Investing for Sustainable Gains

Normally I love Dean Baker at CEPR, because he’s correctly figured out that our problem is horribly wasteful policies, such as the worst-in-class Medicare system.  But I don’t like many of his solutions, and I especially hope he stops writing these articles about the National Debt not being a problem.  I hope D.B. realizes at some point that the U.S. can and does have a really bad debt problem, even though lenders are willing to lend to us at low short-term rates.  Sure, we could borrow more money, but would we be spending it wisely to get out of debt in the future? I don’t see evidence of that.  And borrowing money simply to waste it is NEVER a good idea!

Right now the U.S. government makes the proverbial drunken sailor look like a pillar of rectitude!  After all, the drunken sailor can only spend money he already has — no one will lend to him!

In the case of Uncle Sam, just because the bond market is currently offering Uncle Sam what amounts to a teaser option ARM loan with zero interest for the next 6 months (or 3 for 10 years even), does not mean we should borrow the funds! The relevant timescale is far greater than 10 years, the bulk of our debt burden is on the short end, and the bond market is a fickle creature.  We could be cut off in less than a year — just ask the countries that have gone belly up in the last 100 years!  We shouldn’t borrow without a _really_, _really_ careful re-examination of what we are buying with the added debt, and an assurance that the marginal loan will produce a real improvement in our economy. Congress isn’t doing that, so the people need to force the issue.  We need to raise the price for our future debt servitude!

From another angle:  Just because the bond market is overflowing with rentiers who are desperate for safe “investments”, does not mean the U.S. can afford to borrow more. Federal debt-to-revenue already vastly exceeds sustainable levels, and there’s absolutely no Keynesian cushion for the next recession!! (Which, if we are back to the classic 4-year business cycle, is due in only a few months, given that the last recession started in Q4 of 2007…)

It makes no sense to borrow more funds for imperial wars, for wasteful tax breaks for people who are already very well-off, for wasteful tax policies that stimulate malinvestment in nonproductive assets, for a medical system that is grossly wasteful - the worst in the developed world. Etc. Dean, why should we lend THIS Congress another dime, without structural policy reforms?  What good will it do?

We need a smarter federal spending prioritization. We need better policies — policies that boost job creation without adding to the deficit. We need to encourage all the spare cash sitting on the sidelines to purchase tangible products rather than financial “investments”. Negative real rates ought to do it… and that would also push out some inflation to bring the nominal debt back to a reasonable proportion of the economy.

I’d be a lot more comfortable with this debt ceiling hike if Congress showed even an ounce of financial sense in terms of how to spend the money to fix the nation’s problems! I see no reason to give Congress more money if all it will do is continue to line the pockets of gluttonous special interests.  What we need is federal investments that deliver… sustainable gains.

Blindly borrowing more is just feeding the squid…

De-financialization:  To beat the squid, we may have to quit the game!

It is hard to fathom that during today’s episode of Bankrupt Greeks vs. Bankrupt Bankers, the herd fled into Treasuries, gold and silver, dumping the Euro, stocks and oil.  Given the unsustainable debt levels here, the long-term U.S. economic picture has to include either severe deflation or severe inflation (or both in alternating sequences).  But apparently Greece is on fire now and our own conflagration remains in the future, so the herd has moved here for temporary safe haven.

But isn’t this a bit like hiking to the stern of the Titanic, to avoid going down first with the bow, only to be sunk later?

In an over-financialized world, it’s unlikely that either the debtors or the lenders will win. Deleveraging means de-financialization, and that means less net interest going to the lenders. Some lenders have to lose.

Meanwhile, the lack of new credit means that not only do the ponzi borrowers go broke (those who require fresh loans even to pay interest), but even the speculative ones (who can cover interest but not principal) start to have real trouble rolling over their debts.  And in the maelstrom of inflation, deflation and unemployment, nearly everyone loses something.

It reminds me of the classic line from the movie War Games, when the insane computer finally learns the truth about the nuclear war “game”:  “The only winning move is not to play.”

So how does one “invest for sustainable gains” in this environment?  Shakespeare’s line comes to mind next:  “Neither borrower nor lender be.”

