Is the recession over? Seems likely

Evidence is growing that the recession is over. This is at odds with some recent Fed comments. which suggest that the low interest rate policy will last for the rest of the year. The exception to the recovery story has been in two areas, employment and housing, but even here patterns are falling into place which suggest we have turned a corner.

The employment numbers have started to move positive, but the last two recessions have had very shallow recoveries especially with respect to job creation. This recessions seems to be following the same pattern. Take away the analysis of the poor employment picture which is a lagging indicator and the overall economic story looks like it is clearly improving.

The housing area is also showing improvement with some areas actually producing price gains but this part of the economy has a long way to go before there are actual improvements in consumer wealth. An important story in the housing area is the fact that this it will not be a driver for future economic growth but this is a good thing. Do we need more housing in the country? Absolutely not. There can be a new balance in the economy that can lead to higher productivity and export growth. Nevertheless, new construction will be a drag on both growth and employment.

One of the voters on the NBER recession dating committee is Jacob Frankel. He is clearly arguing that the recessions is over in his weblog. His two graphs above suggest that employment is following the pattern expected in a recovery and points to a recovery.

However, there is a difference between saying the recession is over and that we have made up the output gap. It seems like many analysts are confusing the difference in an economic turn around and a reversal of the output gap.

The adaptation of alpha and market efficiency

Andy Lo has presented an interesting visual picture on the development of alpha through time which is consistent with the efficiency theory of markets through time. There may be a unique way to generate returns outside of market exposure but as more firm uses that technique it only becomes novel. The profits from the process are diminished. As the technique becomes popular, profits are further diminished and the unique value is eliminated.

There is less reason to pay a premium for these alpha generation services. Finally, the technique becomes well known or common and then represents a form of beta exposure. While I cannot always agree that this is a beta, a generalized technique cannot provide excess returns and should not receive a premium price for its generation. It is a beta in the sense that it is measurable and can be empirically tested. Think of the three factor Fama-French model.

This alpha popularization could be what happened to the January effect that used to exist in many equity markets. The value was diminished when everyone used it in their investment scheme. The effect started earlier or did not show up in a year. The small firm effect has been diminished as more managers switched to equities outside the S&P 500 and measure the impact.

Generating strong returns requires constant adaptation and development to stay ahead of the alpha popularization curve.

Swaps spreads negative - suggest Treasury supply problems

Swaps spreads trading through government bonds is out of the ordinary, yet it is happening in both the UK and the US. Can government bonds be that risky? Unlikely. But there is a clear supply imbalance and the market is having a hard time digesting billions issued every week.

10-year - 3-month spreads are at extremes. This should be good news given the classic recession indicator of an inverted curve. A strong positive spread indicates good economic growth. The monetary policy is keeping the front-end rates low, but the longer-term extremes may again have to do with supply imbalances.

Views on market efficiency

"What everyone knows is not worth knowing."

"The market will usually do what it needs to do to prove the majority wrong."

"When one learns how to play the stock market game, they change the rules."

- Ned Davis

From Justin Fox, in the FT:

There are two efficient market hypotheses. One is the bold, unsubstantiated proposition that financial markets are close to perfect and all-knowing. This theory was ferociously and convincingly attacked by Robert Shiller and Lawrence Summers three decades ago and quietly abandoned by its progenitors in the 1990s – although it lived on zombie-style in textbooks, central bank policy and some parts of the financial press until recently. When, these days, a pundit or government official rails against “efficient market theory”, this is what they mean.

A second efficient market hypothesis, however, deservedly survived the financial crisis. It holds simply that it is very hard for any investor (or regulator, or journalist) consistently to outsmart the market. Evidence keeps pouring in to back up this “No Free Lunch” theory, as economist Richard Thaler dubbed it in these pages last year, even as its “Price is Right” counterpart has been shown wanting.

Put another way, financial markets are perfectly competitive and most of the excess profits have been eliminated. The only way to generate extraordinary profits is to produce or generate a new system of returns. Once this system is known, extra profits will be eliminated and a new system has to be adopted.