Sentiment Disconnect

Every few months, we’ve revisited sentiment metrics to see how broader sentiment trends, generally contrarian in nature, line up with the prevailing market direction.  One of the more interesting aspects of the global equity market rally off last summer’s lows has been the consistently low readings registered in various investor sentiment gauges.  Investors love to rely on a bevy of simple clichés to explain market action; one of the most used is the notion that bull markets climb a “wall of worry.”  It surely seems like “wall of worry” behavior is a prominent part of the market advance over the past few months.  

One of the more prominent investor sentiment indicators in the US is the American Association of Individual Investors Bull/Bear sentiment indicator which, according to the AAII website, “measures the percentage of individual investors who are bullish, bearish, and neutral on the stock market for the next six months.”  With data going back to 1987, the numbers provide an interesting history of investor sentiment through several major market crises, such as the ’87 crash, the August 1990 Kuwait invasion, the Asian crisis in 1997/1998, the massive bear market from 2000 to 2002, the financial crisis and recession from 2007 to early 2009, and the sovereign debt crises over the past few years.  In a fascinating development, at almost the exact point the S&P was reaching new all-time nominal price highs (and current cycle highs) last week, the AAII Bull/Bear numbers showed a bullish reading of only 19.3, the lowest reading since the week the S&P 500 bottomed near 660 in March 2009 (the reading then was 18.9) and the 26^th lowest reading in the database of 1,342 weekly readings.  On the flip side, the bearish reading of 54.5 was the 31^st most bearish reading in the data set.  And, taking the differential between the two, subtracting bear from bull, the -35 reading was the 13^th most negative weekly reading over the past quarter century, only exceeded by readings during the reaction to the 1990 Iraq invasion, the aforementioned week of 3/5/2009 when the equity markets hit their absolute low during the financial crisis, other readings generated during the 2008/2009 meltdown, and one week from summer 2010 when the European sovereign debt crisis reached a frenzy.  Below is a list of the most bearish numbers:

Source: AAII, Bloomberg, IronHorse Capital 

As seen above, extremely low readings have generally been precursors to intermediate to longer-term equity market rallies.  Markets rallied smartly after the 1990 swoon, as well as following the 2010 summer declines (though we got a nasty repeat of market disruption the following summer and fall).  Like any other extensive dataset, exceptions exist.  In the above, the readings from early 2008 perhaps provided false hope to contrarians that the worst was over in the months surrounding the Bear Stearns collapse; the bulk of the equity market losses in the crisis occurred later in the year.  Still, and most importantly, we’re currently observing a level of disgust with equity markets that’s more associated with severe equity market disruption, not with new market highs.  This is a situation that belies the notion that sentiment in markets is far too frothy.  

Other longstanding indicators are also showing a healthy dose of skepticism.  The CBOE’s composite put/call ratio, which “tracks the ratio of total equity and index put/call volume traded on the Chicago Board of Exchange,” remains elevated.  The 10-week moving average is currently 0.73 standard deviations above normal, not an alarming result, but notable considering the current positioning of the market (barely off the highs).  The ISE Sentiment All Equities Index shows, “the number of calls traded for every 100 puts.”  Lower numbers show lower sentiment in equity markets, again contrarian.  The 10-day moving average here is currently 1.21 standard deviations below the mean.  They’ve remained in this posture consistently since last summer.  The chart for the ISE Index follows:

Source: Bloomberg, IronHorse Capital

We don’t want to draw any definitive conclusions on the future path of equities based on a few pieces of sentiment data.  In general, the statistical connections between sentiment data and future equity market performance have been somewhat inconclusive.  Even so, we’re always interested when we see readings in data sets that are at or near extremes.  Today, we’re seeing data on sentiment that is very rarely if ever observed at the peaks of long-term bull markets, and is more often observed with significant equity market lows.  Perhaps there are factors distorting some of the data, such as the fact that investors are bombarded by market news through numerous sources, and much of that news is negative in nature in light of the constant crisis posture in Europe and elsewhere.  There’s no way to come to solid conclusions without having complete access to the underlying survey data from AAII. On the surface, though, we think the data provides an interesting insight into individual investors, namely that the individual investor remains decently underweight equities.  In the past, significant upward moves have been sparked when individual investors on the sidelines en masse decide they can’t take the pain of being out of the market anymore and throw their collective hats in the ring.  This type of activity could provide an underlying bid to markets going forward, keep corrections relatively contained, and keep markets grinding higher.  We’ll become very worried when sentiment indicators like those listed above become uniformly and excessively bullish, the flip side of the current marketplace condition.

Small Cap Performance vs. Large Cap Performance

A few weeks ago, we looked at the performance history of Value vs. Growth and observed that the history was prone to longer streaks.  This week, we’ll look at the performance history between large-cap names and small-cap names using the Russell 1000 as a proxy for large-cap, and the Russell 2000 index as our small-cap index.  According to Russell Investments, the Russell 1000 Index , “…measures the performance of the large-cap segment of the U.S. equity universe…” and,  “…represents approximately 92% of the U.S. market.”  Alternately, the Russell 2000 Index, “…measures the performance of the small-cap segment of the U.S. equity universe.”  

As with the data series pertaining to growth and value, small-cap performance relative to large-cap performance has also been subject to longer trends.  Let’s begin by presenting the yearly performance data (simple, i.e. no dividends included) for both indices going back to 1979.  Below, we show the annual return for both indices, and the difference in performance for each year.  A negative number in the “Difference” column represents underperformance by the larger-cap Russell 1000 in that given year.  