In practical terms, that’s not completely possible, but it does provide a sense of direction when considering options and choosing the next path.  The first move is to minimize fees to the financial sector, and to bring loans (bonds) into balance with debts (mortgage and other leverage). Second is to identify low-debt, high-tangible-value stocks and funds, that should hold their real value regardless of inflation or deflation.

Here we now have a portfolio with an overall 0.25% annual average expense ratio, and we’re closing on on zero net debt holdings (while allowing some room to make contrary rate-spread plays as the herd runs back and forth on the Titanic). The challenge of which tangible-value investments to hold is more challenging…

And, as this grows long, more about that later…

Thoughts on this:

http://seekingalpha.com/article/241172-stay-away-from-muni-bonds

Thanks for the fearmongering, but I don’t think it’s quite so bad.

Four points:

(1) The pension problem has been festering for a long time, and I just don’t see a kill-the-market catalyst or crisis other than the banking system having another liquidity crisis (like 2008).  But Bernanke has made it clear liquidity will be unlimited (for at least the next 3 years, eh) and the banks still own Congress behind-the-scenes and will not vote their own suicides. So unlike 2008, the market is unlikely to crash this time.

(2) The ongoing budget problems can and will (eventually) be met with rational cuts to “fluff” services, plus tax increases on those willing to put up with them.  Not to mention the monetary inflation that Bernanke is pumping into the system on a weekly basis!

(3) The ongoing, happening-right-now solution to the pension underfunding issue — once people wake up to the problem — has been (1) stop the bleeding - cease enrolling new employees in the troubled pension system and (2) make the workers pay for the pension - force current members of the plan to contribute to the pension out of salary (e.g. “your 2% COLA raise is now your pension contribution”).  This wave hasn’t reached all shores yet, but it’s visible — even in California (e.g. the University retirement system).  And retiree medical is just gone, at least until this nation gets serious about having a first-world medical system.  The public unions are still kicking, but the writing is on the wall… even in California.

(4) You claimed “My best guess is that two states go down — Illinois and California…” and then “If you have to own munis, own the better-quality states – in fact, own bonds that have first claim on revenues rather than general obligation debt.”  But you neglected to mention that in many states, including California, debt service payments are protected in the state’s Constitution.  Therefore a CA general-obligation bond is in fact quite like a revenue bond, protected by the tax revenues of the entire state.  That doesn’t make them risk-free, but they could well be lower-risk bonds than those issued (at currently lower rates!) by states which currently appear “better-quality” (short-term)!  Because those other states may have a more vulnerable (less diversified) economic base and lack the constitutional default protection…

In short, it might be quite profitable to do your own due diligence here, and wait for these fearful guys to bid up your preferred market after the crisis passes.

Over at tax.com, David Cay Johnson follows up on a Social Security Administration report with some “Scary New Wage Data“:

“Every 34th wage earner in America in 2008 went all of 2009 without earning a single dollar … Total wages, median wages, and average wages all declined, but at the very top, salaries grew more than fivefold.”

“Not a single news organization reported this data when it was released October 15, searches of Google and the Nexis databases show. Nor did any blog, so the citizen journalists and professional economists did no better than the newsroom pros in reporting this basic information about our economy.”

Ouch.

Corroborating this Scary New Wage Data is the chart on Page 21 of the National Economic Trends report put out monthly by the St. Louis Fed (a small PDF: http://research.stlouisfed.org/publications/net/page21.pdf )

Proprietors’ Income and employee “Compensation”, as a share of GDP, have been in decline. Only corporate profits have increased as a share of GDP. The latter have returned to pre-crash historically high “bubble” levels. Compensation is approaching series lows last set in 2006. Proprietors’ Income is declining from a peak in 2004-2005, which may reflect the heyday of many small housing bubble businesses. But it is still above historical norms.

I share David Cay Johnson’s (that is, the original author’s) concern that this information received minimal media coverage. But I suppose that one cannot expect corporate media, funded by corporate advertisers, to publish news which would suggest that actions should be taken to rebuild wages and proprietor’s income at the expense of corporate profits?

