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.

Sunday, January 12, 2014

Living off the Grid - An Exercise in Logic

I admit to being attracted to the notion of living off the grid - separated from the utility networks, living off the land (sort of), and being more secluded than typical city dwellers. Personally I like seclusion, so that's the biggest draw for me. But as I've looked into it, I've noticed a few arguments for living off the grid that sound good at first, but after some thinking may not be altogether accurate.

The first argument is that it is more environmentally friendly to live off the grid. If you are not on the power 'net, then of course the power generation goes down by whatever you consumed. But is the reduction in power usage due to one household going to make an appreciable difference? Frankly I doubt it, especially if the power plant is designed to provide power to, say, 50,000 households. In fact, the power plant will not reduce the amount of energy it produces. What will happen is, if the plant makes more than is needed, the power will be sold to other companies that don't produce enough power (I'm looking at you, California). So the marginal change in power usage is very small. But not zero, and the amount of reduction would become quite meaningful if, say, 1,000 households left the greed. I'll come back to that point in a minute.

Now, what about generating your own power off the grid? This is done through a combination of wind and solar power, neither of which generate carbon as part of the energy generation process. However, the rigs to transfer energy from solar panels & windmills to batteries look pretty complex, and those have to be manufactured. So certainly there is some pollution resulting from the manufacturing of these products. Furthermore, such power generating rigs take up more space per household than do commercial power plants.

So I would argue the environmental impact per household is small, but I don't know in which direction it goes. That would take a fair bit of research and would be based on individual households power usage & how it is supplied. I'm just raising the point that it's not a clear-cut reduction. It could go either way on an individual basis.

On a large-scale basis, I think the story changes and it's because of efficiency & space arguments. If thousands of households go off the grid, they are all going to need individual power stations which will take up space. This is very inefficient, and producing all these power rigs may well generate more pollution than the marginal reduction in power generation, although it would be more concentrated rather than spread out over time.

In this post, I simply wanted to raise a concern about the environmental impact of living off the grid. In my next post, I'll be thinking about off-grid living on a large-scale basis especially as it impacts the amount of space required per person. I plan to show, logically, that off-grid living for a large number of people would necessitate a significant reduction in population. That is to say, the only way the world can support 7+ billion people is through technological efficiency, i.e. on-grid living.

Tuesday, January 7, 2014

Living on 24 Hours per Day

This post is inspired by Arnold Bennett's 1910 book "How to Live on 24 Hours a Day." You can get the book for free online. It's a very short book, taking less than an hour to read. While it's short, it offers a very interesting structure for 'living' as opposed to 'vegetating.' In saying 'living' Bennett means mental development and involvement in the world, with a goal of happiness in one's own life. In this post, I'm going to break down Bennett's program into a simple plan and add in some of my own thoughts on the plan.

Bennett's general program is to take 30 minutes every morning, six days per week, and 90 minutes every other evening, and use that time to read (evening) and reflect (morning). The trick is to make the reading something mentally straining, that requires some exercise of the mental faculty. Bennett discusses several different categories that one might read, but leaves the subject open to the individual pursuing the program of reading & reflection. Bennett acknowledges sequestering 7.5 hours per week involves sacrifice, but also claims it is necessary and worthwhile to live an engaged life.

The steps as I see them (arranged to balance ease & importance).

1) Find 30 minutes in the morning to reflect.

     Reflection means concentrating the mind on a topic and thinking deeply and carefully about the topic. Concentration is quite difficult, and if one is not accustomed to it then it will take time to build this skill. To assist in developing the skill, I would suggest mindfulness meditation (as opposed to mediation for relaxation).

     I understand it may be difficult to find this time. If you work at a day job, morning is often a hectic mess to fly out the door to get to work on time. I suggest trying to rework your morning so that it's calmer. At any rate, public transportation can be an ideal time for reflection. One turns inward, and ignores surroundings, during a period of reflection. Personally I walk to work, so that's not ideal for reflection. But if one takes the train, for example, or a commuter coach, I can think of no better time for reflection.

     If the ride to work is not a good time for reflection, then you have to carve some time out of your morning routine. This might involve getting up 30 minutes earlier than is currently the case, or sacrificing something you are doing in the morning. This is important, because without the period of reflection, you will gain little benefit from the all the reading you will do, and your mind will not grow. The result? You'll be stuck right where you find yourself, without moving closer to a happy, fulfilled life.

2) Find 90 minutes every other night to read.

     Bennett recommends sequestering more than 90 minutes, because if one will read something difficult for a total of 90 minutes, one has to allow for potential distractions. As mentioned earlier, one should chose something that stretches the mind, but it should also be an area of one's interest. Being a specialist in an area is a source of great joy.

     When just starting on the program, one shouldn't set too ambitious of a goal. If you are interested in philosophy, for example, don't try to tackle Kant straight off. Start with some introductory reviews, and then get to the more complex material once you've laid a foundation. Otherwise, you may find the reading too onerous and give up.

     As one is reading, one should be tuned in for anything that gives some indication of cause and effect relationships in the world. The ability to discern cause and effect in the world will go a long way to help alleviate the view that the world is somehow capricious or simply a series of accidents. In Bennett's words, understanding cause and effect will lead one to become "large headed and large hearted."

These first two steps are sufficient for the first three months. As time progresses, more time may be spent reading, or more days. Also, the difficulty of reading may be increased as one's mind becomes more trained. The next steps are really just advanced versions of these two basic steps.

3) Reflect on happiness, the direction of your life, what life is giving you, and the relationship between principles & conduct.

     Bennett asserts that happiness comes from development of reason and the adjustment of conduct to principles. Just what those principles are may come from reflection, or one's own background, or what have you. At any rate, use the reflecting time to dwell on your principles and determine whether or not your conduct is consistent with your principles. As time passes, use your reason to align your conduct with your principles, and you will find happiness. This is much more desirable than letting instinct guide actions, which is far more common.

     One may also expand the reflecting period beyond just the morning time to the evening, on the way home from work. This seems to me a good time to think about one's conduct during the day.

4) Suggested reading topics.

      If you are not sure what to read, Bennett offers some suggestions. His primary suggestion is poetry. From my own experience with poetry, I agree with Bennett. I especially like Kipling, Whitman, Frost, and Service. But poetry is taxing to the brain, and takes a fair bit of thought to understand what the poet is trying to say, which makes is more desirable for the task of expanding one's mind than prose.

     I personally suggest all people to obtain some understanding of economics. Begin with Hazlitt's "Economics in One Lesson" and then move on to Rothbard & Mises. This, in my view, is an excellent method of understanding the cause & effect of the world. Bennett also recommends Marcus Aurelius and Epictetus. But this, in the final reckoning, is the reader's choice.

The idea behind this program is to live a happier, more fulfilled life. One that is more thoughtful, more deliberate, than the one you might be living. But of course, if you are already happy and fulfilled and aren't doing something like this program, then please let us know your secret in the comments section!