where’s the tax selling?

Pretty much all mutual funds and ETFs in the US have tax years that end on October 31st.  They are required by law to distribute virtually all the dividend/interest income and realized capital gains collected during the fiscal year to shareholders by calendar yearend (so that the IRS can collect income tax from holders).

Invariably, funds adjust the size of these distributions during September – October.  Whether this means making them larger or smaller, it involves selling.  This means a seasonal market correction between September 1st and October 15th.  The only exception I’ve seen in over thirty years has been in times directly following a major market selloff like that in 2000 or in 2008-09, when funds are working off massive realized losses–and have no taxable income to distribute.

Last year, for example, the selloff in the S&P was about 7.5% and went from mid-August through late September.  2014’s was 6%+ and lasted from September 19th through October 17th.

This year September has delivered about a 1% loss so far, which would be an extremely small seasonal dip.

 

Where’s the selling?  I don’t know.  Maybe the lack of downward market pressure comes from the fact that the S&P is flat during the current fiscal year.  In any event, if selling doesn’t emerge in the next, say, week, it’s unlikely to develop.

If it doesn’t, we’ll have missed an annual buying opportunity and will have to press ahead with annual portfolio adjustment plans without this advantage.

Odd.

 

will OPEC cap its oil output?

…maybe, for a short while anyway.   Ultimately, no.

Will this move shore up oil prices?

…probably not.

Yesterday OPEC announced a provisionary agreement according to which the oil cartel’s members will limit aggregate output to between 32.5 million barrels per day and 33.0 million.  At the lower end, that would remove 750,000 daily barrels (or 2.3%) from OPEC production.  According to the Financial Timesvirtually all of the reduction would be by Saudi Arabia; other OPEC members promise only not to increase theirs.

Saudi Arabia has previously been dead set against any agreement of this type.  Why?   During the early 1980s oil glut, the Saudis sliced oil liftings from 13 million barrels daily to 3 million in a vain attempt to stabilize prices.  That effort failed because everyone else in OPEC cheated, boosting their output to fill the void.

That such cheating happens shouldn’t come as a shock.  It’s standard cartel behavior–and the reason most cartels fail.  The truly startling development in the modern history of commodity-producing cartels was the solidarity of OPEC in its formative years, when it was a political cartel opposing exploitation of third world countries.  It has lost its power as it evolved into the current economic one.

So, as I see it, there’s no reason not to expect widespread cheating again.

Another factor arguing against this agreement actually stabilizing crude oil prices is that OPEC doesn’t dominate world oil production as it did in the 1980s.  Four of today’s top six oil-producing countries (Russia, US, China, Canada) are not members of OPEC.  There’s every reason to expect that all of the four would boost output as/when prices start to rise.

 

To my mind, the real news the OPEC accord signals is the changed attitude of Saudi Arabia.  I think this must mean that Riyadh is in worse financial shape than is commonly believed.

Certainly, the country is radially dependent on oil   …and has become accustomed to the revenue from  $100+ per barrel prices.  So it is now running a large government budget deficit.  My guess is that it is also having a much harder time than expected in borrowing to bridge the gap between revenue and spending, and that efforts to develop other facets of the economy are not moving forward smoothly.  Saudi Arabia has just announced a salary cut for government workers, which can’t imply greater political stability.

If there is a valid reason for oil to have risen on the OPEC announcement–and I don’t think there is–it would be worries of political developments in Saudia Arabia that disrupt oil production there.

