21st Century Economics

This report was originally created in July 1999 but is as relevant today as it was then. In fact, most of what it predicted has happened and the opportunities for profits (or not taking large losses) have increased.

What happens to our air is critical to our economy.
If it changes, even slightly, we will feel the financial, health and food effects of it. As a global megatrend, it has far reaching implications on the financial well being of every nation on earth but especially the US. For that reason, it is important to understand the forces at work here.

Life as we know it is possible on Earth because of a natural greenhouse effect that keeps our planet about 60o F warmer than it otherwise would be. Water vapor, carbon dioxide (CO2 ), and other trace gases, such as methane and nitrous oxide, trap solar heat and slow its loss by re-radiation back to space. With industrialization and population growth, greenhouse gas emissions from human activities have consistently increased. These steady additions have begun to tip a delicate balance, significantly increasing the amount of greenhouse gases in the atmosphere, and enhancing their insulating effect.

A wide variety of activities contribute to greenhouse gas emissions.
Burning of coal, oil, and natural gas releases about 6 billion tons of carbon into the atmosphere each year worldwide. Burning and logging of forests contributes another 1-2 billion tons annually by reducing the storage of carbon by trees. The result is that the atmospheric level of CO2, the most important human-derived greenhouse gas, has increased 30 percent, fro m 280 to 360 parts per million (ppm) since 1860. Over the same time period, agricultural and industrial practices have also substantially increased the levels of other potent greenhouse gases — methane concentrations have doubled and nitrous oxide levels have risen by about 15 percent. These gases have atmospheric lifetimes ranging from decades to centuries; today’s emissions will be affecting the climate well into the 21st century.

The overall emissions of greenhouse gases are growing at about 1 percent per year. For millennia, there has been a clear correlation between CO2 levels and the global temperature record. Fluctuations of CO2 and temperature have roughly mirrored each other over the last 160,000 years. The current level of CO2 is already far higher than it has been at any point during this period. If current emissions trends continue over the next century, concentrations will rise to levels not seen on the planet for 50 million years.

Which countries account for the largest proportions of CO2 emissions?
In 1995, 73 percent of the total CO2 emissions from human activities came from the developed countries. The United States is the largest single source, accounting for 22 percent of the total, with carbon emissions per person now exceeding 5 tons per year. Over the next few decades, 90 percent of the world’s population growth will take place in the developing countries, some of which are also undergoing rapid economic development. Per capita energy use in the developing countries, which is currently only 1/10 to 1/20 of the U.S. level, will also increase. If current trends continue, the developing countries will account for more than half of total global CO2 emissions by 2035. China, which is currently the second largest source, is expected to have displaced the United States as the largest emitter by 2015.

Opportunities for Profit

These reports on the megatrend of global warming and ocean rise are not so much meant to present immediate investment opportunities as to alert you to an inevitable trend that will eventually affect all of us. This is not speculation but scientific fact. Unfortunately, it is not in our nature to react ro respond to events that unfold very slowly. Our government and that of many other nations will never put global warming above more immediate issues related to current economic growth and prosperity. For that reason, there will be virtually no preventive measures and no preparation for the eventual effects.

Because there are a few scientists that do understand the coming event and can foresee the impact it will have on society and our economy, they must be silenced so as to not upset the rest of us in our ignorant bliss. To that end, the government will frequently offer up studies that contradict those of established scientists so that the public will remain confused and non-responsive to the warnings. This also allows the government to push off any response until it actually begins to affect our economy - i.e., take money out of the pockets of corporate America - THEN we will address the issues and begin to prepare. Unfortunately, that will be very late in the process and little will be able to be done without major upheavals and deep changes that affect many people.

If a stock is being bought and sold in a thin market the volatility will be large. A thin market is when there are few bids to buy and few offers to sell. This can exist if there is a high demand for the stock but a limited supply of shares. The few trades that do occur in a thin market can affect prices significantly. Institutional investors tend to avoid thin markets because when they buy and sell large blocks of stock, they can significantly affect the stock’s price. They may also find it difficult to get into and out of a position.

If you were to plot beta of a stock over time, you might see changes as the volume of shares in a typical trade fluctuates.

A change from a low beta to a high beta can mean that a thin market has developed for this investment. If the company is buying back its stock or there is a developing takeover in which a buyer is trying to buy up all the shares, the market for this stock will become “thin” and the volatility will increase.

Depending on why this is happening, it can trigger a buy signal for a wise investor.

