the Dynamist

Health care is killing the American worker

In the "everything is connected" category, I was reading Michael Santoli's column in Barron's this week and he brought up something interesting:

"There may be no position of more comprehensive agreement than that the U.S. consumer is shot -- earning less, spending less, saving more, repayng debt. How many times have we seen the same numbers trotted out, about how consumer spending jumped from a long-term average of below 65% of gross domestic product to a recent 70%, and must fall back; how household debt soared from 64% of GDP in 1995 to 100% of GDP, and must retrench; or how the savings rate that used to average 7% to 11% before 1992 has just lately popped from zero to 6.9%?

It's all true, and should be expected to restrain spending and economic activity over time. But the nuances within the numbers -- and the unknowable trajectory and degree of adjustment -- helpfully complicate the picture.

The consumer as 70% of GDP needs a footnote. Almost all the growth in personal consumption as a share of the economy has been health-care spending -- even though government covers half of health expenditures. As strategists at Citi and Barclays have noted, personal spending ex-health-care as a share of GDP has been flat for decades. This suggests there may not be too much frivolous shopping to cut out."

I'll admit expecting consumer spending as a percent of GDP to fall has been one of my core economic theses. So I pulled the numbers myself. And lo and behold, the economists at Citi and Barclays are mostly right.

If you exclude medical care, personal consumption as a percent of GDP is only slightly above where it has been since the early 1960s and is below where it was in the 1950s. Half of medical care expenses are paid for by the government and close to half are paid for by employer-based insurance. Please note that these statistics are for medical services. Drugs and medical devices are classified as goods.

This chart really emphasizes my point:

Another statistic that's often bandied about is how the median worker's inflation-adjusted wage has stagnated since the early 1970s. The stat is usually cited by the left as proof that greedy corporations have been raking in all the profits and holding down workers' pay or that all the economic benefits have been flowing to the rich. It turns out that what has bactually been happening is that the rightful fruits of worker's productivity gains have been Hoovered up by the medical-industrial complex.

The Clinton era is hailed by the left as a time when more progressive taxation and such finally allowed the median worker's wage to rise after its long stagnation under Nixon, Reagan and Bush. It turns out, the 1990s was also the age of the hated HMO that "rationed" health care. Health care as a percent of GDP fell slightly from 1993 to 1999 and the average worker's wage surged.

Source: Minneapolis Fed

The following calculation, which includes benefits, shows that American wages have actually risen quite a bit since the early 1980s.

In other words, HMOs created the great Clinton-era wage boom.

Not to pick only on the left. The right (or at least the Wall Street Journal editorial page) is constantly raising the bugaboo of "health care rationing" as the threat of Obama's proposed health care reform. Of course health care needs to be rationed. What else doesn't get rationed in some form? The big question is how to ration health care. Is it done by insurance companies, like under the HMO model? Is it done by the government, like in Canada and Europe? Is it rationed by changing incentives for doctors and hospitals, like what was suggested in my previous health care post?

If health care doesn't get rationed in some form or another, Americans' standard of living (ex. health care) will stagnate. For a while Americans borrowed against their houses to pay for increases in their standard of living. That option is now gone.

Our expensive health care system is robbing American workers of the fruits of their labor. Bring down the cost of health care and more workers will be able to afford coverage. Bring down the cost of health care and more workers will receive pay raises. Bring down the cost of health care and the US can close its trade deficit. Bring down the cost of health care and reduce the future Medicare liability. Bring the cost of health care and reduce US indebtedness to the rest of the world.

I can imagine no more important issue facing voters today.

Q2 Market Update

This Q2 market update builds on the analysis in my Q1 Market Update and my updated revision to my stock market valuation model and market rally analysis.

I've updated the S&P earnings estimates and S&P valuation level (which has only dropped slightly from my most recent update). The S&P earnings estimates have actually be reduced from the Q1 estimates, even though people have been getting more optimistic about the economy. Since I use long term trend earnings, I use as-reported earnings as a base calculation. I arrive at forward trend earnings of $53.46, which is slightly higher than the top-down operating earnings estimate.

The market is currently pricing in a 6.9% long term return, in keeping with its post-Lehman norm.

