Stocks vs Bonds

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June 2nd, 2013

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Grandpa’s Index

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May 26th, 2013

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

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

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

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

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

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

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

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

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

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

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

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

Bennies From Heaven

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May 19th, 2013

During the past several years, a demographic and economic shift crossed below the zero line.  For decades, Social Security taxes collected exceeded Social Security benefits paid.  The Federal Government “borrowed” this excess and used it for other programs.  Since 2010, there has been nothing to borrow.  The Social Security Administration (SSA) has several sources of revenue, but the bulk of its revenues is what we commonly call the Social Security tax, or FICA.  However, this tax has several components.  The largest portion of the tax – the Old Age and Survivors Insurance tax (OASI) – is to pay out social security benefits and it is this component I wanted to look at.  SSA gives a pie chart of its revenue and benefits paid.

I have shown the latest revisions to the pie chart but it gives you a sense of the revenue and expense components.  A table of SSA income and outgo shows only the total receipts and expenditures.  When we look at the OASI component, we can get a sense of the upcoming political debates and financial pressures.  SS benefits paid are already exceeding OASI tax receipts.  Below is a chart of SSA data showing the surplus and deficit for the past ten years.

On January 1st, the Congress let lapse the 2% reduction in payroll taxes.  In the first quarter of 2013, that has meant an additional $245 billion in revenue to the Treasury. (Source).  Since the money all goes into the same Federal pot, the additional revenue has forestalled the debt limit debate till this fall.

The SSA records other income, including income taxes on the SS benefits paid out.  This is a “pencil” income entry: the IRS keeps track of taxes paid on SS benefits and “transfers” them to the SSA.  For decades, this pencil entry has increased the SS surplus and Congress borrowed it.  The SSA charges interest income to the Federal government and records this pencil income as more money that the Federal government owes the SS trust funds.

The bottom line is that SS is a “pay go” system.  Current taxes pay for current benefits.  When benefits exceed the taxes devoted to pay for those benefits, the money has to come from somewhere.  That “somewhere” is the Federal government, but it can only get those funds from you and I and the companies who pay corporate taxes.  More troubling is the ever increasing percentage of federal tax receipts devoted to paying social benefits of one form or another.  These include, SS, Disability, SSI, TANF, SNAP and a host of other programs.

As people become increasingly dependent on the government for their welfare, they will put increasing pressure on politicians to maintain or increase these benefits.  This political pressure only heats up the political debate over how to pay for these benefits.  At the federal level, benefits have increased by $800 billion over the last ten years.

Including the states and local governments, the increase is over $1 trillion.

Any cuts in calculating benefits are met with a firestorm of protest from those who are, or will, collect those benefits.  Few care about the accuracy of calculating cost of living adjustments to these benefits.  Whatever calculation provides the best benefit becomes the most “accurate” calculation.  The current debate is whether to use the CPI or what is called a Chained CPI.  Over several decades, the CPI gives the most increase in benefits.

40% of the calculation of the CPI is housing cost and the calculation of that cost, called Owner’s Equivalent Rent, has almost tripled in the past thirty years, boosting the CPI.

Census data shows that 2/3rds of the 132 million households in this country own their homes.  Before the housing boom, a primary reason for owning a home was to lock in a monthly payment, avoiding rent increases.  Taxes, upkeep, and energy costs do go up, but the majority of a house expense, the mortage payment, is a fixed cost for many homeowners.  However, the Bureau of Labor Statistics, which compiles the CPI, calculates the housing component of the CPI as though a homeowner was renting from herself.

“according to the National Association of Realtors, between 1983 and 2007 the monthly principal and interest payment required to purchase a median-priced existing home in the United States rose by 79 percent, much less than the rental equivalence increase of 140 percent over that same period.” (BLS Source)

We will continue to have a lively debate over the calculation of the CPI because it influences millions of Social Security checks each month.  We can anticipate that this debate will be at the forefront of the upcoming 2014 elections.  Why?  Because the debate stirs passions on both sides and that is what politicians need – passion.  Passion provokes people to vote.  Passion promotes donations.  Passion ignites political volunteer efforts.

The trend of worsening deficits between SS contributions and the benefits paid will only worsen as we get into the latter half of the decade.  Before the 2010 elections, we were treated to the spectacle of angry old people – without makeup – yelling at politicians to keep their stinkin’ government hands off their Medicare, itself a government program.  In the upcoming years, the debates over Social Security will make those earlier demonstrations seem rather mild.  Old people vote.  Angry old people vote a lot.

Out Of the Tent and Into the Forest

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May 12, 2013
We can take some steps to reduce our susceptibility to adverse events but if our primary aim is to reduce uncertainty as much as possible, our lives suffer in quality and our wallets suffer in quantity.  In our financial lives, we must try to find a balance between risk and reward.  There is a high demand for low risk, high reward investments.  Unfortunately, there is little supply of such investments and the few that are offered are usually scams.

There is a good supply of low risk, low return products. In the past ten years, conservative savers have taken a beating.  There have been only two periods where the interest on one year CDs has exceeded the percentage increase in inflation.

