Housing and Stocks

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February 23rd, 2014

The extreme cold in half of the country had a profound effect on housing starts which fell 16% in January.  Less affected by the weather are permits for new housing which slid 5%.

The Bible prescribes that every 50th year should be a Jubilee year, in which all debts are forgiven.  While this policy of redistribution of property might be a practical solution in a smaller tribal society, it is much less practical, even dangerous, in a complex economy.  By targeting a 2% inflation rate, central banks in the developed world engage in a type of gradual debt forgiveness.  Inflation incrementally shifts the real value of a debt from the debtor to the creditor.  At a 2% inflation rate, a debt is worth half as much in 35 years.

Let’s say Sam borrows $1000 from Jane at 0% interest and doesn’t pay her anything for 35 years, then pays off the debt.  The $1000 that Sam pays back in 35 years is only worth $500 in purchasing power.  Half of Sam’s debt has effectively been forgiven.  So why would Jane loan Sam any money?  She wouldn’t – not at 0% interest.  At that interest rate the loan is actually a gift.  Jane would need Sam to pay her an interest rate that 1) offsets the erosion of the purchasing power of the loan amount, the principal, and 2) compensates Jane for the use of her money over the 35 years.

Janes all over the world loan Sam the money and don’t want much interest.  The Sam in this case is Uncle Sam, the U.S. Government.  The loan is called a 30 year Treasury bond.  (Treasury FAQs )

If your name is just plain old Sam though, few people want to loan you money for thirty years, even if it is to buy a hard physical asset like a house.  That is why U.S. government agencies back most of the mortgages in the U.S., essentially funneling the money from around the world to ordinary Sams and Janes to buy housing.  Heck of a system, isn’t it?

The affordability of housing… 

In the metro Denver area, median household income was $59,230 in 2011, compared to the national median income of $50,054. (Source)  According to Zillow, the median home value in Denver is $253,700, or 4.3 times income.   Although Denver is a large city, it is not a megalopolis like New York City or Los Angeles. In Los Angeles, median home values are $491,000.  Median incomes in 2011 were $46,148, so that home values are more than ten times incomes.  Like other megaregions, Los Angeles has a huge disparity in housing and incomes, resulting in a median income that is skewed downward because of the large number of poor people that inhabit any large metropolitan area.  The L.A. Times ranks incomes by neighborhoods.  This ranking shows a median income in middle class areas at about $85K.  Using this metric, housing is still more than six times income.  Using a conventional bank ratio of .28 of mortgage payment to income, a household income of $85K will qualify for a monthly mortgage payment of almost $2K, which will get a 30 year, 4.5% fixed interest mortgage payment, including property taxes, of about $320K.  A 20% down payment of $80K brings the price of an affordable house to $400K, below the median value of $461K, meaning that many middle class Los Angelenos can not afford to live in a middle class neighborhood.

… acts as a constraint on home sales.
 
This week the National Assoc of Realtors reported a year over year 5% drop in existing home sales.  After rising more than 10% over the past year, prices have outrun increases in income.  While we don’t have median household income figures for 2013, disposable personal income actually declined in 2013 so we can guesstimate that household income was relatively flat as well.

As this year progresses, we may see other effects from the drop in disposable income.  Economists and market watchers will be focusing on auto and retail sales in the coming months.  January’s Consumer Price Index showed a yearly percent gain of 1.6%, indicating little inflationary headwinds.  An obstacle to growth is the difference between inflation and the weak growth in household income.

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Minimum Wage

On Tuesday, the Congressional Budget Office released their estimate of the net effect of raising the minimum wage to either $9 or $10.10 from the current Federal level of $7.25 an hour.  Their analysis ranged from a minimal loss of jobs to almost a million jobs lost.  The average of this range, 500,000 jobs lost, became the headline number.  The CBO also noted that over 16 million low income workers would see an increase in income, enabling some to rely less on government aid programs.  Their projection was a slight increase in revenues to government.  A half million jobs is relatively small in a workforce of 150 million.  Some economists would concur that there is no clear evidence that raising the minimum wage has any effect on the number of jobs.  The science of economics is the study of complex human behavior in response to changes in our environment and resources.  Many times the data is not as conclusive as one might like, leading researchers to statistically filter or interpret the data according to their professional biases.

A 2013 analysis of minimum wage workers by the Economic Policy Institute indicated that the average age of minimum wage workers was about 35 years old.  Yet, 2012 data from the Bureau of Labor Statistics, the primary aggregator of labor force characteristics, does not support EPI’s conclusions – unless one includes workers who are exempt from minimum wage laws – like waiters – who are paid below the minimum wage law.  The BLS data shows that 55% of minimum wage workers are below 25 years old.

Too frequently, financial reporters who could summarize the caveats of a particular study either don’t bother or their work is left on the editor’s floor.  Many readers digest the headline summary without question and a difficult guesstimate by a government agency like the CBO is re-quoted as though it were gospel truth.

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Manufacturing Rebound?
On the bright side, an early indicator of manufacturing activity in February showed a rebound from January’s decline.

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Stock Market Dividends
As the market continues to rise, the voices of caution, if not doom, get louder.  Some analysts are permanent prophets of catastrophe.  Eventually they are right, the market sinks, they proclaim their skills of prognostication and sell more subscriptions to their newsletters.  Subscribers to these newsletters don’t seem to mind that the authors are wrong most of the time.

Last August, I wrote about the dividend yield – or it’s inverse ratio, the price dividend ratio – of the SP500 index using data that economist Robert Shiller compiles from a variety of sources.  The dividend yield of the SP500 index is currently 1.9%, meaning that for every $100 a person invested in the SP500 index, they could expect $1.90 in dividends.  The price dividend ratio is just the inverse of that, or $100 / $1.90 = 52.6. The current dividend yield is at the 20 year average.  I will focus on the dividend yield, or the interest rate that the SP500 index pays an investor.

It might surprise some investors that dividend information is available on a more timely basis than earnings.  In the aggregate,  dividends are more reliable and predictable.  Most companies have several versions of earnings and they massage their earnings to present the company in the best light.  On the other hand, most companies announce their dividend payouts near the end of each quarter so that the aggregate information is available to an investor more quickly than aggregate earnings.

Most portfolios contain a mixture of stocks and bonds so it is instructive to compare the dividend yield of the relatively risky SP500 with the yield on what is considered a perfectly safe bond – the 10 year Treasury.  Many investors think of these two asset classes as complementary – they are – but they are also in competition with each other. If the real dividend yield on stocks is the same as ten year Treasuries, it means investors in stocks want to be compensated for risking their principle on stocks.  If the interest rate on 10 year Treasuries is 4% and the  dividend yield of the SP500 is 2%, then the dividend ratio of stocks to Treasuries is 2% / 4%, or .5.  As investors perceive less risk in the stock market, this “demand for yield” from stocks will fall and the ratio will decline.   In the past, this ratio has reached a low of .19 in July 2000 as the stock market reached its apex of exuberance and investors became convinced that the rise of the internet and just in time inventory control had ushered in a new era in business.  Bill Gates, then CEO, Chairman  and founder of Microsoft, scoffed at dividends as a waste of money that could be better put to use by a company in growing the business. At the other extreme, this demand for yield ratio rose as high as 1.28 in March 2009 as stocks reached their lows of the recession.