A change from a high beta to a low beta can indicate that the stock is not seen as being very popular or that is has resolved a major internal problem that has reduced its susceptibility to outside influences. For instance, if an airline is buying fuel on the commodity market, its costs and market position can fluctuate with the price of oil and be influenced by competition with other fuel users - trucks, utilities, heating, manufacturing, etc. This could result in a high beta.

It turns out that, like many computed factors of an investment, particularly stocks, there can be a lot of useful information in examining the volatility of a stock. The most obvious is that it is often taken as the direct corollary to RISK. If a stock can rise fast and fall fast, you are at risk for catching the falls and not the rises. If it falls a lot and you have bought on margin, you can owe a lot of money in a short time that you did not expect to.

A direct measure of the volatility of a stock is a computed value called the “beta coefficient”. It is the covariance of the stock in relation to the rest of the market. By definition, the S&P 500 has a beta of one (1). Any stock with a higher beta is more volatile than the market as represented by the S&P 500 index. A stock that is expected to rise and fall more slowly than the market will have a beta lower than one.

A Beta does not necessarily mean that it will not rise or fall as much as he S&P 500, it just means that it may not move as fast as the index. Beta is based on past performance.

Another related factor is called “alpha”. It indicates the volatility of the investment itself rather than the rest of the market. If a stock is not expected to change in price in the coming year as a result of its inherent values such as growth of earnings per share, then it has an alpha of one (1). If it is expected to grow by 25% in the next year, regardless of the performance of the market as a whole, then it has an alpha of 1.25. Alpha is based on expected or projected future performance.

Putting them together, you can get some interesting insights into the expectations of the investment. (A high is a factor larger than 1, a low is a factor lower than 1).

A low beta and a high alpha would be an ideal investment. It would mean that there is low risk and a projected high return over the next year. This situation is rare in typical investments.

A high beta and a low alpha may be a poor investment since it indicates that the stock is a potentially high risk with lower growth than the rest of the market.

Notice what I have said here. It is NOT inflation itself that has had the impact on the economy but our reaction to it. Granted, inflation does change the economic balance and does create its own effects but then we amplify that effect by over-reacting to it. It is for this reason that any investor needs to understand exactly what it is and how it works - how it really works, not how you think it works and how to respond to it.

Real Inflation

Inflation, has for many years, simply referred to a continuing increase in prices. This is distinguished from price increases as a result of changes in value. Many now believe that price increases that continue are almost always associated with changes in the supply of money.

By today’s standard, the M1 (the government’s measure of the highly liquid money supply) would be a close indicator of inflation under the old definition. It was often discussed that an increase in the money supply might “stimulate” inflation.

Under that definition, we spoke of the “value” of the dollar changing in relation to the value of a dollar. In other words, it was the goods that retained a relatively constant “value” and its “price” changed with the relative value of the currency. A simple supply and demand concept applied to the currency.

Unfortunately, in recent years, inflation has undergone a change of identity. Most now think of inflation as referring to the prices themselves. We even use the CPI as the corollary to inflation indicating that the prices of that hypothetical market basket is the same as inflation. It is not.
Real Inflation is a reflection of the money supply relative to the value of goods. Let’s see this from one more perspective. If there is only $100 in the economy and I can buy 10 identical items - call them widgets - with that $100, then the widgets are priced at $10. If we arbitrarily set this as a standard, then we can also say that the widgets have a “value” of $10 each. That was today. Tomorrow, I print another $100. There is now $200 in circulation. The “value” that I placed on my 10 widgets has not changed from yesterday. I have not made any more widgets so their “value” is still $10 but now each dollar is worth half of what it was yesterday. It now takes $20 to buy each widget.

It was the change in the money supply that caused the change in the price of the widgets. Inflation is the result of that change in the money supply that altered the price (not the value) of goods not the change in the price of the goods.

The Real CPI

To understand CPI, first we have to return to the point made above - that changes in prices are not inflation. This is not something you have to take on faith - it is fact.

The CPI as we know it and as it is defined by the government is not inflation, it is an index of prices for a select group of times. If it changes, it is in response to, not the cause of inflation. If, however, it responds to inflation is a consistent and directly related manner, than it can be used as an indicator or inflation. That is exactly how it is viewed by many. Unfortunately, as you will see, it is neither consistent nor directly related.
Using the CPI to gage inflation is sort of like measuring the overflow of a river to determine if too much rain is flowing into the pool - First off, the rain may have already stopped by the time the overflow occurs. Second, you can never be really sure that the overflow was really from just the rain or was there some other causes also - like other creeks or snow melt or ?.

Finally, you might actually have not change in water volume at all - maybe it is just that someone has opened and shut some flood gates upstream. These are analogous to similar problems that CPI experiences.
As noted in the widgets example above, the reference of value is not the dollar but the goods in the CPI basket. The items in the basket have the almost same intrinsic value from day to day but their price changes because the value of a dollar changes.

