Sunday, January 25, 2015

The Canadian central bank’s rate cuts should put TD Bank on US investors’ watch lists.

TD has many of the characteristics of a quality dividend growth stock

US investors can hold TD shares without incurring direct foreign exchange risk
As a bank with significant operations in both Canada and the US, the weak Canadian dollar could benefit TD bank.

The Canadian central bank’s rate cuts enhance TD’s appeal
A recent (Jan. 16, 2015) article on SeekingAlpha entitled “Toronto-Dominion Bank Analysis Points Toward Growth," provided a general summary of the advantages of TD bank as a growth story for investors considering a Canadian bank.  Rather than repeat that discussion, this posting focuses on characteristics of TD bank that should resonate with US investors.

However, before focusing on characteristics that should be important to US investors, the article makes a point that should be relevant to all investors: “TD's latest report shows profit continuing to be made, but falling shy of analysts' expectations, which those analysts deem a signal of stagnation. Reuters's data predicted $1.05 in earnings per adjusted share and $1.00 per share of net income, but were disappointed when faced with 98-cent profits per share and a 91-cent per share of net income. With these results came a 2.71% decrease in stock price that same day.”  
For short-term investors, missing an estimate is justification for selling, but often for a long-term investor it is an opportunity to purchase a stock that is temporarily depressed because of the short-term focus of many other investors.  I view it in the latter sense and increased my holdings of TD at 10%.  Less that be interpreted as an effort to try to time the market, the balance of this posting focuses on the other reasons for purchasing TD bank shares.  Thus, the earnings miss just influenced the timing of an investment that was planned for a variety of reasons, including the company's long-run prospects as indicated by its fundamentals and portfolio considerations.

For a US investor, the most compelling reason for considering Canadian banks remains the issue discussed in a March 5, 2014 posting entitled “The Widows’ and Orphans’ Portfolio and US Banks.”  If possible, one would want some representative of the financial sector included in a portfolio for diversification.  Canadian banks are subject to far less regulatory risk than US banks.  Reading about and receiving notices concerning lawsuits against you as a stockholder gets tiresome, and one should avoid it if possible.  
When addressing any investment in Canada, the US investor has to keep exchange rates and energy prices in mind.  A good illustration occurs in an article published on January 16, 2015 in the WALL STREET JOURNAL.  It was entitled “What’s the Matter With Canada?” The major thrust of the article concerns Canada's manufacturing sector, but it was impossible for the article to thoroughly address that issue without discussing the impact of oil prices on the Canadian dollar.  The same is true when looking at Canadian banks.  It is how energy prices and exchange rates relate to TD bank's business profile that makes it an appealing investment for US investor who is choosing among Canadian banks.

The first thing to note is that foreign exchange rates do not influence the desirability of TD bank's shares in the same way they would many other Canadian companies.  The shares on NYSE are not ADRs. They are a special class of interlisted securities.   That is true of many Canadian banks. You are buying US shares directly, not ADRs.  So, the US investor is not exposed to foreign exchange risk in the actual price of the stock. 
For TD bank, the advantage of listing on several exchanges is that it allows the company's shares to gain access to more investors and increases a company's liquidity.  The shareholder is exposed to the sentiment of investors in multiple countries.  Thus, the TD bank shareholder has exposure to a foreign stock market without the direct foreign exchange risk.  It is diversification across markets without direct foreign exchange risk in the price of the stock.

Similarly, the US investor holding any Canadian bank has diversified their portfolio to include exposure to a non-US economy.  That is true of any international company whether headquartered in the US or a foreign country.  In the case of TD bank, that exposure is easily quantified: 25% of the bank's retail bank earnings come from the US, 65% come from retail banking in Canada and 10% come from wholesale bank.
Looking at the correlation between the US and Canadian stock market and economies, one sees that the diversification benefit exists, but it is weak.  From the portfolio perspective, that weak diversification across stock markets and economies when combined with the diversification benefit of being able to hold a bank stock without the regulatory risk provides the basis for putting TD bank on one's watch list.

What is important is how foreign exchange rates will affect the profits of TD bank.  TD bank is the fastest-growing Canadian bank. It has a presence outside of Canada that is as large, but not as profitable as its Canadian base. It was the American side of business that specifically concerned analysts.  While only 25% of the bank's retail earnings come from the US, it represents a much larger portion of the bank's retail operation (about 50%) when measured by number of branches.
That TD bank earns a lower return from its US branches is not surprising.  TD bank is essentially exporting services into one of the most competitive banking markets in the world.  It is easy for Canadians to overlook the fact that in the US all one needs is to have 10 bucks and a politician in your pocket, and you can open a US bank.  That TD has been able to compete in that market and maintain overall returns that are competitive with other Canadian banks is very much to its credit.

Like many exporters that have their production facilities in the country where they sell the product, TD bank benefits from the international operation through its impact on its earnings when translated back to its native currency.  In Canadian dollars that 25% of earnings that originate from US operations will increase without any increase in the efficiency or scope of the US operation.  It is, if you will, the opposite of the foreign currency translation that will negatively impact many US multinationals.  From the US investor’s perspective, it is an opportunity to invest in a situation where the strength of the US dollar benefits the holding.
Just as foreign exchange developments justify putting TD bank on one's watch list, energy market developments also justify giving TD bank a close look.  TD bank's footprint is far less affected by energy prices than most Canadian banks.  In the US, TD branches are located in areas that benefit from lower energy prices.  Thus, the retail customers they serve are benefiting and should be better bank customers.  Also, the bank is not overly exposed to commercial loans to the energy sector.

