That Stubborn Yield Curve

John Mauldin | Thoughts from the Frontline
October 27, 2006

There is an arcane debate going on in economic circles. How fast can the economy grow without inflation becoming a problem? The answer may be, not as fast as we thought. And the answer matters because the people who have their fingers on the interest-rate trigger take this arcane stuff seriously. How you answer the question also has implications for the unemployment rate. Yes, there are people who worry about it getting too low. Plus, we look at the Dow. The Dow may be telling us more about how indexes are constructed than about how the economy and the market are really doing. All that, some thoughts on the housing data, and more as we ponder the question, "Is it really different this time?"

But first, one of the really great investment conferences every year is the annual New Orleans Investment Conference. This year it is November 15-19. Originally started by the late Jim Blanchard, the conference has a strong gold contingent, but has expanded to cover a wide range of themes. Last year, the conference had to be rescheduled because of Katrina, but this year it is back and looks to be better than ever.

In addition to yours truly, they have lined up Steve Forbes, Jim Rogers, Marc Faber, Dennis Gartman, and Newt Gingrich, plus scores of other well-known speakers, workshops, and private sessions. If you register before November I, you can save $200 on the full price and half off for a friend or spouse.

In conjunction with my friends at Altegris Investments, we will be hosting a dinner for clients and prospects. If you are an accredited investor and would like to attend the dinner, please respond to mauldin@2000wave.com (not my private email address!). Click on the link below for more information about the conference. (You have to use this link to get the special rate.)

http://www.jeffersoncompanies.com/affiliate/affiliate_process.php?icode=confreg&acode=JM

How About That Dow?

The Dow, except for today, has been relentless in making new highs. Yet a lot of other indexes are still below where they were six-plus years ago. Why is the Dow behaving differently? The evidence suggests it is because of the way the Dow is calculated.

Before we get into that data, I don't want to take away from the impressive performance of late of the Dow and the markets in general. I am not suggesting that we have some false bull market, because the recent increases have been quite real, and my continued stop-clock call for a major correction looks more and more silly with each new high. But as I will make the case below, I can't throw in the towel and jump on the Dow 20,000 (or whatever) bandwagon quite yet.

This sidebar is simply to put the difference between the Dow and other indexes like the S&P 500 into perspective. How you create them makes a difference. The Dow has always been price weighted, so the higher the price of a stock, the more important it is to the index. Most other indexes (like the S&P 500) are market cap weighted, so the higher the total value of the company, the more weighting it has in the index. If you use price as the factor for your index, the size of the company does not make a difference.

As many have noted, only 10 of the 30 Dow stocks are above their January 2000 highs. Fifteen of the remaining 20 are down 25% or more. The biggest reason for the surging of the Dow has been just four of its stocks, which not coincidentally are its highest-priced components. And as Barry Ritholtz noted, not a one of the 30 Dow stocks was at an all-time high as the Dow was making its new index highs.

What would your returns look like if the Dow was capitalization weighted like the S&P 500? I asked my friends Rob Arnott and Jason Hsu at Research Affiliates to do the math for us. And since they also run indexes which are fundamentally weighted, I asked them to tell us what the returns would have been if you had weighted the stocks by valuation metrics rather than price or size.

The Dow was at 11,453 on January 1, 2000. Today it closed at 12,134, up almost 700 points or around 6% over the almost 7 years. Including dividends (which is only fair) the total return on the Dow would have been 20.75%.

What if the Dow had been capitalization weighted? Your total return (including dividends!) would have been only 1.13%! Taking away the dividends, the Dow 30 would still be under its high-water mark by about 13%! The S&P is only 6% from where it was on January 1, 2000, or about 9% from its all-time high. (Back-of-the-napkin math. The exact numbers are not important.)

So, the only reason that the Dow is at new highs is the way they calculate the index. On a cap-weighted basis, the S&P 500 is actually doing better!

But what happens if you weight the Dow components by valuation metrics, like P/E, price-to-book, and so on? A Dow 30 index weighted by valuation, like that used by Research Affiliates, would have yielded a total return of 27.6%.

As an aside, Arnott and Research Affiliates have a patent pending on the intellectual property they developed to create their fundamental indexes. After they published their research, which shows the clear benefits of using valuation as the basis for an index, they have started to create "fundamental indexes" in markets throughout the world. I have written about this concept in the past. I think this concept will be the mainstream long-only index methodology within ten years. Cap weighting is so last century. (http://www.2000wave.com/article.asp?id=mwo051305)

There are some mutual fund firms who seem to be ignoring the patent pending and are pursuing their own fundamental indexes. How that will work for them remains to be seen. Intellectual property is a cornerstone of our economy. If you cannot protect it, whether it is software, chip designs, business processes, or a new widget created in someone's garage, it will cause serious problems in a market-based economy. One of the reasons that there is not more creativity and economic growth in the developing world is the lack of patent protection and outright theft of ideas. Why go to the trouble of creating, or sharing your creation, if someone is going to steal it?

