Idea Credit: Philosophical Economics Blog

Idea Credit: Philosophical Economics, but I estimated and designed the graphs

There are many alternative models for attempting to estimate how undervalued or overvalued the stock market is.  Among them are:

  • Price/Book
  • P/Retained Earnings
  • Q-ratio (Market Capitalization of the entire market / replacement cost)
  • Market Capitalization of the entire market / GDP
  • Shiller’s CAPE10 (and all modified versions)

Typically these explain 60-70% of the variation in stock returns.  Today I can tell you there is a better model, which is not mine, I found it at the blog Philosophical Economics.  The basic idea of the model is this: look at the proportion of US wealth held by private investors in stocks using the Fed’s Z.1 report. The higher the proportion, the lower future returns will be.

There are two aspects of the intuition here, as I see it: the simple one is that when ordinary people are scared and have run from stocks, future returns tend to be higher (buy panic).  When ordinary people are buying stocks with both hands, it is time to sell stocks to them, or even do IPOs to feed them catchy new overpriced stocks (sell greed).

The second intuitive way to view it is that it is analogous to Modiglani and Miller’s capital structure theory, where assets return the same regardless of how they are financed with equity and debt.  When equity is a small component as a percentage of market value, equities will return better than when it is a big component.

What it Means Now

Now, if you look at the graph at the top of my blog, which was estimated back in mid-March off of year-end data, you can notice a few things:

  • The formula explains more than 90% of the variation in return over a ten-year period.
  • Back in March of 2009, it estimated returns of 16%/year over the next ten years.
  • Back in March of 1999, it estimated returns of -2%/year over the next ten years.
  • At present, it forecasts returns of 6%/year, bouncing back from an estimate of around 4.7% one year ago.

I have two more graphs to show on this.  The first one below is showing the curve as I tried to fit it to the level of the S&P 500.  You will note that it fits better at the end.  The reason for that it is not a total return index and so the difference going backward in time are the accumulated dividends.  That said, I can make the statement that the S&P 500 should be near 3000 at the end of 2025, give or take several hundred points.  You might say, “Wait, the graph looks higher than that.”  You’re right, but I had to take out the anticipated dividends.

The next graph shows the fit using a homemade total return index.  Note the close fit.

Implications

If total returns from stocks are only likely to be 6.1%/year (w/ dividends @ 2.2%) for the next 10 years, what does that do to:

  • Pension funding / Retirement
  • Variable annuities
  • Convertible bonds
  • Employee Stock Options
  • Anything that relies on the returns from stocks?

Defined benefit pension funds are expecting a lot higher returns out of stocks than 6%.  Expect funding gaps to widen further unless contributions increase.  Defined contributions face the same problem, at the time that the tail end of the Baby Boom needs returns.  (Sorry, they *don’t* come when you need them.)

Variable annuities and high-load mutual funds take a big bite out of scant future returns — people will be disappointed with the returns.  With convertible bonds, many will not go “into the money.”  They will remain bonds, and not stock substitutes.  Many employee stock options and stock ownership plan will deliver meager value unless the company is hot stuff.

The entire capital structure is consistent with low-ish corporate bond yields, and low-ish volatility.  It’s a low-yielding environment for capital almost everywhere.  This is partially due to the machinations of the world’s central banks, which have tried to stimulate the economy by lowering rates, rather than letting recessions clear away low-yielding projects that are unworthy of the capital that they employ.

Reset Your Expectations and Save More

If you want more at retirement, you will have to set more aside.  You could take a chance, and wait to see if the market will sell off, but valuations today are near the 70th percentile.  That’s high, but not nosebleed high.  If this measure got to levels 3%/year returns, I would hedge my positions, but that would imply the S&P 500 at around 2500.  As for now, I continue my ordinary investing posture.  If you want, you can do the same.

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PS — for those that like to hear about little things going on around the Aleph Blog, I would point you to this fine website that has started to publish some of my articles in Chinese.  This article is particularly amusing to me with my cartoon character illustrating points.  This is the English article that was translated.  Fun!

Photo Credit: Robert Tuck || Of course, in half a cycle here, the moon will look the same

Photo Credit: Robert Tuck || Of course, in half a cycle here, the moon will look the same

 

Financial markets are trendy and noisy in the short-run, sensible in the long-run, and perverse in the intermediate-term.

What do I mean?

Something like this: short-run movements are news-driven, and driven by people trying to catch up with the latest data.  Many people imitate the behavior of others, and over the intermediate-term, some stock prices get out of whack.  Some subset of industries, factors, and/or companies gets out of alignment, and are mispriced.  In the long run, those pricing errors get corrected, but it takes years to get there.

Here’s an example. to make this tangible and understandable.  As a factor, value has been bad for eight years or so, and as evidence I quote Rob Arnott, from his article entitled, ‘How Can “Smart Beta” Go Horribly Wrong?

