer, in response to more complete information or changes to statistical methodologies, the Bureau of Economic Analysis (BEA) revises GDP figures for the most recent years.  A week ago the BEA revised real annual GDP growth rates for the years 2011 – 2014 from 2.3% to 2.0%.  “From 2011 to 2014, real GDP increased at an average annual rate of 2.0 percent; in the  previously published estimates, real GDP had increased at an average annual rate of 2.3 percent.”

A composite of new orders and rising employment in the service sectors showed its strongest reading since the series began in 1997.  The ISM reading bested the strong survey sentiments of last summer. We can assume that the PMI survey is not capturing some of the weakness in the economy.

This level of robust growth should put upward pressure on prices but inflation is below the Federal Reserve’s benchmark of 2%.  Energy and food prices can be volatile so the Fed uses what is called the “core” rate to get a feel for the underlying inflationary pressures in the economy.

The stronger U.S. dollar helps keep inflation in check.  There is less demand from other countries for our goods and the goods that we import from other countries are less expensive to Americans. .  Because the U.S. imports so much more than it exports, the lower cost of imported goods dampens inflation.  In effect, we “export” our inflation to the rest of the world.

When the economy is really, really good or very, very bad we set certain thresholds and compare the current period to those benchmarks.  When the financial crisis exploded in late 2008, the world fled to the perceived safety of the dollar in the absence of a exchange commodity of value like gold.  Because oil is traded in U.S. dollars and the U.S. is a stable and productive economy and trading partner, the U.S. dollar has become the world’s reserve currency.  The conventional way of measuring the strength of a currency like the dollar has been to compile an index of exchange rates with the currencies of our major trading partners.  This index, known as a trade weighted index, does not show a historically strong U.S. dollar.  In fact, since 2005, the dollar has been extremely weak using this methodology and only recently has the dollar risen up from these particularly weak levels.

As I mentioned earlier, a strong dollar helps mitigate inflation pressures; i.e. they are negatively correlated. When the dollar moves up, inflation moves down.  To show the loose relationship between the dollar index and a common measure of inflation, the CPI, I have plotted the yearly percent change in the dollar (divided by 4) and the CPI, then reversed the value of the dollar index.  As we can see in the graph below, the strengthening dollar is countering inflation.

What does this mean for investors?  The relatively strong economy allows the Fed to abandon the zero interest rate policy (ZIRP) of the past seven years and move rates upward.  A zero interest rate takes away a powerful tool that the Fed can employ during economic weakness: to stimulate the economy by lowering interest rates.

The strong dollar, however, makes Fed policy makers cautious. Higher interest rates will make the dollar more appealing to foreign investors which will further strengthen the dollar and continue to put deflationary pressures on the economy.  The Fed is more likely to take a slow and measured approach.  Earlier this year, estimates of the Effective Federal Funds Rate at the end of 2015 were about 1%.  Now they are 1/2% – 3/4%.  In anticipation of higher interest rates, the price of long term Treasury bonds (TLT) had fallen about 12% in the spring.  They have regained about 7% since mid-July.

DBC is a large commodity ETF that tracks a variety of commodities but has about half of its holdings in petroleum products.  It has lost about 15% since May and 40% in a year.  It is currently trading way below its low price point during the financial crisis in early 2009.  A few commodity hedge funds have recently closed and given what money they have left back to investors.  Perhaps this is the final capitulation?  As I wrote last week, there is a change in the air.

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Labor Report

Strong job gains again this month but labor participation remains low.  A key indicator of the health of the work force are the job gains in the core work force, those aged 25 – 54.

While showing some decline, there are too many people who are working part time because they can’t find a full time job.  Six years after the official end of the recession in the summer of 2009, this segment of the work force is at about the same level.

