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.

Monday, December 19, 2011

Bank of Merrillwide

I sometimes forget that not only did Bank of America (BAC) buy Merrill Lynch, which was inexplicably on the verge of an utter meltdown in the fall of 2008, but that it also took own the absolutely toxic Countrywide Financial.  In recent months, it seems to have inherited the same sick death spiral that both of those constituent companies had in the months leading up to their demises.

The mystique of former Bank of America CEO Ken Lewis always baffled me.  Bank of America was rarely a stellar performer, even among the ordinarily demure commercial banking sector (at least it appeared demure prior to 2007).  He made some significant acquisitions of companies such as FleetBoston and MBNA, but to say that those purchases alone made him some financial services management genius would be a little bit of a stretch.  Like many of the CEOs in the commercial banking sector, I think that he envied the apparent success of the investment banks, especially Goldman Sachs (GS), during the mid-2000s.  Indeed, traditional banking business units were often looked at with a measure of disdain during those years since they had declining margins and simply weren't as attractive as hedge funds, private equity, and any number of other newer businesses.

Some banks, like Wachovia, Citigroup (C), and Bank of America bet recklessly on the housing bubble in order to attempt to get attractive rates of growth.  They paid the price for it.  Wachovia nearly died and had to be bought by Wells Fargo (WFC) while Citigroup and Bank of America had close calls.  In the midst of all of it, Ken Lewis thought he would be something between the shrewdest value investor in history and the savior of the financial system by buying up Countrywide Financial and Merrill Lynch when both were on the brink.  Had both not been so terribly flawed, he might have been onto something.  As it was, he created a great big lumbering, wounded giant.

Lewis was booted (well, not really, but you know how this all works), but the legacy of his misdeeds still haunts Bank of America to this day.  Over the past year, the stock has atrophied horribly and now has plunged to devastating lows of less than $5 a share:

While no particular news has come out other than the constant drumbeat of bad news out of Europe, the implicit news that the market seems to have priced into the share price is that Bank of America will have to issue more shares to increase its capital ratios.  After all, it supposedly trades at just 5.5x next year's earnings according to current analyst estimates.  Since the overall market is not utterly panicked at the moment, it stands to reason that there might be something to this expectation.

With headlines like this one swirling around, it might be dangerous to speculate on the unknown here: http://www.marketwatch.com/story/draft-big-bank-capital-rules-expected-soon-2011-12-19

I should caution that while Bank of America has one of the lowest prices you'll see in a major financial stock, it's hardly unique this year.  Look at Goldman Sachs:

The two declines are not qualitatively different.

Wednesday, November 23, 2011

Is there such a thing as an "average" year?

Since we're coming up on the end of the year, we'll no doubt hear about how the next year will be an "average" year.  Very nearly every year I've followed the markets, just about every market commentator, or at least two-thirds of them, have called for a "typical" year of stock market performance.  If it was a bad year in the prior year, they'll say "Things were tough and we're still coming back so I think it will be a slow, average year of recovery."  If it was a good year, "We saw some good things last year, so we'll probably be coming off that somewhat and go back to a more typical rate of return." Even if it was an average year, they would use that as the basis for forecasting an average year.

The reason for this is all very simple, which is that people have an immutable faith in the central tendency of a long-running time series.  The problem is that stock market returns don't follow anything close to a normal distribution (CLICK ON PICTURE FOR LARGER IMAGE):

First of all, I would like to point out that there is a big difference between the compounded annual growth rate (CAGR) and the "average".  This is because averages almost completely ignore the effect of significant down years.  To explain it in a clear example, if you drop 50% in the first year and rise 50% in the next year, the two year average is 0%, but you're actually down 25%.  The CAGR captures this, but the average does not.  As such, the long term typical rate of return is about 140-150 basis points lower, depending on how you draw your time horizon.  The difference is notable, by the way.  At 7.9% per year over 40 years, $1,000 turns into $20,932.  At 6.5% per year over 40 years, it's $12,416.  In other words, please don't base any projections you are doing for your retirement on the average rate of return.

By my count, there is only one year that was +1% or -1% from the long-term CAGR, which was 1993.  Hell, make that a 3% band and you still only get about 7 or 8 years, depending on how you round off trailing digits.


As you can see, this is not a normal distribution by any stretch of the imagination.  

As such, when you see the annual forecasts come out toward the end of this year, feel free to snicker when you see people project that we will see the long-term average rate of return. 

Sunday, November 6, 2011

On Economic Troglodytes

One of the things I see on more "populist" forms of financial news commentary is a grave mistrusting of seasonally adjusted data.  For the uninitiated, a seasonal adjustment is a filtering process for volatile data series that have a clear seasonal pattern.  By correcting for the observed historical seasonal patterns, you can get a smoothed look at what the data are without the typical chop.  Good examples of data with significant seasonal oscillations are housing starts (with far more in the spring and summer than in the winter) and employment (with massive amounts of layoffs right after the holiday season and robust hiring in the summer).

However, there is a group of people who don't trust seasonally adjusted data, largely because I don't think that they understand it.  Take this post from Minyanville.  The author boldly dismisses seasonally adjusted jobless claims data as not being "real" and asks that readers look at the non-seasonally adjusted data.  Then, there is a choice quote later:
The actual weekly initial claims data exhibits week to week patterns each year that are consistent, as certain industries tend to add and subtract workers at the same time each year. Rather than smoothing the data to obscure what really happened last week, we can compare the numbers directly with prior years' performance during the same weeks to get an accurate reading of the current trend. Like an optometrist, we can look at small changes and ask whether they are better, worse, or about the same as last year. By carefully evaluating subtle changes, we gain clarity of vision.
As it so happens, that is precisely what the seasonally adjusted data does, however imperfectly.  The reason that, beyond a simply seasonal adjustment, economists like to look at a 4-week moving average for jobless claims is that, even after going through the rigors of a seasonal adjustment, large one-time events can occur like a major corporate bankruptcy, a strike, or a major weather event.  By taking a simple average, you can somewhat smooth this out.  Doing so is, by definition, somewhat backward looking, but it is a tool that you can use if you so choose.  One thing I've learned in my line of work is that there is no one right way to analyze data.  The circumstances may call for a few different ways of looking at it.

What some of the troglodytes like to do is use a 12-month moving average or something like that instead of a seasonally adjusted number, claiming that actually represents the real data.  A neat little trick here is that the 12-month moving averages of the non-seasonally adjusted data and the seasonally adjusted data come out almost exactly the same, which is what you would expect if the seasonal adjustment is worth its salt.  See this below with housing starts data:


However, 12-month moving averages don't capture "real time" changes in the data.  It's for much the same reason that year over year comparisons are useless.  If you had a huge run up in the early months of the 12 month period, the leveled off and are now starting on a downward trend, you won't catch it in the moving average or the year over year numbers for another few months.  Look at the three measures of potentially judging what housing starts were doing during the housing boom and bust of the last decade (CLICK ON PICTURE FOR LARGER IMAGE)


The seasonally adjusted data catches the inflection point earlier and more decisively than either of the other two measures.  In the other two, you can eventually see it, but the seasonally adjusted data provides the much clearer signal.  This is because, with the seasonal filter, you can look at a current month and judge what it means on a "real time" basis rather than being dependent on backward looking measures that take months to provide a signal.  Also, compared to non-seasonally adjusted numbers, which at best rely on a year on year comparison, you can much more easily detect the trend.

