Tuesday, January 30, 2018

Stocks and Apples

I don’t like to write about the stock market. While the values in the stock market are often related to global macroeconomics, the changes more often mirror my dance moves after a night of consuming JD. But like a good bottle of JD, it is not easy to ignore Da Market.

So today I focus on Da Market as measured by something called the Wilshire 5000. The Wilshire 5000 is not as well known as its cousins: the  DJ Average, the S&P 500, or the NASDAQ. Wikipedia defines the Wilshire index as a market-capitalization-weighted index of the market value of all stocks actively traded in the United States.

I am writing about the stock market because we are obsessed by it. Everyone watches the market indices daily and we cheer its upward advances. More popular than the Philadelphia Eagles, we can’t wait until its next upward movement. But nasty people called shorties tell us that the market, like the apple that supposedly hit Newton on the head, must come plummeting down to earth. With apples, they cite something called the Law of Gravity. With stock prices, it all has to do with Pee Wee Herman or PEs or something like that.

Apples or stocks, what goes up must come down. So I decided to look at the data today and report to you what I found. Take a deep breath – there is no forecast here. Do with it what you will.

Before we begin looking at my huge table below, let’s make one point. The Wilshire 5000 went from a value of 3,291 in 1990 to 27,655 in 2017. When it comes to these 28 years, it is pretty clear that Newton had nothing to say about stock prices. If my calculator is correct, that amounts to a nominal capital gain of 742%. I will take that.

But let’s not stop there. Most people are not as conservative as me. Call me Buy and Hold Larry. Other people are more active in stock markets. Others might have a shorter horizon than 28 years. That’s who my wild and crazy table is for.

What’s in the table? Betty wonders what I do in my office all the time. Basically, I make up tables and rearrange the flowers in my JD bottles. Anyway, the table below was created by going through 324 months of data, one month at a time. I found there were 10 time periods between 1990 and 2017 in which the value of the market peaked, fell for at least a few months, and then returned to its previous peak. The idea of this kind of breakdown is to see what happens after stock prices begin to slide.

Begin with the first row of the table. In June of 1990, the market peaked and was 5% higher than the previous peak. After June of 1990, stock prices fell. They fell and then rose until reaching the previous peak in June 1990. It took 9 months to regain that previous peak. 

This down-up pattern happened 10 times since 1990. Typically prices began falling after a 22% increase since the previous peak and then took about 20 months to fall and then rise to reclaim the previous peak.

But notice there are large variances among the 10 time periods. Half the time, it took 10 months to recover. But notice that in five of these episodes, it took 5 months or less for stock prices to recover. And then there were the episodes in 2000 and 2007 where it took 81 and 63 months, respectively, to regain the previous peak.

It is pretty clear from the table that the time it takes to return to a previous stock price peak is highly variable. Many times it took less than half a year. The average time is less than two years and the median time is less than one year. And then – tada – there were two times when it took 5-7 years. So if the stock market does seem to rise over time, your recommended behavior very much depends upon your time horizon. If you can live through poor stock markets for 7 years – then the past suggests you have no worries. Buy a sailboat. 

The final table column is interesting too. It lists the percentage change from the previous peak to the subsequent peak and downturn. For example, the second line in the table says that between 1990:6 to 1994:1, the stock market rose by 37%. It was after that 37% increase that led to stocks subsequently falling and then rising again. In the case of 1994:1, a previous increase of 37% led to a 13-month cycle. It is interesting that the longest cycles in the table (81 and 63 months) were preceded by relatively modest increases in stock prices of 12% and 10%. The 42% increase in stock prices before 2015:7 surprisingly lead to a down-up cycle of only 11 months (before prices returned to previous highs).

In short, there does not seem to be any correlation between previous stock price increases and subsequent months of return to the previous peak stock price. And thus the 25% increase in stock prices between 2015:7 and 2017:12 does not warrant any special concern from the standpoint of this analysis.

When will prices hit another peak? I am not sure. But if and when stock prices begin to fall, this analysis suggests that the time before the next peak might only be a few months. Of course it might be 8 years too. Those who would scare you out of stocks right now ought to explain to you when they think stock prices will fall – and then when they will return to the previous peak.  

Peak      Months    Wilshire Percent
               To Next    Value      Change
1990:6      9             3,446            5
1994:1     13            4,709          37
1996:6       4            6,629          41
1997:2       3            7,647          15
1997:10     4            9,215          20
1998:7       5          10,822          17
1999:7       4          12,640          17
2000:3     81          14,096          12
2007:10   63          15,556          10
2015:7     11          22,097          42
Average  20                               22
Median     5                                17

Tuesday, January 23, 2018

Out of the Economic Wilderness

Things go in stages. I remember a time when I put a lot of gunk on my hair so it would stand up straight in what was known as a flat top. Then I had a wave. The Air Force preferred something closer to my scalp. Post-Air Force, I let it grow for about four years. My hair had a lot of stages. Today, well, there are a few spots missing here and there.

And so it is with economic thought. I had the luck of taking a wonderful course in the history of economic thought at the University of North Carolina. A main goal of that course was to see that economic thinking evolves over time and very much reflects the natures and problems of a given time or place. This recognition of the temporary nature of economic ideas gives one some confidence that whatever the prevailing wisdom might be today, it is sure to be supplanted by something else in the near future.

As a graying economist, I have seen lots of change during my career. When I was at the University of Arizona getting a masters degree (while stationed in Tucson with the Air Force), the bravado of Keynesians was revealed in their confidence about the accuracy of forecasts of Keynesian models. Keynes had reacted to the failure of previous so-called Classical Models to explain the Great Depression. But it was the eventual failures of Keynesian models that led to a host of competing theories by unreconstructed Keynesians, monetarists, and supply-siders.

Today, we have a mish-mash of models with elements of each of those schools of thought. But there is a very clear and common thread among them that focuses on the apparent short-run instability of advanced industrial (rich) nations. We argue among ourselves about the proper policy in a given country at a given time but the argument is framed within a short-run model that encourages us to focus on moving the economy back to short-run equilibrium. If inflation is running too hot, we try to bring its temperature back down. If the economy is languishing with high unemployment and slow growth, we give it a pep pill. The pill might be designed to alter short-run demand or supply but the focus is always on overcoming an undesirable stage of an economic cycle.

This bouncing around has gone on in the USA at least since the early 1960s when John F. Kennedy announced his famous tax cut that would move us out of a recession. Since then, we have handed the policy ball back and forth between quelling rapid inflation and stimulating recessed spending. One byproduct of this has been a dizzy economic experience. Another offshoot is a national debt that reaches for the sky. There have been a few times when the debt as a share of the economy abated somewhat, but mostly it rises and then rises more. Today, it approaches 100% of the size of the US economy and promises to go even higher than that.

I think the dizziness plus debt is wearing us out. Worse is that it is becoming more and more obvious that this preoccupation with the economic cycle is distracting us from recognizing and treating what has become the new scourge of industrial nations. Today, we debate whether the economy is too strong or too weak. Today, we debate whether or not to have stimulative monetary policy. We argue about the stimulative impact of rebuilding the nation’s infrastructure. Imagine all those workers paving during the day and spending at night! 

But the truth is that short-run policy never seems to accomplish anything as we careen from recession to expansion back to recession. And worse than that is that the experience of industrial nations has changed. Whether this change was brought about by industrialization or by globalization, the result is that we are weakened by modernity. Our ability to grow is at risk. Our main economic challenge has gone from trying to reduce the amplitudes of economic cycles to raising our long-run economic growth path. Last week I used the example of a long distance runner. Let’s try it again. You want to win the marathon. To run 26 miles at a fast enough pace to win, you don’t swallow a handful of sugar. You train hard. You build your wind capacity and your muscles.

We are familiar with the difference between short-run and long-run policies. While the richer nations have been toying with cyclical policies, the poor developing countries knew they could catch up only if they focused on long-run structural issues like energy, transportation, legal systems, and so on. Before they could provide adequate incomes and opportunities for their citizens, they had to build a modern infrastructure. Now it is the industrial countries that need to rebuild to meet the challenges of the day. We should replace our short-term focus with longer-term ideas.

What does that entail? The remedies should mirror the problems. Everyone seems to acknowledge that modern competition has reduced the demand for workers in the US and in other rich countries. Despite the fact that the US unemployment rate is very low, we acknowledge that too many people have dropped out of the labor force, taken jobs beneath their skill levels, or work part-time when they prefer 40 hours per week. This is clearly not a short-term issue especially when we know that technology is bringing robots on that might be smarter and prettier than your average macro professor.

This labor supply challenge is constantly on our minds but we process the information with old and worn-out models of the short-run. We continue to ask for more of the same policy gruel – juice up the money supply or give the middle-class a tax break. But we are not in a recession and we don’t need policies that cause the national debt to grow even more. What we need is to reorient the way we think. 

Tending the economic cycle does not create more sustainable economic growth. Economic growth is the salve that soothes but economic growth requires an understanding of how to compete in a high- tech world that wants to replace human hearts with robot brains.

We had to figure out how to evolve from an agricultural to an industrial economy. The transition was not pretty but we had to quit thinking about wooden plows and mules and focus on tractors. Now it is time to figure out how to move from the tractor to the driver-less, sun-powered robot. Arguments about traditional monetary and fiscal policy while creating mountains of debt, are not going to help. Where do we find someone to lead us out of the wilderness? Who understands that in the long-run we are not dead?

Tuesday, January 16, 2018

Economic Growth Confusion

Mixing apples and oranges doesn’t sound too bad until you start making an apple pie. That’s the way I feel about the careless use of terms like "economic growth". Economic growth has so many meanings that it is easy to confuse people. These misunderstandings are particularly troubling today, because of the implications for growth-caused inflation and interest rates.

It is common to discuss the growth of the economy. You can talk about national growth last quarter or last year. Or you can average it over many past years. Forecasters discuss economic growth in the coming year. All that is fine.

What is not fine is mixing these popular uses of the term economic growth with the outcomes of an economic growth model. An economic growth model’s output is probably misnamed. What it ought to be called is JD. No, that’s not right. It ought to be called "long-run economic growth". 

A growth model is a simple mathematical expression that posits that economic growth is equal to the sum of the growth rates of the labor force plus the growth of labor productivity. (Note there is something called a two-factor economic growth model but that complicates matters beyond my meager goals today). Let’s write the economic growth equation:

  Long-term Economic Growth Rate = 

  Growth Rate of the Labor Force
  + Growth Rate of Labor Productivity

Don’t you just love equations?

I use the word "long-term" to make a point. This equation is NOT meant to explain or predict changes in a nation’s output (real GDP) from day to day or from year to year. It is meant to explain how our permanent or sustainable capacity to produce changes over fairly long periods of time.

You could ask, How will economic growth in the next 10 years differ from the previous 10 years? That would be an acceptable use of the growth model described above. When answering that kind of question, the growth model ignores lots of short-term distractions and focuses on what it takes to permanently alter the capacity to produce goods and services. It is inherently supply-side-oriented. Clearly how much labor you have available is critical to sustain an ability to produce. The productivity of labor matters too, and that productivity is very much influenced and determined by how the quantity and quality of capital (plant, equipment, software, etc) change.

The trouble comes when people use discussions of the economic growth equation to talk about the next year or two. Capacity growth is important to next year but so are a lot of other things. For example, low labor force participation might endanger economic growth in 2018 but to focus too much on that one indicator is to not be playing with a full deck of cards.

What is the full deck of cards? Macroeconomic models we use to explain and forecast short-term changes in output (and prices) generally focus on events and factors that impact both the demand and supply of goods and services. A tax cut for moderate income people might encourage them to spend more and therefore impact demand. An increase the energy prices in 2018 might cause the cost of running factories to increase and lead to impacts through the supply of goods and services.

The full deck of cards includes Jokers, Queens, and Kings – and anything and everything that might influence our desires to buy and to sell. Thus, it is possible and desirable to intertwine long-run supply-side factors with the many short-term factors that will impact economic growth. To ignore the short-term changes is to imperil our judgment about the short-run.

The upshot of this is that output growth next year could be much faster or much slower than the long-run model predicts. When we hear the words "capacity output", we think of some kind of physical wall or constraint. But the truth is that for a year or two, output can grow much faster or much slower than capacity. How is that possible? 

Think of a distance runner who knows his sustainable pace for the long race. Call that long-run capacity growth. But think what happens at mile 17 when his arch rival moves ahead of him. For a time, he may run much faster than his overall pace to psychologically attack that rival. If he tries to sustain this high rate, he will run out of gas. But he can dig deep for a little while. Similarly, capacity might be growing at 2% per year but the economy could grow faster than that for a little while.

In the economy, labor force and productivity determine the sustainable long-term pace. But in the short run you can jam more workers into stores and factories than can be sustainable. Think of December when so much output gets sold. That’s not sustainable over the whole year.

The main confusion today is about how faster economic growth might influence such things as inflation and interest rates. Suppose spending kicks into higher gear while capacity moves like a snail. In that case, one might predict stresses leading to higher interest rates and inflation. Instead, suppose spending grows faster while short-run supply does the same. In this case, the economy is not stressed and there may be no additional pressures on inflation and interest rates.

Energy, business deregulation, some of the elements of tax reform, as well as the residual impacts of a global surplus suggest a national supply response that will not bring along the usual increases in wages, interest rates, and inflation. At least not right away. All this could change in a year or two and then we have plenty to worry about. It might be a good idea for policymakers to goose the long-run growth model faster. We will need that extra permanent capacity to keep the economy from strangling itself. 

Notice this implies nothing for the usual monetary and fiscal policy and everything about how a country improves its labor force –  its size, its quality, and its productivity. 

Tuesday, January 9, 2018

Confessions of a Two-Handed Economist

President Truman is famous, among other things, for saying he wanted a one-handed economist who would not say “on the one hand this, but on the other hand, that.” In other words, he didn’t always want a complete and balanced analysis – he wanted to know where things were headed. No hemming and hawing!

Truman would have hated me. I love to tell the whole story no matter how much my audience falls asleep.  I am probably a nine-handed economist. So today I am stopping all that. Today, I am one-handed, and today I will tell you what I really think. Today is the day I am part of a panel at Big Arts on Sanibel Island. So I am killing two birds with one stone – writing this blog and using this lunacy as my presentation to the grey-haired audience at Big Arts.

Sanibel Island is an absolutely wonderful place. Thanks to Chuck and Nancy Bonser, who will remain unnamed, we were introduced to this paradise located off the coast of Fort Myers, Florida. We have been going there off and on for the last 30+ years. It not only has wonderful birds to watch, shells to collect, and seafood to eat, Sanibel has a warm and wonderful group of locals who always make us feel incredibly welcome whether we are bellying up to the bar at the “office” (Sanibel Grill) or arguing politics and economics at the Sanibel CafĂ© or listening to incredible music at George & Wendy’s Restaurant and the Keylime Bistro.

Thanks to Chuckie B, I have been teaching a course and also participating in panel presentations at a place called Big Arts. I will be teaching again at Big Arts in 2018 but before that class begins, I am part of a panel today! I am supposed to talk about the future of the US economy and think I have 15 minutes to deliver a totally persuasive forecast.

So here goes. My forecast is that the US economy will grow faster in 2018 than it did in 2017. That means a growth rate in the range of 3.5% to 4.5%. All you Never-Trumpers can hang up on me now. You have better things to do than to read or listen to this. I know you were hoping for a feeble growth forecast but I am not a politician, and I am trying to be a one-handed economist today. It’s all about the economy, and as usual, you can take it or leave it.

Below are my bets that underlie this forecast. But first are the risks. Just kidding. I am not going to discuss the risks. I have only one hand today and even though there are trends that argue against me, I am going to ignore them. Take that President Truman!

First is brother Mo. Mo is short for momentum. Most of the time forecasters bet on Mo. It’s like knowing that Uncle Jason always stops at the local grocery store on his way home from work and buys one can of Rainier. He never deviates. But sometimes unexpected factors cause him to alter his pattern. Ashley might want him to stop at the Whole Foods. Whatever. On a given day it makes sense to bet on Jason's Rainier and on the economy pretty much performing like it has for the last few years. Go Mo!

Second is gathering confidence. Each year in which the economy does not fall into a recession and employment rises and inflation seems a little less likely to fall creates a floor of confidence that allows the economy to not only continue growing but to grow even faster. Confident consumers are more willing to buy and firms are more willing to produce.

Third is what is happening in the rest of the world. The US led much of the world out of the last recession and is now ready to step back and let some of the other countries pull the wagon. As many of the hardest hit countries recover and as Europe and Japan strengthen, it creates a global environment of growth to which the US benefits.

Fourth is interest rates. Many people worry that rising interest rates will nip my last three points in the bud. But I doubt that will happen. The interest rates we know and love are not controlled by the Fed. The Fed may plan to raise interest rates but that doesn’t mean that rates will behave. Telling your child that you are going to cut his allowance does not always elicit the desired change in behavior. As in the case of the errant child, interest rates are impacted by many things. While the world is getting stronger, it is still typified by an overcapacity in which supply is greater than demand. Output can expand greatly without the usual cyclical factors that raise prices, price expectations, wages, and interest rates. The data supports this view. Last week I showed a graph that questions if and when a new Fed policy to raise interests will actually lead to that result. It's definitely not a slam dunk.

Fifth is geopolitical. My observation as a kid was that bullies loved to harass kids who would not fight back. Bullies often stay away from kids who will dish out at least a little punishment. The US is saying some tough things to the world’s bullies – I don’t need to name them since it is pretty obvious who these bullies are. Some of you worry that this will lead to war and some really horrible consequences. I don’t. I don’t think our government wants war any more than previous governments did. But our government is doing some things that make us less easy to bully. So I am betting that there will be a lot of noise about US defense and security and very little negative reaction that might put my growth forecast in jeopardy.

Sixth is "da Market". The past changes in stock market indexes cannot be ignored. A lot of wealth has been created. While uncertainty about the future means we won't go on a spending spree, it is hard to ignore those trillions of dollars accumulating in our financial statements. Spending some of those wealth increases will add to the party. Another aspect of rising stock prices is the falling cost of capital. The higher are stock prices the lower is the cost of raising a given amount of capital. With interest rates stalling and stock prices rising, it will be a great time to buy plant and equipment. 

Finally, I like that the pendulum is swinging. Government financial regulation, climate change policy, other EPA rules, and other government regulations on business can move a wee bit away from where they were heading in the past eight years without causing the world to explode. I know some of you want ever more progress on various social policies and government regulation. You have good hearts and smart minds. But I don’t think you know enough about the effects of economic growth on all the things you cherish. I am, therefore, happy to see the pendulum swing back a bit with the hope it will generate growth without harming the future of the US and the planet.

Notice I didn’t say much about tax reform. In my humble opinion it might be eighth in the list of seven I just discussed. It should help economic growth but it is such a hodgepodge of good things and gimmicks, I am not ready to pronounce the tax reform as the greatest thing since sliced bread. No, I am not crazy about its implications for the national debt. 

I stuck my neck out. You are invited to chop away. Hope you have a wonderful 2018!

Tuesday, January 2, 2018

Fed Policy and the Market

As the (red line in the) below chart shows, the US Federal Reserve is embarking on a new policy to lift interest rates gradually back to normal levels. Today's post suggests that even if the Fed keeps to its goal of raising the Federal Funds rate gradually in the coming year, the Fed might not get what it is hoping for.

To convince you that this is no slam dunk (to raise market interest rates), it takes a little excursion into interest rates and then a closer look at the below graph.

Let's start with interest rates. There are many interest rates out there, and the Fed has no direct control over them. You can think about an interest rate in two ways -- as a saver or as a borrower. When you put your life savings into your money market account, you soon learn that with today's low interest rates you get enough return to buy yourself maybe 15 minutes on a Bloomington parking meter. If you instead lend the money to the government by buying a long-term government bond, you might get an interest rate of about 2.8%. That means if you buy a bond for $100, you will get back the sum of $2.80 each year you own the bond. That return amounts to a coffee of the day at Peet's. No refills.

You might instead want to borrow money. Most of us borrow for a car or a home or a month's supply of JD. In that case, you would pay the interest rate on a car loan or mortgage rate or whatever rate your friendly credit company charges.

Whether a saver or a borrower, you experience interest rates, and the fact is that interest rates are not set by the Fed or the government or even Santa. Interest rates, prices of stocks and peanuts, respond to market forces. If in today's market everyone wants to borrow and no one wants to lend, this tends to raise interest rates. If tomorrow most people are interested in lending and there are few borrowers around, then interest rates fall. We say interest rates are mostly market driven.

A quick look at the blue line (interest rate on a government bond with a 10 year maturity) in the graph below shows you that interest rates have a pretty exciting life. And this graph only shows you 1999 to present. A graph going back to the 1960s would make your head swim. Remember those 20% interest rates in the 1970s?

Okay, so rates are determined by market forces. Where does the Fed come in? Like most government entities, the Fed likes to try to make the world better. The way the Fed does this is to try to raise interest rates when the economy is acting like a runaway train car. Or when the economy gets slow and creepy, the Fed tries to stoke it with lower interest rates.

I keep saying "tries" because the Fed does not tell banks and other financial institutions how much to charge on auto loans or mortgages. But the Fed can try to influence these rates through its control over something called the Federal Funds Rate (FFR). The Fed sets goals for the FFR and can reach those goals by intervening in something called the FF market where bankers loan each other money on a  daily basis. It's too long a story for the blog today but just take it for granted that the Fed can take actions which either decrease or increase the FFR.

The FFR is the red line below. A quick review: the Fed altered policy several times since 1999, first raising the FFR, then reducing it only to raise it again. It bottomed out at the end of 2008 and was kept near zero until recently. November 2015 marks a turning point in which the Fed started raising the FFR. We are told that since the economy is now humming along at about 70 miles per hour, they need to raise rates to cool things off a bit. Plans are to increase the FFR several times into 2018.

Why raise rates? Presumably because a near-zero percent interest is not normal and it tends to penalize savers. Some think it might make savers want to take on too much risk by buying bitcoins or 8-track players. Whatever the reason, the goal today is to raise the FFR. The goal is to have the rise in the FFR spillover and influence all those other market rates. The chart below is instructive in that regard. We can look at the relationship between the FFR and the interest rate on government bonds with a 10-year maturity (I chose this one market rate because there are just too many too choose from and this one has the reputation of being a good indicator of what is happening to most rates.)

Notice in the chart that increases in the FFR do not always result in higher interest rates.
  • After 1999, the FFR increased to almost 7% while the 10-year rate started to rise but then fell.
  • After 2004, the FFR went from 1% to over 5% yet the 10-year rate bobbed up and down like a tuna in a shark tank and ended up only a smidge higher than it has been in the recent past.
  • After 2016, the FFR gently increased while the 10-year rate's downward trend was only interrupted in 2017. But notice that the 10-year rate today remains below its peak value in 2014 and is well below other previous peaks.
Since you are still a bit slow from your New Years' partying, I will refrain from taking this much further. But the obvious question to ask at this point is why the 10 year rate has been so fickle. It is supposed to do what the FFR tells it to do. The bottom line is that market rates are impacted by many things -- psychological and other -- and only one of those many things is the level of the FFR. The chart shows how important markets are to interest rates and why it is possible that Fed policy may not succeed in its goal to protect the US economy from immodest growth. Worth speculating about at George and Wendy's is the long-term downward trend observed in the graph. The 10-year rate has been on a downward slope for about 17 years. I wonder what it will take in the way of Fed policy to reverse that.