« September 2012 | Main | November 2012 »
October 29, 2012
When A 10-Year Treasury Yield Just Isn't Enough
In a world of abnormally low interest rates, the search for yield has become a priority for many investors. The good news is that there are several opportunities for boosting your investment income relative to the usual suspects. The bad news is that higher yield tends to come with higher risk. That's nothing new, of course, which is to say that risk management is still essential for designing portfolios, regardless of your objective.
How to proceed? As usual, it's a good idea to start with a benchmark and then consider the alternatives. A 10-year Treasury Note currently yields 1.78%, as of October 26. Its inflation-indexed counterpart has a negative yield of 69 basis points, so let's eliminate this option right away.
Where else can we look for higher yields? The possibilities among ETFs are an obvious starting point. Here's a list of ETFs representing various slices of the major asset classes and their trailing 12-month yield through October 26, according to Morningstar.com. In all cases below, the yields exceed the 10-year Note's payout:
If you bought all 11 ETFs above and weighted them equally, the trailing yield on the portfolio would be 3.90%, or more than twice as high as the current yield on the 10-year Treasury. The market's capacity for providing yield-enhancing possibilities, in short, is alive and kicking. What's the catch? Risk, of course.
Juicing yield over a "safe" Treasury is a risky proposition. Quite a lot of the risk is minimized by holding 11 different ETFs that focus on different asset classes. Let's assume that the 3.90% trailing yield is a reasonable forecast for what this 11-ETF portfolio will deliver for the foreseeable future. In that case, your work is done. But what if 3.90% still falls short of what you need?
It's time to consider another possibility: taking on more risk to engineer a higher expected yield. One option is to reweight the 11 ETFs above so that the portfolio yield rises. Pushing the strategy further, you might simply hold the five highest-yielding ETFs in the table above in equal portions. In that case, the trailing yield jumps to roughly 5.3%, or nearly three times the 10-year Treasury's yield. But what you've picked up in terms of higher yield comes with higher risk by concentrating the portfolio in a smaller set of asset classes—asset classes that are likely to suffer a fair amount of price volatility.
The question, then, is deciding if boosting the yield to 5.3% from 3.9% is worth the extra risk of holding a smaller number of asset classes? There's no right or wrong answer because these types of decisions should be customized for each investor, based on risk tolerance, investment objective, time horizon, etc.
Meantime, I don’t want to leave the impression that the table above is the last word on the possibilities for earning higher yields. There are many other ETF and mutual fund choices, along with a world of possibility via individual securities.
The larger point is that the basic framework outlined above—consider the benchmark and a broad list of relevant alternatives--is a reasonable roadmap for designing a portfolio that will provide the highest yield given your risk tolerance and financial situation. Obvious? Perhaps, although there are too many recommendations out there these days that suggest otherwise. For instance, I've seen a number of articles advising readers to load up on the high-yielding investment du jour in the search for yield, be it an ETF or a handful of individual securities. That's fine if you've considered a broad set of alternatives first.
Unfortunately, too many investors rush into a handful of investments without considering the strategic perspective. A better approach, and one that works well for portfolio design and management generally, is to start with an expansive set of potential choices and then customize the mix to suit your particular needs. For most folks, that means ETFs and mutual funds.
Keep in mind that building a higher-yielding portfolio isn't all that difficult. The real challenge is building one that's appropriate in risk-adjusted terms.
Posted by jp at 8:26 AM | Comments (0)
October 27, 2012
Book Bits | 10.27.12
● Misunderstanding Financial Crises: Why We Don't See Them Coming
By Gary Gorton
Summary via publisher, Oxford University Press
Before 2007, economists thought that financial crises would never happen again in the United States, that such upheavals were a thing of the past. Gary B. Gorton, a prominent expert on financial crises, argues that economists fundamentally misunderstand what they are, why they occur, and why there were none in the U.S. from 1934 to 2007. Misunderstanding Financial Crises offers a back-to-basics overview of financial crises, and shows that they are not rare, idiosyncratic events caused by a perfect storm of unconnected factors. Gorton shows how financial crises are, indeed, inherent to our financial system. Economists, Gorton writes, looked from a certain point of view and missed everything that was important: the evolution of capital markets and the banking system, the existence of new financial instruments, and the size of certain money markets like the sale and repurchase market. Comparing the so-called "Quiet Period" of 1934 to 2007, when there were no systemic crises, to the "Panic of 2007-2008," Gorton ties together key issues like bank debt and liquidity, credit booms and manias, moral hazard, and too-big-too-fail--all to illustrate the true causes of financial collapse. He argues that the successful regulation that prevented crises since 1934 did not adequately keep pace with innovation in the financial sector, due in part to the misunderstandings of economists, who assured regulators that all was well.
● ValuFocus Investing: A Cash-Loving Contrarian Way to Invest in Stocks
By Rawley Thomas and William Mahoney
Summary via publisher, Wiley
ValuFocus Investing is written for the contrarian investor who wants an investing method that is based on cash flow facts, not on media hype and speculative impulse. This book combines an accessible presentation of a contrarian investment model and the ValuFocus tool that offers a highly studious, detailed explanation of understanding a company's true intrinsic value. If you can calculate a company's intrinsic value on the basis of knowing if the market is currently under, fairly, or over pricing its stock, then it is possible to invest wisely in the stock market. Investors who want to buy undervalued stocks, or sell (short) overvalued ones will find this book immensely useful. The ValuFocus investing tool calculates the intrinsic value of every company in their database automatically. Thus, an individual investor can become an "A" student of a modeling process, or can go right ahead in using this tool to pick stocks and manage their own portfolio. Additionally, this book helps to develop an enhanced framework to fundamental equity valuation.
● Tiger Head, Snake Tails: China Today, How It Got There, and Where It Is Heading
By Jonathan Fenby
Review via The Guardian
China, Jonathan Fenby argues in his new book, "does everything on a scale that breeds shock and awe". It has the largest monetary reserves in the world, at more than $3.2 trillion; it consumes more than a third of the world's supplies of key metals and half the world's cement. Every two and a half minutes, Greenpeace estimates, it produces enough toxic ash to fill one Olympic-size swimming pool. It is a nation of violent contrasts: it may have as many as 600 dollar billionaires, as well as 300 million people without access to clean drinking water. Despite the government's fixation on national unity (its "tiger head"), Fenby asserts, it is a mass of snake's tails. "There is not one China but a hundred, a thousand or a million."
● The Dawn of Innovation: The First American Industrial Revolution
By Charles R. Morris
Review via USA Today
The United States of America, a fledgling nation during the 19th century, managed to thrive against colossal odds, even surpassing Great Britain as the world's hyperpower. Charles R. Morris — lawyer, former banker and prolific popular historian — has wondered how the metamorphosis occurred. So he decided to write a book on the subject. To some extent, "The Dawn of Innovation" is of a piece with Morris' opus. For example, it grows organically from his previous book "The Tycoons: How Andrew Carnegie, John D. Rockefeller, Jay Gould and J.P. Morgan invented the American Supereconomy." On the other hand, the new book seems far afield from his book-length profile of AARP, subtitled "America's Most Powerful Lobby and the Clash of Generations," as well as his previous book "American Catholic: The Saints and Sinners Who Built America's Most Powerful Church."
● The Indispensable Milton Friedman: Essays on Politics and Economics
Edited by Lanny Ebenstein
Event announcement of discussion with editor via Heritage Foundation
Milton Friedman is one of the most famous economists in history. His writings and theories on everything from capitalism and freedom to deregulation and welfare have inspired movements, influenced government policies, and changed the course of America’s economic history. In The Indispensable Milton Friedman: Essays on Politics and Economics, Dr. Lanny Ebenstein brings together twenty of Friedman’s greatest essays in the only collection of Friedman’s writings to span his entire career – including some of Friedman’s never-before-republished writings as well as the best and most timeless of his works. These exceptional essays not only illuminate the progression of Friedman’s thought, but also explain how America might overcome some of its most difficult challenges.
● A Debtor World: Interdisciplinary Perspectives on Debt
Edited by Ralph Brubaker, Robert M. Lawless and Charles J. Tabb
Summary via publisher, Oxford University Press
A Debtor World contains a collection of contributions about the societal implications of private debt. The essays comprising this volume are authored by dozens of leading U.S. and international academics who have written about debt or issues related to debt in a wide range of disciplines including law, sociology, psychology, history, economics, and more. The goal of this collection is to explore debt neither as a problem nor a solution but as a phenomenon and to promote the exchange of knowledge to better comprehend why consumers and businesses decide to borrow money. It asks what happens to businesses and consumers under a heavy debt load, and what legal norms and institutions societies need to encourage the efficient use of debt while promoting a greater understanding of the global phenomenon of increased indebtedness and societal dependence.
● The Book of the Poor: Who They Are, What They Say, and How To End Their Poverty
By Kenan Heise
Summary via publisher, Marion Street Press
Collecting dozens of interviews conducted over 50 years to give voice to the 16 percent that live below the poverty line, journalist Kenan Heise's The Book of the Poor addresses unemployment, prison, nutrition needs and hunger, the lives of impoverished children, panhandling, health-care struggles, the role of race in poverty, and dumpster diving, This moving work attempts to correct misconceptions surrounding an all-too heartbreaking and persistent social problem, offering a historical perspective on American’s attitudes toward poverty—from Thomas Jefferson's chance conversation with a poor French woman laborer, to Confederate war widows rioting for food, to the lasting effects of Reaganomics on the poor and incarcerated.
Posted by jp at 4:31 AM | Comments (0)
October 26, 2012
US Economic Growth Strengthened In Third Quarter
The U.S. economy grew at an annualized 2.0% rate in the third-quarter, the Bureau of Economic Analysis reports in its initial GDP estimate for the July-to-September period. That's an improvement over Q2's sluggish 1.3% pace, and another sign that recession risk in recent months was considerably lower than the dire warnings issued by some analysts.
No one should mistake today's GDP update as a sign that the economy has broken free of the slow-growth gravity that's prevailed of late. But once again we have another data point that supports what's been fairly clear all along: the economy continues to grow, albeit modestly.
Is the improvement in Q3 GDP a surprise? No, not really. As I've been discussing over the past month, the incoming data has been telling a fairly consistent story of moderately stronger growth. From the ongoing rebound in housing to continued strength in industrial production to the persistence of slow but steady jobs growth, the overall picture for the economy has been strong enough to keep us out of a recession so far. This relatively encouraging profile was also showing up in last week's final GDP nowcast before the release of today's report—a nowcast that pointed to a decent improvement in the growth rate of the economy in Q3 over Q2. It was a similar story earlier in the month, as this October 8 GDP nowcast reminds.
As a recap, here's how The Capital Spectator's GDP nowcasts evolved over the past month (for details on methodology, see the definitions at the end of this post):
The case for thinking that the relatively upbeat nowcasts have been reliable signals is strengthened by the record of the regular updates for The Capital Spectator Economic Trend Index (CS-ETI), which continued to offer statistical support for arguing that recession risk through September was relatively low. Last week's CS-ETI review, for example, made it clear that the odds are minimal that the NBER would declare September as the start of a new downturn. That's in sharp contrast with some analysts who have been arguing that we're already in a recession.
None of this should be used as an excuse for complacency. There are (still) several large risk factors lurking on the macro landscape, including the potential for economic turmoil if the so-called fiscal cliff threat isn't resolved.
The future, as always, is loaded with uncertainty. The recent past, by contrast, is relatively clear. As it turns out, a careful analysis of what just passed can usually provide quite a lot of strategic value for analyzing the risks in the immediate future. As Yogi Berra famously quipped, you can see a lot just by looking. In the context of the business cycle, it's critical to be looking at a broad data set and in a way that minimizes short-term distortions and revision risk. Even so, there are still no iron-clad guarantees. But you can do quite well by keeping a close eye on the incoming numbers and interpreting the data with basic econometric tools. For different reasons, that's less than standard operating procedure in the grand scheme of macro commentary.
Yes, the potential that the indicators are misleading us can never be wiped away entirely. That inspires looking at the numbers from several angles, using different models and techniques in search of deeper perspective. Short of a bolt from the blue, a relatively unbiased, econometric-based review of the data that adds up to the business cycle can reveal a lot.
The economy will, of course, one day weaken and a new recession will arrive. When it does, and that change for the worse is clear by way of the numbers, you'll read about it here. Could it happen with the October economic profile? Yes, that's a possibility. But with no major economic reports for this month available yet, a dark forecast remains highly speculative. Clarity, of course, is coming. Meantime, there's still some growth momentum to consider. That's not everything, but it's surely something.
Posted by jp at 9:25 AM | Comments (0)
Chicago Fed: September Economic Improves
Yesterday's update of the Chicago Fed National Activity Index (CFNAI) strengthened the case for what's become obvious in recent weeks: economic conditions overall improved modestly in September. Last week's review of the numbers published to date certainly looked encouraging, as tracked by The Capital Spectator Economic Trend Index (CS-ETI). Not surprisingly, the September read on the economy via CFNAI tells a similar story.
The three-month moving average of CFNAI, a weighted average of 85 indicators, increased to -0.37 last month from -0.53 in August. A reading of -0.70 or below for the CFNAI’s three-month moving average is considered a signal that a recession has begun. By that standard, we have yet another data point that tells us that the economy wasn't contracting last month and so the NBER is unlikely to label September as the start of a new downturn. To be sure, September's economic profile is relatively weak, but not weak enough to argue that the economy was shrinking.
The rush by some analysts in the recent past to declare that a recession has started is curious when you consider that a sober reading of a wide range of economic and financial indicators offered little support for such a dark view. When recession risk is truly elevated, the numbers tend to speak loud and clear. Keep in mind that a high-confidence signal will be slightly dated, which is to say that the arrival of a new recession will only be obvious after the fact.
A careful review of history suggests that the best-case scenario is declaring that a recession has started two to three months after the cycle has peaked. That still leaves enough time to prepare for the worst—most folks don't recognize that a recession has started until much later.
The alternative is to speculate what might happen in the weeks and months ahead. Of course, that requires making decisions without any data. Not surprisingly, the record with this approach isn't much better than tossing a coin. Why's that a problem? Because preparing for a recession that doesn't strike can be as troublesome as ignoring the warning signs when a new downturn is a virtual certainty.
A much better solution: carefully monitor a broad set of data for the earliest signs that a new recession has started in the recent past. By that standard, according to CS-ETI and similar techniques, September wasn't the beginning of a new downturn, based on the data in hand. When the numbers tell us differently, you'll read about it here.
