Building A Peak

June 3, 2018

by Steve Stofka

First I will look at May’s employment report before expanding the scope to include some decades long trends that are great and potentially destructive at the same time. In the plains states of Texas, Oklahoma, Kansas, and Nebraska, summer rain clouds are a welcome sign of needed moisture for crops. That’s the good. As those clouds get heavy and dark and temperatures peak, that’s bad. Destruction is near.

May’s employment survey was better than expected. The average of the BLS and ADP employment surveys was 203K job gains. The headline unemployment rate fell to an 18 year low. African-American unemployment is the lowest recorded since the BLS started including that metric in their surveys more than thirty years ago. As a percent of employment, new unemployment claims were near a 50-year low when Obama left office and are now setting records each month.

During Obama’s tenure, Mr. Trump routinely called the headline unemployment rate “fake.” It’s one of many rates, each with its own methodology. Now that Mr. Trump is President, he takes credit for the very statistic that he formerly called fake. The contradiction, so typical of a veteran politician, shows that Mr. Trump has innate political instincts. A President has little influence on the economy but the public likes to keep things simple, and pins the praise or blame on the President’s head.

The wider U-6 unemployment rate includes discouraged and other marginally attached workers who are not included in the headline unemployment rate. Included also are involuntary part-time workers who would like a full-time job but can’t find one. Mr. Trump can be proud that this rate is now better than at the height of the housing boom. Only the 2000 peak of the dot com boom had a better rate.

Let’s look at a key ratio whose current value is both terrific and portentous, like a summer’s rain clouds. First, some terms. The Civilian Labor Force includes those who are working and those who are actively seeking work. The adult Civilian Population are those that can legally work. This would include an 89-year old retiree and a 17-year old high school student. Both could work if they wanted and could find a job, so they are part of the Civilian Population, but are not counted in the Labor Force because they are not actively seeking a job. The Civilian Labor Force Participation Rate is the ratio of the Civilian Labor Force to the Civilian Population. Out of every 100 people in this country, almost 63 are in the Labor Force.

While that is often regarded as a key ratio, I’m looking at a ratio of two rates mentioned above: the Labor Force Participation Rate divided by the U-3, or headline, Unemployment Rate. That ratio is the 3rd highest since the Korean War more, ranking with the peak years of 1969 and 2000. That is terrific. Let’s look at the chart of this ratio to understand the portentous part.

CLFUIRatio
Whenever this ratio gets this high, the labor economy is very imbalanced. Let’s look at some previous peaks. After the 1969 peak, the stock market endured what is called a secular bear market for 13 years. The price finally crossed above its 1969 beginning peak in 1982. In inflation-adjusted prices, the bear market lasted till 1992 (SP500 prices). Imagine retiring at 65 in 1969 and the purchasing power of your stock funds never recovers for the rest of your life. Let’s think more pleasant thoughts!

For those in the accumulation phase of their lives, who are saving for retirement, a secular bear market of steadily lower  asset prices is a boon. Unfortunately, bear markets are accompanied by higher unemployment rates. The loss of a job may force some savers to cash in part of their retirement funds to support themselves and their families. Boy, I’m just full of cheery thoughts this week!

After the 2000 peak, stock market prices recovered in 2007, thanks to low interest rates, mortgage and securities fraud. Just as soon as the price rose to the 2000 peak, it fell precipitously during the 2008 Financial Crisis. Finally, in the first months of 2013, stock market prices broke out of the 13-year bear market.

We have seen two peaks, followed by two secular bear markets that lasted thirteen years. The economy is still in the process of building a third peak. Will history repeat itself? Let’s hope not.

May’s annual growth of wages was 2.7%, strengthening but still below the desirable rate of 3%. The work force, and the economy, is only as strong as the core work force aged 25-54. This age group raises families, starts companies, and buys homes. For most of 2017, annual employment growth of the core fell below 1%. It crossed above that level in November 2017 and continues to stay above that benchmark.

Overall, this was a strong report with job gains spread broadly across most sectors of the economy. Mr. Trump, go ahead and take your bow, but put your MAGA hat on first so you don’t mess up your hair.

///////////////////////////////

Executive Clemency

This week President Trump pardoned the filmmaker Dinesh D’Souza, serving a five-year probation after a 2014 conviction for breaking election finance laws. He helped fund a friend’s 2012 Senate campaign by using “straw” contributions. D’Souza complains that he was targeted by then President Obama and General Attorney Holder for being critical of the administration. A judge found no evidence for the claim but if he didn’t see the conspiracy against D’Souza, then he was part of the conspiracy, no doubt. I reviewed the 2016 movie in which D’Souza unveiled the perfidious history of the Democratic Party and its high priestess, Hillary Clinton.

Could Trump Be Right On Trade?

May 6, 2018

by Steve Stofka

On Tuesday morning I had an epiphany. Some background first. I disagree with Donald Trump about many things. One of them is his fundamental tenet of international trade: it creates winners and losers. This violates an established principle of economics: comparative advantage. Trade between countries benefits the people of both countries, or a win-win. That is Principle #5 in Greg Mankiw’s Principles of Economics taught in many colleges and universities. From the textbook (6th Ed): “Trade allows countries to specialize in what they do best and to enjoy a greater variety of goods and services.”

