Sunday, April 24, 2016

Liberal Macroeconomics and Free Trade

Friday, April 22 the WALL STREET JOURNAL had an opinion piece entitled “Five Big Truths About Trade,” by Alan S. Blinder.  It was an excellent description of why trade benefits a society.  It was also revealing because it illustrates why liberal macroeconomics is failing the general population of the US and many other countries.  The very fact that Dr. Blinder felt that the opinion piece was timely reveals that failure.  However, all one would have to do to know that the failure has occurred is to realize that Dr. Blinder's analysis of the benefits of free trade are accurate and to compare that to the absolute nonsense being spouted by all of the leading political candidates for the US presidency. 

The reason for the failure can be seen in the opinion piece.  It correctly points out that trade has winners and losers.  But then it goes on to suggest that the public sector can somehow provide assistance that will mitigate the detrimental effects on the losers.  It does this as an article of faith.  There is absolutely no justification presented for why one should believe that the public sector has any incentive to mitigate the harm that is incidental to the benefits related to free trade.  That failure to look at the incentives of the public-sector and provide any analysis of why one would believe that the public sector could mitigate the effects of trade is telling.  Liberal macroeconomists repeatedly make the assumption that the public-sector can somehow address the costs associated with a functioning marketplace.  Better they should brush off their microeconomics and analyze whether the public sector has any incentive to undertake the tasks that they blithely assume it can address.

By cultivating a blind faith in the public sector's ability, they are only encouraging the protectionism being demonstrated by current leading political candidates.  After all, if the public sector can solve this problem and hasn't with the current policies it is pursuing, then it is perfectly logical to assume that it could solve the problem with the different policy like protective tariffs.  By failing to address the fact that the public sector is not the appropriate mechanism for mitigating the side effects of free trade, Liberal macroeconomists are in fact cultivating very protectionism that this opinion piece is designed to offset.

Thursday, February 4, 2016

The Three Fund Portfolio in 2016.

A good year to get to know yourself

Easy to manage if you know yourself
Get to know your reaction to volatility
Get to know your willingness to stick with your investment time horizon
Most importantly, get to know whether you can make money from stocks.

On February 11, 2014 this blog began a series of postings on “The Three Fund Portfolios.”  In the next two postings, a core portfolio consisting of three funds was described.  Both the rationale for holding funds and an example of a three fund portfolio were included.  The origin of that series was frequent requests by novice investors for some suggestions on how they could profit over the coming decade.  This is the kind of year when one discovers whether such a portfolio works for the investor.

A posting last month, “Watchwords for 2016: Time inthe Market Versus Timing the Market,” contained a forecast for market and economic conditions for the coming year.  For what it is worth, it argued that there is a high probability of a recession developing during next year.  If that is correct, 2016 should be a telling year for those invested in the three fund portfolio.

The reason it will be a telling year is simple.  As that posting stated, “It is easy to overestimate the change in behavior that an investor should make in response to an environment like we are likely to experience over the next year or two.  As successful investors know, the environment is probably less important than the investor’s objectives in determining what the appropriate strategy is…. It [the 2016 environment] necessitates actions that properly reflect the investors’ disposition toward volatility and willingness to stick with their chosen time horizon.”  

The only adjustment in behavior that the outlook for 2016 justifies for investor in the three fund portfolio is dollar-cost averaging.  Put simply, at the beginning of the year the investor should decide how much more they want to add their investments and then invest equal dollar amounts periodically.  Since the portfolio is composed of mutual funds, it is easy to divide by 12 and put 1/12 of the planned annual investment into the mutual funds each month.  If they have assigned equal weights to the three funds, they would invest each month in the fund that shows the smallest balance.  If they have been assigned different weights, the investments would just be in whatever fund needs to be rebalanced to maintain the assigned weights. 

Why, you might ask, would one increase one's exposure to financial assets (other than cash) if the outlook is that there is a high probability of a recession and a down stock market?  There are three reasons.  First, the outlook is always uncertain and the recession and down market may not materialize.  Second, and more importantly, if the market is down, that is exactly when one wants to be acquiring financial assets.  After all, one wants to acquire financial assets when they are cheap.  However, the overriding reason is the same reason that one acquired the three fund portfolio in the first place.  It is of little consequence what the market does in the next year if the purpose of the portfolio is to produce an increase in wealth five or 10 years out.  Viewed in a five or 10 year perspective, a rational investor would actually want the market to go down so that he or she could acquire more assets at a lower price.

It may be rational to want to acquire assets in a down market, but it is not a natural reaction.  Brain scans have shown that the natural reaction to negative news is processed in a totally different way from how the brain processes positive news.  The gut reaction to negative news is to assume a defensive posture or flee.  The equivalent investor behavior is to sell or to not invest.  The only successful approach to this natural response is to view a down market as positive.  It is, after all, positive from the perspective of one who wants to acquire assets.

It is also helpful to keep in mind that both behavioral economics and stock market folklore demonstrate a tendency of investors to want to participate in bull markets when prices are high and to want to avoid bear markets when prices are low.  Clearly, both behavioral economics and stock market folklore caution against a tendency to buy high and sell low, the opposite of the blueprint for success in investing.  Research using actual investor’s portfolio data has shown how widespread the tendency is. 

Interestingly, an article in the January 31, 2016 edition of BARON’S (Hulbert on Markets, Best Bear Market Strategy: Remain Invested in Stocks) pointed out that trying to time the market by consulting the newsletters of those who purport to be experts on the market does not help.  The supposedly experts who write newsletters are as likely to be wrong as right when it comes to market timing.  One has to wonder why investors would assume that they can time the market better than newsletter writers who have spent their whole career monitoring the market.  But Herbert's review of the newsletters supports a simple conclusion: “Crazy as it sounds, history shows it’s better to stay in the market rather than sell and try to time your return.”

Despite the prescription above, the purpose of this blog is not to tell people how to manage the money; it is, after all, their money.  Rather, all the points made above are background that one should consider as one makes decisions during 2016. It is perfectly legitimate to decide not to invest this year or even to sell the mutual funds and invest the money somewhere else.  But, by doing so, one is revealing important information about one’s financial management.  It is perfectly rational to move out of the mutual fund portfolio if one finds its volatility too distressing. 

