Bloomberg Befuddled by Racial Incorrectness

Posted on August 5, 2014 by tomdoerflinger

It’s not often I have money-making advice for Mike Bloomberg, but here’s a suggestion: You could improve the ratings of Bloomberg Radio/TV by finding one or two conservatives to spice up the conversation, as Joe Kernen and Rick Santelli do on CNBC. Some spirited disagreement would elevate both the entertainment value and the intellectual level.  We might even occasionally hear the words “Obamacare” and “structural unemployment” in the same sentence. Right now, Bloomberg TV’s notion of political diversity is to balance a Manhattan liberal from the upper west side with a Manhattan liberal from the lower east side—perhaps leavened with a couple of West Coast liberals.  It gets kind of boring . . . . except when the on-air liberals have to contend with – eeek – a real, live conservative.

A case in point is “The Hays Advantage” with Kathleen Hays and Vonnie Quinn. Much to their credit, they invited as a guest the WSJ’s Jason Riley, to talk about his new book Please Stop Helping Us. Riley—did I mention he’s black!—argues liberals are doing far more harm than good by “helping” blacks with supposedly well-intentioned measures like affirmative action and raising the minimum wage. These initiatives harm the average black person while empowering paternalistic liberal elites that pretend to be protecting downtrodden blacks from racist conservatives—despite the manifest failure of liberal policies to improve the lot of poor blacks. Because they find this anti-racist posturing so personally satisfying and politically expedient, Riley argued, liberals try to destroy any black opponent of racial paternalism by labeling them an “Uncle Tom.” Which is why Riley was very courageous to write the book.

Riley told Hays and Quinn that what poor blacks need to get ahead is not more “help” from liberal elites but, rather, embracing traditional habits of self-help – finish school, get a job, get married, take care of your kids, save some money. Too many blacks dismiss such behavior, Riley said more than once, as “acting white.”

Alarm bells sounded in the liberal brains of Hays and Quinn. Despite their best efforts to play it cool, you could hear the consternation and confusion in their voices as they probed and challenged this wayward black conservative. “Aren’t the behaviors you describe also characteristic of other poor people?” Quinn wanted to know. Late in the interview, Kathleen Hays asked the standard liberal question: “What should Washington do?” To which Riley answered “Stop! Stop trying to help us.” What blacks need is self-help, not help.

Riley ended with a searing indictment of liberals’ cynical opposition to school choice: “President Obama has never found a public school good enough for his own children, not before he was president, not since he became president. Yet since the day he entered the oval office, he has been trying to shut down school voucher programs right there in Washington DC that would give the black poor the same educational options that his own children have.”

You don’t hear conservative common sense like that on Bloomberg very often.

Copyright Thomas Doerflinger 2014. All Rights Reserved.

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How Overvalued Are High Yield Stocks? We Deploy the PETTR Principal

Posted on August 1, 2014 by tomdoerflinger

Today’s 30-point sell-off in the S&P 500 is consistent with my warning a few weeks ago that the Fed was “behind the curve.” It made no sense, I argued, for Chair Yellen to still be pursuing an emergency monetary policy, with zero short rates and continued bond buying, five years into an economic expansion that is finally gaining some traction. Fear of rising inflation could hit the bond market hard, particularly because Dodd Frank has dried up capital on the trading desks of those nefarious investment banks.

That warning has been validated by a 4% GDP print for Q2 and a 0.7% jump in the ECI (Employment Cost Index)—figures that obviously are not consistent with a labor market that has plenty of “slack.” Throw in “unrest” in Ukraine and Gaza, stiffer sanctions on Russia that will hurt European “growth,” and incoherent domestic policy with respect to tax policy, the Texas “border,” etc. and you get a 2% sell-off which may get worse.

The stocks most at risk of a bursting bond bubble are “bond surrogates” such as utilities with juicy dividend yields. They have looked expensive to me for quite a while but performed well as investors “reach for yield.” Which got me to wondering—how over-priced are these “bond surrogates,” some of which I own? So, I turned to my oh-so-sophisticated valuation model, the PETTR Principal, which is the equation:

PETTR Ratio = (PE of the stock on consensus 2014 EPS) / (dividend yield + long-term EPS growth rate)

So, for a stock with a PE of 16x, a dividend yield of 2%, and a growth rate of 11% the PETTR ratio . . .

=16 / (2+ 10)

= 1.33

(In this equation, the PE ratio and the dividend yield are established fact; the growth rate you have to estimate based on your knowledge of the company and economy. No database will provide it. And remember this is about the future, not the past; extrapolating the past four years probably won’t work too well.)

Solving for the Growth Rate Consistent with a PETTR Ratio of 1.5

The stocks I own—a broad selection of quality growth stocks—have an average PETTR of 1.5. So, I looked at a group of “bond surrogate” stocks – 8 electric utilities, the 2 big telecoms, 3 consumer staples, and 4 big pharma names—and asked “What growth rate do these names need to have, for their PETTR Ratio to be 1.5?” For example, AEP has a PE of 15.3x and a dividend yield of 3.8%, so it would need to have a growth rate of 6.4% for the PETTR ratio to be 1.5—that is, 15.3/(6.4+3.8)=1.5.   The next step is to look at that 6.4% growth rate and ask “Is this figure look realistic, given analysts’ EPS estimates for the company, and what we know about the state of the industry?”

Before we get to the results, consider a few characteristics of the 17 “bond surrogates” studied:

  • Their average dividend yield is 3.9%, about twice the S&P 500
  • Their average PE is 16.7x, about the same as the S&P 500
  • Their dividend payout ratio averages 64%, about twice the S&P 500—which, by definition, means their retention ratio (1 minus payout ratio) is half the S&P 500.

