CAPM is Absurd

The CAPM—the standard model upon which much of the investment industry is built—is “absurd,” according to University of Navarra Professor Pablo Fernandez, and its assumptions have “no basis in the real world.”

I am inclined to agree.

For those unversed in the language of modern finance, the CAPM—or Capital Asset Pricing Model—is a formula that calculates the required return on an investment as a function of its volatility relative to the market (“beta”).  In other words, the more volatile a security relative to the market, the higher the return you’ll require to hold it.

Every MBA finance student the world over has to learn the CAPM formula, and I could rant for days about how impractical the formula is in the real world of investing.  But let’s see what Professor Fernandez has to say on the subject.

Fernandez specifically attacks the assumptions baked into the model, namely that all investors have equal expectations of asset returns and volatility, can lend and borrow unlimited funds at the risk-free rate, can short any asset or hold fractional shares of any asset, and have identical time horizons.

Common sense would tell you that none of these assumptions are true.  Investors have wildly different views of potential returns and risks; you need both bulls and bears to make a market, after all.  Borrowing and lending at the risk-free rate (i.e. the rate the U.S. Treasury pays on its debts) is unrealistic for regular investors, to say the least.  Shorting is not always possible; it depends on the availability of shares to short. Fractional ownership of shares is not always possible, though it certainly would have been desirable.  Consider recent history when Apple (AAPL), Google (GOOG) and Berkshire Hathaway (BRK-B) all traded at share prices in the multiple hundreds or thousands of dollars.  And finally, time horizon will vary wildly from person to person based on their age and unique circumstances.

More fundamentally, I take issue with the fact that returns expectations ignore valuation altogether.  Any decent value investor knows that the returns you generate are ultimately dependent on the price you pay.

I agree with Fernandez; CAPM is absurd.  Thankfully, it is rarely used outside of academia.

Fernandez’s paper is available here.

Will Technology Make Us All Jobless?

According to a recent study at Oxford University, nearly half of U.S. jobs are at risk of computerization. 45% of America’s occupations will be automated away over the next two decades.

That sounds scary, and my bet is that it proves to be true.

But it’s also nothing new.  Technology has been making jobs obsolete since the dawn of civilization.  Ever since the first farmer got the bright idea to hitch his plow to an ox and make a team of farm hands obsolete, homo economicus has been destroying labor.  The rate of change went parabolic during the Industrial Revolution, and we’re seeing the same kind of upheaval today, during the Information Revolution.  But there is nothing new under the sun here.  Technology destroys jobs.  It also creates new ones and raises our inflation-adjusted incomes.

Here’s a little stat that will probably blow your mind:  the United States manufactures more today than it did in the 1970s.

Yes, you read that correctly.  I said “more.”  As in a lot more.

Figure 1: U.S. Industrial Production

Take a look at Figure 1, which tracks U.S. industrial production, adjusted for inflation.  You can see a massive dip during the 2008-2009 financial meltdown and recession, but the picture here is clear.  The United States manufactures more today than at any time in its history and two-and-a-half times more than in 1970 — the supposed heyday of American heavy industry before globalization and cheap foreign labor “hollowed it out.”

Figure 2: U.S. Manufacturing Employment

There is a hollowing out, of course.  But it’s not in manufacturing, per se.  It’s in manufacturing employment.  Take a look at Figure 2.  Since 1978, manufacturing employment has declined by about 40%.  Over the same period of time, the U.S. population has grown by about 40%.  As a percentage of a much larger workforce, the percent of U.S. workers in manufacturing has declined by more than half.

Without getting lost in the statistics, let’s state the obvious: technology made us more productive.  We are now able to produce more with the same resources and to do it all far more cheaply.

And what was the result of all this?  Did unemployment go through the roof as robots replaced workers?

Not exactly.

Up until the Great Recession forced unemployment to multi-decade highs, unemployment had been steadily trickling down since the early 1980s.  The “real unemployment rate,” as some have taken to calling the U6 rate, which includes those working part time for lack of better options as unemployed, was also trending downward up until the 2008 meltdown took a wrecking ball to the employment picture.

Economics as a profession tends to focus a little too heavily on heavy industrial jobs.  Perhaps this is because the profession came of age during the Industrial Revolution, or maybe it’s because industrial data is easier to quantify than services and information data.  But the same forces at work are reshaping the employment picture here as well.

Consider the travel industry. Travel agencies used to be the medium through which you booked your flight and hotel. Today, those fuctions are handled by websites like Priceline (PCLN) or Orbitz (OWW).  Agents have been replaced by software or relegated to consierge roles.

