Wednesday, November 30, 2011

Intrade Odds on Republican Nominee

Here are the latest odds from Intrade.  This particular graph begins 1-Oct-11.  Gingrich went from essentially zero to nearly 30 in very short order.

Ronmey and Gingrich seem to be converging, much to Romney's angst, I'm sure.  However, Gingrich isn't the first candidate to "surge", but his timing is sure good. 

What's a Degree Worth

Less and less, it seems.

This piece confirms what Jeff and I discussed in an earlier post regarding the value of education.  It appears to me this also confirms that not everyone should attend college. 

Read about it here.

Tuesday, November 29, 2011

Nanny State set to Regulate Salt in Foods

As if our overbearing government hasn’t intruded enough into our lives lately, the FDA has (quietly) announced plans to regulate the amount of salt in our food.  The super smart and clairvoyant folks at the Food and Drug Administration have determined that Americans are eating too much salt, and they must take action.  Thank God we have our government looking out for our best interests.  How mankind survived before federal regulation is beyond explanation.

How the FDA will regulate this essential mineral, taste enhancer, and preservative is anyone’s guess.  Most likely, the FDA will issue pages of regulations dictating the maximum amount of salt in every single food item churned out by the food industry.  It matters not that I can grab my readily available salt shaker and add salt to my salt-deficient grocery store food.  No.  Other people have determined that I don’t need all that salt, and by God they are not going to let this travesty befall me and my fellow Americans.

I don’t care what reason the FDA trots out to justify this intrusion into my dinner table – it falls well beyond the scope of their responsibility.  My preference for choosing salty foods trumps any dreamed-up responsibility the government believes it has to protect my health.  Either I am free to express my preferences at the grocery store or we have entered a new paradigm where government is free to impose its preferences upon me in the name of: safety, health, ______, etc.  Hence, I am no longer free, but subject to the whims of a benevolent dictator.

If you should care to leave a comment for the FDA regarding this new idiotic proposal, you may do so here.

Now, please pass the salt.

Thursday, November 24, 2011

What Should You Be Thankful For?

One Thanksgiving tradition my family has is to state what each person is thankful for before eating. This is done in place of grace (the prayer before eating). To my recollection, nobody has stated what we should truly be thankful for at our gatherings. It is this: freedom. If it weren't for freedom, most of us that currently live in North America would not exist. Many would have perished in those first harsh winters at the Plymouth colony.

But freedom did prevail, and the Plymouth colony, which had been previously organized in a communistic structure, was reorganized in a free market or capitalistic structure. Whereas upon arrival everyone worked common land and contributed to a common fund, after reorganization everyone worked their own land and contributed to their own well being. The effect? Harvest yields went up, way up. Theft and other commercial crime went way down. Given these two effects, I speculate that life in the colonies was much better under the free market than under the communism that prevailed beforehand.

So today, give thanks for freedom. And, by God, do everything you can to promote it.

Sunday, November 20, 2011

Characteristics of a Price Bubble

After the tech bubble and real estate bubble each burst, there is much discussion as to the next bubble. From what I can tell, there are two popular candidates: education, i.e. tuition, and health care, i.e. insurance premiums. In this post, I’ll discuss the two first bubble candidate. I want to first discuss in general terms what constitutes a bubble.
Define the capitalized value of an asset as the present value of its future expected net cash flows (revenues less expenses). A general formula looks like this:

P0 = CF/(r-g)

where P0 is the price of the asset (capitalized value today), CF is the net cash flow per period, r is the discount rate, and g is the expected growth rate in the cash flow. The discount rate should reflect the time value of money and all the risks faced by the asset holder due to the asset ownership.

For stocks, CF is the free cash flow available to equity holders (FCFE). Free cash flow is available for reinvestment in the firm or to be paid out to equity holders as dividends or stock buybacks. Negative free cash flow means the firm needs financing from outside, whereas positive free cash flow means the firm is generating more internal cash flow than needed to maintain its business.

The capitalized value of the asset increases if expected future cash flows increase, or if the discount rate decreases. Of course there is a lot of noise in those expectations, so we expected capitalized values of assets with noisy information to be at least somewhat volatile.

