The Big Picture

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• Quarantine
• The Instagram Generation
• 10 Tuesday PM Reads
• Goldbugs Push Back
• Business Cycle Chart
• NDR: 1980s Gold Pattern Suggests $660/oz
• 10 Tuesday AM Reads
• Income Inequality and Income-Class Consumption Patterns

Quarantine Posted: 08 Oct 2014 02:00 AM PDT Quarantine David R. Kotok October 07, 2014   "The practice of quarantine, as we know it, began during the 14th century in an effort to protect coastal cities from plague epidemics. Ships arriving in Venice from infected ports were required to sit at anchor for 40 days before landing. This practice, called quarantine, was derived from the Italian words quaranta giorni, which mean 40 days." (Centers for Disease Control and Prevention) The modern world is now moving toward a full Ebola quarantine. I personally recall flying home from Europe in the 1960s while I was in the US Army. The plane was diverted to the Azores, and while it was refueled, the military passengers (mostly US Navy submariners) were released into the Azores for a few hours of shore leave. The commanders were not aware that a virus was loose in the Azores. When we reboarded the plane and subsequently learned of the virus, we also learned that we would be diverted once we reached the US. We had to sit on a runway in Rhode Island and wait for the US health authorities to inspect the plane. They tested everyone on it and held us while they observed whether the virus had run its course. Quarantines are a pain in the neck. They are also necessary to isolate viruses and break the chain of transmission. We see in modern countries with mature economies and functioning health systems that the use of quarantine is understood and is being implemented now in response to Ebola. The scares in Spain and Texas will ratchet up the level of quarantine. The period of 21 days will become a well-known time measurement. In this morning's edition of The Gartman Letter, Dennis Gartman listed the assorted plagues that have claimed countless lives during the last many centuries. It is a terrific summary and helps develop perspective. We tend to focus on the isolated case and not think about the system. It is scary to watch modern media portray viral spread and resultant death. We are concerned for good reason. Smallpox, for example, ran rampant many times over the ages, and the groups above believe that perhaps several hundred million people have been killed over the eons by smallpox, with 300 million killed in the 20th century alone. In 1967, 15 million had the disease and 2 million were killed. However, effectively since 1979 there have been no outbreaks of smallpox and the disease is all but eliminated. In 1918-1919 Influenza, and specifically H1N1, commonly referred to as Spanish flu, killed 50 million people. 675,000 Americans were killed during that period. The Plague … Bubonic Plague … killed 20 million Europeans between 1340-1771, with the majority of those who died having done so between 1345-1350, with approximately one of three Europeans alive during that period having died due to the Plague. Malaria has been around for thousands of years, and only two years ago Malaria killed 1.2 million people, primarily in equatorial climates. The WHO believes that 1.8 million died during a particularly malevolent outbreak of Malaria in '04, and we are told that 60 thousand US soldiers died of malaria in World War II. Choleraaffects 3-5 million people every year according to the WHO, of which 100-120 thousand die… every year! The WHO counts seven cholera pandemics since the first in the very early 19th century. AIDShas killed 25 million people since 1981 and it killed 3.1 million in '05 alone. The WHO estimates that there are 40.3 million people alive today suffering from HIV. Tuberculosishas been around for nearly five thousand years, and as recently as '12 there were 8.6 million people infected with TB and 1.1 million who died from the disease in that year alone. TB raged through Europe in the 1600s, killing one of every seven people alive at the time. Typhushas been extant for nearly three thousand years, and it killed approximately 3 million people between 1918-1922 [Ed. Note: Remember, the Spanish flu was extant at that time, killing 50 million people, so between typhus and influenza, 53 million people died of diseases in those five years alone!] Here in southeastern Virginia, 3,200 people died of yellow fever in 1855, and that was of a population then of only 15,000, so 1 of every 5 people living in Norfolk, Portsmouth and Hampton died from the disease. In all, yellow fever killed 100,000 people here in the US at the time. Dennis Gartman, The Gartman Letter, 7 Oct. 2014 A historical perspective is necessary as we consider how best to address the Ebola threat. Quarantine in St. Louis, Missouri, prevented the spread of Asian Flu (H1N1) during the 1918 epidemic. In Philadelphia, Pennsylvania, there was no quarantine in effect, and the virus was deadly and spread quickly there. People felt healthy on their way into work in the morning and were dead by afternoon. We are worried about Ebola and how it will impact economic activity. It is human nature to defend ourselves and our loved ones, and quarantine is a form of self-defense. Defense against any illness, especially one that is viral, requires putting up barriers between yourself and others. Governments and businesses that have the ability to institute rules and barriers in response to Ebola will do so. At Cumberland Advisors, we ask our staff not to come to the office if they have any symptoms of illness. We install electronic equipment so that they can work from home while maintaining a personal quarantine. We believe millions of other business enterprises do the same. Ebola will shrink economic activity to some extent. The impact could be major or it could be minor, but there will be a price to pay for this virus, as there is for every natural phenomenon that has destructive characteristics. We thank Dennis Gartman for giving us permission this morning to reproduce his viral history for all to consider. We agree with Dennis: concern, caution, and quarantine are warranted. Hysteria is not.   ~~~ David R. Kotok, Chairman and Chief Investment Officer, Cumberland Advisors

