As I am traveling in Europe for a few more days, it seems appropriate to review
Everywhere I turn is another article about Quantitative Easing Part 2. Will they or won't they? My question last week was will it make any difference? After I sent my letter out, I came across this missive from the always fascinating Ed Yardeni. I like to read Ed because he is not afraid to take an out of consensus call. He is his own man, something of a rarity in the world of economists.
He highlights a report from the Fed on the problem with the money multiplier. It has gone away. (Really? You think?) If you took Econ 101 this was a basic staple.
He writes: "Fed officials are clueless about how quantitative easing is supposed to impact the economy. They aren't even sure if it has any effect on the economy. The Fed study cited here confirms this known unknown."
I include the rest of his letter to let you know what type of material he does daily, as some of you might want to take a closer look at his service. ( www.yardeni.com). I really liked his take on housing. This is an excellent choice for Outside the Box.
I am starting to adjust from the travel. Have a great week!
Your ready for some NBA basketball to start analyst,
John Mauldin, Editor
Outside the Box
All QE2, All the Time
Why QE Doesn't Work
By Ed Yardeni
BULLET POINTS: (1) Fed study buries textbook money multiplier. (2) The Treasury's lap dog. (3) Kohn's exit speech admits Fed is clueless. (4) In 1988, Bernanke questioned money multiplier model. (5) The fiscal multiplier is also baloney. (6) The administration's stimulators are jumping ship. (7) Profitable companies, not bloated governments, create jobs. (8) No double dips in Earnings Month. (9) Double dip in consumer sentiment. (10) No recovery in housing industry.
I) MULTIPLIERS: Wow, there are Existentialists at the Fed! Two economists, Seth B. Carpenter and Selva Demiralp, recently posted a discussion paper on the Federal Reserve Board's website, titled "Money, Reserves, and the Transmission of Monetary Policy: Does the Money Multiplier Exist?" (See link below.) The authors note that bank reserves increased dramatically since the start of the financial crisis. Reserves are up a staggering 2,173% from $47.3bn on September 10, 2008, just before the financial crisis began, to $1.1tn now. Yet M2 is up only 11.4% since September 10, 2008, and bank loans are down $140.2bn. The textbook money multiplier model predicts that money growth and bank lending should have soared along with reserves, stimulating economic activity and boosting inflation. The Fed study concluded that "if the level of reserves is expected to have an impact on the economy, it seems unlikely that a standard multiplier story will explain the effect."
That not only repudiates the textbook money multiplier model but also raises lots of questions about the goal of the Fed's quantitative easing policies. As I discussed yesterday, under QE-1.0, Bernanke & Co. offset the shrinking of the Fed's emergency liquidity facilities with purchases of mortgage securities. QE-1.5 was adopted at the August 10, 2010 FOMC meeting when it was decided that maturing mortgage securities would be offset by purchasing Treasuries. If the Fed decides to implement QE-2.0, as was suggested by Tuesday's FOMC statement, then it is widely presumed that the Fed would expand its balance sheet again by purchasing $1.0tn of US Treasuries.
The Carpenter/Demiralp study implies that QE-2.0 won't be any more successful in boosting M2 growth and bank lending than QE-1.0. If so, then the Fed should be renamed "Feddie." Like Fannie and Freddie, Feddie now owns lots of mortgages. If Feddie buys another $1.0tn of Treasuries, it is simply enabling the US government to continue down the road of reckless deficit-financed spending. The Fed then becomes the lap dog of the Treasury. No wonder that the price of gold is at a new record high this morning.
The Carpenter/Demiralp study quotes former Fed Vice Chairman Donald Kohn saying the following about the money multiplier in a March 24, 2010 speech: "The huge quantity of bank reserves that were created has been seen largely as a byproduct of the purchases that would be unlikely to have a significant independent effect on financial markets and the economy. This view is not consistent with the simple models in many textbooks or the monetarist tradition in monetary policy, which emphasizes a line of causation from reserves to the money supply to economic activity and inflation. . . . [W]e will need to watch and study this channel carefully."
