Archive for Most Recent Stories – Page 2

Three Things I Think I Think

I’m pretty sure I think all of these things.  Let me know what you think you think about the things I think I think.

1)  On Piketty and R > G.  I was doing some more thinking on Piketty and his idea that the problem of inequality is ultimately about the way that wealth concentrates into the hands of a few people primarily due to inheritance.  But how true is this of the world we actually live in?  For instance, if you look at the Forbes 400 list of richest Americans the list is a revolving door of names (including last names).  The list in the 80′s looks nothing like the list in 2013.  And perhaps more importantly, there’s actually an increasing trend in upward mobility in this list (via Kaplan and Rauh):

“in the U.S., the share of Forbes 400 individuals who are the first generation in their family to run their businesses has risen dramatically from 40% in 1982 to 69% in 2011. Figure 2 illustrates that the percent that grew up wealthy fell from 60% to 32% while the percent that grew up with some money in the family rose by a similar amount. The share that grew up poor remained constant at roughly 20%. The Forbes 400 of recent years therefore did not grow up nearly as advantaged as those in decades past. Those who grew up with some wealth in the family were far more likely to start their own businesses rather than inherit family businesses. Furthermore, these findings about generation and wealth in the family are very similar when the results are weighted by wealth. These results suggest that there has been an increase, not a decrease, in wealth mobility at the very top.”

This doesn’t mesh well with the concepts and conclusions that Piketty cites in his book.  Now, it doesn’t mean inequality isn’t a problem, but it does mean that the inequality argument is not always being framed correctly.

2)  John Hussman discussed what he called the “Iron Law of Valuation” in this week’s letter.  Hussman says that the market is overvalued and that investors are not properly positioned for the potential relapse.  As regulars will know, I am not a big fan of trying to claim that the market is worth “this much”, and investors think it’s worth “this much” therefore you need to be bullish or bearish.  The whole concept of “value” appears nebulous to me.

So, I’d introduce the Iron Law of Behavioral Finance – the market can remain irrational longer than you can remain solvent.  You might very well know the true “value” of the market at present.  You might have some software or indicator that tells you precisely what the market is worth.  But if the rest of the market doesn’t agree with you then your concept of value is 100% useless.

And this is the flaw in so many value approaches.  While many of them reject concepts like rational expectations or the efficient market hypothesis, they implicitly embrace these views by assuming that their own view is the rational view and that that market will eventually come around to it.  I reject these views and embrace the idea that the market is filled with irrational people and more often than not, understanding the market and protecting yourself within it is about protecting yourself from the madness of the crowd rather than trying to predict what it’s thinking at any given time.  Or worse, waiting and hoping that this mad crowd will one day agree with your idea of what is or isn’t “valuable”….

3)  I loved this chart from the guys over at Pension Partners showing the contrast between 2013 and 2014 asset price performance.  It’s well known that recency bias tends to lead us off the cliff of focusing excessively on recent performance.  Study after study has shown that our obsession with the recent past leads us to chase returns and chase the “hot hand” or the hot manager.  And time and time again this proves to be a losing battle as recent winners are often just riding a wave that is more likely cresting than surging higher.  It meshes well with the growing importance of behavioral finance in portfolio management.  Beware of high flyers and the hot hand.  What worked in the recent past isn’t necessarily a sign of what’s going to work in the future.



How well do Economists Predict Turning Points?

By Hites Ahir & Prakash Loungani, VOXeu

Forecasters have a poor reputation for predicting recessions. This column quantifies their ability to do so, and explores several reasons why both official and private forecasters may fail to call a recession before it happens.

Since the onset of the Great Recession, much of the world has been in a state of economic winter: nearly 50 countries were in recession in 2009 and 15 countries slipped into recession in 2012. After weak global growth in 2013, economic forecasters are predicting a rosier outlook this year and next. Can these forecasts be trusted? Or are forecasters simply intoning – like Chauncey Gardner, the character played by Peter Sellers in the movie Being There – that “there will be growth in the spring”?

The 2008–2012 record

In a classic 1987 paper, William Nordhaus documented that, as forecasters, we tend to break the “bad news to ourselves slowly, taking too long to allow surprises to be incorporated into our forecasts.” Papers by Herman Stekler (1972) and Victor Zarnowitz (1986) found that forecasters had missed every turning point in the US economy.

These traits appear to have persisted to this day. In our recent work we look at the record of professional forecasters in predicting recessions over the period 2008-2012 (Ahir and Loungani 2014). There were a total of 88 recessions over this period, where a recession is defined as a year in which real GDP fell on a year-over-year basis in a given country. The distribution of recessions over the different years is shown in the left-hand panel of Figure 1.

Figure 1. Number of recessions predicted by September of the previous year



The panel on the right shows the number of cases in which forecasters predicted a fall in real GDP by September of the preceding year. These predictions come from Consensus Forecasts, which provides for each country the real GDP forecasts of a number of prominent economic analysts and reports the individual forecasts as well as simple statistics such as the mean (the consensus).

As shown above, none of the 62 recessions in 2008–09 was predicted as the previous year was drawing to a close. However, once the full realisation of the magnitude and breadth of the Great Recession became known, forecasters did predict by September 2009 that eight countries would be in recession in 2010, which turned out to be the right call in three of these cases. But the recessions in 2011–12 again came largely as a surprise to forecasters.

A robust finding

In short, the ability of forecasters to predict turning points appears limited. This finding holds up to a number of robustness checks (Loungani, Stekler, and Tamirisa 2013).

  • First, lowering the bar on how far in advance the recession is predicted does not appreciably improve the ability to forecast turning points.
  • Second, using a more precise definition of recessions based on quarterly data does not change the results.
  • Third, the failure to predict turning points is not particular to the Great Recession but holds for earlier periods as well.

Figure 2. Predicting recessions in advanced economies, 1989–2008



These points are illustrated in Figure 2 above, which presents evidence on how well recessions were predicted in advanced economies over the period 1989 to 2008. Consider the panel on the left. The line labelled ‘unconditional forecast’ shows the normal evolution of forecasts of real GDP growth. On average across countries, forecasters start out by predicting – in January of the preceding year – that annual growth in the following year will be about 3%. This forecast is then lowered slightly over the coming 24 months.