In some parts of the country job gains in Construction have been strong.  Overall, not so much.  As a percent of the work force, construction jobs are relatively low.  In the chart below I have shown three distinct phases in this sector since the end of World War 2.  Extremes are most disruptive to an economy whether they be up or down.    Note the relatively narrow bands in the post war building boom and the two decades from 1975 through 1994.  Compare that to the wider “data box” of the past two decades.

For several months the headline job gains have averaged about 225,000 each month.  The employment component in the ISM Purchasing Managers’ Index (on which the CWPI above is based) is particularly robust.  New unemployment claims are low and the number of people confident enough to quit their jobs is healthy.  The Federal Reserve compiles an index of many factors that affect the labor market called the Labor Market Conditions Index (LMCI).  They have not updated the data for July yet but it is curiously low and gives more evidence that the Fed will be cautious in raising rates.

Procession, Not Recession

May 24, 2015

Existing home sales of just over 5 million (annualized) in April were a bit disappointing.   Since the recession, there have been only about six months that sales have been above a healthy benchmark of 5.2 million set in the late 1990s to early 2000s.

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Procession, not Recession Indicator

When reporting first quarter results, many of the big multi-national companies in the Dow Jones noted that sales had declined in Europe.  The broader stock market, the SP500, has not had a 5% decline for three years and is due for a correction.  Greece is likely to default on their Euro loans in June.  Combine all of these together and some pundits predict a 30 – 40% market correction this summer and/or a recession this year.  Corrections can be overdue for a long time.  Some treat the stock market as though its patterns were almost as predictable as a pregnancy.  Here’s an early 2014 warning that finds a chilling similarity between the bull market of today and, yes, the one before the 1929 crash.

Bull and bear markets tend to confound the best chart watchers.  The bear market of 2000 – 2003 was not like that of 2007 -2009.  Some argue that market valuations are like a rubber band.  The longer prices become stretched, the harder the snapback.  However, the data doesn’t show any consistent conclusion.

The 2003 – 2007 bull market ran for 4-1/2 years without a 5% correction.  That one didn’t end well, as we all know.   The mid-1990s had a three year stampede from the summer of 1994 to the summer of 1997 before falling more than 5%.  After a brief stumble, the market continued upwards for a few more years.  Turn the dial on the wayback machine to the early 1960s for the previous stampede, from the summer of 1962 to the spring of 1965.  That one ended much like the 1990s, dropping back before pushing higher for a few more years. These long runs occur infrequently so there is not much data to go on but the lack of data has never stopped human beings from predicting the end of the world.

April’s Leading Economic Indicator was up .7%, above expectations, but this increase was helped along by an upsurge in building permits.  This series has been unreliable in predicting recessions and its methodology has been revised a number of  times to better its accuracy.  Doug Short does a good job of tracking the history of this composite and here is his update of April’s reading.

A much more consistent indicator of coming recessions is the difference in the interest rates of two Treasury bonds.  The time to start thinking about recessions is when the 10 year interest rate minus the two year rate drops below zero.  The current reading simply doesn’t support concerns about recession in the mid-term.

The Federal Reserve has made it easy for us to track this flattening of the yield curve.  They even do the subtraction for us.  The series is called T10Y2Y, as in “Treasury 10 year 2 year.”

CPI and Wages

Dec. 24th, 2012

Merry Christmas, Everyone!

This is part two of a look at the CPI, comparing the price index to wage growth.  Part 1 is here

In the years 1947-1980, the average hourly earnings of production workers rose 6.08% annually while the CPI grew 4.03% (Source)  In effect, earnings rose 2% higher than prices.   Since 1980, earnings have risen 3.55% annually as the CPI rose 3.29%, giving workers a real growth rate of less that a 1/3rd of 1%.

The rise in worker productivity fueled gains in worker compensation until the past fifteen years.  Below is a chart of real, that is inflation-adjusted, compensation and productivity.

Increased Productivity means more profits.  For several decades in the post-WW2 economy, workers shared in those profits.  After the recession of 1982-1984, workers’ share of the increase in output slowly decreased.  As incomes barely kept up with inflation, workers tapped the equity in their houses.

