What Is Not Seen

In a couple of my earlier posts, I have argued that the manufacturing sector make up the largest part of the modern industrialized economy, especially the U.S economy. While the press keeps nagging about the fact that consumption constitute 70 % of GDP, manufacturing constitute totally 62 % of the whole economy! To quote from one of my earlier posts:

By looking at the broader statistic provided by the Bureau of Economic Analysis, Gross-Output, total spending in the US economy is approximately $24 trillion. With GDP of $13 trillion, industrial spending including spending on manufacturing can be estimated roughly to $14,9 trillion. This would infer that consumer spending constitute only 38 % of total economic spending not 70 % according to the GDP. The other 62% can be subscribed to spending in earlier stages of the production process, in particular manufacturing.

Now, according to the latest numbers, the manufacturing sector gained momentum during May. Looking at the ISM survey (Institute for Supply Management), released yesterday, we saw that PMI growth in manufacturing increased to 49.6 % in May, up from 48.6 %, in April (A number below 50 signifies a slowing manufacturing sector). The biggest positive change was found in production, new orders and prices, where production increased 3.2 % to 49.7 % and new orders 2.1 % to 51.2 %, sending an apparently bullish signal.

Also, today’s Census report on Manufacturers’ shipments, inventories and orders agree with the ISM survey, showing an increase in manufacturing with 1.1 % for new manufacturing orders in April.

Looking back on 2007, we see that manufacturing peaking in July. So, what then does these numbers tell us. Is the April readings possibly a through for manufacturing?

Not likely! While ISM new orders increased, we saw a sharp 5.5 % decline in order backlogs. Backlogs can be viewed as total value of sales orders waiting to be fulfilled. Thus, by merely looking at new orders compared to backlogs, we see that the gain in new orders is smaller than the decline in backlog. Keeping in mind that ISM is only a survey, the net effect indicates a slower overall demand for manufacturing goods.

Another important fact regarding new orders can be seen in the Census report. According to the headline number, new orders in manufacturing increase by 1.1 % in April. However, non-seasonally adjusted change during the month for new orders declined with -2.7 %. That is a positive adjustment of totally 3.8 %.

The case with ISM production, on the other hand, is not as obvious as with new orders. Looking at the downward trend since July 2007, when manufacturing peaked, the May production reading is likely nothing more than a short-term divergence from the long term-trend. According to economic theory, manufacturing in this stage of the business cycle should experience severe problems.

But what about the FED cutting interest rates? Since September 2007 the FED has cut interest rates by 3.25 %. While the rate cuts often have a direct impact on the stock market, they have a lagging effect on the economy.

First, a lower interest rate means lower financing costs for companies, as they now can borrow money more cheaply. This low rate environment creates an artificial boost to accounting profits as capital is allocated to the manufacturing sector.

Second, an artificially low interest rate creates monetary inflation. Eventually, this inflation results in higher prices. The recent surge in commodity prices, such as energy, metals and agricultural goods, is partially a consequence of prior rate cuts.

Looking at the ISM report, prices reached 87 % during May, the highest reading for the index since it registered 88 percent in April 2004. A surge I input prices directly affects capital intense businesses, such as manufacturing, resulting in lower profit margins.

At this point, it is too early to call for a new “bubble” in manufacturing. Although, the rate cuts still have a distorting effect, keeping malinvested capital from being liquidation. Surging input prices have put a cap on growth in manufacturing. As long as prices on energy and other input goods keeps on piling up, manufacturing will suffer. Hence, we should expect further weakness going forward.

Finally, to answer the initial question: What’s up with manufacturing? let us once again turn to the ISM survey to see what respondents are saying:

“Higher prices, tighter supply, longer lead times, shrinking inventory (same as last month).” (Transportation Equipment)

“Just two months ago we were cautiously optimistic, but now sales inquiries are coming in at a snail’s pace.” (Machinery)

“Ethanol-driven agricultural commodity increases continue to pose major hurdles.” (Food, Beverage & Tobacco Products)

“Pricing is skyrocketing for chemicals.” (Chemical Products)

“Current forecast flat for Q2 through Q4 after dip in Q1.” (Computer & Electronic Products.

