Why the Federal Reserve Mandate Means That Bernanke Doesn't Have to Worry About Bubbles

Earlier this week I discussed the dangers of misunderstanding “helicopter money” and higher inflation targets. A focus of that post was the incentives stemming from negative real interest rates that will lead to greater investment in real assets, not businesses. The obvious implication is that negative real interest rates entail significant risk of spurring asset bubbles.

This discussion of asset bubbles comes on the heels of St. Louis Federal Reserve Governor Jeremy Stein’s speech that suggested the Fed was becoming increasingly concerned about bubbles, not inflation. According to a recent Bloomberg article, apparently Fed Chairman Bernanke was not onboard with the supposed shift (h/t Tim Duy):

Federal Reserve Chairman Ben S. Bernanke minimized concerns that the central bank’s easy monetary policy has spawned economically-risky asset bubbles in comments at a meeting with dealers and investors this month, according to three people with knowledge of the discussions.

Do Bernanke’s comments imply the change Stein alluded to is not really happening? Not necessarily. To understand why, one must consider the goals assigned to Bernanke or any Fed Chairman for that matter. The following is from Chapter 2 of the Federal Reserve System’s own publication, Purposes & Functions:

The goals of monetary policy are spelled out in the Federal Reserve Act, which specifies that the Board of Governors and the Federal Open Market Committee should seek “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”

Although no explicit mention of preventing asset bubbles is made, the goal of stable prices leaves the door open for such an interpretation. Before addressing the Fed’s own interpretation of stable prices, its worth discussing the specific types of assets that are seemingly most prone to bubbles. The three major categories are commodities (e.g. oil, copper, sugar), financial assets (e.g. stocks and bonds), and housing. During the past decade real interest rates have actually been negative more often than not (Real Interest Rate = Effective Fed Funds rate - core PCE):


Unsurprisingly the past decade has also witnessed asset bubbles in commodities, stocks and housing:


Prices of these assets have clearly been anything but stable. So has the Fed failed in that aspect of its mandate? The answer is a resounding “NO.”

To remedy the cognitive dissonance readers may be experiencing, consider how the aforementioned real assets affect the FOMC’s preferred inflation measure, core Personal Consumption Expenditures (PCE). Financial assets are noteworthy in their distinct omission from the type of products making up PCE. Commodities are included in the general price measure, however core PCE is calculated by excluding a couple of the more volatile commodity components: food and energy. Housing is actually included in core PCE but is calculated using the space rent of nonfarm owner-occupied homes, not actual house prices. Focusing on core PCE thereby removes any direct concern with asset bubbles.

Bernanke has already announced his plans to step down as Fed Chairman early next year (2014). Given the Fed’s stated mandate and preferred measure of prices, it is no wonder that Bernanke is unconcerned with asset bubbles. The goals of his chair are to maximize employment and maintain stable prices. Since the types of assets prone to bubbling are not included in core PCE and appear relatively uncorrelated with that measure, to the degree that bubbles can benefit employment in the short run, they may actually be desirable.*

These institutional incentives of a Fed Chairman are unfortunately at odds with the country’s longer term economic goals. Asset bubbles created by excessive lending and/or negative real interest rates are always followed by busts. These busts are simply the recognition of malinvestment that already took place during the boom. If the booms are financed with significant leverage, the resulting deleveraging may lead to a debt deflationary spiral. Whether or not that’s the case, though it usually is, malinvestment suppresses both employment and economic growth over time.

One can argue over whether Bernanke’s views on the effectiveness of monetary policy are correct or not, but his decision to ignore asset bubbles is perfectly rational given the circumstances. Shifting the Fed’s focus from inflation to bubbles will therefore require changing the institutional incentives.


*The three major asset categories mentioned above presumably will have very different effects on employment. Among the three, commodity bubbles are least desirable from an employment perspective. Higher commodity prices generally hurt consumer spending, which may lead to a temporary decline in employment. Housing bubbles are the most desirable in these terms since the increased demand can generate a temporary employment boom in construction and housing-related services.  

