Tuesday, November 22, 2011

New EconViz Blog & Survey Results

Thanks to those of you who have tried out the preview draft version of the How the Economy Works Visual Tutorial and submitted feedback! (And thanks Tom for the extra traffic from your post).

I have created a dedicated blog for EconViz.org on which I'll announce major content and functionality updates to that site. Feel free to subscribe to the RSS Feed if you are interested in seeing what unfolds there and perhaps giving further feedback. So far there are two posts -- an introduction, and the results of the mini-survey I included at the end of the tutorial.

My goal is to keep up occasional posts on this blog on macroeconomics topics outside of concept visualization -- hopefully more frequent than they have been recently! But neither will be a high volume blog any time soon.

Public Service Announcement for Google Reader users: If like me you were driven crazy by the huge amount of wasted screen space in the "refresh" to Google Reader a few weeks ago, I recommend the Google Reader Demarginfier script (works with the Greasemonkey browser add-on).

Wednesday, November 16, 2011

Concept Visualization and Macroeconomics

Across many theoretical subjects, it seems that much more effort has been spent on data visualization than on concept visualization. There are a number of good reasons for this, but I think concept visualization is still behind where it should be (at least in the educational material I've been exposed to).

Macroeconomics is a subject extremely well suited to conceptual visualization, yet the majority of the educational material on the web seems to be text-centered (other than supply-demand curves and the occasional simple diagram or balance sheet). While equations such as “GDP = C + I + G + ( X – M )” provide precision and rigor and aren't even mathematically complex, their inclusion in content (for example, blog posts) necessarily narrows the potential audience.

As most readers know, my first attempt at concept visualization for macroeconomics was the Macroeconomic Balance Sheet Visualizer. However, it did not appear to be as accessible to newcomers as I'd initially hoped. So I've been working on something intended for a broader audience.

Design goals include:
  • Anchor as much of the verbal content to visual representations as possible, to reduce ambiguity and help illustrate concepts
  • Be as concise as possible while covering the most important core concepts
  • Have the core content be beginner friendly, but have additional details available just a click away at each step along the path for those who want more
  • Use a web site rather than blog format, so the content can be evolved and improved in-place over time
While the content and illustrations are very far from complete (think of it as an evolving framework still in the rough draft stage), I think it's crossing a threshold where it could be worth having available to the public while work on it continues. (There's a chance I will take it offline again for a while if I get the impression it may do more harm than good in its current form).

My “to do” list is enormous for it... there is much much more that can be done graphically as well with better verbal coverage of concepts. It simply takes time... And you'll also have to excuse the amateurish graphics, for now.

That said, it's very useful to get feedback to help prioritize the “to do” list, plus you may have creative suggestions that aren't on my list! Also I hope you'll help keep me on track with direct and honest feedback (including negative reactions) if you think parts of it are heading in the wrong direction, or I've messed up or left out important things! If you do choose to try this new visualizer and respond, you can give anonymous feedback directly from a link at the bottom of each page in the tutorial, or you can post comments to this blog post, or email me.

And if you're just learning MMT and are short on time, you may want to just wait for a future improved version rather go through what's there now, since it's full of gaps and placeholders.

Here it is:


P.S. I do still have a good sized list of potential topics for this blog too, but have still been giving the EconViz stuff priority for the time being, so please excuse the silence.

Thursday, August 25, 2011

Looking for a Volunteer

As previously mentioned, I've been gradually working on a new MMT-inspired visual tutorial on how the economy works. (It is completely separate from the macroeconomic balance sheet visualizer). My hope has been that integrating an animated flow diagram alongside the verbal explanations would make the concepts accessible to a broader audience than those willing to read and digest a typical MMT blog post.

I have a partial "proof of concept" working, though it's still too rough, ugly, and incomplete to release into the public wilds of the internet.

I would value high level directional feedback on what is working well and what isn't. Please email me privately if you'd be willing to take a look and give feedback. It could be especially helpful if you are either:
  1. someone who has experience attempting to explain MMT to others, or
  2. someone who is learning MMT and still trying to get up to speed on the core concepts.

