Friday, September 30, 2011

Externalities in energy production

OK - today a slightly non-finance post.

There has been much hand wringing recently over the Solyndra Solar scandal in which it is alleged that the solar company received government support without proper controls.  Solyndra filed chapter 11 and is now being investigated by the FBI.

In the same way that I don't think subsidies for agriculture make sense, I don't think that subsidies for certain industries make sense either.  The government shouldn't subsidize solar power.  But it also shouldn't subsidize fossil fuels either.  Turns out that fossil fuel subsidies are a lot larger than the solar subsidies.  A whole lot larger.  This of course, doesn't get Solyndra, its management or the government off the hook in the current scandal.

(graphic from the Environmental Law Institute )

But the Solyndra case is a distraction to the bigger issue.  Even ignoring federal subsidies of fossil fuels, these industries are able to provide low cost energy because they impose negative externalities on other parties.  These externalities are primarily airborne pollution which have a very significant effect on the economy overall.   A recent paper published in the American Economic Review (the very top journal in Economics) finds that the magnitude and costs of these externalities are huge.  If the article is a bit dense, Paul Krugman gives a nice summary of the article.

The solution is to impose a Pigovian Tax - a tax on carbon.  A carbon tax works by raising the cost of carbon fuels towards a point that more accurately reflects their true cost (externalities included).  The key element of such a tax is that it is revenue neutral.  This means that all proceeds are rebated back to tax payers.  The most obvious way of doing this would be to reduce payroll taxes.  Greg Mankiw, the noted Harvard economist, who will admit to being on the opposite side of many debates to Paul Krugman, is a huge fan of a Pigou Tax.

With such a tax in place, and the removal of federal fossil fuel subsidies, the playing field would then be fully leveled for alternative fuels to compete based purely on their merits.

Wednesday, September 28, 2011

Price risk in the junk bond market

In one of my classes we've been talking about price risk and reinvestment risk for bonds.  These occur when market rates move from the initial YTM that an investor purchased the bond off of.  A great example is the current junk bond market where yields have risen very high and resulted in prices falling dramatically.  As a result year to date returns on these bonds are now negative.

Article here, HT Felix Salmon

Why do firms break up?

Aswath Damodaran has put together a really fantastic post on why firms break up or spin off divisions.  This is well worth a read.

Berkshire Hathaway to buy back shares

This story is a few days old, but Berkshire Hathaway is planning to start a share buyback.  This is pretty big news in that the company has never distributed cash to shareholders before.  Warren Buffet claims that the stock is significantly undervalued.  If this is so, then the buy back probably makes sense.  The evidence on buy backs is a little mixed, but in general there it supports the view that firms that do buy backs usually do so when their stock is undervalued.  We know this from two observations.  First buyback announcements are usually greeted with a positive stock price reaction, and second, valuation models show that firms that commence buybacks are, on average, undervalued compared to other firms.

Goodbye Wachovia

Here in Raleigh NC, the Wachovia building has long dominated the downtown skyline.  Not anymore.  It's now the Wells Fargo building.   My local newspaper has a nice set of pictures showing the transformation.

Robert Shiller on Stock Valuations

From Greg Mankiw: Robert Shiller thinks stocks aren't that cheap.

Tuesday, September 27, 2011

Pension fund returns

My colleague, Craig Newmark, links to an article on why Public Pension Plans can't be expected to earn returns of greater than 8% in the future.

The article argues that because the real risk free rate of interest is very low - close to zero, the expected return on pension assets should be reduced also.  I agree, but I would also point out that a non-trivial part of the historic return earned by pension funds comes in the form of inflation.  A far more sensible approach would be to  create pension plan return expectations in real, not nominal terms.

I've posted on this topic before.  Aside from over optimistic return assumptions, the other problem of state pension plans is that they discount their liabilities at the same return that they use for their assets.  Pension plan liabilities are virtually risk free and should be discounted at a much lower rate.  The net result of doing this would be to increase the value today of those liabilities and most likely reveal that most pension plans are horribly underfunded.

Dairy subsidies

A new proposal for dairy industry basically makes dairy producers pay premiums in good times in order to get a bailout in bad times - basically this an insurance policy.  The proposal would be voluntary.

I have some concerns...
First, I don't really understand why the government needs to insure farmers.  Why can't they buy private insurance?
Second, and probably the explanation for the first point - I bet this program will loose money.
Third, as someone who doesn't consume dairy products, I fail to see why dairy is so important to our nation.  I
think beer subsidies would be a much better idea.
And finally, this quote cracked me up:
Some farmers objected to the federal government limiting how much milk they could produce, saying the answer to problems facing the dairy industry was less government interference, not more.
I completely agree - but if you want less government interference you also have to take less handouts.

HT: Vegan blog

Is high frequency trading causing market volatility?

No - according to the founder of a HFT trading shop.  He makes a valid point - that a large amount of the movement in prices is from close to open - in other words after the market closes and before it opens the next day.

Friday, September 23, 2011

The HP 12c is 30 years old.

Most finance students use newish calculators like the HP BAii, but the granddaddy of them all, the HP 12c turns 30 this month.  

The 12c is a quirky calculator, but as the Financial Times says this morning: "By slapping the old HP 12c down on the table, you’re saying: ‘I’m a complex thinker, I can handle detail and I mean business”.

Apparently the 12c and the BAii are the only calculators permitted on the CFA exams.

Thursday, September 22, 2011

Markets are down and the 10 year bond rate is at 1.77%

Not good (unless you want to refinance your mortgage).

The Greek default

My colleague, Steve Allen has an excellent discussion of the impending Greek default.  Bottom line.  It isn't going to be pretty.  Everyone will get hurt.  Why - well it turns out that everyone is involved in some way.  JP Morgan tried to explain it with Lego figures. Click here for an explanation.

