Corporatist Pigs!

Via Mises.org:

Throngs of tweenies rushed to buy their copies of the June 2009 issue of Rolling Stone, eager to read about the adorable Jonas Brothers. As they flipped it open, questions rushed through their heads: “Are they on tour?” “Do they have girlfriends?” “What do they look for in a girl?”

What those girls weren’t asking themselves was “How was Goldman Sachs, the world’s most profitable investment bank, involved in creating the current financial crisis?” But that didn’t stop Matt Taibbi from answering that question in the same issue of Rolling Stone, in his article, “The Great American Bubble Machine.”

Interestingly, in a November 9, 2007, interview with Marty Beckerman of Reason, Taibbi actually described himself as “more of a libertarian than anything else.” Unfortunately, in keeping with Rolling Stone‘s dominant line, Taibbi’s attack on Goldman Sachs was quite antimarket. He coolly placed the blame for the US financial crisis on the shoulders of this lone company.

However, he did manage to illuminate the bank’s relationship with government regulators and the Federal Reserve. As the saying goes, “even a broken clock is right twice a day.”

…Taibbi first characterizes the corruption at Goldman Sachs as an inevitable result of “free markets and free elections,” then argues that it was made possible by “the aid of a crippled and corrupt state.” So, which is it? The free markets or the state-sanctioned corruption? These are entirely different arguments and they must be carefully treated as such.

I will be the first to argue against the state aiding and abetting corporations. Among the advocates of the laissez-faire system, there is a clear understanding that such aid is corporatism or corporate socialism.

Yet in all such schemes, the hand of government regulators is disguised so well that when the scheme fails, most people see the puppet but overlook the puppet master. Perhaps Taibbi can be forgiven for the error. After all, we have been witness to numerous such shell games at the hands of government.

Read the full article here

Why Markets Make Mistakes

Via Simoleon Sense:

Introduction (Via SSRN):

The research described in this article calls into question the assumptions of rationality, transparency, efficiency, and homogeneity on which many models of markets are based (see for example Samuelson 1948; Bass 1969; Fisher and Pry 1971, Malkiel 1973). The classic models assume, at least implicitly, that decision makers understand the structure of the market and how it produces the dynamics which can be observed or might potentially occur. Are these models acceptable simplifications, or can they be seriously misleading?
This article explains why markets routinely and repeatedly make “mistakes” that are inconsistent with the simplifying assumptions and often produce disastrously wrong business decisions. The undesirable outcomes could include vicious cycles of investment and profitability, market bubbles, accelerated commoditization, excessive investment in dead-end technologies, giving up on a product that becomes a huge success, waiting too long to reinvent legacy companies, and changes in market leadership. The article illuminates the effects of bounded rationality, imperfect information, fragmentation of decision making, and extrapolating past trends.

Click Here To Learn Why Markets Make Mistakes

What We Talk About When We Talk About the Efficient Market Hypothesis

Via The Curious Capitalist:

Eugene Fama said that in order to test whether markets were efficient in this sense you needed an economic theory of how prices were determined. He chose the Capital Asset Pricing Model, devised a few years before by Jack Treynor, Bill Sharpe and John Lintner. It said risky stocks would outperform less-risky ones, with the risk that mattered being something called beta—the correlation of a stock’s movements to those of the overall market.

Roll started pointing out issues with CAPM in the 1970s, and Fama and French concluded in 1992 that the conjunction of CAPM and the EMH simply didn’t match the data. They chose to jettison CAPM, not the EMH (Fischer Black made more or less the opposite choice). But without an economic theory of how stock prices should move, there’s no way of testing the claim that markets are efficient in the “price is right” sense. Pricing models like the arbitrage pricing theory or the Fama-French factor models simply assume that prices are right, then extrapolate from that what the relevant risk factors must be that determine prices. But this assumption that prices are right is now based on no empirical evidence at all. In fact, both Fama and Roll have said that there’s just no way to tell whether prices are right or not.

That leaves us with an efficient market hypothesis that merely claims, as John Cochrane puts it, that “nobody can tell where markets are going.” This is an okay theory, and one that has held up reasonably well—although there are well-documented exceptions such as the value and momentum effects. But if “we can’t tell where the markets are going” was all the finance professors had to offer, they wouldn’t have had much influence.

