Tuesday, April 28, 2015

A short guide to measures of employment, wages and income

Over the last few years I’ve spent a lot of time discussing employment with various other market participants, commentators, reporters and other assorted interested observers and, in my experience, one of the biggest obstacles to productive exchange is an incomplete understanding of the various measures of income & employment, what they attempt to estimate and how the estimates are arrived at. I put together this short description, which I hope to keep updating in the future, in an attempt to create a quick reference to various measures of employment, wages and income both for myself and colleagues.

To avoid any confusion related to nomenclature, it’s important to define some of the terms that I will use and how they relate to each other. The labor force is the portion of the population that is employed, unemployed, or discouraged (1). Estimates of the labor force, (un)employment levels, and demographic characteristics of the labor force come from the Current Population Survey (CPS), commonly referred to as the “household survey”, collected from a sample of 60,000 households by the Bureau of Census for the Bureau of Labor Statistics (BLS). Some key definitions are reproduced below:

Employed persons consist of: persons who did any work for pay or profit during the survey reference week; persons who did at least 15 hours of unpaid work in a family-operated enterprise; and persons who were temporarily absent from their regular jobs because of illness, vacation, bad weather, industrial dispute, or various personal reasons.
Persons are classified as unemployed if they do not have a job, have actively looked for work in the prior 4 weeks, and are currently available for work. Persons who were not working and were waiting to be recalled to a job from which they had been temporarily laid off are also included as unemployed.
Discouraged workers are a subset of persons marginally attached to the labor force. The marginally attached are those persons not in the labor force who want and are available for work, and who have looked for a job sometime in the prior 12 months, but were not counted as unemployed because they had not searched for work in the 4 weeks preceding the survey.

In addition to the household survey, the BLS also conducts the Current Employment Statistics (CES) survey, commonly referred to as the “establishment survey” because it surveys establishments (employers). It covers about 143,000 employers which, in aggregate, employ over 588,000 persons (2). The establishment survey includes any full- or part-time worker that was paid during the pay period that includes the 12th of the month excludes self-employed workers, farm workers, domestic workers and non-civilian government workers. In addition to estimates of payroll employment, the establishment survey provides estimates of hours worked and hourly earnings for the estimated 77.2 million workers paid at hourly rates (3).

I will use the word “worker” to describe a member of the labor force and the word “employee” for a person on an establishment’s payroll. It is important to note that because an employed worker may be employed by zero (e.g. in the case of self-employed) or more establishments, these are not interchangeable. The household survey counts as “employedworkers who may or may not be on a payroll, while an employee is a worker that is currently on a payroll. The sum of all the remuneration employees receive for their work is compensation.

An estimate of Compensation of Employees is released quarterly by the Bureau of Economic Analysis (BEA) as part of the National Income accounts. Compensation of employees is the sum of wages and salaries and noncash benefits (e.g. retirement plan contributions and employer-provided health care plans) paid or provided to US residents by US or foreign employers. (4) This measure can effectively be thought of as the “labor share” of income. It is important to note that this measure excludes income from self-employment, including what is commonly referred to as “1099 income,” non-employee compensation paid to independent contractors, which is recorded as Proprietor’s Income.

Wage & Salary Disbursals, a monthly estimate which is lagged by one month is an almost perfect proxy for the wages & salaries portion of compensation of employees. This measure represents the actual aggregate compensation that employers paid both wage and salary employees and is a function of employment levels, salaries, hours worked and the rate at which those hours were paid, including overtime and paid time off. This measure deviates slightly from the quarterly series in that it is based on disbursements while the quarterly series is based on accruals.

The two most popular measures of employment are the establishment survey’s non-farm payrolls (NFP), an estimate for the number of jobs in the universe covered by the establishment survey, and the employment level estimate from the household survey. As previously mentioned, these measures are not equivalent, but the closest measure to NFP in the household survey is probably Employment Level - Nonagriculture, Wage and Salary Workers. As can be seen clearly here, the difference between the two is explained almost entirely by multiple jobholders.

Average Weekly Hours and Average Weekly of Production and Nonsupervisory Employees are measures of hours worked (not scheduled). It is calculated by dividing the total weekly hours by the number of employees paid for those hours for a cell and then calculating a weighted average across industries (2).

