Accounting or Sales?

Is this glass half full? Or half empty?

Photo: Viktor Hanacek. Source: Picjumbo

Sales types look out and see infinite possibilities. Accountants see the world as debits and credits, as a process to be managed. Sales-dominated organizations emphasize growth; accounting-centric firms focus on profitability. Put simply, sales brings in the dough, while accounting gets to the bottom line. Both are necessary to any successful enterprise. But there’s often a lot of conflict between the two.

Sales people can feel like they own the business. After all, if there isn’t anything on the top line, there won’t be any bottom line. And they often have to deal with hostile competitors and regulations to get to reluctant customers who never seem to return their calls. But accountants can feel like they manage the business. Without proper accounting, payments can’t be processed, bills and payroll won’t get paid, reports aren’t filed, investors and lenders will cut off funds, and no one has a job. Both sides need the other, and need to respect the essential role everyone plays.

Photo: Jon Sullivan. Source: PD Photos

The same is true in a diversified investment portfolio. Some companies emphasize growth. They’re continually improving their revenues. They’re in areas that are rapidly developing, like technology or robotics. Their top-line growth is unbelievable. Sales people there are ascendant. Other firms focus on profitability. They’re able to squeeze more money out of stable or even shrinking markets. Their margins are incredible; everyone wants to know how they do it. In those firms, accountants rule, and for good reason.

But no one can afford to be smug. Successful firms balance the top line and the bottom line. They put the right incentives in place so revenues grow, and they make sure those revenues cascade through their financial statements so everyone benefits. And successful portfolios grow too, but they grow with efficient companies that have sustainable processes, that won’t flame out in a year or two.

Optimists see the glass half full; pessimists see it half empty. But seen correctly, it’s balanced. And no bigger than it needs to be.

Douglas R. Tengdin, CFA

William Baumol, RIP

Who was William Baumol?

Source: Journal of Economic Perspectives, American Economics Association

William Baumol was an economist who taught for years at Princeton. He died last week at the age of 95. He had a long and productive career, writing papers and books over the course of seven decades. He is perhaps best known for his theorem on wages, Baumol’s Cost Disease, which explains why cars and computers get cheaper while haircuts and college tuition get more expensive. Essentially, areas of the economy with productivity gains drive up the cost of labor for everyone else, because workers can always change jobs. This also explains why restaurant meals are more expensive in the city: managers have to compete for labor, and that labor is more expensive when it has lots of alternatives.

But some of Baumol’s most profound work has to do with entrepreneurship and capitalism. He once stated that economics without entrepreneurs is like Hamlet without the Prince of Denmark. If you want to understand how an economy works, you have to look at innovation and enterprise. Why, for example, did a society like the Romans invent a steam engine but then used it for nothing but toys and religious ceremonies? The answer has to do with incentives. For the Romans, the route to wealth and prestige was through estate farming and military command. Commerce was left to slaves and former slaves.

Primitive steam engine. Source: Wikipedia

This also explains why big firms tend to produce little innovations, while little firms produce big innovations. Again, it has to do with incentives. If you’re an engineer in the jet engine division at Pratt and Whitney, it’s unlikely you’ll introduce a technology that makes jet engines obsolete. Rather, you’d start a new firm to capitalize on your invention. This is perhaps why stock market returns are positively skewed: most of the market’s returns come from a minority of small firms that make it big, like Amazon or Google. Again, big changes come from small firms, often with a visionary entrepreneur.

Source: Blackstar

Baumol outlined these concepts in clear prose with a minimum of algebraic contortions. Maybe that’s why he never won a Nobel Prize: you didn’t need a degree in number theory to understand him. He was truly a titan when it comes to economic thinking. Economists like William Baumol help us understand the way the world works – or doesn’t. He’s made us all a little richer.

Douglas R. Tengdin, CFA

French Revolution?

What does Sunday’s election mean?

Photo: Lorie Shaull. Source: Wikipedia

On Sunday the reformist candidate Emmanuel Macron defeated populist Marine LePen by a landslide, 66% to 34%. The 39-year old will become the youngest French head of state since Napoleon. Macron has been described as a social democrat, who supports liberal social policies but who wants to enact conservative fiscal reforms, along the lines of the “third way” advocated by Bill Clinton, Tony Blair, and Gerhard Schröder.

