Diagnosing America's ills

Last week the World Economic Forum reported that the US has fallen from second to fourth in its competitiveness rankings. It lost its top spot last year to Switzerland. This year, it had been overtaken by Singapore and (socialist!) Sweden.

In many of these surveys, the scores of the top countries are all clustered together so small movements in rankings aren’t terribly meaningful. However, for the US to slip from first in one year and then to fourth the following year is a disturbing trend.

Here are the cited reasons for the decline in American competitiveness:

The report said a lack of macroeconomic stability continues to be America's greatest area of weakness, with repeated fiscal deficits leading to burgeoning public indebtedness.

It also said that U.S. business leaders show less trust in politicians and the government's ability to maintain an arm's-length relationship with the private sector.

Populism rears its ugly head
In other words, things are getting tough and people are getting cranky. I have written before about the risks of populism and a cranky population before (see examples here and here). The level of discontent rising and the risk of class warfare is going up with it. Consider these items that have appeared recently, some of which has come from middle-of-the-road figures):

• Profiting from layoffs (CNN)
• HP: The face of America’s decline (Commentary on the culture of rewarding slash and burn CEOs while offshoring jobs from Fabius Maximus)
• What makes America great: Layoffs (CNBC via Barry Ritholz)
• Land of Opportunity running out of opportunities (MarketWatch)
• A pity party for America’s rich and powerful (Commentary on Daniel Loeb’s comment about unfair taxation from Fabius Maximus)
• Despite US corporations sitting on $2T (in cash), the work force has become the New Expendables (Barry Ritholz)
• End wage inequality to end the recession (Robert Reich)
• A belief in free markets has turned us into Matrix drones (The Independent)

What’s wrong with America?
I believe that America’s ills stems from neglect, largely from the short-term nature of American thinking. There has been a neglect of infrastructure, a lack of focus on basics of innovation and wealth creation, as well as an erosion of the advantages bestowed by education.

The most recent infrastructure report card gives American physical infrastructure badly failing grades: Aviation (D), Bridges (C), Dams (D), Drinking Water (D-), Energy (D+), Hazardous Waste (D), Inland Waterways (D-), Levees (D-), Public Parks and Recreation (C-), Rail (C-), Roads (D-), Schools (D), Solid Waste (C+), Transit (D), and Wastewater (D-). Fixing this shortfall requires spending of over $2T. Nevertheless, there are calls for greater infrastructure spending as a way to build an economic recovery.


The erosion of education as a competitive advantage
Mike Mandel, who has blogged extensively on innovation, has complained that there has been too much spending on housing, too little on IT. While education has been the key to higher value-added jobs, the competitiveness advantages conferred by education have been eroding. IT skills, as an example, are becoming commoditized and offshored, according to this New York Times article:

These higher skills have become commodities, said Catherine L. Mann, a global finance professor at the Brandeis University International Business School who studies the outsourcing of jobs. The programming language “C++ is now an international language,” she said. “If that’s all you know, then you’re competing with people in India or China who will do the work for less.” In addition to lower wages, developing countries offer significant consumer growth, giving businesses a reason to make more products closer to the buyer, and hire locally.


And increasingly, these new, lower-cost research centers, while perhaps initially intended to adapt products for local use, are becoming sources of innovation themselves.

James Kwak, who blogs at Baseline Scenario with Simon Johnson, explains:

But since 1980, and especially since 1990, the world has become more open. If the American capitalists want to make more money, they still have to invest in new technology, and they still need an increasingly educated workforce. But now, because of globalization, they can get that workforce anywhere in the world. You can think of this as arbitrage: China doesn’t have that many college graduates as a proportion of its population, but they come cheaper than American college grads. Or you can think of it as free riding: if China (or Korea, or India, or Brazil, or anywhere else) is willing for whatever reason to invest in increasing the number of domestic college graduates, the American capitalists can simply expand their operations over there and save themselves the trouble and expense of investing in the American educational system. (And for China, the returns on investment in education might be higher than the returns for America, because the marginal productivity of new investments in education is probably higher.) And as a result, average educational attainment only went up by 0.8 years from 1980 to 2005.

Perhaps the next big engine of growth will not come from Silicon Valley, but from another sector. Mike Mandel believes that the US has made a big bet on life sciences, in the form of the human genome project, but it hasn’t paid off. In addition, other countries have exploited the competitive disadvantage of American restrictions on stem cell research to catch up and overtake US research in this field.


Two paths
I don’t have the answers to America’s ills. I can see two paths, both equally likely.The first path leads us to Greece (see this excellent Vanity Fair article on Greek culture and the crisis), where people have turned inward and milk institutions (governments, foreign entities such as the IMF, EU and ECB) for everything they can get away with, while public institutions wither.

As it turned out, what the Greeks wanted to do, once the lights went out and they were alone in the dark with a pile of borrowed money, was turn their government into a piñata stuffed with fantastic sums and give as many citizens as possible a whack at it. In just the past decade the wage bill of the Greek public sector has doubled, in real terms—and that number doesn’t take into account the bribes collected by public officials.

