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Why Commodities Are a Better Bet These Days

January 16, 2018 2 comments

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It’s been a long time since an article about commodities felt like ‘click bait.’ After all, commodity indices have been generally declining for about seven years – although 2016 saw a small advance – and the Bloomberg Commodity Index today sits 63% below its all-time high set in the summer of 2008. I’ve written before, quite a bit, about this absurdity of the market, represented in the following chart comparing one real asset (equities) to another real asset (commodities). The commodity index here is the Bloomberg spot index, so it does not include the drag (boost) from contango (backwardation).

This is the fair comparison for a forward-looking analysis. Some places you will see the commodity index plotted against the S&P, as below. Such a chart makes the correct inference about the historic returns to these two markets; the prior chart makes a more poignant point about the current pricing of stocks versus commodities.

There’s nothing that says these two markets should move in lock-step as they did from 2003-2007, but they ought to at least behave similarly, one would think. So it is hard to escape the reasoning that commodities are currently very cheap to equities, as one risk-asset to another.

Furthermore, commodity indices offer inflation protection. Here are the correlations between the GSCI and headline inflation, core inflation, and the change in those measures, since 1970 and 1987 respectively.

Stocks? Not so much!

So, commodities look relatively cheap…or, anyway, they’re relatively cheaper, having gone down for 7 years while stocks went higher for 7 years. And they give inflation protection, while stocks give inflation un-protection. So what’s not to like? How about performance! The last decade has been incredibly rough for commodities index investors. However, this is abnormal. In a watershed paper in 2006 called Facts and Fantasies about Commodity Futures, Gorton and Rouwenhorst illustrated that, historically, equities and commodity futures have essentially equivalent monthly returns and risks over the period from 1959-2004.

Moreover, because the drivers of commodity index returns in the long run are not primarily spot commodity prices[1] but, rather, the returns from collateral, from roll or convenience yield, from rebalancing, and from “expectational variance” that produces positive skewness and kurtosis in commodity return distributions,[2] we can make some observations about how expected returns should behave between two points in time.

For example, over the last few years commodities markets have been heavily in contango, meaning that in general spot prices were below forward prices. The effect of this on a long commodity index strategy is that when futures positions are rolled to a new contract month, they are being rolled to higher prices. This drag is substantial. The chart below shows the Bloomberg Commodity Index spot return, compared to the return of the index as a whole, since 2008. The markets haven’t all been in contango, and not all of the time. But they have been in serious contango enough to cause the substantial drag you can see here.

So here is the good news. Currently, futures market contango is the lowest it has been in quite a while. In the last two years, the average contango from the front contract to the 1-year-out contract has gone from 15% or so to about 2% backwardation, using GSCI weights (I know I keep switching back and forth from BCOM to GSCI. I promise there’s nothing sinister about it – it just depends what data I had to hand when I made that chart or when it was calculated automatically, such as the following chart which we compute daily).

That chart implies a substantial change in the drag from roll yield – in fact, depending on your weights in various commodities the roll yield may currently be additive.

The other positive factor is the increase in short-term interest rates. Remember that a commodity index is (in most cases) represents a strategy of holding and rolling futures contracts representing the desired commodity weights. To implement that strategy, an investor must put up collateral – and so an unlevered commodity index return consists partly of the return on that particular collateral. It is generally assumed that the collateral is three-month Treasury Bills. Since the financial crisis, when interest rates went effectively to zero in the US, the collateral return has approximated zero. However, surprise! One positive effect of the Fed’s hiking of rates is to improve projected commodity index returns by 1.5-2% per year (and probably more this year). The chart below shows 3-month TBill rates.

I hope this has been helpful. For the last 5 years, investing in commodities was partly a value/mean-reversion play. This is no longer so true: the change in the shape of the futures curves, combined with rising interest rates, has added substantially to the expected return of commodity indices going forward. It’s about time!


[1] This is a really important point. When people say “commodities always go down in the long run because of increased production,” they’re talking about spot commodity prices. That may be a good reason not to own spot gold or silver, or any physical commodity. Commodity spot returns are mean reverting with a downward slant in real space, true. But a commodity index gets its volatility from spot returns, but its main sources of long term return are actually not terribly related to spot commodities prices.

