Tuesday, January 31, 2017

The Reality of NAFTA

Trade is not a zero-sum game.

Neither trade nor negotiations are zero-sum games. Unfortunately, Mary Anastasia O’Grady in “President Trump’s Mexican Standoff” (1/30/2017 WALL STREET JOURNAL) misses that point. As a strong advocate of free trade and one who favored NAFTA consistently since its initial negotiation during the Bush administration, I commend her for her efforts to present the benefits of freer trade with Mexico. One of my complaints about Bill Clinton's run for the presidency was the hypocrisy in his campaigning against NAFTA and then claiming its signing as a major accomplishment. The hypocrisy of cultivating a distrust of free trade despite knowing that it is desirable has been a hallmark of Democratic politics. A legitimate concern is that the consistent failure of politicians to defend free-trade while demonizing those who do defend it has led to the election of a president who may not understand those benefits.

However, it is extremely important to present the benefits as well as the costs honestly. Much of the protectionist sentiment in America reflects a failure to honestly acknowledge both the costs and benefits. Thus, it is extremely important when trying to defend free-trade that the economics be clearly stated. The author’s presentation falls short of an honest presentation of the counter argument against the proposed tariff on Mexican exports. It is not honest to say that the 20% cost of the tariff would be paid by American consumers. Assuming no currency adjustment, the cost of the tariff will be distributed between consumers in the form of higher prices and producers in the form of lower output depending upon the elasticity of demand for the product. If the product is considered a “must have” by US consumers, they will pay the 20%. If the product is very discretionary, consumers will rebel against a 20% price increase and just do without the product. Mexican producers will suffer a loss of sales equal to that reduced consumption.

Also, the author’s presenting the fall in the Mexican peso as something the Trump administration would welcome is sheer nonsense. The perception that it strengthened Trump’s negotiating position seems to be based upon a perception that the objective of the negotiation is to win a zero-sum game where one side wins and the other loses. It makes no sense if the objective of the Trump administration is their professed desire for more balanced trade. The weaker peso makes Mexican exports more desirable to US consumers. It only increases the urgency of the administration's need to resolve the issue and constrains their flexibility in the negotiations. Not only does it weaken Trump’s position with respect to Mexico, it also weakens his position vis-à-vis Republican’s advocating a border adjustment tax instead of Trump’s approach. The drop in the peso is exactly the currency responses that advocates of the border adjustment tax say will eliminate any inflationary impact of their tax plans.

When presenting the benefits of free trade, economists can show that relative advantage results in all parties involved in free-trade being better off in aggregate. However, as is illustrated by the peso's adjustment, the theoretical underpinnings of the advantages of free trade are often illustrated by exclusively focusing on goods and services. In the real world there is an important additional commodity being traded: it is the currency.  It would behoove those thinking about what constitutes more balanced trade between the US and Mexico to keep in mind the fact that the dollar is a reserve currency. To the extent Mexico requires reserves it will need to export more to the US than it imports from the US. That's the only way Mexico can accumulate the dollars it needs to hold as a currency reserve. By contrast the US has no need to import pesos. Consequently, it's totally unrealistic to think that the US exports to Mexico should, or could, ever equal Mexico's exports to the US over a long period of time.

NAFTA should be evaluated based upon the extent to which it allows the free exchange of goods between willing parties. It's totally inappropriate to pretend that the balance of that exchange provides the criteria by which NAFTA can be evaluated. If the balance of trade is lopsided, it isn't due to the structure of free-trade. No country has a relative advantage in all things.

Wednesday, January 4, 2017

The Hypocrisy Should Bother Them: Student Loans

Or perhaps they're not so smart

This is the third posting on student loans. The first two postings focused upon how we could organize student lending to achieve greater social benefit. They reflect the general philosophy that it is more productive to focus on potential improvements than to concentrate on failures of the current environment.

Unfortunately, many people are so wedded to rigid ideologies that they are blind to alternatives. Others lack the imagination, intelligence, and open-mindedness to see any alternative other than what exists. Either many people formulating policy are tremendously hypocritical or they just aren't smart enough to see alternatives to the disaster they are creating.

So, critique of the current system may be a prerequisite for getting people to address its deficiencies. However, it would be totally unproductive to just critique the current system without at least providing the outline of a viable alternative. With that in mind, this posting begins with a brief summary of the general outline of the major conclusions from the previous two postings.

