“The Policy Environment”—Bloomberg’s No-go Zone

A few days ago on Bloomberg Radio Tom Keene and Barry Ritholtz interviewed Stephen Stanley of Amherst Pierpont Securities, focusing on his gloomy outlook for GDP growth. Twice Stanley stated that the “policy environment” was holding back growth. First he observed that “Some of the reasons potential growth has slowed are not permanent reasons. The policy environment has been very unfavorable toward business investment and that is something that obviously could change over time.” A couple of minutes later, in response to a question from Tom Keene about weak capital spending, Stanley said, “Investment has been the biggest disappointment relative to expectations for several years now. A lot of that has to do with the hostile backdrop. Corporate tax reform just sits there, and never happens. The regulatory environment has been difficult for a lot of industries. Firms are only doing what they have to do. They replace machines that break down . . .”

So how did Messrs. Keene and Ritholtz—ever eager to elucidate future economic developments for their thousands of listeners—follow up on Stephen Stanley’s dour assessment of the “policy environment?” Did they ask for more specifics? Challenge his assumptions? Find out what policy changes Stanley hoped to see out of Washington?

Not a chance. Nothing. Nada. Rien. You see, in BloombergLand, the wretched “policy environment” crafted by Obama Administration is off limits. Whether because of the network’s obvious liberal bias or the myopia of Wall Streeters obsessed with the Fed, the broader “policy environment” is a no-go zone. Bloomberg reporters and pundits would rather spend a month at the Chernobyl Nuclear Exclusion Zone than explore how Obama has stunted economic growth and killed jobs, thereby increasing inequality and hurting the poor. (The affluent Washington bureaucrats who live in suburban Maryland are doing just fine; Baltimore’s poor blacks, not so much. Let’s blame the police and Fox News.)

Why does this matter to investors? Because, as Stephen Stanley clearly implied, a new Republican administration with pro-growth policies could jump-start economic growth, proving Larry Summers and fellow Secular Stagnationists wrong. With the torrent of revelations about Hillary and Bill starting to make the Corleone Family look like amateurs, a Republican administration appears increasingly possible. This would be much more positive for equities than for bonds.

Copyright Thomas Doerflinger 2015. All Rights Reserved.

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Fidelity versus the S&P 500: Round Two

A couple of days ago the WSJ reported big news in the mutual fund world—active managers have outperformed index funds thus far in 2015. Which prompted me to update a little study I did three years ago that compared the 10-year performance of Fidelity Investment’s actively managed domestic equity funds with its index funds. Once again, the active managers failed to beat the index funds by enough to cover the higher taxes and higher risks associated with active management. One other important finding: Fido’s mid-cap funds tended to outperform large-cap funds.

I looked at 31 actively managed funds (24 large-cap and 7 mid-cap) and compared them with 3 index funds. Here are the results:

  •  The three index funds had an average annual return over the past decade of 8.62% (median 8.77%).
  • The average performance of the 31 actively managed funds was a trivial 24 bps better than the index funds.
  • The 24 large-cap funds underperformed the index funds by 35 bps.
  • The 7 mid-cap funds outperformed the index funds by an impressive 104 bps (median 113 bps). This is consistent with what others have observed. Mid-cap stocks are the “sweet spot” in the equity universe. They are stronger than small-caps but unlike large-cap stocks they are not battling the “law of large numbers;” they are likely to be acquired by larger firms; and they may command a higher valuation (PE multiple) as they grow in size, became more liquid securities, and pick up Wall Street coverage.
  • The risk in owning actively managed funds is substantial. Of the 31 funds, 6 (all of them large-cap funds) posted returns of less than 7%. These 6 funds posted an average of 5.92%, underperforming the index funds by a huge 270 bps.

Investment Conclusions

  • Large cap mutual funds generally don’t outperform index funds meaningfully—certainly not by enough to cover higher taxes and the risk you will buy a crappy fund that substantially underperforms.
  • If you do buy index funds, don’t just stick to large-cap funds. Allocate some capital to a mid-cap index fund, such as a fund that equal-weights the stocks in the S&P 500. (Because the top 50 stocks in the S&P 500 account for half of its total market cap, it is effectively a large-cap index. However, if you equal-weight all 500 names, it becomes a mid-cap index.)

The Trouble with Index Funds . . . 

. . . is that you will fully participate in the stock market mega-manias that develop over time—energy stocks in the late 1970s, tech stocks in the late 1990s, financial stocks in 2008. By 1999, for example, the S&P 500 had a huge 40% weighting of TMT (technology, media, telecom stocks) not only because these sectors had strong earnings and sky-high PE ratios, but also because the Standard & Poors Index Committee added tech stocks to the index once they became “important,” “representative” stocks – that is, after they had run up in price. This was disastrous for index fund investors, who got little of the upside but all of the downside on dozens of “high-flyers” that fell to earth. Hypothetical example: XYZ Inc. goes public with a market cap of $500 million, zooms up to $10 billion where it becomes “important” enough to be added to the S&P 500, eventually rises to a $15 billion market cap during the final bull market blow-off, but then—in the harrowing tech wreck of 2000-2002–collapses to $1 billion. Studies I conducted while working on Wall Street showed this happened to dozens of S&P 500 firms, giving the index terrible performance. The index became a stealth growth stock fund with a strong TMT bias. Index investors got none of the run-up in XYZ from $0.5 billion to $10 billion, but all of the collapse from $10 billion to $1 billion. No thank you. In that period it was pretty easy to outperform the S&P 500 if you avoided the tech mania—particularly because many non-tech stocks were so neglected they had absurdly low PEs. For example, homebuilders had PE ratios of 5x or 6x.

