December 30, 2011
Best of Book Bits 2011 (Part II)
Here's the second installment of my bids for the best economic and finance books for 2011 (you can find Part I here). Yes, it's subjective and there are other worthy titles that go unmentioned. Space may be unlimited on the web, but time is still finite. On that note, here's one that got away: Pandora's Risk: Uncertainty at the Core of Finance, by Kent Osband. This one should have been tapped for Book Bits when it was published this past summer. Better late than never. In any case, Osband takes the market bull by the horns and brings us on an enlightening quantitative journey through the crucial business of thinking about and managing risk in the money game. An instant classic that's at once provocative, thought-provoking, and practical (pay special attention to his innovative take on measuring price volatility in chapter 11). Meanwhile, here are some of the more memorable names that actually made it to these digital pages during the past 12 months of Book Bits:
● Models.Behaving.Badly: Why Confusing Illusion with Reality Can Lead to Disaster, on Wall Street and in Life
By Emanuel Derman
Review via Bloomberg
Disturbed, disillusioned and ashamed: Those aren’t emotions you expect a Wall Street quant to express when asked why taxpayers were obliged to bail out wealthy bankers. Unless, of course, the quant is Emanuel Derman, a particle physicist and former head of quantitative finance at Goldman Sachs Group Inc. “I am ashamed at the hypocrisies of the system,” Derman writes in “Models.Behaving.Badly,” an erudite yet pleasantly readable exploration of why financial models failed during the U.S. mortgage meltdown and why modelers must learn to use them more wisely. “We were told not to expect reward without risk, gain without the possibility of loss,” he says in disgust. “Now we have been forced to accept crony capitalism, private profits and socialized losses, and corporate welfare.” Unlike many quants, Derman says he wasn’t surprised that models failed in 2007, as events predicted to happen “once in 10,000 years happened every day for three days,” as one strategist at Lehman Brothers Holdings Inc. put it. The breakdown, Derman argues, flows from a misunderstanding of the difference between models and theories.
● The Era of Uncertainty: Global Investment Strategies for Inflation, Deflation, and the Middle Ground
By Francois Trahan and Katherine Krantz
Summary via publisher, Wiley
The recent credit crisis in the United States ushered in a new era of uncertainty. Like other bubbles, it was born out of an extended period of easy money that fueled prosperity and engendered speculation, but it was not the same as a euphoric run up and crash of technology stocks; it was an assault on two pillars holding up middle-class America: homes and credit. The remaining two pillars—employment income and investments—were collateral damage. People can no longer count on ample access to credit, increasing home values, and abundant job opportunities to propel them into a better lifestyle. In The Era of Uncertainty: Global Investment Strategies for Inflation, Deflation, and the Middle Ground, François Trahan, Vice Chairman and Chief Investment Strategist of Wolfe Trahan & Co, and Katherine Krantz, Managing Director and Founding Partner of Miracle Mile Advisors, LLC, present a new framework for investing in a dynamic, macro-driven world. The book addresses the creation and aftermath of bubbles from a top-down perspective and shows how applying the macro framework can help investors profit from the interwoven inflationary and deflationary scenarios likely to evolve in the next several years. It also examines the role of macro analysis in the markets: how top-down forces influence the direction of financial markets; how including macro analysis in research improves the odds of investment profits; and the potential pitfalls of ignoring macro trends in the investment process.
● Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System
By Barry Eichengreen
Summary via publisher, Oxford University Press
For more than half a century, the U.S. dollar has been not just America's currency but the world's. It is used globally by importers, exporters, investors, governments and central banks alike... This dependence on dollars, by banks, corporations and governments around the world, is a source of strength for the United States. It is, as a critic of U.S. policies once put it, America's "exorbitant privilege." However, recent events have raised concerns that this soon may be a privilege lost. Among these have been the effects of the financial crisis and the Great Recession: high unemployment, record federal deficits, and financial distress. In addition there is the rise of challengers like the euro and China's renminbi. Some say that the dollar may soon cease to be the world's standard currency--which would depress American living standards and weaken the country's international influence.
In Exorbitant Privilege, one of our foremost economists, Barry Eichengreen, traces the rise of the dollar to international prominence over the course of the 20th century. He shows how the greenback dominated internationally in the second half of the century for the same reasons--and in the same way--that the United States dominated the global economy. But now, with the rise of China, India, Brazil and other emerging economies, America no longer towers over the global economy. It follows, Eichengreen argues, that the dollar will not be as dominant. But this does not mean that the coming changes will necessarily be sudden and dire--or that the dollar is doomed to lose its international status.
● Economics Evolving: A History of Economic Thought
By Agnar Sandmo
Review via The Enlightened Economist
I’ve just finished reading Economics Evolving: A history of economic thought by Agnar Sandmo, and commend it to every economist and student of economics. It’s a clear and fair account of the contribution to the subject by the key figures in its intellectual history, with a focus on Adam Smith and his immediate predecessors to the 1970s. The book would make an ideal text for a history of thought module in a degree course, but is also an accessible general read for an economist seeking some perspective on the state of economics today. I particularly appreciated not being able to tell the author’s own opinions; the book simply gives a straightforward account of both sides of the various controversies... Anyway, Economics Evolving is a highly commended book, which completely defied my initial impression that it was going to be worthy but dull. Heilbronner’s The Worldly Philosophers is still a terrific introductory read but is nothing like as substantial as this book, which is the best overview I’ve come across of the history of thought in economics.
● The Coming Jobs War
By Jim Clifton
Review via MoneyWeb
Clifton asserts that job creation will surpass all other issues to dominate politics. He likens the challenges to the second world war while further asserting that the war has already begun... It seems likely that “job creation” is destined to become the leader among business publication categories adding to the pressure on politicians everywhere. Few companies have Gallup’s experience in discerning data. The book points out that the world has 7 billion people with 5 billion being of working age. Of those, 3 billion desire full-time formal employment while globally there are only 1.2 billion jobs that meet his criteria, “pay check from an employer and steady work that averages 30-plus hours per week”.
Thinking Optimistically For The Year Ahead
As 2011 comes to a close, the risk of a new economic recession in the U.S. looks low. Or at least lower than it was a few months ago. Not everyone agrees, but you'll have no trouble rounding up dismal scientists who think that better days are coming. For instance, 20 economists polled by CNN this week collectively estimate the odds of a downturn at 20%, or down slightly from 30% three months earlier. "Preliminary data is pointing to a solid fourth quarter of GDP growth that should carry the economy through the next 6 months," says Sean Snaith, a University of Central Florida economics professor.
There's a fair amount of supporting data for thinking that the risk of recession is low for the near term. For instance, Macroeconomic Advisers estimates that U.S. GDP rose by a strong 1.3% in October. Data from various corners of the economy also looks encouraging. Bloomberg reports that "North American railroads’ freight volumes surged 17 percent last week, the most in a year, in an indication that the U.S. economy will avoid a second recession." Meanwhile, yesterday's update of the ISM Chicago Business Barometer held steady in December, just below November's seven-month high. "2011 is ending on a solid note, advises Ryan Sweet, a senior economist at Moody’s Analytics. “Manufacturing has some momentum and we’re starting to see some signs of life in housing.”
The number of people poised to buy home, as tracked by signed contracts, rose to a 19-month high in November, the National Association of Realtors reports. This appears to be more than statistical noise given the encouraging rise in housing starts and newly issued building permits in recent months.
Last week's rise in jobless claims pares the optimism, but for the moment the trend in new filings for unemployment benefits still looks favorable. The four-week moving average for this volatile series has been steadily declining for several months and is at its lowest level since the recession was formally declared at an end as of June 2009. The implication: job growth will continue, and perhaps at a higher rate in the months ahead.
"Despite the rise in the weekly claims data, the longer-term trend ... suggests that the recovery in the labor market is maintaining its momentum," says Michael Gapen, an economist at Barclays Capital, in a research note to clients. An AP survey this month of 36 economists points to expectations for average monthly job growth of 175,000 next year, up from an average of 143,000 a month for the three months through November.
The Labor Department will confirm, or deny, the optimism for employment with next week's release of payrolls data for December. Briefing.com sees a net gain in employment of 150,000, up from November's rise of 120,000.
What could go wrong? Take your pick—there's plenty to worry about, although the leading hazard is probably Europe, which appears to be destined for recession. BBC reports that 34 UK and European economists who regularly advise the Bank of England "believe recession will return to Europe next year." Will there be a spillover effect for the global economy? Probably, but the degree of pain that awaits for the rest of the world is still open for debate.
In the U.S., the single-biggest risk factor is jobs, or the lack thereof. If the recent fall in jobless claims is a head fake, and the anticipated pick-up in hiring doesn't materialize, much of the other revival news for the economy of late won't mean much. Another potential trouble spot is the recent weakness in personal income.
Overall, there's a case for cautious optimism that moderate growth will roll on in 2012. But don't let the New Year's revelry cloud your judgment. The recovery is still held together with glue and feathers. It's looking better, but a strong wind could blow it all away.
If you find yourself on the fence for deciding what comes next, you're not alone. The collective wisdom that is the stock market is betwixt and between too. The S&P 500 is basically flat on a year-over-year basis. In recent months, the equity market dipped to a slight loss vs. year-earlier levels. History suggests that when the market suffers a sustained bout of red ink in annual terms, a recession is near. By this standard, there's plenty of uncertainty to digest. Maybe January will bring us clarity.
December 29, 2011
Re-reading Irving Fisher
Irving Fisher had it all figured out in real time. His investment advice was famously ill-timed, but he redeemed himself in macro. As the Great Depression was unfolding, he identified the disease and the cure. That's old news, but it's debatable if it's widely understood. But it can be, and for free. The St. Louis Fed has generously re-published several of Irving Fisher's books, including 1932's Booms and Depressions: Some First Principles. Among dead economists with relevant advice in the here and now, this dismal scientist is the first among equals. The details of our current troubles are different, and the disinflation/deflationary winds are comparably mild by the standards of the early 1930s. But it's hard not to recognize the parallels across time. History doesn't repeat, but it does seem to rhyme at times. The same might be said of the recommended cures. There's nothing new under the sun, even if we're told otherwise. Maybe we didn't see it coming, but it still looks rather familiar in hindsight. Judge for yourself with a few excerpts from Booms and Depressions… and then read the book.
► As will be seen, the main conclusion of this book is that depressions are, for the most part, preventable and that their prevention requires a definite policy in which the Federal Reserve System must play an important role....
► There are those who ascribe this individual impoverishment to the very fact of collective wealth—not overpopulation, but "over-production"—too much food and too much of all else.
Later in these pages there will be more about this. It is enough here to note that those who, at the beginning of a depression, cry "over-production" and expect recovery as soon as over-production ceases usually become disillusioned when later almost universal poverty appears. If, in 1932, anyone thought there was still over-production, he should follow his own argument all the way through as follows: "How do I know there is over-production of goods? Because more goods are for sale than the public will buy. And why, then, will the public not buy? Because they haven't the money. Why haven't they the money? Because they are not earning it. Why aren't they earning it? Because they are not producing: men and machines are idle!" But if non-production is the trouble, why call it overproduction?
► What, now, are the consequences of a mistake of judgment on the part of debtor or creditor or both? First, consider the individual debtor. If he has not borrowed enough, he can, under normal conditions, easily correct the error by borrowing more. But, if he has gone too far into debt,—especially if he has misjudged as to maturity dates—freedom of adjustment may no longer be possible. He may find himself caught in a trap....
► When over-indebtedness, whether by sheer bulk or by rashness as to maturity dates, is discovered and attempts are made to correct it, distress selling is likely to arise....
► Distress selling perverts the operation of the law of supply and demand....
► Few people look at money for their explanations, because most people simply look through money, think in terms of money, take money for granted, assume that a dollar is always a dollar. Since we measure everything else in dollars, it does not readily occur to us to measure the dollar itself. Few people realize, for instance, that the depression dollar of 1932, as compared with the pre-depression dollar of 1929, became really a dollar and two thirds; and still fewer realize the tremendous significance of this fact. Yet its significance is all the greater just because it is not clearly realized....
► And it should be equally clear that deflation, or dollar bulging, is not an "Act of God" with a special mandate to baffle the human race. We need not wait for a happy accident to neutralize deflation. We ourselves may frustrate it by design. Man has, or should have, control of his own currency....
► But the mere fact that the debt disease may lead to the dollar disease does not prove that it must do so. The dollar disease will be unavoidable only "if other things remain equal." Should other elements in the body of the currency not remain equal—should gold coin, for instance, become copious in the nick of time—this gold inflation might counteract the credit deflation. Prices might even go up instead of down; that is, the dollar might dwindle instead of swell. And the same result might come from paper inflation—for instance, by way of financing a war.
And it should be equally clear that deflation, or dollar bulging, is not an "Act of God" with a special mandate to baffle the human race. We need not wait for a happy accident to neutralize deflation. We ourselves may frustrate it by design. Man has, or should have, control of his own currency.
Such a control, so exercised as to neutralize the influences which tend to swell the dollar, would, of course, not avert from any rash initial debtor the measured consequences of his own rashness j but his punishment would be due to the nature of his separate debt and would, there fore, be chiefly confined to himself and perhaps a small circle of associates. The rest of the community would not suffer from any vagaries of the universal dollar. And even the rash debtor has a right to pay his debt in the same dollar in which he contracted it. It is manifestly unfair to require even a rash debtor to pay $1.50 or $2.00 for every dollar he really owes. The principle of simple justice implied in the term "real wages" is no more applicable to wage earners than it is to debtors.
In a word, if we must suffer from the debt disease, why also catch the dollar disease? If we catch cold, why let it lead to pneumonia?
December 28, 2011
Research Review | 12.28.2011 | Forecasting: What Have We Learned?
Predicting Recessions: A New Approach for Identifying Leading Indicators and Forecast Combinations
Chikako Baba and Turgut Kisinbay (IMF) | October 2011
This study proposes a data-based algorithm to select a subset of indicators from a large data set with a focus on forecasting recessions. The algorithm selects leading indicators of recessions based on the forecast encompassing principle and combines the forecasts. An application to U.S. data shows that forecasts obtained from the algorithm are consistently among the best in a large comparative forecasting exercise at various forecasting horizons. In addition, the selected indicators are reasonable and consistent with the standard leading indicators followed by many observers of business cycles. The suggested algorithm has several advantages, including wide applicability and objective variable selection.
Predicting the Small Stock Premium Over Different Horizons: What Do We Learn About its Source?
Valeri Zakamouline (University of Agder) | October 2011
In this paper we present the evidence that the small stock premium is predictable both in-sample and out-of-sample using a set of lagged macroeconomic variables. It is possible to forecast the size premium over horizons from one month to one year. We demonstrate that the predictability of the size premium allows a portfolio manager to generate an economically and statistically significant active alpha. The results obtained in this paper support the view that the small stock premium tends to appear in economic bad times. Yet the size premium seems to be not a risk premium, but a behavioral phenomenon. Our findings suggest that the small stock premium appears mainly as the result of a delayed and strong reaction of small stocks to good news after a period of prolonged bad times.
Forecasting Bond Risk Premia Using Technical Indicators
Jeremy Goh (Singapore Management University), et al. | November 2011
While economic variables have been used extensively to forecast the U.S. bond risk premia, little attention has been paid to the use of technical indicators which are widely employed by practitioners. In this paper, we fill this gap by studying the predictive ability of using a variety of technical indicators vis-a-vis the economic variables. We find that the technical indicators have statistically and economically significant in- and out-of-sample forecasting power. Moreover, we find that utilizing information from both technical indicators and economic variables substantially increases the forecasting performances relative to using just economic variables.
Analysts’ Earnings Forecast, Recommendation and Target Price Revisions
Ronen Feldman (Hebrew University of Jerusalem) | June 2011
This study examines the immediate and delayed market responses to revisions in analyst forecasts of earnings, target prices, and recommendations. Consistent with prior literature, revisions in earnings forecasts are positively and significantly associated with short-term market returns around the revisions. However, we show that short-term market returns around target price revisions and recommendation changes are even stronger. We also find superior future performance (return drift) for portfolios that use information from all three types of revisions to those using information from only one of the three types of revisions.
Do Stock Prices Influence Analysts’ Earnings Forecasts?
Lisa Sedor (DePaul University and Jeffrey Miller (Notre Dame) | September 2011
We examine whether current-period stock prices influence analysts’ earnings forecasts. Using an experiment with financial analysts, we find that analysts updating their earnings forecasts in response to a management earnings forecast provide different forecasts depending on the stock price reaction to management’s forecast. Lower (higher) stock price leads to lower (higher) analysts’ forecasts. Further, we demonstrate that the influence of stock price on analysts’ forecasts is moderated by uncertainty about future earnings: higher earnings uncertainty increases the influence of stock price on analysts’ forecasts. Additional analyses indicate that this effect is mediated partially by analysts’ confidence in their forecasts and appears to be unintentional. Evidence from a follow-up survey, however, indicates that some professional analysts intentionally incorporate stock price information into their earnings forecasts. Overall, our evidence suggests that the association between prior security returns and analysts’ earnings forecasts documented in prior research is due, at least in part, to professional analysts incorporating stock price information, intentionally and unintentionally, into their earnings forecasts.
