More on Corporate Profits

Back in September of last year, I showed this chart outlining that corporate profits as a percent of GDP were approaching a three-standard deviation event. Since that time, the relationships has gotten even more extended hitting an all-time high.

Which brings me to this morning's tweet from PIMCO's Bill Gross:

Simple formula: US profit growth rate = (real GDP x 5) – 10. No “ka-ching” at 2% or less GDP growth.

I appreciate the insight that profits can be thought of as being leveraged to economic growth (hence the wide fluctuations), but struggling to see why nominal profit growth would have a relationship with a real (after inflation) economic growth or why those specific numbers (why 2% real and not 2.5% real?) were used.

Anyhow... I was interested enough to see what this equation looked like using actual data, so I put together the below chart going back 60 years against corporate profits, as well as against my old simple standby of using nominal economic growth (my preferred long-term measure for corporate profits as simple math tells you that corporate profits can't grow faster than the economy over the long term or else they'd be bigger than the economy itself - hence profit growth tends to mean revert relative to nominal growth).

The chart...

What do we see?

Well corporate profits are basically right on trend (a surprise to me), but nominal growth is well below trend and the PIMCO formula (the formula based on 2% real growth) is WAY below trend, indicating corporate profits are significantly above trend (by that record 30% level relative to nominal growth and an off the charts 200% relative to the PIMCO formula).

Seems like the old nominal GDP standby has historically been more reliable, but I will be thinking more about the insight that corporate profits are leveraged to (and in need of) specific levels of economic growth. If anything, this may indicate earnings are potentially more stretched than I previously thought.

For those interested, there was a great piece by GMO on the topic of extended profits a few months back.

Source: BEA

Leading Indicators Up in May

Marketwatch reports:

The risk of a downturn in the second half of this year is relatively low, the Conference Board said Thursday as it reported that its index of leading economic indicators rose 0.3% in May. "Economic data in general reflect a U.S. economy that is growing modestly, neither losing nor gaining momentum," said Ken Goldstein, economist at the Conference Board.

Update: while leading economic indicators held up in May, first signs of June are UGLY.

Source: Conference Board

Fed's Ugly Forecasts

Over the past two months, the Fed's FOMC has:

• Reduced forecasts for growth in 2012, 2013, and 2014
• Increased expectations of unemployment in 2012, 2013, and 2014
• Reduced inflation expectations (from a level already below the 2% target) in 2012, 2013, and 2014

Source: Calculated Risk

Financial vs. Capital Expenditures and Equities

Yesterday, I made a bullish case for equities over the long run (especially when compared to bonds), today I will outline one of the reasons I am a bit concerned over the intermediate time frame.

Meb Faber (via a paper by Mauboussin from Legg Mason) shows a table that outlines:

How companies have spent their cash over the past 25 years. Interesting to note is that they spend on average, about 60% of their total spend on capital expenditures, 20% on M&A, and about 10% each on dividends and executed buybacks. The total amount of spend bounces around a bit but is a fairly consistent 20% of market capitalization. Note that buybacks exceeded dividends in 7 out of the past 10 years

Along with the market cap of these corporations, the table shows (as part of a broader paper outlining the benefits and analysis of each) the amount corporations spent on:

• Dividends
• Share buybacks
• M&A
• Capital expenditures

I'll simplify things and group the first three as "financial expenditures" (or at least spending that isn't used for organic growth) and compare this figure with capital expenditures.

The first chart I'll show compares historical capital expenditures and financial expenditures, normalized as a percent of GDP. While Meb outlines the averages for each category above, what we see is financial expenditures have been trending higher while capital expenditures (as a percent of GDP) have been trending lower. This despite slower underlying economic growth (i.e. slowing growth of the denominator in the capital expenditure to GDP ratio), in part caused by a slowdown in (you guessed it)... capital expenditures. Some thoughts on why financial expenditures have increased in relative importance include the boom in private equity and financial engineering, the shorter-term focus of investors, and a lack of perceived opportunities to deploy cash on projects. Also note how volatile financial expenditures (mainly buybacks and M&A) have been.

