Thursday, May 28, 2009

What Price Stability Means to Market Sentiment

Recession or recovery? As pundits debate a possible inflection in economic growth, another factor continues to impact market sentiment.

Deflation fears that gripped the market over recent months highlighted price stability as a significant confidence mover. Deflation's emergence and abatement led to correlative movement in investor fear.

But the effect isn't just limited to this period. The general price level in the economy has been a longstanding driver of sentiment.

Consider our regression analysis below, and its corresponding equation: Y = 62.871 -19.412(X) + 5.8565.

We use the VIX index to measure market sentiment ("Y"), and the TIPS spread to gauge price stability ("X"): see explanations below.

For every ten basis-point change in inflation expectations, the VIX index moves 1.94 points the opposite direction. High (inverse) correlation indicates a strong relationship between the two variables.


No doubt, other factors contribute to sentiment, and we by no means recommend our analysis as a rule of thumb. It does, however, suggest a meaningful association over a six-and-a-half year period (1600 days).

Since its March 9th low, the S&P 500 has gained 34% while the VIX index has declined 36%. This denotes a substantial turnaround from the prior six month period, when the market shed half its value, the VIX reached a high of 80, and the TIPS spread bottomed at 4 basis points. Over the previous five years, the VIX and TIPS spread had averaged 16.95 points and 237 basis points, respectively.

The chart below compares the VIX index (right-hand scale, green line) with the TIPS spread (left-hand scale, blue line) over the complete period.

  • The TIPS spread marks the difference between the 10-year inflation-indexed Treasury and the conventional note. A deflationary spiral began immediately in September, and continued through December.
  • The VIX index measures expected annualized change in the S&P 500. At its worst, the VIX anticipated an 80% move in the S&P 500. The level has since "improved" to 30. Over the last ten years it's averaged 15.
  • Correlation between the two lines is -86%, indicating just how much market participants fear deflation, and don't mind a mild, predictable price increase.

Why so fearful? The prospect for a 1930s-style deflation weighed down hard, and so too the uncertainty over whether fiscal and monetary policy would reverse its course. The September-to-March period also coincided with a change in government, and a corresponding shift in economic policy, from Friedman to Keynes.

Of course, the great unknown today is the potential for accelerating inflation. And while the market clearly favors a modest rise in prices as a sign of pricing power, a rapid increase would re-ignite fear. The VIX index, perhaps anticipating this, remains elevated despite its retracement.

Recent news suggests we could retest an inflation rate similar to what occurred in the late 70s and early 80s – or even worse. (Unfortunately, TIPS and the VIX don't date back to this period, so we can't apply the same analysis.)

In contrast to the deflation scare, inflation – ugly as it could be – is a more familiar beast, and, now, so too is the government that would fight it.

For market participants, the truth is this: better the devil you know than the devil you don't.

Tuesday, May 26, 2009

Health Care Reform: Declare Your Right to Informed Decisions

Life, liberty and the pursuit of happiness: rights we declare to be inalienable. Government's job is to safeguard those rights. And the individual, in return, bears certain obligations to society.

Ideally, individual and societal needs balance each other, but capitalism is not an even-handed process. Innovation, for example, constantly tests this equilibrium. Though necessary, it can be disruptive, and while it benefits lots of individuals, it often disadvantages some along the way. This, though, is what we all expect from risk-taking.

Occasionally, innovation's utility inverts, and a few gain at the expense of many. Wall Street's meltdown is one such occurrence. Another could be health care's collapse.

Both industries allocate necessary resources: capital allocation and medical care. While we may want limitless access to these services – may even consider that access a moral right – they remain economic products, created by the sweat of someone's brow, and can't be conjured at will to satisfy our boundless human appetites.

And while both have long been heavily regulated, they now confront even deeper Beltway involvement.

In the financial industry, government justified massive new intrusion with warnings of "systemic risk" and "too big to fail." And in return for the bailouts, it's aiming to rewrite rules, including the prospect of "guidelines" (and we all know what that means) on compensation.

In health care, government is already forcing the system to operate in a single payer fashion. Using complex, committee-determined pricing formulas, it has effectively dictated physician pay since the early 1990s. Commercial health plans such as Aetna or Cigna could never undercut Medicare, and, in fact, reimburse at much higher levels.

Unlike any other aspect of our economy, supply (physicians) does not actually transact with demand (consumers). As a result, there's no means to define value.

So, back to the individual. How, in the example of government-sponsored health care, do the rights of taxpayers and patients intersect? What if my tax bill increases to fund the consequences of another person's bad behavior? Could I demand that government denies all high-risk individuals any access whatsoever to cigarettes, booze or fatty-foods?

Or, is government defining societal need as something favoring the patient? Is it, in fact, requiring a moral obligation of me? What does this say for innovation?

