Clearly, observers of American football do not know how the national anthem ends

It is not your fault. Usually by the time the singer is belting out the last question, there are a bunch of really noisy F-18s overhead and the crowd is cheering hysterically. But just as a refresh, here is the anthem, with the recently relevant bits highlighted for emphasis.

O! say can you see, by the dawn’s early light,
What so proudly we hailed at the twilight’s last gleaming,
Whose broad stripes and bright stars through the perilous fight,
O’er the ramparts we watched, were so gallantly streaming?
And the rockets’ red glare, the bombs bursting in air,
Gave proof through the night that our flag was still there;
O! say does that star-spangled banner yet wave
O’er the land of the free and the home of the brave?

A guy willing to draw extreme public disapprobation on himself, to follow the dictates of his own conscience, would be an awesome example of the values highlighted in the last line.

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The chart

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I see some liberal bloggers are upset by this chart.  How dare Yellen imply that there is a 1/7 chance the the funds rate is above 4 1/2% by the end of 2018.  The forward markets have never missed that far to the downside, so why do we assign such high odds of their doing so this time?  This is just more evidence that the Fed is in hawkish denial about reality, according to the worriers.

I’m not so worried. I think this is just another case of the Fed serving up bravado and sounding more hawkish than they will end up being.  This is also Yellen being passively aggressive against the hawks on the committee, while dissing their dots. It is like when you present your thesis to the boss and he says, how will you know when you are wrong?

Her point is not that rates could rise sharply. Rather, her point is just to reinforce an effort she has been exerting for a while.  She would rather not have those dots, because — among other things — interest rate guidance is not helpful in a presumed tightening program. Interest rate guidance makes sense only when the Fed is at the zero bound and casting about for additional means of stimulus. I have said why in other posts and will not repeat here.

The salient point is that there is inertia in the Fed’s communication template, so for now they are stuck with the dots. Rather than say, my colleagues are dumb, ignore them, Yellen just chooses — with steadily increasing ingenuity — to emphasize that the dots are likely to be wrong.

Mission Accomplished: The market is ignoring them, not freaking out about the 1/7 risk of rates going above 4 1/2%.

More broadly, the Fed is talking up a storm of fibs these days. They all fit into what I have called the Summer’s Principle: when in a position of authority, it is probably best to let on that you have the situation more in control than you do. Downplaying the downside for the  economy  while up-playing the upside is part of this. But that does not mean the Fed will drink its own Kool Aid.

I don’t mind the fibbing all that much. Better than sincerely doing the wrong thing.  It is just that you can’t follow the game if you don’t have a program! And I do find the consensus Fed watcher’s gullibility a bit irritating, I concede. A friend called them “fax machines”, thinking I should be familiar with the term. I am now.

 

 

 

 

 

Jupiter Effect II

Update: This post indirectly got me interested in the trimmed mean PCE deflator, also produced by Dallas Fed.  I have been asserting for a while that it has an upward bias.  I figured I should document that.  Here is the trimmed mean deflator, depicted as I depict the more standard ones. So you know I am not cherry picking methodology.

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The Fed’s target is the headline deflator. They monitor progress towards that target with the core, whose inflation rate is less noisy but has the same trend. The trimmed mean is also less noisy, but does NOT have the same trend as the headline. For the past decade, it has had an upward bias of 25 bps. If you trim out more quickly rising than slowly rising prices to get your “trim”, you should not be surprised by this.

——–

A while ago I published a snarky post mocking the lengths to which people will go to claim that below-target inflation is otherwise. They just know that inflation has to have risen because of all the “unprecedented monetary accommodation”, whatever that is. All they need is the right index to show this truth.

Stripping out medical services inflation is one I forgot to mention. It went from far above average to about average.  So the hawks want to strip it out now?  Odd timing.

The guy who wrote the headline for this research piece from the Dallas Fed must have been in that camp.