And that's just the Greek solution for "when the lights go out" and no one is watching. Other countries behaved differently and abused the system differently:

What they wanted to do with money in the dark varied. Americans wanted to own homes far larger than they could afford, and to allow the strong to exploit the weak. Icelanders wanted to stop fishing and become investment bankers, and to allow their alpha males to reveal a theretofore suppressed megalomania. The Germans wanted to be even more German; the Irish wanted to stop being Irish. All these different societies were touched by the same event, but each responded to it in its own peculiar way.

Will Time heal our wounds?
There is a more optimistic solution to global healing. The second and more benign solution is simply time. Ken Rogoff explains in his excellent commentary entitled Why America isn't Working:

The honest answer – but one that few voters want to hear – is that there is no magic bullet. It took more than a decade to dig today’s hole, and climbing out of it will take a while, too. As Carmen Reinhart and I warned in our 2009 book on the 800-year history of financial crises (with the ironic title “This Time is Different”), slow, protracted recovery with sustained high unemployment is the norm in the aftermath of a deep financial crisis.

Rogoff went on to skewer traditional macro solutions such as supply-side economics and Keynesianism. In the end, he does warn about the growing class divide, which I also worry about as it can lead to class warfare, populism and the disintegration of the social fabric:

[T]here is a fairness issue. By some measures, nearly half of all Americans do not pay any income tax already, so cutting taxes skews an already very unequal income distribution. Deferred maintenance on income equality is one of many imbalances that built up in the US economy during the pre-crisis boom. If allowed to fester, the political consequences could be severe, including trade protectionism and perhaps even social unrest.

Are "Black Swans" not so black anymore?

John Hempton at Bronte Capital recently blogged about the puzzling condition of rising gold prices and falling  bond yields. Indeed, we have seen rising commodity prices in the form of the CRB Index (pictured below) and the CRB Raw Materials Index, which is largely composed of nom-traded raw materials, is only 3% from its all-time highs.

Normally, bond yields rise as inflationary expectations rise. But instead of rising yields, we have seen falling bond yields – which is typically associated with deflationary episodes instead of rising inflationary expectations.

Rising tail risk
I interpret these conditions as Mr. Market being worried about both inflation and deflation. Moreover, when we see stories like Titan Capital Joins Black Swan's Taleb in Raising Bets on Crash, it seems to me that Mr. Market is also worried about rising tail risk, i.e. extreme events.

This may be an indication that tail risk is becoming a crowded trade.

Is this a time to sell tail risk volatility?

Waiting for 2017 (or 2018)

A lot of long-term analysis seems to be converging towards the launch of a new secular stock bull in the 2017-2018 timeframe.


Jeremy Grantham revisited his “seven lean years” scenario in his July quarterly letter July. About a year ago, Art Cashin highlighted the 17.6 year stock market cycle, which pointed to a bottom around 2017. I also wrote about an academic study that correlated demographic trends to P/E ratios, which pointed to a long-term bottom around 2018. I also suggested that while markets are likely to be flat longer term, they are going to be volatile and experience huge intermediate term swings.


Investment Policy for a Lost Decade
At best, this scenario means nearly a decade of flat returns. In this case, standard buy-and-hold asset allocations will disappoint investors with their low returns and high volatility.

Some investment strategists, like David Rosenberg at Gluskin Sheff, advocate an approach of focusing on yield and safety for return and risk mitigation. That's a good "first order" solution, but there is another way. During Japan’s Lost Decades, there were huge swings in the market that an astute investor could have profited from. Albert Edwards of SocGen agrees and wrote:

I have long maintained that even within a structural bear market, there are huge returns to be made in equities from participating in short-lived cyclical rallies like the one we have just seen. The Nikkei regularly used to enjoy 40-50% rallies as policy stimulus drove pronounced cyclical upturns in both GDP and profits.

My preferred investment approach, which I wrote about in the Qwest Investment Management’s September 2010 newsletter, is to embrace the volatility and use dynamic asset allocation techniques to trade the intermediate swings in the market.

When social mores and free markets collide

I would like to try something different for a change this Labor Day long weekend. In these pages I have been an advocate of examining assumptions so that a modeler can understand the weaknesses of his models. With that thought in mind, here are a thought experiment that I would like to conduct. Bear in mind that there are no right or wrong answers, only better answers about yourself and your world views.


The plight of the Chilean miners
Economists generally like free markets as they are efficient allocators of resources. But what happens when free market principles collide with social mores?

Consider the plight of the 33 Chilean miners who were trapped underground by a rock slide. The plan is to drill a hole roughly half a mile down through solid rock to rescue them:

Walter Herrera, quality control and risk manager for the Chilean mining company GeoTech, has said his company was bringing a specialized device typically used for boring water holes to the mine. The drill would use one of the three bore holes already made as a pilot and widen the diameter to about 28 inches, which officials have said is wide enough for the miners to be hoisted through.