The value effect was first identified in the late 1970s, notably by Basu (1977), in the aftermath of the Nifty Fifty bubble, a period when value stocks were becoming increasingly expensive, priced at an ever-skinnier discount relative to growth stocks. More recently, for the past eight years, value investing has been a disaster with the Russell 1000 Value Index underperforming the S&P 500 by 1.6% a year, and the Fama–French value factor in large-cap stocks returning −4.8% annually over the same period. But, the value effect is far from dead! In fact, it’s in its cheapest decile in history.

And then later he says:

How many practitioners who rely on the value factor take the time to gauge whether the factor is expensive or cheap relative to historical norms? If they took the time to do so today, they would find value is currently cheaper than at any time other than the height of the Nifty Fifty (1972–73), the tech bubble (1998–2003), and the global financial crisis (2008–09).

The underlining is mine, to give emphasis. Now I would like to quote from a very old article of mine, The Fundamentals of Market Tops that was originally published at RealMoney.com back in 2004:

You’ll know a market top is probably coming when:

a) The shorts already have been killed. You don’t hear about them anymore. There is general embarrassment over investments in short-only funds.

b) Long-only managers are getting butchered for conservatism. In early 2000, we saw many eminent value investors give up around the same time. Julian Robertson, George Vanderheiden, Robert Sanborn, Gary Brinson and Stanley Druckenmiller all stepped down shortly before the market top.

Point (b) is what I want to highlight… not that we have had many value managers forced into retirement recently, but value funds of all kinds have been losing clients. It’s like being fired fractionally, a sliver at a time, but it adds up to a lot.

Combine that with Arnott’s insight that the valuations of value stocks are at exceptionally low levels – this gives me some hope that we are in the seventh inning or later in this market cycle regarding value investing.

Going Back a Step

Value isn’t the only cheap area presently — European stocks and emerging market stocks look cheap as well.  When areas of the market with bad relative performance have a lot of people giving up on them to pursue recently successful strategies, that helps to put in the bottom on the underperformers, and the top on the outperformers.

You can’t tell exactly when the process will end, but those jumping from one strategy to another, chasing performance, will just add a new set of losses to the old ones.  The trick is to try to anticipate when the cycle will turn for a given market strategy, factor or industry.  No one can do it perfectly, but it makes sense to act when relative valuations are in your favor.

Minimally, those that stick with a valid strategy through thick and thin can benefit from the strategy over the long-term… and that takes some courage, because there are times when your strategy will be out of favor.  That’s what I do with value investing.

Maximally, you would sell a strategy that you were invested in that was topping out in relative terms to buy a strategy that has been trashed for a while, and might be ready to outperform.  That’s even more difficult than sticking with one strategy through thick and thin.  Everyone wants to buy a past winner, and nobody wants to buy a past loser. but that is what would offer large returns if the timing could be right.  Another way of phrasing it, is to always look half a cycle ahead, to where a strategy will be when the excesses correct, or as is more likely, overcorrect, and take the appropriate action now.

Doing that is beyond me.  I’m just grateful that the period of relative underperformance of value may be nearing its end.

Photo Credit: Falcon® Photography

Photo Credit: Falcon® Photography  || In this story, TSB stands for “The Storage Bank”

This piece is another one of my experiments, please bear with me.

“Measure Twice, Cut Once” — A very intelligent woman (I suspect) whose name never got recorded the first time it was uttered

“Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.” — Warren Buffett

Imagine for a moment:

  • The public secondary markets didn’t exist
  • Investment pooling vehicles were all private, and no one published NAV estimates
  • Stocks and bonds existed, but they were only formally offered through the companies themselves, and all private secondary trading was subject to a right of first refusal on the part of the issuing corporation.  This includes short-term debts like commercial paper.
  • Banks and life insurance companies still offer products to retail savers/investors, but nonforfeiture laws didn’t exist, and CD penalty clauses were very ugly.  In other words, because of no public secondary markets, the price of liquidity was very high, with a strong incentive to hold financial instruments to their maturity date.
  • Accounting rules are only partially standardized.
  • Deposit insurance still exists.
  • So does limited liability.

In this thankfully fictitious world, what would investing be like?

The main factor would be that liquidity would be dear.  Because the “out” doors for liquidity are thin or closed for a long time, money would go into any investment only after great study.  The 4 Cs of credit would be present with a vengeance — character, capacity, capital and conditions — and character would be chief among them as J. P. Morgan famously said.

This would be true even if one were investing in the stock of a firm, rather than the debt.  Investing in such a world, even with limited liability, is tantamount to an economic marriage back in a time where divorce was mostly for cause, and not easy to get.

You’d have to be very certain of what you were doing.  Perhaps you would diversify, but one would quickly realize how difficult it can be to keep up with a bunch of private firms — we take for granted how information flows today, but with private firms, you are subject to the board and management.  What do they choose to share with outside passive minority investors?

Excursus: It is said that it is easy to teach a child to say “please,” because it is the equivalent of “gimme.”  It is harder to teach them “thank you,” until they realize that it means, “I’d like an option on the next deal.”

Why would private firms choose to be open with outside private minority investors?  They want a continuing flow of capital, and with no secondary markets, that can be difficult.  Granted, there are always hucksters that say with P. T. Barnum, who is alleged to have said, “There’s a sucker born every minute.”  Those characters exist regardless of market structure, but in a healthy culture, they are a small minority in the markets.

