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Philip Mause
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My name is Phil Mause. I am a Senior Advisor with the Pacific Economics Group, focusing on energy, regulatory and valuation issues. I retired from 40 years of law practice earlier this year. I am a yield oriented investor and in the last two years, I have done reasonably well in junk bonds,... More
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  • Thoughts On Piketty's Capitalism

    I always jump around in reading books and I am doing that with Piketty's Capitalism in the 21st Century. I will not write a review until I finish the book but I already have a few thoughts.

    Acknowledging the difficulties in defining "capital", Piketty nevertheless tries to measure it and to make various calculations. He demonstrates reasonably well that there has been a trend toward a greater disparity in the income levels of the top 1% (centile) and the top 10% in comparison with everyone else. He concludes that high income households will save more than everyone else. Over time, their investments will result in an increase in the ratio of "capital" to GDP. This, he argues, will mean that more national income will be used to provide a return on capital over time and less will be used to generate wages. This, in turn, will widen wealth gaps and lead to the emergence of a "rentier" class and a focus on inheritance as the major avenue to wealth. He frequently refers to accounts of the 19th century drawn from Balzac, Austen and other writers and suggests a reversion to a depressing period of class stratification and stagnation. The wealthy will exert disproportionate political influence and distort democracy producing a society we may not even recognize. Much like the counterfactual trip taken by the protagonist in "It's a Wonderful Life" visiting a world in which he had never been born, we will travel back to the poorhouses of the Dickens era and the exploitation described by Upton Sinclair.

    His premise is largely based on a pessimistic estimate of future GDP growth - although the last few years have established a trajectory which gives some credibility to his assumptions. His data concerning income disparity appears consistent with other observers and is reasonably well grounded in reliable statistical sources. Wealth concentration is notoriously greater than income concentration so that his assumption that the iron law of compounding will produce ever larger fortunes owned by those wealthy enough to reinvest rather than spend the income generated by their "capital" is superficially plausible.

    While his thesis is provocative and should set off a vigorous debate, I take exception to his basic thesis for several reasons.

    1. Inheritance - His assumption is that wealthy people will leave most of their wealth to their children. Even making that assumption, however, the pace of wealth concentration will still depend a great deal on family size, whether wealthy people marry other wealthy people, charitable contributions and taxes. At the ultra-high end of the wealth scale, there has always been a tendency in the United States for enormous amounts of money to be given away. Piketty mentions the fact that private universities in the US have endowments totaling $400 billion (in 2010 - doubtlessly much higher now) but he doesn't focus on where this money came from. The enormous non-profit sector of our economy is a testament to the proclivity of the wealthy to give away their money. Of course, the examples of Gates and Buffet loom large in our current situation but one need only to reflect on why universities are named "Stanford", "Duke", "Vanderbilt", and "Cornell" to be aware of the important role charitable contributions have played in the development of our excellent private university system. The family size and choice of spouse issues will probably not lead to much diffusion of wealth and the tax issue is, of course, up for debate.

    2. Slow Growth - I find it hard to imagine a world in which there is an explosion in the amount of invested capital but growth stays at low levels. It is not hard to think of areas in which capital investment would increase jobs, improve living standards and increase GDP. In the energy area we have enormous opportunities to deploy technologies whose "first cost" is higher than alternatives but whose "life cycle cost" is much lower due to reduction in energy consumption. Presumably, the gushing forth of rivers of capital looking for a home would help solve this problem. Of course, more money would be available for R&D, startups, and business expansion. Almost inevitably, the pace of technological change and therefore productivity growth would be accelerated. The combination of a huge increase in capital and slow growth is hard to imagine .......... unless we assume macroeconomic mismanagement.

    3. Macroeconomic Policy - This is an area Piketty neglects. The real problem with an income distribution dumping huge amounts of money on the top centile is that consumer spending will decline as more income is saved and, perhaps even worse, consumer spending will become very volatile because wealthy people engage in more "discretionary" spending which can be cut back suddenly in response to market jitters. This will result in steeper recessions and will mean that financial panics will immediately lead to sharp fall off in demand. If our government is dominated by dunderheads who feel compelled to "balance the budget" at all costs and under all circumstances, then a trip back to the 1930's is on our near term itinerary. However, if Keynesian countercyclical deficit spending is utilized and the government essentially prints more money and hands it out for people to spend unless and until inflation becomes a problem, then all will be well. Put another way, in recessions we should definitely increase transfer payments to those out of work; the smart way to do it is by printing more money but, if the only way we can get the necessary money is to grab it from the "rich", that is probably what will happen.

    Piketty appears to harbor a latent hostility to the affluent. In that regard, French history has created a very different dynamic than we experience here. France spent a long time battling over the existential monarchy/empire/democracy debate between 1789 and 1870 and then faced deep divisions leading up to WW2 and culminating in the Vichy Era. Many wealthy people and business leaders "collaborated" in one way or another - often out of necessity (the best customers for industrial products were often the various brances of the German military). After the War, this may have led those involved to be discredited. In the United States, the only real parallel is the occupation of the South between 1862 and 1876 and the emergence of "carpetbaggers" and "scalawags" who allegedly profited by cooperating with an army of occupation. In reaction to this, we got a wave of anti-business populism in the South and an enormous allegiance to William Jennings Bryan.

