Tuesday, 24 March 2015

Bubble Extraordinaire

We have long since established that the U.S. stock market has completely dislocated from many economic indicators (here's a selection). The inflationary policies, nurturing low interest rates and increased money supply, making ordinary bank savings a sure loser, have no doubt helped pushed the stock market into "I'm all in and hope for the best" territory. 

As we've seen many times throughout history, the stock market can stay overvalued much longer than one would perhaps think "rational" and "risk averse" investors would endure. Eventually however, certain basic relationships between the stock market and the economy as a whole need to revert toward more reasonable levels. 

The chart below shows the relationship between the Wilshire 4500 stock market index and the U.S. weekly leading index published by the Economic Cycle Research Institute. This leading economic index attempts to predict turns in the economy (i.e. predict the business cycle). As of 13 March, the indicator has declined on a y/y basis for 13 consecutive weeks, i.e. every week this year. Prior to this, the index increased 118 weeks in a row on a y/y basis (24 August 2012 to 21 November 2014). Currently, the index is 1.3% lower than same week last year. 

The Wilshire 4500 index on the other hand has now increased every single week on a y/y basis for 138 weeks starting 3 August 2012. The most recent reading shows a 10.5% increase compared to same week last year. Result? Since the beginning of August 2012, the stock market has increased 74.1% while the leading index for the economy has only increased 7.3%. The stock market has hence outpaced the economic index more than 10-fold during this period. But it gets worse: going back to the previous stock market peak in October 2007, the stock market has since surged 79.9% while the leading economic index has, wait for it, declined by 6.6%, leading to a 92.5% jump in the ratio between the two. 

One could argue that the above ratio reflects expectations of future improvements in the U.S. economy. The leading index, which has a reasonably good track record, is however telling us that not only is the U.S. economy weaker today than back in October 2007, but it's also weaker today than one year ago. 

With ever increasing government debt and a U.S. economy fuelled by centrally planned low interest rates and inflationary monetary policies, there are currently few good reasons to expect a progressing U.S. economy over the near to medium term. Only a falling stock market can therefore bring the above ratio down towards a more reasonable level and it might very well have to catch up with a future (sharp) fall in the leading index, too. It's just a matter of time.

The Simplicity of Economic Theory

By Fernando Herrera-González

Economic theory is the science which tries to explain economic phenomena. Just as Newton observed an apple falling from a tree and started searching for an explanation to the phenomenon, which eventually took him to the Universal Law of Gravitation, other thinkers observed the existence of a price for that apple (or the usury for loans), and looked for explanations to these other phenomena. That is the way in which economic theory started taking shape.

Unlike the fall of the apple and other natural phenomena, economic phenomena have their origin in the human individual and their actions. Absent the human being, the apple keeps falling to the ground. In contrast, absent the human being, there is no price for the apple. Economic theory does not make sense unless there are people around.

Because of this, the method for developing economic theory takes (or should take) the human being and their actions, human action, as the starting point. It is not a coincidence that Ludwig von Mises used that name for his magnum opus. The methodology derived from this is named praxeology, and it is one of the main features that differentiate the Austrian School of Economics from other economic schools.  The cornerstone on which praxeology rests is arguably the following axiom: the individual acts when they think that the state they will reach as a consequence of their action is preferable to the original state. In other words, when the ‘revenues’ they expect to obtain exceed the ‘costs’ they expect to incur. Starting from this axiom, unprovable but undisputed, theories may be developed to explain different social (not only economic) phenomena that we see around us.

Although the starting axiom may seem simple and intuitive, its application in practice is certainly complex. Firstly, the revenues and costs to which it refers are subjective. Only each concrete individual knows (or thinks they know) the costs to be incurred by carrying out a course of action, and the revenues they may attain as a consequence. However, these costs and revenues are not necessarily of a monetary nature. The motivations for most individuals, if not for all individuals in most cases, have nothing to do with receiving or spending money.