Average Hourly Earnings and Average Hourly Earnings of Production and Nonsupervisory Employees are not measures of wage rates. They are aggregate measures of the amounts paid to workers which may include distortions such as overtime or holiday pay or fluctuations in the proportion of hours worked by higher or lower waged workers. They are calculated by dividing the sum of the payroll by the total hours worked for a cell and then calculating a weighted average across industries. It’s important to note that these series cannot be used as a measure of wage inflation as they do not control for overtime or the composition of the workers. For example, in a rising wage environment that coincides with an increase in low wage employees and an increasing number of hours worked by those employees, average hourly earnings could fall even though a measure that controlled for occupation would rise. Special bonuses and non-cash compensation are not reflected in this measure.

Multiplying the estimates of average hourly earnings and average weekly hours would result in an estimate of average weekly earnings, the average gross weekly pay for an hourly position before any deductions (such as payroll and income taxes, health plan deductions, etc.) which are available on a monthly periodicity; however, a better measure of hourly earnings is released quarterly based on the household survey. The Usual Weekly Earnings of Wage and Salary Workers as part of the provides an estimate of quantile boundaries of weekly earnings before taxes and other deductions (5) which control for various demographic factors as well as weighted aggregates meant to be representative of the population.  In contrast to all the previous data series mentioned, this release holds information as to the distribution of earnings and allows us to see where changes in wages and employment are happening in the context of sex, age, race, occupation, full- or part-time status, and educational attainment.

Together, these measures give us an idea of how money is paid by employers, to how many people, as well as how that income is distributed and the aggregate utilization of hourly workers. However, none of these measures are a true measure of wage inflation, although the median of earnings of full-time employees by occupation can be close. For a closer look at wage inflation we have to look at the National Compensation Survey (NCS).
The NCS is a quarterly establishment-based survey that provides comprehensive measures of employer costs for employee compensation, compensation trends, and the incidence of employer-provided benefits among civilian workers, excluding federal, quasi-federal workers, overseas, and self-employed workers (6). The two main components of the NCS are the Employment Cost Index (ECI) and Employer Costs for Employee Compensation (ECEC). The ECI, one of the better measures of compensation inflation, provides a “measure of the change in the cost of labor independent of employment shifts amongst occupations and industry categories” and its composition by occupational groups and industry supersectors grouped into private sector or state & local employers. The ECI tracks changes in compensation within establishment jobs, not individuals, so an employee being promoted or changing jobs within the establishment would not affect the index. While the ECI measures changes in per employee hour wages paid to employees and is presented as an index level, the ECEC measures changes in the cost of per employee hour cost to employers and is presented in dollar amounts.
Finally, the US Treasury provides a daily record of assorted deposits and withdrawals in the Daily Treasury Statement (DTS) which includes deposits for “Withheld Income and Employment Taxes,” the portion of gross pay that employers withhold for income and FICA tax purposes. In contrast to numbers from the previously mentioned releases, this is not an estimate and is not revised. It is a true, real-time indicator of aggregate wages disbursed and can be used as a proxy until Wage & Salary Disbursals data is ready later-on. It is important to note that, because deposits for withholdings are not necessarily made simultaneously with payroll (the Treasury allows for a short lag between disbursal and deposit) and payroll periodicity varies between establishments, short-term periods will be noisy and this data can’t be used to approximate month-to-month changes in the seasonally-adjusted annual rate of disbursals without significant adjustments. In particular, deposits tend to be elevated on common “paydays” like Friday, Monday, and the turn of the month.

Works Cited

1. Bureau of Labor Statistics. Labor Force Statistics. Current Population Survey. [Online] April 2015. http://www.bls.gov/cps/lfcharacteristics.htm.
2. —. Technical Notes for the Current Employment Statistics Survey. Current Employment Statistics. [Online] April 2015. http://www.bls.gov/web/empsit/cestn.htm.
3. —. Minimum wage workers: Characteristics of minimum wage workers, 2014. Current Population Survey. [Online] April 2015. http://www.bls.gov/opub/reports/cps/characteristics-of-minimum-wage-workers-2014.pdf.
4. Bureau of Economic Analysis. Methodology Papers. Bureau of Economic Analysis. [Online] November 2014. http://www.bea.gov/national/pdf/chapter10.pdf.
5. Bureau of Labor Statistics. Usual Weekly Earnings Technical Note. Current Population Survey. [Online] April 2015. http://www.bls.gov/news.release/wkyeng.tn.htm.
6. —. Handbook of Methods, Chapter 8, National Compensation Measures. National Compensation Survey. [Online] http://www.bls.gov/opub/hom/pdf/homch8.pdf.