How Does the FOMC Learn About Economic Revolutions? Evidence from the New Economy Era, 1994-2001
Richard Anderson and Kevin Kliesen (St. Louis Fed) | December 2011
Forecasting is a daunting challenge for business economists and policymakers, often made more difficult by pervasive uncertainty. No such uncertainty is more difficult than projecting the reaction of policymakers to major shifts in the economy. We explore the process by which the FOMC came to recognize, and react to, the productivity acceleration of the 1990s. Initial impressions were formed importantly by anecdotal evidence. Then, policymakers—and chiefly Alan Greenspan—came to mistrust the data and the forecasts. Eventually, revisions to published data confirmed initial impressions. Our main conclusion is that the productivity-driven positive supply side shocks of the 1990s were initially viewed favorably. However, over time they came to be viewed as posing a threat to the economy, chiefly through unsustainable increases in aggregate demand growth that threatened to increase inflation pressures. Perhaps nothing so complicates business planning and forecasting as policymakers who initially embrace an unanticipated shift and, later, come to abhor the same shift.
The Wisdom of Competitive Crowds
Kenneth Lichtendahl Jr. (University of Virginia), et al. | November 2011
When several individuals are asked to forecast an uncertain quantity, they often face implicit or explicit incentives to be the most accurate. Despite the desire to elicit honest forecasts, such competition induces forecasters to report strategically and non-truthfully. The question we address is whether the competitive crowd's forecast (the average of strategic forecasts) is more accurate than the average of truthful forecasts. We analyze a forecasting competition in which a prize is awarded to the forecaster whose point forecast is closest to the actual outcome. Before reporting a forecast, we assume each forecaster receives two signals: one common and one private. These signals represent the forecasters' past shared and personal experiences relevant for forecasting the uncertain quantity of interest. In a set of equilibrium results, we characterize the nature of the strategic forecasts in this game. As the correlation among the forecasters' private signals increases, the forecasters switch from using a pure to a mixed strategy. In both cases, we find that the competitive crowd's forecast is more accurate and measure the improvement. These findings suggest that forecasting competitions may be attractive alternatives to prediction markets because they are easy to implement and may be more accurate.
Do Commodity Futures Help Forecast Spot Prices?
Shaun Roache and David Reichsfeld (IMF) | November 2011
We assess the spot price forecasting performance of 10 commodity futures at various horizons up to two years and test whether this performance is affected by market conditions. We reject efficient markets based on in-sample tests but, out-of-sample, we find that the forecast from the futures market is hard to beat. We find that the forecasting performance of futures does not depend on the slope of the futures curve, in contrast to the predictions of well-known models of commodity markets. We also find futures’ forecasting performance to be invariant to whether prices are in an upswing or downswing, casting doubt on aspersions that uninformed investors participating during bull markets impede the price discovery process.
Forecasting the Price of Oil
Ron Alquist (Bank of Canada), et al. | July 2011
We address some of the key questions that arise in forecasting the price of crude oil. What do applied forecasters need to know about the choice of sample period and about the tradeoffs between alternative oil price series and model specifications? Are real or nominal oil prices predictable based on macroeconomic aggregates? Does this predictability translate into gains in out-of-sample forecast accuracy compared with conventional no-change forecasts? How useful are oil futures markets in forecasting the price of oil? How useful are survey forecasts? How does one evaluate the sensitivity of a baseline oil price forecast to alternative assumptions about future demand and supply conditions? How does one quantify risks associated with oil price forecasts? Can joint forecasts of the price of oil and of U.S. real GDP growth be improved upon by allowing for asymmetries?
December 27, 2011
Sometimes Inflation Is Less (Or More) Than It Seems
Inflation is uncomplicated… most of the time. But sometimes economic conditions turn it into a vexing subject. The American mindset is conditioned to treat high/rising inflation as forever bad, and low and falling inflation as perennially good. Thinking in these terms is understandable, given the inflationary bias through time for a fiat monetary system. Most of the time the relevant analysis can be reduced to a simple rule: higher inflation is bad; lower inflation is good. The trouble arises in those rare periods when disinflation/deflation dominates. Recent history is one of those periods.
Hold that thought as you consider an article in today's Wall Street Journal:
U.S. inflation is slowing after a surge early in the year.
This is good news for Americans, as it means the money in their pockets goes further. It also is welcome at the Federal Reserve, which has been counting on an inflation slowdown. It gives the Fed some maneuvering room in 2012 if central-bank officials want to take steps to bolster economic growth.
In normal times—such as the 40 years or so through 2008—the statement above would be regarded as a self-evident truth. But a few things changed in 2008 and so the standard narrative for inflation and the economy no longer applies. Economist David Glasner complains that equating falling inflation with "good news for Americans" harbors an "unstated assumption that the number of dollars people have in their pockets has nothing to do with how much inflation there is." Glasner charges that "it is inexcusable to ignore the truism that rising prices necessarily put more dollars in people’s pockets and simultaneously assert, as if it were a truism, that rising prices reduce real income."
The inherent conflicts in the Journal story become clear when the reporter notes that the slowing inflation of late "is welcome at the Federal Reserve, which has been counting on an inflation slowdown. It gives the Fed some maneuvering room in 2012 if central-bank officials want to take steps to bolster economic growth." Glasner responds:
Well now, we are switching theories, aren’t we? According to that assessment of the Fed’s options, falling inflation means that the Fed could ease monetary policy, thereby helping the economy grow more rapidly than it is now growing. How, one wonders, could the Fed do that? Um, maybe by preventing the rate of inflation from falling even faster? In other words, maybe inflation would drop down to zero or even to a negative rate, i.e., deflation. Don’t want that. But if falling inflation is good news, then, really, why not let inflation keep falling? In fact, why not go for deflation? How does falling inflation turn suddenly from being good to being bad?
The answer is that whether inflation is good or bad depends on the circumstances.
It can be easily demonstrated that falling inflation in recent years is no longer in the "good news" camp. A few months ago I reviewed some of the evidence, including the stock market's recent tendency to fall when inflation expectations declined, and vice versa--the "new abnormal," as I dubbed it. The new abnormal has also altered gold's traditional role as an inflation hedge to one that offers a defense against the blowback from debt deflation, courtesy of the transmission process via shifting conditions for the real yield.
Professor Harlan Platt of Northeastern adds a fresh dimension to this issue with a new research paper that asks: Where Did All the Inflation Go? When Will The Real Estate Market Recover?
Until the American economy again experiences inflation, it is unlikely that real estate prices will change at a rate sufficient to give the average investor a real rate of return, i.e., when the rate of nominal profit is greater than the rate of inflation. Put another way, real estate won’t be a good investment until the economy heats up and creates more jobs, more income, and more inflation.
As Scott Sumner reminds, deciding if inflation is good or bad depends on the circumstances. We just happen to be in one of those rare periods when higher inflation is almost surely a good thing. Eventually, it'll be a bad thing again, and that'll be good. Got it?
The dynamic aspect of inflation can be confusing, but it's hardly inexplicable. But some observers make the task harder than it should be. For instance, there's a widespread assumption that the demand for money—liquidity—is constant. Okay, it's true that most folks don't think about money demand in formal terms, if at all, but they act as if they do and the implied theoretical assumption is that the appetite for liquidity is written in stone. If you accept that premise, consciously or not, then you must conclude that a rise in money supply is always inflationary. But as The Wall Street Journal tells us, inflation isn't soaring and perhaps its pace is slowing.
That's extraordinary if monetary demand is constant. Reality tells us different, of course. Indeed, the annualized rate of M2 money supply has been growing two to three times as fast as consumer price inflation in recent years. For the year through last month, for instance, M2 money supply is higher by 9.8% while CPI is up 3.4%, or slightly below the inflation rate that prevailed when the Great Recession began in December 2007. Why hasn't inflation soared in the wake of a large rise in money supply? Because money demand has surged. A crude measure of money demand can be calculated with the inverse of what's known as M2 velocity (the ratio of nominal GDP to a measure of the money supply). By this benchmark, it's easy to see that the demand for money has been in a powerful bull market.
Reading the inflation signals, in other words, is highly dependent on current macro conditions. It's easy to overlook this point because money demand doesn't usually soar. But sometimes it does and the usual guidelines take a holiday. As David Beckworth recently advised, "we have rapid growth in M2 coming from a surge in money demand. This is a big deal, because money is the one asset on every market and an increased demand for it will thus affect every other market. The more money demand there is, the less nominal spending there will be on goods, services, and other assets. This development means the economic slump is being prolonged."
Now that we've got that straight, we can all focus on the more-pressing questions: Does the recent drop in jobless claims signal a stronger labor market? Or is the cycle set to fall victim to a slowdown in the growth rate of personal income?
December 26, 2011
The Nature Of The Beast
Models have the capacity for behaving badly, warns Emanuel Derman. Yet modeling market behavior is still essential, even if it comes with risk. The solution is to be aware of modeling's limitations and act accordingly. There's danger here if we let ourselves become blinded by the numbers, but modeling can tell us a lot about the risks we face.
As a simple example, consider the profile of the stock market in terms of its return distributions. The standard practice is to assume a normal distribution. If that was an accurate description of how markets behave, extreme losses would relatively rare and the distribution of negative and positive returns would be symmetric. That's a good first approximation, but no one should stop there. Indeed, history isn't always destiny, but it can't be ignored either.
Average monthly returns for U.S. stocks since 1881 are tightly clustered between the range of -5% and +7.5%. This range accounts for 95% of returns. Of those returns, more than 80% are flat to positive. In other words, history suggests that monthly returns are likely to be moderately in the black for any given month in the long run.
If we shift the investment horizon to longer-term holding periods, the return distribution leans further into positive territory. For example, the second chart below shows how 10-year periods stack up for the U.S. stock market. Performances in the range of zero to 12.5% represent nearly 89% of the distribution.
Profiling the market's long run performance distribution provides us with some useful context, but it's not terribly practical if we want to understand the limits to this sunny profile. Risk modeling for most investors is focused on one question: How bad can it get?
It's well known that financial markets suffer from tail risk and so it's only natural that we spend some time reviewing these events as a rough guide for thinking about the future. An obvious starting point is profiling the worst-case scenarios. For instance, on a monthly basis, the deepest 5% of losses for the equity market since 1881 range from a 5.9% retreat down to a crushing 26.5% implosion. Yes, it can get quite ugly, even for average monthly results. If you're expecting a normal distribution, you're asking for trouble... eventually.
Applying a conditional Value-at-Risk, or CVaR, analysis of the historical data for the 5% tail tells us that the weighted average of the expected loss is 9.7%. In other words, we should be prepared for a monthly loss of around 10% on average if our investment horizon for U.S. stocks is one month.
How do the numbers compare if the holding period is 10 years? The next chart summarizes the results.
If we have the discipline to hold pat for 10 years, the expected loss in the 5% tail drops to 4.9%, based on a weighted average of the historical data. The message is that by increasing the holding period to 10 years from one month cuts the average expected loss in the worst 5% of cases by around one-half.
The question is whether the 50% drop in the expected loss in the tail by committing to a dramatically longer holding period is a worthwhile tradeoff? The answer isn't obvious, or at least not if we're looking for a general rule for every investor. Risk tolerance varies from investor to investor, as do financial objectives, net worth, and other factors. Even if we're using the average investor as a guide, there are other ways beyond increasing the holding period to manage risk. Still, if we're intent on developing additional perspective on this topic the next step might be estimating CVaR in the 5% tail for a range of different holding periods and comparing the results, perhaps with an eye on choosing the optimal investment horizon for a given set of investor assumptions.
History can only reveal so much about the future, of course. All models behave badly at times in part because all models are slaves to historical data in some degree. Models can help us minimize the element of surprise, but they can't tell us what the future holds. Understanding the distinction is the first step for intelligently modeling market behavior.
Ultimately, we, the humans, are in charge--not the models. Investors too often act as if the relationship works in reverse. As Derman observes in Models.Behaving.Badly: Why Confusing Illusion with Reality Can Lead to Disaster, on Wall Street and in Life, "One has to treat people as responsible for their actions, and yet also recognize that they can't help what they do."
Some hazards in finance (and life) simply aren't subject to quantification.
December 24, 2011
But I heard him exclaim, ere he drove out of sight,
"Happy Christmas to all, and to all a goodnight!"
December 23, 2011
Best of Book Bits 2011 (Part I)
The year behind us delivered one of the better runs in publishing for finance and economic books. What follows are some of the more memorable names from my weekly Book Bits column over the past 12 months. Next week I'll follow up with Part II. Meanwhile, here's the first installment of a somewhat arbitrary listing of worthy titles from 2011:
● Expected Returns: An Investor's Guide to Harvesting Market Rewards
By Antti Ilmanen
Excerpt via publisher, Wiley
We should humbly recognize the limits of our understanding. Realized returns are dominated by randomness, structural uncertainty, and rare events. Expected returns are unobservable, at best estimated with noise. We should resist hindsight biases wired in us—the outcomes that materialized seem more inevitable or predictable than they truly were. It is worth recalling that experts can only explain a fraction of realized return variation afterwards, and this is an inherently easier task than predicting. Any observed return predictability is mild, possibly spurious, and rarely robust. Therefore I stress humility in interpreting empirical results and even more in making predictions and in trading based on them.
● The Quest: Energy, Security, and the Remaking of the Modern World
By Daniel Yergin
Review via The Economist
Providing sufficient energy to seven billion increasingly affluent humans without burning up the planet may be humanity’s greatest challenge. “What is at stake”, writes Daniel Yergin, “is the future itself.”
Mr Yergin’s previous book, "The Prize", a history of the global oil industry, had the advantage of an epic tale and wondrous timing. Years in the making, it was published, to critical and popular acclaim in 1990, two months after Saddam Hussein invaded Kuwait, thereby putting Saudi Arabia’s oilfields in peril. “The Quest”, as its more open-ended title suggests, is a broader and more ambitious endeavour. It is, first, an account of the many ways in which people have sought to produce energy—by burning fossil fuels, harvesting the wind, brewing biodiesel and trapping the sun’s heat. It is also an analysis of the increasingly fraught political context in which this business is conducted, especially with regard to three big and longstanding fears: energy scarcity, energy security and, more and more, the environmental ruin that energy can cause.
● Red-Blooded Risk: The Secret History of Wall Street
By Aaron Brown
Summary via publisher, Wiley
From 1987 to 1992, a small group of Wall Street quants invented an entirely new way of managing risk to maximize success: risk management for risk-takers. This is the secret that lets tiny quantitative edges create hedge fund billionaires, and defines the powerful modern global derivatives economy. The same practical techniques are still used today by risk-takers in finance as well as many other fields. Red-Blooded Risk examines this approach and offers valuable advice for the calculated risk-takers who need precise quantitative guidance that will help separate them from the rest of the pack. While most commentators say that the last financial crisis proved it's time to follow risk-minimizing techniques, they're wrong. The only way to succeed at anything is to manage true risk, which includes the chance of loss. Red-Blooded Risk presents specific, actionable strategies that will allow you to be a practical risk-taker in even the most dynamic markets.
● Retirement Heist: How Companies Plunder and Profit from the Nest Eggs of American Workers
By Ellen E. Schultz
Review via Publishers Weekly
The retirement crisis is no accident, claims Wall Street Journal investigative reporter Schultz; large companies have played a significant role in its creation to protect the wealth of its top executives. When GE, IBM, Verizon, and others slashed pensions and medical benefits for millions of American retirees, they pointed fingers everywhere but at themselves--but who was really at fault? Pension funds were not bleeding the companies of cash. GE hadn't contributed a cent to the workers' pension plans since 1987, but still had enough money to cover all current and future retirees. Executive pensions at GE, with a $6 billion obligation, are a drag on earnings. These are largely hidden, however, lumped in with the figures for regular pensions. Schultz's methodical cataloguing of these abuses paints a highly unflattering picture of companies that cut benefits to boost earnings, lay off older workers who are entering the years in which their pensions will spike, inflate retiree health benefits to boost profits, lobby for laws that keep the system inequitable, hoard death benefits, and fire whistle-blowers.
● Thinking, Fast and Slow
By Daniel Kahneman
Excerpt via The New York Times
Although professionals are able to extract a considerable amount of wealth from amateurs, few stock pickers, if any, have the skill needed to beat the market consistently, year after year. The diagnostic for the existence of any skill is the consistency of individual differences in achievement. The logic is simple: if individual differences in any one year are due entirely to luck, the ranking of investors and funds will vary erratically and the year-to-year correlation will be zero. Where there is skill, however, the rankings will be more stable. The persistence of individual differences is the measure by which we confirm the existence of skill among golfers, orthodontists or speedy toll collectors on the turnpike.
November's Weak Spending & Income Report Clouds Outlook
Disposable personal income (DPI) fell slightly last month while personal consumption spending for November rose by a mere 0.1%, the Bureau of Economic Analysis reports. It's a disappointing report overall and one that adds up to the softest month for spending and income since August.
