Showing posts with label John Mauldin. Show all posts
Showing posts with label John Mauldin. Show all posts

Wednesday, December 2, 2015

How Big the Gig Economy Really Is

By John Mauldin

There is growing awareness of what is being called the “gig economy.” It’s not just Uber driving or Airbnb. There are literally scores of websites and apps where you can advertise your services, get temporary or part time work, and do so from anywhere you happen to be.

Some “gigs” actually pay pretty good money, but they are for people with specialized skills who prefer to live a somewhat different lifestyle than the typical 9 to 5’er does. My hedge fund friend Murat Köprülü has been busy researching and documenting this phenomenon and regularly regales me with what he finds.

He goes and spends evenings and weekends with young gig workers, trying to figure out what it is they really do and how they make ends meet in New York City. It turns out they need a lot less to support their lifestyle than you might imagine, and they prefer working intermittent gigs, being able to do what they want, and having no boss.

A close look at the data indicates that the gig economy is indeed big and growing. But there is a great deal of debate among economists about how big it really is.

It’s Much Bigger Than the Employment Data Suggests

Gig workers don’t seem to show up clearly in the BLS employment data. Typically, we would expect those working in the gig economy to appear in the self employed category, but that category is actually drifting downward in numbers—relatively speaking.

But Harvard economist Larry Katz and Princeton’s Alan Krueger, who are working on research to document the rise of the gig economy in America, says that our current measures ignore the bulk of the gig economy.

 From a story at fusion.net:
Katz said two pieces of evidence suggest current measures of self-employment and multiple-job holding are “missing a large part of the gig economy.” The first is that the share of the employed (and of the adult population) filing a 1099 form, the tax document “gig economy” workers must file, increased in the 2000s, even as standard measures of self-employment declined in the 2000s. Other groups have confirmed this: Zen Payroll, a site that tracks the sharing economy, found increases in the share of 1099 workers across many major U.S. metros.

Mauldin-Economics-Gig-Economy
Source: Zen Payroll via Small Business Labs

And data from research group EconomicModeling.com show the share of traditional, 9-to-5 workers in the labor force has declined…..

Mauldin-Economics-Gig-Economy
Source: Fusion, data via EconomicModeling.com

… while those who categorize themselves as “miscellaneous proprietors” is climbing.

Mauldin-Economics-Gig-Economy
Source: Fusion, data via EconomicModeling.com

A recent survey found 60 percent of such workers get at least 25 percent of their income from gig economy work.

The problem with the BLS estimates is that they overlook a sizable chunk of the true gig economy.
And this report absolutely squares with what my friend Murat’s research is showing: that gig economy is not shrinking. On the contrary, it’s on the rise, and a quite rapid rise.

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The article was excerpted from John F. Mauldin’s Thoughts from the Frontline. Follow John Mauldin on Twitter. The article How Big the Gig Economy Really Is was originally published at mauldineconomics.com.


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Friday, November 13, 2015

Investing Inspiration from the World of Sports

By John Mauldin 

One of the most successful investors in the world is Howard Marks of Oaktree Capital Management. One of the things I look forward to every quarter is the letter he writes to his clients – it goes right to the top of my reading list. Not only is it always full of generally brilliant investment counsel, Howard is also a really great writer. He has an easy style that pulls you through his letter effortlessly.

I have never sent his letter to you as an Outside the Box, as the copies I get are clearly watermarked and copyrighted. So I was surprised and delighted to learn that the letter is free when I listened to a speech by Howard in which he encouraged everyone to get it. Unlike another hundred billion dollar hedge fund company that shall go unnamed, Oaktree evidently thinks that brilliance should be shared.

I am especially pleased to be able to pass on this latest issue, in which Howard returns to a theme he has used in the past, which is the parallels between investing and sports. He recounts the career of Yogi Berra, who sadly passed away in September. Yogi was always a fan favorite, and he was certainly one of mine; but it was his consistency, both on offense and defense, that made him great.

Marks goes on to defend the seemingly indefensible: in last year’s Super Bowl, Pete Carroll, coach of the Seattle Seahawks, called for a passing play on the one yard line as time was running out, which as anyone who watched that game would remember, was one of the most spectacularly unsuccessful decisions of all time. But Howard asks us, “His decision was unsuccessful, but was it wrong?”

Can we judge a career on one play? I am grateful that my investment and writing careers are not judged solely by my many mistakes.

This past weekend at the T3 Conference in Miami was enlightening. Todd Harrison put together a great lineup of speakers who represented a wide range of investment styles and strategies. Perhaps because I have been looking at alternative income strategies in a world of low interest rates, I was particularly intrigued by how investors are finding reasonable yield income. I wrote seven years ago that I thought private credit would become a very large part of the investment spectrum in the future, and it is certainly turning out that way. The whole burgeoning world of “shadow banks” has been an unintended consequence of Dodd-Frank.

That overreaching regulation, coupled with enhanced liquidity requirements, has severely limited the ability of small banks to lend. Private credit funds are being set up to go where banks can’t or won’t, and frankly they have a natural advantage. Their cost of money is lower than banks’, and their overhead is even less. They typically don’t leverage as much as banks do, but they can still produce returns that any bank would be happy with. There is more and more interest in making these investment vehicles more accessible to the public, and I applaud anyone who tries.

Plus, it was just good to see so many friends, then sit by the pool for an afternoon after the conference was over. It was supposed to rain, but we got lucky and caught some sunshine in Florida.

Now I’m back in Dallas and working away on the new book. I am told we have all the volunteer research assistants we need, so if you haven’t contacted us yet, my staff has asked me to suggest that we are full up.
Have a great week, and go to your favorite spot to read and think as you enjoy Howard Marks’ latest memo.

Your glad to be back home analyst,
John Mauldin, Editor
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Memo to: Oaktree Clients
From: Howard Marks
Re: Inspiration from the World of Sports


I’m constantly intrigued by the parallels between investing and sports. They’re illuminating as well as fun, and thus they’ve prompted two past memos: “How the Game Should Be Played” (May 1995) and “What’s Your Game Plan?” (September 2003). In the latter memo, I listed five ways in which investing is like sports:
  • It’s competitive – some succeed and some fail, and the distinction is clear.
     
  • It’s quantitative – you can see the results in black and white.
     
  • It’s a meritocracy – in the long term, the better returns go to the superior investors.
     
  • It’s team-oriented – an effective group can accomplish more than one person.
     
  • It’s satisfying and enjoyable – but much more so when you win. 

Another angle on the investing/sports analogy has since occurred to me: an investment career can feel like a basketball or football game with an unlimited number of quarters. We may be nearing December 31 with a substantial year-to-date return or a big lead over our benchmarks or competitors, but when January 1 rolls around, we have to tackle another year. Our record isn’t finalized until we leave the playing field for good. Or as Yogi Berra put it, “It ain’t over till it’s over.” It was Yogi’s passing in late September that inspired this memo. [Since most of the references in this memo are to American sports, with their peculiarities and unique terminology, this is a good time for an apology to anyone who’s unfamiliar with them.]

Yogi Berra, Baseball Player 

Lawrence “Yogi” Berra was a catcher on New York Yankees baseball teams for eighteen years, from 1946 to 1963. Although he was rarely number one in any offensive category, he often ranked among the top ten players in runs batted in, home runs, extra base hits (doubles, triples and home runs), total bases gained and slugging percentage (total bases gained per at bat). He excelled even more on defense: in the 1950s he was regularly among the top three or four catchers in terms of putouts, assists, double plays turned, stolen bases allowed and base stealers thrown out.

Yogi was selected to play in the All-Star Game every year from 1948 through 1962. He was among the top three vote-getters for American League Most Valuable Player every year from 1950 through 1956, and he was chosen as MVP in three of those years. The Yankee teams on which he played won the American League pennant and thus represented the league in the World Series fourteen times, and they won the World Series ten times. He was an important part of one of the greatest dynasties in the history of sports. To me, the thing that stands out most is Yogi’s consistency. Not only did he perform well in so many different categories, but also:
  • He led the American League in number of games played at the grueling catcher position eight years in a row.
     
  • He was regularly among the catchers with the fewest passed balls and errors committed.
     
  • He had around 450-650 at bats most years, but over his entire career he averaged only 24 strikeouts per year, and there was never one in which he struck out more than 38 times. (In 1950 he did so only 12 times in nearly 600 at bats.) Thus, ten times between 1948 and 1959 he was among the ten players with the fewest strikeouts per plate appearance. 
In short, Yogi rarely messed up.