Wednesday, June 22, 2011

A Visual Guide to Endogenous Money and the Failure of QE

I've wanted to do a more comprehensive post on the dynamics of endogenous money and the private sector's response to large exogenous events such as quantitative easing, but for now this post will be another incremental update to my previous posts on the topic from October and April. As stated previously, it's possible I've reached some incorrect conclusions, however my interpretation of a piece of Post-Keynesian Circuitist literature I was referred to suggests to me that these ideas are on the right track.

Basic QE Mechanics

Some people have read that the direct mechanics of Quantitative Easing only increase bank reserves but not deposits (broad money supply). That is true only in the narrow case where banks are net sellers of bonds from their own balance sheets to the Federal Reserve. But the evidence suggests banks have not drawn down their net bond assets in this way since QE began (the Fed has bought over $2 trillion in bonds!), and that the primary sellers are non-banks. To see why the immediate mechanical result of this is for QE to increase bank deposits (and thus broad money supply), please visit the Macroeconomic Balance Sheet Visualizer and run the operation "Quantitative Easing (Variation 1 - Households Sell)". Also, see this guide from the NY Fed:
"When the Fed buys an asset, the effect on the broad money supply depends on who sold the assets and what they do with the funds they receive. If the seller is a bank, reserves go up, but broad money only increases if the bank responds to the increase in its reserves by lending more to households and businesses. If the seller is an investor other than a bank, reserves go up, and broad money also goes up in the first instance as the seller's bank puts a sum equal to the amount it receives from the Fed into the seller's bank account. But if the seller uses the money to pay down debt, the broad money supply declines again by the amount of the debt repayment. As of early 2011, the behavior of the broad money supply, economic activity and inflation all suggested that recent money growth had not been excessive."
The guide mentions the well known idea that the broad money supply increase resulting from QE has been muted due to debt repayment, but as my past posts have indicated, I think that's only half the story.

Actual Broad Money Supply Changes During QE

The first graph shows broad money supply as measured by MZM (Money Zero Maturity), the second graph shows the year on year change.

It's not obvious that either QE program had a direct impact on the broad money supply trends, even though they should have if you consider only the direct mechanical results of the Fed buying bonds, and don't consider any private sector response! Of course it is difficult to tell for sure, as the money supply changes for lots of reasons besides just QE (e.g., it generally expands during economic growth, but perhaps also during times of uncertainty).

So where did part of the roughly $2 trillion in "money" that replaced bonds go? Did it only "disappear" to the extent that the private sector wanted to pay down debt? I've argued that it disappeared INDEPENDENTLY of whatever level of desire there was to pay down debt, and that the money supply growth that did occur would have occurred to almost the EXACT SAME DEGREE even if QE had not happened. In other words, money supply grew because the private sector "wanted" a larger money supply as part of its aggregated portfolio preferences.

A Visual Guide to Money Supply Endogeneity

First, consider the general situation in which bank loans expand the broad money supply. The "Bank Loans" and "Bank Credit" bars are the same size by identity because loans create deposits:

Next, consider what happens during Quantitative Easing in terms of the immediate mechanical result. Broad money supply expands, "backed" by an increase in excess reserves held by the banking system:

The private sector controls all quantities with white labels. Excess reserves, with a yellow label, is the only quantity here fully controlled by government! The light yellow label on Required Reserves indicates partial control. Banks lend first and look for needed reserves later, and the Federal Reserve's open market operations ensure that reserves sufficient to meet reserve requirements will automatically become available (either as a result of the Fed buying/selling treasuries as part of OMO, or via loans from the Fed). So the quantity of Required Reserves adjusts in response to changes in the quantity of Bank Loans, and the government only controls the size of Required Reserves if it changes the rules.

Lastly, consider how the private sector can work to "undo" the change in money supply imposed by QE, without having to alter its borrowing desires!