Source: IronHorse Capital and Bloomberg

From 1979 through the end of last year (34 years of data), the small-cap Russell 2000 index outperformed its larger-cap counterpart by approximately 1% per year, 9.36% per annum vs. 8.36% per annum.  These performance numbers belie a wide range of performance outcomes when the numbers are examined by decade, or when broken down by the winning streaks for each series identified in the data set.  

Going by decades, you can see that larger-cap names outperformed significantly during the secular bull market years of the 1980s and 1990s, but have underperformed during the secular bear market we have experienced since 2000.  

Eyeballing the annual data series above, and moving beyond the confines of tidy decades, it appears that outperformance and underperformance regimes run for approximately 15 years or so, again roughly in-line with the broader secular bull/bear positioning in the market.  From 1999 through 2012, 14 years, small-cap names outperformed 10 times with a cumulative return over that time frame of 101.29% vs. 22.87% for the larger-cap Russell 1000.  On the flip side, from 1984 to 1998, 15 years, the Russell 1000 outperformed 9 times.  Cumulative performance: 611.3% for the Russell 1000, 275.8% for the Russell 2000 small-cap index.  Of note, prior to the 1984 turn towards a large-cap streak, the Russell 2000 small-cap index had outperformed for 5 straight years from the late 1970s through the early 1980s recession years, which happened to mark the end of the 1968 to 1982 secular bear market.  

It seems counterintuitive that small-caps would outperform large-caps during secular bear markets in light of the fact that small-caps would seem to benefit more from consistent, strong economic growth, usually a feature of secular bull periods, lower volatility, another characteristic of secular bull markets, and better access to debt and equity capital markets (theoretically better during secular bulls).  Various analysts ascribe performance differentials to everything from the direction of interest rates and inflation in bull and bear periods to growth in real GDP.  Looking back at various data sets, there doesn’t seem to be a consistent pattern to create a storyboard when it comes to macro data.  For instance, small-caps outperformed during the 1970s and early 1980s according to Ned Davis Research, a period defined by rising interest rates and inflation/stagflation (again, our available data set ends in 1979; we’ll have to take Ned Davis’ word).  Small-caps outperformed during the 80s and 90s as seen above, a period defined by strong economic growth, declining interest rates, and declining inflation.  This led some to conclude that higher interest rate environments turned out better for small-caps at the expense of large-caps.  However, the 2000s have been defined by a continue drop in interest rates, and even lower inflation metrics.  Nonetheless, small-caps reversed their underperformance and resumed a leadership position.  We’ll leave it up to academics and others to ascertain the exact reasons why small-caps have been outperforming during poor overall market periods.  Suffice to say, it’s a curious quirk in the data, but one that investors should pay attention to.  

Based on the fact that large cap names have been mired in a long period of underperformance (nearly 15 years) that matches the length of past streaks, it seems small-caps may be pushing the limits with the current winning streak.  Valuation may confirm this as well.  At the last major performance turn, small-caps were consistently overvalued versus large-caps on an EV/EBITDA basis.  At the end of 1998, for instance, the Russell 2000 was trading at 10x EV/EBITDA vs. 13x for the Russell 1000.  That situation is now reversed.  The Russell 2000 is now trading at approximately 12x vs. 9.5x for the Russell 1000.  

Taking all into consideration, we believe large-cap will outperform small-cap in coming years, and based upon the data on growth and value we outlined in an earlier post, believe value will take the performance baton back from growth.  As with our last post, we’ll leave you with a chart that gives a visual representation of small and large-cap out/under performance through the years.

Source: IronHorse Capital and Bloomberg

On the Situation in Cyprus...

Wading into an issue like the Cyprus bailout is a dangerous prospect, indeed.  We couldn’t help it, though, after receiving a breathless email this week from a family member warning that this was the first step in Western governments’ attempts to “confiscate” all of our deposits and wealth in general through outright theft.  Of course, this family member was responding to a breathless appearance by a pundit (who will remain nameless) on financial television this week warning Americans that we’re next in line.  Don’t get us wrong, there certainly are plenty of problems, politically and economically, to ruminate about in the US and, of course, Western Europe.  Financial repression, an age-old tactic, has been implemented to some extent judging by the consternation surrounding low interest rate regimes around the world.  Perhaps, governments will try to “inflate away” our debt over the long run.  Some view “Abenomics” Japan as some sort of variation on this theme.  Inflationary tactics have certainly been used before throughout history, though in a world with such a large demand deficit and a private sector still working to deleverage, we have our doubts that a massive bout of global, developed market inflation is in the cards anytime soon.  We tend to sympathize with those more worried about deflationary tendencies in the Western developed markets owing to the massive output gaps that still exist and the continued slack in many labor and capital markets.

