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The Optimistic Case for the US Economy

April 11, 2010 Leave a comment

Daniel Gross waxes optimistic about the state of the American economy:

But the long-term decline of the U.S. economy has been greatly exaggerated. America is coming back stronger, better, and faster than nearly anyone expected—and faster than most of its international rivals. The Dow Jones industrial average, hovering near 11,000, is up 70 percent in the past year, and auto sales in the first quarter were up 16 percent from 2009. The economy added 162,000 jobs in March, including 17,000 in manufacturing. The dollar has gained strength, and the United States is back to its familiar position of lapping Europe and Japan in growth. Among large economies, only China, India, and Brazil are growing more rapidly than the United States—and they’re doing so off a much smaller base. If the U.S. economy grows at a 3.6 percent rate this year, as Macroeconomic Advisers projects, it’ll create $513 billion in new economic activity—equal to the GDP of Indonesia.

This is all well and good, and it would be nice if it comes to pass. But here’s the thing: Gross is essentially being a contrarian here. He looks good if the economy turns out to perform better than the consensus opinion suggests, and, well, if the economy crashes, none of us are exactly going to be looking to him for guidance anyway.

Shocker: Real Estate Prices and Interest Rates are Inversely Related!

April 11, 2010 Leave a comment

One of the more annoying things about reading about residential real estate is this repeated claim by those who should know better that real estate is an inflation hedge.

But, if you stop and think about it for a moment, you will quickly realize that’s a foolish argument. Residential real estate is principally financed by debt; therefore, its price should move inversely to inflation, just as do other debt securities such as bonds.

In any event, it’s very refreshing to see the New York Times accurately reporting on the relationship between real estate prices and interest rates:

The impact of higher rates is likely to be felt first in the housing market, which has only recently begun to rebound from a deep slump. The rate for a 30-year fixed rate mortgage has risen half a point since December, hitting 5.31 last week, the highest level since last summer.

Along with the sell-off in bonds, the Federal Reserve has halted its emergency $1.25 trillion program to buy mortgage debt, placing even more upward pressure on rates.

“Mortgage rates are unlikely to go lower than they are now, and if they go higher, we’re likely to see a reversal of the gains in the housing market,” said Christopher J. Mayer, a professor of finance and economics at Columbia Business School. “It’s a really big risk.”

Each increase of 1 percentage point in rates adds as much as 19 percent to the total cost of a home, according to Mr. Mayer.

The Mortgage Bankers Association expects the rise to continue, with the 30-year mortgage rate going to 5.5 percent by late summer and as high as 6 percent by the end of the year.

I would say that I hope this augurs financial literacy on the part of buyers of residential real estate, but even I am not that optimistic.

Should You Invest with the Random Guy Down the Street?

April 11, 2010 Leave a comment

Apparently the new thing is for people to invest with miscellaneous investors who have generated some good returns:

Who needs a stock broker or mutual fund when you can take on the big shots at their own game? A growing number of investors are casting their lot not with Wall Street’s giants but with the small-time stock pickers on Main Street.

Covestor.com, the site that Mr. Risch uses, has grown from a handful of registered users to more than 27,000 since it launched in 2007. Another upstart, kaChing.com, says it has attracted more than $6 million from clients who follow its “geniuses”—seasoned pros plus a handful of individual investors who have racked up exceptional records verified by the site. Those individuals include a former chemist, a health-care industry worker and a college student who caught the investing bug after watching the Oliver Stone movie Wall Street (and who is up more than threefold in the past year).

The assumption seems to be that these individual investors have some insight into the market that professional market players don’t. Admittedly, a lot of the advice proffered by self-described market pros isn’t worth the energy they expend propounding on the markets, but it doesn’t follow that following the random investment ideas of small investors will yield better returns over time. In any event, these services are a rather expensive proposition:

Fees for most managers on Covestor average $98 a year for each $10,000 invested, but managers charge up to 2.3% for the more actively traded portfolios. That doesn’t include trading commissions that clients pay separately. KaChing’s fees average 1.25% before commissions, and it has some managers who charge more than 2%. That compares with the fund industry’s average expenses of 1.4% for actively managed domestic stock funds. KaChing CEO Andy Rachleff says the fees aren’t high when you factor in other expenses, such as marketing fees and sales charges that can jack up the costs of mutual funds. Covestor CEO Perry Blacher adds, “There are no hidden fees, no middlemen, no Wall Street conflicts of interest.”

