Archive for Myth Busting – Page 2

“Smart Beta” & Smart Beta Hypocrisy

Smart beta is the new buzzword on Wall Street.  No one really knows what it is because the term doesn’t have a specific definition, but the easiest way to understand what “smart beta” funds do is that they’re basically tweaking index funds to try to generate some extra return.  For instance, instead of using a market cap weighting you might use an equal weight.  Then these fund managers perform all sorts of backtests, crank out something with a heavy dose of confirmation bias and sell an ETF that’s basically an index fund marketed as something that’s superior than a broad index.

I think Burton Malkiel really nails it here on the WealthFront website when he says:

“Smart Beta” strategies rely on a type of active management. They are high cost and tax inefficient relative to traditional index funds and none have reliably and consistently beaten the market. As recent research and commentary from Vanguard Group puts it “Smart Beta” strategies are often, “active bets and not substitutes for traditional index funds.”

“Smart Beta” portfolios are more a testament to smart marketing rather than smart investing.

That’s basically right.  “Smart beta” is basically marketed as a more efficient form of indexing.  But what’s surprising about Malkiel’s rejection of this is that his new firm, WealthFront, actually does something that’s very similar.  For instance, if you run through the WealthFront portfolio design process for a young, middle income investor with a high risk tolerance you come up with a portfolio that looks like this:

US Stocks: 35%

Foreign Stocks: 24%

Emerging Markets: 18%

Dividend Stocks: 9%

Natural Resources: 5%

Municipal Bonds: 9%

Another way of saying this is:

Stocks: 86%

Commodities: 5%

Bonds: 9%

So what Malkiel is endorsing is actually very similar to what he’s criticizing.  His firm claims that they can pick better or more efficient funds than broad indices.  And then they sell this idea as something “optimal” and back it up with all sorts of vague research that confirms some preconceived bias.  After all, if Malkiel were a true indexer and merely picked the Vanguard Balanced Index or chose three broad funds  like the Vangaurd Total Stock Index, the Vanguard Total Bond Market and the iPath Dow Jones-UBS Commodity Index then my guess is that most of their clients would ask them why the heck they need WealthFront when they can simply open up a discount brokerage account and buy ONE or THREE simple funds?   Of course, that’s where Malkiel will tell you that his firm has chosen “optimal” allocations and enhanced returns through other “active” portfolio management techniques (like tax loss harvesting or “tax aware allocation”).

And this is the problem with trying to define “active” versus “passive” approaches.  The reality is that Malkiel is actually endorsing a strategy that is more active than owning a simple Vanguard Balanced Index or the broadly diversified three fund alternative.  And they’re selling it as something different so they can differentiate their business model and justify charging higher fees than the broad aggregates do.  The reality is that we’re all active to some degree and that the closest thing to a truly passive portfolio is a portfolio that simply buys aggregates rather than pretending to know which funds will generate “optimal” returns INSIDE of specific aggregates.  In other words, as a smart man once said:

“[these] portfolios are more a testament to smart marketing rather than smart investing.”

 

The Lack of Business Investment Myth

There’s a myth in the current economic recovery that just won’t die.  It’s this flawed idea that businesses aren’t investing, aren’t hiring and aren’t contributing at all to the recovery.  This is not true.  In fact, businesses are one of the only reasons this economy hasn’t sunk back into recession already.

First of all, gross private domestic investment is higher than it’s ever been in nominal terms.  It’s true, as a percentage of GDP, private investment is still climbing out of a very deep hole, but it is certainly climbing.  And it’s climbing pretty quickly.  The year over year rate of change in private investment has averaged 9.3% since 2010.  During the 80’s and 90’s, when it’s widely perceived that the business environment was booming, investment averaged just 6.8%.

myth1

If we look at GDP by contributions private investment has been one of the only bright spots since 2010 (see the green bars):

myth2

This has been crucial to understanding the health of the US economy in recent years.  I’ve consistently highlighted private investment as a key driver of not only corporate profits, but also GDP growth (see here and here).  This was particularly crucial in recent years as the government’s deficit declined.  Had we seen a large decline in private investment alongside the deficit then it’s likely that we would have seen much worse economic data.  But the reality was that the deficit was declining, in large part, because investment was booming thereby leading to higher tax receipts and not the “fiscal austerity” that many were using as “evidence” of potential future problems in the economy.  Lots of people said the sequester and other reductions in the deficit would hurt the recovery.  But they’ve been wrong.  In large part because they focused too much on the government sector and not enough on private investment.

