Statistical Shenanigans

 After a tough loss in Cincinnati, in a post-game press conference, legendary Chicago Bears coach Mike Ditka blurted out "Statistics are for assholes!" in response to a reporter's question in which the scribe quoted some game stats. While I'm not in full agreement with Iron Mike's proclamation in this matter, I do believe that there is a general proclivity for individuals and other entities to selectively abuse and distort data to enhance certain narratives, positions, and worldviews. While our major political parties, the Democratic Party and the Republican Party, certainly support differing ideologies, they both are equally guilty of employing opaqueness and diversionary tactics when they are confronted with data that puts them in a negative light. A classic example of this would be the games played by both the Trump Administration and Biden Administration as concerns the unemployment numbers and the new jobs report churned out every month by the Bureau of Labor Statistics.

The BLS unemployment data comes from the Census Bureau's Current Population Survey, which interviews about 60,000 eligible households each month. The main figure, the headline number that voters, market participants, and policymakers hang their respective hats on, is known as the U-3. This metric is deeply flawed and in no way does it accurately measure the health of the economy. It may make politicians look good, but the U-3 measurement is grossly simplified and it distorts the true level of economic hardship. For purposes of the U-3, a person is classified as unemployed if and only if they are currently available to work and have looked for a job in the last four weeks. A part-time employee who might find only one hour of work per week is treated as employed in the U-3 formula. While individuals who've given up looking for work aren't even counted as unemployed. If you have an extremely low unemployment rate because you've got a whole bunch of people who don't think they'll be able to find jobs, that's not a healthy labor market. That's a discouraged labor market. Does reliance on the U-3 make any sense at all?

The BLS has another metric - called the U-6 - that is much more comprehensive and revealing, even though it's rarely if ever, mentioned by the corporate media and economists. The U-6 factors in the unemployed who have given up looking for a job, as well as workers who settled for part-time employment but would rather work full-time. The U-6 rate tends to be at least double the headline U-3 rate. So, why is a single, simplistic unemployment statistic (U-3) used to gauge the condition of the job market? Politics, my friend. Like almost everything related to the economy, it's political. The government would rather announce a jobless rate of 3% or 4%, not 10% or 12%.

And then there is the "True Rate of Unemployment" (TRU) generated monthly by the Mises Institute, a nonprofit think tank, that measures the percentage of the U.S. labor force that is "functionally" unemployed. Using data compiled by the Bureau of Labor Statistics (BLS), the True Rate of Unemployment tracks the percentage of the U.S. labor force that does not have a full-time job (35+ hours a week) but wants one, has no job, or does not earn a living wage, conservatively pegged at $25,000 annually before taxes. The TRU rate currently stands at 24.5%, approximately six times the standard U-3 rate. There are obviously millions of underemployed workers whose jobs pay poverty wages or don't make use of their abilities. The headlines say the job market is strong, but it's not true. We have to start talking about the quality of the work that is available to people.

Next, we'll turn our attention to another government-generated statistic that is consistently inaccurate and thus disingenuous. On the first Friday of every month, the aforementioned Bureau of Labor Statistics releases the "Employment Situation Summary," colloquially known as the employment report, or jobs report. For a couple of years now, seldom without fail, the business media machine has proclaimed blow-out numbers for exceeding expectations. The surprising numbers, almost always to the upside, then proceed to goose the buying fever on Wall Street and even many disciplined investors succumb to FOMO (Fear of Missing Out).

Also seldom without fail, the monthly numbers are revised downward when the subsequent month's numbers are released. The revisions don't garner much fanfare and are essentially ignored by market participants. The size and frequency of the adjustments are most likely attributable to faulty assumptions in the birth/death model for businesses. This subjective estimate for business openings and closings has been totally out of sync with the anecdotal evidence emerging from the labor market. Data revisions have subtracted more than 650,000 jobs over the past 18 months. It should also be noted that negative data revisions usually cluster during recessions.

When one takes the time to do some digging and look under the hood, things don't look as rosy as we are led to believe. The jobs economy is following a pattern that began in December 2023: namely, full-time jobs are disappearing, and the "job growth" reported so enthusiastically by the mainstream media is virtually all part-time jobs. Year-over-year measurements of full-time jobs have fallen into a territory typically associated with recessions. Over the past year, total part-time jobs have increased by 1.4 million. During the same period, full-time jobs fell by more than 1.3 million. Moreover, nearly a quarter of new payroll jobs are government jobs. Are these signs of a robust economy? I think not.

