Posts Tagged ‘Post War’
Wednesday, July 11th, 2012
Could “Confidence” Add 50 Percent to the Stock Market?
by James Paulsen, Chief Investment Strategist, Wells Capital Management
Fear (a lack of confidence) has dominated the economic and investment climate since the 2008 crisis. Indeed, excessive fears during the crisis likely accentuated the magnitude of the economic collapse far more than did poor economic fundamentals alone. Similarly, the inability to revitalize confidence since has also hampered both the economic and stock market recoveries.
A culture devoid of confidence has proved a chronic liability during the last five years. However, could a slow but steady revival in confidence soon become a primary asset driving stock prices higher? For a third time in the post-war era, since 2008, the U.S. stock market has traded below its long-term trendline level (that is, the level of the stock market if it rose through time at a constant pace equal to its long-term average return). While the slope of the stock market’s trendline tends to approximate the sustainable earnings growth rate, the degree to which the stock market trades above or below its trendline level has depended primarily on economic confidence. As shown below, should confidence simply rebound to a normal recovery level in the next several years, the return of the U.S. stock market may be boosted by 50 percent!
Post-War U.S. Stock Market vs. Trendline
Charts 1 and 2 compare both the U.S. stock market and U.S. corporate earnings relative to their respective post-war trendline levels. In each case, the trendlines are calculated by a simple regression of the (natural log) level of the stock market or profits against time. The slope of each trendline is a proxy for the average annualized growth rate over the entire period. Not surprisingly, since stock prices respond to earnings, the trendline slope of corporate profits and of the U.S. stock market are nearly identical at about 7 percent. And, 7 percent is very close to the annualized growth in nominal GDP—since 1949, nominal GDP growth has averaged about 6.7 percent overall. Essentially, over long periods of time, earnings cannot grow faster than overall economic growth and the buy and hold price only return from the stock market approximates the long-term pace of earnings growth.
Is Historic Earnings Trendline a Good Guide to Future?
In the post-war era, the annualized total return from stocks has been about 11 percent comprised by about 7 percent earnings growth and about 4 percent dividend returns. As shown in Chart 1, however, in the last decade, the stock market has significantly trailed relative to its trendline. Is the old trendline growth rate of about 7 percent still a reasonable expectation for the future?
Certainly, U.S. balance sheets are more leveraged today and the savings rate has been far lower in recent years compared to earlier in the post-war era. Moreover, aging U.S. demographics almost ensures slower labor force growth in future years (a moderating force for overall economic growth) unless immigration policy is considerably liberalized. Alternatively, in the last couple decades, the global economy has created a fabulous new economic growth booster—functioning emerging world economies! So far, these new economic entities have mainly augmented supply capabilities but several are on the cusp of becoming burgeoning middle class economies which should dramatically boost global demand and perhaps help maintain global economic growth rates even as developed economies age.
Most encouragingly, however, as shown in Chart 2, U.S. earnings continue to follow the long-term trendline established throughout the post-war era. Despite noticeably slower average GDP growth in the U.S. since 1985, earnings growth has continued to approximate its historic long-term trendline. Indeed, despite the pronounced and ongoing concerns surrounding the contemporary recovery, U.S. earnings bounced quickly above trendline after the recession and have since risen in line with trendline growth. Overall, earnings show no signs yet of breaking below long-term results suggesting the long-term trendline for the stock market may remain near post-war norms.
The Valuation of the Earnings Trend
Although stocks are ultimately tethered to earnings, in the short-run, the stock market often trades at a premium or discount to its trendline. As illustrated in Chart 1, the difference between the stock market and its long-term trendline is a good proxy for investors’ valuation of the long-term earnings trend. Since 2008, for the third time in post-war history, the U.S. stock market has traded persistently “below” its trendline. This also occurred after WWII until the mid 1950s, and again between the early 1970s until the late 1980s.
This is also illustrated in Chart 3. What causes investors to value the earnings trend sometimes at a 25 percent (or more) premium and sometimes at a 25 percent (or larger) discount? Certainly, multiple factors comprise this complicated valuation. During the late 1940s, the discount to trendline seemed to be driven by a post-war inflation surge, in the 1970s escalating inflation and interest rates appeared to lower valuations, and in the contemporary period persistent anxieties surrounding the potential for a global financial calamity have dominated. By contrast, the huge premium paid by investors for trendline earnings in the 1960s coincided with attitudes reflected in the “Camelot Kennedy Years” while the record-setting premium valuation reached in the late 1990s was a product of a “new-era” mania.
Confidence & Valuations
As shown in Chart 4, the discount or premium valuation of the stock market relative to its trendline is perhaps best explained by economic “confidence.” This chart overlays the percentage differential of the stock market relative to its trendline with the consumer confidence index. Although not a perfect relationship, the level of confidence has done a good job tracing changes in the “valuation of the earnings trend” during the post-war era.
Since at least 1950, premium and discount valuations of the stock market to its trendline have corresponded closely with periods of strong economic confidence and periods of broad economic fear. Currently, U.S. economic confidence is hovering in the lowest quartile of its post-war range and the U.S. stock market is about 25 percent below its trendline. This is not a coincidence. As was the case in the late 1940s, early 1950s, and again in the 1970s, early 1980s, a slow but steady revival in U.S. confidence could represent the biggest driver of stock market performance in the next several years!
An Investment Possibility?
The confidence index illustrated in Chart 4 has oscillated between about 60 and 110. With the exception of the late 1990s when the index briefly reached above 110, “normal” economic recovery confidence peaks have been around 100. Stock investors should consider what could happen should confidence slowly recover to normal again in the next five years eventually reaching a level between 95 and 100. Using history as a guide (reading across to the left scale in Chart 4), if confidence returns to normal, the stock market would likely trade at a 25 percent to 30 percent premium to its trendline level.
Of course, in five years, the stock market trendline level will also be higher. If the historic trendline growth rate remains a good guide for the future, the trendline (the dotted line) in Chart 1 would rise by about 7 percent a year in the next five years suggesting a trendline by 2017 of about 2425. However, to be conservative, assume in the next five years trendline earnings only grow at a pace of 3 percent, significantly “less” than the long-term trendline growth rate of 7 percent. Currently, the S&P 500 trades at about 1350 and its trendline level (from Chart 1) is about 1800 (i.e., 25 percent higher than the S&P 500 current price of 1350). With these assumptions, the stock market trendline would rise by 16 percent in five years to about 2100!
Finally, from Chart 4, assume confidence improves from its current level to about 95 boosting the investor valuation of the trendline from its current 25 percent discount to about a 25 percent premium in five years. A trendline target in five years of about 2100, combined with a valuation premium of about 25 percent implies a target price for the S&P 500 of about 2600—nearly a double from today’s level!
While we are not forecasting a doubling of the stock market during the next five years, this analysis does highlight the longer-term upside potential from stocks which exist today solely because of widespread cultural fears. Chart 3 shows the stock market has a historical tendency to oscillate between periods of glee and gloom.
The eventual impact of the Great Depression and WWII on investor attitudes kept the stock market selling at a discount until the late 1950s. By contrast, the cultural euphoria which swept the country during the baby-boom years kept stocks oscillating about a 25 percent premium between the late 1950s and the early 1970s. The stock market could be bought at a 60 to 70 percent discount in the 1970s when runaway inflation and interest rates destroyed confidence. Twenty years later in the late 1990s, investors could not buy stocks fast enough in the “new-era” even though they paid a 60 to 70 percent premium! Since 1945, two bouts of cultural glee (1960s and 1990s) subjected investors to significant risks while recurring bouts of cultural gloom have treated investors with three remarkable “fire sales”—1940s, 1970s, and “today”! Stock prices will continue to oscillate and scary sell-offs will occasionally feed fears, but don’t miss this sale!
Tags: Chief Investment Strategist, Corporate Earnings, Corporate Profits, Earnings Growth, Economic Collapse, Economic Confidence, Economic Fundamentals, Investment Climate, Lack Of Confidence, Post War, Simple Regression, Slope, Steady Revival, Stock Earnings, Stock Prices, Third Time, Trendline, Trendlines, U S Stock Market, Wells Capital Management
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Monday, July 2nd, 2012
by John Hussman, Hussman Funds
In the first week of March, the U.S. stock market established a set of conditions placing it among the most negative 2.5% of historical observations (see Warning: A New Who’s Who of Awful Times to Invest) – a short list that includes the major peaks of 1972-73, 1987, 2000, and 2007. Since then, we’ve seen an increasing set of indicator syndromes that are associated with historically hostile market outcomes, maintaining us in a hard-defensive stance that is as rare as it is imperative. Last week, the market reconfirmed the “exhaustion syndrome” that I discussed several months ago (see Goat Rodeo). Prior to 2012, there were 112 weeks in post-war U.S. data where our investment strategy would have encouraged a similarly defensive position with that syndrome in place. Following those instances, the S&P 500 plunged at an average annual rate of -47.5%.