It seems to me that the standard advice of a broadly diversified portfolio of low-cost index funds is what most small investors should choose. Boring, but (relatively) safe.

Offshoring Jobs and the Myth of a Static Economy

April 6, 2010 1 comment

It has become a commonplace that American jobs have been eliminated in favor of cheaper labor overseas. To some extent, this is true, but it misses the real story. Most of the jobs that have moved overseas, and which are not coming back to the United States, are jobs for which educational requirements are minimal. The poorly trained and uneducated are the victims of structural changes in America’s economy.

(Other victims of structural changes in the American economy are the overeducated who pursue education in fields for which there is very little demand, such as humanities PhDs. But there is little sympathy for naive academics who find themselves unemployable.)

But, there’s nothing new about this. When elevators went from manual to automated, the people who lost out were elevator operators, who, of course, did not need much in the way of education to do their jobs. Likewise, when sock or textile manufacturers move their operations from, say, the Midwest, to China, it is the employees of American textile mills, who, by and large are relatively uneducated, who lose. Other Americans gain.

Now, to a very large extent, this is blaming the victim for economic forces beyond his control. That is true. However, it is also true that if the American economy wants to continue to grow over the coming decades, there will be winners and losers in it. Egalitarianism is a false ideal upon which Stalin murdered tens of millions of people. That is what social safety nets are supposed to account for (in part). It is also incumbent upon people to realize the precariousness of their current employment and pursue opportunities to develop skills that are transferable. The United States’ deplorable educational system does not help in this regard.

But we can’t conclude from any of this, as some do, that the overall number of jobs in the United States has decreased because a lot of those jobs have been moved overseas. Neither the economy nor the number of jobs is a static thing. Buggy whip manufacturers were driven out of business by the development of the internal combustion engine, but in the decades since the internal combustion engine was invented, many more jobs than were ever lost by buggy whip manufacturers have been created.

The Problem with Confirmation Bias

April 3, 2010 Leave a comment

Confirmation bias is endemic to financial markets because their participants have money on the line and those participants want to know that the bets they are making will be profitable. Therefore, investors, traders, financiers, and all other manner of market participant seek reassurance. This type of cognitive bias makes an appearance in other places, and it’s useful to consider how it harms those unaware of it.

The New York Times has an interesting article about Tiger Woods, his inner circle, and the loyalty he demands from the same:

Tiger Woods, a self-acknowledged control freak, insists on loyalty as a fundamental quality in employees, associates and friends. Just how much Woods values allegiance was summed up by his father, Earl, in an interview shortly before he died.

“Loyalty is No. 1 to Tiger,” Earl Woods said in a biography of his son. “You’re loyal or you’re history.”

The problem here is a lack of perspective. If all the people with whom you deal hew to the party line you have no way of understanding perspectives different from your own experience. (North Korea’s cult of personality is probably the most extreme demonstration of this cognitive bias.)

How does this type of bias manifest itself in finance? The always-invaluable Robin Hanson at Overcoming Bias writes:

We’d love for things to go well. So we’d love people to think that things are going well. So we want folks to hear news about how things are going well. But sometimes people hear bad news, about how things are going bad. Gee – why don’t we fix this by banning bad news? Then people will only hear good things, and so only good things will happen, right?

This argument is transparently stupid to most everyone, at least when they think of “bad news” as appearing in newspapers or TV shows. Sadly, that insight seems to disappear when it comes to financial bad news communicated via short sales.

Just as Tiger Woods seems to want to avoid any appearance of discord or disagreement within his empire, and so has suffered as a result, financial market players don’t want to contemplate news that doesn’t comport with their view of the world. It is likely true that most investors are a rather optimistic lot–else, why bet on the future outcome of an investment–and so don’t want to contemplate that maybe the future is not as rosy as the conventional wisdom.