(Late) 2013 Predictions

Last year I took a chance and threw my own projections into the ring. Similar to Byron Wien and Edward Harrison, I mostly selected events that were widely seen as having a low probability (less than 33%) but which I believed held a greater than 50% chance of occurring. The final results were a bit disappointing, but that won’t stop me from trying again this year. Since these predictions already represent a late release, without further adieu, here are the 2013 predictions:

1) Spain requests access to ECB’s OMT - Since ECB President Mario Draghi announced the OMT program, yields on Spanish debt have fallen rather dramatically. Although this eases financing pressure, it has done little to alter the actual economy’s downward spiral. During 2012 Spain’s GDP growth became increasingly negative, falling by 1.8% year-on-year in the fourth quarter. Meanwhile unemployment continues its meteoric rise to over 26% for the general population and nearly 60% for youth. With the large banks still severely undercapitalized and households over-indebted, private sector lending continues to decline:

Seeing no recovery and potentially a worsening decline, “bond vigilantes” will eventually test Draghi’s threat. At that point Spain will be forced to accept a Memorandum of Understanding (MoU) in return for ECB bond-buying through the OMT program.

2) The Euro finishes the year above $1.30 - After falling nearly 10% during the first half of 2012, the euro has more than recouped its losses on the back of optimism and deflationary policies.

At points during 2013 the optimism is likely to fade, but I expect politicians and central bankers will take the necessary steps to quell fears for the time being. Unfortunately those steps will involve further deflationary policies that push the euro higher. These competing forces will largely cancel out, leaving the euro close to or above where it began the year.

3) The Eurozone remains in recession the entire year - Forecasters now expect euro-zone economic activity to be flat this year, down from a previous prediction of 0.3% growth made just three months ago. Last year saw practically continuous downgrades to GDP growth forecasts and I expect this year to be no different. Austerity measures are momentarily easing, but more will likely be enacted based on the outcomes of several elections. The recent appreciation of the euro against several major currencies will also dampen growth by putting pressure on net exports. With banks across Europe trying to build up capital and persistently high unemployment, the private sector will remain especially weak. Though Germany may experience a temporary rebound, the Eurozone as a whole will not register GDP growth this year.

4) The Japanese yen rises above 90 per $ - Since the election of PM Shinzo Abe, the yen has fallen fast and is down more than 20% from recent highs.

During this time the Nikkei has risen more than 20%, yet yields on Japanese sovereign debt are little changed. This suggests many foreigners may be speculating on the supposedly forthcoming monetary and fiscal stimulus. As previously stated, the fiscal stimulus will probably be small and short-term. On the monetary front, short of actually entering the foreign exchange market, the Bank of Japan (BOJ) has essentially no mechanism to spur inflation and thereby cause a sustained depreciation of the yen. When market participants recognize the inability of Japan to avoid continued deflation, the yen will return to appreciating against the dollar.

5) Gas prices will peak above $4.20 per gallon and set a new yearly record-high average above $3.75 per gallon - Gasoline prices have been on the rise for the past 31 days, currently averaging approximately $3.75 per gallon. Though this current streak will probably end soon, prices are unlikely to give back much of the gains before beginning the typical rise into summer. The ongoing potential for flare ups in the Middle East will keep prices elevated throughout the year. Higher gas prices, which already account for 4% of before-tax household income (chart below), will be a drag on consumer spending in 2013.


6) U.S. Yearly GDP growth falls below 1.5% - Forecasts of ~3% annual GDP growth over the past couple years have been overly optimistic as real growth in 2011 and 2012 was merely 1.6% and 1.9%, respectively. Apparently forecasters are being a bit tamer in their estimates this year, now expecting only 2% annual growth. Unfortunately I suspect these estimates will once again prove too optimistic. Various tax hikes and the upcoming sequester (which will go through in some respect) will reduce the budget deficit by a few percent this year. Housing is likely to remain a bright spot, but further declines in interest rates will not lead to similar magnitudes of the wealth effect. Credit remains tight for many households and small business, which should also limit private sector activity. All of these factors combined will probably not be enough to bring about a new recession but will lead to the lowest annual growth rate during this upswing.


