21/2/2014: Homeownership, Negative Equity, Entrepreneurship: Data from France

Over recent years I wrote extensively about the issues of negative equity and the costs of this phenomena to the society and economy at large. Much of the research in this areas focuses on the US data, with some departures for German and Italian data sets. Here is a recent paper using French data and dealing with the issue of housing collateral (house prices-linked borrowing constraints) and entrepreneurship.

"HOUSING COLLATERAL AND ENTREPRENEURSHIP" by Martin C. Schmalz, David A. Sraer, David Thesmar (Working Paper 19680 http://www.nber.org/papers/w19680) provides evidence on whether entrepreneurs "face credit constraints, which restrict firm creation, post-entry growth, and survival, even over the long run. The existing literature documents a strong correlation between entrepreneurial wealth and the propensity to start or keep a business (Evans and Jovanovic, 1989; Evans and Leighton, 1989; Holtz-Eakin et al., 1993)."

The problem is that there is still "a considerable debate …about whether such a correlation constitutes evidence of financial constraints. For instance, individuals who experience a wealth shock, through personal accumulation or inheritance, may also experience an expansion of business opportunities for reasons unrelated to their wealth (Hurst and Lusardi, 2004)."

The authors used "variations in local house prices, combined with micro-level data on home ownership by entrepreneurs. …We compare entrepreneurial outcomes of entrepreneurs owning a house and entrepreneurs renting a house, and compare this difference across geographic regions with different house price dynamics. The comparison between owners and non-owners allows us to filter out local economic shocks that may drive the creation, growth, and survival of local businesses." Do note the important aspect of this data set - by controlling for home ownership v renters, the paper also allows us to look at the potential benefits of the former or the latter in terms of entrepreneurship.

"We investigate both the extensive and intensive margin of entrepreneurship, that is, entry decisions as well as post-entry growth. Our investigation starts with firm growth and survival, conditional on entry. We construct a large cross section of French entrepreneurs starting a businesses in 1998. Combining survey data and administrative data, we are able to observe a variety of personal characteristics, in particular, the home location of the entrepreneurs, as well as their home-ownership status. We match this information to firm-level accounting data of the newly created firms for up to eight years following creation."

Now for the results: 

• "We find that in regions with greater house price growth in the 1990s, firms started by homeowners in 1998 are significantly larger and more likely to survive than firms started by renters." Oops, for the folks saying that homeownership should not be encouraged or incentivised. "In other words, the difference in the size of businesses created by owners and renters is larger in regions in which house prices have appreciated more in the past five years. 
• This effect is robust to controlling for a large set of entrepreneurial characteristics. It is also persistent: in 2005, firms started by entrepreneurs with lower collateral values in 1998 remain significantly smaller in terms of assets, sales, employment, or value added. 
• Finally, this effect is economically large: going from the 25th to the 75th percentile of house price growth in the five years preceding creation allows homeowners to create firms that are 6.5% larger in terms of total assets."
• "We then verify how collateral shocks affect the probability of starting a business, that is, the extensive margin of entrepreneurship. …We find that homeowners located in regions where house prices appreciate more are significantly more likely to create businesses, relative to renters located in the same regions. In other words, the difference between owners and renters in the propensity to start a business is larger in regions in which house prices appreciated more in the past. 
• Again, the effects are economically sizable. Going from the 25th to the 75th percentile of past house price growth increases the probability of firm creation by homeowners, relative to renters, by 9% in our preferred specification."
• More to the above: "We confirm the importance of this result in the aggregate: total firm creation at the regional level is more correlated with house prices in regions where the fraction of homeowners is larger."

As an aside, consider also the following discussion from the paper: The link between funding of start ups and wealth constraints is non-trivial. "Robb and Robinson (2013) document that debt is a large source of financing for start-ups (approximately 44%) and that its availability is related to the scarcity —and therefore the value— of real estate collateral. Hurst and Lusardi (2004) and Adelino et al. (2013) are closest to our paper, because they also investigate the role of housing wealth on firm creation."

However, the latest paper "makes two significant advances relative to these papers:

1. the information on individual homeownership allows us to control for local economic shocks that might create a spurious correlation between entrepreneurial rate and local house prices, and 
2. the nature of our data allows us to track not only firm creation (the extensive margin), but also post-entry growth and survival over a long horizon (the intensive margin)."

"Several earlier papers focus on the role of inheritance shocks to firm quality and survival. Holtz-Eakin et al. (1993) find that firms started after a large inheritance are more likely to survive, a finding they interpret as evidence of credit constraints. By contrast, using Danish data, Andersen and Nielsen (2011) find that businesses started following a large inheritance have lower performance. This finding suggests the relationship between wealth and entrepreneurship may be driven by private benefits of control, or in other words, that business ownership has a luxury-good component (Hurst and Lusardi, 2004). The relation between wealth shocks and post-entry growth/survival thus remains an open discussion."

The latest paper "contributes to this debate by looking at wealth shocks generated by local variations in house prices for homeowners. Arguably, these shocks are much less likely to be correlated with the unobserved heterogeneity in entrepreneurial outcome than inheritance shocks."

"Fracassi et al. (2012) also provide a clean identification on the role credit constraints play small business survival, by exploiting a discontinuity in the attribution of loans to start-ups at a small local bank. In a similar vein, Black and Strahan (2002) find that banking deregulations in U.S. states led to a large increase in firm creations. Whereas these papers focus on the effect credit supply on firm creation and survival, our paper focuses on credit demand via the supply of collateral."

There is an intuitive link between the above forces: "When house prices increase, firms and households have more collateral to pledge, which raises borrowing capacity. On the credit-supply size, banks, balance sheets become stronger, which allows them to lend more. Recent papers have documented the link between house prices and household borrowing and consumption (Mian et al., 2011; Gan, 2010), the link between real estate prices and corporate investment (Gan, 2007a; Chaney et al., 2012), and the link between real estate bubbles and bank lending (Gan, 2007b)."

And the conclusion is: "Our paper shows that entrepreneurial activity also strongly reacts to changes in the value of collateral available to potential entrepreneurs."

So back to that 'negative equity only matters for those who want to move from their current house' meme that Irish economists and policymakers keep pushing around… My suggestion: go back to study economics, folks.

21/2/2014: Fed Transcripts, 2008: Icebergs, Titanic, Violins...

Marketwatch are running a live blog on Fed's release of 2008 transcripts

http://blogs.marketwatch.com/capitolreport/2014/02/21/the-feds-crisis-era-transcripts-of-its-2008-meetings-live-blog/

My comment: Fed transcripts from 2008 show a circus hit by a hurricane drowning in a surge of self-delusion.

Bernanke waffling on, in September 2008, about 'moral hazard' in a virtually academic exercise that is more about him being 'decidedly confused and muddled' shows the extent to which the Fed (and do keep in mind - this is the most competent Central Bank out there) was left completely unprepared for a systemic crisis. Forget the nature of the crisis or specific causes of it. The point is that some 14 months into huge pressure pilling up in the markets, the Fed was utterly unprepared to face a crisis.

