Saturday, August 30, 2014

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Thursday, August 28, 2014

How You Can Play to Win When Market Makers Are Calling the Shots

By Dennis Miller

The American Legion sponsored a carnival every summer when I was a young lad. My dad was a legionnaire, so each year I had a job. Beginning at age 12, I hauled soft drinks and food to the various concession booths well into the night, which probably violated some labor laws.

Dad warned me about the carnival barkers, telling me to never play games where you try to win a giant teddy bear. They were rigged, he said, and no one ever wins—“So don’t waste your money.”

I questioned Dad’s advice when I saw other boys carrying giant teddy bears to the delight of cute teenage girls. So I quietly watched some of the games. Some people won silly goldfish, but few won the giant teddy bear.

Then I befriended some of the carnival workers and told them what my dad had said. To my surprise, they took his remarks personally. Each one stepped outside his booth to demonstrate just how easy it was to win by pinging ducks or knocking over little stuffed clowns with ease. The guy who shot the BBs told me to ignore the rear sights because they were off center. He also told me exactly where to hit the moving duck to make it go down. Ping, ping, ping! He knocked them down one after another.

He argued that the game was not rigged; if it were, eventually no one would play. But the odds were tilted toward those who practiced. I tried it, lost a dollar (one hour’s pay), and realized it was cheaper to buy the teddy bear than to spend the money to learn how to win consistently.

I think about those carnival games often, when friends and readers ask about market makers, brokers who help keep markets liquid and profit in the process. Do they just hold a unique position, or is something fishy going on?

24 Men Make History Under a Buttonwood Tree


Let’s take a step back to answer that question. The history of what would later become the New York Stock Exchange began in 1792, when 24 brokers and merchants signed the Buttonwood Agreement outside 68 Wall Street—under a buttonwood tree, of course.

The securities market grew, particularly in the aftermath of the War of 1812, and in 1817, a group of brokers established the New York Stock & Exchange Board (NYS&EB) at 40 Wall Street. At that time, stocks were traded in a “call market” during one morning and one afternoon trading session each day. A call market is exactly what it sounds like: a list of stocks was read aloud as brokers traded each in turn.

Whatever the benefits of this seemingly orderly system, it did not foster liquidity, and in 1871 the exchange, which had been rechristened as the New York Stock Exchange (NYSE) in 1863, began trading stocks continually throughout the day. Under the new system, brokers dealing in one stock stayed put at a set location on the trading floor. This was the birth of the specialist.

Designated Market Makers (DMMs), who are assigned to various securities listed on the exchange, have since replaced specialists. DMMs are one type of market marker, which are broker-dealers who streamline trading and make markets more liquid by posting bid and ask prices and maintaining inventories of specific shares.

Since the NYSE is an auction-based market, where traders meet in-person on the floor of the exchange, the DMMs, who represent firms, maintain a physical presence on the floor. Unlike the NYSE, the National Association of Securities Dealers Automated Quotations (NASDAQ) is an exclusively electronic exchange. Plus, it has approximately 300 competing market makers (not physically present at the exchange). Stocks listed on the Nasdaq have an average of 14 market makers per stock, and they are all required to post firm bid and ask prices.

Why Market Makers Matter to Retail Investors


You may be thinking, “That’s great, but why should any of this matter to me?” Well, because the existence of market makers should affect a few of your trading habits—for thinly traded stocks in particular.

Trades are not automatically executed via magical computer elves. When you place a buy or sell order (likely via the Internet), your broker can choose how to execute your trade.

When you place an order for a stock listed on the NYSE or some other exchange, your broker can pass that order on to that particular exchange, or it can send it to another exchange, such as a regional exchange. However, your broker also has the option of sending your order to a third market maker, a firm ready to buy and sell at a publicly quoted price. It’s worthwhile to note that some market makers actually pay brokers to route orders their way—say, a about penny or so per share.

On the other hand, your broker will likely send your order for a stock traded on the Nasdaq, an over-the-counter market, to one of the competing Nasdaq market makers.

And of course, your broker can always fill your order out of its own inventory in order to make money on the spread—the difference between the purchase and sale prices. Or it can send your order (limit orders in particular), to an electronic communications network (ENC), where buy and sell orders of the same price are automatically matched.

With that in mind, there are two steps you should take to make the most of your trades:

Always place orders at limit prices, as opposed to market prices.

As of Tuesday, the price for Coca-Cola is a bid of $41.23, and the ask price is $41.24; the spread is a penny.

If you put in an order to buy at $41.24, a market maker could buy at $41.23 and sell it to you for $41.24, pocketing a penny per share. If you buy 100 shares, they make $1.00. That is their profit for making the market.

If you put an order in at “market,” it can cost you a lot more. The depth of the current bids goes all the way down to buy at $34.01 (there are a couple of orders to buy KO for $22.12 and even one as low as $3.00, but the probability they will be filled is negligible), and the sell side goes up to $53.68 (again, there is one order to sell KO at $88 but this investor won’t find a counterparty in his right mind that would take it). That means there are currently orders sitting with the market maker to be executed at those respective prices.

If the market maker sees a market order, he would buy the stock at $41.23 and sell it at a much higher price. A market order is basically a license for the market maker to steal. You want the best price for any stock you’re trading; entering a market order will ensure you don’t get it.

The spreads for thinly traded stocks are generally larger. If you want to buy, you can offer a lower price than the bid, or perhaps a penny higher. If you want to trade several thousand shares, consider doing so in small tranches, so you don’t show your full hand to the market maker.

Know the role market makers play when executing stop losses.

For the Miller's Money Forever portfolio we generally set a trailing stop loss when we buy a stock. Entering a stop loss order with your broker will automatically generate a sell order should the stock drop to that number. A market maker can see that number and may drop down to buy your stock at the low price and then resell it for a profit.

As a practical matter, I set stop losses for big companies like Coca-Cola that trade millions of shares per day. The stop loss was there for a reason, and I don’t want to risk the price dropping further before I can sell it.

Some pundits think you should never enter a stop loss with your broker. They prefer another method: a stop loss alert, which many brokerage firms offer. They notify you through an email or text message if the stock drops to the stop loss price, and then you can go to your computer and enter the sell order. We always use the alert for thinly traded stocks, so we’re less vulnerable to an aggressive market maker.

If you are concerned about showing your hand to the market maker, by all means, use a stop loss alert. If you think the risk associated with stop losses is minimal for high-volume stocks, you may want to use both stop losses and stop loss alerts, depending on the stock.

Whether any of this means the market is “rigged,” I’ll leave to those $500-per-hour lawyers to hash out. This is the game we’re playing, so it’s critical to understand the rules, whether we like them or not.

Whether you’re a retail investor or just a guy shooting at moving ducks at a carnival, you need knowledge and skills to succeed. My free weekly missive, Miller’s Money Weekly, exists for that very reason. We provide retirement investors with the education and tools essential for a rich retirement. Receive your complimentary copy each Thursday by signing up here.



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Employers Aren’t Just Whining: The “Skills Gap” Is Real

By John Mauldin


Paul Krugman and other notables dismiss the notion of a skills gap, though employers continue to claim they’re having trouble finding workers with the skills they need. And if you look at the evidence one way, Krugman et al. are right. But this week an interesting post on the Harvard Business Review Blog Network by guest columnist James Bessen suggests that employers may not just be whining, they may really have a problem filling some kinds of jobs.

Unsurprisingly, the problem is with new technology and the seeming requirement that workers learn new skills on the job – you know, like when the student pilot has to take the helm of a 747 in a disaster movie. Perhaps there’s not quite the same pressure in the office or on the factory floor, but the challenges can be almost as complex. Most of us have had the experience of needing to learn completely new ways of doing things, sometimes over and over again as the technology for whatever we’re doing keeps changing.

The proverb about old dogs and new tricks is being reversed, as old dogs are required to learn new tricks to keep up with the rest of the old dogs, not to mention the new pups. It’s either that or go sit on the porch. What follows is not a very long Outside the Box, but it’s thought-provoking.

There hasn’t been much happening in Uptown Dallas chez Mauldin. Lots of reading, routine workouts, long phone conversations with friends, and the occasional appearance of offspring. The amount of material hitting my inbox has slowed down considerably as well, although I know that will change in a week as everyone comes back from holidays. And even if we’re not on vacation, there is a certain slack we seem to cut ourselves in late summer.

Growing up, Labor Day marked the beginning of a brand new school year. Even though many school districts have pushed the start time back a few weeks, Labor Day seems to be a sort of national mental reset button that tells us we must refocus our attention on the tasks in front of us.