The same would apply to the debt markets.  The fourth C, Conditions, would also impact matters.  If you can’t get out easily/cheaply, then you will limit the term of the borrowing at which you are willing to lend, unless there are features allowing for participation in the upside, such as stock conversion rights.

You might also find that insolvency becomes a very personal matter, as prior capital providers who know the business better than others, are invited to “prepackaged reorganizations” when the business is illiquid or insolvent.  The bankruptcy code might still exist, but gaining enough data on a firm in trouble would probably prove difficult. The board and management, unless legally compelled, might not find it in their interests to be open.  Control is a valuable option, one that is only surrendered when the situation is virtually hopeless.

That said, a man very good at estimating character and business value could make some amazing profits, because “in the land of the blind, a one-eyed man is king.”  And, the opposite would be true for many, as they get taken advantage of by less scrupulous management teams.

Back to the Present

“…[R]isk control is best done on the front end.  On the back end, solutions are expensive, if they are available at all.”  — Me, in this article, and a bunch of others.

The purpose of what I just wrote is to get you to think about an illiquid world as a limiting concept.  All of the problems of our world are there, usually in a form that is less severe than we experience because of the benefit of liquid secondary markets and vehicles for diversification.

If valuable for no other reason, market panics make liquidity disappear, and it is useful to think about what you will do in an absence of liquidity before the time of trouble happens.  The same is true of corporations needing liquidity.  Buffett said something to the effect of, “Get financing before you need it; it may not be available later.”

It’s also useful to consider more carefully the financial commitments that you make, so that you don’t make so many blunders.  (True for me, too.)  The ability to trade out of investments is useful but limited, because we don’t always recognize when we are wrong, and mechanical trading rules can lead us to the “death by one thousand cuts.”

Beyond that, realize that character does matter.  A lot.  The government tries as hard as it can, but it is far better at punishing fraud after the fact than it is catching fraud before the fact.  It will always be that way because the law is tilted in favor of the one in control; it has to be, or property rights are meaningless.  But consider those that try to warn about financial disasters — they do not get listened to until it is too late.  Madoff, Enron, housing bubble, various short sellers alleging improprieties, etc., etc.  Very few listen to them, because seeming success talks far louder than an outsider.

My counsel is the same as always, just look at the risk control quote above.  But to make it stark, ask yourself this, a la Buffett, “Would you still buy this if you couldn’t sell it for ten years?”  Then measure twice, thrice, ten times if needed, and cut once.

Photo Credit: thecrazysquirrel

Photo Credit: thecrazysquirrel

Before I start tonight, I just wanted to mention that I was on South Korean radio a few days ago, on the main English-speaking station, talking about Helicopter Money.  If you want listen to it or download it as a podcast, you can get it here.  It’s a little less than 11 minutes long.

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The bravery of Steve Kandarian and the executives at MetLife is a testimony to something I have grown to believe.  Frequently the government acts without a significant legal basis, and bullies companies into compliance.  If a company is willing to spend the resources, often the government will lose, when the laws are unduly vague or even wrongheaded.

This was true also in a number of the allegations made by Eliot Spitzer.  Lots of parties gave in because the press was negative, but those that fought him generally won.  Another tough-minded man, Maurice Raymond “Hank” Greenberg pushed back and won.  So did some others that were unfairly charged.

MetLife won its case against the Financial Stability Oversight Council [FSOC] in US District Court.  The government will likely appeal the case, but though I have been a bit of a lone voice here, I continue to believe that MetLife will prevail.  Here’s my quick summary as to why:

  • The FSOC’s case largely relies on the false idea that being big is enough to be a systemic risk.
  • Systemic risk is a mix of liquidity of liabilities, illiquidity of assets, credit risk, leverage, contagion, and lack of diversity of profit sources.
  • Liquidity of liabilities is the most important factor — in order to get a “run on the bank” there has to be a call on cash.  Life insurers have long liability structures, and it is very difficult for there to be a run.  People would have to forfeit a lot of value to run.
  • Contrast that with banks that use repo markets, and have short liability structures (w/deposit insurance, which is a help).  Add in margining at the investment banks…
  • The only life insurers that suffered “runs” in the last 30 years wrote lots of short-term GICs.  No one does that anymore.
  • Life insurers invest a lot of their money in relatively liquid corporates, and lesser amounts in illiquid mortgages.  Banks are the reverse.
  • Leverage at life insurers is typically lower than that of banks.
  • Insurers make money off of non-financial factors like mortality & morbidity.  Banks run a monoculture of purely financial risk.  (Okay, increasingly many of them make money off of “free” checking, and then kill their sloppy depositors who overdraw their accounts… as I said to one of my kids, “Hey, your best friend “XXX bank” sent you a love note thanking you for the generous gift you gave them.”)
  • That makes contagion risk larger for banks than life insurers — banks often have more investments across the financial sector than insurers do.
  • Life insurers tend to be simpler institutions than banks.  There is less too-clever-for-your-own-good risk.
  • State regulators are less co-opted than Federal regulators.  They also employ actuaries to analyze actuaries.  (At least the better and larger states do.)
  • Finally, life insurers do more strenuous tests of solvency and risk.  They test solvency for decades, not years.  They have actuaries who are bound by an ethics code — the quants at the banks have no such codes, and no responsibility to the regulators.  The actuaries with regulatory responsibility serve two masters, and though I had my doubts when the appointed actuary statutes came into being, it has worked well.  The problems of the early ’90s did not recur.  The insurance industry generally eschewed non-senior RMBS, CMBS and ABS in the mid-2000s, while the banks loved the yieldy illiquid beasties, and lost as a result.

