Brad DeLong's Semi-Daily Journal: A Weblog

http://www.morganstanley.com/GEFdata/digests/latest-digest.html

Searching for Growth
Stephen Roach (Sydney)

Financial markets are telling us that the search for growth is getting tough again. At least, that’s the message I take from another significant downleg in global bond yields and renewed selling pressure in equity markets. My own travels corroborate that inference. I was in Europe a couple of weeks ago, where the growth outlook remains so dour that many Europeans are now getting excited about a reacceleration back to 2% growth. And now I am back in the Asia-Pacific region for the first time in four months, where concerns are mounting over growth prospects for 2005. With an unbalanced world lacking in a broad base of support, it doesn’t take much to trigger a global growth alert.

The immediate source of the latest concerns is oil. I first sounded the oil-shock alert in early August, when WTI-based oil prices were surging toward the $50 threshold. At that time, I expressed the view that if oil prices held at that level for at least three months, it would be appropriate to treat this development as a full-blown shock. At $50, the oil price would be more than 70% above the post-2000 average of $29, putting this spike on a par with significant energy-related disruptions of the past. Inasmuch as oil shocks and recession have gone hand in hand, I assigned a 40% probability to renewed recession in the US and the US-centric global economy as oil prices moved into the high-$40 range last month. As oil quotes then backed off from that worrisome threshold, my concerns eased. But now it’s back in the danger zone, near the $50 threshold. Accordingly, I believe it’s appropriate to reinstate my warning of a 40% chance of US and global recession in 2005.

http://www.nytimes.com/2004/09/24/business/24norris.html

As Bull Market Nears a Birthday, Few Seem Ready to Celebrate
By FLOYD NORRIS

TWO years ago, gloom hung over stock markets around the world. The bear markets that began after the technology bubble burst in 2000 had grown worse after the Sept. 11 terrorist attacks. The American stock market suffered its deepest plunge - 49 percent from top to bottom - since the Great Depression.

But all that ended with a bang. Markets in most countries hit bottom on Oct. 9, 2002, and rallied sharply. A spring retrenchment sent some to new lows, but they then came roaring back. Now stocks around the world are generally trading for at least 40 percent more than they fetched at the 2002 lows. This week both the Organization for Economic Cooperation and Development and the Asian Development Bank released optimistic forecasts.

But with the second anniversary approaching, few seem ready to celebrate. The bull has been limping this year, with markets trading in narrow ranges after hitting highs in the spring. There is a sense, in Europe and America, that the world is out of control, with jobs moving away and governments unable to solve real problems.

Unfortunately, stock market history indicates big gains may not be on the immediate horizon. The third years of bull markets are seldom a lot of fun, as Sam Stovall, the chief investment strategist at Standard & Poor's, notes. This is the 10th bull market since the end of World War II, using the definition that a bull market requires a 20 percent gain and continues until a decline of at least 20 percent begins, and in only two of the previous nine has the third year posted a gain of more than 10 percent. The average is a rise of less than 1 percent, and three bulls died in their third year.

This bull market began with a surge that surprised a lot of pessimists, but over all it has been a bit subpar. The Standard & Poor's 500-stock index rose 33.7 percent in its first year, three percentage points below average, and 6.7 percent so far in its second, about half the average.

Inflation at nearly 3%? Well, CPI is up 2.7% y/y, but the 3-month pace of rise is just 1.3%, so headline inflation is cooling fast. And Buttonwood is refering to headline CPI. Most economists prefer other measures, many of which are not all that close to 3%, and most of which are flat or, like headline CPI, slowing markedly. Real overnight rates may not actually be negative (Berner says the Fed is tightening to keep real rates at zero), and certainly not by 1.25%.

The dollar is weak? The broad, trade weighted dollar is down about 11% from its high at the beginning of 2001, but up 28% from 10 years ago and up over 80% from 20 years ago. How old do we figure Buttonwood is?

The dollar looks set to get weaker? Says...who? The best forecast of the dollar's value tomorrow is the dollar's value today, no? If we knew what the dollar's value tomorrow would be, that would be its value today, with adjustment for borrowing costs.

The stock market "thinks" the economy is in good shape? The S&P is down roughly 4% from its high this year in the first quarter, and has been trending lower, with a number of ups and downs, ever since. Regress S&P closing values from the beginning of the year against time, plot the line, and its slopes down, my friends, not up.