TD bank has relatively limited exposure to the current slumping oil market.  It would be a mistake to view that as just avoidance of a negative situation.  In fact, it creates a very positive environment for TD bank.  The central bank of Canada just cut interest rates which should guarantee that the favorable foreign currency affect discussed above will grow. 
At the same time, one of the concerns regarding Canadian banks is the potential that Canada is developing a housing bubble and a consumer debt bubble.  The lower interest rates that are the central bank’s response to the impact of energy prices on the Canadian economy should, at least temporarily, mitigate any impact of the perceived bubbles.  However, the US investor is aware that the bubble in the US housing market was a product of our institutional framework.  No similar chaotic institutional pursuit of serving consumers who want to increase their leverage seems to exist in Canada.

Lower interest rates are generally viewed as unfavorable to banks.  They pressure the interest rate margins.  However, as discussed in a SeekingAlpha article entitled “Surprise rate cut not yet feeding through in Canada,” TD has not immediately respond by lowering its interest rates.  Until they do, the impact on interest rate margins will not show up. 
It is important to keep in mind that for 50% of TD bank's retail operations, US interest rates are equally important.  If the US central bank raises interest rates as is expected, interest rate margins on the US of TD bank's operations could improve.  That improvement would occur at the same time that a strengthening dollar is making the earnings of US operations appear more significant in Canadian dollars.  The divergence between the policies of the central banks of Canada and the US should ensure that the benefit to TD bank persists for a while.

In summary, TD's appeal applies to both Canadian and US investors to the extent that it results from the interaction of its geographic footprint and the effect of a weakening Canadian dollar.  What is unique from a US investor’s perspective is the ability to diversify across stock markets and national economies without incurring foreign exchange risk directly.  When that diversification risk is added to the ability to avoid the regulatory risk embodied in US bank stocks, it makes TD bank an appealing alternative.  That the impact of a strengthening dollar on TD bank's earnings could be the opposite of the impact of the strengthening dollar on other holdings of multinationals just adds to its appeal.

Friday, January 23, 2015

Rebalancing and Risk

What is tail risk and how does it relate to the stability of the correlation matrix? 

How does it interact with rebalancing?

Is it possible to identify the benefit one gets from rebalancing based upon market developments?

How do oil price fluctuations and foreign exchange fluctuations relate to the benefit of rebalancing?

What are the implications for a US investor’s international holdings?

This posting advances the notion that instability in the correlation matrix is indicative of a rise in the potential tail risk.  Further, the potential for tail risk should inform an investor’s approach to rebalancing his or her portfolio.  The conclusions drawn in this posting may be unique to market fluctuations caused by oil price and exchange rate instability.  The posting does not attempt to look beyond potential consequences of oil price and exchange rate instability.  It concludes by looking at the investment implications of the central thesis regarding the relationship between the correlation matrix and potential tail risk.  Not surprisingly, the conclusions regarding the implications vary dependent upon one's home currency.  This posting focuses specifically on the implications for US investors.

In finance, “risk” is usually equated with volatility.  Sticking with that definition, tail risk would be extreme volatility.  It is important in financial markets because of the phenomenon known as the fat tail: basically, the probability of an extreme event is higher than what one would assume from a normal distribution.  According to that definition, tail risk is just the same as “risk.”  It is the probability that makes it significant.

A second definition of tail risk is a low probability event that has huge consequences.  The second definition does not quantify low probability.  Instead it focuses on the magnitude of the consequences.  However, it is silent on whether those consequences are the volatility of the variable concerned or some other event that is triggered as a result of the low probability event.  Volatility of the variable is illustrated by a tendency for the amount of change to go exponential when it approaches an extreme.  Triggering of some other event is illustrated by, for example, an extreme change in the price of a commodity forcing a government to default on its loans.

The final candidate as a definition of tail risk considers a phenomenon in finance that is extremely important.  It combines elements of the two previous definitions.  It is associated with, and perhaps a consequence of, extreme volatility.  When there is extreme volatility, it is often accompanied by a breakdown in the relationship between different financial assets.  In financial jargon, the correlation matrix breaks down. 

Being statistical measures, how well things are correlated are not a constant.  They fluctuate.  Thus, while a breakdown in the correlation matrix is often associated with tail risk as defined in the first and second definition, it also sometimes occurs without the realization of tail risk.  A breakdown in the correlation matrix can be viewed as a necessary-but-not-sufficient condition for tail risk.

This last definition based upon the stability of the correlation matrix has the advantage that it provides room for recognition of the fat tail of the distribution of  returns and it defines “the event with huge consequences” in terms of financial market performance.  More importantly, tail risk usually proceeds quickly.  By contrast, deterioration of the correlation matrix can be seen before it completely breaks down.  Thus, one can view the deterioration in the correlation matrix as a continuous variable that will change going into a tail risk event as defined in the first two definitions.

