Jamie Dimon on America

April 10, 2014

Jamie Dimon, CEO of JP Morgan Chase, in his annual shareholder letter expresses sentiments with which I wholeheartedly concur:

I have spoken about this in the past, and I don’t believe that it is blind optimism or patriotism.  America today may be stronger than ever before.  For example:

  • The United States has the world’s strongest military, and this will be the case for decades.  We also are fortunate to be at peace with our neighbors and to have the protection of two great oceans.
  • The United States has among the world’s best universities and hospitals.
  • The United States has a reliable rule of law and low corruption.
  • The people of the United States have a great work ethic and “can do” attitude.
  • Americans are among the most entrepreneurial and innovative people in the world — from those who work on the factory floors to geniuses like Steve Jobs.  Improving “things” and increasing productivity are American pastimes.  And America still fosters an entrepreneurial culture where risk taking is allowed — accepting that it can result in success or failure.
  • The United States is home to many of the best businesses on the planet — from small and middle-sized companies to large, global multinationals.
  • The United States also has the widest, deepest, most transparent and best financial markets in the world.  And I’m not talking just about Wall Street and banks — I include the whole mosaic: venture capital, private equity, asset managers, individual and corporate investors, and the public and private capital markets.  Our financial markets have been an essential part of the great American business machine.

America’s future is not guaranteed, and,of course, America has its issues… But throughout history, we have shown great resiliency and a capacity to face our problems.

 

US flag Jamie Dimon on America

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Money Goes Where It Is Treated Best

August 30, 2012

Further confirmation of this came in a Wall Street Journal article about corporate behavior.  Companies are moving their corporate headquarters outside the US because they can save money—tens of millions of dollars—by incorporating overseas.  Here’s just one example:

Eaton, a 101-year-old Cleveland-based maker of components and electrical equipment, announced in May that it would acquire Cooper Industries PLC, another electrical-equipment maker that had moved to Bermuda in 2002 and then to Ireland in 2009. It plans to maintain factories, offices and other operations in the U.S. while moving its place of incorporation—for now—to the office of an Irish law firm in downtown Dublin.

When Eaton announced the deal, it emphasized the synergies the two companies would generate. It also told analysts that the tax benefits would save the company about $160 million a year, beginning next year.

I added the bold.  Money talks.  $160 million yells pretty loudly.

Ironically, the goal of the 2004 legislation was to promote companies staying in the US.  However, due to the poor tax treatment in the US relative to many other countries, it has not worked. The WSJ points out:

Since 2009, at least 10 U.S. public companies have moved their incorporation address abroad or announced plans to do so, including six in the last year or so, according to a Wall Street Journal analysis of company filings and statements. That’s up from just a handful from 2004 through 2008.

If the goal of corporations is to make money for their shareholders, of course they are going to take advantage of favorable tax treatment.  If we want businesses—and thus jobs—here in the US, then we have to be competitive.  Money really does go where it is treated best.

Incentives are a pretty important part of economics—some would say the most important part.  It’s critical to get incentives right if we want the US economy to continue to be the strongest in the world.

money Money Goes Where It Is Treated Best

Source: The Murninghan Post

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From the Archives: Chaotic Evolution

February 6, 2012

John Kay of the Financial Times has recently written a nice article explaining why the chaos of free markets leads to significantly better results than centrally-planned economies, as has been tried and failed in the Soviet Union, East Germany, Nigeria,  and Haiti (and periodically makes inroads in economies found in Great Britain, the United States, and others.)

Kay explains that free markets generate superior results because:

Prices act as signals – the price mechanism is a guide to resource allocation rather than central planning. Markets are a process of discovery – an economy adapts to change through a chaotic process of experimentation. The third element is the capacity of the market to bring about diffusion of political and economic power. This is the most effective way to protect society from rent-seeking – a culture in which the principal route to wealth is not creating wealth, but attaching oneself to wealth created by others…

… Centralized systems experiment too little. They find reasons why new proposals will fail – and mostly they are right. But market economies thrive on a continued supply of unreasonable optimism. And when, occasionally, experiments succeed, they are quickly imitated.

If market economies are better at originating and diffusing new ideas, they are also better at disposing of failed ones. Honest feedback is not welcome in large bureaucracies, as the UK government’s drug advisers can testify. In authoritarian regimes, such reporting can be fatal to the person who delivers it.

Disruptive innovations most often come to market through new entrants. The health of the market economy depends on constant replenishment of ideas, often from unpredicted sources. If you had been planning the future of the computer industry in the 1970s, would you have asked Bill Gates and Paul Allen? If you had been planning the future of European aviation in the 1980s, would you have asked Michael O’Leary or Stelios Haji-Ioannou? If you had been planning the future of retailing in the 1990s would you have asked Jeff Bezos? Of course not: members of the politburo, cabinet or large company board would have consulted grey men in suits like themselves.

I wholeheartedly agree with Kay’s macro-economic analysis.

Furthermore, this line of logic also underpins the process that we employ to manage money.  Price (specifically relative price performance) acts as a signal to guide portfolio allocation.  We rely on rules-based relative strength models to sort out the winners from the losers from a given investment universe.  We buy any security that meets our criteria and sell every security out of the portfolio that fails to maintain strong relative strength.  There are no committee meetings where the portfolio managers debate the merits of the stocks before making a decision.  There is no emotional attachment to current holdings.  Rather, the models, which we have designed,  execute a plan that is based on a method with a track record of generating superior investment results over time.  A large percentage of our trades turn out to be either losers or just market performers.  To the uninitiated, the process can indeed appear to be chaotic.  It certainly leads to inferior investment results over certain periods of time (just like free-market economies periodically experience difficulty.)  It is only a minority of our trades that turn out to be the big long-term winners.  Frequently, the trades that end up generating the biggest gains are trades that made us scratch our heads when they were added to the portfolio.

It turns out that perceived chaos, on both the macro-economic level and on the portfolio management level, leads to very desirable outcomes over time.

—-this article was originally published 11/4/2009.  Price acts as a signal in portfolios too.

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The Profit Motive is Not the Problem

February 3, 2012

Justin Fox has an article in the Harvard Business Review assailing the profit motive in financial services.  I don’t deny that some banks and brokerage firms have behaved badly—but the logic of the critics is (I think) all wrong.  There is a behavior problem that needs fixing perhaps, but I think it can be approached more elegantly.  Mr. Fox’s thesis is this:

If you let the financial services industry do exactly what it wants, the financial services industry will eventually get itself — and by extension the economy — into staggering amounts of trouble. If you force it to behave, it might just thrive.

I don’t think you can ever force anyone to behave.  I was never successful forcing my kids to behave when they were four years old, and I have no more success now that they are teenagers.  This thesis leads to some bad logic.  Mr. Fox continues:

I thought about this while listening Tuesday to David Swensen, the legendary manager of Yale University’s endowment, arguing that acting as a fiduciary for other people’s money and maximizing profits are incompatible activities. “A fiduciary would offer low-volatility funds and encourage investors to stay the course,” he said. “But the for-profit mutual fund industry benefits by offering high-volatility funds.”

Swensen said this at a Bloomberg Link conference held in honor of that great fiduciary, Vanguard founder Jack Bogle.