More importantly is the movement of this ratio from peaks and troughs, indicating a change in sentiment among investors.  Note that the early 2003 market lows after the tech bubble burst were about the 50 year average of this ratio.  Compare that relative calm to the spikes of fear in this ratio since late 2007 to early 2008.  For the past 18 months, this demand for yield has declined but is still above the 50 year average.  There is still enough skepticism toward the stock market that it continues to curb exuberance.

Transfer Payments

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February 16th, 2014

In this election year, as in 2012, the subject of transfer payments will rear its ugly head with greater frequency.  In the mouths and minds of some politicians, “transfer payments” is synonymous with “welfare.”  Don’t be confused – it is not.  As this aspect of the economy grows, politicians in Washington and the states get an increasing say in who wins and who loses.  Below is a graph of transfer payments as a percent of the economy.  I have excluded Social Security and Unemployment because both of those programs have specific taxes that are supposed to fund the programs.

Transfer payments, as treated in the National Income and Product Accounts (see here for a succinct 2 page overview), are an accounting device that the Bureau of Economic Analysis (BEA) uses to separate transfers of money this year for which no goods or services were purchased this year.  The BEA does this because they want to aggregate the income and production of the current year. Because that category includes unemployment compensation, housing and food subsidies, some people mistakenly believe that the category includes only welfare programs.   Here’s a list of payments that the BEA includes:

Current transfer receipts from government, which are called government social benefits in the NIPAs, primarily consist of payments that are received by households from social insurance funds and government programs. These funds and programs include social security, hospital insurance, unemployment insurance, railroad retirement, work­ers’ compensation, food stamps, medical care, family assistance, and education assistance. Current transfer receipts from business consist of liability payments for personal injury that are received by households, net in­surance settlements that are received by households, and charitable contributions that are received by NPISHs.

That settlement you received from your neighbor’s insurance company when his tree fell on your house is a transfer payment.  Didn’t know you were on welfare, did you?  Some politicians then cite data produced by the BEA to make an argument the government needs to curtail welfare programs.  Receiving a Social Security check after paying Social Security taxes for forty plus years?  You’re on welfare.  A payment to a farmer to not grow a bushel of wheat – an agricultural subsidy – is not a transfer payment.  A payment to a worker to not produce an hour of labor – unemployment insurance – is a transfer payment.  Got that?  While there are valid accounting reasons to treat a farmer’s subsidy check and a worker’s unemployment check differently, some politicians prey on the ignorance of that accounting difference to push an ideological agenda.

That agenda is based on a valid question: should a government be in the business of providing selective welfare; that is, to only a small subset of the population?  Some say yes, some say no.  If the answer is no, does that include relief for the victims of Hurricane Katrina, for example?  Even those who do say no would agree that emergencies of that nature warrant an exception to a policy of no directed subsidies or welfare payments.  It was in the middle of a national emergency, the Great Depression, that Social Security and unemployment compensation were enacted.  Government subsidies for banks began at this time as well.  Agricultural subsidies began in response to an earlier emergency – a sharp depression a few years after the end of World War 1.  Health care subsidies were enacted during the emergency of World War 2.  The pattern repeats; a subsidy starts as a response to an immediate and ongoing emergency but soon becomes a permanent fixture of government policy.

Tea Party purists think that the Constitutional role of the federal government is to tax and distribute taxes equally among the citizens.  Before the 16th Amendment was passed a hundred years ago, the taxing authority of the Federal Government was narrowly restricted.  However, the Federal Government has always been selective in distributing  the resources at its disposal.  Land, forests, mining and water rights were either given or sold for pennies on the dollar to a select few businesses or individuals. (American Canopy is an entertaining and informative read of the distribution and use of resources in the U.S.) By 1913, the Federal Government had dispensed with so much land, trees and water that it had little to parlay with – except money, which it didn’t have enough of.  Solution: the income tax.

In principle, I agree with the Tea Party, that the government at the Federal and state level should not play God.  How likely is it that the voters of this country will overturn two centuries of precedent and end transfers?  When I was in eighth grade, I imagined that adults would have more rational and informed discussions.  Sadly, our political conversation is stuck at an eighth grade level on too many issues.

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While most of us pay attention to the unemployment rate, there is another statistic – the separation rate – that measures how many people are unemployed at any one time.  The unemployment can be voluntary or involuntary, and last for a week, a month or a year.  Not surprisingly, younger workers change jobs more frequently and thus have a higher separation rate than older workers.  In the past decade, almost 4% of younger male workers 16 – 24 become unemployed in any one month.  Put another way, in a two year period, all workers in this age group will change jobs.  For prime age workers 25 – 54, the percentage was 1.5%.  In a 2012 publication, Shigeru Fujita, Senior Economist at the Philadelphia Federal Reserve Bank, examined historical demographic trends in the separation rate.

On page five of this paper, Mr. Fujita presents what is called a “labor-matching” model that attempts to explain changes in unemployment and wages, primarily from the employer’s point of view. Central elements of this model, familiar to many business owners, include uncertainty of future demand and the costs of finding and training a new worker.  Mr. Fujita examines an aspect that is not included in this model – the degree of uncertainty that the worker, not the employer, faces.  In the JOLTS report, the BLS attempts to measure the number of employees who voluntarily leave their jobs.  These Quits indicate the confidence among workers in finding another job.  The JOLTS report released this week shows an increasing level of confidence but one which has only recently surpassed the lows of the recession in the early 2000s.

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Labor Participation
In a more recent paper, Mr. Fujita examines the causes of the decline in the labor participation rate, or the number of people working or looking for work as a percentage of the people who are old enough to work.  As people get older, fewer of them work; the aging of the labor force has long been thought to be the main cause of the decline.  That’s the easy part.  The question is how much does demographics contribute to the decline? What Mr. Fujita has done is the hard work – mining the micro data in the Census Bureau’s Current Population Survey.  He found that 65% of the decline of the past twelve years was due to retirement and disability.  More importantly, he discovered that in the past two years, all of the decline is due to retirement.  The first members of the Boomer generation turned 65 in 2011 so this might come as no surprise.  The surprise is the degree of the effect;  this largest  generational segment of the population dominates the labor force characteristics. During the past two years, discouraged workers and disability claims contributed little or nothing to the decline in the participation rate.  Another significant finding is that relatively few people who retire return to the work force.

In this election year, we will be bombarded with political BS: Obamacare or Obama’s policies are to blame for the weak labor market; the anti-worker attitude of Republicans in Congress are responsible.  Politicians play a shell game with facts, using the same techniques that cons employ to pluck a few dollars from the pockets of tourists in New York City’s Times Square.  Few politicians will state the facts because there is no credit to be taken, no opposing party to blame.  Workers are simply getting older.

