Nov 19 14

Financial Advice from the Fed Chair

by Jeff Speakes
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In two recent speeches Federal Reserve Chairman Janet Yellen has highlighted issues of personal finance. In each case she referred to results from the Fed’s triennial Survey of Consumer Finances (SCF), the most recent version of which (2013) was released just last month. In September, Chairman Yellen commented on the meager levels of wealth for families in the bottom quintile of the wealth distribution. The average net worth reported by the bottom fifth was just $6,400 in 2013. The next fifth had median net worth of $27,900. She commented on the importance of having a financial cushion to absorb shocks, and the benefits of asset building more generally. In October, the Chairman gave a lengthier speech on trends in income and wealth inequality. Again referring to the 2013 SCF, she noted that the top 5% richest families owned over 60% of total wealth in 2013, as compared to just over 50% in 1989. This is due to people at the top doing really well and most of the rest just treading water. The Chairman appears to be extremely concerned with these trends, particularly inasmuch as they suggest declining economic opportunity.

In the October speech, Chairman Yellen goes on to discuss four means by which economic opportunity can be enhanced. The first of these is greater pre-school and K-12 funding for poor neighborhoods. She suggests that funding public schools through the property tax naturally leads to highly unequal resource availability across communities. The second means to achieve greater upward mobility is availability of affordable higher education. Thirdly, she points out that business ownership has long been a part of the American dream and is a source of wealth enhancement (at least, for the 10% or so of start-ups that do not fail). She notes a downward trend in the rate of business ownership as reported by the SCF. She does not speculate on reasons why it has become harder to start and build businesses in America. Finally, the Chairman mentions the role of inheritance in helping improve families’ financial situations. I find inclusion of inheritance surprising in this context. Certainly, it would be great for a poor family to receive a large inheritance, but that must be very rare for low wealth households.

I think the Chairman could usefully combine her two speeches and by doing so come up with a fifth source of upward mobility, namely, save more. The essence of the September speech was the importance of building up assets. I take that to mean that Chairman Yellen is in favor of higher savings rates.

It is interesting to ponder what levels of savings the Chairman would consider appropriate. For example, would the Chairman be content if everyone got religion and the savings rate immediately jumped substantially, say, up 10 or 20 percentage points? The patron saint of Keynesian economists, Lord Keynes himself, described a situation wherein higher rates of intended savings backfired. In this situation, the so-called “Paradox of Thrift,” higher savings rates result in lower aggregate demand and equilibrium income, so that the amount of savings is lower even though the rate is higher. Assuming Chairman Yellen is a good Keynesian, I wonder if she would be comfortable in promoting large savings rate increases.

Anyway, while broad-based substantial increases in the savings rate are almost surely not in the cards, it is interesting to speculate about what could be accomplished at the household level by healthier savings. My colleague Richard Stern and I have developed software (FINSIM1.0) that estimates the probability of reaching various financial goals including wealth building and retirement spending. Consider the median income family, with income around $50,000. Let’s assume this family is also the median wealth family, with financial wealth of $75,000. Finally, assume the family follows the advice of consumer advocate Senator Elizabeth Warren and saves 20 percent of income. FINSIM runs show that this family is likely to move well up the wealth distribution. Over the remaining lifetime of the household head (currently aged 40), and assuming a 50/50 investment allocation to stocks and bonds, a 6% expected real return on stocks and a 0% real return on bonds, we estimate a one in two chance of moving from the 50th percentile of the wealth distribution to the 75th percentile, a one in three chance of moving up to the 90th percentile ($1 million net worth in real terms), and a 1 in 10 chance of moving up to the 95% percentile ($2 million net worth).

If we take the median college graduate (that is, the college graduate with median income and zero wealth), the chances of moving up the wealth distribution are even greater. Bottom line, there is a lot of upside potential.

Of course there are important reasons why people are not saving. One reason is sluggish wage growth in recent years combined with lots of exciting new products to buy (the latest smart phone, your own 3-D printer, etc.). And a second reason is simply that current interest rates are really low. In fact, the real after-tax return on “safe” money market or deposit products is negative (maybe Chairman Yellen is in a position to do something about this). Why defer enjoyable consumption when the rate of return is less than zero? In our simulations, as noted above, we assume 50/50 allocation to stocks and bonds, with a six percent expected real return to stocks and a zero real return to bonds. Effectively, we are assuming an expected real return of 3% and return volatility of 10%. You will not earn a positive real return if you are unwilling to take stock market or other risky asset exposure. To get ahead, you have to take some risk as well as defer consumption.

Oct 10 14

Compression at the top

by Jeff Speakes
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One of the major stories of recent years is that of rising income and wealth inequality, whereby the rich are supposedly getting richer and the poor poorer. A primary piece of evidence for this is increases in the shares of income and wealth accruing to the top 10% of the distribution, the top 1% of the distribution, and the top 0.1%. This effect seems to be stronger the higher you go up in the distribution. That is, the share of the top 1% is growing faster than that of the top 10%, and the share of the top .1% is growing faster than the share of the top 1%.

However, at the very top of the distribution, in the realm of the “richest man in the US” (the top .000001%), the situation is very different. Not only is the richest guy not keeping up with the rest, but the wealth of the richest guy actually appears to be falling. In 1992, the richest guy in America was Sam Walton, founder of WalMart, with $65 billion (well over $100 billion in today’s dollars). He was eclipsed by Bill Gates in the mid-1990s. In 1999, when Microsoft hit its all-time high price, Gates had a reported net worth of $101 billion. Today, Gates is still at the top of the list, but his net worth has plummeted to around $70 billion. Thus, despite substantial increases in aggregate net worth over the past 15 years (in fact, a doubling, from $40 trillion to $80 trillion), and rising concentration of wealth, the richest guy has lost 30%!