This is contrary to what most people think about when they view inflation and money. We normally think of the dollar as having a fixed value and it is the intrinsic value of the CPI basket of goods that have changed because of changes in labor costs, transportation, energy or some other contributory cause. That is a false concept but one that the government makes no attempt to change. In fact, changes to the labor, transportation and energy costs and others all may be simply responses to changes in the money supply.

Given the method of measure (fixed basket of goods) of the CPI and the lack of response to technology and expenditures in stocks and taxes, the CPI tends to be more positive than actual inflation really is. In other words, CPI is going to always be lower than the real inflation. By how much is the big question. When we look at historical data, we see that its accuracy varies but it is more incorrect at times when the economy is about to take a downturn - meaning that it softens its predictive value just as it is needed most. The reason for this is that consumers begin to alter their buying habits as money tightens and employment changes - all precursors to a economic downturn but the way that CPI is determined does not take these changes in consumer behavior into account.

CPI is not the figure to use to measure inflation but because it may be a metric that responds to inflation, you might think that it can still be useful to be used as a comparative index of how the supply of money has changed the prices of goods- in other words, it may be seen as a measured response to the money supply - or is it?

Historical Views and Theories

Profit 2000 takes the position proposed by Don Paarlberg in his book, “An Analysis and History of Inflation” (Praeger Publishers). In it, he studied 15 different economies from Ancient Rome to modern day Brazil and concluded that a moderate degree of inflation is usually accompanied by increased economic activity. This has certainly been borne out by recent US history.

It turns out that economic thought is divided into two theories: Keynesianism which believes that an increased money supply can lead to increased employment and output; and Monetarists (like Paarlgerg) that believe that an increased money supply ultimately affects only prices, leading to inflation and that output is not increased.

Monetarists support their position with some fancy math called the quantity theory of money and the equation of exchange. These are formulas that equate spending and buying to money movement from buyer to seller on a total economic scale.

The result of the math is to show that inflation is equal to the growth rate of the money supply minus the growth rate of real output. The growth rate of the money supply is controlled by the Fed. The growth rate of real output is determined by resources and technology and has historically been about 3% per year. Therefore, if the Fed allows growth rate of the money supply to exceed 3%, we have inflation.

Alan Greenspan has announced that the current Fed’s goals for M2 growth is 5% per year. He is allowing that if the Keynesianists are correct, then there is a goal of 2% inflation to increase employment and output. If however, the Monetarists are correct, then he is figuring that 2% is a controllable amount of inflation that can be easily managed with interest rate hikes and other Fed controls.

Like many theories of modern times, there are smart people on both sides and there is sufficient evidence to argue both sides with vigor. It often depends on what data you look at. Paarlberg chose to look at historical economies as well as modern ones to validate his perspective.

In keeping with his monetarists perspective, Paarlberg also proposes that inflation is not caused by production or prices but by the supply of money controlled by governments. A careful examination of what the US Treasury, M1 money supply and other currency exchanges were doing in each of the 11 inflationary periods over the last 50 years proves that Paarlgerg is right.

The M1 supply adjusted for CPI plus stocks and government taxes (collectively referred to as the MCCPIG) has flattened or declined prior to every single one of the 11 economic downturns since WWII - with no misses or false alarms.

By contrast, the quoted government figure for the M1 supply rose 3.7% between May 97 and May 99 - remarkably close to the average government figure for average CPI of that period which was 3.6%. There is no other economic indicator with as good a record for predicting economic activity, but as we will see, both the CPI and the M1 may not be consistently accurate.

Now let’s examine why.

The Real Money Supply

First some Facts: As of March 1999, the M1 has risen 1.5% over the past year, the M2 has risen 8.6% over the past year and the M3 has risen 10.6% over the past year. I should note also that M2 has been showing rates above 8% since Feb 1995 indicating a positive economic outlook.
Studies show that Personal consumption expenditures are equal to 92% of disposable personal income - meaning that an indicator such as M2 which is close to a measure of what people have available to spend is 92% of what they DO spend. If we know that M2 has change upward, we can forecast that consumption expenditures will rise by a proportional amount and vice versa. Therefore, these “M” supply numbers tend to be good indicators of future economic activity.

Let’s try another analogy. I have a large tub of water with a hose in it. The hose puts water in and takes water out of the tub. I can definately say that if I can see water coming OUT of the hose, then the water in the tub is going down. Depending on the size of the tub and the hose, there may be a very small response in the tub to the water moving in the hose. The M2 is the tub of water. The hose is money flowing into the economy from the treasury or out of the economy by putting it in less liquid forms - long term CD’s, purchase of goods, etc.