In 2011, MIT economist David Autor published a study on the growth of disabiliity claims during the past two decades and the accelerating growth of these claims during this Great Recession.  Mr. Fujita’s analysis reveals an ironic twist – at the same time that Mr. Autor published this study, the growth in disability claims flattened.  The ghost of Rod Serling, the creator and host of the Twilight Zone TV series, may be ready to come on camera and deliver his ironic prologue.

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Lower automobile sales accounted for January’s .4% decline in retail sales. Given the continuing severity of the weather in the eastern half of the U.S., it is remarkable that retail sales excluding autos did not decline.  In the fifth report to come in below even the lowest of estimates, industrial production posted negative growth in January.  By the time the Federal Reserve meets in mid-March, the clarity of the economy’s strength will be less obscured by the severe winter weather.

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A reader sent me a link to short article on the national debt.  For those of you who need a refresher, the author includes a number of links to common topics and maintains a fairly neutral stance.  I still hear Congresspeople misusing the words “debt,” the accumulation of the deficits of past years, and “deficit,” the current year’s shortfall or the difference between revenues collected and money spent.  Could we have a competency test for all people who wish to serve in Congress?

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The House and Senate both passed legislation to raise the debt ceiling this week.  The stock market continued to climb from the valley it fell into two weeks ago and has regained all of the ground it lost since the third week of January.

January Employment and Economic Production

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February 9th, 2014

The ISM manufacturing report for January reported a severe decline from the robust readings of past months.  New orders suffered the most, dropping from a strong reading of almost 65 in December to just a bit above the neutral reading of 50.  Prices jumped significantly.  Manufacturing’s drop off in new orders comes on the heels of a similar decline in the service sector in December.  This is the third report in the past thirty days that came in below even low estimates, the other two being pending home sales and December’s employment gains.  At mid week, ISM released their January estimate of the health of the service sector which is the bulk of the economy.  Happily, this showed continued growth, helping to offset concerns about a broad slowdown in the economy.

The CWI that I have been tracking continues to show an overall strength, declining slightly to 58 from the rather vigorous reading of 60 last month.  As I noted a few weeks, this index anticipated a winter lull before picking up energy again in early spring.

A reader had difficulty understanding the wave like graph of the CWI.  I indexed it to a starting base then indexed that to the SP500 average in 1997.  Perhaps this will help visualizing the long term response of the SP500 to underlying economic activity.

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ADP reported a gain of 175,000 private jobs in January, below the strong 227,000 job gains of December.  There was only a slight revision to ADP’s previous report, confirming the suspicion of some that the greater flaw lies in the BLS figures for December.

On Friday, the Bureau of Labor Statistics (BLS) released their estimate of 113,000 job gains in January, far below the consensus of about 180,000.  Here’s a story from the Atlantic that captures some of the highlights.  Forgive some of the misspellings, if they are still there by the time you read it.

As I did last month, I’ll show the average of monthly job gains estimated by the BLS and ADP.  ADP does not report government jobs so I’ve just added those in from the BLS report.

The decline below the replacement level of 150,000 may be a temporary response to severe weather conditions in the populous east coast and Chicago region.

The market responded quite favorably to this labor report. A slackening labor market prompted hopes that the Federal Reserve will not accelerate their easing of bond buying.  A large revision of job gains in November was a big positive in the report.  Another positive was the half a million increase in the core work force, those aged 25 – 54.  Men accounted for most of this increase.

The number of people working part time because they can’t find a full time job dropped by a half million but there are still more than 7 million people in this situation.  A 232,000 decrease in the number of long term unemployed was heartening although many lost their unemployment benefits at the end of the year and may have had little choice but to take whatever job they could find.

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Doug Elmendorf is the head of the Congressional Budget Office (CBO) that advises the Congress in constructing the budget, making appropriations, and the anticipated or actual economic effects of policy.  In advance of his testimony before the House Budget Committee this past week, the CBO released the highlights of their report. Some talk show hosts and conservative media were trumpeting a loss of 2.3 million jobs due to Obamacare.  In his testimony, Mr. Elmendorf explained that the 2.3 million jobs mentioned in the CBO report are not lost jobs because the CBO does not estimate any reduction in the demand for employees because of Obamacare. The CBO estimated the number of hours that employees would voluntarily reduce their hours in order to meet qualifications for subsidies under Obamacare and divided those total hours by what a full time employee would work in a year.  Since there is a surplus of labor in this country, this voluntary reduction would help those who are either looking for a job or want to work more hours.  The CBO sees no impact on part time jobs that can be attributed to Obamacare.

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Republicans and some Independents have repeated the claim that the rich are paying most of the personal income taxes in this country. IRS 2010 data (Table 2 ) doesn’t seem to support that contention.  The top 5% of taxable returns with taxable incomes greater than $200K had taxable income of $1.9 trillion, or 36% of the total $5.3 trillion in taxable income.  On that income, the top 5% paid $513 billion in Federal income tax, 49% of the total.  In a flat tax system, the top 5% would have paid a bit more than $360 billion.

When Republicans use the code words “broaden the tax base” what they mean is that they want a flat tax so that rich people pay the same percentage of tax as poor people.  Several states have such a flat tax system.  To Democrats, a broadening of the tax base means making more of the income of rich taxpayers subject to progressive tax rates.

When Democrats use the code words “paying their fair share” they mean that the rich should pay proportionately more than the additional load of about 32% that they are currently paying.  To Republicans “fair share” means a flat tax.

What the IRS data shows is that the rich are not paying most of the income taxes in this country.  Often tax policy and social benefit programs are lumped together, confusing the issue in the minds of many.  The Tax Foundation did an analysis of the net benefit and expense of taxation and benefit programs.  They report that:

As a group, the bottom 60 percent of American families receive more back in total government spending than they pay in total taxes.

Government tax and spending policies combine to redistribute more than $2 trillion from the top 40 percent of families to the bottom 60 percent.

The methodology that the Tax Foundation uses presumes that everyone benefits equally from public spending like defense, police and the courts.  An alternative assumption that people benefit according to their income results in a $1.2 trillion redistribution, about 40% lower, according to the Tax Foundation.  (Kudos to the Tax Foundation for making both computations.)

What the report does not do – because it is just so hard to do – is calculate age and circumstance related movements of taxpayers from the top 40% to the bottom 60%.  Consider a taxpayer – I’ll call her Linda – making $100,000 who is in the top 40%.  She loses her job and starts collecting unemployment for several months.  Her income now puts her in the bottom 60%.  “Past Linda” was supporting the bottom 60% but “present Linda” is now part of the bottom 60%, according to the methodology used by the Tax Foundation.  Yet if we isolate this one taxpayer, we can say that “past Linda” was actually supporting “present Linda.”  When Linda was making $100K, she presumably paid a lot in income and other taxes, including unemployment taxes paid by her employer.  The Federal Government does not keep records that would allow this kind of inter-temporal analysis.  As a result, we get a distorted view of what is actually happening.

