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How About That Dow?
An Optimistic Fed
The Economy Slows Down
That Stubborn Yield Curve
Has the Housing Market Bottomed?
Time to Be a Bull
 There
is an arcane debate going on in economic circles. How fast
can the economy grow without inflation becoming a problem?
The answer may be, not as fast as we thought. And the answer
matters because the people who have their fingers on the
interest-rate trigger take this arcane stuff seriously. How
you answer the question also has implications for the
unemployment rate. Yes, there are people who worry about it
getting too low. Plus, we look at the Dow. The Dow may be
telling us more about how indexes are constructed than about
how the economy and the market are really doing. All that,
some thoughts on the housing data, and more as we ponder the
question, "Is it really different this time?"
But first, one of the really great investment conferences
every year is the annual New Orleans Investment Conference.
This year it is November 15-19. Originally started by the
late Jim Blanchard, the conference has a strong gold
contingent, but has expanded to cover a wide range of
themes. Last year, the conference had to be rescheduled
because of Katrina, but this year it is back and looks to be
better than ever.
In addition to yours truly, they have lined up Steve Forbes,
Jim Rogers, Marc Faber, Dennis Gartman, and Newt Gingrich,
plus scores of other well-known speakers, workshops, and
private sessions. If you register before November I, you can
save $200 on the full price and half off for a friend or
spouse.
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In conjunction with my friends at
Altegris Investments, we will be hosting a dinner for clients and
prospects. If you are an accredited investor and would like to
attend the dinner, please respond to mauldin@2000wave.com
(not my private email address!). Click on the link below for more
information about the conference. (You have to use this link to get
the special rate.)
http://www.jeffersoncompanies.com/affiliate/affiliate_process.php?icode=confreg&acode=JM
How About That Dow?
The Dow, except for today, has been relentless in making new highs.
Yet a lot of other indexes are still below where they were six-plus
years ago. Why is the Dow behaving differently? The evidence
suggests it is because of the way the Dow is calculated.
Before we get into that data, I don't want to take away from the
impressive performance of late of the Dow and the markets in
general. I am not suggesting that we have some false bull market,
because the recent increases have been quite real, and my continued
stop-clock call for a major correction looks more and more silly
with each new high. But as I will make the case below, I can't throw
in the towel and jump on the Dow 20,000 (or whatever) bandwagon
quite yet.
This sidebar is simply to put the difference between the Dow and
other indexes like the S&P 500 into perspective. How you create
them makes a difference. The Dow has always been price weighted, so
the higher the price of a stock, the more important it is to the
index. Most other indexes (like the S&P 500) are market cap
weighted, so the higher the total value of the company, the more
weighting it has in the index. If you use price as the factor for
your index, the size of the company does not make a difference.
As many have noted, only 10 of the 30 Dow stocks are above their
January 2000 highs. Fifteen of the remaining 20 are down 25% or
more. The biggest reason for the surging of the Dow has been just
four of its stocks, which not coincidentally are its highest-priced
components. And as Barry Ritholtz noted, not a one of the 30 Dow
stocks was at an all-time high as the Dow was making its new index
highs.
What would your returns look like if the Dow was capitalization
weighted like the S&P 500? I asked my friends Rob Arnott and
Jason Hsu at Research Affiliates to do the math for us. And since
they also run indexes which are fundamentally weighted, I asked them
to tell us what the returns would have been if you had weighted the
stocks by valuation metrics rather than price or size.
The Dow was at 11,453 on January 1, 2000. Today it closed at 12,134,
up almost 700 points or around 6% over the almost 7 years. Including
dividends (which is only fair) the total return on the Dow would
have been 20.75%.
What if the Dow had been capitalization weighted? Your total return
(including dividends!) would have been only 1.13%! Taking away the
dividends, the Dow 30 would still be under its high-water mark by
about 13%! The S&P is only 6% from where it was on January 1,
2000, or about 9% from its all-time high. (Back-of-the-napkin math.
The exact numbers are not important.)
