Is it “inflation”? Or is the instrument broken?
Designing an index presents a technical challenge that is much more complex than it might seem. Indexes are sophisticated technological objects, which is why the companies that know how to design them are so valuable – as described in a previous column. However, like all advanced technologies they are subject to certain vulnerabilities and predictable failure modes. Some of these vulnerabilities are associated with the occurrence of “unusual behaviors” of the system that the index is intended to track and measure, which may provoke what we may call “error messages” that compromise the quality of the signal that the index produces.
Right now, and for about the last year, the Consumer Price Index (CPI) — the headline “inflation” number that is driving much public and professional anxiety lately – is stuck in just such an “error message” state. It is giving false readings that do not reflect the underlying reality that it is intended to measure. The distortion is severe; it inflates “inflation” by as much as 25-50%. The problem is recognized by some (including, it appears, the leadership at the Federal Reserve), but is not reflected in many media accounts.
Aside from the psychological effects of this exaggeration upon the public and the body politic, this distortion has serious practical consequences. Because the CPI is used to calculate the Cost of Living Adjustments to federal and state entitlement programs (and some union wage agreements) it adds to the government deficit and gooses the very inflation it seeks to measure. The CPI is also used to set the interest rate for inflation-protected government bonds, so any distortion in the index is creates a knock-on distortion in the capital markets.
To make this case, let us first consider an analogous situation involving the other most prominent index that we interact with on a regular basis: the S&P 500 index of the U.S. stock market.
An Analogy: The S&P 500 Index
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While the public might think of the S&P 500 Index as a simple cumulation of the share prices of the 500 largest U.S. public companies into a unitary, transparent data-point reflecting the price-level of the broad “market”… it is nothing of the kind. For one thing, there are actually 505 securities included in the S&P 500, and the index does not include hundreds of companies that would qualify if the criteria were simply market capitalization. In fact, it is not even an “average.” The share prices of those companies that are included are combined in a complex formula that is frequently “adjusted” to smooth out the trend. The somewhat clunky mechanics of these adjustments can make for sometimes clunky market movements (the storm around the addition of Tesla to the Index last year is a prominent case in point). Nor is the process “transparent — there are no clear rules for index membership, and the decision as to which companies to include or not is so secretive that the identities of the members of the S&P committee that manages the index are kept secret from the public. (I have addressed the S&P structure and its “issues” in a series of previous columns, beginning with this one.)
The initial design challenges in index construction are:
- component selection: what “elements” to include in the index
- weighting of the components, which includes (1) how are the weights calculated, and (2) how are individual components assigned the correct weights
The problems facing an index designer/manager don’t stop there. As the underlying phenomenon changes over time, distortions can appear in the index. These are of at least two types:
- Composition changes: for various reasons, the list of index components may need to be updated
- “Skewing” problems: sometimes a component may go haywire, and pull the whole index with it, to the point where the index no longer measures accurately what it was designed to measure
In the case of the S&P 500 index, the composition adjustments are driven by changes in the market and the economy which require updating the list of companies that are included, dropping some and adding others. This requires some behind-the-curtain mechanics that are not always straightforward, but the guiding idea is to make the changes as smooth as possible.
The tendency to skew is a more intractable problem. It arises when a few components break away from past trends and context, and start to drive the overall index into a new pattern. In the case of the S&P 500, this problem has recently become acute. There is a large and growing distortion of the index by just a handful of individual stocks. In January, for example, the 10 largest market-cap stocks accounted for just under 30% of the entire value of the index – the highest skew ever recorded (5% higher than the peak of the dot-com bubble). The top 5 stocks – just 1% of the total components of the index – accounted for 21.1% of – vs the long-term average of just 10-12%. Two years earlier, the top 10 contributed only 17% of the total.
Bizarre market patterns have developed on occasion. During one 10-week period in 2017, the top five stocks (1% of the S&P 500 components) added $260 Bn in value – while the other 99% lost the same amount of value.
