21st Century Economics

Nearly all of the wars in the past 3,000 years can be traced to having a strong motivating factor of a disparate distribution of wealth within or between countries. When that has not been the direct cause, it has been a major contribution factor.

Now consider this:

The United Nations reported last month that the net worth of the three richest families in the world (the Gates family, the Sultan of Brunei and the Walton family) is greater than the gross domestic product of the 43 poorest nations on Earth — combined.

A recent issue of Nation contained an article noting that pharmaceutical companies spend far, far more money researching lifestyle drugs for the affluent than life-saving drugs for the hundreds of millions of the world’s poor people. Instead of trying to come up with treatments for life-threatening diseases, resources go into treatments for wrinkles, impotence, baldness and obesity.

Recent business surveys indicate that the ratio of the salary and perks of a firm’s CEO to that of the average employee of the firm is at an all-time high. Nowhere in the world is it higher than in the US.

Other studies indicate that although profits are rising, productivity is increasing and the stock market is advancing, employee compensation remains flat.

A professor at New York University estimates that the richest 1 percent of Americans own half of all stocks, bonds and other assets.

These stories and many more like them indicate that there has a been a basic paradigm change in our basic moral sense of fairness and philanthropy. Greed, ego and self-preservation has taken over as the predominant factor in many social and business decisions. Although this is being observed all over the globe, it is by far the most egregious in America.

Other reports in this information service have also told you about the “information haves and have-nots” and the impact of that growing gap.
Combine this with the historical cause of revolutions, wars and social upheavals and you have the formula for some bad, sad times to come.

Of course, the object of this blog is to discuss Profit and that does certainly seem to demand that we limit our rock throwing while standing in our glass house but there are good reasons why we must examine even the worst of our most advantageous behavior.

The simple answer is that there is not a shred of evidence, analytical data or economic, historical or scientific justification to believe that the good times will continue for very much longer. In fact, by historical standards, we are way overdue. By social standards, we are stretching the rubber band of class tensions almost to the breaking point. By economic standards, we have surpassed conditions which have, in the past, precipitated great economic upheavals or social unrest. Standby, it will happen again.

As an investor, you should understand two very important factors that have been absolutely proven to be fact:

Timing Does Not Work - Study after study has shown that, in the long run (actually as short as 3 years)that investment timing does not work as compared to invest and hold strategies.

This does not, of course, apply to investments in known events that have an economic consequence. In fact, that is precisely the premise of 21st Century Economics - that the only way to make a timely investment is to either (1) plan for a long term investment or (2) invest in a known event that has economic consequence. The failure of the timing in the classic sense is that it applies to the chasing of money that is common in day trading and in the rapid and short sighted buy-sell mentality that has always pervaded Wall Street. See a separate report on this subject elsewhere on this service.

Good Times Don’t Last Forever - The extensive reporting contained elsewhere in this service on the concept of Regression to the Mean is not an investment philosophy. It is scientific and mathematic fact. The mean growth rate of the stock market since before 1900 has been under 7% - no matter how you figure it or what adjustments you make. We have had a 3 year growth rate in excess of 25%. It is a FACT and an absolute certainty that 50 years from now, we will again look back at the average growth of the stock market and it will not be appreciably higher than 7%.

Any finite period can show growth or loss depending on the time selected but over long periods of time, a gradual increase in the rate of growth is possible but nothing like 25% - more like 3% in 50 years. If the mean that the average growth of the market returns to is 10% in 50 years - then when do you suppose it will change from 25% growth back to less than 10% so that its mean will be 10% in 50 years?

What all this rambling is about is that the known event that has economic consequence is that our world society is headed for a major adjustment in the social order based on the distribution of wealth, information and influence. That “adjustment” will be of such large economic consequence that those that have money now will need to begin now to prepare for it.

How? Like this:

Diversify your portfolio - The tried and true investment strategy of spreading your money across a range of investments is an old one precisely because it works.

