What Spooked the Market Today

One of the main things that spooked the market today was the report of a 0.7% increase in the Q2 employment cost index (ECI), a quarterly index covering total employment costs including health and other benefits in addition to wages. Although this was largest quarter-on-quarter increase since the recession, observers generally failed to consider that there was a 0.35% drop in the previous quarter so about half the change was "bounce back" from Q1. The year-over-year that gives a more reliable picture showed an increase of only 2.1%, about the same that prevailed in 2011 and only slightly above the 1.8% to 1.9% level that has prevailed since 2012.

Reporters jumped on the fact that it was the highest quarterly increase since the recession because everyone on Wall Street is anxious to see signs of inflation that will provoke the Fed into tightening money and driving interest rates up. They tended to overlook the more meaningful measure of inflation contained in last week's Q2 GDP report. This measure, the PCE price index which is the one the Fed watches, showed June headline inflation running at only 1.6% year-over-year, and the more meaningful core PCE at only 1.5%, well below the Fed's 2.0% target.

Our society, of course, has been conditioned to cheer for higher interest rates because the oligarchs are tired of getting such meager returns on the trillions they have stashed away in Treasuries and other safe short-term securities, and they are fearful of the risks in higher yielding investments. The 0.01% don't mind if tight money brings another recession, or even if it curbs the exuberance of the stock market because that's not that their thing. They leave the grubby, rough and tumble business of running companies and making venturesome investments to the 9.99% (10 - 0.01), preferring the safe and comfortable life of clipping coupons.

A glance at the chart below shows the true picture of employment cost inflation over the last decade. As you can see, that sharp little up tick at the extreme right side of the chart is nothing to get worked up about. Employment cost inflation is still running far below pre-recession levels, more like 2% instead of the 3.5% to 4% earlier in the decade. One of the main reasons for the much lower rate, by the way, is the sharp slowing of the annual increase in health benefit costs from 12% to 2%.

So if you are like just about everyone else, anxiously sitting on the edge of your chair expecting inflation to break out any moment, the Fed to reverse course, and interest rates to soar through the roof --- RELAX, IT AIN'T GONNA HAPPEN ANYTIME SOON.

What is Secular Stagnation & What Can Be Done About It?

Secular stagnation is an abnormal situation in which structural changes make it impossible for the natural forces of the economy to generate enough demand for goods and services to create jobs for those who want to work and to give businesses the incentive to make investments that add to productive capacity. In normal times the growth of the population together with advances in technology and the spreading of education and skills that make the workforce more productive, lead to increases in production, employment and incomes that in turn make consumers able and willing to buy more, and businesses ready and willing to add production capacity, i.e. to invest in the new plants, machinery and software systems needed to increase production, grow the economy and fully employ the workforce. With all systems functioning normally, the economy has a natural built-in potential to grow at a certain speed, say 3% or 4% per year. If something gets out of whack, the economy may only be able to grow at 1% or 2%, which means that some people who want to work are unable to find jobs, and many businesses find that there is insufficient demand for their product to operate at full capacity, and hence less incentive to invest in expanding their businesses or starting new ones.

In 1938 as it became obvious that the economy had still not recovered completely from the low point of the Great Depression six years earlier, economist Alvin Hansen, often referred to as the American Keynes, introduced the concept of “secular stagnation”. In addressing the annual meeting of the American Economic Association as its newly elected President, Hansen presented a paper arguing that changes brought about by the Depression had altered the structure of the economy in such a way that made it impossible for it to reach its previous potential. He attributed the situation mainly to a decline in the birth rate, and a higher rate of saving that left the economy chronically short of sufficient demand to reach and sustain full employment. Shortly afterwards war began in Europe and the U.S. government sharply increased spending on military equipment and supplies to aid the Allies, leading to a burst of economic activity that continued undiminished to the war’s end. Hansen’s work on “secular stagnation” was quickly forgotten and left to gather dust on library shelves until recently rediscovered and then brought to prominence by the forceful remarks of Larry Summers at the IMF Economic Forum last November.

The “secular stagnation” debate among economists is couched in esoteric terms such as “the natural rate of interest” and “liquidity trap”, but what it is really all about is much simpler. It’s about whether monetary policy acting alone is capable of returning the economy to self-sustained growth with full employment, or if it needs to be supplemented by fiscal measures to stimulate demand such as increased government spending on infrastructure even at the cost of temporarily increasing the deficit and adding to the national debt. Those arguing that we may be headed for “secular stagnation” question the effectiveness of monetary policy and express concern about the costs of the non-conventional monetary policies that have been pumping massive amounts of liquidity into the economy. They argue that this artificially raises asset prices creating a potential for “bubbles” that could unexpectedly burst bringing about another devastating financial crisis while at the same time contributing further to the growing inequality of incomes and wealth. Opponents object to the idea of increased government spending and deficits, arguing that it would lead to the greater danger of a debt crisis with interest rates spiraling upward out of control. They argue that the confidence building effects of fiscal austerity outweighs any drag on the economy via diminished aggregate demand, while the others run models predicting that more spending and larger deficits in the short run actually reduces the debt burden in the long run by stimulating faster growth and rising government revenues.   

