The Sacrifice Ratio
John Mauldin
The Bernanke Era
The Sacrifice Ratio
How Important is Housing to the Economy?
On the Contrary: Why It Pays To Be Different
Toronto, Miami and New York
This week we will look at a few very interesting items that did not make it into
last week's forecast, as that letter was already overly long. Bernanke's
arrival, the importance of the housing market to the economy, the length of the
recent rally and a note from good friend James Montier on why it both pays, and
is painful, to be a contrarian. I include a quick note to some of my fellow
brokers at the end of the letter along with a few places to visit on the web for
fun. I think we will find a few tidbits to enlighten us.
But first, I must issue a correction and an apology to Elaine Garzarelli.
Business Week showed her as the most bullish of forecasters, predicting the Dow
to go to 14,000. In an attempt at humor, I asked her what she was smoking? She
wrote me a very polite note, saying that she does not normally forecast the Dow
and the Nasdaq. "Based on the S&P 500 forecast my staff took the percentage
change forecast for the S&P and applied it to the Dow for the Business Week
article. I was in Europe." And she noted in a hand-written comment, "I
unfortunately do not smoke or drink."
Elaine's work forecasts EPS of 84.40 and their estimate of a fair value of 18.8
for the P/E ratio, based on the equations of how bond yields, productivity,
inflation rates, growth deficits, and a host of factors all influence investor
willingness to buy at such a P/E ratio. She has not always been bullish, as in
1999 when she thought the market was 46% overvalued. I hope she is right about
this year. Bull markets are a lot more fun. And while I still think she will be
wrong, her track record for 20 years has been quite good. And she is clearly an
astute lady as she noted she enjoys my letter. You can read more about her
forecasts at www.garzarelli.com.
The Bernanke Era
Federal Reserve watchers are going to have to adjust to a new era. Greenspan,
who has the ability to answer a question without actually having anyone
understand the answer is going to be replaced by Ben Bernanke who actually
writes and speaks very clearly. I wrote this about Bernanke's first speech as a
fed governor back in November of 2002.
"...this speech was actually delivered in very clear, well written English. The
average layman could read and follow the thoughts. Bernanke thus disqualifies
himself for the role of Fed Chairman when Greenspan finally steps down, as it
seems a requirement for the job of Chairman is the ability to talk at length and
say very little that can be taken clearly."
So much for my predictive prowess. Now that Bernanke will be installed as Fed
chairman February 1 let's look at what we can expect.
First, Bernanke writes and speaks very clearly and it is likely he will continue
to do so. I would suggest that serious students go to the Fed site
www.federalreserve.gov and read Bernanke's speeches. He has argued that the Fed
needs to be more transparent and now he gets to walk his talk. I think he will.
That will be good for the markets. Guessing games create uncertainty, and the
market hates uncertainty.
It is fashionable in some circles to refer to Bernanke as "Helicopter Ben," a
reference to the speech mentioned above where he said in the effort to fight
deflation the Fed could as a last resort drop cash from helicopters. When you
read the speech, I think this was clearly an attempt at humor, which shows why
he is not making a living as a standup comic. But you can also assume Bernanke
is not going to let the country slip into deflation in the next recession. Given
the choice between mild stagflation and a deflationary depression as in Japan, I
would pick the former devil over the latter, and I think most observers would
agree. Let us hope we never have to live through either.
You can get my take on Bernanke and that helicopter speech by
reading my e-letter from last October. But in general, the speech was an academic exercise to suggest
that the Fed could indeed keep the US economy from going into deflation, which
was a very real concern at that time. From reading Bernanke's textbooks and
speeches over his life, he is a serious inflation fighter. We will not be
running outside waiting for cash to fall every time we hear a helicopter while
he is chairman.
We will get our first real peak into Bernanke's mind as Chairman when he appears
before Congress in February. He is going to be asked about the Fed and inflation
targeting. Bernanke has long been a proponent of inflation targeting. It will be
interesting to see if he will actually state what he thinks that target should
be now that he can greatly influence the number.
