Even as we advance professionally to new challenges, most of us carry fond memories of earlier roles in our career. And sometimes, they are quite different than we imagined at the time. During my seven years at UBS, I got to know investment professionals around the world, and made friends that will last a lifetime. I thought I would cherish those moments and those friendships, and I most certainly do. Oddly enough, however, the thing I miss the most about the day-to-day in the office was my Words From Keynes For Today , posted to UBS’s global research chat line. Keynes was a man who believed that growth was good, and so do I!

Every day, I would find a passage in my dog-eared copy of the General Theory that would needle NAIRU-ist and monetarist (or worse, both!) colleagues that belittled my Brave New United States thesis. Drove some of them mad, so they told me, even as they admitted it was the first thing they read in the morning. I considered that combination the highest compliment they could pay. Still do! I can only hope that they now long for the Brave New United States to become truly the Brave New World.

My favorite Keynesian scripture for the day, however, was not actually a pro-growth sermon, but rather the trading parable of the beauty contest:

“Professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he think likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those of which average opinion genuinely thinks the prettiest. We have reached the third degree were we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.”

I’ll never forget the first time I read that passage back in college in 1977. It struck me then, and still strikes me now, as the essence of how economics is applied to trading in real time: Anticipating what the other guy is anticipating, what the other guy is anticipating, what the other guy is anticipating!

There must, to be sure, be some element of fundamental economic “understanding” in all that anticipating, or there would be no basis for second guessing others’ second (third, fourth or fifth!) guesses. Nonetheless, real time trading is only loosely connected to fundamental matters of valuation, and far more linked to sentiment and momentum, commonly known as “technicals.”

Most of us try to maintain that we are immune to such “noise” and are really “value” investors. Most of us also lie. It is not easy to be a contrarian, as Keynes intoned, and for active portfolio managers living in a world of Sharpe Ratios, it is also not necessarily wise. Rich can get richer, and cheap can get cheaper, and excessive “tracking error” can lead to early retirement!

Turning Points Are About Overshoots

In deregulated, global financial markets, with increasing central bank transparency of tactics (but not strategy!), I submit that cyclical overshoots of secular value are no longer the exception, but the rule, and are fueled by precisely the pick- a-winner process described by Keynes. Turning points are no longer generated by contrarian value investors, assuming they ever were, but rather by the fundamental consequences of the bubbles created by momentum investors.

Thus, “value” investing is no longer just about determining when something has become rich or cheap, but determining when that richness or cheapness has reached a sufficient extreme to become a “fundamental” event in its own right. More specifically, turning points are about when central banks stand up to be counted, contradicting the second (third, fourth and fifth!) degrees of market sentiment. Put differently, central bank watching has become ever more meaningless on the straightaways, but ever more relevant in the turns. The real turns, I stress!

At the moment, there is a potential for all of the G-3 central banks to be on the cusp of such turns. The Bank of Japan desperately wants to “normalize” short rates (circa Greenspan in 1994), putting its finger in the eyes of those who’ve successfully bet for ten years that the Bank of Japan is a liquidity pipe with a broken faucet. The European Central Bank desperately wants to see its currency go up, putting its boot in the backside of those who have successfully bet since its inception that it is a damp squib. And the Federal Reserve desperately wants to see the equity market go sideways or down, making fools of those who have successfully bought every dip since Greenspan has been in office.

To me, this is the stuff of real turning points. Note, I said “stuff!” I’m not trying to signal here either my own, or PIMCO’s conviction, about the timing of anything. My point is simply that the investment environment is pregnant with opportunities for bona fide contrarian thinking. I’ll leave it to my more informed colleagues to ruminate on the Bank of Japan and the European Central Bank, but want to take up myself the issue of the Federal Reserve. 

Transforming the Sword Into A Swizzle Stick

Everyday, I read that the markets are rejoicing that incoming data, plus Fed rhetoric, imply that the “Fed is on hold for the indefinite future.” I certainly agree with that proposition from a fundamental perspective. From a market perspective, however, I think that proposition is wrong. While the markets may have rejoiced in the spring and early summer about the Fed putting away the tightening sword, not so in recent weeks. The markets are now, I submit, romancing easing. Hot and heavy. Few Wall Street economists are forecasting a swizzle stick of Fed easing, of course, with most protesting that the notion is either flat wrong or at least “premature.” But non-economists putting dollars on the line are, in Keynesian fashion, anticipating that others are anticipating that others are anticipating Fed easing.

As a fundamental matter, I ain’t a buyer of the proposition, for the simple reason that Fed easing would be totally inconsistent with Greenspan’s avowed desired to break the pattern of “bailing out” buy-the-dips equity speculators. More specifically, I don’t think Greenspan wants to see NASDAQ over 5,000 again for a long time, which I think would happen virtually immediately if he were to even hint that he has easing on his mind. Thus, if you’re buying on the notion of Fed easing, I think you will be severely disappointed. But I must also note that you could very well make some serious money as the easing romance becomes a movement, like the singing of a few bars of Alice’s Restaurant.

Oysters From Manufacturing

What might fuel the romance? Here, my years of trafficking in Wall Street economics does provide an answer (no good deed goes un-punished!). If there is one indicator above all in calling turning points in Fed policy it is the National Association of Purchasing Index (PMI). Indeed, I’ve often mused that if you put me on a desert island and let me have only one economic release, I’d want the PMI (why I’d want an economic release is a topic for a different day).

