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The Last Boomer
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I am not a professional investor. I am a quantitative consumer market researcher and analyst with an MBA degree. I got interested in the financial markets about three years ago and started reading voraciously books on finance and investing. I find some similarities between quantitative stock... More
  • Gold And Interest Rates

    About a year ago I read a post by Paul Krugman on the price of gold and its relationship with other investments. Building upon a paper from Salant and Henderson ("Market Anticipations of Government Policies and the Price of Gold"), Krugman believes that the gold story is basically about the real interest rates and concludes that "the price (of gold) has risen because the expected returns on other investments have fallen".

    In the current post I examine the statistical relationship between the 10 yr treasury constant maturity rates and the gold price.

    Interest Rates and Gold Price

    I use two time series.

    Monthly gold prices courtesy of and monthly rates on the 10 yr treasury bonds. Both series start in December 1969. The chart below shows the natural logs of the two time series plotted against each other. The price of gold is measured on the left y-axis and the treasury rates on the right y-axis.

    (click to enlarge)

    A casual look at the chart above shows that the relationship between interest rates and gold prices has been changing over time. The correlation between the two time series is -0.44 over the entire time period from Dec 1969 to Nov 2012. The negative correlation means that when the interest rates decrease the price of gold increases. If we take only the period since the beginning of 2000 to Nov 2012, the correlation is -0.84. It looks like gold attracts buyers when the return on other investments like Treasuries goes down.

    So, in order to assume further gold price appreciation, one needs to assume further declines in the Treasuries' yields. How likely is that? Are the treasuries' yields more likely to go up or down? Currently the real yields on the 10 yr treasuries are actually negative. With the yields that low, the likelihood that they'll go further down is not very high. My bet is that as the economic growth gradually accelerates, the yields will start inching up over the years to come. With government bonds and other investments offering increasing returns, the gold prices most likely will go down if the historical relationship between interest rates and gold prices holds.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Dec 24 1:30 PM | Link | 2 Comments
  • Relationship Between Corporate Profits And Government Deficits

    Dick Cheney famously said in 2004 to then Treasury Secretary Paul O'Neil: "You know, Paul, Reagan proved that deficits don't matter."

    Our current research tries to determine if deficits matter for corporate earnings. How do government deficits impact corporate earnings: positively or negatively? To answer this question we use four time series compiled by FRED at the Federal Reserve Bank of Saint Louis. This is the link to our data: The four time series are:

    • Corporate earnings (NYSE:CP)
    • Net federal government savings (FGDEF)
    • Net state and local government savings (SLDEF)
    • Gross private domestic investment (GPDI)

    We use statistical analysis to determine what type of relationship exists between government deficits and private investment on the one hand and earnings on the other hand.

    The time series spans from the second quarter in 1957 to the second quarter in 2012. Figure 1 shows what happened to earnings over this period. We use natural log of the earnings to show an unbiased view of the long-term trend. On the y-axis we show the natural logs of the quarterly corporate earnings between 1957 and 2012. There is a clear upward trend with four periods when profits stagnated or even decreased: 1965 to 1971, 1979 to 1987, 1997 to 2003, and 2006 to 2009.

    Figure 1

    (click to enlarge)

    CP_LN: lognormal of corporate earnings

    In all four periods of stagnating/decreasing corporate profits the US also experienced recessions: 1969, 1981, 2001, and 2008.

    Figure 2 below shows the absolute amounts in dollars of the net federal government savings. Before 1970 the savings swung between positive and negative until they firmly plunged in the negative territory in the 70s except for the brief period of government surpluses under Bill Clinton. In early 2000s the deficits got deeper faster as a result of big tax cuts, expansion of entitlement programs, and unfunded wars. Then they fell off a cliff at the start of the Great Recession. Very recently, as of 2010, the deficits started slowly to shrink while still remaining deeply in the red.

    Figure 2

    (click to enlarge)

    Below is another chart that plots corporate profits against federal deficits starting in 1970. The two lines are almost mirror images with the exception of the brief period of surpluses during the Clinton administration. As federal deficits grew larger, corporate profits got bigger.

