Thursday, October 23, 2014

September Inflation

Core minus Shelter inflation still looks pretty weak, while shelter inflation remains strong.  My position is that shelter inflation reflects a negative supply shock and core minus shelter inflation reflects a negative demand shock.  The economy might be strong enough to limp along with no help from the housing sector and with negligible core minus shelter inflation, but the downside risk is significant if it can't.

Looking at the 1 year inflation indicators in the next graph, it might be worth noting that core minus shelter inflation was this low in 2004 when short term rates began increasing and the economy continued to recover (along with inflation).  But, inflation expectations were rising then, while they are falling now, and mortgage markets were flying then and are dead now.

We now have 4 months with no cumulative core minus shelter inflation.  I think the best hope at this point is coming from FHFA.  Clearly the implicit regulatory liabilities banks now have for mortgage credit are stifling.  If this can be corrected, maybe it will pull out some pent up housing demand and we will see home prices begin to climb again.  If that happens, it's smooth sailing.  If it doesn't, it's hard to tell how things will work out in the near future.


Wednesday, October 22, 2014

Follow up on Earnings Yield

In the previous post, I compared the earnings yield to interest rates and leverage.  In one graph, I added inflation to the earnings yield so that it was comparable to nominal interest rates, but that was not the best way to do it.  The better way to do it is by taking inflation out of nominal interest rates.  I am just subtracting CPI TTM inflation from the 10 year rate, so this is hardly a perfect measure of real 10 year rates, but it seems to come pretty close.

There are several relationships here:

1) leverage seems to be related to nominal interest rates

2) to compare equity earnings yields to the bonds yields, I think the appropriate comparison is between the earnings yield and the real interest rate.

3) the effect of leverage on the earnings yield should be reasonable without any inflation adjustments.

Here is the original graph I posted in the earlier post, which has nominal interest rates, unadjusted earnings yield, and leverage.

Below is the same graph with real interest rates instead of nominal interest rates.  This is the best version of the graph for looking at the earnings yield relationships.  I have shortened the time frame because inflation adjustments before the modern era are very volatile.

I think this makes a much stronger case for the earnings yield being associated with leverage.  There may be an inverse relationship between earnings yield and real bond rates.  And, this does suggest that in low interest rate contexts, risk insensitive investors are capturing some premium from the risk averse debt investors.  Looking at it in the way I framed it in the previous post, if the entire universe of savers shifted to a more risk averse position, the total return to assets (risk free rate + equity premium, which is the forward looking version of the earnings yield) might need to rise, in which case the equity premium would rise by even more than the real risk free interest rate was declining.  This looks like it may have been the case in the late 1970s & early 1980s.  So far, though, in this cycle, the total required return to assets doesn't seem to be unusually high.

Maybe that is the difference between low inflation and high inflation, and thus low leverage and high leverage.  The high risk aversion we see today might have a slight effect on equity earnings yields, but the low leverage of corporations is a stronger effect, and so equity earnings yields remain in the normal range.

In a regression, both leverage and real rates are strong variables for estimating the earnings yield, with leverage being the strongest.  But, this may not mean much because leverage and earnings yield both have equity market values in the denominator of the variables.  Let me know in the comments if you have an idea for avoiding that problem.
 
 
I would like to make a subtle distinction from the typical use of that relationship.  I think it is generally seen as a sort of arbitrage situation, where investors should rebalance to equities until the return on equities is bid down to something close to the return to bonds.
 
But, I don't think this is an arbitrageable relationship.  The difference between these rates of return is a product of a public sentiment toward risk.  There will probably be a change in sentiment at some point, but the difference between these rates of return will come mostly from a rise in long term rates as that sentiment changes.  So, the equity investor does receive the higher return on investment, and avoids the low returns on bonds.  But the convergence of this rates of return isn't so much an arbitrage as it is a speculative position on changing sentiment.
 
In some ways, it's a distinction without a difference, since a risk insensitive investor would still tend to want to add weight to equities in this context, all else equal.
 
As I noted in earlier posts, historically, the 1940 to 1970 period was the golden era of equity risk premiums (see chart to the right).  That comes through very clearly in the chart above, as the earnings yield was consistently above the real interest rate throughout that period.
 
