Financial Bull Riding is out!

Laissez-Faire Books has released Financial Bull Riding. I would love to hear what you think!

The book examines the faulty economic theory behind conventional investment wisdom, especially the idea that business cycles are random events, explains the ABCT and offers some guidelines for investing. Here is the table of contents as of today:

Obama inflames envy

"I believe this is the defining challenge of our time," Obama said in a speech at an event hosted by the Center for American Progress, a pro-Obama think tank. "It drives everything I do in this office,” 

“The growing gap between rich and poor can be closed by actions ranging from an increase in the minimum wage to better education to following through on his health care plan, Obama said.”

The quote above was from an article in USA Today. If people care about the poor, they will give their own wealth and encourage others to voluntarily do the same. Focusing on inequality is more than just a legitimate concern for the poor: it’s an attempt to inflame envy, as the sociologist Helmut Schoeck explained in his book “Envy: A Theory of Social Behavior.” Schoeck demonstrated that almost all intellectuals, poets, historians and philosophers through the ages condemned envy and feared it as a persistent threat to society. Organizing society to assuage envy kept humanity poor and on the edge of starvation until Christianity tamed it in the 17^th century, which led to the industrial revolution.

Slate Article Pays No Dividends

Slate magazine's business and economics correspondent, Matthew Yglesias, advertises his ignorance of investing in his latest rant against dividends: Dividends are Evil. Concerning GE and AT&T's increase in their dividends, Yglesias wrote,

The only problem is that dividends are terrible. Bad for the economy, bad for business, and surprisingly unfavorable to investors. A barbarous relic of a less financially sophisticated era, they’re also indelibly coated with misleading rhetoric that perpetuates sloppy thinking about business, profits, and investment.

 Yglesias then tells what companies should do:

 The impatient move that would benefit the economy would be for a cash-rich firm with an already high share price to invest. Hire more people and do more stuff, upgrade the training of your existing workforce, reward your better employees with raises and bonuses so they don’t go elsewhere, cut prices to build customer loyalty. That’s how profits lead to rising incomes, and how rising incomes lead to demand for the stuff businesses sell.  

Of course, the left does not understand what business is for. Businesses don't exist to "benefit the economy." They exist to make profits for their owners, the people who have invested their savings in the company. No one invests one's savings without the expectation of a decent return in the form of profits. Profits are to business owners what interest is to lenders: profits are repayment of the opportunity costs of giving up the use of one's money.

The Fed's Zombie Apocalypse

Economists are trying to figure out why the Fed hasn't generated higher inflation. According to Gavin Davies, "In most countries, headline CPI inflation has been falling significantly since the end of 2011, and it has now dropped to less than 1 per cent in both the US and the euro area." Here's a graph of inflation in the US and UK from Davis:

Buffet the Great

Authors of a new paper, "Buffett’s Alpha", Andrea Frazzini and David Kabiller at AQR Capital Management crown Warren Buffett one of the best investors ever. I welcome this after decades of having to endure the worship of Keynes as the greatest investor. Keynes achieved his reputation, after years of failure, by investing in gold mining stocks during the time in which he used his political influence and notoriety to convince the US and UK to abandon the gold standard. Keynes succeeding through insider trading. Buffett did it the old fashioned way.

Here are excerpts from the paper:

We show that Buffett’s performance can be largely explained by exposures to value, low-risk, and quality factors. This finding is consistent with the idea that investors from Graham-and-Doddsville follow similar strategies to achieve similar results and inconsistent with stocks being chosen based on coin flips. Hence, Buffett’s success appears not to be luck...

Looking at all U.S. stocks from 1926 to 2011 that have been traded for more than 30 years, we find that Berkshire Hathaway has the highest Sharpe ratio among all. Similarly, Buffett has a higher Sharpe ratio than all U.S. mutual funds that have been around for more than 30 years...

We identify several general features of his portfolio: He buys stocks that are “safe” (with low beta and low volatility), “cheap” (i.e., value stocks with low price-to-book ratios), and high-quality (meaning stocks that profitable, stable, growing, and with high payout ratios).

What we have here is a failure to coordinate

                The great Austrian economist Ludwig Lachmann described the way the stock market works better than any economist I have read. He taught that expectations play a vital role in coordinating the decisions of entrepreneurs in the market process. Spot prices communicate important information, but only information about the past. For the economy to function well, that is, stay out of recessions, markets must coordinate the expectations of buyers and sellers, producers and consumers. Recessions are nothing but a failure to coordinate. Markets communicate expectations through the futures markets, including options and other derivatives, but primarily through the stock market.

                Following are excerpts from Lachmann’s books on the vital nature of the stock market to a well-functioning market economy. Lachmann shows that the market is neither mechanical, as the EMH suggests, nor irrational as behavioral finance insists. 

