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Household balance sheet update


The Federal Reserve today released its Flow of Funds report for Q3/11, and this chart extracts the relevant data for the status of households' balance sheet. Net worth fell about $2.5 trillion in the third quarter, mainly due to the 14% decline in the stock market during that period (the third quarter ended one day before stocks hit their Oct. 4th low for the year). Real estate values increased marginally, and debt declined marginally during the quarter.

I think it's important to note that households have rebuilt their net worth to almost what it was in 2005, just prior to the great housing market collapse. Given the rebound in equities to date, household net worth today is likely very close to its 2005 levels. In other words, despite the massive destruction of home equity values and the meager 2% average annual return on the S&P 500 since the end of 2005, households have managed to regain their financial footing mainly by boosting savings. We would all like to be richer, and millions would still love to again find they have positive equity in their homes, but we are making progress.

Inventories continue to rise


Wholesale inventories in October rose much more than expected. With the help of this chart, which shows the level of inventories with a logarithmic scale, we can see that inventories are slowly getting back to their long-term trend. This is yet one more of the many indicators that the recovery is still proceeding despite all the headwinds. On the margin, things are improving, even though the degree of improvement is disappointing.

Markets, however, are priced to the expectation that things will begin deteriorating soon, and probably in a serious way. For markets to rally, all we need is to avoid a big deterioration. A continuation of meager, 3% growth should be enough to push equity prices higher, because that would be a far better outcome than what is currently expected.

Best argument for limited government

Jon Corzine's testimony regarding the disappearance of many hundreds of millions of his customers' money: "I simply do not know where the money is, or why the accounts have not been reconciled to date."

As Kevin Williamson notes:

Why should we believe that the motives of people in (cough, cough) “public service” are different from the motives of people in the for-profit sector? Was Jon Corzine a rapacious self-seeker at Goldman Sachs, then a public-spirited man when he was in the Senate and in New Jersey’s governorship, only to revert to form when he went to MF Global? If you doubt that this is true, and suspect that Jon Corzine was the same guy all along, why would you want to give government more power? 

Credit spread update


This chart compares the spread on 5-yr, A1-rated industrial bonds with 5-yr swap spreads. Swap spreads have risen a bit from their lows earlier this year, but are not particularly high, which suggests that U.S. financial markets are only mildly stressed and that the level of systemic risk in the U.S. economy is fairly low. Industrial spreads, however, have risen by a greater degree, and are now at the same levels that we saw going into the 2008 recession. Are credit spreads thus foreshadowing another, and perhaps imminent, recession? I think the message here is too mixed to be conclusive. At the very least, swap spreads would need to be a lot higher than they are today to worry about an imminent recession. But can we safely ignore the message of credit spreads?


I would argue that this chart says the answer to that question is "yes." The chart compares the yield on 5-yr A1 industrial bonds with the yield on 5-yr Treasuries (the baseline against which A1 and swaps are measured in the top chart). Credit spreads are typically thought of as the extra yield that investors demand to compensate for the perceived risk of default. So spreads are a good proxy for default risk. But sometimes spreads can exaggerate default risk, and I think now is one of those times. As this second chart shows, the main reason that credit spreads have increased this year is that Treasury yields have plunged to exceptionally low levels. Credit yields are at their lowest level ever, which means that A1-rated industrial companies now enjoy the lowest borrowing costs of all time. A1 industrial yields today are fully 300 bps lower than they were at the onset of the 2008 recession. That's not exactly the same as saying the bond market is fearful of lending to these companies. In fact, if all you knew was the level of corporate bond yields, you would conclude that the bond market was highly infatuated with industrial bonds.

What is distorting the message of spreads is the exceptionally low level of Treasury yields. Those yields, in turn, are likely being artificially depressed by the world's intense desire for safe-haven assets in a time of great sovereign debt uncertainty in the Eurozone. The creditworthiness of U.S. firms is not the issue. The financial fundamentals of the U.S. economy are not reflecting any significant deterioration at this point.

Claims point to a U.S./Eurozone decoupling


Seasonally adjusted claims for unemployment fell to 381K, their lowest level (with the exception of one week last February, which we now know was purely the result of a seasonal adjustment problem) since July '08. Actual claims, however, rose by 151K to 524K. This is the time of the year when companies begin laying off people that were hired earlier in order to meet the demands of the holiday season. So today's news tells us that actual claims rose by less than is usual around this time of the year. We may see a repeat of this in coming weeks, since actual claims will almost certainly rise by much more going into the first week of January, but maybe not by as much as the seasonal factors expect. Firms may well continue to fire fewer people than usual, because they have already pared staffing to the bone, and that is one reason why corporate profits have been so strong.

