Author Archive for Cullen Roche

Global Inflation Update – Continued Disinflation

Global disinflation has picked up pace in recent months and several regions of the global economy are now on the verge of a full blown deflation.

The latest readings on inflation are just about unanimous – there’s widespread disinflation, or a slowing rate of positive inflation. The latest reading out of the USA showed a stagnant, but well below historical average rate of 1.7%.  China’s rate of inflation has slowed from 2% to 1.6%.  The UK slowed sharply to 1.2% from 1.5%.  And the EMU is on the verge of deflation at 0.3%.  The one outlier of the major economic regions is Japan where the rate of inflation spiked following the currency devaluation due to Abenomics.


Rail Traffic Just Keeps on Chugging

The latest trends in rail traffic showed more of the same that we’ve been seeing for the last few months.  Interestingly, despite the Ebola scare and the brief Europe shock, there was no substantive change in rail trends.

The latest weekly reading came in at 3% which is just below the 12 week moving average of 4.3%.  That’s down marginally over the last few months, but still a strong reading in the grand scheme of things.  Via AAR:

“WASHINGTON, D.C. – Oct. 23, 2014 – The Association of American Railroads (AAR) today reported increased U.S. rail traffic for the week ending Oct. 18, 2014 with 297,130 total carloads, up 2.7 percent compared with the same week last year. Total U.S. weekly intermodal volume was 272,554 units, up 3 percent compared with the same week last year. Total combined U.S. weekly rail traffic was 569,684 carloads and intermodal units, up 2.9 percent compared with the same week last year.”



Negative Interest Rates – How’s That Working Out?

Back in June the ECB initiated a small negative interest rate on deposits held at the ECB.  Over the last 5 years we’ve repeatedly heard economists and other pundits say that Central Banks just need to reduce the demand for Excess Reserves by charging a negative interest rate and that this would surely cause inflation to increase as banks would lend out their reserves or “stop sitting” on their money (as Scott Sumner likes to say).

So, we’re almost 6 months into this policy change and what can we conclude thus far?  Well, as I stated back in June, this policy wasn’t likely to have much of an impact and in fact, the Eurozone has deteriorated since then.   Chart 1 shows the level of bank lending since the beginning of the year.  Clearly, the ECB’s negative rate policy isn’t forcing banks to “stop sitting on their money”:


Sumner also claimed that “If they did [charge a penalty] it would be easy to get inflation expectations up to 2%.”  But the rate of inflation has continued to decline since then:


Of course, the misguided thinking on this stems from the myth that banks lend their reserves in some money multiplier style fashion or that the Central Bank can control the rate of inflation directly by steering the banks to act in precise ways.  But bank lending is primarily a demand side function so supply side economics doesn’t apply to the degree that some economists seem to think.   This isn’t rocket science, but very smart people, even after all this time, continue to misunderstand the importance of bank lending and endogenous money….

Thus far, it’s pretty clear that this policy is having no discernible positive impact on either lending or the broader economy.


What This Nerd is Reading: X-CAPM – An Extrapolative Capital Asset Pricing Model

Just passing this paper along which I missed.  Noah Smith mentioned it yesterday on Twitter and it looks pretty interesting.  If any fellow nerds have thoughts feel free to use the comments…

X-CAPM: An Extrapolative Capital Asset Pricing Model

Nicholas Barberis, Robin Greenwood,
Lawrence Jin, and Andrei Shleifer

Yale University and Harvard University


Survey evidence suggests that many investors form beliefs about future stock market returns by extrapolating past returns: they expect the stock market to
perform well (poorly) in the near future if it performed well (poorly) in the recent past. Such beliefs are hard to reconcile with existing models of the aggregate stock market. We study a consumption-based asset pricing model in which some investors form beliefs about future price changes in the stock market by
extrapolating past price changes, while other investors hold fully rational beliefs. We find that the model captures many features of actual prices and returns, but is also consistent with the survey evidence on investor expectations. This suggests that the survey evidence does not need to be seen as an inconvenient obstacle to understanding the stock market; on the contrary, it is consistent with the facts about prices and returns, and may be the key to understanding them.

Read it here.

