economic forecasting

The Rear View Mirror and the Windshield

canstockphoto46724780

Nobody we know would drive down the highway with eyes glued firmly to the rear-view mirror. The mirror tells us only where we’ve been. The windshield, on the other hand, gives us information about the road ahead.

Yet an investment method popular with many financial representatives and firms relies on a combination of rear view imagery and elaborate statistical calculations. Years of data about the behavior of different investment sectors is fed into a computer program, which spits out the optimal proportions for ownership of every sector. It is said to deliver hopes of the best returns for a given level of volatility.

We see three flaws with this method, called Modern Portfolio Theory or MPT.

The future will not be like the past. MPT is really just high definition, computer-assisted hindsight. It tells you what would have worked up to now, by looking only into the rear-view mirror. Many financial crises provoke a lot of disappointment in people with MPT portfolios.

Our behavior changes with our experiences, thereby changing the future. It was thought going into the 2007-2009 financial crisis that mortgages were safe investments because people always paid them first, even if they couldn’t pay other bills. In reality, auto loans outperformed while mortgages went unpaid. Consequently, the next crisis may well feature large losses in auto loans as too much capital has poured into this ‘safer’ category. MPT cannot see these kinds of dynamics.

People attribute more certainty to MPT computer output because it calculates portfolio holdings and potential variation in account value out to two decimal places. They forget that these are estimates. Adding detail to what is basically a guess does not make it more accurate.

Clients, you have heard us talk about our three principles over and over again. They help us assess the economic and investment landscape. They give us a way to think about how the future might unfold. Although we have no guarantees to offer, or even assurances that our methods are better, at least we are trying to look out the windshield—instead of focusing on the rear-view mirror!

We would rather figure out how to live with volatility and aim for higher returns instead of pretend that focusing on the rear-view mirror will save us grief in the future. If you would like to discuss your situation in more detail, please email us or call the shop.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.

The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Investing involves risk, including possible loss of principal.

Cryptogenic Market Action: How it Can Help You

© Can Stock Photo Inc. / gajdamak

The field of medicine has a pair of terms that mean the same thing. The words describe an incredibly useful concept. The concept has important applications to the investment markets, and other economic and business usage. We were aware of the idea, but previously had no handy term to describe it.

The words are “cryptogenic” and “idiopathic.” They mean ‘of uncertain or unknown origin.’ For example, a cryptogenic stroke is one that has no known causative factors. Sometimes doctors know why something happened, other times they don’t. When they don’t, the diagnosis includes one or the other of these descriptions.

How would this apply to investing?

Every day at the market close, commentators speak or write as if they know exactly why the market did what it did. Despite the market averages being set by millions of people making billions of dollars in transactions for a nearly infinite variety of reasons, commentators boil it down to ONE REASON. “The market rose today over better-than-expected whatever,” or “The market fell today because of poor whatnot.”

We have said as many ways as we know how: the market goes up and down. It just does. To put it in more clinical terms, the market has cryptogenic rallies and idiopathic falls. The short-term action is of mostly unknown or uncertain origin.

According to Investopedia.com, in 1602 the Dutch East India Company issued shares that could be traded on the first stock exchange in Amsterdam. We suspect that at the close of trading on the first day, somebody said something like, “The market rose today because the tulips looked set to bloom early.” And this nonsensical tradition continues to this day.

If we accept the idea of cryptogenic stock market action day to day, we can focus instead on long term trends and fundamentals that may prove more fruitful.

The Next Recession is Coming, Continued

Federal Reserve Bank of St Louis
Federal Reserve of St. Louis

Once again it is time for our quarterly assessment of economic conditions. Is the economy growing or shrinking? This is the fundamental question.

The next recession is always out there, of course, as is the recovery which will follow it. The excesses that build up in good times lead to imbalances that get corrected by economic downturns. But what are the current indications?

• The Index of Leading Economic Indicators is supposed to point to the direction of the economy in the months ahead. It has remained solidly in positive territory.
• The bond market speaks to us about economic conditions through the yield curve. Although it has flattened somewhat recently, it remains in growth mode.
• The Current Conditions Index from LPL Research remains in positive territory.
• The “Overs,” a proprietary LPL measure of potential over-spending, over-borrowing, and over-confidence, point to continuing expansion.
• Details on the LPL Research work are available here.

Economic news is always mixed, and can always be better. But jobs and incomes and spending continue to grow in fits and starts. The weight of the evidence says we are doing OK, at least.

We do have challenges. Policy makers attempt to manage the economy from above, using a philosophy that was discredited long ago. Their interventions create distortions which we monitor carefully. Much of our work involves avoiding the problems created by people trying to “help us.”

We are on the job, doing the best we can to preserve your interests and take advantage of opportunities as they arise. Call or email us if you have questions or comments.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All indices are unmanaged and may not be invested into directly.

The Smell of Money

© Can Stock Photo Inc. / LakeviewImages

The modern world developed from a society of subsistence farmers. The metaphors of nature, crops and orchards and seasons and livestock, have deeply rooted appeal. They remind us of a simpler time. But the metaphor in this story is personal history, not a fairy tale.

