$1 earned in a recession = $2?

Asset prices are incredibly low right now - DOW @ 7000, S&P @ 730, everything on sale, housing prices incredibly low, etc. These low prices make any income seem much greater than normal - since you can buy more for less and save/invest at low prices. For someone making 100,000/year who would typically save 20000/year - might now be able to save $30000/year without a change in lifestyle.

That savings of 20000 vs 30000 is also going into depressed asset prices - so when a recovery occurs, that savings will grow to be that much more.

This suggests that decisions to earn an income should accelerate - those who may have pursued other pursuits could arguably be more attracted to jobs because they pay that much more. Similarly, companies could afford paying less - not only because of higher unemployment rates but also because the value of the dollar as implicitly increased.

This reasoning is similar to that of why low beta stocks rise during recessions - because people prefer cash in recessions - not only because its safe, but because it can buy more.

Defense Spending

Republicans generally argue for low taxes and limited government spending with the exception of defense spending. Generally, the argument is protection of individuals to live free and act as profit-maximizing capitalists. The defense spending is justified as a means to protection only, not economic stimulus.

Beyond the stimulus, defense spending seems to be particularly well-aligned with Republican economic ideas: 1) since government's are the sole purchasers of military equipment - they are best positioned to act in a utility-maximizing way, 2) The spending does not crowd out private investors, and 3) (related to 1 and 2) the money is a pure stimulus to the economy.

There are probably other reasons as well. I never thought of it this way - I suspect many others are the same. Thought I'd share.

Other forms of Equity

There is a lot of literature that describes pension funds as a fixed income investment. And people generally know that investing in their own company is risky since it lacks diversification. Then why do bankers invest so much in equities?

It seems that a banker's bonus is heavily tied to the equity markets. When the markets are doing well, they get a big bonus; when they are doing poorly they get a small bonus and perhaps even get fired.

If you look at the first year VP as an example. This person is probably worth ~$1mm and their bonus in a good year can vary from anywhere as low as $300K to as much as $500K. That is a $200K difference (or 20% of the individual's net worth) that is heaving correlated with the equity markets.

If the difference between a good market and a bad market is 20% (say +/- 10%) - then, it would seem that this investor already has $1mm invested in equities by being a banker. As he thinks about asset allocation, it would seem that he should assume that 50% of his portfolio is already invested in equities.

A similar argument can be made for other groups whose income is heavily correlated with the market (university endowments, CEOs, etc)

Dividend Policy

When thinking about dividend policy, a company generally needs to decide if its marginal ROE is greater than its cost of capital. In recent months, many companies have cut their dividends.

These companies must believe that either their cost of capital has reduced or their ROE has increased. With increased risk premia and higher costs of debt, it would seem that costs of capital have generally increased. So does this mean that companies believe their ROE has increased?

More pragmatically, companies are obviously cutting their dividends to preserve capital so that they can avoid having to raise more cash later and bankruptcy costs.

How do we reconcile these two concepts? Well - its the ROE on this cash that is being distributed. If the company would have gone out of business, but this extra cash allows it to stay in business, then its ROE would be very high.

Education Investment

Tonight, President Obama asked all Americans to spend at least 1 year in post-secondary school. And he said, that not graduating high school is no longer acceptable. He also set a goal of being the nation with the highest % of its citizens college graduates.

The nation has been heading this way for years with some support from government, but more because markets have created the necessity to do so. If you want a job making more than 50K/yr, you almost certainly need to work - and generally, that should be enough of an incentive to take on the student loans and loss of lower salaries.

It seems that government interference may cause a glut of over-educated people. Who will be the garbage collectors, the fast food employees, the mailmen? Who will want to go to college to end up with a low paying job? Will there be enough jobs to satisfy the college educated? While a more educated society sounds logical on the surface, what will be the effects on the supply/demand for jobs standpoint? Supporters must believe that a more educated society will cause the supply of jobs to increase as more value-add companies are created.

