October 5, 2012 | Leave a Comment
It would be interesting to see what Mr. Krisrock says about the numbers. He's been predicting this for at least a year, and let us all in on what was in store for this October at the last spec party.
Tyler McClellan writes:
"Western scholars have found many reasons to think that the measurement of Russian national income is too important a task to leave to Russian statisticians."
Hieronymus of Rhodes in the second book of his scattered notes relates that in order to show how easy it is to grow rich. Thales, foreseeing that it would be a good season for olives, rented all the oil mills and thus amassed a fortune.
Are we supposed to take Bruno's word that no one ever made money speculating in commodities against the real life experience of one of the seven sages?
Kim Zussman writes:
Investment and speculation are the same thing only differing in degree.
Good afternoon everyone,
Would anyone be able to suggest any alternatives to the US dollar that I would be able to put my money into? What currencies or commodities would be worth using to reduce the risk of dollar? I must admit I know very little about this particular subject. I'm not necessarily looking at this as an investment in which I'm trying to get rich, I'm just looking for something that will hold its value better than the US Dollar. As I put money aside for various things in life, I would hope there is something I could have that would be worth the same ten years from now as it would today. Any insights or suggested reading material would be appreciated.
Tyler McClellan comments:
If you want to buy things in dollars in the future then you'll want to hold dollars.
Gary Rogan counters:
That's like saying, "if you want to put gasoline in your car in the future you need to own gasoline today". Given the 90%++ loss of purchasing power of dollars in the last 100 years there just could be better alternatives than holding them today. If the point is that nobody knows what they are with any degree of certainty, that's a valid point.
Anton Johnson writes:
Inflation protected (at least to the extent of official figures) US series I savings bonds seem to be a decent savings vehicle, especially when they are accumulated over time. Unfortunately, there are minimum ownership periods and the maximum annual purchase is limited to 10K per person.
Craig Mee advises:
Beware of selling the low, Corban, effectively adding size in a market that's been trending south for some time.
If Euro goes to the dump, and USD goes bid a la 2008-09, then that may be a nice way to offload USD then and say buy Aussie at 60c to the USD. (We do have stuff in the ground that helps, although with interest rates cuts just coming through, it appears some goodwill that was present at the start of the year is being priced out of the market against the USD).
Good luck. Oh…beware of the Fed, or in this case FEDS, to up end things at any time…. though if history only always repeats to the letter, it would make investing a wee bit more straight forward…
Alston Mabry writes:
With a decent time horizon, you could put some money into corporate bonds and good divvy-paying stocks. That way you get the divs and also exposure to cap gains. just happen to be researching some recently, so here is a diversified group of sample tickers:
Leo Jia adds:
This is an age of vast changes. For that reason, we can easily lose our vision into the future in terms of what will be more valuable. Even though there are many discussions around the topic, I can't decide easily if the US dollar will be more valueless than any other currencies in the future. Many argue that it will lose more value, but I tend to think that it perhaps will be more valuable than most other sound currencies, for the very simple reason that the US has a more fundamentally solid mechanism of being a most promising country. The very fact that the people with big money are not running away from the US demonstrates it.
There is the notion (as Gary Rogan pointed out) that the dollar has lost 90% of its purchasing power over the last 100 years. While I agree that there has been a devaluation process going on, I don't think the notion should really be understood literally. Many things around any purchase (including venue, environment, safety, transportation, etc) have vastly changed from 100 years ago. All these add legitimate values to the product and hence cost for the purchaser. One can argue that the egg he buys today is not that different from that his grandfather bought 100 years ago. Yes, sure, but things in a social economy can not be taken separately. Many things in it are vastly different from 100 years ago: farmers' lives, air-condition for the chickens, refrigeration along the transportation, etc.
As to what can hold value better for the future, I would like to have agricultural commodities (hope to hear other arguments). I buy into the view that because people in China and India (accounting for nearly 40% of the world population) are getting richer, they will be demanding more higher-scale food like meat which then will demand more amount of lower-scale produces like corn or wheat (I have been actually experiencing the above view personally for the last 10 years in China). Sadly, the production of these lower-scale produces can not be increased easily, so these prices must go up. In the long term, the pressure for the price rise due to the imbalance of demand and supply will be added to the legitimate price rise (as I seasoned in the last paragraph), resulting in much higher prices in dollar's term. One note to add is that the inherent volatilities associated with these commodities along the way should be carefully considered.
Additionally if I may add as an option to where to put your money, it should be into your life, your personal and business interests, and perhaps some interests of any community you are in. My feeling is that this might be more important than anything else.
Laurel Kenner writes:
There are no safe havens any more. People have been remarkably complacent about the obvious rigging and zombization of financial markets, the transfer of power to lawbreaking elite firms, the restrictions on capital movement out of the country, the baldfaced lies about the nonexistence of inflation, the steady fiscal confiscation of personal assets, The fact that we still can have a meal at pleasure and joke about our plight means nothing in terms of economic freedom. Unfortunately, the one point that holds true is that the foundation of individual liberty is economic liberty. We have merely slipped back into the iron pattern of historical kleptocracies. Maybe that is why there has been so little effective resistance. Those who protest are marginalized by the mainstream propaganda machines. Case in point: Did the Fed just bail out Europe without anyone blinking an eye, and what does that mean for the global future?The only advice that I have found to make sense at all lately is "Be flexible." We are playing against a relentless statist enemy. Some Specs recommend Australian and Canadian currencies. That's merely a play on commodities. I need not remind anyone here that in the past century, the U.S. government made it illegal to own gold, and that a few upward ratchets on certain margin requirements would kill the commodities market. I don't speak from lack of experience. We are all traders; we all like the freedom that brings; and our livelihoods are in jeopardy.
Good luck to us all. The world has changed, and continues to speed with reckless blindness toward a future that I doubt will turn out well.
Alston Mabry writes:
Here is a question that might elicit some interesting answer:
Let's say you have $X (USD) that you must commit for the next five years. Where would you put it? Leave it in dollars? (Though a 5-year Treasury would make the most sense for "cash" with a 5-year lockup.) Gold? Stocks? Some other currency? Norway bonds? And why?
I don't have a good answer to that yet.
Steve Ellison writes:
My starting point on this question would be that diversification, including international diversification, reduces risk. The US economy and the Eurozone have roughly equal GDPs. Japan and the UK are smaller but still quite significant. China is tied to the US dollar. Therefore, a diversified cash portfolio might be 40% US dollars, 40% euros, and 5% each of yen, pounds, Swiss francs, and gold (in recognition of gold's historical role as a form of currency). One could fine tune this allocation to include small percentages of currencies such as the real and Canadian dollar. I would think of this allocation as the equivalent of an index fund, before considering the insights of the many on this list that know more about currencies than I do.
November 8, 2011 | Leave a Comment
Real interest rates are back near their recent record lows (5 year TIP= negative 1.2%; 10 Year TIP= negative 0.15%); and gold's recent behavior is once again consistent with these facts. Riddle me this, Batman:
If I buy a 5-year TIP at a negative 1.2% real yield, and hold it to maturity, that means I am certain to lose 1.2% of purchasing power over the next five years. BUT: Were I instead to short a 5-year TIP at a negative 1.2% yield, and hold the short to maturity, does that mean I am certain to make 1.2% of purchasing power over the next five years? And, how can BOTH of these statements be false?
Private riddle for The Chair:
What do Galton, Batman, and Robin have in common?
Robin: Holy molars! Am I ever glad I take good care of my teeth!
Batman: True. You owe your life to dental hygiene.
Sushil Kedia writes:
Logic Riddle is a misnomer for what is truly a contradiction. The presentation has a contradiction. In life, in markets there are no contradictions. Allow me to quote Ayn Rand from the Atlas Shrugged, "If there is a contradiction, check your premise".
Rocky, your logic is based on inflation remaining what it is right now the same also during the maturity and at the point of maturity of the 5 year TIPS! Market is not pricing that! Market is pricing inflation will come down! That's all. Check the premise, there are no contradictions.
Purchasing Power is a good term to help create this contradiction. Purchasing power will be Cash in your hand on day of maturity Divided by (1+inflation)^5 if I take the Annualized realized inflation readings. Realized Inflation readings five years from now will be known only then.
Rocky Humbert responds:
1. You should check your bloomberg before you check your premise. These bonds are trading above 105 in price (even forgetting about the inflation adjustment).
2. That means it's possible to have not only a negative REAL YIELD but it's also possible to have a negative NOMINAL RETURN! (So much for the risk-less treasury market.
3. Your definition of purchasing power is unusual. Purchasing power has absolutely nothing to do with the cash in your hand. It's WHAT YOU CAN BUY with the cash in your hand. (Stefan — please elucidate this point).
4. Your statement "Market is pricing inflation will come down! That's all. Check the premise, there are no contradictions" is 100% UPSIDE DOWN. There is little justification for locking in a negative 1.2% compounded real yield UNLESS you have no alternative investment that does better. You need an inflation assumption of RISING INFLATION not falling inflation due to the way these seasoned bonds behave.
I reckon, back of the envelope, north of 3.8% compounded CPI…. is required to have these TIPS beat the bullet 5 year … and even then you still lose 1.2% of purchasing power (compounded) per year. If you want to bet on disinflation/deflation, you would short these bonds at 105 with an inflation factor of 226/220 with abandon, and buy 5 year bullet bonds to term.
Batman just ended. The Flintstones are on now.
Charles Pennington writes:
That's a very nice riddle.
These bonds trade dearly I think because there aren't many other competing foolproof CPI inflation hedges.
Obviously if you short the bonds AND hold the short sale proceeds in cash, you are at risk of losing money. You short $1 million in bonds and hold the $1 million proceeds in cash. The bonds could go up in nominal terms by a factor of ten to $10 million. Meanwhile your short sale proceeds sit there in cash, still just $1 million, and when you cover, you lose $9 million. That's a loss in any terms.
Of course, if you could use your short sale proceeds to buy something that tracks the CPI without the built-in "negative carry" that the TIPS have, then you'd have a perfect arbitrage. But such a thing doesn't exist.
Tyler Mcclellan comments:
A 1 year bond is four three month bonds.
A three month bond is a treasury bill financeable for cash as legally defined by the government at the rate set by the federal reserve.
If ex ante you knew that rate, let's say it would be zero for the next year, then if the one year note traded at 1 percent, there would be risk free arbitrage in buying the note (because the note is defined as acceptable collateral to get cash without exception at the overnight rate, it is perpetually fungible).
But all of this is true because arbitrage needs a unit that you're left with at the end, say for example cash, to make the calc.
I will not solve the last part of your riddle yet Rocky.
Let me ask, can the fair value of cash, the unit of account in arbitrage, which is merely the desire to lend known resources today for unknown future wants x years from now, change?
I don't want to lend at these rates.
I'd rather just have the money in the bank.
But if you know the money in the bank is guaranteed to earn zero shouldn't you buy the bonds and finance them at zero?
And if you know that the nominal bond is priced on the arbitrage condition above, and you believe that inflation will be three percent,t hen if you short the bond and earn the overnight rate risk free, and buy the tip and pay the over night rate risk free,and you hold these positions to maturity, since they are both fungible for cash, then you are guaranteed to earn the difference between future CPI and the ex ante break-even, which is an unknown variable free to take any value.
If you had an opinion on the future rate of inflation you could express that view only because of the other variable being priced to remove arb.And the riddle you speak of which seems to be, why would you commit ex ante to a negative real return can be answered by saying arbitrage of the other instruments demands that only the break-even and not the real rate is solved for by the buyers and sellers in the tips market.
Then What is the real rate set by? That is a very tricky question. The answer is in the above, but not obviously.
Duncan Coker writes:
I believe selling the 5 year Tip and buying the 5 year bond would do better than 1.2% (anti negative real rate) and would actually capture the inflation rate of around 2%. Empirically if you convert them to zero coupon for calculations then sell the 5 year tip around 105, buy the 5 year bond at 95, this makes for a compounded return of around 2%, 10 profit, holding to maturing. But then again there is a reason I don't trade bonds much.
