Friday, November 13, 2009

Are We on the Road to Serfdom?

Appreciation for Hayek continues to spread: As the freshwater and saltwater economists continue their never-ending fight to see who could be more reluctant to consider ideas that fit outside their narrow frameworks, many people are starting to embrace the idea of the Austrian school of economics. After reading some great material on the Austrian school, I wrote an article on Hyman Minsky and now Amity Shlaes has penned on op-ed piece on the Austrian- influenced economist Friedrich von Hayek. According to Shlaes, one of Hayek’s ideas that is most pertinent to today has to do with the loss of personal freedoms at times of national stress. Hayek believed that wars and crises led to national planning, creation of influential special interest groups and an erosion of individual liberties. Hmmm, does that sound familiar? National planning? Well, the government now decides what companies survive and fail and is looking into nationalized health care. Powerful special interest groups? We can’t forget the banking oligarchy that has captured Washington and now imposes its will on Main Street with no repercussions. Loss of liberties? Remember all that wire tapping and other invasive activity that came with the renewed focus on Homeland Security? Sounds to me like the government has used 9/11, the Iraq and Afghan wars, and the financial crisis to become a much bigger influence in our day to day lives.

The problem with this dynamic, according to Hayek, is that the economy suffers due to too much government involvement. Even worse, in the long run he believed that we would all become serfs. I have to admit that in some of my darkest moments I worry that the in recent years the government and the banks colluded and conspired to create a nation of indebted people who would be no more than passive participants in their own lives. Zombie consumers. It’s hard to rise up and question the status quo that includes huge bankster bonuses, crony capitalism, and reduced freedoms when the bank is standing on your doorstep ready to take your house. I hope Hayek was wrong and that Americans will not stand for being trivialized and marginalized indefinitely. One of the few things I have faith in these days is that we are capable of forcing our government to change. I just pray it does not take some kind of point of no return tragedy to wake people up:

As the war came to end, Hayek penned an apocalyptic tract, “The Road to Serfdom.” His thesis was that war gets people used to national planning. So the planners continue to plan, even in peacetime. These incremental expansions of the social- welfare state aren’t benign. They foster the creation of ever- more-powerful interest groups. The economy becomes less productive. Political corruption in turn gives rise to dictators. Foreign-policy tension or economic crisis accelerates the trend.

“‘Emergencies,’” Hayek wrote, “have always been the pretext on which the safeguards of individual liberty have eroded.”

For a number of decades the main thing about Hayek seemed to be that he was wrong. Britain did head to the left, far to the left. After the war, the U.S. also institutionalized government planning in new areas. Yet neither Britain nor the U.S. went socialist or trampled personal freedoms. On the contrary, they eventually turned toward Margaret Thatcher and Ronald Reagan

But this low estimation of Hayek fails to appreciate his central thought: the economic damage is subtle and is evident only over time…

Hayek understood that a good decade where government expansion seems to stall -- the 1990s -- doesn’t mean government won’t expand when the next crisis comes.

The recent pattern of following a war and a financial collapse with the creation of a new entitlement is a perfect example of the Hayekian dynamic in action…

The U.S. is on the road if not to serfdom then to less growth, less innovation, more rationing and more political corruption…

Brad Delong defends the stimulus: The debate over the efficacy and impact of the $787B stimulus package continues to rage on. Many conservatives have called it a failure because it has not arrested unprecedented job losses. Others, such as Paul Krugman worry that the US will need another round of stimuli because the first allotment was insufficient to repel deflation. Some think it did not focus enough on rebuilding the deteriorating infrastructure in this country. Others wish that it had put more money in the hands of consumers through tax cuts. Curiously, within this cacophony of criticism, the Obama administration has come out with a claim that the stimulus package has saved or created 640K jobs. I am clearly skeptical of government statistics in general. But, in reality, I have no way of assessing the validity of such data. However, this is the same government that continues to claim that small business start ups are adding around 80K jobs a month. To that I say, with what credit and to cater to what demand?

