The Gremm Take

Occupy Whatever

2011-12-29T10:17:00.000-08:00

The media mentions the Occupy movement in the same breath as the Arab Spring activists when they talk about important events in 2011. However, the two don't seem to have much in common beyond the ability to draw crowds to public places.

The Arab Spring has a very clear objective: out with the old dictators, in with a democratic government. The Occupy movement does not seem to have any objectives other than turning city parks into campgrounds. Their closest thing to a demand is an aversion to income inequality, but even that seems to stop at 'We don't like it!' rather than an actionable plan for how to change it. If the Occupy movement wants to occupy anything other than thin air in 2012, they need to figure out what they want and how they want to get there.

There are two ways to reduce income inequality. Do something about the poor or do something about the rich. The Occupy movement seems to favor the latter without being clear about what they seek to accomplish.

Let us imagine a world without the top 1%. We would have to do without the innovators such as Bill Gates, Steve Jobs and many more. Microsoft and Apple employ about 150,000 people and provide many products that we use daily. Neither would exist without Gates and Jobs.

We would have to do without large successful companies like GE unless you believe that such organizations fall fully formed from the sky and don't require someone with vision and a steady hand to keep them from falling apart. GE employs about 300,000 people and provides many products that make our standard of living possible. The CEO of GE, Jeff Immelt, made around $10 million in 2011. That's about $30 per job. GE's employees are probably not the only ones who think this is money well spent.

We would have to do without people who spend many years of their lives to acquire specialized skills, including most of the medical profession, attorneys, bankers, etc. One might argue that attorneys and bankers are not very valuable, but an Apple or a Microsoft could not exist without patents, access to financing, the ability to issue stock or debt, the ability to do international transactions, etc. None of these things work without bankers and attorneys. We would also have to do without your favorite actors, authors, musicians, and athletes.

Does this sound like a world you want to live in?

If income inequality needs to be addressed, a better approach may be to boost the income of the poor. Of course this will cost something, which is especially problematic in times of serious budget deficits. Nevertheless, a small broad-based tax hike to redistribute more wealth to the poor is a better solution than to punish those who make the greatest contributions to our quality of life.

Such a tax increase may be palatable if the wealth transfer is not just a hand out. Perhaps something like Roosevelt's Civilian Conservation Corps, the organization that employed millions to built the national park infrastructure that we all enjoy today, could do the job.

Whatever the solution, the Occupy movement needs to come up with clear and actionable objectives if they want to be more than a bunch of kids hanging out in public spaces.

Not so Fast, Bloomberg News

2011-12-19T09:43:00.000-08:00

Today Bloomberg News informs us that S&P's downgrade of US debt was absurd, citing market action. There has certainly been rising demand for US assets since the downgrade this summer, but that does not mean the downgrade was absurd.

S&P is not in the business of predicting market direction. They strive to be an early warning system to help investors detect financially unsustainable conditions by assigning a risk grade to borrowers. At a debt to GDP ratio of well north of 100%, the US is not a terribly credit worthy borrower. For comparison, France recently saw its borrowing rates jump and its credit rating outlook cut to negative, even though its debt to GDP ratio is 'only' about 90%.

Most people would agree that betting your entire net worth on a single spin of a Roulette wheel in Las Vegas is fairly risky. Even if you win, it is still risky. Should you keep doing it, you will eventually loose it all.

S&P is telling us that lending to the US is risky. Bloomberg News is telling us that S&P's risk assessment is absurd, because people who have let to the US have done well for themselves. We are telling you that Bloomberg News' conclusion is as flawed as that of a gambler who succeeds with his first bet in Las Vegas and concludes that gambling is riskless.

There is another reason why the Bloomberg analysis is wrong. Investment allocations are often based on relative merit, while credit ratings are based on absolute merit (assuming that they truly reflect credit risk).

Sovereign wealth funds and other large investors generally need to stay invested, but they can choose where to concentrate their holdings. The two largest pools of liquid investment vehicles are the US and EU markets. Given the crisis in Europe and the possible demise of the Euro, it is not surprising that large investors have moved funds to the relative safety of the dollar and US assets. It would be wrong to interpret this move as a ringing endorsement of the US. It simply reflects that currently Europe looks even uglier than the US.

Europe Rightly Refusing the Morphine Solution

2011-12-02T14:41:00.000-08:00

In this entertaining piece, Ms. Baum exposes the absurdity of trying to borrow or spend yourself to prosperity. Of course everybody knows this. Just ask the person drowning in credit card debt, ask the person who bought too much house, ask the Greeks, ask anyone in Europe or the emerging markets for that matter.

The Europeans are right to ignore the advice from Geithner, Obama, Bernanke, and the rest of the DC crowd. Unlike our politicians, many of them have personally experienced the consequences of printing money. They understand that it works a lot like morphine: the pain goes away now, but you are left with a nice addiction that will most likely kill you.

The Europeans were wrong not to face facts until it was (almost?) too late. A year ago, it would have been possible to admit that Greece is bankrupt, write down its debt, recapitalize the banks, and move on. Now Europe faces a much bigger problem, because markets have lost faith in the quality of virtually all European sovereign debt.

The morphine solution, advocated by the US, would be to print unlimited amounts of money to buy sovereign debt. That would keep interest rates low and allow over-leverages states to continue as before. It is the painless solution that fails to solve the underlying problem. The only way to keep it painless is to administer more and more morphine. Clearly this is not a sustainable path.

The alternative to the morphine solution is to take the pain associated with addressing the underlying problem now. Greece is doing it involuntarily, England is doing it voluntarily, and many other European countries are implementing austerity measures of their own. It is the only way to fix the problem so it stays fixed.

Ostrich Policies

2011-10-19T11:00:00.000-07:00

Bloomberg's Chart of the Day column often presents well-known facts in simple graphical form. This would be a completely useless endeavor except for the human tendency to adopt Ostrich Policies. Ostrich Policies are modeled after the (presumably apocryphal) habit of ostriches to stick their head into the sand when facing danger. This does little to address the situation, but it provides the illusion of safety for a little while.

Today's chart shows the per capita GDP and the per capital National Debt, both adjusted for inflation. The debt line (red) is expected to cross the GDP line (blue) this year. We have reached a debt to GDP ratio of 100%.

There is nothing magic about this number. We don't go from 'everything is fine' at 99% to 'this is the end of the world' at 100%, but nevertheless it is a milestone along an unsustainable path.

And this is where the ostriches come in. Greece shows where this path ends: with austerity measures, a deep recession, and social unrest. And yet our politicians propose debt-increasing measures that cost today and may or may not be paid for by taxes years down the road. Or they propose fixing the deficit by only taxing people making over a million dollars a year, which wouldn't even work if they each paid their entire income in taxes.

These proposals are just gleaming white piles of sand in which voting ostriches are invited to bury their heads. One way to win an election is to distract enough of the electorate with measures that don't address the big problems. If nobody acknowledges that a problem exists, nobody can expect politicians to solve them.

The chart above shows that the situation this time is quite different than at any time since the early '80s. There are no good solutions today and finding acceptable ones becomes harder with every passing day.

It is time to rub the sand out of our eyes and push Washington to address this problem! It doesn't matter much how we go about fixing it (higher taxes, benefit cuts, whatever), but it is essential that we do. Otherwise we will end like Greece where everyone loses.