This is why, even though seasonally adjusted numbers are not "real" numbers, they do provide the best picture of what is going on of all the data that get presented.  Frankly, people who reject seasonal adjustments as being some statistical creation are nothing but troglodytes.

Sunday, October 30, 2011

The CPI Food and Energy Debate

Occasionally I see something that annoys me so much that I feel the need to respond to it in a blog post.  Today, it was that I saw people on a message board saying that the Consumer Price Index (CPI) no longer includes food and energy so you shouldn't pay attention to it.  There are some legitimate criticisms of how CPI is calculated, but this isn't one of them.  The headline CPI number does include food and energy, but economists are usually more interested in the so-called "core" CPI rate, or the change in prices excluding food and energy.  The reason that they prefer this measure is that it isn't as driven by possibly arbitrary changes in commodity prices.  If inflation is truly endemic, it will show up in less volatile prices because wages are likely also inflating at a rapid rate, pushing up the prices of more stable goods as well as services.

Some have also wondered if over time the two come out more or less the same.  After all, according to some, inflation and food and energy is always faster than other prices so if you follow core inflation only you are missing the story.  Well, not really:


For most of the years after 1981, core CPI actually outpaced total CPI because energy and food prices were quite sedate while health care costs went through the roof.  Since the mid 1990s, however, it is true that total CPI has outpaced core inflation.  In fact, the compounded annual growth rate (CAGR) of total CPI vs core CPI has been 0.5% a year higher than core inflation since September 2000.  Still, what history would suggest is that these two will not diverge by a great deal for that long.

Now, as to the volatility, adding food and energy does add a great deal of volatility.  The average monthly inflation rate of both measures over the past 54 years is about 0.32%, but the standard deviation for the total CPI is a full 0.06% higher than for the core CPI.  It might not sound like a lot, but it does matter.

So no, there isn't some evil conspiracy behind excluding food and energy.  In truth, I look at both anyway as alternative measurements.  It doesn't take too long and there isn't much harm in doing it.

The European Debt Crisis: Was the Rescue Package Enough?

The stock market's initial reaction appears to offer the answer of "yes", but then again we saw fairly convincing rallies early on in the financial crisis in 2007 (as I always like to remind people, our problems began in the summer of 2007, not 2008).  Equity markets often give false signals, perhaps more frequently than other markets.

As of right now, it does not appear that European debt markets are buying into the program here.  For instance, we have not seen Italian bond yields gap down:

The same troubling thing holds true in Portugal:


There rates are down a touch, but still nothing noticeable, considering that they are trading close to 1,000 basis points above German 10-year bonds.

The issue, as I see it, is a similar one to what we went through in 2009.  Let's back up for a moment here and state clearly why sovereign debt defaults are important to us: they threaten the health of major banks.  That's the whole reason that even more stable countries live in mortal fear of a Greece or a Portugal going under.  Banks like buying sovereign debt for their reserves due to its low default rate.  If the debt they buy becomes distressed so they have to mark it down or if the borrowers default, that undermines the banks' capitalization and they need to, at best, issue more shares to recapitalize, which dilutes the value of existing shareholders.  In a worst case scenario, the whole rotten thing comes crashing down and the banks fail catastrophically.  I think that we all know the consequences that stem from that scenario.

As such, just like the situation we faced in early 2009, this is about whether the banks can reasonably attain enough capital to recapitalize to offset massive losses coming down the pike.  In our case, it was the continuing doubts over the mountains of bad mortgages that banks were carrying on their books above the likely value that they could realize those assets at.  Investors speculated for weeks and months about just what kind of hits our banks would have to take and it caused our markets to go into a total tailspin that took the Dow down to 6,500 at one point.  Just an aside, there is no rational model by which one can call that a fair price for the market at that point.  What came along to really solve the issue were the stress tests of our banks that detailed the amounts our banks needed to raise in additional capital in order to survive two differing economic scenarios.  While there was criticism over the rigor of the tests at the time, it really did prove to be a turning point, along with expansionary monetary and fiscal policy that had begun just before that.  They put a number on how much the banks would have to raise and investors could use that figure to pivot their decision making on whether or not to buy shares.  Before that point, it had been somewhat of an unknown.

The markets had already begun a recovery before the release of the test results in May 2009 (the bottom was March 9th), including a massive rally in bank shares, but as the year went on, the financial stocks eventually added another huge leg to their rally in the summer as the recapitalizations went along without much incident.  From then on in, the markets regained confidence, and things began to return to some level of normalcy.  There were many other measures taken, so I don't want to exaggerate the importance of the stress tests, but the point is that once the health of the banks was assured, the markets and the economy at large could move on.

The key to Europe is whether the banks will now be sufficiently recapitalized.  The stress tests there have been of questionable credibility, often only focusing on macroeconomic conditions and not pricing in what would happen with large write-downs of sovereign debt.  That has started to change in the most recent iterations, but some analysts think that the stress tests are low-balling the needed capital by as much as $200 billion.  As long as investors are not convinced that the banks' balance sheets are now as secure as the Maginot Line... wait a moment... as unsinkable as the Titanic... as solid as the walls of Constantinople... erm, well, pretty safe, we will be prone to a renewed crisis.

Of course, history may well show that this was the turning point and many of the naysayers have been wrong. After all, credit spreads here did not really start coming in until a full month after the stock market bottomed in March of 2009.  (CLICK ON IMAGE FOR LARGER PICTURE)

                             

Spreads did not begin their true downward trajectory until early to mid April and did not actually reach quasi-normal levels until October.  In other words, it could be a while before we really know.  At this moment, I am doubtful that we have seen the last of this crisis.

The 1998 Time Warp

One of my earliest memories of following the financial markets was the meltdown in 1998 caused by the Russian Debt Default and the subsequent collapse of Long Term Capital Management.  It was the most severe and sustained collapse in equity prices that I'd ever seen, which wasn't that impressive since I was only 12, but it still left a mark on me.

For that reason, I am struck by how similar the bottoming process in the stock market looks now to what it looked like then. (CLICK ON IMAGE FOR LARGER PICTURE)


The scale of the rout this year is also very comparable at about -19% from peak to trough and the rally is happening at about exactly the same time and at very nearly the same trajectory.

However, while history does tend to rhyme, it doesn't fully repeat and the next verse can be very different from the first.  There are considerably more risks now than there were, at least immediately, in 1998.  Also, as I will address in my next post, the European bailout package just does not seem to be of the magnitude necessary to completely dispel the considerable worries of the financial markets.  However, the equity markets were so terribly undervalued at their most recent bottom that the present rally is fully warranted.

Getting Back Into the Swing of Things

Due to slavish commitments at work and all manner of other nonsense, I took a bit of a hiatus, but now I should be posting fairly regularly again.  It's a fascinating time to come back into it, so hopefully there will be some good posts to come.

Tuesday, August 23, 2011

Why is there no hyperinflation?