What is going on here? It appears that there are significant forces working to constrain wealth. One of which is competition. In 2009, Microsoft was the undisputed titan of the software world. Since then that company has faced huge challenges from small and large competitors. Today, Microsoft shares titan status with Apple, Google, Facebook and others.

A second force is mortality. The Walton family Walmart fortune is still largely intact, but it is now spread across six of Sam’s kids, and soon to be many more grandkids.

A third force is charitable giving. Over the past 15 years the Bill and Melinda Gates Foundation has given away multiple $ billions to support initiatives in education, health care and poverty alleviation.

This example of the richest guy seems to me to contradict the argument that wealthy people just keep getting wealthier. Instead, it looks like wealth runs up against a number of powerful forces that tend to slow or even reverse further gains. Maybe these forces apply more generally than just to the richest guy. To see if this is true, we would need to follow specific people as they enter into the rarified atmosphere of the top 1% or .1% of the wealth distribution. The type of a study that would do this is called a “panel data” study wherein a set of people (the “panel”) is followed over a period of years. Indeed, there are ongoing panel studies that monitor the distribution of income, but as far as I know only for broad classes of the income distribution. For example, the IRS recently released a study showing that over the period 1999 to 2007, more than 40% of the top 10% of income earners in 1999 were no longer in that category eight years later.

Unfortunately, I am not aware of a study like this for the top 1% of the wealth distribution. All we know (or think we know) is that the combined wealth of the top 1% is bigger today than it was a few decades ago. But almost surely the top 1% today is not comprised of the same people as the top 1% then. Instead, my guess is that we have substantial entry into and exit from the top 1%.

While we don’t have visibility into the top 1%, we can look a little more deeply. The same source for the richest guy (the top .000001%) also provides data on the richest ten (top .00001%) and the richest hundred (top .0001%). This source is the “Forbes 400” which is a listing of the 400 richest people in America published annually by Forbes Magazine since 1982. By comparing the names on the list from year to year we can get an idea of the degree of stability at the top. For example, in 2014 the Forbes 400 contained 24 names that did not show up in 2013. This also means that 24 names that did appear in 2013 have disappeared in 2014. This 6% “turnover rate” has been pretty steady over the years. This implies that over one generation (since 1982) more than 85% of the richest people have been replaced in the top ranking.

Again, we don’t have adequate data to explore the turnover rate in other parts of the wealth distribution. But if we did, my guess is that we would find substantial turnover there as well. What I think this means is that we are not creating a permanent upper class of rich people.

Sep 15 14

The Vice President and the SHED

by Jeff Speakes
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In order to better understand the state of household finances, the Federal Reserve has recently conducted a special survey called the Survey of Household Economics and Decision making, or SHED. This is in addition to the tri-annual Survey of Consumer Finances. Key findings from the SHED include the following: (a) most families indicate that they are “doing okay” or “living comfortably,” (b) still, about one in three families felt they were financially worse off than they were five years ago, (c) only about half of the respondents were putting some of their income away in savings, and the median savings rate of the savers was 10% of income, and finally, (d) only about one in four households was actively preparing for retirement. While not worrying about retirement is somewhat understandable for young people, it is eye-opening that less than half of people over the age of 50 are not preparing for retirement.

There are certainly valid reasons for not thinking about, nor preparing for, retirement. One reason is that you really enjoy your work and do not plan to retire. Another is that you have a terrific pension plan at work; one that enables you to maintain your consumption levels indefinitely (for an example, see below). But my guess is that most people do not fall into either of these categories. Instead, most people will be forced to downsize spending (“retrench”) during their retirement years.

Financial advisors are generally supportive of the retrenchment strategy. After all, they say, family expenses tend to peak and then decline once children are out of the house and on their own. In fact, the data do show that older households spend less. But is this because expenses are lower or because resources are constrained? My guess is the latter.

The fundamental problem is that most people do not save enough during their working years. The facts that only half of households have saved at all, and the median savings rate for them is 10%, suggest that 75 percent of households have savings rates below 10%. Of course, some people can get away with no or low savings. For example, consider our Vice President.

VP Biden

According to a recent Bloomberg News report, Vice President Joe Biden is proud of the fact that he has no savings account, nor does he own a stock or a bond. Presumably, he is pleased to be able to make these claims inasmuch as it appears to place him clearly in the majority 99% instead of the affluent 1%.

But, can this be correct? No savings account? No mutual fund? This seems weird for a man that has had a very long and successful career; not only weird, but also somewhat irresponsible. Once you get to the point that you are making a decent income, it is incumbent upon you for the sake of your family to forego consumption and build up some savings.

Of course, in Joe’s situation there is no need to do this. After all, as of 2016 Vice President Biden will have had a forty-plus year career in Congress and eight years as Vice President. For this, he earns a substantial salary and an even more impressive pension (which is adjusted for inflation). Given this salary and pension, he really doesn’t need to save (assuming he does not intend to leave a financial legacy for his children). So maybe it is understandable that he has created no savings or investment account.

Yet from another perspective this is troubling.

The primary source of capital for new ventures is savings, and their ultimate placement in equity securities or debt securities or mutual funds. The fact the Vice President Biden views it as a positive that he has not saved is unfortunate. It reflects a view from one of the preeminent members of the Democratic Party that building up a savings account is a bad thing. What happened to Benjamin Franklin?

This sends a bad message. It is through savings that capital is cumulated. Along with knowledge, accumulation of capital is a primary source of improved productivity and improved standards of living. We want to promote savings, not denigrate it.

Bottom line: Don’t Retrench, Ratchet!

