Brick and mortar retail is falling down

Brick and mortar retail is dying according to many reports. Here’s an example:

American retailers are closing stores at the fastest pace ever.

Roughly 10% of mall retail space - or 1 billion square feet - is on the verge of being closed, having rents slashed or transformed into something else. And in March, retailers cut 30,000 jobs, the same as in February.

It was the worst two-month span of job cuts for the sector since 2009 - during the depths of the Great Recession!

This year, as many as 8,640 total stores may close - which would outpace the 6,200 closed in 2008.

And as I've pointed out for years, it's because the companies failed to adapt. They were slow to recognize the changing tides and are now being destroyed by a single company... Amazon .”

Caterpillar needed the Austrian business-cycle theory

Caterpillar is facing its fourth year of declining sales, the longest in its history. It expects total revenue this year to be 39% below its peak in 2012 and profits will be down 68%. Its stock is now 25% below its peak. Through the first six months of 2016, the company’s overall revenue was down 21% from the same period in last year.

CEO Doug Oberhelman is stepping down, but when he took the reins in 2010 the world, especially China, couldn’t get enough metals. Prices were soaring and everyone thought the good times would last. That’s the first mistake most investors and businessmen make – linear forecasting instead of thinking in terms of cycles. Oberhelman should have understood cycles after working for Caterpillar for 35 years. The capital goods sector is the most volatile in the business cycle. But he didn’t understand them. Caterpillar’s problems began when it invested heavily at the peak of a cycle according to an article in the Wall Street Journal:

Sector rotation confirms ABCT

Mark Skousen in his excellent economics text, The Structure of Production, shows that professions on the front line such as accountants and investing experts, follow the Austrian business-cycle theory (ABCT) often without know it. Schwab confirmed that in March of this year with a chart titled “The Business Cycle: How Does Each Sector Perform.”

The chart divides the business cycle into four segments – early expansion, maturing expansion, late expansion and recession – and shows which sectors perform the best in each segment of the cycle. I do something similar in Financial Bull Riding but use segments of the cycle described by Lord Overton in the mid-1800s.

The first Austrian economist - Washington Irving

Washington Irving is best known for his short stories "The Legend of Sleepy Hollow" and "Rip Van Winkle," but he also wrote many essays. Before he lived by the pen he was a business man and one essay proves that he was a good economist as well. He wrote about the Mississippi Bubble in France of the 1720’s which he published as part of the “Crayon Papers” essays.

At the time Irving wrote this essay, in the 1820’s, there were no good business cycle theories. The most common ideas blamed a shortage of money (gold or silver) or a general overproduction. Say, the French economist, distilled his famous law as part of an effort to debunk the overproduction theory. The Manchester school in England didn’t attempt its explanation until the middle of the nineteenth century and of course Mises didn’t put it all together until early in the twentieth century. Somehow, Washington Irving figured out the essence of the Austrian business cycle theory long before.

Watch out for falling productivity

The government reported recently that productivity in the US rose 1.3% from the last quarter, but that was little comfort to the Maestro, Alan Greenspan, who is worried about the collapse in productivity. Investors should be worried as well. StreetInsider.com reported Greenspan saying:

I think it's the most serious problem that confronts not only the United States but the world at large and more exactly the developed world especially. American productivity is not significantly different from zero growth in the last 6 or 8 quarters. And the cause of that, if you work backwards through the causative chain is capital investment has been inadequate to fund the amount of assets that you need.

The interviewer, Tom Keene responded with “There was a moment when we were bewildered by why nation's productivity was so good and America running on all cylinders. It is a distant memory.”

Why has productivity fallen and what does it mean? The answer lies in Hayek’s Ricardo Effect. Profits in consumer goods sectors will peak near the end of the expansion phase of a business cycle. Profits rise because investment in capital goods sectors has increased employment, and therefore demand for consumer goods before new consumer goods arrive on the market. Prices and profits rise in step.

Car sales are bad news

The worst recessions in history have all followed excessive investment in housing, personal transportation and the stock market. Today, the US is hitting two out of three. Take a look at the auto sales graph below. US sales have reached pre-recession levels.

You can see one of the reasons for the high sales volume in the next chart. Interest rates on auto loans are lower today than during the crisis. Auto loans seem to have replaced lagging real estate loans for banks.