Isn't that wonderful? Fed officials are clueless about how quantitative easing is supposed to impact the economy. They aren't even sure if it has any effect on the economy. The Fed study cited here confirms this known unknown. The Bank of Japan tried quantitative easing to revive their economy and avert deflation, but it didn't work. By the way, Kohn's March 24 speech was titled, "Homework Assignments for Monetary Policymakers." (See link below.) He just retired after spending 40 years at the Fed.
Here are more shocking revelations from the study under review: "In the absence of a multiplier, open market operations, which simply change reserve balances, do not directly affect lending behavior at the aggregate level. Put differently, if the quantity of reserves is relevant for the transmission of monetary policy, a different mechanism must be found. The argument against the textbook money multiplier is not new. For example, Bernanke and Blinder (1988) and Kashyap and Stein (1995) note that the bank lending channel is not operative if banks have access to external sources of funding. The appendix illustrates these relationships with a simple model. This paper provides institutional and empirical evidence that the money multiplier and the associated narrow bank lending channel are not relevant for analyzing the United States."
Did you catch that? Bernanke knew back in 1988 that quantitative easing doesn't work. Yet, in recent years, he has been one of the biggest proponents of the notion that if all else fails to revive economic growth and avert deflation, QE will work.
So why hasn't it worked just when we need it most? My theory is that the Keynesian apparatchik in both Japan and the US welcome economic and financial crises as great opportunities to grab power. So they come to our rescue with massive spending programs financed with lots of borrowed money. The Japanese government built roads and bridges to nowhere that nobody needed. The US government can't seem to even do that. Instead, the stimulus spending has been focused on keeping unionized public workers employed. The government's intrusion into the economy, with its huge deficits and mounting debt, depresses the private sector. Watching the central bank enable it all by purchasing some of the government's debt is even more depressing. This is why quantitative easing doesn't work.
So the textbook model of the money multiplier is irrelevant. Early last year, I argued that the textbook model of the fiscal multiplier is also baloney. In the February 9, 2009 Morning Briefing, I wrote: "I can't think of a more tired old theory than the Keynesian notion that $1 of additional government spending will generate $1.5 of real GDP. This 'multiplier effect' is taught in every introductory macroeconomic textbook. Yet, it is both theoretically and empirically questionable." I then went on to quote the supporting evidence for my view in an OECD working paper by Roberto Perotti titled "Estimating the Effects of Fiscal Policy in OECD Countries," which is linked below.
College students should be required to read a paper written by Christina Romer and Jared Bernstein, titled "The Job Impact of the American Recovery and Reinvestment Plan," dated January 9, 2009 (linked below). When the Obama administration came into office, Romer chaired the Council of Economic Advisors and Bernstein became the chief economist for VP Joe Biden (seriously). The Romer/Bernstein analysis was based on a super simplistic Econ 101 fiscal multiplier model. The government boosts spending by $800bn. GDP rises by 1.5 times as much, i.e., $1.2tn. That creates 4mn jobs. It's that simple. Sadly for the millions of Americans who are out of work, economists who were skeptical were right to be so. The American Recovery and Reinvestment Act did not work as advertised. Now, some of the major proponents of the fiscal multiplier are leaving the administration, including Romer, Orszag, and Summers.
• Mortgage Market (weekly): What's happening in the mortgage market? (1) The MBA applications new purchase index fell for the second straight week, down 3.3% in the week ending September 17 following a 0.4% decline the prior week. The index had increased 8.9% over the previous three-week period. The 4-wa rose for the third straight week, but remains around 14½-year lows. (2) The refinancing index fell for the third straight week, down 0.9% w/w and 14.3% over the three-week span. That followed a five-week climb of 29.8%. The level is still more than double the reading at the start of the year. (3) The rate on 30-year fixed mortgage (FRM), based on Freddie Mac data, edged up 5bps the past two weeks to 4.37% from 4.32%, a low for the series going back to 1972. The spread between the FRM and the 10-year Treasury yield is around its historical average, while FRM remains high relative to the federal funds rate.
