tag:blogger.com,1999:blog-74152000611274670282024-03-04T21:36:06.023-08:00Finance MonitorFinance Monitorhttp://www.blogger.com/profile/00569154006489050897noreply@blogger.comBlogger230125tag:blogger.com,1999:blog-7415200061127467028.post-53950839100358973242014-05-16T18:14:00.001-07:002014-05-16T18:19:25.113-07:00JCPenney Coming Back?First, full disclosure here, I hold a modest position in January 2015 JCPenney (JCP) $10 call options as a small proposition bet that JCPenney would indeed at least recover enough for me to make some money. I'm a little more ambiguous on the idea that the company will totally recover from what it's been through.<br />
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With that out of the way, JCP rallied quite a bit today, jumping 16.25% to $9.73, its highest close since about November, on a favorable earnings report last night. Sales growth topped estimates and the losses were narrower. See this press release for the overview: <a href="http://www.marketwatch.com/story/jcpenney-reports-fiscal-2014-first-quarter-results-2014-05-15">http://www.marketwatch.com/story/jcpenney-reports-fiscal-2014-first-quarter-results-2014-05-15</a></div>
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Part of the reason same store sales growth was pretty solid at 6.2% was due to a pretty favorable comparison since in the first quarter of last year they were really in their down stroke phase and sales dropped by solid double digits. Add to that the fact that closing your weakest performing stores prunes the numbers to give some extra lift and you get a pretty decent number. I'll be awfully curious to see if this can be maintained going forward.</div>
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Importantly, gross margins have started firming up and the company apparently expects them to continue to grow. It also appears that they are beginning to move toward eliminating their longstanding hemorrhage of cash. This is important since one of the very legitimate concerns with JCP is that the company was swiftly moving toward Chapter 11. Those concerns are gone for now. Based on present information, it's not easy to see how that risk is still relevant.</div>
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I think that their result today shores up my conviction in my January 2015 $10 calls, but I'm not exactly hot and bothered to add to the position. There are still a great many difficulties there, including the possibility of share price dilution should the company need to recapitalize. It doesn't have the prettiest balance sheet in the world with a shareholder's equity position that has fallen from $5.46 billion in 2011 to just over $3 billion now. This is also just a much smaller company than it once was, with revenues dropping from $17.76 billion in 2011 to $11.86 billion in 2014. While they seem to have stabilized at the present level, it's quite unlikely that they'll be making any runs at their old all-time highs anytime soon. Just to give a sense of what has happened to it, have a look at this:<br />
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<tr><td style="text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjp9dSZ0vRrXu4nm5fOpEMSDyhyphenhyphenVwJV_vialszeGdOX2Mkxp2j2TP94Ao-OD4t6nu8FOK-ukbIou4KQyBRDXHIkng77wsZqGbGJh3pS8V0cnD5USYdxY1cj_WKxdpe6mauETZ0Rq4t8fCY/s1600/JCP+5-Year.png" imageanchor="1" style="margin-left: auto; margin-right: auto;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjp9dSZ0vRrXu4nm5fOpEMSDyhyphenhyphenVwJV_vialszeGdOX2Mkxp2j2TP94Ao-OD4t6nu8FOK-ukbIou4KQyBRDXHIkng77wsZqGbGJh3pS8V0cnD5USYdxY1cj_WKxdpe6mauETZ0Rq4t8fCY/s1600/JCP+5-Year.png" height="210" width="400" /></a></td></tr>
<tr><td class="tr-caption" style="text-align: center;">Chart courtesy of Marketwatch.com</td></tr>
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Here are some stories by those that have spent more time than me on JCP, first those expressing caution:</div>
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The Value Investor at Seeking Alpha: <a href="http://seekingalpha.com/article/2223443-j-c-penney-a-battle-has-been-won-but-not-the-war">http://seekingalpha.com/article/2223443-j-c-penney-a-battle-has-been-won-but-not-the-war</a></div>
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24/7 Wall St: <a href="http://www.marketwatch.com/story/jc-penney-not-out-of-the-woods-yet-2014-05-16">http://www.marketwatch.com/story/jc-penney-not-out-of-the-woods-yet-2014-05-16</a></div>
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Morgan Stanley: <a href="http://www.benzinga.com/analyst-ratings/analyst-color/14/05/4562916/update-morgan-stanley-reiterates-on-j-c-penney-company-o">http://www.benzinga.com/analyst-ratings/analyst-color/14/05/4562916/update-morgan-stanley-reiterates-on-j-c-penney-company-o</a></div>
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Michael Maggi at The Street: <a href="http://www.thestreet.com/story/12712120/1/jc-penney-stock-delaying-the-inevitable-disappearing-coin.html?puc=TSMKTWATCH&cm_ven=TSMKTWATCH">http://www.thestreet.com/story/12712120/1/jc-penney-stock-delaying-the-inevitable-disappearing-coin.html?puc=TSMKTWATCH&cm_ven=TSMKTWATCH</a></div>
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On the more bullish side, we have these stories:</div>
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Achilles Research at Seeking Alpha: <a href="http://seekingalpha.com/article/2222573-j-c-penney-you-aint-seen-nothing-yet-well-on-its-way-to-18">http://seekingalpha.com/article/2222573-j-c-penney-you-aint-seen-nothing-yet-well-on-its-way-to-18</a></div>
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Dante's Investing Ideas at Seeking Alpha: <a href="http://seekingalpha.com/article/2222473-giddy-up-j-c-penney-could-hit-22-sometime-this-year">http://seekingalpha.com/article/2222473-giddy-up-j-c-penney-could-hit-22-sometime-this-year</a></div>
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Of course, this is what makes a market. I'm a little cautious myself since the department store industry in general isn't a particularly great one at the moment, even if JCPenney is embracing an online presence very aggressively. Its glory days are, I think, in the past and we're just basically speculating that it got undervalued due to death-spiral concerns about its liquidity. If it can hang on and restore modest profitability, JCP makes sense for my position and for maybe some quick trades, but I'm skeptical regarding its long-term prospects.</div>
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Of course, I've been burned on clothing retailers before, so I'm prepared to be surprised again.</div>
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Finance Monitorhttp://www.blogger.com/profile/00569154006489050897noreply@blogger.com0tag:blogger.com,1999:blog-7415200061127467028.post-50080729355475279512014-05-07T16:18:00.003-07:002014-05-07T16:22:53.323-07:00How long do you have to hold stocks to smoothe out all of the swings?This is a question, or some variant thereof, I get quite a lot. We very often hear that you'll earn anywhere between 7-10% on stocks per year over the long term. This is true, but just how long are we talking here? If we do the stretch of 1928-2013, the historical compounded annual growth rate (CAGR) was around 9.2%.<br />
