Felix Salmon

It’s time to get working on labor mobility

Felix Salmon
Aug 20, 2011 16:05 UTC

One of the problems with the news cycle is that perennial issues — problems and solutions both — tend to get ignored in favor of things which have changed in the last few hours or days or weeks. As a result, when it comes to the global economic crisis — the thing which came to the world’s attention in 2008 and which no amount of Panglossian dreaming of V-shaped recoveries can wish away — one of the key potential solutions has been left all but ignored from the outset of the crisis through the present day.

So it’s worth taking a big step back, and looking at the global economy from 30,000 feet. When you do that, you see a lot of wasted resources — in food, in energy, in water, and of course in war. But add them all together and they still don’t come close to the human resources that are wasted every day. This is the 21st Century — the age of information technology and service-sector value-addition. The two most valuable companies in the world, Apple, and Exxon Mobil, both have fewer employees than the population of Moses Lake, WA. The right people in the right place are worth more now than at any point in history — even as the total population of the planet, and therefore its gross human potential, has never been higher.

At the same time, however, the universe of people with the potential to really change the world is vastly smaller than it ought to be. Silicon Valley entrepreneur Marc Andreessen, writing in the WSJ on Saturday, complains with good reason:

Many people in the U.S. and around the world lack the education and skills required to participate in the great new companies coming out of the software revolution. This is a tragedy since every company I work with is absolutely starved for talent. Qualified software engineers, managers, marketers and salespeople in Silicon Valley can rack up dozens of high-paying, high-upside job offers any time they want, while national unemployment and underemployment is sky high.

Does the world have a shortage of good software engineers? Yes. Does Silicon Valley have an artificial shortage of good software engineers? Yes. There are lots of highly-qualified software engineers from India, Russia, and elsewhere — even Canada — who would love to work in Silicon Valley but can’t, for visa reasons. Even if you got your qualification at Stanford University, right in the heart of Silicon Valley, it’s decidedly non-trivial to get a job in Palo Alto or Cupertino upon graduation. You know the companies, you know the people, they know you, they would love to hire you — but the Bureau of Citizenship and Immigration Services gets in the way, and forces you out of the country instead.

If you’re more ambitious than that, of course, the situation gets even worse. There are at least ways of getting a work visa in the US; they’re far too onerous, and leave far too much to chance, but it’s possible. If you want to become an entrepreneur, on the other hand, there’s really no point in even trying. Recent graduates are perfectly positioned to build the great companies of the future: they’re bright, they’re hard-working, they’re up to speed on the state of the art, and they generally don’t yet have families which require job security and a steady income. But if they’re not US citizens, it’s almost impossible for them to build the economy of the future in this way.

And Silicon Valley has historically been a very good place for immigrants — think Intel’s Andy Grove, or Google’s Sergei Brin. It’s no coincidence that the most vibrant areas of the economy are also the places with the highest immigration. Immigrants — especially rich and well-educated immigrants — work hard, create jobs, pay much more in taxes than they take out in benefits, and tend to have overachieving children: they’re a recipe for economic growth and prosperity. The US is a nation of immigrants; from the Statue of Liberty’s beaconed hand glows world-wide welcome, at least in theory. In practice, the US has shot itself in the foot in this regard, especially when compared to its Anglophone competitors like Canada and England. America would have an all but insurmountable competitive advantage in the fight for talented immigrants, were it only to bother competing.

Take another step back, and the lack of mobility of the skilled global elite is a microcosm of a much larger problem, which is the lack of labor mobility more generally, both between and also within countries. Detroit, for instance, has painfully high levels of unemployment just because there aren’t nearly enough jobs in the city, any more, to support its population. The solution is for people in Detroit to move to where jobs are more plentiful. Similarly across the US: one of the reasons why a single currency works well across 50 disparate states is precisely because there’s a decent amount of labor mobility between those states. But as a rule, the more labor mobility the better, and one way of ensuring that jobs get filled by the best-qualified people is to maximize the ease of moving geographically from one job to another.

Moving is always painful, of course, especially for families, but this is one area where homeownership is very much a bad thing. Selling a house is difficult, expensive, and time-consuming — all the more so in today’s depressed market, when millions of homeowners are underwater on their mortgages. In the short term, the government should be doing everything it can to bring liquidity back to the real-estate market — and that means forcing banks to do principal reductions on underwater mortgages. In the long term, it should phase out the mortgage-interest tax deduction, which artificially increases homeownership and decreases labor mobility.

