On Wealth Accumulation and Inheritance

While most of us are busily engrossed in our oh-so-American habit of trying to accumulate unbounded wealth, it is instructive to remind ourselves of the words of philanthropic wisdom penned by Andrew Carnegie more than a century ago:

"[T]he duty of the man of wealth . . . [is] to set an example of modest, unostentatious living, shunning display or extravagance; to provide moderately for the legitimate wants of those dependent upon him; and after doing so to consider all surplus revenues which come to him simply as trust funds which he is called upon to administer . . . to produce the most beneficial results for the community." (Andrew Carnegie, from essay on "Wealth" published in the North American Review, 1889)

A quintessential living example of Carnegie's model philanthropy of 1) living frugally, 2) providing modestly for the material well-being of family members, and 3) giving the remainder back to the community, is Chuck Feeney, the so-called "billionaire who wasn't":

"He was prepared [in 1997] to reveal his secret to the world, that he was not a billionaire, as he was usually referred to in the business pages, and that he had long ago given everything, including his DFS [Duty Free Shoppers] shares and his businesses, to his two philanthropic foundations, the Atlantic Foundation and the Atlantic Trust, based in Bermuda. He was personally worth less than $2 million, a fact known only to a tight circle of family and friends. . . ." (excerpt from Conor O'Clery, The Billionaire Who Wasn't: How Chuck Feeney Secretly Made and Gave Away a Fortune, 2007)

Apparently, at least for Feeney in 1997 at the age of 65, less than $2 million out of his $4 billion fortune is all that he felt necessary to retain to assure his (and his wife's) own personal financial security during the remainder of their lifetime.

Taken together, the above two quotes on philanthropy provide what I consider to be valuable ancillary guidance on inheritance, particularly for any parents deliberating over how much wealth to leave to their children:

a. "Provide moderately for the legitimate wants of those dependent upon [them]": Though Carnegie is not more specific on this point in his "Wealth" essay, it seems fair to interpret "legitimate wants" to range from basic needs to a modest though comfortable lifestyle, and "those dependent on [them]" to refer to children of minor age and any dependents of majority age in need of funds due to illness, unemployment or other significant financial setbacks in life;

b. "Less than $2 million": If a person who made not "just" millions but billions of dollars can feel secure retaining less than $2 million in personal wealth, then we can reasonably infer that anyone outside of this rarified circle of billionaires ought to require no more than $2 million to feel materially content. In other words, we should interpret $2 million as an upper limit on the total amount of accumulated wealth that a single individual or married couple could possibly require to meet personal needs, including whatever earnings and savings they are able to realize through their own efforts prior to considering any inheritance.

The implication here is that parents should not feel obligated to bequeath to their children any more than $2 million minus whatever the children are able to accumulate through their own careers, and for children with high earnings power this means no inheritance whatsoever is in order. As Carnegie states, most giving spreads "a spirit of dependence on alms, when what is essential for progress is that they [the recipients] should be inspired to depend on their own exertions." In an even earlier age, Plutarch issued the warning, "he that first gave thee money made thee idle, and is the cause of this base and dishonorable way of living."

My own view is that the best gift that parents can provide their children is making sure that the children learn by the time they reach adulthood how to educate themselves, earn their own living and save for retirement through their own effort and ingenuity, without counting on any inheritance to be forthcoming from parents or the proverbial "rich uncle." Large gifts of money and assets unfortunately subject recipients to the risk of reduced motivation and deflated self-esteem, arguably to a larger extent than providing any real benefit to their material well-being. After children reach adulthood, parents should, while continuing to offer open-minded and big-hearted emotional support, provide for their children (and grandchildren) not much more than a financial safety net, similar in substance to temporary unemployment benefits--all in the spirit of, as Carnegie put it, "helping those who will help themselves."

How Guessing Market Direction Can Be PREDICTABLY Bad for Your Financial Health

"The game is called probability guessing. . . . [S]ubjects are shown a series of cards or lights which can have two colors, say green and red . . . appear[ing] . . . with different probabilities but otherwise without a pattern. . . . The task of the subject, after watching for a while, is to predict whether each new member of the sequence will be red or green. . . . Humans usually try to guess the pattern, and in the process we allow ourselves to be outperformed by a rat. . . ." (excerpt from Leonard Mlodinow's The Drunkard's Walk--How Randomness Rules Our Lives, 2008)

In a stock market context, the probability guessing game described above would read like this: In any given year, the stock market either rises (green) or falls (red). If we look over the past six decades, from 1950 through 2009, we find that during the sequential decades (1950s, 1960s, and so on) the S&P 500 Index rose in 8, 6, 7, 9, 8 and 6 out of the 10 years (using data from Yahoo! Finance). In other words, during a "typical" decade annual stock market returns are "green" about 7 or 8 out of the 10 years, and "red" about 2 or 3 out of the 10 years. Based on these historical data, we can infer that the stock market tends to rise during any particular calendar with a probability of about 75%, and fall with a probability of about 25%. As investors, we, of course, would like to try to predict whether this year (or next year, or any future year for that matter) will be green or red.

For us investors, the million-dollar question is: Should an investor attempt to "time" the market, by investing in stocks during years the market is more likely (in the investor's opinion) to rise and staying out of the market during other years when the market is more likely (again, in the investor's opinion) to fall?

Obviously, if the investor truly has enough information, foresight or precognition to know with a high degree of certainty when the market will rise or fall, then market-timing makes perfect sense and will lead to higher returns. However, what happens if the investor only believes that he knows but actually does not, so that for all practical purposes the investor is really faced with the 75% green versus 25% red probabilities described above? Is any harm done by guessing?

Analogous to the general guessing game Mlodinow mentions in his book, let's consider two strategies:

1. Buy-and-Hold Strategy: Since the market rises during 75% of the years, one could just go long the market by buying an exchange-traded fund tracking the S&P 500 Index (or buying individual stocks), without attempting to time the market at all. A buy-and-hold investor can expect to generate positive returns 75% of the years but must also accept the unavoidable "fact" that the market will typically fall 25% of the time. In this "simpleton" strategy, an investor's long-run win percentage (i.e., the percentage of years the investor's portfolio will show positive returns) is expected to be 75%;

2. Market-Timing Strategy: A presumably more "sophisticated" investor will, through some combination of fundamental and technical analysis and application of his general intelligence and market wisdom, come up with a convincing explanation for why the market is more likely to rise (or fall) during any particular year. Believing he can distinguish beforehand (i.e., predict) which years are among the 75% "green" years when the market will rise and, likewise, which years are among the 25% "red" years when the market will fall, such an investor will want to go long 75% of the time and stay out of (or go short) the market 25% of the time.

If the bright and sophisticated market-timing investor has an "edge" over the the naive and unthinking buy-and-hold simpletons, then he will end up being right more than 75% of the time and will show higher long-run returns. At the other extreme, if it turns out that the market-timer only believes he has an edge but actually does not, one would think that his edge would just vanish and there should be no penalty for guessing, right?

Well, you might think that guessing carries no penalty, but that's actually wrong! Quite counter-intuitively, investors should expect lower returns when they guess. Here's why.

Let p be the (stationary) probability that the the market will rise in a given year, i.e., p = 0.75, representing the 75% "green" probability. Supposing that the market-timer's guesses do not give him any significant edge, his overall win percentage is given by a straightforward weighted-probability calculation:

Market-Timer's Win Percentage
= (Portion of time the market-timer goes long) x (Probability that market rises)
+ (Portion of time the market-timer stays out of market) x (Probabiility that market falls)
= p x p + (1 - p) x (1 - p)
= p² + (1 - 2p + p²)
= 2p² - 2p + 1.

On the other hand, the Buy-and-Hold Investor's Win Percentage is just p, as we saw earlier. Consequently, we may write that the expected potential downside of the market-timing strategy versus the buy-and-hold strategy is the difference:

(Buy-and-Hold Investor's Win Percentage) - (Market-Timer's Win Percentage)
= p - (2p² - 2p + 1)
= -2p² + 3p - 1
= 2(p - 0.5)(1 - p),

where the last expression is the factored-form equivalent of the quadratic polynomial in the previous line.

From the factored-form expression, we can easily see that whenever p is in the "physical" range (i.e., consistent with the probabilities indicated by market history for a wide variety of investment time windows) from 0.5 to 1.0, a buy-and-hold investor is expected to outperform any market-timer who is really just guessing without appealing to any special knowledge of market direction. In particular, when p = 0.75 (which is the historical win-percentage for a sequence of annual returns), the Market-Timer's Win Percentage becomes 2(0.75)² - 2(0.75) + 1 = 0.625, or 62.5%, which is 12.5 percentage points worse than the Buy-and-Hold Win Percentage of 75%.

