Thursday, October 20, 2011

Target Zero Inflation

Why do we take for granted an inflation target of two percent?  Is it because we buy the argument that it is a small number, and that the Fed needs wiggle room to lower rates in times of recession?  Is this target really as innocuous as it sounds?

Part of the rationale for a positive inflation target is that people will stop spending if prices go down a little bit.  Some economists believe we will put off purchases for as long as we can to get a better deal in the future. Really?  You won't buy something today because it will cost one or two percent less next year?  I don't buy it, no pun intended.

If you have worked hard and saved money inflation causes problems.  Interest rates reflect a number of forces.  First, there is the return needed to compensate for risk and to compete with other investment opportunities.  This is called the "real" rate of interest.  The interest rate also reflects expectations about future inflation.  Add the two together and you get the "nominal" rate of interest - the number quoted in the news and at your bank.

The problem with inflation is that if you choose not to invest - maybe you just didn't see anything you liked - you will lose money as inflation will make your dollars worth less in the future.  This forces people to invest money when they wouldn't otherwise.  Isn't it possible that savers would get a better deal, a higher real interest rate, if there was no inflation?  This could occur because borrowers would have to compete against the saver's option to do nothing.  Inflation takes this option away and offers nothing in return.

Wednesday, October 13, 2010

The Flash Crash and High Frequency Trading

The Security and Exchange Commission’s 151 page treatise on the “Flash Crash” may seem like a meek effort compared with heath care and financial reform.  However, I have the feeling they are just getting warmed up.  Expect a sequel in the form of new regulations on how stocks are traded.  You can simply substitute “high frequency trader” and “algorithm” for “insurance company” and “banker” and otherwise retain the gist of the same old plot.  Bad guys exploit good guys, regulator-politician rides in, pen in hand, and saves the day.
If it were only so easy.  To understand some of the underlying problems exposed by the Flash Crash we have to rewind the clock a bit.  In the 1990’s the regulators had an idea.  To help investors do better they decided to change something called the “minimum tick”.  For those not in the know, the minimum tick is the smallest price increment used in trading stocks.  Think of it like a penny when you go into the store.  Back in the old days the minimum tick was 12.5 cents, better known as one-eighth of a dollar.  Stocks were quoted and traded in “eighths”.  Too bad if you wanted to pay $50.05 to buy a share.  You couldn’t do it.
Over the turn of the millennium the regulators succeeded in reducing the minimum tick from an eighth to a penny.  In a tip of the hat to the American consumer, trading stocks could now feel just like going to Walmart.  Everything seemed peachy until the Flash Crash occurred.  Like red-faced parents whose kids have acted out in the playground, Mary Schapiro at the SEC and Gary Gensler at the CFTC demanded to know “who done it”.  Angry politicians couldn’t pass up the opportunity to stick another pin into the Wall Street voodoo doll.  Now that the culprits have been fingered all we have to do is sit back and wait for the rule makers to fix the problem.  I am going to submit to you that the regulators have it all wrong, and argue that they themselves are to blame.
The move to trading in pennies was a bad idea.  A sound market is defined by a relative balance between those who consume liquidity and those who supply it.  In addition, it is a place where no one can jump ahead in the line and check out first.  When we went to pennies the liquidity suppliers quickly became discouraged.  They found that whenever they tried to post a meaningful order someone would soon jump in front of them for the cost of a mere penny.  To make things worse, current rules allow orders to be filled away from the exchanges, using exchange prices as a guide, without any regard for the people taking the risk to set the prices in the first place.  The combination of these two has proven to be toxic to market quality as the number of bona fide liquidity providers has shrunk and the number of liquidity consumers has grown.
Don’t blame the high frequency traders.  They are rational and innocent actors in this drama.  The change to pennies placed a premium on speed, both for quotes and orders, as the number of price points increased dramatically.  It significantly reduced the compensation for providing liquidity by granting free options to free riders.  Order sizes shrunk and message overhead grew, prompting exchanges and their clients to invest in technology and cut deals to put computer servers close to the action.  
Confusing and ever evolving order priority rules have allowed off-exchange venues to flourish as it is relatively costless to transact in front of existing orders on the exchanges.  For folks like internalizers, the SEC decided it was OK to cut the penny.  
There is a way to fix this mess.
First, make the minimum tick a function of the stock price.  One cent for stocks under $10, two cents for stocks between $10 and $20, three cents for stocks between $20 and $30, and so on.  With a mandated minimum spread that makes some economic sense the relative balance between liquidity consumption and provision can be restored.
Second, those who seek to internalize order flow or participate in dark pools need to satisfy similarly priced existing orders on major exchanges before participating in the trade themselves.  Allow no splitting of the minimum tick and require all trading venues to honor the same minimum tick.  
Third, define what an exchange is and what it does.  It seems that we have gone from one bad extreme to another; from insider owned exchanges with special privileges to a tangled mess of communication networks.  We need to find a middle ground where exchanges serve their utility purpose with adequate competition and minimal complexity.
Fourth, ensure a level playing field by making no distinction between different players in the market.  
Fifth, ban the market order.  An investor needs to state a minimum or maximum price or they are not an investor.
Finally, regulators and investors have to accept that the world is fraught with risk.  Investor confidence comes from a market that is fair and easy to navigate.  Sure, there will be times when imbalances result in volatility.  A good regulator should not try to hide this fact but instead should ensure that it creates the price signal necessary to find a new equilibrium.  The fact that the Flash Crash lasted only minutes and not days is testimony to the fact that prices do convey information that motivates investors to trade.  The key is creating an environment that favors price discovery over a frenzy of prices. 

