Getting Back Into the Swing of Things

Due to slavish commitments at work and all manner of other nonsense, I took a bit of a hiatus, but now I should be posting fairly regularly again.  It's a fascinating time to come back into it, so hopefully there will be some good posts to come.

200th Blog Post!

Apparently, there is a perfect image out there for this occasion:

Huzzah!

If you thought that the stock market can be volatile...

Gallup polls on a number of kind of, well, random sentiments. Among them is this poll on whether or not people would categorize themselves as "energized" or "ailing". Frankly, I'm amazed that 30-40 percent of people always consider themselves to be "ailing", but more peculiar than that is the constant back and forth chop in the numbers. Given that these changes reflect net rather than gross changes in each category, I'm amazed that as much of the population swings back and forth as it does.

http://www.gallup.com/poll/110128/Gallup-Daily-Health.aspx

I would be curious to see, all other factors being held constant, if you line up these numbers with stock market performance on a day to day basis if there would be any relationship.

Government Compensation's Effect on Private Sector Compensation

You might scoff at the very notion that there is an effect, unless you have an understanding of economics. I assure you that what follows is not just because I work in government, but it is in the spirit of good analysis.

It is useful to think of the labor market as being two discrete parts: a public sector and a private sector. This is a gross oversimplification as there are sub-sectors in each that are more numerous than a blog post can readily accommodate as a forum for discussion, but it will serve our purposes. The demand schedules for labor in both are driven by the demand for their services as well as the ability of both to compensate workers for those services. Nothing earth shattering there. Their supply schedules, too are fairly similar, and they are functions of each other to a certain extent.

To explain that point a little more clearly, it can be fairly reasonably said that if public sector compensation is increased, all other things being held constant, that workers at the margin will go to the public sector instead of the private sector. In that shift, what you will see is that the marginal workers that shift from the private sector to the public sector are of a talent level that the private sector would otherwise liked to have had, assuming both markets were in equilibrium previously. In order to secure the same quality of labor that the private sector had previously, private firms, on average, will increase wages to drive a shift in labor supply back to the private sector. Conversely, a decline in government compensation that is determined exogenously (by elected officials, for example) will shift the labor supply for government in while shifting the labor supply for the private sector out, which reduces wages in the private sector.

The illustration of this is fairly simple in the event of an exogenous reduction in public sector compensation (CLICK ON PICTURE FOR LARGER IMAGE):

Some might say that a reduction in public sector wages will simply reduce the amount of labor supplied in the public sector and there will be no additional bleed-over. The problem with that is that labor supply is not all that elastic. It's part of the reason that tax cuts don't generate more revenue than they cost and why tax increases actually do raise revenue. In extreme cases of, say, a 90% tax increase or a 50% wage cut, you will see the supply of labor decline. Interestingly, it is unlikely that private sector employers would increase their demand for labor since the primary determinants remain mostly unchanged.

As I said at the outset, this is fairly over-simplified as there are a lot of little nuances here and there. For instance, many in the public sector are trained in fields that do not have, in the terms of private sector human resources advisors, "transferable" skills to the private sector. For instance, fire fighters and teachers both would have a difficult time finding equivalent private sector jobs, though teachers would find a narrow number of opportunities in private sector schools. As such, many public sector workers may have a difficult time switching between the two sectors.

The long and the short of it is that the recent efforts to roll back public sector compensation at nearly all levels will likely further add to the deflationary tendencies in the labor markets that exist right now.

I'm not sure that these people care about the price of gasoline

http://www.forbes.com/wealth/billionaires

I always love to thumb through this list to see if there are some executives of companies that have not been performing too well on here. Michael Dell jumps out. That he has almost $15 billion is a crime considering that stock performance. There are also always the Walton kids who simply won the genetic roll of the dice. Rupert Murdoch hasn't delivered much to his shareholders in nearly 20 years and yet still seems to do just fine, somehow.

The other thing I always find amazing on these lists are the numbers of brothers, twins, or other relations that pop up. There are the Kochs, Ziffs, Waltons, and Strungmmanns among others.

Then, of course, there is my personal favorite, which is George Lucas, sitting atop his $3.2 billion. Frankly, I think he should take about half of that and reimburse people for seeing his awful prequel trilogy, but we all decided to pay him the price of admission... and the price of the DVDs... and the price of various computer and video games. Okay, he deserves every dime he has. The man's a genius at making money.