It’s astounding that Macron was elected. He did not come up through normal political channels. His opponent, Marine LePen, has been in politics for decades, as had her father before her. While she has been labeled a populist because of her anti-Euro and anti-immigrant views, in many ways she is more a product of the political establishment. Macron promises he will upend the French economic system, which has a larger government sector than any other country in Europe – over 60% of the economy.

And the economy has been stagnant – growing 0.8% per year for the past 5 years, with 11% unemployment. The French electorate voted decisively to reject the established order. And – if he can assemble a government – Macron will do just that. He has no allegiance to France’s dirigist and corporatist heritage. His greatest difficulty may come from his sudden, astounding success.

Because it will be impossible for him to please all of his supporters. People voted for Macron for many reasons, and because he has almost no political history, he is a blank slate upon which they project their hopes for reform. In that way, he’s a lot like Barak Obama – a symbol to many of hope and change. But symbols don’t run things.

Photo: Claude Truong-Ngoc. Source: Wikipedia

The challenge now comes in formulating and enacting an agenda. As George Washington says to Alexander Hamilton in the hit musical:“Winning was easy, governing is a lot harder.”

Douglas R. Tengdin, CFA

Reading the Sines

Is history a cycle?

Sine wave. Source: Constructonomics

The philosopher George Santayana said that those who cannot remember history are condemned to repeat it. Mark Twain quipped that history doesn’t repeat itself, but it does rhyme. Since the financial crisis, economist Marvin Minsky’s view has become quite popular, that stability leads to excessive risk-taking, which sows the seeds for the next crisis.

But this theory requires that people act against their own interest – that they become blind to the risks that are facing them. While that was true for many folks in the years leading up to the Financial Crisis, not everyone was fooled. Indeed, one reason the Financial Crisis did not become another Great Depression is that the government acted decisively to restore confidence in the financial system. While many banks failed, the system did not collapse.

There’s a view out there that recessions are inevitable. Since the US has gone 8 years now since the last recession, they say, we’re due for a downturn, and soon. But that’s like saying a Major League Baseball hitter in a slump is “due” for a hit, because he’s currently below his long-term batting average. But in fact, hitters in a slump tend to stay in a slump until they address what got them there. And economies that are expanding tend to keep expanding, until imbalances and policy errors knock them off track.

Business cycles aren’t like the seasons or the movements of the planets. There’s no law of nature that causes our economy to go into recession every 5 years or so. Economic growth isn’t like retrograde motion. Some countries have gone decades without a downturn. In Australia it’s been 26 years since their last economic contraction.

Apparent retrograde motion. Illustration: Brian Brondell. Source: Wikipedia

Eventually, the US economy will experience another recession. We don’t know exactly when. But our leading economic indicators are still positive. Let’s hope they stay that way.

Douglas R. Tengdin, CFA

Drugs and Dropouts

Why are so many men not working?

Photo: Arielle Jay. Source: Morguefile

Over the past 40 years the rate at which prime-aged men participate in the labor force has fallen from 94% to 88%. That may not seem like a lot, but it’s over 7 million men who could be working, but aren’t. They’re not retired – it takes a lot of money to pay for retirement that early. Some of them are in school, but not enough to explain why the US has fewer men working than any other country, except Italy.

It could be because wages are so low and disability payments are so high. That means there’s less incentive to work. It could be that a lot of these labor force dropouts have criminal records. There are over 20 million current and former felons among the population. It’s a lot harder for convicts to find a job, so they get discouraged and drop out. But drug abuse is a major issue. Nearly half of all non-working prime-aged men take opioids daily, either because they’re sick or because they’re addicted. A recent study in Ohio found that over 10% of the population had been prescribed pain-killers over a three-month period.

Labor Force Participation Rate for Men Aged 24-54. Source: Bureau of Labor Statistics

This is a vicious cycle. There are millions of open positions that companies want to fill. Many of these jobs come with training, good wages, and health insurance. But firms need sober workers – monitoring precision machinery or interacting with customers. You can’t do that very well when you’re high, and firms have zero-tolerance drug policies, for good reason.

Yellow line is job openings. Source: Calculated Risk, BLS

The latest employment report shows our economy continues to create jobs faster than people are entering the labor force. Unemployment is going down and wages are going up. The Fed is gradually raising interest rates. Companies are expanding, but job openings are going unfilled. The workers needed to fill them are staying home, stoned, watching TV.

Douglas R. Tengdin, CFA

It’s Wonderful

Where does bread come from?