DPI dropped by a scant 0.04%, but it was the first monthly decline since the summer and it's a reminder that the pace of income growth has yet to rebound to levels that prevailed before the summer slump. Consumer spending is doing better but it remains sluggish.
It's not terribly surprising to find that the rate of consumption is slowing. As I've been discussing in recent months, spending has been growing at rates that are too lofty relative to income. As the second chart below shows, there's been a substantial gap between the two when measured on a year-over-year basis. That's unsustainable. Either spending is set to fall or income's growth will rise.
Today's numbers are hardly devastating, but the slowing pace of annual growth for income is particularly troubling… if it continues. Although DPI is still rising on an annual basis, the trend isn't encouraging at the moment. The American economy relies heavily on consumer spending, which in turn draws hefty support from household income.
On the other hand, it's premature to give up hope just yet. Private-sector wage growth looks much better when measured against year-ago levels. For the year through last month, private wages are higher by 4.1%, the best rate since April.
But trouble may be brewing here as well. Wages fell slightly last month vs. October, the first monthly retreat since August. The slight decline hasn't shown up in the annual trend, but it will if wage growth continues to suffer.
The possibility for salvation resides primarily with the labor market. If the recent decline in initial jobless claims is a reliable leading indicator for thinking that job growth will pick up, the worst fears for income may be overblown. History tells us to think positively when jobless claims drop substantially, but only hard numbers for job growth will convince anyone at this late date in the cycle.
Meantime, today's numbers have set up a challenge that can't be ignored. “In the absence of a significant pickup in income, we won’t see a big boost in spending,” says BNP Paribas economist Yelena Shulyatyeva. “The momentum will slow in the fourth quarter, but the economy is still growing.”
Will the growth suffice? The jury's still out, and today's mixed report on durable goods orders for November doesn't help clarify the outlook. Yes, new orders for manufactured goods rose by a healthy 3.8% last month, the Census Bureau reports--the most since July. The annual trend looks good too, with new orders jumping 12% vs. a year ago. But a big chunk of last month's gain was powered by the volatile transportation sector. Take out that slice of business and new orders were virtually flat in November.
It's hardly encouraging that new orders for capital goods (a subset of durable goods that's considered a leading indicator because it's a proxy for business investment) slipped more than 1% last month. Capital goods orders are still up by 6.5% on the year, but any setback raises fresh worries these days.
All the more now that the crowd's wondering anew if Joe Sixpack is stressed. "The lack of real income growth really raises questions as to what is going to happen to the economy in the first quarter," opines Mark Vitner, senior economist at Wells Fargo Securities.
December 22, 2011
The Naive Strategy Of Equal Weighting Looks Pretty Smart
As an investment strategy, equal weighting has two powerful attributes: it's simple and it's competitive. That's a tough combination to beat. For some thoughts on why equal weighting does well, take a look at my article in the December issue of Financial Advisor: Model-Free Investing.
Jobless Claims Drop For Third Straight Week--Lowest Since April '08
New filings for unemployment benefits dropped again last week, falling 4,000 to a seasonally adjusted 364,000. That’s a relatively modest decline, but it’s encouraging because it follows last week’s big drop that pulled new weekly claims down to a 3-1/2 year low. The fact that the previous tumble didn’t reverse offers one more data point for thinking that the recent slide in jobless claims is the real deal. If so, the outlook for the labor market is somewhat brighter, which of course is the critical variable these days in reading the macro tea leaves for the U.S.
The last time initial claims were this low was April 2008. There’s no assurance that the downward trend of late will continue, but if it does it’s going to get tougher to argue that the labor market isn’t set to grow at a faster rate in the months ahead.
For another perspective on the trend in jobless claims, let’s review the year-over-year percentage changes without the seasonal adjustment. As the second chart below shows, a virtuous cycle seems to be building here as well. Claims were nearly 16% lower last week than at the same time in December 2010. That's the biggest decrease since August. The drop isn't as pronounced compared with the seasonally adjusted weekly data, but progress is still progress. And when you see declines of some magnitude from both perspectives, it's clear that there's more than statistical noise unfolding.
The true test of this leading indicator’s influence will be confirmed (or denied) in future employment reports in the months ahead. History suggests that a drop in firings is an early signal of more hirings ahead, but until we see the numbers we're all doubting Thomases. The next update arrives on January 6, when the December payrolls numbers are released.
"Claims have been improving pretty rapidly,” Sam Coffin, a UBS economist tells Bloomberg. "The labor market is gaining some momentum. The question about the first half of next year is how rapid growth is."
On that note, we should expect that claims will back up at some point in the weeks ahead. This is a volatile series and so it's likely that we'll see wide swings in the short run. The question is whether there's a trend here, namely, a falling trend.
It's getting easier to answer in the affirmative, but no one needs an excuse these days to wonder if we're setting ourselves up for disappointment. It's not clear that the eurozone troubles are solved and so the potential for one of those infamous exogenous shocks can't be dismissed just yet.
Meanwhile, in other economic news today the Bureau of Economic Analysis reports that U.S. GDP growth has been revised down to 1.8% for the third quarter from the previous 2.0% estimate. Before that, in the first round of guessing, the government said the economy expanded by 2.5%.
In other words, there's a lot riding on the jobless claims numbers. If there's a case for thinking that the economy will continue growing, the single-best source for that optimism resides in jobless claims. So, yes, today's the first day of winter. The question is whether there's an early spring approaching for the business cycle. There are lots of arguments for dismissing such a radical idea, but there's at least one new number that offers a cup of cheer. 'Tis the season.
"When you fire fewer people, hiring unquestionably follows," advises Dan Greenhaus, chief global strategist at BTIG. True? We'll find out soon.
Strategic Briefing | 12.22.2011 | The ECB Lends After All
ECB unleashes a wall of money
Financial Times | Dec 21
If the answer to the eurozone crisis was a “wall of money”, it was provided on Wednesday by the European Central Bank. More than 500 banks borrowed a total of €489bn in three-year loans – equivalent to about 5 per cent of eurozone gross domestic product and the largest amount provided in a single ECB liquidity operation.
A Central Bank Doing What It Should
NY Times | Dec 22
After long resisting the kind of financial force Washington used at the height of the financial crisis in 2008, European central bankers on Wednesday pumped nearly $640 billion into the Continent’s banking system. The move raised hopes that the money could alleviate the region’s credit squeeze.
Good start from Draghi -- but much more to do
Irish Independent News | Dec 22
The good news is that European banks were able to borrow much more than anyone had expected from the ECB yesterday. They borrowed a total of €489bn of cheap three-year funding from the ECB as against the €300bn that had been widely predicted. The bad news is that European banks are probably in even worse shape than most observers had suspected.
ECB lends banks $639 billion over 3 years
AP Business | Dec 21
Struggling banks snapped up €489 billion ($639 billion) in cheap loans from the European Central Bank on Wednesday, a sign of just how hard or expensive it has become to borrow from each other. The huge demand for newly available three-year loans comes as fears rise that heavily indebted European governments could default and force banks and other bond holders to take big losses... "The good news is, the ECB's efforts to increase liquidity are working," said Jennifer Lee, an analyst at BMO Capital Markets. "The bad news is, high demand for the loans creates worries that banks are urgently in need of funds to boost liquidity."
European stocks gain as bank funding pressure eases
Reuters | Dec 22
The European Central Bank, in its first-ever three-year tender, lent 523 banks a record 489 billion euros ($638 billion) at low interest rates on Wednesday, well above the 310 billion euro take-up forecast. The scale of the funding operation initially exacerbated concerns about the health of the financial system but was increasingly being seen has having eased pressures on the banks, though concerns remain that it offers no fundamental fix for the debt problems facing the euro zone. "In the longer-term the liquidity provided yesterday is not going to solve the debt crisis, it is not going to help southern European countries with their problems in getting control of their public debt," said Niels Christensen, FX strategist at Nordea.
How Bad Ideas Worsen Europe’s Debt Meltdown
John Cochrane (Bloomberg) | Dec 21
Conventional wisdom says that sovereign defaults mean the end of the euro: If Greece defaults it has to leave the single currency; German taxpayers have to bail out southern governments to save the union. This is nonsense. U.S. states and local governments have defaulted on dollar debts, just as companies default. A currency is simply a unit of value, as meters are units of length. If the Greeks had skimped on the olive oil in a liter bottle, that wouldn’t threaten the metric system. Bailouts are the real threat to the euro. The European Central Bank has been buying Greek, Italian, Portuguese and Spanish debt. It has been lending money to banks that, in turn, buy the debt. There is strong pressure for the ECB to buy or guarantee more. When the debt finally defaults, either the rest of Europe will have to raise trillions of euros in fresh taxes to replenish the central bank, or the euro will inflate away.
Eurozone zombies follow Mario Draghi's cheap money
The Telegraph (Britain) | Dec 21
Far from reassuring markets, the scale of Wednesday's bail-out for eurozone banks by Draghi's European Central Bank (ECB) should simply confirm worst fears. European banks face a €600bn tsunami of debt coming due in 2012 (mostly in the first quarter) and many simply can't pay up because the usual source of refinancing, wholesale money markets, are refusing to lend them any more. Sound familiar?
'The Euro-Zone Bailout Programs Must Be Stopped'
Der Spiegel | Dec 20
How to save the euro? Some believe that the European Central Bank is the key to any solution. Others think that the euro zone should be contracted and the weak members squeezed out. Spiegel spoke with two leading German economists about the currency's future. Their one area of agreement? Something must be done quickly.
Spiegel: Mr. Starbatty, Mr. Bofinger, can the euro still be saved?
Starbatty: All of the measures that are currently planned take effect in the long term. But rescue measures are needed now. That's why many politicians want to pull out the so-called bazooka and inject money into the market through the European Central Bank (ECB) or introduce euro bonds. Both are deadly sins. It would be better to shrink the monetary union to a hard core that can sustain the euro.
Bofinger: That would be a disaster. But I agree with you that time is of the essence. The highly indebted countries must be able to borrow at moderate interest rates so they don't go bankrupt. This could be achieved with euro bonds. And if they can't be implemented that quickly, the ECB has to stabilize the system. In doing so, it would not create inflation but would in fact avoid deflation.
December 21, 2011
Take A Walk On The Dark Side Of Macro Expectations
In the great debate about whether there’s another recession heading our way, economist Andrew Smithers, head of Smithers & Co. and author of Wall Street Revalued, weighs in with a persuasive argument that the year ahead will be no stranger to risk and so it’s premature to dismiss the idea that a new downturn is lurking. A persuasive argument isn’t always the same as fate, but regardless of your macro outlook it’s helpful to consider an array of opinions if only to stress test your own convictions. The world is awash in forecasts, of course, but Smithers’ take strikes me as valuable for framing the linkages in markets, politics, and the economy. It’s a thankless task, of course, but someone’s got to do it and he does a commendable job in a new research note sent to clients today.
The foundation for Smithers’ concern is his claim that "the US stock market is seriously overpriced and profits are almost certain to fall over the next few years as a necessary condition for fiscal retrenchment." The calculation is based on two metrics that Smithers favors: the so-called q ratio and the CAPE metric (you can find some background information on these measures here.)
Smithers goes on to warn that the rate of decline in corporate profits will be closely linked with "the speed at which budget deficits are reined in" for the U.S. Good luck with that. If the latest round of political dysfunction in Washington regarding the payroll tax is any indication, corralling the deficit challenge looks set for a long and winding road and an uncertain outcome.
Even more byzantine complication awaits, Smithers continues:
Thereafter the path of US fiscal policy will depend on the outcome of the 2012 elections. These involve massive uncertainties: (i) the policies, if any, on which the election will be fought, (ii) the result of the voting, (iii) the policies that the parties will espouse after the election and (iv) the policies that will be agreed between the new Administration and the new Congress.
Add that risk to the eurozone mess and "there is clearly a significant risk that the developed world will fall back into recession and that there will be a sharp fall in world stock markets," Smithers writes. But all's not lost, he adds, anticipating that 2012 will bring slow growth rather than an outright contraction.
I tend to agree, but there are some analysts who take issue with even this tepid outlook. But the economic news in the U.S., while not exactly encouraging, isn't conspicuously dire these days. A number of economic reports have been bubbly lately, if only on the margins. That includes last Friday's update of commercial and industrial loans, which posted another gain for November by rising 6% on an annualized basis. If there's a recession brewing, are bank loans likely to be rising? Maybe. Macro trouble may show up in the data slowly. There's also the problem of confusing the parts with the whole. As John Hussman recently advised:
It is very difficult to obtain useful views about economic direction using the standard "flow of anecdotes" approach that is the bread-and-butter of many analysts. The economic data reported daily are a mix of leading, coincident and lagging indicators, often noisy and subject to revision, and without any overall economic structure. Adjusting one's entire economic views following each report, as if each somehow adds significant information, is a recipe for confusion. Treating economic data as a flow of anecdotes, without putting any structure around them, is why the economic consensus has failed to ever anticipate an oncoming recession.
Nonetheless, at some point the evidence for a new recession will be conspicuous for all to see. That day may be coming, or not, but it didn't arrive today. Today's major economic release was for existing home sales, which popped again last month by a seasonally adjusted 4% vs. October. That puts existing home sales higher by more than 12% vs. the year-earlier figure, a gain that provides support for yesterday's good news on housing starts and new building permits. Alas, revisions for the historical record in recent years show that the housing slump was worse than originally reported.
One step forward, one step back. Par for the course in the post-Great Recession era.
December 20, 2011
Is The Housing Market Poised For A True Recovery This Time?
A number of analysts tell us that the weak housing market has been the main impediment to stronger growth in the broader economy. One recent study advises simply that Housing Is The Business Cycle. Unfortunately, that relationship has only brought trouble in recent years, courtesy of a housing market that fell off a cliff and remained flat on its back. But thinking about residential real estate in something other than a deeply negative light is topical again this morning after reading today's update on housing starts and newly issued building permits for November. Both series posted handsome gains on the month. Yes, we've been here before only to see the apparent rebound sputter out. But the latest rise is accompanied by something else we haven't seen in a while: a rising trend over recent months. Could this be the long-awaited turning point for housing?
No one really knows, but what is clear is that November was a good month for housing activity and that's a start. Housing starts jumped 9.3% last month on an annualized basis as new building permits rose a respectable 5.7%. The bigger news is that both series have been drifting higher since the spring, as the chart below shows.
There's a case for arguing that the housing market has finally bottomed out, although it's still a leap of faith for thinking that the end of contraction has now given way to sustainable growth. Still, the thought is a bit less preposterous after reviewing today's numbers.
“It’s a solid report,” Brian Jones, a senior U.S. economist at Societe Generale, tells Bloomberg News. “For months we’ve been flagging the strength in multifamily construction, but now we’re starting to get signs that single-family is pulling itself off the canvas.”
Nonetheless, it's important to maintain perspective, which AP provides:
The Commerce Department says builders broke ground on a seasonally adjusted annual rate of 685,000 homes last month, a 9.3 percent jump from October. It's the highest level since April 2010. Still, the rate is far below the 1.2 million homes that economists say would be built each year in a healthy housing market.
The question, of course, is whether we're finally on the road to climbing out of the hole? The best we can say at the moment is that the trend is at its most encouraging in roughly two years. To see why, take a look at 12-month rolling percentage changes for housing starts and permit data. By reviewing the numbers through this filter, it's easier to see how the cycle appears to be reviving for a second time since the recession ended:
It's premature to aruge that we're now on a sustainable path to growth. But it's also true that housing starts and permits have posted their best run in recent months since late-2009/early 2010. The earlier revival went nowhere. Will the second attempt at resurrection fare any better?
Joseph LaVorgna, Deutsche Bank's chief U.S. economist, is leaning toward that view. As he advises in a note to clients today via CNNMoney: "There has been a noticeable uptrend in several key housing metrics in the back half of this year, so even though we are downplaying the November data to some degree, it does appear that residential construction is finally beginning to rise from its post-recession lows."
Research Review | 12.20.2011 | Housing & The Business Cycle
How Long Do Housing Cycles Last? A Duration Analysis for 19 OECD Countries
Philippe Bracke (London School of Economics) | Oct. 2011
19 OECD countries. I provide two sets of results, one pertaining to the average length and the other to the length distribution. On average, upturns are longer than downturns, but the difference disappears once the last house price boom is excluded. In terms of length distribution, upturns (but not downturns) are more likely to end as their duration increases. This duration dependence is consistent with a boom-bust view of house price dynamics, where booms represent departures from fundamentals that are increasingly difficult to sustain.
End in Sight for Housing Troubles?
Daniel L. Chertok (XR Trading) | Sep. 2011
A historical relationship between home prices and family income is examined based on more than 40 years of data. A new home aordability ratio based on the average home price, family income and mortgage rates is analyzed in the historical context. This indicator is used to gauge the current state of the residential housing market in the United States. Historical data points to an imminent but slow recovery in the housing market over the next few years.