Time to tie a bow on this blog. So, what is the moral of the story? That's easy: Take with a grain of salt, or more likely a boulder of salt, any and all economic statistics released to the public by the various agencies of the United States government.

Financial Repression

 Financial repression is a term and concept that holds practically no familiarity with most Americans. The theory (financial repression) was developed in the 1970s and was initially used to describe bad policies that held back the economies in less developed nations. Although originally associated with countries often referred to as "Banana Republics," we are likely entering an era where U.S. economic policymakers could very well implement financial repression. If this transpires, it will be to the long-term detriment of our economy and the prosperity of most American citizens will be adversely affected.

The national debt for the United States now stands at a staggering $35 trillion, which translates to around $100,000 per person. While the sheer amount is disconcerting in itself, the truly scary statistic is the percentage of Gross Domestic Product (GDP) - 123%. This number was as low as 77% a mere 15 years ago. In historical terms, a high level of government debt as measured as a percentage of GDP can be lowered by one or more of the following:                                                                                                A.) Government austerity programs                                                                                                             B.) Above-average economic growth for an extended period                                                                     C.) High inflation                                                                                                                                     D.) Increased financial repression                                                                                                               E.) Restructuring of debt involving a partial default                                                                       

 If I were a betting man, the bulk of my wager would be placed on "D" above, with some of the bet sprinkled on "C," simply because financial repression offers the path of least resistance for the government to reduce debt.

In a nutshell, financial repression is a gutless, sneaky strategy for the government to channel funds from the private sector to itself to facilitate debt reduction. The government steals growth from the economy with subtle tools like zero interest rates and inflationary policies to knock down its debts. This action results in savers earning rates less than the rate of inflation and is therefore repressive. Other measures include such tactics as caps on interest rates, regulation of capital movement between countries, a tighter association between government and banks, restrictions on entry to the financial industry, and directing credit to certain industries. A couple more direct methods of implementing financial repression would be outlawing the ownership of gold and requiring banks to hold a significantly larger amount of government debt than is necessary for prudential purposes. It wouldn't surprise me to see any of these possibilities come to fruition. 

In a free market economy, capital market interest rates are decided purely by the markets themselves, whereas at times of financial repression, long-term interest rates (bond yields) are kept artificially low by additional demand. The source of this demand and the subsequent buyer of an onslaught of Treasury securities is the Federal Reserve Bank. In addition, in this type of environment, commercial banks and large insurers are also aggressive buyers and holders of government debt. Lastly, issuing debt directly to retail investors, if large in scale and with the specific purpose of lowering yields, also amounts to financial repression. Direct debt sales to retail investors suck out funds from bank accounts. Rather than being intermediated to the private sector, these funds will finance government borrowing. The crowding out of private-sector investment will lead to lower growth and inflation. Ultimately, a lower accumulation of capital will result in limitations to the supply side of the economy. When there is a rise in demand, this will lead to higher inflation.

There is historical precedence for financial repression in the United States as a solution to reducing the public debt burden. Following the Second World War, the Federal Reserve pegged interest rates on government debt at a low level until 1951. Thereafter, the Fed kept interest rates below the level of inflation for several years. While the combined borrowing during the Great Financial Crisis (2008-2009) and the Covid-19 pandemic (2020-2021) probably is responsible for over one-third of our national debt, we cannot continue to spend money at the federal level at amounts we have witnessed over the past couple of years. We simply are no longer in a financial situation where we can do everything for everybody.

One pronounced side effect of financial repression is that it enhances wealth disparity and increases social inequality between segments of the general population. People with financial assets benefit under a regime of financial repression while those without tend to suffer. Those with modest savings accounts earning less than the rate of inflation are penalized. Meanwhile, holders of equities are rewarded. The great majority of modest-income savers do not have the financial resources to take on equity exposure to a significant degree. Whether intended or not, the minority with equity investments are disproportionately benefiting from the constant monetary stimulations that have flooded liquidity into the system over the past 15 years.

                                                                                                                                                                                                                        

The Fed Is Royally Fucked

Note: Although posted in July 2024, this blog was actually written in April 2024. 

The Federal Reserve Bank currently finds itself between the proverbial rock and a hard place. The Central Bank believes it needs to cut interest rates because our debt-riddled economy can't function in a high-rate environment. But the Fed can't plausibly cut rates with price inflation still far above its target of 2%. The Fed's obsession with targeting a 2% inflation rate makes little or no sense, but that is a subject for a different time. Suffice it to say that most consumers, including myself, would prefer an annual inflation rate of -0- to 1%.

