Saturday, August 31, 2013

There was no housing bubble,, I'm serious.

As a follow-up to the previous post, I've been trying to reconcile this graph from an earlier post

with this graph from

So, was there a sustained period of overbuilding, or wasn't there?......There wasn't!  As outlined in the previous post, there are several parallels between the 1970's and the 2000's.  One of them is an overabundance of 45-65 year olds, who are earning the highest incomes of their lifetimes, whose savings is peaking to its high point before they transition into retirement where they will start dissaving, and who are beginning to transition their savings into low risk fixed income.

One of the outcomes of this demographic context is that the prices of single family housing units is bid up, partly because that demographic can afford it and can use it, and partly because for them it is a superior investment to other low risk investments.   The peculiar dual role of housing as consumption and investment gives it an especially superior profile as a pragmatically low risk investment.

We can see in the 2nd graph that in the 1970's, starts for single family homes hit all-time highs.  This is especially striking, considering the very high nominal rates of the time.  As I speculated in the previous post, the high inflation at the time probably served to mitigate the trend of single family homebuilding that likely would have surged otherwise.  The 2000's saw low inflation and low nominal rates, so that when the baby boomers hit that age range, there were fewer constraints on homebuying.  The number of houses built skyrocketed to new highs, along with prices.  But, as can be seen in the 2nd graph, this came at the expense of multi-unit building.

So, while the investment preferences of baby boomers did lead to a boom in housing, the total housing stock remained level.  We didn't overbuild housing; we just accommodated the baby boomer preference for single family homes......both graphs are true!

Real Interest Rates and the Housing Boom

The housing boom of the 2000's was not a bubble.  The bust of 2007-2009 was a Fed-imposed liquidity crisis, with the banks its victims.  Hear me out.
(Here is a brief follow-up.)

Long Term Housing, Equity, and Interest Rate Comovement with Demographic Foundations

Here are a couple of articles from the Minneapolis Fed that discuss a series of papers on the similarities of the 2000's and the 1970's, which got me thinking more about aging population and long term macro cycles.

This paper from Piazzesi and Schneider argues that a combination of demographic and cyclical issues caused a decline in real interest rates and a transfer of wealth from equities to housing in the 1970's:
In the 1970s, U.S. asset markets witnessed (i) a 25% dip in the ratio of aggregate household wealth relative to GDP and (ii) negative comovement of house and stock prices that drove a 20% portfolio shift out of equity into real estate.
FRED GraphHere is a Fred graph that extends a basic version of their ratio into the 2000's.  We can see a similar dip in net worth that comes from a decline in equities in 2000-2002.  But in the 2000's, the housing boom was much more extreme, so there is the huge bump in net worth from 2003 to 2007, which breaks down in the financial crisis.

Piazzesi and Schneider argue that high inflation was integral in the shift from equities to housing.  So, the mystery is, why did we see this effect explode in the 2000's in a low inflation environment?

Here is a graph from P & S, showing Home Price to Rent ratios in a range from 20 to 25, peaking in the 50s, 70s and 2000s (roughly coincident with low real interest rate environments and similar population distributions, with population bulges in late middle age).

In addition, here is an updated Price to Rent graph from Calculatedriskblog that puts the subsequent peak of Home Price to Rents in the mid 30s.

Trying to get at the mystery, I put together a model to find the break-even price of owning a home versus renting, with the following variables:

Expected change in home values
Expected change in rental rates
Real long term risk free rate of interest
Down Payment %
Tax Rate
Home Price, expressed as Price to Rent

I had expected to find large consequences from housing's preferential tax treatment and from low down payments leading to the treatment of home ownership as a call option.  I was surprised to find very little effect from these factors.  In fact, the benefit of ownership increases with higher down payments.  And, in line with P & S, home ownership becomes more profitable with high inflation, ceteris paribus.

So, how could home prices have exploded in the 2000s?

The overwhelming factor justifying a higher Home Price to Rent (PTR) is the real interest rate.  That is because much of the value of owning, versus renting, is as a hedge against future nominal increases in rent.  And, the present value of those relative gains is very sensitive to real rates.  Here is a graph of interest rates:
FRED Graph

The green line is the 30 year mortgage rate.  The blue and red lines are rough proxies for real 10 and 20 year rates (nominal rates minus the inflation rate).  The mortgage spread is pretty stable over time, so most of the difference between the mortgage rate and the real rates is a reflection of the inflation premium.

Using my model, I found that, as an alternative to risk free fixed income, assuming no qualification constraints, the following PTR ratios could be justified simply from changing the level of real rates:

These justified prices assume a reversion to a long term PTR of 24.  In other words, the buyer of a house with a PTR of 28.69 can expect the house to lose 17% of it's value in real terms over 30 years, and the 28.69 PTR is still justified.

With naïve price expectations (expected home price growth and expected rent price growth equal to the inflation premium), PTR would range from 17.5 at a 5% real risk free rate to 32.6 at a 1% real risk free rate.

So, we could expect prices very similar to what we saw in the 2000's with little or no bubble behavior.

So why doesn't this show up in the 1970s?

The model justifying the prices of the 2000's has one big assumption - no qualification constraints.  No qualification is required on fixed income investments that are alternatives to homes.  But, to invest in the home you live in, you have to commit to purchase the entire house.  And, the method the bank uses to affirm your investment has nothing to do with a comparison between a long term bond investment and your home.  The bank simply compares nominal interest rates to your annual income.  So, even though the return on a home investment is higher in a high inflation environment, making nominal payments from your income becomes the constraining factor.

But, even as late as 1979, when mortgage rates were above 10% and rising, PTR was still rising at 25.  It was only the advent of higher real rates that sent home prices back down.

Low inflation in the 2000's meant that this constraint was minimal, so the prices that could have been justified in the 1970's in terms of return on investment could now be bid.