Wednesday, January 21, 2015

Labor: To the Moon!

A year ago I wrote about the coming sectoral re-balancing, with a focus on the imminent increase in the share of labor income at the expense of corporate profits due to an increase in labor bargaining power, declining labor slack, recovering aggregate demand, and increase in public sector employment as a result of improving tax receipts. Let's re-visit how this all panned out. Capital formation? Up as both Net Investment and capex increased.

The average YoY% increase in aggregate wage and salary disbursals was 4.3%, north of the 4% average increase for the first three quarters in nominal GDP.

Also showing robust growth, was Income & Employment Tax Withheld (the stuff withheld on your paycheck) which increased a total of 5.3% for the year as a whole, a clear indicator that more people earned more money.

And, for those who think we still have a lot of labor slack to work through, I present the following chart. At the current pace of job gains, we are a couple of months away from full employment. As the blue line falls below zero, labor bargaining power should really hit traction leading to the increase in real wages and inflation that will eventually lead to the next recession (which is still years away).

Far from being a drag on the labor force like it was last year, public sector employment has now become an impulse tighter, and it's growing at an accelerating rate, with a whole lot of room to run as those increasing tax receipts translate into new jobs.

The corporate sector will try to cut costs but Q1, 2 & 3's federal government tax receipts on corporate income for were 21.6%, 38.1%, and 33.9% higher than the previous year leading to a SAAR of over 500B in corporate income taxes paid. For calendar Q4 (fiscal 1Q15) the increase was even larger at 41.8% YoY (no seasonal adjustments). The effective tax rate of the corporate sector is going nowhere except up until legislation changes it or we get another recession. The marginal dollar of sales goes increasingly to the workers and the government. If you believe in micro theory, this is the aggregate result of firms increasing the quantity supplied until marginal net profit is close to zero.

As I said last year, the gap in quality between the mean and median household balance sheets (wealth skew) has probably peaked and is headed nowhere but down and the accumulated stock of corporate sector savings is being transferred to the household and public sectors. We are way past #PeakPiketty.

We are only getting started and labor is only going to get tighter from here until the next recession from a cyclical perspective. Additionally, as the growth in the millennial "echo boom" is increasingly digested into the labor force and retirement of the baby boomers progresses, it is likely that we will not see another large expansion of the workforce until millennial' kids enter it, and given low birth rates, that's not going to happen for another 2-3 decades. It's going to be a long, long ride UP for labor, and anyone betting on technological unemployment, secular stagnation, continuing rentierism or cost-push deflation is going to miss one hell of a p&l party. Oh, and for those worried about what CEOs get paid: It's going to be a lot harder to get large bonuses and raises for executives when net margins are declining in the midst of an expansion. Expect increasing pressure on executive compensation as traditional measures of profitability and efficiency decline.

And, just to clarify one more time: labor tightness, labor bargaining power, and wages are going nowhere except UP.  And wealth/income-skew (sometimes called "inequality") is going nowhere but down.

Monday, January 20, 2014

Personal Savings Rate and the Balance of Payments

Personal Savings Rate & Current Account Balance. Source: FRED
One of the most common--and yawn-worthy--criticisms of my December post outlining why the rise of labor bargaining power was going to be very negative for corporate profits (my estimated CAGR for the next 20y is 1.65% nominal on the upper end) was that corporate profits would be able to survive an increase in real wages because nominal demand would expand at a greater-than or equal-to rate as wages. When confronted with the fact that this would necessitate a lower savings rate, an anonymous reader stated that the savings rate would decline because, "it's demographic." This is, of course, total nonsense. Although the baby-boomers will indeed draw down their stock of savings as they retire, these are most likely to be offset by rising stock of savings of the echo boom and millennials resulting from higher employment and real wages.

Arguing for a decline in the personal savings rate means--by definition--an increase in the rate of growth of one or more of the following in excess of the rate of growth in personal income:
  • Corporate savings (profits - dividends)
  • Government savings (budget balance)
  • Foreign savings (current account deficit)
The first, as I indicated in my December post, is not happening.The second one, a contracting deficit is currently taking place as a result of the labor recovery and the last is actually in contraction. It is this last one I want to talk about here.

Although the causality is bidirectional, the savings rate is intimately tied to the balance of payments by the accounting entity CA= NS-NI (Current Account Surplus =  National Savings - National Investment). As such, a revisiting of the low savings rates associated with the 2000s would need to be coincident with a much much larger current account deficit and tighter fiscal policy. The main driver in the 2000s for this were the so-called "Clinton surplus" followed by the large current account deficit.