And now, let's look at why Fed governors have been warning us about inflation of late.

An Optimistic Fed

At the August 8 Fed meeting, the policy makers sitting around the table were given briefing material called the "Greenbook" (for its green cover). I have been highlighting for several months that Fed governors are increasingly sounding hawkish in their speeches, asserting that inflation is too high and hinting that it is still possible we could see interest-rate hikes.

We now know that what they saw in the Greenbook obviously influenced their speeches. Federal Reserve economists showed data which suggested the previously assumed linkage between economic growth and inflation may be too optimistic. Basically, the assumption is that if the economy grows too fast, unemployment will decrease, driving up wages, and capacity utilization will increase, driving up prices. Thus an economy can grow too fast and cause inflation. (Note that developing economies can grow much faster without inflation because they have high unemployment.)

In effect, policy makers were told last month that time is running out for inflation to fall. The forecasters expect "only a small gap" between what the economy can produce running at full speed and the actual growth rate over the next several quarters. That means any unexpected acceleration in growth might well heat up inflation.

By 2008, according to meeting minutes, the staff expects the economy to be roaring ahead at close to its speed limit, making it more urgent to get inflation under control now.

Staff economists revised the noninflationary growth rate down once again at the September meeting. The first reason for slower potential noninflationary growth comes from research done by senior staff economists, published this spring. The paper suggested that the US is beginning a slow slide downward in the percentage of workers participating in the labor force.

The report said, "Such a slowing in labor input would, in turn, reduce the sustainable rate of economic growth" unless there is another surge in productivity. But since productivity is high, this did not raise many eyebrows. And then the productivity numbers changed.

The Department of Commerce revised their data for the past three years. The result is that the economy did not grow as fast as previously thought in the three years 2003-2005. Growth was revised down from 3.5% to 3.2%. Growth in output per hour was revised down, which meant productivity was revised down. Business investment on equipment and software did not rise as fast as previously thought.

Therefore, since we are not as productive as we thought, the growth rate that doesn't create more inflation is lower. At least that is the argument the Fed economists make, and clearly the Fed governors take them seriously.

JP Morgan Chase estimates that the noninflationary growth rate has dropped from 3.5% to 2.7%, mirroring the Fed concern. And aside from the very poor GDP numbers today, the Fed and most economists think that GDP will grow faster than 2.7% next year.

If the economy does indeed pick back up before inflation is brought down, it could signal the need for further rate hikes. Thus the concern by Fed governors in their speeches and in the press release from the FOMC meeting concluded this week.

The debate is framed by two very different estimates of economic growth and Fed policy. Because JP Morgan Chase, mentioned above, thinks that the economy is going to grow enough that inflation will remain a problem, they think there will be three more interest-rate hikes between now and June, taking the Fed funds rate to 6%.

But there are others, like Goldman Sachs, who think the economy will slow and bring inflation down with it. Goldman thinks the Fed will cut rates five times next year, bringing the Fed funds rate down to 4%.

And if you are a Fed governor, you have to make a decision each and every meeting. But you did get some data today which suggests that inflation may finally be slowing. The favorite Fed measure of inflation, the core Personal Consumption Indicator (PCE) fell to 2.3% in the third quarter. Another few months of that trend and Fed governors will have to get a new topic for their speeches.

The Economy Slows Down

Today, the Commerce Department reported that the economy did in fact grow less than 2.7% in the last quarter, coming in at 1.6%, far below consensus expectations. Of course, we know that these numbers are subject to revision. And a former Commerce Department economist says that the number will be revised down sharply.

Joe Carson, now director of economic research at Alliance Bernstein LP in New York says the growth rate should have only been 0.9%. The 1.6% number was the result of a statistical fluke which yielded an unexpected increase in auto production last quarter, in spite of announced cutbacks by Ford, GMC, and others.

" 'A drop in the wholesale price of SUVs and light trucks as the automakers cleared leftover 2006 models made production look stronger than it actually was,' said Carson. The economic fallout from the auto-industry cutbacks will instead come this quarter, he said.

"'Last quarter was weak even with the benefit of this mismatch and the fourth quarter will now also be weak because it's going the other way,' Carson said. 'Whatever output you have this quarter, which will probably be down, will be discounted by a likely rebound in prices.'

"Carson stressed that there wasn't an error in procedure requiring a correction from the government. It's the way the Commerce Department always computes the data and doesn't mean the statisticians committed any mistakes, he said." (Bloomberg)

Basically, they use prices to estimate output. And since auto companies dropped prices by 5.5%, it made inflation-adjusted production look larger for autos larger than it actually was. As an aside, most economists predict this quarter will be 2.5%. Carson thinks GDP will be 1.4% and he wouldn't be surprised "if it was half that."