So, the only reason that the Dow is at new highs is the way they
calculate the index. On a cap-weighted basis, the S&P 500 is
actually doing better!
But what happens if you weight the Dow components by valuation
metrics, like P/E, price-to-book, and so on? A Dow 30 index weighted
by valuation, like that used by Research Affiliates, would have
yielded a total return of 27.6%.
As an aside, Arnott and Research Affiliates have a patent pending on
the intellectual property they developed to create their fundamental
indexes. After they published their research, which shows the clear
benefits of using valuation as the basis for an index, they have
started to create "fundamental indexes" in markets
throughout the world. I have written about this concept in the past.
I think this concept will be the mainstream long-only index
methodology within ten years. Cap weighting is so last century. (http://www.2000wave.com/article.asp?id=mwo051305)
There are some mutual fund firms
who seem to be ignoring the patent pending and are pursuing their
own fundamental indexes. How that will work for them remains to be
seen. Intellectual property is a cornerstone of our economy. If you
cannot protect it, whether it is software, chip designs, business
processes, or a new widget created in someone's garage, it will
cause serious problems in a market-based economy. One of the reasons
that there is not more creativity and economic growth in the
developing world is the lack of patent protection and outright theft
of ideas. Why go to the trouble of creating, or sharing your
creation, if someone is going to steal it?
And now, let's look at why Fed governors have been warning us about
inflation of late.
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An Optimistic Fed
At the August 8 Fed meeting, the policy makers sitting
around the table were given briefing material called the
"Greenbook" (for its green cover). I have been
highlighting for several months that Fed governors are
increasingly sounding hawkish in their speeches, asserting
that inflation is too high and hinting that it is still
possible we could see interest-rate hikes.
We now know that what they saw in the Greenbook obviously
influenced their speeches. Federal Reserve economists showed
data which suggested the previously assumed linkage between
economic growth and inflation may be too optimistic.
Basically, the assumption is that if the economy grows too
fast, unemployment will decrease, driving up wages, and
capacity utilization will increase, driving up prices. Thus
an economy can grow too fast and cause inflation. (Note that
developing economies can grow much faster without inflation
because they have high unemployment.)
In effect, policy makers were told last month that time is
running out for inflation to fall. The forecasters expect
"only a small gap" between what the economy can
produce running at full speed and the actual growth rate
over the next several quarters. That means any unexpected
acceleration in growth might well heat up inflation.
By 2008, according to meeting minutes, the staff expects the
economy to be roaring ahead at close to its speed limit,
making it more urgent to get inflation under control now.
Staff economists revised the noninflationary growth rate
down once again at the September meeting. The first reason
for slower potential noninflationary growth comes from
research done by senior staff economists, published this
spring. The paper suggested that the US is beginning a slow
slide downward in the percentage of workers participating in
the labor force.
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The report said, "Such a slowing in labor input would,
in turn, reduce the sustainable rate of economic growth"
unless there is another surge in productivity. But since
productivity is high, this did not raise many eyebrows. And
then the productivity numbers changed.
The Department of Commerce revised their data for the past
three years. The result is that the economy did not grow as
fast as previously thought in the three years 2003-2005.
Growth was revised down from 3.5% to 3.2%. Growth in output
per hour was revised down, which meant productivity was
revised down. Business investment on equipment and software
did not rise as fast as previously thought.
Therefore, since we are not as productive as we thought, the
growth rate that doesn't create more inflation is lower. At
least that is the argument the Fed economists make, and
clearly the Fed governors take them seriously.
JP Morgan Chase estimates that the noninflationary growth rate
has dropped from 3.5% to 2.7%, mirroring the Fed concern. And
aside from the very poor GDP numbers today, the Fed and most
economists think that GDP will grow faster than 2.7% next
year.
If the economy does indeed pick back up before inflation is
brought down, it could signal the need for further rate hikes.
Thus the concern by Fed governors in their speeches and in the
press release from the FOMC meeting concluded this week.
The debate is framed by two very different estimates of
economic growth and Fed policy. Because JP Morgan Chase,
mentioned above, thinks that the economy is going to grow
enough that inflation will remain a problem, they think there
will be three more interest-rate hikes between now and June,
taking the Fed funds rate to 6%.