With regard to monetary policy, a looser policy that brought inflation to the 3-4% range might not create much of a boost for investors through changing yields.  The earnings yield would probably rise slightly along with some corporate releveraging, and that increase in required returns would keep equity prices from increasing.  But, that releveraging would be partly the product of short term debt markets that would be freed of the frictions caused by the zero lower bound and of long term debt markets freed of the frictions still remaining in the mortgage market.  Improvements from looser monetary policy wouldn't, therefore, lead to higher stock prices because of the first order effect of changing rates.  They would move higher because the more optimal monetary policy would be leading to more real economic activity due to the removal of those frictions.  (edit: TravisV points out in the comments that I neglected to note that the higher NGDP growth that would come from a 3-4% inflation range would also be likely to reduce equity risk premiums because it would reduce the risks associated with very low interest rates, which would have all sorts of positive effects, including rising equity prices.)

The Earnings Yield, Interest Rates, and Leverage

In some previous posts I have shown how high PE ratios and profit margins can, ironically, be a reflection of lower risk.  Given a set level of operating profits, and, say, an 8% required return on the unlevered firm's assets, a firm facing 3% interest rates with a 5% equity premium, at the optimal allocation of capital, will have lower leverage, higher net profit margins, and a lower share price and a lower PE ratio, than the same firm facing 5% interest rates and a 3% equity premium.

Low Interest Rates High Interest Rates
High Equity Premium Low Equity Premium
Leverage Low High
Net Profit Margin High Low
Share Price & Enterprise Value Low High
PE Ratio Low High


This is complicated in a business cycle shock because frequently firms experience operational dislocations and/or are pushed out of their optimal capital allocation targets.  But, at this late point in a cycle recovery, when dislocations have been generally repaired, when interest rates go up, leverage will go up, profit margins will decline, and share prices will increase from both revenue growth and multiple expansion.

This might seem counterintuitive in some ways, but this should follow from a Modigliani-Miller framework where corporate income is taxed.  Where I think intuition is wrong is that we tend to conceive of debt in a consumption context.  Debt tends to be described as a risky and greedy attempt at overconsumption, or for corporations, a dangerous way to create false growth that exposes them to higher risk.

Of course, a firm leveraged imprudently would face high risk.  And, firms that have been exposed to deep revenue shocks tend to meet their ends when they can't pay the interest payments on their debt any more.  But, I think what we see mixes with these perceptual biases in a way that creates a false interpretation.  If a firm didn't have any debt, it might fail at the point when it couldn't pay its workers anymore.  Would we say that hiring workers is a risky proposition that, generally, causes firms to fail?  I suppose in any failure we can claim that workers were overpaid or unproductive.  But, generally, clearly, firms need workers to produce.  So, while hiring workers inefficiently would be a problem, workers themselves are not a source of risk.  I propose that debt is the same.  It can be handled poorly, but it is simply a part of the stakeholder structure of the firm, and is not, in and of itself, a risk.  Some workers might have fixed salaries while others receive wages tied to profits or revenues in some way.  And, some capital (debt) receives a fixed payment while some capital (equity) received residual payment.  All firms must decide on a mixture of fixed and variable costs, but there will always be a reasonable level of fixed costs above zero.....Anyway, I'm going on too long.

Over time, total required real returns on firm capital appear to be fairly stable.  Generally, when interest rates fall, equity risk premiums rise.  This suggests that there are fairly stable factors regarding delayed consumption and the myriad other factors that create profit for investment and that within the ownership claims on investment, there is a risk trade between debt and equity.  Debt holders trade risk with equity holders.  So, instead of having a single class of owners in a unlevered firm, there are owners with a certain payout structure and owners with the remaining residual payout structure.  Because certainty has value, debt holders accept a discounted payout, and thus, the equity premium is always positive.

The long term balance between debt and equity does seem to follow the trends I described in the table above, and this can be explained with the Modigliani Miller framework as a product of corporate taxation.  But, note, this also aligns with a risk-trading perspective.  Low interest rates are a sign that investors have become risk averse, and they are willing to trade away a higher discount from the unlevered return on assets to the remaining equity holders in order to minimize local risk.  We might imagine that the demand for low risk ownership would push debt levels up.  But, this would leave a bifurcated set of investors - many investors with low-return/low risk payouts, and few investors with very risky payouts.  It may be more realistic to imagine a normal distribution of investors where the mean level of risk aversion has increased, and the entire body of investors has shifted or skewed.  So, when investors as a group become more risk averse, driving down interest rates, the marginal investor in the switch between equity and debt will also be more risk averse.  Corporate deleveraging changes the nature of equity, making it less volatile, and thus low interest rates are associated with falling debt levels as the marginal investor is attracted into the less volatile equity position.


