One thing casual observers of China's real estate markets always try to say is that there is comparatively little leverage in the system, which means that any decline in prices is borne principally by the holders of the property and there are not ripple effects through the rest of the system. This is similar to how declines in stock prices tend to have very little collateral damage since they are very nearly entirely bought without leverage. Sure there is up to 2% of stock bought on margin in periods of excess, but compared to real estate markets, it's modest. That's why the stock market could shed $7 trillion in value during the 2000-2002 bear market and the broader economy felt very few ill effects from it. However, a similar decline in the value of residential real estate nearly destroyed the global financial system.
In China, however, it is simply not true that all real estate transactions are financed with equity. Indeed, a great deal of development is done by local governments, who engage in a program not entirely dissimilar from Tax Incremental Financing (TIF) in this country, where they borrow to develop certain properties and hope that they eventually pay for themselves (that's a very quick and dirty version of it). However, their practices are far sloppier than TIF districts in this country, and that's disheartening since a good number of TIF districts have run into trouble as well. Needless to say, in both cases, if the development stops, these financing deals run into serious serious trouble.
However, unlike TIF, properties are not valued according to fair market value, but in many cases in appears that local governments can just simply say what they're worth and use those amounts as collateral. This would be similar to if a financially troubled TIF district could hire an assessor to say that a $5 million hotel was really worth $57 million and collect the corresponding taxes on it. Fortunately, we have many safeguards in our system of property assessment and property taxation that prevent that from happening, including appeals and state oversight of local governments. China does not have much of a system of property taxation (though that is starting to change), and hence no good comprehensive system of property assessment.
Here are a couple of stories to chew on:
http://www.reuters.com/article/2011/07/14/markets-ratings-china-idUSL3E7IE0F520110714
http://www.bloomberg.com/news/2011-06-27/china-audit-office-warns-of-risk-on-1-7-trillion-of-local-government-debt.html
Sunday, July 24, 2011
When do the markets start taking the obvious insanity of politicians seriously?
It's been clear up to this point that the financial markets have not taken what is an ever clearer picture of the true insanity of members of Congress seriously. How do I know that the markets haven't taken it seriously? Because we are still standing far too close to one year highs. The fact that we have fundamentalists in Congress who believe that they must obtain a total victory or they'll take the whole country with them should be more disquieting to markets than it has been so far.
I fear that this may be like the TARP vote, which I will maintain to my dying day was necessary, where financial markets had to absolutely implode in order for financial markets to jar Congress out of its tizzy. However, the fundamental problem is that we may not have quite that window available to us. While it is entirely possible that the Treasury can find enough scraps of money around to keep debt service going for a little while if it puts off other key functions, the simple truth is that at some point there will simply not be enough cash on hand to make a particular interest or principal payment. If the Treasury has to pay $25 billion one day and only has $13 billion on hand, to quote a number of characters in a number of movies, "Well, shit". That would cause the requisite collapse in financial markets, but at that point it would be far too late.
As I've noted before in this entire debate, the U.S. has had its AAA credit rating for years for a number of reasons, but one of the most principal reasons is not only has the U.S. never defaulted before, but it has never even really come particularly close to defaulting (with one modest exception in the Panic of 1893) and our politicians have never really considered it a possibility that they would allow it to happen. I think that this bizarre charade alone warrants a loss of the AAA rating more than our current debt load does.
I fear that this may be like the TARP vote, which I will maintain to my dying day was necessary, where financial markets had to absolutely implode in order for financial markets to jar Congress out of its tizzy. However, the fundamental problem is that we may not have quite that window available to us. While it is entirely possible that the Treasury can find enough scraps of money around to keep debt service going for a little while if it puts off other key functions, the simple truth is that at some point there will simply not be enough cash on hand to make a particular interest or principal payment. If the Treasury has to pay $25 billion one day and only has $13 billion on hand, to quote a number of characters in a number of movies, "Well, shit". That would cause the requisite collapse in financial markets, but at that point it would be far too late.
As I've noted before in this entire debate, the U.S. has had its AAA credit rating for years for a number of reasons, but one of the most principal reasons is not only has the U.S. never defaulted before, but it has never even really come particularly close to defaulting (with one modest exception in the Panic of 1893) and our politicians have never really considered it a possibility that they would allow it to happen. I think that this bizarre charade alone warrants a loss of the AAA rating more than our current debt load does.
Sunday, July 10, 2011
Some thoughts on the debt ceiling debate
So, it would appear that the stage is set for some significant retrenchments in federal government expenditures. It's hard to say what spending categories will see the hammer fall the hardest, but aid to state and local governments is a likely category. It's also somewhat troubling as state and local governments have already been hit quite hard by the lag effect of the recession:
In fact, it really should be little wonder that the economy has run into such turbulence of late. The retrenchment in state and local spending appears to be accelerating at a time when private sector demand is not exactly robust either. In particular, local governments have been laying off workers at a steady and alarming rate as you can see in the graph below. Some 400,000 and the rate is only accelerating now. A few items are causing this. One is the growing loss of state aids to local governments. State aids to school districts and municipalities are one of the largest expenditure items for state governments, usually comprising a plurality or even a majority of their general fund budget. They are also one of the easiest items to cut compared to corrections or medicaid, the other two huge items in a state's general fund budget. The other factor hitting them now is a squeeze on their own revenue sources, particularly those with sales and income taxes. While those sources are turning up, there is a lag effect.
