Month: August 2024

Stimulus and Response

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August 25, 2024

by Stephen Stofka

This week’s letter continues my look at the dance of our responses to events. In a newsletter a few years ago, Kyla Scanlon coined the term vibecession to describe a general consumer sentiment that is contrary to positive economic data on unemployment, wages, and GDP. Why are consumers ignoring positive data and a rising stock market to direct their focus on rising inflation, interest rates and home prices? Analysts have identified a tangled string of factors that contributed to this negative consumer mood, but identifying a primary cause is difficult.

We assign importance weights to events as we experience them or learn of them. Adam Smith wrote how we can mourn the loss of a tip of our finger more than the deaths of a million Chinese people in an earthquake. Our reaction to even a small tax hike can be out of all proportion to the quantitative change in the tax. State legislators are reluctant to increase a gasoline tax by a few pennies a gallon because they fear the voter backlash. On a ten gallon fill up, the extra tax might be only thirty cents, an amount someone might leave in a tip jar at a coffee shop. To many consumers, that thirty cents is insult added to insult, an example of government sticking its greedy hands into consumer pockets.

The frequency of an event like a sales tax may lead us to consider the entirety, the sum of events, as we react to any one event. Within this perspective, an inappropriate response to a particular event may look entirely appropriate. This can help explain why a person of a minority group reacts in a particular manner in their encounters with police. Their reaction is not to the encounter itself, but a lifetime of more than average encounters because of their skin color.

Sometimes the response is entirely proportional. In Colorado, the growth of property taxes was held in check by a law called the Gallagher Amendment, which taxpayers repealed in 2020. In the past five years, property taxes in Denver have more than doubled. An analysis by the Common Sense Institute determined that many property owners saw an average increase of 27% in their 2023 property taxes. Responding to voter anger, the legislature passed a law in May 2024 that enacted tiny decrease in taxes, from 6.765% to 6.7%. Many voters perceived the paltry tax relief as an insult and have shown strong support for a ballot initiative this November that will curtail the growth of property taxes. Scared that voters will again take more control of state and local revenue growth, the governor has called for a special session this summer, hoping that legislators can craft a measure that will provide substantial tax relief and deflect voter anger this coming November.

Having insurance can lower our reaction to a damaging event like a car accident or a hail storm. By diversifying our portfolio, we act as our own insurance company. However, it is not practical to own multiple homes to diversify the risk of hail damage, so we reduce the impact of such an event by buying a policy from an insurance company. The insurance companies insulate themselves from the impact of large losses, particularly weather-related events, by buying insurance themselves from global reinsurance companies. Because reinsurance companies have a global portfolio, they are able to distribute the risk of local weather phenomenon across all regions.

Unlike animals, most of us monitor and modify our reaction to daily events. Here again, the frequency of an event helps us manage our reaction because we are better able to predict the effect of a particular event. When we first learn to drive, the flow of traffic on a city street can be disconcerting and confusing. Over time we learn to anticipate the movement of the vehicles around us and this expectation reduces our confusion. This reaction management can become a multi-level cognitive process where we modify our management of our reactions. Commercial drivers required to take defensive driving classes are taught not to over-anticipate the actions of others. “Lights do not stop cars. People stop cars.”  “Some drivers use their foot to drive. A safe driver uses their brain.” Per mile of city street, there are many drivers of machines capable of great damage but few lights and signs. We get where we are going because people follow rules both written and unwritten. We pay attention to signs posted and unposted.

In human affairs, event and reaction are not separable like the Newtonian model we are taught in grade school. They may be the two heads of that peculiar animal called a pushmi-pullyu in The Story of Dr. Doolittle by Hugh Lofting. Because of that symbiosis, there may be backward causation. Did x cause y or did y cause x? There may be a factor z that affects both x and y. Event and reaction are a symbiosis that we manage through expectations, diversification and informal rules. Institutions like insurance and laws help us coordinate our individual responses. Somehow we survive in this world of complex causality.

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Photo by Kris-Mikael Krister on Unsplash

Keywords: taxes, event, reaction, quantitative, qualitative.