The previous posting, “Markets in Motion,” talked about the market volatility in oil prices and foreign exchange rates.  Both phenomena raise the probability of tail risk by all three definitions discussed above.  Historically, extreme foreign exchange rate fluctuations have been associated with equally extreme economic and financial events.  The reason for the extreme importance of foreign exchange rates is simple.  Foreign exchange rates feed through both to the stability of the financial system and the performance of the underlying economies.

Many financial advisors recommend rebalancing a portfolio regularly.  The end of the year or the beginning of the new year is a convenient time for financial advisors to include a reminder about rebalancing.  There is no magic associated with annual rebalancing, but the change in the calendar does provide a convenient marker for financial advisors or investors who need a reminder. 

Rebalancing a portfolio is often presented as a way for an investor to reduce risk that may have developed as a result of differences in performance of different assets.  However, in fact,rebalancing does not necessarily reduce or increase the risk in a portfolio.  Whether it increases or decreases the risk depends upon what assets are being sold and what are being bought.  (Technically it depends upon the volatility of the assets being bought and being sold).  The real reason for rebalancing is to keep the risk-return profile stable at some level initially set to represent the investor’s risk tolerance. 

A previous posting entitled “Does AlgorithmicTrading Make Sense for Small Investors?” discussed the limitations on some of the assumptions associated with the approach when applied across asset classes.  Instability in the correlation matrix was one of the limitations mentioned.  So far, the phenomena discussed in “Markets in Motion” have not resulted in tail risk in this sense, at least not for US investors.  Consequently, for a US investor, rebalancing seems to have achieved the desired results so far in 2015.  For example, as stock prices declined, bond prices increased. (It is worth noting, however, that when one takes a global perspective, rebalancing has not worked for investors in every country). 

However, when examined closely, it can be seen that rebalancing appears to have achieved the desired objective, but that appearance is due to returns.  The point of "Markets in Motion" was that the phenomena being discussed, oil prices and exchange rates, have increased volatility of all assets.  The portfolio’s overall risk has changed if the change in the volatility of different asset classes is not uniform.  It seems naive to assume that the volatility of all asset classes is changed in the same way. 

In order to achieve a rebalancing that maintains the risk-return profile, one has to forecast not just how returns vary with fluctuations in oil prices and exchange rates, but also how volatilities of each individual asset class is changed.  In and of itself, the fluctuations in volatility may make any portfolio of financial assets more risky.  That is true if the fluctuations in oil prices and exchange rates increase the volatility of all asset classes.  It is also conceivable that it would reduce the risk. 

To illustrate using just using US stocks and bonds, in 2014 the returns on stocks and bonds can be represented as follows: the S&P (NYSEARCA:SPY) delivered 13.5%, a broad-based bond index (NYSEARCA:AGG) delivered 6%, long-term Treasuries (NYSEARCA:TLT) delivered 27.3%.  Thus, a portfolio of stocks, bonds and Treasuries would be rebalanced at the end of 2014 by selling Treasuries and increasing stocks and non-Treasury bond holdings.

One way to view that rebalancing is to believe that during 2014 the increase in the value of Treasuries reduced the risk in the portfolio to the point where rebalancing into stocks and bonds was needed in order to restore it to a given risk-return profile.  In other words, the rebalancing is needed to restore the risk that was eliminated in the portfolio by the increase in the weight of the Treasury component.  The alternative is to view the volatility associated with a higher returns to Treasuries as implying that they are more risky than they were going into 2014.  In this view, Treasuries are now viewed as an asset with greater risk than they had at the beginning of 2014.  Selling the Treasury reduces the risk because Treasuries have become more risky assets. 

One could argue that because an investor must anticipating the impact of oil and exchange rates on two variables (the level of asset prices and their volatility) it has introduced additional uncertainty.  That is a real source of increase in risk, but it is not potential of tail risk.  The important change in the risk associated with any portfolio becomes apparent when one adopts a definition of tail risk that involves only financial assets.  For the US, it is reasonable to assume that the increase in the price of Treasuries has increased their potential volatility.  It is easy to dismiss that as just true of any asset that gains significantly in price.

However, one should keep in mind that a significant portion of the increase in the price of Treasuries is a response to foreign exchange fluctuations.  In short, foreign exchange rates have made Treasuries more risky by increasing their price.  But again, that is just normal portfolio adjustment.  Once one starts to think in terms of global investors, one has to realize that each investor has an investment option that is analogous to Treasuries for US investor.  That option is their home country’s sovereign debt.  Some of the investments moving into Treasuries last year, and especially so far this year, moved from foreign countries’ sovereign debt.  However, those flows come from both equity and bond holdings in those foreign countries.  The correlation between stocks and bonds has broken down for those foreigners if funds flow out of all asset classes.

For the US investor, the potential for tail risk is currently concentrated in the international portion of their portfolio.  A previous posting entitled “Funds for AssetClass Diversification” discussed two mutual funds used to achieve international diversification.  The posting also discussed the philosophy behind holding those two funds.  They are treated similarly to any other position.  Thus, mutual funds are not the only way international diversification is achieved.  In addition to the funds there are individual stocks in non-US companies.  The potential of tail risk impacts each fund and individual stock holding differently.  Since this posting has so far discussed rebalancing in terms of asset classes, the balance of this posting will focus on the funds.  Individual stocks will be the subject of future posting.

