The “Uncertainty” Dodge: Policy Certainty Is the Real Problem

Posted on September 26, 2013 by tomdoerflinger

In my previous post I discussed the national revolt against the effete DC policy elite.  Meet William A. Galston, Obama supporter and holder of the “Ezra Zilkha Chair in the Brookings Institution’s Governance Studies Program, where he serves as a senior fellow.”

Writing in The Wall Street Journal, Galston blames the crappy Obama economy on “endless strife over public policy” which increases uncertainty and slows economic growth.  Galston cites research by three economists who developed an Index of Policy Uncertainty (IPU)*, which is constructed from three components: media comments on economic policy, the number of tax provisions that are about to expire, and the dispersion of economists’ GDP forecasts.  (It’s a little weird that the VIX, Wall Street’s “fear gauge,” is not included.)  As with many such indicators, cause and effect are hard to disentangle.  The IPU tends to be high during recessions and low during economic expansions when Washington and Wall Street are complacently drifting along on a comfortable credit bubble, toward an unseen waterfall.  (Think 1997, 2006.)

Galston notes that the IPU reached its all-time high during the 2011 debt ceiling battle, and he implies we could be headed there again.  The index actually does not support this fear; it is now only modestly above its 1985-2013 median value.**  Galston warns that “policy uncertainty directly affects economic activity” and quotes the IPU’s creators as follows:

“When businesses are uncertain about taxes, healthcare costs and regulatory initiatives, they adopt a cautious stance.  Because it is costly to make a hiring or investment mistake, many businesses naturally wait for calmer times to expand.  If too many businesses wait to expand, the recovery never takes off.”

There‘s just one problem . . .

. . . with this disquisition on “policy uncertainty.”   Right now, businesses are NOT AT ALL “UNCERTAIN” about the direction of public policy.  On the contrary they are HIGHLY CERTAIN that while Obama is in the White House taxes will tend to rise, healthcare costs will increase, and onerous new “regulatory initiatives” could hit their business like a lightning bolt at any time.  Just look at today’s newspaper.  The EPA is attacking coal-fired electricity plants, which will raise energy costs for consumers and employers (particularly heavy industry) in the Midwest—good bye “high paying blue collar jobs” that liberals claim to love. To placate the regulatory hyenas, J.P. Morgan Chase (a fine company that helped regulators during the crisis, taking two big bankrupt companies off their hands) is willing to pay a fine of $5 billion, or is it $7 billion? – no, it may be as high as $11 billion!  And one of America’s largest hedge fund may pay a $2 billion fine to the SEC.  Those CERTAINLY sound like three good reasons for companies to stay cautious.

In the loopy logic of Washington policy wonks like Galston, it is not Obama’s anti-capitalist policies that discourage investment and hiring, but rather Republican efforts to rein them in.  He laments the “uncertainty” created by the 2011 budget clash between Obama and Tea Party Republicans but forgets that the resulting policy—the sequester—has been instrumental in reducing the budget deficit.  Because it reduces the risks of a tax increase, the sequester has actually reduced policy uncertainty.

Galston’s tortured effort to exculpate Obamanomics by blaming its failures on its opponents nicely exemplifies the disconnect between DC and the real world beyond the Beltway.

*Scott R. Baker, Nicholas Bloom, and Steven J. Davis.  See www.policyuncertainty.com

**The current reading of 112.3 is in the 63rd percentile of the distribution from lowest to highest uncertainty since 1985; i.e., 63% of readings show “lower uncertainty” than 112.3 and 37% show “higher uncertainty.”

Copyright Thomas Doerflinger 2013.  All Rights Reserved.

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Revolt Against the Elites

Posted on September 26, 2013 by tomdoerflinger

Something big and fundamental is happening in America—a broad-based revolt of ordinary citizens against Washington elites, left and right.  Elite arrogance and ineptitude across a multiplicity of issues has provoked the unwashed masses beyond the Beltway.  Let us count the ways.

Titans of the foreign policy establishment, ranging from Republicans John McCain, Lindsey Graham, Brett Stephens and Bill Kristol to New York Times pundits Bill Keller and Nick Kristoff, argue the U.S. should provide military aid to “moderate”  Syrian rebels fighting Assad.  To ordinary people this is a really, really dumb idea, and they let Congress know it.  What part of the phrase “civil war” do these “experts” not understand?  Have Iraq and Afghanistan taught them nothing?  Why support rebels who hate Christians, Jews, and Americans as much as they hate Assad?  When has America ever gotten credit for helping Muslims in the Mid East?  How does the U.S. benefit from spending billions of dollars in Syria?  Absurdly, elites characterize these cautionary queries as “isolationism” – as though the Syrian civil war resembled Hitler’s invasion of Czechoslovakia.

Then there is Obamacare, opposed not only by Republicans but also by labor unions and Democratic Congressmen (at least when the law applies to them).  Rasmussen reports that 50% of Americans believe the law will worsen the healthcare system and only 30% think it will improve it.  Obamacare’s 30/50 rule (companies must provide health insurance if they have 50 “fulltime” employees, defined as those working at least 30 hours per week) is creating a part-time workforce, which hurts low-income workers the most.  The law overcharges young workers already burdened by education debts and a weak labor market.  (Get ready to pay IRS fines if you don’t comply.)  Waivers for favored interest groups and delay of sundry Obamacare provisions are unconstitutional selective enforcement of legislation.

Then there is the NSA Scandal, which unites ACLU lefties and Rand Paul libertarians.

Then there is the IRS Scandal, where the taxmen became an arm of the Democratic Party.