The next chart shows the ratio between the two expenditures (financial expenditures divided by capital expenditures). In the late 1980's / early 1990's the ratio was consistently at or below 0.4 (meaning for every $1 spent on dividends, buybacks, and M&A they spent $2.5 on internal growth opportunities), whereas since the late 1990's the ratio has gone above 1 almost 50% of the time (i.e. corporations are now more interested in financial management then building their business through organic growth).

So what does this mean for an investor? Well, returned cash sounds good, but taking the above ratio and comparing it to the three year forward change in market cap (i.e. the value of corporations three years forward) we see a relatively strong (negative) relationship. Unfortunately (and not too surprising when you think about it), when corporations don't put money back into their businesses, the value of these corporations is negatively impacted (they are essentially liquidating vs reinvesting).

I'll leave with one additional point... this all likely reduces the impact of monetary policy (if a corporation is returning cash even at these low rates, why would they borrow more?).

Source: BEA / Meb Faber

Valuation Matters.... Equity vs Bonds Edition

I've shown that valuation matters numerous times over the years when it comes to long-term equity returns (see here, here, and here for some of my favorite examples). The below post uses the same concept in that it compares valuation (i.e. yields) with forward returns, but in this version we compare the relative performance of equities vs. bonds.

The first chart shows the factor that serves as our starting point for valuation... earnings yield of the S&P composite (i.e. the inverse of the P/E ratio) and the yield of the ten year Treasury bond going back 100 years. What we see is a relationship between the two starting about 50 years ago that was non-existent the previous 50 (and the recent divergence that is the widest in almost 40 years).

But the lack of a relationship from 1912-1962 doesn't mean it the relationship wasn't always important. The next chart outlines the forward ten year return differential (annualized) for each starting point against the starting excess yield (the equity earnings yield less the bond yield). Interesting to note that we can easily see the unwarranted excess return that equities saw over bonds starting in the 1980's (i.e. the equity bubble), that was given back over the past ten or so years.

To summarize the above, the next chart outlines the forward ten year return differential (annualized) for each starting point by "bucket" (note that at current valuations we just made it into the 5-7.5% bucket, hence the yellow highlight). The takeaway is that starting yield differentials matter... a lot. To be more specific, the current 5-7.5% bucket means that for every period over the past 100 years when the yield differential was between 5-7.5%, the average annualized ten year forward return differential was a bit more than 8% (8% over the current 1.5% ten year would be 9.5% absolute returns for equities).

While I refuse to state that returns will be anywhere near this 9.5%, by almost all measures stocks appear cheap on a relative basis to Treasury bonds. Unless earnings collapse back to a "normal" percent of the overall economic pie abruptly (definitely possible, but in my view not likely) or the economic pie contracts abruptly, stocks are going to outperform bonds over the next ten years.

Source: Irrational Exuberance

Retail Sales Sluggish

BusinessWeek details:

U.S. retail sales declined in April and May, pulled down by a sharp drop in gas prices. But even after excluding volatile gas sales, consumers barely increased their spending.

The Commerce Department said Wednesday that retail sales dipped 0.2 percent in May. That followed a revised 0.2 percent decline April. The back-to-back declines were the first in two years.

The weakness reflected a 2.2 percent plunge in gasoline station sales. Still, excluding gas station sales, retail spending rose just 0.1 percent in May. And it dropped 0.1 percent in April. That left retail spending roughly flat outside of gas sales for the two months, a sign that slower job growth and paltry wage increases may be leading consumers to pull back on spending.

The one thing not mentioned above that I find interesting is that furniture and motor vehicles (i.e. large purchase retail items) are #1 and #2 respectively in terms of strength. Perhaps (though not certain) people are just putting other items on hold as they make these purchases.

Source: Census

The End of the Middle Class

The NY Times details:

The recent economic crisis left the median American family in 2010 with no more wealth than in the early 1990s, erasing almost two decades of accumulated prosperity, the Federal Reserve said Monday.

A hypothetical family richer than half the nation’s families and poorer than the other half had a net worth of $77,300 in 2010, compared with $126,400 in 2007, the Fed said. The crash of housing prices directly accounted for three-quarters of the loss.