I think people would be better off if they adopted a plan that allowed them to spend more as they age. To accomplish this is easy: just estimate your total economic resources (including future earnings power) and keep annual spending to a modest fraction (1% or 2%) of total resources. For most people, implementation of this plan will mean lowering the amount of current consumption. But the good news is that, barring disastrous investment performance, the implication of this strategy is that your wealth will rise over time and so will your spending. Not only that, but the economy’s overall performance will be better as well.

Aug 19 14

What’s up with housing?

by Jeff Speakes
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Housing is traditionally a very volatile sector of the economy. It tends to lead the business sector (indeed, some economists like Ed Leamer of the UCLA Forecasting Group say that housing IS the business cycle). Housing is subject to booms and busts. A case in point is the major housing boom of the early and mid 2000s, that ended up as a major bust between 2006 and 2010. The boom was marked by a huge run-up in housing prices and substantial over-building. Housing affordability fell dramatically even as the homeownership rate increased. The supply of vacant homes increased massively.

The excesses were largely eliminated in the subsequent housing bust. Affordability has increased as housing prices have fallen and mortgage loan rates are near all-time lows. The stock of vacant homes is near normal levels. Demographics look positive as well. Each year about 4 million young people reach the age of thirty, historically the typical time for first time home ownership (granted, the rate of household formation is lagging behind as many young people today are slow to venture out on their own). The rate of homeownership has declined to historical averages, after rising sharply during the housing boom.

Based on these fundamentals, we perhaps should have expected that a very strong housing recovery would be underway. But if we expected that, we would be wrong. Since the bottom in late 2010, housing starts have picked up 20% or so, but that still leaves the pickup in construction activity well below the improvement in prior cycles, even those that began at higher levels of activity.

Bottom line, housing remains weak. Why is that?

One possibility is simply that the traditional home affordability measures are misleading. The home affordability index published by the National Association of Realtors asks the following question: what percent of the median priced home can be purchased by the median income family given the current market rate for 30-year fixed rate mortgage, and assuming a down payment of 20% and a debt-to-income ratio of 25%. This measure reached a record high of 196 in 2012, and has receded to a still high by historical standards 175 as housing prices have picked up since then.

One factor that the affordability index does not take into account is the amount of consumer debt, in particular student loan debt that has now reached $1.2 trillion. High levels of student loans impair the ability to save up for a down payment and increase the overall debt burden. Both factors surely impact the mortgage underwriting decision, even they don’t show up in the affordability index.

Another issue is expected financial return from home ownership. In the past, owning your own home has been widely perceived to be the surest path to financial security. So long as home prices increase, and mortgage amortization reduces indebtedness, home equity builds up. The rate of return is amplified by imputed rent (you pay rent to yourself instead of a landlord) and various tax benefits from home ownership. While the long-term return to homeownership has been challenged by some economists, notably Robert Shiller, the fact remains that home equity has been the primary component of net worth for the majority of households.

However, confidence in home ownership as a means to wealth enhancement was obviously shaken if not shattered by the widespread declines in home prices between 2006 and 2010. Much like the generation that grew up during the Great Depression swearing off stocks for decades, a similar phenomenon may be going on with the Millennial generation and home ownership.

Compounding the concern about home price appreciation is concern with wage growth. The recovery from the Great Recession has been mediocre and likewise the rates of job and wage growth. While the level of wages is captured by the affordability calculation, which as noted above is looking pretty good, so long as economic prospects appear to be bleak, who has the confidence to undertake a huge investment?

Finally, mortgage underwriting standards today are significantly tighter compared to the lax standards prevalent certainly during the prior housing expansion. Naturally, tighter underwriting standards mean that a smaller percentage of the potential home buying universe can qualify for a loan.

The combination of large consumer debt, concern over future housing appreciation and wage growth, and tougher mortgage standards appears to have diminished the appeal of home ownership, at least temporarily. Eventually, there will develop pent-up demand by first-time buyers as young people become frustrated with apartment life or hanging out with Mom and Dad. But there is little sign of that at present.

Aug 7 14

The California Economy: A Strength VS Weakness Breakdown

by Bill Watkins
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Previously published on July 11, 2014 on

Part two of a two-part report. Read part 1.

The problem with analyzing California’s economy — or with assessing its vigor — is that there is not one California economy. Instead, we have a group of regions that will see completely different economic outcomes. Then, those outcomes will be averaged, and that average of regional outcomes is California’s economy. It is possible, even likely, that no region will see the average outcome, just as we rarely see average rainfall in California.

California’s Silicon Valley region continues to be a source of innovation, economic vigor, and wealth creation. But the Silicon Valley, named because silicon is the primary component of computer chips, no longer produces any chips. The demands for venture capital are also changing, with the demand for cash falling because new products often take the form of apps instead of something that is manufactured. This type of investing doesn’t need the infrastructure that the Silicon Valley provides. Increasingly, other communities such as Boston, Northern Virginia, and Houston are becoming centers of technological innovation.

Workers recognize the changes. They may not know the reasons, but they know the impacts, and they are voting with their feet. Domestic migration — migration between states, — is a good measure of how workers see opportunity. California’s domestic migration, in a dramatic reversal of a 150-year trend, has now been negative for over 20 consecutive years. That is, for over 20 years more people have left California for other states than have come to California from other states. Workers simply haven’t seen opportunity in California. How can this be? Why would people be leaving when jobs are being created in the Silicon Valley?

The Silicon Valley jobs are rather specific. They require higher skill sets than most workers possess. One consequence is that the Silicon Valley’s prosperity hasn’t helped California’s other workers much. We are left with a situation where California’s tech firms search worldwide for workers, while California workers search for work.