    Figure 3

    (click to enlarge)

    I used a linear regression model with appropriate variable transformations. The regression has a very high R square of 0.96.

    The standardized regression coefficients represent the change in terms of standard deviations in the dependent variable (profits) that result from a change of one standard deviation in the independent variables (government savings and private investment).

    The Federal Savings (FGDEF) has a standardized regression coefficient β of -0.555. This means that as the Federal Savings decline (deficits increase), the corporate profits increase.

    The graph below shows the nature of the relationship between federal savings and corporate profits. Corporate profits are on the y-axis and federal savings on the x-axis. It is a linear, negative relationship meaning that when savings increase (deficits decrease), profits fall.

    (click to enlarge)

    The Gross Private Domestic Investment (GPDI) has a standardized regression coefficient β of 0.851. This means that as the Private Investment increases, corporate profits increase as well.

    The graph below shows the nature of the relationship between private investment and corporate profits. Profits are on the y-axis and investment on the x-axis. The relationship is linear and positive: as investment grows, profits increase as well.

    (click to enlarge)

    In summary, our analysis shows that corporate profits depend on federal deficits almost as much as they depend on private investments. The corporate profits grow when private citizens and corporations invest and/or when the federal government expands its deficits. Today there is a great focus on deficits and almost universal agreement that they need to be decreased. In the long run this might be good for the country but in the short term it will impact negatively corporate profits. The only way to avoid the deterioration of corporate profits when the government starts cutting deficits is to increase the gross private domestic investments. Corporations will have to open their vaults and start investing as the government deficits wind down. Otherwise, the decrease in government spending coupled with continuing corporate frugality may induce harsh austerity with Greek-like results.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Dec 21 8:28 AM | Link | Comment!
  • Corporate Profits And S&P 500

    First published in the fall of 2011

    What is exactly the relationship between the stock market and the corporate profits? In order to shed light on this relationship, I plot quarterly data of corporate profits and end of quarter levels of S&P 500 since the beginning of 1987.

    Sources: Bureau of Economic Analysis and E-Trade

    The chart shows that generally there is a strong correlation between the stock market and corporate profits. The stock market got ahead of profits during the dotcom boom of the late 1990s. There was also some divergence that started in 2004 with stocks lagging profits. Since the bottom of the financial crisis at the end of 2008, profits have risen faster than the stock market. The current divergence suggests that either profits will come down hard or the stock market will do some catching up. For the profits to come down to the current stock market level, they will have to collapse by almost 50%. Currently the profit growth is slowing down but the predominant opinion among the analysts is that profits will still rise, not collapse. If this assumption is correct, we will have to conclude that the stock market will have to go up significantly in order to restore the historical relationship between stocks and profits.

    I am updating this post at the beginning of January 2013

    This time I use S&P 500 operating earnings per share quarterly data and S&P index data (end of quarter values). This is the chart plotting earnings versus the index value.

    (click to enlarge)
    The chart above shows that S&P 500 earnings are closely correlated with the S&P 500 index. The Pearson correlation coefficient is 0.83 from March 1988 to September 2012. The first chart in this blog ends in Q3 2011. At this point the earnings were ahead of the index and my conclusion was that either the index will go up or the earning will collapse. What happened actually is that the earnings flatlined and the index went up thus catching up with earnings. As of Q3 2012 (the last quarter for which we have available data), the index still lags somewhat the earnings but most of the gap existing by Q3 of 2011 has been closed. The market is more fairly valued now than it was in Q3 2011. The Q4 2012 earnings season started yesterday (Jan 8, 2013) and this season will be critical for determining the direction of the market. The estimates are for operating profits per share of $25.29. If this estimate is met, it won't do much for stocks: it will not make the market go up or down; it will most likely just support the current market level.

    Conclusion: as of Q3/Q4 2012, the stock prices have caught up with earnings after lagging earnings through 2011 and now the market seems fairly valued.

    Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.

    Tags: S P 500
    Dec 25 9:56 AM | Link | Comment!
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