Disclaimer

Opinions and observations expressed on this blog reflect the authors' individual experiences and should not be construed to be financial advice. None of the members of this blog are licensed financial advisors. Please consult your own licensed financial advisor if you wish to act on any recommendations here.

Friday, December 31, 2010

Year End Asset Allocation Model Update

I just realized that I hadn't done one of these in about two months, but the model still just barely puts allocation at the 80% equity/20% bond split that it has since May. I will point out that the model has consistently described a positive environment from stocks and even with the summer sell-off, this has clearly been the right call in a macro sense. That being said, the signals are not as overwhelmingly bullish as they were in the summer after interest rates dropped through the floor while stocks took a 15%+ hair cut.

The aggregate composite indicator on which the allocation percentages are based was off the chart this summer in a way it had not been since March 2009 and in some respects it even exceeded those levels. Since then it has come down, though we are still in very bullish territory.

Based on this and a series of positive economic indicators, I think I very solid case can be made for a good stock market for at least the next six months barring a full-blown financial collapse in Europe, which is a possibility.

Happy New Year, and I am glad that we can end on a positive note.

Friday, December 24, 2010

Some time in the shame corner

I occasionally (and sometimes often) get things very very wrong. I once thought M&I (MI) was one of the better bank stocks out there in 2007, for instance, something that was only true if you compared it to Washington Mutual or Wachovia. In September, admittedly not knowing anything about fashion I thought Skechers (SKX) was the better buy over Crocs (CROX). That was... um.... very very wrong. Steve rightly pointed out that Skechers stores in the malls seemed devoid of customers while Crocs were still in fashion, to my utter amazement. Thank God I exercised prudence and didn't speculate in an area I knew nothing about.

If those five unheard of companies I recommended in early August were my moment of pride and joy this year (if you bought a basket of them you did quite well), this is my moment of shame, where I got a call absolutely 100% dead wrong.

Saturday, December 18, 2010

One good reason to stay away from Europe generally...

http://www.businessweek.com/news/2010-12-16/imf-eu-say-latvia-needs-adjustment-for-budget-goal.html

The case of Latvia is one where the country has followed all of the advice European Union and IMF policymakers have given them... and their economy has contracted over 20% from the peak and unemployment is unspeakably high.

http://online.wsj.com/article/SB10001424052748703471904576003370480205348.html

Instead of engaging in a policy of devaluation to make its goods and services more competitive around the world in a more normal fashion, the EU and IMF have basically force-fed deflation so that wages are being pushed down in a brutal fashion, which is one way to reduce imports... I guess. To paraphrase what Paul Krugman said about this, Latvia was told not to devalue its currency or it would face economic disaster. I respond with, "What exactly is a 20%+ contraction in GDP, 18%+ unemployment and dramatically falling living standards for everyone else?". What Latvia has been put through is nearly criminal.

If this is going to Europe's continued approach all around the periphery of the continent, investors are wise to stay away for the most part except for those European companies that do little business in Europe itself. Deflationary policies are good only for the holders of credit (and even there only in the short run) and bad for just about everyone else.

Thursday, December 16, 2010

Best Buy and Other Retailers

Suffice it to say that the Best Buy (BBY) warning the other day was a bit of a clarion call for retailers. I've rarely seen a stock in a solid uptrend reverse so suddenly and so severely except in asset bubbles. I would be careful about extrapolating these results across the whole of the retail sector, but I think that the run in retail stocks that we've seen since the middle of the year may have seen its best days.

The sell-off after April was largely based on the incorrect assertion that the consumer was going to lead us back into a recession or at least total stagnation. In absence of that occurring, retailers were largely undervalued. Playing retail as a group in that environment was sensible, but we are now entering a stage where one has to be quite selective. The easy money is definitely already made in this group.

Sunday, December 12, 2010

The Out-performance of Silver and Asset Bubbles

 So, from the above chart you can see that the silver ETF (SLV) has recently had a huge run, far outperforming the gold ETF (GLD). Some have wondered why this is, but it's really no great mystery. As you can see, silver's movements are directionally the same as gold's, but are just much more exaggerated in the last three months. Arguably, they are both part of the same play as a hedge against dollar devaluation, inflation, financial instability and so on so why the disparate performance the favors arguably the less intrinsically valuable asset?

It's much the same reason in the late 1990s that the more detached a stock was from its fundamentals, the better. Just off the top of your head, if I asked you which stock would perform better in a huge bull market, a stock with a well established earnings history and reasonably reliable forward earnings projections or a fly by night enterprise with extraordinarily speculative earnings prospects, you would probably choose the former. However, that's not what happens. Instead, when the wind is at their backs in a particular asset class investors turn to the more speculative members of that asset class. Take GE (GE), Cisco (CSCO), JDS Uniphase (JDSU) and Microstrategy (MSTR) in the window of December 1998 through March of 2000. All of these stocks did well and all became quite overvalued, though to far differing degrees.


You can barely see GE's advance there, Cisco returned a very respectable 200% and the other two went nuts with JDSU setting the pace. The last three were all part of the same general play, which was speculation on the growth rate in technology company earnings, while GE was part of the broader bubble in stocks. In order, GE's earnings were the most stable and well known, followed by Cisco, followed by Microstrategy, followed by JDSU. In the earlier days of the bubble, the margin of out-performance of the two trashy stocks was not as large, but it really took off about September-October 1999.

In other words, the trashier the better when a bubble occurs and that would seem to indicate that the surge in silver might be a signal that we are at the apex of a precious metals bubble.

Wednesday, December 8, 2010

The Reason That Quantitative Easing Won't Cause Massive Inflation


I think that a lot of people who expect that quantitative easing of the amount the Federal Reserve is currently engaging in will lead to a large outbreak of inflation is that they assume that monetary velocity is a constant. We know that, empirically, it is not. If velocity was a constant, increases in money supply would lead to matching increases in nominal GDP, which, if not supported by gains in real output, would lead to a corresponding increase in the price level.

However, in the current environment it appears that the damage to monetary transmission mechanisms was so severe that large increases in money supply simply just sit around and don't actually make their way into the economy. The same thing happened in Japan after their real estate collapse where no amount of easy money policies would cause inflation.

The above chart is related to M1, but here is an alternative measure (MZM) which includes a broader measure of money supply.


Japan had a similar case during its slide into deflation:

This is the nature of a liquidity trap in that no increase in money supply will help because all that will happen is that velocity will continue to drop as there is no demand for money. If velocity drops by amounts sufficient to offset the increase in money supply, no inflation will occur. As of right now, this pattern seems to be holding.

Monday, December 6, 2010

On the Fed's Lending to Financial Institutions

I was forwarded this link today: http://www.thinkbigworksmall.com/mypage/archive/1/55002/

I think one of the misconceptions in most discussions of the Fed's interventions during the financial crisis was that they simply handed this money out and it was never heard from again. In some cases that was what happened, but for the vast bulk of it these were short term liquidity facilities that were repaid in short order. This isn't as though the U.S. Treasury issued $3.3 trillion in bonds, wrote checks to a long list of domestic and foreign institutions, and sent them out.

The overall size of the Fed's interventions was a function of the magnitude of the crisis, which paralyzed nearly every conventional lending channel during the worst of the panic. The Fed stepped into the breach and lent out money in a nearly panicked way in which it seems that it extended aid to all comers. Having followed the credit markets very closely at the time, they were so broken that municipal issuers even couldn't take their issues to market reliably, which is actually astounding. In that environment, it is easy to understand how vast amounts of Fed lending occurred.

As far as the lending to foreign institutions, the financial crisis not only paralyzed markets here, but around the world. The Fed is one of the few institutions (the only other two being the ECB and the Bank of Japan) with the resources necessary to backstop not only our own financial markets, but those around the world. As to whether or not it should be in this role, that is a legitimate discussion, but it is also one that inevitably ends in the argument that it was necessary. I'm not sure that those that have it in for the Fed will ever fully appreciate just what we were facing back in late 2008. Not every action undertaken by the Fed or the Treasury was necessary or correctly handled to be sure, but I'm willing to give a pass on the errors given the alternative.