It would also appear that the Obama administration has been a great friend to business, given that corporate profits as a share of GDP have increased nearly 4% since he took office.

Mean reversion of corporate profits/GDP to historical norms is to be expected, and implies a 30-50% reduction in the ratio (with magnified impact on equity prices since P/E ratios will contract as well) … but by what mechanism?

I’d like to welcome my readers (all 2 of them?) from my other blog, Do Not Feed The Squid!  “DNFTS” was a great idea (and still is, so I’ve put it in the tagline above!) but I do not have time to keep up two blogs.  Also, the idea behind “Do NOT Feed The Squid”, that we’re going to have to take personal actions to stop the large financial corporations from continuing to abuse the legal system and destroy the public trust, is no longer as politically radical as it used to be.  It’s no longer a distraction from the “Ethical Investing” and “Sustainable Gains” themes here.  In fact, it’s pretty clear that investors in the mortgage lending apparatus have failed to invest ethically and are discovering that their fraudulent gains are not sustainable.  (Whether they continue to succeed in ripping off the taxpayers, only time will tell… but hopefully the public will not put up with this any longer!)

The 6 posts from “Do NOT Feed the Squid” have been moved over here verbatim, without any updates to their timestamps.

For those who may not have reviewed the “Do NOT Feed The Squid” site, here’s a list of the 6 posts in, reverse chronological order:

Post-Squid Investing Attitude Shift

Squid-Free Investing (small victories)

Preventing the Next Crisis? Automatic Stabilizers?

Restoring the Federal “Reserve”

A Quick Guide to Squid-Free Banking

What is the Squid?

A recent post by Calculated Risk reminded me to comment that the Federal Reserve’s “EMRATIO” metric is worse than it looks (and it looks bad already).  EMRATIO is frequently misreported as being “the employment to population ratio”. Sometimes the writer aims to be less inaccurate and says it’s the “fraction of adults who are employed”.  EMRATIO is really meant to measure how much of the potential labor force is currently working, and typically runs around 0.6, meaning 60% of the “adult population” is “employed”. EMRATIO has recently been declining as a result of job losses during the recession, which is bad enough.  But there is a demographic issue in play as well, because of the aging population, and EMRATIO doesn’t capture this very well.  In EMRATIO, the “population” not only excludes children, it also excludes “institutionalized” adults (who still need to be fed … and many of whom could be productive).  EMRATIO doesn’t include the military - it’s just “civilian” employment. And EMRATIO also appears to include working teens in the employment number, but not in the “adult population” number.  So EMRATIO is really an approximate “civilian employment to adult workforce ratio”.  Which is fine, but not if everyone thinks it’s the actual employed workforce divided by the total population… because that number is substantially lower!  The employed workforce has to feed not only the unemployed adults but also the children, the military and the “institutionalized” adults (including criminals and more).

So EMRATIO is useful, but misleading.  I think what really matters is the “Mouths To Feed Ratio”, that is the number of “mouths to be fed” divided by the “number of workers” - and there’s a way to generate that using the Federal Reserve’s FRED graphs database:

What this shows is that during the Baby Boom years of the 50’s and 60’s, when there were a lot of single-worker households and a lot of children, there were 2.6 to 2.8 people per worker.  From the early 60s until 2000 or so, that number trended down.  Each worker had fewer and fewer mouths to feed, as demographics became more and more favorable.  But that situation has reversed.  The 2003-2008 boom failed to bring in enough workers to bring the MTF ratio back down, and the Great Recession’s job losses, together with older workers retiring, have sent the MTF ratio back up to levels last seen in the early 1980s.

In fact, if we invert the MTF ratio, we can compare it directly to EMRATIO, and we see that the MTF ratio is about 13% lower than EMRATIO.  I am surprised that this ratio isn’t smaller still, since there should be enough children to take it down 20-25%.  But clearly less than half of the nation is currently employed:

Finally, the last plot below shows the two components of the MTF ratio (but beware the suppressed zero in the graph).  Both have trended upwards and basically doubled in the past 60 years, but in the last decade the population growth has outstripped the employment growth.