The 30-year inflation assumption is down slightly from the June 15 peak of 2.5%, which has dragged down the S&P value accordingly. I personally believe that at current tax rates the equilibrium return for stocks should be 7.6%. Obviously, there is more risks that dividend and capital gain taxes will rise than fall, which means there is more risk for equity return compression.

At various (pre-tax) return targets, I arrive at the following target S&P levels:

I have 7.6% as an equilibrium return. To achieve such a return, I think the market would need to fall by 19%.

Looking at bond yields (Treasuries by actual yields, the rest as represented by Vanguard bond funds), we have the following levels:

It looks like intermediate and long bonds other than treasuries are fairly valued, long treasuries are roughly fairly valued, and the shorter end of the bond curve is overvalued. I am still in the deflation camp over the inflation camp, meaning I find more relative value being short the inflation hedge (long bonds) rather than long the inflation hedge (long stocks).

In terms of our other inflation indicators, gold at $929/oz. remains above my $1,000 inflation warning threshold, and the dollar is in the middle of its long term trading range against major currencies and is at the top of its range against all currencies.

There appear to be no glaring mis-pricings in the markets today. Boring…

The Death (and rebirth) of Media Private Equity

I recently wrote an article for peHUB on investing in traditional media.  Advertising revenue will likely bottom in 2009, but nearly every private equity-backed media company is bankrupt anyway.

The article can be found HERE.

It is the summary of a research report we recently released at Catalyst, which can be found HERE.

Must-read health care article from the New Yorker

Everyone thinks we need to do something about our health care system, but there's not much agreement about what needs to be done.  I am far from an expert in this field, but have come across some interesting articles recently.  I am a big picture guy, mostly, so I'll start from the top.

The Democrats generally focus on providing coverage for the uninsured and the Republicans generally focus on the high cost of our system (if they aren't defending the status quo, which they also do).

This chart from the Economist tells us alot:

On the basic question, the Republicans appear to be more correct, the US clearly has a problem with costs, without providing better outcomes.  The fact that there is a high number of uninsured is a symptom of the fact that health insurance is expensive, not the core failing of the US system.

RULE #1 - WE SHOULD BE SPENDING LESS ON HEALTH CARE, NOT MORE

What is different about the US system that results in high costs?  Here are some possiblities:

• We waste money on the bureaucracy of private insurance - maybe, but the chart shows that we spend as much as or more than other countries publicly, even though most people get their insurance through the private market...besides since when are government bureaucracies known for being efficient?
• Other countries free ride on our innovation - true, but I doubt that makes up the whole difference
• Other countries don't have large medical malpractice claims - also true, but also unlikely to make up the difference
• Since everything is free, people overconsume - true, but it is free in other countries too, and besides, do consumers really stand a chance of figuring out what they should pay for procedures, how to negotiate prices and what is necessary and unnecessary?
• Our care, for those insured, is better - this is true in some ways...we are more likely to make use of cutting-edge technology but our outcomes are not necessarily better in key measures
• Other countries ration - also true, but they do not necessarily have worse outcomes...besides everything else in the world gets rationed in some way, why not health care?  Since when do we expect to get unlimited free anything?

This article from the New Yorker looks in depth at the cost issue by comparing two Texas cities with similar demograpics, similar health outcomes, but vastly different healthcare spending per capita:

http://www.newyorker.com/reporting/2009/06/01/090601fa_fact_gawande?yrail

Supposedly, Obama is making this article required reading for his staff.  Obama talks about the cost problem all the time, like he totally gets it, but then he rolls out a plan that involves spending over a trillion dollars more than we already do.  It's mindboggling.  Why, Obama, why???

Anyway, what is the punchline?

RULE #2 - LIKE WITH MOST THINGS, IT'S ALL ABOUT INCENTIVES...IT IS THE DOCTORS THAT ARE OVER-CONSUMING, NOT PATIENTS

The system incentivizes doctors to order expensive procedures, incentivizes the use of specialists, incentivizes the use of expensive drugs, incentivizes the use of tests, incentivizes the use of expensive technology, and disincentivizes the use of general practictioners, collaboration between doctors and preventive care.

The difference between the two Texas cities is that one has an entreprenurial culture among doctors whereby they rack up huge costs and the other doesn't.  Supposedly, if the high cost areas of the US were brought down to the levels of the better low-cost areas (like the Mayo Clinic), the gap between the US and other countries would vanish. 