The evolution of forecasts in years that will turn out to be recessions is shown by the red bars. While forecasts in recession years start out very close to the unconditional average, they start to depart from it slightly around the middle of the previous year, suggesting that forecasters are already starting to be aware that the year to come is likely to be a departure from the norm. Major departures of the forecasts from the unconditional average, however, only start to occur over the course of the current year and occur in a very smooth fashion. By the end of the forecasting horizon in December, forecasts are only slightly above the average outcome in recession years, which is shown by the solid blue line. (Note that, on average, growth is not negative during recessions in advanced economies because the dating of recession episodes is based on the quarterly data and annual growth tends to remains positive during many recessions.)

The evidence for recessions associated with banking crises is shown in the right panel of Figure 2. Here, the departure from the unconditional forecast starts earlier than it does for other recessions. This is followed by a smooth pattern of downward revisions to the forecast. In this case, even the terminal forecast greatly underestimates the actual decline, which on average is about 1.5%. To summarise, the evidence over the past two decades supports the view that “the record of failure to predict recessions is virtually unblemished,” as Loungani (2001) concluded based on the evidence of the 1990s.

Are official forecasts any better?

Forecasts from the official sector, either from national sources or international agencies, are no better at predicting turning points. In the case of the US, the March 2007 statement by then-Fed Chairman Bernanke that “the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained” has received a lot of attention. Another Fed Chair, Alan Greenspan, told his colleagues in late-August 1990 – a month into a recession – that “those who argue that we are already in a recession are reasonably certain to be wrong.” Forecasts by Fed staff have also missed turning points, as discussed in Sinclair, Joutz and Stekler (2010).

During the Great Recession, Consensus forecasts and official sector forecasts were so similar that statistical horse races to assess which one did better end up in a photo-finish. As an example, Figure 3 compares Consensus forecasts with those made by the OECD. For both the year-ahead forecasts (those made in June of the previous year) and the current year forecasts, the correlation between the two sources of forecasts is extremely high. Hence, an analysis of the OECD’s ability to forecast recessions gives results very similar to those shown earlier for Consensus forecasts.

Figure 3. Correlation between Consensus forecasts and OECD forecasts



For the case of the IMF too, a recent independent evaluation concluded “that the accuracy of IMF short-term forecasts is comparable to that of private forecasts. Both tend to overpredict GDP growth significantly during regional or global recessions, as well as during crises in individual countries” (IMF 2014).

Searching for an explanation

To paraphrase Oscar Wilde, to fail to forecast a few recessions may be misfortune, to fail to forecast nearly all of them seems like carelessness. Do forecasters simply not update their forecasts often enough to be alert to the onset of recessions? That simple possible explanation turns out not to be true. As shown in Figure 2 earlier, the consensus forecasts in recession years are revised every month; they just are not revised down enough to capture the onset of recessions. Related work by one of us – which looks at the behaviour of individual forecasters rather than just the consensus – also finds that forecasts are updated quite often (Dovern, Fritsche, Loungani, Tamirisa, 2014).

So the explanation for why recessions are not forecasted ahead of time lies in three other classes of theories, which are not mutually exclusive.

  • One class says that forecasters do not have enough information to reliably call a recession. Economic models are not reliable enough to predict recessions, or recessions occur because of shocks (e.g. political crises) that are difficult to anticipate.
  • A second class of theories says that forecasters do not have the incentive to predict a recession, which – though not a tail – event are still relatively rare. Included in this class are explanations that rely on asymmetric loss functions: there may be greater loss – reputational and other kinds – for incorrectly calling a recession than benefits from correctly calling one.
  • The third class stresses behavioural reasons for why forecasters hold on to their priors and only revise them slowly and insufficiently in response to incoming information (Nordhaus 1987).

Regardless of the explanation for why recessions fail to be forecasted, the evidence suggests that users of these forecasts need to be cognizant of this feature. Forecasters may be predicting that “there will be growth in the spring” but their ability to predict a sudden snowstorm is rather limited.

*  The authors are researchers at the IMF.  

Market Monetarism – Monetary Base Overdrive

By JKH (cross posted from Monetary Realism)

Martin Wolf has written (HT Cullen Roche) an excellent article on the recent Bank of England paper.

Here are his key summary points from that article:

First, banks are not just financial intermediaries. The act of saving does not increase deposits in banks. If your employer pays you, the deposit merely shifts from its account to yours. This does not affect the quantity of money; additional money is instead a byproduct of lending. What makes banks special is that their liabilities are money – a universally acceptable IOU. In the UK, 97 per cent of broad money consists of bank deposits mostly created by such bank lending. Banks really do “print” money. But when customers repay, it is torn up.

Second, the “money multiplier” linking lending to bank reserves is a myth. In the past when bank notes could be freely exchanged for gold, that relationship might have been close. Strict reserve ratios could yet re-establish it. But that is not how banking operates today. In a fiat (or government-made) monetary system, the central bank creates reserves at will. It will then supply the banks with the reserves they need (at a price) to settle payments obligations.

Third, expected risks and rewards determine how much banks lend and so how much money they create. They need to consider how much they have to offer to attract deposits and how profitable and risky any additional lending might be. The state of the economy – itself strongly affected by their collective actions – will govern these judgments. Decisions of non-banks also affect banks directly. If the former refuse to borrow and decide to repay, credit and so money will shrink.

The act of saving does not increase deposits. If your employer pays you, the deposit merely shifts from its account to yours

Fourth, the central bank will influence the decisions of banks by adjusting the price it charges (the interest rate) on extra reserves. That is how monetary policy works in normal times. Since it is the monopoly supplier of bank reserves and since the banks need deposits at the central bank to settle with one another, the central bank can in this way determine the short-term interest rate in the economy. No sane bank would lend at a rate lower than it must pay the central bank, which is the banks’ bank.

Fifth, the authorities can also affect the lending decisions of banks by regulatory means – capital requirements, liquidity requirements, funding rules and so forth. The justification for such regulation is that bank lending creates spillovers or “externalities”. Thus, if many banks lend against the same activity – property purchase, for example – they will raise demand, prices and activity, so justifying yet more lending. Such a cycle might lead – indeed often has led – to a market crash, a financial crisis and a deep recession. The justification for systemic regulation is that it will, or at least should, attenuate these risks.

