Q1 Market Update: The Stock Market is Now Overvalued

tylerdynamist1 Comment

Since the market bottom in March, I have been rationalizing the rally in equities by observing that the market seemed to be honing in on a target return on the S&P 500 of about 7%. What was changing over time was the market's view of long term inflation. Projected equity returns are calculated as the opening dividend yield (with the dividend based on the historical payout ratio on next year's trend earnings) plus the long term growth rate of inflation-adjusted trend earnings times the long term rate of inflation. As market prices have risen, the dividend yield has fallen, but the projected rate of inflation has risen. In 2010, however, the yield has continued to fall while the market's assumption for inflation has not risen commensurately.

Right now (April 16, 2010) the S&P 500 is pricing in a 6.6% return.

Such a low return is hard to justify. I can make the argument that 6.8% is a reasonable return (assumes a 4.5% equity risk premium over the equilibrium 30-year TIPS rate). Even a 6.8% return is much lower than the long term return that most market participants assume to be 8-10%.

The trend earnings being used in my calculation is $59.22, which approximates the projected 2010 as-reported earnings (as projected by Standard and Poor's analysts on a top-down basis) of $62.09.

In addition, I continue to believe that the market's assumption for long-term inflation of 2.7% is high. I view the equilibrium inflation rate to be 2.25% (the Fed's target), and feel that given the high debt levels in our economy we face more risk from deflation than from inflation. (I realize that this is not a very popular view, and that most people feel the opposite.)

If we look at the rates on fixed income investments, it appears that the long end of the yield curve holds the most value, for Treasury Bonds, Municipal Bonds and Investment Grade Corporate Bonds. (High yield bonds and TIPS, on the other hand, are overvalued.) Long bonds are not undervalued, necessarily, but deserve at least a target weighting in a portfolio.

I do believe that the stock market is likely to keep rising in the near term as the economy and earnings expand. It should be noted, however, that investors are now playing with the house's money, and that in the next recession stocks are likely to at least revisit the current levels, if not go below them.

Predicting Inflation: Gold versus Bonds

tylerdynamist1 Comment

Predicting Inflation

In my most recent market commentary, dated 2/9/10, I discussed how sensitive market prices are to future inflation expectations. To the extent that you can discern whether the market expectations for future inflation is too high or too low, you should be able to beat the market by using tactical asset allocation. During the market chaos of early 2009, long run inflation expectations had fallen to 1.0%. If you were able to predict that the federal reflation efforts would be successful (at least in the short term) and that market inflation expectations would rise to where they are today (2.6%), you could have caught the market bottom and benefitted from the 70%+ run up in the S&P since that time. I was too pessimistic and missed most of the run-up.

In normal times, the market appears to view 2.5% as the natural long-term inflation rate. The Fed claims to view 1.5-2.0% as its desired inflation rate. In my market equilibrium model, I have used 2.25%, but have tended to favor a range of +/- 0.25% with the acknowledgement that market outcomes aren't that precise. My general argument has been that the market is too focused on inflation, and that deflation is the primary threat. Many market pundits, on the other hand, have been proclaiming that the market (particularly the Treasury bond market) is massively underestimating inflation.

There are two primary market indicators for future inflation expectations: (1) the Treasury-TIPS spread and (2) the price of gold.

What bonds are telling us

As of 3/26/10, the Treasury curve looks as follows:

If you compare this curve to the curve at year end 2009, you'll see that the nominal Treasury rates have moved up slightly (the 30-year rose to 4.8% from 4.6%), TIPS rates moved up (the 30-year TIPS rate rose to 2.2% from 2.0%) and inflation expectations fell slightly (fell to 2.6% from 2.7%, yes there is rounding involved here). The TIPS curve is steep and the inflation curve less so, which makes sense. Below is what I consider to be the "equilibrium" yield curve, using my 2.25% inflation rate as a target:

The bond market is basically saying that the Fed will be a little slow to remove accommodation (which is why short rates are below equilibrium), but that long run inflation expectations are well-anchored.

What gold is telling us

The gold market is telling us something different. A rise in the gold price tends to lead a rise in commodities prices, which in turn leads a long term rise in CPI. Gold also has a history of volatility and of overshooting its equilibrium, however.

Below is a chart of the price of gold since the 1950s:

The gold price was fixed at its Bretton Woods price of $35 per ounce from the early 1930s to the late 1960s, jumped to (briefly) over $800 per ounce in 1980, fell to a new equilibrium range of around $375 per ounce from the mid-1980s through 1995, fell again in the late 1990s to $250 per ounce, and then rose during the past decade to over $1,000 per ounce.

If gold wasn't so volatile, we could expect it to rise steadily over time as the Fed promotes positive inflation. It should be noted that during the entire century between the early 1800s and the early 1900s, there was no sustained inflation in the United States as the dollar was convertible into gold at $20 per ounce. It is only since the Great Depression that the government has actively promoted inflation. In fact, because of the productivity of the capitalist system, you would expect prices to fall over time as producers became more efficient, not to rise as tends to be the case.

All things being equal, if you were expecting the Fed to target consumer price inflation of 2.25%, and you expect productivity gains of 1.75% per year, you would expect the gold price to rise by a rate of 4% per year to indicate that the dollar is being devalued accordingly.

