The FAA, SEC, and You

We fly because of the FAA is doing its job. The FAA exists because the airlines want it to.  We invest on Wall Street even though we know the SEC is not doing it's job.  Besides proof that greed is more powerful than fear as a motivator in the financial markets, and visa versa for travelers, this shows us that until the financial firms want to be regulated (and call off their dogs in DC), there will be no meaningful financial regulation.

There are a few simple things that the individual investor can do to influence this situation:

1. Sell your stocks
2. Influence the institutions (it worked with divestiture from South Africa) 
3. Tell everyone why you are doing it.

Once such an exit from the markets gets going, others will follow if for no other reason than self preservation.  Which will drive the markets down further.

Once wall street realizes they need regulation to rebuild trust in the markets, then financial reforms will come easily.

The first to advocate for regulation will be the honest firms -- after all, the guys who were maintaining their airplanes before the FAA had to pick between skimping on maintenance (to be competitive) or advocating for regulation to make the other guys maintain their planes.  I don't see any financial firms advocating for regulation yet -- so maybe none of them are honest!

What to do with your money if you take it out of the market?  Check out my recommended portfolio allocation here.

Beware of the Drowning Golden Socks

Anyone who has been through lifesaving class knows that a drowning person, in an effort of self preservation, will try to save himself by pushing you under.  Goldman Sachs could be drowning and we should be on the lookout for GS to try to save itself by grabbing anyone nearby.  We saw the first evidence of this last week when an attempt was made to implicate Warren Buffet.  Anyone in finance faced with drowning would pick Buffet as a good place to find some buoyancy.

Deflecting to the system is another defense that Goldman is almost certain to invoke.  So watch for the everyone was doing it/ if you arrest us you have to arrest everyone defense.

We should expect this same dynamic to play out in other areas where titans are threatened.  After all, the mightiest do the most amazing things to hang on to their power, and the most desperate things on the way down.

I would also put Facebook, Google, Apple, and maybe even China in the category of titans. 

My Current Thinking About Wall Street

After thinking and reading about this issue for some months now I have settled on the following set of conclusions:

•  The stakes are very high so we can expect the financial sector to continue to attract the smartest, most self assured, and most self centered people.
• Knowing that the participants are motivated almost entirely by personal gain, it is probably not fair to call them corrupt -- until they take positions in government.  Yesterday's action by the SEC vs Goldman Sachs puts an interesting twist on this one.
• The relative size of the finance and insurance industries to the rest of our economy is an important macro measure of economic health.  Finance and insurance certainly must be in the single digits, and 5% would be a good goal.

 Other Reading

Krugman in March 2009

NY Times this week about potential reforms

NY Times today about SEC vs Goldman Sachs

Australia's Numbers

Along with all of the coverage of the great recession we have also seen a good deal of coverage of the countries that have escaped relatively unscathed.  The one that keeps catching my eye is Australia.  The 22 million people in Australia have been faring pretty well through these difficult years.  Phil Dobbie has a good piece on Bnet about it.  He cites China as a reason, along with Australian banker sanity.  One other key number is immigration.  Australia is attracting alot of immigration -- 1.3% immigration in the year ending march 2009.  I wrote a post about our immigration numbers the other day -- we currently allow .37% immigration.  Australia's current level of immigration is about the same as we had during our peak immigration year in 1907.  Ever since then we have thought the American experience a little too good to share with very many others.

Australia had enough immigration that their GDP per capita fell slighly during the recession.  So is a country, and by extension its people, better off if it achieves overall growth but at the sacrifice of GDP per capita?  I suspect not if it is sustained trend, but for a few years it probably works.  Here are some other interesting numbers from the CIA Factbook.

Australia GDP per Capita: $38,500 (23rd) -- the US: $46,400 (11th)

Australia Income Distribution:  Rank 110 out of 134 or 23rd best score -- the US: 43 out of 134 or 91st place.

