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Employment update

The unemployment rate, now 10.2%, is just about as high as it's ever been since the Depression (see top chart). Job losses keep mounting, and so far it's another jobless recovery. In fact, jobs haven't grown at all for about 10 years. It's painful, and it's miserable. It's terribly unfortunate that the Obama administration dumped so much "stimulus" money down a black hole earlier this year, when cuts in marginal tax rates could have unleashed the power of the private sector instead of redistributing a trillion dollars from the haves to the have-nots. 

But things could be a lot worse, as the second chart shows. That's the so-called "Misery Index" that was invented in the late 1970s to capture the dual problem back then of very high unemployment and very high inflation. Today we're fortunate that inflation is still relatively low. We worry that inflation might rise in the future, but for now that remains tomorrow's problem.

Most of the changes on the margin that I see are quite positive. Despite the lack of jobs, it is still the case that the pace of job losses is slowing. We're well past the worst part of the recession and in the early stages of a recovery. Financial markets have undergone tremendous healing. The private sector has already reorganized itself to become extremely productive: the productivity of the workforce surged at an 8.1% annual pace in the six months ended September, and productivity is likely still improving. Businesses are becoming more profitable. There is plenty of cash out there. Confidence is returning. The velocity of money is picking up. Global economic activity is rebounding. It is only a matter of time before we see net job gains. It still pays to be optimistic, but one needs to be patient. 

TIPS valuation update

This comes in response to a reader's question. TIPS are a bit of a challenge to value, since they have several potentially valuable characteristics: 1) the real yield paid to the investor, 2) the future inflation adjustment paid to the investor, and 3) the change in the market price that may occur (which is determined by the change in the real yield). This chart focuses on the first characteristic, the real yield to maturity of 10-year TIPS, which is a decent proxy for where the TIPS market happens to be. (Right now, short-maturity real yields are about 1%, while long-maturity yields are 2.4%.)

The colored valuation bands on this chart are my creation. I think that on the basis of their current real yield, TIPS are not undervalued, and are actually a bit overvalued.

To step back for a minute, it is important to note that TIPS offer the only real yield that is guaranteed by the U.S. government; it is the coupon paid on TIPS whose face value is adjusted daily (prorata) for changes in the CPI two months earlier. No other security promises a guaranteed return above the rate of inflation. As such, the real yield on TIPS is extremely unlikely to rise beyond the 4-5% level, whereas the nominal yield on Treasuries can theoretically rise without limit. Why? Because the world's investors could not possibly turn down the opportunity to make a 5% guaranteed real yield for 10 years—no asset class could compete with that. Real yields could conceivably fall below zero, however, but I think that would only happen in a scenario in which inflation rose dramatically (into double digit levels) and demand for TIPS proved to be extremely strong. At that point an investor would effectively be giving up some of his inflation adjustment for the privilege of being protected against raging inflation.

As for the second characteristic, TIPS look to me to be cheap relative to Treasuries. That's because the difference between the yield on TIPS and Treasuries of similar maturity (which equates to the market's expectation of future inflation) is only a bit over 2%. The market expects the CPI to average about 2.1% over the next 10 years, whereas it averaged about 2.5% over the past 10 years. I think there's a good chance that inflation will be more than 2.5% on average going forward, so that means that the Treasury market, internally, is undervaluing TIPS. This in turn means that you should prefer TIPS to Treasuries.

As for the third characteristic, I think the likelihood of price gains relative to current prices is low. The one significant risk faced by TIPS investors today, in fact, is that their market price is likely to fall when the Fed starts tightening policy, and especially if they tighten policy sooner than expected.

To sum up, I don't think you are going to make a killing by buying TIPS today, unless inflation truly skyrockets. TIPS are best thought of as a guaranteed way to keep money safe from inflation while also earning a modest real yield. If you currently own Treasuries, you might be wise to trade them in for TIPS. If you currently hold cash as a hedge against risk in general, you might be wise to hold TIPS instead.

Weekly claims update

Claims continue to slowly decline. Weekly claims for unemployment have declined by about 23,000 per month, on average, since peaking at the end of March. If progress slows a bit going forward, as it usually does in the first year after the end of a recession, then claims might reach 400,000 per month in about six months. Coming out of the 2001 recession, that was the point at which the unemployment rate began to decline. So politicians could be very nervous for many more months, since we are not likely to see any significant improvement in the unemployment rate until the second quarter of next year at the earliest, if these trends continue.

