How Guessing Market Direction Can Be PREDICTABLY Bad for Your Financial Health

"The game is called probability guessing. . . . [S]ubjects are shown a series of cards or lights which can have two colors, say green and red . . . appear[ing] . . . with different probabilities but otherwise without a pattern. . . . The task of the subject, after watching for a while, is to predict whether each new member of the sequence will be red or green. . . . Humans usually try to guess the pattern, and in the process we allow ourselves to be outperformed by a rat. . . ." (excerpt from Leonard Mlodinow's The Drunkard's Walk--How Randomness Rules Our Lives, 2008)

In a stock market context, the probability guessing game described above would read like this: In any given year, the stock market either rises (green) or falls (red). If we look over the past six decades, from 1950 through 2009, we find that during the sequential decades (1950s, 1960s, and so on) the S&P 500 Index rose in 8, 6, 7, 9, 8 and 6 out of the 10 years (using data from Yahoo! Finance). In other words, during a "typical" decade annual stock market returns are "green" about 7 or 8 out of the 10 years, and "red" about 2 or 3 out of the 10 years. Based on these historical data, we can infer that the stock market tends to rise during any particular calendar with a probability of about 75%, and fall with a probability of about 25%. As investors, we, of course, would like to try to predict whether this year (or next year, or any future year for that matter) will be green or red.

For us investors, the million-dollar question is: Should an investor attempt to "time" the market, by investing in stocks during years the market is more likely (in the investor's opinion) to rise and staying out of the market during other years when the market is more likely (again, in the investor's opinion) to fall?

Obviously, if the investor truly has enough information, foresight or precognition to know with a high degree of certainty when the market will rise or fall, then market-timing makes perfect sense and will lead to higher returns. However, what happens if the investor only believes that he knows but actually does not, so that for all practical purposes the investor is really faced with the 75% green versus 25% red probabilities described above? Is any harm done by guessing?

Analogous to the general guessing game Mlodinow mentions in his book, let's consider two strategies:

1. Buy-and-Hold Strategy: Since the market rises during 75% of the years, one could just go long the market by buying an exchange-traded fund tracking the S&P 500 Index (or buying individual stocks), without attempting to time the market at all. A buy-and-hold investor can expect to generate positive returns 75% of the years but must also accept the unavoidable "fact" that the market will typically fall 25% of the time. In this "simpleton" strategy, an investor's long-run win percentage (i.e., the percentage of years the investor's portfolio will show positive returns) is expected to be 75%;

2. Market-Timing Strategy: A presumably more "sophisticated" investor will, through some combination of fundamental and technical analysis and application of his general intelligence and market wisdom, come up with a convincing explanation for why the market is more likely to rise (or fall) during any particular year. Believing he can distinguish beforehand (i.e., predict) which years are among the 75% "green" years when the market will rise and, likewise, which years are among the 25% "red" years when the market will fall, such an investor will want to go long 75% of the time and stay out of (or go short) the market 25% of the time.

If the bright and sophisticated market-timing investor has an "edge" over the the naive and unthinking buy-and-hold simpletons, then he will end up being right more than 75% of the time and will show higher long-run returns. At the other extreme, if it turns out that the market-timer only believes he has an edge but actually does not, one would think that his edge would just vanish and there should be no penalty for guessing, right?

Well, you might think that guessing carries no penalty, but that's actually wrong! Quite counter-intuitively, investors should expect lower returns when they guess. Here's why.

Let p be the (stationary) probability that the the market will rise in a given year, i.e., p = 0.75, representing the 75% "green" probability. Supposing that the market-timer's guesses do not give him any significant edge, his overall win percentage is given by a straightforward weighted-probability calculation:

Market-Timer's Win Percentage
= (Portion of time the market-timer goes long) x (Probability that market rises)
+ (Portion of time the market-timer stays out of market) x (Probabiility that market falls)
= p x p + (1 - p) x (1 - p)
= p² + (1 - 2p + p²)
= 2p² - 2p + 1.

On the other hand, the Buy-and-Hold Investor's Win Percentage is just p, as we saw earlier. Consequently, we may write that the expected potential downside of the market-timing strategy versus the buy-and-hold strategy is the difference:

(Buy-and-Hold Investor's Win Percentage) - (Market-Timer's Win Percentage)
= p - (2p² - 2p + 1)
= -2p² + 3p - 1
= 2(p - 0.5)(1 - p),

where the last expression is the factored-form equivalent of the quadratic polynomial in the previous line.

