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Stock Market PE

I have been asked to repeat some of my past post on the stock market. In particular they wanted to see this long term chart of the S&P 500 price/earnings ratio. Until the 1990s bull market a PE of over 20 on trailing earnings was always a signal of an impending bear market as a PE of over 20 was never sustained. There is a long pattern of the market PE swinging from over 20 to under 10. Moreover, even though many Wall Street strategist talk about the long term average PE of about 15, there is no central tendency for the market to converge on the average of 15 and it really does not stay around 15 any longer than around any other value. Prior to 1926 the data is from Robert J. Shiller’s Irrational Exuberance . From 1926 to 1989 it is from S&P and after 1989 I calculate it from S&P’s estimated operating earnings data.

I use operating earnings because it is what most professional investors use and I believe that the estimate of on going operations is the most relevant measure to value future earnings. Of course, right now it does not make much difference as operating EPS and reported EPS are about the same. Last year’s big difference between the two measures stems largely from the massive write-offs by financial firms . Moreover, much of the recent big snap back in earnings is the write-offs rolling out of the four quarter trailing earnings data.

But as these write-offs rolled out of the data is generated a big drop in the market PE based on trailing earnings to about 19. In my valuation model that makes the market fairly valued to cheap.
In a highly cyclical environment as we are now experiencing many people like to use an estimate of “normalized earnings” to eliminate cyclical earnings distortions. So if you use the 7% trend growth in the above chart of operating vs reported earnings to estimate the market PE you get very similar results. Shiller, and some commentators at this blog use the 10 year trailing earnings. When you are dealing with an individual company where the long term earnings growth trend can change, that rule is a very good practice and builds in a measure of safety. But the long term earnings growth for the entire market is unlikely to change rapidly, so I feel comfortable with this approach.
If the economy is in a Japaneses deflation trap of course the trend earnings would be lower.

In my experience the impact of rising interest rates depends on whether of not the market is expensive or cheap. Over the long run the relationship between the PE and interest rates is roughly that a 100 basis point change in yields will generate about a 100 basis point drop in the market PE. But if the market is overvalued like it was in 1987 — my estimated PE was 14 and the market PE was 22 before the crash — the market tends to rapidly close that gap. But if the market is cheap it can withstand the pressure of rising rates much better.

So maybe we should look at the prospects for earnings. The recent productivity report received much attention. But I did not see anyone point out that the spread between nonfarm corporate prices and unit labor cost was 5.25%, the widest spread on record.
This spread is the single most important variable driving corporate profit margins and implies that you should expect major positive earnings surprises.

In addition, corporate profits are very much a function of deviations from trend in real GDP growth. So with margins extremely wide and reasonable prospects for above trend growth, profits should continue to rebound strongly.

With the big margins improvement profits in the national accounts have already rebounded to above trend.

The other thing investors worry about that could be a major threat to the market is inflation. I’m in the school that believes sufficient excess capacity in the economy, whether measured by the output gap, the unemployment rate or capacity utilization, to keep inflation under control for the time being.
However, there may not be as much excess capacity as many believe. Much of the unemployment is structural . Moreover, the Fed estimates that industrial capacity is actually contracting and the growth of potential real GDP is at record lows.
For this year, I do not expect this to impact many prices outside of basic commodities, but in the out-years it could become a significant problem.

Contrary to many claims, the reason capacity creates a potential problem is weak business fixed investment. Despite low marginal tax rates and record profits real
business fixed investment was extremely weak over the last cycle. I will not go into a whole litany of reasons for weak investments, but I will just point out that in the 1960s, 1980s, 1990s, and the 2000s that capital spending was inversely proportional to marginal tax rates.

So, I’ve given everyone a wide range of topics to discuss and debate. Have fun.

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Money-Driven Medicine on Link TV

T.R. Reid hosts a Presentation of Money-Driven Medicine on Link TV (see reception information) As taken from Maggie Mahar’s Health Beat Blog. A special investigative TV program is being aired detailing healthcare costs and the healthcare system. The topic is timely and well worth the time watching in order to gain a greater understanding on what is wrong with healthcare in the US.

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Thank You Marjorie Margolies-Mezvinsky

Robert Waldmann

Let me join Brad DeLong in Saying

Let Me Join Pete Davis in Saying: “Thank You Marjorie Margolies-Mezvinsky”
Pete Davis expresses the sentiment very well:

Thank You Marjorie Margolies-Mezvinsky: I’ve always wanted to thank Marjorie Margolies-Mezvinsky (D-PA) for her courageous deciding vote for President Clinton’s 1993 deficit reduction bill. Her Republican colleagues jeered her as she walked down the aisle to cast her vote with shouts of “Bye, Bye Marjorie!” Her crime — voting for the Omnibus Budget Reconciliation Act of 1993 that reduced the FY94-FY98 deficits by an estimated $496 b., with $241 b. of tax increases and $255 b. of spending cuts. The bill capped a 12-year deficit reduction effort, leading to the budget surpluses of FY98-FY01. She paid the political price, losing her seat in suburban Philadelphia after her first term in office, but she set the U.S. economy on course for its strongest decade since the 1960s.