That response should be viewed as an indication that the investor has trouble assessing their tolerance of asset price volatility and their ability to firmly anchor their investment horizon.  If that is the case, the investor should reconsider their commitment to the objectives that prompted the initial investment in the three fund portfolio.  One also should reconsider how realistic it is to expect to make money from investing in stocks if a periodic event like a recession and a down market is unacceptable. 

Down markets and recessions are a part of investing in equities.  In fact, investing during such events contributes substantially to investment success.  If an individual finds that they cannot accept the volatility and continue to focus on their long-run horizon, a perfectly acceptable, but more difficult, alternative is to just save more and invest in more stable but less profitable alternatives like bonds and CDs.

Disclosure: As explained in the postings introducing the three fund portfolio, the Hedged Economist’s principal investment focus is individual stocks and bonds.  In that case, the three fund portfolio is used as a place to park money intended for future investment in individual stocks and bonds.  Consequently, if as is expected, 2016 creates some opportunities to purchase individual stocks at bargain prices, there will be a temptation to let the balance of the three fund portfolio fall.  However, recognizing the value of the diversification that the three mutual funds provide, the plan for 2016 is to maintain the balance in the three fund portfolio by making additional investments using the dollar-cost-averaging approach described above.

Friday, January 22, 2016

Watchwords for 2016: Time in the Market Versus Timing the Market

Know your objective

Why should an investor be concerned about the chance of a recession?
What are the implications of the potential recession in 2016?
What shape would a recession take?
What risks are implicit in a recession?


It seems with the turn of the year there is a ritual where market observers and investors (they are not the same thing) feel obligated to prognosticate on the coming year.  For market observers the folly of such forecasting actually makes sense.  Their job, after all, is to entertain by doing such things.  One thing for sure is that their forecasts may entertain but certainly don't inform.   

A good illustration of that occurred on January 7, 2016 on  There were two articles with contrasting forecasts.  One was entitled “2016 Recession Imminent” and the other was entitled “A Happy New Year After All.”  They were both interesting articles with each presenting an argument to support their contrasting forecasts for 2016.  Their forecasts, in and of themselves, regardless of whether right or wrong, didn't contain a lot of information useful to investors. Similar contrasting forecast appear in just about any financial news medium.

By contrast, an investor may try to forecast the coming year, but the forecast itself is little more than background.  Articles like those cited above may be useful to those who prefer an analysis rather than wading through the raw data to arrive at their own background forecast.  After all, the investor has to make decisions about the allocation of resources including the division of cash between immediate consumption and investment with a view toward future income.  Such decisions are inherently future oriented and thus, whether explicit or not, they imply a forecast. 

However, the implications of the forecast depend upon the investor’s objectives. Consequently, the same forecast for 2016 can have markedly different implications for two different investors.  The implications can be so markedly different because of differences in objectives.  Of those differences in objectives, none is more important than differences in the time horizons of different investors.
With that introduction, it is reasonable to look at what to expect in 2016, but always from the perspective of what it implies for people with different sets of objectives.  For those with a very short-term horizon of a year or less, 2016 will be a year when it is probably better for them to be out of the market.  By contrast, those with a 5 to 10 year horizon can view 2016 as a wonderful opportunity to invest. 

An astute reader has probably already realized that those comments imply a “forecast” of a volatile, down year for the markets in general.  The 22 days since I wrote that sentence have pretty much eliminated the possibility that it will be wrong.  The year has already demonstrated volatility and dropped enough to make an up year unlikely.  It also should be apparent that those comments imply a definition of investor that excludes individuals who think they can rapidly buy and sell in order to profit from short-term (less than a year) fluctuations.

Besides short-term market timing, there are two other strategies that will be ignored in the subsequent discussion.  They are short selling (including short selling designed to produce a market neutral portfolio) and various option strategies.  Thus, the discussion that follows focuses on long-only strategies, and it ignores the potential use of cash-covered puts and covered calls as a part of the strategies.

Types of recessions

It is important to keep in mind that stock market cycles and economic cycles are different-but-related phenomena.  The timing on stock market cycles and economic cycles is different.  In fact, stock market cycles are frequently considered as fairly reliable leading indicators of economic cycles.  A closer examination and consideration of the causality shows that stock market cycles lead certain economic phenomena and lag other economic phenomena.

Stock performance is ultimately related to the profitability of the companies one owns by owning equities.  Often stocks are portrayed as being priced based upon future profitability.  However, projections of profitability are based upon both current and historical information.  As a consequence, stock prices often lag profitability.

The WALL STREET JOURNAL on 8/24/2016 published an article entitled “Will Spending, Profits Resume Climb?”  It started with the following comment “Profit growth for the constituents of the S& P 500 index stalled in 2015…”  In fact, profits have been declining for two quarters.  Other articles have referred to it as a profits recession based on the two quarter figure.  We are about to go into another earnings season, and it is unlikely that the trend will be reversed.

Lest one conclude that the phenomena is peculiar to the larger companies represented in the S&P 500, one should keep in mind that more small businesses are closing shop than are being started up.  Measures of publicly traded small-cap and mid-cap companies’ profitability also reflect a profits recession.  There are also various international surveys of business climates and the ease of starting a business that show a decline for the US.  So, when populist politicians seeking the fan envy talk about corporations earning record profits, like the president did in his State of the Union address, don't take it as investment advice.

In their book THIS TIME IS DIFFERENT, Carmen Reinhart and Kenneth Rogoff reminded readers of the fact that is all too obvious to economic historians.  No two recessions are exactly the same.  As in the quote often attributed to Mark Twain, “History never repeats itself, it only rhymes.”  It is particularly important to understand the difference in the path and financial implications of the recession brought on by a failure of profit growth versus recessions that result from a financial crisis.  The implications of liquidity crises are quite different from the implications of an environment in which the private sector cannot identify ways to produce general profitability.