I can't recall a period in American economic history when monetary policies implemented by the Federal Reserve Bank were at such odds with the fiscal policies as determined by Congress. It makes no sense whatsoever. While the Fed has been taking action over the past couple of years to cram the inflation genie back into the bottle with higher rates and QT, Congress has opened the floodgates and spent money like a drunken sailor. Back in the day, sailors would come ashore after a long time at sea and go on a wild spending spree. This spend-thrift behavior was constrained by the amount of their paycheck. Unfortunately, Congress is not faced with similar limitations. The best analogy I've heard is that while the Fed is pushing hard on the brake to tighten economic conditions, Congress is pushing even harder on the accelerator to loosen conditions.

Large fiscal deficits and deficit spending are here to stay. It is past the time when federal politicians and relevant federal bureaucrats should publicly acknowledge that the current national debt of $35 trillion will never be reduced absent a default event. An explicit default is unlikely. The more likely occurrence is that the federal government will implicitly default on the debt. This will be done by creating inflation, monetizing the debt, and implementing financial repression. Please note that a future financial blog dedicated to financial repression will be forthcoming shortly from the same author who drafted this paper.

Although it remains perennially murky, cloudy, and foggy - my crystal ball provides snippets of our macro-economic future: In an era of consistently excessive federal spending, long-term bond maturities may outright reject the Fed's attempt to push down interest rates on the long end. This will throw a wrench in the machinations of the central planners. Instead of the cliche, "Don't fight the Fed," we may see "Don't fight the bond market." For now, however, we have entered an era of fiscal dominance. Debt service interest payments are approaching $1 trillion per annum and already represent 20% of federal expenditures. At current spending levels and interest rates, it won't be long before the national debt strangles the economy. At that point, the Fed will be forced to forsake its mandate of price stability and surrender to the erosive forces of inflation. At a time when it should be further raising interest rates, it will revert to artificially depressing interest rates to feed the debt monster created by irresponsible and clueless politicians.

The remainder of 2024, in particular the second half of the year, should be very interesting for the financial markets. Look for the Fed to reduce their monthly Quantitative Tightening (QT) by 50% during the summer months, followed by a cessation of QT within a couple of months after the initial 50% reduction. Wall Street and our feckless federal politicians have been clamoring for a reduction in interest rates for several months now. I believe they will get their wish a month or two before the elections in November (2024). The first rate cut and the bond market's reaction shortly thereafter will be extremely telling. Say the Federal Open Market Committee (FOMC) votes to reduce the Fed Funds rate by 25 basis points at their September 2024 meeting. Two weeks after this move, investors should check the yield on 10-year Treasury securities. Did the 10-year yields drop, stay the same, or go up? I predict the bond market will respond by bitch slapping the Fed with higher yields on the 10-year. This will be monumental and a sign to batten down the hatches.

I am disappointed in Fed Chairman, Jerome Powell. Although I prefer his leadership to his predecessor, Janet Yellen, I feel he has been remiss by remaining silent while Congress attempts to financially ruin the country. Powell contends he needs to stay in his monetary lane and not venture into expressing an opinion on fiscal policy. To a certain extent, that is admirable, but when fiscal management is so egregiously botched as we have witnessed, Powell needs to call a spade a spade and be critical of the politicians who are making it impossible for him to do his job. With the politicization of practically everything, we shouldn't be surprised the supposedly independent Federal Reserve Bank has been tainted, and it could get worse. The 4/27/24 issue of the Wall Street Journal features a page one article titled "Trump Allies Draw Up Plans to Blunt Fed's Independence." Most reasonable people would describe the prospect of Trump influencing interest rates as a horrifying thought. Do we want the "King of Debt" with a past littered with multiple business-related bankruptcies involved with this process? It would be akin to letting the Orange Fox guard the henhouse.

Will Passive Investing Break The Stock Market?

 I don't have the answer to the question appearing above, but many people, including myself, feel this could certainly happen. The trend away from active management and to what's known as passive investing has been ongoing for some time, but in the past decade or two, it has relentlessly picked up steam. With a market share approaching 50%, passive investment vehicles have attained 800-pound gorilla status.