Yet another V sign

The ISM Service Sector index is yet another of many indicators which suggest the economy is experiencing a V-shaped recovery. Conditions were abysmally bad at the end of last year, but they have rapidly returned to some semblance of normality.

Job losses continue to slowly decline

The ADP employment report suggests that the BLS will announce job losses this Friday that will be somewhat less than they were last month. Maybe not as much of a reduction as the market expects, but the trend in the numbers continues to point in the right direction. The labor market continues to slowly heal. We're still many months away from net job gains, but we'll get there sooner or later.

Meanwhile, though, the unemployment rate is going to remain uncomfortably high, especially for all those politicians who argued so fervently early this year that dumping a trillion dollars of tax rebates, transfer payments, make-work projects and general government largess into the economy over a period of years would guarantee a quick economic turnaround. As the evidence accumulates, we see instead that it would have been far better to just let the economy follow its own course. Better still, we could have used the money in a much more intelligent fashion by making permanent cuts in marginal tax rates that would have quickly resulted in more work and more investment.

Let's hope this ends up being an expensive lesson in how not to stimulate an economy. Voters seem to be getting the message already, to judge by yesterday's election results. Politicians, as usual, will be late to the party.

Corporate layoffs have all but vanished (5)

I've been showing this chart for quite some time, and it was one of the early indicators of significant improvement in the economy. Big corporate layoff announcements are essentially a thing of the past, according to this tally by the folks at Challenger, Gray & Christmas. While that is not the same as a wave of new hiring, it is the first step on the path to a growing economy and an increase in the number of jobs. The good news just keeps coming, but the market remains highly skeptical. Investors continue to climb walls of worry, and that's what a bull market is all about.

TIPS get a whiff of inflation concerns

The TIPS market is finally beginning to understand that inflation is not going to be unusually low forever. As the first chart shows, the breakeven inflation rate on 10-year TIPS has risen to 2.1%, the highest level we have seen just before the Lehman collapse last year. (This same rate averaged about 2.5% during the 2004-2007 period.) As the second chart shows, the five-year, five-year forward breakeven rate (as calculated by Barclays) has risen to 2.6%, which is in fact a little higher than it was during the 2006-2007 period. Inflation expectations have been slowly working their way higher all year, and it shows up in the combination of declining real yields on TIPS, as demand for TIPS's inflation expectation increases, and rising nominal yields, as demand for unprotected bonds declines.

I've argued many times this past year that the bond market is not the best place to go looking for signs of inflation. That's because the bond market is heavily influenced by what the Fed says and does, and the Fed is not always right about the direction of inflation. Bonds (and the Fed) tend to be late to the inflation or deflation party, and that's one way that inflation or deflation feeds on itself.

So while the bond market's inflation expectations have increased substantially this year, it is not really sending any warning signals about inflation, but rather confirming what objective observers have known for some time: 1) deflation is a total no-show, and 2) inflation as we have known it for the past 10 years is still very much alive and well. Early this year the bond market was convinced that deflation was very likely for the next several years. Now, after watching oil prices almost double over the course of this year, gold prices rise from $875 to $1090/oz., and spot commodity prices rise by one third, the bond market has so far only concluded that it was mistaken about deflation. It has yet to figure out that higher inflation is the thing to worry about. That will be the next shoe to drop.

Full disclosure: I am long TIPS and TIP as of this writing.

Thoughts on gold

Gold is in the news today, setting a new all-time high of $1085/oz. as of this writing. The first chart here shows nominal prices, while the second shows gold in constant dollar (real) prices. Either way you look at it, gold has enjoyed a pretty spectacular run since early 2001. At the risk of slighting the obvious geopolitical risks that motivate gold buyers these days, gold has for the most part benefited from years of accommodative monetary policy from almost all of the world's central banks. Easy money helped inflate the housing bubble several years ago by keeping rates artificially low. Easy money works by effectively lowering the hurdle rate for purchasing hard assets. People must always ask themselves this key question before buying gold, commodities, or real estate: "Will gold (or oil, or copper, etc.) prices in the future rise by more than the interest rate on safe assets?" The lower the interest rate, the easier it is to answer in the affirmative.

Easy money thus erodes the demand for money and boosts the demand for hard assets, resulting in rising tangible asset prices. Money loses its value relative to things, and that's what inflation is all about.