Let’s look at an older taxpayer – I’ll call him Sam – who retires.  Sam was making $80K before he retired and was in the top 40%.  With social Security income and income from savings, Sam now makes $36K in retirement, which puts him in the bottom 60%.  Is Sam being supported by the top 40%?  Statistically he is.  However, most of us would say that Sam is simply living off the benefits that he paid into during his working life.

I appreciate the exhaustive work that the Tax Foundation does but the problem is more complex than they present.  Furthermore, many people are not aware of the difficulties and complications of calculating who supports whom.  Some use this analysis to present the case that the majority of Americans are sucking on the teats of the few well off.  Presidential contender Mitt Romney’s unguarded comment about “the 47%” who are living off the efforts of others did not serve him well in the past election yet a sizeable percentage of voters believe this.

The 16th Amendment passed a century ago allowed the Federal government to tax the income of individuals directly and it was intended to be progressive.  Relatively few paid any income taxes in the first decades after the enactment of the income tax.  Whether one likes the progressivity of the tax code, one has to recognize that the law was intended to be that way when it was passed.

I would like to see the repeal of the 16th Amendment for two reasons: 1) protect individuals from the power of the Federal government; 2) slow the consolidation of money in Washington.  Money brings power and power begets patronage, if not downright graft.  We can never get rid of patronage, only retard the concentration of patronage. Studying 5000 years of history, we have learned that the concentration of power in any political institution ultimately leads to the downfall of that institution.  Only corporations can exist with such a concentration of power and even they sometimes fall when top leadership in a company becomes resistant to change.

Perhaps we could adopt a taxing system where the Federal government taxes the states based on the population in each state.  If a state has 10% of the country’s population, then they would owe 10% of any tax used to replace the current income tax.  Let the states determine how they will collect the money.  Racism has been a constant nemesis of this country and legal protections could be enacted which would prevent states from taxing citizens based on race or sex.  Head taxes have a tawdry reputation because they were often used to disenfranchise poorer voters.  If the population count of a state was simply used as an allotment mechanism and not applied directly to each citizen, I think that this could be a fairer and safer system of taxation.  Certainly, legislation could be passed preventing the denial of rights to a citizen based on a tax.

Could Doug Elmendorf and his cohorts at the CBO build a model based on such a system?

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Tidbit:

And we’re talking about nine million individuals who are eligible for both Medicare and Medicaid. They are responsible for a significant amount of spending in both programs — approximately 46% of Medicaid and close to a quarter of Medicare spending annually.  Estimates range that that is anywhere from 300 to $350 billion a year total that we’re [CMS] spending. 
Melanie Bella, Director of the Federal Healthcare Office at the Centers for Medicare and Medicaid Services, Federal Coordinated Healthcare Office Conference 11/1/2010

Diminished Expectations

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February 3rd, 2014

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Market Bumps

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January 26th, 2014

In a holiday shortened week, the market opened higher than the previous Friday but fell a bit more than 3% by week’s end.  On this same week in 2012, the market lost 2.5% in 3 trading days.  As I mentioned last week, there were few economic reports this past week to detract from the focus on corporate earnings.

IBM opened up the week by beating profit estimates but missed revenue estimates by $1 billion, or about 3%, and were about $1.5 billion less than the final quarter of 2012.  The 4th quarter is usually IBM’s strongest quarter each year; lower revenues from this giant indicate a cautious business investment outlook.  IBM is selling for the same price now that it did in mid 2011, a price earnings ratio of 12.

The following day, China announced that the country’s industrial production has fallen just below the neutral mark.   The reaction to the news was exaggerated by sharp declines in some emerging market currencies, which started a cascade of selling. See SoberLook blog for some charts. Similar weakness out of China last summer prompted a much more subdued reaction.

On Thursday, McDonald’s reported weak sales growth, which added to concerns.  After a run up of 30% last year, many traders were on high alert for any negative news.  The U.S. stock market has enjoyed a tail wind from Federal Reserve stimulus policy, but a global economy is largely outside of the Fed’s influence.

A 14 month support trend line that has been in place since November 2012 sets a mark at about 1760.  Dropping below that would signal a short to mid term shift in market sentiment.  The SP500 index closed at 1790 on Friday, 1.7% above that support trend line.  The 10 month average of the index is 1700.  A drop below that mark would signify a change in mid to long term sentiment. A few weeks ago, I noted that the market was close to 10% over its 10 month average.  This week’s decline puts that percentage at a bit over 5%.

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Existing home sales notched up a bit in December but the yearly percent gains were relatively flat.  The 4 week average of new claims for unemployment declined to 331,000.  Several weeks ago it was close to the psychological 350,000 mark.  Mitigating the decline in new claims, continuing claims have been rising lately and are approaching the 3 million mark.

To put that 3 million people in historical perspective, take a look at the chart below.

The number of long term unemployed is ever a concern.

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In early October I noted the relative sluggish performance of retail stocks vs the larger market index of the SP500 ahead of the Christmas buying season.  Below is an updated chart of a retail index ETF vs the larger market.

Shortly after that post, renewed hopes for a strong Christmas season led to higher prices for the group.  Disappointing sales gains announced as the season ended deflated that balloon.  Since the new year began, a composite of retail stocks has lost 8%.

Typically retailers report their earnings in mid to late February.  Traders have already priced in a rather disappointing earnings season for the retailers.  In the context of a longer time frame, retail stocks are still up 25% year over year.  If an investor had bought this composite on this date seven years ago when the economy was strong and retail stocks were at a high, she would still have doubled her money, easily outpacing the 38% gains in the larger market since then.  The resilience of consumer demand, despite an extremely severe downturn when unemployment and falling house prices put a brake on consumer spending, has helped make this sector a sure footed long term winner.  

Housing, Unemployment and CPI

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January 19th, 2014

A strong retail report for December and an improvement in sentiment among small business owners buoyed the market at the start of the week.  Both reports continue a trend that indicates a healthy economy:  results are at at the upper bound or above expectations.

The latest report of  jobless claims at 325,000 pulled the 4 week average further down away from the psychological mark of 350,000.  This is sure to reassure short to mid term traders.  The weak BLS employment report released a week ago may have just been an anomaly.  Other employment indicators, as well as retail sales and business production simply do not confirm the headline numbers from the BLS.

The Consumer Price Index for December showed a mild 1.5% year over year increase and will reassure the Fed that its stimulus program poses little danger of igniting inflation.

The National Assn of Homebuilders reported continued strong growth in their Housing Market Index.

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Featured on one of the blogs that I link to is a chart of the annual returns of the SP500.  Double digit gains in the index, like the one we had last year, are rather common, occurring about 40% of the time.  A reassuring takeaway for the longer term investor is that the market goes up in 75% of the years for the past eighty years.

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The number of unfilled job openings in November was the highest since March of 2008, indicating continuing strengthening in the labor market.  Job openings have been above the ten year average for over a year now.

The number of people who voluntarily quit their jobs continues to climb over the past year.  Employees quit when they feel more confident about job prospects. While this metric has been improving, it is only at the lowest levels of the past decade.