A More Permanent Return

So, thankfully, most of the budget work is out of the way. If you have not been paying attention, Wisconsin's budget has been drawing a bit more controversy than usual this year and, as one of the Governor's budget analysts, my workload has been a bit much. However, we are now past the worst of the crunch and I can get back to my hobbies.

71% of Americans Want a Crippling Financial Crisis

http://www.reuters.com/article/idUSTRE70B38620110112

So, 71% of Americans don't want to raise the debt ceiling, but they also don't want meaningful spending cuts or tax increases. In that case, the only inevitable result is default. Luckily, Congress will likely ignore the will of the people, as it should, and do the right thing here. This was an issue that many demagogued on during the recent elections, but really is not a legitimate issue unless you have a meaningful way of reducing the budget deficit.

Oh well.

Quantitative Easing Explained.... By Sane People

This isn't as silly as the much more popular version that was made by Austrian (school) economists/Tea Party/etc idiots, but it is fundamentally much more correct.

Some people should not talk about public finance

Ugh. W. Kurt Hauser wrote a piece in the Wall Street Journal that nearly gave me an aneurysm.

He asserts that no matter what you do with taxes, tax revenue comes in at 19% of GDP because tax increases hurt economic growth and tax cuts increase it. Oh really?

If you average the Bush years versus the Clinton years, the federal government average taxes as a percentage of GDP nearly 2 full percentage points below the Clinton years. This was despite a huge run up in corporate tax receipts as corporate profits hit an all-time high that had just about nothing to do with tax policy since corporate tax rates were left at 35%. Comparing peaks in the business cycle we also have about a 2 percentage point gap. 

Not all of this is the static effect of taxes being at lower levels. It is also a function of the fact that the economy did not grow nearly as quickly in the 2000s as in the 1990s. However, that in of itself would seem to indicate that tax cuts don't generate additional revenue as there was nothing particularly remarkable about economic growth following two significant tax cuts in 2001 and 2003. 

Ah, but Mr. Hauser says that we can see that economic growth was revived by the tax cuts. He says the six quarters following the tax cuts averaged a GDP growth rate of 3.8% compared to an average of 1.8% prior to the 2003 tax cuts. First of all, he is ignoring that the larger of the two tax cuts was passed in May of 2001. Secondly, he is ignoring the fact that the Federal Reserve was substantially aiding the recovery from the recession with massive monetary stimulus. Thirdly, the recovery in the economy was led by residential fixed investment, which had little to nothing to do with tax policy changes. Fourthly, at comparable portions of the business cycle, tax revenues as a percentage of GDP were lower in a systematic way. So, not only did GDP not grow as fast, we collected less of it in taxes. 

Looking at the same comparison he attempted to make for just the 2003 tax cuts, we have 1.3% average growth in the six quarters following the 2001 tax cuts compared to the six quarters preceding them at 2.2%. Also, for the recent stimulus (which I am sure Mr. Hauser does not approve of), we have averaged 2.3% since its passage compared to -2.1% in the six quarters before it. Is this disingenuous? Oh heck yeah, but what he did also was. This sort of analysis does not constitute any form of economic analysis. It is selectively applied correlation analysis, but there is no systematic approach applied to compare the period he selected with other similar periods and other tax policy decisions, or to control for what other economic trends were at work (Federal Reserve interest rate decisions, reductions in oil prices, housing market trends, etc.), or... well... any kind of analysis at all. 

Incidentally, under a similar form of analysis I could point out that the six quarters following the Reagan tax cuts averaged -0.9% GDP growth, but that isn't fair since the Fed killed economic growth to subdue inflation. Similarly, you cannot credit the growth that started in Q4 1982 to the tax cuts entirely because the Fed was the primary agent stimulating economic growth at that point. 

If you make decisions on whether or not to invest on political pundits such as Mr. Hauser, who also apparently has an incredibly inflated ego, I urge you to reconsider. I would remind everyone that many Glenn Beck followers completely missed the largest stock market rally in recent history from the March 2009 lows because they were convinced that some Communist takeover had just occurred. 

Sometimes the interplay between politics and economics doesn't make sense:

http://www.ritholtz.com/blog/2010/11/wtf-data-point-dems-lost-seats-better-economies/

When you think about it, Democrats did quite well in California (12%+ unemployment) and quite badly in my home state of Wisconsin (7.8% unemployment). Does that make much sense? Not really. Of course, I have argued that we are simply in an era of dramatic political volatility rather than any particular ideological movement one way or the other. If you look at Europe, center-right governments in Germany, France, and Italy are all on the verge of collapse or are at the very least deeply unpopular. The newly elected center-right government in the UK already has fallen behind Labour in recent polling.