The Instagram Generation Posted: 07 Oct 2014 05:00 PM PDT “The ‘Instagram Generation’ now experiences the present as an anticipated memory” -Professor Daniel Kahnema, Psychologist and Nobel Prize winner

10 Tuesday PM Reads Posted: 07 Oct 2014 02:30 PM PDT My afternoon train reads: • "Stocks and bonds aren't good enough anymore" – Wall Street (TRB) • American Banks Stockpile Treasuries as Deposits Top Loans (Bloomberg) • As Gross Joins Janus, Key Man Risk Examined (CIO) but see Watch Out, Gundlach: Bond King Gross Could Rise Again (Think Advisor) • “I Have No Idea” (Motley Fool) • Bernanke, Paulson and Geithner Face Grilling Over AIG Bailout (WSJ) • China Helps Push Mercedes Brand to Record Month: Daimler Group Sales Rise 12% in September (WSJ) • I’m an Internet Troll and Proud of It (Bloomberg View) • Clean Coal Era Begins  (Scientific American) • The Bacon Boom Was Not an Accident (Businessweek) • Venture capital and the great big Silicon Valley asshole game (Pando Daily) What are you reading?     Gas Prices Down 11% From YTD Highs   Source: Bespoke Investment Group

Goldbugs Push Back Posted: 07 Oct 2014 11:30 AM PDT   “Never try to teach a pig to sing- it wastes your time and annoys the pig." – Robert A. Heinlein, The Notebooks of Lazarus Long   Whenever I write about Gold, the pushback is always robust. Yesterday's column How Low Can Gold Go? was no different. As a public service, I thought I would address the feedback, criticisms and complaints amongst the many emails and comments I received. Some of the commentary was worthwhile discussions related to investing in general and precious metals in particular. These insightful souls seem to always generate inspiring food for thought. Their comments help me clarify my thinking on trading and commodities. Unfortunately, those folks are the exception. The bulk of the pushback comes from people who have been long and wrong, and refuse to hear from any source suggesting they are on a bas trade. The attitude seemed to be along the lines of "Who are you going to believe, me or my lying P&L? Quite an astonishing collection of denial Before we continue, one quick note to commenters: It is astonishingly easy to tell when a commenter did not read the column and is merely responding to the headline, which is typically written by an editor. Believe me, after 30,000 blog posts, you can tell at a glance which comments had nothing whatsoever to do with your column. Note original comments/emails are in italics, and my comments follow: On to the pushback:   Continues here

Business Cycle Chart Posted: 07 Oct 2014 08:30 AM PDT I love this chart from Fidelity:   How to Invest Using the Business Cycle Source: Fidelity

