A Brief Performance Update
New ProfitScore IQ Publication Schedule
What were they thinking?
The 800-Pound Gorillas
Enter 800-Pound Gorilla Number 2
The Jobs Conundrum
Summing Up the Bearish Case
Case for the Bulls
One of Boise's Favorite Summer Activities
Have you ever promised more than you can deliver and it finally catches up with you? It happens to me all the time and my family suffers from my over commitments. Sound familiar? More on that below about the future publication schedule of the ProfitScore IQ.
I was riding in my truck the other day listening to the radio and I heard a news snippet on the radio that stated that deaths caused by automobile accidents are at a low, not seen since the 1950's. My first thought was, wow! Then I thought what a worthless piece of information. Without normalizing the data by the number of drivers today versus the number of drivers in 1950, you can't possibly compare the accidents in the 50's to today. It is an apple to oranges kind of comparison. On a normalized basis, we probably passed the 50's number decades ago.
The world's worst defender of statistical manipulation is the government, followed closely by the financial press. Yes, I guess that counts me too. We are two years away from our nation's next presidential election, which has historically been good for stocks, so I thought I would normalize some of the government's economic data to give you a better understanding of the true strength or weakness in our economy. I am not trying to persuade you one way or the other, I am merely trying to remove the deception from the data. I will present a case for the bears followed by the bulls, as there are two sides to every argument and I encourage you to make up your own opinion based on the facts.
To do this and to keep you informed, this IQ has more charts than any IQ I have ever published. It is going to print longer than normal, but will be well worth the read. My hope is that it will help you see through the statistical lies that will soon be told as we go through what is one of our nation's most important presidential elections. We are already seeing the fireworks start in raising the debt limit. The stakes are high and we sure as heck need to have our facts straight.
You hear a lot of different arguments, or "SPIN", about economic theory these days. As I mentioned before, when this mess is over, it will no longer be theory but fact because countries are taking different paths to prosperity. If you haven't seen this entertaining music video produced by two economic professors explaining the difference, it is well worth your time.
A Brief Performance Update - Update Performance
Below are some quick performance stats. For more detailed performance analysis, click on the blue highlighted portfolio names listed in the table below.
Jan 08 to
S&P 500 (SP500)
New ProfitScore IQ Publication Schedule
I hadn't really planned on going this long without writing the ProfitScore IQ. Actually I hadn't planned on stopping at all. Due to a death in our family around Christmas and recent shoulder surgery I had in January, it just wasn't possible to produce the IQ. Then another month went by, followed by another.
Publishing the IQ is a love hate relationship. After it is published, I feel a great sense of satisfaction, but completing the research to write the letter weighs on me like a school bus sitting on my chest.
Due to the fact that I simply don't have enough hours in the day, I have decided to reduce the publication of the ProfitScore IQ back to once per quarter. I have kicked around the idea of launching a blog to publish smaller snippets more often and that may materialize in the future, but for now my only commitment to you is write an excellent ProfitScore IQ once per quarter. I may throw in another one during the middle of the quarter if the need arises but my normal schedule will decrease from monthly to quarterly.
Since I will have more time to prepare my thoughts, I hope you find the quarterly publication of the IQ worth the wait and I hope it adds lot of value to your financial prosperity.
We've all read headlines making sweeping declarations that seemed indisputable. For example, the U.S.A. has the largest military expenditure in the world. Another is that Sweden has one of the highest standards of living thanks to its generous social programs.
But sensational statements such as these ignore the effect of normalization - to make normal so that it conforms to a standard or norm.
Yes, the U.S. does spend the highest number of dollars on its military, but as a percentage of GDP (4.7%), it is far below that of Saudi Arabia (11.2%) according to a study conducted by the Stockholm International Peace Research Institute.
And yes, Sweden is considered by many liberal thinkers to have one of the highest standards of living in Europe. But how many know that on a GDP per capita, or personal prosperity basis, If Sweden was considered a U.S. State, if would be considered one of the four poorest states in the U.S.A. according to a 2004 study by Timbro, a Swedish academic organization?
We've all heard just how serious the financial collapse was and how our debt has soared out of control. In this IQ, we take a look at the situation and normalize the data so that it can be analyzed, measured, and compared in ways you have not seen in the regular or financial media.
Getting Inside the Heads of the Fed - What were they thinking?
When politicians and central bankers first moved to repair the damage wrought by the financial crisis in 2008, monetary policy was changed forever. Long-standing accounting rules were broken, the line of moral hazard demolished, and the ‘too big to fail' loophole was born. The risk taken by most major financial institutions was magically lifted from their shoulders. Economies and financial markets would never be the same again.
