BusinessWeek, I love and despise you

New economic article by BusinessWeek talks about how bottlenecks could cause inflation. Ostensibly a "economic bottleneck" follows the same logic as water through a pipe. It would be limited by the exit of each section of the pipe. If there are not enough factories, or steel or workers than firms will not be able to respond to increased demand. Thus, prices will rise in a short period to allow the market to clear.

Seems plausible, the author even cites James Bullard, President of the St. Louis Federal Reserve Bank in which he points to the stagflation period after the recession in 1974. He states that the Fed at the time overestimated the productive capacity of the economy and inflation resulted until Mr. Volcker killed it in the early 1980s.

Three charts in retort.


This is duration of median unemployment hitting all time highs. These are workers who have not had work in almost 6 months. You think their demands for pay will be higher or lower than that of the workers in the 1975 who had been out of work for 3 months?


Here is the employment-to-population graph. You can see we have a lot of room to fall to hit the level of jobs related to the entire population that we experienced in the 1975 recession.


Finally, you can see here that unemployment rate is also higher than that of the 1970s, also showing that inflationary fears are very dim.

Now the article does take a balanced view of the economic environment. The author still feels that deflation is the bigger threat at this point, but that inflation always needs to be watched. While I can agree with the sentiment, I find it very dull to be espousing this information in this manner to the non-economic audience reading Businessweek. It is a very nuanced argument that needs to be made, just like the one Bullard made that the article cites.

What the Fed is doing is telegraphing its actions for when it actually defeats deflation. There are methods in which it stops buying Treasury securities, where it stops repo'ing [very short term loans to i-banks] collateral, where it stops buying MBS, stops buying Frannie paper and removes reserves from banks by changing the amount of interest it credits to banks. This will remove the monetary stimulus from the economy very quickly, if needs to be, but can also be done at the margin, like a Father guiding the handlebars on his child's bicycle.

Given the last paragraph, I find it very disenginous to discuss inflation to an audience that does not understand what the Fed has done, and is going to do. BW should be cheering on the Federal Reserve and hoping for inflation because deflation is far, far worse.

BusinessWeek, just put my subscription on hold

Cooper's article again lacked any whiff of rational thought and underlying facts to support his thesis but an even more egregious article was penned by Ben Levishon and Mark Scott. (Editor's note: don't click the link to the article unless you want some cheesy advertisement to queue up and start playing. WTF is that?) I imagine the penning of this article took place after a long three martini afternoon at the Delmonico.

I won't bore you with the details of the article but here is the handy dandy chart (which I had to re-create because they don't include it in their online article version. Seriously, WTF?)

Notice damage, pay extra, fewer choices, cost rising.

Notice now: may affect, may ..., could rise

So based on something they overheard while watching a monkey wrestling match at Delmonico even then they could not bring themselves to state that these reforms will actually affect any pricing. "I don't know what we are yelling about... Loud Noises!!"

Derivatives
They did find a partner whose firm represents JP Morgan Chase, ABN Amoro, Barclay's and BNP Paribas to state "it won't make it any easier for companies and investors to dig out of the recession." So they quickly put that in their sub-head on their collateral damage chart, except the editor made them add the caveat "may."

The authors then pen this gem "Credit Default Swaps - blew up, prompting huge loses at insurer American International Group and other companies. The reforms are meant to prevent another disaster." The thing is though, they did not blow up, in fact CDS's were the only market actively trading during the entire crisis. What did happen was that AIG posted no collateral for the CDS trades they initiated. They "wrote" these contracts meaning they would take in premium periodically over the life of the contract and if the underlying security defaulted then they would have to pay out.

Well some of their contracts triggered and then they need to pay those claims out. Then their counterparties demanded that they start posting collateral for CDS they underwrote. This created a $180 billion dollar hole in AIG's balance sheet almost over night. It was not the instrument!! It was that unlike contracts that trade at the CME, the Merc, NYMEX where you have to post collateral when contracts go against you, there was no action you could take against AIG until it was too late, thus the run on the company.

