the Dynamist

A Grand Unified Theory of US Politics, Part One

 

Conservative or Liberal? Those seem to be the two ideological choices that face voters in the US these days. What if I'm neither? Then you are "moderate" or "independent". If I'm an anti-union, anti-tax businessman that favors abortion rights and votes for both parties, then I'm a moderate. What if my neighbor is an anti-abortion member of a private sector union that votes for both parties? Then she's a "moderate", too. But aren't we like, opposites?

You'd think Presidential candidates Mike Huckabee and Bernie Sanders are political opposites. Huckabee is a socially-conservative Southerner and Bernie Sanders a socially liberal Northeasterner. But both have strong approvals from the NRA, both look fiercely protect Social Security and Medicare, both are protectionist on trade and loudly anti-Wall Street. Are they really opposites? 

Let me throw one more brain twister at you. Did you know that Vermont used to be the most reliably Republican state in the nation? And that South Carolina one of the most reliably Democratic? In what world did that make sense?

So enough with the questions. The point is that much commentary on US politics is overly simplistic and informed by inherent bias. As we head into the long presidential election season, I'd like the readers of the Dynamist to be armed with the right framework through which to analyze the different candidates and their positioning vis-à-vis the electorate.

Here are the four key laws in my Grand Unified Theory of US Politics:

1. Ideology isn't a left-right line, it's a circle;
2. Each voter is a member of an interest group, whether they like it or not;
3. The ideology of the electorate is more stable than the ideology of the political parties; and
4. Neither party is right and neither is wrong...they are more like yin and yang, bringing balance to each other. 

Let's start with law #1, ideology isn't a left-right line, it's a circle. In my first paragraph above, I contrast two theoretically moderate voters of archetypes that most would recognize: the "economically conservative, socially liberal" businessman and the "economically liberal, socially conservative" private sector blue collar worker. To use now nearly passe terms, the "country club Republican" and the "Reagan Democrat". Very different types of moderates, but both who largely voted for Reagan and Clinton, GW Bush and Obama. Of course it is also possible to be both socially and economically conservative or liberal as well. So here is how we should look at the ideological continuum:

Figure One: The four poles

(click to enlarge)

The lower right pole is "Socially Conservative", which is centered around conserving traditional values and the traditional economy. Also focused on security. The church. Farming, ranching, mining, oil and gas. Military and police. Anti-immigration. NRA. The traditional Right.

Its opposite is "Socially Progressive" in the upper left. These are folks concerned with looking out for marginalized social groups and the environment. Also those in newer professions like technology, media, higher education. Women's rights, LGBT rights, abortion rights, climate change, hackers, immigrant rights, trial lawyers, college professors.

The upper right pole is "Economically Libertarian". (I don't use "conservative" because they are actually in favor of dynamic economic change, not protectionist conservation.) These are folks that focus on making sure that businesses and the economy can function in an unimpeded manner, which they believe produces faster economic growth. Large and small businessmen. Anti-federal government activists. The Tea Party.

It's opposite is the lower-left, "Economically Communitarian" pole, which favors government or union intervention in the economy to provide regulations and a safety net. Unions, the working class, minority groups, the dependent elderly, public sector workers.

Law #2 is that each voter is a member of an interest group, whether they like it or not. Each of us has one or two issues that we actually vote on. I have a whole variety of nuanced views on a variety of subjects, but when push comes to shove my default vote is generally for the GOP because I am anti-tax and anti-Federal government. I have good friends that I agree with on 85-90% of issues, but they almost always vote Democratic because they tend to vote based on whether a candidate supports abortion rights. There are the people that seem like economically communitarian Democrats in every way, except they vote Republican because they vote on Second Amendment rights. The chart below takes a stab at further segmenting the ideological continuum based on voting interests.

Figure Two: The Interest Wheel

(click to enlarge)

In the above chart each of the quadrants is broken up into four interest groups. While I don't know how large each group is, the idea is that if you can build a coalition that includes more than half of the interest groups, you can win. The problem is, of course, that adding any group on the wheel to a coalition alienates that group that sits as its opposite. You can't please both the religious right and college professors on social issues. You can't please both blue collar unions and the corporate elite on economic issues. You can't please both the dependent elderly and small government libertarians on entitlement reform. The interest wheel is why no party seems to be able to build a "permanent majority". Temporary majorities fade when the relevant issues of the day change.

Understanding the GOP primary

Looking at the Interest Wheel helps us better understand the GOP primary. The oft-referenced "Republican Establishment" are the interests in the top middle to upper right. The Establishment-style candidates are Bush, Kasich, Christie and Fiorina and in 2012 it was Mitt Romney. The Establishment candidates usually prevail because they have the easiest time raising money and because they can win primaries in the populous "blue states" and swing states in the Northeast, Midwest and West coast.

From the upper right to middle right are States Rights Conservatives, traditional small government conservatives with traditional values. These types of voters are the original "Tea Party" supporters, although that term is now used (inaccurately in my view) to describe all non-Establishment conservatives. The Tea Party standard bearer is currently Ted Cruz (and to a lesser extent, Rand Paul) and in 2012 it was Newt Gingrich or Herman Cain. Marco Rubio started his career as a Tea Party candidate and has learned to straddle the Establishment and Tea Party blocs.

In the lower right you get the Social Conservatives and traditional rural/ small town voters. Right now they have coalesced around Ben Carson. Rick Santorum was this constituency's candidate last time around.

In the bottom middle to bottom right you have the Conservative Populists...Appalachian Jacksonians, blue collar social conservatives, police and military...that used to be the heart of the Democratic Party as recently as the early 1960s. This is where Donald Trump is getting his support, and is where Jim Webb was making his play on the Democratic side before he realized that that Democratic Party is long gone. While the 2012 election didn't have a strong GOP candidate for this constituency, you can think of Sarah Palin as a good example of this type of politician. Mike Huckabee tries to straddle the Conservative Populist and Social Conservative constituencies, but is currently getting overshadowed by Trump and Carson.

If you start at the bottom and move counter-clockwise, you can see the poll standings of the candidates...Trump, then Carson, then Cruz and Rubio, then the other establishment types splitting up that vote.

What about the Democrats?

The Democrats are a little easier to understand. From the upper middle to upper left is the Liberal Elite. White collar professionals, old money, Hollywood, Silicon Valley and many Wall Street folks that vote more based on social issues than economic issues. This was the constituency that Bill Clinton and Barack Obama have successfully solidified into the Democratic Party but with whom Ronald Reagan had success.

Moving counter-clockwise from there you have the New Left...academics, environmentalists, minority rights groups, women's and LGBT rights groups. This group is the heart of the Democratic Party and it gets its money and support from the Liberal Elite. Hillary Clinton has her base of strength in the intertwining of these two groups...think the Clinton Foundation writ large.

In the lower left is the Old Left of unions, public sector workers, the dependent elderly and the working class. This constituency gets much less focus from the Democratic Party than it did in its heyday under FDR and LBJ, when the Old Left and the Conservative Populists were the core of the Democratic Party. This is where Bernie Sanders is making his strongest play and where Hillary Clinton is the most vulnerable. It has remained part of the Democratic coalition, because even though the Democrats have been more focused on the interests of the Liberal Elite, the GOP has been rigidly doctrinaire about protecting the interests of the Republican Establishment and the States Rights Conservatives, leaving the Old Left mostly out in the cold. That said, if the Democratic nominee was Sanders, the GOP would have an opportunity to make a play into the Liberal Elite, many of whom would vote their pocketbook as long as the GOP nominee was somewhat palatable.

Figure Three: The Party Factions

(click to enlarge)

Elites vs. populists

If we think about the groups that have been dominating politics over the past several decades, the New Left, the Liberal Elite, the Republican Establishment and the States Rights Conservatives, we notice that they fall along the top, or elite, side of the Interest Wheel. To the elites, the parties seem very different, vastly split on social issues. But together, they protect each other's core interests: progress on social issues and economic libertarianism. For the Old Left, Conservative Populist and Social Conservative voters along the bottom, or populist, side of the wheel, however, the parties seem largely the same, generally united on economic issues while letting the working class suffer a degradation in their livelihoods, communities and families.

This leads us to Laws #3 and #4, which will be covered in Part 2 and are about the strategy and tactics of coalition-building. Most of US history has been fought around 50-50, like what we have now. The Twentieth Century, however, had a few aberrant elections where the parties were able to build big tents with contradictory voters under the same roof. I'll talk about how this works and what it all might mean for the 2016 presidential election.

 

Have we entered a bear market? Probably not. What to watch for.

Over at Seeking Alpha, Eric Parnell, CFA, has written an interesting post entitled A Bear Market has Two Phases. In it he posits, based on evidence from the last two bear markets (early 2000s and 2007-2009), that there are two phase to a bear market. In the first phase, the leading sector(s) of the previous bull market breaks while other sectors hold up. In the second phase, the rest of the market follows suit in a general liquidation.