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But the actual author of the piece, assuming it was a different guy (which I can’t be sure about) had some sort of pang of conscience that, at the end, forced him to get it right. I hate when you have to read all the way to page 3 to understand.

 

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There is a fun irony here. As I mentioned in my original Jupterian post, the trimmed mean PCE deflator, run by the Dallas Fed, and favored by the hawks, has an upward bias. Series description here:

For the series presented here, 24 percent of the weight from the lower tail and 31 percent of the weight in the upper tail are trimmed. Those proportions have been chosen, based on historical data, to give the best fit between the trimmed mean inflation rate and proxies for the true core PCE inflation rate. The resulting inflation measure has been shown to outperform the more conventional “excluding food and energy” measure as a gauge of core inflation.

At first, I had a false memory that the trimmed mean symmetrically excludes the 20% of items whose prices are rising most quickly and the 20% whose prices are weakest.  And I assumed that the structural upward tilt in the index reflected that the more volatile prices just tend to be those falling. Wrong! That is not why. The Dallas Fed trimmed mean excludes more weak than strong prices.

One set of prices that are nor more likely than not to be in the trimmed mean because they are no longer rising quickly are those for — with for it — medical services!

Incidentally, despite its upward bias, the trimmed mean PCE inflation rate is now equal to the core PCE inflation rate. If it upward biased and less nosing, then it provides a STRONGER dovish signal than the core PCE deflator. When will the hawks who love this index deliver an updated speech on its important properties?

Would you care for some financial balance?

A high-level view from the financial balances perspective suggests that the medium-term recession risk has risen.  Combined with some other considerations, particularly the approach of full employment, this probably implies that the risk of recession at a 2- or 3-year horizon has risen to (somewhat) above average. But the financial balances perspective itself is not particularly alarming just now. It is more a case of it no longer being a no-brainer positive.

I will elaborate briefly on the position of financial balances in this post. But before I do, I want to put in place, first, a couple caveats; and second, a bit of perspective about what I mean by “above-average.”

On the first point, there is a cottage industry dedicated to estimating econometrically the risk of the economy dipping into recession over various horizons. I do not participate in that industry because I lack the econometric background and willingness to deal with minutia. It is definitely a relevant game, but one I leave to others. If they say something interesting, I will just steal it.  I prefer spending my own time on a more qualitative approach, for good or ill.

On the second point, a friend at Goldman economics recently told me that their old colleague Ed McKelvey used to joke that the odds of recession were 10%. Full stop.

I guess the source of the humor there is that Ed realized that economists don’t know much and did not want to fall into the rookie mistake of base rate neglect. Let’s start with how common recessions even are, before getting too fancy – or pretentious. Sound advice. Base rate neglect is a real thing, in my experience. Also, Daniel Kahneman got a Nobel Prize for warning us off it — and other behavioral finance pratfalls.

According exhibit A of the NBER’s Business Cycle Dating Committee, the US economy has been in recession about 15% of the time since 1945. I worked up my own calculation for the slightly-shorter period since 1960, which – unsurprisingly – also shows a recession frequency of about 15%.

But that is not quite the right metric for assessing the odds of falling into recession from a point of non-recession. A little handy-work with compound IF statements in Excel shows that, on a frequentist interpretation and using data since 1960, the risk of falling into recession over one-year is 12%, while the risk of falling over two years is 23%.  Please don’t treat the charts below as time series. That would be a bit misleading. They show only the path to my current estimate.

Under some simplifying assumptions, which I dare not guess, the odds of avoiding recession for two years is the square of the odds of surviving one year. And my numbers are roughly consistent with that.  But it’s probably a fluke and I am not going to puzzle over small samples and what it means to be able to “die” twice in two years. I’m just going with what the Excel sheet says.

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Ok, so on to the financial balances perspective.  This perspective is often pushed by the Jerome Levy Institute and Goldman, and is apparently associated with “post-Keynesianism.” I say apparently because I have trouble keeping my Keynesians straight.

