What happened in the market today

Looking at the markets fall, there are three negative events that stand out as possible explanations: The ash cloud from Iceland’s volcano is still spreading over Europe, the University of Michigan released a lower than expected consumer confidence number and the SEC suing is Goldman Sachs (Suspiciously, on a day when there is news about how they ignored Allen Sanford’s Fraud in 1997).

1. The Ash Cloud: This seems back and should theoretically lower consumer spending and oil consumption temporarily, but the market didn’t really distinguish between European and US stocks today.

2. Consumer confidence surprised on the downside at 69.5 instead of an expected 75.0 and housing starts surprised on the upside. Here is a chart showing how little the U. of Michigan Confidence number seems to matter:

Lacking historical minutely data, I looked at the market close to market open futures data to determine if the U. of Michigan numbers have any market impact:


The impact looks rather negligible, perhaps because there are other more timely indicators of consumer confidence and divergences in this survey relative to expectations is as likely as not to noise. At the very least, any signal seems to be drowned out by the noise from earnings releases or other market data.

3. Today Goldman Sachs’s market capitalization fell from over 100 billion dollars to a little over 87 billion dollars on news that the SEC is suing them for fraud related to how they represented CDOs. No one thinks that Goldman is going to lose 13 billion dollars in the lawsuit, but because of the chance that it may be a tip of the iceberg type of event or that this negative news will hurt their credibility and therefore their business the market’s move may not be too excessive. Other financial stocks fell in sympathy, along will most other risk assets, either because of fears that these banks did the same, hedging by Goldman who knew of the lawsuit ahead of time, or because their regulation will be harsher if financial companies are perceived in a more negative light.

I’m glad that I don’t have to explain market moves every day, as usually “more buyers than sellers” or vice versa makes more sense than the majority of news stories coming out about market drivers.

Tax Day Post

Via the twitter of Garett Jones, comes a presentation on the economics of taxation... by Garett Jones.

Here are some of the more interesting points on the impacts of taxation (Comments in parenthesis are mine):
  • On a micro basis, taxes influence the decision to work or not to work, not the amount of hours worked.
  • Married women are one of the more marginal groups of worked that are more impacted by changing incentives to work.
  • Older workers might respond to tax incentives by retiring earlier (Whether or not this is particularly important for the aging developed world depends on if the workers have saved enough to comfortably retire)
  • The choice to work taxable jobs vs. less-taxable jobs such as waiters
  • Low earnings respond to income incentives more than average earners.
  • Capital taxes hurt workers in the long run (But as we saw with health care reform, they are politically popular!).
  • The rich do respond by working different amount, by switching between different types of careers such as high stress vs low stress, investing vs wage labor, etc.
  • Economists prefer a consumption tax, which may lead to 0.2% faster growth rate with is a little more than a 10% larger economy over 50 years. Some economists think that this will increase the growth rate by 0.5% and lead to an economy that is over 25% larger over 50 years.
It is worth noting that the presentation seems to be more focused on micro studies. There has been some debate in the blogosphere about whether or not tax rates explain the difference in work hours between the United States and Europe. Most of the studies that Jones cited in his presentation are micro studies that follow people over time rather than macro labor supply elasticity measurements such as this one by Edward C. Prescott (Although the point about married women being a group of marginal workers is also referenced in Prescott's paper, but this is because he is looking at a change in tax treatment to two worker households between 1970-1974 and 1993-1996).

Economic Freedom Index Biased Towards Rich Countries

Over the past few years, it has been interesting to see the United States slowly lose its top spot in the Index of Economic Freedom. In 1995 the United States was in 4th place, behind Hong Kong, Singapore and UK. In 2010 the United States is in 8th place, behind Australia, New Zealand, Ireland, Switzerland and Canada but no longer behind the United Kingdom, which fell to 11th place. This change is mostly due to other countries improving, although the United States has fallen from a score of 90 on corruption to 73 in 2010.

However, when I dug deeper into the methodology I encountered an anomaly. The index adjusts many of the costs to per capita income or some other metric. This makes sense in one sense, as requiring a year's salary to start a business in a poor country is much worse than needing a few thousand dollars somewhere in the developed world. However, the side effect of this type of measurement is that the United States rates more highly in Business Freedom than other countries partially because of its baseline.  Fiscal Freedom and Government Spending are measured the same way. As Greg Mankiw has pointed out, the taxes paid per person in the United States are very comparable to other countries in the developed world, it is merely the rate that is lower.
The United States is still one of the most free economies in the world, but people who follow these indices should realize that this is partially because the United States is rich to begin with. Poorer countries that try to mimic its policies will be seen as far less rich than the United States.
Edit: It looks like some countries were missing in 1995. In the 1996 data that I am using New Zealand and Switzerland were both added to the index, pushing the United States back to 5th place (It was ahead of the UK by 1996).