In the bear market of the early 2000s, it was technology stocks that were the first to break, beginning their decline in March of 2000. The great late 1990s bull market had been highly concentrated among technology, telecom and multinational growth stocks, while the rest of the market had been almost neglected. While technology stocks, represented by the SPDR Select Sector Technology ETF (XLK) had fallen 64% by August 2001, the rest of the market hadn't really declined much at all. The general market was attempting to rally in mid 2001. Then after the terrorist attacks of 2001, the general liquidation began, which carried right through until the announcement of the launch of the Iraq War in [   ] 2003.

The bull market in the mid 2000s was led by the financial sector, including it's close cousin, the homebuilding sector. In the bear market of 2007-2009, it was financial stocks that were the first to break, beginning their decline in 2007, culminating in the failure of Bear Stearns later that year. The market then attempted a rally, although financial stocks failed to regain their high. Stress returned in the summer of 2008, culminating in events around the failure of Lehman Brothers in September 2008 and the general liquidation and chaos which ensued after that.

Mr. Parnell shows good illustrations of the theory through use of the Sector SPDR ETFs. What he does not do, however, is lay the theory on top of the current business cycle. To look at the current cycle, one would have to (1) identify the leading sector and (2) spot its decline ahead of the rest of the market.

The Clear Bear Case: Energy is the Leading Sector

The easy case that we have entered a bear market under this theory would be to identify energy as the leading sector (and its relatives in materials and emerging markets). If we look at the energy sector ETF (XLE), we can see that it peaked in June of 2014 and is now off 40% from its high. The materials sector ETF (XLB) peaked in February of 2015 and is now off 20% from its high and industrials (XLI) also peaked in February and are off 15%. (It's also worth pointing out that valuations on speculative tech companies...the sector I am personally involved with...also appears to have peaked in February 2015.)

The rest of the sectors (except interest rate-sensitive utilities), peaked in May-July 2015 and are were only down mid-single-digit percentages as of Friday August 21. It would be easy to then say that energy was the leading sector both in the market, and in the economy with the fracking boom, and that China was the secondary leader, and both are in big bear markets and the rest of the market and economy is finally catching on.

The Not-so-clear Bear Case: Consumer Discretionary is the leading sector

If you look at the numbers, however, it's hard to make the case that energy was/is the leading sector of the recent/current bull market. While energy far outpaced the S&P 500 in the bull market of 2003-2007, it actually underperformed in the bull market from 2009 to its peak in 2014 and its peak was only 14% higher than its previous peak in 2008. In my personal view, energy, commodities and emerging markets are more tied to the dollar cycle than the core market and are rarely likely to be a lead market sector in the US. The dollar cycle drives the 3 business cycle, disinflationary-reflationary-balanced model that I use to set over-weights and under-weights within my portfolio. In 2013 (in my last post...egad I've been slacking), I suggested that we were transitioning from a balanced cycle (the "Rounded Bottom" scenario of 2009-2012/3) to a disinflationary cycle (the "subdued mid-late 1990s" thesis).

As I said then:

My core base case at this time is that we are in the midst of a regime change in the market driven by a shift in the economic cycle. The timing of economic and credit cycles both in the US and abroad should be turning the market relationships of the last 10 years on their heads. I'll cut to the chase: over the next several years I expect the dollar to strengthen, I expect growth stocks to outperform value stocks, I expect real interest rates to rise and bond prices to fall (but only modestly), I expect inflation to remain subdued, I expect commodity prices to fall, I expect emerging markets to have problems, I expect Europe and Japan to recover modestly, and I expect US real estate to perform ok.

Cyclically, I would compare where we are today to a subdued version of the mid-1990s.

Not to pat myself on the back, but the thesis is actually playing out in the markets. Economically, the recent, energy, emerging market and commodities crash would be analogous to the emerging market crash of 1997-1998, which cemented the trend of a global allocation of capital to the US, which then flowed into an investment and consumer spending boom of epic proportions, led by technology and telecom.

Why do I think the economy and market will be more subdued than the 1990s? This time around, the underlying cycle has been much slower to turn than in the 1990s due to higher debt levels and lower inflation. The market cycle has turned up faster than the economy due to the corresponding low interest rates and quantitative easing. Whereas in the 1990s there was latent capacity for the global economy to lever up with more debt (a process that continued into the early 2000s), in the post-financial crisis world the trend has been de-leveraging, particularly in the private sector.

That said, there is pent-up demand for capital investment after the under-investment of the past decade and a lack of true excess in the US system that sets us up for disaster (as far as I can see). I therefore find it unlikely that we are staring at a recession in the very near term caused by a slowdown in energy and emerging markets. And it would be highly unlikely if we were heading for a generalized bear market if we weren't also headed for a recession.

If we look at the performance of the stock market, it should be noted that the broader market peaked along with the lead sector in early 2000 and 2007. The broader market fell, then rallied but failed to regain their highs at the beginning of bear market phase two. In the most recent case, the market has continued to make news highs in the year after energy stocks and emerging markets began their bear market in 2014. Don't get me wrong, overall market breadth has clearly deteriorated, with the above-mentioned breakdowns in industrials, utilities, speculative tech and transportation in early 2015, but the actual lead sectors and the market as a whole have made new highs. 

So what have actually been the lead sectors of the market? Using the sector ETFs, the clear winner is the Consumer Discretionary SPDR (XLY). At its recent peak in July, the XLY was up 392% from its trough in March 2009 (vs. 209%) and was up 100% from its previous peak in 2007. The top holdings of the XLY include Amazon, Disney, Comcast, Home Depot, McDonalds, Starbucks, Nike, Netflix, Time Warner, Priceline, Lowe's...media, internet retail, home improvement, restaurants, automakers, etc. In other words, growth stocks levered to the US consumer. The other leading sector has been the Health Care SPDR (XLV). At its recent peak in July it was 245% above its trough in March of 2009 and 100% above its peak in 2007. Both sectors are levered to the US, so are less affected by a strong dollar. The XLY, however, is cyclical and highly vulnerable to a recession and the XLV is vulnerable to big changes in the health care laws (i.e. vulnerable to a GOP electoral sweep on the right or a Bernie Sanders win on the left).

So are we starting a bear market or not?

Of course nobody really knows the answer to that. If past patterns hold, a bear market starting now would play out as follows: the market has a big downturn/correction through September/October, with the losses slowing soon and accelerating again near the end. The XLV and XLY lead the way down. The Fed steps up and does/says something to assuage the markets and the broader market rallies with many sectors nearing their old highs but the XLV and XLY would remain way off. The broad market fails to retake its high by next summer. The selling then resumes, with a broad selloff cascading through next fall and beyond. And a recession beginning in early-mid 2016.

I'll call this my alternate hypothesis.

I suspect we're not there yet. I think we are definitely in the late innings of this bull market, but not in the 9th. There is no over-arching reason today for the big economic trends to break. I expect another rally higher, but with far narrower breadth, as industrials, materials, energy, utilities, transports and maybe financials fail to keep pace with a rally led by consumer discretionary, health care and technology. The dollar resumes its rise, squeezing broad corporate profits, which the market ignores for a while. Eventually however the lack of global demand relative to over-optimistic US investing and deflationary forces around the world (a renewed Euro crisis, a second wave of emerging market problems, a true financial crisis in China?) will finally pull us under.

That's my base case (for now).

I am not your financial adviser. I write these articles purely for my own amusement. Please consult your own financial adviser before acting on any of the opinions expressed herein.  

Mid-year 2013 Market Overview: The Plates are Shifting

My core base case at this time is that we are in the midst of a regime change in the market driven by a shift in the economic cycle. The timing of economic and credit cycles both in the US and abroad should be turning the market relationships of the last 10 years on their heads. I'll cut to the chase: over the next several years I expect the dollar to strengthen, I expect growth stocks to outperform value stocks, I expect real interest rates to rise and bond prices to fall (but only modestly), I expect inflation to remain subdued, I expect commodity prices to fall, I expect emerging markets to have problems, I expect Europe and Japan to recover modestly, and I expect US real estate to perform ok.

Cyclically, I would compare where we are today to a subdued version of the mid-1990s. The 1990s had the benefit of being within the Kondratiev Autumn of the long cycle, helped along by the tailwind of falling interest rates and risk spreads (and rising investment valuations) and both consumers and business leveraging up with debt. The 2010s are in the Kondratiev Winter, where interest rates are already low (and risk spreads are already tight, thanks to the Fed's reflationary actions) and consumers are still reducing their debt leverage.

We are heading into the most powerful part of the upwave in both the 15-20 year infrastructure cycle and the 7-10 year standard business investment cycle. Barring some major catastrophe that throws the economy off course, the next 2-5 years are likely to be the best economic years we enjoy in the whole period from 2008 to the mid 2020s, driven by the continued recovery in business investment.

We are probably exiting the "Rounded Bottom" recovery and entering into a US-centric expansion.

