Bubble world is here

Lance Roberts has a new post with a neat graph:

Screen Shot 2018-07-13 at 7.11.59 PMI like the term “everything bubble”.  For a number of years I’ve been claiming that the 21st century would be full of “bubbles” that were not actually bubbles.  In other words, asset valuations would be higher than expected based on traditional valuation methods, but nonetheless justified.  This is from the spring of 2015:

In the 21st century, pundits will be unable to see anything other than recessions and “bubbles.”  There will no longer be periods of stable growth without “bubbles,” like the 1960s.  Of course bubbles don’t actually exist, but low interest rates as far as the eye can see means that asset prices will look bubble-like unless artificially depressed by a tight monetary policy that drives the economy into recession.

Of course we were told back in 2015 that this was all an artificial bubble due to QE, which is now being withdrawn as the Fed raises rates.  And yet asset prices keep rising.

Back in 2011 I challenged Robert Shiller’s pessimistic take on stock prices:

But (seriously) are stocks now overvalued?  Because I’m an efficient markets-type, the only answer I can give is no.   So why does Robert Shiller say yes?  Apparently because the P/E ratio is relatively high by historical standards.  And he showed that for much of American history investors did better buying stocks when P/Es were low than when P/E ratios were high.  Of course hindsight is 20-20.

I’d rather not get into the minutia of all the various ways of calculating P/E ratios.  And I have no idea where stocks are going from here.  Instead I’d like to focus on three arguments for relatively high P/E ratios in the 21st century American economy (however you’d like to measure them):

Of course I was careful not to predict rising stock prices, as if I had been successful it would lower my reputation.  I’m an EMH guy who claims it’s impossible to forecast stock prices.  But I did challenge Shiller’s claim that P/E ratios were too high in 2011.  That judgement may have been valid in the 20th century, but performance in past centuries is no guarantee of performance in the current century.

Again, the 21st century is the “bubble” century.

PS.  I was amused by this exchange in a recent NPR interview of Jay Powell:

Ryssdal: Let me ask you then about inflation and about prices which are as you say starting to tick up to where the Federal Reserve wants it to be. I’ll note here that we’re talking at 8:24 in the morning on the day that consumer prices come out. They come out in six minutes. With the caveat that this is going to air now in five, six hours from now, whatever it is, you have the number in your back pocket, you know what the number is. Inflation CPI?

Powell: Well, let’s just say that I do get a look in advance at these things. Yes.

Ryssdal: You’re not going to tell me what it is even though we are not going to air this until —

Powell: Definitely not. Definitely not.

Ryssdal: Score one for the chairman’s adherence to the rules.

Powell: Not going to say anything that would suggest what it might be.

Not even a tweet?

HT:  Pat Horan

The market and the Fed

Stephen Williamson recently made this observation:

As a side note, I thought the part of the FOMC discussion where the staff gives a presentation relating to an alternative indicator – the difference between the current fed funds rate and what the market thinks the future fed funds rate will be – was good for a chuckle. If the FOMC thinks the market knows more about what it’s going to do than what it knows about what it’s going to do, we’re all in trouble.

I have the opposite perspective; we are in big trouble if the FOMC thinks it knows more than the market about what it will do to rates in the future.

Back in late 2015, the Fed began raising their target interest rate.  At the time, they anticipated another 4 rate increases in 2016.  Markets were skeptical, expecting only about one rate increase in 2016.  In fact, rates were not raised again until the very end of 2016.  That’s because economic growth and inflation during 2016 were below Fed expectations.  The markets were correct on this occasion (not always).

If you want an efficient estimate of the future path of interest rates, look at the market forecast, not the “dot plot”.  The dot plots are primarily useful as a measure of how deluded FOMC members are in their appraisal of the economy.  Because they were too optimistic in late 2015, they set rates too high.  That slowed the recovery, and probably tilted the (very close) election toward Trump.  And now, to quote Williamson, “we’re all in trouble”.

Interest rates are now higher than in 2016, but monetary policy is actually more expansionary than two years ago.  To Williamson’s credit, he is one of the few economists who seems to understand how this can be possible.