Therefore, to the extent that a market-timer is "only guessing" (and who can really be so certain?) about market direction, he is (presumably unknowingly) effectively "shooting himself in the foot," following a self-destructive path of degrading his expected returns by staying out of the market 25% of the time (by the way, shorting the market 25% of the time would make matters even worse). Despite his seemingly sophisticated ways, this market-timer can actually be expected to underperform the simpleton buy-and-hold investor in the long-run.

Lesson: Don't attempt to "time the market" unless you are absolutely certain that your market-timing strategy actually works, since your expected downside from "believing without knowing" far exceeds your time spent strategizing, not to mention your trading costs and commissions consumed.

Perpetual Income Generation

A student who earned a few thousand dollars over the summer working remarked to me yesterday, "I don't know how I'm going to spend the money if I don't use it to travel over the holidays."

At first, this statement seemed quite innocuous, in line with what I have come to expect in our work-and-spend, consumer-oriented society. People earn money working and then, quite predictably, spend the bulk of their earnings soon thereafter, buying all types of consumer goods and services with whatever remains after paying for life's essentials.

Three Personal Financial Management Philosophies

Upon further consideration, I became struck with just how one-sided the student's attitude on what to do with his money is. On the spectrum of personal money management philosophies, he is at the consumerist end of the two extremes:

Consumerist Philosophy: Earn and spend; earn and spend; earn and spend. In short, spend all of today's earnings on consumer items, because another paycheck will always come "tomorrow." Examples of this type of philosophy include people who live paycheck-to-paycheck more by choice than circumstance, the young woman from England who won a multi-million dollar lottery six years ago at the age of 16 and now regrets having spent all of the money so frivolously, and highly successful, high-income celebrities like photographer, Annie Leibovitz, and singer, Michael Jackson, who, despite their millions in earnings, have ended up "awash in debt" due to their personal financial management, or lack thereof.

Wealth Accumulator's Philosophy: What's important is accumulating as much wealth as possible during one's lifetime. Be frugal, even to the point of being miserly. Save as much as possible from one's earnings, prudently invest one's savings, and reinvest as much as possible of one's investment earnings. An example of this type of thinking is self-made billionaire, Warren Buffett, who not only is worth some $40 billion but is rumored to have once stooped down to pick up a penny in an elevator, remarking to those around him, "This is the start of my next billion."

My opinion is that most of us will be best off following neither of the above extremes but, instead, adopting a middle-of-the-road philosophy, which emphasizes neither consumer spending nor wealth accumulation:

Perpetual Income Generation: Use one's "excess" earnings (i.e., whatever is not needed to pay for basic necessities) from work and investments to build an investment portfolio that will reliably generate long-term income to cover all of life's expenses. The focus here is neither on spending all of one's earnings, just because one has money currently available to spend, nor on stockpiling cash without limit, primarily to see how much wealth one can accumulate. Rather, the core of this philosophy is to accumulate enough wealth to reach an ongoing state of financial independence, which means that the income generated from one's investment portfolio should over time be enough to support one's lifestyle without relying on external employment.

Historical Analogies

I'm now reading Jared Diamond's insightful work, Guns, Germs, and Steel, which discusses how and why some societies developed farming and technologies and came to dominate societies that remained hunter-gatherers throughout the millennia since the most recent Ice Age some 13,000 years ago. We can draw a simplistic analogy between hunter-gatherer societies and the consumerist philosophy mentioned above, since both emphasize current consumption without any significant savings component. Similarly, agricultural societies may be compared to the wealth accumulator's philosophy, since any excess harvest can be stored or sold for income, allowing for investment in technology development, which in turn can be used to promote further wealth accumulation.

As Diamond mentions, the recurring pattern throughout history has been that agriculture-based societies have not only developed better technology but have also deployed it to exploit societies having more primitive technology. A striking 19th century example is how, in December 1835, a group of 900 Maoris from New Zealand's North Island sailed 500 miles east to the Chatham Islands and conquered a peaceful society of 2,000 Moriori hunter-gatherers, brutally and indiscriminately killing men, women and children who refused to become their slaves. Apparently, what induced the Maoris to attack the Morioris en masse was news from a seal-hunting ship that visited the Chathams, revealing islands rich in shellfish, eels and berries, with inhabitants who "do not understand how to fight, and have no weapons."

Such are the tragic consequences of the collision of societies. Other well-known examples range from the probable driving of the Neanderthals into extinction by Cro-Magnons some 40,000 years ago, to Cortes's and Pizarro's 16th century conquests of the Aztec and Inca empires, respectively, to the so-called Manifest Destiny of European settlers in the 19th century to expand across North America, decimating native Indian tribes in their path.

I mention these historical analogies because of the perspective they bring to personal financial management. As history shows, societies that have had a "savings" component in their culture have inexorably won an upper hand over societies with more purely consumption-oriented habits. If taken to the extreme, this might seem to indicate that pure wealth accumulation should be, at least from a survival point of view, our preferred personal financial management strategy. Hence, my advice to the student I mentioned at the outset could be to save all of his summer earnings in order to maximize wealth accumulation, but is this really best?

Goal: Perpetual Income

Pure consumers live for the present, much as hunter-gatherer societies have throughout history. On the other hand, pure wealth accumulators emphasize the future, based on a "stockpiling" mentality that always favors acquiring more, no matter how much one already has. Rather than simply consuming or saving, it is, in my judgment, critical to forecast one's future financial needs and reach the right balance between consumption and savings that will best optimize one's overall life satisfaction.

So, my advice to the student is: Instead of focussing on how to spend your earnings, or saving all of it for the future, ask yourself how best to utilize your earnings to begin to create a perpetual income stream that will allow you to gain financial independence and support your future lifestyle. Your focus should be neither on consumption nor on wealth accumulation, but on how best to employ your earnings, consumption, savings and investments to one day to replace your own labor as the primary source of income in your life. (Note: Some people call it "retirement," but for me it's closer to financial "rebirth.")

College and Salary: "With Whom" You Study Matters as Much as "What" You Study

The topic of how attending a "good college" relates to getting a "good job" came up in a recent conversation I was having with my high school-aged son, whom I am encouraging to give serious consideration to both what he enjoys doing and what type of lifestyle he wants to have after he graduates from college.

Using the popular U.S. News & World Report ranking of universities and salary data from Payscale.com, we can take a look at the correlation between university attended and resulting mid-career median salary. The table below shows the top 30 U.S. universities and the mid-career median salary of their graduates.



As might be expected, Ivy League schools (Harvard, Princeton, Yale, University of Pennsylvania, Columbia, Dartmouth, Cornell and Brown) figure prominently on the list, along with the well-known science and engineering schools (Caltech, MIT) and the so-called non-Ivy Ivies (Stanford, University of Chicago, Duke, etc.).

The relationship between university attended and salary can be seen in the graph below.



The regression line is:

Mid-Career Median Salary = $121,400 - $900 x (Ranking of University Attended),

giving a decrement of about $9,000 in annual salary for each 10 spots in university ranking. For example, a graduate of a university with a ranking of about 5 might expect to have a mid-career salary of about $9,000 more per year than a graduate of a university with a ranking of about 15. The numbers actually show more scatter and skew than is captured by the linear regression, as evident in the following examples of ranking-university-salary:

4. Caltech, $115,000
5. MIT, $126,000
6. Stanford, $124,000

14. Johns Hopkins, $94,900
15. Cornell, $106,000
16. Brown, $107,000

24. UCLA, $97,000
25. University of Virginia, $97,200
26. USC, $103,000.

The general trend of higher ranking (smaller number) correlated to higher salary (correlation of .63) is clear. While there are, of course, many individual exceptions to the rule, one of the tell-tale indicators for predicting lifetime earnings and net worth is the college one attends.

As I tell my son, the college one attends (i.e., with whom one studies) is just as important as what one studies in college. Choice of a college typically has a lifelong impact on one's social circle, which in turn often influences whom one does business with throughout one's career.

The Impact of Sidelined Cash in Disequilibrium on the Stock Market

The purpose of this note is to reconcile two contrasting viewpoints on how the amount of cash in our economy impacts future stock prices:

A. Sidelined Cash View: An example of the view that cash held in investor accounts matters is Alexander Green's commentary this week: 'In February . . . the decline in stocks was just about over [because] . . . [t]here was more money available to buy shares than at any time in almost two decades. The $8.85 trillion held in cash, bank deposits and money market funds was equal to 74% of the market value of U.S. companies, the highest ratio since 1990, according to the Federal Reserve. . . . [T]here is still over $8 trillion on the sidelines earning next to nothing in short-term deposits. . . . Expect to see cash coming off the sidelines to accumulate shares of the largest, most liquid firms around the globe.'