Personally, not owning any oil stocks at present, I’m thinking that the seasonal low point for demand, that is, January/February, would be a better entry time than right now.

interest rates and economic growth

Over the past few days, I’ve written about two approaches to the question of the appropriate level for interest rates.

fixed income as an investment on its own

The first considers fixed income as an investment, with no reference to current economic conditions or to use of rates as a government policy tool.  According to it, holders of short-term fixed income instruments receive protection against inflation + a small real return; holders of long-term instruments receive inflation + a real return of 3% or so + an extra return if the instrument carries higher risk.

rates and economic policy

The second looks at short-term interest rates as a tool of economic that aims at steering growth along the preferred path of a given nation’s government.  The monetary authority slows the economy down and speeds it up by raising/lowering rates as circumstances dictate.  In the US, the recent preferred metric for judging success has been the employment figures.

quantity of money

There is a third, admittedly subjective, approach to this topic, one that many professional investors have traditionally used to gauge the tone of financial markets.  The idea is that the economy requires a certain amount of liquidity (i.e., money) in order to operate efficiently.  This is to maintain inventories, pay salaries and fund new investments.   It operates best when it has precisely that amount.

In a period like the current one of continuous radical supply chain and financial innovation, it may be hard to judge when too little money is available, and therefore activity is constrained and rates are too high.

On the other hand, adherents to this idea think that when money is too abundant, the excess inevitably finds its way into economically destructive financial speculation.  The signs that rates are too low are easier to spot:  soaring housing prices, bubble-level stock PEs and high-risk, nevertheless covenantless, junk bonds.

recent financial market worries

This third idea is the basis for the recent conversation in financial markets that ultra-low interest rates have passed their best-by date and are now doing more harm than good.  The strongest evidence that this is the case is in the junk bond market, I think.  However,  if there’s speculation in one corner of the financial markets, it must also be at work in the others.

issues with the traditional business cycle picture

As I mentioned yesterday, one BIG problem with the traditional business cycle model (the one taught in business schools) is that although it explains what happens abroad, it no longer fits with behavior in the US economy–which is, after all, the biggest in the world (for believers in purchasing power parity, the second-biggest   …after China).

The model says that lower interest rates energize business capital spending, which produces new hiring, which leads to higher consumer activity as new employees spend their paychecks.

Makes sense.

the US experience

In the US, however, consumer spending recovers first.  Typically, soon after the Fed begins to lower interest rates, US consumers have been back in the malls, spending up a storm.  Rather than industry lifting the consumer, the consumer pulls industry out of its slump.

How so?

Economists theorize that what’s at work in the US is the “wealth effect.”  Two aspects:

–maybe lower rates are like Pavlov’s dinner bell ringing and consumers begin to salivate in advance of recovery  (my personal take on this is idea that the office/plant grapevine signals that the worst is over, that layoffs have stopped and new hiring will soon begin)

–lower rates = house prices start to rise, as do bonds and stocks.  So consumers feel wealthier as rates fall, because their accumulated assets (their wealth) are worth more.

The problem here is that we’ve had zero rates for eight years without seeing the traditional recession-ending spending surge

where’s the capital spending?

Whether capital spending is the locomotive or the caboose, it’s still arguably an integral part of the economic recovery train.  Why haven’t we seen a capital spending surge in the US?  Is the lack of capital spending an indication of continuing weakness in the US economy, as the traditional business cycle theory would suggest?

I think four factors are involved here, the sum of which suggests reality has sped far ahead of theory:

–the internet.   Typically, there’d be a surge in construction of shopping malls as recovery gains speed.  But as online commerce has developed, we’re finding that we already have maybe 20% too much bricks-and-mortar retail space

–globalization.  Continuing industrialization in emerging economies like China during the last decade has decisively shifted lots of low-end US-based manufacturing abroad.  In addition, I’m also willing to entertain the thought that crazy spending in China has produced an enduring glut of manufacturing capacity there, although I have no hard evidence

–software.  For many (most?) US companies, the largest target for new investment spending is not bigger, newer plants but faster, more efficient software. The National Accounts, the government system of tallying economic progress, have no effective way of recording this expenditure for analysis.  The traditional business cycle picture is similarly stuck in the world of fifty (or a hundred) years ago

–skilled vs. manual labor.   This is a thorny issue, and one I have strong opinions about.  Here, I think it’s enough to say that the traditional model doesn’t distinguish between a twenty-year old with a grade school education and a strong back vs. a college dropout like Mark Zuckerberg.  A generation ago, the distinction wasn’t important.  today, it’s crucial.

