Friday, November 2, 2012

Mr. Market Is Disappointed

Stocks have now given back most of yesterday's euphoric gains within the past hour. Today's unemployment report showed greater-than-expected job gains, but a higher unemployment rate that rose to 7.9%. Stocks rallied briefly -- about 10 minutes -- then sold off and have grown weaker in the past hour. The Dow is down 110 points.

Thursday, November 1, 2012

Party On, Pollyanna

Two misses, one marginal beat. Now that's data to rally on! The Pollyanna Party continues on Wall St!
 ISM Manufacturing: 51.7, Exp. 51.0, Last 51.5
 Consumer Confidence: 72.2, Exp. 73.0, Last 68.4
 Construction Spending: 0.6%, Exp. 0.7%, Last -0.1%
And since when does ADP have any credibility any more, since in recent months, it has revised its previous months' lower by about HALF the subsequent month, once the headline-seeking HFT algorithms are no longer watching? It changes its methodology, then revises its figures downward the next month, and does so with regularity.
And initial claims "beats" expectations again? Last week's "beat expectations" was revised lower this morning such that it no longer "beat expectations" last week.
Note how another media organization -- one that actually does more than post a headline -- predicted actually what the WSJ did today: "Oh, and this week's just as manipulated print of 363K, which was a beat of expectations of 370K, will be spun as a 9K drop in initial claims of course. Next week this number will be revised to 365K-366K as usual, because the BLS has now upward revised its weekly claims number for something like 80 weeks in a row."
This week's "beat expectations" will be revised next week such that it was about as expected -- or a "missed expectations" as last week's revision showed. How do I know? Because today's initial claims "beat expectations" was the 80th week -- in a row -- that has "beat" expectations, only to be revised worse the following week! How can that kind of record be anything BUT either bad data or manipulated data? And since when are just 158,000 considered to be "strong", as the Wall St insider was quoted to say in the article? With that many jobs created, we won't even create enough jobs for population growth, much less a robust or prosperous economy!

Dow up 140 points.

Wednesday, October 31, 2012

Stocks Slip On Bad News

Bad News All Around Today

It's a steady stream of bad news today. However, with stocks having ramped up while markets were closed over the past two days while Hurricane Sandy pounded the Northeast, there is strong support and stocks are down only modestly thus far.

The Long-Term Consequences of Statism

Authored by Charles Hugh-Smith via Peak Prosperity,
With the US elections approaching next week, as well as the threat of another fiscal cliff showdown looming, we asked contributing editor Charles Hugh Smith to revisit his earlier work on how the expansive Central State has come to dominate both private society (i.e., the community) and the marketplace, to the detriment of the nation’s social and economic stability. In this updated installment, we will examine six critical dynamics that will lead to the devolution of Peak Government.

Massive Borrowing

In a misguided attempt to maintain an unsustainable Status Quo, the Federal government is borrowing unprecedented amounts of money that then must be serviced.  And the Federal Reserve is expanding its balance sheet by trillions of dollars (“printing money”) and intervening in stock, bond, and other markets for the purposes of managing perception (“the recovery is here!”)
These government funds are not just paying the government’s bills – they are being used to guarantee loans and mortgages that subsequently enter default, transferring what was private debt to the public and subsidizing politically powerful special interests.
Guarantees and subsidies both incentivize what is known as moral hazard: the separation of risk from consequence.  This can be summarized very simply.  People who are not exposed to risk act completely differently than those who are exposed to risk.  When risk has been transferred to the taxpayers by guarantees, give-aways, and subsidies, then speculation and mal-investment are incentivized.  If the bet pays off, I get to keep the gain, but if it loses, then I personally lose nothing, as the loss is transferred to the taxpayers.

Institutionalized Mal-Investment

The net result of these policies – borrowing immense sums to prop up an unsustainable Status Quo and institutionalizing moral hazard – leads to misallocation of scarce capital on a grand scale.  In effect, the money borrowed by the federal government and electronically printed by the Federal Reserve is mal-invested, because those receiving the funding are personally not at risk and face no consequence if the money is squandered on speculation or unproductive programs. Once moral hazard has been institutionalized, it becomes a positive feedback loop.  Since everyone in the system faces little personal consequence from mal-investment, the institution loses the ability to police itself.
Even worse, concentrations of private wealth readily influence public institutions via lobbying and political contributions, exacerbating moral hazard and mal-investment of the publicly borrowed money.

Erosion of Trust in Government

Mal-investment inevitably yields poor results, and just as inevitably, the government seeks to mask the dismal results of moral-hazard riddled policies and agencies.  This “perception management” is driven by political expediency, as public outrage at failed policies and unproductive spending would eventually lead to a political price being paid by the leadership.  So failed policies are declared great successes, negative data is massaged into positive data, and unflattering frauds involving public funds are buried or transformed into pseudo-realities.
This institutionalization of mal-investing borrowed funds and the politically expedient falsification of fact to manage perceptions have a destabilizing consequence: The public loses faith in public institutions.