Consistency and minimization of error are two of the attributes that characterized Yogi’s career, and they can also be key assets for superior investors. They aren’t the only ways for investors to excel: some great ones strike out a lot but hit home runs in bunches the way Reggie Jackson did. Reggie – nicknamed “Mr. October” because of his frequent heroics in the World Series – was one of the top home run hitters of all time. But he also holds the record for the most career strikeouts, and his ratio of strikeouts to home runs was four times Yogi’s: 4.61 versus 1.16. Consistency and minimization of error have always ranked high among my priorities and Oaktree’s, and they still do. 


Yogi Berra, Philosopher 

Although Yogi was one of the all time greats, his baseball achievements may be little-remembered by the current generation of fans, and few non-sports lovers are aware of them. He’s probably far better known for the things he said:
  • It’s like déjà vu all over again.
     
  • When you come to a fork in the road, take it.
     
  • You can observe a lot by just watching.
     
  • Always go to other people’s funerals, otherwise they won’t come to yours.
     
  • I knew the record would stand until it was broken.
     
  • The future ain’t what it used to be.
     
  • You wouldn’t have won if we’d beaten you.
     
  • I never said most of the things I said. 
I’ve cited Yogi’s statements in previous memos, and I borrowed the Yogi-ism at the top of the list above for the title of one in 2012. “Out of the mouths of babes,” they say, comes great wisdom. The same was true for this uneducated baseball player, and many of Yogi’s seeming illogicalities turn out to be profound upon more thorough examination.

“Baseball is ninety percent mental and the other half is physical.” That was another of Yogi’s dicta, and I think it’s highly useful when thinking about investing. Ninety percent of the effort to outperform may consist of financial analysis, but you need to put another fifty percent into understanding human behavior. The market is made up of people, and to beat it you have to know them as well as you do the thing you’re considering investing in. 

I sometimes give a presentation called, “The Human Side of Investing.” Its main message surrounds just that: while investing draws on knowledge of accounting, economics and finance, it also requires insight into psychology. Why? Because investors’ objectivity and rationality rarely prevail as much as investment theory assumes, and emotion and “human nature” often take over instead. That’s why my presentation is subtitled, “In theory there’s no difference between theory and practice. In practice there is.” Yogi said that, too, and I think it’s absolutely wonderful.

Things often fail to work the way investment theory says they should. Markets are supposed to be efficient, with no underpricings to find or overpricings to avoid, making it impossible to outperform. But exceptions arise all the time, and they’re usually attributable more to human failings than to math mistakes or overlooked data.

And that leads me to one of the most thought-provoking Yogi-isms, concerning his choice of restaurant: “Nobody goes there anymore because it’s too crowded.” What could be more nonsensical? If nobody goes there, how can it be crowded? And if it’s crowded, how can you say nobody goes there?

But as I wrote last month in “It’s Not Easy,” a lot of accepted investment wisdom makes similarly little sense. And perhaps the greatest – and most injurious – of all is the near unanimous enthusiasm that’s behind most bubbles.

“Everyone knows it’s a great buy,” they say. That, too, makes no sense. If everyone believes it’s a bargain, how can it not have been bought up by the crowd and had its price lifted to non bargain status as a result? You and I know the things all investors find desirable are unlikely to represent good investment opportunities. But aren’t most bubbles driven by the belief that they do?
  • In 1968, everyone knew the Nifty Fifty stocks of the best companies in America represented compelling value, even after their p/e ratios had reached 80 or 90. That belief kept them there . . . for a while.
     
  • In 2000, everyone thought tech investing was infallible and tech stocks could only rise. And they were sure the Internet would change the world and the stocks of Internet companies were good buys at any price. That’s what took the TMT boom to its zenith.
     
  • And here in 2015, everyone knows social media companies will own the future. But will their valuations turn out to be warranted? 
Logically speaking, the bargains that everyone has come to believe in can’t still be bargains . . . but that doesn’t stop people from falling in love with them nevertheless. Yogi was right in indirectly highlighting the illogicality of “common knowledge.” As long as people’s reactions to things fail to be reasonable and measured, the spoils will go to those who are able to recognize this contradiction. 


Looking for Lance Dunbar 

There may be a few folks in America who, like the rest of the world’s population, are unaware of the growing popularity of daily fantasy football. In this on-line game, contestants assemble imaginary football teams staffed by real professional players. When that week’s actual football games are played, the participants receive “fantasy points” based on their players’ real world accomplishments, and the participants with the most points win cash prizes. (Why is it okay to engage in interstate betting on fantasy football but not on football itself?

Because proponents were able to convince the authorities that the act of picking a team for fantasy football qualifies it as a game of skill, not chance. But last week, Nevada became the sixth state to ban daily fantasy sports, concluding that it’s really nothing but gambling.) The commercials for fantasy football say things like, “Sign up, make your picks, and collect your winnings.” That sounds awfully easy . . . and not that different from discount brokers’ ads during bull markets. 

In daily fantasy football, the challenge comes from the fact that the participants have a limited amount of money to spend and want to acquire the best possible team for it. If all players were priced the same regardless of their ability (a completely inefficient market), the prize would go to the participant who’s most able to identify talented players. And if all players were priced precisely in line with their ability (a completely efficient market), it would be impossible to acquire a more talented team for the same budget, so winning would hinge on random developments.

The market for players in fantasy football appears to be less than completely efficient. Thus participants have the possibility of finding mispricings. A star may be overpriced, so that he produces few fantasy points per dollar spent on him. And a journeyman might be underpriced, able to produce more rushing (i.e., running) yards, catches, tackles or touchdowns than are reflected by his price. That’s where the parallel to investing comes in.

Smart fantasy football participants understand that the goal isn’t to acquire the best players, or players with the lowest absolute price tags, but players whose “salaries” understate their merit – those who are underpriced relative to their potential and might amass more points in the next game than the cost to draft them reflects. Likewise, smart investors know the goal isn’t to find the best companies, or stocks with the lowest absolute dollar prices or p/e ratios, but the ones whose potential isn’t fully reflected in their price. In both of these competitive arenas, the prize goes to those who see value others miss.

There’s another similarity. Sports media employ “experts” to cover this imaginary football league, and it’s their job to attract viewers and readers by offering advice on which players to draft. (What other talking heads does that remind you of?) My musings on fantasy football started in late September, when I heard a TV commentator urge that participants take a look at Lance Dunbar, a running back for the Dallas Cowboys, based on the belief that Dunbar’s price might understate his potential to earn fantasy points. The commentator’s thesis was that the Cowboys’ star quarterback was injured and, because of the replacement quarterback’s playing style, Dunbar might get more opportunities – and run up more yardage – than his price implied. Thus, Dunbar might represent an underappreciated investment opportunity.

Or not. Dunbar tore his anterior cruciate ligament in the next game, meaning he won’t produce any more points – real or virtual – this season. It just proves that even if your judgment is sound, randomness has a lot of influence on outcomes. You never know which way the ball will bounce.

“Sign up, make your picks, and collect your winnings.” If only everyone – fantasy football entrants and investors alike – understood it’s not that easy.


Are the Helpers Any Help?

In investing, there are a lot of people who’ll offer to enhance your results . . . for a fee. In an allegorical treatment in Berkshire Hathaway’s 2005 annual report, Warren Buffett called them “Helpers.” There are helpers in sports, too, especially where there’s betting. This memo gives me a chance to discuss an invaluable clipping on the subject that I collected nine months ago and have been looking for an occasion to mention.

The New York Post’s sports writers opine weekly as to which professional football games readers should bet on (real games, not fantasy). Each week, the Post reports on the results of the prognostications for the season to date. When they published the results last December 28, they might have thought they demonstrated the value of those helpers. But I think that tabulation – nearly at the end of the football season – showed something very different.

By the time December 28 had rolled around, the eleven forecasters had tried to predict the winner of each of the 237 games that had been played to date, as well as what they thought were their 47 or so “best bets.” By “the winner,” I assume they meant the team that would win net of the bookies’ “point spread.” (Without doing something to even the odds, it would be too easy for bettors to win by backing the favorites. To make betting more of a challenge, the bookies establish a spread for each game: the number of points by which the favored team has to beat the underdog in order to be deemed the winner for betting purposes.) How often were the Post’s picks correct? Here’s the answer:

Percentage correct Total picks (2,607 games) Best bets (522 games)
All forecasters 50.9% 49.4%
Median forecaster 50.6% 47.9%
Best forecaster 58.5% 56.2%
Worst forecaster 44.8% 39.6%

An incorrigible optimist – or perhaps the Post – might say these results show what a good job the forecasters did as a group, since some were right more often than they were wrong. But that’s not the important thing. For me, the key conclusions are these:
  • The average results certainly make it seem that picking football winners (net of the points spread) is just a 50/50 proposition. Evidently, the folks who establish the point spreads are pretty good at their job, so that it’s hard to know which team will win.
     
