Tuesday, March 24, 2020

Stupid Questions Can Yield Brilliant Results


  • Are some populations less susceptible to (severe) infection?
  • Is there a genetic, cultural, experienced condition that could be used to thwart the virus? What about dietary practices?
  • Does a person’s specific pH level factor into infection and symptom risk?
  • Should we expect latitude or altitude to help especially in regard to humidity and average temperature?
  • How would a plumber fix a leak behind a wall without ripping down the wall?
  • What counterintuitive action might aid treatment and recovery? Forced activity? Forced suppression?
  • Is quasi-herd immunity the next line of defense—i.e., identifying those with antibodies or simply recovered people and having them be the non-social distancing economic/logistical conduits for a while.

THIS IS JUST A PARTIAL LIST! We need everyone adding to it and (responsibly) acting on it in the real world.

Imagine going back in time to 50, 100, 500 years ago and asking dumb questions:

  • Are we sure we should drain the ill person’s blood to release the bad humors? (no)
  • Maybe a severe sunburn will cure this fever? (no)
  • Perhaps a small, very small, creature is causing this? (yes)
  • Maybe interaction with lots of people including those in outlying areas is a problem? (no)
  • Should we wash our hands between patients? (yes)

In the midst of COVID-19, we need lots of experimentation. We need to harness and leverage creativity and experimentation. The private sector working in a free market is unmatched in this capacity. Frankly, a catastrophe-risk, global threat is no time to rely on government. In the current context this includes everything from suppressing and replacing the FDA to “radical” ideas like not nationalizing supply chains.

For every challenge to a medical practice, prescription, and diagnosis we have to ask a critical question: Is this bloodletting or is this hand washing?

From truly dumb questions we can derive amazing successes.

Sunday, March 22, 2020

Partial List of the Best Cityscape Observation Points

The best aren’t usually in the tallest buildings or the most popular spots. 

Saturday, March 21, 2020

A Price Paradox

This is a continuation of my previous post "Markets Don't Hate Uncertainty".

Don’t think about the stock market like you do for a specific good like, say, bananas. If a large group of the banana-consuming public suddenly decides they don’t like bananas very much anymore, the demand curve for banana shifts massively to the left meaning market prices will fall greatly and future quantities produced/consumed will too--remember the immediate supply curve is nearly vertical and the long run supply curve is much closer to horizontal.

However, that is not the case for stocks. The value of stocks is determined by the net present value of future cash flows. In simple terms: Buying a stock means being a part owner of a company. As an owner you are entitled to a share of future profits (eventually paid out as dividends--a reasonable, simplifying assumption). Those profits come in the future, so we have to value them today at a discount since a dollar today is worth more than a dollar tomorrow--the so called time value of money (TVM). Adding up all future cash flows individually discounted for how far out into the future they are gives us a figure for net present value (NPV). This is the "value" of the stock, which should equal its price. Let's assume for now there is no uncertainty about expected future profits.

An essential premise in the banana hypothetical is that the value of bananas has plummeted. Remember value is always a subjective concept. Suppose a large demographic group like the Baby Boomers in aggregate start reducing their desire to hold equity investments (stocks), it is not because they don’t believe in the value of stocks in general. Rather it is likely due to the fact they don’t want to have an asset exposure so much tied to the volatility associated with stocks. So they want to reduce their investment holdings in stocks. So in one sense there is no reason to believe that their selling activity should materially change the price of stocks because the investment value of stocks (NPV of future cash flows) is unchanged in the market overall.

But they are trying to sell, and their selling has to be met by buyers. In order to find a willing buyer they should have to offer a more attractive (lower) price than the current price. Hence, we have a paradox--prices shouldn't change but they have to change. The solution lies in a reframing of what investors are trying to achieve. They don't want stocks for the sake of stocks--this would be the banana model. They don't want the future cash flows per se--those are only attractive relative to the price paid for them given the risk associated with realizing them. They want the expected return--the future cash flows purchased at an appropriate price today adjusted for the risk.

