Odds In The Skeptic's Favor

By: Michael Ashton | Sun, Mar 25, 2012
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Friday's shocking news was that new home sales are weak!

I would say that sometimes I don't understand market reactions, but the fact is that I fully understand them much of the time; I just can't understand how investors can be so myopic. New Home Sales came in at 313k, below the 325k that had been expected. The stock market initially didn't take the news well, and bonds rallied. But look at the chart below - what number, short of 500k, would have been great news?

And in fact, there was some good news in both the New Home Sales data and the Existing Home Sales data from Wednesday, and that is that the inventory of homes continues to decline. While it's certainly true that there could well be "shadow inventory" of existing homes to come on the market, the actual inventory that is out there now is near the lowest level it has seen since 2005, and in somewhat of a 'normal' range (see Chart). The inventory of new homes, already at multi-generational lows, fell further. Both of these facts speak to the likelihood that we are not likely to see a new leg lower in home prices soon, although the fact that there probably is some shadow inventory means home prices might continue to lag inflation a bit on the upside (thereby falling in real price terms).

Friday trading volumes were light, and stocks rebounded to close with small gains with the S&P just shy of 1400 again. Treasury bond yields fell again, by a smidge. But gasoline prices, now at a $3.89/gallon nationwide average price at the pump, continue to roll higher as the front Gasoline contract rose to a new record for March ($3.3852). Support for energy prices was partly due to a report that Iranian crude exports declined this month - again, in a shocking surprise since Iran has been saying they are cutting exports.

But for myopia, it's hard to beat economists. The Atlanta Fed macroblog on Friday had an article by research director Dave Altig that is worth reading even though I am about to focus on something about it that annoyed me. Most of the posts on the macroblog are fairly interesting, but in some cases they are interesting in the same way it is interesting to look at tree sloths at the zoo. You can gaze at economists behind the glass and muse "they really aren't like us, are they?"

In this case, Dr. Altig shows a number of intriguing charts showing the weak pace of job growth in this recovery, before raising the good question about "whether historical standards represent the appropriate yardstick today."[1] Then he goes off the rails a little bit:

"In other words, is the correct reference point the level of employment or the pace of improvement in the labor market from a permanently lower level? For the proponents of the latter view, the bubble chart might very well look like a return to normal, despite the fact that employment has not returned to prerecession levels.

"One way to adjudicate the debate, in theory, is to rely on the trajectory of inflation. If there remains a significant amount of slack in labor markets, as the conventional interpretation of things suggest, there ought to be consistent downward pressure on prices. The case for consistent downward pressure on prices is not so obvious...

"There may not be much evidence of building disinflationary pressure, but neither is there building evidence of an inflationary push that you would expect to see if the economy were bumping up against capacity constraints. Obviously, the story isn't over yet."

Readers of this column know that I've pointed out a number of times that the failure of the growth-causes-inflation theory in this recession - the worst recession in eighty years didn't cause prices to fall on a year-on-year basis even a little, or to even get very close; moreover, if you exclude the imploding cost of housing, inflation didn't even slow very much at all - ought to more or less end the debate over whether growth (or recession) causes inflation (or deflation). It takes a Herculean feat of open-mindedness to say "the case for consistent downward pressure on prices is not so obvious" when core prices have accelerated for 15 of the last 16 months.

But Altig actually it trying to resuscitate the moribund theory by suggesting that perhaps what is wrong isn't the theory, but rather the estimate of how much slack there is in labor markets. In other words, the theory is still good, but they were just completely wrong about what the limits of productive capacity were. My question is, if the theory's parameters can be so wrong, is it useful as a theory? And the Occam's Razor explanation is that...the theory is wrong.

I find the continued resistance to that possibility, despite the accumulating evidence that it is the case, almost incredible. I think it is probably a consequence of the way we try in college to teach the current state of knowledge as the 'right answer' instead of 'our best guess right now.' Students think they are learning the answers, and therefore they don't need to question the answers. This is a sad state of affairs. We should be always looking for ways the prevailing theory is wrong, rather than just assuming it is right, because we find over and over and over again, in almost every category of knowledge from physics to astronomy to economics, that the prevailing theory is, in fact, wrong. The odds are in the skeptic's favor!

And that is one reason that true contrarians (as opposed to those people who want to be just like the other contrarians) tend to do well in markets.

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I will be in San Diego for the next few days, where I am speaking at the IMN Public Funds Summit on the topic of innovations in inflation hedging and trying to make contact with potential clients in the public funds space. Accordingly, there will be no commentary produced until Thursday evening (and an article at that time will depend on work load!).

 


[1] Note that this isn't the place to argue the demographic (baby boomers retiring) angle because the Unemployment Rate, which is based on a survey which incorporates job seekers' intentions, still shows a very high rate. This debate is on the jobs-creation side: have jobs been permanently destroyed here, so that we are rebuilding the economy from a lower plateau rather than restoring lost jobs? I think that's fairly likely, given the depth and length of the recession.

 


 

Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA
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Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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