  • The symmetrical distribution of the results and the way they cluster around 50% tell me there isn’t much skill in predicting football winners (or, if it exists, these pickers don’t have it). The small deviations from 50% – both positive and negative – suggest that picking winning football teams for betting purposes may be little more than a matter of tossing a coin.
     
  • Even the best forecasters weren’t right much more than half the time. While I’m not a statistician, I doubt the fact that a few people were right on 56-58% of their picks rather than 50% proves it was skill rather than luck. Going back to the coin, if you flipped one 47 times (or even 237 times), you might occasionally get 58% heads.
     
  • Lastly, all eleven writers collectively – and seven of them individually – had worse results on the games they considered their “best bets” than on the rest of the games. So clearly they aren’t able to accurately assess the validity of their own forecasts. 
And remember, these forecasts weren’t made by members of the general populace, but rather by people who make their living following and writing about sports. 

My favorite quotation on the subject of forecasts comes from John Kenneth Galbraith: “We have two classes of forecasters: Those who don’t know – and those who don’t know they don’t know.” Clearly these forecasters don’t know. But do they know it? And do their readers?

The bottom line on picking football winners seems to be that the average forecaster is right half the time, with exceptions that are relatively few in number, insignificant in degree and possibly the result of luck. He might as well flip a coin. And that brings us back to investing, since I find this analogous to the observation that the average investor’s return equals the market average. He, too, might as well flip a coin . . . or invest in an index fund.

And by the way, the average participant’s average result – in both fields – is before transaction costs and fees. After costs, the average investor’s return is below that of the market. In that same vein, after costs the average football bettor doesn’t break even.

What costs? In sports betting, we’re not talking about management fees or brokerage commissions, but “vigorish” or “the vig.” Wikipedia says it’s “also known as juice, the cut or the take . . . the amount charged by a bookmaker . . . for taking a bet from a gambler.” This obscure term refers to the fact that to try to win $10 from a bookie, you have to put up $11. You’re paid $10 if you win, but you’re out $11 if you lose. N.b.: bookies and sports betting parlors aren’t in business to provide a public service.

If you bet against a friend and win half the time, you end up even. But if you bet against a bookie or a betting parlor and win half the time, on average you lose 10% of the amount wagered on every other bet. So at $10 per game, a bettor following the Post’s football helpers through December 28, 2014 would have won $13,280 on the 1,328 correct picks but lost $14,069 on the 1,279 losers. Overall, he would have lost $789 even though slightly more than half the picks were right. That’s what happens when you play in a game where the costs are high and the edge is insufficient or non-existent.


Another Look at Performance Assessment

This memo gives me an opportunity to touch on another recent sporting event: Super Bowl XLIX, which was played last February. I’m returning to a subject I covered at length in the “What’s Real?” section in “Pigweed” (February 2006), which was about the meltdown of a hedge fund called Amaranth. Among the ways I tried to parse the events surrounding Amaranth was through an analogy to the Rose Bowl game played at the end of the 2005 college football season to determine the national champion. In the game, the University of Texas beat the favored University of Southern California. While leading by five points with less than three minutes left to play, USC had a fourth down with two yards to go for a first down.

They lost largely because – in something other than the obvious choice – the coach elected to go for it rather than punt the ball away, and they were stopped a yard short. UT got the ball and went on to score the winning touchdown. Before the game, USC had widely been considered one of the greatest teams in college football history. Afterwards there was no more talk along those lines. Its loss hinged on that one very controversial play . . . controversial primarily because it was unsuccessful. (Had USC made the two yards and earned a first down, they would have retained the ball and been able to run out the clock, sealing a victory.)

Something very similar happened in this year’s Super Bowl. The Seattle Seahawks were trailing the New England Patriots by a few points. On second down, with just 26 seconds to go and one timeout remaining, the Seahawks had the ball on the Patriots’ one-yard line. Everyone was sure they would try a run by Marshawn Lynch (who in the regular season had ranked first in the league in rushing touchdowns and fourth in rushing yards), and that he would score the winning touchdown. But the Seahawks’ maverick coach, Pete Carroll – ironically, also the coach of USC’s losing Rose Bowl team – tried a pass play instead. The Patriots intercepted the pass, and the Seahawks’ dreams of a championship ended.

“What an idiot Carroll is,” the fans screamed. “Everyone knows that when you throw a pass, only three things can happen (it’s caught, it’s dropped or it’s intercepted) and two of them are bad.” The Seahawks lost a game they seemed to be on the verge of winning, and Carroll was vilified for being too bold and wrong . . . again. His decision was unsuccessful. But was it wrong?

With assistance from Warren Min in Oaktree’s Real Estate Department, I want to point out some of the considerations that Carrol may have taken into account in making his decision:
  • Up to that point in the season, more than 100 passes had been attempted from the one-yard line, and none of them had been intercepted. So Carroll undoubtedly expected that, at the very worst, the pass would be incomplete and the clock would stop (as it does after incomplete passes) with just a few seconds elapsed. That would have given the Seahawks time for one or two more plays.
     
  • With only 26 seconds remaining and the Seahawks down to their last timeout, if they ran and Lynch was stopped, the clock would have kept running (as it does after rushing plays). Seattle would then have been forced to either use their precious timeout or try a hurried play.
     
  • Malcolm Butler, the defender who intercepted Seattle’s pass, was a rookie playing in the biggest game of his life, and he was undersized relative to Ricardo Lockette, the wide receiver to whom the pass was thrown.
     
  • According to The Boston Globe, of Lynch’s 281 carries during the 2014 regular season, 20 had resulted in lost yardage and two more had yielded fumbles. In other words, the Seahawks had experienced a setback 7.8% of the time when Lynch carried the ball. Further, Lynch had been handed the ball at the one yard line five times in 2014, but he scored only once, for a success rate of 20%. Thus it was no sure thing that Lynch would be able to gain that needed yard against a defense expecting him to run. 
To the first level thinker, Carroll’s decision to pass looks like a clear mistake. Maybe that’s because great running backs seem so dependable, or because passing generally seems like an uncertain proposition. Or maybe it’s just because the pass was picked off and the game lost: outcomes strongly bias perceptions.

The second level thinker sees that the obvious call – to run – was far from sure to work, and that doing the less than obvious – passing – might put the element of surprise on the Seahawks’ side and represent better clock management. Carroll made his decision and it was unsuccessful. But that doesn’t prove he was wrong.

Here’s what my colleague Warren wrote me:
The media and “talking heads” completely buried the decision to throw because of one data point: the pass was intercepted and the Seahawks lost the game. But I don’t believe this was a bad decision. In fact, I think this was a very well informed decision that more people possessing all the data might have made given ample time to analyze the situation.

As you always say, you can’t judge the quality of a decision based on results. If we somehow were able to replay this game in alternative realities to test the results, I think the Seahawks’ decision wouldn’t look so bad. But they certainly lost, perhaps because of bad luck. Now, similar to the USC/Texas situation, the media has written some very significant storylines regarding legacies:
  • The Patriots secured “dynasty” status by winning four Super Bowls since 2001.
     
  • Tom Brady, the Patriots’ quarterback, is hailed as one of the greatest of all time.
     
  • The Seahawks’ defense, which was talked about as being “the greatest ever,” is 
lauded no more (despite the fact that it wasn’t defense that lost the game).
But should this one victory – which swung on a single play – really place the Patriots and Tom Brady among the greatest? And was Carroll actually wrong? All of this goes back to one of my favorite themes from Fooled by Randomness by Nassim Nicholas Taleb, for me the bible on how to understand performance in an uncertain world.

In his book, Taleb talks about “alternative histories,” which I describe as “the other things that reasonably could have happened but didn’t.” Sure, the Seahawks lost the game. But they could have won, and Carroll’s decision would have made the difference in that case, too, making him the hero instead of the goat. So rather than judge a decision solely on the basis of the outcome, you have to consider (a) the quality of the process that led to the decision, (b) the a priori probability that the decision would work (which is very different from the question of whether it did work), (c) the other decisions that could have been made, (d) all of the events that reasonably could have unfolded, and thus (e) which of the decisions had the highest probability of success.

Here’s the bottom line:
  • There are many subtle but logical reasons for arguing that Coach Carroll’s decision made sense.
     
  • The decision would have been considered a stroke of genius if it had been successful.
     
  • Especially because of the role of luck, the correctness of a decision cannot necessarily be judged 
from the outcome.
     
  • You clearly cannot assess someone’s competence on the basis of a single trial. 

What all the above really illustrates is the difference between superficial observation and deep, nuanced analysis. The fact that something worked doesn’t mean it was the result of a correct decision, and the fact that something failed doesn’t mean the decision was wrong. This is at least as true in investing as it is in sports. 


