Understanding the Market

At typical financial markets, traders make a market in financial instruments, such as corporate equity, government bonds and currencies.  But there are markets in many other items ranging from commdities (such as wheat and frozen pork bellies) to more conceptual items such as hurricanes or the number of jobs reported on the monthly Employment report.  Futures and options exchanges have rapidly expanded their product offerings in recent years (see here for a little history of the Chicago exchanges).

These markets have several roles; participants in the markets for these products can reduce their risk; a farmer can lock in a price for his crop at the start of the season or a manufacturing company can lock in a price for a particular commodity that it uses. But the futures price generated in these markets should be an accurate prediction of the price. Speculators should be willing to buy contracts when the futures price seems too low or sell contracts when the futures price seems too high, to profit from the expected price change; for example, suppose news comes about bad weather that will destroy a large part of the corn crop; speculators will start buying contracts until the price reflect the best expectation of the future price.  The logic is similar to the Delphi method (discussed here): a number of informed analysts will converge on the truth by pooling their information. In futures markets, the pooling is accomplished by allowing the analysts to trade and profit from their access to information or their ability to analyze it.

The University of Iowa became known for trading, among other things, presidential futures (see here for some history); on this market students trade “shares” of political candidates or parties. The market prices of the Iowa Election Market were fairly accurate forecasters of election results

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, even when compared to traditional polls (see here for some data). This prompted a great deal of interest in creating futures markets on many events, from sporting events to terrorist attacks (see here for an article about an unsuccessful proposal from the Pentagon).

Intrade is an Irish “incorporated service business” that allows the public to trade futures on many public events, ranging from the date of the capture of Osama bin Laden to the top marginal tax rate in the US in 2011.   These contracts are all of the “winner take all” variety; you can buy a contract on whether an event will occur and you receive $1 if you are correct and nothing if you are wrong. Below you can find the chart of the Obama and McCain contracts, that is contracts that will pay $1 if Obama or McCain is elected President.

INTRADE.COM Price for Obama to be elected President

INTRADE.COM Price for McCain to be elected President

At the time that I am writing (August 21)

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, Obama shares are trading around $.60 and McCain shares around $.40. These prices imply that in aggregate, traders believe that Obama has a 60% chance of winning the election and McCain 40% (these two numbers should add up to a bit less than one if there is a small chance that someone else will win; if the of total prices were greater than $1, a trader could sell both contracts for, say, $1.05 and then pay off the winning contract $1 and keep the difference).

Both of these contracts have traded at much lower prices in the past, when other candidates (e.g., Hillary Clinton) were more likely to be elected President.  There are many other contracts traded and many ways to make use of them.  For example, there are contracts on how each state in the country will vote (recall that the US Presidential election is determined by the outcomes in the individual states, with the winner of each state election receiving the number of electors from that state; see here and here for more).  One site (see here) uses the Intrade prices from each state contract to predict the electoral college (see here for a lengthy pdf that describes the history of the electoral college and several criticisms).

Needless to say, speculators in political futures markets are not perfect.  During the 2004 election

, exit poll data (that is the results of surveys of people who voted on election day) revealed that John Kerry was doing much better than expected.  The political futures markets reacted sharply and the price of the Kerry contracts rallied

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, before the actual data showed that George Bush would win the election (see here for a nice write-up).

The U.S. is a consumption driven economy; personal consumption expenditures (PCE), that is consumption by households and nonprofits represent approximately 70% of GDP; in comparison, Japanese private consumption is a bit less than 60% of GDP (Japanese GDP data are available here) and German final consumer expenditure is around 57% (see

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,templateId=renderPrint.psml”>here for German GDP data).

The U.S. is in the process of changing the way it presents PCE data; in this article I will briefly describe the new method to be implemented in 2009, described by the BEA in an article published in May 2008 (see here for the pdf).  The main change are that the BEA is using the international System of National Accounts (SNA) classifications and making the PCE data more compatible with other data that the government compiles (such as the consumer price index, CPI).

Roughly 98% of PCE are household consumption expenditures (the rest are the consumption expenditures of nonprofit institutions).  Health and housing are the largest categories, each roughly 18% of PCE, followed by transportation (11%) and then recreation, food purchased for off-premises consumption (largely food consumed at home), financial services, food services and accomodations (food consumed in restaurants and hotel expenditures) and other goods, services and household furnishing and clothing, that comprise most of the rest of the category (between 4 and 9% each).

