Bad Ideas Result in Bad Outcomes

October 7, 2009

As regular readers know, I’ve been away from blogging for a bit while I’ve been in the middle of a job transition. In my month-long hiatus, it seems like little has changed: the health care debate continues, the deflation/inflation and economic outlook remains uncertain, and the stock market continues to “climb a wall of worry.”

As the immediacy of the financial crisis recedes, the question of what has brought us to our present state remains largely unanswered. Or rather, there are dozens of answers, not THE ANSWER.  Among the myriad causes that are put forth: the Fed, Wall Street greed, deregulation, excessive regulation, Chinese savings rates, the Democrats and the Republicans. In past posts, I’ve added my 2 cents by pointing to the culture of “overspeculation.”

Fundamentally, bad outcomes are generally the result of either bad luck, bad ideas, or some combination of the two.  It may well be that the “bad idea” from which our financial upheaval arose is the belief that homeownership is an unequivocably good thing.  I came across a prescient 2004 article in BusinessWeek that outlined some of the reasons why home ownership is not as advantageous to the poor:

  • a house is often a poor family’s sole investment: concentrating their assets in an a vehicle that combines the historically lackluster long term returns of housing with the high risks of leverage
  • the poor have a higher “cost of carry” in home ownership than the wealthy, because they often pay higher interest rates and their lower tax rate reduces the effective subsidy of a mortgage deduction
  • while a mortgage was once considered a means of “forced savings,” the growth of easy-to-obtain home equity lines, interest-only and negative amortization mortgages all have negated the (already dubious) savings argument

British economist Andrew Oswald has noted the correlation between high unemployment and high home ownership.  Although more recent work has created a more nuanced interpretation of that relationship (good overview in a Slate article here), this “Oswald Hypothesis” clearly has at least a grain of truth.  The theory argues that home ownership makes people “sticky” geographically, and therefore less likely to move to find a job or better employment.  This may be particularly true for the poor given that “borderline” housing is typically already less liquid than homes in upscale neighborhoods, further reducing labor mobility.  This lack of salability in poorer neighborhoods is particularly acute in economic downturns, just the time when geogrpahic flexibility for workers is most important.  

Those who defend policies that promote broader home ownership often point to social benefits — homeowners have a sense of “skin in the game” of American society.  These arguments are no doubt true and important.  But the advantages of reinforcing such a sense of inclusion should be weighed against the costs.   Moreover, there other ways to promote engagement with community without the consequences attached to distorting housing market incentives.

This is not necessarily to argue against such incentives for home owners.  Certainly, I and many others personally benefit from many of these.  But every policy that distorts market mechanisms has consequences, many of which are unintended and adverse.  We may not yet be through thoroughly testing the “Oswald Hypothesis.”  If that theory is correct, current real estate conditions, whereby many homeowners have negative equity, will make labor mobility particularly poor this cycle.  This, in turn, would suggest particularly intractible rates of unemployment and consequent sluggish economic growth.  If blind faith in the “goodness” of high home ownership rates is indeed a bad idea at heart, we may not yet have seen all the corresponding bad outcomes.

The Prisoner and the Bonus Recipient

August 26, 2009

This afternoon MarketWatch published an article I wrote that applies the classic game theory problem of “The Prisoners’ Dilemma” to Wall Street’s bonus culture.  Read the article here.

Some Stocks Could Benefit from CFTC Restrictions

August 24, 2009

Saturday’s Wall Street Journal carried a story (subscription required) on the potential for proposed new CFTC rules to restrict issuance of shares of commodity ETFs.   The withdrawal of earlier grants of rule exemptions has already led certain ETFs to suspend new share issuance.  As the Journal story notes, this has driven UNG, the natural gas ETF, to trade to a 16% premium to net asset value. 

There is clearly an increased focus at the CFTC in protecting market integrity through he imposition of position limits, rules which restrict the amount of interest in a market for any non-commercial entity.  To date, most of the truly effective ways of implementing this (e.g., extending the restrictions to the OTC swap market and international regulatory coordination) are still on the drawing board.  However, if the CFTC does move forward in this direction there will be significant investment implications.

While the Wall Street Journal focused on the loss of investment opportunities, this is not necessarily so.  From a trading perspective, demand for a commodity ETF whose new issuance has become restricted might offer existing shareholders the opportunity for valuation expansion similar to what has already happened with UNG.  But such premiums are fickle and fleeting.  Investors with long memories may recall the spectacular valuation expansion of the closed-end Germany fund whose market price soared to double its net asset value in early 1990 in the wake of the fall of the Berlin Wall.  Then, as likely now, such premiums are unsustainable as lookalike products flood the market with new supply, or investors assess the risks created by such premiums.  For ETFs this is particularly problematic, since one of the key selling points of this structure is the elimination of discount/premium valuation worries. 