In any event, the continued decline in the level of adjusted claims is a legitimate indicator that the economy is on a more solid footing. The labor market fundamentals continue to slowly improve, and that is consistent with a lot of other indicators which point to ongoing economic growth of about 3% or so.

Markets, however, are still very fearful that growth fundamentals are on the verge of deteriorating. Eurozone sovereign defaults are widely thought to be the likely catalyst for a sudden and sharp deterioration in global economic activity, and markets fear that it will be very difficult for the U.S. economy to avoid contagion. No one can say for sure that the U.S. can avoid contagion, but so far the U.S. economy appears to be decoupling from Europe, as Europe slumps but conditions here continue to improve.

Malkiel disses Treasuries, and he's right

Burton Malkiel, author of the classic (and frequently updated and highly recommended) A Random Walk Down Wall Street, and long-time proponent of portfolio diversification and the virtues of passive vs. active investing, has decided that enough is enough: government bonds stink. In his op-ed in today's WSJ, "The Bond Buyer's Dilemma," Malkiel takes the courageous step of urging investors to un-diversify their portfolios and actively eschew government bonds. And he is right.


I highly recommend his article, and I offer here some charts, thoughts, and additional recommendations to help flesh out his larger points. As the above chart shows, 10-yr Treasury yields today are as low as they have ever been. Malkiel argues that interest rates on government bonds are being artificially depressed by policymakers in an effort to "inflate away" the real and growing burden of debt. While that may be true at least in part, I prefer to think that yields are extremely low because investors are extremely fearful of the future and are willing to pay an exorbitant price for default-free, interest-bearing assets such as Treasuries, TIPS, German Bunds, and Japanese government bonds. Whatever the drivers of extremely low government bond yields, it is true, as he says, that:

Artificially low interest rates are a subtle form of debt restructuring and represent a kind of invisible taxation. Today, the 10-year U.S. Treasury bond yields 2%, which is below the current 3.5% headline (Consumer Price Index) rate of inflation. Even if inflation over the next decade averages 2%, which is the Federal Reserve's informal target, investors will find that they will have earned a zero real rate of return. If inflation accelerates, the rate of return will be negative.


Actually, the negative real rates of return are already with us. As the above shows, real interest rates on 10-yr Treasuries have been declining for the past 10 years and are now distinctly negative. If and when Treasury yields rise, real returns could not only be very low or negative, as they were in the rising inflation 1970s, but bondholders would also suffer from sharply declining bond prices as interest rates inevitably rise, thus suffering miserable total returns for years to come.


Malkiel recommends that investors who want a better alternative to the safety and income of government bonds should look to other bonds with "moderate credit risk where the spreads over U.S. Treasury yields are generous." He suggests municipal bonds, and I would add that lower-quality corporate bonds with generous yield spreads are also very attractive. As the chart above shows, the yield on high-yield (junk) bonds is almost 9%. That's a huge spread to Treasuries, and it signifies that investors perceive that many of these bonds are highly likely to suffer defaults in the years to come. But if you are even the slightest bit optimistic about the ability of the U.S. and most global economies to avoid a calamity, and if you are worried that super-accommodative monetary policies from most major central banks are going to push inflation higher in the years to come, then high-yield corporate bonds should do pretty well. Actual defaults are likely to be lower than expected if we avoid another economic calamity, and rising inflation will improve the cash flow of almost all corporate borrowers, which in turn would also work to reduce default risk. My chart compares the yield on high-yield bonds to 2-yr swap spreads, in order to show that the current level of systemic risk in the U.S. economy is relatively low, and that the yield on junk bonds is priced accordingly.