Families’ income also continued to decline, a trend that predated the crisis but accelerated over the same period. Median family income fell to $45,800 in 2010 from $49,600 in 2007. All figures were adjusted for inflation.

The chart below outlines median family net worth among different percentiles. While all wealth brackets have witnessed a hit since 2007, the wealthier you are... the less you've likely been impacted in percent terms (they were less levered / more diversified in their investments and are less reliant on income from a job for their wealth). Since 2001, it is even more divergent as the only bracket to have seen an increase in wealth are those in the top 10% decile of all wealth.

Source: Federal Reserve

Drop the Inflation Concerns

As I've outlined before, wages tend to be the one of the better predictors of inflation (or deflation) out there as wages tend to be very sticky and stable (so when they move, it tends to mean there is a new underlying trend).

So how are wages currently holding up?

Well, earlier this week, the BLS released compensation figures for Q1 and even with negative real interest rates and multiple quantitative easings, there is absolutely no wage inflation in the pipeline. In fact, the year-over-year change in nominal wages came in at just 1.3% at the end of March and 0% over the last six months, the lowest since the crisis and below the rate of inflation.

Even more concerning (to me) is that these figures are as of March, before business sentiment took a turn for the worse on renewed European concerns.

With no inflationary pressure and limited growth potential, a low yielding Treasury bond almost appears justified.

Source: BLS, BEA, Fed

Dividend vs. Treasury Yields

The dividend yield of the S&P 500 is above that of the ten year Treasury for the first time since the financial crisis. Before that we have to go all the way back to the 1950's to find a time when this was the case.

The kicker... stock dividends have only made up about 45% of total S&P composite stock returns over the past 100 years, while Treasury bond coupon payments have made up north of 96% of Treasury bonds returns over that same period (see below). What this means for an investor is unless you think dividends will be cut and/or capital appreciation will be negative (i.e. corporate America will shrink in terms of nominal value), stocks are poised to outperform.

My take... stocks appear to be very cheap relative to bonds for investors with a long-term investment horizon, while near term investors need to be careful as we seem to be in a world that is likely to have binary outcomes (i.e. either a boom or an absolute collapse).

The remaining 55% of S&P stock returns have been in the form of capital appreciation, which has become increasingly important since the 1950's (see above), as corporations reinvested earnings back into their businesses / bought back shares (vs paying out dividends), while investors evaluated the relative merits of equities relative to bonds (see the much tighter relationship to bonds, which ratcheted up P/E multiples).

Source: Irrational Exuberance

Europe's Core / Periphery Imbalances Going Parabolic

George Soros' recent speech on what created the Euro bubble (and how it will need to play out) is making the rounds (although he deleted the speech from his personal site for some reason, a pdf version is here). While I strongly suggest reading the whole thing, a key takeaway is that:

The authorities didn’t understand the nature of the euro crisis; they thought it is a fiscal problem while it is more of a banking problem and a problem of competitiveness.

The result is that the issues have not been addressed and problems have only gotten worse.

The real economy of the eurozone is declining while Germany is still booming. This means that the divergence is getting wider. The political and social dynamics are also working toward disintegration. Public opinion as expressed in recent election results is increasingly opposed to austerity and this trend is likely to grow until the policy is reversed. So something has to give.

Which can be easily seen in a variety of metrics, including unemployment which is shown in the below chart and is simply unbelievable. It shows the current unemployment rate of Spain (currently an unreal 24.3%) divided by Germany's (less than half 2005's level at 5.4%) going back to 2000. It was only 5 years ago that Spanish unemployment was actually lower than Germany's (though that employment coincided with a massive housing bubble in Spain funded by cheap German financing from excess German savings).

Source: Eurostat

Put Selling as a Replacement For Stocks

The higher that market implied volatility becomes, the more attractive put selling (as a replacement to being long stocks) becomes.

The chart below outlines one such example, this being the put option payoff structure of March 16th, 2013 expiry puts on the ETF SPY. As implied volatility moves higher, the put premium (think of this as the insurance premium you are selling) moves higher (i.e. the payoff structure moves up).