Still, if we give Helicopter Ben credit for bringing the financial system back from the ledge (despite the fact that he was one of the men who allowed it to get so close to the precipice), then maybe we can give Congress and the Obama administration the benefit of the doubt and assume that the stimulus did help prevent a more dramatic initial economic decline. (I say initial because I am deeply concerned that we are setting ourselves up for an even nastier round two) Within this context, I found some interesting commentary from Berkeley economist Brad DeLong. His thesis is that we cannot in retrospect just dismiss the need for stimulus because we automatically assume that “this time is different” and the 54% decline in industrial output that occurred during the 1930s could not have happened again in this crisis:

It is worth stepping back and asking: What would the world economy look like today if policymakers had acceded to the populist demand of no support to the bankers? What would the world economy look like today if Congressional Republican opposition to the Troubled Asset Relief Program (TARP) program and additional deficit spending to stimulate recovery had won the day?

The only natural historical analogy is the Great Depression itself. That is the only time when (a) a financial crisis caused a widespread, lengthy, and prolonged reinforcing chain of bank failures, and (b) the government neither intervened nor passed the baton to a consortium of private banks to support the system as a whole.

It is now 19 months after Bear Stearns failed and was taken over by JP MorganChase with the assistance of up to $30 billion of Federal Reserve money on March 16, 2008, and industrial production stands 14% below its peak in 2007. By contrast, 19 months after the Bank of the United States, with 450,000 depositors, failed on December 11, 1930 – the first major bank collapse in New York since the Knickerbocker Trust failure during the panic and depression of 1907 – industrial production, according to the Federal Reserve index, was 54% below its 1929 peak.

Opponents of recent economic policy rebel against the hypothesis that an absence of government intervention and support could produce an economic decline of that magnitude today. After all, modern economies are stable and stubborn things. Market systems are resilient webs that offer the best possible incentives to people to make deals and use resources productively. A 54% fall in industrial production between its 2007 peak and today is inconceivable – isn’t it?

If so, then the unavoidable conclusion must be that things would not have been so bad if the government had refused to implement an expansionary fiscal policy, recapitalize banks, nationalize troubled institutions, and buy financial assets in non-standard ways. The problem, though, is that all the theoretical reasons to think that depressions as deep as the Great Depression simply do not happen to market economies applied just as well to the 1930’s as they do to today.

But it did happen. And it could have happened again.

DeLong’s point is that doing nothing could have been disastrous and just because it is not 1930 anymore, does not mean the US is immune to that type of a downturn. People reading the newspaper in 1930 did not know that they were about to enter a Great Depression and they probably believed some of the same hype that is being spouted today by the government, banks and media cheerleaders. Obviously, the idea that the stimulus had a part in staving off Armageddon is even harder to prove than how many jobs it has saved. But, despite my skepticism surrounding the Keynesian response that includes unabashed money printing, I grudgingly admit that DeLong may have a point.

A preliminary post mortem on the crisis by Howard Marks: For anyone who is not in the habit of checking Oaktree Capital Management’s website periodically just in case there is a new piece from Howard Marks, I suggest you bookmark the site and set a monthly reminder on Google Calendars. Marks is in the same league as Buffett and Klarman in terms of being able to deliver prescient, articulate and poignant commentary on the financial markets. For value investors especially, his words are pure gold. The latest piece from Marks includes an analysis of what how the US economy, banks and consumers all got into such a terrible mess. It has the feel of an 18,000 foot view of the crisis taken long after the situation had stabilized. Unfortunately, his analysis may turn out to be nothing more than a halftime assessment of what went wrong in the first half. Based on the complete lack of reform and behavioral changes, it appears that we have learned nothing from the bubble years and the subsequent implosion of the global economy. As such, there is little reason to believe that the second half will play out any differently from the first half. Accordingly, I think it is now even more important than ever to understand the biases, greed, incompetence, and blindness that produced such an extraordinarily negative outcome on so many levels. In that case there is no one better than Marks to illustrate where changes need to be made if we are to return to sustainable prosperity:

The recent crisis came about primarily because investors partook of novel, complex and dangerous things, in greater amounts than ever before. They took on too much leverage and committed too much capital to illiquid investments. Why did they do these things? It all happened because investors believed too much, worried too little, and thus took too much risk. In short, they believed they were living in a low-risk world…

Belief that risk has been banished is a key element in allowing people to engage in practices they would otherwise view as risky, and in permitting assets to be bid up to prices that would clearly be too high in a world perceived to involve risk.