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Housing starts declined slightly in December to a million but is still growing from the lows of the bust.

Let’s get a bit of perspective. There is a decided shift downward from the post war building boom.  Below is a graph of  housing starts adjusted for population growth.

Adjusted for population growth, the multi-family component of housing starts has reached the normal levels of the past two decades.  This is the more stable component of housing starts.

Starts of single family homes have not yet reached the lows of past recessions.  The words “improvement” and “recovery” should be viewed in the context of these abysmal lows.

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The Consumer Price Index (CPI) for December showed a year over year increase of 1.5%.  I believe this understates current inflationary pressures on consumers but it is the official rate, one that the Federal Reserve will use to guide policy.  The low rate will help allay fears that continuing stimulus will spur inflation in the near term.

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Stock prices will be driven largely by earnings reports at this time.  About 10% of SP500 companies have reported this past week, too few to get a solid feel yet for the past quarter.  62% of companies have beat expectations, a bit less than the more normal 70%.  The market is largely trading sideways as it digests both the past quarter’s results and the forward guidance that companies give when they report.  IBM, Johnson and Johnson, and Verizon kick off this holiday shortened week when they report earnings on Tuesday. McDonald’s, Microsoft, Proctor and Gamble, and Netflix are due to report this week as well.  There don’t appear to be any significant market moving economic reports coming up this week.  Existing Home Sales on Thursday might have some minor impact and traders will be watching the continuing trend in new unemployment claims.

Labor’s Journey

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January 12th, 2014

A dramatic decrease in new orders, mostly for export, for the non-manufacturing sector of the economy offset other positives in the December ISM report.  The composite non-manufacturing index dropped slightly but is still growing.  A blend of the manufacturing and non-manufacturing indexes, what I call the CWI, declined from its peak as expected. A month ago I noted the cyclic pattern in this index, and the shorter time between peaks as the economy has formed a stronger base of growth. Most businesses are reporting expansion, or strong growth.  Some respondents to the survey noted that the severe winter weather in December had an impact on their business.

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Ringing in the New Year, the private payroll firm ADP issued a strong report of employment growth before the release of the BLS figures on Friday.  The reported gain in jobs was above the best of expectations.  In the past few months,  several reports in production and now in employment have exceeded expectations or come in at the upper bounds of estimates.

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Wells Fargo announced that they will be offering non-conforming mortgages to selected buyers who present a low risk.  Non-conforming mortgages may be interest only, or have loan to values that don’t meet guidelines. Reminiscent of the “old days,” Wells Fargo intends to hold onto the mortgages instead of selling the paper in the secondary market.

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The Gallup organization announced their monthy percentage of adults who are working full time, what Gallup calls the P2P.  I call this the “Carry the Load” folks, those people whose taxes are supporting the rest of the population.  At 42.9%, it is down a percentage point or two from previous winters.

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The 4 week average of new unemployment claims is still below 350,000 but 20,000 higher than a month ago.  As I mentioned last week, this metric will be watched closely by traders in the coming weeks.  Although there is little statistical significance between a 349,000 average and a 355,000 average, for example, there is a psychological boundary marked in 50,000 increments.

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Friday I woke up and found that somebody stole the ‘1’s at the Bureau of Labor Statistics.  The BLS reported net job gains were 74,000 and I thought that there was a smudge on my computer screen blocking the ‘1’ of 174,000 and reached out to wipe it off.  There was no smudge.  It is difficult to interpret the discrepancy between the ADP report and the BLS report.  Some say that the particularly harsh winter weather in the midwest and east caused many people to stop looking for work or that many businesses returned their BLS survey late.  If so, we may see some healthy upward revisions to the employment data when the February report comes out. Here’s a look at total private employment as reported by BLS and ADP.

As you can see there is a growing divergence between the two series.  As a percentage of 120 million or so employed in private industry, the divergence of a few hundred thousand is slight.  The BLS assumes a statistical error estimate of 100,000.  But people closely watch the monthly change in employment as a forecast of developing trends in the overall economy, changes in corporate profits and consequently the price of stocks.  Here is a chart of the difference in private employment as measured by the BLS and that measured by ADP.  A positive number means that the BLS is reporting more employment than ADP.

As with any estimates, I tend to average the estimates to get what I feel is a more accurate estimate.  This averaging works well when bidding construction jobs and some statistical experiments have proven the method reliable.  Averaging the two estimates for private payrolls gives us an estimate of job growth that is still above the replacement threshold of about 150,000 net job gains per month needed to keep up with population growth.

The figures above do not include 22 million government employees, or about 14% of total employment.  Flat or declining employment in this sector has dragged down the headline job gains each month.  Adding in net job gains or losses in the government sector gives us a net job gain of about 150,000 in December.

For those of you interested in more analysis of the employment report, Robert Oak at the Economic Populist presents a number of employment charts similar to the ones I have been doing in past months.

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For the past 5 – 10 years, much has been written about the growth in income inequality during the past 30 to 40 years. I’ll call income inequality “Aye-Aye” because the abbreviation  “II” looks like the Roman numeral for “2” and because Ricky Ricardo used to exclaim “Aye, Aye, Lucy!” on that much loved comedy series.  Those on the left blame former President Reagan,  British Prime Minister Thatcher, and deregulation for Aye-Aye.  Those on the right blame increasing regulation that disincentivises businesses from taking chances, from making capital and people investments to pursue robust growth. The expansion of social welfare programs makes people ever more dependent on government and less likely to take jobs that they don’t want.  Economists cite the aging of the population as a cause of the growth of Aye-Aye.  Few I know of seriously challenge the idea that Aye-Aye has been happening.  The argument is over the causes and the solutions.

Thomas Piketty’s Capital in the 21st Century will add to the debate.  The English translation will be published in March.  A book review in the Economist outlines some of the ideas in the book.  Piketty’s analysis of almost 150 years of data from several countries indicates that the slower an economy grows, the more unequal the distribution of income.  One might think that the U.S. would have the most unequal income distribution, but Piketty reveals that it is France that tops the list.

Piketty’s rule of thumb is that the savings rate divided by a country’s growth rate will approximate the ratio of capital wealth to gross income.  As this ratio increases, more of the national income goes to those with capital wealth. So, if the savings rate is 8% and the growth rate is 2%, then capital wealth will be about four times gross national income.  Furthermore, he finds that population growth accounts for about half of economic growth over the past century and half.  Slowing population growth in the developed nations therefore leads to greater inequality of income.  If this rule of thumb is fairly accurate, stronger economic growth is the only way to lessen the inequality of income that has grown steadily over the past thirty to forty years.

If you are familiar enough with French, you can read a preview here or pre-order the English version here.  The book is sure to spark some lively discussion between those in the economic growth camp and those in the demographic camp.  The topic has long been a topic of discussion in emerging economies.  I will quote from an Asian Pacific policy journal published in 2003, “The most important determinant of inequality is not [emphasis mine] economic growth, however, but rather changes in demographic age structure.”

Year In Review

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January 5, 2013  2014

The start of any year presents an opportunity for reflection on the past year as well as the upcoming one.  At the start of the year, few, if any, analysts called for such a strong market in 2013.  The S&P500 closed the year at 1850, a 30% gain. After a correction in May – June of this year, the index rose steadily in response to better employment data, industrial production, GDP increases, and the willingness of the Federal Reserve to continue  buying bonds and keep interest rates low.

I was one of many who were mildly bullish at the beginning of the year but got increasingly cautious as the index pushed past 1600.  Yet, month after month came not only positive or mildly positive reports but a notable lack of really negative reports.  Leading economies in the Euozone, teetering on recession, did not slip into recession.  Fraying monetary tensions in the Eurozone did not explode into a debt crisis.  China’s growth slowed then appeared to stabilize.  Although the attention has been on the Eurozone the past few years, the sleeping dragon is the Chinese economy, its overbuilt infrastructure, the high vacancy rate in commercial buildings in some areas of the country and the high housing valuations relative to the incomes of Chinese workers.

A year end review is an exercise in humility for most investors.  Some fears were unfounded or events unformed which confirmed those fears.  People are story tellers – stories of the past, imaginings of the future.  An investor who keeps all their money in CDs or savings accounts is predicting an unsafe investing environment for their savings.

Perhaps the best strategy is the one that John Bogle, the founder of Vanguard, advocates.  He doesn’t try to predict the future or be the best investor.  He aims for that allocation of stocks, bonds and other investments that, on average, forms a suitable mix of risk and reward for his goals, his age and the financial situation of his family.  He looks at his portfolio once a year.  I do think that a good number of individual investors had adopted the same outlook as Mr. Bogle advocates – until the 2008 financial crisis.

Since the financial crisis, too many investors have adopted a paralyzed strategy, a “deer in the headlight” reaction to the financial crisis that has been hugely unrewarding. Part of this year’s rise in the stock mark can be attributed to individual investors moving cash back into the stock market but I would guess that many of those investors are ready to pull it back out at the first sign of any trouble.  This shows less a confidence in the market but a frustrating lack of alternatives.

Long term bond prices took a significant hit in the middle of the year on fears of an impending rise in interest rates.  Bond prices had simply become too high, driving down the yield, or return, on the investment. Lower bond yields and meager CD and savings rates provided little return for investors, leaving many investors with little choice but to venture back into the stock market.

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The Coincident Index of Economic Indicators remains level and strong.  A decline in this index below the 1% average growth rate of the population indicates the start of or an impending recession.

Note the index in 2002 – 2003 as it fell back, never rising above the 1% level.  I have written about this economic faltering before.  Much of the headlines were focused on the lead up to and start of the Iraq war.  The recovery from the recession of 2001 and 9-11 was very sluggish.  Fears that the country was entering a double dip recession similar to that of the early 1980s prompted Congress to pass the Bush tax cuts in 2003.  It was only the increased defense spending of 2003 that offset what would have been a decline in GDP and another recession.

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A worrisome rise in new unemployment claims has puzzled some analysts.  Typically, new claims for unemployment decline at the end of the year, particularly in a year such as this one when reports of strong economic growth have been consistent.  Since 2000, rises in claims at the end of the year have been a cautionary note of things to come.  Mid-term investors and traders will be paying attention to this in the weeks to come.

However, the decline this year may be more of a leveling process that has been forming for most of the year.  On a year over year basis, the long term trend is down – which is up, or good.

In March 2013, I wrote “when unemployment claims go up, the stock market goes down … On a quarterly basis, this negative correlation has proved to be a reliable trading signal for the longer term investor.  When the y-o-y percentage change in new unemployment claims crosses above the SP500 change, sell.  When the claims change crosses below the SP500 change, it’s safe to buy. ”  The percent change in SP500 is still floating above the change in unemployment claims.

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Sales of motor vehicles in November were above even the most optimistic expectations.  The ISM manufacturing index showed a slight decline but is still in strong growth mode and the already robust growth of new orders continues to accelerate.  The manufacturing component of the composite index I have been following since last June is at the same vigorous levels of late 1983 and 2003 when the economy finally breaks free of a previous recession.  I’ll update the chart when the non-manufacturing report is released this coming Monday.

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In a healthy economy, the difference between real GDP and Final Sales Less the Growth in Household Debt (Active GDP) stays above 1%, which incidentally is the annual rate of population growth.  As the chart below shows, this difference dropped below 1% in late 2007.  Finally, six long years later, the difference has risen above 1%, indicating a healthy, growing economy.

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And now a brief look at the year in review.

At the end of 2012, the price of long term bonds had declined slightly from the nose bleed levels of the fall but there was more to come.  I wrote “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?”

During the past year, long term bonds declined another 10%.  They seem to have formed a base over the past several months.  Intermediate term bonds are less sensitive to interest rate changes so they are the safer bet.  They lost about 6% in price over the past year.  Short term corporate bonds are a good alternative to savings accounts.  They pay about 1% above the average savings account and they usually vary very little in price so that the principal remains stable.

At the end of 2012, I wrote “the underlying fundamentals of the economy give reason for cautious optimism.” A month later, “As the saying goes, ‘The trend is your friend.’ When the current month of the SP500 index is above the ten month average, it’s a good idea to stay in the market.”  In January 2012, the monthly close broke above the 10 month average. This is a variation of the Golden Cross that I wrote about in January and February 2012.

Let’s look at this crossing above and below the 10 month average.    When this month’s close of the SP500 index crosses above the 10 month average of the index, it indicates a clear change in market sentiment.  I have overlayed the percent difference between each month’s close and the ten month average.

As you can see, the close near the end of December is near 10% above the 10 month average.  If the above chart is a bit too much information for you, here is a graph of the percent difference only.

Is the market overheated?  As you can see the market has sustained a robust (or some might call it exuberant) 10% for 6 – 9 months in 2003, 2009, and 2010-2011.  From 1994 to 1999, the market spent a lot of time in the 10% percent range. Some pundits are talking about this market as a bubble but we can see that this market has not penetrated the 10% mark.  At the end of January 2013, the market closed at more than 7% above it’s 10 month average, over the 4 year positive average of 5.6% (the average when the difference is positive).  The market is 20% up since then.

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In March I introduced the “Craigslist Indicator,” the number of work trucks and vans for sale in a local area, as a gauge of the health of the construction industry.  It was a funny little indicator that indicated a growing strength in the construction industry at the beginning of the year.  Now for the amended version of the Craigslist Indicator: when there are a lot of older work trucks and vans advertised for sale on Craigslist, that indicates a robust construction market.

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On March 24th, 2013 I wrote ” For the past year, the Eurozone has been in or near recession, yet some are hopeful that increased demand in this country and some emerging markets are helping to balance the contractionary influence of decreased demand in the Eurozone. Let’s hope that this surge in the first part of the year does not fade as it did in 2012.”  Instead, emerging markets began to contract and the Eurozone expanded slightly. Investors who bought emerging markets in March 2013 witnessed a more than 10% decline during the summer but the index ended the year at about the same level as nine months ago.