The authors continue "Exchange-based derivatives cut into cash reserves. Under current requirements, companies have to fork over 3% of a contract's value as collateral up front in case the transaction goes south." Well, we already talked about that above. Their argued flaw is actually the enhancement that will prevent AIG-type companies from blowing up!!! Avoiding collateral charges because of their AAA ratings is not reasonable. This idea ensures that counterparty exposures can be nipped in the bud when companies bet wrongly in the derivative markets.

So there goes one of the boys arguments.

"The changes could also make derivatives a less effective tool for controlling expenses. Derivatives sold over the counter are tailored to a company's individual needs, while exchange-traded contracts are standardized."

The regulators are treading lightly. They want safety for the financial system, but also not to deter consenting adults from making contracts. The hope is to move CDS contracts to the exchanges where there are more safeguards. Thus far, regulators only want to move standardized contracts to the exchanges. Tailored CDS solutions will still be allowed if that is what a client needs. However, it will be out in the open and very transparent that companies will take on a huge counterparty risk if it chooses a non-exchange traded contract.

Another one bites the dust and now for the nail in the coffin.

Here is the real reason the shills are heading their masters' calls. From Satyajit Das "Derivatives by their inherent nature are also have a Mr.Hyde side. The ability to use derivatives to speculate, create off-balance sheet positions, increase leverage, arbitrage regulatory and tax rules and manufacture exotic risk cocktails will continue to be a major factor in derivative activity. The reality is that hedging and risk management is secondary to the other uses. For companies, the ability to use derivative trading to supplement traditional earnings, which are under increased pressure, is irresistible."

Commodities
From the article, "In light of the changes, financial firms are pulling back on some commodity offerings for small investors...Barclays Wealth recently told high-net-worth clients to ditch exchange-traded funds that focus on commodities in favor of hedge funds and other alternatives that invest in this area."

This is probably a sane idea as well from Barclays. There is a must read article from David Merkel about investors in Commodity ETFs are being snookered.

Here is the money quote for those short on time. "One of the problems that some commodity open-end funds and ETFs run into is that their investment strategy is too simple. “Buy the front month futures contract, and roll to the second month contract before the front month expires.” Nice, it should replicate holding the commodity itself, until a large amount of money starts to do it, and other investors recognize what a slave the funds are to their strategy. So, what do the other investors do? They take the opposite side of the trade early, in order to make it more expensive to do the roll. Buy the second month contract, and short the first. As the first gets close to maturity, cover the first, sell and then short the second, and go long the third month contract. What a recipe to extract value out of the poor shlubs who buy into a commodity fund in order to get performance equivalent to the spot market."

Too bad, so sad. No real problem there accept small investors may be better protected from ETFs that do not work as advertised.

Oh no the dread of all publishers who publish an honest-to-god hold-in-your-hand periodical, there is only two paragraphs left!!!!

High-Frequency Trading

"The technique [high-frequency trading] has been controversial of late as big trading firms have booked billions in profits while their clients' portfolios have dwindled."

The Daily Show With Jon Stewart	Mon - Thurs 11p / 10c
Cash Cow - High-Frequency Trading
www.thedailyshow.com
Daily Show Full Episodes Political Humor Ron Paul Interview

Well that was fun but seriously HFT is not a bad thing. It's much worse.

Commissions have gone down for trading. The spread may have lessened as Professor Lo points out. However, someone is paying for the spread and it is the retail investors. Now, back in the old days there was a market maker and he took the spread. He has now been pushed aside by the HFT supercomputers since they both perform the same function. However, investors and traders were willing to pay the spread to the market maker for liquidity. So when you bought the market maker sold; if you sold he bought. With the HFT there is no guarantee or onus of guaranteeing liquidity. If the bots do not want to play no one can make them. Thus, liquidity can be withdrawn from the system overnight and liquid positions may not be based on the, relatively [may be this is a mixed metaphor], solid pillar the trader believes them to be. There is a lot of information at this website.

So all in all not bad for BW, they missed on all three accounts.

Serial Drivel

I usually breeze through BusinessWeek in about 10 minutes, just trying to sense the flavor of what MSM is cooking. But this week I could not just bypass this article without adding a comment, or two, or three. So below is the article with my notes attached.

