shifting Federal Reserve priorities

long-term unemployed

For some time the Fed has made it clear that its number one priority has been the economic well-being of the millions of workers laid off during the Great Recession who have yet to find work again.  The Fed’s worry is that the longer this group stays unemployed the greater the chances it will morph into a permanent underclass of the type Europe has long had.

Recently, the Fed has been increasingly vocal about the fact that monetary policy can do little for these incipient lost economic souls.  Their rescue is really a job for fiscal policy that promotes job creation–say, reform of the tax code or infrastructure spending–sound advice that is falling on deaf Congressional and White House ears.

shifting gears

The Fed’s priorities appear to be changing, however.  It’s primary focus is shifting to preparing financial markets for a long journey away from today’s emergency-low interest rates to more normal (that is, higher) ones.  The agency is doing this in its usual indirect way.  It has been so long since investors have had to contemplate a higher cost of money, however, that many may not understand the ritual dance that is now beginning.

Fed signals

So far, the signaling has included:

–remarks by outgoing Fed Chairman, Ben Bernanke,

–discussion by other ranking Fed officials,

–mention in Fed meeting notes,

–hints dropped to favored reporters and columnists.  Their identities as conduits for Fed information are well-known to Fed watchers, who immediately understand the true source of the reporters’ statements.

its purpose

The idea is to get the markets to start to move by themselves in the direction the Fed wants.  That way Fed interest rate hikes seem to be only validating positions the markets are already taking, something the Fed prefers.

Two factors make this process more daunting than usual:

–bond investors have been conditioned for over three decades to think that interest rates only go down,

–in the Fed’s view, overnight money has to rise by more that 400 basis points to get back to “normal,” a huge move that will likely take place over several years.

The real trick will be to prevent bond market from rushing ahead and making the entire move in one leap once investors figure out what’s going on.  It seems to me that this is the purpose of the apparent Fed “confusion.”  It’s deliberate–and it’s intention is to get the interest rate train rolling without gathering too much of a head of steam.

the 21st century stock market cycle

Last Friday, I started to write about the stock market cycle, prompted by a phone call from my younger son.  This is the second installment.

the old model

In a closed economy, unaffected by imports and exports and untroubled by external shocks, the cyclical rhythms of GDP growth–and therefore of the stock market–are controlled by the government.  In the US this has meant, theoretically at least, applying stimulus when GDP begins to falter and taking it away when the economy begins to expand at an unsustainably high rate.  The peak-to-peak or trough-to trough cycle that this action produces has averaged about four years during the post-WW II period–broken out into 2 1/2 years of up and 1 1/2 years of down.

Not over the past two decades, though.

the world has changed

After almost a half-century of globalization–of governments forging ever stronger economic links with one another–the rest of the world is much more important than previously to almost any nation’s domestic stock market.

In the case of the US, the available data suggest that only about half of the profits of S&P companies now come from the domestic economy.  The rest derive in roughly equal amounts from Europe and from the Pacific + other emerging areas.

Surprisingly, this increased economic openness hasn’t been an important disrupter of the US stock market cycle so far.  The culprit has been government policy instead.

policy mistakes in the US

In hindsight, Alan Greenspan made a series of monetary blunders in the 1990s and early 2000s that extended economic cycles but created in both cases stock market/economic bubbles that ultimately collapsed of their own weight.  The damage these collapsing bubbles created was severe.

1997-1999:  the internet bubble

In 1997, a banking crisis in heavily indebted Thailand began to spread to other smaller Asian economies.  Mr. Greenspan chose to open the domestic money taps to offset possible negative economic effects on the US, at a time when domestic considerations alone would have had him either neutral or tightening.  Two years later, he expanded the money supply further.  He feared the possible economic disaster that might occur if all the world’s electronic devices stopped working on January 1, 2000–as prophets of doom like Ed Yardeni were predicting (horse-drawn plows were in short supply, for example, as survivalists planned for a post-Y2K apocalypse).

These actions, however, also allowed the Internet Bubble to form.  That was a heady concoction of hype and fraud concocted by investment banks and the loony predictions of internet “analysts” like Henry Blodget (subsequently barred from the securities business) and Mary Meeker. The bubble collapsed when earnings reports showed the so-called TMT business had begun to contract in early 2000, not expand.

2003-2007:  the housing bubble

This was a much more devastating episode and a much more complex one.

–The Fed supplied the easy money.

–Mr. Greenspan failed to supervise the mortgage industry the way he was supposed to.  “Liars loans” proliferated.

–Congress, which had barred commercial banks from the securities business for their role in causing the Great Depression, let them back into the fray during the late Clinton years–just in time to work their “magic” again.

–Bank and securities regulators failed to stop the spread of complex, badly understood–but nonetheless toxic–derivative securities spawned by commercial and investment banks.

