• "Kee Points" with Jim Kee, Ph.D.

    I hope to discuss in Kee Point things that I think are of interest to our clients, and this week I thought I would take advantage of the long holiday weekend to talk briefly about the trendy fields of behavioral economics and finance.


    The “behavioral” movement: There is no Nobel Prize for psychology or mathematics, so it is not uncommon for scientists from these fields to win the Nobel Prize in economics, presumably because it is the closest related field for which there is a Nobel Prize (the other five Nobel categories are literature, physics, chemistry, peace, and physiology & medicine). This combination of economics, psychology, and mathematics has led to both progress and confusion.


    A key difference between economics and psychology is that economics abstracts or makes generalizations about human behavior, whereas psychology gets into the particulars. In fact, a common critique of economic theory is that its assumptions are unrealistic, i.e. that it generalizes too much, abstracting away important details until it doesn’t reflect reality. Economists respond that this burdens theory with the role of description, which is not what it is intended to do. In the words of George Stigler, who himself won the Nobel Prize in economics in 1982, “the role of description is to particularize, while the role of theory is to generalize - to disregard an infinite number of differences and capture the important common element in different phenomena.” But taken too far, complete abstraction results in pure mathematics, which means that the potential danger of excessive “mathematization” in economics is that it omits something(s) that is truly important. So economics requires some abstraction or generalization but not too much, like a roadmap that includes major cities but excludes every pothole. Unlike pure mathematics it needs people and assumptions about their behavior, but unlike psychology it is more interested in the average behavior of the group than of the behavior of the individual.


    This is where “behavioral economics” and “behavioral finance” come in, two related fields that began gaining traction about 20 years ago, although the issues they confront go back much further. Again, traditional economics is predicated on avoiding the countless vagaries of psychology by relying instead upon only a few basic assumptions about human behavior. These assumptions or generalizations include the notion that people prefer more wealth to less, and that they act in their own (self) interest in commercial transactions (and often enough in non-commercial transactions, e.g. you might give a suit to the poor, but not your best suit). It is amazing how much of the behavior of large economic systems like the global economy and the countries and industries and firms within it can be explained with only a handful of such behavioral postulates. No uber-rational, optimization-calculating "economic man” is needed. In fact, the late Gary Becker argued that in a fully-integrated global economy characterized by a high degree of specialization, those who don’t make decisions rationally and intelligently aren’t likely to last long enough in a system of profit and loss to be impactful.


    The behaviorists, on the other hand, argue that certain behavioral traits that are important have been omitted from economics and finance. Just about everyone today has heard the laundry-list of behavioral anomalies (e.g. anchoring, confirmation and hind-sight and bias, etc.) that seem to contradict even the most basic assumptions made by traditional economic theory. In finance, these are believed to lead to asset miss-pricings, bubbles, and other market inefficiencies and problems. When he was alive, Becker countered with, “one of the things some behavioralists have missed is that a specialized economy eliminates many mistakes because vulnerable people don’t get put into positions where they can make these mistakes.” The financial crisis and the Great Recession hardly resolved any of this, with the behavioralist saying, “see, we told you markets weren’t efficiently or rationally pricing assets!” and the traditionalists arguing, “see, we told you that interfering with markets would create perverse incentives and bad outcomes!”


    Traditional economists (including Becker above) have argued that the rationality assumptions required to validate, say, the law of demand, which states that people in the aggregate buy less of a good at higher prices than at lower prices, are very low. “People do a lot of nutty things,” writes economist John Cochrane, “but when you raise the price of tomatoes they buy fewer tomatoes” (economists have worked out the effects of higher prices on perceived quality, “snob effects” of luxury goods, etc., over the past 70 years but it gets pretty technical). Perhaps most famously, in 2010 former UK Prime Minister David Cameron set up a Behavioral Insights Team, informally known as the “Nudge Unit” from Richard Thaler’s book by the same name. One of the group’s assertions was that the best way to get people to cut their electricity bills is to show them how much they are spending relative to how much their neighbors are spending and relative to what energy-conscious neighbors are spending (Cameron even did a TED talk on it). Traditionalists would respond (similar to Tim Hartford’s response in the Financial Times) that no, the best way to reduce energy consumption would be to simply raise energy prices, perhaps through a tax. I think these examples give you an idea of the ongoing back-and-forth between “behavioralists” and “traditionalists” in economics.


