Saturday, March 21, 2015

Weekly Indicators for March 16 - 20 at

 - by New Deal democrat

My Weekly Indicators post is up at

Continuing weakness in steel production and domestic rail carloads are warning flags for a continuing slowdown in industrial production.

Friday, March 20, 2015

International Economic Week in Review: Minute by Minute, Edition

This is over at

No, the yield curve is NOT forecasting mediocre growth. Right now it actually isn't forecasting anything

 - by New Deal democrat

A 3 dimensional view of the yield curve in the treasury bond market at the New York Times has gotten a lot of play in the econoblogosphere yesterday.  

Why pay attention to the yield curve, i.e., the difference in interest rates paid by short term vs. long term treasury bonds?  Here's why:  an inverted yield curve, I.e., short term interest rates higher than long term interest rates, is a nearly perfect warning of a recession 12 to 18 months in the future. In the last 100 years, it has had only one false positive (1966). 

If we are sure we will have inflation rather than deflation in the next several years, a normally shaped yield curve is also a perfect indicator for the economy about 12 to 18 months later. In times of deflation, however, a normal yield curve is not reliable. An inverted yield curve in the presence of deflation is much to be feared. It has only happened twice in the last century – in 1928 and 2006.

For a detailed look with helpful graphs, herehereand here.
The NY Times 3D graph is not animated, and not interactive.  For the last 15 years, however, Stockcharts has had the aptly named interactive Dynamic Yield Curve, a tool which I have made use of frequently over the years.  Here is a snapshot I made today comparing the present yield curve (lower) with the yield curve in Q1 2003, one year before the best YoY real GDP growth of the 2000s:

The yield curve is founded on a solid economic signal.  Since normally you would want to be paid more interest in order to take the risk of holding on to a bond for a longer time, when the curve inverts, it means bondholders think current rates are too high compared with the longer term – they expect weakness.
One statement in the NY Times article, however, looks flat out wrong: “The yield curve is fairly flat, which is a sign that investors expect mediocre growth in the years ahead.”
Not so. Below is a graph of the spread between 10 year and six month bonds, currently at 2%. The graph then subtracts 2 so that the current spread = 0.

Prof. Menzie Chinn of Econbrowser has posted a similar graph for the 10 year vs. 3 months and 10 year vs. 2 year Treasuries:

While the spread between the 10 year and 3 month bond is in the lower half of the distribution, the spread between the 10 year and 6 month treasuries (my graph) and 10 year vs. 2 year (red in Prof. Chinn's graph) is steeper than most other times during the last 30 years. 
It is also equivalent to if not steeper than almost all times between 1933 and 1954 (blue is long term government bonds, red is 3 month treasuries): 

during which time the US saw the strongest growth in its entire history:

So,*NO,* the yield curve is not telling us there will be mediocre growth.  Because we are presently in deflation, even though the yield curve is positive, it actually isn't forecasting anything.

Thursday, March 19, 2015

Is 2% core inflation the Fed's target, or a ceiling?

 - by New Deal democrat

I really don't have much to add to what you have probably read elsewhere about the Federal Reserve's policy statement, except that it appears to me that 2% inflation isn't really being treated as a target so much as a ceiling.

Their estimate of NAIRU has declined to 5% - 5.2% unemployment, which is an acceptance of  the reality that there is zero pressure on inflation from wage growth at this point, and likely won't be for awhile.

All well and good, but here is the Fed's high end estimates for inflation for this year and the next two years:

Core inflation
2015 1.4%
2016 1.8%
2017 2.0%

The Fed doesn't expect core inflation to hit their 2% target for two years!  Yet here is what they say:
[T]he Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of energy price declines and other factors dissipate..
....  In determining how long to maintain this target range, the Committee will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation. ...  The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term
Since lower gas prices are likely to cause core inflation to slightly decrease over the next year as they feed through into the broader economy, it will take well over a year for such factors to "dissipate."  But the Fed is going to raise rates in advance of 2% YoY core inflation, to ensure it does not exceed that level.

