Some Abbreviated but Important Thoughts on Housing

November 29, 2017 3 comments

I posted this chart yesterday to my Twitter feed (@inflation_guy, or @inflation_guyPV through PremoSocial for some additional content), but didn’t have time to write very much about it. This is the Shiller 20-City Home Price Index year/year change (Source: Bloomberg).

My observation was that when you take out the housing bubble, it looks more ominous. It’s actually really the bubble and bust, which makes the recent trend look uninteresting. This is what the chart looks like if you go further back like that.

So it actually looks calm and stable, because the axis explodes to -20% to +20%. The volatility of recent years has caused us to forget that for decades before that, the behavior of home prices was actually pretty sedate. Although residential real estate over very long time periods has only a slightly positive real return, adjusted for the maintenance and other required expenditures, that means the ratio of home prices to median income has tended to be fairly stable. We have historically valued homes as a consumption good only, which meant that the home price traded as a multiple of rents or incomes within a pretty narrow range. Here’s a chart of median home prices to median household income going back to the 1970s (Source: Bloomberg, Enduring Intellectual Properties calculations).

This is true even though there have been important tax changes along the way which changed the value of the home as a tax shelter, changes in the structure of the typical family unit, and so on. Despite that, homes were pretty stable investments – really, they were more savings vehicles than investments.

The fact that home prices are now accelerating, and are rising faster than incomes, implies several things. First, as the last chart above shows, the ‘investment value’ of the home is again inflating to levels that, in 2005-2008, proved unsustainable. The bubble in housing isn’t as bad as it was, and not as bad as stocks are now, but the combination of those two bubbles might be worse than they were when they were mostly independent (in 2000 there wasn’t a housing bubble and in 2007 the bubble in stocks wasn’t nearly as bad as in 2000 and now).

The second implication is that as home prices rise, it isn’t just the value of the investment in the home that is rising but also its cost as a consumption item. Because shelter to rent is a substitute for shelter that you own, rising home prices tends to imply that rents also accelerate. Recently, “Owner’s Equivalent Rent” has been decelerating somewhat, although only coming back to our model. But the gradual acceleration in the home price increase implies that shelter inflation is not going to continue to moderate, but rather should continue to put upward pressure on core inflation, of which 42% consists of “Rent of Shelter.”

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Higher Wages: Good for You, Not Good for Stocks

November 27, 2017 2 comments

The documentation of the endless march of asset markets higher has become passé; the illustration of the markets’ overvaluation redundant and tiresome. After years in which these same arguments have been made, without any discernable correction, the sober voices of warning have been discredited and discounted. The defenders of higher valuations have grown more numerous, more vocal, and more bulletproof.

I recently commented in a forum on cryptocurrencies…something to the effect that while I see blockchain as being a useful technology – although one which, like all technologies, will be superseded someday – I don’t expect that cryptocurrency in any of its current forms will survive because they don’t offer anything particularly useful compared to traditional money, and moreover have a considerable trust hurdle to overcome due to the numerous errors, scandals, and betrayals that have plagued the industry periodically since MtGox. Whatever you say about ‘traditional’ money, no one worries that it will vanish from your bank account tomorrow due to some accident. I don’t see anything particularly controversial about that statement, although reasonable people can disagree with my conclusion that cryptocurrency will never gain widespread acceptance. However, the reaction was aggressive and unabashed bashing of my right to have an opinion. I hadn’t even uttered an opinion about whether the valuation of bitcoin is a bubble (it obviously is – certainly there’s no sign of the stability you’d want in a currency!), and yet I almost felt the need to run for my life. The bitcoin folks make the gold nuts look like Caine in the TV show “Kung Fu”: the epitome of calm reasonableness.

But, again, chronicling the various instances of bubble-like behavior has also become passé. It will all make sense after it’s over, when the crowd recovers its senses “slowly, and one by one” as Mackay had it about 170 years ago.

Today though I want to address a quantitative error that I hope is hard to argue with. It has become de rigeur throughout this…let’s call it the recent stages of an extended bull market…to list all of the reasons that a continued rally makes sense. I always find this fascinating because such enumeration is almost never conducted with reference to whether these things are already “in the price.” On the weekend money shows I heard several pundits opine that the stock market’s rally was likely to continue because “growth is pretty good, at around 3%; interest rates are relatively low; inflation is relatively low; government has become more business-friendly, and wages seem to be going up again.” As I say, it seems to me that most of this should already be in the market price of most securities, and not a cause for further advance. But one of those items is in fact a bearish item.

Make no mistake, wages going up is a great thing. And it’s nice to hear that people are finally starting to note that wages are rising (I pointed this out in April of 2016, citing the Atlanta Fed’s macroblog article on the topic, here. But not everyone reads this column, sadly). The chart below shows the Atlanta Fed’s Wage Growth Tracker, against Median CPI.

So wages are going up for continuously-employed persons, and this is good news for workers. But it’s bad news for corporate earnings. Corporate margins have been very high for a very long time (see chart, source Bloomberg), and that’s partly because a large pool of available labor was keeping a lid on wages while weak global demand was helping to hold down commodity input prices.