In general, these nominal numbers get thrown around as if there was a transfer of that magnitude to executive compensation of these banks or to the bottom lines of those institutions. Nothing of the sort happened. I remember when there were headlines that combined the value of the guarantees issued on deposits with the short term lending facilities of the Fed and the value of TARP to arrive at a $13 trillion bailout. The next logical thing for people to say was "They've taken out $13 trillion of the taxpayers' money and given it to the banks!". None of that was the case, but it made for good outrage. That being said, I'm all for questions being asked over why specific loans were approved. That's fine and we may find cases where the Fed was in error and their internal control procedures failed. I have nothing against that. However, looking at the totality of the Fed's actions, I do not find fault with them.

Now, on a somewhat related issue, that is not to say that the approach taken in the aftermath of those dark days has been sound. The lack of fundamental reform has been disheartening and there were very weak efforts to ensure that the emergency relief would be used entirely for the preservation of the firms rather than the enrich the executives of those firms at the same time. Frankly, all officers of every firm that got assistance should have gotten nearly zero pay and been forced to pay back their bonuses for prior years since they clearly did not deserve that compensation. To some extent, this is the fault of hopelessly complacent shareholders who accept every proposal from the board of directors without question. However, given that our government and others had to provide such massive assistance both through the central banks and through programs such as TARP (which has to be viewed separately), the onus falls on them and the taxpayers to demand concessions and inevitably that did not happen.

It could be argued that because the Fed got us through the worst of the crisis and avoided complete disaster, we no longer have the leverage to make the changes that were needed and the impetus for true reform has been lost. In the meantime, it appears that the anger of a public increasingly weary from recession and high joblessness is being misdirected at the institution that saved the world from utter collapse rather than the actors who caused the world to get to that point in the first place.

Well, looks like we avoided a sharp fiscal contraction

http://www.nytimes.com/2010/12/07/us/politics/07cong.html?partner=rss&emc=rss

That payroll tax cut in particular is an immensely expensive, and therefore stimulative, provision. On the other hand, all talk about a sharp fiscal contraction to be more fiscally responsible just went right out the window. This is a statement by the US Congress that they do not give a damn about the deficit.

The good news is that this lays the groundwork for a decent year economically next year. That payroll tax cut provides some real oomph for consumer spending and to businesses. I'll be curious about the impact on the Social Security trust fund, but that's another discussion. Of course, this raises my concerns about the long term deficit and debt picture. Tax rate reductions are more permanent in their fiscal effect than spending increases. Spending can much more easily be frozen at current levels than tax rates can be increased. In that sense, it is much easier to work off the deficit impact of spending measures than tax rate cuts.

Tax rates will have to be revisited soon if there is to be any serious discussion of the deficit.

Sunday, December 5, 2010

The Bear Market That Wasn't...(Yet)

Bloomberg has an interesting article on how, despite seemingly bad signals for equities ranging from a slow economy to an entire continent teetering on the edge of disaster, the great bear market of 2010 didn't happen.

Many might think that this is a bubble or out of line by some measure, but the reason stocks have done well is that, fundamentally, they are quite cheap. That was what provided a good underlying bid for most of the year. That, and the fact that there are very few alternatives. You can earn almost as much in blue chip stocks just on dividends as you can on U.S. treasuries.

Now that this headline is out there, we are probably destined for a collapse, but at least it didn't happen in 2010.

Thursday, December 2, 2010

Stocks and Inflation

Just a real quick point about stocks and inflation because I saw an article yesterday about how you don't want to own stocks during periods of high inflation.

First off, inflation still is not anywhere on the horizon. Until there is wage inflation, there can't be any real outbreak of inflation. Anything else that occurs will be transitory. Second, stocks are priced in nominal dollars because their earnings are based on nominal dollars. This means that, all other things being constant, stocks should actually rise as a result of inflation in the long run. However, because all things are not constant, interest rates rise in the short run, which compresses the multiple that stocks can command. This is what happened during the 1970s. Corporate earnings grew quite a bit, actually, but interest rates nearly tripled during the decade.

Once the inflation subsides and interest rates drop, stocks' multiples expand on a larger earnings base. This is, to a large extent, why the 1980s were so good for stocks, particularly in the first two years of the rally. Stocks had gotten ridiculously cheap and the decline in interest rates starting in 1982 helped to provide for a robust multiple expansion.

The upshot of this is that in the long run, stocks are as much an inflation hedge as any other asset can possibly be. In the short run, however, they can take a hit due to interest rate surges. Still, this is purely an academic discussion since inflation is not a threat. Incidentally, yes, deflation is uniformly bad for stock prices.

Monday, November 29, 2010

Illiquidity vs. Insolvency and The European Crisis

There's a big distinction that needs to be made between illiquidity and insolvency when it comes to debt crises and it is useful for thinking about when looking at Ireland.

A crisis of liquidity arises when some kind of short term shock prevents an entity from making a regularly scheduled payment or a huge one-time crisis causes a huge blip in the flow of funds. For instance, let's say I normally can roll over a $10,000 loan every 12 months without issue, but suddenly the bank says no, leaving me with a $10,000 hole in my balance sheet. I can liquidate financial assets, but I don't have enough time to arrange everything. My friends can look at me and say, "Sure, here's 10 grand. Pay us back soon." and this is no big problem for me. A few weeks later, I am done liquidating assets and I have paid them back. This is actually kind of similar to what happened to AIG, incidentally.

Let us look at a case where I would be insolvent. Let's say I had a $500,000 mortgage and I could service it with a $120,000 income fairly easily. However, my income was based on a bunch of one-time incentive pay that I won't get again and my more regular pay is about $50,000. Combined with the mortgage, I have a large car payment, high property taxes and so on. What's more, because the economy is bad, I can't reasonably expect to increase my income any time soon. Over the next year, I am obligated to pay more than my entire gross income in these various payments. Even worse, I am $200,000 underwater on my mortgage because of the real estate slump. If you came along and said, "I'll give you a credit line of $20,000 that you have to pay back in three years." I would tell you it just doesn't matter. To use a technical term.... I'm screwed.

Europe's approach is very much like the latter, but with an added twist. They give you the credit line, but force you to take a pay cut in the form of austerity policies that reduce your tax base through deflationary forces. In the case of Greece, they deserve to suffer from austerity policies as they were profligate. Ireland, on the other hand, was not and everyone is paying for the sins of overly leveraged, irresponsible banks that took advantage of their size to maximize risk and doing so while knowing the state would inevitably bail them out. Ireland will never be able to pay it back, not with an economy relegated to depression. Ireland should default, or just come close to it, so that Europe gives more favorable terms to a country that doesn't deserve what is happening to it.

Saturday, November 27, 2010

Quantitative Easing Explained.... By Sane People



This isn't as silly as the much more popular version that was made by Austrian (school) economists/Tea Party/etc idiots, but it is fundamentally much more correct.

A peculiar resiliency of markets to geopolitical crises

One of the interesting sub-plots of the ongoing crisis between North and South Korea is that it's had a comparatively small effect on South Korean stock markets. 


Sure, markets have sold off a little bit, but considering the prospect of a potentially ruinous war, markets have been taking it all in stride. Then again, if you look back to the Cuban Missile Crisis in 1962, our markets did not sell off much. The Dow fell from about 586 to about 569 during the crisis. That's a fairly puny decline of around 3%. As a point of fact, it's hard to make the argument that a decline that small was even caused by the crisis. 

When you compare it to the vast overreaction to 9/11 or the sell-off preceding the Iraq War, which had very little economic effect, such reactions are puzzling, but it seems that markets don't sell off much on the low probability of disastrous events and sell off drastically on the high probability or the occurrence of relatively minor events. 

