RIP, Angus Maddison

The world recently lost economist Angus Maddison. A tribute in the most recent issue of The Economist captured the spirit of his professional contributions well:

GDP is a modern term, but the urge to count the nation’s produce and compare countries’ standards of living predates Adam Smith. Maddison saw himself as heir to a tradition that began with William Petty, the pioneer of “political arithmetick”, who in 1665 estimated the income of England and Wales at £40m. That calculation was of pressing concern to Petty, who wanted to show the king how to pay for the war against the Dutch. But why did Maddison care about the GDP of the distant past?

He believed that the “pace and pattern” of economic activity had deep historical roots. Economies, he thought, do not “take off”, as if from nowhere. Even the industrial revolution was too gradual to warrant the term revolution and too broad to be considered merely industrial…

Even scholars who believed there was a lot of economic progress to measure before the 19th century doubted there was enough data to measure it. Maddison made the most of whatever was available. He drew on one scholar’s work on probate inventories in 17th and 18th century England, which showed that each generation passed on more property, furniture and houselinen to its descendants than the last. His economic portrait of Mughal India was influenced by a 16th-century survey by Abu Fazl, vizier to Emperor Akbar. His estimates of Japan’s population relied on the annual register of religious affiliation, brought in after the Portuguese were expelled and Christianity outlawed in 1587. One of his students, Bart van Ark, now chief economist of the Conference Board, says Maddison urged him to venture beyond libraries and statistical offices. Even a painting in a museum might provide some clue to a country’s standard of living centuries before.

Van Ark also posted a short memoriam on Maddison’s homepage.

http://www.ggdc.net/maddison/

http://www.economist.com/business-finance/economics-focus/displaystory.cfm?story_id=16004937

http://www.ggdc.net/maddison/Personal/In%20Memoriam.pdf

Another Katyn Tragedy

We woke up to the tragic news this morning that Poland had lost its president, central banks head, army chief of staff, and other important political figures in a plane crash. The incident is made all the more tragic by the fact that the delegation was headed to a memorial of the Katyn Massacres.

In our Opportunistic Portfolio model, we hold a 2% position in Market Vectors Poland ETF (PLND). While this is sad news for Poland, we don’t think it will have any lasting impact on the country’s current economic outlook (though a closer look at the central bank’s succession policies might be in order). Thus, we’ll gladly bring the position back to its target weight should this news have a negative impact on its price.

URLs:

http://news.bbc.co.uk/2/hi/europe/8612825.stm

http://news.bbc.co.uk/2/hi/europe/8612843.stm

http://www.novinite.com/view_news.php?id=115084

http://en.wikipedia.org/wiki/Katyn_Massacre

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC is a state registered investment advisor. The foregoing information is for informational, educational, or entertainment purposes only. It does not constitute an offer to buy nor a solicitation to sell any security, or to engage in any investment strategy. Some clients of the firm own shares of PLND.

International time machine investing

Neat article on country selection by Dan Richards, who recently asked an audience how they would allocate their equity investments in 1970 between Australia, Canada, Europe, Hong Kong, Japan, and the U.S. if they had a time machine. The responses and the data are pretty interesting. Richards’ key observations capture some timeless lessons for investors:

1. When looking at returns, don’t overlook volatility.
2. Beware the cognitive bias caused by ’recency effects’.
3. Avoid extrapolation bias.
4. Understand the impact of currency rates; for example, over 20% of Europe’s outperformance versus the U.S. was due to exchange rate effects (the currency adjusted returns for Japan are even more dramatic — 74% by our calculations!).
5. The recent “lost decade” for equity investors has been largely a U.S. phenomenon.
6. Look before you leap; i.e., do your homework, base your decisions on evidence and data and not just feelings and opinions, and so on.

URLs:

http://www.advisorperspectives.com/newsletters10/pdfs/Lessons_from_an_Investing_Time_Machine.pdf 

http://www.theundergroundinvestor.com/2006/11/a-today-a-lesson-in-investment-psychology-101/

http://www.moneyweb.co.za/mw/view/mw/en/page66?oid=199249&sn=Detail

Masters of the Universe: They’re baaaack…

A new BIS paper has some very telling data points. First, they demonstrate the extent to which leveraged financial speculation drove foreign currency movements in the financial crisis (it’s quite reasonable to assume that this factor was at work in other asset class dislocations too). Second, it provides evidence that highly leveraged masters of the universe were back to their old tricks in fairly short order.