Michael Cohn comments:
I think of tips only in term of the real yield. It would take a very unusual set of circumstances to get me excited about investing in a situation where I can earn a negative real return. These bonds, if I recall all have CPI floors built into them so persistent deflation while sapping a bond of its built in inflation accretion can't turn the redemption figure below par. Each bond has a different sensitivity to the built up inflation component depending upon when issued. This is because the bond pays the same real coupon and the principal balance is adjusted by prior CPI (riding on a train so can't look up)
Certainly these bonds are one of the only high quality ways to hedge inflation. There are a number of global ways to do this but France, etc. Have bigger issues.
So what can happen when you short one of these. I wonder for those who can obtain info what the cost to borrow for the short is here. Obviously the overnight reinvestment is not a plus here.
Seems like I should expect to earn the real yield in this case which is a depreciation toward par but what is my short cost?
Tyler McClellan responds:
I set up my example clearly.
The reason the thirty year bond cannot be arbitraged to short term rates is very simple. There is no way to credibly make the claim that short term rates will be X for thirty years. There is no institution that can impose the stick. I put very little weight on all the other things. Its the fact that short terms rates could be radically different in the future that generates the volatility not the other way around. Long bonds are very convex and thus this is a major reason they should have a lower yield, offsetting the term premium.
Your examples about LTCM and MF Global are meaningless. Their assets were never fungible at 100 percent leverage for the overnight rate. The Fed conducts monetary policy by making cash and bonds of certain maturities exchangeable for each other at certain overnight rates. To compare this to MF global where the bonds are explicitly not instantaneously fungible with cash (euros) is very odd.
Your example about RV strategies in fixed income is a good counterpoint to the limits of arbitrage. I agree that a one year rate 29 years forward is not subject to the same laws of arbitrage as other instruments. This is for a simple reason. The one year rate 29 years forward is not something that is dynamically set in the market by participants trading until equilibrium. It is an artifice of other things that are traded in this manner and thus it "falls out" of other asset prices.
In general arbitrage is the mechanism by which the sum of views in the market derive their equilibrium condition. You have to have a variable that reflects some view for arbitrage to do heavy lifting. I cannot arbitrage a one day interest rate 17.75 years forward for the simple fact that there are no views on that variable and thus it is merely an artifice that arises from the ecology of the market.
As for mingling "real and nominal". You do not understand your own analysis. The market already believes that we will have about 2% inflation and is nonetheless holding cash at 0%. So the accepting of negative real returns ex ante exists in many markets as a necessary fall out of accepting other variable. To say that this comes from the TIPS market is strange. All the tips market does is allow people to have differing views on the future rate of inflation. Everything else is determined by much more liquid (and therefore likely to be subject to arbitrage pricing) markets.
You will get negative real returns (your vaunted guaranteed decline in real wealth (a phrase that I dont understand)) ex ante in either the nominal or the TIPS market. If you reread what you wrote, you will understand this has nothing to do with TIPS.
As for your last question. You already understand the answer rocky. You get more than PAR day one for being short the TIP.
1) take all those proceeds and reinvest them at the fed fund rate at the future path
2) and if inflation is equal to the breakeven-rate
3) then you will lose the real value of the capital lent to you at exactly the same rate that the market says the real value of the capital lent to you must go down ex ante.
Put another way,
1) you must earn the nominal return priced in the market,
2) experience the inflation rate priced into the market,
3) and deposit your funds at the monopoly price set by the FED,
then you are indifferent between the two outcomes and are guaranteed to earn the same negative return. Which is of course why there is a market. All of which i wrote a long time ago as a explanation for why it might make sense to be short tips but if an only if you could tell me why based on your estimate of the above three variables. Any speculation on the real rate is meaningless, it is not a variable one can have a view on outside of the above (if and this is a key assumption, cash money from the fed reserve is the unit of account you wish to sum all the steps across. Its very possible the real term structure of other commodities is different)
Rocky Humbert responds:
I will address your many points more specifically when I have some time. But I will make a very simple observation (which you ignored)….which has to do with the interactions between inflation and tax policy and the zero interest rate boundary problem.
Let's assume a simple Taylor rule and that the fed sets overnight funds at inflation+100 basis points. Let's further assume a marginal tax rate of 30%.
Case I) Let's assume that inflation is running at 5%. Then fed funds is 6%. Then my after-tax nominal return = 0.7x 6% = 4.2% and my after-tax real return is negative 0.8%.
Case II) Let's assume that inflation is 2%. Then fed funds is 3%…and my after-tax nominal return = 0.7×3%= 2.1% and my after-tax real return is positive 0.1%.
Case III) Let's assume that inflation is NEGATIVE 2%. Then fed funds is 0% … and my after-tax nominal return = 0%, but my after-tax real return is positive 2%.
This is a clear example where real after tax returns behave in counter-intuitive ways…. and so the apparent negative return on TIPS might have less to do with inflation expectations per se, and more to do with the tax effects…. (or more succinctly, an investor in Case III above would be willing to buy a tip that has a negative 2% real yield and would be indifferent to case II, where the same TIP has a +100 real yield.) Just a thought
Tyler McClellan writes:
Very true. I once worked with Paul McCulley on the tax implications of same. As you never posed that as a question I didn't address it.
I agree with your points and thing it is a modest contributor the the current equilibrium pricing.
Philip J. McDonnell writes:
I think one point that has not really been made in this discussion is that TIPS are paid back at the greater of inflation adjusted value or par. This means that they have an implied deflation protector built in.
It is like a deflation put which has intrinsic value in and of itself. In many ways we are in a deflationary environment caused by the great credit bubble unwinding throughout the world economy.
Gary Rogan comments:
I just scanned the riddle discussion. It seems to me that the reason you can't make money shorting TIPS is like the obviously idiotic action of shorting dollars in dollars. Let's say you decide to short a million dollars, and sell it to someone for a million. That's what shorting is, and yet you are in exactly the same situation as you once were.
If TIPs are losing purchasing power against a basket of commodities, but dollars are losing it faster, if you short TIPS you get something that loses purchasing power even faster than TIPS, hence no gain. If you could find a way to get paid for your shorted TIPS with a basket of commodities, and there is high inflation, you can buy them back with fewer commodities, so you make a profit.
August 23, 2011 | 5 Comments
People are lining up in Wesport, CT to sell gold coins, according to a report on Seeking Alpha .
Has anyone ever reliably made profits from bubbles? If so, their existence can be prospectively determined, if not there is no clear answer. It's true that there may be people who know a bubble with 100% certainty, but they don't know where they are in the cycle so they are too worried about shorting them. This is pretty morally equivalent to having no idea about the existence of a bubble, although not quite. I'd say if someone can reliably predict that within a "reasonable" time the bubble will deflate below the current level, and are willing to bet on that, they "know" the bubble exists.
Jeff Watson writes:
Look at the 1980s Hunt Brothers silver debacle. Despite the big move in silver, I never knew anyone that made a boatload of money off of that huge move. I heard lots of tales of people getting rich off the silver market, pyramiding $5,000 into millions, but those people were always friends of friends twice removed, and nobody in my clearing firm, none of my buddies ever nailed silver. I suspect those people who got rich off of the silver market are as elusive or mythical as the Yeti. I also suspect that if you were long that silver market with a $5,000 account that you would have stood a better than even chance going bust.
Rocky Humbert comments:
The Hunt Brothers episode was a corner in an overleveraged market. I'd argue that the gold story today is totally different. Importantly, it's not a leverage-fed, euphoric or happy bull market. It's a funereal bull market. Because if gold is right, and it keeps going and going and going (?5,000? ?10,000 ?20,000 +++) all of one's paper assets will be worth what they are printed on, and the Chair will find out exactly what 2008/09 would have looked like without massive central bank liquidity infusions. (And being short stocks won't help either, since there won't be anyone left to pay you back.)
Hey Gary — for someone who thought total financial collapse was the "ONLY" outcome, how can you NOT be massively long gold??? That's not a bubble! Or is it? As I've been writing for two years now, gold's ascent is a confluence of negative real interest rates; undisciplined central bank behavior; a growing loss of confidence in government policies and financial systems; loss of Swiss bank secrecy; an accumulation of economic wealth by individuals in parts of the world without stable property rights and rule of law; etc. The CME can raise margin requirements all they want; but there needs to be a change in the underlying fundamentals (and/or perception of the fundamentals) to end this period. What will that change look like? Shouldn't that be the question on the table ….
Gary asks, "Can anyone reliably make profits from a bubble?" Hmmmm. Warren Buffett keeps a sealed envelope in his desk drawer with the name of his successor. In contrast, I keep a sealed envelope in my desk drawer with the EXACT high price in gold. Neither of us allow any peeking (or peaking.)
Note to Anatoly: You recently wrote that you think gold won't go all the way back down. If you believe that this is a genuine bubble, then you'll have been wrong on the way up. And on the way down. See Jeremy Gratham's extensive work on bubbles — and his observation that they retrace >100% of the parabolic extension.
Stefan Jovanovich says:
The U.S. Treasury had enough gold to be able to promise to redeem the customer balances of every member bank of the Federal Reserve in the United States in 1930; had that step been taken, the U.S. would not have suffered the extraordinary collapse in demand that created the death spiral of world trade
Tyler McClellan asks:
Just for fun, how would you have lowered real interest rates in the US, without dramatically widening the gold points, or say just abandon them all together.
Stefan Jovanovich replies:
Why would I want to administer interest rates at all? The problem with the Federal Reserve system is that its underlying premise is that the government should do so. Nothing can prevent speculation from having a component of folly and ruin — like all of life. The idea that the government — which is itself an interest group of the employees and beneficiaries of government borrowing and spending — can somehow avoid the same folly and ruin in its speculations seems to me to be the funniest of all the lunar illusions. Remove the notion that somehow banking is a special kind of business that requires absolute government guarantee (which, as we have seen, the government cannot afford any more than anyone else) and a great deal of the folly and ruin disappears because the truth — that everyone in commerce works without a net — is transparent. As someone once said, the illusion of safety is the most dangerous of all ideas.
I highly recommend the book Against the Stream: Critical Essays on Economics by Gunnar Myrdal.
Almost all of it is intellectually reprehensible, but the frankness of the views and the plain speak with which a nobel laureate holds forth (and he is amazingly funny) is worth investing some time in.
May 11, 2011 | 1 Comment
I keep wondering if AAPL will be the first $1T-market-cap company. It's hard to accept that number if you're an old fart with a set of mental reference points that do not encompass market caps that begin with "T".
Right now AAPL has ttm net income of about $20B, and sells for 16x that number. So at the same multiple, $1T in market cap would require roughly $65B in net income. Is it possible they could get there in the next 3-4 years? They may break $100B in revs in calendar 2012. They also have $65B in cash on the balance sheet right now. By 2015 that will be…$150B? $200B?
The first $100B market cap was a big deal, too, though I don't remember which company it was.
Tyler McClellan writes:
The reason apple will never get close to a 1 trillion market cap is very intuitive.
At that level they would be the largest net lender to the U.S. economy other than Japan or China. What are the prospects of a company that lends all its profits to the U.S. at zero percent interest rates.
In fact, I will go further and say that the cash on the balance sheet at Apple is exactly equal to the amount of savings that society wants to do and apple refuses to accommodate.
For all of you who think you understand economic theory very well. What company supplies net capital to the economy at ever increasing rates even as its own prospects continue to improve vis-a-vis the economy?
Apple is a great lender to you and me, who have no need and no want for these lent funds, in exactly the opposite proportion to the amount you and I want to save in apple given its huge scope of opportunities.
Apple positively refuses to allow people to save. They force people to dis-save.
And for those of you who think the impetus to competition makes up for this (i.e., inducement effect of high market cap). Microsoft makes more net cash flow than all of the venture capital in the united states.
Apple itself makes nearly as much in free cash flow as the entirety of venture spending (that's in all categories at all stages).
Jeff Rollert writes:
Aren't market caps just measures of human preferences? If so, then they are good measures for where you are, not where you will be, as much of this behavior mapping is coincident.
A trillion seems to trite these days.
Alston Mabry writes:
I think size matters. Here are some more stats for AAPL:
last two quarters' YOY rev growth: 70%, 82%
last two quarters' YOY earnings growth: 74%, 91%
annualized growth rate of net income since 2005: ~60%
PE based on most recent 4 quarters: 16.3
PE after backing out $65B in balance sheet cash from mkt cap: 13.2
Now, imagine you saw those growth rates for revs and earnings, and that PE ratio, in a company with a $1B market cap, a company that had relatively limited market penetration for most of its products. "Is that something you might be interested in?"