Random walks.

Finance academics often view stock prices as being "random walks" in that the price change at any given time is basically random.  If it wasn't, then you'd be able to predict where the price was going and make a killing trading stocks.  But random walks also occur in other areas of life.  For example, in professional basketball, a recent research paper shows that the scoring pattern can be characterized as a random walk.  

I finally feel vindicated, as in all my 20+ years living in the USA I have never seen the point of professional basketball.  With games frequently scoring in the high double digits, but the winning margin only being a few points, it always seems that the final outcome is really just down to luck.  Turns out this is not so far from the truth.


Sorry, I got that wrong - the best city in America, according to Businessweek.

As a resident of Raleigh for the past 9 years, I have to agree.  It gets a bit warm in the summer, but other than that, this is a nice place to live.

(Also posted by Craig)

Thursday, September 15, 2011

Jack Bogle, diversification and idiots.

Finance Professor blog posts a video of Jack Bogle (the father of indexing) talking about indexing.

Jack is responding to Mark Cuban's recent claim that "diversification is for idiots".  I am sure Mark is a talented entrepreneur but being a entrepreneur requires taking undiversified risks.  Investing for your retirement is completely different - diversification is essential.  If Cuban doesn't realize this then he is the idiot here.

Moral Hazard in Investment Management.

Via Craig: The overlooked failure in pension markets

Moral hazard occurs in pension markets because investment advisers have the incentive to maximize fees, but don't really get rewarded for performance.

Consider a simple example:

You have $100,000 with an adviser.  The annual management fee is 1%.  The annual dollar fee paid is therefore $1,000.  If the adviser works hard and earns you say an extra 2% return, his fee will increase to: 100,000*(1.02)*(0.01) = $1,020.

Alternatively, the adviser could recommend an "new" investment for your portfolio that charges a 1.5% fee.  Total fees in this case would be $1,500.

Given how hard it is to beat the market and earn an abnormal return, the adviser's best bet is to try and push his clients into higher fee products.

I've said it before and I'll say it again.  There are really only two things you can control in saving for retirement.  One is the amount of money you put in your account.  The other is the fees you pay to invest that money.  Your goal is to maximize the first and minimize the second.

Two more articles on correlation

Via Felix: Correlations are at dysfunctional levels
Via Craig: The guide to picking stocks when everything is correlated

People just don't understand inflation.

A recent article on Yahoo Finance talks about "Hedging 7 Big Retirement Risks"

The article is OK overall, but demonstrates a serious misunderstanding of the effect of inflation on stock prices (something that I am particularly interested in).  The offending paragraph states that:

To guard against inflation, you can invest in inflation-protected securities or other investments that will gain value as overall prices climb. For instance, stocks in your portfolio aimed at growth rather than income will provide a hedge against inflation, says Michael Reese, Certified Financial Planner and founder of Centennial Wealth Advisory based in Traverse City, Mich
 It is incorrect that growth stocks (low dividend paying high P/E stocks) will be a better inflation hedge than dividend paying stocks.   The value of both stocks derives from the present value of the cash flows generated by the underlying business.   Growth stocks reinvest this cash flow, income stocks tend to pay it out.  Either way, on average, the cash flow will grow at the rate inflation.  Thus the expected return on both types of stock is directly correlated to the expected inflation in the economy.  They are both "real" assets and should provide a hedge against inflation.

Rogue Trader at UBS

UBS is likely to post a loss this quarter because a Rogue Trader lost $2bn.  Ouch.

If you haven't seen it, the movie "Rogue Trader" about the Barings trader Nick Leeson is worth watching.

Sunday, September 11, 2011

High fees aren't just a problem for small investors

There are two things individual investors can control: how much money they put in their retirement portfolio and the fees that they pay.  They should maximize the first and minimize the second.

High fees will destroy your wealth.  But individual investors aren't the only ones who can end up paying too much for investment services.  Consider the case of the Libyan Investment Authority.   You'd think that these guys would be able to get a pretty good beak on the fees paid.   Not so as the FT reports. In some cases the fees paid were approaching 10% of the fund's asset value.

So remember, it doesn't matter whether you are just an ordinary investor or a crazy dictator of an oil rich nation, you need to watch out how much you are paying in fees.

Correlations are up again

A year ago I posted about correlations between major asset classes and stocks being higher than they had been in the past.  In reality what was going on was that the portion of the stock's risk that is due to the market was higher relative to the portion of a stock's risk due to firm specific factors.   For my MBA students, this should all be familiar as we've just covered the single index model in class.  Anyhow, apparently we're back to high correlations again as this article in the FT reports. Movement of big US shares harks back to Black Monday

Is social security a ponzi scheme?

Rick Perry recently stated that social security is a ponzi scheme.  Marginal revolution has a good analysis starting with Paul Samuelson who once said that social security was a ponzi scheme that worked.

Tuesday, September 6, 2011

Finance Theater

This post is mostly for folks living in and around Raleigh - the Burning Coal Company is putting on the play "Enron" by Lucy Prebble.  The play has been well received in London and New York.  The play will run from September 8-25 at the Murphey School in Raleigh.   Check out their website for details.

I plan on going. As the Artistic Director of the theater company told me, the play is "Music, Dance and Derivatives".  Sounds like a fun night out.

Saturday, September 3, 2011

The birth of the index fund

From Marginal Revolution - a great article about the birth of the index fund.  The full article is hidden behind the WSJ's paywall but the MR summary is good.

Friday, September 2, 2011

A triple A subprime mortgage bond.

Felix Salmon discusses a new triple A subprime bond.  He's not impressed and neither am I - I would have thought Standard and Poor's would have learned at least something from the ratings debacle of a couple of years back.