[2] In other words while stocks “crash” downwards, commodities tend to “crash” upwards. But this isn’t necessary to understand what follows. I just want to be complete. The term “expectational variance” was coined by Grant Gardner.

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Summary of My Post-CPI Tweets (Jan 2018 – Dec figure)

January 12, 2018 Leave a comment

Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guyPV and get this in real time, 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.

  • 22 minutes until CPI. Not sure I am looking forward to this one. The little birds are all whispering that this is supposed to be high, and that concerns me.
  • Not the economists: consensus forecast is for a reasonably high 0.24% on m/m core. But we drop off 0.22% from last December so the y/y won’t move much from 1.7% if that’s the print we get.
  • Yes – there are lots of reasons this COULD be higher. Chief among them is the divergence between surveys of used car prices and the BLS cars index. Cars are 6.4% of CPI, so it matters. But PPI showed weakness in vehicles for another month. (I usually ignore PPI, though).
  • ..it’s December, which means it’s crazy-seasonal-adjustment month. December is the only month of the year where you can confidently reject the hypothesis that there’s no seasonal (on headline CPI), as prices tend to fall. But there’s also a lot of volatility.
  • Rents have come back to model, and home prices continue to rise, so decent chance that housing starts to contribute again here soon.
  • What I fear is that some of the forecasts for a “surprise” higher are coming from the fact that the inflation markets have been rallying, so people are afraid “someone knows something.” Economists don’t ignore markets. But in this case I think it’s just year-end reassessment.
  • …let’s face it, inflation bonds are cheap. About 50bps cheap at the 10-year point by my model. Commodities are cheap. And everything else is expensive. I don’t have to believe inflation is coming to swap out of stocks into commodities.
  • Of note – inflation swaps have been rising in every major market recently. So there definitely is an undercurrent of inflation concern.
  • Don’t fade the whispers! +0.3% on core. Actually 0.277%. But enough to put y/y up to 1.77%, rolling it to 1.8% rounded.
  • Wow, 2 yr Tsy above 2% for the first time since September 2008!
  • Last 12 CPIs. Try hard not to see an uptrend here. It’s an illusion caused by the low mid-year figures. But that said, this is highest in a while.

  • Let’s see…Housing up slightly, Transportation up, no change in medical care (talking major subgroups here)…will be interesting to see where the wiggle is.
  • Core services 2.6% vs 2.5% and core goods -0.7% vs -0.9% y/y. That’s the least goods deflation since last July. But it’s still deflation.
  • Pulling in the micro data now. The BLS series is so rich. But while the sheet is calculating this is a good time to remind everyone that these figures are for DECEMBER so try hard not to get too excited. The breakdown will be more important to tell us if this is ‘real.’
  • If you haven’t read Ben Inker’s piece in the latest GMO quarterly, arguing why inflation is a bigger risk for portfolios right now than recession, do so. Very good piece. “What happened to inflation? And What happens if it comes back?” https://www.gmo.com/docs/default-source/research-and-commentary/strategies/gmo-quarterly-letters/what-happened-to-inflation-.pdf?sfvrsn=5
  • One more item of context before we dive deeper: Median CPI is at 2.3%. So we should be expecting something right around 0.2% per month if there’s no trend. The uptick from 1.7% to 1.8% is just catching up, mostly.
  • OK on the breakdown. New and Used cars, 8% of core CPI, rose to -0.33% from -1.05%. As expected, and that’s a big part of the surprise.
  • I say “surprise,” but it really oughtn’t be a surprise. Remember that Hurricane Harvey had a similar effect to Cash for Clunkers in terms of the number of cars removed from the road. The private car prices indices were showing this. BLS has a lot of catching up yet.

