My Amazon Review of Mark Spitznagel's, "The Dao of Capital: Austrian Investing in a Distorted World"

Money manager Mark Spitznagel has written a very wordy paean to Austrian Economics. If ever a book needed a tight fisted editor this one is it. However, once you get beyond reading every thing Spitznagel knows about Austrian Economics the reader will get a better understanding of economics and the investment process. The key takeaways from the book are the core notions of Austrian Economics which value roundabout(indirect) production over direct production and the role of monetary policy to distort investment decisions. For example, in the case of the former, the direct route to catching a fish would be to try to grab one in a pond while the roundabout and far more profitable route would be to make a net first and then use it to catch fish. In case of the latter, the low interest policy of the Federal Reserve induces investment that will be proved unprofitable once interest rates normalize leading to a bust. This knowledge leads investors to hedge tail risks when the stock market trades at high price/replacement cost ratios and to buy individual stocks that with high returns on capital that won't be affected by increases in interest rates. Nothing really new here, but puts some real foundation underneath it. That is the value of the book.

Spitznagel uses the biographies of the three great Austrian economists, Carl Menger Eugen von Bohm-Bawerk and Ludvig von Mises to explain Austrian economic theory. All of that is to the good, but he leaves out perhaps the greatest Austrian economists of all time, Joseph Schumpeter and Friedrich von Hayek. I guess Schumpeter's and Hayek's work don't quite fit into his theories. He also ignores the work of three American economists who built on the work of the Austrians: Irving Fisher, Frank Knight and Jack Hirshleifer, a former professor of mine. For example Hirshleifer, in his "Investment, Interest and Capital" outlines a general equilibrium approach to interest rate determination with a society's rate of time preference and an intertemporal production possibilities function, pure Austrian economics.

The full Amazon URL is:http://www.amazon.com/The-Dao-Capital-Investing-Distorted-ebook/product-reviews/B00D7P2K1W/ref=cm_cr_pr_hist_3?ie=UTF8&filterBy=addThreeStar&showViewpoints=0&sortBy=bySubmissionDateDescending

My latest USNEWS Blog, "The U.S. Needs Some New Management"

This is a follow-up to my blog on the government shutdown and the implementation of Obamacare. For the complete article see the following url: http://www.usnews.com/opinion/blogs/economic-intelligence/2013/10/23/obama-and-the-gop-should-be-fired-over-the-shutdown-and-obamacare-glitches

After Action Report on the Government Shut Down

The wrecker caucus within the Republican Party failed in their attempt to perform a late-term abortion on Obama Care. After 16 days of folly the wreckers succeeded in damaging the Republican brand name and escalated the civil war inside the Republican Party that will certainly rage until at least the 2016 convention. It won't be pretty.

Strange as it may seem the wreckers were rescued by Senate Minority Leader Mitch McConnell who enshrined the 2011 sequester in the upcoming budget negotiations. The congressional negotiators will be fighting it out on Republican terrain which makes it likely the Republicans will eke out a small victory with respect to spending and taxes. Furthermore government as a whole has taken a big hit, and for better or worse, it will be harder to rally the country for the domestic and international tasks ahead.

Meantime the Obama Care roll out has been disaster. The entry website is not working; it is not a technical glitch, but rather a fundamental software failure. Simply put the back end of the software may not be working which means inaccurate information is being sent to the health insurance companies. This is more than a software failure, it is a fundamental management failure on the part of the Obama Administration. Let's face it President Obama is not a manager and it looks very obvious there was very little hands on control over the past three years on the implementation of his signature program. At the very least HHS Secretary Kathleen Sebelius should be fired.

Over the longer run, despite the explosive rally in the stock market, the U.S. will pay a big price in the global financial markets for threatening to default on our debt. It means the dollar's status as a reserve currency has been devalued. It means higher interest rates, a weaker dollar and a loss of geopolitical credibility. For the wreckers to even threaten default  was criminal negligence.