7) U.S. Unemployment rises above 8% - Currently sitting at 7.9%, the unemployment rate is forecast to decline during 2013. Due to weaker GDP growth, corporate revenues will barely rise again this year. As companies face increasing pressure to maintain profit margins at record levels, a new wave of layoffs may occur. Separately, continuing economic growth will encourage previously discouraged workers to re-enter the job market. Both of these factors will lead to slightly higher measured unemployment.

8) Federal Reserve forecasts shift first rate hike to 2016 - After extending their forecast for the first rate hike to 2015, the Federal Reserve changed its tactics to a more rule-based monetary policy. The Fed has, in effect, promised to keep rates low until we've hit either 6.5 percent unemployment or 2.5 percent inflation. Based on the above outlook for unemployment and a continuing decline in inflation expectations (chart below), FOMC members will revise their own forecasts and push back expectations for the first rate hike.


9) U.S. Corporate Earnings (ex-Federal Reserve) finish year below 2012 peak - Meager revenue growth was not enough to prevent U.S. Corporate Profits after tax from reaching record highs in the fourth quarter of 2012 on the back of record profit margins.

US Corporate Profits After Tax data by YCharts

As global growth slows in 2013, revenues will come under further pressure. At this point the ability of firms to continue cutting costs without sacrificing output seems limited, which means margins may begin to compress. As margins revert to previous norms, earnings will register a yearly decline.

10) Bonds outperform stocks - During the first seven weeks of this year the stock market has been on fire, even though earnings estimates continue to fall.


Multiple expansion is currently being driven by the Federal Reserve’s actions despite their ineffectiveness at generating actual NGDP growth. When investors eventually turn their attention to continuing troubles in Europe, ongoing deflation in Japan, and/or weakening growth in China, U.S. earnings may once again enter the picture. Recognition that S&P 500 earnings growth has slowed substantially may cause the market to give up much of this year’s gain. These concerns combined with declining inflation expectations will result in many investors returning to the safety of U.S. Treasuries. The subsequent rise in prices (decline in rates) will generate another year of positive returns for the Treasury market.


Will my predictions prove too pessimistic once again? Only time will tell...

Bubbling Up...

1) Buffett’s Favorite Valuation Metric Surges Over the 100% Level by Cullen Roche @ Pragmatic Capitalism

For the first time since the recovery began, Warren Buffett’s favorite valuation metric has breached the 100% level.  That, of course, is the Wilshire 5,000 total market cap index relative to GNP.  See the chart below for historical reference.

I only point this out because it’s a rather unusual occurrence and the recent move has been fairly sizable.  It happened during the stock market bubble of the late 90′s, but then occurred again just briefly during the 2006-2007 period when the valuation broke the 100% range in Q3 2006 and stayed above that range for about a year.  We all know what followed the 2007 peak in stock prices.

Woj’s Thoughts - These days it’s becoming increasingly tough to find stock market indicators that are not either approaching all-time highs or levels that have only been reached just prior to the onset of a bear market. As shown by the previous two market peaks, clearly this measure can go higher still. Nevertheless, this metric supports the view that the current bull market is much closer to the end than the beginning.

2) A Future of Low Returns? by Timothy Taylor @ Conversable Economist

Here's a figure showing U.S. experience in the long run. The bars on the far right show how annual returns on equity have outstripped those for bonds and for bills from 1900-2012. The middle bars show a similar pattern, a bit less extreme, for the last half-century from 1963-2012. The bars on the far right show the 21st century experience from 2000-2012. Stocks have offered almost no return at all; neither have bills. Bonds have done fairly well, given the steady fall in interest rates, but as interest rates have headed toward zero, the gains from bonds seem sure to diminish, too.