In theory you might avoid this sad scenario by avoiding an S&P 500 Index fund and instead buying a “total market” fund. But that is a very imperfect solution, because the entire market can have a long-term, ultimately disastrous bias in favor of one sector. Financials, for example, became a larger and larger portion of the stock market between 1990 and 2007 as many new financial companies were created and went public (REITS, mortgage banks, mortgage insurers) while large, well-established firms also decided to go public (investment banks, mutual life insurance companies such as Met Life and Prudential) and some giant non-financial companies (GE, GM) diversified into financial businesses. All of these companies were benefiting from the long-term trend toward lower interest rates, deregulation, and credit creation from 1982 to 2007, and they all got killed by the financial crisis. Index fund investor fully participated in the debacle, including terrible mega-caps like Citigroup.

Right now the glamorous part of the stock market that eventually could mimic tech or financials is healthcare, though maybe not for many years. It has exciting fundamental growth drivers (demographics, new technology, Obamacare, rising healthcare standards in emerging markets), but also quite a bit of financial froth (booming M&A activity, lots of interest from venture capitalists).

To Control Risk, Don’t Fall in Love with Any Sector

Whether you want to “create your own conglomerate” by selecting your own stocks or prefer to buy mutual funds, a key to long-term success is to recognize that Wall Street invariably takes every powerful economic and financial trend to wretched excess. It’s OK to participate in the “hot” sector in a disciplined and sane manner; don’t try to be a stoical contrarian. But control your risk by not becoming hugely over-weight any one sector.

Copyright Thomas Doerflinger 2015. All Rights Reserved.


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Blinder’s Blinders

In a recent WSJ article, Princeton professor Alan Blinder, formerly vice chairman of the Federal Reserve, ruminates on the decline in productivity growth in the past couple of years. He methodically runs through various possible explanations for the slowdown. Is it a “statistical illusion”? Payback after the “marvelous performance” of 2009 and 2010 when GDP grew but companies were still too scared to hire? He thinks “a third hypothesis, weak investment, is more important”—which, however, only begs the question, why is investment weak? Then he points to “two less conventional, even counterintuitive, hypotheses.” Maybe the economy has become “less entrepreneurial” (which again begs the question, why?) or maybe – the final entry in his causal laundry list – technological progress has slowed.

Hilariously absent from Blinder’s list is the avalanche of new taxes and regulations that the Obama Administration dumped on the economy—Dodd Frank, Obamacare, the EPA war on fossil fuels, higher marginal tax rates plus a raft of Obamacare taxes, fulminations against “millionaires and billionaires,” no Keystone XL Pipeline, no corporate tax reform, etc. etc.   We have cited before the bitter complaints of CEO’s of major corporations—Intel, Eaton, 3M, JP Morgan, Wynn Resort, etc.   You cannot talk to a Wall Street pro without getting an earful about the huge increase in compliance costs; when firms hire tens of thousands of lawyers and compliance officers, productivity growth falls. Small banks complain they are burdened with the same regulations as too-big-to-fail behemoths; no wonder the number of bank start-ups has plummeted. The NFIB small business confidence index is still—six years into an economic recovery—well below the 1983-2007 average (which includes two recession). Given all this hostile interference from a know-it-all Federal bureaucracy, it is hardly surprising that business investment has lagged. What makes Blinder’s blinders all the more unpardonable is that this is a replay of the 1970s, when a raft of new regulations led to a productivity slowdown that was ultimately reversed by deregulation initiatives started in the Carter administration and continued by Reagan.

Blinder unintentionally demonstrates that, for all its scientific pretensions and mathematical pseudo-precision, economics is an inherently political discipline. You will not find what you do not look for, and liberal economists like Blinder and Krugman ignore government regulations that increase the risk and reduce the profitability of business investment. Then they wonder why business investment is weak.

The good news is that Washington’s attack on productivity could be reversed fairly quickly by a Republican administration that cuts taxes and regulations and prioritizes growth over redistribution.

Addendum: Obamacare and the Weak Consumer

Partly because they did not factor in the bearish impact of Obamanomics, Street economists have been too bullish on GDP for the past six years. Now they wonder why consumers have not boosted spending in response to the “tax cut” of dramatically lower oil prices. One plausible hypothesis that the Street has been very slow to embrace—but which is discussed in a CNBC article today—is that Obamacare is hitting consumers, in at least two ways. One is higher deductibles and co-pays for the expensive “soup-to-nuts” policies Obama forced on the middle class as a deceitful, hidden subsidy to the poor. Also, the “individual mandate” – get coverage or pay a fine – is hitting consumers this year.  Republicans ought to focus on this issue in order to connect Obamacare directly to “wage stagnation.”

Copyright Thomas Doerflinger 2015. All Rights Reserved.


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Victorian London and Baltimore’s Post-Capitalist Proletariat

Meet John Walker, alias “Black Jack,” a licensed hawker in Victorian London. He makes a living distributing coal to Londoners in winter and selling sand to stables in summer. Like larger entrepreneurs, he plays the spread between wholesale and retail. “Wholesale, a sack [of coal] fetches me one and six; but it pays best to sell it to poor folks, my chief customers, in small lots at a penny and two pence a lot.” Sand he buys at 11 shillings a ton and lays down for 30 shillings a ton. But there’s overhead to consider—the donkey. Remarked one hawker, “I always feed my beast to make sure he gets his grub regular. I look after him too, as I would a brother. He’s worth all the trouble I can take about him.” Fortunately Black Jack’s beast was reliable—“my donkey’s took me home many a night when I had a drop o’ drink in me.”

