Can Global Energy Consumption Stabilize On Its Own? (The answer may surprise you!)

            As a nation we fear higher oil prices, and we should! Energy is the foundation of our society.  One element of price fluctuations (and a source of potential anxiety) is the variance in global consumption. Each market uses energy to create goods and services all across the globe.  So every time a country builds and grows markets, there is increased demand for energy. The most clear example is China recent surge in demand for automobiles. 

Once might assume that as counties such as China and others in Africa start to develop and build more markets that the energy consumption will destabilize. After all, with so many different markets the potential swings from quarter to quarter activities could become tremendous.

This view of the world however is false. Baring extreme circumstances like an embargo or war, the reality is that energy consumption will increase, but the variance in that consumption will stabilize. The reason can be found in modern portfolio theory in finance. A good conservative portfolio has many different securities. Many of which are interconnected in risk and reward.  In other words, they are correlated, either positively or negatively if at all. Like corporate stocks, markets with their respective energy consumption can be correlated to some extent.  For instance, if companies use more motor oil to better power machines and build more bikes, kids will buy more bike oil to keep those bikes operating.  

One way to get in the thinking is to imagine a computer that picks random numbers from a bell curve.  If you just ask the computer to spite out a two or three observations, it may look unstable with just a few extreme results. But, if you ask the computer to spite out 10 million observations, the bell curve will form nicely. The same is true for the energy market.   

If we think of global energy consumption as our “portfolio”, as more and more markets emerge and start producing goods and consuming energy, the variance in energy consumption that effects the huge proportions of the energy market will effect the variance. This known as systemic risk.

To see if this prediction holds any water, lets directly compare the prediction to the data.  looking at the data from the world bank development indicators, since 1970, the variance in global energy consumption per capita appears to have fallen.
            Note that all this is before supply and demand for energy is considered. But developing markets themselves act as a stabilizing force, if and only if we can continue to find new ways to meet the next generation of energy demand.

Stagflation Blues

It seems that inflation has gotten worse over the last year.  The current rate of inflation over the last year has been about 3.8 percent.  (The general rule of thumb for healthy inflation is roughly 2%) Thus far the Fed has not changed course on its policy.

This means that for every dollar you have today, you will only have about 96 cents left a year from today. 

Are we looking at Stagflation? Lets hope not, but keep a close eye in inflation.

The Information Alchemist: How to Understand and Interpret the Stock Market. Part 1

Have you ever felt confused when our beloved news pendants report on the stock market?  Things seem to move so quickly and so much financial jargon gets tossed around, before you can say “What on God’s green Earth was that all about?” suddenly, the story is over and its time for the pendants to move on to the next big scare.  The recent media panic from the downgrading of U.S. treasury bills has highlighted some of the public confusion in interpreting data from the stock market. The manufactured debt crisis led the Dow Jones Industrial Average to fall significantly.  I have never enjoyed the “panic first and ask questions later” approach of our media.  So this post will address two particular issues that cause public confusion regarding the market.  The first of which is basis point measurement. When major network pendants get the chance to report on the stock market, one gets the impression that they (and their talking heads) have no clue what a basis point is. So what good it is to you? Secondly (and absolutely more importantly), I wish to address the interpretation of the stock market.  That is, what can we infer about the economy’s performance from what we observe in the stock market.

            First of all, for those readers who do are not yet familiar with the structure of the stock market: A corporation will sell off ownership (and thus risk) by selling its stock on the open market. The stock is then traded based on the markets perception of the value of the corporation and thus the value of the stocks.  There are other ways to make money in the stock market besides buying low and selling high, but for this post we will stick to the basics.  If you believe the value of a stock will increase in value and you can handle to risk, you ought to buy it. The Dow Jones Industrial average is a collection of 30 of the largest corporations with their respective stocks.  The motivation for this collection of corporations is to understand the industrial leaders to get a sense of what the industrial followers will do next.

            What is the basis point system and why do they use it?  It turns out that a basis point is nothing more than simple multiplication.  If the stock increases in price by 1%, that 1% becomes 100 basis points.  Or for 10% that’s 1000 basis points.  Yup, that’s all folks, just divide by 100 and you go from basis points to percents, which we all know and love.  Is it odd? Yes. Is it pointless? Quite possibly. Than why do they use it?  I do not personally know, however one of my undergraduate TAs maintained that they use such pointless measurements and terminology to keep the public out of the market by sounding overly educated.  I do not know if his theory is true, but I do know in finance they use a large number of terms to explain any given idea.

            In the news where we often hear something to the tune of “The Dow Jones fell by 300 basis points.” In English that means the corporate stocks in the Dow Jones on average fell in price by 3%.  Presumably such a figure indicates that the value on average for all those corporations fell by 3%.  However, this is the point in the discussion where we detach from simple measurements and begin on a more intuitive thought process for interpreting the stock market.   

            So is the stock market a perfect refection of the true value of those corporations?  The answer is simultaneously yes and no.  For no particular reason, lets suppose that Exxon/Mobil stock fell 300 basis points, or 3%.  Does that mean that 3% of Exxon/Mobil’s assets, cash, customers, and profitability all vanish in a matter of hours? Of course not, it takes much longer for corporations to change in value.  But the change in the price of the stock is a refection of the expectations of the value in the corporation.  This idea is critical. The changes in the value of a stock is a reflection of the expectation for that stock.   

