State of Capital: Vol.1

The third quarter of the year saw a revised reading of Gross Domestic Product of 3.3%, while the second quarter read 3.1%. Unemployment fell to 4.1% in October. The US stock market if off to new highs as is bitcoin. Inflation edged up to 1.8% after five months stuck at 1.7%. In fact, inflation, as measured by the NY Fed’s underlying gauge, is nearing 3%. Consumer confidence remains at a 17 year high. These headline numbers in the US bode well for overall economic strength and footing. Behind the curtain there is a slightly different story.


1. Yield Curve

fredgraph (10).png

59 basis points. That is the spread of the yield curve, as measured by the 10 year treasury bond minus the two year treasury. The spread between the two keep falling. To be clear, a flatter-than-usual yield curve, like one we see now, is not necessarily a death sentence, but it does not bode well for credit expansion through intermediaries. What bank would want to receive a net of 0.59% for lending ten years from borrowed money to be paid in two. I’m sure not many are thrilled at the prospects. If measured inflation does not create more upside pressure on long yields while the Fed continues it’s path of rate increases, a further flattening could occur. This would not be a welcome sign.


2. Junk Spread

fredgraph (11).png

The Junk Spread, as measured by the Bank of America Merrill Lynch US High Yield Option-Adjusted Spread, resides at 3.7%. This means that investors who buy high-yield bonds are accepting 370 basis points above a comparable-maturity Treasury to take on the risk of losing capital. In early 2016, those same investors were offered almost 3x that compensation. To be fair, this was due to the fear of energy companies going under as oil prices fell through the floor. Nevertheless, this does not seem to me to be a fair wage.


3. Market Capitalization vs. Gross Domestic Product

fredgraph (12).png

Much of the credit for this valuation measure has been given to the Oracle of Omaha. When measured against the output of a nation, the dollar value of all publicly-traded stocks can give an indication of the how far ahead market participants have pulled returns from the future, or how little they are valuing prospective returns. Since the early 90’s this measure has been helpful in pointing out when trouble could be ahead. A cyclical peak followed by a downward movement has been the signal to look out for. At the moment, it does not look great, but where did you expect all of this easy money to go? Into consumption? The next reading should give us more clues.


4. Transports


Although we transitioned to a service economy a long time ago, shipping of goods is still a telling indicator of economic momentum. When the aggregate stock value of to shipping stocks starts to lag behind the market as a whole, there may be something to be taken from it. If goods are not being moved across the country from supplier to end-user, it may be a sign that consumers are not demanding services that require goods from suppliers, or that they are not interested or able to buy certain goods. So far, the year-to-date performance of the transports does not support the thesis of a thriving economy. On a side note, perhaps the old stalwarts are being squeezed by new disruptors like Amazon and gig-economy startups who take advantage of excess capacity that exists in the average consumers’ automobile and time.


5. Monetary Policy

Last, and possibly the most influential to the buoyancy of risk assets, is monetary policy. With Jerome Powell taking the reins a the Federal Reserve in the coming months, many are speculating that Janet Yellen’s easy yet dwindling policies will continue.  This, although good for assets in an absolute sense, is relatively bearish for US assets because other leading central banks, namely the ECB and BOJ are still much more loose.

Now, despite homing in on relatively higher rates, money still seems to be easy according to the Chicago Fed’s National Financial Conditions Index. This index does include a measure for equity markets, which could be making it seem easier than it is through the so-called “wealth effect”. Either way, the index shows the easiest financial conditions since the early 90’s.