To understand all this we have to first understand what the M1 really is. It is defined as the money that can be spent immediately. It includes cash, checking accounts and NOW accounts. The M2 is the M1 plus assets invested in short term money-equivalents such as money market funds. In other words, it is the liquidity of the money that determines if it is counted in the M1 and M2 supply numbers.

At issue is just exactly what does that really include. Upon more careful examination, the government defines this in such a way that it counts money that are otherwise committed to be used as taxes and that are locked up in the stock market.

The M1 and M2 have risen steadily since about 1930 but since 1995, the M1 has turned down while the M2 has turned up. The difference between M1 and the M2 is investments in money equivalents such as money market funds and bank deposits but M2 contains M1 so how can one go down and one goes up? This was an indicator to look further at where all the money was actually going.

The other place that has collected a lot of money is the stock market. The M2 supply reflects the $600 billion that investors have put into the money market funds but it does not reflect the $3 trillion in equities - that is an 1100% increase since 1980. That’s a lot of money that is not reflected in the M1 or the CPI.

The Anomaly

There is more money flowing into the economy than can be accounted for by the CPI with respect to prices. Under the basic supply and demand concept, which we will assume is an inviolate law of economics, there should be more price rise than is indicated by the CPI as a result of the increases in the money supply.

So what does this mean? What we have are some indicators that do not accurately indicate what we think they do.

They show rate of money being created by the Treasury. If we do not use the M1 and M2 absolute values but only the changes over time, we see that M1 and M2 have constantly risen since 1930 but if we include the money invested in the stock market and the money paid in taxes, we will see that M1 and M2 should be much higher than they are being reported that they are now.

The M1 supply adjusted for CPI plus stocks and government taxes (collectively referred to as the MCCPIG) has flattened or declined prior to every single one of the 11 economic downturns since WWII - with no misses or false alarms;

By comparing the CPI index level at two different times, you can make a statement about how prices have changed between he events. For instance, In December 1988 the CPI was 120.7 but December of 1998 it had gone up to 163.9. Doing the division of 163.9/120.7 =1.358, now subtract 1 and multiply by 100 to get a 35.8% rise in the CPI in the 10 years from 1988 to 1998 or about 3.6% per year rise.

The contents of the ” fixed basket of goods and services” is determined by the Bureau of Labor Statistics (BLS) after conducting a survey of consumer expenditures about every 10 years. The items being purchased rarely change but the BLS can adjust the weights of each of the 364 items in the basket. Some major changes were made in 1998 to the CPI.

The number of categories that the ” fixed basket of goods and services” is divided into went form 7 to 200 and the item structure and weights were changed. A more important change is that the CPI will not be calculated using a geometric mean estimator for about 60% of the expenditure categories that comprise the hypothetical market basket. The effect is subtle but important. It means that the quantities of goods in a particular category can change in response to the relative price changes. The new method of CPI calculations lowers the CPI value by about .2% over the old method.

In the past, the quantity was fixed and as prices of the items increased the CPI rose. The problem was that this did not reflect consumer spending. For example, if the cost of one vegetable rises, consumers will migrate away from that by buying a different one that has not risen as much. If the CPI reflected only the one that rose in cost, it would distort the picture of consumer inflation.

CPI’s value is that it is taken to be regarded as THE measure of inflation but because it is subject to consumer responses and handles the introduction of technology poorly, it sometimes results in a number that is larger than actual inflation by .5 to 1%. It also does not reflect stocks or government taxes which can have a major impact on the economy. Still, it remains one of the best indicators of inflation.

As noted above, the value of the CPI has risen by an average of 3.6% for the past 10 years but this does not reflect the month-to-month volatility of the usual method of reporting CPI which is to report the percentage change from the previous month or to report the CPI on a monthly basis.

For instance, the monthly percentage change CPI in April 99 was .7% but in March 99, it was .2%. You might interpret this to be a 350% rise in CPI from March to April when, in fact, the actual rise was from 165.0 in March 99 to 166.199 in April 99 - a rise of about 1.2 index points our of 165. A very small amount. Even if this were seen as the inflation rate for that month and you projected that for 12 full months, it would equate to an annual inflation rate of 8.7%. This gives a totally incorrect view of the economy and would be drastically out of line with the trend for the past 10 years of 3.6%. In fact, the entire year to date (January 99 thru May of 99) has a total rise in the CPI of .97% (less than 1% overall or an average of about .19% per month giving an annual rate of just 2.3%) or about 25% of the 8.7% figure). This is how the Wall Street wingnuts and economic pundits manipulate figures to scare people into buying or selling their advice and products.