Dimson, Marsh, and Staunton have some grim news for those waiting for a bounceback to 20th century levels of returns: "[M]any investors seem to be in denial, hoping markets will soon revert to “normal.” Target returns are too high, and many asset managers still state that their long-run performance objective is to beat inflation by 6%, 7%, or even 8%. Such aims are unrealistic in today’s low-return world. ... The high equity returns of the second half of the 20th century were not normal; nor were the high bond returns of the last 30 years; and nor was the high real interest rate since 1980. While these periods may have conditioned our expectations, they were exceptional."

Woj’s Thoughts - Most people are probably aware that equity returns have been dismal, so far, during the 21st century. What I find striking is how small the gap between equities and bonds has been over the past fifty years. Sure 2.3% in real terms is significant, especially over a long-time horizon, but given the severely different levels of risk shouldn’t this figure be higher? For those interested in many other great charts and more in-depth discussion, check out the Credit Suisse Global Investment Returns Yearbook 2013.

Fear of Bubbles, Not Inflation, Returns to the Fed

St. Louis Federal Reserve Governor Jeremy Stein recently gave a speech titled "Overheating in Credit Markets: Origins, Measurement, and Policy Responses."
Carola Binder was struck by the historical relevance of the chosen terminology and offered the following comment in a post on Overheating and the Fed:

In the New York Times, Binyamin Applebaum writes that Stein's speech "underscored that the Fed increasingly regards bubbles, rather than inflation, as the most likely negative consequence of its efforts to reduce unemployment by stimulating growth." In fact, the Fed's concern about bubbles is not so new. After the Great Depression, it was widely believed that the stock market overheated in the 1920s, leading to the Great Crash in 1929 and the onset of the Depression. In those days, the word for bubbles or overheating was speculation, and it became a dirty word indeed. After the Great Depression, speculation remained a major concern of the Fed. The Fed very explicitly regarded bubbles as the most likely negative consequence of its efforts to reduce unemployment by stimulating growth.

Apparently the Fed has come full circle. Carola goes on to provide a couple excerpts from FOMC minutes during the 1950’s, the last time the Federal Reserve was concerned with asset bubbles instead of inflation. The subsequent change in thought is not overly surprising given that stock markets flatlined starting in the mid-1960’s, as inflation picked up and became a major cause for concern throughout the 1970’s. What is disturbing, is the Federal Reserve’s failure to recognize the changing landscape over the past three decades.

During that time, commercial bank lending has largely shifted its priorities from financing tangible (capital) investment through business loans to financing the purchase of already existing assets (e.g. houses, stocks and bonds):

(BUSLOANS = Commercial and Industrial Loans; REALLN = Real Estate Loans; LOANS = Loans and Leases at All Commercial Banks)

It should therefore come as no surprise that the transmission mechanism of monetary policy is now primarily through various asset markets (i.e. real estate monetary standard).

Consider the following charts showing various asset prices and inflation rates during the past 30 years:

Stocks:


High-Yield Corporate Debt:


Houses:


Inflation:


Over the past few years I’ve been very critical of the Federal Reserve’s actions spanning the last couple decades. One of the primary reasons behind this view was the incessant focus on limiting inflation and utter lack of concern regarding asset bubbles. The present risk of a zero interest rate policy (ZIRP) and QEternity lies mainly in inflating new asset bubbles, not creating excessive measured inflation. If the Fed has finally come back around to this realization, that would certainly be a big step in the right direction.

Misstating Corporate Earnings

Perceptions of Beauty & Stock Valuations by Satyajit Das @ Fear & Loathing in Financial Markets

Stock spruikers argue that equities are “undervalued”. But changes in the economic environment may make quaint measures such as price-earning (“PE”) ratios misleading. In a world of low growth, the dynamics of corporate earnings, which ultimately underlie stock prices, have become more complex.

Profit margins and cash flow improve, perversely, in a period of low growth. Initially, companies cut costs improving profitability. As revenues are stagnant, companies have no need to invest in expanding capacity or working capital, releasing cash flow.