Diminishing Returns on Public Debt

Massive borrowing also has a consequence.  Interest on the immense sums being borrowed squeezes out other government spending.
This triggers two self-reinforcing feedbacks.  Public spending that is not rewarding moral hazard is cut, as those in charge protect their perquisites, and taxes on what’s left of the productive economy increase, reducing the private investment that is the bedrock of capitalist growth and innovation.
This institutionalized mal-investment leads to diminishing return.  Where each dollar of additional public debt generated nearly a dollar of additional GDP in the early 1960s, now borrowing a dollar generates negative growth, as the cost of servicing the debt exceeds the meager yield.  Thus the Federal government borrowed and spent a staggering $6 trillion in a mere four years (2008-2011), while the GDP has yet to return to 2007 levels when measured in real (inflation-adjusted) dollars.
All these forces reinforce each other in a death spiral.  As trillions more are borrowed, interest payments crowd out spending, causing the Central State to borrow even more, which generates even more interest costs, and so on.  As moral hazard infects the entire government and its numerous private contractors and beneficiaries, there are few constraints on rising public debt and mal-investment of public funds.  As trust in institutions that increasingly depend on perception management rather than real solutions declines, public faith in government deteriorates further.

The Hidden Tax of Inflation and the Institutionalization of Falsification

The government has one trick to create the illusion that it is “keeping its promises.”  It prints money to meet its obligations, depreciating the nation’s currency by expanding the money supply.  Creating money out of thin air does not create wealth, productive assets, or prosperity.  What it does is lower the purchasing power of money, which we call inflation.
Inflation robs every holder of the currency and is effectively a form of government-sanctioned theft, or if you prefer, a hidden tax on productivity, as productive people and enterprises are taxed to support crony-capitalist, unproductive mal-investments and the rising interest on public debt. In effect, inflation is a way of transferring wealth from the productive to the unproductive, which then leaves the productive with less capital to invest in innovation. This starves the economy of capital while robbing purchasing power of every citizen, establishing a positive feedback loop of lower income, lower capital formation, and lower productivity.
Since the government has obligated itself to adjust Social Security payments to inflation, the culture of understating inflation (i.e., falsifying data) has been institutionalized, for the Central State has the impossible dual mandate of increasing inflation so that it can meet its obligations with cheaper money while keeping the inflation-indexed cost-of-living adjustments low, lest program costs balloon out of control.
A “modest” rate of 3% inflation will, in a decade’s time, reduce the purchasing power of stagnating paychecks by a third, while setting the “official” rate of inflation at 2% or less will inexorably reduce the purchasing power of Social Security payments.
If the rate of inflation was to rise at a rate similar to that of the late 1970s, i.e., 10% to 12% per year, while the “official” rate was held to half the real rate, all those whose incomes did not rise by 10% a year would be impoverished as the purchasing power of their incomes evaporated. Meanwhile, even as its policies impoverish most of its citizens, the Central State would assure everyone that it was meeting all of its obligations as promised. This is how trust in government is not just eroded but ultimately destroyed.

Self-Reinforcing Feedback Loops of Self-Interest

Government at all levels responds to shrinking tax revenues from a declining economy and budgets squeezed by higher interest payments by seeking additional revenues by whatever means are at hand. Tax rates are raised, junk fees are imposed, fees for minor infractions are jacked up, and deductions and exclusions are eliminated.
The public that does not work for the government (that would be five-sixths of the workforce) increasingly resents what it perceives as predatory extortion in an economy where everyone’s disposable income is falling.
Unfortunately, there is a great divide between those who work (or worked) for the government and those who work in the private sector.  Those in government service understandably view the promises made to them in good times, eras that we now understand were brief speculative bubbles, as sacrosanct. 
The promises were based on the abnormally high returns earned by pension funds in the brief windows of speculative frenzy, and even supposedly conservative pension funds based their projections on annual yields of 6% to 8%.  As the Federal Reserve has attempted to reignite borrowing by lowering interest rates to near-zero, low-risk yields have fallen to 3%, less than half the expected returns.
As a result, there is a massive and sustained shortfall of public-employee pension funding, a shortfall that must be paid out of general tax revenues at a time when those revenues are declining as employment and business activity stagnate.
The net result in many communities is that schools and other local services are falling apart as budgets are slashed to meet skyrocketing pension obligations.  From the point of view of parents, the pension promises that government employees hold as sacrosanct were unrealistic, and what should be sacrosanct (but is not) is the education of their children.
Those of us in the private workforce with spouses, relatives, and friends in government service understand the frustration of those who work for government, but should the self-interest of the few dominate the public budget and chart the course for the many?
The key difference is that the government holds the power of coercion and the citizens do not. Thus those in government who seek to serve the interests of their unions, colleagues, departments, and agencies can impose fees and taxes on all citizens to fund their own perquisites and power.
From the point of view of those inside government, sharply rising parking tickets, higher property taxes, and so on are small prices to pay for essential services. But as citizens observe government services degrading even as fees and taxes increase, they see little value being added, even as self-service and moral hazard remain in institutionalized abundance.
Two destructive feedback loops are generated by this divide: Governments, desperate for more revenues, ignore public resentment and loss of trust, which only deepens the disconnect between those in government and the public.  And the private citizenry sees a lack of accountability, soaring public debt, accounting trickery, political dysfunction, and mal-investment of public funds as the hallmarks of their government.