Let’s start with a  quick primer on “carry trades.”  A carry trade occurs when a financial market participant borrows in some currency with a low nominal interest rate (the “funding currency”) and invests the loan proceeds in some asset(s) (a “target asset”) that’s expected to appreciate at a rate that exceeds the interest rate due on the borrowed currency. The target asset can be a higher yielding currency, a credit instrument, equities or a stock market proxy, commodities or a commodity index proxy, and so on.

The Yen carry trade — borrowing low yielding Japanese Yen and using them to acquire riskier assets – has been increasingly employed by speculators since the 1990s, and appears to have played a key role in the speculative period of 2004-2008.

Speculators engaging in this activity are taking risks (sometimes massive risks) with (for the most part) Other People’s Money (OPM). When it works, they return the borrowed funding currency plus interest, and pocket the difference. When it goes terribly wrong, you wind down operations and hide from your creditors behind a corporate liability shield, forcing them to write down the value of their loans to you (their funding currency assets).

Nice work if you can get it, and amazingly, investment banks and their subsidiaries have been falling all over themselves to make these loans to privileged clients — including their own proprietary desks and funds — since the late 1990s (in competitive strategy, herd pursuit of bad ideas is usually a sign of an over crowded industry).

Better yet for the carry traders, increasingly lax financial regulation has allowed speculators to lever their carry up to levels not seen before in modern history, meaning they can borrow more money for a given level of collateral, and/or purchase more assets with a given amount of funding currency.

As some of those trades started to go bad in 2008, the result was a breathtakingly sharp and sudden reversal in the key funding currency, the Yen. This can be seen in the circled graph below, along with the following observations:

• The rate of appreciation in the Yen was far greater in 2008 than in the 1997 and 1998 global financial crises. The left most graph shows foreign exchange movements between the Yen and thirty three other currencies during the Asian crisis of 1997. Clearly, forex movements in that crisis were country specific.
• The middle graph shows currency movements against the Yen during the 1998 crisis associated with the Russian sovereign debt default. The appearance of a positive slope is apparent, implying that forex dislocations were due more to speculative behaviors including the rising use of leverage than to country-specific risks (for that we can probably thank the pioneering geniuses at LTCM and their investment bank benefactors).
• The third graph shows the appreciation of the Yen during the recent global financial crisis. The slope, which gives an idea of how sharply the Yen appreciated against those 33 other currencies, is breathtaking. The median interest rate on the target currencies (on the horizontal axis) also appears to have been roughly half of what it was in 1998.

Translating into English, this means that in 2008-09, the Yen appreciated even more sharply than it did in 1998, and against target assets that offered half the expected return of those in 1998. This calls to mind a question we raised recently, which is whether some powerful financial market participants are confusing ”efficient dislocation” with “market efficiency.” That would be understandable after all. History shows that the fatter the economic rents being justified, the more deluded the economic rationales tend to be.

In the BIS paper, the author also notes that carry trade activities are inherently pro-cyclical: borrowing activity tends to push down the market value of the funding currency, while investing activity tends to push up the market value of the target assets, and this will tend to invite increasing levels of speculation until something causes a breakdown.

Higher degrees of leverage make the pro-cyclicality and the eventual fallout that much worse. Unfortunately, while a great deal has been made of John Maynard Keynes’ alleged return in the past year, it appears that the brief 2008-09 resurgence of Hyman Minsky — who warned presciently of such dangers – has already been forgotten.

That “Minsky fade” appears to be supported by the bottom right graph (though admittedly, this case isn’t as strong as the leveraged carry trade evidence discussed above). The negative slope in that graph shows that less than a year later, the Yen depreciated markedly against many currencies, especially against higher yielding target currencies, which runs counter to the aftermath of 1997 and 1998.

The implication is that the Yen carry trade came back on line fairly quickly after financial markets regained their footing. Apparently financial cockroaches are, like their arachnid namesakes, largely immune to the effects of fallout. As described by the BIS author:

…with extreme risk aversion abating, carry trade activity – a relatively risky strategy – may have returned in the second half of 2009. Indeed, carry trades in a number of high-yielding currencies, especially those of commodity exporters, provided extraordinarily high ex post returns over this period. Moreover, near zero interest rates prevailed in many major currencies, increasing ex ante profitability not only for traditional funding currencies such as the yen. Carry-to-risk ratios support this conclusion…

A a critically important aspect of this issue is financial regulatory reform. Very little has been done from a regulatory standpoint to bring down the astronomical leverage that was available for carry trade speculation prior to 2008. Yesterday, Larry Summers gave an interview to CNBC in which he emphasized that the scope of the proposed “Volcker Rule” was limited to particular types of banks.