The Victor’s Mindset 

It often seems that just as I’m completing a memo, a final inspiration pops up. This past weekend, the Financial Times carried an interesting interview with Novak Djokovic, the number one tennis player in the world today. What caught my eye was what he said about the winner’s mental state:

I believe that half of any victory in a tennis match is in place before you step on the court. If you don’t have that self-belief, then fear takes over. And then it will get too much for you to handle. It’s a fine line. (Emphasis added) 

Djokovic’s statement reminded me of a conversation I had earlier this month, on a subject I’ve written about rarely if ever: self confidence. It ranks high among the attributes that must be present if one is to achieve superior results.

To be above average, an athlete has to separate from the pack. To win at high level tennis, a player has to hit “winners” – shots his opponents can’t return. They’re hit so hard, so close to the lines or so low over the net that they have the potential to end up as “unforced errors.” In the absence of skill, they’re unlikely to be executed successfully, meaning it’s unwise to try them. But people who possess the requisite skill are right in attempting them in order to “play the winner’s game” (see “What’s Your Game Plan”).

These may be analogous to investment actions that Yale’s David Swensen would describe as “uncomfortably idiosyncratic.” The truth is, most great investments begin in discomfort – or, perhaps better said, they involve doing things with which most people are uncomfortable. To achieve great performance you have to believe in value that isn’t apparent to everyone else (or else it would already be reflected in the price); buy things that others think are risky and uncertain; and buy them in amounts large enough that if they don’t work out they can lead to embarrassment. What are examples of actions that require self confidence?
  • Buying something at $50 and continuing to hold it – or maybe even buying more – when the price falls to $25 and “the market” is telling you you’re wrong.
     
  • After you’ve bought something at $50 (thinking it’s worth $200), refusing to “prudently take some chips off the table” when it gets to $100.
     
  • Going against conventional wisdom and daring to “catch a falling knife” when a company defaults and the price of its debt plummets.
     
  • Buying much more of something you like than it represents in the index you’re measured against, or entirely excluding an index component you dislike. 
In each of these cases, the first level thinker does that which is conventional and easy – and which doesn’t require much self confidence. The second level thinker views things differently and, as a consequence, is willing to take actions like those described above. But they’re unlikely to be done in the absence of conviction. The great investors I know are confident second level thinkers and entirely comfortable diverging from the herd.

It’s great for investors to have self confidence, and it’s great that it permits them to behave boldly, but only when that self confidence is warranted. This final qualification means that investors must engage in brutally candid self assessment. Hubris or over confidence is far more dangerous than a shortage of confidence and a resultant unwillingness to act boldly. That must be what Mark Twain had in mind when he said, “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” And it also has to be what Novak Djokovic meant when he said, “It’s a fine line.” 

So there you have some of the key lessons from sports:
  • For most participants, success is likely to lie more dependably in discipline, consistency and minimization of error, rather than in bold strokes – high batting average and an absence of strikeouts, not the occasional, sensational home run.
     
  • But in order to be superior, a player has to do something different from others and has to have an appropriate level of confidence that he can succeed at it. Without conviction he won’t be able to act boldly and survive bouts of uncertainty and the inevitable slump.
     
  • Because of the significant role played by randomness, a small sample of results is far from sure to be indicative of talent or decision making ability.
     
  • The goal for bettors is to see value in assets that others haven’t yet recognized and that isn’t reflected in prices.
     
  • At first glance it seems effort and “common sense” will lead to success, but these often prove to be unavailing.
     
  • In particular, it turns out that most people can’t see future outcomes much better than anyone else, but few are aware of this limitation.
     
  • Before a would be participant enters any game, he should assess his chances of winning and whether they justify the price to play.
These lessons can serve investors very well.

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Wednesday, November 4, 2015

Breakfast Inflation is Either Wonderful or Terrible

By John Mauldin

Is inflation making breakfast more or less affordable? It depends on what you order. Recently my Mauldin Economics colleague, Tony Sagami, showed how basic grocery staples are rising in price. His evidence: the Wisconsin Farm Bureau’s semiannual “Marketbasket” survey. The survey shows prices for a basic grocery list rising 2.7% in the last year.


Not every item rose, however. The full breakdown since last spring is tells us more.


The six month price changes span a wide range. Eggs jumped 72% and milk dropped 13%. Several other items had double digit percentage changes. The list illustrates how differently we can perceive inflation. A hearty breakfast devotee who ate eggs (up 72%) and toast (white bread +25%) saw very high breakfast inflation.

Someone who liked their daily Cheerios (down 6%) and milk (down 13%) had a different experience. Other goods and services have similar differences. That’s why “average” CPI inflation never precisely reflects our own individual experiences. Few people are exactly average. We all spend our money differently.

No surprise, then, that some of us see high inflation while others don’t.

This article is based on John Mauldin’s Thoughts from the Frontline newsletter of Nov. 1, 2015. You can read the full issue here.



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Thursday, October 29, 2015

The Financialization of the Economy

By John Mauldin


Roger Bootle once wrote:
The whole of economic life is a mixture of creative and distributive activities. Some of what we ‘‘earn’’ derives from what is created out of nothing and adds to the total available for all to enjoy. But some of it merely takes what would otherwise be available to others and therefore comes at their expense.

Successful societies maximise the creative and minimise the distributive. Societies where everyone can achieve gains only at the expense of others are by definition impoverished. They are also usually intensely violent. Much of what goes on in financial markets belongs at the distributive end. The gains to one party reflect the losses to another, and the fees and charges racked up are paid by Joe Public, since even if he is not directly involved in the deals, he is indirectly through costs and charges for goods and services.

The genius of the great speculative investors is to see what others do not, or to see it earlier. This is a skill. But so is the ability to stand on tip toe, balancing on one leg, while holding a pot of tea above your head, without spillage. But I am not convinced of the social worth of such a skill.

This distinction between creative and distributive goes some way to explain why the financial sector has become so big in relation to gross domestic product – and why those working in it get paid so much.

Roger Bootle has written several books, notably The Trouble with Markets: Saving Capitalism from Itself.

I came across this quote while reading today’s Outside the Box, which comes from my friend Joan McCullough. She didn’t actually cite it but mentioned Bootle in passing, and I googled him, which took me down an alley full of interesting ideas. I had heard of him, of course, but not really read him, which I think may be a mistake I should correct.

But today we are going to focus on Joan’s own missive from last week, which she has graciously allowed me to pass on to you. It’s a probing examination of how and why the financialization of the US and European (and other developed world) economies has become an anchor holding back our growth and future well being. Joan lays much of the blame at the feet of the Federal Reserve, for creating an environment in which financial engineering is more lucrative than actually creating new businesses and increasing production and sales.

There are no easy answers or solutions, but as with any destructive codependent relationship, the first step is to recognize the problem. And right now, I think few do. What you will read here is of course infused with Joan’s irascible personality and is therefore really quite the fun read (even as the message is sad).

Joan writes letters along this line twice a day, slicing and dicing data and news for her rather elite subscriber list. Elite in the sense that her service is rather expensive, so I thank her for letting me send this out. Drop me a note if you want us to put you in touch with her.

I am back in Dallas after a whirlwind trip to Washington DC. I attended Steve Moore’s wedding at the awe-inspiring Jefferson Memorial; and then we hopped a plane back to Dallas and Tulsa to see daughter Abbi, her husband Stephen, and my new granddaughter, Riley Jane, who was delivered six weeks premature while we were in the air.

The doctors decided to bring Riley into the world early as Abbi was beginning to experience seriously high blood pressure and other problematic side effects. Riley barely weighs in at 4 pounds and will spend the first three years of her life in the NICU (the neonatal intensive care unit). Having never been in one before, I was rather amazed by all the high tech gear surrounding Riley and all of the usual medical devices shrunk to the size where they can be useful with preemie babies.

The doctors and nurses assured me that the frail little bundle I was very hesitant to touch would be quite fine. And Abbi is much better and already up and about.

As I was flying back to Dallas later that afternoon, it struck me how, not all that long ago, in my parents’ generation, both mother and daughter would have been at severe risk. Interestingly, both Abbi and her twin sister were significantly premature as well, some 30 years ago in Korea. The progress of medicine and medical technology has allowed so many more people to live long and productive lives, and that process is only going to continue to improve with each and every passing year.

And now, I think it’s time to let you get on with Joan McCullough’s marvelous musings. Have a great week!
Your glad I’m living at this time in history analyst,
John Mauldin, Editor
Outside the Box

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The Financialization of the Economy

Joan McCullough, Longford Associates
October 21, 2015

Yesterday, we learned that lending standards had eased and that there was increased loan demand from institutions and households, per the ECB’s September report. (Which was attributed to the success of QE and which buoyed the Euro in the process.)

