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Mutual fund flows show investors are still very bearish

As the equity market moves higher, to new post-recession ground, many argue that investors are becoming too bullish, and this exposes the market to lots of downside risk should the economy stumble again. I've seen surveys that say bullish sentiment is relatively high, but surveys are one thing, and real money moving around is another. So I put together these charts, which compare the net monthly flows into and out of equity and bond mutual funds with the level of the S&P 500 index. The data on fund flows comes from ICI.

As should be quite obvious, retail investors haven't added more than a few drops to equity mutual funds for the past 5 years. Maybe $40-50 billion here and there, but that's nothing; since the beginning of 2007, investors have withdrawn a total of more than $470 billion from domestic equity funds. Withdrawals have been huge and relatively steady until last month, when net flows were close to zero. If retail investors were really turning bullish, we should have seen big inflows in the past several months, but we haven't seen any. To be sure, retail investors are typically slow to react to changing conditions. But all that means is that retail investors have yet to believe that stocks are worth buying. The upside in the equity market has all come from a change in the relative attractiveness of stocks; the economy has done better than expected, so those who still hold stocks have become reluctant to sell. And as we know, volume in this rally has been very light.

As for bond funds, inflows have been gigantic, totaling over $840 billion, and they are continuing, even though bond yields are close to generational and historic lows. But of course that's why yields are so low: investors are terrified of taking on equity risk, and are willing to accept extremely low yields in exchange for a modicum of security. The big flows in the markets are being driven by fear, not by greed.

Adding it all up, I would say that we are a long way from seeing over-priced equities. Let's wait to see many months or even a few years of inflows to equity funds before concluding that the guy on the street is too bullish.

Equities are still cheap

With February data now available, I've updated these charts covering equity valuation. As the first chart shows, the 12-month trailing PE ratio for the S&P 500 is still meaningfully below its long term average. This is remarkable, since a) Treasury yields are very close to all-time lows, so equity multiples should, all other things being equal, tend to be near all-time highs, and b) corporate profits according to the NIPA are at all-time nominal highs and all-time highs relative to GDP. This all points strongly to equities being underpriced and therefore quite attractive, provided one is reasonably optimistic about the future.

The second chart compares the earnings yield on equities to the yield on BAA corporate bonds. It is rare for the equity earnings yield to be greater than corporate bond yields, since this reflects a very pessimistic assumption on the market's part. You would only pass up a 7% earnings yield on stocks in favor of a 5% yield on corporate bonds if you thought that the outlook for earnings was dismal, and you therefore wanted to lock in a 5% yield with first claim on those earnings.

Looked at another way, corporate profits, according to NIPA data, have increased over 150% since 1999, but the S&P 500 index is essentially unchanged. Message: nobody trusts these profits to last; at the very least the market is priced to a huge mean-reversion in profits. So if profits just stay flat and/or fail to collapse, the equity market is going to have to rise considerably. As it is, S&P 500 profits are up 14.7% year over year, and up at an almost 20% annual rate in the past three months. This market is still very pessimistic. If you hold any hope for the future, equities are still very cheap.

Full disclosure: I am long the equity market at the time of this writing.

Auto sales on a tear

This chart uses preliminary data from Automotive News (HT: reader Unknown) for February auto sales, which have posted a very impressive 13% increase year over year. From the depths of the recession in 2009, sales have surged by over 60%. That is a very impressive recovery, and augurs well for continued signs of recovery—however modest—in the months ahead.

UPDATE: The official figures from Commerce put February auto sales at 15.03 million. That represents a 12.3 year over year increase. Domestic vehicle sales rose 14.5% year over year. I've corrected the chart from the original post. The recovery is still very impressive; gains like this are almost certain to "trickle down" into a variety of different industries in the months to come as production schedules are ramped up.

Construction spending is firming

The evidence of a bottom in construction spending continues to build. At the very least you can look at this chart and see that spending has been flat for two years or more. And it's not hard to discern the makings of a modest upturn. In any event, construction spending, having hit an all-time low of 2.2% of GDP in Q3/11, is now quite unlikely to subtract from GDP going forward. More likely, it will continue making a modest contribution.

P.S. I'm taking a breather from skiing today. A little sore from a fall yesterday, plus it's snowing and the visibility is poor.

Equities respond to improving fundamentals

The improvement in weekly unemployment claims has been dramatic. Businesses have done most of the cost-cutting that they needed to. The next shoe to drop will be a pickup in hiring, which at this point seems inevitable.