In practice that's a ceiling, not a target.

Wednesday, March 18, 2015

The S&P Case Shiller Index as objective evidence of a housing bubble, and a leading indicator for core inflation

 - by New Deal democrat

Recently I had a pretty good and spirited discussion about macroeconomics and forecasting the Great Recession.

One issue is, how easy or not was it to spot the housing bubble? Dean Baker certainly did. But was there objective evidence?  There was.

Home prices themselves are not part of the CPI, although "owners equivalent rent," the housing portion of CPI, constitutes over 1/3 of that index. Ideally the inflation rate for each should stay relatively close, since rent is presumably the trade-off for housing.  But in a bubble, that trade-off ends because "Everybody knows house prices only go UP!!!"

At that point, the tradeoff vanished. Rent inflation was subdued because renters wanted to become homeowners.  And look what happened to the cost of housing (via the Case Shiller 10 city index) vs. owner's equivalent rent (in the linked graph, both are normed to 100 in 1987):

House prices went from about 1.15x the rent index to 1.85x the rent index, a 50%+ increase, in just 4 years.  That is the signature of a bubble.

What did the Fed do in the face of that objective evidence of a bubble?  Nothing, until it was far too late.  Tim Iacono of "The Mess That Greenspan Made" came up with a great way of looking at housing inflation, by substituting the Case Shiller Index for the Owners' Equivalent Rent in the CPI, calling the result the CS-CPI.  The below graph shows the CS-CPI in blue, and the Fed Funds rate in red:

The Fed treated inflation as subdued, and kept the Fed funds rate at 1%,when measured by the CS-CPI it was as high as nearly 10%.  (I have always suspected Greenspan held off for political reasons, to assist the re-election of W.  But Greenspan would never be political, would he?)  Not only that, but the Fed subsequently kept the funds rate at 5% after the bubble had completely burst.

The run-up in house prices vs. rents in 2012-14, by contrast, is pretty subdued.

An interesting by-product of this is that the Case-Shiller house price index appears to lead owners equivalent rent by about 1 year:

There has been a big downturn in the growth of the Case Shiller index in the last year, that doesn't appear to have fed through into owners' equivalent rent. Nor has the recent big downturn in gas prices fed through into the direction of core CPI, which typically also takes about a year.  Together, these two trends strongly suggest that core CPI inflation, already below 2%, is going to decrease further. Which by the way means that the Fed ought to hold off on rate increases, and let (hopefully) higher wage growth and lower unemployment continue.

With a Yield Over 5%, Take A Long Look At Phillip Morris

     This article is not a solicitation to buy or sell these securities.  You might also want to do your own research into this; heck, you just might learn something.

     Recently, Morningstar wrote a story titled, "The Ultimate Stock Pickers Top 10 Dividend Stocks" which contained a total list of 20 stocks whose dividend was higher than the S&P 500 and whose shares were owned either by a leading manager or leading fund.  Topping one of the lists was Phillip Morris (PM). 

     Let's start by taking a look at the weekly chart:


     The chart is certainly not one to get excited about.  It's been trading in a fairly tight range of 75-89, with a tighter range of 79-89 over the last three years.   However, the stock price has recently dropped to the 78 level, making it attractiveSo, let's take a deeper look at the company.

     According to their latest 10-K, Phillip Morris and "[o]ur subsidiaries and affiliates and their licensees are engaged in the manufacture and sale of cigarettes, other tobacco products and other nicotine-containing products in markets outside of the United States of America. Our products are sold in more than 180 markets and, in many of these markets, they hold the number one or number two market share position. We have a wide range of premium, mid-price and low-price brands. Our portfolio comprises both international and local brands."  Their market cap is about 120.5 billion, making them the largest cigarette company according to the website.  They are one of the top three cigarette makers, with British American Tobacco and Altria group close second and third runners-up.

