Quantitative Easing Explained

Jim Grant on the Future of America and Keys to Investing

Jim Grant on the Future of America:


On Keys to Investing:


See more videos here.

The World's Gone Mad

First of all, let's take a look at what happened to Wal-Mart (from this article in WSJ):

"Wal-Mart sold $750 million worth of three-year bonds paying 0.75% a year. It sold $1.25 billion of five-year bonds paying 1.5%, $1.75 billion of 10-year bonds paying 3.25% and $1.25 billion of 30-year bonds paying 5%."

"Remember that those bond coupons are subject to two hidden costs. First, bond interest is taxed as ordinary income. That means that if the bonds are held in a taxable account, they will be taxed up to 35% right now—and as high as 39.6% next year if the Bush tax cuts expire as planned."

"Second, bonds face a serious risk from inflation. Who wants a piece of paper paying 5% a year for 30 years if inflation jumps to 7%? Nobody. If that happens, the price of the bond would plummet."

Now let's take a look at Wal-Mart stock.

"At $54, it has barely moved over the past 10 years. Yet during that time the company's annual sales and net income have more than doubled. Net operating cash flow has nearly tripled. And dividends have quadrupled, from 24 cents to $1.09."

Read the article for more.

Second, Italy is a bigger sovereign risk than Indonesia, according to Business Week.

"Italy’s debt costs more to insure against default than that of the Philippines or Indonesia, as Europe’s financial woes overshadow a credit rating six levels higher than either of the emerging-market nations. Credit-default swaps on Italy, the only borrower among Europe’s so-called peripheral nations not to suffer a cut in its credit rating since last year, trade at 165.5 basis points. That’s more than the 131 basis points for Indonesia, which had to restructure some of its debt in 2000, or the 129 basis points for the Philippines."

Third, the Reserve Bank will tell you, "Since the beginning of the year, non-residents have been net buyers of equities and bonds to the value of R100 billion, of which R75 billion were bond purchases. This compares with net purchases of bonds totalling R15,5 billion in 2009 as a whole. Whereas in previous years bond flows appeared to be mainly speculative in nature, the recent developments suggest that there could have been a fundamental shift in these flows. There are indications that a significant proportion of these flows are more long term in nature as foreign pension funds and other fund managers take advantage of higher yields in emerging-market economies. The higher levels of bond market inflows are not unique to South Africa. It is estimated that emerging-market bond funds have recorded year-to-date inflows of US$32 billion, compared with the previous full-year high of US$9,7 billion in 2005."

Fourth: Pension funds, who rely on an 8% assumed return on capital over long time periods to match growing liabilities, have decided it's a good idea to flee stocks for the "safety" of bonds. A fool and his money will tell you this is a ridiculous idea:

"Alcoa's U.S. pension fund had 57% of its assets in stocks in 2006. The stock market started sliding late in 2007, and by the end of 2008 the decline had pulled stocks down to just 33% of Alcoa's pension portfolio. The fund's value tumbled by more than $2 billion, to $6.5 billion. Alcoa officials decided against restoring the stock exposure to its former level. With the blessing of the board, they looked for ways to insulate the fund from future damage. By early 2009, the board signed off on a plan to push stocks down to 30% of fund assets, selling shares and buying bonds. As the stock market surged back starting in early March that year, Alcoa continued to sell stocks to keep that weighting at 30%."

The pension boards will tell you it's to reduce volatility and protect principal, and that changing your strategy based on economics and markets is not what they are doing. That would be true except, "About two decades ago, in 1988, corporate pension funds had just 38% of their assets in stocks, according to the Center for Retirement Research. And 401(k)-type plans, in which individuals control investment decisions, also held less than 40% in stocks, according to the Center. During the stock boom of the 1990s, the percentage invested in stocks jumped for both groups, with individuals hitting 68% in stocks in 1999 and corporate pension plans hitting 67% in 2001."

And as for this gold illusion, it's pretty clear there's no correlation between the rate of change in M3 and the gold price, and there's clearly a somewhat complicated relationship to explain movements in the gold price related to the M3 money supply over long time periods.

All in, a good time to be buying companies at attractive prices.

Currency Wars - A Few Contrasting Views

Is the world headed for a "currency war"? Massive capital inflows into emerging market bonds coupled with a weakening dollar has seen emerging market currencies such as the rand and real appreciate.