Tuesday, October 30, 2012

Debasing More Than Just Currencies

I can only pass on Societe Generale’s work to you once in a while, but the piece for today’s Outside the Box is important enough that its author, Dylan Grice, worked hard to convince his bosses to let me share it with you. Dylan is one of my favorite investments analysts, as well as just an all-around nice guy.
In a change from his usual fun-loving demeanor, Dylan issues a serious warning here.

I am more worried than I have ever been about the clouds gathering today (which may be the most wonderful contrary indicator you could hope for...). I hope they pass without breaking, but I fear the defining feature of coming decades will be a Great Disorder of the sort which has defined past epochs and scarred whole generations….
So I keep wondering to myself, do our money-printing central banks and their cheerleaders understand the full consequences of the monetary debasement they continue to engineer?
He runs through some of the Great Debasements of the past, starting with third-century Rome, running through Europe’s medieval inflations and the French Revolution, to the monetary horror story of Weimar Germany in the 1920s.
His key point is that inflations and hyperinflations don’t just hurt money, they hurt people and the societies they live in. Inflating money is less trustworthy money, and so people doing business trust each other less. Plus, those who are farthest from the source of artificially created money suffer the most (the “Cantillon effect”).
And now the social debasement is clear for all to see. The 99% blame the 1%, the 1% blame the 47%, the private sector blames the public sector, the public sector returns the sentiment the young blame the old, everyone blame the rich yet few question the ideas behind government or central banks ...
I’d feel a whole lot better if central banks stopped playing games with money….
All I see is more of the same – more money debasement, more unintended consequences and more social disorder. Since I worry that it will be Great Disorder, I remain very bullish on safe havens.
In just 10 days we will see how the US elections turn out. Depending on what happens after, the US will either remain as one of those safe havens (and perhaps become even more of one) or those of us who reside here will need to start thinking more globally. I know a lot of thoughtful people who are already contemplating (if not acting on) plans to make sure their life savings maintain their buying power through the coming decade. I remain optimistic that we will set ourselves on a course that ends in a safe harbor, although the sailing will be quite volatile. What Dylan describes are the unintended consequences of people who think they understand macroeconomics and who are well-intentioned but whose policies can be most disruptive.

The Problem with Dynamic Condition-Dependent Multipliers

by John Mauldin and Rob Arnott:

“As far as the laws of mathematics refer to reality, they are not certain; and as far as they are certain, they do not refer to reality.”
– Albert Einstein
“To trace something unknown back to something known is alleviating, soothing, gratifying and gives moreover a feeling of power. Danger, disquiet, anxiety attend the unknown – the first instinct is to eliminate these distressing states. First principle: any explanation is better than none… The cause-creating drive is thus conditioned and excited by the feeling of fear …"
– Friedrich Nietzsche
“Very few beings really seek knowledge in this world. Mortal or immortal, few really ask. On the contrary, they try to wring from the unknown the answers they have already shaped in their own minds – justifications, confirmations, forms of consolation without which they can't go on. To really ask is to open the door to the whirlwind. The answer may annihilate the question and the questioner.”
– Anne Rice, The Vampire Lestat
The last two weeks we have been looking at the problems with models. First we touched on what I called the Economic Singularity. In physics a singularity is where the mathematical models no longer work. For example, models based on the physics of relativity no longer work if one gets too close to a black hole. If we think of too much debt as a black hole of sorts, we may understand why economic models no longer work. Last week, in “The Perils of Fiscal Cliff,” we looked at the use of fiscal multipliers by economists in order to argue for or against governmental economic policies. Do you argue for austerity, or against it? There is a model that will support your case, most likely using the same data that your adversary uses.
These letters have generated a great deal of positive response and conversation. While I very rarely suggest to readers to go back and read previous letters, but reading these may help you appreciate why it is so difficult to understand what is happening in the global economy today.
This week, in a somewhat shorter letter, we once again consider the vagaries of measurements and models. Growth of the US economy, we are told, was 2% last quarter. That number will of course be revised, but what is it we are measuring? Should we attach any importance to the measurement at all? The short answer to the last question is yes, but it is important to understand that there is no certainty in that number. Or at least not any certainty according to the generally accepted meaning of that word.
The Problem with Dynamic Condition-Dependent Multipliers
I use the above subhead with a great deal of irony. I garnered that phrase from a rather insightful letter from my friend Rob Arnott (founder of Research Affiliates, whose brilliant work is used to manage over $100 billion). I am going to start this week’s Thoughts from the Frontline with his letter, with my comments inserted in brackets [and italicized]. He was responding to last week’s letter on the problem with economic forecasts. Incidentally, Rob and his family spent five days in Italy with me this summer. There were many late-night discussions (and lunchs and dinners) about this topic.
“Most fiscal multiplier data is simplistic, trying to convert dynamic condition-dependent multipliers into static multipliers [i.e., if you adopt this tax cut or that spending increase you will have a very specific effect on the economy].  Why?  Because that makes economics, economic forecasting, and policy prescriptions pretty simple and easy to explain to reasonably intelligent people.  In so doing, ignore the impact of:
  • the starting levels of debt, magnitude of deficits, rate of change of demography
[This is important and at the root of Economic Singularity. If you start with massive debt, as the Greeks or Spanish have, stimulus spending has much less effect than if you have a very small debt. There is a significant difference between the economic policies of Japan and Brazil, for instance, because of the age of their populations. What works in one country may be counterproductive in the other.]
  • different multipliers between taxes and spending, and between increases or cuts in either [The academic literature suggests that there is a clear difference between the effects of income taxes and consumption taxes on the economy. Trying to use a one-size-fits-all multiplier on taxes or spending is bad economics. Much easier, of course.]
  •  differential multipliers for temporary vs permanent tax changes (the mythical temporary tax cut and its famously useless multiplier)
  • different multipliers for categories of fiscal stimulus (bridge to nowhere – bad; repair creaking bridge between economic centers before they collapse – better)
  • the effects that employment policy choices can have on the fiscal multiplier (i.e., let’s not forget the role of the private sector!). 
“Move away from a static multiplier, and there are so many possibilities.
“Most of the factors that affect multipliers are not easily controlled by government; and most changes inflict pain before they deliver their promised benefits.  Reciprocally, changes that deliver immediate benefit carry a daunting long-term price tag.
“Consider the vicious cycle embedded in fiscal multipliers.  If aggregate tax rates are 50% (between income and VAT and property taxes, not to mention regional or city taxes) in most of Europe today, a multiplier of 2 creates infinite feedback [which brings us to a Point of Economic Singularity where the models will produce silly results, so economists just assume away any such condition].
“… in such a world, you could boost taxes by 1% of GDP and watch GDP drop 2%, producing no more tax revenue than before; rinse and repeat, until you’re beyond Greece.  At Hollande’s 75% rate (80% if the wealthy actually spend anything and incur VAT), you hit this cycle if the multiplier is 1.25.  And will the multiplier be affected by tax-rate levels?  Of course.  Higher taxes strangle the private sector so that the multiplier for incremental change in tax rates will increase. [Note: Rob is not arguing for the use of the specific multiplier, just pointing out that a single-variable multiplier can seriously distort the models.]
“The right answer is to not get into this mess to begin with.  After we’ve blundered into this situation, the predictable political reaction seems to be, ‘I can’t inflict pain on my watch.  Every pain must be immediately rewarded by gain.’  With a dearth of useful alternative ideas, this leads to the ‘kicking the can’ nonsense, which makes the eventual implosion far worse.