It is not clear to me how to convert the income distribution numbers into a meaningful real world number, but considering how close together the GDP per capita numbers are and how far apart the income distribution numbers are, I would guess there is a pretty good chance that if you take out our hedge fund managers, and put military spending back to a rational level, the average person in Australia is probably better off than the average person in the US. 

One of these days I will have to go and check that place out.

Unprecedented

Literally without precedent.  The financial models that brought down our economy (and still could) were incapable of managing events that were without precedent.  The quants call these black swans because mathematically the conditions that created them were impossible to model despite the fact that they do exist.  And we can all see them.  Time and again we allow these super smart people to convince each other that black swans cannot exist.  After convincing each other they eventually convince everyone else and presto the bubble is born.  

There is at least one unprecedented financial event every ten years and more non financial ones.  The discovery of the new world, the invention of the telephone, penicillin, the airplane, and the computer - all unprecedented. The collapse of the ruble, the dot com bust, the mortgage bubble - all unprecedented.

The next one will be unprecedented too and those guys will look at us again and say who could have predicted this?

What if we could convince these big brains to focus on solving real problems instead of finding new ways to game the financial system for personal gain? 

Step one?  Stop giving them our money to invest. 

Step two? Don't bail them out.

We fly because the airlines don't profit from our death (and the FAA helps a little).  We should not put our money into the hands of people that make even more money when they crash the market.

If we all start buying t bills we could take our debt back from the Chinese and put the wall street parasites out of business.

We can't do that you say.  We will lose too much money.  T bills pay less than 1 point and historically the market returns 15.  Well, try this portfolio allocation:  one quarter in each treasuries, residential real estate (your home - maybe even without a mortgage), foreign stocks, and start ups.  You can do all of this without the aid of anyone on wall street.  If enough of us do it those Wall Street guys would really start looking for an answer to their credibility problem. 

If we don't do it, then we deserve to get wiped out during the next unprecedented event - which even I know will happen before 2020.

Third Party Payer Systems Under Siege

The passage of the Obama Health Care plan establishes a crack in one of the most dysfunctional third party payer systems that plagues us.  It is interesting to note that some other third party payer systems are also threatened.  Could it be that we are seeing the end of this business construct -- even though it has been in place for so long?  Here are some examples:

Health Insurance:  By far the largest and most complex.  With employers paying premiums to insurance companies, insurance companies paying for services, and employees as the "customer" getting market rationality into purchasing decisions seems hard to even imagine.  Add to this the prospect of insurers pursuing reimbursement from the government, new layers of taxation, doctors and hospitals sending bills to both insurance companies and the customer -- and we have alot of cleaning up to do.

Advertising:  Pretty simple.  Advertising pays the newspaper, magazine, radio, or TV production company and the "customer" gets the content for free or close to it.  Most attempts to get the customer to pay directly for content fail but we pretty much all agree the media industry is in decline. 

Mortgage "Products" and other Financial Derivatives: Get extra money out of your house and use it to go on vacation.  Seems like pretty simple finance until the terms of the mortgages were so easy to get that the money was free.  Here the third party structure was fragmented and hard to identify -- since it was really a general injection of cash into the economy.  On a larger scale you had firms that called themselves banks making big bets on synthetic financial inventions to the extent that the business we all thought they were in was a footnote on their financial statements.  It would be great if this was behind us, but there are already signs that the banks are back at it already.

Public Education System:  We believe in the importance of education just like we believe in national security, so we fund it through tax revenue.  Today it seems that anyone with the means moves out of the public education system and into private schools. By virtue of the tax system however, they private schoolers are still paying for the public system, so we have a significant and growing third party payer system here too.

All types of Agency:  Travel agents, real estate agents, and many other intermediaries that deliver services to customers while getting paid by someone else, are in decline as transactions get more and more direct.

So are we on the verge of a world where customers will pay directly for the services they value?  It might actually be easier to sort some of this stuff out if we gravitated back to making rational purchasing decisions and paying for the products and services we get.

US Savings Rate: Headed Over 10%?

For a long time we have had one of the lowest savings rates in the world.  Even now, we are just about 4%.  