B. Equilibrium View: The opposite view, that consideration of market equilibrium reveals the "tautology" of speaking about cash on the sidelines, is voiced by John Hussman in his comment this week: '[A]s a result of more than a trillion dollars of new issuance of Treasury securities with relatively short durations, it is a tautology that there is a mountain of what is mistakenly viewed as “cash on the sidelines” invested in these securities. This mountain of “sideline cash” exists and must continue to exist as long as these additional government securities remain outstanding. It is an error to view outstanding debt securities as if they are “liquidity” poised to “flow back into the stock market.” The faith in that myth may very well spur some speculation in stocks, but it is a belief that is utterly detached from reality. The mountain of outstanding money market securities is the result of government debt issuance that must be held by somebody until those securities are retired. It is not spendable “liquidity” – it is a pile of IOUs printed up as evidence of money that has already been squandered. The analysts and financial news reporters who observe this enormous swamp of short-term money market securities, and talk about “cash on the sidelines” as if it is spendable in aggregate immediately reveal themselves to be unaware of the concept of equilibrium and of the nature of secondary markets (where there must be a buyer for every security sold, and a seller for every security bought).'

Which view is right? Is it useful from a trading or investment timing perspective to think of sidelined cash as waiting to flow back into the stock market? Or, does any particular stock transaction involve a mere transfer of cash from buyer to seller and, therefore, leave the aggregate amount of cash in the economy, sidelined or not, unchanged? Further, what is the long-run impact of the amount of cash in our economy, i.e., the money supply, on stock prices?

The Fed, the Treasury and the Private Sector

Three primary parties feature in our analysis: the Federal Reserve ("Fed"), the U.S. Treasury and the private sector. To illuminate essential points, I intentionally employ a "no frills" simplified model of the creation of cash (or, more generally, a broader measure, M2), bonds and stocks in the economy:

1. Cash Creation and Swap: The Fed creates cash (in the amount of 50 units) and swaps it with the Treasury for a like notional amount of newly issued government bonds.

Fed: Cash = -50, Bonds = 50
Treasury: Cash = 50, Bonds = -50

(In each of the skeletal balance sheets here and below, the sections shown in bold indicate a change from the immediately prior stage of the analysis.)

2. Deficit Spending: The government uses the cash to finance expenditures such as national security, infrastructure projects, entitlements and other deficit spending. The private sector ends up holding the cash, received from the government through employment and entitlements.

Fed: Cash = -50, Bonds = 50
Treasury: Cash = 0, Bonds = -50
Private Sector: Cash = 50

3. More Bond Issuance: The Treasury issues more bonds, this time to private sector investors instead of to the Fed.

Fed: Cash = -50, Bonds = 50
Treasury: Cash = 50, Bonds = -100
Private Sector: Cash = 0, Bonds = 50

4. More Deficit Spending: The government deploys the cash in accordance with its budget, with the private sector again being the recipient of the cash.

Fed: Cash = -50, Bonds = 50
Treasury: Cash = 0, Bonds = -100
Private Sector: Cash = 50, Bonds = 50

5. Entrepreneur-Led Growth: Assisted by years of government spending on infrastructure, enterprising individuals form companies and develop new technologies and products for growing consumer markets. Rising stock prices of these entrepreneurial companies represent new wealth creation, seemingly materializing "out of thin air," but actually resulting from the "value-add" through conversion of natural resources, labor, capital and technology into useful products and services.

Fed: Cash = -50, Bonds = 50
Treasury: Cash = 0, Bonds = -100
Private Sector: Cash = 50, Bonds = 50, Stocks = 100

6. Business Cycle: As the market's perception of future business prospects shifts, stock prices rise and fall. The corresponding aggregate wealth held by the private sector in stocks fluctuates from a cycle low of, say, 75, to a cycle high of, say, 150. At the nadir of the business cycle, the corresponding cash-to-stocks ratio is 50/75 = 67%, while at the peak this ratio is 50/150 = 33%.

7. Government's Rescue Plan: During the depths of an extended recession (i.e., when stocks = 75), the government implements an economic rescue plan, involving

a. Creation of more money (25) by the Fed;
b. The Fed's use of this money to purchase lower credit assets from banks;
c. Banks' use of the proceeds to purchase new bonds from the Treasury.

This plan strengthens bank balance sheets and provides the government with cash for new deficit spending. (By deliberate design, this model parallels the actions taken by the Fed and Treasury over the past half year in dealing with the current financial crisis.)

Fed: Cash = -75, Bonds = 50, Other Assets = 25
Treasury: Cash = 25, Bonds = -125
Banks: Bonds = 25, Other Assets = -25
Private Sector: Cash = 50, Bonds = 50, Stocks = 75.

8. Still More Deficit Spending: The government deploys its new cash of 25 as part of a stimulus package to jump-start the economy (cf., Obama's approximately $1 trillion fiscal stimulus package, currently being deployed). As before, the cash ends up in the hands of workers and consumers in the private sector.

Fed: Cash = -75, Bonds = 50, Other Assets = 25
Treasury: Cash = 0, Bonds = -125
Banks: Bonds = 25, Other Assets = -25
Private Sector: Cash = 75, Bonds = 50, Stocks = 75.

The result is an increase in the cash-to-stocks ratio to 75/75 = 100%, which is a sign of the gross disequilibrium now inherent in the economy, since the cash-to-stocks ratio is outside of its "normal" range of 33% to 67% shown in Stage 6 of our model.

How Both Views Can Be Right

First, although our model is very simple, it exhibits important monetary, fiscal and economic trends in the U.S. economy:

• The amount of cash in the economy increases over time (from 0 to 75 in our model) as the economy grows and the Fed prints money to provide a currency to accommodate transactions among consumers and producers;
• The amount of government debt increases over time (from 0 to 125 in our model) as the Treasury issues bonds to fund the government's growing budget deficit;
• The value of the stock market rises secularly (from 0 to 100 in our model) as innovation, population growth and economic growth drive aggregate earnings of companies higher;
• Also, stock prices are prone to fluctuations (from 75 to 150 in our model), due to changes in market participants' perceptions of the future business prospects and earnings potential of companies within the economy.
  

This situation is hardly one of steady equilibrium. On the contrary, our economy is a dynamic system, continually evolving from one point of instantaneous and imperfect equilibrium to the next. Population growth, innovation and technological change drive secular increases in the amount of cash, bonds and stocks, and government monetary and fiscal policy alters the money supply, bond issuance and tax revenues in a Keynesian attempt to influence the course of the economy. The result is an economy in perpetual disequilibrium, wherein apparently the only constant aspect is change itself.

Within a framework of disequilibrium, let's now examine the situation at the end of Stage 8 of the scenario presented above. Given the new infusion of cash (from a sudden increase in the money supply), the stock market (along with other assets such as real estate) is arguably likely to rise, consistent with the Sidelined Cash view, as investors chase higher returns by buying stocks with the new portion of their "sidelined cash" (now 75, up from the recent figure of 50 in our model). The idea here is that, when enough newly printed aggregate cash from fiscal stimulus makes its way into consumers' and investors' hands, some combination of more consumption and more investment will (eventually) push asset prices higher. Though ostensibly at variance with the Equilibrium view he espouses, Hussman points out that a probable outcome of current government policy is "a near-doubling of the U.S. price level over the next decade," citing Nobel economist Joseph Stiglitz's characterization of the government's strategy as "trying to recreate the bubble [in a way] [t]hat's not likely to provide a long-run solution . . . [but instead] says let's kick the can down the road a little bit."

To sum up:

• The Sidelined Cash view correctly points out that "cash on the sidelines" can drive stock prices higher; however, by failing to distinguish between aggregate cash in the economy and cash held by individual investors, this view leaves too much room for (mis)interpretation;
• The Equilibrium view is right in pointing out that the aggregate amount of cash in the economy does not change when investors trade stocks with each other; however, this view fails to incorporate the disequilibrating impact of new cash creation by the Fed (and the banking system).

I offer the following combined "sidelined cash in disequilibrium" view as a synthesis of the two views: The private sector of our economy operates, not in equilibrium, but in perpetual disequilibrium, due to the impact of our government's deficit spending using money printed by the Fed and accounted for as borrowing by the Treasury. New cash created by this dynamic process (which drives additional cash creation via fractional reserve banking) enters the economy through fiscal stimulus and becomes the "sidelined" component of aggregate cash that is forever chasing new opportunities and effectively encourages future economic growth.

So, we might say that cash is continually rolling off the printing presses at the Fed as our government's deficit expands and the economy grows. This capacity of our government to print money, constrained at any moment but secularly unlimited, provides a large pool of sidelined cash that can jump-start a recessionary economy and, in practice, has an inflationary impact on stock and other asset prices. The ultimate long-run outcome of our government's deficit spending policy and its influence on the relative strength of the U.S. economy versus that of other countries is debatable but, in my opinion, a correct prognosis will involve both a) interpreting "sidelined cash" to include the capacity of the Fed to print new money and b) recognizing that our economy is always in disequilibrium.