 

 

 

the traditional business cycle

The easiest place to start is at the low point of the cycle–and to talk about every place in the world except the US.

the target for government policy 

A typical rule governing policy action would be for a country to act so as to maintain the highest sustainable (that is, non-inflation-inducing) rate of economic growth.

the bottom

At its low point, activity in an economy is advancing at considerably less than that.  The economy may even be contracting.  The cause may be prior action by the government to slow the economy from a previous overheated state (policy actions are blunt tools:  most often they overshoot their objective) or the economy may have been hit by an out-of-the-blue event, like an oil shock or a financial crisis.

In either case, companies are laying off workers, reducing inventories, closing now-unprofitable operations  …all of which is causing the slowdown to feed on itself.

The traditional remedy to break the downward spiral is to lower interest rates–we might also describe this as lowering the cost of money by making a much larger quantity available to borrow.

What does this do?

In theory, and often also in practice, companies have a list of new capital projects they are ready to implement but which are unprofitable at the high interest rates/weak growth that accompany/trigger a slowdown.  By lowering rates, the monetary authority makes at least some of those projects into moneymakers.  So companies commit to new capital projects.  They hire planners and construction firms; they buy machinery; they hire workers to staff new plants.

As these formerly unemployed workers get paychecks, they begin to consume more–they buy clothes, and then houses and new cars.  They begin to eat restaurant meals and go on vacations again.  As consumer-oriented service industries see their businesses picking up, they begin to hire again, too–adding to the new wave of consumer spending.  At the same time, the supply chain begins to expand inventories to be able to satisfy rising demand.  Similarly, manufacturers hire more workers and begin to expand their own productive capacity.

In this way, self-feeding slowdown turns into self-feeding expansion.

the top

At some point, the economy reaches full employment.  Companies want to continue to expand because they now see many profitable investment projects.  But there are no more unemployed workers.  So firms begin to offer higher wages to bid workers away from other firms.  They begin to raise prices to cover their higher costs.  This activity doesn’t create more output, however.  It only creates inflation.

Either in anticipation of, or in reaction to, budding inflation the monetary authority begins to raise interest rates to cool down the now feverish expansion.  It keeps rates high until it begins to see signs of slowdown–inventory reductions, new project cancellations, layoffs.

 

The economy eventually reaches a low point   …and the cycle begins again.

observations

–in the model just described, industry recovers first, followed by consumers.  This happens in most of the world.  In the US, however, as soon as interest rates begin to decline, the consumer typically begins to spend again.  Business follows with a lag.

–conventional wisdom is that money policy actions need 12 – 18 months to take full effect.  In the current situation, short-term interest rates have been effectively at zero for eight years (!!) without seeing a sharp surge in economic growth in either the US or the EU.

–economists have been concerned for years that there’s been no oomph in capital spending in the developed world, despite low rates.  The traditional model explains he concern–business capital spending is thought to be a key element in any recovery.

 

More tomorrow.

 

 

 

interest rates, inflation and economic growth

A reader asked me to write about this.  I think it’s an interesting topic, since traditional relationships appear to be be breaking down.

interest rates

Let’s just focus on government debt, since other debt markets tend to key off what happens here.

 

At the end of the term of a loan, lenders expect the safe return of their principal plus compensation for having made it.  In the case of all but gigantic mutual fund/ETF lenders, participants in government bonds also enjoy a highly liquid secondary market where they can sell their holdings.

The compensation a lender receives is normally broken out into:  protection against inflation + a possible real return.

In the case of T-bills, that is, loans to the government lasting one year or less, the total return in normal times would be: protection against inflation + an annual real return of, say, 0.5%.  In a world where inflation was at the Fed target of 2%, that would mean one-year T-bills would be sold at par and yield 2.5%.

In the case of a 10-year T-bond, the annual return would be inflation + a real return of around 3% per year, the latter as compensation for the lender tying up his money for ten years.  In a normal world, that would be 2% + 3% = a 5% annual interest rate for a bond sold at par.