These facts suggest their growth rate should be less than the S&P 500, because the very high payout ratio and low retention ratio mean they have comparatively little capital to reinvest in their business to generate future earnings growth.

Anyhow, here are the results:

  • For all 17 companies, the average growth rate needed to have a PETTR ratio of 1.5 is 7.3%; the median is 6.2%. These figures are not ridiculously high, but they do look too high for 17 big, mature companies with very high dividend payout ratios. Judging from history and the current weak state of the global economy, the future EPS growth rate of the entire S&P 500 (which includes many fast-growing companies) is probably 6%. These companies will probably grow  only 4-5%, not 6-7%. Bottom line: as a group, they do look overvalued.
  • From a “bottom-up” perspective, when I examine the individual companies and compare the growth rate consistent with a PETTR ratio of 1.5 with my best guess at the “actual” future growth rate (based mainly on analysts’ estimates over the next three years), on average the actual growth rate is 1.2% lower. Again, they look overvalued.
  • Most overvalued are the electric utilities, where the actual growth rates look to be 2.2% (220 bps) less than the growth rates consistent with a PETTR ratio of 1.5. The industry faces slow growth because demand for electricity is slowing, plus the government-subsidized “roof-top solar revolution” will hurt growth as consumers produce their own power. Companies may be obliged to maintain transmission infrastructure while they are starved of revenue from generating power. I would avoid all electric utilities that are not restructuring stories or “special situations.”
  • The two telecoms, VZ and T, look reasonably valued; VZ looks cheaper than T.
  • The three consumer staples (MO, PM, KRFT) also look reasonably valued, though not as cheap as tobacco stocks used to be.
  • The four big pharma names (MRK, PFE, BMY, JNJ) look rather expensive. On average their growth rates look 120 bps lower than the figure consistent with a PETTR ratio of 1.5. I admit the growth rates are idiosyncratic and hard for an amateur like me to assess; they depend on the ability of these companies to develop new drugs. JNJ has been doing this lately, but in general big pharma has a poor track record of drug development over the past decade. Furthermore, Wall Street was treating Pfizer as a “streamlining” story that had shifted from an acquisitive behemoth to a more nimble, focused company—until it tried to acquire Astra Zeneca. This gives me pause. In general, the risk / reward in these names does not look compelling, although, again, it all depends on the specific pipelines.

Investment Conclusion: Avoid electric utilities, treat big pharma with caution.

Copyright Thomas Doerflinger 2014. All Rights Reserved.

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The Bianco Golden Ratio vs. Lew’s Inversion Perversion

Posted on July 24, 2014 by tomdoerflinger

Deutsche Bank’s ace stock market strategist David Bianco—a friend of mine and formerly a colleague—has devised a nifty new ratio to summarize the health of the U.S. economy. He calls it the Golden Ratio; I call it the Bianco Golden Ratio. It is real GDP growth / the inflation rate. More formally:

Yr/yr percent change in real GDP / Yr/yr percent change in CPI

David reckons that when that ratio is 1.6x or higher—for example, with GDP growth of 3.2% and inflation of 2%—the economy is in good shape. At such times, he writes, “productivity and capex are strong, interest rates are benign while providing decent returns to savers, and risk premiums are low and the job market is vibrant with prosperity gains broadly shared.” In general, PE ratios tend to be higher when these conditions prevail and the Bianco Golden Ratio is high. A few examples:

  • In the wonderful early 1960s (1961-65), GDP grew 5.1%, inflation was 1.3% and the Bianco Golden Ratio was a sky-high 3.92.   In these years, the trailing PE of the S&P 500 averaged 18.8x.
  • In the awful 1970s (1974-79) GDP – boosted by a surge of women and baby boomers into the workforce – grew 3% but inflation was 8.5%, so the Golden Ratio was an abysmal 0.4%. PE’s were very low, averaging 9.4X and just 8.4X if you exclude recessionary periods when PE’s were boosted by depressed earnings.
  • In the late 1990s (1995-99) GDP grew 4.1%, inflation averaged 2.4%, the Bianco Golden Ratio was 1.9x, and PE’s averaged a lofty 21.2x. Obviously a bubble developed late in the decade; before then, in 1995 and 1996, PEs averaged 16.2x.

Crappy Economy, High PEs—Huh?

Against these three earlier periods, the current situation is anomalous—crappy economy, high PE ratios. Since the beginning of 2011, GDP growth has averaged a pathetic 2.1% and inflation is about the same, 2.2%; therefore the Bianco Golden Ratio is about 1x.  Despite this poor performance, PE’s have averaged a fairly high 14.7x since 2011 and—more importantly—over the past year the S&P 500 PE averaged a lofty 16.9x.

So why are PE ratios high despite poor U.S. economic performance? That’s a complicated question with several answers. Better than average corporate management, and share-holder friendly use of cash are important. But the cause I would highlight, and the one conventional economists continue to miss, is: Regulatory mismanagement is restraining economic growth, especially employment growth, which is prompting the Fed to keep rates low, forcing investors to buy stocks to get a decent return. I still see no evidence Chair Yellen has figured this out.

Looking at the litany of regulatory blunders by the Obama Administration, arguably the most egregious is failure to reform corporate and individual taxes, despite bipartisan desire to do so. The Stimulus had some Keynesian logic, even if it became a slush fund for Democratic special interests. Dodd Frank may be a monstrosity, but Wall Street did need reform. Obamacare may be one of the worst laws in American history, but expanding healthcare access is a worthy goal.

On the other hand, refusal to reform America’s antiquated corporate tax code – with its excessive rates and global incidence that force firms to keep trillions of dollars offshore—is pure negligence, born of Obama’s anti-capitalist ideology. The President simply hates the idea that, properly incentivized by a rational tax system, companies can do good (like creating jobs) while doing well. His reform proposals have all centered on taxing the foreign profits of U.S. firms, which is a non-starter in Congress. Result: no reform.