Higher wages are, in fact, a negative for stocks.

The argument for why higher wages seem like they ought to be a positive for stocks goes through consumption. If workers are earning more money, the thinking goes, then they can buy more stuff from companies. But this obviously doesn’t make a lot of sense – unless the worker is spending more than 100% of his additional wages in consumption (which can happen if a worker changes his/her savings pattern). If a worker earns $10, and spends $9 buying goods, then business revenues rise by less than wage expenditures and business profits fall, all else being equal.

This shows up in the Kalecki profits equation, which says that corporate profits equal Investment minus Household Savings minus Government Savings minus Foreign Savings plus Dividends. (Look up Kalecki Profit Equation on Wikipedia for a further explanation.) Rearranging, Kalecki profits equal Investment, minus Government Savings (that is, surplus…so currently the deficit contributes to profits), minus Foreign Savings, plus (Dividends minus Household Savings). So, if workers save some of their new, higher earnings then corporate profits decline. The chart below shows how the Kalecki decomposition of profits tends to track pretty well with reported business profits (source: Bloomberg).

Now, profit margins have been high over the last year despite the rise in wages (not because of it) because the personal savings rate has been declining (see chart, source Bloomberg).

If wages continue to grow, and workers start to save more of their earnings (paying off credit cards perhaps?), then it means that labor is taking a larger portion of the pie compared to the historically-large portion that has been going to capital. This is good for workers. It is not good for stocks.

Categories: Stock Market, Theory, Wages

Summary of My Post-CPI Tweets (Nov 2017)

November 15, 2017 Leave a comment

Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guyPV by going to PremoSocial or sign up for email updates to my occasional articles here. Investors with interests in this area be sure to stop by Enduring Investments or Enduring Intellectual Properties. Plus…buy my book about money and inflation. The title of the book is What’s Wrong with Money? The Biggest Bubble of All; order from Amazon here or get it a little cheaper on our site here.

  • Consensus is for a soft 0.2% m/m on core CPI, keeping the y/y figure at 1.7%. I think the consensus works out to about 0.16%.
  • We are dropping off, from y/y numbers, last October’s 0.147% print. The last two months we’ve seen are 0.25% in Sept, and 0.13% in Oct.
  • The upshot is that to get the y/y to round up to 1.8%, we need 0.201%
  • We will be paying attention to cars and trucks. Today the Daily Shot caught on to something I pointed out a while ago:

  • That chart is actually out of date; the Mannheim used car index has risen further. Floods lead to car price increases. Only Q is when.
  • I don’t spend a lot of time on headline CPI forecasts – they obv matter more to TIPS holders in the near-term but they’re all gasoline vol.
  • Still, the consensus of 0.1% m/m looks low to me given the rise in gasoline prices. To me, gasoline should be additive this month.
  • Does seem like everyone talking about upside risk, which scares me a bit. Guess we’ll know in 6 minutes.
  • 10y breakevens -1bp on the day. Investors concerned they’re out over their skis at 1.89% breakevens!!
  • 1%/0.2%. But it’s a hefty 0.2%, 0.225% to three decimals.
  • y/y to 1.774%, rounding up to 1.8%.
  • Last 12 months. Is high the aberration or low?

  • 10y breaks back positive.
  • New and Used cars and trucks are NOT the culprit so we will have to see.
  • Medical Care broad category 1.68% from 1.56%, so the breakdown there will be interesting.
  • Core goods stayed at -1.0%; core services rose to 2.7%. Three months ago core services y/y was 2.4%; a year ago it was 3.2%.
  • y/y core cpi. BUY THE DIP!! Well, something like that. Those dips were one-offs, and those one-offs are fading (I think…calculating now)

  • OK, breakdown…housing was unch at 2.786% y/y. But primary rents dropped again, to 3.695%. OER rose slightly, to 3.196% from 3.182%.
  • Those two effects don’t quite offset, actually a net drag.
  • So new vehicles (3.68% of CPI) was -1.38% vs -1.00%; used cars (1.99% of CPI) was -2.89% vs -3.79%. So used cars contributed a tiny bit.
  • But still….wayyyyy lower than it should be. Unless the Manheim index is just plain wrong, and BLS is right, this is all in future.
  • In Medical Care, always fun: Drugs dropped further to 0.88% from 1.01%. So crazy. But Prof Services, and Hospitals, both rose:
  • Prof services 0.38% vs 0.23%, hospital services 4.54% vs 4.27%. Not big increases, but changing the direction.
  • Health insurance still basically zero: 0.15% vs 0.06% y/y. This should change if my latest renewal is any indication.
  • Professional Services y/y. A bounce, but don’t get too excited!

  • @pearkes: doesn’t CPI HI measure profit margins, not gross premiums?
  • Replying to @pearkes: Well, sort of, tho not exactly. But if all of the pieces of medical care are low, and insurance rises sharply, gotta show up somewhere.