Then there is Benghazi, where the supreme incompetence of Hillary’s State Department led to the death of four officials, which Obama and Hillary blamed on a You-Tube video that supposedly inspired a spontaneous riot that somehow morphed into a military attack, complete with mortars and truck-mounted artillery.

Then there is the dreaded sequester.  Obama thought any belt tightening by Uncle Sam would be a disaster, but out here in the Real World – where relentless, continuous corporate restructuring and cost-cutting are normal—it was no big deal.  Ironically, the resulting decline in the deficit is one of Obama’s few economic successes.

Behind the Revolt: O’Poverty

As I have been predicting for a few years, elite arrogance and bureaucratic overreach are squelching “animal spirits” in the private economy.  What company would be eager to hire when confronted with: A) an avalanche of regulation – Obamacare, Dodd Frank, the EPA’s war on fossil fuels, proliferating OSHA regulations, huge fines on banks; B) big hikes in marginal tax rates; C) a dearth of pro-growth initiatives such as tax reform and free trade agreements; D) the anti-capitalist rhetoric of Barack “you didn’t build that” Obama.

Last week the U.S. Census gave the President his annual economic report card.* It was not one you would rush home to show Mom and Dad:

  • For Obama’s vaunted “middle class,” this is the worst recovery in over forty years.  In 2012 median real household income was flat with 2011 but still down 4.3% since the recession ended in 2009. By contrast, in comparable three-year periods of prior recoveries this metric was: -1.6% (after the 2001 recession), -0.2% (1991), +4.3% (1982), +6.3% (1975).
  • For the third year in a row, the poverty rate was a lofty 15% (after 14.3% in 2009). In the 44 years prior to 2010, it was at or above 15% in only three years—during or right after recessions.  While G.W. Bush was president it averaged only 12.5%.
  • Despite Obama’s attack on high earners, inequality is increasing.  The Gini Coefficient climbed steadily from 0.466 in 2008 to an all-time record of 0.477 in 2012.  (It averaged 0.466 while G.W. Bush was President.)  Another, less abstract, metric tells the same story.  In 2012 the 95th percentile of the income distribution earned 3.75x the median household income, far above the average of 3.56x when G.W. Bush was President.

The Leader of the Revolt Should . . .

The Republican politician who most effectively leverages this discontent will be one who respects Tea Party Values but goes way beyond the “base” to pursue an inclusive, culturally modern, pro-growth, small government, pro-privacy agenda that puts the DC elite in its place.  Key features:

  • An optimistic focus on economic growth and opportunity.  Repeal and replace Obamacare so healthcare laws do not abridge privacy and discourage hiring, as Obamacare does.
  • Agree with statist pundits like Tom Friedman that the “sequester” needs to be replaced with long-term entitlement reform because it is squeezing “vital investment” such as medical research and infrastructure.
  • A positive environmental agenda focused on protecting more natural habitat without shutting down economically beneficial activity. End the war on fossil fuels but encourage “renewable” energy via basic research—not subsidies and mandates.
  • Privacy from government snooping—a big, big issue for the Millenial Generation, which lives on the Web.
  • An inclusive pro-growth immigration policy based on effective border security, attracting the best and the brightest, and letting illegals stay in America but without a special path to citizenship.  (Citizenship is far more important to Democratic bosses than immigrants themselves.)
  • Assuming he does not run for President, appoint the brilliant Dr. Benjamin Carson to a prominent position in charge of helping inner city communities escape the vortex of poverty, drugs, crime, broken families and bad schools.

*U.S. Census, Income, Poverty and Health Insurance Coverage in the United States: 2012 published September 2013

Copyright Thomas Doerflinger 2013.  All Rights Reserved.

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Trayvon, Antiq, and the Failure of Liberalism

Posted on September 20, 2013 by tomdoerflinger

The look on Anderson Cooper’s face was taut, anguished, stricken – as though he had just learned that his boyfriend had had an affair with his mother.  Actually, it was worse than that.  The prosecution in the Trayvon Martin case had just finished another bad day.  This spurious tale of white racism, actually involving a Hispanic shooter, was unraveling like a cheap sweater.  Nevertheless the liberal media doggedly followed the trial to its predictable conclusion.  MSNBC’s website has 375 mentions of Trayvon Martin.

By contrast, Antiq Hennis gets only six MSNBC mentions.  Antiq who?  He is the sixteen-month old toddler who was gunned down in his stroller while being pushed across a Brooklyn Street.  The intended victim was his father Anthony, a 21-year-old with a long rap sheet and alleged gang associations. Anthony refuses to help the cops nail his son’s killer; street etiquette demands silence at NYPD interviews.

Both incidents were tragedies (as is the shooting of a three-year-old on a Chicago playground last night).  But to racial aristocrats like Anderson Cooper and the MSNBC crowd, Antiq’s murder merits little notice because it is black on black violence, like 93% of black homicides in America. You can’t spin that into a paternalistic tale of white racism and black victimhood.  Racial aristocrats have little interest in addressing the social pathologies implicated in the killing of Antiq Hennis. They would rather strike a pose than solve a problem. They are on a narcissistic quest for progressive authenticity and moral superiority.  Fifty years of failed liberal social policies in the inner city do not phase them; it’s the thought that counts, not the results.  That’s why they favor failing public schools over charter schools that empower inner city parents.

Trayvon and the “Katrina Effect”

Conservatives are starting to handle the racial aristocrats more effectively.  Back in the fall of 2005, when Hurricane Katrina devastated New Orleans, a city with an incompetent black Democratic mayor, located in a state with a clueless white Democratic governor, ALL the blame for the Katrina debacle was heaped on President George W. Bush.  He deserved some of the blame, not all of it.  But Republicans stood silent while liberals managed to spin Katrina into a case of white racist neglect, while incompetent Democratic officials were let off the hook.