The two funds in question are Spartan International Index Investor Class and the Lazard Emerging Market Equity Blend Portfolio.  The reader should keep in mind that it is not these particular funds that are at issue.  They were just chosen as representative of an asset class.  That is the role they played in the portfolio, and it is their role in this posting.  So, the issue becomes whether just having a representative of the asset class continues to make sense.

If the hypothesis that volatile foreign exchange rates and oil prices have increased the tail risk associated with foreign assets is correct, neither fund continues to provide the benefits that justifies including it in the portfolio.  In addition to the diversification benefits, the funds also embody a new higher probability of tail risk. An alternative strategy is to focus on specific stocks in non-US companies as a way to avoid the tail risk.  It should be possible to pick countries and companies that are less exposed to the potential of a collapse of the financial system of the country.

Since both funds include equities denominated in a variety of currencies, shifting to individual holdings could increase the currency risk as well as the company specific risk.  However, the tail risk seems to justify accepting the need to bear the foreign currency risk.  The currency risk was always there; picking individual holdings just makes it apparent.  The decision regarding how many non-US stocks and how many currencies have to be represented then becomes an issue of how confident the investor is in their ability to trade off tail risk against more concentrated currency and stock specific risk. 

Sunday, January 18, 2015

Markets in Motion

Pick your poison: no return on safety or more risk on your return. 

Lower oil prices are beneficial for oil consumers whether they be oil-consuming countries or consumers in the US filling up at the gas pump.  That does not mean they are beneficial to financial markets.  The price of a financial asset is determined by the return one expects to earn from holding the asset and the amount of risk or uncertainty associated with that return.  A rapid change in any environmental factor increases the uncertainty associated with the return and therefore reduces the value of the financial asset.
There have been numerous articles about the falling fortunes of the oil sector.  On January 19, 2015 BARONS presented a summary of one analyst’s estimates of how much the earnings of the S&P 500 would be reduced by the reduced earnings of the energy sector.  The estimates do not seem worth quoting since they were developed without addressing the issue raised by the first sentence of this posting.  While the energy sector’s earnings will be reduced, earnings in some other sectors will benefit.  The net result is the introduction of considerable uncertainty into any forecasts of the profitability of a large number of companies.  That uncertainty will repress stock prices.

Thus, the uncertainty introduced by rapidly changing energy prices definitely has stock market implications.  However, the December 17, 2014 posting entitled "Oil Prices" pointed out that the greatest macroeconomic risk associated with falling oil prices would be their impact on foreign exchange markets: “The foreign exchange markets are so big that a major dislocation there can have all sorts of unanticipated consequences.”  The financial market implications of foreign exchange
Furthermore, it is quite conceivable that foreign exchange markets and oil markets could reinforce each other.  They could reinforce each other in terms of their financial market impact even when their macroeconomic impact diverges.  By introducing instability, they both could be contributing to lower stock prices by increasing the risk associated with holding stocks.  That can be true regardless of whether they have a positive or negative impact on the return.
The December 17, 2014 posting went on to note: “One should keep in mind that financial institutions make markets in both currencies and foreign bonds.  If a major financial institution gets caught with excess inventory of the wrong currencies or bonds, dislocation to the financial system could be significant.” One could argue that financial institutions also make markets in commodities such as oil, and therefore, that risk should be noted.  However, as big as it seems, commodities markets are small compared to foreign exchange markets. 

On Jan.16, 2015 WALL STREET JOURNAL was full of stories illustrating just how disruptive unanticipated foreign currency fluctuations can be.  However, the foreign currency fluctuations were only very indirectly related to oil prices.  The topic du jour was an action by central banks, current action taken by the Swiss central bank and anticipated actions by the European central bank and the Fed.  Between in following articles: Swiss Move Roils Global Markets,” Bankers, Traders Scramble to Regroup After Swiss Move,” Fallout From Swiss Move Hits Banks, Brokers,” Europe’s Smaller Central Banks Likely to Cut Rates After Swiss Move,” Swiss Shock Tarnishes Central Banks,” Swiss Bank Shares Plummet After SNB Move,” Gold Shines as Traders Seek Safety From SNB’s Shock Move,” Swiss National Bank’s Franc Move Buoys Dollar,” U.S. Government Bond Yields Fall for Fifth Straight Session,” and UBS and Credit Suisse Earnings Get a Swiss Finish,” one gets an idea of just how important foreign currency fluctuations are. 
The scope includes non-oil commodity prices (e.g., gold), earnings of banks, pressures on central banks in countries like Denmark, impacts on the economies of many nations, government bond yields, stock market prices in some nations, and the reputation of central bankers.  The disruption is not just restricted to turbulence in all those markets, it also involves financial institutions closing their doors (e.g., Global Brokers NZ Ltd.) or having to raise additional capital (e.g., FXCM Inc.).