So why aren't we more interested? Because people think AAPL is too big already. But maybe we have entered a new era of an expanding global economy in which there will be many companies with trillion-dollar market caps. As a popular and much-quoted writer and self-styled philosopher called it: the "JK Rowling Effect".
At one point in January 2000, the top ten (or twenty…I can't remember) stocks in the Nasdaq 100 had a total market cap of $1.6T and aggregate net income of about $19B, for a PE of 83. AAPL's current ttm net income is $19.5B, it's market cap $320B.
Frame of reference…point of view…big round numbas….
Alston Mabry asks:
So you're assuming that rates will still be zero in, say, 2016? Could be. But what if the whole curve is pushed up two or three hundred basis points by then?
Tyler McClellan writes:
Their actions as representative will force the rates to be low.
If the worlds most rapidly growing large enterprise refuses to borrow funds at 70% internal growth rates and is more than happy to lend them at 0% interest rates, then what possible companies demand to invest more than their willingness to supply savings?
It's a big fake that no one is supposed to talk about, our best companies don't want any money no matter how fast they grow, and in fact the faster they grow the less money they want. But wait, that's great, you say, because it means they create value out of nothing, and that what economics is. And isn't it true that companies can have value only if the sum of their discounted cash flows are positive, so doesn't that mean were wealthier if all of our companies have really high net cash flows.
And of course the answer to the above is categorically no, but I don't suspect what I've written to make a bit of difference, so back to my little day solving equations.
Rocky Humbert writes:
Tyler: I'm not sure it's appropriate to generalize from AAPL to the entire economy. AAPL is sitting at the top of the technology food chain, and they are benefiting from the investments being made underneath them. It's surprising, but Apple is NOT investing in R&D in a meaningful way… and this demonstrates that they are much more of a marketing company (like Proctor&Gamble) than a technology company. Hence they will eventually need to either buy back stock or pay a dividend….
R&D as a Percent of Revenues:
(Source: Bloomberg, FA IS page, trailing 12 months)
"The Poor" have very little to surrender. Direct payments to people who are broke - cash, housing and food stamps - are about 1% of the unified local, state and Federal budgets. The debate is about "jobs" - i.e. working for the government and doing work that only government regulations require to be done. The argument over Medicaid - the largest single expenditure for "the poor" - is about the medical paperwork and other make-work that program supports far more than it is about the medical care actually being provided to the poor.
As a friend of mine once said about the Peace Corps (he had himself been a volunteer), "if they had taken all the money they spent on me, my plane ticket and the support and divided it up among those people I was "helping" (sic), they could have bought enough decent farmland to become rich in their own country." When I wrote to him recently to ask if he had changed his mind, he wrote back with this:
"Hell, no. If anything, I was being soft-headed; I still thought that people really intended to help the poor, but they just didn't understand how to go about it. That was a childish illusion. Changing the world" by official decree and government action is and always has been first and foremost about having conferences and meetings and policy discussions and their own pensions. That is why everyone who rants for social justice is so quick to accuse others of selfishness; they are worried sick that somebody else might get their hands on the public purse."
Tyler McClellan comments:
I have never met a person who I felt truly understood social security. Let me point the way forward in all humility. The money could never have done anything but be spent immediately upon receipt. The goal of social security was two fold, a transference of net wealth to the old in the first generations as an inducement for other things and more importantly, the creation of an indefinite means of savings. Savings that would be repaid based upon whatever happened in the future with no need for action in the present to make any reference to that specific future which would square the circle: a perpetual and confident solvency with only the extent of the future burden left to calculation.
It was a great leap to realize that all savings is contingent, and that which is most contingent is that which is most valuable. No trust fund ever existed, nor ever will, but by this great leap we have been able as a society to save without any commitment to the form our means of saving must take. If we spent the money poorly, no matter, so long as some in the future acquired income wisely that we might tax.
Of course the program has worked brilliantly because it is the only one to deal honestly with a contingent world (aided no doubt by the twist of phrase that we all earned it by paying in, an infantile but successful appeal to merit).
Certain people have never liked social security but that is related to the fanatical obsession with Say's law that is a great undergirding shibboleth to a whole caste of mind. The caste of false rectitude.
If all Americans gave 90 percent of their income to the poor in Africa and Africans bought nothing from Americans, 90 percent of the income in America would cease to exist and our per capita income would become African.
I'll leave it as an exercise to the reader to prove that it is impossible to transfer cash from one group to another in any large sense if they don't bank or trade with each other.
I didn't want to embarrass my friend by allowing Vic to publish this, but he said OK– anything for the one guy I have ever known you, Stefan, to voluntarily address as the Chair. So, publish away.
Victor Niederhoffer responds:
You are much more of a chair than I. The chair has a connotation of derision in it which I like which my former employees gave to me because I was somewhat immobile in my positions when they went against me, and in my seat unless I was playing tennis because of my old hip problems. They used to call me vicious vic when I played squash but I changed that to relentless vic or some such which my opponents were quick to adopt because they were afraid that if they didn't, I wouldn't let them maneuver to get on the other side of the draw from me so they woudn't have to meet me until the finals. I do not have that mojo with my trading as of yet, but I am hopeful that instead of being known as the blow up artist that some day they will call me the Phoenix or some such.
Stefan Jovanovich replies:
No question. My friend's suggestion presumed that the owners of the better farm land already traded with America since they were the very politicians who cut the ribbons in the photo ops with the visiting Peace Corps' senior officials. If the poor farmers had the U.S. legal tender with which to buy the land, the politicians would be willing to sell because they couldn't put the soil in their foreign bank accounts. It would be another form of graft (less complicated than the grand tradition of stealing and selling the U.S. food aid), but this form of graft would actually benefit the poor. My friend says it would have been another form of "honest graft" - just like the old days when your cousin (my friend's name uses its y's for vowels) got a job working in the sewers and actually worked in the sewers. The only net losers would be the Peace Corps' officials who, given their respectable backgrounds, could surely find other work.
Ralph Vince writes:
What certainly won't happen in our lifetime (and, sadly, our forefathers had big balls and small brains, and never had the vision to bite this bullet) is to create a pension to sink ALL future government liabilities. The scourge of taxation should have been eliminated by now, and we have yet to even start down that necessary path.
Look, if we could pay down the national debt, even to a small degree, then, feasibly, the entire thing could be retired. And, if that were the case, then a cache of 50 trillion to the positive, at thirty year domestic rates, produces the (quite obscene) 4.5 trillion budget.
But we never got to that point — and we never will until we see that it can be done, must be done, resolve to it, and then start down that long road. It will take generations — and although a pity no previous generations had the vision or will to do this, doesn't excuse ours.
I'm writing this only because I think it might clarify some sloppiness in how people frame the U.S. debt problem. Thanks for the great site and the consistent advocacy for substantive discourse.
The Hydraulics of Debt are quite simple. It is impossible to lend without someone borrowing. When I buy shares in the stock market, someone is selling the shares. The marginal price at which this transaction takes place becomes a means of savings only in a roundabout way. At the end of the period we look back and say, well society earned $15 in money income, how was it spent? Some of it was consumed; some of it was held over against the future periods either in the form of additions to the capital stock or in the accumulation of inventory. Theoretically, the transactions that establish the price of the existing stock of assets (via the marginal buyers and sellers trading in continuous price discovery) also proscribe the amount of real investment that firms do . This happens both by encouraging existing firms to add or remove capital from their existing stock and also by incentivizing new entrants to produce capital of greater market value than production cost. No one saves by putting money in the stock market.
That's it, market prices effect our collective prosperity only through this roundabout and tenuous manner. Why is this relevant to the debt question? To understand the debt question, we have to first understand how tenuous savings is. Society as a whole cannot save by everyone putting money in the bank. Society is not better off if all its companies are profitable. If every company in society returned cash to its claimants (profits less capital expenditure), then society would be getting progressively poorer. We would be consuming our capital stock and suffering a real diminishment of wealth. We might care that companies are profitable because it means that their stock prices will be high, but the truth of this proposition rests on the further observation that these high prices for the stock of wealth induce creation of new wealth. High stock prices can be useful in accommodating demanded savings by serving as the basis for investment.
There are many reasons why our psychological demand to save might differ wildly from our psychological demand to invest. Most of us experience this radical difference every day. We accommodate our pessimism about the future by saving. We accommodate our optimism about the future by borrowing (investing). We are able to divorce these two things by an institutional sleight of hand. I need not intermediate my own saving demand and my own investment demand. Rather the market will intermediate all such savings and investment schedules. How this is accomplished is too long a story to go into. At the end of the period, the fact that savings and investment will be equal to each other is an identity of accounting that gives no flavor for the the great search in time that renders this identity true when looking backward. This is the fundamental insight of economic modeling. Things that are both identically true from one perspective and radically undetermined from another constitute the economic field.
All of this as a long prelude to an identity which should be hammered into every college students head. The borrowing by foreigners, businesses, households and governments has to be exactly equal as an identity to the money lent by foreigners, businesses, households and governments. It is nothing more than an identity to say that if foreigners, businesses, and households are all net savers then by definition the government must be a net borrower. But it is a deeper truth to say that the government borrowing is the means by which this savings is even possible.
So far we're on solid ground. Most observers understand intuitively that the motives causing businesses to fail to invest all their net proceeds are not related to current government policy (this has been a longstanding trend based on the increasing power of the tautology that a business is worth only the sum of its discounted future cash flows). Some observers still claim a mythical means by which government is causing this gap between funds received and funds spent. A concise refutation of this idea is that the hydraulics of debt necessitate companies lend this difference to the government. "We have no faith in our government, but we'll lend them trillions".
Most observers think it is right for households to become net savers, although the people who work building houses might disagree. But again, as a class, you cant be a net saver without someone else being a net borrower. We have already seen that businesses also refuse to be this class of borrower.
Most observers, other than the foreign governments themselves, believe that America should increase its foreign savings (by decreasing its borrowing from foreigners). We're trying, but we've also been trying for many years.
And so we're right back where we began. But now, instead of the government borrowing being an identity, we've suggested that much of this borrowing in involuntary in the sense that it has been driven by the collective desire to hold excess savings. The people's pessimism is driving their government's borrowing at least as much as their government's borrowing is driving the people's pessimism.
This has gone on way too long, for which I apologize. Ill just end by making a quick allusion to the "unfunded liability problem". Be wary of false identities. If we have a 200 trillion unfunded liability we also have a 200 trillion unrecorded asset. If those benefits were ultimately paid out they would flow through the economic system and redound to who? You guessed it, us! So what is the true fear about this unfunded liability? Ill leave that for another time. Maybe we should run around screaming, "those doctors and nurses are about to make off with our unfunded 200 trillion asset, to the barricades!"
Connections. That is the nerve center of market knowledge. Recently I came across a great connection that sheds considerable insight on an important but controversial subject (please forgive Mr. former rocket scientist) in Mortal Games by Fred Waitzkin. He describes a disease that grandmasters get. It's the disease of thinking that every other grandmaster after them who made more money and achieved more fame was morally corrupt. Botvinnik believed that Fisher had bribed Spassky to win their match. Spassky believed that Kasparov had bribed Karpov to end their matches in a draw and that was the reason that in game 19 of their title match when Karpov had a seeming winning position, he had shaken hands with Karpov, offered him a draw and then sat animatedly analyzing the game.
Okay, if that disease doesn't afflict the old men who don't want anyone else to invest in derivatives or anyone else to pay anything but higher service rates than the current, what does? What is the bacterium that causes this disease? And how can it be used to predict markets and deflate the self serving ballyhoo of these old lions?
Tyler McClellan writes:
Let me suggest, not too strongly, that the answer has something to do with the propensity of wealthy capitalists to make gardening their post retirement focus.
March 17, 2011 | 1 Comment
As $/Yen exchange rate slowly, but as surely as the Geiger counter ticking through 80.00 and toward its all-time record in 79-handle - one pauses and contemplates: is this supposed to be real or surreal?
Here you have a liquid, instantly tradeable 24-hour instrument, which may allow as much as 100:1 leverage to those who qualify and wish to indulge. You have country plagued by apparently irreversible demographic deterioration, now hit with quite a real prospect of not wanting any new pregnancy for decades to come, period. Its Central Bank can, is and will print this currency in perpetuity. Am I wrong in assumption that the only current bidders for Yen are Japanese multinationals, that must temporarily curtail their offshore enterprises in favor of domestic operations? And no one else…
Kim Zussman writes:
A biblical flood: so much money it flows even where it doesn't belong.
