Why Might Good News Make Stocks Go Down?

This runs the risk of being the most ill-timed post I've made since current recession risk is probably elevated. Don't take this as direct investment advice or as timely commentary on the current market. 

Consider a hypothetical couple planning for retirement and in the midst of that plan they are considering the upcoming year's vacation options. They can either have a staycation with peanut butter and jelly sandwiches and TV watching or a blowout Hawaiian vacation. 

As they consider which vacation they can afford, I arrive at their door having traveled from the future. Don't get caught up in the unrealistic assumption of time travel. The point is that I can credibly tell them the future looks very bright--perhaps I'm just Carnac the Magnificent. I tell them their investments will do well and times ahead are very good. How will they react? They go on the Hawaiian vacation. In other words they sell or forego savings (investments) and buy current consumption. 

The more technically accurate but less intuitive way of looking at it is the following. To get them to forgo enjoying the vacation now opting instead to save/invest, the market would need to pay them a higher rate of return (their discount rate, required rate of return, has increased). In order for current assets to have higher future returns, prices today must decline. Here is a fuller explanation from John Cochrane. His main point is that positive news can make market prices suddenly decline (if profit expectations stay the same but discount rates increase) but also negative news can make market prices suddenly decline (if profit expectations decline). 

If you find an unanswered question in this analysis, you are on to something. Good news can make the market decline but so can bad news. What exactly makes stock market prices suddenly go up? New, higher profit expectations could be the answer. Unfortunately, this is harder to come by than might be assumed. Remember, we are talking about long-term profit expectations. Those are tied to fundamental growth rates of ideas (innovation/productivity) and market size (population as well as density--a million people in a city are more productive than a million people spread sparsely over a large space). Moving that needle positive is much, much harder than negatively shocking it.

An Analogy For Cliff Asness

The great Cliff Asness recently wrote a piece about the difficulty in explaining a market-neutral portfolio at an intuitive level. The problem is more fundamental than explaining the performance--as troubling as that can be. It is also a problem just helping people understand what they own. Here is my attempt to help him out.

Consider a bunch of guys in a basketball gym. Suppose I was an investor in their performance. First just think about all of them simply shooting baskets like in a warm up before a game. If I could “invest” by paying $1 each time one of my chosen players shot and making a return of $2 each time one of my chosen players made a basket, I would want to pick the best shooters and avoid the worst. I would be making money based on their shooting accuracy. At the extreme I would want to pick Stephen Curry and Lebron James (pick a couple of darling stocks and go all in with them). However, this is hard to do because the star performers are not that obvious—this is after all just a bunch of strangers in a basketball gym not a bunch of strangers plus a couple of NBA all stars. More likely I would need select quite a few players based on some metrics for selection and “invest” in their shooting percentage (build a long portfolio of many stocks). 

That analogizes to the typical portfolio. But what if instead I deliberately chose two teams from the group of guys and had them play a game. My investment's return would then be determined by which team wins and by how much. I gain more as my team wins by more points and I lose more as my team loses by more points. Now my ability to pick the teams (stacking the talent in my team) is the deciding factor of my success and I am essentially long the team I own and short the opponent. From the standpoint of each individuals' shooting percentage (the first approach that analogized a long stock portfolio) my long/short investment isn't highly intuitive, but when viewed as a group against a group it probably is.

I Know Why Dracula Is So Rich

Before we can understand why Dracula is so rich, we need to understand why investments make money at all. Why isn't the current price simply the sum of all future returns? Well, because future returns are uncertain. A business venture might be profitable. Money lent might be returned. And the investor might be around (alive and well as today) to collect when the future return is available. Hence, an investor needs to be compensated for the risk that the investment will not generate a return and for the risk the investor cannot use the invested funds as well in the future as today.

I am positing that uncertainty is the single (the one and only) source of financial investment return above the time-value of money (TVM). Assuming we all have an identical time preference, which we do not, the time-value of money can be summarized as a single discount rate, an annual compound interest rate. Let's set the discount rate to 3% whereby $100 today is equal to $103 in one year, $106.09 in two years, and 1.03^n into perpetuity. To any degree that there is uncertainty about collecting the future investment, one would require a premium to the discount rate--an increase in it to compensate for risk (e.g., 3% becomes, say, 5%, which would be 3% for TVM plus 2% for risk). I realize "discount" is counterintuitive, but understand that it simply means discounting a future amount to be equal to a value in present terms. 

One way to get rich is to have a discount rate (a time-value of money) less than 3%—like say 2%. Then getting someone to pay you 3% in one year’s time is like getting paid almost 1.5 year’s interest in a single year since you only require 2%. It wouldn’t take much leverage (or much time) to make this a very real and very big get-rich-quick (or eventually) plan. 

Another way to get rich is to have less uncertainty about the future--the mythical crystal ball. Even if it is cloudy, it plus what everyone else (the market) knows is better than only what everyone else knows. 