Reduction in depreciation charges and the ability to use cash flow to reduce debt reduces interest expenses. In the present cycle, sharp decreases in interest rates, though not necessarily interest margins, have also improved profit margins.

These effects are short term. In effect, they misstate earnings.

Woj’s Thoughts - After recently being called a permabear, a separate post on my equity outlook is certainly called for. In the meantime, consider the many ways (more at the link) in which Das shows companies are effectively misstating earnings. Although Das’ list is long, I think it is far from exhaustive. My general view is that companies are finding clever ways to increase current earnings at the expense of future capacity to drive revenues higher (i.e. borrowing to fund stock buybacks). If revenue growth continues at a pace well below previous cycles, earnings may peak much lower than most expect and P/Es of an earlier day may no longer be warranted.

S&P 500 Sales Per Share data by YCharts

Bubbling Up...1/25/13

1) S&P 500 Earnings Squiggles by Ed Yardeni @ Dr. Ed’s Blog

The estimates for 2012 and 2013 mostly fell all last year, yet the S&P 500 rose 13.4%. I have the Squiggles data back to 1979 on a monthly basis. More often than not, they tend to trend down; yet more often than not, the market has trended higher. That’s because the market discounts 12-month forward consensus expected earnings. A good proxy for this concept is forward earnings, i.e., the time-weighted average of consensus estimates for the current and coming years. It tends to be a good 12-month leading indicator for actual profits, with one important exception: Analysts don’t see recessions coming until we all do too.

Woj’s Thoughts - After viewing this chart a few times, several observations stand out from the rest: 1) Each “earnings squiggle” that rises near the end is associated with higher actual earnings. 2) Each “earnings squiggle” that falls near the end forecasts at least a temporary decline in actual earnings. 3) Earnings estimates for 2010, at the beginning of 2009, were higher than forecasts for the current year (2013) and equivalent to current estimates for 2014. 4) The clear upward bias in estimates promotes higher prices, to the degree market participants trust the forecasts. 


2) Why the US economic crisis is a depression and not a recession by Edward Harrison @ Credit Writedowns

What is now playing out in Congress is very much in line with what I said a little over three years ago in October 2009. Deficit fatigue has become too large to resist. Austerity is coming to the US. The crux here is to remember that this has been a crisis brought on by high private debt – not public debt or deficits. The government has been effective in preventing a private sector debt deflation by providing economic stimulus, permitting large-scale deficit spending and bailing out the banks. This has added a huge slug of net financial assets to the private sector and supported asset prices and private sector balance sheets. When these government deficits get cut, there will be serious pain in the private sector because balance sheets are still stressed and the result will be a relapse into economic depression.

Woj’s Thoughts - The House Republicans have agreed to temporarily raise the debt ceiling and postpone the debate over sequestration in return for Congress (focusing on the Senate Democrats) actually passing a budget for the first time in four years. Backed into a corner, this is probably the best decision for the Republicans as it puts the onus (temporarily) on Democrats to reach a budget agreement. This progression raises the chances that spending cuts, either tied to sequestration or the budget, will take place this year. With the tax hikes already in place, the smaller deficits could very well lead to the outcome that Edward fears.  

3) Ben Bernanke Is Facing A Legacy Problem by Bruce Krasting @ Money Game

Bernanke’s term at the Fed will set many historical precedents. To a significant extent, history will judge Bernanke on what he did while chairman of the Fed. But the books will also look at what happened after he left.

I believe that Bernanke would very much like to leave his successor with a Fed that had policy choices. As of today there are no options left.  Just more useless QE. I doubt that Bernanke wants to exit with the Fed’s foot planted firmly on the gas pedal. The next guy does deserve a cleaner plate than now exists.

Is the Legacy factor influencing Bernanke? I think it has some sway in his thinking. Consider what Greenspan did before he left. After years of soft monetary policy he ratcheted up the Federal Funds rate 17 times in 22 months. He took the funds rate from 1% all the way up to 6%. Part of that rapid increase was driven to get monetary policy “neutral”, so that Bernanke could do as he wished. Not long after Bernanke took over, he took the funds rate down to zero.