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The problem is that after an 85-year holding period you'll look something like this:<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEigrMDgI7-2rpIFnM-5xqPS-u6PEC3lde_0JHNY1bKTUaXLeIqWmh42NAx6bQn4YKZ8dgZzfxmoqA77os_wkISk1KCN00oLoSa8SFY9KGzmkVzg8BueiICSoRUwgjpriJ_hsWF2WwmQa5g/s1600/Indiana+Jones+and+the+Last+Crusade+4.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEigrMDgI7-2rpIFnM-5xqPS-u6PEC3lde_0JHNY1bKTUaXLeIqWmh42NAx6bQn4YKZ8dgZzfxmoqA77os_wkISk1KCN00oLoSa8SFY9KGzmkVzg8BueiICSoRUwgjpriJ_hsWF2WwmQa5g/s1600/Indiana+Jones+and+the+Last+Crusade+4.jpg" height="171" width="400" /></a></div>
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5 years isn't anywhere near enough and neither is 10 years. The answer is that you'll have to hold for 20 years or more to really guarantee that you'll get something in that range. Even the 20 year holding periods can swing a little bit above or below those long-term targets, but once you get out to 30 year or 40 year periods we're finally there. You get nice stable rates of return that don't vary much at all. Over those periods, stocks are basically as risky as going to the bathroom. See the chart below. The way to read this is that each line represents the annualized return of that holding period through that year. So, for 1968, the 40-year line represents the annualized return for the 40 years through 1968.</div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh5QsiVdEuwq1U4EHAKeeyCBMGs5rLCSen7ZUiax1h5aldD4G_al1gC19VOhArMrTt0u6m1Wwwvt-OuxHesrB5UIaJLEY3AIYhLWVE2YgNb8jaL3SAOmpZTwmDLqlhZJIitxBLoRejHYKU/s1600/Evolution+of+Annualized+Returns.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh5QsiVdEuwq1U4EHAKeeyCBMGs5rLCSen7ZUiax1h5aldD4G_al1gC19VOhArMrTt0u6m1Wwwvt-OuxHesrB5UIaJLEY3AIYhLWVE2YgNb8jaL3SAOmpZTwmDLqlhZJIitxBLoRejHYKU/s1600/Evolution+of+Annualized+Returns.jpg" height="257" width="400" /></a></div>
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So, if you're thinking 10 years gets the job done and averages everything out, think again. You have to invest with a long time horizon if you want to truly wash out the wild swings.</div>
Finance Monitorhttp://www.blogger.com/profile/00569154006489050897noreply@blogger.com1tag:blogger.com,1999:blog-7415200061127467028.post-25239475587923600762014-05-07T06:03:00.000-07:002014-05-07T06:27:40.451-07:00Putting Riskier Assets Into Your Portfolio Stabilizes It?Alright, that was a much longer hiatus than I would care to ever repeat and I decided to get back into the swing of things here by writing about one of my favorite little facts in portfolio theory. That is the peculiar fact that adding stocks to an all-bond portfolio actually stabilizes your returns and you get a higher return for less risk.<br />
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You know how economists always say there's no free lunch? Well, there's an exception to that rule and it comes from what is referred to as the "efficient frontier," which amounts to a rule about assessing the true relationship between risk and reward. Long story short, there isn't a straight linear relationship. There's a weird bend in the curve that makes a 27% stock portfolio as safe as a 0% stock, 100% bond portfolio and makes a 15% stock portfolio the least risky of all. For all of the charts below, I used data on total returns for stocks and 10-year U.S. from 1928 to 2013.<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEja0HSUmMAUacj-05LoPNWrHP4wvLxjvLmzw-E08Q2_Ve-oiw85UTVCCApOF-7v70Ntk5oW1xnyH4e5wQEn7vEyNMn_STOfkIiS0P-gbi_R7fvnBoTjXKvCTZvVbMPA1wPlmTL7nJ_3SNk/s1600/Risk+Reduces+Volatility.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEja0HSUmMAUacj-05LoPNWrHP4wvLxjvLmzw-E08Q2_Ve-oiw85UTVCCApOF-7v70Ntk5oW1xnyH4e5wQEn7vEyNMn_STOfkIiS0P-gbi_R7fvnBoTjXKvCTZvVbMPA1wPlmTL7nJ_3SNk/s1600/Risk+Reduces+Volatility.png" height="240" width="400" /></a></div>
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But wait, there's more! Because of the fact that adding stocks to a portfolio increases your long-term annual returns, this actually means that you can reduce your volatility and increase your returns in that backward-bending portion of the volatility curve. </div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjh4cLftBjYWc6EtuNSM_GSIz4e1BrX5OsaXo14uc-E1MWDJ8-RpIRz0zSk60zeLjsDMT3gN_IPynPfzHSZAYE46kGJq5d01GTXBwLKP9M605UGbBzJSXMk1fG08LbKC-db1AltJJKHySw/s1600/Reward+With+Less+Risk.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjh4cLftBjYWc6EtuNSM_GSIz4e1BrX5OsaXo14uc-E1MWDJ8-RpIRz0zSk60zeLjsDMT3gN_IPynPfzHSZAYE46kGJq5d01GTXBwLKP9M605UGbBzJSXMk1fG08LbKC-db1AltJJKHySw/s1600/Reward+With+Less+Risk.png" height="240" width="400" /></a></div>
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The idea that risk and reward are strictly linearly related has been a longstanding fallacy that most people buy into, but there are even every day exceptions to that. For example, you can walk into a street with cars going 25 mph and the odds are that they will stop and not run you over, even though they'll be incredibly angry with you for making them hit the brakes. However, they might not hit the brakes and then you'll be run over. The risk there is pretty high and the reward is saving a few seconds on your commute. </div>
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The reason that it's not linear in the case of investments has to do with the fact that the factors which move stocks and bonds are different. Bonds typically do well in environments where investors are risk-averse and the outlook for inflation is declining, often because growth is declining. Stocks generally (surprise!) do well when growth prospects are strong. There are years where their interests coincide, very notably 1995 and 1982, because falling interest rates are good for bonds and stocks, all else being held constant. The consequence is a distribution of returns that looks something like this.</div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj66Zl9WTURhWuLErUcEcDlvcLLkO274T1OttQFNU_TpuHCSQZAq1wepP4mpsSpxqQEHpe6fUCDlfnWnxUPkE1OkhFTZdn7_E-nNdpLnKLeeEMlrp3hKoNr-dcpVlPluQnQcncE0WwLFb4/s1600/Stock+vs.+Bonds.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj66Zl9WTURhWuLErUcEcDlvcLLkO274T1OttQFNU_TpuHCSQZAq1wepP4mpsSpxqQEHpe6fUCDlfnWnxUPkE1OkhFTZdn7_E-nNdpLnKLeeEMlrp3hKoNr-dcpVlPluQnQcncE0WwLFb4/s1600/Stock+vs.+Bonds.png" height="240" width="400" /></a></div>
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There's a smattering of about 8 years where they both do very well and you can see that in the upper-right corner, but otherwise there's a decently strong inverse relationship between the two.</div>
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So, the conclusion here is that by introducing a riskier asset class, in this case stocks, into a portfolio that starts as 100% bonds, you actually reduce your long-term volatility and increase your returns at the same time.</div>