The most likely long-term outcome of any robust CFTC position limits will be a reevaluation of the entire commodity-as-asset-class story at both the retail and institutional levels.  As noted in an earlier post, this has always been a suspect concept, more a creation of Wall Street’s salesmanship than reality.  Those same product pushers are likely to rediscover that which has always been true — certain commodity related equities offer similar or superior portfolio characteristics to the underlying commodities. 

In this regulatory scenario, we may well witness a surge of interest in commodity related equities, assuming of course that the bullish case for commodity prices (primarily emerging market demand and weak dollar) remains intact.  Morgan Stanley already created an index of 20 commodity related equities: AA, ABX, ADM, APA, APC, BHI, BHP, CAG, DVN, FCX, GG, HES, IP, MRO, NEM, POT, SLB, TSN, WY, X.  Such names may benefit not only from generic interest in commodity related equities, but from specific products, yet-to-be-created, that are linked to this or similar indices. 

Interest in energy-linked stocks both on individual merit and as part of packaged index vehicles may well lead the way.  Contrary to the claims of the marketers of futures-linked product, energy stock indices correlate well to energy prices, provided you use the right index, such as the Dow Jones U.S. Oil Equipment, Services & Distribution Index.  Another  index that correlates well to energy prices, the Dow Jones U.S. Oil & Gas Producers Index already has an ETF (the i-Share, ticker IEO). 

Strict CFTC limits will indeed close off some avenues for investors.  Those funds have been sitting in markets ill-designed for such purposes (see the dangers of this here).  However, this will also open the door for inflows into appropriate vehicles in the equity markets, which were designed for just such investments.  Investors who can look beyond any new restrictions will recognize some new opportunities.

Disclaimer:  neither the author nor his clients have any direct positions in the securities mentioned in this piece.  Both may or may not indirectly hold these securities through third-party managers.

The One Good Outcome of the Healthcare Debate

August 20, 2009

In a recent post, I alluded to the need to have a meaningful public debate about healthcare choices in America.  Unfortunately, I think that opportunity has now been lost as what could have been an opportunity to forge a national consensus has devolved into a shouting match with our polcymaking class eagerly jockeying for political gain.  So goes Washington…

In our financial planning practice we often talk with clients about “playing the movie” of what happens at their death.  I’m generally a little less diplomatic and go with the “let’s say you’re hit by a bus…” approach.  Either way, while the focus is on estate planning, it also gets into end-of-life choices.  While this is an important to discussion to have, I’m not sure it should government-sponsored in the way that some of the House bills propose.   Depending on which side of the shouting match you’re on, this element of the healthcare debate is either about empowerment and dignity or the promotion of a death culture.

So what’s the good outcome?  This end-of-life discussion has renewed interest in “Soylent Green,” a 1973 movie with Charlton Heston and Edward G. Robinson, in which the government facilitates suicide of the elderly as a population control method.  The whole movie was a great reflection of the zeitgeist of the 1970s — Malthusian visions of limitations, starvation and an environmentally decimated Earth.  As 36 years have passed since its release, we’re now much closer to movie’s 2022 setting, and I’m happy to report that the screenwriters dismal vision of the future is not on track!  I have not seen the movie since being a teenager, but it has always stuck with me, particularly the haunting demise of Edward G. Robinson’s character, Sol.  Courtesy of the healthcare debate, you can now find this scene on YouTube:

Understanding the “Q” Recovery

August 18, 2009

There’s been an active discussion as to whether we should expect an “L”  recovery or a “V” recovery.  For those not familiar with these terms, each letter resembles the shape of a GDP graph of the respective scenario.  In other words, an “L” recovery represents a sharp economic decline followed by a period of zero growth.  The “V” scenario represents a similar drop, but one followed by a robust recovery.  Those seeking to fit our current economic environment into one or the other of these categories miss the point — we are in a recovery that has elements of both scenarios.  I argue that we are in the early stages of a “Q” recovery.  The letter “Q,” after all,  is the letter precisely between an “L” and a “V.”  But this is more than a mere hybrid or average of these latter two.  The “Q” recovery is a distinct  animal that must be understood on its own terms.