An alternative approach.

The previous two postings suggested an approach that involves having the government discontinue most subsidies of demand for post-secondary education and shift resources to subsidizing supply. Academic institutions should be forced to bear some risk associated with the product they deliver by making them partially responsible for the risks that individuals incur in order to finance education. The risk that individuals bear by borrowing to finance education should be treated the same way as the risk associated with any loan. Student loans should be treated in bankruptcy like any other consumer loan.

The previous postings.

The first posting done on October 27, 2015 was entitled "Educational Loans: Dare We Ask Who Benefits from the Subsidy? Sometimes it pays to ask the right question.” It focused on questions related to what should be the proper objective of subsidies to post-secondary education. It acknowledged the need for subsidies and discussed how the benefits of subsidies end up being distributed.

It pointed out that the appropriate objective for public subsidies to post-secondary education is a level of post-secondary education that is justified in terms of the benefits it provides to society. That definition of an objective implies an assumption that post-secondary education provides social benefits. Put differently, it assumes that we all benefit from an educated population. However, it also points out that while that social benefit exists, its magnitude is open to debate. Thus, the posting emphasizes methods for ensuring the socially desirable level of post-secondary education without specifically defining the magnitude of the social benefit.

To achieve that objective, most public subsidies should focus on increasing the supply rather than increasing the demand for education.  Public subsidies of student loans may actually be counterproductive in terms of the public policy objective. There is considerable evidence that the educational establishment from the lowest instructor through the administrative apparatus, including the Department of Education, has positioned itself to capture the benefits of subsidies to demand. Any supplier of a good has an incentive to respond to increased demand by increasing price and constraining supply. The educational establishment is no different.

At the same time, student loans are a necessary component to making access to post-secondary education available to the entire population, another desirable social objective. The benefits to the individual from post-secondary education accrue at a different time from the cost. Not all families and individuals are in a position to finance that difference in timing. Educational loans can fill that void, but since that benefit accrues to the individual, it does not need to be subsidized by public entities. Demand subsidies, such as government guaranteed student loans, increase the price of post-secondary education and thus make it less available to those with limited financial resources.

The difference in efficient methods appropriate to achieving these two social objectives has tripped up those responsible for formulating policy. The problem is not new.  As the posting states, “When addressing subsidies for post-secondary education, policy makers should first compare who benefits from post-secondary educational loans to who bears the risk of those loans.

If they did, they would realize that analyzing who benefits is a prerequisite to addressing the appropriate level of expenditures for education” (i.e., combined public and private expenditures on education) “and the appropriate participation of the public sector” (i.e., a public subsidy that reflects the social benefit of an educated population). The distribution of benefits has to be addressed because if student loans result in benefits that are captured by the educational establishment, it follows that “The US will never get the right level of investment in education and a justified public subsidy to post-secondary education...”

 “They would also realize that it is clear that the educational establishment should be bearing some of the risk” (i.e., the risk that the student is bearing by taking on debt under the assumption that the education will produce an adequate positive return to pay back the debt). In short, educational establishments should have to bear some of the risk associated with student loans.

The misplaced incentives created by the current system are widely recognized.  For example, Mr. Duncan, a former secretary of the Department of Education, has noted the problem and stated: “Government, at both the federal and state level, along with accreditors and Congress, need to flip the current incentives in higher education,” Mr. Duncan said. “In the current system, only students, their families and taxpayers lose when students do not succeed. That simply doesn’t make sense.” 

Having educational institutions bear some of the risk for student loans would be a very efficient way to force them to ensure that education delivers a benefit to the student that justifies the loan. The alternative of having students sue the school, professors, and the faculty unions whenever their education is disappointing would be far less efficient. Further, it is unlikely that the government will sue academic institutions when their graduates are unable to repay their loans, although government suits would be more efficient than individual student suits.

The second posting on student loans was on December 28, 2016. It was entitled "It's a Wonderful Life: Student Loans: It isn't whether you win or lose but…." It focuses on the impact of student loans on individuals and families.

It points out that:   “If the government is taken out of the role of the student lender or guarantor of student loans, the basic structure of the student loans is no different from any other loan. The government may provide a subsidy in a form other than a loan guarantee, but there's no reason why that subsidy has to dictate the terms of the loan.”

