Tuesday, September 2, 2014

A Perennial Argument in Financial Economics


This post addresses the presence of “bubbles” in asset prices. The first task is to define a “bubble,” partially so we know what we’re discussing, and partly so I can stop using scare quotes. The intrinsic value of an asset is the present value of the future cash flows, discounted at the appropriate rate, called the capitalization rate. The capitalization rate is the required return on the asset less the expected growth rate of the cash flows themselves. For equities, the cash flow is the sum of: (1) dividends, (2) capital gains including those arising from buybacks. VNote that a lot of the work in finance is about the correct model for the required return. For example, the Capital Asset Pricing Model (CAPM) and the Fama-French three factor model. I’m not going to go over those specific models in this post, but I will discuss the importance of the required return shortly.

When discussing the stock market as a whole, we can arguably use a simplified valuation equation, known as the Gordon Growth model. The Gordon model assumes a constant growth rate of the cash flows. This simplification allows us to see the three factors that affect asset values: expected future cash flows, required return, and expected growth rate. These factors are the fundamentals of the asset. Now, in financial economics, we think of a “bubble” as a fourth factor, one that causes the market price to deviate from the intrinsic value. The equation would thus be:

So is any deviation from intrinsic value is a bubble? That would be true in a world of perfect information and foresight. But recall we estimate everything, and have imperfect knowledge and information, so the market value can substantially deviate from the intrinsic value without there being a bubble. This fact makes a bubble extremely difficult to detect except (maybe) in hindsight. Essentially the best we can do is to say something like “market values are very difficult to justify based on what we know about stock market fundamentals and what’s likely to happen in the future.” But caution doesn’t put your name in the papers.


My opinion is that most disagreement comes from the growth rate. I remember during the asset price run-up in the late 1990s (the so-called tech bubble) so many talking heads on the financial television shows were spouting “new economy” to justify extraordinary valuations of stocks. That’s basically an argument about growth rates. Another source of disagreement, although less so, is the required return. The problem with required return for the stock market as a whole is that it is often backed out of the valuation equation (2) using current asset values. Thus it amounts to the same bit of information but viewed in a different way.


So now we have the definition of a bubble: market prices that are not justified by the underlying fundamentals. We also now realize how difficult a definition this is to apply. That’s two reasons we see so much fighting about bubbles. And, even if we could positively identify a bubble to everyone’s satisfaction, we have no ability to time the bursting of the bubble.


I recall a paper by Scheinkman, in the early 2000s, in which he showed that a market participant that knew, for a fact, the market was currently in a bubble would still have incentive to trade because of the ‘bigger sucker’ factor. So merely recognizing the bubble exists is not enough to say it should pop. It’s also a question of when others decide there’s a bubble. By the way, there can also be negative asset price bubbles; it’s just that most bubble talk happens when asset prices appear to be abnormally high.


In the interests of responsible journalism, what I’d like to see happen is replacement of the use of “bubble” with “asset prices seem abnormally high/low.” While that might seem mealy-mouthed to some, it’s actually the only truly justifiable statement. And, if you truly believe asset prices are abnormally high, keep your mouth shut and trade: buy puts for example.


To close this post, I'll draw your attention to the trend lines drawn in the graph of Real NYSE prices below. The trend line with the highest slope would be what we'd get if we had the same stock returns during the tech boom. It's off the chart at the top. The trend line with the lowest slope is simply connecting the low point prior to the tech boom and (almost) the low point reached when the real estate crash bottomed out. The third (moderate) trend line is tracing the slope from prior to the tech boom, and assuming that the returns during that period are a reasonable guide. If that moderate trend line is correct, then a large portion of the stock boom since the mid-1990s has been unjustifiably high. But the question is, where's the bubble? It depends on where the trend line "should" be.





Wednesday, March 5, 2014

Obamacare Just Made Americans Richer Without Anyone Noticing


That’s what the headline in the Huffington Post said.

If all we need to become richer is legislation from Washington D.C., why hasn’t this been done before and sooner? If mere laws can create wealth, our riches are limited only by our imagination. 

The sad and undeniable truth is that wealth is not created by legislation. Washington can only force the transfer of previously-created wealth from group A to group B, while skimming a little off the top for itself. Even my grade school children are wise to this fact.


Crimea = Iraq?


I  read today where the government of the United States is preparing to enact sanctions against Moscow for invading Crimea. Isn’t this just a little hypocritical? Did Russia, or any country for that matter, slap the United States with sanctions when we invaded Iraq ten years ago?

After 9/11, not only did we falsely claim that Saddam Hussein was preparing to unleash a torrent of WMDs against the United States, but we deployed our finest salesmen to convince a skeptical world that it was true. Now, we scorn another world power for doing what we did.
  