I'm not sure why we want to read Buttonwood on financial markets. The "oil is a tax" notion is far from new (Barry Ritholtz, are you out there? and are you ready to argue?), assertions that the dollar is low and that the stock market is high don't show a great deal of perspective, and the claim that (s)he knows which way the dollar is going is undermined by Buttonwood's apparent need to continue working for a living.

Could the stock market be reflecting a higher share of GDP going to corporate profits? Can't say I've crunched any numbers on this, but if profits grow at the expense of other GNP components, then stocks would overperform relative to the total GNP growth rate?

"The dollar is weak? The broad, trade weighted dollar is down about 11% from its high at the beginning of 2001, but up 28% from 10 years ago and up over 80% from 20 years ago."

KHarris :)

>>
Why aren't bond traders shorting stocks (which they see as overvalued) while stock traders short bonds (which they see as overvalued)?
>>

Because -- the time horizon to actually make profits on these bets is far too long, and may involve some ugly losses, or even bankruptcy, in between, even if the bet is "rational." Remember Dornbuch's stages of these overvaluation episodes. The bond market has been stuck in one of those intermediate stages for years.

Anne, I am crossposting this from the discussion we were having on an earlier thread regarding devaluation:

...I'm sorry I delayed answering until this is about to scroll off into history.

When one makes a list of net export industries for the US, it is very short. To take one shocking example, last I checked, the US was only a bare net exporter of agricultural products (55B ex/45B im according to one source). Projections were that we would soon become a net importer. Ignoring shifts in consumption for the moment, for a currency shift to advantage a country, it must be a net exporter.

There's another issue and that is whether devaluation of the dollar will break currency pegs. On oil, and on our trade with China, that would cause a net loss to the US, the latter unless we're prepared to compete with Haitian workers being paid 50 cents a day.

Posted by Charles at September 24, 2004 12:17 PM

The problem is: EVERYTHING is overvalued?? as the true believers in each market set the price:

Stocks are still high, although somewhat flat. But true believers set the price.

Long term interest rates are RIDICULOUSLY low: given the high probability of large tax or inflation tax in the next 20 years, would YOU loan 30 years at 6%? But true believers do teh lending.

Real estate is outrageous: A condo equivelant to my apartment costs $100+/month more in just tax-ajusted interest and property tax than I'm paying in rent (that's NOT including another $200 for HOA costs). But true believers do the buying.

And none of these you can short-sell, because short-selling is a short-term option, while bubbles are only LONG term unstable: you have to be able to predict the future to make the short-term bets work.

The normal pattern is for lower rates to generate higher PEs and a stock market rally.

However, as Harris correctly point out with his great suggestion to do a trend of the S&P 500 year to data, we now have falling stocks when
earnings are still growing at, or near double digit rates and bond yields are falling. Rational analysis say that this should generate a rising stock market as the bond rally should offset the negative impact of higher inflation on the present value of future earnings.

Moreover, for the most part growth stocks are underperforming the market that again says we are getting a falling PE in the face of a bond market rally, and at least in the short run inflation moderating. Something funny is going on here. But than again, Bush is the first President since Hoover to run for relection sithg the S&P below where it was when he took office. And the market is down in the face of profits being higher and rates and the inflation rate below where they were when Bush took office.

This is not logical and defies standard economic theory. Moreover, with lower taxes on stock market returns every Bush economists tells us the market should be higher. Something is going on in the market that is causing the risk premium to plunge under Bush after it rose sharply under Clinton. If you are not trying to figure out why the risk premium is falling you have no hope of understanding what is happening.

Outsourcing was supposed to provide the Profits which Stockholders have come to demand, but they have not. This demand has arisen because the average age of the new Stockholder is reducing, and the Young are dedicated to get rich quickly. The 401k plans now kick in, where funds have to be invested or taxed. They tie the Bond market far more closely to an inverse relationship with the Stock market. The unexpected Bond market rally is not really unexpected. lgl

kharris wrote, "The dollar looks set to get weaker? Says...who?"

IMHO the dollar will decline quite a bit when Japan and China stop purchasing T notes.

Spencer

"Something is going on in the market that is causing the risk premium to plunge under Bush after it rose sharply under Clinton. If you are not trying to figure out why the risk premium is falling you have no hope of understanding what is happening."

Agreed...

Dan Ryan,

Nice touch. The question you've raised doesn't seem like one that could be answered in the short term, given the noise in financial markets, but in time, if shares going to labor and capital remain skewed toward capital, we could see very different patterns of valuation.

Liberal,

Yes, but it remains YHO. There is no authority to the statement, from you, Buttonwood, or Greenspan. When such stuff is written into a comment on financial markets in the "Economist", something more than IMHO is to be hoped for.