II) STRATEGY: If the monetary and fiscal multipliers are figments of the imagination of macroeconomic textbook writers, what works? Profits! The Fed does not create jobs. The Treasury can't do it either. Profitable companies create jobs and expand their capacity to hire more workers when they are optimistic about the outlook for profits. Profitable companies can drive up the stock market even if investors aren't doing so. They can do that by using their record cash flow to buy other companies and to buy back some of their shares.
The Q3 earnings season is set to begin soon. The bottom-up consensus estimate for the S&P 500 is currently $20.68 per share, up 26.4% y/y. The estimates during the previous six earnings seasons just before companies started to report were all too low by 10.0% on average, in a range of 4.6% to 15.4%. Another underestimate is likely this quarter.
• S&P 500 Sectors Forward Earnings & Valuation (weekly): What's the latest direction in weekly forward earnings per share and valuation for the 10 S&P 500 sectors? In the week ended September 16, forward earnings edged lower for 9/10 sectors, but valuation rose for all 10 sectors. Forward earnings at a record high for Health Care, and near a record high for Consumer Discretionary, Consumer Staples, and Tech. Forward earnings near a cyclical high for the rest: Energy (21-month high), Financials (21-month high), Industrials (21-month high), Materials (23-month high), Telecom (11-month high), and Utilities (19-month high). S&P 500 P/E up to 12.2 from 11.9 and from a 16-month low of 11.5 in early July, but down from a 27-month high of 15.1 in October 2009. P/Es are up from cyclical lows 11 weeks ago for all of the sectors, but the relative P/E is near a 14-year low for Tech, and near a six-year high for Telecom. For detailed charts including squiggles, see Earnings Week (with Squiggles) on our website.
• S&P 500 Sectors Quarterly Earnings Growth Trends: Any big changes to quarterly earnings and revenue growth forecasts lately? Analysts expect the S&P 500 to record mostly double-digit percentage earnings growth and high single-digit revenue growth from Q3-2010 to Q2-2011, but have trimmed their forecasts in the past month. The S&P 500's y/y earnings growth forecast for Q3-2010 is down to 27.8% from 28.7%, and the revenue forecast is down to 7.7% from 7.9%. All sectors have had their Q3 growth rate edge lower in the past month, and Telecom was the only sector to have its revenue growth rate rise. Y/Y earnings and revenue growth is expected to be positive for 9/10 sectors in Q3. The earnings growth rate is expected to improve q/q in Q3 for the S&P 500 and three sectors: Financials, Industrials, and Utilities. Revenue growth is expected to slow for the S&P 500, but improve for Industrials and Utilities.
III) EARNINGS MONTH: Joe and I have updated our Earnings Month with September data. So far, there are no double dips in the forward earnings of the 10 S&P 500 sectors and 100+ industries. In fact, new record highs were reached by four of the sectors: Consumer Discretionary, Consumer Staples, Health Care, and Information Technology. Seventeen industries had forward earnings at record highs: Apparel Retail, Biotechnology, Computer Hardware, General Merchandise Stores, Footwear, Gold, Health Care Distributors, Industrial Gases, Leisure Products, Packaged Foods, Pharmaceuticals, Railroads, Restaurants, Soft Drinks, Specialty Chemicals, Systems Software, and Tobacco. This is a good mix of noncyclical and cyclical businesses.