South Africa's Finance Minister believes a global currency war is coming, while US Treasury Secretary Tim Geithner says "there's no risk".

Brazilian Finance Minister Guido Mantega believes a "currency war is currently underway".

All of Brazil, Japan, Thailand, Switzerland and others have taken pro-active steps to intervene in their respective currency markets.

A picture paints a thousand words.

Estimating the Magnitude and Age Distribution of Lifetime Healthcare Expenditures

Research Paper by Berhanu Alemayehu and Kenneth E Warner

Principal Findings:
Per capita lifetime expenditure is $316,600, a third higher for females ($361,200) than males ($268,700). Two-fifths of this difference owes to womens' longer life expectancy. Nearly one-third of lifetime expenditures is incurred during middle age, and nearly half during the senior years. For survivors to age 85, more than one-third of their lifetime expenditures will accrue in their remaining years.

Conclusions

Given the essential demographic phenomenon of our time, the rapid aging of the population, our findings lend increased urgency to understanding and addressing the interaction between aging and health care spending.

Link to Full Paper

Michael J. Burry: How did nobody see this coming??

ALAN GREENSPAN, the former chairman of the Federal Reserve, proclaimed last month that no one could have predicted the housing bubble. “Everybody missed it,” he said, “academia, the Federal Reserve, all regulators.”

But that is not how I remember it. Back in 2005 and 2006, I argued as forcefully as I could, in letters to clients of my investment firm, Scion Capital, that the mortgage market would melt down in the second half of 2007, causing substantial damage to the economy. My prediction was based on my research into the residential mortgage market and mortgage-backed securities. After studying the regulatory filings related to those securities, I waited for the lenders to offer the most risky mortgages conceivable to the least qualified buyers. I knew that would mark the beginning of the end of the housing bubble; it would mean that prices had risen — with the expansion of easy mortgage lending — as high as they could go.

I had begun to worry about the housing market back in 2003, when lenders first resurrected interest-only mortgages, loosening their credit standards to generate a greater volume of loans. Throughout 2004, I had watched as these mortgages were offered to more and more subprime borrowers — those with the weakest credit. The lenders generally then sold these risky loans to Wall Street to be packaged into mortgage-backed securities, thus passing along most of the risk. Increasingly, lenders concerned themselves more with the quantity of mortgages they sold than with their quality.

Meanwhile, home buyers, convinced by recent history that real estate prices would always rise, readily signed onto whatever mortgage would get them the biggest house. The incentive for fraud was great: the F.B.I. reported that its mortgage fraud caseload increased fivefold from 2001 to 2004.

At the same time, I also watched how ratings agencies vouched for subprime mortgage-backed securities. To me, these agencies seemed not to be paying much attention.

By mid-2005, I had so much confidence in my analysis that I staked my reputation on it. That is, I purchased credit default swaps — a type of insurance — on billions of dollars worth of both subprime mortgage-backed securities and the bonds of many of the financial companies that would be devastated when the real estate bubble burst. As the value of the bonds fell, the value of the credit default swaps would rise. Our swaps covered many of the firms that failed or nearly failed, including the insurer American International Group and the mortgage lenders Fannie Mae and Freddie Mac.

Read the rest of this Op-Ed piece here...

Jim Grant on Alan Greenspan

Jerome Booth on Emerging Markets (Forbes.com)

Forbes: How do you define emerging markets? You've got a unique definition of that.

Booth: I define it by risk perception. All countries are risky and the emerging markets are the ones where it's priced in.

And the opposite of course is a developed country where the domestic investor base doesn't even think of their own sovereign risk. So I don't think it's a surprise that Iceland is a developed country. It wasn't that people couldn't have worked out that there was a problem. A 13-year-old probably could have typed in IMF.ORG and worked it out in 2006. Likewise Greece, which today has a probably larger risk of default, sovereign default, in the next one year than any major emerging market. So it's really about risk perception. And that's the particular way I define it.

Forbes: Now political risk. How do you define political risk and why do you find that higher in so-called developed countries than your bailiwick of emerging markets?