Clearly, Greenspan tried to get monetary policy back to neutral before he left, I don’t see any reason why Bernanke would think differently. Are we watching a repeat of history? At a minimum, his legacy, and where he wants the Fed to be when he leaves,  is part of Ben’s thinking today.

Woj’s Thoughts - It’s hard to argue with this logic given Greenspan’s actions as Fed Chairman prior to the last two years of his reign. While deserve is an overly strong word in this instance, my guess is the next Fed Chairman would appreciate having the option to ease, beyond merely expanding QE. With initial unemployment claims now at multi-year lows and a labor force still in decline, the table is set for a further meaningful drop in the unemployment rate. As the rate approaches 7 percent, I suspect Fed chatter about ending QE will pick up. If the legacy issue is simultaneously weighing on Bernanke’s mind, the urge to pull back on easing may be too great to ignore. Considering the ongoing multiple expansion in stock markets, it appears most market participants are not yet discounting this potential outcome.

Corporate Revenues Fail to Keep Pace with Tiring Market Rally

According to Comstock Partners, The Market Rally Is Based On Four Dubious Assumptions: 

These assumptions are as follows:

1) Since almost every central bank in the world is aggressively easing, the market cannot go down.

2) Although the U.S. is facing a fight in Washington over the debt limit, the sequester and the expiration of the annual federal appropriation, various political threats over the last two years have passed without substantial market damage, and the same will happen this time.

3) S&P 500 earnings will rise to $108 in 2013, resulting in a current P/E multiple of only 13.7.

4) The economic recovery will kick into full gear once the problems in Washington are solved or again "kicked down the road."

I won’t deny that the ongoing strength and length of the current bull market has caught me by surprise. Large government budget deficits were initially very supportive of corporate profits, however those effects are waning just as profit margins are peaking. Meanwhile, weak economies at home and abroad have severely limited corporate revenue growth. The following chart looks at the percentage change in the S&P 500 sales per share, earnings per share, and operating earnings per share since the recession began in December 2007:

S&P 500 Sales Per Share data by YCharts

Considering the meager growth in GDP, one might have expected that sales per share would be effectively flat over this period. What may be surprising, is that minimal revenue growth has not prevented an astonishing rise in earnings per share. Regarding earnings per share, it’s worth pointing out the noticeable difference in volatility between the two separate measures. While I am no expert in accounting, there are countless ways in which companies can “manage” their earnings across time. With an increasing prevalence and usage of such (generally legal) measures, I suspect the magnitude of changes in earnings per share will continue to grow in both directions.

Out of curiosity, I decided to add the S&P 500 index to the chart above:

S&P 500 Sales Per Share data by YCharts

Despite the widespread focus on earnings and their supposedly fundamental value to stock valuations, prices have more closely tracked the cumulative change in revenues since the recession began. If profit margins are truly mean reverting and earnings are increasingly manipulated, than it is possible sales now provide a better metric of corporate profitability over the course of a business cycle. That being said, it’s equally plausible (perhaps more so) that this data merely represents an anomaly.

Regardless of whether the above graphs prove useful for forecasting, trend growth of earnings has been slowing rapidly. With interest rates practically at the zero lower bound (ZLB) and central bank balance sheet expansion already set in place, potential drivers of further multiple expansion appear limited. In the near-term I expect that current momentum will drag markets higher, possibly to new all-time highs (for the Dow and S&P 500). However, looking further out on the horizon (3-5 years) I believe the present cyclical bull market is tiring and that the secular bear market will re-exert itself, leading to tests of the 2009 lows.   

Fading Tailwinds of QE and Cost Cutting Represent Future Headwinds for Stocks

Over the past year or so, I’ve continually made the claim that QE and Operation Twist would have little impact on the broader economy aside from pushing investors further out on the risk curve. Despite being correct in that view, the persistent bullishness within US equity markets has been surprising. Taking a different approach by looking at market internals, Microfundy offers a new perspective on how QE Failed.