Some people should not talk about public finance

Ugh. W. Kurt Hauser wrote a piece in the Wall Street Journal that nearly gave me an aneurysm.


He asserts that no matter what you do with taxes, tax revenue comes in at 19% of GDP because tax increases hurt economic growth and tax cuts increase it. Oh really?

If you average the Bush years versus the Clinton years, the federal government average taxes as a percentage of GDP nearly 2 full percentage points below the Clinton years. This was despite a huge run up in corporate tax receipts as corporate profits hit an all-time high that had just about nothing to do with tax policy since corporate tax rates were left at 35%. Comparing peaks in the business cycle we also have about a 2 percentage point gap. 

Not all of this is the static effect of taxes being at lower levels. It is also a function of the fact that the economy did not grow nearly as quickly in the 2000s as in the 1990s. However, that in of itself would seem to indicate that tax cuts don't generate additional revenue as there was nothing particularly remarkable about economic growth following two significant tax cuts in 2001 and 2003. 

Ah, but Mr. Hauser says that we can see that economic growth was revived by the tax cuts. He says the six quarters following the tax cuts averaged a GDP growth rate of 3.8% compared to an average of 1.8% prior to the 2003 tax cuts. First of all, he is ignoring that the larger of the two tax cuts was passed in May of 2001. Secondly, he is ignoring the fact that the Federal Reserve was substantially aiding the recovery from the recession with massive monetary stimulus. Thirdly, the recovery in the economy was led by residential fixed investment, which had little to nothing to do with tax policy changes. Fourthly, at comparable portions of the business cycle, tax revenues as a percentage of GDP were lower in a systematic way. So, not only did GDP not grow as fast, we collected less of it in taxes. 

Looking at the same comparison he attempted to make for just the 2003 tax cuts, we have 1.3% average growth in the six quarters following the 2001 tax cuts compared to the six quarters preceding them at 2.2%. Also, for the recent stimulus (which I am sure Mr. Hauser does not approve of), we have averaged 2.3% since its passage compared to -2.1% in the six quarters before it. Is this disingenuous? Oh heck yeah, but what he did also was. This sort of analysis does not constitute any form of economic analysis. It is selectively applied correlation analysis, but there is no systematic approach applied to compare the period he selected with other similar periods and other tax policy decisions, or to control for what other economic trends were at work (Federal Reserve interest rate decisions, reductions in oil prices, housing market trends, etc.), or... well... any kind of analysis at all. 

Incidentally, under a similar form of analysis I could point out that the six quarters following the Reagan tax cuts averaged -0.9% GDP growth, but that isn't fair since the Fed killed economic growth to subdue inflation. Similarly, you cannot credit the growth that started in Q4 1982 to the tax cuts entirely because the Fed was the primary agent stimulating economic growth at that point. 

If you make decisions on whether or not to invest on political pundits such as Mr. Hauser, who also apparently has an incredibly inflated ego, I urge you to reconsider. I would remind everyone that many Glenn Beck followers completely missed the largest stock market rally in recent history from the March 2009 lows because they were convinced that some Communist takeover had just occurred. 

Monday, November 22, 2010

The Irish Financial Crisis Becomes a Political Crisis

http://www.nytimes.com/2010/11/23/world/europe/23ireland.html?_r=1

This has been an ongoing concern of mine for most of the European debt crisis. First, universal austerity simply does not work as a strategy for dealing with massive debt levels as its deflationary influence essentially digs the hole deeper as you are trying to get out. Secondly, it's politically damaging considering that it will coincide with a severe economic crisis. Ireland is in the midst of what can only be described as a depression and that will not correct anytime soon. In fact, it will get much much worse considering the magnitude of their fiscal contraction. The incumbent government will lose the next national election considering that the prime minister has a whopping 11% approval rating from the last poll I saw. Frankly, they should lose given that they have been in power for the boom and now the collapse.

This really is an issue where many Irish sense that their nationally sovereignty is at risk in these bailout agreements. At the same time, they really don't have a choice, but then again neither does Europe. The EU cannot allow Ireland and its banks to fail due to the collateral damage. It will be interesting if Ireland decides to take the approach that they will limit what austerity measures they put in place because they realize their importance to European financial stability. In the long run, Ireland's economic situation will get so bad that it risks severe political instability of the sort that we haven't seen in a while in most developed countries. They already have a 14.1% unemployment rate and that will not get better with the austerity measures being proposed.

As far as the EU's approach on all of this, I am doubtful of its long term viability. Basically, Germany and France are on the verge of backstopping Greece, Ireland, and then Portugal and Spain. If and when Spain becomes part of the mix, I really don't know that they are good for the money. At the same time, they are pursuing deeply deflationary policies which pose a particular problem in the context of a deflating asset bubble. The deflating real estate prices in Ireland, the UK and Spain are one of the major causes of the ongoing banking problems and austerity will only contribute to further deflation of those prices. As this pain continues, it will be difficult for governments to maintain policies of retrenchment.

Frankly, there is a serious risk that Europe is entering a deflationary spiral of a fairly severe magnitude, which will invariably lead to continued political instability.

Wednesday, November 17, 2010

Ireland and Financial Contagion

So, I believe it is time to bring out this table again of U.S. banking exposure:

As you can see, our banks have a fair amount of exposure to Ireland, but more worrying is this article from the Daily Telegraph. The exposure that British banks have to Ireland may be sufficient to sink them in their already battered state. What's more is that the current government in the UK is already somewhat hobbled by flagging approval ratings in the face of budget cuts. I am not certain how much stomach there is for potentially another big round of bailouts. International coordination might take some of the sting out of it, but we are looking at another round of substantial bailouts that are quite unpopular. Apparently, the IMF stands ready to save the day. The indications are that Ireland is actually the reluctant party and that the EU and and the IMF have been attempting to push for a bailout for some time.

Fundamentally, a bailout is needed to prevent a severe near term financial crisis in Ireland. While many have tried to point out that Ireland's government is funded through mid-2011, that is only relative to current spending. Ireland has guaranteed basically all deposits at domestic banks, meaning that widespread failures would trigger significant immediate government spending. In short, if the banking crisis gets bad enough, there is a solvency issue.

Frankly, I'm amazed that the Irish banks are still standing after a run amounting to 11% of deposits has already taken place. We'll see if an international backstop stops the bleeding. If you want to speculate on worthless Irish bank stocks, have at Anglo Irish (AIB), but what little is left of the value there is probably at risk even at these levels. At best we are probably talking serious dilution.

Monday, November 15, 2010

The Municipal Bond Rout

One thing I've always marveled at is just how quickly a bond market panic can materialize. Case in point, the municipal bond market rout over the past several trading days.

My favorite proxy for munis, MUB, has sold off in spectacular fashion, but this rout has not been entirely confined to munis. Treasuries have sold off too, as shown in this comparison with TLT.

Still, when you consider the generally narrower bounds in which MUB trades due to not only being long term securities, it is clear that this sell-off is more than just a turn away from government bonds generally. Now, as to the proximate cause of this panic, it is hard to say. There isn't a general financial panic like there was when muni bonds did this back in 2008.
That sell-off was caused by hedge funds desperately raising cash from whatever they could and they liquidated municipal bonds without mercy. This sell-off has been partially blamed on a large issue by California  coming to the market. I'm not so sure about that. I have a hard time buying that a $12 billion issue by California is enough to cause this mayhem. It is true that with Republicans now controlling one house of Congress that federal aid to state and local governments is unlikely to aid them as they attempt to bridge their budget gaps. Still, the election outcome was not a surprise and usually bond markets price things like that in.

The PIMCO California Municipal Income Fund (PCQ) might be making a bit of a fool of me, though. It has shown a sharper rout than munis in general and because California is such a large segment of the muni market this may make sense. However, with California now having the ability to pass budgets more easily, I'm not sure that questions about California's solvency are quite as pertinent as they used to be. Regardless, California munis have been obliterated.