If true, over leveraged areas of global financial markets are likely to continue escaping prudent regulation, which means that the pronounced cycles of euphoria and distress in risky asset classes will continue. While those swings create opportunities for contrarian investors, the dynamic behind them is a zero-sum or even net-negative economic game. In the long run, it causes more economic harm than it’s worth.

And while interest rates have converged substantially since the 1990s, current spreads are likely to persist in the decade ahead for multiple reasons, not least being variation in demographic cycles, which will mean lower nominal rates in most developed countries, and higher rates in most emerging markets.

In other words, the roach bait isn’t going anywhere soon. That means that sound regulation absolutely must fill the void in order for the gains from financial market speculation to approach something resembling a social optimum.

UPDATE 3/2/2010 – AP report on further progress in Senate Finance on financial regulation

URLs:

http://www.bis.org/publ/qtrpdf/r_qt1003f.pdf?noframes=1

http://654advisors.com/index.php/blog/2010/02/wsj-hedge-fund-career-trades/

http://news.yahoo.com/s/ap/20100302/ap_on_bi_ge/us_financial_overhaul

Krugman vs CNBC

A couple of CNBC commentators ripped Paul Krugman for today’s op-ed on budget deficits, with Rick Santelli saying something about lining a bird cage. We aren’t defending Krugman against charges of self-contradiction or factual inaccuracies, but we are definitely siding with him on the economic substance of his argument (the lonely wingnut’s sojourn continues).

Prevailing rhetoric holds that the U.S. government is over extended, and that there’s precious little room for additional economic stimulus. That would be true if US dollars could only be obtained by taking them from people who have them, or by digging new ones out of the ground. In that case, servicing our debts — both private and public — would be quite burdensome. But the reality is that in a modern monetary system, monetary units are simply ledger entries. Whether carried in hand as a Treasury obligation, or held digitally in a bank account, all dollars are created out of thin air by the Federal Reserve in response to demands of the banking system.

The federal government does not have direct control of the Federal Reserve, so its control of money creation is only indirect (if Congress wished, it could wrest control of USD creation from the quasi-private Fed, a measure that a small number of radical but diverse members might like to see). But existing arrangements do not change the basic fact that the U.S. has the capacity to print the money (the non-interest bearing debt) used to service its public debt. That means that the only meaningful constraint on the level of our pubic debt is people’s willingness to accept the USD. And despite the sophomoric rhetoric on that point, people are still overwhelmingly willing to accept USDs.

The claim that Congress is “spending money that we don’t have” is even more egregious. To reiterate: if USDs could only be dug out of the ground, or pulled out of taxpayers’ pockets, then the argument might make some sense. But as long as we have the ability to create USDs out of thin air, then Congress has the ability to spend new USDs instead of existing ones.

The conservative argument against this type of Keynesian activism rests on a couple of key pillars, and under certain conditions, they’re valid: (1) as long as government constraints on the private sector are moderate, an economy will grow at or near full capacity; (2) public demand for capital will always tend to ‘crowd out’ private sector borrowing; and (3) public sector allocation of capital is inevitably distorted, which imposes long run economic costs. 

As long as those assumptions are valid, then Congressional thrift, beyond a basic level of social insurance and national defense spending, is a desirable objective. However:

(1) History doesn’t lend strong support to the idea that an unbridled private sector will always and everywhere produce positive growth; and if monetary policy is constrained by a zero bound (i.e., interest rates can’t go below zero), then whenever growth is below potential, fiscal stimulus is appropriate (and can be enacted in myriad ways that appeal to lefties or righties). This is especially true for long economic cycles, such as the Great Depression, Japan from 1989 until 2008 or so, and several developed western economies since roughly 1999. Judging by the available empirical research, demographic composition could be the main driver of these cycles (and if the effect is strong enough, it might deemphasize the importance of rationality vs behavioralism in theory and policy making).