We The Economy – 20 Short Films You Don’t Need to Watch

Morgan Spurlock has a new set of films out supposedly explaining how the economy works.  They’re 20 short films that explain various elements of the monetary system and economy.  The only problem is that the films are filled with basic errors.  For instance:

    • The film on “What is Money” uses a money multiplier model which, as I’ve explained a million times, is totally wrong.  The money multiplier is a myth.
    • They use a barter economy in an early video to try to explain how the market works.  Of course, a barter system is nothing like a monetary system and this obsession with barter is part of why so many people misunderstand how the modern monetary system actually works.
    • In the video on the Federal Reserve they state that the Fed “doesn’t even answer to Congress”.  The depiction is of a Central Bank that is some reckless and independent entity that does nothing but “print money” and hurt the economy by causing inflation and bailing out banks.  Actually, the Fed does answer to Congress, was created by an Act of Congress and does not really “print money” in any meaningful sense as I’ve explained multiple times in my explanations of Quantitative Easing.  Also see “Common Myths About the Federal Reserve”.
    • The same video says the Fed “controls the money supply”.  Actually, the Fed controls the overnight interest rate which only indirectly impacts the supply of money in the banking system at any given time.  The banking system controls the supply of money and the Fed only facilitates the use of this money.  See here for more details.
    • The film even states that the Fed has a triple mandate, one of which is to “help determine interest rates for people trying to buy homes”.  That’s a real quote.  Of course, the Fed has a dual mandate of full employment and price stability.

That only scratches the surface here.  I hate to be overly critical, but this is junk economics that perpetuates dangerous myths and does a great disservice to anyone who has a genuine interest in trying to understand how the economy really works. If you want to watch a useful film on the monetary system and the economy then try Ray Dalio’s 30 minute film. It will save you a ton of time and help you avoid having to unlearn some of the concepts you might think you’re learning from the Spurlock films.

Q&A – Answers

Here are the responses to this week’s Q&A:

Q:  Your book says commodities aren’t good investments as a core piece of a portfolio because of their poor real, real returns. But what about MLPs?

CR:  There’s a difference between buying commodities outright and buying commodities for the purpose of investment.  A firm that buys oil in order to innovate is very different from a trader who just buys oil for the purpose of speculation or hedging.  I am not against owning firms who purchase commodities for the purpose of future production.  The thing you have to be aware of with MLPs is that they’re very sensitive to shocks.  We saw this in the recent downturn when MLPs fell over 10% in a matter of days….

Q:  How will you know if we are in a bear market?

CR:  The technical definition of a bear market is a -20% decline in the stock market.   So we’ll all know when that happens.  I don’t think it’s very useful to try to predict every micro move in the markets.  Instead, I focus on the macro picture and construct a framework for being able to ride the big trends while tilting the portfolio in a cyclical manner.  For instance, we know that tail risk events tend to occur inside of recessions.  This makes sense since this is the time when corporate profits falter.  Every 30%+ decline in the S&P in the last 75 years has occurred inside of a recession.  

So, if we can model the macroeconomy in a manner that helps us identify the 10-20% of the time when the economy is in recession (we don’t have to get it perfectly right, we just need to get moderately close) then we can tilt the portfolio in a manner that reduces exposure to big tail risk events. This is in keeping with my view of adaptive asset allocation and the understanding that relative risks of asset classes evolve over the course of the business cycle.  

In essence, the key isn’t identifying when the market will make small shifts.  Rather, it’s much more important to identify the larger trend, take advantage of Mister Market along the way when he makes mistakes (like the recent downturn) and make cyclical adjustments when it looks like the big trends are being disrupted.  The best part is, this can all be done in an extremely low cost and tax efficient manner if you’re mindful of it….

Q:  Where do you see the US dollar in one year – higher, lower or about the same?

CR:  The US dollar index has averaged a -0.5% return for the last 30 years.  The basket just isn’t that volatile in the grand scheme of things.  And since currencies are a zero sum game I don’t know how much sense it makes to try to forecast currencies.  Basically, I wouldn’t expect the USD to do anything spectacular in the next years.  It’s the world’s most stable currency in the world’s strongest economy.  I think the Fed would love to see it decline, but they’re not intervening directly so the better question might be whether China, Japan and Europe can devalue relative to the USD?   The answer to that is probably yes on all fronts….

