Tag Archives: The Big Short

Would You Give Up Your Smart Phone for $100,000?

Median household income is $1.5 million; you just didn’t know it. That’s what the Wall Street Journal’s Andy Kessler thinks. I’m not making that up. He dedicated his most recent column to constructing a proof for that thesis.

Granted, Kessler doesn’t say it exactly like that. Instead, he works backwards from nominal median household income of $51,640 in 2016 to the equivalent, in his estimate, of a mere $347 in 1973. But to go from $51,000 to $347 in 44 years, you have to discount the $51,000 by around 12% annually. If that sounds like a big discount rate, it is. But that’s what Kessler thinks all the technological advances that have occurred since 1973 are worth, despite the fact that the clumsy Bureau of Labor Statistics inflation numbers haven’t accounted for them accurately.

However, if we move in the opposite direction, beginning with the nominal median income in 1973 — $10,500 — and compounding it for 44 years at 12%, we arrive at around $1.5 million. This is what a more accurate “hedonic adjustment” for technological advances would reflect as the median household’s purchasing power, according to Kessler. For example, smart phones, as Kessler describes them, act as:

“Our newspaper deliveryman, librarian, stenographer, secretary, personal shopper, DJ, newscaster, broker, weatherman, fortuneteller—shall I go on? The mythical man of 1973 certainly couldn’t afford $100,000 or more for dozens of workers at his beckoning.”

And, Kessler asks, how much would we pay for someone to sit in our cars and perform the task of automatic breaking systems? Of course, the answer could well be nothing. We’d simply live with the extra risk as we did from the invention of the automobile until the invention of automatic breaking. And most of us would give up our smart phones for an extra $100,000 or roughly twice the median household income. If smart phones are really worth what Kessler says they are, this is the test they must pass. I doubt a smart phone would stack up to $100,000 for most people.

Here’s another way to think of hedonic adjustment and whether the middle class is living “high on the hog,” as Kessler says. In 1973, the average rent was $175 per month or $2100 per year. In other words, rent was around 20% of household income. Today, however, rent is around $1200 per month or $14,400 per year. That’s 28% of $51,000. So we have smart phones and automatic breaking systems on our cars, but do those things make up for rent taking out a bigger piece of our paycheck every month? Kessler doesn’t say.

He does say that most hedge fund managers he knows think the CPI is obsolete as a measure of inflation, and prefer the CRB Commodity Index. There’s nothing particularly wrong with using a basket of commodities as an inflation gauge, but it’s hard to know how a commodity index accounts for the technology development that Kessler thinks is so sorely missing from CPI.

More importantly, Kessler talks to hedge fund managers and was once one himself, but he doesn’t seem to have ever had a conversation with one of the investors Michael Lewis profiled in his book The Big Short. As Lewis tells it, Steve Eisman was trained as a stock analyst specializing in banks and other lending companies, and he didn’t know much about the bond market. But he arrived at his decision to short  subprime mortgage-backed bonds partly from having observed as an equity analyst of “specialty finance” companies that middle class Americans were experiencing income stagnation and could only maintain their standard of living by borrowing through credit cards and against the value of their homes. Of course, Wall Street and the companies Eisman covered were happy to oblige them in this endeavor.

Eisman was a big critic of the banks leading up to the crisis, and shorted many of their stocks in addition to subprime mortgage-backed bonds. But here’s Eisman’s statement in a 2016 NYTimes op-ed column, where he argues against breaking up the banks after their post-crisis reforms, lest that would cause us to avoid the real  problem of income stagnation:

“The central economic problem of our time is income inequality, especially the lack of personal income growth for most Americans, which was one of the underlying causes of the financial crisis. In lieu of rising incomes, credit was allowed to be democratized. Living standards were maintained only because increased credit supplemented deteriorating incomes. That helps explain, post-crisis, why United States growth is slow: Without easy credit, consumers cannot increase spending, because their incomes have fallen since 2007.”

I don’t know what prescient bets the hedge fund managers Andy Kessler speaks to have made. But when he contemplates the fortunes of today’s middle class, Kessler might want to expand the circle of investors with whom he exchanges ideas.

See A Bubble? Get Out Of The Way.

In early March, we reprinted an article I wrote for Citywire on bubbles. That article focused on an academic paper called “Bubbles for Fama” by Robin Greenwood, Andrei Shleifer, and Yang You on spotting bubbles. It tried to provide a definition that would satisfy proponents of the efficient markets hypothesis who doubt that bubbles exist.. The authors noted that 100% run-ups of asset prices in a two-year period resulted in a heightened probability of a subsequent crash.