Lew’s Inversion Perversion

Now Obama’s tax reform negligence has turned into a crisis, as one company after another acquires a foreign firm to do a tax inversion that will permanently raise its return on capital—and likely its PE ratio—by lopping about 1000 bps off its tax rate. This is not a new phenomenon; Wall Street nerds, myself included, have been discussing it for about six years. But the trickle has become a flood as more and more companies invert A) because they decided Obama will never reform taxes, B) to remain competitive with industry peers that have already done it, C) to get it done before a punitive preventive measure is passed.

Having belatedly noticed the inversion flood, which could become a tsunami, Treasury Secretary Lew wrote a letter to Democratic Senators on the topic. He starts out by noting that “the President has called for undertaking business tax reform as a way to improve the investment climate.”   Which is true—Obama “called” for reform but did nothing to make it happen, like compromise with Republicans. Then Lew asks for a stop-gap measure to prevent inversions, even though it would become a barrier to comprehensive reform. Echoing the sophomoric rhetoric of his boss, Lew opines, “What we need as a nation is a new sense of economic patriotism, where we all rise or fall together. We know that the American economy grows best when the middle class participates fully and when the economy grows from the middle out.”

Lew knows this proposal will get nowhere. He is simply trying to turn a policy failure into a campaign issue for Democrats. But his letter goes far toward explaining why we have a crappy economy and high PE’s. Companies have managed  to protect themselves from regulatory incompetence with such moves as inversions and low capital investment that limits capacity growth and protects profit margins. This helps shareholders but not average workers, who are hurt by Obamacare, the War on Coal, higher tax rates on entrepreneurs, etc. Consequently profits as a share of GDP are near record highs while the Fed’s zero-rate policy keeps valuations high. Wall Street flourishes while Main Street struggles—not exactly the “hope and change” Obama promised in 2008.

Maybe the Grass Really Is Greener in 2017

The good news is that Obama leaves office in thirty months (but who’s counting?). Hopefully his successor, even if it is Hillary, will adopt policies that promote rather than hinder economic growth. Then the Bianco Golden Ratio will move up, justifying elevated PE ratios even if interest rates are higher than they are now.

Copyright Thomas Doerfligner 2014. All Rights Reserved.

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Skip Piketty; Read Easterly

Posted on July 16, 2014 by tomdoerflinger

Here’s all you need to know about the most popular, least read, business book of the year. In his ponderous, repetitive, tedious, tortuous, tendentious, repetitive tome on the evils of inequality, Capital in the Twenty-First Century, Thomas Piketty, in the process of advocating for redistributive policies that—as I predicted two years ago—have failed spectacularly in his native France, unwittingly makes a great case for privatizing Social Security in the United States.

Piketty claims rising inequality is inevitable because investors’ return on capital exceeds the growth rate of GDP and workers’ incomes. If he is right, the best way to reduce inequality is to encourage workers to invest in stocks and bonds. Social Security prevents this by confiscating wages that workers could have saved and invested on their own account, creating middle class wealth that can be passed on to their kids. If you believe Piketty, reforming Social Security to permit this process of middle class fortune building is a no-brainer. In addition to reforming Social Security, Republicans should propose other reforms–such as creating 401K plans for all adults—that encourage workers to invest in stocks and bonds.

Easterly’s The Tyranny of Experts – a Brilliant, Iconoclastic Assault on Econo-Conventional Wisdom

William Easterly, an economics professor at NYU, is an expert on international development who takes a properly jaundiced view of his own profession. Years of seeing pompous, know-it-all development “planners” like Bill Gates and Jeffrey Sachs formulate costly schemes that fail to reduce poverty have given him a fresh perspective on the whole topic of economic growth, in both developed and developing nations. Here are a few insights:

  • The World Bank, IMF, Ford Foundation, etc. practice “authoritarian development.” Planners routinely ignore the rights of individuals in favor of the state. Easterly prefers “spontaneous cooperation” of individuals via markets, as opposed to “conscious design” by out-of-touch experts.
  • Top-down planning fails because planners simply do not have the necessary knowledge of on-the-ground local conditions, nor do they have an incentive to maximize the utility of the local population. For example, Thomas Jefferson thought the Erie Canal, the most successful infrastructure project in American history, was a really, really dumb idea; it had to be planned and financed by local politicians in the State of New York. One thinks immediately of Obamacare, where Ivy League professors and Congressional staffers force small businesses to use insurance policies the planners refuse to use for their own families. (Ivy League health insurance plans all brag about the “choice” and “flexibility” they offer participants; Jane and Joe Doe get no such choice.)
  • Planners place excessive emphasis on the performance of nations, when in fact patterns of development are regional—the countries in Latin America or sub-Saharan Africa tend to share similar problems.
  • Markets are “associations of problem solvers” using the price system to equilibrate the utility of consumers and the income of producers. Bureaucracies (think the Veterans Administration or the IRS) don’t answer to consumers; they answer to other bureaucrats and so have no incentive to maximize the utility of consumers.
  • One of the best ways to reduce poverty is immigration—whether from West Virginia to Ohio, or from Haiti to Florida. Plus, successful immigrants often send money back home to relatives, alleviating poverty in their home country. Liberal pundits (such as Alan Blinder in a recent WSJ column) routinely ignore how rising immigration necessarily increased “inequality” in the U.S. since 1980, even as it alleviated the poverty of immigrants and their relatives in the home country to whom remittances were sent. By the way, measured inequality in the U.S. is lower than it appears precisely because immigrants send money home, making the American residents appear poorer than they actually are.
  • Breakthrough technologies, such as the horse-drawn cart or the railroad, are often constructed from prior technological innovations. (In the case of the railroad, rails were originally used in mines, and steam engines were first used in factories and steamboats.)
  • Clueless development experts often operate with a “blank slate” – they have zero knowledge of the historical circumstances of particular countries. You might find an expert on Asia writing a detailed plan for how Brazil should be developed. We are now seeing the results of “blank slate” thinking in foreign policy; I doubt folks in the Bush Administration understood the significance of the Sunni / Shia schism before they invaded Iraq.
  • Here’s an insight from one of Easterly’s colleagues in the anti “development” fraternity, Dambisa Moyo: Development aid tends to undermine the political and economic power of a nation’s indigenous business community, because corrupt rulers can take a cut of the aid dollars while ignoring the needs of business community. Result: the rulers get rich but the economy remains under-developed. I suspect something similar has happened in the U.S. African-American community, where politicians and “community leaders” spending government money have more influence than black entrepreneurs and professionals.