Malkiel likes the bonds of some countries, like Australia, where fiscal policy is a lot more conservative than ours (i.e., fiscal deficits are much lower) and interest rates are substantially higher. I would caution, however, that while his reasoning is sound, buying Australian government bonds is not a clear-cut, obvious strategy. As the chart above shows, the Aussie dollar is currently about as strong relative to the U.S. dollar as it has ever been (i.e., the gap between the current value of the currency and its purchasing power parity is huge, reflecting what might be called an "overvaluation" of the Aussie dollar). In other words, investors are well aware of Malkiel's arguments, and have already bid up the price of the Australian currency to reflect the much more optimistic outlook to be found there these days. If the outlook for the U.S. were to improve relative to the outlook for Australian, the Aussie dollar could suffer a significant decline in the years to come, thus wiping out most or all of the current interest rate advantage offered by Australian bonds. Hedging the currency risk is not a complete fix for this problem either, since current hedging costs run on the order of 4% per year.

Malkiel also likes "blue-chip stocks with generous dividends" as a better alternative, and I would agree. Not only are the dividend yields on many stocks competitive with government bond yields, but the earnings yield on the entire S&P 500 is much better than the yield on junk bonds, as my chart below illustrates.


This is a highly unusual state of affairs, since this chart shows that investors are willing to give up about one-third of the earnings yield on large-cap stocks (currently 7.5%), and forego any future price appreciation, in order to enjoy a privileged position in the capital structure and receive a yield of 5.3% or less on BBB corporate bonds. This only makes sense if investors are scared witless by the potential for a global economic and financial market meltdown.

What this all boils down to, of course, is that the major asset classes are priced to really awful expectations for the future. Government bonds with no default risk are priced at incredibly high levels, while just about everything else is priced to the expectation that the sky is going to be falling, and soon. If you agree with the doomsayers, then it makes sense to ignore Malkiel's advice. And who knows, perhaps the doomsayers will be right this time. But if you have even a shred of optimism; if you think that the U.S. economy is likely to continue to grow at least modestly while the Eurozone struggles and maybe suffers from PIIGS defaults; then the opportunities to be found outside of government bonds are fantastic. Faced with pricing that reflects the expectation of something like the-end-of-the-world-as-we-know-it, I'm an optimist. Even though I am fully aware of all the headwinds still confronting the U.S. economy.

Housing fundamentals are starting to improve



The top chart shows the rate on 30-yr fixed conforming and fixed-rate mortgages, and the bottom chart is an index of new mortgage applications. Mortgage rates have been at all-time lows for the past several months, and new applications for mortgages have jumped 30% since last August. It's looking like the appeal of cheap financing and the unprecedented affordability of housing prices have finally gotten the attention of consumers. Demand for home purchases is finally responding to favorable prices. Or, to put it another way, prices and financing costs have finally fallen by enough to stimulate demand. The recent upturn in new mortgage applications may prove to be the signal that the housing market has finally hit bottom and is beginning to pick up. Very encouraging.


This chart shows the housing affordability index published by the National Assoc. of Realtors. It is saying that a median family income is now almost double what is needed to purchase a median-priced home using conventional financing. Homes are more affordable than ever before.


This chart shows the S&P Homebuilders ETF, which is behaving in a manner consistent with the housing market having seen the worst, and the beginnings of improvement, albeit still modest. Homebuilders' stocks are down almost 70% from their 2005 high, and new housing starts are down by a similar amount. If the outlook for housing is indeed beginning to improve, homebuilders' stocks could have some tremendous upside potential in the years to come.

Good news: income tax receipts are booming


This chart shows the 12-mo. rolling sum of federal revenues: total revenues in blue, and individual income tax receipts in red. A very remarkable thing has occurred over the 12 months ending last October: individual income tax receipts have increased by almost 22%, far outstripping the 7% increase in total federal revenues over the same period. If income tax receipts are booming, then it's a safe bet that incomes are booming as well. Although we have seen only modest jobs growth over the past year (130K per month on average, with a yearly gain in total jobs of only 1.2%), incomes are rising much faster. This helps explain why retail sales growth has been robust, and personal consumption expenditures have climbed almost 5% in the past year. It's not that consumers are over-spending, it's that consumers are in much better financial shape than the broader economic statistics suggest. Incomes are rising much faster than jobs, a fact that has somehow remained under the radar and under-appreciated. This is a very healthy development, to say the least. I note, furthermore, that income tax receipts are very real and not likely to be overstated.