Coming back to Cyprus, it quickly gets lost in the weeds (punditry) that Cyprus presented an incredibly unique situation, not applicable in any consistent way to the other countries of the Eurozone, or the United States for that matter.  The country is tiny.  Its population of 1.1 million is smaller than approximately 50 US metropolitan areas.  Yet, Cyprus had built up quite a business as an offshore banking and tax haven, with a particular gift for catering to billionaire and millionaire Russians with wealth they wanted to spirit out of the country for various reasons, some legitimate, many not-so-legitimate.  As a result, the size of the banking sector in Cyprus came out to several times the level of GDP.  The three major banks in Cyprus funded their balance sheets mostly through these deposits from offshore customers, not via the debt markets.  Cyprus banks made a common error, of course, which was investing in assets that failed the “money-good” test, namely a bunch of assets in the Greek isles that collapsed in value with the Greek economy.  When the proverbial chickens came home to roost, there was absolutely no way Cyprus was going to be able to handle the burden of recapitalizing its banks on its own due to the fact the size of the banks dwarfed the broader economy (due to the unique circumstances as an offshore tax haven).  Owing to the structure of the banks’ liabilities, there were fewer debt-holders to haircut or “bail-in.”  If burden-sharing of some sort were to take place under these unique conditions, higher-status depositors were going to come into focus.  Everybody in Europe knew the primary source for the massive deposits.  There wasn’t any way politicians around the rest of Europe were going to bailout Cypriot banks to protect Russian oligarchs.  On the flip side, the Russian (and other foreign) depositors knew there was risk in the system, yet made a major gamble that the European authorities would blink and make everyone whole in Cyprus.  

What happened next, of course, has fueled the breathless “confiscation” cries around the globe.  Cyprus, given orders to come up with several billion euros to help with the overall bailout package, announced that insured depositors under €100,000 would get haircut, along with the big-time offshore depositors.  Most likely, Cypriot authorities committed this unforced error in an attempt to placate these offshore customers, reducing their burdens so they presumably wouldn’t abandon Cyprus over the long-run and flee to other tax havens.  This obviously turned out to be a major error in judgment, causing massive hand-wringing and protest among their citizens, not to mention condemnation and disbelief among European authorities, who basically said, “Go back to the drawing board.”  Again, to reiterate, these troublesome issues were a direct outgrowth from Cyprus’ unique status as a banking haven and the Cyprus government’s uniquely ridiculous attempt to protect an offshore client base.  It certainly didn’t help that there didn’t seem to be a consistent guiding hand on the process from the rest of Europe.  It was never necessary to even consider haircutting insured depositors.  Very few if any serious observers believe that is type of depositor haircut policy is sitting on desks in Brussels, or Frankfurt, or London, or Washington DC waiting for implementation at the next sign of banking crisis.  As Martin Wolf of the Financial Times pointed out this week: 

One could conclude that the action over Cyprus tells us little about the monetary area. After all, the island is unique because of the size of its banking liabilities, the unpopularity of its banks’ creditors and the borderline insolvency of its state. Or one could believe it is a template, but only for other countries with similarly weak states. Or you could see it as a template for all eurozone states, except when there is a financial crisis of 2008 dimensions. Finally, an observer could believe Cyprus is a template for all eurozone states in all circumstances. Which of these readings is right? Nobody knows. But it is probably the first or the second. A consensus on the principle that creditors, not taxpayers, should pay if a bank becomes insolvent does not yet exist across the eurozone. Does anybody imagine the German government would not rescue Deutsche Bank if it were in trouble? Of course it would.

So, as it pertains to “confiscation”, we tend to side with the Martin Wolfs of the world in believing that insured depositors in western countries need not worry at all that governments are coming after their cash stuffed in banks.  Furthermore, we tend to find some of the commentary out there whipping up the frenzy on financial channels and on certain financial blogs and websites as ill-informed at best, and deliberately manipulative and pernicious at worst.  These breathless proclamations don’t serve anybody well.  In many cases, we’re probably watching people talk their own books of business.  Maybe they want to sell more newsletters.  Or, maybe their portfolios are positioned for crisis and Armageddon.  Whatever the case, they’re probably best ignored.

What, however, does this mini-crisis and kerfuffle say about the state of European politics and the overall structure of the European Union?  It says a lot.  First, it reconfirms that admitting marginal European countries like Cyprus was probably an error in judgment from the get-go.  There’s very little that can be done about this now, though we’re amazed that expansion talk continues.  Second, and most importantly at this juncture, it shows again that the structure of the EU, a currency union without political/fiscal union, lends itself to unforced error after unforced error after unforced error.  As observers around the globe have watched Europe lurch from one crisis to the next over the past three years, one can’t help but be amazed by the communication inconsistency that rears its ugly head every time trouble crops up.  These communication problems have a habit of taking marginal issues and blowing them up into hand-wringing crises, or taking big issues and blowing them up into existential hurricanes.  This, of course, is a direct result of the fact that the Eurozone by current design consists of numerous leaders and very few followers.  With its diffuse power structures and combination of essentially sovereign states within a broader, loose political structure, the current situation is not unlike the US Articles of Confederation that preceded our current form of government under the US Constitution.  There are too many voices out there in the wilderness.  Neither individual citizens, nor corporate leaders, nor investors know who to listen to or who to trust.  Conflicting proclamations and information are the norm.  On any given issues, it’s not unfathomable to hear simultaneously from Angela Merkel, Francois Hollande, Mario Draghi, and umpteen other officials, all of whom have roughly similar power and standing within the Eurozone.  Oftentimes, they’re pushing completely different agendas.  This week, Eurogroup head and Dutch Finance Minister Dijssellbloem caused problems by stating that this template of haircutting depositors could be seen as a template of sorts.  He was quickly and rightfully criticized by Eurozone leaders, but not before damage was done and the aforementioned conspiracy theories on confiscation were flamed.  This was apparent even last summer in the midst of what many consider to be the Eurozone’s biggest policy success in terms of quelling the financial turmoil, Draghi’s assertion in a magazine interview that the ECB would do “whatever it takes” to preserve the monetary union.  Within an hour of the news hitting the market tape, officials from Germany and elsewhere were either disputing the statement or offering counter-positions muddying the water.  Markets continued to rally, but in an uneasy state.  The lead-in to the official ECB rate decision and news conference following the news of the statement was a time of incredible uncertainty.  Contrast these exercises in communication futility with the United States.  Surely, there are times when a Fed Governor or Representative or Senator can ruffle some feathers.  But when the going gets rough, most know to focus on three or four folks: the President, the Speaker, the Senate Majority Leader, and/or the head of the Federal Reserve.  As witnessed at the depth of the ’08 crisis, American economic policymakers can act quickly and decisively.  Americans know to focus their attention quickly on one power center: Washington.  We’ve had a few unforced errors.  But, if a Governor of Texas or California comes out criticizing Federal Reserve action, very few pay it a bit of attention.