The resulting house of cards began to implode as large numbers of borrowers were unable to make their mortgage payments.

flying by the seat of our pants

That’s where we are now, I think.

The old four-year economic cycle idea hasn’t worked recently.  I don’t see much to generalize from in the two most recent cycles that would provide a framework to replace it. Both downturns were caused by systematic shocks.  But both emanated from the US.  Both had excessively easy money policy at their root.  The Great Recession added in regulatory and Congressional incompetence.

The only practical tool I can see is the general principle that government policy is accommodative while the greater worry is economic weakness.  It turns contractionary (and upward stock market movement ends) when the greater fear is inflation.

Despite my periodic worries about the apparently high current level of the S&P, I think we’re still in accommodative mode, not contractionary.

One other comment:  given that interest rates are zero and that Washington is dysfunctional, the US is especially vulnerable at present to external shocks–though I see none on the horizon and have no strong ideas of when/where one might arise.

current Intel (INTC) strength

I haven’t had the time over the weekend to give the topic of the 21st century stock market cycle will look like the time and attention it deserves–tomorrow, I hope.  Fathers Day with my family and the wedding of the daughter of close friends have shattered my good intentions.  A brief note about INTC instead.


INTC has been a pretty terrible stock in the two years or so I’ve owned it.  Yes, it has gone up.  But so has the market–and the latter by a much larger amount.

INTC made an immense leap from just above $19 a share in August 2011 to briefly stick its head above $28 in April 2012.  But then it gave just about all the advance back as it became clear that no major manufacturer of mobile devices was going to take the chance last year of putting INTC microprocessors in its devices.  INTC chips were still too big and too power-hungry, despite the enormous amounts of money the company had spent–and continues to spend–on R&D and new production facilities.

differences today

A year later, the story is basically the same, waiting for success in the mobile arena, with four differences:

–the market appears to be rotating away from high-dividend defensive issues toward the tech sector,

–INTC’s newest chips are smaller, much more powerful, generate less heat and use less battery than last year’s

–PC makers appear to be making a competitive response to the appeal of tablets (cheap + instant-on) by lowering prices and coming out with tablet-like devices that have significantly more power, and

–INTC has its first “real” customer for a tablet chip–Samsung.

It isn’t all clear sailing yet for INTC.  Some holders, fearing a repeat of the price action of 2012, will be tempted to declare victory and sell.  So far, they’re in the minority.  As for me, I’m content for now to wait and watch.

economic/stock market cycle: 4 years or 8?

phone call from sunny CA

My younger son called the other day to talk about the stock market.  He reminded me that I had often spoken as he was growing up about the four-year stock market cycle seen in the US.  It’s sometimes called the presidential election cycle, from the belief that the sitting president injects PEDs into the economy in the fourth year of his term to aid his reelection bid.  It’s also called the inventory cycle.

the traditional four-year market cycle

The idea behind this is that in the post-WW II US the typical period of business cycle expansion, during which government policy is to stimulate growth, has lasted about 2 1/2 years.  As we reach full employment and upward wage pressure commences, the policy stance reverses.  Interest rates rise; the economy slows–and sometimes contracts.  This latter period lasts around 1 1/2 years.

The stock market exhibits the same behavior–2 1/2 years of up followed by 1 1/2 years of down–but leads the economy by about six months.

a rule of thumb

The four-year cyclical pattern generates a practical rule for investors:

–when the stock market has been rising for two years, start thinking about becoming more defensive, and

–when the market has been falling for a year, think about becoming more aggressive.

the eight-year cycle

The point of my son’s phone call is that this traditional pattern can’t be found in charts of market action for almost two decades.  It has been replaced instead by an eight year cycle–5 1/2 years of up, followed by 2 1/2 years of down.  More importantly, two months ago, we entered the fifth year of rising market.

His conclusion from looking at the charts:  early in 2014 the S&P will hit the skids.


This is a very interesting thought, even if it turns out not to be correct.  It makes you stop looking the leaves on individual trees and start to think about the shape of the forest as a whole.


Is the stock market situation today substantially different from the tail end of the internet bubble of 1999, or of the emergence of the mortgage fiasco/financial crisis of 2008?  If so, what are those differences?   …can we conclude that today’s story will end up any better than those two did?

I think there are key differences.

More about this on Monday.



to raise cash or not

raising cash

I find myself raising 10%-15% cash in the taxable joint brokerage account my wife and I use to pay for much of our living expenses.  No change in our fully invested stance in our IRAs or 401ks, just the taxable account.