I guess I’m some sort of a Keynesian. I don’t cock my head sideways, clutch my pearls, put on a pained quizzical look and demand incredulously what one could you possibly mean  when referring to “aggregate demand.” I guess that is the test.

Anyhow, the financial balances perspective says that the risk of an economic accident is highest when the most financially fragile sectors of the economy are running capital spending well ahead of saving or when their “financial balances” are deeply negative.  The fragile sectors vary over time and context, and may occasionally be identified simply as those that are most overextended. (In the United States, the government sector is an exception. A big imbalance there may actually be stabilizing, as I discuss below.)

For example, during the late 1990s, the corporate sector was running a dangerously large financial deficit, reflecting the over-investment cycle in tech and dark fiber, which was propped up in large part on the NASDAQ bubble.

And during the mid-2000s, we had the housing sector running a dangerously large deficit because the housing bubble had encouraged both a decline in personal savings and huge surge in residential investment.  Both those episodes ended badly, but we were also reminded that dysfunctions in real estate credit tend to be particularly toxic because they inevitably implicate the banking system.  This is something one should have known without being reminded about. Bygones!

The point is, we have to pay attention to the evolving detail and not just look at one single metric that we might mistake as appropriate for all seasons.  Now that the overinvestment cycle in the energy patch has reversed out, while leaving the expansion intact, I am just going to badly assert here that it is hard to find major imbalances in any particular sector. I noticed Jared Bernsteimaking the same point, and so I will lean on him.

With that, I will jump up to the highest level of aggregation and point out that in the last two cycles things have become dodgy when the overall private sector’s financial balance has become deeply negative.

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(The government deficit peaked quarterly at 11 1/2% of GDP, but I cut off the scale in the left panel of the chart to narrow the vertical scale and avoid the lines flattening out too much.)

To measure the private sector’s financial balance, we can work through detail in the Financial Accounts of the United States, which used to be called the Flow of Funds, a term I prefer.  But the detail in the Flow of Funds is extremely noisy and full of statistical discrepancies. That does not mean you should toss them out.  It is just that you have to be aware of all the weird idiosyncrasies.  (I assume there is that one guy at the Fed is really well informed.)

I infer the financial balance in the private sector from two measures that are presumably measured without that much noise: the current account and the general government financial balance. By virtue of an accounting identity, the private sector financial balance is equal to the government deficit less the current account deficit.  (I use “deficit” rather “balance” because the balances tend to be deficits and people are familiar with them as such.)

So here’s what we got. The private sector financial balance became worryingly negative prior to the recession of 2001 and mini-depression of 2008-09.  After the most recent crisis, the private sector financial balance surged, accommodated a lower current account deficit and a sharply higher federal deficit, which reflected both the role of automatic stabilizers and, for a while, discretionary fiscal ease.

While the economy the deficit was surging, the economy was in free fall, and so it might seem odd to say that the surging deficit was stabilizing.  But at a certain point, the pubic sector had absorbed and placed into stronger hands the financial imbalances that were previously the private sector, and I think it is fair to say that that helped stabilize the situation.

Recently, the private sector’s financial surplus has come down, accommodated by a smaller fiscal deficit and a stabilization in the current account. Previously, the current account had been moving in a “favorable” direction, reflecting the lagged effects of weak demand in the US, the previously lower dollar, and the fracking boom.  More recently, on a rate of change basis, it has been closer to a neutral.

But the private sector is not yet in deficit, and a more granular assessment of financial balances, which I will not get into here, also does not show alarming imbalances.  So taken in isolation, this is a case of less great, rather than spooky.  For now.

There are two related points that I would like just quickly to highlight here without going into too much detail.  First, note that the US current account deficit started moving into deficit after the late 1990s and continued to “deteriorate” (in this context I will break my rule not to be normative about trade balances) right up until the financial crisis after 2007. I interpret this as providing some support to Larry Summer’s secular stagnation thesis and specifically his claim that the headwinds impeding US demand growth predate the crisis.