From the factored-form expression, we can easily see that whenever p is in the "physical" range (i.e., consistent with the probabilities indicated by market history for a wide variety of investment time windows) from 0.5 to 1.0, a buy-and-hold investor is expected to outperform any market-timer who is really just guessing without appealing to any special knowledge of market direction. In particular, when p = 0.75 (which is the historical win-percentage for a sequence of annual returns), the Market-Timer's Win Percentage becomes 2(0.75)² - 2(0.75) + 1 = 0.625, or 62.5%, which is 12.5 percentage points worse than the Buy-and-Hold Win Percentage of 75%.

Therefore, to the extent that a market-timer is "only guessing" (and who can really be so certain?) about market direction, he is (presumably unknowingly) effectively "shooting himself in the foot," following a self-destructive path of degrading his expected returns by staying out of the market 25% of the time (by the way, shorting the market 25% of the time would make matters even worse). Despite his seemingly sophisticated ways, this market-timer can actually be expected to underperform the simpleton buy-and-hold investor in the long-run.

Lesson: Don't attempt to "time the market" unless you are absolutely certain that your market-timing strategy actually works, since your expected downside from "believing without knowing" far exceeds your time spent strategizing, not to mention your trading costs and commissions consumed.

How Guessing Market Direction Can Be PREDICTABLY Bad for Your Financial Health

"The game is called probability guessing. . . . [S]ubjects are shown a series of cards or lights which can have two colors, say green and red . . . appear[ing] . . . with different probabilities but otherwise without a pattern. . . . The task of the subject, after watching for a while, is to predict whether each new member of the sequence will be red or green. . . . Humans usually try to guess the pattern, and in the process we allow ourselves to be outperformed by a rat. . . ." (excerpt from Leonard Mlodinow's The Drunkard's Walk--How Randomness Rules Our Lives, 2008)

In a stock market context, the probability guessing game described above would read like this: In any given year, the stock market either rises (green) or falls (red). If we look over the past six decades, from 1950 through 2009, we find that during the sequential decades (1950s, 1960s, and so on) the S&P 500 Index rose in 8, 6, 7, 9, 8 and 6 out of the 10 years (using data from Yahoo! Finance). In other words, during a "typical" decade annual stock market returns are "green" about 7 or 8 out of the 10 years, and "red" about 2 or 3 out of the 10 years. Based on these historical data, we can infer that the stock market tends to rise during any particular calendar with a probability of about 75%, and fall with a probability of about 25%. As investors, we, of course, would like to try to predict whether this year (or next year, or any future year for that matter) will be green or red.

For us investors, the million-dollar question is: Should an investor attempt to "time" the market, by investing in stocks during years the market is more likely (in the investor's opinion) to rise and staying out of the market during other years when the market is more likely (again, in the investor's opinion) to fall?

Obviously, if the investor truly has enough information, foresight or precognition to know with a high degree of certainty when the market will rise or fall, then market-timing makes perfect sense and will lead to higher returns. However, what happens if the investor only believes that he knows but actually does not, so that for all practical purposes the investor is really faced with the 75% green versus 25% red probabilities described above? Is any harm done by guessing?

Analogous to the general guessing game Mlodinow mentions in his book, let's consider two strategies:

1. Buy-and-Hold Strategy: Since the market rises during 75% of the years, one could just go long the market by buying an exchange-traded fund tracking the S&P 500 Index (or buying individual stocks), without attempting to time the market at all. A buy-and-hold investor can expect to generate positive returns 75% of the years but must also accept the unavoidable "fact" that the market will typically fall 25% of the time. In this "simpleton" strategy, an investor's long-run win percentage (i.e., the percentage of years the investor's portfolio will show positive returns) is expected to be 75%;

2. Market-Timing Strategy: A presumably more "sophisticated" investor will, through some combination of fundamental and technical analysis and application of his general intelligence and market wisdom, come up with a convincing explanation for why the market is more likely to rise (or fall) during any particular year. Believing he can distinguish beforehand (i.e., predict) which years are among the 75% "green" years when the market will rise and, likewise, which years are among the 25% "red" years when the market will fall, such an investor will want to go long 75% of the time and stay out of (or go short) the market 25% of the time.

If the bright and sophisticated market-timing investor has an "edge" over the the naive and unthinking buy-and-hold simpletons, then he will end up being right more than 75% of the time and will show higher long-run returns. At the other extreme, if it turns out that the market-timer only believes he has an edge but actually does not, one would think that his edge would just vanish and there should be no penalty for guessing, right?