Operation Twist - The Latest Fed Dud

2011-09-21T15:49:00.000-07:00

Today the Fed bestowed Operation Twist on us. It amounts to buying long-dated Treasury bonds to lower long-term interest rates. The market was singularly unimpressed, either because the futility of this effort is apparent or because they were expecting free money for everyone.

The purchases for Operation Twist will be offset by a reduction in short-term securities, so for once the Fed is not printing money. Earlier attempts to lower long-term interest rates involved buying bonds with freshly printed money. This is a step in the right direction.

The Fed is rumored to have a model that predicts how much consumer spending to expect for a given decrease in interest rates. Presumably this model was developed using data from the '80s to the '00s when everybody was trying to live as far above their means as possible. In such an environment, lowering interest rates does spur consumer spending because the affordability of credit is the only limiting factor. Given unlimited credit, everybody would have had a dozen Ferraris in the driveway of their mansions.

The Fed apparently still thinks this is how the world works. They should know better! None of the past attempts at Quantitative Easing have done much to stimulate consumer demand. However, they did increase the domestic inflation rate to 3.8% for consumer prices and 6.5% for producer prices. These are the highest since late 2008.

The reasons why Quantitative Easing hasn't worked and won't work this time are very simple.

Generally borrowers care about interest rates. They tend to borrow more if rates are lower and less if they are higher. However, if long-term money is essentially free, reducing the cost even more has limited effect just like lowering the price of something from $0.10 to $0.05 would have limited impact on your decision to buy it.
Companies sit on record cash balances. They don't see the opportunities to invest the money they have, let along borrow more. Since the ability to borrow isn't holding them back, the level of interest rates has no effect on them.
Consumers have finally seen the error of their ways. The desire to own 12 Ferraris and a huge house seems to have disappeared for now. Instead people are focusing on living within their means, rebuilding their savings, and paying down debt. These are all good things, but they invalidate the Fed's model that predicts consumer spending as a function of interest rates. A person set on paying down debt is very unlikely to suddenly take out a new loan to go on a shopping spree just because the interest rate dropped 0.2%.

The Fed is still living the the dream world of the '90s when life on credit was the norm. In the current environment it would probably be much more effective to establish a believable program to balance the budget, remove antiquated and redundant regulation that impedes business activity, and generally show that the political leadership can address the economic challenges instead of just temporarily papering them over with freshly printed money.

Ireland is an example of a country that has restored confidence in just this way. The population and the politicians have rallied behind an austerity program that actually fixes Ireland's problems. People see that the situation is getting better, which breads the optimism to invest for the future and puts the country on a sustainable path. Something similar could be done in the US. There is plenty of 'can do' attitude to go around. What is missing is someone to lead the way.

Market Myths

2011-09-06T11:15:00.000-07:00

It has been a turbulent summer for financial markets. Stock indices have moved more than 2% on quite a few days and other asset classes have also experienced big swings. Some blame high frequency traders for stock price volatility, but so far there isn't much evidence to support this claim. Whatever the reason, the market response to fairly insignificant changes in the data has been disproportionately large.

The frequency of big moves is easier to understand. Everybody from the Federal Reserve to you and me makes financial decisions based on their understanding of market forces and how they interact. The problem is that many of the truths we hold to be self-evident are false.

Since the last recession, the economy has not behaved as one would expect based on those false truths. Consequently every piece of new information is a surprise that causes market participants to change their assessment of the state of the economy and their asset allocation.

Here are three of the most popular myths:

Consumer Spending Drives the Economy. False! Consumer spending is the result of prosperity (someone invents something useful, makes money on it and spends it) or ballooning credit card debt. It is never the source of prosperity, just a method of spreading it. Virtually all attempts to 'fix' the economy focus on stimulating consumer spending. Whenever this 'unexpectedly' fails, markets swoon. The only way to fix the economy is to encourage value creation. In time that will result in consumer spending.
High Unemployment Hurts the Economy. Mostly false! High unemployment makes for disgruntled voters and in extreme cases social unrest. It does not necessarily mean that the economy is failing. In most developed countries there is high demand for skilled workers and low demand for unskilled ones. This is a sign that the economy is focused on the right things. The developed world can't compete with the developing world in terms of unskilled labor costs. It can compete in terms of innovation, R&D, technology, highly skilled manufacturing, etc. The unemployment rate for highly skilled workers would be a much better gauge of the long-term health of the economy. Unemployment among lower-skilled workers has little bearing on how well an economy is innovating and bringing competitive products to market.
This is 2008 All Over Again. This claim is popular with the pundits, but it is mostly false! In 2008 we had an enormous housing bubble, massive amounts of sub-prime mortgages that were initially thought to be illiquid but turned out to be worthless, rich stock valuations (Price/Book for the S&P 500 was 2.6), $2.6 trillion of outstanding consumer debt, and an ISM manufacturing index below 50. Today we have a partially unwound housing bubble with prices about 30% below the peak, most of the sub-prime debt written down to its true value of zero, much more reasonable stock valuations (P/B of the S&P 500 is 1.9), a more manageable consumer debt load of $2.4 trillion, an ISM manufacturing index (barely) above 50, the healthiest company balance sheets in a long time, and a mountain of European sovereign debt that is currently thought to be illiquid, but will turn out to be worthless. There clearly are similarities between the current situation and 2008, but the starting point is much healthier than it was back then. The biggest challenge is finding the least damaging way to write down Europe's debt.

Several decades of economic growth driven by consumer spending on credit have trained us to look at indicators like unemployment, consumer sentiment, and consumer spending to assess the state of the economy. We have somehow forgotten that economies don't compete on consumer spending, but on whether they can offer attractive goods and services to internal and external customers.

Policy makers should focus on ensuring that the US can continue to compete. This requires good infrastructure, a well-educated workforce, and a competitive regulatory environment. Similarly, market observers should focus more on indicators that show how well the US is positioned to compete with other countries in the years to come (R&D spending, number of patents filed, PhD's granted, etc.), and less on the latest unemployment figures.

A renewed focus on long-term competitiveness would not only reduce market volatility by deemphasizing volatile indicators such as consumer spending, it would also lead to more productive use of public funds.

Gold: Bubble or Not?

2011-08-24T13:59:00.000-07:00

This week GLD, a gold ETF, surpassed SPY, an ETF tracking the S&P 500, to become the largest Exchange Traded Fund. Gold prices also set a new all-time high. This should ring the bubble klaxon!

Gold is a useless asset. It does not produce earnings, it does not pay dividends or interest, and it has few industrial uses. The only thing it does well is look pretty. So why is everybody buying it instead of stocks, bonds, rental properties, or anything else that does produce an income stream? There are two possible answers: Gold is undervalued even at its current price. Or herding behavior causes people to buy into a bubble.

Gold Price

The gold price has increased from $255 in August 1999 to well over $1800 today without serious dips or pullbacks. It is easy to see why this attracts investors, especially when compared to the turbulence in the stock market over the same period of time. It is also easy to see why people might expect that gold will continue to rise after watching it gain consistently for well over a decade.

However, history shows that asset prices cannot continue to go up indefinitely. There are always pull backs, crashes, and bear markets. The last time this happened to gold is a distant memory, but we all remember recent examples such as the tech stocks in the '90s and home prices in the '00s.

