Analysis: Q4-2017 Macro Update

Global economic expansion, falling unemployment levels, low interest rates, and low volatility have coalesced, creating a Goldilocks environment for asset valuations. This party continued throughout the fourth quarter and perhaps it will continue far into the future, as markets appear to be betting on; trees will grow to the sky, and everyone will get rich. But perhaps not.

As always, I have no idea what the near-term future will bring, which naturally leads me towards skepticism whenever expectations are at or near extremes (things are rarely as bad as they seem, and things are rarely as good as they seem). In the face of uncertainty, the best thing we can do is study up on economic history, trying to get a better sense of how today’s world fits in a larger picture. There isn’t much money to be made in trying to time the market, but there is plenty of money to be made in understanding the world a little better than the crowd.

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Year in Review: 2017

As each year ends, I try to pause and reflect on some of the year’s themes and how poorly I predicted them. The goal of this exercise is to relearn some of the lessons we relearn every year: Mainly that nobody, including myself, has any idea how macroeconomic and sociopolitical events will play out, nor how they will affect the markets. The best we can do is predict that past inertia will continue into the future – e.g. the stock market will return about 7.0%. We know this is an illusion since, within any chaotic, complex system, inertia is ephemeral at best, but it’s a nice illusion.

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Analysis: Q3-2017 Macro Update

The resiliency of the economic expansion continued throughout the third quarter. GDP growth remained steady, unemployment remained low, the US dollar weakened, and the Fed remained on track for its second interest rate hike of the year. On the other hand, geopolitical concerns increased, the chance of tax reform decreased, and market valuations rose to a level that leaves little room for error.

As always, I have no idea what the near-term future will bring. This post is merely an attempt to see if we are closer to the top or the bottom of the economic cycle.

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Analysis: Q2-2017 Macro Update

Say we throw a ball up in the air and want to predict what will happen next. Newton tells us that transferring kinetic energy to the ball will accelerate it upwards, and the force of gravity will accelerate it downwards. We can confidently say the ball will eventually come back down to earth. Now, try predicting what would happen to the ball if instead, a random survey of the human population decided its movements. If more people felt like the ball should go up it would go up and vice versa.

There is no shortage of forecasters who would take a simplified approach to this problem – just assume the physics bound world and ignore the human element. Eventually, the two should match up. We can think of this as the efficient market camp. Contrast that to the behavioral camp, which focuses primarily on the human element. They note that the fear and greed of a crowd can push the ball to further extremes than the constraints of physics would suggest.

Our goal today is to predict where that economic ball is going. We will borrow from both camps, while not forgetting that this is an exercise in art, not science. We can’t predict where the ball is going nor when it will get there with any certainty, but we can get a decent idea of where the ball is. If the ball is closer to earth, odds are it will begin its journey upward. If the ball is closer to space, odds are it will begin its journey downward. Give or take ten years.

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Economics #8: Cost Disease


In economics, there is a simple idea called the Cobb-Douglas production function that tries to explain the relationship between labor (the total number of person-hours worked), capital (the real value of all machinery, equipment, and buildings), total factor productivity (the ability to produce more output with less input), and the total output of an economy. The idea is that since labor and capital are relatively fixed, economies grow by increasing their productivity, which technology is the main driver of.

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Economics #6: Fiscal Policy

In 2009, as economies around the world faced the prospect of economic collapse, massive packages of tax cuts and spending were enacted to halt the decline. In the United States, President Barack Obama signed the American Recovery and Reinvestment Act, which over three years would spend about 6% of the countries GDP split between tax cuts and infrastructure projects.

The idea was simple, if there is slack in an economy (idle factories and workers), then the Government can borrow and spend to close that gap. Flash forward to 2011, at the height of the euro crisis, when a similar economic contagion was spreading throughout Europe. This time, the response was a package  of bail-outs contingent on imposing strict fiscal discipline in the troubled countries. The idea was also simple, recklessness had brought about the crisis, so discipline should help fix it.

If these responses seem contradictory, they should. In both cases, some economists argued for fiscal stimulus, some for fiscal austerity, and each side had their own evidence which ultimately boiled down to how they modeled something called a “fiscal multiplier”.

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Economics #4: Economies of Scale

What are some industries are characterized by many small firms in fierce competition (retail, restaurants, etc) while some industries are characterized by a few large firms with market power (telecommunications, railroads, etc)?

What is it about the restaurant industry that allows competitors to open up a shop across the street. What is it about the telecommunications industry that often limits competition to one or two providers in a city.

That answer these questions we will start with the concept of economies of scale and then apply that to industrial organization.

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Economics #3: Comparative Advantage

In 1776, Adam Smith popularized the idea of specialization:

If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry employed in a way in which we have some advantage.

For example, if we are good at brain surgery and bad at making shoes, it makes sense to focus on brain surgery and trade for shoes. Same goes for legal work, accounting work, landscaping work, etc. If they guy down the street can do my taxes better than I can, I should ask him to do them. But what happens if we are better at everything? We can perform brain surgery, make shoes, practice law, file tax returns, and mow our lawn better than anyone else could. Do we just do everything ourselves?

In 1817, David Ricardo sought an answer to this question in the context of international trade. Why would a country that was better at producing everything, trade with a country that was worse at producing everything?

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Economics #2: Financial Instability Hypothesis

On January 13, 2010, the chief executives of four top Wall Street institutions gathered together in Washington to testify on what went wrong in the years leading up to the great recession. Jamie Dimon, the CEO of JPMorgan Chase, noted that:

In mortgage underwriting, we somehow missed that home prices don’t go up forever.

Lloyd Blankfein, the CEO of Goldman Sachs, added:

Whatever we did, it didn’t work out well. We were going to bed every night with more risk than any responsible manager would want to have.

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Economics #1: Information Asymmetry

Imagine you’re in the market for a new car. The used car you purchased last year is still fresh in your mind – it broke down every other day – so you decide to buy new. You sign some papers and drive-off in your new car. An hour later, for whatever reason (maybe you remember you’re allergic to automobiles), you decide to sell your car. To your dismay, you find that you can only get about 75% of what you originally paid for it.

Part of that 25% reduction is simply due to the dealership mark-up. Best case, a dealership would repurchase your car at wholesale. But the dealership may also wonder what happened in that hour which you owned the car. Maybe you discovered something that they don’t know about. Maybe the car is haunted (or more boringly a lemon).

This gap in knowledge – the same gap that stopped you from buying used in the first place – is known as information asymmetry and it’s the subject of today’s post. In our example, information asymmetry caused us to lose a couple thousand dollars. Taken to the extreme, information asymmetry can cause complete market failures.

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