View From Down Under

I’m (slowly) reading On Being Certain, which I highly recommend.  One of the key messages is that there is a ‘feeling’ of certainty that in reality has nothing to do with being right.  I suspect we can all recall a time when something we knew with every fiber of our being actually turned out to be incorrect.  I put that into the ‘life is humbling’ basket.

A recent Boston Globe article has highlighted the same thing (h/t EconomistMom).  More and more studies are now confirming that once a person ‘believes’ something, even facts that prove them wrong do not change their belief.

In case you missed that, even when we are conclusively proved to be wrong, we very often don’t change our belief.  We dismiss the facts rather than change our minds.

Which goes a long way towards explaining things like the Birthers, or why so many intelligent people believe Bush’s tax cuts increased revenue, or (not to pick too much on the right wing) the overwhelming belief among Democrats that George W Bush is stupid.

It also goes a long way towards explaining the influence of entertaining (but factually challenged) political commentators (cough, Glen Beck, cough), and the fervor of their followers.

Unfortunately, it means that one of the goals of this blog – to encourage people to think beyond the sound bite – is ultimately doomed.

But I’m an optimist, and ultimately believe (perhaps despite the facts) that there are those who are willing to at least entertain the idea that if the data doesn’t support their belief, they may need to adjust their belief.

Here’s hoping…

Two years ago the state of Arizona implemented speed cameras on their highway system.  Last year, fatal accidents dropped 25% – saving over 80 lives.

Conservative Republicans cried foul.  “It’s inherently wrong and un-American”, says the current governor, and she is “uncomfortable with the intrusive nature of the system”.  It’s an invasion of privacy, and spying on the citizens, says the website of the Arizona Citizens Against Photo Radar.  Oh, and because the technology was developed in Australia, it is also a violation of sovereignty.

The cameras will be turned off this week.

Meanwhile, the state has passed legislation that, in effect, says if you look like you might be Mexican (or not ‘American’), you are required to carry proof of legal residence.  Which, of course, is not an invasion of privacy at all.

This is what passes for conservatism in the US today.  Cameras which catch people clearly breaking the law are “wrong and un-American” while requiring anyone with darker skin to carry proof of residence is simply enforcing the law.

UPDATE:  Now they have Nazis with assault rifles patrolling the border.

Just had a quick squiz at the 80^th Annual Report of the Bank for International Settlements.  (H/T  New Deal 2.0).  Apparently the BIS believes the actions taken to protect the global economy from collapsing are now inhibiting the recovery.  It’s a pretty good primer into the austerity thinking now sweeping the globe – thinking which, if translated into policy, could very likely push the world into an even more severe economic crisis.

Their first argument is that “Direct (central bank) support is delaying vital post-crisis adjustment and runs the risk of creating zombie financial and non-financial firms.”  Although I was unable to find a suggested remedy in the report, the implication is the BIS prefers failing banks – and the ripple effect it has on the global economic system (we need more Lehmann Brothers!).  Frightening stuff from a central banker!

Then we have the argument that low interest rates are dangerous, because “Previous episodes of low interest rates suggest that loose monetary policy can be associated with credit booms, asset price increases, a decline in risk spreads and a search for yield.”  While this is true, and clearly puts some of the blame for the recession on excessively loose US monetary policy from 2006-2008, it is amazing to see the logic applied today.  The BIS is saying that even though we have experienced a substantial decline in asset prices and a continuing credit crunch, we can’t keep rates low because that might lead to recovery!

The final argument I’ll highlight is the Bank’s concern over deficits.  “High and rising levels of public debt imply significant risks for the global economy. As demonstrated by the recent European debt crisis,  concerns about government default may lead to a sharp rise in interest rates, which could further aggravate financial fragility and put the incipient economic recovery at risk.”

Note the use of the words ‘may’, ‘could’, and ‘imply’.  Here’s some data on interest rates for the US, UK, and Germany.  Remember that the BIS is saying that high and rising levels of debt may lead to a sharp rise in interest rates.

Or, it may not lead to a sharp rise in interest rates.

No matter.  On the basis that there might be concerns in the future which might cause higher rates, which might actually be a good thing as it would prevent another asset bubble, let’s all adopt austerity budgets to cut spending.

Here’s the BIS report’s take on the implications:  “Such (austerity) measures may have adverse effects on output growth in the short term, but the alternative of having to cope with a sudden loss in market confidence would be much worse.”

Basically, we should send the global economy into another recession (or worse), because the potential loss in market confidence may cause problems if we don’t.   Problems like, um, a recession.

This report is frightening because the extraordinary illogical thinking is being espoused by the world’s central bank.

It’s no wonder that economist Paul Krugman believes we may be entering a long depression as a result of this kind of policy failure.