On January 17, 2015 the WALL STREET JOURNAL reported estimates of the losses of a number of financial institutions.  The article entitled “Surge of Swiss Franc Triggers Hundreds of Millions in Losses” included estimates for Deutsche Bank and Citi.  While the hundreds of millions of dollars involved might seem significant, for US banks they pale compared to the regulatory risk pointed out in the March 5, 2014 posting entitled “The Widows’ and Orphans’ Portfolio and US Banks.”  Nevertheless, they are just one more reason to avoid US banks in a portfolio designed to have a low volatility and a stable return.
Even when addressing issues that seem totally unrelated to foreign currency, it is impossible to ignore a market as large as the foreign currency market.  A good illustration occurs in an article published on January 16, 2015 in the WALL STREET JOURNAL.  It was entitled “What’s the Matter With Canada?” The major thrust of the article concerns Canada's manufacturing sector, but it was impossible for the article to thoroughly address that issue without discussing the impact of oil prices on the Canadian dollar.

It may well be that the decline in US stock prices so far in 2015 is an adjustment to the uncertainty introduced by the volatility in oil prices and currency markets.  It certainly is consistent with the increase in uncertainty or risk associated with holding stocks.  However, when foreign currency fluctuations are involved, there is a significant increase in what is known as “tail risk.”  Countries can default, financial institutions can go broke, and governments can be forced to support their financial system and their economies.  Such shocks are often viewed as exogenous and therefore impossible to predict.
It is true; they are impossible to predict and this posting in no way constitutes a prediction that they will occur in the US.  However, they are not totally exogenous and the ground is fertile for them to occur.  Just that fact will impact the return on financial assets.  The first half of 2015 will provide significant opportunities to investors as companies adjust to the recent volatility in oil prices and currency values.  The next few postings will address their portfolio implications, but what is apparent is that regardless of what adjustments are made in a portfolio, the risk associated with any asset has increased.

 

Monday, January 12, 2015

When the Emperor Has No Clothes.

Government supported scammers

The WALL STREET JOURNAL had an interesting opinion piece by Gerald Walpin on Jan. 6, 2015.  The title “How to Stop a Class-Action Scam” undoubtedly caught the attention of most investors.  The column noted that, “If you own any stock, you know the frustration of getting a notice announcing settlement of a lawsuit, commenced by a lawyer on behalf of a class composed of all shareholders—you included.”
The article points out that generally the members of the class received little or nothing as a result of the suit.  At the same time, the members of the class have to pay the lawyers filing the suit millions of dollars in fees.  The class gets to pay for suing itself.  In essence, the class-action racket is set up to add injury to insult.

The author talks about the class-action abuse in general terms and then goes on to use a specific example: “Case in point: On Nov. 10, 2014, I received a class-settlement notice regarding my Verizon stock.”  Verizon was one of the stocks identified as a part of the “Widows and Orphans Portfolio” in a posting at the beginning of 2011.  It is a part of a core portfolio that has been discussed a number of times since then. 
It is no accident that the suit was filed against the type of company that would be in a portfolio for widows and orphans.  Large-cap, widely-held stocks are the perfect target for these class-action criminals.  The management, constrained by their fiduciary obligation to their stockholders, will settle in order to avoid a costly defense.  In addition, the wide dispersion of stocks ensures that it is unlikely any single shareholder will find the expense of objecting to the outrageous legal fees of the class-action lawyers worth the cost of intervening.  In short, widows and orphans make good targets for this extortion racket.
 
As someone who has managed a portfolio of common stocks for many years, The Hedged Economist has probably been defined as a class member a couple of dozen times. The experience has provided an opportunity to read through many class-action notifications.   It is amazing how totally corrupt and absolutely imbecilic the process is.  In fact, it is so bad that it is difficult to figure out where to start in terms of any thoughts of how it could be reformed. 
What is worse is that the process has been set up so that an individual is unable to protect oneself.  The simple solution would be if government, in its infinite wisdom, would recognize that perhaps individuals are able to judge whether they are victims of the abuse the class-action lawsuit supposedly addresses.  However, instead the government has set things up in such a manner to make it inconvenient to avoid being defined as a member of the class that has been selected to pay the class-action lawyers their ransom. 

In fact, in some instances opting out of the lawsuit requires providing confidential information that an investor may reasonably choose not to disclose.  Clearly, disclosing information such as Social Security number, brokerage account number, name and address (despite the fact that they have already mailed items to you) is not something that should be undertaken lightly.  Especially, when the disclosure is to individuals who have demonstrated that they are probably crooks willing to undertake frivolous lawsuits for personal gain.  At a minimum, they have demonstrated that they are not acting in your interest, and disclosing information to such individuals is more likely to result in harm than benefit.

Since our elected officials have known about this corruption of our legal system for years, one would be foolish to assume that they will address it.  One can hope, however, that the consumer watchdog organization for financial products created as a result of the Dodd-Frank legislation would recognize that stocks are a financial product and stockholders should be protected from this sort of extortion.

