“Kee” Points with Jim Kee, Ph.D.

  • Markets and the Economy
  • The Alchian-Allen Effect
  • Market Valuation Levels

Markets and the Economy

Markets in the US continue to power forward, with stocks on track for a positive fourth quarter. Economic growth looks good for the fourth quarter as well, with nowcasting models from both the Atlanta Fed and the New York Fed measuring fourth quarter GDP growth in excess of 3%. That would be the third quarter in a row of GDP growth in the 3% range. Analysts are watching holiday sales, which tend to accelerate spending in the fourth quarter, at the expense of spending in the first quarter of the following year. That’s one reason for the strong seasonality in quarterly GDP growth numbers, with the first quarter on average being the lowest. It will be interesting to see how the interaction of online sales and brick and mortar (retail stores) sales play out, for example between conventional “black Friday” sales (Friday after Thanksgiving) and the newer “cyber Monday” (Monday after Thanksgiving) sales.

There is a lot of speculation over the “Amazon” effect, or the challenges to conventional retailing that online retailing has brought. Conventional retailers have struggled with sales and profitability, no doubt a function of online buying. Many have argued that this struggle is also due to a failure on the part of conventional retailers to execute, that is, to make buying in their stores a pleasant experience. I see both occurring, but to me the real mystery is why this all seemed to occur around the middle of 2015. Literally, conventional retail ROIs (and stock prices) were increasing and strong up to that point and then began to rapidly decline. One obvious simultaneous occurrence was the collapse in oil prices, which peaked in 2014 and declined through 2015 and have remained low ever since. How would that help retailers? Possibly by lowering transportation costs, as a significant problem with online purchases is delivery costs. That’s particularly true of lower cost items, where delivery costs make up a significant portion of total costs to the buyer.

The Alchian-Allen Effect

Known as the Alchian-Allen effect after UCLA economists Armen Alchian and William Allen, this effect states that when the prices of two goods are increased by a fixed amount (per unit), consumption will switch toward the higher quality product because the higher quality product is now relatively cheaper. Tests of this back in the day had to do with drug potency. An ounce of low quality marijuana might have sold for $50, while an ounce of high quality or high potency marijuana might have sold for $100, or twice as much. Now suppose increased law enforcement reduced the supply of marijuana in general, adding say $50 to the price of both low and high quality marijuana (lower supply = higher price). Now the higher quality substance would sell for $150 per ounce while the lower quality stuff would sell for $100. The higher quality marijuana would no longer be twice as expensive as the lower quality marijuana but only one-and-a-half times as much. That’s what it means to say that adding a fixed cost (like transportation costs) to two items makes the more expensive or higher quality item relatively cheaper than it was before.

Economists would often use the Alchian-Allen effect to show that making drugs illegal added a fixed cost (going to jail or the expenses of avoiding it) to low potency and high potency drugs alike, making high potency drugs relatively cheaper. And studies showed that to indeed be the case: wherever drug enforcement spending was stepped up, the potency of the drugs stepped up as well (which would ostensibly increase the incidence of overdose and death). The effect was initially postulated in 1964 and applied to shipping costs for fruit (“Shipping the Good Apples Out”). The idea was that if you had low and high quality apples, and out-of-state buyers had to pay added shipping costs, the shipping costs made the higher quality apples relatively cheaper, and that’s what would be shipped. The application to drugs, I think, was a product of the times, the 1960s and 1970s being an environment where economics professors could make an easy connection with students by providing a rational for drug legalization. Applied to retailing, the Alchian-Allen effect would argue that reducing a fixed cost, like transportation costs, would make lower quality goods relatively more attractive. In this context lower quality goods would be goods bought online without the higher quality help and service that the retail experience is supposed to supply. That doesn’t explain all of the disruption, of course, but I do think it helps to explain why lower energy prices might translate into more online buying.

Market Valuation Levels

Back to the stock market, the apparent lack of tangible legislation on President Trump’s part has lead to a skepticism of the market’s run-up this year. But that isn’t entirely the case. On the legislative front, this is the first year in quite a while where the threat of new regulations or increased regulations or a sweeping new regulatory increase has essentially been zero. That’s also true of business taxes, for while the timing of a tax bill passage is unknown, there are no proposals for widespread increases in corporate and business taxes, so the likely overall direction of taxes (down) is known. On the monetary side, Fed policy has been largely predictable, transparent, and well-telegraphed. In fact, another reason often cited for higher valuation levels for equities is today’s lower interest rate and inflation environment.

That makes sense, as a lot of the value of US companies and hence their stock prices is in future earnings, and a dollar of future earnings is worth more when inflation and interest rates are low. With inflation this is pretty intuitive, as a dollar to be received in the future is worth less than a dollar to be received today if inflation is high. That’s true by definition, as inflation is defined as a decline in the value or purchasing power of a currency (or a rise in the general price level, which amounts to the same thing).

With interest rates, think about it this way: If current interest rates were 10 percent, a dollar today could be invested at 10 percent per year and would be worth $2.60 in 10 years. So if you think about it, a dollar to be received 10 years from now would have to be “discounted” by a factor of 10 percent per year to get at what it would be worth today. How much would it be worth? About 38 cents, because that’s how much you would need to invest today, at 10 percent per year, to have a dollar ten years from now. The lower that interest rate - that 10 percent - is, the more a dollar to be received 10 years from now would be worth in today’s dollars. The math is a little tricky, but the point is that when interest rates are low, a dollar of future corporate earnings is worth more than when interest rates are high, which is one reason for higher stock market valuations given the current, low interest rate environment.

But don’t take this too far, and I have seen many who have! (myself included). When markets’ valuation levels have risen like they have today, there is a tendency for analysts to rationalize it by taking the earnings of US companies and discounting them by using the 10-Treasury yield (currently 2.33 percent). That makes some sense based upon the discussion from financial economics given above, but I want you to know that it almost always results in the conclusion that the market is still undervalued. Various versions of this analysis at the peak of the tech boom in 2000 showed that the market was still over 60 percent undervalued, and the same was true in 2007, prior to the 55 percent peak-to-trough decline in US indices (international stocks fell even more). So yes, stocks do deserve higher valuation levels when interest rates are low, but I would be wary of anyone telling you that stocks today are “cheap” or 50 percent undervalued.