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Plight of the Fed Model

A very common refrain among stock market bulls these days – and an objection some made to my remarks yesterday that markets are still not making sense – is that the low level of interest rates warrants a high multiple, since future earnings are being discounted at a lower interest rate.

My usual response, and the response from far more educated people than me, like Cliff Asness who published “Fight the Fed Model” back in 2003, is that low interest rates explain high multiples, but they do not justify high multiples. High multiples have always historically been followed – whether explained by low interest rates or not – by poor returns, so it does no good to say “multiples are high because rates are low.” Either way, when multiples are high you are supposed to disinvest.

But I thought it would also be useful, for people who are not as familiar with the argument and only familiar with the sound bite, to see the actual data behind the proposition. So, below, I have a chart of year-end Shiller P/E ratios, since 1900, plotted against year-end 10-year nominal interest rates.

nomvsshiller

Note that it is generally true that lower nominal interest rates are associated with higher multiples, although it is far more clear that higher nominal interest rates are associated with lower multiples, whether we are talking about the long tail to the right (obviously from the early 1980s) or the smaller tail in the middle that dates from around 1920 (when 5% was thought to be a pretty high interest rate). But, either way, the current multiples represent high valuations whether you compare them to high-rate periods or low-rate periods. The exception is clearly from the late 1990s, when the long downtrend in interest rates helped spark a bubble, and incidentally spurred the first widespread discussion/excuse of the so-called “Fed model.” If you take out that bubble, and you take out the 1980s high-rates tail, then there is left just a cloud of points although there does seem to be some mild slope to it from lower-right to upper-left.

But in short, the data is hardly crystal clear in suggesting that low interest rates can explain these multiples, never mind justify them.

More interesting is what you get if you compare P/E ratios to real rates. Because equities are real assets, you should technically use a real discount rate. Since real economic growth in earnings should be reflected in higher real interest rates generally, only the incremental real growth in earnings should be discounted into higher values today. This eliminates, in other words, some of the ‘money illusion’ aspect of the behavior of equity multiples.

I haven’t seen a chart like this before, probably because the history of real interest rates in the U.S. only dates to 1997. However, using a model developed by Enduring Investments (and used as part of one of our investment strategies), we can translate those historical nominal rates into the real rates we would have expected to see, and that allows us to produce this chart of year-end Shiller P/E ratios, since 1900, plotted against year-end 10-year real interest rates – using Enduring’s model until 1997, and actual 10-year real interest rates thereafter.

realvsshiller

I find this picture much more interesting, because there seems to be almost no directionality to it at all. The ‘tail’ at upper right comes from the late 1990s, when again we had the equity bubble but we also had real rates that were higher than at equilibrium since the Treasury’s TIPS program was still new and TIPS were very cheap. But other than that tail, there is simply no trend. The r-squared is 0.02 and the slope of the regression line is not statistically different from zero.

And, in that context, we can again see more clearly that the current point is simply at the high end of the cloud of historical points. The low level of real interest rates – actually quite a bit higher than they were last year – is of no help whatsoever.

None of that should be particularly surprising, except for the buy-and-hope crowd. But I thought it constructive to show the charts for your amusement and/or edification.

Awareness of Inflation, But No Fear Yet

June 24, 2014 1 comment

Suddenly, there is a bunch of talk about inflation. From analysts like Grant Williams to media outlets like MarketWatch  and the Wall Street Journal (to be sure, the financial media still tell us not to worry about inflation and keep on buying ‘dem stocks, such as Barron’s argues here), and even Wall Street economists like those from Soc Gen and Deutsche Bank…just two name two of many Johnny-come-latelys.

It is a little surprising how rapidly the articles about possibly higher inflation started showing up in the media after we had a bottoming in the core measures. Sure, it was easy to project the bottoming in those core measures if you were paying attention to the base effects and noticing that the measures of central tendency that are more immune to those base effects never decelerated much (see median CPI), but still somehow a lot of people were taken by surprise if the uptick in media stories is any indication.

I actually have an offbeat read of that phenomenon, though. I think that many of these analysts, media outlets, and economists just want to have some record of being on the inflation story at a time they consider early. Interestingly enough, while there is no doubt that the volume of inflation coverage is up in the days since the CPI report, there is still no general alarm. The chart below from Google Trends shows the relative trend in the search term “rising inflation.” It has shown absolutely nothing since the early days of extraordinary central bank intervention.

risinginflationsearch

Now, I don’t really care very much when the fear of inflation broadens. It is the phenomenon of inflation, not the fear of it, which causes the most damage to society. However, there is no doubt that the fear of inflation definitely could cause damage to markets much sooner than inflation itself can. The concern has been rising in narrow pockets of the markets where inflation itself is actually traded, but because we trade headline inflation the information has been obscured. The chart below (source: Enduring Investments) shows the 1-year headline inflation swap, in black, which has risen from about 1.4% to 2.2% since November. But the green line shows the implied core inflation extracted from those swap quotes, and that line has risen from 1.2% in December to 2.6% or so now. That is far more significant – 2.6% core inflation over the next year would mean core PCE would exceed 2% by next spring. This is a very reasonable expectation, but as I said it is still only a narrow part of the market that is willing to bet that way.

coresincedec

If I was long equities – which I am not, as our four-asset-class model currently has only a 7.4% weight in stocks – then I would keep an eye on the search terms and for other anecdotal evidence that inflation fears are starting to actually rise among investors, rather than just being the probably-cynical musings of people who don’t want to be seen as having missed the signs (even if they don’t really believe it).