Nigel Davies writes:
If Japan needs to spend a lot on reconstruction whilst having little power to export then surely a strong yen makes sense.
Tyler McClellan writes:
It's not relevant to what you guys are talking about,
but of course the truth is precisely the opposite. To the extent Japan needs to get real resources from the rest of the world and can offer fewer real resources as recompense, it ought to offer a greater real share on its future production (which of course can be brought about by having a weaker currency).This is all just water on the bridge, but at least provides a reasonable basis for the conventional idea that the currency should weaken.
But these economic flows arguments are dominated by the change in the relative stock affects. There is a preponderant group of people who want to exchange a stock of dollar denominated assets for yen denominated assets. For purposes of this example, it doesn't matter that they dont know in which form to hold these yen assets (certainly not in stocks).
There is a meal for a lifetime here, but it is a complex one. It has to do with this observation, what does it mean for a given type of assets to be priced as the marginal equilibrium between buying and selling? Does this sensitivity to various changes of marginal preferences say something about the assets class and how partial equilibrium is achieved?
Perhaps I'm being not being clear enough, for the foreigner who happened to hold his worth in indeterminant yen assets, this constellation of events has been perfect. Why should that be the case?
Before one is seduced into buying some five year, one should remember that the average real-yield for five-year notes (versus cpi):
Over the past 10 years: +103 basis points
Over the past 20 years: +215 basis points
Over the past 30 years: +321 basis points
Over the past 40 years: +240 basis points
Currently: 1 basis point.
Instead of buying a five year note, one's time may be better spent watching the scene from Das Boot when the U-boat sinks to crush depth. The sounds of the hull pressure is an apt soundtrack for the current contortions of the yield curve. Despite the bearish observations above, if life follows art, the bond market may be able to surface noch einmal by blowing out the ballast tanks after the refunding … and then limp home…
Tyler McClellan writes:
Well, the geometric return to t bills for all developed countries int he 20th century was about .5% .
The return for longer dated bonds was about 1%.
Over the past 30 years inflation has gone from 10% to 2%. By definition then, monetary policy was sufficient to lower money rates of inflation. Negative real returns to bonds were consistent with modest inflation in the developed world for a 20 year stretch of the twentieth century. And historically the incredibly high real money rates from 1980 to 2000 were more anomalous than any low real rates today or in the past.
Let me make my observation another way. How do you make money being short a two year bond unless short term interest rates are raised? Isn't a five year bond a two year bond plus a three year bond?
By the way, one trade I do like because it is not that negative carry unlike other flatteners, is a real yield curve flattener. (Or just outright buying twenty year tips if they get back to 2%.)
While reading this article "Buying Home Is Cheaper Than Renting in 72% of Big U.S. Cities", I started thinking that one of the major errors of most debt deflation theories of our current predicament is their repeated failure to take account of the fact that by and large rents have not changed in the United States. Namely, it is our expectations of the future (and all the economic activity commensurate with such expectations) that have undergone radical transformation, not the set of possible uses of resources in the present.
This is equivalent to saying a society for which the PE ratio of its equity assets declines is not in and of itself getting poorer.
January 24, 2011 | Leave a Comment
First, why are so many people unemployed? The answer is very simple.
Because there is no profitable work for them to do as present labor
rates. Thanks to previous meddles, the US economy focused itself on
building houses and importing geegaws from overseas for people who
couldn't afford to pay for them. This was a dead-end economic model. And
the end came in 2007. Now, the latest figures show an uptick in
manufacturing…which is clearly the direction to go. But it will take
years before the US economy has made the adjustment to a new, healthier
model…making and selling things at a profit.
In the meantime, unemployment levels will remain high.
But wait…there's more. For which the adjustment is taking place, US
authorities are trying to block it. How? By taking resources from the
new, unborn industries and using it to prop up the old, dying ones. Like
Wall Street, for example. The financial industry grew like Topsy in the
bubble years. It began to shrink in the crisis of '07-'09, but the feds
came in and pumped more than a trillion dollars into the financial
sector, producing record profits for the big banks, but depriving the
rest of the economy of much needed capital.
Not only that, the feds also take the pressure off labor to make
adjustments. Food stamps, minimum wages, unemployment compensation,
make-work, shovel-ready boondoggles - all these things cause workers to
think they can continue as before…that a "recovery" of the good ol'
days is just around the corner…and that they'll soon be earning as
much as they were in 2007. Maybe more!
Want to really fix the unemployment problem? Listen up. Eliminate all
bailouts, subsidies, giveaways and support systems - both to business
and to labor. Abolish all employment restrictions and employment
paperwork. All free labor - undocumented non-citizens - to compete
equally with native-born workers. Cut taxes to a flat 10% rate for
everyone. Abolish every government agency that begins with a letter of
the alphabet. Then abolish the rest of them.
We confidently guarantee that the nation would be back at full employment within 30 days.
Tyler McClellan comments:
This whole argument is bullshit.
The productive industries are by their own choice and for their own
reasons net suppliers of capital to the rest of the economy. It's a
myth, complete myth that capital flows to where it is most profitable.
It flows from where it is most profitable to where it will be accepted.
Stefan Jovanovich writes:
I wish I could agree with Craig, but he omits a significant handicap.
Because of the catastrophic decline in the productivity of American
elementary and secondary and college education, the skill sets of
workers under 30 are far, far lower than they were in 1945 - 1955. The
transcripts are immeasurably more impressive that they were for people
coming out of the military service and leaving college after the GI
bill. That Army confirms this sad fact in its recruiting statistics. The
handicaps for inductees in WW II were that some had had very little
formal education and were underweight from having struggled through the
Depression. The Army found that these could be remedied with "basic
training" in the 3 Rs (Reading, writing and arithmetic) - usually a 3-4
month course - and some decent chow.
The handicaps for recruits now are obesity and the creeping dumbs -
almost all the kids from the inner cities and slum suburbs are fat,
illiterate and without any learning skills. No entrepreneur in his or
her right mind is going to hire these kids, even if Craig's hallelujah
miracle of sane political economy suddenly appears. Full employment is a
long, long way off - as far away for this generation as it was for
people like my father-in-law in 1930. He had degrees in geology and
petroleum engineering from the Universities of Texas and Oklahoma, and
it took him half a decade to find steady work - initially as a
roughneck. These poor (in all senses of that word) kids don't stand a
Gary Rogan responds:
While I agree with all the recommendations, guaranteeing full
employment within 30 day while possible contradicts some fairly recent
Nobel prize work (of course the very fact that Krugman has one
invalidates it stature, but still it's something to consider).
The work of the winners,
Professor Diamond of the Massachusetts Institute of Technology, Dale
T. Mortensen of Northwestern University and Christopher A. Pissarides of
the London School of Economics, is best known for its applications to
the job market.
The researchers spent decades trying to understand why it takes so long
for people to find jobs, even in good economic times, and why so many
people can be unemployed even when many jobs are available.
Traditional economics, after all, would predict that wages should simply
drop, helping the labor supply to meet labor demand automatically and
sweeping jobless workers into whatever positions were immediately open.
These researchers’ explanation addresses the complications that come
from searching for jobs and job candidates: it takes time for unemployed
workers to be matched with the proper opening, since people are not
identical, cookie-cutter units, and neither are jobs.
While all this may seem intuitive, in the 1970s it was considered quite
radical. The resulting insights about how search costs can affect
markets also helped revolutionize not only labor economics, but fields
like public finance and housing economics as well. The work is
especially relevant today, as policy makers try to understand and combat
the causes of stubbornly high unemployment in countries like the United
Stefan Jovanovich responds:
The equilibrium assumption behind the Diamond, Mortensen, Pissarides
study is fascinating. Why should there be any necessary match between
ALL the skills being offered and ALL the skills being demanded? Prices
can adjust supply and demand where markets exists; they cannot produce
demand for skills that offer no profit to the buyer at any price. The
neo-Keynesian fallacy is that money dropped from helicopters will cause
private employers to find profits in having holes dug and then filled up
again; the original Keynesian fallacy was that the government can take
money from the incomes of people whose skills are marketable and give
the money to the hole diggers without reducing the amount of savings
available for investment.
Scott Brooks writes:
Capital doesn't flow where it will be accepted, it flows to where the government allows it to flow.
America is like a sick body riddled with metastasizing cancer. Nothing
works properly in a body that is fighting for it's life. Nothing "flows"
properly. The "Body America" is riddled with the cancer of statism. As a
result, the entire "financial organ" of the "Body America" isn't
Mr. Albert comments:
The 'Greatest Generation' had an enormous advantage. After the war,
the US faced essentially no mercantile or manufacturing competition, and
thus dominated foreign markets at a time of enormous replacement need.
It was easy for the unskilled and unlearned to find work in that
environment. This advantage lasted essentially for the career length of
that generation. Fortunate circumstances coupled with the wealth
transfer of government borrowing and spending fuels the illusion that
somehow they had it right and the next three generations don't.
Craig Mee writes:
Thanks Stefan and co. It
seems he brings up many areas, but at the heart of it, is protection,
and political correctness and slowly slowly, and looking after the
flexions. When in fact a case of strong medicine is often needed, and a
swift kick up the butt.
Stefan Jovanovich comments:
Tyler makes the conventional mistake of assuming capital and savings are
equivalents. People, by and large, have been remarkably canny about what
they do with their savings as long as their money is immunized from the
manipulations of the government and the better class of people
(academic joke). "Capital" - that Marxist construct now used by central
banks presiding over fiat monetary systems - will always want to snuggle
up to the Emperor and the Praetorian Guard and stay as far, far away
from the unruly uncertainties produced by the getting and spending of
the plebs in the marketplace and their insistence of being paid in
Gary Rogan comments:
While there is something to the paradox of thrift as a game-theory
type concept, the idea that the government can solve it through directed
spending is one of the more evil ideas that ever occurred in terms of
Tyler McClellan comments:
I feel very confident in saying you simply
don't understand the paradox. you have likely never read it, have no
idea (unlike stefan) that it arises from the identity of private sector
account that savings must be equal to investment but that our motivation
towards the one is the opposite and equal of the other. That they are
intermediated by the financial system under any circumstance just at a
level that is previously not computable because it would require knowing
what everyone's planned savings and investment were prior to some of
their income being destroyed by or added to based on others similar
calculations. In aggregate society cannot save by dissaving.
Oh yes it can via the production of indeterminant claims by the
government which is a result of excess private sector savings demand
over and above each individuals in aggregate investment demand (real
investment as a flow).
Now Stefan is learned enough to admit that he at least simply doesn't
believe in the identity, which I must admit is too difficult of a
concept for me to think about after years of trying to have kept at it.
Stefan Jovanovich responds:
Tyler and I have a quarrel over the nature of money, and his is most definitely the majority opinion. Mine is the quaint antiquarian notion that (almost) predates utility curves. You find the odd vestige of it (like a kind of monetary appendix) in the valuation of gold at the price set by President Roosevelt's order under the Trading with the Enemies Act (the loophole that allowed the provisions of the Federal Reserve Act to be superceded). This pricing of gold at a U.S. dollar figure other than the current market serves no evolutionary purpose in a world where Tyler's tautology is not only the economic rule but also the legal tender law.
But these odd remnants of a past economic world should serve as a reminder that the idea that a bank's reserve should be specie - a monetary thing tangibly powerful enough to stop even the most severe breaches of trust - was once common wisdom. It is no accident that the term "reserve" came from military doctrine; a reserve was supposed to be the troops strong and brave enough to held back from the front lines with the understanding that they would be sent forward when the frontline troops had been routed. We have nothing like that now. The Reserves of the Federal Reserve and every other central bank are to be found behind the curtains of the neo-Mussolini architecture (both inside and out) of their buildings where there lie printing presses (excuse me - computer keyboards - with linkages so vastly powerful that no skepticism about the ultimate exchangability of the bank's units of "capital' dare be whispered, even by the girl in the ruby slippers. Until now, that is.