Worry and its relatives, distrust, skepticism and risk aversion, are essential ingredients in a safe financial system. To paraphrase a saying about the usefulness of bankruptcy, fear of loss is to capitalism as fear of hell is to Catholicism. Worry keeps risky loans from being made, companies from taking on more debt than they can service, portfolios from becoming overly concentrated, and unproven schemes from turning into popular manias. When worry and risk aversion are present as they should be, investors will question, investigate and act prudently. Risky investments either won’t be undertaken or will be required to provide adequate compensation in terms of anticipated return.

But only when investors are sufficiently risk averse will markets offer adequate risk premiums. When worry is in short supply, risky borrowers and questionable schemes will have easy access to capital, and the financial system will become precarious. Too much money will chase the risky and the new, driving up asset prices and driving down prospective returns and safety…

One of the errors committed in 2003-07 – forming a cornerstone of the crisis – consisted of believing too much in the ability to predict the future. Investors, risk managers, financial institution executives, rating agencies and regulators trusted forecasts, extrapolations and computer models. This made them comfortable with risk, always a dangerous arrangement. The “I know” school of investing has received frequent mention in my memos (e.g., “Us and Them,” May 7, 2004). Its members – money managers, Wall Street strategists and media pundits – believe that there’s a single future, it is knowable in advance, and they’re among the people who know it. They’re eager to tell you what the future holds, and equally willing to overlook the inaccuracy of their past predictions. What they repeatedly ignore is the fact that

(a) the future possibilities cover a broad range, (b) some of them – the “black swans” –can’t even be imagined in advance, and (c) even if it’s possible to know which one outcome is the most likely, the others have a substantial combined probability of occurring instead.

Thus one key question each investor has to answer is whether he views the future as knowable or unknowable. An investor who feels he knows what the future holds will act assertively: making directional bets, concentrating positions, levering holdings and counting on future growth – in other words, doing things that in the absence of foreknowledge would increase risk. On the other hand, someone who feels he doesn’t know what the future holds will act quite differently: diversifying, hedging, levering less (or not at all), emphasizing value today over growth tomorrow, staying high in the capital structure, and generally girding for a variety of possible outcomes.

The unemployment problem in a nutshell: I know Tyler Durden included a portion of this piece from David Rosenberg regarding the unemployment situation in the US. However, I wanted to make sure that everyone had a chance to read it. In just a few paragraphs Rosenberg explains why employment is not going to just turn around on a dime like the bulls will have you believe. I heard financial blogger Mish call it a “job-loss recovery” as opposed to a “jobless recovery.” I happen to think he is spot on because there are structural problems facing this country that are going to preclude companies from hiring and new businesses from forming immediately. Having said that, there are a lot of people much smarter than I am who believe that the jobs will eventually come. Just like we could not have predicted the internet boom, the claim is that some new sector will take the lead and create millions of jobs. It could be from health care. It could be from education. It could be from a green energy or some other form of infrastructure-based revolution. If you ask me I hope it is all of the above. We sure need to rebuild the education system, health care system, energy grid and physical infrastructure of this country if we want to maintain the standard of living we have become so accustomed to. The problem is that it could take years for one or all of these to start creating meaningful jobs. In the meantime, we have to deal with unemployment (both U3 and U6) that will continue to rise until the imbalances that have been created by over-retailing, over-building, over-banking, and over-consumption are eradicated. We should all be thankful that Rosy is here to keep things in perspective and make sure that our expectations for a sustainable job and stock market recovery are realistic:

There are serious structural issues undermining the U.S. labour market as companies continue to adjust their order books, production schedules and staffing requirements to a semi-permanently impaired credit backdrop. The bottom line is that the level of credit per unit of GDP is going to be much, much lower in the future than has been the case in the last two decades. While we may be getting close to a bottom in terms of employment, the jobless rate is very likely going to be climbing much further in the future due to the secular dynamics within the labour market.