To elaborate, if we take the current account balance to be largely exogenous, imposed on us by surplus foreign savings, then it has required policy makers here to choose between slow growth and policy initiatives that would encourage a rise of demand in the domestic private sector — even if it were to lead to ultimately dangerous financial imbalances.  To cite the most obvious example, and following the spirit of Summers, the Fed’s decision to keep rates relatively low during the mid-2000s offset drag from the trade sector and contributed to the housing bubble. I would not blame the Fed for this because it is virtually implausible they could have made another choice. Rather, it is not hard to find support for Summers’s thesis here.

Secondly, after 2007, the the numb nuts at Fix The Debt, in the Congress and at CNBC worrying about the destabilizing effects of the federal deficit were not just crying wolf but actually getting the whole dynamic backwards.  You don’t have to be a modern monetary theorist, and I certainly am not, to see that the large fiscal deficit accommodated stabilizing improvements in other sectors.  CNBC, in particular, likes now to enthuse bout all the “cash on the sidelines.” That “cash”, ultimately, is short-term government debt. With these guys, one does not know where to start.

A stabilizing or stimulative effect of a large deficit and large stock of government debt would remain intact for as long as the federal debt were still low enough to allow Treasuries to remain safe, rather than risky, assets.   The US fiscal capacity is not infinite, contra MMT, but it is higher than we have used up.  So Treasuries are still very clearly safe assets.

Without invoking the quackery of MMT, which is not necessary, it is hard to see that changing within the next five to ten years.   This is not to say fiscal reform is not a good idea. It is a narrower point about the effect of the deficit on economic stability in the next five to ten years.

What would Jesse do?

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Having just finished the pretty-depressing new book on Jess Livermore’s wasted life, I have self-awareness on my mind.  It is a very important quality, like sincerity. If you can fake that, you got it made.

Jesse Livermore made a very strong effort to be self-aware, in his trading, if not so much in his personal life.  On the day of his suicide, he was still responsible for the rent of a mistress. How did he think that would affect his third wife, who incidentally was paying all the bills by this time?

I want to apply this idea self-awareness to all these monetary policy regimes people keep dreaming up.  First, there was the cut of the funds rate to zero, which looked benign to me, but was no big sea change. If anything, it just reflected the influence of the zero bound, which fated monetary policy to be insufficiently stimulative, rather than to deliver “unprecedented accommodation.” Remember that? I’ll put forward guidance of continued ZIRP under this heading, just to save space and time.  That bothered me none either.

Second, we did QE, which riled people up about the Fed “printing money” and “distorting asset prices”, even though QE was nothing more than an interest rate signal, a slight deception about intentions, and most tangibly a mere shortening of the maturity of the federal government debt. By this point, you can just look that up. It is no longer controversial, although there is still a debate about how effective it was. Answer: not very.

When QE left the economy with inflation below target, the intellectuals then moved on to h money, which the great and good told us “had” to work “inevitably” because it delivers “manna from heaven.” Ok, we can argue about that. It doesn’t.  But have you noticed that in the US at least they have just kind of quietly dropped that?

And now they are on to raising the inflation target.  Guys, slow down. There are only so many monetary policy regimes I can process per month.  Janet Yellen downplayed the importance of the idea at the Jackson Hole Conference, in front of some very oddly dressed middle-aged people.  (Fleece under your sports jacket? Really? Are you doing DSGE or going hiking? Or is the air conditioning at the indoor conference center cranked up too high?)

So anyhow, Yellen extremely predictably playing down the idea of raising the inflation target (if only because it would cause the Congressional wing of the GOP to completely flip out) prompted the headline writers at WSJ to tell us this:

Janet Yellen, Once the Challenger, Is Now the Challenged

Twenty years ago, Janet Yellen was the unorthodox one. Now it’s her orthodoxy that’s being tested.