The Sacrifice Ratio
Along with Andrew Abel, Bernanke has written a well-received graduate level
economics text, which talks about inflation targeting and such arcane topics as
the sacrifice ratio.
David Kotok of Cumberland Advisors believes that the sacrifice ratio is now and
is going to be even more a key component of Federal Reserve policy. The
Sacrifice Ratio (SR) in very simplistic terms measures the amount of increased
unemployment that will be caused by an increase in interest rates vs. the amount
of future inflation that will lowered as a result of the increase in rates.
The Fed has two mandates, which the SR demonstrates are in actual conflict with
each other. They are supposed to contain inflation and do what they can to
increase employment. The SR is the way they measure the tradeoff. It may be
their ratio, but it is the unemployed who are sacrificed.
Of course, if they allowed inflation to come back, you would have stagflation
and even higher unemployment, so you have to be willing to go through a little
potential pain to avoid serious inflation. But how much and how fast?
Kotok wrote this about the SR last October:
"Clearly a low and falling SR is more desirable for Fed policymaking than a high
and rising SR. This is where and why the rubber hits the road in 2005. What is
the SR now? What was the SR in the Volcker and early Greenspan period?
"Here are the September 29 words of Fed Governor Don Kohn. Remember: Kohn was
the Secretary and an economist to the Board of Governors of the Greenspan Fed
before he became a Governor himself.
" '......the sacrifice ratio rose from around 2 or 3 in the mid-1980s to around
4 currently. Imbalances between demand and potential supply would thus now be
slow to show through convincingly to inflation, but when they do, they may be
costly to correct.'
"Here is Chairman designate and then Fed Governor Bernanke's SR reference in
a 2003 speech. Bernanke said: 'Now make the assumption that the sacrifice ratio
is 4.0, a high value by historical standards but one in the range of many
current estimates.'
"What does a rising SR mean for interest rates?
"It means the Fed is likely to persist hiking rates higher and longer than the
market expects. We have looked at the changes in Fed Funds futures pricing. It
is clear that these futures are short term oriented and do not capture this
element of Fed policymaking.
"The Fed believes the SR at 4 is higher than in the past (1980s when it was 2 or
3) and that it is rising. They fear that inflation in the future will be much
more painful to fight because the SR is this high. That is why the Fed is acting
preemptively. It wants to keep inflation low. It does not want to fight a future
higher inflation when the SR is this high.
"The Fed is forward looking in its work. The Fed's staff generates the estimates
of the SR from very complex equations. In simple terms, the staff's forecasts
and their econometric work are warning the Fed that the SR is at a level where
risk is compellingly great.
"Therefore the Fed would rather take rates higher now and deter inflation
rather than fight the actual inflation later. The Fed's research work also
suggests that a gradual policy application has the effect of lowering the SR
over time. This is why the Fed has been 'measured' in its rate hiking."
You can read the whole very interesting piece on the SR by Kotok at
www.cumber.com/comments/103105.htm.
As Kotok recently pointed out, and I agree, the Fed is likely to be through with
raising rates after Bernanke's first meeting in late March. But a lot of people
think they will be cutting rates later in 2006.
Maybe. Maybe not.
What a high SR implies is that if inflation is allowed to come back it will be
more painful in the future to deal with it than to deal with it today. While I
think inflation will gradually be coming down over this coming year, there are
real risks that this might not be the case. If we see persistent inflation, the
Fed may feel constrained to either keep raising rates or to not lower them in
the face of a mild slowdown. They will not cut until there is clear evidence of
a real slowdown in the economy.
Given Bernanke's position on inflation targeting and his watchful eye on the SR,
we should be mindful of it as well when we start to project new policy. If this
economy is still growing north of 3.5% in June, it would not surprise me to see
the Fed raise rates again.
As Kotok says, "We disagree with those who are already speculating about a Fed
rate cut in the second half of 2006. It's not very likely. It will take a
catastrophe to get it. The Fed is at the high end of neutral and the sacrifice
ratio is high. They will not cut rates unless they see pronounced slowdown
characteristics in the pipeline. One example of an indicator that will trigger a
rate cut discussion is the ISM numbers under 50. Negative numbers from the NFIB
surveys could also trigger cuts. So could a housing meltdown instead of a
leveling. These are possible, like all other things, but not likely as long as
the economy stays around trend growth rates.