Investors are mentally ill – Nobel Laureate

Nobel Laureate in economics Robert Shiller spoke at the AAII investor conference this month where he quoted Keynes on investing: "Most probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits—of a spontaneous urge to action rather than inaction."

Keynes thought investors were driven by animal spirits. Shiller has even a lower opinion of investors. He said at the World Economic Forum held in Davos, Switzerland in 2010 that hecould identify bubbles using the same methods that psychologists use to diagnose mental illness in patients. His key points were these:

1. Sharp increase in the price of an asset.

2. Great public excitement about these price increases.

3. An accompanying media frenzy.

4. Stories of people earning a lot of money, causing envy among people who aren’t.

5. Growing interest in the asset class among the general public.

6. New era “theories” to justify unprecedented price increases.

7. A decline in lending standards.

Fight the Fed or profit from its profligacy?

The Federal Reserve is a century old this year, but instead of cheering, good economists are lauding the apology in the Wall Street Journal by a Fed insider, Andrew Huszar, a senior fellow at Rutgers Business School and a former Morgan Stanley managing director. In 2009-10, Huszar managed the Fed’s $1.25 trillion agency mortgage-backed security purchase program.

It’s important to call the Fed out on bad monetary policy, but the few who do will not change the Fed because it has the support of mainstream economics. The Fed is only doing what mainstream econ teaches it should do, so until mainstream economics changes nothing will change at the Fed. Changing mainstream economics will be difficult to do because the professors have a lot invested in their paradigm. Cracks in the paradigm will not change their minds. Nothing short of a nuclear explosion will work.

S&P 500 Headed Up!

Here is the update to my forecast of the S&P500:

A Monkey with two bananas - Why the Obamacare web site cratered

The Obamacare web site fiasco has proven to be a gold mine for the late night comedians. The failure has been so massive that even the left listing mainstream media has to acknowledge it. No one should be surprised that socialists can’t manage projects well because they have a notorious contempt for the profession of management. 

I have heard managers tell good employees that they could give a monkey two bananas and the monkey could do the employee’s job. That’s a lousy manager. One of the manager’s most important jobs is to motivate employees and the monkey with two bananas story only demoralizes them. 

The left think the same thing of managers and the profession of management, so they never bother to study it or imitate good managers. Recall President Obama’s contempt for management during the financial crisis and ridicule of them for using corporate jets. Obama would never consider taking a trip of any distance in any vehicle other than Air Force One because his time is so valuable. But he considers the CEO’s time to be worth so little that he can ridicule them for doing the same thing he does. 

Questions for Free Market Moralists

All Souls College, University of Oxford, philosopher Amia Srinivasan, wrote in the New York Times Opinionator that defenders of the free market and classical liberalism must answer “yes” to four questions to remain consistent. She thinks her four questions rope and tie free marketeers like a calf in rodeo: if we answer ‘yes’ to all four we prove what disgusting immoral people we are, but if we answer no to any of them then we don’t support free markets. 

However, like most debates with socialists, Amia’s success in roping and tying us free marketeer calves depends upon us accepting her definitions of words and her economic assumptions, which she cleverly keeps hidden from the sleepy rodeo fan. So before I answer her four questions and still maintain that I support free markets, let me clear out some of the manure that people are stepping in. 

First, no one has to accept Rawls’ definition of justice. He spun it and wove it from his own imagination. It’s an interesting one, but that’s all. His entire argument hinges on readers accepting his definition. If we don’t, the rest of his argument collapses. So why did Rawls feel compelled to invent a new definition for justice? Because he didn’t like the results produced by the definition that dominated the West for 300 years. 

Great Expectations part II

The previous post introduced the concept of elasticity of expectations as developed by Ludwig M. Lachmann and applies it to the stock market. Lachmann added that the velocity of price change is important as well as the practical range and break outs from the range: 

“‘Explosive’ price change is seen to be the main cause of elastic expectations, both in the sense of violent change, and in that it destroys the existing basis of expectations, the sense of normality, which provided a criterion of distinction between the more probable, the less probable, and the highly improbable. It does so by demonstrating that the highly improbable, which had been excluded from our range, is possible after all. Now, as we saw, a price will pass the limits of the range with difficulty. As it approaches them it encounters increasing pressure from inelastic expectations resulting in sales at the upper and purchases at the lower limit. To overcome the pressure of these stabilizing market forces the price movement will most probably have to be carried by a strong ‘exogenous’ force, i.e. one originating outside the market, unknown to it and therefore not taken into account when expectations were formed.”[1]

Financial Bull Riding

Laissez Faire Books, the great publisher of books defending the free market, has agreed to publish my book Financial Bull Riding as an e-book this December. In short, the book uses the Austrian Business Cycle Theory to help investors time entries and exits in the market.