Early this week, Research Affiliates weighed in on which assets might be in a bubble today, citing another research paper by Greenwood and Shleifer discussing how investors behave with strong “extrapolative tendencies.” In other words, investors anticipate strong returns after strong return periods, when future returns are likely to be lower, and also anticipate weak returns after weak returns periods, when future returns are likely to be higher.

What’s A Bubble?

But before we get to that argument, Research Affiliates founder, Robert Arnott, and his colleagues, Shane Shepherd and Bradford Cornell try to keep the definition of a bubble simple. They argue a bubble is a “circumstance in which asset prices 1) offer little chance of any positive risk premium relative to bonds or cash, using any reasonable projection of expected cash flows, and 2) are sustained because investors believe they can sell the asset to someone else for a higher price tomorrow, with little regard for the underlying fundamentals.” (Can you say Bitcoin?) There are bubbles now in technology stocks and cryptocurrencies, according to Research Affiliates. Overall, the U.S. stock market is very expensive too.

The authors are aware that modern academic finance would find their definition lacking. Adherents of the efficient markets hypothesis think “[t]he market’s willingness to bear these risks {of high prices relative to reasonable projections of cash flows] varies over time. . . . .high valuation levels don’t represent mispricing; the risk premia just happen to be sufficiently low so as to justify the prices.” Of course, if risk premia or required returns can vary so widely, what’s the difference between and efficient market and an inefficient one?

More realistic observations come from behavioral finance which shows that investors bring their own psychological baggage to markets even when they know and understand formula-based valuation models. Moreover, Greenwood and Shleifer show that investors are so tied to recent price trends that they anticipate higher expected returns after big price runs when valuation models anticipate subpar returns, and lower expected returns when valuation models anticipate robust returns. Moreover, investors bet accordingly, putting more money into stocks after they have gone up, and withholding it after they’ve gone down.

What Can Investors Do?

If you’ve spotted a bubble, the temptation is to short it. But that turns out to be very difficult, despite the success of the hedge funds depicted in Michael Lewis’s The Big Short.  Arnott et. al. recount the story of Zimbabwe at around the time of the financial crisis. At first, when Zimbabwe’s currency crashed, the stock market soared. Then the stock market crashed as the currency continued to crash more. And finally, when the currency collapsed, so did the stock market for good. The problem with having shorted stocks in this case is that their initial run up might have bankrupted you. And even when asset prices don’t react to a currency failure the way Zimbabwe stocks did in 2008 by shooting up initially and then cratering, bubbles can keep getting bigger and bigger. Not everyone facing a bubble has the advantage that the hedge funds doing “the big short” had — knowledge of when most of the adjustable rate mortgages issued would reset at higher rates, causing most borrowers saddled with them to default. A bubble might be easy to spot, but it’s hard to trade.

Instead of shorting, the easiest thing to do when you spot a bubble is to avoid it. Nobody needs to own Bitcoin or cryptocurrency. Also, nobody needs to own any technology stocks right now. Moreover, there are many stock markets around the world cheaper than the U.S. market. The cheapest stock markets around the world are the emerging markets, according to both Research Affiliates and Grantham, Mayo, van Oterloo (GMO) in Boston. It’s true EM stocks often come with an extra dose of volatility, but their valuations are lower than that of the U.S stock market. Also, none of this means those are the only stocks you should own though. There are ways to mitigate overvaluation of U.S. stocks such as with an ETF that owns more of the cheapest ones like the iShares MSCI USA Equal Weighted ETF (EUSA) or the PowerShares FTSE RAFI US 1000 ETF (PRF). But when things are expensive, it’s fine to stay away from them.

Even being relatively conservative by overweighting emerging markets stocks rather than shorting U.S. stocks entails some “maverick risk,” as Research Affiliates calls it. This is sometimes called “career risk,” because clients will fire and advisor or asset manager who deviates too much from a benchmark or his peers for too long a period of time. Investors must be honest with themselves about how much maverick risk they can tolerate, and advisors must be careful not to exceed their clients’ tolerance for maverick risk.

Most of all, when contemplating asset prices and prospective returns, remember that your mind may be playing tricks on you when you expect unusually large or unusually small returns. Don’t extrapolate recent return history into the future. The future might hold the opposite scenario from the recent past.