That Stubborn Yield Curve

As long-time readers know, I have been suggesting we will see a slowdown or a mild recession next year. Among other reasons, an inverted yield curve is the most reliable predictor of recessions of all our forecasting tools, and the inversion of the yield curve is continuing to deteriorate. Today the ten-year bond is 43 basis points below the 90-day T-bill. This is the largest differential this cycle.

The yield curve inverted in the third quarter of 2000 when nearly all economists were projecting solid growth. Something like 50 of 50 Blue Chip economists did not predict a recession. As it turned out, the economy was actually in a very mild recession in the third quarter, but we did not know it for another few years as the GDP kept being revised downward. The actual beginning of the "official" recession as tracked by the National Bureau of Economic Research was not until March of 2001 through November of 2001.

The general stock market was just fine, making new recent highs (except for the tech bust, of course). Calling for a recession, as I did, in August of 2001 was not a consensus view. And reminding people that stock markets dropped an average of 43% during recessions was not popular. Everyone was rooting for the return of the bull, and it sure looked like it was coming back.

Just for fun, let's see what the differential on the yield curve looked like in the "pre-recession" year of 2000 and then compare it to this year. The thick (red) line is this year and the thin (blue) line is 2000. Notice the inversion got worse as the year progressed. We can't statistically make too much of this, other than to see it for the cautionary resemblance of this year to 2000.

Has the Housing Market Bottomed?

Residential housing construction fell at an annual rate of 17.4 % last quarter, the biggest decline since the first quarter of 1991, after shrinking at an 11.1% pace in the previous three months. The decline subtracted 1.12% from GDP growth, the most in almost a quarter century. Will a continued decline in housing construction push us into a recession next year?

In August of 2005, I wrote about Greenspan's speech at Jackson Hole. Reading between the lines, he very clearly said the Fed was targeting asset prices and more precisely home prices. I said then the Fed would keep raising rates until the housing market cried uncle. And they did. Laying aside the inflation problem I wrote about at the beginning of this letter, let's assume, for the sake of argument, the economy slows down and enters into a recession. Can we expect the Fed to come to the rescue at that point? The answer is, they will try and do so. But the always perspicacious Paul McCulley suggests that lower rates might not be enough. Writing this month in his Fed Focus , he says:

"While the housing bubble was inflating, it seemed impervious - or inelastic - to the Fed's rate hiking, so the Fed kept tightening, on the thesis that an unresponsive mule is not really unresponsive, just in need of additional whacks on the head with a two-by-four. And it worked, as the mule has gone into severe retreat this year. No surprise here, really, as housing is, using the word of George Soros in the mouth of PIMCO's housing guru Scottie Simon, one of the most "reflexive" asset markets in the world, the ultimate momentum market: can't get enough on the way up and can't run away fast enough on the way down.

"Which brings me to my core thesis looking forward (and on the opposite side of former Fed Chairman Greenspan): housing is going to be very inelastic to falling interest rates on the way down, just as it was very inelastic to rising rates on the way up. To think otherwise after a bubble is to not understand bubbles. Risk appetite in property markets will not be restored by modest declines in market-determined interest rates, particularly if the Fed refuses to "validate" them with lower short-term policy rates, limiting or even reversing declines in market-determined interest rates.

"Thus, just like policymakers and market participants kept ratcheting up estimates of the time-varying neutral real short rate while the housing bubble was inflating, I think they will be ratcheting down those estimates, again and again, as the air continues to escape from the property bubble. Put differently, irrational exuberance, which lifts the cyclically neutral short rate, will, when followed by irrational fear, reduce the cyclical neutral real short rate."

New-home sales have increased for the second straight month. A lot of analysts see this as an indication that worst is now behind us. Well, maybe. The first thing you need to remember is that the inventory of unsold new homes is up to a record 157,000, up 47%.

And good friend Barry Ritholtz tells us we should look under the hood on those increased sales. His comments were so right on, and a good read, that I will quote him at length:

"First, a quick word on New Home Prices:

"The reported sales prices were pretty awful. 'Median sales prices dropped 9.7% in the past year to $217,100, the lowest price in two years. It's the largest percentage decline in median prices since December 1970. Median prices for existing single-family homes are down 2.5% in the past year, the largest decline ever recorded'

"Here's the amusing part: Despite the huge price drop, the reported price changes actually understate the actual price changes . This is due to Builder Incentives. Have a look at some of the freebies builders have been using to get sales going: Sub zeros, pools, BMWs, even paying the property taxes for 2 years!