Q: Asness mentions four market inefficiencies in his work (value, momentum, carry and risk parity). If it is fair for me to ask, what other strategies if any do you see mispriced by market (inefficiencies)?

CR:  I don’t know if I have a specific strategy style that I view as taking advantage of market inefficiencies. Markets are dynamic and inefficient at time.  So it makes no sense to be static and apply Efficient Market Hypothesis type thinking.  I believe an asset allocator should implement a macro adaptive approach not dissimilar to the way William Sharpe has discussed Adaptive Asset Allocation.  That means they should understand the big picture, ride big trends, and understand that the markets are dynamic.  This is somewhat similar to risk parity in that you’re basically allocating assets across broad classes while being mindful of the fact that relative asset class risks are dynamic during the course of the business cycle.  This means your portfolio should at least tilt at times to account for this dynamic landscape.  

The problem with risk parity is that you basically always conclude that fixed income is less risky than equity which I don’t think is necessarily true.  But I take an approach that is very similar to a risk parity approach in that I am using a broad asset allocation approach which is cyclically adjusted to account for changing relative risks in asset classes.  I don’t try to create risk parity as much as I try to tilt away from high risk asset classes during the periods of the business cycle when we know there’s a high probability that they will be risky in relative terms….

Q:  As I understand from the Kalecki equation, if the government cuts back on its spending then the private sector increases its level of debt to maintain growth levels. And since 2008, developed countries have slowed their accumulation of debt (and some have improved their trade deficit as well) whereas emerging have largely increased their debt levels. Does the world observe a global Kalecki equation of sorts influenced by the imports/exports or is each country a stand alone entity and in a closed system. That is, is this increase of emerging market debt the result of the slower debt accumulation in developed market?

CR:  There is no hard and fast law that is derived from Kalecki’s profits equation.  That is, if the government stops spending it doesn’t mean that debt necessarily needs to rise or that private sector profits will decline.  I think a lot of people expected this to happen in recent years as the deficit declined and I tried to explain on several occasions that this wasn’t necessarily going to be the case.  The reason why is because the deficit responds to changes in the private sector.  So, in the last 5 years we’ve seen steady govt spending and huge increases in tax receipts due to the improvement in the private sector.  The govt didn’t really do anything.  But the deficit responded by endogenously improving due to the organic improvement in the private sector.  So I think you have to be careful deriving changes directly from the deficit.  You have to look at what caused the deficit to decrease/increase in the first place.  

Now, one trend we’ve seen over the last 30 years is rising debt levels as inequality has increased.  I think what’s going on is that the middle class is borrowing to maintain a certain living standard.  As incomes have stagnated they’ve borrowed to make up the difference.  I would say that the deficit could be a lot larger in this environment, but I wouldn’t say it’s the cause of the borrowing.

Q: My question concerns the question of QE in the EU. I keep reading articles that suggest that the threat of deflation clearly implies the need for QE on a massive scale (or at least more larger than has been promised to date). Yet another strain of literature questions whether QE has been/can be effective in stimulating faster price inflation in the US and Japan where it has been tried on a large scale. The arguments that imply that QE has not/will not overly stimulate inflation (that it primarily adds to bank reserves that are not being lent out) seem to imply that it simply has not been very effective in doing anything except driving asset prices upwards. Why is it presented as a foregone conclusion that this is a wise strategy (resisted only by the selfishness of Germany) that is necessary to prevent deflation, if it has actually had little impact on inflation at all?

CR:  I don’t expect QE to do much in Europe.  First, we should be clear that banks don’t “lend out” reserves.  Banks lend first and find reserves later if necessary.  The money multiplier is a myth (see here).  So what Europe is basically doing is changing the composition of private sector balance sheets (see my QE primer here) from bonds to deposits/reserves.  I don’t see why this should do anything.  It might alleviate some funding needs at the sovereign needs, but that issue appears to have been solved with the OMT backstop.  So I don’t know why they expect QE to do much.  What Europe really needs is a massive peripheral fiscal program and a reformation of the system via the implementation of a central treasury like the USA has.    QE doesn’t fix the inherent problem in Europe’s monetary system.  

Q:  A question on inflation: What is it that is driving inflation in markets such as Indonesia or Kazakhstan – why is it so much higher than in say Singapore?

