Zombies threaten growth in 2017

Most economists expect the economy to grow at its most rapid rate next year. One of my favorite economists wrote this:

“If the new Trump administration cuts taxes and deregulates the economy, expect higher economic growth and another good year on Wall Street. However, I also expect higher interest rates and more inflation. 'King Dollar' should continue its rise, which will make it difficult for gold and other commodities. Avoid bonds and gold -- stay invested in the stock market.”

Let’s get the obvious problems with that forecast out of the way: higher interest rates and inflation are bad for the stock market and inflation is good for gold prices. And inflation means a lower dollar, not higher.

Year ahead forecast - stormy

Austrian economists are not huge fans of forecasting as are most mainstream economists, especially those who add a decimal point to lure the gullible into thinking the forecast is accurate. But that doesn’t mean Austrians don’t forecast. Hayek wrote in his Nobel Prize acceptance speech that... 

"Without such specific information about the individual elements we shall be confined to what on another occasion I have called mere pattern predictions - predictions of some of the general attributes of the structures that will form themselves, but not containing specific statements about the individual elements of which the structures will be made up."

I call Hayek's concept of forecasting, pattern predictions, or qualitative forecasting vs quantitative. In other words, Austrian economists can tell what will happen next but not exactly when or how much.

That doesn’t mean that Austrian economists don’t ever use numbers in forecasting. Obviously, I have provided a few of those. But I hope readers interpret those forecasts as tendencies and illustrations of theory, not as point-accurate forecasts.

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 dot.com 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.

S&P 500 Forecast

While profits in the energy sector cratered in the last quarter, a jump in retail profits of $28 billion in the fourth quarter from the previous year suggests that the S&P 500 will continue to rise. The forecast calls for an average of 2056 for the S&P 500 for Q2 and 2185 for Q3 this year.

In order for the quarterly averages to reach such heights, the index would have to set many new record highs. That could happen if more European and Japanese funds cross the oceans to invest in the US as they flee the destruction of their own currencies by their central banks. However, I’m skeptical. 

Another way to interpret the forecast is as a moving average. In technical analysis, moving averages of varying lengths guide investors timing their purchases and sales. The market crossing the moving average is a buy/sell signal, depending on the investor’s strategy. The graph above shows that the forecast sometimes leads and sometimes follows the market but when the two cross it indicates a turning point. The two lines have shaken hands recently, which could be our turning point for this market.

Gross shocks conventional wisdom

Bill Gross told investors this week to

Beware the Ides of March, or the Ides of any month in 2015 for that matter. When the year is done, there will be minus signs in front of returns for many asset classes. The good times are over.

Gross is the legendary bond fund manager who left the company he founded, PIMCO, for a job as a portfolio manager at Janus Global Unconstrained Bond Fund, so most people pay attention when he writes. The prediction came inside the January Investment Outlook for investors. But for the mainstream financial media, he might was well have expelled foul smelling gas at a crowded party. The media quickly pointed out how contrarian his forecast is. For example, the Bloomberg reporter wrote: 

2015 Q1 Forecast

The latest forecast from my model of the S&P 500 index for the first quarter of 2015 indicates that the market continues to outrun corporate profits. The pattern is similar to that of the late 1990s. When the market turns, it will fall below the level that profits would indicate as investors become pessimistic and afraid. It's likely that any January effect this next quarter will be small as the market corrects for profits.

When the market gets ahead of the forecast it means that the P/E ratio is expanding because investors are willing to pay more for the same level of profits. Some of that optimism comes from chasing yields as more bond holders grow weary of earning about one percent in real terms on bonds. Other buying comes from speculation about what the Fed will do.

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.

Q4 2014 Forecast

Here is my latest forecast of the S&P 500 quarterly averages. The market is quite a bit above what profits would justify, which means the PE ratio is expanding, or to put it another way, people are so desperate for earnings that they're willing to take higher risks. The market is above the forecast as it was in the late 1990's bubble.

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.”

S&P 500 Forecast Q4 2014

Stock market forecast Q3 2014

Here is the latest forecast of the S&P 500 average for the fourth quarter this year. The market made a head fake lower last year so it may turn around again depending on how well profits for the first quarter of this year turn out. But from the looks of things we have probably hit the high for this year and maybe for the bull market. This is a good time to think about gold and silver or possibly emerging markets since they have fallen so low.

S&P 500 Forecast

Here is the latest forecast of the S&P 500 index through Q2 2014 base on my own model. The values are quarterly averages because the model uses profits to predict the market and profit data comes out quarterly.

Fight the Fed or profit from its profligacy?

The Federal Reserve is a century old this year, but instead of cheering, good economists are lauding the apology in the Wall Street Journal by a Fed insider, Andrew Huszar, a senior fellow at Rutgers Business School and a former Morgan Stanley managing director. In 2009-10, Huszar managed the Fed’s $1.25 trillion agency mortgage-backed security purchase program.

It’s important to call the Fed out on bad monetary policy, but the few who do will not change the Fed because it has the support of mainstream economics. The Fed is only doing what mainstream econ teaches it should do, so until mainstream economics changes nothing will change at the Fed. Changing mainstream economics will be difficult to do because the professors have a lot invested in their paradigm. Cracks in the paradigm will not change their minds. Nothing short of a nuclear explosion will work.

S&P 500 Headed Up!

Here is the update to my forecast of the S&P500:

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.