Really, a few liberal bloggers* and some policy analysts with ADD agitate for a higher inflation target and all of the sudden Janet Yellen’s “orthodoxy” is being “challenged.” If only she were not so hidebound and had more credibility as a free thinker.

Look at the 5-year forward, five-year inflation breakeven. It is at 1.6% for the CPI inflation rate. That maps to a PCE deflator inflation rate of 1.2 to 1.4%.  The debate in the market is whether Yellen will be able to push inflation all the way up to the inflation objective she reportedly supported back in the day – and is now the Fed’s formalized objective.

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The bond market can be wrong, obviously. I think the deep thinkers would tell you that the odds of it being precisely right are infinitesimally small. But it is the most liquid and efficient financial market in the world and presumably reflects what interested people think on balance. The credibility assigned to those “challenging” Yellen is certainly not very high.  Gun to head, I like breakevens because they are too low relative to the current “orthodoxy”, but that is a separate discussion.

The BEA just gave us the new inflation figures for July, which allowed me to update the charts at the very top of this post.  As JPM roughly accurately estimated, as is their wont, the core PCE deflator was up 0.09%. Separately, the headline deflator was unchanged.  Headline and – more importantly – core 12-month inflation rates remain well below target, with the latter showing no tendency to quicken in recent months, despite claims to the contrary by people who choose not to be unduly influenced by evidence.

Moreover, the period over which the Fed continues to miss its 2% target to the downside lengthens without interruption. On the data, they seem now to have a target of 1.5%.  I think that data is misleading misleading OF THEIR INTENTIONS and that they need to allow inflation to overshoot in the late cycle to get inflation expectations back up to a sensible level. I have been over that, tediously. I think they will, although it is a speculation, not a reading of the data.

* In liberal circles, that is called “hippie punching.” Pick a soft target and do it violence to establish your centrist bona fides. I feel shame, like a Hansen Brother.

Don’t get a CFA or take BI seriously

So, what do CFA Institute Financial NewsBrief respondents make of the fixed-income market today? As noted, 87% of respondents see the bond market in bubble territory in some way. In other words, they believe that bonds today fail to compensate investors for the costs and risks of ownership.

I am trying to tidy up this blog to take out the self-indulgent, puerile stuff and to leave only what strikes me as having some substance.  I hope that airbrushing does not seem too Soviet to you, and I feel a pang of guilt compelling me to be direct about it.

Besides the guilt, there is another problem. I just don’t seem to have the discipline not to get sucked into expressing outrage over the crazy but unimportant stuff I see on the internets every day. They keep dragging me back!

For now, my solution is occasionally to let it rip and then to just delete it, once I smarten up and realize, well it seemed like a good idea at the time. Comparing Theresa May with Brit Marling would be an example. I undelete that, probably temporarily, so you can see what I’m talking about.

With that in mind, I thought this piece on Business Insider, almost inevitably BI, was a bit of a siren call striking while my hands were not tied to the mast.  The article, which originally appeared at the CFA Institute, claims that there is a bubble in bonds because 87% of people surveyed say there is a bubble there “in some way.”  I will get to whether such a claim is self-defeating on contrarian grounds in a second.

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But first, they didn’t, did they?  They didn’t just add up all the percentages that weren’t “None of the Above” to come up with their 87%.  An institute whose main mission is financial numeracy would not sponsor such innumeracy. Would it?

Let me get about my Casio solar-powered calculator, available at Duane Reade.  Yes, they did, although apparently they used the unrounded figures.  And BI published it. No jury would convict me for breaking my promise to avoid the puerile to discuss this.  Wow.

What about the super-obvious idea that an asset class cannot be in a bubble if everybody thinks it is. That is what originally raised my ire here. But I think my original impulse  is wrong, and that this is the one area where the BI article was not far off base.