Here are some questions, as a thought experiment, as a litmus test of true belief in free market principles:

1. Mining is a dangerous profession and the miners knew the risks. Certainly they would have been paid a risk premium for dangerous work and someone with rational expectations would have bought insurance to prepare for such an event. Drilling down half a mile through solid rock using specialized equipment can’t be cheap. Given the costs involved, do they deserve to be rescued?
2. If the answer to the previous question is “yes”, then who should pay for the rescue? If the company pay, has it done a cost benefit analysis of paying compensation of no rescue vs. the cost of a rescue? (Does the company bear any legal liability in this case given the miners knew that they knowingly took risky jobs?) If the government pays, doesn’t that just socialize the costs, just like the banking bailouts? Should the miners themselves pay? After all, they should have known that mining is a risky job and therefore demanded a risk premium in their wages. If that was the case, why would they not have hedged (bought insurance) against such an eventuality? In the tradition of Hayek and Friedman, they were free to choose their own risk profiles.

If you find these questions objectionable, then how do you react to a hypothetical case of an American without health insurance who is diagnosed with cancer? Should the patient be asked to pay for his or her care? What if the cancer is not immediately life threatening and care was not mandated? Is your answer any different from your previous answers about the Chilean miners?

What about these issues raised by Brad Delong on the segmentation effects of genetic testing on the life insurance business? We can identify with the Horatio Alger story of the self-made man. Free market principles are about creative destruction: aallowing people to succeed (and allowing failure). What are the effects when someone wins or loses the genetic lottery without any action on their own?

Isn't the practice of genetic screening just the free market at work?

Back in the days of the Soviet Union, there were endless essays about the "purism" of various schools of Marxist thought. This has been a self-test of the purity of adherence to free market thoughts.

Remember, there are no right or wrong answers, just insights about yourself and your assumptions about the world.

Time to sell Australia

Back in late May I suggested that a cheap way to buy Canadian-like equity exposure would be to buy the Australian market, as both markets and economies are fairly similar. The chart below shows the relative returns of the iShares Australia ETF (EWA) relative to iShares Canada (EWC) and what the pair has done since the call:

Since my post, the Australian market has beaten the Canadian market by about 8%. The maximum outperformance of this trade was about 11%. The pair trade has reached parity. It's time to take profits.

The joys of west coast living

A post totally unrelated to investing: Yesterday I heard on the radio that there was a grey whale cavorting off one of the local piers. This is an unusual event but the sockeye salmon run this year has at record highs so that's what the whale was likely feeding on. We grabbed our child and got some pictures:

Here is another:

Back in May, there was also a grey whale spotted in the area. Here is a video report from the local TV station of the latest sighting.

Ah, the joys of Canadian west coast living!

Making new bullets for policymakers

Ben Bernanke’s much awaited Jackson Hole speech implicitly showed the constraints that he operates under. In his speech, he outlined the tools available to the Federal Reserve:

I will focus here on three that have been part of recent staff analyses and discussion at FOMC meetings: (1) conducting additional purchases of longer-term securities, (2) modifying the Committee's communication, and (3) reducing the interest paid on excess reserves. I will also comment on a fourth strategy, proposed by several economists--namely, that the FOMC increase its inflation goals.

On the fourth “inflation strategy”, he said [emphasis added]:

A rather different type of policy option, which has been proposed by a number of economists, would have the Committee increase its medium-term inflation goals above levels consistent with price stability. I see no support for this option on the FOMC. Conceivably, such a step might make sense in a situation in which a prolonged period of deflation had greatly weakened the confidence of the public in the ability of the central bank to achieve price stability, so that drastic measures were required to shift expectations. Also, in such a situation, higher inflation for a time, by compensating for the prior period of deflation, could help return the price level to what was expected by people who signed long-term contracts, such as debt contracts, before the deflation began.

On the fourth “inflation strategy”, it seems that the Fed does not want a policy of debt monetization. Of all the analysis of the Bernanke speech, the one that I find most interesting comes from Mohamed El-Erian of Pimco:

What Bernanke did not say, or said only timidly:

• Very few linkages to other components of macro policy—particularly fiscal and structural policies
• Very few references on what is going on in the rest of the world and how this impacts the US
• Virtually nothing on whether the US is navigating through a series of national and global re-alignments

 Some open questions in my mind that I still worry about:

• Is the Fed trying to carry too much of the macro policy burden?
• Is the Fed under-estimating the risk of a liquidity trap?
• Does the Fed have sufficiently-effective tools at its disposal?
• Is the Fed under-estimating national and global structural re-alignments?

Are policymakers out of bullets?
On his latter points, the main concern among market participants is the question of whether the Fed out of bullets. Former Fed vice chair Alan Blinder recently wrote an editorial stating that the Fed was running low on ammo. Blinder believed that while the Fed is not out of bullets, the ammunition remaining left in its pouch is weak and not very effective.

Then can we rely on fiscal policy? The Dallas Fed put out a paper entitled Can the Nation stimulate its way to prosperity? The apparent answer is no [emphasis added]:

Compared with no stimulus, the stimulus plan in 2009 alone was expected to increase GDP by 1 to 3 percentage points, raise payroll employment by 500,000 to 1 million jobs and lower the unemployment rate by half a percentage point.