One of the reasons bank loans can be replaced by other forms of borrowing (perhaps with a lag?) is that when you look inside the aggregates, the economy is very dynamic under the surface. There are always some households and companies borrowing new money, others making debt repayments and others completely paying off debt.

Some bank loans may be repaid early and replaced by non-bank borrowing, but in general there is always new borrowing being done, even when the big picture is one of deleveraging.

When there is "excess" money and investors would rather hold bond assets, those investors will likely outbid banks in the contest to fund new borrowing needs. That is how the mix of bank debt versus non-bank debt can be affected. Even unconventional borrowing markets may play a part in this, such as "peer-to-peer" lending (going to family and friends for a loan instead of to the local bank). Another example of non-bank borrowing is new corporate equity issuance — perhaps angel investors and the like are outbidding banks on meeting funding needs, too.

Overview of Ways the Private Sector Can Reduce "Unwanted" Broad Money Supply:
  1. Replace loans (which create money) with non-bank borrowing (which does not create money) independent of total debt levels. Examples of non-bank debt include corporate bonds, peer to peer loans, securitized loan pools, housing agency debt, etc. Most of this post focused on this mechanism.
  2. Induce less bank lending by changing aggregated propensities to borrow. For example, many reports indicate a record number of cash buyers have been supporting the housing market. Logically, if there is an "excess" of deposits in the economy, then investors who would rather own other assets may outbid other potential buyers of those same assets who would have bought using debt. Thus, while QE's added money supply in this case doesn't eliminate existing bank loans, it serves to reduce the number of houses bought using bank loans, while at the same time other loans are continually being paid down. The net effect is that bank lending moves to a lower level than it would have been at had QE not occurred. Those who lost the bid for houses (who would otherwise have bought with a bank loan) might rent from the investors instead, so this point does not imply that QE will cause some to have no place to live.
  3. Banks can sell assets (treasuries, loans, etc) to the rest of the private sector. A net decrease in assets in this way causes a net decrease in broad money supply. To see how this works, visit the Macroeconomic Balance Sheet Visualizer, and choose the operation "Bank Loan" followed by "Bank Loan is Securitized" (which is one way banks sell assets to the non-bank sector).
  4. Banks can fund themselves with a higher portion of non-deposit liabilities (e.g., bonds) instead of deposit liabilities. This results in less broad money supply. As I understand it, this was part of the dynamic that RSJ described in this post.

Why does this matter? To the extent that these dynamics really occur as described in my three posts so far:
  1. This shows in even stronger terms why Quantitative Easing as practiced so far (targeting quantities rather than prices) has had no meaningful effect other than on sentiment. QE truly was a placebo.
  2. It lends even more power to the concept that money is always debt and can NOT be modeled like a commodity. Its quantity is extremely dynamic and subject to the portfolio desires of the private sector. IS/LM curves and the like are not relevant. One of the arguments by the Fed was that QE would increase deposits in portfolios relative to the supply of available bonds and provide a bid under other assets due to "formulaic" institutional portfolio investing, but the premise of persistently expanded money supply and reduced longer duration assets appears to be false.
  3. It lends even more weight to the idea (frequently argued by MMTers) that interest rates are determined independently of borrowing demand, and thus that there can be no financial crowding out of the private sector when the government issues debt! Economy-wide interest rates truly are anchored to the short term Fed Funds rate plus expectations of future rate settings. (Not that the market can always consistently estimate future rate settings!)
  4. Conventional wisdom is that one goal of QE was to help the banking system. Ironically, QE may have hurt banks more than it helped them! The banking system seems to operate as a private sector lender of last resort, and by triggering a shift to additional direct (non-bank) lending, QE seems to have reduced the role of banks in the economy, and thus reduced their potential to accrue earnings from loans!
UPDATE 6/23/2011: Made a few minor edits for clarity, and added Implication #4. Also, here are the two previous related posts:

Some Thoughts on US Economic Growth

Here is an updated chart from a previous post (Real GDP Growth in the US and Japan: A Closer Look at Consumption, Government Spending, Net Exports, Investment, and Inventories).