This dawned on me when I was listening to Jason Wiser's retelling of Bram Stoker's Dracula (Dracula: The Night King (part 3 of 3), specifically about the 35:21 mark). Because he is an immortal monster, Dracula can simply wait out any temporary problems--go to sleep for forty years as those who hunt him age and die. Now, think about Dracula's time preference for money or anything else. He plays the loooong game. He doesn't need to consume now and can let his wealth work for him quite easily--decade-long naps allow for very deferred consumption. Relative to mortals, he has a very, very low discount rate because his time horizon is astronomically longer and uncertainty from his perspective is much, much lower. 

What are the implications for us in the non-fictional, mortal universe? Tyler Cowen's Stubborn Attachments wrestles with this concept (confession: I have not read it yet, but I have purchased it, intend to read it, and have listened to approximately 3.79 trillion podcasts of him discussing it). As I understand it, he argues for a discount rate of 0% thereby valuing the future as equal to the present. In such a framework at the individual level you would not be paid a premium for deferring consumption. However, I believe he is proposing this at the societal level and more as a framework for policy making. A conclusion this leads to is generally favoring growth as the primary goal/aspiration for social policy.

What about implications for investors? Individuals are not immortal; so unless you are planning a trip to Transylvanian, you better continue to demand compensation for deferred consumption (TVM) and some premium for risk being taken.

What about endowments and foundations? I would propose they are not nearly as much like Dracula as they would like to be--in the time horizon and uncertainty dimensions. I won't at this time accuse them of having other Dracula-like qualities (fodder for a future "shots fired" post perhaps). These entities have current and continual demands for withdrawals. An X% annual spending policy and a collection of interested parties with very different perspectives strongly challenges any argument for a lower discount rate. The foundation as a concept may theoretically have an infinite time horizon, but its donors, beneficiaries (both current and near-future ones), and employees do not. At the very least it will be difficult for them to think and act as if there is an infinite time horizon when they should (deferring consumption in tough times) and rather easy for them to do so when they shouldn't (assuming future growth will solve all current shortcomings). 

Lastly, what about governments? Well, should they really expect to be around into perpetuity? How many can reasonably expect this? So far at least technically the success stories number zero. (Perhaps another future post expanding on this question and applying to foundations as well.) I will grant that governments in a practical sense to a degree (magnitude matters) can assume very long time horizons borrowing against the future. It will work just fine until it doesn't. Given enough splinters (growth-hampering regulations, inflation, entitlement promises, etc.) you'll eventually have a wooden stake. Governments may aspire to be Dracula (see below), but they face many, many obstacles in getting there. 

This brings us to a Partial List of why governments are like vampires:

1. The light of day is toxic to their way of behaving.
2. Taxes = blood.
3. They can seduce with their promises.
4. They create captured minions whose self interest becomes subservient and aligned to the master's.
5. We trust them blindly at our peril.
6. They are incapable of looking themselves in the mirror.

One High Net Worth Investment Manager's Plea: "Raise Tax Rates to 70% NOW!"

Shout it (and dance it) from the rooftops! We need higher tax rates on the rich. I'm not greedy. This is all I ask.

Please raise rates like in the good ole’ days.

Give me a way to help rich people shelter income from the tax man.

Bring back all the intentional loopholes, the legal methods to ensure that old money stayed on top.

Help me tie up capital in ways that benefit the haves and fill my pockets as well as those of tax lawyers and Wall Street financiers. It isn't just me that is hurting. Plenty of other people were promised lifetime high incomes and prestigious positions. Now we are forced to sully ourselves with talk of "adding value" and "matching the benchmark"--as if I should have to justify my 6-figure bonus. I have an MBA, for God's sake!

I don't mean to lose my cool, but I have had enough. In this world of passive investing, low fees, minimal commissions, and democratized capital we desperately need a way to justify our enormous salaries which fund our lavish lifestyles.

I am so disappointed in recent politicians. I'll tell you something. This country is going to the dogs. You know, it used to be when you bought a politician, that SOB stayed bought. Now they are raising the standard deduction and taking away options like having taxpayers help rich people pay for stuff--no more tax breaks for $100,000 football suites, etc.

We had a great system. It was working just fine during the days of Ike. They warned that kid, Kennedy, not to go down that path of "rising tide lifts all boats". Don't let the camel's nose into the sheikh's tent. He did it anyway.

Dream of a better tomorrow starting today. Imagine how more complex and elaborate our schemes could be in the modern world of international world of finance. Give me a 1,000 billable hours and a few well lobbied-for loopholes, and I could craft a perpetual wealth-shelter machine to ensure no taxman or 99-percenter ever touched a penny of great-granddad's fortune.

First they come for the 150-foot yachts...


Taking my tongue out of my cheek, the sad reality is we are still far, far away from an efficient, effective, fair, and simple tax regime (see also the long version). Progress has been made, but so much remains.