I have a few issues with this.  First, the data argues that low-volatility funds are not the answer.  If low volatility were the answer, customers would hold their low-volatility bond funds longer than they hold their high-volatility stock funds—but they don’t.  Holding periods, according to DALBAR data, are only marginally different, around three years in each case, so that argument goes up in flames.  Second, investment firms always encourage investors to stay the course, sometimes to a fault.  (And they usually end up getting criticized for it later by some Congressional panel with 20/20 hindsight.)  Seriously, did you ever read material produced by any reputable investment firm suggesting day-trading or short-term speculation?

Mr. Fox extols Jack Bogle and Vanguard for being great guardians of the investor, yet Vanguard is one of the biggest players in exchange-traded funds, something Mr. Bogle has decried as a terrible product that encourages speculation!  Does that make Vanguard evil?  (I don’t agree with that either.  ETFs don’t kill people; investors shoot themselves.)  Reality is a lot messier than an idealogical paradigm.

It all boils down to incentives.  Human beings are not all that tractable.  It’s certainly not easy to get investors to behave rationally either, and it’s not for lack of pleading by the investment companies.  Believe me, every firm would rather you keep your account there permanently!  But rather than “forcing” someone to behave, why not give them incentives to behave?

An anecdote might illustrate my point.  I worked many years ago at Smith Barney, Harris Upham when it was still private.  Share ownership was widely distributed and many people—partners and aspiring partners—felt like they had a stake in how things worked.  It was viewed in the industry as a stodgy firm that was not willing to take big risks, which was pretty much true.  The partners didn’t want to take big risks with the firm’s money because the firm’s money was their money!  Eventually the partners sold out to a public company.  The first convertible bond underwriting client that was engaged after the firm became public went bankrupt before it made its first semi-annual interest payment.  I can’t prove it, but I suspect that the partners weren’t as concerned about the underlying credit quality of the issuer when it wasn’t their money at stake anymore.  (In an interview, John Gutfreund of the old Salomon Brothers said using other people’s money was the beginning of the end.)  How many toxic mortgages would have been securitized if the partners’ personal money were at stake, or if even public firms had been required to retain substantial amounts of each pool?  Surely much less monkey business would have gone on.  (Stupidity you can’t regulate.  But if someone knows they have a grenade, they’re not happy about playing catch with it.)  Intelligent structuring of incentives will solve many of the problems that Mr. Fox rightly points out.

And, one could argue that incentives are already having an effect.  Mr. Fox mentions in passing some good actors in the industry (and I’m sure there are others):

Some of these for-profit advisers (Capital Group and T. Rowe Price spring to mind) have built a reputation for looking out for investors’s interests.

And guess what?  These firms are now huge because they realized they would have the best chance at sustainable, long-term growth by looking out for investors.  Enlightened consideration of their incentives led them to behave in ways that maximized their long-term growth.  There are other firms in the industry that have marketed celebrity portfolio managers, or have pushed performance when they were hot, or have launched all manner of ill-conceived products, but they have generally come to grief in the longer run.  (Short-termism, by the way, is not limited to for-profit enterprises.)

Could the industry incentivize even better behavior?  Possibly, and that is certainly a goal worth pursuing.  But to lay the blame for industry problems on the profit motive is just lazy thinking, in my opinion.

HT to Abnormal Returns

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Why Capitalism Works

January 25, 2012

Incentives!  I first saw this story on Carpe Diem, the blog of economist Mark Perry at the University of Michigan.  He excerpts a story from NPR‘s Planet Money that details a secret contract that Chinese farmers made in 1978, during a period of communist rule.  Everyone in a small village essentially agreed to become capitalists!  And the results were remarkable.  From NPR:

In 1978, the farmers in a small Chinese village called Xiaogang gathered in a mud hut to sign a secret contract. They thought it might get them executed. Instead, it wound up transforming China’s economy in ways that are still reverberating today.

The contract was so risky — and such a big deal — because it was created at the height of communism in China. Everyone worked on the village’s collective farm; there was no personal property.

“Back then, even one straw belonged to the group,” says Yen Jingchang, who was a farmer in Xiaogang in 1978. “No one owned anything.”

At one meeting with communist party officials, a farmer asked: “What about the teeth in my head? Do I own those?” Answer:  No. Your teeth belong to the collective.

In theory, the government would take what the collective grew, and would also distribute food to each family. There was no incentive to work hard — to go out to the fields early, to put in extra effort, Yen Jingchang says.

“Work hard, don’t work hard — everyone gets the same,” he says. “So people don’t want to work.” In Xiaogang there was never enough food, and the farmers often had to go to other villages to beg. Their children were going hungry. They were desperate.

So, in the winter of 1978, after another terrible harvest, they came up with an idea: Rather than farm as a collective, each family would get to farm its own plot of land. If a family grew a  lot of food, that family could keep some of the harvest.

This is an old idea, of course. But in communist China of 1978, it was so dangerous that the farmers had to gather in secret to discuss it.

One evening, they snuck in one by one to a farmer’s home. Like all of the houses in the village, it had dirt floors, mud walls and a straw roof. No plumbing, no electricity.

“Most people said ‘Yes, we want do it,’ ” says Yen Hongchang, another farmer who was there.   “But there were others who said ‘I don’t think this will work — this is like high voltage  wire.’  Back then, farmers had never seen electricity, but they’d heard about it. They knew if you touched it, you would die.”

Despite the risks, they decided they had to try this experiment — and to write it down as a formal contract, so everyone would be bound to it.  By the light of an oil lamp, Yen Hongchang wrote out the contract. The farmers agreed to divide up the land among the families. Each family agreed to turn over some of what they grew to the government, and to the collective. And, crucially, the farmers agreed that families that grew enough food would get to keep some for themselves.

The contract also recognized the risks the farmers were taking. If any of the farmers were sent to prison or executed, it said, the others in the group would care for their children until age 18.

The farmers tried to keep the contract secret — Yen Hongchang hid it inside a piece of bamboo in the roof of his house — but when they returned to the fields, everything was different.

Before the contract, the farmers would drag themselves out into the field only when the village whistle blew, marking the start of the work day. After the contract, the families went out before dawn. “We all  secretly competed,” says Yen Jingchang. “Everyone wanted  to produce more than the next person.”

It was the same land, the same tools and the same people. Yet just by changing the economic rules — by saying, you get to keep some of what you grow — everything changed. At the end of the season, they had an enormous harvest: more, Yen Hongchang says, than in the previous five years combined.

Listening to this story makes me much more optimistic about the possibility for eventual intelligent economic reform.  The power of incentives to transform behavior is truly remarkable!  Thoughtful incentives make the economy better for everyone.  I hope it is not lost on policymakers that a 15% tax on the huge harvest generates more revenue than a 70% tax on the lousy harvest.  (Even bad incentives, I suppose, make the economy better for certain groups while making it worse for others.  Relative strength is a good way to detect who is benefiting and who is being held back.)

HT to FT Alphaville.

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Clarion Call For Leadership

December 17, 2011

Richard W. Fisher, president and CEO of the Federal Reserve Bank of Dallas in a speech on Dec. 16:

Quoting Martin Luther King Jr. on the topic of the responsibilities of leaders in a democratic society:

“Cowardice asks the question—is it safe? Expediency asks the question—is it politic? Vanity asks the question—is it popular? But conscience asks the question—is it right? … There comes a time when one must take a position that is neither safe, nor politic, nor popular, but one must take it because it is right.”