Why had the financial system become so unstable leading up to the crisis? What had allowed institutions to become so big that their failure would put our financial system at risk?
If there was any one factor responsible, it was that debt had risen almost exponentially thanks in part to a rising dependence on loose monetary policy. But this was not a new phenomenon. Debt across all aspects of the U.S. economy had been rapidly rising for years. Was debt solely responsible? Had monetary policy gotten too easy? Or had some other economic tipping point triggered the most serious financial crisis in nearly a century?
In this ProfitScore IQ, we will examine the economy from the perspective of the Fed officials who've dealt with the crisis and its aftermath. Using their data together with our own perspective, we compare the financial world before and after the crisis. However, what you'll see is not the type of analysis you will find in the Federal Reserve's Beige Book, FOMC statement, or in the media.
Finally, we will discuss how these changes have impacted the economy and markets, and what trends are telling us about what to expect in the months and years ahead. By understanding what risks lay ahead, we will be better equipped to avoid getting caught in the maelstrom when the next inevitable crisis hits. There is a lot to cover so fasten your seatbelts!
The 800-Pound Gorillas
When I look at how big our debt has grown, I am immediately reminded of the quote from our great American sage and poet, Will Rogers.
"If you find yourself in a hole, the first thing is to stop digging."
Seems simple enough, doesn't it? So why are policy makers having such a hard time taking his advice?
Figure 1 -Our debt addiction shown by this monthly chart of total U.S. debt showing the parabolic rise in debt since 1950. Total debt has only declined in four of the last 240 quarters. After dropping between Q4-2009 and Q3-2001, debt was again rising at 6.45% per year as of Q2 - 2011. Wow! I wish public debt was an asset class that I could invest in.
Undoubtedly, total U.S. debt (total credit market debt) is the biggest gorilla in our economy as Figure 1 shows. Between 1953 and 1970, total debt raised an average of 6.9% per year. However, once the U.S. went off the gold standard in August 1971 for the last time, total debt sky-rocketed. In January 1972, the annual growth rate of total debt surged into double digits for the first time.
As the first chart shows, total U.S. debt is now more than 33 times (3,315%) greater than in was forty years ago! Since 1971, debt has grown at a compound rate of more than 9.2% per year. There have been just four quarters in which debt levels have fallen since the Fed first began collecting the data in the early 1950's, and that was only recently between the fourth quarter 2009 and third quarter 2010. The insert window at the top of Figure 1 shows total debt, total debt per citizen, total debt per family and the average savings per family.
Our economy has also grown rapidly in the last sixty years. How rapidly has our economy grown when normalized by the growth of total debt? As Figure 2 shows, total debt has grown from 129% of GDP in the early 1950's to more than 350% by early 2011 after peaking at 375% in January 2009.
Debt has grown even faster compared to total U.S. wages and salaries, from 255% in the early 1950's to a whopping 810% debt-to-wages ratio by early 2011 as the purple line in Figure 2 shows.
So why is this important? Falling debt levels relative to other growth metrics like GDP and wages & salaries would be positive for our economy if it were sustained. Conversely when debt rises relative to our economy, it's a negative.
Figure 2 - Total credit market debt versus GDP and total wages & salaries.
Enter 800-Pound Gorilla Number 2
Debt cannot rise in a vacuum. It needs help and lots of it. Some help, such as strong economic growth is good. Other types of help, such as loose monetary policy and stimulus programs can be counterproductive, especially when they are over-used.
In the early 1990's, total debt was growing at an average rate of 5% per annum. Inflation was low and the economy was relatively strong. There was a recession in 1991, but it was relatively brief, after which the economy recovered. The combination of a strong economy and relatively easy money helped push the debt annual growth rate above 10% by early 2008.
In an effort to address the economic malaise in 2001-2, Captain Greenspan and crew of the USS Fed dropped the Fed funds overnight lending rate from above 6% in 2000 to just 1% in 2003 where the rate hovered for the next year. The strategy worked. A new stock market rally was ignited thanks in large part to low interest rates and "accommodative" monetary policy.
So when the financial crisis began to unravel in late 2007 and early 2008, the new Fed Captain simply did more of what had worked under his predecessor's watch - lower interest rates. When that failed to do the trick, he initiated a series of stimulus programs and quantitative easing to get the economy and markets going again.
But something had changed. The strategy wasn't working as planned. Undaunted, Chairman Bernanke kicked the program into high gear and that included pumping trillions into the economy and stock market. Between August 2008 and February 2011 the money circulating through the U.S. economy known as adjusted monetary base grew from $875.7 billion to $2.3 trillion. In two and a half years, the amount of money in circulation had nearly tripled.