Despite all the volatility in the gold price and inflation since the 1960s, the long term trend shows that gold has led increases in CPI, less a producitivity factor.

In the chart above, we can see from the trendline equation that CPI has been falling at a rate of 1.8% per year relative to gold since the 1950s, but that the relationship has been volatile. Gold was undervalued relative to consumer prices in 1970 and 2000, was overvalued in 1980, and was fairly valued in the mid-1990s. In many of my models I find that the mid-1990s was a well-balanced economy, before Robert Rubin's dollar bubble and the following dot com and housing bubbles threw the economy off kilter, to put it mildly.

One more factor to take into consideration is that economy-wide prices don't adjust instantaneously. I've found that it takes about 10 years for the overall CPI to catch up to a sustained devaluation of the dollar relative to gold. The inflation rate for the next 10 years is therefore dependent on whether monetary and fiscal policy are tightened enough so gold falls back in line with the current consumer prices, or whether prices keep rising to catch up with the new equilibrium level in gold.

My calculations of the theoretical gold price and CPI reveal the following:

  • If gold has overshot to the high side as a function of the financial crisis, and the treasury market's inflation rates are correct, then the current equilibrium gold price would be $550-600 per ounce.
  • If gold has found a new equilibrium level at the current $1,100 per ounce, then we should expect a 10-year inflation rate of over 5%.

This is a massive divergence.

  • If the bond market is correct, then bonds and non-precious metal commodities are fairly valued, and stocks are slightly overvalued.
  • If the gold market is correct, then most bonds are overvalued, TIPS and commodities are way undervalued and stocks and even real estate are slightly undervalued.

So what market should we listen to, gold or bonds?

The bond market is more liquid and understands the deflationary risks of high leverage. While the argument can be made that Treasuries are overpriced (yields too low) due to the Fed's holding rates too low and to Chinese manipulation. If nominal Treasuries were being manipulated by structural factors, then I would expect TIPS to be yielding nearly 0% across the curve. As can be seen above, however, the TIPS yield curve is showing positive real yields right around their equilibrium levels.

The gold market is a bit more ideological, attracting those that tend to dislike the government in power. It should be said, however, that the gold market was far more adept at tracking the debt bubble of the 2000s than the Federal Reserve proved to be, right through to predicting the extraordinary measures taken in the bubble's aftermath. The political landscape, on the other hand, is implying that consensus is building to fight the deficit, reform entitlements and to rein in financial system leverage. While that may be wishful thinking on my part, it would be hard to make the case that the wind is shifting in the other direction. My view is that the health care bill will be one of the last acts of giving us things for some time. The next decade will be occupied mostly by our government taking things away.

Conclusion

The answer to the debate is not obvious. Risk management, therefore, should be the primary focus for investors. I'll do my regular quarterly market update in a few days, but the lesson for me would be to overweight TIPS, commodities and cash, and to underweight precious metals. At the very least, it is probably time to trim bond positions back to a neutral weighting (I have been overweight bonds for years now). It also probably makes sense to have at least a neutral weighting in stocks for the time being, if we are to assume that the ultimate inflation outcome likely lies somewhere between what the bond market and gold market is predicting.

I am not a financial advisor. These analyses are conducted for personal enjoyment only.

The GOP will not repeal ObamaCare

tylerdynamist2 Comments

Now that ObamaCare has passed, we can mostly put that year's worth of debate and rancor into the rear view mirror.  Contrary to what the GOP seems to be telling itself, the 2010 elections will not be decided based on the potential repeal of the health care bill.  It will be decided based on the array of issues that will be decided in 2011 and 2012, and based on how big a check the people want to put on the Obama administration.

First, with regard to health care:

  • The bill can't be repealed while Obama is still president
  • As I've written before (here, here and here), our exisiting health care system is deeply flawed and preposterously expensive (and getting worse), making it hard to defend the status quo
  • Any bill that comprehensively deals with such a large and complicated system (and has the ability to pass Congress) will be flawed and imperfect
  • Polls have consisently shown over decades that Americans care about this issue, that they are open to governent-run health care, that they are worried about costs, that they would like access to be universal (but not necessarily free), they favored the "public option" right up until the end
  • The people in the middle of the electorate (i.e. the ones that really matter) will prefer to see this bill tweaked rather than have it junked and return to the status quo ante
  • As we have seen with other entitlements, the principle of universal access is now established, and will not be taken away
  • People (rightly) don't believe that the bill will reduce the deficit, and the real threat to long-term solvency of the US come from the $38 Trillion present value of the unfunded Medicare liability (see here, page 70), so health care is now THE deficit issue going forward
  • The Medicare liability can't be reduced without reforming the way medicine is paid for.  It will not be about raising taxes or tweaking benefits.  It will either be about rationing by government edict (a less-sensational version of "death panels") or by using market forces to ration care.  The moral element of health care makes market purity difficult, however.
  • There will also be alot of experimentation around the edges: tort reform, punishing unhealthy eating, promotion of exercise, etc.
  • Health care will be one of the dominant economic issues for a generation…we want to continue to invest in health care innovation, but we don't want it to engulf the entire economy

As for the 2010 election, barring some foreign crisis, the issue set is as follows:

  • Financial reform (favors Democrats; the GOP will be crazy to block this and allow it to still be an issue in the 2011 election)
  • Trade with China (mostly favors Democrats; it is time to stand up to their mercantilistic practice of building currency reserves to promote exports at our expense)
  • The deficit (favors Republicans; divided government is best for fighting deficits; the issue will have more potency if interest rates rise and less if rates stay where they are)
  • Expiration of the Bush tax cuts, estate tax (mostly favors Republicans; although a strict anti-tax position could backfire if they are unwilling to compromise on deficit and entitlement reform)
  • Energy reform (mixed; people want compromise, like more domestic energy coupled with reasonable investments in efficiency and green energy)
  • Health care reform (favors Republicans; as long as they focus on reformist ideas like tort reform and HSAs and don't blather on about lost liberty and creeping socialism)
  • Entitlement reform (favors Republicans; divided government would force the compromises that are required, i.e. raising taxes and cutting benefits)
  • Jobs (mixed; "jobs" is not an actual issue, it is a shortcut taken by lazy pundits; the "jobs" issue favored Obama in 2008 because he was most likely to support fiscal stimulus; the stimulus chamber is mostly empty now, so there is no actual "jobs" issue on the table outside of the economic issues outlined above or other small-bore initiatives that might get brought up as window-dressing)
  • Social issues (mixed; the Democrats elected a good number of social conservatives in swing districts in the last two elections, and the Republicans weren't focused on these issues in NJ, VA and MA, either; it seems to be mostly about economics now)
  • Foreign Policy (not an issue; the President runs foreign policy)

Good news for Republicans, the following issues are now off the table:

  • Iraq
  • Universal health care

Please don't shoot the messenger with this.  I am trying my best to just give you my analysis, with as little personal bias as possible.  In this day and age, with the hyperbole thrown around by both sides (Bush is a Nazi! Obama is a socialist!), we must remember that the actual US electorate is pragmatic and centrist and is just doing the best it can with the choices it has available.

Reform the Tax Code Now

tylerdynamist1 Comment

The United States has a tax code that encourages borrowing and consumption at the expense of savings and investment. I believe this concept is pretty well understood. What is less understood is that the rest of the world does not. The much-derided (in the United States at least) European-style welfare states actually have less progressive tax systems than the US, as do the developed Asian countries of Japan and South Korea. This means they are more apt to discourage consumption and to promote exports with value-added taxes. Most of these countries have found a policy balance that produces neutral trade deficits. Countries like China and Germany, on the other hand, take it even further and use their tax code to actively promote massive trade surpluses, a key source of the "global imbalances" that are threaten the world economy. Even worse, within the US tax code we discourage domestic investment in general, yet we lavish subsidies on specific old-economy industries like real estate, agriculture and energy extraction and even encourage US multinationals to invest overseas instead of in the United States. Our distorted tax policy is a bipartisan failure that must be addressed soon or our country will begin to lose ground economically while struggling under a mountain of foreign-owned debt.

How we got here

Much of The Dynamist blog is devoted to analyzing long term trends in economic policy, market valuations and political cycles. One of the consistent themes (for examples see here and here) is that the United States needs to focus on reducing its structural trade deficit. When we run a trade deficit, we are importing capital (i.e. borrowing) from abroad. Importing capital is not inherently bad. If the US had a surplus of investment opportunities relative to its pool of savings, investment capital may come in from abroad to make up the difference. In such an event, the investments would presumably increase the long run growth rate of the US economy.

The trade deficits that the US has run since the mid-1990s, and in the 1980s before that can generally be attributed to policy distortion by the Federal Government or by the Federal Reserve. The Fed's policy of high real interest rates in the early 1980s and late 1990s drew in a great deal of capital from abroad. In the 1980s, it funded Reagan's tax cuts and military buildup. In the 1990s, it funded the investment in a large increase in US manufacturing production capacity. In the Dynamist's view, neither of these investments were bad things and they generally made the US stronger.

The problem came when the disinflationary high interest rate policy was unwound. In both the late 1990s and 2000s, the combination of falling real interest rates, a weakening dollar, a surge in liquidity and an upturn in inflation create a ripe environment for a junk bond and real estate boom. Finance-fuelled booms like these tend to leave behind banking crises, overleveraged LBOs and real estate overcapacity. In the 1980s, the S&L deregulation led to a commercial real estate bubble. In the 2000s, the flow of Chinese money into the agency debt of Fannie Mae and Freddie Mac, combined with the policy innovation of "securitizations" and credit derivatives created the housing bubble. While such investments aren't useless, they don't have much of an impact on future US productivity.

I've written before about how US economic policy since the Great Depression has basically promoted consumption and real estate investment at the expense of saving and business investment. Domestic tax policy is skewed toward taxing high earners and lenders and supporting lower earners, borrowers and leveraged equity owners, particularly in real estate and farming (this even after the income tax rate reductions of the Reagan and Bush eras). When examining how domestic policy leads to distortions to the external trade and capital accounts, it is worth comparing how our policies compare to those of our largest competitors.

Global tax rates

A couple of months ago, The Economist had an interesting table outlining the tax policies of various countries (it can be found here, by those with a subscription). I worked with the numbers a bit so we could compare the state's take (including state and local taxes) relative to GDP across various types of taxes. I don't have the underlying data, nor do I know the policy details behind how various countries collect taxes, but in rough terms the data give one a good idea about the thrust of tax policy.