Booth: Well political risk is everywhere, but I think it's on the increase in the developed world, whereas I think in the emerging world. For example, last year you had Indonesia and India, two examples of elections where the domestic the electorate returned the existing government's, prior reform governments because they understood that this was an external shock. They don't have credit crunch. And they didn't blame their politicians, but they also understand the importance of continuity. Whereas in certainly my country and a lot of the developed world I think you've got a massive increase in political risk. You've had several pieces of retroactive legislation. You've got measures really which are denying the scale of the credit crunch. Nobody should talk about the credit crunch in the past tense, you see. All the academic research on this is pretty clear. It will take many years to delever.

And political risk is everywhere. Political risk is when there is a risk that a road project as a private equity investor, say, the government or a local government will change the terms of the deal before it's completed. And that in some sense is often as high in a developed country as it is in the emerging world, frankly.

Watch the video here

Patents and R&D in Emerging Markets

Number of international patents and R&D show how the future of innovation is taking shape.

There is a strong link between the number of international patents that a country is granted and the amount that it spends on research and development. A 2007 snapshot shows this clearly, and also that America and Japan led the pack.

The size of each dot represents total spending, and their colours represent the number of patents per capita, red for higher intensity and blue for lower.

Click “play” on the bottom left to watch as the countries that spent more on R&D over the past two decades reaped the benefits by gaining progressively more patents. Then click on "Emerging markets take off" above.

Click here for The Economists interactive tool.

The new masters of management

Developing countries are competing on creativity as well as cost. That will change business everywhere:

"Just as Henry Ford and Toyota both helped change other industries, entrepreneurs in the developing world are applying the classic principles of division of labour and economies of scale to surprising areas such as heart operations and cataract surgery, reducing costs without sacrificing quality. They are using new technologies such as mobile phones to bring sophisticated services, in everything from health care to banking, to rural communities. And they are combining technological and business-model innovation to produce entirely new categories of services: Kenya leads the world in money-transfer by mobile phone, for example."

Read The Economist's Special Report

Buffett: Charlie is Too Pessimistic

Warren Buffett on Charlie Munger's "Sad Parable"

Why China Insists on Controlling its Currency

U.S.-Chinese relations have become tenser in recent months, with the United States threatening to impose tariffs unless China agrees to revalue its currency and, ideally, allow it to become convertible like the yen or euro. China now follows Japan and Germany as one of the three major economies after the United States. Unlike the other two, it controls its currency’s value, allowing it to decrease the price of its exports and giving it an advantage not only over other exporters to the United States but also over domestic American manufacturers. The same is true in other regions that receive Chinese exports, such as Europe.

What Washington considered tolerable in a small developing economy is intolerable in one of the top five economies. The demand that Beijing raise the value of the yuan, however, poses dramatic challenges for the Chinese, as the ability to control their currency helps drive their exports. The issue is why China insists on controlling its currency, something embedded in the nature of the Chinese economy. A collision with the United States now seems inevitable. It is therefore important to understand the forces driving China, and it is time for STRATFOR to review its analysis of China.

An Inherently Unstable Economic System

China has had an extraordinary run since 1980. But like Japan and Southeast Asia before it, dramatic growth rates cannot maintain themselves in perpetuity. Japan and non-Chinese East Asia didn’t collapse and disappear, but the crises of the 1990s did change the way the region worked. The driving force behind both the 1990 Japanese Crisis and the 1997 East Asian Crisis was that the countries involved did not maintain free capital markets. Those states managed capital to keep costs artificially low, giving them tremendous advantages over countries where capital was rationally priced. Of course, one cannot maintain irrational capital prices in perpetuity (as the United States is learning after its financial crisis); doing so eventually catches up. And this is what is happening in China now.

STRATFOR thus sees the Chinese economic system as inherently unstable. The primary reason why China’s growth has been so impressive is that throughout the period of economic liberalization that has led to rising incomes, the Chinese government has maintained near-total savings capture of its households and businesses. It funnels these massive deposits via state-run banks to state-linked firms at below-market rates. It’s amazing the growth rate a country can achieve and the number of citizens it can employ with a vast supply of 0 percent, relatively consequence-free loans provided from the savings of nearly a billion workers.

