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A 130-year long argument against the Solow growth model

Staff and Wire Reports — Fri, 10 Feb 2012 21:03:00 +0000

We have already presented strong quantitative arguments against the Solow growth model, which presumes that the rate of change in real GDP per capita must approach some constant level. In developed countries, the annual increments of real GDP per capita have been rather oscillating around constant level since 1955. We use the estimates of real GDP per capita published by the Conference Board’s total economy database. Since the late 1990s this database has been developed and maintained in conjunction with the Groningen Growth and Development Centre (University of Groningen, The Netherlands). As of the summer of 2007 the database has been transferred from the University of Groningen to The Conference Board and is maintained there. The GGDC also provides historical estimates of real GDP developed by Angus Maddison. It is instructive to use these historical estimates in order to reject the Solow model by empirical data.

Under our empirical framework [1,2,3], real GDP per capita in developed countries grows as a linear function of time, we call it inertial growth, when population pyramid does not change much in the long run:

G(t) = At + C (1)

Relationship (1) defines the linear trajectory of the GDP per capita, where C=G_i(t₀)=G(t₀) and t₀ is the starting time. In the regime of inertial growth, the real GDP per capita increases by the constant value A per time unit. The relative rate of growth along the inertial linear growth trend, g(t), is the reciprocal function of G:

g(t) = A/G(t) (2)

Relationship (2) implies that the rate of GDP growth will be asymptotically approaching zero, but the annual increment A will always be constant. This is different from the Solow model where the rate of growth is a positive (nonzero) value. Moreover, the absolute rate of GDP growth is constant and is equal to A [$/y]. This constant annual increment thus defines the constant “speed” of economic growth in a one-to-one analogy with Newton’s first law. Hence, one can consider the property of constant speed of real economic growth as “inertia of economic growth” or simply “inertia”.

In Figure 1, we present the estimates of annual increments of real GDP per capita in the USA since 1870. At first glance, these data support the Solow model, i.e. annual increments increase with time. However, we know that since 1955 the increment has been oscillating around constant level of $423 (2011 US dollars) and the accuracy of GDP measurements (actually obtained by reconstruction) before 1950 can hardly be characterized as a high one. In Figure 2, we display the estimates of annual increment since 1955 as measured by the Bureau of Economic Analysis. There is no linear time trend in the curve and thus the Solow model does not work well.

The period between 1940 and 1955 is characterized by extremely large oscillations. This period corresponds to the Second World War and the development of the concept of Gross Domestic Product (Simon Kuznets introduced this idea in 1934). Therefore, the war and the development of measurement procedure may introduce significant structural breaks in the time series and we remove the years between 1940 and 1955 from our consideration as a mixture of an artificial step in measurements (say, the transition from mph to km/h) and the effects of noneconomic factors in economic evolution. Figure 3 shows the period between 1871 and 1940 (70 years). Not surprisingly, there is no linear time trend and the overall length of the period when the Solow model is not applicable is now ~130 years.

All in all, the Solow model of economic growth (and all its branches and versions) contradicts hundred and fifty years of observations. We are going to report the evolution of real GDP per capita in other developed countries.

Figure 1. The estimates of annual increment of real GDP per capita in the USA since 1970.

Figure 2. Annual increments since 1955 as reported by the BEA. There is practically no linear trend.

Figure 3. The annual increment between 1871 and 1940. The mean value is $65.

Transports Head South

Nicholas Santiago — Fri, 10 Feb 2012 16:00:11 +0000

This morning, the important transportation sector is declining sharply lower. The iShares Dow Jones Transportation Index (NYSEARCA:IYT) is trading down by $1.41 to $$93.40 a share. This index is followed by many institutional traders as a leading indicator. When the transports decline it is a sign of economic weakness and contraction. The opposite is true when the transports advance, it is viewed as a sign of economic expansion and growth. Traders can watch for intra-day support on the ITY around the $93.00, and $91.70 levels.

Some leading transport stocks that are retreating lower today include FedEx Corp (NYSE:FDX), Union Pacific Corp (NYSE:UNP), and United Parcel Service Inc (NYSE:UPS). All of these stocks still remain strong on the daily charts, therefore, this simply looks like a normal pullback at this time.

Nicholas Santiago
InTheMoneyStocks.com

Crude and steel – an unbreakable pair

Staff and Wire Reports — Fri, 10 Feb 2012 08:58:00 +0000

We have been reporting on the trade-off between the producer price index of crude oil (domestic production) and the PPI of iron&steel since 2009. It has been always a linear and lagged link between them. Our previous update included PPI data through July 2011. Here we present an annual wrap-up.

We reported that the PPI of crude oil had been likely evolving in sync with that of iron and steel, but with a lag of two months in September 2009. In order to present both indices in a comparable form, the difference between a given index, iPPI (i.e. iron&steel and crude), and the overall PPI was normalized to the PPI: (iPPI(t)-PPI(t))/PPI(t). These normalized differences represent the evolution of the rate of deviation from the PPI over years.

Figure 1 depicts the corresponding time histories of the normalized deviations from the PPI, including the most recent period through December 2011. Even a simple visual inspection reveals the following feature: the (normalized deviation from the PPI of the) index of iron and steel lags by approximately two months behind the (normalized) index of crude oil.