Very oddly, this has been accompanied by a sell-off, not a rally, in gold. If there's one asset I would expect would do well in a rout of safe assets, it would be gold.

This bears watching and there's easy money to be made in munis if the sell-off gets out of control. Don't be so foolish as to pick up individual issues since if you happen to buy a special district's issues without understanding what revenue stream backs its payments, you can end up in a world of hurt. Those can and do default.

Sunday, November 14, 2010

A Brief Editorial on What Is Needed to Balance the Federal Budget

Because I was asked to give my thoughts on the long term federal budget deficit picture, I will. Nothing I am about to express is any official position tied to my post with the State Budget Office in the Wisconsin Department of Administration and neither reflects the views of the outgoing administration nor the incoming administration. Now that those preliminaries are out of the way, on to the real business at hand.

It is important that the deficit is first framed correctly and to get past all of the politics of it. What it boils down to is that this is an issue that primarily relates to revenue, rather than expenditures. Yes, one could argue that if we reduced our expenditures to a more "reasonable" level (whatever that means), we could make current revenues adequate. However, in terms of actually determining how we got from moderate, though still large deficits, to extraordinarily huge ones, we need to look at the revenue side of the ledger. What we find here is that, despite these assertions by some that taxes are far too high, taxes as a percentage of GDP are the lowest the have been in recent memory.


What we have seen since the recession began is a large one time spike in expenditures due to higher automatic stabilizers (unemployment benefits, food stamps, Medicaid, etc) and of course the bailouts, which were necessary to prevent a complete meltdown. Unfortunately, the aspect of this that isn't one-time is the large addition of debt, which will increase debt service payments dramatically. Most of the other increased expenditures enacted over the past few years are nothing out of the ordinary and don't amount to a dramatic increase in permanent spending much beyond what would have occurred otherwise.

The combination of the 2001 and 2003 tax cuts along with the cut punch of this recession has driven tax revenues as a percentage of GDP to right around 15%. With an economic recovery and the reversal of the Bush tax cuts, the CBO projects that revenues would return to over 20% of GDP by fiscal year 2014. Of course, the difficulty is that there is not a chance we will be able to reverse all of the tax cuts, even though we really should do so. As a consequence, instead of a 3.0% of GDP deficit by the middle of the decade, we are probably looking at more along the lines of 4-4.5% of GDP, depending on how much of the tax cuts we retain.

We do need to recognize that we need more than just tax increases on upper income earners in order to solve the revenue side of the equation. There needs to be a broad based tax increase, possibly led by what the deficit commission has laid out with the elimination of a variety of tax expenditures including the mortgage interest deduction. I am particularly in favor of that since I've believed for years that the mortgage interest deduction is one of the many things that drastically distorts the housing market. I would be in favor of keeping it in a compromise, but with a low maximum deduction. The tax code, generally, needs to be simplified so that the rates are more meaningful both to taxpayers and to policymakers, but this needs to be done in a decidedly revenue additive way.

Additionally, while a progressive tax code is desirable, we do need to increase taxes in a broad way since relying on only the highest tier of income produces a great deal of revenue volatility as bonus and interest income that is subject to the highest marginal tax rate is immensely variable in economic booms and recessions. One way of achieving a broad based tax increase that would be gradual would be to suspend indexing of the brackets for several years while also raising rates on the top three brackets. In an ideal world, income between $100,000 and $200,000 would be taxed at 35%, between $200,000 and $350,000 at 40% and $350,000 and above at 45%. There should be no offsetting tax cuts whatsoever. The only shift I think would be desirable would be the elimination of the corporate income tax and a commensurate shift of burden onto personal income taxes. Of course, good luck getting that done politically.

Though I've generally been in favor of preferential tax rates for investment income, when you look at the national income accounts, it is clear that we can't just wall off dividend income from paying its fair share of taxes. We're talking around $800 billion to $1 trillion a year in dividend income and, additionally, several hundred billion a year in capital gains realizations. Further, due to various tax schemes that we can get into another time, a lot of income gets sheltered into the more favorable investment tax rates (see carried interest). In more flush times, I might be in favor of maintaining the preferential treatment of investment income, but as it stands now this is a sacrifice that might have to be made. A consequence would be a contraction in valuations since expected after-tax earnings on investments would be reduced.

I haven't done all of the math, but instead of what the deficit commission has suggested with taxes as a percentage of GDP never topping 21%, we should approach it with a mind to increase taxes as a % of GDP to 23% or even 24%. It's an inevitable payback for having taxes far too low in relation to spending for too long. It's not that spending has been out of control, but rather that we haven't been paying for our existing commitments. As a consequence, the deficits accumulated have rolled up into a large future debt service burden that will crowd out other necessary areas of federal spending that are realistically too painful to cut back on.

On the expenditure side, in the short run defense spending has to bear the brunt of the reductions. Outside of one-time economic stimulus spending, non-defense discretionary spending has not increased a great deal in a fairly long time. That's not to say that it shouldn't be reduced, but that quite frankly there isn't enough there to cut. In defense spending, there is a good deal of froth that doesn't do us very much good. I know some have tried to argue that defense spending is more stimulative than other forms of government spending, but that is utterly preposterous. If someone can tell me how this:
is more stimulative than this:
I'm all ears. The truth is that defense spending delivers very poor bang for the buck in terms of the domestic economy. Spending money on capital equipment that is not used for the provision of future goods or services does not deliver the same multiplier as spending that is used for future production. The appropriate lesson drawn from the World War II spending is that when you are in a massive economic slump, a heroic deficit can bridge the gap in private consumption. To say that building thousands of Sherman tanks to be destroyed on the fields of France is more stimulative than building new schools, highways and power grids is fairly astonishing. In any case, the end result of this is that spending cuts should be concentrated in what is a truly bloated defense budget to the tune of $100 billion, concentrated in procurement, the navy and the more extraneous portions of the air force.

I'm all in favor of a non-defense discretionary spending freeze starting in FY13 and possibly even reducing spending then by 5%. In truth, most of the effects here are marginal at best, but there is some effect there to be sure. I'm not willing to cut NIH and some of the other major chunks of the non-defense discretionary budget that are vital to long term research and development in this country, which is where we need to be focusing investment. This economy will only continue to be competitive with massive investments in human and physical capital and those have to be well targeted. Spending cuts must be prioritized based on economic impact. Those with less economic disruption must bear more of the burden than those that have high returns in the sectors that are our growth engines in science and technology.

As far as the timing of all of this, it is not vital nor prudent that any of this be done right away. It is not vital because the deficit will narrow considerably as some of the one-time revenue hits and spending hikes wear off. It is not prudent because a sudden and drastic fiscal contraction of 3-4% of GDP would invariably cause a recession and once again depress tax revenues into the 15-16% of GDP region. In the next fiscal year we face a steep contraction in state and local government budgets that, combined with severe federal budget reductions, could drastically damage domestic consumption. We need to get over the hump and be well on the way to sustained economic growth before taking on a sharp fiscal contraction. If we repeat the mistakes of 1937-38, we will regret it. In general, I would prefer to wait at least one year before bringing on the pain. Some of the defense cuts can be done sooner than that since their effect on the macro economy is likely to be quite muted. The mix of the fiscal contraction should be initially weighted toward high income tax increases and defense spending cuts since those have the smallest short term contractionary effects on the economy.

While Social Security and Medicare changes are not that important in the short run to righting the deficit, in the long term the deficit will become truly massive nearly entirely on account of Medicare. Social Security is easy to fix where you eliminate the cap on taxable earnings and also go to lower inflation factors for benefits. This would actually throw off a lot of excess cash that would inevitably go to the general fund. What's better is that neither change would undermine the basic functions of the program. These changes can be implemented years from now and we will still avoid disaster.