It didn’t have to be this way. High housing prices and environmental regulations, a result of state policies, have driven away the jobs that could be performed by typical California workers. Those jobs are now in Oregon, Texas, or China.

A short distance away, in California’s Great Central Valley, there is poverty as persistent, deep, and widespread as anyplace in the United States. A recent report shows that California has three of the 20 fastest growing US cities in terms of jobs. It has four in the bottom 20.

For a while, at least, the differences between California’s fastest growing regions and its slowest (or declining) areas will grow. In general, coastal areas will see more rapid economic growth than inland ones. Even within these broad regions, there will great heterogeneity. Bakersfield, boosted by a booming oil sector, will see stronger growth than Stockton. San Jose, with its thriving tech sector, will see far more growth than Santa Barbara or Monterey. Furthermore, the best performer among California’s inland cities will probably see faster growth than the slowest growing coastal city.

On average, California’s economic growth will be far below its potential. In most of the state it will be disappointingly low to dismal, as California’s economy is held back by well-meaning but seriously flawed regulations. At the same time, a few super-performing cities may see spectacular growth, at least for a few years.

Eventually, even California’s most vibrant economies will slow, gradually strangled by the lack of affordable housing and of an infrastructure necessary to move people from affordable housing to their jobs. People are willing to drive very long distances daily in pursuit of the twin goals of income security and the American dream of a home in the suburbs. The traffic on Highway 14 between Palmdale and Los Angeles reminds us of this twice every working day. But, they need roads, and affordable housing within commuting distance.

Different growth rates and different levels of economic vitality will exacerbate the vast gulf that exists between California’s wealthiest communities and its poorest. Inequality will increase as California’s fabulously wealthy become ever wealthier, and California’s poor suffer in surprising silence, living on whatever aid we give them, denied the hope and the basic dignity that comes from a job.

Domestic outmigration will increase, but the people who leave won’t be California’s poorest. Instead, young middle-class people will lead the exodus, as they move to wherever opportunity is more abundant. This, of course, will further increase California’s inequality and decrease its economic vitality.

We will also see an increase in consumption communities. Already, many of California’s coastal communities are reflexively averse to any new activity that actually creates value, opting instead to become ever more exclusive playgrounds for the very rich. These communities will see rising home prices as they restrict new units, and will see rising demand, a result of ever greater concentrations of wealth worldwide and the unmatched amenities available in Coastal California.

By contrast, some inland areas will see declining home values and eventually declining populations, as the lack of opportunity drives potential home buyers to places like Phoenix and Houston.

For many of us, this is a depressing forecast, and it is fair to ask whether or not it is inevitable. It isn’t. Few things are. At a statewide level, I hope that representatives of California’s large and growing minority communities demand policies that support the opportunity that previous generations of Californians enjoyed. Absent such demands, California’s policies are unlikely to change.

At a local level, cities would do well to eliminate all policies that contribute to economic stagnation. When a business is making locational decisions, it reviews lists of positive and negatives for the candidate communities. No place has only positives, and few places have only negatives. California cities are endowed with one huge positive: California is a wonderful place to live. That’s not enough, though. A city would do well to minimize the list of negatives.

For businesses, an aggressive minimum wage is a negative, as it raises costs. Uncertainty and delay in a city’s response to an economic proposal increases the risk and costs of proposals. It’s a negative. So is unaffordable housing, as it increases wage demands and makes it harder for businesses to recruit top talent. The best way for a city to encourage the supply of affordable housing is to allow new-home development.

Finally, areas of economic blight increase crime, raise city costs, reduce city revenues, and are unattractive to businesses considering moving to or expanding in an area. Cities need to be flexible in responses to proposals for these areas. Our work at CERF convinces us that we will need less commercial space in the future. Therefore, almost any proposal for dealing with these areas is preferable to inflexible adherence to existing zoning or plans.

California cities are constrained by California policy. That doesn’t mean that California cities are without tools for economic development. Almost any California city — no matter which region it is in — is a better place to live than almost any city in, say, Texas. If that can be leveraged by minimized costs, flexibility, and creativity in adapting to the needs of job-creating businesses, a California city, even today, can assist businesses creating opportunity for its citizens.

Aug 7 14

The California Economy: When Vigor and Frailty Collide

by Bill Watkins
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Previously published on July 10, 2014 on

Part one of a two-part report.

California is a place of extremes. It has beaches, mountains, valleys and deserts. It has glaciers and, just a few miles away, hot, dry deserts. Some years it doesn’t rain. Some years it rains all winter. Those extremes are part of what makes California the attractive place that it is, and, west of the high mountains, California is mostly an extremely comfortable place to live.

Today, we have some new extremes. Some of our coastal communities are as wealthy as any in the world. At the other extreme, we have some of America’s poorest communities. San Bernardino, for example, has America’s second-highest poverty rate for cities with population over 200,000.

From the beginning, we’ve had the fabulously wealthy. For the first 140 years after gold was found, California was a place where people could find, or, more correctly, build, success. The new part is the poverty. It used to be that the poor were mostly newcomers, people who hadn’t yet had time to show that they had what it takes. Today, our poverty is dominated by families who have been here a long time. While San Bernardino certainly has some newcomers, it is mostly a city of native Californians.

The change became visible in the early 1990s. Many analysts will tell you that the change was caused by the collapse of the Soviet Union and the resulting peace dividend, which led to a dramatic downsizing of America’s defense sector, once a major component of California’s economy.

I believe the way to think about this is that the downsizing of the defense sector exposed the weaknesses in California’s economy, as opposed to causing them. Sure, the downsizing had an economic impact. California lost hundreds of thousands of jobs. But the defense sector eventually bounced back and again became a source of good jobs. The problem is that it bounced back someplace else. It didn’t come back in California. In fact, it continues to decline in California.

