Monday, July 29, 2013

The Ben Bernank ordering breakfast doesn't make him hungry, or . . .

Getting cause and effect backwards.

Often I hear investment pundits describe an effect as a cause giving them reason to be bullish or bearish on particular sectors, etc. The typical mistake runs like this: "We expect equity flows (investments into stocks) to increase driving stock prices higher." Think for half a second how one might determine the value of a stock . . . Stock is ownership in a company. That company derives value for owners by creating profits. Those profits eventually must become a series of cash flows back to the owners. If we could make a good estimate of the timing of those cash flows and apply a reasonable discount rate, we could approximate the present value of the cash flows (what they are worth in one, lump-sum price today) and hence the present value of the company.

Nowhere in that analysis is room for the thinking that if more people like the cash flows, they are worth more. True if more people like the series of cash flows, the discount rate goes down and the present value goes up. But here again we are getting it backwards. Why do people like the series of cash flows at a given price more all of a sudden? Because the discount rate used to calculate the present value now seems wrong. Therefore, the price seems low making it more attractive driving the desirability up until the price seems right again.

The girl is more attractive after the Extreme Makeover not because people are now more attracted to her. People are more attracted to her because of the makeover.

So how does this relate to The Ben Bernank and The Fed? I think many people including some economists often get it wrong in describing the cause and effect related to the economy and Fed activity. Consider this Arnold Kling post which points back to this Scott Sumner post which points back to this David Glasner post all of which got me thinking about this issue once again. And here is a money quote from another Arnold Kling post that illustrates my thinking:
Probability that monetary policy “merely reacts to what would have occurred anyway” = .75
I think I would put that probability at least that high. To explain why, I'd like to introduce a metaphor that I believe aptly illustrates the right way to think about the Fed's role in the economy as it "sets" monetary policy ("sets" is too powerful a word here; "escorts" might be better):

Think of The Federal Reserve as the regulator of a man-made lake where The Fed controls the dam and where it controls a floating dock that many boats use as a prime spot for anchoring. The lake is the money supply and the dock is both the Federal Funds Rate (the interest rate at which reserves held at The Fed are traded between banks) and the Discount Rate (the rate at which The Fed will lend money to banks to cover short-term needs). The Fed can control the outflow from the lake to help determine the water level (money supply), but this is a clumsy process. If The Fed doesn't have a good handle on what nature (the market) will bring in terms of rainfall and drought (i.e., if indicators are poor), then too much or too little water may be in the lake. Likewise, if The Fed sets the federal funds rate or the discount rate inappropriately low (high), the dock will be under water (way out of the water). In either event, boats can't use the otherwise popular dock which makes lake activity difficult.

Some want The Fed to look out on the lake with omniscient vision seeing well-planned development. In truth The Fed is simply trying to accommodate the level of water nature otherwise wants for the lake while trying to satisfy those who desire to use the lake as a resource--adding or reducing water to smooth the ups and downs. If only The Fed could ask nature what was in store for lake water levels (an NGPD futures market), it could do so much better getting the water level "correct".

Sunday, July 28, 2013

Highly linkable

John Cochrane points us to a painting depicting the history of trade. We see the (symbolic) beef, but I'm left wondering where's the gold?

Noam Scheiber of The New Republic says we're about to lose another Big.

Steven Landsburg brings us another great riddle whose solution I did not reach on my own. My downfall was a knee-jerk reliance on the ubiquity of the Monty Hall Problem.

Finally, if you want some good ideas of places to go to get away from it all (including people), check out this.

photo by Mark Stevens

Monday, July 22, 2013

WWCF: Driverless cars or 3D printers in the average household?

Which will come first?

50%-household penetration for driverless cars
50%-household penetration for 3D printers

News about both of these technologies of the future are in vogue right now. I've talked a bit about them here and here. The economic possibilities are quite promising. In fact, I see the factors slowing the progress of each to be more political in nature rather than technological. Regulators will be the first to cry, "Jane, stop this crazy thing!" Some of the very serious people are already sounding alarms about robot cars. Expect them to be joined soon by all those millions, and don't doubt for a second that it is indeed millions, of people whose livelihoods are threatened by a driverless future. For 3D printers the fears begin with guns and end with patent infringement run amok. Nevermind the fact that I've already solved the patent problem, et al

But back to the question at hand. While the Makerbot is selling like hotcakes, John Deere is already selling a driverless lawnmower. I say the driverless car edges out the 3D printer by less than five years, and I expect the 50% mark to be hit by the winner before 2033.

PS. With driverless cars you effectively don't need compulsory insurance or state licensing just as you don't have those conditions for guns, chainsaws, swimming pools, or outdoor grills. Good luck with that logic, though.

Wednesday, July 17, 2013

And how many words have I got to say?