If population growth continues to exceed employment growth, there will be ever more Mouths To Feed per worker.  This in turn puts pressure on workers to lower their savings rates and defer retirement, or to lower their personal standards of living in order to support household dependents. It also creates pressure on both workers and employers to pay more in taxes, to maintain benefits for an increasing number of non-workers, via Social Security, Medicare, education and so on.  This will be a major challenge for public policy, and it also has major implications on the sustainability of economic growth and the current high level of corporate profits relative to GDP.

Footnote:  My data is from the FRED site; I would appreciate clarifications if anyone who reads this has some good links.

I ran across a fine posting tonight at Illusion of Prosperity which raised a topic that has been puzzling me for some weeks.  Why are TIPS yields so low, can they go any lower, and are the “inflation expectations” implied in the TIPS-Treasuries spreads meaningful?  The implied inflation expectations have been trending down through 2010, into the 1-1.5% range and well outside the 2-3% zone that the market lived in from 2004-2008, and the Fed is clearly worried about this.

Mark pointed out that those worried about deflation will pick Treasuries since in that case TIPS have zero yield.  Those worried about serious inflation will invest in hard assets. So why are so many people buying TIPS?

I had two comments regarding the TIPS:

First, not everyone is absolutely convinced that deflation is imminent, nor is everyone convinced that inflation is imminent.  But many are convinced that we’re going to have one or the other, but are just not sure which, as that appears to be a political choice. For those people, TIPS until recently made a decent “safe either way” option, particularly for tax-protected accounts. [Note: at current yields I no longer think TIPS are a safe choice against inflation… we are currently letting our TIPS ladder run off and finding other uses for the money until TIPS yields recover. ]

Second, I think it’s a serious flaw in Fed policymaking to assume that the TIPS and Treasuries markets are efficient enough to produce a meaningful “inflation expectations” measure through the relative yields.  One of the great lessons of the 2008 crash is that modern portfolio theory and the efficient markets hypothesis are both deeply flawed. I suspect it would be very interesting to plot the “TIPS/Treasuries Inflation Expectations” chart against actual 5, 7- and 10-year CPI growth, and see how accurate the metric has(n’t) been!  For instance, in 2003 the implied 5/7/10 year inflation expectation was about 1.5%/year, and the actual 5/7 year inflation was 2.5-3.0%. Similarly, in 2008 the implied inflation swung from 2.5% to -1% within a few months, and of course most of that range will prove in a few years to have been grossly wrong.

For my part, I find the TIPS yield alone to be very provocative. Bonds historically are expected to return 2-3% above inflation.  So the current 10-, 20- and 30-year TIPS yields of 0.7-1.5% could be taken, in and of themselves, to imply a negative inflation rate.  Alternatively, the 0% yield on the 5-year (and the other anomalously low yields) could be seen as implying that other asset classes look so overpriced (or corrupt and unappealing?) as to make even a 5 year zero real return rate look attractive!

Or maybe it just means that Treasury needs to issue more TIPS relative to Treasuries, to bring supply back in line with demand!  In that mindset, one can take the “implied inflation expectations” with a grain of salt, since Treasury controls the relative supply and can therefore radically influence the yield spread!  The U.S. recently tripled the annual issuance of Treasuries…  and the Fed is in QE mode… so what else would one expect but low real TIPS yields?  The real mystery may not be why are TIPS yields so low, but why are Treasury yields so low?  Higher Treasury yields are vital to increasing the “inflation expectations” implied in the Treasuries-TIPS spread… yet the Fed is actively buying Treasuries as it rolls over its (illegal) MBS holdings, and presumably (if it goes into the QE mode promised in this week’s FOMC statement) will buy even more!

A tangled web, indeed…

A few months ago, Kinder Morgan Energy partners came up on a stock screen of mine.  The stock has been performing well and the company is in a vital economic sector, so I was attracted to it.  But when I was reviewing the financials, I couldn’t help wondering about the apparent fact that the dividend payout currently exceeds the earnings cash flow.  KMP has been bulking up its capital and using some of the proceeds to maintain its dividend.  This smells Ponzi to me!  And given the forward economic climate, this also smells very risky.

