Putting the pieces together...

Kasriel Economics and An Income Bias

Very little seems to have changed in a month. Bonds and gold are down a bit and stocks up a bit. The news remains riveted to the "subprime garbage" mess as it is increasingly called. My investment accounts are up 5.6% on the year, and with gold (metal) added (metals stocks are in the investment account totals already) I'm up 7.6% on the year. Good enough for keeping a retirement account up with inflation, nevertheless the worst returns since 2002. Partly this is due to a conscious decision, documented here over the year, to switch from a growth bias to an income bias. In a way the market has told me that my decision was timely. Some friends who retired in 2000  did not make the investment bias change in time. They lost substantially from their retirement kitty during the bear market. Nothing can be more demoralizing than losing a lot just after retiring. It changes everything you hoped for, whether your hope was well-placed or not. It's very hard to recover.

I spent the last several days reading Paul Kasriel's 2007 reports. Frankly, I had forgotten about him and hadn't read any of his analysis since about 2002. Kasriel is the chief economist at Northern Trust which is a major investor for wealthy trust beneficiaries. He is normally sceptical or even negative, as most old-line trust officers used to be with their clients before go-go tactics and happy face hedge fund investing became the norm. Kasriel spends most of the time during economic expansions and stock bull markets perfecting his identification methods for the next recession and the associated bear market. If you are looking for bad news, you will find it, and bearers of bad news are not very welcome at the bull's parties. But when I ran across Kasriell's name in my web browser favorites list after a long absence, I wanted to know the worst.

I'll post his URL below, but the major development is that he now has his own recession model based upon on only two indicators: the year-over-year percent change in the quarterly average of the CPI-adjusted monetary base (reserves and currency held by banks and currency held by the non bank public) and the four-quarter moving average of the percentage-point spread between the Treasury 10-year note (bond) yield and the Federal Funds rate. Just two indicators as opposed to the ten used by the Conference Board: the growth of the US monetary base adjusted for consumer inflation, and the spread between the Fed Funds interest rate that  the FED  controls and the ten year Treasury note yield which it does not control. Well, at any rate the FED doesn't control the ten year note yield directly or immediately.

Then, using a two phase switching probability schema--recession or no recession--and these two indicators, Kasriel can estimate the probability  of a recession within the next year. Readings and estimates are made monthly based on twelve month smoothed data in the two indicators. As of Friday, December 21, 2007 the probability is 65.5%,  or two-to-one, that we will have a recession within the next year. Kasriel finds the National Bureau of Economic Research's definition for a recession superior to the two quarters of declining GDP often quoted as a definition: "According to the NBER, a recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales." (NBER is the arbiter or score keeper of US recessions.) In other words a recession needn't be a 19th century or 1930's wipeout-- Armageddon-in-our times-- although it presumably could be. Notice there are no dire warnings about credit, the stupidity of Wall Street, presidential election politics, etc. involved in Kasriel's prediction process. Just what the FED does or doesn't do and how the credit market responds.  To be sure, Kasriel has opinions on many of the newsworthy economic topics of the day, but they don't figure in his recession model. Since I am primarily a technical analyst--if you'll permit me to include sentiment as part of the technical world--this is my kind of economics. Since 1968 a recession has either started  just as the probability got to about this probability level or within a year at the latest. There have been no false signals or missed signals.

Kasriel documents that a stock market decline is important for recession but not definitive for prediction. No recession since 1948 has started without a down year in the SPX, but not every down year was followed by a recession. The SPX closed out 2006 at 1418.30 and this past week at 1484.45, so we're up only 4.7% on the year with a few trading days to go.

In one of his other recent reports Kasriel mentions his view on stagflation by demonstrating that inflation usually peaks during recessions. It is a lagging indicator in that sense. But in view of my last report here, it was nice to hear a professional of some standing who agrees with me on stagflation. Look here for more and also check his "Econtrarian" series as well in the left hand column of the Northern Trust website:

http://www.northerntrust.com/pws/jsp/display2.jsp?XML=pages/nt/0601/1138283684288_6.xml&TYPE=interior

So what's the bottom line? I have continued to prune my accounts and raise more cash and near cash, primarily on strength. I'm still in a quandary regarding bonds. Most of the bonds I own through Vanguard Wellesley and Loomis Sayles Bond Fund and T R Price Spectrum Income are intermediate term with effective durations under 6 years, but they can still take a hit if rates go up. Bonds were very choppy during 2001 and 2002 and did not make the big bond bull run until the recession was officially over, although conditions remained rocky well after the November 2001 NBER "official" end of the recession which wasn't "confirmed" until July 2002.