“The right answer, once we’re already on the gurney, needing glucose to stay alive, but needing to shed the consequences of past glucose overdose, is only a little more subtle.  First, we adopt the Hippocratic Oath: ‘First, do no harm.’  E.g., do nothing that carries lasting consequences that might exceed the near-term benefits.
“So, what are the possibilities?
  • One thing is to try to understand dynamic condition-dependent multipliers, even roughly, over multiple time spans.  As the economics profession seeks simple models that can win Nobel Prizes, they’ve let us down by doing far too little of the work on condition-dependency or horizon-dependency. 
  • Absent convincing models on the multipliers, do not dismiss common sense!  Would borrowing and spending another $10 trillion produce a positive multiplier for next year?  Of course.  Over five years?  Of course not.  It’s no different from a family that boosts the GFP (Gross Family Product … i.e., family run-rate consumption) by buying a car they can’t afford.  Would stimulus diverted to pork projects boost near-term GDP more or less than long-term debt?  The latter is pretty obviously the correct answer.  It’s no different from a family deciding to buy bling rather than upgrading to a more reliable commuter car.  Common sense trumps mathematical models, every time.
  • Apportion austerity *and* stimulus, short-term pain and gain, in measures that deliver maximum deficit reduction, ideally without deep recession.  E.g., stimulus spending has an okay short-term multiplier, but it almost always delivers more long-term debt than near-term economic stimulus; spending cuts reverse this effect at a cost of near-term recession.  Tax hikes, if perceived as permanent (they usually are), have a terrible long-term multiplier; tax cuts reverse this … unless the bond market is spooked by default risk.  
“Liberalizing private sector labor laws is very underrated, because we have attached such a deeply ingrained [public sense of what is “right” and “fair”]:  [Labor laws] have a vast multiplier whenever regulation actively discourages new job creation, as is true throughout the developed world.  Get rid of the minimum wage?  How dare you?!?!  But, suppose it’s replaced with a negative income tax that allows flat rates at all income levels.  In effect, we’re replacing a regulatory minimum wage, imposed on employers and discouraging employment, with public funding of a minimum wage, supplanting much of the public welfare bureaucracy. [This is one of Rob’s more interesting proposals and would go a long way towards alleviating youth unemployment, a topic near and dear to this Dad’s heart. If you can hire a teenager for relatively little cost, you can give them a job and training that will mak e them more productive later in life.]
  • This means we can combine a high-multiplier positive policy choice, delivering immediate positive GDP gains, before (perhaps mere weeks before) instituting a lower-multiplier adverse policy choice, like cutting public spending, that has known long-term benefits at a cost of short-term pain.  The combination can offer goldilocks outcomes. [Or, what Rob might not argue, raise taxes while cutting spending in a compromise to control the deficit.]
“None of this happens without clear leadership at the top.  While my libertarian political leanings are well-known, there’s catnip in the sensible solution for both parties.  But, I doubt any of this will happen in time.  We ‘hire’ our political leadership for their perceived ability to respond well to crises, not to anticipate and avert crises.  Why would I say this?  Because averting crises usually requires short-term pain for long-term gain.  And no politician who deliberately imposes pain, successfully deflecting a crisis, will ever get credit for the success.  Why?  Because no one ever sees the crisis that didn’t happen!”
It is here that I am more optimistic than Rob; and as my friend Newt Gingrich emphasized when he sat in on some of those late-night sessions in Tuscany, most politicians on all sides of this debate recognize the sheer magnitude of the disaster that it would be to avoid dealing with the deficit in what has now come to be the near term. Admittedly, they have different solutions, but they recognize the problem (note that I said most politicians – certainly not all). While Rob is right that no politician can run on a platform of cutting the things you like and raising taxes, if we’re not prepared to do something very much like that in the first part of 2013, the Fiscal Cliff we talk about will seem like merely stepping off a curb, compared to what comes next.
Measuring GDP
We will circle back to this discussion in a minute, but let’s visit this week’s announcement that GDP rose by 2% in the last quarter, up from 1.3% in the second quarter, which itself ended up being revised down almost 2% from the initial estimate. My guess is that we will see the same downward revisions over the next few months, as the other economic data last quarter was not robust. But clearly, we are not in a recession, just a Muddle Through Economy, as predicted here.
A 2% number is not bad, but there is more to it when you look at the underlying components. A large factor in the quarterly growth was defense spending, which leapt by a quite robust 13%. Personal consumption was up just 2%. Then there is inflation. If you think inflation was 2%, then the GDP number is overstated by 0.5%. Couple that with normal defense spending, and growth would have been less than 1%. That would not have been a political winner.
Inflation can be measured in several ways. GDP data does not use the Consumer Price Index, which shows inflation of more than 2%. You can get a much different GDP depending on what inflation number you use, and those numbers are dependent on what assumptions you make about how to figure inflation.
And while we all seem to use GDP, is that really the measure that makes the most sense in today’s world? Might we be better off targeting Gross Domestic Income, rather than looking at a consumption-based number like GDP? And isn’t Gross Private Production what we really need, rather than just an indicator that includes changes in government spending? At the end of the day, government spending can only be a function of what is produced in the private sector.
The Economics of Assumptions
We all want to have numbers that are “real.” But economics is different from accounting. Economics makes assumptions in almost all of the models it uses, and those assumptions come with biases. How many discussions do we get into that proceed along the lines of:
“Look at this statistic. It clearly goes up [or down] with GDP [or employment or…]. Therefore, if we could just fix ‘X,’ we would solve the world’s problems.”