Other hawkers dealt in strawberries purchased at Covent Garden. The business worked as follows: “Three partners, with a joint capital of 4 pounds [sterling] may invest in a lot that will turn out thirty-five or forty dozen ‘punnets’ [baskets]. These they will readily dispose of the same day at an average price of four pence a basket, or a trifle less.” Strawberries had to be handled with care. “Strawberries ain’t like marbles that stand chuckin’ about,” explained one dealer. “They are what you may call fancy goods. . . .You should never let them know you’ve got fingers, leastwise fingers like mine – all thumbs. They don’t like it. They must be worked without touching. . . . They won’t hardly bear to be looked at.”

Other laborers worked the Covent Garden flower trade. About two thousand men were employed bringing flowers to the hundreds of stalls in the market; another two thousand fanned out around London, carrying flowers to the various purchasers. These men were paid job-by-job, but an elite group had regular employment in the flower stalls; at 5:00 AM they brought the flowers from the wholesale market to their shops, where they arranged the inventory in a pleasing manner.

A Post-Capitalist Neighborhood

Because these men, though poor, were firmly connected to London’s commercial economy, they earned the income and self-respect that comes with having a real job. That’s not the case with all too many young black males in America’s inner city, which makes them susceptible to substance abuse and crime. According to the Urban Institute, in January 2010 the employment / population ratio (which takes account of both the unemployment rate and labor force participation rate) was just 39.9% for young black men, versus 57.4% for young white men and 52.8% for young Hispanic men. So 60% of young black men were not working. And that is a national figure—it is even higher in inner cities.

A NYT article by a Johns Hopkins historian argues that Baltimore’s poor are exploited by capitalists who control retailing and real estate. Unfortunately he’s wrong. Mainstream business interests have pretty much abandoned vast residential areas in Baltimore, Philadelphia, Detroit and other cities. There’s not a lot of profit in selling to households earnings $20,000 or $30,000 per year, especially when taxes are high and costs for security, insurance, pilferage, etc. are inflated by high crime. A tour, via Google maps, of the Baltimore neighborhood where the CVS store was looted and torched reveals only a smattering of national brands such as Subway and Burger King. Interestingly, there is a super-abundance of “carryout stores” mostly selling chicken and Chinese food—which suggests many residents don’t have the facilities or access to fresh produce that would allow them to cook at home. There are also plenty of check cashing stores, tax preparers, liquor stores, beauty salons and small stores selling clothes, used furniture, etc.

Wrong Turn

Such neighborhoods are a forlorn monument to liberalism. In the late 1960s the Civil Rights Movement and War on Poverty morphed into a campaign for income redistribution that was all too successful because both Democrats and Republicans were frightened by urban riots and took perpetual prosperity for granted. Transfer payments soared. Across the political spectrum capitalism was deemed un-cool and unnecessary; it was Richard Nixon who stupidly, and disastrously, imposed wage and price controls in 1971, setting the stage for double-digit inflation in 1973. (If you know you can’t raise prices while your own costs are rising, you don’t build new capacity.) During the dreary 1970s mainstream businesses decamped from increasingly over-taxed, crime-ridden cities, leaving the poor to the tender mercies of corrupt politicians and public employee unions.

A Capitalistic Anti-poverty Agenda

Liberals triumphed; the poor suffer. They are not literally “trapped” in “ghettos;” suburbanites commute into central cities, so obviously reverse commutes are possible and, indeed, are made by many. What is needed is economic reform that produces a prolonged period of strong GDP growth and robust labor demand, such as we had in the late 1990s. That was a period of welfare reform, a capital gains tax cut, soaring stock prices, and rising income inequality—but also major progress for poor black Americans. The percentage of blacks in poverty dropped from 33.4% in 1992 to 22.5% in 2000.

Today the indicated reforms are pretty obvious—corporate tax reform that repatriates $2 trillion in corporate cash stranded overseas, an “all of the above” energy policy, school choice for poor inner-city parents (not just rich liberals like the Obamas and Gores), and repealing anti-full-time-employment regulations such as Obamacare. Republican Presidential candidates should aggressively push a capitalist anti-poverty agenda for the inner city but eschew dumb gimmicks like “enterprise zones” and temporary tax holidays.

Copyright Thomas Doerflinger 2015. All Rights Reserved.

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The Wisdom of Michael Steinhardt

Last weekend we, along with a few hundred other garden enthusiasts, visited the famous gardens of hedge fund impresario Michael Steinhardt, located in the NYC suburbs. My wife and I realized this was not your typical mega-estate when an attendant told us to park in front of a wooden fence that was part of the enclosure for four camels and two zebras. There are also llamas, giant tortoises, and a pond that accommodates a dozen pink flamingoes and monkeys who inhabit an island in the middle of the pond.

The gardens—fifty acres or so—are unusual, as much for what they lack as for what they contain. There are no English–style garden rooms or mixed herbaceous borders, no Victorian bedding out, no fancy geometric parterres, no picturesque cottage garden, herb garden, rose garden or knot garden. What it does contain is an orchard, a splendid pinetum (collection of conifers), a huge array of specimen maple trees, a wonderful rock garden and sprawling naturalistic water gardens grouped around a network of ponds and streams. Where it excels is in integrating garden elements into the surrounding forest. This is extremely difficult to do; I have seen other efforts that fell flat and looked ridiculous. The key to success seems to be to avoid certain common garden plants – such as hostas, bleeding heart, and rhododendrons – that just don’t look right in a northeastern forest.