The Role of Capital Gains Taxes in the Housing Bubble
W. Gavin Ekins (Emory University) | Oct. 2011
Capital gain taxes are integrated into an excess-bid model to develop an analytical narrative of the housing market crash. Housing data is used to support the narrative. The paper concludes that sudden changes in capital gains tax rates can cause formed bubbles to burst. Research recommends gradual changes in capital gain taxes rather than large one-time changes.
Household Balance Sheets, Consumption, and the Economic Slump
Atif R. Mian (UC Berkeley), et al. | Nov. 2011
The large accumulation of household debt prior to the recession in combination with the decline in house prices has been the primary explanation for the onset, severity, and length of the subsequent consumption collapse. Using novel county level retail sales data, we show that the decline in consumption was much stronger in high leverage counties with large house price declines. Levered households experiencing larger house price declines faced larger drops in credit limits, were unable to refinance mortgages into lower rates, and paid down existing debts at a faster pace. Using zip code level data on auto purchases and exploiting within-county variation, we show that the consumption response to declining house prices was stronger in areas with more reliance on housing as a source of wealth.
What Fuels the Boom Drives the Bust: Regulation and the Mortgage Crisis
Jihad C. Dagher and Ning Fu (IMF) | Sep. 2011
We show that the lightly regulated non-bank mortgage originators contributed disproportionately to the recent boom-bust housing cycle. Using comprehensive data on mortgage originations, which we aggregate at the county level, we first establish that the market share of these independent non-bank lenders increased in virtually all US counties during the boom. We then exploit the heterogeneity in the market share of independent lenders across counties as of 2005 and show that higher market participation by these lenders is associated with increased foreclosure filing rates at the onset of the housing downturn. We carefully control for counties’ economic, demographic, and housing market characteristics using both parametric and semi-nonparametric methods. We show that this relation between the pre-crisis market share of independents and the rise in foreclosure is more pronounced in less regulated states. The macroeconomic consequences of our findings are significant: we show that the market share of these lenders as of 2005 is also a strong predictor of the severity of the housing downturn and subsequent rise in unemployment. Overall our findings lend support to the view that more stringent regulation could have averted some of the volatility on the housing market during the recent boom-bust episode.
Real Estate Bubbles and Weak Recoveries
Adrian Peralta-Alva (St. Louis Fed) | Dec. 2011
As the real estate bubble burst, the U.S. economy found itself with a stock of residential and nonresidential structures higher than desired. Under these conditions, economic theory predicts investment in structures should collapse (just as observed in the data) and stay low until the desired level is attained (either by natural depreciation or by actively restructuring the housing stock to more desirable uses). Moreover, this adjustment process is expected to be slow, given the relatively low rate of depreciation of residential and nonresidential structures.
December 19, 2011
The Mysterious Case Of Recession Risk: Dec 2011 Edition
Will the threat come from within or without? Or are we set to be a two-time loser? Perhaps the more pressing question is whether it’ll come at all?
The odds of a new recession appear low to many analysts, but the Economic Cycle Research Institute's weekly leading index (WLI) is still anticipating a fresh period of contraction. The latest reading of the rolling growth rate for ECRI's WLI is -7.5, the group reported on Friday. That’s up slightly from the previous week, but it's not enough of a change to spur a revision in ECRI's recession call that still stands since it first issued the warning in late-September.
The appearance of a stronger U.S. economy over the past month or so vs. the ongoing recession forecast by ECRI is gaining attention as analysts consider if the improving trends in some of the economic news are misleading us. The latest addition for thinking that there's no recession coming these days is the weekly initial jobless claims report. Last week's update suggests that the labor market is strengthening. It's always dangerous to rely on one number for predicting the economic cycle, of course, but the sharp decline in this leading indicator looks compelling for expecting the labor market to maintain a moderate growth rate if not accelerate.
A new research note from the St. Louis Fed muses: Initial Claims and Employment Growth: Are We at the Threshold? It's not yet clear, the author concludes, but the possibility of stronger employment growth isn’t beyond the pale. If so, the odds of a new recession appear low.
But ECRI doesn’t agree. The consultancy has a strong record of making cyclical calls, but no one should assume its crystal ball is flawless. A complicating factor is ECRI's black box methodology. One blogger has tried to deconstruct ECRI's process, but it's difficult to make any hard and fast conclusions when you're an outsider looking in. You can find deeper context for ECRI’s process in a book co-authored by two of the firm’s principals: Beating the Business Cycle: How to Predict and Profit From Turning Points in the Economy. But as The Wall Street Journal recently noted, the index that ECRI publishes weekly for all the world to see "is not the one... used when it made its famous recession call a couple of months ago — they relied on a longer-term leading indicator, which they only show to paying clients."
If there's a risk of a new U.S. recession, perhaps the biggest threat comes from beyond its borders. France seems to be in a recession, implying that the eurozone overall will follow, as the latest update of the Markit Eurozone PMI Composite Output Index implies. Britain’s economy looks wobbly too.
If Europe rolls over, China may succumb too, thanks to the Middle Kingdom’s heavy reliance on exports to Europe. It all adds up to new headwinds for the U.S. “Alone, conditions in Europe might not cause another U.S. recession,” writes economist Peter Morici, “but in concert with China's renewed mercantilism, banking problems and higher gasoline prices, those could sink America quite nicely.”
Christine Lagarde, managing director at the International Monetary Fund, is quite pessimistic as well, warning that the global economy is at risk of a severe downturn.
We may be doomed, but the threat isn’t obvious in the last full month—October—of economic reports for the U.S., as I noted here. The numbers so far via the November updates don't reveal any smoking guns either. The year-over-year trend in several key indicators remain positive. Retail sales, for instance, are firmly in the black through last month. Industrial production slipped modestly on a monthly basis for the first time since April we learned last week, but the annual change is 3.7% vs. November 2011--an historically strong rate of growth for industrial production.
The stock market, meanwhile, seems to be on the fence. Every recession in the past half century has been accompanied by a 12-month decline in the S&P 500. At the moment, the market’s marginally higher vs. the year-earlier level.
On balance, looking at industrial production, retail sales, nonfarm payrolls and other indicators suggests that another recession isn’t near. But if there is a downturn just around the corner, macroeconomic forecasters may have to rethink their assumptions. The notion that a recession can arrive with minimal warning is disturbing, but not necessarily surprising. Maybe we're looking at the wrong signs. Forecasters generally failed to anticipate the Great Recession, notes Simon Potter, the New York Fed’s director of economic research. There’s hardly compelling evidence for thinking that it'll be different this time.
There are always exceptions among the seers, of course. ECRI has a history of seeing trouble when others don’t. John Hussman of Hussman Funds also made a timely recession call ahead of the last downturn. What does Hussman expect these days? “Recent U.S. economic reports have improved modestly from the clearly negative momentum that we saw in late-summer,” he wrote earlier this month. But he’s not convinced that the good news delivers the all-clear signal. A deeper review of the data, Hussman explained, seems to fall in line with ECRI’s recession prediction:
Unfortunately, the underlying recessionary pressures we observe are largely unchanged. When we take the present set of economic evidence in its entirety, we see very little evidence of a meaningful reduction in recession risks. Indeed, the evidence from the rest of the world, both developed and developing, reinforces the expectation that the global economy is approaching a fresh contraction.
If so, we should see confirming numbers in the U.S. data soon. And if we don't? Well, cyclical analysis may be set to get a lot more complicated. Stay tuned.
December 17, 2011
Book Bits For Saturday: 12.17.2011
● Frontiers of Modern Asset Allocation
Edited by Paul D. Kaplan
Summary via publisher, Wiley
Building on more than 15 years of asset-allocation research, Paul D. Kaplan, who led the development of the methodologies behind the Morningstar Rating and the Morningstar Style Box, tackles key challenges investor professionals face when putting asset-allocation theory into practice. This book addresses common issues such as:
• How should asset classes be defined?
• Should equities be divided into asset classes based on investment style, geography, or other factors?
• Should asset classes be represented by market-cap-weighted indexes or should other principles, such as fundamental weights, be used?
• How do actively managed funds fit into asset-class mixes?
Kaplan also interviews industry luminaries who have greatly influenced the evolution of asset allocation, including Harry Markowitz, Roger Ibbotson, and the late Benoit Mandelbrot. Throughout the book, Kaplan explains allocation theory, creates new strategies, and corrects common misconceptions, offering original insights and analysis. He includes three appendices that put theory into action with technical details for new asset-allocation frameworks, including the next generation of portfolio construction tools, which Kaplan dubs "Markowitz 2.0."
● Risk Less and Prosper: A Guide to Safer Investing
By Zvi Bodie and Rachelle Taqqu
Review via All Things Financial Planning Blog
Co-authors Zvi Bodie, Ph.D. Professor of Finance at Boston University (author of Worry Free Investing) and Rachelle Taqqu, CFA and Principal of New Vista Capital, reveal a smart and safer way to plan for your lifetime goals. Like Christopher Columbus discovering that the world is not flat, the authors debunk timeworn investment beliefs and practices that expose investors to more risk than ever imagined — and more risk than investors can afford to take.
● Getting it Wrong: How Faulty Monetary Statistics Undermine the Fed, the Financial System, and the Economy
By William A. Barnett
Summary via publisher, MIT Press
Blame for the recent financial crisis and subsequent recession has commonly been assigned to everyone from Wall Street firms to individual homeowners. It has been widely argued that the crisis and recession were caused by “greed” and the failure of mainstream economics. In Getting It Wrong, leading economist William Barnett argues instead that there was too little use of the relevant economics, especially from the literature on economic measurement. Barnett contends that as financial instruments became more complex, the simple-sum monetary aggregation formulas used by central banks, including the U.S. Federal Reserve, became obsolete. Instead, a major increase in public availability of best-practice data was needed. Households, firms, and governments, lacking the requisite information, incorrectly assessed systemic risk and significantly increased their leverage and risk-taking activities. Better financial data, Barnett argues, could have signaled the misperceptions and prevented the erroneous systemic-risk assessments.
● Measurement and the Economic Emergence of the Modern World
By Douglas Allen
Summary via publisher, University of Chicago Press
In The Institutional Revolution, Douglas W. Allen offers a thought-provoking account of another, quieter revolution that took place at the end of the eighteenth century and allowed for the full exploitation of the many new technological innovations. Fundamental to this shift were dramatic changes in institutions, or the rules that govern society, which reflected significant improvements in the ability to measure performance—whether of government officials, laborers, or naval officers—thereby reducing the role of nature and the hazards of variance in daily affairs.
● The Hedge Fund Mirage: The Illusion of Big Money and Why It's Too Good to Be True
By Simon Lack
Excerpt via publisher, Wiley
If all the money that’s ever been invested in hedge funds had been put in treasury bills instead, the results would have been twice as good... Hedge fund investors in aggregate have not done nearly as well as popularly believed. The media focus on the profi ts of the top managers has obscured the absence of wealthy clients. Although the industryperformed well in the 1990s, it was small and there weren’t many investors. In recent years as its rapid growth has continued, results have suffered and many more investors have lived through mediocre returns compared with those enterprising few that found hedge funds when the industry itself was undiscovered.
December 16, 2011
A Closer Look At Yesterday's Encouraging Report On Jobless Claims
Is this the real deal? Yesterday's update on new jobless claims, which fell to a 3-1/2 year low last week, suggests that the labor market will continue growing, perhaps at slightly faster rates than we've seen in 2011. “This is unexpectedly great news,” says Ian Shepherdson at High Frequency Economics. But skepticism abounds, and rightly so. There have been several false starts to the recovery since the Great Recession was officially declared at an end in June 2009. There's no way to know for sure if the latest drop in new filings for unemployment benefits signals a true turning point for the better this time, but the possibility can't be dismissed either, at least not yet.
Still, economist Brad DeLong has his doubts about the latest fall in claims. "The seasonal adjustment factor makes it shaky news," he writes. Perhaps, but if we strip out the seasonal adjustment and look at the raw claims data on a year-over-year basis the latest numbers are in line with the trend in recent months of a roughly 10% annual decline. In fact, the latest report shows that unadjusted new claims were lower by nearly 12% vs. the year-earlier figure—the biggest drop in two months.
Some analysts worry that future revisions to the jobless claims data will wipe away some or all of the recent good news. One can never discount that possibility, but here too the trend appears friendly when we look at recent history. The next chart tracks changes in revisions for the weekly seasonally adjusted claims reports. Revisions are defined as the latest reported number for a given week less the initially reported number. As the chart shows, the revision trend has been only moderately upward yet stable for much of this year. That's one more reason for thinking optimistically about the labor market. Moderately higher revisions for claims aren't helpful, of course, but there's nothing in the data that suggests that this drift is about to change. In short, relatively minimal upward revisions are no threat to a trend that's generally moving lower.
The acid test is still ahead of us, however. The drop in claims has to prove itself by holding its ground if not moving lower. That's a key test because this is a volatile data series on a weekly basis and so any single report has to be interpreted cautiously. More importantly, we need evidence that the drop in claims is translating into job growth. History suggests that new claims are a strong leading indicator of future economic activity, including payroll changes. Still, everything is murky in real time and there's only so much confidence one can muster from looking at history.
Meanwhile, the uncertainty about what happens next with the euro crisis continues to hang over the global economy. The dysfunctional political bickering in Washington over the budget negotiations is another potential trouble spot. The trend is still precarious, but perhaps less precarious than the pessimists recognize. Yes, it's still one day (and data point) at a time.
December 15, 2011
Jobless Claims Drop To The Lowest Level Since May 2008
Now we’re getting somewhere. Initial claims for new jobless benefits fell last week by a hefty 19,000 to settle at a seasonally adjusted 366,000. That’s the lowest tally since May 2008, which is to say before the Lehman implosion that turned a financial problem into a macro crisis. That's a significant change for this leading indicator and it implies that the U.S. economy is poised to muddle through at a stronger pace in 2012.
Today’s drop in claims, combined with a review of the recent downward trend, is far too substantial to dismiss as statistical noise. Making bold predictions in economics is always a dangerous affair, especially these days. But looking at today’s claims update suggests that the modest growth in the labor market may be poised to rise a notch or two.
What could derail this positive momentum? In a word, the euro. The eurozone challenges, which are being exacerbated by Germany's reluctance to let the European Central Bank act as a lender of last resort, complicate economic forecasts for the U.S. and the global economy. It’s always something. Nonetheless, even with the caveat that Europe could drag us all over the edge, there’s no denying that the drop in new claims in recent months is a sign that the odds of an imminent U.S. recession have suffered another setback. Today's update strengthens the hand of the optimists by more than a trivial degree.
Nonetheless, a deeper confidence that today's number is more than a blip will only come with corroborating evidence in the weeks ahead. The true test is whether the drop in new claims translates into higher job growth. For the moment, at least, there's a bit more support for thinking that better times lie ahead.
Inflation's Split Personality
The consensus forecast for tomorrow's update on consumer inflation is expected to show that prices rose by a slight 0.1% in November, according to Briefing.com. Inflation, in other words, remains a non-event, despite the ongoing howls of protest from the usual suspects.
Inflation hawks have been telling us for some time now that dramatically higher inflation is just around the corner. Eventually they'll be right, but not yet. The numbers are an inconvenient fact for worrying about pricing pressure at this juncture. Despite massive increases in the Fed's balance sheet, consumer inflation remains modest by historical standards. In the chart below, the year-over-year percentage change in the broadly defined M2 money supply (green line) has recently soared. Inflation's pace also increased (blue line is headline CPI, red line is core CPI), but the rise is hardly the hyperinflationary rates that some predicted.
Huh? Haven't we been told that printing money is a sure path to dangerously high inflation? If so, why isn't inflation responding in kind? Some conspiracy theorists charge that the government manipulates the data and so the official inflation numbers vastly understate the true rate. Perhaps, but independent estimates of inflation are also relatively mild. MIT's Billion Prices Project, for instance, generally tracks the government's CPI numbers. As Rex Nutting at MarketWatch reminds,
The fact is, we’ve got plenty of independent sources of information to double-check the government bean counters.
If you don’t believe the government’s data on job creation, you can verify the numbers through other sources, such as Gallup’s polls, reports from ADP, Intuit, Monster and Manpower, or the surveys from the Institute for Supply Management and the National Federation of Independent Business. The government itself produces alternative data on the labor market in the daily tax receipts report, the weekly jobless claims report and the monthly household survey.
If inflation really is contained, one might wonder what's going on with the relationship between the money supply and prices. The short answer is that money supply is only half of the equation. There's also money demand. As Professor John Cochrane recently explained, "money-stock measures are not well correlated with nominal GDP; they do not forecast changes in inflation, either. The correlation is no better than the one between unemployment and inflation." He continues:
Why is the correlation between money and inflation so weak? The view that money drives inflation is fundamentally based on the assumption that the demand for money is more or less constant. But in fact, money demand varies greatly. During the recent financial crisis and recession, people and companies suddenly wanted to hold much more cash and much less of any other asset. Thus the sharp rise in M1 and M2 seen in the chart is not best understood as showing that the Fed forced money on an unwilling public. Rather, it shows people clamoring to the Fed to exchange their risky securities for money and the Fed accommodating that demand.