The Natural Rate of Interest

Economists’ discussion of secular stagnation focuses on the concept of the “natural rate of interest”, the general level of interest rates (adjusted for inflation) at which the supply of savings matches up with an economy’s desired level of investment when it is running at full potential with full employment. If real market rates of interest are above their “natural” level, as for example if the central bank’s monetary policy is too tight, saving will be too high (consumption too low) and businesses will be reluctant to borrow and invest leading to a slowdown in the economy. On the contrary, if market rates of interest (adjusted for inflation) are below the “natural” rate, perhaps because of monetary policy that is too accommodating, then saving will be inadequate (consumption too high) and the demand for credit and investment will be excessive, leading to an overheated economy and buildup of inflationary pressure.

Larry Summers and others who raise the possibility of “secular stagnation” suggest that there have been signs of a substantial decline in the “natural” or equilibrating level of interest rates going back as far as the 1980’s. They point out that despite relatively easy monetary policies and low interest rates in the intervening years -- policies that gave rise to periodic financial bubbles -- economic growth was not especially fast, there was persistent slack in the economy, and inflation remained low, so low that inflation appeared to be a thing of the past and economists began referring to this period as “The Great Moderation”.  

This emphasis on interest rates in this analysis as the critical policy instrument and regulator of the economy is probably overdone. It arises from the current generation of economists’ dismissal of fiscal policy as being politically impractical, and a bias in favor of theories that  accept monetary policy with its control over interest rates as the most efficient regulator of economic activity. Having been educated by an earlier generation of Keynesian economists among whom fiscal policy reigned supreme and monetary policy was considered less effective (e.g. “pushing on a string”), I am accustomed to thinking in Keynesian terms where government fiscal policies (the structure of taxation and government spending), consumers’ propensity to consume, and the “animal spirits” and current profitability of investment are the most powerful movers of the economy, not interest rates, with monetary policy mainly coming into play when the economy is overheated and inflation has become excessive.

Earlier generations of economists were heavily influenced by Knut Wicksell and the Stockholm School that preceded Keynes. Wicksell first introduced the concept of the “natural rate of interest” in 1898, but both he and Keynes saw interest rates having relatively little effect on both consumption and investment demand, the latter being mainly determined by the marginal efficiency of capital (the profitability of investments) and what Keynes called the “animal spirits” of investors. For both men the differences between market and “natural” rates of interest played a secondary role.

Central bankers and the current generation of economists pay homage to Wicksell by assuming that there is such a thing as a “natural rate of interest”, but they go much farther than Wicksell in giving it a dominant role in equilibrating the economy. They tend to treat the “natural” rate as a long run constant whereas Wicksell saw it varying under the influence of current economic conditions. Wicksell wrote:

“The natural rate is never high or low in itself, but only in relation to the profit which people can make with the money in their hands, and this, of course, varies. In good times, when trade is brisk, the rate of profit is high, and, what is of great consequence, is generally expected to remain high; in periods of depression it is low, and expected to remain low.”  

Despite widespread use of the concept of the “natural rate of interest”, there remains much confusion and controversy about how the term should be defined, how to measure it, and exactly what role it plays in the economy. These questions are important, but the basic concept of secular stagnation remains valid nevertheless. The answers can affect the details of how secular stagnation works, but not the essence of the theory. For now It suffices to say that central bankers and the current generation of economists would do well to look beyond the concept of the “natural rate of interest” to many of Wicksell’s other keen insights into the relationship between the real and the financial or money side of the economy, ideas that are currently given insufficient attention.       

How Does Secular Stagnation Come About

Secular stagnation requires a very low real natural rate of interest, so low that central banks find it difficult or impossible to keep real market rates of interests as low or lower than the real natural rate. A lower natural rate is evident in the persistent decline in the yields of inflation-protected government bonds so that today despite extraordinarily easy monetary policies, we see negative real interest rates for terms in excess of 5 years. Since the natural rate can be thought of as a proxy for the average return on investment, a question to ask is what could make the returns on investment so low?

Three main categories of cause immediately come to mind.

The first would be the slowing growth or long term decline in the working age population such as that experienced by Japan, increasingly by Europe, and to a lesser extent by the U.S. where the effect has been moderated by a sizable inflow of immigrant workers. A slower growth of the work force, of course, directly translates into slower economic growth except to the extent offset by rising labor productivity. An aging population also has a propensity to save more and consume less, which reduces demand and diminishes the need for capital investment. With more saving and less demand for investment the returns are bound to diminish.

A second important cause would be an increased concentration of income and wealth in the hands of a relatively small number of people, leading to less consumer demand, more saving and an excessive accumulation of capital. The increased supply of capital would be expected to result in a lower return, thus diminishing the opportunities and incentives for productive investment.

