See You Next Week

After a relaxing week that involved sitting on a beach, I expect posting to resume next week.

But, to leave you all with a song for the week... Foster the People with Helena Beat

Nominal Mortgage Rates Never Lower

The AP details:

Fixed mortgage rates have fallen to historic new lows for a fourth straight week and are likely to fall further.

The average on a 30-year fixed mortgage fell to 4.01 percent this week, Freddie Mac said Thursday. That's the lowest rate since the mortgage buyer began keeping records in 1971. The last time long-term rates were lower was in 1951, when most long-term home loans lasted just 20 or 25 years.

The average on a 15-year fixed mortgage, a popular refinancing option, ticked down to 3.28 percent. Economists say that's the lowest rate ever for the loan.

Mortgage rates tend to track the yield on the 10-year Treasury note. The 10-year yield has risen this week to around 2 percent. A week ago, it touched 1.74 percent -- the lowest level since the Federal Reserve Bank of St. Louis started keeping daily records in 1962. As recently as July, the 10-year yield exceeded 3 percent.

Source: Federal Reserve

Rebalancing and the Recent Equity Pop

There are lots of reasons why equity markets have sprung back to life (and bonds have "normalized" away from lows) the past few days. The most front and center reasons include a potential European debt deal and the fact that markets were simply oversold (I agree on both fronts), but here is another... institutional rebalancing.

The Example of Corporate Pension Plans

Over the past quarter bonds have ripped, while equities have RIP'd.

This has a profound effect on many an investor, none more so than corporate defined benefit plans. As some may not know, liabilities (i.e. the benefits they must pay out to employees) are discounted using a yield made up of high-quality, long duration corporate bonds. As a result, when long bonds perform well, this is actually a negative (all else equal) event for corporate plans as their liabilities increase at roughly an equal rate. A decent proxy for this is the BarCap Long Government / Credit index (below in red). Over the long-term, corporate sponsors hope to outperform this liability by investing in a mix of assets, including (or should I say predominantly) equities (below in blue).

The chart below shows just how trying this quarter has been for the approximately $2.5 trillion in size defined benefit plans (assets off... a lot, liabilities up... a lot).

This has been an UGLY quarter for pension plans. A back of the envelope calculation puts the loss in funded status terms (i.e. how much assets they have for every dollar of liability) for a plan with a roughly 60% equity / 40% long bond asset allocation at ~15% (i.e. if they were 90% funded, they are now ~75% funded).

But what does this have to do with rebalancing and the recent bounce in equities and sell-off in rates?

A corporate plan with that same 60% equity / 40% fixed income mix would have to reallocate ~6% of their fixed income allocation to equities just to get back to that 60% / 40% mix to start the fourth quarter. 6% x $2.5 trillion (the rough size of the corporate defined benefit market) = $150 billion (note that this is down from the $200 billion just a few days back).

I'd note that all corporate plans do not have the same asset allocation and some may have flexibility to hold back rebalancing, but this is offset by other institutional investor rebalancing outside of corporate plans that is bound to / has happen(ed).

As a result, I personally wouldn't be surprised to see support at these levels for equities and less support for long bonds through the end of the week (though if we were to weight Europe vs. rebalancing in importance, Europe dominates). After that, we better get some better news (or at least less bad news).

Source: Yahoo Finance

10/1 Update: Well that post proved itself wrong!

It's Not a Crash...

When prices are still up 45% (SLV) and 26% (GLD) over the past 12 months, I would call it a correction.

That's not to say it doesn't have risk to the downside (see Gold Prices Can Go Down).

Source: Yahoo Finance

Leading Indicators Outside the Fed's Control Remain Weak

While leading economic indicators expanded 0.3% during August, the expansion remains focused on areas controlled by monetary policy rather than the underlying economy. For the third month in a row (and four of the past five), indicators outside the Fed's control were negative.

Source: Conference Board

Fixed Income vs Equities Dislocation... Which is Right?

Over the past ten years (less so prior), the relationship between the change in the 10 year Treasury yield and the change in the S&P 500 has been strong with the 10 year Treasury leading. Note the breakdown in the relationship over the past year (perhaps due to Fed intervention).

Source: Federal Reserve / Yahoo Finance

Tax (My Neighbor) Please

The Big Picture has an interesting table outlining recent polling results asking how individuals would prefer the budget deficit to be reduced; taxes (higher) or spending (lower). The chart below summarizes the most recent polls for each (some had more than one) and normalizes the responses by taking those for some / all taxes and dividing that by the number selecting no taxes (I did this as not all polls added to 100).

The Results

The results varied by survey showing there is always bias in polling (the NY Times -liberal- is near the top and Rasmussen -conservative- is near the bottom), but an overwhelming number of individuals favor at least some increase in taxation.