State governments, too, have been laying off:
Slightly over 100,000 jobs lost in state governments since their most recent high. Furthermore, automatic pay raises have been delayed and pay has even been cut in some cases. As real incomes have stagnated or declined, so too has real expenditures by government workers.
I would like to take this time to remind people of something regarding the analogy between households and government. People often like to say that government should behave more like a household in lean times and cut back when its revenues decline. That's all well and good, but I would feel constrained to remind them of the simple fact that there is an effect there. After all, when a household cuts back to bring its costs in line so that they can service their debt burden, their standard of living tends to decline. The family's does not become wealthier. When everyone does the same thing, the total level of spending in the economy declines. The same holds true for government. When it withdraws, there will be fewer services, fewer jobs, and fewer expenditures to businesses who provide services to the government. This will cause a decline in overall spending and employment. None of this should be earth-shattering. It was all laid out in the General Theory by John Maynard Keynes.
Indeed, government should not behave as households do, with the common household's tendency to leverage up rising incomes in the good times while slashing and burning when incomes decline in recessions. All that does is exacerbate to underlying economic cycle by strengthening the booms and deepening the busts. If, instead, the federal government tries to keep a basic underlying level of growing spending and employment (whatever is deemed politically desirable) that uses the ability to borrow to smooth out its consumption, the procyclical effects of following the typical household's pattern can be avoided.
This logically follows from another perspective, which is that most government services either do not really vary with economic conditions such as education, infrastructure repairs, and basic bureaucratic licensing and oversight functions, or they tend to become more strained in lean periods, such as with UI benefits, TANF, and Medicaid. The former group a basic baseline level of expenditures that really should remain fairly stable and not be whipped around. The latter group is vital and designed to avoid destitution due to the various spasms of the business cycle. To have either following the pattern of the business cycle is nonsensical.
Furthermore, the argument that a reduction in government expenditures and employment will benefit the private sector is highly dubious at this particular moment. If interest rates were phenomenally high due to fears of a debt default, this might make sense. The mechanism there would be that a firm deal to reduce deficits would soothe markets, reduce interest rates, and thereby increase the affordability of capital, which has numerous positive benefits. However, this condition is not currently present. That interest rates continue to be as low as they are is indicative of capital not finding many productive outlets for investment. As such, that avenue is not open to us.
Another argument would be that we could reduce taxes on the private sector if only we could get government expenditures down, which would be stimulative. Due to the magnitude of the present deficit, that is not really an option. It's also a questionable proposition that reducing taxes and government expenditures at the same time produces a net positive economic effect as most evidence appears to support the opposite conclusion, but I'll just do a little bit of hand-waving on that one for now.
Then, we turn to the argument that business confidence would be substantially improved if there was greater clarity on the long-term trend in the deficit, public expenditures, and tax rates. To be perfectly honest, there is probably just about nothing to this argument. Very few businesses cite the long-term finances of the federal government as a factor in their decision-making. "Uncertainty" can, of course, have an effect as it did to some extent in the fall of 2008 when the solvency of major financial institutions was in question. Speaking for myself, I know a pulled in a little bit when all of that was going on, though largely so that I would have more capital to deploy for the buying opportunities to come. Furthermore, the evidence that the bulk of consumers and businesses take into account their future expected tax burdens when making decisions in the present is extraordinarily weak. There might be some marginal players on the fringes of society who do, but as a mainstream proposition, I very much doubt it.
Much more likely, consumers have continued to hold back on house purchases due to persistently declining prices. I know I have made my decision not to buy a house on that very proposition, though the rate of decline has slowed enough I am starting to consider it. This persistent drag has caused consumer spending to remain very modest as well as stunting growth in spending on new houses, which in turn is depriving businesses of the revenue growth that they need to "feel confident". There are other contributors as well, such as corporations and even small businesses that had relied on a steady flow of credit who had brushes with death in late 2008 and early 2009 deleveraging their balance sheets and accumulating cash to provide more certainty in a financial crisis. Very little of this has a whole lot to do with the federal government's financial position. Furthermore, if there is a stifling effect of government spending just being there, it would stand to reason that our economic performance would be improving rather than deteriorating as state and local governments, which account for the vast bulk of government employment and direct expenditures, have retrenched.
