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Rigorous Thinking

Financial and economic commentary reflecting Ativo’s world view:

Bob Aliber’s Quarterly Update

Sunday, April 28, 2013


Once every couple of years, I become extremely envious of the title of a new book because it dazzles and captures a lot of shelf space. So it is with The Physics of Wall Street, by James Owen Weatherall. . The title suggests a deterministic model, like Newton’s laws of thermodynamics or Kepler’s laws of planetary motion. I purchased Physics in the hope that there would be a discussion of the forces that lead to large changes in stock prices.

One story line in Physics is the history of modern finance. (Thus the book is similar to Nicholas Dunbar’s Inventing Money: The Story of Long Term Capital Management.) Another theme is that some quantitatively oriented investors have achieved higher rates of return than Warren Buffett, who nevertheless is richer because of his long head start. The quants do not forecast changes in stock prices; instead they accumulate bundles of nickels—real money—from “strategies” that look at temporary mis-pricing or at the momentum in the changes in the prices of securities. The success of the quants is reminiscent of the meteor-like ascendance after 1994 of Long Term Capital Management, which was saved from bankruptcy in 1998 because the Federal Reserve coerced its creditors to become equity investors.

The “competition” between the Buffetts and the quants is one more chapter in a continuing debate on whether investors can make more money by focusing on the current and prospective values in balance sheets and income statements or by focusing on changes in stock prices. Benjamin Graham and David Dodd highlighted firm-specific data, while Charles Dow (the father of the stock price indexes and also of the Dow Jones and the Wall Street Journal) searched for patterns in the changes in stock prices and in the volume of trades to deduce market sentiment. Graham forecast stock prices in six months, momentum traders seek to forecast prices in three to six weeks, and high frequency traders in six seconds.

What is the source of the profits for these competing approaches? Obviously, investors want to buy low and sell high. The money taken off the table by those who follow an approach based on inputs comes from buying stocks that are as yet undiscovered values. The source of the money for the quants is that they take money off the table that would otherwise have been realized by those who trade on the basis of the fundamentals.

The focus of this letter is whether the prices of bonds and stocks in February 2013 differ significantly from their long-run equilibrium prices—say, the prices that will prevail on July 4, 2015. Will a plain vanilla portfolio that is 60 percent stocks and 40 percent bonds outperform a skewed portfolio that is either all bonds or all stocks? Hence two forecasts are made here. One is centered on changes in the prices of bonds as that market moves toward equilibrium, and the other is a preview of stock prices. Then I discuss the prospective developments in the U.S. economy; the major good news story is that there is likely to be a sharp decline in the price of petroleum as a result of new drilling technologies.


Disequilibrium In The Bond Market

The planets have their orbits, and each has been in an equilibrium relationship with the others since nearly the beginning of time. The pattern in the bond market is that the prices vary around a “real constant,” which has averaged three percent after adjustment for changes in the commodity price level. When economic growth is sluggish, bond prices are high relative to the long-run average, and when growth is exuberant, prices are low relative to the average. Similarly, as the anticipated inflation rate increases, bond prices decline relative to trend.

Bond prices now are so high that they challenge the law of gravity. The interest rate on the 10-year bond is about two percent, and the interest rate on long-term U.S. Treasury bonds is three percent. The current inflation rate is just below two percent, and hence the real interest rate is barely positive on the 10-year and about one percent on the 30-year U.S. Treasury bond.

The cells in Figure 1 show the prices of zero-coupon bonds of different maturities with interest rates of one percent, three percent, and five percent. Long-term U.S. Treasury bonds have been priced to yield about three percent in real terms. If investors anticipated that the price level would remain constant, a 30-year zero-coupon bond would sell for $41.20 at a three percent rate and $74.20 at a one percent rate.


Figure 1

Prices in the Bond Market

The high prices of U.S. dollar bonds today relative to their long-run average prices—which are crudely approximated by the spread between the first and second rows—reflect that the Federal Reserve has been a massive buyer in its quantitative easing programs (QE1, QE2, and QE3). Similarly, the Bank of England, the Bank of Japan, and the European Central Bank have maintained aggressive monetary policies. These high prices suggest a shortage of bonds, despite the surge in the supplies from massive fiscal deficits.