Why the Fed won't raise rates

The VIX (volatility index) is in a coma, so most investors are dozing while danger signs about the current stock market pop up. The idea that the Fed causes recessions by raising interest rates has relaxed many investors. Some writers have assured nervous investors that it won’t be until the Fed’s third rate increase that the market will respond.

In this previous post, I used Hayek’s Ricardo Effect to explain that recessions can happen without rising interest rates. Now, Hoisington Investment management adds support for Hayek from a different perspective. In the Quarterly Review and Outlook for the first quarter of this year, Hoisington wrote about the financial histories of nations with over-indebted economies. That history goes back two thousand years, but the US has suffered through four such seizures in the 1830-40s, 1860-70s, 1920-30s and the past two decades. The report offers six characteristics of excessive debt:

Bitcoin won't save us

Libertarians have waxed poetic about bitcoin for years. It pokes a finger in the eye of the state by breaking the state’s monopoly on money and rescues citizens from a rapidly eroding dollar. But aside from the block chain innovation and its potential use in other industries, I can’t get excited about bitcoin. Other than symbolic, what advantage does bitcoin offer?

Say you produce oil field equipment in Tulsa and made a big sale to a production company in Marrakech, Morocco and to make the sale you offered them 90 days of credit. Also, you’re local sales rep made the deal in Moroccan dirhams. So you’re worried that in the 90 days before you get paid that the value of the dirham will depreciate against the dollar (that is, it will buy fewer dollars) and you’ll lose money on the deal.

China's slow growth omen

Reading the daily economic news in hopes of navigating our location in the business cycle reminds me of ancient priests trying to discern the movements of the gods by examining the contours of the liver of a sacrificed goat. Even the ancients priests understood that the more omens they could combine the better their predictions would be.

Another omen appeared this week when China announced that official China Federation of Logistics’ January purchasing managers’ index (PMI) slid to 49.8 from 50.1. The HSBC and Markit private sector PMI also fell from 49.8 to 49.7. Indexes like these are designed so that any outcome below 50 indicates contraction in the sector. In the worldwide division of capital, China is primarily a consumer goods manufacturing nation that supplies the US and the Big EZ (Euro Zone), which are the world’s largest manufacturers of producer and capital goods.

The Austrian Business-Cycle Theory (ABCT) at its simplest divides economies into raw materials, producer goods and consumer goods. Hayek’s version, employing the Ricardo Effect, says the turning point in an expansion comes when spending on consumer goods increases and the greater profits cause consumer goods makers to stop buying new equipment. That generates a profit crisis among producers goods manufacturers who begin to reduce employment and the recessions begins. The large jump in GDP, which mostly measures sales of consumer goods, in the third quarter was an omen of bad things to come from the producer goods sector. Sales of consumer goods (GDP) fall when enough workers in the producer goods sectors have lost their jobs.

BIS Pushes ABCT Draws Fire

ABCT investing offers financial advise derived from the Austrian business-cycle theory, so to be confident in that advise investors need to be confident in the theory. The most visible institution promoting the theory today is the Bank for International Settlements (BIS). The BIS is the central bank for central banks based in Basel, Switzerland. Just as the Fed in the US coordinates the exchange of funds for commercial banks, the BIS acts as a clearinghouse that coordinates the international transfer of funds between the central banks of nations. 

Claudio Borio and William White of the BIS have used the ABCT for years to analyze events and create policy. Recently, the bank created a minor storm in the world of economics and central bank policy with the release of its 84th annual report. The report asserts that the loose monetary policies of the world's central banks as well as fiscal policies of governments have failed and continuation of those policies will prove harmful. Mainstream economists trashed the report. Martin Wolf of the Financial Times descended to juvenile language. Gavyn Davies, also of the FT,  wrote of the report,

The Bank for International Settlements (BIS) caused a splash last weekend with an annual report that spelled out in detail why it disagrees with central elements of the strategy currently being adopted by its members, the major national central banks. On Wednesday, Fed Chair Janet Yellen mounted a strident defence of that strategy in her speech on “Monetary Policy and Financial Stability”. She could have been speaking for any of the major four central banks, all of which are adopting basically the same approach.