Interesting Links

1. Arnold Kling has thoughts about the race between a broken health care system and improving technology.

2. Kevin Drum has ten things gnawing at him when he hears people speaking optimistically about the current economy. (HT: MR)

3. Eric Falkenstein reminds people what regulators were really focused on during the housing bubble. Subprime sounds so bad these days, but when most people talked about affordable housing they weren't talking about loosening zoning restrictions and selling more government land.

4. Scott Sumner looks at a successful voucher program's supposed failure.

Over exaggerating market relationships

It is good to have an understanding of underlying relationships between assets. Knowing that gold goes up when the dollar goes down or that airlines and consumer discretionary stocks do not benefit from higher oil prices is important for someone trying to understand the market.  However, sometimes these relationships are given an importance that masks what is really going on.  Howard Simons has an article up at Minyanville that makes this mistake.

“The current partial contribution of crude oil prices to the S&P 1500 Supercomposite remains positive, 0.59% on a net weighted beta at last calculation. The reason for this is simple: The positive impact across the Energy and Basic Materials sectors outweighs the negative impact across the Consumer Discretionary, Consumer Staples, and Health Care sectors. 

He is right that higher oil prices are generally better for Energy and Basic Materials sectors than for the others. Energy companies selling oil and oil services make more money when oil is higher, and oil is highly correlated to the price of many other commodities that materials companies make money selling.  However, implying that the S&P 1500 was driven up despite the negative effect of oil on consumer discretionary stocks is proved false by simple data analysis.

The chart below shows the weekly percent change of oil versus the weekly percent change of the AMEX Consumer Discretionary Select Index from March 2009.

The relationship between oil and consumer discretionary stocks is positive, as both have been rallying due to more positive economic and financial expectations.  The more intuitive relationship of higher oil prices mean consumers have less money to spend on everything else is masked by the more extreme financial market effects. Simons does recognize this factor when he discusses that global economic growth is partially behind the high correlation between crude and the S&P 500, but it doesn’t make his earlier statement about sectors any more correct. 

The below chart looks at crude oil weekly returns vs. the relative beta adjusted weekly return of the consumer discretionary stocks (Consumer Discretionary weekly return times beta to S&P500 minus S&P 500 weekly return). Since October 1st, even this relationship has been slightly positive.

The chart below shows how the relationship between crude oil and the S&P 500 is variable over time (The rolling 26 week T-stat of crude oil explaining the S&P 500). Theoretically, the relationship is positive when crude oil and the stock market are being driven by economic growth and it is negative when oil is acting more of a constraint on growth due to supply restrictions. When the oil squeeze comes, this chart will fall below zero.

The charts were made with tools from Palantir Finance, which released some good news today.

Sectors with potential capital gains to be taxed

When thinking about the inevitable capital gains tax increase, it is interesting to look at which sectors will be most affected. The marginal non-institutional investors with large capital gains in a stock might be motivated to sell their shares into year end in order to avoid the 5% tax increase. However, the sectors impacted by a changing capital gains tax depend on the distribution of holding times by investors.  If investors hold stocks for a year and a half on average it has a very different implication than if the average investors hold stocks for 2 or more years. 

On a 6 month time horizon, by the end of the year people who bought 6 months ago will be able to see their holdings at the long term capital gains tax rate:

1 year time horizon with returns over 50%: Everything rebounded this year, but particularly consumer discretionary and financial stocks.

2 Year Time Horizon with returns over 20%: Technology and consumer discretionary stocks are the ones with capital gains.

3 Year Horizon: Investors with a three year time horizon are sitting on gains everywhere but in financials and utilities.

5 Year Time Horizon with returns over 40%:

Source: Palantir Finance

Impact of Greek Troubles

Greece has been in the news again recently. The 5 year credit default swaps have jumped from 344 basis points last Friday to 444 basis points today, surpassing Iceland as the most worrisome sovereign debt in Western Europe. One hundred basis points in one week is a relatively large move, so it is expected that the impact of a worsening situation in Greece should impact both currency and equity markets. 

The more trouble Greece is in, the more people worry about the future of the Euro. However, it doesn’t take a probability of a currency crisis to drive the currency lower; it only takes an expectation of a relatively weak monetary policy in Europe to support Greece.

