Wednesday, April 30, 2008

What Now?

Are we near an inflection point in markets? I have heard numerous talking heads on CNBC recently saying that markets are near a turning point. The mantra goes something like this: the dollar is near a bottom, therefore commodities are topping out and stocks will move higher. While all this may come true, I think there are reasons to be skeptical.

The dollar has rallied from the lows against the Euro as well as gold, but the trend is still intact.

The idea behind the dollar has bottomed meme is that the Fed is done with interest rate cuts and the ECB may have to start cutting rates. While I don't disagree with the Fed pause, I have serious doubts about the ECB cutting. Here's Axel Weber, ECB Governing Council member on April 26 in an interview with a German newspaper:

"I am concerned that, with regard to the conduct of wage and fiscal policy, the recent temporary heightened inflation rate could be consolidated for longer than is necessary above the tolerance level of the Eurosystem," Weber said.

"Should indications of this increase, we must react with interest rate policy," he added in an interview with Germany's Welt am Sonntag. "We are therefore observing the current wage agreements and finance policy decisions very closely."

And here's Christian Noyer, another Governing Council member (via Bloomberg)

``Our big problem is to make sure that inflation falls back below 2 percent next year,'' the Bank of France governor said in an interview on RTL radio. ``We'll do what it takes for that,'' he said, adding, ``If needed, we'll move rates.''

I could go on, but you get the picture. One may be tempted to think that these two are the ECB equivalent of Richard Fisher and Charles Plosser who both dissented on today's rate cut by the Fed, but remember, the ECB hasn't cut rates during the credit crisis. They have preferred using their lender of last resort status to provide liquidity where it is needed. Oil probably wouldn't be almost $120/barrel if the Fed had followed the same policy. So the idea that the ECB is on the verge of cutting rates in Europe seems more hope than probability.

That doesn't, however, rule out the possibility that the dollar is due for a rally. Certainly, it's the Rodney Dangerfield of currencies; even supermodels don't want Uncle Sam's money. The sentiment against the dollar is pretty extreme and any good contrarian has to consider the possibility that the bottom is in. But we need more evidence; until then, the trend is your friend.

Commodities may be in a topping process, but again we don't have enough evidence to make that call yet. My guess is that we are in for some kind of correction, but the bull market will remain intact:

Commodity prices are, in my opinion, inflated a bit, but the long term trend is for higher prices. As long as the Fed keeps real interest rates negative (Fed funds 2% with inflation at least 3.5%) I don't think we need to worry too much about commodity deflation. I have reduced our commodity positions somewhat recently (and I may reduce some more), but our positions had grown and were over our allocation target. Furthermore, if commodities do correct, I will be more inclined to buy than sell more.

The trend in the stock market hasn't changed yet either:

There are hopeful signs about the market, but reality is that the trend has not changed with the recent rally. The major indices are trading below their 200 day MA and until we get a close above that, the trend is still down. Again, understand that I'm not saying that the trend can't change or that it won't soon; we just don't have enough evidence yet to make that call.

I'm actually pretty optimitic about the market and the economy. Earnings have generally been pretty good outside the financial sector and the economic stats are not nearly as bad as they've gotten in prior recessions. Consumer sentiment is awful, but sentiment is not a good predictor of future economic activity.

Notice that consumer confidence fell during most of 2002 when we were most definitely not in a recession. Notice also that consumer confidence bottomed ahead of the stock market in 2003. Consumer confidence hit bottom in early 2003 but the market didn't make its bottom until October. That would argue that we are still some ways from re-establishing the bull market. That could mean a prolonged period of base building or it could mean testing the lows again. I don't know, but the conservative thing to do is not get too excited about stocks just yet. If you are a trader, you might consider taking some profits here (and I'm sure there are a lot people thinking that way so a correction seems natural here), but long term investors should probably ride out any short term price corrections.

So, while everyone else seems to think, or hope, that we are about to reverse some long standing trends, I can't make that leap just yet. Things could change quickly and if they do, I'll make changes but for now, I see no reason to believe that things have changed that dramatically just because the Fed has tired of cutting rates.

Recession? Bettors Don't Think So

Prediction markets have proven very accurate at predicting future events such as election outcomes. These markets tend to be more accurate than polls because real money is at risk. Telling CNBC that you think we're in recession carries no risk except reputationally and even that is minimal. If economists got fired for getting predictions wrong, every economist employed on Wall Street would have to change jobs. Anyway, the Intrade contract on recession is falling:

Actually, the chart doesn't appear to show the action from today. The contract is currently 33-35. These contracts are pretty volatile and this could be pointing to recession next week, but at least for now, the betting crowd says no recession in 2008.

Fed Speak

The FOMC cut interest rates by another 1/4 point today. Here is the statement released after the meeting with my interpretation of its real meaning:

The Federal Open Market Committee decided today to lower its target for the federal funds rate 25 basis points to 2 percent.

We really didn't have any good reason but the market was expecting it and we so hate to disappoint Wall Street.

Recent information indicates that economic activity remains weak. Household and business spending has been subdued and labor markets have softened further. Financial markets remain under considerable stress, and tight credit conditions and the deepening housing contraction are likely to weigh on economic growth over the next few quarters.

0.6% GDP growth will not get us reappointed to our cushy jobs at the Fed. We need households and businesses to spend money but they aren't cooperating for some reason. That is probably due to the fact that the only people who can get a loan right now are people who don't need one. Housing will bottom someday - we hope.

Although readings on core inflation have improved somewhat, energy and other commodity prices have increased, and some indicators of inflation expectations have risen in recent months. The Committee expects inflation to moderate in coming quarters, reflecting a projected leveling-out of energy and other commodity prices and an easing of pressures on resource utilization. Still, uncertainty about the inflation outlook remains high. It will be necessary to continue to monitor inflation developments carefully.

Core inflation isn't bad but apparently regular people have to drive and eat. Who knew? We think inflation might moderate someday, but damn if we know when since we don't know what's causing it. We actually have no clue when inflation will come down but we're hoping and praying really hard.

The substantial easing of monetary policy to date, combined with ongoing measures to foster market liquidity, should help to promote moderate growth over time and to mitigate risks to economic activity. The Committee will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability.

We've cut rates and we're printing dollars like lotto tickets. We sure hope this works because we don't have any other ideas.

Still Waiting.....

1st Quarter GDP grew 0.6%. Not a great number under any circumstances but still not a negative number. I have been consistent in my belief that the US economy will avoid recession - for now. The problems in the economy are primarily financial problems. These problems are obviously having an effect on the economy but I still believe they won't be severe enough to cause a recession. At least so far, that has been correct.

The doom and gloom crowd will find plenty in this report to keep them in the gloomy camp. The biggest positive contributors were exports and inventory investment. Negative contributors included residential fixed investment (down 26.7%), non residential strucutures (down 6.2%) and a drop in personal consumption of durables. Real Final Sales were down 0.2%. Imports rose which is a negative for GDP.

Those who are negative will concentrate on the inventory build but I would point out that inventories were liquidated in the 4th quarter and subtracted more from GDP than the build added in the 1st quarter. The drop in residential fixed investment shouldn't surprise anyone but the drop in non residential structures will look ominous to anyone waiting for the commercial real estate shoe to drop. Lastly, the rise in imports subtracts from GDP but the last time we came close to a trade balance was in the 1990 recession. Our mercantilist friends in Congress may think imports are bad, but that has no economic basis.

I would not be surprised if this GDP number gets revised downward. The official inflation numbers fell from the 4th quarter rate, something that seems dubious at best. Nevertheless, to date we don't even have one quarter of negative growth, much less the new depression that some have talked about. With the rebate checks going out soon, I suspect next quarter will be somewhat better. I don't expect a big jump though as most of the rebates will be used to pay down debt or saved. But some of the rebates will be spent and that should keep us afloat for now. We'll have to wait and see what happens after that.

ADP Employment Report

US employment in the private sector rose by 10,000 in April, according to the ADP employment report released Wednesday. The number was way above estimations, as analysts were expecting an 80,000 decline in both private and public sector payrolls. Subtracting the usual 20,000 in new government jobs, private sector employment was expected to be closer to a negative 100,000. To see a gain of 10,000 is tremendous.

According to the report, the service sector produced all of the jobs in April, adding 64,000 jobs. Employment in the goods-producing sector fell by 54,000, and manufacturing jobs declined by 26,000.

See Full Report.

Tuesday, April 29, 2008

Conference Board Consumer Confidence

The consumer confidence index fell to 62.3 in the month of April, down from an upwardly revised 65.9 in March. The index is at its lowest levels since March 2003. The number is above estimations though, as economists were expecting an April reading of 61. Lynn Franco, director of consumer research at the private Conference Board, adds:

This continued weakening suggests that not only has the feeble level of growth in the first quarter spilled over into the second quarter, but that economic conditions may have slowed even further.

Inflation expectations came in at a 3-year high, at its highest level since Hurricane Katrina. Consumers expect prices to rise 6.8% in the next 12 months. In March, consumers' inflation expectations were 6.1%.

See Full Report.