At the same time, Japan has recently lurched right after electing its first clear center-left government in several decades. Some of the Latin American governments seem to be shifting right, though that certainly didn't hold in Brazil where the Worker's Party (which is effectively Socialist) won quite easily. Spain's socialist government is probably quite likely to lose when the next election happens there due to truly crippling unemployment rates and an economy very unlikely to right itself anytime soon.

We are simply at a time where it is advantageous not to be in power and this was even true in 2008 as well. There were parts of the Democrats' success, or alternatively the Republicans' weakness, that under most elections would have been quite stunning, but in an environment of extreme economic strife such things can happen. The same applied this year as well in reverse.

I suspect that 2012 will see a fairly large number of seats change hands again in the House. If we enter a protracted period of stagnation, or something that at least feels like it, don't be surprised if party control changes routinely. The interesting consequence of that is that we might see truly paralyzed decision making at a time when fairly decisive action is required.

And for a brief moment of levity...

If you feel that you are behind on your rent and that is preventing you from accumulating sufficient wealth to save and invest, this man is for you:



Edit: Incidentally, this man is also right. Look at New York City rents: http://www.tregny.com/manhattan_rental_market_report

Stock Options Teaser

Because I've only finally gotten my brokerage account upgraded to allow for options trading, I felt that I should talk some about stock options. Before I do, here's the relevant Wikipedia article for those not versed on the subject: http://en.wikipedia.org/wiki/Option_(finance)#Trading

About those moves toward protectionism...

http://www.guardian.co.uk/world/video/2010/oct/18/angela-merkel-multiculturalism-germany-video

This is more along the lines of anti-immigrant rhetoric, but I always look at these sorts of things as part of the same overall package. Countries that wish to shut their borders to immigrants because they make immigrants a scapegoat for their problems are only a couple steps away from blaming foreign competition as well. In Germany, that would be a bit of an odd case, but it isn't implausible. I'm still wondering if and when we will see a major country send its trade barriers on up.

Mr. T Pities the Fool Who Doesn't Buy Gold

http://www.bloomberg.com/video/63695708/

I think this, and the ever shifting series of justifications for gold (including arguments that it is your hedge against inflation, deflation and prosperity all at once) are beginning to flash big warning signs that gold is about to top out and possibly top out for some time to come.

Blogger Barry Ritholtz, who is a far more esteemed observer of financial markets than I, argues for maybe having 5% of your total liquid assets in gold or precious metals more broadly. I can't say that I'm entirely opposed to that proposition, but I think the issue here is the entry point. While no one has ever developed either a good empirical or theoretical framework for valuing gold, the odds are that gold has seen its best days for some time to come.

Just how volatile are global politics right now?

Very, it turns out.

Labour now polls even or possibly ahead of the Tories in the UK just four months or so after the most recent election. http://itn.co.uk/6ec09e8f6e13a874aa91c427f4437806.html

Normally I would say ignore politics, but I think what you may be seeing in a number of countries is a move by many democracies toward being ungovernable. That is a risk that we have to keep in mind as the economies of the developed world remain languid. Germany's government is precariously positioned and that is unlikely to improve. The same goes for Australia's. One basic rule of history that I remind myself of when there are situations like this one is that it doesn't necessarily have to end well.

We still haven't seen any headlong plunges toward protectionism by any major parties around the world in order to garner votes, but that's certainly a possibility. It would be a big vote getter in countries that are convinced that all they have to do is improve their trade balance to grow their economies. However, given that all countries seem to be trying to collectively devalue their currencies, it is a possibility trade protections will start popping up. One serious aggravating factor there is that China operates behind somewhat of a trade wall while most of its trade partners are as open as any economies have ever been.

If we do see parties start to flap their gums about protectionism, suddenly even low yielding bonds would look attractive. We aren't there yet, but we could be before long.

Opposing Views on Gold and GOOG

I have recently been critical of both gold and Google (GOOG). In the interest of presenting multiple views, here are a couple of articles disagreeing with what I have been saying lately.