Money demand rose for a second reason: Since the financial crisis, interest rates have been essentially zero, and the Fed has also started paying interest on bank reserves. If people and businesses can earn 10% by holding government bonds, they arrange their affairs to hold little cash. But if bonds earn the same as cash, it makes sense to keep a lot of cash or a high checking-account balance, since cash offers great li¬quidity and no financial cost. Fears about hoards of reserves about to be unleashed on the economy miss this basic point, as do criticisms of businesses “unpatriotically” sitting on piles of cash. Right now, holding cash makes sense.
For another perspective, consider that many economists distinguish between good and bad deflation. It's well known that a sustained period of falling prices generally can be devastating for an economy, as shown by the experience in the early 1930s and, more recently, Japan's malaise. But sometimes deflation is helpful. In particular, a bout of deflation that arises from higher productivity can be beneficial. In contrast, deflation born of the blowback of a recession triggered by a financial crisis is toxic. If we recognize two types of deflation, shouldn't we acknowledge the same for inflation? Scott Sumner thinks that's reasonable:
I recently attended an economic conference with mostly conservative-leaning economists. Someone had a paper that mentioned how certain types of deflation can actually be good, as when rapid productivity growth helped reduce prices in the late 1800s.
I agree with this, and mentioned that I rarely hear conservatives talk about “good inflation.” Well I might as well have thrown a skunk into the middle of the room. Let’s just say that the idea of “good inflation” didn’t go over too well.
And isn’t that the problem? Isn’t that why we are where we are? We have all sorts of models that are basically symmetrical. You might argue that a stable price level is ideal, and that any inflation or deflation is bad. But if you argue that some deflation is bad and some is good, then you implicitly have a model that distinguishes between demand and supply shocks. So supply or productivity-driven deflation is good. Of course those models imply that inflation caused by a fall in aggregate supply is also good. The models are completely symmetrical. This shouldn’t even be controversial.
This brings us to the current challenge for the global economy, which may be set for a new round of trouble due to the euro crisis and the German-led effort to prevent the European Central Bank from acting as a lender of last resort to counteract the Continental surge in money demand. As The Economist warns, "The move to austerity is most dramatic within the euro zone—which can least afford it. Operating without floating currencies or a lender of last resort, its present predicament carries painful echoes of the gold-standard world of the early 1930s."
Higher inflation shouldn't be considered a cure-all in all situations. Focusing on inflation, in fact, misses the larger point, according to a small but growing band of economists who recommend what they say is a better policy: nominal GDP targeting. But to the extent we're talking about inflation, it's crucial (especially now) to put the topic into proper historical perspective. It's wrong to assume that an economy can inflate its way to prosperity. But as Paul Krugman reminds, sometimes there's a critical nuance to this caveat: "Nobody thinks that an economy operating somewhere near full employment can inflate its way to higher output. But under depression conditions — which is what we have now — inflation is very much a positive thing."
Richard Koo, an economist at Nomura and author of The Holy Grail of Macroeconomics: Lessons from Japans Great Recession , warns in a new research note that the risk is rising that Europe and the U.S. "may be headed toward a Japan-like lost decade."
Inflation at this point, in other words, is the least of our macro troubles. That too will change… one day. But for now there are (still) more pressing challenges ahead.
December 14, 2011
Research Review | 12.14.2011 | Asset Pricing & The Business Cycle
Implied Risk Premium and the Business Cycle: You Can’t Always Get What You Want
Georg Bestelmeyer (University of Cologne), et al. | December 1, 2011
We analyze the link between investor’s risk premia demands and overall business conditions. In contrast to previous studies we focus on ex-ante risk premia expectations implied in market prices and earnings forecasts rather than ex-post realized excess returns. We find that implied risk premia are counter-cyclical and strongly driven by the economic environment. On average, implied risk premia are higher (lower) when the economy is contracting (expanding). In contrast, realized excess returns on a monthly frequency do not show this pattern over our sample period March 1983 to December 2009. In addition, implied risk premia are highly sensitive to macroeconomic risk factors such as term- and default spreads. Our findings emphasize that implied risk premia are time varying and strongly tied to the business cycle – much more than realized excess returns.
Do Mood Swings Drive Business Cycles and is it Rational?
Paul Beaudry (University of British Columbia), et al. | December 2011 (Dallas Fed)
This paper provides new evidence in support of the idea that bouts of optimism and pessimism drive much of US business cycles. In particular, we begin by using sign-restriction based identification schemes to isolate innovations in optimism or pessimism and we document the extent to which such episodes explain macroeconomic fluctuations. We then examine the link between these identified mood shocks and subsequent developments in fundamentals using alternative identification schemes (i.e., variants of the maximum forecast error variance approach). We find that there is a very close link between the two, suggesting that agents' feelings of optimism and pessimism are at least partially rational as total factor productivity (TFP) is observed to rise 8-10 quarters after an initial bout of optimism. While this later finding is consistent with some previous findings in the news shock literature, we cannot rule out that such episodes reflect self-fulfilling beliefs. Overall, we argue that mood swings account for over 50% of business cycle fluctuations in hours and output.
When Credit Bites Back: Leverage, Business Cycles, and Crises
Oscar Jorda (University of California Davis), et al. | November 2011 (San Francisco Fed)
This paper studies the role of leverage in the business cycle. Based on a study of nearly 200 recession episodes in 14 advanced countries between 1870 and 2008, we document a new stylized fact of the modern business cycle: more credit-intensive booms tend to be followed by deeper recessions and slower recoveries. We find a close relationship between the rate of credit growth relative to GDP in the expansion phase and the severity of the subsequent recession. We use local projection methods to study how leverage impacts the behavior of key macroeconomic variables such as investment, lending, interest rates, and inflation. The effects of leverage are particularly pronounced in recessions that coincide with financial crises, but are also distinctly present in normal cycles. The stylized facts we uncover lend support to the idea that financial factors play an important role in the modern business cycle.
Confidence Matters for Nowcasting GDP: Euro Area and U.S. Evidence from a PMI-Based Model
Gabe De Bondt (ECB) and Stefano Schiaffi (Bocconi University) | November 17, 2011
This paper assesses the nowcasting performance of confidence in a one-equation model based on the Purchasing Managers Index (PMI). We look at the interactions between the PMI and confidence and the reasons why confidence affects real GDP growth besides the PMI. Moreover, we explain why our model fits euro area and US data differently. Finally, we test for a possible differential relevance of confidence across the business cycle using a smooth transition model. The results underline that confidence always matters in nowcasting the euro area and the US output, both in good and in bad times.
Skyscraper Height and the Business Cycle: International Time Series Evidence
Jason Barr (Rutgers), et al. | December 2011
This paper is the first to rigorously test how height and output co-move. Because builders can use their buildings for non-rational or non-pecuniary gains, it is widely believed that (a) the most severe forms of height competition occur near the business cycle peaks and (b) that extreme height are examples of developers “gone wild.” We find virtually no support for either of these popularly held claims. First we look at both the announcement and completion dates for record breaking buildings and find there is very little correlation with the business cycle. Second, cointegration and Granger causality tests show that height and output are cointegrated and that height does not Granger cause output. These results are robust for the United States, Canada, China and Hong Kong.
The behaviour of small cap vs. large cap stocks in recessions and recoveries: Empirical evidence for the United States and Canada
Lorne Switzer (Concordia University) | North American Journal of Economics and Finance (2010)
This paper examines the relative performance of small-caps vs. large caps surrounding periods of peaks and troughs of economic activity, and reexamines the relationship between the small firm anomaly and the business cycle. Small-cap firms outperform large caps over the year subsequent to an economic trough. In the year prior to the business cycle peak, however, small caps tend to lag. US style based large caps perform better over peaks, but there is no dominant category across size and book to market asset classes over troughs. The US small cap premium is related to default risk, although recessions per se do not on average impact on this premium. Default risk and the inflation risk differential between Canada and the US significantly impact on the Canada–US equity premium. Abnormal positive performance observed for US small caps in the recent (post 2001) period as well as for the long horizon is attributable to the small cap growth cohort. Canadian small firm stocks also exhibit significantly positive performance in the post 2001 period.
December 13, 2011
Since revisiting the Great Depression, its causes and consequences, seems to be in vogue again, it's only fitting that David Glasner reviews what we learned about the gold standard and "the worst economic catastrophe since the Black Death of the 14th century." It's an old lesson, or at least it should be. But relearning lessons is what macroeconomics is all about, or so it seems.
Without further ado, David Glasner...
Not only did Hayek make the wrong call about the gold standard, he actually defended the insane French policy of gold accumulation in his lament for the gold standard after Britain wisely disregarded his advice and left the gold standard in 1931...
So what do we learn from this depressing tale? Hawtrey and Cassel did everything right. They identified the danger to the world economy a decade in advance. They specified exactly the correct policy for avoiding the danger. Their policy was a huge success for about nine years until the Americans and the French between them drove the world economy into the Great Depression, just as Hawtrey and Cassel warned would happen if the monetary demand for gold was not held in check. Within a year and a half, both Hawtrey and Cassel concluded that recovery was no longer possible under the gold standard. And as countries, one by one, abandoned the gold standard, they began to recover just as Hawtrey and Cassel predicted. So one would have thought that Hawtrey and Cassel would have been acclaimed and celebrated far and wide as the most insightful, the most farsighted, the wisest, economists in the world. Yep, that’s what one would have thought. Did it happen? Not a chance. Instead, it was Keynes who was credited with figuring out how to end the Great Depression, even though there was almost nothing in the General Theory about the gold standard and a 30% deflation as the cause of the Great Depression, despite his having vilified Churchill in 1925 for rejoining the gold standard at the prewar parity when that decision was expected to cause a mere 10% deflation.
Slower But Still Growing Retail Sales In November
The pace of growth in retail sales slowed in November, but the overall trend was still up. We can debate the details of whether a lesser rate of growth is a sign of things to come, but if you’re looking for a smoking gun that screams recession you won’t find it in today’s update on consumer spending.
Seasonally adjusted retail sales rose 0.2% last month, the slowest rise since June and well below Bloomberg's consensus forecast of 0.6%. Some corners of retail reported lower sales on a monthly basis, but the generally rising trend is intact. Notably, the cyclically sensitive auto sector had another good run in November with auto sales up by a tidy 0.7%.
There’s some weakening in the year-over-year pace of retail sales, as the next chart shows. But a degree of downshifting has been expected for this series, which has been rising at an unsustainable pace for some time. Even so, the 6.7% annual rise through November is quite respectable in historical terms, and it’s worth noting that recessions aren’t linked with this level of consumption growth. That’s no guarantee that broad economic expansion will prevail, but the annual rise in retail suggests that the odds of an imminent downturn are still low.
The concern is that the slipping annual rate of growth in retail sales has legs. If so, at some point gravity is the enemy. But it’s too soon to say if we’re in the early stages of breakdown or just the usual statistical noise.
"Sales are growing, but they just aren’t accelerating," notes Ryan Wang, an economist at HSBC Securities. "There have been some real slight hints of improvement in the labor market, but until we get sustained growth in income, spending is going to be moderate."
Nonetheless, "I think we are still on track for a pretty decent holiday shopping season," predicts Mark Vitner, senior economist at Wells Fargo. The level of holiday sales "is still extremely, extremely strong."
Perhaps, but some dismal scientists remain wary in the current climate. MarketWatch reports:
Economists were expecting stronger sales in light of robust demand for automobiles and a record increase in spending during the Thanksgiving holiday weekend, which kicks off each year with the Black Friday shopping bonanza. Economists surveyed by MarketWatch expected retail sales to rise by 0.5% overall, or by 0.4% excluding the auto sector.
Peter Buchanan, an economist at CIBC World Markets, called retail sales a “fairly disappointing report” that could spur some firms to cut their estimates for fourth-quarter growth. The U.S. is projected to grow 3% in the final three months of 2011 based on the latest MarketWatch forecast.
Yes, many of us are prepared for discouraging news. Yet much of the economic updates lately have been mildly encouraging. Is there a disconnect between what's coming and what the numbers tell us? Will the stats be revised down? Is the euro crisis poised to explode and drag us down into recession after all? Or is the trend more resilient than many analysts recognize? These and other tantalizing questions will be answered, but not yet. Meantime, retail sales are softer, but there's still no sign of a downturn in the number du jour. Steady as she goes.
Another Partial Solution: Conditional Sharpe Ratio
“What this country needs is a good five-cent cigar,” Thomas Marshall (Woodrow Wilson's vice president) once remarked. Updating the quip for 21st century finance might run as follows: Investors need a good risk metric. Alas, what's needed and what's available isn't usually, if ever, one and the same in the money game. The next best thing is tapping several flawed metrics that are flawed in different ways.
Last week I discussed one "partial solution" in the search for an upgrade to the nearly 50-year-old Sharpe ratio, the widely used but flawed measure of quoting risk premiums (return less a risk-free rate) per unit of performance volatility (standard deviation). As many critics have charged over the years, standard deviation falls well short of the ideal definition of investment risk. So, too, does everything else.
One big challenge is modeling what's known as tail risk, or the possibility—the virtual inevitability—that investment losses will exceed expectations implied by a normal distribution. Last week's look at one attempt at trying to anticipate non-normality was the modified Sharpe ratio, which incorporates skewness and kurtosis into the calculation. Another possibility is the so-called conditional Sharpe ratio (CSR), which attempts to quantify the risk that an asset or portfolio will experience extreme losses.
To understand CSR it's necessary to start with so-called value at risk (VaR), the much maligned metric that was (and still is) widely used and widely abused. At its core, VaR tries to tell us what the possibility of loss is up to some confidence level, usually 95%. So, for instance, one might say that a certain portfolio is at risk of losing X% for 95% of the time. What about the remaining 5%? That's where the trouble lies, of course, and trying to model the last 5% (or 1% for a 99% confidence level) is devilishly hard. Some analysts say it's simply impossible. Misinformed or not, conditional VaR, or CVaR, dares to tread into this black hole of fat taildom. For the conditional Sharpe ratio, CVaR replaces standard deviation in the metric's denominator.
As a recent research paper from Ibbotson Associates explains,
CVaR is a comprehensive measure of the entire part of the tail that is being observed, and for many, the preferred measurement of downside risk. In contrast with CVaR, VaR is only a statement about one particular point on the distribution. Intuitively, CVaR is a more complete measure of risk relative to VaR and previous studies have shown that CVaR has more attractive properties (see for example, Rockafellar and Uryasev (2000) and Pflug (2000)).
The main question with CVaR is one of choosing a methodology for calculation. The standard approach—the parametric method—is to assume a normal distribution, in which case CVaR can be estimated with only three inputs: average (or expected) return, volatility, and a conventional assumption about distributions. Easy but fraught with caveats.
Fortunately, there are several alternative approaches for estimating CVaR. One is using Monte Carlo simulations, which come in a variety of flavors and assumptions. The basic version can be easily run in Excel. You can also estimate CVaR based on an historical sample. If, for instance, you were calculating tail risk for the S&P 500 through a CVaR prism, you would identify the extreme return outliers in the past and factor the data into your CVaR modeling. WIth a little bit of work in a spreadsheet, you can come up with a rough estimate fairly easily. More sophisticated analytics require programming in Matlab or R.
Readers at this point are probably wondering how much insight is offered in CVaR, and by extension the conditional Sharpe ratio. Probably less than its strongest advocates argue. The basic message in conditional Sharpe ratio, like that of its modified counterpart, is that investors underestimate risk by roughly a third (or more?) when looking only at standard deviation and related metrics. That's a critical message. The details get fuzzy once you move beyond that reasonable conclusion. One reason is that quantifying expected risk in the tail is a serious challenge and open to a fair amount of debate.
Indeed, you can't model uncertainty per se. Even when it comes to modeling the known unknowns it's still best to regularly repeat the following: no one risk measure can profile the true nature of risk in all its fury and variation. But we can try, if only to develop a deeper understanding of risk analytics' strengths and weaknesses. At some point, however, you're still flying blind.
December 12, 2011
Another Trip Down The Macro Memory Hole?
Ryan Avent at The Economist links to a new research paper citing "a remarkable lecture by economist Gustav Cassel, who is quoted as saying that the world's central banks should 'come together and make an end of the depression simply by declaring that they intend, from this moment on, to supply the world so abundantly with means of payment that no further fall in prices will be possible.'"
Cassel was ahead of his time, as the 1931 quote above reveals. Looking for a monetary policy response to severe economic contraction just wasn't in the cards in the thirties. But now we know better. In the 21st century, one could argue that the self-destructive decisions with monetary policy in the 1930s are now recognized for what they were: colossal errors. Countless research papers and books over the years provide the smoking guns (including the titles listed here and here, for instance). Case closed? Not quite. This is economics, after all. Consider Nobel prize-winning economist Joseph Stiglitz, who writes in the new issue of Vanity Fair:
The argument has been made that the Fed caused the Depression by tightening money, and if only the Fed back then had increased the money supply—in other words, had done what the Fed has done today—a full-blown Depression would likely have been averted. In economics, it’s difficult to test hypotheses with controlled experiments of the kind the hard sciences can conduct. But the inability of the monetary expansion to counteract this current recession should forever lay to rest the idea that monetary policy was the prime culprit in the 1930s.
