Thursday, August 28, 2014

Point of No Return

As Burton Malkiel points out in this article, popular sentiment is growing that the stock market is reaching or has passed fair value. As he also points out, beware your attempts to "time" the market--selling out to buy back in after the "inevitable" dip.

The stock market will go up and down and up and up and down and up and down and down and up and . . . Of course, history shows that those downs don't fully counter the ups. The composition of ups and downs in both frequency and magnitude matter. Historically it has been the case that the rides up are slower and longer while the trips down are sharper and shorter. I've discussed this before. While that pattern isn't always followed, the strong historical trend has been an upward bias in returns--the long-term trend in the stock market is positive.

Add to that the fact that the market is very efficient, and you are left with virtually no reason to try to time the market. Yet, many are not convinced. They still feel compelled to sell out with the belief (hope) the market will decline allowing them to buy back in cheaper. My advice then comes in the form of a question: What if you're wrong? What is your contingency plan for that?

It better be to find a point to throw in the towel and get back into the market. Of course, you'd like to know how to recognize you were in fact wrong. After all, just because the market has risen from where you exited doesn't mean it won't come down still.

Here is perhaps a little guideline. Looking at the monthly total returns for the S&P 500 since January 1970 through June 2014 (44.5 years or 534 months), I isolated all of the drawdowns for the index. I then ranked them and calculated the implied percentage gain for each. This last figure would be the amount the index would need to increase in order to overcome the drawdown. For example, if the market declines 25%, it would then need to increase 33% to get back to even. A 50% decline requires a 100% increase from that new low point. Here are all 36 drawdowns for the period charted:

Your reentry point might be once the market has gained some threshold amount above the point in which you sold out. Because the general trend is for the market to grow, you would want to buy back in once that threshold of growth has been achieved no matter how difficult it feels to do so. And it will feel difficult--you sold out at a lower point for a reason. Your complaint might be that just when you thought you were out, the market pulls you back in.

To give you some comfort, though, notice how rare very large drawdowns are. Couple that with the fact that over this time period (January 1970 to June 2014) the S&P 500 increased over 8,300%. Like I said, are you sure you want to time the stock market? If you do, consider that once the S&P 500 has increased about 20% from your exit point only five times in the past 44 years has it dropped so much that it would return to your exit point. And that drop needs to happen ASAP. The index's average growth over this period was about 10.4% per year or about .83% per month. You risk being left behind for good.

When it comes to beating the market, market timing as a strategy isn't even on the map. The implication is discipline beats (mythical) exceptional skill--most value added by professional financial advisers (perhaps as much as 90%) comes from simply finding appropriate asset allocations, fulfilling it with appropriate (not sensational) investments (styles and classes are more important than particular names and issues), and KEEPING with it in good times and bad.

Wednesday, August 27, 2014

A World of Plenty

I have a client who is a former home builder. He has lots of interesting stories of home buyers with punch list requests. When it came to concrete, he always told them two "essential truths": (1) Nobody's gonna steal it and (2) It's gonna crack. It may be obvious, but the first part is pretty interesting. Why is this the case? It is not because of our harsh, one-strike-and-you're-out policy on concrete theft. Rather it simply doesn't pay to steal it. And it is not just concrete that carries this property. Do this experiment: place a new HDTV in your front flower garden and leave it over night. Do this for long enough, and you will wake up to find (nothing but) flowers. The thieves were there. They just weren't and generally wouldn't be in the market for flowers.

Megan McArdle recently wrote on this subject of crimes not meeting the cost-benefit test, but I think she left it undone. Let me think through the implications a little further.

Compare the cost of a hammer today to a hammer 100 years ago. Basic hammer quality and technology has really not changed in this time span (well, some hammer technology has changed, but a basic hammer is the same to the consumer today as back then--I said basic, not this one). The only impact of technology and progress has been in the production of hammers--they are A LOT cheaper today.