The failure of the current system

WALL STREET JOURNAL on December 27 ran an article entitled “Student-Loan Market Warms Up: Trump administration is seen as making the sector friendlier to private lenders.” It illustrates how ideology can blind observer to options. It treats government lending or private lending, primarily bank lending, as if they are the only alternatives.

It ignores important aspects of the issue. For example, should the government be guarantee student loans at all? Should bankruptcy proceedings include student loans along with other types of debt? At the same time, the article is to be commended for pointing out that student debt has become an issue with over $100 billion (by government estimates) that the government plans to forgive. Also, the article is a report rather than an editorial, and thus, can be forgiven for just reporting on the two sides taken by various policy advocates. The real critique is that none of the policy advocates has the imagination to see that the either/or decision they're posing is a blueprint for failure regardless of who wins.

The article points out the expectation that some change will take place. The Republican Party’s platform called for a return of private lenders. “The federal government should not be in the business of originating student loans. In order to bring down college costs and give students access to a multitude of financing options, private-sector participation in student financing should be restored.”
It fails to knowledge how government guarantees on any loans can cause the loans to be mispriced. 

Regardless of whether the government or banks make the loans, if there is a government guarantee, the loans will be mispriced because the value of the risk in the loan has been shifted to the taxpayers. Consequently, many individuals will be encouraged to take on larger loans with longer payment periods than is appropriate. The fact that we currently have some people on Social Security who are still paying back their student loans clearly indicates that the issue of government versus bank loans only addresses part of the problem.

But those who are ideologically blinded to the true issue because of their commitment to private-sector financing aren't the only ones at fault. The magnitude and crisis nature of the ballooning student loan burden goes way beyond the results of mispricing. The problems that the private sector can create when government guarantees distort loan risk pale compared to the mess that can be created if the government takes responsibility for actually doing the lending. It is very hard to come up with any conceivable justification for the exponential growth of the student debt burden under the Obama administration.

The Obama administration has either been totally blind to the mess they created or extremely hypocritical in its handling of the student loan issue. Giving the Obama administration the benefit of the doubt, one can only conclude that they were not smart enough to see the disaster they created. As the article points out, under President Barack Obama, responsibility for student lending “was transferred entirely to the U.S. government, already the dominant force in the market.”

The move was designed to lower lending costs for the government….” They were wearing complete ideological blinders if they really believed that taking on increased responsibility for mispriced loans would lower cost. The WALL STREET JOURNAL article points out that they “wanted to redirect savings to student grants and to offset costs associated with the Affordable Care Act.” Whether one endorses those objectives or not, the mechanism by which they tried to accomplish them just wasn't smart. (In passing, it is worth noting that the previous postings endorsed their objective of increasing student grants as an alternative to mispriced lending).

The article notes that: “The result has been a student-loan market run almost entirely by the federal government— and for which taxpayers are ultimately on the hook.” By government estimates that hook is already over $100 billion, and there are numerous reasons to think it will grow.

The article goes on: “An added concern: Most of this federal debt was extended to borrowers without checking their credit scores. When the government totally ignores the benefits of the market allocation of credit, loans go from just being mispriced to being mispriced and distributed in ways that are irrational.   How could anyone imagine that it benefits anyone to lend to individuals without any regard to their ability and likelihood to repay the loan? The borrower ends up with a debt burden they can't pay and the lender loses their money.

Clearly, the policies of the Obama administration were going to saddle some students with an unbearable loan burden. The hopelessness of the situation that the government was putting them in was clearly going to undermine their future. Many students have no hope of ever being able to demonstrate the responsible behavior that would allow them access to the financial resources they'll need later in life. Even if the loans are forgiven, that failure to repay their debt is going to undermine their sense of financial responsibility for their behavior. It's almost as if the Obama administration is pursuing a policy designed to undermine students’ sense of achievement and sense of responsibility.

The full extent of the hypocrisy of the Obama administration can be appreciated when one considers some of the steps the Obama administration took to ensure that it had control of all student lending. As the article points out: “Regulatory scrutiny of private lenders also intensified after the Consumer Financial Protection Bureau opened in 2011.”

Keep in mind that the Consumer Financial Protection Bureau is supposed to protect consumers from predatory lending. Even a cursory examination of student loan debt burdens and default rates make it clear that the predatory lender in the student loan market is not private lenders. It is the government. Yet, the Consumer Financial Protection Bureau has not initiated any steps to rein in the abusive lending practices of the Department of Education. It is the epitome of hypocrisy for the Consumer Financial Protection Bureau to ignore predatory lending by government agencies.

