The first statistic is a macroeconomic indicator called the Employment-to-Population Ratio (E/Pop, to distinguish it from E/P or earnings yield). I prefer E/Pop to all other employment-health indicators because, unlike the unemployment and labor force participation rates, it takes the least amount of manipulation to calculate it.

E/Pop is simply the number of adults (16+ YO) employed in the US divided by the number of people 16+ living in the US who are not in institutions (jail, mental health facilities, etc.) or in the military. No one has to guess whether these people are “looking” for work or really “participating”. It measures the  number of people truly working relative to the number of us relying on those who are working to pay our collective bills. After all, the money that pays our bills can only come from people who produce; it is not created from thin air.

If there is a weakness in this indicator, it is that it overestimates economic strength by including in the numerator those who work part time, especially now when the proportion of part time workers is elevated.

http://www.advisorperspectives.com/dshort/updates/Full-Time-vs-Part-Time-Employment.php

Robust economic conditions are indicated by relatively high E/Pop ratios and weak conditions by relatively low E/Pop ratios.

The E/Pop has indicated that the economy is weak and that this “recovery” since 2007 could easily be labeled “stagnation”. The E/Pop plummeted in the housing crisis and despite unprecedented fiscal and monetary stimulus, it has barely gotten off the mat since. May’s reading announced today is 59.4%. The last time (before the current stagnation) that it was this low was in April 1984 when the economy was still digesting Paul Volcker’s attempt to choke off the inflation debacle of the late 1970s.

The second statistic–one that continues to worry me about the stock market–is Robert Shiller’s Cyclically Adjusted PE (CAPE) ratio. The latest reading shows that the stock market’s price equals 27.38 times its trailing ten-year earnings. The last time it was this high was July 2007, almost to the day that the housing crisis began and about one year before the stock market plummeted in response. It was higher only twice before in history, just before two of history’s most terrifying market crashes.

I write about these “macro” themes because, as Howard Marks says, it’s important for “intelligent investors” to know where the economy and market stand as they go about their business of evaluating businesses one-by-one and determining whether they can purchase those businesses at prices that deliver a Margin of Safety. Since 2011, the level of the CAPE helps explains why investors have found so few opportunities that possess a Margin of Safety. Invest appropriately.

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The S&P 500 Index delivered a 13.69% return in 2014 as the market continued to reach new highs after reaching new highs in 2013. This year, for the first time, I have highlighted the years corresponding with the inflation and bursting of the DotCom bubble (grey) in addition to the Great Depression (yellow) and the Housing bubble (blue).

Clearly, there were more extremes and more years of extreme results during the Great Depression than the two most recent crises. In eight of the years from 1928 through 1938, the market either lost or gained more than 30%. In contrast, in each of the DotCom and the Housing bubble periods, the market had just one year of such an extreme.

There were obviously more extremes and more years of extreme outcomes during the Great Depression than the two most recent crises. Over the eight years from 1928 to 1938, generic cialis sales grew by 40% and you can read more about these successes on the main page of our website.

In half of all years since 1825, the market delivered a return between -10% and +10%. So, if we narrow the definition of extreme to losses or gains of more than 10%, the Great Depression experienced nine such years, the DotCom bubble five, and the Housing bubble five.

Many argue that the Federal Reserve is getting better at managing crises, and the above data would seem to agree. The Great Depression was the first crisis that the Fed experienced and many recent policy makers, including Ben Bernanke, went to school on Great Depression policy. On the other hand, others argue that the mere awareness of a Federal Reserve “put” is creating crises that future Fed policy will be unable to fix. I guess we will know who is right soon enough.

The return mode is still 0% to 10%. In a large majority (71%) of years, the market is positive. And, the market experiences declines of 10% (20%) or more in a mere 13.7% (4.9%) of years. So, an outsider’s perspective indicates that investing in the broad market is clearly in your favor, in part because of natural inflationary increases, and in part because of real increases in productivity and earnings due to technological and human capital advances.

The insider’s perspective is a different story. As of January 19, 2015, Shiller’s CAPE sits at 26.7, which is 61% above the average CAPE of 16.6 since January, 1881. The only periods in which the CAPE was higher than today were 1929 – 1930, immediately before the Great Depression; late 1996 – 2002, immediately before and after the DotCom bubble burst; and from late 2004 – late 2007, immediately before the bursting of the housing bubble. So, the CAPE is not a great short-term timing mechanism because recent extremes were able to persist for long periods, but it is an excellent indicator that the piper has to be paid eventually.