Gold: http://money.uk.msn.com/investing/articles.aspx?cp-documentid=154762364

The basic premise here is that since we are still at a time when central banks seem to be focused on devaluing their currencies in order to boost exports. I would agree that in the short run this provides some support to gold. Still, I don't buy the win-win scenario for gold because if gold is truly an asset class for all seasons, even a marginally efficient market would have already priced it as such. The risk to gold is that if stable economic growth is restored without an major outbreak of inflation it will suffer horribly. A restoration of 2-3% inflation is not bullish for gold. However, this author makes his case and it helps to have opposing views.

Google: http://blogs.marketwatch.com/cody/2010/09/23/googles-headed-to-2000-heres-why/

Now, there the author says that Google is going to $2000 a share by 2020, which would be about a 4x increase. I actually don't doubt that as a possibility, but I would be inclined to take the under on that one. There is plenty of upside for Google and it is true that the major trends are with them, but a decade is a long time in information technology and Google seems somewhat undisciplined in terms of achieving good operating results. I do think that Google makes a great deal of sense as a long term holding as I have a hard time figuring how it doesn't outperform the overall market over the next several years. Google just frustrates me because they could be more profitable than they are if it was a more professionally managed company.

A (Very) Brief Digression on Economic History

I normally wouldn't want to venture into this territory, but there are certain facts which have been distorted somewhat due to the fact that this is a political season and somewhat due to the fact that some people want to push certain narratives. I just wanted to provide some simple facts that I think have gotten distorted.

One is that the 1970s were an absolutely hellish decade while the 1980s were wall to wall prosperity. This is true when it comes to the performance of financial markets where stocks had a wretched decade in the 1970s, largely due to the fact that they entered the decade with elevated valuations due to the run ups in the 1950s and 1960s, but also because interest rates rose throughout the decade due to inflation from the Federal Reserve's incompetent management of monetary policy (and due to certain oil producing countries behaving badly).

However, in terms of income growth it certainly wasn't horrible. Here are the CAGR numbers for inflation adjusted personal income by decade.

1950s: 4.06%
1960s: 4.62%
1970s: 3.50%
1980s: 3.13%
1990s: 3.07%
2000s: 2.48%

The same holds reasonably close with GDP, which shouldn't be a surprise since income growth and GDP should be closely related.

Part of the reason the stock market was so nicely positioned for a good decade in the 1980s was that nominal earnings had risen substantially during the 1970s while nominal stock prices remained practically constant, even down somewhat. As a result, stocks in the first few years of the 1980s were badly undervalued. The PE ratio of stocks in April of 1980 was about 7x trailing earnings. Once interest rates began to fall to more reasonable levels, stocks appeared badly undervalued.

If there's a lesson from this it is probably that you should always look up data yourself rather than believe it wholesale from someone who is trying to make an ideological point or create some kind of narrative of the financial markets.

Funny Blast from the Past

So, I was going through some books of mine, and I found this one sitting in a bin from my move from my old apartment:

I think this was one my brother picked up around 2003 or so at a rummage sale for about $0.50. In truth, it's probably worth less than that, but it may surprise you to know that this book is not devoid of data and rational argumentation. It actually made a somewhat persuasive case and not all of it was nonsense (though most was). Rather, I think it was a case of where the author had already made up his mind of what he thought the markets were going to do and built his evidence around his prejudices.

Incidentally, this same author is projecting another Great Depression in the near future. Take that for what you will.

A September 11th Financial Retrospective

Shocking events such as September 11th usually have dramatic effects on the financial markets because financial markets are made up of individuals and if individuals suddenly, all at once, feel uneasy about the world, things can get ugly in a hurry. After the 9/11 terrorist attacks, the markets certainly reflected this.

Just as a little refresher, the first plane hit the WTC before the markets had opened and they were instantly shuttered. If one has been in that part of New York City, I am sure they can see why. It's uncomfortably close to the NYSE and American Stock Exchange. Leaving the markets open all day as the rest of the events unfolded could have led to a truly unfathomable sell off. With all of the rumors of as many as 40 planes high jacked, false reports of a bomb at the State Department, and everything else, we would have easily broken the 10% decline barrier that causes a one hour shut down at the NYSE and probably would have broken the 20% barrier as well. In fact, I think there would have been an outside chance at the 30% barrier as well. Rumor and fear were really out of control. Though I didn't have a brokerage account, I do have to say that watching the cascading collapse of the twin towers would have probably been enough to put in market sell orders.