Source: The Big Picture

EconomPics of the Week (9/16/11)

Economic Data

• Interconnected Markets
• The Evolution of Food Consumption
• Retail Sales Flat in August
• Real Median Household Incomes at 1996 Levels
• All Eyes on Europe
• Students Heart Debt... Everyone Else Deleveraging

Investments

• Extended Corporate Profits
• Unprecedented Times... Treasury Edition
• Hedge Fund Performance Update
• Quits / Layoffs

Other

• Remembering...

And your video of the week... Broken Bells (lead singer from The Shins) with The Ghost Inside.

Enjoy the weekend everyone!

Extended Corporate Profits

Source: Federal Reserve (Flow of Funds - Section F.7)

Interconnected Markets

In a recent conversation with a friend, we discussed how interconnected global financial markets were (the conversation began with my assertion that the European situation could cause a lot more pain the U.S. than consensus likely believes).

Below are a few charts that outline just how interconnected things have become.

The first chart shows the international investment positions of the U.S. (the level of U.S. owned assets abroad and foreign assets owned within the U.S.). I normalized the amounts by showing the level relative to the size of the U.S. economy. As can be seen, the level of ownership both in and out of the U.S. has spiked since the early 1970's, with foreign ownership of assets within the U.S. increasing at a faster pace (U.S. owned assets abroad by almost 15% of GDP or more than $2 trillion).

The next chart outlines what makes up that $2 trillion difference. While U.S. investors own more in terms of foreign equity (direct investment and stocks) than foreign investors own within the U.S., foreign investors are much larger creditors within both the public (government) and private (corporate) sectors.

Rather than make any bold statement of what this truly means (I am trying to digest it myself), I'll instead leave readers with two (conflicting) quotes:

“A creditor is worse than a slave-owner; for the master owns only your person, but a creditor owns your dignity, and can command it.” -Victor Hugo

“If you owe the bank $100 that’s your problem. If you owe the bank $100 million, that’s the bank’s problem.” -Jean Paul Getty

Source: BEA

The Evolution of Food Consumption

Illusion of Prosperity presents an interesting chart outlining the stagnation is real per capita restaurant sales over the course of the past decade (hat tip GYSC). I wanted to take a deeper look.

What the below charts outline are real per capita retail sales for food services (i.e. restaurant) and food stores (i.e. food for home). The figures are the result of discounting the nominal retail sales by inflation (the BLS breaks out inflation data for both food at home and food away from home), as well as population growth.

The results...

The overall level of food consumed appears to be relatively sticky (right around $300 / person per month), though overall consumption is down by 5% in real terms since 1992. During that time there has been a sizable shift to eating out, which could mean the decline in real terms has to do with eating "cheaper" fast food.



Breaking out each component, we can clearly see the shift to eating out from 1992 to 2006. Since then, it is pretty amazing to see the drop in both components during the crisis and the subsequent rebound (albeit to levels below the previous peak) since.



While not a surprise, this is rather concerning. I recently outlined that bottom earners have been earning less for the better part of the past 15+ years and it looks like it may be actually impacting the dietary habits of Americans (i.e. eating less [unlikely] or eating cheap / unhealthy food [likely]).

Source: Census, BEA, BLS

Retail Sales Flat in August

The WSJ details:

Retail and food services sales were virtually unchanged from the previous month at an adjusted $389.50 billion, the Commerce Department said Wednesday.

Economists surveyed by Dow Jones Newswires had forecast a 0.3% increase. July retail sales were revised down to a 0.3% gain. The Commerce Department originally estimated 0.5%.

Back in February, I outlined that retail sales data was extremely noisy during periods of volatile prices as the data is shown in nominal (rather than real) terms. As the chart below shows, the relationship between retail sales (again, a nominal figure) and commodity prices (as reflected by ETF DBC) is strong.



This in itself fed into the PPI data that was released today, showing energy related prices have retreated from earlier this year, and my expectation is that CPI will come in below consensus tomorrow (we shall see).

So, retail sales are stronger than shown? Not so fast. Looking at the components of retails sales we see weakness in big ticket items (autos, furniture) and restaurants (details of why that may be troubling can be seen in the Pub Power index), offset by electronics and sporting goods (back to school?).



Net net, the consumer (who the U.S. economy relies on for ~70% of growth) is definitely stretched and the economy is definitely slowing.

Source: BLS / Yahoo Finance

Real Median Household Incomes at 1996 Levels

The WSJ details:

The income of the average American worker—long the envy of much of the world—has dropped for the third year in a row and is now roughly where it was in 1996, adjusted for inflation.

The U.S. poverty rate, meanwhile, has continued to rise. America's median household income—what the statistical middle of the pack earns in a year—fell 2.3% to $49,445, adjusted for inflation, according to the Census Bureau's annual snapshot of living standards. The figure has fallen each year since 2007 as high unemployment and a tougher job market has made it harder for working Americans to get bigger paychecks.

