Many investors fear that stock prices will plunge when the Fed raises interest rates to “normal levels.” Others say, not to worry, the Fed only controls short-term interest rates, and stock prices depend on long-term rates. Yet others argue that, even if long-term rates do rise, the historical correlation between stocks and bonds is very loose.
Who is right? These arguments are all reasonable, but divert attention from what should matter to value investors.
It is certainly true, other things being equal, that higher interest rates make stocks (and bonds) less valuable.
It is certainly true that the Fed directly controls short-term interest rates, while long-term rates depend on anticipated future Fed policies, inflation expectations, and more.
The alleged failure of Republicans to repeal the mis-named Affordable Care Act (ACA) predictably has the conservative punditry up in arms. “Why Can’t Republicans Get Anything Done?” was one of many frustrated headlines lamenting the GOP’s lack of legislative success. One editorial asserted that Republican failure to ‘do something’ about the ACA “is one of the great political failures in recent U.S. history, and the damage will echo for years.” Really?
Implicit in all the conservative ranting about the need to repeal, or worse, fix the ACA, is that healthcare was a wholly unfettered, dynamic source of free-market driven innovation before President Obama was elected. Let’s try to be serious for a moment.
Repeal of the ACA would have been an impressive headline, but the short and long-term politics of repeal for Republicans would have been worse than doing nothing. That is so because expectations about a looming nirvana would have been created, only for healthcare to at best return to its less-than-stellar-self that existed before passage of the ACA in 2010.
Importantly, none of what’s been written so far should be construed as support of the ACA. It was foolish legislation, and evidence supporting the previous contention is that the ACA was already dying before our eyes. No surprise there. Legislation meant to give some Americans a lot for a little with a lot taken from others in return for very little was bound to fail. The ACA was plainly imploding as the constant rush of insurance companies out of ACA exchanges revealed in bright colors. Why abolish what the laws of economics were already abolishing?
Those who rail against free trade as a job killer are beginning to grasp that they are boxing a shadow. The realization that jobs aren’t going to Mexico or China so much as to robots, digitization, and other technologies has spawned the emergence of a new Ludditism, aimed at saving jobs by stopping or slowing technological advancement. But all it could ‘save’ us from is greater prosperity.
The recognition that Americans (and those in other developed countries) are not being replaced by foreigners so much as by robots has seeped through, spawning a new target. The same job-protection impulse that drives opposition to free trade is being directed against the technologies that are actually causing dislocation in the workforce, and it is just as misplaced and counter-productive. In New York, cab companies are demanding a ban on self-driving cars, citing job losses. One group is even calling for a 50-year moratorium to be placed on autonomous vehicles. Elsewhere, taxi companies are trying to block ridesharing services with human drivers. Microsoft founder Bill Gates has even suggested that robots be taxed to help humans keep their jobs, or pay for adjustment costs.
Let’s skip quickly over the hypocrisy inherent in such arguments: In the early 1980s, when Microsoft was getting off the ground, should we have imposed a tax on computer software, which also makes many jobs redundant? A century ago, should we have imposed a 50-year-ban on automobiles, to protect the jobs of drivers of Hansom cabs? And if we had, would Gates and cab plate owners – and the rest of us – be better or worse off today?
More importantly, trying to stand in the way of new technologies to save jobs is self-defeating. Both improved living standards and social stability depend on constant economic growth. Either we continuously bake a bigger pie, or we end up fighting over the crumbs. Economic growth, in turn, depends on improved productivity, which depends on leveraging technology –– to reduce the amount of labor, capital, energy or materials that go into producing goods. Virtually every new technology from the spinning wheel to the combine to digitization has eliminated somebody’s job, which is why technological progress has continuously prompted many to attempt to stand in the way and shout ‘halt’, going back even before the original luddites tried to destroy weaving machines in 19th-century England. But banning any technology would have made us all poorer today. An American worker today earns more (in terms of buying power) in 10 minutes of work than mid-19th century English mill workers earned in a 12-hour day. Technology has made us more productive, and improved productivity has made us better off.
“We have to get this done in 2017.”