Thirty years of professional training and experience tell me this is always a mistake.  But I’m doing it anyway.

why pros don’t do this

The easy answer is that pros typically can’t.  Their contracts with pension funds routinely require that the managers they hire remain fully invested.  The idea is that the pension fund and its consultants control the asset allocation (thereby justifying paying themselves the big bucks) and parcel out various pieces of the overall portfolio to specialists.  If managers stray from the asset classes where they’re experts they risk mucking up the overall asset allocation strategy.

Although mutual fund charters usually offer much more leeway, the manager will be pilloried if he raises a large amount of cash and the market goes up.

More importantly:

–to make a significant difference in performance, you have to raise a ton of cash–30%-40% of the portfolio at least.  This turns the portfolio into a Las Vegas-like all-or-nothing bet.

–I’ve never met an equity professional who’s any good at timing the market.  People tend to either understand either market bottoms very well–when to invest aggressively–or market tops–when to become defensive–but not both.  So they either raise cash much too early, or they get that timing right and never put the money back to work.  In either case, the cash-raising exercise tends to backfire.

This doesn’t mean there aren’t any successful market timers.  I just don’t know, or know of, any.  And I’ve seen lots of managers punch big holes in the bottom of their performance boats by trying their hand.

–the desire to raise cash invariably comes at times of stress and high emotion.  Emotional decisions in investing are almost always bad ones.

what pros do (or should do) instead

Make the portfolio less aggressive, so it will perform better in a downturn.  Eliminate speculative, smaller-cap, or highly economically sensitive names.

Look harder for new names.  If everything in the industries you feel most comfortable in looks too expensive, broaden your scope to include other sectors.

Go on vacation.

If you absolutely have to sell something (for your own emotional well-being), do it in small enough size that it won’t do much damage.

why I’m ignoring my own advice

Several reasons:

–low interest rates have forced me into a very high equity allocation

–in this account, I’m more interested in having money on hand to pay bills than in beating the S&P.  So I’m willing to accept underperformance.

–history says that stocks go sideways to up during periods when the Fed is removing emergency money stimulus from the economy.  I think this should hold true again.  On the other hand, while stocks appear reasonably priced to me, the size of the interest rate raise now underway is about double the normal size.  So there is an uncharted waters aspect to this Fed move.

Also, the tone of the market seems to me to be increasingly set by short-term traders who don’t have the skill or temperament needed to analyze economic fundamentals.  Their behavior is harder to predict with confidence–just look at what’s going on in Japan.

the late 1970s: the last real inflationary period in the US

inflation in the 1970s

The most recent US experience with a real inflationary spiral came in the late 1970s.  In early 1977, prices were rising at a 5% annual rate.  A year later, inflation was running at 7%.  A year after that, the number was 9%, with 14% posted in early 1980.  Then Paul Volcker was appointed as Fed chairman.  He pushed the Fed Funds rate from 11% to 20%, creating a deep recession but breaking the back of the inflationary psychology that was feeding the accelerating rate of price rises.

There’s an academic debate, itself with political dimensions, as to what caused the spiral in the first place.  One side says it was a series of mistakes by the Fed, whose inflation forecasts were systematically too low–that therefore its setting of short-term interest rates(the main tool it used to regulate the economy) was, too.  The other side says it was Washington’s political meddling.

who lived through it?

If you were in your mid-twenties in 1975, when the world was just emerging from a horrible recession (the UK had to call in the IMF to rescue its economy), and the subsequent inflation problem was just being ignited, you’d be in your sixties now.

In other words, virtually all commentators about the perils of inflation today have no practical experience with the phenomenon.  Most of them are clueless.

two parts to runaway inflation

In my view, for what it’s worth, runaway inflation has two characteristics:

1.  money policy that’s too accommodative (read:  interest rates are too low), and that stays that way in the face of rising inflation, and

2.  a resulting mindset change that accepts rising inflation as a fact of life and seeks to benefit from it.

how people deal with rising inflation

I’ve seen this behavior in the US in the late 1970s, and also in high-inflation emerging economies around the world since then:

1.  The price of everything is going to be higher tomorrow than it is today. So you should buy now, rather than wait.  That’s true of everything …houses, cars, clothes, appliances.  If you have to borrow, do it!  In fact, if you can borrow at a fixed rate, inflation will probably soon make the loan look like a gift from the lender and you’ll profit from that, too.

Companies will load up on extra raw materials inventories, expecting to profit from holding them while prices rise.

2.  Workers will look for protection from inflation through contracts where wages are indexed for inflation (wages will rise in lockstep with the general price level). Companies will look for the same in multi-year sales agreements. Many contracts signed in the 1970s had prices indexed to the CPI or other indices that overstate inflation.  Good for the seller, but this also added to the inflation problem.

3.  Economists talk a lot about “money illusion,” the idea that most people can’t figure out how fast prices are rising.  So they’re satisfied with, say, a 5% raise when prices are going up by 8%.  In reality, that’s a 3% wage cut, after inflation.  Of course, once you’re aware of this possibility, you’ll ask for a 10% pay increase–fueling the inflationary fires.