[Editor’s note: I don’t usually put comments and responses in this summary but that was an important question]

  • College tuition & Fees: 2.17% vs 2.08%. Tuition increases have been moderating because endowments are flush thanks to the bull market.
  • Core inflation ex-housing: 0.71% vs 0.58%. The sudden drooping in primary rents is really the main story now.
  • Oddly, CPI for shelter in Houston has decelerated from 2.6% to 1.5% the last two months. That’s at odds with what happened after Ike.
  • But this may be another delayed effect.
  • 10y breakevens spiked 1-2bps on the print, but are fading. Word on Street is “used cars, shelter, airfares…this was all expected.”
  • Apparently not so expected that they could have forecast it. And primary rents were down, not up.
  • and used cars were not up more than the seasonal expectation so the y/y didn’t change. So really, no.
  • Early guess at median is 0.24%-0.26%…median category looks like one of the OER subindices and the BLS doesn’t release the seasonal adj.
  • This is our model for OER. So I think Primary Rents’ decline is the outlier.

  • And here are primary rents.

  • I think the real story here is that medical was not the drag it has been recently. But the one-offs still haven’t really reversed hard yet.

  • Speaking of one-offs…the most famous one is wireless telecom. This will all smooth out over 12 months.

  • OK, inflation in four pieces: First Food & Energy.

  • Next less-volatile piece: Core goods. Deflation here surprisingly persistent, given dollar’s retreat.

  • Core services less rent of shelter bounces for 2nd month in a row. This is where medical care shows up.

  • And rent of shelter we have already discussed. It’s where it should be and probably accelerates marginally from here.

  • Last one: weight of categories above 3% still hanging out just below 50%. Still some very long left tails separating core from median.

  • Thanks for tuning in.
  • As a bonus for my private followers – if you’d like a copy of the Quarterly Inflation Outlook (out today or tomorrow), DM me your email.

Thanks again to everyone who tuned in. If you want to get these tweets in real time so you can impress and amaze your friends, then please go to the PremoSocial signup page and contribute a ten-spot.

This data is going to get increasingly important as the one-offs fade and the next upswing in inflation happens. And we don’t need anything really weird to happen in order to get that upswing. The cell phone aberration will gradually exit the data, and make year-on-year comparisons of cell phone service very easy (actually, we might have inflation in cell phone services, simply because after unlimited data it’s hard to have any more big quality improvements!). Autos will eventually respond to the heightened demand post-flood. Medical Care is unlikely to be flat forever, once all of the compositional shifts have happened (and, if Obamacare is gutted, as the Republicans keep trying to do, then the compositional shifts back could make medical care inflation seem illusorily high, just as now it is illusorily low).

The next few months see difficult year-ago comparisons for CPI: 0.18%, 0.22%, 0.31%, 0.21% are the m/m figures for November and December 2016 and January and February 2017. That averages 0.23%, compared to 0.20% for the last three months we have seen. Ergo, rises in the y/y figures will happen slowly if at all, until March’s data in April. March/April/May/June/July averaged 0.05%, so in that time frame the y/y will be rising 0.1%-0.2% every month. And that’s when alarm will set in in the bond market, even though this is totally foreseeable.

Inflation is rising globally. The only place this isn’t really clear is in Europe, where it’s rising but from such a low level that the wiggles change the visceral appearance of the chart every month. This will keep the US central bank tightening, and other central banks will gradually exit QE. This is very bad for asset markets, and as rates rise and money velocity perks back up, the vicious cycle may well be ignited. 2018 is going to be very, very interesting.

Categories: CPI, Tweet Summary

Velocity and Rates and the Vicious Cycle Possibility

November 1, 2017 3 comments

There was a potentially important development in inflation recently, but one that was generally overlooked.

Perhaps it was mostly overlooked because it is way too early to say that a trend is developed that could cause an adverse inflation occurrence. But I think that the main reason it was overlooked is that monetary velocity is not very well understood. In particular, most people seem to think that money velocity – definitionally, the number of times a unit of money is transacted in a year, on average – is somehow tied to nervousness about the economy. So, when money velocity fell in the global financial crisis, many observers attributed that to savers stuffing dollar bills in the proverbial mattress.

There may be some role for investor/consumer uncertainty in the modeling of velocity, but at best it is a secondary or tertiary cause. The main cause of changes in velocity is simple: when the cost of holding money is high, we work hard to hold less of it, and when the cost of holding money is low, we don’t mind holding more of it. Friedman first noticed this, so it isn’t a new discovery. In monetarist speak, velocity is the “inverse of the demand for real cash balances,” and the demand for such balances depends of course on the relative cost of cash balances relative to other investments.

The chart below shows the power of this relationship. I’m using the 5-year constant maturity treasury rate, but there are obviously other investments that would get thrown into this relationship. But it’s easy to envision the effect here. When interest rates are at 6%, then money does not sit idle for very long or accumulate without limit in your bank account – you will invest those monies in, say, a 5-year CD or Treasury Note, rather than earn basically nothing in a checking account. But when interest rates are at 1%, the urge to do so isn’t as much.

