Urban Inequality – the Paris Syndrome, U.S. Style

After stepping off an Amtrak train in Washington DC, you drag your luggage down a ramp into a nice, modern, well-organized space with waiting areas, newsstands and mid-priced eateries, plus a few retailers such as H&M. Overhead signs instruct you to keep walking through this space to reach taxies and busses; you find yourself in a huge hall with marble floors and soaring coffered ceilings, where there are a couple of nice restaurants and, on a lower level, a food court. But you still haven’t reached the taxi line. Keep going and you will find yourself in the officially branded “Great Hall,” which has no discernible function but sure is impressive with its polished floor and yet another soaring, barrel-vaulted ceiling. Finally, on the other side of the Great Hall, you find the taxi line.

While Washington’s Union Station has three giant halls, other major Amtrak stations on the northeast corridor – Baltimore, Wilmington, Philadelphia, Newark, New York, New Haven, Providence, Boston – barely have one between them. Their stations are all, to a greater or lesser degree, dumps. Philadelphia’s is the best of the lot, with a spacious art deco waiting area that, unfortunately, appears not to have been cleaned since it was opened in 1933. New York’s Penn Station may well be the worst major train station north of the equator—a crowded, dirty, cacophonous multi-level catacomb of unsightly corridors and passageways.

The same goes for subways—immaculate platforms and sky-high ceilings in the DC Metro versus cramped, decrepit, claustrophobic, outmoded transit systems in Philly, New York and Boston.

The Protection Racket

Of course, this transit dichotomy is symptomatic of a larger reality. In Obama’s Washington, bureaucrats and politicians multiply taxes and fines and regulations and rules and guidelines and mandates with the stated aim of reducing inequality. In reality they are retarding economic growth and dramatically increasing inequality by burdening America’s private economy with excessive regulation, even as Washington’s regulatory economy booms. The city is brimming with lawyers and lobbyists who, for a stiff fee, will stretch the tax code or “improve” a piece of legislation. (How do you think Denny Hastert got the $1.7 million he allegedly paid to a blackmailer?) Whereas the business districts of Baltimore and Philadelphia are shrinking into a pathetic, dilapidated core of banks and government offices, downtown Washington has block upon block of gleaming 10-story office buildings; interspersed among them are innumerable luxury hotels and fancy restaurants, not to mention ornate embassies and high-rent apartment buildings. And DC’s booming suburbs claim six of the ten richest counties in the U.S.

Rich Regulators

The 2013 median household income of the Washington-Arlington-Alexandria metro area was $90,149, far higher than other cities; next highest was San Francisco at $79,624. Boston was $72,907, New York $67,194, and Philadelphia $60,482. So incomes were fully 50% higher in Washington than Philadelphia. Talk about “inequality.”

Call It the Paris Syndrome . . .

. . . . elites clustered in the capital, ruminating about inequality while making a mint taxing and regulating the real economy to death. Of course the national media are oblivious to the Paris Syndrome because they live in Washington and are out of touch with the real world beyond the Beltway. To them Georgetown – with its quaint tree-lined streets and immaculate ivy-clad townhouses – is a typical urban neighborhood. But nothing similar is to be found in Baltimore, Philadelphia, Wilmington, or Newark, whose impoverished citizens are supposedly benefiting from the torrent of regulation pouring out of DC.

Copyright Thomas Doerflinger 2015. All Rights Reserved.




Posted in Uncategorized | Tagged , , , | Leave a comment

The Winner of the 2015 Ig-Nobel Prize, for the Worst Book by a Nobel Prize Winner Is . . .

Ignoble   adjective 1. Not honorable in character or purpose

Synonyms: dishonorable, unworthy, base, shameful, contemptible, despicable, vile, degenerate, shabby, sordid, mean, dastardly

Ladies and Gentlemen, thank you for attending our Annual Gala, where we present the Ig-Nobel Prize, our humble effort to identify the worst books written by the smartest people. This year was particularly challenging for the Prize Committee. The Committee was torn. The book that eventually won the prize as the Worst Book by a Nobel Prize Winner was actually deemed, by 6 of the 13 committee members, to be the best book because it broke new ground in literary technology. It used sophisticated algorithms to produce a complete 52-chapter book—admittedly a terrible book, but you have to start somewhere—by producing 51 chapters that merely re-ordered the key words and hackneyed concepts presented in Chapter I, including:

  • Inequality
  • Rising inequality
  • Shrinking middle class
  • 1%
  • .1%
  • financialization
  • speculation
  • deregulation
  • too big to fail
  • rent seeking (wealth appropriation)
  • rent seeking (taking a bigger piece of the pie)
  • excessive leverage
  • monopoly profits
  • talented tax lawyers
  • pollution tax
  • carbon tax
  • financial transaction tax
  • higher income tax
  • essential public investments

Ultimately, however, the Prize Committee concluded technological innovation was not exculpatory. A terrible book is a terrible book, even if ghost-written by a computer. Therefore, the 2015 Ig-Nobel Prize goes to . . .

. . . the envelope please . . .

. . . . Joseph Stiglitz for his latest “book,” The Great Divide. It says pretty much the same thing in every chapter, with little documentation and no consideration of conflicting evidence or alternative points of view. Nevertheless the book (which is a compendium of previously published articles) does have merit as a window into the mind of a doctrinaire socialist who throughout an illustrious career has had no hands-on contact with the private economy he hates. Here, for example, are . . .

. . . Six Stiglitz Bloopers

Regarding the 2008 financial crisis, JS claims “for the preceding three years I, together with a small band of other economists, had been warning of the impending implosion.” Hold the self-congratulation, JS. You actually failed to predict the financial crisis even after it started. In a Vanity Fair article published in December 2007 (four months after the crisis began) you lament the Bush tax cuts, shrinking budget surplus, and Iraq War but failed to predict a housing bust or banking crisis. The big challenge of the “next president,” you wrote, will be moving the economy from a savings rate of zero to a more normal 4%. No mention of a banking collapse.

JS’s hobby horse is “rent seeking” (grabbing wealth via monopoly rather than creating it) which supposedly is how the notorious 1% gets its money. He forgets that the biggest rent seekers are governments and non-profits such as the Federal government, teachers unions, universities, the UN, the IMF, and the World Bank. Of the ten richest counties in the U.S., six are in the Washington DC area. Universities comprise a credentialing cartel that kills competition and uses its market power to jack up tuitions.

JS believes financial deregulation produced rising income inequality as Wall Street vampires sucked the blood out of the real economy. But why, then, has financial re-regulation—Dodd-Frank, giant bank fines, etc.—failed to reduce inequality?

JS opines, “there is no begrudging the wealth accrued by those who have transformed our economy—the inventors of the computer, the pioneers of biotechnology. But, for the most part, these are not the people at the top of our economic pyramid. Rather, to a large extent, it’s people who have excelled at rent seeking in one form or another.” As usual, he provides no evidence; here is some. Of the top 50 people on the Forbes 400 list, 41 possess wealth generated in the “real economy” and only 9 are in finance; 37 are self-made men (sic) and 13 are second generation wealth. Financiers are resourceful entrepreneurs, not parasitic rent seekers. One reason for faster GDP growth in the U.S. than Europe and Japan is wider and deeper financial markets, as well as shareholder pressure on companies to become more efficient.

JS largely ignores big government’s central role in creating the housing bubble. Based on the myth (since disproven) that mortgage lenders, contrary to their own self-interest, were discriminating against credit-worth minorities, Clinton and Cuomo pressured Fannie, Freddie and private banks to make risky, low-down-payment loans to marginal borrowers–most of which were later re-labeled “predatory loans.” It was the Federal bureaucracy and pressure groups such as ACORN—not Wall Street—that destroyed the credit culture of the mortgage market.

JS claims “growing inequality is the flip side of something else: shrinking opportunity.” History suggests otherwise. In a buoyant economy such as the 1920s or 1990s the rich get richer and inequality rises, but living standards also improve for other income groups. Median household incomes rose 10% in the tech-frothy 1990s. Conversely, in troubled economies (1930s, 1970s) inequality declines as companies and financial markets stagnate, but the middle class struggles as well. Between 1970 and 1983 median household income fell 1% despite a huge increase in the number of women in the workforce. Perversely, Obama’s anti-capitalist agenda has produced the worst of both worlds: rising inequality and declining opportunity. Median household income was 8% lower in 2013 than 2007. Faced with anemic 2% GDP growth (bad for the poor and middle class) the Federal Reserve has tried to stimulate growth by pumping financial liquidity into the economy (great for investors, speculators, and Wall Street deal makers).