Compare those figures with today’s one-year T-bill yield of 0.6% and 1.62% for the ten-year and we can see we’re not in anything near normal times.  We haven’t been for almost a decade.

How did this happen?

Fed policy

The highest-level economic objective of the government in Washington is to achieve maximum sustainable long-term economic growth for the country. Policymakers think that growth rate is about 2.0% real per annum.  Assuming inflation at 2.0%, this would imply nominal growth at 4.0% yearly.

expanding too fast

In theory, if the economy is running at a nominal rate much faster than 4% for an extended period, companies will reach a point where they’re ramping up operations even when there are no more unemployed workers.  So they’ll staff up by poaching workers from each other by offering higher wages.  But since there are no net new workers, all that will happen is that wages–and selling prices–will go up a lot.  They’re be no greater amount of output, only an acceleration in inflation.  This last happened in the US in the late 1970s.

Before things get to this state, the Federal government will act–either by lowering spending, raising taxes or raising interest rates–to slow the economy back down to the 2% real growth level.  Typically, the economy ends up contracting mildly while this is going on.

Given long-standing dysfunction in Congress, the first two of these remedies are long since off the table.  This leaves money policy–raising interest rates–as the only weapon in the government arsenal.

growing too slowly/external shock

If the economy slows too much or if it suffers a sharp out-of-the-blue economic shock, the possible government remedies are: lower taxes, increase spending, reduce interest rates.  Washington has elected to do neither of the first two in response to the financial collapse in 2008-09, leaving monetary policy to do all the work of helping the country recover.

Fed policy in cases like this is to reduce the cost of debt to below the rate of inflation.  That hurts lenders (the wealthy, pension funds, retirees) severely, since they are no longer able to earn a real return or even preserve the purchasing power of their money through buyng government securities.

On the other hand, this is like Christmas come early for borrowers.  In theory, they now have many more viable projects they can launch.  They’ll not only be making money on the merits of their new products/services; inflation will also be eroding the real value of the loans they will eventually have to pay back.

 

More on Monday.

 

 

more casino gambling folly in New Jersey

Tax revenue from casino gambling in Atlantic City has been an important source of income for the state of New Jersey since its inception in the 1970s.  The Atlantic City gambling market peaked, however, in 2006 and has been cut in half since then.  The financial crisis accounts for maybe a fifth of the contraction.  The rest is due to the introduction or expansion of casino gambling in nearby states, notably Pennsylvania.

New Jersey’s response to this development has been a bit bizarre.

Its first idea was to increase casino space in Atlantic City by funding an upscale casino project which had been trying unsuccessfully to get private financing for years.  How that would address overcapacity in the market was never explained.  But luckily this plan never got off the ground.

Then there was internet gambling, introduced in late 2013, which the state predicted would soon be a billion-dollar industry.  2016 revenue from this source, year to date through August, is about $32 million.

The state has also attempted to institute sports gambling in the casinos, unsuccessfully so far.  The main stumbling block, as I understand it, is that doing so is expressly forbidden by federal statute.  Before that legislation was passed, state were polled to see if they wanted to be exempted–and New Jersey said no.

The latest idea, being pitched in advertising as a cure for unemployment, is again to open more casinos–only this time in northern New Jersey, within striking distance of New York City.

As a general rule, I think that–with the exception of resort locations like the Las Vegas Strip– consumers in general, and casino gamblers in particular, normally tend to patronize the closest venue to where they live.  If so, these proposed new casinos may draw some New Yorkers away from NYC-area casinos and keep some New Jerseyans from crossing the Hudson River.  But they will certainly make a huge dent in the gambling traffic that now goes from northern NJ to Atlantic City.

 

The new casinos need voter approval before the projects can go ahead.  Hence the commercials now airing to promote their advantages.  It’s not clear, however, that their opening will be a plus for the state.  The question is not whether they’ll do damage to Atlantic City–they certainly will, I think.  It’s how many more AC casinos will be forced to close their doors, and whether as a result their south Jersey/Pennsylvania patrons will opt to gamble in PA instead.