Improving labor mobility is not easy. Italy, for instance, has been a unified country with a single language and a single currency for 150 years, but it still has minimal labor mobility from the south to the north. The lack of labor mobility has been one of the biggest macroeconomic problems facing the Eurozone; again, the millions of unemployed people in the south are not filling jobs in the north. (There’s a bit more mobility from east to west, but not much more.) And globally, discrimination on the basis of one’s country of nationality is the one universally-condoned form of discrimination still in existence: every country in the world puts up significant barriers to prevent foreign nationals from living and working within its borders.

This is not a problem which can or even should be fixed overnight. But it’s a huge problem all the same, and the world’s policymakers should be working on it rather than ignoring or exacerbating it, as they’re doing at the moment. If we want to maximize long-term growth, eradicate global poverty, and give everybody in the world the opportunity to achieve their potential, then a vast improvement in global labor mobility is top of the list of prescriptions.


The right people in the right place at the right time are indeed valuable. With this confluence, businesses will have people working for $1 a day. America will be a 3rd world country – actually all countries will be 3rd world with a very few rich spread out in a few world wide affluent cities.

I was a boy scout, straight A student through college (engineering), and I don’t buy this “free trade” “no borders” guff for a second. I believe in the American dream and of human rights. Everything that businesses want is antithetical to this.

Wake up and stop parroting industry talking points. There never has been a shortage of high tech workers. Do your homework and research. You’ll find that visas like the H1-B were designed solely to undercut the wages of high educated workers.

Man you are pedestrian.

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Hewlett-Packard and the M&A scoop

Felix Salmon
Aug 19, 2011 19:34 UTC


The death of the M&A scoop is going to happen slowly, but frankly it should happen as quickly as possible — and the past 24 hours in the history of Hewlett-Packard is an excellent indicator of why.

Yesterday, just after noon, Bloomberg found itself in possession of some market-moving news about HP: it was engaging in a major strategic shakeup, closing its WebOS division, buying UK company Autonomy for about $10 billion, and putting its PC business up for sale. (Bloomberg has since updated its story to reflect HP’s formal announcement, so I can’t link to the scoop itself.)

The markets, suffering through a massive down day, loved the news, in its leaked-to-Bloomberg form. HP shares were trading about $29.85 before the news came out; a few minutes later they were as high as $34. That’s a rise of 14%, or, to put it another way, an increase in market capitalization of some $8.5 billion.

One blogger, at least, was unimpressed. Zero Hedge, in an astonishingly prescient post entitled “Hewlett Packard Leaks Good News Early, To Mask Bad News Later,” explained exactly what was going on:

With less than 5 hours until the company’s official earnings release, Hewlett Packard just leaked to by Bloomberg that it would spin off its PC business and purchase British software developer Autonomy PLC. This is the oldest trick in the book to get a stock to drop from a higher level in the hopes that staggered releases of news, first good, then bad offsets each other, instead of having the good news be overwhelmed by the bad… We very much doubt this surge will sustain itself for more than a few minutes after the scam is understood. We also very much doubt that today’s earnings release will have anything good to say about the future.

By the end of the day, HP was back to its pre-report levels, in anticipation of a weak earnings report. But no one guessed just how weak the earnings would be.

HP was still spinning, though: its official news release was headlined “HP Confirms Discussions with Autonomy Corporation plc Regarding Possible Business Combination; Makes Other Announcements.” Among those “other announcements”:

FY11 GAAP diluted EPS is expected to be in the range of $3.59 to $3.70, down from its previous estimate of at least $4.27.

In English? “We’ve been telling shareholders to expect earnings of at least $4.27 per share this year. But actually we’re not going to come close. In fact, we’re not going to make more than $3.70, and we might make as little as $3.59.”

The drop from $4.27 to $3.59 is a whopping 16% — a huge miss, given that we’re already more than three quarters of the way through Hewlett Packard’s fiscal year. HP didn’t even attempt to guess what 2012 might hold in stock, perhaps because it’s likely to take most of that year to slough off the PC business it poured so much money into back in 2002.

And so when HP shares opened for trading today, they fell sharply — just as Zero Hedge predicted they would. They’re now trading at less than $24 per share — a 20% fall from the closing price yesterday and a whopping 31% fall from the post-leak knee-jerk exuberance levels of about 12:15pm or so yesterday.