Every day tens of millions of people now have an astonishing and remarkable ability to make use of the answer to that question in the subject line. We now have tools and venues that give our thoughts, ideas, and opinions voice in ways that were physical if not theoretical impossibilities for the past 99% of human history. Here are some thoughts on how the Internet and the devices that connect to it give us "voice":

  • There seems to be some emerging norms regarding which way certain social networks are to be used. But there is a lot of variation with significant dispersion. Serious versus light-hearted is one dimension. Professional versus personal is another.
    • Facebook seems naturally more personal in nature since one speaks only to one's "friends" or a subset of friends in nearly all cases. So it always surprises me how some use it for more serious topics or for advancement of political or ideological positions. For me it just seems more social in nature; so I find it hard to take too seriously given the alternatives.
    • Twitter on the other hand is a voice to the world (potentially) with no audience filter per se except the bounds which one's own reach has set. Seems like we'd be as nervous tweeting as we would be speaking at the Oscars, but reasonably we are not. Since we don't expect people from outside our intended audience to hear our tweets, we don't have the apprehension. 
    • Google+ seems to be still seeking its definition in this dimension. I see it more naturally as a place of both personal and professional self promotion as well as recommendation. In that sense I think it competes eventually with LinkedIn, and the case for Google+ will be very strong with the more natural crossover to mini-blogging.
    • Isn't it always interesting if not awkward when someone seems to use one of the above out of tune with the "local", that is group-specific, norm?
  • We are now audiences of individuals. Our group action is both more powerful than in the past but less prone to peer pressure. Many would disagree with this point, but it seems strong to me. Failure to conform in the audiences of the past (theaters, church pews, dinner parties, et al.) met strong and effective opposition. Switch cost in terms of behavior is now much lower. At the same time the ability of even a small group to mount counter voice is quite high--the thrust of this post is about this very point. 
  • The noise versus signal aspect is interesting. Bloggers tend to face a more pure market test. These other social networks have audience stickiness that insulates the speaker. Are you really going to defriend Grandma because she keeps posting Great Depression-era recipes? Noise versus signal is context dependent. It is subjective to the individual audience member. While every social network has some logic helping to mute noise and boost signal, all are highly imperfect. The next great advancement in social networking may be a mastery of this domain. 
  • Here is a great example of how the Internet is revolutionary greatness offering to give us all a voice never before so vocal and therefore offering us all experiences never before so dreamed: What Ali Wore.
We live in amazing times. 

Saturday, July 13, 2013

The first of Which Will Come First?

I am introducing a new theme on the blog: Which Will Come First (WWCF)? This could alternatively be called "Can you believe people used to? . . .", but I wanted to make it more predictive with a comparison. Here is the first in the series.

Self-cleaning, style-programmable clothing
Fractional jet ownership for the middle class

The first negates the need to haul a sufficient portion of one's wardrobe around when travelling. The second is NetJets for the hoi polloi, a democratization of high-end air travel, which potentially ends most of the hassle costs of flying commercially. 

Thinking back to Mark Perry's post, which was the inspiration for this post of mine, we see that the real cost of air travel per passenger mile has fallen from about $.31 in 1980 to about $.14 today. 

The cost of a G5 per passenger mile is about $1.67. Using the decline rate in the curve above (about a 2.5% reduction in cost per year), we would very simply extrapolate that I'll be in a G5 in about 90 years--when the $1.67 cost has decline in real terms to $.14. But that is probably a big oversimplification that understates the realistic decline expectations. It is leaving out income growth (not me personally, but for the middle class) and increasing returns to scale as we get closer and closer to the destination.

Let's assume real disposable income growth is below the historic trend and is 2.5% per year. Now Malcolm in the Middle is circling Fantasy Island in less than 50 years. And we have still not considered how as a new innovation becomes closer to reality the cost curve spirals downward spurred by a virtuous cycle of investment and breakthroughs. Just think about the Walkman for 20 years followed by the iPod for 10. 

Unfortunately, I don't have anything substantive on high-tech clothes. I'll add it here and in a follow-up post when I stumble upon it.

My guess is that the clothing will be widely used about a decade before fractional-jet-ownership will commonly used by the middle class. 

Thursday, July 11, 2013

A low-hanging fruit rant

Re: The Great Stagnation

I've been thinking about low-hanging fruit from changes in political economy. I mean this as a constructive group of points, ideas, questions  . . . I don't mean to go off on a rant here, but nevertheless . . .

There still seems to be low-hanging fruit when we look at certain aspects of government policy. Tax code simplification and ending the war on drugs are two great examples. Immigration expansion and school competition (where tax dollars follow parental choices) would be two others. I'm not saying these would be or should be politically a snap--obviously they are not--but consider simplifying the tax code:

  • Where are the environmentalists on simplification of the tax code? Why can't we free up these resources (labor is the huge one and as we know our precious time is the one resource environmentalists tend to disregard, but still)? 
  • Why can't we get liberal, conservative, libertarian, Democrat, Republican, et al. to agree on this? It can be as progressive as you like. Let me concede to your desire for an intrusive, expansive, colossal government. Just don't make me use a spoon to dig your ditch.
  • How can we not defeat the vested interest on this issue? If your business plan depends on tax policy (tax lawyers and accountants, MLPs (to a degree), some charities, realtors, et al.), you are not adding value to society. 
  • The bootleggers and Baptists on preventing tax code simplification would be those who want to punish others aligned with those who want to advance their own special, vested interest. I'm not sure which group is the bootlegger.
My point is that these changes would be affect massive improvement to society. The magnitudes are strong. There are still low-hanging fruit if we will just pluck them. 

Wednesday, July 10, 2013

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.