Technically one could argue that the Consumer Financial Protection Bureau is an independent agency that is not a part of the Obama administration. In fact, it is an agency that is responsible to no one. But that would be extremely disingenuous given that it was created as a result of the Dodd-Frank financial reforms and that the Democratic party has refused to acknowledge that Dodd-Frank could be less-than-perfect.

If we don't address the deficiencies in the student loan market, taxpayers, many of whom never had the benefit of college, will be saddled with the bill for hundreds of billions of dollars. Unfortunately, the result of that tax will not be a responsible educated population. Forgiving the debt of students who can't repay it will cultivate the selfish attitude that they, the college-educated students, have no responsibility for returning the resources to society that society put into their education.


Students taking on a post-secondary education deserve every opportunity to start adult life with a sense of accomplishment, an appreciation of the importance of responsibility, and a chance to demonstrate responsible behavior. They should be able to graduate with a sense of pride rather than responsibility for government insured loans that do nothing but guarantee that some of them will experience financial failure.

A major benefit of the approach outlined in the previous two blogs is that if the “Student loans could then be treated like other loans, and if it’s impossible to repay them, they could be dismissed in bankruptcy. Thus, students who borrow and then repay or that finance the education within the family, as in the “It's a Wonderful Life,” will demonstrate how to play the game: take responsibility, be grateful for the opportunity, be thankful for the subsidy that would replace the loan guarantee, and do the best you can. Win or lose that seems like a better route to wonderful life than living with the illusion that others are responsible for your future.” 

Wednesday, December 28, 2016

It's a Wonderful Life: Student Loans

It isn't whether you win or lose, but….

Whether one even sees that there is an issue associated with student loans depends upon one's approach to the game of accomplishing socially desirable objectives. Differences in attitudes about student loans reveal how people approach the game. Some people see only one way to subside demand for education. Their approach whenever there is a problem is for the government to throw money at it. A totally different approach is to try to figure out how society can be organized so that the educational objective is achieved as a natural result of the way things are organized.

A previous posting suggested that the wrong institution, government, is accepting responsibility for guaranteeing student loans. If subsidizing educational demand by lending students money to finance education is appropriate, primary beneficiaries of subsidized demand are the academic institutions and their faculties. They should participate in risk associated with the loans in some fashion.

The academic institutions that benefit from subsidizing demand are only a part of the story. Those who overlook the possibility that there are solutions other than the government throwing money at the problem, frequently fail to recognize that all policy issues involve individuals. Students and their families are involved.

At this time of year it seems appropriate to use the classic movie "It's a Wonderful Life" to illustrate the point. In previous years the movie was used to illustrate points about good financial management both at the personal and national policy levels. That is not too surprising given the relationship between good personal financial management and a wonderful life.  In addition, national financial events are an important backdrop for events in the movie. However, the movie's relevance to how student loans relate to a wonderful life is more subtle. It illustrates an unfortunate and telling change in attitudes toward how one should achieve a wonderful life.

“It's a Wonderful Life” reveals so much about how to achieve a wonderful life that it's easy to miss the message regarding student loans. However, attitudes toward getting a higher education appear at a number of points during the movie. But the dinner conversation between George Bailey and his father is particularly telling.

The conversation covers a number of topics, most importantly the father-son relationship between George Bailey and his father. But, with regard to education, it shows just how much achieving an education was considered a family affair. George references working to save up money to go to college, and he discusses how he and his brother plan to coordinate their efforts to get a higher education.

What is particularly relevant is that there is no assumption that the world owes them an education. Rather, it is something they can achieve, and it's their responsibility to achieve it if that's what they want. Perhaps the message of the movie is that that attitude of accepting responsibility is the key to a wonderful life.

It is unfortunate that we as a society are depriving a generation of that sense of achievement. As discussed in a previous posting entitled “Educational Loans: Dare We Ask Who Benefits from the Subsidy?” there are social benefits to having an educated population. That previous posting argued that given our current approach, it is unlikely that we will get a level of investment in education that results in achieving the appropriate social benefits. One might also argue that achieving that objective without facilitating the growth of a sense of responsibility is inappropriate and is a disservice to the individuals involved.

