Into Hot Water

FrogJourneys are wonderful. A change in location generally encourages the reexamination of assumptions, reference points and orientations. Sometimes they even lead to moments of clarity, or better, a complete intellectual reboot.

The current investment environment is emblematic of a frog that can not sense the water gradually warming around it, and is eventually boiled alive. This startling revelation greeted me uponreturning from a multipurpose trip to Peru. The water appears to be a steaming roiling mass.

While fully re-embracing a daily process of sifting through reams of econometric and corporate information it became obvious that much of the headline grabbing economic reports and underlying data are flawed. The money supply, inflation and unemployment have been adjusted over time in such a way that provides results that are as different as live and cooked frogs.

In the following pages are details of three basic, yet immensely valuable, economic metrics used in determining whether or not the US is in an environment that is constructive for investing. Current comparative examination is difficult primarily due to changes in definitions that have slowly occurred over the past 30 years. After adjusting for these changes, it should become clear that the environment is barely neutral at best, and hostile at worst.

On a positive parting note, about 40% of the planet is likely to emerge from this environment fairly intact. Their economies are healing due to internally generated growth and regional advantages1. They are ‘merely’ experiencing liquidity rather than solvency crises. Committing new capital to these areas will be put off until the world’s largest economy and markets (the US) are anticipated to significantly delink from the more healthy regions.

The following charts were constructed from data generously provided by American Business Analytics and Research LLC.

Money Supply

While some people consider this a dry area of economic research, it is probably one of the most useful all purpose tools for investing. Since WWII there has not been one instance where the broad money supply significantly contracted that was not followed by a contraction in the economy. This measure is also predictive in identifying a weakening banking system. Up until 2006, the broadest measure of this was known as ‘M3’. The term ‘was’ is used because the Federal Reserve ceased publishing it as of March 23rd, 2006. Fortunately there are folks that continue to estimate and track M3. The adjacent chart shows the worst contraction in M3 since WWII – even though the Federal Reserve has been frenetically attempting to avoid a contraction by expanding the monetary base. This would seem to indicate that future economic reports will likely disappoint to the downside.

Annual US Money Supply Growth


Once upon a time inflation was measured as an expansion of the monetary base by central banks, which then generally caused the money supply to increase and thus prices of virtually everything to rise – except the value of money itself. Some liken this process to turning precious stones to sand. It is hard to disagree with this analogy. The chart below details CPI-U which is the broadest measure of inflation. In the early 1980s the Bureau of Labor Statistics saw fit to begin tinkering with its construct. When the methodological changes are netted out, a striking disparity emerges. The adjusted, much higher, measurement is corroborated by the just released AAA ‘Your Driving Costs’ report which details that the average cost to own and operate a sedan rose 4.8% during 2009 – a year when reported CPI-U inflation averaged -0.34%. It also may be instructive when considering that the non-partisan Congressional Budget Office recently testified that the growth rate for health care costs averaged 8% for the past two decades. Perhaps health care costs are merely in line with actual inflation. The alternate data seems to show this. Wouldn’t it be terrible if the core reason for passing the recent health care legislation was based on erroneous expectations of what health care inflation should be?

Annual US Consumer Inflation


According to the April Bureau of Labor Statistics report the official unemployment rate (known to data nerds as U3) is at 9.9%. This number probably rings a bell as it is what the general media frequently quotes.

Unemployment Rate vs. ABA&R Alternate

Less well known is the so called U6 measurement. This is the sum of U3 (the ‘official rate’ quoted above) plus ‘discouraged workers’ and those only working ‘part-time’. This broadened measure of unemployment is currently 17.2%.

However, this is where the frog begins to boil. The current definition of a discouraged worker is a person who has not found work during the past month and has stopped looking. Prior to 1994, a discouraged worker was defined as a person who had not found work within the last 12 months and has stopped looking. The effect of the current method is to understate the number of people actually out of work.

When U6 is adjusted back to the more conservative 1994 standards real unemployment would be more properly quoted at ~22%. This implies that we are quickly closing the gap on unemployment rates last seen during the Great Depression. At that time unemployment ‘officially’ rose as high as 25%. It should be noted that during the Great Depression about 27% of the US working age population worked on farms – today that number is just 2%. Thus it could be argued that controlling for this massive disparity in the farm portion of the workforce that unemployment during the Great Depression effectively peaked in the 30-35% range. So, where are the soup lines of the 1930s? One only needs to look at the May 4th report from the USDA which identifies 40 MILLION individuals reportedly on the Supplemental Nutrition Assistance Program (otherwise known as food stamps).

In short, when the many and various adjustments to economic data series are ignored, we become no better than the frog that does not realize what is happening while its environment boils it to death.

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