The Eurozone still has a long way to go in deciding what it wants to be when it grows up, at least from a political perspective.  As it stands now, the continuing danger from Europe remains a situation where poor communication and divergent voices lead the area to stumble unintentionally into problems with major systemic consequences.  In the US, a major municipal bankruptcy or a state financial problem need not become an existential problem.  In Europe, a problem like Cyprus that could have been nipped in the bud relatively quickly and painlessly becomes an absolute nightmare within days, requiring much more time and effort than should have ever been expended.  Until Europe either learns how to speak with one voice within the current edifice, or to create institutions that force it to speak with one voice, Cyprus type problems are going to continue to plague the currency union and drive fear and confusion.  Do Europeans have the will to take these steps over coming years?  We have our doubts.  

MSCI World Value vs. Growth: A History of Lumpy Relative Performance

It’s been a Sisyphean task promoting a global equity style of investing over the past several years.  When one sits down and examines the performance history for the MSCI World Value Index vs. the MSCI World Growth Index, it becomes apparent that the current underperformance streak is notable in several respects.  Fortunately, streaks have tended to revert over time and the rebounds have tended to offset, or more than offset, the prior underperformance periods.  Looking at the numbers for the two indices since inception in 1974 reveals some interesting dynamics in the continual tug of war between global growth and value investors.

Before we begin examining the numbers, let’s use MSCI’s own words to define the methodology behind choosing value and growth stocks for these indices:

MSCI Global Value & Growth Indices categorize value and growth securities using clear and consistent sets of attributes and a rigorous methodological framework. Style characteristics are defined using eight historical and forward looking variables (three for value and five for growth).

Each security in an underlying MSCI index is given an overall style characteristic derived from its value and growth scores and is then placed into either a value or a growth index (or is partially allocated to both). Ultimately, the adjusted market capitalization of each constituent of the underlying index is fully represented in the combination of the value index and the growth index, with no "double counting".

Msci.com

Here are the yearly performance numbers for the MSCI World Growth and Value Indices:

Using simple returns (dividends excluded), the MSCI World Value Index has outperformed the Growth Index over the past 38 years by nearly 0.90% per annum: 8.19% per year versus 7.30%.  The annualized numbers, however, mask a “lumpiness” and “streakiness” to returns that is surprising to many investors.  Over the 38 year time frame, Growth has actually outperformed Value in 20 of the years.  The average differential is 0.63% per year, but the median differential is -0.17% indicating Value outperformance tends to be skewed to the big upside performance differentials.  The biggest year of outperformance for the MSCI World Value Index was 2000.  The differential was +24.82%.  This followed on the heels of a massive underperformance streak for value, which we’ll address further below.  The biggest negative year for Value relative to Growth occurred in 1998; Value underperformed by 18.5%.  Calculating the standard deviation for the yearly differentials gives us another frame of reference for “lumpiness.”  At 7.99%, very high relative to the average differential of 0.63%, we see that performance in individual years tends to be very wide.

Under and outperformance tends to be streaky.  The current yearly streak of Value underperformance exceeds anything ever observed in the history of the data series, though.  Value has underperformed Growth for the past six years, 2007 through 2012.  Prior to the current period, the longest yearly streak of underperformance stood at three years.  During the current streak (through the end of 2012), cumulative performance for the Value Index stands at -21.63% vs. +3.21% for the Growth Index, a cumulative deficit of 24.84%.  This represents the second largest cumulative deficit.  The biggest deficit belongs to the years surrounding the tech/equity bubble in the late 1990s when growth stocks went on a massive performance rip to the upside.  Though growth “only” outperformed value for three years (1997 through 1999), the cumulative outperformance for growth totaled 50.81% over those three years, dwarfing the cumulative deficit witnessed during the current streak.  Needless to say, the late 1990s represented a big-time period of frustration for those in the value space.  It was very hard for value investors to stick to their guns.  

What’s the good news for Value investors, especially those frustrated with the current period of underperformance?  Streaks of underperformance have been followed by streaks of outperformance.  And, in every case since the inception of the indices that the Value Index has underperformed the Growth Index for two or more years consecutively, the subsequent outperformance streak has produced cumulative excess returns that offset the losses felt during the prior underperformance period.  For instance, as mentioned, during the three years of the late 90s bull run, the MSCI World Value Index rose 48.79% vs. 99.59% for the World Growth Index, a deficit of 50.81%.  Over the next seven years, 2000 through year-end 2006, Value rose 33.56% vs. -20.44% for the Growth Index, a cumulative performance differential of 53.99%.  Compound out the yearly performance over those ten years and Value handily outperformed Growth from year-end 1996 to year-end 2006, 98.71% vs. 58.80% for Growth.  While the value investor experienced significant frustration, the investor was ultimately vindicated.  This type of “through the cycle” outperformance has occurred in every case since 1974.  The lesson: no matter how infuriating the underperformance streaks for value, it pays to stick with the strategy.  