What drives the savings rate?  Are we motivated by what is better for our country (to own our own government debt instead of China)?  Of the nations tracked by the OECD, the savings rates ranged from 17.9% in Spain to 1% in Australia.  If you sort the list by savings rate there is a direct correlation to the stability of the economy and government.  Translation:  people save more when they have low confidence in their government.

So great news for the US, our savings rate is going up! 

The Economist: Is America Ungovernable?

Last week the Economist magazine posted the question to its readers:  Is America Ungovernable? 

Their main point was that the party in power had more power than any administration in memory and still could not get anything done.  The comments back from readers followed the lines you would expect:  the R's blame the D's and visa versa.  The Economist circled around and said that in fact the government is working.  A very interesting debate indeed.  

I would say that we are generally not worried enough about the future of our country.  Properly motivated we know we can solve any problem.  Each entity involved today is mostly focussed on getting some for themselves -- the political parties want more power, the politicians want to be re-elected, industries want the paying field tilted in their favor, and companies really cannot do anything but look out for themselves.  Everyone must know the trend is unsustainable, but so did everyone when they were buying tech stocks in 1999 or real estate in 2007.  Sure it will end someday, but I will get mine and get out before it happens.  

We can only hope that we will wake up to the precariousness of our situation and turn our attention away from personal greed and to fear for the survival of our country.  Then we can get down to the business of governing.

China in Your Backyard

Until I saw this article I thought low cost goods made from pirated designs with super cheap labor in China entered our markets through those shipping containers we see stacked everywhere.  Now it seems Chinese companies are invading with illegal immigrants and copying products locally and undercutting prices -- all without having to put a Made in China label on the products.  

Sound unbelievable? -- check out this story in the Financial Times. Sure it is just Italy now, but who is next?

There is a war going on and we don't even know it.

What to do with the Cash

We give China $20 Billion in cash every month (our trade surplus).  Other countries give China cash too.  This is a big problem for China -- because they are running out of places to put the money.  They put some in US Treasuries -- but we pay essentially zero interest, and they already have a trillion dollars of our debt.  They put a great deal into domestic projects, but there is a limit to that (inflation). They put another small mountain of cash into pre-purchasing natural resources like oil and copper from other countries, until those prices go up too much and everyone screams.  

Now they are building infrastructure projects in other countries as reported in the NY Times.

It should be a priority for us to figure out how to stop giving them all this cash.

Capacity of a Salesperson

How many salespeople does a country need in order to achieve its GDP growth? Can salespeople increase GPD (pull us out of a recession)? If we only had enough salespeople, we could put the whole country back to work. Clearly the world is not this simple, but hidden in a ridiculous argument like this may be a few interesting things to think about.

Every industry has its key metrics and just about every industry has salespeople.  From what I can tell the mid point in salesperson production is about $1 Million in revenue and $100,000 in compensation.  A Starbucks Barista would generate much less and get paid much less, and a bond salesperson on Wall Street -- well much more on the pay part anyway!

So I know this number is weak, but let's just go with it for this discussion.  One salesperson = $1M in Revenue.

The other day I analyzed 8 tech companies including Apple, Google, Microsoft, IBM....  Together those companies generate $400 Billion in revenues.  Using our little formula above, they collectively would need to have 400,000 salespeople to generate this amount of business.  Even though they collectively employ 900,000 people, clearly half of their employees are not in sales.

So where do all of those other sales come from?  Some from automation (Google's service apparently sells itself), but most comes from channel partners.  Partners ranging from the distributors, to the retailers, to the four person computer consulting company in Everytown, USA.

Despite what has been happening on the NYSE the last few days, the economy is showing signs of life.  Our President is looking for ways to get more jobs into the recovery.  Many economists are pointing towards small business as the place where the hiring is going to happen.  Well the President should be proud because this is exactly what we are seeing happen right now.  