So with that background, let's discuss the state of the markets:

Interest Rates

The chart below breaks down the current interest rate yield and risk curves:

Chart One

(click to enlarge)

 

As I discussed in "Why Gold is in a Bear Market", real interest rates have risen since my last market update in Q2 2012 "Have Corporate Profits Peaked?" as demand for private investment capital has risen. Private investment remains at levels normally associated with recessions (mainly due to low levels of real estate investment), but today's current level of real interest rates (represented by the interest rate on TIPS in the chart above) is also abnormally low. We are moving from depression levels of real rates to recession levels instead. An improvement nonetheless.

I actually don't think the Fed has helped the yields of treasuries that much...if anything the Fed has kept rates elevated by maintaining inflation expectations in the equilibrium range of 2.25% rather than at the lower levels had deflation been allowed to run its course. Where the Fed has helped the markets is by crowding out private investment from the risk-free treasury bond and government-back mortgage securities market and into the risk markets of corporate bonds and equities. This is evidenced by the lower-than-equilibrium risk spreads even during a relatively weak economy.

The only area where risk spreads are wider than usual is the municipal bond market. Seeing what happened to Detroit recently may make the reason for this obvious. Nevertheless the only cheap asset class in the fixed income market is long term municipal bonds. Floating rate bank debt funds can also make an attractive option to get some spread while hedging against the risk of rising interest rates (which make bond prices fall).

US Dollar

The dollar has been rallying a bit but has remained cheap as the Fed has remained more aggressive on the easy money front than the European Central Bank. Nevertheless as real interest rates rise in the US with increased investment demand, I expect the dollar bull market to continue. Go back to my 2011 piece "Get Ready for a Dollar Bull Market" to see more on why I think we're due and what a stronger dollar means for the financial markets.

Chart Two

(click to enlarge)

As we can see in Chart Two above, in nominal terms against major currencies the dollar has rallied to near the top of its long term (downward-sloping) channel. Against a trading basket of all currencies, however, and in real terms (which is what matters economically), the dollar is still weak. This means that the dollar still has alot of potential to rally against emerging market currencies and that the US terms of trade remain pretty favorable (good for exports and US industrial activity).

Housing

The housing market got a good bounce off the bottom in the second half of 2012 and so far in 2013.

Chart Three

(click to enlarge)

US housing has gone from being a cheap asset class to a fairly valued one pretty quickly. The stabilized economy and financial system should be good for housing, while rising real interest rates provide a headwind. Its a fine time to buy a house, but not for speculative purposes, assuming the overhang of the bubble will prevent another bubble run to rival the last decade's.

Equities

Figuring out the right price for stocks is trickier. I've long been unenthused about stocks, even as they've risen strongly over the past four years. I've owned them because I maintain a diversified portfolio, but I've felt they are riding the advantages of low interest rates, a cheap dollar, moderate inflation and a particularly capital-friendly environment to artificial heights. That said, the absence of alternative, attractively-priced investment options make stocks seem like the best of a bunch of bad choices.

Here are my calculations:

Chart Four

(click to enlarge)

The market is priced at about 16x the $103 earnings assumed by S&P analysts for 2013. That, on the surface, would appear to be fairly priced. I believe, however, that we should price stocks off of long term trend earnings (which smooth out rises and falls in business and inflation cycles) which are currently $66. The 16x multiple (which is the fair multiple) on trend earnings leaves a fair value of the S&P of 1,049, 38% below the current level of 1,686. It should be noted that S&P earnings fell (slightly) in 2012 compared with 2011. Although they do appear to be rebounding in 2013. Perhaps fiscal austerity, a stronger dollar and higher real interest rates won't hurt earnings because the economy is going to move into a higher gear, which I do believe it will.

I have a problem with this alternative hypothesis. The analysis shown in Chart Four shows that my trend line of real earnings shows growth of 2.5% per year over the past 50+ years, which makes perfect sense, as it is in line with or slightly below real GDP growth. If we add a 4.5% equity risk premium to the equilibrium long term treasury bond yield, we get an assumed long term return on stocks of 8.8%, in line with long term performance. If we assume the 8.8% return, and real earnings grow at 2.5%, inflation is assumed to be 2.25% (which is clearly the equilibrium level that has been assumed by the market over the last four years), and we assume the payout yield is 60% (dividends plus buybacks), we mathmatically arrive at the PE of 16x, which is also the historical average (a little higher even). The theory is sound.

So where could I be wrong? My trend line could be using the wrong y-intercept, because it doesn't have data going back far enough. Perhaps if earnings were higher in the 1940s and 1950s, the full long cycle trend would have a 2.5% growth line cutting through today's assumed earning level of $103 as the mid-cycle trend earning level. The other thing that could be wrong is that the equity risk premium has shifted permanently to a lower level, like 3%. Or maybe earnings will continue to grow faster than the economy.

This last chart is what makes me nervous when I try to embrace any of the above theories:

Chart Five

(click to enlarge)

 

Corporate profit margins are at a peak level as a percent of GDP. Given the historical pattern (i.e. margins don't seem to linger a peak levels very long), we should assume that corporate earnings start growing more slowly than the economy for a spell. Perhaps margins will continue to hit new records (possible) or perhaps it won't matter because the economy is going to start growing very quickly. I don't see a catalyst to make stocks plunge anytime soon, but I'm weary nonetheless. I will continue to take profits if stocks rise and keep myself hedged. Stockpicking is the name of the game, I think. Large cap growth will likely have the upper hand.

I am not a financial adviser and write these articles purely for my own amusement. Please consult your financial adviser before acting on any of the recommendations posted here. 

Why Gold is in a Bear Market

First of all, apologies for not writing this column many months ago. I haven't had much time to sit down and convey my thoughts on this matter. Most of the money being short gold has probably been made, but I'd like at least to do my best to hypothesize why gold has slipped into a major bear market even while the Fed and other central banks around the world have been "printing money" with their QEs, Abenomics and the rest. Gold has slipped into a bear market because the improving economy and increasing private investment are pointing to an eventual normalization of real interest rates to a positive level away from a gold-friendly negative level.

Gold as a neutral currency

Over the long term, the way to look at gold is as the "neutral currency", i.e. a store of value against paper currency inflation and the price of things in general. In the short run, however, gold is as prone to speculation as any asset and tends to go through long bull and bear markets depending on traders' views of monetary policy and the structural state of the economy.

Why does gold serve as a store of value more than other commodities? Because it doesn't get "used" in the same way that oil or corn get used, nearly every ounce ever mined is still in human possession either as jewlery or bullion. That means the gold supply is extremely stable, virtually unaffected by the amount that gets mined each year.

This quality is why gold has been used as a monetary asset throughout history. As an investment, however, gold doesn't pay interest, so it only serves as a long term store of value or as a short term vehicle for speculation.

In a normal environment, holding a dollar in the bank would pay enough interest to compensate you for the risk of holding that dollar. Because the FDIC guarantees cash bank deposits against default, the only risk of holding cash at a bank is that the interest rate may improperly compensate the holder for inflation.

Gold versus cash

All things being equal, if the interest rate on bank deposits is less than the rate of inflation, then the value of bank deposits are losing purchasing power and thus gold would serve as a better store of value than cash and the price of gold in dollars would rise. If the interest rate on cash is above the rate of inflation, then you would get a positive "real" return on cash and because gold pays no interest you would prefer cash and the price of gold in dollars would fall.

As a side note, if we assume a 2% inflation target and a 28% average tax rate on bank interest (or short term treasury securities), the "neutral" overnight interest rate would be 2.8%, generating an after-tax, after-inflation risk free return is 0%. So if there was no business cycle and/or the Federal Reserve Bank was perfect at executing policy, then all future maturities of US Treasury bonds would yield 2.8%, inflation would always be the Fed's 2% target and the rate on Treasury Inflation Protected Securities ("TIPS") of all maturities would be 0.8% (to compensate investors for taxes).

The forward market for real interest rates

Of course all things are never equal. The capital markets are always trying to anticipate the future. When looking at the market for Treasury securities, investors are making assumptions about how real interest rates will average out in the future based on the Fed's reaction to the business cycle and how it will effect inflation and the business cycle itself. The business cycle is primarily driven by the changes in psychology of the suppliers of cash (savers and banks) and the demanders of cash (businesses, governments and real estate developers). The treasury market represents the market's assumptions about the future of the market for risk-free cash, while the rest of the securities markets represent the market's assumptions about the performance of non-risk-free investments relative to the market for cash.

Because the future is uncertain, a normal treasury curve has a rising, positive slope to reflect increasing amounts of uncertainty over time. The assumption I have always used for my market model is that the overnight level of real rates is 0.8% and that the 2-year TIPS yield would be 1%, the 5-year TIPS would be 1.3%, the 10-year would be 1.8% and the 30-year would be 2.3%.

During recessions, when the demand for cash by savers is high relative to longer term investments, the Fed engineers cash interests rates below the rate of inflation to entice savers to increase their demand for longer term securities.