Rising gold prices are thus a signal that interest rates are too low and monetary policy too easy. There is more money in the system than the system wants, and that is the fundamental monetarist equation for inflation. That we haven't seen inflation show up in the CPI (well, at least not very much so far) is simply a reflection of the long and variable lags between monetary policy and the real world.

I've always thought that the primary objective of a central bank that chose to adopt interest rate targeting as its method for implementing monetary policy (as all major central banks have done) should be to pick the interest rate that leaves the market indifferent between buying government bonds and tangible assets such as gold and real estate. In practice, this could be described as a type of gold standard: the central bank should simply raise or lower interest rates (by selling or buying government bonds) in order to keep the price of gold within some specified range. Shrinking or expanding the money supply in this fashion would automatically keep the market indifferent between buying financial assets and tangible assets, because it would avoid monetary excesses or deficiencies, and thus deliver an essentially zero rate of inflation. Such a policy would inevitably lead to a very low and stable interest rate environment. And that, according to supply-side tenets, would be the best way for monetary policy to stimulate the economy.

If the Fed were to do this today, what should its target price for gold be? That is a question that has no definitive answer, but I'm going to guess that it should be somewhere in the $400-500/oz. range. As it happens, the real price of gold over the past 100 years has averaged about $450. If $450 is the price of gold that corresponds to "neutral" or zero-inflation monetary policy, then gold today is trading for a premium of over 100%; buying protection against inflation in the gold market is very expensive. Put another way, the Fed is going to have to continue to stand pat, and/or inflation is really going to have to accelerate just to keep gold from falling. If the Fed were to tighten policy sooner than expected, and with vigor, gold prices could tumble dramatically.

I'm not arguing against an investment in gold today, since rising gold prices seem to be the path of least resistance for now, considering that with one single exception (the Australian central bank), the world's major central banks have given every indication that a tightening of monetary policy is unlikely in the near future. My point is that buying gold is a very risky proposition now that it is trading at these lofty levels. In a best-case scenario for gold, we might see it revisiting its 1980 high in today's dollars (about $1800), but in a worst-case scenario it might fall back to $400. That's a very lopsided risk/reward proposition (aka an extremely speculative investment).

What could drive the worst-case scenario? Gold prices are extremely vulnerable to the mere suggestion that the Fed might begin reversing its liquidity injections. Gold prices are also very vulnerable to signs of stronger-than-expected growth, since the market can easily put two and two together and realize that a stronger economy means an earlier and more aggressive monetary tightening.

And while on the subject of vulnerable gold prices, these same arguments hold for T-bond prices. Yields on Treasuries are very low, mainly because the Fed is expected to be very easy for a very long time. Even the slightest change in those expectations could result in a sharp rise in Treasury yields, and a significant decline in T-bond prices.

Car sales are rebounding

Car sales came in higher than expected in October, suggesting that underlying demand was not sapped by the "cash for clunkers" program.

Healthcare reform is doomed

The Tax Foundation has analyzed the Pelosi and Baucus healthcare reform proposals, and finds that they are going to be financed by huge cuts in Medicare and huge taxes on individuals. This is getting to be so ugly that I can't imagine either bill will survive. Thank goodness! Pelosi is going to make healthcare affordable for those who don't currently have it by slashing spending on Medicare for those that do have it? Baucus is going to make healthcare more affordable by imposing a huge tax on those who already have it? Ain't gonna happen. In the interest of public service, I reproduce the essentials:

The $1.05 trillion House health care reform legislation unveiled by Speaker Nancy Pelosi yesterday is financed primarily through net cuts to Medicare (which would save $472.8 billion, or 39 percent of the bill's 10-year cost), and a 5.4 percent surtax on high-income individuals (which would generate $460.5 billion, or 38 percent of the bill's cost), according to the Tax Foundation's review of the Congressional Budget Office's (CBO) analysis.

By comparison, nearly half of the $829 billion Senate Finance Committee plan is financed through Medicare cuts ($377.8 billion, or 41 percent of the bill's 10-year cost), and 22 percent would come from an excise tax on so-called "Cadillac" health insurance plans, which would raise an estimated $201.4 billion over 10 years. The House plan would reduce the deficit by $104 billion and the Senate version by $81 billion.