• S&P 500 Sectors Relative Forward Earnings (September): How did forward earnings per share and P/Es perform for the S&P 500 and its 10 sectors in September? S&P 500 forward earnings rose 0.6% m/m, and was up for a sixteenth straight month. The forward P/E edged up to 12.2 from an 18-month low of 12.0 and is up from a 23-year low of 9.5 in November 2008, but is down from a 27-month high of 15.1 in October 2009. Forward earnings rose for nine of the 10 sectors in September, but P/E ratios rose for all 10 sectors. Four sectors had record high forward earnings: Consumer Discretionary, Consumer Staples, Health Care, and Tech. Tech forward earnings up for 19 straight months, Consumer Staples up for 18 months in a row, and Health Care up in 18 of the past 19 months. Financials' forward earnings up 82% from its cyclical bottom in May 2009, and rose 1.9% m/m in September for the best gain in the S&P 500. Industrials' P/E ratio down to 13.7 from a five-year high of 16.9 in April and is second highest in the S&P 500. Telecom (14.9) was the highest P/E sector and at a 35-month high in September. Materials P/E of 13.6 down to fifth highest from first in February, and down from a seven-year high of 21.4 in September 2009. Financials' P/E ratio down to 11.4 from an 11-year high of 17.6 in September 2009. Energy P/E of 10.6 is the lowest of the 10 sectors again, followed closely by Health Care at 10.8.
• S&P 500 Industries Relative Forward Earnings (September): What did forward earnings momentum do among the S&P 500 industries in September? The positive Mo was stronger than in August. Sixty-six of these 77 industries rose in September, up from 58 in August and back in the range of 64 to 69 rising industries seen from April to July. It had been down to a record low of five in November 2008. Seventeen industries had forward earnings at record highs: Apparel Retail, Biotechnology, Computer Hardware, General Merchandise Stores, Footwear, Gold, Health Care Distributors, Industrial Gases, Leisure Products, Packaged Foods, Pharmaceuticals, Railroads, Restaurants, Soft Drinks, Specialty Chemicals, Systems Software, and Tobacco. Valuation rose for 58/77 industries in September, up from 30/77 industries in August and 13/77 industries in July. During May, valuation fell for 76/77 industries. Semiconductors P/E up from a record low in August, but Semiconductor Equipment fell to a record low. (See Earnings Month posted on yardeni.com.)
IV) US CONSUMER: The US economy is depressing. That's not my opinion, but rather the opinion of respondents to the monthly Consumer Sentiment and weekly Consumer Comfort surveys during the first half of September. Debbie notes that that the three-month drop in the Consumer Sentiment Index (CSI) from 76.0 during June to 66.6 in mid-September was led by a drop in sentiment among high-income families. Interestingly, sentiment among low-income families increased for the second straight month. Perhaps the former are expecting that their Bush tax cuts will expire, while the latter are expecting that their tax cuts will be extended.
In any event, the double dip crowd can add the CSI to their supporting evidence. It is the lowest since August 2009. The expectations component of this index is down sharply over the past three months from 69.8 during June to 59.1 in mid-September. That's the lowest since March 2009. There's no double dip in the weekly Consumer Comfort Index because it never really recovered. Debbie notes that it has been range bound at record lows since early 2008.
• Consumer Sentiment: How are consumers feeling? Still depressed. The Consumer Sentiment Index (CSI) dropped to 66.6 in mid-September, the lowest since last August. Sentiment among high-income families fell to a 13-month low, while sentiment among low-income families increased for the second straight month. The expectations component sank to an 18-month low, while the present situation was little changed around recent lows. House-buying attitudes remained around 4½-year highs, though near the bottom of its recent flat trend. This month, 73% of consumers said it's a good time to buy a house, while 26% said it was a bad time to buy. Car-buying attitudes skidded to a 21-month low, with those saying it's a good time to buy a car falling from 65% to 59%, and those saying it's a bad time to buy rising from 22% to 26%. Consumers' opinion of government remains around highs for the year. However, the percentage saying the government is doing a bad job (41%) is more than double the percentage of those saying it's doing a good job (16%). The one-year expected inflation rate dropped to a year-low of 2.2%.
• Consumer Comfort (weekly): ABC News/Washington Post Consumer Comfort Index (WCCI) fell 3 points during the week ending September 18, the largest weekly loss since mid-April. The decline sends the index back to the middle of its range for the year, only 8 points above its all-time low. The buying climate component dropped 6 points for the week, while the personal finances component was 2 points lower. The economic component was unchanged for the fourth straight week.