The bottom line: businesses are contributing to the current recovery.  Could they do more?  Of course.  But businesses are typically reactive to the economic cycle and tend to ramp up investment later in the business cycle as they see demand improving.  That’s got its own set of problems to it, but thus far I think it’s safe to say that business investment has been one of the key reasons this weak economy doesn’t look MUCH weaker than it is.  And we should all be thankful for that.

 

The Best Thing You’ll Read Today: Settling the Profit Margin Debate

You should read this post by Jesse Livermore on profit margins (you can also find him on Twitter here).  He goes through a meticulous macroeconomic analysis of the corporate profit margin debate, how it’s been misleading, how it’s been useful and how to improve it.  Here’s a snippet of some of my favorite parts, but you should spend some time reading the whole thing:

cpataxgdp

This latter chart, CPATAX/GDP, and that of its twin brother, CPATAX/GNP, is anillusory result of flawed macroeconomic accounting.  In the paragraphs that follow, I’m going to try to clearly and intuitively explain why.  Hopefully, the chart will disappear once and for all.

For investors, refusing to respond to changes in reality will lead to destruction.  Reality will not tolerate it.  If a variable that allegedly mean-reverts refuses to revert over long periods of time, then we need to acknowledge the possibility that the variable is not naturally mean-reverting, or that the mean that it naturally reverts to has changed. Economics is not physics.  There are no “divinely-ordained” constants that govern the system.  The averages that economic variables exhibit, and the settling points towards which they gravitate, can and do change as secular conditions in economies change.  This fact is true of almost anything “economic” that we might measure–growth rates, interest rates, inflation rates, asset valuations, and profit margins.

Utilizing the data in NIPA Table 1.14 (FRED), we end up with the following chart, which is the only accurate NIPA chart of net profit margins for the macroeconomy, and the only NIPA chart that anyone should be citing in this debate.

npmdb1

 

 

The Biggest Myth About Quantitative Easing

I have spilled a huge amount of ink about Quantitative Easing and its impacts over the last 5 years (see here).  One of my key points about QE is to highlight how it probably hasn’t had as much impact on the broader economy as some people tend to imply.  In other words, it’s not as stimulative as many think.

But one thing that’s undeniable is that QE has an impact on asset prices.  It not only has a strong behavioral impact, but directly impacts the supply of outstanding assets thereby forcing the private sector into other assets like corporate bonds and stocks.  Anyone who says this has no impact on asset prices is ignoring reality.

On the other hand, I do fear that some advocates of the “QE = higher asset prices” have a tendency to imply that there has been no fundamental reason for the rally in stocks.  In other words, they imply that the current rally is all a house of cards that is built on fake “money printing” and fake demand.

But this view totally ignores the key driver of asset prices.  Yes, you can alter the supply of an outstanding asset, and all else being equal, it will rise in value.  But all else is only equal in mythical economic models.  All else is never equal.  For instance, a company can reduce its outstanding share count thereby boosting EPS and its current price, but if the underlying fundamentals deteriorate then the asset will not likely sustain any boost in price from the buyback.  QE is very similar.  Yes, the Fed can reduce the outstanding investable assets in the private sector, but that doesn’t mean there can’t be underlying fundamental strength to sustain any rise in prices (although markets can obviously remain irrational for long periods of time).

And I think this is a key point that many of the QE alarmists gloss over.  There has been real fundamental underlying improvement here.  The most important of which is shown in today’s Z.1 Flow of Funds report in the form of business spending and corporate profits.

qe1 qe2

These two charts prove, without a shadow of a doubt, that there has been real underlying fundamental improvement in corporate balance sheets.   We can argue about whether the market is “expensive” or a good “value”, but I think one thing we shouldn’t imply is that the current rally is purely driven by a false underlying driver such as QE.  That’s clearly not entirely accurate.

 

Is “Maximizing Shareholder Value” a Myth?