Anyway, that’s my summary case.  I haven’t always been a fan of the industry that I was raised in, but the life insurers learned from their past errors, and as a result, made it through the financial crisis very well, unlike the banks.

PS — there are some things I worry about at life insurers, like LTC and secondary guarantees, but I doubt the FSOC could figure out how big those are as an issue.  A few companies are affected, and I’m not invested in them.  Also, those risks aren’t systemic.

Full disclosure: long ENH NWLI BRK/B GTS RGA AIZ KCLI and MET

Photo Credit: Liz West

Photo Credit: Liz West

A friend I haven’t heard from in many years since he left the USA wrote me. He closed the letter in an unusual way, saying:

PS — USA has gone completely bonkers these days? or what the heck is going on over there? would love to pick your mind over a glass of wine. someday!

I’m not intending on writing on politics as a regular habit at Aleph Blog, and most of what I am going to say is economics-related, so please bear with me.  Hopefully this will get it out of my system.

To my friend,

There are a lot of frustrated people in the US.  Though you’ve been gone a long time, you used to know me pretty well; after all, I trained you on economic matters.

Let me give a list of reasons why I think people are frustrated, then explain how that affects their political calculations, and finally explain why they have mostly misdiagnosed the issues, and won’t get what they want regardless of who is elected.

The electorate is frustrated because:

  • Living standards have declined for the lower 80% of society.
  • Many people lost jobs, homes, pensions, etc., during the recent financial crisis… those assets are not coming back anytime soon.  Much of the fault was theirs, but they don’t recognize that, preferring to blame others for their problems.
  • Many formerly attractive jobs are disappearing either due to technological change or offshoring (whether corporations or subsidiaries).
  • The economy muddles along, and economic policies that average people don’t understand dominate discussion.  Many wonder if anyone is seriously trying to improve matters.  They generally distrust the Fed.
  • It doesn’t seem to matter who gets elected, Democrat or Republican — the status quo remains because business interests support the Purple Party, which is the consensus of establishment Republicans and Democrats who duopolize politics in the USA.
  • Nothing good seems to happen in DC, and what few significant pieces of legislation have occurred in the Obama years have turned out to be bad (Obamacare) or useless (Dodd-Frank to the average person who doesn’t get it).
  • Immigration issues get short shrift, also trade issues.
  • Moral issues have basically disappeared from the political agenda in any classical form.  Everything is pragmatic, geared to serve the Purple Party.
  • In general, the candidates are pretty lousy, and the moral tone of the campaign has been poor.  That said, negative campaigning works, and the candidates that focus on being negative are doing better.

Now take a moment and think about what people do when they are desperate.  In short, they take longer-shot chances than they would ordinarily take.  They think:

“This person couldn’t be that much worse than what we have going now, and he sounds a lot different than the politicians that I have been hearing for so many years, ad nauseam.  He talks about issues that affect my situation, and is not willing to mince words.  He could be a LOT better than the status quo, which stinks.  

So, the downside is limited, and the upside could be significant.  I don’t care about the rough edges of this guy; the media always blows things out of proportion anyway, and helps foster the consensus candidates that never solve anything.  So, I’m just going to hold my nose and vote for (fill in the blank).”

In my opinion, that’s why politics is nuts over here right now.  Given the relative inability of the electorate to digest complex explanations, there are a lot of matters that they can’t understand, and as a result, regardless of who they elect, they won’t be happy.

Most of the economic and political problems stem from:

  • Technological change
  • Increasing returns to those that are smart versus those that are not
  • Not enough productive children being born
  • Attempts to improve the economy that don’t work
  • Gerrymandering
  • A diminishing consensus on what is right and wrong, and the proper role of government

The technological change is the most important factor, and explains why attempts to limit immigration or limit free trade won’t help.  As a result of the internet, businesses can set up in many areas and benefit from the different aspects of each area — labor here, capital there, taxes way over there.  Unless governments are willing to work together to limit this, and they compete, they don’t cooperate here, this can’t be solved.

Information technology can make lower skilled workers far more productive, leading to a diminution of jobs in many sectors.  This can happen anywhere — in banks, investment shops, factories, and restaurants.  It works anyplace where you can turn 80%+ of a job into a set of rules.  That can move jobs away from where they currently are to places where inexpensive labor can do the work.

In the short-run, this is a problem for many.  In the long run, it will release labor to more valuable pursuits.  That said, many older people will not be capable of retraining, and younger people will gain the opportunities if they are smart.  the “know nots” are becoming “have nots.”