This downdraft is part of a longer trend that has wiped out the wage gains of the last decade. Inflation-adjusted household income is now down 7.1% from its peak in 1999, and 2010 is the first time since 1997 that American households made less than a median of $50,000.

As the chart below shows, even upper incomes have been affected by the sluggish economy.

A large factor driving the have / have nots has to do with education. In the past (i.e. a long time ago), an individual could use either their hands or their minds and make a "livable" salary. As EconomPic has detailed multiple times, education matters and labor intensive jobs are no longer a viable means for most.

The issue has been amplified because individuals didn't act as if incomes were stagnant. Back to the WSJ.

"The past decade was just a mirage," says Justin Wolfers, an economics professor now visiting at Princeton University. That's because wage gains earlier in the decade were never that robust, yet people were able to take advantage of surging housing values and easy credit to spend more than they earned.

Source: Census

All Eyes on Europe

The lack of posts have been two-fold:

• I’ve been swamped
• I have been trying to wrap my head around the European situation (i.e. the slow moving car wreck)

While I don’t pretend to be an expert on Europe (though it was obvious enough to be asking the question back in January 2009 whether it was possible that a country would leave the Eurozone), below are my super high level thoughts.

In my opinion (the fact that this is only my opinion is key), it seems more and more likely that the only way the situation in Europe can be successfully resolved, is if the end result is a European fiscal union (this is just another way of saying that Germany needs to bail out those within the broader European Monetary Union if we are to avoid another systemic crisis). If this is the case, the obvious question becomes... is Germany willing to bail out the broader European Union?

The pros / cons of such a bailout for Germany can be broken down into at least two areas; political and economic.

Political

Short-term: Politically, it seems that the easier choice is for Germany to say no, as German citizens are broadly opposed to a bailout. However this is countered by existing politicians who have their legacy tied to the European Union and will likely do anything it takes to maintain that legacy.

Long-term: If Germans are to take a longer term view, a fiscal union helps maintain peace within the region (which was the whole point of the economic union to begin with). That is unless the economic ramifications of a bailout cause political tensions between countries in a scale that exceeds those benefits.


Economic

I have no clue whether the systemic issues that Germany would inevitably feel resulting from sovereign defaults in Europe are greater than the cost of a bail out.

Positives of a bailout for Germany include allowing Germany to maintain an undervalued currency, bailing out Europe = bailing out European trading partners (which maintain demand for German exports), and most important (in my opinion) effectively bailing out the European banking system that owns all the European sovereign debt (including German banks).

Negatives of a bailout include the cost (unless you believe this is just one big liquidity crisis, it will be very expensive) and there is no historical precedent that these countries would get their house in order (i.e. will this just happen again?). More important (in my opinion) is what happens if the broader European solvency issue infects the last remaining healthy European balance sheet (i.e. is a German bail out similar to Bank of America purchasing Countrywide).

Remembering...

As someone who lived and worked very close to the World Trade Center ten years ago on that horrible day, I have been greatly impacted by those day's events even though I was extremely lucky to have not known any of the victims at the time. I wish everyone the best that was directly impacted that day and I am amazed by the resiliency of so many and of the city itself. I just hope that ten years from now we are able to look back and see a lot more positive things that may still come from dealing with the tragedy, as well as resolved some of the hate that resulted from that day. Even though I have recently left NYC, I will always be a New Yorker and I know the city still has its best to come.

Unprecedented Times... Treasury Edition

Last August (2010), I outlined why I thought those claiming Treasuries were in a Bubble was Blasphemy, but even I didn't expect how much more room there was for Treasuries to run.

Reuters details:

Treasury debt prices rose on Friday, taking benchmark yields to the lowest in at least 60 years as investors looked for a safe haven on revived worries a European debt crisis could have a significant global impact.

Note the "at least" 60 years. The chart below shows the ten year Treasury yield over the last 110 years combining monthly data from Irrational Exuberance and daily data from the Federal Reserve once available.

The 1.91% reached today appears to possibly have been, a new all-time low (assuming there was no intra-month low pre-1962 lower than the end of month print).

Students Heart Debt... Everyone Else Deleveraging

Bloomberg details:

Consumer borrowing in the U.S. rose by the most in more than three years in July, led by a gain in non-revolving credit that includes student loans.

Credit increased $12 billion after a revised $11.3 billion rise in June, the Federal Reserve said today in Washington. Economists projected a $6 billion gain, according to the median forecast in a Bloomberg News survey. The rise in non-revolving loans was the most since November 2001.

Revolving credit showed the biggest decrease in six months, indicating Americans may be cutting back on non-essential items as limited job and wage growth depresses consumer confidence. Employment and income gains may be required to help spark the household spending and the recovery.

Note that the chart above assumes all non-revolving consumer loans held by the federal government are student loans (and they mainly are).

Source: Federal Reserve

Hedge Fund Performance Update

Hedge fund performance per Barclay Hedge (yellow are broader indices, compared to the S&P 500).

