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 July 2005 Needless Worries
That's why investors are always trying to get a leg up on everyone else. They've got to feel they know more than the person on the other side of the trade or they may find themselves on the wrong end. In the process, a lot of data gets analyzed. Much of it comes from the economy. Historically economic and market cycles have run together. Indicators from the former may offer insight into the latter, so it makes sense for investors to closely follow the economy.
Of course not all economic series are created equally. While some are extremely useful in forecasting movements in the financial markets, others aren't. As with any data, the trick lies in distinguishing the meaningful from the meaningless. Just because the government, a major university, or a private firm tracks and publishes an economic series, doesn't necessarily make it significant. You won't get this from the media since they make a big deal over any economic data du jour, but investors shouldn't get sidetracked by the noise. Counting ChangeConsider, for example, the money supply. This venerable measure is one of the oldest and well-known economic statistics. Roughly speaking, the money supply is a measure of liquidity. The Fed started calculating and reporting it on a weekly basis in 1971.The 1970s and 1980s were periods of high inflation, often described as too many dollars chasing too few goods. As the number of dollars in circulation climbed, so did the cost of goods and services. Economists believed that inflation could be contained by controlling the money supply.
The Humphrey-Hawkins Act of 1978 required the Federal Reserve to set one-year target ranges for the money supply (see Chart 1). If the money supply exceeded the upper bound, inflation would continue to be a problem. If it fell below the lower bound, recession became a risk. If money supply remained within the Fed's limits, the economy could enjoy non-inflationary growth. As you can clearly see from Chart 1, implementation of this approach was never very successful. Like any monetary policy, controlling the money supply is more of an art than a science. But what about the relationship between money supply growth, inflation, the economy, and the financial markets? While they all may have tracked rather closely in the 1960s and early 1970s, any relation has broken down over the past two decades. Chart 2 actually shows a negative correlation between the money supply and inflation rather than the positive one supposedly leading to "too many dollars chasing too few goods". The Fed realized this over a decade ago. "The historical relationships between money and income, and between money and the price level have largely broken down, depriving the aggregates of much of their usefulness as guides to policy," said Chairman Alan Greenspan in July 1993. "At least for the time being, [the money supply] has been downgraded as a reliable indicator of financial conditions in the economy, and no single variable has yet been identified to take its place." Indeed, when the Humphrey-Hawkins legislation expired in 2000, the Fed ceased setting targets for the money supply. In July 2003, the Federal Reserve of New York declared, "Money supply growth does not provide a useful benchmark for the conduct of monetary policy." Maybe the advent of derivative investment vehicles and increased international monetary flows made it impossible to correctly measure the money supply. Perhaps money supply growth never really was a benchmark. Spurious relationships can be found almost anywhere. But there are still economists, analysts, and politicians who can't seem to let go of the past. While the Fed may no longer place a lot of weight on the money supply figures, they still do.
For example, there was great concern when the Fed allowed the money supply to spike to offset worries about Y2k. This proved to be a non-event, but money supply alarmists still associate this with the demise of the 1990s' equity bubble. Today they point to the fact that despite the Fed's recent tightening regime, the money supply is still growing over 3% annually. This, they argue, is inflationary and shows that the Fed is not moving fast enough to soak up the excess liquidity still lingering since 2000. Money supply is still included in the Index of Leading Economic Indicators, but they, too, have lost some of their reliability. You have it on good authority -- the Fed itself -- that money supply growth is not a meaningful measure for the economy. The Fed looks to other measures and you should, too. No Crowd HereFor the most part, the Fed now concentrates primarily on managing interest rates. That's the focus of most economists and analysts, too, but here again, some indicators are better than others.As a case in point, consider the federal deficit. Many people were surprised to see it almost vanish in the late 1990s. Most had thought they would never see a current year budget surplus, much less a decline in the national debt, but that's exactly what happened with the end of the Cold War through reductions in military spending increases. But 9/11 and a spendthrift Congress changed all that. After hitting a low in the recession year of 2001, the federal debt is again rising and to some, that's a dire economic signal. The reasoning goes like this: As the federal government spends more and more, it must increasingly borrow to finance the debt. Unlike an individual who would have to go to a bank, the government is able to issue debt -- Treasury securities -- for this purpose. Still, even these must be sold in the open market, saturating the bond market and driving up interest rates. This is essentially the old Keynesian concept of "crowding out": As the government borrows more and more, interest rates rise. Faced with higher costs of borrowing, individuals and businesses are crowded out of the debt market, unable to finance their projects ultimately leading to a slowing economy and possibly recession. You hear this now if you listen to some deficit-hawks and the economists who support them. Variations on the argument often cite "leaving massive debt for our children to repay" or subjecting the country to the mercy of foreign investors. The latter stems from the fact that foreign governments are some of the largest holders of U.S. Treasury securities. All this makes for compelling campaign rhetoric, but the facts don't bear it out. Speaking of the national debt as if it were that of an individual or business is at best misleading and at worst disingenuous. It doesn't have a particular maturity coming due all at once on a certain cohort ("our children") of taxpayers.