How does this change the interpretation of the 2000's?

From this point of view, the home prices of the 2000's were rational.  The apparent bubble activity that seems excessive (no doc loans, low down payments, interest only loans, etc.) now can simply be described as methods used to further remove constraints which were keeping investors from making a reasonable real estate investment.  Since low inflation caused monthly nominal payments to be low, buyers could reduce capital constraints by using methods that reduced other constraints, such as a down payment, with the cost of increasing the monthly payment.  Trends, such as lower down payments, also served to increase the option value of the mortgage, lowering the required return of the real estate. (There might still have been a bubble for AAA rated securitizations at the banks, but if my interpretation of events is plausible, then I don't think the CMO market would have more than a small effect, as long as nominal rates were low enough to reduce the qualification constraint.)

These methods would not have been useful in the 1970's, because the constraint then was in making the monthly payment.  A larger, unamortized mortgage principal would have only increased the constraint.

Also, note that before the financial crisis, real rates rose by about 1% from 2005 to 2007.  And, coincidentally, PTR peaked in 2005 and fell by about 4 points by the end of 2007.  This is exactly the behavior we would expect from a reasonably priced housing market that is constrained by expected returns instead of qualification constraints.

All of those mortgages were basically put options on homes, held short by the banks.  And, the Fed caused a deflationary liquidity crisis, starting at the end of 2007, which meant that many of those options were exercised.  The image of the Fed as a fat cat stuffing $100's into the tuxedos of its favored friends may be less accurate than the image of a waiter bringing out a free dessert after the chef burnt the entrée.

How does this change our expectations?

We can already see a rebound in the housing market, post-crisis, which is reportedly very heavy in all-cash purchases from sophisticated investors.  We don't have an overheated CMO market and we don't even have a generous real estate credit market.  What we do have are low real rates and low inflation.  I expect that there will be much gnashing of teeth as credit markets loosen up and homeowners take on a larger portion of home purchases as prices rise once again, with stories built around smart money and dumb money.  But, it is possible that this will be reasonable behavior.  I would expect real rates to rise somewhat as the economy continues to recover, and at some point, as in 1980 and 2006, this will become the constraint for home prices.  But, I suspect that we will see PTR at 25 or more before that happens.

And, the really interesting thing to watch will be if the Fed continues to be hawkish on inflation, and real rates fall again within the next decade, while baby boomers are still holding their peak level of low risk savings.  It could be possible that even under a conservative regime of mortgage qualification rules, PTR could head well into the 30's again in that environment.

The investment landscape and possible policy reactions, which could be misplaced, in that context, would bear consideration.

This is yet another reason why an inflation rate of 4 or 5% might not be so bad.  In addition to preventing sticky wages when inflation in non-cash earnings is high, it would help bond markets clear at rates safely above zero while real rates remain low or negative, and it might just help to stabilize home prices.

Tuesday, August 27, 2013

Could JFK have ended poverty with today's government?

He probably would have thought so.

Here is a graph of GDP and government spending per capita, in 2009 dollars:

Government at all levels today spends the equivalent of the entire US economy of 1961.

Monday, August 26, 2013

Minimum Wages and the Business Cycle

I'm still working on an update of the minimum wage and employment.  One problem with analysis of the national minimum wage is that there are really only 7 episodes of isolated minimum wage increases, so even if it has very poor employment effects, it would be hard to find statistically significant results.  Five of the seven episodes just happen to coincide with significant downturns in the labor market.  Here is a graph of part time employment since 1987:

It seems like there are correlations within the broad national data that point to a large disemployment effect, yet, as can be seen in this graph, interpretation can be difficult.  Here we have 2 episodes where a drop in age 16-19 part time employment drops and age 20-24 part time employment climbs, which could result from a substitution effect, and these both coincide with broad recessionary labor markets.  Then, a third episode seems to have no effect on employment at all.  And, a fourth notable event is another recession that has the same signature of the recessions that coincided with MW hikes.

Political Calculations points out that the 2001 episode coincides with a large MW hike above the federal level in California, but I'm not convinced that the timing and scale of the labor market declines fit that story.

And, the 1994 episode happened to come during what was possibly the strongest labor market in the last 80 years, where the labor demand was strong enough to create a bulge in the greater-than-full-time labor force unprecedented for this period.

I think I've got some ways to get some indications through the fog of data, but it's a funny situation, where MW hikes have an unlikely and uncanny coincidence with poor labor markets, yet there is enough noise to cast doubts on using the broad national data to confirm anything definitive.  Maybe it's not worth my time, as this has been a frequently studied topic, but there are interesting things to learn from the data along the way.

PS.  One other thing this graph makes clear, again, is that the reports of a labor market that is only strong among part time workers because of Obamacare seem to be based on specious measurements.  There is a surge in part time employment and a plateau in full time work over the past few months, but these are noisy indicators, and the same thing could have been said at some point each year since the recession ended, so significant confirmation would be required to be able to say that.  The lack of any trend in the year over year part time employment data in the chart here suggests that a confirmation is unlikely.

More on Unemployment Duration and Emergency Unemployment Insurance

Average unemployment duration always increases with age. In the previous post, I found that this recession caused an unusual amount of extra unemployment duration among the older age groups.  I thought that I might be able to further estimate the effect of EUI on unemployment by using the ratio of Duration/UNRATE.  Basically, this is a rough measure of how much variance there is among the durations of unemployed workers. If most workers get a new job within a few weeks, this number will be low.  But, if some workers get a job in a few weeks while others take months, then this ratio will be higher.

The results are somewhat inconclusive.  First, as an explanation, this ratio has a somewhat funny behavior, because when unemployment first kicks up, the ratio decreases, since many newly unemployed workers bring down the average duration.  After unemployment peaks, the ratio grows, as the number of newly unemployed workers declines relative to the existing pool of unemployed workers.