Those odd people who insisted that the Federal Reserve Act itself affirm the exchangeability of U.S. Notes (what were to become our Federal Reserve Notes) into gold under the Constitutional standard thought Tyler's aggregations were dangerous because they established a full substitution between money and credit in the name of "capital". Most of the time this aggregation did no harm; but when people were tempted to borrow and spend (as they had in the American Civil War/War Between the States) without any regard to whether the borrowings could, in fact, be repaid in money as good as gold, the ability of the government to create savings by simply increasing paper bank reserves was a fatal temptation. As we have seen, that temptation has been impossible for modern governments to resist whether the war is one "to end all wars" or "against poverty".
Gary Rogan writes:
Whatever the nature of money is, sooner or later there is a war that interrupts even the most stable tax/spend regimes, and there is never enough political will/desire/ability to tax enough to support it. Or there is a "crisis" and the voters in the next election are always more important than the ones in the following one. So sooner or later the government will find a way to corrupt the monetary standard. It just gets irritating when someone like Bernanke is p***ing on everybody's shoes an telling them this is the rain that will finally end the drought.
George Parkanyi writes:
And what government/country/civilization in the past hasn't done this? It's the nature of the beast. Different regimes will do it a different pace, but the long-term historical result will be the same. Read Machiavelli's "The Prince". This is an excellent treatise on how politics relates to human nature. You could always try working your way into office and try to change the government, or become some kind of guru and try to change human nature -good luck with either.
Stefan Jovanovich responds:
No, George. Machiavelli wrote The Prince as a satire. That is why the book was banned by the Pope aka the Medici's ally Julius II. Machiavelli was a republican - i.e. someone who thought tyrannies were bad because they were so ultimately stupid. Under the Florentine Republic Machiavelli was in charge of the militia and he insisted that only citizen-soldiers serve, breaking with the tradition of hiring foreign mercenaries. If you want to know what the man actually thought about "how politics relates to human nature", read Discourses on Livy. Machiavelli had no doubt that people can and do change the government and the world of political-economy they live in; it is the Princes who want us to think that history is a Hobbesian monotony.
Basic economic theory, Marxist, Hayekian, Ricardian, are all in agreement that rich countries should benefit from explosive growth in poorer countries even if they are becoming relatively poorer due to comparative advantage. And in that vein, all readers can rest assured that global energy use (of exclusively fossil fuels even) has been going up very evenly per capita even as the population has exploded.
Stefan Jovanovich writes:
People trading freely with one another, within one country and across borders, benefit from comparative advantage; in a world of administered currencies there is no proof that "explosive growth" benefits anyone since it involves the fundamental mispricing of resources that Hayek found so dangerous. Global per capita energy consumption has grown, but its growth has been anything but "even". Energy consumption per capita was LOWER in 2000 than in 1990.
This reader remains assured that the vanity of unquestioned aggregation is the one vein whose reserves are never exhausted in the mines of economic theory.
Capitalism rests in an energetic sense on one and only one assumption: that the total useful energy surplus keeps going up for a fixed amount of input (either energetic or monetary). This hasn't been true now for a while.
Kim Zussman adds:
To Tyler's point, the attached chart plots annual change in hourly output (blue), and annual change in unit labor cost (red), 1970-2009. Recession-era peak/valley years are noted adjacent to their respective peaks and valleys.
Over the past 40 years, the general trend has been a lower rate of increase in cost of labor and increasing hourly output, with a marked transformation after about 1982 (coinciding with the inception of the great bull market in stocks). Another change was the nature of recessions: The recessions of 74, 80, and 82 were associated with large jumps in labor costs and declines in hourly output. 1990 exhibited this pattern as well, though with much smaller magnitude. However the recessions of 02 and (thus far) 09 go the opposite direction; decline in labor costs and increase in hourly output.
Perhaps some of this change is due to decreased unionization of labor.
Tyler McClellan replies:
Wel,l basic economic theory, Marxist, Hayekian, Ricardian, are all in agreement that rich countries should benefit from explosive growth in poorer countries even if they are becoming relatively poorer due to comparative advantage. And in that vain all list members can rest assured that global energy use ( of exclusively fossil fuels even) has been going up very evenly per capita even as the population has exploded.
October 12, 2010 | Leave a Comment
It's generally accepted that large electric utility stocks are interest rate sensitive. They also have earnings growth based on a regulator-sanctioned "acceptable return on capital." The stocks are considered cheap when they are trading near book value (not now), and also when their yields are relatively high versus treasuries and bonds (yes now). There's some economic sensitivity to electric demand of course– but the stocks are still very low beta.
I posit that at their current relative prices, a basket of quality utility stocks should outperform TIPS… with similar risk and reward. The reason is not that utility stocks are particularly cheap, but rather because many TIPS have trivial and/or negative real yields. In a rising inflation environment, utilities should be able to get regulator approval to raise prices [to maintain their statutory ROE]– and in the current status quo environment, the stock yields will exceed the TIP yield.
At this moment, the 5yr Treasury has a 1.1% nominal yield, the 5 year TIP has a -0.50 real yield, and the UTY has a 4.34% nominal yield.
What am I missing here? Other than regulatory risks, in what environment will the UTY significantly underperform a 5-year TIP held to maturity?
Mr Krisrock comments:
In his book on theory, Ray Dalio of Bridgewater theorized that "stress testing" an investment theme by asking other unsuspecting traders their views, in effect is a surreptitious poll, as we note here in this textbook case of pedestrian "street begging".
Rocky Humbert responds:
Perhaps Mr. Krisrock will be so kind as to put a penny in this beggar's cup with an insight using all of his over-sized frontal lobe (and not just the amygdala).
I thank the speclisters who kindly pointed out (offlist):
1) During the 1930's depression, utility stocks held their dividends… And people who paid their bills saw higher rates to compensate for the people who did not pay their bills.
2) The TIPS will return par at maturity — there is no similar guarantee for utility stocks.
3) Because TIPS are currently trading at a premium to par, outright deflation can be injurious to their returns.
4) Utilities are taxed as corporations — and are also subject to the risks of cap&trade etc. However, the state rate-setting boards may/may-not compensate for the increased costs of cap&trade with rate hikes.
The daily and weekly statistical correlations between utes and tips are quite poor. But as the attached chart shows, they do seem to move in the same directions.Perhaps foolishly, I'm least worried about technological innovation– because the primary motivation for investing in a regulated utility is that they set rates based on a statutory ROE….
Jeff Watson writes:
Wireless electrical power transfer has been around since Leyden, Franklin, van de Graaf, and Tesla, just to name a few. Radio waves are a wireless electrical transmission system….just ask me, as a ham radio operator I have gotten many very nasty RF burns when my system wasn't properly grounded, or I stood directly in front of a beam antenna when someone keyed up the transmitter putting 2KW through the antenna. Further back was the study of charged amber by the ancient Greeks and the ability to turn static electrical potential into kinetic energy. The thermoelectric effect has reputedly been described since the middle ages. Now, the newest commercial application of wireless electrical transfer is with those new cellphone and iPod chargers where you just lay them on the pad and it magically charges the batteries with no electrical circuit. One might expect for more practical applications as time goes by and the market demands the convenience.
Mr. Krisrock adds:
In India, for example, there are many rural areas without electricity or the likelihood of same. Some years ago we partnered with Reliance and built cell towers with solar panels that allowed locals to plug in their mobile phones into the cell towers to recharge them. Until we did this they had to send them back to the cell phone company to recharge them…clearly some pennies for the beggars cup….
Tyler Mclellan comments:
You're missing this. The future nominal rates are the sum of the short rates (at least to some point on the yield curve). If you finance the position at overnight money (which many marginal buyers do), you cannot lose money if the sum of the short rates is less than the yield. I repeat, no matter what happens to inflation etc…you cannot lose money so long as the short rates one finances at are less than the yield. Through one more iteration, TIPS work the same way.
So i suspect the answer to your question has to do with the nature of "return".
David Hillman adds:
Once we could not imagine a wheel nor a printing press nor telescopes nor electricity, nor steamships, nor the camera, nor the radio, nor the automobile, nor the incandescent light, nor telephones, nor submarines, nor television, nor computers, nor endoscopic surgery, nor nanotechnology.
The 4 ounce, 4.75"x2.5"x0.5" device clipped to my belt is a GPS, a voice recorder, an 8MP camera, a calendar, an alarm clock/stopwatch, a music/video/tv player, a language translator, a dictionary, an encyclopedia, a library, an internet browser, it allows remotely operating a computer half-way across the globe, it connects to gmail, to WiFi, it recognizes touch commands and voice commands, it will both convert the spoken word to text and vice versa, and oh, yes…..it's a telephone, too. The cost of entry is $99 + $55/mo. Such a device was not imaginable as recently as 20 years ago.
A world without a power grid depends upon a collective will to have it, vision, investment, R&D, innovation, efficient production, practicality, affordability, and profitability.There are many individuals moving "off the grid" now, some adopting current [no pun intended] technology, wind, solar, water, other renewable, that allows same, others eschewing that technology in favor of more basic passive and mechanical means, horsepower and elbow grease.
But while basic technology exists, instead of pursuing advancement in earnest, we persist in taking the easy, short-sighted, petroleum-based way out, screwing ourselves in the process.Still, given the history of technological advancement, one might suggest somewhat optimistically that, someday, we will will it and the question is less "could there be?" than it is "when?" Until then, we'll just plod along from crisis to crisis as we humans are wont to do. Plus ca change…..
Jeremy Smith comments:
You wrote, "It's generally accepted that large electric utility stocks are interest rate sensitive. They also have earnings growth bas…"
"Generally accepted" is statistically incorrect, at least since 1994, which is a long time. Correlation to bond prices is actually negative. Utility dividends also increase. They can estimate 3-4% increase for an index of these, more for the better companies. Of course the longer you hold a higer yielding stock with dividend growth, the more hopeless fixed income is by comparison, especially with regard to income generated. As income rises it forces higher the value of the instrument producing the income, all other things being equal.
Phil McDonnell comments:
I do not think that it is generally accepted that utilities are negatively correlated with bonds but that appears to be the case. I picked idu for utils, tlt for 20+ treasuries and shy 1 yr treasury. For last 105 days of daily net changes we have the following co-terminal correlations:
idu tlt idu
shy - 54 74
Perhaps the utility– interest rate connection is more complicated than upon first reflection. 1. They are heavy borrowers for their capital equipment financing so one would think they are hurt by higher rates. 2. Their are regulated, so when their regulators are convinced that rates have risen they will often give them rate relief which means higher rates are eventually mitigate. 3. The stocks sell in competition for investment dollars with other income producing assets such as bonds etc. So they must be priced to yield competitive returns.
Steve Ellison writes:
Could it be that there is little interest rate sensitivity when rates are very low? Or that the correlation was arbed away when everybody knew about it? Last year, I noted a similar regime change in the correlation of stock prices and interest rates.
Tyler McLellan writes:
Look, stocks and bonds have been Correlated negatively in price terms since 1999/2000, I would bet that utilities have been correlated enough to the market as a whole that they've been at least partially along for the ride.
One reason to suspect this? Maybe if equity price are set my marginal preferences of equity investors if tech stock a goes down and that makes people want to sell some ute b to buy more, it might not matter that bonds are twenty bps lower, especially when the bond buyers don't care about either.
Rocky Humbert writes:
I played with the data a bit more, and it looks like the Tyler and Steve's observations account for most of the the regime change. The Ute's stock market beta/correlation dwarf their bond market beta/correlation (notwithstanding the low stock mkt beta of Utes.) Since stocks versus bonds have gone their separate ways over the past 12 years– the ute's regime change riddle is mostly solved.
There is one last data point worthy of mention: more than 65% of the UTE's total return is due to their dividends…and the attached chart graphically illustrates investor preference for utility dividends versus bond market dividends. This chart highlights the fact that the mean dividend yield for utes is 69% of the bond yield … and we are currently 3 sigma cheap…on a yield comparison basis. But that's true of many stocks…
My intuition remains that Ute's will probably outperform 5-year TIPS from these relative prices, but it appears that this intuition is a restatement of my bias that stocks overall should outperform bonds from these relative prices. If Ute's get whacked because of a hike in dividend tax rates, this may provide an attractive entry point for Ute's on their own absolute-return merits.
I'd like to thank everyone for contributing their thoughts (especially when they disagree with my thesis). It's a pleasure and privilege to interact with a group of such intelligent, independent-thinking people.
Jim Sogi comments:
Undistributed power using local generation, solar, wind, battery, water will be what undermines the monopoly just as cell phone undermined the phone land grid.