Now, observe that having done the deed of acting outside any confidence about the impact of his actions, Bernanke subsequently defends his choices by saying that "I just don't believe that you can allow systemically critical institutions to fail in the middle of financial crises and expect it to be not a problem." Which, of course begs the question: does he believe that he should fail these institutions ex post after the crisis is over? And how the hell does he propose we go about that restoration of 'zero moral hazard' state? By sending in the FBI?..

In short, the man is still out of touch with reality. First, with the one he was thrown into in September 2008, second, with the one he constructed in response to September 2008 events.

Poor Ben... he goes on: "“We did not have—as the Europeans have or as we have FDICIA for banks—a system that was set up to allow a reasonable and responsible orderly resolution of nonbank systemically critical institutions. I think we now have made a lot of progress there. The TARP will provide a good interim solution.”"

Come again? What is that that 'the Europeans' have? "a system ...to allow a reasonable and responsible orderly resolution of nonbank systemically critical institutions"? Dear, oh dear... he needed retirement rest and relaxation back in 2008.

Still, the Fed transcripts show how the Central Bank did move to face the reality, unlike 'the Europeans' who basically used the Mongols' tactic for capturing Beijing - throw bodies against the walls. Even though Fed's 'data' included Yellen's quotes about plastic surgeons reporting customers delaying elective procedures... and she subsequently followed up on this pearl by expressing (in December 2008) concern about rising labour force participation...


In short, the transcripts make us, macroeconomists, look decidedly scientific and impossibly human, compared to the Central Bankers... And this before we get any transcripts from that bastion of surreality in Frankfurt, called the ECB...

20/2/2014: Gold Demand 2013: US Mint Sales

I recently posted on the 2013 demand for gold:

• http://trueeconomics.blogspot.com/2014/02/1822014-gold-demand-trends-2013.html started with highlights of the World Gold Council report and was followed up with 
• http://trueeconomics.blogspot.com/2014/02/1822014-demand-for-gold-netting-out.html covering demand for gold stripping out changes in ETFs holdings.

To complete this analysis, let's take a look at another area of demand.

Sales of gold coins by the US Mint are usually seen as representing more stable, long-only and non-instrumented demand for gold. US Mint coins are first and foremost used by investors interested in a store of value and secondly as long term savings. These are principally non-speculative in nature and do not rely heavily on shorter term volatility in prices (as some o the statistics discussed below show).

The series covered here include American Eagles and American Buffalos. The data we have for both series goes back to the start of 2006.

We shall focus in this post on annual values.

In 2013,

• US Mint sold 1,095,500 oz of gold in the form of coins, marking the third largest demand in the series history. The demand in terms of total weight was up 29.8% y/y, reversing previous 3 consecutive years of annual declines.
• US Mint sold total of 1,697,500 gold coins in 2013, marking the third highest year of sales by coinage, and up 39.1% y/y.
• Average weight of coin sold in 2013 was 0.645oz/coin, down on 0.692oz/coin in 2012. Overall, this was the third lowest annual average oz/coin sold performance.

Correlation between price and weight of gold sold was 0.349, and between price and coins sold 0.450, while correlation between price of gold and oz/coin average weight was 0.137.

Monthly series confirm that there is little sustained correlation between prices and gold sales via US Mint coins:

Looking at longer-range series:

• Average sales of coins by total weight in 2005-2009 was 874,250 oz per annum, against 1,092,250 oz per annum for 2010-2013 period.
• Average sales of coins by total number in 2005-2009 was 1,174,625 coins per annum, against 1,548,625 coins per annum for 2010-2013 period.
• Average sales of coins by average weight per coin sold in 2005-2009 was 0.705 oz/coin, against 0.703 oz/coin for 2010-2013 period.

In conclusion: US Mint sales of gold coins suggest healthy demand for gold, strengthening in 2013 on foot of both - improved affordability and rebounding in the underlying demand toward the 2010-2013 average levels.

19/2/2014: Ukraine's Political Economy is… political first, economy last

This week's acceleration in the Ukrainian crisis is moving the country closer to the final denouement of sorts. Sadly, the one we are currently facing is of a less palatable variety: absent strong (majority, not plurality) mandate, any Government - be it new or old - will face continued chaos, political upheaval, internal in-fighting, external corruption and voter polarisation, with little hope for a constructive outcome (for the outline of a constructive resolution, see: http://trueeconomics.blogspot.com/2014/02/622014-what-does-future-hold-for.html).

With this, there is little hope for a sustained economic recovery on the horizon and investors are likely to remain in the state of high alert and volatility.

Tried measures to-date have failed:

• Removal of the Prime Minister and early negotiations between the incumbent regime and the opposition was not enough to clear a path to a shared power arrangement;
• Amnesty for protesters and reversal of the anti-protest law were not enough to clear the barricades; and
• A crackdown on protesters is unlikely to yield significant stabilisation, but will certainly amplify polarisation, making a shared power arrangement infeasible and further mobilising the internal splits amongst the already fragmented and fractious protest groups.

Thus, the only way forward will be for President Yanukovich to call early elections and resign prior to these - an outcome that is likely to solidify deep divisions within the electorate and shatter the opposition. In the long run, the outrun of snap elections will be the worst case scenario, since a poll today will be unlikely to generate a stable government. A presidential vote in current environment will simply force Ukraine into the perpetuation of a lingering conflict that the country entered following the Orange Revolution.

Crucially, Russian debt support for Ukraine is likely to be revised if the elections produce an anti-Russia Presidency, and absent this backstop, Ukraine will require full EU and/or IMF assistance. Securing this assistance will be very painful and is likely to throw a newly elected leadership into another crisis. Furthermore, Ukraine seeking EU funding is a can of worms that no one, least of all Brussels, would want to open.

Absent a very strong popular mandate for an established and well-known (aka predictable in her/his policies) Presidential candidate, the uncertainty will continue weighing heavily on bond yields, the battered currency and the economy. This is already reflected in the analysts' valuations, with S&P rating Ukraine as CCC+ for foreign currency debt, with outlook negative, while ECR rates the country in the highest risk tier 5, ranked 125 in the world (for comparison, Russia scores 54.62 in ECR and is ranked 51st in Tier 3 risk category).

Economy will continue stagnating or even contracting in either scenario (continued Yanukovich presidency or snap elections), with GDP heading for another drop in 2014, after a 1.1% contraction now estimated (preliminary data) for 2013.

There is a third alternative to the currently unpalatable ones of snap elections or continued violence: a referendum on splitting the Ukraine into two states. Given that the Ukraine is deeply divided between Western and Eastern parts, the referendum held today will likely lead to a nasty split (Ukraine is no Czechoslovakia when it comes to civil culture, as we can see now). While in the long run this can prove to be the only feasible arrangement, in the short run it will likely turn violent and will lead to massive dislocations in social and economic areas.