What you can see in the chart is that interest rate moves tend to precede movements in money velocity, which is what we would expect from a causal relationship such as this. So the reason that money velocity plunged in the GFC wasn’t because people were scared; it was mostly because interest rates fell, taking away the incentive to invest longer-term.

Changes in money velocity, of course, tend to cause changes in inflation. MVºPQ, after all, and Q tends to be mostly exogenously determined by aggregate fiscal variables, industrial policy (what’s that?) and the like. Changes in M and changes in V tend to be reflected mainly in P over time.

Also, interest rates are affected by inflation, or more properly by the expectations of inflation. And expectations about inflation tend to follow inflation.

So, the history of the 1980s’ declining inflation can be read like this, without too much of a stretch: declining money growth under Volcker caused declining inflation initially. The decline in inflation tended to cause interest rates to decline. Declining interest rates tended to cause declines in money velocity. Declining money velocity tended to cause declines in inflation…and we were in a virtuous cycle that extended, and extended, and extended, until we were close to zero in interest rates and inflation, and money velocity was as low as it has ever been.

Now, you can see from this chart that interest rates bottomed in 2013, but really have not appreciably risen above the lows, and so money velocity hasn’t reversed its slide although since the beginning of last year the trajectory has been slowing (I suspect some nonlinearity/stickiness of this relationship near zero). But the GDP report from last Friday, combined with recent money growth and increase in the price deflator, implied that money velocity actually rose slightly.

It has nudged higher before, but not by very much. And this is why I am reluctant to make a huge deal about this being the start of something, except that this is the first time since 2008 that there has been a reasonable expectation that interest rates might continue to rise because the central bank wishes it so.

And so I don’t think it’s wrong to consider the “what if” of the next cycle. Normalization of interest rates implies normalization of velocity, and there’s just no way to get appreciably higher velocity without higher inflation. Higher inflation would probably produce higher interest rates, because however much your expectations about inflation are “anchored” they are likely to become unanchored if inflation of 3%-4% starts to print. Higher interest rates could lead to higher velocity, and we have a cocktail for the opposite of the 1980s virtuous interest rate cycle.

This speculation isn’t destiny, and a lot depends on whether interest rates start to move higher and by how much. But there is already starting to be some concern about inflation and the FRBNY’s “Underlying Inflation Gauge” has recently gone to new post-crisis highs (see Chart above, source Bloomberg), so I don’t think it is unreasonable to consider and prepare. Because the best case for the next inflation uptick is that it rises a bit and falls back. But there are elements in place that support a much worse case, and that is a feedback loop through interest rates and velocity. The chances of that outcome are considerably higher than zero.


Note: these articles are now first released on my private Twitter feed, which you can subscribe to for only $10 per month here. Subscribers also get my real-time tweet analysis on the monthly CPI report, which are not on my public feed, and I am working on adding a free chart package to the mix as well.

The Limits to Trusting the Robots

October 20, 2017 1 comment

After another day on Thursday of stocks starting to look mildly tired – but only mildly – only to rally back to a new closing high, it hardly seems unusual any more. I have to keep pinching myself, reminding myself that this is historically abnormal. Actually, very abnormal. If the S&P 500 Total Return Index ends this month with a gain, it will be the second time in history that has happened. The other time was in 1936, as stocks bounced back from a deep bear market (at the end of those 12 months, in March 1936, stocks were still 54% off the 1929 highs). A rally this month would also mean that stocks have gained for 19 out of the last 20 months, the longest streak with just one miss since…1936 again.

But we aren’t rebounding from ‘oversold.’ This seems to be a different situation.

What is going on is confounding the wise and the foolish alike. Every dip is bought; the measures of market constancy (noted above, for example) are at all-time highs and the measures of market volatility such as the VIX are at all-time lows. It is de rigeur at this point to sneer “what could go wrong?” and you may assume I have indeed so sneered. But I also am curious about whether there is some kind of feedback loop at work that could cause this to go on far longer than it “should.”

To be sure, it shouldn’t. By many measures, equities are at or near all time measures of richness. The ones that are not at all-time highs are still in the top decile. Buying equities (or for that matter, bonds) at these levels ought to be a recipe for a capitalistic disaster. And yet, value guys are getting carried out left and right.

Does the elimination (with extreme prejudice) of value traders have any implications?

There has been lots of research about market composition: models, for example, that examine how “noise” and “signal” traders come together to create markets that exhibit the sorts of characteristics that normal markets do. Studies of what proportion of “speculators” you need, compared to “hedgers,” to make markets efficient or to cause them to have bubbles form.

So my question is, what if the combination of “buy the dip” micro-time-frame value guys, combine with the “risk parity” guys, represents a stable system?