So far this year, the MSCI World Value Index is outperforming the Growth Index by 0.63%.  There’s a long way to go for global value to erase the recent deficit.  If history is a guide though, value investing’s time in the sun may be approaching.  We’ll leave you with a chart showing the ratio of the MSCI World Value Index price to the MSCI World Growth Index showing just has much relative performance has oscillated over the past 16 or so years.

IronHorse Capital

2013: A Positive Year?

Since February ended on a positive note for the S&P 500, we’ve come across a number of stories discussing S&P 500 performance during years in which both January and February closed in positive territory.  In nearly all of the stories, it’s mentioned that the S&P 500 has never ended in negative territory for the year when this has occurred.  There have been 26 instances since 1945 where both January and February exhibited positive performance.  Based on our calculations, excluding dividends and using only price appreciation, there have actually been 25 positive years, and one very slightly negative year.  On a price appreciation basis, 2011 ended essentially flat, down 0.03%.  Still, it’s an impressive record overall.

Most of the stories, however, failed to discuss the nature of the performance for the remainder of the year after the January/February positive run.  Was performance run of the mill relative to other years for the other months?  Were most gains for the entire year achieved during January and February?  Should investors feel comfortable investing after January/February runs?  

Looking at performance for the final 10 months during these January/February episodes, we found that performance for the remainder of the year was exceptionally strong, especially compared to the final 10 months of years in which either January or February (or both) came in negative.  Let’s move on to the data. 

As mentioned, there have been 26 years since 1945 in which both January and February were positive.  Here is a table showing the years of occurrence, the cumulative performance for January and February in those years, and the cumulative performance for the 10 months following in those years:

Year	Jan to Feb Return	Mar to Dec Return	YR Return (Simple Return)
2013	6.20%	????	????
2012	8.59%	4.43%	13.406%
2011	5.53%	-5.25%	-0.003%
2006	2.59%	10.75%	13.619%
2004	2.97%	5.85%	8.993%
1998	8.13%	17.14%	26.669%
1997	6.76%	22.71%	31.008%
1996	3.98%	15.66%	20.264%
1995	6.12%	26.37%	34.111%
1993	1.76%	5.20%	7.055%
1991	11.16%	13.63%	26.307%
1988	8.39%	3.70%	12.401%
1987	17.36%	-13.06%	2.028%
1986	7.40%	6.72%	14.620%
1985	8.34%	16.61%	26.333%
1983	5.28%	11.39%	17.271%
1975	19.01%	10.54%	31.549%
1972	4.39%	10.77%	15.633%
1971	4.99%	5.52%	10.787%
1967	8.03%	11.17%	20.092%
1964	3.71%	8.93%	12.970%
1961	9.17%	12.78%	23.129%
1955	2.17%	23.72%	26.404%
1954	5.40%	37.59%	45.022%
1951	6.71%	9.04%	16.349%
1950	2.56%	18.64%	21.680%
1945	7.68%	21.40%	30.723%

The first fact of note from the table: of the 26 years exhibiting positive performance in both January and February, there were only two instances in which the S&P 500 posted a negative performance number for the final ten months, 2011 and 1987.  The summer and fall months of 2011 were negatively affected by the European debt crisis and the sovereign ratings downgrade for US debt.  Of course, 1987 was the year of the October stock market crash.  Even with the devastating crash, the S&P 500 only posted a negative 13% number for the final 10 months, relatively tame compared to many other episodes in market history.  Moreover, 1987 produced one of our favorite fun facts: the S&P 500 was actually up for full year 1987 despite the crash.

Now for some summary statistics that show the strength of the cumulative performance for the final 10 months, both in years with positive performance in both January and February and years without:

	Jan/Feb Both Positive	Jan/Feb (other)
Average	12.00%	4.57%
Median	10.97%	4.04%
St. Dev	10.08%	16.18%
Min	-13.06%	-32.12%
Max	37.59%	51.70%

As you can see above, average and median performance was much higher over the final 10 months for “positive” years compared to years with either a negative Jan. or Feb.  Dispersion or volatility of the returns is also much lower as indicated by the standard deviation, minimum, and maximum summary statistics.  

Is there a statistical relationship between strong January/February returns and returns the remainder of the year?  There’s a very weak statistical relationship.  The R-squared between them is a paltry 0.08.  Correlation is -0.298 indicating that there is a negative statistical relationship between the two (i.e. higher cumulative Jan/Feb returns mean lower Mar to Dec returns), but again the strength of the relationship is weak.  In layman’s language, just because the first two months are positive in a big way doesn’t mean the final 10 months are going to come in below average relative to the other 25 years, or vice versa.

What can we take away from the exercise?  There appear to be reasons for optimism the rest of this year.  Cumulative performance for January and February this year came in at 6.2%, slightly below, but close to in-line with the average over the other 26 episodes of 6.8%.  There are certainly going to be bumps in the road over the course of any year, but the historical record for performance in years with positive January and February performance is consistently strong.  March is off to a good start.  Let’s hope the remainder of 2013 doesn’t prove to be the very rare exception.