Friday, January 9, 2015

A Quick Comment on the Jobs Report

It is unfortunate when ideology blinds observers to the obvious

Friday's jobs report showed a drop in the unemployment rate, a growth in payroll employment, and a decline in the average wage.  Many observers cannot understand why the wage would go down when the unemployment rate and pay-rolled employment indicate a tightening labor market.  The reason is obvious.  However, before one can see it, one has to discard the notion that there is an aggregate labor market.
Unfortunately, many observers, especially economists, are blinded by the Marxist notion that there is a great lump of something called labor.  If you assume all labor is homogeneous and all jobs are homogeneous, then a tightening labor market should increase wages, but no such homogeneity exists.  The theory was wrong when Marx advanced it and it is still wrong.  People are individuals.  Each job requires a different set of skills and contributes a different amount to the output of the organization hiring the individual.
It never occurs to observers that as markets tighten, they increasingly draws in individuals who are less productive, less willing to work, and less skilled.  Not surprisingly, those individuals cannot command the same wages as the individuals who are already employed.
What is surprising about this inability to see the obvious is that there has been considerable handwringing about the loss of skills attended with long-term unemployment.  Also, anyone paying attention has noticed that the unemployment rate among the prime working age population has been consistently lower than the unemployment rate of demographic groups more marginally attached to the labor market.  The young and those with less education, as well as those most inclined to just drop out of the labor market, represent a disproportionate share of the available labor.
Also, as the economy expands it becomes profitable to employ people to work on things that would not be worth it if the economy were not expanding. There is also what is referred to as the composition issue.  Put simply, the composition issue is the question of what firms are hiring and whether those firms are in high wage industries hiring for high wage occupations.
For those who love to see a political issue in any economic data, there is also the impact of the incentives our government provides to employers to avoid hiring people for full-time jobs.  Part-timers tend to earn less than full-time employees.  Finally, lest we forget, wages are quite different from employee compensation, and we have enacted legislation that mandates the substitution of health insurance for higher wages in many instances.
So, let the handwringing continue; it is easier than giving up an obsolete theory.

Friday, December 26, 2014

“It's a Wonderful Life” versus "The Interview"

Get serious

Washington and media are all aflutter about Sony's movie "The Interview."  One has to wonder what they are thinking.  No one has ever represented "The Interview" as worthy of serious minds.  Of course, at this point nobody who's talking about it has seen it.  So naturally, they can speak with authority about the political and social implications of the movie’s setbacks.  Such is the thinking of Washington and the media.
One doubts whether anyone, in Washington, the media, or the general public, thinks, even for a minute, that they would be better informed if they were allowed to watch "The Interview."  By contrast, ever since the very first posting on the Hedged Economist, at about this time of the year “It's a Wonderful Life” has provided a source of wisdom relevant to Washington and the general public.  Perhaps, rather than fretting about "The Interview," we should insist that policymakers take a break and go watch “It's a Wonderful Life.”
Just perusing the WALL STREET JOURNAL on December 20th provided two good examples of instances where “It's a Wonderful Life” would have provided policymakers with guidance they clearly need.  As we all know and are constantly reminded by the media, about six years ago we had a liquidity crisis.  Since we haven't had a change of administration since then, we still have a lot of people in Washington running around like chickens with their head cut off trying to fix whatever led to the last liquidity crisis.  Alas, they seem to have learned nothing from the actual experience of that crisis.  So, my hope is that if they view “It's a Wonderful Life,” the experience may help them to understand what happened.
The news is not encouraging.  For example, one of the lead stories on the 20th was “Bank Bailouts Approach a Final Reckoning.”  It summarized the experience of the Treasury as it completed the sale of its last holding from the assets it acquired during the financial crisis bailout program.  One has to love the media that can describe an investment that makes billions of dollars as a “bailout."  It would seem more realistic to refer to it as a low-risk, low-return investment for the Treasury.

To quote the above article: “The U.S. government closed a chapter in financial-crisis history Friday when it sold its remaining shares of Ally Financial Inc. and shuttered its auto-bailout program, ending the last major pieces of a $426 billion rescue package that saved a swath of U.S. companies but never won public support…. netted a small profit, returning $441.7 billion on the $426.4 billion invested in firms.”
“It's a Wonderful Life” contains a classic scene of the impact of a liquidity crisis.  While in the 21st century their form will change, in the 19th and 20th centuries they took the form of bank runs.  Bailey Building and Loan experiences a bank run.  When George Bailey decides to turn back from his honeymoon and go to the Building and Loan to manage the run, he finds the crowd there waiting for their money.

It seems that Washington wants to join the crowd in the lobby at Bailey Building and Loan.  First, remember when TARP was initially raised in Congress, Congress voted it down.  As circumstances would have it, I was on vacation and watching it with a friend as the vote was taken.  My comment at the time was that just the act of voting down TARP would extend the recession by a couple of years.  The vote would have to be reversed, but it was the sheer folly of Congress’s failure to address the “crowd in the lobby” that would extend the recession.  
As has been pointed out by Mr. Obama and Mr. Bush, TARP helped avert an even more severe recession following the financial crisis.  But, by demonstrating their collective ignorance, Congress raised serious doubts about whether that objective would be achieved.  That kind of uncertainty assured that the financial crisis would be deep and have lasting effects.

That's history.  Perhaps Congress has learned from its experience and realizes there is a role for a lender of last resort.  However, I wouldn't recommend getting one’s hopes up.  It seems Congress missed the little back room conference between Uncle Billy and George Bailey.