But in a nutshell, to be calling for a 12.0-13.0% unemployment rate is meaningless except that it is very likely going to be a headline grabber. The most inclusive definition of them all, the U6 measure of the unemployment rate, which includes all forms of unemployed and underemployed, is already at 17.5%. The posted U3 jobless rate that everyone focuses on is at 10.2% (though if it weren’t for the drop in the labour force participation rate, to 65.1% from 66.0% a year ago, the unemployment rate would be testing the post-WWII high of 10.8% right now). The gap between the U6 and the official U3 rate is at a record 7.3 percentage points. Normally this spread is between 3-4 percentage points and ultimately we will see a reversion to the mean, to some unhappy middle where the U6 may be closer to 15.0-16.0% and the posted jobless rate closer to 12%. This will undoubtedly be a major political issue, especially in the context of a mid-term elections and the GOP starting to gain some electoral ground.

Think about it. We haven’t yet hit bottom on employment but that will happen at some point. Employment is not going to zero, of that we can assure you. But when we do start to see the economic clouds part in a more decisive fashion, what are employers likely to do first? Well, naturally they will begin to boost the workweek and just getting back to pre-recession levels would be the same as hiring more than two million people. Then there are the record number of people who got furloughed into part-time work and again, they total over nine million, and these folks are not counted as unemployed even if they are working considerably fewer days than they were before the credit crunch began.

So the business sector has a vast pool of resources to draw from before they start tapping into the ranks of the unemployed or the typical 100,000-125,000 new entrants into the labour force when the economy turns the corner. Hence the unemployment rate is going to very likely be making new highs long after the recession is over — perhaps even years.

Good luck generating alpha in the herd: Hat tip to Yaser Anwar for providing access to this piece from Dylan Grice of SocGen. Between the work of Grice and Albert Edwards, I think SocGen may produce the only sell-side research worth reading (Just kidding sell-side guys—you know I love you). Having spent my time on the buy-side I think I take a little too much pleasure in seeing data that suggests that for the most part the sell-side analyst community struggles to add a lot of value. I happen to know a number of sell-side analysts who are amazing and have a depth of knowledge regarding their coverage space that I could only dream of. But as whole, they unfortunately comprise a somewhat biased herd and any good contrarian investor knows there is money to be made by betting against the herd. To illustrate this point further, Grice decided to see if there was any relationship between the number of analysts that covered a stock and the relative performance of that stock. I won’t give the secret away as you can peruse his findings below, but let’s just say that the data does not disprove the value investing mantra that it is better to fish where others are not:

It was with all of this in mind that I read Charles De Boissezon, one of our Financial Engineering team’s excellent analysis of sell-side coverage of stocks in Europe. He calculated the extent to which a stock was overbroked by dividing the number of analysts covering a stock to its market cap, and uncovered such gems as Nokia being the most covered stock with 63 analysts “and still it can come up with ‘shocking’ numbers” and Q-Cells (1bn free float) being covered by 44 analysts. Hours of fun.

But it got me wondering whether or not this might be a good proxy for measuring herding within the sell-side research management community. The obvious motivation for hiring a sector team is that there is plenty of commission to be won…

So I took Charles analysis a little further. Let’s call his ratio of coverage to market cap the Banks Aggregate Analyst Herding Index, or the BAAH Index for short (as in the noise bleating sheep make). I used Factset sector classifications with the FTSE World Index and got the results given on the front page. That chart shows herding is most pronounced in the clothing and construction sectors and least pronounced in energy and tobacco. Then, I backtested the strategy on Factset by ranking each sector according to its BAAH index (beginning in 1987) and calculating the subsequent years returns. I rebalanced the portfolio annually. It turns out that a long-short strategy of buying the sectors where herding is less dominant and shorting those where coverage is deepest would have generated around 7% p.a. since 1987For a given market cap, it seems, the more analysts you see swarming around a sector the more wary you should be of being able to extract alpha from it. (Emphasis added) Leave the herd to its dopamine fix and have another think about the less-crowded sectors.

(Picture of Hayek courtesy of