The trend-following components of our market action measures remain negative here, but it is important to note that those components are moderately – probably a small number of positive weeks – away from an improvement that could shift us from such a tightly defensive stance. While our outlook would not become bullish by any means, this shift would rein in the “staggered strike” put option hedges we presently hold in Strategic Growth. These positions (which raise the strike prices on the long-put portion of our hedges) substantially improve performance during market plunges, but make us vulnerable to the loss of put option premium during “risk on” advances such as we saw last week. That is uncomfortable even if the puts only represent a very small percentage of assets (as they do here).
Suffice it to say that we are most likely a single number of weeks away from either substantial market losses, or enough stabilization in market action to ease our defensiveness. In any event, we will not maintain our present stance indefinitely.
So far, hopes for massive bailouts and monetary interventions have allowed the market to forestall the more violent follow-through that it experienced in 1973-74, 1987, 2000-2002 and 2007-2009 from similar conditions. Yet the market impact from various monetary actions has become progressively weaker, and the exuberance from various “agreements” out of Europe has become progressively shorter. More importantly, in data spanning more than a century, including Depression, two world wars, rapid inflation, credit crisis, and numerous bubbles and crashes, we’ve seen that relevant global events show up in observable data such as market action, credit spreads, valuations, economic indicators, sentiment, and specific syndromes of conditions. As a result, we don’t need a “Euro breaks up” indicator, or a “Bernanke bubble factor” in our data set, nor do we need a live feed showing constantly refreshed CT-scans of Angela Merkel’s spine.
When the observable data shifts, so will our investment stance. We certainly struggled in 2009 and early 2010 to ensure that our methods were robust to Depression-era data, and the repeated bouts of monetary intervention have narrowed our criteria for establishing staggered-strike hedges, becoming more sensitive to trend-following factors than was necessary prior to 2009. The past few years would have been more comfortable if these adaptations had not been necessary, but they also leave us well-prepared to weather a broad range of potential outcomes, in the expectation of returns that resemble what we’ve achieved in other complete market cycles (e.g. peak-to-peak 2000-2007, trough-to-trough 2002-2009). Both the internet bubble and the housing and credit bubble offered plenty of temptation to believe in a “new era” where historically important market factors were irrelevant. The same temptation exists today despite accelerating global economic challenges. We remain just as unwilling to shift our investment discipline away from testable evidence, or to rely on a blind faith in policymakers to make risk simply go away.
Anatomy of a Bear
Last week, the market re-established the “exhaustion syndrome” that we observed several months ago. The associated rally was uncomfortable, not only because banks and financials advanced (where we hold very little exposure), but also because the advance took our staggered strike put option hedges from in-the-money to out-of-the-money while the CBOE volatility index dropped to just 17. It is easy to forget that we experienced much the same thing near the 2000 and 2007 market peaks. As I noted in the March Who’s Who piece: “A word of caution… When we look at longer-term charts like the one above, it’s easy to see how fleeting the intervening gains turned out to be in hindsight. However, it’s easy to underestimate how utterly excruciating it is to remain hedged during these periods when you actually have to live through day-after-day of advances and small incremental new highs that are repeatedly greeted with enthusiastic headlines and arguments that ‘this time it’s different.’ For us, it’s particularly uncomfortable on days when our stocks don’t perform in line with the overall market, or when the ‘implied volatility’ declines on our option hedges.”
Though our level of defensiveness will remain sensitive to any improvement in our measures of market action, my opinion remains that the global economy is entering a new recession, and that stocks are already in the beginning of a bear market. Because bull and bear markets can only be confirmed in hindsight, we prefer in practice to focus on the broad set of observable evidence at every point in time. Our investment stance is based on that evidence, not my views about recession or bear market status.
As veteran market analyst Richard Russell has noted, investors often equate the concept of a bear market with the expectation that prices will continuously fall. Indeed, if you think back to the 2000-2002 bear, or the 2007-2009 bear, that is probably the memory that those bear markets invoke. In fact, however, those bear markets can be seen on a smaller scale as a constant process of hope and disappointment, with periods of risk-seeking abruptly punished by fresh waves of risk-aversion. This can make it very difficult to live through a bear market day-after-day with a clear sense of the larger picture.
In an attempt to reinforce this picture, the following charts present the initial the 1973-74, 1987, 2000-2002, and 2007-2009 bear markets, respectively. For each period, the initial portion of the bear market is on the left side, while the complete decline is on the right side. Those complete declines represented market losses of about 50% from the highs, except for 1987 which was more abrupt but somewhat less extensive. The final chart shows the S&P 500 from early March through last week. Notably, each of those previous bears started from conditions that match the “Who’s Who” syndrome we observed in March of this year. The feature to notice about these early bear markets is that in each case, despite a hard initial decline, the market recovered within a few percent its bull market high at some point between 2-9 months after the bear market had already started. In effect, investors mounted an “exhaustion rally” despite already deteriorating market internals and rich valuations.
The unusually bad outcomes of similar historical precedents help to convey why we retain such a durable sense of doom, even after last week’s scorching “risk on” advance. Again, a moderate continuation of constructive market action would likely be sufficient to move us to soften our presently hard defense by retreating from a “staggered strike” option hedge. At present, conditions remain aligned with those that have preceded some of the most negative consequences in market history.
On Europe’s Plan to Have a Plan to Have a Memo of Understanding
The following is Friday’s statement from the EU (emphasis added):
“We affirm that it is imperative to break the vicious circle between banks and sovereigns. The Commission will present Proposals on the basis of Article 127(6) for a single supervisory mechanism shortly. We ask the Council to consider these Proposals as a matter of urgency by the end of 2012. When an effective single supervisory mechanism is established, involving the ECB, for banks in the euro area the ESM could, following a regular decision, have the possibility to recapitalize banks directly. This would rely on appropriate conditionality, including compliance with state aid rules, which should be institution-specific, sector-specific or economy-wide and would be formalised in a Memorandum of Understanding. The Eurogroup will examine the situation of the Irish financial sector with the view of further improving the sustainability of the well-performing adjustment programme. Similar cases will be treated equally.
“We urge the rapid conclusion of the Memorandum of Understanding attached to the financial support to Spain for recapitalisation of its banking sector. We reaffirm that the financial assistance will be provided by the EFSF until the ESM becomes available, and that it will then be transferred to the ESM, without gaining seniority status.
“We affirm our strong commitment to do what is necessary to ensure the financial stability of the euro area, in particular by using the existing EFSF/ESM instruments in a flexible and efficient manner in order to stabilise markets for Member States respecting their Country Specific Recommendations and their other commitments including their respective timelines, under the European Semester, the Stability and Growth Pact and the Macroeconomic Imbalances Procedure. These conditions should be reflected in a Memorandum of Understanding. We welcome that the ECB has agreed to serve as an agent to EFSF/ESM in conducting market operations in an effective and efficient manner.
“We task the Eurogroup to implement these decisions by 9 July 2012.”
The upshot here is that Spain’s banks are undercapitalized and insolvent, but rather than take them over and appropriately restructure them in a way that requires bondholders to take losses instead of the public, Spain hopes to tap European bailout funds so that it can provide capital directly to its banks through the European Stability Mechanism (ESM), and put all of Europe’s citizens on the hook for the losses. Spain has been trying to get bailout funds without actually having the government borrow the money, because adding new debt to its books would drive the country further toward sovereign default. Moreover, institutions like the ESM, the ECB, and the IMF generally enjoy senior status on their loans, so that citizens and taxpayers are protected. Spain’s existing bondholders have objected to this, since a bailout for the banks would make their Spanish debt subordinate to the ESM.
As a side note, the statement suggests that Ireland, which already bailed its banks out the old-fashioned way, will demand whatever deal Spain gets.
So the hope is that Europe will agree to establish a single bank supervisor for all of Europe’s banks. After that, the ESM – Europe’s bailout fund – would have the “possibility” to provide capital directly to banks. Of course, since we’re talking about capital – the first buffer against losses – the bailout funds could not simply be lent to the banks, since debt is not capital. Instead, it would have to be provided by directly purchasing stock (though one can imagine the Orwellian possibility of the ESM lending to bank A to buy shares of bank B, and lending to bank B to buy shares of bank A). On the question of whether this is a good idea, as opposed to the alternative of properly restructuring banks, ask Spain how the purchase of Bankia stock has been working out for Spanish citizens (Bankia’s bondholders should at least send a thank-you note). In any event, if this plan for a plan actually goes through, the bailout funds – provided largely by German citizens – would not only lose senior status to Spain’s government debt; the funds would be subordinate even to the unsecured debt held by the bondholders of Spanish banks, since equity is the first thing you wipe out when a bank is insolvent.
It will be interesting to see how long it takes for the German people to figure this out.