But there are others, like Goldman Sachs, who think the
economy will slow and bring inflation down with it. Goldman
thinks the Fed will cut rates five times next year, bringing
the Fed funds rate down to 4%.
And if you are a Fed governor, you have to make a decision
each and every meeting. But you did get some data today which
suggests that inflation may finally be slowing. The favorite
Fed measure of inflation, the core Personal Consumption
Indicator (PCE) fell to 2.3% in the third quarter. Another few
months of that trend and Fed governors will have to get a new
topic for their speeches.
The Economy Slows Down
Today, the Commerce Department reported that the economy did
in fact grow less than 2.7% in the last quarter, coming in at
1.6%, far below consensus expectations. Of course, we know
that these numbers are subject to revision. And a former
Commerce Department economist says that the number will be
revised down sharply.
Joe Carson, now director of economic research at Alliance
Bernstein LP in New York says the growth rate should have only
been 0.9%. The 1.6% number was the result of a statistical
fluke which yielded an unexpected increase in auto production
last quarter, in spite of announced cutbacks by Ford, GMC, and
others.
" 'A drop in the wholesale price of SUVs and light trucks
as the automakers cleared leftover 2006 models made production
look stronger than it actually was,' said Carson. The economic
fallout from the auto-industry cutbacks will instead come this
quarter, he said.
"'Last quarter was weak even with the benefit of this
mismatch and the fourth quarter will now also be weak because
it's going the other way,' Carson said. 'Whatever output you
have this quarter, which will probably be down, will be
discounted by a likely rebound in prices.'
"Carson stressed that there wasn't an error in procedure
requiring a correction from the government. It's the way the
Commerce Department always computes the data and doesn't mean
the statisticians committed any mistakes, he said."
(Bloomberg)
Basically, they use prices to estimate output. And since auto
companies dropped prices by 5.5%, it made inflation-adjusted
production look larger for autos larger than it actually was.
As an aside, most economists predict this quarter will be
2.5%. Carson thinks GDP will be 1.4% and he wouldn't be
surprised "if it was half that."
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That Stubborn Yield Curve
As long-time readers know, I have been suggesting we will
see a slowdown or a mild recession next year. Among other
reasons, an inverted yield curve is the most reliable
predictor of recessions of all our forecasting tools, and
the inversion of the yield curve is continuing to
deteriorate. Today the ten-year bond is 43 basis points
below the 90-day T-bill. This is the largest differential
this cycle.
The yield curve inverted in the third quarter of 2000 when
nearly all economists were projecting solid growth.
Something like 50 of 50 Blue Chip economists did not predict
a recession. As it turned out, the economy was actually in a
very mild recession in the third quarter, but we did not
know it for another few years as the GDP kept being revised
downward. The actual beginning of the "official"
recession as tracked by the National Bureau of Economic
Research was not until March of 2001 through November of
2001.
The general stock market was just fine, making new recent
highs (except for the tech bust, of course). Calling for a
recession, as I did, in August of 2001 was not a consensus
view. And reminding people that stock markets dropped an
average of 43% during recessions was not popular. Everyone
was rooting for the return of the bull, and it sure looked
like it was coming back.
Just for fun, let's see what the differential on the yield
curve looked like in the "pre-recession" year of
2000 and then compare it to this year. The thick (red) line
is this year and the thin (blue) line is 2000. Notice the
inversion got worse as the year progressed. We can't
statistically make too much of this, other than to see it
for the cautionary resemblance of this year to 2000.
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Has the Housing Market Bottomed?
Residential housing construction fell at an annual rate of 17.4 %
last quarter, the biggest decline since the first quarter of 1991,
after shrinking at an 11.1% pace in the previous three months. The
decline subtracted 1.12% from GDP growth, the most in almost a
quarter century. Will a continued decline in housing construction
push us into a recession next year?
In August of 2005, I wrote about Greenspan's speech at Jackson Hole.