Copyright Thomas Doerflinger 2014. All Rights Reserved.

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Has Yellen Heard of Obamacare?

Posted on July 15, 2014 by tomdoerflinger

In this week’s Barron’s Randall W. Forsyth, citing research by Stephanie Pomboy’s Macro Mavens, makes a point I have been making for a few years. Supposedly strong employment gains in recent months, Pomboy notes, consist largely of part time jobs. Because of Obamacare, small companies are holding workers to less than 30 hours per week so that they do not count as “full-time employees” who must be given lavish benefits. In June full-time employment was still 3.4 million below its pre-crisis level. Mort Zuckerman made the same point in today’s WSJ.

The inevitable result of a shift to a part-time America is weak personal income growth. In May real personal disposable income grew only 1.9% year-on-year, and the 12-month moving average of this metric is a dismal 1.4%. How does that compare with years before the financial crisis, during the supposedly terrible reign of President George W. Bush? Between 2005 and 2007 the yr / yr percentage change of real personal disposable income averaged 2.6%, nearly twice as fast as the recent 12-month average. And don’t forget, Obama has delayed the employer mandate, so employers have not yet been socked with the full impact of the law. Furthermore, the cost of insurance will be rising rapidly for the next couple of years, which will inhibit hiring even more.

Fed Policy and Obamacare

Although many Wall Street economists continue to look the other way, the baneful effects of Obamacare on employment are pretty well recognized at this point. What people are still missing is the impact on Fed policy. When Janet Yellen looks at an economy with low labor force participation and just 1.4% average real personal disposable income growth, she sees an economy burdened by too much debt, which is allegedly restraining demand. She forgets about supply side constraints– regulations that are raising costs, hurting employment, and discouraging investment, such as:

  • Obama has sharply raised marginal tax rates on highly productive individuals.
  • Failure to reform America’s laughably dysfunctional tax code, which is impelling more and more companies to decamp to Europe.
  • Obamacare penalizes small business that go over the limit of fifty full-time workers. It pays to stay small.
  • The war on coal.
  • The Keystone XL Pipeline freeze.
  • The absurd ban on oil exports.
  • Onerous ozone regulations.
  • Dodd Frank curtails small business lending by wrapping community banks in unnecessary red tape.
  • Huge, capricious fines on major banks.

No wonder we have what Larry Summers mischaracterizes as “secular stagnation.”  By limiting supply and raising costs, these policies slow economic growth and make the economy more inflation-prone. Because she is misreading the causes of weak job growth, Chair Yellen’s easy monetary policy runs the risk of triggering inflation. I keep hearing that inflation can’t be a problem unless wages start to inflate. This makes no sense to me. Prices are a function of supply and demand; companies will raise prices if they can do so, regardless of what is happening to their own costs. A couple of weeks ago, I had a hard time finding a hotel room in Boston for less than $400—not because wages are rising in Boston, but because the hotel market is tight after five years of solid growth in the local economy.

I will be interested to see if Chair Yellen mentions regulation tomorrow in her Congressional testimony.

Krugman Flunks Finance 101

The good professor thinks he has figured out why conservatives oppose the Fed’s ultra-loose monetary policy, five years into economic expansion. Not only are they (unlike Krugman himself, of course) insufferably ideological and unscientific; they are also greedy. See, Fed policy has driven down interest rates, and it’s rich guys and gals—not the middle class retiree with a few hundred thousand dollars to invest—who get the largest share of their income from interest payments. Greedy rich conservatives hate Fed policy because their interest income is under pressure.

Krugman needs a refresher course in bond math. When interest rates decline, bond prices rise. These rich guys who supposedly have been hurt by Fed policy actually have garnered huge capital gains since 2007, while “working families” continue to be screwed by Obamanomics. For example, the iShares 10-20 year Treasury Bond ETF has appreciated from 96.96 on July 9 2007 to 129.37 now, a gain of 33.4%, in addition to which holders of this ETF have received 2%-5% per year in interest. That’s a total return, straight through a searing financial crisis, of about 7% per year. People in the top 0.1% who own lots of bonds have done much, much better than the average worker facing weak job growth and declining median household income since 2007. Krugman / Obama rhetoric favors the 99%; their policies favor the 1% and especially the 0.1%, even if they are not smart enough to know it.

Krugman seems to think super-easy money that risks inflation will help “working families,” but the opposite is true. The labor market is still weak enough that most workers do not have the bargaining power to get wage gains in excess of price increases, so their real incomes would decline if inflation picked up. The 1970s were a good decade for commodity speculators, but not for average workers.

Copyright Thomas Doerflinger 2014. All Rights Reserved.

