Keep it Real

You may have heard that the NASDAQ stock market index hit a new all-time high yesterday. The index set new records for both the intraday mark and the closing value. For many, this conjures up images of the NASDAQ "bubble" of the late 1990s. Don't be afraid dear reader. Nominal thinking can be quite misleading. If you fear the new highs, perhaps the below chart will calm you down. It plots the NASDAQ in real terms (i.e. priced in ounces of gold) since inception. Nothing to see here. 



On Trend

I have no meaningful opinion on how the stock market will perform in the near future. However, I'm not convinced the market is significantly out of norm on the high side. As the chart below shows, the S&P500 is currently right on it's long-term trend (log scale of SP500 index, scaled to begin at 1.0 on 1/3/1950, +/- one standard deviation)

Emerging Markets Investing

I generally endorse indexing, but there are some obvious problems. It matters how the index is constructed. Here's an example. The financial indexers have grouped several large, unrelated financial markets together and called them "Emerging Markets". Take a look at the last two years. The four major countries, Brazil (EWZ), Russia (RSX), India (PIN), and China (FXI) have very dispersed returns. The index (EEM) is simply the muddle average of these four. (Click for a more dispersed image). Note, other EM index funds are similar to EEM, in this aspect. The issue is that the four major markets are very diverse, and they respond to different macro-economic factors. 

Who Creates New Jobs?

The conventional answer to this question is "small businesses". As we discussed in this podcast, there is a more refined answer. In short, all net job growth can be attributed to new companies. Granted, most new companies start out small, but not all small companies are new. This research is a key insight from the Kauffman Foundation.
Any entity attempting to spur economic development should study the important new details about job creation and destruction released by the U.S. Census Bureau in recent years. The Business Dynamics Statistics have shattered conventional thinking about who creates jobs.  Between 1987 and 2005, startup companies (those which did not exist the prior year) added about 3% annually to the existing job pool.  Over the same time period, total job growth averaged 1.8% per year.  This means all existing companies, grouped as a whole, reduced the number of jobs by 1.2% per year.  Stunningly, all net job growth can be attributed to startup companies.  For example, in 2005 startups added 3.5million net new jobs, but the economy as a whole added only 2.5million net jobs.  As a group, existing businesses lost over 1million jobs that year. 

Here's a letter  I wrote on this topic to my local paper more than three years ago.

Research Dollars

An interesting note related to

this podcast

, is how it began. Dr. May penned

a blog post

arguing for more public funding of research and development. I emailed him to disagree, essentially arguing the US is way down the list on R&D funding but very high on lists of innovation and growth. It lead to a discussion in his office, which lead to my interview. 

In the podcast, I chose to focus more on his college and how they are making future innovators. I purposely chose not to debate public funding in the episode, as I thought the topics we did discuss had broader appeal. However, in the episode, Dr. May mentions that public research has been reduced the past several years (and may now be starting to rebound).  In private conversation with him outside the podcast, I challenged his take. 

I went to the site and looked up federal spending on research and spending from the

National Science Foundation

. Here are a few charts from the data (click to see larger image).   

The below chart suggests total R&D spending did dip slightly after 2009.

Basic R&D at universities surged in 2009, then pulled back but remained on trend throughout.

Applied R&D spending also jumped in 2009, then pulled back, but remained on trend throughout.

Below we see that applied R&D at universities surged in the 2000s, so the recent decline is minor.

Lastly, consider the percentage of applied research and total research that flows to universities. 

Oppressive Government


In Durant's The Complete Story of Civilization he recounts a tale from the life of Confucius that marvelously equates voting and migration:
Returning to Lu, Confucius found his native province so disordered with civil strife that he removed to the neighboring state of T'si, accompanied by several of his pupils. Passing through rugged and deserted mountains on their way, they were surprised to find an old woman weeping beside a grave. Confucius sent Tsze-loo to inquire the cause of her grief. "My husband's father" she answered, "was killed here by a tiger, and my husband also, and now my son has met the same fate." When Confucius asked why she persisted in living in so dangerous a place, she replied; "There is no oppressive government here." 
"My children," said Confucius to his students, "remember this. Oppressive government is fiercer than a tiger."

Don't Pay the Teachers, Compensate Them

In complex issues, simplification is common but improper. On the issue of what teachers are paid, it is a gross over-simplification to focus on their salaries. Yet that is all anyone ever talks about. I try to point out this flaw in a recent letter.