Challenged by low interest rates on CDs, savers have fled the market.

Older people who rely on their savings to generate income continue to search for yield, or the income generated by an investment.  The iShares High Yield Corporate Bond ETF, HYG, and the iShares Dividend Select Index ETF, DVY, have posted strong gains.  As more investors chase yield and drive up prices, the yields correspondingly become lower.   In December 2007, DVY paid out an annualized 4.7% yield on a price of about $53.  In March 2013, the yield was 3.4% on a price of $65 (Source)

Despite the fact that the Federal Reserve has held interest rates at historic lows, the amount of household savings continues to climb.  Some of this is due to an aging population which has more in savings and tends to be more conservative.

The Federal Reserve is essentially kicking people out of the tent and into the forest where the wild animals live.  It’s risky out there in the forest.  How come the banks don’t want our money?  Some people do not realize that a CD or savings account is essentially a loan to the bank.  Through the FDIC, the U.S. government insures most of these loans.  Loan your brother in law money for a  year and you might not get it back.  Loan your bank the money and you are assured that you will get it back.

In the simplified models of banking we learned in grade school, the bank pays us interest for the money we loan it (deposits) and loans that money out to other people at a higher rate of interest.  The difference in the two interest rates is how banks pay their employees and other business costs and make a profit. The reality is much more complex.  A bank does not take a $10 deposit from Mary and loan it to Joe.  The bank takes the $10 deposit from Mary and loans $100 to Joe.  Where did the other $90 come from, you ask?  It is created out of thin air in a process called fractional reserve banking, which allows a bank to leverage the $10 deposit by ten times, in this example.  Because banks are leveraging money, there is a labyrinth of financial metrics of stability to insure that the banks are not taking too much risk.  Some of these metrics include the risk weighting of assets (deposits, loans and securities, for example) and capital asset ratios.

In a 1985 paper by Federal Reserve economists, they note that “There is remarkably little evidence, however, that links the level of capital or the ratio of capital to assets with bank failure rates.”  This paper was written before the S&L crisis of the 1980s.

The financial crisis in 2008 led to a surge of bank failures, peaking at more than 150 in 2010.  In this past year, failures have dropped to a level that can be counted with two hands.

 During the recession, the amount of commercial and industrial loans declined but have risen to nearly the same level as 2008.

From a thirty year perspective, we can see just how severe the decline was.

While loans and interest bearing accounts, or assets, at the largest banks are nearing 2007 levels, assets at small banks have declined.

The banking industry has been consolidating, larger banks eating up the smaller ones.

This past Friday, the Chairman of the Federal Reserve, Ben Bernanke, expressed concern that some of the larger banks are still prone to failure.  The ever increasing size of the big banks has enabled them to have an even greater voice in the halls of Washington.  Bernanke’s remarks hint that he is a proponent of further regulations which would reduce the amount of leverage that banks can use to increase their profits.  Banking industry lobbyists are making the case that if they are required to reduce their leverage, it will hurt the economy by reducing the amount of loans they can make.

The banks are feeling squeezed and they are sure to let lawmakers know.  Their net interest margin, or the spread between what they pay to depositors and what they charge to borrowers, has fallen to pre-recession levels, putting pressure on banks to take more risk to increase their bottom line.

I am reminded of a comment made by Raymond Baer, chairman of Swiss private bank Julius Baer, in 2009 who warned: “The world is creating the final big bubble. In five years’ time, we will pay the true price of this crisis.”  Let’s see: 2009 + 5 = 2014.  Hmmmm….

But we can’t live our lives waiting for the next catastrophe.  We must take some risk, be diversified and be vigilant.  As the stock market reaches new highs with each passing day, more investors will reassess their risk profile.  Some will curse their caution of the past few years and move money from safe but low yielding assets to the market, helping to fuel rising market prices.  The demand for yield creates a feedback loop that actually makes it harder to achieve yield.  If only we could live in a world where they didn’t have these darn feedback loops.

Job Trends

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This past Wednesday the payroll firm ADP released their monthly report of private employment with a rather tepid 119,000, prompting an equally tepid sell off in the market, which lost about .7% by the end of Wednesday.  Although the price move was under 1%, the volume of trading was high.  Was this the end of the 6+ month run up in stock prices?  Was the economy slowing down? 

Came Thursday and a very cheery weekly report of new claims for unemployment and moods brightened.  The market regained the ground lost Wednesday and then some, but on rather low volume.  Standing on the sidewalks of Wall Street, traders repeatedly opened up their umbrellas, then closed their umbrellas, put on their sunglasses, then took off their sunglasses. 

[And now a pause from our sponsor.  A trader tells his doctor he’s anxious and asks for a prescription.  The doctor gives him some advice: “stop looking at the market so much.”]

Back to our story. Friday morning dawned, the heavens opened and the sun shone.  The Bureau of Labor Statistics issued its monthly weather – er, labor – report and traders threw down their umbrellas and put on their shades.  Huzzahs rang throughout the canyons of lower Manhattan.  Some slacker dudes cooly tossed their stocking caps in the air, while men dressed in crisp suits wished that they too had hats.