Source EIA
As increases in petroleum production cause imports to decline, the portion of the trade balance associated with petroleum declines. Additionally, the ongoing rebalancing of the Chinese economy towards consumption (as well as the ongoing RMB revaluation) will continue to drag on China's current account surplus--and, in my opinion, turn it into a deficit--making the return of 6% current account deficits highly unlikely.

There is quite a few reasons to be bullish on increases in nominal final demand, but a decline in the personal savings rate is not one of them. The gap in quality between the mean and median household balance sheets (wealth skew) has probably peaked and is headed nowhere but down. As I have said before, the accumulated stock of corporate sector savings is about to be transferred to the household and public sectors.

Friday, December 13, 2013

Even more evidence of shifts in labor markets

The following charts are part of December 13's Bloomberg Economics Brief. The top chart is Bloomberg's Economic Surprise Index. As you can probably  notice, the labor market has been surprising significantly to the upside lately. On the bottom, is changes in nominal wages for the month of November by selected industry. The red line represents the Fed's symmetrical target for inflation while the yellow highlight indicates value of the year-over-year percent change in the PCE deflator.  

While wage growth leaves lots to be desired, all but two industries, utilities and Leisure & Hospitality, showed wage increases in excess of PCE deflator increases. This is good news, these are real wage increases and more evidence of labor market tightening, even if very marginal. This is my 3d post in 2 weeks about this and you better get used to them, because there's probably going to be a lot more of them. The tide is changing, and labor is on its way up!

2013-12-12 -- More on labor bargaining power
2013-12-05 -- Profit margins, tax receipts, and labor demand curves

Thursday, December 12, 2013

More on labor bargaining power

Last week I wrote about how a number highly reliable indicators are indicating the bargaining power of labor is increasing and that it will lead to tighter labor markets and wage inflation.

On Nov 26, The New York Times reported that NYU will once again recognize the graduate assistants' union. The voting was scheduled to take place this week, but a search of press releases shows no results yet as  to the outcome. Excerpt below, emphasis mine.
 Some 1,200 graduate assistants at N.Y.U. and the Polytechnic Institute of N.Y.U. in Brooklyn are scheduled to vote on Dec. 10 and 11 on whether to join the union...
An issue that had long prevented agreement between N.Y.U. and the union was whether graduate research assistants in the natural or physical sciences could be included in the union. The university argued that the research those assistants did was an essential part of their academic training, and should not be viewed as employment. In their statement, the union and N.Y.U. acknowledged that they had not resolved their differences over whether the 275 graduate research assistants in the so-called hard sciences had bargaining rights. They will therefore not be included in the union.
NYU's claim that the work (they called it "work") their research assistants do is part of their training, they are acknowledging it is, indeed, work. As with the recent unpaid intern cases, some will argue that this is not valuable enough to be compensated and the benefit of it mostly accrues to the employee/intern/assistant but, if their labor is truly of so little use, maybe they should be free to apply those resources elsewhere. Like in the intern cases, the labor slack as a result of the financial crisis created a large number of people who wanted work and were willing to sacrifice wages in the hopes that experience would be worth something and make it easier to find a paying job in the future. This shift right in the labor supply curve would have led to lower clearing price for labor, the evidence of which is everywhere. Whether this was unfairly exploited or not is up for the judges to decide, but what seems self-evident to me is that the trough in the bargaining power of labor is behind us and, as a result, the labor consumer surplus--in the neoclassical sense. remember, employers are consumers of labor--is about to be redistributed.

At the risk of oversimplifying, but in the interest of avoiding a black-hole, I will skip discussion of dead-weight losses, the welfare state and heterodox theories of economic surplus, and simply say this: If you believe any of the following:
  • welfare initiatives like the Earned Income Tax Credit subsidize low salaries leading to a higher quantity of labor supplied at a point below the incentive-free equilibrium
  • price elasticity of supply of labor flattens significantly on the left side (positive first derivative)
  • some people will agree to work for less to build a resume or gain experience
Then, the logical conclusion is that, as labor markets recover, the lions share of the benefits will accrue to the household and public sectors. Not only on the marginal increase of production (a change in quantity or labor demanded), but on the entire level of production (a shift in the demand curve).