Hey, Baseball Fans: Winning Takes Money

Investing and professional sports have a lot in common--competition, winners and losers, uncertain outcomes, lots of data, and a wide range of opinions among participants, spectators and analysts. During a conversation the other day with a friend, I casually mentioned what I thought to be an accepted truism in the sport--that, just as money is a vitally important determinant in the business world, Major League Baseball teams with higher payroll (hence, better players by presumption) ought to win more often than teams with lower payroll.

To my surprise, my friend, who is a baseball fanatic, retorted that money and winning are not as intimately linked as one might presume, and proceeded to recite from his encyclopedic memory a number of examples of World Series play over the past 10 years--the Arizona Diamondbacks over the New York Yankees in 2001, the Los Angeles Angels over the San Francisco Giants in 2002, and the Florida Marlins over the Yankees in 2003--all cases in which teams with significantly lower payroll took the championship from their more generously compensated opponents. All right, I had to admit, I take "strike one" against my follow-the-money presumption.

After getting off the phone, I did a quick web search to check further. The first study I came across stated that "results from the two years of data [2002 and 2003] indicate that there is no real correlation between a team's salary and its win percentage." In other words, higher salaries do not significantly boost win percentage. Hmm--strike two, I mused. . . .

Wanting to avoid striking out, I resolved to find the data and run numbers myself.

Team Payroll and Win Percentage Data

The USA Today Salaries Database gives MLB payroll figures for all 30 pro baseball teams in both the American and National leagues going back to 1988. The ESPN MLB standings database shows seasonal win percentages from 2002. Combining the data for the seven years from 2002 to 2008, we can generate the scatter plot shown below.



A least-squares analysis of team payroll versus win percentage gives the "best fit" regression line:

Win Percentage = 0.426 + (Team Payroll in $ Millions) x 0.00097,

indicating that approximately each one million dollars of team payroll adds about 1 point out of 1,000 (i.e., 0.001) to the win percentage. The t-statistic for the regression is 6.96, which means that we can state this relationship between payroll and win percentage with an extremely high degree of confidence (in fact, the likelihood of a false positive is less than one in ten billion!).

It is also instructive to look at the data on a team-by-team basis for the same seven-year period from 2002 to 2008. Notice how the New York Yankees and the Boston Red Sox have not only the first and second highest average team payrolls ($181 million and $122 million) but also the first and second highest average win percentages (0.600 and 0.580), respectively. At the other extreme, the three teams with the lowest average win percentages--Kansas City Royals at 0.410, Tampa Bay Rays at 0.423, and Pittsburgh Pirates at 0.431--are among the five Major League teams with the lowest average team payroll (each less than $50 million).



I also provide a table showing the payroll of baseball teams playing in the World Series over the past 20 years (actually from 1988 through 2008, with the exception of 1994 when, as baseball fans will recall, the Series was cancelled due to a player strike), assisted by data from Baseball Almanac. The results reveal that in 14 out of the 20 years, or 70% of the time, the team with the higher team payroll defeated the team with the lower payroll in the World Series. This result is consistent with the strong relationship between team payroll and win percentage shown in the graphs above.



What I conclude is that money does matter in professional baseball. Teams that have higher payroll generally do win more games, both during the regular season and during the World Series. Suffice it to say: the correlation between performance and pay is surely at least as high in baseball (and, in all likelihood, in other profesional sports as well) as it is in the business world. On a related though distinct topic, I would conjecture that, based on the relationship between payroll and win percentages, it is undoubtedly much easier to predict outcomes in Major League Baseball than in the stock market and other financial markets.

A Note on Statistical Analysis

In case anyone is wondering why my conclusion differs so radically from the study I mentioned as being my "strike two," I provide an explanation here. Warning: Only those interested in statistical analysis should continue reading, since the discussion becomes somewhat technical. However, I encourage anyone who at least occasionally spends time looking for patterns in data to read on, since an important lesson in applying the right tools to the job at hand will arise from the detail.

The author of the study I cited chose to analyze that data using a multiple regression, in an effort to determine how each of three variables--starting pitchers' salaries (P), fielders' salaries (F) and closing pitcher's salary (C)--affects a baseball team's win percentage. For example, for 2003, the study produced the following regression result,

Win Percentage = 0.406 + 0.0022 x P + 0.0015 x F + 0.0018 x C,

along with corresponding t-statistics of 1.72, 1.46 and 0.41 for the significance of the regression coefficients corresponding to independent variables P, F and C, respectively. With all t-statistics less than 2.00, the study was unable to discern at the standard minimum of 95% confidence any dependence of win percentage on the three payroll variables.

Interestingly enough, when I perform the analysis using the same 2003 data, but formulating the problem as three separate one-variable single regressions (instead of one comprehensive three-variable multiple regression as employed in the study), I arrive at t-statistics of 2.93 for dependence of win percentage on starting pitchers' salaries, 2.77 for dependence on fielders' salaries, and 1.49 for dependence on closing pitcher's salary--all higher than the t-statistics for the multiple regression given above. Further, if I combine starting pitchers', fielders' and closing pitcher's salaries into a single variable (i.e., P+F+C) and again run a one-variable regression, I find an even higher t-statistic, namely, 3.49.

In other words, by "zooming out" and viewing the data using an effectively lower resolution microscope, we actually find a more robust statistical pattern--this is reminiscent of the proverbial necessity of stepping back from the individual trees in order to view the grander forest. But, you might be wondering, how can this be? How is it possible in a regression to see a pattern at a lower resolution that essentially disappears at a higher resolution?

To understand the mechanism behind this paradoxical statistical behavior, consider a very simple regression example. Suppose we are trying to understand the relationship between a dependent variable, z, and two independent variables, x and y, based on five data points:

Data point 1: x = 1, y = 1 and z = 1
Data point 2: x = 2, y = 2 and z = 2
Data point 3: x = 3, y = 3 and z = 3
Data point 4: x = 4, y = 5 and z = 4
Data point 5: x = 5, y = 4 and z = 4.

Graphically, three plots are relevant:

a) Multiple Regression: Three-dimensional plot of x and y versus z,
b) Single Regression: Two-dimensional plot of x versus z (same as y versus z), and
c) Single Regression: Two-dimensional plot of combined variable, x+y, versus z.



In the multiple regression, the t-statistics are 3.3 for each of x and y. Observe the "dispersion" of data points 4 and 5 in the three-dimensional plot, with each of these points offset in a different direction from the straight line that can be drawn through data points 1, 2 and 3. This dispersion adds extra error to the regression, creating a relatively poor regression fit to the data.

In the single regression of x versus z (or, symetrically, y versus z), four of the five data points are collinear, and only the fifth data point introduces error into the otherwise perfect linear fit. This tighter fit of the data to a straight line yields a t-statistic of 6.9, higher than in the multiple regression case.

Still better yet, if we regress on the combined variable, x+y, we end up with a t-statistic of 17.9, substantially higher than in either of the other cases. By combining x and y into a single variable, we eliminate the oppositely directed "dispersive meandering" of x and y. The combined variable allows the regression analysis to reveal a closer correspondence between the independent variable (x+y) and the dependent variable (z).

Back to Baseball . . . and a Lesson

In an analogous way, the baseball statistics study relying on multiple regression produces a poorer picture of the relationships between variables than does the single regression. Behind the scenes is probably a mechanism akin to the following: Owners and managers of a given baseball team work within budget constraints during any particular season, so that the total amount of money available to pay all players on the team may be viewed effectively as a fixed quantity for that year. If more money is spent paying starting pitchers, then less money is available to hire and pay fielders and closers. Similar to how in the simple example above, x is less than y at data point 4, but y is less than x at data point 5, a particular baseball team may decide to spend less of its budget on starting pitchers than fielders, while another team may decide to flip the allocation the other way around, with less of its budget going to fielders than starting pitchers.

When the salaries of the all pitchers and fielders are combined, a more meaningful variable results against which to regress the win percentages. For this reason, the single regression using the combined salaries produces a higher t-statistic and better fit to the linear regression model.

The basic lesson here is that, when analyzing problems, it helps always to look for simpler relationships, explanations and solutions first, before implementing more sophisticated analytical tools. In working with scientific, financial, economic, sports or any other type of data, we are often warned against fabricating false patterns (artifacts of the analysis) by overfitting data to a model. In a similar vein, our discussion shows how it is also sometimes possible to overlook robust patterns by forcing an overly complicated model onto an intrinsically simpler set of data.