The Fed’s QE programs seem like one more addition to a Rube Goldberg finance contraption in which overshooting and undershooting are routine. First, there was a disequilibrium in the real estate markets; prices in the United States and six or eight other countries became absurdly high in 2005 and 2006 because of either the inattention of the central banks to macro developments or their incompetence; Greenspan’s Fed was reluctant to raise interest rates or undertake other measures to dampen the increase in real estate prices . The subsequent decline in real estate prices surprised the central banks, and it became clear they had not developed contingency plans to cope with this collapse. The bond price support programs then adopted by the central banks to arrest the decline in real estate prices—and to protect the banking system — then introduced disequilibrium in their bond markets. Goldman, JP Morgan Chase, et al would be 10 feet under if they had not been rescued by the Fed’s aggressive monetary policy and the Troubled Assets Relief Program (TARP).

The Fed announced its QE3 program in mid-September 2012 even as the data indicated that the U.S. housing market was in a recovery phase; prices had been increasing for nearly a year. Most or all of the excess supply of more than two million units at the end of 2006 has been absorbed by the increase in population and by purchases by foreign investors. Real estate prices have been increasing for more than a year, and are six percent higher than a year ago.

Because the U.S. economy is operating with a large output gap, bond prices today would be higher than their long-term averages even in the absence of the Fed’s price support program. But because of this program they are much higher than they would otherwise be.

The buyers of bonds—of governments, mortgage-related securities, and high-yield bonds—incur a duration risk, the likelihood that the price of the bonds will decline. As the rate of economic growth quickens and the output gap shrinks, the demand for credit will increase, and bond prices will decline.

The Fed has said that it will continue the policy until the unemployment rate declines to 6.5 percent. Maybe. But if there were a significant increase in the U.S. inflation rate, the Fed might attach higher priority to the price-level target. A third outcome is that bond traders take the initiative and that investors sell their bonds in anticipation that prices will fall, and by a large amount, which would compel the Fed to be the buyer of last resort.

Eventually, the Fed will stop buying bonds, although it is likely that the pace of purchases will first slow and then the prices at which it buys bonds will decline. Since the volume of bonds that are maturing each month will be larger than its purchases, its holdings of bonds will decline. Bond prices would be declining because the U.S. Treasury would have to offer higher rates of return to obtain the cash to pay the Fed for the maturing bonds.

The owners of bonds will incur losses when the prices of those bonds decline, and these losses could be large relative to the interest income of three percent a year for the previous several years. In the long run, the real rate on the 10-year should be about two percent; if the inflation rate remains at two percent, the nominal interest rate must increase to four percent. The implication is that the price of the ten year zero coupon bond will decline from $90.53 to $74.41 as the as the nominal yield to maturity increases to four percent.

If the duration risk is high, then there would appear to be an “excess return” available to investors who would short bonds with the intent of buying them at much lower prices in future years. (One criticism of this argument—the efficient market criticism—is that investors already would have shorted the bond market. These investors would have to pay a premium to the longs of three percent a year, and many are reluctant to pay this premium.)

The size of the “accident” in the bond market depends on the pace of the U.S. economic expansion and the Fed’s policies as the economic expansion gathers momentum. The paradox is that the more successful the Fed’s QE policy is in stimulating the economy, the larger the accident. The accident is over the horizon, and maybe just over the horizon–which means that a portfolio that is 40 percent bonds is exceptionally risky. So is one that is 20 percent bonds.


Is the stock market in equilibrium?

Bonds and stocks are both substitutes and complements. Some investors shift between these securities in response to changes in anticipated price relationship. Increases in bond prices tend to pull up stock prices because of the decline in the interest rate that is used to discount the projected stream of dividends. In the 1970s the sharp decline in bond prices “pulled down” stock prices. However, increases in stock prices—more precisely, increases in anticipated prices—may lead to a decline in bond prices as investors sell bonds to buy stocks. Bond prices increased after 2000 as investors sold bonds from their super-high levels.