The corporate rent-seekers masquerading as capitalists will argue the corporate sector will simply not hire or invest if faced with rapidly declining margins or increasing costs at the margin, but the truth is that almost 3 decades where productivity gains have disproportionally accrued to capital and record-high profit margins mean that the ability of capital to bring a credible bluff is just about non-existent. This trend is going to be with us for a long, long time.

UPDATE: The NYU vote was overwhelmingly for organization and both parties expect to have completed a contract by the end of the academic year.
UPDATE-2: "Machinists reject Boeing labor contract offer"

Tuesday, December 10, 2013

Corporate Debt / Market Cap as a predictor of forward returns

Earlier tonight, Matt Busigin tweeted a link to the series "Credit Market Debt as a Percentage of the Market Value of Corporate Equities" from the FRB's Z.1 report. After some back-and-forth with some other folks, Greg Merrill suggested that high debt to market cap looked like it it would correlate positively with forward returns. Intuitively, this works because, if we assume creditors are generally somewhat rational about underwriting standards, a sharp increase in Debt / Market Value would signify a sharp decrease in the value of equity from a level at which underwriters thought it was safe to lend. Stepping back, what we would be doing is measuring the "fair value" using debt as a proxy. 

After thinking about it for a few seconds, I decided to plot our the series against annualized forward returns, shamelessly mining for the forward period that offered the best correlation. After starting with 5y (R=0.5985), 7y (R=0.7069), 10y (R=0.8411) and 11.5y (R=0.8677). After peaking at 11.5y (46 quarters) the correlation starts declining again.

The actionable value of this exercise is questionable given the small sample size but, in my opinion, probably reflects the rational behavior of lenders and CFOs regarding debt levels.  The average Debt / Market Value ratio for the sample is 57%, which is 9.1% higher that the latest (Q3) reading of 47.9%. Since the end of Q3 the Wilshire 5000 has risen 6.84%, representing a market-cap increase of $1,229 billion. We currently have no estimate for net corporate debt issuance since the end of Q3 but, if we extrapolate Q3's 2.2% increase, we get an estimate of a current 45.8% debt to market-cap ratio, which would correspond to a pretty average 7.8% annualized forward return for the next 11.5y. This expected return stands in sharp contrast to much lower expected returns obtained with similar methods by John Hussman using non-financial market cap as % of GDP and the Price/Sales ratio of the S&P 500  as predictors. I should note here that this expected return also lies significantly above my own 10y expected return of just 4.5%.

Of course, the current Debt / Market Value lies in a particularly dense zone with significant dispersion, which--when combined with the 2.45% standard error of the linear regression--should give us pause as to the reliability of any such measure. In this particular casse, the expected total holding period is 132% and the -1 and +1 sd  bands would lie at 82% and 207% respectively--not exactly a Swiss watch.

Thursday, December 5, 2013

Profit margins, tax receipts and labor demand curves

Much has been made of the record levels of corporate tax profits over the last two years. From GMO's warnings of an 1100 "fair price" for S&P 500, to Hussman's forecast of 10y of negative nominal returns, to the economics "It" girl of the moment, the Kalecky-Levy profits equation. Real median household income, in my opinion at a cyclical bottom, is back to early-to-mid 90s levels and as ZeroHedge (the best indicator of policy bear zeitgeist) reports, wages are at an all-time low relative to profits. Meanwhile, it seems like the entire Very Serious Old Guy complex is warning of mean reversion in a laundry list of ratio measures, but nobody wants to talk about whether it will be the nominator or denominator that will change. It is my intention to illustrate exactly how these measures will mean revert in a simple, common-sense way accessible to anyone with a cursory understanding of supply and demand curves and lay out what I expect to be a way to make investments guided by this thesis.

Corporate profits are high because effective tax rates are low, real wages are low, and debt to large companies is cheap, a point I've previously made. They are about to start shrinking. When? Like right now. Maybe last month, or last quarter, even. What led me to write about this is, believe it or not, is public sector employment. Employees of State, Local and Federal governments are not many, they peaked at 14.68% of the labor force (not including the census high) exactly as private payrolls hit bottom, and hit a trough in June and July 2013 at 14.01% representing 21,826,000 employees. In other words, fiscal drag added 0.67% to the unemployment rate.