Blind Men and the Elephant: On the Urgency of Asset Price Reflation

You've surely heard of the six blind men and the elephant. If we adapt the traditional story to our current financial and recessionary crisis, the key role-players become:

1. The Fed, who figures that the money supply and interest rates are what matter, and proceeds to lower short-term rates all the way to zero percent, while starting open-market purchases of commercial paper and mortgage securities to reel in credit spreads;
2. The Treasury, who decides that weak banks are the problem, and spends $350 billion of TARP funds recapitalizing banks and financial institutions, and deliberates over details of how to deploy the remaining $350 billion;
3. The FDIC, who feels that confidence in the financial system matters most, and boosts deposit insurance limits to $250,000 to help prevent runs on the banks;
4. Democrats in the House and Senate, who are sure that our problems will go away if the government spends more without worrying so much about the deficit, and quickly assemble a massive $900 billion stimulus package;
5. Republicans, who are certain that only tax cuts matter, and refuse to support the Democrats' proposal; and
   
6. President Obama, who believes that jobs and working together matter most, and pushes to get his stimulus package passed to jump-start creation of the 3 million jobs being forecast by his economic advisers, while reiterating his willingness to compromise for the sake of expediency.

That's six governmental players and six differing viewpoints, each of which may be construed as complementing the others, but together still falling short of definitively identifying the beast they are touching. In the traditional story, the six blind men do not realize that it is an elephant; and in the case of our economy, the elephant that everyone is touching but not seeing is an obvious truth that has gotten lost in the debate.

You see, the publicly spoken solution to our economic crisis--which seems like it ought to go away if only interest rates were lower, if the banks had more capital, if depositors and consumers had more confidence, if the government were to spend more to stimulate demand, if we had lower business and personal taxes, or if we could replace lost jobs--is really missing one essential ingredient. The elephant that everyone is touching but not quite comprehending (or at least not openly acknowledging) is the pressing need for a reflation of assets, home prices in particular.

In what now seems like quaint history, our economic woes began with a "minor" subprime mortgage problem in the middle of 2007. Through an unfortunate combination of regulatory leniency, misplaced incentives, financial irresponsibility and sheer Wall Street greed, a sizable number of underqualified, overleveraged borrowers began to have difficulty paying their mortgages and, as home prices fell, found themselves "upside-down" with negative equity, holding mortgages exceeding the value of their homes. Mortgage problems quickly spread to other highly leveraged borrowers as well, and over the ensuing year and a half have precipitated a downward spiral of plummeting real estate and stock prices, loan defaults and foreclosures, deteriorating bank balance sheets, abnormally tight credit markets, depressed consumer demand, a rising number of layoffs, etc.

Some wisdom may be gleaned by going further back in history to the last time our economy faced a crisis of this magnitude. As described by Irving Fisher in 1933, the basic problem we are experiencing is over-indebtedness, which leads to price deflation, which in turn makes matters only worse:

"[I]n great booms and depressions [the] two dominant factors [are] over-indebtedness to start and deflation following soon after. . . .

"Debt liquidation leads to distress selling and to . . . contraction of deposits and of their velocity . . . [which] causes . . . [a] fall in the level of prices, . . . [a] still greater fall in the net worths of businesses, precipitating bankruptcies and . . . [a] like fall in profits, which . . . leads . . . to . . . [a] reduction in output, in trade and in employment . . . to [p]essimism and loss of confidence, which in turn lead to . . . [h]oarding, . . . [all of which] cause . . . [c]omplicated disturbances in the rates of interest.

"[I]t is always economically possible to stop or prevent such a depression simply by reflating the price level [bold added] up to the average level at which outstanding debts were contracted by existing debtors and assumed by existing creditors, and then maintaining that level unchanged."

(Irving Fisher, "The Debt-Deflation Theory of Great Depressions," Econometrica, 1933, pp. 337-357)

Indeed, it is curious that, although we all recognize our over-indebtedness and are suffering through painful dislocations because of it, no policymaker is placing front-and-center the glaring need for asset price reflation.

In addition to the Fed's policy of keeping inflation moderate, which is a long-run strategy to stabilize the rate-of-change of prices, current crisis-oriented policy must target a short-run higher absolute price level, if we are to steer ourselves out of the mess we are in. Essentially, we need to re-create wealth by reflating asset prices, as quickly as possible, up to a high enough level to make our bad debt problem go away. When the relationship between home prices and indebtedness returns to a more manageable level comparable to where it was prior to the onset of our current crisis, we will find that those underwater mortgages are not so underwater anymore, that the banks are no longer on the verge of bankruptcy, that consumer confidence and retail sales are rising again, that companies are no longer laying off workers, and that our economy is finally on the road to recovery.

Two recent news items are relevant here:

• Senator Johnny Isakson has proposed a homebuyer tax credit, approved last night by voice vote in the Senate for amendment to the stimulus package being worked out. The measure "would offer new homebuyers a tax credit of up to $15,000 or 10 percent of the purchase price of a house that could be spread over two years." This tax credit would create increased demand among homebuyers and is fairly direct way of supporting home prices. In my opinion, the legislation should be amended to offer even more stimulus to the housing market and economy, by both a) raising the upper limit on the tax credit to $50,000, and b) allowing the amount of the credit to be carried forward indefinitely and applied to taxes owed until used in full by the taxpayer.
• UCLA economics professor, Roger Farmer, proposes that "just as it sets the fed funds rate to control inflation, the Fed should set a stock market index to control unemployment." Targeting the price level of a stock market index, like the S&P 500 or even a broader index, would give the Fed a more direct handle on influencing performance of our economy. With our wealth as a society linked to the stock market, consumer psychology (which determines demand) is impacted more by a 10% drop in stock prices than by a substantial change in short-term interest rates. The Fed should continue to use all of the existing tools at its disposal--rate cuts, open-market operations and so on--and with an added mechanism for targeting for stock prices, policy objectives would become clearer and more effective, particularly in market environments like the present with standard interest rate easing already pinned to its zero percent lower limit.

I like to think that the actions of policymakers matter more than their words, but, particularly today with our global economy in crisis, vocalizing a credible plan with concrete and realizable objectives can make a difference. If Obama, Geithner, Bernanke or another official in a position of authority would openly acknowledge a policy objective of asset price reflation--the need to raise the prices of homes, other real estate and stocks--then we would at least be looking the elephant directly in the eye. Thereafter, the task of getting our stubborn economic elephant to move in the right direction would become more straightforward.

Needed: A Large Drop of Helicopter Money

During the past half year, the concerns of the Fed have shifted from worry about commodity-driven inflation (recall $147 oil in July) to its polar opposite--fear about the onset of deflation (coinciding with oil falling below $40 today). With short-term interest rates now lower than the targeted 1% rate, traditional monetary policy measures have become less potent and the U.S. economy is more susceptible to descending into a "liquidity trap." As mentioned by Ben Bernanke in a 2002 speech, one way out of such a predicament is a "helicopter drop"--effectively dropping money from helicopters to consumers and businesses below in order to thwart deflation, stimulate spending and prevent economic stagnation.

Consumer-Based Crisis

The financial crisis we are facing today first surfaced a year and a half ago as a consumer-based subprime mortgage problem that soon developed into an institutional credit crisis, morphed into a pervasive illiquidity dilemma, and earlier this week was, long after the fact, officially named an economic recession that began 12 months ago! As parallels with the Great Depression of the 1930s and Japan's stagnant economy of the 1990s grow more conspicuous, the gloomy predictions of NYU economist Nouriel Roubini loom larger and closer. We are now one year into a recession that, according to Roubini, will most likely extend at least another year. What began as a seemingly minor problem has expanded into a full-blown, global financial crisis that could very well extend into 2010, becoming the most severe economic downturn in the adult lifetime of anyone alive today--unless, of course, our policymakers take appropriate and sufficiently drastic measures to stabilize the financial system.

Bush, Bernanke and Paulson have tried to fix the problem with a whole series of measures--a moderately sized consumer stimulus package in early 2008, bailouts of financial institutions, successive rate cuts, capital infusions to strengthen bank balance sheets, an increased limit on bank deposit insurance, government backstops on portfolio asset losses, purchases of illiquid assets, etc. So far, nothing has worked as well as anyone would like, and our faltering economy and plunging real estate and stock markets continue week after week to drive each other lower, in a relentless asset deflation spiral that is dragging down even the endowments of elite institutions like Harvard. Come January 20, President-elect Obama (incidentally, a Harvard Law alumnus) and newly appointed Treasury secretary Geithner will replace Bush and Paulson, respectively, and we can only hope that the stimulus package in Obama's vision for the future of our economy will be large enough to usher in real change in a favorable direction.

As for the root cause of our economic problems, the consensus opinion among economists and laymen alike implicates overleverage, basically too much debt and too little savings, particularly among consumers. Everyone agrees that saving more would be prudent for any individual consumer facing an uncertain future, but when aggregate consumption falls our economy unfortunately enters a vicious circle, as reduced consumer demand (from saving more) leads to reduced delivery of goods and services and higher unemployment, which, in turn, reduces demand still further. To halt this vicious circle before it does further collateral damage to our fragile economy, we need to find a practicable way to provide debt relief at the consumer level--as soon as possible. This is where the helicopter money comes in.

