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Housing update

Just a few updated charts to chronicle the ongoing improvement in the housing market:

Although September sales were down a bit from August levels, the above chart shows that the uptrend in sales is still intact. Sales are up 11% in the past year.

Despite all the talk about the great shadow inventory of foreclosed properties that have yet to hit the market, the inventory of homes for sale has fallen to 5.9 months' worth of sales. This is much lower than the levels that prevailed in the 1980s, and is only marginally higher than what we saw in the boom years of the early 2000s. Bloomberg's story on the subject contains these choice tidbits: "sales of previously owned U.S. homes decreased in September ... restrained by a lack of supply," and ""the median price from a year earlier jumped by the most since 2005 as inventories dwindled." If home-buying enthusiasm picks up, we could see some real shortages—and higher prices—in the coming year or two.

This last chart illustrates the degree to which prices have rebounded over the past year.

Sales are down and prices are up because of restrained supply: quite an amazing development.

36 more reasons why industrial policy is a bad idea

Heritage has done us all a favor by compiling a list of 36 "green energy" companies that have received federal support and have either gone bankrupt or are laying off workers and headed for bankruptcy. Even with millions and billions of federal help, these companies could not compete in the real world, because green energy is still way too expensive to compete with existing forms of energy, and politicians are foolish if they think that federal largesse is the only way to change this reality. (I won't even get into the fact that most of these same companies were big contributors to Obama's campaign, since crony capitalism and corruption are to be expected whenever politicians—of whatever stripe—shower taxpayer money on favored industries.) Throwing money down the "green" drain just takes away money from more promising technologies and more promising ways to improve our lives through gains in efficiency and productivity. When someone finally does come up with a "green" energy technology that really makes economic sense, the world's capital markets will be there, ready and willing to provide all the funds necessary.

See the list here.

HT: Instapundit, my choice for MVB (most valuable blog)

The Reluctant Recovery: Part 3

This is the title of a presentation I gave October 10th to The Economic Club of Sheboygan. This post summarizes the key points of the presentation, and is the third in a series (see Part 1 here and Part 2 here). In this third part, the main focus is fiscal policy. I argue that Congressional deadlock has allowed the growth in federal spending to slow significantly, with the result that there has been a welcome decline in spending relative to the economy; and that economic growth has increased federal revenues without any increase in tax rates. This has combined to reduce the burden of the deficit substantially. From this it is easy to see a simple and straightforward solution to our trillion-dollar deficit nightmare: continue to exercise spending restraint, avoid increasing taxes, and broaden the tax base by reducing deductions and loopholes.

To begin with, it's important to understand that we are indeed in the midst of a fiscal debt crisis. As the chart above shows, the burden of the federal debt (measured by comparing outstanding federal debt held by the public to nominal GDP) has increased by much more during the Obama administration than it has during any previous post-war administration. By early next year the federal debt burden will be over 70% of GDP, having risen from 46% in early 2009. The impact of the rapidly increasing debt burden has been muted by the fortuitous fact Treasury yields have fallen to their lowest levels in history. This could change dramatically for the worse, of course, if the economy and/or inflation picks up in coming years, since higher interest rates combined with the relatively short maturity of existing federal debt could make federal debt service payments soar even if deficits were to decline meaningfully.

The first chart above shows federal spending and revenues as a % of GDP, while the second shows the nominal level of each. Government spending has declined relative to GDP mainly because the growth in spending has slowed sharply as the economy has grown. Slower growth in spending owes much to a gridlocked Congress, and also to improvement in the labor market, since 6.8 million people have dropped off the unemployment insurance rolls since early 2010. Revenues have increased much more than spending has declined, thanks mainly to the growth of the economy, which in turn has generated more jobs and more corporate profits. We didn't need to raise tax rates to increase tax revenues, because economic growth caused the tax base to expand. In fact, tax revenues have risen even though social security contribution rates have been reduced for most of the past two years (i.e., the "payroll tax holiday"). Unfortunately, liberals seem to be dug in on the need for higher tax rates on the rich and more income redistribution, both of which could weaken the economy and aggravate the budget problem. 