Well, you might think that guessing carries no penalty, but that's actually wrong! Quite counter-intuitively, investors should expect lower returns when they guess. Here's why.

Let p be the (stationary) probability that the the market will rise in a given year, i.e., p = 0.75, representing the 75% "green" probability. Supposing that the market-timer's guesses do not give him any significant edge, his overall win percentage is given by a straightforward weighted-probability calculation:

Market-Timer's Win Percentage
= (Portion of time the market-timer goes long) x (Probability that market rises)
+ (Portion of time the market-timer stays out of market) x (Probabiility that market falls)
= p x p + (1 - p) x (1 - p)
= p² + (1 - 2p + p²)
= 2p² - 2p + 1.

On the other hand, the Buy-and-Hold Investor's Win Percentage is just p, as we saw earlier. Consequently, we may write that the expected potential downside of the market-timing strategy versus the buy-and-hold strategy is the difference:

(Buy-and-Hold Investor's Win Percentage) - (Market-Timer's Win Percentage)
= p - (2p² - 2p + 1)
= -2p² + 3p - 1
= 2(p - 0.5)(1 - p),

where the last expression is the factored-form equivalent of the quadratic polynomial in the previous line.

From the factored-form expression, we can easily see that whenever p is in the "physical" range (i.e., consistent with the probabilities indicated by market history for a wide variety of investment time windows) from 0.5 to 1.0, a buy-and-hold investor is expected to outperform any market-timer who is really just guessing without appealing to any special knowledge of market direction. In particular, when p = 0.75 (which is the historical win-percentage for a sequence of annual returns), the Market-Timer's Win Percentage becomes 2(0.75)² - 2(0.75) + 1 = 0.625, or 62.5%, which is 12.5 percentage points worse than the Buy-and-Hold Win Percentage of 75%.

Therefore, to the extent that a market-timer is "only guessing" (and who can really be so certain?) about market direction, he is (presumably unknowingly) effectively "shooting himself in the foot," following a self-destructive path of degrading his expected returns by staying out of the market 25% of the time (by the way, shorting the market 25% of the time would make matters even worse). Despite his seemingly sophisticated ways, this market-timer can actually be expected to underperform the simpleton buy-and-hold investor in the long-run.

Lesson: Don't attempt to "time the market" unless you are absolutely certain that your market-timing strategy actually works, since your expected downside from "believing without knowing" far exceeds your time spent strategizing, not to mention your trading costs and commissions consumed.

Perpetual Income Generation

A student who earned a few thousand dollars over the summer working remarked to me yesterday, "I don't know how I'm going to spend the money if I don't use it to travel over the holidays."

At first, this statement seemed quite innocuous, in line with what I have come to expect in our work-and-spend, consumer-oriented society. People earn money working and then, quite predictably, spend the bulk of their earnings soon thereafter, buying all types of consumer goods and services with whatever remains after paying for life's essentials.

Three Personal Financial Management Philosophies

Upon further consideration, I became struck with just how one-sided the student's attitude on what to do with his money is. On the spectrum of personal money management philosophies, he is at the consumerist end of the two extremes:

Consumerist Philosophy: Earn and spend; earn and spend; earn and spend. In short, spend all of today's earnings on consumer items, because another paycheck will always come "tomorrow." Examples of this type of philosophy include people who live paycheck-to-paycheck more by choice than circumstance, the young woman from England who won a multi-million dollar lottery six years ago at the age of 16 and now regrets having spent all of the money so frivolously, and highly successful, high-income celebrities like photographer, Annie Leibovitz, and singer, Michael Jackson, who, despite their millions in earnings, have ended up "awash in debt" due to their personal financial management, or lack thereof.

Wealth Accumulator's Philosophy: What's important is accumulating as much wealth as possible during one's lifetime. Be frugal, even to the point of being miserly. Save as much as possible from one's earnings, prudently invest one's savings, and reinvest as much as possible of one's investment earnings. An example of this type of thinking is self-made billionaire, Warren Buffett, who not only is worth some $40 billion but is rumored to have once stooped down to pick up a penny in an elevator, remarking to those around him, "This is the start of my next billion."

My opinion is that most of us will be best off following neither of the above extremes but, instead, adopting a middle-of-the-road philosophy, which emphasizes neither consumer spending nor wealth accumulation:

Perpetual Income Generation: Use one's "excess" earnings (i.e., whatever is not needed to pay for basic necessities) from work and investments to build an investment portfolio that will reliably generate long-term income to cover all of life's expenses. The focus here is neither on spending all of one's earnings, just because one has money currently available to spend, nor on stockpiling cash without limit, primarily to see how much wealth one can accumulate. Rather, the core of this philosophy is to accumulate enough wealth to reach an ongoing state of financial independence, which means that the income generated from one's investment portfolio should over time be enough to support one's lifestyle without relying on external employment.