So, even with a somewhat reduced schedule, deadlines loom, and I have to do research on secular stagnation. It’s an interesting topic, but the stuff I’m reading about it reminds me to wonder why economists and investment writers feel they have to write in a way that is utterly stultifying and bone-sapping. A course or two in creative writing, with a focus on the creation of a narrative and some attention paid to the concept of a slippery slope ought to be requirements for an economics degree. Not that I have one – and maybe that’s my advantage.

Have a great week, and enjoy these last few days of August.
Your worried about how our kids will deal with the changing work landscape analyst,
Have a great week, and remember that robots need jobs too.
Your wanting more automation in his life analyst,
John Mauldin, Editor
Outside the Box


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Employers Aren’t Just Whining – the “Skills Gap” Is Real

By James Bessen 

Harvard Business Review HBR Blog Network

Every year, the Manpower Group, a human resources consultancy, conducts a worldwide “Talent Shortage Survey.” Last year, 35% of 38,000 employers reported difficulty filling jobs due to lack of available talent; in the U.S., 39% of employers did. But the idea of a “skills gap” as identified in this and other surveys has been widely criticized. Peter Cappelli asks whether these studies are just a sign of “employer whining;” Paul Krugman calls the skills gap a “zombie idea” that “that should have been killed by evidence, but refuses to die.” The New York Times asserts that it is “mostly a corporate fiction, based in part on self-interest and a misreading of government data.” According to the Times, the survey responses are an effort by executives to get “the government to take on more of the costs of training workers.”

Really? A worldwide scheme by thousands of business managers to manipulate public opinion seems far-fetched. Perhaps the simpler explanation is the better one: many employers might actually have difficulty hiring skilled workers. The critics cite economic evidence to argue that there are no major shortages of skilled workers. But a closer look shows that their evidence is mostly irrelevant. The issue is confusing because the skills required to work with new technologies are hard to measure. They are even harder to manage. Understanding this controversy sheds some light on what employers and government need to do to deal with a very real problem.

This issue has become controversial because people mean different things by “skills gap.” Some public officials have sought to blame persistent unemployment on skill shortages. I am not suggesting any major link between the supply of skilled workers and today’s unemployment; there is little evidence to support such an interpretation. Indeed, employers reported difficulty hiring skilled workers before the recession. This illustrates one source of confusion in the debate over the existence of a skills gap: distinguishing between the short and long term. Today’s unemployment is largely a cyclical matter, caused by the recession and best addressed by macroeconomic policy. Yet although skills are not a major contributor to today’s unemployment, the longer-term issue of worker skills is important both for managers and for policy.

Nor is the skills gap primarily a problem of schooling. Peter Cappelli reviews the evidence to conclude that there are not major shortages of workers with basic reading and math skills or of workers with engineering and technical training; if anything, too many workers may be overeducated. Nevertheless, employers still have real difficulties hiring workers with the skills to deal with new technologies.

Why are skills sometimes hard to measure and to manage? Because new technologies frequently require specific new skills that schools don’t teach and that labor markets don’t supply. Since information technologies have radically changed much work over the last couple of decades, employers have had persistent difficulty finding workers who can make the most of these new technologies.

Consider, for example, graphic designers. Until recently, almost all graphic designers designed for print. Then came the Internet and demand grew for web designers. Then came smartphones and demand grew for mobile designers. Designers had to keep up with new technologies and new standards that are still changing rapidly. A few years ago they needed to know Flash; now they need to know HTML5 instead. New specialties emerged such as user-interaction specialists and information architects. At the same time, business models in publishing have changed rapidly.

Graphic arts schools have had difficulty keeping up. Much of what they teach becomes obsolete quickly and most are still oriented to print design in any case. Instead, designers have to learn on the job, so experience matters. But employers can’t easily evaluate prospective new hires just based on years of experience. Not every designer can learn well on the job and often what they learn might be specific to their particular employer.

The labor market for web and mobile designers faces a kind of Catch-22: without certified standard skills, learning on the job matters but employers have a hard time knowing whom to hire and whose experience is valuable; and employees have limited incentives to put time and effort into learning on the job if they are uncertain about the future prospects of the particular version of technology their employer uses. Workers will more likely invest when standardized skills promise them a secure career path with reliably good wages in the future.

Under these conditions, employers do, have a hard time finding workers with the latest design skills. When new technologies come into play, simple textbook notions about skills can be misleading for both managers and economists.

For one thing, education does not measure technical skills. A graphic designer with a bachelor’s degree does not necessarily have the skills to work on a web development team. Some economists argue that there is no shortage of employees with the basic skills in reading, writing and math to meet the requirements of today’s jobs. But those aren’t the skills in short supply.

Other critics look at wages for evidence. Times editors tell us “If a business really needed workers, it would pay up.” Gary Burtless at the Brookings Institution puts it more bluntly: “Unless managers have forgotten everything they learned in Econ 101, they should recognize that one way to fill a vacancy is to offer qualified job seekers a compelling reason to take the job” by offering better pay or benefits. Since Burtless finds that the median wage is not increasing, he concludes that there is no shortage of skilled workers.

But that’s not quite right. The wages of the median worker tell us only that the skills of the median worker aren’t in short supply; other workers could still have skills in high demand. Technology doesn’t make all workers’ skills more valuable; some skills become valuable, but others go obsolete. Wages should only go up for those particular groups of workers who have highly demanded skills. Some economists observe wages in major occupational groups or by state or metropolitan area to conclude that there are no major skill shortages. But these broad categories don’t correspond to worker skills either, so this evidence is also not compelling.

To the contrary, there is evidence that select groups of workers have been had sustained wage growth, implying persistent skill shortages. Some specific occupations such as nursing do show sustained wage growth and employment growth over a couple decades. And there is more general evidence of rising pay for skills within many occupations. Because many new skills are learned on the job, not all workers within an occupation acquire them. For example, the average designer, who typically does print design, does not have good web and mobile platform skills. Not surprisingly, the wages of the average designer have not gone up. However, those designers who have acquired the critical skills, often by teaching themselves on the job, command six figure salaries or $90 to $100 per hour rates as freelancers. The wages of the top 10% of designers have risen strongly; the wages of the average designer have not. There is a shortage of skilled designers but it can only be seen in the wages of those designers who have managed to master new technologies.

This trend is more general. We see it in the high pay that software developers in Silicon Valley receive for their specialized skills. And we see it throughout the workforce. Research shows that since the 1980s, the wages of the top 10% of workers has risen sharply relative to the median wage earner after controlling for observable characteristics such as education and experience. Some workers have indeed benefited from skills that are apparently in short supply; it’s just that these skills are not captured by the crude statistical categories that economists have at hand.

And these skills appear to be related to new technology, in particular, to information technologies. The chart shows how the wages of the 90th percentile increased relative to the wages of the 50th percentile in different groups of occupations. The occupational groups are organized in order of declining computer use and the changes are measured from 1982 to 2012. Occupations affected by office computing and the Internet (69% of these workers use computers) and healthcare (55% of these workers use computers) show the greatest relative wage growth for the 90th percentile. Millions of workers within these occupations appear to have valuable specialized skills that are in short supply and have seen their wages grow dramatically.



This evidence shows that we should not be too quick to discard employer claims about hiring skilled talent. Most managers don’t need remedial Econ 101; the overly simple models of Econ 101 just don’t tell us much about real world skills and technology. The evidence highlights instead just how difficult it is to measure worker skills, especially those relating to new technology.

What is hard to measure is often hard to manage. Employers using new technologies need to base hiring decisions not just on education, but also on the non-cognitive skills that allow some people to excel at learning on the job; they need to design pay structures to retain workers who do learn, yet not to encumber employee mobility and knowledge sharing, which are often key to informal learning; and they need to design business models that enable workers to learn effectively on the job (see this example). Policy makers also need to think differently about skills, encouraging, for example, industry certification programs for new skills and partnerships between community colleges and local employers.

Although it is difficult for workers and employers to develop these new skills, this difficulty creates opportunity. Those workers who acquire the latest skills earn good pay; those employers who hire the right workers and train them well can realize the competitive advantages that come with new technologies.

More blog posts by James Bessen
More on: Economy, Hiring


James Bessen

James Bessen, an economist at Boston University School of Law, is currently writing a book about technology and jobs. You can follow him on Twitter.

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Tuesday, August 26, 2014

A Nation of Shopkeepers

By John Mauldin



“To found a great empire for the sole purpose of raising up a people of customers may at first sight appear a project fit only for a nation of shopkeepers. It is, however, a project altogether unfit for a nation of shopkeepers; but extremely fit for a nation whose government is influenced by shopkeepers.”