We still live in a world, sadly, where it’s considered good journalism to get a scoop like Bloomberg’s and to move the market by publishing it — in the world of financial journalism, moving markets like this is the gold standard of what editors and proprietors are looking for. Even if you move them in what turns out to have been entirely the wrong direction, with a one-sided story which leaves out the most important news of the day.

It’s clear today that HP’s strategy is failing, that the big strategic moves are something of a hail-Mary pass, and that it’s massively overpaying for Autonomy. We got there in the end. But the M&A scoop which kicked off the news cycle looks like an attempt by HP to manage media coverage and to distract attention from its dreadful earnings guidance. And, at least for a few short minutes, it actually worked.


“I’ve never seen such a well managed well run company fall down a flight of stairs so quickly after a management change.”

Quality management is proven over a period of years… Fiorina saddled HP with a low-margin PC business, at a time when well-managed companies like IBM were getting out. Hurd slept with the help, while the board was playing footsie under the table. Apotheker may be taking the company in the right direction, but does he have the vision to make it work?

The management of HP has been generally abysmal for a decade, yet they have leading positions in servers and printers/copiers, and have a decent chance of establishing themselves in services. The Autonomy purchase is probably overpriced — but it is a profitable and growing business. Even bad management ought to be able to turn a profit on that mix!

As for selling their PC division, I wonder if Microsoft could be interested? They certainly have the cash to do so, and the demise of HP/Compaq would be the death knell for their Windows franchise. If Google saw synergies in the integration of their software with Motorola’s hardware, might Microsoft grasp at the same straws?

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How austerity blooms on Keynes’s grave

Felix Salmon
Aug 19, 2011 15:37 UTC

James Macdonald has an extremely valuable way of putting things into stark focus:

The markets have highlighted a fundamental shortcoming in Keynes’s ideas: He assumed that governments would always be able to borrow. If they cannot, then Keynesian economics is dead in the water.

The thesis of Macdonald’s essay is simple and scary — and, I think, correct.

We have been living through, and are now probably witnessing the end of, an era with no historical parallels: what might be described as the “great debt experiment.”

In many ways this is a good thing. We’ve relied far too much, in the developed world, on debt-fueled growth — and that kind of growth rapidly becomes unsustainable in a world where the amount of growth that can be squeezed out of every marginal dollar of debt has been falling steadily for decades.

But deleveraging,which is great from a systemic-stability perspective, has another name in the short term: austerity. And that’s something we’re only starting to get used to, and which is going to get much more painful, especially in Europe, before this cycle has played itself out.

Greece was the first Eurozone country to find itself locked out of public markets; it won’t be the last. And even now, Greece can still borrow: the ECB and Eurozone have enough faith in Keynesian principles that, for the time being, they’re willing to step in as the lender of last resort to troubled sovereigns. But Greece is small enough to save in that matter; Italy, not so much. If the public markets shut out Italy, or if the Eurozone lacks the political will to continue throwing good money after bad, then we’ll immediately enter the most severe crisis of our lifetimes.

Here’s a couple of charts from Spiegel’s excellent slideshow on the subject to put Europe’s sovereign debts in perspective; the second one should be titled “debt”, not “deficit”. But the first one is the scarier one: it just shows the debt coming due by end-2013 in the five crisis countries. We have a serious liquidity issue here, never mind the questions of solvency raised in the second chart.



The Maastricht limit, of course, is the maximum debt that Eurozone countries are allowed to have. So much for that idea. And debt in general, as we saw in 2008-9, is a treacherous and precarious beast — you never want to push it to its limits. The market will roll over a country’s debts happily and indefinitely — until it won’t. Some countries, like Japan, are relatively safe in that regard: “the market”, there, is domestic savers in a country with a high domestic savings rate. But when a country is reliant on foreign investors to buy its debt, and can’t easily fund itself domestically, it’s playing an extremely dangerous game.

Is that the case in the US? Happily, no — as you might suspect, given the 10-year Treasury yielding 2%. But you’d probably be surprised how much of America’s $14 trillion debt is money we’ve lent to ourselves in one form or another.


So the US, by rights, should be the last country onto the austerity train. We’re the happy recipient of the global flight-to-quality trade, we fund in our own currency, and we fund largely domestically. (Yes, the “public debts” includes a lot of foreign investors, and even some foreign sovereigns, but all that money being taken out of our paychecks in the form of social security contributions and the like goes a surprisingly long way — it’s forced lending to the US government, and it’s not going away.) There are serious questions about some countries’ ability to be able to continue to tap the capital markets; there are no questions at all about others. The US is, happily, in the latter category: if the Treasury ever stops borrowing, that will be thanks to Congressional edict, rather than due to any reluctance on the part of the markets to roll over debt.