(2) When private sector demand for capital is contracting, as can happen in a long down cycle, then public sector demand for capital (i.e., deficits and debt issuance) is beneficial, and should foster rather than crowd out private sector credit demand. However, under certain conditions, this will only work if money creation is supportive of public sector credit demand, i.e, if new money is created to finance the public sector debt (the conservative point of view tends to see this as banana republic monetary policy, but that isn’t always the case). Today, banks are taking advantage of a steep yield curve to borrow funds from the Federal Reserve (which creates new USDs) to purchase higher yielding Treasury debt, i.e., a significant amount of our public debt is being ‘monetized’. While that would be a bad thing in an inflationary environment, it’s a good thing when it offsets deflationary forces. Almost everyone who parrots the prevailing rhetoric is overlooking this dynamic.

(3) Public sector capital allocation is certainly prone to distortion in as much as it is not subjected to competition and the judgement of diverse agents. But asymmetries in the private sector can have powerfully negative effects too (financial crisis, anyone?). And while there’s room in our political system for new institutions designed to allocate public resources more optimally, the existing ones, such as voting, negotiation, and oversight, should do a good enough job in the meantime.

Krugman wrote that “there’s no reason to panic about budget prospects for the next few years, or even for the next decade,” and apparently this has some pundits and analysts pulling their hair out. But if prevailing demographic ratios are going to drive another decade of subpar economic outcomes…then he’s absolutely right!  

When the real economy is humming along, we can leave the creation and allocation of new USDs to the private sector, and rein in public deficits without doing too much harm. But when the state of the real economy is uncertain, as it certainly is now (pun intended), the refusal to finance public spending, investment, and intermediation via the creation of new dollars (within the constraints dictated by inflation objectives and expectations) is inherently deflationary and destructive. And that is what undermines the sophomoric notion that we are “leaving a mountain of debt to our grandchildren.” If the public sector is not active enough to offset destructive forces acting in the economy today, then our grandchildren will be worse off. Like most economic variables, public debt levels mean nothing in isolation. And we shouldn’t just look at it relative to current GDP. We must also look at it relative to opportunity cost, or looked at another way, to future GDP. There are actions that the public sector can take today to favorably impact GDP in the future, but they all require financing, including deficit spending. We should only be frightened of deficits when they are scarier than the opportunity costs imposed by government saving. Today, that is simply not the case.

So Krugman is right to be concerned about the policy outlook, which he has a rather pessimistic view of:

Washington now has its priorities all wrong: all the talk is about how to shave a few billion dollars off government spending, while there’s hardly any willingness to tackle mass unemployment. Policy is headed in the wrong direction — and millions of Americans will pay the price.

We’ve expressed similar concerns since 2H09, but it now looks to us as though the Obama administration is “triangulating” on deficits and the federal debt, with no intention to substantially withdraw fiscal stimulus in the government’s 2011 fiscal year (though again, we’re still trying to figure out how the president’s emphasis on PAYGO fits into this). If we’re right, then the readjustments underway in exchange rates, specifically the Euro and USD, are being driven by the Euro and sovereign debt concerns, rather than from the USD side. That means we should settle into a new exchange rate equilibrium in the coming weeks, at which point risky assets should start to recover. It’s going to be a bumpy ride, but we’ll get there.

URLs:

http://www.nytimes.com/2010/02/05/opinion/05krugman.html

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC is a state registered investment advisor. The foregoing information is for informational, educational, or entertainment purposes only. It does not constitute an offer to buy nor a solicitation to sell any security, or to engage in any investment strategy. Symmetry Capital Management, LLC is an Amazon.com associate, and earns a commission on sales generated through links from our website. At the time of writing, the firm, its principals, and its clients did not own any securities mentioned, or any securities issued by entities mentioned.

Obama Budget & 4Q09 GDP

We were feeling a little smug about Friday morning’s GDP print, given our argument in 2H09 that growth prospects were probably being under estimated. At 5.7%, it wasn’t quite the six handle that we thought we might see, but barring any significant downward revisions, it was closer than most expected, and nominal GDP did indeed have a six handle.

Interestingly, headline government spending added little to the quarter’s numbers, so there will be an interesting debate over how much of a role ‘fiscal demand’ is playing, but we’re cautious about that for a few reasons. First, the slower pace at which private inventories were liquidated was a large contributor to GDP, but sustainable private sector growth and employment are unlikely as long as inventory building remains anemic.  Second, federal spending was down due to a lower defense spend, while non-defense spending was up 8% versus 7% in 3Q09, so it’s hard to argue there was no fiscal component. Third, it ignores the possibility of lag effects between public sector spending or deficits and subsequent private sector activity. And if we’re right that fiscal expenditures are still playing a role, the GDP data could imply a very healthy multiplier, a possibility sketched out in this recent academic paper.