I read an interesting piece in the Washington Post this morning about the “myth” of maximizing shareholder value.  In the piece Harold Meyerson shows, correctly, that there is no law requiring corporations to maximize shareholder value.  He then goes on to argue that this concept has contributed to some of the problems in the US economy today. But I think he incorrectly dismisses the concept of “maximizing shareholder value” in much the same unbalanced way that the concept has come to be abused by those who worship at the altar of shareholder value.  There are a lot of moving parts here, but I’ll offer my views with (hopefully) some brevity.

First of all, it’s true that there’s no law requiring companies to maximize shareholder value.  But this has nothing to do with the basic premise behind the concept of “maximizing shareholder value”.  For instance, corporations have a legal responsibility to abide by the regulatory framework within which they must operate.  This doesn’t mean they have a responsibility to maximize public good.  It just means they can’t break laws that might otherwise harm the general public.  But this legal requirement doesn’t make private entities servants of the government or even the general population.

More importantly, when we discuss the idea of capitalist entities we must consider who the company serves.  A capitalist entity is not legally required to serve anyone.  After all, a company can be run in any manner in which those in charge choose.  It can serve a poodle in Bangladesh if management so chooses. Of course, that wouldn’t help the entity survive, but you get the point.  So, who does a capitalist entity serve?  Ultimately, the company serves lots of different people and even itself.  The company serves its customers.  The company must also serve itself to some degree.  And the company must serve its owners.  This is generally a complex balancing act and only the best companies can maintain this balance over the long-term.

In the case of owners, most claimants are shareholders.  That is, it is the shareholders who have a legal right to the residual profits that a company earns and they elect the Board of Directors who elect the management of the firm.   Most good capitalists (no, that’s not an oxymoron although it certainly can be!) understand that they must abide by the laws, serve their customers, serve their employees, do what’s in the best interest of the firm and hopefully generate a profit which rewards the owners as well as the corporation and all involved (after all, a company that goes out of business can’t benefit anyone).  These goals are not necessarily at odds with one another.  In fact, the best and most viable corporations generally balance them all pretty well.  The problem is, it’s not easy to balance all of these goals and most companies fail in trying.  In addition, I think one could argue that, in the last 30 years, some components have been ignored at the expense of others.

On the whole, the concept of “maximizing shareholder value” is not a myth at all.  But if taken to an extreme, I think that capitalists can abuse the concept and try to implement this concept with the hope of near-term gains at the expense of long-term gains.  This makes the concept of “maximizing shareholder value” a potentially dangerous one because the desire to maximize short-term gains can, at times, hurt the firm in the long-run.  And that generally involves a good deal of collateral damage. So, it’s not that this concept is inherently evil.  More likely, it’s that the concept can be abused by people who misunderstand how it should be conceptualized within a broader framework of a capitalist entity’s long-term goals.

The “Fat Pitch” Myth

I was intrigued by comments in this interview with Marc Faber of the Gloom, Boom and Doom Report.  He said:

“I am hoping for the market to drop 40% so stocks will again become, from a value perspective, attractive again…I think stocks are, by and large, fully priced.”

I run into this sort of thinking quite a bit.  It’s the idea that you’re just going to sit on your cash and wait for the next fat pitch and then hit the big home run that sets you on the path to financial freedom.  After all, that’s what hot shot investors like Warren Buffett do, right?  Buffett famously talked about how he likes to wait for “fat pitches”:

“I call investing the greatest business in the world,” he says, “because you never have to swing. You stand at the plate, the pitcher throws you General Motors at 47! U.S. Steel at 39! and nobody calls a strike on you. There’s no penalty except opportunity lost. All day you wait for the pitch you like; then when the fielders are asleep, you step up and hit it.”

“Wait for a fat pitch and then swing for the fences.”

I really don’t like this way of thinking about the world of asset management and I think it blurs the line between what someone like Buffett does and what most of the rest of us do when we allocate assets.  Most importantly, it distorts what we really should be trying to do. Here’s my reasoning:

    • Warren Buffett does not always engage in market transactions that resemble anything remotely close to what the rest of us do.  Buffett is a true “investor” in the sense that he is often fronting capital for future production.  And the process by which he does so generally involves a tremendous amount of information or competitive advantage that the rest of us simply don’t have.  Buffett is getting fat pitches thrown at him all the time.  For instance, he had General Electric and Goldman Sachs, two of the most prominent firms in history, banging down his door begging to give him high yielding warrants in 2008.  The rest of us couldn’t get that “fat pitch” in our wildest dreams.  It’s a pitch most of us will never even see because it doesn’t get thrown to the average person.