That said, the US is running into enormous political problems just trying to make up with sovereign borrowing what the economy has lost in private-sector borrowing over the course of the recession. If it can’t rise to the Keynesian challenge domestically, there’s absolutely no way it will let itself be dragged into becoming a lender of last resort globally.

Which means that we’re in the final innings of the Keynesian game. If you look at the history of sovereign debt, we started with countries borrowing large sums of money from rich private-sector individuals like the Rothschilds. When those sums weren’t enough, the era of big publicly-owned banks began, and borrowing capacity rose sharply. Then we moved into domestic capital markets, and eventually international capital markets. Each move increased the amount of money available for lending to sovereigns. Finally, when sovereigns get tapped out, they can try to appeal to super-sovereigns: the ECB, the EFSF, the IMF and the like. But those funds are limited, and don’t last long. Hence the move to austerity — the only other option. Or, of course, there’s always inflation — the other way that the ECB can bail out overindebted sovereigns. But that doesn’t seem likely any time soon.

Update: Matt at Obsolete Dogma has a really smart response.


theinfamoush6, imagine if Al Gore had been elected. Then he would have got the blame for the crash after the dot com bubble, for not doing anything about 9/11, corporate scandals like Enron and WorldCom and probably destroyed his and Clinton’s reputation. Instead he is a multimillionaire Nobel Prize winner private jetting around the world telling people to lower their carbon footprint. Will bet he thanks all the major deities at night.

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Why the correlation bubble isn’t going to burst

Felix Salmon
Aug 19, 2011 14:36 UTC

Everybody knows that correlations go to 1 during a crisis. But markets and crises move at many speeds. Rodrigo Campos quotes one technical analyst today as saying that during the latest bout of market volatility, “We were moving over a three and a half day period like we were during the flash crash, just more orderly. It was totally irrational.”

Paul Amery today takes a bigger step back, looking at stock-market correlations over the past five years or so. The chart is instructive, I think:


The methodology here is a bit complicated — you start with the implied volatility of stock index futures and then strip out the implied volatility of single-stock options. And towards the end of each contract’s life things can go a bit haywire — especially if the contract is expiring in January 2009, right in the middle of the crisis. But the big picture seems clear: correlations are not only very high, but they’re on a steady uptrend, too. What we’re seeing right now is not some kind of unusual spike: it’s entirely in line with how the stock market has been trading for years now.

JP Morgan, in a research report last year, looked even further back, using a different methodology.


The big thesis of the report was that correlations had overshot, and were likely to come back down; that didn’t happen. Instead, the trend has only continued since then: correlations have been increasing for a good 20 years at this point, and are now at levels exceeding those seen even in the aftermath of the 1987 crash, when portfolio insurance products forced high correlations on the market as a whole.

There are many reasons why correlations are high and rising. The rise of high-frequency trading is one; the rise of ETFs is another. Both of those are here to stay.

And then there’s the broader economy. Here’s how JP Morgan puts it:

A significant driver of correlation between stocks is the prevailing macroeconomic environment. During periods of high macro uncertainty, stocks prices are largely driven by macro factors such as economic growth, unemployment, interest rate changes, inflation expectations, etc. Therefore, during changes in macroeconomic regimes, stock prices tend to move in unison leading to a high level of correlation.

On top of that, macroeconomic uncertainty tends to lead to stock-market volatility, and stock market volatility in turn is associated with higher correlations. So the more uncertain the macro environment, the higher correlations are likely to go. JP Morgan might be right that we’re in a “correlation bubble”, but if we are, I don’t think it’s going to burst any time soon, just because macro uncertainty is going to remain very high for the foreseeable future.

What are the implications of this? For one thing, expect your broad-based S&P 500 index fund to give you much less diversification benefit than it would have done ten years ago; similarly, you can expect it to be much more volatile than it would have been ten years ago, too. Essentially, indices are behaving more and more like risky individual stocks, with the proviso that they can’t go to zero.

On top of that, it’s going to remain very hard to make money as a stock picker in this market. It’s easier than ever to play the indices, thanks to ETFs, which now account for 40% of all exchange-traded activity in equities. And if you want extra risk, that’s easy, too: just play bank stocks instead of the broad index. Because of their inherent leverage, they always fall more than the index when it’s going down, and rise more when it’s going up. But if you’re carefully doing the Graham-and-Dodd thing, poring over balance sheets and trying to find value, make sure you have a long time horizon and aren’t liable to get run over by the correlation steamroller. Your carefully-picked stock will, to a first approximation, do exactly the same thing as all the other stocks are doing, and if you’re planning on waiting for corporate fundamentals to assert themselves, be prepared to wait a long time.