US: Contributions to Percent Change in Real Growth Domestic Product (2005/Q1 - 2011/Q1)

(click to enlarge)

Note that 2010-2011(Q1) does not look all that different from 2005-2007!

I don't know where to from here. I think a "double dip" is very possible but if I had to guess, I don't think a new recession is the most probable scenario in the near term. But that depends on difficult factors to predict such as whether current US congressional antics really are only short term theater as many allege, and the potential size of negative demand shocks from the rest of the world (China, Europe, other various housing bubble countries like Australia and Canada, etc).

I believe a common mistake is to consider high oil prices to be one of the drags on growth. Rising oil prices are certainly a drag on growth, but stable oil prices (once lagged effects of previous changes have dissipated) are growth neutral, as I understand it. Even the generally excellent Calculated Risk might have gotten this wrong in a recent outlook post where he says "Also the recent decline in oil and gasoline prices will help, although $100 oil is still a drag on the economy." However he could be correct if he considers a drag on the economy to be a separate phenomenon from a drag on economic growth. (If you think I'm the one who's gotten this wrong, please let me know!)

Similarly, deleveraging is not a drag on growth unless the rate of deleveraging increases. Deleveraging is just one determinant of the household savings rate. A stable household savings rate is growth-neutral. However, deleveraging does reduce the likelihood of a falling savings rate and the associated boost to GDP growth that such a shift would provide. So in terms of current economic growth (i.e., ignoring impacts on future growth), steady-state deleveraging is the absence of a positive rather than an actual negative.

Note that this post only focused on GDP growth... clearly we still have crisis levels of unemployment and underemployment that policy makers should be actively working to address!

Thursday, April 21, 2011

Further Evidence that the Private Sector Fully Controls the Money Supply and QE Doesn't "Work" as Advertised

In October, I wrote a post titled How the Loan/Bond Choice Helps the Private Sector Self-Determine the Money Supply — AND Yet Another Reason QE is a Non-Event for the Economy. To give a brief summary, it described my thoughts on the inter-relational dynamics between debt, money supply, and Quantitative Easing, as follows:
  1. There are two high level ways that borrowing occurs in the private sector — bank loans, and all other forms of borrowing, i.e., bond issuance, securitization, peer to peer lending, etc.
  2. When there is an "excess" of short duration assets (primarily money) held by the private sector, the holders of those assets will be eager to lend it out, and thus acquire a higher yielding asset. The money supply remains unchanged.
  3. When there is no "excess" of money to lend (i.e., portfolio preferences are satisfied with the current levels), then banks will have a higher propensity than non-bank lenders to fulfill the economy's current borrowing needs, because they can lend an [almost] unlimited amount, independent of their level of money/reserves. (Their only limit on lending to worthy borrowers, and it is temporary, is how much equity capital they can raise). Bank lending increases the money supply, so from a macro perspective, banks could be considered the private sector's lender of last resort.
  4. By choosing the relative proportion of the two type of borrowing, the private sector is able to choose its portfolio mix of long duration assets and short duration assets (money), independently of the actions of the federal government, and [mostly] independently from the desired level of private sector borrowing!
  5. When the Federal Reserve conducts Quantitative Easing, it buys long duration assets (treasury bonds, etc) out of the private sector, and gives the private sector short duration assets (money balances) instead.
  6. If the private sector is not happy with this new portfolio mix resulting from QE, it likely has the power to "undo" the change over time via shifts in the proportion of bank loans versus other types of lending that it uses!
If the balance sheet impacts of bank lending, non-bank lending, and quantitative easing are not familiar to you, please play with the Macroeconomic Balance Sheet Visualizer — it is a graphical web-based tool, now with a step-by-step walk through mode.