I do suspect, however, that there is a vast medical-industrial complex that will fight this sort of change, thus we will end up just poring more slop into the trough for the health care pigs to feed off, with little actual reform.

As an final note: an article in this week's BusinessWeek highlights the medical-home model that may serve as an antidote to our health care boondoggle:

http://www.businessweek.com/magazine/content/09_27/b4138034173005.htm

On the question of how do we incentivize for outcomes (quality) rather than quantity of care?  Honestly, I have no idea.

The Recent Market Rally Explained

On April 24, I updated by stock market valuation model and noted it's sensitivity to the assumed inflation rate.  It was fitting that I made that observation, because it appears that virtually 100% of the rally in the S&P 500 since the March 9 bottom can be explained by a rise in market inflation expectations.

Constant assumptions:

Inflation-adjusted 2009 Trend Earnings: $54.94
Normalized Payout Ratio: 50%
Inflation-adjusted Earnings/Dividend Growth Rate: 1.6%

March 9 Inputs:

S&P 500 Level: 680
Implied dividend yield: 4.0%
Implied real return (dividend + growth): 5.6%
Market Inflation Rate (30-year): 1.3%
Total Implied S&P 500 Return: 7.0% (rounded)

June 15 Inputs:

S&P 500 Level: 921
Implied dividend yield: 3.0%
Implied real return (dividend + growth): 4.6%
Market Inflation Rate (30-year): 2.5%
Total Implied S&P 500 Return: 7.1%

This is why the stock market, treasury yields and gold prices have all been positively correlated with each other for the past year.  The stock market hates deflation and adores mildly positive inflation.  To the extent that the Fed and Treasury seem to be successful in promoting reflation, the stock market goes up.  While the market will dislike runaway inflation, as I noted in my post from May 26, that is not currently a threat, despite what many commentators are saying.

So it appears that the market's equilibrium S&P return is 7%, not the 8% that I have been assuming based on historical return premium calculations.  So what changed to reduce the return premium?  Almost all of the drop in return expectations can be explained by the decrease in dividend taxes in the Bush tax cuts of 2003.  It appears that the stock market targets a 2% spread over the equilibrium after-tax return on 10-year corporate bonds.

More on American Manufacturing

In my previous post on US trade deficits and manufacturing productivity, I discussed how US manufacturing has actually thrived, even in the last three decades while manufacturing employment was plunging. 

Such numbers might prompt one to ask how it can be, when their are abandoned, crumbling factories all around us, particularly in the old industrial cities of the Northeast and Midwest.  There are two answers.  One is that alot of manufacturing activity has moved from the unionised North to the right-to-work South and West, where factories are allowed to be run with fewer employees that cost less.

Another is that the US has been abandoning lower tech, mostly labor-intensive, manufacturing and reallocating capital to higher tech areas.  While this is no consolation to former textile workers in the US, it's the natural evolution of things.

This chart from the Economist illustrates it nicely:

Most advanced nations have been shifting away from low tech manufacturing and such manufacturing is being picked up by developing nations like China. In the US and Britain, where capital has been allocated the most freely, the trade balance is most positive in high tech manufacturing.  South Korea has also made great advances in high tech. 

I think the most interesting aspect of this chart is that Germany and Japan, the two largest advanced economies besides the US, have huge surpluses in mid-high tech but deficits in high tech.  I would argue the reason for this is that Germany and Japan have been among the most aggressive in promoting an industrial policy to build up the old mass market manufacturing economy (exemplified by autos) and have financial systems dominated by commercial banks.  They have very conservative systems that were great at building up the post World War II economy, but lack the venture capital/ IPO/ public stock/ high yield debt/ private equity culture that, for all its faults, relentlessly reallocates capital to the highest-return investments in innovative sectors.  They are also the two developed countries most manifestly in danger of being in secular decline.

I realize that sometime the US system gets its capital allocation very wrong, like with the recent housing bubble.  But I would like to bring up the fact that housing is the sector most heavily promoted by our government.  This "industrial policy" was successful for years, but eventually it got taken way too far and will be difficult to unwind, given all of the powerful constituencies that are now invested in promoting real estate speculation.