The labor report is released an hour before the market opens at 9:30 AM.  The market opened up 1%, drifted higher but ended the day at about the same price as it opened.  So, huh? We’ll get to the huh part later.

The reported job gains of 165,000 for April were just slightly above the 150,000 jobs consensus estimate and the replacement rate needed to keep up with population growth.  Spurring the initial enthusiasm was relief that job gains were not as weak as some had feared (100,000 or so) and the revisions to previous months job gains, adding 114,000 to February and March’s job gains. But February’s revision from strong to very strong job growth provokes some head scratching.

What good things happened in February to inspire such strong job growth?  Hmmmm….here’s a table of the past 12 months data from the establishment survey. 

There was a lot to like in this month’s report.  The unemployment rate dropped a tenth of a percent to 7.5%.  We just passed employment levels of February 2006 – yep, it’s been a slow recovery.

To get the big picture, let’s look at the last forty years.

From this perspective, we can see just how deep the job losses have been since 2008.  From this rather sobering point of view, let’s look at some of the positives from this month’s report.

Professional and Business services added a whopping 73,000 jobs this month, far above the 49,000 average of the past 12 months.  Restaurant and bar jobs were up 50% above their 12 month average, showing gains of 38,000. Temp help posted strong gains of 31,000, its highest of the past year.

Construction jobs showed little change, a surprise at this time of year.  Construction has been averaging gains of 27,000 a month for the past six months. This past week, I spoke to a woman at a Denver branch of a national temp agency.  This branch focuses on manual labor, mostly for the construction industry.  She confirmed that business has been brisk but most of the calls are for road repair and rebuilding and some commercial construction.  When I asked her about calls for helpers and job site clean up for residential construction, she said it had been sporadic.

Job gains in health care were somewhat below their 12 month average of 24,000 but any slack in health care was made up by strong growth in retail.  Government jobs continue to contract slightly each month.

Underlying the positive aspects of the job market are some anemic indicators.  The average of weekly hours dropped .2 hour to 34.4; the average has lost .1 hr in the past year.  The ranks of the long term unemployed dropped by 258,000 workers but the number of people working part time who would like a full time job jumped 278,000.  The ranks of the “involuntary” part timers – those who would like a full time job but can’t find one – is about 5 million.  Here’s a surprise. Today’s levels of involuntary part timers as a percent of total employment is only the third highest in the past fifty years; the late 1950s and the early 1980s were worse.  But this only means that the ranks of part timers have fallen mercifully from nose bleed levels.

The diffusion index is showing some weakness; this is the share of employers who are reporting job gains vs. job losses, with a value of 50 being neutral.  Manufacturing employers are already reporting more job losses than gains.  Overall, employers are slowly drifting toward neutral in their hiring for the past several months.

The core work force aged 25 – 54 is still limping along.

Even more disturbing is the participation rate of this core work force.

Shortly after the market opened on Friday came the report on factory orders and it muted some of the enthusiasm generated by the labor report.  New orders for durable goods, a barometer of business confidence, fell 5.8%, confirming the slowdown in manufacturing.  Employment in this sector has been flat the past two months.

While the monthly labor report makes headlines, it is not a leading indicator. Professional investors watch the squiggles of daily and weekly economic and news reports, trying to anticipate developing trends.  Many of us have neither the time or inclination.  For the long term “retail” investor, continuing job gains are positive, particularly if they are at or above the replacement level of 150,000. The long term investor is more concerned about significant losses in their retirement portfolio.

What if an investor lightened up on their stock holdings shortly after the BLS reported the first job losses?   I looked back at historical employment releases ; I wanted to use the original releases, not the revised figures of later months, to capture the sentiment at the time.  We must make decisions in the present.  We don’t have the luxury of going into the future, looking at data revisions, then coming back to the present and making our investing decisions.  That would be a good time machine, wouldn’t it?  Here’s an example of how employment data can be reported initially and later revised.  The graph shows the later revisions.

In early August 2000, the BLS reported job losses of 108,000 in July.  But this was due to the layoff of 290,000 temporary Census workers.  Do census workers really count in our strategy?  Let’s say not.  We wait till next month’s report, which shows a loss of 105,000. Should we use our strategy?  Again, those darn census workers.  Without them, there would have been a small gain in jobs.  So we don’t sell in September.  Then, in the beginning of October comes the news of strong job gains in September, followed by more job gains in October, November and December.  Good thing we didn’t sell at that first downturn, we tell ourselves.  Meanwhile the stock market has been slipping and sliding since that first negative job report.  Eventually, it will fall about 40%.

Wow, we should have taken that first signal and avoided all those losses!  But if our strategy is to then buy back in when there are positive job gains reported, then we could be in and out of the market like a yo-yo in years when the economy is struggling to find direction or strength. We were looking for a more even tempered strategy.