Medicare is tricky as the policy levers available are either brutally simple (strictly capping benefits, raising eligibility age, etc) or nearly impossible to assess (increasing competition in the health care industry, capping medical malpractice awards, better enforcement actions). I generally subscribe to the view that at some point health care inflation will slow down considerably, which is not baked into most of the long term budget forecasts. Regardless, CBO has modeled what happens under such slowdowns and you still come nowhere near closing the gap. I have to admit I don't have good answers here beyond draconian ones. I am willing to wager that health care inflation won't always be such a high multiple of inflation in general solely because at the rates the "experts" are speaking of it would crowd out the rest of the economy. At some point before then, employers would scream and drop coverage if costs didn't come down and state and local governments might do the same. Even so, the aging of the population, which is a somewhat (though not entirely) separate issue from high rates of health care inflation, will drive up expenditures significantly as is. This simply cannot be bridged with tax increases because the sorts of tax increases we would need would be utterly ruinous. Unless a strong regimen of cost control is implemented in one form or another, this will destroy us. To repeat, I don't have good answers here.

Now, let me briefly address those who think that you can cut taxes and the deficit at the same time. This is baloney. The reason why tax cuts generally are followed with higher nominal dollars of revenue is that the tax cuts that have been implemented are smaller than the underlying growth in revenue. There is basic simple math that makes it nearly impossible for tax cuts to pay for themselves. If you are at 20% of GDP in taxes and you implement 1% of GDP in tax cuts, GDP has to grow 5% above where it would have in absence of the tax cuts in order to make up the gap you have created in revenue. That's a multiplier of 5x. I've never seen a single study that suggests anything like that is even remotely possible and most suggest multipliers of less than 1x. It's a little more complicated than that because the distribution of income might change more heavily toward upper income groups with lower rates as upper income earners might be comparatively more incentivized to work, pushing more income into higher marginal rates. Even so, the numbers are nearly impossible. It's true that the stimulative effects of tax cuts do replace some of the lost revenue, but they will not improve your fiscal position nor will they even break even.

Those are my thoughts for now. I regret not having more specific dollar amounts available since I didn't have the time necessary to model all of this even in a rough fashion. Luckily there is a New York Times tool that has some estimates for various proposals: https://www.nytimes.com/interactive/2010/11/13/weekinreview/deficits-graphic.html

Friday, November 12, 2010

Strength of Treasury Auctions

This table is from Haver Analytics. When you look at the bid to cover ratios (value of bids/value of accepted bids), yes the recent auction was disappointing relative to auctions this year. However, when compared to actions in normal times, such as 2006, it's still stronger than at that point. I don't remember anyone in 2006 saying that the U.S. government was on the brink of default. 

The same certainly goes for shorter term bills and notes, where we have actually seen record high bid to cover ratios for some issues. Some of these levels are about 2x what they were in 2006. Generally, the shorter term you go right now, the higher the bid to cover ratios are. Bid to cover ratios have generally been a little bit stronger (and I do mean a little bit) on the short end of the curve than on the long end, probably due to there being a greater preference for more liquid assets. 

Now, what we are seeing in recent action is that bid to cover ratios for short term instruments are running around 4-5x compared to long term running around 2.3x to 2.7x. The reason for this disparity is that long term treasuries are simply a very risky proposition at these interest rates. The odds of significant principal loss are high whereas you don't run that risk with the short term bills. You don't earn any interest on them either, but it's still reflective of individuals and institutions being more concerned about capital preservation than appreciation. 
There was a bit of concern on Wednesday about a "disastrous" 30-year treasury bond auction. In truth, by the metrics that are typically used, it really wasn't that bad.

Thursday, November 11, 2010

Deficit Reduction

So to my surprise, Obama's deficit reduction committee announced some ideas recently. http://www.foxnews.com/politics/2010/11/10/deficit-commission-recommends-changes-social-security/ . The reason it surprised me is that usually these types of committees don't amount to anything. But, since they are led by some former politicians, they are savvy and know that the first person to propose something sets the discussion for the future debate.

As for the actual merits of their proposals? I would love to hear from the expert on government spending, Mr BQ Budget Master.

Dirty Sexy Money

Money and politics go hand in hand, but luckily, there is still some hope for democracy. This site lists candidates by how much of their own money they spent on their election. As one can see, the self funders don't have the greatest record. http://www.washingtonpost.com/wp-srv/politics/dollars-per-vote/index.html
 
However, there is still plenty of money in politics with so much political fundraising as well as outside spending. I guess we need to make some smart investment choices so we can buy votes in the future.

Tuesday, November 9, 2010

Something interesting from MMC's earnings report

Marsh and McClennan (MMC) has been a perpetually disappointing stock and the single worst of my DRIP plans since I bought it in 2005. That was one of those cases where I tried to venture into something I didn't understand after they had a bid rigging scandal that crushed the performance of their primary insurance brokerage unit and then had a scandal in their Putnam Funds unit as well. The result was that until recently every single earnings report they had was an incredible disappointment. Now they are just mildly disappointing.

In any case, when I was going through their press release, I couldn't help but notice that Mercer Consulting is seeing strong revenue growth in the area of health benefits (8% growth on an underlying basis). Earlier this year they were only experiencing about 2% growth. It could be that comparisons are easier now, though I don't quite think that's the case. More likely, this is an interesting side effect of the health care reform law. An entirely different storyline is visible in their "Rewards, Talent & Communications" line which often has to do with HR consulting for executive compensation packages. The growth there was quite strong at 12% on an underlying basis. It's possible that this signals more white collar employment and compensation growth in the near future, though it is good to avoid reading too much into any one number.

Milton Friedman on the Gold Standard

Since Robert Zoellick, a man of a profoundly meager intellect, decided to open his trap on the Gold Standard, I think it might be worth having a man of a far greater intellect speak on the subject. While I certainly do not endorse everything Milton Friedman stood for, he was a brilliant man who was a generous enough man to recognize the brilliance of Keynes even though he disagreed with him vehemently.

Robert Zoellick is an Idiot

http://www.ft.com/cms/s/0/213e17aa-eb5d-11df-b482-00144feab49a.html?ftcamp=rss#axzz14mw57feO

Basically, Robert Zoellick, head of the World Bank, is saying that we should entertain the return of gold-backed currency largely because markets, at the moment, are treating gold as an alternative to paper currency. Somehow, he believes, currencies backed by gold would provide more stable economies. Never mind that while global economies were on the gold standard in the 19th and early 20th centuries we had routine severe financial crises about every seven years and a very nasty tendency toward deflation.

James Hamilton over at Econbrowser has a fairly succinct post on this matter about how the gold standard actually contributed to the Great Depression (and probably made previous depressions worse as well). http://www.econbrowser.com/archives/2005/12/the_gold_standa.html

Sunday, November 7, 2010

QE and the Macro Climate for Stocks, Bonds, and Commodities

Since the Fed has decided to further monetize the debt in bid to try even more monetary stimulus, a few things are clear. One is that the Federal Reserve is absolutely nowhere near tightening and won't be for many months to come. That should be no surprise considering the size of the present shortfall in employment. The other is that the dollar looks like an extremely unfavorable investment right now, meaning that foreign stocks are comparatively more attractive in the interim as the supply of dollars will increase greatly as well as the fact that US interest rates will do a poor job of attracting fixed income investments. Foreign investors holding dollar denominated investments better watch out.

One thing that is abundantly clear is that financial markets have interpreted this Fed action as an all clear signal and everything from gold to Goldman Sachs (GS) has joined in. We are not in bubble territory in the stock market, though we are almost there in some, though not all, commodities markets. Those who are using commodities as a substitute for investing in financial assets in times of loose monetary policy continue to push those assets further and further from their fundamental values. There is no need to be worried about a bubble being fueled in the real estate markets. Those are so far deflated that no amount of monetary or fiscal stimulus could re-inflate them because investor expectations of returns have been so brutally throttled.