Sequester Sideshow

March Madness has arrived early.  The much debated and huffed-about sequester begins today barring some unforeseen action by Congress and the President.  Suffice to say, this has been one of the most overwrought political situations we’ve observed in quite a while.  We find the sequester and the debate surrounding the sequester fascinating, not because of the nitty-gritty embedded policy details or the fireworks between all the politicians and pundits, but because it presents another example of many policymakers and political activists missing the forest for the trees.  So much time and energy is spent in the US bemoaning discretionary government spending as a whole.  Interests on both the right and left have their pet projects and initiatives. Each side fights tooth and nail for its own interests and demonizes the other side’s wants, whether defense spending, welfare moms, research, general government services, or a number of other programs.  The cacophony is overwhelming.  All the while, the true hundred pound gorillas in the room—entitlements—are forgotten, perhaps conveniently considering Medicare, Medicaid, and Social Security are “third-rail” political issues.  The simple fact of the matter is that both defense and non-defense discretionary spending are not big problems from a long-term budgetary standpoint.  It’s the entitlement programs that are problematic, especially health care entitlements.  Let’s take a look at some numbers.  

First, here is a backward-looking chart showing federal spending as a percentage of GDP in four major categories, Defense, Nondefense Discretionary, Social Security, and Medicare.   

Source: American Prospect and Congressional Budget Office

As seen above, defense spending as a percentage of GDP has declined materially over time.  Granted, the Vietnam War affected the numbers at the outset of the timeframe.  Still, the War on Terror has been a significant event spending wise, yet defense spending as a percentage of GDP is only back to the late-1980s/early-1990s levels.  Nondefense discretionary, which basically includes all government spending ex-defense that doesn’t fall into the entitlement buckets, has risen since 2000, with a notable bump during the Great Recession years as both the Bush and Obama administrations responded to the economic crisis.  This figure has been in decline over the past few years, however, and has remained comfortably within the long-term range.  After leveling off, Social Security expenditures have begun creeping higher again as a percentage of GDP.  Medicare expenditures as a % of GDP have consistently crept higher.  Of course, as the Baby Boomers retire in increasing numbers, the entitlement numbers will begin to grow quickly as we’ll observe later.  Looking at these numbers, nothing in the defense or non-defense discretionary realm looks particularly egregious relative to historical precedent.  

So, what does the future look like on the discretionary side?  Judging by the rhetoric, we’re absolutely doomed because of all that out of control discretionary government spending.  Actually, not so much.  Here are a couple of charts that show the projected trajectory of defense and non-defense discretionary spending after the passage of the Budget Control Act.  As you can see, even before the sequester cuts kick in, both defense and nondefense discretionary spending were slated to decline over the next 10 years as a percentage of GDP to levels below the lowest levels observed since World War II.  To repeat, discretionary and nondiscretionary government spending were already set to decline below the lowest levels witnessed in the past 50 or 60 years relative to GDP.  Both are already below the trailing 30-year averages.

Source: Bipartisan Policy Center and Congressional Budget Office

Source: Bipartisan Policy Center and Congressional Budget Office

So what’s the bugaboo that that keeps budget analysts up at night if discretionary spending is under control?  Mandatory entitlement spending.  First, a side note.  Obviously, projecting figures out to 2040 or 2050 is always a dangerous exercise, especially considering we have a hard enough time making predictions a quarter or two ahead of time when it comes to economic growth, policy, and other factors.  One thing we can see coming with relative accuracy is demographic waves.  We know with a decent degree of accuracy how many folks will retire over the next 30 or 40 years and what they’re owed pension-wise.  Life expectancy projections will probably turn out reasonably accurate as well.  On the other hand, the growth trajectory of health care spending is a major wild-card.  The health-care related entitlement programs are expected to account for the bulk of budgetary problems moving forward.  Most projections show health care costs increasing at a similar pace over the coming decades as observed over recent decades.  Of course, health care costs have outpaced CPI handily for years.  Many people attack long-term entitlement spending projections on these grounds, perhaps rightfully, arguing that natural market forces will dampen health-care inflation and that the numbers will ultimately come in better than expected.  So OK, let’s assume there’s a not-insignificant chance that health care inflation declines; isn’t it still prudent to consider the worst or “worser” case scenarios?  If health care inflation moderates a good bit, that’s gravy.  If not, we’re adequately prepared.  As it stands now, using the lesser-case projections, entitlement spending is projected to explode over the next few decades:

Source: Heritage Foundation and Congressional Budget Office

As seen above, under the less optimistic cost scenarios, and under assumptions that current entitlement policy remains intact, entitlement spending alone will eat 100% of Federal revenues within approximately 30 years.  Assuming that we can bring health care cost inflation under some semblance of control, US demographics and other factors still suggest that entitlement spending will eat a significant amount of governmental financial resources over coming decades.  The US government will increasingly become a “retirement program with a…large army,” as described by writer Paul Waldman.

What’s the bottom line?  Though it remains the focal point for a lot of activists and loudmouths on the left and right, government discretionary spending, both defense and non-defense, is a minor irritant at worst and a non-factor at best.  Are there inefficiencies throughout government?  Most certainly.  But, Congress and the President could decide today to cut every single dollar of nondefense discretionary spending today from the budget, for instance, and would eliminate less than half of the budget deficit projected for this year.  As we’ve seen, under current policy, discretionary spending is moving towards low levels not seen for a few generations.  The sequester debate no matter the side you’re on is small potatoes compared to the larger debates we need to have moving forward about entitlement spending.  Current Washington games are an annoying sideshow and distraction.  Dealing with entitlements will require incredibly tough discussions between younger and older generations about benefit levels to retirees, payments to providers, eligibility ages, means testing, public health, and a number of other issues.  Somehow, Americans across generations are going to have to shed the tendency to exhibit “not in my backyard syndrome.”  Unless these issues are addressed sooner rather than later, and unless they’re addressed honestly without band-aid, can-kicking solutions, there won’t be any room for guns or butter in the budget, only dentures and dialysis machines.