    With respect to economics, my taste runs more closely with the traditionalists, and I see the contributions of the behaviorists more in the realm of psychology (e.g. using prices ending in odd numbers to denote value, and even numbers to denote quality, etc.). With respect to investing and finance, I am most in agreement with those like economist Victor Canto of La Jolla Economics who (for over a quarter of a century) have argued that the extreme doctrinaire version of the efficient markets (EM) school took market efficiency to a point where the core of economics, the simple behavioral response functions that dictate how markets adjust, was discarded. In that sense behavioral finance scholars, at least those at the top of the field rather than on the internet, seem to be bringing it back in what seems to be a meeting in the middle. In the words of Richard Thaler, past president of the American Economic Association and widely considered the “founding father” of behavioral finance, “I predict that in the not-too-distant future, the term “behavioral finance” will be correctly viewed as a redundant phrase. What other kind of finance is there?"


  • "Kee Points" with Jim Kee, Ph.D.

    One thing that was worth noting last week was the The Wall Street Journal’s article on the US petrochemical industry, which has been a big beneficiary of US fracking as it uses oil and gas as inputs to produce things like plastics. “Staggering” is how they described the scale of investment in the sector, with chemical plant expenditures alone accounting for half of all capital investment in manufacturing last year. Most of this is along the Gulf Coast. Another thing that caught my eye was Indian Prime Minister Narendra Modi’s article in Monday’s WSJ. This was of interest not so much because of his focus on India and the US as partners for growth (that assertion is expected), but because of his description of the tremendous amount of capital needed for India’s future for, “the planned 100 smart cities, the massive modernization of ports, airports, and road and rail networks, the construction of affordable housing for all (1.3 billion people; the US has 325 million)...rapidly expanding aviation needs, and our increasing demand for gas, nuclear, clean coal and renewables.” 


    As expected, MSCI (Morgan Stanley Capital Index) will start including a small weighting of mainland China stocks (China A-shares) in their emerging market index. This will begin in August of 2018 with an initial weighting of .73%, which is 2.49% of the MSCI China Index. I know most of you are thinking, “they didn’t do that already?,” but China still has some way to go institutionally in order to earn a stronger presence. Of more importance, in my opinion, was MSCI’s decision not to move Argentina back up to emerging market status from its current “frontier" market status. At the beginning of the 20th century Argentina had a per-capita GDP that was starting to rival that of the US and the UK; it was on the way up. But it went down a bleak road of political and monetary instability, and this is where it ended up. That’s tragic, and a key lesson is that “progress isn’t inevitable.”  


    Finally, GOP leaders are still asserting that the Senate will vote on a bill that overhauls the Affordable Care Act (ACA), but Senate Majority Leader Mitch McConnell has delayed a vote on the legislation until after the July 4th recess while he works to bring the half a dozen or so wavering republicans (WSJ) on-board. The Congressional Budget Office (CBO) reported that the bill in its current form would result in 22 million fewer insured by 2026 compared to the ACA, which has led to dissent by some republicans and a critique of the CBO’s forecasting track record by others. Again, republicans would like to pass a bill that reduces expected expenditures (mostly through reduced Medicaid spending) before they take on tax reform, which reduces future revenues and increases projected deficits. Having taught “Health and Medical Economics” over twenty years ago, I can tell you that few economists liked the health care system as it was before the ACA, or the ACA itself, or the current replacement bill. Reminds me of the tax code!


    And speaking of the tax code, there is some debate as to which is a more effective stimulant to growth, a corporate income tax cut or 100% expensing of capital purchases. Recall that businesses don’t get to deduct 100% of purchases of capital equipment at the time of purchase. Instead, they can only deduct a portion of the purchase in the current year, with the rest deducted in future years. That means their income tax bill is higher in current years, which is one of the reasons politicians favored “depreciation” over “expensing” in the first place (going back to the 1930s, although Section 179 of the tax code modifies this a bit). The best way to think about the two is that increasing the amount of capital purchases that businesses can expense is aimed more at new capital investment; less so with a corporate income tax rate cut. 