Inevitable Inflation

Which got me to thinking about Steinhardt’s career. I reached deep into my memory bank and recalled a remark he made about the financial markets round about 1980 or 1981. At the time “everyone knew” that high inflation would continue indefinitely; wise economists explained to anyone who would listen that, even if a concerted effort were made to rein in inflation (which would be politically impossible because it would cause a recession) it would take at least five years to accomplish. Accordingly, far-sighted corporations bought inflation hedges. In 1976 GE acquired Utah International, a producer of coal, copper and uranium; five years later Fluor bought another miner, St. Joseph’s Mineral Company. Wall Street also belatedly adjusted to the “reality” of secular double-digit inflation by dumping bonds. In the first six months of 1982 the 30-year Treasury bond had an average yield of 13.75%, up from 8.4% in 1978 and 7.2% in the early 1970s.

I recall Michael Steinhardt remarking that this interest rate surge created a truly extraordinary investment opportunity. You could lock in a 14% return – 40% above the long-term return of equities – for 30 years, with no credit risk. After being tortured by a thirty-year bond bear market, investors were extremely slow to recognize that inflation crested in 1980 and disinflation was the new normal. Bond yields peaked in the autumn of 1981 at 14.7%, just as Paul Volcker was engineering a severe recession that would slash inflation from 13.5% in 1980 to 3.2% in 1983. Because investors feared a return to high inflation, real interest rates remained extremely high in the first half of the 1980s.

Why Should We Care?

Because there is a good chance we are in a similar situation now. “Everyone knows” the world is threatened by deflation, which is why central banks in Europe and Japan have QE programs and the Federal Reserve—six years into an economic expansion—still cannot get up the guts to raise interest rates from zero. Inflationary pressures are starting to build. The employment cost index is accelerating while productivity growth —harmed by Obamanomics’ sins of commission (over-regulation, excessive taxation) and omission (no tax reform)—is running at around half the 2004-2006 pace. Meanwhile the deflationary reprieve provided by plunging oil prices and a soaring dollar is starting to reverse, and Europe is growing again.

Financial markets are starting to price in the new non-deflationary reality. Bund yields have surged and Treasury Bond yields have climbed from 1.9% to 2.23%. Which creates risks for equities. With profits growing slowly (flattish this year; up 8-10% in 2016) stocks look expensive on most metrics. As Chair Yellen said today, equities only looked inexpensive when compared to current bonds yields (but not if yields rise to 3% or 4%). In this environment “bond substitutes” such as utilities, staples, and REITs will perform poorly; financials that benefit from higher rates (banks, asset managers) are likely to outperform.

Copyright Thomas Doerflinger 2015. All Rights Reserved.





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Bubbleicious: Don’t Get Too Comfortable In This “New Era” of Negative Bond Yields

Bottom Line: Bond yields may stay absurdly low for quite a while longer, but eventually sanity will prevail and bond bulls will get killed. Don’t let Europe’s negative yields, and their spillover into the U.S., cloud your thinking about the appropriate PE for U.S. equities.

In the real world, as opposed to the make-believe mathematical world of economists, economies stagger from one mania to the next, much as drunks stagger from lamp post to lamp post. Often one mania corrects the imbalances created by the previous one. The current mania was captured in a recent FT headline: “Switzerland makes history by selling 10-year debt at negative interest rates.” German 10-year bunds yield all of 20 bps, meaning it would take 347 years for an investor to double his money. Debt with an aggregate value of several trillion euros carries negative yields.

This is really weird. It’s like telling your landlord, “I’m willing to stay in the apartment for another year, but forget about that rent check I’ve been sending you. From now on, you pay me $300 a month. Is that clear?” No reversion to sanity is imminent; Mario Draghi promises to stay the course on his bond-buying program. But it’s not all Super-Mario’s fault; Europe needs his monetary medicine because it refuses to make pro-capitalist structural reforms.

No Historical Parallels

To find out just how unusual negative bond yields are, I consulted UK interest rate data on measuringworth.com, the valuable compendium of historical data created by Lawrence H. Officer and Samuel H. Williams.* (I used UK data because, as a more mature and wealthy economy than the U.S., interest rates tended to be lower.) Between 1729 and 2014, the lowest annual bond yield was 2.15% in 1897—a hefty 221 bps above where Switzerland sold 10-year bonds last week. That 2.15% yield in 1897 occurred in a period of bona fide deflation; prices declined 0.2% per year during the prior decade. Today, by contrast, the UK is experiencing inflation of around 3%, so deflation provides no justification for today’s low bond yields, as some people claim.

It’s all about monetary policy. Central bankers are the new Masters and Mistresses of the Universe (move over Bernie Ebbers of WorldCom, Ken Lay of Enron and Angelo Mozillo of Countrywide Financial). They are vacuuming up bonds and driving up prices. Private traders are happy to go along for the ride. An HSBC strategist told the FT, “We have unconventional central bank policies at work so you have to expect unconventional outcomes. One is that bonds are no longer trading like bonds. They now trade like commodities, with investors speculating on the price.”