I like Richard Thaler’s definition of a bubble, which is far superior the conclusory silliness offered at the top of the BI article. Thaler has said — and I assume he still says — that an asset class is in a bubble when people believe it is overvalued but are invested on the expectation that it will become more overvalued based on the the stupidity of others. When the price is set by the greater fool theory, it is a bubble.

What I love about this definition is that it is at least in principle measurable. You can just ask people if they own and why they own, as Thaler has.  Sure people lie and don’t know their own motivations, so your surveys may be wrong. But with Thaler, at least we know what we mean. The concept is, in principle, measurable.  Plus Thaler applied this conception brilliantly to the NASDAQ bubble, as I have mentioned on another occasion.

So I think it is actually ok to claim that bonds are in a bubble because everybody believes they are. It is against my first instinct, but my first instinct is wrong, I think.

The problem is more that, umm,  not everybody believes they are in a bubble. Indeed, according to the CFA guy, the vast majority of people believe they are not in a bubble. So of course, naturally, the story’s main point is the exact opposite.

BI, you’re doing a heckuva job!  “The future of media,” as its owner never tires of saying.  Maybe that guy didn’t change so much after all. Separate discussion.

Also a separate discussion is that Bloomberg seems to be competing on dumb with BI, because they too need the clicks. It is like Gresham’s Law applied to journamalism. Of course Bloomberg has some non-stupid to balance it out. For example, there is Noah Smith.

Here is my view, for whatever it is worth.  I am not a fan of Jim Grant usually, although I appreciate his sense of humor. He once opened a speech with the claim that he has been covering what the bond market would not do for about twenty years now. Good one.

He also says (or recently said) that Treasurys currently offer the exact opposite of the financial unicorn: “return-free risk.” That seems right and gets style points. Smartest guy in New York, according to a survey.

You can say to bonds meh, without claiming they are a bubble! And besides, whatever happened to just believing the price might be wrong because it discounts a fundamental premise that will end up being wrong.  Not every price about  to change reflects a bubble.

Plus the term premium, which is set by QE, as we all know, is now more negative than it has ever been, as QE gradually unwinds. Snigger snigger.*

Snark aside, the term premium is meant to be the expected excess return. And it is now negative. It seems you could be short or — more prudently — just interested in other things.

* Goldman has made the point that market for duration risk is global. As I read that, they are assuming that many investors have a preferred habitat in a type of trade, rather than in a currency of denomination.  I am very skeptical that QE does much, but I think that is actually a pretty fun thought, and totally plausible.  If it is right, then I can’t really declare victory on the grounds that US QE is unwinding and yet the term premium keeps sinking.  So my snark would be misplaced.  I just think GS overstates the scale of these effects, in part by conflating rates guidance (explicit and implied) with the supply effects of the government bond purchases themselves.  This ain’t over. Somebody should add up all the 10-year equivalents not be taken down by QE, globally or in the OECD. Summers et al did it for the US, which I loved, because it made my point in spades. But other smart guys like GS should do it globally.  The idea that global QE has made core market duration scarce assumes facts not in evidence, although it might end up being true. It would be fun to see the numbers.

Shiller CAPE, philosophically speaking

Solution: don’t read books

In this post, I will describe how I produce an analog of the Shiller P/E or CAPE, which is meant to be a measure of equity market valuation that is roughly invariant to the position of the business cycle.

I would not say this is scintillating reading. It is more a technical appendix, to which I may refer occasionally over time, when using the main outputs. The bottom line is that equities look priced to generate poor returns, but that is different from saying they are egregiously expensive and need to reprice lower. Also, valuation can get you only so far. The cycle usually dominates.

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Regarding the logic of CAPE, valuing equities on current earnings can be misleading when earnings are well above trend in the late cycle or well below trend in recession and early recovery. This is familiar stuff.

Despite its advantages, Shiller’s CAPE suffers from a couple technical weaknesses that inclined it to give an unduly bearish signal during the recovery from the global financial crisis. And I suspect it may soon begin to give an unduly bullish signal, at least on a rate of change basis, as those technical issues unwind.