It bears repeating that our present defensiveness is not a reflection of European concerns or even our view that the U.S. economy is entering a recession. We try to align our investment position with the prospective return/risk profile that we estimate on the basis of prevailing market conditions, and those conditions are what keep us tightly hedged here. As noted earlier, a moderate further recovery in market internals would move us to reduce the tightness of our hedge, though it’s fair to say that the required improvement is not simply a stone’s throw away and would likely require at least a small number of positive weeks. Here and now, present conditions remain among the most negative in history from a prospective return/risk standpoint. Strategic Growth Fund remains tightly hedged, with a staggered strike position where the additional put option premium at risk represents about 1.8% of total assets. Strategic International also remains fully hedged, and Strategic Dividend has nearly 50% of its stock holdings hedged (its most defensive stance). Strategic Total Return continues to carry a duration of about one year, with about 14% of assets in precious metals shares, and a small percentage of assets in utility shares and foreign currencies.
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Tags: Action Measures, Anatomy, Defensive Position, Defensive Stance, Defensiveness, Exhaustion, Goat, Hedges, Hussman, Hussman Funds, Investment Strategy, John Hussman, Market Losses, Market Outcomes, Market Plunges, Post War, Put Portion, Rodeo, Substantial Market, Syndromes, U S Stock Market
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Tuesday, March 20th, 2012
by James Paulsen, Chief Investment Strategist, Wells Capital Management (Wells Fargo)
Since 1945, the U.S. stock market has fluctuated between valuation and earnings cycles. Both the scope and scale of these recurring valuation/earnings cycles have been remarkably similar. As the S&P 500 rises above 1400 for the first time since 2008 and as the possibility of a new all-time record high lingers in the not too distant future, some insight may be gained by appreciating the repetitive nature exhibited by U.S. stocks during the post-war era.
The accompanying exhibit compares trailing four-quarter earnings per share to the S&P 500 Stock Price Index since 1945. As highlighted by the exhibit, the post-war U.S. stock market can be described by a recurring three-step cycle:
Stage 1. Earnings Production—Earnings surge while stock prices trend sideways over a series of years.
Stage 2. Getting Paid—A valuation-driven stock market whereby investors are finally “paid” for earnings previously produced. Stock market surges even though earnings per share trend sideways.
Stage 3. Traditional Run—A stage whereby both earnings and stock prices rise—i.e., a traditional earnings-driven stock market.
This historic cycle—earnings production, getting paid, and the traditional run—has already begun its third iteration of the post-war era. While each repetitive cycle has of course been unique, they all have shown a tendency to rhyme!
Post-War Cycle #1 – 1945 to 1970
After being roughly flat for more than 15 years (i.e., between 1930 and mid 1940s), earnings per share on the S&P 500 Index nearly tripled (from about $1 to almost $3) between 1945 and the end of 1950. Despite the fastest earnings growth of the post-war era, the overall stock market remained essentially flat during this period as country-wide confidence was extremely low in the aftermath of the Great Depression and WWII. These concerns and escalating post-war inflation combine to lower the priceearnings multiple (PE) during the “earnings production” stage of cycle #1.
In the next stage of the cycle (Getting Paid) lasting roughly from 1951 until 1961, the stock market rose 3.5-fold even though earnings per share flat lined. Essentially, confidence throughout the country was slowly resurrected and as fears subsided PE valuations rose steadily allowing investors to finally “Get Paid” for the earnings which actually were produced in the late 1940s.
Finally, the first post-war stock market cycle was capped by a “Traditional Run” stage lasting from the early 1960s until about 1970. During this final stage, the stock market simply followed earnings gains higher as both earnings and stock prices rose by about the same amount.
Post-War Cycle #2 – 1970 to 2000
Between 1970 and 1982, the S&P 500 Stock Price Index remained essentially unchanged despite an almost tripling of earnings per share (i.e., S&P earnings per share rose from about $5 to about $15— quite an “Earnings Production” stage)! PE multiples were cut by almost two-thirds during this period as the economy was overwhelmed by runaway inflation and surging bond yields.
In the “Getting Paid” stage between 1982 and 1994, the stock market surged by almost four times even though earnings rose only modestly and essentially trended sideways during the period. As the inflationary spiral broke in the early 1980s, inflation expectations slowly calmed, bond yields began a secular decline, and the PE multiple rose from about 8 times at the low in 1982 to about 22 times trailing earnings per share by early 1994.
In the last “Traditional Run” stage of post-war stock market cycle #2, both earnings and stock prices generated excellent results. Between mid 1994 and the peak in 2000, earnings per share rose about 2.5 times while the stock market rose by about 3.2-fold! Although PE valuations did continue to rise in this stage, most of the gain in stock prices was due to the technological-driven boom in earnings performance.
Post-War Cycle #3 – 2000 to ????
The contemporary stock market cycle, the third of the post-war era, began at the dot-com stock market peak in 2000. Since, although the stock market has trended sideways in a volatile range, earnings per share have demonstrated stellar results—almost doubling during this period from about $55 at the 2000 peak to nearing almost $100 today. Similar to the previous two stock market cycles, the last decade epitomizes the character of the “Earnings Production” stage.
Although the overall gain in earnings in the contemporary cycle is less than the near tripling of earnings which occurred both in the late 1940s and during the 1970s (although in both periods, earnings were assisted by faster inflation than has occurred since 2000), a near doubling of earnings with a flat overall stock market is still very reminiscent of stage 1. The question for investors is whether the contemporary stock market cycle (the third of the post-war era) will continue to exhibit a close similarity to the two previous cycles? For if it does, the “Earnings Production” stage is probably nearing its conclusion and the “investor reaping stages” (i.e., the “Getting Paid” and “Traditional Run” stages) may lie directly ahead!??
Concluding Comments, Speculations, and a Little Math?
History will not perfectly repeat itself. However, the stock market has exhibited a remarkable repeating cycle in the post-war era which should not be ignored. Already, the experience of the last “lost decade” looks amazingly similar to the character of the “Earnings Production” stage which occurred at the beginning of each of the last two stock market cycles.
In the 1970s cycle, the driving force behind the 1980s-1990s stock market bull run was a secular decline in bond yields. This catalyst is not available today since yields cannot decline any further. However, the “next couple stages” of the contemporary stock market cycle could rhyme closely with the 1950s-1960s stock market bull. In this instance, the primary catalyst was a slow but steady resurrection of economywide confidence after it was destroyed during the Great Depression and WWII. Even though interest rates rose throughout the 1950s-1960s era, the stock market continued to advance as valuations and earnings improved despite rising yields since confidence was rising from such depressed levels.
Could the 1950s-1960s stock market run be a potential blueprint for the next two stages of the contemporary stock market cycle? Similar to the aftermath of the Great Depression, today interest rates are near all-time record lows and simply cannot decline much further. Also, confidence in the early 1950s was cautious after the depression and the war just as it is today after 9/11, Iraq, and the Great Crisis of 2008. Like the 1950s-1960s bull, could a slow but steady resuscitation of confidence in the next several years provide the catalyst for another buy-and-hold era?
The next two stages may depart from the character of the last two stock market cycles. The contemporary cycle could be prematurely aborted by numerous problems including another financial crisis, a war or simply a renewed period of escalating inflation. However, if this cycle does continue to “rhyme” with the previous two post-war cycles what does some simple math suggest about possibilities?
Currently, share earnings on the S&P 500 are closing in on $100. If we soon enter “stage 2” of the stock market cycle (i.e., “Getting Paid” where earnings growth is subdued if it grows at all), earnings growth will likely prove very modest in the next several years. Assume earnings per share only rise at a pace slightly less than nominal GDP growth. And, further assume only a very modest 5 percent annualized gain in nominal GDP during the next five years (i.e., 2.5 percent inflation and 2.5 percent real growth). If earnings per share grow at an annualized pace of 4 percent during the next five years (i.e., 1 percent slower than nominal GDP), share earnings will be about $122. Finally, assume that with such modest (but sustained) growth in nominal GDP, the inflation rate and the 10-year bond yield remain low by historic standards. Under such assumptions, it seems likely confidence will be slowly restored (similar to the 1950s) as the Great Crisis of 2008 fades in memory and as the economic recovery persists leading to an eventual rise in the S&P 500 PE multiple. Assuming only a modest increase in the PE multiple during the next 5 years to around 17, the target price on the S&P 500 would be 2074. From the current level of around 1400, this would yield investors about an 8.2 percent annualized price return. Adding dividends would provide investors with a buy-and-hold total annualized return in excess of 10 percent!
Who knows what investors will face during the next five years? However, if the contemporary stock market cycle continues to rhyme with the past, perhaps investors can “dream a little” about the prospects of another period of “Getting Paid” and a “Traditional Run”!!?