For more on my thoughts on hedge funds more broadly (some are good, some aren't), see my post What is an Investment in Hedge Funds?

Source: Barclay Hedge

Quits / Layoffs

Bloomberg details (the below was pieced together from a broader article):

The quits rate can serve as a measure of workers’ willingness or ability to change jobs. The number of quits (not seasonally adjusted) in July 2011 increased from 12 months earlier for total nonfarm, total private, and government. In the regions, the number of quits rose in the Midwest and West.

The layoffs and discharges level (not seasonally adjusted) declined over the 12 months ending in July for total nonfarm and government. The number of layoffs and discharges was little changed in all four regions over the year.

So, in theory an increase in the number of quits relative to layoffs should reflect an improving economy and an improving economy should be reflected in the equity market. I was surprised by how strong this was reflected in the data (maybe just luck).

If one were to believe in this relationship, then one would notice how equities seem to lead out of recessions, but the ratio would have given investors a heads up that things were not right back as early as late 2006. I'd also note that the ratio has come back since the market bottom, but not nearly as much as the equity markets have.

Source: BLS / Yahoo Finance

EconomPics of the Week... (Lack of) Labor Day Weekend Edition

Asset Classes
The Predictive Power of "Stocks as Bonds"
Generation Vexed... Housing Edition
The Month that Was...

Economics
Happy Labor Day Everyone!!!!
August Employment Shows No Job Recovery
Consumer Confidence Smack Down... Jobs Edition
On the Response to Irene...
Real GDP per Capita at March 2005 Levels
Manufacturing at Stall Speed... Production and New Orders Decline
Why a One Size Fits All Policy Doesn't Work
Where's the Investment?

And your quote of the week (don't expect this to be a regular occurence... I just really liked this quote):

Great minds discuss ideas; Average minds discuss events; Small minds discuss people.

-Eleanor Roosevelt

And your video of the week... The Decemberists with 'The Wanting Comes in Waves'

Happy Labor Day Everyone!!!!

Robert Reich (via PBS):

Labor Day is traditionally a time for picnics and parades. But this year is no picnic for American workers, and a protest march would be more appropriate than a parade.

Not only are 25 million unemployed or underemployed, but American companies continue to cut wages and benefits. The median wage is still dropping, adjusted for inflation. High unemployment has given employers extra bargaining leverage to wring out wage concessions.

All told, it’s been the worst decade for American workers in a century. According to Commerce Department data, private-sector wage gains over the last decade have even lagged behind wage gains during the decade of the Great Depression (4 percent over the last ten years, adjusted for inflation, versus 5 percent from 1929 to 1939).

He later notes:

The ratio of corporate profits to wages is now higher than at any time since just before the Great Depression.

Source: Politfact

August Employment Shows No Job Recovery

I'll keep my comments brief... any way you cut it, the employment report was extremely weak. Off to a long weekend...

Household Survey - unlike the establishment survey, this actually showed jobs being added (reversing last month's figure which showed a decline)... just not as fast as labor force growth)

Hours Worked per Person - once again turning negative

Source: BLS

Real GDP per Capita at March 2005 Levels

First, what are we looking at...

• Blue line: real GDP per capita (in 2005 dollars)
• Red line: same 1951 starting point in real GDP terms, growing at the 2.15% annualized rate seen from 1951 through 2001 (hence the two lines intersect in June 2001)
• Yellow line: the difference between the two

Highlights:

• Real GDP per capita is currently at March 2005 (6+ years ago) levels
• We are currently "below trend" (if you believe in trend) by $7000 per person (assuming all 300+ million people share the growth equally)
• Real GDP per capita growth actually turned negative in Q1 2011 (flipped positive in Q2)
• Despite the end the recession, the gap between real GDP per capita and trend is growing

Bulls would say "if you believe at all in mean reversion, then the U.S. economy is bound to bounce back". Bears would say "this time truly is different and the recession didn't wipe out excesses (i.e. debt, imbalances between classes, etc...), thus we still have a way to go".

Source: Population / Real GDP

Manufacturing at Stall Speed... Production and New Orders Decline

What respondents are saying:

• "Earlier chemical price increases are beginning to soften." (Chemical Products)
• "Business is soft, confidence is down, and we are cutting inventory and expenses." (Machinery)
• "Exports continue to be strong — domestic weak." (Computer & Electronic Products)
• "Domestic sales are showing small improvements. International sales are showing larger improvements." (Fabricated Metal Products)
• "Demand remains constant and strong." (Paper Products)
• "Current headwinds in the national and international economic environment have increased uncertainty, and are affecting our customers' willingness to commit to high-dollar equipment purchases." (Transportation Equipment)
• "We continue to post solid numbers, but the situation seems tenuous." (Plastics & Rubber Products)
• "Automotive business (represents 52 percent of our sales portfolio) continues to be strong. Core business has pulled back slightly." (Apparel, Leather & Allied Products)
• "Sales continue to be sluggish." (Furniture & Related Products)

Source: ISM

Generation Vexed... Housing Edition

Source: Census via Calculated Risk

The Month that Was...