Figure 3 - Chart of the Adjusted Monetary Base or money in circulation showing the increase between 2008 and 2011. The annual rate of growth is shown in red.
However, as physicist Sir Isaac Newton once famously postulated, for every action there is an equal and opposite reaction. What longer term impact would pumping trillions into our economy have?
Figure 4 - Fed chart showing the ratio of total U.S. debt to adjusted money in circulation.
Figure 4 shows how the ratio of total debt to adjusted monetary base changed. The size of the debt relative to the money in circulation dropped like a stone from 2008 through 2010. It was as if the Federal Reserve was trying to inflate the debt problem away, except now instead of just dropping interest rates to zero, t hey were printing money and spreading it around. This included buying toxic assets which effectively transferred the risk from private and quasi-government corporations to the taxpayer. (For detailed money supply explanations, please see Definitions below).
Magically in March 2009 stocks began to rally once more with a vengeance. Throwing money out of helicopters helped kick start stock markets at least in the short-term. But how effective would this strategy be in getting the economy running smoothly again, seeing American jobs return and the unemployment rate drop back to pre-recession levels?
Next, we see how our consumer-driven economy and accommodative monetary policies have impacted economic growth (Figure 5). As this chart shows, the annual rate of economic growth has slowly but surely trended lower since peaking in the late 1970's. As a point of reference, the drop in 2009 was the worst since the recession of the late 1940's, following the aftermath of World War II. As the chart shows, the economy quickly rebounded. However, only time will tell if the current growth rate will be sustainable without continual fiscal stimulus from the Fed.
As Figure 4 shows, debt had been reduced relative to cash in circulation which means new debt again would be easier to create. Was this a good idea?
As Figure 5 of the annual rate of economic (GDP) growth demonstrates, after peaking the late 1970's the rate of growth has trended lower until hitting a low in 2009. It was the worst contraction since the late 1940's. Each growth rate recovery post 2000 has been lower than the last. Would all the stimulus and easy money policies work longer term? We may not have the answer for a while but there are indications that GDP growth is again falling as the following few charts demonstrate.
Figure 5 - GDP annual growth rate showing the growth peak in the late 1970's and decline since then.
Figure 6 shows how the economy has performed relative to M2 money supply, the broadest measure of our money supply (after M3 data was discontinued in 2006 by the Fed). This chart shows that relative to money supply, our economy is back to 1985 in terms of performance. In other words, it takes significantly more money sloshing around to keep our economy going today than it did a decade or more ago.
Figure 6 - The ratio of GDP to M2 Money Supply, the broadest measure of money still in circulation (after M3 was discontinued five years ago). As is the case with the Adjusted Monetary Base, steadily increasing the money supply has been necessary to keep our economy growing albeit at a slower rate.
Next, Figure 7 shows economic growth (GDP) relative to adjusted monetary base (money in circulation). Our economy has actually been shrinking if measured per dollar in circulation. This ratio has been trending lower since the mid-1980's and looked like it was starting to recover in 2005-6, but then the crisis hit. It took a lot more money to get the economy growing again as the fish-hook pattern on the far right shows, but we are not out of the woods yet.
Figure 7 - The ratio of GDP to Adjusted Monetary Base showing the big drop in 2008-9.
Figure 8 is a chart of the M1 money multiplier showing how efficiently money is driving our economy. Note the similarities between it and Figure 7, as well as the differences. While the ratio in Figure 7 has turned up, the one in Figure 8 recently turned down reflecting a continued drop in the efficiency of money.
In technical terms, the money multiplier is the amount of money the banking system generates with each dollar of reserves and is the reciprocal of the reserve ratio. In layman's terms, the money multiplier reflects how effectively money is circulating through the financial system and how much economic activity one dollar generates. As you can see, it takes more than three times as many dollars now to achieve the same economic activity that we enjoyed in 1986.
The only publicly available money multiplier data is for M1, which is the narrowest money supply measure. If the Fed does track other money supply multipliers, it does not make the data public hence the need to look at GDP in relation to other money supply measures for clarity (Figures 6 & 7).
Figure 8 - Chart showing the M1 Money Multiplier - the amount of money the banking system generates with each dollar of reserves and is the reciprocal of the reserve ratio. M1 is the narrowest measure of money supply.
The Jobs Conundrum
Perhaps the biggest criticism of current fiscal policy is that it has successfully kick-started stocks and corporate profits as we'll see later, but sustained economic and jobs growth remain a challenge. You may have seen the chart in Figure 9 before. Here is a recently updated version.