I took the average of five European-style welfare states (Britain, Canada, France, Germany and Italy), two developed Asia industrial powerhouses (South Korea and Japan), the US, China and Germany stand-alone. Their sources of tax revenue relative to GDP are shown below:

Source: The Economist, author's calculations

Unsurprisingly, governments in the United States collect a smaller amount of taxes as a percent of the economy than the four European countries and Canada. To compare apples-to-apples, however, the 6-8% of GDP that flows to privately-funded health care in the US should be added to the relatively regressive "social contributions" line item, for health insurance costs are deducted directly from our compensation just like Social Security and Medicare taxes. That would move US taxes to within 4-6% of European levels.

Surprisingly, the total tax take from "progressive" sources like income, capital and property in the United States is almost identical to that of Europe. The big difference between the two systems is in the "regressive" taxation of consumption. The European-style welfare states use value-added taxes that collect consumption taxes to the tune of 10.4% of GDP. The US taxes consumption, mostly in the form of state sales taxes, at only 4.4% of GDP. In other words, the US has a more progressive tax code than the European-style welfare states. The result is Europe as a whole runs a trade balance and the consumption-driven US runs a trade deficit.

The developed Asia countries of South Korea and Japan tax their economies by a similar percent as the US and have similar percentages for social contributions. The difference is that developed Asia taxes income less and consumption more than the US, with a difference of about 3 percentage points in each category.

Now look at China. It has a weak social safety net, and collects nothing in terms of "social contributions". It then gets nearly two-thirds of its tax base from consumption taxes, with most of the rest coming from taxes on companies. No wonder China has huge levels of savings and investment and low consumption levels. Combine that with a policy to suppress currency values and you have the ideal recipe for large trade deficits.

Germany is another great promoter of global imbalances, particularly within Europe, as has come to light with the recent Greek debt crisis. It collects a huge portion of its tax base from regressive consumption taxes and social contributions, while collecting less than the US in progressive income, capital and property taxes. Additionally, of the developed countries it takes the lowest percentage from companies. By taxing employment so highly via social contributions, and taxing companies at such a low level, Germany is encouraging "capital deepening", or investment in its great export machine. Germany's high consumption taxes have also encouraged the lowest level of consumption of the major developed economies.

Domestic distortions

Even within the US tax code, the US discourages domestic business investment relative to encouraging US multinationals to invest abroad; punishes businesses in general with the second-highest corporate tax rate in the world while it lavishes massive subsidies on individual sectors like agriculture, energy extraction, and real estate; forces companies to write off investments in productive capacity over long periods of time while other countries offer massive incentives for multinationals to invest. In the past 30 years, the US has gotten away with its disincentives to business investment funded by domestic savings by replacing domestic savings with foreign savings flowing through its levered-up capital markets casino.

Reform the Tax Code

It was nice while it lasted. We got lots of investment, bigger houses, a beefed-up military, technological innovation, and debt-fuelled consumption with low domestic savings. Now that the bill has come due, we either need to encourage more saving or live with less investment. Opting for the latter is not the path to long run prosperity. The tax code needs to be reformed to tax more consumption (which could include a carbon tax, an export-promoting value added tax and/or larger deductions for saving), not to increase income taxes and to reform the corporate tax code to replace the subsidies for specific old-economy industries with incentives for investment in domestic manufacturing capacity and R&D.

For corporate taxes, I would propose a general reform that would lower the statutory rate by eliminating special-interest subsidies and the deferral of international income, while also allowing the full, immediate expensing of business investment and R&D. I would also support the deductibility of dividends, while returning the tax rate on individual dividends back to the income tax rate. This reform would discourage corporate cash-hoarding for buybacks and ill-conceived acquisitions. (If you can't convince the capital markets to fund an acquisition, you probably shouldn't do it.)

In a globalized economy, large differences in tax policy cause trade and capital flow distortions. The US can no longer pretend it is an island unto itself. Our tax code is harmful enough to our national interests as it is, it gets even worse when allows the rest of the world to take advantage of us.

The Long-term, Real Return on Stocks is only 4-5%

tylerdynamist1 Comment

Caltech Professor Bradford Cornell has written a great paper published in the Financial Analysts Journal called "Economic Growth and Equity Investing". He has performed a detailed, eloquent analysis that backs up my stock market valuation model (described here, updated many times here, and most recently conducted here).  He posits that long-term, real earnings and dividend growth is unlikely to exceed 2% (I use 1.7% for the S&P 500 based on the historical trend).  When combined with the dividend yield you are looking at a total real return of 4-5%.

Professor Cornell's paper is here: Download Economic Growth and Equity Investing I warn you, it is "wonky".

So if trend earnings growth is fixed, and the dividend yield is known at any given time, the variable in valuing the market is the assumption for future inflation.  (Projected Return = dividend yield + real trend earnings growth rate + long term inflation rate.)  Provided the long term inflation assumption is moderate, and thus interest rates are reasonably low, inflation and equity prices are positively correlated.  I explain here how sensitive the market multiple is to changes in inflation expectations.

The key to beating the market short term is determining whether the market assumption for long-term inflation expectations is too low or too high.  The rise in inflation expectations from 1.3% in March to 2.7% in January can explain virtually all of the rise in the stock market in that time.