The price-is-right combo of EMH and CAPM allowed finance professors to say much more than “we dunno.” They may not have known exactly where a stock’s price was headed, but thanks to CAPM they could confidently predict the bounds within which it would move. Thus armed they went on to conquer the world, eventually transforming MBA curricula, legal thinking, corporate governance, financial regulation and many aspects of investment practice. It’s admirable that finance scholars—especially Fama, since it was his theory in the first place—kept sniffing around and eventually concluded that the EMH/CAPM combo didn’t match the evidence. It’s not so great that some of them now pretend that the price-is-right version of the efficient market hypothesis never existed, and fail to fully confront what its demise means for a lot of the other things taught in finance and investment classes.

Read the full post here

A Fundamental Confusion About the Nature of Wealth

Via The Economist:

People nevertheless use the stockmarket as a barometer of economic health. So a rise in equity markets can be (and has been) seen by governments and central bankers as evidence that the economy is headed in the right direction. That can lead to policy mistakes, such as a lax monetary stance, and further irrational exuberance.

Housing is more complicated than the stockmarket since people get utility from their homes (shelter, relaxation) while simultaneously treating them as assets. Even so, a rise in house prices that outpaces GDP growth does not make a society richer. Instead, all that is achieved is a transfer of wealth from first-time buyers to retirees exiting the property market.

In theory house prices can rise faster than GDP for a while if citizens decide to devote more of their incomes to housing services (for example, they may prefer a bigger flat to a bigger car). In practice it is hard to disentangle such structural shifts from the speculation that is prominent in all property booms.

It is the link between speculation and asset prices that explains this crisis. The ability to borrow money to buy assets fuelled the rise in asset prices. And the wealth effect of higher prices persuaded those in English-speaking countries to borrow money to sustain consumption.

Not long ago the BBC transmitted a programme about credit-card use. One man said he felt “wealthier” because he was given a credit-card limit of £5,000 ($8,000). Of course, once he used the card he was poorer. Not only did he have to repay the £5,000, but he had to service a double-digit interest rate as well. Similarly those who buy an overvalued asset with borrowed money have not made themselves richer but poorer.

Read the full article here

Size Really Does Matter…for ETFs

Via Abnormal Returns:

We are no strangers to the world of ETFs, but the following observation took us by surprise.  A single fund, the iShares MSCI Emerging Markets Index Fund (EEM) generates some $240 million in revenue per annum for its sponsor.  Ian Salisbury at WSJ goes on to note how lower trading costs have kept EEM on top against its much thriftier competitor the Vanguard Emerging Markets Stock ETF (VWO).  In short, size matters in the ETF industry.  And by industry, we mean industry.

There certainly are benefits to size in the ETF world, but there is a downside as well. Funds that were originally thought to be niche products have in some cases have seen explosive growth.  This growth has put pressure on their ability to produce the returns they set out to generate.  Therefore owning an ETF that invests in gold, commodities, or junk bonds is not the same thing as holding the underlying asset(s).

In some of these cases the ETF industry has tried to take something that is complex and make it seem simple.  Unfortunately something can get lost in the translation.  In addition the issuance of an ETF can change the dynamics of a market, something not always contemplated prior to a fund launch.

That is not to say that being too small in world of ETFs is not a problem as well.  We have written about the risks of so-called orphan or “zombie ETFs” that are too small and illiquid.  One need not look far to see that a broad swath of the ETF industry is potentially on the chopping block.

…ETFs can be a wonderful tool for investors, but ETFs are also a business.  A big business.  If you want to continue playing in the ETF sandbox make sure you know the distinction between a good ETF and a bad ETF.  Because the ETF sponsors are not going to tell you which is which.

Read the full post here

Do You Have the Mental Fortitude to Accept Huge Gains?

I am not a follower of Elliott Wave Theory, but this is a very accurate passage from Robert Prechter:

“Do you have the mental fortitude to accept huge gains?”