A cycle caused by lack of profitable investment opportunities takes a particular path.  First, profits become harder and harder to produce.  Then in response, corporations cut capital expenditures and entrepreneurs reduce the number of companies starting up.  The article cited above reports on both of these phenomena as follows:

“Expenditures by members of the S& P 500 index fell in the second and third quarters of 2015 from a year earlier, the first time since 2010 that the measure has fallen for two consecutive quarters, according to data from S& P Dow Jones Indices. Another measure of businesses spending on new equipment—orders for nondefense capital goods, excluding aircraft—was down 3.6% from a year earlier in the first 11 months of 2015, according to data from the U.S. Department of Commerce.”

“More broadly, only 25% of small companies plan capital outlays in the next three to six months, according to a November survey of about 600 firms by the National Federation of Independent Business. That compares with an average of 29% and a high of 41% since the surveys began in 1974.”

For a while, corporations can maintain reported profitability by cutting capital expenditures and introducing efficiency initiatives.  In the US, both those options seem to have run their course.  Once those two opportunities have played out, financial markets have to respond to the increased risk and reduced profitability.  That can take the form of investors selling assets or just not investing.  We have reached that status of not buying and, in some cases, of actually selling assets. 

Public pensions and mutual funds are holding increasing amounts of highly liquid short-term assets (i.e., cash).  In our words, they are not investing in long-term assets.  Households have increased their savings rate, and although many commentators can't see past the reduction in consumption implied by an increased savings rate, viewing it relative to mutual fund flows shows that households are not using net savings to invest.  They are also keeping it in near cash form and reducing their debt.  Both the cash and the reduced debt indicate they are increasing their liquidity.  Increased capital requirements and the risk weightings used to determine capital requirements for different types of loans are inhibiting the free flow of that near cash into productive investment.  In an environment where no other sector is investing in long-term assets, it should not be surprising if corporations are also retaining more cash and cutting capital expenditures.

The next phase in this type of recession is for consumers to shift their focus from just not investing to reducing their consumption.  To date, that has taken the form of a fall in the rate of growth of consumption.  The most recent retail sales numbers show an estimate of virtually no growth and an actual contraction if one removes auto sales.  There is an outside chance that government retail sales data underestimate sales because they don't adequately capture the shift from brick-and-mortar retailers to e-commerce.  That may introduce more uncertainty, but it hardly supports an argument that retail sales are still growing.  If anything, it would indicate that the government may be underestimating the falloff in retail sales.

Reports from Nielsen regarding cash register scans and credit card companies’ reports of transactions (which would include most e-commerce), all support the notion that retail sales have plateaued or begun to decline.  The notion of a disappointing holiday season is also consistent with reports from the shipping companies that handle most e-commerce.  They may have successfully avoided finding themselves with excess capacity when shipments didn't rise as much is expected.  However, the fact that they not only maintained but actually were ahead of schedule on deliveries would indicate that the volumes were not as high as they had expected.

Further, there have been numerous reports of retailers’ over inventoried for the holiday season.  In fact, when considering investments in the retail sector, how the retailer accounts for markdowns in that over inventory can be an important influence on when they report a contraction in their margins.  Inventory build can temporarily sustain an economy, but since World War II many mild recessions resulted from inventory cycles.  When inventories are built in anticipation of growth that actually materializes, they contribute to growth.  But, when inventories build because of an unanticipated fall off in sales, they contribute to a downturn.  Going forward, orders fall off while the companies involved clear the excess inventory. 

To this point, the discussion has been about how things are developing.  But developments to date can only reflect what could happen.  How they will play out in the future is not predetermined.  For example, it is quite possible that consumers will not respond by cutting consumption.  In fact, that would be the forecast of those who think we will avoid recession.  They would argue based upon current employment developments that consumption will turn up.

There are number reasons to doubt that employment will be a good predictor of future consumption.  The first concerns the implications of employment.  Consumption is not based upon employment: it is based upon the wages earned.  Wage data is far less easily interpreted than employment data.  The survey and the definitions used to generate wage data introduce some uncertainty into how to interpret the data.  But, one thing is for sure: wages are not rising.  They may actually even be falling on average.  It isn't until personal income data is made available that one can verify conclusions based on wage data. 

By looking at the wage component of the personal income data, one can separate out the wage effect from the other components of personal income.  That exercise is rather discouraging.  The role of wages as a component of personal income is being decreased by the increasing importance of property income (rents, interest, dividends, and royalties) and transfer payments (Social Security and Disability benefits, as well as other components of the “safety net" such as food stamps, subsidized healthcare, tax credits, etc.).

One might try to argue that income is income and this doesn't matter whether increases in personal income are due to the wage component or some other component.  But, there is a problem with that argument as noted in the December 30, 2015 posting entitled “’It’s a Wonderful Life’ Rebroadcast.”  It commented: “How many pundits point out that about two thirds of Gross Domestic Product is represented by consumption?  They don't bother to note that it is previous investment and labor that produces 100% of Gross Domestic Product.  One can’t consume what isn't produced.”

In an environment where the incentives to invest in productivity-improving capital are weak, there may actually be a substitution effect between wage growth and growth in other components of personal income.  That may be particularly true of transfer payments since they involve shifting income away from those who generate output to those who receive the transfer payments.  If it discourages work incentives or investment incentives, such a transfer will manifest itself through lower productivity and lower wages.

That type of response to incentives would be very hard to detect.  However, there is other data that would suggest it is occurring.  That other data concerns productivity.  The productivity data is consistent with the notion that wages will not rise without an increase in capital expenditures.  One should note however the productivity data is derived indirectly from data in the National Income and Product Accounts (the data used to estimate Gross Domestic Product).  Thus, even though the data is consistent with this hypothesis, it's worth noting it may be underestimating.

Previous to the development of National Income and Product Accounts, economist relied on trade figures and hardgoods output figures to try to estimate whether the economy was expanding or contracting.  As services have become increasingly important in the economy, the output of goods (manufacturing and mining output) has become a less reliable measure of overall prosperity.  If that were not case, there would be little doubt that we would currently be assuming we are already in a recession. 

