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Tuesday, April 28, 2015 12:18 PM


Richmond Fed Manufacturing Index Negative Second Month


The Fed manufacturing surveys continue to disappoint. Today, the Richmond Fed reading came in at -3 matching the lowest guess on Bloomberg.

The headline index is in the minus column for the second month in a row, at minus 3 vs March's minus 8. New orders are in the negative column for the 3rd month in a row, at minus 6, while backlog orders, at minus 8, continue to extend their long negative streak. Shipments are negative, at minus 6, and capacity utilization is negative, at minus 4.

Yet despite the weakness in orders and despite the weakness in shipments, employment in this report, as it curiously has been in other manufacturing reports as well, is up, to plus 7 vs plus 6 in March. This must reflect confidence that ongoing weakness is only temporary and that order and shipment momentum is certain to build.

Other details include depressed price readings, consistent with other reports as well. The manufacturing sector is being held down by weak exports and trouble in the oil & gas sector, but it's not keeping firms from hiring.
Misplaced Confidence?

The Richmond Fed reports Manufacturing Sector Activity Remained Soft; Employment and Wages Grew Mildly
Overall, manufacturing conditions remained soft in April. The composite index for manufacturing moved to a reading of -3 following last month’s reading of -8. The index for shipments and the index for new orders gained seven points in April, although both indicators finished at only -6. Manufacturing employment grew mildly this month. The indicator gained one point, ending at a reading of 7.

Manufacturers looked for better business conditions in the next six months. Survey participants expected faster growth in shipments and in the volume of new orders in the six months ahead. Producers also looked for increased capacity utilization and anticipated rising backlogs. Expectations were for somewhat longer vendor lead times.

Survey participants planned more hiring, along with moderate growth in wages and a pickup in the average workweek during the next six months.
It's important to note that a single firm hiring one person will counterbalance another firm firing 50. It's entirely possible employment is not as strong as it looks (not that 7 is a particularly strong number in the first pace).

Finally, I suspect confidence is on the high side looking ahead. Given strength in the US dollar and a clearly slowing China, I see no reason to believe there is going to be a big second quarter recovery, or if there is one, that it will last.

This isn't all due to the weather.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com

11:31 AM


Deconstructing and Debunking Shadowstats


An interesting article came my way today courtesy of a friend "BC". The article is Deconstructing ShadowStats. Why is it so Loved by its Followers but Scorned by Economists? by Ed Dolan.

Mish readers likely know that I believe inflation to be understated, and that I also believe Williams' ShadowStats is wildly on the high side. For example, please consider GDP, Real GDP, and Shadowstats "Theater of the Absurd" GDP.

I have also mentioned food inflation on many occasions. While food prices (especially beef) did jump in the last year or so, I recently bought chicken breasts for $.99 a pound and very lean center cut pork chops for $2.49. Sale prices on center cut pork chops have generally ranged from $1.79 to $2.49 for 15 years! Not on sale, I have seen them as high as $5.49.

So I buy pork chops on sale, and freeze them. Same with chicken and beef. While non-sale prices have gone up more, ShadowStats calculations seem absurd.

Want to combat food inflation? Buy a big freezer, buy food on sale, and freeze it.

I never dove in into Williams' numbers to see where he may have gone wrong. Ed Dolan just did that, with convincing tables, graphs, and commentary.

Here is a snip.

A can of tomato sauce that cost $.25 at Piggly Wiggly in 1982 cost $.79 at my local market in early 2015. Starting from the 1982 price, the CPI predicts that it should cost $.61 in 2015 while ShadowStats predicts that it should cost $2.64. Starting from the 2015 price and working backwards, the CPI predicts that it should have cost $.32 in 1982 while ShadowStats predicts that is should have cost $.08. Based on these calculations, we see that the CPI underestimates inflation, as measured by the Tomato Sauce Index: The ratio of the 2015 predicted price of $.61 to the 2015 actual price, $.79, is .77, an underestimate of 23 percent. The ratio of the ShadowStats prediction to the actual price is 3.32, an overstatement of 223 percent. For tuna, both indexes overestimate inflation, the CPI by 34 percent and ShadowStats by 478 percent, and so on.