Okay, we've had warnings ever since early 2009 about the prospect of a breakout of massive inflation due to a massive increase in the monetary base.  The logic, such as it is, goes something along the lines of:

1. Monetary velocity is a constant
2. The Fed has increased the monetary base substantially
3. Nominal GDP will rise substantially, but real GDP won't
4. The difference will be taken out on us in inflation

If you believe the first step of this sequence, that all follows.  If you double the amount of money in the system and everyone still does everything in the same way, meaning consumption patterns in terms of unit quantities don't change and production also does not, prices should approximately double.  However, the way money is "made", through bank lending, has been a broken mechanism as the demand for credit is very weak.

So, as the Fed has dramatically increased money supply, nothing much has happened.  All that has happened is that monetary velocity has collapsed (left scale is velocity, right scale is monetary base in billions):


Velocity is about a third of what it was during the period just preceding the crisis while the monetary base has approximately tripled.  With the banking sector still sick and consumers still deleveraging, this situation will not change soon.  A strong increase in money supply is a necessary (in most cases), but clearly not a sufficient ingredient for inflation.

Is Bank of America Sick? Maybe

Its stock sure acts like it and here's a little bit of an article on the subject:

http://www.businessinsider.com/bank-of-americas-stock-collapse-2011-8?op=1

Two things disturb me about Bank of America (BAC) at the moment. One is the persistent and massive decline in its stock price. The other is the fact that even on a good day it could not rally.

The good news is that it appears that its potential capital problems probably won't come to a head all at once and it will have time to remedy them.  As bad as the past few weeks have been, this isn't at all like 2008.

Saturday, August 20, 2011

A Few Weeks Later: Did the Debt Downgrade Matter?

Well, we've had a bit more time to analyze the situation since the S&P downgrade of the U.S.'s credit rating.  Did it impact interest rates? Yes, but not how it was expected.

Ten year treasury rates have dropped off a cliff and are now well below the year on year change in CPI (3.6%).


Granted, this isn't the best measure of "real" interest rates, but it does give some sense of where we are now. This has actually gotten more extreme in August where we would be in near historic territory, except for the few blips in the 1970s where there were peculiar alignments of inflation rates and interest rates for brief periods.  It's clear that we have not seen any increase in real rates and don't seem to be near it either. 

Once again, all of the devastation has been in the equity markets.  As I said earlier this month, we would have a brief period of stabilization before a resumption of the fall.  We followed that traditional pattern and appear to be on another down leg.


At this point, it seems quite likely that we will see more difficult days ahead, but not because of a debt-induced panic.  Rather the issue is that growth prospects have utterly and decisively collapsed at this point.  The Philly Fed Index this last week was an utter disaster.  At over -30 (or under depending on how you look at it), it is at a level that has never failed to be associated with recession.  Once again, the threat is deflation and stagnation. 


Tax Equity Turned on Its Head

There's been a reasonably common theme recently that low income Americans pay so very little tax compared to wealthy Americans that it's unfair to wealthy Americans.  Hell, Rick Perry even basically argued that the fact that 50% of Americans do not pay the federal individual income tax is a great sin.  This discussion seems to have melded into a single line of "Half of Americans aren't paying any taxes".  What some have suggested is slashing and burning the individual income tax deductions, exemptions and credits to make marginal rates more closely resemble effective rates, and this would be the revenue raising tax reform that might emerge from the deficit debate.

On the face of it, this argument has appeal, as does the flat tax argument.  Everyone pays the same percentage on all of their income.  It has a visceral effect on most people that hear it.  Without thinking anything more, it will tickle their hearts and their guts with a warm sense of justice.  No games or adjustments, just a single rate.

Well, first off, I think that one does have to look at the entirety of the tax system in the United States, from local taxes all the way up the spectrum.  After all, higher levels of government provide significant support to lower levels of government.  The federal government provides significant support to state governments in the form of Medicaid, child welfare, transportation, and environmental expenditures in particular.  State governments in turn provide significant aid to their local governments in the form of school aid and aids to counties and municipalities.  In 2008, state governments got close to $450 billion of their $1.6 trillion in intergovernmental revenue while local governments got $524 billion out of $1.5 trillion of their revenue from intergovernmental revenue.  However, excluding the state transfers to the locals, one can look at the Feds as giving $481 billion to both state and local governments together, or just shy of 1/5th of all state and local revenues.

As such, one must look at the entirety of public finance.  If you look at the whole thing, one must include not only federal income tax, but state income taxes, state sales taxes, local property taxes and even user fees.  Use fees and charges brought in $373 billion at the state and local level in 2008 and thus pay for a substantial portion of government services.  All of the state and local level taxes are, at best, a wash in terms of progressivity.  User fees are quite regressive as are gasoline taxes and other excise taxes as they do not discount their costs at all on ability to pay.  Taken together, the state and local side of public finance certainly does not spare the poor and the middle class from paying "their share".

Then let us move on to the federal level.  Here, FICA taxes bring in nearly as much as individual income taxes these days and most of that burden is borne by people earning less than $75k a year.  Indeed, with FICA the effective tax rates are higher on low income earners than they are on high income earners (those making more than $106,800) due to the wage cap on Social Security taxes.

I am not arguing that the tax system overall is not progressive, though the favorable rates of taxation on capital gains and dividends (both presently taxed at 15% regardless of income levels for long-term capital gains and qualified dividends) make the federal side slightly less progressive than it first appears. Except at the very high end, effective tax rates, all things being included, do tend to rise with income, but it isn't as simple as just looking at individual income taxes at the federal level.

Leaving all of that aside for the moment, let's just look at the individual income tax, which seems to be the focus at this time. The primary concern seems to be that low income earners, those earning less than $35,000 a year in particular, have it particularly easy as they pay anywhere between little and no tax, or even get a refund due to the child tax credit and the EITC. Coupled with deductions and exemptions, these credits mean that taxpayers up to a fairly high threshold will not pay taxes.

Working through the exercise, for a married couple the present standard deduction is $11,600. On top of that, there are exemptions of $3,700 per family member. Let's say that they have two kids, so a total of four times $3,700 for $14,800. Taking that together, $26,400 of this hypothetical family's income is not subject to federal income tax. If they have a total income of $40,000 (pretty typical), they will only have taxable income of $13,600. On this, a 10% tax rate is applied, or $1,360. However, the combination of the EITC, of which they would get a small amount, plus the child tax credit, will eliminate their federal income tax liability. Somehow, this is supposed to be a scandal. Some would look at the exemptions and standard deduction (and deductions more generally) and say "Well, there's the problem! Just get rid of those! We'd get a lot more tax revenue."

However, let's think for a moment why the exemptions and deductions are there. The idea is to shield a certain amount of income from taxation to cover certain basic expenditures.  For instance, why is there a $3,700 increase in exemptions per person on a return?  Well, it's an amount that correlates fairly closely with the increase in the poverty line per additional child, the idea being that a child will increase your baseline expenditures by about that much.  It seems reasonable to exclude that from tax.  As much as people pretend (hopefully they are pretending) not to understand the rational for the basic exemptions and deductions, there is a reason that they are there.  It simply costs a certain amount to just barely get by and a great many households are at or below that point.  As such, subjecting them to a flat tax of, say, 15%, on ALL of their income would dramatically increase their living costs ($6,000 in the example I used).