What's Ahead for Stocks - precise predictions

Seriously?!? You clicked thinking you'd find some nonsense about, say, money about to [do something in regards to] "the sidelines", or perhaps you wanted to know how many technical indicators were crossing arbitrary thresholds. Oh, maybe it was an insider's take on smart money that you sought. But what would make the traders behind it "smart", how would I know what "they" (in unison? all on the same side of each trade?) were doing, and if I did, why would I share it?

Markets recalibrate constantly to new information. They also recalibrate constantly to changes in the weighted-average risk appetite of market participants. Did something change over the past couple of weeks? Of course, there is always something changing. But what?...

John Cochrane offers a great post for that question. Short answer: nobody knows. It cannot be known.

But what if we're in a bubble? Yeah, about that... Scott Sumner has two recent posts on that topic and more. He suggests we not be so sure about labeling past prices bubbles and lower the status of pessimists (I agree). He also suggests we should not offer explanations for events for which we are ignorant (I agree).

The standard advice is still the best advice:

• Set your asset allocation as appropriate for best achieving your goals and personal constraints.
• Get broad (very broad) diversification . . . cheaply.*
• Go for lunch.
• Check from time to time (not minute to minute) readjusting if needed to more appropriately fit your current goals.

*There are LOTS of investment options out there. The links show just two--albeit, two very good ones for achieving broad, cheap diversification. Also, maybe this.

Saving Enough for Retirement? - New Year's Resolution fulfillment post

It is time again to report on my perpetual New Year's Resolution - to change my mind about a belief I hold strongly. Happy to report that I was again successful achieving it some time last spring. As I read and reflected upon this argument against increasing Social Security expansion and this counter-conventional wisdom post (HT: Don Boudreaux), I realized I needed to challenge myself against assuming I know what "you" or "we" need to save for retirement.

Formally presented: I have overturned my long-held and thoughtlessly repeated mantra that "typical Americans are not saving 'enough' for retirement". I should have had strong reservations about this mantra as it is a bold affront to my principles to presume that I know the correct amount people should be saving (or consuming).

The heart-breaking stories of the poor not having adequate if any savings for retirement is as misleading as looking at the Forbes 400 as a barometer of retirement preparedness. We do not and should not expect a household that finds itself in the rare but tragic condition of always being in the lowest income deciles to have retirement savings. Those are the households for which Social Security, private charity, et al. are supposed to be the safety net. To analyze the potential problem, one must look at much deeper data and analysis concerning aggregates and focusing on where households actually stand. Andrew Biggs at AEI does that exceedingly well as indicated by this post (HT: again Don Boudreaux).

Make no mistake: there is government-induced crowding out and misleading, many examples of individuals with unrealistic expectations, and bad financial decisions aided largely by government-protected culprits. But the basic belief I formerly held is not substantiated.

Investment List Question Partially Answered

A few days ago I posted two partial lists of investments and posed the question to identify the key distinction between them. Here is the answer.

The key distinction is cash flows. I contend that the assets in list #1 meaningfully generate cash flows while the assets in list #2 do not.

Consider what a cash flow is: a stream of payments going (flowing) to asset owners generated by the asset itself. This does not include money or other assets taken in exchange for ownership of the asset. That trade value is important, but using it to evaluate current (present) value must ultimately rely on guess work--namely guessing what someone in the future will pay for it. Using cash flows is a very useful method to value assets and get around this resale (aka, "greater fool") theory of value. 

Once you have a guess as to what cash flows will be for a given investment, all you need to do is apply a discount rate, sum the results, and viola you have a net present value (current price). And more importantly you now have a method to compare various assets' valuations. Of course, it is not quite that easy. We have to guess/argue about the timing and amount of cash flows, and we have to appropriately guess what discount rate to apply for a proper time-value of money adjustment. But there is even more complication.

There is a tension between my logic and my lists. The implied rent payment one saves by owning their home is fairly vague while the returns from turning copper into the product of electrical wiring is not so vague. Conceivably, if you define "cash flow" broadly enough, everything has a potential utility value that could be described as a cash flow (or in cash-equivalent terms). For this reason I said list #1 meaningfully generated cash flows. I am assuming a reasonableness standard we can generally agree to. 

As such, I don't view gold as an investment in the same realm as I view, say, a share of stock. Gold's value is too reliant on the presumption that someone else will want to buy it at a later date. (Here is some of what the Oracle has said about gold. Read at least #4.)

My two lists of investments are not intended to be uniformly separate. Each item to varying and changing degrees exists on a continuum. Think of it loosely as the Beanie Babies to U.S. Treasury Bonds scale. The "cash flow" from Beanie Babies is only the joy one may get from holding one and the opportunity to sell it down the road. The cash flow from UST bonds is semi-annual interest paid and the promise to mature at par value. Where do you put gold on this scale? As you answer that question for each asset, you start to see a large gap forming naturally separating the two emerging lists of investments. 

P.S., When I first started to answer the question, I fell down a deep rabbit hole that took me quite a while to escape. Read on if you'd like to witness the journey. Bonus points for realizing the subtle point that creates the difference between the answer above and the answer below.