For decades the cries of those warning of high government deficits have been roundly ignored by the public.  Now, however, the deficit busters seem to have gained some ground with the electorate.

One aspect of this I find interesting is that virtually all of those crying loudest for deficit reduction today are not those who were vocal about it several years ago.  The main proponents of deficit reduction today are in fact the very architects of that deficit.

Despite the blatantly political nature of the debate, the belief that the US must cut its deficits to prevent economic calamity has garnered surprisingly widespread support.  A recent study found that the percentage of Americans citing the deficit as the most important national problem has nearly doubled to 11%, the highest percentage in almost 20 years.

Republicans have pounced on this marketing success, and are now calling for austerity as the only responsible way forward.

Most economists disagree, claiming that austerity programs at this point in the cycle would be lunacy, and endanger the economic future.  They cite FDR’s balanced budget of 1937 that is widely believed to have sent the country back into recession.

There are some economists who are in favour, but the only rational economic argument for austerity now is that continued stimulus runs the risk of debt crisis in the future.  While that may be true in a country like Greece, whose debt is primarily financed in currencies it does not control, the argument holds little weight when applied to the US.

Certainly the investment community does not believe the US is running a risk of a debt crisis in the future.  Rates on US treasury notes are at historic lows.

Why the appeal of austerity?  At one level the argument makes sense.  If a household is in a financial crisis, austerity is usually the only way out of the mess.  Therefore, surely that would be true of a government as well.

Except that a government is very different to a household.   Households can’t tax, or borrow against future income, or promote the general welfare, and government austerity in a time of financial crisis quite clearly exacerbates the problems – as we’ve seen recently with California and other states with balanced budget amendments.  Since tax revenues decline dramatically in a recession, these states are forced to cut services and lay off thousands – which only adds to the downward economic spiral.

Nonetheless, the right wing have found an issue that they believe will help Republicans do well in the mid term elections (already a certainty), and no doubt we will continue to hear the clarion calls for austerity until at least early November.

As an aside, I find it amusing that Republican administrations have been the biggest deficit producers.  Also interesting is the Republican budget alternative calls for increased defense spending and lower corporate taxes, offset by cutting Social Security, Medicaid and Medicare benefits.

We should keep in mind, though, that voters are generally more concerned about the state of the economy than about a potential future debt crisis – not at all surprising when over half of those in a recent survey admitted to being financially impacted by the recession.  The 11% who nominate deficits as the country’s biggest problem are swamped by the 55% who nominate unemployment or the economy.

The Obama administration has fortunately not bought into the austerity argument, and whether the right wing likes it or not, the President may be the only thing keeping the US from a double dip.

Last week, the Senate once again failed to act to reduce unemployment.  Republican senators stymied the President’s proposal for state aid critical to preventing layoffs of hundreds of thousands of teachers and other state employees.  They also blocked the proposal to extend unemployment benefits.

Republicans are using the deficit as an excuse to be the party of no.  According to Senate minority leader Mitch McConnell:  “Americans see what’s happening in Europe, and they’re begging us to bring the debt under control, to cut it down before we face a similar fate. Instead, Democrats in Washington just keep piling on, as if they’re oblivious to the consequences.”

Don’t forget that these are the same Republican senators who drafted multi-trillion dollar tax cuts a few years ago.  Cuts that were not ‘paid for’ with spending cuts and clearly contributed to massive US deficits.  Cuts where Mr McConnell was indisputably ‘oblivious to the consequences’.

The time for fiscal austerity was five years ago, not today.

The biggest contributor to the increase in the deficit is the soft economy.  Tax revenue declined dramatically in 2009 as corporate profits dropped, wages and bonuses dropped, and fewer people were employed.  Spending automatically increased as unemployment rose and entitlements kicked in.  The impact of these far outweigh the cost of the stimulus package and TARP.

Consequently, the best way to decrease the deficit in the current climate is to do whatever it takes to get the economy back to strong growth.  One can argue about the kinds of actions best suited for that, but clearly belt tightening is not among them.  Whether this is ignorance on the part of Republican Senators, or an attempt to create a double dip in advance of mid term elections, I’ll leave to the reader to decide.

A few months ago, I thought only a dip in growth in China could stall the recovery.  I didn’t account for Republican senators.

Despite the best efforts of governments over the years, we are subject to economic cycles.  The high points of these cycles involve asset inflation (“bubbles”) accompanied by easy credit.  This is inevitably followed by price collapses (“busts”) and credit tightening, which creates liquidity crises with effects far beyond the original bubble asset base.  The most recent bubble and bust was largely concentrated in US and UK housing and sub prime mortgage assets.  The bust before that was concentrated in internet and technology companies.  The bust before that was oil and energy assets.

After each bust, pundits were quick to call the end of the world as we know it – just as during each boom different pundits were justifying the asset inflation with end-of-the-world-as-we-know-it arguments.  (It’s not about profits, it’s about eyeballs!)