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Now, a related question is what allocation avoids the worst performance historically. The answer isn't quite the same, but it's close. </div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj75_zUJ01Ywy3zFNnH8mVX8IXgzlIe6PUmVKyqL1-gCmWn0r4Ht1A8A81EmLbbzrRdz2N6QamsZ-StnBlAODdQg0hj3h88KzCiBrwj2FlGWBK9UgfTibbK9rBl6TVYvsu67yGKvmLPuMQ/s1600/Worst+Year.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj75_zUJ01Ywy3zFNnH8mVX8IXgzlIe6PUmVKyqL1-gCmWn0r4Ht1A8A81EmLbbzrRdz2N6QamsZ-StnBlAODdQg0hj3h88KzCiBrwj2FlGWBK9UgfTibbK9rBl6TVYvsu67yGKvmLPuMQ/s1600/Worst+Year.png" height="240" width="400" /></a></div>
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It works out that an 11% asset allocation to stocks has had the smallest 1-year decline of any asset allocation at just over a 7% drop. This of course prompted the question of what is the best year each asset allocation has seen. There's no question that 100% stocks will see the best year, but the rest of the curve is kind of interesting.</div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhEtnGyLARMftF8uYbd5QfbNRt0f2eom2TuT-bSY0SM32Ta5GpmbIYADcbXHUJCHTfxuQ7uh9yrE6ocjEFIBfhkUq6FYNlzO3HIcHvuPd2kwObG-xoDFUbWjGRLwGrZxWZW8qTUMGKMXfc/s1600/Best+Year.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhEtnGyLARMftF8uYbd5QfbNRt0f2eom2TuT-bSY0SM32Ta5GpmbIYADcbXHUJCHTfxuQ7uh9yrE6ocjEFIBfhkUq6FYNlzO3HIcHvuPd2kwObG-xoDFUbWjGRLwGrZxWZW8qTUMGKMXfc/s1600/Best+Year.png" height="240" width="400" /></a></div>
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I know it's a little spooky, almost like Quantum Entanglement, but facts are facts and it's important to know what asset allocations are truly best for reducing volatility if that's your preference.</div>
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In case you're curious about the history of this idea, Harry Markowitz, one of the all-time greats in financial economics, was the one who really popularized it. </div>
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With that, it's good to be back and I hope to be posting more in the future.</div>
Finance Monitorhttp://www.blogger.com/profile/00569154006489050897noreply@blogger.com0tag:blogger.com,1999:blog-7415200061127467028.post-57714646346841242502012-01-05T18:50:00.000-08:002012-01-05T18:50:44.750-08:00What Do Jobless Claims Tell Us About Nonfarm Payrolls?With a very strong ADP number this morning, some are wondering if tomorrow's jobs report could be a blockbuster. There's a good chance it could be fairly decent given the recent trend in jobless claims.<br />
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Here's the relationship between the two since January 2004:<br />
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<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjnsSZlDbxEc_fUALwu83gnVXtZjJQMv5rg3jvJzIyaUTatNMR9Km7V3iHq0ts0_htMpOJl9u78rqmHcfrujlUw2FNZCS175RHO7rLCQQD5_CXwzUojGdewBKc93ch4ID8LoKkYPa1sQC0/s1600/Jobless+Claims+Nonfarm+Payrolls.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="290" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjnsSZlDbxEc_fUALwu83gnVXtZjJQMv5rg3jvJzIyaUTatNMR9Km7V3iHq0ts0_htMpOJl9u78rqmHcfrujlUw2FNZCS175RHO7rLCQQD5_CXwzUojGdewBKc93ch4ID8LoKkYPa1sQC0/s400/Jobless+Claims+Nonfarm+Payrolls.png" width="400" /></a></div><br />
That there is a relationship between these two is not a surprise as they have a very strong intuitive link. However, the relationship is clearly not consistent as there have been months where jobless claims average 500,000 a week and yet jobs changes were near the flat line. Similarly, we have had months with net job losses where jobless claims have averaged less than 400,000 a week for that month. Coming off of the recession, it seems that we can generate net increases in jobs at relatively high levels of jobless claims. In the past month, jobless claims have averaged 375,600, the lowest May of 2008, which was actually a time when we lost over 200,000 jobs. On the flipside, we had a month in February of 2011 when jobless claims averaged 392,500 and nonfarm payrolls grew 235,000. Go figure.<br />
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The basic reason is that the change in nonfarm payrolls is the residual of the massive amounts of gross job gains and losses that occur each month. Millions of jobs are created and eliminated every month. Jobless claims are effectively a measurement of gross job losses. As we enter recession, the offsetting gains diminish and thus we can lose fairly substantial amounts of jobs even at apparently benign levels of jobless claims. The inverse is true as well. The question is always "Which part of that slope are we on?". At this time, we appear to be at a time with accelerating gross job gains that are allowing us to have substantial net job creation even close to the 400,000 level in jobless claims. As such, it is quite likely that we actually will see net private sector job gains of over 220,000 in the report tomorrow. Government losses will offset that amount to some extent, but overall it should be a decent report.Finance Monitorhttp://www.blogger.com/profile/00569154006489050897noreply@blogger.com0tag:blogger.com,1999:blog-7415200061127467028.post-23183211157766342652012-01-05T18:03:00.000-08:002012-01-05T18:03:07.018-08:00A Simple Discussion on Deductions and ExemptionsAs someone who works in the tax policy field, I understand where the frustration comes from when people look at the massive schedules of deductions available to both individual taxpayers and businesses. As such, since tax code simplification is a popular subject these days, some just throw up their hands and say, "Get rid of them all and tax every dollar of income!". It's an emotionally appealing argument in times like this, but let's remember some theoretical bases behind why we set up the tax code the way we did.<br />
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First, I would like to remind people of how businesses are taxed in this country. Except in a few states where either gross receipts taxes or some form of value added tax exist, businesses are taxed on their net income. Net income is a defined term that doesn't correlate with cash flow, except in some cases by accident. For tax purposes, it is the business' gross receipts - deductions for various expenses or bonus deductions for certain activities. As a general rule, though, the idea is to impose a tax on what is available to the business after it has paid for all of its normal operations. Businesses not keeping their heads above water don't play taxes.<br />
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The same principal is applied in a different way to individuals. Individuals do not have a "net income" as we commonly understand it. Individuals have a great deal of latitude in how to incur expenses and pretty much anyone can expand their expenses to fit any income. However, there are certain minimums that people can't go below and this is the basis of the baseline deductions and exemptions. A certain amount of income will not be subject to tax in order to allow individuals to pay for baseline expenses without having to pay taxes. This is to avoid taxing beyond their ability to actually pay their bills. The effect is to try to create a parallel to business net income for individuals and in so doing not taxing them beyond their ability to pay.<br />
