Demarest and Fischer on the Collapse of Civilizations

What kind of insights into the frailties of civilization would you get if you were a genius archaeologist, expert on the Maya, with a PhD from Harvard, living in a tent in Guatemala? Read this piece in which Arthur Demarest, and his interlocutor, Ted Fischer, both of Vanderbilt, talk about how and why civilizations collapse. Gloomy stuff, with no prediction intended on my end, but interesting and well worth the time.

The related audio podcast is excellent, too. A highlight is the unusual, but persuasive, way in which Demarest thinks about ideology and religion. This comes up eleven minutes into the conversation.

Worth reading: Greenspan and Tett

This discussion, between Alan Greenspan and the brilliant Gillian Tett of the Financial Times, is well worth reading. It's an interview at the Council on Foreign Relations in New York two weeks ago.

The former Fed chairman comments on the difficulties he sees when the Fed needs to remove the easing it has applied. His comments on gold are maybe the most surprising of all. (He seems to love it.)

Surprising and thought-provoking stuff. I sent it to my clients recently.

(There is a video of the discussion online, too.)

A Debate with Myself

Have the long-term, equilibrium valuation multiples of the stock market increased?

THESIS: in a fiat money world, inflation insurance is worth paying a premium for. This raises valuation multiples like the price/earnings ratio and q (price / replacement value). Deflation, which would hurt equities, is no longer much of a risk, now that it is so easy to create money.

ANTITHESIS: An arbitrage exists. If companies trade for more than it would cost to create them, which appears to be the case now, business people will start them, sell shares in public offerings, and pocket the difference. This is more apparent with the q ratio than price/earnings. And there is no limit to number of companies that can be created and sold off. Prices will get competed back down to replacement value (or in other words, the q ratio will tend back toward a value of 1.0).

SYNTHESIS: Fiat money creates the venture capital industry! or at least supports it.

Advice to a Younger Me

I sometimes try to imagine what, in my maturity, I would say to a younger me. What useful advice could the married-with-kids, 52-year-old Jon Shayne give to the me who was in college?

For one, I could encourage the younger me to trust my own instincts more, and to worry less about what others think.

Of course, that advice is easier to give than to follow.

For the most part, I have a hard time coming up with anything useful I could tell a younger me. But recently, I figured out something that might have been useful, back when. A truly insightful bit of advice that the me-of-today could have given to the Jon Shayne of the early 1980s.

When I was in college at Harvard, the course catalogue was very thick. It was a paper book of perhaps 350 pages. One of the courses was titled, "Compunications," with a p. My college roommate, John Rabinowitz, and I used to laugh about it. We never took the course; we were liberal arts students. We just noticed it in the catalogue. The name struck us as pretty ridiculous.

This was probably 1981 or '82. The course description said that computing and telecommunications were in the process of merging, so much so that it would soon no longer be useful to think of them as two separate fields. According to the catalogue pitch, we should think of them as one field: compunications. The logic of this was lost on me, because John and I were too busy chortling about how the word sounded.

What impresses me now is that the professor who created this course, whoever he or she was, was completely correct. None of us students had cell phones, nor personal computers. We still used land lines and typewriters at that point. But the professor apparently foresaw, in some sense at least, the internet and voice-over-IP telephony.

So my advice to the young me: you can pretty much ignore the whole course catalogue, except for "Compunications." It is not as silly as it sounds. Quite the contrary. Master it, and you will have a lot of fun, and will wind up owning a few islands in warm, sunny places.

Although I guess this rhymes with the advice, "Plastics," given to Dustin Hoffman's character in The Graduate (1967).

Is there a moral here? Well, perhaps only that outlandish ideas are not necessarily bad. They are sometimes brilliant.

Quote of the Day

"Central bankers have had enormous responsibilities thrust on them to compensate, essentially, for the failings of the political system. And my worry is we don’t have sufficient tools to do that, but we’re not willing to say it. And, as a result, we push as hard as we can on the existing tools, and they may create more risk in the system."

-- Raghuram Rajan, Governor of the Reserve Bank of India. In other words, he runs India's central bank. The quote is from this interview with him in the FT today (registration may be required). He used to be an economist at the University of Chicago's business school, and is former chief economist of the IMF.

Rajan is famous for a prescient 2005 paper, "Has Financial Development Made the World Riskier?" Larry Summers famously derided him when Rajan presented the paper at the 2005 Jackson Hole conference, but Rajan got the last laugh. (I love stories in which nice guys finish first.)

How to Reduce the Volatility of Your Stock Portfolio, in Five Words

It's easy: don't look at the prices.

I was reading a piece about investing in farmland. The measured volatility of returns on land investments is very low compared to stocks, because you only get prices for land when you appraise it. And you don't do that very often.

Hence, my idea, which is surely worthy of a Nobel Prize, or at least a MacArthur Foundation genius grant, on how to reduce stock market volatility.

Of course, you can afford not to look only if you have not taken out a margin loan. (And that is one more reason not to take out a margin loan.)

I'm not going to hold my breath waiting for the call from Sweden.

Shadow Banking, Defined

Matt Levine gives a useful definition of "shadow banking" in a recent Bloomberg column:

Roughly speaking, "shadow banking" refers to the parts of the world that are regulated according to the capital markets view -- lots of disclosure regulation, much less capital-and-risk regulation -- but treated by their investors more according to the banking view, where the customers try not to think too hard about the risks. You can see why this would be scary: If regulators aren't worrying about the risks (it's not a bank!), and investors aren't worrying about the risks (ehhhh it's a bank!), then ... no one is worrying about the risks? That seems bad.

Levine's column is on money market funds.