When speaking of money itself, M1 and the broader M2 can be useful indicators of money getting in the hands of those who are willing to spend. The year-over-year change in M1 and M2 are shown below. Over the last 25 years, whenever M2 starts to grow, and maintains a rate faster rate than M1, it seems as though the second half of the business cycle is solidified.  We are seemingly not there yet.

fredgraph (14).png


The yield curve has been said by many great investors and market observers to be the single most important forward indicator of an economy. It points to a less than healthy future despite many other factors pointing up. GDP is on it’s way up and unemployment is low but perhaps not as helpful an indicator due to the quality of employment. Underlying inflation may be on the rise and money is still cheap. Unfortunately the yield curve is flattening, risk-assets are pushing up on valuations and therefore investors are accepting less risk premium.

This volume of the State of Capital points to a mixed bag of readings; coincident indicators point to current health while forward-looking indicators are less than promising. Remember, the higher the asset price now, the lower the expected return.


Sources: FRED, NY FED, BLS, Conference Board



The Big Mac Index

The Big Mac Index is an index of how much it costs, in local currency, for a McDonald’s Big Mac sandwich. The idea is that the purchasing power of a currency would be evident if viewed in relation to a common good purchased around the world. This is a measure of the purchasing power of the local currency. What it can tell us is how strong or weak a currency is relative to others.

For example, a Big Mac in the US costs about $4.79. In Switzerland it costs 6.74 francs. The implied purchasing power parity is $4.79/6.74 CHF = 0.71. The actual exchange rate is 0.96 CHF / USD.

(0.71-0.96)/ 0.96 = 26%

This makes the CHF 26% overvalued when looking at just the price of a McDonald’s Sandwich. This strong currency is something that has plagued large international Swiss exporters such as Nestle, Roche and Novartis. On the flip side, the benefits of being a safe haven currency have come with stability and trust. When speaking of fiat currencies, trust may be the most valuable trait.

While this is not the “end all, be all” of valuations for currencies, it is a useful tool as a quick-check to roughly see the state of currency strength around the globe.



Source: The Economist, Wikipedia

The law of Excess

“In financial markets, the law of excess applies. Prices tend to go to extremes, on both the upside and the downside, and investment bankers conform to the unwritten rule that every good idea must be driven into the ground like a tomato stake.” This timeless piece of wisdom from James Grant covers two points worth looking into. First of all, humans are not perfect. Second of all, humans are not perfect.

We have cycles because we seem to think you can never have too much of a good thing. When asset prices are high, the collective takes this as positive feedback and pushed them higher. The same goes for nadirs. When an efficiency or new idea hits the market, there can never be enough, until there is, of course. As J.P. Morgan is credited with saying, “prices will fluctuate.” There is no point in guessing the future, but at a certain point, a price gets so low that it would be hard to turn down a purchase despite it’s quality. The same goes for high-priced assets; at a certain point, it doesn’t matter how good the future looks, a 1000x P/E rarely seems like a good bet.

When it comes to flooding the market with a hot idea, a la the tech bubble, that is also dangerous. When competition becomes high and owning a website domain is all it takes to raise a few million in funding, there may be a problem. This is oft brought up in Benjamin Grahams work. The initial public offerings are something to watch. Where is capital flowing? and why? Because the financial markets work within the law of excess, it pays to pay attention.


Source: Money of the Mind



Adjusting Retirement Expectations

With social security’s future viability a toss-up and the average american undersaved, retirement expectations may need to be adjusted. As the shift from defined benefit plans moved to defined contribution plans, employees began to bear the responsibility for their future, often with a lack of education on the topic. This brings us to today.

Those who have not prepared as well as necessary to maintain a similar lifestyle in retirement have likely moved along the risk curve to improve yield on their investments, yet they have taken on more risk, which, at their stage of life can deliver devastating results. As Jon Acuff wrote in Finish, one reason why so many people fail to finish is because their goals are too large. He goes on “Remember, we’re up against quitting. The options we’re talking about right now aren’t: 1. Finish perfectly, or 2. Cut the goal in half. Those aren’t the choices we’re debating. The options are: 1. Quit the goal because it was too big, or 2. Cut it in half and finish it.”