Direct output data highlights a contraction, but that's generally attributed to the shift away from manufacturing.  Nevertheless, there is no doubt that there has been a falloff in trade. Shipping activity in general is falling off.  International trade data has been contracting for a while and the railroads are currently reporting that shipments are down.  That is to be expected.  If there is less economic activity, there is less to ship.  Consequently, any hypothesis that sees employment as a stimulus for growth has to address the question of whether expanded employment in low productivity, low wage service sectors can accomplish the task.  It can only accomplish that if it is additional employment as opposed to a substitute for higher productivity, higher wage manufacturing and mining employment.

The decrease in productivity has occurred simultaneously with public-sector efforts to try to boost productivity by placing a floor under the wage component.  That's being done by essentially raising the opportunity costs of employment by placing a floor under income regardless of whether one is working or not.  That increase in the floor below which one can expect people not to work takes many forms.  They range from minimum wages (below which employment is illegal), subsidized consumption that would be lost if one increases income (food stamps is a prime example, but welfare payments also have to be considered since the Obama administration eliminated the work provisions implemented by the Clinton Administration), and Social Security and Disability benefits that are structured in a way that discourages work.

While all of these conditions would point to a downturn, they also would result in it being mild and short-term.  The lack of investment discussed above is being accompanied by a strengthening of the balance sheets of the financial and corporate sectors.  It also means that households are increasingly liquid.  That liquidity of businesses, financial institutions, and households will eventually be invested once profitable opportunities arise.  It also provides a cushion to absorb decreases in the value of assets as the recession proceeds.  In short, the threshold at which a write-down of asset values will produce a financial crisis has been raised.

All of these factors discussed above have a negative economic impact.  They will probably produce a slowdown at a minimum.  During this expansion the economy has experienced a number of slowdowns.  They are sometimes attributed to shortcomings in the way seasonality is handled in the economic data.  In other cases, they are attributed to external shocks (the winter was too cold, winter was too warm, there was uncertainty about political developments). 

In the current environment, shocks such as cold-weather, warm weather, a political impasse, or an adverse international development will produce much more than a mild slowdown.  Economists often attribute reversals in an expansion to what is referred to as an external shock.  But, external shocks occur all the time: it is the internal dynamics described above that ensure that this year any external shock has a high probability of putting the US economy into recession.  The nature of the shock could make the recession far more severe than the economy’s internal dynamics would by itself.

Investment implications

It is easy to overestimate the change in behavior that an investor should make in response to an environment like we are likely to experience over the next year or two.  As successful investors know, the environment is probably less important than the investor’s objectives in determining what the appropriate strategy is.  At the same time, recessions are usually accompanied by down stock markets and shouldn't be ignored.

Given the introductory discussion of objectives, the question is: How should long only investors proceed if their objective is to build a portfolio that will provide current or future income?  In the current environment, three approaches suggest themselves:

One approach is to dollar-cost average all investments over the coming year or two.  That approach has the advantage of ensuring that the investor will not be caught out of the market if the forecast turns out to be wrong.  But, it should be undertaken with an understanding that investments made early in the year may be at higher prices than are available later in the year.  If it is a down year, investments made during the year will contribute substantially to future growth in the portfolio.  They may not result in immediate growth in income, but with a 5 to 10 year horizon that is of little consequence.  If the investor’s horizon is one year, the comparable approach is to not invest this year.
A second approach is to not let the economic environment influence the timing of the investment.  Rather, the investor can target acquisitions in stocks that perform relatively well in such an environment.  For example, the widows’ and orphans’ portfolio was discussed in a 2011 blog (“Investing PART 9: One version of the“Unfinished symphony”) and was updated periodically, most notably in the only blog that discussed actually selling one of the holdings in the portfolio (“TheWidows’ and Orphans’ Portfolio and US Banks”).

If one is building a portfolio like the widows’ and orphans’ portfolio, it is close to a permanent investment.  The current and likely outlook over the near-term could be used as an opportunity to select from the options implied by the portfolio. 

For example, a down market is a good time to be adding to the consumer staples category if one wants to reduce volatility implied by a recession.  Companies like Pepsi, General Mills, Procter & Gamble, Kimberly-Clark, Clorox, and Colgate-Palmolive mentioned in connection with the widows’ and orphans’ portfolio would be reasonable additions to the portfolio early in the year.  Johnson & Johnson is another firm that will hold up during an economic downturn.  If one has been building a position in pharmaceutical, medical devices, or healthcare products companies other than Johnson & Johnson they also may should hold up well. 

By contrast, industrial firms like General Electric, United Technology, Honeywell, Emerson, Eaton, PPG and 3M would not look like timely acquisitions until they have come down more in price.  If they are acquired early in the year, it should be done with the understanding that they could go down in value significantly during the year.

The third approach is to try to expand the portfolio by adding new names.  The diversification the portfolio provides could be expanded by entering new industries.  For example, the only extractive firms identified in a portfolio are major integrated oil companies.  Adding holdings in extractive firms represent one approach consistent with expanding the portfolio.  That approach is tricky since it involves try to pick the bottom.  However, resource cycles are long.  As a consequence, there is no reason why an investor should feel an obligation to pick the absolute bottom in the resource cycles.  If one sticks the companies with strong balance sheets, all one loses by not getting the absolute bottom of the resource cycle is time.  But, with a 5 to 10 year horizon, most resource cycles will have played out by the intended target date.  The loss from bad timing on resource companies is often the opportunity costs of having money tied up in equities that are not performing well.

Another approach to adding diversification would be to acquire a firm in the technology area.  Technology is interesting in that the investor can either try momentum investments or value investments.  If one needs names, understanding that I tend to be a value investor, I would provide Microsoft or Intel as examples.  But, as always, investors should do their own research. 

In the original widows’ and orphans’ portfolio the only defense exposure came with Boeing.  Boeing is dominated by commercial aircraft manufacturing.  So, if one is looking for defense exposure, an additional holding may be appropriate.  Both General Dynamics and Lockheed Martin are positioned to experience performance that will be uncorrelated with the economy.

