Zebra Investing

The Macroview 2010

2010-01-06T15:15:00.000-08:00

A condensed outline of the current pressures and dynamics in the global and US economy
- 1/6/2010

I. Developed world balance sheets

As growth rates slow in developed economies and demographics change, it becomes more difficult to maintain a strong balance sheet.

US Government

US State and municipal governments have budget issues due to promising/providing more services than they can afford, especially in those dealing with slowing population growth rates where problems echo national issues
US National government has similar issues in promising/providing more services than they can afford, in addition to unfunded liabilities in S.S. and Medicaid, a large deficit, and eventual difficulty finding treasury buyers at low interest rates.
Government spending to grow the economy has the consequences of inefficient allocations of money to pork projects, corporate subsidies, ineffective or nonproductive stimulus projects, defense spending, bailouts of bad companies and bad risk takers.
Balance sheets are still weak, even without unfunded liabilities, but government continues to spend to try to stimulate and preserve the strength of the economy, funding this spending through treasury issuance.
After the crisis, bailouts and quantitative easing allowed financial institutions and large corporations to strengthen their balance sheets rather than go bankrupt, but banks are not lending or spending the money they received.

US consumers

US consumers are poorer due to low savings rates during the boom years and credit card/zero money down type mentalities.
Their high spending rates were based on feelings of security, macroeconomic and personal financial stability, as well as perceived wealth in house and savings, a high proportion of which was money held in common/S&P 500 type stocks.
Today there is less household wealth because of poor investments in housing and stock market bubbles, as well as a struggling job market. Households today are financially less well off, but the savings rate is higher at 4.6%

Banks

Banks and other assorted institutions had bad balance sheets due to excessive leveraging, risk-taking, and Mortgage backed securities.
This resulted in bailouts and the fed's MBS purchase program. The same people are basically still in charge, and the bad assets have been bought up by the fed.

III. The United States position within the Global ecology/ecosystem/economy

In the long term, economies develop and growth rates slow. Technologies and strategies can be copied and performances regress to the mean. Key natural resources such as oil, natural gas, industrial metals, timber, fresh water, farm land are limited. In any system there are always key constraints and limits.

In a stable, slow growth environment, multinationals are able to use their size and other advantages to be the best (high margins, cash rich) competitors. Advantages of being big include:

patent portfolios, copyrights, licensing, R&D, technical expertise, proprietary knowledge
brand strength, marketing science and ability to manipulate psychology/habits, consumer loyalty
growth of competitive edges through acquisitions
effect of size: legal, lobbying, political power
effect of size: economies of scale, more opportunities to creatively use capital

Unrealistic expectations about growth rates and myths about American exceptionalism contributed to attempts to stimulate as economic expansion rate slowed, getting the US into more unproductive debt
The sense that Americans can have a high standard of living regardless of what they do, that they can spend without consequence, and that the US economy is the best by default are clearly misplaced. Myths of "american exceptionalism" should not guide policy.
Rising interest expense, rising mortgage expense, rising materials expense
Emerging economies have the most room to grow into.

V. US Strengths and weaknesses

Ecological limits to resources, space and population, limits to fossil fuels, industrial metals, timber, productive farmland, and fresh water are one drag on the growth of the economy. Accumulation of pollution, trash, and waste is another. A third is increased competition between factions within the global economy, as opposed to expansion against outside frontiers, as the global economy grows there are simply less frontiers to go around. These are all ecological limits.

GMO's Ben Inker writes that “The productive capacity of the economy comes from the skills and size of the workforce and the country’s accumulated intellectual and physical capital.” While there are ecological limits, the importance of these factors to the size of the economy means that even in an economy with a population growth rate of zero, complexity can grow, technology can grow, real wealth and the economy can grow.

The US strengths are in its great blue chip multi-national companies, the US military, its expertise in technology, its strong workforce and educational hubs of science and entrepreneurship, the dollar, the great plains basin and its geography, and its mostly friendly neighbors.

Its weaknesses are in government and consumer balance sheets, a growing wealth gap, the inability to grow the real economy with quantitative easing and poorly designed stimulus programs, and in rising costs and prices.

V. Federal reserve, QE, debt reflex

In response to a slowing growth rate in the US, the Fed buys government bonds, and government spending is implemented through the corporation-lobbyist-government complex. The parts of the economy tied to the this complex improve. Meanwhile, inflation of the monetary supply taxes savings, and incentivizes the purchase of something other than dollars. As opposed to be loaned out, large amounts of liquidity that the fed provided go into the stock markets, which rise across the board from influx of money. Consumers and businesses do not take risks or spend more than necessary, because from their perspective, the real economy is poor and uncertain, even if equities and other assets are rising. The effect is of deflation in goods, but inflation in domestic, international, emerging equity, and commodity markets.