In the example below, the current payoff over the next 10 months of an at the money put is almost 10%, which can be thought of as the "upside" should stocks stay at current levels or move higher, while downside moves in the same 1:1 fashion as owning the underlying SPY ETF (but you are cushioned by that 10%). If you want more cushion in the form of allowance for downside movement, you can sell further out-of-the-money puts (but collect a smaller premium).

A few months back, I outlined that implied volatility was so low that I was replacing some of my long positions with long call options (and short positions with long put options). If volatility moves higher, I will likely be doing the opposite and replacing these long call / put positions with short calls / puts.

Note: the payoff structure in the above chart should be moving down at a crisp 45 degree angle for all of the above put payoffs (the reason they don't is I am being lazy in the number of data points I used to create the chart).

Source: Yahoo Finance

First Quarter GDP Revised Down to 1.9%

Marketwatch details:

The U.S. economy ran into a deeper soft patch in the first quarter than initially estimated, a government report showed on Thursday.

The Commerce Department estimated that the economy grew at a 1.9% pace in the first quarter, slower than the 2.2% rate initially reported.

This is down from a 3.0% growth rate of real gross domestic product, the output of goods and services produced in the U.S., in the fourth quarter.

Source: BEA

What Happened to the Great Bond Sell-Off?

It's amazing that it was only a bit more than two months ago that I wrote this post defending bonds against what was labeled the "Bond Market Arab Spring". It's also amazing how wrong pundits continue to be as Long Treasuries have now caught up to the S&P 500 year-to-date after the ten year Treasury reached an all-time low.

Source: Yahoo

Existing Home Sales Rise Across the Board

While the overall level of existing home sales is still well below the bubble peak (4.62 million vs. 7+ million in mid-2005), the trend is positive across housing markets and prices.

Source: Realtor

Leading Economic Indicators Turn Negative

Source: Conference Board

(U.S.) Relative Strength

Despite the recent turmoil, unlike when I showed this chart last August (a time when the dollar was selling off and gold / commodities were roaring), the ETF's showing the least strength are all currency or real assets. I believe this accurately reflect the current (relative) strength of the U.S.

Source: Yahoo Finance

Checking in on Inflation

Marketwatch details:

Inflationary pressures are fading, just as Federal Reserve officials expected. But don’t think that the decline in the inflation rate will automatically lead to further quantitative easing by the Fed.

The consumer price index was flat in April, the Bureau of Labor Statistics reported Tuesday. And the CPI is expected to drop by at least 0.2% in May on account of the big drop in gasoline prices.

The CPI has increased 2.3% compared with a year ago, down from a 2.7% year-over-year rate in March and 3.9% last September. By May, the year-over-year rate could slow to 1.8%, below the Fed’s longer run target.

Looking into the details, there isn't much of a pattern, but it looks like most "stuff" we consume (clothes, food, medicine) increased in price at a faster pace than the headline figure, with the exception of alcohol (hence, I'm not complaining).

Source: BLS

EconomPics Recap

I just came to the realization that I haven't had an EconomPic recap since March 9th, so here goes:

Economic Data

• Trade Deficit Blow Out
• The Consumer is Back... Consumer Credit Positive (even excluding student loans)
• Ugliest Employment Chart You'll See?
• Employment Market Continues to Muddle Along
• Personal Income and Outlays... A Few Charts
• GDP Breakdown
• How's That Austerity Working?
• Leading Economic Indicators (less Fed Control) Negative
• Retail Sales Continue to Show Strength
• State Taxes
• What's Another Trillion?

Investing

• Stocks for the Long Run?
• When Leverage Attacks
• April ETF Performance Recap
• Baby's Got Sauce... Checking in on the World's Greatest Rotation Strategy
• More on that Treasury Blood Bath
• The Power of Momentum
• Why Investors are Reaching for Yield?
• Chinese Treasury Holdings Back to 2010 Levels
• The VIX as an Equity Hedge
• Baseball Valuations Soar
• "Risk On" in Q1
• Not All Bonds are the Same
• About that Treasury Blood Bath

Random

• Quantifying March Madness

And your video of the week... Beastie Boys (RIP MCA) closing out 'The New Style'.

Trade Deficit Blow Out

Remember when we thought the U.S. was going to export our way back to prosperity riding European and emerging market aggregate demand (that wasn't a crazy statement even a year ago... promise)?