Even successful businesses and individuals don't completely avoid debt, they manage it. Businesses maximize profits through securing the lowest cost of capital available from a mix of debt and equity. Few individuals would ever own a home without mortgage financing. They're not all going to hell in a hand basket so why should we assume the U.S. will? And how is the U.S. debt being managed? Much better than the alarmists would have you believe. As shown on Chart 3, it's presently just under 38% of GDP, roughly the same level as in 2000. In fact, it was substantially higher throughout the boom years of the 1990s. But perhaps the most significant aspect is the lack of evidence supporting crowding out effect. For crowding out to occur, the price level -- meaning inflation and interest rates -- would have to rise with federal debt. There should be a noticeable positive correlation. That, however, hasn't occurred. Chart 3 compares federal debt with the 10-year Treasury yield. There's a slight positive correlation, with less that 2% of the movement in the bellwether bond yield being explained by changes in the federal debt level. That's certainly not the mark of a reliable indicator. It's hard to tell if the crowding out effect ever really existed. Even the Keynesians admit the expected effect would be blunted by the stimulative effects of government spending. The increasing role of foreign investment may also work to offset it. When interest rates rise in the U.S. -- whether because of government spending or any other cause -- they become relatively more attractive to foreign investors, driving up demand and putting a lid on yields. Many believe that's what's been happening over the past year as long-term yields have fallen in the face of Fed tightening. The Fed seems more concerned with international investment than federal debt, too. In early June, Mr. Greenspan acknowledged, "Among the biggest surprises of the past year has been the pronounced decline in long-term interest rates on U.S. Treasury securities despite a 2-percentage-point increase in the federal funds rate." His preferred explanation? "I do think the most relevant and likely reason why we're dealing with this is new forces at play in the international market." If that's what the Fed's watching, investors should, too. Crude BehaviorWhich brings us to one of the most dominant headlines of the year: The soaring price of crude oil. Certainly this can't be good for inflation, earnings, and stocks.
Oil is, after all, a major expense for many industries. Higher prices will either have to be passed on to the consumer or absorbed into lower corporate profits. Neither alternative is supportive of the economy or share prices. That's why U.S. automakers are finding themselves in such difficulty and why Ford continues to cut 2005 earnings guidance. It's why FedEx saw fiscal fourth quarter revenues rise 9% yet profits drop sending shares down 8% in one day. Other air freight and trucking stocks are suffering from similar concerns. Curiously, as logical as it might sound, there's little evidence that the inverse relation between crude oil and stock prices has held in the past. In fact, both have tended to move in the same direction. Looking back over 20 years of Baseline data, the S&P 500 and crude oil have a moderately strong positive correlation of +.44. (Correlations range from a perfect positive relation of +1.00 to a perfect negative relation of -1.00. Values around 0.00 indicate little or no correlation.) For the past 15, 10, and 5 years the correlations are also positive +0.43, +0.35, and +0.05, respectively. For the past two years, the two have moved almost in tandem, with a strong positive correlation of +0.80.
Most recently, crude closed at a near-term low of $46.80/bbl on May 20. From then through June 24th, it rose 12.8%. For the same period, the S&P was up almost 2%. Over time, crude oil prices may indeed weigh on share prices, but they aren't much of a short-term forward indicator. To be sure, there is some point at which high energy prices will begin to sap corporate earnings and share prices, too. Last year many thought $50/bbl would do it, this year they thought $60/bbl, and now one analyst is predicting $105/bbl. With so little correlation between crude oil prices and stock prices, why bother guessing when energy costs will affect corporate earnings and simply focus on earnings themselves? Corporate earnings have a direct relationship with stocks. Again from Baseline data, correlations tend to be the highest when corporate earnings lead by eleven months with the highest values (+0.81 and +0.68) occurring over the past two and five year periods. In other words, current earnings trends are relatively good indicators of stock movements in the next eleven months. According to First Call, analysts expect second quarter earnings to increase 6% on a year-over-year basis. They then expect them to remain flat for the remainder of the year and decrease in 2006. This is probably a better predictor of share prices than anything derived from the tenuous relation with crude oil, government debt, or money supply. There's good news, too. Negative pre-announcements and estimate reductions usually come before the end of the quarter while positive surprises are often saved for the actual profit reports. In the final weeks of June, a number of companies saw their share prices fall by 10% or more on the heels of reduced profit estimates. However, many others, fearing the effect of rising oil prices, have been very conservative in their guidance. Should they end up reporting positive surprises, their shares should be rewarded. Crude oil may make good headlines, but don't be fooled: It's still earnings that make a good stock. Successful investors avoid market and media distractions, and keep their eye on the ball. In this case, the ball is corporate earnings. Search this site! Just enter you key word or words:
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Y ITS VERY NATURE, investing is a zero-sum game. There has to be a seller for every buyer. For everyone on the right side of a trade there has to be someone on the wrong side. For every winner there's a loser.