NDR: 1980s Gold Pattern Suggests $660/oz Posted: 07 Oct 2014 05:30 AM PDT Gold is one of those topics that always generates fierce pushback whenever I write about it. Yesterday's column How Low Can Gold Go? was no different. A deluge of emails and over 150 comments soon followed. I may post some of the more informative, vociferous and misguided comments / emails from readers later today as a public service to everyone else. But note that I find this pushback highly encouraging, as it suggests a topic that not only resonates, but is a hot button emotional issue. The lack of rationality is obviously so dangerous for investors. These last two make the subject especially intriguing to me. One more thing: As it turns out, I am not the only one who has been skeptical on Gold since its uptrend cracked late in 2010. This weekend’s Barron’s, citing Ned Davis Research, excerpted part of a recent research report from John LaForge and Warren Pies of NDR on historical gold cycles: “[F]rom its peak in January 1980 through its trough in February of 1985, gold suffered 65.8% losses. So far in this cycle, it's lost 35.7% from its August 2011 peak, so if it were to follow its 1980s path, it could easily slip below $700 an ounce. There were a number of factors working against gold in the 1980s, but notable among them was the strength of the U.S. dollar: It rose 54% from January 1980 to February 1985, versus as basket of major currencies.  LaForge and Pies write that it's not difficult to see how the same pattern could play out again, weighing on gold. These waters aren't friendly to contrarian investors, who usually lose out when betting against a rising dollar. Nor does it seem like a time for bargain hunters in gold, if the price is in danger of falling significantly more and pessimism hasn't yet reached its peak. NDR concludes: "Gold is not worth additional capital at this point. It is oversold, but is trending poorly. Like gold, the overall commodity super-cycle looks to be dying." -Ned Davis: If Gold Follows 1980s Pattern, Expect $660 An Ounce   Feel free to take the other side of the trade from what is widely regarded as the most astute technical analysis firm in the world . . .

10 Tuesday AM Reads Posted: 07 Oct 2014 05:00 AM PDT Good Nobel morning to you. No worries if you did not get a phone call from Stockholm, we still have a prize awaiting you: your morning train reading! : • S&P 500 Companies Spend 95% of Profits on Buybacks, Payouts (Bloomberg) • The Real Lesson of Lehman (NY Books) see also A.I.G. Bailout, Revisionists' Version (Dealbook) • Solar and Wind Plunging Below Fossil Fuel Prices (Ramez Naam) •  AQR's Asness: Prices Are Too High—But It's Not All Bad (CIO) Continues here

