"Kee" Points with Jim Kee, Ph.D.

Stock market facts regarding terrorist attacks: The terrorist attacks that occurred in Paris last Friday will certainly lead to increased market volatility as markets incorporate various data points to assess the depth (ability to coordinate) and breadth (geographical footprint) of the terrorist threat. Typically, markets respond to crisis events large and small with short-term sell-offs as uncertainty rises, followed by strong rebounds once action (whatever it is) is taken and uncertainty resolved. Here are some quick facts about how the market has reacted during 21 crises occurring in prior bull markets over the past 50 years (Bay of Pigs, JFK assassination, 9/11, Gulf War, Reagan shot, etc.) On average, the initial market reaction has been a -4.3% sell-off lasting 8 days, followed by a rebound to pre-crisis levels after an average of 37 days. The bull market tended to continue for another 27 months (again on average) gaining an additional 44%.


Retail sales: Several retailers reported disappointing results last week, which was in-line with a rather weak monthly sales report. But the monthly data are volatile, and year-over-year (annual) data show total retail sales growing at about 1.7%. That’s pretty consistent with the muted growth in income during this expansion, and income growth has been the primary driver of retail sales growth. Retail sales have a distinct seasonal component, with big positive spikes occurring in November and December, followed by large declines in January. That’s what we’ll be expecting and watching for in the data through the end of the year. I know I have mentioned this before, but that is consistent with the year-end holiday spending surge, followed by the post-holiday hangover, and it is also why first quarter GDP growth is on average the lowest.


Unique Fed insights: It is hard to know what influence the events in Paris will have on the Fed’s decision whether or not to raise interest rates in December. A former colleague of mine (from about 20 years ago!), Dr. Marc Miles, discussed some fascinating insights recently regarding Fed policy that I would like to share (Global Economic Solutions). Miles pointed out that low interest rates favor capital (which is financed) over labor (which is not), so low interest rate polices tend to encourage a substitution away from labor/workers towards now cheaper capital/technology. Lower demand for workers translates into lower wage growth. It also means that capital’s share of profits or returns increases relative to labor’s share of returns. Wages stagnate and the income gap between the owners of businesses and that of workers widens. If true, then hiring and wage growth should start to pick up after the fed raises rates, because that makes capital more expensive relative to labor and encourages a substitution away from capital and towards workers. That’s what Miles found.


The other insight I would like to share (I’ve discussed it before) is the tendency of the economy to accelerate as the Fed raises rates. Part of this is no doubt because the Fed raises rates when the economy strengthens, but part of it is probably because companies and individuals move forward (in time) interest rate sensitive activities in anticipation of higher rates in the future. So what you see is the Fed raising rates, followed by perplexingly “stronger than expected” economic numbers, and so on. Likewise when the fed cuts rates and alludes to further cuts, people tend to withhold interest rate-dependent activity in anticipation of further rate cuts. This all is known as intertemporal output migration, or simply that fed policy affects the timing of certain activities. George Katona of the University of Michigan pointed this out in the first rigorous surveys of business and individual behavior over 50 years ago (that work led to the well-known “Michigan Consumer Sentiment Index”). So the economy tends to move with the Fed, not against it. Combined with Miles’ insights, that would lead one to expect that, as/if the Fed raises rates through 2016, you should expect to see stronger than expected economic numbers, followed by stronger than expected wage growth and employment. Perhaps that is why stocks tend to rise during the full year (but not necessarily the early months) following the onset of fed rate hikes (Wall Street Journal).


Finally, another big headline today is that Japan’s economy has slipped back into recession. That’s officially two quarters of negative growth from Japan, but certain sectors are doing well and in fact Japanese stocks have outperformed their global counterparts. Japan has been mired in this low to negative GDP growth pattern for almost a quarter of a century. It should not be surprising that Japan’s huge quantitative easing program has not stimulated growth, as monetary policy has not been the reason for the 25-year malaise. Nor are Japan’s aging demographics or its debt-to-GDP ratio of 230%, though those will be challenges going forward. Rather, it was Merton Miller who pointed out Japan’s problem was its somewhat perverse, non-market allocation of capital, and Miller did this in a series of talks in the early 1990s. I’ve discussed it in Kee Points before so I won’t go into here, except to say that Miller (a late Nobel Laureate) was the only one to get it right, and some of his speeches can be found in the 1997 book Merton Miller on Derivatives. Don’t be intimidated; it is a very accessible read if interested!