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Nick Rizzo
Aug 19, 2011 04:11 UTC

Michele Bachmann has promised to bring back $2 per gallon gas. But I want a chicken in every pot!

Tim Geithner’s 50th birthday cake is about as depressing as this economy. He should have just eaten a “supercookie.” Oh wait, no, that’s actually a new method websites are using to track your browsing history, the WSJ tells us.

British gilt yields fall to their lowest since the 1890s. German guilt’s still really high, otherwise they would have told PIIGS to take a hike by now.

Some great photographs of What They Were Thinking, then and now, in the New York Times Magazine.

AT&T charges you 10,000,000% more for sending data when it’s in a text message. While we’re on the subject of unfair, capricious bureaucracies, here’s an interesting Q & A with Eliot Spitzer on ratings agencies. “The metaphor I used to use is that it’s like getting a speeding ticket. You learn the lesson for some period of time but then 20 miles down the road, 30 miles down the road, your foot starts going back down on the accelerator. It’s a question of for how long we’ve learned the lesson.” Er, should we expect to find some more hookers twenty or thirty miles down the road?

Hundreds of foreign students in the U.S. on a summer work visa program staged a walkout at a Hershey’s plant, alleging heavy exploitation. I wonder: did the Oompa Loompas ever try that?

Ezra Klein says that FDR devaluing the dollar (and some help from Hitler) helped end the Depression. Bit of trivia: that same Executive Order is why Glenn Beck shills gold coins at a hefty markup.

And Anderson Cooper has a very severe case of the giggles.



Spitzer hookers! Ha ha, that never gets old!

On the other hand, nobody since him has been more effective than he was, so getting him nuked b/c he was paying for bootie was maybe a mistake.

Talk about a victimless crime.

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Why the SEC shouldn’t push index funds

Felix Salmon
Aug 19, 2011 01:31 UTC

Peter Rudegeair, who has the memory of an elephant, thought of me when he saw David Swensen’s op-ed in last Sunday’s NYT. Back in March 2009, he recalled, I posted a short blog entry entitled “The Dangers of Listening to David Swensen”. In light of the new piece, Peter asked, what do I think now?

The answer is that Swensen still doesn’t look so good, despite the fact that he’s mainly advocating something perfectly sensible — investing in low-cost index funds. Still, there are two problems with the piece. His argument doesn’t really hold up, and it also looks suspiciously self-serving.

Swensen is right, of course, that the mutual fund industry has a conflict between making money for itself and making money for investors. But then he starts getting specific about how the industry takes money from investors and turns it into profit for itself:

Mutual fund companies, retail brokers and financial advisers aggressively market funds awarded four stars and five stars by Morningstar, the Chicago-based arbiter of investment performance…

In 2010, investors redeemed $152 billion from one-star, two-star and three-star funds and placed $304 billion in four-star and five-star funds. In the crisis-scarred year of 2008, even as investors withdrew $174 billion from one-star, two-star and three-star funds, they added $47 billion to four-star and five-star funds. Year in and year out, flows to four-star and five-star funds prove remarkably resilient and overshadow flows to the three bottom categories.

This churning of investor portfolios hurts investor returns. First, brokers and advisers use the pointless buying and selling to increase and to justify their all-too-rich compensation. Second, the mutual fund industry uses the star-rating system to encourage performance-chasing (selling funds that performed poorly and buying funds that performed well). In other words, investors sell low and buy high.

Ill-advised buying and selling of funds costs the investing public a substantial sum. In 2010, Morningstar found that if mutual fund investors in 2000, as a whole, had simply bought and held their funds for 10 years, their investment outcomes would have improved by an average of 1.6 percentage points per year. That 1.6 percent may not sound like much, but it adds up to tens of billions of dollars per year.

Swensen is right that people are more likely to sell underperforming funds, and buy outperforming funds. And he’s also right that there are fund managers out there who recommend precisely that course of action: I wrote about one of them a few weeks ago. But he’s wrong that the tendency to rotate from underperforming funds into outperforming rival funds is responsible for that 160bp of negative alpha. If that was the case, all you’d need to do is trade the opposite way — sell the five-star funds, buy the one-star funds — and you’d make a fortune.