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I thought that home prices in the early spring has reached a peak and wrote on March 31st, “The upturn in home prices is still above the trend line growth of disposable income and until personal income can resume or surpass a 3% growth rate, any rise in home prices will be constrained.” The Purchase Only House Price Index (HPIPONM226S) rose steadily throughout the year.
In late summer, I noted the falloff in single family home sales that began in the spring.  But prospective buyers were incentivized to make the deal as interest rates began to climb from their historically low levels.  Home sales surged upward; a lack of inventory in many cities also formed a support base that propped up prices.

A sobering note in September, “Rising home values are good for those who own a home but increasing valuations make it that much more difficult for buyers trying to buy their first home.  People in their twenties and early thirties who are most likely to be first home buyers have been hit hard by the recession.”

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After a decline in the stock market in June, I wrote “For the long term investor, periods of negative sentiment can be an opportunity to put some cash to work.”  Although I took my own advice, I wished I had acted with more conviction.  Of course, if the market had declined 10%, I would have been patting myself on the back for my cautious stance.  Smiley Face!!

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In July I noted the rather dramatic decrease in the value of securities held at the nation’s largest banks “Recently rising bond yields have contributed to banks’  operating profit margins but the corresponding value of banks’ bond portfolios has fallen quite dramatically.  This decline in asset value affects bank capital ratios, which makes them less likely to increase their lending … [and] will be an impediment to economic growth.”  The rising stock market and a respite in the decline of bond prices helped stabilize those portfolios in the second half of the year.

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In September, I noted “Despite all the daily and weekly responses to political as well as economic news, the SP500 stock market index essentially rides the horse of corporate profits.”  Profits have more than tripled in the past ten years.  We should stay mindful of that stock price to profit correlation as we look out on the investment horizon.

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From time to time I comment on the venality of our elected representatives.  Although they might appear to be idle rants to some readers, they are a caution.  Politicians make promises to get votes.  People become more dependent on those promises.  Inevitably, the day comes when the promises can not be met – as promised.  Those nearing or in retirement become increasingly dependent on political promises and should leave themselves a cushion – some wiggle room – if possible, when they make income and expense projections.  This Washington Post article on proposed budget cuts to military pensions is a case in point.  As long as “they” come for the other guy, we don’t pay too much attention – until they come for us.  Over the next ten to twenty years, we can expect many small cuts to promised benefits.  The cuts have to be small or target a small sector of the population so that they don’t anger voters too much.  In several blogs, I have shown how a simple recalculation of the Consumer Price Index eats away at the incomes of workers and retirees.  Expect more of these “recalculations” in the future as politicians follow a long standing tradition of making promises to win votes and bargain patronage to gather financial support for their campaigns.

We have the midterm elections to look forward to this year!  OK, calm down. Republicans will be hoping to take the Senate and make President Obama’s life miserable for the following two years.  I am guessing that the political campaigns for some Senate seats will vacuum in more money than the GDP of a lot of small and poor countries.

Employment Growth

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December 29th, 2013

In several past blogs here and here, I have noted a “rule of thumb” guide to recessions based on the unemployment rate.  When the year over year percentage change in the unemployment rate goes above 0, recession smoke alarms go off.  Sorry, no phone app for this alarm. This metric sometimes indicates a recession that doesn’t quite materialize in the economic data, a false positive, although the market may react to the possibility of a recession.  Employment is but one factor in a complex economy and no one indicator can stand as a fail safe predictor of a serious enough decline in the economy that it gets labelled “recession” by the NBER.

Another related measure is the total employment level.  This employee count comes from the Establishment Survey conducted by the BLS and is the source for the monthly headline job gains or losses. To show the correlation between payroll and economic activity, I took a measure of GDP – I’ll call it active GDP – that excludes changes in business inventories and net exports.  From this I subtracted the change in real household debt in each quarter.  This measure of economic activity reflects what consumers can actually pay for.  Below is a chart of the yearly change in this adjusted measure of GDP and the number of people working.  There is a remarkable correlation.

As I will show below, the employment market has not fallen into an unsafe zone but the decline in growth of domestic demand indicates a fragility that should not be overlooked.  Comparing the number of people working to the 12 month average reveals trends and weaknesses in the economy.  Historically, when the number of workers falls below its 12 month average we are almost certainly in a recession.  As of now employment is maintaining a healthy but not robust growth rate.

When the difference between the monthly count of people working and its 12 month average (I’ll call it DIFF) falls below 1% (I’l call it WEAK), it shows a pre-recession weakness in the economy. In past decades, this DIFF might fall to .75% before recovering, a temporary weakness.  Since June 2000, employment growth has been in a WEAK state, never recovering above 1%.  Following the dot com bust in 2000, 2001 included an 8 month recession, the admittance of  China to the World Trade Organization and the sucking up of low skilled manufacturing jobs, and the horrific events of 9-11.  For two years the country endured a painfully slow and fitful recovery, prompting a Republican Congress to pass  what are called the Bush tax cuts.  Neither tax cuts or the overheated housing market of the mid 2000s could kick the DIFF above 1% although it got very close for a number of months in late 2005 and early 2006 as the housing market peaked.

When the DIFF falls below 500, we can mark fairly closely the beginnings and ends of recessions as they are called by the NBER many months later.

It is important to note that historical data is already revised data.  We must make investment decisions with the data available at the time. (See an earlier blog for some examples of revisions to payroll data.)

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This week’s reports were generally better than expected.  These included durable goods orders, sales of new homes, personal income and spending.  Housing prices, as shown by the FHFA purchase only index, are maintaining an 8% year over year change.  Over the past quarter century, housing prices have followed a 3.2% annualized growth rate.

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In previous blogs, I have examined the PCE inflation measure that routinely produces the lowest rate of inflation.  This is not the headline CPI index but is used to produce what is called a chain type price index.  Inflation estimates based on this indicator showed 0% inflation in November and less than 1% for an entire year.  Isn’t that great?  Rents, food, utility bills, insurances have barely increased over the past year.  Yes, I know you are ROFL until you realize that the joke is on you, on all of us.

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Let’s get in the wayback machine and go back to early 2007 when the Bush administration released their estimate of GDP for the years 2007 – 2013.  Every Presidential budget indulges in the folly of predicting the future economic growth of the largest economy in the world.  When we dig into the figures, the process is rather simple.  These estimates simply take actual figures from 2006 and calculate 5% annual growth in nominal GDP.  Any of us could do this with an Excel spreadsheet.   An unemployment rate below 5% is rather infrequent and unlikely to continue for very long but the Bush Administration projected that this sub-5%level would continue for another six years.  If your 12 year old came to you with these calculations, you would probably praise them for their effort and smile inwardly at the innocence of the projections.  You wouldn’t tell your twelve year old that things don’t stay rosy indefinitely because they will find that out in due time.  This kind of middle school mentality is what passes for wisdom in Washington.