To emphasize how the revisions in employment can mean the difference between job gains and job losses,  take a look at the chart below.  These are the revised figures.  I have noted months where the initial monthly labor report showed positive job gains but were later revised to job losses.  Some of these revisions can happen months later.

From the first reported job losses in mid 2000, more than three years passed before job gains would exceed the “replacement” level of 150,000.  That is the number of jobs needed for the growth in the labor force. While many, myself included, have blamed the knucklehead politicans who enacted the Bush tax cuts in 2003, it is understandable that they were beginning to wonder if the labor market would ever turn around.  Three years of job losses is a long time.

Let’s move on to the last decline.  The market had already begun its decline before the first job losses were announced in early February 2008.

In this past recession, the job losses were severe but the first job increases were announced about two years after the first decrease, in early April 2010.  When reviewing the historical BLS releases, this really surprised me that the 2000 – 2003 labor downturn lasted longer than this last one, though it was much less severe.  By the time the first job increases had been announced in 2010, the market had already been on an upswing for a year. 

In short, the headline monthly job gains don’t appear to offer a long term casual investor any particular insight or advantage.  In a work force of 143 million, a hundred thousand jobs can be a slip of the pencil.  But reported job gains of 150,000 or more do offer an investing hint – quit worrying about your retirement portfolio for at least another month.  Go fishin’, play with the kids, hang out with friends.

A labor indicator that seems to be more reliable is the year over year percent change in the unemployment rate, which I have discussed in earlier blogs.

Although the unemployment rate – or percentage – is derived from the count of total employment, the revisions are much smaller.  Secondly, we are using a percentage gain in that percentage, further reducing swings.

The stock market continues to post new highs in anticipation of good corporate profits in the latter part of the year.  What is a bit troublesome is the number of revenue shortfalls reported by companies in the first quarter.  Reducing expenses and boosting productivity can only get a company so far.  Profit growth becomes harder and harder to come by without revenue growth.

The Madness of Methodology

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April 28th, 2013

A fight between economists is not as exciting as a dinosaur smackdown (Jurassic Park), but the controversy can be as damaging.  Politicians and pundits love to trot out those economic studies and theories which justify their actions or political point of view.  In 2009, two economists Carmen Reinhart and Kenneth Rogoff (now affectionately known as RR), published a study which showed that a country’s GDP growth becomes slightly negative when its debt grows above 90% of its GDP.  The study was cited by many politicians and pundits in Europe and the US, including VP candidate Paul Ryan, as they proposed various forms of austerity to curb the explosive growth of national debt.

Here’s what the debt to GDP ratio looked like 1940 – 1960

In the years 1947 – 1959, we had an annualized growth rate of 3.6% but a strong component of this growth was our strategic advantage in exports, being the manufacturing capital of the world after much of the production capacity of the developed world was destroyed in WW2.

Here’s what it looks like now; the same spike of debt.

But we have lost the advantage of being the leading manufacturer.

Given the assignment of replicating an existing economic study, Thomas Herndon, a PhD candidate at UMass, discovered some glaring spreadsheet errors in the original data set compiled by RR.  You can read an Alternet article summarizing the details here.

Some quick background.  There are two categories of economic policies.  Fiscal policy encompasses taxing and spending measures by a government.  Monetary policy is conducted by a country’s central bank and are targeted at the supply of money and interest rates.  Economists argue over which policy is more effective in a given circumstance.  Each of us goes about our daily lives under the influence of both fiscal and monetary policy. 

During the 1930s depression, the economist John Maynard Keynes proposed that governments borrow and spend money during recessions to make up for the lack of aggregate demand in the economy.  After the economy recovered, governments would then raise taxes to pay back the borrowed money.  Another leading economist, James Buchanan, predicted that nations who followed Keynes’ ideas would have permanent deficits.  While Keynes’ economic model was elegant, Buchanan argued that there was no incentive for a politician to raise taxes.

In 1963, with the publication of A Monetary History of the U.S., economists Milton Friedman and Anna Schwartz argued that the Depression had been largely a result of failed monetary policy by central banks.  During the 1970s, when government fiscal policies of increasing intervention in the economy failed to ingnite growth or curb inflation, Keynes’ policies fell into disfavor. 

The age old debate about the effectiveness of fiscal and monetary policy never dies. The recession that began in 2008 revived Keynes’ ideas.  In the late 1990s and early 2000s, economist Paul Krugman and Federal Reserve chairman Ben Bernanke were proponents of monetary solutions for Japan’s moribund economy.  As the world economy imploded in 2008, both men changed course and became advocates for fiscal policy as the most effective solution for the country’s economic woes.

In a recently published paper UMass professors Michael Ash and Robert Pollin (Herndon’s advisors), explained their methodology and took RR to task for their lack of follow up on incomplete data analysis after several years.  What they had missed was a follow up paper by RR in February 2011 and another published in the summer of 2012.  In these papers, RR modified their initial findings, saying that GDP growth slowed but did not necessarily turn negative.

