Essential Investment Tool: Basic Economic Literacy

As we all plan our investments for 2009, no factor is more important than the economy. It is a subject on which everyone has an opinion. That is the natural state in the American democracy, dating back to the observations of Alexis de Tocqueville. His famous work, Democracy in America, is still read by every student of political science.

While a complicated work should not be summarized in a sentence, the Wikipedia article includes a good warning:

Democracy in America predicted the violence of party spirit and the judgment of the wise subordinated to the prejudices of the ignorant.

The 21st Century

Democratic opinion has advanced into the 21st century. Modern scholars are impressed with how well de Tocqueville's work has held up, but there are some changes. With the help of the Internet, everyone is able to offer an opinion about anything and everything. Millions of readers are consumers of these opinions.

Readers' motives vary. Many simply want to confirm existing beliefs. That is easy. Those seeking information and analysis face a challenge: How does one identify an expert?

In particular, how can an investor form intelligent opinions about the economy. At a minimum, one needs basic economic literacy.

A Few Elements of Economic Literacy

Bob McTeer's blog, once again, provides some valuable information for us all. In his article, Economic Literacy: A Few Basics, he cites ten principles that anyone should know before drawing conclusions. They are all great points, but let us pick a favorite, as follows:

Decisions are made at the margin-a little more of this means a little less of that. You maximize profit when the marginal revenue from the last unit produced just matches the marginal cost of producing it. Fixed costs don't count. Once you've bought the tickets, their cost is irrelevant the next day when you're deciding wither to go to the game.

Anyone who thinks an economic question is some black and white causal relationship does not understand this fundamental point. Pundits who do not understand marginal analysis say things like the following:

• There is no "pent-up" demand for housing. This is wrong because housing demand is a continuous function, more demanded at any lower price, more offered at a higher price. The question of whether demand (or supply) curves will shift is a microeconomic problem that might be affected by public policy decisions.
• Stimulus packages do not work. This is wrong because any stimulus creates new demand at the margin. Professionals can debate the magnitude, but the broad-brush, X or Y conclusions are inaccurate.
• Retail is dead. This is over-stated because the level of sales is a continuous function. Reductions are in percentages.
• And many more similar examples of business and consumer spending and employment, all continuous functions.

Here is another good principle from McTeer:

The fallacy of job counting. We will always have more work to do than workers to do it. Therefore, let's not count jobs; let's make jobs count. Workers are scarce and will go where their return is highest. Politicians focus on creating jobs for their own sake. If they focus on real needs, the workers will come. The false idea that there is too little work to employ all willing workers leads to things like France's 35-hour work week.

Many pundits focus on this count of jobs. In fact, jobs are created all of the time. Even in bad times the US economy creates over 2 million new jobs each month. In bad times of course, even more jobs are lost. It is not a question of whether jobs are created, but rather how many, and how quickly. The net job change is the result.

These are just examples. Readers can test themselves -- and they should - by checking out the entire article.

Conclusion

There are two important conclusions for investors.

1. It is important to realize what you know, and more important to realize what you do not know. Many investors are making decisions -- right now-- based upon their personal conclusions about the economy. They fail to realize that they are consumers of the economic conclusions of others. They are just reading the newspaper or a pundit.
2. It is important to choose sources who understand these principles, not just "pop econ" journalists who throw around some economic terminology.

Our Take

Many of the popular pundits and journalists would come to a standstill if asked to do the following practical, open-end essay test:

Take a legal pad and start writing what you really know about economics.

It would be interesting to see how many would stall out at page one. The pop econ approach does not extend very far, but it resonates with readers whose knowledge is at exactly the same level.

The current Internet democracy, an echo of de Tocqueville, does not serve the investor. Pundits have media appearances that consist of barely-challenged sound bites. Journalists assume the role of the expert rather than that of wise communicator. Readers must figure it out for themselves. To do so, one must have economic literacy.

A wise investor knows his happy zone, a concept we borrowed from the Splendid Splinter. The investor must also know when a pundit is swinging at an outside pitch.

Comments

[Alan von Al...:]

Achoo. Allergic to GM..

"We will always have more work to do than workers to do it."
"Fixed costs don't count."

2008 Dec 28 09:18 AM

[Jason Rines...:]

Thanks for the article Jeff. Back to fundamentals and dilligence on management teams.

2008 Dec 28 10:55 AM

[J. Richardson:]

On a practical level, investors should consider what they have in front of them, i.e. their stock portfolios, and act for change. For instance, shareholders should begin to vote their proxies. Studies suggest that this isn't happening. But that should change. See: "Vote No and Vote Often" at globalinvestmentwatch..../

2008 Dec 28 11:28 AM

[CautiousInv...:]

To take the article one step further, I think it useful to "juxtapose" the market over macro economic statistics to better understand the behavior of the market in the context of economic developments.

For example, long-term interest rates tend to have an inverse relationship with P/E ratios; thus average P/E ratios by themselves at market bottoms are of marginal value in examing the value of today's market. Today's interest rate must be taken into account.

Given housing's role in the current economic crisis, I think it is interesting to note that since 1964 an upturn in the housing has always occurred within the recession while unemployment can continue to rise after the recession is officially over.

The point is that I believe you can use both economic and financial data to make better decisions.

2008 Dec 28 01:19 PM

[morph366:]

You point to the critical decisions being made at the margin and it is always useful to consider that day to day valuation of assets is also done at the margin. In the case of a company when we take yesterday's closing price and multiply that figure by the number of outstanding shares to derive a market capitalization value that does not tell us that the amount so calculated reflects the true or underlying market value of the business. It simply provides a snapshot valuation at a moment in time
More problematically it would make a large difference to know the strategic nature of the transactions. For example, far less useful information would be revealed about valuation if the bulk of the trading in yesterday's session in say Apple (AAPL) was the usual back and forth actions of trading desks rather than discovering that Steve Jobs had sold a large lot during the session.