For instance, I can clearly demonstrate to you that raising taxes on the rich will have no effect on their spending, if I use just one or two correlations in certain time frames. Throw in a few good stories, and the obvious conclusion is that we should raise taxes on the rich again and again. Just ask Monsieur Hollande – it’s their fair share.
Then I can just as easily show you that raising taxes on the rich will result in serious economic calamity. “Just see what it did in this situation. And see what cutting taxes did there.”
The counterargument then runs that your interpretation misses some other factor, so your conclusion is wrong. And so on and on. This goes back to the quote from Anne Rice at the beginning of the letter. While her character was talking about another form of knowledge, the observation applies doubly to economics. Here it is again:
“Very few beings really seek knowledge in this world. Mortal or immortal, few really ask. On the contrary, they try to wring from the unknown the answers they have already shaped in their own minds – justifications, confirmations, forms of consolation without which they can't go on. To really ask is to open the door to the whirlwind. The answer may annihilate the question and the questioner.”
Human beings seek certainty. We actually get an endorphin rush when we get an explanation for something we do not understand. Whether it’s religion, politics, philosophy, a crossword puzzle, or economics, we want to be able to come to a definite conclusion that we think is correct. There is psychological rest in certainty, along with the physiological rewards). Models, even flawed ones, give us the illusion of certainty. We need to be careful of what illusions we cling to.
Economics becomes quite a problematic discipline when it tries to create mathematical models that are supposed to guide political philosophy and praxis. So many assumptions have to be made to get to a result, that basing policy on a simplistic model is dangerous.
One size does not fit all, and past performance really does not indicate future results. The entire economic environment must be taken into consideration. We cannot extrapolate simplistically from the Reagan or Clinton years and say, “If we just reverted to those policies, we could get the same results.” Only if you could change all the other variables that are beyond the control of the government!
Models can be useful, but they are not exact. They give us a sense of direction. Using them is more like navigating by the North Star than using a GPS system. The more variables that enter into the actual situation, the less likely we are to be able to come up with that one “easy-button” policy prescription.
In the end, the only real tool we are left with is common sense, guided by our models and an appreciation of history. We “know” that, in general, the lower the price the higher the demand. If you tax something, you will get less of it.
We get that we can’t let financial institutions run amok. There have to be some protections for the public. Debt is useful until it becomes a burden, and we have to be careful in how we use it. We can come up with dozens of such truisms, based on common-sense wisdom.
We elect politicians and then expect that somehow the world will improve in accordance with their promises. What we really need to do is try to see what general direction they are leading us in and base our votes and our personal decisions on whether we like that direction. But to trust an economist, or even worse a politician, with a model? That can be dangerous.
Let’s close with a quote from my favorite central banker, Richard Fisher, who is president of the Dallas Federal Reserve.
“It will come as no surprise to those who know me that I did not argue in favor of additional monetary accommodation during our meetings last week. I have repeatedly made it clear, in internal FOMC deliberations and in public speeches, that I believe that with each program we undertake to venture further in that direction, we are sailing deeper into uncharted waters. We are blessed at the Fed with sophisticated econometric models and superb analysts. We can easily conjure up plausible theories as to what we will do when it comes to our next tack or eventually reversing course. The truth, however, is that nobody on the committee, nor on our staffs at the Board of Governors and the 12 Banks, really knows what is holding back the economy. Nobody really knows what will work to get the economy back on course. And nobody – in fact, no central bank anywhere on the planet – has the experience of successfully navigating a return home from the place in which w e now find ourselves. No central bank – not, at least, the Federal Reserve – has ever been on this cruise before.”
We indeed have not been on this cruise before as a nation and as a world. We know what happens when one country or another runs up against the limits of borrowing power. But when the bulk of the developed world does? Another cruise, indeed.
Investing in an Uncertain World
I’ve been writing about the virtues of absolute-return investment vehicles, such as hedge funds, for years. Markets continue to remain uncertain, and investors are increasingly seeking ways to achieve more consistent returns but with less downside risk. Equities still represent the greatest potential for long-term outperformance over bonds and cash; yet the road looks bumpy, and most investors tend to be biased toward long-only equity. Offsetting some of that long-only exposure with a long/short equity strategy may potentially help create greater risk-adjusted returns – or, in other words, help create a smoother path.
The long/short equity strategy is one of the oldest and most popular hedge fund strategies, in terms of quantity of assets under management.  The strategy has attractive characteristics over traditional long-only equity approaches, including the potential ability to capture a significant portion of the equity upside while minimizing drawdowns and protect capital.  Equity long/short is also a highly opportunistic, liquid, and transparent strategy that makes it appealing to many. My partners at Altegris have recently written a paper on the long/short equity strategy, “Long Short Equity: Opportunism in the Best Sense of the Word.”  The paper provides a terrific overview of the long/short equity strategy – how the strategy works, what the potential portfolio benefits are and, most importantly, what investors need to look out for when assessing long/short equity fund managers.  The crux of the long/short equity strategy is that, while it seems intuitive to investors, it requires a highly skilled, well-disciplined manager.