Sixth, banks do not lend out their reserves, nor do they need to. They do not because non-banks cannot hold accounts at the central bank. They need not because they can create loans on their own. Moreover, banks cannot reduce their aggregate reserves. The central bank can do so by selling assets. The public can do so by shifting from deposits into cash, the only form of central bank money the public is able to hold.

Finally, quantitative easing – the purchase of assets by the central bank – will expand the broad money supply. It does so by replacing, say, government bonds held by the public with bank deposits and in the process expands the reserves of the banks at the central bank. This will increase broad money, other things being equal. But since there is no money multiplier, the impact on the money supply can be – and indeed has recently been – modest. The main impact of QE is on the relative prices of assets. In particular, the policy raises the prices of financial assets and lowers their yield. The justification for this is that at the zero lower bound normal monetary policy is no longer effective. So the central bank tries to lower yields on a wider range of assets.

This is not just academic. Understanding the monetary system is essential.

These ideas are not new. But Wolf summarizes them well.

Market monetarists have had some problems with this paper, which is understandable given their emphasis on monetary aggregates rather than interest rates as the appropriate framing for monetary policy and theory. Nick  Rowe in particular has  written a series of outstanding posts that help connect the market monetarist dots on this issue. Scott  Sumner also. And David  Glasner opines on aspects relating to the paper and the associated debate. Rather than dwell on the details of what various people have written on this subject (market monetarists and others), I’d like to offer a general impression of the way in which market monetarism and like-minded interpretations respond and object to this sort of characterization of monetary policy.

Market monetarism (or perhaps monetarism more generally) embraces two analytical orientations that inform its worldview. The first is the tendency to view the monetary base as a single entity rather than a complex composition of reserve balances held by banks and currency held mostly by the non-bank public. The second is the tendency to subsume central bank short term interest rate operations within a longer term view of how the (undifferentiated) monetary base affects the broader monetary aggregates, price level, NGDP, and employment.

Market monetarists associate the detailed operational characteristics of central and commercial banking with a myopic perspective on monetary policy. This is the case especially as it relates to the central bank’s role in setting the short term policy interest rate target. They look at the monetary base as a whole and its ultimate effect on the economy, rather than on the nuts and bolts of central banking interest rate mechanics and its transmission through the banking system.

The monetary base is defined as the totality of central bank monetary liabilities issued to the private sector – which includes bank reserve balances and currency. The central bank issues these two different liability types mostly for the benefit of two different institutional stakeholders. Bank behavior in using reserve balances is different from non-bank behavior in using currency – because of institutional differentiation and purpose.

Reserve balances are used by banks to clear customer payments for both asset allocation and GDP expenditure behavior (largely via bank deposit liability activity) across the financial system. Banks also participate as principal actors primarily in the asset allocation process via their reserve accounts. Currency is used almost entirely for GDP expenditure activity – not so much as the medium of exchange in asset allocation decisions. Thus, reserve balances are inextricably linked to financial intermediation and currency is not. That should tell us something. It is notable that the sea change in the relative proportions of reserve balances and currency due to central bank quantitative easing in recent years has not been associated with any change in this normal alignment of functionality.

Market monetarists tend to dismiss the importance of banks in monetary theory. The construct of a seamless “base” becomes a catalyst for this perspective – because it does not differentiate overtly between banks and non-banks. One particular thought experiment often invoked by monetarists is the imagined substitution of currency for electronic reserve balances. But this only begs the question. The issue is not the physical or electronic difference between reserve balances and currency. The issue is the identification of the two different parts of the monetary base held by two different types of users. This is important because supply and demand functions differ as between reserve balances and currency.

For example, in the short term, the central bank has no choice but to supply the quantity of currency demanded by the public. The public acquires currency from the banks by paying for it with deposits. The banks acquire currency from the central bank by paying with reserve balances. The central bank supplies the quantity demanded through this acquisition sequence. This supply function is fully elastic to the prevailing demand. This is a fact of banking operations. In the longer term, market monetarists interpret that the central bank determines this currency demand function as part of total base demand – which results from policy that somehow influences that demand.

Also, in the short term, central banks control policy interest rates. This is the view that is expressed in the Bank of England paper and which seems to be the cause of some consternation among market monetarists. They eschew the description of such a mechanism as a legitimate characterization of monetary policy. Market monetarism interprets that in the longer term the central bank targets things beyond the short rate (e.g. inflation, NGDP) and responds to larger forces which determine the required path of the short rate – which in turn is a function of the path of the monetary base that achieves the desired monetary policy. Conversely, those observing from the operational perspective interpret this longer term connection directly as a succession of short term interest rate control decisions (consistent with inflation targets or other objectives).

The different institutional constituencies come to satisfy their needs for the two components of the monetary base in very different ways. The case of currency was noted. In the case of reserve balances, the central bank has a greater degree of operational and policy freedom in responding to demand than it does for currency. For example, in the case of a central bank channel reserve system, with upper and lower bound standing facilities, the central bank can shift its reserve balance supply to meet a desired policy interest rate target. In the case of quantitative easing, the central bank can set a floor rate for the payment of interest on reserves, enabling it to meet its interest rate target under any quantity of reserves supplied. But there is no comparable short term pricing mechanism in the case of currency, because bank deposits are redeemable at par on demand in exchange for currency.

The robust nature of this monetary base bifurcation is most evident in the extraordinary reversal of the relative shares of currency and reserve balances that has occurred in the US banking system over the period of the financial crisis and the consequent long term asset purchase program (LSAP) of the Federal Reserve. Most observers are familiar with the famous graph that delineates the multi-trillion dollar expansion of excess reserve balances held at the Fed – up from a pre-2008 starting point of only several billion dollars. Over the same period the Fed has transitioned from an asymmetric reserve channel system to an ad hoc floor system where interest is paid on reserve balances in order to manage interest rate target levels while excess reserves have increased a thousand fold.

LSAP (large scale asset purchases) is an unconventional channel for the injection of outsized excess reserve balances into the commercial banking system (otherwise known as quantitative easing or QE). Previously, reserve balances were provided or withdrawn through central bank “open market operations” (OMO), or something similar, in which the central bank transacts directly with a dealer network that in turn works in close proximity with the commercial banks. Indeed, most of these dealers typically are owned by the commercial banks as part of a “universal bank” holding company structure.