HT:  Tyler Cowen.

Things that smart people don’t know

It would be interesting to make a list of things that smart people don’t know.  Unfortunately, I don’t have enough paper or barrels of ink.  One of my favorites is trade, where smart people think China is an outlier.  Actually, only tiny Belgium has more balanced trade than China:

Screen Shot 2018-07-09 at 2.16.19 PM

Why don’t smart people know this?  Because they don’t bother looking at the data.

Another misconception is that trade deficits are bad.  This article at National Interest caught my eye:

Trump is right to push on trade. A simple return to anything resembling a balanced international trading system would result in massive gains for the United States. What presidential advisors Peter Navarro and Wilbur Ross call the deficit drag depresses the American economy by about 3 percent overall. That is to say, if international trade were balanced, the American economy would be 3 percent larger than it is now.

I had to read this twice, to make sure my eyes weren’t deceiving me.  The Navarro/Ross argument is based on this equation:

GDP = C + I + G + (X-M)

They assume that if X-M is negative 3% of GDP, then this causes GDP to fall by 3%.  Actually it has no effect, because the negative caused by subtracting M (imports) is exactly balanced by a positive to C + I (consumption and investment).  Every time you buy an imported car, consumption rises by the amount of the purchase.  Every time someone buys an imported truck, investment rises by the amount of the purchase.  If you switch from imports to domestic cars, the labor to produce those domestic cars doesn’t just magically appear on the scene, it gets diverted from some other type of production.  Can reducing the trade deficit boost total aggregate demand? No, for standard monetary offset reasons.  But even if I’m wrong, higher AD has no long run impact on employment, for standard “natural rate” reasons.

Yup, this is all just EC101. And yes, Trump’s top economic officials do not know this stuff.  It reminds me of when freshmen in economics get lost trying to write an answer to an essay question:  “Demand goes up so price rises.  The higher price causes demand to fall.  The fall in demand then lowers the price, which causes demand to increase . . .”  Eventually they give up and stop writing, hoping for the curve to allow them to pass the course.

Irving Kristol, who was a supply-sider, founded The National Interest back in 1985.  Perhaps it’s fortunate he passed away in 2009, and did not have to see what happened to his neoconservative journal.  The article was titled:

Trump Is Right: The U.S. Can’t Lose a Trade War

BTW, Trump supporters who care about trade deficits (do they even exist?) might be interested in knowing that Trump’s policies are making the US trade deficit larger.  Or maybe they don’t care.  In fairness, it’s not growing as fast as the budget deficit, which is now rising rapidly. During an expansion.

PS.  The comment section after my previous post reminded me of an old joke.  A guy tells his friend that he has an uncle who insists that there’s an alien from Alpha Centauri who wears a sport coat with pink polka dots, and that lives in a tiny teapot on his fireplace mantle.  The friend responds, “Oh come on, how likely is it that someone from Alpha Centauri would rear pink polka dots.”

Commenters thought the best way to respond to Trump’s latest outrage was to discuss the merits of breastfeeding.

Screen Shot 2018-07-09 at 6.08.15 PM

Bizarro world

No need to even comment on this:

A resolution to encourage breast-feeding was expected to be approved quickly and easily by the hundreds of government delegates who gathered this spring in Geneva for the United Nations-affiliated World Health Assembly.

Based on decades of research, the resolution says that mother’s milk is healthiest for children and countries should strive to limit the inaccurate or misleading marketing of breast milk substitutes. . . .

American officials sought to water down the resolution by removing language that called on governments to “protect, promote and support breast-feeding” and another passage that called on policymakers to restrict the promotion of food products that many experts say can have deleterious effects on young children.

When that failed, they turned to threats, according to diplomats and government officials who took part in the discussions. Ecuador, which had planned to introduce the measure, was the first to find itself in the cross hairs.

The Americans were blunt: If Ecuador refused to drop the resolution, Washington would unleash punishing trade measures and withdraw crucial military aid. The Ecuadorean government quickly acquiesced. . . .