The Boredom Always Ends

After fairly boring trading through the first half of the month, the equity market has shot to new highs over the last few sessions. Could it be mere boredom on the part of investors, who are seeking more excitement?

Stocks have been expensive for a while, with Shiller P/Es near 25, yet the battle cry among bulls has been “but look, the trailing P/E is still low.” Although the trailing P/E recently has incorporated earnings that represented unusually high margins (see chart, source Bloomberg), the “see no evil” crowd brushed that complaint aside. But now, the trailing P/E ratio of the S&P 500 is at 17.6, and at 18.7 before the write-off of “extraordinary items” (which, while extraordinary for any given company in a given year, are not extraordinary for the index of a whole, which always has some of these write-offs).

marginsSo it isn’t as if the equity market is now rising because earnings have been rising and prices are just catching up. The trailing P/E is now at a level slightly higher than it was prior to the 2007 top, and on par with the levels of the Go-Go Sixties prior to the malaise of the 1970s (see chart, source Bloomberg). Let us not forget that earnings quality isn’t what it once was, either. And again: I am not a fan of a 1-year trailing P/E; I am merely pointing out that even this bullish argument is going away.

histpespxTo be sure, trailing P/Es aren’t at the pre-crash levels of 1987 or 1999 – but, again, let us recall that margins are at cyclical highs, so that if we look at the S&P price/sales ratio, we again get a disturbing view that has equity valuations higher than at any time other than the 1999 bubble run-up. (See chart, source Bloomberg – note that Bloomberg history for this series only goes back to 1990.)

pricesales

Now, some observers will draw exaggerated offense to the notion that stocks might be priced for somewhat poor forward returns, and insist that the recent rally in bonds means that the ratio of the “Earnings yield” to bond yields is merely being maintained. Aside from the fact that this “Fed model” is explanatory rather than predictive (that is, it helps explain why prices are high, while not suggesting they will remain high…and indeed, rather suggesting the opposite as future returns are inversely correlated with the P/E of the starting point of the holding period), we also can’t give credit for the equity rally to the bond market rally this year from 3% 10-year yields to 2.50% yields without simultaneously asking why investors didn’t sell stocks when yields rose from 1.70% to 3% last year.

Admittedly, I was probably saying roughly the same thing at this point last year. Sour grapes? No, it just concerns the question of investing rules versus trading rules. In other words: I’m not telling you how to vote; I’m telling you how to weigh. Nothing has changed valuation-wise since last year, other than the fact that the market as a whole is growing more expensive.

On the “good news” front, corporate credit growth has been re-accelerating again. This is somewhat of a sine qua non for faster economic growth. We had seen decent credit growth in 2011 and into 2012, but when QE3 kicked off loan activity had ebbed. But now quarterly growth in commercial credit is nearing a 10% annual rate (see chart, source Board of Governors), something that hasn’t happened since the beginning of 2008 – other than for a brief spike around the crisis itself.

commbkquart

While this is good news, it is not unmitigated good news considering that the Federal Reserve as yet has no viable plan for exiting QE before all of those horses leave the barn. One of the biggest concerns, in terms of a risk of unpleasant surprise, is that few seem to be giving the inflation risk much thought, either in markets where 10-year inflation swaps float in the middle of the 2.40%-2.60% range they have occupied for the last twelve months, or in policymaker circles. This is on my mind today because I was reading an article published on the BLS website entitled “One hundred years of price change: the Consumer Price Index and the American inflation experience” and ran across this passage:

“Why the return of inflation when it seemed to be guarded against and feared? One possibility is a change in the perspective of policymakers. Some have argued that inflation was tempered in the 1950s by a Federal Reserve that, believing that inflation would reduce unemployment in the short term but increase it in the long term, was willing to contract the economy to prevent inflation from growing. By the 1960s, however, the notion of the Phillips curve, a straightforward tradeoff between inflation and unemployment, ruled the day. Citing the curve, policymakers believed that unemployment could be permanently reduced by accepting higher inflation. This view led to expansionary monetary and fiscal policies that in turn led to booming growth, but also inflationary pressures. However much policymakers professed to fear inflation, the policies they pursued seemed to reflect other priorities. The federal government ran deficits throughout the 1960s, with steadily increasing deficits starting in 1966.

Aside from the dates, it strikes me that this paragraph could have been written today. The Phillips Curve, now “augmented,” is still a key tool in the Fed economist’s toolkit even as responsible control of the money supply is deemed passé. As for accepting higher inflation the FOMC changed its inflation target a couple of years ago to be 2% on the PCE, which was implicitly a bump higher from the previous 2% CPI target since PCE is normally 0.3% or so below CPI, and various officials have mooted the idea of letting price increases exceed that rate “for a time” since expectations are well-grounded. And then, of course, you have economists like Krugman arguing for a higher inflation target. Not that we ought to pay any attention to Krugman, but somebody invited him to speak at that conference and that suggests he still has credibility somewhere.