But this summer we had three important developments:
  1. The labor force stopped growing
  2. The number of public sector employees stopped shrinking and may be growing
  3. Real average hourly earnings growth of non-supervisory employees accelerated to a level coincident with the last expansion
Public (blue rhs) and Private employment as % of labor force
In economic parlance, we can translate the first one as a change from a marginal pressure right on labor supply curve  (curve inching slowly right as labor force grows) to curve shifting slowly left. Ceteris paribus, and assuming a downward slopped demand curve, the consequences would be an increase in the price of labor (coincident with #3) and a slight reduction in quantity demanded at the new price. The second would represent the public sector going from a marginal impulse left on the labor demand curve, to neutral or right maybe a slight force right, which will lead to stable or increasing price of labor (coincident with #3) and an increasing quantity of labor demanded at the new price. The third observation, present since Q1 of 2013, tells us that despite the public sector drag in the first half of 2013, private sector employment growth (demand curve shifting right) has been enough to lift average wages and increase the number of units of labor demanded at the higher price.

With the private sector labor demand growing, public sector stable, or growing, and labor supply (labor force) stable or shrinking, the only plausible answer is wage growth. And, as the marginal unit of labor required to produce a marginal unit of final output goes up in price, so must marginal profit margins fall. But this is not the most interesting part.

Capital expenditures / GDP (blue, lhs)
After-tax profits / GDP (red, rhs)
The interesting part about the position we find ourselves in is that, because of the very low effectivecorporate income tax rate (~16.35% last year), and very low corporate investment rate, the marginal dollar earned by the corporate sector has very little impact on the economy, it just sits as retained earnings. Using Manufacturers' New Orders: Nondefense Capital Goods as a proxy for capital expenditure we can see that even though corporate profits as a share of GDP have increased, capital expenditures as a share of GDP have decreased, meaning the marginal propensity to invest in new capacity is low. This is because of depressed aggregate demand caused by the low labor share of income and previously mentioned low real wages.

This, finally, gets me to my much delayed points:
  1. If the marginal effective tax rate of the household sector is higher than that of the corporate sector, which we know is true because FICA on its own is 15.3% (split by employer and employee), a marginal dollar that moves from profits to wages will increase tax receipts
  2. If the marginal propensity to consume of households is larger than the marginal propensity to invest of corporates, a marginal dollar that moves from profits to wages will increase aggregate demand
  3. If the marginal propensity to consume or invest of the public sector is greater than the marginal propensity to invest of the corporate sector, the increase from #1 will increase aggregate demand
  4. Any savings by households and/or government in excess of investment will be coincident with lower profits, all else equal.*
  5. Any increase in demand for labor by the public sector in response to #1 (in the form of bigger budgets) will be a marginal pressure to the right in labor demand which, all else equal, will lead to an increase in both the price and quantity demanded at the new price of labor. 
  6. Increases in employment and household income will reduce the cyclical deficit and reliance on government assistance programs like medicaid and "food stamps." This is, once again, an increase in government savings which is negative for profits. 
I will stop here, as you are likely seeing the self-reinforcing cycle that will be triggered. Because payroll and individual income taxes make up the lions share (~ 80%) of federal tax revenue, this will lead to a very strong self-feedback loop that will ultimately pressure corporate profit margins down and real wages up, reducing both the income and wealth distribution skew (the proverbial labor/capital divide) while redistributing corporate savings to the household and public sector.

10y treasury yield minus %YoY change in CPI (blue)
%YoY change in average non-supervisory hourly wage
minus %YoY change in CPI (red)
If the past is any indication, a real increase in wages will lead to higher nominal and real rates of interest for long term securities (thanks to Matt Busigin for this one) which, if you recall earlier discussion, is one of the primary reasons for the elevated levels of profit margins. As liabilities mature and reprice at higher rates, this will be a direct hit to profit margins, especially so if the increase in the rate of financing is not only nominal but also real. Given the very low present financing rates (without even mentioning qualitative measures like easy covenants) any future liability repricing is likely to increase the cost of capital and, once again, pressure profit margins.

Grantham, Hussman, Gross and many other investment managers have expressed concerns over elevated profit margins. To my knowledge, none of them have chosen to describe exactly how and why profit margins will fall and who will benefit and how. In this analysis, it is obvious that the beneficiaries of the sectoral rebalancing will be wage-earning households and tax receipts. The losers will be the labor-intensive employers, especially those that are highly leveraged because the cost of debt capital and cost of labor will rise at a speed greater than final demand or price inflation. It should also be clear by now the role of low investment (capital formation) and high unemployment (and associated cyclical deficits and low household savings rates) have had in the final sharp impulse upwards of corporate profits during a struggling economy and that, as labor markets recover, the household and government savings rate will gradually recover as corporate savings decline. Perhaps ironically, the same lack of investment that has helped prop-up corporate savings and holding unemployment high and kept inflation low will, as real wages increase, be the cause of any future increase in inflation. As, Matt Busigin has shown before and you can see to the right, this analysis is not only theoretically sound, but also empirically true.