Mario Draghi’s infamous speech on July 26th hinted at more asset purchasing/easing causing the markets to roar higher. As you can assume, taking a look at the internals of that two day rally, you would see out-performance by the high yielding blue chips. THIS WAS NOT A GOOD RALLY! It’s akin to EPS growing via cost cutting. I don’t care if the S&P goes to 2,000 by year end, if it is led higher by XLU & XLP, that’s telling me that it is a QE fueled rally that is not being sustained by growth or a economic recovery etc. It is being caused by the powerful “hunt for yield”, and the unfortunate belief & wager that we are Japan! That is not a rally to be celebrated, because just like cost cutting… it’s unsustainable!

The analogy between effects of QE and cost cutting, in particular, caught my attention. Since the market peaked in mid-’07, earnings per share of the S&P 500 have grown over 50% despite sales per share only growing by ~3%.

S&P 500 Sales Per Share data by YCharts

While QE has generated a “hunt for yield”, cost cutting has also been providing a significant tailwind for stocks over the past few years. Extending the time range a bit further shows that the market has generally been nearing its peak when earnings diverge upwards from sales.

S&P 500 Sales Per Share data by YCharts

Growth from cost cutting and lower yields appear to be reaching their limits just as revenue growth turns south. Without these tailwinds for earnings and multiple expansion continuing, the market is probably much closer to an interim top than bottom. Whether or not earnings will witness a precipitous drop similar to ‘08 remains to be seen and likely hinges on the future stance of fiscal policy (in the US, Europe and China). Regardless, patience remains warranted as far better entry points to the market will present themselves in the next few years.

Bubbling Up...

1) How Good An Indicator Was "The Death of Equities" Cover

Just how good of a buying indicator was the BusinessWeek cover from 1979, though?  If you ask most investors about that cover story, they seem to remember that the market almost immediateley took off after the issue was published.  The reality, however, is that nearly eight months after the cover story was published, the S&P 500 was down 8.5%.  While the market did rally from that level, three years after the infamous BusinessWeek cover, the S&P 500 was still down nearly 5%.  It wasn't until 8/12/82 that the S&P 500 really took off and the bull market began in earnest.  Granted, time horizons have gotten a lot shorter in the last thirty years, but three years is an eternity in this market.

Woj’s Thoughts - Our memories can deceive us by filling in stories with logical steps. Cover stories often do mark extremes in sentiment, yet those extremes may persist for quite some time. As a signal for contrarian investors, recognizing this reality is critical.

2) Why I don’t believe housing has put in a secular bottom by Edward Harrison

For the bottom to be in you have to believe two things from a macro perspective. First, you have to believe that the overshoot phase to the downside has been arrested. Most bubbles end with a significant overshoot that makes it a no-brainer to tip a toe in the market. I think we are approaching those levels in markets like Phoenix. But we never really got down to reasonable levels in places like Washington or New York. Second, you have to believe any US recession is both remote in time and mild in duration/severity. I question this. I think any US recession will re-start the house price decline dynamic because consumers are still overindebted, interest rates are at zero percent, and mortgage rates are as low as they can get. My point is that from a cyclical perspective 2012 is as good as its going to get. Calling a bottom at the top of a cyclical bull market in asset prices and the economy is folly. Wait until the bottom of the cycle to make those calls.

Woj’s Thoughts - Early this year I made the claim, Don't Rush to Buy a Home! At the end of May I was Still Not Buying A Housing Recovery. Edward lays out many/most of the reasons for my continued lack of optimism on housing prices over the next couple years.
 