Friday, April 25, 2008

Putting a Face on Free Trade

Democrats who oppose the free trade agreement with Columbia (I would say "politician" but I can't find a Republican who opposes the deal) claim their opposition is due to human rights abuses in Columbia, specifically murders of labor officials. Nicholas Kristof points out in this NYT Op-Ed that the real human rights abuse is in rejecting the deal:

Some Democrats claim that they are against the pact because Colombia has abused human rights. Those concerns are legitimate — but they shouldn’t be used to punish people like Norma Reynosa, a 35-year-old woman who just may snip the flowers that go into the Mother’s Day bouquet that you buy.

Free trade is about the rights of individuals not organizations. There are real people in Columbia, like Ms. Reynosa, who are affected when politicians grandstand on free trade. Yes, there are real people affected (negatively and positively) in the US as well, but why should lines on a map decide who is more worthy of our compassion?

Where Our Money Goes

Arnold Kling has a post at EconLog that shows how our tax dollars are being spent:

Figures in parentheses are from FY 2000, when we ran a $200 billion surplus. I am estimating as best I can from these tables

Defense: $515 billion ($294)
Homeland Security: $38 billion ($0; was in Domestic Necessary)
Domestic Necessary: $713 billion
Domestic Worthy Causes*: $305 billion ($217)
Social Security: $644 billion ($409)
Medicare: $408 billion ($197)
Medicaid and SCHIP: $224 billion ($136)
Interest: $260 billion ($223)
Total: $3107 ($1789)

(*Domestic worthy causes = Agriculture, Commerce, Education, Energy, Health and Human Services, Housing and Urban Development, Interior, Labor, Transportation, NSF)

And how the money is raised:

Personal income taxes: $1259 billion ($1004.5)
Corporate income taxes: $339 billion ($207.3)
Social Insurance receipts: $949 billion ($652.9)
Other taxes: $153 billion ($161)
Deficit: $400 billion (surplus $236 billion)

Several things deserve comment.
1. Domestic Necessary (which Kling explains as courts, justice, Treasury and the "mysterious" other mandatory spending) seems ridiculously high.

2. Domestic Worthy (Agriculture, Commerce, Education, Energy, Health and Human Services, Housing and Urban development, Interior, Labor, Transportation, NSF(?)) is not worthy. You could eliminate at least 7 of those categories and no one would even notice.

3. While I detest deficits, interest costs have risen the least on this list.

4. The Medicare drug add on has SS and Medicare already running at a deficit. Everybody talks about how in the future these programs will be too costly; the future is apparently today.

5. Spending on Medicaid and SCHIP has climbed almost as much as Defense (65% rise for this versus 75% rise for Defense). It would appear that we are well on the way to a system where government pays the tab for healthcare. I wonder why we aren't getting better results? Hmmmm, maybe government involvement in healthcare is the problem.

6. Corporate taxes have boomed (up 65%).

7. There is no way we can raise taxes enough to eliminate the budget deficit.

8. Kling says that taxes will have to rise to balance the budget, but I would dispute that. Raising growth could get us there without tax hikes if we control/reduce spending.

My question is this: Are we really getting our money's worth with this massive spending? If we eliminated the Departments of Energy, Agriculture, Education, Labor, Commerce and Transportation, would anyone complain except the industries who have captured these agencies for their own benefit? Would anyone really notice that the Department of Commerce was missing? Does anyone here know who heads any of these Departments? If they were kidnapped tomorrow would anyone reading this blog be willing to contribute to the ransom payment?

The cost of complying with the tax code is somewhere in the neighborhood of $300 billion. Estimates are all over the map, but that is an estimate taken from the Tax Foundation and other sources and includes corporate and individual compliance. What would it do for growth if we quit wasting that money? How much faster would the economy grow if we eliminated all the market distortions caused by the tax code(which has grown to somewhere between 17,000 and 60,000 pages depending on who you ask and how you count)? Can't we do better than this?

Protect Us From Bacon Dogs!

Drew Carey has a new video at Reason TV on the efforts of the LA County Health Department to protect us from Bacon Dogs. Apparently it is critical that LA remove these hazardous items from the streets of LA.

Amid the hustle and bustle of downtown Los Angeles, there exists another world, an underground world of illicit trade in-not drugs or sex-but bacon-wrapped hot dogs. Street vendors may sell you an illegal bacon dog, but hardly anyone will talk about it, for fear of being hassled, shut down or worse. Our camera caught it on tape. One minute bacon dogs are sold in plain view, the next minute cops have confiscated carts, and ordered the dogs dumped into the trash.

Here's the Video

Thursday, April 24, 2008

Recession? Not Yet....

Kelly Evans has in interesting post at the WSJ economics blog about the potential for recession:

We know by now that the old rule of thumb for recession – two consecutive quarters of negative growth in gross domestic product (GDP) – is out the window. Still, at least there were two quarters of contracting GDP during the last recession in 2001. This time around, we just can’t seem to get a negative print — at least, not yet.

Conventional wisdom right now holds that when the National Bureau of Economic Research – the outfit tasked with declaring recessions – finally determines when the current recession began, they’ll choose December or January. (The NBER does not define a recession in terms of two consecutive quarters of decline in real GDP. Rather, a recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.)

And yet when the government prints its estimate of first-quarter GDP next Wednesday, it’s highly unlikely the number will be negative. Today’s economic data further reinforces that scenario. Jobless claims, which typically hover above 400,000 per week during recessions, dropped by more than thirty thousand last week to a seasonally-adjusted level of 342,000, the Labor Department said. Even the smoother four-week average fell to 370,000.

Meanwhile durable goods, a key gauge of the manufacturing sector’s health, dropped by 0.3% in March from the previous month, the Commerce Department said - but much of the weakness was in the auto sector. Excluding transportation, orders were up 1.5% during the month. And the component of the report that feeds into GDP – known as core shipments – rose by a strong 1.2%.

That, combined with strong inventory growth, prompted Lehman Bros. economists to raise their estimate of first-quarter GDP by nearly half a percentage point to 0.7%. Macroeconomic Advisers, a GDP-tracking firm, raised their estimate of first-quarter growth by two-tenths to 0.4%.

I've said all along that the housing mess will not cause a recession. Monetary policy is powerful medecine. Taken in excess over a long period of time it causes other illnesses such as inflation but in the short term, it works.

Tax Freedom Day

Yesterday was Tax Freedom day in the US. All the money Americans earn from January 1 to April 23 goes to pay taxes. Here's a music video from the Tax Foundation celebrating Tax Freedom Day (via the Adam Smith Blog):

Tax Freedom Day Video

And here's one from Lichtenstein that is a lot funnier:


Initial Jobless Claims

First-time claims on unemployment benefits fell sharply for the week ending April 19, according to the Department of Labor. Initial claims fell 33,000 to 342,000,a 2-month low. Economists had been expecting a gain of 3,000 to 375,000.

The four week moving average, a less volatile measure of initial claims, fell by 7,250 to stand at 369,500.

See Full Report.

New Home Sales

New home sales plunged by 8.5% in the month of March, falling to a seasonally adjusted annual rate of 526,000. In February, the annualized rate was downwardly revised to 575,000 units, from 590,000. The index is at a 17-year low, and it is down 36.6% in the last year. The report gives little hope that the housing market is near a bottom.

Prices fell sharply as the supply of homes on the market continued to rise, the Commerce Department reported. The median price of a new home fell 13.3% in the past year, to $227,600, the largest decline in 38 years. Inventories fell for the 12th consecutive month, but due to a slower sales pace, the supply of homes on the market rose to 11 months. It's at its highest level in the last 27 years.

See Full Report.

Wednesday, April 23, 2008

Grassley: Let Them Eat Rice!

I ripped Democrat Sherrod Brown this morning on free trade, so in the interests of bipartisanship, this post will rip Sen. Charles Grassley (R, Ethanol). From the Des Moines Register :

Washington, D.C. - Maybe the Chinese should eat rice instead of corn-fed beef and pork, Sen. Charles Grassley said.

The Iowa Republican said Tuesday that if it's right to blame rising food prices on the use of corn for ethanol, then it's OK to also question the growth of meat consumption in China, which increases the use of grain for livestock feed.

"If part of our problem is that the Chinese are going to eat meat and you've got to have corn and soybeans to feed the Chinese their meat, then why isn't it just as legitimate for the Chinese to go back and eat rice as it is for us to change our policy on corn to ethanol?" Grassley asked in a conference call with reporters.

Is it any wonder we're not well liked around the world? What a tool....

Grassley said he wasn't recommending that China and other countries reduce their meat consumption. "I'm saying it's legitimate for me to raise that as a question, just as it's legitimate for them to raise the question of us of corn to ethanol," he said.

Yeah, because you know it's just as important for Charles Grassley to get re-elected to the Senate as it is for the Chinese to upgrade their diet. Ethanol is bad for the environment, distorts the commodity markets and takes food from hungry people. But Grassley doesn't care about any of that; he just wants to bring home the bacon.

Global Cooling?

I've seen other articles about the potential for global cooling (rather than warming) due to a lack of sun spot activity, but this is the scariest yet:

THE scariest photo I have seen on the internet is, where you will find a real-time image of the sun from the Solar and Heliospheric Observatory, located in deep space at the equilibrium point between solar and terrestrial gravity.