Source: Yahoo Finance

Why a One Size Fits All Policy Doesn't Work

Source: Eurostat

Where's the Investment?

Calculated Risk posted some great recession measure "drawdown" charts:

• Real GDP / GDI
• Real income less transfer payments
• Industrial Production
• Employment

One additional area not outlined in the post was investment, which is the only component of GDP (of the C + I + G + NX) to still be in negative territory relative to pre-crisis levels.

The bulk of the decline is concentrated in residential investment, but non-residential investment has declined over that time as well.

Source: BEA

Consumer Confidence Smack Down... Jobs Edition

I was just having a conversation with a friend who asked me how retail spending could remain strong (up more than 8% year-over-year through June in nominal terms) , while consumer confidence was taking a dip.

I outlined transfer payments (i.e. unemployment), lower taxes, bifurcation between classes (as he rephrased it, 'the top 10% of income earners have one "vote" each in the confidence measures, but multiple "votes" in the spending category'), and quite frankly that the bounce in year-over-year retail spending hid the fact that in real terms, we were still below pre-crisis (i.e. 2007) levels.

Here's one more thought... the present situation confidence index had been weak, but individuals thought things were going to get better. If August is not just noise, that may no longer be the case.

The devil's advocate in me wants to point out that historically, a large decline (10+ points) in consumer confidence has on average been a great time to buy risk assets as it tends to mark a bottom (see here).

We shall see.

Source: Conference Board

The Predictive Power of "Stocks as Bonds"

My recent post Corporate Profits, Economic Growth, and Equity Valuation outlined that equity performance can be quite volatile, but over the long-run tends to mean revert back to its underlying factor... economic growth.

Which brings me to a model created by the great Eddy Elfenbein (of Crossing Wall Street), which I initially came across in his post What if the Stock Market Were a Bond, back in October 2010. Eddy's explanation of that concept:

I took all of the historical market performance of the S&P 500 (including dividends) and invented a hypothetical long-term bond that matched the market’s monthly gains step-for-step.

I assumed that it’s a bond of infinite maturity and pays a fixed coupon each month.

The result, which starts December 1925, is the following (reproduced) chart.

Crossing Wall Street Model for Stocks (12/1925 - 8/2011)

While I expected a strong relationship between the above chart with forward equity returns (the model is driven by equity performance, but accounts for the market being rich / cheap to its long-term trend and normalizes returns using backward and forward looking performance), I was surprised by how closely it tied (data was pulled from Irrational Exuberance).

Crossing Wall Street Model vs Ten Year Forward Equity Returns

Same Chart, but a Change in Scale to the Right Hand Side

The likely question is how well this model will predict the future as it shows a 12%+ annualized ten year forward return. My initial thought is don't read too much into the model for predictive power UNLESS the underlying factors that drove the last 85 years of equity performance are expected to continue (and at the same level). In addition, Eddy lays out one more issue:

There’s one hitch, though. I have to choose a starting yield-to-maturity for the beginning of the data series in December 1925. So this isn’t a completely kosher experiment because the starting point is based on my guess.

This issue can be seen in the below model which goes back further... all the way to 1871. Rather than predict a forward ten year equity return of more than 12+%, the model predicts returns of less than 5% (due to lower equity returns between 1871 and 1925).

Source: Irrational Exuberance / Crossing Wall Street

On the Response to Irene...

I loved this post a buddy of mine (and long-time trader), Dave Nadeau, made over Facebook (reprinted with his permission) regarding the response ahead of Irene.

I personally think the administration did a great job.

Much like Y2K, the preparedness leads to the letdown. Lack of preparedness leads to panic if things go wrong. Lower Manhattan dodged this by mere inches. Loads of coastal areas did get sacked.

Among those of us who price risk for a living there is a saying: "buy 'em when you can, not when you have to." Bear-runs and short-squeezes are actions of the well capitalized trying to beat the ever-loving-shit out of the unprepared. No one is more well capitalized than Mother Nature.

Well done.

EconomPics of the Week (Hurricane Edition)

A relatively quiet week at EconomPic, but posting a weekly recap because I simply wanted to share a song that I can't get out of my head (love this tune):

Corporate Profits, Economic Growth, and Equity Valuation

Hurricane Irene... Be Extra Safe

Does the Decrease in Continuing Claims Reflect an Improved Employment Situation?

Gold Prices Can Go Down

Equities Up... Fixed Income Down

Can Negative Interest Rates Cause Savings to Increase?

That song is... Edward Sharpe and the Magnetic Zeros with Home

Corporate Profits, Economic Growth, and Equity Valuation

Scott Grannis asks:

Corporate profits are fantastic—what's wrong with equity prices?

