A Small Cap-Based Disproof of the Efficient Market Theory (EMT)

I have a puzzle to pose to those of you who have slightly more training than the common investor. 

I found this graph at a Fundrise page for an innovation venture fund.

I am contending that the data on this graph effectively disproves EMT. Can you explain why I am making this claim?

If it is not evident, I can give you a hint. It is: What if you consider the Stocks, Bonds, Bills, and Inflation results versus this graph?

If the answer is still not at hand, then let me give you a second clue: consider the material presented on this Fundrise page about private equity. 

The EMT Problem

The first important clue to the puzzle is that the small cap ROR shown above is below that of mid cap and large cap equities. We should generally expect that riskier investments have higher rates of return, but somehow that has not been the case from 1984 to 2015. The volatility is in the right direction, but not ROR. Mid cap equities have both higher return and higher volatility, as we would expect. 

A parallel problem is that non-U.S. equities have much higher volatility, but lower ROR than any of the U.S. equity categories. 

Another important clue: Buyout funds have higher ROR and lower volatility than any of the equity classes. 

A Thesis about Why Small Caps have Under-performed

An important point made in the Fundrise page is that tech companies have been remaining private longer. Some of them emerge from their IPOs as mid caps or large caps. Private capital is capturing more of the gains of early stage companies. That leads us to the conclusion:

Private equity is skimming off the best small cap companies from the public markets.

But if the market were efficient, then their attempts to "skim" would for naught, as any attempt to buy the "best" small cap stocks would be countered by higher small cap prices in the public markets prior to acquisition. The way to get a reduction of the small cap ROR from the SBBI results (which include 1926 to 1984 as well as the more recent years) is for private equity to have a "stock picker's edge" in selecting small cap stocks.

This edge can also be seen in the high ROR for buyout funds.

Not all small caps were bought by private equity funds. Some were bought by other public companies, including public companies that had an edge in buying their small cap competitors. The FAANGM have bought and eaten hundreds of small cap companies over the last 20 years, and it wouldn't surprise anyone if the people running those companies had an inside edge on which public (or non-public) small cap companies were worth buying. Or you could think of the FAANGM as being venture or mutual funds in themselves. Then the excess return one would typically associate with a small cap instead would show up as enhanced return of the tech large cap stocks. This certainly feels plausible, as the FAANGM cluster has done inordinately well over the past 10 to 12 years.

Entanglements with SBBI

This presents problems for those who rely (such as we did in our advice on outperforming professional investors) on SBBI results to prospect for future returns. If the future small cap candidate pool will have been cherry-picked by private equity, then what does that say about the future of SBBI and small cap index funds?

What could account for this outcome? SBBI only dates back to the early 1970s. As the SBBI results became more widely believed (perhaps in the mid-1980s?), private equity became an increasingly large force in the overall marketplace for equity. We might think that there were forces tending to make the market efficient, and this is reflected in how private equity has been scooping superior small caps from the market. If there had not been a small cap premium, there wouldn't be opportunities for capturing the excess that fed private equity.

One piece is missing: Many would argue that a strong component of private equity performance is the additional management expertise, aligned with capital, that can be brought to a deal. Then a small cap equity returning 12% in the public market could in theory return perhaps 13% or 14% or more under alternate ownership. This in turn means that public small cap stocks that would "naturally" return less than 12% could also be bought out and it would be more efficient for private equity to buy them and manage them than if they were publicly owned. An 11% stock with a 2% gain due to private ownership then becomes a 13% return; better than public ROR, and better than if the private acquirer were to only hold a partial stake in the company as publicly owned. This in turn would then explain the gap in the graph above. Only below average small caps would remain in the market after private equity had cherry-picked the better performers.

Other Theories About Small Business Formation

If business formation is substandard to past eras, then the supply of small business could be less than the long term historical norms. I have not made a systematic study of this, but this chart seems to show that U.S. business formation has been declining.

We also have anecdotes like the "flying cars" comment by Peter Thiel that expresses this sentiment. Government regulation has increased over the last 30+ years as well. The economy has shifted from rewarding physical work to intellectual work, starting in the early 1970s, which raises both the entrance requirements for building the average new business and the stakes involved.