Dear Editor:
Friday's MDJ reported on the level of salary for some Cobb County school teachers and compared those salaries to what is offered in other area school districts. Although I have sympathy for the idea we should pay our (Cobb) teachers more, there are three key concepts missing from this discussion.
First, the focus of the discussion centers on salary, instead of total compensation. A proper analysis would measure all the ways a teacher is compensated. This would include other monetary factors such as paid time off, insurance benefits, and, importantly, retirement compensation (pension, insurance, etc). This would also include non-monetary compensation, such as work environment (class size, safety, quality of students, facilities, quality of co-workers and supervisors, opportunities for advancement, etc.). And a proper comparison would take into account the cost of living. Just as a teacher in Wyoming can live an equivalent lifestyle on less compensation than one could accept in metro Atlanta, teachers in Cobb enjoy a lower cost of living than many surrounding areas.
Second, the analysis should include some comparison to other available jobs, not just teaching jobs. Could a recent graduate with an education degree earn more or less in other professions? And if the district's goal is the pay enough to hire the best, shouldn't it pay enough to be competitive with other industries?  Is the goal to hire the best math teacher or the best mathematician; the best science teacher or the best scientist?
Third, it appears the analysis treats all employees at a given level as identical. In many other professions, employers pay varying amounts even to rookie employees based on many factors. Perhaps if the system had flexibility to pay those with better resumes more money, the district could hire better employees without a significant increase in total cost. I understand there maybe collective agreements prohibiting this, but it should be acknowledged these practices are sub-optimal.
Russ Wood
West Cobb


From Jude's essay, Karl Marx Revisited:

It is more than a convenience for modern economists to ignore the role of risk-taking and innovation. The profession's determination to convert Keynesian demand theory into an exact science ran afoul of Princeton mathematician John von Neumann, who in 1936 demonstrated that risk and innovation could not be converted into mathematical equations. To this day, the computers that drive economic policymaking in most of the West cannot handle questions relating to this basic ingredient of entrepreneurial capitalism. Taxation of either business profit or an increase in the value of capital assets (a capital gain) are dealt with in static, linear fashion, as if the risk-taker is largely unaffected by variations in reward.14
In Human Action, Ludwig von Mises's 1949 magnum opus, we find the first connection between confiscatory taxation of risk-taking as an instrument of the bourgeois oligarchs, much as the oligarchs employed the Smoot-Hawley tariff to thwart external competition. We quote at length this fascinating passage:
Confiscatory taxation results in checking economic progress and improvement not only by its effect on capital accumulation. It brings about a general trend toward stagnation and the preservation of business practices which could not last under the competitive conditions of the unhampered market economy...

Every ingenious man is free to start new business projects. He may be poor, his funds may be modest and most of them may be borrowed. But if he fills the wants of consumers in the best and cheapest way, he will succeed by way of "excessive" profits. He ploughs back the greater part of his profits into business, thus making it grow rapidly. It is the activity of such enterprising parvenus that provides the market economy with its "dynamism." These nouveaux riches are the harbingers of economic improvement. Their threatening competition forces the old firms and big corporations either to adjust their conduct to the best possible service of the public or to go out of business.

But today taxes often absorb the greater part of the newcomer's "excessive" profits. He cannot accumulate capital; he cannot expand his own business; he will never become big business and a match for the vested interests. The old firms do not need to fear his competition; they are sheltered by the tax collector. It is true, the income tax prevents them, too, from accumulating any capital. But what is more important for them is that it prevents the dangerous newcomer from accumulating any capital. They are virtually privileged by the tax system...

The interventionists complain that big business is getting too rigid and bureaucratic and that it is no longer possible for competent newcomers to challenge the vested interests of the old rich families. However, as far as their complaints are justified, they complain about things which are merely the result of their own policies. Profits are the driving force of the economy...He who serves the public best, makes the highest profits. In fighting profits governments deliberately sabotage the operation of the market economy.15

While von Mises is viewed by America's intellectual aristocracy as an extreme conservative in his economic views, there is a definite flavor of Marx in this passage. In fact, even though the two are at polar extremes, they merge in their hostility to the politically entrenched vested interests of the Big Business bourgeoisie. If they were alive today, they no doubt would have similar perspectives on the state of the world economy, which is, after all, what this essay is all about.