Posted by jp at 6:31 AM | Comments (0)
October 25, 2012
Today's Economic Reports Bring A Sigh Of Relief
Today's updates on jobless claims and durable goods orders bring good news, or at least good relative to the worst fears inspired by recent data points in these series. There's still plenty to worry about and it's premature to conclude that we've pulled out of the bog with these statistics. But if you're looking for fresh evidence that the economy is crumbling, you won't find it in the numbers du jour.
Let's start with durable goods orders, which rebounded in September, reversing the steep decline posted in August, the Census Bureau reports. Last month's 9.9% rise is the highest monthly increase since January 2010, although most of the surge was due to the volatile transport sector. Still, durable goods orders ex-transport rose 2.0% last, suggesting that demand generally improved in September.
One exception is the market for capital goods, which continues to show signs of stagnating. New orders for durable goods ex aircraft and defense—business investment—was flat last month, which implies that corporate America remains skittish on the outlook for the economy.
The good news is that durable goods orders generally perked up last month on a year-over-year basis. It may be noise, but new orders rose 2.5% in September vs. the same time a year ago. That's encouraging after August's 6.7% drop on an annual basis—the first red ink by this benchmark in more than two years.
The jury's out if the relatively favorable trend via September's durable goods numbers will roll on in October. What we do know is that September's overall profile for the economy looks modestly encouraging, as I discussed last week. Today's durable goods report adds more positive shine to that reading.
So too does the latest update on jobless claims, which fell 23,000 last week to a seasonally adjusted 369,000 through October 20. And just in time!
As noted in last week's update, the sharp rise in new filings for unemployment benefits for the week through October 13 looked ominous. As usual, I reminded that this is a volatile series and so any one number should be taken with a grain of salt. Today's update is no less shaky on that front, although the fact that new claims didn't continue rising is encouraging just the same.
More importantly, the year-over-year change in raw claims data as of last week returned to its long-running trend of dropping roughly 10% a year. That's a clue that the labor market continues to heal, albeit slowly.
The outlook would be quite a bit darker today if the annual pace in new claims increased, as it did for the week through October 13. But that surge now looks like a one-time event, although it'll take a few more weeks of data updates to be sure.
For now, it looks like we dodged another bullet. Based on the numbers in hand, the economy overall continues to grow, or so the September reports tell us. Confidence is low, however, for thinking about what comes next, starting with the arrival of the early October data releases next week.
Posted by jp at 10:19 AM | Comments (0)
October 24, 2012
New Home Sales Rise In September, But...
The pace of new home sales in September rose nearly 6% vs. August and is up 27% vs. a year ago, the Census Bureau reports, offering more evidence that the housing market continues to improve. The volume of new sales is still far below the pre-Great Recession levels, but in the here and now it’s no trivial matter that residential real estate is on the mend. Housing, after all, is said to cast a long shadow on the economy through a variety of channels, and so every month of improvement brings a bit more confidence for thinking that the economy can continue to muddle forward.
The news that newly minted homes sold at a faster pace last month isn’t all that surprising after last week’s bullish update on housing starts and permits for September. Today’s report on sales is more or less confirming what was already conspicuous: real estate made another solid step forward last month, strengthening a sector that suffered its worst collapse on record.
It’s clear that September was a solid month for housing generally, at least in relative terms. In fact, a broad review of economic and financial indicators shows that last month posted an encouraging performance too, as I discussed in last week’s update of The Capital Spectator Economic Trend Index (CS-ETI). The question is whether the ongoing deterioration in Europe's economy will have repercussions for the business cycle in the U.S. in the months ahead?
Today's news that sentiment in the industry and trade sectors in Germany is still weakening certainly offers no encouragement for thinking positively. For the sixth straight month, companies in the Continent's biggest national economy :again expressed growing dissatisfaction with their current business situation," according to the Ifo Institute, which today released the October update of its widely watched business climate index. "The business outlook nevertheless remained unchanged at last month’s low level," although "the clouds over the German economy are darkening," the institute advised in a press release.
Today also brought news of a surprisingly weak report on the UK's industrial sector via the Confederation of British Industry (CBI). Nonetheless, analysts are still expecting that Britain's double-dip recession will be declared over with tomorrow's release of third-quarter GDP.
Meanwhile, there's rising optimism that China's slowdown in growth is finally over, offering a potential bright spot for the global economy. As The Economist reported last week:
A number of economists concluded that China’s protracted slowdown had at last run its course. Their confidence was bolstered by monthly figures showing the economy gaining strength as the third quarter wore on. Exports grew by 9.9% in the year to September, for example, having grown by only 2.7% in August. September’s industrial production beat expectations narrowly; retail sales beat them comfortably.
But even an optimist has to admit that the numbers around the world are still mixed these days. The same can be said for the U.S., although the American economy demonstrated a fair amount of resilience in September. Most of last month's initial economic reports have been published and so the potential for negative surprises overall on last month's numbers are quickly receding. The last batch of September releases yet to come:
• Durable goods orders (Thursday, Oct 25)
• Personal Income & Spending (Monday, Oct 29)
Considering that the September updates released so far are generally encouraging, it's hardly a shock that analysts are expecting more of the same for durable goods and consumer income and spending. In addition, the scheduled release on Friday of the initial estimate of third-quarter GDP for the U.S. is expected to show modest improvement over Q2's meager 1.3% rise, according to Briefing.com. The relatively upbeat outlook on Q3 GDP has been noted in our GDP nowcasts over the past month, including the last week's update.
Nonetheless, no one's assuming too much at this point, and so it's touch and go with each new data point. It's a precarious round of growth in the U.S. (still), although there's still a case for thinking that a modest recovery will roll on. The statistical evidence, for good or ill, on October starts arriving next week with the ISM Manufacturing Index on November 1, followed by the employment report on November 2. Just in time for one more data blast before the November 6 election.
Posted by jp at 3:55 PM | Comments (0)
Strategic Briefing | 10.24.12 | ADP Revises Employment Report Methodology
ADP and Moody's Analytics Enhance ADP National Employment Report
Press release via ADP | Oct 24
ADP, a leader in human capital management services, and Moody’s Analytics, a leading independent provider of economic forecasting, today announced enhancements to the ADP National Employment Report, ADP’s widely followed gauge of U.S. nonfarm private sector employment. The newly expanded ADP National Employment Report will be issued each month by the ADP Research InstituteSM, a specialized group within ADP that provides insights around employment trends and workforce strategy. The first enhanced monthly report issued in collaboration with Moody’s Analytics will be released on November 1, and will report private payroll changes for the month of October 2012.
Dogged By Accuracy Questions, ADP Will Revamp Jobs Report
Forbes | Oct 24
Payroll giant ADP will expand and change the formulation of its monthly employment data after several months of questions about the figures’ accuracy. The report, which includes a new partnership with credit-rating provider Moody’s Analytics, will give a more detailed breakdown of the data as well as a new methodology to better align “with the final, revised U.S. Bureau of Labor Statistics (BLS) numbers.” The first new report will come next month and estimate October’s employment growth. While ADP estimates that its jobs data almost always matches the finalized government numbers—a 96% correlation since 2006, according to ADP—this year’s volatile jobs data has cast some doubts on whether ADP is a useful indicator. ADP’s report on hiring by private businesses is typically released two days before the official data. This release alone often causes a shift in the markets, and is later used to make last-minute tweaks to unemployment and job-growth estimates.
ADP overhauls U.S. private payrolls report
Reuters | Oct 24
A monthly reading of U.S. private sector employment will undergo changes to put it more in line with the more closely watched government non-farm payrolls report. Automatic Data Processing (ADP.O) said on Wednesday it had made the changes to its private job market report as part of a new partnership with Moody's Analytics. While economists use the report to fine-tune their labor market forecasts, ADP has had a spotty track record of predicting the initial reading for non-farm payrolls. The report will include an increased number of industry categories and business sizes, ADP said. It will use a larger sample size and new methodology to further align it with the final revised readings from the Bureau of Labor Statistics.
ADP's monthly figures are typically released a couple days ahead of the government's report.
ADP making changes to monthly employment report, will now team on it with Moody's Analytics
AP via Fox News | Oct 24
Automatic Data Processing Inc. is making some changes to its monthly employment report, including adding more industry categories. The company said Wednesday that the number of business sizes on the ADP National Employment Report will also be expanded. A new methodology that will better align with the final, revised U.S. Bureau of Labor Statistics numbers will be implemented as well. In addition, the sample size used to create the report is being increased. ADP said that it will no longer team with Macroeconomic Advisers LLC on the report. The companies had worked together for six years. ADP will now work on the report with Moody's Analytics.
ADP making changes to monthly employment report, will now team on it with Moody’s Analytics
The Washington Post | Oct 24
Automatic Data Processing Inc. is making some changes to its monthly U.S. employment report, including adding more industry categories. The report will now increase to five industries from three industries. The five industries — construction, financial activities, manufacturing, professional and business services and trade, transportation and utilities — make up more than 50 percent of all U.S. private sector employment, according to ADP. The company said Wednesday that the number of business sizes on the ADP National Employment Report will also be expanded to five company-size classes from three company-size classes. A new methodology that will better align with the final, revised U.S. Bureau of Labor Statistics numbers will be implemented as well, ADP said. In addition, the sample size used to create the report is being increased.
Posted by jp at 8:53 AM | Comments (0)
October 23, 2012
Passive Asset Allocation Vs. The World
What can you expect from a passive asset allocation strategy that owns all the major asset classes? More than you might think. Owning everything has a tendency to deliver average-to-above-average returns relative to a broad set of actively managed asset strategies across the risk spectrum. Surprised? You shouldn't be.
The numbers, as usual, tell the story. As the chart below shows, a market-value weighted mix of the standard asset classes (Global Market Index, or GMI) generated competitive returns over the last decade compared with more than 1,200 actively managed asset allocation mutual funds with at least 10 years of history. If that sounds familiar it's because it is. I update this data every so often on CapitalSpectator.com and the results don't change all that much. Back in May, for instance, I crunched the numbers on the asset allocation horse race and the message didn't look all that different from what you see in this chart:
If you simply bought and held a broad mix of asset classes, weighted the pieces by market value, you'd have done fairly well in absolute and relative terms. Rebalancing the mix back to the initial market weights every December 31 did a bit better. Equal weighting the asset classes--a model-free strategy, as I like to call it--and rebalancing the portfolio back to equal weights at each year's end did even better.
For example, my proprietary GMI (a market-value asset allocation strategy that's never rebalanced) earned 7.6% a year for the 10 years through September 2012. That's just under the 75th percentile asset allocation fund, based on analyzing data supplied by Morningstar Principia software. The universe of active products here is comprised of 1,200-plus mutual funds that use a variety of active strategies to manage multi-asset class portfolios. This group ranges from traditional balanced funds all the way up to hedge fund-type strategies, and everything in between.
As usual, there are a handful of funds that deliver stellar performance, along with the opposite extreme of abject failures that somehow manage to suffer unusually low and even negative returns over long spans. The vast majority, predictably, fall into varying degrees of mediocrity. As such, the operative question is: why pay more for average returns? That's a high-probability outcome if you're not careful. More than a few of the active allocation funds in Morningstar's database charge hefty fees of 1%, 2% and even higher in terms of net expense ratios. By contrast, you can replicate GMI or something comparable with ETFs for under 50 basis points.
Why not pick the best active performers and enjoy the ride? Easier said than done, of course, in part because the winners aren't a static list. Figuring out which active managers will soar in the next period, and avoiding the ones that dive, is no mean feat, which is why relatively few investors are able to routinely cash in on the leaders and earn impressive returns without taking on big risks.
By comparison, broadly defined asset allocation strategies offer better odds for average-to-above-average results vs. the playing field of active managers. Is the performance history in the chart above a random outcome? No, not at all, and for a variety of theoretical and empirical reasons, as I outline in my book Dynamic Asset Allocation: Modern Portfolio Theory Updated for the Smart Investor
Can you lose money with a passive or quasi-passive strategy that owns everything? Yes, of course. Beta risk is a constant, with active and passive strategies. So, what’s the value proposition of an expansive, passive or quasi-passive definition of asset allocation? Mainly it’s a powerful tool for hedging the active risks that come in all shapes and sizes, ranging from choosing the wrong set of asset classes to reaching too high with timing rebalancing to attempting to identify winners and losers on an individual security level. Such ambitious efforts can deliver impressive results, of course, but all too often it ends up as a sizable opportunity cost for most folks.
The lesson here isn’t that you should slavishly own a passive mix of all the major asset classes, although you’d probably do fine with such a strategy in time. Rather, the point is that you should consider two key factors in money management before assuming that risky bets away from passive allocations are always better: First, diversify broadly, across asset classes. We can have a healthy debate about what asset classes are reasonable, but I prefer to err on the side of caution by owning more rather than less.
Second, plan on implementing some form of rebalancing by trimming back on the winners and redeploying assets to the losers. That’s a dangerous proposition with individual securities, but it’s prudent when we’re talking of broadly defined asset classes. Again, the details are open for debate, but most investors can't afford to ignore this powerful tool for managing risk and, perhaps, boosting return.
I’ll be the first to admit that the finer points on how you structure and manage a portfolio are less important if--a big if--you embrace a broad mix and put a limit on how high, or low, any one slice of the portfolio is allowed to travel. Within reason, there are many paths to engineering a satisfactory investment return over the long haul. Keep in mind, however, that not all of them come with relatively high expected odds of success.
One that does can be summed up as piggybacking on a wide mix of betas. We should certainly keep an open mind to the idea that Mr. Market’s asset allocation can be enhanced by customizing the portfolio to match each investor's risk tolerance, time horizon, etc. That’s a reasonable idea… up to a point. The problem is that too many investors (and institutions) go off the deep end.
Ultimately, all the positive alpha earned is financed by the negative alpha. The available returns going forward, in other words, are a zero sum game. It's a mathematical certainty, as Professor Bill Sharpe famously observed. Everyone would like to cut a bigger slice of this pie, of course, but there are constraints at the financial feeding trough. Meantime, the counterintuitive strategy of focusing on grabbing a modest slice has a habit of delivering above-average portions in the end. That’s not always obvious in the media circus of financial advice, but a sober review of the numbers helps us stay focused on how markets actually work, as opposed to how we’d like them to work.