What is important is how the market reacts to the CPI. If the CPI changes, in general the market goes in the opposite direction. Bonds (fixed income) and equities go down when the CPI goes up and vice versa. It is seen as less volatile than the PPI and so it is used as a better indicator of long term inflation trends.

Like most economic indicators, CPI does not provide proof positive of any particular trend but in combination, it can provide some insights into where the “trends” and “pressure” is pushing the economy.

Right now, the total picture, including the CPI, indicates that the although inflation is being constrained by heroic efforts by the Fed, we are seeing a weakening US Dollar, rising unemployment and very high energy prices that are adding to building pressures to push inflation higher. Employment compensation is rising rapidly, housing and vehicle markets are taking a dive, raw materials have risen and the Fed has lowered the rates several times with a high likelihood of a second lowering later in the year.

21s Century Economics takes the position proposed by Don Paarlberg in his book, “An Analysis and History of Inflation” (Praeger Publishers). In it, he studied 15 different economies from Ancient Rome to modern day Brazil and concluded that a moderate degree of inflation is usually accompanied by increased economic activity.

This has certainly been borne out by recent US history. He also proposes that inflation is not caused by production or prices but by the supply of money controlled by governments. A careful examination of what the US Treasury, M1 money supply and other currency exchanges were doing in each of the inflationary periods over the last 50 years proves that Paarlgerg is right.

The M1 supply adjusted for CPI plus stocks and government taxes (collectively referred to as the MCCPIG) has flattened or declined prior to every single one of the 11 economic downturns since WWII - with no misses or false alarms. The M1 supply rose 3.7% between May 97 and May 99 - remarkably close to the average CPI of that period.

A chart of M1 (deflated by the MCCPIG) since 1994 shows a percipitous drop from an index value of just under 170 in 1994 to under 100 in 2000. Given the Paarlgerg theory, the adjusted M1 (deflated by the MCCPIG) indicated that we were headed for a monster recession of epic proportions. At that time, Alan Greenspan said, “..storm clouds are massing over the western Pacific and heading our way”. Buy an umbrella! He and the MCCPIG were right on. In March, the bottom dropped out of the tech market and we entered a protracted bear market.

Personal income represents the compensation that individuals receive from all sources - wages, dividends, interest payments, proprietor’s income, transfer income (social security, welfare, unemployment) and other labor income. If we see this rise, expenditures often rise soon after. If Personal Income rises but expenditures don’t, then more people are putting money into savings. The nominal Personal Income and the Real Income (adjusted for inflation) are considered very good indicators of the current strength of the economy.

Increases in the PCE causes = The Stock Market to Rise
The Bond Market to Decrease
The Value of the Dollar to Rise

Decreases in the PCE causes = The Stock Market to Decrease
The Bond Market to Rise
The Value of the Dollar to Decrease

Bear Market Implications
People will spend money for three reasons:
(1) Because they have earned more
(2) Because they are buying something important
(3) Because they think that the value of money will soon decrease drastically

In both (1), you would see a rise in Income precede a rise in Expenditures. In (2) you would see a rise in Expenditures without a rise in Income. Often this would be matched by an increase in Durable Goods Orders. (See Guide on the Economic Indicator: Durable Goods Orders).
The same rise in Expenditures would happen in (3) with no rise in Income and often with a lesser rise in Durable Goods Orders. This is because when people are trying to expend money that they think will soon lose much of their buying value, they tend to buy consumables - food, gasoline, heating fuel, clothes, ammunition, etc.

If there are more people out there that think an impending Bear Market is real and will result in a major market setback, then you will see a large increase in Expenditures in the prior time period with no corresponding rise in either Income or Durable Goods Orders.

If on the other hand, there are more people that think that the economy will survive intact with little or no effects from Iran, Iraq, the new president or any other economic downtown, then the Expenditures will rise normal for the near term, and no rise at all for a seasonally adjusted Expenditure indicator.

If you see the Expenditures indicator abnormally rising, you can bet that people are stocking up on all the Bear Market kinds of supplies that all the doomsayers are saying will be needed after a major stock market setback - like moving funds out of equities and into gold or other cash equivalents. If that is the case, then you should be invested in stocks, bonds or commodities that reflect that potential.

If you see this rise, you can also expect that the value of the dollar will rise. If you see that, then buy gold as soon as you see a pattern of rise.

This rise in Expenditures may precede the actual rise in the value of the dollar and of monetary equivalents. The Expenditures rise should peak in just prior to an expected crisis (the indicator comes out between the 22nd and the 31st of the month) .