    When Piketty thinks of the 1870 - 1914 period, he thinks of a stratified society throttled by privileged snobs and scarred by the exploitation of labor. When I think of the period, I think of robust economic growth, the emergence of entirely new businesses, all sorts of "rags to riches" stories, and an increasing standard of living. Immigrants arrived and became film producers, retailers, industrialists and, often in a single generation, turned themselves into a new elite. Of course, the reason immigrants came to the United States was that it offered much, much greater opportunities than did Europe. Looking forward, it is vital that we continue to be "The Land of Opportunity".

    If we employ macroeconomic policies designed to pick up the slack in demand that may be created when the top centile gets scared and cuts back its spending we will probably be fine. If we don't, Piketty's model may play out and lead to a very ugly future.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Apr 29 6:57 PM | Link | 4 Comments
  • The Lessons Of 1914

    One hundred years ago, a series of events led to the commencement of what was then called the Great War; the war, in turn, led to developments (the Russian Revolution, the US entrance onto the World stage, the rise of Fascism and Nazism, financial instability) which changed the world forever. Are there any lessons to be drawn from the events of 1914 for us today as we ponder developments in Eastern Europe, the Middle East and elsewhere? I think there are although the conclusions are ones which should be obvious even without the evidence of 1914 to back them up.

    1. Don't Confront Everyone At The Same Time - Duh! When facing multiple enemies or potential enemies, it is really stupid to force them all into an alliance against you at the same time. World War I could very well have been limited to a conflict with Germany and Austria on one side and Russia and Serbia on the other side. Germany would almost certainly have been on the winning side and Germany's main concern - the modernization of the Russian military - could have been alleviated by the creation of buffer states and other measures so that in any future global conflict Germany would have been in a stronger position. But Germany's infamous Schlieffen Plan required the invasion of France through neutral Belgium so that Germany added the UK, Canada, France, Belgium, Italy, Australia, the United States, Portugal and probably a few others to its enemies list. If Germany had a plan to simply fight a defensive war on its border with France while dealing aggressively with Russia, history would have been completely different. France might not have entered the war or might have entering it apathetically. The UK certainly would not have entered a war in which Germany was simply fighting defensively against France on the Western Front. The lesson for us is clear. Don't confront Russia, China, and everyone in the Middle East at the same time. If we are going to be in a situation of confrontation with Russia, then we should cool things down with China. If we are going to confront Iran, then we should cool things down with other potential enemies in the Middle East.

    2. No Invisible Lines - In 1914, the UK was - for a time - undecided about whether or not to intervene but then the German invasion of neutral Belgium tipped the balance and the UK signed on with France and Russia. There is some evidence that Germany was surprised by this. There is evidence that the Korean War resulted from statements of Dean Acheson defining the US defense perimeter in a way to exclude South Korea leading to an assumption by the North Koreans that we would not intervene if they invaded the South. A similar misunderstanding about the US response to an invasion of Kuwait by Iraq is said to have led to the first Gulf War. In dealing with Russia, the stakes are so high that this kind of misunderstanding could have catastrophic consequences. We must spell out clearly what we find to be intolerable. For example, the Baltic states are NATO members but have Russian minorities. If we would really go to war over an invasion of one of these countries by Russia, we should let them know and put boots on the ground so that they will have to fire on Americans if they want to proceed. With respect to the Ukraine, we should define what we consider intolerable in very clear terms. I would suggest that Ukraine minus Crimea should not be violated by force although room should be created for a process with honest plebiscites and other internationally supervised peaceful measures that could lead to restructuring. As to the Eastern European states that were never part of the Soviet Union, we should demonstrate in every way possible that Russian incursion will be considered an act of war against the United States. We were able to live peacefully with the former Soviet Union because both sides understood quite clearly what was and wasn't tolerable. For decades there was no action against a militarily insecure target (West Berlin) isolated behind the lines and neutral "buffer" states like Finland and Austria were permitted to function without interference by mutual agreement. Even Josef Stalin understood the rules and even though he was dealing with what he considered to be decadent capitalists, he was much, much more cautious than he was in 1939-41 when dealing with a madman frothing at the mouth. The reason was that we made it very clear what our position was and we backed it up on the ground. It turned out to be the safest and most anti-war strategy we could have used and it gave us years of peace. It is time to dust off the old playbook and get down to serious business.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Apr 07 5:08 PM | Link | 2 Comments
  • The Perils Of Backtesting

    Analysis of whether the market is overvalued has become more and more popular. As a general matter, it appears that "back testing" (comparing current ratios with past periods in which such ratios arose) is very popular. We have pricing data going back to 1876 and so it is possible to amass a great deal of market data and perform complex calculations demonstrating the degree to which current ratios deviate from prior patterns. The ratios that are most often analyzed are the price earnings ratio (NYSE:PE) and the Shiller 10 year trailing price earnings ratio (NYSEARCA:CAPE). Analysts and pundits purport to be able to make Sigma and standard deviation calculations with detailed accuracy using this data and contend that they can predict the future course of the market based on this back testing. I have seen articles which employ arcane mathematical tools and purport to reach extraordinarily precise conclusions about valuation and future market action. This post will explore some inherent problems in this kind of analysis.