What is scary about the picture is that there is only one tiny sunspot.

Disconcerting as it may be to true believers in global warming, the average temperature on Earth has remained steady or slowly declined during the past decade, despite the continued increase in the atmospheric concentration of carbon dioxide, and now the global temperature is falling precipitously.

All four agencies that track Earth's temperature (the Hadley Climate Research Unit in Britain, the NASA Goddard Institute for Space Studies in New York, the Christy group at the University of Alabama, and Remote Sensing Systems Inc in California) report that it cooled by about 0.7C in 2007. This is the fastest temperature change in the instrumental record and it puts us back where we were in 1930. If the temperature does not soon recover, we will have to conclude that global warming is over.

Global warming is something , even if it occurs on the scale that Al Gore thinks, to which we can adapt. Global cooling and especially a new ice age are much tougher to deal with. And according to this article (written by Phil Chapman, geophysicist and astronautical engineer; in other word, a lot smarter about this stuff than me) a new ice age is inevitable:

The bleak truth is that, under normal conditions, most of North America and Europe are buried under about 1.5km of ice. This bitterly frigid climate is interrupted occasionally by brief warm interglacials, typically lasting less than 10,000 years.

The interglacial we have enjoyed throughout recorded human history, called the Holocene, began 11,000 years ago, so the ice is overdue. We also know that glaciation can occur quickly: the required decline in global temperature is about 12C and it can happen in 20 years.

The next descent into an ice age is inevitable but may not happen for another 1000 years. On the other hand, it must be noted that the cooling in 2007 was even faster than in typical glacial transitions. If it continued for 20 years, the temperature would be 14C cooler in 2027.

By then, most of the advanced nations would have ceased to exist, vanishing under the ice, and the rest of the world would be faced with a catastrophe beyond imagining.

This is interesting but so far no more likely than the much talked about alternative. The difference is that global warming can be dealt with through adaptation. A new ice age would be catastrophic. Maybe we should be spending some of that global warming money studying this just in case Al Gore knows less about science than this guy.

Sherrod Brown is a Protectionist

Sherrod Brown, Democratic Senator from Ohio, has an op-ed in the WSJ today titled, "Don't Call Me Protectionist". Sorry, Mr. Brown but you are a protectionist and I mean that in the most derogatory fashion. Mr. Brown says:

Our country deserves a real debate on trade, not a debate where labeling one side protectionist is game, set and match.

Well, I'm sorry Mr. Brown, but if the shoe fits....

The supporters of our trade policy rarely mention our exploding trade deficits. In just 15 years, our annual trade deficit has mushroomed to over $800 billion from $38 billion in 1993. With Mexico, our trade surplus evolved into a $90.7 billion trade deficit. With China, our trade deficit jumped to $250 billion today from about $22 billion. President George H.W. Bush once estimated that a $1 billion trade deficit represents 13,000 lost jobs. Do the math.

We rarely mention trade deficits because they are a meaningless statistic. Trade deficits are the flip side of positive investment in the US. There is no evidence whatsoever that a trade deficit is a net job loser (see this paper by Russell Roberts of George Mason University). When China earns a dollar by selling us something they have to do something with that dollar. They can choose to buy US goods or services or they can invest in the US. They won't just stuff that dollar in a mattress somewhere, but even if they did it wouldn't hurt the US. The only unfortunate part of this equation is that too many of those dollars right now are being invested in US Treasury Bills, Notes and Bonds to fund a government spending beyond our means. And that is a direct result of people like - Sherrod Brown.

Advocates of free trade rarely want to debate the fact that unregulated trade with China has recently allowed toys with lead paint, contaminated toothpaste and poisonous pet food into this country. We take for granted our clean air, pure food and safe drinking water. But these blessings are not by chance: They result from laws and rules about wages, health and the environment. Trade agreements with no rules to protect our health, the environment and labor rights inevitably create a race to the bottom and weaken health and safety rules for our trading partners and for our own communities.

Chinese companies that manufacture contaminated products will find that they have difficulty selling more of those products until they fix the problem. No action by Sherrod Brown is necessary. As for "protecting our health, the environment and labor rights" it would seem that those are problems for workers in those countries to resolve. It certainly isn't the job of the US Congress. Trade will allow other countries to reach a level of wealth, like in the US, that allows them to address those issues. Richer countries have more healthcare, higher wages and cleaner environments than poor countries. How will they reach that goal if we cut off trade?

Mr. Brown finally makes some good points at the end of his rant:

Let's focus on the merits of the agreement (the Columbia Agreement). Supporters sell it as a free-trade agreement, a great opportunity for American companies because it eliminates tariffs on our products. If that were true, the agreement would be a few lines long.

Instead, we have a trade agreement that runs nearly 1,000 pages and is chock full of giveaways and protections for drug companies, oil companies, and financial services companies, and incentives to outsource jobs now held by Americans.

Nafta. The Central American Free Trade Agreement. China. Now Colombia. We have a pattern in our trade policy that aims to protect special interests, but betray our workers, our environment, our communities.

Mr. Brown is absolutely right about all of these regional or single country "free trade" agreements. They are full of exceptions and protections for specific industries. But the solution to that problem is to adopt unilateral, real free trade even if our trading partners do not. Then lobbyist wouldn't be able to pay off Senators to write special rules for a favored industry. And unions wouldn't be able to pay off the likes of Mr. Brown to lobby against specific agreements. We could reduce corruption and help the economy all at the same time. I bet Mr. Brown wouldn't like that.

Tuesday, April 22, 2008

Feed the World? Free the Market!

Sean Corrigan points out that the solutions being offered to food shortages will only make the problems worse:

Instead, the policies actually being pursued can only enhance scarcity, while the inability to finance such mechanisms of self-defeat honestly can only lead to a further descent into inflation — an age-old curse poised to undermine prosperity further and to seed the commonwealth with the kind of venomous discontent which is the wellspring of an even more self-destructive politics of fear, anger and hatred.

Feed the world? — Then free the market!

From agricultural subsidies to corn ethanol, government got us in this mess and the answer is not more government intervention.

Academic Imprimatur for Our Investment Strategy

Our investment strategy is based on the idea that including non correlated assets in a portfolio can raise returns while reducing volatility. The difference between our portfolios and traditional portfolios is that we use assets whose returns have low or negative correlation to stocks. Traditional portfolios pay lip service to this concept by including bonds and token allocations to REITs and Commodities. Our portfolios include much larger allocations to REITs and Commodities due to their ability to deliver non correlated returns. Tim at The Mess That Greenspan Made has a post that highlights recent academic research which vindicates our view:

There's a new study out by Professor Craig Israelsen at BYU that provides more good news about commodities as an asset class.

As a number of other reports have also done in recent years, it dismisses the notion that commodities should be viewed as some sort of a "No Go Zone" for individual investors. Instead, in this report, commodities are shown to provide good diversification for typical investment portfolios while boosting overall returns.

Professor Israelson's study can be found here and an interview can be found here.

Here's the key part of the study that supports our strategy: (HAI): What did your study on correlations show?

Craig Israelsen (Israelsen): Basically that diversification really works. That's a real stunner, isn't it?

HAI: Shocking. But seriously, how did it work?

Israelsen: I built equal-weighted portfolios out of up to seven different asset classes: large-cap U.S. equities, small-cap U.S. equities, non-U.S. equities, U.S. intermediate-term bonds, cash, REITs and commodities.

For commodities, I used the S&P GSCI commodities index going back to 1970. I'd note that before 2001 or 2000, the GSCI was not investable, so I'm making the assumption that there could have been an actual portfolio tracking that index back in 1970.

In my original analysis, I started with an equally weighted two-asset class portfolio composed of large-cap and small-cap U.S. stocks, and I looked at the returns. Then I started adding more asset classes: non-U.S. stocks, bonds, cash, REITs and commodities. I found that as you added the additional asset classes, you improved the returns and limited the worst one-year drawdown of the total portfolio. But importantly, it was not a linear relationship.

HAI: How so?

Israelsen: There's a major change when you get to commodities and REITs.

With the five-asset portfolio - large-cap U.S. stocks, small-cap U.S. stocks, non-U.S. stocks, bonds and cash - which is about what the typical target date portfolio held three years ago, you get a 10% internal rate of return while sustaining retirement withdrawals. The worst one-year drawdown since 1970 is 17%.

When you add REITs and commodities, the internal rate of return rises to 11.3%, which is nice. But the worst one-year drawdown falls to 10%. That's a 40% reduction!

Most people wouldn't immediately notice a 1.3% increase in the annual return. But they would notice a 40% reduction in the worst one-year drawdown. You can feel that.

HAI: Why does that happen?

Israelsen: Commodities and real estate have fairly low correlations to the core assets of large-cap U.S. stocks, small-cap U.S stocks and developed markets international equities.

When people buy foreign stocks, they think they are diversified. But the three main equity asset classes have correlations of 0.7 to 0.9. You don't get a lot of correlation benefit from adding more equities to an equity portfolio.