It’s also amazing how unprofitable such a country can be. The Chinese system, like the Japanese system before it, works on bulk, churn, maximum employment and market share. The U.S. system of attempting to maximize return on investment through efficiency and profit stands in contrast. The American result is sufficient economic stability to be able to suffer through recessions and emerge stronger. The Chinese result is social stability that wobbles precipitously when exposed to economic hardship. The Chinese people rebel when work is not available and conditions reach extremes. It must be remembered that of China’s 1.3 billion people, more than 600 million urban citizens live on an average of about $7 a day, while 700 million rural people live on an average of $2 a day, and that is according to Beijing’s own well-scrubbed statistics.

Moreover, the Chinese system breeds a flock of other unintended side effects.

Read STRATFOR's Full Article Here

John Mauldin on The Recovery

Last week I wrote a letter to my kids trying to explain what Greece meant to them. Reader Ken V wrote: "Great letter, John. Now you should write one for the adults who are retired and don't have the long future your kids do. If the US becomes Greece, things won't recover in time for much of the rest of my life to be more than one grim, dreary period. What is your investment advice for those with roughly a 10-year horizon, not 30-40-50 years?"

A very good question Ken, and one that was asked more than a few times. So today I will touch on that thorny issue, as well as look at the employment numbers for what we see about the potential for an actual recovery.

First, let me say that what I am not doing here is giving you, gentle reader, specific advice. To be able to do that I would need to have specific knowledge of your situation, assets, location, needs, health, etc. But what I will try to do is give you a general assessment of what I see for the economy over the next few years and what the investment climate might look like. I am also going to refer to a lot of previous letters I have written, for those of you who want to do further research.

Is This a Recovery?

First, we are in a nascent recovery from the depths of the Great Recession, but the question is "what kind of recovery?" Many suggest that we will see a typical recovery, like we have seen with every recession since World War II. As regular readers know, I don't think we've gone through a typical, garden-variety recession, and to expect a typical recovery is more faith-based than factual. We had a deleveraging recession and we are still deleveraging. The process, as shown in studies I have written about, takes years to conclude.

When I started talking in 2002 about a Muddle Through Economy for the rest of the decade, I had a lot of people giving me a hard time by 2005-6. But as we closed out the decade, average growth of US GDP for the entire decade was less than 2% annualized, which by my definition is Muddle Through. For the US economic machine, that was pretty anemic growth. It resulted in a lost decade for stocks, except for the NASDAQ, for which it was merely a dismal decade. Traditional 60-40 (stocks to bonds) portfolios did not fare well, coming nowhere close to the projections of standard-issue money managers.

I think we are in for yet another Muddle Through period, at least for 5-7 years and maybe for the decade, depending on a few scenarios I will come to in a minute. As my friend Prieur du Plessis outlined for us in last Monday's Outside the Box, if we measure the stock market by either earnings or dividend yields, valuations are in the top 10% historically. Average (!) returns, going out for ten years, are 2.6% real, with some historical 10-year periods being negative. Below is the range of returns, based on dividend yields. It does not look much different from the chart based on earnings. We are currently at the far right-hand bar.

This does not suggest a happy outcome for those who espouse buy-and-hope portfolios, at least not if you have expectations or needs of 7-8% or more.

This Time is Different

If you are a new reader, I suggest going to the archives at http://www.2000wave.com/archive.asp and searching on the name "Rogoff," to read the letters I have written on his and Carmen Reinhart's must-read book, This Time is Different, which shows us that it is never different this time. They looked at 266 financial crises in over 60 countries across a span of 200 years.

Debt crises have sadly similar conclusions: they always end in pain and tears. And although we have stopped, as private citizens, from accumulating debt (or in some cases, such as mortgages, have just walked away from the debt), our national government has stepped into the breach and is borrowing at mind-boggling levels.

Below is a chart that is a wonderful illustration of an economic truth: if something can't happen then it won't happen. We cannot borrow $15 trillion in the next ten years. Not at anywhere near the low interest rates we enjoy today, and probably not even at nosebleed rates. (Note that the chart was created before the health-care reform bill. Add at least another trillion to the total. Anyone who thinks that bill was revenue neutral is kidding themselves.)

The End Game

Something has to change. We have two paths to choose from. We can either slowly bring the US budget deficit back into balance (or at least to a level less than the growth in nominal GDP) or we can continue on the current path and become Greece or Japan. (Again, go the archives and search for "Japanese Disease".)

The first choice is a bad one, but the latter choice would be disastrous. If we take the first choice, which I call the Glide Path Option, a meaningful reduction would have to be on the order of $200-250 billion a year. That, along with reduced spending by state and local governments could (and probably will) amount to reducing spending by a little more than 2% of GDP.