The Elasticity of Our Spirit

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August 18, 2024

by Stephen Stofka

This week’s letter is about the effect of quantitative phenomena on our quality of life. Why do events impact people of the same socioeconomic circumstances differently? We are part of a group responding to the event, so we interact with the collective responses of the group around us. Our direct response to the event is a small part of the total impact on our quality of life. Imagine we are a rubber duckie in a group of rubber duckies on the ocean’s surface as a wave passes. As we rise with the water that displacement causes a lot of jostling by the duckies around us. Much of the effect we experience is not the wave but the reaction of the others around us to the wave. Yet we attribute the cause of our experience to the wave, not our fellow duckies.

One hundred years ago, Louis de Broglie introduced a wave theory of matter. A few years later Erwin Schrödinger proposed a wave equation of electron motion to explain the quantum world. Those two ideas are cornerstones of quantum mechanics, the most tested theory in physics and the foundation of our current electronic technology. As you read this on a computer or smart phone you are watching quantum mechanics at work. Not all wave are alike. Light and radio waves are electromagnetic waves that don’t need a medium to travel in. Even in the vacuum of space, the electromagnetic field they create acts as a type of medium. Some waves, called transverse waves, cause matter to move in a direction that is partly perpendicular to the force of a wave. A rubber duckie bobbing up and down in the water is an example.

We are hunters of cause. We are interested in the origin of phenomena, thinking that the origin of something will enhance our understanding of that thing. For that reason, some economists like to debate the origin of money. One morning a few weeks ago, our cat woke up, yawned and stretched out a paw on the bed. A claw caught in the quilt and slid it sideways so that it formed a tunnel. Like a wave through water, the direction of the paw was parallel to the quilt, but the quilt reacted in a direction perpendicular to that movement. Kitty pulled her paw back and the tunnel mostly collapsed. She then stretched out her paw again and the quilt rose up. Her hunter reasoning led her to believe that a mouse was the cause of the tunnel under the quilt, so she attacked. She pounced and pawed the quilt to find that imaginary mouse, then lost interest, jumped to the floor and left the room. How often do we search for the cause of a phenomena that is mostly a response to the collective action of a group?

When prices go up, we can look to our side for contributing factors, the decisions of many consumers and businesses. A quantitative change in prices affects the quality of our lives. Like a cat, we often judge quantitative phenomena with an instinctive appraisal. We notice the rise in prices more than we do the rise in our wages because we are more sensitive to loss than gains. The Bureau of Labor Statistics reports that the annual increase in average hourly wages and weekly earnings is now higher than inflation. A rise in the price of the goods we buy has a greater effect than a similar rise in our income because we perceive a rise in prices as a loss of our purchasing power. We are particularly loss averse, according to Daniel Kahneman, the author of Thinking Fast and Slow, who won a Nobel Prize for his research into the less than perfect reasoning we employ in our decision making. He and Amos Tversky proposed a concept called Prospect Theory to describe and model the mechanics of our decision making.

Elasticity is a term that economist John Marshall borrowed from physics to describe the reaction of consumers to changes in the prices of goods. The most common measure is called the Price Elasticity of Demand and businesses pay close attention to this metric. It is the change in the percentage of goods bought in response to a 1% change in price – a ratio of two percentage moves – the zig divided by the zag. If the price of butter goes up 1% and the amount of butter sold declines by 2%, then the ratio of percentages is 2 to 1 and butter is considered to be elastic. If the quantity of butter sold declines only 1%, then butter is said to be unit-elastic. If the quantity of butter barely changes, then it is inelastic. When businesses sense that consumer demand for their good or service is inelastic, they can charge higher prices with less effect on the quantity sold and make a higher profit. Businesses respond to consumer decisions and tastes.