Earnings Yield

If there is any truth to my framing above, the comparison of the earnings yield on equities and the yield on bonds is not very helpful.  There may be a tendency for earnings yields to decline when interest rates are low.  But, this may be related to the deleveraging of equities, so that the lower earnings yield simply reflects the lower relative risk of equities in that context.

A low earnings yield may not be a signal to a risk-insensitive investor to switch to bonds.  It may be a signal to leverage up or beta up her equity portfolio.


First, please let me know if anyone knows a source for S&P 500 debt/equity ratios that goes back further than 1952.  I'd love to see how it looks with a longer time frame.

Regarding the graph, the earnings yield looks like it tracks with leverage as much as it tracks with interest rates.  (Note, as an aside, the unusual behavior during two demand shock recessions in the 2000's, where revenue shocks caused earnings to decline and leverage to increase, both temporarily, as corporations were thrown into disequilibrium.)

One could say that leverage and earnings yield track simply because they both have equity value as the denominator.  That is true.  It is interesting that debt as a proportion of net operating profits is fairly stable over time, and that is what leads to this co-movement.

On the other hand, the co-movement of the earnings yield and bond yield is problematic for another reason.  The bond yield includes an inflation premium.  The earnings yield is simply a measure of the trailing earnings.  The inflation premium will come from future nominal growth of earnings and share price.  When this adjustment is made, these indicators don't move together as tightly in the high inflation 1970s.  In fact, using an equity risk premium (which takes growth expectations into account) instead of an equity yield, there tends to be an inverse relationship so that inflation adjusted interest rates and equity premiums tend to add up to a fairly stable return level.

I suspect there are times when a low relative earnings yield should signal higher weights in bonds and other times when a low relative earnings yield signals higher weights in equities (to make up for low leverage).  I don't know if there is a coherent way to decipher the signal.  As such, I'm not sure how useful earnings yield relative to bond yield is as an allocation tool.

Thursday, October 16, 2014

Update on Interest Rates

Well, interest rates got interesting fast after I posted my update Wednesday.  Here are updated versions of a couple of the graphs.

The market reaction seemed overblown compared to the information contained in the economic data that was released Wednesday.  I have been pleasantly surprised by the reaction from FOMC officials that suggests they are willing to loosen up, at least a little bit.  I'm not sure if it will be enough to make much difference.

In the meantime, labor markets continue to look strong.  So, I think we might still be looking at a situation of weak signs in financial markets but a strong economy in terms of production and employment.

I think this is a speculator's market.  These are the kind of situations I look for in individual equities, like in my current favorite Hutchinson Technologies.  The ability of markets to provide stable and efficient prices breaks down when the distribution of possible outcomes deviates from normal behavior.  For some time, prospects for HTCH on a 5 to 10 year horizon have been such that they are likely to be worth very little or something more than $10.  They have been trading in the $2 to $5 range.  The distribution of outcomes is kind of an upside-down normal curve.  It is highly unlikely that HTCH will be trading at $3 in 5 years.  This kind of situation causes the expected cash flows of the marginal investor to take a back seat to other issues, like reputation, fear of losses, etc.  Expected monetary returns can be very high, and returns to unobservable stock picking skills become very high.

We have a similar situation now in the broader market. It has been that way for some time.  Under QE, investors were split between high inflation expectations and worries about perma-QE at the zero lower bound.  I think the decline in the TIPS spread in 2013 might have reflected a reduced variance in expected inflation more than a reduced mean expectation for inflation.  In fact, that was the subject of my very first post on this blog, and a couple of follow ups.

After the rate increases in mid 2013, through most of 2014, I had a slightly bullish position on rates (short bonds) that I traded as a synthetic short option.  (I traded so that I gained from mean reverting volatility).  That is because I forecasted a positive labor market for 2014.  I predicted that, on net, the distribution of possible outcomes in the near future would become less variable.  This is because the taper of QE3 would quell fears about inflation while the strengthening labor market would quell fears about deflation.  I expected housing to eventually recover more strongly than others seemed to expect, which would eventually bias markets even more away from deflation worries.  In the meantime, I traded the transitory volatility in the day to day markets.