Shades of Donald Rumseld, known knowns, and unknown unknowns. It's o.k. to have a financial product that is regulated. It is also o.k. to have one that is unregulated, and known to be unregulated. But beware the product that is unregulated, but thought by investors to be regulated. That is the problem with retail money market funds.

Money market fund share prices should float, even for individual investors. Stable values should be the province of regulated banks, not mutual funds.

Recommended Reading

Andrew Smithers is blogging some very good material on stock market valuation at the website of the Financial Times.

(There is no charge to read the Smithers FT blog, but you do have to register. It is well worth it.)

Must-See TV: "Silicon Valley"

The first episode of Mike Judge's new show, "Silicon Valley," is freely available on YouTube. Really sharp satire. This may be the funniest thing I have seen since "Curb Your Enthusiasm."

Son of "Why Money has Value"

Last month I posted on why paper money, like the U.S. dollar, has value.

The basic idea is that even though our fiat currency is not backed by gold or silver, we need it to stay out of prison. If we earn anything, we owe taxes, and taxes have to be paid in dollars. So, dollars are a "get-out-of-jail-free" card, as in the game of Monopoly.

I have written an expanded version of this piece for the PBS NewsHour, at Paul Solman's Making Sen$e page. They have just published it today. It goes into a bit more depth.

Why Money has Value

Here's a question I can answer for you: why does a paper-backed currency, like the U.S. dollar, have value?

Because it's a get-out-of-jail-free card. Kind of like in Monopoly.

The U.S. dollar is not backed by gold or silver, but you can use it to keep from getting jailed for failure to pay federal taxes.

It has value is because our courts say it does. And what good is the opinion of a court, which is, after all, just words on paper? Well, if you are condemned to years in jail by a court decision, you will, in fact, spend years in jail. So, yes, court opinions are words on paper, but they mean a lot more than greeting cards.

In the U.S., your income is taxed, and you need to pay the tax in dollars. Even if you earned your income through barter. For example, if you started the year with an old baseball worth $1.00 and, through clever trading, ended the year with a speedboat worth $25,000, you would need to pay income tax, in dollars, on the gain you enjoyed, $24,999. You would need to barter your boat for some dollars in order to pay it.

This is what distinguishes the U.S. dollar from Bitcoin. No one needs bitcoins. They are elegant and, in their way, beautiful, like a work of art. But you do not need them for anything. But Americans need dollars, if they want to stay out of jail. (Yes, I know, we need beauty to be happy. True, but not important here.)

This way of thinking about fiat currency is not a new argument. I do not remember where I encountered it first. It does not get as much "circulation" as it should.

UPDATE 3/14/14: Modern Monetary Theory emphasizes the role of tax obligations in the value of a fiat currency.

Trendline S&P 500 EPS

Chris Brightman has a new piece out that is worth reading. He is with Robert Arnott's firm, Research Affiliates, in Newport Beach, CA.

Brightman's point is that reported earnings per share for the S&P 500 composite are markedly above trend. He is likely to prove too pessimistic, at least if he means to suggest a "multi-decade period of zero or negative growth in real earnings per share," which he mentions at one point. However, the underlying logic of his piece is good.

What I love about the piece most, though, is the bonus feature. Brightman compares current EPS to a trend line that goes back to the start of 1871. But he then provides a widget that lets you set your own time frame for the comparison. In other words, we may all agree that we're over trend, but whether we are 30% or so above, or almost 60%, varies with the start date. The widget lets you see how the slope and position of the trend line differs depending on the dates through which you draw it.

Will earnings revert back to some version of the trend lines we can draw with the widget? That seems like a fairly good bet, in the long run at least. This is, in part, because the politics of the situation will ultimately demand it, as Brightman argues.

But when will reversion happen? No one knows.

Keep in mind that the measurement of inflation and the rules of accounting have changed over time, which can distort things a little and make the tool less precise than it looks. Increasing use, over time, of stock option compensation and share buybacks are also factors. Having dug into such issues from time to time, I do not think any of them is big enough to distort the basic picture. Sometimes they offset each other, as in the case of previously-unexpensed options and buybacks. Anyway, a degree of approximation goes with the territory.

As you use the widget, please note that: (1) it's the dotted line, not the solid line, that moves when you change the start and end dates, and (2) the "Distance to Long-Term Trend" always compares current EPS to the 1871-2013 trend, rather than to the shorter period you may pick. Just keep your eye on the dotted line you are drawing.

By the way, I have written before about profits being high as a share of GDP.

HT for the Brightman piece: Michael Brakebill.

POSTSCRIPT (2/28/14): If the real (inflation-adjusted) trend line growth in earnings per share of the S&P 500 is around 2%, as it is in the Cowles Commission data series, then Brightman is correct that it should take more than a decade for the trend line to catch up to where earnings are now. A catch up in nominal terms, however, would be a lot easier to achieve and would happen sooner.

The Economist's Greg Ip on Obamacare

Greg Ip, of The Economist, does a very good job here of trying to keep the Obama administration realistic in their statements about the effect of the Affordable Care Act on employment.

Sounds as if there really are some disincentives to work built into the program. Which is true of many other programs, too, but we need to be realistic about it. Perhaps these can be addressed as the plan evolves, as it surely will, over time.

Quote of the Day

“When you’re one step ahead of the crowd, you’re a genius. When you’re two steps ahead, you’re a crackpot.” -- Rabbi Shlomo Riskin

From the 3rd quarter newsletter for FPA Crescent Fund, which recently won a big award from Morningstar. The FPA managers are skilled, honest, and always worth listening to, whether quoting rabbis, or talking about investments.