At first glance, it doesn’t appear the stimulus achieved these objectives. In the year after the plan’s passage, the labor market continued to hemorrhage jobs and unemployment climbed above 10 percent. Indeed, the unemployment rate is now higher than it was expected to be without the stimulus plan—and has been every month since the plan’s passage.

Already there are worries about a looming debt crisis. The stimulus question is getting highly politicized. There is a fight brewing over tax policy ahead of the November election and suggestions/accusations that the Republicans are blocking stimulus for political gain.
Notwithstanding the politics, what can fiscal or monetary policymakers do?


When you have a hammer…
I believe that the question has been improperly framed. As the saying goes, if you have a hammer, every problem looks like a nail. As we have economic problems, fiscal and monetary authorities look for macroeconomic solutions.

The Economist recently raised a couple of interesting points about the current situation. First, the Fed may be helpless over unemployment because of its current structural nature. In that case, we may be looking for solutions in the wrong places. The answer may be to look beyond stimulus, which is macroeconomic in autre, and look to microeconomic policies for solutions:

Much of what economists know about structural unemployment has been gleaned from the sorry history of continental Europe, where fat benefits and rigid firing rules dulled labour-market efficiency. That experience mostly offers pointers to what not to do, from adding to employers’ regulatory burdens to letting the long-term jobless shift to the disability rolls.

Getting the to-do list right is trickier, not least because misguided meddling could make unemployment worse. But two avenues seem worth pursuing. The first is a more determined effort to help those trapped in “negative equity” to restructure the mortgages on their homes—an area where the Obama administration has been notably timid. The dire figures for house sales during July, released this week, show how urgent this is. Legal changes, such as a revision to the bankruptcy code that allowed judges to reduce mortgage debt, could help. The second line of attack is to overhaul schemes that help workers retrain and encourage them to search for work. That need not mean more spending (though America does spend a lot less than other rich countries on such “active” labour-market policies). The bigger problem is that existing schemes are fragmented and often ineffective.

I have not fully considered the implications of these suggested microeconomic policy solutions and therefore I have no strong opinions about them, but I think that it’s time to think about a new framework of considering micro as well as macro solutions to the current slow growth environment.

Buy the news, sell the rumor?

The Trader's Narrative weekly report of sentiment surveys indicate that short-term trader sentiment at a bearish, but not panic, extreme. Institutional investors remain relatively sanguine on the market outlook.

When I consider last Friday's market reaction to the much anticipated the GDP report and the Bernanke speech, along with the sentiment picture, Friday may have marked a short-term low for as the bears have found themselves in a crowded trade as the market began to reverse.

Having sold the rumor (of an ugly GDP report), is it time to tactically buy the news?

A Generational New Frugality?

I have written about the economic headwinds faced by the Atlas generation before. Now David Rosenberg (free registration required) has highlighted a New York Times op-ed by Norihiro Kato on the emergence of a Generational New Frugality in Japan entitled Japan and the art of shrugging:

Three years ago, I saw a television program about a new breed of youngster: the nonconsumer. Japanese in their late teens and early 20s, it said, did not have cars. They didn’t drink alcohol. They didn’t spend Christmas Eve with their boyfriends or girlfriends at fancy hotels downtown the way earlier generations did. I have taught many students who fit this mold. They work hard at part-time jobs, spend hours at McDonald’s sipping cheap coffee, eat fast food lunches at Yoshinoya. They save their money for the future.

These are the Japanese who came of age after the bubble, never having known Japan as a flourishing economy. They are accustomed to being frugal. Today’s youths, living in a society older than any in the world, are the first since the late 19th century to feel so uneasy about the future.

I saw young Japanese in Paris, of course, vacationing or studying, but statistics show that they don’t travel the way we used to. Perhaps it’s a reaction against their globalizing elders who are still zealously pushing English-language education and overseas employment. Young people have grown less interested in studying foreign languages. They seem not to feel the urge to grow outward. Look, they say, Japan is a small country. And we’re O.K. with small.

It is, perhaps, a sort of maturity.

It is interesting that this form of youthful New Frugality can be observed in Canada as well. A recent Scotiabank study indicated that the young Canadians are saving more:

While building a nest egg for emergencies is important to Canadians of all ages, the necessity of saving for a rainy day is most keenly felt by the younger generation (18-34) and they are just as likely to have a plan in place to achieve their savings goals as those in older age brackets, according to a recent Scotiabank study conducted by Harris/Decima to assess the saving patterns of Canadians.

They are also more prudent in their spending patterns:

The Scotiabank study also found that younger Canadians are the most prudent in financing their major purchases, with 38 per cent indicating they would prefer to save up and then pay for the whole thing compared to 28 per cent of those aged 35-44 and 27 per cent in the 45-54 and 55+ age groups.

The implications for consumer spending should this form of Generational New Frugality take hold and become the new zeitgeist are enormous. Unlike their elders, this Atlas generation will not be aspiring to the McMansions and other excesses of the last 10 or 20 years.