Given my own inflationary opinion and Kasriel's comments, I am likely to cut these funds back somewhat and go to cash or shorter term bonds with the proceeds. I hate to tinker with what I think is is a reasonable portfolio, so I will probably simply cut back but not eliminate anything entirely. (So far I am not changing the municipal bond accounts.) Just as it was lovely to be able to invest from substantial intact cash in 2003, so would it be lovely again to have a stash of cash to invest  if we have another recession and bear market. 

Liquidity and Velocity

As we are in interesting times, I am spending more time than usual on current events and less on portfolio analysis. For in fact only by understanding what is going on will I know what to own. I think my current portfolio is "OK", but it may need some changes going forward,

Anatole Kaletsky and the father and son Gave's have emerged in recent years as among the very best market economists and investment analysts. Google them or their firm GaveKal for a list of publications.

Kaletsky has been writing a stream of articles recently for the Times of London on the monetary crisis there and in the US.  John Maudlin has made available an update of GaveKal thinking today.

This is an excerpt, but I urge you to read the whole argument:

"In 1933, Mellon famously advised Roosevelt to "liquidate labour, liquidate capital, liquidate the financial markets. It will lead to a much more moral society." This, better than any other statement, encompasses the "perma-bear" philosophy: sinners have to pay for their sins; and when the central banks step in to give sinners a helping hand, this can only ensure eternal damnation for the rest of us (either in the fires of an inflationary bust, or those of a deflationary bust, depending on the perma-bear to whom you speak)."

"Needless to say, with the Fed having just cut 50bp, the prophets of inflationary doom are having a field day. Everywhere we care to turn, we are told to sell the US$ and buy gold. Once again, paper currencies are going to be shown to be worthless."

"But is the Fed's track record really that horrendous? As Milton Friedman himself wrote in the WSJ "on August 19th, 2003: "Fifteen years ago... I wrote 'no major institution in the US has so poor a record of performance over so long a period as the Federal Reserve, yet so high a public recognition'. As I believe I demonstrated at the time, that judgement is amply justified for the first seven decades or so of the Fed's existence. I am glad to report that it is not valid for the period since".

"Indeed, for all of the perma-bears' laments that the Fed keeps on pushing inflation in the system, we are not sure that this assertion is backed up by the data. Indeed, let us ask a very simple question: were recent interest rate cuts by the (according to Milton Friedman) competent Fed followed by a rise in the CPI shortly afterwards? Let us have a look:

"Since 1970, most cuts by the Fed (1970, 1974, 1985, 1989, 2001) were followed for at least two years by massive declines in the inflation rate. There were, however, exceptions: 1980 (which was quickly taken back by Mr Volcker) and 1998 (which was also quickly taken back)."

"Which leaves us with the following question: Will the recent Fed cut prove to be right? Or will it be, like 1980 and 1998, a mistake quickly taken back? We tend to believe that the Fed was right to cut and that, given the massive collapse in velocity, commercial banks will need a steep yield curve in order to recapitalize their fragile balance sheets and avoid a Japanese-style deflationary bust."

"However one puts it, we can't escape the conclusion that Milton Friedman was (once again) right: In recent years, the Fed has been more broadly right than wrong (five out of seven). Better yet, when it has been wrong, it was quick to change its course and adjust to the underlying realities. Can the perma-bears claim the same batting ratio and the same intellectual flexibility?"

http://www.investorsinsight.com/otb.aspx

HUSSMAN and the FED MODEL

John Hussman runs a mid cap stock mutual fund (HSGFX) which he hedges with put options on both the Russell 2000 and S&P 500 indexes. The concept is that superior stock selection will beat the sector index averages over time and give us an even better risk/reward rating if the good stocks are bought and the average stocks are sold against them via puts. This is the basic stuff of long/short hedge funds. Hussman's bias is toward "value" stocks based upon standard, historic value analysis. And his record is decent, especially from 2000 to 2004 when hedging or not hedging made the real difference between victory and defeat if you were long.