The equity market has responded to the improving fundamentals in the jobs market. The market is being driven by improvement in the fundamentals, not by unwarranted or excessive optimism. This has the makings of an enduring rally, or one that might be termed "a slow melt-up."

The seven fatal flaws of ObamaCare

In a series of posts in the past few years in which I discussed the growing list of fatal flaws in healthcare reform, I opined that "the defects of this legislation are so massive and pervasive that it will never see the light of day." Arguably, that's still true today, especially as we can now add one more fatal flaw to the list, thanks to an amicus brief recently filed by the Institute for Justice: 

The individual mandate violates a cardinal rule of contract law—to be enforceable, all agreements must be voluntary ... the principle of mutual assent, under which both parties must consent for a contract to be valid, is a fundamental principle of contract law that was well understood during the Founding era and is still a cornerstone of contract law today. Indeed, contracts entered under duress have long been held to be invalid. Yet the mandate forces individuals to enter into contracts of insurance that would never be valid under this longstanding principle.

To celebrate the increasing likelihood of ObamaCare's eventual demise, let me recap the fatal flaws as I see them:

Fatal flaw #1: The penalty imposed for not buying a policy is very likely to be less than the cost of insurance for a great many people. This, combined with the requirement that insurance companies may not deny coverage to anyone with a pre-existing condition, means that a large number of people will forgo signing up for a policy, knowing that they a) will save money and b) can always sign up for insurance if they turn out to develop a serious medical condition. Thus, the actual revenues will far way short of projections.

Fatal flaw #2: The government has no ability to enforce the penalty for noncompliance.

Fatal flaw #3: Mandating that people buy a health insurance policy simply because they are alive is arguably unconstitutional. The Supreme Court has already decided to take up this issue and will begin hearing oral arguments this month. I note that a recent USA/Gallup poll shows that an overwhelming 72% of Americans believe that the individual mandate is unconstitutional. The mandate is also a way of hiding the fact that young people will effectively be paying a huge new tax in order to subsidize older people.

Fatal flaw #4: Regulating the price which insurance companies must charge for policies, coupled with a requirement that companies must rebate to their customers the amount by which their loss ratios fall below 90%, effectively turns these companies into government-run enterprises and would likely result in the effective nationalization of the healthcare industry. That is a violation of the Fifth Amendment, and of a Supreme Court requirement "that any firm in a regulated market be allowed to recover a risk-adjusted competitive rate of return on its accumulated capital investment."

Fatal flaw #5: A government-imposed restructuring of the healthcare industry can't possibly improve our healthcare system, and is extremely likely to make it worse. As Don Boudreaux has noted, "Trying to restructure an industry that constitutes one-sixth of the U.S. economy is ... so complicated that it's impossible to accomplish without risking catastrophic failure." No collection of laws or government bureaucrats can achieve anything close to the efficiency that free markets can deliver; the demise of socialism is the most obvious proof of this. Government control of healthcare will inevitably result in higher prices and rationing, leaving everyone worse off. UPDATE: Acknowledging this reality, the CBO in March '12 calculated the cost of ObamaCare to be $1.76 trillion over a decade, almost double the $940 billion forecast when the bill was signed into law.

Fatal flaw #6: In cases wherein companies find that complying with the law would result in large increases in healthcare premiums that would threaten employees' access to a plan, the Dept. of Health and Human Services may grant a waiver to the company. As evidence of the first five fatal flaws accumulates, and as healthcare insurance companies continue to raise premiums to pay for the unintended consequences of government attempting to regulate an entire industry and hundreds of millions of people, more and more companies are likely to apply for waivers. To date, over 1200 companies have been granted waivers. At some point the whole edifice will come crashing down of its own weight. 

Fatal flaw #7: The individual mandate violates centuries of contract law, since in order to be valid, contracts to purchase health insurance must be entered into freely.

I have a more detailed discussion of the first five of these flaws herehereherehere, and here.

Lest I be accused of offering only non-constructive criticism, I refer readers to previous posts about the right way to reform healthcare, herehere, and here.

More signs of gradual improvement in the economy

The slow melt-up in equity prices since early last October has not been a sign of increasing optimism, it's been a sign of decreasing pessimism—brought on by the accumulation of data points which have shown the economy to not be as weak as everyone had feared. The economy has improved a bit in recent months, but it's nothing to get hugely excited about. As the chart above shows, the ISM manufacturing index—which came in weaker than expected but does not point to any significant weakness—is telling us that the economy is probably growing at a 3-4% rate in the current quarter, a little bit faster that the 3% rate of the fourth quarter. I think this observation is very consistent with other news in recent months.