Unhappy is the country which needs heroines.

So she lost her seat, but who else’s service in Congress do I remember with such gratitude ? Answer, Senator George [ed] Mitchell*.

It is important that Marjorie Margolies-Mexvinsky’s political heroism is not forgotten. The fact that it is remembered might help some current Representatives find some courage.

* He turned down a seat on The Supreme Court and didn’t run for re-election so that he could concentrate on passing Clintoncare. No good deed goes unpunished. For his virtue he was sent to try to solve the damnable question of Northern Ireland. He succeeded. No great deed goes unpunished either and he is now in charge of mideast negotiations. In a just world, Newt Gingrich would be trying to get Israel and Hamas to make peace, and Mitchell would be cashing in** and appearing on TV to pontificate. But, in a just world we wouldn’t need Marjorie Margolies-Mezvinsky or George Mitchell.

** Of course he has cashed in, but that was long ago, and in another country (the USA).

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Recently the Wall Street Journal editorial page and numerous conservative/libertarian bloggers have shown charts comparing the last few years spike in the teen age ( 16-19 year olds) unemployment rate with the rise in the minimum wage in an attempt to blame rising teen unemployment in 2008 and 2009 to the minimum wage hike. But more detailed data from the BLS shows that teen employment at the minimum wage rose 46.1% in 2008 and 50.1% in 2009. This detailed data implies that the rise in the teen unemployment rate from around 15% in 2007 to over 25% in late 2009 was entirely due to the great recession, not the rising minimum wage. This data is so compelling that I think at a minimum these conservative/libertarian at least owe us an explanation as to why it does not disprove their argument.

On 9 February–Minimum wage disinformation –I published a chart that showed since 1960 there have been 18 increases in the minimum wage. Nine of those increases were accompanied by a falling teen unemployment rate and nine were accompanied by a rising teen unemployment rate. The difference was that the nine times teen unemployment rose were also associated with a recession while the other nine occurred in an economic expansion. This chart and regression analysis clearly implied that the bulk of the increases in teen unemployment since 1960 was due to recessions, not rising minimum wage.

Now the BLS has published more detailed data on teen employment at and above the minimum wage in recent years. This data contains several surprises that tend to strongly contradict the standard theory of teen employment and the minimum wage taught in most economic textbooks.

First it shows that during the years 2002 to 2007 when the nominal minimum wage was unchanged, teen employment at the minimum wage was less than 10% of teen employment. Over 90% of teens were paid more than the minimum wage.

Second, over this period of a flat nominal minimum wage the real minimum wage was falling and each drop in the real minimum wage was associated with a drop in the number of teens employed at the minimum wage. Teens clearly though that school work, public service — so important in college applications — sports or leisure activity like video games was a more valuable use of their time than working at a minimum wage job. Consequently, firms had to offer a higher wage than the minimum wage to induce teens to work for them. This is why the share of teens paid more than the minimum wage rose from 2002 to 2007. This should not be any great surprise to an economist. It is standard economics 101 that if you want more of something you offer a higher price. I have never really understood why most economics instructors spend much of an economics course teaching that if you want more of something — raise prices. Than they turn around and teach that you will get more teen minimum wage employment if you offer a lower price. YEAH RIGHT — and they wonder why the students have trouble getting it.

Third, the data shows that from 2007 to 2009 while the minimum wage rose from $5.15 to $7.25 — a 50% increase — teen employment at the minimum wage rose from 373,000 to 818,000 — a 119 % increase. Moreover, teen employment at more than the minimum wage fell from 5,061,000 to 3,579,000, almost a 30% drop. The drop in teen employment at more than the minimum wage accounted for 130% of the 1,037,000 fall in teen employment from 2007 to 2009. Again, this should not be a big surprise to economist. A large increase in the real minimum wage generated a large increase in teen employment at the minimum wage. It is standard economics 101. This data also implies that essentially all of the drop in teen employment from 2007 to 2009 was due to the Great Recession, not higher minimum wages. I suspect that if we had this detailed data for other periods of a rising minimum wage it would show a similar pattern.

In my blogging about the minimum wage I have never taken the position that raising the minimum wage does not lead to weaker employment. All I have done is point out that the available data completely contradicts the theory that the minimum wage causes weaker employment. Moreover, the more data that becomes avilable, the more it condraticts standard textbook theory.