Here’s Professor Trump on trade with the Japanese during their boom years in the late 1980s: “First [the Japanese] take all our money with their consumer goods, then they put it back in buying all of Manhattan. So either way, we lose.” (1990 Playboy interview quoted in National Review).

As I put my dishes in the dishwasher, a memory from a 1989 Christmas party in Los Angeles flashed through my mind. I was visiting from Colorado, doing more listening than talking. At the party were several people in real estate, construction and software development.

One guy complained that the Japanese were buying up chunks of California and there should be a law limiting their ownership. The comment began a spirited discussion and I sensed the resentment in the group. I asked if the Japanese owned that much California real estate. They were able to name landmark office buildings and vineyards.

As was my habit, I made a note to find out how much California real estate the Japanese did own. The Japanese had bought a few headline grabbing commercial properties, but they owned less than 1/10th of 1% of California real estate. The number of Japanese investors who bought homes did affect ordinary Californians, however. The percentage of homes bought was small but helped drive up prices, and fueled resentment of the Japanese.

The principle of comparative advantage is modeled on trade in goods. Real estate is different. That’s the point that I missed at the Christmas Party almost thirty years ago. Real estate is an investment whose present value is based on an estimate of future cash flows. A common refrain is “location, location, location.” Unlike an investment in a plant or machinery, real estate often consists of two types of asset: 1) a building, which has a limited, depreciable life; and 2) la location that has an unlimited, and appreciable, life. The first part is like a bond. The second part is like a stock. Real estate is a hybrid product of both asset types.

Let’s go to the first part of Trump’s statement: “First [the Japanese] take all our money with their consumer goods.” Let’s follow the money with an example. A company called Taro has a factory in Japan (not financed with U.S. dollars) that makes computers which it sells to U.S. consumers. Because Taro is making so many of these computers, people and peripheral businesses move near the factory.  This drives up the value of the factory’s real estate in Japan.

Taro’s capital is better deployed at making computers, so it sells the factory and land to a private equity firm, from which it leases back the factory. Taro then invests the U.S. dollars it has accumulated from computer sales, plus part of the proceeds from the sale of its real estate in Japan, to buy an office building on 5th Ave in Manhattan, that I’ll call Fifth.

To buy Fifth, Taro must outbid another buyer for the property, a U.S. investor I’ll call Bulldog. The higher price that Taro pays implies that the future cash flows from Fifth will be more than Bulldog’s estimate. If those future cash flows are mis-estimated by Taro, then Taro has introduced a form of bad money into the economic system of New York real estate. Gresham’s law states that bad money tends to drive good money out of circulation. We’ll see that the principle applies here.

There are two parts to Taro’s equity in Fifth. The first is the profits in U.S. dollars from selling computers to U.S. customers, a re-bundling of U.S. dollars. The second part is the profits from the real estate frenzy in Japan. What fueled the lofty sales price in Japan? Rosy estimates of future economic activity, robust cash flows, and a limited supply of property in desirable areas of Japan. Taro has transferred that frenzy, and risk, from a property in Japan to a property in the U.S.

Banks and other credit institutions, both U.S. and foreign, fund the rest of the sale. Because Taro has more equity to put into the property than Bulldog, the ratio of financed principle to Taro’s equity may be nearly the same as Bulldog’s proposal (the numbers are at the end below).  The rosy estimates that drove the Japanese valuation now influence, or infect, the wider international finance community as well.

Because the U.S. is not in a boom, Bulldog may not have access to the same funds and credit that Taro does.  This puts Bulldog at a disadvantage. Bulldog does not buy the building. No big deal, right? He’ll just buy another property with a more reasonable evaluation. But, wait. At any one time, only a fixed amount of credit money is available at a particular interest rate. The money that a bank lent to Taro for its acquisition is no longer available to Bulldog at the same interest rate for his buy of another property. Taro’s purchase, fueled by speculation in Japan and agressive estimates of cash flow in New York, will cost Bulldog money.

Economic models of comparative advantage tend to ignore the financing aspect for two reasons. Money is regarded as neutral in economic models, and the machinations of international finance are difficult to model.  The competition for credit is global and fierce, fought by vast private and public pools of capital and policy.  Those who buy and sell premium real estate in markets like New York City are regularly reminded of the fact.  They put their textbooks down and come out fighting.

//////////////////////

The numbers:  For every $100 in price that Bulldog offers, Taro offers $110. To finance Bulldog’s offer, he can put up $20 for every $100, or 20%. Taro can put in $27.50 for every $110 of its offer. In Bulldog’s case, $80 is financed. In Taro’s offer, $82.50 is financed. Taro has a leverage of 4-1 ($110 / $27.50), compared to Bulldog’s leverage of 5–1 ($100 / $20). Taro’s leverage looks safer. Its future cash flow estimates are 10% higher, but the finance ratio on the deal is only 3.1% higher ($82.50 / $80). If Taro’s cash flow projections are 5% too high, a lender calculates that Taro can still make payments.