Tags: Chief Investment Strategist, Cycle 1, Distant Future, Earnings Growth, Earnings Per Share, Great Depression, Mid 1940s, Post War, Quarter Earnings, Repetitive Cycle, Repetitive Nature, Stock Market Cycle, Stock Price Index, Stock Prices Rise, Third Iteration, Time Record, U S Stock Market, War Cycle, Wells Capital Management, Wells Fargo
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Monday, March 12th, 2012
The last time we plotted European youth unemployment in what was dubbed “Europe’s scariest chart” we were surprised to discover that when it comes to “Arab Spring inspiring” youth unemployment, Spain was actually worse off than even (now officially broke) Greece, whose young adult unemployment at the time was only just better compared to that… of the United States. Luckily, following the latest economic (yes, we laughed too) update from Greece, it is safe to say that things are back to normal, as Greek youth unemployment is officially the second one in Europe after Spain to surpass 50%. In other words, Europe’s scariest chart just got even scarier.
And so while the Greek economy is in tatters, following another downward revision to its GDP as reported last week, this time dragging Q4 GDP from -7.0% to -7.5%, that’s only the beginning, and it now appears that a terminal collapse of not just the Greek financial sector, but its society as well, has commenced, as the number of people unemployed in the 11 million person country is now 41% greater than its was a year ago. From Athens News:
The average unemployment rate for 2011 jumped to 17.3 percent from 12.5 percent in the previous year, according to the figures, which are not adjusted for seasonal factors.
Youth were particularly hit. For the first time on record, more people between 15-24 years were without a job than with one. Unemployment in that age group rose to 51.1 percent, twice as high as three years ago.
Budget cuts imposed by the European Union and the International Monetary Fund as a condition for dealing with the country’s debt problems have caused a wave of corporate closures and bankruptcies.
Greece’s economy is estimated to have shrunk by a about a fifth since 2008, when it plunged into its deepest and longest post-war recession. About 600,000 jobs, more than one in ten, have been destroyed in the process.
Things will get worse before they get better, according to analysts. “Despite some emergency government measures to boost employment in early 2012, it is hard to see how the upward unemployment trend can be stabilised in the first half of the year,” said Nikos Magginas, an economist at National Bank of Greece.
A record 1,033,507 people were without work in December, 41 percent more than in the same month last year. The number of people in work dropped to a record low of 3,899,319, down 7.9 percent year-on-year.
When will the Greeks ask themselves if the complete and utter destruction of their society is worth it, just to pretend that life as a European colony is worth living. Especially now that pension funds have been vaporized?
Tags: 24 Years, Athens News, Average Unemployment Rate, Bankruptcies, Budget Cuts, Collapse, Debt Problems, Downward Revision, Financial Sector, Greece Economy, Greek Economy, Greek Youth, International Monetary Fund, Post War, Q4 Gdp, Recession, Seasonal Factors, Tatters, Young Adult, Youth Unemployment
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Monday, January 24th, 2011
by John P. Hussman, Ph.D., Hussman Funds
This week’s comment focuses on the current, unstable stance of monetary policy. We’ll start by reviewing some important monetary relationships. While I’ve included a variety of graphs and equations to support the analysis, I’ve boldfaced several key points, and my hope is that the text has enough detail that you can skip some of the equations if you’re not a math fan.
One of the best known relationships in economics is the concept of “liquidity preference” – essentially money demand. Both theoretically and in actual data, there is a fairly tight relationship between short-term interest rates, and the amount of non-interest-bearing money that people are willing to hold, either directly as currency, or indirectly as bank reserves. Basically, the lower interest rates are, the more cash or reserves (“base money”) people are willing to carry around, per dollar of nominal GDP. As interest rates move higher, people naturally respond to the opportunity to earn interest by reducing the amount of cash they carry, both directly and indirectly.
You can see this relationship in the chart below, which plots the 3-month Treasury bill yield versus liquidity preference for base money. Though “liquidity preference” is often used to describe the broad demand for money, we will define liquidity preference more specifically here as the amount of base money demanded per dollar of nominal GDP. In post-war data, the lower bound for liquidity preference has been roughly 5 cents of base money holdings for every dollar of nominal GDP. With interest rates nearly zero at present, people are directly and indirectly holding much larger amounts of base money, currently slightly more than 13 cents for every dollar of GDP. The cluster of points at the extreme right of the graph are recent data. In a panic to hold cash, liquidity preference hit 15 cents at the height of the 2009 credit crisis.
By comparison, Japanese liquidity preference has historically ranged from a low of about 0.08 to a high of nearly 0.12 when interest rates have been pressed toward zero.
The idea of monetary “velocity” seems slightly more theoretical, but velocity is simply the inverse of liquidity preference: it measures the amount of nominal GDP per dollar of monetary base. Not surprisingly, the chart of velocity is a mirror image of liquidity preference.
The exchange equation
OK. So we’ve established that there is a clear relationship between money demand and interest rates. As it happens, there’s also a well-known relationship between money, velocity, output and prices, which is called the “exchange equation.” The exchange equation is actually just a simple identity. Notice that nominal GDP is just real GDP (“Y”) times the GDP price index (“P”). Velocity is equal to nominal GDP divided by the monetary base, so
V = PY/M
which is usually written
MV = PY
Although this is a simple identity, people like to tinker with one variable or another while incorrectly assuming that the other parts of the equation are simply constant. For example, people often assume that doubling the monetary base will simply double the price level, but that requires V and Y to stay constant, which is hardly an accurate assumption. Likewise, advocates of easy money seem to believe that increasing the money supply will buy you more economic output, but this requires holding V and P relatively constant.
If you look at the historical data, neither of these arguments hold a great deal of water. Rather, what seems to be true is that the strongest effect of an increase in the money supply is to drive short-term interest rates lower, thereby increasing liquidity preference (i.e. reducing velocity). So periods of very high growth in the monetary base are typically accompanied by nearly proportionate plunges in monetary velocity, without any strong effects on output or prices. As we’ll see below, that isn’t quite the whole story, but to a first approximation, the main effect of changes in the monetary base is to produce opposite and proportional changes in velocity.
From this perspective, there is little reason to expect the Fed’s policy of “quantitative easing” to have real effects on economic output. Thus far, quantitative easing has had the effect of increasing idle bank reserves by about $62 billion since September, with a slight downward impact on Treasury bill yields. On a seasonally-adjusted basis, the monetary base has increased by about $36 billion since September, but since the seasonal adjustment factor plunges in the first two months of the year as holiday cash demands subside, the seasonally-adjusted monetary base will spike by about $60 billion even if the Fed does nothing in the next two months.
Of course, QE2 has had additional effects on the financial markets, but these have not been driven by monetary factors. Instead, they are rhetorical, based on the view that somehow the Fed’s actions create a “backstop” that will prevent potential losses in risky assets. As Ambrose Evans-Pritchard has noted, “the Fed no longer even denies that the purpose of its latest blast of bond purchases, or QE2, is to drive up Wall Street, perhaps because it has so signally failed to achieve its other purpose of driving down borrowing costs.” Unfortunately, it is easy to demonstrate that the greater the volatility of a security or income stream, the smaller the “wealth effect” that can be expected from a given increase in value. Volatile dollars have less impact on consumption than smooth dollars, which is why housing values have historically had a much greater wealth effect than stock market values.
Moreover, people clearly believe that the additional reserves are flowing wildly into risk assets, pushing prices higher as if secondary markets are some sort of balloon to be filled (one second of reflection will establish that every dollar that goes “into” a secondary market in the hands of a buyer comes back “out” of the secondary market in the hands of a seller). The fact, however, is that these reserves are sitting comfortably in the banking system as idle balances.
As a study by the Bank of Japan of its own huge experiment with QE concluded, “While we can enumerate several routes of the monetary base channel which suggest that expansion of the monetary base can have some expansionary effect on the economy, our analyses suggest that the quantitative magnitude of any such effect is highly uncertain and very small.” [The Effect of the Increase in the Monetary Base on Japan's Economy at Zero Interest Rates - An Emprical Analysis, Bank of Japan, 2002].
In any event, it is clear that with regard to risky securities, the enthusiasm and rhetoric about QE2 has caused a reduction in the willingness of sellers to sell, and an increase in the eagerness of buyers to buy. That imbalance of eagerness between buyers and sellers has clearly affected prices of risky assets, but it does not generate new cash flows – it simply raises the valuation that the market places on existing streams of future cash flows, and thereby lowers the subsequent rate of return on holding those securities. I suspect this will end badly, but that’s not the topic of this discussion.
Quantifying monetary policy
So let’s review. Liquidity preference is simply the amount of monetary base that people are willing to hold, per dollar of nominal GDP. We’ve seen that this demand for base money is essentially a function of short-term interest rates. When interest rates are low, people are willing to hold higher cash balances. When interest rates are high, people tend to economize on cash balances.