Illustration: Little Fluffy Clouds: Source: Wonderfulloaf

Russ Roberts had done it again. He’s the economics professor who produced a couple of hip-hop videos a few years ago that explained macroeconomics via a rap-battle between two early 20th-century economists: Friedrich Hayek and John Maynard Keynes. So far, the YouTube videos have been downloaded almost 10 million times.

He’s currently a research fellow at Stanford University. But that doesn’t mean he’s given up teaching. He just came out with a delightful lesson on how economic structures and institutions emerge: “It’s a Wonderful Loaf.” The lesson comes in the form of a poem – like his rap battles – that’s animated and set to music. In his poem, Roberts ponders the question of how a simple staple like bread can be so universally available – in all its myriad forms – without a Bread Czar or universal planner making universally binding decisions.

The answer is emergence – the same phenomenon that allows fish to swim in schools or birds to flock or grains of sand to form ripples and beaches. Simple rules, when followed by a large number of smaller things, create a larger system that couldn’t be predicted. Who knew that hydrogen bonds in water would freeze into the crystalline lattice that would emerge as a snowflake?

Source: TED

Roberts explains that the same self-organizing principle allows economic systems to come together. In the case of bread, farmers and millers and truckers and bakers all organize themselves into a smoothly functioning system, with no one giving them orders or directives. Yes, we need roads and laws and a sound currency to transact – infrastructure – but generally, if a Bread Czar were running things, there would be shortfalls and surpluses. Roberts explanation is a pleasure to read, watch, and listen to. I can’t get his music out of my head!

Economics has been called “the dismal science” because it deals with scarcity and allocation and hard choices. But if educators as talented as Russ Roberts keep at their craft, it could easily be re-named, “the delightful discipline.”

Douglas R. Tengdin, CFA

Bubble, Bubble, Toil and Trouble

Is the stock market ready to pop?

Photo: Brocken Inaglory: Source: Wikipedia

A comprehensive new study from Harvard University goes a long way toward delineating the nature of stock market bubbles:

We evaluate Eugene Fama’s claim that stock prices do not exhibit price bubbles. Based on US industry returns 1926-2014 and international sector returns 1986-2014, we present four findings: (1) Fama is correct in that a sharp price increase of an industry portfolio does not, on average, predict unusually low returns going forward; (2) such sharp price increases do predict a substantially heightened probability of a crash; (3) attributes of the price run-up, including volatility, issuance, book-to-market ratio, market P/E ratio and the price path of the run-up can all help forecast an eventual crash; and (4) some of these characteristics can help investors earn superior returns by timing the bubble. Results hold similarly in US and international samples.

Our broad conclusion is one that historians – particularly Kindleberger — have reached already. There is much more to a bubble than a mere security price increase. There is innovation, displacement of existing firms, creation of new ones, and more generally a “paradigm shift” as entrepreneurs and investors rush toward a new Eldorado. Our contribution is to show that this shift is to some extent measurable in financial data, so one can also identify – imperfectly but well enough to predict returns – asset price bubbles in advance.

Kudos to the researchers for this important work.

The precise definition of a bubble, of course, will always remain elusive. The market is a human construct, so at some level we’re stuck with Stewart Potter’s definition of pornography: “I know it when I see it.”

Justice Potter’s famous remark reminds us to consider the white space. Bubbles are hard to define. It is possible to know what isn’t a bubble. The NASDAQ Composite, for example, is currently trading in an orderly fashion (Charts 1 & 2). And since an orderly trend is not a bubble… well, you get the point.

To our way of thinking, the NASDAQ isn’t in a bubble – at least not yet.

Chart 1. NASDAQ price history

Chart 2. NASDAQ versus S&P 500

Mark Ungewitter

The Wages of Sleep

Can we sleep our way to success?

Illustration: Lorenza Walker: Source: Wikipedia

We all know that sleep is good for our bodies – that it helps us heal and refresh ourselves, restoring our immune, nervous, and muscle systems. But can sleep be good for our finances, too? Because getting enough rest helps us concentrate and interact more positively with others, sleep could improve our wages. On the other hand, you obviously can’t work while you’re sleeping. How does sleep impact our earnings?

It’s hard to estimate the income effects of getting more sleep. As your income goes up, the opportunity cost of sleep goes up as more. Your time is worth more. But a lack of sleep clearly has direct economic costs: doctors make more mistakes, students do worse on tests, folks running cars or trains or planes fail to pick up important signals. A few years ago, two Northwest pilots overshot the Minneapolis – St. Paul Airport by 150 miles because they were probably dozing in the cockpit. They lost their pilot licenses.