One way that BEA classifies PCE is by the type of good purchased; goods are divided into nondurable goods (23%), durable goods (13%) and services including purchased meals and beverages (64%).  The services category is greatly expanded by including the purchased meals and beverages category (formerly included in nondurable goods).  While the behavior of the US consumer did not change

, this reclassification emphasizes the size of the US services sector.

Unlike GDP numbers, PCE is available both monthly and quarterly.  Normally the monthly PCE number comes out a day or two after the GDP number.  For example

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, the first revision of second quarter 2008 GDP (so-called preliminary GDP) will be released on August 28 and then July PCE numbers will be released on August 29.  This schedule creates a slightly odd result: at the end of August, we get a revision of 2008:II (April to June GDP numbers) and July PCE; at the end of September we get a final revision of 2008:II GDP and August PCE; by now we know 2/3 of the PCE data for the third quarter.  At the end of October the advance estimate of 2008:III GDP is released; this release includes the quarterly PCE.  Yet we do not learn the September monthly PCE until a few days later (there is some residual uncertainty about the PCE in the third month, even when the quarterly PCE is already known, as there are usually revisions to the earlier monthly numbers).

If you look at a data calendar (see here for a calendar and here for my essay) you can find out when certain data are released (for example, the Employment Report is typically released on the first Friday of the month at 8:30 am Eastern Time).  The Employment Report essay (here) explains how the Bureau of Labor Statistics calculates the numbers that are included in the report; in this essay, we explore the announcement process, that is how analysts forecast the data, how the consensus forecast is obtained, what are “whisper” numbers, the lock-up and what happens at 8:30 am on the first Friday of the month. For the purposes of this essay I will use the monthly announcement of the Employment Report but the same analysis could be applied to other announcements.

Economic analysts regularly forecast upcoming economic numbers.  These forecasts range from sophisticated statistical models (see here for a pdf of a recent academic paper that examines 30 variables that could be used to forecast the change in employment) to “back of the envelope” calculations (like the one described here).  Companies that provide data services to traders (such as Bloomberg and Reuters) routinely ask economists for their forecasts and use them to find the average or median forecast.

There is a lengthy literature behind the idea (sometimes called the Delphi method) that the average or median forecasts typically outperforms any individual forecaster (see here for an online book with an extensive bibliography).  But economic analysts work for profit making enterprises and do not wish to give away their best forecasts for free.  So they play a game something like this: early in the process they give away to Bloomberg a free forecast

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, which may (or may not) reflect their actual thinking.  The consensus forecast is formed on the basis of these early forecasts.  But as more information becomes available (closer to the data of the announcement) the forecaster may only distribute his forecast to preferred clients; this forecast is referred to as a “whisper” number, that is not printed and distributed (there are a number of services that claim to provide whisper numbers for company earnings: see here, here and here but none that I know of that provide whisper numbers for economic data; please send me an email at ckendall ##at## umrkt.com if you know of any).

At 8:30 am the data are released and broadcast on the news wires and television; but before then there are approximately 20 journalists who have seen the data and written reports at the “lock-up” (see here for an excellent essay describing the lock-up).  Accredited journalists from major news organizations receive the data release a half-hour early and prepare their articles that can be released at exactly 8:30 (they are “locked up” in a room where they are not allowed to contact the outside world before the official release).  The data are usually available to senior government officials the night before the release so that the appropriate cabinet secretary can be prepared to speak just after the release.

Then at 8:30 the data are released to the public; typically the data are announced on television (CNBC and elsewhere)

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, on news wires and on the web sites of the agencies that release the data.  Traders often react to the initial announcements and analysis by the reporters in the lock-up before; later analysts will release comments on what the data really mean through to their traders

, through wire services and in letters to clients (a service performed by the author of this article).  But an hour later there is another announcement and a month later a revision and five years after that a benchmark revision and the data will look very different.

This essay will provide an overview of the Gross Domestic Product (GDP) of the United States, Subsequent essays will provide more detail on the components of U.S. GDP.

The GDP is an attempt by the Bureau of Economic Analysis (BEA) to measure the value of final goods and services produced in the US in a given period of time (see here for a pdf primer by the BEA that explains the GDP as well as other measures of economic activity).

A few key points: GDP measures mostly market production

, that is activities that people pay for (leading to the old economist joke that if a man marries his housekeeper-or a woman marries her accountant-it will result in a decrease in the GDP). GDP measures production, not sales. GDP also tries to capture the services generated by owner-occupied housing. The idea here is that when one rents a house the BEA can measure the service flow (the apartment produces, say, $800 of services a month), but unlike the housekeeper/accountant example above, when the renter buys his apartment the BEA tries to continue to measure the service flow. The BEA does this by estimating the rent on comparable housing and imputing (or attributing) the income to homeowners. In other words, BEA counts the rent payments that homeowners would have paid as part of the GDP.

