The Gravy Train

October 1, 2017

In the newly published “The High Cost of Good Intentions” author John Cogan relates a 230-year history of Federal entitlements, beginning with veterans’ pensions after the Revolutionary War. For 150 years the expansion of veterans’ benefits was prompted by budget surpluses brought on by high import tariffs. Each was targeted to a small number of soldiers who had died or become wounded during a war. Each program expanded into giant giveaways to any soldier or state militiaman and their wives.

Republicans expanded Civil War pensions to secure control of federal and state legislatures at the turn of the 20th century. Twenty years later, FDR and the Democratic Party used the same strategy of benefits to wrest control from Republicans.  First, the old system of service for benefits had to be curtailed. Like previous pension programs, benefits for WW1 veterans had been extended to those with non-service disabilities. Immediately after assuming office in 1933, FDR persuaded Congress to give him emergency authorization to alleviate the financial crisis. FDR eliminated almost a half-million veterans with non-service disabilities from the pension rolls and reduced pensions across the board. For the rest of the decade Congress tried to reinstate veteran’s benefits over the Presidential veto.

In 1934, the administration launched the New Deal, a series of programs to alleviate Depression-era hunger and unemployment. For 150 years, military service had been the prerequisite for federal benefits. Under FDR need, not service, became the primary requirement. An act of compassion quickly became a political tool that secured Democratic control at both the federal and state levels. Under the newly introduced Social Security program, a small amount of tax paid during the working years now entitled an older voter to federal pension benefits. No military service required.

For eighty years, benefit programs have become a political football. Two-thirds of the ten legislative increases to the Social Security program have occurred in election years. Today the total cost of entitlements is 60% of the $4.2 trillion in Federal spending.

If asked to list the federal entitlement programs, how many could we name? In addition to veteran’s benefits for service to the country, there are:
Income replacement programs like Social Security retirement and disability;
Income supplemental programs for poor families, such as the earned income tax credit (EITC), unemployment insurance, SSI and TANF;
Health insurance programs like Medicare and Medicaid, and the ACA’s health insurance subsidies;
Food assistance and price support programs like food stamps (SNAP) and child nutrition (WIC);
Business and individual loan guarantees and subsidized insurance programs including Sallie Mae education loans, FHA mortgage programs, and flood insurance subsidies.
This list does not include the many tax subsidies handed out by Congress.

I found that I could open this book at random and be both informed and entertained. Mr. Cogan combines an engaging narrative style and extensive research to construct an epic story of human need and greed, and the politics of pork.

I’ll turn to another book, “The Framer’s Coup” by Michael J. Klarman for some related backstory. At the Constitutional Convention in 1787, anti-Federalists objected to the “general welfare” clause of the proposed Constitution. What was to stop the Federal government from becoming a charity funded by taxes, they asked?

Nonsense, Constitutional delegates James Madison and Edmund Randolph countered, pointing to the enumerated powers in the Constitution as a restraint on the Federal government. Just as the anti-Federalists feared, the Court has long adopted a liberal interpretation of the Federal government’s enumerated powers. In the 1819 case of McCullough v. Maryland, Chief Justice Marshall set a precedent that the Congress could enact legislation that was “convenient or useful” to the exercise of its enumerated powers.  After that decision, then ex-President Madison admitted that if the Constitution had clearly stated the signers’ intention to firmly restrict the power of the Federal government, the Constitution would not have been ratified.

Turn the dial forward to the present. In the expansion of the welfare state during the 20th and 21st centuries, the Supreme Court has never found that the Federal government has exceeded its enumerated Constitutional powers. The most recent example was the Court’s finding that, under the enumerated power of taxation, the federal government could force people to buy health insurance under the ACA program.

The liberal interpretation of those two clauses – “convenient or useful” and “general welfare” – has unleashed the Federal government, whose agencies have become an omnipresent force in every American’s life. Each month, politicians in Washington take tax money from one set of voters and give benefits to another cohort of voters. Everyone  who receives benefits convinces themselves that they have paid into the system in some way. When it comes to tax money, it has always been better to receive than to give.

As the benefits to the receivers slowly exceed the taxes from the givers, there will be a crisis, and then some urgent half-baked legislative fix will be passed. I wish there was a better way.  Oh wait, I forgot.  There is a better way.  Paul Ryan, Speaker of the House, introduced the plan last year. Now that Republicans control the Presidency, Senate and House, they will fix the problem and avert a looming crisis of entitlements.  Silly me.  I can focus on the baseball finals now and stop worrying.