Consider what a cash flow is: a stream of payments going (flowing) to asset owners generated by the asset itself. This does not include money or other assets taken in exchange for ownership of the asset. Ultimately, for an asset to have value, it has to be intrinsically valuable to someone. Take a bond for instance. A bond is intrinsically valuable because it generates income in the form of interest. And that interest (cash) has value because it can buy stuff like beanie babies and food, which are intrinsically valuable because . . . because my daughter likes beanie babies and she and I both need food. . . okay, we might have a problem here. If you didn’t catch the circular logic, go reread that.

Any time you hear “intrinsic value”, your spidey sense should start tingling. That concept suffers from what I call the artificial logical stopping point. It is the fallacious attempt at halting what becomes “turtles all the way down”. In a chain of subjective value propositions we assert at some point that one of those values is so esteemed, so important, that it is an intrinsic value. If that sounds arbitrary, it’s because it is arbitrary. One can always challenge the leap to the intrinsic showing that leap to be invalid. Objectivism philosophically solves this conundrum by basically rejecting the need for an intrinsic value concept. I believe that is the correct way to conceptualize value—value is the relation between the object valued and the individual valuing it, but can I reconcile it with my belief that the two lists are distinguished by the presence of cash flows? I can because of what I am arguing cash flows are and what they are useful for... [this is where I caught my mistake and began anew].

Highly Linkable

Thank God they don't make 'em like they used to.

Watch this and be sure to watch the last "magic" point about a 52-card deck which starts at the 14:06 mark.

Tucker Max offers great advice on why he stopped (and you should stop or not start) angel investing.

This is not a top ten ranking for a university to aspire to.

Steve Landsburg brings his always valuable counter-conventional perspective to Serial: Season One. It is as hard for me to argue with his logic as it is to accept his conclusion. I believe he is right, but I also believe he has introduced an implied simplifying assumption(s) that ignores principles of justice and that may reduce or even reverse his conclusion. I think these principles could impact the model in both a practical sense (given the iterative and complex/diverse nature of the world of crime and punishment, including these principles might get us to better outcomes) and an ethical sense (it seems problematic to have low thresholds for high severity crimes). I might also quibble with his standard of proof and his philosophical position that a juror should be trying to reach a state of belief rather than my philosophical position that a juror should be trying to validate that the prosecution "undoubtedly" proved its case.

Let's look in on how the nation's first experiment with a $15 minimum wage is going--"Look Away . . . I'm Hideous!" Wonder how the guy who wants to take this model nationwide would react? And keep in mind Seattle's cost of living index is about +20% above the national average. How would this minimum wage sell in Peoria, Illinois, to name just one low-cost-of-living place?

Finally and while we're mentioning The Bern, don't miss Reason's take on Charles Koch's friendly letter to Bernie.

Two Partial Lists of Investments

The following partial lists of investments have at least one key, distinct difference between them. Can you identify it?

List 1:

• Stocks (equity ownership - residual claims on assets)
• Bonds (credit lending - contractual claims on assets)
• Real Estate (equity ownership of real, surface property such as your personal home, a home or apartment you rent out, a business building, a REIT, etc.)
• Mineral Estate/Rights (equity ownership of real, under-the-surface property - the right to mine resources)

List 2:

• Currencies (US Dollars, Euros, Yen, etc.)
• Commodities (energy and agricultural such as oil and frozen concentrated orange juice)
• Precious Metals (gold, silver, etc.)
• Industrial Metals (copper, nickel, aluminium, etc.)

I will follow up with the answer in a few days.

Highly Linkable

Visit these 18 fabulous libraries.
Go there (someday) in a "windowless" airplane.
Ask if you can fly a drone around inside to potentially produce videos as cool as these.
If they'll let you, film it for a week so it can get on prime-time Norwegian TV. Those guys plus the drones are getting close to my ideas.

Barry Ritholtz shares his basic simple truths of investing. These are highly recommended. Make sure you read the whole (short) list as the last two are as important as any.

Once you've got your investing house in order, better get to work on correcting these misconceptions about exercise--many of these are no surprise to loyal readers of MM.

Before leaving the body, don't fall for any detox nonsense in your New Year's Resolutionating.

John Cochrane goes all Principal Max Anderson in reviewing Ken Rogoff's proposal to eliminate physical currency. I fully am with Cochrane but I did want to quibble with his confusion about how this would actually affect monetary policy. You or I can immunize our own exposure to the negative interest rate, but we cannot all jointly eliminate it--the burden can only be transferred. I believe Scott Sumner has this criticism nailed.

We are repeatedly reminded that the overwhelming majority of NCAA athletes will go pro in something other than sports. For those the depressing fact is their degree wasn't worth that much. That doesn't surprise David Berri who also notes how the NBA age-limit rule (friendly for the NCAA) harms players while helping colleges and coaches.

Lot of count-ups and downs in this link fest. Here are 20 reasons the wind industry's case is (motionless) hot air.

Tim Harford reminds us in this post that most ventures are failures and we can learn from the losers.