Taking a step back our country has been through this before. 75 years ago this Veterans Day Kate Smith introduced Irving Berlin's "God Bless America" to a national radio audience. True the country was divided about the coming European War, but she offered hope. We still live in a great country and I think you will enjoy the following clip, http://www.youtube.com/watch?v=_zF7a0wB-Lg

On Strike, Shut it down

Taking their lead from the student anti-war protesters of the 1960s, the wrecker caucus in the Republican Party led by Senator Ted Cruz is on the verge of shutting down the government. Unlike their 1960s counterparts ( I know they just hate that analogy), today's ideologues can cause real damage. Recall that in the 1960s all the students succeeded in doing was shut down a bunch of universities for a few days. All the university employees got paid, and, for the most part, a good time was had by all. Not to be so cavalier, more than a few people were seriously injured. In the interests of full disclosure I was a participant and sometimes close to being a leader.

To be sure the students highlighted their opposition to the Vietnam War, but along the way they helped set the stage for a conservative revival with the election of Ronald Reagan to California's governorship in 1966 and Richard Nixon to the presidency in 1968. That was hardly the outcome the students were seeking.

Today the situation is far different. The stakes are much higher. Hundreds of thousands of people will be furloughed, others will lose their jobs and essential government services will not be provided. Nevertheless, the House Republicans did one very politically smart move in preparing a continuing resolution that will exempt the Defense Department, but the rest of government will feel the full brunt of the shut down. I remember the 1995-6 shutdown under President Bill Clinton. People got really pissed and Clinton ended up smelling like a rose. And remember the Republican had just come off their great 1994 triumph and controlled the Senate as well as the House. This time they are coming off losing the presidency and seats in both the House and Senate.

Simply put, the Republicans can't win this fight. In the eyes of the American people the Democrats are the party of government and the Republicans are the party of at best limited government, or at worst anti-government. So guess who the American people will blame. This would be true even if President Obama were 100% totally at fault. Thus as a matter or pure politics the government shutdown could very well be setting the stage for the return of Nancy Pelosi as Speaker of the House.

To the the wrecker caucus it is all about defunding or delaying Obamacare. I hate to break it to them, it ain't going to happen. No way the Democrats or President Obama will give up on their signature program. My guess is that the wreckers fear that it will work, and therefore they have to abort the program in the womb. I think that is wrong headed thinking. If Obamacare is going to fail, it will fail of its own weight. My guess is that in 10 years time neither the proponents or the opponents of the health care law will recognize it. In its current form it is way too complicated, but over time it will change, likely for the better.

The Fed Makes a Mistake

The Fed made a mistake yesterday in not modestly tapering back their quantitative easing program. Simply put the FOMC had a free option from the markets to start the long awaited process of gradually reducing their $85 billion/month bond buying program. Had they reduced the program to, say, $75 billion/month, it would have been a nonevent. After all what difference does a $10 billion change in a monthly bond buying program make for a $16 trillion economy? Instead by continuing the program at its current level, stocks and bonds soared. Also soaring were gold and oil prices and the U.S. dollar tanked. If Fed Chair Bernanke wants to get the inflation rate up to somewhat above the 2% target level, he is going to get that in spades.

Why? Despite all of the recent good news on the inflation front, underneath the data there are troubling signs that inflation will not be as modest as most market participants now expect. For example buried in August CPI report, medical care services surged 0.7% (up 3.1% year-over-year) and rent paid for a primary residence is also up 3% year-over-year. The Fed's move yesterday added fuel to the embers that will increase commodity and import prices.The upshot of it all is that already hard hit real wages will be hammered even harder. Perhaps that is what they want.

I fully understand that the FOMC was concerned about "tightening financial conditions" caused by Wall Street's "taper tantrum." Those concerns were manifested in a stall in the housing market that in all likelihood is temporary. If the FOMC was so concerned about this they could have toned down Wall Street's consensus expectations that called for a modest taper.  By failing to do this, the Fed has lost credibility and when the Fed finally moves to end the quantitative easing program that nearly all market participants and the Fed itself view as unsustainable, watch out below!