It’s Only Money

September 24, 2017

Republicans in Congress hope that they can enact comprehensive tax reform that will lower taxes for individuals and corporations. The Congressional Budget Office estimates  that, under current law and before any tax reform, the current $20 trillion deficit will grow to $30 trillion by 2026. They recommend a combination of decreased spending and increased revenue that would amount to $620 billion (in current dollars) annually, about 15% of current Federal spending of $4.2 trillion. CBO’s goal is to achieve a level of public debt to GDP that is about 40%, the 50-year average.

Lawmakers struggle to cut even 5% of spending but let’s assume that they could accomplish that and reduce spending by $210 billion. That might be the easier task. The Federal government is currently collecting 18.5% of GDP in taxes, a few tenths more than the 18.2% collected during the Reagan years. The CBO says that the dollars collected is not adequate to meet the Federal government’s current level of spending and obligations and they project that annual deficits will increase over the next decade. The 70-year average of federal revenues is 17.5% of GDP.

FedRevPctGDP

Raising an additional $410 billion, or 10% extra in revenue, will require raising taxes or increasing GDP. Republican lawmakers and some economists hold fast to a theory that reducing tax rates will increase economic growth. To raise an additional $410 billion for a total of $4 trillion dollars, and collect the 50-year average of 17.9% of GDP in tax revenue, GDP next year would need to be almost $23 trillion, a whopping 20% increase from the 2016 level of $19 trillion. No amount of tax decrease will spur that much growth. A Republican Congress will not pass a tax increase.

In a recent Senate budget committee hearing, I was surprised to learn that half of the cost of corporate taxes is borne by the workers, as estimated by the Tax Foundation. The OECD finds that corporate income taxes are most injurious to people’s incomes and is why most developed countries have lower corporate tax rates than the U.S. These countries augment their revenues with a consumption tax, most often a VAT, or value added tax. Another surprise: consumption taxes are less of a burden to a worker than higher corporate taxes.

The founding of this country was instigated by a protest over a tea tax. In the Framer’s Coup, Michael Klarman relates the bitter debates over slavery and taxes at the 1787 Constitutional Convention. 230 years later, the debate over slavery may have ended but the debates over taxes are just as ferocious.

Since last November, the stock market has priced in the probable passage of tax reform by the end of this year or early next year. Republican lawmakers have been unable to repeal Obamacare and I think they will have an equal amount of difficulty passing tax reform.

CBO budget projections restrain the freedom of lawmakers to enact their favorite theories. Lawmakers are highly motivated to answer the whoops and hollers of their voters, many of whom may not be interested in the achingly dull but necessary procedures of budget craft. The parliaments of European governments can enact sweeping legislative changes that are difficult under our federalist system. The U.S. chose a different path of checks and balances embedded in a Constitution hammered out by compromise and a suspicion of human beings given legislative power. Time and time again we are reminded that those suspicions were well founded. Voters and lawmakers may become frustrated with the procedural obstacles of crafting legislation but the U.S. Constitution is the longest living Constitution because of those obstacles.

History lesson done. Stock investing lesson: don’t count your tax reform before it hatches.

Bull Runs

September 17, 2017

Lloyd Blankfein, the CEO of Goldman Sachs, commented recently (CNBC) that the length of this bull market has worried the traders at Goldman. Being a curious sort, I wondered how this bull market compared to previous ones. Wanting a big picture, I looked at the quarterly data for the SP500 index for the past sixty years. A lengthening sequence of quarterly closes above the three-year average is a reliable indicator of a bull market.

In the 1980s, the SP500 had a run of 19 consecutive quarters above its three-year average. That streak ended in the 3rd quarter of 1990, at the start of a mild recession that lasted until March 1991. The animal spirits of the stock market could not be contained for that long. After one quarter down, the market began another streak in the 4th quarter of 1990, a monster bull run of 40 consecutive quarters above the average until the first quarter of 2001.

BullRun1990s

The end of the dot-com boom, the start of a mild recession, then 9-11, the Enron and accounting scandals – all of it led to a 50% drop in the index. Almost three years later, the market finally closed above its three-year average. That began a 17-quarter bull run that ended March 2008.

