Invest in Education!

"Invest in education!" It is the rallying cry of many who think that more education spending is the silver bullet that is going to solve most of America's problems. However, the bullets seem to be hitting student's balance sheets more than America's other problems. In the past year, Mark Kantrowitz of claimed that the total education debt outstanding has passed the total credit card debt outstanding. Unlike credit card loans, these are loans that cannot easily be discharged in bankruptcy. These loans will follow students for the rest of their lives, potentially going so far as to allow lenders to go after tax refunds or a person's social security payments.  This is a debt overhang that cannot be solved by jingle mail*.

The confusing thing about education is that it is partially a private good and partially a public good. An educated person is be more likely to promote positive aspects of society by being a well behaved and productive citizen. Basic education is obviously very valuable, because a literate population is capable of many more things than an illiterate population. It is also necessary for most people to be trained in more advanced skills, since there is a level of educational attainment that it is important for a developed country to reach. In the past, economic growth has been associated with increases in education. Economists have documented this trend and like many forecasters they assume that the relationship that has occurred in the past will continue to hold into the future. However, the nature of education as a private good might be causing this correlation to breakdown. 

Education is also a private good because it serves as signal to other people of the student's qualities, and that signal only benefits the person holding the degree at the expense of those who don't hold a degree or those who hold a lesser degree.  Bryan Caplan suggests that the qualities signaled are work ethic, intelligence and perhaps even the conformity required for an employee to be a productive corporate worker. If education is being used mainly for signaling purposes, the limited number of degrees being given out by top colleges would be a feature and not a bug.  The value of adding on more slots at lower tier colleges is also low because lower tier colleges generally price themselves similarly to top tier colleges so that they don't look like they are lower tier.  

An important question is whether or not education is more of a cause behind students becoming more productive students or if the kids who are selected to become students were already going to be more productive in the first place.  One way to measure this is to look at the demand for university material by non-students. If many non-students thought they could receive most of the benefit of an education by attending lectures given at the top colleges and doing the work on their own time then we would see more security outside of lecture halls keeping non-students out.  ITunes would also be able to sell their lecture series for nontrivial prices that they are now giving away for free at ITunes U.  Another question is how much additional spending directed towards education helps. When inflation in education has increased at four times the rate of inflation since 1986, it should make people stop and think before deciding throwing more money at the problem is the obvious answer. 

If education is more about signaling than teaching, then it means that as spending increases most of that spending is merely being wasted on an inefficient status competition.  Perhaps this is why Peter Thiel has been calling education a bubble.  One way he is drawing attention to this bubble (while at the same time cleverly expanding his network for recruiting talent) is with his "20 under 20" program. This program involves paying 20 students to leave college for at least two years. One of the ingenious things about this program is that the applicants are being promoted as very elite students with articles about the program specifying that many of the applicants are from top colleges. If this program is repeated year after year and becomes fixed in people's minds as one of the most elite programs out there for aspiring entrepreneurs it should give the winners the status they were hoping to get from their college diploma. They will only go back to college if they think that they will really benefit from the education.

Those who agree with this general perspective and think bubbles should have direct tradable implications should review Steve Eisman's May 2010 Ira Sohn conference presentation about the for-profit education companies.  If there is a subprime of the education bubble it is probably the for-profit education companies. For-profit education has the unfortunate distinction of being among the lowest status providers because of their willingness to take almost any type of student in order to make a profit.  If people wake up to the idea that most of the value in colleges comes from increasing a person's relative status** and that these colleges are at the bottom of the totem poll, then the for-profits will be in trouble.

It's nice to think that education is a race to the top that everyone can win, but we shouldn't ignore that once we get near the top the real game starts to look more like king of the hill.

*The situation is more complicated than this for many of the people who took out multiple loans on their houses. It will also be hard for some of these people to walk away.
**Certain government workers who are merely trying to get additional certification in order to quality for higher pay might be the last to care until their compensation system is changed.

Links: The "Some people on the internet are wrong!" Edition

1. Naked Capitalism's april fools prank came 3 days late. Just to consider one of the most glaring errors of the letter, the author seems to have no idea that many academics earn money based on the value of their connections and knowledge from their governmental positions. Thus, their main patrons would be factions that might end up running the government. See Elizabeth Warren's use of weird metrics in order to make politically charged studies which led to her current position as a special advisor to the Consumer Financial Protection Bureau.

2. One of the bloggers at the Economist has no idea how hedge funds work. They are unable to tell the difference between a decrease in assets due to investors pulling money out of a fund and negative returns. To be fair, the blogger is apparently based out of Kansas City.