When savers become more optimistic, the prices of long term securities improves and the Fed would then be able to normalize the level of short term rates to balance the demand for cash versus long term securities.

When savers become too optimistic about the business cycle, the excess demand for long term securities pushes the cost of capital too low, causing more marginal projects to get funded. If the Fed sees this happening, it raises the short term interest rate to above the rate of inflation to entice savers to invest less in long term securities and hold more cash. Of course it's very hard to get this exactly right, as we'll see below.

The chart below reflects the assumptions of the treasury market over the course of the recent bull market in gold (2003- ):

Chart 1

(click to enlarge)

The real estate boom, 2002-2005. In the early 2000s, we can see that even though the short term interest rate (in green) was well below its equilibrium (and the rate of inflation) following the downturn of the early 2000s, the TIPS market was assuming that the Fed would get the balance basically right over time and the rate on the 5-year and 10-year TIPS were relatively stable around their equilibrium levels. In early 2004, the Fed started raising rates. Instead of its practice in 1994, when it raised rates to above equilibrium relatively quickly, the Fed embarked on a telegraphed, incremental program of raising rates.

The credit boom and real estate top, 2005-2007. It took a full year (until mid-2005) for short term rates to reach equilibrium. By this point the housing market was already going haywire and the credit markets were gaining a sense of false confidence due to the Fed's telegraphed game plan, even though it kept raising rates to above equilibrium levels. From this period until mid-2007 long term real interest rates also rose to an above-equilibrium level as investors felt that the investment wave was strong enough to withstand an extended period of above-equibilirium short term rates.

The bust and the aftermath, 2007-2009. Of course that is not what happened. Higher short term interest rates eventually made real estate investment less attractive. Construction peaked in 2006 and prices peaked shortly thereafter. More and more marginal loans were being made and the credit allocation system was far more fragile than investors realized. As the credit market started to unravel, the Fed started cutting rates and long term real rates started to fall, touching very low levels in early 2008. During the height of the credit crisis in late 2008 and early 2009, long term real rates reversed and spiked as the market feared uncontrolled deflation, but then quickly dropped again as they realized that the Fed was on top of things and willing to do what it took to keep inflation positive.

The "U" shaped recovery, 2009 - 2013. In the period since, private investment in general, and real estate investment in particular, has been very weak, so demand for cash for long term projects has also been weak. The Fed has been aggressive about keeping rates below inflation and about reducing the cost of capital of long term securities. Even though businesses have returned their levels of investment to more normal levels, real estate investment has remained at abnormally low levels while excess capacity from the boom was worked off. During this period, investors came to the conclusion that investment would be abnormally weak for a long time and that the Fed would thus have to hold rates below inflation for a long time. The 10-year TIPS yield has been negative, implying that we would be in this state of affairs for 10 years or more on average.

Private investment

As we can see in the chart below, private investment relative to GDP was actually pretty healthy in the early 2000s when the Fed was erring on the side of being too easy. That was the major mistake that fed the housing bubble (in addition to their failing to recognize the excesses in the shadow banking system). After the credit bubble, on the other hand, investment fell to its lowest level since World War II. Thus the Fed has been correct to err on the side of being easy during the lackluster recovery.

Chart 2

(Click to enlarge)

Private investment, while improving, is only just above the level at which recessions usually bottom, so the Fed can be easy (i.e. keep rates below inflation) for a while longer without doing too much damage. The housing market has started to turn and housing has a long investment cycle. Investors can therefore see the economy returning to a relatively normal level over the intermediate term and not wallowing in the state of perpetual weakness that would necessesitate 10 years of negative real interest rates. It is the improving housing market, not the Fed's jawboning, that is causing long term real interest rates to rise.

Bringing it back to gold

OK, but real interest rates are still predicted to be negative over the next five years and the Fed's rate hikes are a year away at least. So why is gold falling now?

The market for gold, like the one for treasury securities, is focused on the future. For a long time the people focused on gold were very different than those involved with the more mainstream fixed income markets. In the early 2000s, gold had gone through a 20 year bear market and had been left for dead by all "respectable" market participants. During the high real interest rates of the technology investment boom of the late 1990s, gold had fallen to under $300 per ounce. The people that followed gold at that point were mainly ideological...people who hated paper currencies.

Gold bugs are contrarians that think an economy built on paper currency is a castle made of sand. I know, because as I was investing I gold during the early and mid 2000s, I used to traffic gold bug websites. Because there was no greater castle of sand than America riding the dot com bust, followed by the Iraq War, followed by the housing bubble, all on the back of a falling dollar and Chinese imports, the gold bug crowd was having a contrarian field day in the early 2000s.

The gold bull market had three phases that correlated with the the phases of the treasury market described above. The first phase lasted until about early 2006. As the Fed eased policy and the dollar declined from its lofty levels of 2000, the price of gold normalized to its old level of $350-$400 per ounce that held before the tech bubble. In late 2005 and early 2006, the gold market recognized the Fed's mistake of feeding the credit bubble with its telegraphed policy and that the housing market would eventually fall, necessitating a major Fed easing. It was during this period that the price first spiked to $600+, signalling a real bull market.

Chart 3

(click to enlarge)

Gold had a hard time rallying in 2006 and 2007 as real interest rates were high, but it held its ground as it rightly anticipated that there would be a recession and real interest rates would fall again. Then by early 2008, gold investors realized that the credit bubble was even worse than they thought, and prices spiked to $1000 per ounce anticipating a massive Fed rescue.

In late 2008 and early 2009, however, the market feared that the Fed may be erring on the side of being too tight, and real interest rates spiked and gold fell to below $800 per ounce. Then the Fed and the Treasury Department rode to the rescue and the gold and TIPS bull market resumed. As can be seen in Chart 3 above, the gold market has done a pretty good job of anticipating the decline in long term TIPS yields (shown on an inverted scale).

In 2011 and 2012, these markets started topping out for fundamental reasons. The economy is improving, the Fed has not proven to be overly reckless, price inflation is quiescent and it has gotten pretty tough to justify buying long term TIPS at a yield of negative 1%. Gold bugs point to consipiracies and treasury investors can blame the Fed, but it was time for real rates to rise and the smart money started getting out of both gold and TIPS.

So what's the right price for gold?

In a bear market that follows a big bull market with three upwaves and two consolidation waves, you figure the bear market wipes out the last upleg or "extended fifth wave". That would take us down to the $800-1000 range.

The other old rule of thumb is that an ounce of gold over time is about equivalent to the price of a "decent man's suit". This follows the store of value or neutral currency notion. When I was gruaduating from college and starting work, a suit at Brooks Brothers cost about $350, about equal to an ounce of gold. The price of a Brooks Brothers suit today...$1000 (interestingly, currently marked down to $700). Sounds about right.

I am not your financial advisor. These posts and the observations therein are written purely for the author's pleasure. Please consult your own financial adviser before making any investment decsions.

2012 Election Preview (and quasi-endorsement)

My core theory of US politics can be summed up with two, very optimistic principles. The first is that the US electorate as a whole is very wise, notwithstanding the less-than-wise nature of many individuals. The second is that the US political system, as devised by the Constitution and its collective amendments, is self-healing; it is the greatest application of complexity theory in the history of the world. I realise these two principles go against the grain of much educated thought, but they have proven themselves over time, having really failed only once (in 1860). I can go more into these principles and why I believe in them in some future post.

Previous writings from the Dynamist: from realignment to backlash

Back in 2010, I wrote two pieces analyzing the state of politics. In the first from March 2010, "The GOP will not repeal ObamaCare", I first walked through why I thought the outright repeal of Patient Protection and Affordable Care Act ("PPACA" or "ObamaCare") would not really be a winning political issue for the GOP in the end, even though the nature of the Democrats' overreach on the issue was certainly helping the GOP in the 2010 midterms. I then ran through the laundry list of remaining issues (from the perspective of the electorate) and found 4 favoring the Republicans, 2 favoring the Democrats and 3 mixed. In the second from October 2010, "The Middle Class is Still Up For Grabs", I previewed the Democrats' upcoming defeat (where I believe I was the first to use the term "shellacking", but received no attribution from President Obama). I put that defeat into the context of building political coalitions, and how neither party had built a platform that truly builds up the middle class.

Both of these articles represented an adjustment from my 2008 writings which posited that 2008 might have been a "realigning election" that created a new majority coalition in favor of the Democrats and the northern, "blue" states. If I had to reflect on the realignment theory today, I would instead say it happened in two steps. First, in the late 1960s and early 1970s, when the "New Left" was forming in opposition to Vietnam and Jim Crow and in favor of women's rights, environmentalism and affirmative action, it could just as easily formed within the Republican Party as the Democratic Party. At the time, it was the Southern, socially-conservative Democrats that had gotten us into Vietnam and had defended segregation in the South. The Republican Party made the choice, however, to shortcut a longer term realignment in favor of uniting with Southern conservatives to implement an economically conservative agenda which has since become dominant in our politics, achieving realignment in 1980 with Ronald Reagan and gaining in strength during the 1990s and early 2000s under Clinton and Bush II. While the New Left would become marginalized during the Nixon and Reagan years, it eventually mellowed a bit and strenghened during the Clinton years before achieving realignment status under Obama.