4.  Investors of all stripes will look for assets that will protect them from rising prices.  Typically, these would be physical things, like property, oil and gas or metals.  At the same time, they’ll shun financial assets.  Investors may even short financial assets by borrowing heavily, at fixed rates when possible.

In fact, in the late 1970s many companies made what turned out to be disastrous acquisitions as they tried to work the inflation game, with, say, an industrial parts maker borrowing heavily to buy a coal mine or a chain of hotels.  These turned into almost certain recipes for Chapter 11 after inflation was tamed.

At one time in Brazil, investors bought used cars and stacked them up in their back yards as inflation hedges.  Sounded good at the time, but…

5.  Stock market investors will look for hard-asset companies or firms that can grow their profits at a faster rate than nominal GDP.  This excludes most defensive industries, like telecom or gas/electric utilities, where rates of return on investment are regulated, or like staples, where large price increases cause consumers to look for cheaper substitutes.

an alternate reality

Sounds like an alternate reality?  I think so.

But that’s the point.  It shows how far away from an inflationary environment we are today.

today’s potential inflation threat

Yesterday I wrote about inflation in general.  My two-post idea has morphed into three, though.  Today I’ll write about the current situation.  Tomorrow, I’ll write about what happened during the last bout of runaway inflation the US experienced, in the late 1970s.

why are the money taps wide open?

It’s partly because we’re wrapping up the fourth year of recovery from the economic lows of 2009 and still have about three million people (2% of the workforce) unemployed.  In those workers lives, today is a repeat of the depression of the 1930s.

As Fed Chairman Bernanke has been saying in testimony to Congress with increasing force, the Fed is not well-equipped to prevent them from becoming part of a European-style permanent underclass.  That’s a job for fiscal policy shaped by the administration and for Congress–stuff like reforming the tax code to stimulate new business formation, or infrastructure spending, or retraining.

But Washington has no interest, leaving the Fed money policy, which is legally obligated through its “dual mandate” to try to maintain full employment, as the only option.  (The Fed’s other mandate, by the way, is to try to create the highest sustainable–meaning non-inflationary–level of GDP growth.)

unemployment is a bigger economic threat than inflation,

in the Fed’s view.  Therefore it feels justified in maintaining its massive money stimulus.

can the situation change?

Inflation in a developed economy starts up when there are more job openings than there are people to fill them.  Companies then begin to headhunt workers away from rivals with large wage increases.  Fast-rising wage levels–together with newly-flush workers’ relative indifference to paying more for things–are what creates overall inflation to spring up.

monitoring the unemployment rate

One way of keeping an eye out for incipient inflationary impulses is to keep track of changes in working hours and wages.  The Bureau of Labor Statistics does this.  The Fed also uses the unemployment rate as its key leading indicator of wages.  The rationale is that it’s hard for a worker to ask for a big raise while there’s a long line of qualified unemployed eager to do the work for the current wage–or less.

one big assumption

Over the past few years there’s been a continuing debate among economists as to how much of the current unemployment is cyclical and how much is structural.

“Cyclical” means that the workers have skills employers want but business in general isn’t strong enough to justify adding staff.  “Structural” means that a potential worker is unemployed because he doesn’t have the skills employers want.  Maybe he can’t use a computer, for example.

The Bureau of Labor Statistics tries to help measure the difference between cyclical and structural through its JOLTS (Job Openings and Labor Turnover Survey) reports.  These show the number of job openings in the US that are currently unfilled.  A new JOLT report comes out at 10am Eastern time today.  The previous one, from May 24th, shows 3.5 million unfilled jobs in the US.  That’s about 10% below the pre-Great Recession highs.  It’s also 75% above the mid-2009 lows of 2.0 million.

to my mind, the JOLTS reports suggest at least part of the unemployment problem is structural–something loose money can’t do anything about.  But no one knows exactly how much this might be.

What if all the open jobs are from tech firms that want to hire college graduates with IT backgrounds, while the three million “extra” unemployed are all high school grads who used to work in construction and have limited computer literacy.  If that were true, we’re already at full employment.  Continuing Fed easing would already be in the process of igniting an inflationary upward wage spiral.

I’m not aware of anyone who is saying this is the case.  But how close are we?  No one really knows.

That’s the risk the Fed is taking–not because it wants to, but because it sees Washington as giving it no other choice.  It’s the reason the Fed is talking about taking its foot off the monetary gas pedal when the unemployment rate is at 6.5%, even though full employment more likely means 5.0%-5.5%.

It’s also the reason, I think, that the financial markets have decided all by themselves in recent weeks–as they typically have in the past–to start to do the Fed’s tightening work for it.

More tomorrow.