2008 Dec 28 01:30 PM

[zayttrader:]

"Stimulus packages do not work. This is wrong because any stimulus creates new demand at the margin. "

If you actually believe stimulus packages work, why stop at 1 trillion? Why not do $100 trillion? Hilarious. You're a poster child for economic illiteracy.

Better yet, let's all take money out of our right pockets and put it into our left pockets. We'll all get rich!! Great thinking Jeff!

2008 Dec 28 02:39 PM

[Moon Kil Woong:]

A few things. Not to pop bubbles but "isn't almost everything a continuous function?" Likewise I don't think anyone thinks retail will dissapear. Retail is dead tends to be used in contrast to online and other non brick and mortar forms of shopping.

I do agree basic economics is something that should be studied. I think you should start with the Fed and Treasury not average people. First, 0% rate policy has never succeeded and ecorages deflation. Also offering interest on money deposited at the fed is an incentive to park money at the fed. I understand it is used to backstop less savory loans, however, this is also deflationary. So, if the fed really wants to inflate why are they peddling backwards.

If economic stability is the goal why is the Treasury acting erratically which generally creates confusion and instability? Why are they supporting companies that have almost no hope of recovery and are slashing jobs with bad management that won't leave? Isn't that what bankruptcy is all about. So far the only difference is the bad management never leaves. You still have an implosion of their business and layoffs etc. All the same as a bankruptcy except that bankruptcy opens the books to see what they have been hiding, the government sterilizes the losses, management can get axed and illegality can get sussed out, and many compamnies come out of bankruptcy to become healthy again or are acquired by others.

Rather, instead we have poorly managed zombie companies that keep asking for money like AIG. Really, educate the Fed and Treasury please.

Lastly, Keynsian stimulus packages work. Fed would disagree. Stimulus that is used to start a economy stuck in a rut is a well known economic theory. Especially if that stimulus comes with jobs and goods and services produced.

What people are rightly questioning is if stimulating a deflating economy of $10 trillion every 6-12 months with inder $1 trillion will work, esp. if most of it goes to bad debt payments by "should be defuct entities that make no new jobs". Also stimulating while at the same time deflating is rather ponderous and is being asked by many economists who know anything about zero rate policies. Lastly, stimulating badly managed companies has been a big bone of contention by almost every economist regarding every poorly run 3rd would country. Isn't it shameful that I don't hear more people speaking up when the US is now doing it. What wrecks Latin America can surely wrech North America just as easily.

People have an uncanny sense of knowing what won't work. Don't catch a falling knife is a term often used by the general public. I think it is a wise policy and would be happy if the Fed and Treasury would pay attention to the peanut gallery in that respects. Supporting a deflating economy is like hitting the gas pedal when your car starts smoking and slows to a crawl. The best thing to do is let it cool down repair it and then start it back up. Stimulate at the bottom... It costs less and actually works.

2008 Dec 28 03:00 PM

[zayttrader:]

Construct & Jeff,

"stimulus" packages worked wonders for Japan didn't they? The Japanese govt. has sunk money into massive public works projects for over a decade and all they've achieved is one of the largest public debt/GDP ratios in the developed world.

It bogles my mind that some people still believe that taking money from productive companies and individuals through higher taxes (or indirectly through crowding out), and handing it to govt. agencies and incompetent companies like GM will somehow create economic growth. Truly stunning. Such a belief can only breed in the brackish waters of abject economic illiteracy.

2008 Dec 28 03:16 PM

[rogersails:]

"Take a legal pad and start writing what you really know about economics"
I bet more "ordinary" people of common sense saw this coming than those who fill legal pads with their "understanding" of economics.

2008 Dec 28 04:21 PM

[Steven Hansen:]

great article and comments. knowing too much about economics makes you blind to the market. the market does what the market does.

the bottom line here is are stocks cheap based on p/e ratios. a good company can be profitable in good or bad times - look at wal-mart and mcdonalds. unfortunately, most companies were not positioned properly for this downturn - and ignored economic indicators of the economic hell we are entering. this means the p/e ratios will deteriorate making most stock values 'expensive'.

unfortunately, there is no analysis or rating agency that looks at the mechanics within the company to independently judge the technical aspects.

there does not have to be a linkage between profitability and the economy - but unfortunately there almost always is.

2008 Dec 28 09:20 PM

[Anthony Alfidi:]

Ben Stein, Jim Cramer, and Larry Kudlow wouldn't be able to fill half a page with what they know about economics. If by some miracle they managed to get all the way down the legal pad, they'd do it by contradicting themselves a half dozen times.

2008 Dec 28 11:10 PM

[carey_jim:]

The great paradox of knowledge is that you can only appreciate someone's knowledge if it is just a little more than your own.

As soon as the level of knowledge goes far enough beyond our own, it seems like mumbo-jumbo or, to use the popular expression, 'bullshit'

At that point, the only thing that counts is results, or metaphorically speaking, can he fix my computer or not?

grep 'eli' /etc/passwd /dev/null is either a brilliant move or magic, depending on the level of your unix.

2008 Dec 29 01:02 PM

[thatguy57z:]

this will give you some in site how it is going to start working. and how they've all ready have it moving foreword go to.
www.youtube.com/watch?.... copy and paste to your web browser , or click on my website

2008 Dec 29 09:20 PM