Queen Elizabeth I Formed World's First Franchise 350 Years Before Ray Kroc

Fascinating history lesson in last week's Economist on The East India Company. Queen Elizabeth I chartered the company in 1600 as a way to facilitate British trade around the Cape of Good Hope to Asia. The Economist says this event marked the beginning of the modern world:

The East India Company foreshadowed the modern world in all sorts of striking ways. It was one of the first companies to offer limited liability to its shareholders. It laid the foundations of the British empire. It spawned Company Man. And—particularly relevant at the moment—it was the first state-backed company to make its mark on the world.

I found this passage particularly interesting. It sounds like QE1 invented the modern franchise.

The Company improvised a version of what Tom Peters, a management guru, has dubbed “tight-loose management”. It forced its employees to post a large bond in case they went off the rails, and bombarded them with detailed instructions about things like the precise stiffness of packaging. But it also leavened control with freedom. Employees were allowed not only to choose how to fulfil their orders, but also to trade on their own account. This ensured that the Company was not one but two organisations: a hierarchy with its centre of gravity in London and a franchise of independent entrepreneurs with innumerable centres of gravity scattered across the east. Many Company men did extremely well out of this “tight-loose” arrangement, turning themselves into nabobs, as the new rich of the era were called, and scattering McMansions across rural England.

How is this arrangement different than owning a McDonalds restaurant? You own the property, but  the french fries and Big Macs must be made precisely as the company says. And, if you work hard and keep the place clean, you're almost guaranteed to get rich. 
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Why the Republicans are Right on Payroll Taxes

News flash: the rich are getting richer, the rest of us are sucking wind. What should Washington D.C. do about it?

The Democrats want to raise taxes on the wealthiest 1%, the Republicans cry "class warfare" and decry any tax on "job creators". Meanwhile, our deficit is enormous and growing nearly $4b per day. How can we square these differing views?

How about a surtax on the rich, as the Dems have proposed. But, these lucky folks could recoup their tax dollars if they really do create jobs...anybody who employs Americans should be able to claim a tax credit of 1% of U.S. payroll against their personal income tax. This credit should be distributed to shareholders for publicly traded companies.

The net effect would be similar to a Republican proposal to reduce employers' share of payroll taxes, but doing it my way would make it more palatable for Democratic constituencies. It would also provide more of a boost to the economy than the Democrats current proposal to extend the payroll tax cut for employees into next year. That tax cut doesn't help the unemployed one whit, while giving the cut to employers encourages them to hire jobless Americans. While folks with jobs would certainly appreciate a tax cut, our biggest problem is folks without jobs! If we could fix that, the rest would take care of itself. Tweet

Our Schools Should Teach Less Math

When did schools remove weaving from the curriculum? How about abacus training? Does anybody still teach basic slide rule skills?

All of these used to be incredibly useful, until they were made obsolete by machines. We (as a society) eventually decided that these skills were no longer needed, and our schools stopped teaching them. Instead, we started teaching more relevant skills like computer programming and auto repair.

Yet, in the year 2011, we still spend countless hours teaching poor frazzled seventh graders how to do long division! Granted, being able to quickly do basic addition and subtraction without the aid of a calculator is a useful skill. But when was the last time you used a paper and pencil to divide a 4 digit number into a 5 digit number? I'll bet it was seventh grade!

Schools are slowly getting with the program, and have started teaching useful twenty-first century skills like spreadsheets, power-point presentations, Spanish, and Chinese. But there are only so many hours in the school day, and so many days in the year, and only a short 12 years to pack all this info into our children's pliable little minds. And we can't afford to waste time teaching obsolete skills like long division. In another generation, all mechanical math skills (fractions, even multi-digit multiplication, addition and subtraction) will be obsolete.

What should we teach instead? Here's an interesting article from Wired Magazine. It turns out that kids are great at using computers, but are lousy searchers:

High school and college students may be “digital natives,” but they’re wretched at searching. In a recent experiment at Northwestern, when 102 undergraduates were asked to do some research online, none went to the trouble of checking the authors’ credentials. In 1955, we wondered why Johnny can’t read. Today the question is, why can’t Johnny search?