Cash is a good diversifier, and so are bonds. But they don't have a very attractive long-term return. The real benefit comes when you add REITs and commodities. They have equity-like returns, but low correlations ... and in one important way, they have lower risk than equities.

We don't equal weight the asset classes in our portfolis so our results are somewhat different that what is mentioned here - our returns are higher and our one year drawdown is smaller - but the basic concept is the same as what we have been using for some time. I developed the models we use way back in 2001 when I was working at Oppenheimer. It is nice to finally see specific academic research that verfies what we have experienced in the real world.

The Manufacturing Myth

Both Democratic canidates for President have talked on the campaign trail about the decline of manufacturing in the US. They imply that the US doesn't manufacture anything anymore and blame the loss of manufacturing jobs on free trade with low wage countries such as China. The problem with that argument is that it simply isn't true. The US was shedding manufacturing jobs long before NAFTA or any other trade deal signed in the last 30 years. Daniel Griswold at Cato explains to Hillary that the US manufactures lots of things - we just do it with fewer workers:

One huge problem with her statement is that manufacturing output in the United States has continued to EXPAND in recent decades. According to the Federal Reserve Board, America’s factories produced 30 percent more in real output in 2007 than a decade earlier and three times more than in the 1960s.

And just what sort of things do Americans make? According to the U.S. Commerce Department, in 2006 U.S. factories produced:

• 4,522 complete civil aircraft and 12,299 complete civil aircraft engines.
• 87 million metric tons of raw steel and 113 million tons of shipped steel products.
• 11,260,300 cars and light trucks.
• 26,925,715 million computers (digital, analog, hybrid, and other).
• 11,966,177 household refrigerators and refrigerator-freezers.
• 9,993,990 washing machines.
• 7,654,882 water heaters (electric and non-electric).
• 7,402,333 dishwashing machines.
• 6,004,765 household gas and electric ranges.
• 1,399,938 clothes dryers.
• 1.93 billion square yards of carpet and rugs.
• 11.4 million short tons of chlorine gas, 8.9 million tons of sodium hydroxide, 4.7 million tons of hydrochloric acid, and another 2.6 million tons of commercial aluminum sulfate, sodium sulfate, finished sodium bicarbonate, and sodium chlorate.
• 1,537.7 million gallons of paints and allied products at $13.60 a gallon.
• $127 billion worth of pharmaceutical preparations (except biologicals).

The real beef of the Democratic candidates and their union allies is that all that stuff was made with fewer unionized workers than in years passed. We can make more and better things with fewer workers because of soaring productivity.

Please remind me what’s so bad about that.

If this were 1900, Hillary and Obama would be moaning about the loss of farming jobs.

Existing Home Sales

The US housing market continued its downward slide into March, as resales of homes and condos fell 2% for the month. Sales fell from a seasonally adjusted annualized rate of 5.03 million in February to 4.93 million in March. The number was in-line with economists expectations. Resales of US homes have fallen 19.3% in the past year.

Sales of single-family homes fell 2.7% in March and are down 18.4% in the past year. Condo sales rose 3.6%, but are down 25.5% in the past year.

Regionally, resales fell 6.5% in the Midwest and 3.5% in the South. Sales rose 2.2% in the Northeast and West.

Inventories of unsold homes increased for the month, gaining 1% to 4.06 million units for sale. That represents a 9.9 month supply.

See Full Report.

Monday, April 21, 2008

Oil Bubble?

Jerry Taylor at Cato lays out several reasons for the rise in oil (and commodities generally). First, he lays out the "fundamental" explanation:

I am unsure whether we’re witnessing a bubble in oil markets today. Two “non-bubble” explanations for the price run, after all, are perfectly plausible. First, it may very well be that low-cost crude is running low and/or that demand will continue to surge to such an extent that prices have nowhere to go but up. Second, OPEC member states may continue to invest modestly in upstream capacity in order to maximize revenues, so even if there is plenty of low-cost oil still available in the world, the cartel will prevent new supply from reaching the market. For the record, I am skeptical of both propositions, but I do not dismiss them out of hand.

Then he moves on to the commodities as an asset class explanation of which I guess I'm a part:

The best argument against “speculation” in the subsequent price spiral is offered by oil economist Phil Verleger, a fellow I think quite highly of. Verleger believes that, whatever truth there might be to the simple “supply-and-demand” story I offered above, those price increases were greatly exacerbated by a huge move of dollars into commodity futures. That influx of cash was not driven by speculation (classically defined). According to Verleger, it was driven instead by the market recognition of the fact that, historically speaking, (i) commodities provided better returns over long periods of time than provided by equities, and (ii) returns on commodity investments are negatively correlated with returns on equities.

Hence, market actors thought they found an investment vehicle that provided a hedge against volatility in stock markets while also promising excellent long-term returns to boot.

And finally, the Fed inflation explanation:

The most recent Fed actions to combat the deteriorating state of the macroeconomy added even more fuel to the oil price fire. With market actors increasingly convinced that the Fed is willing to entertain inflation in the course of injecting liquidity into the market, investors are looking for investments to hedge against inflation. And what do you know? Returns on commodities have historically been better during inflationary periods than during non-inflationary periods. Ben Bernanke thus sent another strong infusion of cash into commodity futures – again, largely into oil and gas futures.

The increased demand for oil futures drives spot prices because it diverts oil from immediate use into inventories. The stepped-up infusion of oil into public inventories (the Strategic Petroleum Reserve and the emerging state inventory maintained by the Chinese government, for instance) has also contributed to the diversion of oil from immediate use and thus, has further increased prices. Federal mandates for low-sulfur fuel hasn’t helped either.

Taylor never really decides whether we have a bubble in the oil market, but he seems to come down on the nay side. As for me, well I tend to think that commodities in general are bubbly. That is a direct consequence of Fed policy and it will end as all the other Fed induced bubbles have - commodities will fall back to a price that really reflects fundamentals. When that happens, I have no idea but my guess is that it will happen when something causes the Fed to tighten policy. And that doesn't appear imminent.

Revisiting the Corn Laws 2008 Version

The rise in the price of rice has caused rioting and governments are reacting. As I've said, these government interventions will just make the problem worse. Steve Hanke likens the current interventions to the Corn Laws:

Now that governments in the rice-consuming countries have hit the panic button, we are witnessing a stampede to introduce more interventionist measures, discredited central planning solutions and more government-to-government trade deals.

This amounts to trying to deal with the problems created by massive government- created market distortions in the rice trade by throwing in some more distortions. This will, no doubt, simply magnify our current rice problems.

Rice laws and regulations are going in the wrong direction. It takes one back to the British Corn Laws. These mandated the virtually complete government regulation of British agriculture at the start of the nineteenth century.

Fortunately, that yoke was removed in 1846. Thanks to the efforts of Richard Cobden, John Bright and the Anti-Corn Law League, the Corn Laws were repealed. This resulted in the promotion of free trade, the importation of cheap food and a major surge in British standards of living.

What rice needs today isn't more government meddling but a modern version of the Anti-Corn Law League.

The first part of this article explains well why prices are high. It has much more to do with interest rates than ethanol production or any of the other dubious explanations I've seen:

The economics of commodity markets provides the key to unlocking this mystery. The net cost of carrying inventories is equal to the interest rate, plus the cost of physical storage, minus the "convenience yield".

The convenience yield is driven by the precautionary demand for the storage. When the convenience yield is zero, a market is in "full carry", future prices exceed spot prices and inventories are abundant.

Alternatively, when the precautionary demand for a commodity is high, spot prices are strong and exceed future prices, and inventories are unusually low.

As the term structure of rice prices makes clear (see chart), the precautionary demand in Thailand is not elevated and inventories are ample. Indeed, for the term structure of prices to be signaling unusually low inventories, the term structure would be negative in slope, not positive.

Commodity prices are rising because of monetary policy and no amount of government intervention will change that. The only governemnt policy that will solve this problem in the long run is to stop the original government intervention - in the money markets.

Cap and Trade Preview

All of the Presidential contenders still standing have endorsed a cap and trade system in response to global warming worries. None of them have talked about the costs of such a system. None of them have talked about the practical difficulties of implementing such a system. And none of them have talked about the EU system which has failed to produce the expected reductions in emissions. So if you want to see how a system like this would work, it makes sense to take a look at the existing ones to see how they are doing. The EU system is not working:

Europe's Dirty Secret: Why the EU Emissions Trading Scheme isn't Working

EU Climate Change Plans "A Failure"

EU plans fail to spark carbon price rally

EU Greenhouse-Gas Emissions Rose 1.1% Last Year

Of course, maybe it's just that the Europeans don't know what they are doing and us Americans will get it right? Well, we have a real world example. California is trying to implement it's plan right now and guess what? They're having some problems:

Fighting global warming is the feel-good cause of the moment.

But in California, the self-congratulation that followed the 2006 passage of the nation's first comprehensive law to curb emissions of planet-warming greenhouse gases is fast turning to acrimony.

A ferocious behind-the-scenes brawl over how to regulate electricity plants, the biggest source of carbon dioxide after motor vehicles, has pitted Southern California's public power generators against its for-profit utilities.