Suppose equity volatility starts to rise. Then the risk-parity guys will start to sell equities, which will push prices lower and tend to push volatility higher. But then the short-term value guys step in to ‘buy the dip.’ To be clear, these are not traditional value investors, but rather more like the “speculators” in the hedger/speculator formulation of the market. These are people who buy something that has gone down, because it has gone down and is therefore cheaper, as opposed to the people who sell something that has gone down, because the fact that it has gone down means that it is more likely to go down further. In options-land, the folks buying the dip are pursuing a short-volatility strategy while the folks selling are pursuing a long-volatility strategy.[1]

Once the market has been stabilized by the buy-the-dip folks, who might be for example hedging a long options position (say, volatility arbitrage guys who are long actual options and short the VIX), then volatility starts to decline again, bringing the risk-parity guys back into equities and, along with the indexed long-only money that is seeking beta regardless of price, pushing the market higher. Whereupon the buy-the-dip guys get out with their scalped profit but leaving prices higher, and volatility lower, than it started (this last condition is necessary because otherwise it ends up being a zero-sum game. If prices keep going higher and implied volatility lower, it need not be zero-sum, which means both sides are being rewarded, which means that we would see more and more risk-parity guys – which we do – and more and more delta-hedging-buy-the-dip guys – which we do).

Obviously this sort of thing happens. My question though is, what if these different activities tend to offset in a convergent rather than divergent way, so that the system is stable? If this is what is happening then traditional value has no meaning, and equities can ascend arbitrary heights of valuation and implied volatility can decline arbitrarily low.

Options traders see this sort of stability in micro all the time. If there is lots of open interest in options around, say, the 110 strike on the bond contract, and the Street (or, more generally, the sophisticated and leveraged delta-hedgers) is long those options, then what tends to happen is that if the bond contract happens to be near 110 when expiry nears it will often oscillate around that strike in ever-declining swings. If I am long 110 straddles and the market rallies to 110-04, suddenly because of my gamma position I find myself long the market since my calls are in the money and my puts are not. If I sell my delta at 110-04, then I have locked in a small profit that helps to offset the large time decay that is going to make my options lose all of their remaining time value in a short while.[2] So, if the active traders are all long options at this strike, what happens is that when the bond goes to 110-04, all of the active folks sell to try and scalp their time decay, pushing the bond back down. When it goes to 99-28, they all buy. Then, the next time up, the bond gets to 110-03 and the folks who missed delta-hedging the last time say “okay, this time I will get this hedge off” and sell, so the oscillation is smaller. Sometimes it gets really hard to have any chance of covering time decay at all because this process results in the market stabilizing right at 110-00 right up until expiration. And that stabilization happens because of the traders hedging long-volatility positions in a low-volatility environment.

But for the options trader, that process has an end – options expiration. In the market process I am describing where risk-parity flows are being offset by buy-the-dip traders…is there an end, or can that process continue ad infinitum or at least, “much longer than you think it can?”

Spoiler alert: it already has continued much longer than I thought it could.

There is, however, a limit. These oscillations have to reach some de minimus level or it isn’t worth it to the buy-the-dip guys to buy the dip, and it isn’t worth reallocation of risk-parity strategies. This level is much lower now than it has been in the past, thanks to the spread of automated trading systems (i.e., robots) that make the delta-hedging process (or its analog in this system) so efficient that it requires less actual volatility to be profitable. But there is a limit. And the limit is reach two ways, in fact, because the minimum oscillation needed is a function of the capital to be deployed in the hedging process. I can hedge a 1-lot with a 2 penny oscillation in a stock. But I can’t get in and out of a million shares that way. So, as the amount of capital deployed in these strategies goes up, it actually raises the potential floor for volatility, below which these strategies aren’t profitable (at least in the long run). However, there could still be an equilibrium in which the capital deployed in these strategies, the volatility, and the market drift are all balanced, and that equilibrium could well be at still-lower volatility and still-higher market prices and still-larger allocations to risk-parity etc.

It seems like a good question to ask, the day after the 30th anniversary of the first time that the robots went crazy, “how does this stable system break down?” And, as a related question, “is the system self-stabilizing when perturbed, or does it de-stabilize?”

Some systems are self-stabilizing with small perturbations and destabilizing with larger perturbations. Think of a marble rolling around in a bowl. A small push up the side of the bowl will result in the marble eventually returning to the bottom of the bowl; a large push will result in the marble leaving the bowl entirely. I think we are in that sort of system. We have seen mild events, such as the shock of Brexit or Trump’s electoral victory, result in mild volatility that eventually dampened and left stocks at a higher level. I wonder if, as more money is employed in risk parity, the same size perturbation might eventually be divergent – as volatility rises, risk parity sells, and if the amount of dip-buyers is too small relative to the risk parity sellers, then the dip-buyers don’t stabilize the rout and eventually become sellers themselves.

If that’s the secret…if it’s the ratio of risk-parity money to dip-buyer money that matters in order to keep this a stable, symbiotic relationship, then there are two ways that the system can lose stability.

The first is that risk parity strategies can attract too much money. Risk parity is a liquidity-consumer, as they tend to be sellers when volatility is rising and buyers when volatility is falling. Moreover, they tend to be sellers of all assets when correlations are rising, and buyers of all assets when correlations are falling. And while total risk-parity fund flows are hard to track, there is little doubt that money is flowing to these strategies. For example one such fund, the Columbia Adaptive Risk Allocation Fund (CRAZX), has seen fairly dramatic increases in total assets over the last year or so (see chart, source Bloomberg. Hat tip to Peter Tchir whose Forbes article in May suggested this metric).