– Adam Smith, The Wealth of Nations

One of the great pleasures of writing this letter is the fascinating correspondence and the relationships that develop along the way. The internet has allowed me to meet a wide range of people all over the world – something that never happened to me pre-1999. Not only do I get to meet a wide variety of people, I also come into contact with an even wider range of knowledge and ideas, much of which comes my way from readers who send me work they think I’ll have an interest in. I have a bountiful, never ending source of thoughtful material, thanks to you.

This week’s letter emanates from a rather provocative email I received from David Brin. Science-fiction aficionados will immediately recognize him as the many-time winner of every major sci-fi writing award and an inductee into the Science Fiction Hall of Fame. Non-SF junkies might remember the movie The Postman (with Kevin Costner). Brin’s 2002 book Kiln People is one of my favorites, and I think it’s one of the more important books for trying to understand the impact of technology in our future. Will the science he describes be available? Probably not. But different technological variations on it will be, I think. And the book has a great plot. (David is also something of an expert on the role of and loss of privacy, which is a central theme of the book.)


David is something of a polymath. His degrees are in astrophysics and space science (Caltech and UCSD), but like many science fiction writers he is interested in almost everything. He frequently takes me to task, always constructively, sometimes publicly, about my writing. He is also a bit of an Adam Smith junkie.

I am going to use his latest complaint as a launching point for today’s letter. He was responding to last week’s Outside the Box, about the future of robotics and automation, which I introduced with a shot off the bow at the reigning Keynesian paradigm. He objects.

Today’s letter will be more philosophical in nature than most – we won’t be looking for technical signals; but it’s August – half the trading world is on vacation (except for the unsleeping computers run by high-frequency traders, which create the bulk of the volume these days), and so any technical signal we picked out this week would be suspect. Yes, August is a great time to think philosophical thoughts about the political economy. So, without further ado, let’s see what has my close friend Dr. Brin so upset.

Supply-Side (Voodoo) Economics?


John, excellent missive on automation.  I share your overall optimism.
Still... although Keynesianism deserves lots of criticism for the 30% of the time that it has proved wrong... and Hayek had a lot of good and important things to say... it remains disappointing that you do not use your influence to help hammer nails into the coffin of the Rentier Caste's catechism... Supply Side (Voodoo) Economics (SSVE), which is not just 30% wrong. It has proved to be almost 100% diametrically opposite to right, with every forecast that SSVE ever made having proved to be calamitously wrong.

Adam Smith might have had some problems with Keynes... and some with Hayek. But Smith warned us incessantly about the horrific economic effects of favoring monopolistic-collusive rent-seeking oligarchs, who destroyed freedom and markets in 99% of human cultures. When the Olde Enemie – who wrecked freedom and markets across 6000 years... the enemy Smith warned against and the US Founders rebelled against... comes roaring back... aren't you behooved to help raise the hue and cry?

Some Thoughts on Adam Smith

David,
You will perhaps forgive me if I use you as a straw man to draw out a few principles for my readers. And I’m sure you’ll have an eloquent answer posted within a few hours. (Interested readers will be able to find that at http://davidbrin.blogspot.com/ along with fascinating commentary on all matters technological and philosophical. David relishes his role as self-appointed uber-contrarian.)

Your comments on Keynesianism and supply-side economics are so wrong that I think I will hold my tongue and save my criticisms of them for next week. You are expressing a common meme that totally buys into the reigning economic nonsense that passes for thinking about economic theory – a sin you’re usually not guilty of. But I’m not about to respond to you (not anymore!) with an off-the-top-of-my-head analysis, so I will spend the bulk of my week thinking about secular stagnation and the causes of growth, and then respond.

Neither is what follows totally off the top of my head; there was some work involved. What I would like to take up is Adam Smith views on the rentier class, which, for me at least, is a far more intellectually interesting topic than Keynesianism versus… SSVE. You keep quoting Adam Smith at me as if somehow Adam Smith’s is a gospel that must be adhered to. And I admit to being a serious Adam Smith enthusiast. Smith demonstrates an amazing amount of intellectual prowess. I stand in awe. His insight seems even more profound when you put the man in the context of his times.


And Smith was totally a man of his times. He was making observations about the changing nature of the economy and wealth in mid-18th-century Scotland and England, and his thoughts were disturbing to many of his associates at the top – the 1%, in modern parlance. He described a political economy in such stunning detail that it has influenced minds for almost 250 years. Yet, he was an early explorer in a land (that of the political economic landscape) that was not yet much trodden. He did however come along at a time when people were trying hard to understand the changes erupting around them. England especially and Scotland to some extent were transforming from a feudal agrarian society (which Smith clearly did not like) to one that was more commercial, as the Industrial Revolution took root and began to send forth green shoots.

Smith welcomed change, but with some reservations that are not often talked about. We’ll look at some of them today. As we will see, Smith was a complicated person. But he is best understood if we put him back into his times and recognize that he is not penning his observations on the “wealth of nations” to deal with our situation today, though many of his insights are timeless.

Over the last 200 years, the ways scholars have looked at Adam Smith have changed. There have been Adam Smith fads. While the fact is not much discussed in modern-day polite society, Smith was a clear influence on Hegel, who of course informed Marx. As hard as it is to understand today, there were those along the way who thought Smith was foundational to Marxism. In the 19th century, socialists and neoliberals of all stripes approvingly cited Smith’s Wealth of Nations.

Smith was not held in much favor by classical economists, though that has changed. Who can forget Margaret Thatcher moaning that she could not win the hearts and minds of Scotland, “‘home of the very same Scottish Enlightenment which produced Adam Smith, the greatest exponent of free enterprise economics till Hayek and Friedman.” Yet only a few years later Gordon Brown (a Scot and English Prime Minister) offered up a speech in which he claimed that Adam Smith (who lived in the region Brown represented in Parliament) would in fact be center-left, were he on the scene today.

You, David, are seemingly part of a coterie described by Neil Davidson in “The Battle for Adam Smith” in the Scottish Review of Books. (Note: Davidson makes some points I categorically disagree with, but I think he has an excellent handle on the history.)

Finally, there have been attempts, perhaps surprisingly from the radical left, to discern in Smith’s work a model of a ‘real free market’ which has been violated by ‘the global corporate system’. As John McMurty writes, ‘every one of Smith’s classical principles of the free market has been turned into its effective opposite’. This is an attractively counter-intuitive idea, which challenges the neoliberals on their own terms. Other writers, like the late Giovanni Arrighi have gone further and argued, not only that the market system envisaged by Smith can be distinguished from capitalism, but that ‘market-based growth’ distinct from ‘capitalist growth’ is now embedded in Chinese or perhaps East Asian development more generally.

[Sidebar: American readers may be puzzled to learn that neoliberalism is a label for “economic liberalism which advocates under classical economic theory support for economic liberalization, privatization, free-trade trauma, open markets, deregulation, and reductions in government spending in order to enhance the role of the private sector of the economy.” Who knew that the large fraction of my readers who consider themselves conservative thinkers are actually neoliberals? Sadly, the word is now generally used pejoratively by the left. Personally, I think it is more fun to think of oneself as a neoliberal than as an Austrian.]

On the other hand, conservative British Parliament members of the Whig Party were castigated by one observer for superstitiously worshipping Smith. And certainly, (conservative) neoliberal thinkers have quoted Smith appreciatively.

Thus, it turns out that Smith can be read in many different ways. “A man hears what he wants to hear and disregards the rest.” Let’s take a look at some context.

In Book 1 of The Wealth of Nations, Smith noted that the division of labor was changing the character of commercial society. In his classic analysis of the manufacturing of pins (probably from French sources), he wrote about the amazing productivity possible when different aspects of the manufactory process were divided among artisans (laborers). (He decided there were 18 different processes involved, although current scholarship would suggest there were as few as nine, but his point is still made.) He saw the same dynamic at work in a variety of industries, and he approved. He really did not like the feudal system and “overlords” (rentiers) who benefited from association with the king and other authorities, living on “rents” for which they performed no useful work. He valued productive activity far more than anything else, apparently.

I think it will be useful here to pull a few paragraphs from Book 1 of Wealth of Nations. (Interested readers can find the whole book for free at The Library of Economics and Liberty.)

To take an example, therefore, from a very trifling manufacture; but one in which the division of labour has been very often taken notice of, the trade of the pin-maker; a workman not educated to this business (which the division of labour has rendered a distinct trade), nor acquainted with the use of the machinery employed in it (to the invention of which the same division of labour has probably given occasion), could scarce, perhaps, with his utmost industry, make one pin in a day, and certainly could not make twenty. But in the way in which this business is now carried on, not only the whole work is a peculiar trade, but it is divided into a number of branches, of which the greater part are likewise peculiar trades. 