Pay off Debt - We are a debtor nation now, currently spending more than we earn and with a national savings that is negative. When the economic turnaround happens, you don’t want to be in debt for a lot of luxury items that you can’t afford to maintain. If you are wealthy now, use that wealth to pay off your debt. If you are spending beyond your means now, stop and begin to prepare for a time when those that do that will be on the streets, out of work or worse.

Save - I am not going to predict the nature of the economic turnaround that will happen, only to say with confidence that it will happen but there are certainly some powerful pointers that it will not be good.

The retiring baby boomers will cause the real estate collapse of the second decade of the new millennium will the worst in history.

The boomers will also create the worst stock market fall in history - mostly because of how high it has risen above the “norm”.

If we make it to 2010 without a major social upheaval that is economically motivated, then the one that is motivated by the aging world population, demands on the publicly funded infrastructure and the disproportionate power of the older generation will certainly cause problems.

Wealth:
A professor at New York University estimates that the richest 1 percent of Americans own half of all stocks, bonds and other assets.
Power: Largely as a result of the wealth and also due to the usual time in one’s life that you typically gain that wealth, the vast majority of the power in this country is in the hands of the “older” generation - that is, those age 43 to 65. This is the age that most people exercise the most influence on their environment because it is in their interest and ability to do so.

Influence:
A recent study revealed that 80% of the domestic news stories on television network news concern only 4% of people; most of the remaining 20 percent of domestic stories on the evening news cover the other 260 million of us.

Demographics:
The aging population of the US and the rest of the world means that the wealth, power and influence will continue to shift more and more into the hands of an older and older population.

Impact

Politics:
We know that the older generation is largely conservative and mostly Democrats. They favor the continued high levels of spending on the federal level to fund programs that they benefit from such as Social Security, Medicare and tax benefits for the elderly.

This will not only continue but it will rise to levels never seen before - Rise to levels that will make the other age groups and generations into minority citizens with no control over their own lives and futures.

Investments:
For the most part, the finances of the era of retiring boomers will be a shambles.

(1) 71 million baby boomers will be trying to sell their stock portfolios at the same time - dropping the market to its lowest level in 75 years;

(2) 71 million baby boomers will be trying to sell their expensive homes in order to move into more modest sized retirement condos. This will create the greatest drop in real estate prices in history. One bedroom Florida condos will cost $200,000 while the 30 room brick colonial in upstate New York will remain on the market for 3-4 years while the price drops to below its current mortgage balance and sells for under $150,000;

(3) When 71 million baby boomers reach retirement, we will see the effects of three decades of excess at the expense of no savings. Social Security and Medicare will be overwhelmed while millions of boomers that did not save discover they cannot maintain their previous lifestyles on their $900/mo. social security stipend. They will vote, in mass to increase Social Secuity taxes to the loss of millions of younger workers.

Society:
The conservative nature of society will pervade everything. Care designs, books, movies, music, religion and news. The majority of the audience for the mass media will be old people with money. Who do you think they will cater to?

Wealth, Power and Influence is about to undergo a major adjustment in the next two decades, it will change everything - especially investment opportunities - or lack thereof.

In the 60’s and 70’s, as the baby boomers moved into the marketplace, the flood of labor drove labor prices down and created intense competition for jobs. The early boomers - born in the late 40’s and early 50’s - moved into and up the corporate ladder fairly easily but they were still there when the late boomers - born in the late 50’s and early 60’s - arrived. This slowed expansion and limited movement up the corporate ladder.

This and other aspects of the massive movement of the baby boomers into the labor force have had far reaching effects on our economy and on the world economy. Many of these effects are not immediately obvious.

Let’s examine some:

As the competition for jobs increased, businesses found that they did not have to pay premium rates for labor to get a good labor force. Conversely, they discovered that they could grow in size of the labor force while keeping their percentage of investment in labor about the same. This allowed many companies to grow every large at relatively modest increases in labor costs.