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I would be the first to admit that we have far too many specialized deductions and credits that serve very particular interests or that have outlived their usefulness, but to simply rid the tax code of deductions and exemptions is not the answer. It doesn't even make good theoretical sense. The reason that more and more people are falling of the tax rolls is because the indexing of exemptions and deductions continues to push people with stagnant nominal incomes below zero taxable income. What this reflects is that the cost of living is accelerating faster than their ability to pay. Simply deciding to redefine the boundaries of the tax system to have those people pay more in taxes doesn't seem to make logical sense.Finance Monitorhttp://www.blogger.com/profile/00569154006489050897noreply@blogger.com1tag:blogger.com,1999:blog-7415200061127467028.post-11102821632342201152011-12-19T19:40:00.000-08:002011-12-19T19:40:02.455-08:00Bank of MerrillwideI 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.<br />
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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.<br />
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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.<br />
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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:<br />
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<div class="separator" style="clear: both; text-align: center;"><a href="http://www.marketwatch.com/kaavio.webhost/charts/big.chart?symb=US:BAC&sid=147233&time=8&startdate=&enddate=&freq=1&comp=&compidx=&uf=7168&ma=1&maval=50&type=2&size=1&lf=1&lf2=4&lf3=&style=1013&mocktick=1&rand=362209498" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="400" src="http://www.marketwatch.com/kaavio.webhost/charts/big.chart?symb=US:BAC&sid=147233&time=8&startdate=&enddate=&freq=1&comp=&compidx=&uf=7168&ma=1&maval=50&type=2&size=1&lf=1&lf2=4&lf3=&style=1013&mocktick=1&rand=362209498" width="385" /></a></div>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. <br />
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With headlines like this one swirling around, it might be dangerous to speculate on the unknown here: <a href="http://www.marketwatch.com/story/draft-big-bank-capital-rules-expected-soon-2011-12-19">http://www.marketwatch.com/story/draft-big-bank-capital-rules-expected-soon-2011-12-19</a><br />
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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:<br />
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<div class="separator" style="clear: both; text-align: center;"><a href="http://www.marketwatch.com/kaavio.webhost/charts/big.chart?symb=US:GS&sid=147544&time=8&startdate=&enddate=&freq=1&comp=BAC&compidx=aaaaa~0&uf=7168&ma=1&maval=50&type=2&size=1&lf=1&lf2=4&lf3=0&style=1013&mocktick=1&rand=95760524" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="400" src="http://www.marketwatch.com/kaavio.webhost/charts/big.chart?symb=US:GS&sid=147544&time=8&startdate=&enddate=&freq=1&comp=BAC&compidx=aaaaa~0&uf=7168&ma=1&maval=50&type=2&size=1&lf=1&lf2=4&lf3=0&style=1013&mocktick=1&rand=95760524" width="385" /></a></div>The two declines are not qualitatively different.Finance Monitorhttp://www.blogger.com/profile/00569154006489050897noreply@blogger.com2tag:blogger.com,1999:blog-7415200061127467028.post-76531655655985537862011-11-23T09:25:00.000-08:002014-05-06T16:53:35.446-07:00Is 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.<br />
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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):<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi9vPkp710QI_q6jE979RzGLOWloyhL-dz3J5eh06b7Ku0Pk3zJZklXpKG5qnS8LgDjfYQmxuD8qwPyI3EHiAfbsNhbe-1kXli199H6VTMC7_3m-0OdEFII0gh1n31nBooh5movpDbEpMg/s1600/S%2526P500+Annual+Returns.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi9vPkp710QI_q6jE979RzGLOWloyhL-dz3J5eh06b7Ku0Pk3zJZklXpKG5qnS8LgDjfYQmxuD8qwPyI3EHiAfbsNhbe-1kXli199H6VTMC7_3m-0OdEFII0gh1n31nBooh5movpDbEpMg/s640/S%2526P500+Annual+Returns.png" height="640" width="128" /></a></div>
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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. <br />
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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.<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgCeD4qRPxvhh9J6LGTmUF6UcWBTT8XsWQhyDtoV4oIShpWn-wLqOiPZohS9Pfy1a-Q5mhyphenhyphenqBbboF8su6YkGVcrbyq6J8Xm7wBcIKGdAWVhqYNijOF6jwM1f3CyTafZqTctSM121PTJroE/s1600/S%2526P+500+Annual+Returns+Distribution.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgCeD4qRPxvhh9J6LGTmUF6UcWBTT8XsWQhyDtoV4oIShpWn-wLqOiPZohS9Pfy1a-Q5mhyphenhyphenqBbboF8su6YkGVcrbyq6J8Xm7wBcIKGdAWVhqYNijOF6jwM1f3CyTafZqTctSM121PTJroE/s400/S%2526P+500+Annual+Returns+Distribution.png" height="240" width="400" /></a></div>
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As you can see, this is not a normal distribution by any stretch of the imagination. </div>
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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. </div>
Finance Monitorhttp://www.blogger.com/profile/00569154006489050897noreply@blogger.com0tag:blogger.com,1999:blog-7415200061127467028.post-64286619513033113022011-11-06T06:28:00.000-08:002011-11-06T06:31:11.075-08:00On Economic TroglodytesOne 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). <br />
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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 <a href="http://www.minyanville.com/businessmarkets/articles/seasonally-adjusted-unemployment-claims-unemployment-data/10/20/2011/id/37497?page=full">Minyanville</a>. 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:<br />
<blockquote class="tr_bq"><span class="Apple-style-span" style="background-color: black; color: white;"><span class="Apple-style-span" style="font-family: arial, helvetica, sans-serif, verdana; font-size: 15px; line-height: 20px;">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' </span><span class="itxtrst itxtrstspan itxthookspan" id="itxthook3w0" style="background-attachment: initial; background-clip: initial; background-image: initial; background-origin: initial; border-bottom-style: solid; border-color: initial; border-color: initial; border-color: initial; border-color: initial; border-left-style: none; border-right-style: none; border-top-style: none; border-width: initial; border-width: initial; border-width: initial; border-width: initial; bottom: auto; display: inline; float: none; font-family: inherit; font-size: inherit; left: auto; margin-bottom: 0px !important; margin-left: 0px !important; margin-right: 0px !important; margin-top: 0px !important; padding-bottom: 0px !important; padding-left: 0px !important; padding-right: 0px !important; padding-top: 0px !important; position: static; right: auto; top: auto;">performance</span><span class="Apple-style-span" style="font-family: arial, helvetica, sans-serif, verdana; font-size: 15px; line-height: 20px; text-align: left;"> 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.</span></span></blockquote>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.<br />