This leads us to the Obama budget released today, which will be a real tooth gnashing, garment rending piece of work to many. But it looks pretty good to us at first glance (see the criteria on page six of this Idle Speculator), far better than recent rhetoric led us to expect. The deficit is forecast to be a record $1.56T in 2010 and to remain above $1T in 2011, and it’s beginning to appear that Obama is “triangulating” on fiscal austerity measures, or at least on the time frame over which deficit reduction will occur (though it’s not clear how PAYGO fits into this).

The President’s budget will be tough for some to swallow, but as we’ve pointed out elsewhere, the belief that government is always and everywhere the problem, or that it cannot contribute to real economic growth, is based on a massive underlying assumption: that the private sector is always and everywhere able to grow. It’s not hard to reduce that position to an absurd one, e.g., if a natural or biological calamity were to severely impact private sector potential, a government with a monopoly over money creation could pick up some or perhaps all of the slack.

Reality is far more complicated of course, but since demographic ratios came to our attention, it seems patently clear that private sector potential can vary wildly over multi decade periods, especially in economies where a steep fall in childhood mortality occurred at some point in history. Japan is the most recent example of a two decade downswing in potential output, and its policymakers mistakenly approached the problem as a cyclical rather than a secular one. The U.S. and other western nations are roughly ten years behind Japan in demographic terms, so there’s still roughly a decade of slow, no, or even negative growth ahead of us, barring an active public sector (note: “active” can include tax cuts). As we wrote last November:

We’re familiar with the major [economic] catechisms; we’re just not sure that the evidence supports any one of them over another. Structural economic conditions can and do change — age structure is just one example of how this can come about — and different conditions may call for different approaches.

There are several economic measures that, when viewed over the last two decades, support our assessment that demographics are playing a powerful role in the performance of the U.S. economy (and by extension, these measures tend to undermine arguments against Republican budget profligacy in the 2000s). For example:

The year over year decline in state and local income tax revenue has never been so precipitous, and it has become far more volatile since demographic ratios first turned negative in the late 1990s;

The trend in real private inventories has also been declining since the late 1990s; and 

Equipment and software investment has been in a similar downtrend since the late 1990s.

Admittedly, we’re just eyeballing graphs here and speculating on whether they correspond well to more robust empirical analyses. But we’re fairly confident in our speculation, and this has led us to accept that we are in a Keynesian moment, or more accurately, two Keynesian decades with a Minskian moment in the middle. In such an environment, where private sector expectations are pessimistic, the optimal response is for the public sector to pick up the slack in consumption, investment, and intermediation, within the constraints set by inflation expectations (granted, inflation is a messier issue in a world where the USD is the global reserve currency, and based on a first cut view of today’s budget, we believe our tradable goods inflation thesis is back in play).

The Obama budget appears to pick up a healthy measure of private sector slack, and should thus be favorable overall for employment, asset prices, and economic output. The inflation issue will be far more slippery: on the one hand, a well designed federal budget gives the Fed more room to tighten, as private sector expectations improve; on the other, fiscal direction is uncertain, especially beyond 2011, and prone to shocks, so central banks will have to be rather nimble (more nimble than they were in 2003-05 and 2008) to avoid taking an overly easy or tight approach to policy.

Obama’s proposed tax increases on high income households will cause some resentment, but it’s hard to see how the income disparity pendulum could keep swinging on its current arc. The administration might also believe that higher tax rates on higher incomes will be supportive of state and municipal debt financing. We’d feel better about it if there were an accompanying reinvention of the corporate tax code, as we believe that would have some positive second and third order effects on lower and middle class incomes; first order effects could be achieved by instituting a payroll tax holiday as Warren Mosler has suggested.

Unfortunately, we place a zero probability on corporate tax reform happening any time soon (the budget calls for increasing taxes on certain sectors of the economy), and a near zero probability on a long payroll tax holiday. Despite that, the President’s budget does brighten the economic outlook a bit for 2H2010 and 2011, and the possiblity of a double dip might have been pushed back to 2012 or 2013 (which clearly calls the semantics of ”double dip” into question).