As I've discussed numerous times (an example is Equity Valuation Matters), over the long run, earnings matter for equities and those earnings are very closely tied to underlying economic activity. However, over the short-run, earnings (and equity prices) may dislocate from the underlying economy due to a number of factors. In the current market where earnings have dislocated in a positive direction, some reasons may include cost cutting, accounting that allows banks to smooth write downs, low taxes, cheap financing, and a lack of competition for corporations (i.e. the struggles we've seen within the small business sector).

This is another way of saying that all earnings are not created equal. If earnings could in fact consistently grow faster than the underlying economy, then earnings would eventually be larger than the economy itself (a mathematical impossibility). A warning sign is that in the most recent data, as shown in Scott's chart, corporate earnings as a percent of GDP are above 10%, 4% above its 50+ year average.

While this 10% level is unprecedented over the past 50+ years, dispersion between earnings and/or equity performance and nominal economic growth is not. However, in the long-run (sometimes a very long-run), the relationship tends to be very tight. The chart below shows this connection in a chart normalizing data going back to 1951 (the BEA has data going back three more years to 1948, but the relationship is the same).

As for equities being cheap, I actually happen to believe there is in fact a lot of value out there, but I personally wouldn't call the broader market cheap with all the tough issues that need to be addressed. In addition (ignoring whether earnings are / are not sustainable), it matters when you start looking. As Scott outlined, over the last 10 or 20 years, earnings have grown faster than equity valuations. However, over the last 60 years (i.e. the chart above), equities are actually outperforming (i.e. P/E's have expanded).

Source: BEA, Yahoo Finance

Hurricane Irene... Be Extra Safe

Reuters details:

President Barack Obama on Friday warned Americans to take Hurricane Irene seriously and urged them to obey orders to evacuate from the path of what is likely to be an "extremely dangerous and costly" storm.

"All indications point to this being a historic hurricane," Obama said in a statement to reporters from the farm where he is vacationing on this island off the Boston coast.

When the Swine Flu panic was spreading a few years back, I posted the following table outlining a potential reason why (what turned out to be excessive) panic made sense when viewing the potential outcomes of overstating vs. understating the issue.

Let us only hope that the bold statements made regarding Hurricane Irene have been done for a similar reason (instead of staying home for the swine flu, please LEAVE your home if told to).

To all my family and friends back east (who would have thought moving to San Francisco would have allowed me to avoid two natural disasters in one week), I am thinking of you.

Be safe!

Does the Decrease in Continuing Claims Reflect an Improved Employment Situation?

The Street outlines that continuing claims are continuing to trend down:

The total number of Americans filing for unemployment look a bit better than the initial claims data. Continuing claims for the week ended Aug. 13 fell to 3.641 million from 3.721 million, reaching the lowest level since September 2008. Economists were expecting the reading to come in at 3.7 million.

While this is not in itself a bad thing, it requires additional research to determine if it is in fact a good thing. The problem is that individuals are losing coverage as the length of many of those unemployed has extended well past the length they can receive benefits. In addition, the number of newly unemployed is unlikely to grow at the same pace even if the economy remains under pressure, as the overall number of individuals employed is smaller and "low hanging fruit" (apologies to anyone that is unemployed) were already laid off.

To account for some of this issue, the chart below shows the level of continuing claims since 2007 (which shows the peak in continuing claims in 2009), plus the increase in the number of individuals not in the workforce over that time to account for those no longer collecting unemployment.



Source: DOL / BLS

Gold Prices Can Go Down

FT Alphaville asked if this two day decline in the price of gold was the Kiss of Death for Gold?, while Nouriel Roubini compared the recent run up to the Nasdaq bubble. Others simply noted that the two day decline gets prices all the way back to where they were... last week.



Expect more pressure over the next few days as the CME Group ups margin requirements to match the recent run up in the price of gold. Per Bloomberg:

CME Group Inc. raised the margin requirements on gold trading at its Comex unit for the second time this month, after prices surged to a record above $1,900 an ounce and then plunged today by the most since March 2008.

The minimum cash deposit for borrowing from brokers to trade gold futures will rise 27 percent to $9,450 per 100-ounce contract in the speculative Tier 1 category at the close of trading tomorrow, Chicago-based CME said in a statement. On Aug. 11, the increase by the exchange was 22 percent to $7,425.

I am in Nouriel Roubini's camp in that I do believe the gold run (i.e. bubble) will pop in impressive fashion, but I am not ready to claim that moment is about to occur when gold continues to make new highs each month. As I said back in March 2009:

I've learned my lesson with the Internet Bubble (and recent housing bubble) that most people are illogical and invest based on fear (sometimes fearing loss, sometimes fearing they will miss out on the next big thing) and money can be made even if the premise makes absolutely no sense in the long run. As long as fear reigns supreme and equity markets remain volatile, there will be plenty of people convinced gold is the only "safe" investment.