This recession does show very high variance of duration behavior in every age group.  But, I don't think this would count as evidence of EUI effects because, (1) it is difficult to compare the ratio over time on an absolute scale because many factors, such as structural impediments to reemployment, the amount of churn in the labor market and the rate of change in the unemployment rate will effect the dynamics of it; and (2) if EUI were a factor in the recent recession, I would have expected the effect to be more pronounced in the older age groups, since they naturally start with a higher average duration, and would be relatively more affected by insurance over 26 weeks.

But, I can imagine other interpretations.

I will point out that for economists who argue that unemployment is mainly an aggregate demand problem, I would think that the EUI would have to be a prime suspect for the high unemployment durations.

Saturday, August 24, 2013

Uneasy Money on the Great Depression

Naive market maker strategy in forward interest rates

There is a profit to be made over the next year in forward interest rate markets as a sort of naïve market maker, which I touched on here and here.  This is basically a leveraged asset rebalancing approach.  Everyone should do some unleveraged rebalancing.  You can goose the returns to rebalancing by leveraging up the adjustment.  For instance, if you're 50/50 stocks and bonds, and after a year, you find that you are now 40/60, then you might expect stocks to rebound, so you could rebalance to 60/40.  As with any leveraged strategy, this can get you in trouble in proportion to the leverage you take.  With enough leverage, it becomes a classic hidden fat-tail risk situation.  You make excessive gains like clockwork, but most of the time you are carrying some unrealized losses, as you buy into weakness.  Then the day comes that the markets go against you one too many days in a row, and those unrealized losses become realized losses, and you can't rebalance any more.

But, if you can draw a boundary around the potential volatility you can expect to handle, you can make sure your leverage is low enough to prevent a meltdown.

This graph represents the potential payouts of this kind of strategy.  It books profits over time, but as the price moves away from the midpoint, the losses can become catastrophic quickly.

We have an unusual situation in forward interest rate markets, where short term rates are certain not to budge, and at some point around the end of 2014, we can expect short term rates to follow a path, managed by the Fed, up to some higher level.  The first rate increase is very likely to come between September 2014 and March 2015.  In the meantime, there is a lot of volatility in the middle part of the yield curve, around 2016-2018.  So, the question is, if we want to earn profits by mitigating that volatility, where would we set our boundaries?

FRED Graph

This is a graph roughly measuring the slope of the yield curve along several segments, over time.  There appears to be a typical slope in the short end of the yield curve that reaches about 2%/year at the point in time where the Fed is expected to raise Fed Funds rate for the first time.  In other words, if the 1 year interest rate is 3% when the Fed starts to raise rates, forward markets will price the rates one year ahead at about 5%, 2% above the beginning rate.  The yield curve levels off to a slope of 1%/year or less after that.

This should put a cap of about 4% on contracts that are about 3 years out from the initial interest rate increase.  So, while short term rates are near zero, the bullish boundary would put September 2017 contracts at about 4.25%.  I estimate that a bearish scenario of a rise in March 2015, with a slower rate of expected Fed Funds increases would give an expected value for the September 2017 contracts of about 2.75%.

Daily volatility is fairly high, as investors second guess Fed stances and daily economic indicators.  But, I expect there to be a very strong mean reversion behavior within these boundaries, until the rate increases commence.  As the date of the rate increase approaches, the planned range of the strategy can be occasionally adjusted to reflect new information on the health of the economy, if necessary, although this can create some costs, depending on where prices are at the time of the adjustment.

The low rate environment limits the ability of the expanded money supply to goose investment and spending, so I expect the eventual path of short term rates to be slower than 2% per year.  But, by the time the actual spot rates start moving, it will probably be time to put this strategy away for a while.

Friday, August 23, 2013

More on Duration, Demographics, and Emergency Unemployment Insurance.

I've been looking some more at unemployment duration data, to see if we can make any broad estimates of what is going on.  I realize that my back of the envelope estimates aren't academically rigorous, but I hope this provides plausible food for thought, and some grist for speculative decision making.

Postscript: Upon further reflection, I think the approx. .75% of age-related unemployment, anomalous to the recent recession, which I found in the demographics section, is probably closely related to the .7% excess unemployment that I found in the later section on EUI related to excess unemployment duration above 26 weeks.  So, in total, of the approx. 5% in cyclical unemployment that we saw at the peak, I am attributing approx. .5% to age demographics and at least .75% to EUI.  This leaves 3.75% attributable to other factors, although EUI would likely be responsible for some of the remaining 3.75% in ways that I haven't been able to isolate here.

Under the fold.....

Tuesday, August 20, 2013

Predictable Variations in Economic Growth

Along the lines of the demographic issues I've been thinking about recently, I wonder how we can make the appropriate adjustments to our standard measures of economic activity.

In 1995, 12.5% of the population was above 65 years old.  In 2015, it will be up to 14.4%, and by 2035, it will be up to 20.7%.  Compared to the boom times of the 1990's, an additional 8% of the population will be of retirement age.  Whether we measure the effect of this change on the economy through consumption or production, there will be a tremendous drag on the standard measures of economic growth.

But, the point I would make is that this will be a purely statistical drag.  For those 60 million retirees, this will be a perfectly predictable part of their life plan.  They worked harder and saved when they were younger so that they could enjoy a long life of retirement.  The coming reductions in GDP growth will be a reflection of success, a product of an incredible time in history where we can expect to spend much of our lives being economically unproductive.

It seems like there should be some adjustment for that, similar to an adjustment we would make for inflation:  "Real GDP grew at a rate of 1.5% this quarter.  Nominal GDP grew at 2.5%.  And, lifecycle adjusted GDP grew at 3.5%."

