Creative Destruction in the Advertising Industry

The money spent on newspaper advertising as a percent of GDP has been declining since the 1950’s.  To some degree, this slow decline is expected as the industry gets more efficient and advertising demand takes up fewer resources relative to the rest of the economy. However, when looking at newspaper advertising revenue divided by GDP, there is clearly something more going on than a gradual improvement in efficiency.

Source: GDP data from the BEA, Newspaper ad data from the Newspaper Association of America. In 2003 forward online newspaper ad revenue was included in the calculation.

 

To put the drop from 2003 through 2009 in perspective, here is a chart of Google’s revenue (99% of which is from advertising) versus the advertising revenue of the entire newspaper industry:  These numbers are before netting out the cost of acquiring this revenue.

Google doesn’t incorporate all of new media, but it is interesting that one company in the same general industry of advertising is about to eclipse an entire industry. The death of newspaper ad revenue has been on horizon for a while. Newspaper ad revenue has been declining for retail and classifieds since 2000. Classified ad revenue has been hit the hardest by the free competition on the internet are at one third of their 2000 peak. The competing retail ads aren’t quite free, so they have declined at a slower rate and newspaper retail ad revenue is at 50% of their peak. Despite the competition from the internet, national advertising and online ad revenue combined to keep pushing up newspaper revenue until it peaked in 2005. Right now, the one bright spot for newspapers is online ad revenue, which has increased from 2.6% of total revenue when it was first measured to 10% today. Unfortunately, online revenue is still very small and it is not enough to support the industry in its current form.

Palin 2012?

The high value of Palin’s 2010 Republican nominee Intrade contract is probably more representative of the wishful thinking of certain Palin supporters than an unbiased prediction of future probabilities. This happened in the last election with Gore’s VP contract, so Palin supporters probably shouldn’t get too excited about this market’s prediction.

The Economic Freedom Index: Revisiting assumptions

Andrew Gelman links to an interesting piece by Dave Armstrong on the Heritage Foundation Economic Freedom Index. I have my own issues with some of the subtleties of the index, but the approach taken is a good example of how a quantitative approach can sometimes miss the qualitative point altogether.  In the analysis of the components of the economic freedom, the assumption of unidimensionality is made.

“Unidimensionality - that there is only one underlying source of variation. Here we are assuming that each indicator is an imperfect indicator of Economic Freedom and that once we take account of economic freedom, there is only random variation left over.”

By making this assumption, he can then decide that factors that aren't correlated to the common factor of the other variables do not actually measure economic freedom.  In the subsequent analysis, fiscal freedom, a measure of taxes, and government spending are found to be uncorrelated with the common factor of variables. This is where a quick qualitative check would have been helpful. The amount of money the government controls and taxes from the private sector is a priori related to economic freedom. Instead of assuming that government spending and fiscal freedom are not related to economic freedom, the assumption of unidimensionality should be reassessed. 

The new index created with the unidimensionality assumption that takes out government spending and taxes could be very interesting as a rule of law index, it just isn't an index of economic freedom.

The quantitative approach does yield some useful insights, as the article does make a good point about statistical significance of the change in rankings. The United States index score is still well within its historical range, so the United States's move off of the list of most free countries is not really statistically significant. The most relevant part of the ranking change is that over the ten year period certain countries have become more free, but that is a relative and not absolute US decline.

Thoughts on High Dividend vs. Non-dividend Paying Stocks

One of the aspects of the coming capital gains tax raise is that stocks that pay out their earnings in dividends become relatively more attractive when compared to stocks that retain their earnings or give money back to shareholders via buybacks and so are more likely to return value to shareholders via capital gains rather than dividends.

Low dividend/High Dividend Paying Stocks, unadjusted for dividends:

Note on creation of indices: (Done with Palantir Finance)

S&P 500 companies

Excluding lowest decile of 11 month return to filter out failing companies

High dividend stocks: Top Quartile of High Dividend Paying Stocks, current average dividend yield of almost 5%.

Low Dividend Paying Stocks: Bottom quartile, average dividend yield close to 0%

The big decline in 2000 through 2002 was the unraveling of the tech bubble.  The dip in 2008 looks cyclical, as companies at the closest to the epicenter of the boom and bust are less likely to be the ones returning money to shareholders. In the same way, the companies that outperform at the end of a crash are the companies who barely survived, and companies that barely survive are less likely to be distributing needed cash to shareholders.

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