This has been bothering me. Because it is a great example of the debate over “financialization” of an economy, i.e., is it a good thing or a bad thing?

The need to further explore the topic was provoked by reading this morning that one of the larger shipping alliances, G6, has again announced sailing cancellations between Asia and North Europe and the Mediterranean. This round of cuts targets November and December. The Asia-Europe routes, please note, are where the lines utilize their biggest ships and have been running below breakeven. So it’s easy to understand why such outsized capacity is further dictating the need to cancel sailings outright. G6 members: American President, Hapag Lloyd, Hyundai Merchant Marine, Mitsui, Nippon and OOCL. So as you can see from that line-up, these are not amateurs.

We have already discussed in the past in this space, the topic of financialization. But seeing as how the stock market keeps rallying while the economic statistics have remained for the most part, punk, time to revisit the issue once again. Is it all simply FED or no FED? Or is the interest rate issue ground zero and/or purely symptomatic of the triumph of financialization over the real economy?

Further urged to revisit the topic by the seemingly contradictory developments of the ECB banks reportedly humming along nicely while trade between Asia and Europe remains obviously, significantly crimped. Let’s make this plain English because it takes too much energy to interpret most of what is written on the topic.

Snappy version:
Definition (one of quite a few, but the one I think is accurate for purposes of this screed):
Financialization is characterized by the accrual of profits primarily thru financial channels (allocating or exchanging capital in anticipation of interest, divvies or capital gains) as opposed to accrual of profits thru trade and the production of goods/services.

Economic activity can be “creative” or “distributive”. The former is self- explanatory, i.e., something is produced/created. The latter pretty much simply defines money changing hands. (So that when this process gets way overdone as it likely has become in our world, one of the byproducts is the widening gap called “income inequality”.)

You guessed correctly: financialization is viewed as largely distributive.

So now we roll around to the nitty-gritty of the issue. Which presents itself when business managers evolve to the point where they are pretty much under the control of the financial community. Which in our case is simply “Wall Street”.

This is something I saved from an article last summer which ragged mercilessly on IBM for having kissed Wall Street’s backside ... and in the process over the years, ruined the biz. “And of course, it’s not just IBM. ... A recent survey of chief financial officers showed that 78 percent would ‘give up economic value’ and 55 percent would cancel a project with a positive net present value—that is, willingly harm their companies—to meet Wall Street’s targets and fulfill its desire for ‘smooth’ earnings.... http://www.forbes.com/sites/stevedenning/2014/06/03/why-financialization-has-run-amok/

IBM is but one possible target in laying this type of blame where the decisions on corporate action are ceded to the financial community; the instances are innumerable.

You probably could cite the well-known example of a couple of years back when Goldman Sachs was exposed as the owner of warehouse facilities that held 70% of North American aluminum inventory. And how that drove up the price and cost end-users dearly. (Estimated as $ 5bil over 3 years’ time.)

First link: NY Times article from July of 2013, talking about the warehousing issue.
http://www.nytimes.com/2013/07/21/business/a-shuffle-of-aluminum-but-to-banks-pure-gold.html?pagewanted=all&_r=0

Second link: Senate testimony from Coors Beer, complaining about the same situation.
http://www.banking.senate.gov/public/index.cfm? FuseAction=Files.View&FileStore_id=9b58c670-f002-42a9-b673- 54e4e05e876e 

Well, here’s another from the same article which makes the point quite clearly: Boeing’s launch of the 787 was marred by massive cost overruns and battery fires. Any product can have technical problems, but the striking thing about the 787’s is that they stemmed from exactly the sort of decisions that Wall Street tells executives to make.

Before its 1997 merger with McDonnell Douglas, Boeing had an engineering driven culture and a history of betting the company on daring investments in new aircraft. McDonnell Douglas, on the other hand, was risk-averse and focused on cost cutting and financial performance, and its culture came to dominate the merged company. So, over the objections of career long Boeing engineers, the 787 was developed with an unprecedented level of outsourcing, in part, the engineers believed, to maximize Boeing’s return on net assets (RONA). Outsourcing removed assets from Boeing’s balance sheet but also made the 787’s supply chain so complex that the company couldn’t maintain the high quality an airliner requires. Just as the engineers had predicted, the result was huge delays and runaway costs.

Boeing’s decision to minimize its assets was made with Wall Street in mind. RONA is used by financial analysts to judge managers and companies, and the fixation on this kind of metric has influenced the choices of many firms. In fact, research by the economists John Asker, Joan Farre-Mensa, and Alexander Ljungqvist shows that a desire to maximize short term share price leads publicly held companies to invest only about half as much in assets as their privately held counterparts do.”

That’s from an article in the June, 2014, Harvard Business Review by Gautam Mukunda, “The Price of Wall Street’s Power” also cited in the Forbes article. This is the link; it is worth the read though you may not agree with parts of the conclusion: https://hbr.org/2014/06/the-price-of-wall-streets-power

The upshot to this type of behavior is that the balance of power ... and ideas ... then migrates into domination by one group.

Smaller glimpse: Over financialization is what happens when a company generates cash then pays it to shareholders and senior management which m.o. also includes share buybacks and vicious cost cutting. This is one way, as you can see, in which the real economy is excluded from the party!

Part of the financialization process also includes ‘cognitive capture’ where the big swingin’ investment banking sticks have the ear of business managers.

And the business managers/special interest groups, in turn, have the ear of the federal government. See? The control by Wall Street is still there, but sometimes the route is a tad circuitous! The clandestine formulation of the TPP agreement is a perfect example of this type of dominance. (Congress shut out/ corporate lobbyists invited in.)

So the whole process goes to the extreme. Therein lies the rub: the extreme. So that business obediently complies with the wishes of these financial wizards. Taken altogether, over time, our entire society morphs to where it assumes a posture of servitude to the interests of Wall Street.

An example of that? John Q.’s sentiment meter (a/k/a consumer confidence) is clearly known to be tied most of the time to the direction of the S&P 500. Which of course, is aided and abetted by the foaming at  the mouth Talking Heads who pretty much .... dictate to John Q. how he is supposed to be feeling.

Forty years on the Street, I am still agog at the increasing clout of the FOMC to the extent where we are now hostages to their infernal sound bites and communiqués. Another example of the process of creeping financialization? I’d surely say so!

This is not an effort to try and convict “financialization” as indeed it has its place. When it is used prudently. Such as to facilitate trade in the real economy! Sounds kind of Austrian, eh? You bet. The simplest example of this which is frequently cited is a home mortgage. The borrower exchanges future income for a roof via a bank note.

And so it goes. Financialization humming along nicely, facilitating trade in the real economy. Unfortunately, along the line somewhere, it got out of hand. Which is where the World Bank comes in.
http://data.worldbank.org/indicator/FS.AST.PRVT.GD.ZS

As they have the statistics on “domestic credit to private sector (% of GDP)”

Why do we wanna’ look at that? Well the answer is suggested by yet another institution who has studied the issue. Correct. The IMF. Which espouses the notion that “the marginal effect of financial depth on output growth becomes negative ... when credit to the private sector reaches 80-100% of GDP ...
https://www.imf.org/external/pubs/ft/wp/2012/wp12161.pdf

Does the above sound familiar? Right. Too much financialization crimps growth.
That’s when we turn to the above-referenced World Bank table. Which shows the latest available worldwide statistics (2014) on domestic credit to private sector % of GDP.

Okay. Maybe we oughta’ read this bit from the World Bank before we get to the US statistic:
... “Domestic credit to private sector refers to financial resources provided to the private sector by financial corporations, such as through loans, purchases of nonequity securities, and trade credits and other accounts receivable, that establish a claim for repayment. ...
The financial corporations include monetary authorities and deposit money banks, as well as other financial corporations ...
Examples of other financial corporations are finance and leasing companies, money lenders, insurance corporations, pension funds, and foreign exchange companies.” ....

Clear enough. Again, the IMF suggests that 80 to 100% of GDP is where it gets dicey in terms of impact on growth.....

In 2014, the US ratio stood at 194.8. In 1981 (as far back as the table goes), our ratio stood at 89.1.
For comparison, also in 2014, Germany stood at 80.0; France at 94.9. China at 141.8 and Japan at 187.6. Which is suggestive of what can be called “over-financialization”. So what’s the beef with that, you ask?
For all the reasons mentioned above which led to increasing dominance by the financial sector on corporate and household behavior, the emphasis leans heavily towards making money out of money. Which I’d like to do myself. You?