There's no such thing as consensus in macroeconomics, but it seemed as though a majority of dismal scientists were of the persuasion that the Fed screwed up in the early 1930s. In fact, there's plenty of collective blame to go around among the world's major central banks in the years leading up to and during the Great Depression. But what appears as settled terrain is only a temporary respite in matters of macro analysis. Perhaps that's why progress in economics appears to be cyclical rather than cumulative. It's hard to move forward when we keep fighting (and refighting) old battles. Then again, the clash of ideas and keeping the debate rolling is an ancient sport in the profession. The more things change...
The Irrepressible Scott Sumner Does It Again
There's a reason why Scott Sumner is one of the most influential economists in the post-crisis era. Actually, there are many reasons, as his must-read blog posts in recent years demonstrate. No one does a better job of explaining monetary policy, or pointing out how so many otherwise intelligent folks stumble on this crucial subject. He has a knack for explaining what should be clear but isn't. He soon remedies any confusion, and he pulls it off by making his observations appear like revelations. But often he's simply telling it like it is. But sometimes the clear, unvarnished truth can be revolutionary and more than slightly refreshing. Judge for yourself. Here's his latest... yet another classic:
Here’s a typical AP story:
The boldest move left would be a third round of large-scale purchases of Treasurys. But critics say this would raise the risk of future inflation. And many doubt it would help much, because Treasury yields are already near historic lows.
Let’s play around with this story. How else could we convey the information:
The boldest move left would be a third round of large-scale purchases of Treasurys. But critics say this would raise aggregate demand. And many doubt it would raise aggregate demand, because Treasury yields are already near historic lows.
But then the conjunction “and” would be bad grammar. You’d want to say “on the other hand.” How about this:
The boldest move left would be a third round of large-scale purchases of Treasurys. Supporters say this would raise expectations of future inflation, and lower real interest rates. And many doubt it would help much, because Treasury yields are already near historic lows.
Again the “and” is wrong, because if it does raise inflation expectations then the liquidity trap argument is bogus. And how about fiscal policy:
The boldest move left for Congress would be a payroll tax cut. But critics say this would raise the risk of future inflation. And many doubt it would help much, because workers would simply save the tax cuts.
Of course one never sees reporters talk this way. Never. Not once. One never sees reporters discuss both monetary and fiscal policy from the perspective of the standard AS/AD model, where monetary and fiscal stimulus are just two ways of boosting AD. No, they seem to have some other model in their minds. What is that model? Your guess is as good as mine. It’s not new or old Keynesian. It’s not new classical or RBC. It’s not Austrian or monetarist or MMT. But it has become the standard model for talking about stimulus.
Am I being picky here? Surely a bit of confused reasoning in the press would not actually impact important policy decisions involving $100s of billions of dollars. OK, so some reporters don’t understand that fiscal stimulus is just as inflationary as monetary stimulus. It’s not like you see the GOP leadership bashing the Fed for even thinking about providing additional monetary stimulus at zero cost to the budget, and then weeks later turning around and signalling an intention to massively cut payroll taxes.
Oh wait . . .
Technical Messages From The S&P 500
Does the stock market have a momentum problem? Yes, according to a number of market technicians, the folks who study the price charts for signs of things to come. The primary clue is the S&P 500's recent history vis-à-vis its 200-day moving average, which is widely monitored by professional chart readers.
Chartists point to the resistance level of recent weeks represented by the 200-day average. Three times since late-October the market has tried and failed to rally above this level and hold its ground. Last week was another attempt, with the S&P 500 trading just under the 200-day moving average. The continued failure of the market to convincingly pierce its 200-day average would send a bearish signal and raise questions about the recent rally, technicians warn.
Is the 200-day moving average a fail-safe signal of the future? No, but its history is strong enough to take it seriously as one of several indicators for developing intuition about expected return. Yet "no major university offers comprehensive professional instruction in market technical analysis," notes Kent Osband in his recent book Pandora's Risk: Uncertainty at the Core of Finance.
Perhaps that's set to change. There seems to be a renaissance in reconsidering technical analysis signals generally as predictors. A recent academic study reports that a "moving average timing strategy of technical analysis to portfolios sorted by volatility generates investment timing portfolios that often outperform the buy-and-hold strategy substantially," a finding that the authors label a "new anomaly."
Actually, it's not so new, but it may be timely in the final trading sessions of 2011. Bespoke Investment Group advises on Friday after the market's close:
After three straight days of trading above but then closing below its 200-day moving average, the S&P 500 had its worst day of the week yesterday and closed down 2.1%. So with three straight failed attempts, is the market set up for a big let down?
Since the mid 1980s, there have only been four other times where the S&P 500 had a similar pattern of trading above its 200-day moving average on three consecutive days, but then closing below that level on all three days.
Not so fast, counters RBC technical analyst Robert Sluymer via The Wall Street Journal. He thinks it's too early to give up hope:
Short-term trading indicators, tracking 2-4+ weeks shifts, have moved up from deeply oversold levels established at the end of November, but they have not yet reached overbought levels normally associated with a new corrective phase. Daily momentum indicators…suggest it is premature to conclude the rally is aborting and that another 1-2 weeks of recovery cannot be ruled out yet.
But with so much uncertainty still swirling about over the ongoing euro crisis and the debate about the state of the U.S. economy, Sluymer's optimism may fall on deaf ears until, or if, the S&P 500 tells us otherwise via price in context with the 200-day average.
December 10, 2011
Book Bits For Saturday: 12.10.2011
● The Number That Killed Us: A Story of Modern Banking, Flawed Mathematics, and a Big Financial Crisis
By Pablo Triana
Excerpt via publisher, Wiley
In its very prominent role as market risk measure around trading floors and, especially, the tool behind the determination of bank regulatory capital requirements for trading positions, VaR [value at risk] decisively aided and abetted the massive buildup of high-stakes positions by investment banks. VaR said that those punts, together with many other trading plays, were negligibly risky thus excusing their accumulation (any skeptical voice inside the banks could be silenced by the very low loss estimates churned out from the glorified model) as well as making them permissibly affordable (as the model concluded that very little capital was needed to support those market plays). Without those unrealistically insignificant risk estimates, the securities that sank the banks and unleashed the crisis would most likely not have been accumulated in such a vicious fashion, as the gambles would not have been internally authorized and, most critically, would have been impossibly expensive capital-wise.
● Six Myths that Hold Back America: And What America Can Learn from the Growth of China's Economy
By Frank Newman
Q&A with author via Forbes
Q: What about the currency issue? The currency has strengthened over the last several years, yet our trade deficit with China keeps getting larger. Washington still seems to think that if China would only strengthen the renmimbi faster, the deficit will balance out.
A: They’re wrong. The U.S. has to get China to buy more stuff from us, but there’s a lot of bureaucratic problems involved in that, such as intellectual property rights, for example. It’s improving. Our exports to China are increasing.
Q: China isn’t going to listen to a word Washington says about its currency, right?
A: They are not going to do anything to ever look like they are succumbing to foreign pressure. Ever. Period. Consider this, why would China want to put the value of the renmimbi in the hands of the market when in their view — and this is not hard to understand — the market has mispriced assets consistently over the last several years. Is the market really that brilliant? Their record on pricing currency and derivatives is abysmal. Look where the mortgage backed derivatives crisis took us in 2008.
● The Greatest Crash: How Contradictory Policies are Sinking the Global Economy
By David Kauders
Review via Learning From The Dogs
Back in the late 90s, when I was living in England, I attempted to bolster my self-employed income by investing and trading in equities. It was a frustrating game, game being the right word! One day I was lamenting this to a close friend and he gave me the name of David Kauders at Kauders Portfolio Management and suggested I might like to contact him. I followed my friend’s recommendation and met with David. What he outlined at that meeting all those years ago was mind-blowing, no other way of putting it. Essentially, David predicted a financial and economic crisis of huge proportions. He convinced me of the likelihood of that crisis and in November 2001 I became a fee-paying client. As the world now knows that prediction came to fruition... The book, released in paperback in England in October 2011, published by Sparkling Books, is subtitled ‘How contradictory policies are sinking the global economy‘. Frankly, that subtitle doesn’t do much for me. A clearer message that comes from the book is this: the economic world has reached a ‘systems limit’.
● The Delusions of Economics: The Misguided Certainties of a Hazardous Science
By Gilbert Rist
Summary via publisher, Zed Books
In The Delusions of Economics, Gilbert Rist presents a radical critique of neoclassical economics from a social and historical perspective. Rather than enter into existing debates between different orthodoxies, Rist instead explores the circumstances that prevailed when economics was 'invented', and the resultant biases that helped forge the construction of economics as a 'science'. In doing so, Rist demonstrates how these various presuppositions are either obsolete or just plain wrong, and that traditional economics is largely based on irrational convictions that are difficult to debunk due to their 'religious' nature. As a result, we are prevented from properly understanding the world around us and dealing with the financial, environmental, and climatic crises that lie ahead.
● Acts of God and Man: Ruminations on Risk and Insurance
By Michael Powers
Summary via publisher, Columbia University Press
Much has been written about the ups and downs of financial markets, from the lure of prosperity to the despair of crises. Yet a more fundamental and pernicious source of uncertainty exists in today's world: the traditional “insurance” risks of earthquakes, storms, terrorist attacks, and other disasters. Insightfully exploring these "acts of God and man," Michael R. Powers guides readers through the methods available for identifying and measuring such risks, financing their consequences, and forecasting their future behavior within the limits of science. A distinctive characteristic of earthquakes, hurricanes, bombings, and other insurance risks is that they impact the values of stocks, bonds, commodities, and other market-based financial products, while remaining largely unaffected by or “aloof” from the behavior of markets. Quantifying such risks given limited data is difficult yet crucial for achieving the financing objectives of insurance.
December 9, 2011
ECRI's Weekly Leading Index Rises To 13-Week High
The Economic Cycle Research Institute’s weekly leading index jumped last week to its highest level since September 9, the consultancy reports. Nonetheless, the self-proclaimed “leading authority on business cycles” continues to forecast a recession for the U.S., as ECRI’s co-founder, Lakshman Achuthan, explained yesterday on Bloomberg TV.
If macro trouble awaits, you wouldn't know it by looking at the latest measure of sentiment among Joe Sixpack and friends. The Thomson Reuters/University of Michigan preliminary index of consumer sentiment increased to a six-month high. Optimists will be quick to note that there's more than one study that links consumer sentiment readings with consumption. But Paul Dales of Capital Economics warns not to read too much into the rise. "U.S. consumers appear to be ending the year in a better mood," he says. "Although the recent increase may provide that little bit of support to spending in the malls in the coming weeks, it won't lead to a long and lasting acceleration in consumption growth."
Still, it's tempting to wonder if the recent slump in momentum is passing. Or is the uptick that's now also reflected in ECRI's weekly index nothing more than a temporary flirtation with growth?
One reason for staying cautious is the precarious state of Europe, which increasingly looks destined for a new recession. “Fiscal tightening plus credit tightening and the confidence impact of the sovereign crisis point to recession” in Europe, predicts Sarah Hewin, an economist at Standard Chartered Bank. Indeed, some corners of Europe have already succumbed to the Continental pressures of austerity. The R word is also being applied to other economies around the world, including Brazil, which witnessed a slight contraction in its third-quarter GDP.
The U.S. is at risk of getting sucked into the cyclical vortex, warns New York University economist Nouriel Roubini. If so, the statistical smoking guns will be here soon, or so one would think. But not yet. The numbers for the American economy don't yet look convincingly threatening. There is, of course, always next week.
Can We Trust The Moderate Growth Forecasts?
Another day, another economic forecast. The 35 economists polled for the latest Livingston Survey via the Philadelphia Fed project that real GDP for the U.S. will grow at an annualized 2.5% rate for the second half of 2011. That's down from June's 3.2% second-half 2011 forecast. Down, but still not out.
Looking ahead to 2012, the Livingston survey forecasters "see the growth rate of economic output slowing to 2.1 percent (annual rate) in the first half of 2012, and they predict that it will then increase to 2.5 percent (annual rate) in the second half of the year." The economists also expect "a slow recovery in the labor market, with the unemployment rate at 9.0 percent in December 2011 and at 8.9 percent in June 2012." Those unemployment predictions are up slightly relative to the June forecast.
The case for more optimism, or not, surely depends heavily on how the labor market fares. Yesterday's weekly update on jobless claims provides a boost for optimism, courtesy of the substantial fall last week in new filings for jobless benefits. What's needed now is supporting evidence that this was more than a statistical quirk. While we wait for fresh data, anecdotal reports from individual state economies suggest that growth may endure. For instance, consider these recent news items:
• More workers will find jobs, employees will get raises and modest homes could increase slightly in value in South Carolina next year, according to economists at USC. But the economic recovery will remain fragile, according to Darla Moore School of Business economists Doug Woodward and Joey Von Nessen, who spoke Wednesday at the university’s annual economic outlook conference.
• Utah's economic forecast is improving, albeit slower than many would like, according to a national economic analyst. Anthony Chan, chief economist for J.P. Morgan Chase Wealth Management, told an audience of about 300 people that Utah has made "good progress" on the employment front, with lower unemployment than the national average.
The California analysis comes via the UCLA Anderson Forecast, which projects that the U.S. economy will grow at an annualized real 2% pace in the fourth-quarter of this year but at a "sub-2% growth rate for most of 2012." In other words, the odds of a new recession appear to be receding, although the confidence for seeing the glass half full isn't particularly strong.
Forecasts are made to be broken, of course. Reality is never quite what it seems until it arrives. What events might conspire to knock moderate expectations off the pedestal? Take your pick—the possibilities are, unfortunately, quite extensive these days. One risk that's surely on the short list for monitoring is the potential blowback for emerging markets from the various ills infecting the developed world. International Monetary Fund deputy managing director Min Zhu, in a speech today, explains:
Major advanced economies seem to have entered a vicious cycle of weak economic activity, financial distress, and high public debt and deficits. Emerging economies, by contrast, show stronger fundamentals that have underpinned global economic growth so far. But these economies are not immune. In fact, vulnerabilities are increasing, and potential spillovers from advanced economies are weakening their economic outlook. It is not surprising that many Asian policymakers have publicly warned about growing downside risks and have begun to adjust their policy stances.
The good news is that the U.S. economy seems to be holding the line against the forces of contraction. But expectations have been raised. Meanwhile, it's not yet clear that the moderate calls for growth of late will find support in the upcoming economic updates.
In fact, it's best to brace yourself for trouble, warns Lakshman Achuthan of Economic Cycle Research Institute. In an interview with Bloomberg yesterday, he repeated his September recession prediction for the U.S. How can the economy be slipping into a new downturn in the wake of recent improvement in some economic news? Achuthan makes his case here.
December 8, 2011
Jobless Claims Drop To 9-Month Low
The numbers speak loud and clear in today’s weekly update of new jobless claims. New filings for unemployment benefits dropped a hefty 23,000 to a seasonally adjusted 381,000 last week. That’s just what's needed at this juncture to keep cyclical optimism alive and humming.
Indeed, this is the biggest weekly drop in new filings since late September. That brings the total of new claims down to the the lowest level since late-February. It could all evaporate next week and beyond, of course, but here and now the numbers look quite compelling. And momentum counts for something. Fortunately, it seems to be in our favor for this series. The four-week moving average is clearly falling right along with the weekly numbers.
Inevitably we’ll see some reversal in the weeks ahead. These numbers bounce around more than most. But if the trend can at least hold its ground if not make further improvements through the end of the year and in early 2012, it’s going to get a lot rougher to argue that a new recession is coming. Yes, we’ll need to see some confirmation in other economic reports, but the revival in growth momentum that’s been conspicuous in a number of data series just received a strong vote of support with today’s claims update.
The reasoning here is that if the economy’s slipping, we'd see clues in new jobless claims. On that point, the trend speaks for itself. There’s always a danger of reading too much into one batch of numbers, but it’s hard not to notice that new claims have a decent record of dropping warning signs of things to come with the macro trend. The spring spike in claims, for instance, was a harbinger of the summer slump. It’s not unreasonable to wonder if the recent slide under the 400k mark is a sign of better times.
"It looks as if the U.S. labor market does not know how to spell the word euro contagion," says Cary Leahey at Decision Economics. "This is a good report ... adds to the sense that the job market continues to brighten, though very slowly."
Brian Jones, a senior U.S. economist Societe Generale, agrees but says there may be a joker in the deck just the same. "The labor market is improving. The numbers are moving in the right direction. You have to be careful because we’re around the Thanksgiving holiday and the Department of Labor has a hard time adjusting around floating holidays."
We'll have more context next week for deciding how hard that adjustment will be. November readings on retail sales are scheduled for release on Tuesday (Dec. 13) and industrial production on Thursday (Dec. 15). And, of course, another weekly update on new claims arrives next week as well. Meantime, it feels like there's a tailwind blowing.