About the only possible positive scenario is to combine the two unpalatable ones with a stop-gap in between or a cooling-off period. First, snap elections with a strong Presidential candidate with a base support beyond party-politics of opposition. Second, such a candidate should campaign on a promise to hold - say within 3 years - a national referendum on the future of Ukraine (loose federation or split). Third, following the elections, the President will require tripartite support from the EU, Russia and the IMF to fund a major investment deployment into the economy (a Marshall Plan) so the population can be de facto incentivised into voting to continue with singular Ukraine. Fourth, fingers crossed, prayers said, wood knocked… wait and see if the referendum goes the right way. Wait and hold more cash to help whatever merges out of the referendum to weather massive shock that will follow its outcome.


Some facts on economy:

• GDP USD175.5bn or some 12 times lower than Russia's USD2.1 trillion and below Kazakhstan's USD224.9bn
• GDP per capita (PPP-adjusted) is only 7,4222 international dollars against Russia's 18,083 and Kazakhstan's 14,133.
• Total investment is only 16.2% of GDP against Russia's 25.4% while gross national savings are only 8.91% of GDP against Russia's 28.2%.
• Exports of goods and services down 2.582% in 2013 y/y for the second consecutive annual drop. This compares against 1.96% rise in Russia and 2.44% rise in Kazakhstan.
• Private sector investment is collapsing - down around 13% in 2013
• Unemployment is at 8.2% against Russia's 5.7% and Kazakhstan's 5.2%.
• Government finances are bleak: General Government Revenue is 45.22% of GDP (above Russia's 36.06% and Kazakhstan's 25.65%), Government total spending is at 49.51% of GDP (Russia's 36.71% and Kazakhstan's 20.81%). Total government deficit is 4.29% of GDP against Russia's deficit of 0.72% and Kazakhstan's surplus of 4.84%.
• Government debt: 14.1% of GDP for Russia, 13.24% for Kazakhstan and 42.8% for Ukraine. Ukraine's debt excludes some USD30 billion owed to Russian state lenders and local debts. Combined Government debt is estimated closer to 89% of GDP.
• Current account balance: +2.9% for Russia, +4.3% of GDP for Kazakhstan and -7.3% of GDP deficit for Ukraine.
• On trade side, 27% of goal value of Ukrainian exports flows to Russia, and 30% of imports come from Russia. Volumes of exports and imports to and from the EU are similar.
• On positive side, 2013 corporate tax rate was 19%, dropping to 16% in 2014 (assuming policies remain on track) and will be heading to 10% in 2015. VAT is set to fall from 20% in 2013 to 17% in 2014. Upper marginal income tax rate is 17%.
• Officially, roughly 6.6% of Ukrainian population currently works in Russia. These exclude undocumented workers, which probably bring the numbers closer to 4.5-5 million of 45 million total population.
• Russia-Ukraine deal of December 2013 included a loan of USD15bn to cover Eurobond issue. So far, Russia lent USD5bn back in December 2013-January 2014. Cut in gas prices for imported gas and relaxing the terms on late payments on USD2.7bn for Naftogaz Ukraine accrued under the previous contracts.

Simple, but sad conclusion: Ukraine is economically a failed state. And Ukraine is politically a failed state. Time for the West and Moscow to wake up and smell the roses.


Update: latest CDS moves from CMA:

Ukraine with double probability of default that of Greece... more than 4.5 times that of Russia... What was it that I said about the 'failed state' above?..

Update 2: some ECR scores for Ukraine:

Update: Via ZeroHedge, here is the final agreement between President Yanukovich and the opposition: http://www.zerohedge.com/news/2014-02-21/ukraine-crisis-settlement-agreement-reached-full-statement As argued in my posts, the only sustainable resolution of the crisis will require shared power arrangement backed by enforceable commitments to elections and deep political reforms.

18/2/2014: Demand for Gold: netting out ETFs effect

I blogged earlier today on the 2013 data for gold demand (see here: http://trueeconomics.blogspot.com/2014/02/1822014-gold-demand-trends-2013.html). In the post I mentioned three facts (amongst other):

1. Total demand for gold worldwide declined in 2013 by 14.9% 3,756.1 tonnes;
2. ETFs sold net 880.8 tonnes in 2013; and
3. Demand for bars and coins rose to all-time high of 1,654.1 tonnes.

Now, here is a summary of the core demand stats:

Do note that total demand for gold, excluding ETFs is now at all-time high of 4,636.9 tonnes. 

18/2/2014: Have Financial Markets Become More Informative since the 1960s?

In strongly efficient markets, prices of shares transmit strong information about company fundamentals, such as productivity and demand for and risk of investment. As Fama (1970) wrote: "The primary role of the capital market is allocation of ownership of the economy's capital stock. In general terms, the ideal is a market in which prices provide accurate signals for resource allocation: that is, a market in which firms can make production/investment decisions... under the assumption that security prices at any time `fully reflect' all available information."

In recent years, quality of information in the financial markets has significantly improved, while analysis costs have fallen, suggesting that informational content of prices in the markets should have risen as well.

A new paper, titled "HAVE FINANCIAL MARKETS BECOME MORE INFORMATIVE?" by Jennie Bai, Thomas Philippon, and Alexi Savov (Working Paper 19728: http://www.nber.org/papers/w19728, December 2013) measures "the information content of prices by using them to predict earnings and investment. We trace the evolution of price informativeness in the U.S. over the last five decades."

The period of analysis is not ad hoc. "During this period, a revolution in computing has transformed finance: Lower trading costs have led to a flood of liquidity. Modern information technology delivers a vast array of data instantly and at negligible cost. Concurrent with these trends, the finance industry has grown, its share of GDP more than doubling."

In this context, the authors ask "Have market prices become more informative?"

To answer this question, the authors first develop measures of informativeness in the financial markets. They do so by combining Tobin's (1969) q-theory of investment with the noisy rational expectations framework of Grossman and Stiglitz (1980). "When more information is produced, prices become stronger predictors of earnings. We define price informativeness to be the standard deviation of the predictable component of earnings and we show that it is directly related to welfare, as in Hayek (1945): information promotes the efficient allocation of investment, which leads to economic growth."

For empirical testing, the authors regress "future earnings on current valuation ratios, controlling for current earnings. We look at both equity and corporate bond markets. We include one-digit industry-year fixed effects to absorb time-varying cross-sectional differences in the cost of capital. This regression compares firms in the same sector and asks whether firms with higher market valuations tend to produce higher earnings in the future than firms with lower valuations."

Conclusion: "...the amount of informativeness has not changed since 1960."