The BEA estimated that the US GDP (see here for the BEA’s latest release) was around $14,250 billion in the second quarter of 2008 (see Table 1.1.5 here where GDP is measured in current Dollars). This number is “seasonally adjusted annual rates” or SAAR, meaning that if the whole year were like the second quarter then the total GDP for the year would have been $14,250 billion, or that quarterly GDP was roughly 1/4 of that figure.

The GDP is calculated both in current dollars and in “chained” year 2000 Dollars. “Chained” Dollars represent the BEA’s attempt to remove inflation from the calculation and express GDP in so called real terms; this is a complex theoretical and statistical effort (see here for BEA’s introduction of the chained data). When analysts speak of economic growth they usually refer to real or chained data, so that they ignore the effects of price changes and focus on changes in quantities.

Using the expenditures approach to GDP (familiar from Introductory Macroeconomics), GDP is equal to the sum of consumption plus investment plus government spending plus net exports (exports minus imports). I briefly discuss here the data as they appear in the GDP report and how the data are released to the public. Linked essays will discuss these data in more detail.

Consumption of goods and services is revealed in two parts: first retail sales (see my discussion here)

, which represents an estimate of the goods part (28% of GDP in the second quarter of 2008); personal consumption expenditures (monthly consumption of goods and services, 70% of GDP) comes out about ten days later. Goods consumption tends to be more variable than services consumption, so much of the information in PCE is already known before the release. Consumption as a whole is not highly variable but is important due to its size; many analysts have made erroneous forecasts predicting the collapse of the US consumer.

Investment is divided into three categories: nonresidential (companies buying equipment and buildings); residential (home construction) and change in inventories. There are multiple sources for these data; survey data is produced more quickly but measures of spending are more accurate. Important releases include housing starts

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, construction spending, durable goods, factory orders and business inventories. Investment is a smaller component than consumption (15% of GDP) but is more variable; untangling these reports is hard work, and a way that careful analysts distinguish themselves from the pack.

Government expenditure: the Monthly Treasury Statement gives the monthly spending (and revenue) numbers for the US (Federal) government (7% of GDP); the problem is that much of the government budget is transfer programs (such as social security) that do not directly enter the GDP; further, these data are missing the spending by state and local governments (12% of GDP).

Net exports: Trade reports come out much later than other data; for example, June trade data are released in August. Net exports is a relatively small component of GDP (-5.1% of GDP) but can be highly variable; when advance (the first estimate) GDP comes out, only two months of trade have been released, and the BEA actually forecasts the third month of trade in producing their GDP estimate. These numbers are difficult to forecast. Note that in recent years imports have been larger than exports, so net exports are negative and subtract from total GDP.

Thousands of individual stocks trade every day on various stock markets around the world. There are a number of stock indexes that track the movements of stock markets.

The simplest stock indexes (for example, the Dow Jones Industrial Average (DJIA) in the US) are price-weighted indexes. To calculate the value of the index you add up the price of the 30 individual stocks. But over time, the stocks in the index have changed and some of the companies have split their shares; to correct for these changes there is a divisor

, so the sum of the prices of the shares in the DJIA is divided by approximately 0.123 (see here for calculation). This means that a $1 change in the price of a stock in the index results in a roughly 1/.123 or 8.1 point change in the index.

One problem with price-weighted indexes is that a company’s influence in the index depends on the per share price and not the value of the company. In the Dow Jones Industrial Average

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, has a larger weight in the index than General Electric which trades around $30, despite GE’s much larger market capitalization (GE has many more shares outstanding; the total value of the GE shares is around $300 Billion compared to Merck’s roughly $75 Billion).

There is a second class of indexes called value-weighted indexes that assign a value in the index proportional to the size of the company. The Standard and Poors 500 is such an index; recently (December 2007) Exxon, the largest company in the index had a weight of almost 4%, General Electric had a weight of almost 3% and Microsoft around 2.5%; the other 497 companies combined have a weight of only 91% of the index.

Some investors find it useful to own indexes. Individual investors who wish to diversify their portfolios can buy all the firms in an index; this allows individuals to reduce the risk of their holdings (the variability of a group of stocks tends be smaller than the variability of individual stocks). Using index funds individuals can invest in the broad US stock market (say, the Wilshire 5000 index which includes most traded US stocks) or a specific sector (say, the iShares S&P North American Technology Sector Index Fund which tracks US traded technology companies).