The political framework today - stalemate?

Demographic changes have given the New Left its boost over the top in the Obama years, as the coalition of strong support for Obama among African-Americans, Latinos and single women on social issues will likely outweigh the decay of Obama's support among white men and married white women over economic issues over the past four years. The other factor keeping the Democrats in the game, however, appears to be the holdover of the economic Old Left in the industrial Midwest that is not being won over by the GOPs purist free market orthodoxy, particularly led by a former leveraged buyout impresario.

In many ways, the GOP has become a victim of its own success. It's dominant Presidential or Congressional coalitions of the 1970s through the 2000s faded as the party racked up victories on the wedge issues that divided the Democrats: deregulation, free trade, monetarism and inflation, income taxes, the Cold War and defense, urban crime, gun control, illegal immigration, welfare reform, capital gains taxes, the estate tax, the War on Terror and gay marriage. In each case, either the Democrats conceded the issue (gun control, crime, welfare reform, defense) or the GOP took the issue too far (illegal immigration, the War on Terror). Now the parties have fought to a draw on defense (both basically settling in on the center-right) and social issues (by region, with a slight center-left electoral college advantage to the Democrats).

I continue to believe that the economic agenda of the future is still up for grabs, however. The Republicans have become too rigid in their free market orthodoxy, being overly focused on promoting capital formation while mostly ignoring human capital development, which in the new economy can just as, if not more, important as pure capital formation. This is why the regions that have benefitted the most economically from the new economy like New York, Boston, Chicago, the Bay Area, Los Angeles, greater DC don't favor the GOP even though they have done very well under the era of conservative economics. As discussed above, the nearly complete victory of capital over labor in the old economy in the last thirty years has also weakened the GOP economic argument in electorally-rich Midwestern industrial states like Michigan, Ohio, Pennsylvania, and Wisconsin.

The Democrats, on the other hand, still have vestiges of the Old Left in their approach to economics, favoring the kind of centralized approaches to problem-solving that served them well in the industrial, mass-market world of the 1930s through the 1960s, but that are less appropriate for the decentralized, networked world of today. In the long term, the Democrats have an advantage in that they have more flexibility with their base on economic issues than the Republicans, while the Republicans have an advantage in that their basic philosophy is closer to the ulimate endgame if they can back off their fealty to capital and focus more on the middle class (promoting progressive goals with conservative, market-driven means). Until one of the parties seizes the advantage, we have basic stalemate with plodding progress.

Scenarios and issues

With a pretty evenly divided electorate we can be highly confident that the GOP will retain control of the House. Because of two decades of GOP-friendly redistricting, the Democrats need to win the generic House vote by more than 3% or so to flip control. This is pretty important in that the President really doesn't have that much power on domestic issues, and with a GOP House (particularly this GOP House), there isn't much chance of Obama passing any more big agenda items over the next four years. In addition, the Senate is likely to remain evenly divided, so no matter which party nominally has control, there isn't much chance of a president Romney getting the 60 votes necessary to pass any radical policy changes either.

For the next two years at least, the electorate is not voting for either Obama or Romney's agenda. It is instead voting for the type of compromises it wants to see occur. If Romney is elected, the compromises will be as center-right as the Senate will allow. If Obama is reelected, the compromises will be as centrist as the House will allow. If you think about it, this makes much of the apocalyptic rhetoric we've been hearing from both parties seem pretty silly, doesn't it?

Through that lens, the issues:

• Foreign affairs - Here is an area the president does control. Obama is operating in the non-ideological conservative internationalist tradition of Dwight Eisenhower, Richard Nixon (perish the thought) and GHW Bush. After the adventurism of the GW Bush years, Obama's approach pretty well suits the country's mood, which is probably why you saw Romney embrace Obama's positions in the third debate. Despite some of Romney's hawkish talk on the campaign trail, I doubt he would differ much from Obama, but you don't really know, so advantage Obama.
• Social issues - If you vote on social issues, you know who you're voting for. It appears that these issues are helping Obama a bit more, but I'm not going to wade into this, because I don't really vote on social issues and you don't know who won these until you see the turnout on election day.
• Individual Taxes - Polls say people favor seeing the wealthy pay more, which is why Obama isn't being hurt by his stance. Although we can quibble with the math, I think Romney's general approach of flatter rates with less deductions for wealthy is superior. Since I highly doubt the Senate will pass a 20% cut in nominal rates most of Obama's attacks on Romney's "$5 trillion tax cut" aren't really operative. I also think the odds of a "fiscal cliff" disaster would be much lower under Romney as there would be less of a fundamental standoff between him and the House. By the way, this is under the radar screen but both guys are planning to let the payroll cut lapse this year. Advantage Romney.
• Corporate Taxes - Both parties realize that the nominal corporate rate needs to come down to be internationally competitive, offset by a reform of loopholes. Romney favors moving to a territorial tax (focusing on domestic activities only), while Obama wants to tax overseas earnings like domestic earnings (as opposed to only when they are repatriated). While Obama's plan sounds better (taxing companies that "move jobs overseas"), it's not very realistic, since no other country does that and it would therefore encourage foreign takeovers of US companies to save on taxes by moving the corporate domicile abroad. In the end, under Obama, the House will either insist on a territorial tax or nothing will happen. Under Romney, I'm pretty confident we'll see reform pass, so advantage to Romney.
• Fiscal policy in general - I don't think the markets or the economy want a sharp fiscal consolidation in the near term. I think the combination of a slightly revenue-positive tax reform, long term entitlement reform and discretionary spending controls without sharp cuts (aka something like "Simpson-Bowles") is probably the best outcome. While I think Romney would be better at finding a compromise on taxes, I think Obama would have a better chance to craft a broadly-acceptable reform of entitlements if he's willing to do so. Obama has the opportunity to reclaim the Democrats' brand equity on fiscal prudence by crafting a "grand compromise" and a GOP House is likely to go along with it this time around. Advantage Obama.
• Trade policy - Both candidates would be more activist on promoting US exports than the Clinton and Bush administrations, with Romney promising to get tough on China's currency (which I agree with). In the end I think they would both be fine. Toss-up.
• Monetary policy - The next president will get to appoint the next Chairman of the Fed. I would be in favor of reappointing Ben Bernanke or someone like him. It is no longer 1980, where inflation was the big threat and taxes were too high. Now deflation is the threat and tax collections are the lowest since before World War II. We need to move from the default of tight monetary policy and loose fiscal policy favored by the Republicans to a default of loose monetary policy and tighter fiscal policy more favored by Democrats. Advantage Obama.
• PPACA / ObamaCare - The idea of repealing the PPACA with nothing to replace it doesn't seem realistic in the context of our history. Besides, since the Senate is unlikely to repeal the non-budget items, the idea of just starving it seems like a recipe for chaos. While it's a deeply flawed bill, it is probably among the least bad of a bunch of crappy options available to us until we reform the way health care is ultimately paid for. Since the PPACA maintains a "competitive" private system, it leaves the door open for pro-market reforms that could bring costs down while sustaining innovation. If Obama is reelected, keeping the PPACA is place is the only thing that he could really describe as a mandate. Advantage Obama.
• Medicare reform - Medicare will bankrupt this nation if it is not reformed. I actually like the Paul Ryan voucher approach for Medicare in the long run, but ironically I also think that it would need the PPACA in place to succeed. Basically there needs to be a competitive marketplace for individual coverage that can't deny you for pre-existing conditions (like being old). The only way that really works is to have the individual mandate for the PPACA so everyone is in the pool. Ultimately we need to reform the way Medicare pays for health care to move away from the current fee-for-service if we ever want to use competition to drive down costs, so the Ryan plan and ObamaCare go hand-in-hand. Kumbaya! Toss-up.
• Social Security reform - We only need to tweak Social Security to make it solvent. Everyone knows the ultimate solution will be a combination of reduced benefits for the wealthy and a gradual increase in the retirement age, so let's just get on with it already. Advantage Romney.
• Education - Obama and his Education Secretary Arne Duncan have been doing a good job building on Bush's No Child Left Behind reforms, gradually introducing competition to the system. Obama has coopted a bit of the GOPs reform mantle here, but it works. Otherwise, most of the real battles in education reform are at the state and local level. Advantage Obama.
• Energy - We need to ride the fracking, shale oil and deepwater drilling boom as hard as we can without harming the environment too much. While Romney would let it run harder, Obama gets more cover from environmentalists. While I think the idea of millions of "green-collar jobs" is a joke, I'm not totally against investing in research on green energy (solar and wind, not biofuels) and conservation (electric cars, green architecture). Toss-up.
• Infrastructure investment - Obama blew his big opportunity here with his boondoggle of a stimulus bill. If he has focused on bread and butter spending like bridges, airports, roads and local transit, he could have built a strong coalition for a multi-year increase in infrastructure spending. Instead the bill was known for esoteric stuff like high-speed intercity rail and poorly-invested green energy loan guarantees that left people scratching their heads. To me this was the biggest disappointment of Obama's first term. Romney doesn't really talk about this, so I'd still say advantage Obama.
• Financial reform - The Dodd-Frank financial reform bill is a bad bill that can rightly be attacked from both the left and the right. I would have focused on simpler, but more fundamental reforms (like limiting the size of an bank's liabilities relative to GDP and increasing the required capital cushion beyond what is currently contemplated). Instead we have a byzantine mess that was nevertheless better than no reforms at all. Since the GOP hasn't articulated a realistic alternative, I'd have to begrudgingly say advantage Obama.
• Other stuff - Beyond the above on budget issues I'd prefer the GOP's approach. The Federal government should be made to be better at a smaller number of things, with more devolution of responsibility to the states (or to international bodies, where appropriate). I know not everyone agrees with that, but I think it's more appropriate for the decentralized world we live in today. Advantage Romney.