What will drive consumer spending and global growth then?

Some thoughts on the Druckenmiller exit

There is a great article over at CNN Money about the implications of the Druckenmiller exit for the hedge fund industry:

From our skunk-works of chaos theory here at Hedgeye in New Haven, CT, here are some deep simplicities associated with hedge funds that manage to consistently drive absolute returns across bull and bear markets:

1) Hedge funds that consistently find alpha in their idea generation.
2) Hedge funds that maximize that alpha (spreading their wings) when they find it.
3) Hedge funds that truly hedge

In other words, Druckenmiller truly had alpha. Many other hedge funds are just levered beta players, e.g. a levered long-short in emerging markets does not give you much alpha, it's mostly an emerging market beta.

Quants are dying
We can see a similar alpha effect with quant funds. Equity quant funds, which were incredibly innovative back in the 1980s (!), are now in a crowded trade. The cost of entry to being a quant has fallen dramatically over the decades. Everyone went to the same schools and learned the same techniques and they all use the same databases. What's more, I can now create a relatively primitive quantitative equity research platform using free internet resources.

Is it any wonder when the results are similar? Were the events of August 2007 enough of a warning?


Looking for "reasoned" queasy investments

Consumers of alpha have to realize that true alpha requires innovation and some maverick thinking. This means investment approaches that:

1. Make sense, i.e. have some economic basis
2. Untried, or largely untried

In particular, (2) means that the investment theme or process might make you uncomfortable, or even queasy, because you are so far away from the consensus. Here are a couple of "old" invesment approaches that deserve a second look in the current environment:

• Stock picking with a long-term perspective: One of the secrets of Warren Buffett's success was that he wanted to own the whole company. While we all aspire to his track record, the Buffett approach also meant a significant degree of 1) tracking error risk; and 2) short and intermediate term drawdown risk. These kinds of risks make institutional investors and their managers uneasy, (dare I say "queasy"?) Maybe it's time to return to those basics.
• Dynamic or tactical asset allocation: I believe that this is another oldie but goodie. Investors have it hammered in their heads that market timing doesn't work and this approach can also be termed "uncomfortable" for investors. Managers who practice this art are practically extinct these days. In an era of macroeconomic uncertainty, however, these kinds of top-down macro techniques can yield a surprising level of alpha, according to research from First Quadrant. I am biased, of course, as my Inflation-Deflation Timer model belongs in this class.

 

A warning from the cyclicals

Further to my post about the bond vs. stock market conundrum, here are some further warnings from the cyclicals. The first chart shows the relative performance of the cyclically sensitive Semiconductors against Technology stocks. The Semis have been weakening on a relative basis and violated a relative support level in early August.

Looking at the relative returns of the broader Morgan Stanley Cyclical Index against the market, these cyclicals fell through a relative uptrend in early June and have been going sideways against the market ever since. Stepping back, the entire formation (circled in red) looks like an inverted saucer, or dome, top to me.

This is not the stuff of robust cyclical recoveries.

In addition, we had the awful Philly Fed numbers and dismal initial jobless claims readings last week. As well, the latest Merrill Lynch survey of fund managers indicate that a whopping 78% believe that a double-dip recession is unlikely, indicating that the consensus remains bullish. The combination of sentiment readings, the message from market technicals and deteriorating market conditions leads me to a cautious stance.

The Yellow Peril grows up

Now that China has overtaken Japan as the second largest economy, I post the following poem, which was published in the Washington Post in 2008, without comment:

When we were the Sick Man of Asia,
We were called the Yellow Peril.
When we are billed as the next Superpower, we are called The Threat.
When we closed our doors, you launched the Opium War to open our markets.
When we embraced free trade, you blamed us for stealing your jobs.
When we were falling apart, you marched in your troops and demanded your fair share.
When we tried to put the broken pieces back together again, Free Tibet, you screamed. It was an Invasion!
When we tried communism, you hated us for being communist.
When we embraced capitalism, you hated us for being capitalist.
When we had a billion people, you said we were destroying the planet.
When we tried limiting our numbers, you said we abused human rights.
When we were poor, you thought we were dogs.
When we lend you cash, you blame us for your national debts.
When we build our industries, you call us polluters.
When we sell you goods, you blame us for global warming.
When we buy oil, you call it exploitation and genocide.
When you go to war for oil, you call it liberation.
When we were lost in chaos, you demanded the rule of law.
When we uphold law and order against violence, you call it a violation of human rights.
When we were silent, you said you wanted us to have free speech.
When we are silent no more, you say we are brainwashed xenophobes.
Why do you hate us so much? we asked.
No, you answered, we don't hate you.
We don't hate you either,
But do you understand us?
Of course we do, you said,
We have AFP, CNN and BBC. . . .
What do you really want from us?
Think hard first, then answer . . .
Because you only get so many chances.
Enough is Enough, Enough Hypocrisy for This One World.
We want One World, One Dream, and Peace on Earth.
This Big Blue Earth is Big Enough for all of Us.