I must say that I don’t believe in an end to history, in which a permanent and pleasant equilibrium exists in capital markets and economies, which both can continue to expand at a reasonable pace with low and fairly stable inflation and interest rates and generous profit margins. If I did believe in such a thing, then I might think that we had arrived; and then perhaps I would see equity multiples and bond yields as reasonable and sustainable. But I do not, because I have already lived through three periods where the VIX was in the 10-12 range: in the 1990s, in 2005-2007, and in 2013-2014. The first two periods produced very exciting finishes. The boredom always ends, and usually abruptly.

Deflation, Indeed!

May 15, 2014 2 comments

Today’s post-CPI update is later than usual (normally, on CPI day I ‘tweet’ my impressions as I have them). A prospect meeting got in the way – yes, isn’t it interesting that there is demand for creative inflation-linked solutions?

Probably, after today, this will be a trifle less surprising. Core inflation surprised on the high side. Consensus had been for the month-over-month figure to be +0.1%; instead it printed +0.236%. This pushed the year-on-year core inflation rate to 1.826%, the highest it has been in a year…and yet still the lowest it is likely to be for a very long time.

So, with the wonderful perfection of timing that is only possible from elite policymakers, the Fed has begun to chirp about deflation fears at just exactly the time that core inflation is turning higher. Do recall that core inflation never got below 1.6% – very far from “deflation” – and was only that low because of well-known effects stemming from the impact of the sequester last year on Medicare payments. Median inflation, which eliminates the influence of small outlier decreases (and increases) on the number, scraped as low as 2.0%, and now sits at 2.2%. It has not been higher than that since mid-2012. Median inflation hasn’t been higher than 2.3% since 2009, so it is fair to say that inflation is much closer to the highs of the last five years than to the lows. Deflation, indeed.

A closer view of the subcomponents do not give any less cause for concern. Of the eight major subcomponents, six (Food & Beverages, Apparel, Transportation, Medical Care, Recreation, and Education & Communication) accelerated on a year-over-year basis while only two (Housing and “Other”) decelerated.

At first glance, that sounds promising. Housing inflation dropped to 2.5% from 2.8%, and those people who are worried about another housing bust right now will be quick to seize on that deceleration. Housing inflation, which is 41% of the total consumption basket, has been a primary driver of core inflation’s recovery in recent months so a deceleration would be welcome. But a closer look suggests that the number for Housing overstates the ‘deceleration’ case considerably. “Fuels and utilities,” which is 5.2% of the entire consumption basket and about 1/8th of Housing, dropped from 6.8% y/y to 4.2%. That was the entire source of the deceleration in housing. The larger pieces, which are also much more persistent, were higher: Primary rents rose from 2.88% y/y to 3.05% y/y, while Owners’ Equivalent Rent was roughly flat at 2.62% compared to 2.61%. So it is perhaps too early to panic about deflation, since the rise in OER and Primary rents is right on schedule as we have been marking it for some time (see chart below, source Enduring Investments).

updatedOER

Outside of housing, core inflation accelerated as well. Core ex-Shelter rose to 1.16% from 0.90%. The inflation is still significantly in services, as core commodities are still only -0.3% year/year. But that will rise soon, probably starting as soon as next month, based on our proxy measure.

As has been well advertised, the temporary depression in Medical Care inflation growth has officially ended. Now that April 2013 is out of the year/year data, the Medical Care major group saw prices rise 2.42% over the last year compared with 2.17% y/y a month ago. Medicinal drugs are at +1.70% compared with +1.44%. Medical equipment and supplies -1.39% vs -1.53%. Hospital and related services +5.55% vs 4.69%. I don’t see the deflation, do you?

This rise in CPI was broad and deep, with nearly 80% of the lower-level indices seeing increases in the y/y rate. It is hard to find any major component about which I would have to express concern, if I was a Federal Reserve official worried about deflation. The breadth of increase is itself a signal. When some prices go up, it is a change in relative prices and will be considered inflation by some people (those who are sensitive to those prices) and not so much by others. But “inflation” is really about a general rise in prices, in which most goods and services participate. As I mentioned above, not all goods prices are participating but in general most prices are rising and, if this month is any gauge, accelerating.

We should hesitate to read too much into any one month’s inflation number. There is a lot of noise in any economic data, so that it can be hard to discern the signal. I believe that there is enough underlying strength here that this is in fact more signal than noise, though, and so I continue to expect core inflation to accelerate for the balance of the year.

I have no idea how long Fed officials will continue to fret about deflation, nor how long it will take the concern to shift to inflation. I suspect it will take a long time, although the stock market today seems less certain on that point with the S&P at this writing down -1.3%. Curiously bonds, which are clearly overvalued if inflation is not contained, rallied today (although breakevens predictably widened). But I think all markets are safe for some time from the risk that central bankers will develop a concern about inflation that is acute enough to spur them to action. (Not to mention that it isn’t at all clear to me what action they could take that would have an effect on the inflation dynamic in any reasonable time frame given that excess reserves must be drained first before any tightening has teeth). This does not mean that I am sanguine about the prospects for nominal asset classes such as stocks and nominal bonds – but at some point, they won’t need the Fed’s cudgel to persuade them to re-price. When inflation is obvious enough to all, that will be sufficient.