“This comment usually gets a hearty laugh, which merely goes to show how little most people have determined it actually to be a problem. But consider how many times has the following sequence of events occurred? For a full year, you trade futures contracts, making $1000 here, losing $1500 there, making $3000 here and losing $2000 there. Once again, you enter a trade because your (trading) method told you to do so. Within a week, you’re up $4000. Your friend/partner/acquaintance/broker/advisor calls you and, looking out only for your welfare, tell you to take your profit. You have guts, though, and you wait. The following week, your position is up $8000, the best gain you have ever experienced. ‘Get out!’ says your friend. You sweat, still hoping for further gains. The next Monday, your contract opens limit (down) against you. Your friend calls and says, ‘I told you so. You got greedy. But hey, you’re still way up on the trade. Get out tomorrow.’ The next day, on the opening, you exit the trade, taking a $5000 profit. It’s your biggest profit of the year, and you click your heels, smiling gratefully, proud of yourself. Then, day after day for the next six months, you watch the market continue

to go in the direction of your original trade. You try to find another entry point and continue to miss. At the end of six months, your method finally, quietly, calmly says, ‘Get out.’ You check the figures and realize that your initial entry, if held, would have netted $450,000.”

“So what was your problem? Simply that you had allowed yourself, unconsciously, to define your ‘normal’ range of profit and loss. When the big trade finally came along, you lacked the self esteem to take all it promised . . .who were you to shoot for such huge gains? Why should you deserve more than your best trade of the year? Then you abandoned both (trading) method and discipline. To win the game, make sure that you understand why you’re in it. The big moves in markets only come once or twice a year. Those are the ones which will pay you for all the work, fear, sweat and aggravation of the previous years. Don’t miss them for reasons other than those required by your objectively defined method. The IRS categorizes capital gains as ‘unearned income’ that’s baloney. It’s hard to make money in the market. Every dime you make, you richly deserve. Don’t ever forget that.”

. . . Robert Prechter – the Elliott Wave Theorist (1992)

David Rosenberg on Deflation

Rosenberg on the deflation question:

The question is when will we ever move from deflation to inflation. Everyone looks at the Fed’s bloated balance sheet but the problem is that the reserves the central bank has created are sitting as cash on banking sector balance sheets and not being re-circulated into net new credit creation which suggests that velocity is still contracting. Not only is velocity contracting, but so are the broad monetary aggregates.

From a labour market standpoint, there cannot be inflation without accelerating wages, and the economy is now operating at a level that is equivalent to 10 million jobs short of full-employment. So basically, what this means is that we are anywhere from five to 10 years away from seeing any sustained increase in inflation. Indeed, the article on page A2 of today’s WSJ cites a Rutgers study suggesting that we will not see 5% on the unemployment rate again until the end of 2017; Global Insights has a 5.75% jobless rate occurring no sooner than 2019 (see It Will Be Years Before Lost Jobs Return – and Many Never Will).

In turn, this implies that the chances that we get to $83 on S&P operating EPS, which the equity market is in effect now discounting a doubling from current levels, could take at least that long to occur (five to 10 years). Again, this means that income-focused investment strategies are going to remain critical in terms of generating adequate real risk-adjusted returns for the foreseeable future.

To repeat, the employment/population ratio (the “employment rate”) has fallen to a quarter-century low of 58.8%; it peaked at 63.4% in 2007. To get back to a cycle high, we need to create more than 10 million jobs. Before that happens, deflationary pressures are going to trump whatever inflationary risks arise from the Fed, Congress and the White House.

The last time the ratio was this low was back in December 1983. Back then, household debt per capita was $9,900; today it is six times larger at $58,000. At the margin, one has to wonder what is going to be paid for first. The debt-service payments coming out of the paycheck are looking increasingly vulnerable. Default rates are extremely likely to worsen for the foreseeable future; groceries will not be sacrificed; however, credit will.

THE U.S. CONSUMER IS IN HUNKER-DOWN MODE

While thrift is still considered a ‘bad thing’ by most economists who crave a consumer-led revival, we would be happy to open that for debate. It would be much more heartening to see a revival fuelled by capital investment but when over one-third of manufacturing capacity is sitting idle, that may be a stretch; and considering that exports comprise little more than 10% of GDP, the foreign sector is hardly going to be adding a whole lot of torque to the GDP data, at least over the intermediate term. Looks like we are left with government.