Acuff makes a fair point in saying that goals are a marathon and not a sprint; this is evident as people are working longer. What is more difficult is nipping this mindset in the bud. Finding a way to make saving a mandatory activity that cannot be meddled with. Seems simple. Anyways, when it comes to life after work I believe that it is fair to assume that many people need to cut their goal in half, at least those who have time to spare, so that they do not see in as a mountain to climb, but rather a path to lead them to a better destination. This will make it seem more attainable and as Acuff has proven, will lead to better results. As noted in the book, getting started is important, but finding a way to finish is paramount. Lowering expectations may the way to go about it.



How we got here- Debt/GDP

Interst rates have been falling since Paul Volker “broke the back” of inflation from the late 70’s to the late 80’s. This lead to more favorable corporate financing rates and hence, more debt vs. equity financing. Companies weren’t the only adroit operators of the liability side; the government felt it was increasingly a good time to pile it on. While wars have been the main drivers of debt increases in the past, we find a mix in the past half-century.

debt to gdp.png

As you can see above, the Reagan tax bill was the start of it all. When a government relies on taxes as income and they continue to spend the same as before, a deficit, and therefore borrowing, must ensue. This is what may occur if the current tax bill gets passed. The Republicans in Washington claim that the growth that will come of all of this will cancel out and even become a net positive. This remains to be seen.


Sources: WSJ, CBO



Tax cuts and Bond yields

Yesterday the bill to cut taxes passed in the House. What could passing in the Senate mean for bond yields? Well, we run a budget deficit, which implies that we borrow money as a country-just to finance day to day operations. How do we borrow this money? We issue Treasury notes and bonds backed by the full faith and credit of the United States Treasury. The Treasury has recently decided to start issuing more short-term debt and soften up on issuing bonds around the 10-year mark.

This means that there will be an increasing supply of short-term treasury notes. With increased supply comes lower prices. With lower prices come higher yields on bonds. First, the action of shortening the borrowing duration should flood the market with too much short term debt-increasing bond yields. Second, tax cuts should increase the budget deficit, calling for more treasuries to be issued-more supply. Lastly, the Federal Reserve plans to let $6 billion worth of Treasury securities mature every quarter while also increasing that number by $6 billion per quarter, up to $30 billion.

This means there will be $6 billion less demand for Treasuries this quarter, $12 billion next quarter, $18 billion in the quarter following and so on. This decrease in demand will cause bond prices to fall as less buyers want in. To summarize, The Treasury is issuing more short-term Treasuries (increase in supply-short yields rise), Congress is likely decreasing taxes (increase in supply-short yields rise) and the Fed is letting it’s Treasury securities mature without reinvestment (decrease in demand – yields rise).

If inflation does not surprise to the upside in a consistent manner, this seems like a recipe for higher short rates and long-term rates that are neutral, declining or increasing at a rate slower than short-rates. Either way, a further flattening of the yield curve is in the cards.



Another reason we may be seeing such low volatility

When we measure volatility, it pays to think about how a trade is actually completed. As we have seen through many outlets, this year has been one with very few 1% moves in the market. Well, are we all complacent or is it something else. When I want to buy a stock, I go into the market and place a limit order. I may be up against algorithms, but a human programmed them, so essentially the parameters are human. What happens when there is a constant buy pattern, on an automatic schedule? The market would go up steadily.

That may be what automated and index investing has done for us-created a smooth ride up. When a few people decided what is good for us (the index-makers), and we follow herd mentality into it, volatility, or in this case, free thought and action, are less. So now an increasing percent of capital is in an automatic investment plan which tends to focus on index funds. This means less buyers are thinking about price and the index provider is buying no matter the underlying value.

This, in theory, and shown below in practice, has lowered the amount of free-float in the markets.


To combat any ingrained beliefs about indexing, it is a good idea to read a conflicting view. For this reason I am now reading: The Little Book of Common Sense Investing.


Sources: WSJ Daily Shot 9.29.17