Stefan Jovanovich replies:
I think it is an exaggeration to argue that the cell phone has "undermined" the phone land grid. The "land" grid is, in fact, the backbone that now connects all the cell towers; if wireless were truly able to handle the data rates, the towers would be off the grid. They are not; and the "wholesale" wireless technology– microwave– has been the greatest single casualty so far during this wireless revolution.
September 28, 2010 | 4 Comments
Another interpretation of income inequality is compensation for risk. From updated Saez data, note that top 1% does better in good times, and much worse in recessions:
Real Annual Growth Top 1% Income RAG Bottom 99% RAG
Full period 1993-2008 1.30% 3.94% 0.75%
Clinton Expansion 1993-2000 4.0% 10.3% 2.7%
2001 Recession 2000-2002 -6.0% -16.8% -3.3%
Bush Expansion 2002-2007 3.0% 10.1% 1.3%
Great Recession 2007-2008 -9.9% -19.7% -6.9%
Tyler McLellan writes:
I did some work on this a few years ago and determined that the compounding over long periods of time dominates the skew, to be clear compounding of capital and the flow of income there from in any given year.
There is also a very good intuitive reason therefore why income inequality has historically fallen only during calamity, when the actual capital stock is destroyed/seized or more commonly the connection btwn financial assets and real assets is forcefully separated.
Where can one find a decent return on investment? 3-month U.S. Treasury bills yield 0.13%. 10-year U.S. Treasury bonds yield 2.71%.
The expected earnings of the S&P 500 over the next four quarters are 74.30. At current prices, the expected earnings yield is 6.73%, nearly 2 1/2 times the 10-year bond yield. This "Fed model" ratio was below 1 for years in the 1990s.
Alston Mabry writes:
In early 2000, if you aggregated the top 10 companies in the NASDAQ 100 into a single virtual company, that company had a market cap of $1.6T and sold for 14.7 times revenues and 83 times earnings, for an earnings yield of 1.2%. It seemed like a pretty rich valuation, but people were willing to pay it– for a time. Who's to say the yield on the 10-yr won't go to 1.2%?
Tim Melvin writes:
While not disputing that there are opportunities in today's market, anyone who bases any decision on expected earnings is making a foolish mistake. The margin of error on these estimates is incredibly wide.
Stefan Jovanovich writes:
Rocky Humbert writes:
Quick, back of the envelope, the R-squared between the professor's recession index and the closing monthly bond price is 0.18. The r-squared between the professor's recession index and the closing monthly spx price is .16. If I lag the bond price, the r-squared drops to 0.03
The Professor's Index seems to be as useful as a blind man looking in the mirror….
Which means ….that bonds may yield 1.2% … or 3.2% … or …. ???
Tyler McClellan writes:
Time for the repeating track,
The real return to bonds in the 20th century (relatively long time horizon) ex post does not substantiate the claim that we are at an unusual place vis a vis the return to savings in the government bond market, which is the market for which there is much ability to coerce the means of paying this debt regardless of the source of economic prosperity from which it does or does not arise (I am quite confident unique in that stead, and the reason why anyone who has done a deep study of social security/etc… know that there is very trivial difference in the end between fully funded, pay as you go, etc..we get the prosperity we get, period.)
Future inflation expectations do seem to be very historically unusual in both their low mean level and the historically unusual international dispersion around this level.
This article about how the current behavior of the global financial system cannot be explained by "normal" models of economics or finance is an example of fallacy of composition in that it assumes what would be true for an individual is true for the economy as a whole. In this case it is not. GDP is a measure of what an economy produces in the course of a year. It is defined on a gross basis in that it does not account for depreciation of the existing asset base, but one can also look at it on a net of depreciation basis. Aggregate demand can exceed production to the extent that we import more than we export. But that is not what this author of the article was talking about. Each entity that produces either keeps what it produces as inventory or sells it. The resulting purchasing power can now be distributed to pay its employees, bondholders and shareholders or invested back in the entity in the form of investments in plant, equipment, etc. Those who were paid can then in turn can either consume, invest in their own entities, hoard currency, purchase existing or new physical assets or save using financial markets . Amounts saved as either debt or equity then provide the means for other entities to consume, purchase existing assets, make investments. It also can provide governments the financial means to engage in purchases or transfer payments. The recipients of transfer payments can then, consume, etc. Purchase of existing assets just exchanges assets some hold for purchasing power with which to purchase consumer goods, etc. or save via financial instruments (including equity). It switches ownership of goods such as housing but does not increase aggregate demand that allows for increased consumption and investment beyond what is produced (GDP) plus net imports. Looked at from a different perspective, the sale and purchase of an existing asset such as a house does not create any jobs beyond that of the middle men (realtors, etc.) whose contribution is included as part of GDP.
This is not to say that the distribution of ability to buy in excess of amounts earned is without any macro implications. In an economy with specialization we have to be able to produce something that someone else is willing to buy. Investments are made in order to be able to increase future production of consumer goods. Those investments include physical plant and equipment but also R&D, education and training (development of human capital), etc. For the most part in our modern economy the ability to put sheer labor to use it must be combined with capital that someone was willing and able to provide. When people are not able to find something to which they can apply their productive talents that someone else will buy they do not produce or consume except to the extent that someone or some entity is willing to help them out. When producers miscalculate where the future demand will be at prices that exceed costs of production (including necessary return on capital) certain physical capital and human capital will become wasted and those who invested in them will sustain losses. It also means that labor has to be redeployed. That may mean accepting lower payments as one's acquired skills are no longer valued or necessitate more human capital investment to be able to qualify for available jobs. Note that the return on human capital is dependent on the amount of time left in a working career and the premium over what their labor is worth without having that human capital. This makes it more difficult to redeploy older workers. When consumers go on a spending spree based on credit provided by savers they create more demand in industries that produce what they wish to consume. When they have to cut back capital and labor in those sectors will face lower demand and have to be reduced. When investors become more risk adverse because of bad experiences, etc. what happens is that some sectors will face higher risk premiums which may exceed the rates of return they can expect to earn or not be able to obtain capital at all. Those risk adverse investors will just drive the interest rate on low risk assets to very low levels. That can result in an economy in which government transfer payments increase resulting in higher taxes which will work to discourage even more investment and provide a place for risk adverse investors to place they savings in the form of more government debt issuance. That translates into a lower level of GDP. For an economy to maximize its prosperity one needs efficient capital markets that can move capital to where it is needed most, entrepreneurs and managers who correctly anticipate where profitable demand will be, the development of better technology and methods of production and distribution through research, trial and error, etc. and the willingness to accept innovation, flexibility in moving the means of production to where it can be used most efficiently, trust developed through ethics and culture reinforced by adequate legal systems and policing of crime, savers willing to take an appropriate degree of risk (that is prudent risk to allow innovation and new enterprise but without going into pure speculation), etc. It also requires providing the needed amount of transaction and near transaction means (i.e., money and near money) without causing a change in the overall price level (i.e., inflation or deflation).
Tyler McClellan comments:
What a magisterial post, such deep but sensible knowledge.
I think you might have gone slightly further however and elaborated how much of our economic activity does in point of fact depend on expectations of the future, the Keynesian convention of certainty, when none such exists.
I think your lay explanation of how expectations of the future affect both the demand to save and the demand to invest is very good. Hence the complex interest rate outcome. Much better than my own attempts at driving at this fundamental problem.
The real return to bonds in the twentieth century was 1 percent: 1! [Source: Dimson, Marsh, Staunton]
I think a cross section of all developed countries and 100 year periodicity of returns is enough to say, things are just about right, perhaps real interest rates around the world are still slightly too high (I expect long term, 20 year tips rates to settle right below 1 percent eventually)
One of his big insights is that in the real world the relation "return ~ risk" is often not obeyed. He cites many examples, but a representative example is that risky stocks (whether high beta, high volatility, high idiosyncratic volatility, or whatever) have not historically outperformed less risky stocks. I'm thinking that one possible explanation for this is that when you own risky stocks, you sort of get an implied put option "for free". The market makes you pay for that put option by giving you a lower return on the riskier stocks. Here's an example to make it clear:
Suppose investor A buys the whole market, with beta=1, and gets an average return of 10% with a standard deviation 25%. Investor B instead puts just 20% of his money into a diversified portfolio of high beta stocks, with an average beta of 5. He puts the rest of his money into a "risk-free" investment, and for simplicity, I will assume that the risk-free rate is 0%. What return should investor B expect on his stocks? Well, the conventional academic view is that his stocks should have an average return of 5 times that of the market, or 50%, with a standard deviation of 125%. Since B has only 20% of his money invested, his expected average portfolio return would then be 10%, with standard deviation 25%, the same as A.
The problem though is that B has a safer portfolio than A. B has a "floor" on his losses–he can lose at most 20% of his capital. He effectively has a put option that's 20% out of the money. How much is that worth? Well, to get a ballpark understanding, a put option on SPY, expiring 1 year out, 20% out of the money, is currently going for about 6% of the SPY share price. So in a fair world, maybe B's expected portfolio return shouldn't be 10%, but rather 4%, to reflect the idea that the market makes him cough up 6% to pay for the virtual put option that he owns.
If that's all true, then beta=5 stocks should have expected average returns of 20%, not 50%, and a standard deviation of 125%.
This is only a semi-quantitative explanation, but the point is that when you own higher beta stocks, you're implicitly getting an implied put protection relative to lower beta stocks. If the market is efficient and makes you pay for that put, then the returns of the high beta stocks would be reduced as compared to what you'd otherwise expect.
Disclaimer: For all I know, probably some academic has already thought through all this and demonstrated that it's incorrect and/or insignificant, and if that's so, then maybe someone can set me on the right path.
Stefan Jovanovich shares:
An earlier contribution from Eric Falkenstein– David Hakes' story about the risks of publication regarding the subject of risk:
When we submitted the paper to risk, uncertainty, and insurance journals, the referees responded that the results were self-evident. After some degree of frustration, my coauthor suggested that the problem with the paper might be that we had made the argument too easy to follow, and thus referees and editors were not sufficiently impressed. He said that he could make the paper more impressive by generalizing the model. While making the same point as the original paper, the new paper would be more mathematically elegant, and it would become absolutely impenetrable to most readers. The resulting paper had fifteen equations, two propositions and proofs, dozens of additional mathematical expressions, and a mathematical appendix containing nineteen equations and even more mathematical expressions. I personally could no longer understand the paper and I could not possibly present the paper alone. The paper was published in the first journal to which we submitted.
Lars van Dort writes:
I'm not sure I have much to contribute to the main question your post raises (why is the relation risk-return often not obeyed?), but I must say I was intrigued by your example. I felt it must be flawed, but it took me quite a while to see why.
Let's consider the investment in stocks of the portfolio of B, which has an average return of 50% and a standard deviation of 125%. The following could be one of the possible return distributions, from which these numbers are derived:
Average return = 50%
Standard deviation = (pretty close to..) 125%
We see that the worst possible result is -100%, more would not be possible for stocks anyway. Because B has invested 20% of his total portfolio in stocks and 80% risk-free against a 0% return, his worst possible total return is -20%.
We now have to decide what return distribution to assume for the portfolio of A (average return 10%, standard deviation 25%). There are two options.
We take the possible returns from above and divide them by 5:
Average return = 10%
Standard deviation = (pretty close to..) 25%
Or any other distribution with a worst possible return not lower than
-20%. In this case, the portfolios of A and B can both not lose more than 20%!
We do allow for a worst possible return for A of lower than -20%. However, in the equivalent distribution for B this would lead to a worst possible return for B's stocks of lower than -100% (because x5). This is not possible for stocks, but even if we imagine other assets that can take a negative value, this would have the consequence that B's total portfolio loss is no longer capped at -20%.
But what if we take a distribution for A with a worst possible return of lower than -20% AND a distribution for B's stock returns with a low of -100%. In this case (and here comes the point), for all the values to still add up to the mentioned average return and standard deviation, one or more of the other possible returns in the distribution of A would have to be higher, compared (x5) to B.
So, when one wants to argue that in this situation B's portfolio includes a put option because his losses are limited, along the same lines one would have to argue that A's portfolio includes a call option, because his possible returns are also relatively higher. Although I'm not sure how to prove this, it seems logical to assume these options need to have the same value.
The numbers of the example can be changed, but I believe a reply as above can always be given.