Political Risk comes to Manhattan Real Estate

To paraphrase Exodus 1:8, now there arose a new mayor over New York who knew not Michael Bloomberg or Rudy Giuliani. With the reactionary Bill de Blasio becoming the presumptive Democratic nominee for mayor and the odds-on favorite to win the general election in November, the 20 years of progress New York City has made threatens to become undone. Simply put de Blasio is throwback to the truly horrible mayors New York had prior to 1993. Think "bungling" Bob Wagner, the limousine liberal John Lindsay, the hapless Abe Beame and de Blasio's idol, David Dinkins. The last, of course, served as Mayor during the nadir of New York City's modern history. What all of these past mayors had in common was that they turned the city's fisc over to the public employee unions and they let crime run riot. By 1990 most informed opinion believed that the purpose of city government was to manage decline, not to create the thriving city that New York is today.

To New Yorkers of today and for that matter the real estate investors of today, that history is only dimly recollected at best. Instead of rewarding success, de Blasio seeks to punish it with high taxes. Instead of building  on the school reforms of the past decade, de Blasio wants to turn the schools back over to the unions. Instead of managing the budget, de Blasio will reward his union backers with pay raises unrelated to productivity. Instead driving down the crime rate to make New York the safest big city in America, de Blasio would end the very successful stop, question and frisk policy of the Bloomberg Administration. Of course the initial victims will be the people of color that now support de Blasio.

What all this means is that real estate investors who now take New York's well run government for granted will have to price in higher taxes and a diminution of services. Given the heady values of Manhattan real estate all the risk appears on the downside. The same goes for the big office REITs with a Manhattan focus, Vornado, SL Green and Boston Properties. The only hope is that Republican Joe Lhota pulls off an upset.

"Returning to Normalcy, Sort of," UCLA Anderson Forecast, September 2013

 

To paraphrase President Warren Harding’s 1920 campaign slogan, the economy is returning to normalcy. To be sure, the economy will not be normal by historical standards, but it will be noticeably better than in recent years. After growing at a revised 2.5% annual rate in the second quarter, we are forecasting real GDP growth of 2.5% for the second half stepping up to the historical 3% trend growth rate in 2014 and 2015. (See Figure 1) However, we must point out that because of the severe recession of 2007-09 and the sluggish growth thereafter, the economy will still be operating well below what would have been expected prior to the recession. Nothing highlights this better than the fact that, according to Sentier Research, median household income remains lower than in June 2009, the ending month of the recession.

Nevertheless, in keeping with a more normal economy we expect that payroll employment growth will be running at a sustained clip of 200,000 jobs a month over the forecast horizon and that the unemployment rate will steadily decline to 6.5% by year-end 2015. (See Figures 2 and 3) Over the near-term, the quantity and quality of the net increase in employment could very well be held back by the adjustments business firms will make to the implementation of the Affordable Care Act. Simply put, there are incentives for firms to convert full-time employees to part-time and for small business to limit their headcount to 50 full time employees.

 
INTEREST RATES ON THE ROAD TO NORMALIZATION

The era of very low long-term interest rates appears to be over. In response to hints from the Federal Reserve that the quantitative easing program of buying $85 billion a month of treasury and mortgage bonds might be tapered in September, the yield on 10-year U.S. Treasury bonds spiked from 1.6% in mid-May to 2.9% in late August. As one wag put it, the bond market had a "taper tantrum." In our view the Fed will begin to modestly lower its bond purchases in September to about $75 billion a month and continue on a path that would end the program by mid-2014. Simply put with the improved economic outlook and the efficacy of quantitative easing being questioned, it has become a question of when, rather than if the program will be ended. Of course, in response to geopolitical uncertainties, the Fed could very well delay the tapering process until the next Open Market Committee meeting.

Our position is roughly in-line with the market consensus; where we differ is that we think the Fed will actually raise the Fed Funds rate in December 2014, about six months earlier than consensus. Thus, by the end of 2015 we expect the Fed funds rate to be a more normal 2.5% and the 10-year Treasury rate to be 4.3%. (See Figure 4) That would bring the 10-year rate more in-line with the growth rate in nominal GDP which has roughly tracked over a very long time period. (See Figure 5)

Our aggressive view, compared to the current consensus, on interest rates rests on the belief that inflation will not be as benign as many now think. Specifically, as we have outlined before, we believe the full impact of higher rents has yet to be reflected in the official price indexes.^{1 Moreover, we believe that the recent quiescence in health care inflation is about to be jolted by the new demands placed on the system resulting from the implementation of the Affordable Care Act. These effects could very well be temporary, but we believe that insuring an additional 35 million people}

will have, at least, a modest impact on health care inflation in the short-run.