Part of this is payback for not studying enough in school, and/or studying topics that would eventually valuable in college.  As I have said before, “Follow your bliss” is selfish and dumb.  Real value comes, and society improves, from facilitating the bliss of others.  The more people you make happy, the greater the rewards are.

Now, demographics are getting worse for most developing economies.  Most economies do better when the fertility rate is over 2.1 — i.e., that population is growing.  Typically that means that opportunities are growing.  When working populations shrink, social benefit plans begin to collapse, and when populations shrink, countries lose vitality and creativity.  We need youth to replenish its ranks to keep our societies healthy.

Note that efforts to fix fertility by offering tax incentives do not work.  Once women are convinced it is not valuable to have kids, no reasonable amount of effort will change that.

As for economic policy, we are still running policy off of a model that assumes that debts are not high on order for policy to work.  That is why continued deficit spending and abnormal monetary policy (QE & Zero or Negative Interest Rates) aren’t helping.  Helicopter money has its own issues.

Regardless of what happens to the presidency, Congress will remain the same because of gerrymandering.  There’s only so much that even a good President can do if Congress is occupied by ideologues from both sides of the political spectrum.

Finally, the sides of the political spectrum are further apart because there is less consensus on what is right and wrong, and the proper role of government.  In some ways the internet facilitates this because you can filter out the arguments of those who disagree with you more easily.  I set up my news sources so that I am always reading liberals and conservatives, as well as those that don’t fit well on the political map, but few others do.

And that, my friend, is why the political scene is nuts in the US now.  There are a lot of disappointed and desperate people who are willing to try anything to get their prosperity back, even though none of the politicians can do anything that will genuinely help the situation.

It is a recipe for disaster, and absent an act of God, I don’t see anything that will change the attitudes rapidly.  People across the political spectrum are happily believing their own myths; it will take a lot of pain to puncture them all.

PS — I’ve given up alcohol.  We’ll have to figure something else out if we get together.

Photo Credit: Gerard Van der Leun || Personally, I would not have wanted my name on that law

Photo Credit: Gerard Van der Leun || Personally, I would not have wanted my name on that law

 

This should be short.  If you want more, you can read my old piece, “Who Dares Oppose a Boom?

Laws are only as good as those that enforce them.  There was no lack of power in the hands of regulators prior to the financial crisis.  There was a lack of willingness to use the power given, because regulators were discouraged by those above them from using the powers that they could use.  That included both political appointees to high-level positions in the bureaucracy and Congressmen.

The real risk today is not that the laws are inadequate.  Dodd-Frank has its flaws, and I didn’t like handing so many things over to committees, but with respect to banks, it is better than what we had previously.  The risk is that regulators will once again not use the powers that they have, and be lax in enforcement.

I’ve argued before that state regulation of insurance is far superior to federal banking regulation.  There are several reasons for this:

  • Small-mindedness is good in regulation.  Protect the downside, let the regulated suffer.
  • Actuaries have an ethics code.  Their equivalent inside banks do not.  Regulators do not.  (Chartered Financial Analysts also have an ethics code, as an aside…)
  • It’s harder to corrupt 50 states than one federal regulator, particularly if you can choose that federal regulator.

Now, the next big problem may not be in the finance sector… I tend to think that we will see a major developed nation go through a crisis of its finances as the next crisis.  But if there is a significant financial crisis, it will be because the regulators did not do their jobs, whether under outside pressure or not.

Photo Credit: Shiny Things || Apologies, this was the best I could find at Flickr with a Creative Commons License

Photo Credit: Shiny Things || Apologies, this was the best I could find at Flickr with a Creative Commons License

Once I wrote a piece advocating helicopter money, and I called it 2300 Smackers.  For those who were not reading me back during the bailout, you should know that I vociferously opposed it, and wrote a lot to encourage everyone to oppose it.

The 2300 Smackers piece was meant to advocate giving the bailout to the American people, and not the banks.  The piece would have been better if I had advocated limiting the money to debt reduction, but anyway…

Now we are in a situation where helicopter money is once again being advocated — surprising to me, in this Wall Street Journal article, which probably should be an editorial, by Greg Ip, someone I usually respect.  This is what he advocates:

Helicopter money merges QE and fiscal policy while, in theory, getting around limitations on both. The government issues bonds to the central bank, which pays for them with newly created money. The government uses that money to invest, hire, send people checks or cut taxes, virtually guaranteeing that total spending will go up. Because the Fed, not the public, is buying the bonds, private investment isn’t crowded out.

Unlike with QE, the Fed promises never to sell the bonds or withdraw from circulation the money it created. It returns the interest earned on the bonds to the government. That means households won’t expect their taxes to go up to repay the bonds. It also means they should expect prices eventually to rise. As spending and prices rise, nominal GDP goes up, so the debt-to-GDP ratio can remain stable.

If this sounds too good to be true, it’s because usually it is. Throughout history, governments that couldn’t or wouldn’t collect enough taxes to finance their spending resorted to the printing press, from the U.S. Confederacy in the 1860s to Zimbabwe in the 1990s. It’s why so many central banks, including the ECB, are prohibited from financing government deficits.