Posted by jp at 5:56 AM | Comments (0)
October 22, 2012
Still Joined At The Hip: Inflation Expectations & Stocks
The connection between the stock market and inflation expectations may not be on everyone's radar these days, but the link remains strong. That's unusual across the broad sweep of investment history, but it's par for the course in the new world order of the last four years. I call it the new abnormal, and it continues to roll on. Stocks have rallied smartly since (notwithstanding Friday's sharp selloff) and the market's estimate of future inflation has climbed too (based on implied inflation via the yield spread in the 10-year Treasury less its inflation-indexed counterpart). Random events? Guess again.
As of October 19, expected inflation was 2.50%--near the highest levels since the financial crisis was raging in the fall of 2008. Meantime, the stock market is approaching its old pre-recession/crisis highs. Despite what you may have heard elsewhere, the crowd overall is enthused these days with the prospect of higher inflation. Falling inflation, by contrast, is greeted as trouble, as the chart below reminds.
There's an economic explanation for the odd behavior—the so-called Fisher effect. The basic narrative can be reduced to a fear of deflation and an excess demand for money. To the extent those sentiments recede, the investment outlook improves. In short, higher inflation expectations equate with higher stock prices, and vice versa. This abnormal linkage won't last forever, but for now it's a key source of bullish behavior in the stock market. The sight of rising nominal prices generally, in other words, is greeted with cheers from investors.
If the new abnormal remains an influential force for the foreseeable future, it's easy to interpret Fed policy of late as productive for promoting the bullish side of animal spirits. As Bloomberg reported last week:
Federal Reserve Bank of New York President William C. Dudley said the central bank won’t cut back record monetary stimulus too quickly when the economy begins to gain strength.
“If we were to see some good news on growth I would not expect us to respond in a hasty manner,” Dudley said in a speech today in New York.
Policy makers last month increased accommodation to boost an economy that central bankers said still faces “significant downside risks.” Fed officials announced a third round of asset purchases, agreeing to buy $40 billion of mortgage-backed bonds each month, and extended the horizon for record-low interest rates through at least the middle of 2015.
It's anyone's guess when Mr. Market will become wary of higher inflation expectations. But at some point he'll see things differently and rising pricing pressures will be considered a threat to equity prices. One big clue that the end of the new abnormal may be near: the economy moves closer to what might be described as "normal' in terms of cyclical fluctuations. The good news (or bad news, depending on your perspective) is that normal macro behavior still looks like a long shot as the year winds down. Then again, full clarity on the timing of this transition is likely to arrive only with hindsight.
Posted by jp at 5:05 AM | Comments (0)
October 20, 2012
Book Bits | 10.20.12
● The Big Flatline: Oil and the No-Growth Economy
By Jeff Rubin
Excerpt via Bloomberg
For most of the last century, cheap oil powered global economic growth. But in the last decade, the price of oil has quadrupled, and that shift will permanently shackle the growth potential of the world’s economies.
The countries guzzling the most oil are taking the biggest hits to potential economic growth. That’s sobering news for the U.S., which consumes almost a fifth of the oil used in the world every day. Not long ago, when oil was $20 a barrel, the U.S. was the locomotive of global economic growth; the federal government was running budget surpluses; the jobless rate at the beginning of the last decade was at a 40-year low. Now, growth is stalled, the deficit is more than $1 trillion and almost 13 million Americans are unemployed.
● Why I Left Goldman Sachs: A Wall Street Story
By Greg Smith
Analysis via New York Observer
It’s been a leaky week leading up to the publication Why I Left Goldman Sachs, with the firm giving guidance on the potential motivations of its former employee, and reporters getting their hands on copies of the embargoed title. A week ago yesterday, The Financial Times reported on the results of Goldman’s internal investigation into the allegations that Greg Smith made in a New York Times op-ed published in March. What the probe turned up? Prior his very public departure from the firm, Mr. Smith had submitted compensation requests that his superiors believed to be out of line with his performance; 99 percent of the time Goldman employees wrote the word “muppet” in an email, they were referring to the 2011 movie—not about the firm’s know-nothing clients. Perhaps discontented with the attention received by the FT reports, Goldman went and slipped a 9-page summary of the so-called muppet hunt to Bloomberg, which reported today that “the documents paint a picture of Smith that is at odds with the image he fashioned for himself in the op-ed: an altruistic kid from Johannesburg, out of place in the rapacious, wealth-obsessed world of American high finance.”
● Bet the Farm: How Food Stopped Being Food
By Frederick Kaufman
Q&A with author via Marketplace
Natural disasters from drought to flood and almost everything in between can do quite a number on farmers and their crops -- and the prices consumers wind up paying. A prime example: the Midwest this summer. But nature's not the only reason food prices go up. In his new book, "Bet the Farm: How Food Stopped Being Food," Frederick Kaufman says banks are "food neutral" but the transformation of food into a commodity that gets traded has caused food prices to artificially rise.
● Producing Prosperity: Why America Needs a Manufacturing Renaissance
By Gary Pisano and Willy Shih
Q&A with authors via Quartz
The new manufacturing worker is a knowledge worker. No longer equipped with a high school diploma and union card, he’s got advanced skills in programming and statistics. That’s what’s needed for a manufacturing renaissance. Here’s the catch: It might take 50 years. In their new book, released Oct. 16, Harvard Business School professors Gary Pisano and Willy Shih say there is no quick fix but that the sector’s growth is vital to maintaing the US’ competitive advantage in innovation. President Barack Obama has pledged to add 1 million manufacturing jobs over the next four years, which may not be possible, in the eyes of these experts. “The jobs coming back are different than the jobs that went. So while we are sympathetic to the president’s goal, we think it’s not quite framed properly,” says Pisano.
● The Sensible Guide to Forex: Safer, Smarter Ways to Survive and Prosper from the Start
By Cliff Wachtel
Summary via publisher, Wiley
The Sensible Guide to Forex: Safer, Smarter Ways to Survive and Prosper from the Start is written for the risk averse, mainstream retail investor or trader seeking a more effective way to tap forex markets to improve returns and hedge currency risk. As the most widely held currencies are being devalued, they're taking your portfolio down with them—unless you're prepared. For traders, the book focuses on reducing the high risk, complexity, and time demands normally associated with forex trading. For long-term investors, it concentrates on how to hedge currency risk by diversifying portfolios into the strongest currencies for lower risk and higher capital gains and income.
● A Nation of Takers: America's Entitlement Epidemic
By Nicholas Eberstadt
Debate with author via video from American Enterprise Institute
In an American Enterprise Debate on Wednesday, Nicholas Eberstadt of AEI and William Galston of the Brookings Institution squared off on whether America has become a nation of takers. As Eberstadt pointed out, a huge percentage of the American populace now receives transfer payments such as food stamps, Medicaid, Medicare, disability benefits, or Social Security. This indicates that the individualistic, hard-working fiber characteristic of American generations of the past has been supplanted by an entitled, self-centered mentality.
● Boom, Bust, Boom: A Story About Copper, the Metal that Runs the World
By Bill Carter
Summary via publisher, Scribner
Copper is a miraculous and contradictory metal, essential to nearly every human enterprise. For most of recorded history, this remarkably pliable and sturdy substance has proven invaluable: not only did the ancient Romans build their empire on mining copper but Christopher Columbus protected his ships from rot by lining their hulls with it. Today, the metal can be found in every house, car, airplane, cell phone, computer, and home appliance the world over, including in all the new, so-called green technologies. Yet the history of copper extraction and our present relationship with the metal are fraught with profound difficulties. Copper mining causes irrevocable damage to the Earth, releasing arsenic, cyanide, sulfuric acid, and other deadly pollutants into the air and water. And the mines themselves have significant effects on the economies and wellbeing of the communities where they are located.
● Founding Finance: How Debt, Speculation, Foreclosures, Protests, and Crackdowns Made Us a Nation
By William Hogeland
Summary via publisher, University of Texas Press
Recent movements such as the Tea Party and anti-tax “constitutional conservatism” lay claim to the finance and taxation ideas of America’s founders, but how much do we really know about the dramatic clashes over finance and economics that marked the founding of America? Dissenting from both right-wing claims and certain liberal preconceptions, Founding Finance brings to life the violent conflicts over economics, class, and finance that played directly, and in many ways ironically, into the hardball politics of forming the nation and ratifying the Constitution—conflicts that still continue to affect our politics, legislation, and debate today.
● The Founders and Finance: How Hamilton, Gallatin, and Other Immigrants Forged a New Economy
By Thomas K. McCraw
Review via Publishers Weekly
A Pulitzer Prize winner and Harvard Business School emeritus professor, McCraw sheds light on personalities and policies in this overview of the development of early American finance. The newly independent United States “had long been bankrupt”; both the fledgling national government and the states were in hock for the War of Independence. According to McCraw (Prophets of Regulation), brilliant immigrants, such as Alexander Hamilton and Albert Gallatin, lacked the parochial vision common to their peers, who saw the basis of wealth mostly in land. With at least 50 “coinages and currencies... in circulation” in 1789, banking was in turmoil. The main economic resource for the federal government was tariffs on imports, mostly from Britain. Hamilton’s decisive advocacy of a national bank and assumption of state war debts laid the basis for economic expansion and cemented the dominance of federal power. McCraw then turns to Gallatin’s ascendency in Congress, where in 1796 he denounced the growth in the national debt and decried high military spending.
Posted by jp at 4:03 AM | Comments (0)
October 19, 2012
Wrestling With Forecasting
All forecasts are wrong. That’s the nature of trying to look through the fog of uncertainty for guidance on the future. Some forecasts are less wrong than others, of course, but it’s always sensible to assume that the prediction du jour contains noise. That doesn’t mean that forecasting is worthless, but it does make predictions dangerous if you don't look at the estimates in probabilistic terms. But that's hardly standard procedure in the wider world. Thinking through the finer points for forecasting is too often neglected, and sometimes ignored entirely.
Perceptions about forecasts generally fall into three broad categories. One is blindly accepting the numbers. At the opposite extreme is rejecting forecasts out of hand. Somewhere in the middle of these severe views lies the greatest opportunity. But it's no free lunch. The primary challenge is managing the associated risk that bedevils all forecasts—a crucial subject that's at the heart of Nate Silver's new book The Signal and the Noise: Why So Many Predictions Fail-but Some Don't
Silver doesn't offer hot tips or short cuts to better forecasting, for the simple reason that such things don’t exist. Instead, he takes readers on a tour of forecasting as a process across several disciplines—economics, finance, politics, baseball, earthquakes, weather, and a few other areas. The idea here is that by reviewing what's worked, and what hasn't, and why, we can improve our capacity for generating better forecasts and interpreting predictions made by others in a more objective way. The book largely succeeds in its basic mission, and not a moment too soon, given the precarious state of the economy and the explosion of fast-and-loose forecasts about what's coming.
The main takeaway for me in Silver's book is that the forecast du jour is worthless without knowing something about the process behind the guesstimate. That's a reminder that most of the daily deluge of predictions are about as useful as a glass of saltwater in the middle of the Atlantic. "A probabilistic consideration of outcomes is an essential part of a scientific forecast," Silver writes.
The dirty little secret that’s really not all that secret is that good forecasting requires hard work. In economics that means combining theory with empirical fact and blending it carefully, intelligently with an econometric toolkit. As part of this process it’s important to track the forecasts and compare the results with the actual data as it arrives. It’s also crucial to design a forecasting system that’s dynamic, which is to say that the forecasts evolve as new data arrives. I do a bit of this on these pages with the GDP nowcasts and analyzing/forecasting the economic trend.
Tracking and analyzing the errors, which are inevitable, is essential in the forecasting game. This information provides valuable context for improving the process, and for keeping forecasters humble. In the grand scheme of economic prognostications, there’s a sea of guesses ahead of the actual data. What you see very little of is after-the-fact analysis. That’s partly because writing about the full process of forecasting and the post-mortem analysis is time consuming. I spend a fair amount of time tracking my predictions in a bid to learn from the errors. A bit of that shows up on these pages (see the above links, for instance). Most serious economists do the same, and on a fairly sophisticated level, even if the details aren’t available gratis to the public.
Some media hounds are particularly good at making dramatic claims about what’s coming—sometimes far into the future. Just the other day a "respected" hedge fund manager was on one of the talk shows and vaguely warned about a recession at some point next year and/or in 2014. He offered no data, no insight beyond attacking the Fed and other branches of government. This plays well as entertainment and resonates emotionally as the election draws near. But it’s the forecasting equivalent of driving drunk.
Granted, this particular hedge fund guy may have spent hours crunching the numbers before sounding off, but it’s impossible to know, at least from the video clip I saw. He certainly mentioned no serious research.
The reality is that if you do your homework, and routinely analyze the data as it’s updated, you can develop reasonably reliable intuition about the current state of the business cycle. As always, major turning points are a serious threat to even the best forecasts. Otherwise, looking ahead for the short term with a fair amount of confidence is possible, but far from inevitable. That said, the further out in time we gaze, the lower the odds that the forecast will be accurate.
It doesn’t help that economic data is subject to revisions, sometimes dramatically so. "The economy, like the atmosphere, is a dynamic system: everything affects everything else and the systems are perpetually in motion," Silver reminds. That means that any one forecast in macro should be taken with a grain of salt. Meantime, it's important to study the vintage data along with the revised numbers. That’s the basis for arguing that careful forecasting through time, and tracking how the forecasts evolve, is a much stronger methodology for looking forward. Even better is a set of forecasts that draw on different data sets and crunch the numbers with different methodologies. Why? Because no one really knows which indicators work best for predicting the business cycle. Ditto for the models that will always deliver the optimal outputs.
Good information, in other words, doesn’t come easy in macro, even in a world ripe with raw data. That doesn’t stop anyone from making bold forecasts that are based on little more than emotion and a shallow review of a few indicators. Then again, there’s a method to that madness if you’re trying to drum up publicity or promote your hedge fund.
No wonder that simple techniques do a decent job as a general rule in macro. "If you’re looking for an economic forecast, the best place to turn is the average or aggregate prediction rather than that of any one economist," Silver writes. Fair enough. Numerous studies through the years support this notion, and so it’s a reasonable benchmark for judging the wider world of predictions. "And yet while the notion that aggregate forecasts beat individual ones is an important empirical regularity," he adds, "it is sometimes used as a cop-out when forecasts might be improved."
Improvement comes slowly in economic forecasting, if at all, and only with hard work. Quite a lot of that hard work is directly related to minimizing error as opposed to improving estimates proper. On that note, one sure-fire way to enhance our strategic intelligence is to ignore the economic porn that passes as informed judgment. Fortunately, there’s an ample of supply of good forecasters to follow. The bad news is that they’re usually drowned out by the pundits who specialize in drama and quantity over careful analysis.
