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Loose Ends


Apparently, it was too hot to do anything today but stay at home and put in equity bids, and stocks responded to the recent expression of market-indecision by rallying sharply. It surely didn’t hurt that Kansas City Fed President Hoenig opined that “current Fed policy makes asset bubbles more likely;” of course, equities are priced generously and buyers are seriously desirous of a bubble to jump aboard. I do not disagree with Mr. Hoenig, but in the current circumstance “more” likely is still pretty unlikely while wealth continues to be destroyed by a lengthening recession in employment. When the economy someday recovers and begins to grow, then he will be correct, but that bubble will take time to form. Today, I worry that several markets are priced – as I said – ‘generously,’ but I wouldn’t characterize stocks or bonds or credit or gold as being in “bubble” territory at the moment. For example, while 10-year yields sub-3% represents an investment that is very likely to be quite disappointing over that 10-year horizon, for it to be a true “bubble” I’d want to see near-unanimity of thought that there is nothing else that is a sure thing like owning 10-year Treasuries at 0%. I rather sense that skepticism about the bond market is quite high, and rightly so.

Since there weren’t any new economic data of note today, I want to tie up a few loose ends/idle thoughts I have had recently that didn’t necessarily fit at the time I thought of them, or that I recently thought of.

Inventory of homes

I read somewhere that “the national inventory of [new] homes available soared to an 8.5 months supply in May…” The market’s fascination with the months’ worth of inventory is unhealthy. The problem is that in a ratio such as this, it is probably worthwhile to separate the numerator and the denominator. In this case, the fact that the ratio shot up was due to the very low selling pace of new homes last month. In fact, the total seasonally-adjusted inventory of new homes is quite manageable, and suggests that builders have done a reasonable job of cutting back the supply (indeed, some of the low New Home sales rate might even be caused by the low inventory). See the chart (source: Bloomberg).

Inventory of New Homes is NOT that high...

The market made the reciprocal mistake in 2006, when the inventory was under 7 months of sales, but that was only because of a ridiculously high selling rate. The total inventory number told the real story: that there were an awful lot of homes out there, and if the pace of sales were to decline there would be a big problem. Looking at the ratio obscures this important detail. (People make the same mistake with the semiconductor book-to-bill ratio, where each part of the ratio matters too). Ratios like this are only particularly useful if the denominator is pretty stable.

Now, the bad news is that the inventory of existing home sales is still pretty high (see chart below, source Bloomberg). Why the difference? I suspect it is in the intake pipe…home builders are slowing their additions to inventory, but on the existing home side the bank REO will continue to add inventory for the foreseeable future. This hurts the builders too, of course, because the ready availability of a substitute keeps the lid on new home sales (and prices) as well. I think that when you eventually see the inventory of existing home sales dip back below 3mm again, it may be time to consider the builders.

Unfortunately, inventory of existing homes is still elevated.

Problems with recession forecasting models

I am not a big fan of Goldman, but economist Jan Hatzius generally does a terrific job at spotting the key issue. In a recent article, he noted that “Typical recession forecasting models estimate a near-zero likelihood that the economy has entered recession again, or that it will in the near future.  But they suffer from a serious bias: most models use the slope of the yield curve as a forecasting variable, with a flat or inverted curve a classic warning sign of a slowdown or recession.” This is a great point. Recently, Gene Epstein at Barron’s – who is the anti-Hatzius, and mostly misses the key points – has been touting the Credit Suisse “recession model” as virtual proof that there will not be a double-dip recession – see here for example. (My opinion is well-known. We are probably not going to have a double-dip because we are still in the primary recession, which will probably last for a while). Hatzius makes hash of these models by pointing out that the yield curve factor, which is normally a very important indicator of tight money and hence recession risk, is completely useless when the Fed has pedal pressed to metal. He reports that a forecasting model that leaves out the yield curve and also adjusts for “employment related distortions” (presumably Census stuff) estimates a 25% chance that the economy will be in recession six months from now. I would add, “still.”

Animal Spirits: A Book Worth Reading

Although Animal Spirits, by Akerloff and Shiller, isn’t the best book I have read that Shiller has written or co-written (that honor goes to Irrational Exuberance, of course), it is thought-provoking. The authors take issue with the current state of the economic “science,” which models economic actors as rational even while acknowledging that they are not. We all know this, but economics doesn’t really have any clever solutions or “workarounds” for the fact that there are many phenomena that aren’t explainable as the result of interactions of coldly-rational automata. Akerloff and Shiller, of course, are leading behavioral economists and believe that adjustments need to be made to the standard models to incorporate behavioral phenomena.

The best part of the book is Part One, where they discuss several aspects of “animal spirits”: Confidence, Fairness, Corruption and Bad Faith, Money Illusion, and Stories. I find especially compelling their suggestion that confidence and a “confidence multiplier” ought to be added to standard policy-multiplier models and find intriguing their speculation that confidence may be “contagious” and be model-able as an epidemic. My biggest complaint about the book, in fact, is that while they talk about such a thing they don’t actually propose the form of these adjustments (that point may be too academic for a popular book, but perhaps it will follow – or is already out there and I’m just unaware of it – in journal articles. Just because the standard models ignore behavioral factors doesn’t mean we can’t try and model these behavioral factors. Surely something between economics as pure science and economics as pure art is reasonable?). The authors go on in Part Two to discuss how such an approach to economics can help solve some of the classic conundrums: why depressions happen, why the labor market doesn’t clear, why personal savings is so arbitrary, etcetera. Some of the things they discuss in that section have been addressed by standard economics and the authors are just not happy with the answers…and they’re probably right.

In any event, this is a book worth reading, and it’s a fairly quick and easy read. You can find it on Amazon here.

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On Thursday the calendar has Initial Claims (Consensus: 460k from 472k). For 13 of the last 14 weeks, the economists have estimated too low compared to the eventually-revised number – on the June 18th week, the actual turned out to be 3k less than the consensus estimate. That is an amazing run of unrequited optimism about the economy, proving that economists don’t learn quickly. To be fair, the consensus estimate has risen from a low of 435k on the April 2nd week to the current 460k figure, so eventually economists will be in the right neighborhood.

The Treasury will issue $12bln in TIPS tomorrow. Dealers are very concerned about whether this issue will clear well, considering the low level of real yields (about 1.30% right now in the WI). They shouldn’t be. They should be concerned about the overall low level of yields (including nominal yields), but real yields are currently 41% of nominal yields, and haven’t been at an appreciably higher percentage since October. Put another way, the 10-year breakeven implied by TIPS and 10y nominals is around 1.72%, after having been as high as 2.43% as recently as April. That means that TIPS, while arguably expensive on some metrics, are still cheaper than they have been in a while. The auction may be sloppy, because dealers don’t have a lot of risk to take down paper like this, but I suspect the central bank bid will be pretty reasonable and the issue should clear up fine. I’d certainly bid for a tail.

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