Why? Because some taxpayer-owned utilities, such as Los Angeles' Department of Water and Power, get close to half their electricity from the nation's dirtiest energy source: coal.

And under the system envisioned by Gov. Arnold Schwarzenegger to implement the greenhouse gas law, utilities would probably be required to buy the right to pollute from the state.

There is a real cost to reducing CO2 emissions and someone will pay. Politicians are promising both a cap and trade system and increased investments in alternatives. But that may not work out as planned:

Los Angeles' customers, who thus far have benefited from some of the lowest rates in the state, could shell out $450 million to $700 million a year -- money that the utility was planning to spend building wind and solar plants. Smaller coal-reliant cities, such as Anaheim, Burbank and Pasadena, also could pay high fees. Customers' bills could soar under such a plan, municipal utility directors, including Nahai, warn.

So if you give generous permits for polluting as they did in the EU, you get no reduction in CO2 emissions and a collapse in the price of carbon. If you punish the worst polluters by making them buy permits, they won't have the money to invest in alternatives. Michael Peevey, president of the California Public Utilities Commission says:

There's no free lunch," Peevey warns. "We have to reduce CO2 by 174 million tons by 2020. But no one wants to face up to the cost. Everyone wants everyone else to pay."

I am not sure of the science behind global warming or the need to reduce carbon emissions. But I am damn sure that government intervention in the market will not produce a satisfactory result.

Two Cents Worth

The value of the dollar has been falling and there have been numerous proposals to arrest the decline. The most obvious answer is to just stop printing so damn many of the things, but that's about as likely as finding an honest politician so I'm not holding my breath. Maybe a clue to how we can stop the devaluation of the dollar can be found in the lowly penny:

It costs money to make money. This fact is not only true for businessmen, investors, and entrepreneurs, but also for the moneymakers themselves — the Department of the Treasury.

To print bills or mint coins, the United States Mint and Bureau of Engraving and Printing must purchase all sorts of resources, including paper, ink, equipment, and metals. In the case of bills, these purchases are an insignificant fact because it takes very little to add on an extra zero to cover the costs.

Coins, however, are different. The price of the zinc required to mint pennies has been steadily increasing; according to a recent article in the New Yorker, the cost of producing a penny is now 1.7 cents — it costs nearly two pennies to make one. Producing a coin at a higher cost than the value of the coin itself is known as "negative seigniorage." This phenomenon has led many to question the continued existence of the penny and suggest it be abolished. Understanding negative seigniorage in economic terms will lead to an opposite conclusion: hundred dollar bills should be done away with.

The problem with paper currencies is that they are too cheap to produce. When you are in debt up to your eyeballs, as the US is, it is too tempting to just print up a few more and pay the bills. We need to make it more expensive to produce more money.

However, there does not have to be a hyperinflation for the effects of printing more money to be known. Any increase in the money supply, however minute, dilutes the purchasing power of existing dollars and thus throws off economic calculation. Curtailing the power of the government to print money means creating a more sound, prosperous economy.

How can this be achieved? Given that bills can be printed at an extremely high seigniorage, they do not offer a solution because the government will always be tempted to pay for its bloated expenditures with easy-to-print bills. What makes coins and other hard commodities desirable as currency is that they cannot simply be printed. Gold, copper, and silver must be dug out of the ground, so the government is limited in the amount that it can spend and, therefore, inflate.

Thus, the more expensive the penny — or any coin for that matter — the better. It is the paper that ought to be questioned. Does it make sense to give any institution in society the legal right to print money whenever it suits them? There can be no fiscal responsibility with a blank check.

Back in the early 2000s, the Fed was so worried about the potential for deflation that they flooded the economy with dollars. The result was a real estate bubble. What I have never been able to understand is why the Fed is so afraid of falling prices. Would you complain if the price of gasoline fell? The price of food? I think not. The Fed's fear of deflation is, of course, rooted in the Depression during which the US experienced a general deflation. It seems to me though that blaming the depression on deflation is to confuse cause and effect. Is it possible you could have deflation and not a depression? Is it possible to have a fever and yet not get the flu?

In a capitalist economy with sound money, prices should fall:

Government fiat does not raise the standard of living; production on the market does. In industries where there is innovation and more production, prices fall. This is best seen in the technology industry (not surprisingly, the sector of the economy with the least government regulation — contrasted with our interventionist health care system with its rising prices.) The reason prices are falling in technology is because the pace of innovation and production is faster than the pace of government-fueled inflation. Imagine if we had a stable currency and prices were able to reduce dramatically in all sectors of the economy.

The price of producing money should be expensive so that governments will be loath to produce too much. Abolish the dollar bill! Long live the penny!

Saturday, April 19, 2008

Universal Investing Mistakes

Via the WSJ:

The sharp decline in Chinese stocks is approaching a milestone: With a 4%drop Friday, the market has fallen by nearly half since its peak last fall. The decline has wiped out nearly $2.5 trillion of wealth and is testing the government's apparent resolve to let the market find equilibrium on its own.

The plunge has slashed the savings of millions of Chinese investors who jumped into the market as it rose six-fold in two years. It is crimping expansion in the country's nascent financial sector and may put a squeeze in corporate coffers. But so far, it has not slowed the world's fastest-growing major economy.

I stayed away from Chinese stocks through most of the run up so I haven't suffered as it has come back to earth. Now, I'm starting to get interested. Are Jim Rogers and Marc Faber right? Both of these very smart investors have decamped to Asia on the belief that the investing world's center of gravity is shifting away from the US. If they are right and Asia is the place to be, then this Chinese correction may be a great opportunity. The Chinese economy is still expanding rapidly even as the Chinese government attempts to apply the brakes; growth was reported last week at 10.6% for the first quarter. Inflation is higher than one would want, but with the Yuan tied to the dollar, that is more our fault than theirs. And they do seem to be allowing the Yuan to appreciate at a somewhat quicker pace recently. I tend to think that Rogers and Faber are right and that Asian stocks will offer greater growth than the developed markets, but with a much higher degree of volatility.

One thing that doesn't change though no matter what market you are considering. Investor/traders are all the same; they make the same mistakes no matter their nationality. Chinese investors are sitting on some pretty steep losses right now and they sound like any investor anywhere in the middle of a bear market:

Investor psychology, however, has taken a big hit. Last August, Qiu Jiaxin, a 27-year-old school administrator, bought 100,000 yuan, or about $14,000, of Shanghai-listed Western Mining Co. after its stock more than doubled to about 60 yuan a share. Looking at the global resources boom, "we thought it would go up again," says Mr. Qiu.

It didn't. The stock now trades at 20.85 yuan, and Mr. Qiu has delayed a home renovation and pushed plans for his wedding to 2009. The Shanghai resident isn't selling just yet. "It is not a small pool of money. It is a big loss to us," he says. "If we don't sell, it is only a paper loss."

That last sentence is classic. It doesn't matter whether you sell or not; you're sitting on a loser Mr. Qiu! This guy doesn't qualify as an investor or a trader. A good investor would have had a better reason for buying than "we thought it would go up again". A trader wouldn't have ridden this dog all the way down. Ever hear of a stop loss Mr. Qiu?

This is classic behavior too:

Small investor Guan Jun plans to save $3,000 by taking this year's holiday in China's Yunnan Province instead of the Maldives. He bought China Petroleum & Chemical Corp. shares at 25 yuan, and they are now trading closer to 10.43 yuan. "It should be a right time [to sell] when it rebounds," he says.

Guan Jun is future resistance at 25. He's down so much he's just looking to get even so when the stock gets back to where he bought, he'll be a seller. If a lot of other investors bought the stock at that price, the stock will stall at that price until all the sellers are satisfied. And then the stock will go higher to maximize their frustration. In an alternative scenario, the stock keeps going down and Guan Jun's nest egg continues to deteriorate. Guan Jun broke the cardinal rules of stock trading. You must have a sound rationale for owning a stock and you must have a sell discipline. If you follow those rules, you have a fighting chance in the market; if you don't, you are doomed to failure.

The article is referring to mainland shares that non Chinese can't buy so you can't participate directly in this market:

Most U.S. investors are unlikely to feel much direct impact from China's stock fall, because the shares traded in Shanghai and Shenzhen are off-limits to the vast majority of foreigners. While a few U.S. funds have received permission to invest in these stocks, "it's very speculative, and the quality of companies is not comparable to the Chinese companies listed in Hong Kong," says Richard Gao, portfolio manager of the $1.5 billion Matthews China Fund in San Francisco.

However, some international funds are feeling pain because the plunge in Shanghai-listed shares has been matched by similarly steep declines in shares of Chinese companies listed in Hong Kong, New York and elsewhere. The iShares FTSE/Xinhua China 25 Index Fund, an exchange-traded fund listed on the New York Stock Exchange, is off by 33% from its peak last fall. The Matthews China Fund is off by 32% from its peak.

The Hong Kong shares are cheaper than their mainland counterparts:

The Shangahi index remains triple its level at the June 2005 trough, but the market no longer looks as out of sync with global values as it once did. The prices of class-A shares, mainly for domestic investors, of Chinese companies listed on domestic exchanges are now 40% more expensive on average than the same shares of those companies listed on the Hong Kong exchange called H shares. That's down from a peak last August of 54%, according to ABN-Amro analysts.