TIPS update


TIPS are Treasury bonds whose principal is adjusted for consumer price inflation; buy $1000 worth of TIPS and their face value will appreciate in line with the rise in the CPI. TIPS have a coupon which is paid on the inflation-adjusted principal, so the coupon functions as a real yield. The owner of TIPS receives a total return that is equal to the rise in inflation plus the real yield. Like all bonds, TIPS prices vary inversely with their real yield. So today's 0% real yield on 10-yr TIPS means that the price of TIPS has reached an all-time high; in absolute terms, TIPS have never been more expensive. (The colored zones in the chart above are my way of appreciating the "value" inherent in TIPS' real yield.)


Another way of assessing the value of TIPS is to compare them to regular Treasury bonds
of similar maturity. The difference between the nominal yield on Treasuries and the real yield on TIPS is the "break-even" or expected rate of inflation over the life of the bonds. Today, the expected annual inflation that is priced into 10-yr TIPS and 10-yr Treasuries is 2.1%, which is just a shade better than the average that has prevailed since TIPS were first issued in 1997, and a little below the 2.4% average annual rate of consumer price inflation since 1997. So relative to Treasuries, TIPS are about "average:" neither expensive nor cheap, because they are priced to an expectation that inflation in the future will be about the same as it has been in the past.

In sum, if you buy TIPS today, you are paying a very high price (i.e., you are receiving a very low real yield) in exchange for the expectation of receiving an inflation adjustment that is in line with historical experience. The main reason TIPS are so expensive is not that investors are willing to pay an exorbitant price for inflation protection; rather, it is that Treasury yields in general are extremely low because investors are extraordinarily risk-averse (i.e., willing to pay an exorbitant price for protection against default) and have very low expectations for future economic growth.

So what does this mean? How would TIPS perform if inflation turns out to be higher or lower than the market currently expects?

If inflation turns out to be higher than expected—say, 5% per year—then 10-yr TIPS would deliver a 5% annual coupon return (zero real yield plus 5% CPI). That would handily beat the 2.1% annual coupon on 10-yr Treasuries. But what would happen to yields if inflation proved to be significantly higher than is currently expected? Undoubtedly, Treasury (nominal) yields would rise significantly, and the difference between Treasury and TIPS yields would also rise, because future inflation expectations would very likely rise. About the best that TIPS investors could hope for in this scenario would be for TIPS real yields to remain at or close to zero, while Treasury yields rose, perhaps by as much as 500 bps. It's more likely, however, that in a rising inflation environment all yields, both real and nominal, would rise, with nominal yields rising by much more than real yields. That's because higher inflation would eventually force the Fed to raise rates in both nominal and real terms, and that would push up real and nominal rates higher across the board. Of course, rising real yields would cause the price of TIPS to decline, so even though TIPS investors would benefit directly from higher inflation, the price of TIPS would fall by some amount, thereby offsetting, on a mark-to-market basis, some or even a substantial portion of the higher coupon received.

If inflation turns out to be lower than expected—say, 1% per year—then 10-yr TIPS would deliver a 1% annual coupon return (zero real yield plus 1% CPI). That would not be as much as the 2.1% annual coupon on 10-yr Treasuries, which would be disappointing to TIPS investors. The lack of inflation would likely result in the price of TIPS declining, and their real yields increasing, even as Treasury yields held fairly steady. So a very low inflation environment would probably result in lower TIPS prices and a disappointingly low coupon yield—a double negative whammy, so to speak, which might result in zero or negative holding period returns.

So in the best of scenarios for TIPS investors, TIPS are likely to deliver less than whatever the future rate of inflation happens to be. In the worst of scenarios, TIPS are likely to deliver very low or negative returns. TIPS are not likely to produce exciting returns no matter what happens, because TIPS yields have been forced to extremely low levels by the dismal prospects for U.S. economic growth. In short, TIPS, like Treasuries, are extremely expensive and thus not very attractive, even if you think that inflation is going to come in much higher than the market expects. TIPS would likely outperform Treasuries in a rising inflation environment, but not by a whole lot.

About the only reason to get excited about buying TIPS today is if you believe that a) the prospects for real economic growth are dismal at best, b) you are extremely worried about the potential for default risk, and c) you are convinced that inflation is going to rise meaningfully but the Fed is not going to raise rates very much, if at all. I note that one popular TIPS mutual fund (TIP) is very close to its all-time high, and appears to be running out of upside potential.

Full disclosure: At the time of this writing, I hold no TIPS and have only a small exposure to WIW, a TIPS fund that is trading at an 11% discount to net asset value.