Helicopter Money Initiative

As Bernanke pointed out in his speech, even when monetary policy by itself becomes ineffective, there are a number of alternative ways to combine monetary policy with fiscal stimulus to prevent deflation and encourage economic growth, despite being in a near-zero interest rate environment like the one we are experiencing today. These less traditional, more innovative measures are:

A. Broad-based tax cuts,
B. Increased purchases of goods and services by the government,
C. Purchase of private assets via the Treasury, and
D. Increased direct transfer of money from the government to the private sector.

President-elect Obama is already planning to provide tax cuts (measure A above) to at least 95% of Americans and some talk of reducing payroll taxes is also circulating. The large (maybe $1 trillion?) stimulus package (measure B) currently under discussion in Congress will hopefully be ready for signing by inauguration day. Purchase of private assets (measure C) is already underway in the commercial paper and mortgage-backed security markets, but practical limitations (i.e., how to price highly illiquid instruments) have prevented the proposed wide-scale purchase of toxic mortgage assets that was the main objective the initial TARP plan. Consumer stimulus packages (measure D), along the lines of the one implemented in the first half of 2008, work most directly and immediately to maintain GDP growth and, for this reason, deserve further serious consideration.

Because near-term inflation is no longer an issue, policymakers now have the luxury of taking the most aggressive actions possible to turn our economy around. With the financially stressed, heavily indebted American consumer so central to our problems, it makes sense to implement an enhanced version of measure D--this time in much larger size. Just as people suffering in the aftermath of a natural disaster need immediate and basic emergency assistance, prior to tax-related benefits and government spending to rebuild infrastructure, our severely damaged economy needs a very significant injection of helicopter money delivered directly to the overleveraged consumer.

To achieve the quickest and most direct money transfer to the consumer, here's what our government should do:

Beginning during the first half of 2009, write checks to every household filing a tax return, in the amount of, say, $10,000 per dependent (taxpayer, spouse, children, other household members), which is an order of magnitude larger than the consumer stimulus in early 2008.

Offhand, it might appear that this type of seemingly frivolous fiscal policy would be a desperate and highly wasteful use of taxpayer money that could spark a new, undesirable bubble. However, given the precarious state of our economy, such a radical measure stands a greater chance of doing more good than harm and has many benefits:

1. Immediate and Direct Impact: Helicopter money provides an immediate stimulus to consumers and businesses, directly benefiting Main Street (a refreshing change after all the prior rescue plans with trillions of dollars going to Wall Street financial institutions);

2. Reduced Consumer Leverage: Consumers will use some of the money to pay down mortgages, credit card debt, car loans, etc.;

3. Increased Consumption: Consumers will use some of the money to do what consumers do best, i.e., buy products and services, which will immediately boost sales of businesses large and small, preventing further job destruction;

4. Market Support: Some of the money will be invested in the stock and real estate markets, relieving downward pressure on asset prices and helping to create the market bottom that is so badly needed to build consumer and investor confidence and turn our economy around;

5. Global Economic Growth: Reduced consumer leverage, increased consumption and increased investment will all boost the U.S. economy, which in turn will help revive the global economy.

With the U.S. population at about 300 million, this new consumer stimulus package of $10,000 per person would total $3 trillion, which is about four times the $700 billion TARP package but less than half of the approximately $8 trillion in cumulative funds the government has already committed through all of the various measures announced. The net effect of this helicopter money plan would be to shift up to $3 trillion of debt from the consumer to the government. This would reduce leverage at the consumer level and boost aggregate demand to stave off a deflationary spiral.

As Professor Roubini points out in this interview, the basic structural problem we face is a global supply glut cannot immediately be reduced even though demand has fallen. Therefore, at least in the short run, the severity of the current crisis justifies "pulling out all stops" to create the demand necessary to meet existing supply. A large helicopter drop appears to be exactly what is needed to stabilize our economy and sidestep the negative impact that further deterioration in employment and the housing and stock markets will otherwise bring.

Hedging Is Simple, But Market Timing Is Not

What follows is some perspective on the buzz we're hearing about portfolio and fund manager performance in this horrendously painful bear-market year, which most investors would love to forget about--if only they could.

While Miller Missteps (Again) . . .

Recall that around this time in 2005, Bill Miller was being hailed as the most successful fund manager of all time, with his Legg Mason Value Trust Fund outperforming the S&P 500 for a record-breaking 15th straight year. Then, in 2006, Value Trust underperformed for the first time since 1990, returning just 6% versus the S&P 500's double-digit 16%. Last year, in 2007, Miller again underperformed, this time -7% (i.e., a loss) for Value Trust versus a 5% gain for the S&P 500. In 2008, as of last Friday, Nov. 14, Value Trust is down a whopping 50%, versus a 40% decline for the S&P 500, making it quite likely that Miller will underperform once again--for the third straight year.

In his third-quarter commentary published last week (Nov. 12), Miller discusses flaws in the government's delayed ("too late") response to the financial crisis, while also admitting,

"I have made enough mistakes in this market of my own, chief among them was recognizing how disastrous [government] policies being followed were, yet not taking maximum defensive measures [italics mine], believing that the policies would be reversed or at least followed by sensible ones before things got completely out of control."

Miller is alluding here to his failure to implement an appropriate hedging strategy to protect his fund against the precipitous collapse of the market during the past couple of months. With 20/20 hindsight, of course, it is easy to say that he (or anyone long the market) should have either sold their equity holdings, shorted S&P 500 futures, or bought puts to protect the downside.

. . . Hussman Hedges

While most equity fund managers, like Miller, are suffering complete and unforgiving drubbings this year, one fund manager is making news due to his notable outperformance in this year's most disastrous market in decades. John Hussman's Strategic Growth Fund (HSGFX) is running only slightly negative year-to-date through Oct. 31, which sure beats the 40% or larger decline most fund managers are experiencing. Of course, Hussman's stand-alone performance begs the question, what's his secret formula?

Though academic credentials do not necessarily or even typically help one become a better investor, perhaps at least it is no detriment to his performance that Hussman holds a Stanford economics Ph.D. and is a former finance professor at the University of Michigan. His investment strategy, as described on his website and in his fund's prospectus, seems to be a rational approach firmly grounded in interpreting historical data, utilizing "observable evidence" (sounds scientific . . .) in an attempt to distinguish between favorable and unfavorable "market climates" (weather forecasting analogy?), taking into account both "market action" (an allusion to physics or sports?) and valuation (yeah, he has a value-investing approach, similar in some respects to Buffett and Grantham).

To date, Hussman's differentiator has been his hedging. What really distinguishes his investment style from that other fund managers is his ongoing implementation of partial or full hedging of his underlying long-equity portfolio, even though he could potentially become fully invested or even leverage up beyond full exposure if market conditions ever call for it:

"In conditions which the investment manager identifies as involving high risk and low expected return, the Fund's portfolio will be hedged by using stock index futures, options on stock indices or options on individual securities. . . . The Fund will typically be fully invested or leveraged when the investment manager identifies conditions in which stocks have historically been rewarding investments."

In Hussman's framework, although market action remains unfavorable, the market's recent decline has shifted valuation from unfavorable to more favorable, leading him to begin transitioning his portfolio from being fully hedged (underlying stock positions essentially 100% protected by put-call combinations as of a few months ago) to taking on moderate market exposure (now 70% to 80% protected). Currently, Hussman views any near-term market declines as opportunities to strip away a few more layers of protection and increase market exposure, since stocks have become "both undervalued and oversold."

Because Hussman varies the amount of his protection (or exposure) to market moves in accordance with market conditions, he is, in my opinion, attempting at least partially to "time" the market, even though he insists that he is not pursuing "market timing" in the usual sense of the term. In his own words from a recent weekly commentary:

"The Strategic Growth Fund is not a 'market timing' fund. Nor is it a 'bear' fund or a 'market neutral' fund. Strategic Growth is a risk-managed growth fund that is intended to accept exposure to U.S. stocks over the full market cycle, but with smaller periodic losses than a passive buy-and-hold approach. We gradually scale our investment exposure in proportion to the average return/risk profile that stocks have provided under similar conditions (primarily defined by valuation and market action). We make no attempt to track short-term market fluctuations. We leave 'buy signals' and attempts to forecast short-term market direction to other investors, preferring to align our investment positions with the prevailing evidence about the Market Climate."

Hedging Versus Market Timing

To understand the impact of hedging on Hussman's longer-term performance, we can look at his fund's returns, which he conveniently discloses both before and after hedging.