In a WSJ blog post , RR answered the critique from the UMass Professors.  They admitted their spreadsheet error but reaffirmed their other assumptions in the study and their amended conclusions.

Paul Krugman weighed in (or waded in?), voicing his disappointment with RR’s methodology and their conclusion.  Krugman does make a point oft repeated in the social studies: correlation is not causation.  Does high debt cause slow GDP growth?  Or, does slow GDP growth cause high debt?  Or can we say that there is some indication that they accompany each other?

At Econbrowser, U. Cal professor James Hamilton, reviewed RR’s methodology and Ash and Pollin’s critique. (Link)  To which, Professors Ash and Pollin responded with some good points.

Ash and Pollin have made the original data available.  Some have accused RR of purposefully leaving five countries out of their data, saying that these five countries would have weakened or invalidated their findings.  The Excel file shows that this was a simple – but dumb – mistake, not some nefarious plan by RR.  The countries left out are on the last five worksheets which are arranged in alphabetical order.  What surprises many is that two prominent economists could publish a paper based on work that had so little verification before publication. 

What I question is RR’s decision to include many of the smaller countries at all in their analysis.  Finland and Ireland each have less than 2% of the GDP of the U.S. 

What I do hope is that this controversy will spur more analysis of the relationship between a nation’s debt load and its economic growth.  What I am afraid of is that this will discourage researchers from sharing their working data.  Reinhart and Rogoff are to be highly commended for doing so.

Readin’, Writin’ and Arithmetic

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April 21, 2013

In any lively discussion of public education – its effectiveness, the spending and taxes required – some people bring out their swords, others their shields, and some are armed with both.  Armed only with a crayon, I will examine some of these trends.

Let’s look first at higher education spending.  The National Center for Education Statistics (NCES) at the U.S. Dept of Education reported that real – that is, inflation adjusted – spending per pupil had increased 233% in the past 31 years, an annual growth rate in real dollars of 2.8%.

NCES reports a slower spending growth in K-12 education – 185% in 28 years, or an annual growth rate of 2.2%.

But the annual growth rate during the past decade, 1999 – 2009,  has slowed to just under 2%.

 

When we zoom in on the spending growth during the 1960s and 1970s, we see a real growth rate of 3.6%

What we see in the per pupil data is a gradual slowing down of the real growth rate of spending.  Those who claim that there have been spending cuts in education have not looked at the data.  There have been no cuts in real spending, only reductions in the rate of growth. 

Some decry “austerity” policies recently undertaken in some European countries – the U.K. is an example – claiming that a country pursuing these policies has cut spending.  When we look at the spending data, we find that there have been no decreases in real spending, only in the growth of spending.  This misconception is common and results from a comparison of what we expect and what happens. 

If we have usually received a wage or salary increase of 3% each year, we come to expect a 3% increase.  If we get a 2% increase this year, it is 33% less than our expections and feels like a cut.  A retiree who has become accustomed to an annual 8% return on her investments, may feel that she has lost money if her investments only gain 5% this year.  It does no good to mention that she has really not lost anything.

Let’s get up in our hot air balloons and travel to California, where the size of its economy puts the state above many  countries.  California has often been the leading edge of trends that spread to the other states.  Ed-Data reports that per pupil spending has flattened since the recession started in 2008.  In real dollars, there has been NO GROWTH in per pupil spending in the past ten years.

Another complaint from teachers is that money is increasingly being spent on administrative costs, not teaching.  In California, teachers still command the lion’s share of spending  – more than 60%.

The proportion of teacher spending has remained relatively constant – above 60% – in the past ten years.

What has been growing?  On a per pupil basis, “Services and Other Operating Expenses” have grown 4% per year, or 1.8% real annual growth,  above the 2.2% annual growth in inflation.  Administration expenses have grown at the same rate of inflation so that real growth has been flat.  However, spending on teacher salaries has declined in real money at an annual rate of .7%.  However, their benefits expenses have grown 1.4% annually in real dollars.  Again, most people do not “feel” the cost of a benefit increase.  The bottom line to most of us is what we bring home.  It does not pay to tell a K-12 teacher that they are actually receiving a slight increase in real total compensation.

In California, as in many states, property taxes are a major component of revenues for K-12 education.  Over the past nine years, revenues from property taxes for education have declined 3% annually in real money.  For each student, there is $500 less money available from property taxes than it would have been if property tax revenues had kept up with inflation.  As a percent of total revenue for K-12 education, property taxes make up a little over 60%.

In 2011-2012, property tax revenues essentially paid teacher salaries.  Ten years ago, the percentage of revenues from property taxes was about 6% higher.

Other State revenues have had to make up for the shortfall in property taxes; the gap is about $1000 per student.  The problem would be even worse if it were not for the slight decline in students for the past 8 years.

While California faces challenges from declining property tax revenues, what about the rest of the country?  Let’s climb back in our data balloon and look at student enrollment throughout the country.  The NCES reports the same slight decline in K-12 enrollment.  However, they estimate a total 6% growth in K-12 enrollment in this decade.