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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:<br />
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<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi0cgl19V_9azDBkfxY1Mys5Qt8sasIq8eQ7gri6ltwyjDE6ip0tqgpVcgfo89XnFeknUrNL6ug1z6N3iTK82YdlRD2WW7bBcQFCTSYX106p0hC-hEg2guO4XL1DSdP6X9-iKhHKyDOR3A/s1600/Seasonally+Adjusted+Housing+Starts.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="290" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi0cgl19V_9azDBkfxY1Mys5Qt8sasIq8eQ7gri6ltwyjDE6ip0tqgpVcgfo89XnFeknUrNL6ug1z6N3iTK82YdlRD2WW7bBcQFCTSYX106p0hC-hEg2guO4XL1DSdP6X9-iKhHKyDOR3A/s400/Seasonally+Adjusted+Housing+Starts.png" width="400" /></a></div><br />
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)<br />
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<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg0Z9tASF7KeLPwrT69DOT5J1lFAOnUXOozSJWc2fHSEoecDBKRxceZ8bU5M3RX1R2xDC-M88A6VMFxxqbdz_IExuxD5379zP5Bn7xDJ_zMLibO2kp3161nGajtUTe_1aS-y7w1eRbS3X8/s1600/Seasonally+Adjusted+Housing+Starts2.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="290" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg0Z9tASF7KeLPwrT69DOT5J1lFAOnUXOozSJWc2fHSEoecDBKRxceZ8bU5M3RX1R2xDC-M88A6VMFxxqbdz_IExuxD5379zP5Bn7xDJ_zMLibO2kp3161nGajtUTe_1aS-y7w1eRbS3X8/s400/Seasonally+Adjusted+Housing+Starts2.png" width="400" /></a></div><br />
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.<br />
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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.Finance Monitorhttp://www.blogger.com/profile/00569154006489050897noreply@blogger.com0tag:blogger.com,1999:blog-7415200061127467028.post-32810241117165002392011-10-30T08:59:00.000-07:002011-10-30T08:59:01.598-07:00The CPI Food and Energy DebateOccasionally 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.<br />
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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:<br />
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<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgsungXjgXlewV60ELDi_e49fU1-vjtK7bBxF8uNx49NHVDKlB457mQjWbXRgP3EwapE1QfvVBVxR724AEC2UYOON7uPMHPHz6BRpGq0TFcbMQKLrk3Z42HwrfX99goxGAwc4RQ0zh1rrE/s1600/CPI+Ex-Food+and+Energy+vs+Total+CPI.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="290" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgsungXjgXlewV60ELDi_e49fU1-vjtK7bBxF8uNx49NHVDKlB457mQjWbXRgP3EwapE1QfvVBVxR724AEC2UYOON7uPMHPHz6BRpGq0TFcbMQKLrk3Z42HwrfX99goxGAwc4RQ0zh1rrE/s400/CPI+Ex-Food+and+Energy+vs+Total+CPI.png" width="400" /></a></div><br />
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. <br />
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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.<br />
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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.Finance Monitorhttp://www.blogger.com/profile/00569154006489050897noreply@blogger.com0tag:blogger.com,1999:blog-7415200061127467028.post-41751714901870026142011-10-30T08:24:00.000-07:002011-10-30T08:24:22.680-07:00The 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.<br />
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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:<br />
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</div><div class="separator" style="clear: both; text-align: left;">The same troubling thing holds true in Portugal:</div><div class="separator" style="clear: both; text-align: left;"><br />
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</div>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.<br />
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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.<br />
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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.<br />
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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.<br />
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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.<br />
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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)<br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgm0PMfAlC946u4-ycOVCMVnbnr1TaGaUHSn0viQ1ygrah5ny_rVdYESpTuR6AelLsefkJsmMKHaEm9tcfgRDdTUOn6QO-S9nBK45zjiemCerKe0yiCvPwP0__ZgtNA5O-fPlwyzy5GxMk/s1600/Baa-Aaa+Credit+Spreads.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em; text-align: center;"><img border="0" height="290" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgm0PMfAlC946u4-ycOVCMVnbnr1TaGaUHSn0viQ1ygrah5ny_rVdYESpTuR6AelLsefkJsmMKHaEm9tcfgRDdTUOn6QO-S9nBK45zjiemCerKe0yiCvPwP0__ZgtNA5O-fPlwyzy5GxMk/s400/Baa-Aaa+Credit+Spreads.png" width="400" /></a><br />
<br />
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.Finance Monitorhttp://www.blogger.com/profile/00569154006489050897noreply@blogger.com0tag:blogger.com,1999:blog-7415200061127467028.post-70590034311457269602011-10-30T07:19:00.000-07:002011-10-30T07:19:23.224-07:00The 1998 Time WarpOne of my earliest memories of following the financial markets was the meltdown in 1998 caused by the <a href="http://en.wikipedia.org/wiki/1998_Russian_financial_crisis">Russian Debt Default</a> 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.<br />
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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)<br />
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<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjy0LDbt6KYSoZIidxwT-9deY54lAQan5fZpdHzgAWm63kjVs8VWzPfzLx9XvoHLeMRnCLgONZyfNuyJF8DU1ewhWReW1Lkk4HB9h_ypw0-7ipY1m_TKgvu0gq3T7A862MKZ8SskN-Zklw/s1600/1998+S%2526P+500.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="290" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjy0LDbt6KYSoZIidxwT-9deY54lAQan5fZpdHzgAWm63kjVs8VWzPfzLx9XvoHLeMRnCLgONZyfNuyJF8DU1ewhWReW1Lkk4HB9h_ypw0-7ipY1m_TKgvu0gq3T7A862MKZ8SskN-Zklw/s400/1998+S%2526P+500.png" width="400" /></a></div><br />
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.<br />
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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.Finance Monitorhttp://www.blogger.com/profile/00569154006489050897noreply@blogger.com0tag:blogger.com,1999:blog-7415200061127467028.post-2720775291087108382011-10-30T06:58:00.000-07:002011-10-30T06:58:20.463-07:00Getting Back Into the Swing of ThingsDue 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.Finance Monitorhttp://www.blogger.com/profile/00569154006489050897noreply@blogger.com0tag:blogger.com,1999:blog-7415200061127467028.post-65465653395630098772011-08-23T16:31:00.000-07:002011-08-23T16:31:53.913-07:00Why 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:<br />