$1 saved, $1 earned

Given two investments - 1) spend $100 to insulate a house and save $50/year in energy costs versus 2) invest $100 in a stock that returns 20%/year.

The first investment is obviously better - but do investors always see this? It would be interesting to compare similar investment decisions to see if there is a bias towards investing or saving money; or if not a bias, to see how often the correct decision is made.

Other potential comparisons - investing in a gym membership or other health preventative measures, hybrid cars, amazon prime, etc.

Presumably the decision to buy/rent living space started with a question like this one.

Marginal cost/value of employment

The less I spend, the longer I do not have to work. Where does the marginal cost of working go below the marginal value that can be obtained by acquiring extra goods?

A simplistic, but interesting way to look at this, is to assume that 1) we only work for the paycheck (no aspirational value in working), 2) we get paid a fixed wage per hour, and 3) we can work anywhere between 0 and 168 hours per week).

While its a continuous spectrum, we can think of this problem as one of tiers. Working 0-10 hours per week let's you survive, 10-20 hours per week provides food and shelter, 20-40 hours per week provides you with all the basic goods you need, 40-60 hours provides you the ability to support a family, 60-80 lets you live comfortably, 80-100 gives you financial independence until retirement, 100+ lets you consume anything you want.

If these were truly the decisions, would the work force look very different? How would people choose when to stop? Will marginal cost of work still vary across individuals? Will marginal value of work still vary across individuals?

Government Sponsored Research

As an extension of my thoughts on February 12th....

I was reading through the economic stimulus package today in response to a friend's email blasting several points of the bill. In particular, there was a point arguing against funding research.

If the government is going to crowd out long-cycle businesses as I mentioned a few days ago - the least it should do is make sure that we fund what private businesses would have funded without the crowding out. Society has made a decision that we'd rather limit long-cycle businesses (and research) that have long recessions. If this is going to be our decision, then somewhat must make up for the lost research.

This is not to say that the government does a better job of selecting/performing research than private industry. It simply means that through stimulus, the government has made it impractical for private industry to pursue certain very long research projects. So one cost of shorter recessions is that government sponsors research instead of industry - this seems to at least be an improvement over no sponsorship at all.

One pitfall is - what research is the government selecting? Is it the research that was crowded out? If so - great. If not - than the government's stimulus to research will be an additional crowding out and arguably net negative.

Supply/Demand for Cash and Savings

An interesting way too look at it savings is with regards to supply/demand for cash and capital.

When there has recently been a lot of advancements in consumer technology, there would be an increase in demand for cash and spending, so savings will decrease. Companies have just finished a cycle of building to produce this new technology, so they have a lower demand for capital (savings).

When its been a while since new consumer advancements have been made - everyone has the latest/greatest, so no need to spend a lot. At this point, people will save their money to wait for the next round. Here, companies profits will start to diminish and they will be in search of the next great invention, they will demand capital which comes from savings.

These cycles would seem to balance themselves. It would only be when one cycle speeds up while the other does not that problems would occur. One example we are seeing now is a result of too much debt. This debt has allowed consumers to acquire the latest/greatest technology at a much quicker rate, but there has not been an acceleration of innovation. As a result, the typical period where people would be saving and fueling investment is now a period where people are repaying debt.

Athlete Salaries

I have always found it perplexing that people attack professional athletes for their salaries, but never attack the owners for the vast sums of money they must accumulate as owners of teams (even if its just through appreciation since teams are now selling for upward of $1.0bn when a decade ago it was closer to $100mm).

But this year should be interesting. Athletes will not lose their jobs because of the economy and they will not suffer lost bonuses or salaries, but tickets to a sporting event, big fingers, peanuts, and cracker jacks are certainly not basic goods. So why are athletes able to prosper in a recession when no one else can.