A third cause would be the lingering effects of a major financial shock such as that experienced in 2008-09, which resulted in large financial losses, capital impairment, forced deleveraging and consequent risk aversion. The financial crisis left households and all levels of government with an overhang of debt that induced them to cut back expenditures and take a more cautious approach to undertaking fresh commitments. Investors became content with modest returns as they put preservation of capital ahead of higher returns.  

These three are the most obvious, and all have been at work over the last three decades to one extent or another, but there are a number of other possible causes worthy of consideration. Slower productivity growth is an issue, and some see a possibility that the number of transformative technological advances may be waning and the pace of innovation slowing. Others see less need for productive investment because of the declines in the cost of capital equipment, especially those associated with information technology where the operation of Moore’s Law has steadily reduced the cost of productivity enhancing electronic equipment. This means that the same level of saving purchases more capital every year. Then too, we have the fact that billion dollar enterprises can now be launched with little more than an idea as an investment. Persistently low inflation raises other issues because it means that any interest rate translates into a higher after-tax rate than it did when rates were higher. This is evidenced by the steady multi-year decline in inflation-protected bond yields, with the yield on such bonds now negative at a maturity of 5 years.

There are many reasons to believe, therefore, that the “natural” rate of interest at which the supply of saving and demand for capital are brought into equilibrium in an economy operating at full employment and close to its potential output may very well have been under downward pressure during much of the last 30 years. No one knows for sure how low that rate has fallen. It is not a quantity subject to easy measurement. We can study, and estimate, but mostly it is a matter of conjecture. The key question is not exactly how low it might be, but whether it has fallen below the level to which the central bank can steer market rates. If the central bank is incapable, lacks the tools, to push market rates down to the level of the “natural” rate, then investment in productive assets will fall short of the supply of saving, the economy will languish, consumption will lag, there will be insufficient aggregate demand to take up slack in the economy, production will remain below potential, involuntary unemployment will persist, wages will stagnate. A condition of “Secular Stagnation” will exist.

The Liquidity Trap Nonsense

Some economists like Paul Krugman go beyond “secular stagnation” to evoke the “Liquidity Trap” made famous by Keynes in his “General Theory” where he wrote:

“There is the possibility … that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest. But whilst this limiting case might become practically important in future, I know of no example of it hitherto.”

The kind of liquidity trap that Keynes is describing is clearly a rare phenomenon, which if it exists at all (and Keynes says he has never seen it), does so for a brief period in the aftermath of a financial panic when the desire for liquidity is so strong that nothing will induce people to part with their cash for risk assets of any kind, in which case asset prices collapse, stock markets crash, bond yields go through the roof and the central bank is rendered helpless. Hyman Minsky, a follower of Keynes, put the liquidity trap idea in the proper context of “the immediate aftermath of a crisis” in this passage from his book “John Maynard Keynes”:

“The view that the liquidity-preference function is a demand-for-money relation permits the introduction of the idea that in appropriate circumstances the demand for money may be infinitely elastic with respect to variations in the interest rate… The liquidity trap presumably dominates in the immediate aftermath of a great depression or financial crisis.”

What we would expect to see in an actual liquidity trap is prices rising and interest rates falling on assets considered perfectly safe like Treasury bills, while risk assets suffer drastic price declines. This is exactly what happened in the “immediate aftermath” of the 2008-09 crisis but within a few weeks with the Fed pumping in liquidity and a basic level of confidence restored, stock prices recovered sharply beginning a long bull run and interest rates on other non-government debt eased back down. A liquidity trap does not exist unless the prices of risky or imperfectly safe assets are falling and their interest rates are rising. This is not the world we have lived in since 2008.

Talk of a “Liquidity Trap” is an extreme interpretation of Keynes that Krugman, for example, has mainly used for shock effect, as illustrated by the following quote from his blog:

“Being in a liquidity trap reverses many of the usual rules of economic policy. Virtue becomes vice: attempts to save more actually make us poorer, in both the short and the long run. Prudence becomes folly: a stern determination to balance budgets and avoid any risk of inflation is the road to disaster. Mercantilism works: countries that subsidize exports and restrict imports actually do gain at their trading partners’ expense. For the moment — or more likely for the next several years — we’re living in a world in which none of what you learned in Econ 101 applies.”

Krugman then goes on to define being in a “Liquidity Trap” in terms far different from Keynes’ definition:

“In my analysis, you’re in a liquidity trap when conventional open-market operations — purchases of short-term government debt by the central bank — have lost traction, because short-term rates are close to zero. Now, you may object that there are other things central banks can do, and that they actually do these things to some extent: they can purchase longer-term government securities or other assets, they can try to raise their inflation targets in a credible way. And I very much want the Fed to do more of these things. But the reality is that unconventional monetary policy is difficult, perceived as risky, and never pursued with the vigor of conventional monetary policy.”

In other words, Krugman says you are in a liquidity trap when your central bank is not doing as much as he thinks they should be doing.

What Comes Next?