As K-12 enrollment grew by a little more than 1 million in the 2000s, post secondary education enrollment grew by 6 million, or 37%, to over 21 million. (Source http://nces.ed.gov/fastfacts/display.asp?id=98).  The growth rate in older students, those aged 25+ is even faster, rising 42%. In this decade, “NCES projects a rise of 11 percent in enrollments of students under 25, and a rise of 20 percent in enrollments of students 25 and over.”

 The ratio of K-12 students to post-12 students was 28% in 2000; a decade later, it was 38%.  While K-12 enrollment is projected to increase for the rest of the decade, post-12 enrollment is estimated to be much faster.  How do these students pay for college?  The most recent data from NCES is at the start of the recession; I would guess that the need for aid has grown mightily since then. 

Put all of this in the blender: a declining work force (see my blog two weeks ago), a generational swelling of older people retiring, recovering but not robust state and local revenues, and more demand for K-12 AND post secondary education services.  How will politicians react in the midst of so many competing demands for money?

The increasing pressures for money from different segments of the population puts us in the precarious position that we can not afford to go into a recession, an impossible situation since the normal business cycle includes a recession every 7 – 10 years.  Europe is already in recession; China’s growth is still robust but slowing; on Friday, India announced a growth rate below 5%, the weakest in four years; in a hopeful sign, Brazil, the economic powerhouse of South America, is projecting GDP growth over 3%, rising up from an anemic 2.7% growth of the past 5 years.  (World Bank source)

Slackening demand around the world presents challenges for the U.S. economy, problems that a spastic Congress will only worsen. Y’all be careful out there…

Things That Spring

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April 14th, 2013

Across the land, springtime wakens the trees and flowers, birds chirp and squirrels chatter.  From the buildings where the humans live comes the wailing and gnashing of teeth as many procrastinators spend this last weekend before the tax deadline in a spring ritual of angst.  The lost W-2 form is finally found beneath the Netflix DVD that has lain casually on the bookcase, waiting to be watched.  The 1099DIV form is found beneath a birthday card that was never sent.

Lay aside your problems; let’s climb inside the hot air balloon and look at the big picture.  A few weeks ago, economic growth for the fourth quarter of 2012 was revised marginally higher into positive territory, but dropping from the annualized growth rate of 3.1% in the 3rd quarter of 2012.  Let’s look at GDP from a per person basis since WW2.  Until the recession hit in late 2007, economic growth had consistently outpaced population growth.  Then POOF! went the economy and blew away a big gap in GDP.

Let’s zoom in on the past ten years to see the effect.  On a per person basis, the gap is $5,000 of spending that simply didn’t get spent.

Call it the GDP dust bowl of the 2000s, similar to the dust bowl of the 1930s when the wind blew the top soil from the prairie of the Oklahoma panhandle and forced many families from their farms.  In this case, the wind blew away a lot of jobs and chunks of home equity.

Policy makers in Washington want to close that $5000 per person gap.  If they could write a law forcing everyone to spend that $5000, they would.  Instead, they keep giving away money in unemployment benefits, food stamps, disability benefits, crop subsidies – all to keep people from not spending even less and making the problem worse.

Retail sales account for about 1/3rd of the total economy.  Including automobile sales and parts, consumers are still below twenty year averages.

This past Friday, the monthly report on retail sales showed little change from the past month.  When we look at per person real retail and food sales and take out automotive sales we get a feel for core sales, those that we make on a frequent basis.  Once again, we see the same gap that we saw in GDP.  Since mid-2009, this core consumer spending has grown 2.3% annually, above the 1.8% annual growth trend from 1992 through 2006, but it still down $2000 a year from what we would have spent if we had stayed on the same trend line before this past recession hit.

To make it a bit clearer, let’s look again at that chart and compare the 15 year annual growth rate from 1992 to the longer 21 year growth rate.  It has fallen from 1.8% to 1.1% annual growth.

GDP measures spending; let’s look at Gross Domestic Income, or GDI.  A fundamental principles of economics is that it takes money to spend money.  A six year old asks a parent “Why can’t we just go out and get more money?” to which the parent replies “Whaddya think money grows on trees?!”  End of Chapter One in the Parent’s Guide to Economics.

When we compare the country’s income to spending, we find that a dip in income below production precedes recessions.

After the 2008 – 2009 crash and recovery in national income and spending, both are limping along.

A few weeks ago came the monthly New Orders, an indication of business confidence.  As regular readers know, I have been watching this declining trend since September of last year, when the percent change in New Orders was negative.  The recent rise has been a welcome sign of growing confidence but new orders fell 2.7% in February and now hover around the zero growth line. 

On a quarterly basis, the year over year (y-o-y) percent change is still firmly in negative territory, meaning that businesses are not putting up more money to invest in new equipment.  Why?  Because they are still not sure about consumer spending. The six month run up in the SP500 stock index might lead a casual observer to think that the economy and companies are gearing up.  New Orders indicates that there is much more caution out there than the stock index would indicate.