Low interest rates, poor underwriting standards, lax regulations and a feeding frenzy by both home buyers and banks fueled a binge in home prices, followed by the hangover that started in 2007.  Only now is the housing market struggling up out of a torpor that has lasted for several years.

Before the housing bust, magical thinking led many to believe that the rise in home equity was a sure fire way to riches.  Over a century’s worth of data shows that housing prices tend to rise about the same as the CPI.  Housing prices have finally bottomed out at about the same level as the long term trend line of CPI growth.

The boom and bust upended the lives of a lot of people and the repercussions of that “hump” will continue as banks continue to foreclose on home owners whose incomes have flattened or declined. The recovery in the housing market will help some home owners but the real problem is unemployment, underemployment and the decreasing share of workers’ share of the profits from productivity gains.  Until the labor market heals, the housing market will not fully heal.

Those who do have savings have become cautious.  Since 2006, investors have taken $572 billion out of stocks and put $767 billion in bonds, a move to safety – or so many retail investors think.  For decades, home prices never fell – until they did.  For over thirty years, bond prices have been rising, giving many retail investors the feeling that bonds are safe – until they are not.

Companies have been selling record amounts of corporate bonds into this cheap – for companies – bond market.  As this three decade long upward trend in bond prices begins to turn, bond prices can fall sharply as investors turn from bonds to stocks and other investments.  We are approaching the lows of interest yields on corporate bonds not seen since WW2.  Investors are loaning companies money at record low rates and companies are sucking up all that they can while they can.  Sounds a lot like home buying in the middle of the last decade, doesn’t it?

Y’all be careful out there, ya hear?

Obligations and Entitlements

“Social Security and Medicare are the two largest federal programs, accounting for 36 percent of federal expenditures in fiscal year 2011.”  (Trustee’s annual report)

So how did we get here?

When Social Security was enacted in 1935, President Roosevelt promoted it as an insurance program for the old, widowed and orphaned. The language of the law called the employee portion of the tax an “income tax”, and the employer portion an “excise tax,” not an insurance program. Regardless of the language, Social Security has acted both as an annuity for retired workers and an insurance program for disabled workers and survivors of workers.

Several challenges to the law were brought before the Supreme Court, which issued several decisions in 1937 that confirmed that various components of the Social Security tax were valid. By law, the Social Security reserve fund could invest only in the debt of the U.S., either through marketable Treasury bonds or through special bonds which could not be sold. (A history of the financing of Social Security)  Since 1960, the Social Security funds are “invested” in these special bonds, which are little more than promises that the federal government will pay Social Security benefits. 1960 is also the last year that the federal government ran a budget surplus except for the years 1999 and 2000; in two years out of 52, the federal government has been able to balance its books. In overwhelming numbers, voters send lawyers to Washington; most of them have little if any business experience or education.  We reap what we sow.

The Bureau of Labor Statistics (BLS) estimates the total number of workers at 135 million.  More than 55 million people are currently receiving some form of benefit under the Social Security program, a ratio of about 2.5 workers per beneficiary.  In 2011, 2.6 million applied for retirement benefits while one million applied for disability benefits.  In the past 40 years, the number of retirees receiving benefits has doubled, the number of disabled has more than doubled.  Both disabled and retiree claims have declined since 2010.  (Fast Facts

There is a demonstrated increase in disability applications when the unemployment rate rises.  As one guy with a bad back explained to me, “I’d rather be working scheduling service calls.  I worked in the heating and cooling business for almost 30 years.  After looking for a year, I gave up.  Who’s gonna hire a 60 year old guy with a bad back in this economy?”

(SSA Source)

The number of retirees has doubled but the population has grown only 50%.  The growth of women in the workforce has contributed to the growth in retirees and in disability claims.