This notion that “bonds are no longer trading like bonds” is worth wrapping your brain around; it is this cycle’s analogue to Chuck Prince’s fatally prescient comment in July 2007, “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” My loose translation of the HSBC comment: These prices are crazy; there is no intrinsic value in bonds with negative yields. But who cares? We are speculating on short-term price changes, not investing. Whether it is tulips, tech stocks or houses, this is the telltale indication of a “bubble”—prices are being set by traders who don’t care if the assets they buy and sell have intrinsic value. The trend is their friend (until they fall off the cliff).

Bubbles 101: Five Facts to Keep in Mind

After making mistakes in the stock market for thirty years, I have a few observations that put the bond bubble in historical perspective.

  1. This bubble is quite unusual in that it is widely recognized as a bubble. Most observers understand that negative yields are ridiculous.

2.  This bubble is not unusual in being government-sponsored. For example:

  • The 1920s stock market bubble was partly created by the Fed, which kept rates too low for too long to help the UK keep the British Pound pegged to the U.S. dollar at its pre-World War I rate (which was far too high by the 1920s).
  • The 1980s real estate bubble was encouraged by new “free market” regulations that allowed S&L’s (Savings and Loans) – which had nearly gone bankrupt in the inflationary 1970s because they had to fund single-digit mortgage loans by borrowing at double-digit interest rates – to make commercial real estate loans. Congress hoped the profits S&Ls made in this risky and unfamiliar area would restore their balance sheets. Instead they made lots of dumb (and often corrupt) loans to commercial real estate operators. Dozens of S&Ls went bust and had to be recapitalized; the real estate glut they funded did not clear up until the mid-1990s.
  • Alan Greenspan kept rates too low for too long and drank the tech & telecom Kool-Aide. After warning about the stock market’s “irrational exuberance” in 1996, Alan Greenspan signed on to the “new economy” mantra of the late 1990s and failed to rein in equities—refusing, for example, to increase margin requirements in the equity market.
  • Starting in the early 1990s, liberal Democrats, led by Bill Clinton, Andrew Cuomo, and Barney Frank, started to inflate the housing bubble by pressuring banks, as well as Fannie and Freddie, to make ever more risky mortgage loans to “poor and under-served communities.” Eventually they would be rechristened “predatory loans” by the liberals who promoted them.

Why this history matters now: Just because the ECB’s bond bubble is “official policy” does not make it safer and saner. Eventually it will blow up.

3. Bubbles Are Usually Inflated by an Economic Ideology. The equity bubbles of the 1920s, late 1960s, and late 1990s were based on classic “new era” thinking that productivity had accelerated and prosperity would last forever. The housing bubble was justified as creating an “ownership society” – the odd notion that owning a house catapulted you into the middle class, even if you couldn’t afford the mortgage payments, taxes, utilities, and maintenance.

Today’s bond bubble is unusual in being justified by a bearish mantra—the notion that economic growth is being stymied by Larry Summers’ fable of “secular stagnation,” which blames slow growth on debt and demography while ignoring the numerous policy errors that are really responsible. They include the dysfunctional design of the European Union, Europe’s socialistic policies, and Obama’s myriad policy errors (mismanaged stimulus spending, Obamacare, Dodd Frank’s regulatory overkill, higher marginal tax rates, the bank shake-down, the EPA attack on fossil fuels, failure to reform corporate taxes and recapture $2 trillion stranded overseas, etc.).

4.  Bubbles Last Longer than You Expect, which tends to validate them until they finally pop. A few example:

  • In the aforementioned commercial real estate bubble of the mid-1980s funded by deregulated S&Ls, Wall Street pros expected serious trouble by around 1986. But the collapse did not come until late 1990.
  • Tech stocks looked expensive by 1996 but kept soaring for another four years.
  • Housing looked frothy by 2005; the collapse came in 2008.

Before bubble finally burst, the bubble skeptics tend to fall silent because they have been so wrong for so long. In the 1990s stock bubble virtually all the bearish Wall Street strategists were fired before prices peaked. And while the naysayers fall silent, the bubble believers become more and more complacent, even as risks increase. Last week on Bloomberg Tom Keene talked to a longtime bull on bonds, who said, in effect, “For the past five years people have expected growth to pick up and the Fed to start tightening. They have been wrong so far and I think they’ll be wrong in 2015.” Congratulations on a great call, Mr. Bond Bull, but that was then and this is now. In 2010 unemployment was 9.5%; now it is 5.5%. Giant retailers like WMT, TJX and MCD are raising wages. Things do change; past is not prologue forever. The unexpected collapse in oil prices has extended the deflationary story for an extra year or so. But soon enough year-on-year oil price comparisons will turn positive and, with productivity growth weak and labor markets continuing to tighten, investors’ mindset could shift rather quickly from deflation to inflation.

  1. Manias Are Undone in Part by the Economic Distortions They Create. For  example, the “free money” in the 1990s equity market funded over-capacity in tech and telecom, which produced a recession. The housing bubble funded vast over-building of real estate. Today’s negative interest rates will undermine life insurance companies and pension funds, creating major problems for the larger economy. Stay tuned.

When the bond bubble bursts in Europe it will spill over to the U.S., putting pressure on the PE ratios of U.S. equities.  Don’t be surprised.

*   Lawrence H. Officer and Samuel H. Williamson “Annual Inflation Rates in the United States, 1775 – 2014, and United Kingdom, 1265 – 2014,” MeasuringWorth, 2013.Copyright

Thomas Doerflinger 2015. All Rights Reserved.