Thanks to slower growth in spending and a moderate increase in the size of the economy, the federal deficit has shrunk rather dramatically from a high of 10.5% in late 2009 to about 7% today. The 2012 fiscal year deficit came in at $1.089 trillion, however, which is still mind-boggling. The bad news is that the deficit is still very large; the good news is that it's declining. 

Tax revenues are likely to rise further if the economy continues to grow, so that side of the ledger will likely take care of itself. But on the spending side we have two looming problems: payments to individuals and net interest expense. Both are likely to rise meaningfully if and when Obamacare is implemented and if and when Treasury yields rise. Payments to individuals (aka transfer payments) already consume a huge portion of the budget (over 70%), and this category has been growing like Topsy for the past 50 years. Social security, medicare, medicaid, food stamps, etc.; are all non discretionary items that could continue to expand without practical limit unless Congress reforms the underlying programs and their eligibility requirements. As for net interest expense, it is very hard to see how this won't increase significantly; only a continuation of painfully slow growth could keep interest rates from rising, and the deficit is going to be very large no matter what for at least the next several years.

So although the budget picture has definitely improved in the past few years, we are not yet out of the woods. The deficit is still very large, as is the burden of federal debt. But the most important part of the budget, as Milton Friedman taught us, is spending. Spending is the best measure of the burden of government, and it is still at very high levels relative to the economy. Government at the federal, state, and local levels still consumes a huge share of our nation's output, and that is like a ball and chain to economic progress, because government simply can't spend money as efficiently as the private sector can. The only hope for stronger growth and rising prosperity in the years to come is a substantial shrinkage in government spending, and that can come only from fundamental reforms to our many entitlement programs.

In the meantime, it is easy to see how investors and corporations are reluctant to believe that there won't be a big increase in future tax burdens, and reluctant to believe that there will be significant relief from the overall burden of government. Fiscal policy is like a big storm cloud on the horizon. There is still time to avoid disaster, but there are many obstacles on the road to prosperity.

Next installment: the economy

Labor market update

The weekly claims data has been exceptionally volatile of late, which strongly suggests that seasonal factors are at work, distorting the reported numbers. This is when you look at the 4-week average of the data for clarity. As the chart above shows, not much is going on beneath the surface noise—claims are about flat so far this year.

The one area of the labor market that is not receiving the attention it deserves is the number of people receiving unemployment insurance. This has been steadily declining since early 2010: in fact, 6.8 million people have stopped receiving unemployment insurance since the peak in early 2010. Just over 2.3 million so far this year have dropped off the unemployment insurance rolls. Compare that to the 4.2 million new jobs since early 2010, and the 1.3 million new jobs so far this year, and you realize that this represents a significant change on the margin, since it means that there are millions of people out there who now have a stronger incentive to look for and accept a job offer, and who are now much more interested in the health of the economy and the size of the jobs market.

The unattractiveness of Treasuries

CPI data for September were unsurprising. Although the headline number was higher than expected (0.6% vs. 0.5%), the core number was lower than expected (0.1% vs. 0.2%). On a year over year basis, both headline and core inflation are running at 2.0%. Over the past 10 years, prices ex-food and -energy have risen at an annualized pace of 1.9%, while the total consumer price index has risen at 2.5%, with the difference being attributable almost entirely to rising energy prices (crude oil was $20/bbl 10 years ago, and is now $90/bbl). As the chart above shows, while there have been some deviations from the long-term trend, 2.5% per year on average for the CPI is still the norm. Ho-hum. Nothing to see here, move on.

But as this chart shows, Treasury yields are very low relative to inflation. The chart is set up to reflect the long-term difference between 30-yr bond yields and core inflation, which has been about 2.5%: the right-hand y-axis is offset by 2.5% relative to the left-hand y-axis. Note how yields were very high relative to inflation throughout the 1990s, a period in which the Fed was for the most part actively fighting inflation. That period culminated in falling commodity and gold prices—and the Feds' first panic over the possibility of deflation—when the core CPI hit a low of just 1% in 2003. Since then, bond yields have tended to follow inflation with the customary 2.5% difference, up until, that is, the past year, when bond yields have plunged while inflation has risen.

The difference between bond yields and inflation is now as low as at any time since the 1970s, when low real yields helped boost inflation. 30-yr T-bonds now offer only a 3% yield, at a time when inflation is running 2-2.5%. That's a very small premium to insure against the possibility that inflation could outstrip bond yields at some point over the next 30 years. 10-yr Treasury yields are even more unappealing, since at 1.8% they are already below the current rate of inflation. Thus, TIPS real yields (which are negative out to 20 years' maturity) and Treasury yields out to 10-years offer investors either a risk-free, U.S. government-guaranteed loss of purchasing power (in the case of TIPS), or the strong likelihood of a loss of purchasing power (in the case of Treasuries) over the next decade. Wow, what a deal!

It only makes sense to hold TIPS and Treasuries at current yields if a) one is obligated by organizational mandates to invest in risk-free notes and bonds, or b) one is so afraid of suffering losses in alternative investments (e.g., MBS, corporate bonds) that a guaranteed loss of up to 1% of one's purchasing power every year for the next decade sounds terrific. It doesn't even matter if you think that inflation will decline, because negative real yields on TIPS guarantee that you will lose purchasing power even if the rate of inflation declines significantly. (Technicality: If TIPS are held to maturity, investors are protected from negative rates of inflation, but not against receiving a zero inflation adjustment. This is comforting to some degree, but it doesn't help the investor who owns 10-yr TIPS if and when there is a bout of deflation that hits in the next several years.)

But isn't this all the result of Fed meddling in the bond market? Aren't yields artificially low because of QE? I don't believe so. The Fed may be buying a relatively large share of the new issuance of Treasuries (the current Quantitative Easing program only involves the purchase of $40 billion of Treasuries per month, which is a bit less than half the current $90 billion/mo. financing needs of Treasury), but Treasury yields are not set by marginal buying; they are set by the world's demand to hold the existing stock of Treasuries. After all, low yields on newly-issue debt must equal the yields on existing debt, since Treasuries are fungible.

Fed purchases of Treasuries these days are only a small fraction (less than 10%) of the non-Fed-held federal debt held by the public, which is almost $10 trillion. It strains credibility to think that $40 billion in purchases of new debt can massively distort the value and the current yields on $10 trillion of outstanding debt which is owned by individuals, corporations, and large institutional investors all over the world. And let's not forget that many tens of trillions of bonds all over the world are priced off of Treasuries (i.e., their yields are quoted in terms of a spread off Treasuries of similar maturity). Distorting the price on Treasuries means distorting the price on almost all of the bonds in the world. Yet there is no evidence that spreads on non-Treasury debt are unusually or irrationally wide. As an example, the chart below shows how tightly the yield on 5-yr Industrial bonds tracks the yield on 5-yr Treasuries over time. The current spread of 66 bps is actually lower than the average (89) over this same period.

From this I think it is clear that QE is not the driver of low Treasury yields. The real driver is deep-seated pessimism over the outlook for economic growth. The market believes the Fed when it says that it will keep rates very low for a very long time, because the market does not believe that there is much chance of enough growth or inflation in the next several years to sway the Fed from delivering on its promise.

If you agree with the Fed or are even more pessimistic, then you think Treasury yields are attractive at current levels. But if you think the Fed and the market are being too pessimistic about what the future holds, then, like me, you think Treasury yields are very unattractive.

Still more signs of a housing recovery

There likely are plenty of people in the world who still doubt that the U.S. housing market is on the mend. They are for the most part fixated on the huge "shadow inventory" of foreclosed properties and the millions of homeowners who are still underwater on their mortgages. But this group doesn't include homebuilders, who last month started work on 872K new homes (seasonally adjusted annual rate). That was 13% more than expected by analysts, and it was fully 60% more than the level of starts early last year. Even just a cursory glance at these charts makes it clear that the residential construction industry has turned the corner, and decisively. This is for real.

The stock market figured out this was coming years ago. The stocks of major home builders are up 56% from June of last year, and up 240% from their recession low. When I predicted in July 2009 that "it's highly likely that if we haven't seen the bottom in residential construction, we are getting very close," I was almost laughed out of town. The bottom had indeed already occurred, but it took two years before the upturn became established.

As Calculated Risk notes, "the US will probably add around 12 million households this decade, and assuming no excess supply, total housing starts would be 1.2 million per year, plus demolitions and 2nd home purchases. So housing starts could come close to doubling the 2012 level over the next several years." Housing is now adding to GDP—after subtracting for most of the past six years—and the process is just getting started. Over the next 3-5 years, residential construction could almost one percentage point a year to real GDP growth.

Industrial production is flat this year

U.S. industrial production has not expanded this year, but neither has it collapsed. Eurozone industrial production took a hit beginning last September, but has managed to eke out some gains this year. Not a picture of growth, but not one of global recession either. If the worst that happens is that the U.S. and Eurozone economies remain stagnant for another year, that wouldn't be the end of the world. 5- and 10-yr sovereign yields in the U.S., Eurozone, and Japan are priced to the expectation that growth will be stagnant at best, in my view.

The Reluctant Recovery: Part 2

This is the title of a presentation I gave October 10th to The Economic Club of Sheboygan. This post summarizes the key points of the presentation, and is the second in a series (see the first here). In this second part, the main focus is monetary policy. I argue that the Fed has correctly responded to the huge increase in the demand for safe-haven dollar liquidity that was caused by the Great Recession and the Eurozone debt crisis. However, the measures they have taken are so unprecedented and so potentially inflationary that they have introduced a significant amount of uncertainty to the market, and this in turn has contributed to the market being reluctant to believe that the current recovery is sustainable.

Quantitative easing has been accomplished so far by the Fed purchasing $1.6 trillion of Treasuries and MBS, in three stages. QE3 has only recently begun, and it is still relatively modest in size, with purchases scheduled to be about $40 billion per month. These purchases have been paid for not with cash, but with bank reserves. Since the Fed decided to pay interest on bank reserves early on in the quantitative easing process, bank reserves are functionally equivalent to T-bills since they are almost as risk-free and yield a little more (currently the Fed pays 0.25% on reserves, which is a bit more than the 0.09% yield on 3-mo. T-bills). This is very different from how things worked in the past, when reserves paid no interest and banks therefore had a strong incentive to use additional reserves to expand lending. In effect, the Fed has swapped $1.6 trillion of T-bill equivalents for $1.6 trillion of notes and bonds. The Fed has not "printed money" in massive quantities as so many have been led to believe. The Fed has merely supplied an asset to the market that was in very high demand (i.e., T-bill equivalents whose price was so high they yielded almost nothing) in exchange for an asset that was in less demand (i.e., notes and bonds with lower prices and higher yields). 

Quantitative easing was necessary to accommodate increased money demand. When analyzing monetary policy, it is critical to establish whether the Fed's willingness to supply money is greater, lesser, or equal to the world's demand for money. If money supply exceeds money demand, the result is inflation (e.g., too much money chasing too few goods and services). If money supply is less than money demand, the result is deflation (e.g., a shortage of money relative to goods and services). If supply and demand are in balance, the result is monetary nirvana—low and stable inflation. As the chart above shows, the demand for money (M2 is the best proxy for "money" that I am aware of, and comparing M2 to GDP is a good way to see how much money people want to hold relative to their incomes and their spending) skyrocketed beginning with the collapse of Lehman Bros. in late 2008. In effect, the world's demand for money soared; people wanted to save more, spend less, increase their cash balances, and reduce their debt.

In the chart above, the increase in the ratio of M2 to GDP from September '08 through today is the equivalent of approximately $1.5 trillion in additional M2 growth. It is not a coincidence that the world's extra demand for money, sparked by fears of a global financial collapse and/or a global economic meltdown, was of the same order of magnitude as the Fed's injection of $1.6 trillion of bank reserves. The Fed bought $1.6 trillion of notes and bonds and paid for them by crediting banks with bank reserves; a portion of those reserves were eventually exchanged for currency, which has increased by about $300 billion; about $100 billion of those reserves were used by banks to back up increased deposits; and the rest of the reserves found their way back to the banks, who were content to just hold on to them in the form of "excess reserves." Banks were risk-averse too, after all, and reserves were a safe asset that paid at least some interest.

Most M2 growth went to deposits. The chart above shows the different components of the M2 measure of money, with the largest by far being savings deposits. It is not a coincidence that savings deposits account for virtually all of the increase in M2 since the Lehman Bros. collapse. Savings deposits have increased by about $2.5 trillion over the past four years, with $1.5 trillion of that increase going towards satisfying the public's hugely increased demand for money. In short, all of the extra "money" that the Fed created in the form of bank reserves ended up in the banking system. It never made it into the economy.

Money growth has not been excessive by past standards. As the chart above shows, M2 in the past four years has grown only marginally faster than it has on average over the past 17 years. Accelerations and decelerations in M2 growth happen all the time, and the last two—driven by increased money demand—don't appear unusual at all. When inflation was rising in the 1970s, M2 growth was averaging close to 10% per year. M2 growth over the past four years has been an annualized 6.4%, and that is just not enough to fuel a significant rise in inflation.

Benign inflation confirms this. Both the headline and the core version of the Personal Consumption Deflator are within the Fed's target of 1-2%. Although inflation has been unusually volatile in the past decade or so, on average it has not been problematic. This strongly suggests that the Fed's efforts to expand the money supply have been matched by the market's increased demand for money. If the Fed had not launched Quantitative Easing, we would probably have seen deflation by now.

However, inflation expectations are rising. The above chart shows the forward-looking inflation expectations that are embedded in the pricing of TIPS and Treasuries. Inflation expectations have been rising in recent months, but they are still only moderately elevated compared to historical experience. I think this reflects emerging fears on the part of the bond market that the Fed is likely to make an inflation mistake in the future, and that is a very legitimate concern.

The dollar is extremely weak. The above chart shows the value of the dollar against large baskets of other currencies, adjusted for differences in the inflation rate between the U.S. and those other countries. It is arguably the best measure of the dollar's value vis a vis other currencies. That the dollar is very close to its all-time low suggests that the currency market also is feeling uneasy about the Fed's stewardship of the dollar. At the very least it suggests a serious lack of confidence in the future of the U.S. economy. The Fed may have done an excellent job accommodating the world's demand for safe-haven dollars to date, but in the process they may have undermined the world's confidence in the value of the dollar going forward.

Gold and commodities are very strong. Gold and commodity prices have risen significantly in the past 10 years, beginning with the Fed's initial efforts to ease in response to weak recovery that followed the 2001 recession. This is basically the flip side of the dollar's general weakness following its peak in 2002. The world's demand for dollars has been eclipsed by an increased demand for physical assets, which in turn is symptomatic of the beginnings of a rotation out of financial assets that could fuel future inflation. Recall that the sharp rise in inflation in the late 1970s followed a sharp rise in gold and commodity prices in the first half of the 1970s. Gold, which is up strongly relative to every currency, is sending a strong signal that the world is concerned that inflation is going to rise.

Inflation has not risen yet, but that is mainly due to the fact that the demand for dollars has been very strong, and that increased demand has been driven by fears, uncertainty, doubt, and a general lack of confidence in fiat currencies. If confidence in the future increases, the demand for dollars is likely to decline. Will the Fed be able to reverse its quantitative easing and/or increase the interest rate paid on reserves in a timely fashion, enough so as to prevent an excess of dollars—and a significant rise in inflation—from occurring? That is the biggest question lurking beneath the surface today. If the demand for M2 should decline, there is the potential for a $1.5 trillion—or more—excess of dollars to develop. Looked at another way, there is $1.5 trillion sitting in bank savings deposits that could be spent, and banks' excess reserves could be used to make new loans and expand the money supply almost without limit. If the world just attempted to reduce its holdings of savings, $1.5 trillion could find its way into higher prices for goods and services, and that could fuel some significant inflation, and perhaps some additional growth, in the years to come.

In short, it's understandable that markets are reluctant to believe that things will continue to improve.

Next installment: fiscal policy

The Reluctant Recovery: Part 1

This is the title of a presentation I gave October 10th to The Economic Club of Sheboygan. This post summarizes the key points of the presentation, and is the first in a series. In this first part, the main focus is on the message of key market-based indicators. Some suggest that the economic fundamentals have improved significantly, but others suggest that investors are still very reluctant to believe that this improvement will last. Long-time readers of this blog will recognize almost all of the charts and the themes laid out here.