Reading between the lines, he very clearly said the Fed was
targeting asset prices and more precisely home prices. I said then
the Fed would keep raising rates until the housing market cried
uncle. And they did. Laying aside the inflation problem I wrote
about at the beginning of this letter, let's assume, for the sake of
argument, the economy slows down and enters into a recession. Can we
expect the Fed to come to the rescue at that point? The answer is,
they will try and do so. But the always perspicacious Paul McCulley
suggests that lower rates might not be enough. Writing this month in
his Fed Focus, he says:
"While the housing bubble was inflating, it seemed impervious -
or inelastic - to the Fed's rate hiking, so the Fed kept tightening,
on the thesis that an unresponsive mule is not really unresponsive,
just in need of additional whacks on the head with a two-by-four.
And it worked, as the mule has gone into severe retreat this year.
No surprise here, really, as housing is, using the word of George
Soros in the mouth of PIMCO's housing guru Scottie Simon, one of the
most "reflexive" asset markets in the world, the ultimate
momentum market: can't get enough on the way up and can't run away
fast enough on the way down.
"Which brings me to my core thesis looking forward (and on the
opposite side of former Fed Chairman Greenspan): housing is going to
be very inelastic to falling interest rates on the way down, just as
it was very inelastic to rising rates on the way up. To think
otherwise after a bubble is to not understand bubbles. Risk appetite
in property markets will not be restored by modest declines in
market-determined interest rates, particularly if the Fed refuses to
"validate" them with lower short-term policy rates,
limiting or even reversing declines in market-determined interest
rates.
"Thus, just like policymakers and market participants kept
ratcheting up estimates of the time-varying neutral real short rate
while the housing bubble was inflating, I think they will be
ratcheting down those estimates, again and again, as the air
continues to escape from the property bubble. Put differently,
irrational exuberance, which lifts the cyclically neutral short
rate, will, when followed by irrational fear, reduce the cyclical
neutral real short rate."
New-home sales have increased for the second straight month. A lot
of analysts see this as an indication that worst is now behind us.
Well, maybe. The first thing you need to remember is that the
inventory of unsold new homes is up to a record 157,000, up 47%.
And good friend Barry Ritholtz tells us we should look under the
hood on those increased sales. His comments were so right on, and a
good read, that I will quote him at length:
"First, a quick word on New Home Prices:
"The reported sales prices were pretty awful. 'Median sales
prices dropped 9.7% in the past year to $217,100, the lowest price
in two years. It's the largest percentage decline in median prices
since December 1970. Median prices for existing single-family homes
are down 2.5% in the past year, the largest decline ever recorded'
"Here's the amusing part: Despite the huge price drop, the
reported price changes actually understate the actual price
changes. This is due to Builder
Incentives. Have a look at some of the freebies
builders have been using to get sales going: Sub zeros,
pools, BMWs, even paying the property taxes for 2 years!
"Candy bar companies don't like to raise prices, so they simply
make the candy smaller, selling them for the same price; Curb Your
Enthusiasm fans might note how many fewer Cashews go into a can of
mixed nuts ('The whole cashew/raisin balance is askew!').
Paying the same amount for a smaller Almond Joy or less cashews is
price inflation.
"Builders do the opposite: They add cashews. Some feel
the psychology of lowering prices scares off potential buyers - or
at least frightens them into sitting back and waiting. To avoid the
appearance of decreasing prices (or to make them appear less
severe), they
offer more - increasing what they are selling - only without
(apparently) charging for them. This getting more for the same cost
is price deflation. New Home Pricing today - more cashews -
is even more Deflationary than appears...
"Yesterday's increase in New Home Sales caught some economists
by surprise. I look at those sorts of numbers suspiciously. Any time
I want some insight into any particular data-point, I find it
instructive to go to the actual government source's website, and
simply click around. If you do this with a skeptical eye, you may
learn some really interesting facts.