So I implement a couple tweaks to Shiller’s CAPE, which are motivated in large part by some excellent work I saw over at Philosophical Economics. That site is run by a fellow who goes by the pen name, Jesse Livermore.

My own valuation measure is not identical with Jesse’s, although it is very close.  Separately, Jesse has a more-complicated measure of equity valuation that controls for distortions caused by changes of dividend payouts and buybacks.  I think that is very clever stuff, although a bit mind numbing too. For now I will leave it aside, except to say that the controls he offers do not typically generate a qualitatively different valuation signal from what a Shillerized P/E or earnings yield provides.

I assume you know how the CAPE is produced and how to calculate it.  Briefly, it is just the real value of the index level divided by a ten-year moving average of associated real earnings.  By calculating the ratio in real terms, we avoid having equities look misleadingly rich in inflationary environments and misleadingly cheap in low-inflation environments. Again, familiar stuff – I assume.

I make the following tweaks to Shiller’s approach to create an index that is more intuitively familiar and – I hope – less affected by what I would call (admittedly subjectively) “distortions” associated with global financial crisis.

First, I want to use operating earnings rather than reported earnings for all periods over which I have the former.  In the current environment, operating earnings are probably the more meaningful or less misleading, because of the huge write-downs in 2008-09 and 2001.

These artificially depressed Shillerized earnings for a few years after after 2008.  During that period, the Shiller P/E understated the case for equities, as was obvious in real time to anyone paying attention. And in the past couple years, the unwinding of this effects has led to a somewhat misleading (although also predictable) rise of Shillerized reported earnings.  We can partly control for this by using operating earnings where they are available, i.e. after 1985.

Second, I need to adjust the historical reported earnings data so that they may be spliced with the operating earnings I used for all dates after 1985.  Outside recessions, operating earnings tend to be about 10% above reported earnings, as shown in the first panel of the chart at the bottom of this note (1).  Another way to put this is that inflating reported earnings by 10% allows them to sit atop reported earnings for most of that same period (2).

I hasten to add that inflating up the reported earnings for the historical periods introduces a bearish tilt that would otherwise not be there. Or more precisely, it corrects for the bullish tilt that would otherwise be there. Let’s not get that backwards.  A brighter take on the past makes today look less bright by comparison. I have a bull bias, but I am leaning into it here.

Third, I use the PCE deflator rather than the CPI for all periods over which the former is available. Prior to 1947, I use CPI, just as Shiller himself does. This one does not matter that much, but the PCE deflator is a less inaccurate measure of inflation and I rely on it in other contexts.

Fourth, I “center” my Shillerized series by multiplying the entire history by the historical real earnings growth rate, 1.7%, compounded over five years.  This has zero effect on the shape of the P/E series over time or on that of the related earnings yield.  It does, however, make the scale of P/E more intuitively compelling.  That is you can compare the outputs with more conventional metrics, such as price to one-year trailing earnings, without apples and oranges getting in the way.

So with those tweaks in place, what are we looking at here? A few things stand out.

Operating earnings are not even running above their Shillerized value, because the latter has surged, somewhat predictably, on base effects (3). This is interesting to me because it implies that mere Shillerization does not make current period earnings look particularly inflated cyclically. Rather, you get that result only with Shillerization and use of reported earnings. Bears relying on the Shiller CAPE leave every impression of not being aware of this. But at this point, that is water under the bridge. The rally has happened and that technical issue is going to dissipate.

My measure of the Shillerized P/E is 21 ½ vs 27 for the Shiller CAPE.  About 1/3 of this is just due to the centering and is therefore uninteresting, if both series are measured relative to their own history. The rest is due to the other differences in the calculations.