So, what does all of that lead to? Well, the basic structure of any grand deal would hopefully take all of the empirical and theoretical argumentation against what we seem to be careening toward. Rapid reductions in federal government expenditures to quickly close the deficit would likely derail the economy, particularly when joined with substantial contractions in state and local government expenditures, which cannot be avoided due to balanced budget requirements in the states. Further, there is no avenue by which this would benefit private sector activity at the moment. As such, it might make sense to enter into a long-term package to bring expenditures in certain categories down and taxes up, but in the short run the focus should be on continued stimulus. The general agreement should be that the stimulus not be removed until such time as the economy is on a solid footing. At that point, hopefully, we can abandon any talk of adopting the common household's approach to budgeting and instead engage in true counter-cyclical fiscal policies.
If there is some moral necessity that commands us to reduce the deficit, then so be it. However, policymakers should not delude themselves into believing that we will somehow see an economic boom due to that satisfaction of some moral need to have balanced books. If they proceed under that belief, the economic outlook will become considerably dimmer.
In fact, it really should be little wonder that the economy has run into such turbulence of late. The retrenchment in state and local spending appears to be accelerating at a time when private sector demand is not exactly robust either. In particular, local governments have been laying off workers at a steady and alarming rate as you can see in the graph below. Some 400,000 and the rate is only accelerating now. A few items are causing this. One is the growing loss of state aids to local governments. State aids to school districts and municipalities are one of the largest expenditure items for state governments, usually comprising a plurality or even a majority of their general fund budget. They are also one of the easiest items to cut compared to corrections or medicaid, the other two huge items in a state's general fund budget. The other factor hitting them now is a squeeze on their own revenue sources, particularly those with sales and income taxes. While those sources are turning up, there is a lag effect.
State governments, too, have been laying off:
Slightly over 100,000 jobs lost in state governments since their most recent high. Furthermore, automatic pay raises have been delayed and pay has even been cut in some cases. As real incomes have stagnated or declined, so too has real expenditures by government workers.
I would like to take this time to remind people of something regarding the analogy between households and government. People often like to say that government should behave more like a household in lean times and cut back when its revenues decline. That's all well and good, but I would feel constrained to remind them of the simple fact that there is an effect there. After all, when a household cuts back to bring its costs in line so that they can service their debt burden, their standard of living tends to decline. The family's does not become wealthier. When everyone does the same thing, the total level of spending in the economy declines. The same holds true for government. When it withdraws, there will be fewer services, fewer jobs, and fewer expenditures to businesses who provide services to the government. This will cause a decline in overall spending and employment. None of this should be earth-shattering. It was all laid out in the General Theory by John Maynard Keynes.
Indeed, government should not behave as households do, with the common household's tendency to leverage up rising incomes in the good times while slashing and burning when incomes decline in recessions. All that does is exacerbate to underlying economic cycle by strengthening the booms and deepening the busts. If, instead, the federal government tries to keep a basic underlying level of growing spending and employment (whatever is deemed politically desirable) that uses the ability to borrow to smooth out its consumption, the procyclical effects of following the typical household's pattern can be avoided.
This logically follows from another perspective, which is that most government services either do not really vary with economic conditions such as education, infrastructure repairs, and basic bureaucratic licensing and oversight functions, or they tend to become more strained in lean periods, such as with UI benefits, TANF, and Medicaid. The former group a basic baseline level of expenditures that really should remain fairly stable and not be whipped around. The latter group is vital and designed to avoid destitution due to the various spasms of the business cycle. To have either following the pattern of the business cycle is nonsensical.
Furthermore, the argument that a reduction in government expenditures and employment will benefit the private sector is highly dubious at this particular moment. If interest rates were phenomenally high due to fears of a debt default, this might make sense. The mechanism there would be that a firm deal to reduce deficits would soothe markets, reduce interest rates, and thereby increase the affordability of capital, which has numerous positive benefits. However, this condition is not currently present. That interest rates continue to be as low as they are is indicative of capital not finding many productive outlets for investment. As such, that avenue is not open to us.
Another argument would be that we could reduce taxes on the private sector if only we could get government expenditures down, which would be stimulative. Due to the magnitude of the present deficit, that is not really an option. It's also a questionable proposition that reducing taxes and government expenditures at the same time produces a net positive economic effect as most evidence appears to support the opposite conclusion, but I'll just do a little bit of hand-waving on that one for now.
Then, we turn to the argument that business confidence would be substantially improved if there was greater clarity on the long-term trend in the deficit, public expenditures, and tax rates. To be perfectly honest, there is probably just about nothing to this argument. Very few businesses cite the long-term finances of the federal government as a factor in their decision-making. "Uncertainty" can, of course, have an effect as it did to some extent in the fall of 2008 when the solvency of major financial institutions was in question. Speaking for myself, I know a pulled in a little bit when all of that was going on, though largely so that I would have more capital to deploy for the buying opportunities to come. Furthermore, the evidence that the bulk of consumers and businesses take into account their future expected tax burdens when making decisions in the present is extraordinarily weak. There might be some marginal players on the fringes of society who do, but as a mainstream proposition, I very much doubt it.