I believe that investors should err on the side of assuming inflation will be lower than normal.  I know this conflicts with what alot of people believe given our aggressive monetary and fiscal stimulus.  The problem is, that monetary and fiscal stimulus is just offsetting aggressive deleveraging in the private market, particularly among consumers and banks.  Private deleveraging will continue until the housing market stabilizes and the banking system's leverage stabilizes.  The banking system will not stabilize until after it has digested the proposed financial system reforms.  Since the United States can not simply devalue its currency the way that smaller countries can, it can only deleverage via a period of belt-tightening.  Deleveraging and belt-tightening mean struggling with deflation.

In my previous article "These are not Unprecedented Times" I discuss the long wave pattern called the Kondratiev Cycle.  Google that term and you can learn all about it.  While I don't think it can be used as a market-timing system and I realize that each cycle is different, the pattern it describes provides a good framework for understanding what is going on.  Most economists have been building models with data that goes back to World War II and have left out a key part of the long cycle: the Kondratiev Winter.  When the Autumn-season leverage-driven asset inflation has run its course, a long period of debt and asset deflation sets in.  While stimulus may offset actual deflation, it will be difficult for inflation to be above average if the banking system is deleveraging and without a large currency devaluation.  I'm not saying it's impossible.  It's just highly unlikely.

The current market assumption for long-term inflation is 2.6%.  That is slightly above the Fed's implied target of 2.0% to 2.5%.  This with Federal deficits of 10+%, the Fed Funds rate of 0% and a large bout of "quantitative easing".  The foot can not be on the stimulus pedal much harder than it is.

I don't make short-term market calls.  Clearly, the stock market could continue to rise for a whole host of reasons.  The next recession, whenever it comes, will likely be deflationary (no more bullets are in the stimulus gun) and the stock market will be hammered anew.  Investors beware.

Q4 Economic Growth – Be Happy, but Worry

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There is alot to like in the recently announced 5.7% rate of US GDP growth in the fourth quarter of 2009. 

While many commentators are brushing it off as a fluke tied to the vagaries of inventory trends, it is actually very normal for inventory swings to account for a good portion of GDP growth when the cycle is first turning.  The question is always whether growth can then get handed off to sustained consumption and private investment after a few quarters.  I think it can, but extreme swings in public policy could theoretically jeapordize the expansion.

The personal consumption number is encouraging, particularly given that consumer credit has been declining.  This implies that we are moving to a sustainable level of spending, complemented by a positive savings rate.  Government transfer payments tied to unemployment insurance and the stimulus package are supporting spending, of course, and my advice would be to withdraw this support only gradually in 2010, if at all.

Net Exports were actually weaker than the real GDP figures reported.  In nominal terms, the trade deficit actually widened as a percent of GDP in Q4.  Petroleum imports increased in nominal terms, but because of rising prices, fell in real terms.  On the flip side, exports grew 25% in nominal terms, meaning world trade is on the rebound and the US can benefit from a strong rebound in the manufacturing and service sectors if it can borrow excess demand from abroad.  Because both the domestic demand and supply of credit is limited, there is reason to be optomistic that exports should expand faster than imports if the dollar stabilizes at current levels.  From a purely economic point of view, it would make sense for the US tom implement policies to reduce its demand for imported oil (to go along with the environmental and security reasons to do so.)  In fact, virtually the entire trade deficit can be traced to the petroleum and auto sectors.

An increase in business investment, on the other hand, was limited purely to high tech equipment.  Traditional industrial and transportation equipment investment remains in the cellar.  There is good reason to expect investment in transportation equipment to rebound from the currently depressed levels not seen since the 1970s in real terms.  Industry, however, suffers from huge levels of excess capacity.  Many sectors of manufacturing got hammered as a whole in the downturn, and had only been skating sideways at best during the expansion of the 2000s.  The most successful manufacturing sectors in the 2000s were high tech, med tech and defense / aerospace which should all continue to thrive, in addition to housing related sectors like wood products, non-metallic minerals, furniture, appliances and fabricated metal products which are highly unlikely to thrive in the intermediate term.  Much of the rebound in manufacturing to date (again, outside of high tech) has been limited to cars, chemicals and steel bouncing from extremely depressed levels to just merely depressed.

Residential real estate investment has clearly bottomed and has added modestly to GDP in the last two quarters.  As a percent of GDP, however, it is at the lowest level since World War II.  Commercial real estate investment continues to plunge, which can be expected for another couple of quarters before bottoming out at record low levels of GDP as well.  Credit conditions, slowing demographics and recent over-investment will all conspire to keep real estate investment at record low levels for at least the intermediate term.

The huge excess capacity in construction workers and construction-related manufacturing leads me to continue to stress how beneficial it would be to focus additional stimulus on infrastructure spending.  These workers can not easily be retrained for health care, education and high tech office jobs.  The country has been behind on such spending anyway, so it would not be Japan-style "bridge-to-nowhere" investment as long as Congress can be reined in.  For this reason I like the "infrastructure bank" idea that takes some of the planning out of the hands of Congressional pork-meisters.

US Indebtedness as a percentage of GDP actually declined in Q3 from 359% to 355%, due primarily to a decline in financial sector debt.  Household and business debt each declined in Q3 as well, but were offset by an increase in US government debt, which increased to 53%, up from 36% at the start of the recession.  In general, I expect this trend continued in Q4 as well, as the US offsets private deleveraging with public borrowing.