It was different in the Trayvon Martin case.  Conservatives demanded to know why this muddled case of self defense gone awry deserved to become a cause célèbre while the liberal media ignored the far more important problem of black on black violence.  Good question.

Confront Liberalism’s Failures

Conservatives should confront racial aristocrats, black and white, and hold them accountable for their egregious failures.  Consider the Sunday talk shows, where smug liberals regularly sneer at supposedly racist conservatives.  More than once on Meet the Press David Gregory has reminded viewers that Colin Powell  perceives a “dark vein of intolerance” in the Republican Party.  Well, if David Gregory, Colin Powell, George Stephanopolous, Cokie Roberts,  Donna Brazile, Candy Crowley, and Bob Schieffer are so “tolerant” and enlightened, why does Washington DC—despite all the Federal dollars pouring into its economy—have terrible schools and the eighth highest murder rate in the nation?  Baltimore, at the northern end of the Federal Wealth Belt (it is just a one hour drive from DC), has the second highest murder rate, after Detroit.  With “tolerance” like that, who needs racism?

Republicans should constantly remind Americans how Obamanomics and liberalism have failed the inner cities, virtually all of which are controlled by Democrats.  The black unemployment rate is now 13.7%; at a similar point in G.W. Bush’s second term it was only 9.0%.  Median black household income was 9% lower in 2012 than 2004. The percentage of blacks below the poverty line was 27.1% in 2012 versus 24.7% in 2004.  Black conservatives such as Senator Tim Scott, former Congressman Allen West, Dr. Benjamin Carson, and Congressional candidate Mia Love are particularly persuasive in making the case against racial aristocrats.  They deserve strong support.

Copyright 2013 Thomas Doerflinger.  All Rights Reserved.

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Implications of a Part-Time America

Posted on September 11, 2013 by tomdoerflinger

Economists are slowly, belatedly noticing how Obamacare will shift the U.S. labor force toward part-time work, something I have been writing about for a few years.  The obvious avenue is the 50/30 rule–employers must provide insurance if they employ 50 or more “full-time” (more than 30 hours per week) workers.  This has two effects. Small businesses may try to stay small by having fewer than 50 workers, and big companies will try to minimize the number of full-time workers by keeping employees‘ hours per week to less than 30.

A slightly less obvious path to a part-time workforce was highlighted in this week’s Barrons by the always interesting Gene Epstein.  In an article titled “The New Tilt Toward Part-Time,” Epstein cites a study by Casey Mulligan of the University of Chicago, who argues that Obamacare will encourage part-time employment because part-time workers can get as much as $17,000 per year in Obamacare subsidies.  In the old days people worked full-time in order to “get the benefits.”  That is no longer necessary.  I can work part-time, have more leisure, spend less money on work expenses and child-care, and get heavily subsidized benefits from Uncle Sam.

What are the implications of a part-time American?  It will make for a less dynamic economy because people will work less; the U.S. will be more like France or Italy and less like the U.S. of the 1990s. In the current period of high unemployment this may not seem important, but in the long run it will matter because labor force growth is set to slow dramatically as baby boomers retire.  Obamacare will make the slowdown in hours worked even more pronounced.  (Enlightened immigration policies that attract well-qualified workers would alleviate this problem.)

Second, there will be greater inequality as we develop even more of a “two tier” workforce.  At the top will be highly educated go-getters who are still working sixty hours per week, getting decent salaries and benefits, and accumulating capital that generates investment income.  But there will be many more people working part-time, with comparatively low incomes but quite a bit of leisure time.  Call them the comfortably impecunious.

A third impact will be reduced social mobility; poor people will be more likely to stay poor because they cannot get full-time jobs and move up in the organization.  When I was in college more than a few years ago I travelled to the West Coast one summer to stay with a relative in a bungalow on LA’s Venice Beach.  After just a few difficult days I get a decent job at a Bob’s Big Boy working as a cook eight hours per day, six days a week, at a fair starting wage ($2.50 per hour plus unlimited Big Boy Double-Deck Cheeseburgers).   Starting in 2015 (Obama granted himself a waver until after the 2014 election), that may be impossible; to get 48 hours you will need  to shuttle between two jobs, wasting time and money in the process.

A more subtle barrier to social mobility is that low-status hourly employees who work less than 30 hours per week will have a hard time moving up in the organization. If they get a promotion to a more responsible, full-time job, their cost to the employer will jump because he or she will be obliged to provide Obama-style gold-plated health insurance.

When Obama was campaigning for the Presidency, a conservative joked that his campaign slogan should be, “Together, we can become France.”  Alas, that was prophetic.  By the way, French unemployment averaged 8.9% over the past decade; the lowest annual figure was 7.4%.

Copyright Thomas Doerflinger 2013.  All Rights Reseerved.

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A Whiff of Complacency

Posted on September 4, 2013 by tomdoerflinger

Exactly a year ago we wrote a prescient post titled “Muted Expectations Could Set the Stage for a Positive Stock Market Surprise.”  Analyzing Barrons’ survey of 12 equity strategists, published in early September 2012, we suggested (incorrectly) that their forecasts of S&P 500 EPS might be slightly optimistic, but (very correctly) that their PE assumptions were extremely conservative. Specifically, their year-end 2012 S&P price targets of 1425 implied a trailing PE of 13.8x and a forward PE of 13.2x.