Much more likely, consumers have continued to hold back on house purchases due to persistently declining prices. I know I have made my decision not to buy a house on that very proposition, though the rate of decline has slowed enough I am starting to consider it. This persistent drag has caused consumer spending to remain very modest as well as stunting growth in spending on new houses, which in turn is depriving businesses of the revenue growth that they need to "feel confident". There are other contributors as well, such as corporations and even small businesses that had relied on a steady flow of credit who had brushes with death in late 2008 and early 2009 deleveraging their balance sheets and accumulating cash to provide more certainty in a financial crisis. Very little of this has a whole lot to do with the federal government's financial position. Furthermore, if there is a stifling effect of government spending just being there, it would stand to reason that our economic performance would be improving rather than deteriorating as state and local governments, which account for the vast bulk of government employment and direct expenditures, have retrenched.
So, what does all of that lead to? Well, the basic structure of any grand deal would hopefully take all of the empirical and theoretical argumentation against what we seem to be careening toward. Rapid reductions in federal government expenditures to quickly close the deficit would likely derail the economy, particularly when joined with substantial contractions in state and local government expenditures, which cannot be avoided due to balanced budget requirements in the states. Further, there is no avenue by which this would benefit private sector activity at the moment. As such, it might make sense to enter into a long-term package to bring expenditures in certain categories down and taxes up, but in the short run the focus should be on continued stimulus. The general agreement should be that the stimulus not be removed until such time as the economy is on a solid footing. At that point, hopefully, we can abandon any talk of adopting the common household's approach to budgeting and instead engage in true counter-cyclical fiscal policies.
If there is some moral necessity that commands us to reduce the deficit, then so be it. However, policymakers should not delude themselves into believing that we will somehow see an economic boom due to that satisfaction of some moral need to have balanced books. If they proceed under that belief, the economic outlook will become considerably dimmer.
Tuesday, July 5, 2011
July 2011 Asset Allocation Model Update
As has been the case for well over a year now, the asset allocation model that I built and have been tracking for quite some time indicates that a split of 80/20 stocks vs. bonds is still called for in these circumstances.
Though valuations on an absolute basis are not as attractive as they were at this time last year, the slope of the yield curve, combined with very low interest rates continue to provide a strong case for equities. If you look at the past year and a couple of months since we inaugurated it, I think it has been generally correct, though it has been limited to recommending an 80% equity asset allocation:
Since the beginning of the tracking period, the S&P 500 has outperformed long-term bonds by about 1500 basis points. There was a stretch in the summer of last year that I regretted that the model could only go to 80% stocks since the readings were off the charts recommending buying equities. Part of the reason the model has been stuck at 80% in stocks for so long is that it shot so far above the threshold that even though it has since come down somewhat, it is still over the line for 80% in stocks. I may refine the model somewhat to allow for rare cases where you should go "all in" because there are a number of times in the history of the financial markets where that is called for. Conversely, there are times where having just about no equities also makes sense. This, however, is not one of them.
The bottom line is that the comparative case for allocating your money to equities and away from fixed income instruments is very very strong right now.
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:
The bottom line is that the comparative case for allocating your money to equities and away from fixed income instruments is very very strong right now.
Thursday, June 16, 2011
At least they had the good sense to try to head it off
So, there's this story on Bloomberg about Asian real estate markets coming in due to policy tightenings. At least they don't wait for the overshoot to be too large before trying to correct it. We could learn a thing or two about it. Sadly, they will probably blame these policies for any resulting problems and not the runaway speculation. Sigh.
Monday, June 6, 2011
Another Spring Air Pocket?
The May employment report along with a series of other indicators have formed an unmistakable picture of an economy that has hit a growth wall... just as we did at about the same point last year.
Remember the first three months or so of last year? It seemed like the economy was finally firing on all cylinders, perhaps? Then, suddenly, the bottom fell out of growth.
The monthly manufacturing surveys have uniformly turned weak again with most of them barely registering growth at all. The Kansas City Fed, for instance, has gone from a reading of 27 in march to 1 in May. Production and new orders fell off drastically, particularly in the case of new orders, falling to a reading of -15. Basically, this means that 15 percent more firms saw declining orders compared to rising orders. The ISM composite index demonstrated a similar collapse, though it is still in positive territory over 50:
There are a couple of reasons that we may be seeing such a rapid slowdown in manufacturing. One, of course, is from the disruption of Japanese manufacturing in the wake of the devastating earthquake and subsequent tsunami that knocked out a good portion of their electrical power, crippling manufacturing production. Japan is so integral in many manufacturing supply chains as well as is a significant end market for goods itself that its severe dislocations are undoubtedly having a significant impact. We saw that in auto sales in May. The ripple effects through the auto supply chain have been severe. Electronic components have similarly been badly disrupted.