Historical Analogies

I'm now reading Jared Diamond's insightful work, Guns, Germs, and Steel, which discusses how and why some societies developed farming and technologies and came to dominate societies that remained hunter-gatherers throughout the millennia since the most recent Ice Age some 13,000 years ago. We can draw a simplistic analogy between hunter-gatherer societies and the consumerist philosophy mentioned above, since both emphasize current consumption without any significant savings component. Similarly, agricultural societies may be compared to the wealth accumulator's philosophy, since any excess harvest can be stored or sold for income, allowing for investment in technology development, which in turn can be used to promote further wealth accumulation.

As Diamond mentions, the recurring pattern throughout history has been that agriculture-based societies have not only developed better technology but have also deployed it to exploit societies having more primitive technology. A striking 19th century example is how, in December 1835, a group of 900 Maoris from New Zealand's North Island sailed 500 miles east to the Chatham Islands and conquered a peaceful society of 2,000 Moriori hunter-gatherers, brutally and indiscriminately killing men, women and children who refused to become their slaves. Apparently, what induced the Maoris to attack the Morioris en masse was news from a seal-hunting ship that visited the Chathams, revealing islands rich in shellfish, eels and berries, with inhabitants who "do not understand how to fight, and have no weapons."

Such are the tragic consequences of the collision of societies. Other well-known examples range from the probable driving of the Neanderthals into extinction by Cro-Magnons some 40,000 years ago, to Cortes's and Pizarro's 16th century conquests of the Aztec and Inca empires, respectively, to the so-called Manifest Destiny of European settlers in the 19th century to expand across North America, decimating native Indian tribes in their path.

I mention these historical analogies because of the perspective they bring to personal financial management. As history shows, societies that have had a "savings" component in their culture have inexorably won an upper hand over societies with more purely consumption-oriented habits. If taken to the extreme, this might seem to indicate that pure wealth accumulation should be, at least from a survival point of view, our preferred personal financial management strategy. Hence, my advice to the student I mentioned at the outset could be to save all of his summer earnings in order to maximize wealth accumulation, but is this really best?

Goal: Perpetual Income

Pure consumers live for the present, much as hunter-gatherer societies have throughout history. On the other hand, pure wealth accumulators emphasize the future, based on a "stockpiling" mentality that always favors acquiring more, no matter how much one already has. Rather than simply consuming or saving, it is, in my judgment, critical to forecast one's future financial needs and reach the right balance between consumption and savings that will best optimize one's overall life satisfaction.

So, my advice to the student is: Instead of focussing on how to spend your earnings, or saving all of it for the future, ask yourself how best to utilize your earnings to begin to create a perpetual income stream that will allow you to gain financial independence and support your future lifestyle. Your focus should be neither on consumption nor on wealth accumulation, but on how best to employ your earnings, consumption, savings and investments to one day to replace your own labor as the primary source of income in your life. (Note: Some people call it "retirement," but for me it's closer to financial "rebirth.")

Perpetual Income Generation

A student who earned a few thousand dollars over the summer working remarked to me yesterday, "I don't know how I'm going to spend the money if I don't use it to travel over the holidays."

At first, this statement seemed quite innocuous, in line with what I have come to expect in our work-and-spend, consumer-oriented society. People earn money working and then, quite predictably, spend the bulk of their earnings soon thereafter, buying all types of consumer goods and services with whatever remains after paying for life's essentials.

Three Personal Financial Management Philosophies

Upon further consideration, I became struck with just how one-sided the student's attitude on what to do with his money is. On the spectrum of personal money management philosophies, he is at the consumerist end of the two extremes:

Consumerist Philosophy: Earn and spend; earn and spend; earn and spend. In short, spend all of today's earnings on consumer items, because another paycheck will always come "tomorrow." Examples of this type of philosophy include people who live paycheck-to-paycheck more by choice than circumstance, the young woman from England who won a multi-million dollar lottery six years ago at the age of 16 and now regrets having spent all of the money so frivolously, and highly successful, high-income celebrities like photographer, Annie Leibovitz, and singer, Michael Jackson, who, despite their millions in earnings, have ended up "awash in debt" due to their personal financial management, or lack thereof.