So is gold like the tech stocks or residential housing? As is often the case in finance, it depends on how you look at it. We recently posted about the how much S&P 500 earnings an ounce of gold can buy. By that measure, gold is vastly overvalued compared to stocks. However, there are other ways to put the price of gold in relation to the rest of the economy.

The chart at left provides a few examples. We plotted the ratio of the gold price to the value of the S&P 500, to the GDP, to an index tracing industrial metals (i.e. those that are useful rather than just pretty), and to the median family income.

No matter how you look at it, gold was more overvalued in the late '70s and early '80s. That was a time of double digit inflation and several recessions, which increased the appeal of gold. However, once the crisis was over gold fell steadily for about 20 years.

For the last decade, gold has been climbing again. In none of the categories has it surpassed its relative valuation peak from 1980, but we are getting close compared to the median family income and the price of industrial metals.

So what does all of this tell us? Well, we have the usual mess of contradictory economic data.

The size of the gold ETF screams bubble because it indicates that everybody and their dog have bet all on gold. The relationship between the price of gold and S&P 500 earnings also screams bubble. The gold price relative to industrial metals and personal incomes shouts bubble, but compared to the GDP or the S&P 500 index value it only a murmurs the question, "Bubble?"

Over long time periods, gold has been a terrible investment while stock, bonds, and income-generating real estate have produced good returns. This is likely to be the case going forward as well.

Even if gold doesn't unambiguously qualify as a bubble, it is likely that price drops will be drastic when investors shift back into more sustainable investments. The sheer size of the gold ETF virtually guarantees that sellers will not be able to find buyers at current prices. Buyers will appear once gold has become cheap, but all of our ratios indicate that this would require a substantial price drop.

It is always easier to identify assets that are bubbling than to predict when the bubbles will pop. Gold has much more downside than upside at this point, but this has been true for years without slowing price gains. Home prices and tech stocks also suggest that bubbles can exist for years even after objective measures (e.g. P/E ratios or rent to buy ratios) show that markets are out of equilibrium.

It is anybody's guess when gold will correct, but it is very likely that it will be ugly when it does.

Market Update: Don't know where to go, but let's get there fast!

2011-08-18T10:33:00.000-07:00

August has had eight days with stock market moves over 2%. Five were down days and three were up days. Swings of this magnitude are relatively uncommon. 2007, a somewhat choppy year, had 11 down and 6 up days over 2%.

Just based on the fact that we had half a year's worth of big swings in 18 days, we can safely conclude two things: 1. Market participants don't know what to make of the current situation (up and down days). 2. Once they settle on the direction for the day, they run flat out (big moves).

The unemployment figures for the last two weeks are a good example. On August 11th, initial claims came in at 395,000. The market decided that this is great. The S&P 500 gained 4.74%. Today initial claims were 408,000. The market decided that this is a disaster and the index has dropped well over 3% as of this writing. However, it is very hard to claim that there is a real difference between these two numbers.

The August 11 number was later revised up to 399,000, so we know that the initially reported numbers have an uncertainty of at least +/- 4000. The real information in today's report and the August 11 number is that there are 'about 400,000 initial jobless claims.' There really isn't more information to be gleaned from these reports, yet the market response to these reports is drastically different.

Other reports have the same effect. Numbers suggesting that manufacturing is doing okay spark big rallies; numbers suggesting the opposite cause declines even though the changes are too small to have any real significance.

Of course there are real reasons for concern. There is the US downgrade; the latest installment of the European debt crisis; signs that the world economy is slowing; US consumer inflation, which has been well above 3% for the last four months; and the list goes on.

All of this has made investors very jittery, which explains the dramatic reactions to insignificant changes in economic data. However, trading on jitters is rarely a good strategy. Long-term investors should consider long time frames rather than the day to day stream of economic reports.

Factors that are likely to shape the markets over the next decade include:

Bond yields are at historical lows and will most likely get pushed up by inflation and worries about excessive US deficits. Rising yields correspond to falling bond prices.
Inflation is rising quickly, but it is still below historical averages. It is likely to continue to rise, especially since the Fed is doing everything in their power to make it go up.
Stocks are a good long-term inflation hedge and they are cheapest since at least 1994 (measured by P/B for the S&P 500). However, they are also subject to short-term swings caused by the crisis of the day.
Taxes are near an all-time low. They are certain to increase because there is no other way to pay for the entitlement programs that nobody wants to reform.
The housing market will probably remain in a slump for years, which will keep unemployment high.
The dollar is likely to continue to weaken against other currencies, which will reduce its status as the world's reserve currency but help make US products more competitive internationally.

As unpleasant as it is, stock market volatility is a fact of life. However, it is also temporary. Over long periods of time, asset prices are driven by the type of factors listed above. It usually pays better dividends to think about the long term than to join the rest of the world in trading on the latest unemployment number.

The Best Horse in the Glue Factory

2011-08-08T12:37:00.000-07:00

S&P downgrade US long-term debt last Friday. Stock markets have sold off world wide in response, and investors scrambled to buy the freshly downgraded US treasuries.

The stock market response is natural. The downgrade increases uncertainty, which normally causes investors to dump more volatile assets in favor less volatile ones. When the shock wears off, this process normally reverses.

The demand for treasuries makes some kind of sense. According to a friend of mine, the US is 'the best horse in the glue factory.' This is mostly due to the size of the treasury market. Large investors, for example China, have very few other options because they need to invest hundreds of billions of dollars. Even for smaller investors it is often easier to buy a US treasury than, say, a Finnish government bond because the treasury market is so much more liquid.

Credit markets have a history of ignoring the rating agencies. Often the markets sell off a security well before it gets downgraded. Judging by prices, the downgrade has made US treasuries more attractive. It remains to be seen if the credit markets really disagree with S&P's assessment, or whether this is a short-term reaction to the news of the downgrade.

There have been many prominent voices that disagree with S&P's downgrade. We can safely assume that the political class would say that no matter what, but even Buffett blasts the rating cut.

We beg to differ. While one can argue about the timing and maybe about the details of the S&P's calculations, our current Debt to GDP ratio simply doesn't justify an AAA rating. The chart below shows the Debt to GDP ratios for all AAA rated countries (except two tiny ones: Lichtenstein, and Isle of Man) as of 2010.

Even based on 2010 numbers, the US was on the high end of indebtedness. The situation has since deteriorated significantly to push the Debt to GDP ratio up to 100%.

The US can always print more dollars. As long as Washington is willing, there is no real risk of default in the sense of not making payments. The default will occur slowly via devaluing the dollar and internal inflation. Both of these are bad for long-term bond holders. The rating cut simply made this well know fact official.

It is likely that markets will experience big swings driven by assessments ranging from 'this didn't changed anything' to 'there is no place left to hide!' However, the medium-term impact is likely to be small. At most borrowing costs will increase modestly, but US businesses don't care because they sit on a record pile of cash, and US consumers don't care because they are held back by an unwillingness (and maybe inability) to borrow, not by the interest rates.

It was clear that the downgrade would roil the markets, but hopefully this downgrade will also focus Washington on solving our long-term debt problem in a constructive and equitable manner.

Fatigued Markets

2011-08-04T12:16:00.000-07:00

The last few months have been tough for the stock market. We had the Debt Ceiling debacle, the European debt crisis, a slowdown in the world economy, rating agencies looking to downgrade treasuries, and countless other problems. It is no wonder that equity markets have sold off sharply as a result of the accumulated fatigue.