That time is now. Our nation’s economy is at risk. The Federal Reserve has done everything it can to reduce unemployment without forsaking our sacred commitment to maintaining price stability, or crossing over the monetary river Styx into full-blown debt monetization. I personally don’t care which party is in the White House or controls Congress. All I know is that the “honorable” members of Congress and presidents past, Republicans and Democrats alike, have conspired over time, however unwittingly, to drive fiscal policy into the ditch. They purchased their elections and reelections with popular programs so poorly funded that they now threaten the economic well-being of our children and our children’s children. Instead of passing the torch on to the successor generation of Americans, they have simply passed them the bill. This is the opposite of honorable.

Like all of you here, I am sickened by our politicians’ tendency to kick the can down the road, even when it is starkly clear that doing so jeopardizes America’s well-being. Small wonder that some recent polls show only 9 percent of the American people view Congress favorably. (One senator posited that the 9 percent consisted of blood relatives and congressional staff!)

But this is the holiday season, and especially now, I am given to viewing the world through optimistic eyes. The Christmas spirit may be overwhelming my judgment, but I believe that the American people—from the mainstream to the Tea Party to the unemployed and disaffected who have taken to the streets—are in the process of forcing politicians to get their act together. There is a loud, distinct, clarion call for leadership—for the people we entrust to right the rules that determine our economic future, cast away cowardice, expediency and vanity, and get on with leading us out of our fiscal wilderness.

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Doing the Math

November 9, 2011

Transaction taxes are being discussed by some politicians and academics as a way to raise revenue and “make Wall Street contribute its fair share.”  Index Universe has an article discussing actual historical experience with a trading tax and then follows through with the math to show that the amount of potential revenue is clearly overstated by several magnitudes.  The good thing about history is that you can actually learn from the experiences of others.

The best-known example comes from Europe–or Sweden, to be exact–which probably explains why the European proposal has met with such strong opposition.  From 1984 to 1991, Sweden implemented a series of taxes ranging from 0.5% on equities to fractional basis points on certain bond trades.

The results were disastrous.  As any sane person might expect, trading volumes plummeted in Sweden as investors moved their money to more lubricated markets.  Within six years, the options market vanished entirely, futures volumes fell 98 percent, and 50 percent of equity trading moved offshore.  Even bonds, which had fractional basis-point taxes, suffered an 85 percent reduction in trading volume.

The article proceeds to calculate that if volumes stayed unchanged, taxes would amount to another 10% of GDP!  That’s about 50% of the current entire tax base.  As the Swedish example makes clear, volumes won’t be unchanged.  Nor does it seem like a good idea to cripple the economy with a potentially enormous tax increase.  In Sweden, the revenues turned out to be modest, but the damage to the Swedish financial system was severe.

Perhaps we will learn from history, or perhaps we will simply prove Hegel’s theory:  The only thing we learn from history is that we learn nothing from history.

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No One is Happy

October 13, 2011

If you need a graphic representation of how unhappy the American public is, take a look at the latest Gallup Poll results from their annual governance survey.  Here are Gallup’s key findings:

  • 82% of Americans disapprove of the way Congress is handling its job.
  • 69% say they have little or no confidence in the legislative branch of government, an all-time high and up from 63% in 2010.
  • 57% have little or no confidence in the federal government to solve domestic problems, exceeding the previous high of 53% recorded in 2010 and well exceeding the 43% who have little or no confidence in the government to solve international problems.
  • 53% have little or no confidence in the men and women who seek or hold elected office.
  • Americans believe, on average, that the federal government wastes 51 cents of every tax dollar, similar to a year ago, but up significantly from 46 cents a decade ago and from an average 43 cents three decades ago.
  • 49% of Americans believe the federal government has become so large and powerful that it poses an immediate threat to the rights and freedoms of ordinary citizens. In 2003, less than a third (30%) believed this.

The whole article is eye-opening.  People were not happy with the government after Watergate, but they are far more disgusted now.  Gallup has a nice table in response to the question, “On the whole, would you say you are satisfied or dissatisfied with the way the nation is being governed?”

gallup No One is Happy

Source: Gallup

If 81% of Americans—majorities of both political parties—are dissatisfied, that means 19% are happy with how things are going.  Has anyone actually met one of the 19%?

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The Truth About Random Walkers

September 16, 2011

The Mercenary Trader has some fun factoids about one of the most prominent efficient market theorists, Paul Samuelson.  Mr. Samuelson promoted efficient markets, but never believed it himself.  The tone of the article is highly aggrieved and quite a bit of fun to read.  Here’s a great excerpt to whet your appetite:

As background, we all know the arrogance of the Efficient Market Hypothesis, right? Particularly the high and mighty godfathers of EMH. Eugene Fama is on record as saying “God himself” could not dispute the efficiency of markets.

And of those EMH fathers, few were higher and mightier — or more insanely arrogant — than Paul Samuelson, the founder of neoclassical economics…

So here’s the thing that blew me away.

Right at the same time EMH was gaining real traction… and right at the time Paul Samuelson was proclaiming in favor of absolute randomness for the markets…Samuelson was investing his OWN money with Warren Buffett — and with Commodities Corp.

At the very genesis of EMH gaining a foothold as indisputable academic dogma, the guy pounding the table for that dogma was making big side bets with the great investors and traders of the era!

I mean, talk about chutzpah!

Here is this “I’m too brilliant for you to comprehend” S.O.B. telling the entire world that no one can beat the markets — and thus helping to deeply legitimize academic theories that would later be major contributors to systemic crisis through the foolhardy actions of poorly run institutional funds — and at the very same time, the guy is investing his own money in the private belief that markets can be beat!

It’s like the Pope practicing Islam on the side.

….

So the high priests of EMH never actually believed their own theory. They just got legions of less bright minions to take EMH as diehard gospel, with the final culmination of arrogance + ignorance being Alan “Bubbles Can’t Be Recognized” Greenspan and Ben “Global Savings Glut” Bernanke.

In other words, “one of the most remarkable errors in the history of economic thought” — per the description of Yale professor Robert J. Shiller — was not just an error but a lie.

It’s always been our contention that a well-executed systematic process designed around a strong return factor—whether relative strength or value—should have a good chance to outperform the market over time.  Unfortunately, Bogleheads, some financial journalists, and even some financial advisors now assert the superiority of passive investing.  I wonder if they have ever looked at Ken French’s data or wondered why Paul Samuelson was not putting his money where his mouth was?

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From the Archives: Burning Down the House

September 9, 2011

Watch out! You might get what you’re after—-Talking Heads, Burning Down the House

I was in a bookstore over the weekend where I saw no fewer than six books suggesting that capitalism and our economic system had failed. The prescription in most cases was more government and more income redistribution. They system might be broken, but with the way our business and economic incentives are currently structured, I suspect the prescription of more government intervention will not help at all. The underlying incentives need to be fixed.

Adam Smith’s “invisible hand” is a useful economic concept. For a moment, let’s strip away all of the idealogy surrounding the invisible hand and get down to the base assumption: people act in their own self-interest.

Market theorists contend that with everyone acting in their own self-interest that markets run economies much better than bureaucrats. This is stupid. Bureaucrats contend that markets favor some groups and disadvantage others, so they should be able to step in and fix things. This is equally stupid.

The only thing the invisible hand guarantees is that people will act in their own self-interest. That makes the ultimate outcome mainly a matter of creating the proper incentives. If you have dumb incentives, the invisible hand will run the economy like a moron. If you have smart incentives, the invisible hand will run the economy like a genius.