As soon as you see it, if it has risen by 10% or less over the previous money, then sell your gold. This is a cautious approach since you do not want to have to try to time your sell on a day-by-day basis by watching the paper or computer as the price of gold fluctuates.

The reason is believed to be overconfidence in a bull market that is encouraging investors to chase the latest shining star. Even when they miss, the bull market imposes a small penalty but that small penalty is adding up. Net returns are lower than if the investor had just stayed with some basic index fund for the duration and not traded so actively.

There is another source of loss that is a direct result of this increased trading. Each time a trade is made, a taxable event occurs. If you gained, it is taxed and if you loss, you are pressured to create an gain so you can take the loss.

For instance: If you sell at a $10,000 loss in the first quarter of the year, you cannot claim that loss (except under special circumstances) unless you have a gain of that amount some time during the year. If your normal dividends do not amount to $10,000, then you have to sell something to create a gain so you can deduct the loss. Now you have another taxable event.

Or you are just creating extra taxes because of the frequent trades you make in day trading or chasing the numbers. The end result is that you are paying taxes on each transaction that lowers your overall gain.

One other way that you might be gaining in these taxable events is by investing in a mutual fund that has an active manager that believes in a high turnover rate. This creates capital gains that may be distributed to the investors.

An alternative is to invest in a few index funds that do little trading. You could also trade in tax exempt bonds and other investments and move your money into a tax-exempt money fund between trades. If it is in a bank, it continues to earn taxable income.

Finally, whatever you do, try to hold your investments that show a profit for at least one year so you can take advantage of the 20% long-term capital gains tax rate. If you don’t the capital gains can be so high as to offset your profits on the trade.

Many people that have read anything about the stock market know that dollar cost averaging is the best way to invest and that the buy and hold strategy for extended periods has proven to be most consistently sound investment method of all. Despite the views of hundreds of investment gurus that spout about the virtues of timing, demographics, contrarian and other sector investment methods - none have proven to be as reliable as simply buying good solid stocks and waiting.

In recent years, the tech boom market has skewed this view by so much that many are beginning to doubt it. The short term success of Internet stocks or other sectors have made people lose sight of the norms and history of the market. If we accept the concepts of “regression to the mean” as described in other articles on this service, we must view the history of the market to get some insights to where the future lies.

Despite the 25% to 50% returns of many funds and stocks in this bull market, the average return over the life of the stock market is between 4.7% and 6.3% depending on how far back you go and what numbers you use.

Let’s be conservative and say it is 6%. That means that by the rule of regression to the mean, the current bull market cannot continue for much longer without swinging the other way to maintain the historical mean. Even if we allow for a massive change in the mean, it almost certainly will not swing from 6% for the average from 1897 to 1997 to some much higher number over the next decade.

The problem is that many people are thinking and planning for their retirements based on these high returns. I have seen many “retirement guides” that use 12% and 15% as the return on your retirements investment and then they always show you the “magic of compound interest” to convince you to reinvest your earnings. Figures in the millions are often quoted if you being saving when you are young. But is this realistic? Can you expect 12 to 15% returns over your investment careers while you save for retirement? The answer will surprise you.

No one in our entire history has ever been able to do it!

Let’s look at why. Suppose we look back at the average growth of the S&P 500 over the past 15 years (this is called the15 year annualized growth). As of the end of 1997, looking back to 1982, we have had about a 15% growth. But this number is very misleading because it happened for only a very short period of time. That number was only 10% if we look back from 1995 and it was only 8% in 1991. If we go back to 1985 and look back to 1970, the average is below 5% average growth.

Remember, we are averaging the total growth for a full 15 year period. That almost totally obscures such minor adjustments as the 500 point drop in 1987 and other “corrections” and it reflects only the major trends of the economy that have some degree of duration such as recessions, wars, demographics, etc.

In fact, the longest period of time that we have ever been able to sustain a 15% return for a 15 year annualized growth was for a two month period in 1997. The average 15 year annualized growth for the stock market since 1887 is just over 4%.

This means that those lucky few that invested during a short 2 months in 1982 and that left their money in the market until 1997, saw a 15% return on their investment. If they had invested any earlier or later than that, the return would have been much lower and it was never higher at any time in history for a 15 year annualized growth figure.

Even if we drop it back and look at an average of 10%, we find that there have only been a total of 17 years since 1887 that we have experienced a 10% growth annualized over 15 years. Contrast that with 16 years in which we had 5% or less for a 15 year annualized growth.