Has Williams Simply Made a Mistake?

The fact that the ShadowStats inflation rate fails every crosscheck makes one wonder whether Williams has simply made some kind of mistake in his calculations. I believe that he has done just that. The mistake, I think, can be found in a table given in a post that represents Williams’ most complete explanation of his methodology.

... Williams’ use of a running total of inflation differentials to compute a “cumulative inflation shortfall” of 5.1 percentage points exaggerates the true impact of the methodological changes made by the BLS. A better way to estimate the cumulative inflation shortfall would be to look at the differences between CPI-U-RS and CPI-U before 1983, the year when the BLS implemented the first of the changes that it incorporates in the CPI-U-RS series. That approach is not quite as precise when we use real-world numbers, as Williams does in his original table. As explained earlier, the actual data include statistical noise caused by changes in weighting and in relative price changes among sectors. However, we can approximate the true inflation shortfall by averaging the numbers for 1981 and 1982 from Williams’ table, giving an estimate of -0.45 percentage points.

As mentioned above, Williams’ ShadowStats inflation series incorporates an additional 2.0 percentage point correction to reflect methodological changes that are not captured in the CPI-U-RS series. I would like to examine that number more carefully in a future post, but for the sake of discussion, we can let it stand. If so, it appears to me that, based entirely on Williams’ own data, methods, and assumptions, the adjustment for the ShadowStats inflation series should be about 2.45 percentage points below CPI-U, rather than the 7 percentage points he uses.

In my view, Williams alternative measure of inflation would be more convincing if he were to make this correction. It would also be less likely to feed the anti-government paranoia of some of his followers, who allege that the BLS is falsifies source data and manipulates reported indicators in the way that Argentina and some other countries appear to do.
If you are a true believer in ShadowStats numbers, I suggest you read Dolan's article in entirety for a convincing rebuttal.

By the way, Dolan was quite polite in his rebuttal, concluding with "I would like to thank Williams for taking the time to make detailed comments on an earlier draft of this post. Our private dialog has not yet led to a complete resolution of the issues I have raised here, but I hope that he will address them in future public comments. The search for alternative inflation indicators goes on."

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com

1:57 AM


Valuations: Maybe I am Crazy


Relative vs. Absolute Value

As I watch valuations on stocks soar higher and higher into the stratosphere, I keep asking "where is the value?"

The problem for most is confusing "relative" value vs. absolute value. Stocks may be "cheap vs. bonds" but what does that matter if bonds are ridiculously overpriced?

Fair Value Has Three Digits

John Hussman has an interesting post this week entitled Fair Value on the S&P 500 Has Three Digits.

The last time I quoted Hussman, a manager for a prominent investment firm emailed something on the lines of "Mish, please do yourself a favor and stop referring to Hussman".

Actually, that was likely be good advice. The problem I have with the advice is simple: I happen to agree with Hussman.

Right, wrong, or in between, I say what I believe. I do not say things I disagree with to get blog traffic up, investments up, or page hits up. I say what I believe, and I suspect it has cost me traffic. I upset Republicans and Democrats, equity bulls and bears, and US treasury bulls and bears.

Things are so crazy I have been accused of being a flaming Obama liberal as well as being in Bush's pocket. Truth be known, I never voted or Obama or Bush, and I have never missed voting in a national election since I was 18. Of course, some people think I am crazy to vote at all and that comment has come up when I mention that I vote.

Life would be so much simpler for me if I was obnoxiously one sided, if I never offended anyone ever, or if I purposely offended everyone all the time.

There's value in being universally despised, value in being hated by half the people all the time, or in never saying anything to offend anyone (being universally liked). Traffic-wise, those three models make perfect sense.

You can quote me on this: It's a tough business to annoy half the people half the time, when the half constantly switches. 

Nonetheless, here we go again.

Value Investing: Is it Possible? What Does it Mean?

Please consider a few snips from Hussman. Emphasis in bold by Hussman.

