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The Experimental Economy

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From John Goltermann of Obermeyer Asset Management (pdf format)

The Experimental Economy

On the heels of last Thursday’s Fed announcement, there has been much commentary on the whys and wherefores of a new quantitative easing (the so-called QE3). Rather than re-hashing well-covered ground, I want to instead discuss the potential effects and unintended consequences of this policy and how it may impact the investment landscape going forward.

Suffice it to say that the Fed had its reasons. QE3 evidences a belief in the so-called “wealth-effect” – the idea that one will spend more if he/she feels wealthier – and the Fed also believes it can contain any negative consequences. However, others would argue that it’s another shot across the bow of our foreign lenders that we are willing to engage full-out in a currency war as this policy clearly weakens the U.S. dollar. Because the Fed has embarked on a path with little historical precedent – where a central bank has signaled the intent to expand its balance sheet as much as it needs to – we are all now part of an experimental economy.

Leading up to the announcement, weak U.S. economic data had kept rates low and the bond market strong, while also lifting the share prices of income-oriented investments such as dividend stocks, REITS and MLPs (which are generally preferred by reluctant risk takers). Residential real estate also continued to bottom bounce, but a recent rally in bank equities signaled that bank balance sheets had begun to improve. This all by itself could have caused the credit environment to loosen a bit without quantitative easing, which could have easily led to increasing real estate prices, creating a self-perpetuating positive feedback loop. Of course, the Fed may know something we don’t know.

Remember: In 2007, declining share prices of bank equities revealed a problem in the credit environment and presaged the crash of real estate and stock prices, and the recession of 2008- 2009 (see chart below). Today’s increasing bank equity prices could in fact signal the reverse – rising confidence and improved overall risk appetite.

What is hard to know, however, is how much consumer, business and investment confidence will materialize while we have 1) a highly interventionist central bank, 2) a government that tries to cajole and regulate economic incentives, 3) a lack of clarity on future policy and 4) a price discovery process that has been corrupted by interest rate manipulation.

Ironically, the weak data has juiced commodity prices and gold more strongly than the stock market as a whole because many participants (correctly) positioned themselves for a quantitative easing announcement, which they got on September 13th. As the hope and hype of the iPhone 5 launch occupied the bulk of financial media air time leading up to the Fed meeting, materials, energy and precious metals stocks had been quietly outperforming by a wide margin because a tough economy means an activist Fed.

Although QE3 and a relatively quiet period for euro-headlines have bolstered investor confidence, this has been offset somewhat by recent unrest in the Middle East, vitriolic political rhetoric domestically, and a still-unaddressed fiscal cliff. The end result: many investors continue to sit on their hands while riskier assets rally.

Interestingly, while U.S. GDP muddles along at a sub-2.0% growth rate and while Europe enters a recession, oil prices have held firm at around $100/barrel, copper prices have stayed elevated at $3.85/lb. and the CRB (Commodity Research Bureau) Index is above pre-2008-crash levels (see chart on following page). To us, this signals that 1) it is not the U.S. and European economies that will drive future commodity prices, and 2) when speculators get a whiff of quantitative easing, their first reaction will be to bid up the prices of key commodities in order to hedge themselves. Unfortunately, this latter behavior feeds into the supply chain and hurts those who spend larger percentages of their income on food and fuels. It is for this reason that quantitative easing may simply amp up the level of speculation in the financial system and hurt the middle class instead of juicing the real economy. It could also increase income disparity, which itself weakens the economy, presenting the Fed with the ongoing dilemma of policy ineffectiveness.

While it’s not clear that the Fed can do anything about long-term unemployment, it’s not shy about trying. The Fed has been highly accommodative for twenty years, but unemployment is far higher now than it was at any time during the past two decades. Going forward, the Fed’s stance risks its credibility with its foreign lenders. This is a caution that seems to have been thrown to the wind.