My quasi-endorsement of Mitt Romney

So looking at the above, it looks like I favor Obama, but I don't. While I voted for Obama last time, I intend to vote for Romney this time around. Personally, I am most focused on macro economic issues where I tend to prefer Romney's approach. I also think he will be better at crafting compromises with Congress and therefore there would be less of a chance of the kind of stalemate disaster scenarios that have a small chance of occuring under Obama. I am also more familiar with Romney's business background than most and so respect his skill and acumen and think he might make a better problem solver than Obama. That said, I also think neither party nor candidate really has a set of policies to build up the actual employment and earnings of the middle class. I like Obama enough and think he has done a good job on some things and I understand why he is favored to win reelection. As I said before, either man would be pretty hemmed in by Congress if elected. So while I slightly favor Mitt Romney, I'm probably one of the few people in the country who thinks it won't really matter that much in the end.

All opinions expressed herein are my own, and are not meant to represent the views of any organization with which I am affiliated.

5 Questions Every Private Equity Investor Needs to Ask

The following article originally appeared in Fortune.com on July 9, 1012. The original article can be found here.

Many institutional investors are convinced that the days of easy money are over in private equity. Managers need to distinguish themselves through their ability to add actual operating value to the underlying portfolio companies.

Private equity firms are generally active board members of their portfolio companies. Nearly every investment firm spends a great deal of time monitoring the tactical performance of their portfolio companies: Performance vs. budget, sales pipeline analysis, cash flow monitoring, margin assessment, capital structure optimization, valuation, etc. The tactical performance of a company is important, of course. Ultimately, however, as an investor and board member, a private equity investor's role should be more strategic than tactical. It is easy for investors to get lost in the tactical minutia and forget to ask themselves the big strategic questions.

The following are five key strategic questions private equity investors should ask themselves about each of their portfolio companies -- or prospective portfolio companies -- at least every 3 to 6 months.

1. What is the company's core strategic plan? Investors need to evaluate tactical performance within the context of strategic goals. The lifecycle of a company or operating division is basically a series of 3- to 5-year strategic plans. The plan may be to develop a prototype product and win some key first customers. It could be to expand internationally, scale revenues and cash flow or expand the product set into adjacent markets. It could be to manage the transition from a growth to a value orientation by rationalizing the cost structure, or to successfully transition a company from a corporate spinoff to a standalone entity. It could be to narrow the company's focus to a core set of products in a declining market. There are numerous core strategies that are potentially appropriate 3- to 5-year plans for a private equity or venture-backed company. Investors must also consistently evaluate whether the strategic plan remains appropriate if there have been changes in the portfolio company's operating and competitive environment. Companies that clearly identify their core strategic plan almost always execute better than those that do not.

2. Are we the right owners to execute on the strategic plan? This is perhaps the hardest question for investors to ask themselves, but it is fundamental. Private equity firms are generally pretty good at screening deals that don't fit their strategies at the time of acquisition but they don't always recognize when the strategic environment has shifted post-investment. A growth equity firm with a company that has shifted into slow-growth maturity; a company in a consolidating industry that would better off as a product or division of a larger company; a company embarking on a new 5-year product strategy with an investor near the end of their fund life…

These are all situations in which the right decision may be to seek a new owner. Sometimes answering this question requires admitting relative defeat on a certain investment but that is preferable to spending years working on a portfolio company that is outside a firm's investment strategy.

3. Does the company have the right CEO to execute on the strategic plan? Most private equity investors are good at figuring out when a CEO is underperforming. It's more difficult to determine whether a good CEO is in the wrong role, particularly if the core strategy has changed. Sometimes a company needs an entrepreneurial visionary, other times it might need an operational "Mr. Fix-It." Sometimes a company may need a turnaround specialist, other times it may need a sales and marketing expert. A visionary's talents are not appropriate for a turnaround strategy, nor should a sales and marketing guy be focused primarily on operational efficiencies.

4. Is the company earning an appropriate return on invested capital? The key unit economics of the company's products must be earning more than a sufficient return on invested capital. The ROIC methodology varies by industry (a mature product manufacturer needs to monitor different metrics than a growth-stage online software company, for example), as does the cost of capital. No matter what the stage of business, however, at some point the core business must be able to profitably generate revenue. There is no point investing in revenue growth if the unit economics won't work.

5. Is the company gaining market share? If the unit economics are working, a company must assess its total addressable market and its share within that market. If the competition is growing more quickly (while also earning sufficient returns on invested capital), then the investor must figure out why and help look for solutions. It could be a sales and marketing execution problem, or a product problem. It may be a market power problem that can only be fixed by pivoting to a different or more specialized niche. If a company is having difficulty gaining market share in a certain market, then it has to question how long it should remain in that market.

Investors with the discipline to consistently ask these five strategic questions will have a framework to evaluate a company's tactical performance, which in turn will enable the investors to create more portfolio company value. After all, creating portfolio company value is what private equity investors are paid to do.

Q2 2012 Market Update: Have Corporate Profits Peaked?

This post is an installment in a continuing series supported by The Dynamist's Market Valuation Model. Please click the link to see past installments.

Interest Rates

As usual, we start by examining the current state of the interest rate complex, which gives us the market consensus of underlying economic policy. The breakdown of the yield curves of US treasury bonds, muni bonds and corporate bonds is shown below.

If we look at the market's inflation expectations, it is generally assumed that the Federal Reserve will succeed at maintaining inflation right around its target range of 2%-2.25% over a variety of time horizons. Real interest rates (the inflation-adjusted rate on the Treasury Inflation Protected Securities or TIPS) are expexted to remain low for the forseeable future, averaging NEGATIVE -0.5% over the next ten years. This implies that the sluggish economy will force the Fed to maintain nominal interest rates below the rate of inflation for more than five years at least. This would be consistent with my view that we are in a long down cycle as the world economy struggles under its large debt load, resulting in weak demand relative to supply. (The phase known as the Kondriatev Winter to you cycle theory buffs.)

The combination of below equilibrium real interest rates and equilibrium inflation expectations results in nominal treasury yields well below equilibrium. And even though the spreads of municipal and corporate bonds relative to treasuries are currently attractive, their resultant nominal yields are relatively unattractive. While this would normally singal that fixed income in general is overvalued at this time, I believe the bond market is accurately reflecting the likely long term economic scenario, meaning that bond yields are unlikely to rise significantly in the intermediate term at least. Overall, I am overweighting cash and intermediate munis and corporates and underweighting treasuries (and I have sold all of my TIPS).

I'll discuss what this rate structure means for the dollar, gold and commodities in a future post.

Stocks

As long time readers of these columns are aware, I base my assessment of equity values on the S&P price relative to the long term trend in inflation-adjusted earnings. Using long term returns that fail to take into consideration the unnaturally large surge in inflation during the 1970s will overstate the long term earnings growth assumption. It was the great surge in prices (and thus nominal earnings), followed by the long decline in interest rates that underpinned the massive bull market since the 1980s. I tend to believe that it would be folly to expect a repeat of those extreme conditions.

The long term chart of inflation-adjusted S&P 500 earnings is shown below, along with the calculated trend line.

So while the earnings of the S&P500 were $86.95 in 2011 and are expected to be $97.98 in 2012 (according to S&P analysts, not Wall Street analysts) and $108.76 in 2013, the trend earnings were only $64.88 in 2011 are only $67.73 over the next twelve months.  In this view, the trend market PE is about 20, as opposed to 13 or so on projected forward earnings.

The chart below breaks down the components of the projected S&P return, which I calculate to be 7.6%. This return is below what I believe to be the equilibrium return of 8.3%, but is not wildly off.