Last week, the Nasdaq Composite finally clawed its way to breakeven, 15 years after its spectacular bubble peak in 2000. It’s a testament to the overvaluation of technology stocks in 2000 that it has required the third equity bubble in 15 years to reclaim that 2000 high, at least briefly.

Where is “fair value” today? We have to be careful here because the concept of “fair” depends on your assumptions about what a reasonable investment return should be. If I show you a security that’s expected to pay out $100 ten years from today, and I tell you that the current price is $82, you can quickly calculate that the expected return on that security is 2% annually – and you don’t need to know anything about interest rates to do that arithmetic. Interest rates come in after you do that arithmetic. Interest rates then matter only because they give you something to compare with that 2%. Now, if you decide that a 2% annual return over the coming decade is just fine with you, in view of competing alternatives, then it’s fine to call that security “fairly valued.” But even if you decide that the security is fairly valued, you should still expect a 2% annual return over the coming decade. If you viewed a 10-year return of 8% as reasonable, you’d peg “fair value” at $46.32.

On the basis of valuation measures best correlated with actual subsequent market returns, we can say with a strong degree of confidence that the S&P 500 would presently have to drop to the 940 level in order for investors to expect a historically normal 10-year total return of 10% annually. That 940 figure for the S&P 500 would not represent some extreme, catastrophic outcome. It’s not a level that would even represent undervaluation from a historical perspective. It’s the level that we would associate with average, historically run-of-the-mill long-term equity returns. As we observed at the 2000 peak, “if you understand values and market history, you know we’re not joking.”

Last month, Stan Druckenmiller recounted his own experience with capitulation and performance chasing when he was the lead portfolio manager for George Soros and the Quantum Fund:

“I’ll never forget it. January of 2000 I go into Soros’ office and I say I’m selling all the tech stocks, selling everything. This is crazy... Just kind of as I explained earlier, we’re going to step aside, wait for the next fat pitch. I didn’t fire the two gun slingers. They didn’t have enough money to really hurt the fund, but they started making 3 percent a day, and I’m out. It’s driving me nuts. I mean, their little account is like up 50% on the year. I think Quantum was up seven. It’s just sitting there.

“So like around March I could feel it coming. I just – I had to play. I couldn’t help myself. And three times during the same week I pick up a – don’t do it. Don’t do it. Anyway, I pick up the phone finally. I think I missed the top by an hour. I bought $6 billion worth of tech stocks, and in six weeks I had left Soros and I had lost $3 billion in that one play. You ask me what I learned. I didn’t learn anything. I already knew I wasn’t supposed to do that. I was just an emotional basket case and couldn’t help myself. So maybe I learned not to do it again, but I already knew that.”
Not Predictions

Please note that 940 is not a prediction by Hussman or by me. It is a value judgment. The S&P "fair value" number would be higher at an 8% discount and even higher at a 6% discount.

And regardless of the discount rate, stocks can overshoot or undershoot. Stocks can also go sideways for 8-10 years doing much of nothing. Japan is proof enough.

Please don't tell me "It cannot happen here". It can.

Pension plans would be destroyed if stocks go nowhere for 8 years. Moreover, I suspect the Fed would be  relatively pleased at such a benign outcome (assuming that was the only adverse outcome).

Where is Value?

Value is always in the eyes of the beholder. People saw valued in dotcom companies in 2000, in housing in 2006, in gold in 1980, in Japan in 1990.

Today people see value in negative yield government bonds, in junk bonds that pay interest in debt, and in equities that have a smoothed valuation as high or higher than 1929, 2000, and 2007.

Maybe I am Crazy

I see value in in gold and gold miners, in yen-hedged Japanese equities, and in Russian equities at a PE of 6 (see Readers ask "How Does One Invest in Russia?")

But hey, maybe I am crazy. Maybe we see government bonds trading at -5.0% yield and smoothed PEs at 35, topping valuations of 2000 and 1929.

Things are nearly always cheap "relative" to something else. There's a chance the "something else" of the future refers to peak valuations, not now, but rather in 2016.

Feelin' lucky?

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com

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