The supply/demand configurations for OMO and QE are very different. The shortest term supply/demand configuration for OMO within a channel system of any type comprises a nearly vertical inelastic demand function and a perfectly vertical supply function. Moving beyond that OMO frequency range, between the meetings where policy interest rates are confirmed, the short term policy rate configuration includes a horizontal supply curve at the target interest rate. The QE demand function is different again – horizontal at the support floor rate. The supply function is vertical but with almost unlimited shifting flexibility. These are all very different dynamics for reserve balance supply and demand, depending on technical regime and time horizon.

QE widens the distribution of money connected with reserve balance injections in two important ways. The first is that it expands the distribution system for the immediate effects of money injection to a much broader range of market participants, well beyond that reached by normal OMO, including pension funds, insurance companies, mutual funds, and the like. The second is that the reserve injection has a significant material effect through the “back door” of bank deposit liability expansion. Most of the bonds sold into the central bank as part of QE originate from non-bank portfolios.

Indeed, it is the creation of broad money deposits held by non-banks that is the primary money transmission channel for the eventual QE effect on interest rates. The front door effect of reserve balances held by banks is less important, as explained by the Bank of England paper. The back door channel is the route for the effect on long term interest rates – because that is where most of the portfolio management decisions take place that have to do with this aspect. The front door effect is muted – in accordance with the general discrediting of the ancient “money multiplier” theory.

Thus, the Federal Reserve period of quantitative easing through LSAP has resulted in an extraordinary reversal of the historic quantity relationship that has existed between reserve balances and currency.  This phenomenon requires more explanation that can be provided naturally by a monetary theory that prefers to consolidate reserve balances and currency into a monetary base lump and which favors a background role for banks. A long term view should not ignore differentiation in monetary operations and institutions.

Nick Rowe says:

Central banks control their own current and promised future balance sheets. Any influence they have on interest rates, and inflation, and anything else, all ultimately derives from changing the size and composition of their own balance sheets. Targeting interest rates is not what central banks really really do, for you people of the concrete steppes. Interest rate targets are merely a communications device (and a bad one at that), that some central banks sometimes use (see Paul Krugman) as an intermediate step between the machine language of balance sheet quantities and the ultimate target of inflation (or whatever). Nobody should confuse a communications device for ultimate reality.

Central banks control the quantity of reserve balances supplied in the short run but they do not control currency in the same way – because they respond to quantity demanded with a fully elastic supply. Yes, they control reserve balance adjustments they deem appropriate taking into account the quantity of currency they are asked to supply, but interest rate objectives play a critical role in determining just how that control function is executed in the short term.

Also, interest rates are more than a mere communications device in support of quantitative balance sheet operations. The interest rate or yield on a bond or a reserve account is no less important than the quantity of money to which it applies. In monetary policy terms, communication includes interest rate settings as well as inflation or NGDP targets. All of it constitutes communication. The issue is really the interconnectedness and ultimate effect of these various modes of targeting and how well that is communicated and understood.

So while Nick has a point that monetary policy is not just one damn interest rate after another, the framing for the role of interest rates need not be so asymmetric and exclusionary. Moreover, the short term operational perspective on monetary policy has the advantage of being immediately observable and verifiable. The question is how a series of short term operational decisions is best explained by an initial long term view – of which market monetarism is one brand.

Scott Sumner says:

The BoE controls the base in such a way as to target interest rates in such a way as target total spending in such a way as to produce 2% inflation.  And yet in that long chain interest rates are singled out as “monetary policy” … Lots of people use the term ‘reserves’ when they would be better off using the term ‘monetary base.’  Back in 2007 the part of the US monetary base that was “coins” was larger than “bank reserves.”  So it would have been more accurate to talk about central banks injecting coins into the system.  And prior to 2008 new base money mostly flowed out into currency in circulation within a few days, even if the first stop was the banking system.  Banks were not important for monetary policy, although of course they were a key part of the financial system.

It’s not clear that an interest rate focus on monetary policy is any more exclusionary in considering broader economic targets such as inflation than is the case with a monetary base focus. Most who describe monetary policy in terms of interest rates are quite aware that economic considerations form the rationale for central bank interest rate adjustment. It just so happens that the market monetarists have hitched their wagon to the targeting of NGDP by monetary base means. But that involves two quite separate things – the choice of NGDP as the ultimate economic target and the choice of the monetary base (instead of interest rates) as the implementation focus. The focus on interest rates is typically associated with a more status quo choice for economic targeting – such as inflation rather than NGDP. So I think the criticism here obscures what really is a comparable relationship between monetary operations and policy targeting, even if the choice of a more status quo economic target tends to be emphasized less frequently than the choice of a more unconventional one such as NGDP.

Market monetarists have been active recently in commenting on the issue of “the money multiplier”. Whatever they are saying about, it certainly doesn’t resemble the money multiplier process described in some of the older economics textbooks. That’s the one where excess reserves suddenly appear and banks proceed to “lend” those reserves in a geometric series that exhausts the surplus by creating deposits which gradually cause the conversion of those excess reserves into a required reserve classification. It depicts a process in which central banks first supply excess reserves and then those excess reserves get multiplied into loans and deposits. That is both empirically wrong in the order in which new deposits are matched up with the first appearance of corresponding reserves and causally wrong in the way in which banks make decisions to lend. The Bank of England and a host of others have explained the nature of this sort of error. The objection is perfectly rational. It simply doesn’t work that way and never has.

The “newer” Market Monetarist rendition of the multiplier seems in general to present it as a sort of long term portfolio balancing of the monetary base against the topology of broad money. This can include intra-base balancing of the currency component of the base with broad money deposits. Whatever. This sort of portfolio balance and asset mix interpretation seems a bit of a stretch in rescuing a discredited idea that originally had to do with how banks make loans at the operational level. And yes folks – that is the way it was first explained in the old textbooks.

Central banks for example no longer embrace the old money multiplier argument in explaining the intended objective of QE as it relates to the creation of extraordinary levels of excess reserves.  The normal explanation now relates to the intended effect on the interest rate markets that are involved in selling the bonds to the central bank. QE operates in money terms through bank liability profiles that provide the broad money for institutional portfolio managers to make those decisions. QE is a special case of monetary policy that is quite different than how it has been implemented conventionally through Fed SOMA operations (for example). And while the central bank is managing its balance sheet and base money in both cases, it is also targeting its operational effect on interest rate markets in the process.