Possible Evidence from a Post-Keynesian Expert that this Theory may be Correct

In the comments of my previous post, commenter Ramanan helpfully linked to a PDF from Marc Lavoie, one of the leading Circuitists. Circuitists (also known as horizontalists) are one "school" of theory within Post-Keynesian economics, and they share most of the same concepts as Modern Monetary Theorists. In section 9.3.1, Lavoie seems to describe the same dynamic that I have attempted to describe. Here is an excerpt:
"...for apparently the demand for money and the supply of credit are determined by two independent mechanisms. In the Lavoie and Godley (2001-2002) model for instance, the demand for credit, at the end of the period, depends on the part of investment expenditures which has not been financed by retained earnings and new equity issues..."
"...the decision by households to hold on to more or less money balances has an equivalent compensatory impact on the loans that remain outstanding on the production side."
While Lavoie only mentions "equity issues", I have seen evidence elsewhere that he uses that term as shorthand to describe any non-bank borrowing mechanism employed by a firm, i.e., his reference to "equity issues" is supposed to also encompass bond issues and some other types of liabilities.

For reasons that are unclear to me, some MMT authors repeatedly claim that QE does not add to the broad money supply. While it is true that if the primary dealers sell their own treasuries to the Fed, then only base money supply is affected, this scenario is too limited given the size of QE to date. As I understand it, primary dealers frequently act as an intermediaries to facilitate QE buying assets from the larger private sector. But if the private sector can react relatively quickly enough via the mechanisms described here to "undo" the money supply changes, then the money supply data won't show any bulge in broad money supply resulting from QE! (And of course there are other factors impacting the money supply at the same time, primarily a desired deleveraging within the private sector, so it is probably not possible to disentangle these different dynamics when looking at the data.)

Evidence in the Recent Data for the QE in the United States

In the last post on this topic, I showed a graph of Japan's bank and non-bank borrowing. While inconclusive, it suggests that Japan's Quantitative Easing from 2001-2006 may have caused a relative decrease in bank-based borrowing as compared to non-bank borrowing, which could add to evidence of the theories above.

Below is a graph of US borrowing from Q2 2004 to Q1 2011.

Effects of US Quantitative Easing on Bank Lending Compared to Total Borrowing:

(click to enlarge)

The red line shows the annualized percentage change in bank loans and leases, by quarter. The green line shows the annualized percentage change in total private sector debt (from the Z.1 report, which is not yet available for Q1 2011). The blue line shows the annualized percentage change in non-financial private sector debt (since the private sector's debt has many layers that could overwhelm the other trends, I thought it worth separating financials out.) I have not subtracted bank loans out of the total debt data, so the shape of the blue and green lines is slightly impacted by the shape of the red line (though the absolute amount of bank debt is around $7 trillion versus around $41 trillion for total private sector debt, so crossover impact is not huge).

Notice how bank loans declined substantially faster than total debt after the first round of Quantitative Easing started! The gap between the red line and the blue line is probably the most relevant. Despite tracking closely to each other until late 2008, they diverged significantly starting in 2009, perhaps as the private sector favored non-bank lending on a relative basis over bank lending, in order to "shed" the excess money supply imposed by quantitative easing!

The second round of quantitative easing is smaller in magnitude, and the data so far only covers the start of QE2. However, in Q4 2010 the gap between the red and blue lines appears to begin widening again. Will that effect continue? I would guess so, but I could ultimately prove to be wrong.

It is also not clear how big the lag effects in this process are. Also, the changes in bank loans versus total debt diverged most significantly in the middle of QE1, and the gap narrowed partially before QE1 ended. It could be that other dynamics that I am unaware of provide a more accurate explanation than what I suggest here.

Anecdotal Evidence

While it's far from scientific or conclusive, and I don't follow the details of specific financial markets, I occasionally see anecdotal evidence of the private sector's increased eagerness for non-bank lending. For example:
  • Junk Borrowers Turn Tables on Investors With Looser Terms: Credit Markets: "...debt sold this week included a condition that allows the company to call 10 percent of the bonds at 103 cents on the dollar in each of the first four years... [The borrower] is trying to lock in low interest rates while getting the flexibility to repay debt any time, as it would with a loan..."
  • Subprime Bonds Are Back
  • [Maybe] recent increases in venture capital activity? (If true, it would be an example of equity issuance rather than bond issuance, but with a similar macroeconomic effect.)
PostScript / Technical Note

In generating the chart in this post, I discovered the importance of using the percent change bank loan data as prepared by the Federal Reserve in its H.8 release whenever possible, instead of starting with the absolute levels of loans. The latter's level jumps around too much due to balance sheet consolidations, acquisitions, etc, while the percent change data appears to be adjusted to remove this effect, if I am understanding it correctly. Details are on the about page and notes page.