More importantly, acknowledging the benefit to society is quite different from saying that any individual is entitled to education because of the potential social benefit of having a generally educated population. The issue is illustrated in a December 13 WALL STREET JOURNAL article. The article is entitled, “Student-Debt Plan Faulted: Some people who paid off their loans see an injustice in federal forgiveness programs.”

The subtitle pretty much says it all, but the article is quite explicit. It reports that some people who paid back their student loan are “enraged to learn that millions of other borrowers will get off easier. The government is set to forgive at least $108 billion in student debt in coming years under plans that set payments as a share of borrowers’ earnings and eventually forgive a portion of their balances.”

One can focus on the injustice of it, but there is a more important point. Those who have paid off their student debt have a right to feel that they earned the right to their education. They achieved it by accepting responsibility to return to society the resources that society provided to them to facilitate their education. Is it legitimate for them to feel that the federal government wasted $108 billion by educating people who are proving that they didn't deserve the subsidy the government provided by lending them the money?

It's possible that the $108 billion wasn't a waste. It is just possible that a subsidy of that magnitude in addition to the subsidy implied by the government guarantee of their loans is justified. Perhaps there is that much benefit in having people educated. However, it would seem illogical to argue that subsidizing people who don't repay the debt is more productive than subsidizing the more responsible borrowers who chose to pay back the loan.  Arguing that lending to irresponsible people is desirable seems like a stretch. Especially when one considers that if the loans are repaid, society can then lend to other students.

One also has to wonder:  How do those who were never able to go to college for financial reasons feel about paying a share of the $108 billion? The injustice argument certainly seems relevant since they never had the benefits of college but are paying so that others can. One also has to wonder why individuals who never went to college but lead responsible adult life aren’t equally deserving of a subsidy.

The last posting on educational loans was over a year ago, October 27, 2015. Further, the inappropriate structure associated with student loans is not a new phenomenon. The WALL STREET JOURNAL on December 21 had an article entitled “Unpaid Student Loans Bite Seniors.” The article reports that, “The federal government is increasingly taking money out of Americans’ Social Security checks to recover millions in unpaid student debt, a trend set to accelerate as more baby boomers retire….Overall, about seven million Americans age 50 and older owed about $205 billion in federal student debt last year. About 1 in 3 was in default, raising the likelihood that garnishments will increase as more boomers retire.” So, why is another posting on the topic timely now?

There are four reasons to revisit the issue. One is the sheer size of the misallocation of resources involved. $108 billion is a significant sum, and, like any government expenditure, there's no reason to believe that it won't grow. Especially, when one considers that many baby boomers and current students don't view their student loans as an obligation to society.

Second, we have raised a generation who don't think in terms of being worthy, but rather think in terms of being entitled. People who think the government should pay for their education are not likely to feel responsible for repaying society for the resources they've used in getting their education. We certainly haven’t created an educational system that instills a sense of responsibility in students.

Third, both political parties should be willing to address the issue. One political party likes to emphasize the social benefits of higher education to the absurd level of suggesting it should be “free,” or put more honestly, paid for by someone other than the recipient. The other is headed by a president-elect who has acknowledged the obligation of higher education to provide a service of value:  By settling a lawsuit related to the University that bore his name, he has acknowledged that responsibility. Perhaps he will realize that the same approach should extend to all institutions of higher learning. Every college would have to provide value if they were forced to accept the financial risk associated with student loans. It would certainly be a more socially efficient approach than forcing students to sue their colleges when they don't think they received adequate value.

Finally, the previous posting back in October of 2015 was incomplete. If the government is taken out of the role of the student lender or guarantor of student loans, the basic structure of the student loans is no different from any other loan. The government may provide a subsidy in a form other than a loan guarantee, but there's no reason why that subsidy has to dictate the terms of the loan.

Student loans could then be treated like other loans, and if it’s impossible to repay them, they could be dismissed in bankruptcy. Thus, students who borrow and then repay or that finance the education within the family, as in the “It's a Wonderful Life,” will demonstrate how to play the game: take responsibility, be grateful for the opportunity, be thankful for the subsidy that would replace the loan guarantee, and do the best you can. Win or lose that seems like a better route to wonderful life than living with the illusion that others are responsible for your future.

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 SeekingAlpha.com.  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.