This secular frugality theme was on our minds when we saw Flat Holiday Sales? Retailers Say They’ll Take It on page B1 of the Saturday NYT. Is this what a 65% surge in the S&P retailing index from the lows has priced in? A flat sales growth at the most important time of the year. And this would be flat over a 2.0% YoY decline in 2008, which was the weakest holiday showing in 40 years. A holiday study just published by Nielsen found that 85% of Americans are going to be spending the same or cutting back this year compared to what was the worst holiday season since the late 1960s. This is incredible and shows how the near-60% surge in the equity market over the past five months has been totally divorced from economic reality.

The NYT article hit home because it concluded that “people are also continuing to nest in their homes.” We were on top of this about two years ago. And here we are, and the article says that the best-selling item this holiday shopping season is expected to be – get this – “cookware and other kitchen sundries.” Can there be any worse news for the restaurant sector? Husbands are going to be buying their wives a new roasting pan for Christmas and wives are going to be giving their hubbies a fryer.

Luxury goods are expected to fare poorly (jewellery, sporting goods, vacations), and it looks like we may see some very deep discounting in the apparel space (NPD Group is calling for a 4-5% YoY decline this year – see Sales Hanging on By a Thread on page A8 of the Investor’s Business Daily). Ditto for toys, the specials are starting early – Wal-Mart is bringing back its $10 toy section back to all its stores and we’re not even close to Halloween yet. Moody’s reported last week that the holiday shopping period “may be more promotional than anticipated, as consumers have learned to delay shopping in anticipation of higher markdowns”. Now that is definitely a deflationary mindset.

David Rosenberg on Unemployment

Rosie (of Gluskin Sheff) shares his insights on unemployment:

In the last three months, the Household survey shows that civilian employment has plunged 1.33 million. At the time of the end of the 2001 recession, the three-month rally was -3,000 – we hadn’t even entered the jobless recovery at that point. There has never been a time, ever, when a recession ended during a span when the economy lost 1.33 million jobs. So all the calls that the recession is over may have been a tad premature. If the jobs data are correct, and the recession is in fact not over, this entire 60% rally is at risk of unravelling.

There were absolutely no redeeming features in the data. The private nonfarm diffusion index sank to 31.9 in September from 34.9 in August (the manufacturing diffusion index fell to 22.9 from 28.3 in August) which means that for every company adding to their staff loads, more than two are cutting back. The labour force contracted by 571,000 and has plunged now by 1.1 million since May. That again is a sign of the labour market seizing up, which is very disturbing when you consider all the government efforts to stem the tide last quarter – from housing subsidies, to cash-for-clunkers, to mortgage modifications.

The fact that initial jobless claims have peaked and rolled over – modestly by historical standards – tells only half the story which is firings. It is so painfully obvious from the data what is lacking most, is new hiring, especially in the small business sector which accounts for half of the job creation in the United States. The average duration of unemployment rose to 26.2 weeks – a half year! – from 24.9 weeks in August; the median spiked to 17.3 weeks from 15.4. It is so difficult now to find a job that a record 36% of the ranks of those unemployed have been searching with futility now for at least six months. In “normal” recessions since 1950, this ratio peaked at just over 20%. It is nearly double that today. In number terms, we are talking about 5.4 million Americans who have been out of work – but looking – for at least six months. This is troubling.

The U6 measure of the unemployment rate, which is the most inclusive definition of the labour force and takes into account the fact that we have a record 9 million people working part-time because they have been pushed off full-time payrolls, hit a new high of 17.0% in September from 16.8% in August. The gap between this rate and the ‘official’ rate of 9.8% is at a record of seven percentage points. The historical norm is closer to four percentage points and so the concept of mean reversion – Bob Farrell’s first market rule to remember – suggests that the unemployment rate is going to be setting new highs for the post-WWII era before too long (the prior high was 10.8% in November-December of 1982). So the chances that we see a 13% peak unemployment rate this cycle is far from a ludicrous proposition at this point; and just in time for the mid-term elections.

The index of aggregate hours worked, which combines hours worked with the number of bodies at work, seemed to be carving out a bottom in July and August; however, it was a false bottom because this critical ingredient into GDP fell 0.5% in September, to stand at its lowest level in six years. For Q3, aggregate hours worked actually contracted at a 3.0% annual rate, so basically, what is keeping the economy afloat is continued strong productivity gains. But productivity growth alone cannot possibly lead the economy into a sustainable recovery — labour input at some point is going to have to kick in. For Q3, aggregate hours worked actually contracted at a 3% annual rate so basically, what is keeping the economy afloat, is continued strong productivity gains. But productivity growth alone cannot possibly lead the economy into a sustainable recovery, labour input at some point is going to have to kick in.