    Earnings - Since we focus on price earnings ratios, the key data points are prices and earnings. The price part of the ratio is pretty straightforward; we have good data on the prices of securities and can calculate index prices in a fairly reliable manner. It is when we come to "earnings" that problems may arise. The concept of earnings is inherently subjective and can be affected by changes in accounting practices. In this regard, we had a major change in market regulation in the 1930's requiring publicly traded companies to provide periodic earnings reports and attaching sanctions to misrepresentation. I think it is widely agreed that this deterred fraud and made earnings more reliable. Put another way, a dollar of post- 1934 reported earnings may well be worth more than a dollar of pre-1934 reported earnings. I am not suggesting that pre-1934 data should be thrown out but only that it may not be statistically sound to accord that data the same relevance as post-1934 data. Put another way, if the companies now in the S&P 500 were playing by the same reporting rules that were in effect in 1876 or even in 1928, it is likely that they would be reporting substantially higher earnings.

    There is another important point. Even after the SEC was established and reporting was required, enormously complex issues still surrounded the calculation of earnings. In this regard, the accounting profession - with SEC participation - has changed the rules of the game at numerous junctures since the 1930's. For example, we recently had the requirement that share based compensation be expensed (deducted from earnings). At the time, there were howls of protest alleging that earnings of tech companies would be unfairly depressed. I regard the current rule as reasonable but that is not the point here. Rather the point is that the change probably did depress earnings. Looked at another way, if corporations were required to restate their earnings all the way back to 1876 based on the current rules of the game, those earnings might be quite a bit lower (and historic price earnings ratios would be quite a bit higher).

    This hasn't been the only change. The calculation of "deferred earnings", the use of various methods of depreciation and amortization, the decision of when to book income, and the treatment of "off balance sheet" entities are all difficult issues whose treatment has changed materially over the years. In short, measuring earnings is not like measuring a person's height or weight. Of course, it may be that changes have cancelled one another out and that earnings data from, for example, the 1960's is reasonably comparable to current data. My own impression is, however, that the rules have been toughened up so that -even if we limit ourselves to the post-1934 period - current earnings are likely to be worth more than earnings before - for example - the passage of Sarbanes Oxley.

    Share Value - A purchaser of stock gets a stock certificate (or its electronic equivalent) which is a piece of paper creating certain rights. While the legal definition of those rights has been reasonably stable since at least 1934, the practical value of those rights has changed. A number of events in the late 1970's and the early 1980's had the effect of enhancing shareholder rights. The key factors were - 1. the creation of a new issue junk bond market which facilitated takeovers, 2. the increasing prevalence of LBO's, and 3. the SEC's promulgation of safe harbor share repurchase rules. These changes led, in turn, to an increase in shareholder activism and the emergence of individuals like Carl Icahn who sought to unlock the value in corporations whose stocks were mispriced. As a value investor, I can tell you that the result brings tears to my eyes. The wonderful, cheap, giveaway stocks that Graham and Dodd (and Buffett) were able to find in the 1950's are no longer available. Stocks that are ridiculously cheap are either taken out in LBOs or repriced through aggressive share repurchase activity. In a real sense, the result is that the shareholder has more traction with respect to his claim on owner cash flow. Again, the effect is that pre-1980 data may have to be adjusted if it is to reflect post-1980 realities.

    Corporate Earnings as a Percent of GDP - Another claim we often see is that corporate earnings (currently around 11 percent of GDP) are at historically high levels and therefore must decline. In this regard, it is important to recognize that we are talking about "after tax" corporate earnings. If we analyze corporate taxes as a percentage of GSP, we see a fairly consistent decline over time. In the 1950's corporate taxes constituted 4 to 5 percent of GDP and, more recently since the Panic of 2008-09, that percentage has dropped to roughly 1.5. A 3 percent (roughly $500 billion) decline in corporate taxes as a per cent of GDP goes a long way to explaining why "after tax" corporate earnings as a percent of GDP have increased to the current level.

    Conclusion - The problems with incommensurate data are such that I think it very misleading to imply mathematical precision in estimating market overvaluation based on back testing data to 1876 or even using only more recent data. I have suggested in articles the use of price/dividend ratios instead of price/earnings ratios because dividends do not involve subjective judgment or changing accounting standards. I also try to use owner cash flow analysis to identify individual stocks which are cheap. Beyond this, I think that statistical analysis may be as likely to lead to mistakes as to profits. In terms of the market as a whole, when I find it harder and harder to find bargains based on enterprise price to owner cash flow ratios, I start moving some money into cash. I am doing that very slowly right now. I sincerely doubt that any more "sophisticated" market timing tool has merit.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Mar 15 3:41 PM | Link | Comment!
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