Let’s look at a couple of examples. Let’s say that you have a private investment partnership, like Goldman Sachs or Smith, Barney, Harris, Upham used to be. On the one hand, the partners are incentivized to maximize their earnings through trading and underwriting. On the other hand, since the capital in the partnership is their own money, they are also incentivized not to blow up the firm. This prevents all manner of lousy underwriting deals and insures that trading leverage is managed carefully. The result is a company that tries to make as much money as possible without destroying the firm. This is the invisible hand at work with proper incentives. Everyone is working in their own self-interest, but those interests are balanced.

Now, think for a moment about a modern institution we will call Megabank. It is public, not private. Acting in their own self-interest, the traders and investment bankers are still incentivized to maximize their own compensation. However, the money the trading desk is using does not belong to the traders–it is other people’s money (OPM). What are the odds that they will overleverage in an attempt to make a huge bonus? Likewise, what incentive does an investment banker have to underwrite only good deals? (In fact, the bad deals usually come with bigger fees—bring it on.) Plenty of employees will act responsibly, of course, but moral hazard has been introduced. With everyone acting in their own self-interest, the invisible hand has this firm headed for the emergency room.

Think about AIG’s incentives: if they are allowed to underwrite insurance (credit default swaps) that is incredibly profitable because no reserves are required, is it likely they will underwrite a little or a lot? Think about a homebuyer’s incentive: tell the truth and stay in your apartment, lie a little (or a lot) and move into a nice house. Think about a sub-prime lender’s incentive: if they are allowed to offload all of the bad loans through securitization, are they likely to underwrite a little or a lot? Are they likely to care about the ultimate credit quality or default rates? With these sorts of incentives in place, what did policy makers think was going to happen? Now, what would happen if instead they had to eat their own cooking and retain a significant portion of the sub-prime loans on their balance sheet? Might that change their behavior? What if, instead of doing same-day exercise and sale of their stock options, executives had to exercise and hold the company stock for three years after their affiliation with the company ended? Would their stewardship change in any way?

The problem with the invisible hand is not that it doesn’t work—the problem is that it works incredibly well. This puts an enormous burden on policy makers to think carefully about how incentives are structured–and about what the ultimate consequences might be. Congress appears to have a very limited understanding of either the invisible hand or the consequences of incentives. It’s safe to say that most parents, who have to deal with kids and behavioral incentives all the time, are doing a better job, since most of their children live and become productive members of society.

I don’t know whether you think this is a brilliant piece of political economy or something so obvious that a fifth-grader could figure it out. But we, as a society, have apparently not figured it out. If we decide we want vast national savings, lots of capital formation and innovation, and a clean environment—all of that is probably achievable with properly thought out incentives. There are always trade-offs, and incentives usually have to include a lot of carrots and a few sticks. The invisible hand can’t give us everything, but with thoughtful incentives, we can do a lot better than we are doing now. We don’t have to let the invisible hand sucker punch us.

—-this article originally appeared 8/3/2009.  There are still a lot of books suggesting that capitalism has lost its way and, unfortunately, still very little coherent thinking about incentives going on.  It doesn’t have to be this hard.

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Nowhere to Hide

July 28, 2011

Security is mostly a superstition.  It does not exist in nature, nor do the children of men as a whole experience it.  Avoiding danger is no safer in the long run than outright exposure.  Life is either a daring adventure, or nothing—-Helen Keller 

This is a candidate for quote of the week!  It’s a good reminder that risk is omnipresent, in life and in financial markets.  It doesn’t matter what you own or don’t own—you’re still exposed somewhere.

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The Great Divide in Economics

July 27, 2011

Kudos to Mark Thoma, a professor of economics at the University of Oregon, for an article suggesting that there needs to be more interaction between researchers and practitioners.  He writes:

When I was trying to figure out if there was a housing bubble or not, the academic economists I had come to trust said no, the fundamentals explain this. Sometimes this was backed by econometric analysis. But many people outside of academics, or at least a few, said there was a bubble. This was often backed by logic, intuition, and simple charts rather than sophisticated econometrics based upon theoretical constructs. For the most part, I dismissed the people I should have listened to, especially if it contradicted what the academics were saying. Most of all, I relied too much on the experts in the academic community instead of listening to all the evidence and then thinking for myself.

One of the reasons I didn’t listen is that until I started blogging, I was pretty arrogant about academic economists. As far as I was concerned, pretty much, academic economists knew more about everything related to economics than anyone else. But one thing I’ve learned from the wide array of voices in the blogosphere is that I was wrong. Academic economists have a lot to learn if they are willing to listen.

If only some Modern Portfolio Theorists were as honest and open-minded as Dr. Thoma!  The best point he makes, I think, is about listening to all of the evidence and then thinking for yourself.  There’s plenty of blame to go the other way too.  Practitioners have sometimes been all too eager to accept and implement academic theories, even when they make very little sense or have been based on incredibly suspect assumptions that do not obtain in the real world.  Other practitioners are arrogant and dismiss the idea that academics know anything at all, something that is also not true. 

There’s always something to learn from people in other fields.  Daniel Kahneman and Amos Tversky were psychologists studying decision-making processes—until someone connected the dots and realized that market participants make decisions with uncertain outcomes all the time.  Many years later, psychologist Daniel Kahneman ended up with a Nobel Prize in Economics.

There is particularly a lot to learn in finance if academics and practitioners would interact more and actually listen to one another.  Both Warren Buffett and George Soros have written about problems they perceive with the Efficient Markets Hypothesis, yet some academics dismiss their billions of dollars extracted from the market as some kind of lucky coin-flipping.  Even a rudimentary knowledge of statistics and the law of large numbers would tell you that someone who has made thousands of trades a year over four decades and has ended up with billions of dollars in profits (like George Soros) is not just lucky!

Good theory-making always derives from observation: examine data to see what is happening and then construct a theory to explain why it is happening the way it is.  If you can figure out why, you can extrapolate and test your hypothesis.  (The budget debate is a great example of bad theories—everyone has an idealogy, but no one is citing past historical examples or data.  Open-minded economists and business people with common sense are more likely to do the right thing than political idealogues.)  More interaction might lead to better theories, and better theories would lead to better policy-making for all of us.

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A Fate Worse than Debt?

July 14, 2011

Is there a fate worse than debt?  If there is, it seems to be not dealing with the debt.

When there is too much leverage in the system, there is always a risk that things go wrong quickly and unexpectedly.  Ken Rogoff and Carmen Reinhart have an op-ed piece on Bloomberg today about the debt overhang and its implications for economic growth.   They are the only commentators who have been consistently correct about the path of the financial crisis, probably because they are the only one who have studied the actual data.  That, and maybe because Ken Rogoff is a genius.  But I digress.

KenRogoff A Fate Worse than Debt?

Source: www.csmonitor.com

Here is Rogoff and Reinhart on the debt crisis:

As public debt in advanced countries reaches levels not seen since the end of World War II, there is considerable debate about the urgency of taming deficits with the aim of stabilizing and ultimately reducing debt as a percentage of gross domestic product.

Our empirical research on the history of financial crises and the relationship between growth and public liabilities supports the view that current debt trajectories are a risk to long-term growth and stability, with many advanced economies already reaching or exceeding the important marker of 90 percent of GDP. Nevertheless, many prominent public intellectuals continue to argue that debt phobia is wildly overblown.