I have written several letters on the equation GDP = C (consumer and business consumption) + I (investments) + G (government spending) + E (net exports) (again, searchable). The Keynesians point out that when "C" is reduced in a recession, "G" should be increased to offset the effects of reduced consumption. And they are correct that a deficit will help overall GDP in the short run.

But we are coming to the end of the Debt Supercycle. There are limits to what even the US government can borrow, and the sooner we recognize that as a nation the better off we will be in the long run.

But if we start to reduce our deficits (the "G"), it will be a short-term drag on GDP. There is no way around it. That means that if inflation is 2% and we have a reduction in "G" of 2% of GDP, then the nominal growth in GDP will have to be 6% in order to achieve after-inflation growth of 2%. Two percent as in Muddle Through.

But wait, John, didn't we just grow at 5.6% last quarter? Why are you being so gloomy? For several reasons. First, the growth was largely statistical. Part of it came from inventory accounting, as inventories had got as low as they could go. Note that an increase in inventories will increase GDP but possibly result in a lower future GDP as the excess inventory is depleted. And inventories are still rising, but not by as much.

Secondly, a significant portion of the increase in GDP came from the stimulus. As noted above, an increase in "G" will be reflected in current GDP. This stimulus begins to go away in the second half of the year, and I think there is little reason to believe there will be anything other than an extension of unemployment benefits past two years, by way of "stimulus" this year.

I rather think the last half of the year will show a slowing (though still positive) economy. Unemployment will be closer to 10% than 9% at the end of the year, as the large number of temporary census workers will no longer be employed by the government.

Some Good News on Unemployment

The good news is that employment rose by 162,000 jobs last month, with about 48,000 of those being census workers and another 82,000 coming from the birth/death ratio, a way of guessing how many new businesses are started. The birth/death ratio is eventually squared up when we get real statistics, but it will be several years before we know the true picture. So, while the headline is good, the reality is not quite as good. But let's take what we can. The direction is positive, and it should get better over time.

Small businesses have at least stopped laying people off, according to my friend Bill Dunkenberg, chief economist of the National Federation of Independent Business. The improvement is due to fewer reductions in jobs, not gains in new hiring.

There are not a lot of job openings, according to the survey that goes along with this note from The Liscio Report: "The probability of a person unemployed in February finding a job in March fell to from 20.1% to 18.7%, an all-time low for this series (which goes back to 1948).

This reinforces a letter I wrote last November, talking about the prospects for longer-term employment rates. Even the rosy scenarios still have unemployment above 8% in four years. That assumes a total of 1.5 million new jobs can be created this year and two million every year thereafter, with no recession.

Remember, we need about 125,000 new jobs a month to just keep up with the growth in our population. Though if you look at today's employment release, they added a whopping 398,000 people to the civilian labor force (a huge number when compared to the 162,000 new jobs - a discrepancy you didn't read about in any report.). What kept the unemployment rate from rising significantly was that they deducted 238,000 people who are no longer considered unemployed, due to the fact that they have given up looking for jobs. The U-6 unemployment rate rose to 16.0%, however. The U-6 rate includes people who have part-time work but wish they had full-time work. That part-time number rose above 9 million again this month, in a rather large monthly jump.

You can read the whole November letter and see the other two scenarios.

The Effects of a Tax Increase

I have written about the effects of tax increases in several letters. Basically, tax increases have a negative impact on GDP of three times the size of the tax increase. (Again, in the archives, search for "Romer", as in Christina Romer, Obama's head of the Joint Council of Economic Advisors and co-author with her husband of the research).

Taxes may be going up by as much as 2% of GDP in 2011, when you include state and local increases. This could be as much as a 6% drag on GDP over the next three years (probably somewhat front-loaded).

So, let's add it up. We will likely see a reduction in government spending (from all levels) over the next few years, a really nasty set of tax increases, which will hit small businessmen the hardest, and continued high unemployment, and all of it coming in a weakening economy by the end of the year.

I put the odds of a double-dip recession in 2011 at better than 50-50. Not a sure thing, as maybe sanity flowers and they phase in the tax increases over 3-4 years. Plus, the American economy and businesses are more resilient than we think, and it is possible we Muddle Through 2011. Not much growth, but perhaps we avoid that recession.