In conclusion, the strong parts of the economy (high tech, aerospace, health care and education) are now in expansion mode, and the extractive industries (farming, mining, energy) are likely to join soon.  Those manufacturing sectors exposed to export markets like industrial equipment (think Caterpillar) should resume growth as well unless there is a major economic crisis in the emerging markets.   "Old economy" manufacturing and real estate investment remain a problem and are likely to remain so without increased infrastructure investment.  The trick for policy makers is to transition from a period of broad stimulus to one of consumer and government belt-tightening while letting business investment, infrastructure spending and exports become the primary economic growth drivers.  It would be a neat trick, indeed.

Year End 2009 Market Update

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In 2008 and 2009, I honed and refined my market valuation model for equities and bonds. It has been such a wild ride that it has been very hard to interpret. By just trying to ride the bucking bronco that was the financial market of 2009, I have actually learned a great deal.

S&P 500

One great roller coaster has been S&P inflation-adjusted earnings.

From 2003 to 2004 we saw the great spike in earnings, driven particularly by financial earnings and energy earnings. Annual nominal earnings got as high as $81.96 in 2006 and fell to as low as $14.88 in 2008 (the fourth quarter of 2008 was negative due to all of the bank write-downs). Earnings rallied to $49.26 in 2009 and are projected to reach $66.99 by 2011. (Projections by S&P, top-down as-reported.)

The other was the change in the market’s long term inflation assumptions, which were at 2.5% in August 2008 when I first set up my equity market valuation model, fell to 1% by November 2008 during the financial crisis, and are now back up to 2.7%. Obviously, the S&P swung around a lot, too. It fell from 1,267 in August 2008 to 680 in March 2009 (a 46% drop), and is now back up to 1,137 (a 67% rally).

The chart below shows how the changes in equity prices (and thus yields) and inflation assumptions have affected the projected return of my valuation model. (Calculated at the various dates on which I have written about the model on the blog…for a list of these posts see here.) I use a 50% payout ratio assumption to calculate the implied yield on trend earnings, which is in line with the historical ratio.

From these numbers it’s somewhat clear that the equity market has been targeting a 7% return during this period. A 7% nominal return on the equity market equates to a 5% premium to the 10-year treasury bond on an after-tax, inflation-adjusted basis, which is in line with the historical equity risk premium.

If you think that the 2.7% 30-year inflation assumption embedded in today’s treasury yield curve is correct, then today’s equity market is fairly valued. As I’ve repeated many times, I believe that in the medium term (5-15 years) the US may struggle with deflation, in which case we could see the market retest the lows when we have the next recession and the inflation assumption falls back under 2%. In the short term, however, the equity party rolls on as the economic expansion gains steam.

Fixed Income

Using the yields of various Vanguard Funds and the treasury yield curve from PIMCO’s website, I get the following yields vs. their respective equilibrium yields:

According to this methodology, TIPS are moderately overvalued, long treasuries are fairly valued, and long-term inflation is overstated. Intermediate and long term muni bonds are roughly fairly valued and corporate bonds are mostly overvalued. Yields on the short end of the curve for all types of bonds are way below their equilibrium levels.

For fixed income, the risk lies in corporate bonds. Unless you are in the “hyperinflation” camp, treasuries and munis are an ok value, but uninspiring and at risk to a crisis in which interest rates go haywire, which is highly possible (see below).

The Dollar

The dollar against major currencies is in its long term downtrend range of 70-80:

The real dollar index against all currencies is also in its long term range of 85-95:

The dollar may drift somewhat higher this year, but there is no reason to expect it to trade out of its trend range. Generally, when the dollar is fairly valued against other currencies, it is good for exports and emerging markets.

The dollar has continued to fall against the neutral currency of gold:

In the mid-1980s to mid-1990s, the dollar had settled into a nice range around $375-400 per ounce of gold. The gold price fell during the strong dollar era of the late 1990s. It broke above $400 / ounce in 2005 and hasn’t looked back since. The reason that gold has risen so much faster than the dollar has fallen against other currencies, is that all currencies are falling against gold. It is hard to know when and where this trend will stop. I suspect it has something to do with the currency reserve-building practices of China, the Middle East, et al, which have been artificially holding down interest rates relative to the rate at which the money supply (and financial debt) has been expanding. When this practice finally unwinds…which it will someday, probably by the middle of this decade…watch out for the “final crisis of bubble capitalism”.

Commodities

The oil / gold ratio is right about at its historical average, meaning oil is fairly valued given the debased value of the dollar relative to gold.

The CRB futures index, which tracks commodities generally, is actually well below its equilibrium value relative to gold:

This implies commodities could continue to rally strongly as long as the economy is spurting forward.

Conclusion

Outside of a trade in commodities, the market has no obvious pockets of value overall. The macroeconomic risk looming over the horizon (2012?) is foreboding, even if it can’t be felt now. The great bubble of money seems to be flowing to emerging markets, which is in turn flowing into the bubble in developed market deficit spending. If I had to guess now…I think the next great crisis will be in the Chinese banking system, which could result in them selling off their currency reserves, which would spike interest rates and cause a deflationary crisis in the US…but would also finally rebalance the world economy and lay the groundwork for renewed, sustainable growth.

Good luck and be safe.