Of course, there is the oil shock, which has clearly dampened consumer demand. With short lead times, it doesn't take much time for a slowdown in consumer demand to be translated into a drop in orders and then production.
The good news is that neither of these factors need be permanent. The bad news is that neither are of the magnitude to be causing a virtual standstill in economic growth, at least not for a genuinely healthy economy. This leads us to another drag which is a decline in state and local government spending and employment. As the expenditures by governments and their employees are part of what I would term the "base load" of demand, their diminution is particularly devastating.
If I were a betting man, I would wager that the economy and, by extension, the stock market, will survive this spell just as they did last year. However, that is provided that Congress doesn't do the ultimate in stupidity and actually default or even come meaningfully close to doing so. One of the reasons that the U.S. has a AAA credit rating is not just because we have never defaulted, but also because our political leadership has never even contemplated it. Even a close call could be enough to send financial markets into quite the tizzy.
The monthly manufacturing surveys have uniformly turned weak again with most of them barely registering growth at all. The Kansas City Fed, for instance, has gone from a reading of 27 in march to 1 in May. Production and new orders fell off drastically, particularly in the case of new orders, falling to a reading of -15. Basically, this means that 15 percent more firms saw declining orders compared to rising orders. The ISM composite index demonstrated a similar collapse, though it is still in positive territory over 50:
Of course, there is the oil shock, which has clearly dampened consumer demand. With short lead times, it doesn't take much time for a slowdown in consumer demand to be translated into a drop in orders and then production.
The good news is that neither of these factors need be permanent. The bad news is that neither are of the magnitude to be causing a virtual standstill in economic growth, at least not for a genuinely healthy economy. This leads us to another drag which is a decline in state and local government spending and employment. As the expenditures by governments and their employees are part of what I would term the "base load" of demand, their diminution is particularly devastating.
If I were a betting man, I would wager that the economy and, by extension, the stock market, will survive this spell just as they did last year. However, that is provided that Congress doesn't do the ultimate in stupidity and actually default or even come meaningfully close to doing so. One of the reasons that the U.S. has a AAA credit rating is not just because we have never defaulted, but also because our political leadership has never even contemplated it. Even a close call could be enough to send financial markets into quite the tizzy.
Monday, May 30, 2011
Oil's Fair Market Value
This is a popular thread of conversation lately, and I've seen a few things that have piqued my interest in the subject of late.
One is this Marketwatch article that discusses the changing "break-even" price of oil in recent years. Basically, it's not so simple as just the mechanical break-even price of production, which is comparatively low in the OPEC countries almost uniformly (often sub $25 a barrel). It is a question of how much of a profit do they need to turn on their oil in order to satisfy growing political demands at home. According to the article, though this is difficult to verify, that price has increased from $30 a barrel to almost $85 since 2003.
I suspect a good portion of that might be quite recent as a consequence of the uprisings in the nations of the Arabian Peninsula and North Africa. Governments across the Middle East, especially Kuwait and Saudi Arabia, have opened up the fiscal spigots to quell the hot tempers of their simmering people, tired of corrupt and unresponsive governments that also do not reflect their religious values. To be sure, there is a split between more secular reformers and the religious fanatics in their motivations for reform, but the point remains that there is deep dissatisfaction and there should be, to be perfectly honest.
Atop this is the simple factor that supplies from Libya have been badly disrupted by the ongoing civil war there where one of the principal battlegrounds has been near one of the major oil distribution terminals. As oil's supply and demand curves are both highly inelastic in the short-term, that magnitude of disruption is difficult to discount. Similarly, oil traders have generally assigned a security premium of indeterminate value to the price of oil for fear of major disruptions.
The other major factor has been a recent/ongoing rout of the U.S. dollar versus virtually all currencies. However, this is a comparatively modest contributor and we can determine what that effect should be by simple arithmetic.
Working against oil is the fundamental fact that world stockpiles are sitting quite pretty at the moment.
One is this Marketwatch article that discusses the changing "break-even" price of oil in recent years. Basically, it's not so simple as just the mechanical break-even price of production, which is comparatively low in the OPEC countries almost uniformly (often sub $25 a barrel). It is a question of how much of a profit do they need to turn on their oil in order to satisfy growing political demands at home. According to the article, though this is difficult to verify, that price has increased from $30 a barrel to almost $85 since 2003.
I suspect a good portion of that might be quite recent as a consequence of the uprisings in the nations of the Arabian Peninsula and North Africa. Governments across the Middle East, especially Kuwait and Saudi Arabia, have opened up the fiscal spigots to quell the hot tempers of their simmering people, tired of corrupt and unresponsive governments that also do not reflect their religious values. To be sure, there is a split between more secular reformers and the religious fanatics in their motivations for reform, but the point remains that there is deep dissatisfaction and there should be, to be perfectly honest.