3. In one of the recent episodes of "To the Best of Our Knowledge", Lone Frank brought up understanding the "Coke/Pepsi" example as one of the main case studies of neuromarketing. The Coke/Pepsi example is derived from the Pepsi challenge, where the less popular Pepsi is preferred in blind taste tests, but Coke is preferred if the drinks are labelled. This leads neuromarketer proponents to believe that there is something special about the branding of Coke or memories associated with the brand that makes it more appealing than Pepsi and that this difference can be seen directly via brain scans.  However, these neuromarketers are missing a key fact that was pointed out in Malcon Gladwell's book Blink. Coke tastes better in the long run because the sweetness of Pepsi gets more annoying over time. Given this data, the experimental subjects used by neuromarketing analysts are probably associating the brands with their memories of consuming the actual product.  Advertising and other fond memories associated with a brand should also have a measurable impact on the brain that would be interesting to study in more depth, but it is kind of sad that the neuromarketing flagship study* is based on false premises.

*This label is based on how it was the one study that was brought up on the podcast and because it is the only study mentioned in detail on the wikipedia page for Neuromarketing.

Who Predicts Well - Does it apply to financial markets?

What makes a good predictor is a very interesting subject to those involved in financial markets.  Tyler Cowen highlights an excerpt from a piece by Dan Gardner and Philip Tetlock:

"…what separated those with modest but significant predictive ability from the utterly hopeless was their style of thinking. Experts who had one big idea they were certain would reveal what was to come were handily beaten by those who used diverse information and analytical models, were comfortable with complexity and uncertainty and kept their confidence in check."

Having one big idea might be a dangerous thing for money managers, but it seemed to work for some people who shorted the housing market.  The way to reconcile these two facts could be that the people who made money shorting the housing market weren't applying their one big idea about the future downfall of America or the idea that easy money is going to destroy the economy, but instead were the type of people who came to their conclusions about the housing market after studying various metrics and utilizing different analytical models.

It should be noted that just because the experts who are supporting their one big idea might be worse predictors in general, they may not be wrong in the long run. Those who favor a long gold strategy tend to have one big idea: You can't trust fiat currency (particularly the fiat currency of the United States), as throughout history all fiat currency has approached zero.  They see every sign of inflation as a sign that gold should go up in value and every sign of deflation as a sign that gold should go up in value.  Even though they have the wrong cognitive approach, over the past 10 years they've been right far more often than they've been wrong.  If someone marginally familiar with Tetlock's research decided to sell gold because they didn't like the arguments of people buying gold they would have lost a lot money.

On bearish journalists and bullish asset managers

"Any intelligent commentator will over time feel more comfortable from the bear position, just as most traders trade from a bullish bias.  There are more negative things that can be said in an intelligent way. The hidden order of markets that generally make things work is not easily described by a journalist.  The only consistently intelligent bullish commentary I've read has been from Niederhoffer and McKinsey. There is more money to be made buying assets than selling them short.  However, that doesn't prevent dedicated short sellers from making money."

This is an excerpt from an email I sent to a friend over four years ago. It's still rings true today, even if asset managers with a bullish bias have not has positive returns in recent years. There is only so much money that can be allocated towards selling assets short. If it is ever the case that short funds seem almost as popular as long funds, it probably means that it is time to load up the truck and buy equities.

Links: Japan's tragedy and some of its implications

1. A lot of videos of the horrific damage from the tsunami are going around. This one shows how the wave wipes out villages (Warning: Graphic) as it approaches the shore, while this video shows just how destructive a large amount of water can be to a city even when it isn't moving at huge speeds.

2. Some people are wondering how Japan will be able to finance its reconstruction.  Peter Westaway of Nomura expects rating agencies will "cut Japan some slack" for humanitarian/public relations reasons. While this will reduce the need for some institutions with strict rules to keep their money out of Japan it also means that the market could move well before the ratings agencies do.

3.  The Bank of Japan is flooding the market with yen. Weighed against this move and the government's new fiscal position is the repatriation of Japanese household's foreign investments combined with expected insurance payments that will flow into the country. These inflows help explain why the yen hasn't moved very much and has actually slightly strengthened against the dollar despite the huge economic shock that has sent its stock market tumbling more than any other two day period since 1987.

4. There appears to be less looting in Japan than in other recent natural disasters. One politically incorrect explanation is that groups of people with high IQ's are more likely to cooperate in prisoner's dilemmas. (HT: Garrett Jones

5. The biggest impact of this tragedy on America's future might in how it seems to be scaring people away from nuclear power.  If the situation at Japan's power plants gets any worse the future of nuclear power in America will be very dim.

