Raphaël Kahan

Z1

2010-03-11T20:45:00.000+01:00

Today the quarterly Flow of Funds (aka Z1) report was released by the Federal Reserve. What is the Flow of Funds report? Imagine the USA was a company: it's income statement would be called GDP report, and it's balance sheet would be the Flow of Funds. In my opinion this is the most important economic statistics release there is.

Unfortunately for this blog and its readers, I am quite busy at the moment getting ready to commence employment at Keefe, Bruyette and Woods research department in London, and I'm likely to become more and more busy as days go by. I will thus ask my dear readers to confer to the fantastic blogs linked below in the right column of this page for analysis of and commentary on the all-important Z1 report.

Hulbert: advisory sentiment back to dangerously high levels

2010-03-08T20:23:00.000+01:00

Which of course is bearish (link here). Note that this type of contrarian indicator works best at a horizon of a few weeks.

Guest post: Paul Kasriel on fiscal deficits and inflation

2010-03-06T01:02:00.000+01:00

Today I had the pleasure of exchanging a few emails with Paul Kasriel, Chief Economist of Northern Trust. Paul is in my opinion one of the greatest economic forecasters around (you can read him here). I don't think he would disagree if I said he is a great student of Friedman and Hayek, and that he knows what is money and what is inflation. Here is what I asked him and his response:

RK - Some economists argue that money and government bonds are near-perfect substitutes in an investor portfolio. Thus, they conclude, large fiscal deficits will result in higher rates of inflation, whether or not the central bank lets the money supply grow very fast or not. What is your opinion of this theory?

PK - I do not understand the argument. If the government sells the public bonds and the banking system (including the central bank) does not create the credit for the purchase of these bonds, then the public is transferring purchasing power to the government. The public cuts back on its current spending and the government increases its current spending. In contrast, if the banking system creates the credit for the public to purchase government bonds, then the public does not have to cutback on its current spending and the government can increase its current spending. This would be inflationary. In the former case, the Austrian economists refer to this as "transfer" credit inasmuch as purchasing power is transferred from one entity to another. The Austrians refer to the latter case as "created" credit in that the banking system and central bank create credit, much like a counterfeiter, enabling one entity to increase its purchasing power while not necessitating any other entity to cut back on its purchasing power. Perhaps I am missing something in the argument of these economists who believe that government debt issuance is inflationary in and of itself.

Those economists I mention (they seem actually to be a majority of economics scholars), believe that a dollar is a dollar, is a dollar. But if you issue a bond, someone has to cut its spending in order to buy it. Also, why not extend the theory and include AAA rated private bonds to government bonds? And while you're at it, just throw in all investment grade bonds.

To conclude, Japan seems to provide a pretty convincing evidence for Paul's point of view. But as he says, maybe we're missing something?

Conspiracy theorists are not going to like this one

2010-03-01T14:19:00.001+01:00

More precisely, by conspiracy theorists I mean people who have been arguing that the Bush and Sarkozy administrations had been using their connections with media barons to influence the public opinion and thus, voters (Let's leave Berlusconi and Putin out of this...).

James Hamilton over at Econbrowser ~~Menzie Chinn~~ reports on a recent study by University of Chicago professors Matthew Gentzkow and Jesse Shapiro, who use standard econometric methods (which is why this subject is not too far away from the usual posts on this blog) to explain what drives a newspaper's political orientation. Two main conclusions: a paper's political orientation is very correlated to "the political orientation of people living within the paper's market", and "the politics of the paper's owner seem to matter much less". Hamilton ~~Chinn~~ continues:

Gentzkow and Shapiro conclude that papers to some degree are just giving their readers what the readers want so as to maximize the newspapers' profits.

The full study is here.

This rally looks technically ok - for now

2010-02-27T02:24:00.002+01:00

Three weeks ago, I called for the end of the little correction we had experienced in the beginning of the year, and the reason was mostly technical. Today, I cannot find a technical reason to call for the end of this three week old rally: market breadth and internals are quite good (see this post to understand why these indicators should be followed). Sentiment used to be ultra-bullish, which was bearish. It is not anymore. Most of the liquidity indicators I follow have turned up. Volume is lacking, but it has been lacking since the March 09 bottom.

The fundamentals however are deteriorating. Leading economic indicators around the world look toppy, Greece is only the beginning of a multi-year (multi-decade ?) long round of sovereign credit problems, and the financial sector is likely to face renewed troubles due to fading official support and high default rates in commercial and residential real estate (why does everyone thinks that because banks are paying huge bonuses then they must be fine? This is simply flawed logic). Add to this stretched valuations and soon-to-be fading policy stimulus, and voilà! you have a recipe for some choppy waters in risk assets.

But for now, Mr. Market just doesn't seem to care, and the path of least resistance seems to be up.

Hamilton on the Treasury Supplementary Financing Program (SFP)

2010-02-24T10:04:00.000+01:00

Warning: geekiness level more elevated than usual.

Hamilton thinks the increase in the SFP is rather surprising given the other "outs" the Fed could use, and it may be part of a broader, still undisclosed strategy. This strategy in my opinion would simply be the unlegislated bailout of Fannie and Freddie.

Question: Obama worries me more than Greece or anything else so far. Let me know if I should change my viewpoint on the guy...

2010-02-20T12:07:00.001+01:00

Don't discount Greece yet. It may be a small country, but the domino effect could be severe (remember subprime? it was a tiny portion of the US mortgage market). Obama unfortunately, has no understanding of economics and has been relying on a financial intelligentsia (Bernanke, Geithner, etc.), who were instrumental in getting us into this mess, to get us out of it. The result is that the U.S. is following the footsteps of Japan and its "zombie banks" and dire fiscal situation (not to mention the fantastic moral hazard risk brought on by bailing out bank bondholders). To me the only good news since Obama took office is that Volcker seems to be getting a bigger and bigger voice in this administration. I hope this is a sustainable trend.

"Bond on bonds – disaster ahead"

2010-02-16T15:20:00.000+01:00

... in which Barcap's Tim Bond forecasts developed market bond yields to double over the next decade. I tend to agree with that forecast, although Tim Bond and I have completely divergent reasons why.

He thinks an aging population will cause a surge in government debt/GDP ratios, which will increase risk premia. I believe that an aging population lowers potential GDP growth and thus, bond yields as well. I believe that inflation is the one main driver of bond yields in developed markets: cf. Japan, with it's government debt/GDP closing in on 200% (this is much higher than anything forecast for Europe and US in the next twenty years).

However, I am much less confident that the current handling of the financial crisis will not bring a spurt of high inflation down the road. It's not yet in the cards, but avoiding that scenario will require extreme toughness from policy makers - something I have trouble believing in.

By the way, as I have argued in many posts in the past six months, I believe in the near term the risks to bond yields are tilted to the downside: in my opinion, there is still more risk on banks balance sheets than on sovereigns balance sheets, and renewed flights to quality cannot be dismissed. For now.

Stop it with the data-mining, Mr. Rosenberg

2010-02-14T15:30:00.000+01:00

I have a lot of respect for David Rosenberg, the chief economist over at Gluskin Sheff (previously with Merrill Lynch). However, I have a lot of trouble reading his daily commentaries because: 1) they're a tad too long, 2) they often repeat, and 3) Rosenberg much too often cherry picks data to fit and prove his preconceived opinion (opinion to which I agree for the most part - the point being I much rather like people forming an opinion out of data and logic rather than the other way around).

As an exemple, Rosenberg recently highlighted the extremely high (0.95) correlation between the S&P 500 and the Copper/Gold ratio over the past three years. Unfortunately, the reason for this is more the fact that the correlation between stocks and both the metals has been very high over that period. In econometrics, this is known as multicollinearity (a violation of regression assumptions), and is typically detected by a high correlation which carries low significance, reflecting inflated standard errors.

Let's look at the data since 1997: the correlation between stocks and the copper/gold ratio drops to 0.55, while the correlation between stocks and copper is a lower 0.37 (the one between stocks and gold is about zero). 0.37 is still statistically significant so we haven't got rid of the multicollinearity problem, but at least now we can overlook it. Conclusion: Copper/gold has a somewhat significant and relatively high correlation with equities.

Mr. Rosenberg, you see, your point was valid. Why did you have to torture the data to "prove" it?

No more accrued interest for us

2010-02-13T13:26:00.000+01:00

I'm talking about accruedint.blogspot.com obviously.

This adds up to an already too long list of great bloggers who have stopped blogging in the past couple years or so. Somehow I feel that, although the quantity of finance blogs has been increasing exponentially in the past few years, the aggregate quality has remained constant.

Stupid headline of the day

2010-02-12T16:05:00.001+01:00

"Dollar Soars as China Surprises Markets with Reserve Requirement Hike" (source not disclosed out of kindness).

The dollar may be "soaring" (by a full 0.81% !) today, and China may have hiked rates, but the two events are in no way related. You see, when a country has a fixed exchange rate, it has no control over monetary policy: reserve requirement hikes will induce more hot money inflows (looking for a higher return then dollar-denominated money funds, with no currency risk vs. the dollar), which means a higher money supply - since the central bank has to print the yuan needed to be sold to foreigners in exchange for foreign currency so as to keep the exchange rate constant. China has tried to sidestep this with controls on capital flows but everyone knows they are looser than the US-Mexico border. This is econ 101 and is known as the impossible trinity.

What is the relation between this and my saying the above headline is stupid? Because if China is hiking rates, it shows at least an intent, a signal if you will, of tightening monetary policy. But as I just discussed, this can only happen if China lets its exchange rate appreciate.

And that would be everything but positive for the US dollar.

Reversal?

2010-02-08T09:25:00.001+01:00

After opening and spending most of the day in the (deep) red, most risk assets, including equities, managed to turn out a small ~~again~~ gain last friday. This is what technical analyst call a "key reversal day", and is short-term bullish. However, the fall of the past few weeks has done a lot of technical damage: supports and trendlines broken, oscillators and indicators rolling over, etc. As such, the technical picture is not yet supportive of a sustained advance. Stay tuned.

Once again, the Baltic Dry and gold prove to be the best early indicators

2010-02-05T17:00:00.000+01:00

They may call it "Doctor" Copper, but the metal is, just like other industrial metals, at best a leading indicator of industrial activity, and industrial activity is preceded by changes in financial conditions. The earliest signals of the correction we are experiencing in risk assets have been given by the Baltic Dry index and gold -- peaking in end November / early December, with copper and equity markets peaking more then a month afterwards:

Remember this the next time you watch CNBC and hear about "Doctor" Copper.

As an aside, following this logic, equities are not yet ready to stage a sustained rebound.

More on the uncertainty surrounding 2010 GDP forecasts

2010-02-02T23:39:00.001+01:00

This is a follow-up to the previous post, in which I discussed the fact that my GDP model produces a very large range of possible 2010 GDP growth, depending on the number of lags (past observations) of the data.

To illustrate this, I backward tested my model to estimate year-ahead GDP growth as of each January since 2003, in what is called "pseudo out of sample" forecasts. It simply means that I put my model in the situation it would have been at the time, and thus, it cannot use data not known as of that moment. For example, for the 2004 GDP growth forecast, only data published through January 2004 can be used.

I had my model produce forecasts using 8 lags (the past 8 months of data) to 38 lags. Then, I calculated the standard deviation of these yearly forecasts:

To summarize, what this tells is that the uncertainty surrounding the 2010 figure is about five times larger than usual.

The conclusion: either my model is misspecified (which I don't rule out, but it's been very good on a pseudo out of sample exercise), or, fading monetary and fiscal stimulus, combined with an uncertain outlook for private investment and final demand, makes it very difficult to have a strong opinion on 2010 GDP. And it could of course be both.