Tyler McClellan writes:
My quick thought is that this is not a good way to think of it.
The idea is to look at the marginal preferences of people with the same portfolio set.
In your example the relevance is not between the two portfolios you list but between what stocks the person with 80 percent in cash should chose for the remaining 20.
But I also suspect you are on to the correct way of getting insight about this, which is to show that the distribution of portfolio preferces is very correlated to specific holding within a category (for example maybe the person that owns risky stocks is highly likely never to own other stocks), such that a dynamic similar to what you describe does in fact happen. (best I can describe it is that the category of people to drive this relationship away by buying the now theoretically mispriced stocks is not big enough to overwhelm the people that continue to want volatile stocks and cash, or some other asset such as you suggest).
Rocky Humbert shares:
There are many ways to look at this; however using a high beta subset of the index has elements of a self-referential paradox and must be avoided.
One thing to recognize is that REAL and NOMINAL interest rates greatly influence the result. In an environment of very high real and nominal rates, and low stock market volatility, one can buy a five year zero coupon bond and use the discount to buy calls on the s+p with no principal risk. At the extreme, one could achieve full index replication with no principal risk, and I'd argue that this would be the perfect baseline for analyzing the issue.
We are honored to receive a message from Eric Falkenstein:
I appreciate Charles mentioning my name!
I think you can create such arbitrage only because the standard CAPM assumes lognormal returns, and for lognormal returns, only the first two moments (mean and standard dev) matter. So, parceling out put options is like saying there are different relations between how stdevs relate to max drawdown due to 'non-gaussian' transformations via leverage, distinctions that by definition are irrelevant within the framework of the canonical CAPM and its derivatives.
Many people, including Markowitz at the inception of the CAPM, have pointed out that returns may have important higher moments–skew, kurtosis, see here on my web site for references. Indeed, Fama did a lot of work on this in the 1960's (see my blog ),and his take-away was that these adjustments merely make second-order, intuitive changes to the base model–complications without much real add. However, downside skewness may be going thru a revival, as Cam[pbell] Harvey (editor of the JoF and mainstream finance archetype) actually mentioned in comment section of my blog that skewness preferences could explain a lot of these negative volatility-return empirical findings.
Alex Castaldo adds:
As they say in China "Speak of Cao Cao and Cao Cao arrives."
March 10, 2010 | Leave a Comment
Shiller, who correctly called the 2000 stock and 2006 home price bubbles, contends the current rally has taken (his version of) stock market P/E above its long-term average, and the on-life-support real estate market will continue to drag on corporate earnings. The concern is that for some time FED/government intervention has artificially buoyed stocks above their "natural P/E"; beginning with the 1998 Russian debt default (thank you Mr. Meriwether), Y2K, 911, tech bubble bursting, and the recent credit crisis. In spite of all this help, we just ended the worst decade for stocks since 1930.
Professor Siegel counters that Shiller's P/E method is flawed, and that a version of analyst earnings estimate suggests that earnings will increase now that the credit-crisis write-downs have been taken.
Another possible explanation for a new, higher P/E regime is the transformation of investor thinking: Stocks changed from the "sucker bets" of our parents and grand-parents to the main-stream, primary investment for retirement. This is a self-fulfilling prophesy: since people associate economic well-being with the market, governments now borrow heavily to buy puts (of course someone has to pay for these, hopefully only those making more than $250,000/yr).
There is no reason embedded in nature that stocks must center about a certain P/E. They could stay higher or lower for decades without reason. One of the weakest arguments in Siegel's "Stocks for the Long Run" relates to the question of who will buy stocks as baby-boomers retire. His answer was foreign investors in developing countries -who currently look to be pretty well stocked up on American securities.
Currently the heroes of liquidity-provision are the mavens of Wall Street, who now hold the P/E levers and remain beholden to a market too big to fail.
Stefan Jovanovich comments:
I share Kim's skepticism about Professor Siegel's end-game for American securities. There is no historical evidence for the proposition that wealthy people in developing countries want to put their savings into the common stocks of the already developed/relatively declining countries. The periphery does not send capital to the center. Europeans bought American securities in the 19th century and again after WW II, when the U.S. offered superior growth prospects; those were precisely the times when Americans kept their capital at home, except, of course, for buying trips for foreign baubles. (Every time I visit the Huntington Library I find myself wondering how much the sale of Gainsboroughs for the pound; perhaps the rich in Singapore will develop a taste for the Hudson River school). The only event that could drag capital from Asia to North America would be the political collapse of China; if that were to occur, the money would be flight capital, and that would hardly be enough to cash out 50 million IRAs and 401(k)s. If the United States is going to return to the path of financial progress, like Sebastian the crab we will have to do it ourselves. It is going to take a while.
On another note, I finally understand Keynesians. You guys literally don't think balance sheets matter; it's all about the flow. But what do you do when the pipes have sprung a permanent leak? Opening the sluice gates won't help because the little water left behind the dam has to be kept so no one will worry about a drought and the Valley farmers have already used up their allotments.I have no understanding of the world of 3rd party incomes and investments - the one where the students don't pay the teachers and the money to invest is always OPM. I have not lived there in 35 years; my last brief visit was 1 year as a salaried tax lawyer before the combination of the 1976 tax reform act and my unfortunate manner got me fired. Since then, all I have known is the world of incorporated wallets. Right now in Munchkin Land investment bargains exist; but they are there precisely because the income flows are diminished. The prices have come down because the people who own the businesses do not themselves have the cash to reinvest. They simply want out. And, many of the bargains are anything but because the businesses are simply failing.
That, combined with the likely further extension of confiscatory regulation, makes any current investment here in California very much of a dodgy proposition. The risk of loss seems much, much greater than the reward. If there is to be new investment, it will have to come because we greedheads think we can make money, not because we have a positive cash flow. Until we can see a prospect for profit at the prices for capital assets, the flows will go into the bank to wait. Those businesses that have access to bank and government credit may, indeed, be recovering; but few, if any, small businesses and non-government employee customers are. Their own income prospects are lousy, and their balance sheets are under water. Hayek would blame all this on the past nationalization of credit and money. (Cf. Good Money, Vol. I and II). That, and the prospect of having the government tax more of the flow is only encouraging people to look for ways to camouflage their wealth. Someone - it may have been Jim Farley but I can't find the precise source - said about Joseph Kennedy, Sr. that "he was the only guy I knew in 1932 who could buy something without having to sell something else." The Kennedy political tradition may be dead, but the bootlegger legacy is alive and growing.
Kim thought Siegel was being naïve in expecting that new capital to be invested in America from abroad to buy out the retiring geezers like me. I agree, but God only knows; perhaps Brazilians will acquire a taste for windfarms in Tornado Alley. What we do know is that growth in real wages is a pure function of increased investment. Workers who get to play with newer, more expensive machines make more money because things and services can be provided better, cheaper and faster. I don't like the term capitalism, but one should give Marx his due. He did understand what was at stake. The money and credit and assets held by competitive enterprises - what he would define as "das capital" - are the only chips in the game. If the capital stock is diminished, the holders of cash who are able to invest at 6 or 8 x present earnings will probably make money; but they will be doing it at a time when the workers will be making less - as they did in the decade after the 1982 bottom. (Marx would say it was BECAUSE the new investors were making more money; and even if he was wrong about the causality, he was right about the coincidence; workers' wages do not increase dramatically while capital stock is being rebuilt. They have to wait their turn.)
What we also know is that a world of lower stock prices is one in which profits have declined and the prospect for future earnings has grown less cheery. Those situations usually do present opportunities for future gain but only if someone has "das capital". Andrew Carnegie said that, if you have a choice between losing the factories and losing the people, you want to lose the factories because, with the people you can build a better factory. Being a 19th century primitive, Carnegie presumed that a prudent businessman always had a stash of money - what used to be known as a reserve - whose value was not subject to confiscation or abolition by the government. Carnegie also presumed that he and other prudent businessman would use the cash to pay the workers their wages while the new, better factory was getting up and running. What was different in the past was that there was a stock of private capital willing to speculate after a factory had burned down or the market had crashed.
The question that Kim raised– and for which there is still no apparent answer - is where will that real cash come from now? The diminished future can only be a Grand Bargain after private savings are restored. Until then, it is likely to be a Grand Fail with both the young and the old getting far less than they expect. "Other than that, Mrs. Lincoln, how did you like the play?"
Phil McDonnell writes:
One important aspect of this discussion is to look at the required level of stock prices. To this end it is helpful to consider that there is a large store of wealth in the world which must be invested somewhere. Right now Real Estate is in the dog house so people are dis-investing in that area. But bonds and stocks are relatively close substitutes with comparable liquidity.
Thus the required yield on stocks is simply the reciprocal of the P/E ratio. To be competitive stocks must yield something comparable to and competitive with bonds. But bonds yields are remarkably low now largely through Fed intervention. So stock P/E ratios can go quite high and still remain competitive with the historically low yield of bonds.
Alston Mabry comments:
Perhaps Dr Siegel's thesis will be supported by a new paradigm that dispenses with the connection between "American" and "securities", i.e., is Coca-Cola really just an "American" stock? Or Exxon-Mobil? Or Microsoft? Or many smaller US-based companies whose business is actually global in scope? Or think about the large foreign companies that are a big part of daily trading volume here and also part of most/all retirement accounts. Increasingly, it may be that boomers are selling their holdings into a more and more homogeous global market.
from the WSJ article:
"They say they've been chewing over the issue during vacations together at the New Jersey shore."
One shudders to think of the reality-tv-show possibilities….
Rocky Humbert comments:
An alternative way to look at this issue is to consider whether one's ownership of equities is an investment based on an assessment of future earnings and dividends — or a speculation based on a greater-fool theory.
To quote Keynes: "Most of these [professional investors and speculators] are, in fact, largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the public. They are concerned, not with what an investment is really worth to a man who buys it "for keeps," but with what the market will value it at, under the influence of mass psychology, three months or a year hence." Source: Keynes "General Theory," Harcourt,Brace & World 1965 ed. pg 155
This quote is reminiscent to statements made by a certain gentleman from Omaha, whose company has now outperformed the S&P-500 for the past 1, 3, 5, 10, 20 years…
Stefan Jovanovich adds:
The gentleman from Omaha has an easy standard of comparison. If you apply the average tax rate of the S&P companies to Berkshire's past 20 years' earnings, the company's book value drops by roughly 1/3rd. Never mind being a specialist in a bull market; in my next life I want to come back as the owner of an insurance company who is on a first-name basis with the Secretary of the Treasury.
I hate to trash what was once part of Dad's backlist, but Keynes' presumption about what is in the minds of investors and speculators is the truth only because it is theory that has won the academic beauty contest. It has been the most fashionable theory going since neo-Marxism trumped all else (note the reference to "mass psychology"), but it no more likely to be the truth than any other guess about something that is unknown and unknowable.
"The man of system is apt to be very wise to his own conceit. He seems to imagine that he can arrange the different members of a great society with as much ease as the hand arranges the different pieces upon a chess-board." - Adam Smith
Tyler McClellan writes:
I don't understand the relevance of any of the above. There are complicated ways in which falling stock prices affect on economic growth and even more complicated steps through which this transmission affects corporate profits.
But surely other than these effects, we don't care about the price of the capital stock. We care about the return to the capital stock at the given price of transfer. If the profits don't decline, so what if the old transfer the assets to the young at 12x or 15x, excepting of course the old.
Considering the IRR of social security has gone from high 30s for the first generation to slightly negative in mine, I can assure you that we need not worry about the "misfortune of the old". Social security is a flippant example, but the fact is empirically undeniable, the current generation of old people have benefitted from the most massive transfer of wealth to them from the young the world has ever seen. The baby boomers will do materially better than breaking even at current projections (driven almost completely by medicare), and the next generation will do substantially worse.
Its astounding to me that we allow the "old" to impart their wisdom to the "young". Now of course the young will benefit in the non-taxed sectors. If no one in Westchester's children can afford their parents houses, then in aggregate the houses must go down in price. This is a benefit to the children, just as lower stock prices with the same future earnings are a benefit to the young.
I call this the Grand Bargain, either we eliminate the entitlements and the asset prices can stay high, or we pay the entitlements and the asset prices fall. I'm not sure which is preferable.
I am basically a doctrinaire Keynesian, although I'm not sure what analytic work such a concept does or does not perform.