IF stocks were up, bond yields down and fed funds rising, it might evidence that investors are pricing in an end to Fed rate hikes soon. Once stock and bond investors get a whiff of steady rates, both markets generally rally together. The curve's behavior is consistent with a coming end to rate hikes, the Fed funds strip, too, sorta, but the Fed has not let on that rate hikes are nearing an end and, as noted above, stock aren't up. IF stocks were up, and IF Buttonwood had made the point that patterns of price movement in financial markets were consistent with the Fed nearing the end of its rate cycle, THEN we might want to know what Buttonwood thinks of conditions in financial markets.

Before we get too carried away with the recent bond market rally it may be a good idea to remember that the 10 year was at 3.13% on June 13, 2003 and 3.73% on March 9, 2004 and was at
3.96% on 1 November 2003.

Moreover, if you do a trendline through the March and June lows the yield just now barely broke that rising trendline. I'm watching that trendline as a potential bottom bottom of a channel like the one that existed from 1999 to 2003.

kharris, I am trying to follow what you are driving at. You say that inflation is actually low, the dollar is strong relative to 10 years ago, the dollar is not likely to get weaker, and the stock market does not think the economy is in good shape.

So, if I understand you correctly, you think we are in more of a disinflationary time.

There are serious problems with inflation indices. The elderly suffer a greater loss in purchasing power when healthcare costs rise than the young. Traveling salesmen feel the pinch of gas prices more than the rest of us. The very poor realize no benefit from the drop in the prices of computers. People experience inflation in different ways.

As a practical matter, many people are finding that income from safe investments is falling even as the costs of essentials are rising. For them, inflation and not deflation is the problem.

As for the markets, looked at from the 2-year perspective (which I think is more appropriate considering the start date of the Iraq war), they have shrugged off the growing quagmire and the rising deficits. That is cause for concern. As Spencee points out, the apparent risk premium is falling... even as risk of disaster in Iraq and Afganistan rises. The cause seems to be that markets have suspended rationality.
--------------------------------------------------

Anne says, "Accordingly, I believe it’s appropriate to reinstate my warning of a 40% chance of US and global recession in 2005."

That makes you an optimist. Volcker has it at 75%.

Charles, Volcker has it at 75% over the next five years.

Reading the bond market since the Fed tightening cycle began, we find a sharp deline in long term interest rates. The yield curve has flattened. When I look back at other tightening cycles, when the yield curve flattens a slowing of economic growth is in the offing. The guess is the same this time. Possibly low mortgage and long term rates can moderate a slowing, but there is reason to be cautious. The guess is the flat stock market reflects the bond market in caution.

I tend to think the market is overvalued, but not because of trends, interest rates, or those sorts of things. It's because the moon is....no! Wait!

It's actually because I think the probability of disaster is fairly high - higher than the market allows for. By disaster I mean any of a number of things, but primarily a major terrorist attack or a financial crisis. The chance that we will get through the next few years without either one happening seems low to me.

Put another way, the chance that the market will, in the near future, be substantially lower than it is today for a reasonable period of time, seems quite high.

The market has moved away from NYSE to anoymouos offshore trading. The public markets don't tell us much of anything w/o knowing the privatizted markets.

"The market has moved away from NYSE to anoymouos offshore trading. The public markets don't tell us much of anything w/o knowing the privatizted markets."

How can a large spread between "privatized markets" and the NYSE be maintained in the face arbitrage?

Netmaker says, "Charles, Volcker has it [economic crisis] at 75% over the next five years."

Right you are and wrong I was.

anne,

Some of the numbers underlying Charles' statements can be found at http://www.ers.usda.gov/Briefing/Baseline/sum04.htm.

Since total sales of U.S. agricultural commodities are currently around $200 billion, to balance our trade with agricultural exports we would need to increase farm output 300% and export all of the increase.

The worry and refrain of an economic crisis brought about by debt accumulation are mentioned often. The question I have is, how do we invest savings to protect against severe market problems? What simple portfolio measures can be taken? Do we just increase the proportion of investment grade bond funds we hold? What about holding 60% Total Stock Market Index and 40% Total Bond Market Index with Vanguard? After all, we must invest.

Please, if we can discuss how to protect ourselves and still invest, think of ways that are readily available. Brad DeLong often mentions Vanguard, for the company offers a wide selection of low cost funds, especially index funds. What funds might we use at Vanguard in a properly protective manner?