Health care reform raises many issues, none more fundamental than the individual.

Rather than forcing collective answers, we should work towards a system that empowers the individual and his inalienable right to make informed decisions.

Friday, May 22, 2009

Our Great Feast: First Credit, Now the Internet

Think of how we live today. Compare this with a year ago, two years ago or five years go. Then, we feasted on credit. Now, we're searching every way possible to shed those extra pounds.

In those heydays, we spent money we had – and money we didn't have. It was as if we could snap our fingers, and – presto! – anything we wanted would suddenly appear: a large house, an expensive car or a steady diet of fine wine and organic prime rib.

The magic food was leverage. Since 2000, consumers increased indebtedness by $4,400 per person, where now 14 cents of every income dollar goes toward debt repayment. The magic spoon was plastic. Nearly eight in 10 American households have one or more credit cards, 5.4 on average. Six in 10 carry a balance.

Yet, despite massive belt tightening, the addictive impulse is alive and well .

Instead of dollars, consumers are spending that other precious resource: time. As some folks argue for a return to a simpler, less material lifestyle, consumers are still showcasing full plates of self-promotion – just not in terms of big screen TVs or luxury watches.

The eatery, this go around, is the Internet, and the menu, a selection of social networking sites from Facebook to Twitter. Facebook, for example, has a unique global audience of over 108 million people. The profligate 35-49 year old demographic, once debt bingers, accounts for most of its growth. And 45 to 54 year olds are 36% more likely to use Twitter than any other age group.

Since 2006, time spent on social networking sites has increased 93%.

So, does this constitute the makings of the next great crisis? Have Wall Street PhDs figured out a way to securitize all those hours spent tweeting? Are MySpace and Linkedin tomorrow's Citigroup and Bank of America?

Okay, maybe not. The point is this: consumers are never idle. Their constant motion constitutes a potent economic dynamic, which, at times, can overindulge itself.

Clearly, social networking sites encourage this dynamic. However, because they're so new, no one really knows where they're heading, and whether this direction might somehow end in a bad case of indigestion.

Friday, May 15, 2009

Keeping Creditors and Borrowers in Balance

Are we at the birth of a new global system? Yes, argues The Economist. The current issue notes how an ongoing power struggle between creditors and borrowers now favors creditors, which, apparently, is good news for China – and bad news for the United States.

But before conceding the US's economic leadership, consider the element that's missing from this argument: capital markets.

In a world without capital markets, committees or small groups of people, or even an individual, set prices. There's only price transparency to those negotiating a transaction (if you can call it that), and even then no de-politicized mechanism to uphold that transparency, or an assurance of fair information. Transactions essentially take place in a vacuum.

Capital markets bring creditors and borrowers together. Their collective nature allows for efficient price discovery (so long as dangerous concentrations of wealth do not occur). They also allow for optimized capital allocation.

For all its success, China has not yet evolved efficient domestic capital markets. Instead, the communist party decides where and what to invest the vast bulk of the nation's wealth. In the US, we trust the markets for investment efficiency. The consequence might be volatility (creative destruction), but it's a whole lot better than the alternative of socioeconomic control.

Let's not forget, too: China could not have emerged if not for the opportunity US efficiency presented it – which, by the way, also supports rapid economic adjustment.

As The Economist suggests, debtor nations like the US and Britain likely face rising interest rates and weaker currencies. If so, the next adjustment will be to high inflation, and, depending on how and when this plays out, either a means to accelerate deleveraging, or an opportunity to re-load.

Does China become a powerful economic player in the meantime? Possibly, but that depends on what it decides to do with its capital markets. It will also depend on how we treat our own markets.

If we impose rules that make markets less efficient, then we remove an extraordinarily powerful stabilizing mechanism. Capital allocation would become less efficient, depressing returns and forcing greater pressure on the dollar.

And the less efficient markets become, the more it could favor creditor nations, no matter what the state of their capital markets is.

Wednesday, May 13, 2009

How to Turn Wall Street Into a Postwar Phoenix

In war, it's called victor's justice: carte blanche to redefine an enemy's way of life. The same would appear to apply in politics: Winner takes all.

But does accelerating the timetable of legislative and regulatory action for fear of waning electoral support count in the same way? Is the subtext nothing more than an expression of rushed moral superiority, if the understanding is, "Let's get it done while we still have their support"?

The administration's push to curb Wall Street compensation says as much. That's not to say it's wrong to debate compensation. That fact is, compensation skewed risk-taking, forcing dangerous bets with other people's money.

We should not, however, confuse compensation size with method. According to market rules (and hopefully they still apply), banks should pay whatever the market bears. And if a bank compensates a trader $10 million, and return on capital is expanding, then that's the way it is, as unfair as it might seem to the rest of us.