Even though the markets were closed that Tuesday, and the next three days for that matter, time did not blunt the sell off much when the markets finally reopened on September 17th, 2001. While the 17th was certainly the worst day of that week, the rest of the week was certainly not exactly a walk in the farmer's market. By the close of business on Friday September 21st the Dow had dropped about 15%. The total U.S. market capitalization dropped nearly $2 trillion. At the end of the day, however, September 11th had relatively little economic impact. Bear in mind that the recession we were in at the time had started in March 2001. By November, it was over. Outside of the airlines and the hotels, very few companies had to cut their earnings forecasts due to 9/11. Some tech companies were still cutting their forecasts from the ever deflating technology bubble, but that's a different story altogether.

To be a bit more succinct, 9/11 had nearly squat all for economic impact outside of the financial market shock and even that was a very small effect in terms of a permanent impact. In fact, the disruption to air traffic had a very positive effect in reducing oil demand and therefore prices by nearly a third before they slowly started to crawl back. Further, and this is the more interesting part by far, were the opportunities created by the panic.

My favorite example is United Technologies (UTX), which is also one of the all time great stocks generally if you are interested in accumulating core positions. One of United Technologies' businesses is of course aircraft engines and of course if the airline industry was hurting they would buy fewer planes and therefore aircraft manufacturers would buy fewer engines. However, investors in their panic seemed to forget that United Technologies also has a large defense business that was bound to do quite well in an environment of increased defense expenditures. The results speak for themselves.

Bear in mind that this is from 9-10-2001 to 9-11-2006 so this does not show the gain from the bottom, but rather the gain from before 9/11. As you can see, UTX took an approximately 35% hit as a result of 9/11, which is far worse than the market as a whole, but that was quickly erased and then it went on a tear, which has seen it add another 80% to that rally beyond this chart. From the bottom it is up 220%, which is pretty damn good compared to an overall market that is up around 10% or so. The market in general, though it is hard to see here, recovered all of its post 9/11 losses within about six weeks or so and the Dow closed a full 1,000 points above its pre-9/11 levels by March of 2002. Then of course, the accounting scandals of that year, persistent slow economic growth, and fears of a double-dip recession sent the market far below its 9/21/2001 closing lows.

To conclude, whenever an upsetting event like a terrorist attack or natural disaster occurs, at some point your mind may perversely wonder "How will this affect my investments?". The answer is almost invariably that it will not affect your investments as much as the market would seem to indicate in its initial reactions and in those moments you can make a lot of money. Now, a genuine financial crisis like 2008, on the other hand, is quite a different story.

Deflation or Disinvestment?

When diagnosing our present malady, I think there has been too much focus on the technical definition of "deflation". A number of economists have lazily said "Well, CPI isn't falling yet so we can't be in deflation". Fair enough, but why do we care about deflation in the first place? We care about deflation because of its effects, not its tell tale symptom. Its symptoms can be best described as "disinvestment".

Now, disinvestment has another definition that's related to economic boycotts where those who disapprove of the actions of a country or region such as what happened to South Africa under the apartheid regime. In this case, we mean a more literal definition which is the dimunition of investment and its various manifestations. In a deflationary environment, conditions are such that the owners of capital feel little need to earn a high rate of return and indeed they perceive that a high rate of return is not possible to earn. As such, they do not replace depreciating capital investments, place new equity capital into their businesses, or increase the human capital of their labor force. With low or non-existent rates of inflation, the real value of their money is not under pressure and as such there is little cause to take risks. As such, they just draw down on their existing capital, having great profits and cash flows for a little while, but their lack of investment hurts their productivity in the long run.

Further, consumers expect that goods will be at the same prices as they are now or potentially lower while they don't expect their incomes to rise so they see no reason to take on more debt. What's more is that because existing debt burdens are hard to pay down with stagnant wages, debt service becomes comparatively more onerous. While debts get paid down, they are only paid down slowly. As consumers also expect asset prices, principally house prices, to be moribund, they sit on their hands and wait for prices to drop before buying new houses and they also don't deploy their money to the capital markets.

To one extent or another, we are seeing all of these symptoms even while we still technically have some inflation. While weak consumer spending has been evident for some time, some of the business investment indicators that had been turning up are beginning to look a little soft to put it mildly. Now, we had a similar set of data disappointments in 2002 and the economy still resumed growth thereafter so it doesn't mean that we will fall apart here. Still, I think the Fed may be adopting policies with far too narrow a definition of deflation. If they paid attention to these symptoms of disinvestment, perhaps they would adopt more rigorous and also more creative approaches toward stimulus.