The solution for the Eurozone debt crisis is simple

There was some excitement today over the announcement that Merkel and Sarkozy have decided that the European Union treaty needs to be rewritten to include sanctions on countries that exceed the 3% debt/GDP limit that they all agreed to way back when the EU was first established.

The problem with this "solution" is that the mechanism for enforcing sanctions is a deeply flawed concept. The best, and probably the only way to impose real sanctions on governments who spend and borrow too much is to let the market do it. When the yield on your bonds starts to skyrocket, you quickly realize that you can't continue to borrow. You either mend your ways and borrow less, and/or figure out how to grow more, or you default on your debt obligations. And even if you default, you will find it very difficult—if not impossible—to continue to be profligate. That's the way it has always worked in the bond market. It's quite simple: if lenders don't think you can repay your debts, they won't lend you any more money.

A market-based solution doesn't need any agreements or rewritten treaties. It also has the virtue of essentially eliminating moral hazard, since lenders would have a powerful incentive to do their due diligence every time they buy a bond, instead of simply relying on what ratings agencies are saying, or betting that they will be bailed out by taxpayers or other countries if things turn sour. A true market-based solution would even make the ratings agencies obsolete. No serious investor would ever base his decisions on what a ratings agency says anyway; the only purpose that ratings serve in today's world is to facilitate the ability of bureaucrats and technocrats to decide, for example, which assets qualify as Tier 1 capital for banks, effectively overriding the investment decisions of the private sector and thus providing fertile ground for moral hazard.

The only reason that no one is talking about a simple, proven, market-based approach to solving the Eurozone sovereign debt problem is that politicians (urged on no doubt by their investment banking constituents) fear that highly indebted Eurozone countries are more likely to default (i.e., to act irresponsibly) than they are to cut spending, and that this, in turn, puts Eurozone banks (who hold tons of Eurozone sovereign debt) at risk, and that this, in turn, puts the very viability of the Euro and the Eurozone economies at risk. Politicians love to think this way, because it makes them indispensable. The truth, however, is that when politicians step into the fray to fix things, they almost always make the situation worse.

Eurozone countries may indeed default, and defaults may be large enough to bring down the Eurozone banking system, but a collapse of the Eurozone economies is not necessarily the only way this can play out. Defaults happen all the time. Banks fail all the time. Defaults don't destroy currencies, they just destroy the value of debt issued in that currency. Defaults don't destroy wealth, since they are just the accountant's way of recognizing economic realities. Defaults don't destroy demand either, since debt is a zero-sum game: one man's liability is another man's asset. The value of global financial assets fluctuates by trillions of dollars every day and yet economic life goes on. There is a virtually unlimited supply of capital in the world ready to fund profitable new ventures and/or to recapitalize failed banks. Truth be told, the market has already wiped out almost 80% of the market cap of Eurozone financial institutions in the past four years, yet the Eurozone economies continue to function as always.

Will the politicians please stop trying to "fix" this Eurozone debt problem? A trillion or two of defaults might end up doing us all a world of good.

Service sector report unimpressive


The November ISM service sector report was lackluster. It paints a picture of an economy that is just muddling along. There are sectors of the economy that are doing much better, however, which are not reflected in this report: mining and technology, for example. But overall the economy is growing only modestly faster than the growth of population. 


Despite lackluster growth in the service sector, and despite the economy's huge supply of unused physical and human resource capacity, more businesses report paying higher prices than report paying lower prices. This has been a persistent theme for well over a year now, and I believe it is a testament to a) the fact that monetary policy is accommodative, and b) the Phillips Curve theory of inflation is fundamentally flawed. If anything, this tells us that the risk of a monetary policy error (e.g., the Fed not having eased enough to promote a recovery) is very small at this point.


A few months ago this chart was upbeat, but now it is not. It might be reflecting the onset of a double-dip recession, but I think we would need to see meaningful deterioration in a variety of other indicators before getting worried. Consider all the positives that are still extant: weekly unemployment claims are still declining, private sector jobs are still growing, manufacturing and capital indicators are still positive, the yield curve is still steep, auto sales are strong, commodity prices are still quite elevated, industrial production is still expanding, capital spending is still strong, and corporate profits are very strong. Plus, there are increasing signs that the Eurozone is not going to give up without a fight: Italian 2-yr yields are down over 200 bps in the last 10 days, hitting 5.6% today; that's still quite elevated from an historical perspective, but it is meaningfully below the 7% level which many consider to be critical.