A market distortion can drive an index distortion. In December 2021, a Goldman Sachs analysis called attention to such a distortion:
- “Goldman’s research shows that five stocks have accounted for 51% of the S&P 500’s return since the end of April. Those five stocks — Microsoft, Google, Apple, Nvidia and Tesla — account for more than one-third of the S&P 500s 26% return this year.”
The index distortion is serious. The S&P 500 is intended to portray the trend of the overall market. Passive index-tracking funds rely upon the S&P 500 to provide exposure to market “beta.” The severe skew implies, however, that the S&P 500 index has lost some of that value as a measure of the broad market performance. It is becoming more a measure of how Apple, Microsoft, Google, Amazon and Facebook are doing. As commentators are fond of saying, “the S&P 500 has become the S&P 5.”
Or to put it another way, all those passive investors putting their money into index funds are really buying over-weight exposure to a very small set of very large-cap tech stocks.
- “The S&P 500 is supposed to be a broad representation of the US economy. So if you’re plowing money into an index fund, you might think you’re doing a good job of diversifying your assets. You’d be wrong. These days, it’s basically the S&P 5. This could be a big problem for investors who are planning for retirement or other long-term goals who don’t understand the risks of having all their proverbial eggs in one basket.” – Paul Lamonica, CNN
In short, the S&P 500 — under these conditions, at least — no longer offers us high-quality “beta.” It is in reality giving us a lot of tech-sector “alpha.” Not what it was designed to do.
The “Inflation” Problem: Distortion of the CPI
This same type of problem is now distorting the CPI. The index is being overdriven by a small handful of components. It compromises its value as a guide for fiscal or monetary policy decisions.
The CPI comprises dozens of categories and hundreds of individual items. Here is a graphic depiction (from the Pew Foundation) of the major category weightings.
The surge in the CPI over the past year has been strongly driven by just a few of these categories.
The price rises in these categories are far outside the long-term trends. In other words, they are highly skewed.
Gas is a volatile category. But the spike in the last year is outside the trend – 4 standard deviations above the long-term average of inflation for this category.
Lodging Away From Home
Hotel accommodations show a similar pattern – crash followed by a powerful resurgence. The recent values are 12 standard deviations above the long term average.
Used Cars is the most extreme case (described in more detail in the previous column) – more than 20 standard deviations above the trend.
Along with the inflation in air fares (up 8 standard deviations), these categories account for almost 10% of the weight of the CPI. They have jumped above their long-term averages by an average of 12 standard deviations.
This has skewed and distorted the entire CPI. In some months last year, the Used Car component alone was responsible for a third of the total annualized increase in “inflation.”
Yes, some prices are rising — some are jumping – but the index as a whole has been thrown off by extraordinary price pressures in just a few odd categories. Inflation metrics that eliminate these outliers are running at half or less the levels of the Headline CPI.
It is not that there are no inflationary pressures. The point is that the meaning of the index has been distorted. It has a new kink in it, which has deviated it from its designers’ intent. It has ceased to be an accurate indicator of the broad big picture and instead is being overdriven by a few highly stressed components. The analogy with the skewing of the S&P 500 is apt.
What does it mean? Instead of concluding that “inflation is everywhere” and jamming the economy with much higher interest rates, we should be focusing on understanding the mechanics underlying the price movements in a few of these specific outliers, to see what is causing “Used Cars” or “Lodging” or “Gasoline” to suddenly behave in ways that so violate the previously established patterns. We can’t do that in this column, but we can ask (for example): How likely is it that “Used Cars” will go up another 40% in 2022?
In most cases, the answer will be “Not likely” – which favors a “transitory” view of the price trend, and a much more surgical approach to mitigating these price pressures.
Teacher, Police And Firefighter Pensions Are Being Secretly Looted By Wall Street
America’s severely underfunded public pensions are allocating ever-greater assets to the highest cost, highest risk, most secretive investments ever devised by Wall Street, such private equity, hedge funds, real estate, and commodities—all in a desperate search for higher net returns that, not surprisingly (given the outlandish fees and risks), fail to materialize. Transparency—public scrutiny and accountability—has been abandoned, as pensions agree to Wall Street secrecy schemes that eviscerate public records laws.