My starting date for total return data for HSGFX (http://www.FastTrack.net) is from November 21, 2000. For the four years from that date to November 21, 2004, Hussman's compounded total return was 15.7% annually while the Russell 2000 total return index was up 8.5%. Since November 21, 2004 to last Friday, however, Hussman's rate of return is 5% annually while many stock and bond funds have rewarded us with much more generous returns. The Russell 2000 total return index itself is up 9.1% compounded since November 21, 2004. I also remember reading Hussman's analysis during the second half of the 1990's when he was managing private accounts in much the same manner as he's done with HSGFX which started up in 2000. He was bearish nearly the whole time from 1997 to 2000 on value grounds, as were many classically trained or philosophically inclined analysts and managers. So basically it's good to follow Hussman in bear markets and in the initial rebounds off the bear market lows. But most of the time, absent the wipeout of the century when P/E ratios of all stocks go to 6, he is going to earn a bit more or less than the T Bill rate unless we experience a mid-cap value rally exceeding all other stock capitalization sectors and during which Hussman's picks outperform the average mid-cap.

Why am I bringing up Hussman's highly mixed but decent record? Largely becase he has been pounding the table on market analysts who follow the so-called "FED Model" in which stock earnings should match or trend toward the interest rate on the ten year US Treasury Note. Ed Yardeni was an early booster of the FED Model and Don Hays is a current leader of the pack which includes many securities industry sellers to the public who want us to buy for any reason that's popular. This is Hussman's latest essay: http://www.hussman.net/wmc/wmc070820.htm

Hussman's intellectual crusade currently, in addition to constantly pointing 0ut how over-valued the stock markets are, is to show that interest rates and corporate earnings growth tracking between 1982 and 2000, the meat of the FED Model fanatics, were coincidental or accidental and are not the rule in most eras. My view is that both the FED Model and the Hussman views are overly simplistic and/or miss the point of the true relationships of corporate forward earnings, the nominal US Treasury ten year note yield, and stock market returns.

I have put a logarithmic chart of the Dow 30 index above Hussman's recent chart of forward SP 500 earnings and the ten year Treaury note yield. If we look at the record since 1948, it's quite clear that stock market returns were positive when ten year note yields were low or falling EVEN THOUGH forward earnings were falling from 1948 to 1966 and from 1982 to 2000! You could just as well insist that falling forward earnings are good for stocks as to say that a rising yield on the ten year was bad for stocks. Then look at 1966 to 1982 when forward earnings were rising rapidly along with note yields: earnings and rates both went up but stock returns were flat for 16 years.

Both camps in this issue are wrong, or "partially right": both Hussman and the FED Model folks. They miss the fact that low or falling interest rates are good for stocks regardless of projected forward earnings, but that there comes a time when rates get "too high" for stocks. And I don't think there is a specific nominal interest rate number that turns the tide, and the stock market to down. The last "too high" time came in 1966-68 and will come again in due course, as readers of this site know well about the longer term interest rate and inflation cycles. Hint: inflation-adjusted or real interest rates and earnings rates are more germane to the issue. Nevertheless, the Goldilocks "too hot" or the "just right" nominal interest rate is a simple and effective guide to stock returns.

So far rate rises worry us from time to time, as they always should, but stocks are still surviving...so far. Interest rate cycle theory says we should have another ten years or more of stock market rises before interest rates get "too high" for comfort or profit. That doesn't mean a rampant bull market or that we can't have periodic larger corrections, but we shouldn't have a persistently flat or seriously down market as we did from 1966-1982 until rates get "too hot" even though the P/E cycle is contracting.

The bottom line is that stocks rise when interest rates are low (even if they double as between 1948 and 1966)or when interest rates can be seen to have stopped going up (from 1982). When rates are high and/or rising more rapidly, they (and the inflation they reflect) neutralize the effect of quite large nominal increases in earnings (1966/69-1980/81.

Perspectives on sixty one year investments...

A very old lady I knew passed away last year leaving some stocks and some vacant farm land.

The farm was bought at ~$150 per acre in 1946 and may sell for $38,000 per acre in 2007. That would be a 9.5% compounded annual rate. The estate tax reduces that to $25,849 per acre or 8.81% compounded annually. (Note how a very small increase or decrease in the compounded rate over many years greatly affects the dollar amount.)

Over the same period the US Gross Domestic Product Implicit Price Deflator (official measure of inflation) compounded at 3.5% per year. So the real, or inflation adjusted, after tax return for the farm land was 5.31% per year. And this was in a "tax-deferred" investment, as there was no substantial income attributable to the property nor any tax paid except for minimal property taxes.