It is important to emphasize that most economists, including Larry Summers for example, though perhaps not Paul Krugman, are not prepared to proclaim that a condition of “Secular Stagnation” exists in the U.S., or even in Europe. Japan is perhaps a more likely candidate, although even that can be questioned at this time. They argue instead that it is a possibility, a danger that we should be aware of, and one that we should be prepared to counter. The frustration of an economy that seems unable to achieve the “escape velocity” needed for self sustaining growth, and constant downward revisions in the projected path of “potential” (full employment) GDP growth, are warning signs that something is amiss.

And even if the current hesitant recovery makes good headway as many predict, will it be able to continue on a satisfactory growth trajectory after the Fed withdraws the extraordinary measures it has taken to stimulate the economy? Will it be able to withstand the “normalization” of interest rates so fervently desired by all, with the short-term Fed Funds rate eventually reaching the 4% level considered “normal”? Many including myself have grave doubts that, even short of “secular stagnation”, the economy will have the strength to withstand monetary “normalization”, and the longer we put off normalization the greater is the danger of another financial crisis, of asset price bubbles that could develop suddenly and pop unexpectedly before anything can be done to prevent it. Liquidity pumped into the economy by the Fed at a rate well beyond the ability of the real economy to use it productively will inevitably flow into speculative activity and what Hyman Minsky called Ponzi finance -- credit extended on the basis of the expected price appreciation of the collateral rather than cash flow.

The Remedy

The remedy for an actual or threatened condition of “secular stagnation” is simply to do everything possible to increase the aggregate demand that is in short supply. As Summers said, we have an inverse Say’s Law at work. Says Law says that in the normal state of affairs supply creates its own demand so there can never be a shortage of demand. The reverse, which seems to be happening, is that a chronic shortage of demand is reducing supply so that we are stuck with an economy producing below capacity with insufficient jobs for those who want to work.

Larry Summers as the former Secretary of the Treasury in the Clinton Administration and Obama’s former Chief Domestic Policy Adviser is a master policy wonk, so rather than give you my laundry list of possible remedies I will conclude by copying his from a recent article he wrote for the Financial Times:

“... the secular stagnation challenge is not just to achieve reasonable growth but to do so in a financially sustainable way. There are, essentially, three approaches.

The first would emphasize what is seen as the deep supply-side fundamentals – labor force skills, companies’ capacity for innovation, structural tax reform and assuring the long-run sustainability of entitlement program. All of this is appealing – if politically difficult – and would indeed make a great contribution to the economy’s health in the long run. But it is unlikely to do much in the next five to 10 years. Apart from obvious delays – it takes time for education to operate, for example – our economy is held back by lack of demand rather than lack of supply. Increasing our capacity to produce will not translate into increased output unless there is more demand for goods and services. Training programs or reform of social insurance may, for instance, affect which workers find jobs but they will not affect how many find jobs. Indeed, measures that raise supply could have the perverse effect of magnifying deflationary pressure.

The second strategy, which has dominated US policy in recent years, is lowering relevant interest rates and capital costs as much as possible and relying on regulatory policies to assure financial stability. The economy is far healthier now than it would have been in the absence of these measures. But a strategy that relies on interest rates significantly below growth rates for long periods of time virtually guarantees the emergence of substantial bubbles and dangerous build-ups in leverage. The idea that regulation can allow the growth benefits of easy credit to come without the costs is a chimera. It is precisely the increases in asset values and increased ability to borrow that stimulate the economy that are the proper concern of prudential regulation.

The third approach – and the one that holds most promise – is a commitment to raising the level of demand at any given level of interest rates, through policies that restore a situation where reasonable growth and reasonable interest rates can coincide. This means ending the disastrous trend towards ever less government spending and employment each year – and taking advantage of the current period of economic slack to renew and build up our infrastructure. If the government had invested more over the past five years, our debt burden relative to our incomes would be lower: allowing slackening in the economy has hurt its potential in the long run.

Raising demand also means seeking to spur private spending. There is much that can be done in the energy sector to unleash private investment on both the fossil fuel and renewable sides. Regulation that requires the more rapid replacement of coal-fired power plants will increase investment and spur growth as well as helping the environment. And in a troubled global economy it is essential to ensure that a widening trade deficit does not excessively divert demand from the US economy.

Secular stagnation is not an inevitability. With the right policy choices, we can have both reasonable growth and financial stability. But, without a clear diagnosis of our problem and a commitment to structural increases in demand, we will be condemned to oscillating between inadequate growth and unsustainable finance. We can do better.” Understandably missing from Larry's list of remedies are some of the measures I would propose to drain the excess liquidity from financial markets gradually over time, curb excessive speculation with a financial transactions tax, and address inequality through a radical increase in taxation of the super wealthy. These will have to await the revolution.

Why Won't This Market Do What It Is Supposed To Do?

With interest rates going the wrong way, down when just about every market guru has said they should be going up, and stocks going up when the economy is disappointing and we are overdue for a correction, market mavens are confused and many are asking, “Why won’t this market do what it is supposed to do?”