In a major speech last month, House Speaker Paul Ryan didn’t mince words when it came to the urgent need to revamp our federal tax code, outlining what he deemed “transformational tax reform.” Congress and the White House should heed this call to action, as not doing so would be a major blow to families, businesses of all sizes, and our economy.
Over the last thirty-plus years, the tax code has become mired in complexity, loopholes, and inefficiency. Washington has stood idly by while the rest of the world modernized their tax systems to keep pace with an ever-changing global marketplace. Lawmakers must reject our status quo tax code, lest we fall further behind.
To hear Richard Reeves tell it, the upper middle class is fast becoming the bane of American society. Its members have entrenched themselves just below the top 1 percent and protect their privileged position through public policy and private behavior. Americans cherish the belief that they live in a mobile society, where hard work and imagination are rewarded. The upper middle class is destroying this faith, because it’s impeding poorer Americans from getting ahead.
That conclusion is dead wrong, but it contains just enough truth to seem plausible. We need to separate fact from fiction.
Reeves, a scholar at the Brookings Institution, makes his case in a new book titled “Dream Hoarders,” as in the American Dream. The hoarding refers to all the economic opportunities that the upper middle class is allegedly manipulating for itself. Zoning restrictions segregate it into economically homogeneous neighborhoods, with the best schools. This provides an advantage in getting into selective colleges, leading to better internships and jobs.
All this is self-perpetuating, Reeves says. Class structure is becoming frozen. Downward mobility from the top is limited. Upper-middle-class parents are obsessed with supporting their children, from helping with homework to teaching bike-riding. The story seems so compelling that it could become conventional wisdom. Parents are destiny. Just recently, David Brooks, the influential New York Times columnist, bought into most of Reeves’s theory.
A central aspect of the U.S. Senate’s “Byrd Rule” is biased against tax relief, and it needs to be tossed out.
With the battle over repealing ObamaCare, we’ve heard a good deal this year about “budget reconciliation.” What is this arcane federal budget term? Quite simply, budget reconciliation means that the U.S. House of Representatives and the Senate hammer out, in effect, a budget outline that provides marching orders for various House committees dealing with the budget. Eventually, an omnibus budget bill is voted on. Budget reconciliation operates under expedited procedures, including being subject to only a majority vote in the Senate, that is, no filibuster.
Reconciliation was first adopted in the Congressional Budget Act of 1974. But the process was quickly abused – how shocking! – with non-budget issues being slipped into the reconciliation process. These “extraneous” issues led to adoption of the “Byrd Rule,” named for Senator Robert Byrd, Democrat of West Virginia, in the mid-1980s, and being integrated into the Congressional Budget Act in 1990.
So far, so good, right? Well, no.
When last we left Citibank, it was in the middle of 2014 very briefly overtaking JP Morgan for the top spot in derivatives dealing. For the longest time, ages even, JPM ruled that space due to the nature of its business. As the primary triparty custodian in repo as well as the many other money dealing activities the bank sat on top of, to find them so far out in advance of all the others simply made sense.
According to bank call reports aggregated and published by the Office of the Comptroller of the Currency (OCC), at the apex of this eurodollar world in Q3 2007, JP Morgan showed $91.7 trillion in gross notionals, primarily interest rate swaps but including also a (un)healthy dose of credit derivatives. That was up from $48.3 trillion just two years earlier. To be king, you had to expand by all means – parabolically even.
JPM’s nearest competitor, Citi, was doing much the same just not as fast. By Q3 2007, that bank’s derivative book had reached $34.0 trillion, up from $20 trillion in the same two years.
For JP Morgan, that was it. There was going no further than that level of what is true leverage, if unaccounted for and off in the shadows. It wasn’t and isn’t strictly leverage for itself, rather systemic capacity offered to the rest of the global monetary system to achieve monetary ends. By the middle of 2014, it had cut back in that offered capacity to $68.1 trillion, allowing Citigroup for one quarter to get ahead.