Posted by jp at 11:47 AM | Comments (0)
October 18, 2012
Conference Board's Leading Index Increased In September
The Leading Economic Index (LEI) published by the Conference Board increased 0.6% in September, echoing the trend that's been unfolding with the release of individual indicators in recent weeks and summarized yesterday in a broad review of last month's numbers via The Capital Spectator Economic Trend Index. But in the wake of this morning's sharp jump in weekly jobless claims figures for last week, the generally positive numbers for last month carry less weight than they did yesterday. All will be resolved, for good or ill, when we see more data for October in the coming weeks. Meantime, there are some new questions, if only on the margins.
For now, it's still reasonable to assume that September's modest growth will spill over into this month. Growth doesn't usually evaporate overnight, even when it's slow growth. The operative word, of course, is "usually." Turning points in the business cycle can sometimes be elusive to mortal eyes in real time, and so there's always a danger that the latest data points can mislead us. That said, the rear view mirror contains some cheery messages. “The U.S. LEI increased in September, more than offsetting the decline in August," says Ataman Ozyildirim, an economist at The Conference Board, in a press release. "The LEI has been signaling an economy that is fluctuating around a slow growth trend."
The slow growth comes with caveats, of course. As another economist at the Conference Board noted in the press release: “The single biggest challenge remains weak demand, domestically and globally. The struggle to regain firmer ground – in financial markets, international trade and global industrial output – continues because of weak consumer demand and a lack of more robust business investment," Ken Goldstein reminds.
Posted by jp at 10:18 AM | Comments (0)
Weekly Jobless Claims: A Sharp Turn For The Worse
If you needed another reason to treat weekly jobless claims data with caution in the short term, today’s update aims to please. The unusually large drop reported previously (for the week through October 6) evaporated in today's release, and then some. As I noted last week, any big change in the number du jour for this volatile series requires several weeks of corroborating data before it's safe to make hard and fast conclusions. If that wasn't obvious before, it is now.
Jobless claims surged higher last week to a seasonally adjusted 388,000. That more than reverses the previous decline that looked so enticing for the cause of optimism. As a result, claims have jumped to the highest level since mid-July. Suddenly the case for thinking that this leading indicator is treading water is plausible once more.
If you're looking for dark signs, there's a bigger monster in today's data. The year-over-year percentage change in unadjusted claims numbers inched into positive territory last week for the first time in over a year. The burning question, of course, is whether this too is noise, or an early signal of deeper trouble in the weeks and months ahead? The only reliable answer at this point is that no one really knows. But this much is clear: If jobless claims continue to rise on a year-over-year basis, we'll have a genuine reason to worry. If the trend rolls on, the next step would be to look for confirming signs of weakness in other indicators.
Those tasks are for the days ahead. Meantime, let's review what we know so far. September generally was a positive month for a broad set of indicators, as I discussed yesterday. In turn, the case for expecting a stronger pace of growth for Q3 GDP growth (scheduled for release on October 26) vs. Q2's weak rate is credible... to a degree. But that's all about assessing recent history. By contrast, the question before the house in light of today's report is how Q4 is shaping up? More specifically, will the October data reflect a new round of weakness that's not apparently in the September profile? With minimal numbers for October to evaluate, it's an open question that must remain highly speculative for now.
That said, today's disappointing update on claims is one data point that must be weighed against a broad set of relatively positive numbers from other corners of the economy, albeit for the previous month. Given the potential for large revisions and high short-term volatility in weekly data on unemployment filings, it's best to reserve judgment. But the stakes are now a bit higher. If next week's claims report again shows that the year-over-year change in this series is rising, and today's annual gain survives the revision process, it's going to get tougher to dismiss the numbers as noise.
Keep in mind that the last time that new claims spiked into positive territory on an annual basis in unadjusted terms—April 2011—it was a one-time weekly event that quickly faded. The economy, in fact, continued to muddle forward with slow growth afterward. A repeat performance next week with claims data falling would be encouraging. Will it happen? Tune in next week for the answer….
Posted by jp at 9:27 AM | Comments (0)
October 17, 2012
Q3:2012 U.S. GDP Nowcast Update | 10.17.2012
The latest economic numbers have boosted our nowcasts for Q3 GDP, which is scheduled for official release from the government on October 26. Meantime, it’s getting easier to anticipate some improvement over Q2’s weak 1.3% growth.
Here's a review of how today's nowcasts compare with recent history and two widely cited predictions (via The Wall Street Journal's survey of economists and the latest estimate from the National Association for Business Economics):
For additional perspective, consider how our nowcasts have evolved in recent weeks as new macro numbers have been published:
Every guesstimate of what’s coming, no matter how refined, is suspect, of course, and a healthy dose of caution is necessary here. The 2.9% nowcast for Q3 GDP via the 10-factor model is almost certainly overstating the possibilities for what we’ll learn from the Bureau of Economic Analysis at the end of the month. If so, some of the excess optimism is probably due to the fact that this particular model draws on a longer span to make its estimates. When I start the series of Q4 nowcasts, I'll probably refine the 10-factor model so that it focuses exclusively on the quarter-over-quarter trends, if only for more direct comparison with the other models. For now, to maintain continuity with what I've been publishing for Q3 nowcasts, I'll keep all as is through through the end of the month.
Keep in mind that the four-factor model, which sticks with the latest quarter vs. the previous quarter for analyzing the data, also improved recently. That implies that the prospects generally have ticked up for expecting a higher Q3 growth rate vs. Q2’s dismal pace. The 10-factor model may be an anomaly, but the change for the better overall seems to resonate in the numbers.
Ah-ha, you say—the ARIMA and VAR nowcasts are unchanged. True enough, but there was no new information for updating these models (that's a function of how these models are run). By contrast, the 4- and 10-factor GDP nowcasts are higher because the additional reports since we last crunched the numbers on October 8 have been positive. Indeed, September reports for retail sales, industrial production, and new residential housing construction have dispatched a trio of positive data points. As a result, the 4- and 10-factor models that are sensitive to these indicators have perked up.
In fact, a broad read on the economy, based on the numbers published so far, supports the view that growth is holding up, and perhaps even strengthening a bit. It’s always dangerous to put too much faith in any one model or specific point forecast, but the numbers in the final weeks before the Q3 GDP number hits the streets suggest that the economy rebounded somewhat in the July-to-September period vs. the previous quarter.
Here's a brief profile of how each of The Capital Spectator's nowcasts are calculated:
4-Factor Nowcast. This estimate is based on a multiple regression of quarterly GDP in history relative to quarterly changes for four key economic indicators: real personal consumption expenditures, real personal income less government transfers, industrial production, and private non-farm payrolls. This model compares the data on a quarterly basis, looking for relationships with GDP within each quarter from the early 1970s to the present. The four independent variables are updated monthly and so the nowcast is revised as new data is published. In effect, this model is telling us what the data trends in the current quarter imply for the quarter's GDP growth.
10-Factor Nowcast. This model also uses a multiple regression framework for historical data from the early 1970s and updates the estimates as new numbers arrive, but with two key differences relative to the 4-factor model above. First, this model uses more factors—10 in all. In addition to the data quartet used in the 4-Factor model, the 10-Factor nowcast also incorporates the following series:
• ISM Manufacturing PMI Composite Index
• housing starts
• initial jobless claims
• the stock market (S&P 500)
• crude oil prices (spot price for West Texas Intermediate)
• the Treasury yield curve spread (10-year Note less 3-month T-bill)
The second difference is that the 10-factor model analyzes relationships across a longer span of time by considering the average of changes across the trailing one-, two-, three-, and four-quarter comparisons. The intuition here is that there may be influences on GDP that predate activity in the current quarter, and that those influences come from a broader set of economic trends. If so, the 10-factor model will do a better job of capturing those signals relative to the 4-factor model.
ARIMA Nowcast. The econometric engine for this nowcast is known as an autoregressive integrated moving average. The technique is using only real GDP's history, dating from the early 1970s onward, for anticipating the current quarter's change. As the most recent quarterly GDP number is revised, so too is the ARIMA nowcast, which is calculated in R software via Professor Rob Hyndman’s “forecast” package, which optimizes the prediction model based on the data set's historical record.
VAR Nowcast. The vector autoregression model looks to several data series in search of interdependent relationships for estimating GDP. I use the four variables in the 4-factor model noted above to generate VAR nowcasts of GDP. As new data is published, so too is the VAR nowcast. The basic idea here is to let the data specify the model's parameters. The data sets are based on historical records from the early 1970s, using the "vars" package for R to crunch the numbers.
Posted by jp at 4:53 PM | Comments (0)
U.S. Economic Trend Update | 10.17.12
The September data profile is nearly complete and the numbers provided so far reflect an economy that continues to grow. Of the 12 indicators published to date for The Capital Spectator Economic Trend Index (CS-ETI), 9 are trending positive. That’s a strong signal for assuming that recession risk was still low last month.
As the table below shows, there are relatively few signs of trouble according to a broad set of economic and financial indicators. In fact, one danger sign for July and August turned positive last month (ISM Manufacturing).
The 3-month moving average for CS-ETI, which is calculated from the numbers in the table above, is currently at 75.0% through September, based on the published data. As the next chart suggests, recession risk at these levels is a low-probability event according to the historical record. A drop below 60% would be a warning sign, and sliding under 50% would indicate that a new recession is a virtual certainty. Fortunately, CS-ETI’s 75.0% reading appears relatively stable and comfortably above the hazard zone. Although the September level to date is slightly below August's 76.2% on a 3-month moving average basis, that's a slight fall and well within the normal range of fluctuations during periods of economic growth.
For some perspective on CS-ETI’s outlook for the immediate future, consider ARIMA estimates to fill in the missing numbers for September, along with guesstimates for October and November. 1 Each indicator for CS-ETI is forecast independently, with the results aggregated to estimate CS-ETI's 3-month average. Any one forecast is likely to suffer error, of course, but predicting all the indicators in a robust econometric framework should minimize the risk a bit if some of the errors cancel each other out. Using the ARIMA estimates to fill in the gaps tells us that CS-ETI's 3-month average for September will more or less hold steady in the 75% range once the final numbers arrive. Meantime, October and November are expected to post higher readings for CS-ETI, according to the ARIMA outlook.
1. The ARIMA forecasts are calculated in R software, using Professor Rob Hyndman’s “forecast package, which optimizes the model's parameters based on each data set's historical record. ^
Posted by jp at 3:37 PM | Comments (0)
Housing Starts & New Permits Rise Sharply In September
The housing market reached what might be thought of as a new post-recession milestone last month, and for all the right reasons, the Census Bureau reports. The takeaway here: The idea that the economy is caught in a fatal swoon just took another blow with today’s numbers. What’s more, there’s reason to wonder if growth is set to pick up a bit for the economy overall, an outlook that’s supported by my latest nowcasts of Q3:2012 GDP (I’ll have an update later today). That's also the message in the September profile for economic and financial data, as summarized by The Capital Spectator Economic Trend Index (I’ll update CS-ETI today as well). Today’s housing numbers certainly don’t offer any reason to think otherwise.
Housing starts rose to an annualized rate of 872,000 last month, up a strong 15% from August. More of the same appears to be on tap, based on the nearly 12% gain in newly issued building permits for private housing in September.
More importantly, the year-over-year percentage change in starts and permits continues to rise at a healthy pace. Permits are up a sizzling 45% from a year ago (a new post-recession high for the annual rate of change) and the trend in starts is almost as strong, posting a 35% increase in September vs. a year earlier.
The fact that housing has continued to recover is a persuasive signal for expecting that the economy will continue to grow. Housing per se accounts for a relatively small share of GDP, but it’s widely known that the so-called multiplier effect from housing is quite powerful. New home construction generates a wide array of jobs, starting with the building of the structures. The effects ripple through the economy for months after a home is built and sold as the new owners purchase appliances, furniture, etc.
The fact that interest rates in general, and mortgage rates in particular, are at or near all-time lows only strengthens the case for expecting that September’s housing data reflects a trend with legs. Is this good news surprising? Perhaps, but as far back as December 2011 I discussed some of clues that suggested that the housing market was finally poised for a rebound. What’s clear now is that the rebound is unfolding. Yes, tomorrow’s unknown unknown may derail the trend. But if you’re looking for a convincing sign that the economy isn’t deteriorating, today’s housing update is a compelling piece of evidence.
In fact, the signs that the U.S. economy was headed over the cliff into a new recession have been minimal all along. Cherry-picking a few data points and/or focusing too much on the short term changes apparently tripped up some analysts. Others may have been blinded by overly complex models that suffered from overfitting the data. But a clear review of a broad data set looked convincing for thinking that slow growth would prevail. Back in June, for instance, I made the case that the odds of a new downturn appeared low, based on a precursor to CS-ETI. That’s remained clear in the following months, and September’s profile (as I’ll discuss later today) still looks strong enough to seriously doubt the claims from some corners that a new recession has either started or is about to strike at any moment. To be clear, this isn’t my subjective view; rather, it’s what the numbers tell us, based on a broad read of economic and financial indicators.
Yes, all the usual caveats apply, starting with the fact that there are still plenty of risks lurking that could bring trouble in the near-term future. If so, that's trouble that's not reflected in the numbers in hand today. At the top of the list of potential catalysts for turmoil down the road:
* Congress allows fiscal cliff risk to drag us over the edge
* The slowdown in emerging markets deepens
* The euro crisis takes (another) turn for the worse
* One or more of the various hot spots in the Middle East deteriorate and send energy prices skyrocketing
If and when the U.S. cycle takes a convincing turn for the worse, it'll be clear in the numbers, and increasingly so. And, yes, you'll read about the change in the trend here. Meantime, if we’re judging the business cycle now, using the latest numbers available, the cries to run for cover continue to look premature. Tomorrow, of course, as Scarlett famously observed, is another day.
Posted by jp at 9:43 AM | Comments (0)
October 16, 2012
Industrial Production Rebounds In September
Industrial production rebounded in September after a steep decline in August. As the Federal Reserve noted when the August numbers were released, the sharp drop that month was probably due to the temporary effects of Hurricane Isaac. Today’s update appears to offer confirmation that the August retreat was a one-time problem rather than the start of a cyclical downturn. Indeed, industrial production continues to rise at a modest pace, advancing 2.8% on a year-over-year basis through last month. Today’s news brings one more positive contribution to the September economic profile, and one more reason for thinking that recession risk remains low.
