The tax hike and the anti-investment

It is important to note that gold isn’t going to be impacted by the upcoming change in the capital gains tax rate. Gold is already taxed more than other assets because under current tax law gold is a collectible. The capital gains tax on collectibles is 28%, 13% higher than the current tax rate of other assets. With a hike in the capital gains tax rate from 15% to 20% at the end of 2010 this spread decreases to 8%.  If the healthcare bill passes the senate and the house in its currently proposed form then this spread will be reduced even further at the end of 2011.

Gold has always been one of the closest things to an anti-investment; people invest more in gold when they aren’t sure that other investments are a good way to preserve their capital. The current trend in policy of taxing other forms of investment more while not taxing collectibles at a higher rate is only going to make the anti-investment look relatively more attractive.

This Gold/S&P 500 chart helps put the relative performance of gold and equities (unadjusted for dividends) in historical context. Gold’s best relative performance occurred during the deflationary crash of 1929 and the inflationary scare of the 1970’s.

Source: Palantir Finance

Digging Deeper into the Household Situation

In my last post, I mentioned that the lack of children might be a signal that society isn’t looking forward to the future.  There are a few problems with this, mainly that as societies become richer they naturally have more children. This inclination isn’t because people aren’t focused on the future, but because wealthier societies have children that are more likely to survive they don’t need to have that many. On top of that, each child requires greater investment in education so in an advanced society increased investment in fewer children looks like a better strategy than less investment in more children.  With birth control, families are able to make that choice.  So less children per household wouldn’t be a signal of a hyper-present oriented society, but less children overall would still be suggestive.  If less people have children then the pleas to “think of the children” will be more likely to fall of deaf ears.  Data from the U.S. Census Bureau is helpful in digging deeper into these questions.

As mentioned above, the people per household and family have shrunk over time.

Looking at the breakdown of household sizes, this gradual decrease is due to the disappearance of large families and the emergence of the single person household.

In order to determine whether the one person households have been increasing purely due to an aging population, the breakdown in one person households by gender is informative.  If the trend is age driven, single female households should be increasing at a rate much higher than single male households due to the greater female life expectancy.  This is not actually the case, so the increase in single person households is likely preference driven.

The preference for single households increases the nonfamily households as a percent of total households.

 

Non-family households have increased even faster than the percent of one person households.  This may be due to an increased preference of cohabitation over marriage or due to a rising economic necessity for people to have roommates.

It isn’t just nonfamily households that are saving money on rent, a larger percentage of married households than before do not have their own household. These households are most likely living in the house of one of their parents. In bad economic times, this trend is likely to continue.

Even though household sizes have remained relatively constant, families with young children have also decreased as a percent of the total. This is due to both to the aging of the population as well as a decrease in the propensity of the average couple to have children.

Overall, it does look like the decrease in children in our society is due both the decrease in family size and the increasing prevalence of one person households.  The decrease in family size may be a reallocation of investment, but the decision not to have children is more likely to be both a cause and a symptom of present oriented behavior.  

Another Way to Measure Time Preference

The time preference of a society is important to understand because if there isn’t much future oriented activity, then the future is going to be worse than the present.  There are many ways to look at the time preference of a population. The rate of interest, the savings rate, survey data, or even trying to gauge the propensity of the population to engage in short term unproductive activities.  Some people point to the obesity rate as a measure of inability of the average American to think about the future.  One interesting and underappreciated method of looking at the time preference of society as a whole is to see how many people have life expectancies lower than twenty years. Life expectancy is a better measure than pure age because an aging healthy population is more likely to look to the future than a young population that dies early. The population data was taken from the UN World Population Prospects 2008 database* and the life expectancy data is from U.S. Decennial Life Tables at the US Census Bureau. For the life expectancy data, I used basic linear interpolations and projections to create estimates of life expectancy in 2010 and 2030 and created the following chart.

If people with kids are more future oriented than people without children, then the situation is actually much worse than it appears. The below chart doesn’t adjust for the change in average household size, but it does show that the amount of children in society is dropping.

 

By both of these metrics and assuming that there isn’t any breakthrough in life extension technology in the near term, the U.S. is going to become more short term oriented in the future. On a demographic basis, the US is in a better position than Japan and much or Europe, so the problems there can be assumed to be even more severe. Compared to Europe, the US even has a higher life expectancy after the age of 65. The pattern of developed countries using short term solutions that only address the symptoms of actual long term problems is going to get worse. 