Le Battle Royale: France's War of Words with U.S. CEO

If you didn’t hear or read about this week’s testy exchange between Maurice Taylor, the CEO of Titan, a US-based tire company, and the French Industrial Minister, Arnaud Montebourg, you missed some serious sparks.  We don’t wish to wade completely into the middle of a massive firefight, but we think the exchange, specifically the concerns expressed by the Titan CEO, raises some interesting questions about French policy relative to their neighbors, the sustainability of the French model in an ever-changing global economic environment, and the broader role of unit labor costs influencing industrial decision making.  First, here are the two letters in their entirety, with Montebourg’s response following Taylor’s initial letter.

Taylor:

Dear Mr. Montebourg:

I have just returned to the United States from Australia where I have been for the past few weeks on business; therefore, my apologies for answering your letter dated 31 January 2013.

I appreciate your thinking that your Ministry is protecting industrial activities and jobs in France.  I and Titan have a 40-year history of buying closed factories and companies, losing millions of dollars and turning them around to create a good business, paying good wages. Goodyear tried for over four years to save part of the Amiens jobs that are some of the highest paid, but the French unions and French government did nothing but talk.

I have visited the factory a couple of times. The French workforce gets paid high wages but works only three hours. They get one hour for breaks and lunch, talk for three, and work for three. I told this to the French union workers to their faces. They told me that’s the French way!

The Chinese are shipping tires into France - really all over Europe - and yet you do nothing. In five years, Michelin won’t be able to produce tire in France. France will lose its industrial business because government is more government.

Sir, your letter states you want Titan to start a discussion. How stupid do you think we are? Titan is the one with money and talent to produce tires. What does the crazy union have? It has the French government. The French farmer wants cheap tire. He does not care if the tires are from China or India and governments are subsidizing them. Your government doesn’t care either. “We’re French!”

The US government is not much better than the French. Titan had to pay millions to Washington lawyers to sue the Chinese tire companies because of their subsidizing. Titan won. The government collects the duties. We don’t get the duties, the government does.

Titan is going to buy a Chinese tire company or an Indian one, pay less than one Euro per hour and ship all the tires France needs. You can keep the so-called workers. Titan has no interest in the Amien North factory.

Best regards,

Maurice M. Taylor, Jr.

Chairman and CEO

Now, Montebourg, translated from French:

Sir,

Your insulting and extremist words show a complete ignorance of France, its competitive advantages, as well as its worldwide acknowledged attractiveness and its links with the United States of America.

France is proud to welcome on its soil more than 20,000 foreign companies, representing  close to 2 million jobs, a third of its industrial exports, 20% of its private R&D, and 25% of its manufacturing jobs. Every year, we count 700 decisions of investments creating jobs and value in France. And this solid attractiveness does not weaken, on the opposite every year it becomes stronger.

Within those foreign investments, the United States rank at the top. 4200 subsidiaries of American companies employ about 500,000 people. The presence of American companies in France is very old : Haviland since 1842, IBM since 1914, Coca-Cola since 1933, General Electric since 1974. And how many others. Those links are every year renewed: In 2012, companies such as Massey-Ferguson, Mars Chocolate, and 3M have chosen to increase their presence in France.

What are the decisive factors in those investment choices? Foreign companies seek in France quality infrastructure, an enjoyable life-style, and an energy among the most competitive in Europe, as well as an environment very favourable to research and innovation. But above all,  far from your ridiculous and disparaging remarks, all of those companies know and appreciate the quality and productivity of the French workforce, the commitment, know-how, talent and skills of French workers.

To amplify this attractiveness, the French government has recently taken 35 steps within the framework of the National Pact for growth, competitiveness and employment. Among those, tax credit and employment lightens by 6% companies' employment costs between 1 and 2.5 SMIC [ie: SMIC French minimum wages]. Furthermore, the unions have just stroked an agreement on job security, which illustrate the quality of social dialog [French buzzword for negotiation between unions & corporations] in France, and how important it is for my government.

May I remind you that Titan, the company you manage, is 20 times smaller than Michelin, our French internationally famous technological leader, and is 35 times less profitable. This shows how much Titan could benefit and profit enormously from an investment in France.

France is especially proud and happy to welcome American investments as both our countries are bound by an ancient and passionate friendship. Do you even know what La Fayette did for the United States of America? For our part, we French, shall never forget the sacrifice of young American soldiers on the Normandy beaches to deliver us from Nazism in 1944. And, as you choose to criticize your own government in the letter you addressed to me. I have to tell you how much the French government admires the policies set up by president Obama. As the minister in charge of Industry, I am especially impressed by his actions in favour of the relocation of manufacturing jobs in the United States, and of radical innovation. Actually, our current policy exhibits a certain closeness with that inspired by your president.

You evoke your intention to exploit the workforce of certain countries to flood our market. I have to tell you that this unethical and short-term calculation will sooner or later hit the just reaction of the states. That is already the case for France and its increasingly numerous allies within the EU that plead for trade reciprocity and are organizing a response against dumping. Meanwhile, rest assured that you can rely on me to encourage the relevant services to check your import tires with increasing zeal. They shall be especially careful regarding the respect of social, environmental and technical norms.