“Wall Street’s strategists,” we noted, “are using PE assumptions that are very conservative by historical standards, particularly considering that we are in a low-inflation, low-interest rate environment. (italics in original)”  We argued that a positive economic surprise, such as a Romney victory, could boost the PE of the index well above the Wall Street consensus, producing strong stock market gains.  Despite Romney’s defeat, this PE expansion – which we subsequently heralded in multiple posts as “valuation levitation” — is precisely what happened. Even after the recent pull-back, the market’s trailing PE is 15.4x; at the market’s recent peak it was 16.1x.

Fast forward a year, and Street strategists have become decidedly more bullish:

  • They are forecasting EPS growth in 2014 of 7.4% (median), whereas a year ago they expected 2013 EPS growth of just 5.6%, which was quite accurate.
  • Four of the eleven strategists have 2014 EPS estimates of $119 or above, which is just slightly below the analyst bottom-up consensus of $123.  Although analysts are not always too bullish, they probably are now; expecting the bottom-up estimate to drop just $3-4 over the next 19 months is optimistic.
  • Their year-end 2013 S&P price targets imply a trailing PE of 15.7x (versus 13.8x a year ago) and a forward PE of  14.4x (versus 13.2x a year ago).

Complacency Is Setting In

I don’t have an argument with strategists’ PE assumptions, which look reasonable given still-low rates and no recession on the horizon. On the other hand, their profit expectations are optimistic.  After profit growth this year of about 5.6%, they expect acceleration to 7.4% in 2014.  It certainly could happen, and today’s strong ISM Manufacturing report is an important positive signpost.  But profits do face multiple headwinds:

  • Emerging markets are slowing sharply as Fed taper talk craters their currencies, raising their import costs and forceing them to raise rates.
  • U.S. profit margins are already at historic highs.
  • Notwithstanding the strong ISM, U.S. economic momentum is weak, with real personal disposable income rising a pathetic 0.8% over the past year.  (By comparison, growth averaged 3.0%, 2003-2006.)
  • A principal cause of weak U.S. growth, Obama’s anti-capitalist agenda, continues unabated, with ObamaCare kicking in soon, the EPA attacking coal and oil, and big banks facing a new regulatory attack every week.
  • Rising interest rates should dampen the U.S. housing market at least modestly.
  • Fiscal policy will remain restrictive, albeit less so than in 2013.
  • China’s economy is driven in significant measure by local governments investing in grandiose projects.  (Among other things, they are playing the game “my skyscraper is bigger than yours.”)
  • Europe is just gradually emerging from a severe recession, and bank balance sheets are too weak to fund robust growth.

Unlike a Year Ago, Upside Surprise Is Unlikely

The views of prominent strategists are a pretty good barometer of Street sentiment.  (In fact, Merrill Lynch has long used them as a contrary indicator.) Compared to last year, strategists are pretty bullish, which means that – even if they are largely correct — the chances of an upside surprise are decidedly lower than a year ago.

Copyright 2013 Thomas Doerflinger.  All Rights Reserved.

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Larry, Janet, and Democrats’ War on Women

Posted on August 23, 2013 by tomdoerflinger

Lecherous Democrats Bill Clinton, Anthony Weiner, Bob Filner and Elliott Spitzer have given a whole new meaning to the phrase “hands-on management.”  But nearly as indefensible is Obama’s desire to name Larry Summers, rather than Janet Yellen, to replace Ben Bernanke as head of the Federal Reserve.  If Obama does make that mistake Republicans should denounce it as an egregious example of Wall Street crony capitalism and the “old boy network” picking the best man rather than the best person to fill a crucial post.

To gain some perspective, consider this hypothetical. Barry is Chairman and CEO of XYZ Corp., and the head of the company’s biggest division, FOMC, is about to retire.  Over the past few years, FOMC has successfully grappled with tough industry conditions under the leadership of the Division Head, Ben, and his second in command, Janet.  FOMC’s future success depends not only on the smarts of its senior managers but on their collegial cooperation in responding to constantly changing market conditions.  Maintaining comity in the ranks is particularly crucial now, because FOMC is about to roll out a new product that has been under development for four years.  This is no time to “change horses in the middle of the stream.” So Janet is the obvious choice to replace Ben.  But wait.  Barry has an associate (and tennis partner), Larry, whom he’d really like to give the job to.  Admittedly there are pros and cons.  Pros:  Larry is very smart, and Barry has worked with him before; he will be a team player.  Cons:  Larry has never worked in FOMC’s industry, and he is unfamiliar with FOMC’s distinctive organizational structure and culture of collegiality.  Worse still, he is famously abrasive and arrogant, and his inflated regard for his own intelligence has led to imprudent decisions on more than one occasion.

Whom should Barry select?  The answer is obvious.  Except to Barry, who really, really wants Larry.  Stay tuned.

Seven Reasons to Be Leery of Larry

No Fed Experience  Although he has ample experience formulating economic policy and addressing economic crises, Summers has never conducted monetary policy. He has never participated in an FOMC meeting, trying to persuade colleagues to follow a cohesive policy, and then communicating that policy in a market-friendly way.  Even if he were not notoriously abrasive, Larry would have, at the very least, a challenging transition period. And it would be disastrous if global financial markets sensed there was discord and “bad blood” within the FOMC.  Yellen, by contrast, has been at the Fed for many years as a Governor, President of the San Francisco Fed, and Vice Chairwoman. She is widely respected, skilled at building consensus internally and communicating her views to market participants.

Yet Another Citi Crony Capitalist.  As I have shown in previous posts, Citigroup has for decades been mismanaged and periodically running to Washington for favors and bailouts (two during the 2008 financial crisis).  It skillfully cultivates powerful Beltway Buddies such as Robert Rubin, who after helping dismantle Glass Steagall as Treasury Secretary (making possible the merger of Citi and Travellers) just happened to land a lucrative sinecure at Citi.  Now it turns out that Larry Summers has been doing consulting work for Citi; after a stint at the Fed, he could join the bank, just as his mentor Bob Rubin did.  With Citi Alum Jack Lew already serving as Treasury Secretary, U.S. macro policy would virtually become a Citi subsidiary.