The biggest improvement in the various ISM sub-indices came from the export sector, where the survey now shows substantially better-than-average activity. This is encouraging from two perspectives: for one, it reflects continuing growth in U.S. export activity, which contributes to GDP; and two, it reflects a relatively healthy global economy that is eager for U.S. goods and services, and a healthy global economy in turn provides a good backdrop for ongoing U.S. growth.

The employment index remains unspectacular, pointing to only modest improvement.

Treasury yields have been very gradually drifting higher this year. But even at today's 3.18% yield, 30-yr Treasuries are priced to a very gloomy outlook for U.S. growth. Now, with no indication from Bernanke yesterday that T-notes and T-bonds will receive another round of QE support, there is little to keep yields from rising further. Even if the economy just ekes out 3-4% growth for the rest of this year, that will be a lot more than would be consistent with bond yields at current levels. Higher Treasury yields should be viewed as a sign of a healthier (or not as sick as expected) economy. Three cheers for lower Treasury prices!

U.S. swap spreads are back down to levels that are quite normal, while Eurozone swap spreads are still elevated but showing signs of gradual improvement. Liquidity and confidence are slowly returning to the Eurozone, even though the fundamental problem of too much bloated government spending remains to be resolved. Liquid markets are essential to helping economies adjust to unexpected difficulties, and that process is underway in Europe. Europe is not out of the woods yet, but the risk of a meltdown is declining meaningfully. Once again, this paints a picture of the future turning out to be less awful than expected; markets are "melting up" because the economy is not melting down.

Great day at Telluride

After almost one foot of fresh powder yesterday, today we had a beautiful morning skiing. This shot, taken with my iPhone 4S, was taken at the top of the Plunge lift. Magnificent views all over the mountain:

Federal debt burden by president

While relaxing after several hard days of skiing in Telluride, my brother Dick suggested a change to the chart I featured in a post earlier this month. I liked his suggestion, which was to add color to the bars in order to distinguish between periods of rising (red) and falling (green) debt burdens. And I like the chart even more now—though it has been highly controversial, generating more positive and negative comments than almost any post I can remember. Since this is a very important issue, I think it bears repeating. What follows is adapted from the original post, with additions meant to clarify some of the issues that came up in the comments.

The chart above addresses the issue of how much federal debt was accumulated during past presidencies. There are many ways of calculating this, and it is of course difficult to lay the blame on any president for increasing the national debt, since only Congress can spend money. But the president sets the tone of the national debate, and like any chief executive, he must bear the ultimate responsibility for what happens during his watch.

I think there is only one correct way to calculate the burden of our national debt, and that is to compare the debt owed to our national income (GDP). The nominal size of our economy is a critical variable, since it is one thing to owe a million dollars if your income is 10 million, and it is quite another to owe a million dollars if your income is only one million. Using this method, if GDP grows by a nominal 10% and our debt grows by the same amount, then there has been no net increase in the debt burden. Some might argue that the average interest cost of the outstanding debt should be factored in, since it is one thing to owe a trillion dollars when interest rates are 1%, and quite another to owe a trillion dollars if interest rates are 10%. But interest rates tend to track inflation over time, so while higher interest rates increase debt service costs, they don't necessarily increase the overall burden of the debt, since the economy tends to grow by at least the rate of inflation over time. Debt service costs are quite low right now because interest rates are exceptionally low, but this could change dramatically once the Federal Reserve starts raising short-term interest rates, and if inflation starts to pick up. On average, and over time, the effect of inflation tends to cancel out the effect of interest rate costs.

Each bar in the chart above represents the Federal debt burden at the beginning and end of each presidency. In his first four years of office, Obama will have added considerably more to our federal debt burden that any post-war president. (The Federal debt burden reached an all-time high of more than 100% of GDP at the height of WW II, then declined steadily through the early 1970s.)

Furthermore, I note that Obama's contribution to our debt burden during his first term is likely to be about 25% of GDP, while the next biggest post-war contribution came during two terms of Bush II (15.3%). If Obama wins a second term and the economy and fiscal policies evolve along the lines currently projected by OMB, Obama could end up adding more to our debt burden that all past presidents combined. I don't think there is any way to escape the conclusion that fiscal policy under Obama has been conducted in reckless and unprecedented (with the exception of WW II) fashion, especially since all that deficit spending has done practically nothing to improve the economy—indeed, as I have been arguing for the past three years, "stimulus" spending has only weakened the economy, since it has consisted mainly of transfer payments which create perverse incentives.