Gravity

April 7, 2014 1 comment

Is there anything different about the current downturn in stocks, already two whole days old?

It is difficult to get terribly concerned about this latest setback when in one sense it is right on schedule. The modest down-swings have occurred at such regular intervals that the chart of the VIX looks quite a bit like an EKG (see chart, source Bloomberg).

vixekg

A rise in the VIX to the 19-21 zone happens approximately quarterly, with minor peaks at the same intervals. Eerie, ain’t it?

So is there anything particularly ominous about the current pullback? There is no clear catalyst – I am reading that the selloff is being “led” by tech shares, but the tech-heavy indices look to me as though they have fallen similarly (adjusted for the fact that they have higher vol to begin with. The S&P is down around 3%, and the NDX is down 4.6% over the same period. To be sure, the NDX’s recent peak wasn’t a new high for the year, and it has penetrated the 100-day moving average on the downside, but it doesn’t look unusual to me.

Nor do the economic data look very different to me. The Payrolls number on Friday was in line with expectations, and beat it comfortably when including the upward revisions to the prior two months. The generation of 200k new jobs is not exciting, but it is pretty standard for a normal expansion. My main concern had been that the “hours worked” figure in the employment report had plunged last month, but it rebounded this month and assuaged my concerns (although Q1 growth is probably still going to be low when it is reported later this month, it will be reasonably explained away by the weather).

Two things are different now from previous setbacks, but one is positive and one is negative. They are related, but one is somewhat bullish for the economy and the other is somewhat bearish for risky assets.

We will start with the negative, because it segues nicely into the positive. It is nothing new, of course, to point out that the Fed is tapering, and will be steadily continuing to taper over the next several meetings. Despite the well-orchestrated chorus of “tapering is not tightening,” such Fed action clearly is a “negative loosening” of policy – if you don’t want to call that tightening, then invent a new language, but in English it is tightening.

Now, I never want to short sell the notion that President Clinton taught us all, including market denizens, that if you say something ridiculous often enough, it comes to be regarded as the truth. At times, the market meme clearly has kept the market moving upward even though rational analysis argued for a different outcome. For example, in the early part of the equity bear market that started in 2000, the market meme was that this was a “corporate governance” crisis or a “tech selloff”, when in fact it was a broad-based and deep bear market. In the more-recent credit crisis, it started off as a “subprime” crisis even though it was clearly much more, from the beginning.

So I am loathe to bet about how long markets can run on air before the market meme falters. The challenge, obviously, is being able to distinguish between times when the market meme is correct; when the market meme is incorrect, but harmless; and when the market meme is incorrect, and obfuscating a deeper, more dangerous reality.

“Tapering is not tightening” is one of those thoughts that, while not as serious as “this is a corporate governance problem” or “this is about subprime,” is also clearly mistaken, and possibly dangerous. The reason it might actually be dangerous is because the effect of tightening doesn’t happen because people are thinking about it. Monetary policy doesn’t act primarily through the medium of confidence, any more than gravity does. And, just as gravity is still acting on those aboard the “Vomit Comet,” monetary tightening still acts to diminish liquidity (or, more precisely, the growth rate of liquidity) even when it appears to be doing nothing special at the moment.

The eventual effect of diminished liquidity is to push asset prices lower, and (ironically) also may be to push money velocity higher since velocity is correlated with interest rates.

Now, don’t be overly alarmed, because even as Fed liquidity provision is slowing down there is no sign that transactional money growth is about to slow. Indeed (and here is the positive difference), commercial bank credit has begun to rise again after remaining nearly static for approximately a year (see chart, source Enduring Investments). (As an aside, I corrected the pre-2010 part of this chart to reflect the effect of recategorizations of credit as of March 2010 that caused a jump in the official series).

cbc_mb

If you look carefully at this chart, by the way, you will see something curious. Notice that during QE2, as the monetary base rose commercial bank credit stagnated – and then began to rise as soon as the Fed stopped buying Treasuries. It rose steadily during late 2011 and for most of 2012. Then, commercial bank credit began to flatline as soon as the Fed began to buy Treasuries again (recall that QE3 started with mortgages for a few months before the Fed added Treasuries to the purchase order), and began to climb again at just about the same time that the taper began in December.

I don’t have any idea why these two series should be related in this way. I am unsure why expanding the monetary base would “crowd out” commercial bank credit in any way. Perhaps the Fed began QE because they forecast that commercial bank credit would flatline (in QE1, credit was obviously in decline), so the causality runs the other way…although that gives a lot of credit to forecasters who have not exhibited much ability to forecast anything else. But regardless of the reason, the fact that bank credit is expanding again – at an 8% annualized pace over the last quarter, the highest rate since 2008 – is positive for markets.

Of course, an expansion and/or a market rally built on an expansion of credit is not entirely healthy in itself, as to some extent it is borrowing from the future. But if credit can expand moderately, rather than rapidly, then the “gravity” of the situation might be somewhat less dire for markets. Yes, I still believe stocks are overvalued and have been avoiding them in preference to commodities (the DJ-UBS is 7.3% ahead in that race, this year), but we can all hope to avoid a repeat of recent calamities.