URLs:

http://www.bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm

http://faculty.wcas.northwestern.edu/~yona/research/Multiplier-version12.pdf 

http://www.whitehouse.gov/omb/blog/10/02/01/Introducing-the-2011-Budget/

http://654advisors.com/idlespeculation/20100112.pdf

http://654advisors.com/idlespeculation/20091109.pdf

http://research.stlouisfed.org/fred2/graph/?chart_type=line&s[1][id]=ASLPITAX&s[1][transformation]=pc1

http://research.stlouisfed.org/fred2/graph/?s[1][id]=CBIC1

http://research.stlouisfed.org/fred2/graph/?chart_type=line&s[1][id]=NRIPDC96&s[1][transformation]=pc1

http://en.wikipedia.org/wiki/Minsky_moment

http://moslereconomics.com/2010/01/28/tea-party-plan-for-dems-cut-to-the-front-with-tax-cuts/

IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC is a state registered investment advisor. The foregoing information is for informational, educational, or entertainment purposes only. It does not constitute an offer to buy nor a solicitation to sell any security, or to engage in any investment strategy. Symmetry Capital Management, LLC is an Amazon.com associate, and earns a commission on sales generated through links from our website. At the time of writing, the firm, its principals, and its clients did not own any securities mentioned, or any securities issued by entities mentioned.

Those Damn Democrats

In a marked turnaround from 2008, a lot of pundits are predicting that Democrats will take a drubbing in 2010 midterm elections. Our view is that it’s way to early to call, as the economic mood in 2H10 will depend heavily on signals given (and actions taken) by President Obama, Congress, and the Federal Reserve in the first half of the year. But being opportunistic, the conversation gives us a chance to post this wonderful old chestnut:

More confusion on federal deficits

BNET’s Steve Tobak, in a series of retrospectives, penned a critique of federal spending in 2009. While he’s spot on regarding the role of leverage in creating systemic fragility, and about the importance of agency risks, potential and realized, he displays the same kind of confusion about federal deficits and debt levels that threatens to end a still short-in-the-tooth recovery:

I would hope we learned from the subprime mortgage crisis that got us into this mess that too much leverage is a bad thing. That’s sort of a no-brainer, isn’t it? I mean, giving people mortgages they can’t afford with no money down is bad, right? Banks betting the farm on mortgage-backed securities and credit-default swaps … also bad.

And yet, our national response to this crisis has essentially been to leverage the entire country by ratcheting up the national debt to record levels. What message does that send to each and every American business and family with a budget to manage?

When federal deficits and central bank balance sheet expand in response to a financial crisis and deep economic recession, this does not necessarily increase the overall debt in the domestic economy.  Rather, it means that the public sector, because it has the greatest capacity to bear risk, takes on some of the burden of existing private sector debt. To do otherwise would mean a sharper and deeper recession, i.e., a depression. While “liquidation” has its benefits, one of the tradeoffs is a greater level of defaults and even higher unemployment (i.e., even lower national income), at least over the short to intermediate term. And like it or not, our political system, which does a pretty good job of discounting the desires of the entire electorate, decided long ago that unbridled liquidation was not the optimal path for economic policy. Had the federal government and the federal reserve kept the purse strings tight, given the global nature of the recession and – as Tobak pointed out – the high systemic leverage and fragility that preceded it, the outcome would almost surely have been much, much worse.

Tobak also makes the mistake of comparing private sector budgets to the federal budget. There are some critically important distinctions between them, the primary one being that the federal government creates the money needed to pay its obligations out of thin air – which is a critical part of its risk bearing capacity.

Macro errors aside, in another article Tobak offers a great strategic approach for dealing with personal nemeses in the workplace, which we highly recommend.

URLs:

http://blogs.bnet.com/ceo/?p=3499&tag=nl.e713

http://www.j-bradford-delong.net/pdf_files/Liquidation_Cycles.pdf

http://blogs.bnet.com/ceo/?p=3493&tag=nl.e713

Wall Street Stuff

Barron’s cover story this weekend urges Fed Chairman Ben Bernanke to stop punishing savers and raise the Fed’s target overnight interest rate. To support their case, they use an array of market indicators, including the US Dollar index and the USD price of gold, arguing that “big investors have come to see the dollar, commodities and stocks as one-way bets.” A dramatically titled sidebar of charts (‘The Perils of Easy Money’) is provided, but beyond the rising price of gold, there’s nothing in them that offers primae facie evidence of either easy money or impending inflation.  Yes, the USD has declined almost 15% from its peak, but at current levels it is simply back to where it was at the end of 2007 and beginning of 2008. And while the S&P 500 has had a breath taking run off of its March 09 lows, it’s still roughly 20% below its peak.