If markets did what the prognosticators say they are supposed to do, then a majority of participants would make money, but we know the opposite is true. The vast majority of participants do not make money. They account for the noise in the market, the day by day wiggles that cause the market averages to fluctuate above and below the longer term trend, and the sharper spikes and dips in individual issues as they respond to company or industry specific news. This part of the market is a zero-sum game with a minority of the luckier and more experienced traders having a small edge over the less lucky and inexperienced.

The direction of markets, the speed of adjustment and the price levels that they settle at during periods of consolidation is determined by a much smaller group of professional money managers working for investment funds, hedge funds, endowments, insurance companies, brokerages and other such financial institutions. These professional investors account for only a small part of the trading volume because they do not churn their portfolios on a minute by minute, daily or weekly basis, but rather tend for the most part to hold their investments for several months and some cases for several years. They may account for 10% or less of the trading volume, but they control at least 90% of the total assets held, and it is the weight of those holdings that determine the trends and levels of markets.

The forecasts made by economists are carefully studied by these money managers, and as we all do, they absorb into their thinking every other bit of news, business, political and otherwise. But they do not give much weight to the pundits and prognosticators of the popular media. In general they listen most closely to what colleagues and other members of their profession are saying and doing, partly because they speak the same language, using jargon and technical talk unfamiliar to most people outside the profession, and partly because there is security in being a part of the herd or fraternity. Being wrong along with most of their fellow managers is tolerable, but being wrong while at odds with the rest is catastrophic for one's reputation.

The best indicator of what money managers think of the economy is the behavior of the bond market. The stock market is far too diverse and subject to too many influences to be a reliable guide because there one must assess the impact of the economy on particular industries, and on the revenues and profit margins of particular companies, while in the bond market, especially the Treasury market where credit risk is totally absent, little matters other than the economy, fiscal and monetary policy. With fiscal policy immobilized by the political stalemate, and the economy limited by struggling consumers and lagging business investment, monetary policy is left as the overwhelming top consideration of money managers.

Money managers as reflected in the action of the bond market are clearly taking a less optimistic view of the economy than the Fed and most business economists have taken in recent months with their insistence that the weather was the main cause of the poor first quarter data when GDP fell by an estimated 1.0%, and that the lost output would be made up in an even stronger second quarter and remainder of the year. April was another weak month for the economy, tending to confirm the bond market's message. The anticipated signs of strength finally began to emerge in May, but the bond market's reaction was tepid, partly explained by anticipation that the European Central Bank's lower interest rates and aggressive easing would spill over into downward pressure on U.S. interest rates, as it apparently has.

Also influencing money managers is the growing chorus of academic economists led by Larry Summers, Brad DeLong, Joseph Stiglitz, Paul Krugman, and lately Noriel Rubini, reinforced by the appeal of Thomas Piketty's book on inequality, calling attention to the theory of “secular stagnation” which holds that the economy may be permanently locked into low growth and high unemployment by insufficient demand, insufficient spending by consumers and government, and hence insufficient incentive for business investment.

All eyes will now be on next Tuesday and Wednesday's Fed meetings, and the Yellen press conference Wednesday afternoon. Given the unusually large dichotomy of views on the economy, there will be intense interest in seeing how the Fed will characterize the incoming economic data, how far back they will trim their estimate of 2.8% to 3.0% GDP growth for 2014, whether they will stick with their prediction of 3%+ growth in 2015, and if they remain optimistic about improvements in the job market. Money managers, however, will be intensely interested in these numbers mainly for what they portend about future interest rates and not so much about the economy per se. The expectation remains for an end to QE by the end of this year, and for the Fed funds rate to begin being lifted in the middle of next year reaching 1.0% by the end of 2015. Fed optimism about the economy and an unchanged policy stance will be a net negative for both the bond and stock markets (sending interest rates higher), while any recognition of weakness in the economy and signs of dovishness on the part of the Fed will likely propel both markets higher (sending interest rates lower).

If secular stagnation is here, as I believe, then the Fed may be locked into a low interest rate policy and some form of QE indefinitely, despite the dangers they see in more QE. The Fed taper does not mean that it has stopped pumping in liquidity, only that it is doing so more slowly, and influential Fed Governor Dudley has already warned that an end to QE does not mean that the Fed will ever reduce its balance sheet, i.e. sell assets. So with the Fed continuing to pump liquidity into the economy, which asset prices will go up most? Stocks, bonds, commodities, real estate, loans, FX, derivatives, other alternative assets? Take your pick.

With the economy experiencing secular stagnation, it may be impossible for the Fed to tighten policy and raise interest rates in the foreseeable future because to do so would bring on a recession, or worse yet, the deflation that they dread so much. We will be looking for clues as to how the Fed balances the risk of secular stagnation with the risk of excess liquidity. A stagnant economy provides little incentive for investment in plant, machinery, equipment and software, and divided government keeps a lid on government spending, so there is no alternative to the Fed for keeping the economy afloat.