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S&P Is Not GDP: Why Profits Fall While GDP Is Growing

The media, and many of the econo-pundits they interview, are befuddled by the current profit picture. Why, they wonder, will Q1 profits decline materially while the economy continues to grow? They get that energy earnings have collapsed, but isn’t there an offset in lower energy costs for other companies, and more buying power for the consumer? One strategist told CNBC today that 2015 earnings estimates will rise because companies are low-balling their guidance to analysts, and the Street is not properly factoring in the coming benefit of low energy costs: “No one’s talking about lower input costs the second half of the year,” he says,   “If you have lower natural gas prices and lower oil prices, that’s going to help the manufacturing sector.” The estimable Larry Kudlow has sung a similar song for the past few months, claiming low oil prices and a strong dollar are positive not negative, with non-energy segments of the S&P 500 benefiting a lot from low energy prices.

These gentlemen are on the wrong track because they do not fully grasp that S&P is not GDP. The profit recession is not an optical delusion caused by companies giving analysts “conservative guidance.” Low oil prices and a strong dollar really are hurting parts of corporate America, causing profits to decline. The brilliant Larry Fink (who was adamantly bullish on stocks a few years ago when most of the Street was cautious) is correct yet again when he warns the super-strong greenback is a significant headwind to U.S. growth because it will squeeze influential companies.

S&P Is Not GDP: Three Broad Principals . . .

S&P Earnings Are Nominal (include Inflation); GDP is Real (excludes inflation). So collapsing commodity prices hit S&P EPS hard but have little negative effect on—or can actually boost—real GDP, because the GDP deflator increases less than it would have if inflation were higher.

S&P Earnings are global, GDP is Domestic. The strong dollar has a much bigger negative impact on earnings than GDP. Exports are 13% of GDP and will eventually be squeezed by a strong dollar, but only with a long lag (as contracts expire). Around 40% of S&P profits are generated outside the U.S. by multinational firms. If IBM earns $2 billion in Europe, and the Euro falls 10% against the dollar, the value of those earnings when translated into dollars is 10% less.

S&P Earnings are much more geared to manufacturing, energy, and commodity production than the U.S. economy. Only 14% of GDP is mining and manufacturing; the rest is services, government, etc.. The easiest way to appreciate this is to walk around your hometown on a Saturday morning. All around you are businesses that are not in the S&P 500 – the construction company building a house across the street, a car dealership, the deli where you get your bagels, the landscapers putting in shrubs, the nail salon, beauty parlor, liquor store, restaurants etc. – not to mention government, which is 14% of GDP.

. . . and How They Apply to the Profit Picture Now

Let’s start with energy and the Exxon – Jane Doe transfer. Broadly speaking, collapsing energy prices shift national income from the corporate sector (Exxon) to the consumer (Jane); therefore it is negative for profits. A year ago the energy sector accounted for around 10% of S&P earnings, and since then oil prices have collapsed 50%, causing Q1 2015 energy earnings to decline 64% yr/yr. So that is a huge 6.4% hit to overall S&P earnings. There is an additional hit, mainly in the industrial sector, to all the suppliers to energy producers—steel piping from Nucor, helicopters from UTX, compressors from Caterpillar, project management services from Fluor.

But, you ask, what about the offsets? — The energy sector’s pain must be someone else’s gain, as consumers get a “tax cut” and spend more while non-energy S&P companies enjoy lower energy costs. Not so much. Yes, consumers get a “tax cut” but they may save the extra money, and if they do spend it they are likely to spend with a non-S&P 500 company—perhaps on a fancier dinner at a local restaurant.

The “lower energy cost” benefit to the profits of S&P 500 companies is also very modest, which is obvious if you think about it. Companies’ biggest cost by far—around two thirds of total cost—is labor; depreciation, rent, taxes, R&D etc. are also big. There are huge sectors of the S&P 500 where energy costs are trivial (think technology, finance, retailing, healthcare) and only a few where they are really big (airlines, trucking). And in some energy-intensive industries, such as chemicals, the potential cost benefit from lower energy costs is likely to be “competed away” instead of boosting profit margins.

The Impact of a Strong Dollar is More Mixed

We discussed the negative impact on S&P profits of translating earnings of foreign subsidiaries into fewer dollars when the dollar strengthens. But this is largely a cosmetic accounting effect rather than a reduction in underlying cash flows; most companies do not actually repatriate foreign earnings, which would involve paying high U.S. tax rates. That’s why $2 trillion of corporate cash languishes offshore.

To the extent the weak Euro is helping to revive the European economy by boosting net exports, this is a positive for all businesses in Europe, including subsidiaries of American companies. If Germany exports more Mercedes to China, that is positive for Mercedes suppliers in Germany, including U.S. firms like Borg Warner and Lear.

A Rebound in 2016(?)

Although the hit to 2015 earnings from a strong dollar and weak oil prices is real and won’t magically disappear in the second half, stock prices are not taking a big hit because investors believe, probably correctly, that the profit recession won’t continue next year. We could see a solid 8-15% rise in 2016 profits if the dollar does not keep soaring and if oil prices rise even modestly in 2016. But, let’s admit that the two key variables—the dollar and oil prices—are hard to forecast.

Flattish stock prices so far this year are consistent with my December 30 warning that equities were expensive and offered “mediocre risk reward.” As I recently discussed, and the WSJ later echoed, a potential Grexit could also start to weigh on equities. But amidst all the volatility the global economy continues to grow, with Europe performing better than I expected. Value is building in growth stocks, which will start to look fairly cheap on 2016 earnings.

Copyright Thomas Doerflinger 2015. All Rights Reserved.