One man draws out the wire, another straights it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving, the head; to make the head requires two or three distinct operations; to put it on is a peculiar business, to whiten the pins is another; it is even a trade by itself to put them into the paper; and the important business of making a pin is, in this manner, divided into about eighteen distinct operations, which, in some manufactories, are all performed by distinct hands, though in others the same man will sometimes perform two or three of them. 

I have seen a small manufactory of this kind where ten men only were employed, and where some of them consequently performed two or three distinct operations. But though they were very poor, and therefore but indifferently accommodated with the necessary machinery, they could, when they exerted themselves, make among them about twelve pounds of pins in a day. 

There are in a pound upwards of four thousand pins of a middling size. Those ten persons, therefore, could make among them upwards of forty-eight thousand pins in a day. Each person, therefore, making a tenth part of forty-eight thousand pins, might be considered as making four thousand eight hundred pins in a day. 

But if they had all wrought separately and independently, and without any of them having been educated to this peculiar business, they certainly could not each of them have made twenty, perhaps not one pin in a day; that is, certainly, not the two hundred and fortieth, perhaps not the four thousand eight hundredth part of what they are at present capable of performing, in consequence of a proper division and combination of their different operations.

In every other art and manufacture, the effects of the division of labour are similar to what they are in this very trifling one; though, in many of them, the labour can neither be so much subdivided, nor reduced to so great a simplicity of operation. The division of labour, however, so far as it can be introduced, occasions, in every art, a proportionable increase of the productive powers of labour. 

The separation of different trades and employments from one another seems to have taken place in consequence of this advantage.

But that classic observation and explanation of productivity gains from the division of labor and free markets is a long way from the laissez-faire capitalism of Hayek and Friedman.

Let’s return to Neil Davidson:

Anachronistic misconceptions concerning his work could of course be corrected by the radical expedient of actually reading The Wealth of Nations and The Theory of Moral Sentiments, preferably after situating them in their historical context, namely Scotland’s emergence from feudalism. When Smith attacked unproductive labour, he was not making some timeless critique of state employees, but thinking quite specifically about Highland clan retainers. When he opposed monopolies, he was not issuing a prophetic warning against the nationalisation of industries in the twentieth century, but criticising those companies which relied for their market position on the possession of exclusive royal charters in the eighteenth. Above all, unlike his modern epigones, he did not see the market as a quasi–mystical institution that should be made to penetrate every aspect of social life; but rather as a limited mechanism for liberating humanity’s economic potential from feudal and absolutist stagnation.

We have to remember that Adam Smith was writing The Wealth of Nations in 1776 – prior to Watt and the steam engine. The Industrial Revolution was in its infancy. The pin manufacturing process described in Smith’s Book 1 produced about 5000 pens a day for each laborer’s work. By 1820 there were 11 pin factories in Gloucester alone, yet 119 years later (in 1939) there were only 12 in all of England.

By the late 1970s there were only two. But the productivity of the manufacturing process had grown to 800,000 pins per day per person! That is an increase of 160 times. Of course that is using automated and computer-driven machines. Not that I would suggest it, but if you start searching for information on pin manufacturing today, you quickly get bogged down in the intricacies of manufacturing procedures for hundreds of different types of pins, all of which are ridiculously cheap. My guess is that productivity has leapt significantly further in the last few decades.



Smith was troubled by some of the implications that he saw in early manufacturing jobs. Remember when you read the excerpt from Wealth of Nations below that this is from one of the leading lights of what was called the Scottish Enlightenment. If someone were to say those things today, we would question his enlightenment. Just saying. Back to Davidson (emphasis mine):

Even so, the advocacy of Smith and his colleagues for what they called ‘commercial society’ was very conditional indeed. He intuited, long before capitalist industrialisation began in earnest, that it would lead to massive deterioration in the condition of labourers and their reduction to mere ‘hands’. Understood in the context of the Scottish Enlightenment conception of human potential, the description of pin manufacture at the beginning of The Wealth of Nations, reproduced from 2007 on £20 banknotes, not only celebrates the efficiency of the division of labour, but also shows the soul-destroying repetition that awaited the new class of wage labourers. In Book V, in contrast to the more frequently cited Book I, Smith explicitly considered the way in which the division of labour, while increasing the productivity of the labourers, did so by narrowing their intellectual horizons:

The man whose whole life is spent in performing a few simple operations, of which the effects, too, are perhaps always the same, or very nearly the same, has no occasion to assert his understanding, or to exercise his invention, in finding out expedients for removing difficulties which never occur. He naturally loses, therefore, the habit of such exertion, and generally becomes as stupid and ignorant as it is possible for a human creature to become. The torpor of his mind renders him not only incapable of relishing or bearing a part in any rational conversation, but of conceiving any generous, noble, or tender sentiment, and consequently of forming any just judgment concerning many even of the ordinary duties of private life. Of the great and extensive interests of his country he is altogether incapable of judging; and unless very particular pains have been taken to render him otherwise, he is equally incapable of defending his country in war.… His dexterity at his own particular trade seems, in this manner, to be acquired at the expense of his intellectual, social, and martial virtues.

Smith contrasts this unhappy state of affairs with that existing under earlier modes of subsistence – modes which, remember, he was committed to transcending:

It is otherwise in the barbarous societies, as they are commonly called, of hunters, of shepherds, and even of husbandmen in that rude state of husbandry that precedes the improvement of manufactures, and the extension of foreign commerce. In such societies, the varied occupations of every man oblige every man to exert his capacity, and to invent expedients for removing difficulties which are continually occurring. Invention is kept alive, and the mind is not suffered to fall into that drowsy stupidity, which, in a civilized society, seems to benumb the understanding of the people.... Every man, too, is in some measure a statesman, and can form judgments concerning the interest of the society, and the conduct of those who govern it.

I have a fantasy about bringing Adam Smith into the world of 2014. I think he would be overwhelmed, totally fascinated, and at times horrified to see what his intellectual children have done in the last 238 years. But what he would also see is the massive improvement in the standard of living for even those we consider to be poor, at least in the developed world. Overall, he would have to be pleased.

Yet, to show him pictures of the factories that have developed over the centuries or to take him to some of the manufacturing companies in Asia, where thousands of workers sit on benches doing the same thing day after day after day, would disturb him. And yet, there are lines of workers waiting to take those jobs.

[As an aside, David, one of my great hopes for robotics and automation (which I think was apparent in last week’s Outside the Box) is that they will help relieve humanity of mind-numbingly repetitive work and allow us to explore more interesting, life-fulfilling options. Granted, that means we have to figure out how to allow people to make a living in the process. But the transformation of technology in any particular field has always been a rather messy business in regards to labor. Going from an agrarian society to where, in the US, only 1% work in agriculture today (yet feed much of the world) was tumultuous and at times violent. Change is not easy.

It appears that the new generation of robots is allowing companies in the US (and the rest of the developed world) to be far more competitive and is actually increasing the number of jobs in the US as manufacturing is brought back here. While that trend is good for our workers, it means workers somewhere else are being squeezed. But back to our original theme.]

Adam Smith, Revolutionary

I agree with Milton Friedman in the essay he presented at the Adam Smith Institute on its bicentennial in St. Andrews:

Adam Smith was a radical and revolutionary in his time – just as those of us who today preach laissez faire are in our time. He was no apologist for merchants and manufacturers, or more generally other special interests, but regarded them as the great obstacles to laissez faire – just as we do today.

Friedman went on to note that contemporary free-marketers would have to extend their categories of special interests, broadening “the tribes of monopolists to include not only enterprises protected from competition but also trade unions, school teachers, welfare recipients, and so on and on.”

Let’s move on to your point about the depredations of crony capitalism and the use of government to create special opportunities for profit not available to ordinary citizens as one of the main sources of headwinds to growth (Will get back to your critique of supply-side economics. What you called the Olde Enemie.) I think one of the primary roles of government should be to create a level playing field. I think we can agree on this. And we can find further agreement in examining the original thinking of Adam Smith in its historical context, rather than in trying to apply it to the current structure of capitalism.

Sadly, politics as it operates today is the art of employing highly paid lobbyists and other insiders to get governments to enact laws that you favor. We can’t entirely get away from that system (as some of my libertarian anarchist friends would like to do), as we do need a government that will provide and enforce rules and regulations so that the playing field can remain level. But special benefits are not part of a level playing field.