And even the economics of website building are changing.  Building a site these days generally consists of taking a pre-built WordPress theme and customizing it.  This leverages a talented software engineer’s time — a quality theme can be used to build an infinite number of sites — with the end result that the time and cost to set up a new site are a fraction of what they once were.

Perhaps it’s easy for me to speak about this dispassionately; after all, finance has been largely immune from this creative destruction, right?

Not quite.  The widespread availability of stock screeners, charting software, and databases have massively cut back the man-hours needed to do basic investment research.  This frees up more time for interpretation and writing, but it also means less need for entry-level analyst work.

All of this raises a very important question: if technology is shaving back the need for labor everywhere, then where will the jobs of tomorrow come from?

I have no idea.  But if the past 200 years of history have taught us anything, the jobs will come, particularly for those motivated and with a solid education.

The general — and not all that helpful — advice to making your career future-proof is to learn skills that are not easily automated.  That’s easier said than done, of course, but as a general rule the more educated you are the better the likelihood is that you will be a deployer of technology rather than one of its victims.

This article first appeared on InvestorPlace.

Charles Lewis Sizemore, CFA, is the editor of the Sizemore Investment Letter and the chief investment officer of investments firm Sizemore Capital Management. As of this writing, he had no position in any security mentioned. Click here to learn about his top 5 global investing trends and get your copy of “The Top 5 Million Dollar Trends of 2013.”

The Long Divergence: What Turned the Tables Between the West and Islam?

For centuries the Islamic world dominated the West militarily, economically, and culturally.  As late as 1683, when Ottoman forces laid siege to Vienna, Muslim military domination was a legitimate fear for the Christian world.

Excluding the sophisticated Byzantine Empire—which Muslim Arab forces nearly conquered and Muslim Turkish forces did conquer in 1453—and some of the city-states of Italy, the West remained backward and underdeveloped compared to the Middle East for roughly 1,000 years.  Prior to the Renaissance the West had nothing that could rival Damascus, Baghdad or the other great cities of the region.

But then, a funny thing happened.  Europe emerged as an economic juggernaut and turned the tables on the Islamic world.  Starting in the late 1400s and accelerating with the Industrial Revolution of the late 1700s, the West emerged as the dominant military, economic, and cultural force in the world.

The question that has perplexed scholars for ages is why?

None of the popular explanations are satisfactory.  Those who would suggest that Islam is hostile to commerce have clearly never walked the streets of a Muslim country or have never spent five minutes discussing business with a Lebanese—Muslim or Christian.   Arabs—particularly in the Levant—have capitalism in their blood, as do Turks and North Africans.  Try your luck at haggling in a bazaar, and you’ll see what I mean.

The oft-cited Muslim prohibition against the charging of interest also fails to hold water.  The charging of interest was prohibited for Christians in the West for most of the Middle Ages, and neither Christians nor Muslims prevented Jewish minorities within their borders from charging interest.

Islam’s founder was also no stranger to the business of making money.  Unlike Jesus Christ—who lived his earthly life as a humble carpenter and eschewed worldly possessions—Muhammad was a hard-nosed trader and businessman before he became a religious leader, and the Koran is far more “business friendly” than the Christian New Testament.

The second popular explanation—that the Islamic world is poor due to Western imperialism—makes even less sense.  Until roughly 1500 it was the Muslim powers doing the colonizing, not the Christian. And in any event, the West’s eventual colonization of the Islamic world happened only after it had become wealthier, so we’re back to the original question: why did the West rise to the top in the first place?

In his engaging new book The Long Divergence, Timur Kuran believes he has found the answer: the West invented the corporation.

The Christian New Testament is a general guide for spiritual and personal living; it is distinctly not an all-encompassing blueprint for organizing a society.  Ever since Christ’s admonition to render to Caesar what is Caesar’s and render to God what is God’s, there has been an understanding that there are secular areas of life for which religion does not have the answer. This left the Christian world free to experiment with concepts such as double-entry accounting, the limited partnership or the corporation.

Not so in the Islamic world. As Kuran writes,

In principle, Islamic law covered all human activity… In commerce and finance, two areas in which the Middle East fell conspicuously behind, Islamic law played a key role. People entered into contracts that followed an Islamic template and were enforced through Islamic courts. They apportioned estates according to Islamic inheritance rules. Residents of the region’s great cities obtained services mostly from waqfs, which were trusts formed under Islamic law and supervised by officials with religious training. Almost all lawsuits involving at least one Muslim were litigated by Muslim judges, under Islamic legal principles.