Who’s to blame? Not the students. If they’re naive at Googling, it’s because the ability to judge information is almost never taught in school. Under 2001’s No Child Left Behind Act, elementary and high schools focus on prepping their pupils for reading and math exams. And by the time kids get to college, professors assume they already have this skill. The buck stops nowhere. This situation is surpassingly ironic, because not only is intelligent search a key to everyday problem-solving, it also offers a golden opportunity to train kids in critical thinking.

New skills are needed to navigate today's information-rich world. Critical thinking is at a premium. How can one tell if an email is presenting a legitimate opportunity, or worthless spam? How do we know if the Obama's dog really flew in a private jet to join the family on vacation? Believe it or not, a person with a professional degree actually sent me an outraged email with that urban legend. So maybe a high-school class on "Critical Thinking and the Internet" would be useful. Tweet

Rebuttal to Krugman/s "Things to Tax"

In a recent op-ed entitled "Things to Tax", Paul Krugman suggests a financial transaction tax.

And then there’s the idea of taxing financial transactions, which have exploded in recent decades. The economic value of all this trading is dubious at best. In fact, there’s considerable evidence suggesting that too much trading is going on. Still, nobody is proposing a punitive tax. On the table, instead, are proposals like the one recently made by Senator Tom Harkin and Representative Peter DeFazio for a tiny fee on financial transactions.

And here’s the thing: Because there are so many transactions, such a fee could yield several hundred billion dollars in revenue over the next decade. Again, this compares favorably with the savings from many of the harsh spending cuts being proposed in the name of fiscal responsibility.

This is so wrong-headed on so many levels.

The majority of trades are executed for tiny profits. And I'm not just talking about the machines, I'm talking about real human beings. Even a .1% transaction tax would kill this entire business in the U.S. It simply would no longer be a profitable business. Most likely it would move offshore, to non-taxed markets. If there's one thing we've learned from globalization, it's that capital will quickly move to the most profitable location.

Secondly, by removing the high-frequency traders (and believe me, I'm no fan of HFT; the deck has always been stacked against the little guy, now it's practically impossible to beat the computers) liquidity would dry up. Formerly liquid issues would start trading with wide spreads. Costs would go up for the remaining market participants, who don't have the know-how or resources to trade overseas: retail investors. AKA, the suckers who always end up holding the bag.

Professor Krugman has made the classic error when assessing potential revenue from a new tax: he assumes that the new tax would not change peoples' behavior. If this logic worked, why not impose a $1 tax on each U.S. text message? Golly, my daughter sends hundreds of text messages every month, this tax could retire our national debt in a matter of months!

So, a financial transactions tax, which Krugman expects to raise billiions and hurt "the bad guys", would actually raise very little revenue and hurt only "the little guys." Tweet

Is the US becoming Japan? And what's in it for me?

In 1989, Japan was flying high. Prime Tokyo real estate reached $1m per square meter. The Nikkei stock index peaked at nearly 39,000 on December 29. The Japanese snapped up American real estate, including Pebble Beach and Rockefeller Center. "Japan Inc" graced magazine covers, newspaper headlines, and books. It seemed that nothing could stop the Japanese steamroller, and that they were destined to dominate the global economy.

Then, the bottom fell out. The Nikkei plunged, and has never again approached its 1989 high. Real estate plunged as well. GDP growth has been nearly nonexistent; the "Lost Decade" has endured for more than 20 years, with no end in sight. 

In response to this unfortunate turn of events, the Bank of Japan has cut interest rates over and over, but the economy hasn't responded to traditional monetary policy. Japan is stuck in a deflationary cycle, with no end in sight. Paul Krugman and others have suggested that Japan  has experienced a liquidity trap, characterized by a lack of aggregate demand, and ultra-low interest rates that have failed to stimulate the economy.