Retirement: It's not just about money

When I left Mother Merrill in early 2007 and announced that I would be moving into early retirement about nearly 30 years in the business (which eventually drove me crazy), I quoted Todd Harrison in my farewell email to friends and colleagues entitled "Cam really is leaving to spend more time with his family":

I'm not going to say that success is insignificant, we know that's not true, but I can tell you, from experience, that if you look for happiness in a bank account, you're missing the bigger trade.

It appears that I am in good company of people wishing to slow down and to smell the roses. Stanley Druckenmiller recently shuttered his hedge fund following in the path of Richard Grubman (Highland Capital), James Simons (Renaissance Technologies), John Horseman (Horseman Global) and Timothy Barakett (Atticus Capital).

I recognized back then that life wasn't just about money (as important as it is). However, neo-classical economists have tended to focus on wealth creation as a source of growth for an economy. As good quantitative analysts know, optimizing a system based on a single factor can lead to unforeseen results (and possible policy mistakes).


The Paris Hilton effect
Here is an example. One of the biggest issues that faces the heads of wealthy families is the problem of instilling proper values in their children and how to teach them the value of a dollar. We saw that in spades during the dot com era when 20-somethings and 30-somethings working stiffs became multi-millionaires overnight. What message are you sending the kids when you can hop on the private jet and fly to St. Moritz for Spring Break? Do you let each of your children bring a friend along? What message does it send to your kids' friends and your neighbors?

If you don't think those are problems, then how do you prevent your kids from turning into Paris Hilton?


The Good Life
Now a MetLife study confirms my sentiments about the Todd Harrison quote. While wealth is important as a source of happiness, it’s not the only thing:

• Respondents define the Good Life in terms of the three Ms: Money (having enough), Meaning (time for friends and family), and Medicine (good physical and mental health).
• Living the Good Life is highly related with having a sense of purpose and this in turn is interrelated with “vision” (having clarity about the path to the Good Life) and “focus” (knowing and concentrating on the most important things that will get you to your Good Life).
• Meaning, closely associated with the importance of family and friends, remains the primary component of the Good Life for all age groups, despite instability in financial and other aspects of their life. People plan to spend time with family and friends above all else, regardless of age.

What’s more, the study found that these components tend to be stable and unrelated to age. You can have the Good Life whether you are 20, 50 or 70 if these things are in your life.


The changing face of retirement
As the Boomers age, there have been worried discussions about what happens when they find out they don’t have enough money to retire. Such discussions may be overly alarmist because they assume that money is the sole source of happiness.

According to an alternative view in The Economist, saving enough money to retire may not be realistic. If you are trying to optimize Happiness instead of Wealth, then a better way might be to re-define retirement. Instead of an abrupt exit from the work force, consider part-time work:

For us, retirement is a choice—and because we enjoy our jobs and they’re not physically taxing, retirement is not something we tend to embrace. But most people are not so lucky. Even if they like their jobs it, the work may be too physically demanding to continue into old age. A colleague of mine was often told by his father, “Get an education so you can get a job where you use your brain; it’s the best insurance against getting injured.”

A phased transition from full to part time work is possible for some people, particularly in an age when medical science has advanced and so has life expectancy.

As we live progressively longer we must also rethink our retirement expectations. Retiring at the same age that your parents did, or earlier, can no longer be the expectation, or at least not at the rate we are saving. True, working to age 70 will be tough or impossible for some people and it is expensive for employers. Meanwhile, part of the justification for a later retirement age is longer life expectancy, but low income people who worked in hard labour often die younger. In principle we could index the normal retirement age to different demographic life expectancy—so people will have different ages when they can collect full Social Security. But politically that would be a mess, especially because mortality rates are so race-specific. That's why retirement may need to come to mean something different than it currently does. Retirement may not be an abrupt exit from the labour force, but a slow phase out starting with part-time work.

Bond Market 1, Stock Market 0

Recently some have observed that the US stock market and bond markets have rallied together - an unusual condition. The Economist/Buttonwood blog wrote:

This reminds me a bit of the late 1990s when, as a tech sceptic, I wondered why the stockmarket kept surging to stratospheric valuations. Whatever the headlines the market went up. Good news on the economy meant profits would be strong while bad news meant that central banks would cut rates, and thus profits would eventually be strong.

Fast forward to 2010:

[T]he bond market is surely betting that the Fed's actions won't work and that Japan is the template; the equity market is betting that the Fed will be successful and the Goldilocks economy will return. 

Recall James Carville's famous comment that he wanted to be reincarnated as the bond market so that he could intimidate everybody - that’s because the bond market is usually right. In light of last week's market action and the appearance of the Hindenberg Omen, the bond market seems to have scored.

Incidentally, I see that Barry Ritholz at The Big Picture also commented on the stock vs. bond market tug of war by calling the bond market "adult supervision."

Could commodity prices be in for a downdraft?

Several months ago Gluskin Sheff chief economist David Rosenberg pointed out that the Shanghai stock market appears to lead commodity prices by about four months.