Copyright Thomas Doerflinger 2015. All Rights Reserved.



Posted in Uncategorized | Tagged , , , , , | Leave a comment

WSJ Misinterprets Its Own Data to Demonstrate Companies Are Spending Too Little on Capex, too much on Dividends & Buy-backs

To its credit, the WSJ did some serious quantitative work in an effort to determine whether Blackrock’s Larry Fink is correct that companies are paying out too much money to shareholders while starving capital investment. Fink is right, the Journal concluded. However, scrutiny of the WSJ’s own data points toward the opposite conclusion. Capex is not, in fact, being starved, and the relationship between capital spending and capital payout is similar to the 2003-2008 business cycle. Which is not at all surprising, if we think about the “real world” out there. We had a capital spending boom in the energy sector over the past few years; pharma companies big and small are spending heavily to develop new drugs; giant tech companies such as AMZN, FB, AAPL, MSFT, IBM and GOOG are spending heavily on server farms, warehouses, and R&D.  Not exactly a capex drought.

The Conclusion . . .

The article, titled “FIRMS SEND MORE CASH BACK TO SHAREHOLDERS,” opens with its conclusion: “U.S. businesses, feeling heat from activist investors, are slashing long-term spending and returning billions of dollars to shareholders, a fundamental shift in the way they are deploying capital. Data show a broad array of companies have been plowing more cash into dividends and stock buybacks, while spending less on investments such as new factories and research and development.”

The WSJ Data . . .

“An analysis conducted for the Wall Street Journal shows that companies in the S&P 500 Index sharply increased their spending on dividends and buybacks to a median 36% of operating cash flow in 2013, from 18% in 2003. Over that same decade, those companies cut spending on plants and equipment to 29% of operating cash flow from 33% in 2003.”

What Really Happened . . .

That sounds pretty bad: a “fundamental shift” as capex is “slashed” while companies are “plowing more” into dividends & buy-backs. But there are a couple of problems:

  • The data presented are based on shares of cash flow rather than absolute levels, so they simply cannot support the flat statement that firms are “slashing long-term spending.” If the share of cash flow spent on capex falls modestly while cash flow rises capex may increase, perhaps substantially. That is what actually occurred.
  • The WSJ focuses on the end points (2003, 2013) while ignoring the business cycle, which drives capital payouts. The recent rise in payouts is cyclical not secular; a similar pattern occurred from 2003 to 2008. Said differently, the big rise in payouts trumpeted by the Journal comes from comparing a cyclical trough (2003) and cyclical peak (2013).

A Closer Look at the WSJ Data

 Capital spending as a share of cash flow for the median firm: The 2013 figure of 28.7% is not particularly low—modestly below the 2003-2013 average of 29.5%. As noted, this metric is share of operating cash flow, so it may decline not because capex is weak but because cash flow is strong. Profits were, in fact, strong in 2013 at 117% above the cyclical low in 2009. Conversely, the 2003 figure was probably inflated by weak profits at the beginning of the economic expansion; 2003 S&P 500 profits were only 26% above the cyclical low in 2001.

Capital payout as a share of cash flow for the median firm: This metric was 17.7% in 2003, soared to 44% by 2008 as companies increased buy-backs and dividends, and then collapsed to 18% in 2010 as companies hoarded cash during the financial crisis. It has since climbed to 36.1% as dividends and buy-backs have increased, in normal cyclical fashion. But this metric is still below the 2007-2008 level, belying Larry Fink’s claim that activist investors are forcing companies to pay out too much capital.

If schools of journalism, like some business schools, had “case studies” this one would be titled, “Critically Scrutinize and Analyze your Data Before you Write About It.”

Copyright Thomas Doerflinger 2015. All Rights Reserved.


Posted in Uncategorized | Tagged , , , , , , , | Leave a comment

“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.

Posted in Uncategorized | Tagged , , , , , | Leave a comment

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.


Posted in Uncategorized | Tagged , , , , , , | Leave a comment

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.


Posted in Uncategorized | Tagged , , , , , | Leave a comment

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.

Posted in Uncategorized | Tagged , , , , , , | Leave a comment

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.





Posted in Uncategorized | Leave a comment

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.



Posted in Uncategorized | Tagged , , , , , , | Leave a comment

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.


Posted in Uncategorized | Tagged , , , , | Leave a comment