But just because monetizing the debt can cause hyperinflation doesn’t mean it must. In ordinary times, the Fed is continuously monetizing debt to create enough currency to lubricate the wheels of commerce. Between 1997 and 2007, before QE began, its holdings of government debt rose by $355 billion, and currency in circulation rose by a similar amount. In effect, the government borrowed and spent $355 billion and never has to repay it.

In that instance, the Fed only created as much currency as the public wanted. What if it created more, to finance government spending? Even that isn’t necessarily catastrophic. In his book “Between Debt and the Devil,” which advocates helicopter money, the British economist Adair Turner cites Pennsylvania in the early 1700s, the U.S. Union government in the 1860s and Japan in the early 1930s as examples of governments that used monetary finance without triggering hyperinflation.

An even better example is World War II. The federal government had to borrow heavily to finance the war effort and the Fed helped by buying bonds to keep their yields from rising above 2.5%. Between 1940 and 1945, the Fed’s holdings of debt rose from $2.5 billion to $22 billion, an increase roughly equal to 9% of annual GDP. Though this only financed a fraction of the war, it was still debt monetization: most of those purchases proved to be permanent.

The war effort massively boosted nominal GDP. Initially, only part of that showed up as higher prices, thanks to wage and price controls. Most of it came through a stunning rise in real output, made possible by the economy’s depressed prewar state, a flood of women into the labor force and business innovation to meet the demands of war and the civilian economy. As wage and price controls ended, prices shot up 34% between 1945 and 1948. But then, inflation reverted to low single digits.

I would encourage Greg Ip, Adair Turner and anyone else who is interested to read the book Monetary Regimes and Inflation by Peter Bernholz.  Even if there have been some times where monetizing debt has not led to inflation, the odds are really low that that happens historically.  Why?

Well, when a government gets a new policy tool, they tend to use it until it stops working or blows something up.  Seeming success leads to more use (think of trying to trade lower employment for higher inflation in the ’60s), and lack of success leads policymakers their economist lackeys to try more because they say it will work when you do enough of it (think of QE, spit, spit).

It’s kind of like knowing that you have a difficult time with self-control issues, and wondering if you should try a drug offered to you at a party (even alcohol).  You shouldn’t want to take the risk.  Upside is low, downside could be very high, and probabilities are tilted the wrong way also.

Now to his credit, Greg Ip ends his piece like this:

Another obstacle is the institutional separation between monetary and fiscal policy. That separation exists for a good reason: Central banks were granted independence so that they would not become the printing press for feckless politicians. The Fed was uncomfortable doing the Treasury’s bidding during World War II and dates its de facto independence to the end of the arrangement in 1951. In 2013, Treasury was advised to sell the Fed a platinum coin to get around the statutory debt ceiling. Treasury dismissed the idea as a dangerous violation of Fed independence.

Tampering with this long-standing separation should not be done lightly. For the U.S., which is at close to full employment and in no imminent danger of deflation, the tradeoff hardly seems worthwhile. But there may be times, and countries, when it is. Monetary finance isn’t riskless, Mr. Turner says, but the alternatives may be worse: stagnation and deflation, or perpetually low interest rates that fuel dangerous bubbles: “The money finance option should not be excluded as taboo.”

No, money finance should be taboo.  Monetary history is replete with examples of where it ended very badly, and with few examples of success.

You know my opinion here.  It would be far better as a society to get the government out of the macroeconomic policy business, except to regulate banks tightly as they are the source of systemic risk, and let the economy endure booms and busts.  We won’t have perpetually low interest rates unless the government interferes, as they have done recently and during the Great Depression.  If anything, government policy has amplified our booms and busts, and makes the present situation worse.

That said, we are going to take some pain from the present economic difficulties, it is just a question of what pain we will get because of too much debt.  It could be inflation or more debt deflation.  There could be defaults on government debt or considerably higher taxes.  I can’t tell what the government will try to do, but whatever it will be, it will be painful.

Thus, diversify and prepare.  You could do worse than the permanent portfolio idea.  Consider it.

Picture Credit: Arturo de Albornoz || "Do unto others, as you would have others do unto you." -- Y'Shua Ha'Mushiach

Picture Credit: Arturo de Albornoz || “Do unto others, as you would have others do unto you.” — Y’shua Ha’Mushiach

This is an extension of a recent piece Decline Free Food.  Things have gotten worse with the mail situation at the Merkel house as I get older.  It’s not enough that AARP keeps sending us offers join.  (I keep a pile of AARP cards next to my work area to snip up if I am feeling blue. 😉 )  Now that I have turned 55, I am getting a flood of invitations from bloodsuckers financial services marketers asking me to come to their free information session.