Net Investment / GDP
This is likely to be very, very long cycle, even if it hits small cyclical snags along the way. Wages just started growing, the public sector just stopped being a drag on employment and net investment just turned positive. To anyone who missed the historic stock market rally, it may feel like it is too late, but this is just the beginning of the real economic recovery. It is also the beginning of inflationary pressures, but it will benefit wages more than prices. If you are wondering, "what's the play?" it is to favor being exposed to credit risk backed by public sector and household incomes and avoid being exposed to credit risk being backed by corporate incomes, especially those that are labor-intensive or highly indebted. Because the Federal government is considered a credit-risk free entity, this would mean the credit risk of state and local governments (which are ultimately backed by incomes of the residents) and of households, either directly through securitized obligations or indirectly through institutions that have a large exposure to households as creditors. Using extreme examples, you would want to own a company that insures mortgages and consumer ABS securitizations as well as municipal bonds, and avoid the lower tranches of any recent vintage CLO.

Is this a doomsday sign for stocks? Maybe not. It is possible that aggregate demand growth is enough to let profits fall as GDP increases and profits rise more slowly, however, it is not likely in my opinion. Assuming a reversal to mid 2000s effective corporate tax rates of 22% after tax profits as % of GNP to a generous 7% (median is 6.10% and mean is 6.34%) and a NGNP growth rate of 6% (mean 6.11%, median 6.7%, current 3%) over 10 years the CAGR of after-tax corporate profits would not amount to more than 1.65%. But it is also not terrible. GMO likes to flaunt their 1100 "fair value" number and Hussman is partial to his price-to-sales ratio chart, but there is no reason for stocks to fall to their fair value, and every day that passes, their fair value will close in to their present value, and at an accelerating pace. This would make selling short equity a trade with a short lifespan, while other trades--especially those where time works in your favor, like being long high-grade municipal bonds, an asset class which happens to be offering remarkable value--offer much more attractive ways to play the thesis.

Shorter version
Marginal head-winds for employment and wages are turning into marginal tail winds as the economy recovers. These same factors posses self-reinforcing properties and are likely to continue to be positive impulses for, real wages, employment levels, tax receipts, and aggregate demand and negative impulses for corporate profit margins and corporate savings. Favor the liabilities of the household and public sector over those of the corporate sector.

*Going back to Kalecki's Profit equation we can remember that:

Corporate Saving = Profits - Dividends
Profits = Investment – Household Savings – Government Savings – Foreign Savings + Dividends

Tuesday, November 26, 2013

Social Advertising Economics

YoY ad pricing from Yahoo!'s 3Q2013 presentation
Like Facebook before them, new "social" web properties eventually have to monetize to and generate revenue. As properties seek to monetize their user base through the use of display or per-click ads, the amount of ad space being sold will increase. In economics parlance, what we would be seeing as mature high-traffic web properties seek to monetize with advertising is the advertising supply curve shift right, increasing the quantity supplied at a lower price point (ceteris paribus). Of course, one tiny website can't really move the curve, but when Facebook,  Yelp, Twitter, Tumblr, and now Instagram, are all pushing to monetize their traffic--large sites with lots of traffic and lots of growth--it matters.

What this means, in simpler terms, is that as long as the change in web/mobile traffic * the change in density of ads (ads displayed per user/visit/pageview, whatever) increases (S right) faster than the natural growth of advertising budgets * the change in share that web commands vs traditional (D right), the price of ads will fall. Judging by the double digit pageview growth rates and double digit revenue growth targets in most of these names, as well as addition of new entrants as more maturing services start monetizing, it looks a lot to me like advertising space, especially display ads, will see increasing price pressures down and, in my opinion, the market will segment into highly-targeted ads to a small sliver of the users that will command a high but shrinking premium, and the rest, which will be a margin-destroying race to the bottom. If you don't believe me, look at Yahoo!'s YoY change in ads price and ads sold and see if you can pinpoint when Facebook went public. Their price trends have deteriorated while their volume was improved, or rather their volume has improved because their prices have declined.

I think it's very likely that in the next 12 months we will find out what the price elasticity of demand for web advertising is and--particularly for display ads--I think it will be a lot more likely to surprise to the downside.