But when massaged into the extreme which is clearly, I believe, where we find ourselves now ... at the end of the day, we create nothing.

By creating nothing, the economy relies on the financialization process to create growth. But the evidence supports the notion that once overdone, financialization stymies growth.

“ ... The whole of economic life is a mixture of creative and distributive activities. Some of what we “earn” derives from what is created out of nothing and adds to the total available for all to enjoy. But some of it merely takes what would otherwise be available to others and therefore comes at their expense. Successful societies maximize the creative and minimize the distributive. Societies where everyone can achieve gains only at the expense of others are by definition impoverished. They are also usually intensely violent.” ... Roger Bootle quoted here: http://bilbo.economicoutlook.net/blog/?p=5537

In short, corporate behavior is dictated by Wall Street desire which in turn results in a flying S&P 500. Against a backdrop, say, of a record number of US workers no longer participating in the labor force.
So instead of cogitating the entire picture and all of its skanky details, we have so farbeen willing to accept a one-size fits all alibi for stock market action where financialization still dominates; the only choice is what financialization flavor will trump the other: “FED or no FED”.

I now wonder if when Bootle said a few years back ... “they are usually intensely violent”, if this wasn’t prescience. Which can be applied to the current political landscape in the US where the financialization of the economy has so excluded the average worker ... that he is willing to put Ho-Ho the Clown in the White House. Just to change the channel. And hope for relief.

As you can see, I am trying very hard to understand how as a society we got to this level.

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Monday, October 26, 2015

Someone Is Spending Your Pension Money

By John Mauldin 

“Retirement is like a long vacation in Las Vegas. The goal is to enjoy it to the fullest, but not so fully that you run out of money.”– Jonathan Clements

“In retirement, only money and symptoms are consequential.”– Mason Cooley



Retirement is every worker’s dream, even if your dream would have you keep doing the work you love. You still want the financial freedom that lets you work for love instead of money. This is a relatively new dream. The notion of spending the last years of your life in relative relaxation came about only in the last century or two. Before then, the overwhelming number of people had little choice but to work as long as they physically could. Then they died, usually in short order. That’s still how it is in many places in the world.

Retirement is a new phenomenon because it is expensive. Our various labor-saving machines make it possible at least to aspire to having a long, happy retirement. Plenty of us still won’t reach the goal. The data on those who have actually saved enough to maintain their lifestyle without having to work is truly depressing reading. Living on Social Security and possibly income from a reverse mortgage is limited living at best.

In this issue, I’ll build on what we said in the last two weeks on affordable healthcare and potentially longer lifespans. Retirement is not nearly as attractive if all we can look forward to is years of sickness and penury. We are going to talk about the slow motion train wreck now taking shape in pension funds that is going to put pressure on many people who think they have retirement covered.

Please feel free to forward this to those who might be expecting their pension funds to cover them for the next 30 or 40 years. Cutting to the chase, US pension funds are seriously underfunded and may need an extra $10 trillion in 20 years. This is a somewhat controversial letter, but I like to think I’m being realistic. Or at least I’m trying.

The Transformation Project
But first, let me update you on the progress on my next book, Investing in an Age of Transformation, which will explore the changes ahead in our society over the next 20 years, along with their implications for investing. Our immediate future promises far more than just a lot of fast paced, fun technological change.

There are many almost inevitable demographic, geopolitical, educational, sociological, and political changes ahead, not to mention the rapidly evolving future of work that are going to significantly impact markets and our lives. I hope to be able to look at as much of what will be happening as possible. I believe that the fundamentals of investing are going to morph over the next 10 to 15 to 20 years.

I mentioned a few weeks ago at the end of one of my letters that I was looking for a few potential interns and/or volunteer research assistants to help me with the book. I was expecting 8 to 10 responses and got well over 100. Well over. I asked people to send me resumes, and I was really pleased with the quality of the potential assistance. I realize that there is an opportunity to do so much more than simply write another book about the future.

What I have done is write a longer outline for the book, detailing about 25 separate chapters. I’d like to put together small teams for each of these chapters that will not only do in-depth research on their particular areas but will also make their work available to be posted upon publication of the book. We’re going to create separate Transformation Indexes for many of the chapters, which will certainly be a valuable resource and a challenge for investors. And now let’s look at what pension funds are going to look like over the next 20 years.

Midwestern Train Wreck
Four months ago we discussed the ongoing public pension train wreck in Illinois (see Live and Let Die). I was not optimistic that the situation would improve, and indeed it has not. The governor and legislature are still deadlocked over the state’s spending priorities. Illinois still has no budget for the fiscal year that began on July 1. Fitch Ratings downgraded the state’s credit rating last week. It’s a mess.

Because of the deadlock, Illinois is facing a serious cash flow crisis. Feeling like you’ve hit the jackpot through the Illinois lottery? Think again. State officials announced Wednesday that winners who are due to receive more than $600 won’t get their money until the state’s ongoing budget impasse is resolved. Players who win up to $600 can still collect their winnings at local retailers. More than $288 million is waiting to be paid out. For now the winners just have an IOU and no interest on their money (Fox).

As messy as the Illinois situation is, none of us should gloat. Many of our own states and cities are not in much better shape. In fact, the political gridlock actually forced Illinois into accomplishing something other states should try. Illinois has not issued any new bond debt since May 2014. Can many other states say that?

Unfortunately, that may be the best we can say about Illinois. The state delayed a $560 million payment to its pension funds for November and may have to delay or reduce another contribution due in December.

Illinois and many other states and local governments are in this mess because their politicians made impossible to keep promises to public workers. The factors that made them so impossible apply to everyone else, too. More people are retiring. Investment returns aren’t meeting expectations. Healthcare costs are rising. Other government spending is out of control.

Nonetheless, the pension problem is the thorniest one. State and local governments spent years waving generous retirement benefits in front of workers. The workers quite naturally accepted the offers. I doubt many stopped to wonder if their state or city could keep its end of the deal. Of course, it could. It’s the government.

Although state governments have many powers, creating money from thin air is, alas, not one of them. You have to be in Washington to do that. Now that the bills are coming due, the state’s’ inability to keep their word is becoming obvious. Now, I’m sure that many talented people spent years doing good work for Illinois. That’s not the issue here. The fault lies with politicians who generously promised money they didn’t have and presumed it would magically appear later.

On the other hand, retired public workers need to realize they can’t squeeze blood from a turnip. Yes, the courts are saying Illinois must keep its pension promises. But the courts can’t create money where none exists. At best, they can force the state to change its priorities. If pension benefits are sacrosanct, the money won’t be available for other public services. Taxes will have to go up or other essential services will not be performed. This is certainly not good for the citizens of Illinois. As things get worse, people will begin to move.

What happens then? Citizens will grow tired of substandard services and high taxes. They can avoid both by moving out of the state. The exodus may be starting. Crain’s Chicago Business reports: High end house  hunters in Burr Ridge have 100 reasons to be happy. But for sellers, that’s a depressing number. The southwest suburb has 100 homes on the market for at least $1 million, more than seven times the number of homes in that price range – 14 – that have sold in Burr Ridge in the past six months.

The town has the biggest glut by far of $1 million-plus homes in the Chicago suburbs, according to a Crain’s analysis. “It's been disquietingly slow, brutally slow, getting these sold,” said Linda Feinstein, the broker-owner of ReMax Signature Homes in neighboring Hinsdale. “It feels like the brakes have been on for months.”

We don’t know why these people want to sell their homes, of course, but they may be the smart ones.

They’re getting ahead of the crowd – or trying to. Think Detroit. I have visited there a few times over the last year, and the suburbs are really quite pleasant (except in the dead of winter, when I’d definitely rather be in Texas). But those who moved out of the city of Detroit and into the suburbs many decades ago had a choice, because Michigan’s finances weren’t massively out of whack. I’ve been to Hinsdale. It’s a charming community and quite upscale. It is an easy train commute to downtown Chicago.

Look at it this way: with what you know about Illinois public finances, would you really want to move into the state and buy an expensive home right now? I sure wouldn’t. That sharply reduces the number of potential homebuyers. The result will be lower home prices. I’m not predicting Illinois will end up like Detroit…...but I don’t rule it out, either. Further, more and more cities and counties around the country are going to be looking like Chicago. Wherever you buy a home, you really should investigate the financial soundness of the state and the city or town.

Pension Math Review
Political folly is not the only problem. Illinois and everyone else saving for retirement – including you and me – make some giant assumptions. Between ZIRP and assorted other economic distortions, it is harder than ever to count on a reasonable real return over a long period. Small changes make a big difference. Pension managers used to think they could average 8% after inflation over two decades or more. At that rate, a million dollars invested today turns into $4.7 million in 20 years. If $4.7 million is exactly the amount you need to fund that year’s obligations, you’re in good shape.