I think we have mainly gotten to the place I expected us to.  Except, housing credit markets haven't seemed to recover enough to pull home prices up to levels that would re-establish a sustainable housing credit market.  So, I have retracted my bullish position on real estate and home building for now, and my bullish position on interest rates (bearish on bonds).  And, the volatility dynamics are now reversed.  Instead of reverting to the mean with declining volatility, the end result for interest rates is now probably a two-tailed monster.  Much like with HTCH above, the odds that June 2017 Eurodollar contracts will expire at 2% are very low.  But, the problem is we don't know if they will expire at 0.1% or at more than 3%, and much of the outcome depends on coming arbitrary Fed decisions.  So, a directional speculative position will eventually pay off very well here.  But, which direction is anyone's guess.  The trick now will be to take a position on that direction before the market fully prices it in.

In the meantime, this tipping-point context might mean that seemingly small pieces of information in one direction or the other could create large swings in market prices.

That said, looking at the forward Eurodollar curve, this recent move doesn't look as pessimistic as it first did.  With such a large decline in equities, it seemed like the market reaction was a reaction to more possible demand shocks.  But, especially after recovering a little, the change in rates looks like it has come mostly from an expected delay in rising rates, which could reflect some pessimism about near-term markets, but this pessimism appears to be paired with an expectation of a counter-effect of appropriately looser monetary policy.  The end result of the last three days' interest rate moves has been a move back in time of about 1 month in the first rate hike and a slightly slower expected rate of rate increases after that.  The expected date of the first rate hike had already begun moving back earlier in the month, so that, as a whole, since early October, the expected date of the first hike has moved from about June 2015 to about September 2015, according to my model.  I think that's a lot smaller change than some observers realize.

As we move out on the yield curve, forward rates had collapsed since the beginning of the year, from more than 5% to about 3.5%, and the last leg of that collapse had come in early October, along with collapsing inflation expectations.  But, with the rate drops this week, the forward rates at the long end of the curve actually held their own.

I suspect that the long end of the curve is partly a comment on the odds of being stuck at the zero lower bound.  Long term rates have shrunk by about a third, and the slope of the curve during the rate hike phase (2015-2018) has also dropped by about a third (from about 34 to about 23 bps per quarter).  This could represent a bifurcated expected outcome distribution, with a 2/3 chance of seeing rates increasing at more than 1% per year starting sometime around 2015-2016 and topping out at around 5%, and a 1/3 chance of never leaving zero.  (The slope still seems a little low, which I attribute to a weak housing credit market.)  Anyway, if this is a true reflection of market expectations, then the flip out this week may not have reflected any increase in the odds of staying at zero.

All in all, I would say that this week's move signals some confidence in forward monetary policy.  Let's hope that's true.

More Amazing Stuff on Labor Force Participation from the Atlanta Fed

Here is a link to some great labor force participation data from the Atlanta Fed. (HT: EV)  Be sure to check out all the information on this page, too, including the interactive chart and the downloadable data.

Here are a couple of graphs.  But there are tons more.

I think this data generally backs up the notion that much of the decline in LFP has been age related.  I have attributed the disability problem mostly to aging, but the data here makes it clear that there has been a sharp increase in disability, even after adjusting for age.  In fact, among prime age workers, while most employment indicators are now improving, disability is still growing as a reason for dropping out of the labor force.

In the second graph I have posted here, most of the decline in Prime Age LFP in the "Don't want a job" category is due to higher disability claims.  Part of this is due to the unusually large number of 50 year+ workers in the population distribution right now.  But, part of this is due to an increase in disability claims within that age group  (Paging Benjamin Cole!).  Prime-Age includes 25-54 year olds, and much of the decline is due to more schooling at the low end of the age group and more disability at the high end of the age group.

Most of the increase in disability claims during the recession has been among the older working age population, but disability since 1999 has increased across all age groups.

Anyway, don't stop with my post.  Go to the links.  This is great stuff for data nerds.

Wednesday, October 15, 2014

Forward Rates and the Business Cycle

Interest rates have taken a dive recently.  This has mostly been at the long end of the curve.  Here is a kind of messy graph of expected future changes in interest rates (assuming pure expectations) and realized changes in rates.  Forward rates appear to have been a fairly unbiased predictor of rate changes in normal times, but they have tended to overstate forward rates at the extremes.  While flat yield curves have predicted economic contractions, ensuing collapses in interest rates have been much more negative than predicted by the yield curve.


One question is, does the recent decline in rates foreshadow a coming contraction?  I would say, according to the first chart, no.  A fall in the long term yield slope is not unusual, even in the early stages of rising short term rates.