1) Are the owners bearing all the loss which justifies their tremendous gains? 2) Are sports such a premium good that, like expensive jewelry, the people who purchase tickets are rich enough to not be affected by a recession? 3) Are athletes an example of efficient incentives since they are paid on only what they can control? (Though then it begs the argument why are they not being attacked the same way investment bankers are?)

Reallocation of Resources to longer-cycle businesses?

More and more job losses, people moving their investments into cash, inventories being drawn down. We are developing huge gluts of resources just waiting to be redistributed. This seems like an excellent opportunity to create something great - be it new businesses or some other form of revolution.

The government is the largest force trying to use these resources. Its goal is mixed between getting people back to work as quickly as possible and creating something that will drive long-term prosperity (rebuilding roads versus new technology).

One alternative - very long-cycle businesses. It would seem that recessions can make longer cycle business idea more viable. Normally - these business ideas must compete for resources with shorter cycled businesses - which increase their costs and would make their ROE below the point of investment. During a recession, however, costs and ROE expectations are much lower. Since no one is making money now, revenue in 5 years instead of today is more accepted (and good long-cycle businesses might fill a large vacant hole in the economy). So these longer-cycled businesses suddenly start having positive NPV. Plus, since they would be producing, they can aid in the recovery.

Stumbling blocks seem to be: 1) Are there good enough ideas out there that can be found? 2) Will resources remain plentiful for long enough?

While short-term stimulus plans are beneficial to jump start demand of your typical businesses and prevent unemployed individuals from losing their franchise value - they also present a hindrance to these long-cycle businesses.

Wall Street Salaries

We, as a capitalist society, have entrusted the various Wall Street professionals (bankers, hedge funds, private equity, research analysts, etc) with the incredibly difficult yet important task of managing our nation's resources. Everyday, their collective decisions determine what businesses are good, which in turn determines jobs, products available to consumer, technological advancements, and how much debt society can handle (to name a few).

Given this immense responsibility and the difficult nature of the task, we need to attract the most intelligent people to these jobs. Many are attracted by the challenge and the responsibility. But we expect a lot from these people, so they must be rewarded too.

And here is where the challenges for society begin - 1) how do you attract the intelligent people who are excited by the challenge, responsibility, and money, but not let money be the driving force? 2) These issues are so complicated that you need to attract the brightest minds - who is left to understand the issues enough to know when those brightest minds fail? How do you fire them when they do fail? 3) How do you avoid corrupting the process with regulation?

Reaction to the Obama-Geithner Bank Plan

One interesting way to think about the government's injections of capital is to compare these injections to an M&A transaction between two private companies. Often, the acquiror pays an amount for the target that is significantly greater than the target's perceived value as a standalone institution. This is justified by the synergies that exist between the two companies; ie, the combination creates value that would not be afforded to either company by itself.

So the question becomes: what is the franchise value of the various banks and does the government's injection of capital create synergy-like value?

Without a crystal ball, its impossible to know, but there are viable arguments on both sides and worth exploring.

- Without government injection of equity, it is likely that credit markets will remain frozen and franchise value will be destroyed. With an injection of enough equity, the credit markets will open and more than enough value will be created to show a significant ROE to taxpayers. The value created by the opening of the credit markets is analagous to synergies in a private merger.

- Even if it does produce these said synergies, the government's injection of equity can still be damaging if it does the following: 1) increases bad bank value, but franchise value remains negative, 2) allows bad banks to survive extracting value from good banks, and/or 3) crowds out potential new banks from forming and competing in the market place.

Simplistic Relative Valuation and Momentum

Take two stocks - A and B that you, as an investor, that you view as identical (same cash flows and riskiness). Presumably, you'd buy the cheaper one.

Suppose they are the same price and you choose to buy A. If B goes down in value relative to A and you're opinion hasn't changed, you should sell A and buy B.

While, as a friend pointed out, this is simply the relative valuation technique it does offer a reason that stocks chase each other around that has little to do with macroeconomic news. This obvious trading decision would seem to be a likely cause of momentum.