Today, in late 2011, the United States is experiencing a similar post-bubble hangover. The Nasdaq peaked 11-1/2 years ago, the Dow 4 years ago; both are down significantly since then. US stock portfolios have (at best) stood still for more than a decade in nominal terms; in real terms, equities are underwater--even as a majority of Americans have grown to count on the stock market for their retirement savings. Real estate peaked 5 years ago, and is down 30% nationwide; parts of the "sand states" (Nevada, California, Arizona, and Florida) are down more than 50%. Unemployment has remained stubbornly high, even as Ben Bernanke and the Fed have reduced short rates nearly to the so-called "Zero Lower Bound". The Fed is giving money away, and still, there is no demand for it.  Krugman (and many others) have called an American liquidity trap. 

Naturally, students of history are wondering whether America is leading the West into a long-term low-growth era, similar to Japan's "Lost Decade". Recent US short rates have traced an eerily similar path to Japan's rates in the early '90s. David Rosenberg did a nice write-up on how the U.S. is "Turning Japanese", here's his  chart showing the two countries' post-bubble interest rates.

If you're American, you may be saying "Crap! That's terrible! I'm not looking forward to that!" And I'm not, either. But there may be ways to take advantage of the situation...if life gives you lemons, you might as well make lemonade! So, let's talk about adjustable-rate mortgages.

Adjustable-rate mortgages (ARMs) are loans designed for low initial payments, with the borrower paying the loan off relatively quickly (by selling the property or refinancing to a fixed-rate mortgage). If you're thinking of buying a home, or an investment property, or if you're thinking of refinancing your existing mortgage, it's a great time to think about taking out an ARM.

While the vast majority of residential loans are fixed-rate (usually 30 year), the rest are adjustable-rate. Interest rates on fixed-rate mortgages are determined by capital markets; they usually follow Treasuries Bonds. ARMs, on the other hand, follow short rates, which are dominated by the Fed's actions.

On August 9, the Fed announced that it would keep interest rates “exceptionally low" through mid-2013. So Ben Bernanke just told you that (if you take out an ARM before mid-2012) you will enjoy at least two years of "exceptionally low" interest payments. (ARM payments typically adjust annually, so you will have till early 2014 before your rate adjusts up.) Furthermore, if the US follows Japan into long-term economic stagnation, you will enjoy low payments far beyond 2014. Both long and short rates are likely to remain low for several years (we'll look at contrary views a little later).

Let's take a look at some numbers. My credit union offers 1-year ARMs at 2.875%, 3/1 ARMs (fixed for 3 years, then annual adjustments indexed to LIBOR), and 5/1 ARMs at 3.125%. They also offer an interesting option, the 5/5 ARM, at 3.375%. This loan would start at 3.375%, stay there for 5 years, then reset every 5 years. By contrast, a 30-year fixed is quoted at 4.375%. (All loans are 0 points, on a 30-year amortization schedule.)

If you borrowed $200,000, the 1-year ARM payment (principal and interest) would be $830. You would pay  $844 on the 3/1 ARM, $856 on the 5/1 ARM, and $884 on the 5/5 ARM. The conventional 30-year fixed mortgage would cost $998 monthly. So, if you took out a 1-yr ARM today, Ben Bernanke has guaranteed you that your payment won't go up until late 2013, and you will save $168 per month for 24 months, or $4032. This is slightly more than 2% of the original principal. Not bad! In two years you can continue to take your chances with short rates, or refinance to a fixed if the economic picture has changed significantly. If you have a lower risk tolerance, you could select one of the other options. The 5/1 ARM would save you $142 per month for 5 years, or $8520 (more than 4% of principal).  The 5/5 ARM is my favorite, it would save you $114 per month for 5 years ($6840, or 3.4% of principal). And, after 5 years (when I believe rates will still be low, a la Japan), you can lock in for another 5 years of low rates.