Just a note – even if you hate math, it will help to skim the next few paragraphs, but feel free to skip to the next graph if you wish. After inverting velocity, taking logarithms, and doing other calculations that geeks find entertaining, it turns out that the liquidity preference function can be estimated fairly accurately. Using the 3-month Treasury bill (“i”) alone, the relationship in post-war data is well described by:
M/PY = .094 – .022 * ln(i)
which gives you an implied equation for the 3-month Treasury bill yield as a function of liquidity preference:
i = exp(4.27 – 45.5*M/PY)
An even tighter relationship can be obtained by including the value of liquidity preference six months earlier:
M/PY = .0327 – .0077 * ln(i) + .65 * (M/PY)_lagged_6_mos
which again gives you an implied equation for the 3-month Treasury bill yield as a function of monetary variables:
i = exp(4.25 – 129.87*M/PY + 84.42*M/PY_lagged_6_mos)
The foregoing parameters are based on standard scaling factors used for reporting the variables, so GDP are and monetary base are in billions, and T-bill rates are in standard format. For example, given a current monetary base of $2,000 (billion) and nominal GDP of about $14,900 (billion), the expected 3-month Treasury bill yield here would be roughly exp(4.27-45.5*2000/14900) = 0.1592, which is about right (presently, the Treasury bill yield is 0.16%).
Let’s take a quick look at the fit from these estimates. The chart below shows the actual velocity of the monetary base, along with estimated velocity. Notice that we’ve observed an enormous plunge in velocity over the past two years, which is fully consistent with the near-zero level of interest rates at present.
Of course, we can also invert this relationship. The chart below shows the actual level of the 3-month Treasury bill yield, along with the yield implied by monetary variables.
Pushing monetary policy to its unstable limits
But what about inflation? How is monetary policy related to prices?
Here is where things get really interesting. We’ve established that to a large extent, both liquidity preference and short-term interest rates respond fairly passively to changes in the monetary base. But of course, that’s not the whole story. Not every change in interest rates or liquidity preference is passive, and when there is an exogenous “shock” to those factors – watch out.
Let’s go back to the definition of liquidity preference (we’ll call it “L”).
L = M/PY
P = M/LY
It follows that we can impute the price level (GDP deflator) using base money, real GDP, and the level of liquidity preference implied by short-term interest rates.
With real GDP expected at about $13,409 billion in 2005 dollars for the fourth quarter of 2010, the implied GDP deflator is 2000/[(.094-.022*ln(.15))*13,409] = 1.10. The latest reading on the deflator was about 1.11, so the estimate is just about right.
The disturbing fact about this, however, is that inflation dynamics can potentially become unstable when a massive stock of base money is being kept in check by very low interest rates. This is because small increases in interest rates from near-zero levels imply huge changes in liquidity preference and velocity. If those changes are not offset by opposite and proportional changes in the monetary base, strong inflation pressures are likely to follow. Historically, it has usually taken an extended period of such inflation pressures (sustained over 6-12 months) before the implied inflation pressures are actually reflected in price levels. Temporary differences between the actual and implied GDP deflator are not very informative unless they are sustained.
Still, any sustained external pressure on short-term interest rates, even in the range of a quarter-percent or more, would require a rapid contraction in the Federal Reserve’s balance sheet, or the upward pressure on velocity would create very strong incipient pressures on inflation.
For example, let’s repeat the calculation for the implied GDP deflator, but assume a 3-month Treasury bill yield of 0.35%. In that case, holding the monetary base constant at its present level of $2 trillion, the implied deflator is 2000/[(.094-0.022*ln(0.35))*13,409] = 1.27. Compared with the 1.11 deflator implied by a 0.15% Treasury bill yield, the implied change in prices is about 14.4%.
Because the size of the monetary base has become so extreme relative to historical norms, the likely price pressures in response to even modestly higher short-term interest rates are equally extreme. For example, given the present level of the monetary base, an exogenous increase in short-term Treasury yields to even 1% would imply a GDP deflator of about 1.59, which is about 42.9% higher than present levels. In order to counter such pressure, the Fed would have to contract the monetary base by about $600 billion, from the present level of about $2 trillion to a still bloated but less extreme $1.4 trillion.
A larger increase in Treasury bill yields to 4% would imply a GDP deflator of about 2.35, which is more than double the current price level. The implication is that any normalization of interest rates would need to be accompanied by a massive contraction of the Fed’s balance sheet in order to avoid inflation, otherwise the collapse in liquidity preference (resulting from the higher interest rates compared to zero interest on base money) would trigger a collapse in the purchasing power of cash.
The main factor that reduces the risk of massive inflation is that short-term interest rates usually respond fairly passively to changes in the monetary base. Also, while the Fed can do little to increase the returns to holding currency, it does have the ability to raise the interest rate that it currently pays banks to hold idle reserve balances, in order to keep those balances idle. So absent external pressures on short-term interest rates, the Fed may be able to continue playing at the edge of the proverbial cliff for a while longer.
Still, the absence of such pressures should not be taken as a given. Any external pressures on short-term interest rates would wreak havoc on the stability of monetary policy here. In the face of upward pressures on short-term interest rates, the Fed would have to contract the monetary base in an amount equal and opposite to the implied change in the deflator.
At the same time, barring external upward pressures on interest rates, a further non-inflationary expansion of the Fed’s balance sheet of $400 billion, to $2.4 trillion (as contemplated under QE2), would imply the need for 3-month Treasury yields to fall to just 0.05%. Higher rates would be inflationary, because monetary velocity would not be sufficiently restrained. In effect, a further expansion in the monetary base requires that short-term interest rates decline enough to ensure a significant drop in velocity.
In terms of liquidity preference, a completion of QE2 requires liquidity preference to increase to 16 cents per dollar of nominal GDP – easily the highest level in history. We hit 15 cents at the peak of the credit crisis. To get past that, short-term interest rates will have to decline to the point where there is no competition from interest rates at all, but where the slightest amount of interest rate pressure would either drive inflation higher or force a massive contraction in the Fed’s balance sheet to avoid that outcome. Then what?
Again, I should emphasize that even if we observe inflation pressures on the basis of the monetary relationships above, it typically takes an extended period of 6-12 months before those pressures become clearly reflected in price levels (so the relationship between actual and implied inflation is tighter if the data are smoothed over several quarters). In any event, it should be clear that the Fed is operating at an unstable extreme, and further expansion of the Fed’s balance sheet will only increase that instability.
What factors could create pressures on inflation? By itself, monetary policy often involves a simple see-saw, where higher monetary base results in lower short-term interest rates, which induce people to hold that additional base money. Historically, both in the U.S. and internationally, the primary source of inflation pressure has been growth in unproductive government spending (i.e. spending that creates demand without materially expanding productive capacity – think Germany paying striking workers in the Ruhr). Now, it’s very often true that government spending is actually financed by printing money, but in that case, we’ve long argued that the fiscal event is what drives inflation. Simply shifting the composition of government liabilities between Treasury debt and money (without changing fiscal policy) generally causes a change in the profile of interest rates: primarily affecting short-term rates to ensure that the new outstanding quantity of base money is held (as we’ve seen above).
While not all U.S. government spending is unproductive, it is easily seen that the inflation pressures of the late-1960′s and 1970′s accompanied a period where government spending was sharply expanding as a share of GDP (the 1981-82 recession provoked a final gasp of spending even as inflation receded from its peak). While the disinflation since the early 1980′s has had some fits and starts, it is also clear that this period has – until recently – been characterized by relatively stable fiscal policy. From this perspective, the recent explosion of government spending as a share of GDP is a source of longer-term inflation concern.
With regard to the U.S. economy, we continue to observe some surface progress. Barring fresh shocks, our benchmark expectation (based on gradual reversion to potential GDP) would be for job growth averaging about 200,000 per month on a sustained basis, and real GDP growth of about 3.8% annually for several years before slowing. However, that proviso “barring fresh shocks” is my real concern. Nominal GDP may be recovering, but about 10% of that still represents deficit spending. The Fed’s balance sheet, as noted here, stretches the limits of monetary policy – risking instability and a lack of robustness to small shocks.
As for the U.S. financial system – particularly major banks – I am continually perplexed by the juxtaposition of tens of millions of underwater mortgages and millions of delinquent and unforeclosed homes, coupled with a set of FASB accounting rules (revised at the height of the recent crisis) that allows these debts to be carried at face value upon the discretion of the banks that report the data. I’ll say one thing – it should take less than two seconds of thought to recognize that allowing dividends, bonuses, and other withdrawals of capital – without the requirement that banks mark their assets to market – is quite literally how Ponzi schemes function. We’ve laid a lovely turf lawn over a toxic waste dump, and are all too willing to assume that the underlying issues have been solved. The FASB and the Fed have turned the U.S. banking system into the Love Canal.