The problem with that cheerful conclusion is that it depends so much on the effective prosecution of monetary policy not just from the Federal Reserve but from other monetary policymakers around the world. I will have more to say on that, later this week.

Tempest in a Microsecond

April 1, 2014 3 comments

News flash! High-frequency trading (HFT) is happening!

The “60 Minutes” piece on HFT that aired this weekend ensured that now, finally, everyone has heard of HFT. Even “60 Minutes” has now heard of it, four years after the Flash Crash and more than a decade after it began. Apparently the FBI is now suddenly concerned over this “latest blemish.”

Again, this is hardly new. Here is the record of Google search activity of the term “high frequency trading.”

Capture

So why is it that, for years, most of the world knew about HFT and yet no one did anything about it?? According to author Michael Lewis, the stock market is rigged! There should be an uproar (at least, there should be if you are selling a book). Why has there been no uproar previously?

To put it simply: this is a crime where it isn’t clear anyone is being hurt, Lewis’s panicky declaration notwithstanding. Except, that is, other high-frequency traders, who have fought over the tiny fractions of a penny so hard that the incidence of HFT is actually in decline. Let’s be clear about what HFT is, because there seems to be some misunderstanding (one commentator I saw summarized it as “the big banks buy the stock and then the retail investor buys it 5%-10% higher.” This would be a problem, if that’s what was happening. But it isn’t. The high frequency traders are playing for fractions of a penny. And the person they are stepping in front of may be your buy order, or it may be the offer you just bought from – if you ever see fills like $20.5999 when the offer was $20.60, then you were injured to the tune of minus 1/100 of a cent per share. The whole notion of HFT is to be in and out of a position in milliseconds, which basically limits expected profits to a fraction of the bid/offer. And when there are lots of high frequency traders crossing signals? Then the bid/offer narrows. That’s not a loss to you – it’s a gain.

High frequency traders aren’t just buying and pushing markets up. They are buying and selling nearly-instantly, scalping fractions of pennies. From all that we know, they have no net effect on prices. Indeed, from all that we know, both the beneficial aspects and the negative aspects remain unproven (see “What Do We Know About High Frequency Trading?” from Charles Jones of the Columbia Business School.

So, if you’re being ripped off, it’s far more likely that you’re being ripped off by commissions than that you’re being ripped off by the robots.

But let’s suppose that the robots do push prices up 5% higher than they would otherwise be. Either that’s the right price to pay…in which case they made the market more efficient by pushing it nearer to fair value…or it’s the wrong price to pay, in which case the only way they win is by selling it to someone who pays too much. If that’s you, then the robots aren’t the problem – you are. Stop giving them a greater fool to sell to, and they will lose money.

Now, this is all good advertising for another concept, which needs to be stated often to individual investors but probably could be said in a nicer way than “you’re getting ripped off by robots”: yes, the market is full of very, very smart people. And yet, on average returns cannot be above-average! This means that if you don’t know everything there is to know about TSLA and you buy it anyway, then you can be sure you will still own it, or be still buying it, when the smart guys decide it is time to sell it to you. They don’t have to have inside information to beat you – they just have to know more than you about the company, about valuations, about how it should be valued, and so on. This is why I very rarely buy individual equities. I am an expert in some things, but I don’t know everything there is to know about TSLA. I am the sucker at that table.

Long-time readers will know that I am no apologist for Wall Street. I spent plenty of time on that side of the phone, and I have seen the warts even though I also know that there are lots of good, honest people in the business. The biggest problems with Wall Street are (a) those good, honest people aren’t always fully competent, (b) the big banks are too big, so that when you get weak competence and very weak oversight combined with occasional dishonesty, there can be serious damage done, (c) there is not a strong enough culture at many firms of “client first;” although that doesn’t mean the culture is “me first,” it means the client’s needs sometimes are forgotten, and finally (d) the Street is not particularly creative when it comes to new product development.

And I don’t really like the algo traders and the movement of the business to have more robots in charge. But look, this trend (not necessarily HFT but automated trading) is what you get when you start regulating the heck out of the humans. Which do you want? Kill the robots, and you need more of those dastardly humans. Remove the humans, and those lightning-quick robots might trade in front of you. Choose. In both cases, you will be victimized less if you (a) trade large and liquid indices, not individual equities, and (b) trade infrequently.

The far bigger problem in my mind is the opacity, still, of bond trading and the very large bid/offer spreads that retail investors pay to buy or sell ordinary Treasury bonds that trade in large size – often billions – on tiny fractions of 1% of price. Think of it: in equities, with or without HFT you will get a better price for a 100-lot than for a 1,000,000-lot. But in bonds, you will get a vastly better price for a billion than for a thousand. Now that is where a retail investor should get angry.

Ex-Communication Policy

March 19, 2014 6 comments

Well, I guess it would be hard to have a clearer sign that investors are over their skis than to have the Fed drop the portion of their communique that was most-binding – in a move that was fully anticipated by almost everyone and telegraphed ahead of time by NY Fed President Dudley – and watch markets decline anyway.