While economic news will have its temporary effect on market sentiment, the driving force for markets under these circumstances is the Fed, not the economy, and there is no reason that asset prices, especially stock prices, should not continue to rise even in a stagnant economy. Profits will be sustained via updated technology, wage suppression and by corporations using their vast cash hoards for stock buybacks and acquisitions that are accretive to revenue and earnings . The Fed liquidity pump will avoid the kind of cyclical downturn that depresses profits across a broad swath of the economy, and price-earnings multiples can rise substantially from present moderate levels.

Absent dangerous speculative bubbles (none have appeared so far) or severe imbalances in the economy (less prevalent these days because of far more effective tools for managing supply chain inventories), a downward spiral is unlikely -- just slow growth and persistently high unemployment. People are in general still very cautious and risk averse, which is a good thing. The time to worry is when animal spirits get out of control and we see speculative binges emerging, or when deflation causes consumers and businesses to defer spending in anticipation of lower prices in the future (no sign of that yet, inflation expectations remain well anchored).

The threat of a severe adjustment, a Minsky moment, is bound to emerge at some point as we continue pumping up the financial side of the economy at a much faster rate than the real side, but no one can know for sure when that will happen. It could be 5 or 10 years in the future, or even longer if the authorities are sufficiently alert and people remain cautious. It will be interesting to see how the Fed weighs this risk against the risk of recession or deflation.

The U.S. Housing Market Is Crashing and Burning, Crushing Both Middle Class and Lower Income Families in the Process

While many wealthy individuals and investment companies have bought up foreclosed and distressed homes in all cash deals, the 80% in the middle class and lower incomes are having a hard time affording to buy or rent a place to live. One hears very little about this problem because the politicians we elect are for the most part unaware or indifferent, but this is a serious social and economic problem in the making. It’s where the rubber meets the road in the growing wealth divide that is crippling the economy.   

Housing construction fell well behind the rate of new family formation in the Great Recession of 2007-08, and the catching up that was supposed to fill the gap has fizzled. There is a housing boom of sorts underway, but it is concentrated in the million dollar plus segment of the market. We see statistics about how the price of houses is recovering -- a 12% increase we are told over the past year -- but a closer look shows that the increase in concentrated in the booming luxury and vacation home segment of the market where one house recently sold for the all-time record price of $200 million.

One of the beneficiaries of those sales, the luxury homebuilder Toll Brothers (TOL), reported last week that its net income more than doubled last quarter due to strong sales and rising home prices. Its executive chairman, Robert Toll, said he expects sales will rise, and if tight supplies remain, prices could increase rapidly.

Meanwhile there are still 10 million underwater mortgages, where the house is worth less than the mortgage, making it impossible for the hard pressed owners to sell and thus taking these homes off the market creating a shortage of homes for sale. With a scarcity of existing homes for sale, those available are quickly snapped up by corporate and other investors who can afford all cash deals or large down payments. Making matters even worse for first time home buyers, mortgage lenders have tightened loan standards and raised down payment requirements to the point that few are able to qualify.  

Another problem holding back mortgage lending is the lack of any progress whatsoever in resolving the future of Fannie Mae and Freddie Mac, the two Depression Era government sponsored enterprises (GSE’s) that currently account for over 90% of all mortgage insurance and securitization of mortgages. These GSE’s collapsed during the Great Recession of 2007-08 and have been in government receivership ever since. Without these institutions it is no exaggeration to say that there would be no mortgage financing and no housing market to speak of. Conservative Republicans would naturally like to eliminate all government involvement in mortgages and housing, in which case the typical home mortgage would probably look a lot like the 8 year 8% auto loans that are now becoming commonplace, while Democrats realizing that in the present political climate there is no chance of reasonable compromise on reforming the GSE’s, have been content to keep them operating in receivership. Given this uncertainty about the future of mortgage financing, most of the large banks have preferred to sit on the sidelines ceding the lion’s share of the market to one institution, Wells Fargo, that has long excelled in the field.

With construction of moderately priced houses stalled below the rate of new household formation, a shortage of affordable housing has become apparent in many markets. Meanwhile the demand for rentals is rising rapidly because of the middle class and lower income individuals frozen out of the mortgage market and pushed into renting, as well as a growing number who prefer to rent because they no longer see a home as a good investment and are already burdened by student loan debt. This short supply and rising demand has resulted in what Housing and Urban Development Secretary Shaun Donovan calls "the worst rental affordability crisis this country has ever known.”

A recent study by the Joint Center for Housing Studies at Harvard University found that almost half of all renters are paying more than 30% of their income in rent -- more than double the percentage in 1960. Business economists using aggregate data and generally far removed from the lives of ordinary Americans are blind to these realities which is one reason they are so far off in their projections. They have yet to grasp the reality that there are now two Americas, that of the 20% and that of the 80%. Home ownership, which is generally the only significant asset owned by the 80% is rapidly shrinking as many homes are passing from individuals to heavily capitalized corporations like the massive Blackstone Group (BX) and wealthy investors who are converting them to rentals at much higher rates of rent, which is one of the leading mechanisms through which in this case mainly the 3% are sucking the blood out of the 80%. There are hundreds of other mechanisms for transferring income and capital from the 80% to the 3%, but this is one of the most important. Until economists build these new realities into their projections they will continue to be far off in their projections.