For Federal debt I use the amount of debt held by the public, not total debt (which includes debt the federal government owes to itself, e.g., to social security). If I included all debt, then the current debt burden would be more than 100% of GDP. I think it's reasonable and conservative to use debt held by the public, since debt that the government owes itself is not necessarily an inescapable obligation; social security benefits are not cast in stone, and they are not an individual's property, whereas Treasury debt held by an individual is sacrosanct. Social security obligations can change at the whim of politicians (e.g., by raising the retirement age), and the tweaking of benefit formulas—for example, adjusting future payments by the rate of inflation instead of by the rate of wage inflation (which includes a real and an inflation component) would cause the future liabilities of social security to decline dramatically. 

For the amount of debt incurred during each presidency, I have compared federal debt outstanding to nominal GDP at the end of each calendar quarter immediately following a president's assumption of office. Thus, Bush II starts in Mar. '01 and ends in Mar. '09. For one, this allows me to use GDP data which is only available on a quarterly basis. I also think it makes sense to give a new president a month or two to get his feet on the ground, and to credit outgoing presidents with the policies they set in motion before they left. I recognize that a new president may find it difficult to immediately and significantly change the policies he inherits, but he has at least four years to get things right. In this regard, I note that there have been several sizable reversals in the chart above (e.g., Clinton inherited a rising debt burden but managed to reverse that in significant fashion, while Bush II did just the opposite).

In order to project the federal debt burden as of Mar. '13, I assume that the federal deficit in the 15 months prior will be an annualized $1.2 trillion, and that nominal GDP will grow by an annualized 5%. I believe these are conservative assumptions for the purpose of this analysis, since the OMB is projecting a higher deficit and there are many analysts projecting slower GDP growth. A bigger deficit and slower GDP growth would result in a larger increase in the debt burden than shown here.

US equities trounce Eurozone equities

The top chart compares the level of the S&P 500 to the level of its Eurozone counterpart, the Euro Stoxx index, while the bottom chart shows the ratio of the two. U.S. equities have massively outperformed Eurozone equities over the past five years—by over 60%. This could be likened to the price that the Eurozone is paying for its debt-financed bloated government spending.

Housing prices were still weak late last year

By these two measures, housing prices were still weakening in the fourth quarter of last year (these indicators lag reality by at least several months). In real terms, the Case Shiller home price index is down 40% from its early 2006 high. This has been a really ugly housing market, no question. But that's what happens when the government goes all out to promote home ownership—subsidizing mortgage interest, directing Fannie and Freddie to buy mortgages made to people who couldn't afford traditional financing—and the Fed keeps real interest rates very low for years: prices rise to unaffordable heights, too many homes get built. Prices and new construction have to fall in order to clear the market.

Are they getting ready to plunge to new, disastrous lows, or are we close to a bottom in real estate? I've been thinking we're close enough to a bottom that it makes more sense to look ahead to improvement than to worry about further declines, and I continue to feel that way.

Weak January capex probably not a real problem

January capital goods orders were quite weak, weaker than weak expectations. The first month of every quarter is always weak, and this one was no exception. January '11 orders actually fell a bit more than they did this year. On a year over year basis, orders are up 5.9%, but over the past six months they are up only 1.3%. Is this a sign of an economy about to enter a recession? It could be, but a) it's too early to tell, and b) it doesn't jibe with so many other indicators of strength (e.g., a pickup in jobs growth, falling unemployment claims, strong car sales, strong corporate profits, an upturn in residential construction, good ISM service and manufacturing reports, an upturn in commodity prices). The January weakness was predicted by many analysts on the basis of the expiration at the end of last year of a tax incentive allowing full depreciation of equipment purchases, so that needs to be factored in as well.

While noting the recent—and largely explainable—weakness in business investment, the unusual strength in this indicator in recent years is still very impressive, so I'm willing to refrain from drawing any meaningful conclusions at this point.

Consumers get control of their finances

Consumers' financial health continues to improve, as delinquency rates on credit cards and consumer loans in general continue to decline (latest data available is 12/31/11, so it is quite likely that current rates are even lower). Credit card delinquency rates are now at their lowest level since 1991. Mark Perry has some related comments on business loan delinquency rates, which have also fallen impressively. All of this suggests that the economy is much less vulnerable to unforeseen difficulties or slowdowns.

Blogging will be light this week

Blogging will be light this week since this is my annual Guys Ski Week. We're at Telluride this year, and as the photo above shows (taken with my iPhone 4S of course), the views are spectacular. We're expecting snow tonight and tomorrow, so this should be a great week of skiing. Yesterday the snow was good packed powder, and it seemed like the mountain was practically deserted.