A Divisive, Disruptive Confirmation   A third of Senate Democrats and 62 female House Democrats signed letters to Obama supporting Janet Yellen.  Given his close ties to Citigroup and to Obama’s failed stimulus plan, nearly all Republicans will oppose Summers. A Democrat operative told The Washington Post, “Given the level of opposition to Larry Summers within our caucus, confirming him would be a huge challenge and probably a pretty ugly process.”

Tapering Raises the Risks   Putting Larry in charge would be particularly risky now, when the Fed is undertaking the delicate operation of reducing “Quantitative Easing,” or monthly $85 billion purchases of bonds. The mere suggestion of “tapering” these purchases has boosted Treasury bond yields dramatically, in turn driving down the currencies and stock markets of developing nations.

White House Experience Is Irrelevant:  Because the Fed is supposed to be totally separate from the White House, Summers’ experience as economic advisor to Obama in 2009 and 2010 is largely irrelevant.  Arguably it is negative because it reduces the perceived independence of the Fed.

Hubristic Imprudence  Summers is prone to ahistorical analytical hubris leading to imprudent decisions and judgments.  At Harvard he reportedly battled the head of Harvard’s endowment, Jack Meyer, because Summers wanted to take the fund’s entire transactional cash balance and invest it in illiquid long-term investments. Bad call.  The “Checkbook Fund” lost $1.8 billion in a single year.  And Harvard was rocked by a severe liquidity crisis in 2008 when it had to post collateral with Wall Street banks for interest rate swaps, entered into while Summers was President. Harvard literally had to borrow in the middle of a financial panic to meet payroll. Summers also naively underestimated the financial risks created by derivatives, hedge funds, over-levered banks, and skewed incentives for Wall Street executives.  Commenting in 2005 on a prescient paper by  Raghuram Rajan highlighting these risks, Summers called the paper “slightly luddite.”

Great Call, Janet   In contrast to Summers, Janet Yellen was quite early in recognizing the huge economic risks posed by sub-prime mortgages. By the Spring of 2007 her staff was already studying the problem. In late June, 2007, she told the FOMC:

“In terms of the growth outlook, I still feel the presence of a 600-pound gorilla in the room, and that is the housing sector. The risk for further significant deterioration in the housing market, with house prices falling and mortgage delinquencies rising further, causes me appreciable angst. Indeed, the repercussions of falling house prices are already playing out in some areas where past price rises were especially rapid and subprime lending soared. For example, in the Sacramento metropolitan area east of San Francisco. . . . Research by my staff examining metropolitan areas across the country indicates that the experience of Sacramento reflects a more general pattern.  They found that low rates of house price appreciation, and especially house price decelerations, are associated with increases in delinquency rates even after controlling for local economic conditions such as employment growth and the unemployment rate. One possible explanation for these findings is that subprime borrowers, especially those with very low equity stakes, have less incentive to keep their mortgages current when housing no longer seems an attractive investment, either because prices have decelerated sharply or interest rates have risen. These results highlight the potential risks that rising defaults in subprime could spread to other sectors of the mortgage market and could trigger a vicious cycle in which a further deceleration in house prices increases foreclosures, in turn exacerbating downside price movements.

Copyright Thomas Doerflinger 2013.  All Rights Reserved.

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Republicans, Don’t Throw Obama in the Briar Patch

Posted on August 14, 2013 by tomdoerflinger

To the modern ear the Uncle Remus stories sound racist because they’re in the dialect of the “old South,” and call to mind Jim Crow and demeaning racial stereotypes.  But I agree with Professor Damon Fordham (catch his excellent analysis in the video below) that the witty tales told by West African story tellers, passed on to American slaves, collected by folklorists in the late 19th century, published by Joel Chandler Harris as The Tales of Uncle Remus, and ultimately popularized by Walt Disney (Song of the South) should not be buried under a pile of political correctness.  They deserve a better fate.

Republicans can benefit from the most famous of these stories, about “Bre’r Rabbit,” the wolf, and the tar baby.  As Professor Fordham tells it, the wolf saw that someone was eating the peanuts in his peanut patch, noticed rabbit tracks, and decided to put up a scarecrow.  But Bre’r Rabbit was not fooled by the scarecrow and kept eating the peanuts.  So the wolf took a big lump of tar, dressed it in clothes and a hat, put a pipe in its mouth and a cherry for a nose.  Bre’r Rabbit saw the tar baby and thrust out his hand to shake the tar baby’s hand. When his hand got stuck, Bre’r Rabbit tried to dislodge it by pushing the tar baby away with his foot, which also got stuck.  Suddenly the wolf appeared, wrapped a bandana around his neck, and proclaimed “We’re gonna have rabbit stew tonight!”

Bre’r Rabbit replied, “You can cut off my head, you can boil me in the boiling water, but please please please don’t throw me in the briar patch.  You can cut off my ears and slit open my stomach, but just don’t throw me in that briar patch.”

Which the Wolf prompted proceeded to do, tossing the rabbit up in the air and into the brambles.

Then Bre’r Rabbit said, “You forgot two things.  Number One, I was born and raised in the briar patch.  And Number Two, I am now free to eat your peanuts again.”