The housing market is a cycle that needs buyers coming in at the bottom so others can move up. If that chain breaks down out at any point -- because of low supplies, tight lending requirements, or the absence of new buyers due to college debt, low wages or some other reason -- the whole edifice will come crashing down, which is what seems to be happening at present. The breakdown of the housing market is also a significant factor in the high unemployment and sluggish economic performance. The flexibility of the American economy, including the ability of workers of modest means to pick up and move to the places where jobs exist, was always one of its great strengths. With so many frozen in place with distressed mortgages or forced to live with family and friends because of the unaffordability of housing, that great strength has been dissipated. We see a shortage of workers in the booming oil fields of North Dakota and parts of Texas, with those hardy enough to move there paying exorbitant rents to live apart from their families in trailers, motel rooms and dormitories, when in years past we would have seen inexpensive houses spring up overnight by the thousands in such locations.

The result in human terms is that both lower income and middle class families, especially young new families, even when they can find work at very good wages, are having a hard time with no relief in sight.

THE HERD BEHAVIOR OF BUSINESS ECONOMISTS AND SECURITY ANALYSTS

Business economists and security analysts no less than traders and investors are prone to herd behavior. (Academic economists are somewhat but not entirely immune.) This herd behavior -- the comfort of being in the middle of the herd rather than a maverick outlier exposed to the danger of being both wrong and alone -- is probably one of the main reasons that the consensus of market opinion about the economy is at such unusual variance from the current flow of economic information as well as the behavior of the market itself. The actual behavior of the bond market where interest yields are under strong downward pressure is screaming stagnation and deflation risk, but this is totally at variance with the conventional wisdom forecasting sharply higher yields. And while bullish sentiment is still strong in the stock market, even there institutional money managers have until very recently been dumping riskier high-multiple growth stocks for the safety of defensive dividend-paying value stocks.

Despite the very disappointing economic data of the last couple of weeks, stock market bullish sentiment seems to have gained the upper hand over the more cautious safety seeking money managers and the bond market which always gives much more attention to economic data than the stock market. While stock market analysts can take comfort in the stock buybacks and other forms of financial engineering that is keeping earnings going up (though at a slower pace), bond analysts have little to consider in formulating their strategies besides the flow of economic data. Stock prices have therefore shown signs of bottoming and the broad based S&P500 benchmark has even moved up into new high ground while bond yields sink signaling a weaker economy.

When you stop and think about it, the herd behavior is quite rational. It might make sense for an ambitious trader or hedge fund manager to go out on a limb with a maverick strategy. If right he can be richly rewarded with huge profits like a Paulson who bet correctly on the sub-prime mortgage disaster; if wrong … well maybe he can start over again. But there are no huge bonuses for business economists or security analysts who turn maverick, only raised eyebrows from their superiors. If they are right they will get a pat on the back and a few words of praise, if wrong they will be fired and never get another job in the industry.

I have just finished reading a few of the latest weekly reports by the economics departments of some of the largest banks, and it is astonishing how they have dismissed the first quarter’s sharply lower GDP figures, the downward revised business investment and standstill of the housing market as consequences of the harsh winter. Come on! The center of gravity of the economy is no longer in the Northeast and MidWest, it is in the Sun Belt, and sure we had two days of ice and snow here in Atlanta, there were a few cold days in Texas, and a drought in California, but not enough to send even a ripple through the economy! And what about April, the start of the second quarter, when the consumer was supposed to come out of hibernation and carpenters could start swinging their hammers again on all the new homes under construction. How do they explain the fact that the growth of consumer spending in April accounting for 70% of the economy was actually negative in both nominal and real terms? The fact that sales of durable goods slumped well below expectations? And the only housing growth was in multifamily apartments accounting for only 17% of the housing market while applications for mortgages dropped to a 3 year low?

This herd behavior among economists and security analysts is worrisome, because once the data becomes overwhelming and they are forced by the sheer logic of the numbers to revise their forecasts, the herd is likely to stampede towards lower estimates. Fundamentally, I think the economy matters less to the stock market than Fed policy, and weak economic numbers makes it more likely that the Fed will continue its stimulus, but changed expectations on the economy would be a blow to sentiment that could derail the bull market in stocks at least temporarily.

The danger is nearby. Wells Fargo’s economists have bravely set aside all the negative economic data in their latest reports with assurances that it was caused by the weather, and that the economy, including the moribund housing market and consumers that are Wells Fargo’s life’s blood, would come roaring back during the rest of the year. At the same time however, the logic of the new data was so compelling that they were forced to revise their full year GDP estimate from 2.8% to 2.0%! How many more downward revisions like that can we take before sentiment shifts?   

IS THE STOCK MARKET READY FOR ANOTHER LEG UP?

