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That Stubborn Yield Curve
by John Mauldin
October 29, 2006
Introduction
How About That Dow?
An Optimistic Fed
The Economy Slows Down
That Stubborn Yield Curve
Has the Housing Market Bottomed?
Time to Be a Bull
New Orleans, New York, and Coming of Age |
Introduction
There is an arcane debate going on in economic
circles. How fast can the economy grow without inflation becoming a
problem? The answer may be, not as fast as we thought. And the answer
matters because the people who have their fingers on the interest-rate
trigger take this arcane stuff seriously. How you answer the question also
has implications for the unemployment rate. Yes, there are people who
worry about it getting too low. Plus, we look at the Dow. The Dow may be
telling us more about how indexes are constructed than about how the
economy and the market are really doing. All that, some thoughts on the
housing data, and more as we ponder the question, "Is it really different
this time?"
But first, one of the really great investment
conferences every year is the annual New Orleans Investment Conference.
This year it is November 15-19. Originally started by the late Jim
Blanchard, the conference has a strong gold contingent, but has expanded
to cover a wide range of themes. Last year, the conference had to be
rescheduled because of Katrina, but this year it is back and looks to be
better than ever.
In addition to yours truly, they have lined up
Steve Forbes, Jim Rogers, Marc Faber, Dennis Gartman, and Newt Gingrich,
plus scores of other well-known speakers, workshops, and private sessions.
If you register before November I, you can save $200 on the full price and
half off for a friend or spouse.
In conjunction with my friends at
Altegris Investments, we will be hosting a dinner for clients and
prospects. If you are an accredited investor and would like to attend the
dinner, please respond to mauldin@2000wave.com (not my private email address!).
Click on the link below for more information about the conference. (You
have to use this link to get the special rate.)
www.jeffersoncompanies.com/affiliate/affiliate_process.php?icode=confreg&acode=JM
How About That Dow?
The Dow, except for today, has been relentless in
making new highs. Yet a lot of other indexes are still below where they
were six-plus years ago. Why is the Dow behaving differently? The evidence
suggests it is because of the way the Dow is calculated.
Before we
get into that data, I don't want to take away from the impressive
performance of late of the Dow and the markets in general. I am not
suggesting that we have some false bull market, because the recent
increases have been quite real, and my continued stop-clock call for a
major correction looks more and more silly with each new high. But as I
will make the case below, I can't throw in the towel and jump on the Dow
20,000 (or whatever) bandwagon quite yet.
This sidebar is simply
to put the difference between the Dow and other indexes like the S&P
500 into perspective. How you create them makes a difference. The Dow has
always been price weighted, so the higher the price of a stock, the more
important it is to the index. Most other indexes (like the S&P 500)
are market cap weighted, so the higher the total value of the company, the
more weighting it has in the index. If you use price as the factor for
your index, the size of the company does not make a difference.
As
many have noted, only 10 of the 30 Dow stocks are above their January 2000
highs. Fifteen of the remaining 20 are down 25% or more. The biggest
reason for the surging of the Dow has been just four of its stocks, which
not coincidentally are its highest-priced components. And as Barry
Ritholtz noted, not a one of the 30 Dow stocks was at an all-time high as
the Dow was making its new index highs.
What would your returns
look like if the Dow was capitalization weighted like the S&P 500? I
asked my friends Rob Arnott and Jason Hsu at Research Affiliates to do the
math for us. And since they also run indexes which are fundamentally
weighted, I asked them to tell us what the returns would have been if you
had weighted the stocks by valuation metrics rather than price or size.
The Dow was at 11,453 on January 1, 2000. Today it closed at
12,134, up almost 700 points or around 6% over the almost 7 years.
Including dividends (which is only fair) the total return on the Dow would
have been 20.75%.
What if the Dow had been capitalization
weighted? Your total return (including dividends!) would have been only
1.13%! Taking away the dividends, the Dow 30 would still be under its
high-water mark by about 13%! The S&P is only 6% from where it was on
January 1, 2000, or about 9% from its all-time high. (Back-of-the-napkin
math. The exact numbers are not important.)