This time, the quantitative easing experiment commits the Fed to buying $40 billion of mortgage-backed securities per month (it didn’t say which securities), a strategy that moves the U.S. economy further away from being market-based, towards one that is centrally planned out of Washington. In addition to judging potential investments based on their fundamental merits and prices (and what the prices imply about others’ assumptions), investors must now also factor in political motivations and central bankers’ economic theories when they decide on their risk allocations (which are the good risks and which are the bad).

As we have often emphasized, by keeping interest rates below the actual increase in the cost of living, people are incentivized to consume now instead of later (when they would have to pay a higher price) and to take risks because of the insufficient returns offered on cash and savings vehicles. Policy essentially forces people to borrow from the future and, as we now know, has in turn caused massive capital misallocations as evidenced by the obvious bubbles in tech stocks and housing.

Where Fed policy has succeeded is in enriching many financial services providers (and businesses within the financial service ecosystem) at the expense of savers and retirees. This is why we see real estate prices in New York, London, Aspen and Cap d’Antibes surging while those in Chicago and Cleveland remain lackluster. This is why we see the market prices for Picassos continuing to explode while the automobile industry flatlines. Those who earn $100,000,000 don’t buy proportionately more cars relative to their incomes than those who earn $50,000. Actions have reactions and not all of them are good!

As we mentioned above, the Fed’s launching of QE signals its belief in the wealth effect. The problem with the wealth effect is that not everyone participates equally, and it doesn’t account for the skewness (pardon the statistics terminology) of wealth. In other words, average wealth might increase, but median wealth decreases because more and more people have lower real incomes while a few people have exponentially increased theirs into the stratosphere, bringing up the average. So long as the cost of living from food, energy and healthcare continues to skyrocket, more people lose their standard of living and unemployment stays high.

One measurement of income disparity is reflected in the chart below:

Without getting into the mechanics of how the Gini Index is calculated, this chart reflects a dramatic increase in income disparity since 1991. A value of zero reflects a population with equal incomes and a value of one reflects maximum inequality where one person has 100% of the income. I have argued that this has not occurred due to tax policy, but rather due to Fed policy. Since 1991, the Fed has kept short-term interest rates below the increase in the cost of living (see chart below). This, in effect, forces savers to subsidize speculators and has exacerbated the problem. Some have argued that what it has really done is impoverish the people of the United States. I don’t know if I would go that far, but QE3 represents the continuation of a policy that has resulted in increasing income dispersion and high levels of indebtedness.

Many consumers have made up for their income deficit with new debt, so Fed policy could also largely account for the excessive overall debt levels that caused the entire financial system to become fragile and attempt to adjust itself in 2008. Now, without real income growth or debt expansion potential, households have a limited ability to fuel much growth in the 73% of the GDP that depends on consumer buying. The irony is that the Fed, through QE, has signed us all up for low economic growth rates, which it is using QE to address. We are not sure how that cycle will break.

It’s also questionable whether Fed policy positively impacts the overall employment situation. If you look at the labor force participation rate, you’ll see that it has dropped significantly under a highly accommodative Fed and is currently at the lowest level in thirty years.

Moreover, enrollment for disability income (SSDI) has skyrocketed since the recession ended in 2009. While certainly not true in every case, disability payments have been substituted for long-term unemployment benefits for some workers who struggle to find employment and drop out of the labor pool. Again, twenty years of an accommodative Fed has seemingly had little positive impact on today’s employment situation.

The point of all this is that while financial markets celebrate the effects of QE3 and bid up all sorts of asset prices, the wealth effect won’t necessarily benefit everyone equally and may further contribute to an income disparity that acts as a drag on the real economy. This has a self-reinforcing political effect as more and more people are forced to sign up for government benefits as their opportunity set diminishes, as interest rates are kept at zero and as economic growth remains low.

Ultimately, it is not our job to criticize Fed policy but rather to manage assets as best as we can, given how the Fed views the world and what it is likely to do. Our investment process on the equity side is to establish positions in well-managed businesses with good assets that have pricing power, but that can also survive and thrive in a slow-growth environment. It is also important to know that the current Fed policy has special consequences and risks.