The large technology companies are ramping their channel partner programs up in a big way.  This is presenting many opportunities for growth in their channel partners, and those channel partners are hiring.  And for every 100,000 new salespeople we will grow a whole IBM ($100B) worth of new GDP. 

Separate the Diagnosing from the Curing

Ten years ago we spent a bunch of time and money on the Y2K problem. While it is impossible to know if there really would have been a problem at the change over from 1999 to 2000 -- the consensus at this late date is that we dramatically overstated the problem, and dramatically overspent on the solution.

Our military regularly overestimates the size of threats in an effort to bring about a response; either in terms of funding for the military or outright action. We know some form of this played into the Iraq war.

The financial bail out of 2009 was identified and addressed by same people, and those people were tied very closely to Wall Street.

Large food companies have boosted sales of their products, particularly in developing nations, through misleading marketing. So much so that the World Health Organization had to create guidelines to discourage the practice.  

Our pharmaceutical industry routinely convinces us we are sick and then sells us the cure. They are now busily convincing the rest of the world that they are sick too.  

We all need to be wary of anyone who both dispenses the diagnosis and profits from the cure.

People are not Computers

Last week a very interesting book came out, "You Are Not a Gadget" by Jaron Lanier. I am about half way through it and will post a review on this page soon. I had the good fortune of meeting Jaron this morning when he make a short presentation at Emerald City Rotary Club in Seattle. Here are the two main thoughts I took away from his talk and the discussion after:

People are not Computers (or visa versa)

The book goes into this in great detail, but Jaron does a good job of encapsulating the danger of thinking of computers as capable beings. He uses Facebook as an example of a system that we may think tracks in parallel with humans. He went on to point out that Facebook does not come very close to approximating the richness of human relationships. If we give Facebook enough authority in our society we will subject ourselves to its inadequacies. If we subject ourselves to Facebook, and Facebook cannot approximate real life, we will start to limit ourselves in real life to only the things that Facebook can recognize. So what you ask?

In America we are all big fans of reinvention. We built our country on the idea. Those of us that grew up before Facebook never thought twice about creating a whole new self if it suited us. We may not have gone as far as Don Drapper, but I know I tried on many personalities before I decided who I was. It is true that Facebook cannot stop us from doing that (or anything), but we can stop ourselves from doing it because we are worried about how it will be represented on Facebook.

We are giving away both ends of the value creation chain

Some time ago we came to the conclusion that inventing was the place to be, and the making could be done somewhere else. This follows our belief that labor is the main component of making and that ideas are the main component of inventing and we want to be the idea people. Some time later, about ten years ago, we decided that ideas should be free. We decided that writing, music, software, and many other pursuits of the mind should be shared freely (on the Internet) and that money would be made some other way. Sure these two changes were separated by about half a century. So we can forgive ourselves for not connecting them together. But now that we don't make things, and we give our ideas away for free -- what part of value creation do we own?

I am really looking forward to getting to the end of the book because Jaron has made some pretty good arguments that we are driving the bus right off the cliff. I for one don't want to go off the cliff. When I get to the part about what we should do -- I will report back. I suspect education and privacy will be involved.

Here is a link to Jaron Lanier's web page.  

Please do not hesitate to leave your comments.

Paying for Things We Don't Need

I travel a fair amount and like anyone who encounters the TSA regularly, I have reduced the number of things I bring with me as much as possible. This has been a great exercise, because for a quick trip I just do not need much stuff. As a society, we probably need more constraints like this because we have gotten out of the habit of making well considered purchasing decisions.

One of the things I started leaving behind was shaving cream. I did not know if it was a liquid, and the can was clearly over 3 oz. Indstead I used plain soap from the hotel and for me it worked just fine. Soon I was not using shaving cream at home either. It had always bothered me that the company that made it was "innovating" by making it difficult to dispense just the amount of product that I needed. By some miracle of engineering the can always shot out about twice as much as I needed. Fortunately I don't need them at all now.