While the factors listed above are real problems, history suggest that markets tend to overreact to both good and bad news. The reaction to bad news normally involves declining stock prices and, among other things, rising gold prices.

Bloomberg published a chart today that shows how many dollars in earnings you can buy for an ounce of gold. If gold is expensive and stocks are cheap (both signs of fearful markets), you can exchange you gold for a lot of stock, which in turn generate a lot of earnings.

Gold to Earnings Ratio

The Bloomberg chart at right shows how the earnings per ounce of gold have evolved over time. Gold is at its most expensive ever relative to stocks. By this measure the markets have never been as fearful as they are now.

Other fear measures, e.g. the volatility index (VIX), paint a similar picture, but the current levels of fear are not even close to all-time highs. The chart below shows the VIX over the same period of time.

The two measures share the property that sharp spikes are transient. Markets cannot sustain extreme levels of fear for very long.

When the markets calm down, the VIX and the Gold to Earnings Ratio are likely to return to more normal levels. For the Gold to Earnings Ratio, some of it will probably come from declines in the gold price, and some will come from a recovery of stock values.

Once markets have calmed down again, a real assessment of the economic situation can take place. Right now we mostly see knee-jerk reactions to data, rumors, and opinions that are amplified by the overall level of fatigue from months of multiple crises and stresses.

Addendum: 90-day treasury yields briefly dropped below zero today. This is another indicator that the markets are very spooked. Rational investors would not pay the US government or anyone else to hold their cash for three months, but panicked ones might before they come to their senses and put the money under the mattress instead.

Borrowing from Buffett: How to Shrink Public Debt

2011-08-04T08:41:00.000-07:00

It is good to see that our politicians managed to find a way to raise the debt ceiling. It is less comforting to see that they only managed to do it when the walls had closed in so much that they had to take turns breathing in.

Needless to say, the deal to raise the debt ceiling does nothing to correct our unsustainable debt trajectory. It simply makes our public debt explode at a slightly slower rate. With the debt ceiling out of the way for now, it is time to focus on debt reduction.

We have all heard the familiar mantras out of Washington. Democrats want to tax the rich, Republicans want to cut spending, some want a balanced budget amendment to the constitution.

The latter may be good for sound bites on TV, but it is a bad idea for several reasons.

A balanced budget means that you spend what you take in. However, in order to lower the federal debt burden, we need a surplus. This may be a technicality. Balanced budget proponents presumably really want deficit-free budgets. However, defining a balanced budget as a goal understates the severity of the problem. The public debate should be about how to achieve a surplus.

The main problem with requiring a balanced budget is that the government cannot adequately respond to crises. For example, it is a bad idea to limit defense spending in the event of an attack just to balance the budget. The same is true if a major natural disaster strikes. The recovery will be much faster if money for rebuilding is readily available, and this is surely in the public interest.

One could consider providing incentives for politicians to balance the budget instead of a constitutional amendment. Buffett offered an elegant solution: "You just pass a law that says that any time there's a deficit of more than three percent of GDP, all sitting members of Congress are ineligible for re-election."

However, the real problem is not whether there is a budget deficit, the real problem is the amount of public debt. Should a country without debt borrow money, e.g., to build an interstate highway system? Most people would probably say yes, provided it generates enough revenue to pay for itself and the revenue is actually used to pay back the debt. Should a country as broke as Greece do it? Probably not even if they could.

As we have argued before, the current political system has no incentives for paying back public debts. As a result countries borrow until the markets refuse to lend, at which point they suffer the same fate as Greece.

Perhaps a variation of Buffett's plan could change that. How about a law that renders sitting politicians ineligible for reelection whenever the outstanding debt exceeds some target percentage of GDP. The law would have to specify target Debt/GDP ratios for the next 20 or 30 years to get us from the current situation back down to that final sustainable percentage. That final percentage would then remain constant from there on.

This would drastically curb politician's tendency to buy votes today with debt that the next generation will have to pay off, and it would force them to work together to fix our long-term fiscal problems. The extremists on the left and right whose solutions are financially impossible would quickly disappear from Washington, hopefully to be replaced by people who manage our public finances better.

Think this is just a fantasy? It probably is in the United States, but elsewhere something along these lines has already been done: Germany passed a constitutional amendment (in German) that requires essentially balanced budgets starting in 2016.

Debt Ceiling, What Else?

2011-07-28T08:58:00.000-07:00

No working life in finance is complete without commenting on the debt ceiling farce in Washington. Politicians are mostly trading soundbites rather than engaging in any kind of meaningful debate. We would like to suggest a few additional soundbites that would make the exchanges in Washington more relevant:

Not raising the debt ceiling is like not paying your credit card to get out of debt: STUPID and INEFFECTIVE.
All of the proposed plans claim to reduce the DEFICIT, but you need a SURPLUS to pay down debt. Washington is fighting about how quickly things should get worse, not how to make things better.
Total tax receipts cover the cost of entitlement programs and interest. Everything else is financed by issuing debt. You can't balance the budget by ONLY raising taxes or ONLY cutting benefits.Taxes would have to go up by 50% or entitlements have to be cut by 50%. Not doable unless you like riots in the streets.
Everybody wants to close the budget gap with other people's money, but we can only get out of this hole if EVERYONE makes some sacrifices.

We get the government we deserve. Right now that's a bunch of 2-year-olds riding their hobbyhorses around the Capitol crying 'Snot Fair!' and 'No, you are mean!'

Problem Solving by Financial Heart Attack

2011-07-20T07:25:00.000-07:00

After many years of overeating (overspending), Greece is in the emergency room with a major financial heart attack. The doctors (IMF, European finance ministers, the ECB, etc.) are running around trying to save it. Open heart surgery (loans guaranteed by others) has averted the immediate crisis, but Greece is just as overweight today as it was before the crisis. Attempts to lose weight through exercise (austerity measures) cause serious chest pains (riots). The doctors don't want to admit it, but all signs point to a heart transplant (default) as the only way to get Greece onto its feet again.

Greece isn't the only one. It is a veritable epidemic. Ireland, Italy, Portugal, Spain and a host of other countries are having chest pains. Iceland is feeling better now with its freshly transplanted heart. The American home owner is still in the hospital from his financial heart attack after gobbling up vast quantities of real estate, and it has been many decades since Uncle Sam last could see his toes.

By most accounts (e.g. here or Bill Gross' statements in a recent interview), total hidden government liabilities add up to about $60-$100 trillion. That is on top of the $14 trillion of debt carried on the balance sheet. Adding up those liabilities, the US owes at least five times GDP, which currently sits at about $15 trillion. For comparison, Greece's debt is about 1.5 times its GDP.

This is not really a fair comparison, because it leaves out any hidden liabilities Greece may have. The US debt figure includes unfunded entitlements, state and local debt, and underfunded public pensions. Nevertheless, it is clear that this is an unsustainable debt load even if the estimates turn out to be off by a factor of two or four.

Uncle Sam is already more overweight than Greece ever was. If he doesn't change his ways, he will end up in the hospital like Greece, but at present he is partying like there is no tomorrow, gorging himself on entitlement spending, costly wars, bailouts, subsidies, and countless other delicacies.