Using a 15% flat rate on all income as an example, a household with $40,000 a year in total income would pay $6,000 in federal income taxes while a household with income of $200,000 would pay $30,000.  Needless to say, the household with the $170,000 after tax is much better able to bear the burden.  As much as a flat percentage appears to be fair, it really isn't.  The tax code should be based on ability to pay.

This gets to a point I always try to make. Yes, it is true that the richest ten percent have 33.5% of the income and pay 45.1% of taxes. Similarly, filers with more than $1 million in adjusted gross income have 10% of AGI, but pay 20% of taxes. However, if you look at the share of income beyond that needed to cover basic living expenditures, those numbers are a good deal different. Then, when you look at the totality of U.S. public finance, including user fees and state and local taxes, these numbers become more regressive.

The simple point is that taking the burden that the wealthy pay and shifting it downscale to even out the tax burden as a percent of income by "simplifying" the tax code does not improve tax equity. As much as it appeals to a primal sense of fairness for everyone to pay the same percentage of all of their income and not have deductions and exemptions, things would get materially worse for them.  While an additional 10% on someone earning more than $300,000 hurts, it is not fatal.  An additional 10% on someone earning $40,000 could be devastating.

While the theoretical examples that I used here are simply that, "theoretical", the argument that we need to broaden the base and lower the rates generally means subjecting more of the total amount of income to tax, which seems to mean hitting lower income earners.  It could theoretically mean subjecting capital gains and dividend income to the same tax rate as earned income under a progressive system, but that doesn't seem to be the argument holding sway right now.  People seem to be buying into a tax equity argument that has been turned on its head.

Monday, August 8, 2011

The Staggering Collapse of Oil

First, the picture:


Stocks aren't the only thing heading straight down these days. If you needed any proof that inflation is not a threat, how does this chart suit you? Virtually all of the inflation that we have seen lately has come from high fuel prices. Well, those days are over.

This situation is not likely to change soon, either. Well, the perpendicular drop should stop, but a rebound, at least a sharp one, is not probably. A moribund economy will see to that. Oil inventories are also quite robust and demand isn't exactly whittling them down. Every financial crisis does have its silver linings. Falling interest rates and energy prices are among them.

The Strangest Financial Crisis

So, when I looked at the early quotes on ten year treasuries on Friday afternoon, when word of the looming S&P downgrade began to surface, quotes suggested a rise in rates to about 2.55%-2.60%. I thought that was a fairly reasonable reaction since the loss of a grade might be worth a dozen or so basis points in higher yield.

What I did not expect was that rates would plunge today to the lowest levels since the worst of the 2008 panic. This is why I call it the strangest financial crisis. Under most, or all, circumstances the fears surrounding a country's sovereign debt cause the two following reactions:

1. Interest rates spike like mad
2. The currency collapses
3. The equity markets collapse

Well, one of those happened. The other two did not. Hell, the dollar actually rose slightly: http://www.bloomberg.com/apps/quote?ticker=UUP:US

Normally, when people are told there is a bomb in the building, they run out of it for the refuge of other structures. That did not hold today, not one bit. Instead, what seems to have happened is that the markets fear the consequences for economic growth more than they do the downgrade itself. Normally, the channels affecting economic growth would be a spike in real interest rates and a collapse in the integrity of financial markets. In this case, the concern appears to be that our current rate of economic growth is as good as it's going to get because the downgrade has precluded any possibility of stimulative action by the government. Further, the ripple effect of downgrades to private and municipal issuers is likely part of what is at work here as well.

It is also possible that markets are anticipating a major hit to consumer confidence as people pull in their horns in anticipation of future interest rate increases, which I will point out is not a rational behavior. Much like someone prone to panic attacks can induce one due to the fear of one coming on, the markets can collectively do the same thing. The fear of future consumer... fear probably motivated some of the indiscriminate selling today, and it was indiscriminate.

A further mechanical cause is the incredible plunge in oil. It's down almost 20% in a few weeks. This has caused mass liquidations by hedge funds, who have to liquidate virtually everything, including shares in damn good names. I am struck by a plunge like this in United Technologies (UTX), one of the best run companies in the world with a tremendous track record of strong earnings growth and healthy dividends:

Hell, even a company like Church and Dwight (CHD), which is basically immune to recessions and will benefit from the plunge in petroleum prices, has taken a clipping:


The banks got slaughtered, which is understandable. If indeed U.S. interest rates are heading higher, banks' margins will get squeezed. Fair enough. Also, Bank of America (BAC) is one sick puppy these days. Seeing a collapse of this magnitude in a premier financial stock is not reassuring:


Still, the basic theme to take away is simple. The market has rapidly priced in a significant reduction in economic growth prospects and the related effect on earnings growth. This is not principally a U.S. debt crisis and should not be labeled as such. If it were, money would not have sought out U.S. treasuries in such massive quantities today. We are faced with a market that is rapidly pricing in deflation due to a weak economy, which explains the dual decline in stock prices and bond yields. Concerns about inflation are radically misplaced at this time. All of the inflation of the past several months has been driven by food and energy. Those are dead now. Their declines will be seen in CPI over the next few months and year over year inflation will vanish.

At this point, continue to hold cash for the moment. A bounce back, possible a big one (+500 pts or so) or two will happen in the next week or so, but that will probably be greeted with a fresh low sometime thereafter. These things never go straight down then straight up. Even 1998 with LTCM, which is the closest to that trajectory, did not follow that pattern. Stabilization was followed by new lows before a solid bottom was formed. The opportunity will come, but it isn't here quite yet.


Thursday, August 4, 2011

What to do when the world is falling apart

Things will probably stabilize at some point in the near future, but then a cascade of additional worries will take the markets down again shortly after that before a more permanent bottom is found. That's the typical pattern in these crises and I would be relatively shocked if that didn't happen now.

The fundamental question is then what should be done with one's personal investments? Well, there's little profit in rushing into this market at the moment to find a bottom. There is not a single event that could occur that would right all of the wrongs that ail the market at this point. There is no package that the EU could produce or is likely to produce that would soothe markets. There is no stimulus plan that the U.S. is remotely likely to put forward that would boost growth prospects. There is no sector of the economy that is poised to suddenly burst onto the scene with unexpected vigor and drag the rest of us with it. Political shackles have consigned us to quite difficult time at the moment.

For now, the most prudent thing to keep your current cash reserves and not deploy at this time. Also, any safer investments that hold up well will serve as reserves to take advantage of more speculative plays that get hammered. For instance, Brazil is getting destroyed right now: http://www.marketwatch.com/investing/fund/ewz

Before long, there will be fantastic opportunities. There always are after panics.

A Rough Stretch, No End in Sight

With the Euro contagion spreading to Italy and even Belgium (its spread over German bonds is nearly 200 bps), the financial crisis in Europe is deepening at the same time U.S. growth seems to have hit a firm wall. What's worse is that policymakers around the world are doing all of the wrong things. In the face of a private sector unwilling to unleash spending and investment, governments are retrenching. Some have to, others don't.  Worse yet, when they are retrenching they are making foolish choices that seem to maximize the negative impact of their actions.