I have noticed bloggers such as Mark Perry at Carpe Diem, Don Boudreaux at Cafe Hayek, Alex Tabarrok at Marginal Revolution, Megan McArdle at the Atlantic, Ironman at Political Calculations, or Greg Mankiw have advanced the thesis that the recent rise in teen unemployment is due to higher minimum wage, but they need to explain why a doubling of teen minimum wage employment does not contradict their analysis.

This data can be found at
Characteristics of minimum wage workers

Because the BLS reports each years data in a single file, if you want to look at data for multiple years it is easier to go to the top left of the BLS home page and search for “characteristics of minimum wage”.
The search will show a Google search of each of the different years files and moving back and forth from Google to BLS is the best way to switch from the file for one year to another. Also, since the data for 2009 has just been reported it has not had time to collect many hits, so it will be on page 2 or 3 or the Google search.

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Economics Bloggers Forum

Angry Bear Ken Houghton will be a panelist, and other participants in the conference include Mike Shedlock, Mark Thoma, Paul Romer, Alex Tabborak.

Economics Bloggers Forum
8:30 a.m. – 4:00 p.m. CDT
Friday, March 19, 2010

Watch leading economics, technology, and finance bloggers discuss key policy issues and cutting-edge research on topics related to entrepreneurship, innovation, and growth.

View Webcast

Agenda (all Central Times) includees:

9 a.m. Keynote Speaker
David Warsh, author of the online economics column, will discuss his experiences in and assessment of the nascent business of blogging in the context of the evolving print journalism industry. Warsh was a long-time economics columnist for the Boston Globe where he wrote online weekly for seven years. He is the author of three books, most recently Knowledge and the Wealth of Nations: a story of economic discovery.

9:30 a.m. Panel 1-Great Recession: Impact on America’s Future?
Moderator: Paul Kedrosky
Panelists: Bob McTeer, Megan McArdle, Mark Thoma

1:00 p.m. Persuasion and Norms
Paul Romer

1:30 p.m. Panel 2-Is Growth a Mystery? Haiti, Afghanistan, Africa…
Moderator: Tim Kane
Panelists: Alex Tabarrok, Allison Schrager

2:30 p.m. Panel 3-U.S. Fiscal Mess: How Does It End?
Moderator: Robert Litan
Panelists: Donald Marron, Ryan Avent, Ken Houghton, Mike Shedlock

3:45 p.m. Closing Remarks
Carl Schramm, president and CEO, Kauffman Foundation

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John Quiggin Scores Again

Robert Waldmann

I am very glad that John Quiggin has found a group even less worthy or respect than us macroeconomists. He writes

It seemed for a little while as if the delusionists had scored another win, when Phil Jones, the scientist who has been most viciously target by the hackers/harassers gave an honest answer to a deliberately loaded question prepared by them and put to him in a BBC interview

BBC: Do you agree that from 1995 to the present there has been no statistically-significant global warming?


Looking at the responses of ’sceptics’ to this episode we can distinguish four or five sets (depending on your views about set theory)


5. Those genuine sceptics who pointed out the dishonesty of the claim, and called out those on their own side of the debate who promoted it. Obviously, members of this set deserve some serious respect and attention in the future. Unfortunately, the intersection between this set and the set of “sceptics” in the currently prevailing sense appears to be the empty set[2]

That’s 5 sets Professor Quiggin. It’s also statistically significant evidence that global warming skeptics are, on average, either more clueless, more dishonest or both than the general population. Also the data set does not contain statistically significant evidence against the hypothesis that all global warming skeptics are incapable of understanding basic statistics, recklessly irresponsible and total liars.

Quiggin assumes that most are only one or two of these things, but there is no evidence for his belief in the data set he analyses.

Thin comfort for macroeconomics. What Quiggin has shown is that climate science is science, just as he has shown that macroeconomic science is not science in “Zombie Economics.”

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A Tale of Two Clients – And Lessons Lehman Learned Late or Not at All

by cactus

A Tale of Two Clients – And Lessons Lehman Learned Late or Not at All

My first “real” job (i.e., after grad school) was at what was then a Big 6 accounting firm (and is now a Big 4 accounting firm) doing “transfer pricing.” I wasn’t right for the job (or the environment), nor was the job (or the environment) right for me. But I did learn a lot about how the world works.

One of the big clients serviced by the transfer pricing group from the office I was working is a household name. Other than North Koreans and people with some form of mental impairment, I doubt there’s anyone anywhere in the world over age eight who would fail to recognize the company name or its logo. And to be honest, I’m not sure about the North Koreans. Another big client has a name that is only slightly less recognizable. I’ll call them Co. 1 and Co. 2.