If we believe the concept of regression to the mean or if we believe that history gives us some insights into the future, then we have to conclude that no one should be planning on getting 15% return on their money for periods longer than a few months - a few years at best - but certainly not for the life of an investor from early working age until retirement.
You would do better to figure your retirement investments based on a 5% to 6% return over the life of your investment (3 to 4 decades).

Unfortunately, this will have a significant sticker shock to most investors. Those “retirement guides” that use 12% and 15% as the return on your retirements investment and then show you the “magic of compound interest” use figures like this:

You invest $10,000 at age 20 and get 15% average returns for the next 40 years, you will have $3,887,006 for an early retirement at age 60. Sounds great but it has never happened in all of history and is not likely to happen in the future.

More likely is this: You invest $10,000 at age 20 and get 8% average returns (if you are lucky) for the next 40 years, you will have $242,733 at age 60 not counting the effects of inflation for 60 years. Even if you add $100 a month for 40 years at 8%, you’ll only have $349,100 at age 60. That’s less than one tenth what the retirement guide led you to believe you would have and a whole lot less than you will really need to retire early.

A more realistic strategy is this. Start early - of course we all would like to have had the maturity and wealth to begin saving at age 20 but the fact is that many did not. Don’t think in terms of how little you can save for how long at current rates of return. Think in terms of how much can you save for the longest term possible (that means not retiring early) and at much more conservative rates - like 6-8%.

This report introduces, in a simplified manner, the concepts of Activity Based Costing (ABC) as an introduction to the analysis applied to the Process Model and the development of the strategic plan for departmental analysis of the organization.. The department used in this example was the IT department.

Description of ABC

Activity Based Costing (ABC) is a technique that measures the cost and performance of activities and the products or services generated from those activities (Cost Objects). The resources, which are commonly reflected by the general ledger, financial statement, or object class codes are traced to activities based on primary and secondary methods of consumption. Activities are traced to cost objects, which are the functional outputs of the business processes based on their use.
The task of differentiating the organization’s activities as either value added or non-value added is perhaps the most important theme in ABC. Non-Value Added activities become candidates for elimination or reduction whereas Value Added activities become targets for improvement.

Traditional cost accounting systems do not provide adequate information to identify the causes of cost. In situations where costs are deemed by management to be too high, managers tend to rely on across-the-board overhead cuts to control spending in the absence of proper information. Thus, when funds decline or disappear, organizations usually respond by “tightening the belt” in the wrong way at the wrong point in the enterprise.

Common approaches include:

Universal reductions in the budgets of all departments;
Freeze on wage increases;
Freeze on overhead activities;
Early retirement;
Freeze on training and nonessential travel;
Freeze on hiring; and
Freeze on investments.

Such well-intentioned efforts generate a self-feeding cycle of competitive decay. They do not address the demand for overhead resources - the activities that keep people busy. There is a natural tendency for managers to cut expenditure on activities critical to the mission of the organization both in the present and in the future. Deterioration in the quality of service and pressures on an overburdened staff prompt renewed spending and overhead creeps up. The problem is that the fundamental causes of cost were not corrected.

The most common and least understood factor that touches off such a cycle is management operating with the wrong type of data - data geared to accounting rather than management.

How ABC was applied in this case

A baseline represents the inventory of business policies, practices, methods, measures, costs, and their relationships at a particular location at a particular point in time. The baseline also comprises a set of business processes that provides the context to an organization’s work. Activity Based Costing (ABC), often in conjunction with BPR modeling, pulls together all of these factors to enable decisions concerning the advisability, value, and difficulty of implementing various improvement alternatives.

ABC recognizes the causal relationships of cost drivers to activities. Cost drivers are the factors that cause work to be performed and in turn cause costs to be incurred (i.e. resources to be consumed).

The activity based management approach to cost management breaks down an organization into activities. An activity describes what an enterprise does - the way time is spent and the outputs of the process. The principal function of an activity is to convert resources (materials, labor, and technology) into outputs. Activity accounting identifies activities performed in an organization and determines their cost and performance (time and quality).

For purposes of developing an ABC model for the departments, a simple and effective activity based management system incorporating the following steps can be used:

1) Determine enterprise activities.

To identify the activities performed in the IT process a series of surveys and focus group sessions were held with each member of the IT department.

2) Determine activity cost and performance.

Performance is measured as the cost per output, time to perform the activity, and the quality of the output. As part of the interviewing conducted in Step 1, data was collected from each interviewee regarding:
number of transactions for each service area;
duration for performing each activity one time; and
information pertaining to the salary of each individual performing each activity.

Based on the interview results and detailed budget reports, all costs are able to be directly traced to specific activities, except for, miscellaneous expenses and computer supplies. These two categories were allocated to all activities.