Some researchers looked at a large set of sleep diaries from the US. They evaluated sleep time and the local sunset across multiple time zones.

Sunset time in the Spring. Source: UCSD

They found that a one-hour increase in average sleep increases wages by about 16% – the same as an additional year of school. They also found that the optimal amount of sleep is around 9 hours. This is more than the average sleep they found in the diaries – 8.3 hours – and a lot more than the 7 hours per night minimum that most medical researchers believe is needed for our bodies.

Sleep isn’t just a curiosity. It’s a vital part of our economic, medical, and personal lives. We have to weigh the trade-offs between work, health, leisure, and other demands on our time. But if we want to improve our situation, we might start by getting a little more rest.

Douglas R. Tengdin, CFA

Crossing the Tape

Do you love to win, or do you hate to lose?

Photo: Public Domain. Source: Wikipedia

It’s two different things. People who love to win are motivated by the big payoff at the end. They love the thrill of victory that comes from crossing the finish line first, standing at the top of the podium. They can be gracious, too, not minding if someone else climbs higher, later. But nothing takes away from what they’ve done before.

People who hate to lose, by contrast, hate the humiliation that comes from being behind. They see problems as failures. Engineers, doctors, and corporate lawyers are often loss-averse in this way. An error can mean a company can lose millions of dollars, or someone dies. A programmer once had a “morning shower revelation” and had to call his client to tell them not to install some recently completed software – that it had a bug that would cause significant data loss.

In business, we need both kinds. Marketing people love to win. They love bringing home the deal that makes the company profitable. Risk managers hate to lose. They can’t stand the idea of falling short because of an overlooked factor. Most of us are loss-averse: we hate losses more than we love gains. That’s why companies use trial periods, rebates, and free returns: we value something much more once we have it, and we’re less likely to give it up.

Source: Kahneman & Tversky, “Choices, Values, and Frames.” (1983)

Investors need both approaches, too. The stock market is driven by winners: Apple and Amazon and Facebook, who came from nowhere to become some of the biggest companies in the world. By contrast, the bond market is a loser’s market: one Lehman or Puerto Rico bankruptcy erases hundreds of safe maturities. Managers continually need to be looking out for losers while prospecting for the next big deal.

Loving to win and hating to lose are the two sides to the coin of competition. And both drive us.

Douglas R. Tengdin, CFA

Where the Black Swans Hide

What is a “Black Swan”?

Photo: Sergio Valle Duarte. Source: Wikipedia

A Black Swan event is a development that comes as a total surprise, has a major impact, and that we later see as inevitable – with the benefit of hindsight. The term was popularized by the author Nassim Taleb, and it is based on an ancient Latin expression that assumed all swans were white. After Europeans discovered black swans in Australia, however, the phrase was revised.

Taleb notes that many – if not most – scientific, historical, and artistic developments can be seen as Black Swans. They come from outside our normal expectations. They have a deep and widespread impact: it’s impossible to think of the world the same way after they happen. And they seem inevitable after the fact – we rationalize their occurrence as we try to understand our world.

Many major events that we take for granted today could be considered Black Swans: 9/11, smart-phones, the rise and fall of Soviet Communism, the growth of rock music, and so on. Personal events can also be seen this way: meeting a spouse, a car accident, getting into college, receiving new insight regarding a vexing problem. By definition, outliers like these cannot be predicted

When we invest, we want to be prepared for Black Swans. We want to have assets that do well under widely divergent circumstances because we don’t know the future. Stock market returns are not normally distributed. In theory, a one-day 5% rise or fall in the market should happen perhaps once in a 100 years. In reality, it has happened over 100 times in the past century. We call this a “fat tailed” distribution.

One-day returns of S&P 500 over the past 2 years. Source: Bloomberg.

Where do Black Swans hide? They’re embedded in the indeterminate character of the news. It’s our nature to look for patterns and explanations after something happens – to tell ourselves stories to make sense of the world. But our knowledge and understanding are limited. While we can all grow and learn to organize information in useful ways – and have institutions that encourage this – not everyone does.

We don’t know the future. The best we can do is prepare for unknown unknowns by understanding how markets have reacted in the past.

Douglas R. Tengdin, CFA

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