"There are similarities and major differences between the House and Senate plans: Both rely on Medicare spending cuts, although the House plan would cut nearly $100 billion more, and both plans include one large new tax - a high-income surtax in the House version and a tax on high-value health insurance plans in the Senate version," said Tax Foundation Senior Economist Gerald Prante.
Here are the charts that summarize the financing sources for the two bills:

More good news from the ISM

The employment subindex of the ISM manufacturing survey jumped rather dramatically in October. I see this as comparable to the very strong recovery the economy staged in the second half of 2003. The reading of 53.1 on the survey points to net new jobs in the manufacturing sector. Maybe not a lot of new jobs, but conditions have certainly improved dramatically on the margin in recent months.

Construction spending update

This is old news (latest data released today covered September), but it highlights again the likelihood that residential construction spending has hit bottom. Meanwhile, nonresidential construction continues to be soft. I imagine we'll see this pattern persist for some time, with strength in residential offsetting weak in the nonresidential area. What it will amount to is a huge, multi-year shift in the economy's resources away from nonresidential construction and back to residential construction. The current pace of residential construction is much less than what is required to meet a growing population; sooner or later, the excess inventory of homes—now declining—will collide with growing numbers of households look for homes, and the result will be a significant increase in residential spending.

ISM index a clear V-sign

If this chart does make the case for a V-shaped recovery, then I don't know what does. I have been tracking the relationship between the Institute for Supply Management's Manufacturing Index for more than 10 years, and I have seen it consistently do a great job of forecasting quarterly GDP growth rates. With the October release today, the index is pointing to fourth quarter growth of 4-5%.

Yet I continue to be besieged by negative news and worried investors. Corporations are so worried about the future they are sitting on a trillion dollars of cash, equivalent to about 10% of their assets, according to this morning's Wall St. Journal. Investors are pouring money into bond funds, swelling Bill Gross' Total Return Bond Fund to some $190 billion and making it by far the largest mutual fund. Foreign central banks continue to gobble up Treasury debt by the hundredweight. (And if it weren't the case that the world was desperate for the relative safety of bonds, Treasury would be having a much tougher time financing Washington's trillion-dollar deficits.)

Once again I'll say that the Fed's purchases of Treasury bonds and mortgage-backed securities are not the dominant feature on the bond market landscape. Historically low yields and huge money market funds paying almost nothing are a sign that the world's investors are highly skeptical of just about everything these days. (And of course gold trading at $1060/oz. is just more evidence of the market's fears.) It cannot be the case that the stock market is another bubble in the making when bond yields are so low; it makes a lot more sense to assume that the stock market is about as cheap as the Treasury bond market is rich.

Purely anecdotal—but impressive nonetheless

Recessions are painful, but they also are harbingers of better things to come. A recession happens when an economy is suddenly forced to change the way it operates—for example, to shift resources from overbuilt or overextended sectors to sectors that had been neglected. Recessions force changes in relative prices, so that unproductive resources can become productive again, and they force people to figure out new and more creative ways to do things to do in order to survive. Hardship is painful, but it can be beneficial.

Here's what the co-owner of a large design/construction firm in the Pomona Valley specializing in home remodeling told me the other day (he's also the one who told me a month ago that he had just re-hired two architects that he laid off last year), in response to my sending him the above chart which suggests that the third quarter uptick in residential construction activity has probably ended the deepest recession ever to hit the industry:

No wonder I've felt a bit nauseous and dizzy the last 18 months. But as we discussed, I've been asking around and everyone I talk to says that they have had a huge uptick in work flowing in - from my roofer today to other remodeling companies all over the country. My friend in Columbus MO said he had the best sales month ever this last month. I'm sure hoping this is a solid leading indicator!

Friday night my wife and I went to a late dinner at a nice local restaurant. I was surprised to see that the menu now has a special "Light Meals" option available from 5 pm to 6 pm, and from 9 pm to 10:30 pm. For $20 you get a choice of appetizer and a choice from 10 main courses, served in smaller-than-normal portion sizes. At 9:30 pm the restaurant was almost full, something we haven't seen for a long time, and the waiter was simply delighted. This solves several problems for us: not wanting to eat large portions at night, not wanting to share main courses, not wanting to spend extravagantly for a last-minute decision to go out for a bite to eat, and not wanting to go to a restaurant after 9 pm because they are emptying out. It also brings more business to the restaurant, allowing it to remain busy for more hours every day.

I imagine there are all sorts of anecdotes such as these happening around the country, in many lines of business. All this activity—change, if you will—is going on behind the scenes, and it is making the economy more productive. And it is all happening without any help from government stimulus programs. Indeed, I continue to believe that the economic recovery will proceed in spite of government stimulus programs.