Tuesday, November 18, 2014

Abenomics' big fail and the sinking of the rising sun

Economists predicted a 2.25% gain in Japan’s GDP after the 7.3% fall in the second quarter. As usual, they missed it again. Japanese GDP fell 1.6% last quarter according to initial estimates. Mainstream economics’ theory of business cycles states that such downturns in the economy are random events, shocks to equilibrium. As the London School of Economics told the Queen, they had successfully predicted that no one can predict the onset of the worst recession since the great one. Still, they crank out GDP forecasts as if they could predict a recession. They irony is huge, but apparently unnoticed by most of the profession.

However, the most important part of the story was that Prime Minister Abe has been conducting a major monetary policy experiment. He promised to boost nominal GDP and achieve a minimum inflation of 2% by printing as much money as was necessary. No limits. Paleo-Keynesians like Paul Krugman were giddy. 

Abe also promised to reduce the deficit through tax increases and reform the structure of the economy. Partly as a result, the Japanese stock market climbed 55% and the value of the Yen fell 25% in 2013.

Wednesday, November 12, 2014


I recently finished Meban Faber's book, Global Value: How to Spot Bubbles, Avoid Market Crashes, and Earn Big Returns in the Stock Market, and found it to agree very well with the ABCT Investing philosophy. Faber is a co-founder and Chief Investment Office of Cambria Investment Management.

Faber aimed his book at the majority of individual investors who try to time the stock market on their own. Studies of the flow of money into and out of mutual funds prove that most individual investors wait to enter the stock market until it has reached the peak of a cycle and then sell when it is near the bottom of a collapse. In spite of this, most people think they are good investors. It's all part of the syndrome in which most people think they are better looking and more intelligent than average.

Wednesday, November 5, 2014

Burned by Bonds

Austrian economists can get forecasts wrong, occasionally. Many were wrong about inflation when the Fed stuffed its balance sheet with junk bonds. Inflation has remained asleep except in asset markets. That wrong forecast gave some of us a jaundiced outlook for bonds. The reasoning went that higher inflation and a greater demand for loans would force interest rates higher in 2014, and when interest rates rise the price of bonds fall. Also, the Fed was trying to go sober after multiple shots of QE. So I stayed away from bonds this year because the fall in value would erase all of the benefits from the interest earned. As a result I missed out on a great opportunity.
While most of the world was fixated on the choppy stock market, bonds were as stealthy as 007 while soaring. The October 20 Wall Street Journal (page C1) reported that the Wasatch-Hoisington U.S. Treasury Fund earned 28% for investors this year. Lacy Hunt, the fund’s chief economist, said, “I don’t think the Fed is going to raise rates. All they can do is hold rates here for longer and longer time periods.”
So where did Austrians go wrong? First, they didn’t take Hayek and Mises seriously when they warned against assuming the quantity theory of money works mechanically.  The monetarist Milton Friedman influenced too many Austrian economists. The quantity theory states that increases in the money supply will lead to consumer price inflation. That is always true, ceteris paribus, but things are never ceteris, let alone parabus. Many things can break the link between increases in the money supply and prices. Most importantly, we should temper our expectations of the quantity theory with the subjective theory of value. As Mises wrote, people may not always respond to increases in the money supply in the same way. That is the principle of subjectivism applied to money, something Mises is most famous for.

Wednesday, October 29, 2014

Aggregate Blindness

Peering at the economy through macroeconomics aggregates will blind economists. Gavyn Davies offers an example in a recent post in FT.com:

There have been downward revisions to GDP forecasts in the euro area, but these have been offset by slight upward revisions in the US and recently even in China. The latest nowcasts for global activity have remained firm, and data surprises in the world as a whole have been close to flat for several months.
 Maybe the slowdown in the euro area has increased the perceived risk of recessions returning to other parts of the world, but there has been no general downward revision to central projections for global GDP. In fact, J.P. Morgan’s team of economists, which tracks global activity data extremely carefully, said on Friday that signs of above trend global GDP growth were beginning to emerge. Markets have clearly been out of synch with the flow of information in this regard.
 I’m going to pick on Davies here not because he is a bad economist. He is one of the best mainstream economists I know and I read his columns regularly for his insights into mainstream monetary policy. I’m picking on him because his post well represents mainstream thinking on business cycles.

First, anyone who has tracked the accuracy of mainstream forecasts of GDP knows how inaccurate they are. They are very good at predicting the GDP for the next quarter, but forecasts farther out in time or when the next quarter shows a decline in GDP at the bottom of a recession, mainstream GDP forecasts are totally worthless. They’re worse than worthless because when people take them seriously, as Davies has, they become dangerous. How many predicted the major drop in GDP in the first quarter this year?

