Popping Bubbles

Mainstream economists buried the business cycle in the last decade of the 20^th century. Having discovered that pronouncement of its death to be premature in 2008, they have suddenly rediscovered asset markets and cast them in the role of villain in the business cycle melodrama. They think that the popping of asset bubbles triggers recessions so they have been searching for ways to identify bubbles in fetus stage and abort them.

Last week Bloomberg featured an article about Finnish economist Katja Taipalus and her model for detecting asset market bubbles which she explains in her paper, “Detecting asset price bubbles with time-series methods.” Boiling down the 217 page paper to its essentials, she is trying to determine when stock market and housing prices diverge from their “fundamental” value.

Along with most mainstream economists she errs in thinking that assets have an objective value determined by the net present value (NPV) of future income. However, as Austrian economists know there is no objective NPV. Earnings forecasts and the discount rate used to calculate NPV are subjective. Future earnings will vary depending on the optimism of the forecaster. The discount rate changes according to each forecaster’s tolerance for risk.

Taipalus’ model uses the log of the yield of a stock market index to identify bubbles. If the yield falls at a rate set by her test statistics, then the model signals a bubble alarm. Tests of the model show that collapses in asset prices follow within a year of the alarm and recessions follow the collapse.

Experienced investors know that dividend yield is the inverse of the price-earnings (PE) ratio if all profits were distributed as dividends. Yield is E/P whereas price-earnings is P/E. So yield can fall if prices rise faster than earnings and yield will rise if prices rise slower than earnings. Economists love dividend yields for some reason while most investors tend to follow PE, but they tell us essentially the same story.

How to pick stocks

The Austrian business cycle theory suggest that investors buy stocks in the capital goods sector, or cyclical stocks, in the early years of an expansion and switch to consumer goods makers in the later years. Investors can do that easily with exchange traded funds (ETF) which cluster stocks in a dizzying array of industries, commodities and countries. For example, one of the better known tech stock ETFs is QQQ, which contains the stocks of a lot of capital goods companies.

But as happens with any grouping of large numbers of companies, most will be dogs. Only a few will be excellent companies whose profits grow well and whose stock prices reflect that growth. Most of the members of the ETF will act like an anchor on the value of the ETF. The only solution is to buy individual stocks, but analyzing thousands of individual companies takes more time than most part time investors enjoy.

Five years after Lehman - Jobless Recovery Explained

Like a calf staring at a new gate, mainstream economists are mystified at the unemployment data that has given the US a jobless recovery for the past four years, five years after the collapse of Lehman Brothers.  Creative manipulation of the money supply by the Fed, massive bailouts of banks and other corporations, and historic federal spending have failed to lift aggregate demand. Why? Because all aggregate demand isn’t the problem.

Aggregate demand in mainstream economics has two sides, consumer spending and business spending, or investment. Mainstream economists forget that definition of demand. Also, they think that consumer spending drives aggregate demand because it makes up about 70% of GDP. However, GDP leads them astray because of the highly stylized and weird way it calculates business revenues. In reality, it is net domestic product, not gross, but that is a different post.
Austrian economics demonstrates that the investment side of aggregate demand does the driving, not the consumer side. Economist Robert Higgs uses net domestic investment to explain the jobless recovery in a recent article “The Sluggish Recovery of Real Net Domestic Private Business Investment"The Sluggish Recovery of Real Net Domestic Private Business Investment.”

“From these data, I have constructed the following index of real net domestic private business investment from 2005 to 2012, where the 2007 value equals 100:”

2005	81
2006	98
2007	100
2008	68
2009	26
2010	20
2011	36
2012	59

Foxhole conversions

There are no atheists in foxholes is an old saying meant to express what crisis will do to one's thinking. The recent crisis has encouraged many mainstream economists to look at what is wrong with their theories that prevented them from seeing the crisis coming. As a result, prominent mainstream economists have begun incorporating at least parts of the Austrian business cycle theory in their work.

 Coordination Problem discussed a recently published paper by Guillermo Calvo of Columbia University and the National Bureau of Economic Research, “Puzzling over the Anatomy of Crises: Liquidity and the Veil of Finance.” Calvo wrote the following:

“Critical Puzzle 1. There is a growing empirical literature purporting to show that financial crises are preceded by credit booms (Mendoza and Terrones (2008), Schularik and Taylor (2012), Agosin and Huaita (2012), Borio (2012)). This was a central theme in the Austrian School of Economics (see Hayek (2008), Mises (1952))...”

What is ABCT Investing?

Almost everyone has a blog today, so why would I bother to add my teaspoon to the deluge? I did so because I found a hole in conventional investing wisdom which I think needs plugging. I’m not the little Dutch boy who stuck his finger in the hole in the dam and saved the village below. But I think I have a perspective on investing that few others share and which could help people rescue their nest eggs from tragedy.

Stock Market Forecast

“"It is difficult to make predictions, especially about the future,” said Mark Twain.

But, investors have no choice but to attempt to forecast the stock market. Ludwig von Mises wrote,

"Like every acting man, the entrepreneur is always a speculator. He deals with the uncertain conditions of the future. His success or failure depends on the correctness of his anticipation of uncertain events. If he fails in his understanding of things to come, he is doomed. The only source from which an entrepreneur's profits stem is his ability to anticipate better than other people the future demand of the consumers. "[1]

The investor is the entrepreneur and must forecast future prices of stock, even if only to adjust his allocation of funds between stocks, bonds and cash.

Here is my lasted forecast of the S&P 500 for the next two quarters. The upper and lower lines are the upper and lower ranges of the prediction interval, that is, where the model predicts the S&P 500 will be. The middle, blue line is the historical value of the index.