In the short run, meaning the next few weeks, I would not be stunned to see some retracement of recent gains on the order of as much as 5% in domestic stock markets. However, the next 12 months or so should be quite good. Earnings growth for the time being is strong and interest rates will not be a headwind. Commodities markets are probably a better than even shot to outperform in this environment as this global distrust of "paper" currencies seems to really be hitting a frenzy. However, once this current period of extremely loose policy relents those investments will crack much worse than the equity markets in the aggregate because there is much less of a link to fundamental value.

Stocks are supported by extraordinary levels of corporate profitability that make overall valuations quite reasonable. This is due in no small part to the current levels of slack in the labor markets that allow corporations to enjoy a larger share of productivity gains without passing them along as wage increases. However, lack of investment in both human and physical capital means, to a large extent, that corporations are cannibalizing future earnings for current earnings. Invariably this means that future earnings growth will be relatively muted as corporations need to hire and expand plant and equipment to grow sales as conditions normalize. That will prove to have a dampening effect on the later stages of the present rally.

Bonds, on the other hand, are currently being supported by Fed purchases, but this obviously will wear off, particularly as investors in long term bonds become frustrated by their low rates of return compared to high rates of return elsewhere. As such, prices will fall and yields will rise, possibly considerably. Long term treasuries are thus not a particularly good place to be.

Now, all of this is just my own opinion, which in no way constitutes professional advice, and I could certainly be wrong as I have been in the past. Still, it seems to me that this represents a fair summary of where we are right now.

Sometimes the interplay between politics and economics doesn't make sense:

http://www.ritholtz.com/blog/2010/11/wtf-data-point-dems-lost-seats-better-economies/

When you think about it, Democrats did quite well in California (12%+ unemployment) and quite badly in my home state of Wisconsin (7.8% unemployment). Does that make much sense? Not really. Of course, I have argued that we are simply in an era of dramatic political volatility rather than any particular ideological movement one way or the other. If you look at Europe, center-right governments in Germany, France, and Italy are all on the verge of collapse or are at the very least deeply unpopular. The newly elected center-right government in the UK already has fallen behind Labour in recent polling.

At the same time, Japan has recently lurched right after electing its first clear center-left government in several decades. Some of the Latin American governments seem to be shifting right, though that certainly didn't hold in Brazil where the Worker's Party (which is effectively Socialist) won quite easily. Spain's socialist government is probably quite likely to lose when the next election happens there due to truly crippling unemployment rates and an economy very unlikely to right itself anytime soon.

We are simply at a time where it is advantageous not to be in power and this was even true in 2008 as well. There were parts of the Democrats' success, or alternatively the Republicans' weakness, that under most elections would have been quite stunning, but in an environment of extreme economic strife such things can happen. The same applied this year as well in reverse.

I suspect that 2012 will see a fairly large number of seats change hands again in the House. If we enter a protracted period of stagnation, or something that at least feels like it, don't be surprised if party control changes routinely. The interesting consequence of that is that we might see truly paralyzed decision making at a time when fairly decisive action is required.

Saturday, November 6, 2010

How Big is the Employment Gap?

When trolling around blogs, I've seen some discussion about the size of the employment "gap". Put simply this is the difference between where we would be in total employment in a healthy labor market relative to our labor force compared to where we are now. The old rule of thumb that is used is that we have to create about 150,000 jobs a month just to break even on this proposition. Given that we were seeing employment contracting virtually non-stop from the beginning of 2008 until the end of 2009 by a total of nearly 8 million and have grown by less than 100,000 a month on average since then, this gap is huge.

However, there are some complications in arriving at it. One is that the proportion of the adult population involved in the labor force is not a constant even beyond the swings related to economic activity.

Excluding cyclical activity, the employment to population ratio clearly was in an up trend from the early 1970s to the late 1990s as more women entered the labor force. However, it is possible that this has started to slide into reverse, but it is hard to tell at the moment given the enormous magnitude of this recession. If the employment to population ratio is actually in decline, this somewhat lowers the threshold of necessary job creation. Let's say for the sake of argument that the average of the employment to population ratio from March of 2001 (the start of the last recession) to December 2007 (the start of this recession) is a decent proxy for a healthy participation rate. That works out to be 62.79% or so. If we take that percentage and multiply it by the adult non-institutional population, we get something like this:
This is household survey data rather than the headline establishment survey data we generally see in the press. It's harder to turn establishment survey data into these sorts of numbers, but that doesn't mean that I won't try. In any case, by this measure, the employment gap is approximately 10,712,000. This gap gets worse by about 122k a month with no job creation. 

Just for the sake of comparison, let's do something one should never do and compare establishment survey data to this and mix some data sets. This is a big no-no, but it's to try to put the headline number of +151k in context. 
By the way, the reason that the trend has kinks in it is that the non-institutional civilian population number tends to be adjusted periodically and that leads to these one-time adjustments like that. In any case, by this measure we are 11.4 million below where we need to be. What's interesting is that we barely got where we needed to be in the last expansion because it was quite weak. One could argue that outside of the housing bubble and its associated positive effects including booms in the construction and financial services industries, we didn't have much of an expansion at all between 2002 and 2007. Growth was sub-par as it was and Lord knows where we would have been in absence of the housing bubble. Going forward, it appears that the number of new jobs we need in the establishment survey to break even is around 116,000 a month.

The employment gap isn't necessary to close in order to restore growth, but until it starts narrowing a great deal you are going to have substantial downward pressures on wages. The prospects for generalized inflation with this much slack in the labor market are quite low.

Friday, November 5, 2010

October Employment Report

The overall change in non-farm payrolls was +151,000. The interesting piece was what happened to hours worked in that the aggregate hours worked increased a smidge over 0.4%, which is actually a very strong number. Government continues to be a drag, but not in the way that some who say that government is out of control would imagine as employment dropped 8,000. Interestingly, with revisions, the private sector has gained more than 100,000 jobs each of the last three months while government has averaged nearly 100,000 in losses.

Overall, this was actually a flat-out solid report and it does seem to echo what we saw in the ISM indices earlier this week. We still aren't going to make any meaningful dent in unemployment for several months even if we keep this rate up.

Wednesday, November 3, 2010

October Auto Sales Fairly Strong

In case you missed it, October was a, by recent standards, a banner month for auto sales. We are still at levels that during normal times would indicate serious problems or would otherwise be dismissed a freakishly low, but the fact that the automakers are profitable at these sales levels speaks well to the performance of their stock prices.

Ford (F), has had quite a nice run as well all know, but it still is not that richly valued. According to Marketwatch data, it's trading at a little over 7x forward earnings estimates, which are probably too low. Even after rising so much so fast, it's still not exactly that rich. Now, will you make 10-fold on your money again? Certainly not. However, a decent 40% from here is certainly conceivable.

Looking elsewhere in the automotive sector to automotive parts suppliers, I don't see so many good buys, however. Borg Warner (BWA) is looking a little pricey, at least relative to the market. Johnson Controls (JCI), a personal favorite of mine, looks good from here, but not better than Ford. I kind of like Dana (DAN), but it still doesn't exactly scream "buy".

All of them have had impressive one year runs, however.

Notice the S&P 500 down there, having a respectable 15% gain that looks positively puny. Normally, after a sector has had such a break-out performance one would expect that it might be about to go through a phase of dramatic underperformance. However, before that happens I think there is still room to run for the sector as a whole, though Ford seems to be the best positioned. As for the looming GM IPO, I would need to take a good look at their financials. They've been somewhat opaque while in their quasi-public-private status.