When it was just KMP making me nervous, I didn’t feel like posting it, but I’ve seen a few other stocks looking the same way recently — particularly a couple of dividend-yield stocks in the telecom sector — and now I’m wondering just how deep the rot goes.

I know from a separate screen that there are very, very few U.S. companies with excellent financial ratings and low debt-to-earnings ratios. And the ones that I saw generally didn’t have exciting future prospects.

I haven’t seen the “deleveraging” that we were promised, and which I believe is vital to getting the next long bull run of economic growth rolling, so I expect a lot more stock-price volatility within the next couple of years.

On DeLong’s Blog, I got some replies to my comment (see previous post below, where I expanded on the comment).  Robert Waldmann responded: “Brad didn’t assert that stocks are reasonably valued — he asserted that they are undervalued from the perspective of a long term investor. His claim is that stocks have always been undervalued from the perspective of a 35 year old saving for retirement.”

But even with a 30-50 year time horizon, one should not put money into an investment that is quite likely to stagnate for the first 10-20 years. The opportunity cost is too high. With regard to the stock market, one can write out a trio of trivial identities which, when combined, have some distressing import:

Stock Prices = (P/E) * Earnings.

Earnings = (Earnings/GDP) * GDP.

GDP = Population * (Employment/Population) * (Productivity/Employee).

From which:

Stock Prices = (P/E)*(Earnings/GDP)*(Population)*(Employment/Population)*(Productivity/Employee)

The value of this is that each of the components on the right-hand side is fairly well measured, allowing some insight into the broad trend for Stock Prices on the left hand side.  Now, before we dive in to stock price trends, note that total return is of course related to both dividend yields and capital gains (growth in Stock Prices).  But currently, dividend yields are historically very low, so any 30-something (or any other age) investor seeking a comfortable retirement needs capital gains.  So we must consider the factors affecting prices:

1) P/Es have stayed on the high side since the dot-com bubble, and have not yet reverted to anywhere near their historical low points, despite the two market crashes in the last decade.

2) Earnings/GDP is still on the high side and has refused to revert to historical norms, despite a sharp nudge in the right direction in late 2008, thanks to government giveaway policies. (Some might even say we’re robbing the taxpayer to pay boardroom leeches…)  But revert it will; go higher it cannot, if history is any guide.

3) Population growth is slowing and the rising anti-immigration sentiment will not help.

4) Employment/Population is on a downtrend and faces secular headwinds from aging demographics (and not just in the U.S., either).  There is some room for near-term improvement from uptake of the unemployed (and the overseas military who are not necessarily contributing to domestic economic production), but the long-term scenario is not positive.

5) Productivity/Employee has been squeezed hard already during the recession and, absent another huge technological revolution which is not yet evident to investors, is unlikely to grow at anything more than the usual 2-3% for a while to come.  (There is some room to grow hours/employee back to recent highs, though, and productivity here is a combination of hours worked and output per hour.)

So where exactly are we to find the factors that will even yield positive returns, much less 6% returns, within the next 10-20 years?

Footnote:  The above statements are all backed with hard data, which I will endeavor to (re-)post in future notes here.

Brad DeLong, for whom I normally have more respect, recently wrote a takedown of a poorly-argued Atlantic Monthly piece by Megan McArdle. But DeLong himself does not live up to the standards of rigor that we need to adopt if we seek to invest for sustainable gain.  DeLong argued that since P/E ratios are currently in the 5 or 6% range (depending on the timeframe details), and bond yields are lower, stocks cannot be said (as McArdle claims) to be poor long-term investments. However, as I illustrate below, it’s not clear that todays P/E ratios are meaningful.  Nor is it true that just because bonds are currently horrifically overpriced, stocks are not also overpriced.  We could be facing (Japan-style) a very long period of subpar returns in both investment classes.

Here is the comment I posted to DeLong’s article:

C’mon, sir.  It’s trivial to find poorly-written financial articles.  Even your own qualifies!

For starters, it’s a non-sequitur to expect, in a world of creative destruction and transformational technologies, that your Atlantic Monthly should bear any resemblance to your great grandmother’s.  Nor Harper’s, nor even Newsweek.