That seems like a huge gap that will have to be closed someday. Obviously, it can be closed in two ways; A shares can fall or H shares can rise or more likely some of both. Until there is a way to arbitrage the different prices though, A shares will likely continue to trade at a premium. The easiest way to participate in the H shares is through Barclay's iShares FTSE/Xinhua ETF (symbol FXI)I'll be looking for an entry point.

Friday, April 18, 2008

El Salvador's Private Pension System

Juan Carlos Hidalgo has a post at Cato @ Liberty about El Salvdor's private pension system which just passed it's tenth year.

This week marks the 10-year anniversary of El Salvador’s adoption of a private social security system. Following the example of Chile 17 years earlier, El Salvador moved from a government-run (and bankrupt) pay-as-you-go system to one of individual accounts for workers administered by private operators. Salvadorians are free to choose who runs their pension accounts as well as the conditions of their own retirement.

Today, the combined value of the pension operators’ assets — that is, the savings of the Salvadorian workers — represents 21.5 percent of the country’s GDP.

Okay, so El Salvador has a private pension system and we're still stuck with Social Security? What the hell is wrong with this picture?

Friedman Bashing

I missed this Peter Goodman article in the NYT the other day that attempts to blame free market economics (and Milton Friedman by association) for the current problems in the economy. Nothing could be futher from the truth, but he tries his best:

Joblessness is growing. Millions of homes are sliding into foreclosure. The financial system continues to choke on the toxic leftovers of the mortgage crisis. The downward spiral of the economy is challenging a notion that has underpinned American economic policy for a quarter-century — the idea that prosperity springs from markets left free of government interference.

Goodman and most of the public don't seem to understand that the current difficulties in the housing market were not caused by the free market. In fact they were caused by the Federal Reserve, which held real interest rates negative in a successful attempt to avoid deflation. The Federal Reserve's price fixing is about as far from free market as you can get.

In the United States, the reconsideration of the Friedman doctrine came via the global financial crisis that has resulted from the collapse of American real estate. Many economists blame regulators for ignoring warning signs that banks and investors were growing reckless. One Friedman acolyte has taken the brunt of such criticisms — Alan Greenspan, the former chairman of the Federal Reserve.

But as America reaches for regulation to tame the markets, the keepers of the Friedman flame remain resolute that government is no solution.

“Friedman taught some fundamental long-run truths and he was adept and skilled and almost brilliant at getting them into the public domain,” said Allan H. Meltzer, an economist at Carnegie Mellon. “Now we’ve come into a crisis that has dampened enthusiasm for those policies, and we’re headed back into a period of more regulations that will do the same bad things as in the past.”

Banks and investors grew reckless because the Federal Reserve gave them cheap money with which to get reckless. Regulators are only needed because of a failure of central planning, not because of a failure of the free market. At least Goodman quotes Meltzer at the end who gets it right. We will get more regulation out of this while ignoring the root of the problem.

Public Sentiment on the Economy

Over at The Mess That Greenspan Made, Tim Iacono has a post about public sentiment concerning the economy. I've read TMTGM for a while now and anyone who reads this blog knows that I'm totally envious that he snagged that name. On the other hand, Tim is relentlessly negative about the economy and I suspect he will be surprised by how powerful the monetary medecine now being applied will be for the economy.

This post concerns a Washington Post/ABC poll about the economy and the public's perception of same:

Nine in 10 Americans now give the economy a negative rating, with a majority saying it is in "poor" shape, the most to say so in more than 15 years. And the sense that things are bad has spread swiftly. The percentage who hold a negative view of the economy is up 33 points over the past year, and the percentage who rate the economy "poor" has increased 13 points in the past two months. That is the quickest 60-day decline since The Post and ABC started asking the question, in 1985.

Tim, of course, takes this to be a negative and he may be right, but I take it more as a contrarian type signal. If 90% are negative, how much worse could sentiment get? Anyway, like Tim, I also think that the long term prospects for our economy are pretty dire absent some major policy changes, but I am not nearly as negative in the short term. I suspect Tim will have to wait until around 2010 for the real meltdown he expects.

Dow Theory Buy Signal

Market Watch also has an article on the Dow Theory which gave a buy signal today.

ANNANDALE, Va. (MarketWatch) -- The Dow Theory appears poised to go on a buy signal as of Friday's close.All that's needed for that to happen is for the Dow Jones Industrial Average to close above precisely 12,743.19. That certainly looks likely, since the Dow as of midday was some 125 points higher than that. The Dow Theory, for those who don't know, is the oldest market-timing system still in widespread use. Though its adherents do not always agree on all aspects of their interpretations, the theory's general outline is clear enough: A buy signal is generated when both the Dow industrials and the Dow Jones Transportation Average reach significant new highs, while a sell signal is triggered when both averages reach significant new lows.

I'm not sure how much relevance Dow Theory has today, but the sell signal it generated last November 23 didn't do much for investors except generate a tax bill. The sell signal was just about 1% higher than where we are now.

Market Bottom Signals

Market Watch has a good article about signs of a stock market bottom. They look at five common idicators; Sentiment, New Highs/New Lows, Discretionary Spending, The TED Spread and the spread between 2 Year Treasury Notes and Fed Funds. The only one I don't watch is discretionary spending since it usually bottoms later than other indicators. All in all, a good article.

Croesus is Cranky

Robert Lenzner writes a column for Forbes called The Croesus Chronicles. I've never seen it before, but if this is indicative of what to expect, maybe it should be renamed The Cranky Chronicles:

The blame game for the disastrous financial crisis is in full, unedifying bloom, especially as it is being played by former chairmen of the Federal Reserve Board, an eminent institution where ordinarily, discretion is better part of valor.

First, there was former chairman Alan Greenspan blaming the bubble-bursting on "the investment community," and vainly trying to deflect the legitimate and well-deserved carping against his free market Ayn Rand ideology.

Croesus thinks it is credible that regulators could have slowed the runaway train and limited the money-center banks from their reckless greed. Greenspan's need to defend himself smacks of worry about his place in history--fiddling while Wall Street burned. Indeed, the not-too-shy Barry Ritholtz of sounded off some days ago, ladling 85% of the blame for the crisis onto Greenspan and an inexplicable 15% onto his successor, Ben Bernanke.

Everyone knows that Greenspan was once a disciple of Rand but he lost all credibility with that crowd when he joined the enemy at the Fed. Central Banking is the anithesis of the free market. How could price fixing be called free market?


If you click on the title of this post you'll get to read the Bastiat's Candlemakers Petition mentioned in the Bob McTeer post below. It's a classic.

McTeer on Free Trade

Bob McTeer, former Fed governor, has a good post on free trade:

Most educated people understand the benefits of free trade, and that probably includes educated politicians. However, many who understand are only too willing to pander to the many more that don't. The reason many don't is that the benefits of free trade are widely dispersed while the costs are more concentrated. Free trade helps almost everyone a little bit, but hurts a few a lot. Furthermore, the higher standard of living associated with, and attributable to, free trade is not easily identified — while a job lost at a plant moving to China is easily associated with it.

Theoretically, those benefited could use a portion of those benefits to help those harmed get trained for the new jobs created by trade. But, alas, it's easier for politicians to feed the ignorance than to try to educate their constituents, and that seems true for two-thirds of our presidential candidates.

Hopefully, the presidential candidates who claim to be against free trade won't follow through on their threats. Smoot/Hawley II we don't need.

70s Redux

Vincent Reinhart explains food inflation on the editorial page of the WSJ:

What is going on? We can discern four forces at work today pushing up food prices – forces that were also at work in the 1970s, the last time food prices increased so rapidly on a sustained basis:

- Monetary policy in overdrive. Consider the real federal funds rate – that is, the nominal funds rate less inflation. A low real fed funds rate both encourages interest-rate sensitive spending, such as business investment, and discourages global investors from supporting the dollar on foreign exchange markets. At 2.25%, the nominal fed funds rate is now below the prevailing rate of consumer price inflation.

The last time the real fed funds rate was negative for a prolonged period was the mid-1970s. This was also a period when overstimulated demand pushed food prices up and the dollar depreciated sharply. In the end, economic growth suffered as well. Remember stagflation?

- Exchange-rate arrangements in disarray. The 1970s were also noted for turmoil in exchange markets, following the breakdown of the Bretton Woods system. The schism today is that some exchange rates move too little and others too much.

The exchange rates that are moving too little are those of emerging market economies and oil producers. China, India, Korea and Taiwan, and key oil producers such as Saudi Arabia, have been preventing their exchange rates from appreciating significantly by rapidly accumulating international reserves.

They've also effectively adopted the monetary policy of the Federal Reserve by keeping their domestic interest rates close to the fed funds rate. That way, no interest-rate wedge opens between their markets and our own that would otherwise put pressure on their exchange rate. As a consequence, they are following an accommodative monetary policy strategy totally unsuited to their already overheated domestic economies. Higher inflation has followed.