Looking at the chart below, the Shanghai Composite broke down in mid-April. Fast forward four months to today and factor in yesterday's market action, not only in stocks but in commodity prices. Also consider that wheat prices, which had gone parabolic, had been pulling back for about a week, you have the makings of a serious downdraft in commodity prices.

I don't know if the four month Shanghai-CRB relationship is spurious or not, but this is a fascinating theory that can be tested in real-time.

What happens when you ARE the market?

I see that the folks at US Commodity Funds, who brought us the tremendously popular ETFs USO and UNG, is launching an ETF that is designed to combat the return eroding contangoes observed in many commodity futures. The new fund is called the United States Commodity Index Fund and will track the SummerHaven Dynamic Commodity Index. The Index will re-balance monthly and hold 14 out of a possible universe of 27 commodity contracts on an equal-weighted basis. The selection will be strictly rule-based:

USCI is based on a simple but powerful investment thesis: historical data shows that portfolios comprised of commodities trading in backwardation tend to perform better than broad-based commodity baskets or commodities for which futures markets are contangoed. The idea behind USCI is that the optimal form of commodity exposure is achieved through positions in backwardated markets or markets that exhibit the least degree of contango.

An explanation: When long-dated futures are trading above the current spot price, the market is considered to be in contango. When then are trading below spot, the market is said to be in backwardation.

Sounds great? Not!

I am sure the backtests worked really well but this is a case of quants gone wild. No doubt, US Commodity Funds hopes that the success of the new ETF will equal or exceed the popularity of USO and UNG. Were this to happen, the buying pressure put on some of these commodities, which can be quite thin and illiquid, would create enormous return eroding price distortions.

As an aside, you are just begging for the Street to front-run you given the rule-based index construction approach – not a good idea.


Too many ETFs?
In early July, TickerSense reported that the number of US-listed ETFs that they track went over the 1,000 mark. Do we really need that many ETFs?

Are they distorting the market and market liquidity?

Could less sophisticated investors be fooled into believing that an ETF representing a narrow, but sexy, segment of the market be more liquid than it really is? Consider this recent Van Eck Global filing for a Minor Metal (read: rare earths) ETF.

Enough is enough. Some of these ideas are ill considered and are accidents waiting to happen.

The Inflation-Deflation debate continues

As we wait for the FOMC statement, I see that the inflation-deflation debate is continuing. On the deflation side of the debate, the economy remains anemic and Nobel Laureate Joseph Stiglitz is calling for more stimulus. Moreover, Pimco head El Erian warned of deflationary risks in the US economy.

On the other hand, we have the wheat crisis in Russia, which has pushed up food prices and is raising the specter of commodity inflation.


A volatile decade
Which camp is right and what can investors do?

My answer to the first question is “I’m not sure.” However, I do agree with Simon Johnson, who stated that:

The major risk faced by the world economy is not stagnation year-in and year-out, but rather an unstable credit cycle that produces apparent “growth” – perhaps even high recorded growth – in some years for the United States, but then leads to financial crisis, repeated recession, and very little by way of sustained growth. US GDP in real terms is currently at about the same level now as it was in 2006. (Real GDP, annualized, was around $12.9 trillion in the first quarter of 2006 and $13.2 trillion in the second quarter of 2010; see Table 3B in the July 2010 BEA report).[3]

For buy and hold investors, this may mean a decade of low but volatile returns, which is a possibility that I wrote about before here. However, Johnson offers a ray of hope:

Japan’s lost decade in the 1990s was not a sequence of years with zero growth – there were notable expansions and contractions, with high rates of growth in particular quarters and even some years when it seemed that the corner had been turned. Lost decades are evident only in retrospect. The US is currently on track for “losing” at least half a decade of growth (from the beginning of 2006 through the end of 2010).

In other words, there would be significant cyclical ups-and-downs under such a scenario and it would be possible to trade the swings using trend following models such as my Inflation-Deflation Timer model.

An unbalanced China bet?

I have been somewhat skeptical of the current stock market rally but I haven't quite been able to put my finger on the reason - until I looked at the market relative charts to see where the leadership has been coming from.

The downdraft that ended in early July was based on a double-dip recession scare. If Mr. Market truly believed that the recovery was real, then we should see leadership from sectors such as Consumer Discretionary stocks. The chart below shows the relative performance of the Consumer Discretionaries (XLY) against the market. The sector has been fairly flat against the market since early July, indicating that market leadership isn't coming from expectations of a revived consumer.

What about the Financials? This is a sector that has been badly beaten up since the Lehman Crisis and was in need of rescue. Did the Financials lead us up in this rally? A glance at the chart below says "no". In fact, Financials remain weak and in a relative downtrend versus the overall market.

If the leadership isn't coming from the cyclical consumer or beaten up Financials, then where is it coming from?

The answer is in Industrials, which is tilted towards capital goods:

,,,and the resource sector such as Energy (shown below) and Materials (not shown):

A Shanghai relief rally
Under more "normal" circumstances, a market rally would be predicated on a reviving consumer or a recovery in the financial sector. Instead, we have a rally led by hard assets and capital goods. Digging deeper, this rally tracks the rally in the Shanghai Composite, which bottomed in early July and is showing some signs of life.