  • "Kee Points" with Jim Kee, Ph.D.

    The Dow Jones Industrial and the S&P 500 finished at all-time highs yesterday, and to repeat there is no real significance in anything hitting new highs that have historically trended upwards over time (like US stock prices). If instead valuation levels were at an all-time high, which they are not, then that would be a whole other story! In the current environment, my sense is that the market rises and falls more or less in proportion to the odds of President Trump getting major tax/regulatory reform through. Washington expert Greg Valliere, who has been a guest speaker at numerous STMM events over the years, argues that there are “signs of life in the Republican Congress,” and that a crucial vote on a replacement form of Obamacare is possible before the July 4th recess. Tax reform is still very much alive for 2017 as well. One of the impediments to tax reform legislation has been the controversial Border Adjustment Tax, but according to Valliere, House Speaker Paul Ryan has indicated he might be willing to back away from or support delays in the Border Adjustment Tax (which he supports). This tax gives breaks to US companies that ship products abroad, and removes tax breaks from US companies that import goods from other countries. In absolute terms (sheer dollar amounts) the US is the largest importer and exporter among the developed countries. It is slightly behind China, which is considered “emerging,” although the European Union countries combined slightly exceed both. Looking at imports and exports as a percentage of GDP, Germany ranks the highest of the major developed countries (40% and 50% respectively), with the US among the lowest with both imports and exports less than 15% of GDP (HCWE). Top export destinations of the US are Canada, followed by Mexico, China, Japan, and then Germany. We import the most from China, then Mexico, Canada, Japan, and Germany (MIT’s OEC - Observatory of Economic Complexity).


    Yield Curve: The flattening yield curve has also been in the headlines recently, meaning short-term rates are rising relative to long-term rates. I’ve talked in prior Kee Points about bullish versus bearish flattenings, so I won’t go into that here, but there is some concern that the current flattening is signaling slower economic growth going forward. I’ve seen that in some of the downward revisions in the various “nowcasting models” for the second quarter GDP, although all models see an acceleration from the first quarter. The yield curve has been distorted by central bank policies since the Great Recession, which reduces its reliability as a forecasting tool. Right now short-term rates are being influenced by Federal Reserve policies, while longer-term rates are being influenced by lower rates overseas (i.e. European Central Bank and Bank of Japan policies). Normally, if the fed raises short-term rates (i.e. the federal funds target rate) it would translate into higher longer-term rates, as long-term rates are in part a function of expected future short-term rates. But in the current environment of low to negative interest rates overseas, any increase in long-term rates here attracts foreign capital from abroad, driving them back down. I think that is the key dynamic behind today’s yield curve. Also quality spreads (the difference between the yields of high quality and low quality bonds) tend to anticipate growth accelerations and decelerations, and they have narrowed, which is not consistent with a major slowdown in economic growth.


    Oil: Finally, oil prices are back in the headlines as crude oil (WTI) has fallen to $43 per barrel, which is down from around $54 per barrel at the beginning of the year (Brent crude being a couple of dollars higher). Supply and demand influence every market, and both are always at work in the oil market. You can’t really measure these forces directly, but you can infer them by looking at changes in prices and quantities over time. If the prices are lower and the quantities sold are not, it is a pretty good indication that supply increases are the primary driver. The Federal Reserve Bank of New York publishes a weekly “Oil Price Dynamics Report,” in which they attempt to decompose recent fluctuations in oil prices between demand factors and supply factors. Their current report reads, “Oil prices fell steadily owing to decreasing demand and increasing supply.” Demand growth has been far more dependent upon emerging economies than developed economies over the past 10 years, and developed economies are always moving towards lower energy intensity, or lower energy use per unit of output. On the supply side, many US shale firms that purchased $50 oil hedges continue to produce (which is expected to roll off by year’s end), and OPEC still struggles to police output restriction targets.


  • "Kee Points" with Jim Kee, Ph.D.