The decline in California’s economic opportunities began way before the 1990s. As the 1960s progressed, Californians, or at the least the ones making decisions, changed their priorities. California’s spending for infrastructure had once consumed between 15 and 20 percent of the State’s budget. It precipitously fell to five percent or below.

In the ’50s and early ’60s, governors Goodwin Knight and Pat Brown presided over a fabulous investment boom in universities, highways, water projects and the like. None of their successors has even attempted anything on that scale. The profound prosperity that accompanied and followed California’s investment boom hid the impacts of subsequent policy changes for decades.

The decline in public capital spending wasn’t the cause of our changed priorities. It was the change in priorities that caused the change in spending. It is as if we decided that we were wealthy enough, and that future spending would be on social and environmental programs. If we weren’t looking for economic growth, why invest?

At California Lutheran University’s Center for Economic Research and Forecasting, we’ve created a vigor index. It’s composed of net in-migration, job creation, and new housing permits, each equally weighted. It is quite sensitive to changes in economic opportunity. For example, in 2000, North Dakota had the nation’s lowest score, 0.9, and Nevada led the nation with a score of 24.1. By 2013, North Dakota led the country with a score of 20.0, while Nevada had seen its index value fall to only 6.4.

In the following chart, we show California’s index (red bars) compared to that of Texas, Oregon, and Tennessee, from 1980 through 2013.

California is apparently different than the comparison states. The Tennessee, Oregon, and Texas indexes have behaved more similarly to each other than to California since the late 1980s. Texas’ index behaved uniquely in the early 1980s, because of its dependency on oil and the long-term decline in oil prices that occurred during the 1980s.

California appears to be different than the other states throughout the period, but the nature of the difference has changed. Prior to the late 1980s, California tended to outperform the others. For example, its score didn’t decline nearly as much as the others during the early 1980s recession. Given California’s resource endowment, we think this is natural.

Since 1990, though, California’s vigor index has generally remained below those of Texas, Tennessee, and Oregon. Indeed, since 1990, California’s score has rarely exceeded the score of any of the comparison states, and it has never led them all.

The index also shows that California’s investment in infrastructure during the 1950s and 1960s helped drive economic opportunity for two decades. It took two decades without any investment before we saw the consequences of the decision to not invest.

Recently, California has seen budget surpluses and faster job growth than the average American state. The forces for the status quo now claim that this confirms the wisdom of their policies. They are wrong.

California’s budget surpluses are a product of a temporary tax, and an incredible bull market in equities. Our dependence on a highly progressive income tax means that California’s fiscal condition swings on the fortunes of a small group of wealthy individuals.

Equity markets have been amazing over the past few years. The Dow has increased by over 10,000 since it bottomed out on March 9, 2009, and it appears to be divorced from economic activity. It increases on good news and bad, propelled by an unprecedented monetary expansion. Right now, California’s largest taxpayers are reaping huge profits in the stock markets, and California is reaping huge windfalls in its tax revenues.

Someday, the market gains will cease, or worse reverse. Someday, too, the temporary tax will expire. California’s surpluses will wash away like sand on a beach. The state will face a new crisis, a result of a progressive tax structure where revenues swing on paper profits and losses, not on economic activity.

As for our job gains being better than the average state’s, California should not be average.

Employment should be far higher than it is. Even the weak job growth we’ve seen is largely a legacy of a previous age. California has the world’s best venture capital infrastructure, partly because of the investment previous generations of Californians made in the university system. It is also, in part, a result of chance.

An amazing period of innovation was initiated in Coastal California by a few incredibly talented individuals, who were funded by a few far-sighted capitalists. It was one of those rare coincidences that happen from time to time and change the world. The eventual result was the Silicon Valley and economic powerhouses such as Intel, HP, Apple, Yahoo, Google, Facebook, Twitter, and many more.

Another result was the creation of a private, capitalist, vibrant infrastructure. It takes time and vast sums of money before a new idea generates profits. Product design is just the first step. An organization needs to be created to produce and sell the product. Factories need to be designed. Marketing plans need to be put in place.

No inventor or entrepreneur can be expected to have all of the necessary skills or money to turn an idea into a profitable firm. So, an infrastructure appeared. The Silicon Valley’s world-leading venture capital markets and the support structure to enable the fabulous innovation and economic value created there was not the result of any government program or initiative. It was the spontaneous result of lots of people driven to innovate and profit from those innovations. It was capitalism at its very best.

California’s Silicon Valley became the place for talented young people to turn great ideas into reality. It was also the place to go if you had money and wished to invest in vibrant, risky new technologies, or if you knew how to design factories, how to market products, how to build organizations, or how to finance rapid growth. The infrastructure that arose is supporting California today. This amazing capitalist engine of jobs, innovation and wealth is the source of most of California’s economic vigor. But it is a legacy that will eventually slip away, unless California changes its priorities.

Jul 28 14

The New Normal and the New Neutral

by Jeff Speakes
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The “New Normal” is a phrase coined a few years ago by the Pacific Investment Management Company (PIMCO), or at least that’s what they claim. It referred to a lengthy period of slow economic growth that they expected to persist as people recovered from the financial crisis. In view of the very modest economic growth that has occurred over the past five years (since the recession formally ended in 2009), the PIMCO forecast has worked out pretty well. Of course, my colleagues at the CLU Center for Economic Research and Forecasting (CERF) also have consistently projected modest economic growth over this period, and have been at least as accurate as PIMCO. But, we didn’t attach a clever moniker to our scenario.