Yes, September’s 0.4% rise in industrial production is relatively modest compared with recent history, but it’s enough of a gain to provide strong evidence for seeing August’s deep slide as a one-time anomaly.
More importantly, September’s rise is strong enough to raise the year-over-year change in industrial production to 2.8% from the previous annual gain of 2.6% through August. You can't rely on one indicator for analyzing the business cycle, but to the extent that industrial production is informative it's telling us that the economy continues to expand.
The slightly higher annual growth rate in industrial production implies that the economy isn’t weakening. It’s debatable if growth overall is improving, but it’s hard to argue that the cyclical demons have the economy by the throat.
History suggests that recessions don't start with industrial production rising at a 2.6% year-over-year pace. Industrial production’s relatively upbeat trend is supported by a broad read on more than a dozen economic and financial indicators through September via last week’s update of The Capital Spectator Economic Trend Index. I’ll update CS-ETI before the week is out, but at the moment the incoming numbers for the September economic profile—including yesterday’s strong update on retail sales—remains encouraging for expecting modest growth generally.
Posted by jp at 9:47 AM | Comments (0)
October 15, 2012
September Retail Sales: Another Solid Increase
Retail sales posted another respectable advance in September, the Census Bureau reports. The 1.1% rise last month matches the previous gain, which was revised up. It's been a number of years, in fact, since we've seen back-to-back 1%-plus gains in retail sales on a monthly basis. Today’s retail sales update is just one data point, of course, but it echoes the narrative that I've been discussing on these pages for some time: the economy continues to chug along, expanding modestly. That implies that recession risk remains low. (For a broad review of the data behind this view, see last week’s updates of The Capital Spectator Economic Trend Index and the Q3 GDP nowcast.)
Even after stripping out the volatile auto sector, or the potentially distorting data from gasoline sales, consumption still rose handsomely last month. Retail sales ex-autos jumped 1.3% in September and retail sales ex-gasoline advanced 1.0%.
More importantly, the year-over-year change in retail sales continue to rise. For the third month in a row, the annual pace strengthened. Through September, retail sales gained 5.2%. That’s an encouraging signal for expecting that the economy will remain in a growth mode for the immediate future, and it offers a fresh batch of quantitative support for what a broad read of the numbers has been telling us all along.
With today’s retail sales report, we’re about halfway through the September updates. So far, the numbers continue to offer convincing evidence that recession risk isn't a real and present danger. (I’ll have a full update on all the numbers later in the week via The Capital Spectator Economic Trend Index and a new GDP nowcast). Meantime, the case for slow growth, perhaps slightly better than in recent history, remains a convincing outlook.
What might derail this relatively rosy outlook? Take your pick. Any number of problems could create trouble for the economy. Indeed, it’s easy to come up with several plausible scenarios that slap the macro profile to the point that growth evaporates rather quickly. At the top of the list of potential catalysts:
* Congress allows fiscal cliff risk to drag us over the edge
* The slowdown in emerging markets deepens
* The euro crisis takes (another) turn for the worse
* One or more of the various hot spots in the Middle East deteriorate and send energy prices skyrocketing
Yes, there’s plenty to worry about, although on one level that’s always true. For now, the numbers in hand tell us that the U.S. economy continues to grow, sluggishly perhaps, but growth nonetheless. When that changes, the incoming data will tell us so, in relatively clear terms. And, yes, you’ll read about it here. Meantime, let’s acknowledge what’s obvious in the numbers: recession risk, according to the latest numbers, is still low.
Posted by jp at 9:23 AM | Comments (0)
October 13, 2012
Book Bits | 10.13.12
● Plutocrats: The Rise of the New Global Super-Rich and the Fall of Everyone Else
By Chrystia Freeland
Article by author via The Atlantic
F. Scott Fitzgerald was right when he declared the rich different from you and me. But today’s super-rich are also different from yesterday’s: more hardworking and meritocratic, but less connected to the nations that granted them opportunity—and the countrymen they are leaving ever further behind.
● Trade the Congressional Effect: How To Profit from Congress's Impact on the Stock Market
By Eric Singer
Press release for the book
Historical research indicates that, more often than not, when Congress is in session there is a negative effect on equities markets (the "Congressional Effect") due possibly to investor uncertainty surrounding government action or inaction as well as the unintended consequences of Congressional legislative initiatives on the stock market. Author Eric Singer, a financial professional with over twenty-five years of experience, is an expert on this phenomenon, and with this new book he shares his extensive insights with you. Trade the Congressional Effect skillfully details how you can profit from Congress's impact on the stock market. Along the way, it puts this approach in perspective and gives you all the tools you'll need to profitably incorporate it into your investing endeavors. Singer walks you through the process of trading the Congressional Effect and provides practical guidance regarding the possible pitfalls and opportunities you'll face each step of the way.
● The World in the Model: How Economists Work and Think
By Mary S. Morgan
Summary via publisher, Cambridge University Press
During the last two centuries, the way economic science is done has changed radically: it has become a social science based on mathematical models in place of words. This book describes and analyses that change – both historically and philosophically – using a series of case studies to illuminate the nature and the implications of these changes. It is not a technical book; it is written for the intelligent person who wants to understand how economics works from the inside out. This book will be of interest to economists and science studies scholars (historians, sociologists and philosophers of science). But it also aims at a wider readership in the public intellectual sphere, building on the current interest in all things economic and on the recent failure of the so-called economic model, which has shaped our beliefs and the world we live in.
● The Family Wealth Sustainability Toolkit: The Manual
By Fredda Herz Brown and Fran Lotery
Summary via publisher, Wiley
The Family Wealth Sustainability Toolkit gives wealthy individuals, family offices, and the financial planners, advisors and wealth managers who counsel them, the tools they need to better assess their wealth sustainability skills. One part assessment software tool and one part companion book, the online Index allows readers to assess their family enterprise across four dimensions of sustainability, while the Manual acts both as a roadmap to analyzing their results and provides a foundation in best practices.
● The Shrinking American Middle Class: The Social and Cultural Implications of Growing Inequality
By Joseph Dillon Davey
Summary via publisher, Palgrave Macmillan
The United States lost one third of its factory jobs in the past decade as jobs were outsourced offshore, mostly to Asia. Jobs that require a college degree are next to go. China will award six times as many degrees this year as they did ten years ago and any job that can be digitized will be 'tradable'. Estimates of the number of vulnerable jobs range from a low 11 million to a staggering 56 million 'middle class' jobs. The median United States household income has already dropped by seven percent since 2000 and without dramatic changes in the American workforce that trend will become a disaster for middle class Americans.
● How To Really Ruin Your Financial Life and Portfolio
By Ben Stein
Video interview with author via The Tavis Smiley Show
The author of the forthcoming text, How to Really Ruin Your Financial Life and Portfolio, weighs in on abortion, the defense budget, the economy, poverty and how voters choose their candidate.
Posted by jp at 4:39 AM | Comments (0)
October 12, 2012
What Does Consumer Confidence Imply For The Equity Risk Premium?
Estimating the equity risk premium—the return on stocks over a "safe" asset such as the 10-year Treasury or 3-month T-bill—is at the heart of investment research and portfolio analysis. "It is the 'number' that drives everything we do," writes Aswath Damodaran, a finance professor at the Stern School of Business at NYU. The premium "depends strictly on expectations for the future because the investor's returns depend only on the investment's cash flows," advise the authors of the CFA Institute's Equity Asset Valuation
There are three basic methods for estimating the premium, Damodaran notes. You can survey investors and other sources for insight about expectations. You can also analyze history as a guide for thinking about the future. A third approach is crunching the numbers on any number of data sets for clues about the implied premium going forward. Two of the many methodologies in the implied category show up on these pages every so often. Recent examples include estimating the equity risk premium with the dividend yield via a basic application of the Gordon growth model and calculating expected equilibrium risk premiums. There are many other ways to estimate the implied premium, including a methodology that uses consumer confidence metrics, as explained in an intriguing new paper from the Investment Management Consultants Association: "Does the Stock Market’s Equity Risk Premium Respond to Consumer Confidence or is It the Other Way Around?", by Abdur Chowdhury and Barry Mendelson of Capital Markets Consultants.
“The increase in the equity risk premium [i.e., a fall in stock prices] since the beginning of the 2007-2009 Great Recession has led many analysts to believe that risk aversion among stock investors has moved to a permanently higher range in recent years,” Chowdhury and Mendelson write. “Whether the equity risk premium stays within its new wider range—seen in the pre-1960s period—or returns to the range exhibited during the past four decades will prove critically important for stock investors.”
The authors outline a methodology for modeling an idea inspired partly by a recent research note from James Paulsen of Wells Capital Management—"Could ‘Confidence’ Add 50 Percent to the Stock Market?". Paulsen shows that the equity market's premium generally tracks the ebb and flow of confidence in the economy, as measured by the Reuters/University of Michigan U.S. Consumer Sentiment Index. "Since at least 1950, premium and discount valuations of the stock market to its trendline have corresponded closely with periods of strong economic confidence and periods of broad economic fear," he notes. As a result, "a slow but steady revival in U.S. confidence could represent the biggest driver of stock market performance in the next several years!"
Chowdhury and Mendelson advise that their research tells them that "the recent increase in the equity risk premium primarily reflects a temporary collapse in consumer confidence." They go on to explain that
As long as consumer confidence in the sustainability of economic recovery remains low, today's elevated risk premium will persist. In fact, this has significantly improved the stock market's risk-reward profile because lower confidence has introduced a bigger buffer relative to competitive interest rates. Investors should track leading economic indicators (LEI) and their components closely if they want to gain comfort with the direction of the ERP. The higher risk premium seen in the past few years has significantly enhanced the risk-return profile of the stock market.
For some perspective on how consumer sentiment compares with the stock market's price changes over the decades, Paulsen compares the detrended S&P 500 with the Reuters/University of Michigan Index since 1950:
Paulsen observes that "with the exception of the late 1990s when the index briefly reached above 110, 'normal' economic recovery confidence peaks have been around 100. Stock investors should consider what could happen should confidence slowly recover to normal again in the next five years eventually reaching a level between 95 and 100." He goes on to consider the stock market in the context of a rising Reuters/University of Michigan Index.
Assume confidence improves from its current level to about 95 boosting the investor valuation of the trendline from its current 25 percent discount to about a 25 percent premium in five years. A trendline target in five years of about 2100, combined with a valuation premium of about 25 percent implies a target price for the S&P 500 of about 2600—nearly a double from today’s level!
Paulsen wrote that a few months ago, in July 2012. Fast forward to today's October update of Reuters/University of Michigan Index, which "unexpectedly rose in October to its highest level in five years as optimism about the overall economy improved," Reuters reports. The consumer sentiment index is now at 83.1, up from September's 78.3 reading and the S&P is trading at roughly 1434--up nearly 14% year-to-date. It's anyone's guess where we go from here, but Paulsen's reminder to consider what might happen to stocks if the consumer index returns to a 95-to-100 range resonates a bit stronger at the moment.
Posted by jp at 10:32 AM | Comments (0)
October 11, 2012
Can We Believe Last Week’s Big Drop In Jobless Claims?
Maybe not, some analysts warn. As reported earlier today, new filings for unemployment benefits declined last week to the lowest level since January 2008. On its face, the data suggests a big improvement in the dynamics of the labor market. But in the hours after the numbers were released, questions about the validity of the report have been flying far and wide.
Stephen Stanley of Pierpont Securities, for example, thinks the report is hogwash, according to Fox Business News. Writing in a research note, Stanley charged that “this reading [on jobless claims] is worthless in terms of informing on the general economy.” The Fox Business News story also reported that a Labor Department spokesman
said the numbers were skewed by one large state that underreported its data. The spokesman declined to identify the state, but economists believe California is the only state large enough to have such a significant impact on the overall numbers.
According to the spokesman, the reason that state’s claims numbers fell short was because the state left out a pile of unprocessed claims related to seasonal factors around the beginning of the fourth quarter, which began Oct. 1.
If today’s reported is skewed, we’ll soon see a revision that corrects the distortion. But it would take one hell of an upward revision to reverse the generally favorable trend that’s evident in the recent numbers on a year-over-year basis before seasonal adjustment. This is the measurement that matters if we’re looking for relatively reliable signs from this data series in the context of business cycle analysis. On that score, it’s hard to imagine that we’ll have a complete reversal of fortunes next week, much less a change that turns today’s good news into dark news.
Consider that the unadjusted claims total was 301,073 for the week through September 29—a decline of 9.4% from a year earlier. The following week (via today’s reportedly skewed number in unadjusted terms for the week through Oct 6) reveals a rise from the previous reading to 327,063. That works out to a decline of 19% vs. 12 months previous. Even if we learn next week that today’s number is revised upward by an unusually high 50,000, the year-over-year change would still register a decline to the tune of nearly 8%. Even then, the numbers would still be telling us that the labor market is healing, which implies that recession risk is still low. Indeed, jobless claims have been declining by roughly 10% a year for much of the past year. When that trend reverses, and new claims start rising vs. year-earlier levels, we’ll have a strong signal that the economy is caught up in a cyclical swoon.
Meantime, it’s best to remain cautious about any one data point and instead focus on the year-over-year trend for this series, which has a history of high volatility in the short run. By that standard, the case for expecting more of the same—a modest but steady decline in new claims—is still a reasonable view.
For now, however, we have this chart to consider. It's subject to revision, of course, but it requires one heck of a pessimistic outlook to expect that we'll soon see an increase in year-over-year claims data.
None of this would mean much if the rest of the key indicators were sending dark signals about the business cycle, but that's not the case either (for the details, see my post here). That doesn't stop anyone from believing what they want to believe. But if you're interested in what the numbers are telling us, writ large, it's still early to start planning for the economy's funeral.
Posted by jp at 3:26 PM | Comments (2)
Jobless Claims Fell To New Post-Recession Low Last Week
Today’s update on weekly jobless claims delivers the best news for the labor market in recent memory. It certainly one of the strongest reports for this series since the Great Recession ended in June 2009. However you describe today’s news for this leading indicator, it’s unequivocally encouraging, and powerfully so. Yes, it may be misleading, as any one data point for this volatile series can be, and so we should be wary until we see more numbers in the weeks ahead. But at the very least today’s update strengthens the case for expecting continued healing in the labor market and slow economic growth, perhaps at a moderately faster pace. Analysts in the recession-is-here-now camp, in other words, have some explaining to do.