I am afraid that we are looking at a 20 year period where there will be a constant clamoring for poor solutions to problems that only exist in the minds of lazy or opportunistic consumers of statistics.

Monday, August 19, 2013

Bond Market Forecast

I've recently started reading Vince Foster, and I like his articles because he makes good points with an interpretation that differs from mine, and he has much more industry experience than I have.

Here, he talks about the idea that the bond market is selling off as a product of uncertainty from the Fed.

I have floated the opposite theory, here, here, and here.  My theory goes something like this:

The rounds of QE have been more effective at creating forward inflation uncertainty, due to the Fed's large balance sheet and duration risk, than at creating actual inflation in real time.  In fact, I think this is basically how you might describe the point of QE, in terms of the expectations channel.  So, expected inflation hasn't risen much, per se, but TIPS spreads reflect a higher premium due to a wider variance of possible inflation outcomes, depending on the management of the Fed balance sheet.  Since this is a risk premium instead of an inflation expectation, some of that premium would bleed into the nominal bond market, pushing all yields down, but with the appearance of lower real yields and higher inflation expectations.

I think the Fed's communication over the summer reduced this uncertainty, and this caused yields to rise (counterintuitively).  From a speculatory point of view, back at the beginning of the year, looking at June 2017 Eurodollars with rates as low as 1.6%, this suppression of yields meant that a short position could capture the rising yields as these uncertainties diminished over time.  And, the position could be highly leveraged because there was very limited downside risk.  These distortions in the yield curve meant that at 1.6%, the final rate for those contracts at expiration could have risen from the current market price even in scenarios where the Fed wasn't raising the Fed Funds rate until well into 2016.

Now, I believe that much, if not all, of this uncertainty distortion has vanished.  And what I like about Vince's review of the situation is that it points to a speculative opportunity that I would agree with, even though we are coming at it from two different priors.  As he notes, the term spread is as high as it's ever been.  He thinks that this represents uncertainty, and I think it represents a reasonable pure expectations yield curve.  But, in either case, as long as short term rates are tethered to zero, there is a very strong bungee cord attached to the long end of the yield curve.

I also think there are some naturally mitigating forces on yield volatility that will remain in play during this period of time.  The Fed will be hawkish as a balance sheet defense, the propensity of the market to convert currency or bank reserves into inflation will be low as long as we are at low rates, and bank capital would be diminished by further rises in interest rates.  And, looking beyond volatility over the lifetime of long dated Eurodollar contracts, I would expect short term rates to top out at less than 3% during this expansion, due to global trends in real rates.  That is below the current price of Eurodollar contracts dated 2017 or beyond.  The main danger to this scenario would be from unruly inflation coming about as a result a slow Fed response to money supply management as short term rates escape from zero.  But, there should be some forward visibility regarding this phenomenon.

For the next 6 months, a position that is short on yield volatility could be leveraged quite aggressively, considering these factors.  Or, more specifically, a position leveraged for daily to monthly volatility can be less concerned about pulse jumps in yield or serially correlated volatility that would increase volatility exposure over a longer holding period.

Can polite pessimism be inefficient?

This is a typical news source for the monthly unemployment report.

The sentence I would draw attention to is : "The report was discouraging in many regards. While the unemployment rate fell slightly to 7.4%, the drop was partly because 37,000 people dropped out of the labor force. "

Now, what happens in these labor numbers, which are quite noisy from month to month, is that there is a general trend of decreasing unemployment.  However, labor force participation can move up or down from month to month by several 100,000s, due to sampling errors.  So, what happens in practice is that over any 6 month period, the Unemployment Rate drops by a few tenths of a percent, and the months that the drop is noted will happen to be the months where the labor force noise is favorable to the Unemployment Rate.

To be fair, my impression is that this reporting is one-way, but my quick perusal of google actually showed a decent mix of reporters and analysts pointing out the issues with these numbers, including the demographic issues.  News reports also sometimes include this caveat when the UER comes in high because of this noise.  So, maybe it's just my bias that I especially notice this when LPF noise produces a high UER number, and my optimistic bias is causing me to misreport media evenhandedness as a bias.  Please correct me in the comments if this is the case.

In any case, the point of this post, which may, admittedly simply be a reflection of my conceit, is that there appears to be a persistent excess return to holding periods that begin just after the beginning of a recession.

The 1 year holding period doesn't hold up during the last half of the sample period because business cycles have been longer during this time, so there are more bullish months that are unaffected by recessions.  But, the 2 and 3 year holding periods are very strong for either the first half or second half of the sample period.

The holding period inceptions would be backward looking by 6 to 12 months in real time, so I don't think I have made the mistake of measuring predetermined returns.  Results are similar if I move the holding period inception back another 6 months:

One reasonable explanation for this could be that risk premiums are higher coming out of a recession.  But, the volatility of returns shown above is significantly lower for those periods.

I would expect market efficiency to be stronger than this.  But, I wonder if socially enforced pessimism could be a strong enough force to keep prices too low during the early periods of recovery.  At any given time, there should be an array of opinions about economic potential, and those opinions should be roughtly normally shaped, with prices reflecting the decision of the average investor.

But, imagining a news report, an analyst report for a broad audience, or even a private meeting with a wealth management client, it would be very difficult in the early recovery period of a recession to take an optimistic position.  We have all seen comments on blogs along the lines of, "My brother in law has 15 years experience as an electrical contractor, and he's been busting his butt for 18 months trying to find work.  Why don't you step outside your cushy office and see what it's like in the real world?"  In thinking about that normal distribution of opinions that makes a market, there is an awful lot of public shaming aimed at the optimistic half of that curve during these economic periods.

Could that be enough to make markets inefficient, or am I just an optimist with sour grapes?