One of the unintended consequences of such an accommodative Fed is that it has significantly benefitted the economies of, and terms of trade for, our emerging-market trading partners as it essentially incentivizes investment capital to move abroad in search of its highest and best use. This fuels foreign economic development, infrastructure, education and health care systems – making them more competitive on a global scale. We seek to capitalize on this trend (and protect our clients’ wealth) by owning materials firms, infrastructure firms, financiers that do business in emerging markets, agricultural businesses and brands that are highly coveted outside the U.S. And finally, we strongly believe that precious metals belong in everyone’s portfolio in light of the distinct risks that quantitative easing and a weak dollar bring. To deny these risks and avoid an allocation to precious metals could be extraordinarily risky as the grand experiment continues and the outcome remains uncertain.

 


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Wed, 09/19/2012 - 19:39 | Link to Comment LMAOLORI
LMAOLORI's picture

 

 

Fat Finger my Ass people are rigging our election for this experimental economy

Report: 'Fat-Finger' Trade Led to Oil-Stock Price Swings


Wed, 09/19/2012 - 19:46 | Link to Comment Sofa King
Sofa King's picture

Whatever it was caused bizarre changes in product deliveries in NY Harbor. Shit was being diverted all over the place.
I cry shenanigans.

Wed, 09/19/2012 - 23:46 | Link to Comment Nobody For President
Nobody For President's picture

Maybe Batman didn't really get the Joker.

Wed, 09/19/2012 - 19:40 | Link to Comment vote_libertaria...
vote_libertarian_party's picture

Winning!

Wed, 09/19/2012 - 19:46 | Link to Comment negative rates
negative rates's picture

I reiderate, live and spend every day, as if it were your last. Don't save it, don't invest it, don't try to pass it on. Just simply spend it away.

Wed, 09/19/2012 - 21:26 | Link to Comment Yen Cross
Yen Cross's picture

Little early'PUMPKIN HEAD'?

Wed, 09/19/2012 - 19:50 | Link to Comment Snakeeyes
Snakeeyes's picture

Look. The housing market is stabilized and back at 1997 levels of existing home sales. So, The Fed steps in and is going to dump gallons on liquidity on the housing/MBS market?

Besides, NO MONEY VELOCITY or MULTIPLIER, tight credit, It WON'T WORK!!!!!!!!!!

Experiment in terror!

http://confoundedinterest.wordpress.com/2012/09/18/why-did-the-fed-do-qe...

Wed, 09/19/2012 - 23:38 | Link to Comment dexter bland
dexter bland's picture

"as we now know, has in turn caused massive capital misallocations as evidenced by the obvious bubbles in tech stocks and housing."

The problem with the "Wealth Effect" is that consumers won't spend up big if they don't believe that asset prices represent real value and not just the result of another Fed induced bubble.

Problem is consecutive bubbles and collapses has left everyone a little skeptical, and they would still rather pay down debt than take out another low-rate loan to buy assets or more consumer junk.

The "Wealth Effect" is a psychological phenomenon, it can't be conjured purely through monetary manipulation.

 

Wed, 09/19/2012 - 19:54 | Link to Comment khakuda
khakuda's picture

"Remember: In 2007, declining share prices of bank equities revealed a problem in the credit environment and presaged the crash of real estate and stock prices, and the recession of 2008- 2009 (see chart below). Today’s increasing bank equity prices could in fact signal the reverse – rising confidence and improved overall risk appetite."

 

The difference is that the market for bank stocks in 2007 was more of a free market.  Now mark to market accounting is suspended, interest rates are completely artificial and below inflation, $40 billion of crap mortgages are being removed monthly at any price from bank balance sheets courtesy of the US taxpayer, and there is a too big to fail put under all the major banks post Lehman, etc... 

The bank stocks are being forced up by the force of the government doing everything they have to do to push them up.  It's a rigged game now and that is what it reflects.  It reflects confidence and improved risk appetite inasmuch as the government continues to nationalize losses on the back of the taxpayers.