If you were looking for a succinct list of arguments against price controls (ceilings specifically) in the face of disasters, you can relax--Don Boudreaux has provided it.

David Henderson reflects on one of his more memorable times questioning the powerful. If only more of us were so courageous as to continually question the military leadership.

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.

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.

Investing Is Not A Sport

Investing using the sports mindset will leave you saying, "I've made a huge mistake." And it doesn't just take something as colossal as buying real estate in Iraq circa 2002. It is little decisions made all along the way. Examples:

• Buying a stock and then watching its day-by-day or even minute-by-minute performance. This includes trying to explain every fluctuation in price. Most of what goes on over short periods is random noise. This is actually true of sports as well, but it is part of the allure of sports. However, following your investments' gyrations will lead to poor decision making and potentially heart failure.
• Falling in love with a stock. You aren't a fan, you're an investor. You're making an educated evaluation of the asset's value. She's a beauty, but don't fall in love. She's one in a million and there are bound to be plenty better. 
• Thinking that you "obviously" should have purchased some asset that recently had a great run. There is nothing obvious before the fact in investing. That "couldn't miss" real estate deal undoubtedly had tremendous downside risk that just didn't happen to play out. Remember, the reason you're even thinking about it is because it happened to be a winner. "If only I'd had money back circa 2002-03, I would have gobbled up Apple stock." Yeah, Apple's comeback was about as obvious back then as the 2004 Red Sox's comeback against the Yankees in the ALCS right before Big Papi stepped up to the plate in the bottom of the 12th. In hindsight the winning outcome seems logical and likely because it is the winner. We don't have to fully create the narrative as to how it could come to be. Reality has done that for us, but there were many, many other possible outcomes. Often some of these were individually more likely than the actual outcome. 
• Getting wrapped up in performance rather than process. We choose teams and individuals to root for based on a lot of reasons many of which are based on past performance. But successful past performance in investing means buying yesterday's winners--a strategy that doesn't correlate very well with future investing success. Good investing is about finding a good process. That process should generate future investing success.
• Talking yourself into taking a lot more risk than you should simply because the risk started small. Remember this amazing lucky break cum colossal mistake? You are never "playing with house money". 
• As a related point, if you find yourself playing in the equivalent of the championship game, realize that you are mistaken. Investing doesn't work that way. You don't accrue your way into a large reward/low risk situation. Investing is about choosing a risk/reward mix over the long term.
• Sitting a turbulent/uncertain/rough period out on the sidelines. There are no sidelines in investing. Cash is an asset. The mattress, safe deposit box, and interest-free checking account are all examples of investments--albeit, very poorly performing ones. The game is still going on whether you are playing a highly active role or trying to avoid all volatility. Inflation is constantly trying to eat away at the value of your net worth. And ALL periods are turbulent, uncertain, and rough. 

Perhaps golf offers the closest analogy to investing: your performance is largely independent of others' performances, your choices imply the risk/reward mixture (laying up versus going for the green), there is a cumulative effect between actions, the course you choose to play should be dictated by your abilities and your knowledge of the course will affect your performance, about the best you can hope for is a little better than "par", discipline is more rewarded than ability, etc. But even this analogy runs into strong limitations. Investing is always continuously cumulative. You never get to start a new round or new hole. Knowing how to successfully invest relies more heavily on learned skill than raw ability. 

Highly Linkable

My finger painting never looked quite this good.

I like this framework comparing networks to hierarchies. I find it captures something very true. I'll have more to say on it once I get around to starting a new meme on the blog which I will call Dimension Analysis. (HT: Arnold Kling)

Cliff Asness makes the case for HFT and indicates how some of the "facts" and "reasoning" about it might not be quite so factual or reasonable.

David Bernstein weighs in on an on-going discussion over at The Volokh Conspiracy about how legal extremist (and ridiculous) the Obama Administration has been.

Sumner argues that the American system is rigged to favor the rich. I think this is part of a natural evolution and hope to expand on this thought in an upcoming post.

The O'Bannon v. NCAA trial has ended. Michael McCann has a good summary of how the last day turned a bit in the NCAA's favor. Anyway you look at it, though, the NCAA is in a prolonged process much like a divorce where there is no winning--only degrees of losing. They have all but lost the moral/ethical argument. They have been forced to admit to being a cartel (but a good one, not like any of those other bad cartels). Like I tweeted to McCann,

@McCannSportsLaw NCAA:"If we pay players what they're worth, fans will suffer." --May win O'Bannon, but doesn't pass ethics sniff test.
— Steve Winkler (@swinkler78) June 28, 2014

They can't have it both ways in either an ethical or legal sense: the NCAA is either a consumer-harming monopolist or a labor-harming monopsonist (or both, they can fail to have it both ways).

In a different realm of sports meets law meets consumer demand, it only surprises me that this has taken until now to come about. I expect a lot more up and through a tipping point. Poor guy . . .

PS. I've made many promises in this post. I hope I can live up to them.

Adding Value to Investment Management

I've clumsily touched on this before.