Friday, August 16, 2013

Depression era solutions

A good summary from David Henderson of the disastrous New Deal policy of forcing farmers to leave ground fallow and destroy crops and livestock.  I will leave the exercise of showing how this could possibly help a nation escape poverty to the reader.  For anyone not familiar with the story, it's worth the read.

Of course, we had our own brilliant ideas, like destroying perfectly good automobiles (does anybody even remember Cash for Clunkers?) and putting a price floor above the market wage of a third of our young people in a deflationary labor market.

An aside:  The Agricultural Adjustment Act led to Wickard v Filburn - the beginning of the end of the commerce clause as a constraint on government interference.  Here is the outline from Wikipedia:

A farmer, Roscoe Filburn, was growing wheat for on-farm consumption in Ohio. The U.S. government had established limits on wheat production based on acreage owned by a farmer, in order to drive up wheat prices during the Great Depression, and Filburn was growing more than the limits permitted. Filburn was ordered to destroy[citation needed] his crops and pay a fine, even though he was producing the excess wheat for his own use and had no intention of selling it......The Court decided that Filburn's wheat growing activities reduced the amount of wheat he would buy for chicken feed on the open market, and because wheat was traded nationally, Filburn's production of more wheat than he was allotted was affecting interstate commerce. Thus, Filburn's production could be regulated by the federal government.

.....soooooo, it is so important to curtail production when people are out of work and to raise the price of wheat while people are starving that even subsistence farmers should have to destroy their wheat so that they have to buy more chicken feed....Yes, we turned the commerce clause on its head for that.  Who could fault the logic, really?

David has a follow up post on the topic, with a famous quote from The Grapes of Wrath.  This passage is apparently usually interpreted as an indictment of capitalism, as if this turn of events was an inevitable, tragic consequence of agri-markets, with FDR the hero for playing tough with the culprits.  This is a very sad story on many levels.

It's All Demographics, Again

I took the census middle series population forecast by age & sex and I fit these very basic labor force participation trends to them:

The middle age groups follow pretty stable long term trends.  I gave the young age group a level trend, although it doesn't seem to matter much.  And, I projected for the 65+ group to have a pretty aggressive uptrend for the next 50 years.  Here's what the LFPR would be for the total labor force:

Here is the forecast, appended to actual past LFP rates (in blue):

The most important thing to note here is that the current slope of the line basically tracks the slope we have seen since 2000.  You don't need a disillusioned labor force that's given up in order to explain this decline.

There are periods in the late 70's, late 80's, late 90's, and mid-oughts, where LFP goes above trend during especially strong labor markets.  The sharp curvature of the curve makes it hard to see these, but once we correct for this trend, there is nothing special about LFP behavior.

One mistake I see a lot of people making is that they compare the current LFP rate to the rate at the peak of 2007, so they are capturing all of the cyclical variation plus 6 years of a very sharp secular decline.  Because the secular decline started in the late 90's, conventional wisdom also attributes the secular trend in the labor market of the 2002-2007 recovery to a weak recovery.  In truth, the LFP in 2007 was well above trend, and a very strong labor market was masked by demographics.  So the demographic factors here tend to be dismissed as a result of placing errors on top of errors in our analysis.

To show how strong the demographics are as a factor, I tweaked my LFP forecasts so that the 65+ group increases even more aggressively and the other age groups buck their long term trends and level out:

You should note 2 things:
1) This doesn't effect the slope of the line for the next 5 years.
2) Even here, none of us will be seeing 67% LFP again in our lifetimes.

I suspect that those bumps of LFP above trend during the highpoint of the business cycle will become more pronounced as the number of older workers who are semi-retired increases.  That might lead to more pro-cyclical opportunistic labor force participation (in green on the chart above).  Like the last cycle, at it's peak, this will produce a horizontal LFP line that will be interpreted as the new normal, and when the cycle turns sour and the LFP declines to the much lower level, it will be interpreted as another weak recovery that leaves workers behind.  It will be hard to empirically reject this interpretation because there will actually be many discouraged workers, as is typical after a recession.  Only someone totally lacking in social grace would announce during a recession that the labor market isn't as bad as it's made out to be.

I imagine telling my great-great grandparents that in my day, many people are healthy well into their 70's and 80's, and that they are relatively wealthy for all that time, too, even though they stop working by their 60's and don't depend on their children.  (BTW, the male LFP rate for 65+ year olds in 1949 was 47%.) I imagine that their mouths would drop in disbelief.  Is there any news so good that we can't twist it into bad news?

Thursday, August 15, 2013

It's All Demographics, a continuing series

Here are some population pyramids:

 2015 (est.)

Both of these show a crimp in the  35-49 age group.  Right smack in the part of the life cycle where workers are hitting their productivity stride, they are still investing for risk and spending.  And they are totally outnumbered by retiring workers, students, and kids.

Add to that an atmosphere of government overreach (Nixon and Johnson vs. Obama and Bush), and I wonder if we're just seeing a replay of the 1970's but with a low inflation biased Fed instead of a high inflation biased Fed.  Heck, maybe we can blame the poor governance on the demographics, too, for all I know.

Compare those to this pyramid from 1995:

Now, there is a nation full of workers with a decade of experience under their belts.  Maybe Reagan & Clinton just had the good sense to get elected when there were a lot of folks eager to earn, spend, and invest for growth.

So, maybe we're really just still feeling aftershocks of the Great Depression.  People stopped having babies for a decade 80 years ago, and we're still feeling the consequences in long slow waves.

Could this be the ultimate anti-EMH argument?  Do we underestimate predictable trends 80 years in the making?