Well, the pundits are certainly active again, with well written arguments about how Europe is imploding, China is shrinking, US unemployment is not coming down, deficits are out of control, and so forth.

In this part 2 of Why I am a Bull, let’s take a step back and look at where we are in the economic cycle.  Here’s a chart showing the S&P 500 index from its peak in 2007 until June 2010.  Also on the chart is the same index from its peak in 2000 through the last downturn and beginning of recovery.

As you can see, this downturn was sharper than the last (peak to trough of 17 months this time vs 25 months last time) and the recovery has been a bit sharper as well.  Where we are now corresponds to about March 2003, which marked the beginning of a period of very strong returns in the stock market.

Now let’s look at what’s in the papers.  Concern over the wars in Afghanistan and Iraq.  North Korea’s growing aggression.   European banks desperately trying to get bad loans off their balance sheets.

Major concern over growing government deficits, with comments like:  (the current administration’s actions) “have utterly transformed our fiscal outlook, for the worse … nothing short of an economic miracle can save us from a fiscal crisis … And there’s a lesson here that goes beyond fiscal policies. On almost every front the outlook for the United States now seems far bleaker than it did two years ago.”

Add to that a chorus of concerns that we are now in a new, slow growth reality.  Like these comments:  “(T)here are tangible reasons to doubt that the United States will soon return to the heady times … The federal budget deficit is rising, and the aging of the population will slow the growth of the labor force.  Consumers will probably not increase their spending as rapidly as they did in recent years, and businesses — having invested so much in the boom years — still have a lot of idle factories and machinery.”

If you followed any of those links (which I would encourage), you’ll note those articles are all from March 2003.

I don’t mean to dismiss the current concerns.  Greece and other European countries still have pain ahead, continued deficits are ultimately unsustainable, the oil spill is nothing short of a disaster, and the next couple of years are unlikely to be great years for the US economy.

However, all of these worries, and more, are already priced into stocks, and none of them shake my belief that now is a good time to go long.

All things are wearisome, more than one can say.

The eye never has enough of seeing, nor the ear its fill of hearing.

What has been will be again, what has been done will be done again;

there is nothing new under the sun.

With events in Europe, Thailand, and the Gulf of Mexico grabbing economic headlines, there is an increasing number of articles and emails with extreme pessimistic views on the US economy and stock market.  These seem to be one part anger (from right wing Republican still mad about the 2008 election) and one part depression (the economy will never recover, economic Armageddon is upon us).  If you believe the pessimists, it’s time to sell all your stocks and buy gold.

They are wrong, and the next couple of posts will try to explain why I am much more optimistic.

I’ll start with some long term analysis of the US stock market.  Here is a chart of the S&P 500 index over the last 50 years.

You can see the market got a bit ahead of itself in the latter half of the 90s, and the irrational exuberance label was deserved.  The expansion from 2002-2008 was very much in line with the long term trend, and the recession has now moved stocks significantly below that line.

But, the pessimists argue, what about earnings?  The underlying corporate earnings aren’t there, and the market is being held up by an unrealistic Price/Earnings ratio!  The trend will not continue!

So, let’s have a look at that data.

Again you can see the late 90s is a unique period.  Since the recession, there is a spike in 2009 (due primarily to company write downs in one quarter), but current PE ratios are consistent with history.  And given the decline in long term interest rates over the last 20 years, there is a strong economic argument that PE ratios should be higher.

Adding to that, corporate earnings have recovered fairly well since the recession, and are forecast to continue growing.  This is in spite of the problems in Greece, the oil spill, the deficit, and even President Obama.

Of course the past is not an infallible predictor of the future, and things that have never happened before are happening every day.  Nonetheless, the fundamental expectation of continued earnings growth and low interest rates suggest that the market correction is just that, and not the beginning of the end for the economy.

In the next post, I hope to have a look at where we are in the cycle and what we can expect.

So now Congress is working on the “American Jobs and Closing Tax Loopholes Act”, which passed the House on Friday.

Near as I can tell, this bill started out as a collection of tax break for industries which appear to have done a very good job of lobbying.  Most of these breaks were due to expire, and the bill extends them.  These include tax breaks on things like: maintenance of small railroads; mine rescue team training expenses; restaurant buildings; sale of timber by timber REITs; I could go on but you would lose interest (if you haven’t already).

This part is a bit of legislative sleight of hand.  By initially making these tax breaks expire, the costing of the original bills was lower – since bills are costed on a ten year impact.  Whether the intention at the time was to extend the breaks, we can only speculate.