For awhile, the large labor market and large company sizes worked well but when normal cost of living and inflation caused labor prices to rise, the companies found they had a glut of labor that they did not need and that productivity was inefficient. This set up the stage for massive layoffs in the late 80’s and early 90’s that eliminated entire layers of management and consolidated tasks into fewer workers.

The lower labor cost prompted many companies to NOT invest in labor saving devices such as robotics in the automobile industry. Meanwhile Japan did invest in robotics and other forms of automation and labor saving devices.

When the slowly rising labor costs did push US companies to re-examine their labor situation, they found themselves no longer competitive with foreign manufacturers and labor markets. This setup the massive movement to move labor off-shore and into cheaper third-world labor markets. The loss of revenue from the labor and taxes of the lost jobs created recessions in 1975, 1980, 1982 and 1990. The median household income dropped to a 14 year low in 1982 and dipped again to 1971 levels in 1994. During that same period, personal savings as a percentage of disposable personal income dropped to record lows in the late 80’s and has continued lower every since. It hit 3.8% in 1997, the lowest level in 58 years.

Because it took time to adjust the labor market and the productivity efficiencies to the global market changes, the business inventories versus sales ratio rose to a record high in 1991 of 1.80 before falling to a low of 1.35 in 1999. This 1991 figure meant that we had more supply than demand and prices, at that time, were not competitive. This put even greater pressure to lower prices to clear out existing inventories and to control production.

For reasons not entirely clear, there has been a remarkable correlation between the percentage of the labor force that is aged 16 to 34 and inflation. As the boomers moved through this age group in the late 70’s and early 80’s we saw double digit inflation. One theory is that the politics of the economy followed the mood of the voters - at that time, being more liberal than conservative. As he boomers move into their late 40’s and 50’s, we should be able to expect a more conservative economic policy being demanded by the voters.

As the work force ages, there will be changes in how the labor is performed. For instance, one grocery chain found that its employee turnover rate dropped from 400% per year to just 80% per year when they began to hire more older workers.

The middle boom years, 1964 to 1977 when birth rates were down, will create a relative scarcity of workers that will have the reverse effect that the boomers had. Labor wages will climb as companies compete for the fewer workers available. In fact, labor costs have risen by 45% over the past 10 years. There will also be a renewed interest in capital investment in labor saving equipment such as robotics and computer automation. This has created a large rise in investments in plant and equipment since the mid 1990s. It is therefore not a surprise that in 1997, the business investment in plant and equipment as a share of total economic activity rose to a record level of 16% in 1997 (not counting WWII years).

All in all, the demographic economy of the boomer labor force has been one of intense competition in a buyers (employers) market, over supply and lowered wages. In the later retirement years of the boomers, that trend will reverse and there will be an intense competition in a sellers (employees) market, a significantly reduced market and higher wages.

It should be noted that the present economic bull years when the boomers are investing heavily in business and industry, there have been significant expansions of those businesses. This is reflected in the lowest unemployment figures in decades. Unfortunately, when the bulge of the boomer’s prime employment years pass, the period from 1964 to 1977 produced a greatly reduced birth rate. This expanded demand plus the reduced supply will drive wage prices up, unemployment will remain low and there will be a major growth in incentives and benefits to attract and keep workers.

The market demand from the buyers controls the market supply from the sellers. In other words, the seller sells what the buyer is buying. If the demand increases, the supply will expand to meet that demand. There is often a small delay between rapid rises in demand before the supply catches up but this is not of particular importance to large slow swings of market demand as a result of demographic changes. (It can be a factor in fad or impulse marketing, however.)

It is an established fact that people in certain ages of life and career will, on average, buy certain things that are often in common with others in that same age of life or career. For instance, we know that, on average, people buy their first homes between the ages of 25 and 34. Most of this is common sense - you don’t market hearing aids to teenagers or toy dolls to senior citizens. In fact, nearly the entire market of a capitalist economy is based on this concept.

Having established this short list of facts that most of us will agree are intuitively obvious, let’s now look at some additional facts. These are FACTS that can be verified from a number of sources but perhaps the best is the US Census Bureau.