Although we agree that governments must exercise caution in gradually reducing crisis-response spending, we think it would be folly to take comfort in today’s low borrowing costs, much less to interpret them as an “all clear” signal for a further explosion of debt.

Those who would point to low servicing costs should remember that market interest rates can change like the weather. Debt levels, by contrast, can’t be brought down quickly. Even though politicians everywhere like to argue that their country will expand its way out of debt, our historical research suggests that growth alone is rarely enough to achieve that with the debt levels we are experiencing today.

Those who remain unconvinced that rising debt levels pose a risk to growth should ask themselves why, historically, levels of debt of more than 90 percent of GDP are relatively rare and those exceeding 120 percent are extremely rare. Is it because generations of politicians failed to realize that they could have kept spending without risk? Or, more likely, is it because at some point, even advanced economies hit a ceiling where the pressure of rising borrowing costs forces policy makers to increase tax rates and cut government spending, sometimes precipitously, and sometimes in conjunction with inflation and financial repression (which is also a tax)?

The relationship between growth, inflation and debt, no doubt, merits further study; it is a question that cannot be settled with mere rhetoric, no matter how superficially convincing.

In the meantime, historical experience and early examination of new data suggest the need to be cautious about surrendering to “this-time-is-different” syndrome and decreeing that surging government debt isn’t as significant a problem in the present as it was in the past.

I’ve done a massive cut-and-paste job with their essay and tried to hit the highlights.  I recommend that you read the whole piece, which is more extensive and covers additional topics.  Their thinking is important because they are neither alarmists nor happy talkers, just economists who have actually done a careful study of how debt levels affect economies.

Why do I even bother with this, since I am certainly not an economist?  I have two motivations in mind.  1) I think it’s important to focus on the actual historical data, as Rogoff and Reinhart do.  Without data, you’re just another dude with an opinion.  Americans have been subjected to way, way too much idealogy from blowhards in both parties in Congress on the debt issue—and no one is looking at the data.  2) How debt is handled will have a big impact on investment opportunities around the globe.

Think about the differences from country to country!  The UK showed a stiff upper lip and enacted austerity measures immediately.  Greeks are protesting in the streets about the debt, corruption, and proposed austerity and are edging ever closer to restructuring—a polite term for a partial default.  Spain is pretending they don’t have a problem at all.  Japan has endured 20 years of financial repression—20 years!!—with low interest rates for savers, no economic growth, and has piled on even more debt.  The US has gone from hoping for a grand bargain on tax reform and deficits to a mini-plan to squabbling about doing anything at all.

The investment climates will be very different as a result, and money always goes where it is treated best.  Traditional strategic asset allocation will be very difficult in this environment, where responses to the debt problem are still being formulated.  Reliance on past returns, correlations, and volatilities could be ruinous, much as they would have been in Japan in 1990.  It seems to me that a relatively flexible, tactical solution is called for that allows investment in a wide variety of markets, to seek out returns wherever they may be found.

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George Soros on Efficient Markets

July 12, 2011

Investment practitioners have all too readily given up the high ground when it comes to formulating theories on how financial markets work.  Perhaps because practitioners have been too engaged actually making money in the markets by employing realistic theories, most financial theorizing—for reasons that are obscure to me—has been left to academics.  Many financial theories have no doubt been hatched in an attempt to gain tenure rather than actually having to be employed in the marketplace to make money.

Here’s what George Soros had to say about efficient markets in an interview about the financial crisis:

It is important to realize that the crisis in which we find ourselves is not just a market failure but also a regulatory failure, and even more importantly, a failure of the prevailing dogma about financial markets. I have in mind the Efficient Market Hypothesis and Rational Expectation Theory. These economic theories guided, or more exactly misguided, both the regulators and the financial engineers who designed the derivatives and other synthetic financial instruments and quantitative risk management systems which have played such an important part in the collapse.

Pretty harsh.  Mr. Soros has an alternative theory of how financial markets work that he calls reflexivity:

I have developed an alternative theory about financial markets which asserts that financial markets do not necessarily tend toward equilibrium; they can just as easily produce asset bubbles. Nor are markets capable of correcting their own excesses. Keeping asset bubbles within bounds have to be an objective of public policy. I propounded this theory in my first book, “The Alchemy of Finance,” in 1987. It was generally dismissed at the time, but the current financial crisis has proven, not necessarily its validity, but certainly its superiority to the prevailing dogma.

Let me briefly recapitulate my theory for those who are not familiar with it. It can be summed up in two propositions. First, financial markets, far from accurately reflecting all the available knowledge, always provide a distorted view of reality. This is the principle of fallibility. The degree of distortion may vary from time to time. Sometimes it’s quite insignificant, at other times it is quite pronounced…

Second, financial markets do not play a purely passive role; they can also affect the so-called fundamentals they are supposed to reflect. These two functions that financial markets perform work in opposite directions. In the passive or cognitive function, the fundamentals are supposed to determine market prices. In the active or manipulative function market, prices find ways of influencing the fundamentals. When both functions operate at the same time, they interfere with each other. The supposedly independent variable of one function is the dependent variable of the other, so that neither function has a truly independent variable. As a result, neither market prices nor the underlying reality is fully determined. Both suffer from an element of uncertainty that cannot be quantified. I call the interaction between the two functions reflexivity. Frank Knight recognized and explicated this element of unquantifiable uncertainty in a book published in 1921, but the Efficient Market Hypothesis and Rational Expectation Theory have deliberately ignored it. That is what made them so misleading.

Perhaps not shockingly, Mr. Soros thinks that markets trend.  Hmm…George Soros a trend follower?  Who knew?  Here’s how he describes the market process:

Every bubble has two components: an underlying trend that prevails in reality and a misconception relating to that trend. When a positive feedback develops between the trend and the misconception, a boom-bust process is set in motion. The process is liable to be tested by negative feedback along the way, and if it is strong enough to survive these tests, both the trend and the misconception will be reinforced. Eventually, market expectations become so far removed from reality that people are forced to recognize that a misconception is involved. A twilight period ensues during which doubts grow and more and more people lose faith, but the prevailing trend is sustained by inertia…Eventually a tipping point is reached when the trend is reversed; it then becomes self-reinforcing in the opposite direction.

Typically bubbles have an asymmetric shape. The boom is long and slow to start. It accelerates gradually until it flattens out again during the twilight period. The bust is short and steep because it involves the forced liquidation of unsound positions. Disillusionment turns into panic, reaching its climax in a financial crisis.

george soros George Soros on Efficient Markets

Let’s see: markets trend.  First markets trend slowly for logical reasons, then the trend accelerates, eventually for illogical reasons.  Then the market reverses sharply when reality is recognized once again, culminating in a panicky selloff.

That is pretty much the story for every monster investment theme throughout history.  You already know this if you’ve been around markets and have been clever enough or lucky enough to catch a few rockets.  You don’t even have to believe the theory—you can actually observe this happening over and over.

Now Soros doesn’t claim his theoretical model is absolutely right—just that it is better than the academic models currently in vogue.  Since he came to America as a penniless immigrant and has managed to make $14.5 billion, I am going to go out on a limb and say that perhaps he knows more about it than most academics.  At least I do not know of any academics who made $14.5 billion by means of modern portfolio theory.  (Warren Buffett also regularly mocks modern portfolio theory and has managed to make a fortune using his personal theory of how markets operate.)