Surprising result means there is some room for potential mis-specification of the tests. As authors note: "By itself, constant price informativeness does not imply constant information production in markets. It is possible that information production has simply migrated from inside firms to markets. Hirshleifer (1971) first noted the dual role of prices in revealing new information and reflecting existing information. Bond, Edmans, and Goldstein (2012) call the revelatory component of price informativeness real price efficiency (RPE), and the forecasting component forecasting price efficiency (FPE). The financial sector adds value only to the extent that it reveals information that would otherwise be unavailable to decision makers. …the distinction between RPE and FPE is fundamental, and we seek to disentangle them."

The model provides a solution. "When managers rely on prices, they import the price noise into their investment policies. When markets reveal no new information, managers ignore them and prices remain noisy but investment does not. In the opposite case, when all information is produced in markets, managers use prices and both investment and prices are equally noisy. Information increases the predictive power of both prices and investment, but a rise in the revelatory component of prices increases price informativeness disproportionately."

Complicated thinking? You bet. But still, intuitive and testable. "To see if the constant price informativeness could mask a substitution from forecasting (FPE) to revealing (RPE) information, we check to see if the predictable component of earnings based on investment has changed."

Conclusion: the authors find that the predictable component of earnings based on investment has not changed over time. "…this implies that neither FPE nor RPE has risen over the last five decades." And furthermore, "…results show that discount rate variation has also remained stable" over time.

But there is more to the study. It turns out that informativeness is different for different types of investment. "Our strongest positive finding is that a higher equity valuation is more closely associated with R&D investment now than in the past. The same is not true of capital expenditure. However, the increased predictability of R&D is not related to increased predictability of earnings, so we cannot conclude that informativeness has increased."

And the results discussed above are sensitive to the sample of stocks studied. "For most of the paper, we examine S&P 500 stocks whose characteristics have remained stable. In contrast, running the same tests on the universe of stocks appears to show a decline in informativeness. We argue, however, that this decline is consistent with changing firm characteristics: the typical firm today is more difficult to value."

Top conclusion therefore is that having examined "the extent to which stock and bond prices predict earnings", the authors find that "the informativeness of financial market prices has not increased in the past fifty years". 

In the words of Herbert Simon (1971), "An information processing subsystem (a computer) will reduce the net demand on attention of the rest of the organization only if it absorbs more information, previously received by others, than it produces -- if it listens and thinks more than it speaks."

18/2/2014: Wages and Employment: Irish labour market plight

This is an unedited version of my Sunday Times column from February 9, 2014.


In recent months, Irish Government has gone into an overdrive, producing various reports, scorecards and papers on the Irish economy. Much of this activity is a welcome sign that various Departments are starting at last to engage with the world beyond the halls of civil service and political establishment.

The most recent report card on the Irish economy, courtesy of the Department of Finance, presents an interesting read. The document provides an insight into Official Ireland's view of the future, with forecasts covering 2015-2018 medium-term priorities for the Government, including: managing public finances, focusing on jobs, and restructuring the financial system.

To those of us inhabiting the real economy, removed from the MNCs and Government finances, of key importance here are the objectives of "reviving domestic demand" and "increasing employment". The Department’s overarching framework for achieving economic growth in the economy rests on the assumption that over 2014-2016, both total domestic demand (sum of public and private consumption of goods and services and investment) and exports will be positive contributors to growth. In fact, domestic demand is forecast to add, on average, 1.2 percentage points to economic growth annually, accounting for more than half of the GDP expansion in 2014 and 2015 and over 40 percent of growth in 2016.

The Department of Finance vision of the future is a positive one, especially for the financially battered Irish households. Alas, it also reflects some potential contradictions – a sign of the overall dilemma inherent in our economy’s structure. For all the talk about recovery and regaining of our economic independence, Ireland is still facing years of dealing with the debt crisis as well as sustained fiscal austerity. Growing out of this predicament can only be achieved by pushing up exports. But this, in turn, requires moderation in production costs and, thus, suppression of domestic demand. As the 1990s showed, you can’t have both, growth in exports and growth in the domestic economy, until we erase the debt overhang.


By definition, increases in domestic demand can only come from either public or households' consumption and investment uplifts or both.

Growth in Government spending on both current and capital goods and services is not on the cards. In 2014 and 2015 Irish fiscal tightening will continue to reduce domestic demand. In particular, fiscal consolidation, as planned, will take 1.8 percent of GDP in 2014 and 1.1 percent of GDP in 2015. Thereafter, we are still set to face the so-called 'preventative arm' of the EU’s Stability and Growth Pact (SGP). Under the 2011 Six-Pack legislation amending the SGP, a number of fiscal rules will apply to Ireland, including the requirement to continue reducing structural imbalances by at least 0.5 of GDP per annum, plus the debt break mechanism designed to draw debt to GDP ratio down toward 60 percent benchmark over time.

Which means the households are expected to fund the fiscal adjustments in 2014-2015, and fiscal maintenance in 2016 and beyond. All while delevaraging own debts and paying for the banks deleveraging their loan books, without dipping into deposits which will have to remain high to sustain core banking sector performance metrics.

Meanwhile, the Department of Finance forecasts that Ireland's unit labour costs adjustments over 2008-2015 will total 21 percent, relative to the Eurozone average. This projection, turn, underwrites the forecast growth in our exports.

Just how the households of Ireland can be expected to deliver on all of this is anyone's guess. An even bigger guess is required to explain as to how all of the above financial pressures on Irish households can be dealt with while increasing private investment and consumption, e.g. growing domestic demand.


The answer to the above questions rests with the outlook for the labour markets and wages.

In 2013, Irish economy seen the return of growth in employment - the only significant bright spark on otherwise bleak economic horizon. Based on the latest data we have, in 12 months through September 2013, numbers in employment rose in all sectors in Ireland, with exception of Transport and storage, Administrative and support services, Public administration, and Health and social work. Non-agricultural employment rose by 33,000 and the bulk of new employment was generated in the jobs with 35 and higher average weekly paid hours. In fact, in Q3 2013 compared to Q3 2012, the number of people in employment more than 35 hours per week rose 52,500.

This means that employment growth is now beginning to support domestic demand growth.

The problem is that this support is coming off extremely low levels. Between 2008 and 2013, number of jobs with weekly work hours in excess of 35 hours has fallen 242,500. And gains in employment so far are still fragile. At current rates of growth, it will take us some 13 years to get back to the same levels of full-time employment. Of all sectors, only three are currently registering larger number of jobs than in 2007-2008 period: Accommodation and food, Information and communication, and Health.

And the latest Live Register figures released this week show that controlling for State Training Programmes participation, declines in the numbers on the Live Register remained rather static over the last 4 months.

With employment rising off low levels the other source for growth in domestic demand can be found in earnings. And, aptly, in recent months, there has been resurgence in political chatter about the need to raise wages.