The Dao of Investing - It's time to sell

I recently finished Mark Spitznagel’s book The Dao of Capital: Austrian Investing in a Distorted World and highly recommend it. Spitznagel is the founder and President of Universa Investments, which specialized in equity tail-hedging, or as the book jacket says, “profiting from extreme stock market losses.”

The author began his career trading in the futures bond pits at the Chicago Board of Trade and works closely with the Black Swan, Nassim Talib. At one point he was head of proprietary trading at Morgan Stanley.

Nuts and bolts trading advice doesn't begin until chapter nine of ten. I recommend reading those chapters first so that the reader won’t hurry through the very interesting preceding eight chapters trying to get to the caramel nugget at the center.

He begins with the Chinese philosophy of Dao because Murray Rothbard once wrote that the Daoists were the first Austrian style thinkers. That may be so, but in a forthcoming book I show that Moses created the first libertarian society and laissez-faire economy, which makes him very Austrian. 

Spitznagel divides his Austrian investing into sections I & II. Investing I is about timing the market. In Financial Bull Riding I recommended that investors pay attention to reports of historically high profits as precursors to a crash. Investors should abandon the stock market before profits collapse and then re-enter in the depths of a recession. Spitznagel offers another tool that he calls the Misesian Stationarity (MS) index.

“...the MS index is very well represented by what is known as the (Tobin’s) Equity Q ratio – Total U.S. corporate equity divided by total U.S. corporate net worth – which is readily available online through numerous sources...”

The basic idea behind the MS index is that Fed monetary policy distorts the economy and thereby the prices of stocks until the distortion can continue no longer, at which point the market collapses. The author tested what might have happened to an investor who sold when the index rose above 1.6 and bought when it fell below 0.7. He bought treasury bills each time he sold out of the market. His hypothetical portfolio outperformed the S&P 500 by more than 2% per year from 1900 through 2012.

Over say 30 years, even such a small outperformance would mean a huge increase in total dollars returns, but keep in mind that by avoiding the major collapses in the market, hedge funds that underperform the S&P 500 still can almost double actual dollar returns to investors. I go into more detail in Financial Bull Riding about this seeming contradiction.

Next, Spitznagel performs a hypothetical “tail hedge strategy” on the same portfolio.  Instead of selling out at high MS index values, he  bought 2-month ahead out-of-the-money puts as insurance against a stock market collapse. As before, he divided returns according the level of the MS index at the start of each one year period. The resulting increase in returns was even more impressive:

“When the MS index is in the upper quartile (as it is as I write), there has been an approximate 4 percentage-point outperformance of the Austrian Investing I strategy (or a tail hedged index portfolio) over only owning the index (an outperformance that fades as the starting MS index level falls).”

At the time Spitznagel wrote the book the MS Index was above the sell signal and has only gone higher since.

Spitznagel’s strategy doesn’t end with timing the market. The Austrian school suggests advice for picking individual companies instead of owning an index and Spitznagel employs that in Austrian Investing II, which also has two parts:

1.       Pick stocks of companies with high returns on invested capital (ROIC), “...best calculated by dividing a company’s EBIT (operating earnings before interest and tax expenses are deducted) by its invested capital (the operating capital required to generate that EBIT).

2.       Buy stocks of companies with low Faustmann ratios, “...meaning a low market capitalization (of common equity) over net worth (or invested capital plus cash minus debt and preferred equity) ratio.”

The author explains the rationale behind part 1:

“On theoretical grounds, we expect a firm with high ROIC to remain in such standing, as its managers will continue to reinvest in the firm (why wouldn’t they?), and this will only further solidify their positions of competitive advantage.”

“The data match up with our theoretical deduction. It turns out that high ROICs have been sustainable... we see that the Siegfrieds...- defined as firms realizing 75 percent or higher ROIC at the start of each 10-year period – have tended to persist as Siegfrieds – or have retained their elevated ROIC by the end of each 10-year period.”

From 1978 to 2012 the Siegfrieds returned avg 25% annually while the S&P returned 11%.

Investors who grasps the main principles of Austrian economics and especially the Austrian business-cycle theory will not only earn much higher returns on their investments, they will be able to sleep better because they understand how the stock market works and know they are not taking large risks with their funds. Of course, I’m using “risk” in the Austrian sense of uncertainty and not the mainstream economics definition of just volatility.