History certainly favors the “V” scenario.  Most recessions snap back relatively quickly.  The pattern is straightforward as businesses cut production in the midst of a downturn, but retain the capacity for greater output while reducing their costs and inventories.  When demand improves, the lack of inventory means that demand translates almost immediately into increased production, taking advantage of the excess capacity.  With the leaner cost structure and no need for increased capital expenditure to meet the production needs, corporate profits soar (an important GDP component).  The higher corporate profits, in turn, both reflect a pickup in existist demand as well as spurring future demand through higher employment and investment.  The current aggressive monetary policy and the large fiscal stimulus package all support the case for the traditional V-shaped rebound.

Despite the historical case for the “V,” there’s a compelling, and I think, stronger argument for an “L” recovery.   It is increasingly apparent that the fiscal stimulus was poorly constructed, and that we won’t get much bang for the buck.  Monetary policy is only effective if it results in the extension of credit and a pickup in consumption.  Credit remains constrained by our wounded and undercapitalized financial system — it will take years for earnings to fill in the holes in the balance sheets of some of our largest banks.  Even where credit is available, some of the traditional routes by which that was transformed into consumption no longer function as they did in the past.  In particular, the inventory overhang in housing means that even low-cost and accessible mortgages won’t necessarily result in new construction. 

The most convincing case for the “L” recovery lies with the broader case for weaker consumption.  Unlike past recessions, the U.S. consumer will not return to pre-recession spending.  The past decade’s wealth effect, whereby higher stock portfolios and higher home prices spurred consumption, now works in reverse.  Income once directed to spending will now be diverted to rebuilding shrunken retirement savings.  Demographics will be our economic destiny as aging baby boomers have entered the phase of life where acquisition tails off and downsizing begins.   Finally, the spirit of the times reflects a certain frugality and seriousness;  starting in mid-2008, the number of Google searches for “coupons” exceeded the number of searches for “Paris Hilton,” and the trend continues — these are somber times indeed!

Despite the strong case for a zero-growth environment, there are some bright spots that suggest that things are not as bad as they seem, and this strange “Q” recovery will be our future.  Internationally, decades of outsourcing business to India and China can alternatively be viewed as building the future prosperity of those nations.  We may soon reap dividends from that  investment.  The emergence of a middle class in those populous countries brings demand for U.S. exports of technology, agriculture and airplanes, to name but a few.   Domestically, productivity continues to improve in defiance of set patterns of earlier recessions.  Labor flexibility has clearly played a role here, but this also reflects the fact that internet and telecommunications technology will continue to enhance economic growth.  All these positives will not be enough to fully offset the unusal weaknesses of this business cycle, but they argue that proponents of the “L” scenario are overly pessimistic.

For investors, what does the “Q” recovery mean?  The equity market rebound since early March has already given us a glimpse of the future.  The characteristics of the current rally defy our historical experience, with growth stocks leading the way and large company performance in a dead heat with small-caps, contrary to most early stage moves.   Whenever markets move against historic patterns, the best bet is to assume that trend will continue.  Certainly fundamentals point to the continued dominance of  large companies, with their superior access to credit, global markets and lobbyists who shape new regulations to their advantage.   Those companies able to garner growth will gain superior multiples in the slow growth “Q” recovery.  Those that do succeed will find their growth may be largely driven by business investment and emerging market demand, rather than domestic consumers, yet another twist in our unusual environment.  

For most of this decade, investment advisors “beat the S&P” not only by loading up on U.S. small cap companies, but by benefitting from the superior returns of foreign stocks.  Much of the overseas outperformance was due to currency translations; as the greenback fell in value, the price of foreign-denominated securities gained in dollar terms.   In the “Q” recovery, the dollar is likely to be range-bound, and that inherent currency advantage will not be present.  This doesn’t mean there are no opportunities abroad, particularly in the emerging markets, but it does suggest that investors will no longer “have the wind at their backs” in this asset class.  Recent data have suggested that European economies are ahead of the U.S. in recovering from the global recession.  This does raise the possibility that investment flows to those economies could boost their currencies, but investor expectations should focus on foreign stocks as a valuable diversification rather than the star of their portfolios.  While emerging markets offer far more growth potential for outperformance, the size of those markets relative to global inflows suggests volatile boom/bust cycles ahead for equity investors in that sector; prudent participants would be well advised to be more tactical in approach.

For the first time in years, corporate bonds and select tax-exempt bonds offer the opportunity for competitive investment returns, and will likely outperform cash and money markets.   Fears of government deficits and the reliance on global capital for financing that debt could well keep real U.S. Treasury rates high.  While the commodity price component of inflation measures may be resilient, slack domestic growth and continued productivity gains will moderate overall inflation.  Credit spreads can contract from current levels, but the past year’s interventionist government policies will leave a legacy of uncertainty as to “rules of the road,” preventing a return to the narrow spreads of 2005/2006.   Municipal bonds will suffer from credit uncertainty as their issuers struggle to rationalize their commitments with a slow-growth economy.  From current levels, munis are best viewed as “coupon-clipping” opportunities, but, on a risk-adjusted basis, not unattractive relative to other capital markets.