Tyler Newton is not a financial adviser. He is only writing these posts for personal interest. Please be sure to consult with your financial advisor.

2010 Economic Outlook – A strong first half

tylerdynamist3 Comments

In my 4-part 2009 economic outlook, I stated my belief that I thought that the US economy was at a key long-term inflection point. The first two installments dealt with the long-term problems facing the US, namely that US economic policy is geared toward promoting consumption and residential housing investment, leading to chronic trade deficits and the resultant high US indebtedness, and that this trend has probably run its course. The second two installments posited that the bursting of the real estate bubble would result in $1.8 trillion of bank losses and that the banking system would be hobbled without offsetting injections of capital, which could delay the recession’s end into early 2010.

The obvious problem is that dealing with the short term issues surrounding the collapse of the housing bubble and the associated damage to the financial system almost by definition postpones dealing with our long-term structural issues. The corollary is that policies designed to fix America’s long-term problems would inflict major short-term damage on a global economy that is geared toward American consumption and housing investment. The world will need wise leaders that can thread the needle by providing short-term economic support while moving together toward long-term sustainability. The problem is that such a shift would probably require the US (and the UK, Ireland, Spain, etc.) to endure a soft depression similar to what has been endured by Japan and Germany for the past 15 years. The US electorate is less docile than the Japanese, however, and is more likely to take a more active role in shaping economic policy in a way that put the interests of the United States above that of the global economy as a whole. So while 2010 is likely to be a pretty good year for the US economy, I expect the “Tens” to be a volatile, crisis-laden decade.

Real estate vs. everything else. We should make no mistake that the financial panic of 2007-2009 was centered around the housing bubble. The housing bubble was aided and abetted by just about the entire globe. The US government encouraged it, foreign governments encouraged it, conservatives encouraged it and liberals encouraged it. The US government encouraged it with tax deductions (encouraged by conservatives and liberals) and with direct subsidies (encouraged mostly by liberals). The US financial system encouraged it by getting the math wrong on derivatives and securitizations (abetted by conservatives that relaxed banking regulations). The bubble was abetted by foreign central banks that created trade surpluses by recycling dollars from abroad into US agency securities. The bubble was also abetted by the US Fed, which printed money in response to the fallout from the tech investment bubble of the late 1990s. Since banks have become “universal” in services, particularly the money center banks in New York, the collapse of housing finance and the associated large losses restricted the availability of capital for everything else: auto and credit card receivables, business loans, commercial paper, municipal finance, buyout loans, venture capital. Without action to stop the banking panic, the entire financial system would have collapsed in a “vicious cycle” of debt deflation.

The financial crisis recedes. The government executed on a good strategy to stem the collapse of the banking system. The combination of the $245 billion invested in banks under TARP, the $1 trillion expansion of the Fed’s balance sheet, the $200+ billion of private capital that has been raised, the $350 billion of Federal debt guarantees, an unlimited backstop for Fannie Mae and Freddie Mac, high bank profits from the steep yield curve and the suspension of mark-to-market accounting rules stopped the debt deflation cycle. As a result of all of these actions, the equity and credit markets began to rise again around the end of March. The old-fashioned financial panic that had pulled the economy down so hard in the fourth quarter of 2008 and the first quarter of 2009 was over. The “second derivative” of economic growth bottomed in the second quarter and GDP returned to positive growth in the third quarter.

The collapse in the demand for credit. I last year’s economic outlook I erred in thinking that stopping the banking system collapse was primarily what was needed to “normalize” the economy. I was focused on the fact that there was a shortage of the supply of credit. What I missed was that there was (and still is) an epochal decline in the demand for credit as well. US consumers, realizing that the “free lunch” of rising real estate collateral has come to an end, have logically pulled in their horns. US household indebtedness has fallen by $255 billion from its peak in the second quarter of 2008 to the third quarter of 2009. While that sounds like a lot, it is only a 2% decline from the more than $13.8 trillion peak. Household debt as a percent of GDP has declined from 97% at the depth of the recession to 95% in the third quarter. Household debt was only $7.3 trillion and 73% of GDP at the trough of the 2001 recession, so there is more room to the downside. In addition, financial sector debt has declined by over $1 trillion since the fourth quarter of 2008, from a peak of about 120% of GDP to 113% of GDP.

The effect of the stimulus. As I discussed in my November 4th post Government Deficits are Necessary (for now), the huge surge in private sector saving to 10% of GDP in 2009 from -4% in 2006 has resulted in a nearly $2 trillion drain of demand from the world economy. There were similar swings in Spain, Ireland and the UK. All of the US, UK, Spain, Ireland and Japan are making up for the loss of private demand by running government deficits in excess of 10% of GDP. The wide trade deficits of the US, UK and Ireland have shrunk significantly. These government deficits are not “crowding out” private investment. If they were, treasury rates would be above their equilibrium rates, whereby the treasury would be competing with private demand, which they are not currently. The fact that we are running a trade deficit of 2.8% of GDP means that we are still pulling more than our share of the weight of global demand, but this is an improvement from the trade deficits of around 6% of GDP at the height of the housing bubble in 2005-2006.