CR:  Sorry, but I’d have to learn a lot more about those specific economies before I could express a good opinion.  Sorry.  

Q:  You recently posted 3 macro charts that show a strong US economy. Do you analyse more forward looking indicators? If so, what are they telling you given recent movements in financial markets?

CR:  My general view is that the macro picture in the USA has not changed in recent weeks and that Mister Market was just having an Ebola and Europe scare….

Q:  In a previous Q&A ( you said that the current monetary system has not failed. If the developed world ends up like Japan, unable to escape deflation and implementing perpetual QE, would this constitute failure? If not, what outcome would?

CR:  We’ve been in a period of abnormally high growth for the last 75 years so it’s not surprising that the global economy has slowed some.  But the global economy is still growing at a rate of 4.5% so I don’t think it’s anything to get too worked up over.  And yes, developed economies will continue to lose market share to emerging markets.  That’s just competition at work.  When you’re #1 there’s only one direction to go and that’s lower.  The USA is in relative decline in this regard.   The failure of QE is, in my opinion, totally expected.  It’s not a failure of the monetary system.  It’s a failure of economists and policymakers to understand that fiscal policy is a much more powerful lever than monetary policy.  But we have an establishment of economist who are obsessed with monetary policy and what central banks can do.  So the world suffers.  

Q:  Related to the last question is what can the central bank do to cause real economic activity? Or is monetary policy now impotent?

CR:  Monetary policy isn’t impotent.  It’s just extremely blunt.  Some things they could do: 1)  buy long duration debt; 2) buy non-financial assets; 3) buy muni bonds; 4) buy sovereign bonds.  In the case of the states in the USA or Europe the Central Banks could directly fund govt spending.  In the USA the CB could buy non-financial assets which would be real “money printing”.  Of course, they can’t do this stuff or won’t do it, but it would have a big impact because it is, in essence, fiscal policy.  

Q:  Hypothetical question now: Why can’t an economy have competing private sector Fed-like clearing-houses (similar to the ones used to settle future contracts etc.) instead of one public central bank? Before you answer, just imagine the current global competing currencies but instead of spread out around the world, those currencies were all used within the US with competition eventually leading to the best currency system (essentially introducing FULL market forces to the monetary system). 

CR:  The USA already has a private clearinghouse called CHIPS.  The problem is that a clearinghouse is only as good as the liabilities issued by its members.  So with private clearinghouses you still have private sector solvency issues.  The power of the Central Bank is derived from its relationship with the Treasury whereby it can tax the output of the country.  So reserves are valuable and stable because US output is stable and valuable.  Private clearinghouses will never have this degree of stability or value because they’re inherently fragile entities.  So, in my opinion, Central Banks actually make a lot of sense because they stabilize the payment system that is essential to our economic well-being.  

Q:  How are you currently positioned?

CR:  Seated in an upright position.  Also, long stocks and bonds and Orcam Financial Group.  :-) 


Can We Identify Good & Bad Forecasters?

Forecasting is part of life.  And it’s certainly part of economics and finance.  Anyone who puts together a view of the economy or an investment portfolio has to make some forward looking assumptions.  They have to make forecasts about how the future might play out even if they’re just making vague implicit forecasts (for instance, you might be a buy and hold investor because, historically, stocks go up, therefore, you think they’ll continue to go up).  Some people do this in rather intelligent ways while others do this in biased and rather unintelligent ways.

I got to thinking about this as I read this nice post by Noah Smith on the difficulties of forecasting and the trouble with identifying good forecasters.   Noah says:

Obviously, these warnings would have zero informational content about actual inflation. But how would you go about differentiating between such a bot and a real human being? Is there some kind of Turing Test for macroeconomic forecasters?


In the meantime, our tools for identifying unreliable forecasters are rather primitive — a combination of reputation, bluster, excuses, insults and counter-insults. It’s all a bit silly, and it generates a lot of bad feelings all around. But what else can we do?