In part, these calls are driven by wages dynamics during the crisis. As of the end of September 2013, average weekly earnings in Ireland were down across all sectors by EUR16.40 compared to the same period in 2012 and down EUR31.37 compared to 2008 average. However, earnings were up significantly in Information and communication: rising EUR40.28 per week on Q3 2012 and up EUR64.28 on 2008 levels. This is a sector with employment that is predominantly capturing foreign workers into new jobs. In turn, these workers have only tenuous connection to the domestic economy: they rarely invest in Ireland, do not save here and are more likely to spend money abroad than the long-term residents. In almost all sectors of the economy linked more directly to Irish resident workforce, earnings are still declining.

So employment might be growing, but wages are declining or stagnant. Which does not bode well for household incomes and, in return, for domestic demand growth story.

More importantly, earnings deflation or stagnation must continue if the Government projections for exports growth were to materialise.

The maths are further stacked up against the theory of domestic demand growth fuelled by wages rises. Given changes to taxes over recent years, a euro increase in wages from current levels for an average household will yield less than 50 cents in the gains in the disposable income. When juxtaposed against the non-discretionary spending, such as funding mortgages, this means that wages increases are not exactly an efficient path to growing domestic demand. Based on Central Bank data, average mortgage in arrears today is EUR190,372. Per CSO, average household income is around EUR61,000pa, once we adjust for unemployment. Which means that at current tax rates, a 1.5 percent increase in income (corresponding to average weekly earnings rising by EUR10.13 on their Q3 2013 levels) is not enough to offset a 0.25 percent rise in mortgage interest.

This week, we have seen the publication of the research paper showing that some 100,000 households in Ireland are unable to pay their mortgages despite having regular income from employment. That is roughly 63 percent of all mortgages in arrears.

Put simply, from economy’s point of view, it is more effective to raise and extend mortgages interest relief than attempt fuelling wages inflation. With ECB’s policy firmly geared toward lower rates, one might be excused thinking that interest rates increases are for now a distant prospect, but in 2013, house loans rates for outstanding mortgages in Ireland went up 0.1 percent compared to the same period in 2012, while rates of outstanding consumer loans were up 0.34 percent. Overall, these increases, suggest that just to keep up with the cost of funding our immense household debt overhang, households need to see wages increases of some 2.2-2.4 percent per annum. Unless you work in ICT, this is not on the books, given supply-demand imbalances in skills and jobs in this economy.

Which leaves us with only one sector where realities of supply and demand have little to do with pay and employment and where wages increases can be imposed by the state: the public sector. This is precisely where pressures to raise wages are currently emerging, driven by political, not economic considerations. With local and European elections approaching, Labour wing of the current Government is trying desperately to force the reversal of their slide in electoral approval ratings. Labour's traditional support base - the Unions - are happy to oblige, in return for concessions of value to their members.

The problem with this, however, is that in order to keep labour costs competitive on the aggregate, wages hikes in the public sector will require more wages ‘moderation’ somewhere else in the economy. Furthermore, with fiscal policy breaks still in the hands of the EU, increases in the lower skilled wages in public sector are likely to benefit incumbent employees at the expense of the newcomers. And if productivity growth in private sectors does not compensate for labour cost increases in public sector, we will be heading for new layoffs, slower jobs creation and, thus, contracting domestic demand.


Our economy is between a rock and a hard place. We are living through the slowly unfolding nightmare of the exports-led recovery – a recovery during which households’ earnings and employment growth are unlikely to reignite domestic economy any time soon. The only way this dilemma of wages vs exports can be resolved is if it is accompanied by a rapid reduction in household debt. But, of course, you won’t find that featuring anywhere in the Official Ireland glossy presentations or in Labour Party’s exhortations about the need for wages growth.

Box-out:
This week, Irish Spirits Association published the latest statistics on our whiskey sector. According to the association data, Ireland had only 4 registered distillers delivering gross value added to the economy of EUR568 million for all spirits produced. This compares against 108 distillers of whiskey alone, pumping out value added of ca EUR3,630 million in Scotland. Total exports in Ireland stood at 6.2 million cases per annum. Scotch exports were fifteen times that number. The figures highlight both a massive potential for Irish whiskey growth and a huge gap between our sector output and that of our next-door neighbours. Looking at the Scottish model, it is clear that Ireland’s decades-old policy of industrialising production in the whiskey sector has failed spectacularly. We need a new policy approach focusing on stimulating independent distilleries, catering to higher value-added premium segment of the market, and delivering rapid innovation with focus on high quality. Marketing efforts of our trade facilitation agencies are not enough.

18/2/2014: Wither Irish manufacturing? Not so fast! Sunday Times, February 2

This is an unedited version of my Sunday Times  column from February 2, 2014


The news flow was mixed in recent days when it comes to covering Irish economy.

After a massive boost of consumer confidence and a maelstrom of media spin extolling the expected rebound in Christmas season sales, December retail sector statistics came in as a disappointment. Over the entire Q4 2013, core retail sales (excluding motors) were up just 1.1 percent year on year in terms of volume and down 0.5 percent in value. Profit margins in services sectors have shrunk once again in the third quarter and with them, non-financial services sectors activity also slumped in the five months through November 2013.

One bright spot, however, was the return to growth in industrial production. Based on 5 months data through November, in the second half of 2013 industrial output was up 1.2 percent year on year in Traditional sectors and up 3.3 percent in Modern sectors.


This latter bit of news highlights the potential for the sector to play a more active role in delivering long-term source of growth in Irish economy.

Over the second half of 2013, using data through November, Irish manufacturing activity rose 3 percent in volume and 0.1 percent in turnover terms. The improvement in output was largely driven by the MNCs-dominated modern sectors. However, it was also supported by positive performance in domestic sectors, such as food, basic and fabricated metals, and capital and core consumer goods. All in, H2 2013 marked a positive break in the previously negative trend across a number of manufacturing sectors. And this change was even more substantial when one takes out downward pressures exerted on the 2011-2013 figures by the pharmaceuticals, where patents cliff continues to cut into output and revenues of major MNCs operating from Ireland.

Adding to good news, capital goods sectors growth signaled the restart in domestic and international investment cycle. And this confirmed the earlier data on capital acquisitions in the industry.

The latest data is now starting to feed through to official forecasts. This week, the Central Bank upgraded 2014 and 2015 outlook for Irish economy. Specifically, the Central Bank is now projecting investment growth of 8.9 percent in 2014 against 0.1% estimated growth in 2013. Crucially, investment in machinery and equipment, having declined 10 percent in 2013 is now forecast to rise 7 percent in 2014.


The news of the quiet out-of-media-sight stabilisation in the Irish manufacturing is welcome because our exports and economy at large are still heavily dependent on industrial and manufacturing sectors activity.  This news is also positive because manufacturing sectors are responsible for high quality jobs creation and hold a significant potential for Ireland in developing a long-term sustainable economic growth model in the future.  In 2013, weekly earnings in industry were the third highest of all private sectors in Ireland and carried a premium of 33 percent on average private sector earnings.