  • Just lost power. Anyway. Wasn’t just used cars. Used cars went from -2.1% to -0.99% but new went from -1.08% to -0.53%
  • Owners Equivalent Rent went to 3.175% from 3.124%, and primary rents from 3.675% to 3.689%. So housing back on track.
  • Medical Care broadly went to 1.78% from 1.68%. Pharma went 1.87% to 2.37%. Other components pretty stable (in medical). Medicinal drugs (pharma) is about one fifth of medical care subindex.
  • Wireless telephone services again steady. The jump will be fun when the plunge washes out. Right now it’s -10.19% y/y vs -10.24%.
  • Wish I could post my chart of distributions of price changes. Left tail starting to move rightward a bit. Hopefully get power back soon. This is all on backup power to my pc. [Editors’ Note – I added it later, see below]
  • Well, looks like power isn’t coming back on quickly. I will have to come back later with the median CPI estimate etc. Got most of the details out though.
  • Bottom line is that the components we expected to start converging, did. Housing behaved. Medical care behaved. And so we moved towards the real middle of the distribution, around 2.3% or so presently.
  • This shouldn’t be taken as an acceleration in inflation. This is just one (flawed) number converging with the better ones. Core inflation is going to head higher, but this isn’t convincing evidence that it is yet doing so.
  • Having said that, in a couple of months the y/y comps start to get better so the inflation story will have much better OPTICS. And it’s optics these days, more than fundamentals, that drive markets. So don’t jump off the commodities or tips bandwagon. That trend will continue.
  • Power’s back on! Of note is that Median CPI printed at 0.29%, the highest level since July 2008 (sound familiar? That was also true two months ago when it was 0.27%). So y/y up to 2.44% now.
  • Yeah, I know I said don’t think of this was an uptrend. And it’s not; it’s an unwind of one-offs. But still, that’s gotta look scary.

  • Better late than never. Here’s what I meant about the distribution moving right. Those two bars on the left were one bar before today. So you can see those components – largely cars and cell phones – are dragging down core relative to median.

  • The rally in breakevens shouldn’t be terribly surprising – this chart shows it’s just keeping pace (and not even) with the turn back higher in median CPI.

  • The market is NOT AT ALL ahead of itself in this sense.

This was certainly not the easiest time I have had with a CPI report, but that’s mostly because the power grid in this country is as brittle as glass. The story was actually not as much about screwy seasonal as I was concerned about. Actually, it was a fairly humdrum report in many ways, and that’s what is scary if you’re thinking we are in a “lowflation” period. The chart of Median CPI is interesting. Core inflation had risen mostly because car prices are starting to catch up with private measures of car prices – what remains in the gap between the red line and the blue line in the “Manheim” chart would add about 0.5% to core CPI – and housing stopped decelerating. But then Median CPI, which doesn’t care about the New and Used car prices since those are outliers, rose at the highest rate (m/m) in nearly a decade, and the Median-Core spread actually widened slightly this month. That means more core acceleration is ahead.

I mentioned that in a few months the year-ago comparisons will start getting easier. This month, we got 0.28% from core CPI versus 0.22% last year. But in Jan 2017, core CPI was +0.31%. That will be a hard comp to beat. But after that, Feb 2017 was +0.21%, March was -0.12%, April was +0.07%, May was +0.06%, June was +0.12%, and July was +0.11%. At the time, we mused “is the natural run rate for core really 0.5%/annum?” which was what those five months were averaging. That seemed very unlikely. Median CPI told us that wasn’t the case. Now, if core CPI merely averages a monthly 0.17% print from now until July, the y/y figure will be up at 2.20%. And if it’s 0.2% per month, in July we will be sitting at 2.42%.

I don’t think you want to fade those optics, even if you think we’re only going to get 0.15%. Perhaps the next month or two, because of the more-difficult comps, will take some wind out of the sails of the inflation bulls and offer better entry points. But the direction of travel looks fairly clear for the next six months or so. And that also means that the direction of travel for monetary policy is also likely set, to be at least as aggressive as the market is pricing. And, perhaps, the direction of travel for equity prices isn’t quite as clear as it currently seems.

And it bears repeating that this is going to be the case even if inflation is not actually in an uptrend, but just maintaining its current run rate around 0.2% per month (commensurate with median CPI at 2.4%/yr). If inflation is in fact turning higher – and there are some signs of that, though not as widespread as everyone seems to suddenly think – then it could be a lot uglier in 2018. As I said again above: don’t jump off the commodities or TIPS bandwagon yet. But…you might want to trim some of that nominal bond exposure!