Little wonder, then, that the markets are utterly spasming at the moment. The situation seems to call for it. Some measure of bounce may occur for a brief period in the next week or so, but I expect a renewed sell-off before things bottom out in a more sustained way.

I almost forgot some very depressing news, which is that Jean Claude Trichet, head of the European Central Bank and one of the most powerful policymakers in the world, thinks that our primary concern is inflation.

As far as the debt ceiling debate in this country, the markets no doubt were spooked that it even occurred and were probably even less happy about the fact that the outcome was so pathetic and wrongheaded. I endorse the views of this Bloomberg link in very nearly their entirety: http://www.bloomberg.com/news/2011-08-05/world-market-rout-is-a-loud-no-confidence-vote-in-leaders-view.html

Sunday, July 24, 2011

China's Astonishingly Bizarre Land Development Finance System

One thing casual observers of China's real estate markets always try to say is that there is comparatively little leverage in the system, which means that any decline in prices is borne principally by the holders of the property and there are not ripple effects through the rest of the system. This is similar to how declines in stock prices tend to have very little collateral damage since they are very nearly entirely bought without leverage. Sure there is up to 2% of stock bought on margin in periods of excess, but compared to real estate markets, it's modest. That's why the stock market could shed $7 trillion in value during the 2000-2002 bear market and the broader economy felt very few ill effects from it. However, a similar decline in the value of residential real estate nearly destroyed the global financial system.

In China, however, it is simply not true that all real estate transactions are financed with equity. Indeed, a great deal of development is done by local governments, who engage in a program not entirely dissimilar from Tax Incremental Financing (TIF) in this country, where they borrow to develop certain properties and hope that they eventually pay for themselves (that's a very quick and dirty version of it). However, their practices are far sloppier than TIF districts in this country, and that's disheartening since a good number of TIF districts have run into trouble as well. Needless to say, in both cases, if the development stops, these financing deals run into serious serious trouble.

However, unlike TIF, properties are not valued according to fair market value, but in many cases in appears that local governments can just simply say what they're worth and use those amounts as collateral. This would be similar to if a financially troubled TIF district could hire an assessor to say that a $5 million hotel was really worth $57 million and collect the corresponding taxes on it. Fortunately, we have many safeguards in our system of property assessment and property taxation that prevent that from happening, including appeals and state oversight of local governments. China does not have much of a system of property taxation (though that is starting to change), and hence no good comprehensive system of property assessment.

Here are a couple of stories to chew on:

http://www.reuters.com/article/2011/07/14/markets-ratings-china-idUSL3E7IE0F520110714

http://www.bloomberg.com/news/2011-06-27/china-audit-office-warns-of-risk-on-1-7-trillion-of-local-government-debt.html

When do the markets start taking the obvious insanity of politicians seriously?

It's been clear up to this point that the financial markets have not taken what is an ever clearer picture of the true insanity of members of Congress seriously. How do I know that the markets haven't taken it seriously? Because we are still standing far too close to one year highs. The fact that we have fundamentalists in Congress who believe that they must obtain a total victory or they'll take the whole country with them should be more disquieting to markets than it has been so far.

I fear that this may be like the TARP vote, which I will maintain to my dying day was necessary, where financial markets had to absolutely implode in order for financial markets to jar Congress out of its tizzy. However, the fundamental problem is that we may not have quite that window available to us. While it is entirely possible that the Treasury can find enough scraps of money around to keep debt service going for a little while if it puts off other key functions, the simple truth is that at some point there will simply not be enough cash on hand to make a particular interest or principal payment. If the Treasury has to pay $25 billion one day and only has $13 billion on hand, to quote a number of characters in a number of movies, "Well, shit". That would cause the requisite collapse in financial markets, but at that point it would be far too late.

As I've noted before in this entire debate, the U.S. has had its AAA credit rating for years for a number of reasons, but one of the most principal reasons is not only has the U.S. never defaulted before, but it has never even really come particularly close to defaulting (with one modest exception in the Panic of 1893) and our politicians have never really considered it a possibility that they would allow it to happen. I think that this bizarre charade alone warrants a loss of the AAA rating more than our current debt load does.

Sunday, July 10, 2011

Some thoughts on the debt ceiling debate

So, it would appear that the stage is set for some significant retrenchments in federal government expenditures. It's hard to say what spending categories will see the hammer fall the hardest, but aid to state and local governments is a likely category. It's also somewhat troubling as state and local governments have already been hit quite hard by the lag effect of the recession:


In fact, it really should be little wonder that the economy has run into such turbulence of late. The retrenchment in state and local spending appears to be accelerating at a time when private sector demand is not exactly robust either. In particular, local governments have been laying off workers at a steady and alarming rate as you can see in the graph below. Some 400,000 and the rate is only accelerating now. A few items are causing this. One is the growing loss of state aids to local governments. State aids to school districts and municipalities are one of the largest expenditure items for state governments, usually comprising a plurality or even a majority of their general fund budget. They are also one of the easiest items to cut compared to corrections or medicaid, the other two huge items in a state's general fund budget. The other factor hitting them now is a squeeze on their own revenue sources, particularly those with sales and income taxes. While those sources are turning up, there is a lag effect.


State governments, too, have been laying off:

Slightly over 100,000 jobs lost in state governments since their most recent high. Furthermore, automatic pay raises have been delayed and pay has even been cut in some cases. As real incomes have stagnated or declined, so too has real expenditures by government workers.

I would like to take this time to remind people of something regarding the analogy between households and government. People often like to say that government should behave more like a household in lean times and cut back when its revenues decline. That's all well and good, but I would feel constrained to remind them of the simple fact that there is an effect there. After all, when a household cuts back to bring its costs in line so that they can service their debt burden, their standard of living tends to decline. The family's does not become wealthier. When everyone does the same thing, the total level of spending in the economy declines. The same holds true for government. When it withdraws, there will be fewer services, fewer jobs, and fewer expenditures to businesses who provide services to the government. This will cause a decline in overall spending and employment. None of this should be earth-shattering. It was all laid out in the General Theory by John Maynard Keynes.

Indeed, government should not behave as households do, with  the common household's tendency to leverage up rising incomes in the good times while slashing and burning when incomes decline in recessions. All that does is exacerbate to underlying economic cycle by strengthening the booms and deepening the busts. If, instead, the federal government tries to keep a basic underlying level of growing spending and employment (whatever is deemed politically desirable) that uses the ability to borrow to smooth out its consumption, the procyclical effects of following the typical household's pattern can be avoided.

This logically follows from another perspective, which is that most government services either do not really vary with economic conditions such as education, infrastructure repairs, and basic bureaucratic licensing and oversight functions, or they tend to become more strained in lean periods, such as with UI benefits, TANF, and Medicaid. The former group a basic baseline level of expenditures that really should remain fairly stable and not be whipped around. The latter group is vital and designed to avoid destitution due to the various spasms of the business cycle. To have either following the pattern of the business cycle is nonsensical.