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How to Play the Coming Bust in the Yellen Bond Bubble

Posted on July 6, 2014 by tomdoerflinger

It’s starting to get a little weird. Here we are, more than five years into an economic recovery, with an improving employment picture, strong stock market, OK housing market, strong auto demand . . . and the Fed is still easing via QE while keeping short rates at zero. That’s a monetary policy for a financial crisis, not the middle of a recovery. In her July 2 IMF speech, Chair Yellen admitted this is starting to cause excessive speculation, but she nevertheless intends to pursue an easy policy for a quite a while longer. That is music to speculators’ ears.

Two Remedies for Excessive Speculation

Yellen recognizes there are “pockets of increased risk-taking across the financial system” (such as shrinking spreads in the junk bond market). That will not, however, be addressed with higher interest rates, which could kill the patient as well as the disease. Instead Yellen will resort to “Macroprudential Policies” of two kinds—“building resilience” and “leaning against the wind.” “Building resilience” basically refers to the measures Dodd Frank and Basel III are taking to make banks and other institutions more resistant to panics – less leverage, more liquidity, less risk taking, a resolution regime if they get into trouble. Significantly, she had far less to say about “leaning against the wind” (one substantive paragraph versus four). Here she notes that Basle III and the bank stress tests pay due regard to “loss absorbing capacity.” She notes margin requirements could be boosted to rein in speculation.

Here’s the problem. The bond market is already overheated. Another full year of zero Fed Funds, followed by many months of minimal rates (0.25%-1%) will make the situation worse. Meanwhile excess capacity in the U.S. economy is shrinking and inflationary pressures are slowly building. Supply side blunders such as Obamacare, absence of corporate tax reform, the War on Coal, the XL Pipeline freeze, and wrapping community banks in Dodd-Frank red tape, are impeding productivity growth and making the economy more inflation-prone. When the bond market finally cracks, the rise in rates could be dramatic and wrenching, very likely causing a stock market sell-off.

The Tech Bubble

We have been here before, twice actually. We are in the third consecutive “jobless recovery” where the Fed was “looser for longer” than anyone expected, creating asset bubbles in the process – tech stocks in the 1990s, housing in the 2000s. It’s useful to consider what the Fed should have done differently to prevent these bubbles, and why it did not.

In December 1996, two years into the big stock market rally, Fed Chairman Greenspan made his “irrational exuberance” speech. Stocks stumbled but recovered fairly quickly. By 1997 Greenspan had bought into the “New Economy” hype; for example, a breathless Business Week article quotes a colleague saying ”He is very open to the possibility that we have entered a new economic age.” Greenspan was not wrong that improving productivity justified a looser for longer Fed policy in the late 1990s. (The Asian financial crisis also necessitated a rate cut in 1998.)   Where Greenspan erred was in confusing the economy and the stock market. Accelerating productivity did not justify an absurd and obvious mania in TMT (Tech, Media, Telecom) stocks. He should have ended the mania by:

  • first, giving another “irrational exuberance” speech where he explicitly threatened to raise margin requirements

and, later, when that did not work,

  • actually raising margin requirements dramatically, causing a stock market panic as leveraged speculators—day traders on Main Street as well as prop traders on Wall Street—dumped shares.

Clearly, this would have been politically difficult; a TMT crash would have cost influential voters huge losses. However, it would have been far better to have a brief panic in 1997 than a huge liquidation of absurdly over-valued stocks three years later.

The Housing Bubble

In 2005 or 2006 the Fed, OTS, OCC, FDIC and other regulators should have simply prohibited sub-prime mortgages and their close cousins, Alt-A mortgages. As described in my May 21 2014 post “Fed Freakout” (a fake 2006 WSJ article describing the likely fallout from such a ban) it would have caused financial and economic turmoil, not to mention a political backlash. But far better to burst the bubble early; the quality of sub-prime mortgages deteriorated dramatically in 2006 and 2007 as real estate prices became ever more inflated.

Yellen’s Bond Bubble

Yellen should take similar action now—something that surprises traders and prevents the worst junk bond issues from coming to market. A sell-off in crappy bonds and heightened market volatility would scare traders and keep them cautious. She would be castigated by the usual Keynesian suspects who see unlimited slack in the labor market, and also by central bankers in emerging markets enjoying low rates (such as India).

Unfortunately, there is no reason to believe Yellen will do it. On the contrary—and this is a key point—it appears that Yellen is relying on the aforementioned “building resistance” reforms such as Dodd Frank to prevent a bond sell-off from causing financial damage. But that’s a mistake. Financial speculation, like a hurricane’s flood tide, is hard to channel and contain. When the bond bubble bursts it will probably hit areas not now well regulated by the Fed and covered by Dodd Frank, such as ETF’s and bond mutual funds.

Macroprudential Policy Needs to be Unpopular to Work Well

Everyone likes a party, and no one likes the jerk next door who calls the cops when it gets too loud. To end a mania, regulators must take dramatic action that destroys fortunes, roils financial markets, and curtails economic growth. All of which elicit a political backlash that is difficult for regulators to counter because it is impossible to prove “what would have happened” if the mania had continued. Arguably, however, the searing experience of the 2008 crash makes it easier now than in the past for the Fed to step in and pop the bond bubble.

What Equity Investors Should Do

For now, keep riding the bull market higher. But don’t get too comfortable. At some point the combination of higher inflation, the end of QE, rising Fed Funds, lack of liquidity on Wall Street trading desks, and some unforeseeable event (a default, a war, a macro shock) will cause a severe bond market sell-off that scares investors and could slash stock prices 10-30%. It will be good to have some cash ahead of the panic.