Unemployment issues

I just posted a comment at that is a shorter version of my previous posts on this issue:

So, I thought I would post it here for easier reference:

I estimate that without MW, emergency UEI, and demographic factors, we'd be crossing below 6% UE by now, near a new, higher base UER.  A lot of this is hard for me to summarize, because the phenomenon is a kind of hybrid of demographic and cyclical issues.  But, here are a few thoughts & factoids:

regarding Minimum Wage (MW):

While the absolute total size of the labor force has increased since 2006/2007, hourly workers declined by 3.6 million, and 1.7 million of those were teens.

The 40% increase in MW means the MW workforce increased from 1.7 to 4.4 million.  In addition to this, some portion of those 3.6 million former hourly labor force participants were effected by the MW increase.  Broad historical correlations would predict about a 1 million increase in UE from this.  Considering the scale of the other numbers, this seems reasonable.  My estimates suggest that, of the effected workers whose wages would have been below the new floor, only 13% would need to be counted as unemployed to get 1 million new UE.  Of course, the number will slowly decline over time, as long as we don't raise MW again.

regarding Emergency Unemployment Insurance (EUI) and demographics:

As a % of LF, UE durations under 27 weeks have been flat for more than a year at about 4.8%, about 1% higher than the flatline levels of previous recoveries.  UE durations of 27+ weeks of workers not on EUI have flatlined at 1.6% of the labor force, which is also 1% higher than earlier recoveries.  All of the declines in UE since early 2012 have been from decreases in the EUI numbers.

The GAO surveyed workers who had used up their emergency UEI.  Of those who were still not employed, more were on SSI benefits than SNAP benefits.

The number of workers over 55 with UE duration over 26 weeks peaked at a little over 1.1 million and is still at 800,000.  For the 65+ age group, it's still at 200,000, the same level as late 2009.
Workers younger than 45 with less than HS education have average UE duration of 28 weeks.  This increases systematically as age & education increase.  45+ year olds with at least some college have UE duration of 36 weeks.  Married workers also have higher UE duration than unmarried workers.  Clearly, older, more educated, married workers have more ability for consumption smoothing.

The LFP of workers over 55 declined until the mid-90's when it started climbing again.  Until the 1960's, UER for this age group basically followed the same pattern as other age groups, suggesting that in that era, older workers had the same income needs and work patterns as other age groups.  From the 1970's to the 1990's, the UER for older workers stayed at a much lower level than younger groups.  The combination of low LFP and low UER suggests that retirement was the overriding factor.  Since the 1990's UER for older workers has come back up, and in the current cycle, is more persistent than for younger age groups.  I think that this reflects the new era where extended retirement and longer lifespans have led baby boomers to retain a partial connection to the labor force, which includes an unprecedented level of discretion.

Tuesday, August 13, 2013

Finance is Forward Looking

Here is the abstract of some recent research on hedge fund activism.

The Long-Term Effects of Hedge Fund Activism

It's funny that this is a surprise.  Of course value creation is persistent.  To believe anything else would require a complete and utter rejection of the efficient markets hypothesis at all levels.  Of course prices reflect herding behavior and subjective, fickle discount rates.  But, I think it would be hard to model a functional market that is systematically and persistently ruled by predictable, temporary fluctuations in value perception. The best way for an activist to increase the price of their stock is to increase the value of the firm.

The idea that the market is full of "pump & dumps" and a next-quarter myopia is a belief that managers are happy to play to because it gives them an excuse for butt covering, and it's something the public (including a lot of finance folks) are happy to believe because right-thinking people are supposed to be cynical about finance.  And, there is just enough evidence to back it up because sometimes one of the few indicators we have for future performance is current performance.  If a firm has surprising short term performance, most of the added value the marginal investor is going to factor in is going to come from improved performance expectations in the far future.  I don't think this phenomenon can be measured in any way.  I'd love to know if someone has tried.

Here is a study that found lower expected returns on firms that were engaged in aggressive accounting.  There is some room for markets to be fooled by non-transparent aggressive management in the short run.  But, even here, we will tend to see this effect strongest in very quickly growing firms with uncertain futures - a situation where small changes in the trajectory of expected future profits will have large valuation consequences.

Just as often, I find that the market is skeptical of short term performance, so that many times obviously superior equities are available for some time after results have shown a positive surprise.  Really, the well-documented momentum effect is a kind of anti-short run bias.

All of this really comes down to reputation.  A management team might be able to trade in their reputation to trick the market for a few quarters, but a management team with a damaged reputation is just as likely to shout clearly positive outcomes to a market that's not interested in hearing it until they see a few more quarters of proof.  Eventually, the reputational capital shifts to reflect reality.

Prices do fluctuate as a result of these problems around some intrinsic value, but the fluctuations are a part of a complicated puzzle of incentives and signals.  The market that always short-sightedly chases a couple cents from the next quarter is a caricature.

Monday, August 12, 2013

Compensation as a portion of GDP

Here's a chart that is always good for some moral indignation:

That's wage compensation in blue and corporate profit in red.

The great news is below the fold.

Thursday, August 8, 2013

Stop Hatin' on the Trade Deficit (aka: America, Heck* Yeah!)

Conventional wisdom seems to always be a little loopy when it comes to international financial activity, including the trade deficit.  If we think of the trade deficit as an effect and not a cause, here is what it looks like to me:

Series greater than zero are inflows of dollars into the US and series less than zero are outflows of dollars out of the US.

The purple line reflects a persistent outflow of money from the US, mostly in the form of private flows, such as remittances, foreign aid, etc.

The red line is the net income on foreign assets.  This amount is persistently positive.   In other words, Americans consistently earn more from our foreign investments than foreigners earn on their American investments.

Now, here's the real knee slapper.  The green line is net new international investment.  Since this is always positive, this means that foreigners are always investing more money into the US than we are investing abroad.  Where do they get this money?  Well, the only flow left is imports and exports.  They have to sell us stuff in order to fund their new investments.

