Wednesday, September 14, 2016

Preparing for contraction

Here's another graph, building on the post from yesterday.  This has federal receipts as a percentage of GDP, unemployment rate, and equities.  (The equities measure is based on real total returns, detrended with a 3% annual growth rate.)

There is a pretty strong correlation between equities, unemployment, and federal receipts, with equities leading by about 2 quarters.  In real, total return terms, equities peaked in late 2014.  Federal receipts peaked in 2015.  The unemployment rate has been flat for nearly a year.

Meanwhile, the yield curve is flattening.  In 1995 and 1998, the yield curve flattened, and the Federal Reserve lowered interest rates, easing their relative posture, which, in both cases caused long term interest rates to reverse and rise again.  This is a sign of success.  In the late 1990s, the stock market boomed.  This is also, at its base, a sign of success.  Isn't it?  Is there anyone who wouldn't trade today's economy for the 1990s?  I think, in today's self-flagellating mood, this would be considered failure.  Even a couple years of 10% or 15% gains would be met with gnashing of teeth.

Fortunately, we don't have to worry about that.  We aren't going to get a couple years of 10% to 15% gains.  We're slaying that dragon.

In 1995, you can see unemployment bottoming out, then with the timely accommodation, re-establishing its downward trajectory.  There would be plenty of room for that to happen today if we freed the mortgage market.  That would cause long term rates to rise even with today's monetary policy.

In 1998, the economy responded well, too.  And, when the stock market was sky high, labor compensation as a share of GDI was higher than it ever has been since.  And inflation was mild.

Since then, it seems as though the Fed treats falling long term interest rates as stimulus - as a reason to continue tightening.  I have avoided taking a pure defensive position because there is the risk that the Fed would reverse course and trigger a rebound in markets.  But, I have decided that bureaucratic inertia more or less ensures that eventually, another hike will be implemented, and we are already probably too high.

The problem is, I'm not sure where to take a position.  In 1991, a long bond position and some sorts of short positions on real estate would have paid off.  In 2001, a short stock position or long bond position would have paid off.  In 2007, all three positions would have paid off.

The problem is, I don't see much room to fall (or rise in bonds) in any asset class.  For stocks, this looks like 1991, for housing 2001, for bonds, there's just nowhere to go.

Other than leveraged down-market residential real estate, I think the other area where there is potential for a gain is in a position that gains from a low and flat yield curve.  It will take a little bit of creativity.


  1. I think you are right.
    But it could be in a couple years we see US Treasuries at 1% yield.
    So, I guess long bonds is okay.

  2. I'm mostly EMH, so I'd never take a strong position on any particular asset class. Over the last few years I've come to realize as well that forecasting the economy is primarily about predicting Fed mistakes. And for asset markets, I'd then have to predict Fed mistakes relative to market expectations that the Fed will or won't make mistakes. While I'm certain they'll continue making mistakes, I just can't figure out these first, second and third derivative equations. :-)