What happens if you average only 7% over that 20 year period? You’ll have $3.9 million. That is only 83% of the amount you counted on. At 6% returns you will be only 68% funded. At 5%, you have only 57% of what you need. At 4%, you will be only 47% of the way there.

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Tuesday, October 6, 2015

Recession Watch

By John Mauldin 

“Growth is never by mere chance; it is the result of forces working together.”– J.C. Penney

“Strength and growth come only through continuous effort and struggle.”– Napoleon Hill

“We’re lost, but we’re making good time.”– Yogi Berra

The Yogi Berra quote above, which was brought to my attention this week, seems an apt description of where the markets and the economy are today. Nobody is quite sure where we are or where we’re going, but we all seem to think we’re going to get there soon.

I think it’s pretty much a given that we’re in for a cyclical bear market in the coming quarters. The question is, will it be 1998 or 2001/2007? Will the recovery look V shaped, or will it drag out? Remember, there is always a recovery. But at the same time, there is always a recession out in front of us; and that fact of life is what makes for long and difficult recoveries, not to mention very deep bear markets.

The problem is that our most reliable indicator for a recession is no longer available to us. The Federal Reserve did a study, which has been replicated. They looked at 26 indicators with regard to their reliability in predicting a recession. There was only one that was accurate all the time, and that was an inverted yield curve of a particular length and depth. Interestingly, it worked almost a year in advance. The inverted yield curve indicator worked very well the last two recessions; but now, with the Federal Reserve holding interest rates at the zero bound, it is simply impossible to get a negative yield curve.

Understand, an inverted yield curve does not cause a recession. It is simply an indicator that an economy is under stress. So now we are in an environment where we can look only at “predictive” indicators that are not 100% reliable. Actually, most are not even close. Some indicators have predicted seven out of the last four recessions. Some never trigger at all.

Recession Watch
All that said, looking at data from the last few weeks suggests that we need to be on “recession watch.” Global GDP is clearly slowing down, and the data we are getting from the US suggests that we are going to see a serious falloff in GDP over the next few quarters. I want to look at the recent (very disappointing) employment numbers, earnings forecasts (and some funny accounting), credit spreads, total leverage in the system, and the overall environment where credit, which has been the fuel for growth, is under pressure. The totality of this data says that we have to be on alert for a recession, because a recession will mean a full-blown bear market (down at least 40%), rising unemployment, and (sadly) QE4.

The jobs report on Friday was just ugly. Private payrolls increased by just 118,000, which is about the minimum level needed for unemployment not to rise. Government payrolls added 24,000. There were serious downward revisions to the last two months, as well. August was taken down by 37,000 jobs, and July was reduced by 22,000. The last three months have averaged just 167,000 new jobs compared to 231,000 for the previous three months and 260,000 for the six months prior to that.

My friend David Rosenberg dug a little deeper into the numbers and noted: Adding insult to injury and revealing an even softer underbelly to this report was the contraction in the workweek to 34.5 hours from 34.6 hours in August, which is effectively equivalent to an added 348,000 job losses.

So take the headline number, tack on the downward revisions and the loss of labour input from the decline in the workweek, and the "real" payroll number was [a minus] 265,000. You read that right.

He added: “Have no doubt that if the contours of the job market continue on this recent surprising downward path… [m]arket chatter of QE four by March 2016 is going to be making the rounds.”
While the unemployment rate remained at 5.1%, it did so largely because of a significant drop in the labor participation rate, which is not a good way to enhance employment. Further, the U-6 unemployment number is still a rather depressing 10%. Those are the people who are working part-time but would like full time jobs, as well as discouraged and marginally attached workers. Very few part-time jobs pay enough to finance a middle class lifestyle.

Earnings Recession
Leo Kolivakis of Pension Pulse has a downbeat earnings season preview, aptly titled “A Looming Catastrophe Ahead?

Analysts have been steadily cutting 3Q earnings projections, and those revisions threaten to make some richly priced stocks even more so. Thomson Reuters data shows analysts expect a 3.9% year over year decline in S&P 500 earnings. Expectations are falling for future quarters as well.

These expectations have some strategists talking about an “earnings recession.” Just as an economic recession is two consecutive quarters of falling GDP, an earnings recession is two consecutive quarters of falling corporate profits.

The headwinds are no mystery. China’s weaker import demand is hurting all kinds of companies, especially raw materials and infrastructure suppliers. Caterpillar (CAT) slashed its revenue forecast and announced 10,000 job cuts. That probably isn’t playing well in Peoria. Accompanying the falloff in Chinese demand is an increase in the number of containers coming into the US as the strong dollar allows us to buy more and sell less. Not a particularly useful combination.

I love this quote from a Reuters story: “How can we drive the market higher when all of these signals aren’t showing a lot of prosperity?” said Daniel Morgan, senior portfolio manager at Synovus Trust Company in Atlanta, Georgia, who cited earnings growth as one of the drivers of the market. As we all know, it is every portfolio manager’s job to “drive the market higher.” Daniel evidently wants to do his part.

Sadly, despite our best efforts, the stock market faces an uphill climb. More from Reuters: Even with the recent selloff, stocks are still expensive by some gauges. The S&P 500 Index is selling at roughly 16 times its expected earnings for the next 12 months, lower than this year's peak of 17.8 but higher than the historic mean of about 15. The index would have to drop to about 1,800 to bring valuations back to the long-term range. The S&P 500 closed at 1,931.34 on Friday [Sept 25].

Moreover, forward and trailing price-to-earnings ratios for the S&P 500 are converging, another sign of collapsing growth expectations. The trailing P/E stands at about 16.5, Thomson Reuters data shows. Last year at this time, the forward P/E was also 16 but the trailing was 17.6.

The last period of convergence was in 2009 when earnings were declining following the financial crisis. The Energy sector is the biggest drag on earnings, meaning that we now see analysts everywhere calculating estimates “ex energy.” I suppose this produces useful information, but if we are going to exclude the bottom outlier, shouldn’t we exclude the top outlier as well? Healthcare is carrying much of the earnings burden for S&P 500 stocks, but I have yet to see an ex healthcare or ex energy & healthcare estimate. A funny thing about earnings: they’ve been going up for the past year, even as top line revenue has not. Generally, those go hand in hand. What’s happening?

And for the answer I have a story. A few years ago I made an assumption as to how a new stream of income would be taxed. I made that assumption based on my knowledge of having had similar income in the ’80s and ’90s. It turned out the rules had changed, and I hit the end of the year owing what was for me a rather large sum, as I was also trying to finance and build my new apartment.

I told my tale of woe to my accountant, Darrell Cain, who obviously detected the distress in my voice. He smiled at me and said, “John, I have an elephant bullet.” He reached under the table and pulled out an imaginary elephant bullet. “This is a big bullet. But I only have one of them. Once you use this bullet you can never use it again. If another elephant comes down the road, there will be nothing you can do.”

And yes, there were some one time tax maneuvers that reduced my taxes to a manageable number. But as he said, those were a one time option.

There is no way to prove it, but I think corporate accountants have been using up their elephant bullets this past year, as corporations want to be able to maintain the fiction that earnings are rising, so that price to earnings ratios don’t come under stress and cause stock prices to fall. You can move expenses from quarter to quarter, put off certain spending, recharacterize certain expenses one time, and so on. I deeply suspect we are going to find that some recent corporate earnings have been of the smoke and mirrors type.

Further, as I’ve written in previous letters, earnings forecasts are notoriously trend-following and typically miss the turns. If earnings are beginning to fall – and it appears they are – it is highly likely that earnings estimates will miss to the downside. If we slide into a recession at the same time, they will miss to the downside rather dramatically.

Is GDP Flatlining?
The Commerce Department will release its first estimate for 3Q US GDP on Thursday, Oct. 29. By then we will be in the thick of earnings season and will already know how many companies performed.

In the big picture, income (corporate or individual) can’t grow unless the economy grows. GDP may be a flawed way to measure economic growth, but it is the best tool we have. Blue chip estimates right now are that it ran at near a 2.5% annualized growth rate last quarter. However, the Atlanta Fed has sharply revised their GDP estimate for the third quarter down to under 1%. (See chart below.)

Will economic growth come into harmony with income growth? We know they have to meet eventually. At present, it appears GDP will stay in slow growth mode. That means it probably won’t be able to pull earnings up with it.


High-Yield – Rising Defaults
High yield spreads have been tightening and interest rates have been rising for some time. This is starting to cause some distress in the high yield (otherwise known as junk bond) market. My friend Steve Blumenthal has been following and timing the high yield market for 20 years. He recently wrote the following, which I’m going to blatantly cut and paste as it clearly depicts the level of distress in the high yield market.