Our nation’s state and federal securities laws are premised upon full disclosure of all material risks and fees to investors: “Read the prospectus before you invest,” is the oft-cited warning by securities regulators. Nevertheless, teachers, police, firefighters and other government workers today are not allowed to see how their retirement savings are managed or, more likely, mismanaged by Wall Street.
For nearly a decade, the United States Securities and Exchange Commision has warned investors that malfeasance and bogus fees are commonplace in so-called “alternative” investments and, more recently, Chairman Gary Gensler has called for greater transparency to increase competition and lower fees.
Gensler has asked the agency’s staff to consider recommendations on ways to bring greater transparency to fee arrangements in private markets. “More competition and transparency could potentially bring greater efficiencies to this important part of the capital markets,” he said. “This could help lower the cost of capital for businesses raising money. This could raise the returns for the pensions and endowments behind the limited partner investors. This ultimately could help workers preparing for retirement and families paying for their college educations.”
Gensler has stated he would like to see a reduction in the fees these investments charge and has also commented on industry abuses such as ”side letters” which permit private funds to secretly give preferences to certain investors—preferences which harm public pensions.
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But that’s not good enough to protect public pension stakeholders.
No one—including the pensions themselves—seems to care that the government workers whose retirement security is at risk are being kept in the dark.
The SEC needs to do more—actually alert public pensioners as to those abuses the Commission knows full well are rampant, at a minumum. Advise them, Chairman Gensler, to demand to see and read prospectuses and other offering documents related to their hard-earned savings.
Does the SEC think it’s kosher for Wall Street to conspire with public pension officials to withhold this information from investors—any investors?
Since my 2013 forensic investigation of the Rhode Island state pension exposing gross mismanagement by then General Treasurer Gina Raimondo which I accurately predicted would cost workers dearly; my 2014 North Carolina state pension investigation exposing that $30 billion in assets had been moved into secretive, offshore accounts and, most recently, my investigation of the State Teachers Retirement System of Ohio, I have provided my expert findings to the SEC staff for their review. Each and every public pension forensic investigation I have undertaken has extensively discussed Wall Street secrecy schemes that enable looting. In my book, How To Steal A Lot Money—Legally, I quote disclosures from SEC filings that detail industry abuses.
Join me, Chairman Gensler, in giving government workers a clue, a glimpse, a peek, at the alternative investment abusive industry practices that are carefully guarded by Wall Street and being hidden from them.
Teachers, police and firefighters deserve a fighting chance to protect their retirement savings.
It Is Time To Buy Bonds
US 10-year note prices are likely to rise through August. The monthly histogram below shows that July and August have been the two strongest months for the note price.
Monthly Return- US 10-Year Notes
Blue: Average Percentage Change
Red: Probability of a rise on that day
Green: Expected Return (Product of the first 2)
These numbers are static in the sense that they change little over the years. This is only one cycle, the one-year cycle, whereas there are many cycles operative at any one time. In order to get a reading on such other rhythms, a scan is run to identify other profitable price cycles. The graph below reveals the most valuable cycles that are operative at any one time.
10-Year Note Monthly Cycle
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These cycles reinforce the seasonal tendency for notes to rise. Prices have risen in 60% to 65% of the time in these summer months. With the dynamic cycle also in ascent, the probabilities rise to about 65% to over 70%. There are similar and supportive developments in the Japanese and German fixed income markets.
The cycle projection must be confirmed by market activity. The daily graph reveals that price broke through a downtrend line.
10-Year Notes Broke Through Resistance
Here is a helpful sentiment indicator that supports the bullish view. The cover page of this week’s Barron’s points to much higher rates. Applying contrary opinion, this suggests lower rates and higher note and bond prices. The first objective is 123.0.
Will There Be War Over Taiwan – The Next Spy Thriller
I usually go through a rhythm of reading one or two serious books, followed by a few works of fiction and with summer on the way I wanted to highlight a few of both. In that regard I have just finished Laurence Durrell’s ‘White Eagles in Serbia’, an old-fashioned espionage thriller where the hero Colonel Methuen is dropped behind enemy lines in post war Serbia (he speaks excellent Serbo-Croat) and becomes embroiled in a violent plot to overthrow Tito.