If you want to earn an 8.3% return, you would have to wait fot the S&P500 to drop to a PE of 16 on trend earnings. That level is currently 1104, about 19% below where it currently trades. That said, given today's interest rates, a 7.6% return sounds pretty good. In fact I calculate the current the equity risk premium (the spread of the expected equity returns over the risk free rate) to be 5.4%, above the proper premium of 4.0% (according to my read of the literature, at least).

Another way to look at PE is to reverse the ratio to earnings to price, or earnings yield. The chart below shows the earnings yield of trend earnings over time. The current yield of 5.2% is more in line with the late stage bull market of the 1960s than the bear market or early bull market valuations of the 1970s or 1980s.

One potential flaw in my model is that my trend earnings could be too low, dragged down by artifically low earnings in the 1970s and 1980s and ignoring the structural changes like globalization that have permanently increased corporate earning power. There may be some validity to this view, but I could easily counter with the theory that recent earnings have been artificially inflated by financial earnings and the effect of the weak dollar on foreign income.

Have corporate profits peaked?

Let's see what the statistics say. If I take the level of corporate profits in the economic statistics and compare them with GDP, we can see that corporate profits are indeed at record levels.

The trend for corporate profits has been on the way up for the past few decades, now exceeding the levels from the mid 1960s. If we break down corporate profits into domestic profits vs. financial and "rest of the world" profits, however, we come up with a different story.

Domestic corporate earning power relative has remained in the same "trading range" since the early 1970s, oscillating between 4% of GDP at lows to around 7.5% at highs. The level is currently 7.3%, signalling that they may be near a cyclical peak. The big change over time has been the increase in financial and rest of the world profits. Financial profits have increased steadily with the long bull market in treasuries, which we can probably safely say has likely run its course. As interest rates flatten out and as Dodd-Frank and Basel III regulations are implemented, it is highly probable that financial profits as a percent of GDP will decline over the next decade.

Rest of world profits have recently caught up with financial profits (they are roughly equal now). Foreign profits could fall with a strengthening of the dollar or any sort of rollback of globalization, either of which are possible or even likely in this environment. 

Teed up for disaster?

While not necessarily likely, the outlines of a potential meltdown scenario for earnings is becoming more clear: the quagmire in Europe, leading to banking problems, leading to a crash in Chinese real estate, leading to a rising dollar, leading to a crash in commodities, leading to a bout of deflation, leading terrible earnings, leading to a stock market swoon.

The alternative scenario is that we are headed for a weaker version of the late 1990s, where after a mid-cycle slowdown the US economy steams ahead on the back of a powerful investment cycle as real estate investment recovers and business investment picks up its pace. The US could be able to prosper even while Europe languishes, with US imports keeping Asia afloat. In my last post "Atlas Done: The US Can't Carry the World Economy" I argue why this scenario would be difficult to achieve, but I have been wrong before. In this event, we could see domestic profits continue to head higher and to reach the levels to the late 1960s relative to GDP, rendering my trend earnings too low and making stocks a screaming buy at these levels.

The other perhaps most likely scenario is that the US real estate market, Europe and China can all muddle through for the next year or two. In this case, the market would trade choppily for the next few years as time continues to heal the wounds of the credit bubble. Private sector debt levels would gradually decline until the point that the private sector is able take the growth baton back from the public sector. In this scenario, an investor would want to be modestly underweight equities and overweight fixed income. This is the "Rounded Bottom" scenario that I view as my base case.

I continue to believe that we are riding a cyclical bull within a secular bear market and that investors need to be careful here. The chance of a deflationary crash probably exceeds that of a powerful second leg to the bull market. The most likely scenario is more of the same. The good news is that we are likely nearer to the end of the long bear market than we are to its beginning. In the meantime, caution should rule the day.

I am not your financial advisor and I write these articles purely for my own enjoyment. Please consult your own financial advisor before acting on any recommendations or views made in this article.

 

Atlas Done: The US Can't Carry the World Economy

Today's release of the May jobs report showing that the economy only created 69,000 jobs and that the unemployment rate rose to 8.2% confirms what the equity markets have been hinting at for the past month...that the world economy is starting to slow down, perhaps dramatically.  Europe's slow-motion financial crisis is dragging down its economy, which is in turn dragging down Asian export economies, who are  cutting their commodity imports and hitting commodity-producing economies like Australia and Brazil in turn.

Once again, the entire world is depending on the profligacy of the United States to keep the global economy afloat. It doesn't have to be this way, and frankly at some point the US should stop putting up with it. I will get to how the world can fix the current state of affairs later, but first, I must pose the question as to whether the US can continue to muscle through a global slowdown given the state of its own economy.

The common complaint among Keynesian-oriented commentators is that we are suffering from insufficient demand. On the surface this would appear to be true. (All GDP figures reported on a nominal basis and sourced from www.economy.com.)

• Industrial capacity utilization stands at only 79% as of April 2012, up 67% at the trough of the crisis in 2009 (a record low for the post-war economy), but below what used to be considered a normal level of 81-84%.
• Unemployment stands at 8.3%, above a full employment level of 5% or below. If anything unemployment is being understated due to a large decline in the labor force participation rate and the large number of workers working part-time who would like to work full time.
• Wages and proprietors' income as a percent of GDP is at a near-record low level of abut 52%, down from 57% in the early 2000's and the around 60% that frequently prevailed in the 1960's.

Yes, but...

• Personal consumption as a percent of GDP is at a record high of nearly 72%.
• Personal income as a percent of GDP is at a near-record high level of 86%, right around the levels that prevailed in the late 1990's and higher than the levels of the 1960's.
• Personal disposable income as a percent of GDP is at 89%, which is right around the level that has consistently prevailed since the 1960's. Basically the decline in wage income as been continuously offset by rising transfer payments from the government and for health care, and in the past by a large decline in personal tax collections.
• Personal saving as a percent of GDP is at only 3%, below an equilibrium level of 4-6% (although higher than the levels that prevailed at the end of the housing boom).

So basically the government has done a good job of propping up consumer demand with unemployment insurance, transfer payments and tax cuts, just like a good Keynesian should want. Consumers have even kicked in a bit extra by cutting their savings to drive consumer spending to record levels. Consumers, neither rich nor middle class, can be accused of irrationally hoarding cash and holding back our economy.

Another source of demand is private investment.

• Business investment including software, equipment, mines and wells, is running at 7.6% of GDP, firmly in the equilibrium range of 7-9% that has largely prevailed since the early 1970's. It can go higher, but is not irrationally low.
• Real estate investment on the other hand, is at only 4.3% of GDP, far below a more normal range of say 6.5% to 7.5%. Commercial real estate investment is about 1% of GDP below a normal level and residential real estate investment is about 2% below a normal level.

Given the large amount of overbuilding in the 2000's and the slower growth in the working age population now that the baby boomers are starting to retire, there is no way for policy makers to force real estate investment to meaningfully higher levels until consumers' balance sheets are cleaned up and excess inventories have been worked off.

My overall view on real estate has been that investment bottomed in 2011, but that the market would not start clicking until 2013.

• Government expenditures (federal, state and local) are about 19.5% of GDP. (These are direct expenditures and don't include transfer payments.) This figure is about average for the period from 1980 to the present, but lower than the prime Cold War years when the defense budget was far higher as a percent of GDP. The US has room to increase direct government spending, but combined with the massive deficits it is running to support transfer payments, the US government is not being parsimonious.

In addition, how can the US economy be accused of having insufficient demand when...

• The trade deficit is 4% of GDP, meaning we spend 4% more than we produce.
• Our imports are 2% of GDP too high relative to the long term trend of US international trade and our exports are about 2% of GDP too low.
• Running a trade deficit means that our investment is greater than our savings. But, as we established above, our investment is running about 3% of GDP below normal levels. Private saving (business plus consumer) is running at levels slightly higher than normal, so more than the entire trade deficit can be accounted for by a higher-than-normal government deficit.

If demand for investment is outstripping savings, even at abnormally low levels of investment demand, we would expect interest rates, particularly real interest rates to rise. Instead, however, real interest rates are not only negative, but projected to remain negative, on average, over the next 10 years. The cause is of this paradox is that global savings flowing into the US (i.e. the demand for dollar-denominated savings) chronically exceeds the demand for dollar-denominated investment, even during the great business investment boom of the 1990s and the great real estate investment boom of the 2000s.

For the US to bring trade in to line it would either have to cut domestic demand and/or increase exports. Domestic demand can be cut by raising taxes, cutting government spending, and/or raising tariffs to shift demand to domestically-produced goods.  Exports can be increased by running an aggressive trade policy that steps up against those countries that are manipulating trade via their capital accounts (more on that later).

The US has geared its economy to a level of demand, for both consumption and investment, that outstrips its ability to produce. In this case demand equals standard of living. The US needs more investment to make its workers more productive, but it is already operating with excess industrial capacity and high unemployment, which circles back to the fact that domestic demand is insufficient to match domestic supply. In other words, international demand is too low relative to international supply more than US demand is too low relative to US supply.

