• "Kee Points" with Jim Kee, Ph.D.

    Will there ever be agreement in academia and in the popular press regarding the causes of the 2007-09 financial crisis? I doubt it. Does that make it more probable that a similar crisis will occur in the future? Probably. The view I run into the most, that one that seems to be the most commonly shared, is that the financial crisis was caused by three things, (1) unregulated or under-regulated capital markets, (2) former Fed Chairman Alan Greenspan’s loose monetary policy, and (3) plain old Wall Street greed.


    Economist William Poole, retired President and CEO of the Federal Reserve Bank Of St. Louis, took issue with these views recently in Business Economics, the journal of the National Association for Business Economics. In a review of Sebastian Mallaby’s The Man Who Knew: The Life and Times of Alan Greenspan, Poole argues, basically, that Congress under both the Clinton and Bush administrations pushed Fannie Mae and Freddie Mac to accumulate subprime mortgages under pressure from the Department of Housing and Urban Development. These are Government Sponsored Enterprises (GSEs), with Fannie Mae being the Federal National Mortgage Association and Freddie Mac being the Federal Home Loan Mortgage Association. Specifically, Poole, cites Peter Wallison’s case (dissenting member of the 2010 Financial Crisis Inquiry Commission) that affordable housing goals under both Republican and Democrat administrations led to declining underwriting standards (e.g. income tests, etc.) and a huge accumulation by Fannie and Freddie of subprime mortgages (rather than prime mortgages, their traditional function-Poole). Due to accounting irregularities, neither firm presented standard financial reports for years, and when they did, “they lied,” according to Poole.


    These assertions aren’t new but it is somewhat surprising to hear them stated so forcefully by a former FOMC (Federal Open Market Committee) member. Poole’s point is that it will be difficult to avoid the next crisis if the causes of the recent one - lax lending standards promoted by two administrations - aren’t recognized. Specifically, he feels that markets by themselves would automatically have done more due diligence in making loans, but the GSEs reduced the need for that, so the conclusion that markets were to blame is “off by 180 degrees.” Poole also argues that whether or not monetary policy during Greenspan’s tenure leading up the crisis was too loose, (a common explanation for the crisis ) is highly debatable.


    My own view of the financial crisis is that you have to start with the huge reduction in capital gains taxes on housing assets that occurred as part of the Taxpayer Relief Act of 1997. 2002 Nobel Laureate Vernon Smith credited it with “fueling the mother of all housing bubbles.” I think it did increase the after-tax rate of return or yield to housing assets, which should and did cause capital to move into housing, bidding up the price and lowering the yield until it was back in equilibrium with other assets. So I wouldn’t call that a bubble, but I would say that the fairly loose monetary policy that followed in the early 2000s, and the aforementioned pressure on agencies to accumulate sub-prime debt, certainly helped to make it a bubble.


    I also take the economists' view that greed isn’t really an explanation for much of anything. That is, greed is more or less a constant in human nature and human history, and a constant can’t explain a change or catastrophic event. But changing incentives, for a given level of greed, can. All of the above…changing tax rates on housing, HUD pressure on Fannie and Freddie to acquire subprime mortages, and central bank policies of low interest rates (i.e. loose monetary policy), constitute changing incentives. Those changes in incentives, and the normal behavioral responses to them, are what caused the crisis.


  • "Kee Points" with Jim Kee, Ph.D.

    Industrial production jumped up pretty dramatically in April, which is a good sign for manufacturing. Industrial production numbers are more timely (reported monthly) than GDP numbers (reported quarterly) and better counted, meaning subject to fewer revisions. However, they are also more volatile (i.e. more “head fakes”) and less representative of economies to the extent those economies are serviced-based. Not surprisingly then, industrial production numbers are a better proxy for the overall economies in countries that are more manufacturing/industrial based, like many emerging market economies, than in economies that are more service-based, like the US. An old economist’s trick is to look in the back of the Economist magazine for monthly industrial production growth numbers for the world’s major developed and emerging economies, which gives you a quick global snapshot of how things are looking (quarterly GDP growth is also reported). Also reported there are weekly and year-to-date equity market performance of many of those economies. It is very instructive to see how these two numbers often diverge: Industrial production, GDP, etc., is quantity data, which is gathered with a lag and subject to revision. Equity market data, on the other hand, is price data and more forward-looking in general. Prices lead quantities


    An interesting fact: Some years ago, a big story was that the number of mutual funds had actually exceeded the number of publically traded stocks. Recently, the number of “stock index funds” (indices based upon a variety of criteria, e.g. high dividends, emerging markets, etc.) has exceeded the number of publically traded stocks. And this from Christian Ledoux, our Director of Equity Research: In 2015 the top ten stocks of the US market (S&P 500) were up double-digits, while the other 490 stocks were actually negative on average. In fact, by the February 11th low of last year (2016), theaverage stock was down 26.7% from its 52-week high. But since the S&P 500 is cap-weighted (larger companies get a bigger weighting), the official index was down only 15% from its high. So the majority of stocks in the S&P 500 have already been through a “stealth bear market” (i.e. down more than 20%).  