3) The Evolution of Treasury and Muni Bond Yields by Cullen Roche

I’ve discussed this in detail over the years and why the analysts crying for mass US state insolvencies were likely to be wrong, but now we have some interesting new analysis via VOX.  What’s depicted below is the 10 year US Treasury versus the 10 year muni bond index.  As you can see, the yields have an extremely high correlation – muni bonds practically ARE treasury bonds.  So why are yields surging in Italy, Spain, Greece and Portugal, but they’re remaining so tame in the muni market?  Simple – the US government, which can always procure funds via taxes and bond sales therefore making solvency a non-issue, provides substantial federal aid to the states every year.  While this doesn’t eliminate the solvency issue at the state level it certainly helps reduce it substantially.  Europe has no such mechanism in place so what you basically have is a bunch of US states in an environment where they’re left to fend for themselves.  They can’t print their own currency, they can’t devalue their own currency and they can certainly run out of Euros.  The result is bond investors who are terrified about default and end up selling bonds which only exacerbates the budgeting process.*

4) Microfoundations and the capital debates by Matias Vernengo

In that sense, heterodox (classical-Keynesian, by which I mean Sraffa’s prices cum Keynes/Kalecki’s effective demand) does have a coherent determination of long run prices, based on rational behavior, as the foundation of the macroeconomic theory. Markets do not produce optimal outcomes and unemployment of productive resources is the normal, long run, position of the economy. In fact, the capital debates not only say that classical political economy (the surplus approach) provides sound microfoundations, but also that it is NOT possible to do so within the neoclassical/marginalist paradigm.

Woj’s Thoughts - Previously I’ve argued against microfoundations in macroeconomics, but Matias places an interesting spin on the discussion. Quite possibly the issue is not the use of microfoundations but rather the poor choice of microfoundations.

5) Another Summer of Discontent: The Four Factors that Explain Why What We’re Doing Isn’t Working by Daniel Alpert

We must move from stabilize and reflate, to stabilize and recalibrate:

• It is time for creditors throughout the developed world to finally take the write downs that have long been coming their way in connection with the trillions of dollars of truly un-payable household and sovereign debts that resulted from the credit bubble of the 2000s.  Yes, this will pressure lenders and, yes, they will need to be recapitalized to the detriment of their existing stakeholders.  But there is presently no shortage of capital seeking reasonable risk-adjusted returns, and I have every confidence that it will flow eagerly into the financial sector—if only the balance sheets of our institutions were honestly reckoned by having the currently unrecoverable carrying value of assets written down to that which can be recovered today from borrowers and/or underlying collateral.
  
  
• As I have been saying and writing about for years, we must accept the reality of what the credit markets are telling the planet’s most creditworthy governments, particularly that of the U.S.  The message is “please, here, take our money…take it cheaply and keep it safe…we have no fear of lost purchasing power, the trend is not inflationary…now take it (and use it to fix your  economy).” And that is what we must do. We must take as much 30-year money at these depression level interest rates as we need to re-employ our underemployed workers directly, on public infrastructure projects that return benefits to the economy more than sufficient to repay the sums borrowed when the time comes.  The private sector will not hire until it sees a recovery in demand—so the only agent for re-employment of workers and regeneration of demand may, for an extended time until the imbalances at least decline somewhat, be our governments.  It is long past time to pack away austerity agendas.
  
  
• And yes, we must address and manage the process of nominal price, wage and asset value declines. The advanced economies are experiencing the effects of a supply glut, a debt overhang, massive technology-induced productivity (soon to transfer to the emerging economies, worsening the glut), and aging populations. These are all disinflationary factors. And the aggregate effect of their contemporaneous existence is deflationary—full stop. Yet in relying on monetary intervention alone we are fighting the battle to control the pace of deflation (forget about reflation) with one hand tied behind our back.n  Instead of targeting growth in nominal GDP, which I am proclaiming here to be a futile endeavor, we must target renewed global competitiveness and, at the very least, growth in real GDP. That means both allowing our price and wage structures to align themselves with global supply and demand and, more importantly, feeding and nurturing investment in those areas of the private sector that can employ large numbers of people at market clearing wage rates. Especially in those sectors that are more readily protected by geography from global competition.