Housing in the US and the long term stagnation of Japan and Germany are warnings to those that would promote the heavy involvement of the US government in the economy to protect declining industries and to conduct industrial policy in growth sectors beyond the early R&D phase.

Bill Gross on the coming fiscal train wreck

Bill Gross, head of PIMCO, the largest bond investment manager in the world.  Reminds us that THERE IS NO FREE LUNCH...the massive deficits we are currently running are bad enough, let alone trying to fund Social Security and Medicare for the Baby Boomers in the future.

ARTICLE HERE

The truth about US trade deficits and US manufacturing

One of my central economic tenets is that the total debt burden of the United States is too high. I blame economic policies that have encouraged excess consumption and housing investment, funded by money borrowed from abroad and by excess leverage in the financial system. Borrowing money from abroad in excess of money invested abroad creates a capital account surplus for the United States. If the US runs a capital account surplus, it must run a corresponding current account deficit to balance its accounts. The biggest component of a current account deficit is the trade deficit. I therefore believe that the best long-term fix for our problems is to adopt a set of policies that for a period of time encourages the US to run trade surpluses and a capital account deficit. In other words, we should sell more US goods abroad, while we increase savings and repay our foreign creditors.

My four point plan for running a trade surplus

1. Maintain a stable currency and discourage the building of foreign dollar reserves;
2. Improve incentives / remove disincentives for investing abroad;
3. Remove / scale back policies that encourage borrowing and consuming at the expense of saving and investing; and
4. Use policy to improve our terms of trade on energy

Right now point (1) is happening, whether on purpose or by accident. I don't expect (2) to happen anytime soon, and in fact policy seems to be running in the opposite direction. Obama talks like he believes in (3), but his policies also seem to be running in the opposite direction, with higher taxes on capital and high levels of federal borrowing. On the other hand, Obama is clearly a believer in point (4).

The composition of the US trade deficit

In the first quarter of 2009, the trade deficit was equal to 2.4% of nominal GDP (subject to revision). From 1980 to 2008, the trade deficit has averaged 3.1% of GDP.

61% of the deficit in Q1 2009 was due to our trade deficit in petroleum products. Since 1980, petroleum has accounted for 45% of our trade deficit, and the petroleum deficit has been about 1-2% of GDP. This one product is the "low hanging fruit" when it comes to targeting out trade deficit.

Not surprisingly, the US typically runs a surplus in services. In Q1 2009 the trade surplus in services was 1.1% of GDP, which is near the average level since 1990.

The level of trade deficit in goods excluding petroleum has averaged about 2% of GDP. In the goods sector, the US runs at about a balance in foods, industrial supplies and capital goods. In capital goods, the US runs a surplus in civilian aircraft (Boeing) and a deficit in everything else, including computer equipment. The bulk of the non-petroleum trade deficit is tied to autos and consumer goods.

It's not surprising that the US would run a deficit in consumer goods, many of which are labor-intensive like textiles, toys and such. The US should be able to run a trade balance or even a surplus in autos, which is actually a very productive sector in the US, but one in which we are up against rather unfair trade practices abroad. The US should also be running a bigger surplus in capital goods and non-petroleum industrial supplies.

The truth about US manufacturing

It has been so long since the US has run trade surpluses that it seems we have come to believe that it would be impossible to do so again. It is commonly believed that the US has basically stopped "making stuff". Nothing could be farther from the truth. The US is actually the largest manufacturer in the world by far and in most years is the largest exporter in the world. Also, it is important to note that the US's economy is absolutely massive relative to any other country in the world, and that trade (both imports and exports) is a relatively small part of our economy compared with even large economies like China, Germany and Japan. Also, the bulk of our trade deficits since 1980 have coincided (slightly lagged) with two periods of a very strong dollar and high real interest rates, which leads to poorer terms of trade for US manufacturers and increased investment flows from abroad. If we focus on maintaining a stable dollar rather than a "strong dollar", most of the trade deficit problem goes away.

But isn't manufacturing in the United States in decline? While manufacturing employment is certainly in long-term decline, manufacturing production continued to climb right up through 2007. The recent plunge in production has brought US manufacturing back to levels last seen in 1999. Manufacturing employment, on the other hand, is back to levels last seen around the start of World War II. The difference between these two numbers is the increase in manufacturing productivity. Before the recent downturn, we were producing roughly 7.5 times what we were producing in 1948 with roughly the same amount of manufacturing workers, working out to real productivity growth of 3.3% per year.