The three recent ones were:

  • A conference asking “DO YOU HAVE THE COURAGE TO RETIRE RICH?”  The answer is real estate speculation.  Ah, if it were only that easy.  Yes, I know that a tiny amount of flipping has been profitable of late.  The only thing more profitable than flipping and speculating is getting others to pay for your advice and services so that they can go out and lose money speculating and flipping.  As I said to the guy pitching at a “Rich Dad” seminar, “If there’s that much money lying around in mispriced properties, why not go start a REIT and vacuum up all that money yourself?”  His answer, “What’s a REIT?”   I said, “If you don’t know that, you don’t know real estate.”
  • The pitch: “In a moment of decision the best thing you can do is the right thing.  The worst thing you can do is nothing. — Theodore Roosevelt”  A little more classy, but wrong.  Often the right thing to do is nothing, particularly if you don’t know the right answer… better to wait, study and learn.  Don’t be biased toward action, particularly in investing.  Only a salesman wants you biased toward action, and that is for his good, not yours.  In this case, the course offered doesn’t look so bad, and the price is cheap — but they don’t care about the cost of the course aside from the fact that it psychologically commits you to the course, and that you will more likely come, and be more likely to purchase further services from them.  The biggest thing you would learn from the course is that you don’t know much… so buy their services.
  • The next one advertises a dinner.  This one tries to scare you into coming — there’s a crisis around the corner. Boo!  But we can keep your retirement safe.  Inflation is coming.  Boo!  But we will get you an income that keeps up with inflation.  Then, to aid credibility, it mentions that their firm has been mentioned in a variety of local newspapers that no one pays for that cumulatively have less reach than this blog.

When I recently went and spoke to the Baltimore chapter of the American Association of Individual Investors, I told them, “I’m not going to market anything to you,” and I didn’t.  I response to a question, I did show them a page from my blog.  Yes, the one that lists all my worst mistakes.  And, I took a fairly extensive Q&A where if I didn’t know an answer, or there wasn’t a good answer, I said so.

My credibility is worth more to me than a little business.  Beyond that, I never want a client to think that I goaded him into working with me, or, that I went overboard to retain him if he wants to leave.  After all, I say to them, “It’s Their Money.”

As I often say:

“Don’t buy what someone else wants to sell you.  Buy what you have researched that you want to buy.”

I would say if someone sends you a slick ad on financial services, ignore them.  Always.  Do your own research.  The best firms don’t advertise, because they don’t have to.  Talk to intelligent friends, and see what they do.  Ask investment managers if they died and their firm went out of business, who would they want their spouse to use?

Don’t respond to retirement, investment management and financial planning ads.  Develop your own proposal, and put it out for bid.  Let multiple providers tell you what they will do for you.  Have smart friends help you review the submissions. Then choose the best one.

Keep the hucksters and charlatans at bay.  Ignore them.

Doing nothing never did more. 😉  Time for the quarterly examination of the composite views of the Federal Open Markets Committee, along with some choice comments on its chief partner-in-crime, the ECB.   Ready?  Let’s go!

GDP graph

Now, I promised a look inside the minds of the FOMC, and hypothetically, that what this will be.  To begin that, you have to recognize the four regularities of FOMC forecasts, as they might think about it:

  1. We overestimate GDP growth
  2. We underestimate labor unemployment
  3. We overestimate PCE inflation
  4. We overestimate the Fed funds rate

You might ask why they think that way, and if you administered the truth serum, they might say: “We believe the neoclassical view of macroeconomic theory.  We know that Fed policy will work, and so we act like we are in control, when we are something in-between being Sorcerer’s apprentices and clinically insane.  We keep doing the same thing and expect a different result.”

Okay, some of that last bit wasn’t fair, at least not fully.  There *are* some processes where until you do a critical amount of effort, the expected result doesn’t happen.  But textbook monetary policy isn’t supposed to be that way.

So, take a look at the above GDP predictions graph.  The “slope of hope” points downhill as the economy does not grow as quickly as they thought it would, given all of their efforts.

Unemp graph

The unemployment was similar, except here, they weren’t optimistic enough.  As it is, they expect unemployment to remain low for a long time, at about the levels that it is now.  Now, how likely is it for unemployment rates to remain stable for three years?  Not that likely.

PCE Inflation

You can almost hear them thinking, “Inflation will come back to 2%.  After all we’ve been so loose for so long.  There’s no way it should remain so low when we are creating credit left, right, up, down, forwards and backwards.”  But then, it doesn’t come — it always stays low.  Their long run view stays stubbornly at 2%, unlike other views where they let it drift, and that’s because 2% inflation is the religion of the Fed!  It is the Holy Received Goal, that proper monetary policy will create.

But sometimes they wonder, when it’s dark at night and quiet, “What would it take to create inflation?  What?”

FF graph

Finally, they all know that the Fed funds rate will rise.  It can’t stay low forever, can it?

Behind it all is the nagging worry: “Why doesn’t economic activity pick up?!  We’re doing everything we can short of doing a helicopter drop of money!  That has to be enough!  We don’t want to go to buying investment grade corporates or negative interest rates like that basket-case, the ECB, at least not yet.  C’mon grow! Grow!”

Note that for each quarter the FOMC has given its projections recently, they have thrown a quarter-percent tightening out the window.  That’s how overly optimistic they are in setting estimates of future policy.

Leave aside the fact that various risk assets in fixed income land are now flying.  High-yield isn’t doing badly, but emerging markets debt is taking off — note $EMB which has recently broken its 200-day moving average.