My expectation is that eventually the golden bubble will run its course and come crashing back down to earth. If the economy gets worse, people will realize you can't eat the stuff and investors will sell their stakes to pay for necessities. On the other hand, if the economy recovers, investors will have much better opportunities with their capital… as I mentioned Tuesday, asset inflation, especially in precious metals, serves no economic purpose in the long run.

Source: Yahoo Finance

Equities Up... Fixed Income Down

Interesting day. Equities, fixed income, and gold reversed course for the second day in a row after huge runs in the other directions the previous weeks / months, but commodities, EM (equities and fixed income), and non-US currencies didn't participate in the festivities.



I still don't understand these markets at this time (I feel like I would simply be speculating the impact of Bernanke's Jackson Hole comments), so I am largely sitting on the sidelines until I have a better framework for how to play this.

Source: Yahoo Finance

Can Negative Interest Rates Cause Savings to Increase?

At current interest rates, an individual will lose purchasing power in their savings account if there is even an inkling of inflation. A common assumption is that the Fed has done this (i.e. pushed interest rates to historic lows) to increase aggregate demand (i.e. if you are earning nothing, you might as well spend it) or to move investors to riskier investments that might provide better momentum for the underlying economy (i.e. an investment in a corporate bond that makes it cheaper for corporations to borrow).

But what if low to negative interest rates in fact causes the opposite... an increase in the savings rate and derisking by investors? This post is based on a very quick and dirty framework I've been thinking about and focuses on the savings rate, but the same framework could (in my opinion) justify why investors may choose to derisk as well. Any feedback would be greatly appreciated.

Getting to $100 Saved

Let's assume our saver knows that in ten years they will need to have $100 saved (for retirement, college education for their kids, a new car, etc...). Earning 0% on their savings, they would need to save $10 / year. If they were to earn a rate of return on that $10 saved each year, by the tenth year they would have excess savings (i.e. the blue and yellow lines).

As a result, if an investor can earn more than 0%, they do not need to save $10 / year, but a smaller amount. The chart below shows how much that $10 can be reduced based on various rates of return on their savings.

Assuming the individual earned $200 / year, the original $10 was 5% of their income (i.e. a 5% savings rate). The various amounts needed to save each year is converted to a savings rate below. It clearly shows that if a saver can earn a rate of return greater than 0% (i.e. if interest rates were higher), they can save less to get to their goal.

Unfortunately, savers aren't currently able to earn 0% on their checking / savings accounts. With any inflation, an investors is faced with negative interest rates. So, to get to a $100 real level of savings, an investors will need to save more than the $10 / year.

I know some readers will point out that an individual can always choose to add more risk to increase their returns, but what happens if that investment doesn't work out? An even higher level of savings, which they may not be willing or able to do.

So there's the very basic framework. What am I missing?

EconomPics of the Mid-Month

I will (likely) be taking a mini hiatus next week traveling. I will try to be a bit more involved on Twitter, which I had simply been using as another RSS feed. If interested, you can follow me at: http://twitter.com/#!/EconomPic

To the recap of this month's links...

Economic Data

Leading Indicators Outside of Fed's Control Weakens
Inflation (Not Yet) a Concern

Commodity Prices Flowing Through the Producer

Core European Growth Stalls
Capacity Utilization Passing "CACU" Levels

Private / Public Employment "Drawdown"
Unemployment Rate Drops as Labor Force Declines

Manufacturing Rebound Stalls in July

Consumer Credit Jumps in June

Asset Class Performance

QE2 Investment Performance

Ten Year Treasury Yield Breaks 2%

China Still Buying Treasuries, Demand Had Waned Elsewhere

Long See-Saws and Rubber Bands
Ten Year Yield Approaching Unprecedented Territory

VIX Spiking

Relative Strength

July Recap... Fixed Income and Real Assets Roll

Here We Go Again

Investing

How Reliable are Yields?

Gold Model Still Rockin'

Is The Earnings-Yield Divergence Unprecedented?

P/E Excluding Cash and Short-Term Investments

Other

US / China Tensions Heating Up
Things You Can't Make Up... S&P Math Error Edition

And the EconomPic song of the week; one of the best mashups I've heard in a while... Jay-Z + Toto = Girlfriend in Africa

Leading Indicators Outside of Fed's Control Weaken

Source: Conference Board

QE2 Investment Performance

Let's rewind... the Economist detailed back in November:

Even before the Federal Reserve unveiled its second round of quantitative easing (QE) on November 3rd, critics had already denounced it as ineffectual or an invitation to inflation. It cannot be both and it may not be either.