The Stanley hammer from the 1914 issue of Popular Mechanics linked above was priced at $1.25. The Home Depot's hammer also linked above is priced at $5.75. Average hourly wages for manufacturing workers was about $.22 in 1914, which means a worker would have to toil for about 5 hours and 40 minutes to earn enough to pay for a hammer. Average hourly wages for manufacturing workers today are about $19.60, which means a worker today must work only about 22 minutes to earn enough after tax (assuming a high 20% average tax rate) to pay for basically the same hammer. Which all means the hammer is at least 93% cheaper today than 100 years ago. That is one way to see the cost difference. Here is another.

Imagine this: You purchased a hammer two months ago. It has sat in your toolbox for the last two months, or so you think. It actually was stolen a month ago. You discover this while reviewing your personal video surveillance system. You won't need it for another month at which time you plan on hanging some pictures. This theft is but a minor inconvenience to you. And you are actually pretty surprised anyone would steal a simple hammer. In fact, it sounds like some fanciful hypothetical designed to prove a point. Now imagine if it were 1914 and your hammer was just stolen. Ouch!

We may ask ourselves, "Well, how did we get here?" We're naturally blind to the progress, and we are probably equally blind to where it is heading. You'd be wrong to guess that this must be the place where the story ends.

Tomorrow's HDTV's are today's hammers. As goods keep piling up getting cheaper and cheaper and scarcity meaningfully dwindles, virtually all economic theft becomes undesirable from the standpoint of the thief. It is not worth the thief's time to go to the trouble of robbing you for something that basically has no black market. One day a thief's search for diamonds will be no more than grabbing at straws.

Not only will we live in a world basically without economic theft; we will live in a world safer in other ways. You'll no longer have to worry about someone stealing your TV, but you'll also not have to worry about walking in on someone stealing your TV where a burglary turns into a homicide.

That is the future world of plenty we are heading towards. Eventually there are no pirates on the ship no matter the cargo. 

Sunday, August 24, 2014

Highly Linkable

These people and their miniature worlds are so tiny. I'm crushing their heads! Be sure to hit the video at the end.

Megan McArdle asks us to take a moment to marvel at the kitchen wonders some of us (humans) enjoy today.

The rest of this link post is brought to you by Don Boudreaux (directly or via hat tips).

On the 69th anniversary of inexcusable brutality, Boudreaux asks us to remember and remember how conservatives felt about it at the time.

I relate very, VERY much to Sheldon Richman's sentiments in this post.

George Will rightfully takes to task those who would paint inverting corporations as unpatriotic. I love the conclusion:
This illustrates the grandstanding frivolity of the political class. It legislates into existence incentives for what it considers perverse behavior, and then waxes indignant when businesses respond sensibly to the incentives.
Matt Zwolinski has five important moral (and economic) points about payday lending.

The free market is filled with something even better than tolerance--indifference.

Here Boudreaux offers not just a strong argument against cronyistic policies like the Ex-Im Bank but also a strong argument against the minimum wage. To wit: why is it consumers' job (or in the case of the minimum wage, employers of low-wage employees' job) to compensate the "victims" of foreign subsidies (low wages)?

Just how dangerous is it to be a cop? Daniel Bier answers. (SPOILER ALERT: not very).

Monday, August 18, 2014

Highly Linkable

Then there was only the ocean and the sky and the figure of Howard Roark . . .

A new day is dawning in sports. A tyrannical dragon has suffered the first strike of what I predict will be a lethal combination leading to its eventual slaying. The NCAA has lost the O'Bannon case. Michael McCann's take is, as always, a must read. He carefully lays out the limits of the ruling, but my optimism is not naive. The lawsuits have just begun, and the law from which they challenge is various--meaning more ways the NCAA can be harmed--while the judge will be the same--and she didn't mince words in rejecting the NCAA's logic and arguments. Notice that those calling for (market) reform are not satisfied yet. That is important as it means the NCAA hasn't found refuge in a new normal. Rather the hypocrisy and ignorance is being called out. And the silly arguments, which wouldn't mean salvation for the NCAA even if they were valid, are smothered before leaving the nest.

Kevin Erdmann makes an interesting comparison between school choice and financial regulatory choice with a spotlight on Dodd-Frank. The thrust is that a right to exit is essential to good institutional policies and incentives.

Speaking of exit, Arnold Kling points to others showing yet another way we could exit the FDA.

Scott Sumner wants you to know that the American middle class is fine and that is exactly what he means.