So in order for Baby Boomers to sell their stocks they have to increase the expected return of stocks from the perspective of the buyer. Since they can't affect the future cash flows, they have to do one of two things: Either lower their prices to attract buyers or find buyers with different discount rates (buyers who don't value a dollar today as much as a dollar tomorrow). Realize, we are still assuming no disagreement about the expected future cash flows. That wrinkle is not needed to explain this hypothetical or the paradox. Everyone can agree on the expected future cash flows and still people want to exchange their positions (i.e., Baby Boomers want to sell and reduce market risk and buyers want to take on that risk).

Here is the graphical way to think about those two options available to the stock-selling Baby Boomers:

The colored lines B and C represent the change in price over time. The slope of these lines is the expected return. In the first case (top chart) prices today decline along path A and the lower price after Baby Boomers try to sell stocks implies a higher expected return for all stock investors. The market's expected return has increased from the slope of line B to the slope of line C.

In the second case (bottom chart) the difference in how each investor discounts the future price implies a different rate of return. Baby Boomers selling stocks have an expected return of B and buyers of their stock have an expected return of C. (Note: This is related to but not dependent upon Baby Boomers having a shorter life expectancy than buyers. The buyer can be the exact same demographically as long as they have a different discount rate. When compared to the stock-selling Baby Boomers, the buyers value a dollar tomorrow as being closer to the value of a dollar today. Boomers can be selling to other Boomers with lower discount rates.)

You should be feeling uneasy about this for two reasons:

  1. Why don't prices today equal that far-off future price? Didn't we assume there is no disagreement about the amount of future cash flows?
  2. In the second chart why wouldn't this have already come to fruition? Did stock-selling Baby Boomers suddenly just now increase their discount rates?
The answer to the first objection is this. Even if we assume there is no disagreement about expected future cash flows, there is a degree of uncertainty for them; hence the word "expected". The compensation a buyer/holder of stock receives for risk of investing is the expected return--technically speaking, the equity risk premium. 

Assume a stock will pay a dividend next year equal to all of its assets and profits and then cease to exist. All market participants agree that the dividend next year will be either $0 or $2 per share and that the probability of each outcome is 50%. In that case the expected future cash flow is $1 next year. This means the stock today is worth $1 before any TVM discounting. Once the year has passed and the dividend realized, investors will either have $0 or $2 to show for the $1 they put at risk by buying the stock. Therefore, the future price has to be something greater than the current price or no one would be interested in risking the investment.

The answer to the second objection is a little less elegant. Well, basically we have to be assuming Baby Boomers wanting to sell stock have increased their discount rate (i.e., become more risk averse). Otherwise, we can't have the hypothetical. But this leaves another problem: Why isn't there just one expected return in the market? Well, there is, but in the second chart we are breaking up the market into two segments. The blend of the two lines B and C would be the market expected return. That would be some new line D with a new destination in between the two lines B and C. 

So, what is the solution to the paradox? Will prices change? And if so, did the value of stocks change?

The answer is another paradox: Stock prices changed by going down because stock value went up so stock prices could come down because stock value had to go up.

Baby Boomers in this hypothetical all of a sudden wanted less stock because they wanted less risk. In order to reduce risk they have to sell that risk to someone else. That someone else either must want that same risk relatively more all of a sudden (the source of the second objection to the bottom chart mentioned above) or the Baby Boomers need to reduce the risk by offering a lower price. Some of both will happen meaning stocks get less risky simply because Baby Boomers want less risk--a rather surprising result. Here are the implications:

  • The lower the price of stocks, the less risky they are holding expected cash flows and discount rates constant.
  • The change of ownership from higher-discount rate investors (Baby Boomers all of a sudden in our hypothetical) to lower-discount rate investors (the buyers of the Baby Boomer's stock) means stocks are less risky to those who now hold stock without any needed change in price or expected future cash flows. 
  • Stocks become more valuable when prices go down without any other change or expected future cash flows go up without any other change or discount rates go down without any other change. 
  • If expected future cash flows go down and discount rates go up (as has been the case circa March 2020), then prices must go down. 