As to timing, that’s tough to figure. Bull markets often last longer than you expect. Risks are rising but high valuation per se will probably not cause stocks to decline so long as interest rates are low and profits are rising. On the latter topic, bears are mistaken to argue that profit growth is merely driven by non-operational factors such as share buy-backs, restructuring, low interest rates, etc. As Q2 profits are reported over the next few weeks it will become apparent that profit and revenue growth are improving, in turn sustaining strong dividend growth in 2014 and very likely 2015. Using today’s price for the S&P 500 and estimated 2015 dividends, the index is yielding a juicy 2.4%. That’s still quite attractive in Janet Yellen’s zero Fed funds world.

Copyright Thomas Doerflinger 2014. All Rights Reserved.

 

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Greater Bond Market Volatility Ahead

Posted on June 26, 2014 by tomdoerflinger

I agree with comments that RBS’s Alberto Gallo made to Bloomberg in the past few days. Later this year we are likely to run into heightened bond market volatility, which may well hit stock prices for a while. We could see a battle between the bullish impact of a Republican victory and the bearish impact of rising bond yields.

Going into this year the consensus view, which seemed reasonable enough to me, was that bond yields would rise in 2014. This forecast was spectacularly wrong; long suffering bond bears are further discredited while bulls such as Pimco’s Bill Gross have become even more complacent. It reminds me of the stock market in 1999. Which could set us up for a surprising surge in bond yields (drop in price) later this year, due to:

  • QE ends – with the taper completed, the Fed will no longer be buying bonds.
  • Rising inflation as the economy continues to grow and labor markets tighten. Obviously labor is not an undifferentiated commodity like, say, soybeans. Even if many people still can’t find jobs, shortages are appearing in important segments such as engineering, nursing, trucking, oil & gas production, etc. By damaging the supply side of the economy, Obamanomics makes the U.S. more inflation prone, something almost no Wall Street economists are talking about. (See our June 21 post.)
  • Once bond yields start to drift upward, the fast money (hedge funds) will dump bonds. But market liquidity will be terrible because Dodd-Frank and the Volcker Rule are driving those dastardly investment banks to carry much lower bond inventories.  (By the way, in his book Street Test Tim Geithner basically admitted the Volcker Rule made no sense because it is impossible to differentiate between market making and proprietary trading. And prop trading had nothing to do with the financial crisis, which was all about making and packaging bad mortgage loans.) Recent weak profits in FICC are causing investment banks to downsize this business in favor of wealth management; often Wall Street firms make such moves at precisely the wrong time.
  • Here’s where it gets interesting. For a long time the dumb money has been “reaching for yield” by taking big risks it doesn’t understand in low quality fixed income instruments. That includes bond ETF’s and mutual funds, which own fairly illiquid long-term assets but offer instant liquidity to individual investors. This clearly worries regulators; last week the Financial Times reported regulators were considering slapping an exit fee on bond mutual funds to discourage mass withdrawals.  One of the iron laws of Wall Street is that financial innovations developed to meet ebullient investor demand during a bull market don’t work so well when prices drop and market liquidity dries up. That’s when we’ll find out whether ETF’s are as wonderful as their advocates claim. I have no problem with plain vanilla ETFs, such as SPY, sector SPIDERs, etc., but I would not be surprised to see some bond ETFs malfunction in a bond bear market, shocking investors who thought they were being conservative by avoiding stocks. Will busy-body regulators address this future risk now, or wait for a crisis? I am not optimistic.

I don’t think bond market volatility that drives up 10-year Treasury yields north of 3% will be a disaster for the economy or for stocks. However, equities could well take a hit for a few months as investors snap out of their “new neutral” “low bond yields forever” torpor and reassess the macro landscape.

Postscript: You Heard It Here 18 Months Ago—Endowments Post Poor Returns

A couple of days ago, the WSJ ran an article titled, “Big Investors Missed Stock Rally: Pension Funds, University Endowments Diversified Into Other Investments With Disappointing Performance.” This is consistent with my Dec. 22, 2012 post on “stock avoidance syndrome” where I agreed with Larry Fink’s then-contrarian bullish view of stocks. I noted Ivy League endowment funds had very low allocations to domestic equities and high allocations to “alternative investments” such as hedge funds, private equity, commodities, etc.  I wrote, “Individual investors are following the Ivy League money into these ‘alternative investments,’ but will they really deliver attractive returns as money pours in? We’re skeptical.” I have reiterated that view several times since then, most recently in April (Hedge Fund Madness—Providing a Way to Diversify Out of Sound Investments).

The lesson here is that financial markets are susceptible to sentiment swings lasting many years. Institutional investors fell out of love with equities and into love with hedge funds and private equity, which outperformed during the financial crisis but have lagged since 2009 while equities staged a huge rally. Because this surprised the morose media, pundits label it a “stealth rally.” Over the next few years, look for this syndrome to reverse. Investors will shift from hedge funds with high fees, mediocre performance, poor liquidity and limited transparency and back toward equities. Eventually, equities will again become excessively popular, as in 1907, 1929, 1972, and 1999.

Copyright Thomas Doerflinger 2014.  All Rights Reserved.