I was an early adopter of an IP phone service. I tried it out and it worked OK, but then the hardware failed - and well, we never cut over. After paying for the service even though we were not using it for several months, I called to cancel. The company charged me $35 just to cancel my account -- even though they could plainly see that I had no activity on my account. They got my $35 -- but I am no longer a customer.

Here are some other examples of commerce in our daily lives that may not be adding any value.

• Retailers will sell you a warranty on just about anything -- and their business model is to fulfill as little on the warranties as possible.
• Many health insurance companies deny every claim the first time around -- just to see how badly you want them to pay.
• Stock brokers will charge you a fee for an account that goes unused.
• A fairly high percentage of gift cards go unclaimed -- which is pure waste for the purchaser and pure profit for the seller.

How much of our GDP is based on waste like this?

As consumers we should think more about what we buy. As shareholders we should make sure we don't own shares in companies that have revenues earned this way.

You Can't Kill Me -- I'm Rich

One of my favorite authors for casual reading is Larry McMurtry. The Texas native is best know for his western novels including Lonesome Dove. In 2002 he wrote the first of the Berrybender novels set in the 1830s about a very rich English family on an adventure up the Missouri River. Lord Berrybender and his subjects were seemingly oblivious to the danger they were exposed to; as if they felt protected by their aristocracy. Funny thing though, the people of the new American west didn't care that they were aristocrats from England.

They did make some preparations for the trip -- including towing a separate boat behind their steam driven paddle wheeler -- just to carry the wine. The Berrybenders were stunned when they found that some Native Americans would happily kill them, and those that were not interested in murder felt free to just take their wine.

We now find ourselves cast as the Berrybenders. We do not fully understand the way the rules are changing and feel entitled to continue to enjoy our status and lifestyle. I just hope we don't find ourselves frozen in the middle of the river without enough food and no idea what to do next.

Do We Want China to Fail?

In the past 30 years the Chinese economic miracle has raised 500 million people from below the poverty line to above it. Our economy is stuck in the mud and theirs is seemingly growing at whatever number they want. There is a very good article in the New York Times outlining how China's growing economy is impacting its domestic markets. The article states that the average annual income in the cities in China is still under $3,000, and under $1,000 in the rural areas. Despite this, the Chinese now buy more cars, more home appliances and bigger TVs than we do here in the US.

The China story is truly amazing -- after all, they have not had a losing year since 1976 and in those three decades, only two years had GDP growth of under 5%. In 1976 China's economy was 5% the size of ours, now it is 50%. Economists may have differing opinions on many things, but they all agree that markets have cycles. Thirty years without an economic reset in China does imply that one of these days, their economy is going to have a bad patch. When it happens, we will be able to say that even the Chinese markets reset every once in a while, and some people will feel better about themselves. I would argue that it is not in our best interest for the following three reasons:

Life or Death

The delicate balance of the Chinese economy still has more than 600 million people living very close to starvation. China is extremely focussed on growth because without it millions of people starve. And if that is not enough motivation, with starvation comes political unrest -- so a downturn in China would also start a revolution intent on replacing the government. With the recent build up in Chinese military capability, such a change would include the current government turning on its own people -- also devastating.

Keep us Honest

Honesty is in short supply in our country these days, but it would be even less so without a strong competitor. On some days it is nice to be alone on top of the world economic heap, but I would argue that since the fall of the Berlin Wall, we have been without competition, and lack of competition gives us nothing to focus on but gaming our own system. The last twenty years has seen our smartest math and science minds put to use creating financial products on Wall Street, and engineering quadruple razor blades we will never need. A growing and vibrant China motivates us to fix our own country.

Share the Load

A successful China may not get around to helping other nations for fifty years. Just taking care of themselves however, will free the rest of the developed nations to work to solve the other terrible problems facing our world. Who knows, if China continues on its path to prosperity they may even decide they have a responsibility to help others. And we could use all of the help we can get.

So even though we may feel badly that the Chinese are now buying all of the Hummers -- hey, they even bought that company -- and soon will be buying many more of our assets, I would encourage you to join me in pulling for China to succeed. If they do we will all be better off.