In the past few cycles, the recoveries ended with short term rates that rose higher than the yield curve had predicted, then collapsed.  The same pattern happened in the mid 1990's, but we avoided the recession in that episode.

Here is another view of recent rate movements.  This is from Eurodollar markets.  We can see here that expectations about rate increases in the near term have been very stable since the beginning on QE3.  The June 2016 contract has been relatively level since late 2012.  Both long rates and near term rates rose in the summer of 2013, which I consider to be evidence that those movements were a product of improved expectations, and were not related to tapering issues.  But, once, tapering began in late 2013, long term rates began a long decline.  The recent decline worries me, because we are seeing a correction in equities at the same time that we are seeing rates fall across the yield curve.

Here is another view of yield curve movements during the current year.  Here, again we can see that the character of rate increases in the 2015-2017 time frame has been fairly stable.  But long rates have been on a relentless, steady decline.  They are almost down to the ridiculously low level I had expected of them, though I didn't originally expect it this quickly.  I had been positioning for a strong economy this year that would push rates up more quickly than the yield curve predicted.  In effect, I was ready for that bump in rates that we saw at the end of recoveries in the first graph.  But, I have become worried about credit markets in the near term because real estate credit hasn't seemed to have picked up its own steam in the face of the end of QE3.  So, I think we could have a catastrophic period ahead if rates continue to collapse and the Fed delays further accommodation.  It is possible that real estate credit regains momentum and my original yield curve forecast still could hit the mark.  It is also possible, I think, for the economy to have enough strength outside real estate to help us muddle through for a while, in which case rates and inflation might remain low for a couple more years, followed by a delayed rebound in rates.

Here is one more chart, which compares the 3 month rate with the (5,2) forward rate (the rate from,  roughly, year 5 to year 7).  Here we can see the yield curve recession indicator.  The three recessions in this period happened after the short rate hit the same level as the forward rate.  But, I think this graph is interesting, because we can see that in 1984 and 1994 the Fed raised short rates up to the level of the forward rate.  The reason forward rates remained above the short rate was because the forward rate rose along with short rates, and the Fed stopped raising short term rates when the forward rates started to decline again.  But, in 1988, 2000, and 2006, the Fed kept raising the short term rate even as forward rates were falling or remaining level with the short rate.

The worst case scenario is that the forward rate keeps falling even without any short term rate increases.  That was happening before QE3 helped boost forward rates.  The forward rate has a smoother trend than constant maturity treasury rates, because it doesn't include the volatile short part of the yield curve.  (I have bootstrapped treasury rates to estimate the forward rates.)  If forward rates fall back to 2012 levels of below, that will probably be a bad sign.  If they don't, then the interaction of the short term rate with the forward rate might be something interesting to watch.

Tuesday, October 14, 2014

We really have no idea what we're doing

This would be baffling if it wasn't so predictable.  The New York Times reports of concerns among global leaders at last week's IMF meeting:
As economists and politicians heap pressure on global central banks to continue, and even escalate, their unusually loose monetary policies in order to spur global demand, the fear that these measures could provoke another market convulsion is spreading. 

“A major lesson of the last crisis is that accommodative monetary policy contributed to financial excesses,” said Lucas Papademos, a former vice president of the European Central Bank. “We are pursuing a similar policy for good reason. But there are limits — if you do this for too long, risks in the financial markets will materialize.”
Inflation is low and collapsing, households have undertaken unprecedented deleveraging, low risk bonds pay little to nothing, equity premiums are very high.....on and on and on.

And our best and brightest think monetary policy has been "unusually loose" and think our major concern right now is too much risk-taking because financial institutions are going farther and farther afield to bid up safe assets.  I think everyone agrees that the 1970's was a period of loose monetary policy.  What exactly is going on now, in terms of financial risk taking, that mimics the 1970's?  If loose money is the key factor, this should be an easy question to answer.

We tend to think of interest rates and risk premiums in an additive fashion.  We start with a risk free rate and add risk premiums to model risky assets.  I wish we, instead, began with a benchmark required return for assets and then thought of the rate on debt as a discount from that required return.  It looks to me like the market asset real required return has been fairly stable over time.  If we looked at it this way, then we would now say, "Short term risk free bonds are paying an 8% discount in order to avoid exposure to manageable cash flow risk."  It would be easier to think of increases in debt ownership as a flight from risk.  High corporate profit levels are, in part, a product of a huge pool of risk averse savers saying, "Hey, if you're willing to take the residual risk, you keep the profits.  Give me 1% a year, and leave me out of the rest of it."  Since corporations tend to deleverage when debt rates are low (and are currently not very leveraged), some savings is drawn back into equity (because it is now less volatile) and into non-corporate debt.