The hottest topic of today is definitely inflation. The effects from inflation can be seen everywhere. Recently we saw oil prices, surge to over $134 per barrel.

Leaving fundamental factors aside, inflation has contributed to massive gains in commodity prices during the last year. Even deflated government figures like CPI and PPI have begun to show big increases, as monetary inflation has filtered through the economy, pushing over all prices higher.

The Austrian definition of inflation regards monetary inflation. Simply, If the money supply grows, there is inflation. One result from monetary inflation is price inflation, or increasing nominal prices on goods. The price inflation we see today is therefore the result from monetary inflation that happened in the past. Today, we experience the accumulated effect from monetary inflation, that occurred many years ago.

An interesting question is whether we should expect this historical inflationary buildup to continue to push prices higher, as we speak today? Or, as some people argue, that we should expect prices, or price inflation to moderate as the economy slows.

The problems involved with trying to measure statistically, the effect from monetary inflation on for example PPI, is evident. First, there is no “rule” determining how long time it takes for monetary inflation to show up in prices. Second, the effects from monetary infllation on prices is asymmetrical. Third, monetary inflation tends to accumulate over time, making the effects larger when they finally hit the economy. And fourth, not all monetary inflation show up in statistical measures like CPI and PPI.

With these problems in mind, I have tried to create a rough estimate for future price inflation, given the current monetary inflation we can observe. I have looked at the percentage yearly change in money supply, here measured by MZM (Money with zero maturity), and the percentage yearly change in PPI: All commodities, trying to map the changes in MZM to the apropriate effects in the PPI. The red line signifies PPI and the blue line MZM. Number 1 is intended to map on A, and 2 on B, and so on.

Even if this approach is very basic, I belive it can serve as a rough guide for what lies ahead.

Looking at 8 and H, we see something interesting. When the rate of monetary inflation slowed after the tech-boom crash in 2001, PPI didn’t slow at all. Historically a decrease in MZM has followed by a similar decrease in PPI, as we can see for example with 3 and C.

Ever since late 2001, price inflation has grown significantly faster than than it did, any time since the 80’s. This has happened in an environment where MZM has been decreasing. One explanation for this buildup in PPI, is precisely the historical increases of the money supply, that has been building up, and not until recently starting to puch up prices on goods.

This is supported by what happened when MZM once again picked up. After MZM had bottomed in 9, PPI quickly increase from I to new record levels.

Looking ahead, we hypothesize that the bottom I for PPI coincides with the bottom 9 for MZM, and construct a likely scenario for the development of future PPI and price inflation. The time elapsed between 9 and I is 16 months, between June 2005 and October 2006. This means that the last 16 months change in MZM does not yet show up in the PPI numbers.

According to the chart, money supply, MZM has been growing exponentially ever since 8, and currently by 16 % per year. Even if the rate of change in MZM would slow some time soon, we should still expect prices continue to increase. And even if we would see a temporary decline, the trend in PPI is clear. We are entering a period with on average higher prices, both producer prices and consumer prices.

Some economists are trying to estimate the cost of the current mortgage crises, unfortunately, most of them are blind to the real costs of the crises. IMF recently estimated the cost to $945b. This estimate has misled even some distinguished economist in believing that the mortgage crisis isn’t that serious. The political economist, Anthony de Jasay is one example. In his latest article “A trillion dollar “catastrophe”?” the Anglo-Hungarian economist, argues that the sub prime crises isn’t really a crises, but for the most part a zero-sum-game. In his words:

The current “crisis”, as every opinion-maker persists in calling it, is primarily […], one of loss of confidence.

and

[m]ost if not all of the trillion dollars is only a loss to one side in a zero-sum game; it is a gain to the other side. If the mortgagee lends too much on a house to the mortgagor, the latter gains what the former loses; the house itself suffers no material damage. If the mortgagee escapes the loss by having the mortgage “packaged” with many others in a “collateralised debt obligation,” that is passed on to some institutional or private buyer, it is the buyer who takes the loss if some of the mortgages in the CDO turn out to be worth less than their face value. There may be a whole chain of buyers sharing in the loss. Some in the chain may even gain.

