Investing tips from socialist Soros

Even though George Soros is a devout socialist, he knows something about investing. He writes about a typical cycle in the stock market in his book The Crisis of Global Capitalism. He calls his theory “reflexivity,” but the general idea is that the stock market usually tracks profits closely until near the end of the cycle.

As the reader can see from the chart below, the variance in profits isn’t as great as that in stock prices. The two begin to diverge about halfway through the expansion. All that means is that the PE ratio begins to inflate because credit expansion by the Fed is pumping new dollars into the economy. 

If stock prices remained tethered to earnings, stock prices would level off. To prevent that, the media send in the clowns. In a rodeo, clowns distract the bulls to prevent them from stomping the cowboy into the arena dirt, but in the market the clowns distract the investor. The clowns pull from their shirt sleeves old tricks to make the fundamentals look better. They use performance measures that rely on creative accounting, alternative profit measures, pro forma statements, and complicated valuation techniques. The clowns break the connection to earnings so that prices continue their ascent unrestrained by fundamentals. If the market was an actual rodeo, the clowns would be lynched for letting the bulls pulverize the cowboys.

Show me the money

Most business cycle models include the money supply as a leading indicator of the economy, meaning that changes in the money supply tend to precede and signal changes in the economy in the near future. The money supply year-to-year change spiked late last year, giving some money watchers goose bumps.

According to Ryan McMaken at the Mises Institute, the money supply jumped 11.3 percent on the Austrian money supply (AMS) index late last year. Murray Rothbard and Joseph Salerno created the Austrian money supply index to provide a better measure than the Fed’s M2. That spurt in money occurred after a several years of sedate money growth. 

McMaken wrote that since 2014, money supply growth has ranged from about 7 percent to 8.5 percent. In October of last year, money supply growth hit a seven-year low of 6.8 percent. The AMS spiked to 11.3 percent in the fourth quarter, then in February it collapsed back to a year-to-year growth rate of 7.7 percent.

Bank of England: mainstream econ is broken

It seems that the Bank of England has been feeling the heat from its forecast that Brexit would plunge the UK into a depression. Added to the failure of mainstream economists to predict the Great Recession, the public is losing confidence in its gurus, according to a story in the Guardian,

Haldane described the collapse of Lehman Brothers as the economics profession’s “Michael Fish moment” (a reference to when the BBC weather forecaster predicted in 1987 that the UK would avoid a hurricane that went on to devastate large parts of southern England). Speaking at the Institute for Government in central London, Haldane [Bank of England Chief Economist] said meteorological forecasting had improved markedly following that embarrassing mistake and that the economics profession could follow in its footsteps.

The bank has come under intense criticism for predicting a dramatic slowdown in the UK’s fortunes in the event of a vote for Brexit only for the economy to bounce back strongly and remain one of the best performing in the developed world.

Before the referendum on divorcing the EU, Bank of England governor Mark Carney had warned that that the split would cause a recession in the second half of 2016. Instead, the UK economy grew at an annual rate of 2.4% in the third quarter with no signs of a slowdown in the fourth.

The case for a raging market in 2017

Trumpeting a new boss in the White House wasn’t the only cause of the recent spectacular rise in the stock market. Several economic indicators improved in the fourth quarter. Nicholas Vardy wrote,

Consumer confidence stands at its highest level since August 2001. The unemployment rate is at nine-year low. The U.S. economy is close to full employment. S&P 500 earnings are coming out of an earnings recession, and are expected to grow by double-digit percentages in 2017. 

And the money supply jumped:

The supply of US dollars accelerated during late 2016 with October's year-over-year percentage increase in the money supply hitting a 46-month high of 11.2 percent. The YOY growth rate fell slightly to 10.3 percent in November.

This comes after a long period of relatively sedate growth in the money supply through most of 2013, 2014 and 2015.

The recent surge in money supply growth suggests that the likelihood of an economic contraction in the near future has been reduced, with the next downturn being pushed out further into the future. 

Trickle-down economics still doesn’t work

The Bureau of Economic Analysis elevated its estimate of third quarter GDP from 2.9% to 3.2% last week. They intend the decimal points to give an illusion of accuracy when they know there is a lot of slack in the numbers. Corporate profits rose in the third quarter on a year-over-year basis 2.8%, the first rise in profits in five quarters.

Tossed with expectations about Trump’s spending and tax cuts we should have a salad that promises improving health for the economy. It should end business cycles and bear markets, except for the fact that we have seen similar scenarios before. Mainstream economists gathered around the casket of the business cycle in the late 1990s, just before the recession of 2001. Bear markets are wedded to recessions for the most part, so the death of business cycles would mean the death of bears, too.

If that sounds too good to be true, then join me in looking into the numbers a little more closely. The Bureau of Economic Analysis (BEA) explains the jump in GDP this way:

The increase in real GDP in the third quarter primarily reflected positive contributions from personal consumption expenditures (PCE), exports, private inventory investment, and federal government spending, that were partly offset by negative contributions from residential fixed investment and state and local government spending. Imports, which are a subtraction in the calculation of GDP, increased...

Considering job gains, wage increases and low debt levels, Bloomberg quoted Russell Price, senior economist at Ameriprise Financial Inc. in Detroit on the topic:

Growth is going to remain heavily reliant on the consumer, but consumers are in very good position to lead that charge...Overall, it’s an encouraging sign for the path ahead.

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.

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."

Mainstream economists predict the past

Mark Twain once said,"Prophesy is a good line of business, but it is full of risks," and "It is difficult to make predictions, especially about the future." In the Bureau of Economic Analysis’ (BEA) recent statement that the GDP of the US grew by 2.3% in the second quarter of this year, it isn’t predicting the future, but the past. And Twain was right, even that is hard.

Initial GDP growth numbers are not actual data; they are the output of statistical models. That’s why the BEA has to revise them in a month and again years later. Most people pay attention to the first estimate, but the real interesting information comes from the direction of the miss. Most math models will miss on the high side as the economy heads into a recession and the gnomes will revise the numbers downward. In an expansion, they will miss on the low side and be revised upward.

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.

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.

Forecasting Failure

The latest revision of GDP for the first quarter of this year caught most economists by surprise. A decline of 2.9% is the worst since the latest recession. Surprising most economists shouldn’t surprise anyone. The Laissez Faire newsletter alerted me to studies by the IMF economists Hites Ahir and Prakash Loungani on the abilities of private and public sector economists to forecast recessions. In short, their records are almost perfect, failure that is.

The photo of the Queen with the comment “Why did no one see this coming?” comes from a presentation at George Washington University on forecasting by the two economists. In a second photo, a London School of Economics representative responds, “Ma’am, to see this one coming would have ruined our perfect record of failure to see it coming.”

Fed Fail!

With Ben Bernanke's departure, it’s time to grade his portfolio of work. Ben invented new methods to expand the money supply, including buying non-government issued debt. Mainstream economists credit him with having rescued the economy from the latest recession. The economy has recovered slowly in the past five years, but should we give all the glory to the Fed? These charts should answer those questions: