My Financial & Economic Pet Hates

Posted on 10/07/2011


In no particular order, here goes:
  1. Stock/flow errors.  This is usually the mistake of journalists and politicians rather than professional investors, though is still far and away my biggest pet hate due to the basic nature of the error.  For those readers not familiar with the concept, a stock is a measure taken at a specific point in time, while a flow is a measure of a change in a quantity during a particular time period.  Anything measured “per second”, “per day”, “per month” or “per year” is a flow.  For example, Lake Baikal is estimated to contain 23,615cu-km of water, while the River Amazon has an estimated discharge of 209,000cu-m/second.  The former is a stock and the latter is a flow.  The first error is simply to misunderstand which is the stock and which is the flow – I’ve lost count of the number of times I’ve heard UK Members of Parliament confuse the budget deficit (a flow) and the national debt (a stock).  The second major error is to compare one stock to another flow, like this example that compares Apple Inc‘s cash & investments (a stock) to the GDP of countries (a flow).  This is a nonsensical comparison from which no conclusions of any value can be drawn.  If you really did want to compare a company a a country, then comparing net profit plus employee costs (for the company) with GDP (for the country) would be the correct approach as both are flow concepts that measure value-added per annum.
  2. Assuming That Strong Long-Run Economic Growth Projections will translate into Strong Long-Run Equity Performance.  Even the professionals fall into this particular elephant trap.  I regularly hear or read something along the lines of “I recommend people invest in Chinese/Brazilian/India shares as these countries are going to see exceptionally strong economic growth in the coming decades”.  Even if the individual is correct is predicting the economic growth (which could turn out much lower than expected – just take a look at look-term projections for Japan that were made in the 1980’s), long-run empirical studies – such as this one – have shown how there is no link between economic growth and equity returns.  Why?  Because economic growth that occurs due to increasing education and rising populations benefits labour, not capital.  Secondly, economic growth that occurs due to long-term capital accumulation has little benefit for the owners of today’s fixed capital (indeed, new capital investment competes with existing capital, driving-down returns).  This is exhibited through the issue of new additional equity on the stock market in question – a hypothetical investor who owns an index-tracking fund will see his percentage interest in the nation’s capital diluted over time as new companies are born and later issues shares.  Thus, much of the returns that do accrue to capital go to entrepreneurs, not stock market investors.
  3. The UK Government “Helping” first-time home buyers.  This is another one that really gets my goat.  The problem with “helping” buyers is that it increases demand, or to economists, shifts the demand curve outwards.    This results in higher house prices, but a negligible increase in supply given the inelasticity of the supply curve (due to the lack of available land for house-building).  Chief among such policies are government-subsidised shared-ownership schemes, which funnel taxpayer cash towards a lucky few who’re able to meet the predetermined criteria.  This reminds me of the famous scene from the film “This Is Spinal Tap” – embedded below – where Nigel Tufnel explains to Marty DiBergi that their amplifiers “go up to 11” and fails understand the response that the same amp re-badged with “10” would sound exactly the same.  Current government policy will simply lead to more expensive houses and a near-identical number of people without a home, a re-badging of the the house-price amp from 10 to 11.

    If the government really wanted to help potential house-buyers, then the best way would be to make the amplifier louder and implement policies that bring about an increase in supply.  This would most likely involve relaxing planning laws to enable more houses to be built.
  4. Personifying the markets.  This is a favourite of financial journalists and socialists alike, who see financial markets markets as a single living and breathing beast, rather than the sum of many thousands of small decisions made by different investors all around the world.  Consequently, headlines likes “shorts attack country X” or “locusts feed on company Y” don’t make any sense at all.  Financial markets are more like the movement of water under the influence of gravity – money flows into profitable opportunities in the same way that water always flows to the lowest possible point.  No emotion is involved and no overall “decision” is made.  Thousands – if not millions – of investors acting in their own interests leads to the final outcome, just like millions of water molecules under gravity.
  5. Comparing relative value metrics with their historical levels with no reference interest rates.  I regularly read pieces that refer to the current price/earnings ratio (or other metric) at which the stock market is currently trading, which is then inevitably compared to its long-term average.  What these pieces inevitably miss is that the long-term average is a misleading measure, as interest rates have not been consistent over the long-term.  The chart below, which plots the S&P’s current price divided by 10-year average earnings, shows how the current level is well-above the long-term average of 16.4x.  However, what it fails to show is that interest rates are currently at a near-record low.  Investors should be willing to pay a higher multiple of earnings for shares when interest rates are low then when they are high as a lower interest rate means a higher present value of future earnings.  Therefore, simply comparing a P/E ratio to its historical average fails to capture this critical piece of information.  I discuss how interest rates should impact the calculation of the justified P/E ratio in this previous post.
Please add your own financial and economic pet hates in the comment section.
Posted in: My Thoughts