Obama’s Bre’r Rabbit Act

Before he flew off to Martha’s Vineyard to join his fellow 0.01 percenters, President Obama played the rabbit at his press conference, telling Republicans “Please please please don’t shut down the government in order to defund Obamacare.”  Specifically:

“And let me just make one last point about this. The idea that you would shut down the government unless you prevent 30 million people from getting health care is a bad idea. . . I can tell you that the American people would have difficulty understanding why we would weaken our economy, shut down our government, shut down vital services, have people who are not getting paid who then can’t go to restaurants or shop for clothes or all the other things that we’re doing here, because Republicans have determined that they don’t want to see these folks get health care.”

The press is dutifully playing along.  Every one of the Sunday talk shows re-played Obama’s warning not to shut down the government.  The reason is obvious.  Obamacare is quickly turning into precisely the epochal “train wreck” that Sen. Max Baucus predicted.  Hardly a day goes by without Obama suspending another part of the bill, or granting preferred insiders (such as Congressional staff) a waiver, or seeing it attacked by another friendly interest group (Big Labor, IRS employees).  It is becoming alarmingly apparent to Democrats that ObamaCare truly is “historic legislation” – the worst legislation passed by Congress since the Fugitive Slave Law of 1850.  Democrats find themselves inextricably stuck in the Obamacare tar baby.

137 Frequently Asked Questions ! ! !

To appreciate just how bad this law is, you need to do something media pundits rarely do — read the actual legislation, along with hundreds of associated rules and regulations.  They comprise an impenetrable thicket of arcane legalese that even Obamacare experts cannot decipher.   Consider, for example, yesterday’s New York Times story, “A Limit on Consumer Costs Is Delayed in Health Care Law.”  It turns out that way back in February the Labor Department delayed for one year Obamacare’s limit on out-of-pocket deductibles.  However, no one noticed the change for six months because it was “obscured in a maze of legal and bureaucratic language” in the DOL’s answer to one of 137 “frequently asked question.”  Roll that around in your brain for a minute.  137 “frequently asked questions?”  From just one of the many agencies implementing Obamacare?  No wonder job growth is weak and small business confidence remains near recession levels. It’s so bad even economists may eventually notice.

Don’t Throw Obama in the Briar Patch

Rather than defend the indefensible for the next year leading up to the 2014 elections, the Press and the President would like to change the subject from ObamaCare to the imminent shut-down of the government by the dastardly Republicans.  Rather than explain why he grants so many waivers to his wonderful legislation, and offers a delay to the business mandate but not the individual mandate, Obama would much prefer to explain how he will protect Seniors, Children and Veterans from budgetary Armageddon.

To win the 2014 election, Republicans should not let Obama change the subject.  They should force votes in the Senate and the House that oblige Democrats to vote for it or against it.  Many of those who vote for it will be vulnerable next November.  It’s that simple.

Dumb Wolves?

Some tough guys on the right disagree.  Senator Ted Cruz, along with radio heads Limbaugh, Hannity, and Levin, want the House to fund the rest of the government but not Obamacare.  They admit this scheme would never become law.  But during the legislative impasse Senator Cruz would “take our case to the American people.”  Sorry, Senator; Obama and the Press will make sure your case is never heard.  Even leaving aside their political bias, media types would much, much rather cover the excitement of the coming government shutdown than try to explain dreary details of health insurance that, frankly, they don’t understand.

Let’s avoid playing the dumb wolf to Obama’s smart rabbit.

 

Copyright 2013 Thomas Doerflinger.  All Rights Reserved.

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Defending Profitability: This Is Not Your Parents’ S&P 500

Posted on August 8, 2013 by tomdoerflinger

A few weeks ago I had lunch with the strategist for a major buy-side firm who has been correctly positive on stocks.  He said the biggest push-back he got on his bullish call was that profits would be weak.  It’s a valid concern.  S&P 500 net profit margins are at a record 10%, and revenue growth is anemic because demand is soft around the world.  Obamanomics has held U.S. GDP growth to 1.5%, emerging markets have hit a BRIC wall, and Europe will emerge from a severe recession verrrry slowly.

But despite these formidable headwinds Q2 profits were acceptable, with strategists nudging up their 2013 SPX EPS estimates slightly, to around $110.  Bears argue earnings quality was low because the biggest upside surprises came from financials.  Investors don’t pay much for profits emanating from Wall Street’s inscrutable “black boxes.” On the other hand, the other unforecastable sector in the index, big energy companies, reported poor results.  So profits were indeed decent under the circumstances.

Leaner, Meaner, Smarter

Why are profits resilient despite a weak macro backdrop?  U.S. firms (and many European firms as well) are expanding earnings through smart proactive management of their businesses and balance sheets.  Consider the big defense companies (LMT, GD, RTN and NOC, none of which I own).  Going into 2013 it seemed obvious that this was a group for investors to avoid.  The stocks looked cheap, but earnings would be hit by the double whammy of American military disengagement from the MidEast and the Sequester, half of which fell on Pentagon spending.  Bad call.   All four stocks have impressively outperformed, rising 35-45% over the past year versus 22% for the S&P 500.  All four reported big upside EPS surprises for Q2 2013, driven in most cases by better than expected revenues and margins.  Looking at the forecasts of UBS analyst David Strauss, widely regarded as one of the best aerospace analysts on the Street, EBIT margins and EPS will rise modestly between 2012 and 2014 even as revenue declines about 10% between 2011 and 2014. Credit cost-cutting, restructuring, diversification into non-defense markets, selling more military gear overseas, and share buy-backs.