2009 GDP Forecast and a thought on 2010

2010-02-01T23:10:00.001+01:00

With the first GDP estimate for Q4 released, I can now compare the actual performance of U.S. GDP with my model's forecast for 2009. A picture is worth a thousand words, so here's a chart:

This is what my model would have predicted in January of last year (well not exactly as I am using revised data. I believe if I used vintage data the prediction would have been less accurate, although in the same ball park).

Note: the green bands represent the 50%, 75% and 90% confidence bands around the central forecast.

Despite improvements in recent months, my model is still calling for (much) below-consensus growth in 2010. However, because of the extremely wild swings the underlying series have experienced, which are due to unprecedented (in the estimation sample) economic dislocations, I am afraid the model could be being stretched beyond its capabilities.

(Technical note:) What is happening precisely is that, depending on the used number of lags of the data, the forecasts can be extremely different. Lags are how many months of data I let my model use: for example, I could use the past 12 months observations of money supply. I had determined previously that 30 months of observations was a good number of lags, but in any case, if I used 12 months, 24 months or 36 months, the forecasts were not very different. This is no longer the case, and it's a big problem.

However, I believe it is also a reminder that 2010 risks being quite surprising to both bulls and bears. It was easy to forecast a recovery last year when the largest stimulus in history was kicking in. It was also easy to forecast the recession (pardon my lack of humility), when the housing bubble popped. 2010 is a much less obvious story: the contribution from stimulus is going to fade and subtract from growth pretty soon, and private demand seems to be recovering extremely slowly.

Quick market update

2010-02-01T19:30:00.001+01:00

I am reminded that I haven't commented on the market in a little while, so there it is: market's ~~overbought~~ oversold short term (only about 30% of stocks on the NYSE are above their 50-day moving average), and new highs still overweight new lows, so we're likely to see some sort of rally or trading range, but who knows. Longer term risks are still to the downside due to high valuations, complacency among participants, and underestimated economic and financial risks. And the same more or less applies to most risk assets, which do include gold and the euro.

Grantham on the investment management industry

2010-01-28T23:59:00.001+01:00

Link here (do read it. It's Grantham. And it's only quarterly.)

As total fees in the past grew by 0.5%, we agents basically reached into the clients’ balance sheets, snatched the 0.5%, and turned it into income and GDP. Magic! But in doing so, we lowered the savings and investment rate by 0.5%. So, we got a short-term GDP kick at the expense of lower long-term growth.

I guess that makes me a bloodsucker wannabe.

PIMCO: Italy, Spain, Portugal sovereign CDS spreads wider than corporate spreads

2010-01-28T22:08:00.001+01:00

Link here. Extract:

(...) Concern about debt levels and growth prospects has pushed sovereign CDS spreads wider while corporate credit spreads have continued to narrow. The trend is similar in Spain and Portugal.

While only recent, this phenomenon should spark intense debate among market participants. One camp might argue that it is difficult to justify sovereign credit spreads that are wide relative to domestic companies, as the sovereign will always exercise its right to levy taxes and fees to correct its balance sheet at the expense of the private sector. The other camp might suggest that many corporate balance sheets are pristine, and for particularly strong companies with a global footprint, the risk of default is indeed lower than the sovereign as they can only be taxed where they earn revenue and, in an extreme case, could change their domicile.

I am not an expert on credit or on Italy but I would personally be surprised if this situation persisted in the long run.

A few words from veteran analyst Richard Russell

2010-01-28T12:30:00.002+01:00

I want to remind subscribers that (in my opinion) we are now dealing with a bear market rally that is in the process of topping out. The actual bull market topped out back in 2007. Therefore we are now dealing with a rally in a bear market that appears to be topping, and there is a world of difference. A bear rally that is topping out will not give off the same warning signals that a dying bull market will. Thus, many analysts who are still bullish are looking at the wrong thing. They don't see the usual signs of a bull market topping out because that is not what is happening. And this is keeping them bullish. What we're looking at is a rally in a bear market that is in the process of topping out.

Top or not, I don't see the point in having much, if any, exposure to equities at these levels of valuation (see most of my previous posts... this little correction we've had should come as no surprise to regular readers, and it wouldn't be much surprising either if it develops into a full fledged down leg. Upside potential is very limited for the broad U.S. stock indices).

"Emerging Markets Appear Fully Priced"

2010-01-25T21:03:00.001+01:00

From BCA Research: Emerging Markets Appear Fully Priced

Contrary to Nouriel Roubini or The Economist, I don't believe there are "asset bubbles everywhere". There are a few little bubbles here and there (some high end housing markets in fast-developing Chinese cities come to mind). "Fully priced" is more appropriate, and this means upside potential is very limited in most equity and bond markets, as well as some commodities (unless a full-fledged bubble develops, which is unlikely before the banking system starts lending again). It also means downside potential is very important, and we've had a taste of that last week in developed equity markets.

Fed Watch: "It's not about interest rates yet"

2010-01-18T19:02:00.001+01:00

From Tim Duy:

St. Louis Fed President James Bullard is delivering a pretty clear message. In his view, policy for the foreseeable future is about altering the rate of asset purchases, not interest rates. This will be a challenging new ocean for Fed Watchers to navigate. Will the Fed scale up asset purchase by $25 billion? $50 billion? Hold steady? Sell $25 billion back into the markets? Fun, fun, fun.

What I find interesting is that, initially, when the Fed entered quantitative easing (or qualitative easing if you prefer to call it that way - I personally believe it's not what the Fed buys but how much of anything it buys), they decided to start paying interest on excess reserves. The goal was to be able to eventually raise rates without having to scale back the Fed's balance sheet.

Look where we are today: banks are criticized for not lending out their excess reserves and the Fed is talking about managing policy using its long term assets before acting on short term rates.

"Sentiment very bullish... which should be bearish"

2010-01-15T16:14:00.001+01:00

From David Rosenberg:

With the equity market 70% off its lows, we have a mere 23% bearish sentiment reading on the AAII survey (American Association of Individual Investors), a level not seen since four-years ago. Imagine that at the March lows, bearish sentiment on this survey was running at 70%. Now it is 23%.
Looking at the Investor Intelligence poll, the bearish sentiment is all the way down to 16% (the lowest since April 1987). At the March lows in the market, 47% of the investment newsletter editors were bearish. And for the traders, we see that Market Vane bullish sentiment is now at 57%, which is the highest since November 2007; at the March lows, the reading was 35%.

I'm reading the headlines today and I see that, despite bellweathers JP Morgan and Intel beating analyst forecasts, the indices are down almost one percent. This is not good action.
Meanwhile, Mark Hulbert reports that the sentiment picture is improving.

Most popular

2010-01-13T17:55:00.000+01:00

Following are links to the most popular posts on this blog (reverse chronological order):

Option-ARM payment shock

2010-01-12T22:19:00.001+01:00

Via Calculated Risk, a report by Amherst Securities which reaches more or less the same conclusions Credit Suisse did (and reported in March here and again in June here by yours truly).

The conclusions, more or less, are that while the first wave of mortgage defaults in the "Subprime" category has ~~subsidized~~ subsided in recent months, a second wave is about to hit the shores in the Option-ARM category as the payments on these mortgages are recast higher (in the 100% to 150% range).

No recovery yet for commercial paper

2010-01-12T21:56:00.001+01:00

Despite a tentative rebound in the latter part of 2009, all three broad categories of commercial paper outstanding - financial, non-financial, and asset-backed - are still hovering near multi-year lows. This is clearly not a sign of a recovery in this sensitive market.

Source: Federal Reserve

Not much U.S. macro news today...

2010-01-11T18:12:00.001+01:00

... much like every single Monday. Tella Opeyemi and I argued in a 2009 paper this might be a reason for the so-called Monday effect, which is a tendency for stocks to exhibit poor performance on average on Mondays.

Our hypothesis is supported by the fact that this effect is statistically significant for stocks but also for other risky asset classes and risk-free Treasury bonds. "Investors seem to decrease their exposure to all asset classes on average on Monday, and increase their cash holdings, maybe awaiting economic and financial reports released later in the week."

Links 7/1/10

2010-01-07T16:17:00.001+01:00

There have just been too many interesting pieces in the last few days for me to quote them all on this blog, so for once my dear readers, you are going to have to read it all (trust me it's worth it):

Bill Gross: Let's Get Fisical, also: Time's interview
Tim Duy: Fed Watch: Out of the gate with a bang
a sell signal from Mark Hulbert: Bullishness now at dangerous levels
From The Pragmatic Capitalist: The ultimate guide to 2010 investment predictions and outlooks

What's up with the baltic dry?

2010-01-06T21:57:00.001+01:00

The baltic dry index has shed about 35% from its autumn peak, and is still about 70% off its all time peak of 2008. Compare this with copper, which, amid stories of speculative hoarding by private chinese "investors", is within a few percents of reaching records!

Considering the long-time love story between the two, a long baltic dry/short copper trade seems like an interesting bet at a six months horizon:

The long-term costs of bailouts and nationalization of mortgage debt on inflation and external debt

2010-01-05T00:20:00.001+01:00

After years of reading his weekly commentary, I have finally managed to detect a small mistake (actually two) in John Hussman's otherwise implacable logic. Let's see that paragraph, which is about the consequences of the current and future enormous issuance of Treasury debt:

It may not appear to be costly at present, since risk-averse individuals conscious of credit risks, and foreign countries running massive trade surpluses, are still willing to accumulate the Treasury securities being issued, with no apparent impact. But ultimately, those securities will either stand as claims on our future national production, or they will be inflated away. Either the Treasury securities will retain value, so that holders such as China get to use them to acquire our productive assets in the future, while we ultimately tax ourselves in order to pay off that debt, or we must dilute the ability of those Treasuries to claim real goods and services, which is another way of saying we inflate away the debt.

There are two mistakes here, a tiny one and a more important one. First, it is wrong to say that foreigners will in the future acquire more U.S. productive assets: they already, today, by buying these newly issued securities, receive a higher share of U.S. national income through interest. Interest comes from taxes, which are paid thanks to productive assets. In other words, whether foreigners swap their Treasuries for U.S. equities or stick with their Treasuries, they still claim larger share of U.S. assets.

The second, bigger mistake is to believe that the U.S. can choose to swap an international redistribution of wealth problem (the 'either' part of Hussman's argument) for a national redistribution of wealth through inflation. There is no free lunch. 'Inflating away' the national debt is not a good expression as the debt doesn't really go 'away': it is just swapped for other securities, while the same amount is owed to foreigners.

To be specific, inflation will not resolve anything because it will result in a deterioration in the trade balance (higher pricing power to foreign producers), which itself will result in a deterioration in next external assets (claims on foreign assets minus domestic assets owned by foreigners). When all is said and done, the U.S. NIIP (Net international investment position) would have been the same with or without inflating the debt ~~away~~, or maybe even worse due to the fact that some foreign producers are better positioned for a high inflation environment (think commodity exporters), and because a collapsing dollar will allow foreign investors to buy U.S. assets on the cheap.

Inflation does redistribute wealth from savers to borrowers inside a country. It does not allow a nation to escape from transferring its wealth abroad. There is only one way to do that: default.

Hamilton on the Term Deposit Facility

2010-01-03T14:40:00.001+01:00

Excerpts (full post here):

We sometimes describe fiscal policy as determining the overall level of the public debt, while monetary policy determines the composition of that debt between money and interest-bearing federal obligations. By that definition, the Fed has clearly now entered the realm of implementing fiscal policy, by issuing debt directly in the form of interest-bearing reserves, reverse repos, and now term deposits.
The Fed would no doubt argue that it is doing so wisely, and that the decision to absorb Fannie and Freddie's debt and mortgage guarantees into the fiscal liabilities of the U.S. government has already been made by Congress and the President. The Fed is simply taking that reality as given and trying to minimize collateral damage.
Or one might see it this way: political pressures had been the cause of the quasi-nationalization and then de facto nationalization of mortgage debt in the first place, and the Fed found itself inextricably drawn into the mess. There is now political pressure to inflate the debt away, from which pressure the Fed nevertheless sees itself as immune.