Somewhere in here, don’t you have to conclude that markets are not efficient and modern portfolio theory is bunk?  If not, seriously, where is your proof that you can make hordes of money employing modern portfolio theory?

Note: If you haven’t read The Alchemy of Finance, it is worth a look, especially for the one-year trading diary of the Quantum Fund.

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The Real Wealth of Nations

June 21, 2011

This article is about history that is still being written, and about a simple way to create a powerful, sustainable economy.  It is about Lee Kuan Yew and the Singapore Central Provident Fund.  Never heard of it?  Neither had I, until I happened upon a story about it in the book Animal Spirits by George Akerlof and Robert Schiller.  I was fascinated and dug in to do a little further research.  The best thing about this story is that it is true—and therefore it is repeatable.  It has critical lessons for the United States, if we want to remain a world power.  And it is something we can easily do, if we make the choice to do it.

Most debates about the sluggish economy are conducted along Keynesian lines and argue that spending needs to be stimulated.  If people would just spend more, the economy would grow.  After all, the reasoning goes, consumer spending is 2/3 of the economy.  This line of thinking led to citizens actually being sent spending money—stimulus checks—in the mail!  The effect was pretty much what you would expect if you thought about it for more than fifteen minutes: minimal and temporary.  Giving someone money does not create prosperity—note the effects of sudden money on lottery winners.

What we have is not a spending problem, but a savings problem. Savings is what creates dynamic economic growth. Exhibit 1 in my case for the power of savings is Singapore.  Singapore became quasi-independent in 1955, after being a British possession since the 1820s (although it was occupied by the Japanese during World War II).  For a period of time, it was also part of Malaysia, but became fully independent in 1965.  Lee Kuan Yew had some training at the London School of Economics and took classical economists like Adam Smith seriously.  Adam Smith emphasized the capital accumulation that comes from savings.  With no natural resources whatsoever, except its people and their work ethic, Singapore resolved to save its way out of poverty.

Singapore skyline night 1 The Real Wealth of Nations

Singapore Skyline

Source: www.commons.wikimedia.org

Lee Kuan Yew started the Singapore Central Provident Fund in 1955 as a way for citizens to save for retirement.  It has since been extended to include savings programs for housing and healthcare.  According to Akerlof and Schiller:

Initially it required employees and employers each to contribute 5% of employees wage income to the fund, but then contribution rates were rapidly increased.  They were steadily raised until 1983, when employer and employee were required to give 25% each (a total of 50%!).  The contribution rates follow a complicated schedule, but even today high-wage employees age 25-50 pay 34.5% and their employers pay 20%.  The system has not been “pay-as-you-go,” and the sums collected have really been invested. Largely because of the CPF, the gross national savings rate of Singapore has been in the vicinity of 50% for decades.

I put the important part in bold.  This is completely unlike our Social Security system, where the employee and employer payroll contributions are deducted, but then spent immediately.  As a result, in the US there is no actual surplus capital, only net debt which is an IOU on future generations.  Singapore already has essentially privatized their Social Security system.  Far from leading to fiscal disaster as some claim, the huge pool of enforced savings has not only secured the retirements of Singaporeans, it has allowed an enormous amount of capital investment.

Disciplined savings as a nation over a 50-year period literally transformed Singapore from a poor trading outpost that was kicked out of the Malaysian union to one of the wealthiest nations in the world.  According to the Credit Suisse Global Wealth Report:

Household wealth in Singapore grew steadily and vigorously during the past decade, rising from USD 105,000 at the outset to more than USD 250,000 at the end. Most was due to domestic growth and asset price increases rather than favorable exchange rate movements. As a consequence, Singapore now ranks fourth in the world in terms of average personal wealth.

Wealth in Singapore is double the average wealth level in Taiwan and 20 times higher than in a neighbor like Indonesia—not to mention higher than in the US.  Now, I suppose it is not entirely surprising that a high savings rate leads to wealth.  What is more interesting, I think, is what it did to the Singaporean economy.  What grew out of the immense savings was a capital investment boom unlike anything ever seen.  And, the capital investment was not made with borrowed money, robbed from Peter today to pay Paul tomorrow, but was based on actual savings.  Thus, the growth was sustainable.  Coupled with the power of compounding, the results have been astonishing.

The able J.P. Lee did a little digging around for me and put together this graphic on the comparative GDP growth rates of the US and Singapore over the last 50 years.  Shocking isn’t it?

LogScale The Real Wealth of Nations

arithmetic The Real Wealth of Nations

Click to enlarge.  Source: St. Louis Fed; Dept of Statistics, Government of Singapore

The graph on the top is a logarithmic scale which shows how much more rapid the economic growth in Singapore has been.  The magnitude of the compounded difference, though, isn’t really apparent until you take a look at the arithmetic chart below it!  GDP growth in the US over the last fifty years has been a robust 6.8%, but it has been dwarfed by the growth rate in Singapore, which has averaged a stunning 12.2%!  (If we could get even a fraction of this additional growth by privatizing Social Security, sign me up.)

Can you imagine what a national savings program could accomplish in the US?  We have many economic advantages already, ranging from an excellent university system, a diversified economy, and abundant natural resources to an outstanding record of technological innovation.  What we lack is savings.  Intelligent incentives to save and invest, coupled with Social Security payroll deductions that are actually invested in accounts for the participants could have a mind-boggling impact down the road.

Personal savings is something quite different from government savings or spending.  The US government seems addicted to deficit spending, but as a citizen you can’t do anything about that directly.  On the other hand, your level of personal savings in entirely under your control.  Like Singapore, most individuals have the ability to compound their savings for fifty years.  Even if the US never adopts an intelligent enforced savings plan, there is nothing to stop you from doing it yourself.

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Politics and Economic Policy

June 15, 2011

I thought this article from The Economist was insightful and captures some of the frustration Americans feel right now.  Economic policy has been politicized.

If there’s something scary about the potential crises in Europe, America, and elsewhere, it’s this aspect: the status of economic policy as gamepiece in a broader, political conflict. That increases the odds that something big and bad may actually occur.

There is actually quite a bit of economic research showing how economies react in different situations, but it’s all been thrown overboard due to the politics.  I think all Americans would just be happy to get the economy going again.

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Modern Portfolio Theory IS Harming Your Portfolio

June 7, 2011

This title is taken from a long blog post at Value Restoration Project—and no, I didn’t write it.  The author, J.J. Abodeely, is a portfolio manager at Sitka Pacific Capital, and a CFA to boot.  It’s nice to have some brothers-in-arms for a change!  Mr. Abodeely bases a lot of his commentary on a recent article by Scott Vincent, available on the Social Science Research Network.  Here’s the core of his argument:

In the paper Vincent argues that the flawed foundation of Modern Portfolio Theory (MPT) that risk=volatility has allowed MPT advocates to control the language of the debate and set the stage for the obvious conclusion that passive index-based investing is inherently superior. And don’t think for a second that this debate is simply theoretical, academic, or unimportant– the basic tenets of MPT shape the decisions of nearly every institutional money manager, wealth management firm, investment counselor/consultant, and financial planner in profound and often disturbing ways. YOUR money is almost certainly being managed with these ideas at the core. The traditional approach to asset allocation is built on false axioms.