Conclusion

Bad theories beget bad policy tools, which in tern begets bad results.  The FOMC needs an overhaul of its theories, so that it stops creating speculative bubbles, and learns to be happy with an economy that just muddles along.  And who knows?  Give savers a fair rate of return, and maybe the economy will grow faster.

January 2016March 2016Comments
Information received since the Federal Open Market Committee met in December suggests that labor market conditions improved further even as economic growth slowed late last year.Information received since the Federal Open Market Committee met in January suggests that economic activity has been expanding at a moderate pace despite the global economic and financial developments of recent months.FOMC more optimistic than the data would support.
Household spending and business fixed investment have been increasing at moderate rates in recent months, and the housing sector has improved further; however, net exports have been soft and inventory investment slowed.Household spending has been increasing at a moderate rate, and the housing sector has improved further; however, business fixed investment and net exports have been soft.Shades down business fixed investment.
A range of recent labor market indicators, including strong job gains, points to some additional decline in underutilization of labor resources.A range of recent indicators, including strong job gains, points to additional strengthening of the labor market.Shades labor employment up.
Inflation has continued to run below the Committee’s 2 percent longer-run objective, partly reflecting declines in energy prices and in prices of non-energy imports.Inflation picked up in recent months; however, it continued to run below the Committee’s 2 percent longer-run objective, partly reflecting declines in energy prices and in prices of non-energy imports.No change.
Market-based measures of inflation compensation declined further; survey-based measures of longer-term inflation expectations are little changed, on balance, in recent months.Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed, on balance, in recent months.No change.  TIPS are showing higher inflation expectations since the last meeting. 5y forward 5y inflation implied from TIPS is near 1.65%, up 0.12% from January.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.No change. Any time they mention the “statutory mandate,” it is to excuse bad policy.
The Committee currently expects that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace and labor market indicators will continue to strengthen.The Committee currently expects that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace and labor market indicators will continue to strengthen.No change.
 However, global economic and financial developments continue to pose risks.New sentence.  They want wiggle room.
Inflation is expected to remain low in the near term, in part because of the further declines in energy prices, but to rise to 2 percent over the medium term as the transitory effects of declines in energy and import prices dissipate and the labor market strengthens further.Inflation is expected to remain low in the near term, in part because of earlier declines in energy prices, but to rise to 2 percent over the medium term as the transitory effects of declines in energy and import prices dissipate and the labor market strengthens further.No change. CPI is at +1.0% now, yoy.

Shades inflation down in the short run due to energy prices.

The Committee is closely monitoring global economic and financial developments and is assessing their implications for the labor market and inflation, and for the balance of risks to the outlook.The Committee continues to monitor inflation developments closely.No real change, they talked about the global stuff above.
Given the economic outlook, the Committee decided to maintain the target range for the federal funds rate at 1/4 to 1/2 percent.Against this backdrop, the Committee decided to maintain the target range for the federal funds rate at 1/4 to 1/2 percent.No change.
The stance of monetary policy remains accommodative, thereby supporting further improvement in labor market conditions and a return to 2 percent inflation.The stance of monetary policy remains accommodative, thereby supporting further improvement in labor market conditions and a return to 2 percent inflation.No change.  They don’t get that policy direction, not position, is what makes policy accommodative or restrictive.
In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation.In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation.No change.
This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.No change.  Gives the FOMC flexibility in decision-making, because they really don’t know what matters, and whether they can truly do anything with monetary policy.
In light of the current shortfall of inflation from 2 percent, the Committee will carefully monitor actual and expected progress toward its inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.In light of the current shortfall of inflation from 2 percent, the Committee will carefully monitor actual and expected progress toward its inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.No change.  Says that they will go slowly, and react to new data.  Big surprises, those.
The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction, and it anticipates doing so until normalization of the level of the federal funds rate is well under way. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction, and it anticipates doing so until normalization of the level of the federal funds rate is well under way. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.Says it will keep reinvesting maturing proceeds of agency debt and MBS, which blunts any tightening.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; James Bullard; Stanley Fischer; Esther L. George; Loretta J. Mester; Jerome H. Powell; Eric Rosengren; and Daniel K. Tarullo.Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; James Bullard; Stanley Fischer; Loretta J. Mester; Jerome H. Powell; Eric Rosengren; and Daniel K. Tarullo.Not quite unanimous.
 Voting against the action was Esther L. George, who preferred at this meeting to raise the target range for the federal funds rate to 1/2 to 3/4 percent.At last a dissent – maybe the cost of capital can reach normal levels

Comments

  • Policy continues to stall, as the economy muddles along.
  • But policy should be tighter. Savers deserve returns, and that would be good for the economy.
  • The changes for the FOMC’s view is that GDP, inflation, and labor indicators are stronger, and business fixed investment weaker.
  • Equities rise and bonds rise. Commodity prices rise and the dollar falls.
  • The FOMC says that any future change to policy is contingent on almost everything.
  • The key variables on Fed Policy are capacity utilization, labor market indicators, inflation trends, and inflation expectations. As a result, the FOMC ain’t moving rates up much, absent much higher inflation, or a US Dollar crisis.