Point Forecast for Real Equity Returns in 2018

January 3, 2018 2 comments

Point forecasts are evil.

Economists are asked to make point forecasts, and they oblige. But it’s a dumb thing to do, and they know it. Practitioners, who should know better, rely on these point forecasts far more than they should. Because, in economics and especially in markets, there are enormous error bars around any reasonable point forecast, and those error bars are larger the shorter-term the forecast is (if there is any mean-reversion at all). I can no more forecast tomorrow’s change in stock market prices than I can forecast whether I will draw a red card from a deck of cards that you hand me. I can make a reasonable 5-year or 10-year forecast, at least on a compounded annualized basis, but in the short term the noise simply swamps the signal.[1]

Point forecasts are especially humorous when it comes to the various year-end navel-gazing forecasts of stock market returns that we see. These forecasts almost never have fair error bars around the estimate…because, if they did, there would be no real point in publishing them. I will illustrate that – and in the meantime, please realize that this implies the forecast pieces are, for the most part, designed to be marketing pieces and not really science or research. So every sell-side firm will forecast stock market rallies every year without fail. Some buy side firms (Hoisington springs to mind) will predict poor returns, and that usually means they are specializing in something other than stocks. A few respectable firms (GMO, e.g.) will be careful to make only long-term forecasts, over periods of time in which their analysis actually has some reasonable predictive power, and even then they’ll tend to couch their analysis in terms of risks. These are good firms.

So let’s look at why point forecasts of equity returns are useless. The table below shows Enduring’s year-end 10-year forecast for the compounded real return on the S&P 500, based on a model that is similar to what GMO and others use (incorporating current valuation levels and an assumption about how those valuations mean-revert).[2] That’s in the green column labeled “10y model point forecast.” To that forecast, I subtract (to the left) and add (to the right) one standard deviation, based on the year-end spot VIX index for the forecast date.[3] Those columns are pink. Then, to the right of those columns, I present the actual subsequent real total return of the S&P 500 that year, using core CPI to deflate the nominal return; the column the farthest to the right is the “Z-score” and tells how many a priori standard deviations the actual return differed from the “point forecast.” If the volatility estimate is a good one, then roughly 68% of all of the observations should be between -1 and +1 in Z score. And hello, how about that? 14 of the 20 observations fall in the [-1,1] range.

Clearly, 2017 was remarkable in that we were 1.4 standard deviations above the 12/31/2016 forecast of +1.0% real. Sure, that “forecast” is really a forecast of the long-term average real return, but that’s not a bad place to start for a guess about next year’s return, if we must make a point forecast.

This is all preliminary, of course, to the forecast implied by the year-end figures in 2017. The forecast we would make would be that real S&P returns in 2018 have a 2/3 chance of being between -10.9% and +11.1%, with a point forecast (for what that’s worth) of +0.10%. In other words, a rally this year by more than CPI rises is still as likely as heads on a coin flip, even though a forecast of 0.10% real is a truly weak forecast and the weakest implied by this model in a long time.

It is clearly the worst time to be invested in equities since the early 2000s. Even so, there’s a 50-50 chance we see a rally in 2018. That’s not a very good marketing pitch. But it’s better science.[4]


[1] Obligatory Robert Shiller reference: his 1981 paper “Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends” formulated the “excess volatility puzzle,” which essentially says that there’s a lot more noise than signal in the short run.

[2] Forecasts prior to 2009 predate this firm and are arrived at by applying the same methodology to historical data. None of these are discretionary forecasts and none should be taken as implying any sort of recommendation. They may differ from our own discretionary forecasts. They are for illustration only. Buyer beware. Etc.

[3] The spot VIX is an annualized volatility but incorporating much nearer-term option expiries than the 1-year horizon we want. However, since the VIX futures curve generally slopes upward this is biased narrow.

[4] And, I should hasten point out: it does have implications for portfolio allocations. With Jan-2019 TIPS yielding 0.10% real – identical to the equity point forecast but with essentially zero risk around that point – any decent portfolio allocation algorithm will favor low-risk real bonds over stocks more than usual (even though TIPS pay on headline CPI, and not the core CPI I am using in the table).