This is why the tendency to demonize the financial industry seems so dangerous to me.  Market prices contain a wealth of information, which we frequently misinterpret.  (Why would we expect to always understand it?).  We view investors as some sort of Frankenstein monster in a tux, and we demand that it be controlled by committees that can't tell the difference between loose and tight monetary policy.

Here is an educational video about the politics of finance and monetary policy.


Friday, October 10, 2014

Some data on households & housing

Commenter "Glenn" had some input on this post.  He motivated me to check up on some Census data.  I thought what I found was interesting enough to include on a bonus weekend post.

Here is a graph of vacancies:

I think this shows a bit more of a weak supply / strong demand signal than Glenn does.

But, then I looked up household size, which I hadn't looked at for a while.

I would have expected a sizeable hump from this recession, due to the tremendous drop in new home production.  There was a hump in 2009 and a small bump up in 2013.  But, I can't say that there is an obvious deviation from trend.  In fact, I think this is a data point against my (on hold) bullish call on homebuilders.  The decline in household size has added significant housing demand in the past few decades.  Between the probable minimum level that is likely close to the current level, which should prevent further falls in average household size, and a population pyramid that probably points to more growing households over the next couple of decades than shrinking households, this should flatten out, which might be another reason to expect somewhat lower home demand than we have seen in the recent past.  Baby boomers are mostly already in "empty nest" phase, and their children are still early in family-building phase.

At this link, there is a graph of household formation that is updated monthly.  It shows household formation regaining momentum after a weak 2013.

This is a fun graph, as there is fodder here for any framing.  The rise in homeownership could be attributed to baby boomer lifecycles, but the trend suspiciously turns sharply in 1994, when interstate banking expansion was tied to CRA incentives.  But, homeownership leveled off before the steepest part of the home price/rent ratio run up.  P/R bottomed out back at 1990's levels, which seems about right to housing bubble folks.  But it is still below the ratio of the late 1970's, when real rates were previously low, but nominal rates were in the double digits, which confirms the bias of a housing bull like me.

Evidence is Optional for Finance Cynics, a continuing series: Cash Flows to Owners

While I'm complaining about the fact that everyone seems to be wrong about everything, let's talk about cash flows to owners - dividends and share buybacks.

Everyone from Matthew Yglesias at Vox to the Economist are worried about massive buybacks and how this means that corporations are just pocketing your cash instead of investing in America.
Yglesias:  "It means that the basic link between healthy corporate profits and a healthy middle class is broken."
The Economist: "Share buy-backs - Corporate cocaine"
I don't want to even get into the conspiratorial tone with which buybacks are usually treated.  It's simply a return of capital to owners, no different than dividends.  The main adjustment it does demand from us is that historically dividends were the primary method for returning capital to owners, so that indexes, like the S&P500 or the Dow Jones Industrials, which tracked share prices over time also served as decent proxies for the growth of capital.  But, buybacks cause return of capital to be treated, mathematically, like capital gains.  Buybacks have gained favor in recent decades.  So, in order to compare capital growth to other measures of wealth or income, equity indexes need to be reduced by the amount of buybacks.  At this point, return of capital is causing index returns to be overstated by more than 2% per year as a measure of retained capital, which really adds up over time.

I repeat, this is simply a mathematical adjustment that needs to be made for analysis.  Total returns are unchanged, except for this arbitrary change in accounting for them.

But, forgetting all the misconceptions surrounding buybacks, the more basic point is:  There is NOTHING unusual about the current levels of payouts to equity holders.

Here is an excellent article by the inestimable Aswath Damodaran going over the basics of share buybacks.  Here is one of his graphs, showing the total level of corporate payouts to owners over the past 30 years.  The level of payouts is slightly below the levels of the 1980s.

I think arguments can be made for either looking at net payouts or gross payouts.  But, with net payouts between 3%-4% and gross between 4%-5%, both are moderate.