Wed, 09/19/2012 - 20:05 | Link to Comment LMAOLORI
LMAOLORI's picture

 

 

That rigging also benefit's obama investor's are getting that housing for next to nothing that was planned months ago

Flashback

A Huge Housing Bargain -- but Not for You

Now as a result

Illinois Foreclosures Surging Lure Investors: Mortgages

Distressed Home Prices Jump With Inventory Shrinking

Wed, 09/19/2012 - 19:59 | Link to Comment zorba THE GREEK
zorba THE GREEK's picture

Take all your money out of the banking system/stocks/bonds and buy physical PMs.

Don't play their rigged game. I have done that since 2000, and I sleep like

a baby every night, not to mention, I'm a lot richer too. 

Wed, 09/19/2012 - 19:59 | Link to Comment davidsmith
davidsmith's picture

"QE3 evidences a belief in the so-called “wealth-effect” – the idea that one will spend more if he/she feels wealthier – and the Fed also believes it can contain any negative consequences."

 

Unfortunately, this comments sets the whole kindergarten-ish, Pollyanna-ish tone for this weakbrained article.  There is no evidence whatsoever that Bernanke is buying trillions of garbage debt in order to create a wealth effect.  He is doing to buck up the kleptocracy, and he intends exactly that effect.  If anything, he intends to do what corporatist regimes always intend to do: cut wages, cut spending for the purpose of increasing the control of the regime over the society.

 

What's sad is that commentary like this is now so utterly useless and tends to blind its readers.  No, what you want to know now is where we are in the corporatist protocol, how far along we are to an explicit fascist dictatorship, and where the opportunities are for sabotage.

Wed, 09/19/2012 - 20:09 | Link to Comment LMAOLORI
LMAOLORI's picture

 

 

In what way does truth blind a reader?

QE (quantitative easing) is essentially the printing of money and the addition of liquidity into the markets so that stock (and other asset) prices are given an artificial boost. Federal Reserve Chief Ben Bernanke believes that by pulling up stocks, the masses will feel richer and spend more on consumer goods, thus lifting up the economy. This is based on Karl Marx’s reflexivity theory (George Soros essentially paraphrased Marx) that states by turning the small wheel (stocks), you can turn the big wheel (economy), which in turn will come back and turn up the small wheel (stocks). Bernanke subscribes to such a theory, and he wants QE to lift up the small wheel (stocks), which he hopes will lift up the big wheel (the economy).

Wed, 09/19/2012 - 20:14 | Link to Comment davidsmith
davidsmith's picture

It is not the truth that Ben believes in the "wealth effect."  Ben says that in order to throw sand in your eyes.  The author of this article says Ben believes it in order to throw more sand in your eyes.  

Wed, 09/19/2012 - 21:33 | Link to Comment Ness.
Ness.'s picture

"There is no evidence whatsoever that Bernanke is buying trillions of garbage debt in order to create a wealth effect."

 

Did you actually watch his testimony?  I'm guessing not.

 

"if people feel that their financial situation is better because their 401(k) looks better or for whatever reason — their house is worth more — they're more willing to go out and spend," Chairman Ben Bernanke told reporters. "That's going to provide the demand that firms need in order to be willing to hire and to invest."

 

 

Definition of 'The Wealth Effect'

The premise that when the value of stock portfolios rises due to escalating stock prices, investors feel more comfortable and secure about their wealth, causing them to spend more.

Read more: http://www.investopedia.com/terms/w/wealtheffect.asp#ixzz26yALRD7Q

 

Wed, 09/19/2012 - 20:08 | Link to Comment roadsnbridges
roadsnbridges's picture

"The Fed has a reason"

Yeah, the Banksters need mo bonus!

Wed, 09/19/2012 - 20:10 | Link to Comment Ineverslice
Ineverslice's picture

 

 

Take your experiment and shuv it up ur ass.

Boycott and resist.

Wed, 09/19/2012 - 20:13 | Link to Comment roadsnbridges
roadsnbridges's picture

"The point of all this is that while financial markets celebrate the effects of QE3 and bid up all sorts of asset prices, the wealth effect won’t necessarily benefit everyone equally"

Duh.  I repeat, this pig will go up until its returns match the Swiss 2yr.