Profits Used to be More Sensitive to GDP

Why should we care?  Because the defense companies are broadly emblematic of the rest of corporate America, which is managing to grow EPS modestly (about 7% this year) even though comparisons are difficult and the world economy is barely growing.  This would not have happened in the 1980s or 1990s. Historically, GDP slowdowns often led to profit declines; for example, S&P profits fell 5% in 1985 when real GDP growth decelerated to 4.2% from 7.3% in 1984.  Prior to 2003 companies relied on unit growth and price hikes to drive margins, and they were prone to dumb acquisitions and excessive capital spending.  Share buy-backs usually didn’t cut share counts; they merely disguised stock option compensation.  Non-financial companies egregiously over-invested in the late 1990s, but they “learned their lesson” in the 2001-2003 tech crash and then became even leaner and meaner in the 2008 financial crisis, when many companies pared capacity and moved operations to low-cost locales.  Globalization is a big part of the story, of course; an engineer in Boston can work closely with a capable but comparatively inexpensive associate in Hyderbad who works through the night and has work ready when she gets to work the next morning.

This pattern should continue.  As I predicted over a year ago, Obama’s anti-capitalist agenda is keeping Keynesian “animal spirits” well-contained, despite low interest rates and a strong stock market. There is not much risk companies will go on an investment and hiring binge over the next couple of years.

Profit resilience is bullish for equity valuations

If profits are less volatile, normalized return on equity is higher and companies deserve a higher PE multiple.  Because companies are currently better managed and more shareholder friendly, comparisons of today’s PE’s with history are somewhat misleading.  Bears would counter, with some justice, that economic growth is weaker now than in the past, especially if China slows sharply as it “rebalances.” And I would admit that there have been times in the past, particularly the mid-1990s and 2004-2005, when bulls were incorrectly arguing that information technology, just-in-time inventory, and wonderful financial innovations such as derivatives had conquered the business cycle.  Boy, were they wrong.

For the record, the current PE on trailing pro forma EPS is 15.8x, versus an average of 16.1x over the past twenty five years, excluding the tech bubble.  Of course, interest rates were much higher then than now.  A 2% dividend yield looks mighty attractive when the 10-year Treasury yields 2.6%.

Copyright 2013  Thomas Doerflinger.  All Rights Reserved.

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Obama’s Potomac Fever

Posted on July 30, 2013 by tomdoerflinger

In a CNBC interview JP Morgan CEO Jamie Dimon celebrated the manifold strengths of America that will drive the next economic boom:

“This country not only has the best military on the planet, it has got the best universities, the best businesses, it’s got low corruption, the widest and deepest capital markets, it’s hugely innovative from Steve Jobs to the factory floor, it’s got a wonderful work ethic.  We’ve got a royal straight flush.  We don’t have a divine right to succeed but we have an unbelievable hand if we play it well.  And now we have natural gas, shale oil.  America is going to come back, and it’s going to blow people’s socks off when it does.”

In Dimon’s America, excellence and dynamism are widely dispersed; it’s not all about Wall Street or corporate America.  Obama’s America, by contrast, is all about Washington.  In a New York Times interview after the Galesburg speech, it sounded like Washington could grow “the economy” and a “strong middle class” the way a farmer grows cucumbers and corn:

  • “the central problem we face . . . is how do we build a broad-based prosperity”
  • “I want to make sure that all of us in Washington are …[focusing]…on how we grow the economy and grow the middle class”
  • “I want to make sure everybody in Washington is obsessed with how are we growing the economy, how are we increasing middle-class incomes and middle class wages and increasing middle-class security.”
  • “[we need] a conversation that is framed as how are we growing the economy, how are we strengthening the middle class, how are we putting people back to work…..”
  • “our priority needs to be growing the economy faster and strengthening oncomes for ordinary Americans”

Frankly, I am not sure how Washington can “grow the economy.” I thought individual businesses and workers did that. Obama plans to “strengthen American manufacturing,” but U.S. firms do not need Federal “manufacturing innovation institutes.”  “Rebuilding infrastructure” has merit, but wasn’t the $800 billion “stimulus” package supposed to do that?

Obama dislikes unfettered businesses because they supposedly grow the economy from the “top down” rather than “from the middle out,” whatever that means.  In his endless Galesburg speech he named only three U.S. companies: Maytag (which moved a factory from Galesburg to Mexico) and then Costco and the Container Store, which were commended for treating their employees well—as though the rest of corporate America did not.  A few other items were notable as we head toward an autumn showdown on the debt ceiling:

  • Obama frankly loathes House conservatives, who in his opinion will oppose anything he supports.  “Some of those folks think I usurp my authority by having the gall to win the presidency.”  Count on Treasury Secretary Jack Lew to take a hard line in negotiations with Congress.
  • Obama is trying to convince himself that his pathetic economic record merely continues trends “over the past 20 or 30 years.”  Which is obviously untrue; unemployment averaged 5% in G.W. Bush’s second term even though the labor force participation rate was 66% versus 63.5% now. During the 1990s boom labor markets were even tighter and real incomes rose for most demographic groups.
  • Channeling Paul Krugman, he takes credit for the rapid decline in the Federal deficit even as he attacks Republicans for the sequester.

Making Jimmy Carter Look Good

Late in his hapless presidency Jimmy Carter addressed structural inflation by starting to deregulate industries, a process Ronald Reagan continued.  But Carter was a successful farmer who understood business and the costs of over-regulation. Obama does not. He denies, for example, that Obamacare impedes hiring, and he dismisses the employment potential of the Keystone Pipeline, pegging it at an implausibly low 2000 jobs. It’s a little weird to read a windy, bombastic, tedious, repetitive speech about creating middle class jobs, and then hear Obama flippantly dismiss a real-world opportunity to actual do it.  (“Let them eat Federal programs!”)