As a child I was privileged to visit the Omaha Stockyards from time to time in the company of a friend and his father, a “commission agent” who bought and sold cattle for farmer clients. Mr. G was a master of his work and he loved it. The stockyards were the largest in the world. The vast collection of pens and chutes and loading facilities were a temporary home each day to thousands of cattle, in transit from one place to another.

One might say the stockyards presented a rich tapestry for the senses. The fragrance of thousands of cattle in close quarters is one of those things that cannot adequately be described with pen and ink, or electrons.

Upon my introduction to this sensation, I first heard the words thought by some to be only a cliché. But they came from Mr. G, smiling broadly, breathing deeply, with a twinkle in his eye: “Smell that, son? That’s the smell of money!” For Mr. G and his colleagues and companions, the hundreds of workers at the yards and the customers they served, it was true. And there is value in this old tale to investors today.

As contrarian investors, we are mindful that the sentiment of the crowd is a contrary indicator. High levels of optimism may be associated with market drops ahead. Rotten sentiment sometimes points to future gains. When everyone expects the same thing, that expectation usually does not come to pass.

These days, the country seems to be in the grip of pessimism and foreboding. Sentiment about the future in general and the prospects for the markets in particular is poor by many measures. It stinks.

This too shall pass, sooner or later, and the mood of the country will improve. But for now, in the spirit of Mr. G we smile broadly, breathe deeply, and say “Smell that rotten sentiment? That’s the smell of money!”

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

The Next Recession is Coming… Again

chart from research.stlouisfed.org

Regular readers will recognize this headline. The next recession is always coming. Human nature being what it is, the economy will always have cycles just as the world will always have seasons. The excesses that build up in good times lead to imbalances that get corrected by economic downturns.

The most notable feature of the current economic expansion is its slow, plodding pace. Most people with jobs or in business are familiar with one of the reasons for this: unprecedented expansion of the regulatory state. Our shop and many others in many lines are coping with new kinds of nonsense that hampers production or service. (We are not arguing for a Darwinian, regulation-free society, of course.)

The silver lining in our plodding economy is the lack of a boom in any major sector that could create a big downturn. New home construction has not really exceeded the sixty-year average. According to the National Auto Dealers Association, vehicle sales–while near a record–only replaced 1/15th of our vehicle fleet last year. It seems to us that the peak in auto sales lies ahead of us. Capital spending and business investment, which has at times gotten too inflated in the past, has remained extremely subdued.

Energy, of course, did boom—and then busted. But our diverse and dynamic economy has largely absorbed the job losses, and consumers and businesses are enjoying unforeseen low gasoline and energy prices. Corporate earnings have not been great, but should strengthen in the quarters ahead.

The Index of Leading Economic Indicators points to near-term trends in economic growth, and it has flashed a steady positive reading for years. The bond market speaks to us about economic conditions through the yield curve, which remains encouraging and positive. LPL Research publishes a Current Conditions Index which measures economic vitality right now—and it has remained in positive territory. LPL Chief Economist John Canally draws mostly comforting conclusions from the latest labor market statistics (ht.ly/v7Co3003MvP )

So yes, the next recession IS coming. We just do not think it will arrive soon. Our plodding plow-horse recovery continues, no boom—but no bust either. This is good news for investors.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

The Next Recession is Coming, pt 2

© Can Stock Photo Inc. / albund

Regular readers will recognize this headline. The next recession is always coming. Human nature being what it is, the economy will always have cycles just as the world will always have seasons. We humans are great at this: taking a good thing too far. The excesses that build up in good times lead to imbalances that get corrected by economic downturns.

Because investment trends are based loosely on what is going on in the real economy, it makes sense to think about where we might be in the economic cycle. So from time to time we report to you the state of the economy as we see it, with an eye on that next recession. Hat tip to LPL Research, people who do a lot of work on topics we need to know about.

In his latest report, LPL’s chief economist John Canally looked at the current fears in the marketplace and compared them to the groundhog. Many people pay attention to the groundhog, but he actually isn’t worth a darn at weather forecasting. Likewise with the drop in the price of oil, the rise of the dollar, some shrinkage in one sector of the economy—people are paying attention, but these things are not good at forecasting recessions.

Canally also compares the current situation to the 2007 economic and market peak and how things look for consumers. The savings rate is more than double, the mortgage rate is better by a third, household debt is a lower percentage of income and falling, and gasoline prices are….well, you know. Bottom line, we’re in pretty good shape.

Did you know the bond market provides a recession forecast that has worked very well since 1950? The bond market speaks through the yield curve, a simple measure of whether shorter term rates are higher or lower than longer term rates. When short term interest rates get above long term rates, there has always been trouble ahead. LPL’s Anthony Valeri just released a study concluding that the yield curve is not indicating recession.

We’ve never had a recession in recent history that was marked by strong jobs growth. And here we are, with a record 64 straight months of jobs growth. Nor has a drop (or a crash) in the price of oil ever precipitated a recession. The oil price drop is a mixed bag: the energy industry has been hit hard with job losses and reduced corporate earnings. But the losses to energy are gains to the rest of us.

So yes, the next recession IS coming. We just do not think it will arrive soon. Our plodding plow-horse recovery continues, no boom—but no bust either.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.