Summary of My Post-CPI Tweets (Dec 2017)

December 13, 2017 1 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.

  • ok, 10 minutes to CPI. 10y Breakevens unch to +0.5bp. They’re at 6 month highs of 1.92%, but amazing they can’t get to 2%.
  • On CPI: Last month there was an upside surprise with a strong 0.2%, making it 2 of the last 3 months with upside surprises.
  • The comparisons to year ago are about to get more difficult though. Today we drop off a 0.18% from last November.
  • We drop off a 0.22%, 0.31%, 0.21% next three months after that.
  • This month we’re again watching New & Used Cars and Trucks, which have not yet shown any response to survey evidence of increases.
  • Also an eye on Primary Rents, which have been declining although the Shiller Home Price Index is reaching new local highs.
  • Last mo, median CPI scored its largest m/m incr since July ’08. So in short – we’re in an inflation upswing; just need to see how much.
  • Consensus for today’s number is 0.2% on core – almost exactly, keeping y/y at 1.8%.
  • Well, core is 0.1%…but waiting for Bloomberg to drop the actual figures. Looks like a big miss, not a little miss.
  • yeah, 0.12%, pushing y/y down to 1.71%. Last 4 months have seen two high misses and two low misses.

  • Core goods rose to -0.9% y/y from -1.0%, but core services down to 2.5% from 2.7%. SO IT ISN’T THE INTERNET, FOLKS.
  • 10y breaks plunging 4bps since pre-data, on the way to creating another buying opportunity.
  • Only way 1.89% 10y BEI make sense is if inflation is permanently broken. But median CPI is 2.3% y/y. So it’s not broken!
  • (We have TIPS about 53bps cheap at current nominal yields).
  • In major subgroups, Apparel decelerated, Recreation decelerated, Other decelerated. Medical unch. Everything else up. Interesting.
  • In Housing, Primary Rents decelerated slightly again 2.68% from 2.70%, but seem to be converging on our model.
  • OER 3.12% vs 3.20%…there’s your problem…and Lodging Away from Home plunged to 0.60% from 1.36% y/y. But the latter is a small weight.
  • New vehicles -1.08% vs -1.38%; used cars to -2.10% from -2.89%. Not really the bump we are due.

  • In Medical Care: drugs 1.87% vs 0.88%, so that’s a big up. But Prof Services -0.26% vs 0.38% and that’s 2x the weight.
  • Just doesn’t pay to be a doctor any more. Here’s CPI- Prof Services y/y.

  • College Tuition and Fees 2.29% from 2.17%.
  • This is a mysterious number. Haven’t found “the culprit” yet.
  • Core CPI ex-housing 0.65% vs 0.71% y/y.
  • Biggest 1m NSA changes are on apparel, misc personal goods, public transportation, lodging away from home (-15% m/m).
  • Median still looks like it will be 0.22% m/m. Not real surprised it’s outliers. The surprise is that it’s in services.
  • This is even more skewed than usual.

  • But again, most things are inflating.

  • Well let’s look at the four pieces breakdown. Food & Energy:

  • Core goods. Probably starting to head higher. But cars and trucks not helping yet.

  • Core services less rent of shelter. Here’s where Professional (medical) Services lives, and is part of the story on the weak CPI.

  • And Rent of Shelter – not a big deal and not surprising, but part of the softish story too.

  • US #Inflation mkt pricing: 2017 1.9%;2018 2.1%;then 2.1%, 2.1%, 2.2%, 2.2%, 2.2%, 2.2%, 2.3%, 2.4%, & 2027:2.5%. This from CPI swaps.
  • Market is pricing an extraordinary amount of stasis in the global price dynamic.

This was a strange report. The miss was a big miss, but there didn’t seem to be any large culprits. The story seems to be in Professional Services, which deceleration caused a 3bp drag in the y/y, and OER, which was a few bps, and Lodging Away from Home. OER is a little surprising, since the Shiller Home Price Index is rising at the fastest pace in a few years, but that generally only passes through with a lag anyway. Higher wages, combined with higher home prices, means that shelter costs are not likely to be decelerating meaningfully any time soon. But, they recently have decelerated a little bit – we think it’s just coming back to model, however.