There's an old saying in economic forecasting: The consensus is always wrong. But which way? The average forecast of the 52 economists surveyed by Blue Chip Economic Indicators calls for growth in real gross domestic product of 2.7% over the next four quarters, with the annual rate in any single quarter no greater than 3%. This early in the recovery, it's tough to argue that the consensus is either too pessimistic or too optimistic, but one thing is clear. The herd does not think the past tendency of strong recoveries to follow deep recessions will hold true this time. For example, in the first year after the severe slumps in 1973-75 and 1981-82, real GDP grew 6.2% and 7.7%, respectively.

The herd. The author uses the word herd to generate an impression of herd behavior or herd thinking. Too caught up in being like everyone else to see what is really occurring. Fine.

The correlation between the depth of recessions and the strength of recoveries over the last nine business cycles is unmistakable. It relates to the extent of the cuts businesses make in output, payrolls, and inventories. It also reflects the amount of pent-up demand created as consumers and businesses postpone spending. Like a rubber band, the economy snaps back in proportion to how far it was pulled down, as consumers finally upgrade old laptops and buy new clothes, and businesses replace inventories and worn-out equipment.

As he does not posit which business cycles, I will just assume he is talking about NBER's marking of recessions. But why stop there, why not 10; why not the just the last few? Do the 9 really represent what has occurred in this cycle? How about we make a comparison of this cycle to what previously occurred to see if we can rely upon a snapback, v-shaped, pent-up demand recovery that he posits.

Look in the last chart you can see cash for clunkers. However, there is much more in the CFR's report. Suffice to say I am not completely convinced that we can rely on the data from the past 9 cycles to be representative of what has happened and what might happen next. But I will continue to read with open mind in hopes of being persuaded.

If the consensus is right, the economy's departure from past experience would be striking. Economist Robert J. Barbera at the research and trading firm ITG (ITG) notes that after each of the past nine recessions, deep or shallow, real GDP has never required more than three quarters to regain its peak level prior to the downturn. If GDP staged a full recovery over the next three quarters, the economy would grow at a 5.4% annual rate. Even stretched over four quarters, the pace would still be 4.1%.

Again you must accept the wisdom that this is a normal recession just like in 1990, 2001 1981, etc. to then follow the conclusion that growth will be even better than the forecasters median expectation.

The common argument is that the usual rebound effect will be limited by the aftershock of the financial crisis: Credit growth is plunging, because households need to unload debt and save more amid lost wealth and tight credit, limiting the business sector's response. However, that's no sure thing. Data on credit flows are not particularly useful for predicting the strength of a recovery, according to economists at Barclays Capital. They note that in the strong upturns of the 1970s and 1980s, consumer spending accelerated well before the upturn in consumer credit.

My counter-factuals would be: A)that in the 1970's and 1980s Baby Boomers were entering the workforce, and for each one who entered there were more behind him/her coming. Thus, staking your place was fine, you could "buy-the-dips." Now however, those same leaders will be leading the way into retirement. The first Boomers are 63 now and in their mind's eye have been targeting the good life once they hit the Social Security mark. Now however, they will have to either work longer or save more if they hope to maintain their lifestyle. B) Also while the analyst at Barclays argue that credit may not be the major concern, as businesses have hoarded cash to survive this liquidity and solvency crisis. What should be a concern is CapEx spending.

CapEx has been dropping sequentially and year on year. So where are these revenues to come from if no one is engaged in attempting to grow their top line? The companies have done well to keep their profits up by annihilating their variable costs (labor.) So still not quite convinced but there is still more to come.

Early in recoveries, the growth of household income is a more important impetus to spending than credit. As job losses fade, pay from wages and salaries, about 60% of aftertax income, will turn up, as it did in July for the first time in nine months. Also, a lot of spending is done by households and businesses that either don't need to borrow or have good credit quality.

Aha! He has seen the light, it is hiring that will bring everyone back into spending! Let's look at the latest jobs report to see how great the job situation is going, the one that will bring us to above trend growth over the next 9 months.

Wait, what is this. The BLS stating that they have overestimated how many jobs have been lost over the past 20 months. It is actually 824,000 worse, which adds an additional .6% to the already abysmal 9.83% U-3 unemployment. Though it can be said that unemployment is not per se a bad thing when it is short term. It is only when it is long term unemployment that indicates a major problem with the economy.