Tuesday, April 12, 2011

Real GDP Per Capita and Myths about Japan's Stagnation

While addressing some myths about Japan, Bill Mitchell posted some graphs of contributions to real GDP. His graphs cover the same data I graphed last August -- the contributions of Consumption, Investment, Government Spending, and Net Exports toward inflation-adjusted economic growth. (A minor difference is I separated Inventories and other Investment in my graphs). Bill also usefully added in Ireland while emphasizing the negative effects of austerity on growth. Visuals such as these make it obvious that investment falls under austerity -- it doesn't rise on a supposed swell of increased business confidence that austerity proponents often claim will be triggered!

While I've been guilty of parroting some myths on Japan myself in years past, it has been enlightening to put more effort into reviewing the data for myself. Here is a graph I have been meaning to post for quite a while:

Annual Growth of Real GDP Per Capita in the US and Japan (1980-2009)

The blue line is for Japan, the red line for the US. It is quite astonishing how close in both magnitude and direction US and Japanese growth have been, when adjusted for population changes! The main divergences are Japan's burst of higher growth in the late 1980s, and its austerity-driven recession in the late 1990s. Once you adjust real GDP growth for changes in population, what you are left with is largely productivity growth. There are other factors that affect the level of GDP (and important things like employment!) but they have less effect on year-on-year growth rates once the adjustment has occurred.

Japan's famous deleveraging primarily meant a higher savings rate than before the deleveraging (corporate rather than household, in Japan's case), with the main effect being a one time shift downward in GDP level (but not growth). After the GDP shift caused by a savings rate shift, future and ongoing GDP growth is impacted by other factors such as whether aggregate demand is sufficient to bring growth back near potential growth, but Japan may have been a success story in this area! However, its success in achieving this real per-capita GDP growth may have been more a result of the falling household savings rate over the last couple decades than of government fiscal (or monetary!) policy.

Japan's stagnation myths (some people blame too much government spending, others too little!) derive in part from two sources of confusion -- real growth versus nominal growth (Japan has a low and sometimes negative rate of inflation) and GDP growth versus per capita GDP growth (Japan has a low-to-negative population growth trend).

Of course, real GDP growth (absolute rather than per-capita) does affect valuations of financial markets and real estate, since those valuations rely on the size of future earnings streams. Japan's asset markets have famously failed to "recover." To the extent that other nations follow in Japan's demographic footsteps, there will be some downside surprises in asset market returns in the medium to long term for many advanced nations...

UPDATE (same day):

To supplement the year-on-year growth chart above, here is a graph of the actual levels of per capita real GDP indexed for Japan and the US. Japan's surging growth in the late 1980s that accompanied its stock market and real estate bubbles did put it above the US trend, but the levels converge again before year 2000.

UPDATE 5/23/2011: After reading a post by Bill Mitchell today that appeared to contradict the findings in this post, I initially wondered whether I had erred by using the FRED2 data for Japan in which the real per capita GDP data is converted to 2009 US dollars at purchasing power parity. (i.e., perhaps this incorporated exchange rate effects as well.) However, today I extracted the appropriate source data from Japan's cabinet office and generated my own graph using yen-denominated values, and the trend line is identical to the FRED2 data I used. In other words, the trend lines for per capita GDP growth for the US as measured in dollars and Japan as measured in yen still are remarkably consistent with each other, just as this post initially showed. The main divergences in the two trends are in the time periods of roughly 1987-1990 and 1997-2000.

It turns out (based on my own graphs from the source data) that Bill seems to have accidentally switched the labels on the two lines in his second graph, so his nominal and real GDP per capita lines for Japan are reversed.