Onto this pile of tax break extensions, Congress has added the Medicare doc fix – a regular extension of a cost saving program implemented in 1997.  The 97 law says that if health costs increase faster than inflation, Medicare reimbursement rates must drop.  However, this has been ‘deferred’ on a regular basis since then.  Without the doc fix, Medicare reimbursement rates to doctors would now drop by over 20%.  The doc fix will once again push that out for a later Congress to deal with.

All of this looks like a pretty unappealing bit of legislation, so a few tax increases – mainly targeting successful investment managers (including yours truly) – are thrown into the mix to make it look less like just a costly bill.  Still, a pretty unappetizing plate full.

To spice things up, Congress has added a small stimulus package aimed at assisting the longer term unemployed.  This would extend unemployment insurance (and COBRA health insurance) for people who have been out of work for some time and exhausted their state based options.  This bit would cost about $40 billion, and is probably a timely and effective bit of stimulus for a country still struggling with high unemployment.

This allows Nancy Pelosi to say: “It’s about jobs.”

Which, of course, is not entirely accurate.  If it’s about jobs, enact the unemployment extensions and throw out the rest.

Why can’t elected representatives have the fortitude and integrity to tackle each of these issues on their own merits, instead of trying to hide their special interest deals in a bill that is “about jobs”?

The dramatic swings in both the stock market and the US dollar have highlighted a strong negative correlation between the two. Since the last bear market in 02/03, as the stock market moves down, the US dollar strengthens.  Upward moves in the market are accompanied by a weaker dollar.

Clearly this has not always been the case.  Below is a chart comparing the Dow Jones Industrial average to the US dollar broad currency index.  (I have inverted the dollar index to make it clear.)

Before the Asian currency crisis in 1998, there was actually a pretty strong positive correlation – as the market improved the US dollar strengthened.  Something changed after that, and the correlation has clearly moved to a negative one.

I think this is due to a combination of two factors.  First, exchange rates used to be determined by underlying balance of trade and differing inflation rates.  In the last couple of decades these forces have been swamped by the volume of financial trades, and exchange rates are now a function of investor sentiment.  Second, the US dollar is seen as a safe currency (despite the uninformed ranting of the right wing), and investors believe the US dollar will not have a run due to lack of investor confidence (as happened to Russia, Thailand, Mexico, and others).

As a result, US dollar strength has become a proxy for investor risk appetite.  As uncertainty and fear creep into investors’ minds, risk appetite decreases, investors want to hold US dollars (or US dollar assets), and the dollar strengthens.  As fear recedes and the appetite for risk expands, investors are more willing to venture into non US dollar assets, and the dollar weakens.  This seems to be happening largely in transactions called “carry” trades, where investors borrow in US dollars at low interest rates, and invest in higher yielding assets in other currencies.

Personally, I don’t see the relationship between the market and exchange rates changing soon, and suspect the inverse correlation will continue at least until US interest rates return to more normal levels (making the carry trade less interesting).

It does suggest that professional investors do not agree with Fox News that “Greece’s current woes will be (America’s) future”.  It also suggests that the exchange rate is driven by market sentiment, and not the other way around.

The bizarre behaviour of the stock market on Thursday highlights the fact that no one actually knows what is going on in the markets on a daily basis.

Markets have corrections.  A typical bull market has a long, slow upward movement, followed by a short, sharp downward correction.  This ‘sawtooth’ pattern is quite normal.  If you believe the market is in a longer term bull, these drops represent buying opportunities.

However, something over 60% of trades are now done by computer.  These trades, also known as High Frequency Trades (HFTs) are managed by computer programs written and administered by hundreds of different firms.  Although each firm has its own algorithms and proprietary coding, the reality is that they largely act in the same way, and in a very interconnected way.  So if one large trading program initiates a ‘sell-off’ switch, the resulting trades may well trigger other HFT programs to move into sell-off mode.

On Thursday, a normal bull market correction was hit by this selling tsunami.  Almost all of it occurred outside the floor of the NYSE, where human market makers had called a short halt to allow trades to clear.

The truth is that no one knows what happened.  The SEC has called a meeting of all exchanges on Monday to try and figure it out.  However, on a basic level, selling volume overwhelmed buying volume.  If there were then sell orders ‘at market’, there is no limit to how low the market can momentarily go.  In a few minutes, all buying orders were cleared, and apparently where there were no buy orders shares were selling at 1 cent.  Several hundred of these trades are likely to be cancelled, although that process sounds a bit fishy to me.  If you are willing to turn your trading over to your computer program, and the program sells shares indiscriminately, seems to me that should be your risk.

At any rate, some investors responded on Friday by placing buy orders on major stocks at very low prices, hoping that another HFT sell down would allow them to buy cheap.  That may not be a bad idea.

The view from down under is that this is a bull market correction and buying opportunity.  The nervousness about Greek debt is overblown, American consumers appear to be spending, job growth is continuing, and there is no double dip recession.

And Happy Mothers Day.