Beyond the above reasons, there are two basic arguments as to why the latest manufacturing trends are encouraging in the context of sustainable economic development.

The first one is a push-factor, driving Ireland in the direction of the new manufacturing.

Worldwide, we are witnessing a new trend in manufacturing. In the commoditised manufacturing geared toward mass-market supply, global supply chains continue to drive down margins and costs, necessitating ever-increasing degree of automation and labour cost reductions. This trend covers a wide range of goods, such as generic consumer goods and intermediate goods production, ranging from textiles and clothing, to consumer electronics, and basic materials industries. Here, robots are increasingly displacing workers. For example, the McKinsey Global Institute study published this month projects that by 2025 up to 25 percent of the tasks performed by industrial workers in developed countries and up to 15 percent in developing countries will be at a risk of replacement by automated systems.

Meanwhile, highly specialist, customised manufacturing, where the businesses processes are dominated by user-unique design and/or proximity to customers, are seeing development costs and time-to-build lags becoming the main points of competition between producers. Actual production in these sectors is based on high precision and skills flexibility and these drivers are pushing for on-shoring of these sectors to the economies with requisite skills and talent infrastructure. The examples of such manufacturing sub-sectors are also numerous, spanning customised precision equipment manufacturing, professional equipment design and production, medical devices, customised medical equipment, individualised or specialist medicines, technology-intensive and complex machinery, but also high value-added consumer goods. Ireland has some limited experience in this area, with companies such as Mincon and Mainstay Medical, Outsource Technical Concepts and others. And we are witnessing growth in design-rich consumer goods areas, such as homewares, personal accessories and higher value-added foods.

I covered these trends in my recent presentation at the TEDxDublin in September 2013 and over the last three months, major consultancies, such as McKinsey and the Institute for Business Value, IBM have written on the topic.


The second factor is the pull-factor of the opportunities presented by new manufacturing.

The crucial point for Ireland is that this trend offers smaller economies a comparative advantage over larger manufacturing centres, as long as the smaller economies can create, attract, retain and enable core human capital.

The competitive advantage of skills-intensive manufacturing is anchored to traditions of high quality specialist production in the country, and to the innovative and entrepreneurial capacity of the economies. Here, examples of Switzerland, Northern Italy, Germany, Holland, Sweden, Denmark and Finland offer a significant promise for countries like Ireland.

In fact, our immediate neighbours industrial policy platform is now firmly focused on enhancing the connection between industrial design, consumer innovation and manufacturing. This is well-anchored in the UK’s Design Council initiatives and in the Government programmes aiming to systemically increase the role of industrial design in the UK manufacturing. Most recently, Government report “Future of manufacturing: a new era of opportunity and challenge for the UK”, published in October 2013 stresses the importance of merging skills, design and technological innovation in driving the future industrial policy in the UK.


To deliver on this potential, our industrial policy needs to be enhanced further to stimulate growth in entrepreneurship in manufacturing. We also need policies that more closely align product, process and design innovation and R&D, especially within indigenous and traditional sectors.

Skills training in manufacturing should be boosted via a targeted apprenticeship programme that develops key expertise and provides support for training both in Ireland and abroad. Our supports for development of manufacturing clusters in traditional industries need to become more pro-active, providing shared sales and marketing platforms for smaller producers.

We can start by consolidating various promotional agencies under the cover of Enterprise Ireland in order to reduce trade and investment facilitation bureaucracy, while increasing resources available on the ground in the foreign markets. Aligning Enterprise Ireland’s pay and promotion systems with tangible longer-term outcomes for indigenous entrepreneurs and exporters should be considered. The overall thrust of reforms should be on reducing duplication and complexity of the system.

Recent report by the Entrepreneurship Forum, published earlier this month outlined a number of measures aimed at helping the unemployed and underemployed to transition into entrepreneurship. These include reducing the eligibility period for the Back to Work Enterprise allowances and creating an entrepreneurship internship programmes. Beyond this, focused incubation and co-working centres targeting manufacturing entrepreneurs can help develop new capabilities and generate new startups. Aligning these programmes with vertical market access accelerators set up in key cities can help enhancing growth potential of indigenous high value-added entrepreneurship. The above programmes can also stimulate inflow of key talent into the country from abroad, including entrepreneurial talent. One of the core benefits of high value-added manufacturing is that the jobs created and capital investment made in this sector are much better anchored in the economy than comparable outlays undertaken in services sectors.

To simultaneously enhance incentives to undertake entrepreneurial activities and to invest time, effort, talent and funding in such activities, employee stock ownership should be encouraged. Over the recent years, this column has repeatedly argued for a reform of tax codes applying to employee share ownership in startups and SMEs. The Entrepreneurship Forum report echoed these ideas.

Driving growth across the design-rich and R&D-intensive manufacturing will also require managerial talent. Looking across the sectors, Irish management skills are the strongest in the externally trading traditional industries, such as food, beverages, and building and construction services. Here, the pressures of global competition, coupled with the acute need to build exports bases have driven management to adopt lean and effective M&A and organic growth models. Management track record of companies such as CRH, Glanbia, Kerry Group and Ryanair presents the best practices in their sectors that can and should be brought to enterprises in much earlier stages of development.


The encouraging signals from Irish manufacturing suggest that we can put our indigenous economy on an evolutionary path toward ever-increasing reliance on radical technological innovation, design and creativity. This path is closely aligned with the need to develop new models of entrepreneurship that combine disruptive technologies with cultural, managerial and skills-rich talent. The key to success here will be in developing greater agility and flexibility of all systems: from crowdsourcing networks for new product development, to training and education, to data analytics for gauging new demand and to new market access platforms.

Box-out:

This Monday, in its monthly report, Germany's Bundesbank stated that in future crises, countries requiring international assistance should first impose a one-off capital tax on net assets of its own citizens, before any international assistance can be extended to them. In the view of the Bundesbank, a capital tax reflects the principle that "tax payers are responsible for their government's obligations before solidarity of other states is required". These latest musings about the need for a capital or wealth tax come on foot of October 2013 IMF report that estimated that reducing euro area's debt levels to 2007 levels will require a 10 percent tax on net wealth of the euro area residents. Neither the IMF, nor Bundesbank identify explicitly specific assets to which the tax should apply. Alas, past experience with Cyprus suggests that such a tax will most likely take the form of a levy on household deposits. Logically, all other assets held by the households are already either heavily taxed, or illiquid. Property taxes are in place in majority of countries and it is hard to imagine every household being able to come up with cash to cover 10 percent levy on their assets values without being forced to sell their homes. Equity and investment funds are de facto illiquid, as a large scale sell-off of these assets in a distressed economy will trigger a crisis hardly any better than the one the levy will be trying to cure. Business equity is notoriously illiquid. Which leaves deposits as the only readily available cash sitting on captive banks balancesheets. In short, Bundesbank and the IMF might be talking about 'capital levies' and solidarity, but all they really mean are deposits bail-ins and loading pain onto taxpayers. That's one way to underwrite inherently faulty and unstable common currency zone.