2010

2010-01-01T15:53:00.000+01:00

Happy new year my dear readers (all three of you...)
RK

Stock market technicals

2009-12-29T18:13:00.003+01:00

In this post I will take a look at the recent internal behavior of the U.S. stock market and explain why I follow these indicators, using the "army" metaphor to describe the market. The comparison is simple: you want to "buy" an army that is winning the war, and "sell" an army that is losing. I know of four kinds of indicators useful to assess the sustainability of the performance of the stock market (i.e. is the army progressing or receding):

First, are the different sectors of the economy all performing well? You would be wary of an infantry progressing while the Air Force is taking a beating, would you? The same holds true for the stock market. This is why is watch the Industrials, Transports, Utilities, Financials, Techs, etc. Important divergences in the behavior of these indexes signal trouble ahead. This does not seem to be the case right now.
If the generals go on an offensive without support from the troops, what's going to happen to them? You want to see that the troops are following the generals, that is, you want to see as many stocks advancing as possible. This is referred to as breadth. Breadth recently has been quite good, although not as strong as it was this summer.
Next, imagine that your army is making progress on the front, but at the same time the daily number of your soldiers getting killed increases. Furthermore, the enemy is suffering lower casualties every day. What is then the quality of your army's recent advance? Most likely, it is not sustainable. That is why you want to monitor the number of kills (stocks breaking to new highs) and deaths (new lows). These are referred to as the stock market internals, and there's no complains to be made about them at present.
Finally, you want to monitor the exhaustion versus restfulness of your soldiers. If, after an advance, your soldiers still have energy left, it is more likely that this advance can be sustained. You monitor this by looking at the number of stocks above their moving average level: stocks above their moving average tend to revert back. At present the market seems to be very overbought on that basis, although there has been some progress in the past couple months, and this is constructive because it happened while the market worked its way higher.

Alright, there are other kinds of indicators, such as volume. I haven't been able to fit it into my metaphor, but it is quite important, and it hasn't been really good, which brings support to the view that the advance since the March low was just a bear market rally. Overall the technical picture is quite positive at the moment, but the overbought condition suggests to me that we are seeing the last stages (the most speculative) of this advance. As such, caution is warranted, while small exposures to put options for hedging purposes are still, for now, more appropriate than outright shorts.

European stocks breaking out of their trading range

2009-12-24T16:57:00.001+01:00

Technical analysts might call it a triangle or a reverse head and shoulders. Whatever the name, european equities are set to deliver nice returns in the next few weeks:

The rest of the year is likely to be more challenging though.

Are Treasury bond yields headed (much) higher?

2009-12-24T10:35:00.000+01:00

Theory says the ten-year risk-free bond yield should be equal to nominal GDP growth. With inflation expectations currently at 2.25% or above and consensus GDP growth for 2010 at 2.5% and above, the 10-Y Treasury bond yield could easily rise to 4.75% in the first part of the year, which incidentally, is about the level it averaged during the past half-decade.

However, I am expecting both renewed credit concerns and disappointments regarding GDP growth. This should at least put a cap on bond yields at around 4.75%. Since I am quite pessimistic in assessment of the economy, we should also see at some point a renewed flight to quality (well, quality is becoming less and less appropriate to describe treasuries) which could bring yields back towards 3-3.5%.

To sum up, 2010 could see swings in yields almost as wide as those we have seen in 2009.

To break the 4.75% level, we are going to need to witness "tangible" inflation concerns, and this should not be a problem before 2011 at least.

New home sales

2009-12-23T17:33:00.000+01:00

From CR - again:

http://www.calculatedriskblog.com/2009/12/new-home-sales-decrease-sharply-in.html

The euro is starting to get oversold

2009-12-22T19:38:00.001+01:00

The euro has dramatically fallen against the greenback this month, since the surprising U.S. employment report (which was actually not really good behind the appearances, although there has indeed been some moderately positive developments in the job market).

I don't think the euro has much more to fall. From a fundamental perspective, nothing has changed: the Fed is and will remain more dovish than the ECB. Two year bunds yield a lot more than two year notes. And the structural current account deficits of the U.S. are not being addressed.

From a valuation perspective, although the euro is a bit expensive, in my opinion the current price is about halfway from fair value (~1.20) to the all time highs of 2008 (~1.60). As the euro is not at all undervalued by any measure (quite the contrary), I believe there are better ways to play dollar weakness. However I do think the risks are tiltled towards a higher euro in the near term: from a technical perspective, it's already oversold, with 12 down days in the past 15 trading days:

Watch gold, which is usually a good leading indicator of EUR/USD turning points.

Existing home sales

2009-12-22T18:50:00.003+01:00

As per usual with existing home sales figures, no need for churning numbers here -- a simple link to Calculated Risk blog suffices:

http://www.calculatedriskblog.com/2009/12/existing-home-sales-up-sharply-in.html

http://www.calculatedriskblog.com/2009/12/more-on-existing-home-sales.html

Well ok that's two links.

Unlike good salespeople, Markowitz didn't believe in his own BS

2009-12-19T21:36:00.004+01:00

From Hersh Shefrin, Understanding Behavioral Finance and the Psychology of Investing (2002):

In the January 1998 issue of Money magazine, Harry Markowitz explains what motivated his personal choice about allocation. As the Nobel laureate recognized for having developed modern portfolio theory, was he seeking the optimum trade-off of risk and return? Not exactly. He said, "My intention was to minimize my future regret. So I split my contributions fifty-fifty between bonds and equities" (Zweig, 1998, 118).

I have nothing against Markowitz, except for the fact that he received a Nobel prize for a theory based on dodgy (at best) assumptions. 95% of asset allocation decisions around the world are now based on this theory, and I don't think portfolios are better designed today, on average, than they were 50 years ago. Apparently he was smart enough not to believe in it himself.

More on shadow inventory

2009-12-18T12:22:00.001+01:00

From Calculated Risk (by far the best housing blog): http://www.calculatedriskblog.com/2009/12/report-on-housing-shadow-inventory.html

My 2010 U.S. GDP forecast: 0.7% growth

2009-12-17T16:20:00.001+01:00

That is much below consensus. (Note: my model has had an average error of 0.5%.)

Some quick reminders: I do not make one single guess or assumption in this forecast. It comes directly from a model which uses leading indicators of the economy. The single one assumption that is implicitly made is that those indicators, which have been very useful at predicting the business cycle in the past, continue to provide information on the future path of the economy. The forecasts which would have been obtained by my (recently developed) model through back-testing are significantly better than most of the forecasts made by the economists polled each quarter by the Wall Street Journal, and notably, would have predicted the past recession. More on my model here, here and here. More on leading indicators here.

Priceless

2009-12-17T01:47:00.000+01:00

From Time (hat tip CR):

TIME: Do you have a mortgage?
Bernanke: Oh, yes, we refinanced. (...) We had to do it because we had an adjustable rate mortgage and it exploded, so we had to.

Bernanke is one of the smartest person in the world. But when it comes to forecasting, he just doesn't get it - he doesn't get the big picture, or the smaller pictures for that matter.

December stock market update

2009-12-15T18:39:00.001+01:00

A most important problem when trying to assess equity valuation, is that earnings often go all over the place, notably around recessions. Dividends are much more stable in the short run but they are subject to dividend distribution policy. Cash flows are not, and they are more stable than earnings as can be seen on the following chart (data from the BEA):

So let's chart what I would call the "cash flow yield" on U.S. equities, using this previous series (U.S. corporate net cash flows) and the market value of domestic corporations given by the Fed in its Z1 report:

The period average stands at about 13%, compared with today's 10%. So equities are 30% more expensive than during the past half century average using this measure. But note: if we excluded the bubble years of the past decade, the average would have been more in the area of 15%-16%. So stocks would be 50% overvalued at today's levels.

Using the more volatile (thus less reliable) corporate profits series, the picture is even bleaker: equities are more expensive than at any time in the past 50 years except for the bubble and a brief period in the late 1960's.

The last point I want to make concerning this subject is that, even at the bottom of the bear market earlier this year, stocks were never trading at "dirt cheap" levels such as those seen in the late 70's and early 80's.

That being said, markets can remain overvalued for extended periods of time. The only sure thing about today's valuation levels is that a buy-and-hold investor will not see a great performance of his portfolio in the long run. It does also increase the probabilities of a sell-off, as well as the extent of any sell-off should it occur. But since market breadth and internals have recently been very good, I believe the odds are for even higher prices in the short term. My opinion could change rapidly though.

Note: I will update my 2010 GDP forecast in the next few days.

Household debt and stock prices

2009-12-13T14:58:00.001+01:00

Although I would accept criticisms of data-mining concerning the following chart (the series are not stationary and so the correlation could be spurious), I still believe it is quite interesting:

Since it's going to take several years before U.S. household debt expands again, this is likely to damp down stock market performance in the meantime - ceteris paribus.

Rare earth metals shortage

2009-12-12T19:02:00.002+01:00

Via Roubini.com:

William Tahil, research director at Meridian International Research, says that there is insufficient lithium available in the earth's crust to sustain electric vehicle manufacture in the volumes required, based solely on Lithium ion batteries. To power a world automobile fleet in the size required to achieve needed cuts in oil consumption, would merely be switching dependency on one diminishing resource to another.

Although in my opinion the main driver of the commodity bull market is loose monetary policy (via low real rates and currency weakness), the supply situation is also a supportive factor for higher commodity prices in the long run.

Gold: is this a bubble - yet ?

2009-12-10T19:16:00.003+01:00

In this post I'm looking at the usual and less usual metrics for assessing the current valuation of the dollar price of gold. As we will see they all have their advantages and disadvantages. But before that I would like to show a graph of the performance of the metal over the past ~40 years:

Bubbles are usually characterized by both unsustainable valuations and frantic rates of increases. Concerning the later one, it doesn't seem to have happened yet: the yearly rates of change have been much more muted than during the 1970's bull market - both on the upside and the downside.

Now let's see if valuations can be described as bubblesques. When I made the following charts spot gold was trading at $1148, it is now $1125 as I'm wrapping up this post.

The valuation method that is currently touted the most by gold bulls is the ratio of gold to stocks (here I have used the S&P500):

This method makes current gold prices look very far from bubbly: the current ratio is about the same as the sample period average of 1.21. In the early 1990's, when that ratio was at the same levels, hardly anyone argued that gold was in a bubble (although the metal did head lower for a few more years). Assuming stock prices remain constant or increase, gold would have to increase hundreds of percents for the ratio to come back to 1970's levels. However, another way that this could happen is if it were stock prices that came down (which would hardly surprise me). Also, in theory and in the long run, we should expect stock prices to increase more than gold since equities benefit from productivity increases while gold doesn't. Consequently the ratio doesn't have to go back to 1980 bubble levels. So the ratio is globally favorable, but not a case for a quadrupling in the gold price as others may argue.

Gold prices can also be compared to commodity prices. The problem is, there are many, many commodities, and many indices which track them. I have chosen to use the Producer Price Index: All Commodities from the BLS. It's as good as any.

The ratio of gold to commodities is close to the sample period highs reached in 1980, and if you believe (as I do) that it is more likely the ratio will go back down rather than make new highs, then there are two possible conclusions: either gold has to come down, or commodity prices have to increase more than gold prices. I'm of the latter view.

One of the most popular way to value gold is to look at its real (inflation-adjusted) price:

Here the picture is not pretty either: adjusted to inflation, the gold price is low only when compared to the bubble years (and that's hardly an argument for a value investor). In fact, it is almost twice the sample period average, and thus much closer to bubble level than to fair value (if there is such a thing).