Swap spreads are excellent leading indicators of economic health, as the above chart demonstrates. (Here is a primer on swap spreads.) Swap spreads can be thought of as the price that market participants must pay to reduce their exposure to risk. When swap spreads rise, it's because investors are becoming more worried about the future, the market is becoming more risk averse, liquidity is drying up, and/or the economic fundamentals are deteriorating. As a result, it becomes more expensive to get rid of unwanted risk. Swap spreads have risen in advance of the last three recessions, and they have declined in advance of the last two recoveries. The decline in swap spreads in late 2008 led me to predict improving conditions in 2009. Today, swap spreads are about as low as they get, and that suggests that systemic risk in general is very low, and therefore the health of the economy is likely to improve over the next six months.

Systemic risk has declined significantly. To judge by the decline in Eurozone swap spreads, conditions in the Eurozone have improved dramatically so far this year. This reflects serious efforts on the part of the ECB to improve liquidity conditions. When markets are liquid, they can function normally and fulfill their role as a "financial shock absorber" to the economy. A good way to understand this was the "Carmageddon" episode in Los Angeles over a year ago. As I wrote at the time, when people have access to information and an incentive to act on it, they will. In short, the entire population of Los Angeles was well aware that the closure of the 405 freeway could create epic traffic jams, and so people decided to stay at home. The result was no traffic problems at all. And so it was with the Eurozone sovereign debt crisis: when Greece finally defaulted, it caused barely a ripple in the financial markets, because everyone had had plenty of advance warning and those who didn't want to be exposed to Greek default risk were able to transfer their risk to those that did. With liquidity having returned to markets nearly everywhere, investors are becoming somewhat less concerned about the future and that has helped conditions in the U.S. to improve.

The usual precursors of recession are absent. As the above chart shows, every recession in the past 50 years has been preceded by very high real interest rates (the blue line, representing the real Fed funds rate) and by a very flat or negatively-sloped Treasury yield curve (the red line, representing the slope between 1- and 10-yr Treasury yields). High real interest rates are the tool that the Fed uses to slow the economy and damp inflation. They tend to increase the demand for money, punish borrowing, and reward saving, and they signal that money is in relatively short supply. Today the Fed is trying very hard to do exactly the opposite; by keeping real rates very low and negative, the Fed wants to decrease the demand for money, reward borrowing, and punish saving, by making sure that money is plentiful. The bond market steepens the yield curve when it knows that the Fed is very easy and will eventually have to tighten, and it flattens the yield curve when it knows that the Fed is very tight and will eventually have to ease. Today it is clear that the Fed is easy and money is in plentiful supply. Both of these classic indicators of recession and recovery signal strongly that we are still likely in the expansion phase of the current business cycle.

Negative real yields imply dismal growth expectations. Despite the evidence of improvement in key financial indicators (e.g., low swap spreads, a steep yield curve, negative interest rates), the market's expectations for growth remain dismal. The above chart shows that there is a tendency for real yields on TIPS to track the real growth rate of the economy. This is only common sense. When the economy was growing very strongly in the late 1990s and early 2000s, the real yield on TIPS was extremely high. TIPS in effect had to compete with the widespread perception that real yields on just about everything were likely to be strong. Today it's just the opposite. Negative real yields on TIPS are a sign that the market expects real economic growth to be very weak. Investors are willing to sacrifice some of their future purchasing power (by locking in negative real yields on TIPS) because they fear that returns on alternative investments could be far worse. The chart above suggests that the economic growth expectations embedded in TIPS prices could be as low as zero for the next several years.

Credit spreads are still elevated. Credit default spreads on investment grade and high-yield corporate bonds are still substantially higher than they were prior to the onset of the last recession. Even though default rates have fallen significantly and the economy has been growing for the past three years, and key indicators of systemic risk are looking very encouraging, the market is still very worried about the future.

Major bear markets leave investors shell-shocked for years. The two major bear markets in our lifetimes—from the mid-1960s to the early 1980s, and from the early 2000s to the late 2000s—resulted in equity prices falling by roughly two-thirds in real terms. As the saying goes, "once burned, twice shy." Market participants are still very afraid of getting back into the market, worrying instead that another sell-off could be just around the corner. As they say, "bull markets climb walls of worry." It is only natural for markets to still be very worried about the future. There are no obvious signs of excessive optimism to be found these days. Rather, it's much easier to find signs of pessimism.