The Professional Services deflation is a conundrum I’ve commented on in the past. Part of this is probably compositional since the older/more experienced physicians are retiring rather than deal with the new healthcare regime, but the magnitude is surprising. Some of this might be a drag due to ObamaCare phase-ins and the fact that pretty much everyone now pays out-of-pocket for routine care because of high deductibles. But it strikes me as odd that doctors would respond to a decline in business by dropping prices. There may, though, be some other dynamic that is getting into the data – for example perhaps doctors, sympathetic to their patients’ plight, are dropping prices for out-of-pocket expenditures while hiking them (or upcoding) for insurance claims. In any event, this is passing strange. It seems unlikely that doctors’ prices are going to be declining in the long term, given the aging of the US population. But it’s in the data now, and it’s part of that hefty left tail to the distribution of prices.

But most prices are still rising quickly, and median inflation is right around 2.3% and accelerating. The Fed will tighten today, and likely tighten more in 2018 than the market currently expects unless the market breaks. And that’s really what is being priced: some chance the Fed hikes 4 times, and some chance they stop hiking because the stock market begins to return to something approximating fair value.

(And let’s not fully dismiss that latter point. The equity market is delighted with everything at the moment, but the likely failure of the reconciliation committee to produce a tax bill that both House and Senate can pass, and which can be signed by the President, will be discouraging. Currently the market acts as if this is a rubber-stamp process but remember, both tax bills passed by narrow margins, and have dramatic differences that each house required to get the bare majority. Either some Republicans will be asked to suck it up and vote for a bill with components they refused initially, or the tax bill will fail.)

Categories: Uncategorized

Retail Investors Aren’t As Stupid As They Tell You

December 11, 2017 Leave a comment

Let’s face it, when it comes to the bullish/bearish argument about equities these days, the bears have virtually all of the arguments in their favor. Not all, but almost all. However, I always think the bears hurt their case with certain poor arguments that tend to be repeated a lot – in fact, it’s one way to tell the perma-bears from the thoughtful bears.

One of the arguments I have seen recently is that retail investors are wayyy out over their skis, and are very heavily invested in stocks with very low cash assets. This chart, which I saw in a recent piece by John Mauldin, is typical of the genre.

Now, bears are supposed to be the skeptics in the equation, and there is just nowhere near enough skepticism being directed at the claim that retail investors are being overly aggressive. Gosh, the first place a person could start is with asking “shouldn’t allocations properly be lower now, with zero returns to cash, than they were when yields were higher?”

But as it turns out, we don’t even have to ask that question because there’s a simpler one that makes this argument evaporate. Consider an investor who, instead of actively allocating to stocks when they’re “hot” (stupid retail investor! Always long at the top!) and away from them when they’re “cold” (dummy! That’s when you should be loading up!), is simply passive. He/she begins in mid-2005 (when the chart above begins) with a 13% cash allocation and the balance of 87% allocated to stocks. Thereafter, the investor goes to sleep for twelve years. The cash investments gain slowly according to the 3-month T-Bill rate; the equity investments fluctuate according to the change in the Wilshire 5000 Total Market index. This investor’s cash allocation ends up looking like this.

How interesting! It turns out that since the allocation to cash is, mathematically, CASH / (CASH+STOCKS), when the denominator declines due to stock market declines the overall cash ratio moves automatically! Thus, it seems that maybe what we’re looking at in the “scary” chart is just the natural implication of fluctuating markets and uninvolved, as opposed to returns-chasing, investors.

Actually, it gets better than that. I put the second chart on top of the first chart, so that the axes correspond.

It turns out that retail investors are actually much more in cash than a passive investor would be. In other words, instead of being the wild-and-woolly returns chasers it turns out that retail investors seem to have been responding to higher prices by raising cash, doing what attentive investors should do: rebalancing. So much for this bearish argument (to be clear, I think the bears are correct – it’s just that this argument is lame).

Isn’t math fun?

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.”

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
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