Another option is to expand into an area that was briefly mentioned in passing in the original discussion of the widows’ and orphans’ portfolio.  That is fast food restaurants.  My preference there has been McDonald's, but again, investors may choose either momentum or a value investment, and investors should, of course, do their own research.  By way of disclosure, during McDonald's difficulties over the last few years I've periodically added to a position in the company.  I'm not sure I would add to it at current prices, and given the current value of the stock acquired over the last two years, I'm in the advantageous position of not having to make that decision.  In the original widows’ and orphans’ portfolio I mentioned Yum brands as an alternative to McDonald's. 

The point being, during recessions there are some of the best opportunities to invest that investors can expect to experience during an entire lifetime.  Recessions provide an opportunity to buy companies with strong balance sheets, strong franchises, and healthy cash flows at prices well below their norm.  It is very rewarding to purchase a stock when the company may actually be reporting no current earnings and yet receive an increase in the dividend based upon management's understanding that the long-run value of the company is actually increasing. 

Successfully approaching the markets during recessionary periods requires a very well-anchored understanding of one's objective.  It necessitates actions that properly reflect the investor's disposition toward volatility and willingness to stick with their chosen time horizon.

Disclosure: The Hedged Economist holds or is planning to add positions in the stocks mentioned in this posting.  They are appropriate for my particular risk tolerance and investment objectives.  Discussing them does not imply that they would be appropriate for any other investor.

Tuesday, January 5, 2016

The big lie or bad reporting?

You be the judge.

In article entitled “Wealthiest Face Bigger Tax Bite” somebody should have done some editing for content.  Since it is not clear who was responsible for the snafu, it seems appropriate to point out both the author and the source of what may be the deceptive statement.  The article appeared in the final issue of 2015 (Thursday, December 31) of the WALL STREET JOURNAL.  It represents an embarrassing way to finish the year.

First, let's start with what is either the big lie or sloppy report.  The bold has been added for emphasis.  The author has the following quote from Len Burman, director of the Tax Policy Center which he reports as follows: “Capital gains taxes bring in more than $100 billion in some years ‘and almost all of it is realized by people with very high incomes,’ he said.”  The author then goes on to report: “In 2013, the 400 households earned 5.3% of all dividend income and 11.2% of all income from sales of capital assets.” It would seem to me that “11.2%” is not “almost all.” Further, the $100 billion figure does not refer to the 400 households.

The bait and switch in the contrast between Len Burman’s quote about very high incomes and the reporter’s citation of 2013 data about the 400 households makes it clear that someone is either being intentionally deceptive or is misusing potentially interesting data.

If Len Burman was aware that the article was about the 400 highest income households then clearly he was being deceptive.  He would know full well that 400 highest income households do not pay “almost all” capital gains tax.  The reporter cites The Tax Policy Center as a nonpartisan think tank. If Len Burman knew how the quote was going to be used, one would have to seriously question whether the Tax Policy Center is really nonpartisan.  

However, even if Len Burman was intentionally being deceptive, the author of the article, Josh Zumbrun, can be faulted for a poor selection of a supposedly nonpartisan source.  It is also quite possible, and highly likely, that nonpartisan is the label the Tax Policy Center chooses to disguise its partisan efforts, in which case Josh Zumbrun can only be faulted for his political naivety or intentional bias. One should learn to question the partisan motives of anyone who cites capital gains figures without any reference to the fact that capital gains are by their very nature non-repetitive.  When one takes a capital gain, it is a onetime event.  Citing capital gains as if they were ongoing sources of income for a fixed set of households is inherently deceptive.

What is particularly distressing is that there is considerable evidence that the reporter was intentionally being deceptive and that the editor let it get published anyway.  The article starts out with the statement: “Tax rates on the 400 wealthiest Americans in 2013 rose to their highest average since the 1990s, after policy changes that boosted levies on capital gains and dividends.”  So the author has clearly set up the article to be talking about a very limited group of people, 400 households. 

The author even makes a meaningless comparison of what was paid by the 400 households in 2013 with what was paid by a different set of 400 households in the 1990s.  The author treats them as if they were the same households.  He then attributes the higher taxes to changes in tax rates on capital gains and dividends without making any reference to the fact that the incomes of the 400 households were different in different years.  He never makes any reference to how much of the increase in the taxes paid by the households in 2013 could be attributed to the interaction between a progressive tax structure and higher incomes.

One might conclude from that opening sentence that the article was going to be about the taxes of the 400 wealthiest Americans.  But, the very next paragraph makes it clear that the author does not know the difference between a stock of wealth and a flow of income.  That is not a major offense.  It is a very common misunderstanding among reporters and conforms to a common misuse of economic terminology among the general population.  However, one would think a journalist would be literate enough to properly use the English language and careful enough to select the words with the least ambiguity.  Further, one could hope that a newspaper that reports on financial markets would have the good sense to employ reporters who understand the difference between wealth and income.  Using the two words interchangeably is not only sloppy, it is deceptive.

Newspapers will often use wealthy to refer to high income as a simple expediency to cut down the number of words in the headline.  But to continue to misuse wealthy in the text of the article is a more serious issue.  It is particularly awkward since the author’s lack of clarity on the difference between wealth and income is a major deficiency in the article’s reporting on the taxes paid by the 400 highest income households.  One would hope that the WALL STREET JOURNAL would employ reporters who understood the implications, origins, and reason for differences in taxes on changes in wealth (the stock) versus income (the flow). 

That understanding is a precondition to accurately portraying the implications of the quotes that the article has gathered from Scott Greenberg, an analyst at the Tax Foundation; Gabriel Zucman, a professor at the University of California, Berkeley, and Len Burman, director of the Tax Policy Center.  Further, how can a newspaper ever hope to meaningfully report on financial markets if it employs reporters who have no understanding of the difference between a cash flow and market value?

Wednesday, December 30, 2015

“It's a Wonderful Life” Rebroadcast

It’s the holiday season, but what holiday

It’s that time of the year.  The movie “It's a Wonderful Life” has proved to be a fruitful source for observations about personal finance, economics, and financial policy.  This year, like the networks, this blog has resorted to a rebroadcast.  However, as we all know, before every broadcast there has to be a commercial.  So before delving in to the rebroadcast, we first should address something new and trendy.  Even here, “It's a Wonderful Life” can provide a convenient foil.