"Candy bar companies don't like to raise prices, so they simply make the candy smaller, selling them for the same price; Curb Your Enthusiasm fans might note how many fewer Cashews go into a can of mixed nuts ('The whole cashew/raisin balance is askew!' ). Paying the same amount for a smaller Almond Joy or less cashews is price inflation .

"Builders do the opposite: They add cashews . Some feel the psychology of lowering prices scares off potential buyers - or at least frightens them into sitting back and waiting. To avoid the appearance of decreasing prices (or to make them appear less severe), they offer more - increasing what they are selling - only without (apparently) charging for them. This getting more for the same cost is price deflation . New Home Pricing today - more cashews - is even more Deflationary than appears...

"Yesterday's increase in New Home Sales caught some economists by surprise. I look at those sorts of numbers suspiciously. Any time I want some insight into any particular data-point, I find it instructive to go to the actual government source's website, and simply click around. If you do this with a skeptical eye, you may learn some really interesting facts.

"That's what I did with the New Home Sales yesterday, simply looking at the release and trying to figure out what they were really saying thru the bureaucratic jargon and legalese. You don't need to be a forensic accountant (but it wouldn't hurt). Here's what I found:

"1. The reported increase in sales was 5.3 percent. The margin of error was +/-15.6%. Therefore, the likely change in sales ranged from +20.9% to -10.3%. Since this range contains zero, "the change is not statistically significant; that is, it is uncertain whether there was an increase or decrease."

"2. Recently reported increases have been subsequently revised downwards, primarily due to cancellations. Sales in June, July and August were revised down by 67,000.

"3. Year-to-date sales are down 16.5%.

"4. Commerce department does not do an 'Apples-to-Apples' comparison. They report initial New Home Sales (pre-cancellations) versus the prior months adjusted (post-cancellations). This has the effect of lowering the older months data, thereby making the present monthly gain appear larger.

"A more consistent methodology might be to compare unrevised data with unrevised data. So for September, we might look at sales of new one-family houses in August 2006 as initially reported - annual rate of 1,050,000 (seasonally adjusted); Then we look at sales of new one-family houses in September 2006 as initially reported: an annual rate of 1,075,000 - just under 2.4%, as opposed to the reported 5.3%. Note this is still statistically insignificant, given the +/-15.36% margin of error.

"Note that the year over year estimates -- down 14.2% percent (+/-12.2%) below the September 2005 puts zero beyond the margin of error. The range year over year is between down 2% - to down 26.4%!"

It is not likely that we have seen the bottom in the housing market. And if prices slide it is going to affect the mindset of consumers. I met with a very interesting economist by the name of Kathleen Camilli of New York this week. You will be hearing more from her. I picked up the following chart and data from one of her recent letters.

The valuation of US owner-occupied real estate has risen from $4 trillion to $20 trillion since 1980, and by $8 trillion in just the last five years. This enormous increase in wealth is what allowed consumers the psychological "cover," not to mention the actual wherewithal, to continue to increase spending right through the last recession.

What if we have a recession and home values are dropping? Just a thought, and not a pretty one.

Time to Be a Bull

I have the luxury of not directly managing money. I am basically a manager of managers, so I can choose which manager (or partners I work with, who choose) to direct client money. I am really looking forward to the day when I can once again be bullish. It is so much easier both personally and professionally to have a bullish view.

It is so vastly easier to find great managers in a bull market. And there are a lot of managers who have done well over the past few years. But if you have the view that we are going to lower valuations, putting money in long-only indexes and programs is a mug's game. It is trading short-term returns for long-term risk.

There are lots of long-biased managers who will do well in the next bull market, and I love value-based funds of all types. It is a lot harder to find absolute-return managers who can provide good returns in difficult markets as well as the recent bull runs.

If I am right and we are going into a recession or serious slowdown next year, if the market did not have a serious problem, it would be the first time in history. I don't like betting on "It's different this time." So far this year, I have been wrong; but I don't think the game is over. The fat lady hasn't sung. In the meantime, absolute-return investing has the potential to provide good returns while limiting your exposure to a market correction.

And as an aside, I hope I am wrong. I hope we get a soft landing, and that it happened last quarter. I hope new-home sales really do pick up. I hope unemployment stays low and that the porridge will be just right.

New Orleans, New York, and Coming of Age

As noted at the top of the letter, I will be in New Orleans November 15-19. It now looks like I will be in New York for a day or so later this month, and then no planned trips until late January when I go to South Africa.

My #2 son turned 18 yesterday. Just as I watched his five older brothers and sisters, I have watched him mature. It is rewarding to see them take on more responsibility, to take the turn to be their own person. "Dad, I can pay for that. Why should you do it? I want to." When you think that nothing has rubbed off, it makes you smile when your son comes in and starts talking about customers and marketing and values at his job. Maybe there is hope.

Have a great week.

Your ready for NBA basketball to begin analyst,

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