This is not a new observation. China, Germany and the OPEC countries need more consumer demand to sop up excess savings and to increase demand from chronic deficit countries like the US, UK and southern Europe. The US, UK and southern Europe need more investment to maintain or increase their competitiveness versus other countries, but need to fund those investments with more domestic savings.

Here's what needs to happen:

• Germany needs to step up to the plate. Yes, it must be annoying for Germany to have to bail out countries like Greece. Overall, however, Europe has a relatively balanced economy (i.e. a neutral trade deficit), so it has the power to fix its own problems. Germany needs to allow domestic consumption to rise and needs to invest more in southern Europe, which southern European economies need to cut back their state relative to their private economies. Otherwise the other countries are right to protest, as to date Germany has been just looking to cement its advantaged status and protect its own banks.
• The US needs to stand up to currency manipulators. The main culprits here are China and the OPEC countries. If the governments are the ones investing in US securities to keep their currencies fixed and suppress domestic consumer demand, then they are currency manipulators, plain and simple. Letting the dollar weaken won't help, particularly with the OPEC countries, because that just increases the price of oil, making the problem worse. The US should impose capital controls or tariffs on these countries while firming the value of the dollar instead.
• The US needs to cut its petroleum imports. Petroleum accounts for a large portion of our trade deficit. A firmer dollar and a concerted move to domestic natural gas (and electric cars) should do the trick.
• The US needs to increase its savings. It should not be up to the US to support the world economy by running up its debt. The US should implement policies to increase consumer savings, particularly among the middle class.
• The US should increase its infrastructure investment. Such investment should be able to put some construction workers to work while we wait for real estate investment to recover. Plus, its actually needed. This would not be spending money for spending's sake.
• The US should implement policies to encourage domestic investment and exports. Reforming our corporate tax code would be a great place to start.

I realize that many of these solutions sound nationalistic or mercantilistic by themselves. I hope, however, that the facts are pretty clear that most of the demand shortfall that the US faces is due to (i) a shortfall in foreign demand that is a direct result of mercantilistic trade policies, (ii) an excess of domestic demand driven by lower-than-market US interest rates due to excess foreign savings and (iii) a shortfall in real estate development that only time will heal. Outside of using tariffs and capital controls to reduce our trade deficit, the US government doesn't have much further that it can do to stimulate domestic demand without badly distorting the US economy. All of the other actions I recommend are meant to deal with long term structural issues that are also tied to our need to increase the international competitiveness.

Europe has the same internal issue that the US has with China and OPEC, where explicit policies need to be put into place to increase the competitiveness of southern Europe and the UK relative to Germany. These policies need to deal with the short term issue of debts and liquidity, but also with the long term issues of excessive labor regulations, weaker productivity and underinvestment in the tradeable sectors. These improvements will either require a tighter fiscal union or some really enlightened multilateral policy making.

These issues are all fixable, but they arise to remind us that we remain in a Kondriatev Winter, where the economy is consistently weighed down by high debt levels, weak demand and a tendency toward deflation without heroic measures by governments and central banks. Believe it or not, the US has struck the balance pretty well so far. It is now time for Europe to put their house in order before they drag the whole world into stagnation and deflation.

The Death of US Manufacturing has been Greatly Exaggerated

I often get comments from my friends that they look to my blog to get an optomistic viewpoint on the economy given all the "doom and gloom" that pervades most economic and political discourse these days. Seeing as that I call my base case view of the current economic situation a "Rounded Bottom", I figured optimism is clearly a relative concept. That said, I generally do believe in a self-correcting system, and so therefore counsel against panic and dispair. Tough times make people gloomy, and gloomy people call for more radical action than is generally needed. Often times, it is the very government action designed to goose the economy in times of distress that sows the seeds of the next economic downturn (see housing market, the).

It is in times like these that declinist theories roam the land. While I don't deny that the United States has faced a nasty cyclical decline in the housing market that may have led to a secular downshift in consumer spending and debt accumulation, I don't necessarily view that as a long-run negative. Consumerism, while beneficial to one's near term standard of living, can be carried too far if it becomes a debt-fuelled bacchanal that diverts resources from other productivity-enhancing investments like business equipment and infrastructure.

Exhibit A to most declinists is the supposed decline in American manufacturing. This seems like a no-brainer given our huge trade deficit, the large declines in manufacturing jobs and the visible industrial ruins in former manufacturing hubs like Detroit, Cleveland, Pittsburgh, Philadelphia and Baltimore. A closer look at the numbers, however, tells a much different story.

In October 2011, after one of the nastiest recessions and slowest recoveries in modern history, the United States produced $3.3 trillion worth of manufactured goods on an annualized basis (in 2005 dollars). To put this into perspective, the entire GDP of Germany in 2010 was only $3.3 trillion (in 2010 dollars, no less). China's GDP is only $5.9 trillion. The U.S. is thus by far the largest manufacturer in the world. While production is down about 5% from the $3.5 trillion produced at the end of 2007, and it is up 5% from what was produced in 2000. It is fully 80% higher, on an inflation-adjusted basis, than the manufacturing production in 1979, when manufacturing was still the centerpiece of the U.S. economy.

Look at the chart below (click to enlarge):

For comparison purposes, it is important to compare similar points in the business cycle. In the case of manufacturing production and capacity, it is most meaningful to compare cycle peak to cycle peak. I have also included the mid cycle break points (1984 and 1995) where the currency and policy regimes changed somewhat.

The things to notice in the chart above are (1) the long term decline in the peak capacity utilizations (meaning that capacity has increased faster than production); (2) the huge increase in manufacturing production per employee; (3) the decline in manufacturing employment as a percent of total employment from 24% in 1973 to 9% in 2011; and (4) the more modest decline of manufactured final goods production as a percent of GDP from 24% in 1973 to 19% in 2011.

Given the huge gains in technology, finance, professional services, leisure and hospitality, retail, healthcare and education since 1973, the fact that manufacturing has only declined by 4 percenage points from the 1973 peak to the 2007 peak is quite surprising.

In terms of employment, we have to look at manuacturing as the new agriculture. It is a hugely efficient, highly capitalized economic sector that just doesn't employ that many people anymore. I fully believe in supporting manufacturing as a way to increase national wealth, but any politician who tells you that we can bolster the middle class with tons of new manufacturing jobs is out of touch with reality.

Nominal numbers don't provide as much context as relative numbers, however. The following chart translates the numbers above into annual growth rates by business cycle (click to enlarge):

The interesting thing about the chart of above is how the numbers vary from business cycle to business cycle, but that they are pretty stable over the long run. The first thing that jumps out is the huge increase in manufacturing employee productivity since the early 1990s, particularly relative to employees as a whole (as defined by real GDP per employee). The second thing that jumps out is the huge surge in manufacturing capacity (5.4% annualized from 1995 to 2000) in the late 1990s bubble boom. Since capacity growth was so far above trend in the late 1990s, the relatively low levels of business investment of the 2000s is not surprising. The huge surge in the capital-to-labor ratio, combined with advances in information technology, has helped create a large increase in per employee productivity...also not terribly surprising yet highly beneficial for the long run health of the economy.

If we look at the longer 16-17 year Kuznets cycle of long-lived investment (consisting of three business cycles as I define them), we see consistent results. Real GDP grew about 3% p.a. peak-to-peak in both the 1973-1989 cycle and the 1989-2007 cycle. Manufacturing production grew 2.4% in the second cycle versus 2.1% in the first, even though manufacturing was viewed to be in decline in the 1990s and 2000s. Capacity grew 2.6% per annum in both cycles. The big difference between the performance under the two cycles is in employee productivity, which grew 3.9% per annum during the second cycle and only 2.5% in the first. Manufacturing productivity growth far exceeded productivity growth in the economy as whole over both cycles.

The good news is that were are now pretty close to having worked off the excesses of the late 1990s. For that reason, I expect the front end of the current Kuznets cycle to produce a powerful resurgence in business investment, which we should see accelerate over the next 6-8 years (with perhaps one recession occuring dueing that time). We can already see it in the numbers. While everyone is focused on the travails of the housing market, the U.S. economy has gradually become a lean and mean manufacturing powerhouse.

Catalyst Investors Blog: Understanding IT Outsourcing and Web Hosting

Cloud computing. Managed hosting. Managed services. Software-as-a-service.

There are lots of buzzwords that are both used and misused to describe the various types of IT outsourcing and web hosting. Back at the Catalyst Investors blog, I walk through the different layers of the IT outsourcing and web hosting landscape. I explain the difference between cloud computing and traditional computing, and compare and contrast the different layers of the technology stack, including co-location, dedicated hosting, hybrid hosting, infrastructure-as-a-service, managed hosting, platform-as-a-service, application hosting, software-as-a-service, business process outsourcing and business process-as-a-service.

To read the post, click HERE.