Furthermore, the argument that a reduction in government expenditures and employment will benefit the private sector is highly dubious at this particular moment. If interest rates were phenomenally high due to fears of a debt default, this might make sense. The mechanism there would be that a firm deal to reduce deficits would soothe markets, reduce interest rates, and thereby increase the affordability of capital, which has numerous positive benefits. However, this condition is not currently present. That interest rates continue to be as low as they are is indicative of capital not finding many productive outlets for investment. As such, that avenue is not open to us.

Another argument would be that we could reduce taxes on the private sector if only we could get government expenditures down, which would be stimulative. Due to the magnitude of the present deficit, that is not really an option. It's also a questionable proposition that reducing taxes and government expenditures at the same time produces a net positive economic effect as most evidence appears to support the opposite conclusion, but I'll just do a little bit of hand-waving on that one for now.

Then, we turn to the argument that business confidence would be substantially improved if there was greater clarity on the long-term trend in the deficit, public expenditures, and tax rates. To be perfectly honest, there is probably just about nothing to this argument. Very few businesses cite the long-term finances of the federal government as a factor in their decision-making. "Uncertainty" can, of course, have an effect as it did to some extent in the fall of 2008 when the solvency of major financial institutions was in question. Speaking for myself, I know a pulled in a little bit when all of that was going on, though largely so that I would have more capital to deploy for the buying opportunities to come. Furthermore, the evidence that the bulk of consumers and businesses take into account their future expected tax burdens when making decisions in the present is extraordinarily weak. There might be some marginal players on the fringes of society who do, but as a mainstream proposition, I very much doubt it.

Much more likely, consumers have continued to hold back on house purchases due to persistently declining prices. I know I have made my decision not to buy a house on that very proposition, though the rate of decline has slowed enough I am starting to consider it. This persistent drag has caused consumer spending to remain very modest as well as stunting growth in spending on new houses, which in turn is depriving businesses of the revenue growth that they need to "feel confident". There are other contributors as well, such as corporations and even small businesses that had relied on a steady flow of credit who had brushes with death in late 2008 and early 2009 deleveraging their balance sheets and accumulating cash to provide more certainty in a financial crisis. Very little of this has a whole lot to do with the federal government's financial position. Furthermore, if there is a stifling effect of government spending just being there, it would stand to reason that our economic performance would be improving rather than deteriorating as state and local governments, which account for the vast bulk of government employment and direct expenditures, have retrenched.

So, what does all of that lead to? Well, the basic structure of any grand deal would hopefully take all of the empirical and theoretical argumentation against what we seem to be careening toward. Rapid reductions in federal government expenditures to quickly close the deficit would likely derail the economy, particularly when joined with substantial contractions in state and local government expenditures, which cannot be avoided due to balanced budget requirements in the states. Further, there is no avenue by which this would benefit private sector activity at the moment. As such, it might make sense to enter into a long-term package to bring expenditures in certain categories down and taxes up, but in the short run the focus should be on continued stimulus. The general agreement should be that the stimulus not be removed until such time as the economy is on a solid footing. At that point, hopefully, we can abandon any talk of adopting the common household's approach to budgeting and instead engage in true counter-cyclical fiscal policies.

If there is some moral necessity that commands us to reduce the deficit, then so be it. However, policymakers should not delude themselves into believing that we will somehow see an economic boom due to that satisfaction of some moral need to have balanced books. If they proceed under that belief, the economic outlook will become considerably dimmer. 

Tuesday, July 5, 2011

July 2011 Asset Allocation Model Update

As has been the case for well over a year now, the asset allocation model that I built and have been tracking for quite some time indicates that a split of 80/20 stocks vs. bonds is still called for in these circumstances.

Though valuations on an absolute basis are not as attractive as they were at this time last year, the slope of the yield curve, combined with very low interest rates continue to provide a strong case for equities. If you look at the past year and a couple of months since we inaugurated it, I think it has been generally correct, though it has been limited to recommending an 80% equity asset allocation:

Since the beginning of the tracking period, the S&P 500 has outperformed long-term bonds by about 1500 basis points. There was a stretch in the summer of last year that I regretted that the model could only go to 80% stocks since the readings were off the charts recommending buying equities. Part of the reason the model has been stuck at 80% in stocks for so long is that it shot so far above the threshold that even though it has since come down somewhat, it is still over the line for 80% in stocks. I may refine the model somewhat to allow for rare cases where you should go "all in" because there are a number of times in the history of the financial markets where that is called for. Conversely, there are times where having just about no equities also makes sense. This, however, is not one of them.

The bottom line is that the comparative case for allocating your money to equities and away from fixed income instruments is very very strong right now.

Thursday, June 16, 2011

At least they had the good sense to try to head it off

So, there's this story on Bloomberg about Asian real estate markets coming in due to policy tightenings. At least they don't wait for the overshoot to be too large before trying to correct it. We could learn a thing or two about it. Sadly, they will probably blame these policies for any resulting problems and not the runaway speculation. Sigh.

Monday, June 6, 2011

Another Spring Air Pocket?

The May employment report along with a series of other indicators have formed an unmistakable picture of an economy that has hit a growth wall... just as we did at about the same point last year.

Remember the first three months or so of last year? It seemed like the economy was finally firing on all cylinders, perhaps? Then, suddenly, the bottom fell out of growth.

The monthly manufacturing surveys have uniformly turned weak again with most of them barely registering growth at all. The Kansas City Fed, for instance, has gone from a reading of 27 in march to 1 in May. Production and new orders fell off drastically, particularly in the case of new orders, falling to a reading of -15. Basically, this means that 15 percent more firms saw declining orders compared to rising orders. The ISM composite index demonstrated a similar collapse, though it is still in positive territory over 50:

 There are a couple of reasons that we may be seeing such a rapid slowdown in manufacturing. One, of course, is from the disruption of Japanese manufacturing in the wake of the devastating earthquake and subsequent tsunami that knocked out a good portion of their electrical power, crippling manufacturing production. Japan is so integral in many manufacturing supply chains as well as is a significant end market for goods itself that its severe dislocations are undoubtedly having a significant impact. We saw that in auto sales in May. The ripple effects through the auto supply chain have been severe. Electronic components have similarly been badly disrupted.

Of course, there is the oil shock, which has clearly dampened consumer demand. With short lead times, it doesn't take much time for a slowdown in consumer demand to be translated into a drop in orders and then production.

The good news is that neither of these factors need be permanent. The bad news is that neither are of the magnitude to be causing a virtual standstill in economic growth, at least not for a genuinely healthy economy. This leads us to another drag which is a decline in state and local government spending and employment. As the expenditures by governments and their employees are part of what I would term the "base load" of demand, their diminution is particularly devastating.

If I were a betting man, I would wager that the economy and, by extension, the stock market, will survive this spell just as they did last year. However, that is provided that Congress doesn't do the ultimate in stupidity and actually default or even come meaningfully close to doing so. One of the reasons that the U.S. has a AAA credit rating is not just because we have never defaulted, but also because our political leadership has never even contemplated it. Even a close call could be enough to send financial markets into quite the tizzy.

Monday, May 30, 2011

Oil's Fair Market Value

This is a popular thread of conversation lately, and I've seen a few things that have piqued my interest in the subject of late.