 So, how can we differentiate between the two?  How do we identify good forecasters and bad forecasters?  Well, there’s certainly no sure-fire way to eliminate the good from the bad, but I do think we can identify some red flags about forecasters by focusing on common behavioral biases:
  1. Does the forecaster work from a political perspective of the world?  If so, they are likely biased in their views and instead of viewing the world for what it is, they are making forecasts based on how they want the world to be.  We saw this consistently around QE forecasts when people who are politically against the Federal Reserve, made repeated predictions about impending doom.  Political bias is probably the most common and destructive bias that impacts forecasting.  Avoid politically biased forecasters at all costs.
  2. Beware of optimism/pessimism bias.  This often stems from political bias, but we tend to find that people in economics and finance are highly biased towards one view, either optimistic or pessimistic.  This will tend to cloud their thinking and lead them to conclude that any sort of policy or economic variable will naturally conform to their broader biased perspective.  People with a long track record of one consistent optimistic or pessimistic view should be ignored.  Classic examples include permabulls like Jeremy Siegel or permabears like Marc Faber.
  3. Beware the fallacy of composition.  People who can’t think in terms of the big picture are often biased in terms of their narrow views.  We are highly prone to thinking about finance and economics as it pertains to our lives at a personal level, but what’s good/bad for you at a personal level might not be true at the aggregate level.

We’ll never identify perfect forecasters (because they don’t exist).  But we can, with a high probability, eliminate the largely useless forecasters from the more valuable forecasters.  And identifying common behavioral biases is often one of the best ways to achieve that.  More importantly, when making your own forecasts, rather than relying on some talking head, ensure that you aren’t falling for these common biases yourself….

No, Higher Velocity Will Not Necessarily Mean Higher Inflation

In my book I go into some detail about the equation of exchange (MV = PQ) and why it can be terribly misleading. In essence, the equation is based on totally unrealistic assumptions such as the idea that “money” is some easily discernible item in an economy where financial assets have varying degrees of moneyness.  The most basic premise of the equation, the idea that more money necessarily = more inflation, has been thoroughly debunked over the last few decades, but unfortunately, I continue to field a constant barrage of questions about it and how high inflation or hyperinflation are lurking around the corner just waiting for the velocity of money to increase.  The problem is, velocity really has no statistically relevant relationship with the rate of inflation.

This whole conversation is a bit strange to begin with because Milton Friedman often assumed that V was relatively constant.  Which is bizarre because we know that V wasn’t constant even in the era before Friedman wrote his famous 1969 paper on the “Optimum Quantity of Money”.  He also made all sorts of other unrealistic assumptions in the paper such as a fixed money supply, no lending or borrowing and even assumed that people were immortal.  He called this a “hypothetical simple society”, but we really should have called it a “totally useless and fake society”.  How the paper even left a lasting impression on economists is worthy of debate….

Anyhow, I don’t want to get too deep in the weeds on this, but the idea that higher velocity necessarily leads to higher inflation can be easily debunked by looking at our “realistic complex society”.  Over the last 50 years there has been no, I repeat, no statistically significant relationship between the Consumer Price Index and the velocity of M2.  In fact, the relationship is virtually negative.  If you just eye ball the historical relationship you can see that there is none:


If you actually run the regression analysis you can confirm that there is zero relationship between the rate of inflation and the velocity of money:



So no, there is no reason to believe that higher or lower velocity of money will lead to deflation or inflation.  That’s not to say that the equation of exchange is not true.  Of course it’s true.  But you have to deep dive into the assumptions that its conclusions are based on to actually understand how useful it really is.  And when we deep dive into Uncle Milton’s “hypothetical simple society” you find that many of the conclusions are based on a world that resembles nothing like our actual monetary system.  And that is why so much of his economics has been proven void of value over the course of the last 30 years – it was based on a textbook world that made the math appear more relevant as opposed to the actual world we live in.

Yes, Boosting Gross Exports (and Imports) Would be Wonderful…

In a post today Scott Sumner says that the world would be better off if we could increase gross exports.   He refers to this Tyler Cowen post before going into more detail calling it “wonderful”.  I’ll probably never understand the Market Monetarism way of thought.  It just strikes me as reformed old school Monetarism (which has gone the way of the dodo) with a NGDP Targeting twist, but the same old laissez-faire foundation and most of the destructive nonsense that Milton Friedman injected into the field of economics.  Anyhow….