BusinessWeek details the reality:

The trade deficit widened more than forecast in March as American demand for crude oil, computers, automobiles and televisions propelled imports to a record.

The gap grew 14 percent to $51.8 billion, the Commerce Department reported in Washington today. The median estimate of economists surveyed by Bloomberg News called for an increase to $50 billion. A 5.2 percent jump in imports, the biggest in more than a year, swamped the 2.9 percent gain in exports, which also reached a record.

Change in Trade Balance - Chain-Weighted 2005 $$ (i.e. real change in 2005 dollar valuation)

With the re-emerging crisis in Europe since the March trade balance print (and what will likely be a resulting oversupply of goods coming from emerging Asia), don't expect this trend to slow any time soon.

Source: Census

Stocks for the Long Run?

While the below chart cherry picks one of the best performing fixed income sectors, it is still pretty amazing.

Bonds (defined in this example as the Barclays Capital Long Government / Credit index) have now outperformed stocks (defined as the S&P 500 index) going back to November 1980 (10.7% annualized vs. 10.4% annualized) and has more than doubled the performance of stocks over the past 15 years (239% vs. 108%). Note the chart below is total returns including reinvestment coupon payments and dividends.

Is this likely to continue?

Unless capitalism as we know it ends, the answer is a simple 'no' over the next 15 or 32 (or even 3-5) years. The government / credit index shown above yielded a whopping 13.18% as of November 1980 and the next 32 years were the great bond run that has resulted in the current paltry yield of 3.89% (just 7 bps off its all-time low).

Source: Barclays Capital / S&P

The Consumer is Back... Consumer Credit Positive (Even Excluding Student Loans)

SF Gate details:

Consumer borrowing in the U.S. surged in March by the most in more than a decade on growing demand for educational financing and autos.

Credit rose by $21.4 billion, the biggest gain since November 2001, to $2.54 trillion, Federal Reserve figures showed today in Washington. The advance was paced by a $16.2 billion jump in non-revolving debt, including student and car loans.

Americans may have been trying to get school financing before a possible increase in interest rates takes place on July 1. Rising consumer confidence also means that households are more willing to take on debt to boost spending, which accounts for about 70 percent of the economy.

I've been showing the below chart for some time. It shows the year-over-year change in revolving consumer credit, non-revolving consumer (excluding student loans), and student loans. Headline consumer credit has been growing since early last year, but this had been solely due to student loans (not necessarily a bad investment, but it doesn't reflect consumers re-leveraging for goods and services).

Well, as the chart shows, after a strong March where revolving consumer credit (i.e. credit cards) jumped 7.8% month over month and non-revolving (excluding student loans) posted a positive print... the day has arrived in which the consumer is no longer deleveraging in nominal terms (important for all that nominal debt out there).

We'll see if this continues, but the consumer looks like they may be back.

Source: Federal Reserve

Ugliest Employment Chart You'll See?

Per Felix Salmon:

As Mike Konczal noted this morning, a key indicator of labor recession is still in force: if you’re unemployed, you’re still more likely to drop out of the labor force entirely than you are to find a job.

Let's see how that trend has fared over the longer term.

The chart below shows the ten year rolling change in the number of individuals employed divided by the ten year rolling change of those individuals no longer in the labor force. Any number over 1 means that the marginal person of working age is more likely to have gotten a job ten years later than to be out of the labor force.

In the late 1980's / mid 1990's, this marginal individual was a whopping 8x more likely to have found a job than no longer be looking. Today? 0.35x, which means that the marginal individual of working age (relative to 2002) is 3x more likely to be out of the labor force, than to have found a job.

Source: BLS

Employment Market Continues to Muddle Along

The NY Times details:

The nation’s employers added 115,000 positions on net, after adding 154,000 in March. April’s job growth was less than what economists had been predicting. The unemployment rate ticked down to 8.1 percent in April, from 8.2 percent, but that was because workers dropped out of the labor force.

The share of working-age Americans who are in the labor force, either by working or actively looking for a job, is now at its lowest level since 1981 — when far fewer women were doing paid work.