I believe active investment management (e.g., being a stock picker who is aiming to outperform the market) is actually just a proxy for risk exposure--dialing up or down one's exposure to market risk. Consider the market price discovery process as a game whereby success is rewarded, poor performance is punished, and market knowledge increases even if average participant knowledge and skill does not.

For example, consider people betting on football games. The bets placed are on which team will win and by how many points in a given matchup. As people make their guesses over the course of many games and over time, the good guessers are rewarded with more resources while the bad guessers are punished encouraging or forcing them to exit the market. The average guess is the market price, the best estimate of future results. The market's knowledge increases along two dimensions: as more people make guesses, more information is incorporated into the price; additionally, as results come in, the better guessers dominate the guessing. This is a simple illustration of the wisdom of crowds. Yet as a new participant starts making guesses, there is no way to know what his guesses will look like or if they will be more accurate than the average guess. Paradoxically, these new guesses will very likely be less accurate than the market's estimates but their addition to the market will add to the market's accuracy. How does this paradox hold?

Imagine the market estimate is for OU to beat Texas by 10 points. A new bettor comes into the market betting that OU will beat Texas by 17 points. Let's assume that subsequently the market estimate adjusts to OU will beat Texas by 11 points. OU then does beat Texas by 12 points. The market was more accurate than the new guesser, but the new guesser improved the market's accuracy. I contend the specifics of this example are a good representation of new information incorporated into the market. It didn't have to be that the new guesser was less accurate and still accretive to the market estimate. To be clear that is my argument.

Thus, the market price is a random walk (we can't predict the direction or magnitude of the next change in price) with a drift--a drift towards greater accuracy. Active managers are attempting to be smarter than the market. However, the market is pretty darn smart, like +99% smart--meaning that is how close the market generally gets to accuracy (being as accurate as one could be at a given point in time). How confident are we these managers can add to that and why would we think they could, over time, across hundreds of securities at any one point in time? Even if there is a persistent flow of "dumb money" flowing in to the system, why should these managers be in any position to consistently pluck it off? It is very doubtful they would be, and if they were, why is the dumb money so willing to put itself in such a position? We can tell stories here to hypothesize about why, but inherently there is a tension between those stories and the underlying market process that makes those stories necessary--if the market is getting smarter, then the new money must be getting dumber to allow for smart money to be smart (i.e., smarter than the market). But then how can the market be getting smarter???

Active management is risky arbitrage at best. Here is what I mean: imagine I see that the price of rice in Japan is $550 per ton while the price in the U.S. is only $450 per ton and total shipping costs average about $50 per ton. A riskless arbitrage would be if I could instantly buy rice in the U.S. market and sell rice in the Japanese market at the prevailing prices less the shipping cost. Let's say I explore that option but find it is not available. The next best thing is to physically buy rice in the U.S., rent a ship, steam over to Japan, sell the rice . . . then . . . profit. Turns out when I get there they won't let me sell it. Or they will let me sell it but only with a hefty $100 per ton tariff charge. Oh, and the ship might sink before I get there. What I have engaged in is a risky arbitrage. My ignorance of Japanese tariffs or my bad fortune on the high seas means my attempts to beat the market on pricing rice were in vain.

I was operating somewhat in the dark in my rice arbitrage, and more knowledge would have been helpful. Alas, overwhelmingly most knowledge is hidden. Market participants, even the brilliant ones, can never be certain they even have the sign on the price discrepancy right. To wit from our analogy, the price of rice in Japan might be LOWER than the world price once all opportunity costs including risk are considered.

This puts active management in a new light. It isn't an attempt to deliver above-market returns. It is an attempt to deliver more risky or less risky market performance--it could be either case depending on the manager. Modern portfolio theory simplifies the world and says investors achieve this by borrowing or lending at the risk-free rate and then increasing or decreasing respectively their exposure to THE market portfolio. Perhaps active management is a real-world facilitator to achieve these ends.

The Electric Company

This post is in response to a reader’s request. Specifically, the reader asks (I'm paraphrasing) for some explanation as to why even if a stock (i.e., a safe utility) has a dividend above average (e.g., 5%), it is probably still going to take a hit when U.S. Treasury rates rise. The inquiry continues that this is in light of prevailing rates currently being under 3%.

This is a great question. Before we can attempt to answer it, though, we have to challenge the assumption that rising Treasury rates will indeed probably negatively impact a high dividend stock like a utility. Looking back at some historic correlations* using Bloomberg, I see that since January 2000 (nearly 14 years) there is not a strong relationship between utility stocks and U.S. Treasury rates. And that relationship is actually a positive correlation in many cases meaning that when one is up the other is up slightly as well. This lack of a relationship between the two breaks down even more when we look back 24 years to January 1990.