Over the past several years, even as the national fervor over startups has continued unabated, there has been a string of negative findings about the state of American entrepreneurship. The Economic Innovation Group, among others, chronicled a long-term decline in business creation as well as ever-increasing concentration in where businesses are being created. Only five metro areas, they found, accounted for half of the nation’s increase in new businesses between 2010 and 2014. Other researchers have found similar declines across several indicators of economic dynamism—fewer and fewer Americans, for example, work for new and young firms.
Happily, a recent report by Michael Mandel at the Progressive Policy Institute (PPI) highlighted a potential reversal of these trends. (Full disclosure: I have a PPI affiliation.)
Using government data, Mandel charts a “revival of economic dynamism” since 2015 that is fairly widespread: by last year, the “growth gap” between tech hubs in Silicon Valley, New York, Boston, Austin had disappeared.
Cleverly, Mandel also used online job postings to devise a Metro Startup Economy Index to compare startup activity across the country. While the tech hubs dominate this index, Mandel finds encouraging signs of startup activity in what he calls the “Next in Tech” metros. These include Atlanta, Phoenix, and New Orleans. Indeed, in early May, thousands of people descended on New Orleans for Collision, which bills itself as “America’s fastest growing tech conference.”
US measures of core inflation fell from February through May. The US reports June CPI at the end of the week. There is a reasonable chance that the core rate stabilizes. However, the movement away from the target has spurred expressions of caution from numerous Fed officials, even though the minutes of the June FOMC meeting showed that most officials recognized transitory factors weighed on prices.
A careful reading of Fed comments led us to conclude that a consensus on reducing the balance sheet was intact, though a consensus for another hike may prove more difficult until there is more evidence for the official suspicion. Hence we look for the FOMC meeting in a fortnight to only modestly tweak the statement. In September we expect the Fed to announce that it will begin implementing its strategy to gradually reduce its balance sheet starting in October. Depending on the evolution of the economy and inflation, a third rate hike for the year could be delivered in December.
For the same of this exercise, let's assume that there is no chance of a hike before December. No chance may exaggerate it a bit, but probably not very much and it makes for a simpler exercise. Fed funds would likely trade around current levels, which is 116 bp on an average effective basis. This is what is averages for the first 12 days of December. On December 12, if the Fed were to hike rates, we should assume that the new effective average would by 25 bp higher or 141 bp.
That average could last 16 days to Friday, December 29. The effective average rate for the last trading day of the year typically falls post-crisis. Last year it fell by 11 bp. If we assume that the effective rate does the same thing this year, and recognizing that the Dec 29 effective average rate is the same for December 20 and 31, the weekend, Fed funds average 130 bp for the last three days of the month. When you do the math with these points, the outcome is an average of 130.25 bp for the month.
During a 2005 visit with Andy Kessler, the investor, writer and speaker extraordinaire imparted some wisdom to me that’s never been forgotten: the second best answer in the world is no. As Kessler explained it, “no” brings with it certainty that frees those rejected to move on in productive fashion.
Kessler’s thinking came to mind while reading investor, futurist and political economist Russell Redenbaugh’s memoir and motivational book, Shift the Narrative. Redenbaugh has long embraced the finality of life’s seemingly cruelest verdicts, only to ascend to greater and greater career and personal heights.
Redenbaugh’s story begins when he was sixteen, and experimenting with homemade rockets in the garage of his family’s Salt Lake City home. An errant spark led to a thunderous explosion that nearly killed him. He lost an eye, retained partial sight in the other, lost most of his left hand, and retained limited use of his right.
Eight months later, and after countless surgeries on his partially working eye, Redenbaugh heard the verdict on his remaining sight as told to his inconsolable mother: “We have done all that we can do. He will be blind for the rest of his life.” What’s amazing is how the patient responded to news that would perhaps cause most to give up. Redenbaugh was relieved.
Those who complain about jobs ‘lost’ to offshoring generally don’t consider that the purpose of working is to consume. Offshoring production to other jurisdictions helps us to make the goods and services we use as efficiently as possible, by casting the widest possible net for the most economic way to fulfill each stage of production. The alternative to offshoring is to pursue autarky and build a closed economy. How well has that worked out?