 

* The population data has age groups in 5 year increments, and when the cut off for 20 year life expectancy was between these 5 year increments it was assumed that each year contained one fifth of the total in that age group in order to simplify the calculations. Voting age was assumed to be twenty and up to both simplify the calculation and to partially adjust for the lack of participation of younger voters.

Irresponsible investors

These investors think that they are backstopped by the American people.  Having found themselves in a bad position, these investors are shifting their assets into riskier assets knowing that if they screw up someone else will pick up the bill. Nope, I'm not talking about wall street banks, but public pension funds. As the New York Times states:

But states and other bodies of government are seeking higher returns for their pension funds, to make up for ground lost in the last couple of years and to pay all the benefits promised to present and future retirees. Higher returns come with more risk.

Meanwhile, more and more corporations have been moving their assets into safer assets.  On top of that, these pension plans have very optimistic return expectations.

Most have been assuming their investments will pay 8 percent a year on average, over the long term. This is based on an assumption that stocks will pay 9.5 percent on average, and bonds will pay about 5.75 percent, in roughly a 60-40 mix.

Considering the current valuation of the market and the outlook for GDP growth, 9.5% equity return expectations are quite unrealistic. They'll be lucky to get 5%. But it's okay, the people living in these municipality will pay for the rest.

Is it a stock picker's market?

The below chart shows the average 60 day correlation of equities within four different sectors. It looks like many of the sectors are reacting to company specific news again, not just news about the business cycle.  If correlations stay low, this is good news for stock pickers who can try and pick the outperforming stocks instead of having their particular stock act like every other stock in the market.

Source: Palantir Finance

However, if there is a downturn in the market then correlations between equities will jump. This is because of data sampling issues – even if two assets are driven by the same major underlying trends, they won’t move together unless the major trend is changing. One way to look at this effect is to look at the correlation between the stock market indices for the United Kingdom and Japan.

Weekly returns of UK’s FTSE vs. Japan’s Nikkei when the VIX, the stock market volatility index of the US’s S&P 500 market, is under 20. When things are calm in the world the correlation is rather low at 0.29.

Weekly returns of UK’s FTSE vs. Japan’s Nikkei when the VIX is over 20. When the VIX is over 20, signaling that the US market is adjusting to a significant information flow, then the correlation between these two markets is much higher at 0.52.  In more volatile time periods, stocks and stock markets are more likely to be reacting to the same information so their correlations are going to be higher.

Source: Palantir Finance

Right now, the VIX is a bit under 18, helping explain why correlations are low again.  In a market downturn, stock pickers will be hit with the double whammy of falling prices and a smaller diversification effect. Stock pickers can partially avoid this problem by picking lower beta stocks which have tended to outperform in the long run due to their relatively strong performance during downturns, but then they would be missing out on a lot of the returns of the recent rally.

Thin Tails... relative to the hype

A lot of people think that this last recession was caused by fat tails in the market. When they think of the market, they are generally thinking about a stock market like the Dow Jones Industrial Average or the S&P 500.  Fat tails refers to a distribution of returns with more extreme points than suggested by a simplistic approach that only looks at the standard deviation and assumes a normal distribution.  The below chart shows the kurtosis (The higher the kurtosis, the fatter the tail) and volatility of the S&P 500 market over the past 80 years. Click on the chart to enlarge.

Source: Palantir Finance

It is interesting to note that the returns of the S&P 500 during the downturn didn’t have fatter tails than past market meltdowns. While it is true that deleveraging and liquidity events caused some positions popular with leveraged quantitative funds to all move in the same direction and models with uncorrelated and always rising house prices banks used to asses their risk were quite unrealistic, the popular myth that quants just didn’t understand that general market returns are not normally distributed is not true on many different levels.

Correlations between Greece and California

They each have tax receipts that vary with the economy along with fixed expenditures. The recent downturn has made their expenditures far higher than their receipts. Neither California nor Greece have control of their money supply, so printing money is not a solution.  Both live in a union where capable workers can easily leave, so raising taxes won't help much either.  Therefore, they have to make cuts.  This leads people on the receiving end of cuts in each area to periodically riot in protest of realityMegan McArdle's comments on the California students can be equally applied to government workers in Greece.
...I'm not sure what they think is supposed to happen.  There's no money.  This is not some question of reallocating resources from bad uses to good--everything is being cut because their institutions are under serious financial duress.
California is a little bit better off than Greece, at least they weren't caught lying about their finances.