    Antitrust: President Trump’s nomination to head the US Justice Department’s Antitrust Division, Makan Delhrahim (confirmation hearings held May 10), is considered pretty hands-off or permissive when it comes to antitrust enforcement. The impact of antitrust actions on the stock market is pretty under-studied, which I find surprising. George Bittlingmayer of the University of Kansas has probably done and published the most work in this area, though his work is somewhat dated. For example, back in the 1980s his research corroborated the view of economist Irving Fisher, which stressed the importance of antitrust restraint for the stock market boom that occurred during the 1920s. In fact, Bittlengmayer argued that the threat of antitrust enforcement gave rise to the financial panics in the early twentieth century. He would look at the relationship between the number of antitrust case filings on the one hand, and stock market declines (reactions) on the other. A paper of his in 1993 argued that antitrust explains ten to twenty percent of annual stock returns, and later work (2000) suggested that actions filed against Microsoft hurt computer industry firms in general. It would be nice if there was more peer-reviewed research to balance out Bittlingmayer’s views, but I don’t come across much. The point is that his research suggests that Delhrahim’s appointment would be a tailwind for the market.


    Finally, economist William Baumol passed away last week at the age of 95 (WSJ), which is an end-of-an-era event for professional economists. Baumol published in just about every field of economics, but I was most familiar with his textbook on Economic Theory and Operations Analysis. Operations research, or “OR,” has had several false starts in economics, not unlike game theory or even behavioral economics (more on that next week). It involves mathematical optimization techniques, many of which evolved from military research. Back in the 1960s there was great enthusiasm for applying these techniques to solve business problems, and many large firms established operations research teams. But by the 1970s the limitations of mathematization of business problems became obvious, and most of those programs were scrapped (they had broad success in physical applications, like refinery operations). I see a resurgence of sorts now in the field of business analytics, a product of the data generated through the use of information technology. [Aside: typically OR has fallen into one of two groups. The first, characterized by the late Gene Woolsey at the Colorado School of Mines (with whom I studied), asserts that you can only understand a process or operation by actually working every stage of it, from operating the cash register to driving the truck (so to speak). The second, characterized by Eliyahu Goldratt and the Theory of Constraints (TOC), places more emphasis on applying theoretical concepts, in this case finding the constraint(s) in the system and applying resources to that constraint (1920s scholars, long forgotten, called it “finding the neck in the bottle”). I think both are viable ways to skin the cat].



  • "Kee Points" with Jim Kee, Ph.D.

    Okay, it is good to have a week where everything goes pretty much according to expectations. In France, Emmanuel Macron defeated Marine le Pen in the French presidential election on Sunday. Macron was the pro-European Community, pro-euro currency candidate, so his election – though expected – is perceived as a vote for stability rather than a Brexit-type shock to the system. In the US, hiring bounced in April with 211,000 new jobs created (the March number was a disappointing 79,000). Monthly data is noisy, and a rebound was expected, but again, nice to have a week with few surprises. And first quarter company earnings or profits in the US are coming in stronger than a year ago, as is sales or revenue growth. That too was expected. Business investment spending remains muted, but that should change under virtually any plausible scenario of business tax reforms being considered.


    1980’s boom? Don’t let the daily business press distort your thinking on the impact of tax reform on stock market returns. It’s not that taxes don’t affect stock market valuations – they do! They affect company earnings or profits (corporate income taxes), and they affect how much investors are willing to pay for each dollar of earnings or profits (so called “investor taxes” on dividends and capital gains). To understand this last point, consider that investors in the aggregate typically discount future earnings at what is known as investors’ required rate of return, which is after tax and after inflation. Lower investor taxes and/or lower inflation lowers this discount rate and increases equity values: a dollar’s worth of earnings is worth more – you’ll pay more for it - if the taxes you have to pay on it, whether dividend or capital gains taxes, are lower. But remember, markets are forward-looking, so it is reasonable to assume that the markets have already priced in some meaningful tax reform. That wasn’t the case in the early 1980s, when the Dow Jones industrial average was 70% below nominal GDP stated in billions of dollars (Studies at Georgia Tech show that these two tend to be the same over time). But I want to re-state or reiterate what I think is a big theme for global investors going forward, one that is multi-year and in keeping with the appropriate time horizon of equity investors:


    Returns on capital far exceed the cost of capital, which should lead to strong investment spending but has not Business investment spending should be a much stronger driver going forward than it has been. On the demand (for investment funds) side, that’s largely because a decade of policy uncertainty has tended to keep cash (business spending) on the sidelines or held overseas. On the supply (of investment funds) side, some regulatory clarity and simplification on Dodd-Frank banking legislation is likely going forward, and it is fairly widely acknowledged that the evolution of this particular legislation has thwarted credit creation, or the banking system’s ability to serve as a financial intermediary matching capital with opportunity. That’s how Canadian economist Reuven Brenner described capitalism’s wealth-creating tendencies when functioning properly: “It matches brains with capital and holds both sides accountable.”  


    That’s the big-picture case for optimism: You have on the one hand a tremendous amount of global capital tied up in safe-haven fixed income instruments. And on the other you have the majority of the world’s population still in need of massive infrastructure spending as they go from rural to urban, and from primitive to modern. In the developed world you see increasing technological obsolescence as information technology marches on while corporate and consumer spending on technology lags. At some point all of this capital should address all of these needs.


       

  • "Kee Points" with Jim Kee, Ph.D.

    Okay, it is good to have a week where everything goes pretty much according to expectations. In France, Emmanuel Macron defeated Marine le Pen in the French presidential election on Sunday. Macron was the pro-European Community, pro-euro currency candidate, so his election – though expected – is perceived as a vote for stability rather than a Brexit-type shock to the system. In the US, hiring bounced in April with 211,000 new jobs created (the March number was a disappointing 79,000). Monthly data is noisy, and a rebound was expected, but again, nice to have a week with few surprises. And first quarter company earnings or profits in the US are coming in stronger than a year ago, as is sales or revenue growth. That too was expected. Business investment spending remains muted, but that should change under virtually any plausible scenario of business tax reforms being considered.


    1980’s boom? Don’t let the daily business press distort your thinking on the impact of tax reform on stock market returns. It’s not that taxes don’t affect stock market valuations – they do! They affect company earnings or profits (corporate income taxes), and they affect how much investors are willing to pay for each dollar of earnings or profits (so called “investor taxes” on dividends and capital gains). To understand this last point, consider that investors in the aggregate typically discount future earnings at what is known as investors’ required rate of return, which is after tax and after inflation. Lower investor taxes and/or lower inflation lowers this discount rate and increases equity values: a dollar’s worth of earnings is worth more – you’ll pay more for it - if the taxes you have to pay on it, whether dividend or capital gains taxes, are lower. But remember, markets are forward-looking, so it is reasonable to assume that the markets have already priced in some meaningful tax reform. That wasn’t the case in the early 1980s, when the Dow Jones industrial average was 70% below nominal GDP stated in billions of dollars (Studies at Georgia Tech show that these two tend to be the same over time). But I want to re-state or reiterate what I think is a big theme for global investors going forward, one that is multi-year and in keeping  with the appropriate time horizon of equity investors:


    Returns on capital far exceed the cost of capital, which should lead to strong investment spending but has not Business investment spending should be a much stronger driver going forward than it has been. On the demand (for investment funds) side, that’s largely because a decade of policy uncertainty has tended to keep cash (business spending) on the sidelines or held overseas. On the supply (of investment funds) side, some regulatory clarity and simplification on Dodd-Frank banking legislation is likely going forward, and it is fairly widely acknowledged that the evolution of this particular legislation has thwarted credit creation, or the banking system’s ability to serve as a financial intermediary matching capital with opportunity. That’s how Canadian economist Reuven Brenner described capitalism’s wealth-creating tendencies when functioning properly: “It matches brains with capital and holds both sides accountable.” 


    That’s the big-picture case for optimism:  You have on the one hand a tremendous amount of global capital tied up in safe-haven fixed income instruments. And on the other and you have the majority of the world’s population still in need of massive infrastructure spending as they go from rural to urban, and from primitive to modern. In the developed world you see increasing technological obsolescence as information technology marches on while corporate and consumer spending on technology lags. At some point all of this capital should address all of these needs.

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