Economics at Play - Why "dubah-ya" wanted us to Spend

You often hear on the news that because of the economy:

- People are taking less vacations
- Buying less cars
- Buying less technology

Intuitively, this makes sense to all of us, but in looking at the economy as a whole, we can see that there are larger implications. I think that this is very important to discuss, especially when it comes to stimulus plans in the US and the multiplier effect. There are many different ideas at play and it is important to acknowledge their respective effects on the economy.

Marginal Propensity to Consume (MPC) - This is a measure of overall spending habits. It is usually phrased as such: "If I was to give you an extra dollar, how much of it would you spend?". MPC is a measure of individual spending, but also, more importantly money flow. This eventually leads to the powerful idea of a GDP multiplier (why George W. Bush asked us to all go out and spend). When you spend a dollar, the GDP will go up by an amount greater than the dollar. Why? Because if you spend that dollar, the person who receives it will save a portion of it (marginal propensity to save, MPS = 100% - MPC) and spend the rest (MPC). This amount that is spent recursively goes through the same process over and over again. The result is a converging geometric series whose aggregate solution is the multiplier (the multiplier is calculated by 1/MPS, so if we all spend half of the $1 we get, the GDP eventually goes up $2). Hint: The US has a generally higher MPC than Japan (who has a higher MPS). But it also lends itself to volatility (when times are good, a high MPC allows the GDP to grow really quickly, but when times are bad, all the extra GDP growth from strong money flow drys up just as fast).

Income Demand Elasticity - Income Demand Elasticity is essentially a fancy way of saying, if I gave you more money, would you buy more of a particular item. It is a good way of anticipating consumer behaviour for different classes of goods. For instance, if you suddenly made 10x more money, you'd probably not buy any more orange juice than you already do, but you might be tempted to buy that sports car. Conversely, if you got laid off and had to live off of savings for a while (a situation many people are now finding themselves), you might not give up OJ as quickly as the new car. This lends itself to the idea of "defensive" class stocks such as Walmart and McDonalds. These types of companies don't suffer as much (and often thrive) in hard times because peoples spending in these areas don't change.

Whether on an aggregate (GDP) or microeconomic (one particular company) scale, government spending would manifest as a right shift in the demand curve (more demand) which implies (cateris paribus) that both quantity supplied and prices would go up (demand pull).

Based on this, you can see why Democrats and more Keynesian style economists would like to stimulate the economy through spending. However, Republicans and conservatives would usually prefer tax cuts as a method of rewarding working business models and getting government out of the way (another interesting analysis for a future post).

Despite all this analysis, however, it seems like a bit of a moot point in our current environment. The stimulus package won't single handedly solve the problem (as almost everyone has acknowledged that more help will be needed) and it seems that the most important issue that needs to be address is that something needs to be done expediently and there will certainly be a need to reassess the next steps in the near future.

Why Bernoulli based models are rubbish - and why they might work

I've recently read from a brochure from a highly respected Canadian big bank about Behavioural Finance, particularly, the Gambler's Fallacy - The idea that future random events depend on past random events. It proposes the idea that if a stock rises five consecutive days in a row, that if you assumed it's less likely to rise on the sixth day, then you are a victim of a gambler's fallacy. Although I can see their rational, I strongly disagree.

If the analogy was taken into a casino, where future random events *are* independent of past events, then I would agree. However, I think that this model oversimplifies the stock market. And the principles on which this type of modeling is built, Bernoulli trials, should not hold under the Efficient Market Hypothesis.

The reason I'm so confident in making this statement is that I would like to believe that there are *some* rational value based traders out there who, when the stock price varies too far from its intrinsic value, will buy or sell accordingly. In this way, those traders who are doing their homework are essentially profiting off of those who are trading as if each day's outcome is random (or even if you model your risk management as if these outcomes are random). Prices *should* gravitate towards some number, and therefore each day's rise or fall *is* dependent on the day before it. A prime example is the price escalation we recently saw. Bernoulli trials would have simply labeled them as "unlikely" but I'd like to think that a value based trader would see a bubble forming.

Having said that, with all the emotional and fear based trading going on, this lack of faith causes high volatility in prices and using a Bernoulli type model might have some value as a risk management tool based on certain similarities. However, trying to get actionable value from it would be like attempting to profit from chaos which is risky and difficult (like creating a Garbage In Gold Out model).

However, those of you that can profit from this volatility will actually be providing a service to the economy in the form of marginal price stabilization. Anyone who is able to profiteer from the mood swings by reducing the spreads will bring us closer to something resembling that should happen under EMH.

But real stability won't happen until there is enough stable capital in the market that doesn't exhibit flight at the first hint of trouble. And that won't happen until there is broad based confidence in the fundamentals of the economy.

Edelman Trust Barometer

I attended a talk yesterday at Rotman's Fleck Atrium by Richard Edelman. He gave an interesting perspective of our current crisis from a PR perspective and how it relates to the changing relationship between stock holders and stake holders, business and government.