The second way that ratio can lose stability is that the money allocated to buy-the-dip strategies declines. This is even harder to track, but I suspect it is related to two things: the frequency and size of reasonable dips to buy, and the value of buying the dip (if you buy the dip, and the market keeps going down, then you probably don’t think you did well). Here are two charts, with the data sourced from Bloomberg (Enduring Intellectual Properties calculations).

The former chart suggests that dip-buyers may be getting bored as there are fewer dips to buy (90% of the time over the last 180 days, the S&P 500 has been within 2% of its high). The latter chart suggests that the return to buying the dip has been low recently, but in general has been reasonably stable. This is essentially a measure of realized volatility. In principle, though, forward expectations about the range should be highly correlated to current implied volatility so the low level of the VIX implies that buying the dip shouldn’t give a large return to the upside. So in this last chart, I am trying to combine these two items into one index to give an overall view of the attractiveness of dip buying. This is the VIX, minus the 10th percentile of dips to buy.

I don’t know if this number by itself means a whole lot, but it does seem generally correct: the combination of fewer dips and lower volatility means dip-buying should become less popular.

But if dip-buying becomes less popular, and risk-parity implies more selling on dips…well, that is how you can get instability.

[1] This is not inconsistent with how risk parity is described in this excellent paper by Artemis Capital Management (h/t JN) – risk parity itself is a short volatility strategy; to hedge the delta of a risk parity strategy you sell when markets are going down and buy when markets are going up, replicating a synthetic long volatility position to offset.

[2] If this is making your eyes glaze over, skip ahead. It’s hard to explain this dynamic briefly unless I assume some level of options knowledge in the reader. But I know many of my readers don’t have that requisite knowledge. For those who do, I think this may resonate however so I’m plunging forward.

Summary of My Post-CPI Tweets (Oct 2017)

October 13, 2017 Leave a comment

Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guyPV or sign up for email updates to my occasional articles here. Investors with interests in this area be sure to stop by Enduring Investments or Enduring Intellectual Properties. Plus…buy my book about money and inflation. The title of the book is What’s Wrong with Money? The Biggest Bubble of All; order from Amazon here or get it a little cheaper on our site here.

  • Friday the 13th and a heavy data day. What could go wrong?
  • 10y breakevens at local highs of 1.90% – but that’s the biggest spread over core CPI in several years.
  • …yet we still have 10y TIPS 50bps to fair at this level of interest rates.
  • Economist expectations are for 0.21% on core and 1.78% y/y. Interesting given how low it has been recently.
  • I don’t usually look at headline but the y/y number is forecast to jump to 2.3% from 1.9%. That will get some attention.
  • I think the market forecasts are about right for core, but there’s a wide range of upside risks. Autos are due to catch up, e.g.
  • But that’s why the forecasts make sense. 0.15% for trend plus 0.05% for expected value of risks.
  • …in turn, that means the point forecasts are not the most likely prints. They’re in between the most likely prints.
  • Core +0.13%, 1.69% y/y.
  • Breakdown will be interesting. Housing broad category went to 2.79% y/y from 2.91%. Medical Care fell to 1.56% from 1.81%.
  • Used cars/trucks went to -3.7% vs -3.8% y/y, so that rebound is still ahead of us. Surveys of car prices are up a lot, just not in BLS yet.
  • pulling in the breakdown now…core services 2.6% from 2.5%, but core goods deflation deepens to -1.0% from -0.9%.
  • Core goods deflation, however, ought soon to be rising again after the lagged effect of the dollar’s decline passes in.
  • In Housing, Primary Rents plunged to 3.78% from 3.88%. That’s huge. OER dropped to 3.18% from 3.27%. Also huge. There’s your story.
  • Core ex-housing rose to 0.58% vs 0.52% y/y, so there’s more going on here but the housing. Wow.
  • A few months ago we had y/y OER fall by more, but that was when OER was overextended.
  • Here is primary rents y/y. I guess this isn’t DRAMATIC – just quite contrary to my own expectations for a continuation of the rebound.

  • In Medical Care, Medicinal Drugs fell to 1.01% from 2.51%. Wow! But Professional Services and Hospital Services accelerated slightly.
  • Here’s CPI for pharma. Think we’ve discussed this before – likely compositional in nature, more generics thanks to worse insurance.

  • Professional services (doctors) bounced;not significant. Also somewhat compositional as old doctors quit rather than take ins. headaches.

  • College Tuition 2.08% vs 1.89%. Have I mentioned the new S&P Target Tuition Inflation Index recently? 🙂
  • Just b/c …who can get enough of wireless telecom services? Bounced, mostly base effect of course. Bottom line was that dip was a 1-off.