New filings for unemployment benefits dropped 30,000 last week to a seasonally adjusted 339,000, the Labor Department reports. That's the biggest weekly drop in three months, which means that the total claims last week fell to a new post-recession low. In fact, it gets better: last week's claim tally is the lowest since January 2008.
Filtering out the seasonal adjustments and focusing on year-over-year changes brings an equally powerful message in favor of optimism. As the next chart shows, new claims dropped 19% last week relative to a year ago. That's nearly twice as big as the annual decreases in recent months, and it's one more sign for thinking that maybe, just maybe, we have a game-changer on our hands.
It's worth reminding again that weekly claims data is noisy and so we shouldn't get too excited about today's update. Let's see how the revisions go and how incoming data fares in the weeks ahead. If we see today's decline hold, we'll have a much stronger case for thinking that the labor market is poised for modestly stronger growth than we've seen recently.
Meantime, we can say with a high degree of confidence that the labor market continues to heal, which is a critical factor for analyzing the business cycle. As I've been emphasizing all along, the year-over-year change in unadjusted claims is the metric to watch and it's been routinely dropping at a roughly a 10% pace, week after week. Ignoring this trend, as some analysts seem to do, has been a big mistake for looking ahead. This has been, and remains, a strong signal for expecting that the labor market isn't imploding and that jobs growth will roll on for the foreseeable future. It's also a sign that recession risk remains low.
This relatively upbeat analysis is all the more persuasive when you consider that a broad reading of economic and financial indicators tells us that the economy isn't in imminent danger of contracting. Again, I've been making this point for months. Why? Because the data has been quite clear all along, as shown by The Capital Spectator Economic Trend Index (CS-ETI). Today's news on weekly claims offers one more reason for thinking that the economy will continue to grow.
Is the sluggish pace for economic growth set to give way to a faster expansion? It's too soon to tell. But looking at nowcasts of third-quarter gross domestic product suggests that we'll see an improvement over Q2's weak 1.3% real annualized increase in real GDP when the Bureau of Economic Analysis releases its report on October 26.
For now, the worst you can say about the economy is that it continues to expand at a slow rate and so it's vulnerable to any number of risks on the macro landscape, starting with the approaching danger of the fiscal cliff. But suddenly the odds look a bit better for thinking that slow growth might get a bit faster.
Posted by jp at 9:26 AM | Comments (1)
October 10, 2012
Jack Welch, Employment Data, And The Big Picture
Jack Welch insists that the September jobs report, released last week, is "strange" and "implausible." Specifically, the economy's sluggish growth doesn't support the reported drop in unemployment last month to 7.8% from 8.1% in August. It just "doesn't make sense," the former head of General Electric writes in The Wall Street Journal. The problem, he explains, is that the methodology behind the household employment survey, which is the source of the unemployment number, is less than perfect. Agreed. But why stop there? If we're fired up about finding reasons to question economic indicators--one at a time, in a vacuum--the opportunity is unlimited for casting aspersions across the statistical landscape. This is a dead end, however, if we're looking for deeper insight about the economy and the business cycle. Pointing out flaws for a given data series has merit, but not much. The bigger issue is deciding how to interpret the numbers in search of reasonably reliable perspective. Fortunately, the outlook isn't as bleak as Welch's essay implies.
It’s well established that economic data generally is noisy. In other words, it’s best to remain cautious about the number du jour. Welch and others correctly warn that we should be suspicious of the household survey’s estimate that the number of employed persons rose by a dramatic 873,000 last month. Actually, we should remain suspicious of monthly numbers generally and focus instead on year-over-year percentage changes and compare the trend in employment with a broad set of economic and financial numbers for a stronger read on the current state of the business cycle. On that score, the employment data don’t look so “strange” after all.
For example, consider how the rolling 1-year percentage change in the household employment numbers compare with the establishment series, an alternative methodology that surveys businesses as opposed to households. Clearly, the household data (red line) is considerably more volatile than the establishment numbers, even on a year-over-year basis. Over time, however, the two series generally track one another, although at times there can be relatively wide divergences.
For a clearer look at how the two data sets compare let’s zoom in on recent history: the past 10 years. Household employment last month rose roughly 2% vs. the year-earlier level. Meantime, the establishment number increased 1.7% for the year through September. We can argue about which number is a better read on what’s happening in the labor market, but both series are essentially telling us the same thing: the economy is creating jobs, somewhere in the 1.7% to 2.0% range. That's roughly in line with the August reading. In other words, not a heck of a lot changed last month in terms of the broad trend in employment data, even if some pundits are making a fuss about the last data point.
Sure, you can focus on the month-to-month changes, or even the 3-month or 6-month fluctuations. But that's problematic because of the short-term noise that can and does mislead us. Looking at year-over-year changes reduces a fair amount of that noise. Even so, we should still be skeptical. Fortunately, we can enhance clarity a bit further by looking at additional labor market series, such as initial jobless claims and the hours worked. We can and should track other economic and financial indicators as well. In fact, I regularly do just that on these pages via The Capital Spectator Economic Trend Index (here’s the latest update).
Not surprisingly, looking at a diversified set of indicators, primarily on a year-over-year basis, provides a statistically robust measure of economic activity. By contrast, playing up the limitations of any one indicator is the equivalent of a high school prank. If you cherry pick numbers you can see anything you want. But if you're interested in a relatively high confidence read on the business cycle, it's best to ignore the noise—in the data and in the media.
Posted by jp at 9:41 AM | Comments (1)
October 9, 2012
Who Moved My Peak Oil?
The buzz about peak oil has peaked, and for a good reason: the peak remains MIA. That doesn’t mean that the global supply of crude oil is a non-issue. Far from it. But for the moment, at least, statistical evidence in favor of arguing that the world’s output of crude has hit a ceiling, or is in imminent danger of doing so, looks thin.
Global production of crude (defined as crude including lease condensate) hit an all-time high this past April: 75.872 million barrels per day, according to data from the U.S. Energy Information Administration. That wasn't supposed to happen, a number of peak-oil theorists warned over the past decade. In 2001, for example, geologist Ken Deffeyes wrote a widely cited book (Hubbert's Peak: The Impending World Oil Shortage
The peak-oil theorists haven't given up. Instead, they keep revising their peak forecasts, pushing the dates for production crests further out in time. Two years ago, for instance, Charles Maxwell—the "dean of oil analysts"—predicted that the peak will come sometime between 2015 and 2020.
Perhaps, but some observers of the oil scene argue that the peak-oil warnings must be labeled flat-out wrong. George Monbiot, a visiting professor of planning at Oxford Brookes University and author of Heat: How to Stop the Planet From Burning
For the past 10 years an unlikely coalition of geologists, oil drillers, bankers, military strategists and environmentalists has been warning that peak oil – the decline of global supplies – is just around the corner. We had some strong reasons for doing so: production had slowed, the price had risen sharply, depletion was widespread and appeared to be escalating. The first of the great resource crunches seemed about to strike….
Some of us made vague predictions, others were more specific. In all cases we were wrong. In 1975 MK Hubbert, a geoscientist working for Shell who had correctly predicted the decline in US oil production, suggested that global supplies could peak in 1995. In 1997 the petroleum geologist Colin Campbell estimated that it would happen before 2010. In 2003 the geophysicist Kenneth Deffeyes said he was "99% confident" that peak oil would occur in 2004. In 2004, the Texas tycoon T Boone Pickens predicted that "never again will we pump more than 82m barrels" per day of liquid fuels. (Average daily supply in May 2012 was 91m.) In 2005 the investment banker Matthew Simmons maintained that "Saudi Arabia … cannot materially grow its oil production". (Since then its output has risen from 9m barrels a day to 10m, and it has another 1.5m in spare capacity.)
Peak oil hasn't happened, and it's unlikely to happen for a very long time.
It certainly hasn't happened over the last decade. As the next chart reminds, production is up in several of the key oil-producing nations, including Saudi Arabia. According to the EIA, Saudi output is higher by nearly one-third over the past 10 years through June 2012.
As always in the oil game, there are key details behind the numbers. Oil, as they say, isn't just another commodity. Geopolitics, in other words, intrudes big time on what otherwise would be a fairly straightforward supply/demand analysis. In the chart above, for instance, Iraq's big gain is less about new discoveries and more about the country's resumption of production after years of war. Meantime, Iran's retreating production reflects the combined burden of international sanctions and domestic difficulties with aging technology.
Despite the various issues, global production managed to increase 12% over that past decade. That doesn't mean that we should expect oil output to effortlessly rise, year after year. The one forecast that some of the peak-oil theorists got right is that finding and producing oil is getting tougher. But technology is improving too, and so far the net result is that the oil industry has been able to squeeze out more supply from what ultimately is a finite resource.
The idea of peak oil isn't dead, not by any means. At some point, production will top out, plateau, and then fall. Exactly when that occurs is wide open for debate. Even what was considered accepted fact—that U.S. production had peaked and was destined to suffer a long, slow decline—no longer looks true. Domestic output is up 6% over the past decade, and most of the gain has come over the last year or so. A few years ago, almost no one expected a revival. Now we're reading reports of U.S. production at 15-year highs.
The lesson in all of this? Predicting is still hard—especially about the future, and particularly for relatively long time horizons.
Posted by jp at 6:31 AM | Comments (5)
October 8, 2012
Q3:2012 U.S. GDP Nowcast Update | 10.8.2012
The case for anticipating slow growth in the third quarter rolls on. Today's update of The Capital Spectator's suite of nowcasts for third-quarter real GDP remain steady relative to the previous revisions from September 30. The current numbers incorporate last week's economic updates for several September indicators, which continue to signal slow growth for the economy (see here and here, for example). The models tell us that when the government releases the official GDP report for Q3 on October 26, the odds still look favorable for expecting that the economy's real (inflation-adjusted), annualized change will be slightly better than the sluggish 1.3% growth reported for Q3. This outlook is supported by the incoming data for September for estimating the broad economic trend (as we discussed earlier today), which suggests that there's still forward momentum in the economy overall and that recession risk remains low, given the latest numbers available.
Here's a review of how today's nowcasts compare with recent history and two widely cited predictions (via The Wall Street Journal's survey of economists and the Survey of Professional Forecasters):
There are advantages to keeping on eye on multiple estimates, each drawn from different methodologies, and tracking how they change through time. Are the estimates continually rising, falling, or going every which way? The fact that the nowcasts remain relatively steady as new data is published is an encouraging sign, given that the estimates for Q3:2012 GDP are somewhat higher vs. the reported number for Q2. With that in mind, here's how our four in-house nowcasts compare in recent weeks:
Here's a brief profile of how each of The Capital Spectator's nowcasts are calculated:
4-Factor Nowcast. This estimate is based on a multiple regression of quarterly GDP in history relative to quarterly changes for four key economic indicators: real personal consumption expenditures, real personal income less government transfers, industrial production, and private non-farm payrolls. This model compares the data on a quarterly basis, looking for relationships with GDP within each quarter from the early 1970s to the present. The four independent variables are updated monthly and so the nowcast is revised as new data is published. In effect, this model is telling us what the data trends in the current quarter imply for the quarter's GDP growth.
10-Factor Nowcast. This model also uses a multiple regression framework for historical data from the early 1970s and updates the estimates as new numbers arrive, but with two key differences relative to the 4-factor model above. First, this model uses more factors—10 in all. In addition to the data quartet used in the 4-Factor model, the 10-Factor nowcast also incorporates the following series:
• ISM Manufacturing PMI Composite Index
• housing starts
• initial jobless claims
• the stock market (S&P 500)
• crude oil prices (spot price for West Texas Intermediate)
• the Treasury yield curve spread (10-year Note less 3-month T-bill)
The second difference is that the 10-factor model analyzes relationships across a longer span of time by considering the average of changes across the trailing one-, two-, three-, and four-quarter comparisons. The intuition here is that there may be influences on GDP that predate activity in the current quarter, and that those influences come from a broader set of economic trends. If so, the 10-factor model will do a better job of capturing those signals relative to the 4-factor model.
ARIMA Nowcast. The econometric engine for this nowcast is known as an autoregressive integrated moving average. The technique is using only real GDP's history, dating from the early 1970s onward, for anticipating the current quarter's change. As the most recent quarterly GDP number is revised, so too is the ARIMA nowcast, which is calculated in R software via Professor Rob Hyndman’s “forecast” package, which optimizes the prediction model based on the data set's historical record.
VAR Nowcast. The vector autoregression model looks to several data series in search of interdependent relationships for estimating GDP. I use the four variables in the 4-factor model noted above to generate VAR nowcasts of GDP. As new data is published, so too is the VAR nowcast. The basic idea here is to let the data specify the model's parameters. The data sets are based on historical records from the early 1970s, using the "vars" package for R to crunch the numbers.
Posted by jp at 8:20 AM | Comments (0)
U.S. Economic Trend Update | 10.8.12
The September data published to date suggests that the U.S. economy continues to grow. The expansion remains sluggish, but it's still growth. Of the eight September indicators published so far for The Capital Spectator Economic Trend Index (CS-ETI), six are trending positive. That implies that recession risk was still low last month. But the reading is based on incomplete numbers. When the remaining indicators for CS-ETI are updated for September, we'll have a clearer picture of the broad economic trend. For now, the signs look encouraging. One of September's indicators—the ISM Manufacturing Index—turned positive for the first time since May, as we discussed last week. With that change for the better, and no reversal of fortunes so far in the other indicators that have been updated, September's profile is slightly brighter than August's. But with a half-dozen September updates yet to come, it's best to reserve judgment in the current environment.
Here's how the indicators stack up so far:
Taking the 3-month average of these indicators and tracking the changes through time continues to suggest that the economy's forward momentum is still strong enough to keep a new recession at bay. CS-ETI for September is currently at 74.3%. In other words, 74.3% of CS-ETI's indicators are trending positive, based on available data so far. A drop below 60% would be a warning sign, and falling under 50% would indicate that a new recession is a virtual certainty. The good news for the moment is that we're well above those levels. One area for concern is the fact that CS-ETI's 3-month moving average has been falling for four straight months. The decline remains moderate, however, and it's still well within the historical range associated with growth.
For some perspective on how CS-ETI may evolve in the immediate future, let’s turn to ARIMA estimates for each of the indicators and then aggregate the individual predictions for some guidance on the near-term outlook. 1 Any one forecast is likely to suffer error, of course, but predicting all the indicators in a robust econometric framework should minimize the risk a bit. Using the ARIMA estimates to fill in the missing numbers tells us that CS-ETI for September will more or less hold steady in the 75% range and October's reading will rise slightly to around 79%.