There are 71 million households (76 million people) that can be called part of the Baby Boomers - those born between 1946 and 1964.
An Echo Boom of 64 million people (currently making up 41 million households and growing) are the children of the Baby Boomers - are those born from 1977 to 1993.

Between 1964 and 1977, there was a relatively slow birth rate of 41 million babies.

In the next 50 years (1999 to 2050), the share of the US population age 65 or older will go from 12.5% today to 21% - a 68% rise.
The number of people 85 and older will grow to 19 million from just over 3 million today - a 533% rise.

In 1940, 7% of those 65 are expected to survive to age 90. Today, the figure is 25%. By 2050, 42% of the 65 year olds will survive to age 90. (Believed to be a conservative estimate)

These and other similar statistics make up what we call the demographic economics of the boomers and their effects on our economy. Because so many of us are actually a part of this group, we have not visualized it as an historical or unique event but simply the way life is. If you can step back and see this in perspective to what has happened to world economies in the past and how it will affects us in the future, you begin to see this a much more powerful and predicable series of events. And as you know by now, If you can predict an event, you can profit from it!

Imagine if you had been aware of this situation in the 1950’s - what would have been a good investment? How about everything related to schools? As the bulge in boomers moved from kindergartens, to elementary to high school, the demand for books, clothes, food and schoolteachers expanded to historic highs. Gerber foods, for example, doubled its sales in just two years from 1948 to 1950.

In the 70’s and 80’s, the real estate boom was entirely predicable. You had 76 million people competing for the existing housing and the demand exceed the supply for a long time.

If you had invested in industries that supplied this massive but evolving demand, you could have made a fortune - as many did.

In retrospect, you can see lots of missed opportunities but the nice thing about demographics of this kind is that the opportunities are not over yet. The boomers and echo boomers are still there and still affecting the economy in a very big way.

The massive bull market we have been experiencing is no accident and it surely is not the results of actions by our President or Congress - despite the fact that they try repeatedly to take credit for it. It is because 76 million baby boomers (roughly 27% of the entire US population) have moved into their peak earning and their peak spending years.

Sales of new accounts in mutual funds exceeded $1 billion in a 30 day period in January 1998 for the first time in history. In 1960, there was a total of $640 billion in all mutual funds. Now there is more than $7 trillion. Almost all of that was invested by the boomers during their peak earning years. The early boomers are already moving into the age of retirement. This is why there is now more money in mutual funds and other investments than ever before in history.

But it’s not a totally rosy picture. The boomers will move on to the next stage in life starting in 2007 when the oldest ones begin to reach retirement age. The related changes in their buying and saving habits will have a marked and profound affect on our economy and the world. In fact, it is predicted to be the worse economic period in our history and perhaps for the entire world will follow the boomers into retirement.

21st Century Economics will show you the what’s, why’s and how’s to survive this megatrend and how to profit from it. In fact, if you don’t profit from it, you will be caught in it and suffer significant financial losses and personal hardships. This is not a prediction, it is simply a fact that has not yet happened.

We will be updating this service on a regular basis with new information of what the latest active trends are so that you can get in on the earliest part of the upward turn or get out on the earliest downward turn of a number of specific markets.

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;

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.

Our position, at 21st Century Economics, is that we are not addressing the professional Wall Street investor with our service. We, therefore, do not advocate investments that require minute-by-minute attention to the rises and falls of the value of the investment. Futures trading is like that.

It is for this reason that we at 21st Century Economics do not advocate anyone get into the futures market unless you have lots of excess money, lots of time to learn and follow the market and can take the stress and risks of a very volatile market.  

The Short and Simple Explanation:

You pay a fee for the “option” to buy stock at a future price so you can sell it now. In other words, you have the option to sell some stock now at a high price and then, at some time in the future, you buy it when the stock price has dropped.

The real neat trick is that you can wait until that future time to see if the price did, in fact, rise before you elect to sell the stock at today’s price. If the stock does not rise, you simple elect not to complete the transaction and all you forfeit is the cost of the option.