How Inexpensive Credit Spurs Recovery, according to Draghi

Speaking yesterday, ECB president Draghi put forth the following viewpoints according to Reuters,
Cheaper credit is boosting investment projects, driving up business demand for bank loans and aiding the eurozone economy, European Central Bank President Mario Draghi said. 
"As bank lending rates are being reduced, new investment projects -- previously considered unprofitable -- become attractive". "In the short run, this should sustain the demand for credit and investment."
Draghi is correct on most points. Unfortunately, none of them are sustainable long term and will only lead to the wasting  of yet more resources, the opposite of real economic growth. In fact, it is the same recipe that got the eurozone into the current financial problems in the first place. Common sense tells us that one cannot cure a problem with more of what caused it in the first place. Not so for Draghi and the other monetary cranks around the world.

Monday, 23 March 2015

Illusion of Prosperity

President Obama and Federal Reserve chair Janet Yellen have recently been crowing about improving economic conditions in the U.S.  Unemployment is down to 5.5% and economic growth in 2014 hit 2.4%.

Journalists and economists point to this improvement as proof that quantitative easing was effective. They seem to have political blinders on. The boom is artificial and has been built by adding debt on top of excessive debt.  Total household debt increased 2.5 % in 2014 – the highest level since 2010. Mortgage loans increased 1.5%, student loans jumped by 6.6%, and auto loans swelled a hefty 9.6%.  The improving auto sales are based on a bubble of sub- prime borrowers. Auto sales have been brisk because of a surge in loans to individuals with credit scores below 640. Auto loans to individuals with strong credit scores, above 720, have barely budged.

Sub-prime consumer borrowing climbed $189 billion in the first 11 months of 2014.  Excluding home mortgages, this accounted for 41% of total consumer lending. This is exactly the kind of lending that got us into trouble less than a decade ago. This trend can only end in tears.
Here’s the lingering question: is the current boom built on sound foundations? Do we have sharp increases in productivity or real wage growth?

The truth is productivity has barely budged since 2010 and real wages have flat lined, or declined for decades. From mid-2007 to mid-2014, real wages declined 4.9% for workers with a high school degree, dropped 2.5% for workers with a college degree, and sunk 0.2% for workers with an advanced degree.

So is the boom being built on broad base investment in plant and equipment?  The average age of plant and equipment in the US is currently the oldest on record.

Continue reading the article here.

The "Natural Interest Rate" Is Always Positive and Cannot Be Negative

By Thorsten Polleit

Some economists have been arguing that the “equilibrium real interest rate” (that is the “natural interest rate” or the “originary interest rate”) has become negative, as a “secular stagnation” has allegedly caused a “savings glut.”

The idea is that savings exceed investment, and that a negative real interest rate is required for bringing savings in line with investment. From the viewpoint of the Austrian school, the notion of a “negative equilibrium real interest rate” doesn’t make sense at all.

To show this, let us develop the case step by step. To start with, one should make a distinction between two types of interest rates: There is the market interest rate, and there is the originary interest rate.

The market interest rate is the outcome of the supply of and demand for savings in the market place. It can be observed, for instance, in the deposit, bond, or loan market for different maturities and credit qualities.

The originary interest rate is a category of human action, saying that acting man values goods available at present more highly than goods available in the future. In other words: Future goods trade at a price discount relative to present goods. For instance, 1 US$ available today is preferred over 1 US$ available in one year’s time.

If 1 US$ to be received in one year’s time is valued at, say, 0.909 US$, the originary rate of interest is 10 percent. (1 US$ divided by 0.909 minus 1 gives you 0.10, or 10 percent, for that matter.) 10 percent is here the originary interest rate (disregarding any other premia).

Sunday, 22 March 2015

Decline of the Rule of Law

By F.A. Hayek

Political wisdom, dearly bought by the bitter experience of generations, is often lost through the gradual change in the meaning of the words which express its maxims.  Though the phrases themselves may continue to receive lip service, they are slowly denuded of their original significance until they are dropped as empty and commonplace.  Finally, an ideal for which people have passionately fought in the past falls into oblivion because it lacks a generally understood name. If the history of political concepts is in general of interest only to the specialist, in such situations there is often no other way of discovering what is happening in our time than to go back to the source in order to recover the original meaning of the debased verbal coin which we still use.  Today this is certainly true of the conception of the Rule of Law which stood for the Englishman’s ideal of liberty, but which seems now to have lost both its meaning and its appeal.