Banking like other service industries depends on its workforce for returns. The money banks invest in their personnel can take a few years to pay off. If they're lucky, these "assets" will generate increasing returns for many years. Bonuses, in this regard, would be similar to the depreciation costs of a capital investment.

By forcing curbs on compensation, the government is, in effect, reducing investment in a productive asset, precisely when the banks need those assets most.

So, why not view compensation as just that – an asset? If, instead, the administration argued for requiring banks to capitalize payroll (putting it on the balance sheet), then it would force the industry to account for these outlays in the manner that the industry already views them.

In doing so, it would shift a bank's culture to something more closely resembling a partnership structure. The additional risk capital needed to cover the larger balance sheet would impose a more reasoned risk-taking culture.

This is no time for moral superiority or rushed judgment. The solution should be a long-term view towards proper incentives: ones that more clearly balance risk and return.

Post-war reconstruction of Germany and Japan transformed both countries into capitalistic dynamos. Their rise created healthy competition for global capital, which made the United States a better country as a result. Although the parallel does not apply directly, Wall Street can be a postwar phoenix, so long as government does not damage its competitive instinct.

Tuesday, May 12, 2009

A Glossary for Health Care Reform

As the health care reform debate intensifies, so could confusion over certain terms associated with it. The list below – though not exhaustive – details some of the more frequently used ones.

At its most basic, the debate pits opposing viewpoints on the extent of government involvement. It encompasses many different stakeholders, some more organized than others.

This week, Sen. Max Baucus (D-MT) released a white paper outlining his vision for reform. Given his chairmanship of the Senate Finance Committee and outspoken commitment to the issue, he is widely seen as the leading architect of prospective legislation. Over the coming weeks, the debate will address his policies.

The discussion, however, is fluid, and other policies may take root, if, in fact, legislation does come to pass.

Community Rating: an insurance concept prohibiting premium differences based on health status

Comparative Effectiveness: the practice of side-by-side clinical assessment of medical interventions

Evidence-based Medicine: the application of current best evidence in patient care, often in connection with quality and value

Guaranteed Issue: an insurance concept in which the insurer offers a policy regardless of the applicant's health status

Health Insurance Exchange: a national, regional, statewide or local registry of all state-licensed private insurers in the non-group and small group markets, and the public health insurance option if applicable; its design is intended to make plan selection more transparent

Individual Mandate: an insurance concept requiring that all adults purchase insurance through their employer, a government program, or in the individual market

Individual Market: that portion of the health insurance industry consisting of individuals and their dependents who purchase coverage directly from an insurer

Interstate Insurance: the ability to purchase policies sold in different states, where state regulation often creates substantial price variation

Pay-for-Performance: incentive compensation for meeting performance criteria in quality and effectiveness of care

Pay-or-Play Tax: empowers a tax authority to assess employers (pay) while giving them the option to avoid the fee by providing health care or coverage to their workers (play)

Portability: the ability to take health insurance from job to job

Public Health Insurance Option: a federal plan for non-disabled individuals under 65 years of age; three options are currently under consideration

Risk Pooling: an insurance practice of bringing together different risk profiles to offset any one individual claim; in health care, reformers are looking to apply the concept to small businesses and high-risk individuals, or uninsurables

Shared Responsibility: the notion that each component of the supply chain contributes to cost savings – manufacturers, providers, private and public payers, and individuals

Third-Party Payer: private and public sector insurance arrangements in which an individual pays premiums to an entity (third party), which then pays for agreed-upon health care services

For more information, read the Lyceum newsletter Perspectives. This publication features commentaries from leading practitioners, many of whom have devised innovative business practices in the delivery of care.

Monday, May 11, 2009

Going Postal

Here's efficiency for you: net losses in ten of the past 11 quarters totaling more than $10 billion, and yet a 23% pay raise over the past year.

Nope, nothing to do with greedy bankers or the UAW, or anything in finance or capital-intensive industries for that matter. It's the United States Postal Service (USPS).

Today's price hikes on an annual volume of 200 billion units might seem consequential except for a pronounced, negative secular trend.

Last fiscal year, the USPS collected $75 billion in revenues, but incurred $78 billion in expenses. 80% of these expenses went to compensation and benefits, including $7.4 billion in health care for 450,000 retirees. In fact, at $12.8 billion, total health outlays ($5.4 billion of which went to 660,000 employees) amounted to nearly twice the level spent on the actual delivery of mail.

The recession has forced a fierce headwind against the Post Office, but, more important, so has the accelerating trend toward electronic messaging. Since 1998, first class mail volume is down more than 25%.

At 240 years (six times the age of Medicare), the post office dates back to the Second Continental Congress. It's a recognized monopoly in 80% of its business, but law prevents it from raising prices by more than the rate of inflation.