BullRun2000s

People were getting woke to the reality that housing prices can go down. The neighbor living in the house behind my folks in NYC said to me, “I don’t know what’s going on. Housing prices are not supposed to go down.” As though housing prices obeyed a fundamental physical law like gravity. The bailout of Bear Stearns that first quarter of 2008 was just the beginning of a developing financial crisis that would cripple the global economy. In 2010 and 2011, market prices clawed their way above the 3-year average only to fall back.

Finally, in the last quarter of 2011, after the fitful resolution of the budget crisis, the SP500 broke again above its 3-year average. Since then the market has notched 24 consecutive quarters above that average. This latest bull run has beat every previous SP500 streak except for the 1990s run up.

Bullrun2010s

This is what is worrying Blankfein and the traders at Goldman. Long bull runs in the past have ended horribly.  Like the bull run in the 1990s, there have been few negative, or corrective, quarters during this run.  Those are the quarters in red in the chart above. Some negative sentiment acts as a constraint on ever climbing asset prices.  For now, investors are convinced that inflation and interest rates will remain low, a prime environment for stocks.

Employment Trends

September 10, 2017

I’ll review a few notes from last week’s employment report and highlight some long-term trends. There’s good news and bad news.  Figuring out the future is tough because it hasn’t happened yet.  Heck, scholars still haven’t figured out what went on in the past.

The unemployment rates are computed from a Household Survey and is a self-reporting statistic. The answers of survey respondents are not verified. The monthly job gains come from a separate survey of businesses and the data is more reliable. One of the recession indicators I use is the change in employment from the business survey. I regard a 1% year-over-year gain as a minimum threshold for a stable or growing economy. 1% is about the rate of population growth. If our economy cannot keep up with population growth, that is a pretty sure indicator of a coming recession. Here is a chart of the past five years. Growth is still above 1% but there is a definite downward trend.

Employ201608

Here’s a graph of the past two recessions showing that crucial decline below the 1% threshold.

Employ99-09

Due to higher manufacturing employment and higher population growth during the 1960s – 1980s, the recession threshold was closer to 2%. Here’s a graph of the 1970s to 1990s. The exception that broke the rule was the economic shock of the 1973 Arab-Israeli war. The oil embargo that followed straightjacketed the U.S. economy.

Employ1973-1993

The NAFTA agreement signed in the early 1990s began an erosion of the manufacturing base and employment in this country. Still, the decline was rather mild until China was admitted into the WTO in 2001. The streamlining of ocean shipping and land transport of goods by cargo container reduced costs and catalyzed a mass migration of manufacturers and supply chains to China and southeast Asia.

Gains in construction employment are waning. A sustained plateau followed by a decline precedes every recession.  Notice that the growth is not in the actual number of construction employees but in the percentage of construction employment to total employment.

ConstructEmploy

A plateau in construction employment began in April 2000 and persisted through one recession till the spring of 2003. In late 2002, there was talk of another recession. Fed chair Alan Greenspan continued to push rates down to 1% to ward off the boogie man of recession.

ConstructEmploy1998-2005

With unemployment as low as it is, wage growth should be stronger.  In the latter part of 2016 and earlier this year the hourly earnings of private employees sometimes pushed toward 3% annual growth. Since April, growth has stayed rock steady at a mild 2.5%.  It’s like some joker is laughing at the dominant economic models.

Speaking of predictive models, the Fed has discontinued the Labor Market Conditions Index (LMCI), a broad composite of 19 employment indicators. As a general picture of the employment market, it was satisfactory. As a predictive tool of developing trends, the Fed thought it was too sensitive. For those readers who would like a deeper dive, Doug Short of Advisor Perspectives examines the Feds remarks on this index.

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Lloyd Blankfein, the CEO of Goldman Sachs, commented recently (CNBC) that the length of this bull market has worried the traders at Goldman.   Next week, I’ll compare this bull run with those of the past.

Vulnerable

September 3, 2017

Hurricane Harvey invaded the lives, homes and businesses of so many people in Houston and the surrounding area of southeast Texas. People around the world watched the plight of so many who were caught in the rising waters. I was cheered by the dedication of first responders, by those who came from near and far to help with their boats, with food and clothing. I have never been in a flood. Some of those interviewed had been in several. Why do they stay there, I wondered? The answer is some or all of these: their family, their church, their job, their school, their culture.