What if we look at a longer time frame?  Here is 150 years of dividend history, from Robert Shiller's data.  Keep in mind that this is only dividends.  Buybacks have only become popular since the 1980's, so we would compare these payouts to the gross payouts from Damodaran's graph, which were around 6% in the 1980's, dipped to 2% to 3% in the 1990's, and are back up to around 4%-5%.  Historically, payout ratios have rarely fallen much below 4%.  If anything, there is a long term downward trend in payouts to owners, following a range that current levels fall squarely within.

How can there be so many topics where so many people are so confident about things that just obviously aren't so?  Would it be a shocking coincidence if the bad guys in these stories were predictable?

How much human misery has been caused by people who got in the habit of believing things, not based on whether they were true or false, but based on whether they had a predetermined bad guy?  It's kind of the story of human history, isn't it?  I'm excited about biotech, AI, robotics, nanotech, and everything else, but, man, the real breakthrough would be if someone invented a way to point this bias out to each of us in a way that would make us say, "Oh, geez.  You're totally right.  That is what I'm doing.  I will now update my beliefs with this in mind.  Thank you."  Human progress would explode.  The main reason the singularity will happen is because, frankly, the bar is set very low - and I don't exclude myself.  We all purposefully develop strong convictions through gross avoidance of evidence.  It may be the core identifying feature of humanity.

Thursday, October 9, 2014

Framing is Everything: Housing and Monetary Policy

There is some disagreement about the interplay between monetary policy and interest rates.  I will avoid that discussion here.  But, whatever the direction of interest rates (or returns on any security), there are contradictory effects on existing owners and new owners.

If interest rates on a security go up, then for new owners, future returns will be higher.  But, in order to receive higher returns on an existing pool of assets, given a stable cash flow, the nominal value of those assets must fall.  A perpetual bond is the purest mathematical example of this.  If market rates are 5%, and I pay $100 for a perpetuity that pays $5 annually, then if market rates rise to 10%, my perpetuity that pays $5 annually will only fetch $50.  Note that if market rates fall to zero, the perpetuity's value goes to infinity.

So, we have borrowers and creditors; we have current owners and future owners.  As a first order effect, interest rates don't create anything in a closed economy.  A lower rate will mean less income for creditors and more income for borrowers - capital gains for current owners and lower returns for future owners.

It is sadly common for people to frame finance in terms of good guys and bad guys.  This set of contrary players means that commenters can pick and choose from the outcomes above as they people their narrative.  It is surprisingly common to see essays that bemoan low interest rates, because they simultaneously benefit "Wall Street" (by raising asset prices) while hurting "savers" (by lowering returns).  Sometimes, amazingly, "Wall Street" will be cast as the borrower while pensioners are the creditors.  There are so many things wrong here, including the fact that industrial borrowing doesn't rise when interest rates are low.  But, without even getting into the subtleties, savers are Wall Street.  Wall Street is savers.  The idea that "Wall Street" is a net borrower or that it pockets the capital gains from lower rates without suffering the lower returns is wholly incoherent.

The asset class least exposed to risk free interest rates is probably equities.  In low inflation environments, higher risk free interest rates are usually associated with lower risk premiums, and corporate leverage doesn't increase when rates are low, and is fairly stable anyway, so that equity values are only marginally associated with interest rate changes.  Increases in equity prices mainly reflect increased aggregate demand as the Fed reaches policy more optimal for everyone in the face of a negative demand shock.  (Another widely believed pair of opposites is that corporations are binging on easy money to spike their profits and also corporations are sitting on piles of cash instead of investing in the American economy....both at the same time.)

Note that the longer the duration of cash flows on a security - the closer it is to a perpetuity - the more elastic is the price as a function of the required return (the market rate).  A T-bill paying off $100 in one year will only change slightly in price as rates change.  30 year bonds are the longest bond durations we usually see in the US.  Stocks are a type of perpetuity, but since their required returns tend to be higher than bonds because of income uncertainty (decreasing the present value of their future cash flows), and the equity risk premium tends to move contrary to risk free bond rates, their interest rate exposure is usually not so great.  The asset that is closest to a perpetuity is real estate.  And, since real estate rents will rise with inflation, the interest rate that determines broad asset values in real estate is the very long term real rate, which tends to be lower than the nominal rate.