Jasay reaches his conclusion by looking at the nature of derivatives. Since derivatives to a large extent, actually are zero-sum games, where someone’s loss is another one’s gain, he believes the effect of the crisis is limited, mostly to some redistribution effects. But as I argue, the loss from bad derivative transactions are not the only cost that needs to be considered in gauging the effect of the crises. The real costs are the opportunity costs from misallocated investments and capital.

When interest rates where held artificially low in the past, entrepreneurs got the impression that real savings in the economy had increased, fueling capital spending and investments to unsustainable levels. What we now are beginning to see is that entrepreneurs are starting to realize that they don’t have enough funds in order to finish and maintain the new productive structure, causing distress for many businesses.

According to the Austrian business cycle theory, firms far away from consumption, is hit the hardest, as their amount of malinvestments tend to be higher. Therefore, we need to watch the manufacturing sector in order to gauge the real cost from the credit crises fallout.

According to the Institute for Supply Management, the manufacturing sector has now been falling for the third consecutive month. In the April report, increasing price presure and growing inventories show clear signs of troubles down the road as profit margins for manufacturers shrink, leading to slower economic activity, and finally to higher unemployment.

In addition to ISM, the Employment situation show that, non farm employment have now been falling for the fourth consecutive month. While the headline number in the Establishment survey is -20 000, looking at the broader measure for unemployment in the House hold survey, where we include officially unemployed, the number of marginally attached workers, and the number of working part-time for economic reasons, total unemployment surged to 9.2% in April from 8.2% since last year.

A trillion dollar “loss” in derivative related assets may not be Judgement day. But the fact that the manufacturing sector is slowing and unemployment are on the rise, should result in deep concerns, also for people like Jasay.

According to economic theory, illustrated by economic data, the current credit crisis is not only a crisis, but a severe crisis. The real cost for the economy is not primarily related to derivatives, but are found in the malinvested capital. What we are now seeing in the ISM report and in the Employment situation report is a reflection of the process where capital is being liquidated. Some invested capital will be reallocated to better use. But a large part of the capital stock is fixed capital, and cannot be transformed to any other productive use. These investments will be a total waste of resources, and constitute the real unseen cost of the credit crisis.

In my review of Thomas J. Dorsey’s book: Point & Figure Charting, I wrote that technical analysis (especially Point & Figure charting) could be seen as a form of entrepreneurship in the financial sector. When betting on the stock market, technical analysis is an important tool investors use when he is trying to get the odds in his favor.

This is especially relevant in the short term, where prices tend to move according to sentiment and peoples expectations. In the medium to long term, sentiments and expectations play a much smaller part in determining the overall trend. Here, fundamentals become more important as prices tend to conform to the underlying supply and demand dynamics.

In this analysis, Austrian economics can be very beneficial. For people not familiar with Austrian economics, What every Investor should know about Austrian economics and the hard-money movement (1988 ) by Mark Skousen, is a must read. This is a beautiful little book (and perfect for weekend reading), with a very interesting theme: Austrian Economics applied to finance.

However, for people already familiar with Austrian economics, I doubt that What every Investor should know about Austrian economics and the hard-money movement will add much new insight, as it is an introduction. But, because of the scarce supply of Austrian investment books on the market, I still think this little book deserves a place in every serious investor’s personal library.

Skousen does a great job in pointing out some important features of Austrian economics that you don’t easily find in the average text book. In the part called, Followers of the Austrian School of Economics, he mentions the obvious, but often ignored fact, that one of the keys to economic growth and prosperity is a high rate of personal savings and capital formation.

The Keynesian framework provides a relevant example. Here, focus lies completely on consumption, and not on savings. This misconception has serious effects on the economy, as government consumption is believed to produce prosperity.

On Wednesday this week, we could see another example resulting from ignoring this key insight, the GDP report. GDP are supposed to measure the health of the economy for a country. Although GDP is an important number, it almost completely consists of consumption related spending. This takes focus away from what is really the driver of economic prosperity and capital formation, namely savings.

Another Austrian insight mention in the book is that government inflationary policy is responsible for the boom-bust business cycle. What Skousen is refereeing to here is the Austrian business cycle theory (ABCT), first developed by Ludwig von Mises.