"The Fed will not raise rates just because the dollar may be weakening. It would
take an absolute dollar rout to trigger Fed action in the dollar's defense.
Don't count on the Bernanke Fed defending the currency at the expense of the US
economy. It won't."
Actually, David, I think the Fed would secretly like the dollar to go down in a
gradual manner, especially against Asian currencies. This is going to be part of
what is necessary if the trade deficit is going to come down.
We are going to have to be patient and keep a very watchful eye on Bernanke's
testimony and speeches, as well as see how he crafts his first Fed statement
March 28. That will give us our first real clues.
How Important is Housing to the Economy?
I was recently forwarded a very interesting piece of research from Bridgewater
Associates. They suggest that the impact of housing on the economy comes from
three sources: the direct impact of housing activity, and "the impact of
financing activity related to the housing market, and the impact of the wealth
effect of rising or falling home prices. Of the three different impacts,
financing activity is at the biggest extreme and is the most vulnerable, while
the other two are more at cyclical highs."
"...All in all, the direct impact of housing on the economy is at high but not
overly extreme levels, due to high demand for houses and the perception from
people and businesses that the demand will continue and prices will continue to
rise. A return to more normal activity in the housing market should lead to only
about a 1.5% - 1.75% drop in direct GDP contribution over a couple of years.
"Most of the impact of housing has been through the financing of these homes, as
rising prices have provided a source of cash for people to spend on all types of
goods and services. The chart below shows that people are actually borrowing
significantly more money than they are spending on home purchases. As an
economy, the difference between these lines represents the money people have
borrowed through their home mortgages but can spend on anything. Historically
this has been negative as people typically do not finance 100% of their homes,
but the figure has recently been growing and is positive for the last three plus
years. It is now at an all time high of over $330 billion over the last year, or
2.7% of GDP."
A drop in housing prices and thus activity would lead to a potential drop in GDP
of at least 2-3%. (Remember, not all house refinancing would stop, nor would all
housing activity, it would just slow.)
They make another very interesting point. They have a chart which shows equity,
real estate and other forms of wealth as a percentage of overall wealth
allocation. As you can see below, home percentages have risen and real estate
has fallen, but equity is still larger than housing.
They go on to note, "From this perspective, household exposure is still greater
to equities than it is to real estate, and the volatility of equity asset values
is far greater than that of real estate, so the performance of the economy and
equities is likely to have more of an impact on people's saving habits than that
of real estate."
Thus, if we do see a housing slowdown coupled with a poor stock market, you
could see a real slowdown in the economy, which is precisely what I think will
happen in the latter part of the year.
This danger is underscored by Stephen Roach's recent comments:
"Globalization and the powerful cross-border labor arbitrage it has spawned has
turned the US labor market inside out. The manufacturing share of US employment
hit another record low as 2005 came to an end -- down to 10.6% of total nonfarm
payrolls, or about one-third the share prevailing as recently as 1970. At the
same time, employment and compensation is being squeezed in services as well,
where offshore outsourcing is moving rapidly up the value chain. The speed of
this transformation is what's so daunting. Just five years ago, white collar
outsourcing was confined to data processing and call centers; today, courtesy of
IT-enabled connectivity, it has moved to the upper echelons of the
knowledge-worker hierarchy -- software programming, engineering, design,
doctors, lawyers, accountants, actuaries, business consultants, and financial
analysts. The Internet is living up to its reputation of being the most
disruptive technology in the history of the world.
"The implications of these developments are profound. Long lacking in income
support, the spending-addicted American consumer has turned to equity extraction
from asset holdings in order to support the habit. According to Federal Reserve
estimates, the current pace of home equity extraction was around $600 billion in
2005 -- more than enough to compensate for the $335 billion shortfall of real
labor income generation noted above. But if the housing market softens and
financing costs rise -- both quite likely, in my view -- equity extraction will
fade and over-extended American consumers will then have little choice other
than to bring spending and saving back into more prudent alignment with income.
