Saturday, September 5, 2009
Rationality of Markets
Economists assume markets are rational and when they don't function smoothly conclude that markets are therefore irrational. This is flawed understanding of markets. It is better to say that the market is Darwinian: Market actors adapt to the circumstances based on the environment around them. The survivors are those who best adjust to or fit within the market. The losers are those who are unable or fail to adapt.
Thursday, June 18, 2009
What is the real economic picture?
Over the past few months the stock market (defined using the S&P500 index) has sharply bounced off its March 9th lows on the anticipation of "green shoots" that the economy has bottomed and is in the process of recovery. However, most of the data has not been of actual improvement, but of the less bad variety. Bulls have taken these second derivative indicators to mean that it is now safe to go back into the stock market.
Is the worst is behind us? Or is there still more pain to come? With the S&P500 index above 900, the market is no longer cheap, so there is still downside risk that we might be in for another dip or two before we recover. We need to examine the data more closely before we can judge who is right, bulls like Jim Cramer or bears like Nouriel Roubini.
The unemployment rate is often called a lagging indicator because employers are slow to fire at the outset of a downturn and slow to hire at the outset of a recovery. Therefore, to be ahead of the curve, investors use other data to signal a change in the direction of the economy. However, should they? Might one measure of the unemployment rate be or even leading indicator of the economy and a coincident (parallel) indicator of the stock market?
The Bureau of Labor Statistics releases six measurements of unemployment from U1 to U6. U1 is the least bad rate and U6 is worst rate. U3 is considered the official unemployment rate though it only counts those who are out of a job, but are actively looking for work. The broadest measure of unemployment (U6) captures discouraged workers and those working part time who would rather work full time.
I believe U6 rather than U3 is a better predictor of the turns in the economy because it tells us the state of the entire workforce, not just the proactive subsection of workers. I have found using the year-over-year change in U6 is a highly accurately gauge of where the economy stands and the future direction of the stock market. Moreover, the data should be able to tell whether what we see in the economy are "green shoots" or "yellow weeds."
The first chart (above) shows U6 (in blue) and the year-over-year U6 (in red). As the two lines widen the condition of the economy improves and as they come together the condition of the economy deteriorates.
The downturn earlier this decade is illustrated by the dramatic narrowing between U6 and U6 yoy. In September 2001 the two lines almost touch and that point could be considered the peak of the recession even though unemployment would still be elevated for nearly two more years.
As the economy improved the two lines diverged. However, the widening coincided with significant government intervention in the form of hundreds of billions in government stimulus and dramatic cuts in the Fed Funds rate to below one percent by 2003. The widest points were between mid-2004 to mid-2006; at the height of the housing bubble.
By mid-2007 it was evident that the economy was in trouble as the two lines started to narrow. Even as Presidential candidate John McCain said the "fundamentals of the economy are strong" in September 2008, you could tell it wasn't true. Is it any wonder he lost badly?
As the economy worsened both lines shot up past their previous highs, yet it took until December 2008 before the two lines nearly converge (they finally touched in February 2009). As of the end of May 2009, the two line have diverged slightly, which may portend something positive in the future, but with both points highly elevated, it could be awhile before the economy makes any sustained recovery.
The second chart (above) shows the S&P500 index (in blue) and the year-over-year U6 (in red). What becomes evident is that the distance between the lines was a pretty good indicator for investors until recently.
The technology boom of the 1990s led to a widening between the S&P500 and the U6 yoy lines. As the year-over-year U6 steepened in 2000 the stock market fell in tandem. Even though the recession officially ended in November 2001, you could tell that the economy was still in trouble and it was not the time to load up on stocks yet. That point was when the distance between the two lines widened considerably starting in September 2002. Even though the market would retest in early 2003, you could see that it was a good time to buy.
By early 2008, with the S&P500 still above 1300 the narrowing of the two lines gave investors plenty of warning that it was time to at least trim your holdings. Around the time when John McCain made his ill-timed statement, investors should have been out of the market as not only did the two points converge, but they crossed.
The lines kept moving in opposite directions until March 2009 when the S&P500 reversed and headed upward on the pronouncements of "green shoots." While the year-over-year U6 has kept rising the market rose as well. The S&P500 should have been at least flat instead of following the U6 yoy upward. That should not have happened. Therefore, we are at a point of investor confusion.
Bulls see the defiance of the S&P500 as a reason to be optimistic. They argue, where else are you going to get a decent return; certainly not with the low yields from banks. Bears see the elevated U6 and U6 yoy as a reason to be still cautious. Moreover, as investors they don't see an S&P500 over 900 as any kind of reason to buy now.