Wealth Accumulator's Philosophy: What's important is accumulating as much wealth as possible during one's lifetime. Be frugal, even to the point of being miserly. Save as much as possible from one's earnings, prudently invest one's savings, and reinvest as much as possible of one's investment earnings. An example of this type of thinking is self-made billionaire, Warren Buffett, who not only is worth some $40 billion but is rumored to have once stooped down to pick up a penny in an elevator, remarking to those around him, "This is the start of my next billion."

My opinion is that most of us will be best off following neither of the above extremes but, instead, adopting a middle-of-the-road philosophy, which emphasizes neither consumer spending nor wealth accumulation:

Perpetual Income Generation: Use one's "excess" earnings (i.e., whatever is not needed to pay for basic necessities) from work and investments to build an investment portfolio that will reliably generate long-term income to cover all of life's expenses. The focus here is neither on spending all of one's earnings, just because one has money currently available to spend, nor on stockpiling cash without limit, primarily to see how much wealth one can accumulate. Rather, the core of this philosophy is to accumulate enough wealth to reach an ongoing state of financial independence, which means that the income generated from one's investment portfolio should over time be enough to support one's lifestyle without relying on external employment.

Historical Analogies

I'm now reading Jared Diamond's insightful work, Guns, Germs, and Steel, which discusses how and why some societies developed farming and technologies and came to dominate societies that remained hunter-gatherers throughout the millennia since the most recent Ice Age some 13,000 years ago. We can draw a simplistic analogy between hunter-gatherer societies and the consumerist philosophy mentioned above, since both emphasize current consumption without any significant savings component. Similarly, agricultural societies may be compared to the wealth accumulator's philosophy, since any excess harvest can be stored or sold for income, allowing for investment in technology development, which in turn can be used to promote further wealth accumulation.

As Diamond mentions, the recurring pattern throughout history has been that agriculture-based societies have not only developed better technology but have also deployed it to exploit societies having more primitive technology. A striking 19th century example is how, in December 1835, a group of 900 Maoris from New Zealand's North Island sailed 500 miles east to the Chatham Islands and conquered a peaceful society of 2,000 Moriori hunter-gatherers, brutally and indiscriminately killing men, women and children who refused to become their slaves. Apparently, what induced the Maoris to attack the Morioris en masse was news from a seal-hunting ship that visited the Chathams, revealing islands rich in shellfish, eels and berries, with inhabitants who "do not understand how to fight, and have no weapons."

Such are the tragic consequences of the collision of societies. Other well-known examples range from the probable driving of the Neanderthals into extinction by Cro-Magnons some 40,000 years ago, to Cortes's and Pizarro's 16th century conquests of the Aztec and Inca empires, respectively, to the so-called Manifest Destiny of European settlers in the 19th century to expand across North America, decimating native Indian tribes in their path.

I mention these historical analogies because of the perspective they bring to personal financial management. As history shows, societies that have had a "savings" component in their culture have inexorably won an upper hand over societies with more purely consumption-oriented habits. If taken to the extreme, this might seem to indicate that pure wealth accumulation should be, at least from a survival point of view, our preferred personal financial management strategy. Hence, my advice to the student I mentioned at the outset could be to save all of his summer earnings in order to maximize wealth accumulation, but is this really best?

Goal: Perpetual Income

Pure consumers live for the present, much as hunter-gatherer societies have throughout history. On the other hand, pure wealth accumulators emphasize the future, based on a "stockpiling" mentality that always favors acquiring more, no matter how much one already has. Rather than simply consuming or saving, it is, in my judgment, critical to forecast one's future financial needs and reach the right balance between consumption and savings that will best optimize one's overall life satisfaction.

So, my advice to the student is: Instead of focussing on how to spend your earnings, or saving all of it for the future, ask yourself how best to utilize your earnings to begin to create a perpetual income stream that will allow you to gain financial independence and support your future lifestyle. Your focus should be neither on consumption nor on wealth accumulation, but on how best to employ your earnings, consumption, savings and investments to one day to replace your own labor as the primary source of income in your life. (Note: Some people call it "retirement," but for me it's closer to financial "rebirth.")

College and Salary: "With Whom" You Study Matters as Much as "What" You Study

The topic of how attending a "good college" relates to getting a "good job" came up in a recent conversation I was having with my high school-aged son, whom I am encouraging to give serious consideration to both what he enjoys doing and what type of lifestyle he wants to have after he graduates from college.

Using the popular U.S. News & World Report ranking of universities and salary data from Payscale.com, we can take a look at the correlation between university attended and resulting mid-career median salary. The table below shows the top 30 U.S. universities and the mid-career median salary of their graduates.