Historical U.S. economic growth from an ecological perspective

2009-10-27T15:38:00.000-07:00

I wrote the analysis of US economic history/growth in this post while studying abroad in Stockholm during spring 2008. The extra twilight hours when the sun rose early and set late were great for reading and writing. Later in 2009, I went to a presentation on personal finance made to curious students at Hamilton College. It was made by a likeable economics professor, aimed at people of all academic backgrounds who wanted to successfully invest their savings, so it was on a fairly basic level, putting forward an investment strategy based on the following ideas:

The power of compound interest
Historical growth rates of the American economy
Efficient Market Hypothesis; professional money managers; beating the market
Cost of missing a big day

I found myself disagreeing with some of the premises and assumptions that the presenter was using, and the first part of this post is mostly about those disagreements, but first I will just give a summary of the presentation.

The presentation began with the power of compound interest: if your investments earn a high rate of return year after year, and you begin investing as soon as you can, your initial savings will grow to be an impressive amount of money. (For example, if you can manage to earn a consistent 8% a year return on your investments, saving $4,000 per year for 40 years will leave you with a lump sum of $1,036,226…)

According to the presenter, the best bet to achieve that 8% a year return, based on over 100 years of data and historical evidence of strong growth, is in the stocks of American companies. If you look at the various data, trend lines, stock prices, or GDP indexes over the last hundred years, they will show that indeed, America has grown. He argued that the American economy and therefore American stocks will continue to grow and increase in value because of American ingenuity, freedom, opportunity, and the strength of capitalism to create new growth. As seen in the historical data, we have always managed to recover from adversity and collapse in the past, and will therefore continue to do so.

The presentation then moved on to the efficient market hypothesis and the investment industry. The conclusion was that most investment professionals fail to add real value and serve you no better than just investing on your own by buying a no load mutual fund that tracks the S&P 500. This is mostly because the market is so efficient and by definition not all money managers can be "above average". The EMH states that all information currently available is quickly reflected in prices. In addition, people are actively looking hard for more information. For everything you might know about a stock, there are other people who are paid research analysts who know more about it, are meeting with the leadership at the firm, visiting its facilities, doing detailed analysis of future earnings, and doing everything they can to find out how valuable its shares are.

The next point was that you cannot time the market. It is important to continually be investing into the market, rather than trying to time the bottom or top. This is because the majority of historical gains, the points where a majority of returns are made, happen on one particular day. If you are not in the market on one day, then a whole decade of returns could be lost to you. This goes hand in hand with assumption made earlier that the stock market will grow and will always be a good investment. I will just say here, that on any particular day, in order to avoid missing out on big increases in the market, you also will not be missing out on any decreases.

In summary, his advice was: an inexperienced investor should buy mutual funds or ETFs, indexing American stocks, and should buy them consistently rather than trying to pick the best time to put their money in the market. Also, they should invest for themselves rather than paying an adviser to manage their money. Now, there is a lot of this I agree with - the value of diversification and in general avoiding fees for other's management or advice - but I have a couple small points, and one big criticism from the perspective of historical U.S. economic growth.

Criticisms

Advantages of the individual investor
Disadvantages of the individual investor (limited ability to do financial analysis, evaluate NPV, the contents of indexes)
"Efficient" markets
American myths; problems with using history as a guide

One important strength of the individual investor is that he or she does not have to be invested in the market at any particular time. I am making two assumptions. First, there is an actual "value" of a company or index; There is a price that a company's stock is actually worth, given all available information. Second, that at different periods, due to various irrationalities and herd mentality behavior, the market may be overvalued, undervalued, or fairly valued. i.e. The EMH does not hold true. After the past several years in markets, I should think this would be fairly obvious, especially for the strict version of the theory. Given these assumptions that a value of a stock exists, and that the price may or may not equal the value, which I do not think are very radical assumptions, it follows that there are both very good, very bad, and just average times to be buying stocks, based on price and fair value.