The moral to this story could be: DON'T REASON FROM A PRICE CHANGE! Prices reflect value. Value for consumption goods and services like bananas and hotel rooms are subjective. Value for financial investment assets like stocks, bonds, and real estate are subjective too. But they are subject to expectations about the future and the value we place on money today versus money tomorrow.

Prices don't simply change, and a change in price doesn't really tell us anything. The price of bananas declining could be because people stopped liking bananas as much or it could be because it just got a lot easier/cheaper to harvest bananas. The price decline tells us that the value of the next (marginal) banana is lower, but that fact by itself doesn't tell us why that is the case.

Stock prices declining could be because investors in aggregate think earnings from holding stocks will now be lower than estimated before or it could be because investors in aggregate value money today more than money tomorrow. The price decline in stocks tells us that on net one or both of these has happened, but the fact by itself doesn't tell us which.

Sunday, March 15, 2020

Markets Don't Hate Uncertainty

Markets don’t hate uncertainty.

Markets aren’t sentient beings with feelings. It is much more meaningful and accurate to say markets price uncertainties and risks.

As uncertainty rises, markets adjust prices to reflect that information. As risk tolerance changes, markets adjust prices to incorporate that as well.

The current financial environment gives a helpful, extreme example. Lower prices for stocks are likely reflecting two things: increased risk aversion (higher discount rates) and greater uncertainty about future wealth creation (lower earnings/profits, lower quality of life).

Let's look at each of those causes. First, increased risk aversion: If the average person is becoming more fearful of the future, the rational response for them is to increase how much they value a dollar today as compared to a dollar tomorrow. Technically this means they discount the future by a higher rate than previously. They are raising their discounting rate in the formula:

Money Today = Money Tomorrow less a Discount
$0.90 = $1.00 minus $0.10

[slightly more technically]

Money Today = Money Tomorrow times a Discount Rate
$0.90 = $1.00 * 0.9
(even more technically, 0.9 is approximately a 11.1% discount rate)

If our previous discounting rate was $0.05 for every dollar tomorrow and now it is $0.10 for every dollar tomorrow, then the current value of that future dollar has declined $0.05. Prices today on that future dollar fall from 95 cents to 90 cents.

Second, greater uncertainty about future wealth creation: If the average person thinks that future generation of wealth is going to be less than previously thought, the rational response is to lower their expectations for the future. They are lowering the expectation of money tomorrow in the formula:

Money Today = Money Tomorrow less a Discount
$0.90 = $0.95 minus $0.05

If our previous expectation was to generate a full dollar tomorrow and now we fear tomorrow will only see the generation (creation) of 95 cents, then prices today on that future amount fall from 95 cents to 90 cents.

What happens when both happen at the same time? We then would see a compounding effect in prices today. 

What was once
Money Today = Money Tomorrow less a Discount
$0.95 = $1.00 times 0.95

Is now
$0.855 = $0.95 times 0.9

Prices for money today have fallen $0.095 ($0.95 - $0.855) or 10%.

These are the underlying forces that drive the more complex world in financial markets. Investments in equities (stocks) have fallen significantly in the past month. This is very likely an example of both increased discounting of the future (greater risk aversion) and lower prospects on future wealth creation (lower expected future earnings). The market isn't hating the uncertainty about how risky the world is or what future earnings will be. Rather very appropriately the market is repricing the expected value of what the future will be. 

In every moment that passes new information is revealed about the world. This information is an update to all the prior expectations we had. Some of those expectations get confirmed. Some of them get rejected. But that is too binary a way to look at it. Don't think about right and wrong in terms of predictions. Think about constant adjustment. When substantial new information comes to light like when a virus comes into the world, the virus becomes abnormally very serious, and a pandemic emerges, big adjustments to prices today on values tomorrow naturally and appropriately result. 