As might be expected, Ivy League schools (Harvard, Princeton, Yale, University of Pennsylvania, Columbia, Dartmouth, Cornell and Brown) figure prominently on the list, along with the well-known science and engineering schools (Caltech, MIT) and the so-called non-Ivy Ivies (Stanford, University of Chicago, Duke, etc.).

The relationship between university attended and salary can be seen in the graph below.



The regression line is:

Mid-Career Median Salary = $121,400 - $900 x (Ranking of University Attended),

giving a decrement of about $9,000 in annual salary for each 10 spots in university ranking. For example, a graduate of a university with a ranking of about 5 might expect to have a mid-career salary of about $9,000 more per year than a graduate of a university with a ranking of about 15. The numbers actually show more scatter and skew than is captured by the linear regression, as evident in the following examples of ranking-university-salary:

4. Caltech, $115,000
5. MIT, $126,000
6. Stanford, $124,000

14. Johns Hopkins, $94,900
15. Cornell, $106,000
16. Brown, $107,000

24. UCLA, $97,000
25. University of Virginia, $97,200
26. USC, $103,000.

The general trend of higher ranking (smaller number) correlated to higher salary (correlation of .63) is clear. While there are, of course, many individual exceptions to the rule, one of the tell-tale indicators for predicting lifetime earnings and net worth is the college one attends.

As I tell my son, the college one attends (i.e., with whom one studies) is just as important as what one studies in college. Choice of a college typically has a lifelong impact on one's social circle, which in turn often influences whom one does business with throughout one's career.

College and Salary: "With Whom" You Study Matters as Much as "What" You Study

The topic of how attending a "good college" relates to getting a "good job" came up in a recent conversation I was having with my high school-aged son, whom I am encouraging to give serious consideration to both what he enjoys doing and what type of lifestyle he wants to have after he graduates from college.

Using the popular U.S. News & World Report ranking of universities and salary data from Payscale.com, we can take a look at the correlation between university attended and resulting mid-career median salary. The table below shows the top 30 U.S. universities and the mid-career median salary of their graduates.



As might be expected, Ivy League schools (Harvard, Princeton, Yale, University of Pennsylvania, Columbia, Dartmouth, Cornell and Brown) figure prominently on the list, along with the well-known science and engineering schools (Caltech, MIT) and the so-called non-Ivy Ivies (Stanford, University of Chicago, Duke, etc.).

The relationship between university attended and salary can be seen in the graph below.



The regression line is:

Mid-Career Median Salary = $121,400 - $900 x (Ranking of University Attended),

giving a decrement of about $9,000 in annual salary for each 10 spots in university ranking. For example, a graduate of a university with a ranking of about 5 might expect to have a mid-career salary of about $9,000 more per year than a graduate of a university with a ranking of about 15. The numbers actually show more scatter and skew than is captured by the linear regression, as evident in the following examples of ranking-university-salary:

4. Caltech, $115,000
5. MIT, $126,000
6. Stanford, $124,000

14. Johns Hopkins, $94,900
15. Cornell, $106,000
16. Brown, $107,000

24. UCLA, $97,000
25. University of Virginia, $97,200
26. USC, $103,000.

The general trend of higher ranking (smaller number) correlated to higher salary (correlation of .63) is clear. While there are, of course, many individual exceptions to the rule, one of the tell-tale indicators for predicting lifetime earnings and net worth is the college one attends.

As I tell my son, the college one attends (i.e., with whom one studies) is just as important as what one studies in college. Choice of a college typically has a lifelong impact on one's social circle, which in turn often influences whom one does business with throughout one's career.

The Impact of Sidelined Cash in Disequilibrium on the Stock Market

The purpose of this note is to reconcile two contrasting viewpoints on how the amount of cash in our economy impacts future stock prices:

A. Sidelined Cash View: An example of the view that cash held in investor accounts matters is Alexander Green's commentary this week: 'In February . . . the decline in stocks was just about over [because] . . . [t]here was more money available to buy shares than at any time in almost two decades. The $8.85 trillion held in cash, bank deposits and money market funds was equal to 74% of the market value of U.S. companies, the highest ratio since 1990, according to the Federal Reserve. . . . [T]here is still over $8 trillion on the sidelines earning next to nothing in short-term deposits. . . . Expect to see cash coming off the sidelines to accumulate shares of the largest, most liquid firms around the globe.'