As a result, we anticipate that both headline and core inflation as measured by the consumer price index will be in excess of 2% in both 2014 and 2015. (See Figure 6) Although the Fed targets the chained consumption deflator used in the GDP accounts, even by that measure inflation will be running at its 2% target in 2015. It is for this reason we believe that the Fed will raise the funds rate prior to achieving their 6.5% unemployment target.

THE REAL ECONOMY: HOUSING STILL LEADING

THE PARADE

Despite the huge 125 basis backup in the 30-year fixed mortgage rate, we continue to believe that the housing recovery remains underpinned by a five year period of under-building, rising household formations, an improved employment outlook, and still low, by historical standards, mortgage rates. Indeed the sudden backup in mortgage rates could very well have the effect of forcing once hesitant consumers to act quicker once they realize that time is no longer on their side. Simply put, the fear of higher rates in the future makes the current rate environment more attractive. As a result, we are forecasting housing starts to increase to 965,000 units this year compared to 783,000 last year, a reduction from our previous forecast to reflect a slower ramping in production than we had envisioned. For 2014 and 2015 we are forecasting further advances to 1.31 million and 1.55 million units, respectively. (See Figure 7) Consistent with our view for the past year, we believe that multi-family starts will be exceptionally strong throughout the forecast period with starts in excess of 400,000 units in 2014 and 2015.

BUSINESS INVESTMENT AND EXPORTS TO REBOUND

After stalling in 2013, we anticipate that business investment in equipment and structures will begin to grow at a more robust clip in 2014 and 2015. In part, the slowdown in 2013 was almost inevitable as some of the special tax incentives for investment expired at the end of 2012. Investment in equipment which slowed to 4.2% growth rate in 2012 is expected to grow at 8.8% in 7.6% in 2014 and 2015, respectively. (See Figure 8)

After declining in 2013, investment in business structures is expected to rebound by 5.9% and 8.8% in 2014 and 2015, respectively. (See Figure 9) Continued strength in energy related structures (i.e. drilling rigs and distribution facilities) and acceleration in commercial construction will propel the advance.

Export growth which has been sluggish for two years is about to accelerate. Exports have been hampered by the ongoing recession in Europe which now appears to have just ended. While the emerging markets remained strong through 2012, there has been a very noticeable deceleration in growth this year, especially in India, China, Brazil and Turkey. We assume that the waning of the drag from Europe will more than offset the current softness in Asia. As a result, expect export growth to pick up from the sluggish 2% gain this year to about 5% over the next few years, not great, but an improvement. (See Figure 10)

STATE AND LOCAL GOVERNMENT SPENDING GROWING AGAIN WHILE FEDERAL SPENDING CONTRACTS

The long multi-year decline in state and local spending is over. Rising tax receipts coupled with years of austerity have dramatically improved the current fiscal balance of most states and local governments. Thus the way is open for modest increases in spending. (See Figure 11) Nevertheless the longer-term outlook remains cloudy because of increasing liabilities for pension and post-retirement healthcare costs. An extreme example of what can go wrong is the recent bankruptcy filing of the once great city of Detroit.

In contrast, federal purchases are on the decline. Lower defense spending coupled with congressional disagreements have placed a lid on federal purchases. (See Figure 12) Remember in GDP accounting transfer payments do not count as federal purchases. We do note for forecasting federal spending, we assume a compromise will be reached on the fiscal year 2014 budget and the upcoming debt ceiling extension. As a consequence, there will not be a suspension of "non-essential" government functions.

CONCLUSION

Our forecast calls for a resumption of normal growth on the order of 3% a year in 2014 and 2015, far better than the 2% growth we have been used to since the recession ended in 2009. We also believe that the era of very low interest rates will soon be behind us. The recent dramatic rise in bond yields in all likelihood rang the bell. But make no mistake, as good as a resumption of normal growth is, it still will not be enough to restore the economy back to its pre-recession growth path.

ENDNOTES
1. See, Shulman, David, "The Housing Recovery: How Strong? How Long?" UCLA Anderson Forecast, June 2013