Ari,

The Vanguard Total Bond Mkt Index has a duration of 4.5 years and a yield to maturity of about 4% after fees. Depending on your personal situation, in terms of amount invested, taxable status, and time horizon, you might consider a bank CD with better terms. With a fixed maturity date, and an option to withdraw early at some penalty it might offer added protection if you are worried. Use bankrate.com to find the best rates on the net, and keep in mind the FDIC insurance limits (www.fdic.gov).

For stock investment there is also the option of diversifying with international if you are worried about the USA in particular. Vanguard does have an international index, but I think Fidelity is now the one with lower fees. You can also choose (at least at Vanguard) individually from the Pacific Index, European Index or Emerging markets Index if you have an opinion of those regions as well.

"The normal pattern is for lower rates to generate higher PEs and a stock market rally.

"However, as Harris correctly point out with his great suggestion to do a trend of the S&P 500 year to data, we now have falling stocks when
earnings are still growing at, or near double digit rates and bond yields are falling. Rational analysis say that this should generate a rising stock market as the bond rally should offset the negative impact of higher inflation on the present value of future earnings.

"Moreover, for the most part growth stocks are underperforming the market that again says we are getting a falling PE in the face of a bond market rally, and at least in the short run inflation moderating. Something funny is going on here."

I'm not sure I understand the problem. Normally, when profits from bonds look low people will move money to the american stock market. But if america looks like a bad bet it makes more sense to move money offshore. Why invest in either low-performing american bonds or over-risky american stocks if you think you can get a better deal somewhere else?

"This is not logical and defies standard economic theory."

Only if you treat the economy as a close system, right? Standard theory was invented in the old days when things were a little different. I expect the principles are still good but you have to apply them a little differently. Is there a reliable bond market in some safe currency? If so, why do dollars? Is there a foreign economy with a stock market that's likely to outperform the USA, and weather a US crash better than we will? If so, why go NYSE?

Well, funds whose charter says they do american stocks only, have to do american stocks. And if they don't churn the stocks to each other, how can they justify their pay? (This last probably betrays my ignorance. But the rest ought to stand.) When an increasing fraction of the "investment" money is owned by foreign bankers who hold it for political reasons, why would they put it in the american stock market just because interest rates are low?

Well, the obvious answer is -- for political reasons. But if you're a chinese banker who expects to lose 70% on your money, you probably aren't going to speculate in the american stock market hoping to cut your losses to 60%.

I'm no expert and I can't back up anything. Maybe it's an obviously wrong answer. But it sure looks obvious to me.

There will always be a better return from a comparable Vanguard bond than from a CD, if we are prepared to invest through a duration period. Vanguard offer bond funds that are as safe as any insured CD. Bond funds can also be used far more flexibly.

High Yield Tax Exempt Bond Fund has a yield of 4%. The credit quality is fine. Long Term Corporate Bond Fund has a yield of 5.3%, Intermediate Term Corporate has a yield of 4.2%. Both have fine credit quality. Choose a duration, compare yields before and after taxes and settle in. Bonds funds will protect an asset base if an investor has patience.

There just does not seem much long term danger in a 60% - 40% stock index to bond index mix of assets. Look at how nicely the Vanguard Balanced Fund has performed these past 10 years, despite the bear market in stocks, and a bond bear market as well.

It is not that hard to find a 5 year CD that has a rate (not APY) in excess of the rate of the Vanguard Int Term Corporate with 6 year avg maturity (4.7 year duration). It's also possible to do worse, but in any case I don't think it is correct to compare a corporate bond fund to a gov't insured deposit with a put feature. In good times they are comparable, but Ari asked about severe market conditions, and this is when they become not comparable.

All these ideas are much appreciated. I am grateful!

CD investments strikes me as less attractive than using a conservative bond fund, for a bond fund is more "flexible." A treasury bond fund at Vanguard will be insured, I realize, and free of state taxes. Any principle loss could be partly written off by switching funds for 30 days. Also, through Vanguard, I could buy treasury notes or bills from the brokerage at no cost. The GNMA bond fund as well is completely safe in terms of principle. I am learning.

SN Sterling

Thank you. All you say is sensible, but I prefer the safety of an investment grade bond fund to the difficulty of having to look for and bargain for CDs and spreading accounts at different financial companies. I too need to learn, but so far I find Vanguard a terrific invesment company.

Plywood has quatrupled in price and is selling like gangbusters.

" Why aren't bond traders shorting stocks (which they see as overvalued) while stock traders short bonds (which they see as overvalued)? Ah. That is a mystery... " It's asset hugging I guess: bond traders trade bonds, bond portfolio manager manage bond portfolios...