In any event, completing the Fed’s planned purchases under QE2 will require a decline in 3-month Treasury bill yields to just 0.05% in order to avoid inflationary pressure. Otherwise, liquidity preference will not expand sufficiently to absorb the addition to base money, even if we assume real GDP growth at a 4% rate. Given the extreme stance of monetary policy, the avoidance of inflationary pressures increasingly relies on a very persistent willingness by the public to directly or indirectly hold the outstanding quantity of base money in the financial system. Small errors will have surprisingly large consequences. This is not a stable equilibrium.
As of last week, the Market Climate for stocks remained characterized by an overvalued, overbought, overbullish, rising yields syndrome that has historically been very hostile for stocks, but is also accompanied by “unpleasant skew” – a tendency for the market to make a series of successive, marginal new highs, typically resolved by an abrupt plunge that wipes out weeks or months of upside progress in a few sessions. If you look at a chart, you can see this tendency for small, compressed daily ranges advancing to marginal new highs over the past several weeks. You’ll see the same tendency at other periods that we’ve observed this syndrome, including memorable ones such as late 1972, August 1987, and numerous instances in more recent data, February 1997, April 1998 (though the final resolution in that case came several months later, it eventually wiped out all the interim gains and then 15% more), June 2007, January 2010, April 2010, and today.
Based on the broader set of Market Climates we define (see my comments on this over the past two months) we expect to establish moderate, if transitory, exposure to market fluctuations more frequently. That will likely include at least a moderately constructive investment stance (with a safety net around the mid-1100′s) at the point where we clear some element of this syndrome, provided that internals don’t also break down decidedly. Rather than “waiting” for whatever is going to happen to happen, we prefer to focus our efforts on aligning our investment positions with the prevailing Climate we observe in stocks, bonds, and precious metals. In stocks, that Climate is hard negative here and now, so Strategic Growth and Strategic International Equity remain fully hedged.
In bonds, the Market Climate last week was characterized by slightly unfavorable yield levels and increasingly unfavorable yield pressures. The Strategic Total Return Fund continued to have a relatively short duration of less than 2 years, exposing the Fund to little impact from interest rate fluctuations. In precious metals, the Market Climate improved, and we re-established a moderate (not aggressive) exposure to precious metals shares amounting to just under 8% of assets. While an aggressive exposure in precious metals most likely will require a reversal of long-term interest rate trends and some amount of fresh economic weakness, our focus is not so much on the next Market Climate we may observe next but on the Climate we observe at present.
A final note – next week’s update will be very different than most. As you know, we’ve directed a great deal of effort in the past two years to “ensemble methods” and challenging problems involving the use of multiple data sets. While I expect that the benefits of applying this research in our investment approach will become clear over time, I’ll be sharing the results we recently obtained by applying this line of research to a completely different sort of data – and a discovery that we hope will lead to improvements in the lives of hundreds of thousands of individuals.
Copyright (c) John Hussman, Ph.D, Hussman Funds
Tags: 3 Month Treasury Bill, Bank Reserves, Base Money, Credit Crisis, Currency, Extreme Right, GDP, Graph, Graphs, Hussman Funds, interest rates, Liquidity Preference, Lower Bound, Monetary Policy, Money Demand, Money Holdings, Nominal Gdp, Post War, Term Interest, Tight Relationship
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Wednesday, December 1st, 2010
This post is a guest contribution by Asha Bangalore, Vice-President and Economist at The Northern Trust Company.
The soft trajectory of consumer spending and continued reduction in residential investment expenditures reflects the sharp reduction in household debt. Outstanding home mortgages have dropped from $10.606 trillion in the first quarter of 2008 to $10.126 trillion in the second quarter of 2010 (see Chart 1). Household credit card debt has fallen roughly $157 billion from the peak in the third quarter of 2008 to $2.41 trillion (see Chart 1).
Total outstanding household debt as a percentage of GDP has fallen roughly six percentage points between 2009:Q1 and 2010:Q2 (see Chart 2). This decline is the largest on record in the post-war period. The drop of household debt as a percent of GDP in the early 1980s (48.95% in 1980:Q2 vs. 46.65% in 1981:Q3) was significant but smaller than the current occurrence and it was the result of credit controls imposed in the inflation battle of that period. The lifting of credit controls led to a sharp reversal in the mid 1980s (see Chart 2). The root cause of the current deleveraging is an entirely different story where severely indebted households are cutting back on borrowing to finance expenditures.
The reduction in total private sector debt (businesses and households) is also significant and compares closely with the situation after the 1990-91 recession (see Chart 3). Private sector debt as a percent of GDP peaked in the first quarter of 2009 (177.8%), with the second quarter reading at 167.9%. A similar reduction in the 1990s was spread over nearly four years. This sharp decline in consumer and business sector spending has resulted in the elevated jobless rate. These numbers are being tracked closely for an early confirmation of improving conditions. It is not a mere coincidence that economic growth gathered steam only after private sector credit growth was visible following the 1990-91 recession.
Source: Asha Bangalore, Northern Trust – Daily Global Commentary, November 29, 2010.
Tags: Business Sector, Consumer Spending, Credit Card Debt, Different Story, Home Mortgages, Household Credit Card, Household Debt, Inflation Battle, Jobless Rate, Mid 1980s, Northern Trust Company, Percentage Points, Pesident, Post War, Q2, Recession, Residential Investment, Root Cause, Trajectory, Trillion, War Period
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Monday, September 13th, 2010
Except for a burst of census hiring that briefly pushed payroll growth above trend during the second quarter of this year, job growth has been perpetually below trend over the past two years. During the post-war period, the civilian labor force has historically grown at about 0.15% each month, which currently implies that normal “trend” job growth should be about 225,000 jobs per month.
While last month’s labor report was favorably received by Wall Street, that reception was based strictly on the fact that job losses were not as bad as anticipated, given concerns about a “double dip” in the economy. The problem with this celebration, however, is that analysts continue to overlook the typical lags between deterioration in leading indicators and deterioration in coincident measures, much less lagging ones. As I’ve noted frequently in recent commentaries, the typical lag between deterioration in say, the ECRI Weekly Leading Index and the ISM Purchasing Managers Index is about 13 weeks, and sometimes longer. The typical lag with respect to new claims for unemployment is about 23-26 weeks (which puts the likely window of deterioration at about the October – November time frame), and the typical lag with respect to the payroll unemployment report is, not surprisingly, about 4 weeks beyond that. The critical risk area here extends for several months, not a few weeks.
The labor reports of the past three months cannot possibly be considered to be favorable from a macroeconomic perspective. The reason for this is that these reports were each more than 500,000 jobs short of what should have been expected.
To provide some perspective on this, below is a simple estimate of what economists call an “impulse response” profile for the U.S. labor market. When we deal with economic variables – such as employment – that are subject to positive or negative “shocks,” it is often helpful to estimate how those shocks tend to “propagate” over time. For employment, a 1% shock in job creation or destruction (versus trend growth) tends to be followed over the following year by an additional 1% movement in jobs in the same direction. After that, the impulse gradually attenuates over a larger period of years, as the initial positive or negative burst is followed by a trajectory back toward trend growth. In effect, positive and negative “shocks” to job creation have very strong tendency to “cluster,” propagating in the same direction for a period of about 12 months, and then gradually attenuating toward the long-term trend.
Note that the impulse response curve shifts direction after the first year. Evidently, both when hiring workers and when laying them off, businesses tend to shoot first and ask questions later. In economic recoveries, large initial bursts of hiring tend to propagate for a year, and then the new hiring is rationalized. Similarly, large bursts of layoffs in a recession tend to propagate and then reverse.
We can apply this impulse response to prior economic shocks to get an idea of what the economic headwinds or tailwinds would be for the job market in a “normal” cycle. I stress the word “normal” here because in our view, the current economic picture is well outside of postwar norms, and is much better characterized by previous periods of credit crisis. This can be seen most clearly in sluggish final sales, and in the failure of income, less government transfer payments, to show any normal sign of meaningful growth.
Tags: Commentaries, Critical Risk, Deterioration, Double Dip, Economic Variables, Economists, Hussman, Impulse Response, Ism, Lags, Leading Indicators, Macroeconomic Perspective, Payroll, Post War, Purchasing Managers Index, Response Profile, Risk Area, Shocks, Unemployment Report, War Period
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Wednesday, August 18th, 2010
This article is a guest contribution by Dr. Kent Moors, The Oil and Energy Investor.
After a long period of speculation, the Ministry of Mines in Kabul finally acknowledged the extent of newly discovered oil fields in northern Afghanistan. According to the ministry, there are about 1.8 billion barrels.
But the geological studies won’t be completed until January, and thus far, the U.S. Geological Survey (USGS) is not committing to a volume of extractable oil beyond one billion barrels.
Whether it is the one billion the USGS now claims or the some two billion the same agency suggested a few years ago, this is big news for the war-torn country.
One of the prevailing assumptions has pointed to the lack of economic prospects as a major impediment against post-war reconstruction in Afghanistan. The oil finds, therefore, may be just the ticket to begin some discussions of political stability … or to tear the country apart.