Figure 1. The deviation of the iron and steel price index and the index of crude oil from the PPI, normalized to the PPI.

In order to reduce both deviations to the same scale we additionally normalized the curves in Figure 1 to their peak values between 2005 and 2011.

(iPPI(t)-PPI(t))/[PPI(t)*max{iPPI-PPI)}]

This scaling allows a direct comparison of corresponding shapes. In Figure 2, we display the normalized index of iron and steel shifted by two months ahead to synchronize its peak with that observed in the normalized index for crude petroleum. The scaled index of crude demonstrates just short-term deviations from the index of iron and steel in the overall shape and timing of the peak and trough. Simple smoothing with MA(3) makes the curves resemblance even better. As an extra benefit of the resemblance, one can use the two-month lag to predict the future of the iron and steel price index.

Figure 2. Deviation of the iron and steel price index from the PPI, normalized to the PPI and the peak value after 2005 as compared to the deviations of the index for crude petroleum normalized in the same way. The normalized index for iron and steel is shifted two months ahead.

Conclusion

The link between oil and iron seems to be unbreakable. Between 2006 and 2012, the deviation of the price index of iron and steel from the PPI in the USA repeats the trajectory of the deviation of the index of crude petroleum (domestic production) with a two-month lag. Therefore, the prediction of iron and steel price for at this horizon is a straightforward one.

Implications of a Positively Correlated SPX and VIX

Staff and Wire Reports — Fri, 10 Feb 2012 07:28:00 +0000

For those who missed today’s market action and just looked at the post-mortem reports, today probably looked like just another in a series of uneventful days. For those who were paying attention to the likes of the VIX futures and ETPs based on VIX futures such as TVIX (+10.7%) and VXX (+5.2%), however, the tension in the air was obvious.

But the SPX, DJIA and NASDAQ composite indices were all up today, so what’s the big deal? It turns out that investors are easily spooked if the VIX (+2.6%) and the SPX (+0.1%) both move in the same direction. As the graphic below shows, the VIX and the SPX move in the same direction about 22% of all trading days. I think the real issue behind the concern about the direction of the VIX and the SPX is related to a hypothesis I laid out yesterday in What the VIX Kitchen Sink Chart Says:

“…the general consensus seems to be that stocks just do not deserve their current lofty valuation. In this type of environment, many investors become particularly susceptible to confirmation bias and scramble to find one or more indicators which will tell them what they have already begun to believe: that a major correction is likely just around the corner.”

The last time I crunched the numbers for VIX and SPX daily correlations, was in May 2007 and in looking at data from 1990, I concluded that a High Positive Correlation Between VIX and SPX Often Signals Market Weakness. Interestingly, when I ran the numbers today, the data from the last five years had completely reversed the conclusions. Thanks to some particularly strong results from 2009 and 2010, the full data set (1990-2012) now shows that when both the VIX and SPX are up on the same day, the mean returns for the next 1-100 trading days far exceed the typical returns for the full data set.

In terms of key takeaways, it now appears that stocks perform best following days when the SPX is up and the VIX is down (the ROI +1 column refers to the performance of the SPX one day hence) and worst on days when the SPX is down and the VIX is up. Interestingly, if one combines the up/down and down/up days, as I have done in the “split up/down” row, the aggregate data set of the SPX and VIX going in different directions looks almost exactly the same as the full data set in terms of future performance.

Getting back to the up/up phenomenon of today and yesterday, this bodes quite well for stocks going forward, based on historical data. By the same token, down/down days correspond to future performance that is, on average, well below the full data set.

Of course another key takeaway is that no matter what the data says today – for this study or any study – future events may overwhelm the current historical data and invalidate the generally accepted conclusions, even with a large sample size.

Now I will be the first to admit that stocks are overdue for a pullback, but just because the VIX and SPX both advanced on two consecutive days does not necessarily mean the planets are aligning for an Aquarian selloff. If investors are looking for that market reversal silver bullet, the SPX-VIX correlation data are not going to make them happy.

[For the record, the data in the table below includes Fridays and Mondays, so it is possible that calendar reversion may have had an impact on the results.]

Below is a larger than usual set of links for those who may be interested in digging into the history of some of the SPX-VIX correlation themes in this space.

[source(s): CBOE, Yahoo]

Disclosure(s): short TVIX and VXX at time of writing

Hard read tonight but I think I got it

Staff and Wire Reports — Fri, 10 Feb 2012 03:16:00 +0000

This one wasn't as easy to see as the others (may have yet to be valid too, since its still forming as I write). The W is a bearish crab, the white dash. The yellow is a bearish 3 drives pattern with .127 fib on the first dip and .161 on the second. Not sure if the two dips have to have the same fib levels but it seems to work since at about the same place where the two bear patterns met there was a red candle. Was looking for a longer one, but like I said, this thing is still forming as I type. The blue line is a projection, with the guess being a formation of an M (XA is CD of the W, with the blue line being the AB of the M that's forming--got it??). So far I've been pretty decent with natgas futures and these patterns. Wish I was able to do the same thing with S&P daily futures so I can jump in the top calling festivities but be correct for once. But like I say, give me enough time and I'll be right, eventually.