The fact is, as Swensen well knows, that within any given sector, the difference between the best-performing funds and the more mediocre performers is almost always modest. If you look very carefully, over five years or longer, then you might be able to discern a performance differential between, say, five-star and four-star funds. But as a rule, it’s nothing to write home about. So unless you pay massive up-front fees every time you buy and sell funds, being rotated from one value fund to another, or from one emerging-market fund to another, is unlikely to do massive harm to your net worth.

What’s more, investors are actually pretty smart win it comes to picking mutual funds. They’re cost-conscious: the lower the fees, the more popular the fund is likely to be. And if you look back at the funds which investors piled into before Morningstar existed, they tend to be precisely the ones which would have got 4- and 5-star ratings, and which over the long term turned out to be the best bets.

So the 160bp of underperformance — the difference between investor returns and market returns — doesn’t seem to come from the area that Swensen identifies: it’s a lot more complex than that.

A look at the report in question is probably useful at this point; Swensen doesn’t provide a link, but I’m nicer. What we’re looking at here is a gap between investor returns, on the one hand, and the average return of a mutual fund in that sector, on the other. Morningstar’s John Rekenthaler confirmed for me that we’re looking at the unweighted average of all the funds in a sector, regardless of size — so in the smaller sectors, if there were one or two small funds which did extremely well, that could easily throw off the average considerably. What’s more, there’s significant survivorship bias over the course of a decade: the underperforming funds tend to close and not get counted in the figures, while the best performers all live on.

All of which means that Swensen isn’t right when he characterizes the average fund return as the return that investors would have received had they “simply bought and held their funds for 10 years”.

And there’s certainly no evidence to suggest that buying actively-managed funds rather than index funds will cost you anything close to 160bp a year. As I say, mutual fund investors in aggregate are pretty smart: they tend to buy funds which might not be quite as cheap as the cheapest index funds, but which aren’t far off. Even once you take into account the idea that most fund managers underperform the index, you’re still not going to get to that 160bp level.

Instead, Rekenthaler has his own theory for the underperformance, which rings much more true to me. We’re not seeing investors rotate within sectors, we’re seeing them rotate between sectors, something he calls “category chasing”. When tech stocks or real estate or gold are hot, investors pile in; when those sectors crash, the same investors pile out. “Within a category, people are making rational decisions,” says Rekenthaler. “The problem is that they’re chasing categories.”

I hasten to add here that Rekenthaler doesn’t have the empirical data to prove this thesis in an iron-clad manner. But it’s more credible than the Swensen thesis, since it seems as though it’s better at explaining the big differences between stated mutual-fund returns, on the one hand, and the actual returns that investors see, on the other.

And if Rekenthaler is right, then Swensen’s prescription — everybody should just pile into index funds — does no good at all, and in fact might even do harm. As index funds steadily get supplanted by ETFs, the ease of trading in and out of them, from one hot sector to the next, becomes all but irresistible: everybody becomes a market timer. I have a very expensive broker, who performs no useful service for me at all, beyond simply being expensive — and that’s a good thing, because if I know that trading is expensive, then I won’t do it, and if I don’t trade, I’ll make more money over the long term. Fees are bad — but sometimes ease of trading can be bad, too, as Emanuel Derman notes today.

On the other hand, there’s one group which would benefit greatly if Swensen’s advice were taken and the SEC put a lot of effort into pushing all individual investors into index funds. And that’s the kind of hedge-fund managers who Swensen invests in. Because there’s a paradox of index funds: while they make perfect sense for any given individual, it would be disastrous if everybody invested in them. The whole point of having a market is that you need millions of people all competing against each other to allocate capital most efficiently. Investing in an index fund is a way of free-riding on the collective wisdom of active investors, and so you need to have more active investors than index-fund managers in order for the market to continue to work.

The more people that invest in index funds, the easier it becomes, in theory, to beat the index — which is Swensen’s job. And while I’ll continue to recommend that any given individual should invest in index funds, I wouldn’t suggest, as Swensen does, that there’s a public-policy benefit in pushing everybody to do so.


I love all these hopeful articles about how Index funds are so great. Problem is, Index Funds also charge fees. That means for their returns to be the same as the index, they have to take more risk than the index as a whole represents; for their risk to be the same as the index, their returns will always be beaten by the index. Unless they charge no fees, they will never do what it says on the tin.