A populist approach that overlooks facts and shoots from the gut is very trendy in some quarters.  A good illustration of that populist approach is vague references to Glass-Steagall by various politicians.  The first reference to "It's a Wonderful Life" (DECEMBER 25, 2009) in “Did the repeal of Glass-Steagall create big banks and lead to the financial crisis?” discussed policy.  

Interestingly enough those closest to the financial crisis and with access to the best information (e.g., Henry Paulson, Timothy Geithner, most recently, Benjamin Bernanke) as well as numerous financial analysts and economists were able to see the simple truth the movie presents.  But, it is so much trendier to ignore the fact that Bear Stearns, Lehman Brothers and Merrill Lynch were investment banks defined along the traditional lines of Glass-Steagall.  It's also convenient to ignore the fact that Countrywide, IndyMac, and Washington Mutual were not traditional banks.  Heaven forbid that one should note that Wells Fargo and J.P. Morgan Chase, which were big enough to absorb the losses of some of the non-bank financial institutions as defined by Glass-Steagall, were, in fact, the antithesis of the romanticized Glass-Steagall bank.

The next year (DECEMBER 19, 2010) in “Investing Part, 3: Setting the volume” the focus shifted to personal finance, and perhaps the most important and overlooked lesson from the movie.  When addressing personal finance, we must turn to another trendy phenomenon.  We find it in the form of the worship of the consumer.  How many pundits point out that about two thirds of Gross Domestic Product is represented by consumption?  They don't bother to note that it is previous investment and labor that produces 100% of Gross Domestic Product.  One can’t consume what isn't produced.

“It's a Wonderful Life” is subtle and the relevant point it makes is easy to overlook.  One would think that life's experience would make the point far less subtly, but perhaps for that very reason noting that it shows up in the movie might be what's required for many people to see the point: budgeting is important.  

It's absurd for people to worry that the public might be saving the money they're not spending now that gas prices are lower or to fret that corporations have liquid assets on their balance sheet.  Such phenomena only indicate that both consumers and businesses are positioning themselves to be able to consume in the future.  Perhaps, they will take on the counter cyclical spending patterns the economist John Maynard Keynes thought should be filled by the public sector.  Heaven knows, the public-sector is certainly not positioning itself to fill that role.  Politicians can't seem to resist the urge to spend other people’s money, including their future earnings.

Those two themes, appropriate policy and personal financial management spilled over into January of 2012.  Regarding personal finance, “If the Plan Is Right, Stick to It” pointed out the folly of letting financial market performance dictate personal investment behavior.  While “The Role of Banks” pointed out how easy it is for policy to ignore the simple truths about banking that the movie illustrates.

The movie illustrates so many points about personal finance that in December of 2012 there was a whole series of articles concluding with “It's a Wonderful Life’ is truly a gift that doesn't stop giving.”  In the following month of January 2013, regulatory developments were so silly they cried out for references to a more rational approach.  As a consequence, a series of blogs ending with “It's a Wonderful Life’ On Regulatory Policy: Crimes Verses Mistakes” were used to illustrate a number of points about policy mistakes and their implications.

Every year since then it's been possible to illustrate some other lesson the movie holds. In 2013 “It's a Wonderful Life’:How to” trying to put a summary on the points it illustrates about personal finance. As a consequence, in 2014 in “It's a Wonderful Life’versus ‘The Interview" turned to the folly of pop culture’s focus on things that are totally irrelevant.

So, for this year perhaps it's appropriate to turn from pop-culture to what is supposedly serious social thinking.  It's a wonder that “It's a Wonderful Life” is still being broadcast.  There are so many points at which the movie portrays behavior that in the current environment are inappropriate to even discuss if one wants to remain politically correct.  Right from the start it refers to Christmas rather than a non-descript holiday.

It has to be frightening to those who think of themselves as the PC police to have to tolerate a movie that advances the idea that one could be politically incorrect and at the same time have a wonderful life.  However, it is also interesting that the movie is so politically incorrect and, yet, provides so many examples of intelligent and successful personal finance. It raises the interesting question:  Is the same mentality that insists upon PC behavior also hostile to individuals successfully managing their personal finances?  It raises the question why so many of the same individuals who insist upon PC behavior also advocate a culture of dependency.  To them it seems as if feeling victimized may be politically correct.  So, this year instead of being a victim, take the time to watch “Its Wonderful Life.”

Saturday, November 28, 2015

Some Thanksgiving Humor

Who's the turkey?

At first I thought it was a joke.  But, with further investigation it became apparent that we really do have a turkey in charge.  How anybody could get so out of touch with how they are perceived as to blunder into such a farce is beyond me.

Let's start with a quote: “Enough is enough.  The border needs to be sealed…”  The quote is accompanied by recommendations for how to do it. One could easily mistake that for the rant of a Republican candidate for president.  Some of them have succeeded at making some really preposterous statements regarding immigration.  However, it's not a quote from a Republican candidate.  This is a quote from an official in the Obama administration.  (“US urges Turkey to seal Syrian border,” WALL STREET JOURNAL, November 28, 2015).  How could the administration not realize how foolish it looks advising Turkey on how to seal its border?  If nothing else has been demonstrated conclusively by this administration, it is that they can't control immigration across the US border.

I thought the president could not make a bigger fool of himself than his statement that he was going to teach the terrorists a lesson by going to a global warming conference; then, up pops this example of the administration advising another nation on how to control illegal immigration.  I hope that Turkey sees the irony in our administration’s making a fool of itself by giving advice on how to control immigration.

It is just possible that our president has identified his intended legacy as supplying material for Saturday Night Live skits.  Perhaps he's jealous of Donald Trump's success on Saturday Night Live.  What is clear is that the president is making a fool of himself.  Better the fool than the villain he's often portrayed as by his political opponents.

Friday, November 20, 2015

The Corrupting Influence of Vilification

What happens when the criminal can't be the villain?

This is the third posting that asks the simple question: Are we looking at an issue from the proper perspective?

Sometimes the words chosen to describe an issue can create a blind spot.  When that happens, one can end up developing a policy that is totally appropriate but totally inadequate.  The policy only addresses the portion of the issue that the language allows.  However, the language does not facilitate the perception of the totality of the problem. 