Income Inequality and Income-Class Consumption Patterns Posted: 07 Oct 2014 02:30 AM PDT Economic Commentary Income Inequality and Income-Class Consumption Patterns LaVaughn M. Henry Federal Reserve Bank of Cleveland, 10.06.2014   As income inequality has increased in the United States, researchers have rightfully asked whether it has also led to inequality in relative consumption. This is an important question because consumption is clearly a better measure of an individual's well-being than is his or her income. The research findings on the presence of consumption inequality, however, remain somewhat mixed. Many studies have found that consumption inequality has risen less than income inequality in recent decades (Cutler and Katz 1991, Krueger and Perri 2006, Heathcote et al. 2010, Fisher, Johnson and Smeeding 2013, Meyer and Sullivan 2013), while others have found that the rise has been fairly similar (Aguiar and Bils 2012, Attanasio, Hurst and Pistaferri 2013). Despite this divergence in findings, it would be useful to know whether the consumption patterns of individuals in different income classes have been reordered over the same period that income inequality has increased. In this Commentary I introduce a metric for distinguishing luxuries and necessities in consumption data produced by the Bureau of Economic Analysis and use it to reveal trend changes in consumption patterns for different income classes over the past three decades. I find that for lower and middle income quintiles, the share of total inflation-adjusted (real) consumption going to purchase necessities has contracted since 1984, while the share of the total going to purchase luxuries has remained fairly constant or slightly increased. For the highest income quintile, however, there has been growth in the relative consumption of luxuries. Income Inequality, Inflation, and Consumption Much has been written regarding the growing disparity between the wealthiest and poorest Americans in the aftermath of the Great Recession. While average income has returned to pre-recession levels, income gains have been distributed unevenly. To gain insight into the evolution and distribution of income in the United States, economic researchers often delineate the population into income cohorts known as "quintiles." Households are divided into quintiles according to their gross income. Each quintile represents 20 percent, or one-fifth, of all households. The data show that the top 20 percent of earners accounted for more than 80 percent of the rise in household income from 2008-2012 (figure 1). Meanwhile, incomes actually fell for the bottom 20 percent of earners. For example, data obtained from the Bureau of Labor Statistics' Consumer Expenditure Survey show that the highest income quintile in the US experienced an increase in nominal income of approximately $7,100 between 2007 and 2012, while the lowest income quintile experience a decline of approximately $360. All of these changes in income had a direct impact on spending.   Because of the significant changes in the rate of income growth by income class over the last few decades, the consumption patterns of different income classes may also have changed. Such changes are caused by myriad factors, but one way of thinking about them is in terms of income and substitution effects (which comes from the theory of microeconomics). The income effect states that as consumers' incomes rise, their consumption will also increase, up until a point of satiation, while the substitution effect states that consumers' consumption patterns are affected by changes in the relative prices of goods (that is, as prices rise for a given good, consumers will reduce their consumption of that good where possible and increase their consumption of a substitutable good that provides them a comparable level of satisfaction). Since 1984, price inflation for consumer goods, as measured by the Bureau of Economic Analysis' Personal Consumption Expenditure Index, rose at a very moderate average rate of 2.4 percent annually. As one becomes wealthier on a real dollar basis, it is reasonable to assume that one would substitute away from goods and services considered necessities and toward those considered luxuries. To the extent that a person's income growth continues to exceed the rate of growth in prices, we would expect to see this shift toward relative luxuries magnified over the long run. Using these principles as backdrops, we turn to the question of how consumption patterns have changed among income quintiles as income growth changed, coupled with continuing changes in the prices of goods. More specifically, have there been shifts in peoples' relative consumption of necessity and luxury goods as some quintiles have prospered while others have experienced slow income growth? Defining Luxuries and Necessities There is no clear-cut way of classifying goods and services as luxuries or necessities. Any classification is subjective at best and inconsistent at worst. What is a luxury item to one individual—such as an owned dwelling when rental dwellings of comparable quality are available at lesser cost—might reasonably be classified as a necessity to another—such as an owned dwelling when no rental properties of comparable quality are available. This subjectivity makes it impossible to sum the relative utility of various goods and services across individuals. However, by assuming that this variation cancels out across a large number of people in similarly classified income groups, a good or service can be consistently classified as a necessity or luxury within a given cohort by observing the shares of consumption. I employ an empirical classification method to construct a metric for classifying goods and services as luxuries or necessities. I start with one possible definition of a "luxury" as a good or service that is consumed in greater proportions as a person's income increases. By the same token, a necessity would be a good or service whose consumption is proportionately less as a person's absolute income increases. I use this definition to classify categories of expenditures as luxuries or necessities based on whether their share of consumption increases or decreases as income increases (table 1).   