Now, when I was there, Co. 1 was very aggressive on tax issues – which means it was willing to push the envelope and see how far it could push the IRS. The odd fine or two for going too far was just a cost of doing business, and it expected its highly priced Big 6 accounting firm to produce, ahem, tax plans that fit the bill. Essentially that meant coming with, ahem, tax plans that were cutting edge enough that the IRS hadn’t seen them yet but that on the face of it resembled something that had in the past gotten an official OK, either through a regulation or some court decision. That would be enough to get a law firm to write a letter saying it was their opinion this was OK, no matter how much what was being done might sound, to the uninitiated, to be questionable or even illegal. Incidentally – on the rare occasions when the firm came up with a scheme on its own, it was the job of its advisers (i.e., accounting firms and law firms) to get the client to make sure that whatever changes were necessary to keep things on the right side of the blurry line were made.

Co. 2 took more the pussycat approach with the IRS. They seemed to feel that if they didn’t push too hard, they’d avoid a lot of hassle from disputes with the IRS. They were, of course, right, and it cost the Big 6 accounting firm, but then the Big 6 accounting firm wasn’t exactly losing money on this client so it was happy to oblige.

In other words, accounting firms are like criminal attorneys – they represent the client and try to do what their client believes is in their best interest. They advise their client when they think their client has taken a suboptimal turn, but when the client wants to do X, if its not explicitly illegal, the firm finds a way to make it happen.

All of which is to say, if the allegations that came out last week about Lehman’s accounting schemes are true, and if as those stories indicate, Lehman was forced to find a non-American law firm to sign off on what they were doing, one of the following must be true:
a. Ernst & Young personnel working on the account had no idea what Lehman was doing.
b. E & Y personnel working on the account knew what Lehman was doing (perhaps having peddled the scheme to Lehman themselves) but had no idea it was an obvious no-no to the IRS.

Either way, it looks to a casual outsider like me that E & Y had a B-team made up of PONIs (partner of no importance) on the job, and that should have been obvious to Lehman. Now Lehman should have been a big enough client to warrant a few POGIs (partner of great importance). If Lehman did not seek out out or deliberately avoided the best possible representation, they were guaranteeing an eventual disaster. Deliberate ignorance or deliberate evasion (the allegations would imply one of these two to be true) of the law doesn’t go over well when the doo-doo hits the fan.

But it goes the other way too. E & Y’s POGIs should have realized that Lehman’s business model involved taking big risks. Why would they have assumed that Lehman was going to be satisfied with orthodox accounting practices? And as the old saying goes, you don’t send a boy to do a man’s job. The Anderson/Enron debacle is a clear demonstration that if some partners certify a client’s shenanigans, and those shenanigans come to light, the entire firm will take a hit. (And that, of course is the flip side of everyone benefits from the shenanigans as long as they haven’t been forced to a complete halt.)

So, what do you think about the situation?


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‘Republican’ resurgence comes from shift in 65-85 year old group

American Conservative Magazine considers who is feeling the the new anger against ‘liberals’ from the Feb.17 Mt. Vernon statement of the Conservative statement of principles:

One of the things that many people have noticed since the release of Mount Vernon statement on Wednesday is the sharp contrast between the youth of the creators (my link) of the Sharon statement and the notable absence of students and young people from the latest gathering. Christopher Buckley quotes Sam Tanenhaus on this point, “The new/old submission seems more like Geriatrics Against Obama.” Fifty years ago, one could have written, as Nile Gardiner does today, that “conservatism is the future” with some reason for believing the claim to be true, and in the decades that followed there was a significant conservative political coalition that seemed to be growing in strength over time. Today it is increasingly difficult to believe anything of the kind.
On average, Millennials’ underlying social and political views put them well to the left of their elders. If you dig into the full report, you will see that the recent Republican resurgence owes almost everything to the dramatic shift among members of the so-called “Silent Generation,” whose voting preferences on the generic ballot have gone from being 49-41 Democrat in 2006 to 48-39 Republican for 2010. There have been small shifts in other age groups toward the Republicans, but by far it is the alienation of voters aged 65-82 that has been most damaging to the Democrats’ political strength*. As we all know, these are the voters who are far more likely to turn out than Millennials, which is why Democratic prospects for this election seem as bad as they do even though the Pew survey says that Democrats lead on the generic ballot in every other age group. Among Boomers, Democrats lead 46-42, and among Gen Xers they barely lead 45-44. In other words, the main reason why the GOP is enjoying any sort of political recovery is that many elderly voters have changed their partisan preferences since the last midterm. Republicans remain behind among all voters younger than 65. That does not seem to herald the future revival of movement conservatism of the sort Gardiner is so embarrassingly praising.

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