One is this Marketwatch article that discusses the changing "break-even" price of oil in recent years. Basically, it's not so simple as just the mechanical break-even price of production, which is comparatively low in the OPEC countries almost uniformly (often sub $25 a barrel). It is a question of how much of a profit do they need to turn on their oil in order to satisfy growing political demands at home. According to the article, though this is difficult to verify, that price has increased from $30 a barrel to almost $85 since 2003.

I suspect a good portion of that might be quite recent as a consequence of the uprisings in the nations of the Arabian Peninsula and North Africa. Governments across the Middle East, especially Kuwait and Saudi Arabia, have opened up the fiscal spigots to quell the hot tempers of their simmering people, tired of corrupt and unresponsive governments that also do not reflect their religious values. To be sure, there is a split between more secular reformers and the religious fanatics in their motivations for reform, but the point remains that there is deep dissatisfaction and there should be, to be perfectly honest.

Atop this is the simple factor that supplies from Libya have been badly disrupted by the ongoing civil war there where one of the principal battlegrounds has been near one of the major oil distribution terminals. As oil's supply and demand curves are both highly inelastic in the short-term, that magnitude of disruption is difficult to discount. Similarly, oil traders have generally assigned a security premium of indeterminate value to the price of oil for fear of major disruptions.

The other major factor has been a recent/ongoing rout of the U.S. dollar versus virtually all currencies. However, this is a comparatively modest contributor and we can determine what that effect should be by simple arithmetic.

Working against oil is the fundamental fact that world stockpiles are sitting quite pretty at the moment.


U.S. stockpiles (Source: Energy Information Agency) are at very high levels indeed and the OECD as a whole is at the high-ish end of its range in terms of days of supply. Further, as consumption buckles and new production appears more attractive at current prices, the self-corrective mechanism of inventory builds is likely to take hold. However, I would caution against people who look at the current days of supply in oil and say, "Well, golly, why don't we have $30 a barrel oil again.". Things have changed since those old days and the world's oil supply has become fundamentally more difficult to get at and with it production costs have legitimately risen considerably. Cheap oil is simply no longer a possibility. What's more is that current markets are discounting the not too distant future in terms of both rising demand and more constricted supplies. 

Still, there is plenty of evidence that there is some intangible valuation going on with oil. A few weeks back, the price broke by nearly $10 in a single day. Healthy markets simply don't do that. I would struggle to tell you what oil's fair market value actually is, but I suspect that it is presently overvalued by 10-15%. I would not stake my life on such a bet, nor would I make a play like I did with options on silver. That was a clear cut bubble that could not be justified. This, on the other hand, is considerably more cryptic. 

Stay tuned. 

Saturday, May 28, 2011

Do Economic Growth Incentives Pay For Themselves?

As someone who works in public finance, I often get asked outside of my job a number of questions similar to the title of this post. Recently, I negatively commented on tax incentives given out by the state of Kentucky to build a young-earth creationist theme park. I had two basic objections. One was that I thought it promoted an unscientific view of the world, which is ironic since the state spends so much money attempting to property educate its young people in the public school system in the ways of science. The other is another point, which is the primary focus of this discussion, centering on whether or not this use of tax incentives is appropriate from a public finance perspective. Advocates of these sorts of projects almost invariably say, "Oh, but it will pay for itself.". Republicans do the same thing with tax cuts more generally while Democrats do it with transportation infrastructure and education.

Since this is such a common phenomenon, let's actually work through the math and see if it works out. First, let's confront the basic constraint, which any project or tax break must contend with: the basic laws of mathematics. Taxes, particularly on the state and local level, only capture a small fraction of economic activity. Let's be generous at the federal level and say that the government current collects 20% of GDP in taxes. It doesn't, but let's just say that it does. This means that, in a single year, for every dollars you cut taxes or increase spending, it has to produce $5 in order to recoup its cost. At the state level, it's even worse than that. Because states typically collect in the mid-high single digit percentages of tax revenue as a percent of GDP, let's pick 7% for the sake of argument, it has to generate a whopping $14 of new economic activity for each dollar forgone in revenues or increased expenditures.

Now, you might say, "Aha! But what about the later years as well?". Fair enough. Let's work through that exercise, remembering that we have to discount future revenues. Click on the image below to see the entire table. I used a theoretical economy with the government collecting 20% of GDP in taxes and did a 1% reduction in tax rates, which could also some kind of long-term economic development incentive of equivalent magnitude. This tax rate reduction is maintained through-out the ten year period since, if it is taken away the year after it is implemented, the short term boost is lost and demand was just essentially brought forward.


Even assuming a 2.5x multiplier, which is quite generous, not only does the tax cut not pay for itself initially, it never, in any given year, does so. I solved the equation to see what multiplier is needed in this long-term example, and it is 5.26x. That is simply unheard of. Using the tax rates that a state has, this becomes even more intractable. Here I show the multiplier on the table for what is needed to finance a 0.5% tax cut.


A 15.4x multiplier is simply preposterous. I would challenge anybody to find an economic paper that claims to have found anything like that for any policy.

It's actually even worse than this in many respects when you consider the opportunity cost of what else you might have elected to use an equivalent amount of money for. Basically, what you find is that the marginal impact of this in your revenue projections compared to continuing to spend it on, say, public infrastructure is that you are even further behind. That's because if that 1% of tax revenue forgone was current being used to finance some ongoing expenditure, you can no longer finance that ongoing expenditure and thus lose the GDP associated with it. This simplified example basically was meant to demonstrate what would happen if you took a budget surplus of 1% of GDP and gave it out in an ongoing tax cut or long-term economic growth incentive of some sort that came out of current tax revenues. We could work out a similar exercise for a long-term spending increase, but I don't want to clutter up this post too much. The results are very nearly the same.

Now, some programs are more effective and more cleverly structured than others and can obtain significant leveraging of private sector dollars if done properly. There are instances where the dollars deployed have a particularly powerful marginal effect where they may possibly get a development over a certain threshold of financing it would otherwise not have crossed. In those circumstances, a small amount of government financing can achieve bizarre levels of leverage. It must be noted, though, that those cases are not as common as many claim.

As a general proposition, most tax cuts and economic development programs do not "pay for themselves", but that's not necessarily an argument that they shouldn't be done. There are plenty of reasons to undertake a project or policy beyond whether or not it actually pays for itself. However, the basic rule should be that one does not undertake a project or policy because policymakers think it pays for itself.

Saturday, May 7, 2011

Did the Recent Silver Bubble Conform to Our Understanding of Bubbles?

Yes. Yes it did.

Let's think back to this old post of the evolution of a bubble.


As always, click on the image for a larger picture. Essentially, silver conformed to the basic tenant of a bubble that, because of rapidly rising expectations of future prices, suppliers of silver became unwilling to release supply on their old supply schedule. For instance, if I held 100 ounces of silver while it was trading at $15 an ounce, I may have been willing to put twenty of those ounces on the market once the price reached $20 in a more regular time. However, when I see prices go hyperbolic, I reassess the situation and hold on with a "wait and see" approach. My supply schedule shifts in. We saw this in the early stages of the silver rally where suppliers and buyers seemed to be having their expectations change more or less in tandem. What was the tell tale sign of this? Volume did not accelerate all that drastically until the last few weeks. Now, this can be the signs of something other than a bubble and I will discuss that in a minute.