Impact of QE on Forex

via Societe Generale:

The actions of the world's central banks, from driving rates to the limit or beyond ZIRP into the unconventional moeny-printing (or more acquiescent QE), there is little doubt that the currency wars are under way. As SocGen notes, the spillovers from advanced economies' actions (exporting inflation) into EM currency appreciation create subsequent needs for EM bank actions at times when inflationary concerns remain high. With the Yuan at 19 year highs and suffering from outflows, the potential for QE-based inflows this time could be welcome by the CCP.

Via SocGen:
Major stimulus in September & currency wars
Following the unlimited stimulus announced by the ECB in September, the Fed responded by an open-end QE3, while the BoJ extended its asset purchase by 10 tn yen shortly after.

Are the Fed and the ECB working together for zee stabilitee or are they antagonistic (relative to one another things appear flat on the year but as below USD TWI is notably lower)...

Successive easing policies from these 3 large economies and lower uncertainty in financial markets have been a bullish signal for EM currencies.

To prevent currency appreciation and hot money inflows, central banks retaliated with rate cuts notably in Korea, Brazil, Thailand and the Philippines. Inflation risk could grow in some of these economies.
China better off with QEs this time
The yuan is “near equilibrium rate” according to China’s central bank, meaning a currency war has been avoided for now. The PBoC is currently focusing on price stability and increasing exchange rate flexibility rather than weakening the yuan.

Recent yuan strengthening should provide support to domestic demand which is necessary in the context of a global economic slowdown.
Moreover, both exports and imports improved in September, a signal that China’s economy may be benefiting from positive spillovers from global easing conditions.
Capital inflows resulting from QE programmes are welcome this time (at least in the short term), as the country has been struggling with outflows for the past six months.

Source: SocGen

Impact of QE on Commodities

from Societe Generale:

Through a wider looking glass, apart from Gold, commodity prices remain mostly driven by economic cycles rather than central bank actions. The correlation of Gold with Central Bank balance sheets remains the dominant theme as it grows in substance as a true global currency and a hedge against money debauchment. Since September’s coordinated easing from central banks, commodities have turned in mixed performances (-5% for oil, -3% for metals). The direct impact of monetary policy on industrial commodity prices appears very limited today (contrary to the situation during QE2 period), given the bleak global economic outlook and the absence of aggressive easing from China.

Via SocGen:
Gold and monetary stimulus
Gold shows some correlation with the size of balance sheets of major central banks, as it is seen as a global currency and a hedge against money debasement.

Some profit taking has lowered gold prices in the past month but current and future potential QE programmes from the Fed (QE3.5?) and the BoJ (QE9?) among others could send gold prices higher.
Gold’s safe haven status could drive prices higher if renewed tensions were to materialise.
Oil, agricultural and industrial commodities
Since September’s coordinated easing from central banks, commodities have turned in mixed performances (-5% for oil, -3% for metals).

The direct impact of monetary policy on industrial commodity prices appears very limited today (contrary to the situation during QE2 period), given the bleak global economic outlook and the absence of aggressive easing from China.

The oil price remains highly dependent on fundamental factors of global demand and supply (plus geopolitical risk). But massive liquidity injections in the economy may impact oil prices indirectly.

The strong increase in soft commodity prices in 2010-2011 began before QE2, and was driven by significant supply issues.

Source: SocGen

Monday, October 29, 2012

Hussman: Stridently Negative Market Conditions Persist

A few excerpts from John Hussman's commentary on his website today:

"In recent weeks, market conditions have fallen into a cluster of historical instances that have been associated with average market losses approaching -50% at an annualized rate. Of course, such conditions don’t generally persist for more than several weeks – the general outcome is a hard initial decline and then a transition to a less severe average rate of market weakness (the word “average” is important as the individual outcomes certainly aren’t uniformly negative on a week-to-week basis). Last week, our estimates of prospective market return/risk improved slightly, to a level that has historically been associated with market losses at an annualized rate of about -30%. Though that improvement falls into the category of a distinction without a difference, at least we can say that conditions are not the most negative on record.
"...we continue to view the U.S. economy as being in an unrecognized recession that started about mid-year.
"The advance estimate for third-quarter GDP was released last week, showing a slow but above-consensus figure of 2% growth at an annual rate (paced by a 13% surge in defense spending). Surely, this is inconsistent with concerns about recession, isn’t it? No – not if we examine the historical pattern of data revisions early in previous recessions...

Recall that in 2001, with the U.S. economy already in recession for months, Q1 GDP growth was initially reported at 1.2%. That figure was actually revised slightly higher a few months later, but based on final revision, Q1 2001 GDP is now reported at -1.3%. As a side-note, Q2 2001 GDP was positive, while Q3 2001 was negative. The 2001 recession did not contain two consecutive quarters of negative GDP growth. Contrary to what many analysts suggest, that is not how the National Bureau of Economic Research (the official arbiter) defines a recession in the first place.
"The heavy revision of GDP figures is not the exception but the rule. In the first quarter of 2008, as another example, with the U.S. economy already in recession for three months, Q1 GDP was reported at 1% growth. That figure was later revised to -1.8%. Just like 2001, the following quarter was reported at positive growth. The economy then collapsed in the second half of 2008, but by the time that was evident in GDP figures, the stock market had already plunged. The upshot is that early GDP figures are often reported positive even after a recession is already well in progress, and waiting for two consecutive quarterly declines in GDP is a poor way of gauging recession risk, because that pattern sometimes doesn’t emerge until much later revision, if at all. 
"Though our measures of economic prospects are holding fairly steady at negative levels, there are numerous risk factors that could accelerate this weakness, and not many that promise an abrupt improvement. So downside risks predominate here, in my view. First, simply because of the math of quarterly GDP figures, even if Hurricane Sandy was to cause a one-day net loss of activity across one-third of the country, the impact would slow Q4 GDP growth by about -1.5% at an annual rate.
"On the subject of deficits, the situation in Japan seems increasingly strained. The gross debt/GDP ratio in Japan is now about 225%, and net debt (which excludes debt held by the government itself for monetary, pension and other reasons) is about 130%. During the entire post-war period, Japan has enjoyed a significant trade surplus, which has allowed it to run growing government deficits. Meanwhile, household savings have declined from nearly 15% in the 1990’s to next-to-nothing today. Needless to say, that large and persistent trade surplus has enabled economic dynamics that normally would not be sustainable. But over the past year, Japan has fallen into a trade deficit, which has deepened recently due in part to tensions with China. We are now observing an ominous combination of a significant trade deficit, a deep government deficit, non-existent household savings, a steep debt/GDP ratio, and a contraction in both manufacturing and service sectors according to the latest purchasing manager’s surveys out of Japan. While Europe remains our primary source of concern, I am concerned that both China and Japan are likely to have a more destabilizing impact than is widely assumed."