If, hypothetically, you are a mutual fund manager of a fund that is called "The Small Cap Emerging Market Growth Fund" then you somewhat have your hands tied. You can't conclude that emerging market stocks are a bad deal right now and you want to buy shares in large undervalued American companies, you have to own small cap emerging market growth stocks. For most institutional managers, this is the deal they have. It would be risky to tell all your clients, "Well, we haven't actually purchased any stocks in the last two and a half years. Even though the market continues to go up, we think everything is being systematically overvalued, so you've missed out on all those returns." With many of those clients you would have a good risk of being replaced.

The individual investor never has their hand forced in this way. A strategy of just steadily putting all your money into diversified American stock funds regardless of perceived value and how good a deal it is minimizes that strength.

The disadvantage of being an individual investor is difficulty in knowing what the correct value of a stock is. So you have more flexibility in when to buy, but much worse information and time to work with with. Any analysis an individual investor might do is going to be rudimentary compared to the complex modeling and other analysis done by more sophisticated investors. The proposed strategy of investing in large index funds containing many, many companies only exacerbates this problem.

In a way, this investment strategy is a self-fulfilling prophecy. By buying an index fund, you minimize your ability to do analysis (by increasing the variables involved) and to have any idea on what the true value of the stocks you own might be. A large part of the information you have available at that point is the prior prices the index has sold at at different times, which may actually be very poor information about its value (bubbles).

If investors as a whole operate on the assumptions that historical prices are true reflections of prior values, and that stocks are always a good investment regardless of price, then as a group, they pour savings into the market through index funds, and up share prices go, but with no bearing on actual valuations.

On the other hand, by diversifying, an investor minimizes their risk of messing up completely on one individual stock pick. And an individual investor only has so much time to research. There is huge value in diversification. But, to invest regardless of price does not make much sense.

The biggest idea that I would like to address is that America will be the best place to invest at all times in the future, because as the historical data show, the strength of American capitalism, freedom and opportunity cause the American economy to ultimately grow and prosper despite whatever fluctuations or barriers to growth it might encounter.

The claim is based on historical data, and my response is historical as well. The Americas were being explored and developed by Europeans beginning in the late 15th century. Industry and agriculture developed on the new continent, trade flourished, and the colonies grew. The U.S. became independent in 1776, and today, in 2009 we are 233 years removed from that date. Here now, the America founded 233 years ago feels like a very far away and distant country. For many kinds of questions, 200 years is a long enough time to draw a reasonable conclusion, so maybe we feel comfortable enough to make assertions about the American economy based on historical data. But if we want to analyze the growth rate of the American economy two hundred years is actually small. An economy has a long lifetime, and for the majority of time we have spent as the United States we have been developing a new continent.

Ecological metaphors and ideas frequently apply in investing, as an economy is basically ecosystem. The colonization of North America by western civilization was the exact same as the colonization of a new ecosystem by an invasive species. Several hundred years ago, western society is introduced to a whole new continent with an entirely different ecology, containing another human society with entirely different ways of life who are unable to compete with the new invasive society. With no competition, the newcomer grows at a rapid rate and moves quickly through the environment. At some point, a new balance is reached, but it looks remarkably different from the old one. Adapting quickly is hard for the native species, and the new ecology is dominated by the invaders. Cane Toads, Brown Tree Snakes, and Lionfish are some interesting examples if you want to read more on the very interesting phenomenon of invasive species. Combating invasive species is extraordinarily hard, because the native ecosystem that is being invaded has no way of checking their growth. Invasive species aren’t “understood” or “recognized” by native species as competitors, they are adaptable, they have large spikes, they grow faster and shade out weaker competition, they cover everything in sight, they are poisonous and will eat anything, they are hard to remove… the list goes on. Invasive species are just better at competing and more effective at what they do than the players in the current ecosystem.

This kind of revolutionary growth happens in all sorts of other areas, too.

In another more corporate area... being the innovator of a new product or strategy for beating the competition lets a company enjoy an initial period of quick, uncontested growth before its strategies are copied. If you’re the first developer of a new revolutionary technology that everyone needs, you will profit when everyone buys from you, but pretty soon you will be copied by others seeking a profitable business.

One concept suggested by investor Warren Buffett for attempting to understand which of those companies will keep their profits over the long term (who should therefore be invested in if the price is good) and which of those will ultimately have their profits eroded by competition in the market is the concept of sustainable competitive advantage. This is the idea that for long term success, companies must have an advantage over their competitors that cannot easily be duplicated. Companies that aren't able to sustain a large economic moat around their business tend to quickly have their margins eroded by competitors copying and using the same strategies that the first business was using. Essentially, you are looking for companies that have sustainable monopolies and pricing power.

