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  • A Picture Is Worth A Thousand Words: The State Of The Economy

    Availability of timely data is at the core of effective financial and economic analysis. The Federal Reserve Economic Database (FRED) provides a vast array of economic time series via an intuitive graphical interface. If you want to get a read on the U.S. economy, FRED is an outstanding resource. The ability to quickly create customized charts makes it quick and easy to examine a wide range of data. In this article, I am going to show a number of these charts, while exploring the overall economic U.S. economic picture.

    There is almost no economic variable that is as significant as the yield on Treasury bonds. When any economic or financial statistic is at or near a historic extreme, this variable becomes of paramount importance. Treasury bonds are currently at historically low yields and you really get a sense of that by looking at history. For example, have a look at this FRED chart of the yield on 10-year Treasury bonds over the last 50 years:

    chart 1

    The story that this chart tells is enormously significant in terms of how the economy arrived at its current state. In the 1970's and 1980's, inflation was high and bond yields reflected that. Today, the 10-year Treasury yield is 1.6% and the chart shows just how significant that is in terms of the last 50+ years. Low interest rates and bond yields make it easier for companies, individuals, and governments to take on debt. Furthermore, falling interest rates allow borrowers to simply roll their debt forward into lower-rates. The chart above explains one reason the United States has gotten so heavily indebted over the past thirty some years.

    Now let's move to the next picture-the Consumer Price Index (NYSEARCA:CPI), the standard official measure of price inflation. In general, we expect to see prices increase over long periods of time reflecting inflation. When economies are growing and more people are competing for the same goods, prices rise. The historical average annual rate of inflation in the U.S. is about 3% per year. This average is not the whole story though, as the chart below shows.

    (click to enlarge)

    This chart shows the percentage change in the CPI from year to year-the annual rate of inflation. In the 1970s and early 1980s, there were periods when we saw double-digit inflation. During the recent recession, we saw deflation-a drop in the CPI. Today, the CPI is around 2.3%, which is pretty tame. The problem of course is that when the change in the CPI is less than the yield from government bonds, bond investors are actually losing purchasing power by lending the government money.

    Even with modest inflation, government bond yields at historic lows are making it very difficult for savers to generate income from their portfolios. Furthermore, the Fed's stated purpose of keeping interest rates low is to stimulate the economy. As the next few charts show, however, the economy appears to be stuck in low gear despite low rates.

    A standard measure of the health of the economy is unemployment rates. A robust economy effectively applies the human capital of its citizens. We are currently in the midst of a prolonged period of high unemployment, as the chart below shows.

    (click to enlarge)

    The high rate of unemployment, combined with its duration, is something that we have not experienced since the early 1980s. That was right at the beginning of the emergence of computers and related technology. The technology boom of the past thirty years has certainly done its part to create jobs, but so has the enormous growth in borrowing-both public and private-that has been enabled by low and falling interest rates.

    The unemployment chart very clearly shows that unemployment rises in a recession (shaded areas) and falls in a recovery. Since 1950, we have never seen unemployment as high as it is today, this far into a recovery. Unemployment numbers account for people who are looking for work and do not include those who are not in the job market.

    At any time, a certain fraction of the population will be out of the job market because they are retired, disabled, stay-at-home parents, or simply too discouraged to look for work. The percentage of people either employed or looking for work is referred to as the 'labor participation rate.' The chart below shows the labor participation rate for males since the late 1940s. The seasonal cycle in employment is clearly evident in the chart, of course, but it is really striking that we have seen the fraction of adult males actively engaged in the workforce drop from more than 85% in 1950 to 70% today. There are many causes for this trend. The U.S. population as a whole is aging and people are living longer in retirement.

    (click to enlarge)

    When we look at the labor participation rate for both men and women, we see a different pattern:

    (click to enlarge)

    With the large-scale entrance of women into the workforce, the overall labor participation rate in the U.S. climbed steadily from the mid 60's to the late 90's. Since the late 90's, however, the trend has changed dramatically, with a historically-unprecedented decline.

    A low labor participation rate is not inherently bad. It reflects an aging and affluent population. The problem, however, is that even as a higher and higher fraction of the population is leaving the labor force, unemployment remains stubbornly high.

    All of these charts paint an overall picture suggesting that the U.S. economy is in new territory, at least as compared to the past fifty or sixty years. The combination of negative real yields on bonds with high unemployment, even as the labor participation rate is falling, suggests a long-term economic slow-down, consistent with the 'New Normal' scenario first proposed a number of years ago by PIMCO's Bill Gross and Mohamed El Erian. I am not predicting that this is, indeed, our future. My abilities to predict the future are no better than anyone else's. The data does suggest, however, that we are in uncharted territory such that the world looks somewhat different than it has in the past. This situation suggests that we at least question the conventional wisdom with regard to asset allocation.

    Related Links:

    Folio Investing The brokerage with a better way. Securities products and services offered through FOLIOfn Investments, Inc. Member FINRA/SIPC.