If credit becomes more difficult to get, then growth is going to come under stress as well. I note that corporations that I think of as issuing higher quality debt are paying 10%. Thank you very much. Ten percent interest rates don’t seem to me to be very low.

To continue reading this article from Thoughts from the Frontline – a free weekly publication by John Mauldin, renowned financial expert, best selling author, and Chairman of Mauldin Economics – please click here.

The article Thoughts from the Frontline: Recession Watch was originally published at mauldineconomics.com.


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Friday, October 2, 2015

A Worrying Set Of Signals

By John Mauldin 

There is presently a bull market in complacency. There are very few alarm bells going off anywhere; and frankly, in reaction to my own personal complacency, I have my antenna up for whatever it is I might be missing that would indicate an approaching recession.

It was very easy to call the last two recessions well in advance because we had inverted yield curves. In the US at least, that phenomenon has a perfect track record of predicting recessions. The problem now is that, with the Federal Reserve holding the short end of the curve at the zero bound, there is no way we can get an inverted yield curve, come hell or high water. For the record, inverted yield curves do not cause recessions, they simply indicate that something is seriously out of whack with the economy. Typically, a recession shows up three to four quarters later.

I know from my correspondence and conversations that I am not the only one who is concerned with the general complacency in the markets. But then, we’ve had this “bull market in complacency” for two years and things have generally improved, albeit at a slower pace in the current quarter.

With that background in mind, the generally bullish team at GaveKal has published two short essays with a rather negative, if not ominous, tone. Given that we are entering the month of October, known for market turbulence, I thought I would make these essays this week’s Outside the Box. One is from Pierre Gave, and the other is from Charles Gave. It is not terribly surprising to me that Charles can get bearish, but Pierre is usually a rather optimistic person, as is the rest of the team.

I was in Toronto for two back-to-back speeches before rushing back home this morning. I hope you’re having a great week. So now, remove sharp objects from your vicinity and peruse this week’s Outside the Box.

Your enjoying the cooler weather analyst,
John Mauldin

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A Worrying Set Of Signals

By Pierre Gave
Regular readers will know that we keep a battery of indicators to gauge, among other things, economic activity, inflationary pressure, risk appetite and asset valuations. Most of the time this dashboard offers mixed messages, which is not hugely helpful to the investment process. Yet from time to time, the data pack points unambiguously in a single direction and experience tells us that such confluences are worth watching. We are today at such a point, and the worry is that each indicator is flashing red.

Growth: The three main indices of global growth have fallen into negative territory: (i) the Q-indicator (a diffusion index of leading indicators), (ii) our diffusion index of OECD leading indicators, and (iii) our index of economically-sensitive market prices. Also Charles’s US recession indicator is sitting right on a key threshold (see charts for all these indicators in the web version).

Inflation: Our main P-indicator is at a maximum negative with the diffusion index of US CPI components seemingly in the process of rolling over; this puts it in negative territory for the first time this year.

Risk appetite: The Gavekal velocity indicator is negative which is not surprising given weak market sentiment in recent weeks. What worries us more is the widening of interest rate spreads—at the long end of the curve, the spread between US corporate bonds rated Baa and treasuries is at its widest since 2009; at the short-end, the TED spread is back at levels seen at the height of the eurozone crisis in 2012, while the Libor-OIS spread is at a post-2008 high. Moreover, all momentum indicators for the main equity markets are at maximum negative, which has not been seen since the 2013 “taper tantrum”.

These weak readings are especially concerning, as in recent years, it has been the second half of the year when both the market and growth has picked up. We see three main explanations for these ill tidings:

1) Bottoming out: If our indicators are all near a maximum negative, surely the bottom must be in view? The contrarian in us wants to believe that a sentiment shift is around the corner. After all, most risk-assets are oversold and markets would be cheered by confirmation that the US economy remains on track, China is not hitting the wall and the renminbi devaluation was a one-off move. If this occurs, then a strong counter-trend rally should ramp up in time for Christmas.

2) Traditional indicators becoming irrelevant: Perhaps we should no longer pay much attention to fundamental indicators. After all, most are geared towards an industrial economy rather than the modern service sector, which has become the main growth driver. In the US, industrial production represents less than 10% of output, while in China, the investment slowdown is structural in nature. The funny thing is that employment numbers everywhere seem to be coming in better than expected. In this view of things, either major economies are experiencing a huge drop in labor productivity, or our indicators need a major refresh (see Long Live US Productivity!).

3) Central banks out of ammunition: The most worrying explanation for the simultaneous decline in our indicators is that air is gushing out of the monetary balloon. After more than six years of near zero interest rates, asset prices have seen huge rises, but investment in productive assets remains scarce.

Instead, leverage has run up across the globe. According to the Bank for International Settlements’ recently released quarterly review, developed economies have seen total debt (state and private) rise to 265% of GDP, compared to 229% in 2007. In emerging economies, that ratio is 167% of GDP, compared to 117% in 2007 (over the period China’s debt has risen from 153 to 235% of GDP). The problem with such big debt piles is that it is hard to raise interest rates without derailing growth.

Perhaps it is not surprising that in recent weeks the Federal Reserve has backed away from hiking rates, the European Central Bank has recommitted itself to easing and central banks in both Norway and Taiwan made surprise rate cuts. But if rates cannot be raised after six-years of rising asset prices and normalizing growth, when is a good time? And if central banks are prevented from reloading their ammunition, what will they deploy the next time the world economy hits the skids?

Hence we have two benign interpretations and one depressing one. Being optimists at heart, we want to believe that a combination of the first two options will play out. If so, then investors should be positioned for a counter-trend rally, at least in the short-term. Yet we are unsettled by the market’s muted response to the Fed’s dovish message. That would indicate that investors are leaning towards the third option. Hence, we prefer to stay protected and for now are not making a bold grab for falling knifes. At the very least, we seek more confirmation on the direction of travel.

Positioning For A US Recession

By Charles Gave
Since the end of last year I have been worried about an “unexpected” slowdown, or even recession, in the world’s developed economies (see Towards An OECD Recession In 2015). In order to monitor the situation on a daily basis, I built a new indicator of US economic activity which contains 17 components ranging from lumber prices and high-yield bond spreads to the inventory-to-sales ratio. It was necessary to construct such an indicator because six years of extreme monetary policy in the US (and other developed markets) has stripped “traditional” cyclical economic data of any real meaning (see Gauging The Chances Of A US Recession).

Understanding this diffusion index is straightforward. When the reading is positive, investors have little to worry about and should treat “dips” as a buying opportunity. When the reading is negative a US recession is a possibility. Should the reading fall below – 5 then it is time to get worried – on each occasion since 1981 that the indicator recorded such a level a US recession followed in fairly short order. At this point, my advice would generally be to buy the defensive team with a focus on long dated US bonds as a hedge. This is certainly not a time to buy equities on dips.

Today my indicator reads – 5 which points to a contraction in the US, and more generally the OECD. Such an outcome contrasts sharply with official US GDP data, which remains fairly strong. Pierre explored this discrepancy in yesterday’s Daily (see A Worrying Set Of Signals), so my point today is to offer specific portfolio construction advice in the event of a developed market contraction. My assumption in this note is simply that the US economy continues to slow. Hence, the aim is to outline an “anti-fragile” portfolio which will resist whatever brickbats are hurled at it.

During periods when the US economy has slowed, especially if it was “unexpected” by official economists, then equities have usually taken a beating while bonds have done well. For this reason, the chart below shows the S&P 500 divided by the price of a 30 year zero coupon treasury.

A few results are immediately clear:
  • Equities should be owned when the indicator is positive.
     
  • Bonds should be held when the indicator is negative.
     
  • The ratio of equities to bonds (blue line) has since 1981 bottomed at about 50 on at least six occasions. Hence, even in periods when fundamentals were not favorable to equities (2003 and 2012) the indicator identified stock market investment as a decent bet. 
Today the ratio between the S&P 500 and long dated US zeros stands at 75. 
This suggests that shares will become a buy in the coming months if they underperform bonds by a chunky 33%. The condition could also be met if US equities remain unchanged, but 30 year treasury yields decline from their current 3% to about 2%. Alternatively, shares could fall sharply, or some combination in between. 


Notwithstanding the continued relative strength of headline US economic data, I would note that the OECD leading indicator for the US is negative on a YoY basis, while regional indicators continue to crater. The key investment conclusion from my recession indicator is that equity positions, which face risks from worsening economic fundamentals, should be hedged using bonds or upping the cash component.
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The article Outside the Box: A Worrying Set Of Signals was originally published at mauldineconomics.com.


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