My take is that the market is currently overvalued and should see a decent pullback from here because the fundamentals don't justify the market price yet. However, should the U6 and U6 yoy continue to separate, especially if the direction turns downward (which is good), then investors should be prepared to buy, though we still have plenty of time to make that decision.
Is the worst is behind us? Or is there still more pain to come? With the S&P500 index above 900, the market is no longer cheap, so there is still downside risk that we might be in for another dip or two before we recover. We need to examine the data more closely before we can judge who is right, bulls like Jim Cramer or bears like Nouriel Roubini.
The unemployment rate is often called a lagging indicator because employers are slow to fire at the outset of a downturn and slow to hire at the outset of a recovery. Therefore, to be ahead of the curve, investors use other data to signal a change in the direction of the economy. However, should they? Might one measure of the unemployment rate be or even leading indicator of the economy and a coincident (parallel) indicator of the stock market?
The Bureau of Labor Statistics releases six measurements of unemployment from U1 to U6. U1 is the least bad rate and U6 is worst rate. U3 is considered the official unemployment rate though it only counts those who are out of a job, but are actively looking for work. The broadest measure of unemployment (U6) captures discouraged workers and those working part time who would rather work full time.
I believe U6 rather than U3 is a better predictor of the turns in the economy because it tells us the state of the entire workforce, not just the proactive subsection of workers. I have found using the year-over-year change in U6 is a highly accurately gauge of where the economy stands and the future direction of the stock market. Moreover, the data should be able to tell whether what we see in the economy are "green shoots" or "yellow weeds."
The first chart (above) shows U6 (in blue) and the year-over-year U6 (in red). As the two lines widen the condition of the economy improves and as they come together the condition of the economy deteriorates.
The downturn earlier this decade is illustrated by the dramatic narrowing between U6 and U6 yoy. In September 2001 the two lines almost touch and that point could be considered the peak of the recession even though unemployment would still be elevated for nearly two more years.
As the economy improved the two lines diverged. However, the widening coincided with significant government intervention in the form of hundreds of billions in government stimulus and dramatic cuts in the Fed Funds rate to below one percent by 2003. The widest points were between mid-2004 to mid-2006; at the height of the housing bubble.
By mid-2007 it was evident that the economy was in trouble as the two lines started to narrow. Even as Presidential candidate John McCain said the "fundamentals of the economy are strong" in September 2008, you could tell it wasn't true. Is it any wonder he lost badly?
As the economy worsened both lines shot up past their previous highs, yet it took until December 2008 before the two lines nearly converge (they finally touched in February 2009). As of the end of May 2009, the two line have diverged slightly, which may portend something positive in the future, but with both points highly elevated, it could be awhile before the economy makes any sustained recovery.
The second chart (above) shows the S&P500 index (in blue) and the year-over-year U6 (in red). What becomes evident is that the distance between the lines was a pretty good indicator for investors until recently.
The technology boom of the 1990s led to a widening between the S&P500 and the U6 yoy lines. As the year-over-year U6 steepened in 2000 the stock market fell in tandem. Even though the recession officially ended in November 2001, you could tell that the economy was still in trouble and it was not the time to load up on stocks yet. That point was when the distance between the two lines widened considerably starting in September 2002. Even though the market would retest in early 2003, you could see that it was a good time to buy.
By early 2008, with the S&P500 still above 1300 the narrowing of the two lines gave investors plenty of warning that it was time to at least trim your holdings. Around the time when John McCain made his ill-timed statement, investors should have been out of the market as not only did the two points converge, but they crossed.
The lines kept moving in opposite directions until March 2009 when the S&P500 reversed and headed upward on the pronouncements of "green shoots." While the year-over-year U6 has kept rising the market rose as well. The S&P500 should have been at least flat instead of following the U6 yoy upward. That should not have happened. Therefore, we are at a point of investor confusion.
Bulls see the defiance of the S&P500 as a reason to be optimistic. They argue, where else are you going to get a decent return; certainly not with the low yields from banks. Bears see the elevated U6 and U6 yoy as a reason to be still cautious. Moreover, as investors they don't see an S&P500 over 900 as any kind of reason to buy now.
My take is that the market is currently overvalued and should see a decent pullback from here because the fundamentals don't justify the market price yet. However, should the U6 and U6 yoy continue to separate, especially if the direction turns downward (which is good), then investors should be prepared to buy, though we still have plenty of time to make that decision.
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