PS: That the MS Index shows that investors should have exited the market in 2012 shows that investors need to be willing to be wrong for a couple of years and be OK with that. Spitznagel proves that in the long run investors will make more money by following the Index and being wrong for a few years. But that takes a special kind of personality. 

Recession without rising rates?

Can a recession, and the simultaneous meltdown of the stock market, happen without the Fed raising rates? Hayek wrote Prices, Interest and Investment to show that it could and he used Ricardo Effect as the principle to demonstrate it. 

When I decided to teach an intro class in economics at a small private college, I worried about delivering mainstream economics when I had become convinced of the Austrian approach after earning an MA in managerial economics at the University of Oklahoma. But as I taught I realized that mainstream economics textbooks teach a lot of Austrian economics; mainstream economists just don’t know it.

Mainstream economics textbooks present economics as a series of unrelated topics. Even mainstream macro economists have recognized the animosity between micro and macro. I found that the Austrian aspects come out when I stitch together those disjointed topics. Here is an example of how I teach the Austrian business-cycle theory and Hayek’s Ricardo Effect using nothing but the tools presented in standard intro textbooks.

Resurrecting Hayek’s Ricardo Effect will disappoint a few Austrian followers who, having done a quick search of the internet on the topic, have decided that critics demolished Hayek’s theory decades ago. Hayek introduced the effect in his Prices, Interest and Investment and amplified it in The Pure Theory of Capital. The only contemporary author that I’m aware of who takes it seriously is Jesus Huerta de Soto in his book, Money, Bank Credit and Economic Cycles. I include it in my book, Financial Bull Riding.

Hayek didn’t respond to many of his critics so some assume that Hayek had given up on the Ricardo Effect, but he hadn’t. Hayek recognized that his critics didn’t understand the effect because they had a poor grasp of capital theory. In fact, anyone who has read the three descriptions of the effect mentioned above will immediately grasp that Hayek’s critics attacked straw men, but never Hayek’s Ricardo Effect. Hayek answered his critics with Pure Theory of Capital.

Led by the Fed Investing Advice

If you have followed this blog, or read Financial Bull Riding, you’ll know that the stock market tends to follow the business cycle and Fed monetary policy determines the business cycle for the most part. So I was very interested to read this title: "Voices: SteveKrawick, on Asset Allocation Guided by Fed Policy." Krawick wrote

 “There are four phases in a Fed cycle. Today we're in the fourth and final phase of the cycle that began around 2008. This phase is marked by an accommodating Fed, which means low interest rates. Historically, in this environment, consumer discretionary stocks and financials have outperformed S&P benchmarks and their peer sectors. So, during this cycle, we have our clients overweight in that sector and underweight in others like industrials, materials, and technologies, which tend to underperform under current conditions.”

Markov Confirms ABCT

Greg Davies and Arnaud de Servigny offer a different take on diversification in their book Behavioral Investment Management: An Efficient Alternative to Modern Portfolio Theory. Chapter 6, “Representing Asset Return Dynamics in an Uncertain Environment was the most interesting chapter to me, and the one that adds confirmation to using the ABCT as a guide to timing the market. 

Modern portfolio theory tells investors to diversify their portfolios at least between two asset classes, stocks and bonds. A simplistic summary of the method is to use the statistical measure called standard deviation to assess the risks of asset classes and diversify according to risk. But in reality, advisers have found that a fixed ratio, say 70% stocks and 30% bonds, often works better without requiring as much work. 

ABCT Extends to Emerging Markets

Trouble in emerging markets has provided the rationale for at least part of the recent correction in the stock market. Emerging markets, such as, Brazil, Russia, India, Turkey, Thailand and China, are suffering largely because of the withdrawal of US dollar investments from them and this confirms the effects of monetary policy as described by the ABCT, the Austrian business cycle theory. Here is a chart showing the performance of emerging market stocks relative to the rest of the world:

To refresh your memory, the ABCT states that inflationary monetary policies such as those of the Fed for the past five years will cause an unsustainable boom as new money pours into the economy and stimulates demand for consumer goods and for investment. Usually we think of the ABCT in terms of a single nation, but the EM problems demonstrate that it has international implications, especially in a world of increasing trade integration and a currency that other countries use for trade and their banks for reserves.