Maybe Putin is convinced Crimea has WMDs. His only miscalculation may have been failing to convince everyone else before invading.

Tuesday, February 18, 2014

Lack of competition means higher prices


I was shopping at a large E-Mart store in Seoul the other day and decided to do a little sleuthing of their electronics department.  Korean E-Mart is equivalent to Target in terms of inventory selection, store ambience, and shopping experience.  It might compare to nicer, newer super Wal Mart stores, but from my experience, Target is a better comparison.

While perusing the TVs, I noticed that only two brands were offered for sale: LG and Samsung. I could find no other brand of television (or computer) throughout the whole store. No Sony, Panasonic, or Vizio.  Only Korean brands on sale here.  So, what does the lack of competition mean for the average Korean consumer? Higher prices and less selection, of course.



I randomly picked seven televisions for my analysis: 3 LGs and 4 Samsung’s.  I noted their price in Korean Won and converted it to dollars at a 1,060=$1 exchange rate.  I then searched Amazon.com and New Egg for the same model and noted the price.  In cases where Amazon and New Egg prices differed, I took the average.  I then calculated the percent increase that Koreans pay compared to US customers.  Have a look.


In one instance, Koreans paid one-and-half times the price Americans would pay for the same product. I suspect that if I were to analyze computer prices, I would find similar results.
 
Korean culture is fiercely nationalistic, and they pay handsomely for their country loyalty. I’m not exactly sure why non-Korean TVs aren’t sold at E-Mart – it could be a company decision (doubtful, but possible) or government restriction (more likely). However, one thing is clear: these two companies are looting their customers, most likely with the aid of the government. Without any competition from outside brands, LG and Samsung can charge artificially high prices, and the result is that Korean customers are made worse off. Competition would mean more selection and lower prices, something that I bet most Koreans would embrace given the chance.  

Sunday, January 19, 2014

What I Learned About Fitness From Watching My Dog

I have an English Bulldog and I enjoy watching him do his dog stuff. After getting more interested in ancestral (aka primal, paleo, etc.) health, I started to watch him for more than enjoyment. I noticed some lessons I can learn from him regarding exercise.

First, bulldogs are solid muscle. They are not naturally fat. A fat bulldog is a sign of an over-indulgent owner, and that's bad for the dog. But I digress. Bulldogs of all types are solid muscle, naturally. But they don't lift weights or do cardio on machines. They just do dog stuff. Oh, by the way, bulldogs do need a fair bit of exercise. The laziness is a myth. No, they aren't crazy runners like labs or border collies, but they do need a couple miles of walkies every day.

Now, if you take a dog to a big field, or you live on an acreage, you can leave them off the leash and observe their instinctual behavior. My dog likes to patrol. He walks the perimeter rather slowly. Every now and then, he sprints like crazy. Way faster than I can. Apparently bulldogs are natural sprinters. Now, given their weight, bulldogs really only need that walking/sprinting to maintain muscle tone. But they also like to play. He's big on tug-of-war and chewing, both of which are great for his neck and jaw muscles. So all of their activity is 'working out' in a way, because it's exercise, but ultimately it's just play.

So the first lesson I learned: make exercise more like play. Second lesson: walk a lot, but slowly. Spring occasionally. The third lesson comes from watching him jump his weighty butt onto a couch. And that is to lift heavy things occasionally. It's all about functional fitness, because he wasn't doing anything to look good. He's already pretty :).

Thursday, January 16, 2014

Unemployment insurance, but for how long?


If you were the parent of an unemployed child (not referring to age here), how many weeks of unemployment benefits would you continue to dole out to your kid before you realized that those cash payments were becoming a disincentive to work?  At what point do you say enough is enough?

Tuesday, January 14, 2014

Whole Foods Love

A new Whole Foods opened up on my walking route between work and home. I can only say they are going to get a large portion of my paycheck. I was wandering through there today, picked up some nice beef bones for stock (I prefer a good butcher for this, but good butchers are longer than walking distance for me), and a beautiful chuck roast. I also found some Larabars, which are great paleo/primal-friendly snack bars. The main ingredient is chopped dates instead of cereal, so while they have a fair amount of natural sugar, I think they're fine in moderation.

The new find, which I really enjoyed, was an Epic beef bar. It's made from grass-fed beef, with dried cherries and habanero. It was quite delicious and gave me a lot of energy during my trudge (lots of snow overnight) home. Definitely will be stocking up on those bad boys! I love the paleo/primal food movement - it has led to some really excellent developments in all aspects of the food supply chain.