    Dec 10 11:20 AM | Link | Comment!
  • Game Theory, Behavioral Finance, And Investing: Part 1 Of 5

    Watching the market this year has been like observing an exercise in game theory and behavioral finance, and the two fields are closely related. Game theory is the study of how a rational person makes decisions in uncertain situations. As the name suggests, game theory was developed with the intent of developing optimal strategies in games in which chance or the decisions of an opponent play a role in your outcome. Game theory focuses on how rational players can make the best decisions to maximize their satisfaction. Behavioral finance adds the nuance that, in real life, people do not necessarily have all available information and, even if they do, they often make decisions that are inconsistent with those made by a perfectly-rational and fully-informed decision maker.

    There is a huge literature of both game theory applied to financial decisions and behavioral finance. I am going to discuss a select sample of the really striking manifestations and why they matter.

    Notice that in my description of game theory, I write that people act to maximize their satisfaction rather than their returns or their wealth. Investors' sources of satisfaction may differ. Some people like the excitement that comes with a chance at a huge win, even if the statistics show that their odds of winning are not good. Other people, knowing the odds of winning, are more inclined to seek a bet with a high probability of winning, even if the size of the win is not all that great.

    The games on Wall Street come in a variety of forms. We have investors buying and selling from each other. We have fund managers who seek to demonstrate that they have the ability to generate market-beating returns and thereby to attract investors. We have research firms that tell investors that if they just have the right charting tool, they can beat the odds. We also have venture capital firms that seek to rapidly grow out small companies and reap high returns by taking these companies public to great fanfare. A less well-known game occurs between shareholders and corporate management. While management is supposed to act on behalf of shareholders, there are ways that management can (and often do) enrich themselves at the expense of shareholders. Finally, recent research suggests that in making their savings decisions, people act as though they are competing for consumption with a future self who they really can't envision or relate to.

    While the launch and subsequent collapse of a number of web-based software companies has the public's attention today (Groupon, Zynga, etc.) we very recently experienced a very similar event in the 'green tech' bubble in which the hot stocks were those of companies that produced solar panels and other clean energy products (FSLR, STP, YGE). At the end of 2007, First Solar (NASDAQ:FSLR) sported a P/E of 178 and the stock went on to exceed $300 per share in 2008. Today, the stock trades at about $22. How is it possible that investors so quickly forget the last disaster and just move on to the next?

    In this five-part series of posts, I will explore a number of the challenges that investors face from the perspective of game theory and behavioral finance. In part 2, I start with a discussion of how Wall Street provides investors with what they buy rather than what they need. In addition, I explore some of the inherent conflicts of interest (so-called agency problems) that investors must come to grips with.

    Related Links:

    Folio Investing The brokerage with a better way. Securities products and services offered through FOLIOfn Investments, Inc. Member FINRA/SIPC.

    Oct 29 10:34 AM | Link | Comment!
  • Cheap Money + Share Buybacks = Bull Market?

    The market rally of the past twelve months may appear somewhat baffling in light of the fact that individual investors have been pulling money out of the market. The S&P 500 is up 22.5% in the last year, while September marks the 17th consecutive month during which investors took money out of equity mutual funds. The outflows from equity mutual funds are not simply due to investors moving from mutual funds to ETFs. A recent analysis by Bianco Research demonstrates that including ETF flows does not change the results.

    So if individual investors are selling, who is buying? Ron Surz nicely summarizes the data in a recent article. The massive buying that is driving up market prices is share buybacks. Companies are using their own money to repurchase their shares. He cites data showing that net investor redemptions from equity mutual funds totaled $32 Billion in the first nine months of 2012, while share buybacks totaled $300 Billion. For some enlightening charts and figures, see this report from FactSet.

    A company's decision to repurchase its own shares on the open market reflects a decision about how best to use capital resources. A company that has substantial cash on hand has three choices. It can pay a special dividend to investors, invest in new growth opportunities, or repurchase shares. The decision is partly driven by management's outlook as to the returns from growth, as well as the rates at which the company can borrow by issuing bonds. When a company can borrow cheaply (bonds yields are low, as they are today), share repurchases look more attractive.

    While buybacks can be a perfectly rational way for companies to spend their money, a 2012 study from Credit Suisse (published in June) suggests that buybacks are quite often to the detriment of current shareholders. While buybacks will increase the earnings per share (NYSEARCA:EPS), that does not mean that investors necessarily benefit. The real question is whether the company can purchase its own shares below their 'fair' value. If the company can buy its own shares at a discount to intrinsic value, the buyback adds value. This report is well worth reading.

    The data suggests that the current bull market in equities has been substantially driven by share buybacks. Furthermore, there is evidence that share buybacks may not add value for current investors. When both of these factors are taken together, the rise in stock market value in 2012 looks a lot less impressive.

    Related Links:

    Folio Investing The brokerage with a better way. Securities products and services offered through FOLIOfn Investments, Inc. Member FINRA/SIPC.

    Oct 16 12:32 PM | Link | Comment!
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