Saturday, November 21, 2015

Japan, Europe and mainstream monetary theory are out of gas

When a sailor hits a dead spot where the wind refuses to blow he cays he is “in irons.” Japan’s economy sailed into the irons this past quarter when its GDP declined for the second quarter in a row and officially signaled a recession. GDP fell 0.8% in the third quarter after shrinking 0.7% in the second on an annualized basis. This marks the fourth recession Japan has endured since the global crisis hit in 2008.

Following so soon on the heels of massive stimulus, the recession should strike a death blow to mainstream monetary theory. Abenomics, the economic recovery plan that Prime Minister Shinzo Abe launched in 2012, was the poster child for mainstream monetary theory. Japan would wash away deflation and decline with a torrent of new money.

Thursday, November 12, 2015

Debt service burden signals downturn

Investors can never have too many omens of disaster and the Bank for International Settlements has given us a new one to watch for signs of impending recessions - the corporate debt service burden.

Authors Mathias Drehmann and Mikael Juselius first wrote about it in their article "Do debt service costs affect macroeconomic and financial stability?" published in the BIS Quarterly Review September 2012. They summarized their findings this way:

"We find that the DSR prior to economic slumps is related to the size of the subsequent output losses. Moreover, the DSR provides a very accurate early warning signal of impending systemic banking crises at horizons of up to one to two years in advance."

Sunday, November 8, 2015

How GDP fools economists

Economists look to GDP to determine if the US economy is in a recession. Generally, it takes two quarters of the economy shrinking (economists call it negative growth, but they’re linguistically challenged) for the National Bureau of Economic Research to declare a recession. Of course, those two quarters indicate the bottom of the recession, by definition.

Thursday, October 29, 2015

The market outruns profits

I created a new model of the S&P500 that incorporates more variables and some nonlinear action. The chart at the left shows the results. The blue line represents the quarterly averages of the S&P 500 while the red shows quarterly averages produced by the model, the last three quarters of which are forecasts. The data analyzes quarterly averages because profit data is reported quarterly by the Bureau of Economic Analysis.

The model uses data back to 1948, and as the reader can see the value of the market has run ahead of where it should be in proportion to the growth in profits. Something similar happened in the bubble of 2000 but to a greater degree. Obviously, the market can deviate from valuations justified by profits for a very long time if people are confident, less risk averse, and willing to drive PE ratios higher.

The market could continue to rise through the holiday season if investors become convinced that the Fed will not raise interest rates due to poor economic data. And if the data become bad enough, investors might expect more rounds of quantitative easing in which the Fed pumps dollars into the economy by purchasing bonds from banks, or as I wrote last week, introduces the US to negative interest rates.

I don't expect profits to rise enough to justify the high valuations in the market since profits have been at record levels and are declining in the current reporting season. According the WSJ:
Profit and revenue are falling in tandem for the first time in six years, with a third of S&P 500 companies reporting so far. 
 Historically, profits continue to fall once they have climbed to record heights and start descending. The most likely scenario is that the market will fall to valuations more in line with falling profits.

Thursday, October 22, 2015

Fed shuffles from ZIRP to NIRP

Inflation is fading; the economies of Asia, South America and Europe are collapsing; the people have tasked the central banks with fixing all things economic. Yet, reports by Fed economists show that the recent rounds of money printing through QE and low interest rates for six haven’t had the intended effect. They have certainly failed in Japan and the Big EZ (Euro Zone). What can they do to turn the world’s economies around? The answer from mainstream economists at the world’s central banks is more of the same. But if continuing to do the same thing while expecting different results is a sign of insanity?

Thursday, October 15, 2015

Target date funds need good vibrations

Another fad in investing, like “smart” beta, is target date funds that allocate assets in an investor’s portfolio by the investor’s age. Target date funds follow an ancient concept: put most of your money, say 90%, in the stock market while you’re young because you’ll have the time to recover from market collapses. But as you get older you have less time to recover so you reallocate to bonds and cash while keeping just half your funds in the market. In the past, most advisers recommended getting completely out of stocks and into bonds, but the ridiculously low returns on bonds has forced older people to take greater risks and stay in the stock market longer.

Wednesday, October 7, 2015

Good management makes for great investing

Investors with the time will want to imitate Warren Buffet and invest in a few good companies rather than put up with a host of losers in an index fund, but analyzing individual companies in the way that Ben Graham taught is time consuming. Several experts have developed algorithms that examine financial data that helps weed out the worst.

But if an investor is going to marry a business he must become familiar with the quality of its management. Good management can turn a bad company around and value investors often want to buy shares in a company when it has hit rock bottom and has the potential to turn around.