You focus on what I like to call crony capitalism. That is just one aspect of your critique, but let’s deal with it first.

One simplistic way to subvert cronyism would be to lower the corporate tax rate to something like 15%, making the US as competitive as any nation in the world, but at the same time eliminate all of the 3000-odd tax benefits doled out to various corporations. When you and I personally pay more in income taxes than General Electric, something is seriously wrong. Start the corporate tax at $100,000. The form is a postcard. How much your corporation makes minus $100,000 times 15% is your tax. Income generated outside of the United States is taxed at 10%. End of story.  I understand that 15% might seem low to most people, but it would dramatically increase the amount of taxes that we actually collect.

Whoever is the next president should direct (in concert with Congress) the various federal departments to take another look at rules that favor one company or group over another and figure out how to eliminate them. That is not just corporations. I agree with Friedman: include trade unions and other associations. Get rid of the barriers of entry to industries and jobs. Credentials are all well and fine, but not barriers to entry.
(I would also restructure the personal income tax code in such a way as to eliminate almost all deductions, but that is an argument for another letter.)

Next week I’ll deal with your confusion about the roles of supply-side economics and Keynesianism in steering the economy. This is actually a very important topic, as it relates to the current economic discussion about secular stagnation (to which a passing reference in the robotics letter probably caught your attention). You are confusing correlation with causation.

What to do about economic growth is perhaps the single most important question of our time, as the demographics of the developed world are shifting in such a way is that we will simply not have enough money for us all to be able to retire in the style to which we have been accustomed by our governments. An extra 1-2% of growth per year, however, can cover a multitude of structural secular sins. Just as true stagnation would transform even minor sins into those worthy of capital punishment.
As Dr. Woody Brock frequently notes, growth is a choice. And most of the choices that drive growth or hobble it have nothing to do with monetary policy. Monetary policy is just one part of the equation. The banter today about structural secular stagnation is more about making excuses for the failure of theoretical positions than it is about how to actually apply the mechanisms that would allow the “invisible hand” of Adam Smith to produce growth.

And, in this, Adam Smith is 100% relevant: “To found a great empire for the sole purpose of raising up a people of customers may at first sight appear a project fit only for a nation of shopkeepers. It is, however, a project altogether unfit for a nation of shopkeepers; but extremely fit for a nation whose government is influenced by shopkeepers.”

By “raising up a people of customers” Smith means that focusing on overall economic growth and specifically on the growth of the income of individuals should be at the forefront of the social project. A government that does not allow for increases in productivity and thus an improvement in lifestyles will not be one in which the citizens are happy.

We’ll close with that thought for now, but let me offer a precursor to next week, from a recent essay by Woody:

1. Northern Europe Pre- and Post-Industrial Revolution circa 1700-1850: The growth in productivity is estimated to have been zero, on average, in the period 1000 BC to 1700 AD. Productivity growth did not increase, nor did living standards, nor did life expectancy. This continued to be the case worldwide after 1700, except in Northwestern Europe where the Dutch Republic and England (after its Glorious Revolution of 1688) adopted new policies including patent protection, the rule of law, respect of property rights, and so forth. Nations that did not follow suit stagnated.

2. China Pre- and Post-1979: Growth during the Cultural Revolution was negative. It then exploded to over 10% for twenty years. Why this reversal? It was largely because entrepreneurial behavior was de‐criminalized. Recall Premier Deng’s legendary mandate, “It is now glorious to go get rich.” Additionally, the government adopted a massive infrastructure plan that represented productive investment spending in contrast to the unproductive spending that occurred during 2008-2012 (“see-through cities”).

San Antonio, Washington DC, NYC(?), and Training Day

I have been enjoying my time at home these last few weeks. Right now I am scheduled to be nowhere else until I head to San Antonio for the Casey Research Summit September 19-21. My next trip after that falls at the end of the month, when I head to Washington DC for a private conference and a few meetings. That is all that is on my schedule for the next 60 days, and then it gets a little busy. I can’t recall having this much time at home for a decade or two, at least.

Bill Dunkelberg, the chief economist for the National Federation of Independent Business, came to see me last week, and we spent the day trying to decide whether to write a book about the future of work. It is a complicated project, but it is part and parcel of the theme we discussed today, which is economic growth and the division of labor. If the work landscape shifts under the feet of an increasingly large number of people as their jobs are automated, then that means we have to help people transition. And better yet, train them in disciplines that have very little chance of being automated in the next 30 or 40 years.

From the perspective of the Long View, our education system is completely broken. We are not training our children to deal with the future, and we are not helping people transition into sustainable independence. Our welfare and disability rolls are growing faster than new jobs are being generated. Dunk and I are trying to come up with an outline and research topics over the next few weeks, just to see if we even think we have the capability to write on the topic. I’ll let you know.

One of the benefits of being home is the opportunity to get to the gym on a regular schedule. I can feel and see the results. Plus, it is easier to adhere to a stricter diet plan (basically shunning all extraneous carbs), and that is helping, too. It seems strange to me, but I will be turning 65 in another month (on October 4). My goal is to be able to do 65 push ups and to be close to my target ideal weight by then. I am getting into the gym nearly every day and trying to schedule a trainer for six days out of seven each week. Some part of my body is sore pretty much all the time; the trainer just makes sure it’s a different part every day. Getting out of shape was just not a good idea.

I was having lunch today with some of my kids and was surprised to learn the Labor Day is next weekend. Where has the summer gone? And speaking of summer vacation, I note that Senator Rand Paul spent some time in Guatemala performing eye surgeries. I read that he also visited with some patients he treated there 15 years ago. Journalists and political commentators are always talking about optics. Sen. Paul is doing something about optics in a tangible way. His patients will be able to line up a putt with their own eyes. Optics indeed.

I smile at the small irony that I will be writing about growth and labor productivity next week, on Labor Day weekend. I didn’t plan it that way, but it does make it more fun. Have a great week.
Your trying to increase his personal productivity analyst,
John Mauldin



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Thursday, August 21, 2014

Stop Investing in Leveraged ETFs

By Andrey Dashkov

Bigger, faster, better. That’s the turbocharged investment we all want. Miller’s Money Forever subscribers who pay close attention to our portfolio, though, will notice that we don’t hold leveraged ETFs—those with “2x” or “inverse” or “ultra” in their names, which some investors mistake for “better.”

Exchange-traded funds (ETFs) are a great tool for many portfolios. They allow investors to profit from movements in a huge variety of assets grouped by industry, geography, presence in a certain index, or other criteria. You can find ETFs tracking automobile producers, cotton futures, or cows.

For our purposes, ETFs make it easier to diversify within a certain group of companies—easier because you don’t have to buy them individually. You buy the ETF and leave it to its managers to balance the portfolio when needed.

We have several ETFs in the Money Forever portfolio, and they have served us well so far. They expose us to several universes, such as international stocks, foreign dividend-paying companies, convertible securities, and others.

Why Turbocharged Isn’t Always Better


So, if we think the underlying index or asset class will move in our favor, why wouldn’t we opt for the turbocharged version—the versions that use leverage (credit) to achieve gains two times higher?
First, because we’re very cautious about volatility, and leveraged ETFs are designed to be less stable than the underlying assets. Second, there is a trick to leveraged ETFs that can make your investment in them stink even if the underlying index or asset does well.

Before we get to the details, let me pose two questions:
  • If the S&P 500 goes up by 5% over several days, how much would a 2x leveraged ETF based on the index earn?
  • If the S&P 500 goes up and down, then rises, and after a while ends up flat, will our ETF end up flat too?

If you answer 10% to the first question, you may be correct, and that’s the caveat: you won’t be correct 100% of the time. You can’t just multiply an index’s total gain by the ETF’s factor to gauge how much you’ll earn, because leveraged ETFs track daily gains, not total ones.

To show how that works, here’s a brief example that will also answer question number two.

Day # Index Price Daily Return ETF Price
Index ETF
1,900 $100.00
1 1,800 -5.26% -10.53% $89.47
2 1,870 3.89% 7.78% $96.43
3 2,000 6.95% 13.90% $109.84
4 1,900 -5.00% -10.00% $98.86
Total return 0.0% -1.1%
Source: TheTradeSurfer


What you’re looking at here is a hypothetical index with a value of 1,900 at the beginning of our period. It goes up and down for four days, and then is back to 1,900 by the end of day 4. There is also an ETF that starts with a price of $100 and doubles the daily gains of the index.


On the first day, the index goes down to 1,800 for a daily loss of 5.26%. This forces the daily loss of the ETF to be 10.53% (including rounding error), and the resulting price of the ETF is $89.47. The next day the index is up 3.89%, forcing the ETF to grow by 7.78%, to $96.43, and so on.