Not very well, as the experience of the old German Democratic Republic demonstrates. The division of Germany after World War II offered a virtual equivalent of a controlled experiment to determine the effectiveness of closed and open economies at creating wealth. While West Germany sought to import what it needed to prosper, East Germany tried to create an economy that offered a virtual mirror image of the world, creating and producing many goods even if they could be obtained at less cost by importing. While East Germany sought self-sufficiency, West Germany pursued interdependence. Which model worked better?
One of the best examples of the GDR’s pursuit of self-sufficiency was its attempt to achieve a competitive edge in microchips – matching the resources that could be marshalled by a state of just 16 million people against the research and development and production resources of the entire western world. The predictable result? From the time East Germany first attempted to pursue a microchip industry in 1977 to the time the Berlin Wall came down, mission microchip swallowed increasing amounts of internal resources and hard currency – at a cost that far exceeded the alternative of simply importing the component. The East German economy expended 40 marks to make each 40kb microchip, which it could have purchased from the United States or Japan for just 1 or 2 marks. Producing each 256kb chip cost 534 marks, more than 130 times what it would have cost to import from the West. The great leap forward turned out to be a giant leap backward, squandering human and material resources rather than making the most of them.
The East German regime may have thought that their costly investment yielded dividends in the form of jobs. But the costly gamble actually diverted resources that would have been more efficiently deployed in other sectors. They forgot one of the most important principles of wealth creation: Human beings are a resource, capable of producing a number of things. Utilizing that resource to make something that is available less expensively from elsewhere isn’t making the most of human resources, it is wasting them. The East German failure to establish a competitive microchip industry demonstrates that fact, and illustrates why globalization – not economic insularity – is the basis for maximum wealth creation and improved standards of living.
* Opportunities are being created
"Buy at the sound of cannons? If the overall market corrects, as I suspect it will over the next few months, the more traditional brick-and-mortar retail stocks likely will fall back into the bargain bin and could provide a profitable entry point ... The disintermediation of old-line, bricks-and-mortar retailers provides longer-term opportunities for those who buy the right companies at reasonable prices."
--Kass Diary, "How to Profit From Shifting Retail Distribution Channels," January, 2017
The performance of retail stocks on Monday can be described in two words: a debacle.
"Hello darkness, my old friend
I've come to talk with you again
Because a vision softly creeping
Left its seeds while I was sleeping
And the vision that was planted in my brain
Within the sound of silence"
--Simon and Garfunkel, "The Sound of Silence"
At a time in which valuations are stretched, the base case is becoming vague and hard to predict as there is the emergence of numerous and uncertain market, economic, geopolitical and political outcomes.
Risk is being underpriced and volatility likely will be on the rise in currencies, bonds and stocks:
The 19th-century French economist Frédéric Bastiat demonstrated the folly of dirigisme economics through a fictional tale in which candle makers lobbied government to block out the sun because its natural light was hurting their sales. But suddenly the satire doesn’t seem so funny anymore. A couple of solar panel manufacturers have petitioned for duties that would dramatically increase the cost of solar panels and cells in the United States, a move that threatens to block out sunlight as a source of power for millions of Americans – and trigger a global trade war.
While it has been said that nothing succeeds like success, the growing demand for solar energy has led to failure for some panel and cell manufacturing firms that have been unable to compete at declining prices. But consumers have benefited. As the price of panels and cells has gone down over the past few years – about 60 percent since 2012 according to some estimates – the amount of solar generation in the United States has gone up. Between 2014 and 2016, generation from small-scale solar projects nearly doubled. It increased 72 percent from utility-scale installations between 2010 and 2016. That results from improved technologies, which drive down a good’s price and increases access to consumers. In Bastiat’s time, for example, the cost of candle-making declined dramatically with improved technology and manufacturing, allowing candles – once a prerogative of the rich – to become an affordable commodity for the masses.