Labor Market Data Revisions Look Encouraging
The case for seeing a new recession on the horizon for the U.S. looks a bit less compelling these days in the wake of moderately stronger economic reports, but some analysts remain unconvinced that growth will prevail. On the front line of this debate is the Conference Board's leading indicator, which paints a relatively encouraging cyclical outlook, based on its latest monthly update. In the opposing camp is the Economic Cycle Research Institute, which continues to stand by its September 30 forecast that the U.S. is destined for a new downturn. The latest update to ECRI's weekly leading indicator slipped again for the week through November 25, which leaves it roughly unchanged since the end of September.
Perhaps the strongest statistical evidence for doubting ECRI's recession call is the labor market. Private nonfarm payrolls continue to rise, which implies that the odds of a new recession are low. The last full month of economic data (October) is also encouraging. Still, there's lots of uncertainty in a world brimming with trouble and so confidence is low that today's modest growth will prevail.
In the current climate, the search for additional clues knows no bounds. If it turns out that the cycle is tipping over to the dark side, there's a case for thinking that we'll see some evidence in the labor market sooner or later. Later today we'll learn of the latest data point for weekly initial jobless claims, one of the more reliable leading indicators. For now, consider how revisions to this indicator, along with nonfarm payrolls, compare in recent history.
First, some context. Most economic reports are revised one or more times after the initial release. An economy that's strengthening, or at least holding its own, is likely to see bullish revisions. Meanwhile, if the economy is weakening or in recession, the revisions are likely to reflect a weakening trend. With that in mind, let's consider how revisions compare for two measures of the labor market.
First up is private nonfarm payrolls. As the chart below shows, the trend seems to be our friend. The net change in monthly revisions, based on the current revision less the initially reported number through time, has been consistently positive since May. For the first time since the recession was formally declared at an end as of June 2009, revisions have been positive on a sustained basis. The positive revisions are still relative low by historical standards, but if this trend persists—and strengthens—it provides the optimists with one more reason to think positively.
The vintage data for weekly claims maintained by the St. Louis Fed only goes back to 2009, but the limited history for revisions is starting to look encouraging here as well. Since we're talking about new filings for unemployment benefits, downward revisions are a sign of improvement vs. the upward revisions we're looking for with payrolls. The good news is that weekly claims revisions appear set to dip below zero for the first time in nearly a year.
Revisions alone don't tell you much about the business cycle. But in context with a broader review of indicators, there's still a case for anticipating continued growth in the economy.
December 7, 2011
The market's implied inflation forecast continues to hover around the 2% mark, based on the yield spread between the nominal and inflation-indexed 10-year Treasuries. That's a sign that the crowd is feeling relatively optimistic about the economy's prospects. In the New Abnormal, lower inflation expectations are a sign of trouble. The fact that inflation expectations appear to be stabilizing is an encouraging sign... if we can keep it.
The bar was set pretty low, of course. Expectations have been quite dim in recent months for a resolution of the eurozone crisis, to cite one challenge. Meanwhile, prospects for the U.S. economy looked increasingly soft through the summer and early fall. But things are looking up, or at least they're no longer looking down, which is reflected in the market's inflation outlook.
Is this the calm before the storm? No one really knows, in part because so much depends on political decisions—here and abroad. In Europe, leaders are scheduled to hammer out another agreement tomorrow on solving the debt crisis. Hope springs eternal. The "solution," according to some, is imposing more fiscal austerity on the Continent's economies. There's already quite a bit of that blowing through Europe, but the German push for more appears to have the upper hand. For good or ill, tighter fiscal policies appear likely.
A number of analysts take a pessimistic view of the unfolding events in Europe. Austerity in a time of severe economic stress is thought to be exactly the wrong policy. "Public-sector cutbacks today do not solve the problem of yesterday’s profligacy," warns economist Joseph Stiglitz. "They simply push economies into deeper recessions.
Here in the U.S., there's a surplus of uncertainty about what happens next with the budget negotiations in Washington and how the outcome will affect the latest revival in economic momentum. "The problem heading into 2012," writes James Cooper at the Fiscal Times,
is the fiscal drag on economic growth from expiring stimulus programs, including the last vestiges of the 2009 Recovery Act and this year’s temporary stimulus from the cut in payroll taxes and extension of unemployment benefits. Economists at J.P. Morgan estimate that, if all these programs expire on Dec. 31, as scheduled, the total fiscal drag on real GDP growth in the first half of 2012 would add up to 2.6 percentage points on the average annualized growth rate of GDP, with the biggest hit in the first quarter.
Nonetheless, the crowd is feeling better these days. U.S. stocks have rallied in recent sessions and the year-over-year change in the S&P 500 is positive once more, if only slightly. Recession risk doesn't appear to be getting any worse, although it's not yet clear if it's receding for the U.S.
Europe, however, continues to falter. Italy's economy in particular seems to have already fallen to the dark side of the cycle.
We're in a transition once more. But transitioning to what?
December 6, 2011
Modified Sharpe Ratio: A Partial Solution?
The problem of fat tails is everywhere in risk analysis. It’s a big issue, but there’s no easy solution. There are, however, lots of partial solutions. Each comes with its own set of pros and cons, which implies that the practical strategy for dealing with the messy but essential issues related to measuring and managing risk starts with the iron rule to never, ever rely on one risk metric.
The good news is that there’s a small library of risk measures. (A useful reference can be found in a number of finance books, including Carl Bacon’s Practical portfolio performance: measurement and attribution.) But the wide selection is also the bad news. How does one sort through the possibilities? Ah, that could take a while. It seems reasonable to start with the usual suspects, such as volatility, Sharpe ratio, Treynor ratio, beta, to name but a few, and carefully expand your list from there. All of the standard metrics have well-known flaws. That doesn’t make them worthless, but it’s a reminder that we must understand where any one risk measure stumbles; where it can provide insight; and what are the possible fixes, if any.
One of the challenges with adding a new risk metric to your analytical toolbox is deciding how much reality to embrace with the methodology while keeping applications practical. Modeling fat tails and known unknowns in detail is wickedly complex (the unknown unknowns are beyond the ken of mortal minds). As such, one has to be wary of falling down the black hole of time consumption. Compromise inevitably rolls into the picture and so one question that keeps popping up: How does one balance the need for parsimony in risk measurement with the goal of recognizing that market returns aren’t normally distributed? There are a number of intriguing risk gauges that straddle these two competing interests, and one that’s worth considering is known as the modified Sharpe ratio (MSR).
The standard Sharpe ratio (SR) is simply the risk premium of an asset or asset class (total return less the risk free rate) divided by its volatility (standard deviation). This is the original risk metric in financial economics, dating to the 1960s, when it was originally proposed by Professor Sharpe. Its chief flaw, as many analysts have discussed over the years, is that it uses standard deviation as a proxy for risk. That's a problem because standard deviation works best with normal distributions. Standard deviation has some validity over long periods of time, but in the short run normality can fly out the window pretty quickly. The bottom line: extreme losses occur more frequently than you’d expect when assuming that price changes are always and forever random (i.e., distributed normally).
Enter MSR, which is one of several attempts to ameliorate standard deviation’s limitations. MSR is far from a complete solution, but its intriguing nonetheless because it factors in two aspects of non-normal distributions: skewness and kurtosis. MSR’s nod to skewness and kurtosis is through the use of what’s known as a modified Value at Risk measure (MVaR) as the denominator. Laurent Favre and Andreas Signer outlined the process in a 2002 paper, explaining:
If returns are not distributed normally, a simple VaR model can no longer be used, so another method is required to calculate the VaR. One option is the so-called Cornish-Fisher expansion, which can adjust the VaR in terms of asymmetric distribution (skewness) and above-average frequency of earnings at both ends of the distribution (kurtosis). This method of calculating the VaR is hereinafter referred to as modified VaR.
MVaR makes some compromises relative to other adjustment methodologies for VaR, of which there are several. Even so, it’s a step in the right direction and since it’s relatively easy to compute in Excel it’s certainly worthwhile as one of several ways to quantify risk beyond the standard metrics. For some perspective, consider how the modified Share ratio compares with simple volatility and the standard Sharpe ratio for four asset classes via proxy indices over the past 10 years:
Note that in all cases the modified Sharpe ratio is lower than its traditional Sharpe ratio counterpart. The message is that for the past decade, risk-adjusted returns are lower than it appears after adjusting for skewness and kurtosis. Keep in mind that when we look at shorter-term rolling measures of MSR vs. the conventional SR—rolling 3-year measures, for instance—there tends to be more fluctuation with MSR. Depending on the time period, MSR may be higher or lower by more than trivial amounts compared with its standard counterpart. Why? Because MSR has higher sensitivity to changes in non-normal distributions whereas the standard SR is immune to those influences.
The modified Sharpe ratio is hardly a perfect solution for solving the fat-tails measurement challenge. But given MSR’s relatively easy calculation, combined with its greater sensitivity to non-normal distributions, it's a compelling addition for risk analytics. It's not going to solve all our risk measurement problems, but no other risk metric alone is up to that task either. But MSR can and arguably should be part of the solution.
Research Review | 12.6.2011 | Market Timing & Risk Management
A Risk Based Approach to Tactical Asset Allocation
Stefano Colucci and Dario Brandolini (Symphonia Sgr) | November 28, 2011
Faber’s 'A Quantitative Approach to Tactical Asset Allocation' (2009) proposes the use of a very simple trading rule to improve the risk-adjusted returns across various asset classes. The purpose of this paper is to present an alternative and simple quantitative risk based portfolio management that improves the risk-adjusted portfolio returns across various asset classes. This approach, based on the conclusions of Brandolini D. – Colucci S. 'Backtesting Value-at-Risk: A comparison between Filtered Bootstrap and Historical Simulation', has been tested since 1974 for calibration and since 2000 in a real backtest. The asset allocation framework is using a combination of indices, including the Standard&Poors 500, Topix, Dax, MSCI United Kingdom, MSCI France, Italy Comit Globale, MSCI Canada, MSCI Emerging Markets , RJ/CRB, Merril Lynch U.S. Treasuries, 7-10 Yrs , and all indices are expressed in US Dollar. Since 2000 the empirical results present equity-like returns with lower volatility and drawdown and only one negative year both in gross and net of costs returns.
How Expected Shortfall Can Simplify the Equally-Weighted Risk Contribution Portfolio
Stefano Colucci (Symphonia Sgr) | November 26, 2011
In recent years both equity and bond markets have been afflicted by high volatility. In order to build up a conservative portfolio several models may be used, such as minimum variance portfolio or equally weighted portfolio. In 2008/09 another way to deal with diversification came up, that is equally-weighted risk contribution portfolio. This kind of procedure leads not to equalize the portfolio weights but the risk weights. The only thing to understand is how we can measure risk. While many authors focus on volatility, in this paper we shall present an alternative and coherent risk measure, that is Expected Shortfall estimated by Filtered Bootstrap Approach. We shall show how to use the ES properties to derive an easy way to equalize risk contribution, and we shall also present some empirical examples using different models. A model presented in S. Colucci, D. Brandolini "A Risk Based Approach to Tactical Asset Allocation" to compare results will also be introduced. In the end, the empirical result will show that ERC portfolio, ES Stable portfolio and minimum variance portfolio have roughly speaking the same performance risk and distribution, but if turnover and its costs are taken into account, the result changes in favor of ES Stable.
Time-Varying Fund Manager Skill
Marcin T. Kacperczyk (NY University), et al. | November 15, 2011
Mutual fund managers can outperform the market by picking stocks or timing the market successfully. Previous work has estimated picking and timing skill, assuming that each manager is endowed with a fixed amount of each and found some evidence of picking skills and little evidence of timing skills among successful managers. This paper estimates skill separately in booms and recessions and finds that the extent to which managers focus on stock picking or market timing fluctuates with the state of the economy. Stock picking is more prevalent in booms, while market timing dominates in recessions. We use this finding to develop a new methodology for detecting managerial skill. The results suggest that some but not all managers have skill. We describe the characteristics of the skilled managers and show that skilled managers significantly outperform the market.
Managing Sovereign Credit Risk in Bond Portfolios
Benjamin Bruder (Lyxor Asset Management), et al. | October 2011
With the recent development of the European debt crisis, traditional index bond management has been severely called into question. We focus here on the risk issues raised by the classical market-capitalization weighting scheme. We propose an approach to properly measure sovereign credit risk in a fixed-income portfolio. For that, we assume that CDS spreads follow a SABR process and we derive a sovereign credit risk measure based on CDS spreads and duration of portfolio bonds. We then consider two alternative weighting methods which are fundamental indexation and risk-based indexation. Fundamental indexation is based on GDP indexation whereas risk-based indexation uses a risk-budgeting approach based on our sovereign credit risk measure. We then compare all these methods in terms of risk, diversification and performance. We show that the risk-budgeting approach is the most appropriate scheme to manage sovereign risk in bond portfolios and gives very appealing results with respect to active management of bond portfolios.
Time-Varying Sharpe Ratios and Market Timing
Yi Tang (Fordham University) and Robert Whitelaw (NY University) | August 31, 2011
This paper documents predictable time-variation in stock market Sharpe ratios. Predetermined financial variables are used to estimate both the conditional mean and volatility of equity returns, and these moments are combined to estimate the conditional Sharpe ratio, or the Sharpe ratio is estimated directly as a linear function of these same variables. In sample, estimated conditional Sharpe ratios show substantial time-variation that coincides with the phases of the business cycle. Generally, Sharpe ratios are low at the peak of the cycle and high at the trough. In an out-of-sample analysis, using 10-year rolling regressions, relatively naive market-timing strategies that exploit this predictability can identify periods with Sharpe ratios more than 45% larger than the full sample value. In spite of the well-known predictability of volatility and the more controversial forecast-ability of returns, it is the latter factor that accounts primarily for both the in-sample and out-of-sample results.
The Joint Dynamics of Equity Market Factors
Peter Christoffersen (University of Toronto) and Hugues Langlois (McGill University) | September 2011
The four equity market factors from Fama and French (1993) and Carhart (1997) are pervasive in academic empirical asset pricing studies and in applied portfolio allocation. However, the joint distributional dynamics of the factors are rarely studied. For investors basing strategies on the factors or using them to model the returns of a wider set of assets, proper risk management requires knowing the joint factor dynamics which we model. We find striking evidence of asymmetric tail dependence across the factors. While the linear factor correlations are small and even negative, the extreme correlations are large and positive, so that the linear correlations drastically overstate the benefits of diversification across the factors. We model the nonlinear factor dependence and explore its economic importance in a portfolio allocation experiment which shows that significant economic value is earned when acknowledging the nonlinear dependence.
December 5, 2011
Putting A Price On Investment Strategies
How much should you pay for asset management? It's a question that comes up routinely in my travels in finance. There's no standard answer, but most investors (and institutions) should err on the side of caution when it comes to paying hefty fees. The world is awash in claims of success for adding value over investment benchmarks, but comparing audited results with passive indices and/or simple rebalancing strategies begs to differ. Even before adjusting for taxes and trading costs, truly superior active management is a rare bird.
Unconvinced? Here's a simple test. Take a look at a two-year chart for Vanguard Total Stock Market (VTI) and Vanguard Total Bond Market (BND) on Yahoo Finance. VTI, which tracks a broad measure of U.S. stocks, is up around 15%; its U.S. bond counterpart, BND, is higher by roughly 5% (returns as of Dec. 2, 2011). If your portfolio's return for the last two years is inside those performance bands, it's a sign that maybe your strategy delivers less than it appears and/or you shouldn't be paying much for the strategy. Yes, some investors have returns north of 15%, perhaps far higher. But that begs the question: What risks did they incur to get there? It's no great shock to find that you could have earned far higher returns for assuming greater risks. The challenge, of course, is generating strong returns while keeping a lid on risk. History reminds that that's a much tougher trick to pull off.
Granted, the above test is hardly the last word on portfolio attribution analysis. But I'm guessing that a large number of investors, perhaps a majority, earned returns within the 5%-to-15% range since December 2009. Ditto for the vast majority of multi-asset class products available as ETFs and mutual funds. Adding value over a relevant benchmark is tough within a given asset class, and it's no easier for multi-asset class strategies either, as I recently discussed.
Consider the record for big-cap equities. Tom Lauricella in The Wall Street Journal today reports that "over the past 15 years, 42% of large-cap stock funds have posted better annualized returns than the S&P 500, according to Morningstar Inc." That may sound like an invitation to dive head first into active trading (or buying a fund that seeks to beat the market). But the 42% tally overstates the case. "The odds are actually much, much worse for investors," Lauricella continues.
That's because fund companies shut down poor performers, removing the lousy track records of their managers from the public eye—but not the damage from investors' accounts. What results is so-called survivorship bias.
For example, as of September, fund companies had merged or liquidated 41% of the large-cap stock funds that were in the bottom 25% of the group between September 2001 and September 2006. That's according to statistics compiled by S&P, using a database from the University of Chicago that eliminates the survivorship bias.
Going back another five years, 42% of the funds that had been in the bottom 25% for the five-year period of June 1996 through June 2001 no longer existed five years later.