“What happened was tantamount to blackmail, with the U.S. holding the world hostage and trying to overturn nearly 40 years of consensus on the best way to protect infant and young child health,” she said.

In the end, the Americans’ efforts were mostly unsuccessful. It was the Russians who ultimately stepped in to introduce the measure — and the Americans did not threaten them. . . .

In talks to renegotiate the North American Free Trade Agreement, the Americans have been pushing for language that would limit the ability of Canada, Mexico and the United States to put warning labels on junk food and sugary beverages, according to a draft of the proposal reviewed by The New York Times.

I wonder why we didn’t threaten the Russians?

Read the whole thing.

Nasdaq vs. safe investments

This is a follow up to my recent post on the tech bubble.

In my view, 3-month T-bills are the best asset for estimating nominal risk-free returns that can be earned at various moments in time.  During some periods of US history, it’s possible to earn very large nominal risk-free returns (real plus inflation).  During other periods, nominal risk-free returns are depressed by a variety of factors.  During these challenging periods, other investments may or may not struggle to earn high nominal returns.  Usually they will struggle.  (Consider 1929-45).  Nonetheless, it seems reasonable to compare the performance of other investments to this risk-free benchmark.  If you don’t see why, read my previous post, especially the example of why the 30-year Treasury bonds yielding 15% in 1981 was misleading. (A commenter pointed out that those interest payments could not be reinvested at 15%, but it was still a pretty impressive nominal investment, ex post.)

Unfortunately I don’t know how to find the figures I am looking for, but I’ll present my estimates, and then let commenters who work in finance correct my numbers:

1.  A series of investments in 3-month T-bills from the end of 1999:  Roughly a 35% to 38% total nominal return. (Based on a quick look)

2.  Investing in NASDAQ at the end of 1999 (at 4069), then reinvesting dividends:  Roughly a 121% total return.

3.  Investing in NASDAQ at the absolute peak in March 2000 (at 5048), then reinvesting dividends:  Roughly a 78% total nominal return.

My point is not that those Nasdaq returns are all that impressive (especially if you were unlucky enough to buy at the absolute peak), but rather that these returns were earned in a very challenging investment climate, where risk-free returns were quite low.

It’s not obvious to me that the difference between 121% and 37% isn’t enough to compensate investors for the extra risk from Nasdaq stocks  compared to long term investments into a series of T-bills.  As I mentioned earlier, the excess returns earned by stocks from 1926 to 2000 were probably excessive, in retrospect, even accounting for risk.

Here’s how I’d put it.  In 2002, the consensus view was that 2000 had obviously been a bubble, and that Nasdaq stocks were obviously grossly overpriced at that time.  Given what we know today, a fair-minded observer would say that Nasdaq stocks may have been overpriced in 1999-2000, but it’s no longer a slam dunk that an extreme bubble ever existed.

PS.  I tried to find total returns on Nasdaq, but could only find them for the past 10 years.  During that period, 10,000 invested in Nasdaq, with dividends reinvested, rose to 36646.  But the index itself (ignoring dividends) rose by a smaller amount.  Thus 10,000 invested 10 years ago would now be 32750, if you ignore dividends.  The total return figure of 36,646 is about 11.9% higher than the simple increase in the index, over the past 10 years.  So it seems reasonable that over 18 years the total return figure (including dividends) is about 20% higher.  Thus you’d want to calculate total returns as if Nasdaq were about 9000 today (not 7500) relative to investments back at the end of 1999.  Does that make sense?  That’s how I got my estimate of total returns.

Of course real returns would be lower, but they’d be equally lower for any alternative investments (such as T-bills), so it would be a waste of time to work with real variables, even if the inflation numbers were not unreliable.

PS.  Why don’t our history books call July 2002 to April 2003 a “negative bubble” for Nasdaq?  It ranged from 1100 to 1500.  More importantly, why isn’t there even a word for negative bubbles?

PPS.  Even more importantly, why isn’t there even a word for big plunges in NGDP growth?

Happy 4th of July to my American readers.