So, the only reason
that the Dow is at new highs is the way they calculate the index. On a
cap-weighted basis, the S&P 500 is actually doing better!
But
what happens if you weight the Dow components by valuation metrics, like
P/E, price-to-book, and so on? A Dow 30 index weighted by valuation, like
that used by Research Affiliates, would have yielded a total return of
27.6%.
As an aside, Arnott and Research Affiliates have a patent
pending on the intellectual property they developed to create their
fundamental indexes. After they published their research, which shows the
clear benefits of using valuation as the basis for an index, they have
started to create "fundamental indexes" in markets throughout the world. I
have written about this concept in the past. I think this concept will be
the mainstream long-only index methodology within ten years. Cap weighting
is so last century. (www.investorsinsight.com/thoughts_va_print.aspx?EditionID=121)
There are some mutual fund firms who seem to be ignoring the
patent pending and are pursuing their own fundamental indexes. How that
will work for them remains to be seen. Intellectual property is a
cornerstone of our economy. If you cannot protect it, whether it is
software, chip designs, business processes, or a new widget created in
someone's garage, it will cause serious problems in a market-based
economy. One of the reasons that there is not more creativity and economic
growth in the developing world is the lack of patent protection and
outright theft of ideas. Why go to the trouble of creating, or sharing
your creation, if someone is going to steal it?
And now, let's
look at why Fed governors have been warning us about inflation of
late.
An Optimistic Fed
At the August 8 Fed meeting, the policy makers
sitting around the table were given briefing material called the
"Greenbook" (for its green cover). I have been highlighting for several
months that Fed governors are increasingly sounding hawkish in their
speeches, asserting that inflation is too high and hinting that it is
still possible we could see interest-rate hikes.
We now know that
what they saw in the Greenbook obviously influenced their speeches.
Federal Reserve economists showed data which suggested the previously
assumed linkage between economic growth and inflation may be too
optimistic. Basically, the assumption is that if the economy grows too
fast, unemployment will decrease, driving up wages, and capacity
utilization will increase, driving up prices. Thus an economy can grow too
fast and cause inflation. (Note that developing economies can grow much
faster without inflation because they have high unemployment.)
In
effect, policy makers were told last month that time is running out for
inflation to fall. The forecasters expect "only a small gap" between what
the economy can produce running at full speed and the actual growth rate
over the next several quarters. That means any unexpected acceleration in
growth might well heat up inflation.
By 2008, according to meeting
minutes, the staff expects the economy to be roaring ahead at close to its
speed limit, making it more urgent to get inflation under control now.
Staff economists revised the noninflationary growth rate down once
again at the September meeting. The first reason for slower potential
noninflationary growth comes from research done by senior staff
economists, published this spring. The paper suggested that the US is
beginning a slow slide downward in the percentage of workers participating
in the labor force.
The report said, "Such a slowing in labor
input would, in turn, reduce the sustainable rate of economic growth"
unless there is another surge in productivity. But since productivity is
high, this did not raise many eyebrows. And then the productivity numbers
changed.
The Department of Commerce revised their data for the
past three years. The result is that the economy did not grow as fast as
previously thought in the three years 2003-2005. Growth was revised down
from 3.5% to 3.2%. Growth in output per hour was revised down, which meant
productivity was revised down. Business investment on equipment and
software did not rise as fast as previously thought.
Therefore,
since we are not as productive as we thought, the growth rate that doesn't
create more inflation is lower. At least that is the argument the Fed
economists make, and clearly the Fed governors take them seriously.
JP Morgan Chase estimates that the noninflationary growth rate has
dropped from 3.5% to 2.7%, mirroring the Fed concern. And aside from the
very poor GDP numbers today, the Fed and most economists think that GDP
will grow faster than 2.7% next year.
If the economy does indeed
pick back up before inflation is brought down, it could signal the need
for further rate hikes. Thus the concern by Fed governors in their
speeches and in the press release from the FOMC meeting concluded this
week.