I would simply say that the process you outlined in the below is actually quite different than where you began. You seem to argue on the one hand that the businesses wont reinvest because they don't have any cash flow and then in the second that they wont reinvest the surplus cash flow because they are not confident in future X, Y, or Z.
As you can see those are mutually incompatible facts. Keynes believed that because changing expectations of the future largely effect plans reliant on the far future (such as investment), that in times of panic one should create investment to make use of the excess demanded savings, specifically when the excess of demanded savings was sufficient to make lower interest rates incapable of increasing the demand to invest sufficiently to absorb this excess savings.
Expectations of the future are a source of current period aggregate demand. Changing expectations of the future where everyone wants to invest less than he wants to save (which by the way savings is a flow of income as you correctly identify further down in you argument), can only be accomplished by destroying enough income such that the savings is not actually produced. There cannot be more savings than investment. There is no way to store money, there is no flow of savings that is not spent. That is to say, all savings is spent, just some of it is spent on investment.
I suspect you agree with the above and simply doubt that the way to get people to demand greater investment is to do it for them, and that rather we should provide future tax clarity, lower regulation, jump through hoops… fine, and I don't particularly disagree, but you will see that the fundamental insight remains. With no demand to invest, we cannot fulfill the demand to save. Period, end of story.
A recent paper by Doyne Farmer and Ilija Zovko of the Santa Fe Institute shows what I believe is an incredibly interesting approach to diagramming the ecology of the markets, a phrase that has often arise on Daily Speculations.
While I find the conclusions and statistical work not particularly interesting, the research approach in the beginning of the paper is fascinating. The authors look at coded order flow on the LSE and categorize each player on an hourly basis as either a net seller, buyer, or inactive. Then they plot that behaviour for all eligible periods during a month and see what the plots of this behaviour look like on a case by case basis.
Next they look at correlations in a given period between groups of buyers and sellers (for example, do the same groups always sell at the same time, and do they always sell to the same counterparties?). Their conclusions because of constraints upon their data (actually what they can share of their data, as they note briefly) are not particularly enlightening but the extension of this approach if one could secure the data seems a treasure trove of potential research.
How valuable it would be to have these plots, for example for the 50 biggest player in a given stock!
October 23, 2007 | Leave a Comment
No statistical technique can prove causation without a controlled experiment, which is not possible with the markets.
Stefan Jovanovich recounts:
My dear wife and I once spent the better part of an hour searching the graveyard in Edinburgh for David Hume's final resting place. Finally, Susan found it. Over his agnostic bones his sister-in-law had erected a truly monstrous white marble statue of an angel. I doubt Hume would have minded. However, I think he would have objected to the notion that "controlled experiments" prove causation. This is a crude paraphrase, but Hume was rather insistent that our capacity to associate differing perceptions and to define those associations symbolically does not "prove" anything. All it grants us is the capacity to formulate hypotheses and to observe which hypotheses seem more useful than others. As Hume put it, "… that the sun rose today does not assure us that it will rise again tomorrow." Even the most common sense hypotheses can -logically - be treated only as conjectures, not certainties.
Tyler Mcclellan writes:
Causation is ironically exactly equal in logical form to the foundational principles of mathematics. They are both a priori, synthetic formulations that are both deniable and non definitional.
Ironically, Hume failed to understand that arithmetic and causation belong in the same category of thought, but Kant's brilliant insight into Non-Euclidean geometry and Gödel's work in arithmetic theory advanced that thinking to its current general acceptance. One believes Hume would likely have accepted causation if he knew he would be forced to reject along the same lines the foundation of his empiricism.
I believe the above has relevant corollary to the market because the now accepted method of scientific inquiry is that which is also repeatedly offered by Vic and Laurel as the foundation for sound investing: falsification. And why I believe The Logic of Scientific Discovery is the single most important book for applied scientists/thinkers in the modern time.
Stefan Jovanovich replies:
I think Hume would have applauded Tyler's description of causation as an "a priori, synthetic formulation that (is) both deniable and non definitional." I am not certain that I fully agree that Hume would have been comfortable being described as an "empiricist." He seems to me someone who thought that the human understanding of the universe would, with luck, grow and flourish; but it would not — contrary to Kant — ever become more than our own speculations about what might or might not be. Thought, whether pure or unpure, would not let us see G-d. Like many genial people who are deep skeptics, Hume was comfortable with the notion that human thought itself was a form of revelation. (I think that is the main reason he was an irksome outlier to all celebrants of the Enlightenment - both past and present.) He would certainly have agreed that falsification was a better working hypothesis for handling money and stuff than any other, and he would undoubtedly have wanted Vic and Laurel to handle his money; but I suspect he would have sided more with Wittgenstein than the non-Euclidean positivists who are the wizards of the markets. My hypothesis is that his answer to Tyler would have been this: Even when humans discover where the square root of an imaginary number lives, a full understanding of what that mathematical tiger of the universe is saying will still elude us.
December 22, 2006 | Leave a Comment
I continue to think Victor and Laurel’s most singular and brilliant insight is that the market is a system that maximizes entropy; entropy taking the form of the leakage, vig, to the institutional framers of the market system. Given that the physical modeling of financial processes has become the fete du jour in economics, I thought I could suggest a couple working papers for reading over the holiday and that we could then come back as a group after New Years and tackle this likely productive field collectively.
The first two papers, found here and here, are on the structure of order flow, not entropy per se. The third is the landmark paper on utility theory and thermodynamics. All from Santa Fe and most in the vein of the Horse Trader and my former professor, Martin Shubik.
November 14, 2006 | Leave a Comment
I received a book recommendation from Stefan Jovanovich who, like Jim Sogi, utters something of profundity whenever he speaks. He recommends historical books by Peter Green and J. S. Holliday as models of good scholarship. I call on him and others for some good historical books that I can read and augment my library with and share with my children, who are studying history in school, and regrettably have been brainwashed by politically correct curricula, starting with Squanto as the archetypical American hero.
I recommend the book Lessons of History by Will Durant as well worth reading for its lessons on markets as well as a honest attempt to review the lessons from a life long study of the sweep of history in conjunction with this request.
Alston Mabry replies:
Inventing America is a textbook that has an interesting approach and might be an alternative for homeschoolers:
Book Description; W. W. Norton presents Inventing America, a balanced new survey of American history by four outstanding historians. The text uses the theme of innovation–the impulse in American history to “make it new”–to integrate the political, economic, social, and cultural dimensions of the American story. From the creation of a new nation and the invention of the corporation in the eighteenth century, through the vast changes wrought by early industry and the rise of cities in the nineteenth century, to the culture of jazz and the new nation-state of the twentieth century, the text draws together the many ways in which innovation-and its limits-have marked American history.
Some other longtime favorites are The Making of the Atomic Bomb by Richard Rhodes, The Devil’s Horsemen: The Mongol Invasion of Europe by James Chambers, and King Harald’s Saga: Harald Hardradi of Norway: From Snorri Sturluson’s Heimskringla by Snorri Sturluson. You can get the wiki overview here, but the saga itself is a quick read and an amazing story.
Another audio book I have thoroughly enjoyed listening to on cross-country drives is Simon Schama’s A History of Britain. The audio book is in 3 volumes. Schama, a professor at Columbia, is such an excellent storyteller that I would pick up anything he has written. The television series of the same name is also available on DVD and is outstanding.
Stefan Jovanovich replies:
Simon Schama has the gift of charisma. When you watch his narration of the video documentary of the History of Britain, you are instantly aware of it. The trouble is that his histories are not to be trusted. At their worst they are little more than royalist propaganda. Too often he writes the story that the Queen would like to read, not the one that happened. Even though Cromwell was the first head of the United Kingdom to allow Jews to openly practice their religion, Schama finds the Great Protector to be a far greater villain than any of the crowned heads who so routinely persecuted the children of Israel. He is equally severe in his criticisms of those greedy speculators of the Dutch Republic who left Spinoza free to grind his lenses; in Schama’s eyes, those Dutch Reform bigots were guilty not only of inventing capital markets but also of buying too much stuff. The common thread in Schama’s works is the notion that sectarian Christians, with their notions of free markets, are to be feared as dangerous, greedy fanatics who will upset the natural order of the world. The meme continues with Rough Crossings. Schama makes a great deal of the fact that the British offered freedom to slaves who would join the Royalist forces in fighting Washington’s Army while failing to note that the Confederates ended their struggle with the same concession to the dire necessities of war. In general, Schama finds the Christian deism of the slave owning signers of the Declaration of Independence proof of their hypocrisy and, by extension, that of the American nation as a whole. The fact that, for another half century, neither the Archbishops of Canterbury nor the Kings of England had any problem with sanctioning and enforcing slavery in their remaining territories is somehow put aside. So are the origins of the anti-slavery movement in both England and America (those dreadful Methodists). The nearly two centuries old Anglo-American naval alliance (the longest-lived military confederation between democracies in recorded history) had its origins in the anti-slavery patrols off West Africa by both fleets that began in the 1820s. Those were initiated as a political concession in both countries to those same cross-bearing nutballs who thought that the “common” people should have the right to vote even if they did not own a carriage. Ain’t history grand?
Tom Ryan suggests:
Daniel Boorstin’s three books, The Americans, written before 1973, provide a refreshing take on American history in my opinion. I recommend the third in the series, “The Democratic Experience”, which covers the 1870-1970 period in American History. It is unconventional in the sense that it focuses on the stories of the individuals who built, invented, and created this country, the untold stories of the individuals as it were, rather than the typical history of Washington political leadership that is regularly fed to children in grades 4-12.
Steve Ellison adds:
I highly recommend British historian Paul Johnson’s A History of the American People, which goes into detail on many topics, including the relentless economic growth that occurred almost from the outset. A small sample:
By the third quarter of the 18th century America already had a society which was predominantly middle class. The shortage of labor meant artisans did not need to form guilds to protect jobs. It was rare to find restriction on entry to any trade. Few skilled men remained hired employees beyond the age of twenty-five. If they did not acquire their own farm they ran their own business.
Rodger Bastien responds:
I just completed Rubicon: The Last Years of the Roman Empire by Tom Holland. I highly recommend this historical narrative of the final days of the Republic which deals with primarily the years 100 B.C. to 14 A.D. For me, the book brought to life this period which I knew little about but was arguably as important to subsequent civilizations as any period before or since. Caesar, Marc Antony and Cleopatra may have existed centuries ago, but to me those centuries somehow feel a little shorter.
Gibbons Burke replies:
I am finding I am enjoying first-person narrative accounts of historical events and times, so, with that in mind:
- Sufferings in Africa: The Astonishing Account of a New England Sea Captain Enslaved by North African Arabs by Captain James Riley
- Exploring the Colorado River: Firsthand Accounts by Powell and His Crew by John Wesley Powell
- Life on the Mississippi by Mark Twain
and one that’s not a first person, but which is fascinating and has many meals:
- Salt: A World History by Mark Kurlansky
John O’Sullivan replies:
I recommend two books by Anthony Beevor: Stalingrad and The Fall of Berlin 1945. Both mesh grand strategy with individual detail and amazing narrative momentum. I also like three Middle & Far Eastern travelogue/history/biographies by William Dalrymple : Xanadu, From the Holy Mountain and White Mughals. Dalrymple has created his own genre and its a rich mix.
MacNeil Curry replies:
I would have to recommend Bury My Heart at Wounded Knee: An Indian History of the American West. Not only is it a fascinating account of the West from a different perspective, but it highlights quite well that there are two sides to every story and that both must be carefully studied before one can truly come to there own conclusion.
Tyler McClellan replies:
Speaking of John Wesley Powell, Beyond the Hundredth Meridian: John Wesley Powell and the Second Opening of the West by Wallace Stegner is a book with many practical lessons for investing and life that used to be required reading for the history of the American West.
Craig Cuyler replies:
My favourite historical novels are without doubt the three part trilogy by Neil Stevenson called the Baroque Cycle. This body of work, over 2500 pages long, covers life in 17th-century in England, Europe, Russia with special reference to natural philosophy & science. Stevenson weaves in his ideas about currency, calculus in speculation which took place around the central characters like Isaac Newton, Huygens, Hook, Leibniz. The courts of Louis XIV in the battle for the monarchy in England feature strongly. The Baroque Cycle is to science what the Lord of the Rings is to fantasy. Fantastic read!
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