Then there are all these seemingly perfect arguments why Index Funds are better than Active funds – the average return argument. Of course, that works if you compare the Index Fund to the whole index, but most advisers I know are smart enough to look at the consistency of above average returns. If you do this, you will see that the same fund managers inhabit the below average funds in an index, and another group of companies hang around pretty much most of the time in the above average return area. Comparing the average Index Fund to the average “above average” fund will most always result in the active fund pick beating the index.

Then there’s the timing issue: Morningstar averages (and their star system) measure date to date averages, not average consistency. While they can be very useful indicators anyway, it is always important to remember that the whole performance of a fund can be significantly enhanced by one lucky year, or even one lucky week, which could fall at the beginning or end of the date range assessed. Looking at the average of the individual calendar year returns over a date range (perhaps with the YTD figure) gives a helpful alternative that shows the effect of rogue results. You can take this view further with other analyses, but relying only on the term averages (the basis of the Morningstar Star calculations) can be misleading.

As for category chasing, in some cases this can work as it allows for macro-economic effects – even a bad fund in a good sector will beat a good fund in a poor sector. It’s like the “location effect” for housing. But this might need advisors to work with multiple companies since different fund manager companies are consistently better in some sectors than in others.

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The markets are falling, not panicking

Felix Salmon
Aug 18, 2011 17:26 UTC

Allan Sloan says that today is “scarier than 2008-09″ — and looking at the markets, he doesn’t seem far off. Yes, stocks are still much higher than they were at the height of the crisis, but relative to earnings the improvement isn’t all that impressive. Meanwhile the 10-year Treasury hit a new all-time low yield of 1.97% today, inflation figures notwithstanding, and gold too is hitting new highs above $1,825 per ounce.

To be honest, though, I’m not seeing fear or panic right here. For one thing, we’re in the middle of August — the time of year when traders and institutional investors go on vacation, volumes tend to dry up, and market moves can get magnified for no good reason. Today stocks fell as much as 5% and the VIX broke above 40 — moves which are indeed reminiscent of what was happening in those panicked days of 2008-9. But having experienced those days and come out the other side, I feel that the investing public as a whole has been toughened up a bit, inured to volatility in a way they weren’t back then. Plus, of course, they’re much richer, on a mark-to-market basis, than they were when the S&P 500 was below 700.

What I’m not seeing here is deep-seated existential fear — the idea that certain companies might well wind up seeing their stocks go all the way to zero, and then defaulting on their debts. During the crisis, we had the worst possible flavor of that fear — that it was banks which were insolvent. Now, by contrast, bank stocks are low, but the famous TED spread, for instance — one of the best indicators of the degree of faith that financial institutions have in each other — is still less than 30 basis points. It spiked to more than 400bp at the height of the crisis.

If we were genuinely in a period of panic and turmoil, we wouldn’t see multi-billion-dollar deals being done for companies like Morotola and Autonomy; we certainly wouldn’t be seeing extreme equity capital markets deals being mooted like the idea that Manchester United might list its shares on the Singapore stock exchange. The markets are clearly finding it difficult, this August, to determine what the right and proper price is for various financial assets. But that’s not panic. In fact, it might just be a perfectly rational response to an increasingly uncertain world.


I think the current behavior of the market is reflection of people’s attitudes vis-a-vis the economic and political outlook more than anything else.

The economy is stuck in neutral, the employment picture is bleak, and the political system is dysfunctional. Is it any suprise that people are starting to wonder where the increased corporate profits which would support a market upturn are going to come from?

Let’s not forget that until the recent correction, the market had more than doubled from it’s March 2009 lows without a single pullback of at least 10% along the way. It’s not like you needed to be a genius to see that the market was due for a correction sometime soon.

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Matt Taibbi vs the SEC

Felix Salmon
Aug 18, 2011 15:31 UTC

Matt Taibbi’s 5,000-word exposé of the SEC’s document-shredding is a magnificent piece of journalism, and is the first and last place that you should look to understand what’s going on here. After the piece came out, Senator Chuck Grassley — who’s quoted in the article — made growling noises in the general direction of the SEC, which is now very much on the back foot. But all the news and background that you need can and should be found in Taibbi’s article, rather than Grassley’s 325-word press release.