Wednesday, March 30, 2011

Nonfinancial Corporate Earnings: Could They Keep Falling Until the Economy Passes Through Another Recession?

While I ponder aloud whether this is a healthy stock market for investors (as opposed to momentum traders), this will be my second post on the topic, following the last post that graphed long term trends in earnings.

I tend to avoid analyses that take the form of "whenever A happened in the last B years, then C occurred at least D percent of the time." Much of the time this indicates data mining to validate a favored conclusion, whether bullish or bearish. While this post risks getting closer to that territory than I'd like, I'm going to avoid actually calculating percentages and such and keep it vague and qualitative! I have no clear conclusions, I simply found the data interesting.

Here is a graph of nonfinancial corporate business profits after tax (NFCPATAX) and financial corporate business profits after tax (CP minus NFCPATAX) from the national accounts data, generated via FRED2.

  • Nonfinancial profits (the blue line) fell a nontrivial amount in Q4 2010. Have they peaked for this expansion? Or was there a special one-time event (such as an expiration of tax-friendly legislation) that explains it?
  • Look at the historical pattern of past occurrences of nonfinancial profits first starting to fall. If the drop was nontrivial in size, nominal nonfinancial profits continued to fall and only reversed course once a recession had occurred and was reaching its end! This process seemingly can take several years to occur (e.g., especially in the late 1990s).
  • The most obvious exception to the pattern is in the mid 1980s — a large drop in earnings was later followed by resumed earnings growth, with no recession.
  • Financial profits (the red line) in the period leading up to and through recessions have acted quite differently than nonfinancial profits. In the 1991 and 2001 recessions in particular, financial profits kept growing, largely unfazed by recession! This perhaps had a lot due to with the rapid growth in household debt as well as the steeper yield curve due to the Fed lowering rates.
Here is the same data ending in 1992, so that the vertical scale for the earlier years is more visible:

The pattern of nonfinancial profits peaking in nominal terms months or years before recession occurs seems similar but less pronounced than in the later periods. Note that I am intentionally graphing nominal profits in all cases, rather than a ratio such as to GDP. This is because stock prices are likely more sensitive to nominal profits than profits ratios.

A natural question for an investor would be, what are the implications for stock prices?

Here is a graph of nonfinancial corporate profits and the value of the S&P 500 index:

Does the point at which nonfinancial earnings peak represent an "overvalued" stock market price, given that recession often follows within a few years? It appears that in many cases, the stock market continued to rise after earnings peaked, and the eventual stock market low during recession wasn't always lower than the stock price had been at the time of that prior peak in earnings. Thus, waiting to buy stocks wouldn't necessarily have provided a lower entry point in the future. There are of course exceptions, for example the most recent recession taking stock prices well below their price at the time of the prior peak in nonfinancial earnings.

I can suggest no insights from this data regarding the eventual impact on stock prices even if the current contraction in nonfinancial earnings continues. The future direction of financial sector earnings may turn out to be a key determinant of the outcome. Plus, as is well known, valuation multiples expand and contract independently from changes in earnings.

Here is the same data repeated but only up to 1992, so the vertical scale for the earlier years is more clear:

Thursday, March 24, 2011

Stock Market Earnings Trends: What Happens This Decade?

What is the outlook for US stock market returns over the coming decade? There is no shortage of commentary on this topic, and I don't have any unique answers, but I thought I would share two graphs.

A lot of market commentary suggests the stock market is overvalued on the basis of measures such as stock market capitalization to GDP, Shiller's CAPE (10 Year Average Inflation-Adjusted PE ratio), Tobin's Q, etc. But for any elevated ratio, a reversion to the mean can occur via a combination of falling numerator and/or rising denominator. For example, GDP could grow rapidly while stock market valuation grows slowly, allowing the ratio of market cap to GDP to mean revert without a fall in earnings and stock prices. But how likely is the numerator to fall? That is what would most concern a medium to long term investor.