Atop this is the simple factor that supplies from Libya have been badly disrupted by the ongoing civil war there where one of the principal battlegrounds has been near one of the major oil distribution terminals. As oil's supply and demand curves are both highly inelastic in the short-term, that magnitude of disruption is difficult to discount. Similarly, oil traders have generally assigned a security premium of indeterminate value to the price of oil for fear of major disruptions.
The other major factor has been a recent/ongoing rout of the U.S. dollar versus virtually all currencies. However, this is a comparatively modest contributor and we can determine what that effect should be by simple arithmetic.
Working against oil is the fundamental fact that world stockpiles are sitting quite pretty at the moment.
U.S. stockpiles (Source: Energy Information Agency) are at very high levels indeed and the OECD as a whole is at the high-ish end of its range in terms of days of supply. Further, as consumption buckles and new production appears more attractive at current prices, the self-corrective mechanism of inventory builds is likely to take hold. However, I would caution against people who look at the current days of supply in oil and say, "Well, golly, why don't we have $30 a barrel oil again.". Things have changed since those old days and the world's oil supply has become fundamentally more difficult to get at and with it production costs have legitimately risen considerably. Cheap oil is simply no longer a possibility. What's more is that current markets are discounting the not too distant future in terms of both rising demand and more constricted supplies.
Still, there is plenty of evidence that there is some intangible valuation going on with oil. A few weeks back, the price broke by nearly $10 in a single day. Healthy markets simply don't do that. I would struggle to tell you what oil's fair market value actually is, but I suspect that it is presently overvalued by 10-15%. I would not stake my life on such a bet, nor would I make a play like I did with options on silver. That was a clear cut bubble that could not be justified. This, on the other hand, is considerably more cryptic.
Stay tuned.
Saturday, May 28, 2011
Do Economic Growth Incentives Pay For Themselves?
As someone who works in public finance, I often get asked outside of my job a number of questions similar to the title of this post. Recently, I negatively commented on tax incentives given out by the state of Kentucky to build a young-earth creationist theme park. I had two basic objections. One was that I thought it promoted an unscientific view of the world, which is ironic since the state spends so much money attempting to property educate its young people in the public school system in the ways of science. The other is another point, which is the primary focus of this discussion, centering on whether or not this use of tax incentives is appropriate from a public finance perspective. Advocates of these sorts of projects almost invariably say, "Oh, but it will pay for itself.". Republicans do the same thing with tax cuts more generally while Democrats do it with transportation infrastructure and education.
Since this is such a common phenomenon, let's actually work through the math and see if it works out. First, let's confront the basic constraint, which any project or tax break must contend with: the basic laws of mathematics. Taxes, particularly on the state and local level, only capture a small fraction of economic activity. Let's be generous at the federal level and say that the government current collects 20% of GDP in taxes. It doesn't, but let's just say that it does. This means that, in a single year, for every dollars you cut taxes or increase spending, it has to produce $5 in order to recoup its cost. At the state level, it's even worse than that. Because states typically collect in the mid-high single digit percentages of tax revenue as a percent of GDP, let's pick 7% for the sake of argument, it has to generate a whopping $14 of new economic activity for each dollar forgone in revenues or increased expenditures.
Now, you might say, "Aha! But what about the later years as well?". Fair enough. Let's work through that exercise, remembering that we have to discount future revenues. Click on the image below to see the entire table. I used a theoretical economy with the government collecting 20% of GDP in taxes and did a 1% reduction in tax rates, which could also some kind of long-term economic development incentive of equivalent magnitude. This tax rate reduction is maintained through-out the ten year period since, if it is taken away the year after it is implemented, the short term boost is lost and demand was just essentially brought forward.
Even assuming a 2.5x multiplier, which is quite generous, not only does the tax cut not pay for itself initially, it never, in any given year, does so. I solved the equation to see what multiplier is needed in this long-term example, and it is 5.26x. That is simply unheard of. Using the tax rates that a state has, this becomes even more intractable. Here I show the multiplier on the table for what is needed to finance a 0.5% tax cut.
A 15.4x multiplier is simply preposterous. I would challenge anybody to find an economic paper that claims to have found anything like that for any policy.
It's actually even worse than this in many respects when you consider the opportunity cost of what else you might have elected to use an equivalent amount of money for. Basically, what you find is that the marginal impact of this in your revenue projections compared to continuing to spend it on, say, public infrastructure is that you are even further behind. That's because if that 1% of tax revenue forgone was current being used to finance some ongoing expenditure, you can no longer finance that ongoing expenditure and thus lose the GDP associated with it. This simplified example basically was meant to demonstrate what would happen if you took a budget surplus of 1% of GDP and gave it out in an ongoing tax cut or long-term economic growth incentive of some sort that came out of current tax revenues. We could work out a similar exercise for a long-term spending increase, but I don't want to clutter up this post too much. The results are very nearly the same.