Since its inception in 2000, Hussman's Strategic Growth Fund has carved out a winning track record, as evidenced by the stellar performance chart displayed prominently on Hussman's website. For the eight-year period, while the S&P 500 has lost 1.04% annually, Hussman's unhedged portfolio has gained 6.37% annually, and his Strategic Growth Fund has returned 10.76% annually. These results indicate that Hussman's stock-picking ability (or is it luck?--more on this topic below) has boosted his annual return to some 741 b.p. above the S&P 500, while his hedging has apparently added another 439 b.p. to his annual performance. This is a very solid track record over the past eight years, particularly in light of the two bear markets fund managers have had to endure, both in 2000-2002 and beginning from the last quarter of 2007.

Before jumping to conclusions about Hussman's apparent analytical genius or market clairvoyance in largely avoiding both bear markets, let's take a closer look at the data--his data--posted here on his website for the casual (or better, not so casual) perusal by anyone interested. Taking the 33 quarters of data from the third quarter of 2000 through the third quarter of 2008, we can make a scatter plot of his unhedged and realized fund performance versus the S&P 500, as shown in the chart below.

If Hussman's realized fund performance points (in pink) on the chart seem to sketch out a typical, albeit somewhat noisy, hockey-stick-shaped option payoff diagram, this graphical result should come as no surprise, since, after all, the basic purpose of Hussman's hedging is to protect his portfolio against market declines, while allowing participation in market upside potential.

Let's take our analysis of Hussman's performance a step further. In the chart above, observe that the pink points sit above the blue points on the left half, while the reverse is true--pink below blue--on the right half. To understand this behavior, we need to distinguish between hedging and market timing:

• Hedging: The underlying unhedged position is Hussman's long-equity exposure to his chosen portfolio of stocks. If he were always (i.e., without attempting to time the market) simply to buy put options with at-the-money or slightly out-of-the-money strikes to protect his portfolio against market downside, the puts would show a profit when the market declines but would expire worthless when the market rises. The result would be an insurance-like payoff pattern from the hedge--protection against loss in a declining market, but with a cost relative to the unhedged position particularly evident when the market rises.
• Market Timing: On the other hand, if Hussman were attempting to time the market and successful in doing so, presumably by selectively hedging to protect against downside under risky market conditions but operating without a hedge when prevailing conditions are less risky, the data ought to show not only realized fund performance above the unhedged case (pink above blue in the chart) when the market declines, but also at least an occasional occurrence of this type of outperformance of his fund over the unhedged case when the market rises.

By inspection of the data, we can see that for the 14 quarters when the S&P 500 fell about 2% or more, Hussman's realized fund performance always exceeded the S&P 500, indicating that, to date, he has always succeeded in avoiding any sizable market loss. However, there is also a flipside to this flawless track record in falling markets, namely, in the 13 quarters when the S&P 500 rose about 2% or more, Hussman has never outperformed the market. In fact, the negative correlation between the S&P 500 and Hussmans's hedge (being just the difference between his realized fund return and his unhedged return) is a strikingly large -0.96.

What this all indicates is that Hussman's performance is basically consistent with that of someone who makes a practice of always hedging with put options, regardless of market conditions. By and large, it is not what we should expect to see from a portfolio manager implementing a market timing strategy, even though Hussman does at least occasionally remove some portion of his hedge to reduce cost when he believes that risk is low and the chance of a market rise is high.

Skill Versus Luck

The above classification of Hussman as a hedger and not a market timer is in agreement with the often-stated warning to investors and traders that market timing is difficult, if not impossible, and should be attempted only with extreme caution by anyone with risk aversion. In a Tech Ticker interview last week on the topic of skill versus luck in stock-picking and market timing, Professor Kenneth French (whose name figures prominently alongside Fama's in finance theory) states:

"There this a whole academic literature trying to figure out who won because of luck and who won because they truly had skill. We don't know how to do it. I mean there's a little bit of evidence that we can distinguish luck from skill, but, in essence, it's absolutely futile.

"So, when I have a mediocre M.B.A. student who spent the weekend studying Morningstar and is convinced he knows how to pick the winning fund, what I challenge him with is sort of, 'Geez, you know, it's good that you didn't even need to bother to get a Ph.D. and spend the last 30 years of your life solving this problem. You know, those of us who did that, we don't know how to do it. But, congratulations. That was a really productive weekend!'

". . . To basically try to distinguish skill from luck . . . [is] almost impossible. . . . What I'm saying is, I can't tell . . . one from the other. . . . If I can't tell good from bad, why play the game?"

Surely, coming from an accomplished expert in finance, this type of statement is enough to throw into question anyone's claim of having ability to pick stocks and time the market to achieve excess returns in a consistent fashion.

What this means is that we, the investing public, should not read too much into the performance of successful fund managers, however superb their performance may have been (in Miller's case) or appear to be (in Hussman's case). Both Hussman and Miller have certainly assembled relatively long track records as ostensibly excellent stock-pickers, but, as history has shown, anything is possible. If Miller's 15-year winning streak can suddenly undergo a complete metamorphosis into a 3-year (or longer?) losing streak, and if Hussman's track record is solid but exhibits inherent underperformance in rising markets as consistently as it displays outperformance in falling markets, we can only suspect that unquestionable evidence of skill, as opposed to luck, in investing has become that much harder to find.

Although anyone actively managing a stock portfolio may hate to admit it, Professor French is most likely right--unfortunately, in the world of investing, we will probably never really be able to tell if our own or anyone else's performance stems primarily from luck or, as many may want to believe, from having a discernible edge over other investors who are only almost-as-skilled as ourselves.

The Next Boom Will Come

The global economy is in the doldrums. Collapsing housing prices and ensuing foreclosures have brought both borrowers and lenders to their knees, frozen credit markets, depressed stock prices, softened consumer demand, forced oil, metal (even gold) and other commodity prices lower, and now dragged down the commercial real estate market as well. The Bush and Paulson $700 billion financial rescue plan has morphed from an impracticable illiquid-asset buyback plan to shore up bank balance sheets into an across-the-board equity infusion scheme and sadly, along its porky way, lost focus, impact and credibility. Cynics question what benefit Bernanke's many years of academic study of the Great Depression have brought him, or anyone else, for that matter. Respected business figures (for example, Soros and Dimon) warn of a deepening recession in 2009, possibly even a depression.

Given the dour outlook of economic experts and pervasive pessimism of the investing public, it's hard to be optimistic--but I am. I'm confident that better times and a stronger economy lie ahead of us. Really, a brighter future is all but inevitable. Yes, I repeat, just as day follows night, we will see better times. Let me explain the root of my optimism.

Generally speaking, two basic schools of economic thought have been most influential over the past 75 years--Keynesians (including neo-Keynesians), who advocate fiscal measures such as an increase in government spending to stimulate a sluggish economy, and higher taxes to cool an overheated inflationary economy; and monetarists (led by Friedman's Chicago school), who believe that what's more important is controlling the money supply, primarily through buying and selling government bonds in the open market and raising and lowering the discount rate. Both schools of economic thought unabashedly lay claim to real-world successes of their models--Keynesians take credit for lifting the economy back onto its feet through FDR's New Deal spending following the Great Depression in the 1930s, and monetarists boast of steady and prolonged economic growth in the 1980s (Reagan years) and 1990s--despite the many recessions we have seen, including those in recent decades: 1980 (7 months), 1981-1982 (17 months), 1991-1992 (8 months), 2001-2002 (12 months), and presumably 2008-2009.

While these two mainstream schools of economic thought certainly have their differences, they also share an important commonality--both rely heavily on government intervention to control or at least influence economic growth. President Bush's consumer-targeted economic stimulus package during the early days of the current financial crisis and the new stimulus package that President-elect Obama stressed as a high-priority item in his first press conference a week ago are examples of Keynesian policy in action. The Fed's continual "busy-body" adjustment of the discount rate--Greenspan's lowering of the rate to 1% in 2003 during the last recession precipitated by the dot-com bubble, and raising it back up to the 5% range by the time of his retirement in 2006, and Bernanke's pushing the discount rate all the way back down again to 1% last month, while hinting at more rate cuts to follow--are examples of attempts to steer the economy using monetary policy.

In sharp contrast to these two mainstream schools are those who argue that both the Keynesians and monetarists are wrong-headed. For example, the Austrian school, based on the thinking of Mises and Hayek, explain how government intervention is not the solution. Stating that fiscal and monetary policy fail to produce their intended impact, these economists insist that, instead of smoothing the vagaries of the business cycle, government intervention actually causes the booms and busts, through over-extension and over-contraction of credit at artificial prices via the highly government-regulated fractional-reserve banking system. Quite contrary to active intervention, the Austrian school recommends following a laissez-faire "do nothing" approach, theorizing that this is the only way to cure permanently our economic woes. For a coherent exposition of the Austrian school's position, see Murray Rothbard's 1969 essay, "Economic Depressions: Their Cause and Cure," here.