Now PIMCO is extending the new normal idea into a view on Federal Reserve policy and asset prices that they call the “New Neutral.” The argument basically is that in a world of modest economic growth, we should expect low real interest rates and elevated asset prices. In particular, PIMCO argues that the real short-term interest rate ought to be around zero, so that the neutral Federal Funds rate should be around 2%, quite a bit lower than the 4% level commonly associated with the Taylor Rule (the Taylor Rule says that the target federal funds rate should be equal to target inflation (2%) plus the short-term real rate (2%) plus premiums if either inflation is running above target or the economy is running above potential). They acknowledge that longer term yields should include a term premium, so their “new neutral” long-term real rates are 1-2%. The implication is that, for example, the 10-year Treasury yield should be in the range 2.5-4.0% over the next several years. This is below the consensus forecast for bond yields.

PIMCO uses the dividend discount model (DDM) to translate assumptions about real rates into projections for asset prices. The DDM says that fair value for equities is equal to the stream of projected future dividends discounted by the required return on equity, which is the sum of expected inflation, the long-term real interest rate and the equity risk premium. Since the real rate of interest is one component of the required return on equity, the effect of a lower real rate is a higher fair value for equities.

On the assumption that the future growth rate of dividends is constant, the DDM reduces to the Gordon Model which says that fair value equals next year’s dividend divided by the difference between the required return on equity and the dividend growth rate. In symbols

Fair Value = Dividend/(R-G)

Where R is the required return on equity and G is the growth rate of dividends (in the aggregate, this is similar to the rate of overall economic growth). Historically, R has been about 10% and G about 5%, so Fair Value for equities has been roughly 20 times next year’s dividend (1 divided by (.10-.05) is 20). PIMCO’s estimates for both R and G are much lower, about 5.5% for R and 3% for G. This implies a Fair Value of 40 times next year’s dividend (1/(.055-.03) is 40).

Let’s apply this model to the S&P500 index, which at current equity prices has a total market value of approximately $20 trillion (i.e., the sum of the market values of the 500 stocks in the index). Consensus estimates for next year’s total dividends on S&P500 stocks is about $50 billion. Based on historical equity returns and growth rates, the S&P index should be trading around 20*$50B=$10 trillion. Based on PIMCO’s assumptions, fair value is more like 40*$50B=$20 trillion. This is very close to the observed market value. Thus, on the PIMCO assumptions the current level of stock prices is fully justified; there is no equity bubble.

The Gordon Model can also be used to estimate future equity returns. Just replace Fair Value by the observed market value and rearrange the equation

Expected Return = Dividend/Market Value + G
= $50B/$20T + 3% = 5.5%

This is significantly below the historical equity return of close to 10% per year. Thus, while equity prices are not massively over-valued, the prospective return from equity investment is modest.

Components of R and G

The new normal and new neutral stories imply declines in both the equity return (R) and economic growth (G). In order for asset valuations to increase, it must be the case that the decline in R is greater than the decline in G. The components of equity return are expected inflation, the long-term real rate of interest and the equity risk premium. The historical equity return of 10% was comprised, roughly, of 3% inflation plus 2% real rate of interest plus 5% equity risk premium. The projected equity return of 5.5% is comprised, roughly, of 2% inflation plus 1% real rate of interest plus 2.5% equity risk premium.

The components of economic growth are inflation and real growth. When you take the difference between R and G, the inflation term drops out and we get R-G=Real rate of interest plus equity risk premium minus real rate of economic growth. The new normal says that economic growth is 1-2% below the historical norm, and the new neutral says that the real rate of interest is 1-2% below the historical norm. These effects net to zero. The real driving force in the PIMCO story is the assumption that the equity risk premium has declined substantially (from 5% to 2.5%).

Why would this be? Perhaps peoples’ degree of risk aversion has declined due in part to the current and prospective extremely low rates of interest. That is, people are willing to invest in stocks at lower returns simply because the alternatives are so bad. Or, maybe the new normal model, while accurate for the past several years, will soon cease to exist. If the rate of real economic growth should soon revert back to historical levels, then current stock prices are consistent with a much more modest decline in the equity risk premium. Finally, a third possibility is simply that stock prices are way too high today. These three explanations have very different implications for the future direction of equity prices.

Jun 9 14


by Jeff Speakes
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In 1873, Karl Marx published the first volume of his magnum opus Das Kapital (“Capital”, in English) which purported to describe the dynamics of a capitalist economy.  Although I have never studied Capital sufficiently closely to do justice to the work, the basic idea was that ownership of the means of production (capital) becomes increasingly concentrated in the hands of a small number of people and the vast majority of workers become increasingly impoverished and alienated.  Marx predicted that eventually, and inevitably, the workers would rise up and “cast off their chains.”

In what many people are calling the economics book of the year, or the decade, or maybe even the century, French economist Thomas Piketty’s “Capital for the 21st Century,” poses a similar question to Marx; namely, “Do capital dynamics lead to increasing inequality?”  The 700 page book, along with a 100 page technical appendix, is a towering achievement of empirical research.  Professor Piketty (TP) and colleagues have pulled together new databases on the distributions of income and wealth in various countries for multiple time periods, and have subjected them to careful analysis.  His conclusion is yes, the dynamics of capitalism tend to drive wealth inequality.

The fundamental reason, TP explains, is that the rate of return on capital (“r”) is over the long-term significantly greater than the rate of economic growth (“g”).  Wage income tends to grow at rate g and capital income tends to grow at rate r.   TP estimates that the historical rate of return on capital is 4-5% and should be expected to persist.  Meanwhile, he believes that the long-term outlook for the rate of economic growth is just 1-2%.  This is greater than the long-long-run average (pre-1800) of roughly zero growth, but is less than what has been observed in developing and developed countries over the past two hundred years.  The reasons for the projected growth slowdown are a combination of slower population growth and a slowdown in the rate of productivity growth.  TP argues that a consequence of the assumed differential between r and g is that both the ratio of wealth to GDP and the share of income from capital in total income will be high and rising.  Combining this with the assertion that wealth and capital income tend to be highly concentrated, TP concludes that the rich will continue to get richer.  Not only that, but it will become increasingly difficult for the non-rich to become rich.