Tuesday, August 12, 2014

Do We Want To Live In A Third-Best World?

I listened to this NPR story on my way home from work today. The basic facts quickly:
  • A disabled man uses marijuana for medicine. He says it works better than anything else for his symptoms. 
  • The man lives and works in Colorado where the state law allows medical marijuana and where state law prohibits discharging an employee for lawful activities conducted off work premises.
  • The man works for Dish Network, does not use pot while at work, and does not come to work high.
  • Dish Network conducts periodic random drug tests that screen for marijuana, and the test it uses can detect marijuana's THC compound days or even weeks after actual use (the story is slightly murky on this, but I believe it is the case).
  • Dish Network dismissed (fired) the man after his positive test result.
This got me thinking about the world according to a libertarian. Here is the breakdown:
  • In a first-best world marijuana is fully legal. Employers can freely choose to employ or not employ people at their will including considering if they use marijuana on or off premises. Different firms have different policies and people (customers, employees, and everyone else) respond to those policies by respectfully agreeing or disagreeing, engaging or disengaging, and supporting or protesting. This way norms tend to work themselves out and adapt over time. The evolution is completely based on persuasion rather than force. Where disputes come up about rights (always a conflict of negative rights since positive rights do not exist in libertarian utopia), those are handled by a common law process. Again, it is evolutionary from the bottom up. Sadly, we do not live in this world. 
  • In a second-best world marijuana is mostly or fully legal. Employers must adhere to rules governing their conduct as set by a combination of common law and local legislated law, but these rules that emerge from this process are few in number and necessarily local in scope and encumbrance. The relationship between employer and employee is adaptive since it is governed some by rules imposed externally but mostly agreements made between the two parties internally. You'll never have that kind of relationship in a world where you're afraid to take the first step because all you see is every negative thing 10 miles down the road. Hence, we do not live in this world either. 
  • In a third-best world marijuana is mostly illegal. Employers are strictly governed by a multitude of rules set both locally and nationally with little of it coming out of a common law process. These rules are often in conflict with themselves as well as political tensions that dominate at different levels. The environment is ripe for lawsuits since so much is unclear and arguable. And those suits have little hope of bringing precedent-setting resolution or clarity for future disputes. Nothing is ever settled and almost nobody is ever happy with the results. The clarion call for a solution demands a top-down, one-size-fits-all approach that is as arrogant as it is unjustified. Sadly, we live in this world. 
While we work towards a better world that I do believe we can achieve (to wit: No matter what anybody tells you, words and ideas can change the world), we must settle for something less perfect. I hope Brandon Coats prevails in his case under state law. I hope the federal government takes a step back from the employer-employee relationship rather than offer its unhelpful solutions. 

We don't have to live in a third-best world, but it will take people learning to think for themselves. Your move, chief.

Friday, August 8, 2014

Remember... all I'm offering is the truth. Nothing more.

(Updated to correct small grammatical errors due to voice to text problems)

Yesterday's Marketplace Morning Report had a snippet examining different articles from an old 1948 issue of Fortune magazine (starts about the 3:45 point in the short clip). One part of the story stood out to me. It was about business and ethics and specifically about inequality using the example of teachers being underpaid. It is unsurprising but disappointing to me that this story line has been around as long as it has. It is disappointing from the standpoint of it being either economic ignorance or deceptiveness.

Allow me to point out the logical implication of the idea that teachers are underpaid (Fair warning: I do this to be provocative by stating it in a rather harsh but still true manner. This is designed to get a rise out of you but also to make you think critically.). Here goes:
Either they're too dumb or lazy to figure out how to get out of that job and into the one that pays them what they're worth or . . . they're worth what they're being paid.
I will let you seethe on that for a moment.

Okay, now let's be a little more charitable. Notice I won't go so far as to basically canonize everyone in the teaching profession. For those who truly could make a greater total compensation but instead sacrifice for the good of the cause, that is wonderful and to be commended. At the same time, if you are doing it as an act of charity, you have forfeited your right to complain about the pay. For the rest . . .