Tuesday, October 29, 2013

How Much is $1 of Earnings Worth?

Investors often treat reported earnings as the "yield" of equities due to the wide availability of reported earnings and the ubiquitous Price-to-Earnings ratio, however this can be a misleading measure of the actual economic value created for shareholders if earnings are overstated during cyclical upturns and the subsequent adjustment during downturns is reported as one-time items or direct-to-equity adjustments. I propose an alternate measure, a sum of the change in reported book value and dividends paid out as a proxy for the economic value created in a period.

Over the last 22 years, every $1 of S&P500 reported earnings has only led to $0.76 of dividends + book-value gains. If you exclude 2008, the year in which reported earnings and the alternate measure previously described differ most, every $1.00 of earnings generates only about $0.84 of economic value to investors. The sample, admittedly limited in size, was obtained using Bloomberg. Bold red line indicates a slope of 1, lighter black line is a simple OLS regression trend-line with no intercept.

Change in BV + dividends vs reported earnings

Change in BV + dividends vs reported earnings ex-2008
EDIT: A reader helpfully pointed out that I left-out the effect of buy-backs, which accrue to the price of shares but are functionally equivalent to dividends. Lacking a time-series of total buy backs, I can't correct the post to include that. Additionally, any buy-back made at a P/B multiple of > 1 would  dilute BV per share. Assuming book value is understated is a reasonable assumption for companies where marginal investment turns out to be profitable or during inflationary periods where the nominal value of capital stock is understated as a result. My apologies for these careless omissions. I will not remove the post, but I think it is worth noting that these omissions make the prior analysis basically useless.

Saturday, October 12, 2013

The short-term car rental service of the future

In the previous post, I wrote about how I envision smartphones replacing many of the functions of in-car entertainment and navigation systems. In this post I will be focusing on how that can affect automobile ownership and culture.

One of the small features that really blew my mind when I purchased my car was proximity-based keys which allow you to enter and start your car without having to ever put a key inside a lock. Not only that, but each key stores all sorts of preferences, from mirror and seat positioning and suspension settings, allowing each key holder to customize their driving experience. While I welcome this marginal innovation, it leads me to ask, “Why do we even need keys?” With the introduction of NFC and like-technologies into our smartphones, there’s no reason why keys can’t be replaced with our smartphones, the same ones which can then be docked into the car to load your personalized settings. Turning the automobile into a “thin-client” of sorts would allow any car to be your car, introducing a whole new opportunity set for the future of automobile rentals.

A couple of weeks ago I was in Paris for a couple of days. Having limited time and wanting to see as much of the city as possible during my short stay, I opted for renting a bike (velib) and riding around the city. One of the things that caught my eye as I tried to navigate roundabouts and punished my coccyx on cobblestoned streets was the presence of an electric car sharing system called Autolib. While it may not be suitable for many Americans, the success of Zipcar in dense, urban, locations is proof that there is a market for short-term car rental within close proximity to people’s homes. Improving this model by using electric cars with inductive-charging capabilities and reserved docking parking spots located throughout the city, eliminating the need to return the car to the same point of origin would remove some of the final inconveniences.

Imagine basic compact, inexpensive and utilitarian automobiles parked every couple of blocks. If you are a service subscriber, you simply walk-up to the car, use the NFC-capability of your phone to unlock it, and dock your phone on the dash to double as a navigation/entertainment display. The unique identifier of the car is recorded by the phone and submitted to a central database, and if your account is in good standing, a one-time use key is digitally delivered to your phone which allows the car to start. Your phone’s built-in navigation system includes all the car rental locations and availability of both cars and spaces is updated in real-time. A parking-assist function (much easier to implement in fully-electric cars) helps keeps dings to a minimum and internal diagnostic checks are run and uploaded at the time of docking the automobile, allowing the rental operator to easily keep track of maintenance needs and fleet location. Because your identity is linked to your phone and entry / ignition are recorded and associated to you, there is a strong disincentive to vandalize or abuse the cars, and no need to worry about someone breaking-in to steal a stereo--you’re carrying it out.

The uses for this range from short local round trips to places inaccessible by transit, to one-way trips for those nights when you may want to feel free to indulge in a few cocktails with dinner and not have to worry about driving home at the end of the night. Additionally, reducing the cost of not driving your own car out may lead to reductions in drink-driving, an additional positive externality. The logistic challenges are not trivial, but they are not great and all of the technologies listed in this post are already available today, it’s just a matter of someone putting it all together.