A price bubble is defined as a price increase that is not generated by changes in expectations of future cash flows or the discount rate. In other words, it is a price increase that is not connected to the fundamentals of the asset. The trouble with identifying a bubble is that market participants can have legitimate (i.e. based on sound research and reasoning) differences in their expectations of the future cash flow that an asset will generate. Further, people can have a different personal discount rate and attitude toward risk, which leads to differences in discount rates.

Now, in stock/bond pricing, discount rates should not deviate much across investors, since the required return is priced by the marginal investor. That means the only thing driving discount rate differences should be risk factors. But, for things like education, I think the story is different.

With education the asset being purchased is predominantly a signal, with some human capital development. It’s not clear at all that the human capital development can only be done through higher education, but that’s another topic. The point is, the expected cash flow generated from the asset is the so-called education premium. In other words, the student is purchasing a higher expected salary. These expectation differ by degree level (Bachelor’s, Master’s, Ph.D.) and by type (Business, Engineering, Arts, etc.).  

The premium of the typical bachelor’s degree over high school is $20,000/year (data here). Now that includes degrees of all types. I don’t have data for different majors. Using data on average tuition from here, the average state school costs is $33,000 for all four years for an in-state student. But wait one minute! Not only is there tuition, there is the opportunity cost of not working full time while in college. Let’s assume the full-time student won’t work, so we’ll add four years of high-school earnings to the investment. That’s $112,000.

Let’s see what the implied capitalization rate is. Take the average degree premium as the dividend and the total investment as the price, we find the implied capitalization rate is 13.7% in this case. This is an enormous discount. The lower the capitalization rate, the higher is the price relative to the dividend. Implied discount rates for out-of-state students are 12.3%, and for private schools it’s 9%.

At first blush I would say there is little evidence of a bubble in higher education. The problem is coming from bad combinations of tuition and degree (major). If your major does not promise greater than $28,000/year in earnings, on average, the college degree you’re getting is (guaranteed) not worth it.

Now, if you go to an in-state school, in order to get a 5% return on your money, you need a salary premium of $7300/year, after tax. That’s $10,400 before tax, assuming an average tax rate of 30% (federal and state). So if you want to score a job that pays off your education, you need to earn around $40,000/year. If you go with a 10% return, you need closer to $50,000/year. This is reasonable for engineering and some science jobs, and some (not many) business majors. You won’t be getting anywhere close to this with a humanities or social science degree.

My argument is that the average college degree pays off the degree holder. But within that are some very bad choices. In the end, the individual must make careful, informed decisions. 

Friday, November 18, 2011

Some Perspective

The so called congressional supercommittee is charged with coming up with $1.2 trillion in cuts by 23-Nov.  If they fail to reach agreement AND Congress (both houses) doesn’t adopt their proposal by the end of the year, automatic cuts of $1.2 trillion are triggered.  These cuts would begin in FY 2013 (Oct 2012) and would be phased in over 10 years.

Many are predicting doom should Congress fail to meets its deadlines, but let’s calm down.  These cuts are hardly draconian.  The chart below shows two figures: the large bar represents the total budget outlays in FY 2011, and the other bar would be the cuts.    

Question: Would we even notice?

Thursday, November 3, 2011

Government Spending

Government spending is front and center these days.  Even now, the new congressional select committee has just a few days to come up with $1.5 trillion in cuts or automatic cuts of $1.2 trillion go into effect starting in 2013 (to be phased in over ten years).  Should this scenario play out, the Department of Defense will shoulder half of those cuts.  November 23rd is the drop dead date for the committee to submits it’s proposal to the Congress. 

One common and perhaps persistent misperception is that Democratic presidents are much bigger spenders than their Republican counterparts.  To evaluate this, I looked at our two most recent presidents: Clinton & Bush Jr.  I didn’t include Obama because he hasn’t served at least one full term yet.

I used data from the CBO on defense and non-defense spending.  I then graphed spending during the Clinton years and during the Bush years.  The last graph shows percent change from year to year, beginning in 1991.

Looks like Bush, a Republican, is the bigger spender here.  Of course, 9/11 happened on Bush’s watch, and that certainly played a role in the increase in spending.  One thing is for sure, those who claim government isn’t spending enough are flat wrong.