 

    • The “fat pitch” myth assumes that you actually know what a fat pitch is to begin with.  It assumes that the next time the markets slide you’ll be able to know when there are superior “values” in the market or that you’ll be able to control your emotions better than everyone else as you time the bottom of the market and ride it back up to riches.  Maybe you can do that.  But the odds are that you won’t know when the market is a good “value” any better than when your dog will know the market is a good “value”.

 

  • The “fat pitch” myth misses the way most of us get rich in markets.  Most people who make sizeable gains in the markets do not swing for the fences or try to hit home runs.  Sure, the home run hitters are always the people who garner the most attention.  But they’re also a fairly rare occurrence and the fact that someone hit a 800 foot home run in 2008 doesn’t mean that person was necessarily talented or doing something that can be replicated.  The thing is, most of us get wealthy in the markets by hitting lots of singles, doubles and just getting on base a lot.  The best part about the market is that you don’t have to swing a lot.  But that doesn’t mean you have to wait for fat pitches to try to hit out of the park.  In fact, a lot of the time the market will help you score runs by simply doing nothing (ie, walking a lot).  The key to success in this business isn’t about hitting home runs and swinging for the fences.  It’s about getting on base a lot and scoring runs efficiently and consistently over a long period of time.

The bottom line: don’t fall for the fat pitch myth.  It’s more likely to lead you astray as you try to maintain your portfolio over the long-term.

 

The Biggest Myths in Economics

Heidi Moore asked a good question on Twitter yesterday about the most prominent myths in economics. I’ve compiled a substantial number of “myth busting” articles over the last 5 years so I thought it might be worth touching on a handful of the more destructive ones in some detail. A lot of this will be very familiar to regulars, but should provide a nice summary regardless.  So here we go:

1) The government “prints money”.  

The government really doesn’t “print money” in any meaningful sense.  Most of the money in our monetary system exists because banks created it through the loan creation process.  The only money the government really creates is due to the process of notes and coin creation.  These forms of money, however, exist to facilitate the use of bank accounts.  That is, they’re not issued directly to consumers, but rather are distributed through the banking system as bank customers need these forms of money.  If the government “prints” anything you could say they print Treasury Bonds, which are securities, not money.  The entire concept of the government “printing money” is generally a misportrayal  by the mainstream media.

See the following pieces for more detail:

http://pragcap.com/stop-with-the-money-printing-madness

http://pragcap.com/where-does-cash-come-from

2)  Banks “lend reserves”.  

This myth derives from the concept of the money multiplier, which we all learn in any basic econ course.  It implies that banks who have $100 in reserves will then “multiply” this money 10X or whatever.  This was a big cause of the many hyperinflation predictions back in 2009 after QE started and reserve balances at banks exploded due to the Fed’s balance sheet expansion.  But banks don’t make lending decisions based on the quantity of reserves they hold.  Banks lend to creditworthy customers who have demand for loans.  If there’s no demand for loans it really doesn’t matter whether the bank wants to make loans.  Not that it could “lend out” its reserve anyhow.  Reserves are held in the interbank system.  The only place reserves go is to other banks.  In other words, reserves don’t leave the banking system so the entire concept of the money multiplier and banks “lending reserves” is misleading.

See the following for more detail on the basics of banking:

http://brown-blog-5.blogspot.com/

Also see this Fed paper on this topic:

http://www.federalreserve.gov/pubs/feds/2010/201041/201041pap.pdf

3)  The US government is running out of money and must pay back the national debt.

There seems to be this strange belief that a nation with a printing press whose debt is denominated in the currency it can print, can become insolvent.  There are many people who complain about the government “printing money” while also worrying about government solvency.  It’s a very strange contradiction.  Of course, the US government could theoretically print up as much money as it wanted.  As I described in myth number 1, that’s not technically how the system is presently designed (because banks create most of the money), but that doesn’t mean the government is at risk of “running out of money”.   As I’ve described before, the US government is a contingent currency issuer and could always create the money needed to fund its own operations.  Now, that doesn’t mean that this won’t contribute to high inflation or currency debasement, but solvency (not having access to money) is not the same thing as inflation (issuing too much money).