In the part called How to profit from the business cycle, Skousen gives a brief overview of how he sees the business cycle. He divides the cycle into four stages: (1) The inflationary boom, (2) The credit crises, (3) Recession, and (4) Economic recovery. Depending on which stage the business cycle is experiencing, different types of assets are more suitable than other in an investors portfolio.

However, Skousen points out, as also many other Austrians do, that no one rings the bell when we go from one stage to the next. This fact has even made some people question the value of Austrian economics in practical investing.

However, It should be clear, even if Austrian economics cannot answer that question, by understanding the causal relation ship between credit expansion, inflation and the business cycle, people familiar with Austrian economics have a direct advantage over the average nonaustrian economist, in making appropriate long term investment decisions.

In retrospect of the latest manufacturing report, I found an interesting chart, worthy of mentioning here. As it is the largest part of the economy, the goods producing sector play an important role in determination of the overall economic health for a country. Although the ISM index is a good indicatior for the manufacturing sector, I also like to look at total sales and inventories for manufactured goods to get a complimentary view.

By taking the ratio of total inventories over total new orders – excluding defense – from the Census Maufacturing report, we get an interesting chart.

We use new orders as an indication for sales, and non defense manufacturing to get a more accurate reading of business demand for manufactured goods. What we are primarily interested in, is a buildup in inventories relative to sales, which would result in a higher reading in the chart above. What this would tell us, is that there is a back log of goods, that has not yet been sold. By looking back, prior to the tech-boom recession, we can clearly se signs of this happening, as inventory in the manufacturing sector had started to increase in late 1999, signaling trouble.

The reason for this buildup in inventories, can be found in the earlier stages of the business cycle, as credit expansion from the federal reserve system created incentives for entrepreneurs to engage in excessive investing. With artificial cheap funding that did not come from real savings, there was no sufficient future demand for the newly produced goods. This was because the perceived profit opportunity moved capital to sectors most benefited from the earlier credit expansion. This created an increase in supply of capital goods, and finally resulted in shrinking profits, and falling prices together with a liquidation of malinvestments.

According to Ludwig von Mises(p.560),

“[t]he crisis [recession] is precisely characterized by the fact that these [capital] goods are offered in such quantities as to make their prices drop sharply.”

In our case, this results in an inventory buildup and initially, an increase in the inventories/sales ratio, that we can see today. Looking at the chart we can observe that we are presently in a up trend, that started in late 2005. This was at the same time the Greenspan housing bubble started to burst. We can expect to see further increases in inventories/sales. As long as liquidity are getting pumped into the system at an accelerating pace, companies will likely add to their growing stocks, putting aditional pressure on companies balance sheets.

Looking at the current money supply growth, and the latest surge in prices faced by business (+8% according to ISM report), we can se that stagflation is present, causing additional pain as input prices are increasing. This is at the same time business already are experiencing the negative effects of earlier credit expansion.

Finally, I would like to comment on the long term downward trend in the chart. The fact that the inventories/sales ratio has decreased the last 18 years is most likely the result from more efficient inventory planning, making it possible for entrepreneurs to hold a smaller stock of inventories.

An extremely weak employment report from Bureau of Labour Statistics show further deterioration of the US economy. Nonfarm payroll of -80 000 is in a historical perspective a very weak number. The last time nonfarm payroll plunged with more than 80 000 was in mars 2003, when payroll decreased with -212 000. Further economic weakness is clear by looking at the revision of February numbers of -76 000.

Economically, employment is a lagging indicator and does not necessary portray an accurate picture of where we are going in the future. The fact is that the index held up until January 2008, while the financial crises hit the markets as early as august 2007.

With the latest manufacturing report in memory, a closer look at the establishment survey shows a job loss of 48 00 in the manufacturing sector. This can be viewed in contrast to the resent growth in employment according to the ISM manufacturing index earlier in the weak. The apparent mismatch is a result of different ways of estimation methods. Despite the positive read in ISM, the Establishment report accurately show how economic slowdown now has started to show up in the labour markets.