The worry that the Greek crisis will spill over into the financial system, along with its effect on the currency, has made the S&P outperform the Euro Stoxx 50 in dollar terms whenever Greece’s CDS spikes.

The rolling two month differences correlations have been relatively steady at 0.2 and 0.3 for the past 4 months (0.4 and 0.5 when looking at financial stocks). There are obviously other factors affecting currency and relative equity market performance, but the change in Greek CDS has been having a definitive impact. Those who don’t like trading the Greek CDS directly might consider a currency hedged long short equity approach.

Consumer Credit Relative to GDP

The aggregate amount of consumer credit in the economy dropped by 11.5 billion dollars in February, the economists surveyed expected only a 0.7 billion dollar drop.  For those people thinking that the credit correction is completely over, the chart below puts the amount of consumer credit relative to GDP in historical context.  There is still further room for a decline in consumer credit.

Two Papers on the Capital Gains Tax and the Stock Market

I came across two interesting papers on capital gains taxes and their effect on the stock market.

The first paper, “Capitalization of capital gains taxes: evidence from stock price reactions to the 1997 rate reduction” was published in 1999 and was written by Mark H. Lang and Douglas A. Shackelford. 

This paper uses data from 1997 to try to get to the bottom of a few different views on capital gains taxes. The three theories are as follows:

  1. When capital gains taxes are reduced, shares are more valuable to individuals and so share prices rise.  Theoretically, this effect should be larger when share repurchases or liquidation of assets are expected. It should also be larger if stock holders are likely to be individuals who are subject to capital gains taxes.
  2. Capital gains taxes only tax assets that are sold, so they create a lock in effect on current owners. A reduction of the capital gains tax diminishes this lock in effect by reducing the tax on sellers, so a reduction of the tax should drive the value of stocks down.
  3. If stocks are valued as the sum of their future dividends, or if the marginal investors are unaffected by capital gains tax rates, then changes in the capital gains tax rate shouldn’t have any effect at all.

The study found that during the week of the announced 1997 capital gains but not dividends tax cut, non-dividend paying stocks outperformed dividend paying stocks. This result is consistent with the first theory, where lower capital gains taxes increase the value of assets and vice versa.  The paper also failed to find evidence of a lock-in effect, as stocks with prior gains didn’t decline after the new capital gains tax rate went into effect.

The second paper was published in 2001 by James M. Poterba and Scott J. Weisbenner wrote “Capital Gains Tax Rules, Tax-loss Trading, and Turn-of-the-year Returns” 

This paper combines an analysis of end of the year trading anomalies with tax-loss trading. One theory is that losing trades will be sold at the end of the year in order to counter the tax implications of realized gains in other parts of the portfolio. Unfortunately, this same behavior can also be explained by “window dressing”, in which firms sell losers so their investors don’t see bad stock picks in their year end statements.  The paper attempts to distinguish the two by looking at how end of the year effects react to changes in tax laws.  A capital gains tax change would only affect individual investors while it wouldn’t affect window dressing at all, as window dressing may be done by managers for untaxed institutions as well managers for individual investors.  

The study looked at three different regimes.

Regime 1: Six month short term holding period, long term losses 100 deducible against adjusted gross income

Regime 2: Six month short term holding period, long term losses 50 deductible against adjusted gross income

Regime 3: 12 month holding period.

Stocks with losses at the start of the year exhibited less year end anomalies when 6 months was the demarcation before short term and long term holding. The paper doesn't disprove window dressing, but it does show that tax laws impact year end trading.

Forecasting Wisdom from Scott Adams

Scott Adams, the creator of Dilbert, draws on his past experience with budget projections to give us valuable insight into what they guys at the CBO are really doing. His two rules of budget forecasting are:

1. You must assume that trends will continue
2. Trends never continue

While this isn't as true for demographic trends that involve the aging of a large portion of the population, point number two is generally correct. He also has some valuable insight about certain components of government spending.

The budget estimates for defense spending are obviously complete nonsense too. I can't imagine that the guy who handles that part of the forecast for the CBO includes, for example, an assumption that we'll invade at least two smaller countries per decade. I think there would be a lot of pressure on that guy to remove those assumptions, no matter how right he is.

In order to be nonpartisan the CBO has to follow some pretty explicit rules, so they can only forecast what bills say and not what it likely to happen. When it comes to partisan forecasting the bias is much more obvious, as even just forecasting a higher cost for a project can get a person kicked off the team, as Lawrence Lindsey realized in 2002.