Emergency Situations Call For Proven Failed Policies

The pandemic of the novel coronavirus (SARS-COV-2) is upon us. But rest assured; our fearless leaders are here to help by making sure we keep reality at bay. I'm talking about an old favorite of head-in-the-sand, wish-it-all-away virtue signalers--price gouging laws (aka, price controls).

Because it worked so well exactly never but makes those who don't like an certainly very bad and difficult (but nevertheless necessary) change feel like something is being done, we shall inflict self harm.

Let's turn this into a partial list of things to remember about price gouging laws:
  • Price controls that limit market clearing prices don't change the reality that suddenly and acutely certain goods and services are more scarce--demand has risen while supply is temporarily mostly or entirely fixed.
  • They don't allow us to efficiently allocate goods. I hear you cry, "But what pray tell is so great about efficiency in a crisis?!?" Okay, okay, I sneaked in some technical jargon. When economists speak of efficiency, they are sorta saying how can we do the best for the most. We have to get what we have (water, ice, lumber, medical supplies, etc. depending on the disaster) to those who need it most. Most is key. While we always want to satisfy this to the best of our abilities, in a crisis it becomes crucial. What substitutes do we have for allowing prices to gauge who wants/needs it most? We could use:
    • First come, first served
    • Personal, arbitrary preferences
    • Non-price competition (to the beautiful, the rich and powerful, the special interest, etc. go the spoils)
    • Government or other authorities trying (honestly trying) to determine who should get what (more on this fantasy world below)
  • All other methods listed above have SUBSTANTIAL costs associated with them. And there is very little reason to believe they would outperform the price dimension. They are all subject to manipulation (both malicious and innocent; intentional and accidental). They waste resources including time when resources are especially scarce. They encourage hoarding and black markets (more below). The best they possibly can do is match the outcome price would achieve while avoiding some of the dreaded downsides of allowing prices to rise. But just how bad and realistic are those downsides?
  • The downsides to letting prices rise to the new equilibrium levels are hypothetical straw men. If you are worried or distressed by the idea that someone, somewhere will profit off of a bad situation you need to realize that is a reflection of your own envy and a mischaracterization of who actually is in a position to provide goods and services. If you are worried that only "the rich" will be able to get the precious thing(s), then you are ignoring the fact that "the rich" always will have access, ignoring the charitable impulses of most everyone including those with more wealth, and ignoring that your wrongheaded description of "the rich" still leaves "the not rich" without access--store shelves get emptied when prices don't rise properly (see the Art Carden link at the bottom).
  • Black markets will spawn and propagate where markets in the light of day are prohibited. If you think you are ending the high prices "problem" by stopping prices in stores, etc. from rising, you are woefully naive. Those same "greedy" people who would otherwise raise their price up to the market-clearing, too-high-for-your-comfort level will simply take the items off the shelves and sell them in the alley at a more reasonable (given the new economic reality) level. And who do you think is buying in the alley? I can assure you, it is not the Boy Scouts.
  • Demand is not the only curve that can change. Supply very crucially can and will if we entice it. As also indicated in the next bullet point, one must answer the always important question: "And then what?". Allowing prices to rise sends signals literally worldwide that scream: "HEY, STOP WHAT YOUR DOING! THOSE [goods and services specific to the given situation] ARE DESPERATELY NEEDED ELSEWHERE. Help us reallocate them there. And help us make more of them!" The Mike Munger links at the bottom have a lot on this very important point. In a dire situation I don't just want some (water, medicine, etc.). I want all we can get including that for which it has not yet been economical to access/build/develop. I want the best pharmaceutical firms and minds working on a vaccine today--not just the most altruistic. I want the best doctors out of their personal quarantines and on the front lines--not just the most altruistic or frankly those with lower opportunity costs. If you have a severe, acute, and emergency back injury, you don't want to be paying only enough to entice a chiropractor to help you.
  • Think past the first level--there are strong incentives (social and economic) for businesses to not allow prices to fully rise or to themselves supply the charity we would want to make sure those without means can get the goods and services they truly need.
  • It is a very bad way of forcing charity as it imposes the cost of charity on those supplying goods and services as well as those who otherwise would have access to those goods and services. Think of the guy who really needs ice for baby formula or a nearby hotel room to keep his job but who showed up later than the guy who didn't need those things so badly but wasn't deterred from taking them because the price wasn't giving him the crucial information that somebody else needs it more who isn't yet here to say so.
  • It is immoral as it denies the property right that the owner of the resource has and it disallows her from most easily finding the person who needs it most and it punishes her for having been there in the first place to supply it. In a disaster we want the church to have been built and maintained for Easter Sunday. That is expensive. One way to get that insurance policy against pain in a disaster is to allow those who bear it 99% of the time to reap the reward for having bore it. 
  • Lastly, you want to substitute a market process with a government process in a time of desperate need. Do you really, really, really think those in government are in a better position (access to knowledge, incentives and feedback effects, corruption temptations, organizational structure, etc.) than the market to do the job? I would not trust a group of (non-government) people to have the judgement, knowledge, and ethics to dictatorially make the best decisions. Why would that change for those same people if I simply put them into a government system?
Links to more thorough sources:

Wednesday, March 11, 2020


To the Moon, Alice!

Imagine if in the summer of 2018 you embarked on the vacation of a lifetime--a 2-year journey to the Moon with SpaceX. This was their "Get Away From It All" package which includes no contact with Earth during the voyage.

While gone, you left me in charge of your affairs including your investments.

You have a wonderful trip and then return late in the summer of 2020.* Settling back into terrestrial life, you ask me for a rundown of what you missed. My reply: "Well, a few things happened here and there. Perhaps most interesting, we had a pandemic."

"A what?!?" you exclaim.

"I know, a once in a generation viral pandemic. It was bad, but not nearly as bad as some of those in history. Still many people died. There was a lot of chaos and confusion at times. Lots of events were cancelled; so life was pretty disrupted for a while. The overall hit to well being for the typical person as meaningfully, negatively impacted." I explain.

"Oh, that is horrible." You dare to ask, "How are my investments?"

"They are worth basically just as much today as they were when you left plus a little for inflation." I say calmly.

"That's wonderful. Surprising even. But how did you manage that?"

"Well, it wasn't much that I did. There were a few moves here and there that probably added a little value--just sped up the time to recovery. For a while the investments had lost quite a bit. You would have been pretty worried had you been around to witness it. And the values were up quite a bit from when you left right up until the pandemic really set in. All in all it was wild times."

Reassured, you say, "Well, I'm glad that is all behind us. I left after a great 9 years of investing, and I got to ignore a crazy few."

. . . The end is not near, folks. There is a LONG journey ahead. If you don't realize those are positive thoughts, you need to re-read the passage above. The pain that has and will hit human life is beyond sadness. Don’t compound your worries with shortsightedness—in investing or any aspect of life. Cherish those around you and make good choices for the long term.

*Make it a three year trip returning 2021 or a four-year trip until 2022 if that makes this more realistic in your view.

Wednesday, March 4, 2020

To Every Season, Turn, Turn, Turn...

Partial list of ages that have ended or are ending soon: 
  • Increasingly large, mass-attendance sports venues 
  • Government pension generosity
  • Inexpensive (dare I say casual, inclusive, and fun) youth sports
  • Down time for kids (free time to explore, hang out, and otherwise be bored and then self-solve that boredom)
  • Tolerance for average in so many ways
  • Risk of missing broadcast pop culture events 
  • Cultural relevancy for references like this post’s title
  • The great American road trip (perhaps autonomous vehicles will bring this back)