18/2/2014: Gold Demand Trends 2013

The World Gold Council released its annual (2013) report on Gold Demand Trends (GDT). link: http://www.gold.org/investment/statistics/demand_and_supply_statistics/

Highlights are:

• Jewellery: 2013 saw the largest volume increase in jewellery demand for 16 years as consumers across the globe reacted to lower gold prices. Full year demand was 2,209.5t, 17% above 2012 and the highest level since the onset of the 2008 financial crisis.
• Investment: 2013 was a year of contrast between the different elements of gold investment. Demand for bars and coins surged to an all-time high of 1,654.1t as individual investors took advantage of lower prices, while large-scale selling of more tactical ETF positions by western investors generated outflows of 880.8t.
• Technology: Annual demand for gold used in technology stabilised at 404.8t, from 407.5t in 2012. The lower price environment and improved global economic outlook was supportive for gold used in a range of applications in the sector.
• Central Banks: Net purchases by central banks increased global official gold reserves by 368.6 tonnes. 2013 was the fourth consecutive year of net purchases, albeit at a slightly reduced pace due to the environment of heightened gold volatility and slower foreign reserve accumulation.
• Supply: In 2013 the supply of gold declined 2% to 4,339.9t as a drop in recycling activity (in response to lower gold prices) more than offset growth in mine production.

Total demand is 3,756.1 tonnes against 4,415.8 tonnes in 2012 down 14.9% y/y, of which ETFs and similar investment funds' purchases declines accounted for 880.8 tonnes in 2013 against a rise of 279.1 tonnes in 2012. Thus, the decline of 659.7 tonnes y/y was more than accounted for by the net swing in demand from ETFs of -1,159.9 tonnes.

Total bar and coin demand for investment purposes, however, rose from 1,289 tonnes in 2012 to 1,654.1 tonnes in 2013.

17/2/2014: Is Bitcoin a Real Currency?

Bitcoin has been a focal point of many debates and discussions. None as important as whether or not the digital currency is a real currency.

A new research paper, titled "IS BITCOIN A REAL CURRENCY?" by David Yermack (NBER Working Paper 19747: http://www.nber.org/papers/w19747, December 2013) attempts to answer this question.

"Late 2013 became an auspicious time for Bitcoin, a “virtual currency” launched five years earlier by computer hobbyists. During the month of November 2013, the U.S. Dollar exchange rate for one Bitcoin rose more than fivefold, and the value of one Bitcoin, which had begun trading at less than five cents in 2010, exceeded $1,200.00. Two days of hearings were held by the U.S. Senate Commitee on Homeland Security and Governmental Affairs, at which government regulators testified that virtual, stateless currencies like Bitcoin had the potential to play useful roles in the commercial payment system.

Stories appeared in the media about travelers subsisting for lengthy periods by spending only Bitcoin, and various businesses – including Richard Branson’s Virgin Galactic space travel startup – attracted publicity by agreeing to accept Bitcoin as payment. With approximately 12 million Bitcoins circulating, the worldwide value of the currency exceeded $14 billion, equal to the market capitalization of a mid-range S&P500 company."

Yermack argues that "Bitcoin does not behave like a currency at all. Instead it resembles a speculative investment similar to the Internet stocks of the late 1990s." In other words: not even a commodity...

Starting from the money as defined in economics: "having three characteristics: it functions as a medium of exchange, a unit of account, and a store of value. Bitcoin increasingly satisfies the first of these three criteria, because a growing number of merchants, especially in online markets, appear willing to accept it as a form of payment. However, …Bitcoin performs poorly as a unit of account and as a store of value."

Why?

Reason 1: excessive volatility: "The currency exhibits very high time series volatility (see chart below), which tends to undermine any useful role for Bitcoin as a unit of account. A currency should have only negligible volatility in order to be a reliable store of value."

Reason 2: no correlation with other currencies: "Bitcoin’s daily exchange rate with the U.S. Dollar has virtually zero correlation with the Dollar’s exchange rates against other prominent currencies such as the Euro, Yen, Swiss Franc, or British Pound. Therefore Bitcoin’s value is almost completely untethered to that of
other currencies, which makes its risk nearly impossible to hedge for businesses and customers and renders it more or less useless as a tool for risk management."

Reason 3: "Bitcoin lacks additional characteristics that are usually associated with currencies in modern economies." Which are:

• "Bitcoin cannot be deposited in a bank, and instead it must be possessed through a system of “digital wallets” that have proved vulnerable to hackers. 
• "No form of insurance has been developed for owners of Bitcoin comparable to the deposit insurance relied on consumers in most economies. 
• "No lenders use Bitcoin as the unit of account for standard consumer finance credit, auto loans, and mortgages, and no credit or debit cards have been denominated in Bitcoin. 
• "Bitcoin cannot be sold short, and financial derivatives such as forward contracts and swaps that are routine for other currencies do not exist for Bitcoin. The absence of these types of contracts seems to be the most straightforward explanation for the astronomical rise in Bitcoin’s value in November 2013. Since currency investors have no easy way to bet against Bitcoin’s appreciation, skeptics can only watch as optimists trade the currency among themselves at ever-rising prices."

About the only steadily-advanced argument for Bitcoin is that it is a private currency offering anonymity. Alas, it might be the former, but it does not offer the latter. "The benign attitude of U.S. regulators toward Bitcoin, as revealed in the November 2013 Senate hearings, may stem from the existence of a universal online audit trail for Bitcoin transactions. Although many services exist on the Internet that purport to cloak Bitcoin transfers in anonymity, confidence in the security of these protocols appears to be naive. The arrest of Silk Road’s operator in October 2013, which took place amid widespread publicity of online data monitoring by the U.S. National Security Agency, disabused many about the possibility of keeping any information anonymous on the Internet. Tax evasion, money laundering, purchases of contraband, and other illicit activities using online transfers become far more difficult when the use of a virtual currency like Bitcoin can be reconstructed by governments that have sufficient technical skills."

Ouch!

14/2/2014: BlackRock Institute Survey: N. America & W. Europe, February

BlackRock Investment Institute released its latest Economic Cycle Survey for EMEA region was covered here http://trueeconomics.blogspot.ie/2014/02/822014-blackrock-institute-survey-emea.html

Now, on to survey results for North America and Western Europe region. Emphasis is, as always, mine.

"This month’s North America and Western Europe Economic Cycle Survey presented a positive outlook on global growth, with a net of 65% of 110 economists expecting the world economy will get stronger over the next year, (18% lower than within January report).

The consensus of economists project mid-cycle expansion over the next 6 months for the global economy."