Take note that the Bureau of Labor Statistics (BLS) also announced a preliminary estimate regarding the benchmark revisions that get published every February and they suggest an additional 824,000 jobs were lost in the year to March 2009, which would put the cumulative decline at over 8.0 million (versus 7.2 million currently, which, even in percent terms – down 5.2%, is the worst in 64 years).

Many of these jobs are never coming back, either. The share of the unemployed who are not on layoff is at record 54.3% as of September. In prior recessions, this ratio would barely pierce the 40% mark. In number terms, we are talking about 8.5 million Americans who have lost their job due to permanent shutdowns, a figure that is double what you typically see at the peak of the recession.

Full-time employment is down 10.5 million from the late-2007 peak. Many of these folks have lost their job permanently; but over the past two years 2.8 million have managed to at least find part-time work. Even with this surge in part-timers, total employment relative to the size of the population sagged to a quarter-century low of 58.8% in September.

Looking at the demographic split, we can see the new game that families are playing. Parents are working longer to keeping their kids out of a job – but look at the bright side, at least their education will be paid for. Amazingly, employment among those 55 years of age and older rose 69,000 in September while all the other age cohorts combined lost an aggregate 854,000 On a YoY basis, the older age category is up 1.4% while everyone else is down 5.5% so it is so painfully obvious that the aging boomers are either coming into the workforce or are not leaving their jobs as early as their predecessor did – and this in turn is creating a huge unemployment headache for the younger generation because the youth unemployment rate has jumped to a record 26%.

Do Hedge Fund Managers Have Stock Picking Skills?

Via SSRN (paper by Wesley R Gray):

I study novel data from a confidential website where a select group of fundamentals-based hedge fund managers privately share investment ideas. These value investors are not easily defined: they exploit traditional tangible asset valuation discrepancies such as buying high book-to-market stocks, but spend more time analyzing intrinsic value, growth measures, and special situation investments. Evidence suggests that the managers’ long recommendations earn economic and statistically significant long-term abnormal returns. Oddly enough, these managers share their profitable ideas with other skilled investors. This evidence is puzzling in a world where there is an efficient market for fund managers and asset prices.

Read the paper here

Markets After the Age of Efficiency

John Kay writing in the FT:

As anyone who has taken Finance 101 knows, there are three versions of the efficient market hypothesis. The strong version claims that everything you might know about the value of securities is “in the price”. It is closely bound up with the idea of rational expectations, whose implications have dominated macroeconomics for 30 years. Policy interventions are mostly futile, monetary policy should follow simple rigid rules, market prices are a considered reflection of fundamental values and there can be no such things as asset-price bubbles.

These claims are not just empirically false but contain inherent contradictions. If prices reflect all available information, why would anyone trouble to obtain the information they reflect? If markets are informationally efficient, why is there so much trade between people who take different views of the same future? If the theory were true, the activities it purports to explain would barely exist.

Yet although efficient market theory is not true, it may nevertheless be illuminating. The absurdities of rational expectations come from the physics envy of many economists, who mistake occasional insights for universal truths. Economic models are illustrations and metaphors, and cannot be comprehensive descriptions even of the part of the world they describe. There is plenty to be learnt from the theory if you do not take it too seriously – and, like Mr Buffett, focus on the infrequent inefficiency rather than the frequent efficiency.

…The strong version of the efficient market hypothesis is popular because the world it describes is free of extraneous social, political and cultural influences. Yet if reality were shaped by beliefs about the world, not only would we need to investigate how beliefs are formed and influenced – something economists do not want to do – but models and predictions would be contingent on these beliefs. Of course, models and predictions are so contingent, and an understanding of how beliefs form is indispensable. Economics is not so much the queen of the social sciences but the servant, and needs to base itself on anthropology, psychology – and the sociology of ideologies. The future of investing – and economics – lies in that more eclectic vision.

Read the full article here

Further reading: Culture and Prosperity: Why Some Nations Are Rich but Most Remain Poor