Most Markets Closed Due to Hurricane Sandy

Most markets are closed today due to Hurricane Sandy as it approaches the Northeast coast of the United States. Equity futures closed down, despite a ramp-up from deep losses that lasted until about 7 am MST. So far, the S&P 500 has maintained support around the 1400 level.

Impact of QE on Bonds

Via Zero Hedge (intro) and Societe Generale:

The Fed sees the need to reduce interest rates as it takes over the US Treasury and MBS markets; but the ECB's actions are more aimed at reducing divergences between peripheral nations and the core. As SocGen notes, it remains unclear how and when the Fed would exit this situation and in Europe, bond market volatility remains notably elevated relative to the US and Japan as policy action absent a political, fiscal, and banking union remains considerably less potent.

Via SocGen:
Fed action pushes rates to record lows
The Fed bought around $2tn of securities since November 2008, pushing rates to historical lows (US treasuries becoming popular safe havens also contributed to lowering rates).

It remains unclear how and when the Fed would exit this situation. Operation Twist expires at year-end and any extension seems to be put on hold until after the presidential elections.
A potential Romney victory could bring an end to low QE rates in 2014 (when Mr Bernanke’s term expires).
As a result of the very low rate environment, the US equity risk premium is currently extremely high (6.3% in October 2012).
Hurdles in transmission of ECB monetary policy

Yield spreads divergence between peripheral countries and the rest of the eurozone illustrates the difficulties the ECB faces in performing its policy in the absence of a political, fiscal and banking union.
Since end-2011, unconventional measures from the ECB have had a significant impact on rates. The launch of OMT could see peripheral rates tighten even further.
However, bond market volatility in the euro area remains high compared to the US and Japan even though it has decreased recently.

Provided that Mr. Rajoy requests a bailout as expected, rate normalisation should continue, especially after Germany’s election in September 2013.

Source: SocGen

Impact of QE on Equities

From Zero Hedge and Societe Generale:

Fed 'credibility' has boosted stocks from the start of its actions; the ECB, however, only since OMT. But as SocGen's cross-asset class research group notes, poor performance of the S&P 500 since QE3 announcement (-1.6%) may
well be an initial sign of a loss of impact from the Fed’s policy, and US equity volatility is rising - catching up to Europe's.
Via SocGen:
S&P 500 and QEs: third time lucky?

During the two phases of QE carried out by the Fed, US stocks appreciated by around 48% at their peaks, on an annualised basis. The rally during Operation Twist was milder, but still strong at +36% (annualised). As a result, the S&P 500 gained about 15% (ann.) in the past four years as the Fed resorted to unconventional policy tools. Security purchases of past QEs have contributed to lowering rates, which is bullish for risky assets like equities. The upcoming purchases of QE3 aim to push stocks even higher. But, as current equity margins are at historical high and in light of the global economic slowdown, can US stock prices continue to climb at the same pace going forward? The poor performance of the S&P 500 since QE3 announcement (-1.6%) may well be an initial sign of a loss of impact from the Fed’s policy.
ECB: increased credibility but politics prevail

Mr Draghi took over as head of the ECB just one year ago, and already the perception of the ECB’s monetary policy has changed radically. The new president has adopted a more “Fed-like” policy: first with the launch of 3-year LTROs in December 2011 to support bank liquidity; and, more recently, with the OMT, the unlimited bond buying programme to support sovereigns. Following Mr Draghi’s pledge to do “whatever it takes” to save the euro and the subsequent announcement of the OMT, the Euro Stoxx 50 rebounded (+15% in 10 weeks).

The ECB has removed some equity tail risk by providing European governments with more time to find solutions to the euro crisis. However, as Spain still has to request bailout help, the implementation of ECB measures remains constrained by political decisions.

Source: SocGen

Sunday, October 28, 2012

Yet More Job Cuts

Sliding Stocks