Among his points, he highlighted that there is a broad based 3 to 1 ratio of trust in government versus business and that as a result business should partner with government and NGO's (who had much more credibility) to shape policy within the private sector. One intellegent question asked by an audience member was if the organizations with good credibility are put at risk when they partner with businesses. The good response was that as in any "marriage" there is some risk, and that it was incumbant on both parties to know what they were getting into.

Another hot topic was the idea of CEO compensation. With CEO salaries in the multiples of several hundred times some of the lower paid employees, the conflict between sky rocking compensation packages versus the ability to attract the talent and performance they were supposed to was also brought up as an issue of credibility. A good example is what was recently done by the CEO of Canadian banks who, unlike their US counter parts, have demonstrated more stable decline (not as sudden or sharp) but proactively cut their bonuses.

This started to raise a whole host of issues such as social responsibility, dispersion of authority and the need for continuous conversation (I would personally phrase this as closed loop versus open loop communication - the idea that you can't just drop a message and run, but that you have to stick around for feedback and critiquing).

One of the good take away messages that Canada has a strong potential to pick up some leadership in the national landscape as our banks were rated #1 in terms of trust due to our moderate social democracy and well governed mixed economy.

Asset Allocation - A Potential Key to Success

Let's assume that there are three asset classes: Equity, Fixed Income (Bonds), and Cash.

Generally, these three classes are generalized as follows:

Equity - Highest volatility, highest potential for growth and gains (let's say 8%)
Fixed Income - Moderate volatility, moderate gains (let's say 4%)
Cash - No volatility, Low to no gains, incredibly liquid (let's say 0%)

Let's also assume that you are relatively young and looking for growth (let's say 20's to 40's) and that you have 100k to invest. Your allocation might look something like this (numbers will vary based on your individual risk tolerance profile):

E - 50% - 50k
FI - 30% - 30k
C - 20% - 20k

Now let's say that things go according to plan and your portfolio next year becomes:
E - 50k * 108% = 54k (51.3%)
FI - 30k * 104% = 31.2k (29.7%)
C - 20k = (19%)

Your portfolio is now worth $105.2k. If you were to re-balance your portfolio, you'd move some of the value received from equities into fixed income class (.3% worth or ~$315.60) and cash (1% worth or about ~$1.052k). I think this is the most "true" definition of "profit taking" that we often hear about on stocks news shows, where a calculated reallocation of capital takes place from one class to another more liquid class (cash).

Having said that, how does this protect us from huge crashes (as I suggested they might in a previous post)? Well an indicator that a bubble is about to burst is when equity prices start going too high. However, if you notice, as equity prices start to get too high, you start to liquidate your position out of them (to a position which is more comfortable for your tolerance). You begin to take your gains out and put them in more stable instruments.

How about when prices fall? Say the equity component drops as well. If you follow the strategy, you will take money from your FI or C and bolster your E (in an attempt to profit from low prices). You can clearly see that the old adage "Buy low sell high" is built right into the strategy.

Although hardly a perfect strategy, we can improve it's effectiveness by looking at a few issues which arise:

Frequency of re-balancing - There are transaction costs involved with re-balancing portfolios (it might not be simple nor cheap to just sell equity class investments and buy fixed income instruments). Therefore, you might not be able to re-balance the portfolio every time there is a tiny bit of movement. However, re-balancing should take place at regularly defined time intervals (say a year), OR if a certain threshold is met (your equities gaining 20% in a day might be a good reason to reallocate funds).

Seeding your investments - Another way to "re-balance" is for people who regularly contribute to their investment portfolio through regular contributions (RRSP or just general savings). If your portfolio is misaligned, you can divert the funds you were planning on investing into the appropriate category. For example if you had the ratio mentioned above as a plan, but your portfolio was currently overweight in the FI class, you could put your savings directly into E to balance it out.

Redeeming your investments - If you are close to retirement and taking money out, you can take money out of a class which is overweight. Let's say that in retirement you want to move from the ratio mentioned above (50/30/20) into a ratio of 30/50/20, you might start by cashing out your equities first.

Granularization - When you have the opportunity to add (or remove) funds to (or from) a particular class, such as equity, you can use the same recursive thought process for which individual equities you want to buy more of. For instance, you can purchase more of a stock which is currently at a lower price relative to it's counter parts rather than try to buy a spread of stocks (if transactions would prevent that). Or you could buy more of a particular ETF.

Especially for people who want to be more active in their retirement planning, but aren't experts in investing, I'd rank this as a good strategy to use even right up to investors who would categorize themselves as moderate to highly experienced. Even investment firms will practice this in a more sophisticated way but having a variety of funds available to capitalize on different opportunities in the market (and can be classed by weigh in terms of how much capital exposure is allocated to them.)

Lessons and Strategies from Our Current Crisis

Risk Managers have always been seen as people trying to halt deals. Not necessarily the most popular people in the office, they seem to be the "boys that cry wolf" only this time the wolf was there and the economy crashed. Skeptics (aka the cowboys) will decry the predictions, often saying something similar to: "If you say the end is coming enough, you'll eventually be right".