To be sure, the stock market didn’t exactly plunge, but bonds took a serious hit and TIPS were smacked even worse. TIPS were mainly under pressure because there is an auction scheduled for tomorrow and it was dangerous to set up prior to the Fed meeting, not because there was something secretly hawkish about the Fed’s statement. Indeed, they took pains to say that “a highly accommodative stance of monetary policy remains appropriate,” and apparently they desire for policy to remain highly accommodative for longer relative to the unemployment threshold than they had previously expressed.

The next Fed tightening (let us pretend for a moment that the taper is not a tightening – it obviously is, but let’s pretend that we’re only talking about overnight interest rates) was never tied to a calendar, and it would be ridiculous to do so. But it seems that maybe some investors had fallen in love with the idea that the Fed would keep rates at zero throughout 2015 regardless of how strong or how weak the economy was at that time, so that when the Fed’s members projected that rates might reach 1% by the end of 2015 – be still, my heart! – these investors had a conniption.

Now, I fully expect the Fed to tighten too little, and too late. I also expect that economic growth will be sufficiently weak that we won’t see interest rates rise in 2015 despite inflation readings that will be borderline problematic at that time. But that view is predicated on my view of the economy and my assessment of the FOMC members’ spines, not on something they said. You should largely ignore any Fed communication unless it regards the very next meeting. They don’t know any better than you do what the economy is going to be doing by then. If they did, they would only need one meeting a year rather than eight. Focus on what the economy is likely to be doing, and you’ll probably be right more often than they are.

Arguably, this was not the right theory when the Fed was simply pinning rates far from the free-market level, but as the Fed’s boot comes off the market’s throat we can start acting like investors again rather than a blind, sycophantic robot army of CNBC-watching stock-buying machines.

Now, I said above that “the stock market didn’t exactly plunge,” and that is true. On the statement, it dropped a mere 0.3% or so. The market later set back as much as 1%, with bonds taking additional damage, when Chairman Yellen said that “considerable period” (as in “a considerable period between the end of QE and the first rate increase) might mean six months.

Does that tell you anything about the staying power of equity investors, that a nuance of six months rather than, say, nine or twelve months of low rates, causes the market to spill 1%? There are a lot of people in the market today who don’t look to own companies, but rather look to rent them. And a short-term rental, at that, and even then only because they are renting them with money borrowed cheaply. For the market’s exquisite rally to unravel, we don’t need the Fed to actually raise rates; we need markets to begin to discount higher rates. And this, they seem to be doing. Watch carefully if 10-year TIPS rates get back above 0.80% – the December peak – and look for higher ground if those real yields exceed 1%. We’re at 0.60% right now.

Stocks will probably bounce over the next few days as Fed speakers try and downplay the importance of the statement and of Yellen’s press conference remarks (rhetorical question: how effective is a communication strategy if you have to re-explain what you were communicating)? If they do not bounce, that ought also to be taken as a bad sign. Of course, I continue to believe that there are many more paths leading to bad outcomes for equities (and bonds!) than there are paths leading to good outcomes. Meanwhile, commodity markets were roughly unchanged in aggregate today…

A Growling Bear is Bad for Everyone

March 3, 2014 3 comments

I was convinced last week that the stock markets, as well as the inflation markets, were underestimating the importance of the Ukrainian conflict. I thought that I had a little more time to write about that before the crisis came to a head, which turned out not to be true. However, it seems that markets are still underestimating the importance of the Ukrainian conflict.

About the best possible outcome at this point is that Putin stops with an annexation of the Russian equivalent of the Sudetenland, with the episode merely pointing out (again) the impotence of Western leaders to respond to Russian aggression but not actually damaging much besides our pride. Even in that case, to me this signals a dangerous new evolution in the development of Russia’s relationship with the West. But the worse cases are far worse.

The angry fist-shaking of the old democracies is moderately amusing; less amusing are the stupid threats being made about economic sanctions. Let us stop for a minute and review what the West imports from Russia.

According to this article from Miyanville (from early 2013), Russia is the world’s largest producer of chromium (30% of the world market), nickel (19%), and palladium (43%), and is the second-largest producer of aluminum (10%), platinum (12%), and zirconium (19%). It has the largest supply of natural gas (although we are gaining rapidly), the second largest supply of coal, and the 8th-largest endowment of crude oil. The Ukraine itself is the third largest exporter of corn and the sixth-largest exporter of wheat. Meanwhile, the top 10 exports to Russia include engines, aircraft, vehicles, meat, electronic equipment, plastics, live animals, and pharmaceuticals.

So, we are fundamentally exporting “nice to haves” while importing “must haves.” Who needs trade more?

Let me make a further, suggestive observation. I maintain that the tremendous, positive trade-off of growth and inflation (high growth, low inflation) that the U.S. has experienced since the 1990s is at least partly a story of globalization following the end of the Cold War. Over the last couple of years, I have grown fond of showing the graph of apparel prices, which shows a steady rise until the early 1990s, a decline until 2012 or so, and then what appears to be a resumption of the rise. The story with apparel is very clear – as we moved from primarily domestically-sourced apparel to almost completely overseas-sourced apparel, high-cost production was replaced by low-cost production, which dampened the price increases for American consumers. It is a very clear illustration of the “globalization dividend.”

Of course, mainstream economic theory holds that the inflation/growth tradeoff suddenly became attractive for the U.S. in 1991 or so because inflation expectations abruptly became “anchored.” Why look for a good reason, when you can simply add a dummy variable to an econometric model??