Today's October's ARIMA estimates (red boxes in chart above) represent an improvement from our previous October outlook (published on September 28). The uptick in the October estimate is primarily due to the revised ARIMA forecast that expects the credit spread to turn favorable this month for the first time in over a year. The actual data for the credit spread for the first week of October supports this view. According to the ARIMA estimate, more of the same is coming and the corporate spread will close out the month by posting a year-over-year decline, which we haven't seen for over a year (based on average monthly data). A decline in the credit spread implies that the market anticipates a relatively favorable economic climate. By contrast, a widening in this spread suggests that market sentiment sees trouble on the macro horizon.
Overall, the economic trend for September remains positive and the outlook for the immediate future suggests that the incoming data will paint a similar profile. As such, recession risk still looks low, based on a broad reading of the economic and financial indicators to date.
1. The ARIMA forecasts are calculated in R software, using Professor Rob Hyndman’s “forecast” package, which optimizes the model's parameters based on each data set's historical record. ^
Posted by jp at 4:41 AM | Comments (0)
October 6, 2012
Book Bits | 10.6.2012
● Bull by the Horns: Fighting to Save Main Street from Wall Street and Wall Street from Itself
By Sheila Bair
Review via Real Clear Markets
In her new book, "Bull By the Horns," former FDIC chairman Sheila Bair revisits a wide range of policy debates that occurred during her tenure from 2006 to 2011. Chairman Bair has appropriately received acclaim for having steered the FDIC through the crisis, and especially for being among the first to identify the foreclosure crisis and call for policy action to address the problem.... A succinct description of "Bull By the Horns" is that lots of mistakes were made during the crisis - by others. Current Treasury Secretary Timothy Geithner receives particularly vivid criticism, a feature of the book that is not surprising in light of the widely-known animus between the two officials.
● Fear and Greed: Investment risks and opportunities in a turbulent world
By Nicolas Sarkis
Review via MoneyWeek
The section on emerging markets is refreshingly honest. Most authors writing on this topic are bulls on the Brics, but Sarkis is much more bearish. Although valuations are not excessive relative to earnings, Sarkis believes that there are large downside risks in these markets. He also challenges the sloppy thinking that many China bulls are prone to, such as their faith that central planning can tame the economic cycle.
● The Permanent Portfolio: Harry Browne's Long-Term Investment Strategy
By Craig Rowland and J. M. Lawson
Summary via publisher, Wiley
Market uncertainty cannot be eliminated. So rather than attempt to do away with it, why not embrace it? That is what this book is designed to do. The Permanent Portfolio takes you through Harry Browne's Permanent Portfolio approach—which can weather a wide range of economic conditions from inflation and deflation to recession—and reveals how it can help investors protect and grow their money. Written by Craig Rowland and Mike Lawson, this reliable resource demonstrates everything from a straightforward four-asset Exchange Traded Fund (ETF) version of the strategy all the way up to a sophisticated approach using Swiss bank storage of selected assets for geographic and political diversification. In all cases, the authors provide step-by-step guidance based upon personal experience.
● The Cost Disease: Why Computers Get Cheaper and Health Care Doesn't
By William J. Baumol, et al.
Summary via publisher, Yale University Press
The exploding cost of health care in the United States is a source of widespread alarm. Similarly, the upward spiral of college tuition fees is cause for serious concern. In this concise and illuminating book, the well-known economist William J. Baumol explores the causes of these seemingly intractable problems and offers a surprisingly simple explanation. Baumol identifies the "cost disease" as a major source of rapidly rising costs in service sectors of the economy. Once we understand that disease, he explains, effective responses become apparent.
● Information Wants to Be Shared
By Joshua Gans
Press release for e-book
A new ebook from Harvard Business Review Press takes a fresh examination of the economics of information selling in the digital age. What information really wants-what makes it more valuable, useful, and immediate, argues Joshua Gans, a professor at the University of Toronto's Rotman School of Management, is to be shared. Using the tools and logic of information economics, Information Wants to be Shared, shows how sharing enhances most information's value. He also shows how the business models of traditional media companies, gatekeepers who have relied on scarcity and control, have collapsed in the face of new technologies. Equally important, he argues that sharing can revive moribund, threatened industries even as he examines platforms that have, almost accidentally, thrived in this new environment.
● Socially Responsible Finance and Investing: Financial Institutions, Corporations, Investors, and Activists
Edited by H. Kent Baker and John R. Nofsinger
Summary via publisher, Wiley
The concept of socially responsible finance and investing continues to grow, especially in the wake of one of the most devastating financial crises in history. This includes responsibility from the corporate side (corporate social responsibility) as well as the investor side (socially responsible investing) of the capital markets. Filled with in-depth insights and practical advice, Socially Responsible Finance and Investing offers an important basis of knowledge regarding both the theory and practice of this ever-evolving area of finance.
● The Global Farms Race: Land Grabs, Agricultural Investment, and the Scramble for Food Security
By Michael Kugelman and Susan L. Levenstein
Summary via publisher, Island Press
As we struggle to feed a global population speeding toward 9 billion, we have entered a new phase of the food crisis. Wealthy countries that import much of their food, along with private investors, are racing to buy or lease huge swaths of farmland abroad. The Global Farms Race is the first book to examine this burgeoning trend in all its complexity, considering the implications for investors, host countries, and the world as a whole. The debate over large-scale land acquisition is typically polarized, with critics lambasting it as a form of “neocolonialism,” and proponents lauding it as an elixir for the poor yields, inefficient technology, and unemployment
Posted by jp at 4:52 AM | Comments (0)
October 5, 2012
Private Payrolls Growth Remains Sluggish In September
September was another month of slow jobs growth, the government reports. Private payrolls increased 104,000 last month, according to the Labor Department's establishment survey. (Total payrolls, which include government jobs, rose 114,000.) That's up from August's revised gain of 97,000 for the private sector, but no one will be impressed with these numbers. Nonetheless, there's no smoking gun here for arguing that the labor market is collapsing. It may be suffering a slow and lingering death, in which case the last rites may be administered at some point down the road. In the here and now, however, private-sector job growth of 104,000 doesn't signal that the economy's in recession, even if it's not hard to envision a change for the worse in the near-term future. Nor does the 1.7% year-over-year growth in private payrolls through last month tell us that the jig is up. It'd be another matter if September data so far from other sources screamed of free-fall. But that's not the case either (see here and here, for instance).
Meantime, a curiosity worth mentioning: A separate employment survey from the Labor Department shows a much-brighter picture for September. The so-called household survey, which is calculated with a separate methodology, is used for estimating the monthly unemployment rate. The official jobless rate for the nation reportedly fell to 7.8% last month vs. 8.1% in August. Why? The household survey reports that employment rose an incredible 873,000 last month--the best month in nearly a decade. Huh?!?! That's almost certainly overstating the case, and dramatically so, which is probably why most economists tend to focus on the establishment survey. Indeed, the household numbers are far more volatile on a monthly basis vs. the establishment data. (For some details on how the two series compare, see the Labor Department's explanation here.)
On that note, let's review the history of private payrolls via the establishment numbers in recent years for some context with today's update. As the chart below shows, the labor market is still expanding. It's not impressive (notwithstanding the household numbers), nor anywhere near sufficient to inspire much confidence about the longer-term economic outlook. But if we're looking for signs that September will eventually be labeled the start of a new recession, as defined by NBER, the news in today's payrolls report isn't dark enough.
It's important to distinguish between what's increasingly looking like a chronic illness for growth vs. nowcasting the current state of the business cycle. The key points that everyone agrees on: 1) economic growth decelerated over the last six months or so; and 2) the all-important pace of job growth has suffered too. The obvious warning signs in this process can't be ignored, namely, slow growth at some point, if it drags on long enough, will bring us to a new recession.
When the tipping point is reached, however, it'll be obvious in the data. That includes payrolls, but even this key indicator can't be relied on for issuing timely signals about the state of the business cycle. That requires a deeper dive into the data, which is the inspiration behind The Capital Spectator Economic Trend Index (CS-ETI). When we last checked in with CS-ETI for the read through August, the odds that a new downturn had started remained low. The numbers so far for September don't change that view, although it's still early and today's jobs report reminds that we should be prepared for weaker-than-expected news in other September indicators as they arrive in the coming weeks.
Pessimists will point out that data revisions will darken the cyclical skies and so profiles a la CS-ETI are bound to be misleading. Nice try, but the methodology behind CS-ETI minimizes revision risk on several fronts. First, CS-ETI measures a broad array of leading and coincident indicators so that we're not relying on the kindness of the revision fairy for any one data point. That's crucial because revisions are both positive and negative through time across a broad data set. By looking at a mix of indicators, the revisions to some degree will cancel one another out.
Another defense against revisions in CS-ETI is tracking mostly year-over-year percentage changes. That's important because the year-earlier figures are less likely to be revised dramatically, if at all. Year-over-year changes also provide us a clearer read on the cycle compared with trying to see through the seasonal distortion that routinely harasses in shorter time frames.
In addition, CS-ETI uses several indicators that are immune to revisions, i.e., the market data for stocks, oil prices, and interest rates. And the surveys for manufacturing and services via the Institute for Supply Management, along with the consumer sentiment survey from the University of Michigan, have a history of minimal revisions vs. conventional economic numbers.
Finally, to round out this point, I've analyzed the vintage data for the last 10 years and CS-ETI's signals hold up quite well. In other words, revision risk isn't likely to blind us for very long or very deeply, thanks to the design of CS-ETI.
All that aside, there's no denying that economic growth remains weak and is perhaps getting weaker. In terms of a binary analysis—growth or contraction?—the overall summary is that recession risk is still low. A qualitative analysis may tell us otherwise, of course, such as looking at a nowcast of third-quarter GDP, based on the latest numbers (here's last week's update). I'll have an update on that front soon, along with fresh numbers for CS-ETI.
Meantime, the sluggish expansion drags on. It may not be improving, but it's not necessarily getting worse either. We are, it seems, still caught in economic purgatory, somewhere between heaven and hell.
Posted by jp at 9:44 AM | Comments (0)
October 4, 2012
A Slight Jump For Jobless Claims Last Week
Jobless claims rose slightly last week, but the generally declining trend is still bubbling. New filings for unemployment benefits increased 4,000 to a seasonally adjusted 367,000 for the final week of September. More importantly, the large drop reported a week ago is holding up and claims continue to drop each week relative to year-earlier levels.
Claims aren't making much progress on a week-to-week or even a month-to-month basis, but the numbers aren't rising either. The worst you can say about this leading indicator is that it's stuck in neutral. That's not helpful in the sense that it suggests that the labor market's growth will remain sluggish. At the same time, the fact that claims aren't persistently rising implies that economic growth, slow as it is, will struggle on.
Claims data is especially noisy in the short term and so it's helpful to consider the year-over-year changes for a clearer profile. On that front, more of the same prevails, and that's a good thing, namely: claims continue to decline at roughly a 10% annual pace (in raw terms before seasonal adjustment). That's been an encouraging sign all along and it continues to be a bright spot that sends a strong message that jobs growth is still with us, and probably will be for the near term. When new claims start rising relative to year-earlier levels, we'll have a serious problem. But we're a long way from such a dark state of affairs, which is the main reason why this indicator overall continues to support the case for expecting growth rather than recession.
With today's claims report we now have a full set of numbers for September with this series. Although revisions may change the analysis at some point, the full month of claims at the moment provides us with another data point that brings mildly encouraging support for September's economic profile. Based on monthly calculations, jobless claims last month dropped 9% vs. September 2011. In other words, more of the same.
There are still many September economic reports to come, but so far, so good. The productive tally on monthly claims numbers follows yesterday's upbeat news on last month's activity in the services sector, manufacturing, and employment (via ADP).
Will tomorrow's employment report for September from the Labor Department close out the week on a high note? Briefing.com reports that the consensus forecast among economists for private payrolls in tomorrow's release sees a gain of 130,000 jobs for September, a bit higher than August's 103,000 advance. That's hardly impressive, but if it's accurate it would keep hope alive that slow growth rather than recession is still the path of least resistance.
“We’re not going anywhere quickly in the jobs market,” Ryan Sweet, senior economist at Moody’s Analytics, tells Bloomberg. “The job market is just more of the same. Layoffs aren’t the big problem, it’s the lack of hiring.”
That's not good enough to inspire forecasts for stronger growth, but it's not obvious that there's enough weakness to push the economy over the cyclical cliff either.
Posted by jp at 9:38 AM | Comments (0)
October 3, 2012
Services Sector Growth Improved In September
The services sector continued to expand in September, the Institute for Supply Management reports. Its Non-Manufacturing Index increased to 55.1 last month, up from 53.7 in August. That's a sign that the services sector overall grew at a faster pace in September, ISM advises. It's also another clue for thinking that the U.S. economy continued growing last month. Indeed, with today's ADP Employment Report and Monday's release of the September update of the ISM Manufacturing Index, we now have three indicators that collectively suggest that last month wasn't the start of a new recession.
It's still early for making high-probability assessments of how the full data set for September will fare. Based on the published numbers so far, however, it's still reasonable to expect that slow growth is the path of least resistance.
The September ISM Services Index rose to its highest level since March, as did its new orders component. Employment in the services sector weakened slightly, according to ISM, but the index for jobs in this corner remained above 50 last month. Readings above 50 for the ISM indexes equate with growth; below-50 readings indicate contraction.
Stepping back and looking at the ISM services index in historical context in recent years clearly suggests that this indicator remains comfortably above levels associated with recessions.
“Business activity in the services, construction, and government sectors of the economy accelerated in September but these sectors are growing at only a moderate pace,” Steven Wood, president and economist at Insight Economics, advised in a note to clients via Bloomberg. “Growth in the third quarter was slightly better than it was in the second quarter.”
Another analysts says that "it looks more like things are heading in the right direction. It is this new reality--we don't have robust growth, we just have very moderate growth," William Larkin, fixed income portfolio manager at Cabot Money Management, tells Reuters.
That's more or less what a broad reading of the economic numbers have been telling us for some time, as last week's update of The Capital Spectator Economic Trend Index reaffirmed. That hasn't stopped some analysts from cherry-picking a few data points and trying to exaggerate the dark side. But the incoming data so far for September, combined with what we know of the last several months, implies that slow growth rolls on. Yes, it's vulnerable to any number of potential trouble spots, including the possibility of a self-inflicted recession if the politicians allow the country to drive over the fiscal cliff. But if we stick with what we know today, it's still premature to insist that all's lost.