The elasticity of economic goods is not constant because consumer demand responds to a changing economic environment, as well as tastes and culture. In some cases, consumer demand can change abruptly. Such was the case after the pandemic. The airline market is an example of two types of demand elasticities. Business travelers are much less sensitive to changes in price, with an elasticity far below 1, according to research done in the 2010s. Because of that airlines upcharge business customers. Leisure travelers, on the other hand,  have an elasticity of almost 2, meaning that they are sensitive to price hikes. The higher prices that airlines charge business customers effectively subsidizes leisure travelers. However, after the pandemic, the demand for leisure travel surged and airlines responded with higher prices. Average airline fares surged 20% annually in the summer of 2021 then rose sharply by 34% in the summer of 2022. In the first quarter of this year, prices stabilized to pre-pandemic levels. Vacation travel is a luxury good, but it can feel like a necessity when we feel stuck in a grind and stressed at work.

The effect is more frequent for necessities like food, lodging and utilities. That frequency affects the elasticity of our spirit the way a weight on a spring changes the spring’s elasticity over time. The relief checks sent during the pandemic helped some families build a small savings cushion, a relief from the burden of living paycheck to paycheck. In the past two years, families that have dipped into their savings to meet higher housing, grocery and childcare costs feel a sense of loss because their savings are smaller. Even if wage gains have kept up with inflation on average, wage gains are calculated based on gross income before taxes. We buy groceries and pay housing costs with after-tax dollars. The loss is real.

Like water, human society is the medium, transmitting and transmuting the force of thousands of decisions made by people we will never meet. Our circumstances and decisions affect the lives of strangers. There is no single cause because we are part of the cause. Even if we could identify a primary cause like rising prices and remove it with a magic wand, we cannot predict a satisfactory resolution. Yet politicians running for office hold out their magic policy wand and promise to end this or that problem, hoping that enough voters will buy what they are selling. “Here’s the problem,” they say. “I can do something about it.” We want to believe that complex processes have simple causes, and in the final months of this election year, candidates will tailor their message to our belief in that simplicity.

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Photo by Joey Huang on Unsplash

Keywords: prices, inflation, cause, effect, wave

Bond Time

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August 11, 2024

by Stephen Stofka

This week’s letter is about bonds. Many older investors have bond funds in their portfolio because they are told that it adds safety to a portfolio. Like ballast in a ship, bonds reduce volatility when a storm approaches and the water gets choppy. As the Federal Reserve raised rates in the past two years, the bonds in our portfolios acted as a dead weight, producing net negative returns. Why are bond prices so sensitive to changes in interest rates? Why are bonds so weird?

An individual bond is a claim on someone’s debt. A bond fund or ETF is a mixture of individual bonds of various terms to maturity, the length of time to the date when the debt claim ends. These maturities are grouped into three categories: short, medium and long-term. Short-term refers to bonds that mature in less than two years. Bonds with terms of two to ten years are considered intermediate-term and longer than ten years is categorized as long-term.

The length of term is correlated with a bond fund’s sensitivity to interest rate changes. Short-term bonds pay the lowest amount of interest but are the least sensitive to interest rate changes. According to Portfolio Visualizer’s back tester tool, a composite of short-term bonds had an annual return of -0.82% since January 2020. A bond ETF with an intermediate term returned -2.79% annually. Long-term bonds were particularly affected by the rise in interest rates, returning -6.87% annually. I will leave the details in the footnotes.

Why does the price of a debt instrument like a bond react to changes in interest rates? Opportunity cost. If I buy a $1000 mortgage bond paying $50 annually, and shortly after, new mortgage bonds are paying $60 a year, I will have to sell my bond to another buyer for a discount, given the fact that both bonds have the same risk profile and maturity. The income stream on the bond I own cannot compete with the higher income stream from new bonds at the same price.

A bond’s duration is a measure of its price sensitivity to a 1% change in interest rates and is published by financial news outlets like Morningstar, where readers can check the duration of a bond fund or ETF they hold. That number indicates the percentage change in price for each 1% change in interest rates. For readers who want to go deeper into this, Rich Falk-Wallace posted up on X a Bond Math table of forecasted price changes in response to various changes in interest rates.