  • New cars also still deflating, BTW. -1.0% vs -0.68%. Obviously this will change with Houston buying loads of new cars.
  • Speaking of Houston: core CPI in Houston y/y ended June: 1.31%. For y/y ended Aug: 1.90%. But that’s actually before Harvey.
  • In Miami, 2.01% vs. 2.26% (June vs August). Have to wait a bit to get October numbers – they’ll come out in Dec.
  • Bottom line on the storms is that we haven’t seen the impact yet on CPI. Still to come.
  • My early estimate of Median CPI is 0.20%, bringing y/y up to 2.17% from 2.15%.
  • Housing and Medical Care still keeping pressure on core.

  • Interestingly, these other categories, including Food, and Energy too, all saw acceleration this month (except for other).

  • distribution of changes getting more spread out…

  • Percentage of basket over 3% hasn’t changed much, ergo median didn’t change much.

  • Does this change the Fed’s calculus? I don’t think so, especially with wages accelerating. Still waiting for one-offs to unwind.
  • The doves will argue that the unwind of a one-off is itself a one-off and we should therefore look thru and see 0.12-0.14 as the trend.
  • They’re unlikely to carry the day in Dec, even if the data don’t bounce higher. But if core stays weak the mkt will unwind the 3 in 2018.
  • 10y breakevens -3bps since the number. Market had seemed a little long but this is still too low for breakevens.
  • Four pieces. Piece 1: Food & Energy

  • Piece 2: core goods. Won’t go down forever with the dollar well off its highs.

  • Core services less ROS. A bounce. Sustainable? We’ll have to see.

  • Piece 4, Rent of Shelter. Seemingly ignoring continued rise in home prices. Back to model but weaker than I expected.

  • Last chart. here is the argument: do we cheer the weak consumer inflation or worry about higher wages?

  • Yes, wages follow inflation rather than lead…but the Fed doesn’t believe that.

Thanks to everyone who followed my new “premium” (but cheap) channel. I wrote on Wednesday about the reason for changing my Tweet storm; in a nutshell, it’s because research is starting to be priced a la carte at the major dealers and hopefully this means that quality but off-Street analysis might finally be competing on an even footing rather than competing with “free.” If you think there’s value in what I do, I’d appreciate a follow. If not…well, if the market tells me that what I’m producing isn’t worth anything, then I’ll stop producing it of course!

But in the meantime, here is the story of CPI this month. A continuing regression of rents and OER to model levels held core down to recent-trend levels. But there are many one-off and temporary effects that are due to be reversed, and relationships that suggest certain components are due to catch up to underlying realities. For example, here is the picture of Used Cars and Trucks CPI, compared to the Manheim Used Vehicle Value Index 4 months prior.

According to the relationship between these series over the last decade, CPI for Used Cars and Trucks should be growing about 5% faster than it is presently, and rise another 3-4% in the next few months. New and Used Motor Vehicles inflation is about 8% of core CPI, so this effect alone could add 0.7% to core CPI! Or, put another way, right now core CPI is about 0.4% lower than it would be if the CPI was measuring the actual price of vehicles the same way that Manheim does it. That’s a big number when the entire core CPI is only 1.7%.

The continued, and actually extended weakness in core goods is also due to reverse. I don’t mean that core goods inflation will go from -1% to +3% but only to 0.5%. But that 150bp acceleration, in one-quarter of the core CPI, would also raise core CPI by 40bps or so. To be sure, there is some double-counting since a third of core commodities is new and used vehicles, but that merely reinforces the message.

So, too, are the effects in medical. Volatility in those series should persist, which means that since they are at a low ebb there’s a better bet that the next volatile swing is to higher prices.

All of which is to say that the hawks on the Federal Reserve Board actually have it right, in a sense. Prices are headed higher, and inflation is accelerating. It would be a truly shocking development if core inflation one year from now was unchanged from the current level. Indeed, I think there is a better chance that core inflation is above 2.7% than below 1.7%. On another level, the hawks aren’t quite right though. By hiking rates before draining excess reserves, the Fed risks kicking off the vicious cycle I have mentioned before: higher rates cause higher money velocity, which causes higher inflation, which causes higher rates etc. Without control of reserves at the margin, the Fed cannot control money supply growth and so the normal offset to rising monetary velocity in a tightening cycle, slowing money growth, comes down to chance. Either way, the Fed is very likely to tighten in December, but beyond that it probably matters more who ends up in the Chairman’s seat than anything economic data.

The Changing Face of Free Stuff

October 11, 2017 5 comments

Today’s article isn’t about inflation, or the bond market, or the Federal Reserve. It is more of a meta-article: an article about articles or, more precisely, research.

I started my career as a technical and quantitative analyst back when we were still doing point-and-figure charting on large sheets of graph paper tacked to the wall. After coming to Wall Street in the early 1990s, I went to JP Morgan in 1994 as a futures researcher. Subsequently, I became the lead US fixed-income researcher at Bankers Trust before gradually parlaying my research skills into a trading position at Barclays.[1]

In those years, and really until now, compensation of researchers was pretty reasonable. While few researchers – especially in fixed-income – earn seven-figure compensation packages, they still earn an awfully nice living and get to go home at night and not worry about whether their short options position is blowing up in Japan while they sleep. Researchers in general don’t need to wake up at 2am to talk to Hong Kong and delta-hedge the book.