Which economic school is right? Well, first off, practically speaking, it would be grossly out of character and, in fact, outright political suicide for any president--whether lame-duck Bush, or our country's new icon of hope, "renegade" Obama--to tell us American citizens that, after serious dialog and lengthy reflection, the elected officials and their appointed experts have decided that a "do nothing" policy is best. With home foreclosures at historical highs and rising, and growing worries over burdensome credit card balances, auto loans and other consumer debt, the popular approval ratings of even the most charismatic of political leaders would undoubtedly suffer greatly if all their economic advisory team could come up with is to a "do nothing" strategy for tackling the current economic crisis. No, simply put, Americans are by nature more active doers than thinkers, and doing nothing never has been and probably never will be an acceptable alternative for managing our economy.

So, much to the chagrin of Austrian school economists, we must conclude that government intervention, whether effective or not, will continue when Obama and later presidents take office. Given this inevitability that politicians and their mainstream economic advisers will always be inclined to fiddle with the economy, here's the logic of what to expect:

• If the sketchy long-run track record (performing like a "B" student, with 13 out of the 115 quarters beginning in 1980 showing negative real GDP growth, according to BEA data) of the Keynesians and monetarists is any indication, we should see at least some degree of over-shooting in the future, perhaps this time manifested by a delayed but sudden response of our economy to excessive fiscal stimulus or overly loose monetary policy, resulting in either consumer price inflation or yet another asset bubble. (On the other hand, if by chance (or fluke?) policymakers have learned from the last boom-bust cycle and this time around manage to get the economic fine-tuning exactly right, they will have realized the heroic feat of taming the recalcitrant business cycle, macroeconomic volatility will cease, and we will all live, at least economically, happily ever after. . . . but I would tend to believe other fairy tales before placing undue faith in this one, wouldn't you?)
• If the Austrian school is correct in their critical analysis of the shortcomings of Keynesian and monetary policy, the current credit-driven bust will inevitably be followed by a boom, and the more our government intervenes to try to fix the problem, the higher the crest and deeper the trough we will see during the next boom-bust cycle.

In other words, however we dissect our economic situation, the business cycle remains alive and well. Both empirically and theoretically, we can be sure that economic booms and busts will continue. Admittedly, the precise timing is anyone's guess but, following the current, painful de-leveraging and retrenchment of credit in our financial system, at some point in the future, credit creation will again be in vogue, creating over-expansion of credit in some asset class, and soon enough spilling over into other asset classes. Yes, however unlikely it may now appear to be (case in point: was anyone predicting a collapse in oil prices to today's $58 per barrel when it soared above $140 as recently as July?), one day we will experience yet another bubble. Seeing how the collective memory of market participants tends to be selective and short, I wouldn't be surprised if such a rebound happens earlier and quicker than any respected market commentator would now dare to predict.

Suffice it to say, for anyone distraught by the current bust, please have patience: the next boom will come--maybe even sooner than you or anyone now thinks.

Older Bulls Wiser than Younger Bears? Maybe

Old bulls versus younger bears. This could be entirely coincidental. Has anyone noticed that bullish sentiment seems correlated with age?

Bullish and Buying

The most prominent U.S. stock market bull to surface in recent days is highly respected Mr. Buffett, who was born in 1930 and grew up during the Great Depression years. If as a child he was too young to comprehend the hard times and economic turmoil of the era, we can at least presume that, in his early adult years as a student of Ben Graham, Buffett absorbed the first-hand lessons garnered by his teacher, who had lost everything during the stock market crash of 1929, which apparently was the life-changing event that led Graham to formulate his well-known value-investing methodology. Quoting from Buffett's op-ed piece in the New York Times:

Warren Buffett (age 78): October 16, 2008. "Buy American. I am."
"The financial world is a mess, both in the United States and abroad. So . . . I’ve been buying American stocks. . . . I previously owned nothing but United States government bonds. If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities."

Also notable is so-called "perma-bear" Grantham, whose switchover into the bullish camp can be considered significant, since he spent the past couple of decades marauding with the bears:

Jeremy Grantham (age 69): October 18, 2008. "Silver Linings and Lessons Learned"
We "have moderately cheap U.S. and global equities for the first time in 20 years. . . . We at GMO [Grantham's investment management company] are already careful buyers. We are reconciled to buying too soon, but we recognize that our fair value estimate of 975 on the S&P 500 is, from historical precedent, likely to overrun on the downside by 20% to 40%, giving a range of 585 to 780 on the s&P as a probable low."

I am not sure how much weight Glickenhaus's opinion carries today in the investor community, but he is said to be the lone voice who boldly spoke out when stocks fell 23% on Black Monday in 1987, confidently calling a market bottom and the start of the next bull market. FOX Business has interviewed Glickenhaus twice during the past few weeks, highlighting the relevance of his experience of having lived through the stock market crash of 1929 and seen how the government's actions (or inaction) impacted the severity of the Great Depression:

Seth Glickenhaus (age 94): October 27, 2008. "On the Verge of a New Bull Market. . . "
"We are making a painful but meaningful low. . . . This is a rare opportunity to buy stocks at substantially below their intrinsic values. . . . We are on the verge of a new bull market beginning within a week or two. . . ."
(Note: On October 15, 2008, on Neil Cavuto's show on FOX Business, Glickenhaus indicated that a new bull market would start "next week." That day, the S&P 500 closed at 908. Today, a week and a half later, the S&P 500 closed at 849, a fresh, new five-and-a-half-year low.)

Bearish and Avoiding Stocks

As might be expected, so-called "Dr. Doom," Marc Faber, sees the U.S. and world mired in a serious recession that will last a few years. However, he also sees potential for a near-term rally within the longer-term bear market:

Marc Faber (age about 60?): October 20, 2008. "Stocks May Rally, Won't Reach Records"
"We're extremely oversold at the present time. The market is in a position to rebound." However, Faber holds only a small equity position: "stocks make up 7 or 8 percent of his holdings, with cash, bonds and gold, his biggest position, accounting for the rest." Also, his opinion on the U.S. economy remains gloomy: "To rebuild economic health in the United States, you need a serious recession that will last several years. The patient that got drunk on credit growth needs to go into rehabilitation. To give him more alcohol, the way the Fed and the Treasury propose to do, is the wrong medicine."

Next, here's the opinion of a firmly committed, unwavering bear, who is calling for a significantly lower bottom:

Gary Shilling (age in 60s): October 22, 2008. "We Haven't Seen the Worst Yet"
"The economy hasn't hit bottom yet. Neither, in all likelihood, have stocks. . . . If you're an equity investor with a long-only portfolio, it's not too late to take some money off the table. Remember 777--not the airliner but the low that the Standard & Poor's 500 hit in 2002. That's 21% beneath where we are today, but if it's breached, then all the stock rise of the last six years will have been but a bear market rally, and the bear market that started in March 2000 will still be with us."

Finally, representative of the diversity of opinion, here's a market commentator who is one of the few courageous enough to state publicly that Buffett is, whether we like it or not, just plain wrong this time around:

Diane Francis (age in 40s): October 27, 2008. "Buffett Is Wrong: Avoid Stocks"
"Far be it from me to contradict one of the world's greatest stock sages and business analysts. But I will. Seems to me that we are in uncharted territory with this panic until the U.S. election is staged on November 4 and until the global community demonstrates that it is going to appoint sheriffs to patrol the global economy and stop the kind of jurisdictional arbitrage that led to the casino-ization of banking. . . . For me, buying and selling should not be an option at least until the U.S. election and probably until January 2009."

Does Age Matter?

Admittedly, based on a sample size of just three opinions from each camp, we have at hand little more than anecdotal evidence and, consequently, cannot draw any conclusion that comes even close to being statistically significant. However, with the bull opinions coming from investors in approximately the 70-to-90 age group, versus the bear opinions from a younger cohort in the 40-to-60 age group, I suspect that investor age might be an indicator of stock market sentiment.

One interpretation is that the older generation, having closer first-hand experience with the crash of 1929 and economic hard times during the 1930s, have a deeper appreciation for today's unprecedented government efforts to stem the current financial crisis before it reaches depression-era proportions. If the bulls end up being correct, we will in a few years' time look back upon today and have to acknowledge that the older seers professed a certain "market wisdom" that the less experienced, younger generation lacked. On the other hand, if the bears win the battle and the actual market bottom turns out to be much lower, I can already almost hear the youthful crowd "writing off" the elderly bulls as having "gone senile," being "out to pasture," or at least being "out of touch" with these ever so "modern" times of ours.

For the sake of global economic stability, I certainly hope the old bulls really are the wiser. However, on days like today, with the market closing at a new low, we have to fear that the younger bears could be right in the short run.