<br />
1. Monetary velocity is a constant<br />
2. The Fed has increased the monetary base substantially<br />
3. Nominal GDP will rise substantially, but real GDP won't<br />
4. The difference will be taken out on us in inflation<br />
<br />
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.<br />
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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):<br />
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<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi6Xvzntn3y-wYdZl__kviDCyVw3eDXS0851_42vCBattYE9viE-jOqBMdJYmfXQ7F5Tm3YXV4fqcbwSNR7RbDfNy2bwS4C4QC6Npp4KtXQowm5ToeoFZa9dpjKgMOQSjsccDSgl68d61o/s1600/Monetary+Base+Velocity+QE2.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="252" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi6Xvzntn3y-wYdZl__kviDCyVw3eDXS0851_42vCBattYE9viE-jOqBMdJYmfXQ7F5Tm3YXV4fqcbwSNR7RbDfNy2bwS4C4QC6Npp4KtXQowm5ToeoFZa9dpjKgMOQSjsccDSgl68d61o/s400/Monetary+Base+Velocity+QE2.png" width="400" /></a></div><br />
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.Finance Monitorhttp://www.blogger.com/profile/00569154006489050897noreply@blogger.com1tag:blogger.com,1999:blog-7415200061127467028.post-70458484839359089332011-08-23T16:15:00.000-07:002011-08-23T16:15:10.214-07:00Is Bank of America Sick? MaybeIts stock sure acts like it and here's a little bit of an article on the subject:<br />
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<a href="http://www.businessinsider.com/bank-of-americas-stock-collapse-2011-8?op=1">http://www.businessinsider.com/bank-of-americas-stock-collapse-2011-8?op=1</a><br />
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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.<br />
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<div class="separator" style="clear: both; text-align: center;"><a href="http://www.marketwatch.com/charts/int-adv.chart?symb=US:BAC&sid=147233&time=8&startdate=&enddate=&freq=1&comp=&compidx=&uf=7168&ma=1&maval=50&type=2&size=1&lf=1&lf2=4&lf3=&style=1013&mocktick=1&rand=308208644" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="400" src="http://www.marketwatch.com/charts/int-adv.chart?symb=US:BAC&sid=147233&time=8&startdate=&enddate=&freq=1&comp=&compidx=&uf=7168&ma=1&maval=50&type=2&size=1&lf=1&lf2=4&lf3=&style=1013&mocktick=1&rand=308208644" width="385" /></a></div>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.Finance Monitorhttp://www.blogger.com/profile/00569154006489050897noreply@blogger.com0tag:blogger.com,1999:blog-7415200061127467028.post-47865807712764489422011-08-20T19:54:00.000-07:002011-08-20T19:54:35.207-07:00A 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.<br />
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<div class="separator" style="clear: both; text-align: center;"><a href="http://research.stlouisfed.org/fred2/graph/fredgraph.png?&id=DGS10&scale=Left&range=1yr&cosd=2010-08-17&coed=2011-08-17&line_color=%230000ff&link_values=false&line_style=Solid&mark_type=NONE&mw=4&lw=1&ost=-99999&oet=99999&mma=0&fml=a&fq=Daily&fam=avg&fgst=lin&transformation=lin&vintage_date=2011-08-20&revision_date=2011-08-20" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="240" src="http://research.stlouisfed.org/fred2/graph/fredgraph.png?&id=DGS10&scale=Left&range=1yr&cosd=2010-08-17&coed=2011-08-17&line_color=%230000ff&link_values=false&line_style=Solid&mark_type=NONE&mw=4&lw=1&ost=-99999&oet=99999&mma=0&fml=a&fq=Daily&fam=avg&fgst=lin&transformation=lin&vintage_date=2011-08-20&revision_date=2011-08-20" width="400" /></a></div>Ten year treasury rates have dropped off a cliff and are now well below the year on year change in CPI (3.6%).<br />
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<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgBSpdDPKKCNjzD9ZKuYUHmAp_cCGXeRQeggf6rvB6pP-La-dwDPrvItGiaNL0TBE6OWQ3zwBONWxafN0VFnETHaziIZRTUuz9XESioNK3O9UWv1gvAV8OrXC0EG2GpSBQls5f0AyQAcz8/s1600/Real+Interest+Rates.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="240" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgBSpdDPKKCNjzD9ZKuYUHmAp_cCGXeRQeggf6rvB6pP-La-dwDPrvItGiaNL0TBE6OWQ3zwBONWxafN0VFnETHaziIZRTUuz9XESioNK3O9UWv1gvAV8OrXC0EG2GpSBQls5f0AyQAcz8/s400/Real+Interest+Rates.png" width="400" /></a></div><div class="separator" style="clear: both; text-align: center;"><br />
</div><div class="separator" style="clear: both; text-align: left;">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. </div><div class="separator" style="clear: both; text-align: left;"><br />
</div><div class="separator" style="clear: both; text-align: left;">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.</div><div class="separator" style="clear: both; text-align: left;"><br />
</div><div class="separator" style="clear: both; text-align: center;"><a href="http://www.marketwatch.com/charts/int-adv.chart?symb=US:SPY&sid=9864&time=4&startdate=&enddate=&freq=1&comp=&compidx=aaaaa~0&uf=7168&ma=1&maval=50&type=2&size=1&lf=1&lf2=4&lf3=0&style=1013&mocktick=1&rand=337108790" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="400" src="http://www.marketwatch.com/charts/int-adv.chart?symb=US:SPY&sid=9864&time=4&startdate=&enddate=&freq=1&comp=&compidx=aaaaa~0&uf=7168&ma=1&maval=50&type=2&size=1&lf=1&lf2=4&lf3=0&style=1013&mocktick=1&rand=337108790" width="385" /></a></div><div class="separator" style="clear: both; text-align: center;"><br />
</div><div class="separator" style="clear: both; text-align: left;">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. </div><div class="separator" style="clear: both; text-align: left;"><br />
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Finance Monitorhttp://www.blogger.com/profile/00569154006489050897noreply@blogger.com0tag:blogger.com,1999:blog-7415200061127467028.post-85437702375002562862011-08-20T18:42:00.000-07:002011-10-30T09:03:24.052-07:00Tax Equity Turned on Its HeadThere'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.<br />
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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.<br />
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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.<br />
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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".<br />
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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.<br />
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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.<br />
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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.<br />
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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."<br />
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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).<br />