If the bond market is not in equilibrium, can the stock market be in equilibrium? For most of the last five years, investors have sold stocks and bought bonds. The rates of return earned by the buyers of bonds have been exceptionally high because of the Fed’s price support programs. Stock prices have increased from their lows in the crisis.

Consider three financial market values. One is that the profit share of U.S. GDP averages about eight percent in the long run, although there are significant variations as the economy expands and contracts and as the inflation rate increases and decreases. The profit rate and hence the profit share of GDP shrinks in recessions; the profit rate increases in the early stages of inflation, but in the last several years, costs often increase more rapidly than prices, and profits decline.

The second value is that U.S. GDP has increased by five percent in nominal terms, and nearly three percent in real terms.

The third value is that the price-earnings ratio for U.S. stocks has averaged 17, although this ratio also varies significantly. (The “earnings yield” is the reciprocal of the price-earnings ratio; divide 100 by 17 and obtain 5.88 percent, a nickel less than six percent.) Changes in this ratio appear positively associated with changes in the profit share of GDP. In 1990, the profit share of GDP was 4.8 percent, and the price earnings ratio was 15.5; at the end of 1999, these values were nine percent and 41. The implication is that the market price of stocks increases from one year to the next as a result of the growth of GDP. Stock prices increase two years out of three.

Assume nominal GDP now is $16 trillion, and increases by five percent a year in nominal terms (three percent a year in real terms) and that the profit share is eight percent. Then profits increase by $64 billion, from $1.28 trillion to $1.34 trillion. About $40 billion in profits are distributed as dividends, and the rest will be retained and reinvested. If stock prices increase by five percent, the total return to shareholders is eight percent—five percent from price appreciation and three percent from dividends. The relation between changes in bond prices and changes in stock prices for the 1920s and subsequent decades can be inferred from Figure 2; the change in prices is measured from the first year of one decade to the first year of the next.

Figure 2

Trend changes in the prices of bonds and stocks

Sources: The Economist, Wikipedia

Bond prices declined in the 1920s as economic growth was robust and then increased in the Great Depression of the 1930s. Bond prices were flat in the 1940s; interest rates on long-term U.S. Treasury securities were pegged at 2.5 percent as part of the comprehensive set of ceilings on prices and on wages. (Despite the price ceilings, the commodity price level increased and real rates of interest were negative.) Bond prices declined after the 1951 “Accord” between the U.S. Treasury and the Fed, which restored the central bank’s monetary independence. The decline in bond prices in the 1950s was a “return to normalcy,” and the much sharper decline in the 1970s was a response to the surge in the inflation rate.

Bond prices increased from 1981 to 2012 in response to the decline in the anticipated inflation rate. The average annual rate of return in real terms was seven or eight percent; bond prices were far below 100 in 1982 because of the combination of the high anticipated inflation rate and the tough Volcker anti-inflation policy.

Stock prices increased in the 1920s as a result of remarkable growth in the economy, and then surged in the last several years of the decade. Initially, stock prices declined in the 1930s from their bubble-like heights, and then further as corporate profits tumbled in the Depression. Stock prices were flat in the 1940s, and increased in the 1950s and the 1960s; prices at the 1968 peak were three times their levels at the beginning of the 1950s. Stock prices were highly variable in the 1970s around a more or less flat trend. Then stock prices increased in the 1980s and 1990s, and at the end of the 1990s were 10 times higher than at the 1982 trough. Stock prices trended down in the first decade of the 21st century.

Despite the economic intuition that the prices of bonds and stocks should increase and decrease together, this pattern is observable in only three decades—the 1970s, the 1980s, and the 1990s. The first of these three decades was marked by a surge in the inflation rate, and the next two by its reversal, the decline in the anticipated inflation rate. Changes in bond prices in most of the other decades resulted from changes in the level of business activity. When economic growth quickened, as in the 1920s, 1950s, and 1960s, stock prices increased even as bond prices declined. When the economy tanked in the first half of the 1930s, stock prices declined.

Physics provides no insights into the impact of changes in bond prices on stock prices. The experience of the 1950s suggests that the decline in bond prices is not likely to pull down stock prices. But much will depend on the skill of the Federal Reserve in dampening the downward pressure on bond prices.