What is passive investing? Simply put, passive funds are funds whose investment securities are not chosen by a portfolio manager. Instead, they are automatically selected to match an index or part of the market. There are two main types of passive investment vehicles: index mutual funds and exchange-traded funds (ETFs). Proponents of passive investing stress the general outperformance in returns compared to the majority of active managers. To date, this claim is accurate. Part of the reason for the superior returns is that the fees charged are much less for passive mutual funds and ETFs.

There is, however, a dark and potentially dangerous side to passive investing. First, it should be noted that passive investing is far from passive. Passive investors continually buy and sell as new money enters the market and old money leaves the market. New companies enter the market in the form of IPOs while old companies leave the market due to mergers and acquisitions. Indices routinely rebalance and reconstitute their holdings. As such, passive is active. This type of investing has allowed a system to persist that mechanically inflates valuations. It is also a mindless, systemic activity. Passive investors have no interest in the fundamentals of the stocks they purchase. By throwing money at all companies within an index, investors distort company valuations, capital flows, and stock prices. The proportion of price-insensitive market participants has increased which in turn has increased the inelasticity of the market - the ability for prices to change in response to relatively small changes in supply and demand. An important historical filter is being removed from the market.

The largest companies are the least elastic. As they get bigger, the index becomes concentrated among those behemoths. The indices themselves and the market, in general, are becoming significantly less elastic. The top 10 biggest stocks account for more than 36% of the total value of the S&P 500. The five largest companies amount to 27% of this index. And most concerning, the three largest stocks in the S&P 500 - Microsoft, Apple, and Nvidia, make up nearly 21% of its total market value. The argument can be made that passive investing has evolved into a massive momentum-based strategy that arbitrarily pushes up (or down) the prices and valuations of companies in cap-weighted indices. This correlation between market valuations and the flows of passive money will increase in proportion to the volume of passive money in the market.

The United States enjoyed a head start in the passive investment movement and is further along in passive investing than any other market around the world. This helps explain why we ultimately continued to gain share versus the rest of the world. It should come as no surprise that the likes of Blackrock, Vanguard, and State Street led the push to passive investing with their extensive lobbying efforts. A big change came in the aftermath of the Pension Protection Act of 2006. In this bill, 401(k) plans were switched from an opt-in to an opt-out framework. In other words, an employee had to specifically choose not to participate in his employer's defined contribution plan. Another major change at that time was the designation of qualified default investment alternatives, which directed savers to index funds. One can make a persuasive case for how this law and other regulatory changes have corrupted the equilibrium and signaling mechanisms of modern markets.

Although our GDP doesn't support the long-running bull market, the combination of massive government stimulus and passive investing will continue to expand the general asset bubble. Never has the health of the economy and the health of the stock market been so out of sync. You have 100 million Americans who believe their "deposits" in the S&P 500 are safe. I believe they are in for a rude awakening. The world can suddenly change in quite a dramatic fashion. History is replete with market sell-offs, some of great note. I'm not about to make a timing prediction, but mark my words, a Black Swan event, whether it be a financial crisis, a pandemic, a geopolitical conflict, or something entirely novel, the excrement will eventually hit the fan again. On average, the S&P 500 drops over 30% about once every seven years.

A bull market normally ends violently with a bang. At times the equities market simply withers and slowly slides to a point where investors lose a sizeable chunk of their net worth. Models suggest markets are increasingly reliant on employment and the contribution to various 401(k) plans. Job losses attributable to a Recession could reverse passive flows and trigger selling followed by flows out to cover investors' living expenses. Another possible scenario would be Baby Boomers beginning to take out substantial amounts of money from the markets during their retirement years. Demographics are always relevant and at some point, passive investors become net sellers and require liquidity. Ultimately you end up seeing a net redemption that plays the whole value appreciation in reverse. The large index funds hold very little cash. For example, the Vanguard total market index fund is a $1.6 trillion fund with only $80 million in cash. Even a relatively modest amount of negative flow as people request withdrawals from the fund would cause Vanguard to seek liquidity by converting from a net buyer to a net seller.

As mentioned previously, the timing of stock market tumbles is practically impossible to predict. Very few investors are smart enough, or more likely lucky enough, to nail these predictions. Another variable has also entered the scene starting with the Great Financial Crisis (2008-2009). The U.S. stock market in many respects has become the nation's retirement system. In a crisis, the government will feel they can't allow this retirement system to fail. They will intervene aggressively. Measures will be taken to save the system, at least in nominal terms, and thus the can will be kicked, again. However, the buying power of our currency will be further diminished on its way to oblivion.