Here, I have used the FHFA All-Transactions Home Price index and the CPI Rent of Primary Residence index as proxies for home prices and rent to estimate an implied real return on ownership of homes, based on a 100 year home life.  Then, I compare this to the 30 year mortgage rate (minus core CPI), using the 30 year mortgage as a proxy for the required rate of return.  The difference between the implied return and the real 30 year mortgage rate is an estimate of alpha (excess return) to home ownership.  In many financial markets, we would expect this to be arbitraged away.  Frictions to arbitrage include the advantages of owner-occupation, tax preferences for owner-occupants, lack of access to credit for potential owner-occupants, etc.

The absolute level of return is arbitrary.  I am assuming that the costs of ownership are stable over time as a proportion to rent.  If this assumption is relatively benign, then the relative level of excess return should be comparable over time, given an assumed proportional cost.

The first pair of charts assumes low costs of ownership, and thus high alpha to home ownership.  We see that in the low interest rate environment of the 2000's, access to home ownership spread, which led to a decline in alpha.  Price to Rent ratios collapsed in the crisis, as well as long term interest rates, so that alpha to home ownership is again very high.  The alpha isn't the result of difficult monthly payments, as it had been 30 or 40 years ago.  It's due to the dead real estate credit market.

This is why cash and investment buyers have been such a large part of the market.  The level of alpha has been high enough that home ownership provides excess risk-adjusted returns even without the tax benefits of owner-occupation.

Let's say that this version of the model understates costs of ownership.  Interestingly, since this leads to lower implied returns, the cash flows discounted from the future rent payments are relatively larger, the duration of the home itself is longer, the home is more like a perpetuity, and thus the intrinsic value of homes is improved even more by today's low real long term interest rates.  So, an assumption that implies a housing bubble (negative alpha on homes) also implies that current alpha on homes is very high.  In other words, regardless of how much excess returns home ownership provided in the past, it is currently providing very high excess returns.

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Here's my point, regarding framing (no pun intended).  A common view about the Fed is that they are helping "Wall Street" with loose monetary policy and that one way this happens is through nominal inflation of durable assets.  But, this view is confused by a lack of appreciation for the mathematical relationship between asset prices and implied returns on those assets, which I described above.

For a case in point, look at what we have in housing.  Home prices are low because Fed policy has been too tight.  I think everyone would agree that looser monetary policy would raise nominal home prices.  But, who benefits from rising home prices?  By and large, middle class families.  And, who benefits from low home prices?  Well-funded "Wall Street" investors, who earn excess returns on the homes because of the limited number of buyers.  (You might, rightly, suggest that I have just reversed the double standard that I described above.  But, here, I am referring specifically to excess returns over the fully arbitraged market rate.  We would see a sort of revealed preference, here, if home prices do increase by 10% or 20%, at which time we will almost certainly see many more owner-occupier, mortgage-based buyers, and many fewer "Wall Street" buyers).  And who loses because of low home prices?  How about a million construction workers?  How about young families facing rising rent because of crimped housing supply?

Now, let's just imagine that everyone could fold up their tail feathers for a moment, and stop squawking about winners and losers and good guys and bad guys.  We've got people who would like to buy houses, but they can't.  People who would like to live in houses, but there aren't enough.  People who'd like to build houses, but nobody is hiring them.  All these things happen when the prices are right.  The prices aren't right.  This graph is why.

But, none of these people are going to get the things they want, except those darned Wall Street investors who are raking it in with their real estate investments while we patiently wait for homeowner mortgage buyers to come back from the dead.  I really doubt that large scale non-bank real estate investment funds have single-handedly captured the Fed so that they could grab a few extra points on their rental holdings until things get back to normal.  The Fed is just reflecting the national demand for policy failure.  As a matter of fact, housing speculators are the only participants in this story whose activities are actually helping push things back to normal.

I'd say a good measure of the intellectual sanity of this country would be the number of stories we might see in op/ed periodicals, from left-wing to right-wing, lauding housing speculators for helping workers, renters, and homeowners recover from this mess.  Instead, it seems that everyone agrees that homes are too expensive and speculators are to blame.  But the information in defiance of this belief is clear.  Debt service as a proportion of income is at record lows while mortgage debt as a proportion of home values is still too high.  By these measures, home prices have never been more out of whack - to the low side.  I'm beginning to think that there is no error the consensus wouldn't be willing to embrace.  The data is there.  It's not hard to look it up.  The imbalance here - in the opposite direction of conventional wisdom - is unprecedented.

As a speculator, I appreciate the fact that there is no shortage of those willing to take the wrong side of so many trades, but I'd prefer that we stop cutting off our nose to spite our face.  We are the 100%, after all.

PS. Sober Look with additional comments.