This suggests that US equities are rallying based on the belief that China, which has been the last hope of growth in a growth starved world, isn't going to experience a hard-landing despite the bad loan risks in their financial system. In the meantime, indicators such as the ISM Manufacturing Index continue to weaken and so does the much watched ECRI WLI. While a soft landing in China may be a relief to investors, a scenario like that is highly unbalanced and does not provide the basis for sustainable global growth.

More on Iran, China

A couple of brief follow-ups to previous posts:


Rumors of war
Further to my recent post on the possibility of war as the reflationary trade, the Fabius Maximus blog pointed out that VIPS, a group of senior people within the US intelligence community, ihas published an open letter to Obama warning about an Israeli strike on Iran:

We VIPS have found ourselves in this position before. We prepared our first Memorandum for the President on the afternoon of February 5, 2003 after Colin Powell’s speech at the UN.

We had been watching how our profession was being corrupted into serving up faux intelligence that was later criticized (correctly) as “uncorroborated, contradicted, and nonexistent” — adjectives used by former Senate Intelligence Committee chair Jay Rockefeller after a five-year investigation by his committee.

As Powell spoke, we decided collectively that the responsible thing to do was to try to warn the President before he acted on misguided advice to attack Iraq. Unlike Powell, we did not claim that our analysis was “irrefutable and undeniable.” We did conclude with this warning:

“After watching Secretary Powell today, we are convinced that you would be well served if you widened the discussion … beyond the circle of those advisers clearly bent on a war for which we see no compelling reason and from which we believe the unintended consequences are likely to be catastrophic.”
http://www.afterdowningstreet.org/downloads/vipstwelve.pdf

We take no satisfaction at having gotten it right on Iraq. Others with claim to more immediate expertise on Iraq were issuing similar warnings. But we were kept well away from the wagons circled by Bush and Cheney.

Sadly, your own Vice President, who was then chair of the Senate Foreign Affairs Committee, was among the most assiduous in blocking opportunities for dissenting voices to be heard. This is part of what brought on the worst foreign policy disaster in our nation’s history.

We now believe that we may also be right on (and right on the cusp of) another impending catastrophe of even wider scope — Iran — on which another President, you, are not getting good advice from your closed circle of advisers.

They are probably telling you that, since you have privately counseled Prime Minister Netanyahu against attacking Iran, he will not do it. This could simply be the familiar syndrome of telling the President what they believe he wants to hear.

Quiz them; tell them others believe them to be dead wrong on Netanyahu. The only positive here is that you — only you — can prevent an Israeli attack on Iran.

I have had some feedback on my post, some of whom disagree with my assessment that war would be bullish for the markets. Let me re-phrase my beliefs. War would likely be bearish if America was to spend more blood and treasure getting caught in another quagmire. War would be bullish for the US economy if Americans followed the 19th Century imperialist model of "looting" conquered lands - which could happen if Americans controlled the major oil producing regions in the Middle East. I am not passing judgment on whether such a course would be right or wrong, but just stating my assessment of the likely consequences of war.


China moves up the value chain
Further to my last post and essay on the very long view on China, I see that Patrick Chovanec and I are on the same page about rising labor costs in China and China moving up the value chain:

The Chinese economy is changing. There’s no question that companies that continue to rely on cheap labor to produce low-value, commodity goods — like those ones Andrew describes in his article — will increasingly feel the squeeze. As forward-looking companies pay more to deliver greater value-add, the opportunity cost of employing labor rises. That’s good for the economy, and for standards of living, but it means companies that remain stagnant must pay more just to do what they were already doing. With razor-thin margins based purely on eking out lower costs, many will go under.

Materialistic China

A couple of weeks ago the New York Times published an article about the materialistic young in China, as exemplified by the behavior on dating shows. The poster child for Chinese materialism turned out to be a contestant on the popular show If You Are The One (非城勿扰), who was asked if she would like to go for a bicycle ride, she responded "I’d rather sit and cry in the back of a BMW" and be unhappy than be poor and happy. The authorities responded with heavy handed censorship:

Late last May, central government propaganda officials issued a directive calling the shows “vulgar” and faulting them for promoting materialism, openly discussing sexual matters and “making up false stories, thus hurting the credibility of the media.”

So the dating show, and others like it, got a makeover. Gone are fast cars, luxury apartments and boasts of flush bank accounts. Now the contestants entice each other with tales of civic service and promises of good relations with future mothers-in-law. One show now uses a professor from the local Communist Party school as a judge.

There was more to that story. It turned out that the "contestant" modeled lingerie. It appeared that there is a problem with many TV dating shows that the contestants were either fake and were either assoicated with the show in some way or models promoting themselves.


The very long-view on China: Beyond the materialism
Rather than going tut-tut or about the rise of consumerism and materialism in China or commenting on the effects of rising affluence, it is instructive to think about this as an unwanted effect of the one-child policy, which I posted before here. It is further instructive to think about the demographics effect of China's aging population and think about the very very long-veiw on China, which is the subject of an article that I recently wrote about here.