Possessing different characteristics can give companies competitive advantages, some more sustainable than others. Being large or widely used, like MSFT operating systems for example, can provide a competitive advantage through brand recognition, high costs of switching for users, or economies of scale. Barriers to entry into the industry, such as government granted monopolies or high start up costs can provide a competitor free environment to enjoy profits. Some comparative advantages are more transient than others. A patent for the rights to sell a particular drug exclusively expires after a fixed period of time, for example.

From its very start in The New World, until after World War II, the history of the United States has been a history of growth defined by the United States as the beneficiary of a series of unique competitive advantages, and as an innovator in science, finance and technology (but whose methods will eventually be copied). Western civilization is the semi-metaphorical invasive species here.

The advantages that have led to the U.S. sustained growth rate have included:

An entire continent to expand into, full of unexploited natural resources
A unique business culture detailed in The Protestant Ethic by Weber
A political culture of freedom and opportunity made possible by the advantages of starting out in a new country. (There was little competitive pressure between Americans; Americans competed against external forces to complete their "Manifest Destiny" and expand within the continent)
Expertise with powerful new military and industrial technologies
Geographic isolation that left it in a powerful position after WW2
A powerful “brand name” desired, respected, feared and given the benefit of the doubt abroad
The use of the dollar as an international currency

As we go through some of these points, we can see that the advantages which have led to the U.S. economy's success have diminished or are diminishing.

The continent has been expanded into, and is now in a sense, becoming full. We no longer have unexploited space or resources to exploit and expand at previous rates. The United States's unique late start in history and subsequent rapid rise to world economic and cultural dominance has made possible and in turn been made possible by, faith in unlimited individualism, growth and technological progress, and the general practice of short term exploitative thinking. This central ideology, formed in an era of rapid expansion and distant limits, has persisted to today, and will be problematic in an era of slower expansion and more tangible limits. Limits to water supply, oil and other resources we can extract from the ground, waste we are able to put into the environment without damaging it, topsoil, timber, and general space we have available for living are all becoming apparent. The short-term thinking response so far has often been, take on debt in any way necessary to sustain current growth rates, whether these debts are government, consumer, or even "ecological" debts. As we continue to get bigger it becomes harder to expand. There are simply less opportunities and more barriers.

The development of many of the ideological foundations of capitalism came out of the core values of Protestant religions common in colonial America. The roots of capitalism in protestant culture gave western companies and countries, and especially the U.S. a distinct advantage initially. They were the beneficiaries of being the innovators of new technologies, which were in this case mostly methodologies and ways of thinking. American corporations during the 19th and 20th century were the pioneers and innovators of many of the business practices, strategies, accounting, and general models used by modern corporations. Today, that is no longer the case. Capitalist business practices have grown beyond their roots and are employed by people of all cultures in emerging market economies across the globe. Even the great American corporations that grew out of this environment are today becoming more global businesses than they are American.

A similar phenomenon has occurred in the labor and production markets. Elite engineers, computer scientists, doctors, engineers, lawyers, factory workers, education systems, political systems, healthcare systems and so on are not in any way exclusively American. And really there is no reason why they should be. Drawing from Buffet's idea: Do we have a distinct competitive advantage here in terms of the quality of our labor and capital that is sustainable or has our growth been the result of inertia, and the gravity of being the innovator?

There tends to be a regression to the mean effect with most competitive advantages. Whenever the methods of success can be copied, extraordinary “performances” by people, teams, nations, civilizations or cities tend to be unsustainable. Competitors catch on, adapt, and begin using the same strategies to succeed, even adding their own twists and improvements. The set of comparative advantages which have enabled the United States rise to international dominance are beginning to erode. America’s relative position in the world is being weakened, both by the deterioration of its own advantages and by strides made by the rest of the world.

In the next several decades, the United States will be exposed by a loss of key economic advantages, a relative decline in power and relevance to its peers, an overextended infrastructure in need of pruning, fiscal challenges for government, detrimental emigration and immigration, perverse incentives for business and government that make these complex issues difficult to address, and thus long term difficulty in spurring new growth. An investment portfolio of US index funds purchased regardless of price is not a wise idea.

Basket bonds

2009-10-20T14:48:00.000-07:00

In a recent article, The Economist offers some thoughts on the declining dollar. If they don't already exist, I'd like to suggest "basket bonds" as a good name for what buyers of new U.S. debt should be asking for, as in, bonds denominated in a basket of multiple currencies.