Perhaps it would not be such a bad thing if the talks about raising the debt limit failed. After Uncle Sam suffers the resulting self-inflicted mild heart attack (temporary default) and finds out how much fun it is to fetch up in the emergency room, he might be more inclined to take care of himself, slim down, and stick with an exercise regime.

Some kind of a wakeup call is necessary while there is still time to deal with our debt problem. The only way to address it is for Washington to do its job: get everybody to recognize that there is a problem, find a solution that demands some sacrifices from everyone, and work together across party lines to implement it. In the current political environment that does not seem to be possible. Something needs to change the environment. Greece shows that the alternative is not pretty.

Around and Around We Go - Why Momentum Hasn't Worked Lately

2011-06-27T10:47:00.000-07:00

Many investment strategies rely in part on the idea that investments that are performing well are likely to continue to do so. This is called price momentum. It is well known that simply relying on price momentum to select investments is a winning long-term strategy.

Momentum Index vs. S&P 500

The chart at right shows the returns of the S&P BNP Paribas SPECTRUM US Sector Momentum Index compared to the S&P 500 (green) going back to 1993. This index gives greater weight to sectors that have been performing well. This approach has generated strong returns, albeit with considerable volatility. (See our piece on Efficient Markets for other momentum examples.)

Momentum Index vs. S&P 500 (Most Recent 12 Months)

However, lately this approach has not produced particularly attractive results. The chart at left shows the same comparison for the most recent 12 months. The momentum approach has underperformed.

This in itself is not surprising. Any consistent investment approach will encounter favorable and unfavorable market environments. What is somewhat surprising is that the recovery out of a recession is normally a favorable environment for momentum strategies.

12 Month Sector Trajectories

The chart at right traces out the fate of a few sectors (Utilities, Health Care, Industrials, Energy) over the most recent 12 months.

The trace moves right when a sector outperforms its peers and up if the outperformance accelerates. A sector should prescribe a circle over an economic cycle: It starts as an underperforming sector that is starting to move up in the lower left quadrant. As the improvement accelerates, it moves up into the top left quadrant. The accumulated improvement moves it right (towards performing better than its peers) as it moves up. Eventually the improvements slow down and reverse course. This makes the trace move down on the right side. As the sector falls behind its peers, it moves left, which closes the loop.

Momentum strategies are designed to capture the part of the loop where the trace swings up and right. One reason why they are so robust is that the economic cycle predictably drives sectors through these loops as the economy swings back and froth between expansion and contraction.

Over the last 12 months, Utilities (blue) have almost completed one loop, Energy (yellow) has completed about half of a loop, while Industrials (also yellow) have not done anything despite leading us out of the recession. Only Health Care (green) has shows a fairly consistent up-trend over the last 12 months.

This differs in only one respect from the recovery out of previous recessions: the cycles are much shorter than normal. Typically the it takes at least two or three years for a sector to traverse the up and right section of a loop. Currently it is happening in a year or less.

This causes trouble for momentum strategies, because many are designed around the normal three to five year cycles. They often take half a year or even a year to detect a trend, and expect it to persist for another 12 to 18 months after it has been detected. If cycles shrink to a single year, sector trends end just when they have been detected. This puts momentum strategies into sectors when they start underperforming, which explains the poor performance of the momentum index relative to the S&P 500 over the last 12 months.

The market will most likely return to normal cycle lengths, since it reflects the business cycle under normal conditions. Normal conditions does not mean a major bull market. It means a market that is free from major market panics and massive government interventions. In other words, normal conditions prevail most of the time. When they return, momentum strategies should begin to outperform again, just as they have for most of the past 100 years.

Warning: Not all (Financial) Data contains Information

2011-06-20T12:40:00.000-07:00

There is a very big difference between data and information. A string of random numbers is data, but it contains no information, no signal. The signal to noise ratio of a string of random numbers is zero.

A radio broadcast is also essentially a string of numbers. However, it contain information such as the day's news, a weather forecast, or sports scores. Assuming you have good reception, the signal to noise ratio is very high.You get a lot of information with a small amount of static (noise).

In finance, there is an overwhelming supply of data. Every day someone reports something. A lot of it moves markets, indicating that market participants treat the data more like a radio signal that conveys information than random numbers that don't.

Industrial Production

A good example comes from the manufacturing sector that has been leading us out of the recession. Recent reports have suggested that activity in this sector is slowing. This, along with the renewed Greek debt crisis and the recent unemployment figures, has been depressing the US stock market.

If we look at short time frames, it looks like the manufacturing sector has run out of steam. The chart at right shows the US Industrial Production, an index that reflects manufacturing activity. The last two months, the index has been essentially unchanged after fairly consistent gains in earlier months.

The question is whether the more recent data reflects a change in the economy or just short-term fluctuations, perhaps driven by temporary factors such as the wild weather in the Midwest and the supply chain disruptions in Japan.

Industrial Production since 1950

I can't predict the future any better than the next person, but I can shed some light on how much signal (information about the future) is contained in the last two data points in the chart. It is straightforward to do a mathematical analysis, but simply looking at a chart that shows a longer history of this index gives us most of the answer without doing any math.

The chart at above shows Industrial Production, but this time from 1950 to present. Several aspects are worth pointing out:

Expansion cycles typically last several years or even a decade.
Contractions typically last one to two years.
There are noticeable bumps and wiggles during the periods of expansion
The current slowdown is not large enough to produce a noticeable wiggle.

These observations (unfortunately) don't tell us whether the current expansion cycle has run its course, but they do suggest that the markets are reading too much into the recent reports. Sharper slowdowns have occurred in every expansion cycle, and the current one is so far shorter than most. However, similar slowdowns have also occurred at the end of every expansion cycle. The data we have simply doesn't contain enough information to distinguish between the two scenarios, yet the market behaves as if it did.

This is one example of how the markets often overestimate the signal to noise ratio of financial data. Rational investors would admit that there isn't enough information to decide whether the manufacturing expansion has run its course. Real investors often incorrectly assume that all data contains strong signals and move markets accordingly.

Greek Credit Crisis Yet Again

2011-06-16T14:15:00.000-07:00

Every few months we get another installment of the Greek credit crisis and another installment of the market jitters that go along with it. The jitters are understandable. Another global credit panic would certainly harm the world economy.

However, the Greek economy is tiny compared to the worlds larger economies. Greece's
GDP is approximately $300 billion. That is about 1/50th of the US GDP or twice the annual sales of General Electric. We are certainly not talking about peanuts, but objectively a $300 billion economy is not large enough to damage the world economy.

The same picture emerges when we look at it in terms of debt. Outstanding Greek government debt is about $460 billion.This is clearly unsustainable given the size of the GDP. Since Greece cannot unilaterally print Euros to pay its debts (i.e. inflate it away), the only way out is default.

However, even if Greece defaults on all of its obligations, which is unlikely, it would cost the bond holders or the EU tax payers about one and a half times the cost of bailing out Fannie Mae and Freddie Mac ($317 billion). More realistic scenarios would probably cost about the same as bailing out the mortgage companies. Again we are not talking about peanuts, but we are also not talking about amounts large enough to derail the world economy.

The real risk is not that Greece defaults. It is that the market participants react so strongly to the continuing uncertainty that the financial system grinds to a halt. This would transform a manageable problem into a big one, and could triggering a default of other overextended countries such as Spain, Belgium, or Portugal.

European politicians should stop pretending that Greece can become viable through austerity measures alone. Those are absolutely necessary, but without the ability to inflate away debt, they will most likely not be sufficient.