Wed, 09/19/2012 - 20:13 | Link to Comment davidsmith
davidsmith's picture

It is not the truth that Ben believes in the "wealth effect."  Ben says that in order to throw sand in your eyes.  The author of this article says Ben believes it in order to throw more sand in your eyes.  

Wed, 09/19/2012 - 20:27 | Link to Comment roadsnbridges
roadsnbridges's picture

Algos have no eyes.  It's why they are not people - yet.

Though they do have the stupidity part down.

Wed, 09/19/2012 - 20:17 | Link to Comment kevinearick
kevinearick's picture

So, the economy is in complete flux, elections are irrelevant, all capital and middle class asset moorings are gone, and bernanke is experimenting on the fly, in rapidly accelerating history, where small errors in direction result in aggregious outcomes.

welcome to the open source world of quantum labor...where would you like the elevator to go? Give bernanke some data, to install the negative feedback loop, and see if physical dollars pop out. discount assets to those who were not receiving credit in return for community income and measure the rate of quantum return.

got milk?

Wed, 09/19/2012 - 20:23 | Link to Comment roadsnbridges
roadsnbridges's picture

If "elections are irrelevant", the Communist Libs would not spend so much defeating photo-id laws.

Wed, 09/19/2012 - 23:20 | Link to Comment kevinearick
kevinearick's picture

Nothing any elected politician does will affect change; that's what they get paid for, but change there will be. how it plays out is going to be the best show on earth...

Thu, 09/20/2012 - 01:49 | Link to Comment Bear
Bear's picture

Who ever picks the next FED chief may just have a chance

Wed, 09/19/2012 - 20:26 | Link to Comment zorba THE GREEK
zorba THE GREEK's picture

It took a while, but to grasp the value of the dollar, ponder this; Confederate money is now,

on an average, worth more than face value in dollars. They printed it like Zimbawai money

in 1865 when things were going south fast for the Confederacy. 

Thu, 09/20/2012 - 01:48 | Link to Comment Bear
Bear's picture

I don't have 150 years to wait, since on a long enough timeline the survival rate for everyone drops to zero

Wed, 09/19/2012 - 20:29 | Link to Comment MedicalQuack
MedicalQuack's picture

I think in the longrun it won't do much as retail spending is down and people need jobs to spend money, Fedex just gave a pretty mobid outlook as well on their projections.  If people are not working, they can't spend money.

Meanwhile back the ranch corporations, companies and social media companies are making billions with algorithms that mine and sell our data.  I don't think anyone really sees how huge this business is but take a look at Walgreens in 2010 making short of $800 million - SELLING DATA ONLY!  Now add in banks, traders, HFT folks, social media, credit organizations, the pot is huge. 

No company is going to go out of their way to build a factory, hire employees, etc. when they can hire a few geeks, write some code and algorithms, deploy them and at the same time drag government servers down to a crawl with the over abundance of bots mining the data.  This creares another expense with the states having to buy sotftware to limit the bots or in some cases like in North Carolina they got tired of it and kicked Corelogic out as they had not paid the state to obtain the quarterly updates.  So now as a consumer do you think you know why it takes so long for flawed data to get fixed?  Duh? 

Devaluate the algorithms and give manufacturing a chance to expand otherwise they just sell data too, it is called follow the money and we don't get jobs unless we make it lucrative for companies to build and invest.  Those data mining algos make for billions of profits. 

Read about a couple of companies here and don't miss the video in here that is the documentary about the Quants on Wall Street as the alchemists with flawed and fictional data and math. The quants write the code aka business models and remember even Jamie Dimon had no clue about their business model?  Seems to be contagious and it starts a the top with the banks as those algos have teeth and they move money in the pockets of the billionaires, as they design them to work that way.  Also listen to the quant having little regard for ecnomists too as he says they just use stats and other information from the code the quants write and sell to hide risk.

http://ducknetweb.blogspot.com/2012/09/welch-allyn-device-company-to-cut...