3) Determine the output of the activity.

An activity measure (output) is the factor by which the cost of the process varies most directly. For each of the activities identified in the model an output was identified and quantified. These outputs provided the basis for tracing the activity costs to the cost objects.

4) Trace activity cost to cost objects.

Activity costs are traced to cost objects such as products and/or services generated by performing the activities. The best approach to take for identifying the appropriate cost objects is to view the services or products from the perspective of the end user or customer. This is the approach that was used for this cost analysis. The end result of this step is the determination of the costs of various time and attendance methods in the aggregate and on a per transaction basis.

5) Determine corporate short-range and long-term goals (critical success factors).

This requires an understanding of the current cost structure, which indicates how effectively operating activities deliver value to the customer. An assessment is then made based on these critical success factors as to which activities are non-value added and which are value added. Non-value added activities are those activities not providing value to the customer or to the business. These activities are candidates for elimination. Value added activities are by definition critical to the success of the enterprise’s mission.

6) Evaluate activity effectiveness and efficiency.

Knowing the critical success factors enables an organization to examine what it is now doing and the relationship of that action to achieving those goals. Everything a company does - or avoids doing - is measured against the short and long-term goals. This provides a useful formula on which to base a decision whether to continue performing or to restructure an activity. Also, cost control is improved by ascertaining if there are superior methods of performing an activity, identifying wasteful activities, and determining the cause of the cost.  

In the example above, let’s say you are confident that ABC, Inc.’s announcement will increase the stock value within 90 days.

You buy an option to buy 100 shares of ABC, Inc. at $110 per share for the next 90 days, ending at the end of November. The option is a call (the holder has the right, not the obligation, to buy 100 shares of ABC, Inc. at a price of $110 between now and November). It would be written like this, “ABC, Inc. November 110 call”.

After you buy the call option, you hope the stock will increase in value. This rise might be because the product is innovative and a positive advantage to the value of ABC, Inc..

As a result, suppose the stock value goes up to $125 per share in October and you “exercise your option”. That means you now buy the 100 shares at $110 per share and immediately sell them at $125 per share. You made $15 per share or $1,500. If the cost of the option was $250, then you made $1,250.

Now suppose the stock declines from the time you buy your option and at the end of November, the stock is selling for $90 per share. You simply choose not to exercise your option. You are out the $250 that the option cost but if you had purchased the stock at $110, you’d be out $2,000.

Let’s see a slightly different example…..

Now suppose you are really confident that the price of gold is going to go up as a result of a rise in tensions or a full blown outbreak of violence in the Middle East. Such a rise in gold might also rise as a result the outbreak of a political scandal in our own congress or some market segment of the US economy - like the housing market, savings and loans, mortgage holders, Wall Street insider trading, major trade imbalance, devaluation of the dollar, or any of a number of similar and predictable events.

Suppose you bought a call option in August 2007 for 120 days for 1000 ounces of gold at the going rate in August, let’s say it is $650 per ounce. Now you wait and watch the gold price increase as the Middle East and political problems approach and there is an increasing degree of panic among investors. The option is not cheap. It might be as much as $2,500.

By the late of December 2007, the price has gone up to $875 per ounce. You decide to exercise your option. You buy 1000 ounces of gold at $650 and immediately sell it at $875. You keep the difference of $225,000 minus the cost of the option. You pocket a total of $222,500.
But you are not done yet.

It is now January 2008, and the prospect that new politicians will resolve the Middle East issues is improving. There is also the issue of “regression to the mean”. The price of gold is way above its mean of under $500 for the past 35 years. It is unlikely to be able to sustain a 200% rise in the price of gold for very much longer.

As a result, you might be confident that the Middle East/political problem and the investor panic will subside sometime after December 2007 with a corresponding decrease in the price of gold. So in early December 2007, you buy another option. This one is a “put” option.

Your option is for 120 days for 1000 ounces at $875 per ounce. This means that if you exercise your option, the broker will buy your gold at $875 per ounce. In this mythical scenario, the option cost is still $2,500.

Now you wait until the end of February or into March 2008 and see that further political primaries, the Iraq surge and other events have dampened the turmoil in the Middle East and on the home economic front and the price of gold has dropped back to $600 per ounce. You buy 1000 ounces at that price and then exercise your option to sell it at $875 per ounce. The difference of $275,000 minus the cost of the option, nets you $272,500. Combined with your call option, you cleared $495,000 in 6 months and had virtually no out of pocket expense*.

Had the price of gold not followed the expected predictions, you were at risk for the first $2,500 call option but by early December, you would see that the price of gold is not following the predicted trends and you would decide to not buy the second option.