We designed this table to show that even though the underlying index is back to 1,900 in five days, returning 0% in total gain, the ETF is down 1.1% by the end of day 4.

It works like this because ETFs are designed to track daily returns, not mirror longer-term performance of the underlying index, and because of how cumulative returns work. If one share of the ETF costs $100 at the beginning of the period and the market dropped 5%, we should expect double the drop. Our share would now be worth $90. If the next day it reverses and goes up 5%, we should expect double the increase. We would be right in doing so, but our share would be worth $99 now, not $100—because it increased 10% above the $90 closing price the day before.

Leveraged ETFs Are for Traders, Not Investors


If a trader is smart and lucky, she or he would buy the ETF at the beginning of day 3 at $96.43, sell at $109.84, and realize a gain of 14%. But if one bought at day 0 and held until the end of our period, one would lose money even though the underlying index ended up flat.

In general, no one can predict where an ETF will end up because it’s impossible to tell in advance what pattern the underlying index will follow. In practice, it means that an ETF only partially tracks the underlying index; its performance also depends on its own past results.

The ideal case for investing in an ETF (we assume it’s long the market) would be to buy it at the beginning of a multi-day, uninterrupted uptrend. In that case, it would come very close to doubling the market’s performance. But such winning streaks are impossible to forecast, and short-term trading like this is not our focus.

We don’t recommend leveraged ETFs in our portfolio because they’re geared for traders, and we take a longer-term perspective. We are investors.

The additional potential reward from a turbocharged ETF doesn’t warrant the additional risk, particularly when you’re investing retirement money. There are safer ways to maximize your retirement income. Learn more about our strategies for doing just that by signing up for Miller’s Money Weekly, our free weekly e-letter that educates conservative investors about timely investment strategies. You’ll receive ahead-of-the-curve financial insight and commentary right in your inbox every Thursday. Start building a rich retirement by signing up today.

The article Stop Investing in Leveraged ETFs was originally published at Millers Money


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Tuesday, August 19, 2014

Bubbles, Bubbles Everywhere

By John Mauldin



The difference between genius and stupidity is that genius has its limits.
– Albert Einstein
Genius is a rising stock market.
– John Kenneth Galbraith
Any plan conceived in moderation must fail when circumstances are set in extremes.
– Prince Metternich
I'm forever blowing bubbles, Pretty bubbles in the air
They fly so high, nearly reach the sky, Then like my dreams they fade and die
Fortune's always hiding, I've looked everywhere
I'm forever blowing bubbles, Pretty bubbles in the air

You can almost feel it in the air. The froth and foam on markets of all shapes and sizes all over the world. It’s exhilarating, and the pundits who populate the media outlets are bubbling over. There’s nothing like a rising market to lift our moods. Unless of course, as Prof. Kindleberger famously cautioned (see below), we are not participating in that rising market. Then we feel like losers. But what if the rising market is … a bubble? Are we smart enough to ride it high and then bail out before it bursts? Research says we all think that we are, yet we rarely demonstrate the actual ability.

My friend Grant Williams thinks the biggest bubble around is in complacency. I agree that is a large one, but I think even larger bubbles, still building, are those of government debt and government promises. When these latter two burst, and probably simultaneously, that will mark the true bottom for this cycle now pushing 90 years old.

So, this week we'll think about bubbles. Specifically, we'll have a look at part of the chapter on bubbles from Code Red, my latest book, coauthored with Jonathan Tepper, which we launched late last year. I was putting this chapter together about this time last year while in Montana, and so in a lazy August it is good to remind ourselves of the problems that will face us when everyone returns to their desks in a few weeks. And note, this is not the whole chapter, but at the end of the letter is a link to the entire chapter, should you desire more.

As I wrote earlier this week, I am NOT calling a top, but I am pointing out that our risk antennae should be up. You should have a well-designed risk program for your investments. I understand you have to be in the markets to get those gains, and I encourage that, but you have to have a discipline in place for cutting your losses and getting back in after a market drop.

There is enough data out there to suggest that the market is toppy and the upside is not evenly balanced. Take a look at these four charts. I offer these updated charts and note that some charts in the letter below are from last year, but the levels have only increased. The direction is the same. What they show is that by many metrics the market is at levels that are highly risky; but as 2000 proved, high-risk markets can go higher. The graphs speak for themselves. Let’s look at the Q-ratio, corporate equities to GDP (the Buffett Indicator), the Shiller CAPE, and margin debt.






We make the case in Code Red that central banks are inflating bubbles everywhere, and that even though bubbles are unpredictable almost by definition, there are ways to benefit from them. So, without further ado, let’s look at what co-author Jonathan Tepper and I have to say about bubbles in Chapter 9.

Easy Money Will Lead to Bubbles and How to Profit from Them

Every year, the Darwin Awards are given out to honor fools who kill themselves accidentally and remove themselves from the human gene pool. The 2009 Award went to two bank robbers. The robbers figured they would use dynamite to get into a bank. They packed large quantities of dynamite by the ATM machine at a bank in Dinant, Belgium. Unhappy with merely putting dynamite in the ATM, they pumped lots of gas through the letterbox to make the explosion bigger. And then they detonated the explosives. Unfortunately for them, they were standing right next to the bank. The entire bank was blown to pieces. When police arrived, they found one robber with severe injuries. They took him to the hospital, but he died quickly. After they searched through the rubble, they found his accomplice. It reminds you a bit of the immortal line from the film The Italian Job where robbers led by Sir Michael Caine, after totally demolishing a van in a spectacular explosion, shouted at them, “You’re only supposed to blow the bloody doors off!”

Central banks are trying to make stock prices and house prices go up, but much like the winners of the 2009 Darwin Awards, they will likely get a lot more bang for their buck than they bargained for. All Code Red tools are intended to generate spillovers to other financial markets. For example, quantitative easing (QE) and large-scale asset purchases (LSAPs) are meant to boost stock prices and weaken the dollar, lower bonds yields, and chase investors into higher-risk assets. Central bankers hope they can find the right amount of dynamite to blow open the bank doors, but it is highly unlikely that they’ll be able to find just the right amount of money printing, interest rate manipulation, and currency debasement to not damage anything but the doors. We’ll likely see more booms and busts in all sorts of markets because of the Code Red policies of central banks, just as we have in the past. They don’t seem to learn the right lessons.

Targeting stock prices is par for the course in a Code Red world. Officially, the Fed receives its marching orders from Congress and has a dual mandate: stable prices and high employment. But in the past few years, by embarking on Code Red policies, Bernanke and his colleagues have unilaterally added a third mandate: higher stock prices. The chairman himself pointed out that stock markets had risen strongly since he signaled the Fed would likely do more QE during a speech in Jackson Hole, Wyoming, in 2010. “I do think that our policies have contributed to a stronger stock market, just as they did in March of 2009, when we did the last iteration [of QE]. The S&P 500 is up about 20 percent plus and the Russell 2000 is up 30 percent plus.” It is not hard to see why stock markets rally when investors believe the most powerful central banker in the world wants to print money and see stock markets go up.

To continue reading this article from Thoughts from the Frontline – a free weekly publication by John Mauldin, renowned financial expert, best-selling author, and Chairman of Mauldin Economics – Please Click Here.

Important Disclosures



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Monday, August 18, 2014

Casey Research "Our Highest Rated Speech of All Time"

By Olivier Garret, Chief Executive Officer

Never in my life have I seen a round of applause like this one… and at an event normally composed of conservative, introspective investors to boot. But most surprising of all - and I must admit in my bias here  they were applauding a lawyer. A defense lawyer at that.

The usual fare at our conferences has much more to do with how to keep your money safe (and invest it to grow, of course). But we always prefer to mix in a few speakers to give us a real, on the ground reality check of what’s happening to our freedoms. Thus, when we invited constitutional law and criminal defense attorney Marc J. Victor to speak, we expected he'd share his insights into a slowly eroding respect for individual rights. He did not. Instead, he showed us just how bad things are getting and at a breakneck pace just beyond the public eye.

His talk was downright chilling. And now, for the first time, I'm excited to share his Casey Summit presentation in its entirety with all of you. He's the highest reviewed outside speaker we've ever gotten feedback on. This is a must watch.

But first, I'm sharing it with you now because Mr. Victor has agreed to appear once again at next month's Summit with a complete update on his talk. I just checked with our events team, and they say that, per usual, the Summit will likely end up selling out the hotel. There are just over a dozen rooms left for next month's conference.

So, you must register now if you want one of the few remaining rooms on site.