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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.<br />
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This gets to a point I always try to make. Yes, it is true that the richest ten percent have <a href="http://www.taxfoundation.org/blog/show/27134.html">33.5% of the income and pay 45.1% of taxes</a>. 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.<br />
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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.<br />
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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.Finance Monitorhttp://www.blogger.com/profile/00569154006489050897noreply@blogger.com0tag:blogger.com,1999:blog-7415200061127467028.post-13487790233939364142011-08-08T18:32:00.000-07:002011-08-08T18:32:38.322-07:00The Staggering Collapse of OilFirst, the picture:<br />
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<div class="separator" style="clear: both; text-align: center;"><a href="http://quotes.ino.com/chart/history.gif?s=NYMEX_CL.U11.E&t=l&w=15&a=50&v=d12" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="261" src="http://quotes.ino.com/chart/history.gif?s=NYMEX_CL.U11.E&t=l&w=15&a=50&v=d12" width="400" /></a></div><br />
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.<br />
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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.Finance Monitorhttp://www.blogger.com/profile/00569154006489050897noreply@blogger.com0tag:blogger.com,1999:blog-7415200061127467028.post-21185185552516144262011-08-08T17:07:00.000-07:002011-08-08T17:07:57.966-07:00The Strangest Financial CrisisSo, 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.<br />
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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:<br />
<br />
1. Interest rates spike like mad<br />
2. The currency collapses<br />
3. The equity markets collapse<br />
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Well, one of those happened. The other two did not. Hell, the dollar actually rose slightly: <a href="http://www.bloomberg.com/apps/quote?ticker=UUP:US">http://www.bloomberg.com/apps/quote?ticker=UUP:US</a><br />
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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.<br />
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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.<br />
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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:<br />
<div class="separator" style="clear: both; text-align: center;"><a href="http://www.marketwatch.com/charts/int-adv.chart?symb=US:UTX&sid=5140&time=8&startdate=&enddate=&freq=1&comp=&compidx=&uf=7168&ma=1&maval=50&type=2&size=1&lf=1&lf2=4&lf3=&style=1013&mocktick=1&rand=508053004" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="400" src="http://www.marketwatch.com/charts/int-adv.chart?symb=US:UTX&sid=5140&time=8&startdate=&enddate=&freq=1&comp=&compidx=&uf=7168&ma=1&maval=50&type=2&size=1&lf=1&lf2=4&lf3=&style=1013&mocktick=1&rand=508053004" width="385" /></a></div><div class="separator" style="clear: both; text-align: center;"><br />
</div><div class="separator" style="clear: both; text-align: left;">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:</div><div class="separator" style="clear: both; text-align: left;"><br />
</div><div class="separator" style="clear: both; text-align: center;"><a href="http://www.marketwatch.com/charts/int-adv.chart?symb=US:CHD&sid=1211&time=8&startdate=&enddate=&freq=1&comp=&compidx=&uf=7168&ma=1&maval=50&type=2&size=1&lf=1&lf2=4&lf3=&style=1013&mocktick=1&rand=231609523" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="400" src="http://www.marketwatch.com/charts/int-adv.chart?symb=US:CHD&sid=1211&time=8&startdate=&enddate=&freq=1&comp=&compidx=&uf=7168&ma=1&maval=50&type=2&size=1&lf=1&lf2=4&lf3=&style=1013&mocktick=1&rand=231609523" width="385" /></a></div><div class="separator" style="clear: both; text-align: center;"><br />
</div><div class="separator" style="clear: both; text-align: left;">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:</div><div class="separator" style="clear: both; text-align: left;"><br />
</div><div class="separator" style="clear: both; text-align: center;"><a href="http://www.marketwatch.com/charts/int-adv.chart?symb=US:BAC&sid=147233&time=8&startdate=&enddate=&freq=1&comp=&compidx=&uf=7168&ma=1&maval=50&type=2&size=1&lf=1&lf2=4&lf3=&style=1013&mocktick=1&rand=930660426" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="400" src="http://www.marketwatch.com/charts/int-adv.chart?symb=US:BAC&sid=147233&time=8&startdate=&enddate=&freq=1&comp=&compidx=&uf=7168&ma=1&maval=50&type=2&size=1&lf=1&lf2=4&lf3=&style=1013&mocktick=1&rand=930660426" width="385" /></a></div><div class="separator" style="clear: both; text-align: center;"><br />
</div><div class="separator" style="clear: both; text-align: left;">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.</div><div class="separator" style="clear: both; text-align: left;"><br />
</div><div class="separator" style="clear: both; text-align: left;">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.</div><br />
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Finance Monitorhttp://www.blogger.com/profile/00569154006489050897noreply@blogger.com0tag:blogger.com,1999:blog-7415200061127467028.post-91918409699187491552011-08-04T18:56:00.000-07:002011-08-04T18:56:03.898-07:00What to do when the world is falling apartThings 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.<br />
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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.<br />
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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: <a href="http://www.marketwatch.com/investing/fund/ewz">http://www.marketwatch.com/investing/fund/ewz</a><br />
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Before long, there will be fantastic opportunities. There always are after panics.Finance Monitorhttp://www.blogger.com/profile/00569154006489050897noreply@blogger.com0tag:blogger.com,1999:blog-7415200061127467028.post-12873837620379197352011-08-04T18:33:00.000-07:002011-08-04T18:33:58.791-07:00A Rough Stretch, No End in SightWith 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.<br />
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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.<br />
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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 <a href="http://online.wsj.com/article/BT-CO-20110804-718824.html">that our primary concern is inflation</a>.<br />
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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: <a href="http://www.bloomberg.com/news/2011-08-05/world-market-rout-is-a-loud-no-confidence-vote-in-leaders-view.html">http://www.bloomberg.com/news/2011-08-05/world-market-rout-is-a-loud-no-confidence-vote-in-leaders-view.html</a>Finance Monitorhttp://www.blogger.com/profile/00569154006489050897noreply@blogger.com0tag:blogger.com,1999:blog-7415200061127467028.post-88416025943971773872011-07-24T15:06:00.000-07:002011-07-24T15:06:02.831-07:00China's Astonishingly Bizarre Land Development Finance SystemOne 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.<br />