A lack of correlation isn’t surprising. There are a lot of factors that affect these financial instruments. And lost in that noise is the fact that interest rates do most likely have a negative relationship with high-dividend paying stocks. And notice that my quick-n-dirty correlation analysis compares utility indices and not necessarily high-dividend stocks—I was assuming that commonality, but it is a fair assumption. Below is the case for why rising rates might be bad for a theoretical high-dividend utility stock. But keep in mind an important question is why are interest rates rising when they rise. Is economic growth improving? Are inflation expectations increasing? Are the bond vigilantes finally saying they've had enough?

1. High CAPEX: Utility companies have high rates of capital investment. Higher prevailing interest rates (ceteris paribus) imply higher costs; hence, lower profits.

2. Increasing Inflation Expectations: Utilities may have a poor ability to pass on inflation to customers. At best rate increases come with a lag as they wind their way through the political process. If rates are rising because inflation expectations are rising, then that implies lower profitability for the price-restrained utility.

3. Investor Demand: This gets to the heart of the case. The attractiveness of a specific source of yield is relative (and inverse) to the competitive market for yield regardless of how much higher or lower the specific yield in question is. If I give you $100 for the promise that you will pay me $5 per year forever, that promise is worth less when the going rate of such promises rises from $3 per year to $4 per year. I used to have an asset (the promise) that was worth $167 in the open market (present value of 5% interest on $100 when rates are at 3%) but is now only worth $125 (present value of 5% interest on $100 when rates are at 4%). This relative yield component of the theoretical utility stock's price implies another reason rising rates might be negative for the stock . . .

4. Improved Economic Prospects/Alternative Investments: If rates are rising because economic growth is improving, then a lot of investment opportunities start looking better as compared to the utility stock. Just as alternative forms of direct yield (such as dividends or interest) impact the stock’s value, so do prospects for indirect yield (such as price appreciation). The utility has less uncertainty regarding its future value—that's why it can be a good investment in downturns. However, that lack of uncertainty caps the upside as well. Whereas, the high-risk tech startup firm has relatively high uncertainty positioning it to benefit when future prospects improve.

This is not investment advice. I do not directly have a long or short position on utilities; nor do I have a prediction as to what the future holds for them.

*I compared the S&P Mid-Cap Utility and S&P 500 Utility indices with 3-month, 3-year, 5-year, 10-year, and 20-year constant maturity U.S. Treasury series using both weekly and monthly correlation calculations.

The value of authenticity

Business Insider has an article about a new technology, 3D printing that replicates paintings, and the implications are interesting. The article focuses a lot on worries that the technology will threaten the art market. These concerns are misplaced for at least three reasons.

First and foremost, the ability to more easily satisfy demand for fine art including "priceless" masterpieces is a feature not a bug. Certainly those who have invested in art will be worse off in direct proportion to the magnitude that this new technology offers a good substitute. But that is simply a transfer from those who own the art to those who would like to own the art. We would have that same effect if we simply took the art from the current owner and gave it to someone who wanted it. But where that property-rights violating transfer probably is utility reducing since the one who loses the art probably valued it more than the one who received the art, this technology is utility enhancing since it creates value on net. The owner still has the art. Someone who values it for less than the current owner wished to relinquish it prior to the technology's advent now has greater access to it--the price of purchasing the art is lower and hence may now be in reach. And others can enjoy the art by replication in a way not previously possible.

We would see the same effect if we stumbled upon a second Mona Lisa truly painted by Leonardo da Vinci. The Louvre might be upset, but the world would gain a second painting of artistic value. The loss in value to the first would be more than displaced by the gain of now having a second.

Second, the value of art is inherently the value of the creation, not simply the monetized utility of those who yield satisfaction from owning, viewing, possessing, etc. the art. Great art has value even if no one is around to appreciate it. The most popular band is not necessarily the band with the best musical artistry. The best food is not made and could not be made for mass consumption. There really is something to expert opinion on matters artistic rather than appeal to popularity--the so called ad populum fallacy. Unfortunately for those in the business of art and art investment, this technology serves to decouple somewhat the artistic appreciation from the financial appreciation.

Third, having more art more widespread enhances us culturally. The promise of this technology advances the football considerably. Greater availability and exposure means more minds can appreciate, admire, and aspire. The economies of scale are the initial effect. The substantial secondary effect is to deepen the market for art. Music is more widespread today than ever by orders of magnitude. At the same time music appreciation, depth, quality, and variety are greater than ever and growing at a compounding rate.

The lesson here is that sharing and duplication continues to be the future. Only the selfish suffer.

It is also interesting how this technology will serve to clarify the value of authenticity. We will now be better able to see how much the average patron really likes a particular painting versus how much the average patron really likes authenticity. We might also learn a lot about how popular certain artists and works are removed from the rarity via authenticity of the work itself--for example, how many people will be hanging Picassos in the living room? And if no one really likes to look at a particular work, does that imply a change in value? I've thought for some time that a future with machines building mastercrafted furniture, art, clothing, etc. will create a world where the truly old and authentic takes on heightened meaning. But a counter force to this is not just how much easier and cheaper it is to preserve antiques (both yesterday's and tomorrow's). It is more strongly how uninteresting authentic may become when everything old is new again.