Mainstream conventional wisdom says to buy and hold and index of the market and just bite the bullet when the market collapses by 50% as it did in 2008. However, investors can grow their nest eggs much faster and with less risk if they do nothing but avoid such disasters.

The book examines the faulty economic theory behind conventional investment wisdom, especially the idea that business cycles are random events, explains the ABCT and offers some guidelines for investing. Here is the table of contents as of today:

Fed Fail!

With Ben Bernanke's departure, it’s time to grade his portfolio of work. Ben invented new methods to expand the money supply, including buying non-government issued debt. Mainstream economists credit him with having rescued the economy from the latest recession. The economy has recovered slowly in the past five years, but should we give all the glory to the Fed? These charts should answer those questions: 

Great Expectations – an Austrian economist lends support to technical analysis (part 1)

Does technical analysis of the stock and commodity markets have any validity, or is it the financial equivalent of reading tea leaves? Technical analysis encompasses a wide variety of methods, so a workable definition might be any method that uses historical prices and volume to predict future ones. Of course, the efficient market hypothesis denies that is possible. The alternative to technical analysis is fundamental analysis, which looks at earnings, dividends, management, sales growth, etc. to predict prices. 

 Technical analysts search charts for patterns such as head-and-shoulders, hammers, shooting stars, flags, pennants, double tops or bottoms, cups-and-handles, and many others. They employ multiple moving averages, relative strength indices, Bollinger Bands, Dow Theory and many other methods of analyzing price pattern and volume of trading. 

A few financial economists have tried to assess the validity of technical analysis methods with mixed results. Economists typically ridicule technical analysis, but a late great Austrian economist, Ludwig Lachmann, who championed the importance of the stock market more than any economist, provided support for technical analysis in his concept of the “elasticity of expectations.” He applied the concept to all kinds of prices, not just to the stock market, but it fits the stock market exceptionally well.

Popping Bubbles

Mainstream economists buried the business cycle in the last decade of the 20^th century. Having discovered that pronouncement of its death to be premature in 2008, they have suddenly rediscovered asset markets and cast them in the role of villain in the business cycle melodrama. They think that the popping of asset bubbles triggers recessions so they have been searching for ways to identify bubbles in fetus stage and abort them.

Last week Bloomberg featured an article about Finnish economist Katja Taipalus and her model for detecting asset market bubbles which she explains in her paper, “Detecting asset price bubbles with time-series methods.” Boiling down the 217 page paper to its essentials, she is trying to determine when stock market and housing prices diverge from their “fundamental” value.

Along with most mainstream economists she errs in thinking that assets have an objective value determined by the net present value (NPV) of future income. However, as Austrian economists know there is no objective NPV. Earnings forecasts and the discount rate used to calculate NPV are subjective. Future earnings will vary depending on the optimism of the forecaster. The discount rate changes according to each forecaster’s tolerance for risk.

Taipalus’ model uses the log of the yield of a stock market index to identify bubbles. If the yield falls at a rate set by her test statistics, then the model signals a bubble alarm. Tests of the model show that collapses in asset prices follow within a year of the alarm and recessions follow the collapse.

Experienced investors know that dividend yield is the inverse of the price-earnings (PE) ratio if all profits were distributed as dividends. Yield is E/P whereas price-earnings is P/E. So yield can fall if prices rise faster than earnings and yield will rise if prices rise slower than earnings. Economists love dividend yields for some reason while most investors tend to follow PE, but they tell us essentially the same story.

How to pick stocks

The Austrian business cycle theory suggest that investors buy stocks in the capital goods sector, or cyclical stocks, in the early years of an expansion and switch to consumer goods makers in the later years. Investors can do that easily with exchange traded funds (ETF) which cluster stocks in a dizzying array of industries, commodities and countries. For example, one of the better known tech stock ETFs is QQQ, which contains the stocks of a lot of capital goods companies.

But as happens with any grouping of large numbers of companies, most will be dogs. Only a few will be excellent companies whose profits grow well and whose stock prices reflect that growth. Most of the members of the ETF will act like an anchor on the value of the ETF. The only solution is to buy individual stocks, but analyzing thousands of individual companies takes more time than most part time investors enjoy.

Five years after Lehman - Jobless Recovery Explained

Like a calf staring at a new gate, mainstream economists are mystified at the unemployment data that has given the US a jobless recovery for the past four years, five years after the collapse of Lehman Brothers.  Creative manipulation of the money supply by the Fed, massive bailouts of banks and other corporations, and historic federal spending have failed to lift aggregate demand. Why? Because all aggregate demand isn’t the problem.