Only Foreign Companies Can Develop This $1 Trillion Field
Afghanistan has other deposits, primarily in the south, in the Amu Darya River basin on the joint Uzbek, Tajik, Afghan border. That one has an estimated 1.6 billion barrels of oil equivalent. And given the known development on the other side of the Uzbek border, it has prospects for some hefty recovery volume.
That earlier discovery is primarily gas. This new discovery in the north is basically oil, with some associated gas thrown in for good measure. In short, Kabul is looking at the possibility of diversified hydrocarbons production and the likelihood of exporting both. The daily domestic demand will remain well below 150,000 barrels of oil equivalent, meaning the vast amount of production will be heading to the international market.
The ministry has already announced that both major deposits will be put up for tender – Amu Darya is still on track for early next year, while plans for the northern discovery are expected to be announced in a few months.
The tenders are obvious. Only foreign companies can develop these fields. Afghanistan has no domestic oil sector, no local equipment or suppliers, and great need for infrastructure development to reach the finds. That means there will be some heavy front-loaded development expenses from the necessary construction of roads, power lines, communications, and locations for employees, equipment, and supplies.
To add to the interest, the country has also discovered other significant natural resource deposits. These include iron ore, lithium, and copper. Despite the rising instability, both the Afghan and U.S. governments regard the finds as decisive in reducing the nation’s reliance on foreign economic assistance.
Thus far, foreign companies have begun operations only at the large Aynak copper mine south of Kabul. China’s largest integrated copper producer, Jiangxi Copper (OTC:JIXAY), along with Shanghai Exchange-traded China Metallurgical Group (SHA:600030), began development there in 2007. To date, this project remains the only significant foreign investment.
Earlier this year, a U.S. Department of Defense estimate put the potential natural resource largesse at more than $1 trillion. While I continue to have some questions about the methodology used in that study (these guys are military, after all, not economic planners), I do agree that the proceeds will be considerable.
On the other hand, the increasingly serious security concerns may push back any revenue realization by several years.
Nonetheless, the new oil find will be developed and it will have a positive impact on the Afghan market…
Early Indicators of Profits
There are two aspects of the initial phase that will tell us what is likely to happen and in which sequence these activities will unfold.
The first is the tender process and the companies lining up to participate. This will tell us who will be coming in and which secondary providers (of everything from field services and supply, on one end, to processing, storage, and transport on the other) will benefit. Operating companies – those who will compete for the tenders – generally favor certain secondary providers in each category.
Early indications are that Chinese majors Sinopec (NYSE:SHI) and China National Petroleum Corp. (available only through thinly traded CNPC Hong Kong Ltd.; OTC:CNPXF) will be energetically pursuing bids, with some interest likely from Indian majors. I expect a consolidated bid here from Oil India (BY:533106), GAIL (BY:532155), ONGC Videsh (the foreign drilling unit of state-owned Oil and Natural Gas Corp.), and Indian Oil Corp. (BY:530965). That would reflect the same consortium that was bidding recently to pick up the BP (NYSE:BP) Vietnamese offshore projects.
Still unknown is the level of interest among U.S.- and European-based operators. Moving forward, security is obviously an important concern. And Chinese and Indian companies have traditionally had a higher tolerance for these problems than have Western companies.
The second aspect involves the requirements for early front-end engineering and design (FEED); engineering, procurement, and construction (EPC); and related planning.
Here, there is a greater likelihood of Western, in general, and U.S., in particular, involvement. The Chinese would prefer to provide all aspects of a development project, but they may not have the opportunity in this case, especially in light of the political environment.
As it happens, I came back from San Diego Saturday, following a few days of addressing and meeting with major American engineering companies. There are several developments on Iraqi, Kurdish, and Afghan hydrocarbon projects that are coming. These plays will occur well before the required early field services (seismic study, exploration, data analysis, test wells).
Given the more direct U.S. market accessibility for individual investors to the shares of these companies, your move is almost certainly going to come here first.
Copyright (c) Dr. Kent Moors, The Oil and Energy Investor
Tags: Afghan Border, Amu Darya River, China, Economic Prospects, Geological Studies, Good Measure, Hydrocarbons, Impediment, India, Kabul, Moors, Natural Gas, New Discovery, Northern Afghanistan, oil, Oil Equivalent, Oil Fields, One Billion, Political Stability, Post War, River Basin, U S Geological Survey, Uzbek, War Reconstruction
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Thursday, August 5th, 2010
This article is a guest contribution by Bill Hester, CFA, Hussman Funds.
Friday’s GDP report offered up a slew of new data. We learned that the economy’s rate of expansion in the second quarter decelerated again, to 2.4 percent at an annual rate. This is down from 3.7 percent growth in the first quarter and 5 percent growth during the fourth quarter of last year. The Commerce Department also released their annual revisions of the data, which broadly painted a picture of a recession that was deeper than originally thought and a recovery more shallow than first reported.
The revisions in the data help explain why other measures of economic performance like wage gains and hiring have been so weak. GDP was revised lower for 7 of the 12 previous quarters and the economy contracted by 4.1 percent from its peak versus an originally assumed 3.7 percent, making it clearly the worst recession in post-war data. Consumer spending and corporate profits were also revised lower during the period. Likewise, the recovery has been even more anemic than originally thought. The economy grew at a 1.6 percent annual rate in the third quarter of 2009 and at a 5 percent rate in the fourth quarter, versus the 2.2 percent and 5.6 percent rates, respectively, that were originally reported.
Given the arrival of this new data, and because we are now one year past Wall Street’s assumed trough date of the recession, it is a good time to benchmark this recovery against prior recoveries. I’ve periodically shown the unevenness of the current recovery by looking at the four broad measures (income less transfer payments, trade sales, industrial production, and jobs) that the NBER uses to help determine recessionary periods. These are closely followed because they are released monthly. Benchmarking the GDP data adds another important perspective to the analysis, because it’s the broadest measure of the health of the economy. In a recent statement, the NBER said: “The committee believes that the two most reliable comprehensive estimates of aggregate domestic production are normally the quarterly estimate of real Gross Domestic Product and the quarterly estimate of real Gross Domestic Income, both produced by the Bureau of Economic Analysis.” So it’s worth walking through the components of the GDP report to benchmark the current recovery against previous recoveries.
Each of the graphs below plots 4 lines. The black line shows the average performance of each data series around the recessions ending in 1958 and 1982, because the two recoveries that followed are typically thought of as “V-Shaped.” The green line plots the performance of each data series around the end of the recession that occurred in 1980. This is an example of a “double-dip,” where the expansion in output lost its momentum and the economy turned down again into a recession beginning in 1981. The red line plots the current performance of each data series. Finally, the blue line is the average performance of each data series around the six other recessions since 1950 that don’t fall into one of the above groups. This is our “standard” recovery benchmark.
[A note about the construction of the graphs: Because the graphs use quarterly GDP data, I've used the quarterly recession dates provided by the NBER. This will create some variation in the data immediately around the end of recessions. The NBER assumes that the quarter in which the trough occurs is within the recession. So a recession ending in October in monthly data would end in December in quarterly data. These effects are limited when we focus on the full four years surrounding the end of recessions. ]
The first graph plots real gross domestic product, the output of goods and services produced by labor and capital in the US. As this graph shows, and as most of the others also will also show, this is one of the slowest expansions in post-war data, and it has fallen far behind the average expansion. The current recovery even falls behind the 1980/1981 recovery, which lacked the internal momentum to develop into a sustainable recovery in the face of higher interest rates. This graph also offers perspective on the discussion regarding a “typical mid-expansion slowdown.” This is a phrase that is gaining in popularity among investors, even if there’s not much evidence to support it. Neither V-Shaped recoveries nor standard recoveries show any indication of a “typical” mid-expansion slowdown. The only mid-expansion slowdown that shows up in the data from this perspective is the 1980/1981 recovery. That mid-expansion slowdown quickly turned into a double-dip recession.
Final Sales is a measure of demand that excludes the effects of changes in inventory. This series will be important to watch as is looks like the inventory cycle might be winding down. Inventories rose by $76 billion last quarter, the biggest gain in 4 years. The second half of 2008 must still be fresh in purchasing managers’ minds, when inventories relative to sales grew by 15 percent in 6 months. Overstocking is not likely in their plans (at least not intentional overstocking). Final Sales grew just 1.3 percent in the second quarter. This was similar to the first quarter’s 1.1 percent expansion, and a clear downshift from the 2.1 percent rate of growth in last year’s fourth quarter. The growth in Final Sales during this recovery has trailed the typical recession by a large amount. It’s tracking more closely (but still trailing) the weak demand that was experienced during the 1980/1981 recovery.