During the first half of the 20th century, the concentration of wealth fell.  This was widely interpreted by economists, notably Simon Kuznets, to suggest that mature capitalist economies become more egalitarian over time as the benefits from innovations spread throughout the economy.  TP argues that inequality fell in that period due the negative impact on wealth of two major wars, hyperinflation in Germany, and the great depression.  In “normal” times, he believes, the natural tendency is for both wealth and the concentration of wealth to increase.  In support of this notion, since 1950 rising inequality trends have been re-established, and his prognosis is for more of the same.

I have not studied the data nearly as extensively as TP and his associates.  Still, I am interested in the process of wealth creation, am intrigued by the TP argument, and have a few thoughts.  First, rising wealth is not a bad thing.  It is the source of financing for new ventures and should result in greater productivity and higher wages.  If indeed wealth grows at a rapid rate, I think TP’s prediction of 1-2% economic growth will be too pessimistic.  Second, there is no guarantee that wealth-holders will earn 4-5% real returns after-tax, as TP assumes.  To achieve this requires taking on a lot of risk, and making intelligent decisions.  I think that returns like this are quite unlikely for most people, even for those people sufficiently affluent to higher expensive investment advisors.  There is a great deal of evidence to suggest that, after paying fees, expensive investment advisors do not outperform market averages.   So, TP’s assumption of 4-5% returns on capital for the typical rich guy is probably too high.

Third, even more than investment return, the key driver of wealth is your savings rate.  If rich people spend more than 3-4% of their wealth each year they are likely to dissipate that wealth, not increase it.  Of course, some people are so affluent that spending even 1% of wealth is close to impossible (think of multi-billionaires).  TP believes such levels of wealth will lead to dynastic wealth (“non-meritorious” is the translated phrase).  In fact, he conducts some analysis to conclude that a very high proportion of wealth will be owned by heirs, not by the original wealth creators.  But this flies in the face of the “shirtsleeves to shirtsleeves in three generations” process whereby even great wealth is dissipated by multiple heirs and profligate spending.  Anecdotally, the richest person in France is apparently an heir to the L’Oreal perfume fortune.  Perhaps this affects the TP perspective.  Meanwhile, in the U.S. the richest people are self-made – think of Bill Gates, Warren Buffett, the founders of Google, Facebook, etc. (granted, the children of Sam Walton, founder of Walmart, also show up in the ranks of the richest Americans).

Finally, there is nothing stopping the non-rich from becoming rich.  To me, this is the most important issue.  The key is to save a substantial portion of your income.  Although this is arguably difficult to do for those on a modest income, left-leaning Senator Elizabeth Warren, in her jointly authored book on financial planning, recommends a savings rate of 20% for nearly all families.  If you can save 20% of your income and invest so as to achieve market returns (and by doing so outperform the average highly paid investment advisor), you will build wealth and an earnings stream from that wealth.  Then you will be part of the increasing share of capital income in total income that has TP so worked up.

TP has received adulation from the left for his analysis and his policy recommendations to mitigate wealth inequality through dramatically higher tax rates on capital income and inheritance, and by introducing a global tax on wealth.  I applaud his scholarship and efforts to compile relevant and valuable data sets.  But I don’t think that higher tax rates on capital will increase the opportunity for the non-rich to become rich.  Instead, the effects of higher tax rates on capital would likely be to deter upward mobility.

May 15 14

You are not Yale!

by Jeff Speakes
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Yale University boasts one of the most successful endowment funds in the country, and maybe the world.  The Yale fund (“the fund”) has outperformed 99% of like funds for the past two decades.  The manager of the fund, David Swensen, is a superstar in the investment management industry.  I recently perused the 2013 Yale Endowment Fund Report and noticed several interesting points.

First, thanks to large contributions and exceptional investment performance, the scale of the fund is huge.  Total assets at year-end were a bit greater than $20 billion, and the contribution in 2013 to Yale’s operating budget was $1.1 billion (or about four times combined tuition and room and board).  The long-term objective of the fund is to earn a real (after inflation) return exceeding five percent per year.  This would enable the fund to contribute five percent of assets per year (the actual spending formula is a bit more complex than this) and still grow in real terms (even before receiving additional gifts).

Second, the investment strategy is unconventional, or at least it was until other endowment funds began attempting to emulate Yale.    Based on the twin premises a) you must take on equity-like risk to earn positive risk premiums and b) it is very difficult to outperform the market in highly liquid markets, Swensen has led the fund to emphasize non-traditional asset classes including private equity, absolute return, and natural resources over the more traditional equity, fixed income and real estate allocations.  For example, the target allocation to US equities is 6% and the target allocation to private equity is 31%.

Yale’s objective is to perform in the top quartile of each asset class.  To accomplish this, the fund employs a staff of very sophisticated, and highly paid, investment analysts to review and select investment managers to run portfolios.  The assumption is that it is possible to identify top management talent in most every asset class, particularly the less liquid asset classes.  Only the fixed income portion of the fund (target allocation 5%) is managed in-house.

At first blush, the Yale strategy seems to contradict some of the assertions I have made in the past.   For example, for most individuals I favor the passive investment strategy promulgated by Vanguard founder John Bogle:  buy low cost broad based index funds.  Second, I have argued that annual spending 3% of your wealth is reasonable but not really conservative.  Spending 1% each year is conservative.  How is it that the Yale fund can target spending more than 5%?