In the course of our lives, how many times do we come to a carefully calculated answer only to step back and say “Well, that can’t be.  Something’s wrong.”  It seems that there are few in Washington who doubt themselves.  The polarization in Washington means that everyone in any position of responsibility has many critics on the other side of an issue.  Each one then surrounds themselves with others who support their position, their values, their calculations.  There is no stepping back and saying, “Wait, is that right?” The revolving door in Washington ensures that many politicians have little to lose even if they lose their seats.  Many soon find an even more lucrative position in the private lobbying industry.  What they do lose is the ability to wake up in the morning, look in the mirror and say, “I’m important.”  Lose a bit of arrogance, gain a bit of humility.  Not such a bad tradeoff.

The investor who puts his own money at risk, who has skin in the game, as the economist Nassim Taleb calls it, can not afford to NOT step back and take a second look at their investment strategies and allocations.  As we complete another lap, this is a good time to recheck and rebalance.  The 25+% gains in the stock market have probably skewed the allocations of many an individual’s portfolio.  Here’s hoping everyone has a good year!

GDP, Profits, Inflation

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December 22nd, 2013

Merry Christmas!

Last week I reviewed several decades of trends in corporate profits, as well as the 1990 change in measuring inflation that has helped increase corporate profits as a share of GDP.   (For those of you interested in the inflation controversy, here is an article that provides some additional insight.)  This week I’ll look at patterns in the economic growth of this country that sheds some light on recent events and provides some context to understand ongoing trends.

During the 30 years following World War 2, the economy grew at an annual rate of 3.7% after inflation.  Population growth was about 1% per year.  Productivity growth was about 1 – 1.5%.  Government spending, including debt, grew a bit more than 1%.  The chart below shows the compounded annual growth rate.

But I think the story is more clearly told by a different chart constructed from the same data.  The growth rate trend is more easily visible and it is the change in this trend that I will be focusing on.

During the 1970s, an economic trend known as staflation increasingly took hold. This period of high inflation, coupled with slowing growth and growing unemployment, was not thought possible by economists using theories proposed by John Maynard Keynes in the 1930s, during the Great Depression.  In 1974, economist Arthur Laffer first sketched out a theory that tax cuts would stimulate the economy.  As the Federal debt began to rise in the mid to late 1970s, few wanted to take a chance that lower tax rates would produce more revenue for the Federal Government.

The 1980s began with back to back recessions and the highest unemployment since the 1930s Depression. Big spending and tax cuts during the 1980s dramatically increased the federal debt but did little  to spur growth.

During this 13 year period, profit growth slowed to 2.4%.  The myth that the 1980s was a high growth era continues to live in the minds of political pundits.  In a WSJ op-ed on Dec. 18th, Daniel Henninger referred to “the high-growth years of the Reagan presidency.”  Myths live on because they serve a purpose to those who cherish them.  The cardinal rule of politics is “Disregard the Data.”

In 1990, economists at the BLS adopted what is called a hedonic methodology to computing the CPI.  Used by other OECD countries, this supposedly more accurate assessment of the growth of inflation shows a lower growth rate of inflation.  This naturally increases the growth rate of inflation adjusted GDP. (GDP dollars each year are divided by the inflation rate to get the real growth rate.)

The conventional narrative is that the 1990s was an explosive growth period of new technology and growing globalization.  From the beginning of 1990 to the start of 2000, stock market values grew four times.  After the bursting of the internet bubble, 9-11, and the recession of 2001, the economy recovered.  By the mid-2000s, the unemployment rate was less than 5%.  While that may be the conventional narrative, the growth of the economy from 1990 to 2007 was just as slow as the period 1978 – 1989.

Remember that this slow growth would have been even slower if the BLS had not changed their methodology for measuring inflation.  To recap, the 30 year real growth rate of GDP after WW2 was 3.7%.  The following 30 year growth rate was 2.3%.  But that later 30 period is marked by a sharp rise in consumer borrowing.   Without that escalation in borrowing, growth would have been meager.

Families with two incomes borrowed against their homes, drove up the balances on their credit cards and still GDP growth was slow.  Let’s construct a fairy tale, what economists call a counterfactual.  What if the BLS had not changed to this new methodology in 1990?  What would be the growth rate of GDP using an alternate measure of inflation?

The resulting growth pattern is 0% for the 18 year period and is more consistent with the experiences of many workers and families in this economy.  The change in the measurement of inflation has greatly helped mid-size and large size companies.  An understated inflation rate reduces labor costs by reducing cost of living adjustments to salaries and wages.  In addition, companies can borrow at lower rates since many corporate bonds are tied to the inflation rate.  American companies did not engineer this revised methodology of measuring inflation but they have been the largest beneficiaries of the new policy.

In 2008, the financial poop in the popcorn popper began to pop.  In the past 5+ years, we have experienced less than 1% real growth, not enough to keep up with population growth.  Of course, most people are wondering “what growth? It sure doesn’t feel like growth!”

The story may be told more accurately by looking once again at a comparison of inflation adjusted GDP with an alternate version of GDP, one that more realistically reflects inflationary pressures.  This chart shows a decrease of 2% per year.

Did the BLS adopt this methodology under political pressure?  Perhaps.  More likely, it was an alignment of econometric theory with political and corporate interests.  The reduction in published inflation rates did slow the growth of payments to Social Security recipients and reduced Medicare payouts to physicians and hospitals, thus shrinking budget deficits.  The government saves money, corporations make extra money, but – quietly and slowly – families lose money.

Annual cost of living adjustments to Social Security checks have been reduced but the decreased income has forced more seniors to seek assistance through the food stamp program, now called SNAP.  A politically neutral change in the measurement of inflation thus becomes a way for politicians to introduce a means testing component to Social Security income.  Instead of reducing payments based on income, payments are reduced to all recipients and poor seniors are targeted for additional benefits.  Congress has increased eligibility for the food stamp program so that seniors who are dependent on that extra income can receive it in the form of food stamps.  If the BLS had not changed their methodology, seniors would receive appoximately 60% more each month and many wouldn’t need the food stamps in the first place.

With this history in mind, let’s turn to this week’s revisions of GDP and corporate profits for the third quarter ending in September.  The real, or inflation-adjusted, growth of 3rd quarter GDP was raised to a 4.1% annualized growth rate in the third quarter, largely on upward revisions of consumer spending.  Contributing to stronger GDP growth has been a worrisome increase in company inventories, which probably influenced the Federal Reserve’s decision this week to keep any tapering of their QE bond purchases to a minimum.

Corporate profits for the third quarter were revised higher as well.  As a share of GDP, corporate profits continue to reach all time highs.

How likely is it that economists at the BLS will change their methodology to reflect inflationary pressures before we make choices in response to rising prices?  The subject is not easily encapsulated in a sound bite or a short slogan on a placard.  In the 1992 presidential race, independent candidate Ross Pierot was able to use charts to make a point with many voters but few politicians are very good at the easel and unlikely to bring up the subject in the public forum.  Families and workers will continue to suffer and politicians will create more social benefit programs to help those hurt by problems that politicians themselves have either created or failed to address.  Large and mid sized businesses will continue to enjoy the additional slice of pie.