It would certainly appear so given that the S&P 500 broke decisively into new high ground above the 1900 level after the Memorial Day holiday, putting twelve weeks of mostly sideways action punctuated by a sharp 5% dip and several other bouts of weakness firmly in the rear view mirror. On the surface the so-called correction or period of consolidation seemed mild with the broad market holding up well, but underneath there was a vicious rotation out of everything that had been going up nicely and was now considered too bubbly into stodgy defensive issues. Even the slightest earnings miss or hint of slowing revenues was harshly punished. The more growth oriented NASDAQ had corrected over 9% and small cap stocks 11%. Growth was out and value was in, even to the point of a considerable migration out of the U.S. into languishing European stocks and emerging market equities that had been beaten down by the Fed taper and were now considered cheap. All in all, it was very curious behavior, especially in view of the glowing forecasts for a stronger U.S. economy.

While the stock market is shaping up for a possible another leg up, the bond market is telling us that it doesn’t share the consensus view of a stronger economy and higher interest rates ahead. While the consensus calls for the benchmark 10 year Treasury yield to rise above 3% by year end, many calling for 3.25% or 3.5%, and even higher rates next year after the end of QE and the Fed starts tightening, the bond market has surprised everyone by moving in the opposite direction. After topping 3% in January the 10 year Treasury has now fallen to 2.45% with every indication of going even lower. The stock market bulls have come up with at last count 11 different reasons why interest rates have gone in the wrong direction, but have so far steadfastly refused to accept the simple explanation that the bond market expects a stagnant economy and is increasingly doubtful that the Fed will be able to withdraw monetary stimulus from the economy anytime in the foreseeable future. With any more data like the revised GDP numbers showing that the economy actually contracted by 1.0% in Q1, more indications that the expected housing recovery is failing to get off the ground, and that consumer spending fell flat in April, business economists will be forced to cut their rosey GDP forecasts, cautious company guidance will give way to downward revisions of sales and earnings forecasts, and the Fed may even have to taper the taper.

Meanwhile, in the halls of academia the concept of “secular stagnation” coupled with fears of deflation are steadily gaining ground, as is the realization that growing inequality is sapping the ability of consumers to propel the economy forward. When economists introduce into their models the fact that income gains are confined entirely to the top 20% while the 80% are struggling to get by, they will realize that the vaunted wealth effect of rising asset prices no longer translates into rising consumer confidence and consumer spending, and without consumer spending businesses have no incentive to make productive investments. When it becomes clear to all, as I believe it must, that the U.S. economy as presently configured is in no position to rise above 2% to 2.5% growth for as far ahead as anyone can see, and will likely average considerably less than that, markets will likewise have to adjust to the realization that interest rates will also remain very low for the foreseeable future. This is so different from the present expectation of stock market participants that it is bound to have significant repercussions there as well. I am not sure how the stock market will react at first. Much will depend upon how the Fed reacts. I am inclined to believe that the Fed will remain highly accommodative, and that this will be bullish for stocks despite a sluggish economy, but the transition from the present rosey outlook for a steadily strengthening economy to one mired in low growth and high unemployment could create a good deal of turmoil as trader sentiment changes and portfolios are adjusted to the new reality.         

This difficult and important transition to a new reality makes me very cautious about how the stock market will behave over the balance of this year and into the next, but I am not prepared to make any predictions, nor do I believe it is possible for anyone to make a worthwhile prediction of what the market will do more than a few days ahead. I learned long ago that one must set aside any preconceived notions of what lies ahead and simply follow where the market leads day by day ready always to adjust one’s strategy abruptly on short notice.

I tip toed back into the market the week before last when it became apparent that the harshly punished growth stocks were beginning to come back and the more growth oriented NASDAQ was again taking the lead from the more conservative S&P500. The initial moves were into ARRS and GILD, and then after last week’s breakthrough I went in more deeply with ACT, ALXN, FB, PCLN and SLXP, all issues with good liquidity and strong earnings prospects. More concentration in the recently punished biotech sector than I would like, but that’s where the earnings seem most secure and the setups look sound. I also like DVN and EOG in the oil E&P sector as well as SLB in the oil service sector but am holding off for a dip in the price of crude that seems overdue. Some of the smaller oil E&P companies are tempting, especially ATHL and BCEI, but in this environment it is probably better to stick with larger producers like EOG and DVN. Chips are on the upswing but highly cyclical; AVGO, CAVM and MU are worth watching but the rapidity of technological change makes the entire sector kaleidoscopic in nature and almost impossible to keep up with. There are numerous exciting small tech firms like PANW, DATA, CRTO, SPLK, WDAY but the market is too nervous and fickle to deal with them right now. KORS is an exciting “aspirational” retailer but the market hates it and the entire retail sector is under a cloud right now, as is the restaurant sector where CMG and SBUX look promising over the longer run. Airlines are doing well and LUV should be watched as it moves into Washington’s Reagan National Airport with a lot of new slots. In the financial sector banks have an ROE problem, but BX is an excellent private equity firm doing everything right and poised to harvest some large profits.

So there is plenty to choose from but patience is required, timing is everything, and losses should be cut even more quickly than normal (say 4%) because the market is apt to be erratic and full of surprises.