Manufacturing production and employment:

During the same timeframe, manufacturing capacity has been growing at 3.5% per year, so capacity utilization has fallen.

Thus, when this downturn ends, the US has plenty of scope to have its manufacturing production return to its trend line, particularly in high tech equipment and other durable goods.

The key takeaways are:

Don't confuse manufacturing employment with production. Manufacturing employment since the early 1970s has been analogous to agricultural employment in the late 1800s and early 1900s, declining even while production boomed.

US durable goods manufacturing is perfectly competitive. Capital-intensive durable goods manufacturing in the US could thrive if the US government halted the currency policies that were unduly punishing it.

Inflation is not a problem (yet)

I've been saying for a while that the dominant underlying economic force in the United States is that of deflation. If left to its own devices the US economy would collapse into a deflationary depression and take the world economy with it. Of course, the economy has famously NOT been left to its own devices. The federal government has invested $750 billion in the banking system, issued a $700 billion stimulus package AND forecast deficits of 5-10% of GDP as far as the eye can see. The Fed has expanded its balance sheet by $1.25 trillion since the collapse of Lehman Brothers, with plans to expand it even more by buying long term treasury, mortgage and asset-backed debt. The Fed Funds rate has been set at 0% to 0.25%, allowing the banking system to borrow from the Fed at very low short term rates, while risky debt is yielding much higher rates, fattening bank profits (before asset write-downs).

We are in uncharted economic waters, and in a system as complex as the world economy, it is hard to separate signal from noise in terms of what effects our policies will have and how they get transmitted through the economy. In economics class, most rules start with the assumption "all other things being equal", which in the real world is never true. In fact, the economy is in a constant state of disequilibrium, but with a powerful force that seeks to restore equilibrium in some things while creating more disequilibrium in others. In my view, the easiest way to make money is to spot the disequilibrium that faces the path of least resistance to be corrected and to bet on that correction.

The correction occurring right now is the massive unwinding of the inflationary housing bubble. The unwinding of a debt-fuelled inflationary bubble comes in the form of debt deflation. Because an unchecked debt deflation is what caused the Great Depression, today's economists have been taught to fight debt deflation at all costs. Thus we are recapitalizing the banks, printing money like mad and engaging in deficit spending. In other words, we are fighting a deflation specific to real estate (and to a lesser extent, LBOs) with a generalized inflation. The inflationary policies are alarming to many, even prompting a recent round of speculation that the US may lose its "AAA" credit rating. So far, however, market signals are telling us that the greatest set of inflationary policies ever devised has so far only created "reflation", or the undoing of deflation, and are not yet signaling high inflation. The Fed and Congress will need to be vigilant about withdrawing this inflationary stimulus if the market signals do start pointing to inflation, however. The signals I watch are the TIPS spread, the Treasury yield curve, the value of the dollar and the price of gold.

The TIPS spread

The easiest way to look at the market's inflation expectations is with the TIPS spread, or the spread between the yield on a Treasury Inflation Protected Security and a nominal Treasury bond.

As of Memorial Day 2009, the nominal 5-year bond yield is 2.14%, the 10-year is 3.37% and the 30-year is 4.32%. The 5-year TIPS yield is 1.34%, the 10-year is 1.63% and the 30-year is 2.12%. That means the 5-year market inflation assumption is 0.8%, the 10-year assumption is 1.74% and the 30-year is 2.2%. Since the Fed's implicit inflation target is 2% and in historical practice it has been 2.5%, inflation would appear to be well in hand.

However, those numbers assume that inflation averages 0.8% for the next 5 years, jumps to 2.7% for years 5-10, and then settles back down to 2.4% for years 10-30. Not terrible, but probably a pretty good assumption that inflation will accelerate after the eventual recovery.