Monday, April 5, 2010


Have you ever had a discussion about China with friends or business associates? Sometimes these conversations border on hysteria in a way that reminds me of how people viewed Japan in the 1980’s. The paranoia culminated with a best selling book published at the height of the frenzy and titled, “Yen!: Japan’s New Financial Empire and Its Threat to America”. You can now buy a used copy of this book on Amazon for one penny.
Maybe China presents a more serious threat. I believe that one of the biggest challenges of our time is the stagnation in median incomes in the United States. Adjusted for inflation, the income of the typical worker in our country has been basically unchanged for the last twenty years. One of the byproducts of this trend is the divisive state of our nation. How many times over the past couple of years have you heard the phrase “fair share” in political discussions? I don’t think you can have an intelligent discussion on these income trends however without first talking about demographics and trade.
The US worker has been a victim of his/her own success in a world where most of the people are poor. Trade liberalization, improvements in shipping, and the technology revolution have conspired to shift the balance of power between labor and capital. However, the news is not all bad. Tighter economic integration is making the world a safer place and is lifting many of the world’s poor out of what we would consider to be horrific living conditions. Some believe that if the price to pay for this is a generation-long stagnation in wages in the richest country in the world so be it. The question that we have to answer in response is what economic policy should be implemented to improve the state of affairs for American workers.
The typical business education in international economics discusses the benefits from trade in the following way: Assume that there are two islands in the world. On one island the people are really good at growing bananas. On the other island the people are great at fishing. Every day they jump in their canoes and meet midway to trade their goods. At this point, the professor usually runs to the blackboard and puts up some fancy charts and formulas that show exactly how much standards of living are improved by trade. As an encore, the analysis proceeds to demonstrate that both groups are better off with trade even if one of the islands is better at both growing bananas and fishing. This magic is called “comparative advantage” and I encourage you to check it out:
Unfortunately, the application of these ideas in the real world is a bit more complicated. Look closely at global trade and you will find that wage arbitrage, regulatory arbitrage and the exportation of pollution are important drivers of trade flows.  Are the factories in China there simply to benefit from cheap labor or do environmental regulations play a big role? One of the reasons that business leaders in developed countries rail against cap and trade is that it will put their companies at a further competitive disadvantage to places like China where environmental regulation is far less stringent. It is a fair point.  
The Chinese get testy when they are asked about their lack of respect for the environment. A common response involves reminding us that we had our dirty industrial revolution and they have every right to do the same. On the face of it this seems like a compelling argument. What right do we have to look down our noses at the Chinese when we consume and pollute much more on a per capita basis? I believe there is an answer to this and it involves using some economic theory so buckle up.
In economics, pollution is treated as an “externality”, which is a cost not tallied up in the transaction between a buyer and a seller. Instead, the cost is borne by others not involved in the deal. If you believe in free markets it is tough to say that folks who derive no benefit from a transaction should bear some of the costs. Yet this is largely the state of affairs, even in the US. How did we get here? Part of the answer has to do with “network effects”. You might remember network effects as something used to justify the valuations of Internet firms. Consider the telephone. The more people that buy telephones the more valuable the telephone is to each owner. This is an example of a positive network effect and the benefits grow exponentially as the number of users increases. Pollution is a negative network effect. The more people there are the higher the cost of a given unit of pollution. In addition, with more people there are more units of pollution leading to a similar exponential outcome. In the days of Davy Crockett and Daniel Boone people could throw their trash out the window without much concern that negative network effects would run wild. Herein lies the rebuttal to China’s desire for an environmental free ride - today the cost of pollution is much, much higher than it used to be. If you don’t believe it consider that on some days up to three-quarters of the black carbon pollution found in Los Angeles emanates from Asia (source - Wall Street Journal).