But suppose that I am right, and the fall of the Soviet Union in 1991 played a role in the terrific growth/inflation tradeoff we have experienced since then. Incidentally, here are some data:

  • Cold War (1963, immediately following the Cuban missile crisis, until the fall of the USSR): U.S. annual growth averaged 3.4% (not compounded); inflation averaged 5.4%. The DJIA rose at a compounded nominal rate of 5.6%.
  • Post-Cold-War (1991-2013, including three recessions): U.S. annual average growth 2.6%; annual average inflation 2.4%. The DJIA rose at a compounded nominal rate of 7.5%.

This is not to say that globalization is about to end, or go into reverse, necessarily. It is to illustrate why we really ought to be very concerned if it appears that the Bear appears to be back in expansion mode – whether it is something we can prevent or not. And it is also to illustrate why putting a firm end to that expansion mode, rather than sacrificing global trade and cheap energy to a resurrection of the Cold War, is probably worth considering.

I still don’t think that equity investors understand the significance of what is going on in the Ukraine.

What Do You Care What Other People Think?

February 18, 2014 3 comments

In reflecting, over this weekend, about the markets of the last week, I wonder if we haven’t seen a subtle – and subtly disturbing – shift in the markets’ behavior.

Before the Fed began the taper, and even after the Fed began the taper but before we were really sure they intended to maintain it through at least mild economic wiggles, bad news was treated as good news in the markets (both stocks and bonds) because it implied more QE, or a longer QE, or a slower taper. This was lamentable because it suggested that the Fed was more important than global market fundamentals, but understandable at some level. All other forces summed to just about zero, so one big institution with a very big hammer was able to make the market vibrate the way policymakers wanted it to. So, while lamentable, this behavior was at least understandable.

But recently, as the Fed has started ever-so-slowly receding to the back pages, we have started to see behavior that is less unusual, but still not “normal.” Over the last couple of weeks, despite manifestly weak data – from the Employment report to Thursday’s surprisingly weak Retail Sales data and Friday’s weak Industrial Production data (which would have been even weaker if it hadn’t been for the utilities sector humming away) – the stock market has continued a marked rally. However, this is something we’ve seen before: a rally not because weak data would precipitate bullish policy, but because the weak data had a ready excuse in poor winter weather. In this sort of environment, good news is really good news, and bad news can be discounted (even if the cause to do so is sketchy).

There also is some “kitchen sinking” going on even among economists. “Kitchen sinking” refers to when a company takes advantage of a bad quarter to write off all sorts of expenses, all attributed to the “one time event” whether due to it in fact or not. This makes it far easier to score great earnings in the future. It’s understandable (if of questionable legality) in corporate accounting, but when economists do it then we should look askance. Without my naming names: on Friday one well-known macroeconomic advisor told clients that cold weather in November, December, and January will lower Q1 GDP by 0.4%. I am not sure how November’s weather would lower GDP in Q1…in fact, it seems to me that by lowering Q4 GDP, bad weather in December would tend to increase GDP in Q1 because it would be building from a lower base. Whatever the reason for the forecast, though, it certainly lowers the bar for the actual Q1 GDP report and increases the odds of a stock market-bullish surprise (although that’s way out in April).

Much more than the former mode of taking weak data as good because it implied more liquidity from the Fed, this sort of thing – kitchen sinking by economists, and markets taking all news as either neutral or good – is a signature of unhealthy bullishness. The concern is that when the reasons to ignore bad news have passed, the market will not be priced at a level that can sustain actual bad news. And, unlike the QE-baiting, it is something we have seen before. It is a weaker signature, and it’s entirely emotional rather than the twisted but at least debatable reasoning that investors employed when bad news was Fed-good.

It seems almost unfair to continue to list anecdotal signs of frothy behavior, because it’s so easy to do so these days. One that sprang into view last week was the incredibly vitriolic response to the chart that has been making the rounds showing the parallel in equity market action between 1928-29 and 2012-14. For example, here was one objection, which was perhaps a reasonable objection … but note the tone. And this was just one example among many.

Come on, is it really so horrible, such a threat to civilization, to have someone trot out this chart? I will take either side of the argument with no acrimony. Personally, I don’t think it’s almost ever useful to think of the past as an exact roadmap (although if I ignored this chart, and the market did crash, I hate to think of how I would explain that insouciance to my clients after-the-fact), but I also don’t care if someone else does do so. Especially if it leads them to the right conclusion, and I happen to think that if investors start being cautious right now it is the right result, whether it happens because they were scared of a spooky chart or because they understand market valuation metrics.

But again: who cares? This is not a fact which is right or wrong – unlike, say, the claim that the government made a change to the CPI in the early 1980s which subtracts 5% from CPI every year. That is a verifiable statement, and it is demonstrably false. But saying “chart A looks like chart B” can’t possibly be wrong…it’s opinion! My concern isn’t about the chart; it is about the vehemence with which some people are attacking that opinion.