Wed, 09/19/2012 - 20:37 | Link to Comment Tombstone
Tombstone's picture

With fewer people investing in stocks, you can see it in the falling volumes, how will the wealth effect be beneficial?  And if the sideliners do begin to pile into stocks, based on past history, most of the Johnny-come-lately's will be burned at the stake.  Benny is a complete idiot because he fails to realize that the average Joe investor becomes greedy and complacent as markets rise and eventually loses his shirt due to his ego replacing his brain.  The markets are rigged with the reality that only 20% can win and those wins must be supported by the remaining 80% who lose regularly.

Wed, 09/19/2012 - 20:56 | Link to Comment you enjoy myself
you enjoy myself's picture

all the "wealth effect" does is benefit those who already have assets at the expense of those wanting to acquire assets.  all while the cost of consumables goes up for everyone, while wages remain stagnant.  how in the world does creating savings of $25 a month for the subset of people taking on new mortages (or those able to refinance) offset the losses of $50 a month for everyone in the form of increased food and fuel and other input costs?  and why are higher housing prices an inherently good thing according to Ben?  retirees can't get liquid on their home equity if the generation below them can't come up with a down payment because they're getting squeezed.

this is just like the absurd "multiplier effect" that was sold to us during the stimulus - if the coefficient was actually positive instead of negative than it follows that throwing more and more debt into the system would improve output by a predictable amount.  but it didn't, and won't.

 

Wed, 09/19/2012 - 21:21 | Link to Comment Diggintunnels
Diggintunnels's picture

The world will be in flames due to this lunatic.  I hate the fact that 95% of the American public are completely blind to what is going on. If you try to inform them, they look at you as if you are a total nut.  I know a lot of people have thought this house of cards would fall much sooner, but the time is probably very near and the catalyst will most likely be food riots all over the world. 

Wed, 09/19/2012 - 21:34 | Link to Comment Chump
Chump's picture

Society defines sanity, and so I'm sorry to say that you are, in fact, insane.  I accepted this fact myself not too long ago and I feel much better for it.

Wed, 09/19/2012 - 21:38 | Link to Comment Diggintunnels
Diggintunnels's picture

LOL, yes I believe you are correct.  I appreciate the insight to my sanity, or lack thereof...

Thu, 09/20/2012 - 09:36 | Link to Comment WhiteNight123129
WhiteNight123129's picture

THe Fed is not engaged in wealth effect at all.

The Fed is in the process of cornering the Treasuries market so that it can later drip the long end of the curve backwards and force people to dishoard their cash.

The Fed wants to avoid the situation of Japan where the Government bonds are stuck in the hands of people and so the BOJ has no control of hte curve.

SO part 1. Buy all of the bonds,

     part 2 make sure people know you are a crazy printer.

     (As students of the banking school anti-bullionists know higher long end curve always make the cost of production higher while lower rates are deflationary).

    part 3 Have the good guy Fisher warn about inflation expectation moving up

     part 4 Sell a tiny bit of your long end of the curve so you steepen the curve while everyone thinks you are just buying and so people get to believe there is inflation. Cheat on your accounting so that people do not figure it out, buy other stuff so people do not see you are moving the long end of the curve upwards.

     part 5 Get the people to compute their implied inflation data from the curve and worry about inflation

     part 6 People worry about inflation, so inflatio becomes self fullfilling.

     part 7 You just managed to have the people with money forced to spend COrpoartions and Rich (the Richest people control 1.7 Trillions in wealth).

     part 8 People with financial assets (cash bonds ect) convert those assets back in the circulation (wages) forced by the unclogging performed by hte Fed (manipulating inflation expectations and creating inflation by hte same token)

     part 9 Circulation to Debt ratio finally rise nominally, financial assets suck, equities goes up and down, long bonds in bear market for decades

     part 10. Stagflation makes earnings poor, wages up, Gov debt to GDP down, commodities up.

The trick is not to do that too fast to avoid crack-up boom. You just saved hte country, helped the share of wages vs capital reverse course, you fucked the bond holders and the rich, and started a deleveraging.

ANY QUESTION?

 

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