What are the risks in this strategy? Let's think about the future level of interest rates, and what that would imply about the economy. Until 2013, we're certain of interest rates, they will be "exceptionally low". After that, rates are less certain. We could follow the "Japan Scenario": the economy continues to stumble, Fed Funds rates are virtually zero, and long rates stay low (perhaps they'll be even lower than today, if deflation kicks in). In this case, our ARM strategy will look wise, we will have saved quite a bit of money and are perfectly poised to save more.

What if a more normal economy prevails, housing and other asset prices rebound, and both long and short rates rise? This scenario is bad for our interest-rate bet, but is positive for your home value, your career, your savings, and your other investments. So in this case, we can look at our interest rate bet as a hedge--mortgage payments will go up, but we'll better be able to afford them than we are today. And we will have enjoyed many months of savings.

The third case, which I view as quite unlikely at this point, is one of inflation. In this case, both long and short rates will be higher than they are today. The Fed may raise short rates above long rates to slow inflation. In this case, your house will have appreciated and your bank savings will be doing well. It's not as favorable as the second case, but your ARM will have acted as an effective hedge.

Of course, the further out in time we go, the less visibility we have. We can say with a high degree of certainty that we will still be in a low interest-rate environment in two years, but we're less certain in 5 years, and even less sure in 10.  The 5/5 ARM seems the best balance of interest rate risk with a guaranteed long run of low rates (5 years) and another 5 years of very probably low rates.

Disclaimer: This strategy is quite risky, and may not be for you. It's appropriateness depends on many factors: your age, income, marital status, tax status, local real estate market, credit rating, and some I'm not thinking of. DO NOT use an ARM's low initial rate to buy a property that you can't otherwise afford!!! That approach is responsible for many of the recent tsunami of foreclosures. Only take out an ARM if you can afford the worst-case payments.

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Investor Sentiment and other Dumb Statistics

 I just read an interesting post on this weekend's Saints-Texans game (National Football League). The writer (Kerry J. Byrne) says

The 2010 Texans, for example, were dead last in Defensive Passer Rating (100.5), the best way to measure pass defenses because it consistently has a high correlation to wins and losses. Champions throughout history are almost always among the very best in the league at Defensive Passer Rating.

But, do teams win because they have good passing defenses? Or, do teams get ahead, then sit back in a "prevent defense" (5 or 6 defensive backs), against which it is more difficult to throw the ball? Also: the defensive linemen can "pin their ears back" and go after the passer, knowing that their hapless opponents are trailing late in the game and don't have time for a long, time-consuming drive.

To test Mr. Byrne's theory, we need to look at the data in a slightly different way. Does Defensive Passer Rating in the First Quarter also have a high correlation with wins and losses? Presumably, the game is more likely to be competitive in the first quarter than in the fourth. Does DPR show a better correlation to success than other statistics? Obviously, a team with a good pass defense will win more than a team with a lousy pass defense, but is this stat really a superior predictor? I'd be really interested to see the data broken down this way.

My favorite dumb football statistic is the  relationship between having a 100-yard rusher and winning the game (not so common these days, as the NFL has become a passing-dominated league). It used to be that, when a back reached 100 yards rushing, a graphic would flash on the screen, like "Bears are 53-24 (.688) when Walter Payton rushed for at least 100 yards and 58-58 (.500) when he doesn't." Maybe the Bears won because Payton went for 100. Or, maybe they got ahead, then ran out the clock by giving "the rock" to one of the NFL's all-time greats.

Investor Sentiment numbers are a dumb stock market statistic. If you pay attention to these numbers, you will see that sentiment follows the market. Investors become fearful after the market goes down, and greedy after it goes up...sentiment is worthless as a predictor! This chart from wallstreetcourier.com illustrates this point perfectly.

So, when you find a correlation that seems too good to be true, ask yourself if A really causes B, or does B cause A, or maybe an external factor C causes both A and B.

The lesson, of course: Correlation does not mean causation. Tweet

Trading Home Depot around Hurricane Irene: Post-Mortem

On Friday, I outlined a few HD options strategies to profit from the weekend super-storm Hurricane Irene (The Perfect Storm: Trading Home Depot around Hurricane Irene).  Today (Monday 8/29 11:30AM EST), the storm has passed. As expected, implied volatility in HD has collapsed back to it's historical average (32.5%). Let's take a look at how the various recommended strategies fared.