It is like I tell my daughter when someone calls her a dunderhead, or whatever the 7-year-old equivalent is these days. I ask “well, are you a dunderhead?” If the answer is yes, then you have bigger problems than what they’re calling you. If the answer is no, then as Feynman said what do you care what other people think? Similarly, if you’re bullish, what do you care if someone runs that chart? If it’s right, then you have bigger problems than the fact they’re running the chart. And if it’s wrong, then what do you care what they think?

Do Data Matter Again?

February 3, 2014 Leave a comment

In normal times, by which I mean before actions of the Federal Reserve became the only data point that mattered, the monthly ISM report was important because it was the first broad-based look at the most-recent month’s data.

Now that the Fed’s taper has begun – right about the time that the uncertainty of the impact of Obamacare implementation was at its peak, curiously enough – the ISM data seems to have taken on importance once again. I must say that I did not see that coming, but since guessing at the Fed’s actions every six weeks and ignoring all intervening data was so all-fired boring, I suppose I am glad for it. Looking at economic data and trying to figure out what is happening in the economy is more like analysis and less like being on The People’s Court trying to rule on a he-said, she-said case where the hes and shes are Federal Reserve officials. And that is welcome.

That being said, the January ISM report isn’t one I would necessarily place at the head of the class of importance, mainly because it is January. Still, it was an interesting one with the Manufacturing PMI dropping 5.2 points, matching the steepest decline since October 2008. The New Orders subindex plunged to 51.2 versus 64.4 last month, and Employment and Production indices also declined significantly. It’s clearly bad news, but I would be careful ascribing too much value to any January number – especially one based on a survey.

Also standing out in the report was the increase in the (non-seasonally adjusted) “Prices Paid” subcomponent, to 60.5. the jump was initially somewhat surprising to me because as the chart below – which I tweeted shortly after the number – seems to show, we have had a jump in Prices Paid that is not being driven by a concomitant jump in gasoline prices – and Prices Paid is predominantly driven by gasoline prices.

ismpric and gasoline

However, as I noted in that tweet, the Prices Paid index is measuring the rate of change of prices (the question posed to purchasing managers is whether prices are increasing faster, slower, or about the same as the month before), so just eyeballing it may not be enough. The chart below plots the 3-month change in gasoline prices versus the ISM Prices Paid subindex. What you can see is that the first chart is slightly deceiving. The change in gasoline prices has accelerated – back to zero after having been declining since February of 2013. And “unchanged” gasoline prices is roughly consistent with about 60 on the Prices Paid indicator. So, this isn’t as much of a surprise as it looked like, initially.

ismvsgas

Still, whether it was the data or because of continued concern about emerging markets (though the S&P fell nearly as far in percentage terms as did the EEM today, leaving open the question of which is following which), stocks didn’t enter February with much cheer. But never fear, I am sure there is “cash on the sidelines” that will come charging to the rescue soon.

The past week has given a great illustration of one important difference between the price behavior of equities and commodities. That is that stocks are negatively skewed and positively kurtotic, while commodities are positively skewed and negatively kurtotic. That is to say, in layman’s terms, that stocks tend to crash downward, while commodities more frequently crash upwards. This happens because what tends to drive severe movements in commodities is shortages, where the short-term supply curve becomes basically vertical so that any increase in demand pushes up prices sharply. Exhibit one is Natural Gas (see chart, source Bloomberg), where inventories were above normal as recently as October and now are the lowest in a decade.

natty

Exhibit two is Coffee (see chart, source Bloomberg), where drought in Brazil has lifted coffee prices 8-9% today and 35% from the five-year lows set in November. There’s an awful lot of coffee in Brazil, I understand, but there may be less this year.

coffee

In my view, stocks remain very expensive even after this quick 5.75% loss (-2.3% today). Obviously, less so! Commodities have outperformed stocks by basically remaining unchanged, but remain very cheap. Bonds have rallied, as money has shifted from stocks to bonds. This is fine, except that 10-year notes at 2.57% with median inflation at 2.1% and rising is not a position to own, only to rent. The question is, when investors decide that it’s time to take their profits in bonds, do they go to cash, back to equities, or to commodities? If you are one of the people mulling this very question, I have another chart to show you. It is the simple ratio of the S&P to the DJ-UBS (source: Bloomberg).

stockscomm

I think that makes where I stand fairly clear. If both stocks and commodities represent ownership in real property, and both have roughly the same long-term historical returns (according to Gorton & Rouwenhorst), then the ratio of current prices should be a coarse (and I stress coarse) relative-value indicator, right?

But let’s shift from the long-view lens back to the short view, now that a retreating Fed makes this more worthwhile. I am not sanguine about the outlook for stocks, obviously (and here’s one for the technicians: for the first time in years, exchange volume in January was higher than last year’s January volume). However, bulls may get a brief reprieve later this week when the Employment Report is released. Yes, it’s another January data point that ought to be ignored or at least averaged with December’s figure. And that’s the point here. Last month’s Employment Report showed only a 74k rise in Nonfarm Payrolls. That weakness was likely due to the fact that the seasonal adjustments (which dwarf the net number of jobs, in December and January) assumed more year-end and holiday hiring than actually occurred. But the flip side of that is that if fewer were hired in December, it probably means fewer were fired in January. Thus, I expect that the 185k consensus guess for new jobs is likely to be too low and we will have a bullish surprise on Friday. That might help the bulls get a foothold…but it is a long three trading days away.

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