Meanwhile, just because a fund survives and does well for a period of time doesn't mean the odds are in favor of it continuing to outperform. Just 12% of the large-cap funds that landed in the top 25% in that 2001-2006 period also landed in the top 25% over the subsequent five years, according to S&P.
Here's an even grimmer statistic: Over the five years ended September 2011, only 6% of all U.S. stock funds held onto a top-half ranking for five straight 12-month periods.
The numbers, of course, vary for each of the major asset classes, but the basic lesson is unchanged. It's really, really tough to generate positive alpha over time. All the usual suspects conspire against the best-laid plans of active investors, including higher trading costs and taxes.
More generally, it's hard to see around corners. To take the obvious example: How many times have you heard that the bond market was in a bubble over the last year or two? Quite a bit, by my reckoning. Yet bond prices have continued to push higher, Treasuries in particular. The market can stay irrational for longer than most of us can stay solvent, a lesson that even the bond king himself—Bill Gross of Pimco—learned the hard way this year.
The main lesson is that you shouldn't pay a lot for beta. True for individual asset classes, true for multi-asset class strategies. Over the last three years, my proprietary, unmanaged, market-value weighted benchmark of all the major asset classes—the Global Market Index—generated an annualized total return of 11.8% through the end of November 2011. You can replicate GMI for under 50 basis points with ETFs. Clearly, no one should be paying 100 or 200 basis points for this strategy or anything that resembles it. So, how much should you pay a manager to oversee your money? Or an asset allocation fund? Probably a lot less than what most folks (and institutions) end up paying.
Don't misunderstand: I'm not arguing that asset allocation strategies should be passive. Indeed, as I discussed in my book, Dynamic Asset Allocation, the academic literature and the empirical record make a strong case for some degree of active management of the asset mix. But we should be careful lest we go too far down this road, as some basic strategy benchmarks remind. The threat of diminishing returns rises quickly in this arena.
For instance, a simple year-end rebalancing of GMI has a history of boosting returns by 50 to 100 basis points a year with comparable (if not lower) levels of volatility. Meanwhile, equally weighting the major asset classes and returning the portfolio to equal weights every December 31 does even better. A number of products charging high fees are effectively repackaging these basic strategies and gouging investors in the process.
The idea that you can do quite well by diversifying across asset classes and applying some simple risk-management techniques like rebalancing is hardly a secret. For example, take a look at the competitive results of Paul Farrell's Lazy Portfolios.
Yes, you can do better with more active and "sophisticated" strategies. The reality is that that most investors stumble with trying to outsmart the market through time. But the hopeless hope that everyone can be above-average persists in money management. In no other industry is so much empirical evidence ignored. No wonder that most of the finance industry's customers have such a hard time locating their yachts.
December 4, 2011
Is There A Doctor In The House?
Contrary to conventional wisdom, the euro crisis was NOT triggered by runaway spending, Dean Baker reminds. It follows, then, that monetary policy—NOT fiscal policy—is the solution, as Ambrose Evans-Pritchard explains. Instead, the politicians are, of course, pushing for a political solution engineered by Germany. "For the third time in less than twenty years, Germany is trying to force down the throat of Europe a federal 'political union' which, in the eyes of too many European observers, eerily resembles a gentler, kinder Anschluss," writes Tony Corn. You can't always get what you want. The question is whether Europe will get something it needs before it's too late? The jury's still out.
December 3, 2011
Book Bits For Saturday: 12.3.2011
● Cannibal Capitalism: How Big Business and The Feds Are Ruining America
By Michael C. Hill
Summary via publisher, Wiley
Unlike in most other recent instances of financial turbulence, when this crisis hit, the country turned on itself economically, with the powerhouses—corporations, business leaders, and government—throwing the everyman under the bus. In an effort to avoid becoming slightly less rich, the super-rich effectively cannibalized the true engines of growth in the economy, in the process putting the bottom ninety-nine percent of the population at serious risk of losing everything. Cannibal Capitalism fights back, arguing that to really recover we need to educate our children, invest in our small businesses, use our inflated money to develop real things that build real wealth, and get back to exporting in a big way.
● Back to Work: Why We Need Smart Government for a Strong Economy
By Bill Clinton
Q&A with author, former President Bill Clinton, via PBS Newshour
Judy Woodruff: So your book, "Back to Work," is about jobs, it's about how to get the economy going. Let me ask you about today's numbers for the month of November -- unemployment numbers. The picture is improving a little bit. What does the jobs scene look like to you?
Bill Clinton: Well, I think what you're seeing is, the economy got way down with the double whammy of the financial collapse and the mortgage crisis, and the natural rhythms of the American economy, plus the benefit of the payroll tax cuts, which I do think helped a lot to maintain a certain level of consumer spending, a certain level of confidence. And small businesses have been saying for months, about 40 percent of them, they would have hired more people if they could get credit -- and you just felt this building up. So I feel good about it.
● Greenback Planet: How the Dollar Conquered the World and Threatened Civilization As We Know It
By H.W. Brands
Review via Kirkus Reviews
In this succinct overview, two-time Pulitzer finalist Brands (History/Univ. of Texas; The Murder of Jim Fisk for the Love of Josie Mansfield: A Tragedy of the Gilded Age, 2011, etc.) traces the role of the dollar in shaping America's rise to global preeminence. The author looks at historical benchmarks beginning with two signal events: the issuance of greenbacks as legal tender in 1862 and the Emancipation Proclamation in 1863. The establishment of the Federal Reserve System 50 years later formalized the second pole in the pendulum swings of U.S. financial policy—between emphasis on a balanced budget and tight credit and the liquidity needed to support industrial growth and high employment, both of which are at the forefront of today's political controversies. Following World War I, the increasingly important international role of the United States led to the establishment of the gold-backed dollar as a global currency, and its replacement by the greenback in 1971 when Richard Nixon decoupled the dollar from gold. Along with an overview of the past 150 years, Brands examines fascinating little-known sidelights... The author suggests that in the 21st century, American financial hegemony will be replaced, leaving America's international role in the new post-dollar world an open question. A welcome, balanced look at this hotly debated issue, written with the author's usual flair.
● Realeconomik The Hidden Cause of the Great Recession (And How to Avert the Next One)
By Grigory Yavlinsky
Summary via publisher, Yale University Press
This book directly confronts uncomfortable questions that many prefer to brush aside: if economists and other scholars, politicians, and business professionals understand the causes of economic crises, as they claim, then why do such damaging crises continue to occur? Can we trust business and intellectual elites who advocate the principles of Realpolitik and claim the "public good" as their priority, yet consistently favor maximization of profit over ethical issues? Former deputy prime minister of Russia Grigory Yavlinsky, an internationally respected free-market economist, makes a powerful case that the often-cited causes of global economic instability—institutional failings, wrong decisions by regulators, insufficient or incorrect information, and the like—are only secondary to a far more significant underlying cause: the failure to understand that universal social norms are essential to thriving businesses and social and economic progress. Yavlinsky explores the widespread disregard for moral values in business decisions and calls for restoration of principled behavior in politics and economic practices. The unwelcome alternative, he warns, will be a twenty-first-century global economy in the grip of unending crises.
● The End of Finance
By Massimo Amato and Luca Fantacci
Summary via publisher, Polity
This new book by two distinguished Italian economists is a highly original contribution to our understanding of the origins and aftermath of the financial crisis. The authors show that the recent financial crisis cannot be understood simply as a malfunctioning in the subprime mortgage market: rather, it is rooted in a much more fundamental transformation, taking place over an extended time period, in the very nature of finance.
● After the Great Complacence: Financial Crisis and the Politics of Reform
Edited by Ewald Engelen, et al.
Summary via publisher, Oxford University Press
What is the relationship between the financial system and politics? In a democratic system, what kind of control should elected governments have over the financial markets? What policies should be implemented to regulate them? What is the role played by different elites--financial, technocratic, and political--in the operation and regulation of the financial system? And what role should citizens, investors, and savers play?... In the wake of the crisis, the authors argue that social scientists, governments, and citizens need to re-engage with the political dimensions of financial markets. This book offers a controversial and accessible exploration of the disorders of our financial capitalism and its justifications. With an innovative emphasis on the economically 'undisclosed' and the political 'mystifying', it combines technical understanding of finance, cultural analysis, and al political account of interests and institutions.
● Global Energy Innovation Why America Must Lead
By Woodrow W. Clark II and Grant Cooke
Summary via publisher, Praeger
The world is entering the Third Industrial Revolution, an era of remarkable progress in science and technology that will require a global shift away from reliance on fossil-fuel and carbon-based energy. This book explains how America can lead the effort to reverse global warming and become the world leader in global energy innovation... The world's oil supply and other cheap carbon-based fuels are dwindling; climate change and global warming constitute a growing environmental threat; obsolete energy sources, like nuclear, are often the cause of horrific disasters. When will America join the new industrial revolution that is already underway in Europe and Asia? Global Energy Innovation: Why America Must Lead explains why the emerging Third Industrial Revolution will become the largest social and economic megatrend of the post-modern era. With its comprehensive, up-to-date examination of renewable energy systems and related green technologies, this book represents a call-to-action that will benefit any reader, regardless of their status as a lay person, scholar, or scientist.
December 2, 2011
Labor Dept Says Private Payrolls Rose A Moderate 140,000 In November
Private nonfarm payrolls rose 140,000 last month, the Labor Department reports. That’s ok and it’s certainly far enough above zero to keep chatter about an imminent recession at bay. But today’s number is a bit of a disappointment after ADP’s strong report on Wednesday, which implied that the government's estimate of employment growth would be much higher. Still, beggars can't be choosy and a net gain of 140,000 private sector jobs is respectable given all the headwinds from Europe these days.
Even so, November's payrolls growth is middling at best, as the chart below shows. The average monthly increase in private sector jobs so far this year through last month is a moderate 156,000, which puts November's report slightly below average.
Meanwhile, the unemployment rate dropped to 8.6% in November from 9.0% previously. That's the lowest jobless rate since March 2009. The change looks impressive, although it's not really clear how much of the fall in the jobless rate is due to genuine growth vs. more jobless workers giving up on the search and thereby falling off the radar of official surveys. In any case, an 8.6% unemployment rate is still unusually high and it reflects continued stress in the economy. But in an age of diminished expectations the fall is sure to be cited as a harbinger of better times ahead.
As for the job growth last month, virtually all of it came from the services sector. Meantime, the cyclically sensitive goods-producing industries lost jobs for the second month in a row, albeit marginally so. Government payrolls also posted another decline last month—a 20,000 loss overall, which is why the more widely monitored total nonfarm payroll tally advanced only by 120,000 last month.
Overall, there's nothing particularly inspiring about today's employment news, although there's enough forward momentum to at least keep the risk of a new recession to a minimum. Assuming, of course, the euro crisis doesn't worsen and the folks in Washington don't make any cyclically self-defeating decisions. Both of those factors are, well, skating on thin ice at the moment.
Paul Ashworth, an economist at Capital Economics, expects that the U.S. economy will grow by 2.5% in this year's fourth quarter, AP reports. "But he expects growth to slow to 1.5 percent in 2012, partly because of the crisis in Europe. And if Congress fails to extend the Social Security tax cut and long-term unemployment benefits this month, growth is likely to slow even further."
Nonetheless, labor market expansion, mild though it is, remains the strongest inoculation against a new recession—if we can keep it going. For the moment, we dodged another bullet.
Will Manufacturing's November Revival Last?
Yesterday's update on the ISM Manufacturing Index offers another encouraging data point that builds on the acceleration in jobs creation via ADP's November employment report. If it wasn't for ongoing euro crisis and the potential for instability in the budget negotiations in Washington, optimism would be a no-brainer. But we live in interesting times, and so expectations must be managed carefully.
The ISM Manufacturing's pop last month comes at a time when the labor market seems to be strengthening, albeit from dangerously low levels of growth. Ditto for the latest ISM number, which jumped to 52.7 in November, up from 50.8 in October. Readings above 50 indicate growth and so it's helpful that we've put some distance between the dividing line of expansion and contraction. Of course, the fact that we've been flirting with the 50 mark in recent months is a reminder that the macro trend is still precarious.
A change in the ISM trend has been an early clue of things to come in the past. That was true in the first half of 2011, when the ISM Index posted a sharp decline in May. That was a signal of the approaching summer slump and all the trouble for macro we've witnessed ever since. Shortly after ISM's spring tumble, the year-over-year change in the stock market turned lower as well.
Now we have what appears to be a reversal, as the chart above shows. The ISM Index turned up in November and the S&P 500's annual pace is slightly higher too. That's a good sign if you consider that annual declines in equity prices tend to accompany recessions.
In short, we've pulled away from the brink. But there's the uncertainty that comes with the troubles in the eurozone. The potential for a breakup of the euro looms. It may not be fate, but the risks are higher today than just a few months ago. One reason is that we're hearing mixed messages from the Continent's leaders. Mario Draghi, the European Central Bank president, says he's prepared to take more forceful steps to manage the crisis, but German chancellor Angela Merkel is effectively warning that the ECB will not provide the lender-of-last-resort medicine that's needed.
Yes, there's some bubbly economic reports of late, and today's jobs report from the Labor Department looks set to add to the good news. Even auto sales are rebounding. But the uncertainty tied to the euro keeps us wondering if there's another Lucy waiting to pull the football away from Charlie Brown once again.
December 1, 2011
Jobless Claims Rise For 2nd Week In A Row
New jobless claims rose last week, taking some of the wind out of yesterday's inspiring rebound in ADP's November employment report. Filings for unemployment benefits increased 6,000 to a seasonally adjusted 402,000—the first time in a month that the numbers have settled above the 400k mark. But it's too soon to argue that the labor market is headed for a reversal of fortunes.
Let's start with the standard caveat that weekly jobless claims numbers are forever volatile in the short term and so it's the trend that matters. Fortunately, the trend has been mildly friendly in recent months, as the declining four-week moving average shows. Last week's four-week average of less than 396,000 is near the lowest levels since the spring.
New claims continue to fall on a year-over-year basis as well, as the second chart below shows. Weekly filings dropped more than 10% last week vs. the year-earlier week on a seasonally unadjusted basis. That's a bit softer than the annual decline from recent weeks, but it's still quite strong and so it implies that there's more positive momentum ahead for the labor market.
But let's not spin the facts too much. New claims are up moderately for two weeks running, the first back-to-back weekly increases since early October. That alone is hardly disaster, but a third week of increases—a relatively rare even in recent history—would raise some eyebrows. Indeed, the jury's still out on how much damage the U.S. economy will suffer from the eurozone crisis. Yesterday's good news from ADP's employment numbers, coupled with the powerful rally in the stock market, makes it easy to overlook the risks, but it's premature to say the last day or so has changed much, if anything.
Still, the ADP report encourages optimism, which is only slightly tarnished by today's jobless claims report. The next big test arrives tomorrow morning with the Labor Department's update for November payrolls. Nothing less than a full confirmation for the ADP report is expected, or at least needed. All bets may be off if tomorrow's statistic du jour disappoints. Yup, we're still making this up one day (and data point) at a time.
Whatever's in store for the economy, clues are likely to show up in new claims. Indeed, it's been a fairly reliable leading barometer of macro's ebb and flow and more of the same is probably on tap in the weeks and months ahead. But no indicator is perfect. Meantime, we're in another one of those transition periods, or so it seems. That's no surprise. Even robust leading indicators these days remain unusually dependent on decisions from dysfunctional politicians in Europe and Washington. Good luck with that!
Major Asset Classes | Nov 30, 2011 | Performance Update
November was a rough month for asset returns, but it would have been a lot rougher without yesterday's buying frenzy in the wake of the news of a coordinated central bank intervention on behalf of the eurozone. Even so, most risky assets suffered hefty losses in November, reversing a large slice of October's rally. Hardest hit in November: emerging market stocks, which sank 6.7%. The only winner among our broadly defined list of major asset classes: Inflation-indexed Treasuries, which advanced 0.8% last month.
The unmanaged Global Market Index, which passively weights all the major asset classes, turned down in November as well by retreating 2.1%. For the year so far, GMI is lower by 1.7%. In the wake of yesterday's rebound in the capital and commodity markets, there's hope that the year can be salvaged in terms of 2011 performance. But getting from here to the end of the month covers a lot of unknown unknowns. As Channing Smith, co-portfolio manager at Capital Advisors Growth Fund, tells The Wall Street Journal: “It is troubling to think that we were possibly at a Lehman moment over the last couple of days. This is by no means over in Europe.”
In other words, deciding if yesterday's rally has legs is up for debate. By contrast, expecting lots of volatility looks like a safer bet for the foreseeable future.
"We had the worst Thanksgiving week since the ‘30s and then you turn around, you have a 8 percent rally in three days," says William Nichols, senior managing director in equity trading at Cantor Fitzgerald LP, via Bloomberg. In the same article, David Kelly, chief market strategist for JPMorgan Funds, observes: "If I’m a long-term investor, I’d try to ignore the volatility. To me the most remarkable thing in all these screens today, the S&P 500 is within 10 points of where we are at the start of the year. It’s very important for long-term investors to recognize that most of the zigs were offset with zags."