While Vincent’s direct assault seems to be focused on highlighting the mistreatment of active, concentrated equity or fixed income asset managers vs. holding a passive equity or fixed income index, his arguments hold sway over the much larger and dangerous consequences of MPT on asset allocation. My assertion is that most damage to investors portfolios from the traditional approach to investing comes from the foundation of static, backward looking assumptions informing broad asset allocation decisions

I put the good parts in bold—and I think you can make a good case for both of those statements.  Instead of using static, backward-looking assumptions, I think it makes sense to examine tactical asset allocation, where asset weights can vary dynamically based on performance or valuation.   To me, it makes no sense to assume, for example, that bonds are preferable as a client gets older, regardless of the interest rate environment or poor price performance.  If an asset is performing poorly, why would any client be excited about holding it?

Strategic asset allocation is founded on the assumptions of Modern Portfolio Theory, and if the axioms are false, it is not surprising that it has not delivered in the way its apologists suggest it should.  Most distressing to me is the fact that asset allocation models are most sensitive to the inputs for return, and return is the most variable input of the three (returns, correlations, and standard deviation).  By definition, if your asset return assumptions are off, your asset allocation is wrong.  And seriously, if you could actually forecast asset returns accurately, you wouldn’t need asset allocation—you’d just buy the best-performing asset.  The greatest danger in strategic asset allocation, to me, is the assumption that past asset returns will be similar in the future. 

I think that assumption is flat-out wrong, because it flies in the face of the observed life cycles of companies and economies.  When companies are small, they are vulnerable.  Many of them simply don’t make it and go out of business.  Midsize companies that succeed often go through a very dynamic growth phase, where revenues and profits grow at a pace far beyond the growth rate of the underlying economy.  Once companies become very large, it is almost impossible for them to grow at a rapid pace, simply because they are working off such a large base.  It is pretty easy for a 20-store retailer to open ten new locations in a year and have 50% growth.  To get 50% growth at Wal-Mart would require them to open 4,485 new locations in a year, more than 12 per day—and then 18 per day the following year to keep that growth rate up.  That’s substantially more difficult.

Economies are no different.  Developing economies can growth at a fast clip, but not forever.  Once an economy is developed, the growth rate is going to slow down.  Growth can be boosted by productivity enhancements and good incentives, but eventually broad market returns will be connected with revenues and profits in the underlying economy.  In 1800, the US was an emerging market economy and the European economies were the developed markets.  The US has gone through a long period of powerful growth and is now the largest economy in the world.  As the Wal-Mart of world economies, we are not going to have the highest growth rate.  That doesn’t mean we can’t have good stock market returns—and, clearly, plenty of dynamic individual companies will do fantastically well—but emerging markets are likely to have higher growth rates.

As a result, I think it is naive to assume that US returns will necessarily resemble what we’ve seen before.  They will be lower than before if we pass the torch to more rapidly growing emerging economies, and they could be higher if emerging economies sabotage themselves with poor incentives or a lack of political stability.  Money goes where it is treated best and that is always an open question in the future.  Whatever the returns end up to be is a function of how we handle the future, not what has happened in the past.  Asset allocation needs to be forward-looking to be relevant for investors’ performance in the future.

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Quote of the Week

May 27, 2011

We can’t solve problems by using the same kind of thinking we used when we created them—-Albert Einstein

We have a ton of technological innnovation going on all the time.  However, we seem to struggle with new economic ideas because of entrenched political ideals.  I think all Americans would breathe a sigh of relief if the government were willing to innovate and try some new economic incentives, especially on a small, test scale.  Even if the ideas failed, we would learn enough to keep improving. 

Old thinking = same old problems.

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An Inconvenient Truth: the Onion

May 5, 2011

Politicians and markets don’t always get along.  When market prices behave in a way that is politically inconvenient, politicians tend to step in—usually with little understanding of the consequences.  (Note: it doesn’t matter whether prices are plummeting or rocketing, it’s the politics that count.)  When housing prices were rising, everyone was happy.  When housing prices fell, politicians of all stripes felt a need to blame someone for the price collapse and to prop up the market.  When gasoline prices are rising, politicians often feel the need to demonize someone.

One day soon, evil speculators will be blamed for some price misbehavior that is politically inconvenient.  Don’t believe it.  In fact, as Jonathan Hoenig points out in a Smart Money article:

…the fact is that speculative futures markets don’t create volatility, they reduce it.

For proof, let’s go back to the 1950s when farmers began to complain about the price of onions, which were falling.  They appealed to their elected representatives to do something about the evil speculators who were obviously impacting their livelihoods.  The biggest onion producing state at the time was Michigan, so Michigan congressman Gerald Ford pushed through the Onion Futures Act, which banned trading in onion futures.  No more evil speculators.  (According to the Smart Money article, it is still the only commodity-specific futures ban.)

I realize this must sound comical, but yes, Congress actually prevented speculation in onions!

Professor Mark Perry (of the University of Michigan!) recently posted a chart of onion price volatility, showing it in comparison to oil which still has a futures market despite recent calls to exorcise the evil energy speculators.  Oil is much less volatile than the onion market:

 An Inconvenient Truth: the Onion
Source: www.mjperry.blogspot.com

Lest you think that energy prices are just inherently less volatile than onions, even CFTC commissioner Joseph Dial in a 1997 speech pointed out:

…economists “found more cash market volatility in onion prices before and after the period of futures trading than there was while the onion futures market was operating. In other words, futures markets don’t cause volatility — they respond to and decrease volatility.”

Politicians can pass laws to hinder markets from operating efficiently, but they cannot repeal the law of supply and demand.  That’s why price is all-powerful in the end.  Auction markets are critical in determining the proper clearing price so that producers and consumers can make intelligent decisions in the future.  Trying to curb “speculation” just causes poor capital allocation for society.

Postscript: for a complete academic treatment on futures markets and volatility reduction, this paper by David Jacks of Simon Fraser University is fantastic.

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Thought of the Day

April 26, 2011

We can’t solve problems by using the same kind of thinking we used when we created them—-Albert Einstein

For some reason, this is the quote that keeps coming to mind when I hear the talking heads of both parties screaming about the budget deficit.

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Building Financial Wealth: A Primer

April 19, 2011

Many of our clients refer to themselves as “wealth managers.”  For that reason alone, it’s important to define what financial wealth really is and how it is obtained.  Fortunately, there is a very relevant article on MarketWatch today by Jennifer Waters that is a good basic discussion.  First up, a basic definition of wealth:

Wealth is what you accumulate, not what you spend,” according to Thomas Stanley and William Danko, the authors of the seminal tome on America’s wealthy “The Millionaire Next Door,” first published in 1996.

The emphasis is mine.  I think this part is so often overlooked—not by the truly wealthy, but by the general public.  The big spender is usually not actually wealthy, but merely has a high current income.  In fact, people are often wealthy precisely because they don’t overspend:

…most of those with big bucks live well under their means — think about Warren Buffet still living in that modest Omaha home — and they put their money instead toward investments that help them stockpile more wealth.

“It is seldom luck or inheritance or advanced degrees or even intelligence that enables people to amass fortunes,” the authors wrote. “Wealth is more often the result of a lifestyle of hard work, perseverance, planning, and, most of all, self discipline.”

 Building Financial Wealth: A Primer

www.cashadvocate.com

Is this shocking to anyone?  No—but it’s a good reminder.  You might get lucky with an inheritance, but wealth is rarely gained by winning the lottery.  Wealth is achieved by working hard, living under your means so that you can save, and then putting the money toward investments that help you stockpile more wealth.