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Democrats’ Obama Problem: Part Deux

Posted on June 21, 2014 by tomdoerflinger

Back on May 8 I highlighted three New York Times articles lamenting Obama’s foreign policy incompetence, mostly with respect to Syria and Ukraine. All were designed to inoculate Hillary from Obama’s surpassing ineptitude. Alas, that post is already woefully out of date. A lot can go wrong in a month and a half when you are as clueless as Obama & Co. Lemme see, since then we have:

  • The Veterans’ Administration scandal. Obama, who as a Senator sat on the Veterans Administration Subcommittee and has been regularly promising to reduce VA waiting times for many years, claimed to be “shocked, shocked” at the bureaucratic mendacity and incompetence of the V.A..
  • Trading Bowe Bergdahl for five top terrorists–without informing Congress, as required by law.
  • Apparently no one in the Pentagon, CIA, NSA or State Department had a clue that Sunni “militants” would sweep out of Syria and grab a big piece of Iraq.
  • America’s southern “border” has evaporated as Central American children, making good on Obama’s “Dreamers” promise, pour into Texas and Arizona, accompanied by quite a few vicious gang members. They may be relocated to a Federal center near you. This dwarfs Jimmy Carter’s Mariel disaster, when Fidel Castro foisted 125,000 refugees, including many criminals and mental patients, on Florida.
  • The IRS’ absurd redux of the Nixon / Rosemarie Woods 18-minute audio tape gap. After two years of Congressional investigations the IRS casually reveals that, quite coincidentally, the e-mails of Lois Lerner and six accomplices for the relevant time period were lost with the simultaneous crashes of their six hard drives, which were (again quite coincidentally) promptly destroyed. Not even CNN is dumb enough to believe that, though the NYT probably is. You have to give Lerner points for originality. In all the previous investigations of corporations, banks, financiers, government officials, etc., this “hard drive ate my homework” excuse was never used. Unfortunately for Lois, these e-mails were received as well as sent, and exist somewhere in Federal cyberspace.

No wonder Obama’s approval rating is diving faster than a Peregrine Falcon targeting a pigeon. To save the Republic, let’s give him a free membership to St. Andrews and a one-way ticket to Scotland.

The only thing funnier than Obama’s surpassing incompetence is the liberal media’s efforts to change the subject. Supposedly it was a big disaster for Republicans that Eric Kantor lost his job to a dastardly “Tea Party candidate” (who actually received very little official support from the Tea Party). You would never know from the chatter on the Sunday shows that Republicans will gain seats in the House and Senate. What David Brat’s victory really shows is that conservative and many independent voters are fully mobilized because they’re “mad as hell, and we’re not going to take it any longer.” Get set for an earthquake in November.

Copyright Thomas Doerflinger 2014. All Rights Reserved.

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3-5% Inflation Will End this Rally . . . Eventually

Posted on June 21, 2014 by tomdoerflinger

Our bullish note of May 28 explained why stocks would manage to scale a new “Wall of Worry.” Since then stocks have climbed 2.4%; I think they are headed higher still. “Central bankers gone wild” are pumping liquidity into the global economy as if we were still in a deflationary spiral. In reality the global economy is growing and U.S. profits are rising nicely. We are in the proverbial “sweet spot.” Enjoy it while it lasts; inflation lie ahead.

Let’s start with profits. First quarter S&P 500 pro forma EPS were $28.00, which would seem to imply $118 for the year, because Q1 on average accounts for 23.7% of annual earnings. But Q1 results were hurt by bad weather and weak Wall Street profits, and the economy is recovering from its January-March deep freeze. Recent profit reports have been pretty good; see Kroger, Jabil, FedEx, Adobe. And rising oil prices boost profits, unless they cause a recession. Net net, profits should be better than $118, maybe $120-$121. That’s above most forecasts, which are in the $116-118 range.

While profits are better than feared, central bank easing and low bond yields support high PE ratios. At the end of last year, after stocks spiked, the trailing S&P 500 PE was 17x. Using that multiple for the end of this year implies a target of a 2050, up 5% from here. But that may prove conservative if investors celebrate a big Republican win in November. Historically, stocks are strong in the final quarter of mid-term election years.

An Inflation Scare Will End this Rally, but It’s Hard to say When

Last December we explained why “Yellenomics May Blow an Asset Bubble.” The paradigm, which was discussed on Larry Kudlow’s radio show a few months later, is simple. Obama’s systematic macroeconomic malpractice—Obamacare, higher marginal tax rates, the War on Coal, no Keystone XL pipeline, corporate tax non-reform, immigration non-reform, fulminations about “millionaires and billionaires”—are hurting job creation. However, to fight high joblessness Yellen is pumping liquidity into the economy. Because she can do nothing to reduce structural barriers to employment, the result is anemic job growth but rising asset prices. (Which is increasing inequality, but that’s another story.)

I see no evidence that Chair Yellen has figured this out. Despite the fact that we are five years into an economic expansion, with continued moderate GDP growth and increasing evidence of inflationary pressure, we have a zero Fed funds rate appropriate to a financial emergency, and the Fed is still easing monetary policy. “Tapering” of QE bond buying simply means the Fed is not tightening but merely easing less aggressively than a few months ago. But it is still easing.

Inflation Risks: Don’t Forget the Supply Side

Focused as she is on unemployment rather than inflation, Yellen will pursue a too-loose monetary policy as inflation starts to accelerate. That’s fairly obvious at this juncture. But here’s a key point that Wall Street economists tend to miss. Obama’s aforementioned macro-economic malpractice has increased inflation risks by hurting the supply side of the economy. He has shifted supply curves to the left; for any given price offered, less is supplied than in the past. Let us count the ways:

  • Higher minimum wages will constrain expansion of service industries and kill 500,000 entry-level jobs, according to the CBO.
  • The war on coal will raise electricity costs (coal still provides 40% of electric power).
  • Ozone regulation will raise the costs of manufactures, including gasoline costs.
  • As the CBO has documented, Obamacare subsidies will keep 2 million people out of the labor force.
  • Obamacare creates strong incentives for small businesses to stay small in order to keep “under the limit” of 50 workers.
  • Well over $1.5 trillion in corporate cash is kept outside of the U.S., much of which would be invested in the U.S. if it had a rational tax regime. The U.S. loses tax revenue and jobs as major companies decamp for low-tax venues such as Ireland and Switzerland.
  • Higher taxes on “millionaires and billionaires” discourage investment.