Consider three words used to describe a financial transaction where one individual makes a payment to another that is not legal: bribery, extortion, and corruption.  Which word is chosen is related to and influences one's judgment about who is undertaking villainous behavior and whose behavior is too virtuous for them ever to be the villain.  Self-interest can play a major role in the definition of the villain and the choice of words to describe the action.


The Foreign Corrupt Practices Act (FCPA) is an excellent example.  It is designed to pursue a worthy objective but makes the absurd assumption that all corruption originates from the private sector.  That is an easy mistake to make if one assumes that anyone who pursues a profit objective is villainous.  
It helps if one is in a position to ignore potential villains either for convenience or out of self-interest.  It is very convenient and self-serving for the public-sector officials to ignore corruption on the part of other public-sector officials.  They can anticipate that those other public-sector officials will return the favor.

The media has an incentive to write sensationalist, supposedly investigative articles.  There is very little downside to inaccurate reporting if they can paint a picture of villainous activities.  All they have to do is identify who their target audience considers a villain.  Not surprisingly, often they share their audience’s prejudice regarding who is villainous.  Few people in the media or the general public seek information that challenges their preconceived notions of who is villainous.

The net effect is that policy prescriptions often end up only addressing half of the issue.  All the parties involved in a corrupt transaction are acting corruptly.  It is foolish to think that a policy that only punishes one of the parties involved can succeed.  The inherent result of such a policy is to provide an incentive to one of the corrupt parties to continue their behavior.  Without balance, a policy directed at bribery, for example, can end up compounding the misallocation of resources.

The back story

The May 9th, 2015 edition of the ECONOMIST magazine had a number of articles addressing commercial bribery.   The articles provide the back story, but there is a more recent update on some of the relevant information in an October 19, 2015 article in the WALL STREET JOURNAL. 
The WALL STREET JOURNAL article is entitled: “Wal-Mart Bribery Probe Tails Off.”  The government has been working on this probe for over three years and it is not yet over.  Indications are that the probe involved some two dozen prosecutors, agents and investigators from the Justice Department, the Federal Bureau of Investigation, the Securities and Exchange Commission and the Internal Revenue Service’s criminal investigations unit. 

As the WALL STREET JOURNAL article summarizes, “A high-profile federal probe into allegations of widespread corruption at Wal-Mart Stores Inc.’s operations in Mexico has found little in the way of major offenses, ….”   The emphasis is on “summarizes” because although no major offenses were found there were some minor offenses uncovered in Mexico. 

As is often the case when such accusations are leveled, the investigation took on a global scope.  In India there are reports that the corruption involved thousands of small payments to low-level local officials to help move goods through customs or obtain real-estate permits. The vast majority of the suspicious payments were less than $200, and some were as low as $5, but when added together they totaled millions of dollars.

The ECONOMIST magazine provides some idea of the scale of resources used to investigate the charges.  In an article entitled “Corporate bribery: The anti-bribery business” it states: “EVEN for a company with Walmart’s heft, $800m is a sizeable sum. That is what the giant retailer will have spent by the end of this fiscal year on its internal probe into alleged bribing of Mexican officials,”
“By the time bribe-busters at America’s Department of Justice (DOJ) are done with their own investigation, which began in 2012, Walmart’s bill for lawyers’ and forensic accountants’ fees will be well above $1 billion—and perhaps closer to $2 billion. To that can be added whatever fines it may incur, any bills for settling related private litigation, and the harder-to-quantify cost of the tens of thousands of man-hours managers have spent on what has become a big distraction from everyday business.”

The anti-bribery business is truly big business.  There are undoubtedly many law firms, government officials and corporate compliance officers making a nice living off of the anti-bribery business.  However, it doesn't stop there.  The issue provides media talking points for commentators and reporters. 

Keep in mind that the Walmart investigation began in 2012 after the NEW YORK TIMES ran a couple of articles alleging that there was widespread bribery in Mexico.  The Justice Department investigation contradicted some of the allegations in the NEW YORK TIMES articles.  Yet, despite the shortcomings of the NEW YORK TIMES supposedly investigative journalism, they ended up being awarded Pulitzer Prize.

One suspects that neither the NEW YORK TIMES reporters nor the Pulitzer committee members shop at Walmart.  So, a couple of billion dollars of extra cost for Walmart is not coming out of their pocket.  Besides, Walmart, a chain store that serves the working class, is such a convenient target for elitists in the media.

There is a very real risk that the government's response to being unable to find evidence of major corruption, may be to throw more resources at the investigation.  After all, it is a little embarrassing for the government to admit that it has been hoodwinked into such an extensive investigation by an inaccurate press report.  Further, it is often the government solution to a program run amok to just throw more resources at it.  Spending billions of dollars to catch a few million dollars’ worth of corrupt activity is the sort of thing governments do.

The problem

It is not surprising that the government, when passing the Act, wanted to assume, or at least pretend, that the corruption always originates in the private sector.  That they closed ranks with their fellow government employees is not surprising.  If they did not, foreign governments, as well as their own citizens, might call into question their behavior.  It would get quite messy if foreign firms and governments started pointing fingers at the lobbying expenses that US government officials extort from them routinely.

However, governments can acknowledge that there is government corruption.  It just seems that the US is not good at it.  By contrast, the ECONOMIST on Oct 24th, 2015 had two articles that reflect what one finds when a more balanced and objective approach is taken to corruption.  The first article entitled “Business and corruption: Robber barons, beware” discusses the anti-corruption campaign in China.

As is the case with most articles in the ECONOMIST, the full complexity of the issue is addressed.  Nevertheless, the important thrust of this effort to reduce corruption can be summarized with a couple quotes.

“Businessmen targeted so far are mostly senior managers of state-owned enterprises (SOEs), not private firms. In China powerful SOE bosses are also important figures in the Communist Party….Some of those detained are linked to Zhou Yongkang, a former security chief and head of a corrupt network of officials known as the “petroleum mafia”….  Of more than 100,000 people indicted for graft since Mr Xi became leader in 2012, most are politicians and officials—not private businessmen” [emphasis added]. 