            What than would cause a change in the expectation of a corporate security?  For starters let’s say we knew that in a few mounts Exxon/Mobil was going to end production of its main oil producing field just north of Wherevervill.  That tells us that Exxon/Mobil will have less product to sell very soon.  Their stock price falls because investors know that no oil equals no profit.

            For the majority of the time and for the majority of corporations, stocks are well priced.  In other words the market is efficient. If you don’t believe me; try making some money above the true value of any given stock you wish to trade and then we can talk about inefficient stock markets. To further prove my point, CNBC is a major media network almost entirely dedicated to processing information about the market. There is an endless stream of data and new information being processed twenty four hours a day and seven days a week. For that reason, in the long run the stock market is an imperfect, but reasonable measure of economic performance. The now famous Economist Greg Mankiw points to the imprecise correlation between the stock market and real GDP percapita.   However, in short run, stocks tend to be over traded; bought and sold by men and women doing their very best to make profit above and beyond the true value of the corporate stock.

            At the same time there is a hilarious contradiction.  Stock traders in the short run are immensely skilled at detecting excess value in corporate stocks.  If hedge fund professionals were dogs, they could collectively smell a short run trading pattern half way across the globe, buried under 100 ft of soil and covered in dirty gym socks.  At the same time, detecting/forecasting long run excess value can be so astronomically difficult we can fail to detect disasters like the 2007 financial crisis.  In a way, its like asking if you think you should choose a salad over a spinach wrap for lunch on August 17^th, 2025 and feel pretty darn sure that you are choosing the right answer.  

            The next natural questions then becomes; if the stock market is so efficient then why do such disastrous crashes occur? That’s a very good question.  To make a long story short the reason is the speed at which the market adjusts itself.  Stock prices adjust very quickly.  Imagine a Ferrari that can reach 370mph with a master driver at the helm.  It may be that the driver can anticipate far ahead and almost always choose the right path to follow, but when disaster strikes, he may find himself in an 180,000$ death pancake of a rich midlife crisis against a wall at an economic T-intersection.  To be a bit more technical, a stock market crash is more likely to be the symptom rather then the cause of an economic crisis, investors panic and heard out of the stock market when there is great uncertainty about what stock prices truly should be. 

            In conclusion, the stock market tells us about the performance of the top competing corporations. Any stock index like the Dow Jones, the S&P500 or the Wilshire 5000 is just a collection of corporations.  It gives us a closer look at the individual companies whereas something like real GDP tells us more about the economy at large.  I conclude with this central concept; unwittingly, ordinary investors become the information alchemists that compose the titanic processor called the stock market.  Information goes in, which is transformed into expectations which are reflected in the prices of the stocks.  So what is the proper interpretation of the stock market? It is the refection of the expectations by investors as a whole.

Three Easy Tools for the Taxation Debate

Have you ever found yourself debating with a friend (or foe) over how much big business should be taxed? If your like me its happens to often to be proud of.  On the left we hear that big business can be taxed to the end of helping the poor with the revenues gained. On the right they say taxing big business will hurt business and their customers (the poor among them) with higher prices. So which side is correct on this issue?  I’m not going to answer that question directly, but I will give some hard facts about taxation that you can deploy on an unsuspecting victim.

          1) True or false; taxing business will lead to higher prices. True, prices will go up, but the story does not end there.  It turns out we can partially determine how much will prices increase.  If you tax a business at some amount, prices will go up by less then than said amount. That is, if you tax a coffee shop 10 bucks per cup of coffee.  That means that eventually prices will increase by any number less than 10. It might go up by 9, 7 or 5 for all we know, but never more then 10. (unless the tax reduces the number of businesses in the market)

          At this point you may be wondering how this can be true? If a firm is taxed at 10 bucks won’t they need to increase prices by 10$ to make up losses in profits? They would if they could, but they cannot. Produces and consumer each pay a proportion of the tax. (the poor and the rich among them)

          2) True or false; taxing business will not affect social welfare.  False, for all well functioning markets and many not so well functioning markets, taxes will always reduce social welfare. The reason is linked to number 1, prices increase, less trade occurs, and therefore fewer people gain from trade.   However, some markets exist that are inefficient, where if a tax that is set right will increase welfare. This is known as a Pigovian tax.  It is true for markets that positively or negatively affect other markets or people where no voluntary transaction takes place, also known as an externality in econ jargon.  But who is to say that companies cannot resolve an externality issue on their own?

          3) True or false; taxing consumers is different from taxing business.  Very false, it makes zero difference who you tax.  If you tax consumers there is less incentive to buy, if you tax producers there is less incentive to sell by an equal amount.  The best application of this idea is the social security tax.  Politicians in all their wisdom require that part of social security be paid by the employer and the rest by the employee.  It may be true on the books, but what you don’t see are the incentives and wages changing behind the curtains.  With a social security tax hiring someone simply becomes more expensive. Likewise if you tax employees they have less incentive to work (more on this in later posts)  The proportion of the tax paid by consumer and producers is independent of the legal requirements. It may be that employees pay more or it may be that employers pay more; it simply depends on the individual market.  

          Which side of the political isle wins this debate? Firstly, keep in mind that the tools that I listed above are only the beginning of an educated tax debate.  It is true that taxes increase prices and the poor are left to pick up a part of that tab. However, not all markets function well and therefore one might argue that there is a case for all dysfunctional markets to be taxed (or subsidized) at some rate.  However, there can be much difficulty in determining the proper level of the tax.