Arnaud Montebourg

We believe Taylor won the exchange decisively.  In the spirit of the season, however, we’ll be as fair as we can be to Montebourg.  The French government, as Montebourg pointed out, is trying to increase labor market flexibility and reduce labor costs, though the reforms are agonizingly incremental.  And, the Hollande regime, as tone deaf as it’s been on so many other issues, has begun to realize on some level that they better establish a better working tone with domestic and international companies lest the country become a total pariah in international industrial circles.  Hollande has initiated a charm campaign recently in an attempt to cauterize some of the self-inflicted wounds.  

Nonetheless, moving back to the heart of the matter, Taylor’s frustration, whether some consider it excessively harsh, is confirmed by some of the data out there.  Numbers don’t lie.  France relative to its neighbors, and the broader developed and developing world for that matter, has increasingly become an expensive place to conduct business over the past decade.  Trends that were in place prior to Hollande’s assumption of power certainly aren’t being ameliorated by the current regime, at least not at a pace required to compete effectively with competitor nations.  

Let’s look at unit labor costs in the Euro Zone since 2000.  Per the OECD, unit labor costs “measure the average cost of labor per unit of output and are calculated as the ratio of total labor costs to real output…It is also the equivalent of the ratio between labor compensation per labor input worked and labor productivity.”  Generally, we’ll just say that rising unit labor costs indicate a situation where compensation to workers is rising faster than productivity.  If unit labor costs in a particular country get “out of whack” relative to other countries, there’s a good chance that the offending country will experience a loss of competitiveness and negative economic impact.  Here’s a chart based on Eurostat data illustrating European unit labor costs since 2000:

Source: Marc to Market Blog

As you can see above, the periphery countries Greece, Italy, Portugal, Spain, and Ireland experienced dramatic increases in their unit labor cost metrics pre-crisis.  France wasn’t far behind over this period.  German unit labor cost dynamics were relatively stable, owing to labor market reforms enacted about a decade ago.  Since the onset of the Great Recession and the subsequent sovereign debt crises, unit labor costs in the periphery have begun converging with Germany.  Ireland, Greece, and Spain especially have seen a dramatic drop off relative to peak.  Of course, this transition has been incredibly painful in these countries.  Progress is being made. In Greece, for instance, the current account deficit has been cut in half.  With the periphery countries experiencing a dramatic drop off, Italy is the only country in Europe that has experienced a greater rise in unit labor costs than France since 2000.  That’s not the kind of company one wants to keep.  Furthermore, the periphery countries will probably continue to see labor costs decline over the intermediate term which will leave France sticking out even more like a sore thumb.  

Is this affecting French growth?  It’s taken a bit of time, but the economic crises in the periphery are starting to infect French economic prospects.  This week, Markit released their composite output indicators for a range of countries.  The French Composite Index, which includes both private-sector services and manufacturing output, declined from 42.7 in January to 42.3 in February (sub-50 numbers indicate contraction in this diffusion index), far below the 47.3 number for the Eurozone as a whole.  Year over year GDP growth in Q4:2012 came in at -0.3%, the first negative year over year number since 2009.  Considering the decent correlation between the composite PMI numbers referenced above and GDP growth, it wouldn’t be surprising to see these numbers deteriorate further during the first half of this year.  Overall, it’s outside the scope of this post to tease out quantitatively how much competitiveness factors such as unit labor cost differentials are affecting relative economic growth.  We’ll just say, intuitively, it’s certainly not going to be a help going forward to have a labor cost/productivity structure moving further and further away from the peer group.  

The French government and labor groups have their work cut out for them.  The status quo is unsustainable, and the Titan CEO has brashly articulated why.  While it may be noble on the surface to stand up for domestic labor groups and promise the world in terms of wage sustainability and job security, the simple fact is that economies are open and transportation and communication networks are as efficient as ever.  “Money goes where money is treated best.”  The Titan CEO is correct.  The tires the French need can be produced anywhere, whether Eastern Europe, India, or China, and delivered quickly and efficiently to French shores.  Certainly, the French could try a more closed model and try protecting domestic industries, but this would be extremely counterproductive in the end economically.  Eventually, the periphery countries had to succumb to the forces of convergence, and France will too.  The transition has been painful for the periphery countries, especially because the transitions were de facto imposed against their will by markets. French labor groups are probably facing the same dynamics; it would be much better for them to work to become part of the solution and get ahead of the issue instead of waiting to get dragged kicking and screaming to the table. Much talk of late has surrounded the notion of “reshoring” in the United States as companies move production back from China and other areas around the globe.  This gradual resurgence in US manufacturing prospects was preceded by a long decline.  This frustrating period was a story of convergence as well.  Unit labor costs in manufacturing in the US reached unsustainable levels.  As such, all things being equal, it became more attractive to move production to offshore centers such as Mexico and China.  As one would expect, wages in the US stagnated while wages in China, for instance, moved dramatically higher.  The nascent reshoring fad is the fruition a long move towards convergence and equalization between Chinese and US unit labor costs.  Depending on the source, China’s unit labor costs have been compounding at near double digit rates over the past decade while US unit labor costs have remained flattish.  US labor is highly competitive with other countries now when adjusting for factors like transportation and intangibles such as managerial efficiency in terms of managing far flung assets.  It’s been a unpleasant ride, but the US is now increasingly prepared to move forward.  France, on the other hand, may just be getting started down a painful path.  They’d be much better served by seriously addressing their competitiveness issues than pointing fingers at decision makers.