However, there is a downside to being a researcher and that is that historically there hasn’t been a very good connection between the quality of the research (and the eyeballs it commands) and the bonus at the end of the year. On Wall Street, if you don’t have a P&L attached to your name then you don’t have much ammunition when it comes to the bonus discussion. If you can point to a trade that you recommended, the sales force sold, and the trading desk profited from (as well as, hopefully, the clients…since if the clients don’t profit they don’t listen to your next recommendation), and you can compute how much money you made the desk; or if you can claim responsibility for a bond tip that happened as a customer reward for help you gave them on some other matter; or you are a “star” analyst who is the “axe” on some company or market and clients clearly give the firm business so as to have access to you (this is more likely to be the case at a small shop that would otherwise not get such business), then you’re in good shape. But the vast majority of analysts have nothing to say when they sit down with management to discuss their bonuses, because the research bonus pool is essentially a gift from Sales & Trading and not an allocation from their own profits.

Enter the second chapter of the “Markets in Financial Instruments Directive,” aka MiFID II, a product of the European Securities and Markets Authority (ESMA).

I don’t claim to understand everything, or even very much, about MiFID II. I’ve spent a lot of time talking to people who understand more, but no one is really sure what the ultimate impact of MiFID II is going to be, just like no one was sure how bad Dodd-Frank would be for the financial markets. But I want to focus here on the impact of MiFID II on the provision of sell-side and, more to the point, independent research.

Part of MiFID II essentially requires broker-dealers (in Europe, but practically speaking it’s hard to ring fence a global B/D’s activities and clients to just one jurisdiction) to separate the fees for execution and for research. Previously, research – including access to research analysts, for good clients – was provided free to clients in almost all cases. The European regulator, observing that this meant that research must be an ancillary benefit to clients paid for by dealers from their trading profits, reasoned that bid/offer spreads must be wider than they would be if dealers didn’t have to bear this invisible charge.

It is a risible argument, even if it must technically be true. But no trader ever, I am sure, adjusted his bid/offer spread wider to cover the cost of research being provided. Traders think of the bid/offer as being a price for liquidity, period. So I would be shocked if the effort to split these charges resulted in (as is intended) lower trading costs for clients.

Anyway, the bottom line is that now if clients want to get research from their dealers they need to explicitly pay for it, and disclose to the clients what the client is being charged for the research. (We have vaguely similar rules here regarding how ‘soft dollars’ must be used and disclosed, but research that is “free” is not subject to that measurement and reporting.) And so dealers have been announcing what they will charge for research starting on January 1, 2018.

So here’s the interesting side-effect on independent research. Previously, it was virtually impossible for quality independent research providers to make a living. There are a very few who have succeeded at this – Bianco research, Medley, etc – but those numbers are small and those folks have been having a more difficult time of it in recent years. It’s really hard to compete with “free” research coming from the sell side. And so – to bring this home – people like me have had to give away content, hoping to someday recoup the cost of writing and researching by attracting more clients to other lines of business or to a paid research product. Honestly, I’ve tried ten different ways and haven’t figured it out, and I’m the only person I’m aware of with deep domain knowledge in inflation that’s putting out commentary or research.

MiFID II may change that. If buy-side institutions no longer get research for free from the Street, they may be more discerning about what they spend money on. Why pay dealer X for research that used to be free – and was worth about what you paid for it – when independent researcher Y is charging $100 for research that is twice as good? Buy side firms have been wrestling with this question, and there have also arisen several platforms for research providers to hawk their wares – Alpha Exchange, ERI-C, and RSRCHXchange, just to name three. In fact, my company is posting our research on those platforms as well, and in January we will see if anyone is willing to pay for it.

Here is where we make it really personal.

I never wanted to be a ‘blogger.’ I get value from the process of writing my thoughts down, and I get value from feedback from readers. Lots of value. But it takes a ton of time, and it’s hard to justify the time and effort to the fellow stakeholders in my company if there is no revenue attached, ever. And so over the years I have stopped allowing platforms to publish my articles (such as Seeking Alpha) if they weren’t willing to allow me to mention my company, for example; I have also gone from publishing daily (as I did for years) to once or twice per week.

I intend to continue to produce these articles, and distribute them freely on my blog (https://mikeashton.wordpress.com ), on Investing.com, Harvest, and TalkMarkets as well as other places where it is picked up from time to time. And I hope you like them. But my CPI-day tweets, and some other occasional content, will be moving to a new channel. You can go to PremoSocial and subscribe to get access to that “premium content” for only $10 per month. Here is the link.

You can help make sure that this column remains free, by subscribing to that channel. If you think my out-of-the-box viewpoint on markets and especially inflation is valuable, please consider signing up. If the response is very good, it may even justify my spending more time on the research-for-public-consumption (as opposed to R&D) part of the business, and writing more frequent articles. I am eager to see what the response is. Surely my work is worth more than zero. Anyway, I hope so.

Thanks in advance!

[1] I don’t recommend that path for any new graduate starting off on Wall Street. It is quite hard to get from the research desk to a risk-taking role and I got lucky.

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