However, one can make the case that reported figures for inflation are biased, and furthermore, an increasing gold price is a signal of future higher inflation. Very well, let us then look at the price of gold compared to U.S. money supply. Comparing gold with money supply should be informative, notably with regards to future inflation:

Of course the supply of gold itself has increased, but by all accounts this increase has been almost negligible. As you can see, from that angle, although gold is not "dirt cheap" (in fact its price is slightly above the sample period average), it is still quite far from the mid-70's interim top and even further from its 1980 top. In fact it's barely above the 1976 interim low. So this paints a picture more similar to what we learned from the ratio with stock rather than with commodity prices, but with an added advantage: while stock and commodity prices commonly rise and fall, money supply almost never falls. It simply climbs at higher or lower rates:

The reason is... well I don't know, but I would love to ask a central banker why they won't let money supply fall. Anyway, consequently, it is very unlikely that the gold/money supply ratio will move higher due to a fall in the money supply, and this is why I like this ratio much better than the gold/equities or gold/commodities ratios. In my opinion it is also superior to the gold/CPI ratio (e.g. real gold price) because it is forward looking and not backward looking: inflation is a consequence of past money supply growth.

Finally, let us compare the gold price to the amount of assets held by U.S. households and non-profit organizations (this is mostly housing, equities and bonds). This measure makes sense because many asset allocation experts advise to hold x% of one's assets in gold (x being usually around 5). Here's the chart (once again we neglect the change in the supply of gold):

With the usual caveat that the value of these assets could fall (even further than they already have!), this ratio confirms that gold is quite far from being bubbly at these levels. However, it also confirms that gold is not really cheap anymore.

Conclusion: depending on the ratio you look at, you could make a case that the current dollar price of gold is either relatively fair or completely overvalued. However, I believe I have made a relatively strong case that the ratios in favor of the "fair price" view are the most sensible ones. In my opinion the gold bull market is not yet over and I am not selling. I would even add to my positions at around $1000 an ounce.

Note concerning the sample period. This discussion is based on data for the past 40 years or so, which encompasses only two bulls and one bear market, and is very short relative to gold's five thousand years history. But due to the fact that the price of gold used to be fixed*, and to the unavailability of some data, it becomes quite difficult to go further back in time: can you give me U.S. money supply figures for the 19th century, or U.K. stock prices in the 18th?

* True gold bugs would say that the price of fiat money was fixed to gold...

Sources: Reuters, St. Louis Fed FRED, Federal Reserve Board

Paul Kasriel: Airplane thoughts

2009-12-10T17:48:00.002+01:00

http://web-xp2a-pws.ntrs.com/content//media/attachment/data/econ_research/0912/document/ec121009.pdf

Econbrowser: Commodity prices and the Fed

2009-12-10T13:44:00.002+01:00

http://www.econbrowser.com/archives/2009/12/commodity_price_2.html

FT Alphaville: testing the AAA boundaries

2009-12-10T13:43:00.001+01:00

FT Alphaville looks at a recent report from Moody's.

Ever wondered why the real was overvalued?

2009-12-06T20:36:00.001+01:00

From Michael Gomez:

At current differences in like maturity nominal yields between U.S. dollar- and Brazilian real–denominated debt, the U.S. dollar would have to appreciate by 70% versus the real over the life of the investment for U.S. dollar debt to outperform.

Local-currency Brazilian bonds yield up to 13%.

A (little bit) further evidence on the dollar carry trade

2009-12-06T19:51:00.002+01:00

Heiko Hesse, using an econometric tool known as Dynamic Conditional Correlation, finds that the co-movements between the dollar and several asset classes has increased lately. I don't know much about autoregressive conditional heteroskedasticity (the framework from which stems this tool), but in my understanding, this just barely confirms that 80%-90%+ correlations between the dollar and these asset classes are, as suspected, both significant and much higher than they have in the past. (Simpler analysis as in my previous post showed correlations were higher but only very likely to be statistically significant...)

What it does not, however, is state that these high (and higher than unusual) correlations are a definite proof that the dollar carry trade is a major culprit for the froth in risky asset prices. We are still looking for definitive evidence on that, and I'm afraid this is not going to come before regulators start asking banks to report the numbers.

Gold spikes charts update

2009-12-05T12:54:00.001+01:00

This is an updated version of a previous post, in which I am comparing the different spikes gold has experienced in this bull market.

As I was saying in my previous post, in this bull market the metal's price has tended to go up in spikes, followed by long periods of correction and consolidation:

Now the latest one:

Following a much better than expected employment report yesterday, gold and treasuries sold off and the dollar spiked up. Now the big question: has gold topped out yet? I don't know and I don't really care. I wouldn't buy in the middle of a spike, because well to be frank, that's a sucker's game: the probability that once the spike is over, the price will go back to lower levels than the current one is very high. I wouldn't sell my core positions either because I believe gold will go higher eventually in the next few years.

Short sellers may have an opportunity to make a quick buck here, but beware that:

1) that unemployment report may be revised,

2) Fed officials may come out in the next few days and downplay it's importance,

3) gold spikes have usually had longer legs then this,

4) gold mines usually top out weeks before the metal and haven't done that this time,

5) finally, doesn't it seem too easy ? I mean, could one single good unemployment report be enough to trigger a top in any large liquid market? If I have learned one thing about the markets, it's that it's usually pretty hard to make money.

Short seller beware.

Tax incentives-based measures to tackle the financial sector overgrowth and the Too Big To Fail problems

2009-12-02T15:55:00.004+01:00

(Click here for PDF)

Following the history-making rescue of the financial system by public funds, a near-consensus has emerged that no financial institution should be large enough to pose a systemic threat to the world economy. Most of the solutions proposed toward that objective revolve around two basic propositions: 1) break up the institutions deemed too big to fail, and 2) tighten regulations and regulatory oversight on all financial institutions so that the risk of them going belly up is reduced. There are many problems with these two propositions.

Concerning 1), how to judge fairly which institutions are too big and which are not? Concerning 2), there are already thousands of pages of regulations at the local, national and supranational level governing banking and financial activities. This, combined with the complexity of those activities and of the institutions practising them, makes the job of the regulator extremely difficult, if not impossible. The problem is not only in deciding what to do, it is also in how to implement the decisions. Moreover, financial engineering has proven time and time again that it was ahead of the regulation curve: in other words, bankers and lawyers always find a way around the rules (think of buzzwords such as SIV and off-balance sheet). For these reasons, it may be more effective to use carrots rather than sticks. Here are three possible ones:

To reduce the TBTF problem, a simple way is to reduce the size of the financial sector (a sector which is seldom thought to bring important and long-lasting contribution to a country’s productivity). And a simple yet quite dramatic way to reduce the size of the financial sector is to cap, or even eliminate the interest tax shield for households, non-financial corporations or financial corporations or all three of them. This would bring down the optimal leverage ratio and thus the demand for loans, which in turn would reduce the share of the economy devoted to financial activities. Although it would bring down the economy’s growth rate (although probably not in the long-run), it would also go a long way in making it more stable, as well as help reduce government deficits. Plus, why should the tax system reward borrowing in the first place? This is somewhat of a free lunch which should be eliminated.
Another free lunch is portfolio diversification: it brings down volatility (risk) without sacrificing the expected returns of the portfolio. However, there is a consequence, which is that once an investor believes his portfolio risk is low due to diversification, she will let individual companies’ management pursue a very risky strategy in search for high returns (for the investor) and compensation (for management). However, when every investor in every company thinks in that way, systemic risk increases – for everybody, and corporate governance can become inadequate for a large number of companies. This is what we have witnessed for large complex financial groups in recent years. For this reason, returns from very diversified portfolios should be taxed less advantageously then returns from more concentrated portfolios. Investors would then reduce the number of lines in their portfolios, which would have the effect of increasing the number of large shareholders in companies, improve corporate governance and reduce systemic risk. After all, aren’t long term gains taxed less then short term gains for the same reasons?
Last but not least, corporations should be taxed in the same way that individuals are in most developed countries: at a rate increasing with the absolute amount of profits. If that was the case, large banking groups would find it in the best interest of their shareholders to divest some activities as they grow in size. This would not only help tackling the TBTF problem, but also the monopoly one, and relieve the regulator from long and costly processes (remember the Microsoft case?). However, profits are very volatile, so an even more effective way to implement this measure would be to base the corporate tax on revenues (once again, just as for individuals). A third possible way would be to make to corporate tax rate proportional to the company’s market share, although this would be more complicated to implement.

These measures may seem bold, but bold is probably what we need to be if we want to avoid a repeat of the recent (and ongoing) events in the financial sector. Furthermore, they are easy to implement, could be passed unto law very quickly, would have a desirable, important and long-lasting effect on the financial sector and would not impair its ability to innovate.

Two other high-calibre bloggers join the dark side

2009-12-02T11:56:00.001+01:00

After Stephen Cecchetti, gone to the BIS and Brad Setser who left for the White House, the past week has seen two other prominent economic/financial bloggers put their pencils down (so to speak). John Jensen will now work for TD Securities and Willem Buiter will be the Chief Economist at Citi.

I really hope they are listened too.

Dull. Bye.

2009-11-29T15:42:00.001+01:00

This whole Dubai thing is a non-story. So what if a few banks are going to lose a few billions. The amount of write-downs in the past couple years was what, 1500 billions? Wait a few months for the pain to come in the U.S. commercial real estate market, and the Alt-A and Option-ARM mortgage troubles. THAT is going to hurt.

There might be one interesting thing in this, and it's the way the markets have reacted. It seems the 9 months-old rally is finally getting frightened by bad news. This is not a sign of strength. Financials have been underperforming for weeks now. Not very good.

Shadow inventory in housing

2009-11-27T15:34:00.000+01:00

Again, from David Rosenberg:

Meanwhile, the deflation risks in housing have not gone away, and we saw that in the 1.7% slide in median existing home prices in October (sharpest slide since April). This was the FOURTH month in a row of negative pricing action in the resale market. So, while this data may well show that the inventory backlog has come down to what seems to be a respectable 7 months’ supply, we also know from the U.S. Census data that there are around 3½ million homeownership units that are currently being taken off the market for unstated reasons. (We reckon that this is a pretty good proxy for the ‘shadow’ foreclosed inventory at the banks). In other words, we very likely have the inventory backlog at closer to 14 months’ supply and this is why prices are still declining. At the margin, there are still many more sellers than there are buyers.

David Rosenberg writes a very interesting daily report, available here.

More tidbits from the Consumer confidence report

2009-11-27T15:13:00.001+01:00

From David Rosenberg:

In terms of financial markets, and this is a good contrary indicator, those expecting the equity market to go up (33.1 to 36.3) and those expecting it to go down (28.7 to 23.8) have moved to levels last seen in July 2007 (right when the market was peaking out and about to roll over).

Interest rate expectations, meanwhile, have moved in a bullish direction for bonds. Those respondents expecting yields to rise went from 50.1 to 51.3 in November and those expecting yields to fall slipped from 15.3 to 12.9 — levels last posted in August 2007 in what were the early stages of one of the biggest bond rallies in the past 30 years.

Consumer confidence vs. GDP growth

2009-11-24T18:43:00.000+01:00

The highest correlation that can be found between consumer confidence and GDP growth... is not that high (about 0.5):

This makes consumer confidence one of the less-reliable leading indicators of the economy.

Even more on the dollar carry trade

2009-11-24T17:51:00.001+01:00

From "BarCap analysts", via FT Alphaville:

The size of carry traders is notoriously difficult to measure, and there is considerable speculation on their size based on very incomplete evidence. Consider, however, a measure of the classic incentive to put on carry trades — volatility-adjusted spreads. We use two such measures, the volatility-adjusted spread between AUD and JPY and the volatility-adjusted spread between AUD and USD. In each case, we divide the 10y yield differential between by one year implied volatility.
These measures do not encourage the view that carry trades would be put on in size . Whatever the incentives from the rate differentials, implied volatilities remain high enough to discourage carry trades. In both cases, the incentives are not only well below the peak, they are well below the average.