B. Equilibrium View: The opposite view, that consideration of market equilibrium reveals the "tautology" of speaking about cash on the sidelines, is voiced by John Hussman in his comment this week: '[A]s a result of more than a trillion dollars of new issuance of Treasury securities with relatively short durations, it is a tautology that there is a mountain of what is mistakenly viewed as “cash on the sidelines” invested in these securities. This mountain of “sideline cash” exists and must continue to exist as long as these additional government securities remain outstanding. It is an error to view outstanding debt securities as if they are “liquidity” poised to “flow back into the stock market.” The faith in that myth may very well spur some speculation in stocks, but it is a belief that is utterly detached from reality. The mountain of outstanding money market securities is the result of government debt issuance that must be held by somebody until those securities are retired. It is not spendable “liquidity” – it is a pile of IOUs printed up as evidence of money that has already been squandered. The analysts and financial news reporters who observe this enormous swamp of short-term money market securities, and talk about “cash on the sidelines” as if it is spendable in aggregate immediately reveal themselves to be unaware of the concept of equilibrium and of the nature of secondary markets (where there must be a buyer for every security sold, and a seller for every security bought).'

Which view is right? Is it useful from a trading or investment timing perspective to think of sidelined cash as waiting to flow back into the stock market? Or, does any particular stock transaction involve a mere transfer of cash from buyer to seller and, therefore, leave the aggregate amount of cash in the economy, sidelined or not, unchanged? Further, what is the long-run impact of the amount of cash in our economy, i.e., the money supply, on stock prices?

The Fed, the Treasury and the Private Sector

Three primary parties feature in our analysis: the Federal Reserve ("Fed"), the U.S. Treasury and the private sector. To illuminate essential points, I intentionally employ a "no frills" simplified model of the creation of cash (or, more generally, a broader measure, M2), bonds and stocks in the economy:

1. Cash Creation and Swap: The Fed creates cash (in the amount of 50 units) and swaps it with the Treasury for a like notional amount of newly issued government bonds.

Fed: Cash = -50, Bonds = 50
Treasury: Cash = 50, Bonds = -50

(In each of the skeletal balance sheets here and below, the sections shown in bold indicate a change from the immediately prior stage of the analysis.)

2. Deficit Spending: The government uses the cash to finance expenditures such as national security, infrastructure projects, entitlements and other deficit spending. The private sector ends up holding the cash, received from the government through employment and entitlements.

Fed: Cash = -50, Bonds = 50
Treasury: Cash = 0, Bonds = -50
Private Sector: Cash = 50

3. More Bond Issuance: The Treasury issues more bonds, this time to private sector investors instead of to the Fed.

Fed: Cash = -50, Bonds = 50
Treasury: Cash = 50, Bonds = -100
Private Sector: Cash = 0, Bonds = 50

4. More Deficit Spending: The government deploys the cash in accordance with its budget, with the private sector again being the recipient of the cash.

Fed: Cash = -50, Bonds = 50
Treasury: Cash = 0, Bonds = -100
Private Sector: Cash = 50, Bonds = 50

5. Entrepreneur-Led Growth: Assisted by years of government spending on infrastructure, enterprising individuals form companies and develop new technologies and products for growing consumer markets. Rising stock prices of these entrepreneurial companies represent new wealth creation, seemingly materializing "out of thin air," but actually resulting from the "value-add" through conversion of natural resources, labor, capital and technology into useful products and services.

Fed: Cash = -50, Bonds = 50
Treasury: Cash = 0, Bonds = -100
Private Sector: Cash = 50, Bonds = 50, Stocks = 100

6. Business Cycle: As the market's perception of future business prospects shifts, stock prices rise and fall. The corresponding aggregate wealth held by the private sector in stocks fluctuates from a cycle low of, say, 75, to a cycle high of, say, 150. At the nadir of the business cycle, the corresponding cash-to-stocks ratio is 50/75 = 67%, while at the peak this ratio is 50/150 = 33%.

7. Government's Rescue Plan: During the depths of an extended recession (i.e., when stocks = 75), the government implements an economic rescue plan, involving

a. Creation of more money (25) by the Fed;
b. The Fed's use of this money to purchase lower credit assets from banks;
c. Banks' use of the proceeds to purchase new bonds from the Treasury.

This plan strengthens bank balance sheets and provides the government with cash for new deficit spending. (By deliberate design, this model parallels the actions taken by the Fed and Treasury over the past half year in dealing with the current financial crisis.)

Fed: Cash = -75, Bonds = 50, Other Assets = 25
Treasury: Cash = 25, Bonds = -125
Banks: Bonds = 25, Other Assets = -25
Private Sector: Cash = 50, Bonds = 50, Stocks = 75.