What’s more, there’s little about the real U.S. economy that argues for higher nominal interest rates, and inflation (and deflation) can only arise from a misalignment of the financial system with the real economy. There’s still a considerable amount of private sector debt to be worked out in the coming years and decades; excessive household consumption has run its course; and U.S. demographics do not imply a high or rising ‘natural‘ rate of interest in the decade ahead. In fact, based on that latter point, we can sympathize (out of context) with Milton Friedman’s 1965 claim that “we are all Keynesians now”, as research into population demographics and their effects on economic output and asset pricing has produced some powerful (if tentative) insights. At the present time, the U.S. is simply not at a point where, demographically speaking or policy-wise, a low nominal rate of interest on overnight reserves is likely to produce rising asset prices or “excess demand” for goods and services in the same way that it did in the late 1970s. And for that reason, increasing investment in public goods, as many of today’s policymakers advocate, might be a good idea. It might even be inevitable, judging by the experience of Japan, a country ten years ahead of us on the demographic curve. At the very least, we can hope it will be done well (Art Laffer penned a supply side refutation back in May but did not address his underlying assumptions of perfect competition for — and full employment of — real resources).

The real problem with a low Fed Funds target, as we have pointed out previously, is that the USD is still the world’s primary reserve currency. Thus, while a low Funds rate might be appropriate for the U.S. economy, it can have inflationary consequences in parts of the world that have higher expected growth rates (the reverse can also happen, as it did in the 1990s – while a high funds rate and a strong dollar seemed appropriate for the U.S. economy, they wreaked deflationary havoc on much of the world). Rising prices for goods that are globally traded, and thus subject to the Law of One Price, will feed back into domestic U.S. price levels, providing a noticeable whiff of stagflation, much as gold, precious metals, and other commodities are doing now.  The global pressures caused by an easy Fed are also going to cause plenty of political consternation and some financial dislocation abroad, as recent salvos from global trading partners over the USD attest to. But we don’t expect broader inflationary pressures to unfold in the U.S. for quite some time, nor do we expect Congress to even entertain the possibility of revisiting Humphrey Hawkins; which means, in our view, that the Fed will remain easy for some time, probably well into 2010. In the meantime, should the USD continue its current trajectory, we might see some coordinated global interventions, as we did with the Plaza and Louvre Accords in the mid-1980s. But in those episodes, national treasury departments played the lead roles, not central banks.

There are also a couple of Investment News articles that illuminate some of the beefs we have with our industry. The first one is on a Morningstar study that found that over half of all mutual fund managers have no money in their own funds. There are some legitimate reasons why a percentage of mutual fund managers would not own shares of their own fund — but that percentage should be waaaaay below 51%. That’s bad enough, but what really stuck in our craw was the speculation that some fund managers might have their money in separately managed accounts that follow a similar strategy as their mutual fund, as they tend to offer lower expenses (they also offer greater transparency, potential tax advantages, and opportunities for customization). If we ran our Opportunistic Portfolio as a mutual fund, our firm’s principals and employees would own it as a mutual fund, period. As it is, we only offer it as a separately managed account, because that is a more advantageous approach for most investors, and because technology has made it possible for us to offer separate accounts to all of our clients (it’s also a heck of a lot cheaper than forming a mutual fund). I know this stuff goes right over most of our clients’ heads when we try to explain it. Suffice to say, we’re trying to do right by them, and by our industry, on each and every day, and we appreciate stories like this one as they lend support to a key piece of our competitive strategy.

The second article is somewhat innocuous, but offers a glimpse into the prevalence of momentum trading in our business, and the general fascination with market momentum. It quotes a large cap manager at ING as saying that ”There does seem to be something unorthodox about [current equity market behavior], but you ignore it at your own peril.” That’s not an objectionable statement, but the article’s headline was a bit stronger: “Market rebound may be illogical, but ‘ignore it at your own peril,’ manage of $1.7B warns”. Surely a similar thought occurred to each of the 20,000 bison shepherded off of Vore over the eons:

[The site hosting that image is pretty neat - you can read a history of bison and horses on the Great Plains while authentic cowboy/saloon music plays in the background.]

Our beef with momentum investing is that it rationalizes away everything but herd direction. If a manager buys momentum because the underlying investment thesis makes sense, there’s nothing wrong with that. But buying momentum for its own sake is the height of glamor boy laziness and stupidity. There’s too much of it in our business, and it contributes precious little to the economies and societies we operate in.