See the following piece for more detail:

http://pragcap.com/why-the-usa-isnt-going-bankrupt

http://pragcap.com/inflation-is-not-necessarily-a-different-form-of-default

4)  The national debt is a burden that will ruin our children’s futures.  

The national debt is often portrayed as something that must be “paid back”.  As if we are all born with a bill attached to our feet that we have to pay back to the government over the course of our lives.  Of course, that’s not true at all.  In fact, the national debt has been expanding since the dawn of the USA and has grown as the needs of US citizens have expanded over time.  There’s really no such thing as “paying back” the national debt unless you think the government should be entirely eliminated (which I think most of us would agree is a pretty unrealistic view of the world).

This doesn’t mean the national debt is all good.  The US government could very well spend money inefficiently or misallocate resources in a way that could lead to high inflation and result in lower living standards.  But the government doesn’t necessarily reduce our children’s living standards by issuing debt.  In fact, the national debt is also a big chunk of the private sector’s savings so these assets are, in a big way, a private sector benefit.  The government’s spending policies could reduce future living standards, but we have to be careful about how broadly we paint with this brush.  All government spending isn’t necessarily bad just like all private sector spending isn’t necessarily good.  And at a macro level debt doesn’t get “paid back”.  In a credit based monetary system debt is likely to expand and contract, but generally expand as the economy expands and balance sheets grow.

See the following pieces for more:

http://pragcap.com/the-us-government-is-not-16-trillion-in-the-hole

http://pragcap.com/is-social-security-a-ponzi-scheme

http://pragcap.com/the-debt-bad-guys

5)  QE is inflationary “money printing” and/or “debt monetization”.  

Quantitative Easing (QE) is a form of monetary policy that involves the Fed expanding its balance sheet in order to alter the composition of the private sector’s balance sheet.  This means the Fed is creating new money and buying private sector assets like MBS or T-bonds.  When the Fed buys these assets it is technically “printing” new money, but it is also effectively “unprinting” the T-bond or MBS from the private sector.  When people call QE “money printing” they imply that there is magically more money in the private sector which will chase more goods which will lead to higher inflation.  But since QE doesn’t change the private sector’s net worth (because it’s a simple swap) the operation is actually a lot more like changing a savings account into a checking account.  This isn’t “money printing” in the sense that some imply.

See the following pieces for more detail:

http://pragcap.com/understanding-quantitative-easing

http://pragcap.com/why-didnt-qe-cause-high-inflation

6)  Hyperinflation is caused by “money printing”.  

Hyperinflation has been a big concern in recent years following QE and the sizable budget deficits in the USA.  Many have tended to compare the USA to countries like Weimar or Zimbabwe to express their concerns.  But if one actually studies historical hyperinflations you find that the causes of hyperinflations tend to be very specific events.  Generally:

  • Collapse in production.
  • Rampant government corruption.
  • Loss of a war.
  • Regime change or regime collapse.
  • Ceding of monetary sovereignty generally via a pegged currency or foreign denominated debt.

The hyperinflation in the USA never came because none of these things actually happened.  Comparing the USA to Zimbabwe or Weimar was always an apples to oranges comparison.

See the following pieces for more detail:

http://pragcap.com/understanding-hyperinflation

http://pragcap.com/inflation-is-not-necessarily-a-different-form-of-default

7)  Government spending drives up interest rates and bond vigilantes control interest rates.  

Many economists believe that government spending “crowds out” private investment by forcing the private sector to compete for bonds in the mythical “loanable funds market”.   The last 5 years blew huge holes in this concept.  As the US government’s spending and deficits rose interest rates continue to drop like a rock.  Clearly, government spending doesn’t necessarily drive up interest rates.  And in fact, the Fed could theoretically control the entire yield curve of US government debt if it merely targeted a rate.  All it would have to do is declare a rate and challenge any bond trader to compete at higher rates with the Fed’s bottomless barrel of reserves.  Obviously, the Fed would win in setting the price because it is the reserve monopolist.  So, the government could actually spend gazillions of dollars and set its rates at 0% permanently (which might cause high inflation, but you get the message).