On the cost side, the American Postal Workers Union, the National Association of Letter Carriers and other unions continue to negotiate the richest pay packages in the Postal Service's occupational category. (Collective bargaining agreements cover more than 85% of career employees.)

So, unless the Postmaster General can slow volume erosion and extract deeper cost savings, Congress might have to infuse taxpayer money – either that, or it would need to weigh a radical restructuring, perhaps involving steep benefit cuts.

Already, there's talk of reducing delivery days from six to five.

And while economic recovery would be welcome, it would do little to deflect the deeper market shift taking place.

As outlays escalate, there might be no choice but for Congress to consider a private-sector solution. For now, customer satisfaction is high – but where's the benchmark here?

Indeed, a non-government solution would represent a certain irony. Customers, the taxpayers, may demand nothing less.

Saturday, May 9, 2009

Where's the Market Competition in Too-Big-To-Fail?

What, exactly, is too big to fail? Who defines it – and how?

It now appears that one person will be the who, what and how. According to the Treasury Secretary, such power should reside in one person rather than a committee.

Okay, so let's be clear: one person is more capable than a committee, and a committee is more capable than the entire marketplace. Putting it another way, we're being told to commit to a politically appointed individual and his capability to decide whether a failing institution warrants the full faith of the US government.

Now let's suppose I compete in an industry with several large institutions (none of which is actually on the precipice, but if one were, the Fed would deem it systemically important). There's strong demand for my services, and I need capital to expand. My outsized competitors are also sourcing funds. Can I truly expect equal terms for my investment money?

Or what if I'm hiring people. How does the implied job security of the too-big-to-fail firm affect choice?

Or what if the big guy decides to push the envelope. He bets big on a new venture that fails. Does his implied protection make him any more rational in how he allocates money? More important, to what extent will I end up compensating for his poor judgment?

There are two fundamental problems in the too-big-to-fail mindset:

One, the fact that such institutions could exist contradicts basic notions of market competition.

Two, the political equation of "what, who and how" takes place entirely outside of market competition.

There’s no market balance in capital that’s heavily concentrated. It’s what got us in trouble in the first place. Real change would involve introducing regulation that empowers market competition.

About half of small businesses fail in the first five years. And the big guys too come and go. Just look at the Dow composite over the past several decades.

For the person hanging out his own shingle, there’s nothing more frustrating than the prospect of an imbalanced marketplace.

As to the financial system, yes – it is systemically important, which is why making it less competitive is so dangerous.

Sunday, May 3, 2009

Risk-Return in Health Care Reform

Health care reform is an opportunity to change how we price risk.

If we get sick or injured, we expect the best possible care. For some of us, we want access or quality first. Others may view access and quality as identical, the difference depending on the severity of the condition: I trust more physicians treating me for the flu than for a broken leg.

For many, cost never factors into seeking care. But for some, it can, and it can limit not only quality but access as well.

The point is: we as individuals have different preferences, but little control over how we can act on them – regardless of our situations.

The capital markets, by example, function differently. Individual buyers and sellers utilize information to price securities. What price one side is willing to buy or sell at depends on how it assesses various risk factors, such as market liquidity or corporate cash flow.

While single securities can be extremely risky, the fact that all do not correlate with each other keeps the overall market comparatively tranquil (despite recent times).

Commercial health plans pool individual policies to achieve the same effect. Information, however, can be asymmetric, in favor of the policyholder. Whether or not they act on it, policyholders know more about what they're insuring against than the insurer itself.

Some holders will opt out of a policy – and prospective buyers not purchase one – if they believe premiums are more costly than the event itself. The result is an adverse selection of pooled policyholders, skewed to high-risk individuals. This contributes to higher premiums, which further depletes the pool of low-risk holders.

Everyone is harmed. On the one hand, health plans seek to limit coverage, both in whom they're offering it to and what they're willing to cover. On the other hand, spiraling costs put continuous pressure on the plans' medical loss ratios.

And all this would be disheartening at worst, if not for the "dominant"-payer in the market. (Call it "single" if you'd like.) Does any plan dare to compete against Medicare on price? Absolutely not.

And let's also not forget that most people's gateway to access, quality and cost is the self-insured employer, and its method for choosing services on our behalf.

Risk-return, to no one's surprise, is inherently imbalanced throughout the value chain. (Docs basically take whatever they can get.)

Is it possible to get to a system that begins with individuals pricing risk (thereby exerting control), as they do when trading stocks or developing a financial profile with an adviser? That depends on whether legislators can trust individuals to make informed decisions. It also depends on providers willing to accept value-based competition.

Doing so would mean a complete overhaul of health insurance, from government to employer.