A Greek default would certainly shock the markets, but it would also provide clarity once the shock wears off. That clarity is necessary for financial markets to return to normal. The sooner that happens, the better.

Structural or Seasonal Unemployment, That is Here the Question

2011-06-08T09:04:00.000-07:00

Last week, the Bureau of Labor Statistics announced that economy added 54,000 non-farm jobs in May, far fewer than the 165,000 expected by pundits. A quick look at the detailed release shows that several sectors lost jobs. The Local Government sector lost about 29,000 jobs, Manufacturing shrank by 5,000 jobs, and retail lost another 8,000.

These numbers reflect the end of some stimulus programs, extreme weather in the Midwest, supply chain disruptions due to Fukashima, and a continuing structural shift in the US labor market.

The latter is most likely a permanent change that will continue to drive the labor situation for years to come. This is called structural unemployment. Unemployment due to a recession, bad weather, or some other temporary factor is often called seasonal unemployment.

The chart shows how the distribution of jobs across industry sectors has changed over time.

We define an index for each sector that tracks the sector's share of the total number of jobs and set it to 100 for the reference period (shown in blue). Over time, the number of jobs in each sector changes. If a sector is adding jobs relative to other sectors, the index increases, if it is shedding jobs, the index decreases.

The red line shows today's labor market relative to the labor market of 1994. We see a shift away from government, the post office, and manufacturing, and towards education, health, professional services, and resource driven industries.

This amount to a systemic shift from less skilled jobs in manufacturing, government, and even retail and transportation, to more skilled jobs in professional services (accounting, law, IT), education, and health. Leisure and Lodging as well as Mining and Logging are growing sectors that still provide opportunities for less skilled workers. However, it is unlikely that they can absorb all the workers from the shrinking sectors.

This shift to more skilled jobs is almost certainly irreversible, and it will most likely create a large pool of permanently unemployed lower skill workers. The green line supports this view. It shows how the distribution of jobs across the sectors has changed since the height of the financial crisis in 2009.

Not surprisingly, the biggest gains were in government jobs as a result of various stimulus programs, and the largest drops are in Construction and Professional Services. However, the share of manufacturing jobs has continued to decline even as the sector lead us our of the recession. This suggests that efficiency gains have reduced the need for lower skilled labor even during times of sharply rising demand.

Sectors like Construction or Leisure, that have traditionally employed such workers, have not participated in the recovery so far. One reason is that these sectors are consumer-driven. This puts in place a positive feedback cycle. If many potential consumers are unemployed, these sectors will struggle, which keeps people unemployed. Conversely, if these sectors are doing well, they employ more people and transform potential consumers into actual consumers, which increases demand.

Leading up to the financial crisis, easy credit allowed consumer spending to feed on itself. The US economy enjoyed many years of solid growth and low unemployment while public and private debts rose to record levels. The crisis was inevitable, because no credit line is inexhaustible.

Post crisis, the feedback cycle switched directions. Now slow consumer spending is keeping unemployment high, which in turn keeps consumer spending slow.

Policy makers and the media seem to think that this mode of the economy is anomalous and needs fixing. However, in this mode, consumers spend in line with their incomes and don't need to take on more debt. It is a long-term sustainable economic model and a more accurate reflection of the true economy than the bubble phase before the crisis.

Now that structural unemployment has been revealed in the post bubble economy, the US will have to develop ways to mitigate the problem. Europe has been struggling with the same issues for years without finding effective solutions.Whatever the US response will be, it is likely to be expensive. One more reason to get serious about putting public finances on a sustainable path so there is some room to deal with this and other unanticipated problems.

US Presidents - Better than Expected

2011-06-01T12:41:00.000-07:00

The wonderful thing about hard facts is that you can't argue with them, even if they don't match your preconceived notions.

A few weeks ago, Obama, like most presidents before him, made his current tax return public. The return shows about $1.8 million in income, which far exceeds the $400,000 you and I are paying him.

This naturally raises the question of who he is really working for. Presumably the source of the $1.4 million over and above his presidential salary would have a stronger claim on him than the tax payer. It also raises the question of why this question never arose before. There is no reason to think that Mr. Obama is more or less compromised than his predecessors.

The chart at right shows the Gross Income for all presidents going back to 1985. The dark blue part is the salary, the light part is other income.

It is immediately apparent why Obama's tax returns demand more attention than those of his predecessors. He is the first one for whom the presidential salary is a nice bonus rather than a significant portion of his income. For other presidents the salary typically made up more than half their income. Nevertheless, even if a president is making 'only' half of his money doing something else, one should be concerned about potential conflict of interest.

It turns out that the other income for all presidents comes from two sources. Some is passive investment income and some comes from book royalties. This is true for the first Bushs in 1991 (Millie's Book) and it is true for the Obamas as well. The only exception are the Clintons, who had a large gain from Hillary Clinton's business activities in 1996.

It is unlikely that the readers of a book could influence a president's actions even if they provide most of his income. In fact this is probably one of the very few sources of outside income that poses no material conflict of interest because the president's actions after the book is published will have minimal effect on its success.

The hard facts spoiled a juicy blog post. Instead they showed that US presidents as a whole are avoiding conflicts of interest much better than expected, and that Obama is either a better writer or a better salesman than any of his predecessors.

Do we Really Get the Government we Deserve?

2011-05-26T11:29:00.000-07:00

I don't know about you, but I don't deserve it. For decades the US has been on a financially unsustainable path, it has been unable to reform entitlement systems that clearly will break the bank if nothing is done, it has engaged in various costly and pointless military adventures, it has eroded privacy rights and civil liberties in the name of protecting us from the dangers of terrorism, which are orders of magnitude smaller than those of driving to work, it has catered to special interest and subsidized whole industries, and so on ad nauseam.

Whenever a system is not working, it is a good idea to look at the incentives that shape the decision maker's actions. We routinely do this to explain people's behavior and even financial crises. CEOs get paid if risky bets pay off, move to a different company or retire if they don't. Strangely enough, we rarely apply the same type of reasoning to politics.

Given the vast sums of money spent on election campaigns, we can safely assume that politicians are motivated by a desire to get (re)elected. In order to succeed, they need need to give voters what they want. Panem et circenses (bread and circuses) is said to have worked well enough in ancient Rome, but today most people want money in the form of entitlements, tax breaks, make work programs, subsidies, etc.

In a democracy, a politician has two options. He or she can enact policies to transfer assets from a small group of voters to a large group of voters. This will have a net positive effect on election results as the number of receiving a benefit outnumbers the people paying for it.


Stats by Income Quintiles (Dollar values are lower boundary)

This is happening routinely in all western democracies. In the US, 'rich' households, the 20% making over $93,784, account for 25% of the population, make 50% of the money earned in the US, but pay 73% of the taxes. The data comes from this Bureau of Labor Statistics report.

To be fair, there may be other, more valid reasons to enact such policies besides simply buying votes. For example, a civilized society has some responsibility to care for members who can't take care of themselves. For the purpose of the present discussion, we will leave such considerations aside and focus only on the pressures that inform the decisions of a typical self-interested politician.

The second option is to buy votes on credit by running a budget deficit. This has the enormous benefit that it is unnecessary to render any group of voters seriously unhappy by taking all their money. The politician can buy votes from everybody today, and the payment will not come due until after the politician has retired.