Now, Sumner doesn’t actually refer to gross exports, but I am going to assume that’s what he means.  And he’s right – boosting gross exports would be “wonderful”.  Or, said differently, if we all just produced more goods and services that other countries wanted then we could collectively increase our gross exports (as well as our gross imports).   But why is this news or some “wonderful” insight?  I mean, if I could produce a better car than Tesla then I could increase gross production for the global economy and that would be “wonderful”.  But isn’t this just an obvious fact?  But this is how neoliberal economists think. If we can just unleash unfettered capitalism then all of the untapped potential within us would just pour out into the economy, right?  As if there’s an Elon Musk inside of all of us just being held back by high taxes, regulation and the government….

Saying that we should all just boost gross exports is the mercantilists version of telling the poor guy with no job and no skills that he just needs to pick himself up by his bootstraps.  It’s obviously true, but it often makes no sense in reality because picking yourself up by the boot straps is not only extremely difficult, but takes a good deal of time.  From the perspective of economics it’s just obvious (yes, if we could all produce more then we’d likely all be better off).   But from a policy perspective it’s often just political rhetoric that sounds nice in theory and doesn’t translate into the real world in any realistic sense.  And then Sumner (predictably) goes into a bunch of laissez-faire policies that will supposedly unleash all this pent up production thereby allowing us to pick ourselves up by our boot straps.  Of course, none of the ideas are particularly new and many of them are things that many countries have been implementing for years already.  Nothing new here, certainly nothing “wonderful”….

This is the same thinking that has been poisoning economics, policy making and the global economy since the 1970s.  When will it end?

“the most crucial factor for investing success is cost” – FALSE

I was intrigued by this Vanguard response to PIMCO’s defense of active bond management in which a Vanguard spokesman said:

“We believe the most crucial factor for investing success is cost”

This is an empirically incorrect statement.  Yes, costs matter a great deal.  But the way you choose to allocate your assets is far more important to your returns than the costs you incur.

Now, the Vanguard statement was probably more true when the firm was founded and John Bogle was on the rampage against stock pickers charging 2% or 3% for their services.  But the cost of asset allocation has come down significantly over the last decade.  In fact, I’d argue that Vanguard is the leader in funds that are essentially inexpensive, but actively allocated.

Of course, regulars know that I think this “active” vs “passive” debate is misleading to begin with.  Anyone with a sound understanding of macro finance knows that there is only ONE true passive portfolio and that’s the Global Financial Asset Portfolio (see here for details).  That is, there is really only one outstanding portfolio of all the world’s financial assets.  Therefore, the true passive indexer would simply buy and hold the GFAP and take the aggregate market return as opposed to trying to beat what that portfolio can potentially return.  If you choose an asset allocation that deviates from this weighting then you are, by definition, doing what “active” investors engage in by trying to pick assets in an allocation that is superior than the global index.

Ironically, almost all “passive” index funds run by Vanguard and other firms that advocate “passive” indexing are actually deviations from the market cap weighting of the GFAP.  That is, they are inexpensive, but actively allocated deviations from the GFAP.  There’s nothing “passive” about this except that they’re not as active or expensive as the dart throwing monkeys that their research often strawmans (see this prominent indexing “research” for instance).  This is why we often see “passive” index funds underperform the GFAP - they’re nothing more than inexpensive actively chosen deviations from the GFAP.

We should be clear about costs – costs matter.  There’s no doubt that John Bogle was right about his cost matters hypothesis.  But the way you go about choosing your allocation will be a far more important driver in your future returns than costs – especially in a world where asset allocation has become so inexpensive.  I’ve called this the “Allocation Matters Most Hypothesis”.  Interestingly, we can actually prove that the GFAP return is often an inferior asset allocation by studying Vanguard’s own actively allocated funds.

Over the course of the last 40 years bonds have generated tremendous returns.  But the GFAP, which is just an ex-post response to the market’s allocations, had just a 37% bond market weight relative to the 63% equity market weighting in 1970.  If you’d followed this truly “passive” allocation until today you would have generated a 9.65% annualized return with a standard deviation of 12.11, Sharpe Ratio of 0.43 and a Sortino of 0.81.*  Not bad.  But Vanguards own actively chosen allocations beat this allocation on a risk adjusted and nominal basis!