If anything, this suggests that the market may be overestimating the extent of carry trades now in place and underestimating the potential for carry trades to be instituted if implied volatilities pull closer toward historical norms and realized volatility.

Well excuse me anonymous BarCap analysts, but you are pretending to be more stupid than you actually are. The carry trade everybody's talking about is more about capital gains than about pure yield carry, and your measures are not adapted to this. These measures were useful when the carry trade was about shorting yen and going long higher yielding currencies (notably as you mention, AUD) using enormous leverage, hence the need to monitor volatility. The topic du jour is about borrowing dollars and going long low- or zero-yielding things like commodities, stocks or other low-yielding bonds and currencies, presumably with a much lower leverage. Volatility has become less important, but more to the point, AUD volatility is pretty much irrelevent to the debate.

A more interesting argument comes from David Rosenberg (I actually think he borrowed it, I saw that somewhere else recently):

Historically, there is no correlation at all between the DXY index (the U.S. dollar index) and the S&P 500. In the past eight months, that correlation is 90%. Ditto for credit spreads — zero correlation from 1995 to 2008, but now it has surged to 90% since April. There was historically a 70% inverse correlation between the U.S. dollar and emerging markets, such as the Brazilian Bovespa, and that correlation has also increased to 90% since the spring. Even the VIX index, which historically has had no better than a 20% correlation with the U.S. dollar, has now sent that correlation surge to 90%. Amazing. The inverse correlations between the U.S. dollar and gold and the U.S. dollar and commodities were always strong, but these too have strengthened and now stand at over 90%.

Hester: Economic Data Surprises index

2009-11-23T13:05:00.002+01:00

I love Mondays. Why? Every Monday John Hussman, maybe the most brilliant mind in the business (let's say it's a tie with El-Erian), publishes his weekly market comment:

The cumulative tally of surprises in economic reports (a metric we credit to Bridgewater, which Bill Hester adapted here), has also turned down decidedly. Though the historical correlation is not always as strong as it has been during the recent downturn, shifts in economic surprises have tended to lead market turns in recent years.

Still, with market internals mixed but not clearly collapsing, prices strenuously overbought but still achieving marginal new highs, and valuations unfavorable but not as extreme as they were in 2000 or 2007, investors may be convinced that there is still a little bit of punch in the bowl

CR: Effect of Fed buying MBS

2009-11-22T11:56:00.001+01:00

From Calculated Risk Blog:

It isn't that Fannie and Freddie "can’t sell to an end buyer", it is that the GSEs [securities] will be selling for a lower price (higher yield) when the Fed completes the MBS purchase program. At that time mortgage rates will probably rise by about 35 bps to 50 bps (relative to the Ten Year) in order to attract other buyers. Alone that isn't all that "scary".

The Fed has issued more than a trillion Federal Reserve Notes (otherwise known as dollars) to buy mortgage backed securities. This is is serious currency debasement for 50 bps! However, I believe the total impact has been bigger: for one, it probably has driven Treasury yields lower than otherwise, so even though the effect on the spread is only 50 bps, the effect on the yield must have been bigger. Second, it has increased liquidity in this market and increased confidence (perception) towards the ability of the GSEs to retain their role in the financial system.

But combined with the growing problems at the FHA, the distortions in the housing market caused by the first-time home buyer tax credit, rising delinquencies, the uncertainty of the modification programs, and likely further house price declines in many bubble states - there are serious problems ahead for the housing market.

Click here for the full post.

U.S. GDP Forecast update

2009-11-21T14:17:00.004+01:00

Here are my latest forecasts. As a reminder, my model uses only cold hard statistical data. There are no assumptions made here, except for the one that past relationships between leading indicators of the economy and GDP will continue to hold.

One-time unexpected short-term fiscal effects, such as the Cash for Clunkers program, may thus not be captured, and I won't try to make up for it by artificially boosting my model's forecasts. The public demand component is accounted for through other variables, and I do expect my model to capture most of it over the medium-run.

GDP Forecasts:

Next 12 months: 1.5% growth
Q4 2009: 1.1%
Q1 2010: 0.8%
Q2 2010: 1.0%
Q3 2010: -1.3%
Q4 2010: -2.1% (as always, this last one is to be taken with a grain of salt as my model is not made to make forecasts more than 12 months out).

Below is a graph of my monthly GDP forecasts (annualized), along with the 50%, 75% and 90% confidence bands (click to enlarge):

Hulbert: The average gold timer is now more bullish than on each of the past four occasions in which the gold market has topped out.

2009-11-20T17:28:00.002+01:00

Full article here.

Leading Economic Indicators Index increases again

2009-11-19T17:16:00.003+01:00

I am a big fan of the Leading Economic Indicators, however I like much less the Index of Leading Indicators. The reason is because of the way it is constructed: the weights of each component are designed to smooth out the index (precisely, each one of the weights is calculated as the inverse of the component's volatility). As such, the weights don't reflect the predictive power of the indicators, nor their lead length relationship with the economy.

Secondly, the weights are recalculated each year and the components themselves have changed about once a decade.This invalidates historical comparisons.

Still, I prefer to see a rising Index rather than a falling one (click to enlarge):

Unemployment might be peaking sooner than you think

2009-11-17T17:41:00.001+01:00

Although I am more bearish in my GDP forecast than many others (see these posts), I don't believe that should necessarily translate into unemployment peaking in the mid-teens. See this graph (click to enlarge) :

Using this transformation of the data, since the growth in initial claims for unemployment insurance has peaked, the unemployment rate could follow soon. How slowly it will go down is another question.

More on the U.S. Dollar carry trade

2009-11-17T13:18:00.001+01:00

Paul Kasriel believes that proponents of the dollar carry trade hypothesis do not have much evidence on their hands:

There is a lot of chatter that global speculators are borrowing greenbacks at bargain basement interest rates and buying higher-yielding assets denominated in foreign currencies. Some have suggested that this dollar-carry trade is creating yet another asset-price bubble. Other than the fact that the U.S. dollar has been depreciating on a trade-weighted basis in recent months, where is the evidence for this dollar-carry trade? In other words, where is this alleged massive bubblicious U.S. dollar credit creation showing up? I will tell you where it is not showing up – on the books of U.S. commercial banks. In the 26 weeks ended October 28, 2009, loans and investments at U.S.- domiciled commercial banks have contracted at an annual (Devil’s) rate of 6.66% (see Chart 1).

Two remarks here: first, the fact that total loans are contracting does not mean that loans for carry trade purposes are contracting as well. It could mean that loans to the non-financial sector are contracting at an even lower pace than that of the total figure. Second, the top U.S. banks hold large amounts of FX and FX derivative exposure (see Reggie Middleton, subscribtion required). Some of this exposure may be off-balance sheet and thus may not appear in the Federal Reserve figures used by Kasriel and be a part of the carry trade story.

A common misconception I would like to address

2009-11-16T12:12:00.001+01:00

From a very famous source: "The U.S. trade deficit has been closely correlated to Mortgage Equity Withdrawal (MEW, aka "Home ATM"), and I doubt MEW is coming back soon, so I'm not sure we will see a huge increase in the deficit this time".

While the point about MEW is valid, the current account deficit is always equal to the net borrowing of the nation, not only households. The U.S. government borrowing is and will probably continue to be the driver of the current account deficit this time.

Building permits and U.S. GDP growth

2009-11-14T16:48:00.002+01:00

The highest correlation that can be found between building permits and subsequent year-over-year GDP growth is 0.64:

(Note: This is a 15-months rate of change, and Building Permits are advanced 6 months.)

This illustrates one of the missing private demand leg in this recovery.

Bloomberg links: Fed Watch

2009-11-12T18:15:00.003+01:00

Fed Faces Biggest Blow to Authority, Independence in Dodd Banking Measure The Federal Reserve faces the biggest blows to its authority and independence in five decades under legislation championed by its lead overseer in the U.S. Senate.

Fed Officials Say Recovery Will Be Slow as Unemployment Hampers Spending The U.S. economy will be slow to recover from the deepest recession since the 1930s as rising unemployment curbs consumer spending, Federal Reserve officials said.

Fed's Lockhart Says Banks' Commercial Real Estate Losses to Slow Recovery Federal Reserve Bank of Atlanta President Dennis Lockhart said the economy will probably recover slowly from the deepest recession since the 1930s because of rising bank losses, especially in commercial real estate.

Equities: short-term caution

2009-11-11T16:22:00.004+01:00

Many of the short-term technical indicators I follow have turned bearish in the past few days: market breadth and internals, although having not broken down during the last correction, have not been strong during this week's rally. There were eight up days in the past ten days, and the market is back to a short-term overbought condition.

Since in my opinion, valuation levels do not provide for strong long-term returns, the only case that remains to buy stocks now is that, in the mid-term (a few months), the economic recovery is going to be strong enough to support those lofty profit expectations, but not strong enough that the Fed is going to remove accomodation any time soon. This is a thin line the market is walking. Some call it a bubble.

October Senior Loan Officers Survey

2009-11-10T12:07:00.001+01:00

From Asha Bangalore: Improved Picture of Lending Conditions, but Demand for Loans was Weak.

Note: this is a well-made report, however it still belongs to the "less bad news" camp. We're not yet seeing "good" news yet from either supply of or demand for loans.

More on gold (charts)

2009-11-09T13:25:00.002+01:00

As I was saying in my previous post, in this gold bull market the metal's price has tended to go up in spikes, followed by long periods of correction and consolidation. If history repeats itself once again (which I believe is the case), gold, which has just broken out of an ~18 months trading range, has recently started a new spike. At which price will it start to correct is anyone's guess (mine is about $1300, but as I said, it's just a guess). Keep in mind that I wouldn't personally start buying here because 1) who knows when the spike will end, 2) the correction is likely to bring the price back to current levels (maybe even below), and 3) the consolidation period is likely to be quite long-lasting. These are the exact same reasons why I'm not trying to trade in an out of this bull market: I'm just holding to my positions. Below are a few charts to support that (click to enlarge)

Gold is overbought

2009-11-06T20:05:00.001+01:00

I have been an advocate of gold as an investment for many years. I allocated the greatest part of my savings to gold in 2003 when it traded below $350 an ounce, and I can't say I regret that decision. I believe gold is still in a bull market, however now may not be a fantastic entry point:

The Fed is not going to stay on hold forever. Although we are many months away from removing accomodation, Fed officials have already started to discuss exit options. Moreover, Fed balance sheet expansion is probably over (at least for now, until and if we get a second economic leg down). Fedspeak might also become increasingly hawkish as the dollar falls and bubbles develop everywhere (see previous posts). So we may see a short term sell off if and when that happens.
Inflation is not an immediate problem. Fiscal deficits by themselves don't cause inflation, money does. Inflation might become a problem eventually as the money supply has increased quite a lot last year, but since the rate of growth in the money supply has slowed of late, one could still imagine that the money supply will be reined in before inflation pressures develop. I personally don't think that will happen, but that possibility can at some point be priced in by the market, which will not be gold-friendly. Finally, I believe we will see slower than expected growth next year, which will put a damp on inflation expectations (at least for a little while longer).
Gold is overbought. Just look at any chart: it's overbought by any measure on daily charts and weekly charts. Plus it has closed up almost every week in the past several months, which means it has become a one-sided bet.

Since gold tends to go up in spikes, it might go up another 10% or 20% before it corrects. However, when that happens, it is likely that it will go down back to the current levels, maybe even lower. I already own gold and I'm in for the long-term, so I'm not selling (I'm not trading gold, I'm just sitting with it until I believe the bull is over). However, I wouldn't advise anyone to buy a significant amount of gold right now, and short sellers should be on the lookout for a potential short candidate in the near future.