Similarly, solar has been growing into a mass market. But even as dropping prices benefit millions of consumers, they threaten the profits of some manufacturers. Just as Woody Allen once observed there are no atheists during final exams, there seem to be no free traders at a failing company. Sunviva, a manufacturer of solar cells and modules that filed for restructuring two months ago after losing $50 million over two years, has petitioned the International Trade Commission for government intervention. But relief for the Atlanta-based manufacturer would come at a steep cost to the rest of the industry and to consumers, including utilities. Under a little-used section of the trade law that allows imposition of global duties rather than actions against a specific country, the company is seeking a price floor of 78 cents a watt for imported solar panels and import duties of 40 cents a watt on solar cells, which currently go for 25 to 33 cents a watt. The impact on utility-scale developers would be enormous, driving up solar module prices in the U.S. market almost 50 percent, according to solar analysts with GTM Research. The impact on consumers would be costly. Duties would cause Americans to pay more for solar power than any country in the world.
If the ITC approves the petition, it would be up to President Trump to decide on proposed duties. The ITC and the President should think twice before they go head with such a move. Using the same section of the trade law, President George W. Bush reacted to competitive problems in the U.S. steel industry in 2002 by imposing tariffs, which he lifted ahead of schedule in 2003. A study concluded that higher steel prices cost the United States 200,000 jobs – more than 6 times as many as the steel industry claimed the tariffs saved. Many small machine-tool and metal stamping shops were decimated by steel costs that rose as much as 30 percent.
Faced with a protectionist U.S. Administration, the G20 for the first time issued a final statement that included the concept that trade must be “reciprocal.” There are advantages to reciprocity, of course. But the truth is, even if a country reduced trade barriers unilaterally, without any guarantee of reciprocal access for its goods, its people would be better off. The biggest advantage of free trade isn’t that it makes it easier for us to export – it is that it makes it easier for us to import.
Obviously, any discussion of free trade should concede the obvious: Free trade is better when it is reciprocal because a wider circle of people get to enjoy its benefits – economies of scale, increased specialization, improved technology transfer, wider choice, and enhanced competition. But those benefits do not flow exclusively to countries based solely on enhanced potential to export. They flow to countries that open up their markets. Unrestricted trade makes it easier for consumers, because it gives them the option of purchasing imports, makes it more efficient for domestic producers to source inputs, and pressures suppliers all the way down the chain to drive down prices and improve service.
Given that the advantages of free trade are obtained by any country that embraces it, why should adopting it depend on reciprocity? When Great Britain adopted free trade in 1846 by abolishing the Corn Laws, it did so unilaterally. The Brits did not demand that any other country match its move to free trade. They wanted, instead, to curb spiraling food prices that had exacerbated the Irish famine. The result of Great Britain’s unilateral embrace of free trade? Food prices went down, the cost of living declined, manufacturers were better able to afford workers’ wages – and Great Britain prospered.
Why then has reciprocity become a commonly-accepted basis for free trade? Partly because if a country were to embrace unilateral free trade, it would give up its seat at the table. Left with no concessions to make, politicians would have no bait to draw potential trade partners. But even more importantly, tit-for-tat trade concessions make it easier to sell an agreement. If governments tried to sell free trade because it makes it easier to import, many would agree – but few would be motivated to actively support a deal. However, when government sells free trade on the basis of how may jobs it can supposedly create, many are inclined to buy in. But, as is often the case in economics, the truth is counter-intuitive. We improve our standard of living based on how we fare as consumers. It is increased choice and reduced costs that drive forward our economic lifestyles, and they depend on our ability to import.
Donald Trump's foreign policy, such as it is, rests on a massive and apparently indestructible contradiction. Trump wants the United States to remain the "essential" nation, the best embodiment of Western ideals of freedom and democracy, while at the same time deliberately alienating many of our traditional "allies," whose support the United States desperately needs. American leadership becomes difficult, if not impossible.
It is hard to straddle this contradiction, because it reflects a basic misunderstanding of the American "greatness" that Trump so avidly pursues. To Trump, this greatness is mainly measured in economic terms: the number of added jobs; the trajectory of wages; the rate of economic growth. It is a nostalgic and unrealistic yearning for the economic dominance the United States enjoyed in the 1950s and 1960s.