Over the same period the Vanguard Wellesley fund, one of their oldest funds (which overweights bonds on average), generated a 9.96% CAGR, a 9.05 standard deviation, a Sharpe Ratio of 0.57 and a Sortino Ratio of 1.35.  The Wellesley fund’s active deviation from the global market cap weighting “beat the market”.   Of course, the Wellesley Fund costs 0.26% per year but even with that small fee the nominal AND risk adjusted returns were superior than the truly passive index before any fees.  In other words, by constructing a fund that actively deviates from the global market cap weighting of outstanding financial assets Vanguard was able to construct a fund that defies the firm’s own logic.

The cost matters hypothesis is important.  But the allocation matters most hypothesis is even more important.

* Interestingly, if you’d chosen not to rebalance and let the portfolio evolve with the naturally occurring cap weightings you would have generated a lower risk adjusted return of just 0.39 Sharpe and 0.69 Sortino Ratio.  


The Unintended Consequences of Fed Policy

For the most part, I think it’s safe to say that Central Banks are designed to help the economy.  As I’ve described before in detail, at their most basic level Central Banks are just big clearinghouses.  For instance, in the case of the Fed it’s really just an entity that oversees the clearing of payments in the interbank market.  This is an economic positive in that it creates a place where banks can settle payments across the payment network without having to worry about the quality of another bank’s financial assets given that they all deal in a form of pseudo government backed interbank reserves.  Overseeing the smooth operations of this system is the primary purpose of a Central Bank and it is, in my opinion, an unquestionable positive in a system where most of the money is created by risk taking private profit seeking banks.

Of course, Central Banks have become much more than just big clearinghouses.  They’ve become central policy makers via things like interest rate changes and other forms of policy (like QE).  Central Banks implement policy by trying to help the economy (obviously), but their toolkit is an extremely imprecise and blunt set of instruments.  Because of this imprecision there are often unintended consequences that arise  from such a broad instrument.

Today’s earnings report on IBM shed light on a recent trend that I have often criticized – corporate America’s fictitious obsession with boosting EPS by buying back shares.  Since the Fed implemented ZIRP and QE we’ve seen a huge boom in firms borrowing to boost EPS via buybacks.  It’s so inexpensive for a high quality firm to borrow and buyback shares that they can easily boost EPS this quarter without actually having to do anything substantive to the business.  In the case of IBM their revenues have been marginally higher over the last 5 years, but their EPS has shot up 50%.  That is, to a large degree, the result of a 22% decline in the share count thanks to buybacks.  It’s not necessarily “fake”, but it’s nothing like investing in the firm in a way that will create future organic EPS growth.  So these buybacks help in the present, but potentially hurt in the long-term.

There are plenty of other examples of the unintended consequences and the moral hazard of Fed policies.   But the question we have to ask ourselves is whether all of this Central Bank tinkering with interest rates and QE does more good than bad.  I don’t know the answer to that, but I do know that Central Banks operate with a very imprecise toolkit and so relying on them to steer policy over the course of the business cycle seems like a rather naive way to approach the goals of full employment, price stability and growth.

Interest Rates are less Important Than Economists Think

I complain about the state of modern economics a good deal because, as a market practioner and an entrepreneur, I notice that much of the textbook theoretical modeling doesn’t actually reflect anything realistic about the way the world works.  While there are many flawed econ and finance concepts such as the Efficient Market Hypothesis, the quantity theory of money, rational expectations, etc, few are more dangerous than the modern economist’s obsession over interest rates.

There was a time before the 1970’s when fiscal policy dominated policy discussions and Central Banks were viewed as relatively secondary players in policy.  That all changed in the 1970’s when Milton Friedman and the Monetarists defeated the Keynesians during the stagflation of the decade.  The USA shifted dramatically from a focus on fiscal policy to a shift in Central Bank monetary policy.  Of course, Friedman and the Monetarists turned out to be fabulously wrong for focusing on the quantity of money utilizing the Central Bank and the policy focus shifted once again as the US Fed moved from targeting the quantity of money to targeting interest rates.  Although Friedman and the Monetarists were wrong the policy focus never really shifted from the Central Bank.  It just shifted its style.