Unfortunately the costs of overregulation are becoming so obvious that even the liberal Financial Times editorial page has noticed.  Echoing arguments I have been making for well over a year, Edward Luce writes that Dodd Frank has improved the competitive position of giant banks (which can afford platoons of lawyers) at the expense of small community banks and the entrepreneurs they lend to.  Result: a decline in small business creation.  To be fair to Obama, I have yet to hear many mainstream Wall Street economists highlight the growth-suppressing impact of Obamanomics. I guess it wasn’t in the Econ 401 syllabus.

Copyright Thomas Doerflinger 2013.  All Rights Reserved.

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China Double Play: Slowdown & Cleanup

Posted on July 26, 2013 by tomdoerflinger

We revisit two important investment themes:

China Slowdown

Yes, China is a compelling long-term growth story.  So was the U.S. in the 19th century, but it still had financial panics and deep recessions in 1819, 1837, 1857, 1873, and  1893.  Hopefully, China’s slowdown will not be that severe.  But it will be difficult to seamlessly shift GDP growth from exports and investments to consumption, particularly because much of the investment that powered GDP was ill-advised “stimulus spending” on government-sponsored “white elephants” that did little to improve productivity and long-term growth. This is government spending only Paul Krugman could love.  Before the slowdown is over, Wall Street economists will be arguing whether the GDP growth figure will have a 5-handle.  Two new data points, both rather shocking:

1   According to The Wall Street Journal, “China issued a directive on Tuesday banning the construction of government buildings for the next five years, the latest in a series of initiatives . . . to discourage corruption and foster frugality at a time of broad popular resentment against high-living bureaucrats.”  Roll that around in your brain for a while.  A five year moratorium on government buildings?  That’s pretty extraordinary, especially for a developing country.  It is a stark admission that much of the recent spending was a waste.  Keep in mind that construction of those buildings added to GDP in years past but won’t generate much income going forward.

2.  The Journal also carried a story on a $91 billion industrial project – that’s a lot of money, folks, even in China – that was put on hold because it was so ill-conceived.  Surveying empty buildings, steel worker Zhao Jianjun uttered an eloquent haiku to mal-investment:  “You only need to look around to see how things are going.  Look north, west, east.”

We regard China’s GDP figures as fictitious; even U.S. GDP is radically revised, sometimes turning strong growth for a given quarter into a slight decline, or visa versa.  More meaningful than GDP is the HSBC PMI, which for July was 47.7, the third straight decline and weakest since August 2012.  That’s pretty bad for an economy powered by manufacturing rather than services.

China Clean-up

China’s environment is a wreck, and as the middle class grows the political pressure to clean it up becomes ever more intense.  This is a very broad-based theme involving everything from water conservation to air pollution, food safety, pharmaceutical purity, hospital cleanliness, etc.  The issue was highlighted in another WSJ article titled “China Weighs Environmental Costs: Beijing Tries to Emphasize Cleaner Industry Over Unbridled Growth After Signs Mount of Damage Done.”

A clean-up is not just politically popular and environmentally necessary but also vital to China’s international competitiveness. Soccer moms in California, Germany, and Shanghai don’t want to serve fish from China laced with mercury, or give junior a toy adorned with lead paint.  Chinese tourists load up on infant formula when they visit England or Germany because they don’t trust the domestic product; The New York Times refers to “Chinese parents’ obsession with foreign milk powder, which stems from distrust of domestic brands.”  How weird is that?

The two themes are linked . . .

. . . because government spending will be diverted from unpopular and unproductive construction projects toward politically popular environmental clean-up.

A Premier Clean-up Play

One big beneficiary of these trends is Thermo Fisher Scientific, the leading producer of scientific instruments for laboratories and factories. Its slogan is “Healthier, Cleaner, Safer.”  Last year Asia Pacific was 17% of revenue, with much of that in China. TMO makes equipment to identify pollutants such as mercury, lead, arsenic, etc.  You can’t reduce what you can’t measure, so China will be spending a lot of money on such equipment in coming years.  TMO was one of ten attractive stocks recently highlighted by hedge fund impresario Lee Cooperman at the Seeking Alpha Conference.   Full disclosure: I have a long-standing long position in TMO; the stock has appreciated 42.5% so far this year and is not particularly cheap.  Invest at your own risk.

The Q2 2013 TMO earnings conference call contained interesting commentary on the company’s business in China.  Here is an abbreviated version of comments by CEO Marc Casper (emphasis added):

“In China, we’re using our scale to our advantage. We have manufacturing. We have an R&D center. We have multiple training centers. We have a business headquartered there. We’re closing in quickly on 3,000 colleagues. We recruit from the best universities.

“We are clearly very well-positioned in the market, and that’s helping us drive significant growth, having quite a number of quarters of 20%-plus growth and this being one of our stronger quarters that we’ve had. . . we’re very well aligned with the societal needs and the 5-year plan, which is around environmental protection, food safety and expanding health care capabilities, particularly in the west.

“And while I mentioned in my prepared remarks, to get multiple hours with an entire government for 100 million people in a province to really talk about our capabilities and their challenges and what the opportunities are for alignment, gives you a sense of the importance, even though they brought up in the dialogue that, yes, the industrial economy in their own province is a little bit weaker, and that has an effect on their GDP growth, but nonetheless, they thought it’s important enough to actually talk through what we could do and collaborate together to really meet their needs on their own priorities as well.”

Bottom line

We expect China growth to surprise to the downside over the next year; many investors are complacently expecting an easy transition to consumption led growth, despite multiple warning signs.  But look for strong spending on environment clean-up, which will benefit TMO and also quite a few industrial companies involved in helping China build a cleaner infrastructure.

Copyright Thomas Doerflinger 2013.  All Rights Reserved.

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