"That's what I did with the New Home Sales yesterday, simply
looking at the release and trying to figure out what they were
really saying thru the bureaucratic jargon and legalese. You don't
need to be a forensic accountant (but it wouldn't hurt). Here's what
I found:
"1. The reported increase in sales was 5.3 percent. The margin
of error was ±15.6%. Therefore, the likely change in sales ranged
from +20.9% to -10.3%. Since this range contains zero, "the
change is not statistically significant; that is, it is uncertain
whether there was an increase or decrease."
"2. Recently reported increases have been subsequently revised
downwards, primarily due to cancellations. Sales in June, July and
August were revised down by 67,000.
"3. Year-to-date sales are down 16.5%.
"4. Commerce department does not do an 'Apples-to-Apples'
comparison. They report initial New Home Sales (pre-cancellations)
versus the prior months adjusted (post-cancellations). This has the
effect of lowering the older months data, thereby making the present
monthly gain appear larger.
"A more consistent methodology might be to compare unrevised
data with unrevised data. So for September, we might look at sales
of new one-family houses in August 2006 as initially reported
- annual rate of 1,050,000 (seasonally adjusted); Then we look at
sales of new one-family houses in September 2006 as initially
reported: an annual rate of 1,075,000 - just under 2.4%, as opposed
to the reported 5.3%. Note this is still statistically
insignificant, given the ±15.36% margin of error.
"Note that the year over year estimates -- down 14.2% percent (±12.2%)
below the September 2005 puts zero beyond the margin of error. The
range year over year is between down 2% - to down 26.4%!"
It is not likely that we have seen the bottom in the housing market.
And if prices slide it is going to affect the mindset of consumers.
I met with a very interesting economist by the name of Kathleen
Camilli of New York this week. You will be hearing more from her. I
picked up the following chart and data from one of her recent
letters.
The valuation of US owner-occupied real estate has risen from $4
trillion to $20 trillion since 1980, and by $8 trillion in just the
last five years. This enormous increase in wealth is what allowed
consumers the psychological "cover," not to mention the
actual wherewithal, to continue to increase spending right through
the last recession.
What if we have a recession and home values are dropping? Just a
thought, and not a pretty one.
Time to Be a Bull
I have the luxury of not directly managing money. I am basically a
manager of managers, so I can choose which manager (or partners I
work with, who choose) to direct client money. I am really looking
forward to the day when I can once again be bullish. It is so much
easier both personally and professionally to have a bullish view.
It is so vastly easier to find great managers in a bull market. And
there are a lot of managers who have done well over the past few
years. But if you have the view that we are going to lower
valuations, putting money in long-only indexes and programs is a
mug's game. It is trading short-term returns for long-term risk.
There are lots of long-biased managers who will do well in the next
bull market, and I love value-based funds of all types. It is a lot
harder to find absolute-return managers who can provide good returns
in difficult markets as well as the recent bull runs.
If I am right and we are going into a recession or serious slowdown
next year, if the market did not have a serious problem, it would be
the first time in history. I don't like betting on "It's
different this time." So far this year, I have been wrong; but
I don't think the game is over. The fat lady hasn't sung. In the
meantime, absolute-return investing has the potential to provide
good returns while limiting your exposure to a market correction.
And as an aside, I hope I am wrong. I hope we get a soft landing,
and that it happened last quarter. I hope new-home sales really do
pick up. I hope unemployment stays low and that the porridge will be
just right.
New Orleans, New York, and Coming of Age
As noted at the top of the letter, I will be in New Orleans November
15-19. It now looks like I will be in New York for a day or so later
this month, and then no planned trips until late January when I go
to South Africa.
My #2 son turned 18 yesterday. Just as I watched his five older
brothers and sisters, I have watched him mature. It is rewarding to
see them take on more responsibility, to take the turn to be their
own person. "Dad, I can pay for that. Why should you do it? I
want to." When you think that nothing has rubbed off, it makes
you smile when your son comes in and starts talking about customers
and marketing and values at his job. Maybe there is hope.
Have a great week.
Your ready for NBA basketball to begin analyst,
John Mauldin
http://www.johnmauldin.com/
Copyright
2006 John Mauldin. All Rights Reserved.
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