PE ratios are below average. Continued concerns about the future are also reflected in the trailing PE ratio of the S&P 500, which is below its long-term average. The market was exceedingly optimistic in 2000, when PE ratios soared to 30, but today pessimism is the default position. The market is reluctant to trust that profits will continue growing, or even maintain current levels.

Equity yields tower over corporate bond yields. despite record profits. Normally, the earnings yields on stocks is lower than the yield on corporate bonds. That's because equity investors are usually willing to give up some yield in exchange for the expectation of future capital gains. Today, however, the earnings yield on stocks is much higher than the typical yield on corporate bonds. This can only mean that the market is very worried that earnings will fall in coming years—perhaps falling in mean-reverting fashion to 6% of GDP or thereabouts—and thus prefers to own corporate bonds at a much lower yield because they are higher in the capital structure and thus more immune to adversity.

In a global context, profits look sustainable. While it's very tempting to look at profits as a % of U.S. GDP and conclude that they are so high they can only fall by a lot, the above chart suggests that profits as a % of global GDP are not very high at all and could be quite sustainable at current levels. The U.S. economy has become so much more internationalized that it is a mistake, I believe, to confine one's analysis to the U.S. economy. Companies today (e.g., Apple) are able to address global markets that are growing by leaps and bounds. It is not at all unreasonable to find that corporate profits have also been growing at a much faster rate than the U.S. economy, and there is little reason to suspect that this will change any time soon. Even if corporate profits stopped growing, PE ratios would still be low by historical standards, and very low in the context of extremely low Treasury yields.

Next installment: Monetary Policy

Back from Kohler and Chicago

Last week blogging was a bit light since we spent three days in Kohler, Wisconsin, followed by three days in Chicago. The reason for the trip was that I had been invited to present my outlook on the markets and the economy to The Economic Club of Sheboygan. Despite its relative obscurity, the club has attracted an impressive list of speakers over the years, which I was quite honored to join. There were about 100 in attendance, and the questions were lively. Doing presentations like this is one of the things I miss the most about being retired, especially when the audience is filled with businessmen who know what it's like to build and manage a company while coping with the consequences and burdens of government policies and regulations. Many thanks to Clare Zempel and Jim Kitzinger for the invitation and for making our stay so enjoyable.

The venue for the talk was the beautiful American Club Hotel in Kohler, a suburb of Sheboygan. We were awed at the beauty of the little town of Kohler, which owes its livelihood and idyllic charm to the folks who built Kohler Co., renowned for faucets and bathroom fixtures, among other things. During a visit to the Kohler Design Center—a must—we learned why: Mr. Kohler hired the folks who designed Central Park in New York to create a plan for the development of the town. We arrived about a week late for the peak in Fall colors, but as the shots above show, it was still a treat for a Southern Californian. The third photo is the amazing view we enjoyed over lunch at the nearby Blackwolf Run golf course. (all photos taken with my iPhone 5)

In subsequent posts I'll recap the highlights of my presentation, illustrated as usual with lots of charts. The title was "The Reluctant Recovery." Reluctant, because as I've argued for years, the economy is suffering from sub-par growth because of "stimulative" monetary and fiscal policies which have only served to create headwinds to progress, and because market participants have been very reluctant to believe that the recovery would be self-sustaining.

Retail sales surprisingly strong

September retail sales blew past expectations (+1.1% vs. +0.8%), and already-strong August sales were revised upwards from +0.8% to 1.2%. That adds up to a gain of 2.3% in two months, and that reverses all of the decline we saw in the second quarter and then some. As the second chart above shows, even after subtracting inflation, real retail sales have reached a new high, despite the fact that there are 4.5 million fewer jobs today (3.3% fewer) than there were at the prior high in sales.

As the chart above shows, the strength in retail sales goes beyond just the auto sector, where sales have surged at a 14.5% annualized rates since the recession low. This is a broad-based recovery in retail sales.

This last chart zooms in on nominal sales in the past 13 years for a better perspective on recent developments.

Needless to say, there is no sign of anything like a recession in these numbers.