What is going on?  Well, you are not Yale.  For one thing, endowment funds pay very little or no taxes.  It is much easier to earn a 5% return pre-tax than after-tax.  Second, the scale of the Yale fund is such that they can retain very highly paid investment professionals.  This gives them a much better chance of identifying and negotiating with managers that are able to outperform the overall market.  Finally, it is highly likely that Yale will receive large future gifts from successful alumni.  The analogous thing for an individual would be receiving a large inheritance or winning the lottery.  Do you want to count on that?

Evidence in favor of the benefits of large scale comes from the wide ranging magnum opus “Capital for the 21st Century” written by French economist Thomas Piketty.  Piketty’s general argument, which I will address in future blogs, is that the natural dynamics of capitalism result in growing wealth inequality over time.  One part of the argument is that larger portfolios earn higher rates of return due to economies of scale in investment management.

Piketty’s primary evidence in support of scale economies in asset management is, you guessed it, University endowment fund returns. He reports that the top funds, including Yale, Harvard and Princeton, each have more than $20 billion in assets and have achieved 10% average annual returns over the period 1990-2010.  Meanwhile, medium-sized funds (assets between $500 million and $1 billion) have earned 8% over the same period, and small funds (less than $100 million) have earned just 6% on average.  Piketty points out that Harvard’s internal cost to manage their fund is negligible in terms of return, just 0.3% of assets.  But on Harvard’s $30 billion fund, this is $100 million.  Obviously, smaller funds cannot match this level of expenditure.

The argument that scale contributes to return in a positive way is interesting, but to me not convincing.  A counter-argument is that superior managers have greater opportunity to outperform when assets under management are smaller, simply because there is a greater array of potential investments that could have a meaningful impact on overall returns.  Many of the great investors have performed much better when they had small portfolios to run instead of large ones.  For example, the returns on Warren Buffett’s partnerships in the 1950s and 1960s are much greater than the returns on Berkshire Hathaway in the 1990s or 2000s.  This is because Warren was able early in his career to discover small illiquid securities that were highly under-valued.  Such opportunities, even if he could find them today, would not be material to the giant Berkshire Hathaway portfolio.  Evidently, Harvard and Yale have figured a way to offset this problem, but it would be a mistake to assume that bigger size generally means higher return.

The Yale Endowment Fund is a terrific case study; one that I am embedding into my classes on investment management and financial economics.   But it is not feasible for the vast majority of individuals to attempt to replicate the strategy.  In particular, don’t count on achieving a 5% return on investment, after adjusting for inflation and taxes.

Mar 13 14

82% Savings Rate!

by Jeff Speakes
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The bankruptcy rate for professional athletes just a few years from retirement is extremely high.  To take one example, 60% of NBA players are reported to become bankrupt within five years of retirement from the league.  This is a league with average compensation $5 million per year. 

I am interested in applying my Sustainable Wealth (SW) idea to the case of the professional athlete.  The key idea of the SW plan is the spending rule that says you can spend each year 3% of total wealth which includes the discounted value of future earnings (“human capital”).  For professional athletes, this human capital is quite large.  Consider the NBA player with a six year contract paying $9 million per year.  After tax, this is about $5 million per year and the present value is just a bit less than $30 million.  The base SW consumption rule is to spend 3% of $30 million or $900,000 per year.  This is based on the assumption that a reasonably conservative investment strategy can earn a 3% real after-tax return, on average.  The idea of the SW plan is that, regardless of age, the athlete can comfortably spend this amount (adjusted upward for inflation) for the rest of his life. 

$900,000 is certainly a lot of money to spend each year, but from one point of view it is extremely conservative.  If you make $5 million after-tax and spend just $900K, you have a savings rate of 82% (savings is after-tax income less consumption, and the savings rate is savings divided by income, or $4.1M/$5.0M).  Few self-respecting financial planners would tell a client to save 82%, and if they did what client would accept that advice?  Suppose a very conservative advisor recommended spending just 50% of after-tax income, or $2.5M.  That seems doable, right?

Answer:  wrong.  $2.5 million represents 8% of total wealth and will dissipate wealth in just a few years.  This suggests the essence of the dilemma for the professional athlete, or any other of the top 1% income earners who only earn that high income for few years.  If you are going to provide for 60 or 70 years of consumption with only a few years of earnings, you have to save a very high percentage of that income. 

Another interesting feature of very long horizons is that the probability of plan failure increases with the length of the horizon.  This is because the volatility in ending wealth rises over time.  So, even though you are spending a fraction of initial wealth that equals your expected annual rate of return, over a 70 year period there is a non-negligible chance of plan failure.  Even the 82% savings rate is not high enough to ensure success!

If the athlete were my client, I think I would recommend a variant on the SW plan, namely the 1% Ratchet Rule.  This rule says that you can spend each year 1% of the maximum value of your portfolio.  That is, each time your portfolio value increases you ratchet up your spending, but you do not lower spending when the portfolio value falls.  Coupled with a conservative investment strategy, the 1% Ratchet Rule practically ensures that the athlete never runs out of money.  Additionally, there will be a pretty good chance that the athlete’s wealth will rise over time to the point that he can buy the team and become the owner.  But, the guy would have to constrain first year spending to $300,000 and endure the ignominy of having a 94% savings rate ($4.7M/$5.0M).

While this plan is simple in concept, it is not easy to implement.  The famous athlete is almost surely under great pressures by friends, family and associates to spend lavishly and engage in dubious investment schemes.  The huge bankruptcy rate for former athletes is likely to persist due to the difficulty of combating these pressures.