Other market indicators including Tobin’s Q and Buffett’s PE confirm the implications of Shiller’s CAPE. Investors who were cautious in periods like this had dry powder to exploit market declines. Investors who chased returns in periods like this rode the market without a brake (a hedge) and often only got off the ride by jumping off at market lows.

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If it is easy for corporations to borrow in public debt markets because high liquidity keeps interest rates low (in the near term), corporations that lack ideas for organic expansion at high ROI will issue debt and use the proceeds to buy back equity or go on M&A sprees. Those purchases raise the price of equities regardless of underlying fundamentals.

If it is easy to borrow from a bank or in public debt markets to buy a residence for occupancy or investment (see, e.g. Blackstone’s residential investment fund http://www.blackstone.com/businesses/aam/real-estate), consumers and investors will borrow and push up house prices. There is evidence from the structured finance industry that the market that has been least resistant to secondary financing has been the auto loan ABS market, especially in sub prime loans. It’s no surprise, then, that auto prices have held up better than home prices as borrowers find easier access to auto credit than mortgage loan credit.

http://www.standardandpoors.com/spf/swf/auto_abs/index.html#/54

Finally, the least resistant path for liquidity may be in the art world as wealthy investors need to “do something” with their cash that is earning next to nothing in the fixed income market. Doing nothing can be very difficult.

In the year from July 2013, sales of contemporary art at public auctions reached $2.046 billion dollars, up 40 percent on the previous year, Artprice’s annual report said.

http://news.yahoo.com/record-breaking-contemporary-art-103321463.html

Howard Marks has a great maxim for this behavior:

What the wise man does in the beginning, the fool does in the end.

We are in unchartered territory with respect to Quantitative Easing, but as Herb Stein has said, “If something cannot go on forever, it will stop.” The Fed will have to stop providing liquidity eventually. When the Fed stops, many will be caught by surprise and they will suffer. Don’t be one of those people.

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“There was one additional dissenter for the September statement. Philadelphia Fed President Charles Plosser voted against the position in July, and he was joined this month by Dallas Fed President Richard Fisher.

‘President Fisher believed that the continued strengthening of the real economy, improved outlook for labor utilization and for general price stability, and continued signs of financial market excess (my emphasis), will likely warrant an earlier reduction in monetary accommodation than is suggested by the Committee’s stated forward guidance,’ the statement said.”

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http://www.blackrockblog.com/2014/08/07/great-deleveraging-happened-debt-problem/

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In most cases, residential investments deliver net returns equal to the rate of inflation, at best, and that does not factor in the amount of time the homeowner spends dealing with problems, brokers, and tenants, nor all of the aggravation.

http://www.bloomberg.com/news/2014-08-13/bought-a-new-vacation-home-i-m-so-sorry-.html

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I usually have a negative knee-jerk reaction to anyone who says “it’s different this time” and true to form, I disagree with Sufi’s argument that capital can replace labor completely. His is a Luddite argument that has been made since the industrial revolution and never materialized. Capital can only replace labor when (if?) we reach the Singularity and machines can reproduce themselves. (By machines, I mean both mechanical and electronic.) Until then, back-breaking labor will be replaced by machines that, in order to propagate, will need engineers and programmers and maintenance workers and chip makers, and entrepreneurs who can employ machines in purposeful activity, etc.  That reminds me; I also added Ray Kurzweil’s website to the blogroll.

http://blogs.cfainstitute.org/investor/2014/07/23/debt-and-secular-stagnation-amir-sufi-discusses-the-us-recovery-video/

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“…around 50% of our assets are in cash, and that’s a very high absolute number, now around $14 billion and rising…”–Seth Klarman

I recently came across this quote from Seth Klarman of the Baupost Group, which he said during a speech that he gave at James Grant’s Investment Conference in October 2013 (http://www.grantspub.com/mygrants/viewarticle.cfm?aid=4995).

If anything, Seth has less capital employed now than he did then.

If I had to pick one investor with whom I felt closest philosophically (and operationally), it would be Seth. PAR is currently sitting on cash equal to 55% of client capital because our bottom-up process has revealed few bargains and PAR has just about enough invested in the bargains PAR has uncovered.