Thursday, October 28, 2010

Double-Dip Recession Seems Unlikely

This article sums it up reasonably well: http://money.cnn.com/2010/10/28/news/economy/no_double_dip/

We are clearly in a time of slow growth, which was admittedly surprising given how the data were coming in around mid-April. As the Arouba-Diebold-Scotti Business Conditions Index shows, we seemed to hit an air pocket in the late spring and the loss of the temporary Census jobs has made things look even worse since then:


However, this does seem to be abating with regional manufacturing surveys turning up from a three month or so downturn. Additionally, jobless claims may be easing downward slightly again. For a brief time it appeared as though we would be heading back in the 500,000 range again, which would present serious problems. Additionally, despite rapid deleveraging by households, consumer spending has remained steady as balance sheets are being repaired. Auto sales in October appear to be OK by recent standards (and recent standards only) and weekly retail sales have been hanging in there. Nothing stellar to be sure, but hardly the stuff of nightmares.

Housing, of course, remains a potential problem as house prices are declining again and appear likely to retrench for some time. It is possible that a renewed decline in house prices may cause a shock to consumer spending as consumers desperately attempt to rebuild their balance sheets by radically curtailing spending. This is the problem of deflation as consumers become frightened of their collapsing net worth and retrench. If the renewed decline in housing prices is more rapid than expected, this is a potential risk.

Now, the one thing to be truly concerned about is looming cuts in public sector spending, particularly potentially drastic cuts from the federal government. We all know the story about state and local governments (I work in state government so I've seen it first hand) and their pain has already been felt both on the street and in the data. However, with the likely changes in Congress it is quite likely that extensions of unemployment benefits, Medicaid enhancements, and many other programs will be severely cut back, directly harming personal incomes and reducing employment. In a time of depressed demand, it is terribly difficult to see how this is stimulative. Without being political here, the only economic case for a fiscal contraction being stimulative is where there is an ongoing fiscal crisis that is causing elevated interest rates and therefore a general credit crisis. There it is possible to see how deep cutbacks in government spending can be stimulative. In our case, it is hard to see.

Monday, October 25, 2010

El-Erian Says Quantitative Easing Will Cause Inflation

http://www.bloomberg.com/news/2010-10-25/pimco-s-el-erian-says-fed-treasury-purchases-may-disappoint.html

I say "Good". Inflation is necessary to unwind some of the excesses of the credit bubble over the past decade. Debt is denominated in nominal dollars and can be eroded via inflation. Particularly, inflation would help unwind the negative equity situation that many homeowners find themselves in.


Now, of course the flip-side is that this means higher interest rates and the plethora of issues that come with that. However, I think we have proven since mid-2008 that low inflation and low interest rates are not enough particularly in an environment of high consumer debt loads. The issue is if we get the sort of inflation we had in mid-2008 when commodity prices surged and had the effect of rapidly reducing real incomes. That makes servicing debt actually more difficult. To be honest, given the behavior of commodities markets so far, I am concerned about this prospect. It does seem that the excess liquidity likes to slosh in there at the moment (See the commodity charts below).



Thursday, October 21, 2010

Mutual Fund Fees

One of the most mundane, but most important, issues when choosing a mutual fund is the issue of fees. I know very few people who can tell me what their mutual fund fees are, but they should take a good long look at them. The same holds true with ETFs, which also charge management fees.

First, let's talk about why you should care. This is because fee differentials can do murder on your long term wealth. Let's take a large cap value fund at random, say the Janus Perkins Large Cap Value Fund. It has an expense ratio, the percentage of the fund's assets it collects as fees, of 1.12%. Compare that to the Vanguard Value Index Fund, which has an expense ratio of 0.26%. The Janus fund slightly outperformed the Russell 1000 Value Index since December 2008 (13.87% vs 13.65%) and actually underperformed the Vanguard Value Index Fund over th past year by over 300 basis points. This highlights the issue that most actively managed funds cannot (I should say "will not") beat index funds. However, even if it did maintain that 0.22% outperformance over a long period, that fee differential would wreak havoc.

Let's use a ten year example where the value index does 8.00% and the Janus fund does 8.22%. At the beginning of the period you invest $10,000 and the expense ratios are assessed at the end of each year. In the case of the Janus fund you end up with $19,487 and with the Vanguard fund you end up with $21,034, a difference of over $1,500 or nearly 8%. That's even with the Janus fund's small margin of outperformance before fees. Add in the issue that actively managed funds generate more problems with pass-through capital gains and the problem compounds.

None of this is to say that there aren't good actively managed funds that can, reasonably consistently, beat the S&P 500 or any other index that they may track over time. They might not beat it every year, but over the course of several years they do. Of course, do they beat it after fees and pass-through capital gains? That's possibly another story altogether.

What this all gets at is look at the fee schedule you are paying. If the expense ratio is much over 0.70%, you are probably paying way too much unless you have a truly exceptional manager or if it is a fund that gives you exposure to some esoteric market that doesn't have a good index proxy that you can invest in. Also, very importantly, pay attention to the pass-through capital gains that are generated when the fund liquidates positions where they have made a profit. These gains get passed on to you and you have to pay, depending on the situation, either 15% or your highest marginal tax rate. One would be wise to sack fund managers who are not tax efficient.

Disclaimer: I do not own positions in any of these funds. Any advice given here is not to be taken as professional financial advice.

Tuesday, October 19, 2010

And for a brief moment of levity...

If you feel that you are behind on your rent and that is preventing you from accumulating sufficient wealth to save and invest, this man is for you:



Edit: Incidentally, this man is also right. Look at New York City rents: http://www.tregny.com/manhattan_rental_market_report

When good isn't good enough


Apple (AAPL) probably now has produced one of the classic examples of "buy the rumor, sell the news" I've ever seen. Its earnings report blew away all estimates by wide margins on earnings per share and revenues. Its forecast was a little weak, but then again Apple always guides low. Causing this sell-off is the fact that iPad sales were weaker than estimated and the suspicion that the forecast might indicate a slowing in growth. I would not go so far as to say that this decline represents a buying opportunity because, even with its growth rate, Apple shares still trade at a premium to the overall market that is large enough that it warrants caution. At this valuation, there is very little room for error and this sell-off reflects that.

Now, you might wonder why I took a screenshot. The reason is that the change in the stock price after a mixed bag of an earnings report like that one is subject to a great deal of volatility. It could be that eight hours from now any comments about Apple's sell-off might be moot.

Monday, October 18, 2010

Physics and Stocks?

So some physicists decided to try and predict the stock market movements and they found that they could predict with 80% confidence the movement of the Dow with...

Twitter?

Apparently the "calmness" of Twitter had the highest correlation. However, they had no explanation, just a correlation, so I'm not ready to start investing based on Twitter. But, this could be a new way to look at investor sentiment.

If you want to read a more thorough analysis of the paper, check out http://www.technologyreview.com/blog/arxiv/25900/?ref=rss

Stock Options Teaser

Because I've only finally gotten my brokerage account upgraded to allow for options trading, I felt that I should talk some about stock options. Before I do, here's the relevant Wikipedia article for those not versed on the subject: http://en.wikipedia.org/wiki/Option_(finance)#Trading

About those moves toward protectionism...

http://www.guardian.co.uk/world/video/2010/oct/18/angela-merkel-multiculturalism-germany-video

This is more along the lines of anti-immigrant rhetoric, but I always look at these sorts of things as part of the same overall package. Countries that wish to shut their borders to immigrants because they make immigrants a scapegoat for their problems are only a couple steps away from blaming foreign competition as well. In Germany, that would be a bit of an odd case, but it isn't implausible. I'm still wondering if and when we will see a major country send its trade barriers on up.

Friday, October 15, 2010

Mr. T Pities the Fool Who Doesn't Buy Gold

http://www.bloomberg.com/video/63695708/

I think this, and the ever shifting series of justifications for gold (including arguments that it is your hedge against inflation, deflation and prosperity all at once) are beginning to flash big warning signs that gold is about to top out and possibly top out for some time to come.

Blogger Barry Ritholtz, who is a far more esteemed observer of financial markets than I, argues for maybe having 5% of your total liquid assets in gold or precious metals more broadly. I can't say that I'm entirely opposed to that proposition, but I think the issue here is the entry point. While no one has ever developed either a good empirical or theoretical framework for valuing gold, the odds are that gold has seen its best days for some time to come.