First, 12 months ahead outlook: "At the 12 month horizon, the positive theme continued with the consensus expecting all economies spanned by the survey to strengthen except Norway and Denmark, which are expected to remain the same."

Note that Ireland has moved closer to Eurozone average, away from 1st position in the chart it occupied in 2013.

Now, for 6 months outlook: "Eurozone is described to be in an expansionary phase of the cycle and expected to remain so over the next 2 quarters. Within the bloc, most respondents expect only Greece to remain in a recessionary phase at the 6 month horizon. Over the Atlantic, the consensus view is firmly that North America as a whole is in mid-cycle expansion and is to remain so over the next 6 months."

Note: Red dot denotes Austria, Norway and Switzerland.

Notable changes on previous: Greece position is much improved compared to 2013 when it occupied the North-Eastern most corner. Denmark is now in a weaker outlook position than Greece with higher expectations of a recessionary phase 6 months out. Ireland is bang-on on 10 percent assessing current state of economy as recessionary and same percentage of analysts expecting economy to be in a recession over the next 6 months. Coverage for Ireland is pretty solid in terms of number of analysts surveyed, so the above, in my opinion, shows that analysts consensus expects economy to strengthen over the next 6-12 months with strong support for a modest uplift.


Note: these views reflect opinions of survey respondents, not that of the BlackRock Investment Institute. Also note: cover of countries is relatively uneven, with some countries being assessed by a relatively small number of experts.

14/2/2014: Buffett's Alpha Demystified... or not?

Warren Buffett is probably the most legendary of all investors and his Berkshire Hathaway, despite numerous statements by Buffett explaining his investment philosophy, is still shrouded in a veil of mystery and magic.

The more you wonder about Buffett's fantastic historical track record, the more you ask whether the returns he amassed are a matter of luck, skill, unique strategy or all of the above.

"Buffett’s Alpha" by Andrea Frazzini, David Kabiller, and Lasse H. Pedersen (NBER Working Paper 19681 http://www.nber.org/papers/w19681, November 2013) shows that "looking at all U.S. stocks from 1926 to 2011 that have been traded for more than 30 years, …Berkshire Hathaway has the highest Sharpe ratio among all. Similarly, Buffett has a higher Sharpe ratio than all U.S. mutual funds that have been around for more than 30 years." In fact, for the period 1976-2011, Berkshire Hathaway realized Sharpe ratio stands at impressive 0.76, and "Berkshire has a significant alpha to traditional risk factors." According to the authors, "adjusting for the market exposure, Buffett’s information ratio is even lower, 0.66. This Sharpe ratio reflects high average returns, but also significant risk and periods of losses and significant drawdowns."

According to authors, this begs a question: "If his Sharpe ratio is very good but not super-human, then how did Buffett become among the richest in the world?"

The study looks at Buffett's performance and finds that "The answer is that Buffett has boosted his returns by using leverage, and that he has stuck to a good strategy for a very long time period, surviving rough periods where others might have been forced into a fire sale or a career shift. We estimate that Buffett applies a leverage of about 1.6-to-1, boosting both his risk and excess return in that proportion."

The conclusion is that "his many accomplishments include having the conviction, wherewithal, and skill to operate with leverage and significant risk over a number of decades."


But the above still leaves open a key question: "How does Buffett pick stocks to achieve this attractive return stream that can be leveraged?"

The authors "…identify several general features of his portfolio: He buys stocks that are
-- “safe” (with low beta and low volatility),
-- “cheap” (i.e., value stocks with low price-to-book ratios), and
-- high-quality (meaning stocks that profitable, stable, growing, and with high payout ratios).
This statistical finding is certainly consistent with Graham and Dodd (1934) and Buffett’s writings, e.g.: "Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down"  – Warren Buffett, Berkshire Hathaway Inc., Annual Report, 2008."


Of course, such a strategy is not novel and Ben Graham's original factors for selection are very much in line with it, let alone more sophisticated screening factors. Everyone knows (whether they act on this knowledge or not is a different matter altogether) that low risk, cheap, and high quality stocks "tend to perform well in general, not just the ones that Buffett buys. Hence, perhaps these characteristics can explain Buffett’s investment? Or, is his performance driven by an idiosyncratic Buffett skill that cannot be quantified?"

The authors look at these questions as well. "The standard academic factors that capture the market, size, value, and momentum premia cannot explain Buffett’s performance so his success has to date been a mystery (Martin and Puthenpurackal (2008)). Given Buffett’s tendency to buy stocks with low return risk and low fundamental risk, we further adjust his performance for the Betting-Against-Beta (BAB) factor of Frazzini and Pedersen (2013) and the Quality Minus Junk (QMJ) factor of Asness, Frazzini, and Pedersen (2013)."

And then 'Eureka!': "We find that accounting for these factors explains a large part of Buffett's performance. In other words, accounting for the general tendency of high-quality, safe, and cheap stocks to outperform can explain much of Buffett’s performance and controlling for these factors makes Buffett’s alpha statistically insignificant… Buffett’s genius thus appears to be at least partly in recognizing early on, implicitly or explicitly, that these factors work, applying leverage without ever having to fire sale, and sticking to his principles. Perhaps this is what he means by his modest comment: "Ben Graham taught me 45 years ago that in investing it is not necessary to do extraordinary things to get extraordinary results." – Warren Buffett, Berkshire Hathaway Inc., Annual Report, 1994."


There is more to be asked about Warren Buffett's investment style and strategy. "…we consider whether Buffett’s skill is due to his ability to buy the right stocks versus his ability as a CEO. Said differently, is Buffett mainly an investor or a manager?"

Authors oblige: "To address this, we decompose Berkshire’s returns into a part due to investments in publicly traded stocks and another part due to private companies run within Berkshire. The idea is that the return of the public stocks is mainly driven by Buffett’s stock selection skill, whereas the private companies could also have a larger element of management."

Another 'Eureka!' moment beckons: "We find that both public and private companies contribute to Buffett’s performance, but the portfolio of public stocks performs the best, suggesting that Buffett’s skill is mostly in stock selection. Why then does Buffett rely heavily on private companies as well, including insurance and reinsurance businesses? One reason might be that this structure provides a steady source of financing, allowing him to leverage his stock selection ability. Indeed, we find that 36% of Buffett’s liabilities consist of insurance float with an average cost below the T-Bill rate.


So core conclusions on Buffett's genius: "In summary, we find that Buffett has developed a unique access to leverage that he has invested in safe, high-quality, cheap stocks and that these key characteristics can largely explain his impressive performance. Buffett’s unique access to leverage is consistent with the idea that he can earn BAB returns driven by other investors’ leverage constraints. Further, both value and quality predict returns and both are needed to explain Buffett’s performance. Buffett’s performance appears not to be luck, but an expression that value and quality investing can be implemented in an actual portfolio (although, of course, not by all investors who must collectively hold the market)."

Awesome study!