"That underscores the potential for a long-deferred and important transition in
the US -- away from the newfound joys of the Asset Economy back to the Income
Economy of yesteryear. Such a transition undoubtedly spells slower consumption
and real GDP growth over the foreseeable future -- a downshift that may already
have triggered a slowing in the underlying pace of hiring over the past four
months. In that context, further tightening would most likely be out for a
deflation-phobic Bernanke Fed, bonds should rally, stocks could be hit by an
earnings shortfall, and the dollar will likely fall further. Only a spontaneous
and powerful regeneration of labor income would allow the US economy to avoid
such an endgame -- an outcome that would imply nothing short of an unwinding of
the global labor arbitrage. Barring a dangerous outbreak of protectionism, such
a reversal is highly unlikely, in my view."
Finally, the following chart shows us that the current Dow rally is the 6th
longest in duration but the 5th weakest in magnitude. Given the concerns of the
economy, the very poor growth in personal income, high energy bills, an increase
in credit card payments this month due to new legislation coming into effect,
the lag time before Fed rate hikes have an effect, I would be somewhat cautious
with your long only index funds in your investment accounts. We could certainly
see a rally over the next few months, for a variety of reasons, but there are
some real headwinds we will be facing in the second and third quarters.
And finally, I bring you this executive summary of a research paper by one of my
favorite writers, James Montier. James is a contrarian of some repute. I think
my raders will find this very interesting.
On the Contrary: Why It Pays To Be Different
Whilst the consensus may sometimes be right, it is unlikely you will make money
from investing in it. As Keynes put it, investors should "go contrary to the
general opinion, on the grounds that if everyone agreed about its merits, the
investment is inevitably too dear". So going against the crowd is still likely
to be the best recipe for consistently adding value. But where are the big
consensus trades now?
* In a world in which everyone is trying to outperform each other, doing what
everyone else is doing is unlikely to work as a viable source of long term
alpha. As the quotation from Maynard Keynes makes clear, equity prices should
reflect the consensus view. So betting with the consensus is unlikely to
generate significant outperformance.
* New research by Lehavy and Sloan shows the stocks that institutional fund
managers are busy buying are outperformed by the stocks the fund managers are
busy selling. In the three years after portfolios were formed, those stocks that
had seen the lowest level of interest from institutional investors outperformed
those stocks with the highest attraction by over 4.5% p.a. (using data from
1982-2004).
* Of course, going against the crowd is not painless. Neuropsychologists have
found that social pain (the pain of going against the crowd, or being excluded)
is felt in the same parts of the brain as real physical pain. So contrarian
investing is a little bit like having your arm broken on a regular basis.
* The returns to bearing this discomfort can be sizeable. For instance, a model
relating the PE people are willing to pay to measures of underlying volatility
shows that as volatility declines so people will pay more, but of course, they
end up earning less. For instance, buying the market when it is in the comfort
zone (i.e. volatility is low) results in very low real returns over the long run
(an average of 1.3% p.a.). In contrast, buying equities when it feels absolutely
awful to do so can generate high returns. When the market is in the "you must be
mad to buy equities" mode, the real return over ten years is 15% p.a.!
* So, where are big consensus trades at the moment? Many investors seem to have
itchy trigger fingers when it comes to getting into growth styles. The logic
seems to be that after five years of value outperformance, surely growth is due
a bounce back. Japanese equities continue to attract a vast amount of support
from overseas investors, and surveys consistently show Japan is one the most
favoured regions this year. Long US/ Short Europe is becoming another highly
consensus trade. After a couple of years of US underperformance, investors seem
to think it is time for catch up. However, this ignores valuations. Across a
gamut of valuation measures the US is on average 56% overvalued, whilst Europe
is around 'only' 27% overvalued. Small caps also stand out as an expensive
consensus bet.
* Our value-orientated country screen suggests buying Belgium, Norway,
Netherlands, the UK and France. Amongst emerging markets Venezuela, Thailand,
Indonesia, Peru, Korea and Brazil stand out as cheap. Of course, buying any of
these is likely to result in accusations of insanity and calls for your
internment in an institution. Such are the joys of being a contrarian.