Now, it's normal for volume to spike on one-off events like a big earnings report. For volume to increase massively, independently of major events in the context of a large rise is actually not normal. Case in point, Apple (AAPL):

Most of Apple's rally since early 2009 has happened in the context of remarkably stable volume. There hasn't been a huge surge in the number of shares traded during most of the advance. Clearly, this would provide evidence that the suppliers of Apple shares (i.e. current owners) have shifted in their supply schedules as prices have advanced. However, one key trait about Apple's advance is that it typically stalls until rejuvenated by a good earnings report. In other words, the advance is sustained by commensurate news regarding the fundamental improvements in the company's future earnings potential. To underline this point, Apple only trades at about 12x next year's earnings. If anything, one could argue that investors are discounting the possibility that the current trend in earnings might not be sustained.

To return to silver for a moment, there was no particular rationale for sustaining its rate of increase aside from the fact that it was increasing awfully quickly so one would want to buy in. Clearly, an increasing number of investors didn't buy into this idea and liquidated their positions right into the most hyperbolic portion of the increase. Volume surged in the last couple weeks of the rally, far eclipsing the daily average volume of the past several months. What was astonishing, and this is what tipped me off, was that there were enough speculative buyers to sustain the rally in the face of substantial liquidation. Clearly, speculators had become unhinged. The options markets reflected this at the end the last week of April where long-dated put options for SLV in the low 40s were trading at substantial premiums while long-dated call options above $50 were not. In other words, the options traders expected things to get ugly for silver by the end of the year. I decided, based on the frenzy, that silver was going to burst extremely quickly and decided to trade the June $42 puts. I have now liquidated two out of the three positions at large gains.

Now, let's try to piece this all together into a comprehensive picture of a bubble. You may remember from an earlier post back nearly a year ago that I laid out three criteria for spotting a bubble:

1. Is the asset or asset class in question fundamentally more attractive than other alternatives?
2. Is there either little information available or is the information corrupted in some way?
3. Are market actors incorporating available information or are they doing so in a rational way?

Silver began rallying for a real fundamental reason which is that the dollar is nearly constantly depreciating and high rates of money supply growth imply a central bank willing to devalue the currency for some time. This is usually a conventional reason to trade in precious metals as a hedge against inflation. However, the increase in silver far exceeded this fundamental reason as one will note that the dollar declined maybe around 10% depending on the measure you use in the time silver increased more than 150%. Still, there was a reason why the asset class of precious metals, broadly speaking, and silver in particular would be attractive.

On the second point, people have no idea how precious metals should be valued and economists have rarely ever been able to construct a reasonable model for how precious metals can be priced. Their industrial uses are never enough to justify their prices and their sentimental or emotional values to people are impossible to value. Further, there are a lot of people who corrupt what information is available with articles like "Silver going to $200 an ounce?"

On the third point, the answer was clearly no. The increase in volume wasn't based on any event, but on a short term frenzy where people were beating each other over the head with higher and higher bids to get into a crowded market. 

Take this into account with the fact that, like in all bubbles, silver followed the tradition of the trashiest asset in an asset class performing the best. Precious metals are generally in a bubble and silver is the trashiest among them and it performed the best. In fact, platinum performed the worst.

The silver bubble conformed to every basic tenant of what we understand about bubbles and the fact that several people, myself included, were able to call it should not be surprising. By the way, applying th criteria laid out here and in prior posts, you can clearly define Apple as not being in a bubble and the same applies to the overall market advance over the past two years. A large advance (50%+) does not necessarily indicate a bubble, but it does warrant examining the conditions surrounding it. 

Monday, May 2, 2011

Going Short On Silver?

In the interests of full disclosure, I opened up a June put option position on SLV that already yielded a whopping 63% return just since this morning. Of course, that can disappear in an afternoon as this is the options market after all. I fully expect the silver bulls to make another run at it, but frankly this thing is overdue for a major correction. It is hard to justify the run it's had.

That being said, I didn't exactly go in full throttle because bubble markets can produce huge surges that can come out of nowhere and obliterate the short side of the trade. However, I'm reasonably convinced that this thing is coming to an end and soon. The fact that volume and price went up together exponentially in the last few weeks was indication enough for me.

Of course, if I'm wrong, I'm out about $500. Easy come, easy go. I in no way recommend one action one way or the other on this, and do not recommend playing options unless you have money to blow.

On this particular point, I would emphasize the disclaimer on this blog that I am not an investment professional and nothing posted on this blog should be construed as investment advice.

Sunday, May 1, 2011

200th Blog Post!

Apparently, there is a perfect image out there for this occasion:

Huzzah!

Has Commercial Real Estate Reached Bottom?

Link here: http://web.mit.edu/cre/research/credl/rca.html

Take the relative stability in prices along with the fact that the Fed's Senior Loan Officer Survey shows that banks, on net, have ceased to tighten lending standards and are beginning to see demand increase and there might be a good case to be made that we are nearing the end of this long nightmare. We've even seen strong evidence that delinquencies and charge-offs are on the downturn.

However, it is still likely that with fairly high vacancy rates that new construction will still be a while off.

Breaking Down the Q1 GDP Report

While the Q1 GDP report this week was certainly disappointing, I'm not sure that some fully understood why the top line number was as weak as it was. The financial press seems to have gotten it right, but I've seen some more on-the-street commentary attribute it to the high gas prices. Since those were mostly a March phenomenon, this seems unlikely. 

Additionally, when you peel the various pieces of the report apart, it is clear that the weakness came from one thing more than anything else: weak government spending. Contractions in federal, state, and local government expenditures shaved more than a full percentage point off of the annualized growth rate in the first quarter. A full two thirds of that change is attributable to a drop in national defense expenditures, which are fairly volatile due to the unusual timing of larger orders. National defense expenditures added smartly to GDP growth in Q2 and Q3 last year, but took away growth slightly in Q4 of 2010 and this year's Q1. As for state and local governments, most of it happened on the investment side, which would indicate less road building, upgrades at state and municipal-owned utilities, and so on. 

Now, before anyone says, "Well, that's just government and it doesn't matter what is happening there. The private sector is doing comparatively well," I feel constrained to remind them on how GDP is calculated. Each category is calculated at the point of final consumption. The means that government is the final consumer of certain goods and services that are actually, more often than not, obtained from the private sector. The upshot of this is that if weak government spending is holding overall consumption and investment down, it is a real phenomenon of less spending happening in the economy, not just an accounting vagary. 

The effects of higher gas prices were not yet felt in full in Q1 as personal consumption was modestly strong and the trade deficit did not noticeably widen. So far, high frequency indicators of retail sales such as the weekly retail sales reports do not indicate grave weakness, but the regional manufacturing indexes put out by the various Federal Reserve banks showed signs of strain, though we are still in robust expansionary territory. This all bears watching. One or two months of these prices is a sustainable event; four, five, or six becomes a problem. Higher fuel prices have a pernicious effect on economic growth in all sectors.