Risky business

People generally understand the concept of a trade off between risk/return, but their understanding of this relationship is not always technically correct. The true nature of this relationship can be more nuanced than our intuitive feel for it allows. Here is an example of an incorrect way to conceive of risk/return and the appropriate alternative.

All three charts are using the same data set, total return of the S&P 500 by month going back to 1975. In the first case we see how people commonly are led astray when conceiving of this relationship. It is not fully correct to simply think that "return" is what you gain when you gain and "risk" is what you lose when you lose. More appropriately, risk is volatility, deviation from the trend both up and down. Fortunately, the trend is biased upward in the case of the S&P 500 (at least historically and probably in the future). This bias is because upward risk (call this positive volatility) tends to be greater than downward risk (call this negative volatility). Because of this bias and the fact that the S&P 500 tends to outperform many other capital assets, we are encouraged to get exposure to the S&P 500 when we otherwise wouldn't have any. As an added advantage exposure to the S&P 500 comes at a relatively low cost, but that is a little outside of the scope of this blog post.

PS. Note that in the last chart the risk in red depicts the range of one standard deviation of total return above and below actual total return. One standard deviation will tend to capture about 67% of historical volatility. Two standard deviations reflects about 95% of historical volatility. Because we are adding one full standard deviation to return and subtracting one full standard deviation from return, we are depicting in the chart 95% of historic volatility.

You've got to know when to hold 'em

As an investment professional, I run into what I will term "the gambling analogy" a lot. Clients often use it, and in many cases investment professionals will as well. I'll admit it is sometimes tempting as it is intuitively appealing. However, I believe it is flawed reasoning in at least four respects. I will get to those shortly.

Specifically, the gambling analogy is made anytime someone refers to investing as gambling. Often times it is applied exclusively to stocks somewhat because conventional wisdom holds that bonds don't go down in value or at least aren't subject to massive volatility . . . Doh! Doh! Doh! You'll hear the analogy referenced as an off-the-cuff explanation when a stock investment suddenly loses value, "we knew it was a gamble . . . ." You'll hear it as a point to avoid "risky" investments, "I don't want to gamble with this money." You'll hear it as categorical excuse for risk taking, "Life is a gamble. You could die driving to work."

The last one should be the easiest to defeat. Life is not a gamble. The lottery is. You cannot strike it rich driving to work. Life is risky, but risk does not equal gambling. Of course gambling can be a risky activity, and the magnitude and nature of that risk can vary greatly.

We've got to disentangle risk and gambling. Risk is nuanced and subjective. Gambling should be more concretely definable. For example, while it can be descriptive, it is sloppy in a serious conversation to define a long-shot as a gamble. To understand why let's get a working definition of gambling and examine a popular form of the activity.

Let's define gambling as playing a zero-sum game against an advantaged host (aka, "The House") with an expected value that is slightly negative for the player(s). This game offers highly likely, small losing outcomes and highly unlikely, large winning outcomes for the player(s). A common example would be a slot machine. But is a slot machine really a good way to describe say the stock market? It may be, but in a way counter to the intuitive use of the gambling analogy.

Since I continue to allude to how it is inappropriate to apply the gambling analogy to investing, here explicitly are the four ways taken specifically from the point of view of the investment professional:

1. Many people have moralistic beliefs that frown upon or strongly oppose gambling per se. Using the gambling analogy would be counterproductive if not insulting with this group.
2. In a gambling setting the player or gambler typically is taking on an exceptionally more extreme risk/return tradeoff than an investor.
3. Gambling is at least monetarily a zero-sum game while investing is not.
4. The investor is The House.

The first point is self evident. The second can be seen clearly in comparing your 401(k) plan and the Powerball lottery. The third relies on an understanding that investing is the act of allocating capital. When a capital allocator like myself matches people with wealth to people with good ideas, more wealth is created on average. That leaves the fourth point.

Let's look at the total return of the S&P 500 since 1975 as seen in the chart below. 

Because total return has a compounding effect, we'll need to look at the chart in log scale as below. That way it will compare logically (apples-to-apples) to what I'm about to show next.

Now let's see how that compares to a slot machine. To do so I went to the always helpful and informative Wizard of Odds. The great and power wizard breaks down a very typical slot machine here. Using that information, I was able to construct a slot-machine simulator in Excel. To get an analogous comparison to our investment in the S&P 500 above, I examined starting with a bankroll of $1,000 playing this $.25-coin slot machine two coins at a time. Here is what that looks like from the player's perspective using one randomly generated set of play (for those of you who don't believe that slot machines work using random numbers with independent draws, The Wiz has some lessons on slot machine myths and facts for you): 

But what if we flip it and look at it from The House's point of view? 

Ah, there it is. Remember the definition of a gamble before where I said, "This game offers highly likely, small losing outcomes and highly unlikely, large winning outcomes for the player(s)"? From The House's perspective we would say, "This game offers highly like, small winning outcomes and highly unlikely, large losing outcomes." And now you see my fourth point. Slow and steady wins the investment race.