And now, Marc's full presentation:


Marc's shiver inducing talk is exactly the kind of amazing speeches our regular summit attendees have come to expect of our always sold out events. If you've never been to a Casey Summit before, now is the perfect chance to try one.

Click here for complete details on the upcoming conference September 19-21 in the beautiful San Antonio hill country.

Sincerely,

Olivier Garret, CEO
Casey Research



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Friday, August 15, 2014

The Biggest Lesson from Microsoft’s Recent Battle with the US Government

By Nick Giambruno, Senior Editor, InternationalMan.com

A court ruling involving Microsoft’s offshore data storage offers an instructive lesson on the long reach of the US government—and what you can do to mitigate this political risk.

A federal judge recently agreed with the US government that Microsoft must turn over its customer data that it holds offshore if requested in a search warrant. Microsoft had refused because the digital content being requested physically was located on servers in Ireland.

Microsoft said in a statement that “a US prosecutor cannot obtain a US warrant to search someone’s home located in another country, just as another country’s prosecutor cannot obtain a court order in her home country to conduct a search in the United States.”

The judge disagreed. She ruled that it’s a matter of where the control of that data is being exercised, not of where the data is physically located.

This ruling is not at all surprising. It’s long been crystal clear that the US will aggressively claim jurisdiction if the situation in question has even the slightest, vaguest, or most indirect connection. Worse yet, as we’ve seen with the extraterritorial FATCA law, the US is not afraid to impose its own laws on foreign countries.
One of the favorite pretexts for a US connection is the use of the US dollar. The US government claims that just using the US dollar—which nearly every bank in the world does—gives it jurisdiction, even if there were no other connections to the US. It’s quite obviously a flimsy pretext, but it works.

Recently the US government fined (i.e., extorted) over $8 billion from BNP Paribas for doing business with countries it doesn’t like. The transactions were totally legal under EU and French law, but illegal under US law. The US successfully claimed jurisdiction because the transactions were denominated in US dollars—there was no other US connection.

This is not typical of how most governments conduct themselves. Not because they don’t want to, but because they couldn’t get away with it. The US, on the other hand—as the world’s sole financial and military superpower (for now at least)—can get away with it.

This of course translates into a uniquely acute amount of political risk for anyone who might fall under US jurisdiction somehow, especially American citizens. A prudent person will look to mitigate this risk through international diversification.

So let’s see what kinds of lessons this recent court ruling offers for those formulating their diversification strategies.

The Biggest Lesson


The most important lesson of the Microsoft case is that any connection to the US government —no matter how small—exposes you to big risks.

If there’s anything connected to the US, you can count on the US government using that vulnerability as a pressure point. Microsoft, being a US company with a huge US presence, is of course exposed to having its arms easily twisted by the US government—regardless if the data it stores is physically offshore.

Now let’s assume the company in question was a non-US company, with no US presence whatsoever (not incorporated in the US, no employees in the US, no servers or computer infrastructure in the US, no bank accounts in the US): then the US government would have a much more difficult time accessing the data and putting pressure on the company to comply with its demands.

It’s important to remember that even if a company or person is more immune to traditional pressures, there are plenty of unconventional ways the US can respond.

The US government could always resort to hacking, blackmail, or other acts of subterfuge to access foreign data that is seemingly out of its reach. This is where encryption comes in. We know from the Edward Snowden revelations that when properly executed, encryption works. For all practical purposes as things are today, strong and proper encryption places data beyond the reach of any government or anyone without the encryption keys.

Of course, there is no such thing as 100% protection, and there never will be. But using encryption in combination with a company that—unlike Microsoft—is 100% offshore is the best protection you can currently get for your digital assets.

Once you get the hang of it, encryption is actually easy to use. Be sure to check out the Easy Email Encryption guide; it’s free and located in the Guides and Resources section of the IM site.

How easily the US can access your offshore digital data will also come down to the politics and relationship between the US and the country in question. You can count on the UK, Canada, Australia, and others to easily roll over for anything the US wants. On the other hand, you can bet that a country with frosty relations with the US—like China or Russia—will toss most US requests in the garbage. This political arbitrage is what international diversification is all about.

The lessons of the Microsoft case extend to offshore banking.

It’s much better to do your offshore banking with a bank that has no branch in the US. For example, if you open an HSBC account in Hong Kong, the US government can simply pressure HSBC’s large presence in the US to get at your Hong Kong account—much like how the US government pressured Microsoft’s US presence to get at its data physically stored in Ireland.

Obtaining the Most Diversification Benefits


Most of us know about the benefits of holding uncorrelated assets in an investment portfolio to reduce overall risk. In a similar fashion, you can reduce your political risk—the risk that comes from governments. You do this by spreading various aspects of your life—banking, citizenship, residency, business, digital presence, and tax domicile—across politically uncorrelated countries to obtain the most diversification benefits. The optimal outcome is to totally eliminate your dependence on any one country.

This means you’ll want to diversify into countries that won’t necessarily roll over easily for other countries. This is of course just one consideration, and it needs to be balanced with other factors. For example, Russia isn’t going to be easily pressured by the US government. But that doesn’t mean it’s a good idea to bank there.

Personally, I’m a fan of jurisdictions that are friendly with China—which helps insulate them from US pressure—but have a degree of independence and are competently run, like Hong Kong and Singapore.
Naturally, things can change quickly. New options emerge, while others disappear. This is why it’s so important to have the most up-to-date and accurate information possible. That’s where International Man comes in. Be sure to check out our Going Global publication, where we discuss the latest and best international diversification strategies in great, actionable detail.



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Wednesday, August 13, 2014

Low and Expanding Risk Premiums Are the Root of Abrupt Market Losses

By John Mauldin


Risk premiums. I don’t know anyone who seriously maintains that risk premiums are anywhere close to normal. They more closely resemble what we see just before a major bear market kicks in. Which doesn’t mean that they can’t become further compressed. My good friend John Hussman certainly wouldn’t argue for such a state of affairs, and this week for our Outside the Box we let John talk about risk premiums.

Hussman is the founder and manager of the eponymous Hussman Funds, at www.Hussmanfunds.com. Let me offer a few cautionary paragraphs from his letter as a way to set the stage. I particularly want to highlight a quote from Raghuram Rajan, who impressed me with his work and his insights when we spent three days speaking together in Scandinavia a few years ago. At the time he was a professor at the University of Chicago, before he moved on to see if he could help ignite a fire in India.

Raghuram Rajan, the governor of the Reserve Bank of India and among the few economists who foresaw the last financial crisis, warned last week that “some of our macroeconomists are not recognizing the overall build-up of risks. We are taking a greater chance of having another crash at a time when the world is less capable of bearing the cost. Investors say ‘we will stay with the trade because central banks are willing to provide easy money and I can see that easy money continuing into the foreseeable future.’ It’s the same old story. They add ‘I will get out before everyone else gets out.’ They put the trades on even though they know what will happen as everyone attempts to exit positions at the same time.”

As a market cycle completes and a bull market gives way to a bear market, you’ll notice an increasing tendency for negative day-to-day news stories to be associated with market “reactions” that seem completely out of proportion. The key to understanding these reactions, as I observed at the 2007 peak, is to recognize that abrupt market weakness is generally the result of low risk premiums being pressed higher. Low and expanding risk premiums are at the root of nearly every abrupt market loss. Day-to-day news stories are merely opportunities for depressed risk premiums to shift up toward more normal levels, but the normalization itself is inevitable, and the spike in risk premiums (decline in prices) need not be proportional or “justifiable” by the news at all. Remember this, because when investors see the market plunging on news items that seem like “nothing,” they’re often tempted to buy into what clearly seems to be an overreaction. We saw this throughout the 2000-2002 plunge as well as the 2007-2009 plunge.

Yesterday evening, another astute market observer in the form of my good friend Steve Cucchiaro, founder of Windhaven, joined a few other friends for an entertaining steak dinner; and then we talked long into the night about life and markets. It is difficult to be “running money” at a time like this. The market is clearly getting stretched, but there is also a serious risk that it will run away for another 10 or 15%. If you are a manager, you need to be gut-checking your discipline and risk strategies. If you’re a client, you need to be asking your manager what his or her risk strategy is. It’s not a matter of risk or no risk but how you handle it.

What is your discipline? What non-emotional strategy instructs you to enter markets and to exit markets? Is it all or nothing, or is it by sector? Are you global? If so, do you have appropriate and different risk premiums embedded in your strategies? Just asking…. John’s piece today should at least get you thinking. That’s what Outside the Box is supposed to do.