This past Friday, business’ caution to commit to new investment was only reinforced when the latest Consumer Sentiment index was released.  After climbing the past few months, confidence is sinking again.  Maybe it’s the extra 2% coming out of paychecks since January 1st.  Whatever it is, it doesn’t inspire many business owners to put a lot of money into expanding their production.

When the stock market is trading on hope, it looks six months ahead.  The recent run up is hoping for double digit profit growth in the second half of this year.  When the market trades on fear, it looks ahead about 2 seconds, faster than the normal investor can or should react.  Let me get out my broken record for another spin, cue the needle and play that same old song “Diversify.”

P.S. For those of you who are more active investors, check the latest post from Economic Pic in my blog link list on the right.  It shows the past 40 year returns for a strategy of selling the SP500 index in May and buying the long term government / credit index.  The iShares ETF that tracks this index is ITLB.  A comparable ETF from Vanguard is BLV.

Labor Participation Rate

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April 6th, 2013

First I will look at a rather disappointing March Labor Report, released this past Friday.  Then I will zoom up and look at the big picture and some disturbing trends.  The net job gains this past month were 88,000, about half of the 169,000 average gains of the past year.  Remember that it takes about 150,000 job gains each month just to keep up with population growth.  Although the headline unemployment rate dropped .1% to 7.6%, it was because almost half a million people dropped out of the work force, meaning that they had stopped looking for a job in the past month.

Mitigating the meager job gains were revisions to previous months gains as more survey data was returned by employers. January’s job gains were revised from +119,000 to +148,000, and February’s gains were bumped upward from +236,000 to +268,000.  The two revisions added up to an additional 61,000 jobs; adding that to March’s gain of 88,000 gets close to the minimum gains needed of 150,000. The initial reaction of the market was a swift loss at Friday’s market opening of almost 200 points on the Dow.  By the end of the day, the market had regained much of the ground it lost, ending down about 40 points.

The average hours worked increased again to 34.6, a hopeful sign, but earnings saw no change.

Construction continued to show gains; the media’s attention to this area of employment probably gives the casual reader the impression that contruction jobs are a larger part of the work force than they actually are.

Compare that to Professional and Business Services, which has showed consistently strong gains and low unemployment.

Employment in the health care field continues to grow.  As a percent of total employment, health care continues to reach new heights, although its growth has moderated.  Taking care of the sick may be a sign of a compassionate society, but it consumes resources, prompting the question: what is the upper limit?  One in nine workers now work in health care.  Twenty years ago, the ratio was one in twelve. 

Over the past twenty years, the employment market has shifted markedly away from producing goods.  As a share of total employment, about 1 in 7 workers produces goods.  Just ten years ago, the ratio was 1 in 6.

What jobs did those workers find?  Serving food and drink to the ever growing share of people in Professional and Business Services.

The core work force, those aged 25 – 54, shows no growth over the past year.  I use the words “work force” to include only the employed.  “Labor force” includes both the employed and unemployed.  More on that in a bit.

I have written before about the year over year (y-o-y) percent change in the headline unemployment rate, or U-3 rate, and that past recessions usually follow when this change goes above 0.  The unemployment rate has benefitted remarkably from the number of people who continue to drop out and are no longer counted as unemployed.  Because of the drop outs the percent change in the unemployment rate is still in good territory.

A secondary indicator may be the y-o-y percent gain in the employed.  The long term average is 1.5%.  When the percent gain falls below that, recession soon follows.  The percent gain just fell below the long term 1.5% average.

Let’s zoom out to the past forty years to see how this percent gain in employment has preceded past recessions.  The exception was in 1973-74 when the Arab oil embargo created a sudden and deep recession in the country.

There was a decline in the number of people who dropped out but had been searching for work (but not in the past month) and were available to work.

The long term trend of those not in the labor force continues to reach new heights.  As a percent of the population, it  keeps climbing at an alarming rate.

Older workers are retiring, either voluntarily or involuntarily, at the rate of 800,000 a year.

Which brings us to several sometimes confusing concepts, the Civilian Labor Force (CLF), the Participation Rate, and other metrics.  The Civilian Labor Force is those people aged 16 and over who are either employed or unemployed.  To be counted as unemployed, a person is not working but has searched for work in the past month.  The unemployment rate is simply the percentage of unemployed in the Civilian Labor Force, which now totals about 155 million.  An unemployment rate of 7.6% means that about 12 million people are counted as unemployed. 

Then there is the Civilian Labor Force Participation Rate, or simply the Participation Rate, which is the percentage of the Labor Force to what the BLS calls the Civilian Non-Institutional Population (CNP).  Don’t go to sleep on me.  The CNP is those people who are aged 16 or more and who are not in prison or the military. 

So, the Participation Rate (PR) is the number of people who ARE working as a percent of people who CAN legally work; i.e. who are over 16 and not in some institutional setting that prevents them from working or finding work.


Let me give you some numbers and a pie chart.

The total population of the U.S. is estimated at 313 million; the CNP is estimated at 245 million.  The difference between those two figures are mostly children under 16 and people in prison and the military.  Here’s how the Labor Force compares with those not in the labor force and children under 16.