Toronto, Miami and New York
I will be in Toronto next week working with my partners in Canada, Pro-Hedge
Investors. I leave from there to go to Miami, where I will be speaking to a
group from EFG. EFG is a Geneva based private bank with a world-wide presence. I
am delighted to announce that we have come to an arrangement where they will be
my partners in Latin America, the Middle East and Asia, as well as Switzerland.
I will tell you more about that in a later letter, but we are getting closer to
being able to help readers from all over the world get information and access to
alternative investments.
And speaking of traveling, let me recommend the always interesting letter that
my friends at International Living write. It gets me thinking and dreaming. If
you have an interest in living overseas, it is certainly worth your time.
www.isecureonline.com/Reports/IL/WILVG128/
Let me pen a quick note to the regional broker-dealer community. As you may
know, I work with my friends at Altegris Investments to bring alternative
investments like hedge funds and commodity funds to accredited investors. They
have developed a fund which features the work of one of my favorite commodity
traders. We will shortly issue a research report on the fund. If you would be
interested in having the fund available to you and your clients, and would like
to learn more about it, just drop me a reply note and I will have an associate
at Altegris contact you or the appropriate person at your firm with more
details.
Sorry, because of very clear NASD rules this information cannot go directly to
the public. It can only be shown to brokers and then through them to their
clients. If you are an accredited investor and would like to know more about
alternative investments like hedge funds, commodity funds and other private
offerings, I suggest you go to www.accreditedinvestor.ws and sign up for my free
service. My friends from Altegris will contact you and help you find investments
that may be appropriate for you. And now, if you are in Latin America, Europe,
the Middle East, Asia or Canada, we can help you!
(In this regard, I am the president and a registered representative of
Millennium Wave Securities, LLC, member NASD.)
I am a little under the weather tonight, so I am going to close and get home and
rest. Maybe too much great food, really fine wine and too little sleep when I
was with my partners at Altegris in La Jolla for the past few days. They do feed
me well when I am there. Try a great new restaurant called Jack's. One of the
finest meals I have had anywhere. The cod was simply magnificent, and what a
wine list. Tiffani and I want to thank Jon, Bob, Matt and Dick for being great
hosts!
Next week will be an extreme. A cold Toronto and a warm Miami. Hard to pack for
that trip in a carry-on. Enjoy your week.
Note: John Mauldin is president of Millennium Wave Advisors, LLC, (MWA) a
registered investment advisor. All material presented herein is believed to be
reliable but we cannot attest to its accuracy. Investment recommendations may
change and readers are urged to check with their investment counselors before
making any investment decisions. Opinions expressed in these reports may change
without prior notice. John Mauldin and/or the staff at Millennium Wave Advisors,
LLC may or may not have investments in any funds cited above. Mauldin can be
reached at 800-829-7273. MWA is also a Commodity Pool Operator (CPO) and a
Commodity Trading Advisor (CTA) registered with the CFTC, as well as an
Introducing Broker (IB). John Mauldin is a registered representative of
Millennium Wave Securities, LLC, (MWS) an NASD registered broker-dealer.
Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Funds recommended
by Mauldin may pay a portion of their fees to Altegris Investments who will
share 1/3 of those fees with MWS and thus to Mauldin. For more information
please see "How does it work" at www.accreditedinvestor.ws. This website and any
views expressed herein are provided for information purposes only and should not
be construed in any way as an offer, an endorsement or inducement to invest with
any CTA, fund or program mentioned. Before seeking any advisor's services or
making an investment in a fund, investors must read and examine thoroughly the
respective disclosure document or offering memorandum. Please read the
information under the tab "Hedge Funds: Risks" for further risks associated with
hedge funds.
Your wondering what Bernanke's thinking tonight analyst,
John Mauldin
JohnMauldin@InvestorsInsight.com
www.2000wave.com
January 14, 2006
Copyright 2005 John Mauldin. All Rights Reserved.
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John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.
Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs at Millennium Wave Advisors, LLC may or may not have investments in any funds cited above.
PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGED FUNDS. WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER.
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