[The 'glamor boy' link will be nostalgic for anyone who was watching MTV in the late 1980s. While it's hard to take Corey Glover's claims of ferocity seriously while he's wearing a spandex suit and a marching band jacket, it's still a great song.]

URLs:

http://online.barrons.com/article/SB125573856421291217.html?mod=rss_barrons_this_week_magazine

http://s.wsj.net/public/resources/documents/BA-EasyMoney091019.pdf

http://www.frbsf.org/publications/economics/letter/2003/el2003-32.html

http://www.time.com/time/printout/0,8816,842353,00.html

http://economics.uwo.ca/econref/WorkingPapers/researchreports/wp2009/wp2009_2.pdf

http://frank.mtsu.edu/~berc/tnbiz/stimulus/laffer.pdf

http://www.investmentnews.com/apps/pbcs.dll/article?AID=/20091019/FREE/910199975/1094/INDaily01

http://www.investmentnews.com/apps/pbcs.dll/article?AID=/20091019/FREE/910199982/1094/INDaily01

http://www.wyomingtalesandtrails.com/buffalojump.jpg

http://www.youtube.com/watch?v=7XRpuhc9dgU

http://www.wyomingtalesandtrails.com/bison.html

Swine Flu’s “Very Sobering Statistics”

The AP is reporting that government officials are concerned about the virulence exhibited by swine flu to this point:

The swine flu is causing an unprecedented amount of illness for this early in the fall, with the deaths of 11 more children reported in the past week. And less vaccine than expected will be ready by month’s end, federal health officials said Friday.

Of the 86 children who have died since the new swine flu arose last spring, 43 deaths have been reported in September and early October alone, the Centers for Disease Control and Prevention reported. That’s a startling number because in some past winters, the CDC has counted 40 or 50 child deaths for the entire flu season — and no one knows how long this swine flu outbreak will last.

“These are very sobering statistics,” said the CDC’s Dr. Anne Schuchat.

Also disconcerting is that “about half of the child deaths reported since Sept. 1 have been teenagers.” The 1918 global flu pandemic caused so much devastation because of how it affected healthy adults, as opposed to the very young and the elderly. An interesting discussion of current flu epidemiology can be found here, and it amplifies the CDC’s “very sobering” assessment. For example, note in the second graphic that the 5-17, 18-49, and 50-64 year age groups are already at or above their expected hospitalization rates, and we’re only at the beginning of flu season.

The probability of a severe, 1918 style impact is unknown, with best guesses ranging from negligible to 20% to ‘know way of knowing’. But quantifiable or not, it’s an ongoing risk that deserves attention.

P.S. An interesting 2008 paper from Virology Journal was linked in the comments section of the Science Links article. It sets forth an interesting hypothesis that declining Vitamin D synthesis, due to decreased exposure to sunlight, is a significant factor in susceptibility to influenza, and thus its seasonality. The experimental evidence from humans is minimal (n = 104), but what there is seems pretty tantalizing. NOTE: We are not dispensing nutritional advice! If you’re interested in the idea of Vitamin D supplementation, we strongly suggest you seek out a qualified clinical nutritionist. Vitamin D toxicity is nothing to mess with.

P.P.S. This paper is truly mind blowing — the remarkable rise in deaths from coronary heart disease (CHD) in the mid-20th century might have been associated with exposure to the 1918 influenza: “…the data suggest that the 1918 influenza pandemic and the subsequent epidemics up to 1957 might have played a determinant role in the epidemic of CHD mortality registered in the 20th century.” If true, it raises the possibility that a staggering amount of resources invested over 50+ years in analyzing, screening, and treating other factors believed to be associated with CHD mortality might have been put to better use. Yikes!

URLs:

http://news.yahoo.com/s/ap/20091016/ap_on_he_me/us_med_swine_flu

http://en.wikipedia.org/wiki/1918_flu_pandemic

http://www.iayork.com/Images/2008/9-22-08/1918FluMortalityCDC.png

http://scienceblogs.com/effectmeasure/2009/10/why_the_epidemiology_of_swine.php#more

http://www.continuitycentral.com/news02524.htm

http://www.virologyj.com/content/pdf/1743-422X-5-29.pdf

http://en.wikipedia.org/wiki/Vitamin_D#Overdose

http://www.scielo.br/pdf/csp/v18n3/9286.pdf