When this train comes to a complete stop, or reverses direction, the numbers will tell us so, and you'll read about it here. Meantime, arguing that a recession has already started remains a forecast, and one with minimal support from the numbers.
Tomorrow, as always, is another day.
Posted by jp at 11:12 AM | Comments (0)
ADP: A Modest Gain For September Payrolls
Private non-farm payrolls increased by 162,000 last month, according to this morning's ADP Employment update for September. That's down a bit from August's revised 189,000 gain, which suggests that we should keep our expectations in check for Friday's official September jobs report from the Labor Department. Nonetheless, there's nothing conspicuously dark in today's data dump to suggest that the slow growth trend rolled over last month. In fact, when you consider today's ADP release with yesterday's mild rebound in the ISM Manufacturing Index last month, the case is a bit stronger for expecting September to remain in the growth camp (once all the month's numbers are published).
Here's how the last 12 months of ADP data compare with the Labor Department estimates:
How should we interpret today's ADP report in terms of guidance for Friday's government release? The short answer: cautiously. There are times when the ADP estimate implies that its Labor Department counterpart will look relatively upbeat. For example, when ADP's July 2012 estimate was published on August 1, the odds looked favorable (odds that turned out to be accurate) for anticipating a solid improvement in the government's estimate due for release two days later vs. its monthly predecessor. Why? As I discussed at the time when the ADP number hit the street, the monthly divergence between the ADP and government estimates was near a three-year high.
Why's that relevant? It starts by assuming that the ADP and Labor Department numbers will converge through time. That's a reasonable assumption, given the high-quality work behind the ADP data, which comes from Macroeconomic Advisers. The empirical record also tells us to expect that the two employment series will track one another fairly closely generally. The month-to-month estimates, however, are quite noisy vs. one another. As a result, when the noise becomes unusually loud, so to speak, the odds for mean reversion are relatively high, as was the case for anticipating the July Labor Department figures.
Mean reversion tends to prevail eventually when it comes to the differences between the two data series. As the chart below shows, the monthly gaps in the ADP numbers vs. the Labor Department data tend to fluctuate randomly around zero. That's a strong sign that the two estimates won't vary too far for too long. Indeed, the average monthly difference between the two data sets for the past 10 years is a mere +2,000, or the statistical equivalent of zero in context with monthly changes that can swing up or down by 200,000 or more.
Although the divergence through August is climbing again, it's still below the highs of the last several years. We can't rule out the possibility that Friday's employment report will deliver some improvement over July's tepid 103,000 advance in private payrolls. But the second chart above suggests that expecting a sharply better jobs report in two days doesn't look like a high-probability event (as it did two months ago).
Anything's possible, of course, and sometimes big surprises catch the crowd unaware, despite the best-laid plans of statistical analysts. But if we're dealing in probabilities by looking at the numbers available, today's data tells us to expect more of the same for Friday's update: slow growth.
Posted by jp at 9:36 AM | Comments (0)
October 2, 2012
Estimating Recession Risk Probabilities With A Probit Model
Whenever I update The Capital Spectator Economic Trend Index (CS-ETI), as I did last week, someone usually asks how to interpret the data. In particular, how should we translate CS-ETI’s raw numbers into probabilities for estimating recession risk? One solution is looking at the data through the filter of what’s known as a probit model.
For those who don’t know, a probit model is a form of regression analysis that transforms predictions into a range of probabilities between 0% and 100%. I’ll spare everyone the details of calculation here other than to say that a probit regression is moderately easy to compute in Excel, R, and other software.1 Now it's on to the task at hand: translating CS-ETI into something more intuitive.
But first a bit of perspective by letting the raw numbers suggest a rule of thumb. History implies that we should think of recession risk as threatening when CS-ETI falls under the 60% mark, which means that less than 60% of the underlying indicators are trending positive (for the definition of "trending" for each indicator, see the data table in this post). A reading under 50% is an even stronger warning and effectively the point of no return. The lone exception since the early 1970s was in late-1989/early 1990, although it can be argued that the brief rebound after dipping under 50% without a downturn was associated with the bounce of optimism that accompanied the end of the Cold War during that period. In any case, the recession was only delayed for a few months rather than averted. The August reading, by the way, was around 76%. Although that's still well above 60%, it's been falling lately.
The question is whether there's an alternative to the heuristic analysis above that provides more specificity and quantitative discipline for evaluating CS-ETI's signals? Yes, and a probit model shows us the way. Consider the next chart, which transforms the data in the chart above into monthly probabilities of whether a recession is underway in any given month. In other words, CS-ETI is the independent variable and the probit model is using it to predict the state of the dependent variable—the presence, or not, of recession on a month-by-month basis.
It’s all quite straightforward in the sense that we can use NBER’s historical data that labels each month as recessionary, or not. Next, we use the probit model to interpret that history via CS-ETI for estimating where we stand currently. Each month in history is referenced as either a 0 (no recession) or 1 (recession). With some basic econometric modeling, we can regress CS-ETI (or any other set of economic or financial indicators) against that binary history of the business cyle and compute the probabilities of recession risk using the latest data.
As you can see in the second chart above, the fit is rather tight. The current estimate (based on the latest published numbers through August) tells us that the probability of a downturn was quite low—around 1%.
All the usual caveats apply, of course, and so we shouldn’t rely on this measure alone (or any one model) to evaluate the business cycle. That said, I've looked at the vintage data (to the extent that I can find it) for the 17 variables used to calculate CS-ETI and the probit model results are similar—close enough to expect that the real-time updates should provide a relatively timely warning when recession risk is on the march.
Still, there’s no substitute for looking at the business cycle from multiple angles, using a range of data and models. Another approach is "nowcasting" the next quarter's GDP for developing some intuition about the economy's near-term future, as shown here. Plugging in CS-ETI into a probit model is another view, but there's no assurance that it'll always be flawless. Recognizing that limitation, this analysis confirms the message in the raw CS-ETI data, namely: August wasn’t the start of a new recession.
September’s profile, of course, is open for debate. True, an early clue via the ISM Manufacturing Index offers a bit of optimism, but it’s still early. Some analysts have already concluded that the economy is in recession, or that the risk is so high that September's fate has been sealed. They may be right, but their warnings are still suspect based on the numbers available so far. September's profile is still mostly a mystery, but not for long.
^ 1. Any good econometric textbook will outline the mechanics. For example, see pp. 254-257 in the 3rd edition of Robert Pindyck and Daniel Rubinfeld’s Econometric Models and Economic Forecasts
Posted by jp at 5:32 PM | Comments (0)
Strategic Briefing | 10.2.12 | Fiscal Cliff Risk Analysis--Oct Edition
Leaders at Work on Plan to Avert Mandatory Cuts
The New York Times | Oct 1
Senate leaders are closing in on a path for dealing with the “fiscal cliff” facing the country in January, opting to try to use a postelection session of Congress to reach agreement on a comprehensive deficit reduction deal rather than a short-term solution.
IRS Could Buy Time on Fiscal Cliff
The Wall Street Journal | Oct 1
The prospect of the U.S. falling off the “fiscal cliff” is an ominous one for many economists, who warn that the U.S. could plunge into another recession. But exactly how painful a fiscal cliff-dive would be is a matter of debate, and some politicians and economists aren’t that troubled by it. One possible reason: the U.S. Treasury Department and the Internal Revenue Service have broad latitude to adjust withholding rates for Americans – or not adjust them. If the current tax breaks expire on Dec. 31, but tax administrators decided to leave withholding at current levels, some tax experts say that could cushion the economic blow considerably at the beginning of next year, and give Congress more time to reach a compromise.
Toppling Off the Fiscal Cliff: Whose Taxes Rise and How Much?
Tax Policy Center | Oct 1
The looming fiscal cliff threatens to boost taxes by more than $500 billion in 2013 when many temporary tax provisions are scheduled to expire. Nearly 90 percent of Americans would pay more tax, primarily because the temporary cut in Social Security taxes and many of the 2001/2003 tax cuts would expire. Low-income households would pay more due to expiration of tax credits in the 2009 stimulus. High-income households would be hit hard by higher tax rates on ordinary income, capital gains, and dividends and by the new health reform taxes. And marginal tax rates would rise, potentially affecting economic decisions.
Economists: Fiscal cliff a serious threat, but unlikely
CNN Money | Oct 1
Of 17 top economists surveyed, 14 believe the end of tax breaks and the steep federal spending cuts set to take effect at the start of next year would cause the economy to tumble into a new recession. Twelve of them believe the fiscal cliff is the most serious risk facing the economy, more serious than the European sovereign debt crisis, business uncertainty about various government regulations or the continued weakness in the job and housing markets.... But all 17 agree on one thing -- the economy won't plunge over the fiscal cliff. Despite partisan bickering ahead of the election, all the economists said they believe Democrats and Republicans will come together to extend the tax breaks and prevent the spending cuts either during the lame duck session of Congress or early in the new year.
U.S. "fiscal cliff" a risk to global growth, Europe to tell G7
Reuters | Oct 1
Europe will tell the United States, Japan and Canada next week that it is acting to resolve its sovereign debt crisis, but that U.S. fiscal policy and slowing growth in Japan and China also pose risks to the global economy. Finance ministers of Germany, France, Italy and Britain will meet those from the other major developed economies in the Group of Seven at a dinner in Tokyo on October 11.
Three Sectors with the Most to Lose from the Fiscal Cliff
Wyatt Investment Research | Oct 1
Three sectors in particular are sure to be negatively impacted by the mere possibility of the fiscal cliff. Those are:
The Big Banks
Retail Stocks
The Auto Industry
Posted by jp at 6:09 AM | Comments (0)
October 1, 2012
September Manufacturing Activity Revives After 3 Sluggish Months
Manufacturing activity modestly rebounded in September, the Institute for Supply Management reports. Today's update of the organization's widely followed ISM Manufacturing PMI Index reveals that "economic activity in the manufacturing sector expanded in September following three consecutive months of slight contraction." The index rose to 51.5 last month, up from 49.6 in August. A reading above 50 equates with economic expansion. Overall, it's a relatively upbeat report and one that surprised many economists.
It's also encouraging to see components of the broad index reviving as well. For example, the new orders and employment benchmarks also moved higher last month.
It's too soon to say that manufacturing has decisively turned away from what appeared to be a fatal swoon. But for the moment, at least, we can indulge in a sigh of relief with the news that the ISM index didn't continue dropping after a summer slump.
One indicator on its own can be misleading, of course, but quite a lot of pessimism has accompanied each of the last three monthly releases of the ISM report. Indeed, some analysts were quick to conclude that the slight dip under the 50 mark for this measure was a dark sign for the economy overall. It certainly wasn't encouraging, but some pundits jumped the gun. A review of history reminds that a) the ISM index has had quite a number of trips below 50 without the onset of a new recession; and b) when below-50 readings did accompany economic downturns, the ISM index was usually falling persistently. By contrast, the recent dip has been mild, with only slightly below-50 readings. As smoking guns go in cyclical analysis, this one so far has fallen well short of decisive for arguing that the economy has fallen off the cliff.
The fact that the ISM index has popped decisively over 50 suggests that the manufacturing sector, while hardly booming, is signaling that a new recession hasn't started, at least not for September. That alone might not mean much, of course. Judging an entire economy, especially one as big as America's, through the lens of one indicator is asking for trouble. Broader context is essential. The good news is that a wider read of the numbers still supports the idea that slow growth isn't on death's door, based on the numbers in hand. As I noted last week in the update of the Capital Spectator Economic Trend Index, the majority of economic and financial indicators are still trending positive. There's also some econometric support for anticipating that GDP for the third quarter (when the first estimate is released on October 26) will maintain a modest degree of forward momentum to keep us out of cyclical darkness.
All this modest optimism is subject to revision, of course, depending on what we learn in the September economic reports in the days and weeks to come. But the first data point out of the gate for profiling September offers an upside surprise. Economists were expecting a reading of 49.7 for September's ISM index, according to Bloomberg—considerably below the 51.5 that was reported earlier today.
Yes, it could be a fluke. Let's see what the rest of the week brings, including Friday's all-important payrolls report for last month. The consensus forecast sees a gain of 130,000 for private non-farm payrolls, according to Briefing.com. That's still tepid, but it would at least be an improvement over August's disappointing gain of 103,000.
Then again, one has to take the forecast du jour with a grain of salt. Sometimes that works in our favor, as today's ISM surprise reminds. But random error overall is still a two-way street.
Posted by jp at 11:34 AM | Comments (0)
Major Asset Classes | September 2012 | Performance Review
The capital and commodity markets in general enter the third quarter on a strong note. Nearly all of the major asset classes posted gains in September and everything is comfortably in the black for the year through the end of the third quarter. Looking backward suggests that all's well. But rearview mirrors can be misleading at times if momentum is set to give way to mean reversion. .
Such changes aren't easy to time, but you won't have to search long for potential catalysts in the months ahead. Between the fiscal cliff that threatens the U.S. economy, ongoing turmoil in Europe as it struggles on with managing the euro blowback, and any number of potential hotspots in the Middle East that could spin out of control in a heartbeat, there's no shortage of things to worry about. The major asset classes, however, seem to be climbing a wall of worry. Emerging market stocks were especially strong last month, rising 6.0%. REITs were September's big loser, but keep in mind that real estate securities are still enjoying a sizzling 14.9% rise so this year.
Given this lovefest with risky assets of late, it's no surprise that the Global Market Index (GMI) is higher by 9.4% year to date through September 30. If the trend over the past nine months rolled on through the end of the year, GMI would be on track for delivering one of its stronger sprints in terms of calendar-year performances.
But you don't have to be a pessimist to wonder if the fourth quarter will face a bit more challenges than we've seen so far this year. Or, to flip that around, you have to be a strong-willed optimist to think that the next three months will continue to deliver more of the same by the time the dust clears on December 31.
What we can say for sure is that if you've been riding the beta wave this year, cashing in at this point and sitting out the remainder of the year would still leave you with a handsome return for the full year. That's an extreme move, of course, and probably far too radical to be of any use in the context of prudent money management. Still, it's food for thought, as they say. When Mr. Market presents us with an attractive array of considerable gains, the least we can do consider the possibilities from multiple angles, if only in theory.
Posted by jp at 4:28 AM | Comments (0)