These are the people {blacks and the poor} who would benefit most by having tax rates and regulations which stand as barriers to new enterprise pushed aside.21 Professor Reuven Brenner of McGill University in Montreal made this point in a paper on taxation prepared early this month for the new government in Ottawa, 'Taxation in General, of Capital Gains In Particular." Brenner argues that a high capital gains tax produces "a static, frozen, stratified society," whereas a "lowered capital gains tax could facilitate increased movement within the distribution."
A tax that prevents or slows down such movement is a far more progressive tax than one which would impose, let us say, a 50 percent marginal tax rate on the rich, and a 10 percent marginal tax on the poor. For when the revenues from the 50 percent tax on the small number of richer people is redistributed among the large number of the poorer, that will not allow any of the poorer to become rich. They become somewhat less poor, but still stay at the bottom of the ladder. In contrast, when there are more chances of obtaining credit with a lowered capital gains tax, the talented poor have greater hopes of moving up, something that progressive taxation, no matter how generous can never give.

Eminent Failure

Eminent Domain is a process by which the government takes private property, purportedly for the public good. Locally, we have a case of eminent domain where the city has taken an operating business in order to create a public park. The city wishes to pay for the property based on the land value, not its commercial value. The mostly white government is taking land from a minority citizen.
So, I protested. I took the cheap route, using sarcasm, recalling the old sit-com Father Knows Best. In the second paragraph, I play the race card (really, I address race which was mentioned in the article). Honestly, I doubt the city has any racial biases. But the job of a political leader is to be beyond reproach. The mere appearance of a racial bias is a failure. I don't think the city is underpaying this man because of his race. But the city is majority white, and they've never attempted to take a white man's property, especially at less than fair value. The city leaves itself open to charges of racism, which is reason enough not to take private property.

Thursday’s MDJ reported on the efforts of a Marietta man to fight for his property. It is sad to see Mr. Summerour and his neighbors suffer under the delusion they know what is best for their community. Thankfully, Marietta has a benevolent government, willing to educate the children of the family on what is best for them. Around this dinner table, government knows best. Summerour and his neighbors may think they desire a grocery store, but hopefully they will come to see the superiority of the government’s plan for a park.
As for the charge the city is mistreating Summerour due to his race and the race of his neighbors, that cannot be the case. Simply look at all the times the city took property in white neighborhoods by eminent domain so that black communities could access those areas. I cannot recall any, but there must be several of those cases, right?
Russ Wood
Cobb County

The Investment Objective

At first glance, it might seem obvious one's portfolio goal is to maximize returns. In reality, the goal should be to maximize realized returns over the long-term. Realized returns are maximized by avoiding (or minimizing) taxes and fees. For this reason, most investors should favor index funds and trade infrequently. The long-term is defined as multiple market cycles (up and down markets). When it comes to maximizing long-term compounded growth, the key concept boils down to how one's portfolio manages bouts of volatility. This post will focus on the importance of minimizing volatility. Instead of discussing the academic versions of these ideas, let’s review a few hypothetical scenarios.

First, consider three portfolios A, B, and C from the above table. Each one alternates between a positive year and a negative year. In all three cases, the average return is a positive 2.5%, as the magnitude of the positive years is greater than the magnitude of the negative years. As an investor, which portfolio would you prefer? The average annual returns are the same, but the long-term realized returns are very different. As the nearby chart shows, the higher volatility of Portfolio C actually produces negative long-term results, because it takes more than a 35% gain to recover from a 30% loss. The moderate Portfolio B produces no gains for the same reason. The superiority of Portfolio A is not obvious in the annual data.  It only becomes obvious after several market cycles. Portfolio A does a much better job limiting downside volatility, which serves the long-term investor well.

Next, consider these two portfolios. Portfolio A alternates between rising 100% and earning 0% return. Portfolio B earns 50% consistently. Again, both have the same average annual return. Which would you prefer?

Here again, the correct answer is to pick the portfolio with the lower volatility. Portfolio B actually has (an unrealistic) zero volatility and is thus superior, as shown by the Growth of $1 chart.

Lastly, just to use a more realistic return stream, consider these two portfolios.

In this case, there is a difference in the average annual returns. Portfolio A has higher average returns. Portfolio B has similar returns but lower volatility, and that is key.

The point for investors is to focus on volatility, especially downside volatility of their portfolios, not annual returns. That can be more difficult than it sounds, and a topic for another day.