Watching so many vulnerable people reminded me of my own. If given a few minutes to leave my house, what would I put in a garbage bag? In the urgency and stress of the moment so many people in Houston forgot their medications.  My list: Pets, papers, clothes, medications. Food? Will the shelter have food? Pet food, as well? Where are we going? Oops, what about a phone charger? And the laptop. What about the list with all the passwords? That too. What about the photos in the closet? I was going to get those scanned in and uploaded. No time now. Take a few of the smaller framed photos on the shelf in the living room. Out of time. Gotta go. All the questions that must have been bouncing around inside the heads of those forced to evacuate as the brown water took possession of their house.

If I don’t call it Climate Change, I could call it Flood Frequency, or Flood Freak for short. Here is a chart showing the increased frequency of flooding during the past century. This was from an article in the WSJ (paywall).

FloodFrequency
This week’s theme – vulnerability. The signs of it and what we can do to lessen it. Debt is a vulnerability. For the past three years, households have been increasing their debt load in mortgages, auto and student loans. Here’s a breakdown of household debt from the NY Fed. (As a side note, this report gives a breakdown of the different types of debt by credit score. For example, the median credit score for an auto loan is about 700).

DebtBalance2016.png
Mortgage debt is more than 2/3rds of total debt. Despite the rise in home prices, more than 5 million homes, or 7%, are still badly “under water.” (Consumer Affairs)

Credit card debt has stayed stable for the past thirteen years. Households are only using 10% of their after-tax income to service their debt.

DebtService2016

Despite low interest rates, households are continuing to deleverage, to decrease their vulnerability. The ratio of household debt – the total of that debt, not the payments – to income climbed above 2.5 in late 2007. It has fallen below 2.2 but is still high. We are still up to our eyeballs in debt.

HouseholdDebtIncomeRatio

Debt reduction will curb economic growth for the near future. According to several cabinet members, Trump is focused on GDP growth in discussions about trade policy, defense policy, infrastructure spending, and the regulatory environment. How does this or that policy get us to 3% growth? he asks.

2/3rds of the nation’s economy is based on the public willingness to spend money. Jobs helps. Higher wage growth helps. Low interest rates help. But without the willingness to take on more debt relative to income, policymakers may feel like they are trying to goad a stubborn mule to go faster. Tough to do.

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Unemployment

Continuing the theme of vulnerability.  As a percentage of the unemployed, the number of long-term unemployed remains stubbornly high at close to 25%.  I call them the 27ers because 27 weeks of unemployment is the cutoff that the BLS uses to determine whether someone is categorized as long term unemployed. 27 weeks or six months is a long time to be actively looking for work and not finding a job.  Eight years after the end of the recession, today’s percentage of 27ers is at the same level as the worst of most past recessions.

LTUnemploy

During any recession the number of long term unemployed climbs higher. When these past few recessions have ended, the number of 27ers doesn’t start to decline.  Instead, they continue to increase and reach a peak several months after the recession is officially over. In the last three recessions, the peaks came later than previous recessions.

UnemployLTPctCLF
This more vulnerable cohort in the labor force struggles to recover after a recession.  Manufacturing is the more volatile element in the business cycle.  As manufacturing has declined, recessions are less frequent. However, manufacturing used to put a lot of people back to work at the end of recessions.  In a recovery, the service sectors are not as quick to add jobs.

The structural shift in the labor force will continue to leave more workers and families vulnerable and needing help just as many older workers are claiming retirement benefits. More than half of voters, both Republican and Democrat, have received benefits from at least one of the six entitlement programs (Pew Research). Elected officials offer promises of future benefits in exchange for taxes, and votes, today. When circumstances force a clash of priorities and promises, Congress seems incapable of resolving the conflict. President Trump’s approval ratings are in the low thirties, but his popularity far exceeds the public’s dismal ratings of Congress.

In a crisis, Americans come together to help each other but why do we wait till there is a crisis? Have we always been a nation of drama queens?  Maybe that’s the American charm.

Intervention

August 27, 2017

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

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

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

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

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

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

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

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

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

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

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

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

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

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

EffFundsRate-Infation

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

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

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

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

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Debt

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

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

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

The Eclipse of Optimism

August 20, 2017

We are coming up on an anniversary of sorts. Two years ago, the stock market had a series of sell offs in the last week of August. China devalued the yuan, commodity prices around the world swooned, and Greece was in imminent default on its loans. Pictures of empty cities in China prompted speculation that the building boom in China was coming to an end and would bring down the global economy. Over the course of 6 days, the SP500 shed 11%.