Figure 9 - Comparison of job losses in each recession since 1948. Courtesy of http://www.calculatedriskblog.com/
As Figure 9 so clearly demonstrates, this recession has experienced the worst job losses since 1948, and the recovery has been painfully slow. Solutions initiated by government and the Fed have so far failed to have any sizable impact on the jobs. The next two charts (Figures 10 & 11) reveal this situation from two different perspectives.
Figure 10 - One statistic that analysts have pointed to as a sign that employment remains anemic through this recovery - average weekly hours worked per employee.
Figure 11 - Another indicator of a weak labor market is the falling labor participation rate since 2000. This drop accelerated at the onset of the 2008-9 recession and has shown no signs of recovery.
Figure 11, the labor force participation rate, shows the percent of how the size of the working population has changed over time. Like Figure 9, it paints a disturbing picture.
So what happens when we put Figures 10 and 11 together? Figure 12a is the product of average weekly hours times the labor force participation rate. The amount of work being performed by our population has literally fallen off a cliff with little signs of a recovery around the bend.
Figure 12a - This chart is the average number of hours worked multiplied by the labor force participation rate and the incredible reduction in work hours overall in our economy.
Summing Up the Bearish Case
So far the impact of trillions pumped into our economy has been muted on job growth. Economic growth remains tentative at best, prompting critics to declare government and Fed efforts a failure. They say that the results achieved have been accomplished by making a serious debt problem even worse. This will lead to another financial crisis down the road. Another challenge many experts are saying we face is that recessions will be more frequent, business cycle volatility will be more severe, and uncertainty greater. They may be right.
However, there are some hopeful signs that bode well for stocks and even the economy in the next few months.
Case for the Bulls
The flip-side of falling weekly hours worked and a declining labor participation rate is that productivity has been steadily rising, industrial output is on a tear, and exports have been rising. Although higher productivity is not good news for the unemployed, it is good news for our economy.
The next few charts paint a more optimistic picture for stocks. If stocks are a leading indicator of the economy, this is good news indeed.
To paraphrase a well-worn saying, the beauty of a chart is in the eye of the beholder. In the next chart we see Figure 12a with annotations. We noticed when putting it together that there were peaks a few months before each recession (green circles), which marked the end of the business cycle and warned of the impending economic slowdown. Likewise, the chart put in a bottom, either during the recession or shortly thereafter, indicates the end of the slowdown. If this relationship holds, expect to see a bottom anytime soon.
Figure 12b - The same chart of average weekly hours worked times the labor force participation rate with annotations.
Next, we take a look at the dramatic recovery of corporate profits since 2008. Figure 13 is self-explanatory and provides one big reason why stocks have performed so well since March 2009.
Figure 13 - Corporate profits after tax showing their dramatic rise since 2004 with a big dip in 2008 then "V" shaped recovery.
Next we look at capital flows from two different perspectives. The first comes to us courtesy of the Investment Company Institute (ICI) and compares domestic and foreign equity fund flows. As we see, domestic flows have lagged stocks more than foreign flows. Foreign equity flows have been strong since the fall of 2010 and although down somewhat, were still positive according to the latest ICI data.
Figure 14- Domestic versus foreign mutual fund equity flows courtesy of the ICI.
Figure 15 - This Fed chart shows the big drop in foreign net capital flows into 2009 and subsequent recovery. This is good news as long as the primary uptrend continues.
There is another big reason for optimism over the next few months. It is a topic we have discussed before but given the timing, bears re-examination, and that is the four-year election cycle. As Figure 16 shows, more than 60% of Dow Jones Industrial Average gains have occurred in the third or pre-election year, which is good news for traders this year.
Here are some more interesting facts about the pre-election year.
- Q2 (April - June) of the pre-election year is the most powerful quarter of the cycle.
- April is the most powerful month of the pre-election year followed by December, March, June and August.
- September and October are the worst months in the pre-election year and there's not a lot of motivation to jump the gun in November. It's the seventh best (sixth worst) month.
If QE3 does become a reality (an outcome further supported by the fact that we go to the polls in 2012), we expect the rally to continue. According to economist David Rosenberg, there is an 86% correlation between the size of the Fed balance sheet (read stimulus and bailout programs) and stock market performance. QE3 will mean more Permanent Open Market Operations, which have significantly helped buoy stocks over the last two years. For more on POMO, see Playing the POMO put in the November 2010 ProfitScore IQ at http://www.profitscore.com/display.aspx?articleid=E8P1os4oD0o=
Figure 16 - Comparison of years in the election cycle.