Now, some programs are more effective and more cleverly structured than others and can obtain significant leveraging of private sector dollars if done properly. There are instances where the dollars deployed have a particularly powerful marginal effect where they may possibly get a development over a certain threshold of financing it would otherwise not have crossed. In those circumstances, a small amount of government financing can achieve bizarre levels of leverage. It must be noted, though, that those cases are not as common as many claim.
As a general proposition, most tax cuts and economic development programs do not "pay for themselves", but that's not necessarily an argument that they shouldn't be done. There are plenty of reasons to undertake a project or policy beyond whether or not it actually pays for itself. However, the basic rule should be that one does not undertake a project or policy because policymakers think it pays for itself.
Since this is such a common phenomenon, let's actually work through the math and see if it works out. First, let's confront the basic constraint, which any project or tax break must contend with: the basic laws of mathematics. Taxes, particularly on the state and local level, only capture a small fraction of economic activity. Let's be generous at the federal level and say that the government current collects 20% of GDP in taxes. It doesn't, but let's just say that it does. This means that, in a single year, for every dollars you cut taxes or increase spending, it has to produce $5 in order to recoup its cost. At the state level, it's even worse than that. Because states typically collect in the mid-high single digit percentages of tax revenue as a percent of GDP, let's pick 7% for the sake of argument, it has to generate a whopping $14 of new economic activity for each dollar forgone in revenues or increased expenditures.
Now, you might say, "Aha! But what about the later years as well?". Fair enough. Let's work through that exercise, remembering that we have to discount future revenues. Click on the image below to see the entire table. I used a theoretical economy with the government collecting 20% of GDP in taxes and did a 1% reduction in tax rates, which could also some kind of long-term economic development incentive of equivalent magnitude. This tax rate reduction is maintained through-out the ten year period since, if it is taken away the year after it is implemented, the short term boost is lost and demand was just essentially brought forward.
Even assuming a 2.5x multiplier, which is quite generous, not only does the tax cut not pay for itself initially, it never, in any given year, does so. I solved the equation to see what multiplier is needed in this long-term example, and it is 5.26x. That is simply unheard of. Using the tax rates that a state has, this becomes even more intractable. Here I show the multiplier on the table for what is needed to finance a 0.5% tax cut.
A 15.4x multiplier is simply preposterous. I would challenge anybody to find an economic paper that claims to have found anything like that for any policy.
It's actually even worse than this in many respects when you consider the opportunity cost of what else you might have elected to use an equivalent amount of money for. Basically, what you find is that the marginal impact of this in your revenue projections compared to continuing to spend it on, say, public infrastructure is that you are even further behind. That's because if that 1% of tax revenue forgone was current being used to finance some ongoing expenditure, you can no longer finance that ongoing expenditure and thus lose the GDP associated with it. This simplified example basically was meant to demonstrate what would happen if you took a budget surplus of 1% of GDP and gave it out in an ongoing tax cut or long-term economic growth incentive of some sort that came out of current tax revenues. We could work out a similar exercise for a long-term spending increase, but I don't want to clutter up this post too much. The results are very nearly the same.
Now, some programs are more effective and more cleverly structured than others and can obtain significant leveraging of private sector dollars if done properly. There are instances where the dollars deployed have a particularly powerful marginal effect where they may possibly get a development over a certain threshold of financing it would otherwise not have crossed. In those circumstances, a small amount of government financing can achieve bizarre levels of leverage. It must be noted, though, that those cases are not as common as many claim.
As a general proposition, most tax cuts and economic development programs do not "pay for themselves", but that's not necessarily an argument that they shouldn't be done. There are plenty of reasons to undertake a project or policy beyond whether or not it actually pays for itself. However, the basic rule should be that one does not undertake a project or policy because policymakers think it pays for itself.
Saturday, May 7, 2011
Did the Recent Silver Bubble Conform to Our Understanding of Bubbles?
Yes. Yes it did.
Let's think back to this old post of the evolution of a bubble.
Now, it's normal for volume to spike on one-off events like a big earnings report. For volume to increase massively, independently of major events in the context of a large rise is actually not normal. Case in point, Apple (AAPL):
Let's think back to this old post of the evolution of a bubble.
As always, click on the image for a larger picture. Essentially, silver conformed to the basic tenant of a bubble that, because of rapidly rising expectations of future prices, suppliers of silver became unwilling to release supply on their old supply schedule. For instance, if I held 100 ounces of silver while it was trading at $15 an ounce, I may have been willing to put twenty of those ounces on the market once the price reached $20 in a more regular time. However, when I see prices go hyperbolic, I reassess the situation and hold on with a "wait and see" approach. My supply schedule shifts in. We saw this in the early stages of the silver rally where suppliers and buyers seemed to be having their expectations change more or less in tandem. What was the tell tale sign of this? Volume did not accelerate all that drastically until the last few weeks. Now, this can be the signs of something other than a bubble and I will discuss that in a minute.