Having a high income can obviously help you save, but a high income alone is no guarantee of eventual wealth, as the article points out:

People with high incomes who spend all that money are not rich; they’re just stupid.

A wise advisor once pointed out to me that, “Making the first million is difficult.  Making the second million is inevitable.”  What he was getting at, I think, is the point that the first million requires discipline, patience, and investing acumen, especially when you’re starting with nothing.  It takes quite a while for the snowball to accumulate as it rolls downhill.  If you are fortunate enough to acquire the first million, your saving and investing habits are well-established and ingrained, so the next million is relatively easy.  The second million is typically a lot faster than the first—that’s the way compounding works.

Once earned, wealth needs to be protected.  Intelligent portfolio construction is one way that advisors can add a lot of value to clients:

“The wealthiest clients have very, very diversified portfolios that go way beyond just stocks and bonds into hedge funds, currencies, commodities and emerging markets,” said Leslie Lassiter, managing director of the JPMorgan Private Wealth Management.

Flexible exposure to good asset classes at appropriate times can go a long way toward enhancing client wealth.  Whether you use something like our Global Macro strategy, or mix-and-match separate accounts or mutual funds is not so important.  The critical idea is making those investments work together toward the client’s end result.

The biggest objection of most clients boils down to this: they are very concerned that they won’t have fun if they live below their means.  I think this reflects a fundamental misunderstanding of what makes us feel good about our lives.  In the long run, spending more on a nicer car or another pair of shoes isn’t going to help.  In study after study, what gives meaning and enjoyment to our lives is the number and quality of our personal relationships.  That’s where real wealth is found.

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Free Men, Free Markets?

April 7, 2011

According to The Economist, faith in free markets has dropped dramatically in the U.S.:

FAITH in the free market is at a low in the world’s biggest free-market economy. In 2010, 59% of Americans asked by GlobeScan, a polling firm, agreed “strongly” or “somewhat” that the free market was the best system for the world’s future. This has fallen sharply from 80% when the question was first asked in 2002.

According to their graphic, the biggest supporters of free markets are now Germany, Brazil, and China!

 Free Men, Free Markets?

Source: The Economist

Maybe the self-esteem movement has gone too far and Americans just don’t like the idea of failure—but that’s what is supposed to happen in capitalism.  If you run a lousy business, it’s supposed to fail.  That’s the genius of capitalism, the “creative destruction” that Joseph Schumpeter wrote about.  While it may be individually difficult at times, societally it is fantastic.  Each failure is a signpost on the way to ultimate success.  (And, by the way, relative strength is an excellent way to sort the winners and the losers.)

There are still lots of American corporations doing first-class business in a first-class way.  And if this poll is any guide, maybe looking overseas in Germany, Brazil, and China isn’t a bad idea either!

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“Passive” Investing is a Big Lie

February 3, 2011

Bespoke has a nice post and some graphics on how things have changed since the S&P 500 price last visited the 1300 area, back in 2008.

People that are passionately committed to “passive” investing often have a hard time admitting/understanding that the S&P 500 is an active index.  It has massive survivor bias because S&P is constantly dropping laggards and adding strong stocks.  Passive investors often argue that they are buy-and-hold investors, when, in fact, the actual index return is plumped by all of the switches that S&P makes.  A true buy-and-hold investor that buys the actual underlying stocks and holds them generally loses money over time!  An earlier post that I wrote on this topic generated a ton of controversy, although Blackstar’s findings were echoed by DFA.  (There’s no end to the irony in this business!)

If the earlier post didn’t convince you that the S&P 500 is an active index, maybe the graphics from Bespoke will.  As they point out:

In fact, 11 of the 25 current S&P 500 members that have done the best since the last time the index was at 1,300 weren’t even in the index at the time.

Yep, nearly half of the big winners weren’t even in the index! Clearly, S&P is adding the flyers.  So much for passive investing.  Here are the nice tables from Bespoke with all of the gory details.

 Passive Investing is a Big Lie

 Passive Investing is a Big Lie

Source: Bespoke Investment Group

Now, obviously, we are big fans of active investing.  Thank goodness that S&P is constantly tinkering with the index to adapt it to current realities!  Buying strong stocks is what we do, so having S&P add them to the index is a nice thing.  (In fact, the list of big winners has substantial overlap with our portfolios–which we are quite happy about.)  Buying an S&P 500 index fund, then, is just selecting S&P as your investment manager.  If you choose S&P as your manager rather than Dorsey Wright or another active manager, that’s your call.  Just don’t kid yourself that buying an index fund is passive investing–it most certainly is not.

Disclosure: Dorsey, Wright Money Management currently has positions in F, WFMI, CTSH, AKAM, AAPL, BRCM, Q, GR, TDC, NFLX, FFIV, and CRM in various account styles.

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The Distribution of Wealth

February 3, 2011

When you can turn on the television and watch riots overseas on a live feed, it’s a little freaky.  Some of what is going on is clearly political, but often politics have their roots in money and economics.  One of the things that Americans constantly worry about in this country is the distribution of wealth–why do the rich always seem to get richer, and what happened to the middle class?  Will economic inequality eventually result in social upheaval?

This article from the New York Times is a reminder of how good we have it.  It shows the comparative purchasing power distributions in the U.S., India, China, and Brazil.  In each country, there are very wealthy people.  In each country, there are poor people.  But the “poor” people in the U.S. are about as poor as the richest 10% of people in India!  An amazing visual:

 The Distribution of Wealth

Source: New York Times/Branko Milanovic

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The Entitlement Problem

January 11, 2011

From Global Economic Analysis, a federal look at what is a global phenomenon.

 The Entitlement Problem

Source: Global Economic Analysis, Congressional Budget Office

Here is the operative problem:

The main point is from now until 2020, we could eliminate 100% of all federal non-defense discretionary expenditures and still run a deficit.

In other words, cutting out waste, fraud, and abuse will fall way short.  Entitlement programs will need to be cut.  And while entitlement programs are the biggest part of the federal budget, debt service is a rapidly growing slice too.

This process is playing out in developed economies everywhere–Greece, Ireland, Portugal, Japan, Illinois, California, and the entire United States.  Some places will choose to keep  right on spending; others will choose austerity.  These choices could have dramatically different effects on currencies, growth, and ultimately, financial solvency. 

Emerging market countries have defaulted on some of their obligations from time to time in recent memory, but the experience of developed economies being consumed by debt is  something new to most of us–new even to economists.  In the U.S., there is still a vociferous ideological debate between professional economists about the correct path forward.

Ken Rogoff and Carmen Reinhart have written about previous debt-fueled fiscal crises.  In almost all of them, bailouts were initially required, followed by austerity.  If austerity was not imposed, eventually there was some type of default, through partial repudiation of some obligations (like cutting Social Security or state pensions, for example), through inflation, or through outright default.

All of these choices will have investment implications.  Investors will have to be tactically flexible to simultaneously grow their capital and maintain their purchasing power, all the while attempting to avoid catastrophic losses.  Crises create anxiety, but they also create opportunity.  The general public is very turned off to equities and risk in general right now, but rising markets will pull them right back in, so the current condition is likely not permanent. 

If you have excess capital, you are by definition an investor.  How you choose to allocate that excess capital will have a great bearing on your future well-being, so it is imcumbent upon you to make wise choices.  Since no one knows what will happen in the future, the decision framework you select is of critical importance.  We think that trend-following through systematic application of relative strength is the most robust decision framework available.

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