Institutional investors can use index funds to hedge their portfolios; hedge funds often use these funds to reduce the correlation between the return on their funds and other indexes.

Investors can purchase these indexes in various ways. You can try to buy all the stocks, but unless you are a very large investor it is costly to acquire different amounts of 500 companies. More realistically, you can buy either mutual funds or ETFs.

A mutual fund that tracks the S&P 500 may not buy all 500 companies either, as the improvement in tracking the index from owning small amounts of the smallest companies is minimal. The important distinction between a mutual fund and an ETF for an investor is that mutual funds have only one price per day, set shortly after the end of the trading day, while ETFs are traded throughout the day. A mutual fund investor who buys the fund acquires the shares at that price and can sell it only at the end of the day price at a later date. These funds are designed for medium to long term investors, and not for traders who wish to buy and sell at different times during the day. The basis for evaluating such funds is how their return compares to that of the index, which tends to improve with the size of the fund (bigger funds, lower fixed costs, better tracking of the index).

An ETF (exchange traded fund) is a portfolio of stocks that is designed to track an index (see here for the SPY ETF designed to track the S&P 500) that is traded on an exchange. So you can buy the ETF at 11am and sell it at 2pm if you want. For many small investors it is more convenient to hold mutual funds (for example funds will allow you to invest smaller amounts every month) but some investors find the flexibility of ETFs more important.

There are also futures traded on the S&P 500. Like any future these contracts are traded at a futures exchange (in Chicago at the CME) and not on the stock exchange (see here for more information). The futures contract is equivalent to trading the portfolio of stocks for delivery at a future date. In other words

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, in any month, you can arrange to buy or sell the index in the next month or some month after that. There is a fairly close relation between the price of the future and the index (price of future equals price of index times (1 + appropriate interest rate)). Futures require much smaller initial investments than stocks, and trade after stocks have stopped trading (S&P index futures trade more or less continually from Sunday night US time until Friday afternoon). So one can follow the market even when the stock exchanges are closed by watching the price of the futures markets, although the relation between the end of the day cash and futures price must be carefully examined (see here for a discussion of how “fair value” is calculated, and how to examine the difference between the price change from the closing price relative to fair value).

“Twin deficits” (occasionally also called the double deficits) is a shorthand summary for two related economic problems, the government budget deficit and the current account (or international trade) deficit. The government budget deficit is the difference between government revenue (mostly taxes) and government spending; the current account deficit is the difference between exports and imports (there are some adjustments for items such as funds sent abroad). Both deficits occur when someone is spending more than they earn; during the last 25 years the US government has tended to spend more than it collects in taxes and US residents have tended to spend more on imports than they export.

If an individual spends more than he earns he must either borrow money or sell off some assets. Advice columns are filled with stories of people who regularly spend more than they owe and finance the difference with multiple credit card loans that they will never be able to pay off; eventually they face bankruptcy and a reduced standard of living. Presumably a country that follows the same path will experience the same problems.

But it is well understood that individuals tend to have life-cycle consumption patterns: young people spend more than they earn (incurring student loans and mortgage debt), those in middle age tend to be net savers (investing in 401(k)s and building up portfolios and paying off their mortgage); and retirees return to net spending after they stop working.

So it is not necessary to exactly match income and spending in each period. But there are some limits to how much you can borrow if you are going to have a realistic chance of escaping financial ruin. If your lender sees that you are spending more than you will ever be able to pay then it is likely he will start charging you a higher price to reflect the increased risk associated with your debt. The same should be true for a country.

THE US TWIN DEFICIT EXPERIENCE

Starting in the 1980s (during the Reagan Administration) the US had both large budget and trade deficits. The budget deficit (see here for data) had been around around $50 to $75 billion in the late 1970s and grew to over $200 billion in 1983. The current account deficit (see the last line of the table here; you can select annual data for any recent period) was around zero through the early 1980s but exceeded $100 billion in 1985.

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,00.html?promoid=googlep”>here for a February 1986 expression of this view by Walter Heller, who argued that the deficits could “send interest rates shooting up”; yet yields on 3 month Treasury Bills fell from 7.29% in February 1986 to 5.75% in February 1987 and yields on 30 year Treasury Bonds fell from 8.93% in February 1986 to 7.54% in February 1987 while the budget deficit remained around the same size and the trade deficit increased a bit).