Last night's pattern took longer than expected to complete, but it looked like my second higher target was hit before the open:
https://twitter.com/#!/BNGESG/status/167464209716740096

Follow the rules: Cut losses quickly; Don't overtrade; Take profits/sell into strength; Don't chase, watch for the pullback; Have a plan and stick to it

View my other posts/give me some advice at http://part-timepennystocktrader.blogspot.com/. Follow me on twitter @BNGESG.

Groundhod Day Again And Again

Nicholas Santiago — Thu, 09 Feb 2012 20:16:11 +0000

Yesterday, we wrote about the major stock indexes declining in the first half of the trading session only to bounce higher throughout the afternoon. Well, it happened again today. The same exact pattern repeats nearly every trading day since mid-December.

The trading volume in the SPDR S&P 500 Trust (NYSEARCA:SPY), and the SPDR Dow Jones Industrial Average (NYSEARCA:DIA) remains extremely light. The light volume will generally favor the upside as there are simply no institutional sellers to take the market lower. Traders must enjoy this inflation rally while it lasts.

Nicholas Santiago
InTheMoneyStocks.com

Putin and crisis – lie again

Staff and Wire Reports — Thu, 09 Feb 2012 18:27:00 +0000

Another lie from Putin is that Russia was very successful during the last crisis and has recovered to the healthy pace of growth. And we know the name of the hero who led us though these dark years. Unfortunately for Russia, it had hardest problems between the BRICS countries. Figure 1 shows that Russia was the only country in BRICS who had a dramatic fall in real GDP per capita – the best variable describing real economic growth independent on the change in population.

The years of Putin as the Prime Minister are characterized by a deep fall in economic growth and there is nothing to be proud of. As shown in our previous post, the pace of economic growth between 2001 and 2008 was just an extension of the push given in 1998 and not by Putin.

Figure 1. The evolution of real GDP per capita in BRICS.

Attempted Market Break Down Is Foiled Again

Nicholas Santiago — Thu, 09 Feb 2012 17:45:41 +0000

There is a key trend line on the SPDR S&P 500 ETF (NYSEARCA:SPY) stretching from January 31st, to the low of yesterday. This line has been hit multiple times between these two points and has bounced each and every time. Again, the market hammered this line twice in the morning session of trading today. Each time the 10 minute candle on the SPY closed below. As traders were set to pounce, the market spiked higher, negative the close. Each time the markets got below this major trend line, a buy program of epic proportions hit the market. Simply put, computer programs have been set up by institutions in league with the Federal Reserve to keep the markets from breaking this line. It is scary to think of the stock market as being so heavily manipulated. However, watching it trade over the last six weeks leaves little doubt.

As the markets are back in the green, Apple Inc. (NASDAQ:AAPL) is heading towards the major $500 level. It is currently trading at $495.73, +19.05 (+4.00%).

On the opposite side, banks are weak with JPMorgan Chase & Co. (NYSE:JPM) and Goldman Sachs Group, Inc.(NYSE:GS) both negative. The financial stocks lagging does usually send up a caution signal but with the powers that be backing this market, shorting is not smart.

Gareth Soloway
InTheMoneyStocks.com

Base Metal Stocks Struggle Early

Nicholas Santiago — Thu, 09 Feb 2012 16:24:33 +0000

Many of the leading base metal producing stocks are struggling to catch a bid this morning. Rio Tinto Plc (NYSE:RIO) is a leading stock in the base metals and materials sector that is coming under some early selling pressure. This market leader is declining by $1.31 to $60.22 a share. The decline in this market leader comes despite a strong copper, gold, and silver market today. RIO will have short term intra-day support around the $60.00 and $58.75 levels.

Some other leading base metal stocks that are declining lower this morning include BHP Billiton Ltd (NYSE:BHP), Vale S A (NYSE:VALE), and Southern Copper Corp (NYSE:SCCO). Traders should watch the U.S. Dollar Index closely as these stock will usually catch a bid when the U.S. Dollar declines.

Nicholas Santiago
InTheMoneyStocks.com

Cloud Stocks Reaching A Short Term Ceiling

Nicholas Santiago — Thu, 09 Feb 2012 15:48:22 +0000

All of the cloud computing stocks are trading higher again this morning. Earlier today, Oracle Corp (NASDAQ:ORCL) purchased Taleo Corp (NASDAQ:TLEO) for $1.9 billion. This deal is certainly helping many of the leading cloud computing stocks to trade higher today.

Leading cloud stocks such as Rackspace Hosting Inc (NYSE:RAX), Citrix Systems Inc (NASDAQ:CTXS), and Aruba Networks Inc (NASDAQ:ARUN) are all approaching daily chart resistance levels. All of these stocks remain very strong on the charts by trading above the major daily chart moving averages. This tells technical traders that a pullback or some consolidation is likely to occur soon before these stocks can trade higher. Short term traders can watch for intra-day support on RAX around the $48.95, and $48.00 levels.

Nicholas Santiago
InTheMoneyStocks.com