The Economic Outlook for 2013

One view is that the U.S. economy is like the glass that is half full. In fact, the glass is 92 or 93 percent full. The economy grew at a rate of 2.5 percent in 2012, which is more or less its capacity growth rate. However, the output gap is six to eight percent of GDP, and unemployment is four percentage points higher than it would be if the economy were at full employment. The growth rate has been lower than in previous expansions; still, the unemployment rate is 2.5 percentage points below the level during the 2009 trough.

The U.S. trade deficits is $500 billion, three percent of U.S. GDP and the fiscal deficit was seven percent of GDP in 2012, which should decline by one percentage point as a result of recent changes in taxes and expenditures. The counterpart of the U.S. trade deficit is that the oil-exporting countries have trade surpluses that sum to $450 billion and China has one of $215 billion. Germany has a trade surplus of $215 billion, but the Eurozone countries as a group are in trade balance; the surpluses of Germany, Austria, and the Netherlands are offset by the deficits of Greece, Spain, Italy, and other members.

Increasing the U.S. growth rate requires either a higher level of spending by one of the three major sectors—governments, households, and businesses—or a decline in the U.S. trade deficit, which would mean that Americans and foreigners spend more on U.S.-produced goods and services and less on foreign goods and services.

During the last three or four years, the drag on the U.S. economy from the large U.S. trade deficit has been offset by the stimulus spending associated with the large U.S. fiscal deficit. But the U.S. fiscal deficit is too high to be sustainable; in the long run the ratio of the U.S. fiscal deficit to U.S. GDP must be smaller than the rate of growth of U.S. GDP.

The public mood is that government spending financed by borrowing is “naughty,” that we are “borrowing from our grandchildren.” This is nonsense, since few of those grandchildren have the money to lend to the government. Instead, the U.S. government borrows from the current generation of Americans who on the margin would rather save than spend. Moreover foreign central banks also buy U.S. Treasury securities with the dollars they have earned from their trade surpluses; if they had higher prices for their currencies, the U.S. trade deficit would be smaller. But the deficit hawks have a point: There is a limit to the increase in government indebtedness, the larger the interest payments that the government must make in the future.

The challenge is to reconcile the concern of the deficit hawks that the rate of growth of debt must decline with the recognition that the spending associated with the deficit provides positive spending momentum for the economy.

The good news is that in 2013 the U.S. fiscal deficit will decline by $135 billion to $150 billion—about one percent of GDP—as a result of increases in tax rates on high-income earners and the end of the two percentage point reduction in Social Security contributions. The flip side is that household after-tax incomes will decline by the same amount, and household spending may decline by $120 billion—which by itself would reduce the growth rate by three-quarters of one percent.

Maintaining the growth rate of 2.5 percent will require an offsetting increase in spending by households and/or businesses, or a reduction in the U.S. trade deficit. For several years households have saved an an exceptionally large share of the increases in their incomes as they sought to rebuild financial wealth. The ratio of indebtedness to income has declined to traditional levels, and the implication—at least the hope—is that the marginal saving rate will decline.

The housing market news is good, very good. House prices are now 10 percent higher than at the trough. During the boom between 2002 and 2006, owning seemed to be less expensive than renting because of the continued increases in home prices. Then when home prices declined, the cost of ownership soared, and many homeowners were forced to sell their properties. The demand for rental housing surged, and rents increased sharply. As a result of the decline in prices and the increase in rents, owning is increasingly attractive relative to renting.

Some of the largest increases in prices have been in the cities that experienced the largest declines. The increase in house prices has three powerful effects. One is that the net worth of Americans is $1.5 trillion higher; the revaluation of the existing housing stock has contributed more to the restoration of balance sheets than has savings from annual income. Moreover, the value of inventories of homes owned by the banks and Freddie Mac and Freddie Mae has been increasing, which contributes to the increase in the capital of these lenders.

The third impact is that housing starts have increased. Four statistics are relevant. In the 1980s and the 1990s, housing starts averaged 1.5 million units a year. During the bubble years, starts increased to two million units; at the end of 2006, the excess supply was about 2.5 million units. Housing starts declined to less than 600,000 units a year during the trough as prices were rising; starts have increased to 900,000 units. Each increase of 100,000 units leads to a reduction in the unemployment rate of 0.2 percent and an increase in the growth rate of about 0.25 percent. Housing starts could increase by 300,000 units in 2013, which would add 0.75 percent to the growth rate.