By year’s end the SP500 was still slightly below its level at the end of August and did not rise above its mid-2015 price till the summer of 2016. Long term assets at the end of 2015 declined slightly for the first time since the financial crisis (ICI 316 page pdf). There wasn’t a rush for the exits but clearly some investors were spooked. Should I get spooked when the next 10% drop comes?

In the past five years there were 73 daily declines of more than 2% in the SP500 index.  That’s more than one in twenty trading days or about one per month.  2% is more than 400 points on the Dow at current levels.  One bad day per month was relatively mild compared to the previous five-year period from August 2007 to August 2012. Bad days with greater than 2% declines occurred more than once a week!

I wondered if a bad week telegraphed a long term severe decline in stock market prices. Let’s say that within five trading days, the stock market fell 10%, averaging more than a 2% decline on each of those five days. I started my search twenty years ago and each bad week had its own story.

The list:
the LTCM financial crisis of October 1998,
the end of the dot com boom in April 2000,
the week following the attack on 9-11,
the bankruptcy of giant WorldCom and other accounting scandals in July 2002,
the winter months of 2008-2009 during the financial crisis,
the budget battle and fears of the U.S. government defaulting on its debt in August 2011, and the devaluation of the Chinese yuan in August 2015.

In each case investors were jolted by a surprise or some ongoing concern deepened into despair and a rush for safety. In some cases, the crisis ended or a solution was found and the dip was a good buying opportunity. In other cases, the fears signaled a severe and sustained repricing as in 2000–2003 and in 2008-2009.

Let’s say I interpreted a 10% dip as a good time to increase my equities. Imagine the sinking in my belly when stocks continued falling another 20, 30, or 40% as in the two repricing periods above. How could I have been so stupid?

Just as losses of 10% in a week are not reliable predictors of doom, gains of 10% in a week are inconsistent predictors of a market recovery. When bad weeks happen, financial pundits seem so sure that a 50% drop in the market is imminent. The data shows that this is not the case.

Now I’ll turn up the dial and see if I can find any consistency. A drop of 15% in a week is rare. In sixty years, the only instances of this are in October 1987, and October and November of 2008. In each case, there was more pain to come after that initial fall. So, if I happen to be alive when the next 15% weekly drop comes, the market has probably not finished correcting. The only 15% gain in a week was in November 2008, following an almost 20% fall the previous week. Boy, those were the good old days – not.

Since historical data does not give a clear guide for short to mid-term outcomes, my best strategy in reaction to a bout of market darkness may be – gulp! – do nothing. That can be so difficult when I am bombarded with forecasts of catastrophe at those times.  The sun will shine again.  It’s only an eclipse.

Wage Growth – Not

August 12, 2017

Ratios are important in baseball, finance and cooking, in economics, chemistry and physics, and yes, even love. If I love her a lot and she kinda likes me a little, that’s not a good ratio. I learned that in fourth grade.

Each week I usually turn to one or more ratios to help me understand some behavior. This week I’ll look at a ratio to help explain a trend that is puzzling economists. The unemployment rate is low. The law of supply and demand states that when there is more demand than a supply for something, the price of that something will increase. Clearly there is more demand for labor than the supply. I would expect to see that wage growth, the price of labor, would be strong. It’s not. Why not?

I’ll take a look at an unemployment ratio. There are several rates of unemployment and there is no “real” rate of unemployment, as some non-economists might argue at the Thanksgiving dinner table. The rates vary by the types of people who are counted as un-employed or under-employed. The headline rate that the Bureau of Labor Statistics (BLS) publishes each month is the narrowest rate and is called the U-3 rate. It counts only those unemployed people who have actively searched for work in the past month. In the same monthly labor report, the BLS publishes several wider measures of unemployment, U-4 and U-5, that include unemployed people who have actively searched for a job in the past 12 months. U-6 is the widest measure of unemployment because it includes people who are under-employed, those who want full-time work but can only find part-time jobs. Included in this category would be a person working 32 hours a week who wants but can’t find a 40 hour per week job.