Using our sailing analogy, the term of a bond is like the height of a mast on a sailboat. A longer-term bond, like a taller mast with more sail exposed to the wind, will get us somewhere faster in calm winds (or pay a higher dividend), but leave us dangerously exposed when wind speed increases. The table mentioned above shows that a 30-year Treasury bond can have suffer a 30% loss in price for a 3% rise in interest rates, a price response of ten times the change in interest rates. Yikes! The leverage effect is even greater when interest rates fall. The table indicates a price rise of 72% for a 30-year Treasury bond when interest rates fall by 3%, an effect that is 24 times the change in rates!

Relative to stocks, price changes in bonds are tame. In 2022, a broad composite of bonds like Vanguard’s BND ETF experienced a 10% decrease in price, and it was historic. A similar decrease in the price of the SP500 stock index is a “correction,” a cause for concern. A 50% decrease in stock prices is historic. The stock market is like riding on a dirt road in a 4×4 jeep. The bond market is like riding in a car on a paved road. We react strongly to any rough patches or potholes.

There is a positive aspect. Depending on your financial situation, it may be prudent for an investor to convert a regular IRA invested in bonds to a Roth IRA. The investor will have to pay income taxes on the capital gains, but those gains have been reduced in the past two years. Once converted to a Roth, any subsequent gains will be tax-free. A Roth IRA has no required annual withdrawal, so an investor has more control over their funds in retirement. Some investors may have what are called unrealized losses in a taxable account that holds bonds, and these could be used to offset gains this year if sold. These are options that some readers may consider and discuss with their financial or tax advisor.

For several decades, interest rates on savings were so low that investors used index funds as a way to earn a higher return on their savings. In the years following the financial crisis, the lack of inflation was more a risk than inflation. In such an environment, investors may have not fully appreciated the difference in risk between bond funds and money market funds. In the decade following the financial crisis, 2008 through 2017, a broad composite of bonds earned 3% or more when savings accounts were paying almost 0% and money market accounts were barely paying 1%. In the last seven years, the return on bond funds has been 1% or so. Investors who piled into longer-term bonds with higher returns were hit hard when the Fed raised interest rates in 2022 and 2023.

A bond’s term to maturity indicates price sensitivity to interest rate changes. An investor’s term to retirement indicates portfolio sensitivity to market conditions and mistakes in judgment. Someone in their thirties can be more aggressive and recover from judgment errors more ably than someone in their sixties. That reality underlies the conventional advice that people should devote a greater portion of their portfolio to bonds when they are older. However, bond investors may have felt like unlucky victims when bond market prices sank in 2022-23. Dramatic market shifts reinforce the rewards of diversification. At the heart of the math on bond duration and risk diversification is an aphorism we learned as kids: don’t put all your eggs in one basket.

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Photo by Christophe Ferron on Unsplash

Bond Notes: Short-term bond ETF: Vanguard’s BSV. Intermediate-term: BIV; long-term: BLV.

Keywords: investing, bonds

Claims to Truth

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August 4, 2024

by Stephen Stofka

In this week’s letter I will clean up my notes on the judiciary before I start a series on investing next week. For several millennia, human societies have struggled to figure out the how and the who of lawmaking. How to construct a rule whose language is clear enough to be understood but flexible enough to apply to varying circumstances? Who will enforce the rules? How will they be enforced?

Let me start with a real story from my childhood. My younger brother and I were only one and a half years apart in age and were quite competitive. Tired of listening to my brother and I argue over the rules of various card games we played, our dad bought us a book called Hoyle’s Official Book of Games. This resolved some of our disputes, but still we argued over the interpretation of the rules. If a rule in Rummy requires a player to play a card once they have touched it, how to interpret the word “touch?” If a gust of wind threatens to toss a few cards from the deck, can a player reach out to prevent that without having to take that card? What if a player grazes the card with their elbow while reaching for a drink?