The announcement of “QE2” was hardly breathtaking. The Fed said it will buy $600 billion of Treasuries between now and next June, at about $75 billion a month, although it also said it could adjust the amount and timing if need be. That was about what markets expected but far less than the $1.75 trillion of debt it bought between early 2009 and early 2010 in its first round of QE. Yet QE2 seems already to have exceeded the low expectations it has aroused. Since Ben Bernanke, chairman of the Fed, hinted at it at Jackson Hole on August 27th, markets have all done exactly what they should. Under QE the Fed buys long-term bonds with newly created money. This lowers long-term yields and chases investors into riskier, alternative investments.

I understand that a lot has happened since the start of QE2 (Middle East uprisings, Japan tsunami, European crisis, debt ceiling debacle), but QE2 does not appear to have accomplished much in economic terms and now just about as little in asset performance terms.

It does look like the Fed has been making some serious $$ on their Treasury purchases.

Source: Yahoo Finance

US / China Tensions Heating Up

On the basketball court that is. ESPN details:

Georgetown's tour through China turned ugly Thursday when a game between the Hoyas and the Bayi Rockets, a Chinese professional team, ended in a bench-clearing brawl.

Mex Carey, Georgetown's sports information director, told ESPN.com that the game was "very physical," with 57 free throws taken by Bayi to just 15 for Georgetown, and quickly spun out of control.

According to the Washington Post, coach John Thompson III pulled his team off the court with the score tied at 64 midway through the fourth quarter after the teams exchanged punches.

Wow!

How Reliable are Yields?

In my previous post Is the Earnings Yield Divergence Unprecedented? we saw that the current differential in the earnings yield of the S&P 500 relative to the yield of the 10 year Treasury is large, but not unprecedented. This post will hopefully provide a bit more insight into the relationship of yield to both fixed income and equity returns.

First, let's start with bonds...

Bonds

The beauty of a traditional bond is that yield wins in the long run... while performance may fluctuate year to year, if you buy a bond and get the credit work right (i.e. it doesn't default), you get a nominal annualized return roughly equal to the yield over a period that matches the duration of the bond (this is the main reason I called out those claiming bonds were in a bubble around this time last year... don't hear much from those guys these days).

The chart below details this feature using bond data from Shiller going back 140 years. To be specific, it shows the Treasury yield at each point in time, then the forward return on an investment in a bond index eight years forward (close to the average duration of a ten year Treasury). While the below does show some noise due to a fluctuating durations (when yields are low, duration is higher) and reinvestment risk, the correlation is 0.92 over that 140 year period (i.e. strong to quite strong). In other words, do not expect to earn more than 2% annualized from an investment in a ten year Treasury bond.

Equities

Equities are a much more difficult beast. There have been countless studies on whether equities actually have duration (one such study showed that equities have a duration of more than 20 years with a standard deviation of 30 years). For this post I ran the 140 years of equity data through an analysis to determine which duration provided the highest correlation between earnings yield and annualized return.

As the following chart details, the winner is.... 10 years.

While ten years was best, eight years was close (and the duration used above for fixed income). Another thought was that if we are to compare earnings yield to the yield of a Treasury bond for relative value, we need an apples to apples comparison... so the chart below uses eight years.

And what do we find... a chart with a pretty strong (~0.45 correlation) relationship. The difference of course lies in the fact that an investor in equities is guaranteed nothing (earnings can fall) and is at risk to multiple (i.e. P/E) contraction, but also shares in the "upside" (i.e. earnings growth) and potential for multiple expansion.

So.... is there a value in comparing the relative attractiveness of equities to fixed income? Sure. I would say the likelihood of equities outperforming Treasuries over the next eight years is high. But don't confuse relative attractiveness and attractive. Ten year Treasuries are currently yielding just 2%, so the 4% "excess" yield of the S&P translates to only 6% on a non-cyclically adjusted basis (using cyclically adjusted earnings it's less than 5%). As the chart above indicates, there have been plenty of occasions where equity performance has significantly under performed its yield, even over extended periods.

Source: Irrational Exuberance

Inflation (Not Yet) a Concern

The AFP details:

Inflation roared back in July at the fastest pace since March, squeezing consumers just as the economy appears to be veering toward recession, government data showed Thursday.

The inflation numbers came amid a batch of worse-than-expected data on the jobs market, manufacturing and housing, and as US and European stocks markets plunged on rising recession fears.

A sharp rebound in gasoline prices and continued increases in food prices drove last month's inflation surge, the Labor Department said Thursday.

While I am concerned with excessive inflation over the longer term if the Fed determines they should pursue an "inflation or bust" policy (the alternative as I see it is painful deflation... a lose lose if you ask me), the latest figure does have me less concerned with inflation over the nearer term. As can be seen, the higher than targeted inflation level is almost solely due to higher crude prices feeding into gas prices. This has already reversed in part this month.

Source: BLS

Ten Year Treasury Yield Breaks 2%

As I showed last week, we are only slightly above the all-time low of 1.95% we saw back in the 1940's.

Source: Yahoo Finance