In summary, some conceptual friction exists between those favoring an operational perspective on monetary policy and those adhering to a steadfast monetary base view in the long run. Perhaps those coming at the subject from the operational perspective don’t know enough monetary theory. But this is moot if the theorists are under little obligation to present theory that fits nicely with differentiated functionality in real world monetary operations. The important question might be whether such realistic implementation connections are relevant for economics. And so it is unclear why monetary theory should reconcile only reluctantly with the operational details of central banking and commercial banking.



Robo Advisors – Awakening a Giant for the Benefit of All

A lot of people have started asking me about some of these Robo Advisor services like WealthFront and Betterment in recent months.  I’ve started digging into the businesses in more detail, but while I am in the process, I did want to pass on some pretty cool news from Vanguard – they’re getting into the game also.

The rise of the Robo Advisor is good and bad.  I’ll add details later, but the good news is that these low fee providers are driving down costs, automating processes (portfolio management is all about process, process, process) and driving out bad advisors.  I also think they’re perfectly positioned to help the lower income investor which is great news for people who are hesitant to pay up for something they might not need.  Those are huge wins for everyone who’s an investor.   But the Vanguard product is cool because it takes Vanguard’s low cost platform, embeds automation AND offers you the personal touch that is often necessary with financial planning and portfolio advisory.  As Erik Brynjolfsson says, we have to learn to work with the machines, not against them.  Vanguard seems to have gotten the message.

This is all good news.  I’ve long said that the biggest problem in the investment business is the fee structure and if nothing else, this is fantastic news for all involved (except maybe the Robo Advisors who now have to compete with the giant they kicked in the shins).  And hey, while we’re all complaining about the economic consequences of the rise of the robots, let’s not forget that a lot of good is coming from it as well.  This being exhibit A.

* I have no business relationship with any of the firms mentioned above.  I am just an independent financial consultant watching them all duke it out…. 

Don’t bet on the Treasury Bond Rally to Continue

By Sober Look

Treasuries rallied sharply last week, mostly on the back of the sell-off in equities as well as in response to the Fed’s seeming backpedaling on the timing of rate hikes.

Treasury rally


10y Treasury Note Futures (source:

While the equity market pullback makes sense for a number of reasons (including increased leverage and momentum driven activity in a number of shares), the treasury market rally does not. Reading the dovish tea leaves of the FOMC minutes is counterproductive. The Fed’s reluctance (see story) to support its own FOMC members’ projections of higher rates by the middle of next year – which are quite realistic – simply serves to confuse the market. It’s about time the Fed realizes that the US economy can withstand (and in fact could benefit from) higher rates.

Scotiabank: - We think rate hikes next year are a reasonable thing to expect and that the forecast pace is not unreasonable. Indeed, quite frankly, neither do the majority of FOMC officials themselves. Recall that the projections of FOMC officials became more hawkish at the March 19th FOMC meeting when more Fed officials (10 of 16) projected that the Fed funds target would equal 1% or more by the end of next year. This is reflected in chart 2 which is a recreated version of the Fed’s famous dot plot that shows the fed funds target forecasts of individual FOMC officials. Presumably not all 10 of those individuals think that higher rates will commence late in the year and are more spread out in their forecasts, thus making hikes starting in Q2 or Q3 eminently reasonable. More officials also projected a Fed funds target of 2% or greater by the end of 2016 (12 of 16).

It can’t be both ways by way of talking down the risk of rate hikes while still forecasting them. Suppressing yields in the short-term only aggravates the potential for disruptive market behavior later. The Fed either has a forecast to which the balance of Fed officials are committed, or it doesn’t. I might not have views identical to those of all of my bright, ambitious colleagues surrounding me, and thus emphasize different risks to a house view. But conducting policy gives each individual one vote and that weighted perspective on Fed views is turning more hawkish, full stop and regardless of attempts by the Fed’s communications subcommittee to massage the market outcome.

The big debate among the FOMC members has been around the amount of slack in US labor markets. The focus has been on falling labor force participation which is to some extent due demographics.

Wells Fargo: – Compared to previous decades, cyclical factors have played a larger role in the path of the participation rate in recent years as labor market weakness continues to keep some potential job seekers from looking for jobs. However, the participation rate began to decline in 2001, well ahead of the recession, amid demographic and cultural shifts independent of the business cycle. The secular forces of higher female participation and the baby boomers entering their prime working years that led to a four-decade long rise in labor force participation have now reversed. Female participation peaked in 1999, and in 2001 the first of the baby boomers turned 55 years old—an age at which participation begins to decline notably. We find that demographics alone have accounted for about half of the decline in the labor force participation rate since 2007.

The reality is that as the headline unemployment figures continue to improve and wages begin to pick up, the Fed will be forced to hike rates in spite of weaker labor force participation. And key US employment metrics clearly point to ongoing improvement.

Gallop job creation index

Gallup’s Job Creation Index

For those who have been jumping back into treasuries as a result of the Fed’s perceived dovish stance or as a hedge to equities, be prepared for a disappointment.

Barclays Research: – At current levels, we believe outright short duration offers a good risk reward as well. The market has gone too far in discounting the move higher in the “dots” [individual members' forecasts for higher rates] at the FOMC, which was largely driven by an improving outlook of the labor market.

The Alarm Clock Goes Off on Dream Stocks

By AllianceBernstein

Investors have recently woken up to the reality of overpriced US momentum stocks in technology and biotech. But a knee-jerk shift toward defensive sectors isn’t the answer.

In early April, money has flowed away from companies such as Netflix and Twitter, which we call “dream stocks” because investors believed they could grow without any help from the economy. A more thoughtful reaction to this collapse would be to reach for cheap stocks—rather than safe ones—because they have value on their side and will diversify interest-rate risk. And we believe that there are good reasons to anticipate more appreciation ahead—if you focus on the right parts of the market.

Defensive Sectors Look Risky

In the flight from momentum, investors appear to be flocking toward companies in utilities, real estate investment trusts or REITS and consumer staples. Yet these stocks are not risk-free. They are priced high relative to their own history because people are still paying a high price for safety. After all, the argument goes, if the economy doesn’t grow, companies in defensive sectors won’t suffer their usual valuation penalty that traces to high dividends, which leave very little capital for growth.

