Greed Over Fear?

Desperation is unattractive, and desperate greed – needing to have a big return, quickly – is dangerous when it comes to investing. But investors appear to be getting increasingly desperate to swing for home runs rather than to try for singles and doubles, if the increased stampeding of retail investors’ monies into equities is any indication. Again today, stocks rallied steadily for most of the day. As the S&P reaches a new 5-year high with every advance, and is not terribly far away from an all-time (not inflation-adjusted) high, investors are increasingly throwing caution to the wind and plunging back in to stocks. Blackrock’s CEO, Larry Fink, observed today that “…the move back into equities is one of the mega trends we witnessed in the fourth quarter, and that has continued into the first 15, 16 days of the year.”

According to Fink, investors are doing this because of disdain for bond returns, not because of a desire to go “risk on.” And yet, risk-on they are going. They are going risk-on with corporate margins at post-WWII highs and following a Q4 that will be exaggerated by the tax-related movement of income from Q1 into Q4 (for example, via the payment of special dividends), and a Q1 that will end up looking weaker than the underlying fundamentals really are. Are these desperate investors ready to see a few months of weak data when they’re buying in at the highs?

Today’s data offered both the good and the bad. The good was the December Housing Starts number, which achieved the highest level since 2008 (see chart, source Bloomberg). To be sure, building activity is nowhere near the levels that were common in the 1980s, 90s, and 00s, but it is recovering. This should continue, as the inventory of new homes is at a very low level. The bad was the January Philly Fed index, which was expected to rise but which instead declined. The index of current conditions (at -5.8%) is the worst for a January since 2009.

home starts

Much was made of the sharp decline in the Initial Claims figure, which was expected at 369k but instead came in at 335k. My advice is to ignore any Claims figure in the second half of December until late January, as the seasonal adjustment factors are actually much larger than the net number – that is, the report should have a huge error bar around the weekly number, which is a seasonally-adjusted figure. If this is why stocks rocketed higher, then the desperation is even more disturbing. No one ought to ever invest on the basis of a weekly economic number.


After yesterday’s CPI report, I expected to see a number of denunciations of “inflation-phobes,” and I was not disappointed. David Wessel’s column in the Wall Street Journal was one example. Although Wessel came to the wrong conclusion (he agreed with Bernanke that there isn’t “much evidence” that the monetary policy of the last several years is going to be inflationary), at least he did undertake to “weigh…arguments on the other side.”

But he almost lost me straightaway, when he said that “the link between the money supply and the inflation rate is hard to discern in data…” Take a look at the chart below (source: Enduring Investments) and tell me if it’s really hard to discern the link in the data.


Oh, and on a longer-term basis there is this, which I wrote about in this great article.


What is hard to discern in the data is any link between inflation and growth, other than the spurious one that comes from the fact that the 2008 crisis was caused by an implosion of housing prices, which then impacted core inflation with a lag. (See chart, source Bloomberg)

gdp vs core CPI

Or, more consonant with the NAIRU theory, any link between the unemployment rate and core inflation (see chart, source Bloomberg).

unemp versus core cpi

This last chart is fun. If you run core CPI as a function of the unemployment rate from 2000-2012, you get a good correlation that looks like the right thing. But again, it’s spurious: if you look at the same relationship from 1990-2000, you also get a good correlation…but exactly the opposite slope to the relationship (that is, implying that lower unemployment causes lower inflation). Showing them both together makes the point that…you can’t see much in this data.

These latter two relationships are absolutely accepted without question in large swaths of the economics profession, such as when Wessel argues that “it would be difficult to spark and sustain inflation with so many unemployed workers, empty stores and offices and underused factories.” Where does he see that in the data?

I shouldn’t be so hard on Mr. Wessel, because he does make a reasonable effort to give some arguments about why people fear that the Fed will either intentionally or unintentionally make a mistake. But I think his best argument is one that he doesn’t make on purpose: policymakers and many economists just don’t understand what inflation is and how it works, and that creates a very high likelihood of error in the future. Moreover, they not only don’t understand, but they greatly overestimate their degree of understanding. I recognize, as an investor, trader, and economist, that there is some chance that my forecasts are wrong. Furthermore, since I understand that overconfidence is a very common cognitive error, I even recognize that I am most likely underestimating the chances that I am wrong. As a consequence, I am very conservative with my approach to investment when the consequences of an error are very high. Most good investors are very wary of overconfidence.

No such wariness afflicts the economic profession, unfortunately, especially at one particular address on Constitution Avenue Northwest in Washington, DC.

  1. January 17, 2013 at 9:32 pm

    Hi – Great article, as is the “Side Bet with Ben” one. Quick question: what is the rationale behind measuring US AND Euro money growth against US inflation? Thanks…

    • January 17, 2013 at 10:04 pm

      Basically, the idea is that the two economies essentially share enough of a banking system that a surplus of money on one side of the pond isn’t contained…it was driven by an observation that banks will borrow dollars or euro through the Fed’s swap facility – so that’s one place that US M2 has dribbled off to, is to European banks.

      • January 18, 2013 at 1:02 am

        Makes sense… thanks for the reply.

      • rich t
        January 21, 2013 at 1:37 pm

        Mike, one more question on that graph… it looks like the changes in CPI are leading the changes in M2 growth? Why do you suppose that is? Thanks!

      • January 21, 2013 at 2:42 pm

        Mostly spurious. Remember both of these are year-on-year changes, so depending on the lead/lag relationship and where in the year the money growth and/or CPI increase primarily occurred, those peaks will shift back and forth. For example, you can easily think of a circumstance where the 12-month change is still rising while the 3-month change is falling.

      • rich t
        January 21, 2013 at 4:10 pm

        I see. It seems like that kind of thing would averaged out so that there wouldn’t be a CONSISTENT lag in the money supply data. That’s just my gut feel, though, I will have to think about it some more and play with some numbers. Thanks for the reply!

      • January 21, 2013 at 4:22 pm

        No worries. I don’t know that there is really a consistent lag (econometrically speaking)…it may be that it’s mostly the peaks and valleys that line up, and maybe it’s mostly on this time period. When I’ve looked before, and been pretty diligent about controlling for common factors, it has looked like M2 growth led inflation pretty comfortably (like, 6 months or so)…but obviously this gets to be more art and gut feel than science pretty quickly.

    January 18, 2013 at 7:59 am

    Hi Mike, Loved your video after the “great article” Keep up the good work! Best, George

  3. Lee
    January 18, 2013 at 5:53 pm

    Thanks for the great graphs and your answer above. The wage inflation folks are wagering then that money supply will fall evidently, so it should be interesting to see how bonds turn out..

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