The first chart shows the unemployment rate from the payroll survey, which shows the headline improvement.



The next chart shows the issue with the calculation. The reason for the improvement in the unemployment rate is due to the continued departure of millions from the labor force (if you're not looking for a job, you're not technically unemployed).



The final chart attempts to account for the declining labor force through a cyclical adjustment. Similar to Shiller's cyclically adjusted P/E ratio, the below normalizes the labor force participation rate through a 10 year rolling average, then assumes the difference in that average and the latest number of participants are unemployed (or in the case of a rising workforce, it reduces the number of unemployed).

What we see is that the labor force was potentially much stronger than headline figures indicate throughout the 1960's - 1990's as the participation rate increased (in no small part due to women entering the labor force), as it took some time for the labor market to accommodate the increase. Since 2000, the reverse has been true as the participation rate has trended down... now at the lowest rate since 1981. Taking the current number of workers and assuming a cyclically adjusted labor force, unemployment is still above 10%.



Which seems more accurate at first glance.

Source: BLS

When Leverage Attacks

The real estate market is certainly heating up in the San Francisco, my new city, despite the broader Case Shiller Home Index still hovering near cyclical lows.

How soon we forget.

I will admit, real estate does sound like close to a sure thing with mortgage rates at record lows, potential inflation on the horizon, negative real rates in savings accounts (i.e. zero opportunity cost), and prices as much as 50% or more off. And it may be, but not necessarily when leverage is introduced.

But, first, let's take a look at housing without leverage.

Case Shiller Index (without Leverage)

As last week's post The Power of Momentum outlined, the broad Case Shiller Composite-10 index was stagnant from 1987 to 1997, rocketed between 1997 and 2006, and has tumbled since. However, over this entire period we have seen a healthy increase in the price (a bit more than the rate of inflation... assuming growth using the composite-10 index, a house worth $100,000 in 1987 is now worth a bit less than $250,000)

Case Shiller Index w/ Introduction of Leverage

As James Montier of GMO has pointed out:

Real risk is the risk of permanent loss of capital.

Investments made with borrowed money reduces the range that the investment can move without causing a permanent impairment of capital.

Using the same Case Shiller Composite-10 index data as in the above chart, we introduce leverage using the following rules:

• 5x leverage (i.e. a 20% down payment... pretty standard, though not so much during the bubble)
• If prices rise, sell your investment property each year and with the equity gains, buy a more expensive property at 5x leverage

Simplifying Assumptions:

• Mortgage payments = rental receipts
• No taxes / transaction fees

Using the same $100,000 house as an example (this time with 20% down), we get the following:

Returns were actually okay from 1987 to 1997, but were dwarfed by the boom seen from 1997 to 2006 as property values, debt to go along with it, and equity SOARED, taking the original $20,000 investment to $3.7 million.

BUT, it all came crashing down. As property values declined, the new outsized level of debt remained, which resulted in all that hard earned equity flipping negative (in the above example) by early 2008. 5x leverage means that when the value of the property turned down just 20%, the entire equity stake was gone.

Takeaways....

• Real estate investment is not riskless, especially when leverage is introduced
• Down payments of 20% do not prevent bubbles (as the chart above shows, asset appreciation allows an investor to put gains back in the market)

A case can be made (specifically within real estate) that negative equity does not equal permanent impairment. As long as payments continue to be made, an investor is still alive. While this is true, it does completely reduce liquidity (i.e. you can't sell without making the loss permanent) and it require an investor to make mortgage payments that are higher than the current market clearing price for similar properties.

Source: S&P

Personal Income and Outlays... A Few Charts

The Economic Populist notes:

While disposable income increased by 0.4%, when adjusted for inflation, disposable income was actually a 0.2% increase.

Over the longer term and on a real per capita basis, March marked the third month in a row in which disposable personal income printed a negative year over year figure, which shows just how how weak the employment recovery has been.

On the flip side of the income / consumption equation, has been solid spending (both in nominal and real terms), as consumers have reduced their savings rate below 4% (the savings rate had moved above 6% during the beginning of the crisis).