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Get Set for Grexit

Investors should prepare for Greece to leave the Eurozone—not a disaster but likely to cause significant volatility, especially for U.S. and European financial stocks. George Soros, who has made billions betting on currency market ructions, believes there is a 50% chance of a Grexit. Even if Grexit does not occur there will be a lot of nail-biting brinkmanship causing markets to behave as though there is a very high probability it will happen.

The problem is that Greeks love socialism but hate to pay their taxes, which is not a sustainable business model. Greece snuck into the Eurozone the old-fashioned way—by lying and cheating and misrepresenting the size of its budget deficit. Then it dug a bigger financial hole for itself by borrowing on Germany’s balance sheet until the financial crisis. It did in fact tighten its belt after the crisis and reined in the primary budget deficit, but the necessary “structural reforms”—including stricter tax enforcement—were never made.

Then the country voted in a socialist government whose leaders (especially the oh-so-cool Finance Minister in his black leather jacket) have managed to alienate their peers across Europe. But far worse than the bad optics and hard feelings are the hardline socialist policies of the new government, which pretty much guarantee the Greek economy will stall and fail to generate the necessary tax revenue. Consider an article in the Financial Times titled “Athens digs in over golden opportunity.” It seems that Eldorado Gold, a Canadian mining company, was “making steady progress” toward opening a Euro 1 billion mine, but it has been “stymied” by Panayotis Lafazanis, the new minister for a department with the improbable name “Productive Recovery, Energy, and the Environment.”  According to the FT, Mr. Lafazanis has “focused on reversing earlier pro-market policies agreed between Greece and its international lenders, hampering Athens’ attempts to unlock urgently needed bailout money. He has cancelled the planned privatization of state-controlled electricity assets….” This gentleman is not a big fan of private enterprise; he “maintains that private companies should be excluded from developing the country’s natural resources.”

So this simply is not a government the Euro-crats can play ball with. It has neither the will nor even the ability to accomplish the things that need to be done to stay in the Eurozone. Not surprisingly, investors are voting with their feet, transferring their Euros out of Greek banks before they turn into drachmas. It is hard to engineer the economic turnaround of a nation when the balance sheets of its banks are shrinking.

It’s Not All About Germany and Greece

Some commentators believe super-Angela will “find a way” to avoid a Grexit but—despite the nasty high-profile sniping between the Greeks and Germans–it is not up to the Germans alone whether Greece stays or goes. In sparring with the Greek government, some of the toughest negotiators have been the Spaniards. Spain, Portugal and Ireland did in fact make the “tough structural reforms” that Greece failed to make; they inflicted great pain on their citizens in the process, and unemployment is still sky-high. Extreme political parties pose a serious threat to the incumbent leaders in these countries; they fear that voters will revolt if Greece gets yet another bailout that allows it to avoid the reforms endured by other European countries.

Another reason why Grexit is likely is that at this point, with most Greek debts owned by “official” creditors such as the IMF rather than European banks, it would not be a disaster for Europe—just for Greece. Stay tuned, and keep some cash available, to put to work during periods of “volatility.”

Copyright Thomas Doerflinger 2015. All Rights Reserved.


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White Privilege: Universities Should Educate, not Exploit, Black (and White) Athletes

When you’re watching the sweet sixteen, elite eight, final four, and championship game, keep in mind that many of the players are not getting a decent education that will allow them, upon graduation, to thrive in the workplace and be leaders in their communities. These players, many of them black, are being exploited by the universities that employ them but do not educate them. They are generating big bucks for the schools and thrilling entertainment for the (mostly white) students, faculty and alumni and receiving little in return besides a shot at playing in the pros.

Racially Correct, Educationally Corrupt

Which is more than a little ironic, because American universities are the epicenter of racial correctness. They fancy themselves oases of enlightened tolerance in a wasteland of prejudice—a bulwark against intolerant white Republicans. Yet universities recruit thousands of young blacks to play football and basketball and then graduate without being able to read and write at a collegiate level. Instead of elevating the academic competence of these under-educated athletes, universities let them “get by” in sham courses, with the connivance of “academic counselors.”

And it’s not just the Big Ten, but also prestigious schools like UNC at Chapel Hill (see below) and Harvard. As a graduate student at Harvard, I was a teaching assistant in an American history survey course. One of my students was a football player from South Boston who was built like a refrigerator and unfortunately wrote like one too. I got tutoring help for him, but the truth is he should never have been admitted. Tragically, a couple of years later he was caught plagiarizing a paper and expelled. Go Crimson—please.

Many African Americans and working-class whites would be far better off if universities required that all varsity players first pass a rigorous test demonstrating college-level proficiency in math, reading, and writing. Obviously this reform would have to be phased in over several years. It would put salutary pressure on thousands of high school students, parents, coaches, teachers and school administrators to make sure kids were really learning in grammar school and high school. People come up with all sorts of excuses for low academic achievement, but a primary cause is lack of urgency and effort. Which is why poor Asian immigrants excel academically despite many disadvantages.

Explicitly tying athletic achievement to academic success would work wonders. After all, we are talking here about remarkable and admirable young men and women who have the poise and discipline to excel at big-time sports. In college they should be able to read and do math at an 11th grade level, not just an elementary school level, which is the case for quite a few of them (see below).