So how well is the mainstream media reporting this news? Everybody’s reporting Grassley’s statement, of course, as they should be. But the WSJ, Bloomberg, FT newspaper, and even Reuters make no mention of Taibbi or his article at all. The NYT is better, providing a link to the article and saying that the document disposal was “first reported by Rolling Stone magazine on Wednesday”, but the link feels grudging and there’s nothing which indicates that if you follow the link you’ll get a much fuller and richer version of the story than you’ll get from the NYT. Only FT Alphaville draws a direct connection between Taibbi’s article and Grassley’s statement and really encourages you to read the piece.

Blogs and Twitter, of course, are much better. Zero Hedge, Dealbreaker, Naked Capitalism, Daily Intelligencer, Clusterstock, Atlantic Wire, and many others took Taibbi’s article seriously, linked to it prominently, devoted entire posts to it, and mentioned him by name rather than just referencing the name of his publication. The Huffington Post gave the article its standard aggregation treatment, and Arianna tweeted it personally.

As for the substance of the article, Taibbi makes a very strong case. Only Matt Levine has attempted a defense of the SEC, and he says that the agency’s policy of destroying files was “publicly announced”, when in fact it was a secret internal policy which the SEC wouldn’t even admit to when asked point-blank by the National Archives and Records Administration, the agency in charge of all federal document-disposal decisions. Levine says that “the trouble with Big Brother was too much all-pervading surveillance, not too little”; the financial crisis, I think, proves him clearly wrong on that front. The SEC in particular was toothless and ineffective for the entire Bush Administration, effectively giving banks and other fraudsters a green light to do anything they wanted. And its response to these latest allegations has been distressingly defensive and obfuscatory.

I hope this turns into a big scandal and causes significant changes at the SEC — although I’m not holding my breath. But if it does, Taibbi will deserve a huge amount of the credit. And judging by today’s coverage, he won’t get it from the mainstream financial press.


I want to commend you on your work regarding the SEC. It is dispicable what is going on there. Please keep on them. Let me know if there is anything I can do to support you.
thank you

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Inflation: Is it finally back?

Felix Salmon
Aug 18, 2011 13:09 UTC

The much larger than expected 0.5% inflation figure today is certainly worrying, even if I wouldn’t go as far as Joe Weisenthal, who says that it “screams stagflation”. For one thing, we had negative inflation in June, of -0.2%, so there might be an element of mean-reversion here. But if you look at the 12-month inflation figures, they’re all pretty high, with a headline number of 3.6% — significantly higher than anybody at the Fed would normally feel comfortable with.

The problem is separating the signal from the noise. The Fed has one time-tested way of doing this, which is to strip out food and energy prices: if you do that, inflation was just 0.2% last month, and 1.8% over the past year. Meanwhile, energy costs have gone haywire:


It’s very hard to know what to make of a series like this, where you can have 37.2% annual inflation in fuel oil even when it’s fallen in price for three successive months, and where price volatility in fuel is closely connected to price volatility in the markets generally. Gasoline alone, with its 4.7% rise in July, accounts for fully half the headline 0.5% inflation rate — and although no one can know where gas prices are going to head going forwards, it seems improbable that they’re going to continue to rise at that kind of pace. In that sense, gas-price inflation, although certainly painful now, is not something self-perpetuating which the Fed can or should worry about when setting monetary policy.

It’s also worth remembering that the heavily-indebted US economy could do with a little bit of inflation right now, to help deflate real debts and chivvy along growth: an annual core inflation rate of 1.8%, although the highest we’ve seen since 2009, is much closer to optimal than the 0.6% number we saw last October.

So my feeling is that inflation figures, like stock-market prices, should be treated as less than gospel during this summer of volatility. Food and energy prices are crucially important parts of America’s household budgets: they can’t and shouldn’t be ignored. But there are very strong linkages between the two: 97% of the fertilizer applied to crops is manufactured from natural gas, a lot of energy is expended trucking food to supermarkets, and then of course there’s this:


If I were the Fed, I’d be looking very closely at the dynamics of food and energy prices, to work out the degree to which we’re just seeing normal market-based volatility, and the degree to which we’re seeing a secular upwards trend here which is going to have a nasty effect on inflation for the foreseeable future. That said, even if it’s the latter, it’s hard to see what the Fed can do about it. Marginally higher short-term interest rates aren’t going to have much effect on oil prices or refineries.


Mention bacteria and everyone immediately thinks ‘bad’ but there are many good bacteria too. Many of these purify the human biological waste and make it usable for other purposes.

Same could be said about materials we bury in landfills. Why not burn the rubbish and turn it into energy?
http://fifthdecade.wordpress.com/2008/01  /07/politics-is-all-rubbish-these-days/

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