Updates:
Charts
Hulbert Sentiment Index

November Stock market update

2009-11-04T16:07:00.002+01:00

A couple weeks ago I made a case that U.S. equities were overbought and overvalued. We've had a little correction since then, and I've been asked if I think this is the beginning of a sell-off or a opportunity to buy the dip. My answer in a nutshell is: neither.

Stocks (on average, notably if you look at the S&P500) are still overvalued. This, especially in the context of less than goldilocky economic backdrop (see here and here), means that buying at these prices is speculation more than investment.

Furthermore, veteran technical analyst Richard Russell makes a strong case for a deterioration in market technicals (not online):

(1) Far too many distribution days.

(A distribution day is a day when stocks close lower on rising volume.)

(2) The bullish percentage of stocks on the NYSE is declining.
(...)
(5) The Transport Average broke below a preceding decline low October 28.
(6) Sentiment is too bullish regarding the market. Nobody expects this rally to top out and fall apart. Analysts consider it impossible that the March lows will be revisited again. I don't share their opinion.

Well this might not be entirely true: Mark Hulbert's sentiment index isn't showing worrying stubborn bullishness.

(7) My PTI is now only 8 points above its [moving average] and therefore very close to a sell signal.

The PTI is Russell's proprietary stock market indicator.

(8) The Dow, so far, has not been able to close above the 50% level of the 2007-to-2009 decline. The 50% level was 10725.

[10] Whether Lowry's Buying Power and Selling Pressure are spreading apart or coming closer together. Example, if on a given day, Buying Power drops and Selling Pressure rises, the spread between the two widens. That's technical deterioration. Since Oct. 19, the spread between BP and SP has widened by 45 points.

On the other hand, although market internals and breadth have turned a bit weaker in the past couple weeks, they haven't completely broken down in the way I would expect them to if we were on the verge of a nasty sell-off. Plus, in recent days they seem to have stabilized.

In conclusion, my best bet for the short term is that equity indices are going to settle in a trading range and test their recent highs. Whether the highs are bettered remains to be seen, and I am worried that an important top might be in the process of developping. The answer to that story could take weeks or even months to unfold.

Roubini: "Mother of all Carry Trades Faces an Inevitable Bust"

2009-11-03T12:07:00.000+01:00

So what is behind this massive rally? Certainly it has been helped by a wave of liquidity from near-zero interest rates and quantitative easing. But a more important factor fuelling this asset bubble is the weakness of the US dollar, driven by the mother of all carry trades. The US dollar has become the major funding currency of carry trades as the Fed has kept interest rates on hold and is expected to do so for a long time. Investors who are shorting the US dollar to buy on a highly leveraged basis higher-yielding assets and other global assets are not just borrowing at zero interest rates in dollar terms; they are borrowing at very negative interest rates – as low as negative 10 or 20 per cent annualised – as the fall in the US dollar leads to massive capital gains on short dollar positions.

(...) Central banks in Asia and Latin America are worried about dollar weakness and are aggressively intervening to stop excessive currency appreciation. This is keeping short-term rates lower than is desirable. Central banks may also be forced to lower interest rates through domestic open market operations. Some central banks, concerned about the hot money driving up their currencies, as in Brazil, are imposing controls on capital inflows. Either way, the carry trade bubble will get worse: if there is no forex intervention and foreign currencies appreciate, the negative borrowing cost of the carry trade becomes more negative. If intervention or open market operations control currency appreciation, the ensuing domestic monetary easing feeds an asset bubble in these economies.

http://www.rgemonitor.com/roubini-monitor/257912/mother_of_all_carry_trades_faces_an_inevitable_bust

The current state of the economy

2009-11-03T11:32:00.003+01:00

From John Hussman:

One possibility, which is clearly the one that Wall Street has subscribed to, is that the recent downturn was a standard, if somewhat more severe than normal, post-war recession; that the market's recent strength is an indication that it is looking forward to a full “V-shaped” recovery, and that the positive print for third-quarter GDP is a signal that the recession is officially over. Applying the post-war norms for stock market performance following the end of a recession, the implications are for further market strength and the elongation of the recent advance into a multi-year bull market.
The alternate possibility, which is the one that I personally subscribe to, is that the recent downturn was the initial phase of a more prolonged deleveraging cycle; that the advance we've observed in recent months most likely represents mean-reversion – qualitatively and quantitatively similar to the large and often abruptly terminated “clearing rallies” of past post-crash markets; that major credit losses are continuing quietly but are going unreported thanks to changes in accounting rules by the FASB this past spring, which allowed for “substantial discretion” in accounting for loan losses and deterioration in the value of securitized mortgages; that a huge second-wave of mortgage losses can be expected from a reset schedule on Alt-A and Option-ARMs that has just started (following a lull in the reset schedule since March) and will continue into 2010 and 2011; that intrinsic economic activity remains abysmal; that recent GDP growth is an artifact of massive fiscal stimulus that is unlikely to have sustained follow-through; and that recent market valuations are not representative of those observed at the end of most post-war recessions, but are instead similar to those observed at major market peaks prior to the mid-1990's.

GDP forecast update

2009-11-02T17:54:00.003+01:00

Here is my updated forecast for U.S. real GDP growth (chart below). My model doesn't use assumptions about any economic variables, the behavior of households, fiscal policy, etc.: it just uses cold hard data. This data in turn is supposed to lead the state of the economy by a few quarters.

A few comments:

For the next twelve months, real GDP will grow by ~~(1%)~~ 1.1% according to my model. This is much below the consensus.
Although most comentators have already declared the end of the recession, my model says we could see negative growth in some quarters.
Don't be too alarmed by the huge drop forecasted for the last quarter of 2010. The model isn't supposed to be able to do well that far in the future (it does best at a horizon of 6 months or so).

So I hope my readers will not be surprised by disappointing GDP figures, notably starting mid-2010.

Note: the green bands represent the 90%, 75% and 50% confidence around the central forecast.

See below for back-testing against other forecasters for the 2005-2008 period. The model fares much better when 2008 is included as it predicted minus 2% growth for 2008, while no other economist polled by the WSJ called for negative growth. I called my model VAR(30).

ranking among WSJ-polled forecasters

Firm	Average absolute error (%)		Rank		Excluding 2008 (%)		Rank
*VAR(30)*		0.52		1		0.57		16
UCLA Anderson Forecast		1.13		2		0.22		1
Merrill Lynch		1.14		3		0.43		7
UBS		1.17		4		0.34		2
The Northern Trust		1.24		5		0.50		10
Lehman Brothers		1.24		6		0.50		11
Standard and Poor's		1.25		7		0.42		4
Vanderbilt University		1.26		8		0.43		6
Perna Associates		1.27		9		0.50		12
Decision Economics Inc.		1.28		10		0.48		8
Goldman Sachs & Co.		1.28		11		0.58		17
Global Insight		1.28		12		0.42		5
Swiss Re		1.32		13		0.51		13
Maria Fiorini Ramirez Inc.		1.35		14		0.54		14
Econoclast		1.36		15		0.36		3
Morgan Stanley		1.38		16		0.95		38
Credit Suisse		1.39		17		0.73		26
Wells Fargo & Co.		1.40		18		0.61		18
Mortgage Bankers Association		1.45		19		0.64		21
Comerica Bank		1.48		20		0.65		22
RSQE, U. of Michigan		1.48		21		0.55		15
Median Survey forecast		1.50		22		0.64		20
FedEx Corp.		1.55		23		0.61		19
The Conference Board		1.55		24		0.71		25
Wachovia Corp.		1.55		25		0.48		9
Barclays Capital		1.58		26		0.69		24
Economic Analysis		1.60		27		0.75		28
Bank of America		1.61		28		0.83		29
High Frequency Economics		1.62		29		0.88		35
Keystone Business Intelligence India		1.63		30		0.85		32
AllianceBernstein		1.64		31		0.74		27
Hanmi Bank		1.67		32		0.87		34
Wayne Hummer Investments LLC		1.67		33		0.67		23
Nomura Securities International Inc.		1.69		34		0.86		33
National City Corporation		1.76		35		0.85		31
Moody's Investors Service		1.77		36		0.94		36
Eaton Corp.		1.77		37		0.83		30
Bear Stearns & Co. Inc.		1.83		38		1.02		39
Deutsche Bank Securities Inc.		1.84		39		1.13		41
Macroeconomic Advisers		1.84		40		0.94		37
National Association of Realtors		2.09		41		1.13		40

U.S. housing figures

2009-10-28T19:40:00.001+01:00

From CR:

New Home Sales Decrease in September

and

New and Existing Home Sales: The Distressing Gap

More on Barclays

2009-10-27T14:00:00.000+01:00

From Gillian Tett:

(...) Most notably, by selling those $12.3bn assets to Protium, what Barclays is essentially doing is taking a pile of toxic items out of its front room (ie the balance sheet) and stuffing it into an entity that is not inside the house (the garage, or cellar).

(...) For the really dirty secret that currently bedevils the whole financial reform debate is that the more that regulators force banks to clean up their “front rooms” (ie regulated activity), the greater the risk that activity will flee to unregulated corners of finance – if nothing else because financiers have little desire to subject their pay to public scrutiny.

Are the banks fine?

2009-10-26T13:11:00.004+01:00

I was browsing through Barclays investor presentation and dug out a few numbers. I thought they were interesting because they paint a picture quite similar to what I've heard about many other of the large banks. From page 4, you can see that most activities have posted gigantic declines in profits from last year:

UK Retail Banking: - 61%
Barclays Commercial Bank: - 42%
Barclaycard: - 1%
GRCB –Western Europe: - 73%
GRCB – Emerging Markets: - 86%
GRCB – Absa: - 17%
Barclays Capital: + 100%
Barclays Global Investors: +4% (BGI was sold to BlackRock)
Barclays Wealth: - 59%

Head Office went from minus £ 460 mln to a positive £ 330 mln. This swing of £ 800 mln or so is a contribution to profits that is big time cost cutting: Head Office is a cost center, it's not supposed to make money. So this is non-recurring. A second comment: the only other material positive contribution comes from Barcap: about £ 1bn (up from £500 mln last year) contribution to a total of £ 3bn before tax profits. Barcap is the trading arm of Barclays, so these profits come from very risky activities: on page 47, economic profit from Barcap is slightly negative. Economic profit is profit minus the dollar cost of capital (which should be proportional to the riskiness of the project) needed to earn these profits. This is corporate finance 101: if you need to borrow $100 at a 10% interest rate for a business that is gonna bring $9 a year in profits, well it just doesn't make any sense to invest in that business.

Moving on to page 5: leverage is down from 28x to 20x. Improvement? Yes... but. It still means that a (marked-to-market) 5% drop in the value of the bank's assets would completely wipe out shareholders and render the bank technically insolvent. And this does not include, by definition, off-balance sheet activities. How likely is it that the bank's on-balance sheet assets will again be eventually marked down? From the appendix:

Page 9: loan loss rate (Commercial Bank): still climbing. Page 54: arrears rate (UK mortgages): still climbing. Page 55: net charge offs and deliquency rates (UK cards, US cards, UK unsecured customer loans): still climbing...

Buiter on bubbles and China

2009-10-24T10:41:00.002+02:00

Willem Buiter is a very smart and knowledgeable person; however his blog posts are always very (very!) long. No worries dear reader, I am here to select the good stuff for you (from: Beware asset market & credit booms bubbles & busts in emerging markets). I will also highlight a classic rookie mistake he made, much like I did in my previous post.

(...) the world is being flooded with official liquidity by the leading central banks of the overdeveloped world.