To identify which categories of expenditures are consumed in greater or smaller proportions as income rises, I analyze US consumption data from the annual Bureau of Labor Statistics' Consumer Expenditure Survey series. The Consumer Expenditure Survey (CES) program consists of two surveys, the Quarterly Interview Survey and the Diary Survey, which provide information on the buying habits of American consumers, including data on their expenditures, income, and characteristics of their consumer unit (families and single consumers). The US Census Bureau has collected the survey data for the Bureau of Labor Statistics on an annual basis beginning in 1984. Data for the survey years 1984 through 2012 were organized by income quintile, and for each of the income quintiles, average annual nominal levels of consumption for 23 categories of expenditures were identified. Price level deflators from the Bureau of Economic Statistics were used to convert the nominal values to real. All price-related references in the analysis relate to 2009 price levels. The categories included account for 94.9 percent of the average personal consumption basket for the years 1984-2012.1 The results of this analysis show how the shares of different categories of real consumption, averaged across the analysis period 1984-2012, change as income moves from the lowest income quintile to the highest income quintile. The classification in the final column, "relative consumption type," results from this researcher's method.2 A specific type of good or service is classified as a luxury if more of it is consumed, on a percentage basis, as real income levels increase (that is, going from lower to higher income quintiles). Similarly, a specific good or service is classified as a necessity if it accounts for a smaller percentage of consumption as real income levels increase. Changes in Consumption Using this method to sort the data into luxuries and necessities reveals that across all income categories, the consumption of goods and services classified as necessities declined from 1984 to 2012, dropping from 45.7 percent to 36.7 percent (figure 2). Likewise, the average consumption share across all income categories rose for items classified as luxuries over the same time period, from 51.0 percent to 56.0 percent. While this trend movement is similar across the various income quintiles, it is nowhere near consistent. For example, consumers in the lowest income quintile reduced their consumption of goods and services classified as relative necessities from 63.5 percent in 1984 to 54.5 percent in 2012. Consumers in the highest income quintile saw their consumption of necessities decline from 33.8 percent to 27.7 percent.     These results show that consumers have, in general, significantly increased their consumption of luxuries over the last 30 years as their real income levels increased. Recently, however, as figure 2 illustrates, this pattern reversed, as incomes suffered during the recent period of recession and recovery. Since 2007, the year in which the Great Recession started, the consumption of luxuries declined and only recently began to stabilize in 2012. Likewise, the consumption of necessity items began to rise in 2007 and slowed in 2012. As figure 3 illustrates, the relative consumption shares of luxuries and necessities vary greatly between income groups. From the different graphs one can see that, as the income level increases, luxury items account for a greater share of the consumer's market basket. While it is true that all income groups reduced their consumption of necessities over the analysis period, the rate at which they transitioned into consuming greater amounts of luxuries differed greatly across groups. As the results in both table 1 and figure 3 detail, the lowest and highest income quintiles were the most invariant over time with respect to their consumption of luxury goods. Middle income consumers experienced the greatest variation of all the groups. Their consumption of necessities declined by 12.2 percentage points over the analysis period, while their consumption of luxuries increased the most—rising by 6.2 percentage points.   Source:Federal Reserve Bank of Cleveland   Implications If income growth continues to lag for lower to middle income groups, two potential long-term implications for future economic growth come to mind. First, while consumption has gradually been rebounding from the recession, current trends in both income growth and income inequality are altering the mix of goods and services that consumers are purchasing. While macroeconomic models tend to focus on average income effects, there may useful information in the disaggregated patterns. Second, to the extent that consumption of the necessity "education" continues to decline as a share of real consumption for all but the highest income quintile, it may exacerbate the income inequality trend over the coming years; increased education is one of the most reliable paths to increased income. However, the lowest, second-lowest, middle, and second-highest income quintiles have all seen their shares of education decline significantly over the analysis period (8.1 to 2.6 percent, 2.8 to 1.2 percent, 2.5 to 1.1 percent, and 2.6 to 1.6 percent, respectively). The highest income quintile has seen its share of education consumption remain relatively steady, declining only slightly from 3.4 to 3.2 percent. Footnotes Note that the listed categories do not sum to 100 percent because consumption categories listed as indeterminate (by this researcher) are excluded from the summation, and the miscellaneous category (as listed by the BLS Consumer Expenditure Survey) is also not included in the summation. [Back] Categories were classified as indeterminate when there was no clearly obvious trend in pattern in the given consumption category. [Back] References Aguiar, Mark and Mark Bils, 2011. "Has Consumption Inequality Mirrored Income Inequality?" NBER Working Paper no. 16807. Attanasio, Hurst and Pistaferri, 2012. "The Evolution of Income, Consumption, and Leisure Inequality in the US, 1980-2010," NBER Working Paper no. 17982. David M. Cutler and Lawrence F. Katz, 1992. "Rising Inequality? Changes in the Distribution of Income and Consumption in the 1980s," NBER Working Paper no. 3964. Fisher, Jonathan D., David S. Johnson, and Timothy M. Smeeding, 2013. "Measuring the Trends in Inequality of Individuals and Families: Income and Consumption." American Economic Review, 103(3).Heathcote, Jonathan, Fabrizio Perri, and Giovanni L. Violante, 2010. "Unequal We Stand: An Empirical Analysis of Economic Inequality in the United States 1967-2006." Review of Economic Dynamics, 13. Krueger, Dirk & Fabrizio Perri (2006), "Does Income Inequality Lead to Consumption Inequality? Evidence and Theory," Review of Economic Studies, Wiley Blackwell, 73(1). Meyer, Bruce D., and James X. Sullivan, 2013, "Consumption and Income Inequality and the Great Recession." American Economic Review, 103(3). ~~~ LaVaughn M. Henry | Vice President and Senior Regional Officer for the Cincinnati Branch LaVaughn M. Henry is a vice president and the senior regional officer for the Federal Reserve Bank of Cleveland's Cincinnati Branch. Dr. Henry is responsible for building and maintaining a strong presence and reputation for the Bank throughout central and southern Ohio, and eastern Kentucky. He works closely with key stakeholders, including the board of directors of the Cincinnati Branch, business advisory councils, depository institutions, business and civic leaders, and the public.

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