But what if growth accelerates? In our view, companies that are unable to invest in future growth could underperform significantly if the economic recovery accelerates. By concentrating their portfolios in defensive companies, investors may miss an opportunity in those companies that are more likely to thrive in a faster-growth environment.

Understanding Valuations

Stock valuations help point the way. Spreads between the cheapest and most expensive quintiles of stocks based on price/book value are extremely wide. This has been driven largely by the inflated valuation of dream stocks in the most expensive group, as we explained in a recent blog, but also by continued underappreciation of companies with uncertain profit trajectories.

Indeed, price/earnings multiples vary enormously. Even amid the recent declines of momentum stocks, the most expensive stocks trade at valuations that are still 4.8 times the market median (Display)—quite high relative to history, higher than during the financial crisis and approaching the record levels seen during the tech bubble. The pain investors have already experienced in this group could just be the beginning.



Economic Growth to Unlock Value

There are plenty of attractively valued stocks to be found at the other end of the spectrum. Many boast high profit margins that we believe are sustainable. In some cases, sales growth is well below the long-term trend and can be expected to improve. In others, improved cost structures and more benign competitive environments support future profits. These underpriced companies are generally more sensitive to economic growth, so their value could be unlocked when the economic waters become clearer.

But these stocks have another important characteristic. Since the Fed has made clear that interest rates will rise when the US economy’s growth prospects improve, we’re likely to see economically sensitive stocks appreciate just as bond values are falling, providing much needed diversification to balanced portfolios. Those rushing into defensive stocks as shelter from the carnage in the dream stocks may find themselves trading one risk for another as the defensives are likely to underperform when interest rates rise.

Momentum Rout Exposes Passive Flaws

There’s another important lesson from the recent rout in momentum stocks. Investors who have bought into an index have also been buying into dream stocks, often unintentionally.

As these stocks rose to excessive valuations, they automatically became a bigger part of the benchmark. In the aftermath of the correction, we think investors should reconsider the merits of buying the entire market without any scrutiny.

Taking a stock-picking approach can also help avert a rush into expensive defensive stocks. In our view, staying active and focusing on attractively valued stocks that can perform well as an economic recovery unfolds is the best way to get a better night’s sleep in today’s restless markets.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Joseph G. Paul is Chief Investment Officer of US Value Equities at AllianceBernstein (NYSE: AB)

Not Everyone in Finance has Their Head Buried in the Sand….

Paul Krugman asks an interesting question this morning:

“The question is why so many people in finance gravitate toward that view [that emphasizes the dangers of deficits and monetary expansion], and cling to it despite what is at this point overwhelming evidence that it’s wrong.”

He goes on to cite how so many in the world of finance thought that high deficits and QE would lead to higher interest rates, a potential solvency problem in the USA, high inflation, etc.  He goes on to argue that you didn’t need to understand the financial asset world to understand what was going on, but needed a macroeconomic understanding of the liquidity trap concept.  But this can’t be right because there were lots of people in finance (like most of the readers of this website) who understood that the aforementioned concerns were legitimate. And we understood those concepts through an operational understanding of the monetary system, not an understanding of “liquidity traps”. For instance, I’ve consistently, for 5 years, pointed out:

These were important predictions.  And I know lots of other people in the financial world who understood the concepts perfectly well without having to understand what a liquidity trap is.  In fact, all that was required was a basic understanding of the monetary system.  As to why so many people continue to believe these things are problems despite the overwhelming evidence otherwise – my guess is politics rules over reason….

A Lesson in Portfolio Correlations

By Ben Carlson, Proprietor, A Wealth of Common Sense

“It seems like the higher mathematics with more false precision should help you but it doesn’t. They teach that in business schools because, well, they’ve got to do something.” – Charlie Munger

I received a number of comments on my Do You Need Commodities in Your Portfolio?post from fans of investing in commodities. Many asked why commodities wouldn’t be the perfect investment for diversification benefits based on Modern Portfolio Theory because of the fact that they have a low correlation to stocks.

This seems like a good time for a quick primer on correlation. Correlation measures how strongly two data sets are related with one another from a scale of -1 to +1. A negative correlation occurs when one value increases and another decreases while a positive correlation exists when both values increase together. Correlations near 0 means there is no relationship one way or another.

Diversified investors typically look for non-correlated assets so they don’t move in lock-step with one another. In theory, this can reduce your risk.

But many investors mistake correlation for the be-all-end-all in portfolio risk control. Using a single variable such as correlation can lead to problems in portfolio construction if you don’t use some discretion.

Here are four issues to consider when using correlation as a historical data point along with some examples:

1. Low Correlation Is Not Always a Good Thing
Here are the correlations with the S&P 500 of various asset classes going back to 1991*:



These numbers show why low correlation to the broader stock market isn’t the only pre-requisite for inclusion in a portfolio. Cash has little correlation with the S&P 500, just as commodities do, but that doesn’t mean it makes sense to hold cash over the long run.

Cash (T-Bills) earned investors only 3% per year in this time frame while commodities gave you around 4% a year (with much higher volatility). Bonds, on the other hand, returned nearly 6.5% annually and proved their worth as a diversifier to equities.

So low correlation can help, but not always.

2. Correlations Change Over Time
Compare the longer-term correlations above with this 13 year period…



…and this 11 year stretch:



Commodities showed an ability to zig while stock zagged from 1991 to 2003, but have had a much closer relationship since that time. Emerging market stocks have also shown a stronger positive relationship to the S&P while bonds and cash flipped to negative correlations.

Investment environments are never quite the same across time. Interest rates, economic growth, industry leadership, inflation, innovation and a host of other factors are continuously changing as time marches on.  It’s impossible to extract perfect relationships in the movement of the markets strictly using past correlation data.

3. A Strong Correlation Does Not Mean Similar Performance
The correlation between commodities and emerging markets during 2004-2013 was +0.90, a very strong positive relationship. Yet in that time EM stocks were up nearly 200% while commodities rose just 9% in total.

So while these two investments moved together fairly regularly, the total returns weren’t anywhere close to one another in magnitude.

Meanwhile, in the same period, EM stocks and U.S. bonds had basically no correlation with one another (only 0.07) but bonds still made investors nearly 60% in total.

4. Modern Portfolio Theory (MPTDoes Not Rest On Correlations Alone
Although correlations, co-variances and these types of statistics are important aspects of MPT, it’s not enough to simply add non-correlated asset classes together to find the best portfolio.