More importantly, you start with the mathematical truism that “The return on stocks is the dividend yield plus the capital gain.” (but neglect both inflation and taxation) and then proceed to assume that “If the P/E ratio is stable, the capital gain is equal to the growth of earnings.”

The reason I call that an assumption is because, once more, we live in a world of creative deception and transformational technobabble. “If the P/E ratio is stable, the capital gain is equal to the growth of earnings” is only true in a world where “earnings” has a constant meaning.
In point of fact, it appears that ‘earnings’ is a very loosely defined term whose meaning has been subtly shifted during the credit bubble of the past decade(s).  Today, “earnings” as used in the “P/E of 16″ or “P/E of 20″ metrics, manages to exclude a whole host of one-time costs, and poorly accounts for incentive pay schemes.  Even if we shift to GAAP earnings (where P/E ratios have recently been both negative on a quarterly basis, or in the hundreds on an annualized basis — both wildly beyond historical norms and not at all “stable”), we still find fantastic obfuscation and all manner of mathematical mangling by managements.  My third favorite is corporations reporting as “earnings” the capitalized, computer-simulated change in value of mortgage securities holdings, despite the fact that no cash is actually flowing nor can reasonably be expected to flow.  Second best is when a dysfunctional company recognizes the devaluation of its own debt (sometimes due to imminent insolvency!) and then claims the reduction in debt valuation as “earnings” too!  But best of all is when corporations simply lie outright, and stuff things they don’t want to talk about into physically-fictional “off-balance sheet” legal creations… both on the earnings/assets side (to hide management’s side-dealing, personal siphons into what should be secure corporate profit streams) and on the liabilities/losses side…

Back in the glory days of Atlantic Monthly, owners — shareholders — were in most cases much more closely involved in managing the businesses they owned.  I think the current system has led to a lot of bezzle — destruction of shareholder wealth not yet revealed to shareholders — and we will find that recently claimed credit-bubble “earnings” are far from sustainable.

Sir, it used to be that “capital” had physical meaning and represented, usually in a tangible way, the surplus of actual production over actual consumption.  That era ended with the demise of the gold standard and the slow, steady, Chinese-water-torture devaluation of the dollar since.  Capital gains were things you could take home with you and believe in.  And so were earnings, because dividend yields were much higher.

Today, who knows?  But I sure wouldn’t consider P/E ratios as currently reported to be historically normal, nor stocks to be reasonably valued, given what we understand about legally fraudulent and/or morally bankrupt behavior by corporate managements in so many economic sectors.

—-

Let me quantify my point a bit further:  GDP growth can be factored in terms of population growth, employment/population ratio, and productivity of employees.  The first two are bounded demographically and the latter is limited technologically.  Meanwhile, corporate profits are currently near historic highs (as a fraction of GDP) and unlikely to grow faster than GDP going forward.  And P/E ratios are just coming off historic highs even including what appear to be more-than-usually fraudulent earnings.

It is quite likely that we will have (a) low population growth (due to birth rate and sustainability issues), (b) a secular flattening or even outright decline in employment/population ratio (due to an aging population), (c) limited productivity growth (it is always limited), (d) no growth in corporate earnings as a share of GDP, and (e) some reduction in reported “earnings” as accounting practices are cleaned up (to match actual sustainable earnings, as fraud-driven losses are inevitably recognized).

Under those assumptions there is no reason to expect stock market returns to grow much at all, for a long time to come, until one or another of those factors shows a secular change.  And (d) and (e) both point to a significant downside risk to stock prices.  Plus it is also quite possible that given the negative outlook, P/E ratios will mean-revert to the 10-12 range from the current 16-20 range as investors demand a higher risk premium.

It is therefore entirely plausible that money placed in the stock market now may decline in value by 50% over a fairly long time horizon (10-20 years) before the factors above improve.

And this does not include either inflationary losses in purchasing power, or tax-code changes.  One must keep in mind that the Federal Budget cannot remain this imbalanced for long, and those seeking to boost tax revenues will be forced to go where the money is…