The ratio that helps me understand the underlying trends in the labor market is the ratio of this widest measure of unemployment to the narrowest measure. This is the ratio of U-6/U-3. In the chart below, this ratio remained in a narrow range for 15 years. Unemployment levels grew or shrank in tandem for each group. By 2013, the ratio touched new heights, climbing above 1.9 then crossing 2 in 2014. The two groups were diverging. The U-3 rate, the denominator in the ratio, was improving much quicker than the U-6 rate that included involuntary part-time workers.

U-6-U-3Ratio

What would it take to bring this ratio down to 1.85? About 1.5 million fewer involuntary part time workers. What does that involve? Let’s say that those involuntary part-time workers would like an average of 15 more hours per week of work. That is more than 20 million more hours of work per week, which seems like a lot but is less than a half percent of the approximately 6.1 billion hours worked per week in the 2nd quarter of 2017.  These tiny percentages play a significant role in how an economy feels to the average person.

Let’s turn to a ratio I’ve used before – GDP per hour worked. I don’t expect this to be a precise measurement but it reveals long term trends in productivity. In the chart below, GDP per hour has flatlined since the end of the recession.

GDPPerHour201706

There are two ways to increase GDP per hour: 1) productivity gains, or more GDP per hour worked, and 2) reduce the number of hours worked more than the reduction in GDP. Door #1 is good growth. Door #2 is the what happens during recessions. GDP per hour rises because hours are severely reduced. I would prefer slow steady growth because the alternative is painful. Periods of no growth can be wrestled out of their torpor by a recession, a too common pattern. There were two consecutive periods of flat growth followed by recession in the 1970s and from the mid-2000s to the present day.

GDPPerHour1971-1984

The economy can withstand two years of flat growth without a recession as it did in the early 1990s. It is the long periods of flat growth that are most worrisome. In the early 1970s and late 2000s, the lack of growth lasted three years and were followed by hard recessions. The lack of growth in the late 1970s led to the worst recession since the 1930s Depression. GDP per hour growth has been flat for eight years now and I am afraid that the correction may be hard as well. Maybe it will be different this time. I hope so.

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Participation Rate

Some commentators have noted the relatively low Civilian Labor Force Participation Rate (CLFPR). This is the number of people who are working or looking for work divided by the population aged 16 and older. (BLS). The rate reached a high of 67% in 2000 and has declined since then. For the past few years, the rate has stabilized at just under 63%.

A graph of the rate doesn’t give me a lot of information. Starting in the 1960s, the rate rose slowly as more women came into the workforce and the large boomer generation came into their prime working years. So I divide that rate by the unemployment rate to look for long term cyclic trends. Notice that this ratio peaks then begins a downward slide as recessions take hold.

CLFPR-UI1947-2017

In mid-2014 this ratio finally broke above a long term baseline average and has been rising since. Today’s readings are nearly at the peak levels of early 2007.

CLFPR-UI

Some pundits use the CLFPR as a harbinger of doom that includes: 1) too many people are depending on government benefits and don’t want to work; 2) there is a shrinking pool of workers to pay for all these benefit programs; 3) thus, the moral and economic character of the nation is crumbling. During the 1950s and 1960s, when the participation rate was lower than today, our parent’s generation managed to pay off the huge debts incurred by World War 2. It is true that benefit programs were much less than those of today.

In “Men Without Work” Nick Eberstadt documents a long term decline in the percentage of prime age (25 – 54) males who are working.  Some interesting notes on shifting demographics: foreign born men of prime working age are more likely to be working or looking for work than U.S. born males. According to the Census Bureau’s time use surveys, less than 5% of non-working men are taking care of children.

In 2004 the participation rate for white prime age males first fell below those of prime age Hispanic males and has remained below since then.  In 1979, 10% of black males aged 30-34 were in jail.  In 2009, the percentage was 25%.

So why should I care about participation rates and wage growth? Policies initiated in the 1930s and 1960s instituted a system of inter-generational transfer programs.  In simple terms, younger generations provide for their elders. Current Social Security and Medicare benefits are paid in whole or in part by current taxes. We are bound together in a social compact that is not protected by an ironclad law.  Beneficiaries are not guaranteed payments.

For 40 years, from 1975-2008, the number of workers per beneficiary remained steady at about 3.3 (SSA fact sheet). In 2008, the financial crisis and the retirement of the first wave of the Boomer generation marked the beginning of a decline in this ratio to the current level of 2.7.