When George enters Bailey Building and Loan during the panic, he finds Uncle Billy a bit distraught.  Uncle Billy takes a strong drink and pulls George into the back room where he explains, between stammering that “we’re in a pickle,” that the bank called their loan and has drained their entire cash position.  Congress and a number of our national figures seem to have missed the point.  They believe that the Federal Reserve Bank's efforts to provide liquidity during the financial crisis put Wall Street’s interests ahead of Main Street’s.  Perhaps, Congress thinks it would be good to have such loans called. So, Congress outlawed future taxpayer bailouts as part of the 2010 Dodd-Frank law.  One can't find a stupider law or one that will do more to impede the response to the next liquidity crisis.

Since Congress reversed itself on the TARP vote and will come to recognize the stupidity of placing obstacles in the way of future responses to liquidity crises, what's the harm?  Well, as “It's a Wonderful Life” illustrates, liquidity crises are temporary, ephemeral phenomena.  Once George meets the liquidity demands of the first depositor, he then asks the next depositor what he really needs.  The response is $20.  Clearly, with the simple act of demonstrating the folly of the demand for liquidity, George has shifted the mental state of the depositors from one of panic to a more rational focus on what they actually need. 

If George had to wait for Congress to recognize the liquidity crisis before he would meet withdrawal requests, Ms. Davis would never have asked for only $17.50 and Bailey Building and Loan would have failed.  Alas, because Congress will have to scrap the Dodd Frank restrictions on bailouts before liquidity can be injected into the financial system; Congress may have ensured that there will never be a Ms. Davis.
Many of national leaders didn't realize from the start that the so-called bailouts would make a profit.  They didn't hear Bagehot’s advice echoing across the centuries.  Bagehot’s advice, “to lend freely against good collateral during times of financial crisis and you always make a profit,” has been demonstrated to be successful over centuries of experience.  But perhaps, if our leaders can't learn from history and can't learn from the recent financial crisis, they will learn from watching “It's a Wonderful Life.”
Mary and George recognize a liquidity crisis, identify the opportunity to invest, and as a consequence they save Bailey Building and Loan.  More important than saving Bailey Building and Loan is the fact that their action saves their borrowers from foreclosure and results in a wonderful life.

However, as the article notes: “Criticism has persisted that TARP put Wall Street ahead of troubled borrowers whose housing woes were at the root of the crisis….Less than $15 billion of $75 billion promised for homeowner assistance has been spent.”  It is worth noting the subtle change in terminology associated with that quote.  Note that the author presents the $75 billion as “promised.” That's quite different from the terminology used when discussing other parts of the bailout.  The difference between a guarantee to pay and a promise to pay is important.  A promise is much more likely to be viewed as an obligation that must be met while a guarantee is simply a promise that the obligation will be met if needed.
When discussing TARP loans to banks, one should remember that the Congressional authorization was over $700 billion.  The article reports the actual use of the lower expenditure, $426.4 billion.  One can get lost in the details of the accounting, but clearly the cost of TARP would have been far greater if the Fed hadn't essentially guaranteed liquidity.  Witness how European markets responded to the simple statement of their central bank that they would do “whatever is necessary." 

“It's a Wonderful Life” is more subtle as an explanation of why bailing out the banks worked but mortgage relief wouldn't.  One has to remember that many of the people clamoring for mortgage relief didn't lose the equity in their home.  They never had any equity in their home.  One can't lose something one never had.  By contrast, George Bailey can pay the first of his depositors and insist that it is just a loan, because he knows that the depositor has good collateral, the equity in his home.  Similarly, the TARP loans to the banks made sense if they were backed by good collateral.  The fact that the vast majority of the loans were repaid with a slight profit indicates that the collateral was good.  What collateral could underwater homeowners provide?  Using that simple criteria the Treasury lent to banks against good collateral, and as consequence, they were repaid.
That the Treasury demanded good collateral is apparent from the fact that some of the same people who criticize the Treasury for "giving" banks bailouts also complained that it didn't demand enough from the companies.  The contradiction doesn't seem to bother them.  For example, the article quotes Christy Romero, the TARP special inspector general,  as complaining, dare I say whining, that the Treasury did not get concessions from banks taking funds. “There were no strings on the money,” she said.  Perhaps, she forgot what happened when too many concessions were demanded from Lehman Brothers.  One has to wonder at the audacity of those who can feel that the intervening six years have not influenced their perception of the value of the collateral.

There is considerable potential for fault when it comes to the terms banks were forced to accept under TARP.  Bagehot makes the point that during the crisis the lending should be done at usury rates.  It's a legitimate argument that interest and a claim on future earnings in the form of a warrant wasn't adequate usury.  However, one has to wonder whether those complaining about banks receiving the loans would have been willing to accept similar terms.  It's also well worth noting that many banks wanted to opt out of the program.
Nevertheless, one has to admit that attaching a value to collateral during a financial crisis is a difficult task.  It's well worth noting that George Bailey when bailing out Bailey Building and Loan doesn't bother to try.  He does recognize that Potter’s offer of $.50 on the dollar is a disservice to his shareholders.  Potter has just taken over the bank at this point in the movie making him the perfect evil banker for the rest of the movie.  Perhaps, those who criticize TARP as not having inflicted enough pain on the banks view themselves as modern-day Potters.  The point is George Bailey is proved right in that $.50 on the dollar might clear the market but it hardly is justified once the liquidity crisis passes.