According to economic theory, the pattern discerned in the report is interesting. The present economic bust, following the prior multiyear boom is both results of the same thing, namely credit expansion and monetary inflation. In a period of credit expansion and lower interest rates, capital is allocated to sectors further away from consumption, such as manufacturing, goods production and mining, where the amount of capital is relatively high. These, so called malinvestments increase the amount of leverage, pushing prices higher (look at prices in the ISM report +8%), resulting in massive increase of supply. With a deficient amount of demand for manufacturing goods, the inevitable profit squeeze and liquidation is a fact.

If we look at the establishment report, goods-producing industries: construction and manufacturing both experienced a total loss of -93 000 jobs, compared to the service sector that actually gained 13 000 jobs in mars. This scenario conforms to what we would have expected from economic theory.

This stagflationary scenario is similar to what we have seen in earlier recessions, with falling producer prices and rising consumer prices. So far in to the present economic down turn, history seems to remind us of this chain of events.

The last couple of weeks I’ve been reading books about technical analysis and trading. Technical analysis, some times ridiculed by academics for the lack of rigour, is at best regarded as a pseudo science. Although, this method of analysis is widely used by practitioners in the financial world its usefulness is often highly questioned. At the moment I am reading Thomas J. Dorsey book about Point & Figure Charting. This method is one of many tools available for the individual investor interested technical analysis or trading.

Economics in general and Austrian economics in particular properly deal with fundamental causal relationships. When it comes to the content of these relationships or economic laws, theory does not say very much. Instead, this area is what economists call entrepreneurial activity or entrepreneurship. This is the heart of the economic process, where business men offer their different services to each other and consumers in exchange for money, resulting in the formation of market prices.

As mainstream economics primarily deal with economic equilibrium, entrepreneurship does not even enters the picture. Fortunately this process – which allocates capital and adjusts prices according to supply and demand – is thoroughly analysed by the Austrian school of economics.

But still when it comes to the content of entrepreneurship, e g the currant real life relationship between supply and demand Austrian economics does not provide the complete picture. Knowledge of the inner workings of the business cycle and the fact that e g, a price ceiling for product X will raise prices, ceteris paribus, is necessary. But in real life the ceteris paribus assumption does not hold (everything is not equal). Prices can very well move in a counter intuitive fashion. The only thing that we can know is that prices tend to move according to fundamental factors over time. So for the business man or the private investor interesting in trying out the stock market, Austrian analysis and other qualitative assessments is not sufficient, especially not in the short term, where prices move along investors’ sentiment.

It doesn’t matter if you are looking at the price of fish or the price of a stock ABC, both are determined by supply and demand every minute every day. The only different feature is that the prices of stocks tend to change more frequent than the price of fish.

On Wall Street there are an old saying that: “the market can stay irrational longer than you can stay solvent”. If you would enter an investment solely based on the ceteris paribus assumption, the odds that you would loose money is to big to be ignored. So the million dollar question then becomes how you take a logical and rational approach to overcome this problem. Since investing is entrepreneurship and no one knows what will happen tomorrow, there is no closed formula to how one would do this successfully.

Because of the entrepreneurial element of this problem the concept of truth and falsehood does not enter, as in economic propositions. In technical analysis or in investing, concepts like, consistency and accuracy are more suitable for evaluating any particular method.

Thomas Dorsey’s idea about both consistency and accuracy is found in the method of Point and Figure charting. Based in the fundamental truth of supply and demand, first formulated by Charles Dow, P&F charting aims to give the accurate picture of this supply and demand relationship. Simply put, if demand for stock ABC is in control over supply, prices will rise. On the other hand if supply of stock ABC is in control over demand, prices will fall. Based solely on this fact, P&F charting then offers a hint for investors of whether prices will tend to fall, or if they will tend to rise in the future.

Compared to many other analytical tools P&F charting reduces volatility in price movements. Because of this, one can more easily discern important price changes from unimportant noise.

Point and Figure Charting by Thomas J. Dorsey is a valuable tool and a good friend to lean on when you are evaluating the often times erratic market.

According to famous investor Jim Rogers: “Everyone who’s involved in financial markets must understand Point and Figures charting in order to get the full picture, whatever your view of technical analysis”

For more information of Point & Figure charting visit www.DorseyWright.com