The “Q Recovery” will offer investors diverse opportunities, but not broad opportunities.  This will be far from the “rising tide” markets of past cyclical upturns.  However, within the more narrow circle of winners, we believe returns will more than justify the risks of investment.

The Best Way to Cut Healthcare Costs

August 10, 2009

Last week Popular Mechanics published a fascinating interview with Dean Kamen.  While most people associate Kamen with the (frankly odd) Segway, most of his inventions are in the medical device field.  He makes the very good point that, when healthcare costs are viewed over time, it becomes apparent that the route to cheaper and more productive care is through innovation.   High costs today are, in part, investments in less expensive treatments down the road.  In the current parlance, our existing system already “bends the curve” for a given illness.  His analysis certainly doesn’t resolve the debate, but is worthwhile perspective and very worthwhile reading.

Clunker Conservation

August 5, 2009

IMPORTANT UPDATE (8/7/9 10:30 a.m.) — Please see the comments of my reader “David – NC” below.  He caught the error in my calculations and is absolutely correct.  The breakeven for a reasonable tradeoff (an 18 mpg clunker turned in for a 28 mpg new vehicle) is 89,090 miles not the 17,640 miles I incorrectly stated.  Even under my flawed numbers, the program made little sense from a conservation standpoint — given David’s proper numbers, the cash for clunkers program clearly has no conservation benefits.  Thank you David. 

There’s been a tremendous amount of press discussing the “cash for clunkers” program.  Although ostensibly an economic stimulus measure, proponents of the plan also argue that replacing old, less fuel-efficient vehicles with newer models will enhance energy conservation.   In an op-ed in yesterday’s Washington Post, author Gwen Ottinger points out some of the fallacies in the “new is greener” rationale, e.g., confusing efficiency with consumption in appliances, or not taking into account the energy used in the manufacture of the new good.

Although I regard the economic rationale with suspicion, the conservation argument is at least worth examining.  That is, even if it doesn’t make economic sense, is there some social good (energy conservation) that is served?  The core issue is the amount of energy used in the manufacture of a new automobile and whether that is offset by added fuel efficiency.  There are so many variables and assumptions here, that a rough estimate is as good as any.  I came across a website with two different estimates for the amount of fuel used in the manufacture of an automobile and its component parts.   Perusing the internet, the higher number, 42 barrels of oil, seems to be making the rounds as an accepted estimate.   The methodology on these numbers looks a little problematic, but if you assume an oil price of $70/barrel, that means that the energy component of the cost of an average car is $2,940, which seems in the right ballpark relative to the overall cost of the car.

Assuming the 42 barrel number, this equates to 1,764 gallons.  Making a further assumption (not correct, but probably accurate enough) that we can use 1:1 equivalency between oil and gasoline, we can ask at what point does  the energy conserved through higher fuel efficiency of a new vehicle offset the energy used in the manufacture of that vehicle.  Assuming a 10 mpg efficiency difference between the clunker and the new car, the energy usage breakeven is achieved at 17,640 miles. 

Based on average driving rates, this suggests that a conservation break-even point is reached at about 18 months, and after that there are net gains in fuel conserved.  However, there is a major flaw with this reasoning — it assumes that 1) the old clunker and the new car will be driven equal amounts, are 2) that the clunker will go on forever.  A quick perusal of the  list of car models being turned in suggests the problems with this argument.   Most of the clunker cars are 10-15 years old and presumably have 100,000 to 200,000 miles on them.  In a 2+car family, these are probably not the car you take on the long trip, for fuel efficiency let alone the reliability at that age — I would guess that these clunkers are currently driven only half as much as the average car.  Moreover, cars of  that age are in their final years anyway and would have been replaced within a few years.  This added overlay of real world considerations suggests that, in reality, there is no meaningful conservation gain in the cash-for-clunkers program.

My Commentary on the Financial Times Website

August 3, 2009

The Financial Times’ Energy Source Blog was kind enough to publish a piece I wrote that discusses the dangers inherent in overspeculated commodity markets.  Click on the title to read “Why Commodities Regulation is Different.”

Fundamental Misconceptions in the Speculation Debate

July 29, 2009

Today’s Wall Street Journal features a misguided editorial blasting the CFTC for considering constraints on oil speculation.  The piece serves as a good reminder of how often those schooled only in the stock and bond world misunderstand the function of the futures market and the role of speculators within that arena.  The Journal’s editors and others are trying to apply the rules of those capital markets to contract markets like commodity futures.  This makes no more sense than trying to play a game of baseball by the rules of football.  In real life, as in the sports analogy, playing by the wrong rules leads to chaotic consequences.