First remark: the expression "overdeveloped world" may be the best thing I've heard since "Goldilocks economy". It just explains so much in one single world... this is economic poetry! I don't know if Buiter originated it, it is the first time I see it. It continues:

Commercial banks either hoard the newly injected central bank liquidity at the central bank in the form of deposits or use it to purchase safe liquid assets, such as the sovereign debt instruments of reasonably solvent nation states. (...) Broad monetary aggregates are growing little if at all in the overdeveloped world and credit growth to the non-financial enterprise sector and to the household sector remains minuscule. We are therefore unlikely to see a credit boom or asset market frenzy any time soon in the advanced industrial countries, let alone any pick-up in domestically generated inflation for indices like the CPI. The massive injection of official liquidity by the Fed, the ECB, the Bank of England, the Bank of Japan and other central banks in the north-Atlantic region is much more likely to show up as credit and asset market booms, bubbles and - eventually - busts in those emerging markets that are growing rapidly again, that is, most emerging markets other than those in Central and Eastern Europe. China, Brazil, India, Indonesia, Singapore, Turkey and Peru are but some of the countries at risk. (...) The reason for this liquidity spill-over is the desire of many of the rapidly expanding emerging markets to prevent a large real appreciation of their currencies vis-à-vis those of the cyclically lagging advanced industrial countries. (...) The accumulation of foreign exchange reserves that results is only partly sterilised. The result is externally financed expansion of the domestic money supply and more rapid domestic credit growth. This will leak at least partly into domestic asset markets, creating the conditions for boom, bubble and bust.

And now, on China:

China is especially at risk of booms and bubbles in its stock market, its residential housing market and its commercial and industrial property markets. That is because the externally funded liquidity injection resulting from Chinese attempts to keep down the external value of the yuan are reinforced by further domestic credit expansion associated with the Chinese fiscal stimulus. (...) China is creating massive excess capacity in export-oriented industries (and indeed in some of the low-tech consumer goods where it no longer is the global low-cost producer).

(My emphasis). Continues:

In two or three years, when these loans will be going into default on a large scale, the central bank or the ministry of finance will recapitalise the banks, using a mixture of government debt, central bank domestic credit and foreign exchange reserves.

And there it is - the rookie mistake: recapitalising the Chinese banks with foreign exchange reserves. I've seen that countless times but I didn't expect Buiter to fall into that trap. Let me explain: you cannot use foreign ~~exchange~~ currency (in that case, mostly dollars) to recapitalise a domestic currency (yuan) balance sheet. Have you ever heard of a company having equity in foreign ~~exchange~~ currency ? It is just silly ! Now, what you could in theory do is convert this dollars in yuan, and use the proceeds to recapitalise the banks. But that would entail a large appreciation of the Chinese currency: remember, if the central bank just stopped buying dollars, the renmibi would most likely increase by 20% to 40% rappidly. What would happen then if the central bank started to sell dollars ? A very destabilizing overshoot in the exchange rate. Now, would you like to see that happen to your country, if at the same time your country's banking system is in need of being recapitalized ?

Let's continue with Buiter, who is otherwise right to the point:

The boost to domestic demand is overwhelmingly in the form of fixed investment, much of in the the wrong, old industries. Without a miraculous recovery of export demand growth, excess capacity will re-emerge with a vengeance in the export industries.

(...) Other emerging markets too are likely to be faced with domestic asset market booms and bubbles, in particular the oil and gas exporting nations of the Gulf Cooperation Council (GCC). These countries still peg to or shadow the US dollar quite closely, despite a number of attempts, through basket-pegging and similar manoeuvres, to loosen their ties to the US dollar. (...) The credit and asset market boom, bubble and bust I foresee for the rapidly growing emerging markets is not inevitable. It is a policy choice. If the emerging market countries in question are willing to let their currencies appreciate sufficiently against the US dollar and the currencies of the rest of the overdeveloped world, there will be no domestic monetary and credit expansion financed by imperfectly sterilized foreign reserve inflows. For China, preventing excessive credit growth and asset booms and bubbles is more difficult, as in addition to the external liquidity injection, the government is, through the banking system, injecting massive amounts of domestic liquidity into the economy. This would become unnecessary if China were able to switch the composition of production and of domestic demand towards consumer goods and services and non-traded goods and services.

2010 outlook

2009-10-22T18:56:00.000+02:00

I briefly mentionned PIMCO's New Normal, which is the company's secular outlook, in my last stock market comment (PIMCO is one of the largest bond management companies). Here are some some excerpts from their latest cyclical outlook. I will then criticize one of their points, well, because it's by bettering the master that one becomes a master... (already attempted here and here).

Here is their cyclical outlook:

Consider the notion of an “escape velocity” for the economy – a forward movement that is significant enough for a sustained economic expansion to set in. There are three contributors. The first is the unprecedented amount of global fiscal and monetary stimulus. This is now in play in a big way. The second is the inventory rebuilding cycle, which is starting to take hold. While these two factors are necessary for reaching escape velocity – and are very much in play, contributing to seemingly robust growth numbers for the third and fourth quarters – they are not sufficient. We also need sustainable private sector demand.
In PIMCO’s Investment Committee deliberations, Bill came up with an analogy of a rocket, which has fired two boosters but needs to fire a third in order to escape the earth’s gravitational force. That third booster, which is the final component necessary to achieve escape velocity, has to come from a source of private demand: either consumption, investment or exports.
When we look at the extent to which the major economies, especially the U.S., are challenged by their balance sheets right now, we are not yet expecting that the third booster is going to fire. As a result, we question the expectations in the marketplace for a V-shaped recovery.

I am holding back on using my model to compute 2010 GDP forecasts until next week (I am waiting for the Q3 GDP release), but for now it does paint a similar picture: relatively "strong" growth (around 2-2.5%) in the next few quarters, followed by a drop later in 2010. But more on that next week. What I want to talk about now is the following, from the same PIMCO piece:

The extraordinarily low fed funds rate has pushed money out of low-risk and “risk-free” assets into higher risk assets, which has led to the bounce in asset prices.

This is a classic rookie mistake which has me thinking that maybe Gross and El-Erian (the PIMCO heads) didn't write that piece themselves, but rather had an intern do it for them (I should have his job). You see, there is no such thing has money flowing out or into anything. Consider this: one day, the whole earth population wakes up and decides to buy (flow into) equities. Well if the transaction is to take place, someone has to sell equities to them, and will thus necessarily flow out of equities. And this, by the exact same amount of money. Another way to say this is that supply equals demand, always. To go further, imagine that all this money that the buyers spent on equities was previously in money market funds. When they sold these money market funds, someone had be there to buy them: in the end, no net amount of money whatsoever has left the money markets. What can change though, is the price at which buyers and sellers can agree to make the transaction, which depends on their respective eagerness to hold (or not hold) equities.

Reconciliation of residual income and free cash-flow models

2009-10-21T12:31:00.002+02:00

I wasn't satisfied with the usual method of showing how the residual income model is equivalent to the free cash-flow or dividend discount model (see Ohlson & Juettner-Naworth, 2005). It is a stretch mathematically. So a few months ago, I decided to make my own method, which is now available online at http://ssrn.com/abstract=1492062. Reading advised to finance students and anyone interested in the theory of equity valuation (others will probably find it boring and useless...).

Stock market update

2009-10-15T11:56:00.002+02:00

Here's my analysis of the U.S. stock market. Not having to study anymore for CFA exam or dissertation does leave me with a lot more free time.

First we have very high valuations by historical standards, which imply unrealistic expectations for a recovery in profit margins and revenues (see Bill Hester, as well as various PIMCO commentaries on profit margins in what they call the "New Normal" economic landscape). Thus, long-term returns from buying equities at this level are likely to be low, at best, and this kind of valuations imply a lot of downside potential in case of renewed economic problems.

Second, on the technicals front we have a quite overbought condition (see this and this).

Third, on the economics front, we have an inventory rebuilding growth boost that will probably fade by next spring, and a still-climbing unemployment rate which, together with a wave of Alt-A and Option-ARM mortages problem, imply renewed stress on banks and households.

Fourth, we also have Fed officials becoming more hawkish in the face of a falling dollar.

All in all, not a pretty picture.

I would wait to see deterioration in market internals and breadth before shorting this market though: you don't want to be short a climbing market that is exhibiting Soros reflexivity. Other signs of a top would include: increasing corporate bond yields / CDS spreads, a climbing dollar (hopefully accompanied by a drop in treasury yields), a non-confirmation (divergence) between the Dow Industrials and the Transports, relative underperformance of financial stocks, etc.

On the limitations of the yield curve as a recession predictor

2009-10-15T02:48:00.002+02:00

The yield curve has an amazing track record at predicting U.S. recessions: it basically predicted all of them, giving only a few false signals which still turned out to foresee slowdowns. In the current environment however, its predictive ability may be seriously lowered : Wright's model B tells us we would need to see a yield of 0.7% or less on the ten-year T-Bond to have a recession probability of at least 50%... I would bet we could fall back in a recession without ever getting even close to that yield level. Ask the Japanese.

My GDP forecast...

2009-10-09T18:56:00.008+02:00

... for last year, as computed by the model, called VAR(30), that I am presenting as a Master's Dissertation. Excerpt from the results section, followed by the forecast the model would have made back in December of 2007:

The annual pseudo out-of-sample forecasts (performed as of December of each year) were compared to the (December) Wall Street Journal Economic Forecasting Surveys since 2004. VAR(30) would have been the only one to predict a 2008 recession in December, 2007. Over the short, four year period (2005 through 2008) available for a benchmark, VAR(30) outperforms on average all of the private-sector forecasters polled by the Wall Street Journal. This figure is however skewed to the upside by the 2008 extreme outperformance: excluding the 2008 recession year, the rank falls to the 16th place, out of 42 (only forecasters who provided GDP growth estimates for all of the four years were included in this ranking, and thus there can be survivorship bias in the list). This illustrates the importance of Renshaw’s “right ballpark estimate”. Specifically, VAR(30) ranks 15th out of 59 for the 2005 GDP forecast, 41st out of 59 for 2006, 20th out of 63 for 2007, and 1st out of 54 for 2008.
Also presented are fan charts of each yearly pseudo out-of-sample forecasts made each December. Fan charts represent the 90%, 75% and 50% confidence bands around the central GDP forecast.

(click to enlarge)

Accrued Int on Option ARM recasts

2009-08-27T20:20:00.001+02:00

http://accruedint.blogspot.com/2009/08/smackdown-week-interlude.html

Contradicting McCulley

2009-07-26T16:37:00.003+02:00

It is not a great day for me as I am writing this post which is a rebutal to Paul McCulley, one of the persons from whom I have learned the most. He tends to be too keynesian sometimes, and his last month's commentary is one example:

To be sure, we are presently living in an unusual world, in that the Fed is pegging the Fed funds rate at effectively zero. But it is not stimulating robust demand for credit, or alternatively, it is not stimulating bankers to gin up demand for credit by loosening terms and conditions to prospective borrowers. Actually, reality is probably a bit of both: reluctant borrowers and reluctant lenders.

In my opinion this is completely wrong. The Fed's policies have indeed stimulated robust supply of (risk-free) credit from the bankers and robust demand for credit by the Treasury. I don't have a chart at hand showing of how much of the Treasury's recent borrowing has been financed by the U.S. financial system, but I trust that it's the bulk of it.

Thus, we can categorically say that the near-zero Fed funds rate is not, for the moment, fueling an inflationary pace of aggregate demand growth relative to the economy’s supply potential. And neither is the Fed’s Credit Easing, which is the proximate cause for the explosion of excess reserves in the system. Yes, in the fullness of time, zero Fed funds could conceptually re-ignite borrowers’ and lenders’ mojo. Indeed, that’s precisely the Fed’s objective. And if and when that objective is achieved, the Fed funds rate will need to be hiked to temper the re-ignited mojo, so as to prevent the economy from overheating.