Deflation in the US is the dominant force. There is little likelihood today of a worrisome increase in inflation. I have written letters about why this is the case. (Search for "elements of deflation" and "velocity"). Actually a little inflation (2-3%) might be welcome as a protection against slipping into outright deflation, if we slow down next year.

Let's try to sum it up. We have a Muddle Through Economy this year (not much more than 2% overall growth for the year), with a slowing economy next year. Unemployment stays high. If we get our deficits under control, we lock in a slow-growth economy for 5-6 years, but after that we could get back on track. A recession puts that brighter outlook out a little farther. Unemployment would go north of 12%. I might note that the stock market drops an average of 40% during a recession.

Or we do not get our deficits under control. We can go on borrowing for a lot longer than most of us think. But the Rogoff and Reinhart book makes clear that there is an end. You can't solve a debt crisis with more debt. Ask Greece in about 6-12 months, as the "fixes" are temporary. Things go along until there is a loss of confidence in the bond market, and then all hell breaks loose. When is that? Who knows? But it is not ten years away, and probably not five. Rates skyrocket and the currency takes a hit.

And then we are presented with a conundrum. Would the Fed really enable the government to run huge deficits by monetizing the debt? It would be a crisis decision. If they just stand by, interest rates soar and the economy goes into recession or worse. If they print, we could see inflation and a crashing dollar, with rates soaring. As I said above, this would be a disastrous scenario. I think we avoid it, as there will be a growing backlash at the polls against government deficits. But then I am an optimist. If you think the politicians cannot muster the will to make the cuts, then bet on the disaster scenario. Think gold and hard assets and foreign assets and absolute-return funds.

But optimist though I am, I can't rule out disaster. So, either we have a slow-growth economy for 5-6 years, or we hit the wall all at once. Think depression if it's the latter. Either way, it's a tough investment environment.

So, how about those with a 10-year time frame, like the reader I opened with? First, lengthen your time frame. There are some amazing new medical therapies coming your way and you are likely to live longer. I would plan on it. You will need more than you think you will.

Second, really think about your commitment to equities in general. By that I mean the usual index funds. If you have (or your manager has) some real skill in picking stocks, then that is different. But I think it is very possible we'll see another lost decade for stocks in the US. If we do have a recession next year, the world markets are likely to fall in sympathy with ours. At the bottom, it is quite possible that emerging-market stocks will finally decouple from the developed world, so for those who should be in stocks (those with a longer time horizon), think about going beyond the developed world.

For most of you, caution is appropriate. Do not plan to make 8% a year from your portfolio, or to spend 7% of your savings. As Ed Easterling has shown, there are historical periods where people taking 5% a year from their portfolios would be left with nothing after 30 years. In fact, about 50% of those portfolios would run out of money in an average of just over 20 years. The key? Starting valuations. http://www.crestmontresearch.com/pdfs/Stock%20Retirement%20SWR.pdf

For most people already retired, a fixed-income portfolio should be your first choice. High-quality corporate bonds, high-quality state and municipal bonds (do your homework - don't trust the rating agencies!), and a "ladder" of not not more than 4 years. I know that does not yield much, but you should be protecting your principal.

If you have enough income from a portion of your assets to live on, then think about absolute-return-type funds.

Ken, if your time horizon really is ten years, then safety should be your number-one objective.

Also, I know some people are managing their wealth for the next generation. That may make my note of caution not as emphatic, assuming you really do have enough to make your expected time horizon and more.

All that being said, I am still bullish about certain businesses. As I noted a few weeks ago, I see an opportunity in bleeding-edge software consulting for media and other businesses that have to innovate or die, and I'm investing in such a startup. I am also investing in small-cap biotech stocks, with a 10-year horizon. Remember that birth/death ratio? While I do not believe it is as high as they estimate, there are businesses being started all over the country. That is what a free market does.

If I had the stomach to deal with renters, I would be buying distressed homes at prices where I could more than make a reasonable return. For some of you, that may be a way to get income. (Commercial real estate will soon become a real potential as well, for experienced investors.)

The US economy is not coming to an end. There will be lots of opportunities, but it will be harder than in the past. More like swimming through peanut butter. But nothing is ever easy. For the next few years, I simply think being more cautious makes sense - but choose your targets. There are funds and managers I like.