V) FOCUS ON S&P 500 HOUSING-RELATED INDUSTRIES: One of the main reasons why the US recovery has been subpar, and will probably remain that way for a while, is that the housing industry is still in recession. It isn't likely to come out of it for several years. While there has been a modest (tiny) upturn in single-family housing starts since the cyclical record low of 360,000 units (saar) during January 2009, houses under construction dropped to a new record low of 276,000 units during August. (The data start in 1970.) This means that construction-related employment will remain depressed.
Housing starts surged 10.5% in August to the highest level since spring, but the activity was driven by a sharp 32.2% spike in apartment construction, which tends to be volatile. New construction of single-family homes, which accounts for 75% of the housing market, rose a much smaller 4.3% to an annualized rate of 438,000, the first increase in four months, but still down 9.1% y/y.
More importantly, permits for new construction increased only 1.8% in August to an annualized rate of 569,000. Permits for condominiums and apartments rose 9.8%, but permits for single-family homes dipped 1.2%, the fifth consecutive monthly drop.
• Housing Starts: A subpar recovery in housing? That's the most likely scenario. Single-family starts climbed 4.3% in August to 438,000 units (saar) after a 3-month drop of 20.1%. A government tax credit boosted starts ahead of its April expiration. Single-family permits fell for the fifth straight month in August to 401,000 units (saar), down 1.2% m/m and 26.0% over the five-month period. Both starts and permits remain above early 2009 lows, but lack momentum. The housing recovery will likely remain a slow go until the labor market picks up.
• Homebuilding (underweight): The stock price index for underweight rated Homebuilding has tumbled 30.2% from its bull market high for the tenth worst performance in the S&P 500, and is now down 0.6% ytd and trading 9% below its falling 200-dma. Forward earnings positive since February for the first time since July 2007, but has not risen since June. Low mortgage rates and improving credit conditions led to a modest rebound in sales during 2009, and analysts are no longer slashing their consensus annual forecasts. Analysts expect a profit in 2010 for the first time in four years. However, the industry needed a tremendous amount of stimulus to close deals recently, and weak employment remains a concern. NERI had been negative from February 2006 through October 2009 before rising to a five-year high of 24.1% in June, but was negative again in August and September. Housing starts up from their worst readings since the data started in the early 1960s, but likely to remain depressed along with new home sales.
• Home Improvement Retail (overweight): Overweight rated Home Improvement Retail's stock price index is down 18.1% from its bull market high and trades 2% below its falling 200-dma, but has risen 1.7% ytd. Forward earnings has risen in 16 of the past 18 months to a 33-month high even as the housing market remains troubled. After 11 straight years of double-digit earnings growth from 1995-2005, Home Improvement Retail earnings were pummeled by the housing recession, but analysts expect a return to double-digit earnings growth in 2010 and 2011 even though NERI has been negative again since August. P/E up to 14.0 from a 20-month low of 13.4 in July and at a 14% premium to the market as the profit margin surged to a four-year high of 6.3% in Q2. However, the industry's retail sales are down 10.0% from its recent peak in May, and has fallen in three of the past four months.
• Computer & Electronics Retail (overweight): The stock price index for the overweight rated Computer & Electronics Retail industry is down 20.4% from its bull market high, and is trading 2% below its falling 200-dma. Forward earnings rose 2.1% m/m in September and is up in 18 of the past 21 months, but remains 5.3% below the record high in September 2007. Analysts expect earnings to rise 12.9% in 2010 and 10.0% in 2011, and their forecasts have edged higher in recent months. The industry's P/E was up to 9.2 from a two-year low of 8.9 in August, but remains at a near record low 25% discount to the market. Profit margin up to 3.2% in Q2 from an 11-year low of 2.2% in Q4-2007, but we expect the profit margin to remain low for this intensely competitive industry. The forward earnings improvement and the positive NERI since March 2009 is a good start, but consumers need to keep shopping for the price index to keep rising to new bull market highs and for valuation to move higher.