If you compounded the $150 (per acre in 1946) at 5.31% annual real rate of return after tax and inflation (also a tax, as we see), the value today of the farm per acre in 1946 dollars is $3799 per acre, just 10% of its value in 2007 dollars!

If someone bought the Dow Jones Industrial Average on the first day of 1946 at 191 in a tax-deferred account and took all the dividends to live on instead of reinvesting them, the compounded after estate tax rate of return would have been ~6.48% and the inflation-adjusted compound return ~2.93%. In 1946 dollars the Dow today would be 894 which is about 7% of its value in 2007 dollars. So simple farm land outperformed the Dow, although it threw off little income and the Dow did. The Dow's income was of course also highly taxed and deflated by inflation.

Thus the toll that taxes and inflation take is enormous. It is hard, even under a tax-deferred situation with undeveloped land, to make a decent real return. This is why timing and leverage grow ever more important as taxes and inflation increase, as they will surely do. Unfortunately most people do not handle leverage well nor are they good timers. Thus we gradually get wider disparities in national personal  incomes (the Gini coefficient becomes less equitable) as smarter and more capable investors leave the others in the dust. And that results in higher taxes and inflation to "remedy" the social inequality.

Conclusion: The government wins. The smart speculators win.  The losers lose. 

PS: gold increased 4.9% compounded annually from 1946 before taxes and inflation. After estate tax it returned 4.2% compounded annually. Apply inflation to that and gold rose 0.7% compounded annually in 1946 dollars. Plus you had to pay to store it.

The FED and the Wizard of Oz

http://www.hussman.net/wmc/wmc061002.htm

Funnymentals Update and Bullish Wild Card

In "Some Funnymentals"(below) I wrote about some of the factors which explain why most stock indices markets have gone nowhere in 2004-2005.

The main reason is that despite enormous growth in corporate profits, both M2 money growth and the ten year treasury bond yield minus the FED funds rate have depressed growth potentials. See the analysis based upon Paul Kasriel's arguments earlier this summer which were buttressed by the Conference Board's Leading Economic Indicators.

A second reason was the rising household debt to disposable income ratio which Kasriel and I showed as historically impacting spending, and hence GDP, thence stocks.

Nothing goes in a straight line, and we have had a substantial 5-10% sell off in market indexes which validates much of the above. However, in the past three months both M2 money and MZM money (cash) have begun growing again  after a year's pause. FED actions affect these short or no duration moneys, but so do stock market moves. When people take money out of stocks it's either because of profits or fear of losses. In either case it means there is more money for expenditures or for investment. Currently with short term rates rising, cash may also be a preferred investment, with some money market funds (Vanguard's Prime Money Market Fund comes to mind) yielding close to 3.4%. Neverthlesss there is no penalty or loss of investment principal when you take cash  money for another purpose, so cash is always "hot money" in a sense. If you are familiar with Terry Laundry's T Theory of cash build ups, you'll have a good idea where this can lead: http://ttheory.typepad.com

On another subject, I promised earlier last week to write about market analogies between now and 1934-35, because I think this may be the bullish "sleeper" amongst all the gloom and doom scenarios after a stagnant period and pullback.

Over the past four months, four different people have drawn my attention to the similarity of the NASDAQ 100 chart since 2000 and the DJIA chart from 1929 to 1935. I don't  believe any of these four knows any of the others, and each approaches the markets from a different perspective and with different tools. It's possible they all are being influenced by someone else of course. Two are very successful private traders, one in central Europe and one in the US, and two are money managers who publish investment newsletters.

There are whole websites devoted to comparisons of "now" and "before" with percentage similarities on a day to day or week to week basis.  Moore Research Center is one such: http://www.mrci.com/special/

I have always been biased against such minute comparisons as they seem to be favored especially by "crashistas" looking for a 1929 or 1987 crash next month or next week! But there are some superficial similarities of the economies and the markets of 2000 and 1929  and their aftermaths.

Disinflationary booms created manic bull markets followed by three year "crashes" of about 90% in the 1929 Dow and 2000 Nasdaq. Then there were major bullish recoveries of a year or less followed by nearly two years of high level consolidation when the market went nowhere. Don Hays of http://haysmarketfocus.com (this requires a signup process for a three day free look), one of my four sources, adds that the recovery off the 1982 multi year bear market low was much the same. Each of the three markets, 1933-35, 1983-85, and 2004-2005, spent 22 months, 27 months, and 22 (currently) months respectively  before taking off in major bull market extensions for two years more.