For the components of GDP, we’ll focus the analysis on Consumption and Investment, because they are the largest components of GDP that are cyclical in nature. Toward that, the next two graphs show the changes in Personal Income and the changes in Personal Consumption. While Personal Income isn’t a measure of demand, I’ve included it because it helps explain why consumption growth has been so anemic. Personal Consumption expanded at just 1.6 percent in the second quarter, continuing its subpar performance during this recovery. Its rebound since last June is less than half the typical contribution consumers typically make toward a recovery.
The next two graphs show two components of investment: Fixed Investment and Equipment and Software Investment. Fixed Investment, which includes residential investment, is tracking far below the typical recovery (even with residential activity gaining 28 percent in the second quarter fueled by the winding down of the home-buyer tax credit). Investment in equipment and software is the one ray of light in these series of graphs. The expansion in this type of investment is actually outpacing the standard recovery. But at only 7 percent of GDP, business investment’s ability to continue to fuel GDP is limited. And as Bank of Tokyo’s Ellen Zentner recently pointed out, because job growth has been so limited, these investments are very likely directed at replacing equipment and technology. Sustainable growth in business investment will likely depend on robust and persistent job creation.
Although the first GDP report out after the end of each quarter does not include an estimate of corporate profits, benchmarking the profit recovery with the data through the first quarter highlights some interesting trends. The two graphs below shows how corporate profits from both financials and non-financial companies compare with earlier recoveries. The top graph shows the role that the large dislocations in the financial sector have caused on the profits for that group. The bottom graph may be the more interesting of the two. As measured by the GDP report, corporate profits for non-financial firms have trailed the typical recovery. These graphs highlight the incredible amount of volatility and lack of clarity the credit crisis created, and in the increased difficulty in estimating the earnings power of corporations. The implosion of financial sector earnings and the historic rebound in those earnings – fueled by the government’s direct investments in those banks, the Fed-induced upward sloping yield curve, low borrowing costs, and the easing of asset valuation standards – are skewing overall rates of profit growth. Meanwhile, the earnings of private and publically traded non-financial companies are rebounding, but have lagged the gains of past recoveries.
For workers and job seekers, a slow-growing economy is better than one that is contracting. But the speed of job creation following a recession is partly a function of the internal momentum of the recovery. As Lakshman Achuthan of ECRI has observed, companies hire because they are scared of not being able to meet growing demand. Momentum helps economies build a pattern of activity which can protect them against an exogenous shock. The current US economic recovery has very little internal momentum, and what little momentum it has is waning.
For investors, what’s important is the extent to which expected growth in the economy and earnings is priced, or possibly overpriced, into the market. The current subpar recovery should probably warrant a below-average level of valuation compared with prior recoveries. Unfortunately, the opposite is true. To put the current level of valuation into perspective, the table below shows Robert Shiller’s Cyclically Adjusted P/E Ratio (CAPE), which normalizes earnings by averaging the prior decade’s results. The table shows that there have only been two other periods where the economy was recovering from a recession and the level of valuation was higher. One was in November 2002, a year following the end of the 2001 recession. The S&P 500 has achieved a total return of just 4.2% annually in the 8 years since then. The other instance was in February 1962, a year after the 1961 recession ended, when the CAPE was at 21.45 (the S&P 500 quickly lost a quarter of its value over the next few months). The average CAPE level for the periods shown is 16, versus the current level over 20.
|1 Year after End of Recession||Cyclically Adjusted P/E Ratio|
Along similar lines, an article in this weekend’s Barron’s suggested that because the US economy has spent a quarter of the time over the prior decade in recession, investors should expect above-average returns going forward. The column noted that there have been only a few occurrences where the economy was in recession 25 percent of the prior decade: in 1955, 1958, 1975, and 1982. “The subsequent average annual stock-market returns over three, five and 10 years were all above average, between 14% and 16% for each period.”
I’ve mentioned this metric of economic uncertainty in prior research pieces, so it may be useful to add one more piece of color to the analysis. Following extended periods of time where the economy has slipped in and out of recession, valuation levels have typically been far lower. The periods mentioned in the Barron’s article are good examples. In 1955 Professor Shiller’s CAPE was 15. In 1958 it was 13. In 1975 it was 10. And in 1982 the CAPE was 7. Applying those multiples to today’s real 10-year averaged earnings ($55) would imply an S&P 500 Index of 825, 715, 550, and 385, respectively. Clearly, from those levels the expected long-term returns of the market would be more attractive. Secular bear market bottoms have typically occurred when recessions were so frequent that they have knocked the last bit of optimism out of investors. One of the best measures of that remaining optimism is the P/E multiple on normalized earnings, which presently remains stubbornly high.
Measured by most of the components of GDP this is one the weakest recoveries on record. GDP, Final Sales, Consumption and broad measures of Investment are all growing at rates far below the levels seen during standard recoveries, and even less than what proved to be an unsustainable recovery in 1981. To suggest that renewed weakness in the US economy is unlikely because it’s a rare event leaves out another equally as important rarity: the anemic performance of the current economic recovery.
Copyright (c) Hussman Funds
Tags: Bill Gross, Cfa, Commerce Department, Consumer Spending, Corporate Profits, Economic Performance, Fourth Quarter, GDP, Gdp Data, Gdp Report, Hester, Hussman Funds, Market Valuation, Nber, Post War, Recession, Revisions, Second Quarter, Slew, Transfer Payments, Trough
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Sunday, July 25th, 2010
This article is a guest contribution by Doug Short (dshort.com).
How does the current Dow recovery compare with major recoveries in the past? The chart below overlays the first 500 days of sixteen recoveries in the Dow Jones Industrial Average since its creation in 1896. I’m counting market days, so each recovery is truncated to approximately two calendar years. At present we are 346 market days beyond the March 2009 low.
The next chart is based on Dow daily closes with the sixteen rallies highlighted. Since the first chart is limited to 500 days, this chart offers a cross reference to get an idea of the ultimate length and gain of the rallies and also when they occurred in the larger historical context.
Recovery Selection Process
My initial selection criterion was to overlay all the Dow rallies following a 30% or greater decline. Using the traditional 20% decline associated with bear markets would have made the chart too busy, and it occasionally runs against conventional wisdom. For example, the Tech Crash in the Dow consisted of 3 baby bears (if you round up the 19.91% decline in January-March 2000) separated by two rallies over 20%. I consider it a single bear market with a decline of 37.85% and thus included the rally that began in 2002. I also treated the Crash of 1929 as a single bear decline, even though the 20% rule would have divided it into six bear markets with five intervening rallies. Likewise, and more to the point for the overlay, I treated the rally after the 1932 low as a single rally, even though the 20% rule would see it as an oscillation between three bull and bear markets.
Another liberty I took in selecting recoveries for the overlay was to include two rallies after declines of less than 30%. In both cases, they marked the beginning of a new economic era. One is the recovery that began in 1949 after the 23.95% post-war decline. The 12-year, 355% advance that followed warranted inclusion. Likewise I added in the first 500 days of the 250% rally that started in 1982 after a 24.13% decline. The 1982 recovery brought an end to the decade of stagflation and launched the great Boomer bull market. Here’s a larger view of the overlay.
The Current Recovery
The Dow is currently 56.3% above the March 2009 low after reaching an interim closing high up 71.1% on April 26th. Compared to the other 15 rallies at the equivalent point, the current rally is in 8th place. The volatile recovery after the Crash of 1929 leads the pack by a wide margin. The second, fourth, fifth and sixth place rallies date from yet earlier periods.
Where do we go from here? Some of the historic 500-day rallies went on to substantially higher gains — the launch of the Roaring Twenties, the Boomer Era that started in 1982 and resumed after the Black Monday misadventure in 1987. Even the recovery from the Crash of 1929 falls into this category, although the Great Depression would eventually lead to some significant retracements.
On the other hand, several of the earliest rallies (1903, 1907, 1914) would soon falter, a fate that later befell the rallies in 1962, 1970 and 1974. If we look at the Dow chart adjusted for inflation, the failure of these recoveries is more obvious. The chart below is adjusted for inflation using the technique popularized by Robert Shiller, namely adjusting with a spliced index based on the Consumer Price Index for Urban Consumers (CPI-U), which dates from 1913, and the Warren and Pearson’s price index for the pre-1913 inflation estimate. In my real version I’ve chained the daily prices to the May 1896 dollar value.
The Critical Uncertainty
The question remains unchanged from our previous review of this chart: Is the rally of the past 16.5 months the early stages of a secular bull market? Or will the future resemble something closer to the early 1900s, the late 1960s-1970s, or something in between?
For a broader perspective on the history of Dow rallies, see my real (inflation-adjusted) analysis.
Copyright (c) Doug Short
Tags: Bear Market, Bear Markets, Bull And Bear, Calendar Years, Conventional Wisdom, Crash Of 1929, Cross Reference, Decline, Declines, Dow Jones, Dow Jones Industrial Average, Dow Rallies, Historical Context, Inclusion, Initial Selection, Oscillation, Post War, Rally, Selection Criterion, Selection Process
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