The debate is framed by two very different estimates of
economic growth and Fed policy. Because JP Morgan Chase, mentioned above,
thinks that the economy is going to grow enough that inflation will remain
a problem, they think there will be three more interest-rate hikes between
now and June, taking the Fed funds rate to 6%.
But there are
others, like Goldman Sachs, who think the economy will slow and bring
inflation down with it. Goldman thinks the Fed will cut rates five times
next year, bringing the Fed funds rate down to 4%.
And if you are
a Fed governor, you have to make a decision each and every meeting. But
you did get some data today which suggests that inflation may finally be
slowing. The favorite Fed measure of inflation, the core Personal
Consumption Indicator (PCE) fell to 2.3% in the third quarter. Another few
months of that trend and Fed governors will have to get a new topic for
their speeches.
The Economy Slows Down
Today, the Commerce Department reported that the
economy did in fact grow less than 2.7% in the last quarter, coming in at
1.6%, far below consensus expectations. Of course, we know that these
numbers are subject to revision. And a former Commerce Department
economist says that the number will be revised down sharply.
Joe
Carson, now director of economic research at Alliance Bernstein LP in New
York says the growth rate should have only been 0.9%. The 1.6% number was
the result of a statistical fluke which yielded an unexpected increase in
auto production last quarter, in spite of announced cutbacks by Ford, GMC,
and others.
" 'A drop in the wholesale price of SUVs and light
trucks as the automakers cleared leftover 2006 models made production look
stronger than it actually was,' said Carson. The economic fallout from the
auto-industry cutbacks will instead come this quarter, he said.
"'Last quarter was weak even with the benefit of this mismatch and
the fourth quarter will now also be weak because it's going the other
way,' Carson said. 'Whatever output you have this quarter, which will
probably be down, will be discounted by a likely rebound in prices.'
"Carson stressed that there wasn't an error in procedure requiring
a correction from the government. It's the way the Commerce Department
always computes the data and doesn't mean the statisticians committed any
mistakes, he said." (Bloomberg)
Basically, they use prices to
estimate output. And since auto companies dropped prices by 5.5%, it made
inflation-adjusted production look larger for autos larger than it
actually was. As an aside, most economists predict this quarter will be
2.5%. Carson thinks GDP will be 1.4% and he wouldn't be surprised "if it
was half that."
That Stubborn Yield Curve
As long-time readers know, I have been suggesting we
will see a slowdown or a mild recession next year. Among other reasons, an
inverted yield curve is the most reliable predictor of recessions of all
our forecasting tools, and the inversion of the yield curve is continuing
to deteriorate. Today the ten-year bond is 43 basis points below the
90-day T-bill. This is the largest differential this cycle.
The
yield curve inverted in the third quarter of 2000 when nearly all
economists were projecting solid growth. Something like 50 of 50 Blue Chip
economists did not predict a recession. As it turned out, the economy was
actually in a very mild recession in the third quarter, but we did not
know it for another few years as the GDP kept being revised downward. The
actual beginning of the "official" recession as tracked by the National
Bureau of Economic Research was not until March of 2001 through November
of 2001.
The general stock market was just fine, making new recent
highs (except for the tech bust, of course). Calling for a recession, as I
did, in August of 2001 was not a consensus view. And reminding people that
stock markets dropped an average of 43% during recessions was not popular.
Everyone was rooting for the return of the bull, and it sure looked like
it was coming back.
Just for fun, let's see what the differential
on the yield curve looked like in the "pre-recession" year of 2000 and
then compare it to this year. The thick (red) line is this year and the
thin (blue) line is 2000. Notice the inversion got worse as the year
progressed. We can't statistically make too much of this, other than to
see it for the cautionary resemblance of this year to 2000.
Has the Housing Market
Bottomed?
Residential housing construction fell at an annual
rate of 17.4 % last quarter, the biggest decline since the first quarter
of 1991, after shrinking at an 11.1% pace in the previous three months.
The decline subtracted 1.12% from GDP growth, the most in almost a quarter
century. Will a continued decline in housing construction push us into a
recession next year?