Typically, you buy the option and then wait to confirm that it is going to go down. If it begins, then you can elect to exercise your option and sell now at its current price of let’s say $110. Suppose you sell 100 shares for a total income of $11,000. Now you wait for the stock price to drop. When it reaches $85 per share, you buy 100 shares for $8,500. You sold the stock for $11,000 and bought it for $8,500. You made $2,500 minus the cost of the option.

Typically, the usual option buyer would buy much more than 100 shares. You can see that if you bought 10,000 shares, you would have made $250,000. The advantage is that you bought the 10,000 shares with money you made from the sale of the 10,000 shares. Sounds weird but it’s done everyday on Wall Street. You also have a low risk since if the stock goes up or does not change, you can elect to NOT exercise your option. You lose the fee you paid for the option but that’s all you are out of pocket.

Where this is most useful is when you KNOW that the stock will move down. In the case of a known political, economic or Middle East crisis, we often do KNOW that some stocks will go down and some will go up and then down. Therein lies your chance for profit.

You should read this next section but you can also skip down to the section marked Cautions.

The Longer Explanation:

As you might expect, it’s a little more complicated than what is listed above. Here’s how it really works.

You tell your broker you want to short 100 shares of ABC, Inc. at $110. This means that you are entering into an agreement with the broker to temporarily borrow 100 shares of this stock at $110/share for specified period of time. Technically, you are borrowing the 100 shares from your broker in order to sell them to someone else at the current price of $110.

The broker either has the shares in inventory or he borrowed them from a client or another brokerage firm. The sale is made and the shares are now in the hands of a third party that has paid $110 per share for them. At this point, you have not paid the broker any money but you do owe him for the 100 shares.

Now you wait. If the price of ABC, Inc. goes down, to $85, you then buy 100 shares of the stock at that price. You have now spent $8,500 for the 100 shares of stock. You now return to your broker the 100 shares of ABC, Inc. stock that you borrowed. You borrowed the stock at $110 and sold it at that price for $11,000. Then, later, you bought it back at $85. You made $25 per share in profit or $2,500. You sold the borrowed stock for $11,000 and bought it back for $8,500. Technically, you sold something before you owned it and bought it back after you sold it. Sounds crazy but that is what is called Selling Short.

Under some circumstances, it is possible to return the stock to the broker before you have to pay to buy it meaning that it is a paperwork drill until he sends you your $2,500 profit.

Cautions:

As with all stock transactions, there is a down side to this activity. Suppose the price of ABC, Inc. goes up to $125. You borrowed it from the broker and sold it at $110. Now he wants his stock back but the price has gone up. You now have to go into the market and buy 100 shares of ABC, Inc. at $125 per share or $12,500. You can then return the loaned stock to the broker. In this case, you lost $1,250.

There are ways to protect yourself from too much of a rise in price by using a ‘buy stop’ order GTC (Good Till Canceled). You decide that if the price of ABC, Inc. rises $5 you want to get out of the deal. You would place a buy stop order at $115. Then, if the price of ABC, Inc. rises to $115, you are assured that you will get out at about $115.

You may also want to get out of a short trade when you have hit a certain amount of profit. In this case, you would use a buy stop at you maximum loss level and a buy stop at your profit target level. This is called an either/or order. You are placing two orders to protect you if the stock rises and to take profit if the stock declines.

For the most part, brokerage firms do not place a time limit on the shares of stock they loan. This is because they make a commission both ways. And also, they want to keep the customer happy. There are some other rules and limits on this kind of sale but it has its rewards.

As you will see, selling short is a very useful technique when you know a stock or other investment will go down. What do you think will happen to all those defense contracting companies after this Iraq crisis all dies down? What do you think will happen to those defense contracts - like with Haliburton, if an anti-war president is put into power in 2009? What do you think will happen to GOLD after the panic passes about an oil crisis or a war with Iran? You can bet money that they will go down from their Bush Era highs. Make Money!