    Is this a repeat of the tech bubble and bust? If you follow markets you know that last week ended with the sell-off of several big name technology stocks including Apple (down 3.9%), Facebook (down 3.3%), Alphabet (down 3.4%), Amazon (down 3.2%), and Microsoft (down 2.3%). Barron’s points out that, over the past six months, just these five stocks alone had increased in value by $600 billion, equal to the combined GDP of both Hong Kong and South Africa. The tech heavy NASDAQ index was down 1.8%, while the Dow Jones Industrial average finished at a fresh all-time high. The sell-off in the technology sector has drawn comparisons to the late 1990s technology bubble, but I wouldn’t go that far. Technology was up over 16% year-to-date, so a pullback shouldn’t be that surprising. And the tech bubble itself is a little misunderstood. Technology stocks are often about the future, somewhat like looking through a telescope rather than a microscope, and the market prices in estimates of future sales and profitability. Based upon my experience as a portfolio consultant during the late 1990s, what made that market so implausible was not the fact that individual companies couldn’t possibly hit the expected growth forecasts priced into them. The implausible part was that all (well, hundreds) companies were priced to grow at 25%+ annual rates for the foreseeable future (by contrast, the economy was only growing at 3%-4%).


    A company growing at 25% per year triples in size in five years. That’s not unheard of, but expecting many companies in an entire sector triple in size is implausible, and that’s what you saw in the technology sector during the late 1990s tech boom and bust. Bubbles occur when expectations that are plausible for a single company get priced into all companies within the same broad economic sector. This is reflected in studies by McKinsey and Company, which show that overall stock market bubbles and even company-specific bubbles are actually quite rare. It is sector bubbles that are the most common. Thinking about this a little more deeply, UCLA economist Arnold Harberger, in his 1998 presidential address to the American Economic Association, argued that real disruptive innovation occurs at the company level and is sporadic, like mushrooms popping up, rather than occurring evenly across industries, like yeast spreading. Harberger documented this decade-by-decade beginning in the 1920s. The takeaway for investors is to beware of instances where the market is pricing in sector-wide expectations for growth, i.e. spreading like yeast rather than mushrooms. That’s how bubbles are made. Inflated expectations at the sector level occur with some frequency (e.g. technology, financials, energy, etc.), which is why having a discipline of controlling or capping sector exposure is so important.


    So I don’t think that the current run-up in the FAAMG stocks (or FAANG if you replace Microsoft with Netflix) is a replay of the tech crash. I think they might have gotten a little ahead of themselves, but then the market overall has been pretty optimistic, with the S&P 500 running at an annualized rate (if you assumed the rate of increase so far this year for the whole year) of 16.5%, the Dow Jones Industrial average at 20%, and the NASDAQ at 30%. Corporate profits are improving, but I’d say that’s also pricing in some pretty strong expectations for corporate tax and regulatory reform! For some context, the NASDAQ at 6150 is only about 22% above it’s tech boom peak of 5048 (achieved in March of 2000), which was over 17 years ago. The trailing price-to-earnings ratio at that time was over 100, versus today’s 26 (and earnings are accelerating), meaning the NASDAQ was about 4 times more expensive in 2000 than it is today. Pullbacks and corrections should be expected, they just can’t be predicted. And “taking money off the table” during sell-offs greatly increases your chances of being out of the market during the handful of days that make up a disproportionately large share of long-term gains.


    Another interesting point in the weekend Barron’s was a discussion regarding the impact of technology on company profitability, as measured by return-on-investment (ROI). ROIs are a product of operating margins and asset efficiency or (asset “turns”). It sounds complicated but it is actually pretty intuitive if you think about it in terms of running your own business. For example, if you sell pizzas for a living, you make money by either charging a lot for each pizza (high margins), or by selling a lot of pizzas every year (high asset efficiency but lower margins). Technology can help to improve margins by substituting for labor, for example by using automated online ordering instead of having someone taking orders over the phone. And you can also substitute technology for assets like brick and mortar, (improving asset efficiency) which is most obvious in retailing where online shopping takes the place of foot traffic in stores. This impact of technology on business efficiency certainly helps to explain the growth and profitability of the technology sector beyond just smart phones and similar consumer devices.


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