8. Still More Deficit Spending: The government deploys its new cash of 25 as part of a stimulus package to jump-start the economy (cf., Obama's approximately $1 trillion fiscal stimulus package, currently being deployed). As before, the cash ends up in the hands of workers and consumers in the private sector.

Fed: Cash = -75, Bonds = 50, Other Assets = 25
Treasury: Cash = 0, Bonds = -125
Banks: Bonds = 25, Other Assets = -25
Private Sector: Cash = 75, Bonds = 50, Stocks = 75.

The result is an increase in the cash-to-stocks ratio to 75/75 = 100%, which is a sign of the gross disequilibrium now inherent in the economy, since the cash-to-stocks ratio is outside of its "normal" range of 33% to 67% shown in Stage 6 of our model.

How Both Views Can Be Right

First, although our model is very simple, it exhibits important monetary, fiscal and economic trends in the U.S. economy:

• The amount of cash in the economy increases over time (from 0 to 75 in our model) as the economy grows and the Fed prints money to provide a currency to accommodate transactions among consumers and producers;
• The amount of government debt increases over time (from 0 to 125 in our model) as the Treasury issues bonds to fund the government's growing budget deficit;
• The value of the stock market rises secularly (from 0 to 100 in our model) as innovation, population growth and economic growth drive aggregate earnings of companies higher;
• Also, stock prices are prone to fluctuations (from 75 to 150 in our model), due to changes in market participants' perceptions of the future business prospects and earnings potential of companies within the economy.
  

This situation is hardly one of steady equilibrium. On the contrary, our economy is a dynamic system, continually evolving from one point of instantaneous and imperfect equilibrium to the next. Population growth, innovation and technological change drive secular increases in the amount of cash, bonds and stocks, and government monetary and fiscal policy alters the money supply, bond issuance and tax revenues in a Keynesian attempt to influence the course of the economy. The result is an economy in perpetual disequilibrium, wherein apparently the only constant aspect is change itself.

Within a framework of disequilibrium, let's now examine the situation at the end of Stage 8 of the scenario presented above. Given the new infusion of cash (from a sudden increase in the money supply), the stock market (along with other assets such as real estate) is arguably likely to rise, consistent with the Sidelined Cash view, as investors chase higher returns by buying stocks with the new portion of their "sidelined cash" (now 75, up from the recent figure of 50 in our model). The idea here is that, when enough newly printed aggregate cash from fiscal stimulus makes its way into consumers' and investors' hands, some combination of more consumption and more investment will (eventually) push asset prices higher. Though ostensibly at variance with the Equilibrium view he espouses, Hussman points out that a probable outcome of current government policy is "a near-doubling of the U.S. price level over the next decade," citing Nobel economist Joseph Stiglitz's characterization of the government's strategy as "trying to recreate the bubble [in a way] [t]hat's not likely to provide a long-run solution . . . [but instead] says let's kick the can down the road a little bit."

To sum up:

• The Sidelined Cash view correctly points out that "cash on the sidelines" can drive stock prices higher; however, by failing to distinguish between aggregate cash in the economy and cash held by individual investors, this view leaves too much room for (mis)interpretation;
• The Equilibrium view is right in pointing out that the aggregate amount of cash in the economy does not change when investors trade stocks with each other; however, this view fails to incorporate the disequilibrating impact of new cash creation by the Fed (and the banking system).

I offer the following combined "sidelined cash in disequilibrium" view as a synthesis of the two views: The private sector of our economy operates, not in equilibrium, but in perpetual disequilibrium, due to the impact of our government's deficit spending using money printed by the Fed and accounted for as borrowing by the Treasury. New cash created by this dynamic process (which drives additional cash creation via fractional reserve banking) enters the economy through fiscal stimulus and becomes the "sidelined" component of aggregate cash that is forever chasing new opportunities and effectively encourages future economic growth.

So, we might say that cash is continually rolling off the printing presses at the Fed as our government's deficit expands and the economy grows. This capacity of our government to print money, constrained at any moment but secularly unlimited, provides a large pool of sidelined cash that can jump-start a recessionary economy and, in practice, has an inflationary impact on stock and other asset prices. The ultimate long-run outcome of our government's deficit spending policy and its influence on the relative strength of the U.S. economy versus that of other countries is debatable but, in my opinion, a correct prognosis will involve both a) interpreting "sidelined cash" to include the capacity of the Fed to print new money and b) recognizing that our economy is always in disequilibrium.