Transition to “normalization”. In 2010 we will see if the economy can transition to normalization in a way that allows for a sustainable expansion. The demand for private credit will continue to be weak. The housing market is not likely to work off its excess until 2011, which hobbles consumer finance in general. In addition, (much needed) banking regulations will likely be passed in 2010, which will require greater capital cushions and suppress the expansion of financial sector debt. Businesses have ample cash flow to self-finance investment and hiring, however, which should in turn help consumer spending by increasing incomes. Government transfers are also helping consumer spending and direct government stimulus spending will add to demand for the first two quarters of 2010. Without the downward pull of the financial panic, the economy should at the very least get a nice cyclical bounce back to “normal” levels of output in sectors not related to housing. GDP growth could get a boost to over 4% in the fourth quarter of 2009, just by virtue of a halt to the decline in business inventories. Auto and chemical production has been increasing and the new economy sectors of IT and health care will resume growth. Aircraft production (the US’s biggest export) should start ramping up, as well.

Durable manufacturing. In 2009 US manufacturing capacity utilization averaged 66%, while output plunged 14% from 2007 to 2009. Much of the decline was in the volatile durable goods area. At the 2007 peak, US durable goods manufacturing was 16% higher than the late 1990s peak, but has since declined by 19%. Industry groups that saw increases in output in the 2000s vs. the late 1990s were “new economy” sectors like computer and electronic products (which nearly doubled production from 1999 to 2007), medical devices and aerospace, as well as housing-related sectors like wood products, non-metallic mineral products, furniture and fabricated metal products. The new economy sectors have an average capacity utilization of 69% today, down from around 80% at the peak, with production down an average of 9%. We should expect to see these sectors ramp back relatively quickly over the next year or two. The housing-related sectors, on the other hand, have seen their capacity utilization fall to an average of 58%, down from around 82% at the peak (in 2006), with production down 31% on average. The truly sickening declines came in motor vehicle and primary metal production, which fell by around 50% from 2005 peak to 2009 trough. Both have since snapped back by 30-40% after the “cash-for-clunkers” program cleared auto inventories and the auto financing markets were stabilized. Motor vehicle capacity utilization stands at only 53% (up from 37%!) and primary metal utilization is at 59% (up from 45%). While an infrastructure-focused stimulus program could quickly bring primary metal production up to pre-crisis levels, auto manufacturing capacity will likely shrink a great deal. A large chunk of the US manufacturing base related to housing and autos has been permanently impaired by the long-term declines in auto production and housing investment.

The excess capacity problem. The problem of excess capacity is not limited to the United States. China, Japan and Germany run chronic trade surpluses, meaning their production exceeds domestic demand as a matter of course. While the cyclical decline in capacity utilization will reverse with the help of global stimulus, the structural excess capacity in Chinese, Japanese and German “old economy” manufacturing and in housing-related sectors in the US and the EU periphery will not go away anytime soon. The way out is known (an increase in domestic Chinese demand), but if the Chinese don’t muster the political will to reverse their mercantilist trade policies, other remedies may end up being put in place (US tariffs) that will do more to upset the global economic order. Instead, the current Chinese stimulus program is geared toward infrastructure investment, increasing production capacity, while they continue to build currency reserves, suppressing demand for imports and contributing to global excess savings.

Is deflation still a threat? When the world suffers from excess capacity, the threat of deflation is real. The developed world is awash in deflation, but deflation has been offset by the rampant printing of paper currencies. Reserve-building countries in Asia are fighting developed country currency depreciation and artificially holding down sovereign interest rates. The safety valve has been the rising price of gold. The US dollar has fallen roughly 66% against the value of gold since the late 1990s boom, while the Euro has fallen 48%. The US dollar has fallen only 22% against the basket of consumer goods represented by the CPI. This means the market is anticipating significant currency debasement as an antidote to the deflationary undertow.

So what does this all mean for 2010? It is key to remember that it is natural for the economy to grow. Recessions are caused by the sudden restriction of credit, whether it’s induced by the Fed or by a banking panic. With the banking panic over, the resilient parts of the economy will resume growth. That means technology, health care, aerospace, mining, agriculture, oil & gas, chemicals, leisure and hospitality services will resume their upward trends. Non-housing-related durable goods manufacturing will have a nice cyclical recovery. Productivity growth will be monstrously high, and we are likely to see several quarters of 3.5%-4.5% growth. Housing, retail and finance are likely to remain problem areas as the market works off excess capacity. The good news for GDP growth is that housing investment has probably bottomed at the lowest level relative to GDP since World War II (down to 2.6% of GDP from a high of 6.1% of GDP).

The trillion-dollar question will be whether business investment will be in a position to take the baton after the effects of government stimulus and inventory restocking begins to fade in the second half of 2010. Signs to look for will be manufacturing capacity utilization jumping to the mid-to-high 70s, a move to a positive change in business inventories, and a continued decline in the trade deficit.

Policy debates will continue to be interesting, with financial reform and climate change legislation on deck for early 2010. In addition, if economic growth is as rapid as I expect, we will likely see rising interest rates in the middle of the interest rate curve and a debate around a deficit-reduction package that will consist largely of tax hikes. The 2010 elections will likely be fought largely on the ground of tax and spending policy. With the Bush tax cuts expiring in 2011 and huge projected budget deficits, it should be quite a show. I project that as usual the US electorate will make the right choice…it just isn’t clear yet what’s the right choice.

It should be a fascinating ride. Happy New Year!