The news from the energy market also is very good. Domestic supply is increasing relative to demand, and the United States—and North America—is on its way to energy self-sufficiency. There will be downward pressure on the price of energy.

At $100 a barrel, the real price of petroleum is more than thirty times higher than the price in 1970, and more than seven time higher than the price in 1975. This high price contributes both directly and indirectly to the U.S. trade deficit. The direct impact is that the bilateral U.S. trade deficit with the petroleum exporters is $150 billion, while U.S. imports from these countries are $325 billion. The indirect impact is that other energy importers obtain the dollars to pay for their oil imports by increasing their exports of manufactured goods to the United States. Japan imports all of its petroleum, and it obtains a significant part of the dollars that it uses to pay for these imports by exporting more Toyotas and Canon copiers and wings for the Boeing Dreamliners to the United States. Similarly for China and other oil importers.

Each decline of $1 a barrel in the price of petroleum would reduce the export earnings of the petroleum producers by $9 billion. The trade surpluses of some oil exporters would decline on a dollar for dollar basis with the decline in their export earnings, while the surpluses of other oil exporters would decline by a smaller amount since their imports would decline.

One positive impact of the oil price decline is at the household level; this decline is like a tax cut and the real incomes of Americans and other consumers would increase. A decline of $10 a barrel would mean the real incomes of 150 million American families would be higher by $400 a year.

The second positive impact is at the macro level, the spending of the oil consumers would increase by $9 for each increase in their incomes of $10, whereas the spending of the oil exporters might decline by $5 for each decrease of their incomes of $10. Hence the deflationary drag of the high oil prices would decline sharply, which would lead to a reduction in the U.S. trade deficit.

Assume that the price of oil declines by $20 a barrel; that would lead to an increase in household real income of several tenths of one percent in the year when it occurred. Moreover, the trade surpluses of oil exporters would decline; the direct impact is that U.S. trade deficit with the oil exporting countries would decline by $65 billion, and the U.S. trade deficit with other oil importing countries could decline by an amount in the same ball park.

How sharp will the decline in the oil price be? The oil price fell from $29 a barrel in 1984 to $14 in 1986, and from $21 a barrel in 1996 to $12 two years later. Commodity prices often decline in recessions as demand slackens. The changes in technology that are leading to the increases in supply are inexorable, and the price could fall by forty to fifty percent.

If the price were to fall to $50 a barrel, the oil exporters might still have surpluses, but the global deflationary impact would be modest.

Even if the price of oil were to decline to $50, the U.S. trade deficit might still be in the range of $200 billion to $300 billion, which would reflect that China, Malaysia, Singapore and a few other countries maintain exceptionally low prices for their currencies to promote exports and import manufacturing jobs from other industrial countries.

Their beggar-thy-neighbor policies are costly to U.S. employment in manufacturing and contribute significantly to the U.S. fiscal deficit. (The Asians want credit for financing part of the U.S. fiscal deficit, but they fail to recognize that the increases in their trade surpluses and the counterpart U.S. trade deficit erode the tax base and thus contribute to the U.S. fiscal deficit.) In previous letters I have provided estimates of the employment and fiscal implications of the U.S. trade deficit in manufactured goods. The key statistic is that value added per worker in U.S. manufacturing averages $80,000, lower in labor-intensive industries and higher—in some cases much higher—in capital-intensive industries. The arithmetic is that the reduction in the U.S. trade deficit of $1 million as a result of fewer imports and more imports of manufactures means an increase in employment in manufacturing of 12.5 workers. The metric is linear: A reduction in the U.S. trade deficit of $1 billion in manufactured goods means an increase in U.S. manufacturing employment of 12,500, and a reduction in the U.S. trade deficit of $100 billion means an increase in employment in manufacturing of 1,250,000; the U.S. unemployment rate would then decline by one percentage point.