Most people receiving Social Security benefits of one type or another feel as though they entered a contract with the federal government.  In return for their Social Security taxes, retirees and the disabled are owed promised benefits from the federal government, just as one would expect from an insurance company. Likewise, veterans also feel that they entered a contract with the federal government when they risked their lives in defense of the country. In exchange for their service, the federal government made promises of benefits to veterans.  Too many Republican politicians are fond of lumping Social Security beneficiaries and veterans under the umbrella term of “entitlement” programs when the more proper term is one of obligation.  When someone buys a Treasury bond, they expect to be paid the value of the bond when it matures.  Is that person part of an “entitlement” program?  No.  The bond is a contractual obligation between the bondholder and the federal government.  Why should a bondholder be treated with any more or less respect than a person who has “lent” the government money throughout their working years through their Social Security taxes?  Neither Paul Ryan or Mitt Romney understand that, to many of us, an obligation is an obligation.  Period.

So I want to distinguish between obligation programs like Social Security, and entitlement programs.

What are more properly called entitlement programs are those programs for the unfortunate and the vulnerable, whose financial circumstances qualify them for some kind of income assistance program.  Many have paid little in income taxes over the years for any number of reasons.  Some are children, some don’t or can’t work, some work but make so little that they owe no taxes.  Some may have paid a good share of income taxes in the past but found themselves in a bad way in recent times.  There are a lot of programs: SNAP(food stamps), SSI (Supplementary Security Income), and TANF (traditionally called welfare), to name but a few.

Let’s look at one program: SSI, an income assistance program for the blind, disabled and aged, whose beneficiaries comprise a mere 2.5% of the population.  The SSI program is paid out of general revenues, not Social Security taxes. In 2011, blind and disabled recipients made up 86% of the total of about 8 million. (Source)  The average monthly benefit is about $500. The cost of the program is about $50 billion, or 1.4% of total Federal expenditures. 2% of the cost of the SSI program includes vocational training and other back to work programs. When some politicians talk about reforms to “entitlement” programs, they know that some of these programs are small but they cite examples of abuse, of someone gaming the system, because they hope that you don’t know that the programs are small.  Vote them into office and what they really want to chop are the big obligation programs, Social Security and Medicare.

However, there are some legitimate concerns in these small programs; the number of SSI recipients has grown 33% in the past 17 years.

The number of disabled, aged 18 – 64, receiving income assistance under the SSI program has tripled in the past forty years, a growth rate six times that of the overall population. 

The SSI program also helps low income retirees, who have declined in real numbers by 15% in the past 16 years.

The percentage decline is explained partially by the explosive growth of the disabled who are younger than 65.  The number of women receiving SSI payments has also increased dramatically. 

Let’s look at another entitlement program that Mitt Romney and Paul Ryan have targeted in their stump speeches: SNAP or Food Stamps.  “45 million people on food stamps!” is the cry of either of these candidates to illustrate the runaway spending in entitlements and the poor economy.  What neither will tell you is that the program cost $78 billion in 2011 (CBO source).  That is 2.2% of Federal spending.  Whatever reforms these guys propose to this program will save a very small percentage of the budget.  In that same report, the CBO summarized the characteristics of those on the program: “three out of four SNAP households included a child, a person age 60 or older, or a disabled person. Most people who received SNAP benefits lived in households with very low income, about $8,800 per year on average in [2010].”  I can excuse Mitt Romney because he may not be aware of the numbers.  There is no excuse for Paul Ryan, who is the “budget-meister” and certainly knows that any savings to a program this small is chump change in a budget of $3600 billion. 

What both of them are counting on it that you don’t know that.  Their ultimate goal is to reform the big guy, Social Security, so that they can short change one type of federal obligation, Social Security recipients, to pay another obligation, the buyers of Treasury bonds.  Many of the large institutions that buy Treasury bonds are not suckers so Mr. Romney and Mr. Ryan turn to those with the least information – suckers who will vote for them.