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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.<br />
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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.<br />
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Here are a couple of stories to chew on:<br />
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<a href="http://www.reuters.com/article/2011/07/14/markets-ratings-china-idUSL3E7IE0F520110714">http://www.reuters.com/article/2011/07/14/markets-ratings-china-idUSL3E7IE0F520110714</a><br />
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<a href="http://www.bloomberg.com/news/2011-06-27/china-audit-office-warns-of-risk-on-1-7-trillion-of-local-government-debt.html">http://www.bloomberg.com/news/2011-06-27/china-audit-office-warns-of-risk-on-1-7-trillion-of-local-government-debt.html</a>Finance Monitorhttp://www.blogger.com/profile/00569154006489050897noreply@blogger.com0tag:blogger.com,1999:blog-7415200061127467028.post-20732425172506105962011-07-24T14:36:00.000-07:002011-07-24T14:36:29.102-07:00When 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.<br />
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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.<br />
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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.Finance Monitorhttp://www.blogger.com/profile/00569154006489050897noreply@blogger.com0tag:blogger.com,1999:blog-7415200061127467028.post-81789181001932616122011-07-10T19:56:00.000-07:002011-07-10T19:56:09.294-07:00Some thoughts on the debt ceiling debateSo, 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:<br />
<div><br />
</div><div class="separator" style="clear: both; text-align: center;"><a href="http://research.stlouisfed.org/fred2/data/SLCEC1_Max_630_378.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="240" src="http://research.stlouisfed.org/fred2/data/SLCEC1_Max_630_378.png" width="400" /></a></div><div><br />
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. <br />
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<div class="separator" style="clear: both; text-align: center;"><a href="http://research.stlouisfed.org/fred2/graph/fredgraph.png?&id=CES9093000001&scale=Left&range=Custom&cosd=2000-01-01&coed=2011-06-01&line_color=%230000ff&link_values=false&line_style=Solid&mark_type=NONE&mw=4&lw=1&ost=-99999&oet=99999&mma=0&fml=a&fq=Monthly&fam=avg&fgst=lin&transformation=lin&vintage_date=2011-07-09&revision_date=2011-07-09" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="240" src="http://research.stlouisfed.org/fred2/graph/fredgraph.png?&id=CES9093000001&scale=Left&range=Custom&cosd=2000-01-01&coed=2011-06-01&line_color=%230000ff&link_values=false&line_style=Solid&mark_type=NONE&mw=4&lw=1&ost=-99999&oet=99999&mma=0&fml=a&fq=Monthly&fam=avg&fgst=lin&transformation=lin&vintage_date=2011-07-09&revision_date=2011-07-09" width="400" /></a></div><br />
State governments, too, have been laying off:<br />
<div class="separator" style="clear: both; text-align: center;"><a href="http://research.stlouisfed.org/fred2/graph/fredgraph.png?&id=CES9092000001&scale=Left&range=Custom&cosd=2000-01-01&coed=2011-06-01&line_color=%230000ff&link_values=false&line_style=Solid&mark_type=NONE&mw=4&lw=1&ost=-99999&oet=99999&mma=0&fml=a&fq=Monthly&fam=avg&fgst=lin&transformation=lin&vintage_date=2011-07-09&revision_date=2011-07-09" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="240" src="http://research.stlouisfed.org/fred2/graph/fredgraph.png?&id=CES9092000001&scale=Left&range=Custom&cosd=2000-01-01&coed=2011-06-01&line_color=%230000ff&link_values=false&line_style=Solid&mark_type=NONE&mw=4&lw=1&ost=-99999&oet=99999&mma=0&fml=a&fq=Monthly&fam=avg&fgst=lin&transformation=lin&vintage_date=2011-07-09&revision_date=2011-07-09" width="400" /></a></div><br />
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.<br />
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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 <u>General Theory</u> by John Maynard Keynes.<br />
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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.<br />
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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.<br />
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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.<br />
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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.<br />
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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.<br />
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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.<br />
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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.<br />
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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. </div>Finance Monitorhttp://www.blogger.com/profile/00569154006489050897noreply@blogger.com0tag:blogger.com,1999:blog-7415200061127467028.post-18584676752403061702011-07-05T18:03:00.000-07:002011-07-05T18:03:18.035-07:00July 2011 Asset Allocation Model UpdateAs 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.<br />
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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:<br />
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<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjBcYJz4SNVvIpVDLbuXaRv3FOiYNNWvkliHr0G3A6LGdA3wHCAh5QkQ1RkWZ0-y9qPA8SvDbmqhm0vvqTGNiHHWPH-V7ib5KWcOzRKRTSx5-3QhB4aWT8yI4t64BYR2xsGHQQOgKca7Oc/s1600/Asset+Allocation+Model+Since+Inception.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="400" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjBcYJz4SNVvIpVDLbuXaRv3FOiYNNWvkliHr0G3A6LGdA3wHCAh5QkQ1RkWZ0-y9qPA8SvDbmqhm0vvqTGNiHHWPH-V7ib5KWcOzRKRTSx5-3QhB4aWT8yI4t64BYR2xsGHQQOgKca7Oc/s400/Asset+Allocation+Model+Since+Inception.png" width="381" /></a></div>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.<br />
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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.Finance Monitorhttp://www.blogger.com/profile/00569154006489050897noreply@blogger.com0tag:blogger.com,1999:blog-7415200061127467028.post-69413409165416260952011-06-16T21:47:00.000-07:002011-06-16T21:47:01.956-07:00At least they had the good sense to try to head it offSo, there's<a href="http://www.bloomberg.com/news/2011-06-16/mumbai-to-melbourne-home-boom-stalls-as-tightenings-put-brakes-on-prices.html"> this story on Bloomberg</a> 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.Finance Monitorhttp://www.blogger.com/profile/00569154006489050897noreply@blogger.com0