But that’s only the first stage. The incomes of the one million plus newly employed workers will surge. Their spending will increase, since many have been consumption-deprived for two, three, or more years. Most of the increase in their spending will be on U.S.-produced goods and services. The increase in spending will lead to a second-round increase in U.S. employment and a third-round increase, so that altogether employment might increase by 2.5 million. Moreover, as U.S. employment increases and the output gap declines, taxable incomes will increase and fiscal revenues will increase, and the fiscal deficit will decline—automatically. And as the economy moves upward and upward, the decline in the trade deficit will lead to a decline in the fiscal deficit. Trade imbalances will become more acute because the new prime minister of Japan, Shinzo Abe, has been talking down the yen as a way to increase Japan’s exports and stimulate the growth of the economy, even though Japan had a modest trade surplus before the costly accident to its nuclear power plant at Fukushima. The Japanese yen price of the U.S. dollar has increased by nearly fifteen percent in the last three months. Japan has developed a trade deficit because its imports of petroleum have surged as its reliance of nuclear power for electricity generation has declined.

There is greater chatter about currency wars. There is tension among the Eurozone countries about whether the price of the Euro has increased too extensively; when the public chatter was that the Euro might fade away, investors sold the Euro, and its price declined below $1.20; recently the price has been in the mid-$1.30s. Germany and the Netherlands have trade surpluses of 6.0 percent and 8.9 percent of their GDPs; France and Spain have trade deficits of two percent of their GDPs. Britain has a trade deficit of 3.5 percent of its GDP and the economy seems mired in recession; at some stage the Cameron government may find it in its interest to follow the Japanese lead.

Some Asian governments have suggested that QE1, QE2, and now QE3 are U.S. initiatives in a currency war; to the extent that U.S. interest rates declined below their interest rates, the carry- trade investors borrowed dollars and bought the Asian currencies, which led to increases in their prices. The movement of funds to the Asian countries is an unintended consequence of these low interest rates on U.S. dollar securities. These countries have large trade surpluses that have resulted from the low values for their currencies; it’s chutzpah of them to suggest that the QE1 et al. are exercises in a currency war; these have low values for their currencies and large trade surpluses.

The Chinese, the South Koreans, and the Thais are not likely to lose market share to Japanese exporters without complaint. They will respond with measures to weaken their currencies, which means that they will buy U.S. dollars at lower prices when they intervene in the currency market. This is the beggar-thy-neighbor policy all over again.

If Japan increases its trade surplus, and the trade surpluses of the other Asian nations remain unchanged, the U.S. trade deficit will increase. And the question is whether the Obama Administration will remain idle as the Asians to steal more American jobs.

The prospect is that there will be a significant increase in the U.S. growth rate in 2013, despite the concerns about trade market disturbances; the adjustments to the housing debacle and the credit shock in 2008 have been completed. Firms are cash rich. Household balance sheets have been repaired. Consumers are increasingly optimistic. New weekly claims for jobless benefits have been trending down. Housing starts are likely to increase by several hundred thousand over the 2012 level, and they would still be far below the levels of the 1990s. Auto sales will increase to offset the aging of the fleet that began in 2008. The direct impact of the prospective decline in the petroleum price is a sharp increase in after-tax incomes of American consumers, and a sharp reduction in the deflationary impact of the large surpluses of the oil exporting countries.

The outlook for the economy is better than at any time in the last fifteen years.


The Investment Implications

A brief summary. An accident is waiting to happen in the bond market; bond prices will decline as the Fed stops its price support activity. That decline could be sharp, and the Fed may ease the prices downward. The decline in bond prices will tend to pull down stock prices. Those stocks that have bond-like characteristics will tend to decline.

The U.S. economy is more resilient than the headlines suggest, and the projected increase in housing starts will add nearly one percentage point to the U.S. growth rate in 2013, and more than offset the impacts of the fiscal tightening in 2013.

If the accident waiting in the bond market deters the purchase of bonds, then the choice is to buy stocks today or, because of the bond market accident, tomorrow when the prices of stocks will be lower. One analogy is the 1950s, when nominal interest rates on the long Treasury bonds increased by 150 basis points; stock prices surged in the decade, although the P/E ratio at the beginning of the decade was low. Please call or write with comments and concern and questions.

Enjoy this great year