This part is way too keynesian even for McCulley. Kasriel finds a correlation of 0.64 between M2 and inflation, and only 0.08 (!) between the output gap and inflation. Also, look at how inflation flamed up in 1934 while the unemployment rate was in the high teens.

CR: Option Arms

2009-06-14T12:35:00.004+02:00

First post in a long time... CFA exam and all that. From CR:

And here is a repeat of the most recent reset / recast chart from Credit Suisse.

Credit Suisse is using recast dates for Option ARMs and reset dates for all other loans.

As Tanta noted: "Reset" refers to a rate change. "Recast" refers to a payment change.

Resets are not a huge problem as long as interest rates stay low, but recasts could be significant. There are some questions about how the Wells Fargo pick-a-pay portfolio fits into this chart, since Wells Fargo doesn't expect significant recasts until 2012 (see A Bank Is Survived by Its Loans )

Hussman on valuation

2009-05-05T10:27:00.002+02:00

Once again, John Hussman:

What we can observe is that valuations are now in the high-normal range on the basis of normalized earnings. Stocks are no longer undervalued except on measures that assume that profit margins will permanently recover to the highest levels in history (in which case, stocks would still only be moderately undervalued). For instance, the price-to-peak earnings multiple on the S&P 500 is only about 11, but those prior peak earnings from 2007 were based on record profit margins about 50% above historical norms, largely driven by the excessive leverage that has since sent the economy reeling.

On normalized profit margins, valuations are above the historical average, and prospective long-term returns are below the historical average. Overall, I expect the probable total return on the S&P 500 over the coming decade to be about 8% annually, provided we don't observe much additional deleveraging in the economy. At the 1974 and 1982 lows, based on our standard methodology, the S&P 500 was priced to deliver 10-year total returns of about 15% annually. While it has become quite popular to talk about 1974 and 1982, the stock market is presently not even close to those levels of valuation.

So...

2009-04-06T13:52:00.002+02:00

Last month was quite a month (apparently). After FASB changes to mark-to-market rules and the Geithner public partnership plan, you would expect at least a nice rebound in "legacy" (aka toxic) assets. Not so fast:

These are indexes designed to track the prices for non-agency residential mortgage-backed securities. Apparently, the stock market did not pay attention.

Mortgage resets

2009-03-30T13:17:00.002+02:00

From Hussman:

Since this crisis began, the profile of mortgage resets has been well-correlated with subsequent foreclosures. . . .

As the recent housing bubble progressed, the profile of mortgage originations changed, so that at the very peak of the housing bubble, new originations took the form of Alt-As (low or no requirement to document income) and Option-ARMs (teaser rates, with no required principal repayments).
A broader profile of mortgage resets is presented below (though even this chart does not include the full range of adjustable mortgage products).

This reset profile is of great concern, because the majority of resets are still ahead. Moreover, the mortgages to which these resets will apply are primarily those originated late in the housing bubble, at the highest prices, and therefore having the largest probable loss.

Beauty of data-mining...

2009-03-29T12:58:00.003+02:00

...applied to technical analysis:

More on Existing Home Sales

2009-03-24T10:42:00.000+01:00

by CalculatedRisk on 3/23/2009 10:20:00 AM

Here is another way to look at existing homes sales - monthly, Not Seasonally Adjusted (NSA):

This graph shows NSA monthly existing home sales for 2005 through 2009. Sales (NSA) were lower in February 2009 than in February 2008.

Again - a significant percentage of recent sales were foreclosure resales, and although these are real sales, I think existing home sales could fall even further when foreclosure resales start to decline sometime in the future.

The second graph shows inventory by month starting in 2004.

Inventory levels were flat during the bubble, but started increasing at the end of 2005.

Inventory levels increased sharply in 2006 and 2007, but have been below the year ago level for the last seven months. This might indicate that inventory levels are close to the peak for this cycle. Note: there is probably a substantial shadow inventory – homeowners wanting to sell, but waiting for a better market - so existing home inventory levels will probably stay elevated for some time. There is also the possibility of some REOs being held off the market.

It is important to watch inventory levels very carefully. If you look at the 2005 inventory data, instead of staying flat for most of the year (like the previous bubble years), inventory continued to increase all year. That was one of the key signs that led me to call the top in the housing market!

If the trend of declining year-over-year inventory levels continues in 2009 that will be a positive for the housing market. Prices will probably continue to fall until the months of supply reaches more normal levels (in the 6 to 8 month range), and that might take some time.

A large percentage of existing home sales (40% to 45% according to the NAR) are distressed sales: REO sales (foreclosure resales) or short sales. This has created a gap between new and existing sales as shown in the following graph that I've jokingly labeled the "Distressing" gap.

This graph shows existing home sales (left axis through February) and new home sales (right axis through January).

For a number of years the ratio between new and existing home sales was pretty steady. After activity in the housing market peaked in 2005, the ratio changed. This change was caused by distressed sales - in many areas home builders cannot compete with REO sales, and this has pushed down new home sales while keeping existing home sales activity elevated.

I think the keys to watch for the housing market are declining inventory levels, a bottom in new home sales, and the gap between new and existing home sales closing.

Money Supply

2009-03-10T15:30:00.000+01:00

This post is somewhat more edgy than usual. My readers (all three of them) will have to read carefully. Here is an excerpt of an email I sent to Paul Kasriel (Director of Econ research at Northern Trust):

I am writing to you with reference to the latest Econtrarian, in which you explain that a decrease in the amount of stocks that an individual buys as a proportion of its income does not lead to an increase in the money supply since "XYZ’s bank account is debited by the same amount that the employee’s bank account is credited. No new money is created in this process. All that has happened is that the ownership of money has changed".

I can try to extend the argument to the case where an individual sells previously owned stocks and decides to hold the proceeds in her bank account: since there has to be a seller for every buyer, the seller's bank account will decrease by the same amount as the increase in the buyer's account, and so no net new money has been created.

However, I am wondering what you think about the case where someone sells stocks to a foreign buyer (which is likely to have happened in the recent past, as holdings of foreign equities by U.S. investors have decreased significantly). Then, could it be that the U.S. money supply has increased in the process, while matched by an equal decrease in the money supply in the foreign buyers' countries? This could lend support to Asha Bangalore's February 19th argument that "Inflation adjusted money supply is advancing because currency, demand and saving deposits have risen sharply. At the same time, bank lending has contracted", which otherwise would be at odds with your view.

And here is his answer:

Unless the foreign buyer borrowed dollars to purchase the dollar-denominated stock or bond, there is no increase in the U.S. money supply. If no borrowing occurred, then the foreign buyer would have to purchase dollars in the forex market to pay for the stock/bond purchase, which, again, just changes the ownership of dollars but does not increase the supply. The foreign purchaser of stocks/bonds presumably purchases the dollars with her own currency, which changes the ownership of that currency.

I have to admit that I am perplexed as to why the U.S. money supply, excluding currency and retail money market shares, is increasing as rapidly as it is when bank credit and bank assets are declining. Assets equal liabilities plus net worth. With commercial bank assets declining in recent weeks (assets soared back in October due to JP Morgan's assumption of WAMU, a savings & loan), then liabilities plus net worth also must be declining. If net worth and other liabilities are declining, then it would be possible for deposits to be rising even though total assets are falling. The data indicate that this is what is happening. But I still do not understand the process by which this is occurring. I am skeptical that advances in the money supply are as "stimulative" as otherwise when bank assets and bank credit are contracting.

Paul

If anyone believes they can contribute to the discussion, feel free to do so.

Gross' keynesian framework starting to show its limits

2009-03-07T21:22:00.000+01:00

Although I have an immense respect for Bill Gross (for both his accomplishments and his thinking), I have always thought he was a bit too keynesian for my taste. Now it looks like the model is being stretched (emphasis are mine):

Trillions will be required in the U.S. alone and it is critical that there be a high degree of policy coordination among all nations, which avoids protectionist measures reflective of failed policies in the 1930s. To date, PIMCO’s Mohamed El-Erian’s imperative of “shock and awe” has been more like “don’t bother us, we’re working on it.” Get moving. Risk being bold – Washington.

(...) Global willingness to accept American dollars is being tested. Granted, the U.S. currency has appreciated strongly against its counterparts during most of this crisis, but technical short covering as opposed to a flight to quality may have been the dominant consideration. Watch the dollar. If it falls hard, there may be nothing policymakers can do to restore the ensuing financial chaos.

http://www.pimco.com/LeftNav/Featured+Market+Commentary/IO/2009/Investment+Outlook+Bill+Gross+March+2009+Hairy+Lips+Sink+Ships.htm

More Russell

2009-03-06T12:03:00.000+01:00

On July 8, 1932, the Dow sunk to its final bear market low of 41.22.

As soon as the Dow passed that low, volume on the NYSE suddenly soared to 4-5-6 million shares as the market surged higher. A new bull market had started amid the Great Depression. At that time, nobody had any money. The nation was broke. And yet when the market following July 8 turned from bear to bull, volume exploded. The market in its amazing wisdom, immediately recognized the turn. And from a "broke America," money poured into Wall Street as volume on the NYSE surged. I always wondered where that money came from -- wasn't it remarkable -- and it is a lesson I'll never forgot. When the price is right, the money will be there.

Richard Russell

2009-02-27T00:35:00.000+01:00

Which is why I've recommended gold coins. In a funny way, once you buy some coins you are stuck with them. It's so much trouble to buy the coins, that once you buy them and take physical delivery, you tend to sit with them. It's even more trouble to sell the coins so again -- you sit with them. Over time, those who bought the coins and have sat with them -- have done best in the gold bull market. They never traded in and out of the bull market, and they necessarily stayed with the great primary bull trend in gold. In other words, by "doing nothing" they did well.

I'm glad to be able to say "they" applies to me.

Another outstanding piece by PIMCO. Shocker.

2009-02-23T20:28:00.000+01:00

Koyo Ozeki | January 2009

Outlook for Global Finance: The Evolving Crisis and Japan’s Experience

Soros a tendance à mélanger ses opinions politiques et ses prévisions...

2009-02-23T20:18:00.000+01:00

NEW YORK (Reuters) - Renowned investor George Soros said on Friday the world financial system has effectively disintegrated, adding that there is yet no prospect of a near-term resolution to the crisis.

Soros said the turbulence is actually more severe than during the Great Depression, comparing the current situation to the demise of the Soviet Union.

He said the bankruptcy of Lehman Brothers in September marked a turning point in the functioning of the market system.

"We witnessed the collapse of the financial system," Soros said at a Columbia University dinner. "It was placed on life support, and it's still on life support. There's no sign that we are anywhere near a bottom."
http://www.reuters.com/article/email/idUSTRE51K0A920090221

C'est la pire crise depuis des décennies, plus rien ne sera pareil, etc... tout le monde le sait. De là à comparer avec la chute de l'URSS... il reste quand même 80% de l'économie mondiale qui est productive. D'accord il y a encore de nombreux dominos qui vont tomber, par exemple on entend beaucoup parler des filiales des banques ouest-européennes en Europe de l'est (en général les choses arrivent avant que les journaux en parlent). Malgré ça il ne faut pas sous-estimer le pouvoir de relance de dépenses publiques (mondiales) astronomiques, qui plus est financées par la planche à billet (ce qui aura ses conséquences mais c'est un problème pour 2011-2012). Il manque encore un dernier ingrédient qui est la restructuration des bilans des ménages US (seulement 75 milliards, il en faudrait dans les 500). Cela faisait partie du plan de Bernanke en... 2007, mais apparement la pillule à du mal à passer:

http://www.youtube.com/watch?v=zp-Jw-5Kx8k

Frankel: Is $800 Billion Too Big or Too Small? Yes.

2009-02-14T13:13:00.000+01:00

http://content.ksg.harvard.edu/blog/jeff_frankels_weblog/2009/02/13/is-800-billion-too-big-or-too-small-yes/