The conventional wisdom keeps up this far, and here, the story goes, we are selling ourselves into hock in order to buy junk from the Chinese.  But, you see the problem with that story, right?  Even after trillions of dollars of investments into the US, foreigners still can't manage to out earn us.  So, based on historic cost, foreign investments in the US are much higher than US investments abroad.  But, who cares about historic cost?  The market value of US investments abroad is larger than foreign investments in the US, and the net value is growing.  How can I tell?  Because we always have positive net income from net foreign investments.

How can this be?  If I may, it's because Americans kick ass!

Americans are the world's risk takers, and we do it well.   Our foreign investments are more private and more equity based than are foreign investments in the US.  We have filled two needs for the world.  First, we are providing a large amount of at-risk capital that the developing world desperately needs, and we are being compensated handsomely for it.  On the other hand, the US government has managed to create trillions of dollars of a "risk free asset", in the form of treasury debt, for sale to a risk averse world.

As long as these factors remain in play - and I don't see any reason to expect them to change soon - the idea that we have to get rid of the trade deficit to be sustainable is 180 degrees wrong.  At current levels, the playing field is tilted IN OUR FAVOR.  Our net income has grown tremendously.  It would take a trade deficit of more than $200 billion quarterly just for everyone else to be treading water relative to us.

America, Heck* Yeah!

(* edited for propriety at wife's request.)

Wednesday, August 7, 2013

Hanson on Inequality

Robin Hanson has a new post about inequality:

He links to this older post:

And, both posts bring to mind one of my favorite older posts from Robin, which highlights the kind of intra-familial sharing politics that dominate life in a pre-capitalist context:

I suppose that, referring back to the first post, the tools of the nation state have caused national sharing signals to be more easily performed than the intra-familial signals of the hunter-gatherer clan in the third link.  In the national context, we can demonstrate our concern for the weak and our affiliation with a strong political faction without having to personally face down the target of our taking and without taking on any direct consequence.  This national factionalism has so dominated our quest for status that we have completely lost the shared norm of intra-family equality.  It's strange, really, that if we made the kinds of demands directly to a cousin or even a sibling that we commonly make on strangers in a national political context, it would seem outlandish to us.  The hunter-gatherers in the 3rd link would think we have lost our minds if they saw us demanding national redistribution while we visit our wealthy cousins without demanding a thing from them.

Monday, August 5, 2013

Part Time Workers

There has been chatter of changes in part time vs. full time work, as a result of Obamacare.  I previousy thought it could be a factor in the labor market, but I have grown skeptical.
Today, there was an article at, that was pushing this idea, again.  It included this graph:

So, I went to the bls beta site to see what I could find.

I was able to download unadjusted monthly employment data for non-agricultural hourly workers for several levels of weekly hours worked.  Here's what I found.

First, a long term look at employment levels.  Several characteristics of the data are apparent:

1) Cyclical patterns are almost entirely limited to 40+ hour workers, and mostly to 41+.

2) This is from the current population survey, so it's very noisy from month to month.

3) Part time work is very seasonal, and the seasonal pattern appears to have flattened in some of the series, which might be making even year over year comparisons difficult.

4) If anything, part time workers appear to be declining from trend in the most recent period, and since these have a very linear historical behavior, anomalies from the trend should be easy to spot.

5) I don't know the explanation, but the demographic and cultural factors that have created that humped shape in labor force participation over the past 40 years don't seem to show up in the part time series at all, and don't appear to show up much in the 40 hour series, after cyclical adjustments.  I wonder what could explain such a dichotomy.  I would expect overtime work to be cyclical, but I'm surprised at the linear behavior of the other series.

6) Even before Obamacare, I would have expected growing non-wage income to lead to a bifurcation of workers pushed into overtime and workers kept at limited part time.  I take this as yet another data set implying that workers really do get what they want in labor markets.  The stories in the papers bemoan stagnating wages.  I think this graph could be interpreted as saying that workers prefer 40 hour work weeks, and are willing to accept lower cash income to stay at 40 hours.  I would expect employers to prefer 41+ hour employees, in order to reduce the costs of benefits such as health care, and I would expect workers anxious for cash to prefer 41+ hour work.  Furthermore, the reduction in hours worked and stagnation in earnings is not coming from a surge of employees stuck in part time, but it looks to me like it's coming from cultural changes that cause the work week to top out at 40 hours.  I am surprised by these trends.

Bonus note #7)  The recurring theme of demographics: This is another big flashing sign that demographics have a lot more to do with the expansion of the 80's and 90's than the causes that we tend to toss around.  With a 50% increase of 40+ hour workers in 20 years (from boomers hitting middle age and women entering the workforce), we would have really had to screw things up to keep from having strong economic growth.  Interestingly, there are two significant periods where 40 hour workers declined.  One was in the recent downturn, as part of a decline in all full time workers.  But, the other was in the 90's, and appears to reflect conversion of workers to 41+ hour weeks, reflecting the strong economy maxing out its labor force.

What if we look a little closer at recent trends?  Here is more recent behavior, in the YOY change of each category.  Again, mostly what we see here is that the CPS is a noisy data set.  Any claim of a trend from this data using just a few months is going to be bogus.  The decline of full time work during the recession, and some countervailing increases in part time work during that time are clear.  Since then, it looks like standard labor recovery behavior.  No unusual increase in overtime and part time workers.

The employment levels over this time frame also look pretty typical.

The employment levels during the last business cycle look pretty similar except that the trends in full time employment were stronger.  Unemployment didn't take nearly as big a hit in the last cycle:

Could we be looking at multiple job holders?  Here is series LNU02026619, multiple jobholders.  Now, the subset of this series that includes workers with two jobs that are both part time is rising, but it's been rising since 2002:
The takeaway: It's WAY too early to claim that Obamacare is pushing workers into part time work. 
And, it's funny that this is such an unpopular thing to say, but the labor market might just reflect the demands of workers as much as it reflects the demands of employers.  Maybe we're not seeing workers shunted into categories that are convenient for employers because labor markets don't work that way.