In their annual reports, both the SSA and the Congressional Budget Office note the swiftly changing ratio.  Within twelve years, the ratio is projected to be about 2.3.  In 2010, benefits paid first exceeded taxes collected and, in 2016, the gap had grown to 7% (CBO report) and will continue to get larger.

Policy makers should be alert to changes in the participation rates of various age and ethnic groups because the social contract is built partly on those participation rates.  As with so many trends, the causes are diffuse and not easily identifiable.  Economic and policy factors play a part.  Cultural trends may contribute to the problem as well.

Congress has a well-established record of not acting until there is an emergency, a habit they are unlikely to change.  Fixing blame wins more votes than finding solutions, but  I’m sure it will all work out somehow, won’t it?

 

Storage Costs

August 6th, 2017

Last week I discussed the concepts of present and future money. This week I’ll look at the costs involved in storing our money for future use. When I store my fishing boat over the winter, I pay storage costs. When I store money for the future I also pay storage costs. Some of these costs are outright fees. If I have a financial advisor, I may pay them a percentage based on the amount of money they manage for me. All mutual funds charge a fee which is clearly stated in the fund’s prospectus. Pension funds charge fees as well and that is not always as clearly stated.

In addition to fees, there are implied costs. My bank lowers the interest rate they pay me for savings and CD accounts to take care of their operating costs and profits. I could put my future money under my pillow but inflation eats away at my store of future money like rats in a granary bin.

Let’s turn to another cost that is more of a packaging cost– income taxes. But wait, taxes come out of my present money, my income. How can that be a cost of my future money? In the progressive income system that we have in this country, my income is taxed. If I make more money than my neighbor, I will pay a higher rate. My neighbor may pay an effective tax rate of 5% and I pay 15%.

We pay taxes on our leftover income – what we could put away into our store of future money. Let’s say that the median household income is $50K and my family makes $70K. The difference is $20K more than the median. It’s money that I could put into my store of future money. On the other hand, my neighbor’s household makes $40K, or $10K less than the median. Part of my family’s income that I could have put away for the future is going to be taken by the government in taxes.  Some of it will be used as a fee to pay for today’s common expenses like defense, police and courts, research, and infrastructure. Part of it will be given to my neighbor as a transfer payment. My future money becomes my neighbor’s present money.

How did I get my present money, my income? Invariably, it came from someone else’s future money which was previously saved and invested in a business that either hired me or contracted with me. All this money is on a merry go round of time.

Now let’s turn to the prospects for my future money. This article lists 22 reasons for not investing more money in equities at current valuations. I have mentioned several points covered in this article. One is the percentage of household wealth that is invested in the stock market. This past month, that percentage surpassed the level at the peak of the housing boom in 2006-2007.

StocksPctFinAssets201706

Maybe this time is different but I won’t count on it. The heady peaks of the dot-com boom in the late 1990s shows that this can go on for some time before the whoosh! comes.

Housing prices continue to grow above a sustainable trend line. I’ve marked out a 3% annualized growth rate on the chart below. This housing index is for home purchases only and does not reflect refinances.

PurchaseOnlyHPI201706

Check out the growth in commercial real estate loans.  The 10% annual growth of 2015 and 2016 has cooled somewhat in the first two quarters of 2017 but is still a torrid 7.6%.  (Source)

CommlRELoans

Several years ago, I thought that real estate pricing would not get frothy again for several decades. We had all learned our lesson, hadn’t we? Maybe I was wrong. The worth of an asset is what the next buyer will pay for it.  Zillow tells me I am growing richer by the day but there’s a problem.  If I did sell my home, what would I buy?  Everywhere I look, housing prices are so expensive.  Now I come back full circle to another storage cost – storing the future me.

A Choice of Money

July 30, 2017

Gresham’s law states that an overvalued form of money will drive out an undervalued form of money. Let’s say that both gold and silver are accepted as money and the government fixes a ratio of 1:20 between the two metals. One ounce of gold thus equals twenty ounces of silver. Let’s say that people and businesses hold ten times as much silver as gold. The exchange ratio that the government has set is higher than the ratio of the stores of the two metals. Gold is overvalued. Gresham’s law states that people will start using gold as an exchange medium to the extent that eventually silver will be driven out of circulation.

I wanted to explore this concept and substitute two things that are not currencies or commodities: liquidity and debt.  Liquidity is today’s money.  Debt is tomorrow’s money. Today’s money is stable and available.  Tomorrow’s money is not. As soon as money is loaned, it can’t be readily converted to cash.  It’s future money.