The book is a warm-up to reading Durrell’s ‘The Alexandria Quartet’, a work that nearly won him the Nobel Prize. Durrell was part of an interesting Anglo-Irish family, who largely considered themselves Indian – his brother Gerald, the naturalist and writer, touches on this in ‘My Family and Other Animals’.
Though I am not an expert on these matters, I found ‘White Eagles’ a more realistic account of espionage than much of what we see in the media today (Mick Herron’s ‘Slow Horses’ is good), and overall it is a tale of derring-do that is more in keeping with the work of the founding fathers of the genre – Eric Ambler, John Buchan, Erskine Childers and Ted Allebury for example.
It also made opportune reading given what seems to be an epidemic of espionage – with reports of the Chinese hacking group APT40 using graduates to infiltrate Western corporates and notably the admission by the head of Switzerland’s intelligence that Russian espionage is rife in that country (notably in Geneva – for which readers should consult Somerset Maugham’s ‘Ashenden’ as background material).
These and other trends – such as the outbreak of a heavy cyber battle last week (against Lithuania and Norway for instance) and the increasingly public ‘clandestine’ war between Israel and Iran (they have just sacked their spy chief) point to a world that is ever more contested and complex.
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One of the new trends in the space is cyber espionage – both in the sense of stealing state and industrial/corporate secrets, influencing actors (such as the manipulation of the 2016 US Presidential election) and outright acts of hostility such as the hacking of public databases and utilities (i.e. healthcare systems). Here, if readers are looking for some serious literature I can recommend two excellent books – Nicole Perlroth’s ‘This is how they tell me the world ends’ and ‘Secret World’ by Christopher Andrew.
I am personally more intrigued by the difference between a spy and a strategist. A spy’s work could well be described as the pursuit of information about someone who is acting with a specific intent, as well as a sense of their reaction function. There are plenty of examples – from Christine Joncourt (‘La Putain de la Republique’) to Richard Sorge (see Owen Matthews’ ‘An Impeccable Spy’).
In contrast a strategist may try to plot trends and the opportunities, spillovers and damage they may cause. The US National Intelligence department is good in this regard, becoming the first major intelligence agency to publish detailed warnings on the side effects of climate damage.
Spies and strategists might work together, but history is full of examples (LC Moyzisch’s ‘Operation Cicero’) where intelligence fails to make it through the strategic process or is simply ignored for political reasons (might the early warnings on the invasion of Ukraine be an example).
In the spirit of the Durrells and Flemings of the world, what issues might be of interest in terms of digging into unknown knowns and unknown unknowns. Here are a few ideas, most of which are Asia focused (we might see an uptick in Asia focused thrillers).
On the diplomatic front, an interesting recent development was the visit of Indonesian president Joko Widodo to Ukraine, and then Moscow. It was a rare visit to Ukraine by an Asian leader and potentially marks the emergence or at least aspiration of Indonesia (population 273 million) as an emerging world diplomatic player. What has intrigued me so far is that there has been little coordination by the populous emerging (largely Muslim) nations (Nigeria, Indonesia, Pakistan) in the face of high energy and food prices, and that potentially Widodo could play a unifying role here.
Then, still in Asia, but on a more deadly footing, if the Western commentariat is to be believed, China is preparing an assault on Taiwan, and looking to learn from Russia’s military errors in this regard. Other countries are reacting, and I suspect that there will be much intrigue around Taiwan’s ability to acquire sufficiently powerful ballistic missiles that could strike the coastal cities of China, and relatedly how long might it take Japan to produce nuclear missiles (my sources say they could very ambitiously do it in five months!).
So, whilst the espionage literature of the 20th century has tended to be focused on Geneva, Berlin and London in the 21st century we may find ourselves reading about ‘behind the lines’ exploits in Jakarta and Tanegashima.
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