This is how the US political system and other western democracies have worked for the last 60 years or more. Without borrowing ever increasing amounts, the tax rate on the top group in the chart above would be much higher.

It is no surprise that there is virtually no difference between Democrats and Republicans in this context. Both have the same incentives to buy votes on credit. Both distribute the borrowed money to essentially the same large voting pools.

It is worth pointing out that the urge to borrow money and give it to those who have a say in the political process is universal. In democracies, the recipients are generally the voting poor, because there are many and their votes are cheapest to buy. Democratic systems run into trouble, when the entitlements overwhelm the state's ability to tax or borrow.

In monarchies or aristocracies, only the the monarch and some aristocrats have a political voice. Consequently they normally concentrate borrowed and earned assets in the hands of those few. Monarchies run into trouble when the peasants get too hungry and revolt or when the state has exhausted its ability to borrow.

The bank CEOs' bonus (used to) depend on how the bank did in the preceding year. This encouraged them to take big risks with big potential payouts, because they would make out like bandits if it worked, but didn't have to take the consequences if it didn't. New financial regulation may curb this behavior to some extent.

Politicians drive up the deficit to buy votes, because that gets them elected. They too don't have to take the consequences of their actions unless they happen to be unlucky enough to be in office when the sovereign debt crisis strikes.

An ideal constitution would include a mechanism to counter the incentives to buy votes on credit. Without such a mechanism, fiscal irresponsibility is guaranteed. We don't deserve that, but given politicians' incentives to preserve the current system, it is what we will continue to get.

Brace for Impact - Rating Agencies Not (far) Behind on Sovereign Credit

2011-05-23T11:36:00.000-07:00

Credit rating agencies like Moody's and Standard & Poor serve a single function: to assess the creditworthiness of borrowers so lenders can decide how much interest to charge. Historically they have done a lousy job. Orange County and Enron went bankrupt with a stellar credit rating, assorted mortgage bonds that turned out to be worthless had good credit ratings, and it is easy to continue this list.

Perhaps the recent failure to assess the risk of mortgage instruments served as a wake up call to make the rating agencies more vigilant. Alternatively the financial problems of many western countries are so severe that even a comatose rating agency can't fail to recognize them.

The truth lies somewhere in between. Today Italy joined the US in having the outlook for its credit rating cut by S&P. Fitch, another rating agency, revised Belgium's outlook to negative. Washington does not seem to be sufficiently concerned by this growing pessimism about sovereign debt.

The debt to Gross Domestic Product (GDP) ratio is often used to assess a country's ability to pay back its loans. According to the IMF, these ratios are currently 93% (US), 100% (Belgium), and 118% (Italy). The respective credit ratings are AAA, AA+, and A+ (More A's mean a better rating). This makes sense. The higher the debt load, the worse the rating.

The US takes in about 15-20% of GDP in taxes. Leaving aside the ability to print money, this means the US owes about five times as much as it takes in per year, yet it still enjoys S&P's top credit rating. The same would probably not be true for you if you made $100,000 per year but carried $500,000 of credit card debt, and for good reason.

We have argued before, that Europe as a whole can afford to bail out their over-extended members. This is mainly true, because the larger economies in Europe have also been the most fiscally responsible.

However, financial markets are more sensitive to changes in perception than to changes in reality. These outlook downgrades are probably the beginning of a shift in perception. Debts loads that previously seemed perfectly sustainable, e.g. Italy's or ours, suddenly become problematic even though the underlying economic situation hasn't changed.

Greek 10 Year Borrowing Cost

Normally the complacency is misguided, not the sudden realization that debt levels are too high. Greece is a poster child of this phenomenon. Throughout most of the decade ending in 2009, the Greek government had to pay less than 6% to borrow money for 10 years. At the end of 2010 it was over 12% and today it is well north of 17%.

The jump in borrowing costs was partly triggered by a downgrade from A to A- on 1/14/09. This innocuous change in rating made the market realize that Greece is bankrupt.

The increasing frequency of outlook downgrades signals a growing awareness that the current trajectory of government finances in the US and parts of Europe is unsustainable. And as usual, Washington is missing the big picture.

In 2010, the US paid approximately $200 billion in interest. If this were to double to $400 billion, a fairly modest increase given the low current interest rates, it would require saving $200 billion on other programs.

Effectively this amounts to a $200 billion a year cut in government spending that does nothing to reduce public debt or provide any other benefit. The effect of these cuts would far exceed the economic impact of any credible program to right out public finances.

A reasonable program to bring out public finances under control would probably preserve our credit rating, which keeps borrowing costs relatively low, it would put the US on a path of sustainable grow, and it would have much less economic impact than letting the situation deteriorate until the the bond market treats the US like it did Greece. The details of this program are far less important than whether or not one is implemented.

Of course passing such a program would require politicians form both parties to behave like adults and work out a compromise. We all know that this isn't going to happen. So, Brace for Impact!

The Return of Irrational Exuberance

2011-05-19T11:16:00.000-07:00

This week LinkedIn, a social networking site for professionals, went public with truly eye-popping valuations. LinkedIn's timing is excellent. They probably managed to sell themselves to the public during the late stages of bubble formation, but well before the inevitable bust.

At the peak of the tech bubble in 2000, the Price/Earnings ratio of the NASDAQ 100 was well in excess of 200. In other words, people were happy to pay more than 200 times annual earnings for the companies in the index. Even in the extremely unrealistic case that earnings double every year, it would take about 8 years to get paid back. That is why the bubble popped. Today the P/E for the NASDAQ 100 is 17.4, a sustainable value.

LinkedIn currently has a P/E ratio of 1314. Even in the unlikely event that earnings double every year, investors would need 11 years to recoup their investment. If earnings don't grow, it would take 1314 years, about the time from the fall of the Roman Empire to today.

Other valuation measures are equally absurd. the Price to Sales ratio is 13.5 and the Price to Book ratio (measures the stock price vs. the company's assets) is 132. The NASDAQ 100 trades at a P/S ratio of 2.2 and a P/B ratio 3.5 for comparison.

LinkedIn is vastly overvalued, even compared to the famous irrational exuberance of the last tech bubble.

A similar picture emerges for Facebook. Its valuation isn't as easy to determine, because it is privately held, but by most accounts it is worth somewhere between $50 billion and $150 billion. The 2010 sales are said to have been around $2 billion and they are expected to double in 2011. Assuming $4 billion in sales and a $50 billion valuation, we arrive at a P/S ratio of 12.5. Higher valuations or lower sales would increase this already completely absurd number.

Irrational Exuberance has clearly returned to this component of the tech sector. No doubt we will soon hear that 'it is different this time,' and we may even see a return of absurd valuation measures like 'Price to Eyeballs.'

LinkedIn and Facebook would have to find a way to increase their sales tenfold in a very short period of time to support their current valuations. This is virtually impossible to do for these large and relatively established companies.

The social networking sector is ripe for a crash, just like the whole tech sector was in early 2000. It is not clear when, or how it will affect individual companies, but history shows that current valuations in this sector as a whole are unsustainable for long periods.

Who is Pushing up College Costs?

2011-05-09T18:38:00.000-07:00

Exploding medical costs get most of the media attention, but over the last decade educational costs have risen almost twice as fast. It is natural to ask why.