Mainstream economists have failed for a century to predict a single recession. So why would anyone expect them to be able to now?  In fact, the mainstream definition of recessions is that they are random events. So looking at GDP forecasts to try to see them coming is by definition futile.

Second, a decline in GDP is the mark of the end of the recession as defined by the National Bureau of Economic Research. Even if mainstream economists could correctly predict a decline in GDP in the next quarter, they would only be telling us that the recession is almost over.

Of course, Austrian economists can’t predict the quarter that recessions begin or end, either. The difference is that Austrians know that recessions aren’t random events but are caused by central bank manipulation of interest rates. So we look for omens that portend the end of expansions. And we have no confidence in the GDP forecasts.

Mainstream blindness to recessions happens because mainstream economists fixate on aggregate data, such as GDP, and high levels of aggregation hide important changes in the economy. Think about it. In recessions not every business in the nation fails. Actually only a few fail. If GDP contracts by say 3%, the economy is still 97% as good as it was the year before. Yet economists consider a 3% decline in GDP a really bad thing because of the damage it does through unemployment.

But let’s look at employment figures. In the latest recession unemployment climbed to 10%, but 90% of workers were still employed. And if job creation falls to say 100,000 per month, that is a net figure. The economy has created two million jobs that month while losing 900,000.

Recessions are similar. A few industries will do poorly while most will plug along. The recession happens mostly in capital goods industries and to a lesser degree among consumer goods makers.

Some mainstream economists who want to criticize the ABCT will attempt it using aggregate data. For example, they might look at all capital equipment makers together. But the ABCT never claims that all capital goods makers rise and fall together. It’s difficult to predict which capital goods industries will suffer the most. In the recession of 1991 the fiber optic cable industry had the most bad investments. In 2000 it was internet and software. In 2008 it was real estate and autos. If economists only look at aggregate data they will completely miss those features.

Mainstream economists are like house inspectors who drive by and if the house is still standing they declare it to be of sound construction. Austrian economists, taking a micro approach, inspect for termites.

So why is this important to investors? It’s important because long before mainstream economists recognize a recession the market will have crashed. A stock market crash is one of the better leading indicators of a looming recession. Mainstream economists will laugh and say the stock market has predicted 10 of the last 8 recessions. But they fail to see that the market has a better forecasting records than they do.

If investors want to protect their savings, they will ignore the sunny predictions of mainstream economists and look for termites in the economy.

Wednesday, October 22, 2014

The View Through Copper Colored Glasses

If you own a sailboat you know that copper infused paint protects the hull of your boat from barnacles. Plumbers like copper because it kills bacteria. Copper may also be good for your portfolio. To understand why, we need to keep in mind the method the National Bureau of Economic Research uses to define recessions.
The NBER waits until after GDP falls for two consecutive quarters. The lowest quarter becomes the bottom or end of the recession. The next quarter is the beginning of the recovery. Then the NBER gnomes crawl backwards through the data to find the most recent peak of GDP growth. The quarter after marks the beginning of the recession. So we don’t officially learn that we are in a recession until the recovery starts, sometimes 18 months after the recession has begun.

Thursday, October 16, 2014

Pundits Practice Post Hoc

The mainstream media rounds up the usual suspects when trying to explain the latest stumble from the stock market. One expert had this to say:

Many factors have conspired to increase market volatility and push stocks lower over the last several weeks. Chief among them have been nervousness over the timing of Federal Reserve (Fed) interest rate increases, worries over the outlook for the Chinese and eurozone economies, the escalating Ebola epidemic in Africa, and rising geopolitical instability—particularly in the Middle East.
Others add the collapse in oil prices or commodities in general, global warming or just plain irrational fear. Technical analysts will cite the S&P 500 falling below the 200 day moving average or another favorite indicator, but that doesn’t explain why it fell through the glass barrier. Most of these are merely examples of the post hoc fallacy in which people notice that one event followed another and concluded that the earlier event must be the cause of the later one. An obvious example is attributing the rising of the sun to the crowing of a rooster.

Thursday, October 9, 2014

Cover Your Assets

The market isn’t likely to go much higher the rest of this year because as the last post showed it has already out distanced profits by quite a bit. So unless profits improve dramatically, the best an investor can hope for is a flat market with the potential for a major drop. But what if the market does reach higher levels and sets new records as it has several times this year?

Covered calls are great tools for situations like this. A covered call is a strategy for an investor in which he sells or writes call options in the stocks he owns. By selling a call option, the investor is selling to another investor the right to purchase the stock the seller owns at the strike price. The strike price should be higher than the price of the stock at the time of the sale of the option, or what is known as an out-of-the-money (OTM) strike price.

The strategy produces a win/win situation for the seller of the option when the market has risen to nose bleed heights. If the market remains flat, the seller of the option keeps the premium. If the market falls, the premium replaces the lost value of the stocks and gives the investor time to sell.