What a naive long China strategy misses

People who go long China's economic growth by buying their equity index will miss out on a lot China's growth. Via the Economist I came by this interesting fact:

"Qiao Liu and Alan Siu of the University of Hong Kong calculate that the average return on equity of unlisted private firms is fully ten percentage points higher than the modest 4% achieved by wholly or partly state-owned enterprises."

While looking at this, it is important to note that this is just state owned firms and not firms with ownership by government officials. But the outperformance of unlisted firms does suggest that the average investor looking to go long China's listed equities are not participating in a large portion of China's economic growth. Marc Faber anticipated this as far back as 2002 when he wrote Tomorrow's Gold and made the analogy between China today and the United States in the 1800's. The 19th century United States economy grew a lot, but the opportunities available to foreign investors, mostly railroad stocks, didn't give foreign investors corresponding returns.

The beginning of the end for low vol?

Eric Falkenstein wrote one of my favorite books on finance, Finding Alpha. In this book, he goes over the typical lifecycle of market inefficiencies. Markets might mis-price volatility or Eurodollars or under estimate stock market daily reversals for an extended time period, but once people find out about it and have the tools to easily trade it the alpha available to investors in the know decreases.  In the same book and on his blog he also promotes his pet investment thesis: low volatility stocks or avoiding high volatility stocks. If CAPM is wrong and people are basically envious rather than risk averse then their main goal is to outperform the benchmark. Low volatility stocks offer no hope of outperforming the benchmark and in fact consistently underperform it during bull markets. Because of this they are subsequently undervalued and massively outperform during market turbulence.  Their risk adjusted return across stock market cycles is better than the index as a whole by over a percent a year. This doesn't sound like much, but a one percent growth rate differential matters a lot over the long run.

Recently, Falkenblog has been pointing out all of the people coming around to this point of view. As someone who wants to take advantage of this strategy in scale this is worrisome (Even if the prospect of being able to choose to apply this strategy via ETFs is also convenient). It is starting to look like the strategy is going to get crowded. The low volatility strategy probably isn't crowded right now, but it looks like that this cycle might be the time that it finally becomes popular enough to impact returns. If that's true, than that means that this cycle will see low volatility stocks underperform to a much lower extent but also fail to outperform to the same extent during the next bear market.

It will be interesting to see how many low vol ETFs are introduced and their subsequent popularity.  Measuring the AUM of low vol ETFs and funds is a good way to track just how popular the idea is getting because mentions in press and conferences will only matter insofar as they are reflected by the choices investors are making in their portfolios.

Autocorrelated protests

I'm starting to wonder if any of the flame sparked by Tunisia's protesters will spread to the developed world in any form.  The current events in Wisconsin might be slightly related. The Wisconsin protests may have stemmed by opposition to the drastic but mostly necessary measures* proposed by Wisconsin's governor, but they also occurred because events in the Middle East have reminded people about the potential power of crowds. Some people may not realize it, but the protests are effective because there is an implicit threat that the protesters might turn angry. This is part of why it is considered very impolite to protest in front of someones private house

Comparing Wisconsin to the Middle East protests in general and Tunisia in particular seems a little silly at first.  Wisconsin is nowhere near as extreme as Tunisia, the privileges the union is trying to protect and their potential to turn into a scene of large scale destruction** is lower than anything going in the Middle East.  But they do have something in common with Tunisia, Wisconsin will give people feedback on how successfully they can manipulate the political system by mobilizing people for large scale protests.

In 1959, Wisconsin became the first state to give their employees collective bargaining rights. They are going to be a trend setter again. The only question is whether they are setting the trend of disempowering public sector unions or increasing the power of public protests.

*The overall cuts seem reasonable in light of their budget and banning collective bargaining is either to allow local government to more easily balance their budgets or it is a clever ploy to eventually give the unions something that looks like a major victory even after the governor got all of the pension and health care concessions he wanted.  It can also be a threat that is left hanging in the air in order to force the unions to cooperate as long as Republicans are in charge.

**Museums are unlikely to be looted and police stations probably won't be burned down.

AOL risks angering their cash cow in attempt to reinvent itself

Recently, PC magazine had an article highlighting how important old people are to AOL's returns. In the article, "Is AOL Scamming Old People?", they highlighted a quote from the New Yorker article about AOL's CEO Tim Armstrong.