Let’s get back to our predicament with stagnating incomes and the need for sound economic policy. One of our most important assets is the accumulation of intellectual capital in our companies and in our people. Now, consider China’s trade policy and the typical arrangements firms often enter into in order to do business in China. The Chinese know that foreign corporations are desperate to participate in their market. The reason is that if you miss out on selling products to the one billion plus Chinese your firm will be at a big disadvantage to the firms that do because of something called “economies of scale”. Those firms that get to produce in size will have lower per unit production costs and eventually the smaller companies will be uncompetitive. The Chinese leaders have exploited this masterfully and require that foreign firms partner with local ones in order to gain entry. Why do they do this? The answer is that they want access to intellectual capital. It makes one wonder how welcome foreign firms will be once the Chinese feel they have learned enough.
Some companies have decided not to stick around long enough to find out. Google recently decided to stop censoring its Internet search in China and is prepared to exit the Chinese market. Sergey Brin, one of the co-founders of Google, immigrated to the US from Russia when he was a child. One of the factors driving his decision to leave China involved parallels between the actions of the Chinese government and those of the Russian government that he left behind. A massive hacker attack originating in China that targeted Chinese dissidents via their Gmail accounts was the straw that broke the camel’s back. We should learn something from this guy.
Sound policy should involve recruiting more people like Sergey Brin to our country’s schools and businesses. Unfortunately, we do the opposite when we restrict visas. In our discussion of environmental policy we need to encourage domestic research, development and production of technologies that we will use to wean ourselves off of dirty fossil fuels. Instead, we subsidize the production of fossil fuels and corn ethanol while we buy windmills made elsewhere. Our attempt at environmental protection is a cap and trade proposal that will put billions of dollars into the hands of Congress and weaken our businesses. As an alternative, we should try to make sure China is at the table in agreement when we jointly determine a path to reduce carbon emissions. Our tax policy is designed to buy votes from the middle class. Nowhere is there a discussion of the hard choices we need to make in addressing the stagnation of middle class incomes. You don’t get to supersize your pantry at Walmart on the cheap and see meaningful income growth, at least not in a world where so many people make a fraction of what you do.
What should the China policy be? Let's start by focusing on four areas that compromise textbook free trade: currency policy, pollution, labor regulations and intellectual capital. I would propose gradually introducing a system of penalties on imports produced in places where local labor regulations fall significantly short of our policy. In cases where a country refuses to allow its currency to respond to market signals (which act counter cyclically to correct trade imbalances) we need to estimate and impose some price adjustment to be fair to domestic companies. On the issue of pollution externalities, we should obtain firm, verifiable commitments on a timeline to eliminate pollution arbitrage from trade flows. Finally, trade and cross border investment needs to be comparable when it comes to mandatory joint ventures and divestment of intellectual capital.

We could consider a tax policy that motivates companies to locate and hire in the US. A recent bi-partisan proposal by Ron Wyden (D-OR) and Judd Gregg (R-NH) is a step in the right direction. They suggest that we have one single flat corporate tax rate of 24%. It is a surprise to many to learn that the US has one of highest corporate tax rates in the world.  Tax policy is critical because it is one of the few tools we have to help offset the substantial differences in per capita income between our workers and those in less developed countries.  