It’s an interesting week around the Mauldin house. All the kids were over Sunday, and we grilled steaks and later ended up in the pool, shouting and horsing around, all of us knowing that three of the seven would be off to different parts of the country the next day. I know that’s what adult children do, and as responsible parents we all want our children to be independent, but the occasion did offer a few moments for reflection. Sunday night we just told stories of days past and laughed and tried not to think too much about the future.

A friend of mine just came back from California and Oregon complaining about the heat. Dallas has been rather cool, at least for August. If this weather pattern somehow keeps up (and it won’t), I can see lots of tax refugees streaming into Texas from California.

Tomorrow (Thursday) my mother turns 97, and we will have an ambulance bring her to the apartment, where she wants to have her birthday party. She is bedridden but is absolutely insisting on this party, so my brother and I decided to let her have her way. Which isn’t any different from the way it’s always been. Have a great week.

You’re rich in family and friends analyst,
John Mauldin, Editor
Outside the Box

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Low and Expanding Risk Premiums Are the Root of Abrupt Market Losses

By John P. Hussman, Ph.D.
Through the recurrent bubbles and collapses of recent decades, I’ve often discussed what I call the Iron Law of Finance: Every long-term security is nothing more than a claim on some expected future stream of cash that will be delivered into the hands of investors over time. For a given stream of expected future cash payments, the higher the price investors pay today for that stream of cash, the lower the long-term return they will achieve on their investment over time.

The past several years of quantitative easing and zero interest rate policy have not bent that Iron Law at all. As prices have advanced, prospective future returns have declined, and the “risk premiums” priced into risky securities have become compressed. Based on the valuation measures most strongly correlated with actual subsequent total returns (and those correlations are near or above 90%), we continue to estimate that the S&P 500 will achieve zero or negative nominal total returns over horizons of 8 years or less, and only about 2% annually over the coming decade. See Ockham’s Razor and The Market Cycle to review some of these measures and the associated arithmetic.

What quantitative easing has done is to exploit the discomfort that investors have with earning nothing on safe investments, making them feel forced to extend their risk profile in search of positive expected returns. The problem is that there is little arithmetic involved in that decision. For example, if a “normal” level of short-term interest rates is 4% and investors expect 3-4 more years of zero interest rate policy, it’s reasonable for stock prices to be valued today at levels that are about 12-16% above historically normal valuations (3-4 years x 4%). The higher prices would in turn be associated with equity returns also being about 4% lower than “normal” over that 3-4 year period. This would be a justified response. One can demonstrate the arithmetic quite simply using any discounted cash flow approach, and it holds for stocks, bonds, and other long-term securities. [Geek's Note: The Dornbusch exchange rate model reflects the same considerations.]

However, if investors are so uncomfortable with zero interest rates on safe investments that they drive security prices far higher than 12-16% above historical valuation norms (and at present, stocks are more than double those norms on the most reliable measures), they’re doing something beyond what’s justified by interest rates. Instead, what happens is that the risk premium – the compensation for bearing uncertainty, volatility, and risk of extreme loss – also becomes compressed. We can quantify the impact that zero interest rates should have on stock valuations, and it would take decades of zero interest rate policy to justify current stock valuations on the basis of low interest rates. What we’re seeing here – make no mistake about it – is not a rational, justified, quantifiable response to lower interest rates, but rather a historic compression of risk premiums across every risky asset class, particularly equities, leveraged loans, and junk bonds.

My impression is that today’s near-absence of risk premiums is both unintentional and poorly appreciated. That is, investors have pushed up prices, but they still expect future returns on risky assets to be positive. Indeed, because all of this yield seeking has driven a persistent uptrend in speculative assets in recent years, investors seem to believe that “QE just makes prices go up” in a way that ensures a permanent future of diagonally escalating prices. Meanwhile, though QE has fostered an enormous speculative misallocation of capital, a recent Fed survey finds that the majority of Americans feel no better off compared with 5 years ago.

We increasingly see carry being confused with expected return. Carry is the difference between the annual yield of a security and money market interest rates. For example, in a world where short-term interest rates are zero, Wall Street acts as if a 2% dividend yield on equities, or a 5% junk bond yield is enough to make these securities appropriate even for investors with short horizons, not factoring in any compensation for risk or likely capital losses. This is the same thinking that contributed to the housing bubble and subsequent collapse. Banks, hedge funds, and other financial players borrowed massively to accumulate subprime mortgage-backed securities, attempting to “leverage the spread” between the higher yielding and increasingly risky mortgage debt and the lower yield that they paid to depositors and other funding sources.

We shudder at how much risk is being delivered – knowingly or not – to investors who plan to retire even a year from now. Barron’s published an article on target-term funds last month with this gem (italics mine): “JPMorgan's 2015 target-term fund has a 42% equity allocation, below that of its peers. Its fund holds emerging-market equity and debt, junk bonds, and commodities.”

On the subject of junk debt, in the first two quarters of 2014, European high yield bond issuance outstripped U.S. issuance for the first time in history, with 77% of the total represented by Greece, Ireland, Italy, Portugal, and Spain. This issuance has been enabled by the “reach for yield” provoked by zero interest rate policy. The discomfort of investors with zero interest rates allows weak borrowers – in the words of the Financial Times – “to harness strong investor demand.” Meanwhile, Bloomberg reports that pension funds, squeezed for sources of safe return, have been abandoning their investment grade policies to invest in higher yielding junk bonds. Rather than thinking in terms of valuation and risk, they are focused on the carry they hope to earn because the default environment seems "benign" at the moment. This is just the housing bubble replicated in a different class of securities. It will end badly.




Raghuram Rajan, the governor of the Reserve Bank of India and among the few economists who foresaw the last financial crisis, warned last week that "some of our macroeconomists are not recognizing the overall build-up of risks. We are taking a greater chance of having another crash at a time when the world is less capable of bearing the cost. Investors say 'we will stay with the trade because central banks are willing to provide easy money and I can see that easy money continuing into the foreseeable future.' It's the same old story. They add 'I will get out before everyone else gets out.' They put the trades on even though they know what will happen as everyone attempts to exit positions at the same time."

While we’re already observing cracks in market internals in the form of breakdowns in small cap stocks, high yield bond prices, market breadth, and other areas, it’s not clear yet whether the risk preferences of investors have shifted durably. As we saw in multiple early sell offs and recoveries near the 2007, 2000, and 1929 bull market peaks (the only peaks that rival the present one), the “buy the dip” mentality can introduce periodic recovery attempts even in markets that are quite precarious from a full cycle perspective. Still, it's helpful to be aware of how compressed risk premiums unwind. They rarely do so in one fell swoop, but they also rarely do so gradually and diagonally. Compressed risk premiums normalize in spikes.

As a market cycle completes and a bull market gives way to a bear market, you’ll notice an increasing tendency for negative day-to-day news stories to be associated with market “reactions” that seem completely out of proportion. The key to understanding these reactions, as I observed at the 2007 peak, is to recognize that abrupt market weakness is generally the result of low risk premiums being pressed higher. Low and expanding risk premiums are at the root of nearly every abrupt market loss. Day-to-day news stories are merely opportunities for depressed risk premiums to shift up toward more normal levels, but the normalization itself is inevitable, and the spike in risk premiums (decline in prices) need not be proportional or “justifiable” by the news at all. Remember this because when investors see the market plunging on news items that seem like “nothing,” they’re often tempted to buy into what clearly seems to be an overreaction. We saw this throughout the 2000-2002 plunge as well as the 2007-2009 plunge.

As I’ve frequently observed, the strongest expected market return/risk profile is associated with a material retreat in valuations that is then joined by an early improvement across a wide range of market internals. These opportunities occur in every market cycle, and we have no doubt that we will observe them over the completion of the present cycle and in those that follow. In contrast, when risk premiums are historically compressed and showing early signs of normalizing even moderately, a great deal of downside damage is likely to follow. Some of it will be on virtually no news at all, because that normalization is baked in the cake, and is independent of interest rates. All that’s required is for investors to begin to remember that risky securities actually involve risk. In that environment, selling begets selling.

Remember: this outcome is baked in the cake because prices are already elevated and risk premiums are already compressed. Every episode of compressed risk premiums in history has been followed by a series of spikes that restore them to normal levels. It may be possible for monetary policy to drag the process out by helping to punctuate the sell offs with renewed speculation, but there’s no way to defer this process permanently. Nor would the effort be constructive, because the only thing that compressed risk premiums do is to misallocate scarce savings to unproductive uses, allowing weak borrowers to harness strong demand. We don’t believe that risk has been permanently removed from risky assets. The belief that it has is itself the greatest risk that investors face here.

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