We also recommend reading Tom McClellan's insightful October 2010 article - POMO: The Hot New Timing Tool if you haven't done so already. It's available free at
One last note that could make all the difference to an investment portfolio regardless of what assets it contains. We mentioned above that the Fed is doing all it can to inflate debt away and there is no indication that this will end. We have discussed this in past newsletters (see http://www.profitscore.com/display.aspx?articleid=cuQfYXRwSU4= ).
As I write this, gold has corrected somewhat after hitting new all-time highs, and silver is clawing its way back after a similar correction. Yet the Fed would have us believe from the Consumer Price Index that inflation is just 2.1%? From a technical standpoint, the recent decline in metals appears to be corrective and the long-term trend remains higher. On an inflation adjusted basis, Gold needs to reach $2,348 to hit a new inflation adjusted high. We are a long ways from there, but it shouldn't take us long to get there.
Without a fundamental and drastic reversal of current monetary policy, inflation is coming and based on a number of measures, has already arrived. Here is but one measure that shows the growing divergence between the official CPI and reality that comes from MIT's Billion Prices Project (http://bpp.mit.edu/daily-price-indexes/?country=USA ).
Figure 17 - Chart of MIT's Billion Prices Project for the U.S. which is the composite of thousands of prices for sale across the country. As of the latest BPP data, prices across the U.S. were up 103.454 versus the official CPI of 102.126, telling us that price inflation is 62% higher than CPI is indicating.
As is the case with most bull markets, there is plenty to worry about. The most concerning of which is impending inflation. However, until it arrives, there are compelling forces driving stocks higher from here, not the least of which is continued stimulus programs fostered by the desire for elected officials to get elected.
Money Supply Definitions:
M1 - The sum of currency held outside the vaults of depository institutions, Federal Reserve Banks, and the U.S. Treasury; travelers checks; and demand and other checkable deposits issued by financial institutions (except demand deposits due to the Treasury and depository institutions), minus cash items in process of collection and Federal Reserve float.
M2 - M1 plus savings deposits (including money market deposit accounts) and small-denomination (under $100,000) time deposits issued by financial institutions; and shares in retail money market mutual funds (funds with initial investments under $50,000), net of retirement accounts.
M3 - M2 plus large-denomination ($100,000 or more) time deposits; repurchase agreements issued by depository institutions; Eurodollar deposits, specifically, dollar-denominated deposits due to non-bank U.S. addresses held at foreign offices of U.S. banks worldwide and all banking offices in Canada and the United Kingdom; and institutional money market mutual funds (funds with initial investments of $50,000 or more). This metric was discontinued by the Fed in March 2006.
MZM (money, zero maturity) - M2 minus small-denomination time deposits, plus institutional money market mutual funds (that is, those included in M3 but excluded from M2).
AMB (adjusted monetary base) - The sum of currency in circulation outside Federal Reserve Banks and the U.S. Treasury, deposits of depository financial institutions at Federal Reserve Banks, and an adjustment for the effects of changes in statutory reserve requirements on the quantity of base money held by depositories.
MULT (money multiplier) - Describes changes in the amount of cash in circulation, as a result of the banks' ability to lend to customers. It is the amount of money the banking system generates for each dollar of reserves. In 2008, the Federal Reserve began pumping money into banks' balance sheets with the hopes that it would translate to more money in the economy.
One of Boise's Favorite Summer Activities
One of Boise's favorite summer recreational activities is floating down the Boise River on a hot summer day. The river generally opens around the middle of June once water levels reach safe levels. The river has been running higher than normal due to a large snow pack and a cold wet spring, and it just open to rafting a few days ago.
The Boise River is colder than most rivers, but it feels great on a 100 degree day. The rapids are mostly small with a few rough spots. Many people just use a tire inner tube to float the river. Along the way there are a few rope swings to add a little excitement to the trip. My daughters are getting old enough to enjoy a good rope swing. I can only hope they don't do the stupid things I did growing up along the Tennessee River. I am lucky to be alive.
My brother Bill and his beautiful daughter Ann will be paying us a visit during the last week of July. On our agenda, is camping and fishing in Bear Valley, floating the Boise River, enjoying the local water park, and anything else that seems fun. This will be Ann's first trip to Idaho and we want Idaho to be her favorite vacation spot. We live on average 2,400 miles from our closes relative, so we cherish visits from our families.
I hope your summer plans are filled with fun filled activities with family and friends. Talk to you next quarter.
Working to grow your wealth,
John M. McClure
President & CEO
ProfitScore Capital Management, Inc.
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