Even with my adjustments, the Shillerized P/E still looks fairly high (4).  At 21 ½, it is 1 ¼ standard deviations above its average for the entire history after 1909. If we look at the period since 1985, roughly the price stability regime, the PE looks a bit less inflated at ¼ standard deviation above average.  This is largely due to the heavy influence of the equity bubble in the late 1990s when the PE rose exponentially.

A fairer way to look at this is to consider the earnings yield, whose distribution is closer to normal. Right now, the earnings yield is 1 standard deviation below its full-same average and ½ standard deviation below its average sine 1985.  This is rich, but not egregiously so.

The low earnings yield is arguably offset to some extent by the low real yield offered in Treasury securities (5).  The real yield on the 10-year note is just 30 bps, which is 1 ½ standard deviations below its post-1985 average.  As a result, the equity spread (defined as the Shillerized earnings yield less the real bond yield) is just ½ of a standard deviation below its all-sample average and ¾ of a standard deviation above its average since 1985 (6).

How to interpret that last point is a matter of great controversy, which totally trumps any quibbling over how to calculate a CAPE.  If the bond yield decline is just a function of an equivalent decline in the corporate sector’s real growth prospect, then the two influences are a wash and it would be wrong to say that lower bond yields support “high” P/E multiples. (Another way to put that is that my equity “spread” does not approximate a proper equity premium.) Alternatively, if bond yields are low for reasons unrelated to growth, then equities are cheap at current prices, particularly relative to bonds.

Goldman’s equity strategists get around this issue by modeling the outlook for earnings directly, rather than using a Shilerization process (merely) to take out the influence of the cycle. Their proper equity premium that has roughly the same shape as my simple yield spread metric, although it is less volatile, I assume because there is information about growth prospects in asset prices. Not every price move is noise. On their work, stocks are somewhat cheap, even taking direct account of this slow-growth environment. I am not sure if that is what the GS strategists are emphasizing now, but it is my reading of that particular indicator.

So what is the net net here? I would say two things.  First, valuation in equities is not yet egregious, so it is hard to pound the table.  I don’t get why the perma bears continue to place such heavy emphasis on the ideas the Shiller CAPE needs to mean revert. That has been quite wrong-footing.

Second, as I have mentioned before, it is possible for equities to be priced roughly fairly, but to to deliver well-below-average returns.  If low bond yields largely reflect slow growth, and if low economic volatility favors a low equity premium (properly construed), then equities may just drift higher, irritating the hell out of all of us — until the next recession.

The return prospect it too dim to be that bullish, particularly if you consider the entire distribution of possible results, including the extreme pain associated with being wrong at these levels. But the heroic bear call does not seem to be there either.  Full disclosure: with me it never is, because it is hard to pay the risk premium.  One needs to avoid base rate neglect, particularly if one is not that bright.  If I were smarter, I could occasionally be bearish.

That is reading a heck of a lot into some pretty crude valuation metrics, but that is the context in which I interpret these charts.  It is subjective. You may have a different interpretation.

Changing subjects radically here, the pseudonymous Jess Livermore reminds me of the real Jesse Livermore, whose fictionalized biography, Reminiscences of a Stock Operator, came off copyright in 2013.  That allowed Tom Rubython to publish Jesse Livermore, Boy Plunger, The Man Who Sold America Short in 1929The new book contains the same trading aphorisms (about which I know nothing) as Reminiscences but also provides a more accurate account of Livermore’s life.  The guy was self-aware, which is always admirable. But what a sad life he led. At the end, he was financially down on the year and down on the life.  And he took that to be all that mattered, the total measure of himself.

One way the real Jesse relates to the fake Jesse and his valuation work is that the former always warned never to commit to the bull or bear side of the market.  As real Livermore would say, using terms irritating to the modern ear, “a man” need not be wed to either perspective.

Yup.  I somehow managed unwittingly to apply that in 2000, at least as a lowly analyst.  But the more books I read, the harder it became for me to pay the equity premium. So the most bearish I can do these days is out.  Solution: don’t read books!

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