With exchange-rate movements capped by policy makers in so many parts of the world, the burden of adjustment falls more heavily on the nations that allow their currencies to float freely, such as Canada, those in the Euro area, and Japan. The depreciation of the dollar against these currencies is yet another reminder of the 1970s. As a result of these exchange-rate changes, the purchasing power of these regions for any internationally traded good denominated in dollars has gone up. Hence, it is no accident that the dollar price of food is up sharply.

- Unsound market interventions. Policy makers flailed about in the 1970s, enacting environmental legislation without due deference to the costs imposed on industry. They also tried to impede market forces with gasoline rationing and a brief flirtation with outright price controls.

This time round, our government has been force-feeding the inefficient production of ethanol. The result: Corn prices have more than doubled over the past three years, adding to price pressures on commodities that are close substitutes, or which use corn as an input to production.

Meanwhile, policy makers in emerging market economies have bent under the weight of popular unrest to raise food subsidies. This strains their budgets. They are also imposing restraints on exports, thereby losing gains from trade.

- Oil prices on the rise. The lines stretching around filling stations in the 1970s should remind us that large energy-price increases are disruptive. And we have had a large one: Crude prices have more than quadrupled since 2001. Any industry dependent on energy will feel those cost pressures, and modern agriculture, with its oil-based fertilizers and large machinery, is no exception.

But there is an important difference between our troubles today and those of the 1970s. In that decade, aggregate supply sagged as oil producers scaled back production and anchovies disappeared off the coast of Peru. The 2000s have been about demand expansion. Millions of workers in China, India and Vietnam, among others, have joined the world trading system. Beginning from a point close to subsistence, most of their additional income is being spent on food. Thus, the price of food relative to other goods and services has risen.

The good news is that producers respond to relative prices, although it can take some time. Already, the acreage in which corn is planted in the United States is back to levels of the 1940s. More of a production response should follow in other areas as well.

Challenges abound as supply catches up with higher global demand. The Federal Reserve has to be sensitive not to stoke inflation pressures, and to monitor inflation expectations closely. The subsidies proffered to corn producers have to be trimmed, in part to set a new standard for emerging market economies to emulate. And the gains from an open trading system have to be protected to keep our economy efficient.

This mirrors themes I've been harping on here for a while, but this is well said.

Closing the Barn Door

The auction rate securities mess is bringing the various state AGs out of the woodwork to see if they can score some political points from the mess:

Backlash is building against Wall Street for the credit crisis.

The latest case: New York state's attorney general, Andrew Cuomo, has launched a broad investigation into auction-rate securities, instruments used by municipalities, schools, closed-end mutual funds and others to raise money.

Mr. Cuomo's office sent subpoenas to 18 institutions on Monday and Tuesday seeking information on their auction-rate-securities, including some of Wall Street's biggest, such as UBS AG, Citigroup Inc., Merrill Lynch & Co., J.P. Morgan Chase & Co. and Goldman Sachs Group Inc., according to a person familiar with the investigation. The New York attorney general has plans to send out additional subpoenas soon, says the person.

And the state securities regulators are belatedly taking a look at the market as well. That begs the question of where the hell they were before this blew up, but better late than never I guess:

State securities regulators are investigating auction-rate securities as well, the North American Securities Administrators Association announced Thursday in a press release. Their efforts will be coordinated through a task force led by Massachusetts Securities Division director Bryan Lantagne. The task force includes members from Florida, Georgia, Illinois, Missouri, New Hampshire, New Jersey, Texas and Washington, according to the release.

I worked as a broker for over 15 years and I never sold these things. As the Economics Babe has said: "Something about seeing a security with a 25 year maturity in the Cash section of the statement just didn't seem right. How can a long bond always be priced at par? (long term bonds are the most volatile price wise)."

Don't Get Too Excited...Yet

The market has had a very good week, but a look at the charts will tell you that it's nothing to get excited about....yet:

We've been here before and until we get a close above the recent trading range there is nothing really to do unless you are a trader playing the ranges.

Having said that, I am encouraged by the earnings we've seen so far. With the exception of healthcare, pharma and financials, the earnings have been quite good. That should reinforce the point that this "crisis" is a financial event and not necessarily an economic one. Companies with significant revenue outside the US have done particularly well with the weak dollar. And that is also showing up in the divergence between growth and value. The S&P 500 growth has started to outperform and that is primarily due to non $US earnings.

Is this the breakout we've been waiting for? Not yet; we'll see if there is any follow through next week.

Plosser Seems to Get It

From the Real Time Economics Blog at the WSJ, excerpts from a speech given by FOMC dissenter Charles Plosser. Bernanke may be clueless but it seems that at least one FOMC member seems to get it:

The role of monetary policy is to ensure the stability of the purchasing power of the nation’s currency so that markets are not distorted by inflation.

Taking expected inflation into account, the level of the federal funds rate in real terms — what economists call the real rate of interest — is now negative. The last time the level of real interest rates was this low was in 2003-2004. But that was a different time with a different concern — deflation — and monetary policy was intentionally seeking to prevent prices from falling. Recently, we have had reason to be worried about rising inflation, not declining prices. Thus, comparing the nominal funds rate today with the stance of policy in 2003–2004 is like comparing apples and oranges.

We must keep in mind that monetary policy works with a lag. The full impact of changes in monetary policy on output and employment may not materialize for several quarters at the earliest. This lagged response means that monetary policy decisions depend critically on the outlook for the economy over the intermediate term. In times of economic turbulence and uncertainty, forecasting becomes more difficult. That does not mean that you can stop forecasting, but it does mean that the uncertainty surrounding any forecast will be unusually large.

Monetary policy cannot solve all the problems the economy and financial system now face. It cannot solve the bad debt problems in the mortgage market. It cannot re-price the risks of securities backed by subprime loans. It cannot solve the problems faced by those financial firms at risk of being given lower ratings by rating agencies because some of their assets are now worth much less than previously thought. The markets will have to solve these problems, as indeed they will. But it will take some time.

I love that part about how forecasting is more difficult in times of turbulence and uncertainty. If the Fed is to be effective it is exactly during those times when it is most critical to forecast accurately. Which is why Central Banking is ultimately a losing game.

At least Plosser understands the purpose of the Fed. That opening sentence is the most encouraging thing I've heard from a US central banker in a long time. He also acknowledges that monetary policy can't fix all problems. I would argue that monetary policy is the source of more problems than it can solve, but this is a start anyway.

Thursday, April 17, 2008

Punishing Success

Senator Obama was asked in last night's debate about his proposal to raise capital gains taxes. His response says a lot about how he views the government's role in the economy. Dan Mitchell at Cato had this to say:

Every so often, a politician commits the horrible mistake of saying what he really thinks. This happened at the Democratic debate. Barack Obama has a very punitive proposal to nearly double the capital gains rate. When asked by one of the moderators whether this makes sense, especially given the historical evidence of big “Laffer-Curve” effects, Senator Obama dismissed concerns about falling revenue, arguing that a high rate was justified by “fairness.” In other words, Senator Obama is so fixated on punishing success that he is even willing to reduce the amount of tax revenue flowing to Washington that he and his buddies can redistribute.

In my lifetime, every time the capital gains tax has been lowered, it has produced higher revenues. And every time it has been raised it has produced lower revenues. And Obama is apparently aware of that fact and he doesn't care. He thinks that if you are smart or lucky enough to generate a capital gain, well you don't deserve to keep it. He (or some other politician) should get a portion of that gain to pass along to someone more deserving. I'm not sure how they determine who is deserving.

More importantly, Obama (and many others on the left of the political spectrum) don't understand the link between the cost of capital and economic growth or the trajectory of the stock market. Check out this exchange between Obama and Charlie Gibson, the moderator:

MR. GIBSON: But history shows that when you drop the capital gains tax, the revenues go up.

SENATOR OBAMA: Well, that might happen or it might not. It depends on what’s happening on Wall Street and how business is going.

It apparently hasn't occurred to Obama that there may be a link between the cost of capital (which is raised when capital gains taxes rise) and the performance of the economy and the stock market.

Oil Prices in Gold

The blue line represents the price of oil in $US. The red line represents the price of oil in Euros. The purple line? That's the price of oil in terms of gold. Any questions about a gold standard?

Yeah, That's Fair

There's a new poll out showing that 60% of people polled think the amount of taxes they pay is fair. As Coyote blog points out, that is roughly the same percentage of taxpayers who are net recipients of tax dollars. So, basically these 60% think it is fair that they take money from the other 40%. Imagine that.

Flat Tax or Sales Tax?

Dan Mitchell has a video at Cato about a strategy for tax reform:

Let it be True

The Christian Science Monitor has an article headlined, "Time Running Out for US Farm Bill". I wish it were true and that this market distorting, subsidy laden, immoral piece of legislation could just die a quiet death, but the truth is that the argument is not over whether this folly should be continued, but only over the form it takes and how to pay for it with our tax dollars:

Chicago - This was supposed to be the week that Congress finally passed a new farm bill, to replace the one that expired six months ago.