Oh those inflation hawks...

0.1% headline CPI and 0.0% core: http://www.bls.gov/news.release/cpi.nr0.htm

Yep, that inflation's out of control...

Wednesday, October 13, 2010

MBA Purchase Index and Early Read on September Home Sales

From Calculated Risk we see a couple of interesting tidbits on housing. First, the weekly MBA purchase index had a rough week, dropping 8.5%. There's apparently a change in FHA standards related to this. Does anybody happen to know what that is?

Then, September home sales seem to have picked up a bit from August. A 4.5 million SAAR will register as a big percentage increase, but in truth that's still a horridly weak number and will leave inventories at the point where price reductions are likely. Inventories much above 8 months of sales usually lead to some measure of price reductions. 

Still, combine this with auto sales that were slightly up and decent retail sales and we at least aren't seeing the relapse in consumer spending many had feared. From the larger perspective, I'm still not seeing the evidence of a double-dip in the broad economy.

Saturday, October 9, 2010

Is the market cheap or expensive right now?

I'm not going to cop out and say it depends (though what methodology you use matters). I'm just going to come right out and say that it looks slightly undervalued overall.

This headline "S&P 500 Profits Cut First Time in Year by Analysts" should give some pause because I don't like it when earnings upgrades give way to downgrades while the market is struggling to make gains. That generally signals some warning signs. However, there is a fair amount of cushion regarding earnings estimates. The article states that S&P 500 earnings estimates were cut from $96 to $95 for the S&P 500. That's based on a "share" of the S&P 500 if you view the index level as a price. So then, the basic calculation is made with the S&P 500 trading at 1165 and earnings at $95 the S&P 500's PE ratio is a whopping 12.26x. Not exactly a historic high. As such, estimates could be cut a great deal and the market still would be in decent condition from a valuation perspective.

An annoying post from Mish's Global Economic Trend Analysis references the 1970s where, as market historians know, the stock market failed to advance throughout the decade. The S&P 500's PE ratio entered the decade at around 16x and left at under 7x, representing severe multiple contraction. However, if you look at long term interest rates, as we have in previous posts comparing the relative attractiveness of bonds to stocks, this makes sense. 10-year treasury rates rose from around 7% to as much as 12.75% by March of 1980 (the same month cited in that post) and then up to a high of over 15% by 1981. If you look at the comparative earnings yields and interest rates, you have stocks at 6% or so at the start of the decade with 7% on treasuries. In 1980 you have stocks at 14% (approximately) and bonds at nearly 13%. I rounded a fair amount here because I am feeling lazy, but the post I'm responding to was even lazier.

Currently, by the same comparison, stocks at a forward earnings yield of 8.15% (not the same comparison, but let's use it for now) and the ten year treasury is at 2.39%. Depending on your metric, you might use the ten year trailing PE ratio, which puts us at 21x earnings, or the one year trailing which seems to be more like 15x (depending on what is included in trailing earnings). In any case, unless interest rates start rising a great deal, which is highly unlikely, the outlook for stocks is fairly constructive at the moment.

Edit: I just remembered that we had an earlier discussion about whether or not the spread between earnings yield and interest rates is a good predictor of future returns. Generally it isn't, but the relevant comparison is whether or not it is useful for selecting between stocks and bonds which offers the best return and on that count it performs reasonably well.

Monday, October 4, 2010

Not a good bathroom to do Coke in

Here's a question for the people who are smarter than me. What happened with Coca-Cola Enterprises (CCE) today? I understand they gave North American bottling operations over to Coca-Cola Co. (KO), but I guess I'm confused about how the dividend payout caused the immediate drop in the price of the stock.

In addition, my first inclination was to just leave it alone. But with CCE taking complete control of bottling operations in Europe, is it reasonable to expect that their stock will grow at a relatively predictable rate? Or maybe eastern europeans hate coke?

Sunday, October 3, 2010

Checking in With the Mortgage Bond Insurers

In the interest of maintaining accountability on calls recommended on this site, here is a brief update on the performance of the mortgage bond insurers since they were thoroughly examined on July 22nd.


Well, I recommended MGIC (MTG) at that time and it has merely been second best, trailing MBIA (MBI) by a fairly wide margin. Clearly, MBIA has been on fire, even with a slight recent pullback. Ambac and Radian have been disasters while PMI has held in there, very closely tracking MGIC, much to my surprise.

Asset Allocation Model and Rebalancing

There are some thrilling Sunday conversation topics for you.

In any case, I realized that I neglected to post what the asset allocation model said for September. Suffice it to say that it still points toward the same 80/20 split in favor of equities that it has since we have been modeling it. However, after the increase in stock prices in September and a slight narrowing of corporate credit spreads, the overall score wasn't quite as strong. Remember that the model has minimum asset allocations of 20% bonds or equities no matter how favorable the indicators become for one asset class or another.

In any case, now might be a good time to discuss that even with fixed asset allocations like this there are some nuances that you have to take into account regarding re-balancing. If you rebalance every month where you assess your actual allocations compared to the targets, a result many don't think of is that, even with static asset allocations, you do end up accumulating more of the underperforming asset class at its bottom. I've actually gotten some confused looks from people on this point so I will explain it in a clear example.

For example, let's say that you have $100,000 (most of us wish) split 80/20 stocks and bonds respectively. In the course of three months, the stock portion of your portfolio loses 25% and the bond portion rises 10%. You will have a total of $82,000 split $60,000 stocks and $22,000 bonds. Inadvertently, bonds have become about 27% of your portfolio. In order to bring your portfolio back into the proper balance, you take $5,600 out of your bonds and put it into your stock positions to restore your target weightings. In this way, even when your portfolio takes an overall beating due to possibly being overexposed to equities in a bad stretch for them you still buy in at the lows even though it would otherwise appear that you can't commit any more to equities. This isn't exactly a shocking revelation, but it is one that some people don't think of.

Now, if you have a $5,000 portfolio or even a $10,000 portfolio as opposed to a $100,000 portfolio, the transaction costs involved here probably either come close to or entirely eliminate the gains from very frequent rebalancing. If you rebalance every month, you have two transactions at $10 a piece for $240 in a year, not to mention the capital gains you might accumulate in the process. This is one persistent problem for smaller portfolios versus larger ones which is that you are more wedded to individual investment decisions due to a lack of flexibility in getting out of them.

Thursday, September 30, 2010

Economic Report from the Onion

The greatest news source on Earth has decided to do a report on the economy. It is very insightful. http://www.theonion.com/articles/something-about-tax-cuts-or-earnings-or-money-or-s,18169/

Monday, September 27, 2010

Just how volatile are global politics right now?

Very, it turns out.

Labour now polls even or possibly ahead of the Tories in the UK just four months or so after the most recent election. http://itn.co.uk/6ec09e8f6e13a874aa91c427f4437806.html

Normally I would say ignore politics, but I think what you may be seeing in a number of countries is a move by many democracies toward being ungovernable. That is a risk that we have to keep in mind as the economies of the developed world remain languid. Germany's government is precariously positioned and that is unlikely to improve. The same goes for Australia's. One basic rule of history that I remind myself of when there are situations like this one is that it doesn't necessarily have to end well.

We still haven't seen any headlong plunges toward protectionism by any major parties around the world in order to garner votes, but that's certainly a possibility. It would be a big vote getter in countries that are convinced that all they have to do is improve their trade balance to grow their economies. However, given that all countries seem to be trying to collectively devalue their currencies, it is a possibility trade protections will start popping up. One serious aggravating factor there is that China operates behind somewhat of a trade wall while most of its trade partners are as open as any economies have ever been.

If we do see parties start to flap their gums about protectionism, suddenly even low yielding bonds would look attractive. We aren't there yet, but we could be before long.