So how can we balance the knowledge that a potential bubble is building with the understanding that it will eventually burst? Although you can closely monitor the "warning signs", it is tragically difficult to predict the bursting of bubbles (such as Warren Buffet's correct, but poorly timed shorting of tech stocks just before the tech bubble burst).

As portfolio managers and equity analysts will attest, it is becomes difficult (near impossible) to know when the burst will come. From their perspective, they need to always find places where their capital will provide good returns.

As a result, I think it is incredibly important to diligently use asset allocation (*AND* re-balancing) as a strategic method of pre-determining your level of volatility tolerance (conversely known as your aggressive greed level).

The Dual and Compounding Effect of EPS

I've repeatedly mentioned EPS and PE as a model for creating a price for stocks. However, I've also cautioned against using it recently as there are some problems with it in this economy. To further understand how a model like this can fail (or rather, underestimate the effect of EPS on price), I thought it might be prudent to delve further into how EPS movement affects stock price.

Although the formula for price with regards to EPS and PE is quite simple (Stock Price = Earnings Per Share x Relevant Price to Earnings Ratio), it is in determining the appropriate ratio which is particularly difficult.

For instance, I had a previous target of RIM between $57.75 to $64.80 (which has gotten blown away with the recent plummet in stock price). RIM's quarterly EPS guidance was dropped to about the low 80's cents per share mark versus the high of 95ish. This affects RIM's stock price doubly because: EPS now shrinks rather than grows and the PE ratio also shrinks to match the corresponding lack of EPS growth. Especially for a growing company like RIM, investors get spooked when they think that the company won't exhibit the behaviour of a growing company and begin to behave more like a company reaching maturity in its industry - the reaction to their news that they have more subscribers but lower margins could be read as an indicator of that - further compounding the price drop in the "panic" category of selling (technically outside the scope of this post).

So with downwardly revised EPS guidance, the new annual EPS calculation as well as the relevant PE ratio used for PE analysis drops. Since the company doesn't look like it's growing any more, people struggle to find an appropriate PE ratio to assign to the stock. As I mentioned before, a mature company has a PE usually between about 8 to 12. A growing company will usually have ratios between 15 to 20.

[Aside: And I don't think RIM should be trading as if it's some sort of "speculative" tech stock. It's long past those days, yet the volatility just shows that there is some volume in there that is "emotional" (which I believe was confirmed by it's recent recovery and uptick - but again I digress).]

But just as with the PE or PEG ratio, if you aren't (or don't seem to be) experiencing growth, your potential outlook (beyond your current reported numbers) dims also, and your price takes that second hit.

However, having said that, any sign of strength will cause a compounded recovery in price by the same mechanics and this is a leading cause in the volatility of stock prices, especially those with volatile EPS.

Does all of this sound familiar? That's because it's essentially a very similar concept to the Capital Asset Pricing Model (CAPM) and the idea of beta, how the stock price moves with the market (but with more amplified effects). For growing companies who exhibit greater volatility, you can expect that their beta will also be quite high. The idea that with incremental risk come incremental rewards.

Is "What's good for General Motors is good for the country" still true?

Charles Erwin Wilson was once asked if he could make a decision adverse to the interests of General Motors (when he was serving as Secretary of Defense while he was President of GM). Wilson answered affirmatively but added that he could not conceive of such a situation "because for years I thought what was good for the country was good for General Motors and vice versa".

While that ideology has held up in the past, that is clearly not the case today. And while people will point fingers as to what *exactly* went wrong (bad management, poor product development strategies, expensive union labour etc) the clear point here is that there isn't much right.

In this scenario, the capital markets are doing exactly what they are supposed to: weed out weak companies. When the demand for an industry's products decline (left shift in demand) the supply side must respond appropriately (supply shift left) in order for the industry to remain profitable. "Supply shift left" is a very fancy way of saying cutting capacity. This means closing factories and losing jobs in weaker companies.

Recently, GM has been looking for government assistance in various forms (loans etc). But I think this is incredibly unfair, especially to the car companies which are performing well producing products that people want.

The way that our economic model is supposed to work is that companies that can't survive on their own are supposed to die out. The only "stimulus" I think would be fair is one that isn't targeted to specific companies, but rather tax reduction stimulus for the industry in general (for instance, tax deductions for the R&D of fuel efficient cars - or with the drop in oil prices perhaps some other incentive program). That way, the industry is still bolstered, but not disadvantageously towards failing companies (and all companies including GM would benefit greatly and move towards products that people are more interested in buying - something good product development strategies would have taken care anyways of in a strong company).

If you want to approach this from a government spending side to generally soften the pain, I think the most appropriate avenue would be to spend on retraining for the jobs lost in the factories. It's not that I have an irrational dislike of factory workers or their unions, but if we can retrain them for jobs which society will benefit more from, then I wonder why we are not doing it?

Another spending option is improving municipal mass transit by purchasing more buses. Many of these companies have divisions which build larger class vehicles and would benefit from government spending in this area. Although this might erode your long term demand by creating a cheaper substitute for individual commuting, it is certainly in line with the overall tone of environmental sustainability and the goal of less reliance on foreign oil.