Gresham’s law is about people’s preferences and the value of money.  When millions of individual circumstances are added up,  a preference for liquidity or debt emerges. When tomorrow’s money is overvalued, people use it, and drive down the use of present money. “Don’t save up to buy what you want.  Buy it now with future money.  Here I’ve got some,” say businesses and banks.

Let’s look at two representations of present and future money.  M2 is a broad measure of the money supply that includes cash, checking and savings accounts, as well as money market accounts and CDs that can be quickly converted to cash. Future money is the amount of business and household debt.

During recessions (gray areas in the chart below), M2, the numerator in the ratio, goes up and debt goes down. Economists call this a greater preference for liquidity. Banks are more reluctant to lend money, which tightens credit and restrains the growth of debt.  People charge less and stick more money in checking and savings. Businesses don’t borrow to expand their operations and keep more cash on hand to pay present obligations.

In the chart below, I chart the ratio of the yearly change in today’s money, or what the Federal Reserve calls M2 money, and tomorrow’s money, the amount of business and consumer debt.

M2DebtCLIRatio1960-2007

In the recessions of the 1970s and 1980s, the graph shows what I would expect. There was a greater preference for liquidity and the ratio of present to future money rose above 1, a clear sign that people and businesses were worried about the future.  As the recessions ended, the ratio declined as debt, the denominator in the fraction, grew at a faster rate than M2 money, the numerator. The recessions of the early 1990s and early 2000s were fairly mild in comparison and the uptick in a preference for liquidity was mild.

The chart ends in 2007, just before the recession and financial crisis. Let’s now turn to that period. During the early part of 2008, the ratio began to climb to 1, indicating that people and businesses were preferring liquidity over debt. During the first six months of 2008, 700,000 jobs had been lost but this was only 1/2% of the workforce. Almost 300,000 of those lost jobs were in construction, which had become overheated by the building of so many homes. Retail sales growth had gone flat but was probably just a pause in the normal course of the business and credit cycle. Not to worry.

Then a funny thing happened to the economic engine of the country, something that had never happened before in post-WW2 America. The ratio spiked upward, registering nosebleed readings.

M2DebtCLIRatio2006-2008

The preference for present money continued upward but the change in debt, the bottom number in the ratio, plunged downward and this drove the ratio higher. The Federal Reserve began buying some of this debt until it held about $2 trillion.

Debt2008-2010

As the change in debt turned negative, the ratio turned negative, a post Depression first. Month after month, old debts soured.  People and businesses shunned new debt. People who were saving more of today’s money were being offset by those who had to tap their savings accounts to make up for lost income. Toward the end of 2008, the economy lost as many jobs each month as it lost in total for the first six months of 2008. Retail sales dropped a few percent each month.

M2DebtCLIRatio2008-2011

Like a car whose brakes have failed, the ratio continued its downward slide. In a program called Quantitative Easing (QE_, the Federal Reserve began buying more debt in an effort to get this ratio into the positive zone.

By the middle of 2012, the ratio broke into the positive zone as debt stopped contracting. The preference for liquidity was strikingly high, going up above 8, more than three times higher than the 2.5 level of the 1980s recession.

M2DebtCLIRatio2012-2014

The Federal Reserve continued to buy debt as the economy staggered to its feet.  In 2013, the stock market finally surpassed its inflation adjusted value at the start of the recession.  In the early part of 2014, the ratio of liquidity to debt, of present money to future money, finally fell below 2. At mid-2014, the Fed had accumulated $4.5 trillion in debt, $3.7 trillion of which had been added during the financial crisis. After 6-1/2 years, the number of people employed finally rose above its pre-recession level.  The Fed ended its debt buying program.

So where do we stand today? The stock market and house prices continue to make new highs but the current reading of this ratio show that people continue to prefer today’s money over tomorrow’s money.

M2DebtCLIRatio2014-2017

In short, the economy is still healing. During the expanding economy of the 1960s, the ratio was a bit over 1 for half the decade.  People who had grown up during the Depression were understandably a bit cautious. However, both present and future money grew at a steady rate during the 1960s. Today’s households and businesses have been scarred by the financial crisis and are cautious.  Into this cautious confidence, the Fed has a lot of debt to unload.  It must maintain a balance between money preferences as it feeds the debt it bought during the crisis back into the economy.