A 10-year time frame? There is not much I can say that will make you happy. 20 years? That should be another thing. One way or another, this deficit crisis will resolve itself, and then we can get back to doing what we do best.

Understanding Economic Forecasts

In their book, Understanding Economic Forecasts, David Hendry and Neil Ericsson acknowledge the weaknesses of the econometric models in use. The problem, they say, is that they tend to be based on two key assumptions: that the model is a good representation of the economy and that the structure of the economy will remain relatively unchanged.

In reality, the models are mis- specified and the economy is subject to unexpected shifts. “Thus, the failure to make accurate predictions is relatively common.”

Problems of mis-specification, including the use of wrong variables and/or mathematical misrepresentations, are relatively easy to fix and do not necessarily produce bad forecasts. What really wrecks a forecast is a structural break, some underlying parameter or event that has changed in a way that wasn’t foreseen.

An interesting observation: You only have to remember the famous lament by Goldman Sachs’ chief financial officer when the credit crisis broke in 2008, that “we were seeing things that were 25- standard deviation moves, several days in a row”. When, as Hendry points out, one day should have been enough to recognize that the world had changed.

Direct Link to Full Article

Reverse Urbanization in the US

Data released by the U.S. Census Bureau reveals a reverse urban migration trend in the country.

This interactive graph paints the picture.

The recession has played a big role in determining migration trends in the U.S., with most people either staying where they are or returning to where they came from, particularly in big cities. The New York area lost a net 100,000 people in 2009, (down from 220,000 in 2007) while Los Angeles lost a net 80,000 (down from a massive 222,000 in 2007). Chicago lost a net 40,000 residents which is in line with the 52,000 the recession sent packing in 2007. This runs contrary to historical data which shows a net migration of people to big cities, rather than away from them.

Reverse urban migration will decrease the supply of labor and consumers in the cities which could result in lower prices in terms of real estate and consumer goods, not to mention services such as restaurants. In New York, fewer people will impact high-density high-margin businesses such as Starbucks (SBX). Regional focused banks, such as Chase Manhattan, will also have a smaller market to penetrate as they lack national representation like that enjoyed by Bank of America (BAC).

Just an interesting piece of information, especially considering the huge trend seen in China and other emerging markets of mass migration into urban environments which is largely responsible for rising labor costs, increasing inflation and higher consumer spending (all running contrary to current experience in the US on a 3 year view).

America is Not Dead

Based on an article by Paul Krugman which says:

“We’ve always known that America’s reign as the world’s greatest nation would eventually end. But most of us imagined that our downfall, when it came, would be something grand and tragic.”

“Instead of re-enacting the decline and fall of Rome, we’re re-enacting the dissolution of 18th-century Poland.”

Warren Buffett recently made the biggest acquisition of his career in railroads, when he bought Burlington Northern Santa Fe. Why railroads? “It’s an all-in bet on the future of the US economy”, said Buffett. And given the great man’s prowess, I see no reason to jump on the bandwagon, disagree and declare, “America Is Dead”!

The first part is available here.

The second piece to this article was written some days later with the following conclusion:

"In essence the United States is the world’s dominant economy and that advantage will be eroded to some degree by countries like India, Brazil, China and South Africa. However because of the fabric of the people of the US and the economy’s ability to rebound and emerge stronger after what appeared to be impossible odds, the US will still be the world’s most prosperous country in the next 100 years. China has problems which are far vaster in an economic, environmental and social standpoint than the US does yet the ability of the US people know the problems they face; to question, demand answers and hold politicians accountable is one of the very reasons this country will not see it’s own demise. Rather, your kids and grandkids will live a better life than you did, and that’s the ultimate investment one can make."

The Fallacy of Unemployment

"The official unemployment rate grossly understates the actual number of people who, by all realistic measures, are unemployed. It’s very hard to come up with a reliable figure as it’s almost impossible to count all these people accurately. Estimates, however, range from 16% all the way to a gigantic 17.5% ! The Wall Street Journal reckons it’s at about 16.8%!"

"Realistically speaking we are looking at an unemployment rate of closer to 16.5% than the 9.7% we’ve been getting officially. Using my above calculations the situation is dire – around $600 billion in lost income and spending, closer to 5% of the economy."

The full post is available here.