Today, the obsession over Central Banking is as strong as it’s ever been.  And a new research report which was cited in The Economist this weekend shows us that interest rates are a lot less important than economists think.  The paper titled “The behaviour of aggregate corporate investment” by S.P. Kothari, Jonathan Lewellen and Jerold Warner confirms what I’ve long believed – that interest rates are a blunt instrument.  And no, they’re not a blunt instrument because we’re in a liquidity trap as Paul Krugman and others have (incorrectly) argued.  They’re a blunt instrument at all times.  That is, interest rates just aren’t that important in the way corporations actually decide to invest.  That’s not surprising since the Central Bank sets one interest rate which only loosely impacts the rest of the economy.  Therefore, the idea that the Central Bank can steer the economy via this imprecise tool, was always misguided.

Interestingly, as the Fed remains at 0% interest rates and this interest rate targeting proves inept, the policy discussion has shifted yet again.  But it hasn’t shifted from Central Banks.  It’s just shifted to the way Central Banks can implement policies in alternative manners.  Hence the obsession with ideas like QE.  Of course, QE doesn’t do nearly half the things most people seem to think so here we have another shift to a policy that just doesn’t do as much as most economists seem to think.

So, where to next before the profession realizes that its focus on interest rates is largely wrong?  I don’t know.  My guess is we’ll move to targeting other things like an explicit inflation target or a NGDP target.  And when those policy ideas fail, and they will, who knows where we’ll go next?  But it seems to me that the impact of Milton Friedman and the Monetarists is alive and well.  And no matter how badly certain policies fail we seem to keep turning to monetary policy and Central Banks to provide the answer to full employment and high growth.  When will we learn that Central Banks don’t have all the answers?

Sunday Q&A

I wanted to open the comments up here for a Q&A since I haven’t done one in a while.  With the markets so volatile and the global economy looking shaky again I figured people might have some questions.  So fire away if you want.  Anything goes….

Three Bullish Macro Charts

You didn’t think I was going to let you go into the weekend all depressed now did you?  I mentioned last week that the recent downturn in stocks appears to be a purely non-USA event.  That is, the US economic data that’s been coming out in recent weeks really looks no different than anything we’ve been seeing for the last few years.  Specifically, we saw three of my favorite macro indicators this week all come in at record high levels or strong levels.

Retail sales missed expectations on a monthly basis, but are still growing at a 4.5% annual clip.  Healthy by any standard:


Initial jobless claims fell to a 14 year low:


And industrial production hit an all-time high:


Now, the stock market isn’t the economy so it’s not surprising to see temper tantrums every now and then, but I don’t see much of an excuse for a prolonged downturn in equities at this point based on the macro view of the US economy….Sure, some foreign weakness might creep into the balance sheets of US corporations, but a modest expansion in future earnings hasn’t been altered by recent events.  Of course, if some draw dropping change came out of the EMU (like a Greek restructuring of the monetary union) then my views would be void of value, but I don’t see that happening any time soon.  If anything, we’re more likely to move in the direction of more Central Bank intervention as opposed to a restructuring of the system.


“Why Did the Stock Market Decline?”

Whenever the market moves violently in one direction or the other we tend to ask questions after the fact.  In recent days the stock market has been falling rather rapidly.  And people want answers.  But I find this questioning misguided.  Who cares why the stock market went down.  Answering that question serves no purpose.  You don’t get your money back if you find the answer.  You don’t get a prize.  All you get is some comfort knowing that you know why something happened after the fact.  And that’s not worth a whole lot.

The more important question is “why should the stock market rise?”  Or better yet, “what if the stock market declines?” These questions get us to think in a proactive manner. These questions force us to think in a critical manner.  The world of asset allocation isn’t about being reactive.  It’s all about being proactive.

It’s fashionable to bad mouth people who make forecasts and people who “manage risk”, but the reality is that all smart asset allocation involves risk management and forecasting. We are all putting together a portfolio of assets and trying to interpret how we can best reduce risk while achieving our financial goals.  The only way to achieve this is to think in a proactive fashion because once you’re the person asking “why did the stock market decline” you’re the person who is being reactive.  And once you’re reacting to the market’s moves you’re likely already behind the curve.

Smart asset allocators prepare rather than react.  They ask themselves the scary questions before those scary questions need to be answered in real life.  Market declines shouldn’t surprise you.  And they shouldn’t worry you.  That is, of course, unless you’re not prepared.  And to be prepared you have to be asking the right questions.