Friday, August 2, 2013

Unemployment Duration

I have added some additional analysis on some of these issues here.

This chart on unemployment duration echoes some of my earlier concerns about unemployment demographics.

All durations under 27 weeks seem to have flatlined months ago. Unemployment of 26+ weeks is still declining at a, more or less, linear rate.  If we continue to see this pattern, it looks like unemployment would bottom around 6% or more around 2016.  As I outlined in the earlier post, I would be tempted to chalk this potentially higher full employment level up to structural frictions created by federal governance, but most of it is probably the product of an older, wealthier population with more discretion about employment.

Here is a proportional graph of unemployment by duration, where the very long term trend of higher durations, is even more clear - and over this time frame must be the result of something other than age demographics.  Technological advances should have reduced the searching frictions that might prolong unemployment, but a stronger safety net and more sources of interim income must be even stronger forces in the direction of longer durations.  I wonder if employers have developed better methods for identifying productive potential employees, so that there is a bifurcation of unemployed workers who find work quickly and those who struggle for a longer time.  Higher homeownership could potentially limit the ability to move for work.  But, I'm just spit-balling here.

Below is a graph of unemployment over time, with several forecasts, based on unemployment insurance claims.  Through the cycle, there is a logarithmic relationship between claims and unemployment, and the current relationship suggests an unemployment rate of about 5.5% once the emergency unemployment insurance has finally settled down for this cycle, but the current unemployment rate is above trend, suggesting a resting rate of closer to 6%.
I wonder if more consumption smoothing by the workforce is helping to elongate the business cycle.  As the recovery ages, some portions of the labor force re-enter the workforce more slowly than they had in previous generations.  That might help to extend the recovery for several years.
On the next cycle, one question will be whether we continue to have a hawkish Fed, or if the low secular growth that is caused by the aging baby boomers will goad the Fed into inflationary tactics, which might lead to something that looks like the stagflation of the 70's.  Real interest rates are bound to stay pretty low through the next cycle or two, but nominal rates will depend somewhat on the Fed.

Will Wilkinson nails it, as usual

HT: Tyler Cowen

Thursday, August 1, 2013


Core Molding Technologies should be reporting second quarter earnings soon.  This is another position that is in wait-and-see mode.  My long term forecast is not very specific, and includes a little bit of everything.  A little bit of revenue growth from their main customers, Navistar and PACCAR, plus other heavy truck manufacturers, as well as some diversification outside of that industry.  They have signaled that they are gearing up for a significant new customer, and that revenues in the last half of the year will be back to record levels.  This should trigger some margin expansion.  And, further, their continued growth and slow diversification should help create some multiple expansion.  This isn't going to be a 10 bagger, but I think we can reasonably expect a price at least in the high teens within the next couple of years, from the current price below $10.

What I'm looking for in the earnings report, specifically with this quarter:
Guidance on revenues for the second half of the year, including new customer programs and expansion with the main customers.

What I always keep an eye on:
The level of CMT sales compared to total revenues for each of their main customers, and the level of sales for other customers.  These can move around with a significant amount of noise, but generally speaking, their sales to NAVISTAR may have declined somewhat over the long term, but have held up well in recent years.  They seem to have a strengthening position with PACCAR, who is the stronger of the two customers.  And, their other revenues took a large hit in the recession, but have been building well, and appear to be poised to continue increasing.

They remained profitable in 2008, even after revenues were cut in half, which says something about either the business model or the quality of management.  Cutting the other way is their dependence on a few large customers.

All in all, I could see them hitting $200 million in revenues and $2 EPS in the next year or two, with some multiple expansion within their norms to a PE of 10, gives us a target around $20.  Unusual gains with new customers could provide extra gains from both earnings and multiple expansion from there.

It's a nice place to park some capital, but it's not a position with shocking upside.

Another sign of trouble (amended)

In hindsight, it should have been clear that there were deflationary and recessionary forces at play as early as 2006.  The Fed was sucking liquidity out of the economy during that period.  With repos and the shadow banking industry, I suspect the economy might have been able to handle that, if there hadn't been a collapse in the collateral that backed shadow banking.

On a lesser scale, this could be happening again.  There are slightly downward trends in both real GDP and inflation, and the Fed is talking about tapering QE.  I'd say our best hope is that recovery continues strongly enough that interest rates rise on their own, with the Fed chasing them up when the time comes.  We might extend the recovery for several years in that scenario.  I'm afraid that the Fed will start tightening before that happens, and kill any nascent inflation, which is what we need in labor markets to counter the recent deflationary period and excessive inflation in non-wage compensation.

On the other hand, again, with the idea that reserves aren't that important any more as a banking constraint, maybe OMO aren't that important, and that limited banking capital is really all that's slowing down growth right now, especially with all the excess reserves in the system.

Maybe this will resolve itself if rates do ever move up, the propensity to hold cash decreases, and Fed assets lead more directly to increased currency, and inflation.

Boy, I'm confused.  In any case, the graph below is not a sign of an effective Fed nor an inflationary Fed.
FRED Graph

Addendum:  Maybe the trend isn't so bad.  Here is a graph of real GDP changes, comparing total GDP to private GDP (this has direct government purchases subtracted out, but still includes the effect of transfers):
FRED Graph

The recent weakness in real GDP looks to be mostly a product of the reduction in federal spending.  That is basically a one-time event that is finished, and the private sector seems to be growing at a somewhat decent rate, considering demographic headwinds.  Maybe we can expect headline nominal and real GDP growth to kick it up a notch in the last half of the year.

Maybe we'll even see an uptick in the JOLTS data that has looked a little stagnant.