As readers of PAR’s holiday card may have noted, I now view cash the way Buffett’s biographer believes Buffett views it: Cash is an option on thousands of companies and each option has no strike price, no expiration date, and no premium cost other than the lost purchasing power due to inflation. At current inflation rates, the premium is low.

This is the strongest argument to the oft-asked question: Why should I pay [Investment Manager] to hold cash? The answer, of course, is that they are paying [Investment Manager] to have the discipline to buy perpetual options on companies that will one day provide a margin of safety. [Investment Manager] “finds” these perpetual options by selling positions that become fully valued in inflated markets. It takes discipline to sell at or near full value when markets have been rising. Clients who believe that they could do the same as [Investment Manager] need to be introspective and seriously question (and answer honestly) whether they held significant amounts of cash in 2007 and employed it fully in 2009.

Coming into 2014, the market in general was overvalued as evidenced by the CAPE, Tobin’s Q, profit margins, etc., but patient investors will get their opportunities. Those with dry powder, who have been sitting on a perpetual option on every company–i.e. sitting on cash–will be the ones who exploit those opportunities.

My friend Chris Cannon attended Grant’s conference last fall and took some notes from Klarman’s speech that day that I have condensed. Enjoy:

“Seth is a great worrier.  He worries top down but invests bottom up.  He says top down analysis is a lot like sports talk radio – lots of talk and opinions…

Most investors/portfolio managers feel a gun to their head to get fully invested.  This is a weakness…

…if (Baupost) thought the world was going to collapse tomorrow then they wouldn’t return the cash. So he can’t figure out the timing.  But if it does collapse he will ask his investors for more cash…

His biggest concern is that his investors take the cash he returns them and place it with a manager putting up big numbers over the past few years, especially the last two. “This is a recipe for disaster.”  He’s encouraging them to protect it…

Nobody in the White House or the Fed has any practical business experience and handing the reigns to another academic seems totally nuts to him…

He thinks big cap companies (like Jeremy Grantham’s high quality) aren’t mispriced enough for him to do anything interesting with them…

(Because of LBO recaps and refinancings, Y)ou don’t need an economic downturn for a crack up (in high yield), just slightly higher yields… So a crackup in high yield is very, very, likely…

It’s embarrassing that after a crisis that nobody saw, government policy continues pouring on more gas to fuel more speculation to get things (stocks, real estate, debt) back to the same place we were, or maybe even worse now…

It took him at least 15 years of repeating his ideas so clients can see them really work and then they sink in.”

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“For decades, the name of the game for investors has been to make as much money as possible. From now on, Mr. LeBaron thinks, the prime directive will be to “lose as little money as possible…

In Mr. LeBaron’s view, the easy-money policies of central banks, including the Fed, have created what he calls ‘administrative markets’–in which prices are set at least partly by government policy rather than by market forces.

But, he worries, that can’t last forever. ‘In complex systems, the dynamics are predictable but the timing isn’t,’ he says. ‘It’s like adding a grain of sand one at a time to a pile: You can’t tell when it will collapse, but you know it will.’”

Dean offers great advice: “Look for the questions that are not being asked?” I try to think of these at least once per day.

http://blogs.wsj.com/moneybeat/2014/01/17/new-warnings-from-an-investing-pioneer/

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Public Pension Ponzi Scheme; New York Cities Borrow From Pension Plan to Make Contributions.

The definition of Financial Repression:

Several measures that governments employ to channel funds to themselves, that, in a deregulated market, would go elsewhere.

Elsewhere indeed. I feel for the public sector employees who made calculated decisions to take less pay in their careers in return for early retirement opportunities and generous retirement benefits. Of Course that pay disadvantage was pre-2008, because today government employees make more than average private sector employees according to the CBO. But, these were promises made by politicians that could not possibly be kept.

Homeowners have no one to blame for their predicament if they drained the equity out of their houses during the bubble via bank loans and used the cash to buy cars and TVs of ephemeral value and now find their house is worth less than their loan balance. Sadly, public pensioners should also have seen this coming. Grey swan number 8 may be closer than we think.

http://amarginofsafety.com/2012/02/24/a-herd-of-grey-swans/

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