It still might happen. But the behemoth $300 billion piece of legislation – which covers not just commodities subsidies and payments to farmers, but also food stamps, nutrition programs, and numerous conservation and energy programs – is having a rough time in congressional conference as leaders in both houses try to hammer out the differences between their two bills and figure out how to pay for the extra spending.

With agricultural commodities hitting records on a daily basis, why the hell are we passing a bill to subsidize farming?

Vindicating the Autrian View

Steve Hanke takes Hank Paulson to the woodshed in this Forbes article (via Cato):

U.S. Treasury Secretary Henry Paulson's blundering is becoming more breathtaking with each passing week. At the end of March he rolled out a grand plan to crown the Federal Reserve as the nation's new financial stabilizer. The Fed a stabilizer? That's who created the financial mess we're in.

If this wasn't bad enough, Secretary Paulson then donned his cheerleader's uniform and encouraged Beijing to let the Chinese yuan appreciate against the greenback. All the while favoring in this fashion a debasement of the U.S. currency, Paulson proclaimed that we should remain calm and confident because the economic fundamentals are sound. He reminds me of the stockbroker who performed a valuable service to his partners by always being wrong.

Hanke takes a distinctly Austrian view of things:

During the Greenspan-Bernanke era the Fed has embraced the view that stability in the economy and stability in prices are mutually consistent. As long as inflation remains at or below its target level, the Fed's modus operandi is to panic at the sight of real or perceived economic trouble and provide emergency relief. It does this by pushing interest rates below where the market would have set them. With interest rates artificially low, consumers reduce savings in favor of consumption, and entrepreneurs increase their rates of investment spending.

And then you have an imbalance between savings and investment. You have an economy on an unsustainable growth path. This, in a nutshell, is the lesson of the Austrian critique of central banking developed in the 1920s and 1930s. Austrian economists warned that price level stability might be inconsistent with economic stability. They placed great stress on the fact that the price level, as typically measured, extends only to goods and services. Asset prices are excluded. (The Fed's core measure for consumer prices, of course, doesn't even include all goods and services.) The Austrians concluded that monetary stability should include a dimension extending to asset prices and that changes in relative prices of various groups of goods, services and assets are of utmost importance. For the Austrians a stable economy might be consistent with a monetary policy that had prices gently falling.

I've never been able to figure out why our central bankers have such a fear of falling prices. And, as I've argued many times in the past, excluding asset prices from the inflation equation, is why we have had serial bubbles in asset prices. Greenspan and Bernanke may claim that they can't identify bubbles as they happen, but that has always struck me as nonsense. They just didn't want to be the party poopers who took away the punch bowl.

Hanke also points out that the trade deficit, even if it is a bad thing which I would dispute, is not about exchange rates:

It's also no surprise that the dollar remains debilitated, which makes Secretary Paulson's Beijing weak-dollar message so bizarre, particularly since it is based on an incorrect premise propagated by many prominent economists. Harvard professor Martin Feldstein, for example, argues that the bilateral trade balance between the U.S. and China is determined by the yuan-dollar exchange rate. Accordingly, to reduce China's trade surplus with the U.S., he advocates an appreciating yuan.

This advice is nonsense. Trade balances are determined by national savings propensities, not exchange rates. China's savings surplus and America's savings deficiency largely determine our trade imbalance with China. The U.S. Treasury should have learned this lesson after years of forcing the Japanese to adopt an ever appreciating yen, which destabilized Japan's economy without doing a lick of good for trade balances.

The only way to get out of this in the long run is to establish a system of hard money that doesn't allow the Fed to inflate away any perceived economic problem.

More on Economic Hysteria

I've been taking a lot of heat over my repeated insistence that the economy is not in a recession and likely won't fall into one. I have also said that even if we do have a technical recession, it will be mild and short lived. It's nice to know I'm not the only nut out here that still believes that. Alan Reynolds, writing for the Cato Institute has a similar view:

Media hysteria over the mortgage crisis is almost certainly misleading countless people about prospects for the real economy.

The US economy is likely in recession. Yet even that conclusion may be premature — it rests on a short sample of slim evidence. Industrial production has fallen for only one month. First-time claims for unemployment insurance touched recession levels for just one week.

Of course, housing starts are down 1.1 million since early 2006, but nearly that entire problem is behind us — starts couldn't drop much in the future, because homebuilding would then be well below zero.

The focus of the gloomy economic news is on a "credit crisis" or "financial crisis." Yet postwar US financial crises have never resulted in economic disaster. Think of the savings & loan (S&L) crisis of 1986-1995 — a period that also saw Black Monday (Oct. 19, 1987), when Dow stocks fell 22.6 percent.

As Reynolds rightly points out, this is a financial problem but not necessarily an economic problem. And even the financial problems are not as bad as the doom and gloomers would have you believe:

Yet the Los Angeles Times, for one, has gone so far as to ask (March 20) "Could another Great Depression be lurking over the horizon?" This is nonsense on stilts.

"Then, like now," the article noted, "stock prices were highly volatile." So what? Stocks are only down about 10 percent in the United States — a much milder drop than most other markets.

Some papers can't get anything right. An April 6 New York Times piece ("Almost as if The Sky Were Falling," on stock prices) claimed that the "focal point for the stock market's difficulties" is that "banks have been reluctant to lend money to one another, or to anyone else."

Absurd. If banks have been reluctant to lend money to one another, then interest rates on such loans, like the six-month London Interbank Offered Rate (LIBOR), wouldn't have fallen to 2.6 percent from 5.3 percent a year earlier.

And if banks were reluctant to lend to "anyone else," then bank loans wouldn't have increased by 8 percent (as Fed data say they have) since last August, when the mortgage crisis first emerged.

The phrases "credit crisis" and "credit crunch" are not about bank loans, as most suppose, but about difficulties in selling or valuing exotic securities.

Furthermore, as I've pointed out here before, mark to market accounting is part of the perception problem:

Even there, the hysteria mounts. "IMF Puts Cost of Crisis Near $1 Trillion," screamed a Washington Post headline April 9. Yet that estimate wasn't for the United States alone, or mortgages alone. It covered worldwide future accounting losses (amounting to 4.1 percent) on all sorts of loans and securities, from junk bonds to hedge-fund speculations. For mortgages alone, the IMF estimates losses of $115 billion.

And, again, we're talking accounting losses — many of them only temporary.

These are paper losses on mortgage-related securities — taken because accounting rules require financial firms to mark the securities down to some estimated "fair value." These securities still generate ample cash from mortgages — but, as the IMF explained, "Heavy discounting during the crisis . . . produced fair values much lower than their underlying expected future cash flows would imply."

That is, many such securities are likely to be written up sooner or later.

And lastly, the drop in housing prices is not as bad as the press reports either, unless you happen to live in one of those bubble markets (as I do):

Second, the fact that the S&P Case-Shiller index of house prices has dropped 10.7 percent doesn't even begin to justify a nationwide forecast of a 30 percent drop. That index covers prices of single-family homes in only 20 metropolitan areas — with LA, San Francisco and San Diego, accounting for more than a quarter of the total.

Data from the Office of Federal Housing Oversight — which covers the whole country — show home prices down just 3 percent for the year ending in January. Between the fourth quarters of 2006 and 2007, house prices rose by an average of 3.8 percent in 29 states that are excluded by the Case-Shiller index, falling in just two.

Yes, we have some problems in our economy, but they are not nearly as bad as all the "experts" are predicting.

Peak Oil?

Two recent oil discoveries that would seem to poke another hole in the peak oil thesis. First this from right here in the US:

Reston, VA - North Dakota and Montana have an estimated 3.0 to 4.3 billion barrels of undiscovered, technically recoverable oil in an area known as the Bakken Formation.

A U.S. Geological Survey assessment, released April 10, shows a 25-fold increase in the amount of oil that can be recovered compared to the agency's 1995 estimate of 151million barrels of oil.

Technically recoverable oil resources are those producible using currently available technology and industry practices. USGS is the only provider of publicly available estimates of undiscovered technically recoverable oil and gas resources.

And another potential large field offshore from Brazil (via The Economist):

JUST how much oil is there off the coast of Brazil? Until recently, Brazil’s oil reserves were thought to be relatively modest: about 12 billion barrels at the beginning of 2007, according to BP, or about 1% of the world’s total. But last year, Petrobras, Brazil’s partly state-owned oil firm, announced the world’s biggest oil discovery since 2000: the Tupi field, which it hopes will produce between 5 billion and 8 billion barrels. Now the head of Brazil’s National Petroleum Agency (ANP) says another nearby discovery might hold as much as 33 billion barrels, which would make it the third-largest field ever found.

The important part of the first report is the phrase "technically recoverable". The difference in this estimate and the previous estimate has a lot do with the changes in drilling technology. That's the thing that the peak oil folks keep missing. In both of these cases it is the advance in technology that makes these reserves recoverable. To reach Malthusian conclusions, one must assume that technology stands still, which is of course ridiculous.

The rise in oil prices has nothing to do with "peak oil". It has everything to do with monetary policy and an increase in demand from developing countries. I believe that long before we run out of fossil fuels, technological advances will produce an alternative. And in the meantime, technological advances will allow us to further exploit the most abundant energy resource on the planet.