"For long-term HD shareholders: Sell out-of-the-money calls, like the Sept 35 Calls for .70.  By selling out-of-the-moneys, you won't run afoul of the IRS and won't owe any taxes on the underlying shares unless they're exercised. If they're called away, you'll have benefited from this week's 7% gain,  plus .85 appreciation (2.5%), plus .70 options premium (2%). Total profit since last Friday: 11.5%. Profit from today: 4.5%. Not bad in a low-return world. You can also buy back the calls on Monday, after volatility collapses, if you're married to the stock."

Sept 35 Calls are now at .46 (IV is now 31%). Close the position for .24 profit (34% on the options or .7% on the underlying).

"For short-term HD shareholders: Sell slightly in-the-money calls, like the Sept 33 Calls for 1.85.  This gives you a .70 (2%) premium in a pretty sleepy stock, and it can drop nearly 4% before your protection runs out.  Of course, you're giving up any upside if Irene is even worse than expected, and HD adds to it's already impressive run.  Still, you will benefit from collapsing IV."

Sept 33 Calls are now at 1.45 (IV is 34.7%,  time premium is .45).  Close the position for a .40 profit (24% on the options, or 1.2% on the underlying).

"For non-directional options traders: Sell high-IV options, and protect yourself with lower IV options. For example, sell the Sept 30 Puts for .27 (IV=50%) and buy the Nov 30 Puts for .97 (IV=40%) for a net debit of .70. Cover early next week for a small profit as IV collapses. Even bigger bump if HD fades."

Sept 30 Puts now .21 (IV=47.44%), Nov 30 Puts now .90 (IV=38.72%). Spread is now .69, basically break-even with Friday's spread of .70. Not worth the trouble.

"For bullish options traders: Sell high-IV puts. For example, sell the Sept 32 Puts for .54 (IV=41%). If HD rallies next week, pocket the .54. If it drops, you can buy it 9.4% cheaper if it falls through 32 (your breakeven is 31.46, 10% below today's price). Don't be afraid of selling naked puts! It's a very conservative strategy; Warren Buffet uses it to buy companies he likes at a discount, and generate income to boot."

Sept 32 Puts now at .47 (IV=38.5%). Close the trade for .07 profit (13%). Probably not worth it, on a risk-adjusted basis.

"For bearish options traders: Sell high-IV calls, like the Sept 33 Calls for 1.80 (IV=38%). If HD drops next week, pocket the .65 risk premium, plus whatever the drop is, to a max profit of 1.80 at 33 or below. If it rallies into expiration, your effective short price is 2% higher than today's price."

Sept 33 Calls are now at 1.45 (IV is 34.7%,  time premium is .45).  Close the position for a .40 profit (24%).

"For neutral options traders: Sell at-the-money puts and calls.  Sell Sept 34 puts for 1.10, Sell Sept 34 calls for 1.13. (HD now at 34.30). Trade is a winner if HD closes between 31.77 and 36.23 on 9/16. Or, exit the trade early next week. Seems like a nice risk/reward here as premium covers +/-6.5% move in 3 weeks."

Sept 34 Calls at .86 (IV=32.67%), Sept 34 Puts at 1.15 (IV=33.2%). Close the combination for a .22 profit (10%).

Of course, you can also let the trade run, either for a few more days as damage estimates are fine-tuned, or even all the way to expiration. The advantage to the last approach is you save money on commissions and "slippage", and the result may fit your overall portfolio strategy.

Conclusion: 4 wins, 0 losses, 2 ties. Not too bad! To re-emphasize the most important point from the original post, never go long options into an approaching natural disaster! Everybody knows it's coming, but nobody knows how bad the damage will be. You will be paying a high price to gamble on Mother Nature, as premiums will be inflated. Those premiums are sure to return to their baseline when the event has passed.
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