The truth is that American greatness then and later was never about dollars and cents alone. Prosperity was a means to an end, not an end in itself. The greater objective was to promote democracy and mixed economies, with power divided between the market and government. To advance this vision, the United States advocated open trade and provided a military umbrella. The latter created a geopolitical shield against instability.
Trump sees the costs of these programs as showing that past U.S. leaders were willing to sacrifice the interests of ordinary Americans to meaningless global cooperation. U.S. officials negotiated horrible trade deals; American workers lost their jobs to imports; our putative allies didn't pick up their fair share of military spending. These "allies" were rivals, not partners.
A few years back, in one of his finest moments, Senator John McCain said on a Sunday talk show that “Russia is a gas station masquerading as a country.” It was right when he said it, and it’s even more right today.
Vladimir Putin’s circle of corrupt oligarchs gouge whatever money they can from the impoverished Russian economy and move it to bank accounts overseas. And they do this after giving Putin his cut, after which he apparently also sends the money overseas.
Many say Putin is the richest man in Russia, worth billions and billions. So the old Soviet model of the nomenklaturacommunist bureaucrats getting rich while the rest of the country declines is still in place.
But with energy prices falling, Vladimir Putin’s Russia has essentially been in a recession over the past four years. With oil at $50 a barrel or less, Russian budgets plunge deeper into debt. It’s even doubtful the Russians have enough money to upgrade their military-energy industrial complex.
Sometimes people do inhumane things. The Senate health care bill is a case in point. It denies health care to a large group of poor, disabled, and elderly Americans to give a big tax cut to a small group of very wealthy people.
But are Senate Republicans evil people? Do they lack a moral compass? I don’t think so. I think they are simply victims of a once-successful but now discredited economic ideology. That ideology says tax cuts for the rich will create jobs for the middle class. It says cutting benefits, including health benefits, for the poor will cause them to work harder and behave more responsibly. Granted there is a grain of truth in these propositions but they have now become a cartoon of their once-legitimate, Chicago-school ancestors.
Republicans have become trapped in their own rhetoric, crafted during years of being in opposition. As Ross Douthat noted in a recent New York Times column, drawing on new analysis in a report by Lee Drutman, that rhetoric is now well to the right of the beliefs held by the broader Republican electorate. Republican leaders have failed to recognize the fact that the economic views of those who voted Republican in 2016 “lean only slightly to the right.” Republicans could have used the Trump election to effect a political realignment—one that would have combined a more moderate set of economic policies than the Republican elite currently supports with a more moderate set of cultural positions than those espoused by leading Democrats.
Instead, the Republican elites are now out-of-step with their followers and could pay a big political price if they continue down their current path. Where are the new ideas that might free them and us from our current impasse? Are there ideas that might even command some bipartisan support and help to move the country in a more pragmatic and centrist direction?
"Sell in May and Go Away" didn't work, but "Selling in July Before It Gets Ugly" may be the right investment decision now.
The preconditions for a market correction, as articulated in "My Top 10 Reasons Market Lambs Should Be
Scared of a Slaughter," and even the end of the eight-year bull market are potentially in place. Here's why:
* An Early Seder Might May Be Upon Us: Answer my eight, important questions.
In the common perception, the Federal Reserve is all that matters in terms of dollar money. So when the central bank’s executive policy board, the Federal Open Market Committee, decides to change stance it is largely assumed a matter long ago decided. They command; the market does. Even the name of that body plays into this assumption. All the textbooks say that the money supply is controlled through open market operations.
It has never been asked, or quite rarely pondered, how that is supposed to work via federal funds. If the FOMC votes to raise rates, as they have three times over the past six months, then it is believed to be tightening. But the world does not run on a tautology, where simply saying the Fed is tightening means the Fed is tightening. What goes on underneath does matter.
It is, in fact, right now contradictory. In the minutes of its last policy meeting, one where last the federal funds “corridor” was raised 25 bps both top and bottom, there was some unknown level of discussion about this opposite state of markets.
“They also noted that, according to some measures, financial conditions had eased even as the Committee reduced policy accommodation and market participants continued to expect further steps to tighten monetary policy. Participants discussed possible reasons why financial conditions had not tightened.”