That is structural unemployment is the highest it has been in 40 years! I am sure this is just a normal recession so the snap back should be starting any moment now. I wonder if I should mention that there is large proportion of part time employees who will have their hours increased before a firm begins to re-hire which can be seen in the hours worked survey from the BLS as well.

The recovery's oomph will also turn on how much income households feel they need to put away to eliminate debt and restore nest eggs. A rising saving rate weighs heavily on the growth of consumer spending. However, with savings in the second quarter already at 5% of aftertax income, up from 1.2% in early 2008, the saving rate may be about as high as it needs to go to give households the cushion they want.

So since we have established that all the rehiring because of all the revenue opportunities that companies are witnessing, we can then posit that consumers will go back to their prolific ways in spending our way to success. No mention of that as an open economy and the world's reserve currency that national savings will equal investment plus net capital outflows. Since the US dollar is in fact the world's dollar and that countries must use it as a store of wealth and a medium of exchange, which, of course, keeps the savings rate in the US artificially low since domestic investment is funded by foreigners allowing us to borrow freely from them. However, it does not state why consumers after being wounded with a 14 trillion dollar loss of wealth would want to continue to live paycheck to paycheck instead of saving for a rainy day. Please continue...

Historically, saving behavior loosely tracks the ratio of household income to wealth. As that ratio rises, in this case because of plunging stock prices and home values, so does the savings rate. By the second quarter the ratio had risen to the levels of the early 1990s, when the saving rate was about 6%, close to where it is now. Moreover, households in the second quarter recovered $2 trillion of the $14 trillion in net worth lost during the recession, and rising stock and home prices imply another gain of about $2 trillion this quarter.

The author now describes how savings is calculated and then undermines his argument by stating that the saving rate in a seemingly artificial manner dropped because of the rebound in the stock market. So we should actually look at the flow of funds report to see if savings increased not by its proportion but actually cash on cash over the preceding quarter. Here is the latest data 1219.9 followed by last quarter 1311.4 and the quarter a year back 1425.9. Since the economy has shrunk the savings rate shot up despite lower numbers. Although it must be said to save you have to pay off your creditors first.

So far, the raft of surprisingly positive data in recent weeks supports the more upbeat recovery scenario. In particular, the index of leading indicators, a composite of 10 gauges that tends to foreshadow recessions and recoveries, has turned up sharply. Since March the index has grown at an 11.7% annual rate, the fastest five-month pace since the 1981-82 recession.

The ten components of the Leading Economic Index include:

1. Average weekly hours worked by manufacturing workers - negative
   
2. Average number of initial applications for unemployment insurance - negative
   
3. Amount of manufacturers' new orders for consumer goods and materials - negative
   
4. Amount of manufacterers' new orders for capital goods unrelated to defense - negative
   
5. Speed of delivery of new merchandise to vendors from suppliers - positive
   
6. Amount of new building permits for residential buildings - positive
   
7. The S&P 500 stock index - positive
   
8. Inflation-adjusted money supply (M2) - negative
   
9. Spread between long and short interest rates (i.e. the yield curve) - positive
   
10. Consumer expectations - positive

So the positives from the reports are that monetary policy has effectively lifted the spread and the stock market. This has caused consumers to feel a bit better that the economic situation is not getting worse but is stabilizing. The new building permits has risen from a depressed level because of the cash for houses government initiative. However, on the whole no one is hiring, no one is adding more hours to the work week, no one is ordering more capital to build revenues. Seems a bit like a two sided report, everything that the government can touch is being held up by it and the rest is just wishful thinking.

For now, none of this will change the minds of the more pessimistic forecasters. However, the historical pattern is on the side of the optimists.

We finally agree. The analysis is sloppy. He does try to convey that he weighed both arguments for pessimism and optimism but it is not at all as thorough as it should be. I would have felt much better if he tried to dig further into his bullish arguments by explaining what portion of the LEI that he felt gave the economy the best bet. Was it the stock market? If so than his logic circles in this manner: the LEI is going up because the stock market has gone up therefore the stock market is going to continue to go up because the LEI presages it. Huh?