In August of 2005, I wrote about Greenspan's
speech at Jackson Hole. Reading between the lines, he very clearly said
the Fed was targeting asset prices and more precisely home prices. I said
then the Fed would keep raising rates until the housing market cried
uncle. And they did. Laying aside the inflation problem I wrote about at
the beginning of this letter, let's assume, for the sake of argument, the
economy slows down and enters into a recession. Can we expect the Fed to
come to the rescue at that point? The answer is, they will try and do so.
But the always perspicacious Paul McCulley suggests that lower rates might
not be enough. Writing this month in his Fed Focus, he says:
"While the housing bubble was inflating, it seemed impervious - or
inelastic - to the Fed's rate hiking, so the Fed kept tightening, on the
thesis that an unresponsive mule is not really unresponsive, just in need
of additional whacks on the head with a two-by-four. And it worked, as the
mule has gone into severe retreat this year. No surprise here, really, as
housing is, using the word of George Soros in the mouth of PIMCO's housing
guru Scottie Simon, one of the most "reflexive" asset markets in the
world, the ultimate momentum market: can't get enough on the way up and
can't run away fast enough on the way down.
"Which brings me to my
core thesis looking forward (and on the opposite side of former Fed
Chairman Greenspan): housing is going to be very inelastic to falling
interest rates on the way down, just as it was very inelastic to rising
rates on the way up. To think otherwise after a bubble is to not
understand bubbles. Risk appetite in property markets will not be restored
by modest declines in market-determined interest rates, particularly if
the Fed refuses to "validate" them with lower short-term policy rates,
limiting or even reversing declines in market-determined interest rates.
"Thus, just like policymakers and market participants kept
ratcheting up estimates of the time-varying neutral real short rate while
the housing bubble was inflating, I think they will be ratcheting down
those estimates, again and again, as the air continues to escape from the
property bubble. Put differently, irrational exuberance, which lifts the
cyclically neutral short rate, will, when followed by irrational fear,
reduce the cyclical neutral real short rate."
New-home sales have
increased for the second straight month. A lot of analysts see this as an
indication that worst is now behind us. Well, maybe. The first thing you
need to remember is that the inventory of unsold new homes is up to a
record 157,000, up 47%.
And good friend Barry Ritholtz tells us we
should look under the hood on those increased sales. His comments were so
right on, and a good read, that I will quote him at length:
"First, a quick word on New Home Prices:
"The
reported sales prices were pretty awful. 'Median sales prices dropped
9.7% in the past year to $217,100, the lowest price in two years. It's the
largest percentage decline in median prices since December 1970. Median
prices for existing single-family homes are down 2.5% in the past year,
the largest decline ever recorded'
"Here's the amusing part:
Despite the huge price drop, the reported price changes actually
understate the actual price changes. This is due to Builder Incentives. Have a look at some of the freebies builders have been using to get sales going:
Sub zeros, pools, BMWs, even paying the property taxes for 2
years!
"Candy bar companies don't like to raise prices, so they
simply make the candy smaller, selling them for the same price; Curb Your
Enthusiasm fans might note how many fewer Cashews go into a can of mixed
nuts ('The whole cashew/raisin balance is askew!'). Paying the same
amount for a smaller Almond Joy or less cashews is price inflation.
"Builders do the opposite: They add cashews. Some feel the
psychology of lowering prices scares off potential buyers - or at least
frightens them into sitting back and waiting. To avoid the appearance of
decreasing prices (or to make them appear less severe), they offer more - increasing what they are selling -
only without (apparently) charging for them. This getting more for the
same cost is price deflation. New Home Pricing today - more cashews
- is even more Deflationary than appears...
"Yesterday's increase
in New Home Sales caught some economists by surprise. I look at those
sorts of numbers suspiciously. Any time I want some insight into any
particular data-point, I find it instructive to go to the actual
government source's website, and simply click around. If you do this with
a skeptical eye, you may learn some really interesting facts.