The Dance of the Purchasing Managers and the Fed
Figure 1 is a line graph showing the U.S. National Association of Purchasing Managers’ Index (PMI) versus the fed funds policy rate, from 1982 to mid-2000. The chart shows how over the last three decades, when PMI fell below 50, the would subsequently ease (lower the policy rate). The most recent two episodes shown are 1995 and 1998. Near the end of the chart, the fed funds rate reached about 6%, up from about 5.25% in 1999, but the PMI then fell, to 49.5 in August 2000.
Figure 1
Source: Nat’l Assoc. of Purchasing Mgmt.; Federal Reserve

Over the last three decades, as you can see in Figure 1, the Fed has always eased, or been in the act of easing, when PMI falls below 50. The most recent two episodes are 1995 and 1998, both wonderful “buying opportunities” for stocks. Thus, with PMI falling to 49.5 for August 2000, it is easy to see why the easing romance is gathering passion. The irony of it all, of course, is that the PMI is an indicator of the Old Economy, and Wall Street putatively thinks the Old Economy doesn’t matter that much anymore. But as Emerson warned long before Keynes, a foolish consistency is the hobgoblin of small minds!

But what is the PMI actually telling us, you ask (or I hope you ask!)? It’s telling us that the Fed’s tightening campaign of the last year has worked to prevent an acceleration in aggregate demand, while Old Economy producers’ inventory building plans were betting on one. To wit, the Old Economy is entering the dark side of the inventory cycle.

One of my favorite ways of showing that is Figure 2, a “model” from my archives. As you can observe, I construct a momentum gauge for final sales, measured as the year-over-year change minus the four-quarter moving average of the year-over-year change. For technicians amongst you, it would be called an “oscillator;” and for you math types, it’s a variant of the “second derivative.” It’s noisy, as momentum gauges usually are, but captures turning points very well, with a four-quarter lead. To wit, there must be a change in final sales momentum in order to “justify” a change in producers’ inventory plans; if there is no final sales “justification,” then any sharp change in inventory accumulation will be “corrected.”

Flat Momentum in Final Sales Says
Inventory Acceleration is Unwarranted
Figure 2 is a line graph showing U.S. nonfarm inventory change and final sales momentum, from 1970 to 2000. With the two metrics superimposed, the nonfarm inventory changes appear much more volatile. They fluctuated since the early 1980s between an annualized amount of negative $50 billion and positive $115 billion near the end of 1995. The metric is around $70 billion in 2000, off that peak, but up from about $10 billion in 1997. Over that same time span, final sales momentum fluctuated between negative 2.5% and positive 3% change from a year ago, less its four-quarter trailing average. Since 1993, its fluctuations are less volatile, and it’s around zero in 2000.
Figure 2
Source: U.S. Commerce Dept.

As you can again observe, there has been no acceleration in final sales in recent years; they’ve just been consistently strong as horseradish. In contrast, there has been a meaningful acceleration in inventory assumption following the Asia crisis. 1 Thus, the raw material for a manufacturing retrenchment is in place: Flat final sales momentum in the face of accelerating inventory accumulation.

And lo and behold, a second old model of mine, this one in Figure 3, helps us time the process of inventory correction: the PMI leads the deceleration by two quarters. Put these two models together, and you get a simple story:

Sharply slower GDP growth in the quarters ahead, even if final sales “hold up.”

The PMI Says the Unwarranted
Will Be Unwound
 Figure 3 is a line graph showing U.S. nonfarm inventory change versus the Purchasing Managers Index, from 1970 to 2000. Nonfarm inventory changes fluctuated with more volatility over the period, ranging between a chain-weighted annualized change of negative $50 billion to positive $115 billion. The PMI index fluctuated between roughly 32 and 70 over the course of the graph, but has a more narrow range in recent years, between roughly 45 and 58 since 1992. Both metrics tended to track each other, with the PMI tending to lead. Recently, the index fell to about 50 in mid-2000, down from 56 or so early in the year, while the change in nonfarm inventories was around $70 billion.
Figure 3
Source: U.S. Commerce Dept.; Nat’l Assoc. of Purchasing Mgmt.

Enjoy the Romance, But Don’t Rent The Chapel

Which, of course, begets the question of whether the Fed is going to ease in response to manufacturing’s woes, as it “always” has. From a Keynesian beauty contest perspective, that’s probably the way to trade it in the months immediately ahead. From an investment perspective, however, I think the best forecast is for the Fed to keep the Fed funds rate where it is for many, many quarters. While Greenspan can talk out of both sides of his mouth in a manner to which I aspire, I simply don’t think even he can “justify” easing on the basis of Old Economy PMI model, just like he can’t “justify” further tightening on the basis of a Old World NAIRU model.

As for the Bank of Japan and the European Central Bank, I leave you with an entirely different nugget from Keynes:

“The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed, the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.”


Paul McCulley
Executive Vice President
September 6, 2000

1 It is important to note that this is occurring in the context of a secular fall in inventory accumulation relative to GDP; this development reduces the level of inventory relative to sales, but not the cyclicality of inventory accumulation; if anything, it probably intensifies the cyclicality !


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