     Their operations are entirely international, with the following regional breakdown (click for larger image):

In the last three years, the Eastern Europe segment has gained 7.9% of the companies overall sales while the Asian market has decreased 10.3%.  Consider this situation in relation to the high level of the dollar, and the negative impact that will have on earnings.  Many multi-national companies have stated that the strong dollar is seriously impacting their financial performance; don't expect anything different from PM.

     The biggest risk the company faces is litigation and the potential downside of a massive award against the company.  As this table shows, the company currently faces 93 different lawsuits (click for a larger image):

But, the company has been very successful at defending these causes of action.  From the 10-K:  "Since 1995, when the first tobacco-related litigation was filed against a PMI entity, 433 Smoking and Health, Lights, Health Care Cost Recovery, and Public Civil Actions in which we and/or one of our subsidiaries and/or indemnitees were a defendant have been terminated in our favor. Ten cases have had decisions in favor of plaintiffs. Nine of these cases have subsequently reached final resolution in our favor and one remains on appeal."

     While this is no guarantee that future litigation will lead to the same result, it does indicate that Morris' litigation team has been strikingly effective. 

    PM is a leading brand with very high barriers to entry.


     The chart above indicates this is a pure dividend play.  While there is upside potential on the current chart, the fairly predictable trading range of the security over the last three years indicates that once the stock hits the mid-80s, bears will take over.  This means the most important consideration for any investor is dividend safety.  Obviously, the insure a continual payment of the dividend we need, at minimum, revenue and margin predictability.
     For the last 5 years, revenue has risen a bit going from $27.2 billion in 2010 to $29.7 billion in 2014.  Revenue was higher between 2011-2013, coming in a bit over $31 billion.   Expenses have been very predictable over the same period:
COGS: 33%-35%
Operating expenses: 23%-25.6%
Net Income: 25%-28%
     The above numbers indicate that revenue and expenses have been very predictable and should continue to be so over at least the next year.
     The dividend payout ratio has fluctuated between 55.7% in 2011 to 80.5% in 2014, meaning the company pays out a large percentage of its net income to shareholders.
     Just as importantly, PM is a company that prints money, with free cash flow to the firm of between $6.5 billion in 2014 to $9.6 billion in 2011.  Their primary operating expense is property investment, which is very predictable, with the figure right around $1.1 billion over the last three years.  This is only 14% of the lowest number for operating cash flow for the last five years, meaning the company is flush with cash.
     The only drawback to the balance sheet is the company has loaded up on debt, with their long-term debt totals increasing from $13.3 billion in 2010 to $26.9 in 2014.  This makes their long-term debt position a whopping 76% of total assets.  But, their interest coverage ratio at these high levels is 10.86.  And with EBITDA reported at between $12.1 and $14.7 over the last five years (not to mention the company's very strong cash flow position), a default isn't on the horizon.
     In a record low interest rate environment, high paying dividend stocks become exceedingly attractive, so long as there is a consistency to the underlying company's financial performance.  PM has such a profile, with steady earnings and expenses, a more than adequate cash flow and a strong policy of passing earnings onto shareholders.  These factors make PM a solid stock for dividend investors, especially at these levels.

Tuesday, March 17, 2015

Ignore housing starts, housing permits were encouraging

 - by New Deal democrat

You don't need decent weather to get a housing permit.  You need decent (or at least not horrendous) weather to actually start building a house. That makes winter housing starts particularly volatile.

In general, housing starts (red in the graph below) are twice as volatile as housing permits (blue). I've squared the results so that they are all positive, making it easier to see the volatility:

That's why I focus on permits rather than starts.  Plus permits tend to lead starts by a month.  

So what is going on with permits?  Here they are in absolue terms:

And here is the YoY trend:

Housing permits in February were only exceed by last October.  And the YoY trend has turned up mildly.  So consider me unperturbed by the morning's housing starts miss, and encouraged by the good permits number.

February may have seen a sharp intensification of deflation

 - by New Deal democrat

I have a new post up at  According to the Billion Prices Project, consumer prices fell sharply in February.

If so, that puts entirely different gloss on the February decline in nominal retail sales, and suggests that real Q1 GDP will not be as poor as feared.