One area of real consumption weakness... energy in real terms. I am no expert as to specifics of what is making up the decreased demand (clean technology, less people driving to work, more people taking public transportation, etc...), but I will say that demand does tend to decrease when the price of good or service quadruples like energy has in recent years.

Source: BEA

April ETF Performance Recap

In a month where market pundits made it seem like we were experiencing a sell-off we have never seen before, markets were only slightly in risk-off mode, while EVERYTHING (except long treasuries) is now up for the year.

The question for investors is whether the risk-off environment was simply a pause following a sharp rise in risk assets in Q1 (i.e. just the temporary mean reversion seen below).

Or the beginning of a European crisis induced broader sell-off that is a continuation of Q3 2011 (as seen below).

Source: Yahoo Finance

GDP Breakdown

Bloomberg details:

The U.S. economy expanded less than forecast in the first quarter as a smaller contribution from inventories overshadowed the biggest gain in consumer spending in more than a year.

Gross domestic product, the value of all goods and services produced in the U.S., rose at a 2.2 percent annual rate after a 3 percent pace, Commerce Department figures showed today in Washington. The median forecast of economists surveyed by Bloomberg News called for a 2.5 percent rise. Household purchases increased 2.9 percent, exceeding the most optimistic projection. Homebuilding grew the fastest in almost two years

So there you have it... a VERY strong (perhaps unsustainable?) contribution from consumption, reduced impact from inventories, the beginning of contribution from residential investment for years to come (after years of decline), mixed trade, and what is likely to be negative impact from the government sector for years.

Source: BEA

More on that Treasury Blood Bath

Just about a month ago when everyone was calling the end of the 30 year bond rally, I noted.

While any sell-off has the potential to become the large sell-off EVERYONE has been waiting for (economic data is improving, yields are very low, inflation is ticking higher), I am not yet convinced it's the sure thing these "experts" want you to believe.

But, I guess if you keep making the same prediction, eventually it will come true.

Apparently, we need to keep waiting.

A weak (and deteriorating) Europe, low inflation, low growth, an uptick in risk-asset volatility, and continued piling into the asset class by investors (mutual fund flows remain positive), businesses (looking for yield on cash), and government entities (QE) have not only supported the asset class, but made it one of the top performing asset classes month-to-date.

Source: Barclays Capital

The Power of Momentum

Gary Antonacci of Optimal Momentum blog has a great white paper out titled 'Risk Premia Harvesting Through Momentum' that details...

Momentum is the premier market anomaly. It is nearly universal in its applicability.

Gary then outlines how an investor can easily apply momentum through the use of asset pair modules to "effectively harvest risk premium profits". I highly recommend anyone interested in momentum or learning more about momentum to check out the (easy to understand) white paper that you can download here.

Reading the paper gave me an idea for a test that I felt would further show how universal momentum truly is. The test? How well would an investor have done applying momentum to the various cities that make up the Case Shiller Home Price Index, pretending (of course) that each city index was investable and liquid (i.e. things they aren't).

First, a quick update on the Case Shiller Home Price Index. To the Huffington Post:

The Standard & Poor's/Case-Shiller home-price index shows that prices dropped in February from January in 16 of the 20 cities it tracks.

The steady price declines have brought the nationwide index to its late 2002 level. Home prices have fallen 35 percent since the housing bust.

Prices in nine cities fell to their lowest levels since the housing bust. The average price in Atlanta fell 17.3 percent in February compared with a year earlier. That's the biggest annual drop in the history of the index for any city.

Yikes... let's see what momentum can do with this mess.

Rules...

1) Take the 6-month rolling return for each city

2) Allocate the next month to the city that had the highest six month return

How well would we have done?

The chart below outlines the performance of this relative strength allocation, the composite-10, and Portland (which happened to be the best performing city over this time frame... who knew).

For those keeping track at home, that's a 12.7% annualized return for the relative strength index vs. 3.3% for the composite-10 and 4.8% for Portland, despite there being no rule that allowed an investor to get out of the market.

Not too bad.

Source: Case Shiller

One reason I was drawn to Gary's paper is that it is remarkably similar to something I've been working on for the better part of the past year, which itself is based on conversations that I've had with Meb Faber from World Beta over the past few years. If you haven't read Meb's paper A Quantitative Approach to Tactical Asset Allocation, another strong recommendation.