One of my other sources showed that the position of the 50 and 200 day moving averages of the current Nasdaq100 and 1935 DJIA are quite similar, and another source has cogent Gann timing reasons which are virtually identical to 1935.  Also it's probably a coincidence, but each of these examples ended in year 5 of its decade. This reminds me of the famous "Tides in the Affairs of Men", the original decennial pattern of Edgar Lawrence Smith,  discussed and/or extended by many including W. D Gann and Edson Gould. 2005 looks to be an exception to the general rule so far, unless............................

Here are the three charts involving the 1935, 1985, and 2005 ends of high level consolidations after runs up from major bear market lows. You be the judge. (Left click on the images for a large version .)

 

Some "Funnymentals"

Paul Kasriel, economist at Northern Trust in Chicago, has been forecasting a slowdown in the US economy based upon his estimation that the FED has already pushed short term interest rates past the so-called neutral point. The closest Kasriel has come to the "R" word is to mention in passing  a possible "growth recession" for 2006. He recommends the ten year treasury note yield minus the FED funds rate and real M2 money growth rate as leading indicators of economic growth, as indeed does the Conference Board in its Leading Economic Indicator.

In a report from this past summer http://tinyurl.com/d9oqm Kasriel overlays a chart of  quarterly GDP with a one quarter forward-shifted (1QF-GDP) line which combines those two indicators above. Since 1959 these indicators turned down one to several quarters before GDP growth, and this is what we have already seen, as the  1QF-GDP and GDP growth peaked in early  2004. Each of eight prior occurences resulted in a growth slowdown and five of them led to true recessions.

Kasriel has also looked at the household (consumer) increase in debt as a percent of disposable income. http://tinyurl.com/8dhh7 In general the comments one sees on this issue bemoan the long term "implications" of this debt burden. Currently the four quarter moving average of debt/household disposable income is about 12.2%. In both 1977 and 1986 the figure was about 10.5%, so the peak of last year was not astronomically above previous peaks. Nor should we forget that debt/income fell to about 4% in 1992-93, and that it is quite cyclical with peak to peak periodicity of approximately 4-6 years.   This is not a parabolic rise.

What I found more interesting than the "long run" about this debt indicator was that it peaks during the rise to, but ahead of, inflationary peaks. One could say that the  household (consumer unit) begins to cut spending and pay down some debt as prices increases materially squeeze their budgets. We've been hearing anecdotal stories about this phenomenon recently with gasoline prices, but here is a data series which confirms it as a real event.

On a hodge podge chart I stacked a logarithmic Dow Jones 30 chart on top of the household debt/income chart from Kasriel on top a chart of year over year increases in CPI, on which recession periods are shaded pink or salmon. Clearly the debt/income downturns precede recessions, but even if a recession doesn't occur, there is a decline in CPI. This latter was the case in the early 1960's and 1986-87.

Even more interesting for investors is that downturns in household debt/income often, but not always, precede stock market highs. 1999, 1976, 1973, and 1955 were excellent examples. Even more compelling is the observation that upturns from lows in household debt/income occur at or shortly before market bottoms. (Keep in mind that the household debt/income chart is a one year moving average.)

While we have a downturn in the one year moving average of household debt/income from about 13% a year ago to just over 12% now, we don't of course know if this is just a wiggle in the rise from 2001 or a meaningful event which will lead to a major drop in CPI, a recession, and a major fall in stocks.

However, Kasriel's chart of M2 growth and the spread between the ten year treasury note yield and Fed funds have great reliability and are also pointing in the same direction as household debt/income.

"What does it all mean?", as my history professor was wont to ask after a long lecture. How do we  take this to the bank?

My hunch is that should be looking over our shoulder as we saunter down Wall Street. If we see evidence of technical deterioration in the stock markets, given this fundamental background, we should take the money and run.

I do see some technical deterioration in a number of sentiment measures, although short term it looks quite bright. The first hour minus last hour Dow 30 price differential points to long term distribution since early last year. SP500 futures' cumulative on-balance volume line has fallen below its quarterly (65 day) averages for the longest time since the 2003 low. SP500 futures open interest has also fallen on an expiration to expiration (3 month) basis since June. And so forth.

My timing and my hunch suggest another fourth quarter run up to Christmas before a larger decline perhaps lasting through 2006. Final runs are often more powerful than one would suspect, so even if one's hunches are correct, it's best to stay the course. Then too, one's hunches may not be right.