Continue reading the article here.

Friday, 20 March 2015

Global M

By Sean Corrigan

As part of our analytical process, we frequently consult our proprietary estimate of global money supply, something we construct by combining the individual measures for 15 countries (strictly 33, since we include the euro as one of them) which together account for almost three-quarters of global output.

When we do so, it immediately becomes apparent how much more closely trends in global equity markets – here approximated by the MSCI All-Country index – have tended to follow developments in the supply of this money since the onset of the financial crisis.

Continue reading the article here.

"Austrian" True Money Supply Weekly (9 Mar 2015)

The short version of the "Austrian" True Money Supply for the U.S. increased 0.32% on last week for the week ending 9 March 2015. At $10.7919 trillion, a new high, the money supply is now up $189.7 billion, or 1.79%, year to date.

The 1-year growth rate for the week came in at 7.60%, down from 7.82% last week and 31 basis points lower than for the same week last year. 

The 5-year annualised growth rate was 10.00% for the week, the lowest reported for 13 weeks and 80 basis points lower than one year ago. This was the 67th week in a row with a declining growth rate compared to a year ago.

The dramatic monetary expansion in the US since the 2008/9 banking crisis becomes more readily apparent when looking at the longer term growth rates. Since bottoming at 5.57% in January 2007, the 20-year annualised growth rate has since climbed to the current 8.17% and is closing in on the 8.20% record from September 2002. 


Price inflation expectations in the US has dropped significantly since August last year. Back then, the 10-year break even inflation rate (the difference between the 10-year treasury yield and 10-year TIPS) stood at 2.28% compared to 1.73% as of week ending 13 March. 

The "money relation", which measures the relationship between the demand for and the supply of money, also confirms there has been significantly less inflationary pressures during the last year compared to 2013. The current reading signals no immediate "financial crisis", but the fact that the relation has been in negative territory for 13 consecutive months serves as a warning that economic troubles could be looming. Remember that banks and the stock market both thrive when the money supply expands and people demand less money to hold, i.e. an increase in the spending/savings ratio. Conversely, a decline in the money supply growth rate and an increase in the demand for money to hold, i.e. a decrease in the spending/savings ratio, will have the opposite effect on banks, the stock market and prices in general, including stock prices.

Meanwhile, the aggregate money supply growth for the US, eurozone and the UK, measured in US$, has tanked during the last 12 months. Though this to a significant extent has been driven by a strengthening of the US$ compared to the euro, the drop in the growth rate does signal less inflationary pressure. In fact, there has been deflationary pressures for the three economies since October last year as the growth rate has plunged below zero. 

As US bank credit growth continues to expand at a rampant speed and as the ECB has once again started to expand its balance sheet (QE), the growth rate might very well soon climb above zero once again. Investors oblivious to the long term better hope it does.

Visit the "Austrian" True Money Supply archive here.

Friday, 13 March 2015

When The Stock Market Couldn't Care Less About People's Spending Power

This is the result of the stock market surging 122% during the last five years when disposable personal income only expanded 20% during the same period.

For mean reverting pundits, would you bet on a stock market decline or an increase in personal income to bring this ratio towards a more normal ratio? Decide for yourself, but here's what happened in the aftermath of the 2000 and 2007 stock market bubbles.

"Austrian" True Money Supply Weekly (2 Mar 2015)

The short version of the "Austrian" True Money Supply for the U.S. increased 0.77% on last week for the week ending 2 March 2015. At $10.7571 trillion, a new high, the money supply is now up $155.0 billion, or 1.46%, year to date.

The y/y growth rate in the money supply came in at 7.82% for the week, largely unchanged from last week. The current growth rate is 18 basis points higher than the 52-week moving average and 18 basis points higher than during the same week last year, but remains lower than the 8.29% average since 1980.