How's That Austerity Working?

Bloomberg details:

The debt of the euro region rose last year to the highest since the start of the single currency as governments increased borrowing to plug budget deficits and fund bailouts of fellow nations crippled by the fiscal crisis.

The debt of the 17 euro nations climbed to 87.2 percent of gross domestic product in 2011 from 85.3 percent the previous year, official European Union figures showed today. That’s the highest since the euro was introduced in 1999. Greece topped the list with debt at 165.3 percent of GDP, while Estonia had the least at 6 percent of GDP.

Bloomberg continues...

Italy ended last year with the second-highest debt at 120.1 percent of GDP. Spain’s rose to 68.5 percent from 61.2 percent. Germany posted one of the only declines, with its debt shrinking to 81.2 percent from 83 percent, Eurostat said in the report. Only five euro-region nations -- Estonia, Luxembourg, Slovenia, Slovakia and Finland -- had debt within the euro- region’s limit of 60 percent of GDP.

This leaves indebted European countries in an awfully precarious situation.

On one hand they have limited firepower left with debt levels increasing relative to nominal GDP even as they push austerity measure (always important to remember the debt to GDP ratio will rise as long as debt increases more than GDP and that can be in the form of flat debt and declining GDP). On the other, even if the citizens throw out leaders that favor austerity, for those pro-growth, it is unlikely to help as it doesn't address the cause of the problem... the imbalances between countries with vastly different production capabilities, demographics, beliefs, yet a shared currency.

Source: Eurostat

Leading Economic Indicators (less Fed Control) Negative

Excluding the components the Fed impacts, the index is negative for the second time in three months, dragged down by the decline in the average work week.

Source: Conference Board

Why Investors are Reaching for Yield?

Because high yield is just about the only place you can get yield within the U.S. without taking on interest rate risk. The question is whether investors know / are comfortable with the credit risk they are taking.

Source: Barclays

Chinese Treasury Holdings Back to 2010 Levels

For years, the mainstream media reported that China was unloading Treasuries when in fact they weren't (Treasuries were purchased and listed as being held by the U.K., then regularly revised to China). BUT, recent revisions to the TIC Data shows that the slow down we witnessed in late 2011, was actually a rather significant decline.

To BusinessWeek:

The rise in holdings comes after China reduced its position in U.S. government debt in 2011 for the first time since the Treasury started releasing the data in 2001, as yields fell to record lows.

* Chinese + United Kingdom Holdings as some purchases flow through the U.K.

Some of this was simply a reallocation to higher yielding agency bonds, but it doesn't seem to account for that much of it. We'll see in coming months (data will now be revised by the Treasury on a monthly, rather than yearly basis) if the bottom holds at spring 2010 levels or if things are taking a much different turn in China than most market participants believe.

Source: Treasury

Retail Sales Continue to Show Strength

The Washington Post details:

Americans bought more electronics, started home improvement projects and updated their wardrobes last month, inspired by warmer weather and a healthier job market.

The increase capped a strong quarter of gains and contributed to a brighter outlook among economists for growth in the January-March quarter. Businesses are responding by restocking their shelves at a steady pace, a sign that they expect the trend to carry over into the spring.

More retail spending also helped offset a decline in confidence among homebuilders. And it could ease concerns about March hiring, which slowed to half the pace of the previous three months.

Source: Census / BLS

Employment Report: Not as Bad as I First Thought

Upon first glance, Friday's employment release was disappointing, but Scott Grannis pointed to something that does provide optimism.

In the past two months the household survey has made up for that lagging performance by posting growth of 740K jobs.

Below is a breakdown of the household survey broken down by the public (government) and private (business) sectors. The huge divergence accounts for how the household survey could show a net negative growth print for March, while the private sector grew by 336,000.

The private sector recovery over the last twelve months is now the same as the peak we saw last cycle (though that in itself was the "jobless" recovery). The main concern I see is whether the drag from the public sector will in itself cause the aggregate economy to stall, but this makes me much more optimistic than I was on Friday about a continued (albeit slow) recovery.

Source: BLS