Finally, we should change our immigration policy to allow skilled and educated foreigners to come to the US if they partner with private equity investors or other sources of capital to start companies.  Instead of thinking of ways to punish entrepreneurs with higher taxes or barriers to entry we should be sending invitations.  An influx of talent and energy combined with job growth is a proven way to improve both our standard of living and address our budget challenges. 
In the interim, don’t run out and buy a copy of “When China Rules the World: The End of the Western World and the Birth of a New Global Order” at Amazon for $19.77. I have the feeling that the “least worst system” we know as free market capitalism will survive to live another day. All you have to do is play your part by working hard and voting smart, and encouraging others to do the same.

Wednesday, December 3, 2008

Stock Market Expectations

“A stock is just a bundle of information masquerading as a security.”

If this is true then the information being conveyed these days seems quite bad. It is widely assumed that stock prices reflect investor’s expectations about what is going to happen in the future. Our job as investors is to try to determine if these expectations are rational or if there are opportunities for the taking.

To try and put current stock valuations into perspective I built a model to analyze what the market is saying about different industry sectors. The general idea is that at the most basic level all stocks are created equal and it is only differences in future earnings prospects or differences in risk that explain rationally divergent valuations.

The analysis seeks to help answer the following questions:

1. What long run equilibrium earnings yields are necessary to justify today’s sector valuations?
2. What kind of growth rate in earnings is required to explain risk-adjusted valuations?
3. Which sectors seem overvalued and which seem undervalued?

The model is similar to a dividend discount model except that earnings are discounted to obtain a present value for each sector. I forecast net income out four years with a terminal value calculated using the last period’s earnings. The discount rate for each sector is related to its risk and is calculated by multiplying a baseline discount rate of eight percent times that sector’s beta. The beta is the median company beta in each sector, calculated using the prior three years monthly returns. Thus, an important assumption of the model is that long term risk can be adequately represented by historical risk. Informed readers will note that this approach is a watered down version of CAPM combined with discounted cash flows.

In order to equate the present value with the current sector market capitalization, I used a linear program to solve for the required earnings yield in year four. In this calculation, current market capitalization was used as the denominator. Annual net income figures were found by interpolating between the trailing twelve month net income and that in year four. The slope of this net income trend was divided by average net income to obtain the implied growth rate. The results are presented below. Market value and net income (NI) numbers are in millions. The data was based on closing prices on December 1, 2008. The universe is the S&P 1500.

Let’s start by looking at the implied growth rate. The model output suggests that the financial sector recovers in year four to a level of profitability last seen in Q3 2003. To put this in context, this level of profitability is roughly half that seen at the end of Q3 2007. Given the need to permanently reduce leverage, this seems reasonable. For perspective, note that financial sector debt was roughly 20% of GDP in the early 1980’s and got as high as 115% in 2007.

The consumer staples and utilities sectors seems to be showing their stripes as a defensive plays (note the low betas) and appear undervalued. In order to justify its current market valuation, consumer staples profits need to decline by 5%. Profits in utilities need to decline by 12%. Contrast this with information technology, which needs to expand by 9% annually to reach fair value.

As a sanity check it is also useful to see what the model is saying about the broader market. For the market to be fairly valued, at least when using a discount rate of 8%, earnings need to expand by 7% annually to slightly over $700 billion in 2012. This compares with the average profitability over 2005 and 2006. Note that the roughly 2% increase needed in the market earnings yield can be explained by the recovery in profits forecasted for the financial sector.

Like all forecasts, the model used here is highly sensitive to the inputs provided. A decrease in the discount rate, which will be required when risk premiums decline as the financial crisis abates, will signal a major buying opportunity. For example, lowering the baseline discount rate from 8% to 6% indicates that the market is undervalued by 36%. On the other hand, using a rate of 8% could be considered generous in an environment where investment grade corporate bonds yield 7.5% and high yield bonds are off the charts. If we increase the baseline discount rate to 10%, the market is 21% overvalued. It appears that a meaningful and sustained decrease in corporate bond yields is required before stocks can embark on a meaningful recovery.