The whole point of MPT is to create a portfolio that gives you the highest return for a given level of risk. Adding highly volatile investments, such as commodities, simply because they have shown low correlation in the past does not lead to higher risk-adjusted returns. In this construct, higher volatility should lead to higher expected returns (in the long-term) which is something commodities have not done.

Of course, MPT is not a perfect solution to portfolio construction. The most efficient portfolio created by MPT will always be based on historical data that is in a constant state of change, as you can see from the data presented here.

The perfect portfolio is still the one that you can stick with based on your personal circumstances, risk tolerance and time horizon, not the one you create using fancy mathematical formulas.

In Your Money & Your Brain, Jason Zweig told a great story about Harry Markowitz, the Nobel Prize winning creator of Modern Portfolio Theory. Markowitz shared this honest admission with Zweig:

“I should have computed the historical co-variances of the asset classes and drawn an efficient frontier.” (That’s efficient-market talk for draining as much risk as possible out of his portfolio.)

But, he said, “I visualized my grief if the stock market went way up and I wasn’t in it — or if it went way down and I was completely in it. So I split my contributions 50/50 between stocks and bonds.”

Although number crunching can be an important part of your investment strategy, the ability to have some self-awareness in the biases of the data you use is much more important.

As always, the qualitative factors will trump the quantitative factors in your portfolio.

Your Money & Your Brain

Now the best stuff I’ve been reading in the past week:

  • Josh Brown: Your risk tolerance changes with moves in the market so don’t try to pretend it doesn’t (Reformed Broker)
  • Politics don’t make us stupid, they just blind us to our biases (Prag Cap)
  • Rick Ferri’s ‘how I got into the investment business’ story (Rick Ferri)
  • There is a huge difference between the noise you hear and how the markets actually work (Big Picture)
  • Is there a change coming in the financial advisor fee structure? (Motley Fool)
  • These stats on household debt never cease to amaze me: The financial vulnerability of Americans (House of Debt)
  • Get comfortable looking stupid as an investor (Clear Eyes Investing)
  • 5 ways to go nowhere in life using negative knowledge (Seth’s Blog)
  • Video: Jason Zweig & Jonathan Clements on retirement income, stock losses risk tolerance and financial advisors (WealthTrack)

Investors Want More…Investment

No, dummy.  We’re not going to talk about “investment” in the sense that everyone abuses the term – as in stock market “investing”.  We’re going to talk about real investment – spending, not consumed, for future production.   Anyone who’s read my primer on the monetary system knows that investment is one of the most important drivers of overall economic growth.  And while investment has been relatively robust over the last 5 years it is interesting to think about how much more robust this could be.  For instance, take these two charts.  The first is from Goldman Sachs showing how corporations are spending:


Now look at what investors want companies to be doing with their spending:

Cash usage


Corporate balance sheets were never a big problem during the crisis (with the exception of banks and many non-bank financial firms).  But what’s interesting is that investors really want more capex and yet corporations seem to be involved in their usual pro-cyclical increases in dividends and buybacks.  It all makes one wonder – why aren’t corporations actually pouring more money into their own firms as opposed to just handing it back to shareholders?  My best guess is that it’s a lack of demand combined with the short-termism that has come to dominate corporate board rooms.  After all, buybacks are a great way to “make numbers” and boost short-term incentives without hurting the corporate income statement.

Martin Wolf: “Understanding the monetary system is essential”

Martin Wolf has a fantastic new piece in the Financial Times discussing some of the flaws in the thinking that has driven irrational fears around QE and hyperinflation in the last 5 years.  It reads like something I could have written so of course I like it.  But in all seriousness, you should read his article and you should seriously understand the monetary system.  It won’t just help you better understand policy.  It will help you avoid many of the portfolio pitfalls that hurt investors during the last 5 years.

4 Reasons to Expect a Capex Acceleration

By Sober Look

We’ve received a number of e-mails regarding the recent post on the possibility that rising CAPEX spending in the US is driving corporations to tap their credit facilities, thus increasing loan growth (see post). Most were highly critical of this line of thinking in their comments, using words such as “bogus”, “propaganda”, “head fake”, “delusional”, etc. Thanks for all the feedback. The argument that “things are different this time” understandably meets a great deal of skepticism, especially after a number of false starts and years of uncertainty. But evidence for a significant rise in corporate CAPEX spending continues to build. One could write a dissertation on this topic, but let’s just look at 4 key data points:

1. Diminishing uncertainty. As discussed earlier (see post) federal government policy uncertainty (fiscal and monetary) that has been hounding corporate CEOs and investors for years has finally subsided, at least in the nearterm. Even the politically charged uncertainty around the implementation of Obamacare has been receding (more on this later). We can debate about the merits of the various policies but it is often the uncertainty more than the policy itself that spooks corporate decision makers.

The other trend that is often overlooked when discussing corporate spending in the US is the recent period of relative calm in the Eurozone. While the area’s current economic malaise isn’t great for US firms, it is important to remember that during 2011 – 2012, the risk of the monetary union’s collapse was quite real. Imagine trying to make a major corporate expenditure decision when the world is concerned about Italy’s or Spain’s ability to roll government debt, as these nation’s banking systems teeter on the verge of insolvency. Many of the structural issues that caused this crisis are still with us today, but the ECB’s backstop dramatically reduced the nearterm uncertainty.

The constant barrage of scary news is receding, as the news-based uncertainty index finally drops to its pre-financial-crisis levels.

Uncertainty indexSource: Economic Policy Uncertainty

2. Corporate infrastructure is aging. From software to planes to telecommunications equipment, companies have severely underinvested in recent years, and it’s time to start upgrading. Consider the fact that the average age of fixed assets such as factories, storage facilities, etc. is at levels not seen in nearly 50 years.

Fixed assets ageSource: BofA/Merrill Lynch

Moreover, some economists argue that slow productivity growth in recent years (discussed here) is a direct result of weak corporate spending. With plenty of cheap labor one didn’t need to be too efficient in order to be profitable. But at some point companies will need to upgrade their aging technology and infrastructure in order to improve worker productivity.

3. CEO confidence. Based on the analysis done by Charles Schwab, CEO confidence tends to lead key CAPEX expenditures. And CEO confidence has risen sharply in recent months.