This could be another case of the old adage there ain't no money in that. But there is money in that; we just have to understand what type of money there is and what is truly determining that total compensation. If you make the proper adjustments for time off and other benefits including pension plans for public school teachers that may be too generous, you see that actual total compensation is fairly high. It still lags what many talented teachers could earn in other professions, but we have to respect their reasoning for making the choices they make.

So why is teacher compensation largely composed of non-pecuniary benefits like time off and job security? One easy answer would be that most of the teaching jobs are through government, which is subject to the whims of the political arena and haunted by bad incentives.

(I've updated the next paragraph to clarify my point)
Yet the larger economic reason (for teachers' pay structures including the low annual wage commonly kvetched about) is more subtle. Income is overwhelmingly determined by comparative advantage and the size of the market--not intelligence per se. Frankly speaking there are a lot of eligible candidates for teaching jobs despite the work of teachers unions to restrict the employee pool. And in the market for teaching children there are in most cases quickly diminishing returns to intelligence.

Don't believe me that income is a matter of comparative advantage and market size rather than intelligence? Imagine you are a member of a primitive society living on a small, isolated island. Would you rather have as your only differentiating skill to be the one guy who knows how to split an atom or the one guy who knows how to tie knots?

Sunday, August 3, 2014

Will The Boomers Really Kill The Stock Market?

Last week listening to NPR I heard this story on Marketplace. Marketplace's shallow treatment of the story was frustrating although not atypical. The gist of it is a concern that as Baby Boomers age and enter retirement they will begin a mass sell off of the equity portfolios in favor of bonds or cash, etc. and that this activity will depress stock prices.

This is a fundamental but understandable misapplication of supply and demand (SD). SD is different for capital investment assets. At the price I am willing to pay I will purchase stock in a company. If that price rises enough, I will sell. Hence, once I take ownership, I am a supplier. But if after I purchase the price goes down enough and I don't think fundamentally anything has changed, I will buy more. Hence, I am also a demander. This is a peculiar situation where the same entities are both suppliers and demanders.

Normally, you're on one side or the other. Think of Wal-Mart and myself in the banana market. Wal-Mart is clearly the supplier and cannot realistically take the position of a demander no matter how low the price of bananas falls outside of using the bananas as an input for making, say, banana bread and then supplying that. (Wal-Mart can buy more to turn around and sell more, but it cannot actually consume bananas keeping it firmly on the supply side of the equation). Likewise, I cannot realistically become a supplier of bananas no matter how high the price of bananas climbs. (Sure, at some point it is profitable for me to drop the day job and take up a plantation south of Panama with David Lee Roth, but in what world does that happen and I am the guy best suited to do it?) So unlike in regular goods markets, SD clearly has some special properties when dealing with investment assets.

Because most of the time only a small fraction of the total quantity of stock in a particular company actually trades, you need simultaneous and opposite shifts in SD to get a large price change. Conceptually this makes sense if many investors are thought of as both suppliers and demanders simultaneously--my increased interest as a buyer for a particular stock shifting demand to the right is mirrored by my decreased interest as a seller for that same stock shifting supply to the left. Figure 1 below demonstrates.

Perhaps a better way would be to look at the supply curve as fixed (vertical) at the point where quantity equals the total shares outstanding. The demand curve then does all the heavy lifting. The supply curve only shifts when there is increased or decreased short selling or when the firm issues new shares to the market or removes shares from existence. Figure 2 below demonstrates.

Absent a surprise change in the fundamental condition of a stock such as a new product success or a fire destroying inventory, what can actually affect a shift in demand (using Figure 2's modeling of the market)? New buyers of stock enter the market all of a sudden? How would that actually work? For example, imagine a rich, crazy man walks onto the NYSE trading floor (opens a Schwab account for you literalists). He wants to use his entire $10,000,000 net worth to buy Apple stock paying as much as double the market price although nothing has changed fundamentally for Apple. What happens to Apple's price? Well, it goes up, temporarily. What next?

Well, what can he do with the stock once purchased? He can't destroy it. He can hold it. He can sell it. He can give it away. Regardless of the action he takes, the stock always goes back to the rational price. Here we have another case where we simply should insert the response "And then what?"