Treasury Bond Yields

If you assume the Fed has a long term goal of 2% inflation, the equilibrium treasury yield curve would look like a Fed Funds rate of 2.75%, a two-year of 3%, a five-year of 3.5%, a 10-year of 4% and a 30-year of 4.5%. I put a band of 25 basis points (0.25%) around the Fed Funds and the two-year and a 50 basis point (0.5%) band around the 5-30 years, just to account for the fact that this isn't an exact science. (I use 2.75% or the Fed Funds rate, because that leaves a zero percent return after inflation and taxes, which is all you should expect for holding riskless cash.) By this analysis, the Fed Funds rate, the 2-year (at 0.85%) and the 5 year are well below their equilibrium rates, the 10-year is approaching its equilibrium range and the 30-year is in its equilibrium range.

The current yield curve implies that inflation and the Fed Funds rate will be low for several years, but that reflation will be successful but controlled and that is what's being reflected in the 10-year and 30-year spreads.

The Dollar

One problem with using treasury yields for a market indicator is that the short end of the curve is always manipulated by the Fed (and the Fed sometimes gets it wrong) and recently the Fed has even been manipulating the long end of the curve by buying Treasuries. If rates are manipulated too low by the Fed "monetizing" the Federal debt, the pressure would be relieved in the form of a weaker dollar.

When deflation is a problem, people hoard dollars to stay liquid and the dollar rises. In reflation, the dollar is pushed back into its equilibrium trading range. In inflation, the dollar bumps against the bottom of its trading range, as it did as recently as early 2008.

Nominal Major Currencies Index:

The dollar, relative to other major currencies, has been on a mild downward path (less than 1% per year) since we dropped the gold standard in 1973, if we exclude the two dollar bubbles of the mid 1980s and the late 1990s. Given that the original fixed currency values under the gold standard (Bretton Woods dollar standard, really) were set after World War II, when the US had most of the world's gold and the only major economy not devastated by the war, I'd actually say that's not a bad performance for the dollar.

In my view the equilibrium value of the major currency dollar index is between 84 and 70, with a mid-point of 77. It is currently at 79.5. While the dollar has fallen a bit in the last few weeks, it is still near the high end of its range.

Real Broad Dollar Index:

Against all currencies (in real terms), including emerging market currencies, the dollar as of the end of April was at 96, just above its long term equilibrium range of 85-95. Given the action so far in May, it's probably now in the range, but close to the top of the range. This means people are no longer hoarding dollars in a deflationary manner, but it also means inflation is not out of control.

Gold and commodities

Of course nearly every country in the world is printing money and running large deficits to get through this crisis. When all currencies are being inflated, they can all drop together, even while the dollar appears to be in its trading range. When all currencies are weak, the price of gold and other hard commodities rise as investors lose faith in paper assets and move their money to assets that protect the long run value of their hard earned savings. Gold, while it pays no interest, will at least in the long term (since the dawn of man, really) serve as a store of value as long as it's not bought during a speculative fervor.

Gold price in dollars:

The value of the dollar has declined from 1/35^th of an ounce of gold during the Depression to around 1/150^th of an ounce in the mid 1970s, to an average of about 1/375^th from the mid-1980s to the mid-1990s to about 1/900^th of an ounce today. That means the dollar today is worth just 3.9% of what it was during the Depression and World War II.

The price of gold rose from $260 an ounce in 2001, when the dollar was strong and real interest rates were high, to $1000 per ounce during the recent inflationary fervor in early 2008. Had severe deflation taken hold, I would have expected gold to fall back to under $600 per ounce. Instead, it has stayed high (generally in the $850 to $950 per ounce range), and it is currently at $955. If gold remains under $1,000 per ounce, renewed inflation (beyond what the market anticipated before the bubble burst) is probably not a problem.

Another way to look at commodities is the value of a commodity relative to gold. The "normal" price of oil, for example, during the 1980s and 1990s, was $20 per barrel. During that period the normal price of gold was $375 per ounce. If the new normal price of gold is $900/oz, the new normal price of oil is $48 per barrel. Today it is at $60…probably overvalued at bit, but not signaling massive inflation.

Conclusion

The market signals are not currently pointing to inflations' being a problem for the US. That said, the Fed must be vigilant about moving rates to equilibrium or above when the signals start pointing to an inflation problem. The signals pointed to inflation in 2004-2008 and the Fed was slow to respond. Now the Federal government is in on the action as well. Congress will need to rein in it spending when the time is right. Unfortunately, Congress' track record has not always been strong in that regard.

The Economist on the Stress Tests

Good to see the Economist feels the same way I do about the bank stress tests being too easy.

Link Here.