CEO confidence vs investmentSource: Charles Schwab

4. Investors.  Shareholders are demanding that companies begin using more of their massive cash balances toward CAPEX. The chart below from Merrill Lynch is quite compelling.

Cash usageSource: BofA/Merrill Lynch

It seems that the stage is set for corporate spending to finally accelerate. And yes, the experiences of recent years make this possibility hard to accept for some. But evidence continues to mount.


No One Will Ring The Bell At The Top

By Lance Roberts, STA Wealth

The market has had a rough start of the year flipping between positive and negative year-to-date returns. However, despite all of the recent turmoil from an emerging markets scare, concerns over how soon the Fed will start to hike interest rates and signs of deterioration in the underlying technical foundations of the market, investors remain extremely optimistic about their investments. It is, of course, at these times that investors should start to become more cautious about the risk they undertake. Unfortunately, the“greed factor,” combined with the ever bullish Wall Street “buy and hold so I can charge you a fee” advice, often deafens the voice of common sense.

One of my favorite quotes of all time is from Howard Marks who stated:

“Resisting – and thereby achieving success as a contrarian – isn’t easy. Things combine to make it difficult; including natural herd tendencies and the pain imposed by being out of step, since momentum invariably makes pro-cyclical actions look correct for a while. (That’s why it’s essential to remember that ‘being too far ahead of your time is indistinguishable from being wrong.’)

Given the uncertain nature of the future, and thus the difficulty of being confident your position is the right one – especially as price moves against you – it’s challenging to be a lonely contrarian.”

That quote is truest at extremes as markets can remain “irrational” far longer than would otherwise seem logical. This is particularly the case when, despite clear signs of overvaluation and excess, central banks worldwide are dumping liquidity into economies in a desperate attempt to “resolve a debt bubble with more debt.”

It is interesting that when you ask most people if they would bet heavily on a “pair of deuces” in a game of poker, they will quickly tell you “no.” When asked why, they clearly understand that the “risk to reward” ratio is clearly not in their favor. However, when it comes to the investing the greater the risk of loss, the more they want to invest. It is a curious thing particularly when considering that the bets in poker are miniscule as compared to an individual’s “life savings” in the investment game.

However, that is where we clearly find ourselves today. There was never a clearer sign of excessive bullish optimism than what is currently found within the levels of margin debt. Even as the markets sold off sharply in February, investors sharply levered up portfolios and increasing overall portfolio risk.

MarginDebt-NetCredit-040814-2Even professional investors, who are supposed to be the “smart money,” are currently at the highest levels of bullishness seen since 1990.  (The chart below is the 4-month moving average of the net-difference between bullish and bearish sentiment.)


Franklin Roosevelt, during his first inaugural address, made one of his most famous statements:

“So, first of all, let me assert my firm belief that the only thing we have to fear is fear itself…”

However, when it comes to the stock market it is the “lack of fear” that we should be most fearful of.  Throughout human history, the emotions of “fear” and “greed” have influenced market dynamics.  From soaring bull markets to crashing bear markets, tulip bubbles to the South Sea, railroads to technology; the emotions of greed, fear, panic, hope and despair have remained a constant driver of investor behavior.  The chart below, which I have discussed previously, shows the investor psychology cycle overlaid against the S&P 500 and the 3-month average of net equity fund inflows by investors. The longer that an advance occurs in the market, the more complacent that investors tend to become.

Investor-Psychology-Cycle-040814Complacency is like a “warm blanket on a freezing day.”  No matter how badly you want something, you are likely to defer action because it will require leaving the “cozy comfort” the blanket affords you. When it comes to the markets, that complacency can be detrimental to your long term financial health. The chart below shows the 6-month average of the volatility index (VIX) which represents the level of “fear” by investors of a potential market correction.


The current levels of investor complacency are more usually associated with late stage bull markets rather than the beginning of new ones. Of course, if you think about it, this only makes sense if you refer back to the investor psychology chart above.

The point here is simple. The combined levels of bullish optimism, lack of concern about a possible market correction (don’t worry the Fed has the markets back), and rising levels of leverage in markets provide the “ingredients” for a more severe market correction. However,  it is important to understand that these ingredients by themselves are inert. It is because they are inert that they are quickly dismissed under the guise that“this time is different.”

Like a thermite reaction, when these relatively inert ingredients are ignited by a catalyst they will burn extremely hot. Unfortunately, there is no way to know exactly what that catalyst will be or when it will occur. The problem for individuals is that they are trapped by the combustion an unable to extract themselves in time.

I recently wrote an article entitled “OMG! Not Another Comparison Chart” because there have been too many of these types of charts lately. The reason I make that distinction is that the next chart is NOT a comparison for the purposes of stating this market is like a previous one. Rather, it is an analysis of what a market topping pattern looks like.


As you can see, during the initial phases of a topping process complacency as shown by the 3-month volatility index at the bottom remains low. As the markets rise, investor confidence builds leading to a “willful” blindness of the inherent risks. This confidence remains during the topping process which can take months to complete. With individuals focused on the extremely short term market movements (the tree) they miss the fact that the forest is on fire around them. However, as shown, by the time investors realize the markets have broken it is generally too late.

As Seth Klarman recently wrote:

“The survivors pledged to themselves that they would forever be more careful, less greedy, less short-term oriented.

But here we are again, mired in a euphoric environment in which some securities have risen in price beyond all reason, where leverage is returning to rainy markets and asset classes, and where caution seems radical and risk-taking the prudent course. Not surprisingly, lessons learned in 2008 were only learned temporarily. These are the inevitable cycles of greed and fear, of peaks and troughs.

Can we say when it will end? No. Can we say that it will end? Yes. And when it ends and the trend reverses, here is what we can say for sure. Few will be ready. Few will be prepared.”

It is in that statement that we find the unfortunate truth. Individuals are once again told that this time will be different. Anyone who dares speak against the clergy of bullishness is immediately chastised for heresy. Yet, in the end, no one will ring the bell at the top and ask everyone to please exit the building in an orderly fashion. Rather, it will be a “Constanza moment as the adults (professionals) trample the children (retail) to flee the building in a moment of panic.

It is only then that anyone will ask the question of “why?”  Why didn’t anyone warn me? Why did this happen? Why didn’t we see it coming? Why didn’t someone do something about it?