'[M]any of [AOL's subscribers] are older people who have cable or DSL service but don't realize that they need not pay an additional twenty-five dollars a month to get online and check their e-mail. "The dirty little secret," a former AOL executive says, "is that seventy-five per cent of the people who subscribe to AOL's dial-up service don't need it"'

So AOL is making a lot of money from old people who can easily unsubscribe while keeping their email adress. PC magazine said the money AOL was making from these old people was $244 million in Q3 of last year.  With this information in mind, it seems strange that AOL would do something that could get a lot of those old people very angry. With the decision to buy the Huffington Post, they also decided to become the face of liberal media online. While the stock market's reaction implies that the $315 million dollar purchase was a bad idea on its own merits, they are probably missing the consequences of AOL putting a bit "Liberal Media" target on its back.

Most old people lean right.  A 2009 Gallup survey found that 48% of people over the age of 65 identify as conservative while only 16% identify themselves as liberal.  It might not be long until right leaning media personalities decide that they can fight back against liberal media and save their fans money by encouraging them to unsubscribe from their useless AOL accounts. Right now AOL is losing subscribers at a rate of 30% a year. This move may have hastened the decline.  It will be interesting to see if AOL will be able to reinvent themselves and find a new niche to replace the old one they are losing.

China's Innovative Policies

I recently came across a Jul 28, 2010 report by the US Chamber of Commerce, China’s Drive for 'Indigenous Innovation' - A Web of Industrial Policies.  While conceptually it might be easy to understand the idea that unconnected foreign businesses are at a disadvantage in China, this report spells out many of the more specific ways that outside companies are put at a disadvantage when doing business in China and how this ties into China's drive for indigenous innovation.  

In the report, it is pointed out that it is clear to everyone that China's see a large part of its growth path through acquiring foreign technology. They show that China's  “The National Medium- and Long-Term Plan for the Development of Science and Technology (2006-2020) defines indigenous innovation as “enhancing original innovation through co-innovation and re-innovation based on the assimilation of imported technologies.”

A lot of these regulations target multinationals who are trying to compete with domestic brands.  The Chinese Compulsory Certification system often delays foreign companies from getting to market before domestic Chinese competitors have had a chance.  Companies that make products with encryption are reluctant to get the certification at all, as the process requires that they trust the Chinese government with proprietary trade secrets.  China also enacted an "Anti-Monopoly Law" in 2008 which some officials are trying to use to justify compulsory technology transfers from foreign companies dominating specific markets to domestic Chinese companies.  The general implementation of IP law is also said to be rather biased towards local companies, either because those enforcing the law have ties to local companies or because the punishment for stolen IP is still rather low unless it happens to be a ruling in favor of a domestic company against a foreign company.

One of the main ways they get this technology is through foreign companies looking for access to the Chinese market.  In return for partnering with a local Chinese company, the foreign company is given access to the large Chinese market with less regulatory hassle and lower tax rates.  

"The indigenous innovation drive is forcing foreign technology companies to anguish over balancing today’s profits with tomorrow’s survival. With its extraordinary infrastructure plans and a continental-sized consumer market that has just begun to really develop, China is a market no multinational can ignore. But the price of admission is getting more expensive by the day as China opens its policy toolbox to ensure that foreign technology allowed into China is accessible for “co-innovation” and “re-innovation” by Chinese companies."
- China's Drive for 'Indigenous Innovation, Page 31

The report then goes on to detail many different industries, from trains to green energy to airplanes where the foreign multinational enters joint partnerships to gain access to China's market and eventually gets supplanted by their former Chinese domestic partners.

The anecdotal evidence in favor of China's rise to technological prominence is just that - anecdotal.  Many of these anecdotes arise from specific mega projects targeted and funded by the Chinese government, so impressive progress is likely to be contained to major areas of interest. Still, there is no denying that domestic Chinese companies are able to copy ideas efficiently from their western competitors/partners.  When companies decide to do business in China, they better be thinking past the next quarterly earnings time period even if the stock market isn't. For some technology companies, it can make sense to move production to China if the other option is going out of business, but companies that have a sustainable business plan should think twice about who they will be competing with in 5 years time.

How this competition impacts the future is open to interpretation. If the low hanging fruit of innovation* has been picked, then it makes sense for the west to become much more protective of giving away any existing technological superiority. If China became as rich as the west in a world without significant innovation occurring, then while China's citizens would be much better off there would also be a major rise in the cost of resources that would lower the standard of living for most people in the west. However, if innovation is occurring on a normal historical course in these and other areas then while companies should protect their trade secrets China's attempts to catch up should not be a problem for anyone but their direct competitors.

Hat Tip: Mish's Global Economic Trend Analysis

*Much more on this later!