Misconception #1: who should determine price?  In the capital markets, speculators and investors determine the price of securities.   This is not the way the commodity futures markets are supposed to operate.  Commodities are consumables, not investment vehicles.  Economic efficiency demands that the price  be determined by those that produce or  use these resources.  The role of the speculator in price discovery should only be on the margin, testing the limits to see when commercial demand or supply enters the market.  Speculators in these markets should not be the primary determinants of price. 

“Overspeculation” or “excessive speculation” exists when speculators become primary drivers of price.  When this happens, commodities are no longer efficiently allocated —  if prices are driven below the point where commercial supply and demand meet, shortages result.  When prices are driven to excessively high levels, economically wasteful inventory buildup is created; Nobel laureate Paul Krugman recently reversed his opinion on the impact of speculation,  pointing to huge oil stores as evidence that oil prices have been artificially inflated.  More dire consequences also can be the result of these price distortions, including unnecessary and economically damaging price volatility and even the potential for a systemic crisis in the oil industry and it financiers.

Misconception #2:  We need all this speculation for liquidity.  The commodity futures markets absolutely need a healthy amount of speculation to bridge the gap between commercial interests who may not be in the market at the identical time.  But just like any powerful medicine, an overdose causes more harm than good.  Speculation is good only up to the point where speculation becomes the main determinant of price. 

There has been a great amount of confusion between volume, open-interest and liquidity.  Traditional speculators are short-term traders who are indifferent to being long or short the market — such volume indeed creates liquidity.  Much of the problem has been created by the new breed of non-commercial participant, particularly the commodity indexed funds which are long term holders and are overwhelmingly oriented to the long side of the market.  They represent not liquidity, but a big fat bid, which actually drains liquidity from the markets by crowding out long commercial interests.

Misconception #3:  Investors need unconstrained access to the commodity markets to protect against inflation.  The idea that commodities are the only inflation hedge available to investors has been heavily promoted by those that profit from selling commodity-linked products.  This is simply a myth promulgated by Wall Street marketing departments.  As I’ve written about before, investors have very real, and possibly superior, alternatives, from TIPS to commodity linked equities. 

Misconception #4:  Position limits are an abridgement of free market rights.  The confusion of capital markets with contract markets comes into play here.  The imposition of constraints on non-commercial participation is not about heavy-handed regulation, but about appropriate market governance.  In the capital markets, I know of nobody who complains about rules against front-running, touting or insider trading.  Those are rules designed to protect the integrity of capital markets.  Contract markets like futures exchanges need rules to protect their integrity as well.  It’s just that different markets require different types of rules.  In the futures markets, integrity implies that commercial interests determine price, and this requires governance that restrains non-commercial participants.  Speculative position limits are one of the time-tested ways to ensure this critical integrity.

Informed people of good will can argue whether the markets are indeed “overspeculated” at this point.  We can reasonably debate whether position limits are the appropriate response, or whether whole different types of governance are needed.  One can perhaps even argue whether the risks of overspeculation to the economy should be balanced against the risks to Wall Street profits from curtailing their activities.  However, those that argue that the futures markets should play by the rules of the capital markets merely reveal their ignorance.

Be Careful What You Wish For

July 28, 2009

Think quick!  You have a health issue –  in which set of 5 countries would you rather be treated?

Choice A:    Turkey, Mexico, Korea, Poland, Slovak Republic

Choice B:    United States, Switzerland, France, Germany, Austria

The first set of countries represent, in order, those OECD (Organisation for Economic Co-Operation and Devlopment) nations that spend the least on health as a percentage of GDP.  The second set of countries represents, in order, those OECD nations that spend the most on  health as a percent of GDP.  I used 2005 numbers as that is the most recent containing data for all the tracked economies.  (More data can be found here)

Critics of the U.S. system often point to how much we spend on healthcare.  However, this is clearly an inadequate measure.   Greg Mankiw’s blog has pointed to academic work that suggests that higher spending on healthcare is a rational response to higher income.   In his article in the current edition of “City Journal,” physician and Manhattan Institute fellow, David Gratzer, points out the flaws in thinking that, “a dollar spent is a dollar wasted.”

I’m not sure that, as a society, we’ve even achieved any kind of reasonable consensus for we want from our health system.  It is very difficult to make major changes in this system without understanding the end game.  As the above list of countries highlights, simply seeking to lower health expenditure as a percent of GDP may sound appealing, but probably isn’t what we’re really seeking.