A second article in the Wall Street Journal on December 20th illustrates why this will always be a contentious point.  The article entitled “MetLife Vote Wasn’t Unanimous” discusses the decision of the Financial Stability Oversight Council to give the insurer the “systemically important” label.
Insurance does have a role in “It's a Wonderful Life.”  It is the asset (i.e., collateral) that George Bailey can offer to Potter when George is desperate for liquidity because of a lost deposit.

The Financial Stability Oversight Council’s reasoning is designed to explain their interpretation of “systemically important.”  It reveals much more.  It makes clear why regulators are totally unable to assess collateral during a liquidity crisis. 
So, one is left to wonder: what is the concern?  How could MetLife become systemically important?  The Financial Stability Oversight Council cites as reasons for the designation “the scale of MetLife’s investments and also the extent to which the value of that portfolio can fall.”  In other words, they're using mark-to-market accounting during a financial crisis.  Nothing could be less appropriate, unless, of course, they are going to force mark-to-market accounting on MetLife at a time when it's totally inappropriate.  If that's the case, it is the Financial Stability Oversight Council that presents the systemic risk.  Unfortunately, that seems to be the desire of many of the people who complain that TARP didn't impose sufficient costs on its recipients.

In summary, perhaps the next time Ron Paul or Elizabeth Warren are tempted to go into one of their rants about the evils of the bank bailouts they should instead take a deep breath, go to a quiet place, and watch “It's a Wonderful Life.”  The only thing that would be better would be if instead they would restrict their comments to the evils of Sony's decision concerning "The Interview." Wouldn’t that be a wonderful Christmas present?

 

Wednesday, December 17, 2014

Oil Prices


So, a simple question is what do we now do with cheap oil?  What to sell?  What to buy? 

I would suggest buying gasoline but only if the needle on your dashboard gets close to E. 

The widows and orphans portfolio that was posted on this blog a couple of years ago included Exxon and/or Chevron.  The logic behind holding them is that the dividends would be superior to what one could get in a savings account and would grow faster than inflation or rising interest rates.  The logic still holds.  So, someone who owned the widows and orphans portfolio would not do a thing.  On the other hand, if someone were constructing a portfolio, the current price of Exxon and/or Chevron would present a good entry point. 


As commentators have pointed out, the Saudi's might continue supplying enough oil to keep prices down, what they refer to as “a big sweat.” They have done it before in order to drive out higher cost producers.  If they do, Exxon and Chevron's stock could go down more, but their current prices looks good.  Exxon and Chevron will not be the producers that the Saudi's drive out of business.  It is very unlikely that the Saudi's will even be able to force them to cut dividends.  For a very good analysis of the issue of the dividend safety of various oil companies I'd recommend “Which Big Oil Dividends Are Safe?” published today on seekingalpha.com.


There is one wrinkle.  US is now the second-largest oil producer.  A fair share of the high cost production the Saudi's are targeting is in the US.  Today General Electric outlined the effect of lower energy prices on its energy divisions.  We should anticipate more of those secondary effects on firm supplying the energy industry. 
ECONOMIST magazine had an interesting cover two weeks ago.  The title was "Sheikh vs shale."  It showed a picture of a sheikh and a roughneck standing back-to-back with their gas pumps drawn.  It is an interesting concept.  Shale producers are in many respects the swing supply.  However, unlike the high-cost producers of the past, shale production does not require a huge upfront fixed cost to develop the field.  In addition, although shale may be the swing production, it is not necessarily the highest cost production.  Consequently, shale production can gear up and down fairly easily.  Highly leverage producers may go under and have to sell their fields to that less leverage producers during periods when the industry is gearing back.  But, if prices go back up, those less leverage producers will quickly restore production.

If prices stay down long enough to reduce the drilling activity in shale fields, it may also cause extreme duress for other higher cost producers.  The Canadian tar sands are clearly vulnerable especially given the one-two of the Saudi's unwillingness to support prices and environmentalists success at delaying increases in efficiency of the transportation sector that would allow their production to reach global markets.  However, the greatest risk to the global economy may result from governments that own or have strong links to producers.  That affect is already shifting foreign exchange rates.  The Russian ruble has been an early casualty, but the risk to Venezuela, Nigeria, and to a lesser extent Brazil and Mexico are very real. 

The foreign exchange markets are so big that a major dislocation there can have all sorts of unanticipated consequences.  Today PIMCO’s emerging-market fund is showing the stress caused by significant holdings of Russian bonds.  We should expect more of that.  In fact, a default by one of the government's that has nationalized its oil resources, and thus the risks associated with energy production, is not out of the question.  It is worth keeping in mind that the vast majority of oil reserves are owned by governments.

There will also be many winners and losers among European companies that export to Russia.  For US investors in US corporations, exports to Brazil and Mexico may be more important than Russia or Venezuela.  However, the major risk is not from slower exports.  One should keep in mind that financial institutions make markets in both currencies and foreign bonds.  If a major financial institution gets caught with excess inventory of the wrong currencies or bonds, dislocation to the financial system could be significant.  That is a far greater risk for European banks than US banks.  However, some US banks, such as Citi, are so global, and the banking system of the developed economies are so linked, that financial dislocation is not out of the question.