Why does the the Participation Rate (PR) matter?  As it declines, workers have to support more of those who are not working.  Many seniors feel that they “paid into the system” but the “system” – yes, your elected representatives in Congress – spent the additional money paid into the system over the past thirty years.  Social Security is a “Pay as you Go” system meaning that existing workers must somehow pay back into the system to pay benefits for those who retire.  Pay back = higher taxes. As the percentage of the population who works declines, taxes must rise or benefits decrease regardless of who paid into the system. 

This past month the BLS estimated a further decline of .2% to a level of 63.3%.  For comparison, Canada has a PR of 66.6%. 

Part of the decline is a natural demographic change as the population ages.   So how much has the aging of the population contributed to the decline in the PR?  What is the PR for those of working age 16 – 64?  Oddly enough, the time series figures are not easy to come by.  But before we get to that, let’s get to the surprises.

Since 2010, the older labor force, those aged 65+, has grown by 1.2 million. 

In 20 years, the participation rate among seniors has risen 50%, from 11.8% in 1990 to 17.4% in 2010.  The BLS projects that it will rise to 22.6% by 2020, a doubling in thirty years.  Seniors will continue to compete for jobs with the working age population.

Meanwhile, the participation rate of the core work force, those aged 25 – 54, is on a steady decline.

Now comes the biggest surprise, the decline in the working age Participation Rate.  To get the time series, I had to add a number of series together and take some population estimates by the Census Bureau.  Changing demographic shifts and 2010 census revisions make the series not entirely accurate but does give a good representation of the approximate 6% decline.

Let’s look at the last five years for the overall Participation Rate, which has declined about 5%. 

The aging of the population is contributing maybe 20% to the overall decline.  The bulk of the decline is a deterioration of the working age labor force.  Some are going back to school, some have given up looking for a job recently.  Many younger workers are finding it difficult to find a job. The Consumer Credit report released Friday shows another surge in student loans.  The FinAid student debt clock shows that student loans now exceed a trillion dollars. I have the sinking feeling that this will end badly. The participation rate for those aged 20 – 24 has declined about 7% and is now slightly less than the rate for all working ages. 

Payments under the Social Security Disability program, or SSDI, took about 10% of Social Security taxes in 1984.  They now consume 20% of SS taxes and are becoming an increasing burden on the Social Security program even as the boomers begin to retire.  The ranks of the disabled have grown more than 10% in the past three years.

A declining percentage of the population working to pay for an increasing number of benefits – this economic tension is sure to produce social and political conflict.  Many of us probably hold the vague hope that it will all work out somehow.  Some think that politicians in Washington will figure it out despite the fact that the solutions that Congress comes up with to most problems only exacerbate the problem or shift the problem to another area.

On the other hand, the baseball season is still young and anything is possible, right? 

Home Sweet Home

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March 31st, 2013

From its catatonic state the housing market continues to make headlines.  On Tuesday came a somewhat disappointing report on new home sales for February; at 411,000 it was a bit below expectations of 425,000.   A real estate saleswoman told me this week that it’s now a seller’s market in Denver.  I presume that means that buyers are now having to offer the asking price or above when submitting a sales contract to a seller.

For a long term perspective, let’s zoom out fifty years.  Home sales are at past recession bottoms BUT they are better than last year and the year before and the housing and labor markets are hoping.

Will the patient stir, starting to rise, only to fall back on the bed?  PUH-LEEZ DON’T!

Housing Starts, which include multi-family dwellings, are on an upswing but are also coming from a deep trough.

What is more telling for the labor market is the ratio of home sales to housing starts, which continues to decline as more and more multi-unit apartment buildings and condos are being built.

Construction of multi-unit dwellings takes less labor per family unit and the type of construction is often skewed to a different kind of labor force than the construction of single family homes.  There is more steel, concrete and masonry work in multi-unit construction, employing trade skills unfamiliar to some in single family residential construction.  This shifting emphasis of skills in the work force may damper growth in the construction labor market.

Let’s go up in our hot air balloons and take a gander at home valuation for the past 130 years.  The Case-Shiller Home Price index surveys home prices throughout the nation and adjusts for inflation.  The homes of today offer more than the homes of 100 years ago, both in convenience, comfort and safety.  However, the index is approaching an upper range that may be less attractive to potential buyers.

Let’s look at housing evaluations from an affordability perspective.  The National Association of Realtors offers an affordability index based on a composite of mortgages.  I prefer a different measure, one that is based on disposable income – income after taxes.  For many of us, buying a house is the biggest purchase of our lives.  Before we make such a big commitment, we need to have some savings (except during the housing boom) to make a down payment, and we need to feel some certainty about our future income.  Mortgage payments will probably take the largest bite out of our income.  

When we look at a long term history of the growth of the home price index (purchases only) and the growth of inflation adjusted disposable income, they track each other closely – until the housing boom really took off in 2000.  Below is a graph of the past 20+ years, showing the relationship between the two.

 

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.