Medicine has changed significantly over the last decade as new drugs and treatments became available. It is plausible that this can drive up costs. It makes more conditions treatable and more sophisticated treatments are likely to cost more.

But what has changed in education? Nobody has found a way to teach previously unteachable students. Nobody has found a way to implant knowledge directly into student's minds by means of some technological wizardry. So why is the cost of education rising so fast? Gross mismanagement? Private islands for university presidents? Lavish union contracts for the employees? Let's take a look!

We will use the University of California as an example. It is a large public university in a state that is well known for poor management. Problems should be more apparent here than elsewhere. Our data comes from UC's Budget Office.

Cost per UC Student by Source (inflation adjusted)

The chart at right shows the cost of educating one UC student, broken down by the source of funds: state funding, funding from the university, and student fees.

According to the 2011-2012 budget summary, the cost in today's dollars has declined over the last decade. The rate of decline was about 2% per year.

This is reasonably close to the average annual productivity gains for the US economy as a whole. We conclude that UC is about as well run as an average business. Gross mismanagement is not the cause of rising education costs.

The reason why education has become more expensive for consumers is that state support for universities has evaporated. From 1990 to 2000, state funding was cut in half, which translates to a decline of about 7% per year. Over the same period, student fees almost tripled to cover the shortfall.

This shifts the cost of education from tax payers to the individual students and their families. In effect California has been de-socializing education even as more and more medical costs are getting socialized (see Bush's Medicare expansion and Obama's healthcare reform).

It is likely that similar forces drive the increases in education costs for consumer in other states too. Even though the cost of educating a person has declined, student fees may very well continue to outpace general inflation for a while. However as soon as the shift from public to private funding is complete, cost increases should slow down to tracking general inflation again.

Let's All Flee to Questionable Quality

2011-04-19T10:15:00.000-07:00

Yesterday Standard & Poor cut the outlook for US government debt from stable to negative, indicating that there is a 30% chance the US will lose its AAA credit rating. Such announcements increase uncertainty. Will the US pay its debts? Will it be able to fund its extravagant level of spending at manageable interest rates if the rating is cut?

The market has an instinctive response to increases in uncertainty: the 'Flight to Quality.' Fleeing investors sell assets perceived as risky (stocks, commodities, other stuff with big price swings), buy insurance against price declines for positions they continue to hold, and buy assets perceived to be safe (bonds, money market, etc.).

S&P 500

The Flight to Quality tends to be triggered too easily and too often, and it stays in effect too long. As a result, most investors hurt their performance if they succumb to their flight instincts. Nevertheless, it makes sense in principle to invest in safe assets during times of crisis and risky assets when the economy is humming along, it is just very difficult to execute in practice.

The current Flight to Quality is unfolding exactly as it always does. The first chart shows the S&P 500 over the last three days. The red line marks Standard & Poor's announcement. Selling risky assets? Check!

VIX

The VIX Index measures how much investors are willing to pay for options that can be used to insure against stock losses. The second chart shows that the price of insurance jumped right after the announcement. Check!

And finally we need to look at buying safe assets. This is where this Flight to Quality should differ from the standard pattern.

Normally US government bonds are the safe asset of choice, but this time Standard & Poor is creating uncertainty by saying that US debt may not be as safe as previously thought. A smart stampede would avoid the source of uncertainty and flee to something safer. In fact, a smart stampede would sell US debt because it has become more risky rather than buy it as a safe haven.

10-Year Yield

The chart below shows the yield of a generic 10-year treasury bond over the last three days. The red line marks the announcement. Remember that yields move opposite of prices, so if the yield spikes up that means that prices plummet.

Right after the announcement, yields went up and prices went down as investors exited US debt. That's the logical response to the outlook downgrade. But then the reflexive pattern of the Flight to 'Quality' set in as investors redeployed their funds into the traditional safe haven, even though it is exactly the asset class the rating agency had just warned them about.

Markets are extremely inefficient in the short term. This is just one of countless examples where psychology is trumping reason. However, in the long run a rating downgrade, if it actually happens, will drive up bond yields. Investors will reasonably demand higher yields as compensation for the higher default risk that comes with a lower credit rating.

US Credit Outlook Cut to Negative

2011-04-18T11:00:00.000-07:00

Standard & Poor cut the outlook for US long-term debt to negative. This indicates a 1/3 chance that the US credit rating will decrease from AAA. S&P cite Washington's unwillingness to tackle the budget problem as the main reason for the change.

Most European countries that ran up the national debt to fund bailout programs have since enacted austerity measures to bring down deficits. The US stands alone in that Republicans and Democrats spent months bickering about peanuts without even acknowledging the bigger problem of the ballooning national debt.

Of course we now have a Democratic and a Republican plan to tame government spending. It is a step in the right direction, because it put this problem on the political agenda, but given both party's enthusiasm for endless fighting over trivialities, it is unclear that these proposals will evolve into an actionable plan.

The Debt-to-GDP ratio for the US is currently around 97%. This means that the total amount of outstanding debt is about equal to the value of a year's worth of economic activity in the US.

Some people quote a ratio of around 60%. This leaves out the government debt held by the social security trust fund. However, this number is misleading. If the money the US borrowed from the trust fund will have to be paid back, it is real debt and should be counted. If the money doesn't have to be paid back, the social security trust fund doesn't exist and the US has a massive unfunded liability.

Either way, the US will have to come up with the money to cover the value of the debt held by the social security trust fund, so this amount should be included in the Debt-to-GDP ratio.

For context, here are the Debt-to-GDP ratios and S&P rating for a few countries that have made the news recently because of their financial woes.

Ireland 94%/BBB+
Portugal 83%/BBB-
Greece 144%/BB-

And here a few countries with high Debt-to-GDP ratios that are not currently experiencing a debt crisis

France 83%/AAA
UK 77%/AAA
Italy 119%/AA-
Belgium 99%/AA+

Clearly there are many other factors besides the Debt-to-GDP ratio that determine the creditworthiness of of a borrower, but this comparison shows that a Debt-to-GDP ratio of around 100% makes a country vulnerable to rating downgrades (see Italy and Belgium) and sovereign debt crises (see Ireland, Portugal, and Greece).

Perhaps Washington will come up with a real plan to reduce the national debt, but the current proposals won't do it. Both the Republican and the Democratic plan are projected the increase debt levels, albeit at a slower pace than doing nothing.

Slowing the rate of increase is an excellent first step. It buys time, but it is not a solution. The only way to get the Debt-to-GDP ratio back down to more sustainable levels is for the GDP to grow more quickly than the debt. This would require much greater changes than currently envisioned by either party.

Your Itemized Federal Tax Bill

2011-04-13T15:08:00.000-07:00

It is no secret that governments are squandering vast sums of our money bloated and inefficient bureaucracies, military adventures, entitlements, subsidies, and a host of other questionable activities. In a few days we will file our tax returns. It is the one time of the year we see exactly how much we pay for government, but our returns don't show what we get for it.

Luckily there is a website that will give you an itemized tax bill: http://www.mygovcost.org/.

The site calculates your share of the 2011 budget broken down by categories. These numbers should be quite reliable. You will also see results of long-range projections. These are as worthless as cost estimates for new legislation from the Congressional Budget Office, because they depend on too many assumptions about how the world will (or will not) changes over the next 10, 20, or 40 years.

Have fun exploring what your tax dollars do when they are 'at work.'