The relationship between the twin deficits and interest rates is complex. Instead of directly addressing it

, I will try to provide some tools to examine the question of whether the deficits are “too large”.

THE GOVERNMENT BUDGET DEFICIT

It is a fact of life that in recent years virtually every national government spends more than it takes in, resulting in a deficit. These deficits are financed by the issuance of government bonds; the sum total of all past deficits is the current debt. It is important to carefully distinguish between the deficit, the gap between government revenue and spending in any given year, and the debt, or the outstanding obligations of the government.

Making the situation more complicated is that the government makes promises for future spending (for example, social security and Medicare) that do not directly enter into the calculation of government debt. And if that were not enough, the government often borrows money on behalf of others, incurring debt without increasing the deficit by an equal amount. So the data are, to use a precise economic term, messy. See here for a recent speech by a Federal Reserve Bank President who believes that the future obligations are much larger than the measured debt.

To determine whether the US budget deficit is a problem we must know (1) how much does the US government owe, (2) how much is this debt likely to increase in future years, and (3) how much is the government likely able to pay. A way to restate this question to ask whether the US debt to GDP ratio is likely to be stable or growing indefinitely.

As of 2007 the US had a debt to GDP ratio of around 61% (see here for a table of estimates of the debt to GDP ratios of 126 countries), about the same as France (64%) and Germany (63%), much smaller than Italy (104%) and Japan (195%), but larger than the UK (43%) and Spain (35%).

But the level is not the problem, it is the growth rate. For the growth rate to be stable, the size of the deficit must be less than or equal to the growth of the economy. The deficit to GDP ratio is expected to be around 2.7 to 3.2% in 2008 and 2009 (see recent projections in a pdf here at page 1), decreasing to around 1% in 2010 and 2011. The deficit projections are dependent on political and economic conditions and are far from certain (earlier this year, before the troubles in the real estate and financial markets, the CBO estimated that the budget deficit would be 1.4% in 2009 (see this pdf, until the new report is published). As long as the budget deficit is around the same magnitude as GDP growth, the debt to GDP ratio should not increase.

One big problem will occur when baby boomers (people born between 1945 and 1965) start to retire en masse around 2018. There a number of programs that pay for benefits for retirees such as Social Security and Medicare that

, if the current levels of benefits are maintained (and tax revenues do not increase sharply)

, will cause the budget deficit to reach 10% of GDP by 2030, when debt to GDP would be over 100% (see here for several scenarios).

So, for the budget deficit, the short answer is things are fine for the next few years, but things could go very badly in twenty or thirty years. One way to look at this problem is to look at the government bond yield and to note that the interest rate on 30 year bonds is only a bit higher than the interest rate on 10 year bonds, meaning that bond investors do not seem that worried about the events of the late 2030s. Markets seem to expect the government to “do something” about the problem, possibly some combination of benefit cuts and tax increases.

THE US CURRENT ACCOUNT DEFICIT

The current account deficit measures the difference between the exports of US goods and services and US imports of foreign goods and services (the trade deficit measures only goods

, which are increasingly less important in recent years). If the US has a deficit, this means that we are buying things from the rest of the world, and must pay for them in some way. The ratio of the current account deficit to GDP has been as high as 6% in recent years; in 2007:III the current account deficit was around $178 billion, implying a deficit to GDP ratio of around 5.1%.

The high current account deficits in recent years have led to an increase in US international indebtedness, although this is a controversial topic (briefly, foreigners who invest in the US tend to look for safety and buy bonds, which have relatively low rates of return; Americans who invest abroad tend to look for riskier assets that have higher rates of return; it is extremely difficult to track the value of these investments over time; see the pdf article on “Dark Matter” or possible inconsistencies in the measurement of the US international indebtedness here).

In any event, measured US international indebtedness to GDP (see here for some estimates) is probably around 25% and increasing. A crude estimate reveals that if the US current account deficit decreases to around 3%, then indebtedness to GDP will converge to around 50%. If the deficit to GDP ratio remains around 5 or 6%, the indebtedness ratio could rise to 100% of GDP. Most analysts believe that such a ratio around 50% would be sustainable, but a ratio of 100% would have dire consequences. So if the US current account to GDP ratio remains at current levels (or gets larger) then the US will eventually face a crisis. The Dollar has lost considerable value in recent years against some currencies, helping exporters and modestly reducing imports. Credit markets seem willing to absorb US debt at reasonable prices, indicating that they believe that the situation will revert to a sustainable level.