It isn't enough just to make a vague assumption of a market outcome. One needs to have a basis for the outcome and then work through the possible consequences. The same applies to scare hypotheticals (circa 1985) "What if the Japanese buy up all the real estate in the U.S.?!?" or (circa 2014) "What if the Chinese buy up all our oil and gas and coal?!?" Same answer: Okay, and then what?

Without something fundamentally changing in regard to a stock's value, a price change can only happen if risk tolerances* change. Consider a two-asset investment universe (riskier stock and less risky bond). A shift in the average appetite for risk will change the relative attractiveness of the two assets which will be realized through a change in price. If the average risk appetite increases, the riskier asset (stock) will increase in price while the less risky asset (bond) will decrease in price, ceteris paribus. Note that it is unclear in a more realistic many-asset universe how a change in average risk tolerance would propagate into changes in prices as risk is neither linear (one rate of change) nor singular (one-dimensional), but the principle remains the same.

What could Baby Boomers actually do? IF they changed the average risk tolerance of investors, then you would tend to see a decline in more risky asset prices and an increase in less risky asset prices. This could mean a decrease in the price of equities. Yet this change in average risk desire is unlikely. It is not clear that people actually get that much more risk averse as they age. And to the extent that they do, growth in life expectancy and desires to bequeath partially offset any expected increase in risk aversion. Growth in population, which of course occurs at the bottom of the age distribution through births and near the middle through immigration**, will also tend to reverse any age-specific effects on average risk tolerance.

This is the way to think through the situation to find a real path by which a group of market participants like Baby Boomers might affect prices. It is nuanced and fuzzy--two things that don't work well in a three-minute radio broadcast.

*I am being quite liberal with the term "risk tolerances" here as I look to include many facets of taste and perhaps all of Lord Keynes "animal spirits".
**This would only be referring to immigrants who were very disconnected from financial assets since otherwise they would already be a part of The Market, which is indifferent to dashed lines on maps and labels on passports.

Highly Linkable

Andy Schwartz has penned the best analysis that I have ever read of the NCAA, its position as cartel, and the situation before it. Read it to understand the problem(s) and choose a side: Team Market (my group), Team Reform (the bootleggers and Baptists coalition of paternalist progressives and traditionalist conservatives), or Team Cartel (the NCAA today). I believe only Team Market is fully on the ethical and logical high ground. Team Reform's advocated position is not sustainable--the economic incentives will break it down as teams depart the model. Team Cartel might be sustainable in the medium term provided it can unconditionally win the multiple-front legal war it faces. I am being an optimist predicting that Team Market wins decisively and soon. I am simply being logical predicting that Team Market wins eventually.

Speaking of predictions, Randal O'Toole, the Antiplanner, discusses planning for the unpredictable as it relates to city planning and self-driving cars. And Mark Rogowsky makes some predictions about the business side of robo-cars, et al.

More predictions: Scott Sumner discusses some things that can't but will go on forever along with making some interesting predictions.

Here is a prediction that I will make in light of this excellent analysis (HT: Barry Ritholtz): Over the next 5 years hedge fund/alternative asset investment strategies will change A LOT while significantly falling out of favor among institutional money managers (anything outside of the retail brokerage level). I'll predict that in five year average fees are half what they are today and allocations are one-third lower. (UPDATE: To clarify, I am predicting that average fees collected are half as high in five years. If you think about how the average is affected, you'll realize this isn't as bold a prediction as it may seem.)

That's enough predicting for one post.

So Bryan Caplan has basically been following me around chronicling my strategy for success on my terms in life and in business.

Art Carden points out that while there are many negative aspects to poverty and most transcend time, fortunately a low income in absolute terms isn't one of them. Nothing gets you nothing . . .

I had the same reaction as David Henderson to this otherwise good personal finance article by Megan McArdle. People almost always misunderstand the tradeoff between 15 and 30-year mortgages as well as how to figure the cost-benefit of a refinancing decision. It's not about the time to payback on the closing costs and the likelihood of moving in the future. It is a comparison of two (or more) streams of cash flows discounted appropriately. Those other factors are just part of the input variables that must be included.

Like I said recently, the public doesn't understand inflation; Scott Sumner suggests the Fed may be coming around to understanding this and, hence, moving beyond inflation targeting.