Ignoring the supply side

Looking at the above chart, it is clear that either markets don't clear or the cost of becoming or being a doctor in the U.S. is much higher than it is in other countries. Instead of addressing the supply issue, the plan is to raise the capital gains tax will be raised to 22.9% to address the demand side of the health care issue.

The capital gains tax is 15% right now and will revert to 20% next year. Already this will have a noticeable impact on the market.
Assets that have gone up in value over the lifetime of a person's holdings give the owner an incentive to sell going into the end of the year.  While most stocks have gone nowhere this past decade the few stocks that have done well might reverse their course close to year end.  Long term commodity investors sitting on gains might also decide to take profits. When commodities start falling for no particular reason near year end, look for an increase in the number of stories about how China is slowing down.

The possibility of an additional 2.9% hike in 2011 should have a similar effect, with its impact slightly decreased because the hike isn't as large and because investors who reacted in 2010 will have less incentive to react in 2011.  Still, it is interesting that the markets didn't really react to the news of a new capital gains tax*. If stocks today are valued less for their future appreciation than their current expected income stream then this reaction makes sense.

Higher capital gains taxes, less investment in organizational capital and a muted reaction to future capital gains taxes are all related, they each imply that many of the decision makers aren't going to be as focused on creating an economic future that is much better than it is today.

*It is always difficult to tell why markets are moving unless they have a large jump on data releases or pre-planned announcements where the expected number is relatively well known.  There is a real issue in separating the signal from the noise. In this case, economic news releases, earnings reports and news coming out of Greece might have created enough noise that any impact of a possible new capital gains tax was masked. Also, there are many cases where the market will go up on bad news because it expected the news to be even worse.

Net Interest Payments and Reflexivity

While thinking about the CDS model in general and the Greek situation in particular, I realized that I left out a key variable from my previous analysis: Net Debt Interest Payments.

This variable should be very useful, as it implicitly measures net debt as well as the part of the deficit that isn’t changed by fiscal policy.  It also measures interest rates in the previous time period, so the information content contains last year’s CDS prices as well. While using data on which countries were considered at risk last year’s will give us a good idea of which countries are at risk this year, it only helps so much because it doesn’t explain why the country was in trouble in the first place.

However, this is a good example of Soros’s theory of economic reflexivity.  Countries that the markets see as having problems have to pay higher interest payments, making their fundamentals deteriorate further, which in turn drives interest rates even higher.  It will be interesting to see how Greece breaks out of this vicious cycle.

Countercyclical capability?

Garett Jones had a very interesting econtalk with Russ Roberts. He mentions that one the more interesting features of this recession is that productivity has been pro-cyclical rather than counter cyclical.  The graph below shows that during recessions productivity has generally gone down.

Source: BLS, NBER

As Garett Jones points out, this is rather intuitive to the person who thinks about companies cutting the fat in hard times and laying off the least productive workers.  In really hard times, companies might also cut workers who are focusing on projects that might create future revenue. Garett’s original tweet on the topic phrased it this way:

Workers mostly build organizational capital, not final output. This explains high productivity per 'worker' during recessions.  

In order to understand the significance of counter-cyclical productivity, I looked at a paper published in October 2000 by the Federal Reserve called Why is Productivity Procyclical? Why Do We Care? by John G. Fernald and Susanto Basu.  They analyze the four main reasons why productivity is usually procyclical.

  1. Procyclical technological development, where new technologies are invented during the boom rather than the bust.
  2. Imperfect competition and increasing returns means that when the economy is doing well then productivity is rising.
  3. Capital and labor are utilized more than is actually reported during a boom and less than is reported during a bust, so the procyclical productivity doesn’t actually exist but is caused by cyclical measurement problems.
  4. The reallocation of resources across uses, so as cyclical sectors with higher markups utilize a larger percentage of resources productivity goes up.

The study found that explanations #3 and #4 are the most important.  If the recent boom and bust cycles were not quite as procyclical as before, it could be due to many reasons.

  1. Better measurement of labor and capital.
  2. This boom was more financial in nature with the reallocation of resources going less to industries with naturally higher markups and more industries subsidized by cheap financing
  3. More firm specific capital creation in an increasingly globalized world.

Two and three are the most convincing. However, just because productivity doesn’t drop during recessions doesn’t mean that productivity is now countercyclical.  The relationship has merely weakened somewhat from the 1990’s onward, as this rolling ten year correlation between quarter on quarter changes in real GDP and nonfarm business output per hour demonstrates.

Source: BEA, BLS