Most of Apple's rally since early 2009 has happened in the context of remarkably stable volume. There hasn't been a huge surge in the number of shares traded during most of the advance. Clearly, this would provide evidence that the suppliers of Apple shares (i.e. current owners) have shifted in their supply schedules as prices have advanced. However, one key trait about Apple's advance is that it typically stalls until rejuvenated by a good earnings report. In other words, the advance is sustained by commensurate news regarding the fundamental improvements in the company's future earnings potential. To underline this point, Apple only trades at about 12x next year's earnings. If anything, one could argue that investors are discounting the possibility that the current trend in earnings might not be sustained.
To return to silver for a moment, there was no particular rationale for sustaining its rate of increase aside from the fact that it was increasing awfully quickly so one would want to buy in. Clearly, an increasing number of investors didn't buy into this idea and liquidated their positions right into the most hyperbolic portion of the increase. Volume surged in the last couple weeks of the rally, far eclipsing the daily average volume of the past several months. What was astonishing, and this is what tipped me off, was that there were enough speculative buyers to sustain the rally in the face of substantial liquidation. Clearly, speculators had become unhinged. The options markets reflected this at the end the last week of April where long-dated put options for SLV in the low 40s were trading at substantial premiums while long-dated call options above $50 were not. In other words, the options traders expected things to get ugly for silver by the end of the year. I decided, based on the frenzy, that silver was going to burst extremely quickly and decided to trade the June $42 puts. I have now liquidated two out of the three positions at large gains.
Now, let's try to piece this all together into a comprehensive picture of a bubble. You may remember from an earlier post back nearly a year ago that I laid out three criteria for spotting a bubble:
1. Is the asset or asset class in question fundamentally more attractive than other alternatives?
2. Is there either little information available or is the information corrupted in some way?
3. Are market actors incorporating available information or are they doing so in a rational way?
2. Is there either little information available or is the information corrupted in some way?
3. Are market actors incorporating available information or are they doing so in a rational way?
Silver began rallying for a real fundamental reason which is that the dollar is nearly constantly depreciating and high rates of money supply growth imply a central bank willing to devalue the currency for some time. This is usually a conventional reason to trade in precious metals as a hedge against inflation. However, the increase in silver far exceeded this fundamental reason as one will note that the dollar declined maybe around 10% depending on the measure you use in the time silver increased more than 150%. Still, there was a reason why the asset class of precious metals, broadly speaking, and silver in particular would be attractive.
On the second point, people have no idea how precious metals should be valued and economists have rarely ever been able to construct a reasonable model for how precious metals can be priced. Their industrial uses are never enough to justify their prices and their sentimental or emotional values to people are impossible to value. Further, there are a lot of people who corrupt what information is available with articles like "Silver going to $200 an ounce?"
On the third point, the answer was clearly no. The increase in volume wasn't based on any event, but on a short term frenzy where people were beating each other over the head with higher and higher bids to get into a crowded market.
Take this into account with the fact that, like in all bubbles, silver followed the tradition of the trashiest asset in an asset class performing the best. Precious metals are generally in a bubble and silver is the trashiest among them and it performed the best. In fact, platinum performed the worst.
The silver bubble conformed to every basic tenant of what we understand about bubbles and the fact that several people, myself included, were able to call it should not be surprising. By the way, applying th criteria laid out here and in prior posts, you can clearly define Apple as not being in a bubble and the same applies to the overall market advance over the past two years. A large advance (50%+) does not necessarily indicate a bubble, but it does warrant examining the conditions surrounding it.
Monday, May 2, 2011
Going Short On Silver?
In the interests of full disclosure, I opened up a June put option position on SLV that already yielded a whopping 63% return just since this morning. Of course, that can disappear in an afternoon as this is the options market after all. I fully expect the silver bulls to make another run at it, but frankly this thing is overdue for a major correction. It is hard to justify the run it's had.
That being said, I didn't exactly go in full throttle because bubble markets can produce huge surges that can come out of nowhere and obliterate the short side of the trade. However, I'm reasonably convinced that this thing is coming to an end and soon. The fact that volume and price went up together exponentially in the last few weeks was indication enough for me.
Of course, if I'm wrong, I'm out about $500. Easy come, easy go. I in no way recommend one action one way or the other on this, and do not recommend playing options unless you have money to blow.
On this particular point, I would emphasize the disclaimer on this blog that I am not an investment professional and nothing posted on this blog should be construed as investment advice.
That being said, I didn't exactly go in full throttle because bubble markets can produce huge surges that can come out of nowhere and obliterate the short side of the trade. However, I'm reasonably convinced that this thing is coming to an end and soon. The fact that volume and price went up together exponentially in the last few weeks was indication enough for me.
Of course, if I'm wrong, I'm out about $500. Easy come, easy go. I in no way recommend one action one way or the other on this, and do not recommend playing options unless you have money to blow.
On this particular point, I would emphasize the disclaimer on this blog that I am not an investment professional and nothing posted on this blog should be construed as investment advice.
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