Aggregate demand in mainstream economics has two sides, consumer spending and business spending, or investment. Mainstream economists forget that definition of demand. Also, they think that consumer spending drives aggregate demand because it makes up about 70% of GDP. However, GDP leads them astray because of the highly stylized and weird way it calculates business revenues. In reality, it is net domestic product, not gross, but that is a different post.
Austrian economics demonstrates that the investment side of aggregate demand does the driving, not the consumer side. Economist Robert Higgs uses net domestic investment to explain the jobless recovery in a recent article “The Sluggish Recovery of Real Net Domestic Private Business Investment"The Sluggish Recovery of Real Net Domestic Private Business Investment.”

“From these data, I have constructed the following index of real net domestic private business investment from 2005 to 2012, where the 2007 value equals 100:”

2005	81
2006	98
2007	100
2008	68
2009	26
2010	20
2011	36
2012	59

Foxhole conversions

There are no atheists in foxholes is an old saying meant to express what crisis will do to one's thinking. The recent crisis has encouraged many mainstream economists to look at what is wrong with their theories that prevented them from seeing the crisis coming. As a result, prominent mainstream economists have begun incorporating at least parts of the Austrian business cycle theory in their work.

 Coordination Problem discussed a recently published paper by Guillermo Calvo of Columbia University and the National Bureau of Economic Research, “Puzzling over the Anatomy of Crises: Liquidity and the Veil of Finance.” Calvo wrote the following:

“Critical Puzzle 1. There is a growing empirical literature purporting to show that financial crises are preceded by credit booms (Mendoza and Terrones (2008), Schularik and Taylor (2012), Agosin and Huaita (2012), Borio (2012)). This was a central theme in the Austrian School of Economics (see Hayek (2008), Mises (1952))...”

What is ABCT Investing?

Almost everyone has a blog today, so why would I bother to add my teaspoon to the deluge? I did so because I found a hole in conventional investing wisdom which I think needs plugging. I’m not the little Dutch boy who stuck his finger in the hole in the dam and saved the village below. But I think I have a perspective on investing that few others share and which could help people rescue their nest eggs from tragedy.

Stock Market Forecast

“"It is difficult to make predictions, especially about the future,” said Mark Twain.

But, investors have no choice but to attempt to forecast the stock market. Ludwig von Mises wrote,

"Like every acting man, the entrepreneur is always a speculator. He deals with the uncertain conditions of the future. His success or failure depends on the correctness of his anticipation of uncertain events. If he fails in his understanding of things to come, he is doomed. The only source from which an entrepreneur's profits stem is his ability to anticipate better than other people the future demand of the consumers. "[1]

The investor is the entrepreneur and must forecast future prices of stock, even if only to adjust his allocation of funds between stocks, bonds and cash.

Here is my lasted forecast of the S&P 500 for the next two quarters. The upper and lower lines are the upper and lower ranges of the prediction interval, that is, where the model predicts the S&P 500 will be. The middle, blue line is the historical value of the index.

 

 

Is the stock market overvalued?

University of Pennsylvania’s Jeremy Siegel has been shooting again at Yale professor Robert Shiller’s stock market valuation model, the cyclically-adjusted price-earnings ratio, or CAPE, according to William L. Watts at The Tell blog on the MarketWatch web site at http://blogs.marketwatch.com/thetell/.

CAPE showed an adjusted P/E ratio of 23.57 recently, considerably above the long term average and an indication that the market is overvalued. Here is the chart of CAPE from Watts’ blog:

Is the stock market a casino?

The media often portrays the stock market as a casino. That attitude first gained academic cover with J. M. Keynes. Ludwig Lachmann wrote, “Thus, seeing the importance of expectations in asset markets, and disliking the implications of what he saw, he launched his famous diatribe on the Stock Exchange as a ‘casino.’”[1] Here are excerpts from Lachmann’s defense of the stock market against Keynes’ assault:

“Furthermore, in his Chapter 12 on ‘The State of Long-Term Expectation,’ the famous diatribe against the Stock Exchange, it becomes painfully evident that Keynes failed to grasp the nature of the problem posed by the existence of inconsistent expectations. Instead of studying the process by which men in a market exchange knowledge with each other and thus gradually reduce the degree of inconsistency by their actions, he roundly condemned the most sensitive institution for the exchange of knowledge the market economy has ever produced! [2]

“The Stock Exchange is a market in ‘continuous futures’. It has therefore always been regarded by economists as the central market of the economic system and a most valuable economic barometer, a market, that is, which in its relative valuation of the various yield streams reflects, in a suitably  objectified’ form, the articulate expectations of all those who wish to express them. All this may sound rather platitudinous and might hardly be worth mentioning were it not for the fact that it differs from the Keynesian theory of the Stock Exchange which is now so much en vogue.