UNC at Chapel Hill: 18 years of Academic Fraud

Last year an independent investigator hired by the prestigious University of North Carolina at Chapel Hill prepared a 131 page study showing that over an 18-year period at least 3,100 athletes (and likely many more) took sham “paper courses” that required little or no work in order to boost their GPA and maintain their academic eligibility to play football and basketball. Rumors of the scandal had been circulating for several years; top administrators resisted an investigation for as long as possible. Most of the “courses” were in the African American Studies Department. Quite a few people in the university knew about the academic fraud. An e-mail exchange reveals how an “academic advisor” could secure the necessary grade for a “recycled” (plagiarized) paper:

Crowder: As long as I am here I will try to accommodate as many favors as possible. Did you say a D will do for [name of basketball player]?  I’m only asking that because 1. no sources, 2. it has absolutely nothing to do with the assignments for that class and 3. it seems to me to be a recycled paper.  She took AFRI in spring of 2007 and that was likely for that class.

Boxill: Yes, a D will be fine; that’s all she needs.  I didn’t look at the paper but figured it was a recycled one as well, but I couldn’t figure from where!  Thanks for whatever you can do.

The courageous individual who blew the whistle on UNC, Mary Willingham, was for five years attacked by the UNC administration for her trouble. She is bringing a whistle-blower suit. According to CNN, Willingham “said that she had worked with dozens of athletes who came to UNC unable to read at an acceptable level, with some of them reading like elementary schoolchildren.” Of 183 players she surveyed, 60% read between 4th and 8th grade level, and 8-10% read below a third-grade level. No wonder UNC needed “academic counselors” to help athletes stay in school.

UNC Is Far from Unique

If you think UNC is unusual in this respect, I have two big white buildings at opposite ends of Pennsylvania Avenue that I would like to sell to you. CNN tried to survey 38 colleges about the SAT and ACT scores of “revenue generating” athletes and got responses from only 21. Based on that survey, which is very probably skewed in a positive direction, 7-18% are reading at an “elementary school” level – i.e. 4th-grade to 8th-grade level. So, it seems likely that 25-35% cannot read at an 11th grade level necessary to do college-level work.

Universities: Athletic Sweatshops

Universities are highly culpable for exploiting athletes while failing to provide a decent education. If the liberals who dominate both universities and public education were serious about improving the lot of working-class Americans, they would end this charade and require students who wanted to be involved in big-time collegiate athletics to pass a test showing they can work at a collegiate level.

Copyright Thomas Doerflinger 2015. All Rights Reserved.

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European Sojourn

First stop: Bruges, Belgium, which at the end of the 14th century was the commercial capital of northern Europe. Then its population was about 40,000, including hundreds of merchants from all over Europe—Italy, Germany, England, and of course Flanders. Spices and dyes were imported from the Levant via Italy; wool was brought in from England and Scotland to supply the Flemish textile industry; wine came northward from France and Portugal; lumber, furs and occasionally wheat were imported from the Baltic region. In addition to cloth, Bruges exported religion, or at least thousands of small, beautifully illustrated prayer books. Commerce requires credit, so Bruges was a major banking center, second only to Florence.

The city’s stature peaked in 1400; it has been downhill ever since. Which is a good thing, because its ornate medieval architecture and intricate network of canals have survived intact, making it one of the most picturesque cities in Europe. When in doubt, medieval architects always added the extra embellishment—a gilded bear here, an ornate wrought iron sconce there, an angel standing in a corner alcove, a dragon staring down from above a doorway, a narrow tower to give the building a more interesting profile.

Even better than the architecture is the food. The citizens of Bruges seem to subsist on a diet of Belgian chocolate, whipped cream, French fries, and beer. Yet no one gets fat. I discovered why one chilly morning. To commute to work, few people walk, and even fewer people drive cars; everyone is riding bicycles or—if they have a couple of small children—a bicycle hooked up to a miniature two-seated rickshaw. Belgians take their bicycles very seriously. All the train stations have parking lots for bicycles, which look like shiny junkyards if you whizz by them at 120 MHP in a bullet train. Bicycles are one reason why, in Belgium, per capita energy consumption is only 78% of the U.S. level; in the Netherlands it is even lower at 70%.

Zabar’s on a Truck

Wednesday was market day in the Markt—the giant central square, ringed by imposing medieval buildings and paved with (what else?) Belgian blocks. But there was nothing quaint or old-fashioned about this farmer’s market. No rickety tables with a limited selection of fruits, veggies and useless crafts. No no no. Overnight, a fleet of trailers had invaded the Markt and turned it into a high-class supermarket. Comparable vehicles don’t exist in America. An entire side of the trailer is opened up to reveal a complete deli counter, at least as big as the Zabar’s meat department. One trailer was a bakery; several others sold cheese; still others sold pork and beef, barbecued chickens, candy, and flowers.

Clearly this superb selection of fresh foods, conveniently available in the center of town, poses tough competition to the local stores. U.S. investors should pay close attention. According to the U.S. Department of Agriculture, there are 8,200 farmers markets in the U.S., up 76% since 2008. Many of them already sell a wide variety of foods, beyond the familiar fruits and vegetables. If these markets become as sophisticated as Belgian markets, that’s very bad news for Safeway, Wal-Mart, Whole Foods and Kroger.

Here Come the Americans

Bruges’ tourist business was thriving in mid-March, and few of the visitors were from the U.S. When Americans take advantage of the weak Euro this summer, the town will be mobbed with tourists. Two or three full days are enough to see the city, including a couple of superb small art museums, in a leisurely manner. Fair warning: In the summer heat, the canals stink of duck shit, but at least that enhances the medieval ambience.

Copyright Thomas Doerflinger 2015. All Rights Reserved.


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