One prediction in particular that caught my attention was Robert Shiller's suggestion that the S&P 500 will be around 1430 in the year 2020. With the S&P 500 currently around 1300, that represents roughly a 10% total increase (not annual!) over a decade. Robert Shiller is known for recognizing both the dot-com bubble and housing bubble long before most people, so he is worth listening to.

Here is a chart of trailing 12 month reported earnings created from Shiller's spreadsheet, from 1871 through Q3 2010:

The green exponential trend line shows the long term earnings trend. Current earnings have rebounded quickly to well above the trend line. If earnings oscillate around this trend line as they have done historically, they should be centered around roughly $60 in 2020! At a 15 valuation multiple, that only represents an S&P 500 index value of 900 (a 31% decline!) However, this trend is for real (inflation adjusted) earnings, so the nominal level of earnings and corresponding S&P 500 valuation would be somewhat higher assuming continued positive inflation.

But what about the most optimistic case from the perspective of the stock market? What if we are in a sustainable new era in which the recent extraordinary corporate margins, earnings to GDP, etc, can be maintained indefinitely? The next graph shows the same trend line since 1980 but for nominal reported earnings. The red portion of the line is the estimated forward earnings from Standard & Poors S&P500 spreadsheet as of today, which is important because expected earnings represent what the market valuation is currently priced for, i.e., earnings of $90-$95.

This trend line shows the nominal earnings trend reaching the $90-$95 level around 2020. So current earnings and forward estimates are ten years ahead of "schedule"! This second graph seems to align with Shiller's suggestion of an S&P index of 1430 in 2020 (with a 15 valuation multiple, earnings would be $95).

The key question for a stock market investor is what happens to that earnings line over the next decade: does it remain above trend line (not impossible, if you look at the late 1990s period), does it crater again as in 2008-2009, or does something else occur?

This graph shows the extent to which nominal earnings can fall: a 35% fall from 1989-1991, a 54% fall from 2000-2001, and a 92% fall from 2007-2009 . So history shows that a falling numerator is not uncommon, i.e., reversion to mean not exclusively driven by a rising denominator. If falling earnings is a reasonably probable scenario, the next question is, when? With labor cost pressures low and held down by high unemployment, and rising commodities costs representing a possibly more manageable percentage of most cost structures, is a contraction in GDP the only thing that could meaningfully reduce earnings?

Comments are welcome.

Thursday, February 17, 2011

Updated Macroeconomic Balance Sheet Visualizer

Around a year ago, I wrote a blog post about the draft copy of the macroeconomic balance sheet visualizer I had set up, and got some useful feedback (thanks!) At the time, I said:
"If you are learning this like me, I recommend you skip this until an updated version is ready, otherwise you could be unnecessarily misled or confused. I will post another blog entry when a more polished version is ready — both more accurate, and with added features, usability, more accessible step-by-step walkthrough, etc."
Since then, various knowledgeable folks have looked at it, and to the best of my knowledge what's there is correct. (I know the text descriptions still have room for improvement and better precision, which will come over time, but hopefully any issues are minor — let me know if that's not true!)

In the last few weeks especially (apologies for the full year it's taken!), I've made some batches of updates, including:
  • Layout improvements.
  • A "Replay Operation" button.
  • Mouse-over text descriptions for each asset, liability, and equity block (e.g., reserves balances of the banking system).
  • Step-by-step walk-through mode to give visitors who are at a loss for how to start a concrete way to be led through each operation in turn. (And it avoids the "Invalid Operation" message that you get if current balance sheet states don't support a particular operation.)
So if you heeded my warning and held off before, please give the tool a try now and see if it helps you:

Macroeconomic Balance Sheet Visualizer

While I still have a few ideas to work on and improvements to make (especially for the walk-through mode), if you have concrete suggestions for how the visualizer might be further improved, I'd love to hear from you in comments!

I am also still occasionally working on the macroeconomic flow visualizer that I hope will be comprehensible to a wider audience, but my time and progress on it to date have been much less than I'd hoped. So, more on that later, maybe.