Excessively loose monetary policy and a sclerotic supply side will give us surprisingly high inflation, likely over 3%. Bond yields will climb, recession fears will rise, and PE ratios will fall. Historically, declining PE’s trump strong profits (see 1966, 1973, 1980, 1983-84, 1987, 1994). Stock prices may fall 10-20%, or perhaps just flatten out for a year or two while profits rise and PEs fall. In this environment “bond substitutes” such as tobacco, utility, and drug stocks will perform poorly, as will high-flying momentum stocks. “Inflation hedges” such as material, energy, gold, and mining equipment stocks should outperform. I would maintain a diversified portfolio and increase my cash position.

It will take a while for this inflationary scenario to develop, and it is hard to know when the inflection point will come. For now, equity investors will continue to enjoy the “sweet spot,” even if stocks become over-priced. Stocks usually trade above or below, not at, “fair value.” I’m glad I don’t have the job of calling the turn. To mangle an observation of Lord Keynes, “markets can stay irrational for longer than disciplined stock market strategists can stay employed.” In the late 1990s, many bearish—and ultimately correct–stock market strategists lost their jobs before stocks crashed. Cycles often last longer than you expect.

Copyright Thomas Doerflinger 2014. All Rights Reserved.

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In China Gray is the New Green

Posted on June 11, 2014 by tomdoerflinger

I usually wake up around 3:30 to catch the market action in Asia and Europe on Bloomberg and CNBC. It’s nice to get a non-U.S. perspective on all the craziness. Last night I was blown away by this exchange on Bloomberg between the anchor and a smart consultant who is an expert on consumer demand in China. This is a faithful representation but not an exact transcript. (This is not a parody; emphasis mine.)

Bloomberg Anchor: “So, what would you say is the current state of consumer demand in China?”

Consultant: “On the whole, it is the weakest I have seen in years.  The luxury market is weakening because of the anti-corruption campaign. Prada, Louis Vuitton, brands like that will have a much harder time. But tourism and foreign travel to places like Italy are holding up well, which is positive for luxury.”

Bloomberg Anchor: “What about auto demand?”

Consultant: “Oh, demand for autos is very strong. The pollution is so bad in major cities that people don’t want to walk.”

Bloomberg Anchor:  “Oh my goodness.”

Consultant:  “Also, there is a rush to buy autos before the government limits the number of car licenses granted, as part of its anti-pollution drive.”

So this is what it has come to in Beijing, Shanghai and Quanzhou. People drive rather than walk to avoid pollution, but perhaps not for long because auto licenses may be limited by the government. I have not seen enough smart Wall Street research on how to play the anti-pollution drive in China. Clearly, companies involved in producing cars with lower emissions stand to benefit.

From Photosynthesis to Fossil Fuels

I have been reading essays by the great British economic historian E.A. Wrigley.  He makes the important point that the growth of traditional “undeveloped” economies was limited by the availability of land, because such acreage as was not devoted to producing food for man and beast was used to grow timber for construction and fuel. He calls this an “organic” economy limited by the power of photosynthesis to produce crops and trees.

This “organic” constraint, Wrigley argues, was finally broken by using fossil fuels. The Netherlands, the first European economy to grow rapidly, used peat (as well as windmills).  And then England began to use the enormous reserves of coal in the Northeastern counties, which was shipped down to London by coastal vessels.  Coal was dirty but effective in modernizing and industrializing England; it was used both for heating and for myriad industrial activities. Making bricks and glass, for example. After the Great London Fire of 1666 the metropolis was rebuilt in brick, yet the price of bricks remained quite stable during the building boom because brick makers using coal were able to vastly expand output. Thanks to cheap coal, most English farm houses had glass windows, which was not the case in France. Throughout the 19th century coal produced in a fairly small part of Britain was used to turn the country into “the First Industrial Nation,” boasting a higher living standard than continental Europe.

The pattern was different in the U.S., where early economic development was supported by abundant water power (which drove New England’s famous textile mills) and timber (which, converted into charcoal, sustained the iron industry until the 1840s). Steam engines were mainly used in steamships and railroads, not factories, in the first third of the 19th century.

Will Alternative Energy Take Us Back to 1600?

Why should we care? Because today’s “renewable energy” mania is once again making the availability of land a major constraint on energy production, as in the early 17th century. If you don’t get energy from coal mines, oil wells and gas wells, you need to cover the landscape with windmills and solar panels.  Ugh. Let me cite one example, which I highlighted in a November 2012 post titled “Suburban Sunstroke.”   Princeton University is proud to produce 5.8% of its electricity on 27 acres of bleak industrial wasteland (which I have surreptitiously visited) bearing the hilariously euphemistic label of a “solar farm.”  It is fenced off from wildlife; nothing grows there except forlorn weeds shaded by solar panels. Near the entrance are two or three sheds built with sheet metal and, in one corner, a giant heap of black asphalt. We saw a large white tail deer bound up a hill to the chain link fence surrounding the “farm;” it was forced to make a detour of several hundred yards. Very green!!!

Anyhow, let’s do some arithmetic. If the University uses 27 acres to produce 5.8% of its electricity, it would need a “solar farm” covering 466 acres to produce all of its electricity. If we assume, very conservatively, that the Town of Princeton uses as much electricity as the University, the two together would need to use – or should I say destroy? – 932 acres just to produce electricity for one tiny piece of New Jersey. That’s 11% more than the 843 acres in New York City’s Central Park. Oh, and by the way, the University gets subsidies from New Jersey tax payers to make its solar “farm” financially feasible—which means higher electricity bills for poor and middle class consumers to subsidize the green dreams of a university with an $18 billion endowment.  No wonder inequality is rising in Barack Obama’s America.

Copyright Thomas Doerflinger 2014. All Rights Reserved.

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