See the following pieces for more detail:

http://pragcap.com/i-want-to-come-back-as-the-federal-reserve-you-can-intimidate-everybody

http://pragcap.com/the-mainstream-economists-finally-realize-bond-vigilantes-are-mythical

http://pragcap.com/american-bond-vigilantes-asleep-at-the-wheel

8)  The Fed was created by a secret cabal of bankers to wreck the US economy.

The Fed is a very confusing and sophisticated entity.  The Fed catches a lot of flak because it doesn’t always execute monetary policy effectively.  But monetary policy is not the reason why the Fed was created.  The Fed was created to help stabilize the US payments system and provide a clearinghouse where banks could meet to help settle interbank payments.  This is the Fed’s primary purpose and it was modeled after the NY Clearinghouse.  Unfortunately, the NY Clearinghouse didn’t have the reach or stability to help support the entire US banking system and after the panic of 1907 the Fed was created to expand a system of payment clearing to the national banking system and help provide liquidity and support on a daily basis.  So yes, the Fed exists to support banks.  And yes, the Fed often makes mistakes executing policies.  But its design and structure is actually quite logical and its creation is not nearly as conspiratorial or malicious as many make it out to be.

See the following pieces for more detail:

http://pragcap.com/feds-dual-mandate-bull-sht

http://pragcap.com/who-owns-the-federal-reserve

http://pragcap.com/who-does-the-fed-serve

9)  Fallacy of composition.  

The biggest mistake in modern macroeconomics is probably the fallacy of composition.  This is taking a concept that applies to an individual and applying it to everyone.  For instance, if you save more then someone else had to dissave more.   We aren’t all better off if we all save more.  In order for us to save more, in the aggregate, we must spend (or invest) more.  As a whole, we tend not to think in a macro sense.  We tend to think in a very narrow micro sense and often make mistakes by extrapolating personal experiences out to the aggregate economy.  This is often a fallacious way to view the macroeconomy and leads to many misunderstandings.  We need to think in a more macro way to understand the financial system.

10)  Economics is a science.  

Economics is often thought of as a science when the reality is that most of economics is just politics masquerading as operational facts.  Keynesians will tell you that the government needs to spend more to generate better outcomes.  Monetarists will tell you the Fed needs to execute a more independent and laissez-fairre policy approach through its various policies.  Austrians will tell you that the government is bad and needs to be eliminated or reduced.   All of these “schools” derive many of their understandings by constructing a political perspective and then adhering a world view around these biased perspectives.  This leads to a huge amount of misconception which has led to the reason why I am even writing a post like this in the first place.  Economics is indeed the dismal science.  Dismal mainly because it’s dominated by policy analysts who are pitching political views as operational realities.

See the following piece for more detail:

http://pragcap.com/economics-is-mostly-a-policy-debate-masquerading-as-a-scientific-debate

There’s a lot more where that came from.  You can read more myths here.  I would also highly recommend my paper on the monetary system.

* A video version of some of these myths can be seen here.

Please Stop With the “Cutting IOER Will Increase Lending” Madness…

It’s become extremely fashionable in recent weeks and months for analysts and economists to propose cutting the Interest On Excess Reserves based on the assumption that this will suddenly stimulate lending and help the Fed gain some traction on the policy front.  This is extremely misleading in my opinion and often times based on a total misunderstanding of how modern banking works (see here for instance).

First of all, banks have eased lending standards substantially.  The latest Senior Loan Officer Opinion Survey on Bank Lending Practices showed that lending standards have eased considerably in recent years:

LS1

 

Okay, so if banks are flush with reserves, as profitable as ever and lending standards are low then what could be the problem?  Well, it must be a demand side problem then.  And the data confirms this.  The latest survey shows that demand for loans is still relatively weak:

ls2

 

This makes sense considering that households only JUST reported their first year over year increase in debt accumulation in the last 5 years:

cmdebt

 

The lack of lending and increase in the broad money supply from loan creation is the direct result of a lack of demand.  It is not the result of supply side issues.  Reducing the IOER is not going to increase demand for loans.  You can’t fix a demand side problem of this type with supply side fixes so please, let’s stop with this “reduce the IOER” madness.

Related: 

Understanding the Modern Monetary System

The Money Multiplier is a Myth