Interesting, the uniform commercial code imposed by Islam was initially a boon to commerce.  Since all Muslims played by the same set of rules and were held accountable in the same Islamic courts, business deals across borders became remarkably easy.

Unfortunately, these Islamic institutions had several limitations that made them unsuitable for the modern era:

  1. The concept of limited liability did not exist in Islamic partnership law.  All partners were responsible for the obligations of the partnership, which discouraged risk taking.
  2. Islamic partnerships are designed for specific projects and are not designed to be perpetual going concerns.  The partnerships are automatically dissolved with the death of a partner, and any partner can dissolve the partnership at any time.  Partners could not sell their ownership interests in the form of tradable shares of stock or pass their ownership interests to their heirs.
  3. Islamic inheritance law ensures that assets are dispersed among wives, children, and even siblings, and the common practice of polygamy among the wealthy meant that there were more heirs entitled to a share of the inheritance.  Under sharia, a Muslim only has discretion over one third of his or her assets; the rest is distributed per Koranic guidelines.

These restrictions prevented the multigenerational accumulation of wealth  and prevented the emergence of large corporations that were capable of engaging is long-term, global enterprises.  Something like the British East India Company, for example, would have been absolutely out of the question.

It was only in the late 1800s that Muslim rulers began to import Western legal institutions, and these were subject to opposition by religious conservatives.  But by then, the damage was done.  The West had already leapt into the position of world dominance.

Though his explanations may seem too simple to some readers, Mr. Kuran makes a compelling case and he has the research to back it up.  The Sizemore Investment Letter recommends The Long Divergence for any readers that are economic history buffs.

Alas, for the Occupy Wall Street crowd, the book will only provide more proof of the unassailable power of the modern corporation.

John Law: Rake, Murderer, and Father of Central Banking

I commented in a previous article that “if you think that Fed Chairman Ben Bernanke is unpopular, consider the tragic case of Takahashi Korekiyo, who served as Bank of Japan governor from 1911-1913 and as finance minister and prime minister in the 1920s and 1930s.”

Mr. Takahashi helped to pull Japan out of the Great Depression with aggressive monetary stimulus (or “quantitative easing,” in the popular jargon of today) and deficit spending. Unfortunately, like a man who joins the mafia, he found that he couldn’t get out. The Japanese economy had become dependent on stimulus, and when Mr. Takahashi finally decided to risk it by tightening monetary policy and cutting government spending, he was assassinated by a group of rogue army officers.

Ben Bernanke is at little risk of meeting such a fate, though there are certainly plenty in Congress who would love to assassinate his career. If certain members of the Tea Party had their way, the Chairman might meet the fate of John Law, the Scottish adventurer who, as France’s first central banker, became the most powerful man in international finance—and the wealthiest man in the world—before having to flee penniless into exile and obscurity.

Law presided over one of the great financial spectacles in history: the Mississippi Land Scheme, which was aided and abetted by the creation of the first modern central bank in Europe, the French Banque Generale (later re-christened the Banque Royale). Law was an interesting character; a gentleman gambler with a taste for wealth, wine, women and power. His financial career began in the gaming halls of Europe after escaping a death sentence in England for killing a man in 1694, allegedly over the affections of a woman.

One might ask, how did this murdering degenerate come to control the financial destiny of France, then the most powerful nation in Europe? It was a long, circuitous path.
Continue reading “John Law: Rake, Murderer, and Father of Central Banking”

Death Elasticity and Taxes

The following is an excerpt from an article I originally wrote in June 2008.  Today, with the Bush tax cuts set to expire, the insights of this article are more important than ever.

Moving on to a different area in human predictability, Gerald Prante of the Tax Foundation recommended a white paper that examines how people adjust major life decisions—including death itself—in response to tax incentives. Kopczuk and Slemrod’s 2001 paper, “Dying to Save Taxes: Evidence from Estate Tax Returns on the Death Elasticity,” is a fascinating look at these timing decisions.

In an article I penned for the March 2007 issue of the HS Dent Forecast, “Voting for Fertility,” I commented that government pro-natal policies were not likely to work. No government has enough money to convince reluctant adults to become parents unless they were already strongly considering it. Even Russia’s generous $10,000 “baby bonuses” do little to compensate parents for the money, time, and loss of freedom that children bring. Likewise, it is not likely that many couples would permanently forgo marriage to avoid the marriage penalty on their yearly 1040 or that a significant number of healthy people would commit suicide to escape the estate tax. Continue reading “Death Elasticity and Taxes”