"That's what I did with the New Home Sales yesterday, simply
looking at the release and trying to figure out what they were really
saying thru the bureaucratic jargon and legalese. You don't need to be a
forensic accountant (but it wouldn't hurt). Here's what I found:
"1. The reported increase in sales was 5.3 percent. The margin of
error was ±15.6%. Therefore, the likely change in sales ranged from +20.9%
to -10.3%. Since this range contains zero, "the change is not
statistically significant; that is, it is uncertain whether there was an
increase or decrease."
"2. Recently reported increases have
been subsequently revised downwards, primarily due to cancellations. Sales
in June, July and August were revised down by 67,000.
"3.
Year-to-date sales are down 16.5%.
"4. Commerce department does
not do an 'Apples-to-Apples' comparison. They report initial New Home
Sales (pre-cancellations) versus the prior months adjusted
(post-cancellations). This has the effect of lowering the older months
data, thereby making the present monthly gain appear larger.
"A
more consistent methodology might be to compare unrevised data with
unrevised data. So for September, we might look at sales of new one-family
houses in August 2006 as initially reported - annual rate of
1,050,000 (seasonally adjusted); Then we look at sales of new one-family
houses in September 2006 as initially reported: an annual rate of
1,075,000 - just under 2.4%, as opposed to the reported 5.3%. Note this is
still statistically insignificant, given the ±15.36% margin of error.
"Note that the year over year estimates -- down 14.2% percent
(±12.2%) below the September 2005 puts zero beyond the margin of error.
The range year over year is between down 2% - to down 26.4%!"
It
is not likely that we have seen the bottom in the housing market. And if
prices slide it is going to affect the mindset of consumers. I met with a
very interesting economist by the name of Kathleen Camilli of New York
this week. You will be hearing more from her. I picked up the following
chart and data from one of her recent letters.
The valuation of US
owner-occupied real estate has risen from $4 trillion to $20 trillion
since 1980, and by $8 trillion in just the last five years. This enormous
increase in wealth is what allowed consumers the psychological "cover,"
not to mention the actual wherewithal, to continue to increase spending
right through the last recession.
What if we have a recession and
home values are dropping? Just a thought, and not a pretty one.
Time to Be a Bull
I have the luxury of not directly managing money. I
am basically a manager of managers, so I can choose which manager (or
partners I work with, who choose) to direct client money. I am really
looking forward to the day when I can once again be bullish. It is so much
easier both personally and professionally to have a bullish view.
It is so vastly easier to find great managers in a bull market.
And there are a lot of managers who have done well over the past few
years. But if you have the view that we are going to lower valuations,
putting money in long-only indexes and programs is a mug's game. It is
trading short-term returns for long-term risk.
There are lots of
long-biased managers who will do well in the next bull market, and I love
value-based funds of all types. It is a lot harder to find absolute-return
managers who can provide good returns in difficult markets as well as the
recent bull runs.
If I am right and we are going into a recession
or serious slowdown next year, if the market did not have a serious
problem, it would be the first time in history. I don't like betting on
"It's different this time." So far this year, I have been wrong; but I
don't think the game is over. The fat lady hasn't sung. In the meantime,
absolute-return investing has the potential to provide good returns while
limiting your exposure to a market correction.
And as an aside, I
hope I am wrong. I hope we get a soft landing, and that it happened last
quarter. I hope new-home sales really do pick up. I hope unemployment
stays low and that the porridge will be just right.
New Orleans, New York, and Coming of
Age
As noted at the top of the letter, I will be in New
Orleans November 15-19. It now looks like I will be in New York for a day
or so later this month, and then no planned trips until late January when
I go to South Africa.
My #2 son turned 18 yesterday. Just as I
watched his five older brothers and sisters, I have watched him mature. It
is rewarding to see them take on more responsibility, to take the turn to
be their own person. "Dad, I can pay for that. Why should you do it? I
want to." When you think that nothing has rubbed off, it makes you smile
when your son comes in and starts talking about customers and marketing
and values at his job. Maybe there is hope.
Have a great week.
Your ready for NBA basketball to begin analyst,
John Mauldin
John@FrontLineThoughts.com
www.frontlinethoughts.com/gateway.htm
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