It is interesting how when government officials become corrupt they are referred to as businessmen.  One would think that the editors of the magazine would have found it awkward to have to create the distinction between private businessmen and government officials who they have referred to as businessmen.  There is no reason to refer to the corrupt government officials as businessmen other than a bias on the part of the editors that assumes that corruption is a business phenomenon.  They are much in error.  Corruption is very much a government enterprise where force can be employed as opposed to a business practice where transactions are voluntary.  It seems even when the truth is obvious it is hard to admit that government officials can be corrupt.

The second article was entitled “Corruption and natural resources: A fight for light.”  It discusses efforts of NGOs and governments to try to uncover corruption related to mining and energy production.  It notes that “WHETHER the awarding of a license, the sale of state production quotas or some other transaction, dealings in oil, gas and mining are notoriously prone to corruption. This is a problem in countries that have weak rule of law and rely heavily on extractive industries. Sub-Saharan Africa is particularly at risk: its ten largest oil-producing states derived 56% of their public revenues from oil exports in 2011-13.”

The efforts of the Extractive Industries Transparency Initiative (EITI) are complicated by the fact that often the corruption is executed through the establishment of nontransparent shell companies.  The lack of transparency makes it difficult to track the corruption.  Nevertheless, the article points out that “A new report by Global Witness details how in recent years $4 billion was siphoned off to opaque companies, some of them linked to current or former officials [emphasis added], in just a handful of deals in four African countries.”  Global Witness is a Non- Government Organization (NGO) that is trying to monitor the (EITI).

The two articles make it apparent that when one looks at the issue from a broad, global perspective, it is apparent that corruption is not restricted to the private sector.  There is also no logical reason to assume that when a corrupt transaction occurs only one party is acting inappropriately.  It seems more appropriate to assume that both parties are acting inappropriately.  Further, since money is being transferred from private companies to public officials, it would seem far more appropriate to question the motives of the public officials.  

Private companies are not inclined to go around the world with bags of money spreading it widely in order to corrupt governments.  In fact, private companies prefer to operate in countries with honest governments and often have extensive internal controls to avoid the inappropriate use of funds.
Even serious analyses can be led astray

While clearly a media firm, the ECONOMIST magazine often contains serious analyses of economic issues.  Their coverage is broader than just the Walmart case; they discussed Siemens and Alston as well.  Both their assembly of the relevant facts and their interpretations of their implications deserve consideration. 

In the initial article “Bribery: Daft on graft” the magazine pointed out that “A hard line on commercial bribery is right. But the system is becoming ridiculous.”  

The articles in the ECONOMIST make the case for a number of reforms:

“First, regulators should rein in the excesses of the compliance industry and take into account the cost to firms of sprawling investigations.

Second, governments should lower costs by harmonizing anti-bribery laws and improving co-ordination between national probes.

Third, more cases should go to court.

Lastly, anti-bribery laws should be amended to offer companies a “compliance defense.”

All of their recommendations definitely make sense, are much needed and are justified.  However, they are also representative of what can happen when serious analysts fall prey to the language and context of those with less serious and objective intentions.  The ECONOMIST articles have a blind spot that they share with the FCPA.  As a consequence, their proposals are appropriate but are not adequate if the objective is to reduce corruption.

The selection of the word “bribery” in the titles of the ECONOMIST's articles and FCPA’s assumption that they know the villain in such cases illustrate the problem.  If one substitutes extortion for bribery, it automatically changes the context of the issue.  The same would be true if the word corruption were substituted for bribery.  But, the title of the article reflects the assumptions of the FCPA. 

The need for balance

The ECONOMIST article explains the rationale for the desire to end bribery.  The article points out that “Bribery distorts competition and diverts national resources into crooked officials’ offshore accounts.” What it fails to explain is: when businessmen have to make payments to government officials in order to get the officials to do their job (e.g., decide whether to issue a permit, perform an inspection, or even note that paperwork has been submitted) how can punishing the businessmen solve the problem?  The government official is receiving a salary to do the job.  They are also benefiting from the payment.  The businessmen are only exposing themselves to the potential of being fined and branded as corrupt.

If the corrupt official is allowed to keep the money, they have every incentive to continue the practice.  On the other hand, the businessmen have an incentive not to do business in the area.  The absence of the businessmen who were thus deterred also distorts competition.  If the objective is to avoid distorting competition, all parties involved have to be given incentives not to participate in the corruption.  Fining the government officials or the governments involved in corrupt transactions makes as much sense and should be balanced with the fines leveled against the companies.

As soon as one begins to think about a balanced approach that involves recovering the bribes from government officials, it becomes apparent that there are major opportunities to structure the process in a way that is conducive to honest government.  While ultimately the objective is to recover the bribe from the official who took it, the fine need not be directly assessed against that individual.  That is only one approach.  It could also be assessed against the organization responsible for enforcing honest government.  As a last resort, it could be levied against the national government with the proviso that if it is not paid, tariffs on the country’s exports will be used to collect it.  That would make it apparent that the government of the US is serious about honesty in business and government.  If other countries followed suit, it would soon become apparent that honesty is a prerequisite to dealing in the global economy.


Vilification of one of the parties involved in a corrupt act while ignoring the other party does not promote a better allocation of resources.  While it may sell newspapers and be entertaining to some audiences, no one is made better off except the author and publisher.  A serious effort to correct the misallocation of resources that result from extortion, bribery and corruption requires a more balanced approach.

Government policies to address the issue should acknowledge and prosecute all the parties involved.  Honesty is as much a prerequisite of good governance as it is of good business practices.  It is naïve to assume that an effort that focuses only on one of the parties involved in corrupt act can accomplish anything other than promote a corrupt industry to deal with the corrupt acts.  That is exactly what we have gotten as an industry has developed around the Foreign Corrupt Practices Act.  What is particularly embarrassing is that serious analysts are questioning whether the US government has shifted from promoting honesty in business to using the Foreign Corrupt Practices Act as a method of developing its own corrupt extortion racket.  A more balanced Foreign Corrupt Practices Act might offend some foreign governments, but it would demonstrate good intentions on the part of the US policy.