Former Supreme Court Justice Stephen Breyer (2024) wrote that many cases the court decides can hinge on the interpretation of one or two words in a law. In the Heller decision on the Second Amendment, the majority and dissenting justices wrote 80 pages of argument over the meaning of “bear arms” in the Second Amendment. He quotes the example of a railroad that required passengers to pay full fare for each animal they brought on board. When a biology teacher brought a number of snails on the train for a class, the conductor charged the teacher a fare for the snails. When the teacher complained that the rule was meant for pets, the conductor explained that the rule used the word “animals,” not “pets.” Snails are animals.

If you were a judge, how would you rule? Breyer’s story raises the question: what if the rule said, “domestic animals?” What does the term “domestic” specify regarding animals? An animal related to a person’s home or family. Snails can be kept at home so even this change in the rule could be interpreted to include snails. The most important symbol in mathematics is the equals sign. There are specific rules of valid operations on either side of an equals sign. Plain language has no equals sign. For centuries, French was the language of diplomacy. The language has fewer words, which conveniently left agreements between diplomats open to interpretation.

If the truth were an island, it would be stained with the blood of millions. Throughout history, kings, philosophers and countries have laid claim to and fought over the truth. In 17th century Britain, a civil war erupted between monarchists, those loyal to the king and the power of the king, and Parliamentarians, those loyal to the Parliament as representatives of the people’s will. Robert Filmer, a noted monarchist, argued that the right to property comes from God through the King. John Locke argued that the right to property comes directly from God. When God drove Adam and Eve out of the garden, He told the couple they would have to work the land for their survival. Therefore, those who cultivate the land add value to the land and “thereby makes it his property” (PDF link, p. 116). The state merely recognizes that title. In later centuries, the American colonists would use this reasoning to deny that Indians had any right to the land because they did not cultivate it.

Journalists often make claims on the truth. Matthew Yglesias wrote on his Substack “this is journalism, and we owe a duty of truth to our audience.” He referred to “journalists’ obligations of candor,” but truth and candor, or honesty, are different. In its 1964 decision New York Times v. Sullivan, the Supreme Court ruled that statements about public officials were not subject to claims of libel unless they were shown to be made with “actual malice” and a disregard for the truth. That is a standard of candor, not truth.

The American Bar Association states that lawyers “must be honest, but they don’t have to be truthful.” They distinguish between being honest and being truthful. “A defense lawyer has no obligation to actively present the truth.” Being honest requires only that “Counsel may not deliberately mislead the court.” A lawyer who serves their client’s interest by making a false representation to the court risks disbarment. Rudy Guiliani was recently disbarred for making deliberate misrepresentations to further Trump’s claims of a stolen election.

A witness, on the other hand, must vow to “tell the whole truth” to the court. Politicians take no such vow, nor do they pledge a vow of candor, to be honest with the public. They take an oath of office to “support and defend the Constitution against all enemies,” a vague statement open to wide interpretation. It is up to the public to judge their lies, and to assess the importance of those lies. Abraham Lincoln supposedly claimed that all the people could not be fooled all the time, but a politician does not have to meet that high bar. They only need to fool enough of their constituents to get re-elected.

Should Congress set minimum years of service as a judge for Supreme Court nominees? Chief Justice John Roberts, and Justices Kagan and Thomas had the fewest years on the bench before joining the Court. I will leave the details and links in the footnotes. I have many more notes after reading Breyer’s recent book, but I will close this for now. Next week, I hope to present some perspective on investing in plain language without equations.

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Photo by John Cameron on Unsplash

Keywords: rules, honesty

Breyer, S. G. (2024). Reading the constitution: Why I chose pragmatism, not textualism. Simon & Schuster.

The link to the justices’ bios is here. Chief Justice John Roberts served as an Appeals Court judge for only 2 years before becoming Chief Justice. Justice Clarence Thomas – one year. Justice Samuel Alito – 16 years. Justice Elena Kagan had no prior judge experience. Justice Sonia Sotomayor – 16 years. Justice Neil Gorsuch – 10 years on an appeals court.. Justice Brett Kavanaugh – 12 years. Justice Amy Coney Barrett – 3 years. Justice Ketanji Brown Jackson – 9 years.