If we assume that the efficient market theory applies to privately owned small businesses all the way down to sole proprietorships and companies employing less than 15 people, then this graph is not something that can be overcome by "boosting" small businesses via Small Business Development Centers, government programs, special grants to disadvantaged entrepreneurs, and similar interventions. Special programs that favor women-owned, minority-owned, and Native American-owned businesses in Federal Government contracting are rampant and have been in place for a long time, so there are more opportunities for entrepreneurs, not fewer.

It could also be that the costs of being a public company are higher than before. Increased regulation would also cause this to happen. If so, then the founder of a private company would tend to hold onto it longer before selling shares to the public, and therefore could potentially collect more of the superior returns available inherently in the business while it is growing rapidly. This also matches what Fundrise's second chart shows:

(Considering the current moral climate of the country, I feel it worth mentioning that having the founder "skim" from his own company by delaying when he takes his company public is completely fair. It is ridiculous to suggest otherwise; no owner "owes" it to others to take a company public sooner. Before 2020 I would not have written those sentences; now I feel that such needs to be said because there are many people who will automatically assume that founders have a duty to work harder than everyone else, take the risks on themselves, and then deliver the resulting profits to the public for free.)

If there is a shortage of small caps, then the value generated by a good new small business will be captured faster than it was before. So, from the perspective of an investor who is also willing to be an active investor, this era calls for angel investments and personal entrepreneurship as active and increasing percentages of the total investment portfolio. It is certainly the case that a great business will reward the owner far beyond the SBBI averages. If you can maintain a 20% to 30% ROE, then your money is better placed on the liabilities side of the general ledger of a small business you run yourself, because that's your return, 20% to 30%.

In some circles it might be common to write poetic lamentations about how people have lost their fire, their passion for new ventures. I scarcely think that is relevant; it is just emoting. If we believe America's SBDC and their 8/2/2022 blog entry, business formation is not suffering from any lack of enthusiasm:

"2021 broke a record year for entrepreneurship with five million new businesses started."

Where to Put Your Mind

It is a never-ending quandary in investing that you can never know enough to create an optimal investment portfolio. If you broaden your search and knowledge, then your expertise in a particular sector will be thin compared to those who specialize in that sector. If you specialize in a sector, then you may outperform others in that sector while completely missing out on other sectors that outperform yours. With enough hubris and in-borne talent you might attempt to know a lot about everything, but even if you succeed, by the time you learn it the knowledge will be obsolete or you will have allowed too much of your life to pass by to enjoy the fruits of your information advantage. 

It gets worse. With respect to knowledge about a particular sector or stock, understanding your position in a skill hierarchy is costly. Even when you act within your circle of competence, you must decide either to act with your current level of superior knowledge, or invest more time in refining it further, to beat the competition. Among specialists with which you compete some may have greater talent than you, but in order to know when you are at the top of the game you would need to invest time in learning how much the other experts know and how much they are investing in sharpening their skills. Such an effort would then compete with the time you have to invest in sharpening your skills.

When understanding the broader landscape, the more you search, the more time expended. You can attempt to locate the best performing sector, but at the start there is no guarantee that you will find it within an appropriate level of effort, or that the differentials among sectors will be worth the investment in cataloging their relative performance. Even if you locate an outperforming sector, you must then engage in extracting value from that knowledge, which may involve understanding that sector in at least some degree of detail. You might make the assumption that indexing across the sector would be sufficient, but in order to be sure that the assumption was correct, you would need to expend further effort understanding your selected sector.

Supposing that you were lucky or informed so as to have good breadth of knowledge of sector performance and depth within a chosen sector, you would still have the problem of evaluating the degree to which your knowledge would decay over time. That would control whether the advantage gained from the time invested would actually pay off in greater rates of return for long enough to pay back your time investment.

Systematic Methods

Those in quantitative professions are likely to answer these doubts with a systematic approach. The answer, at least to start, might be to survey, index, and gather numeric data on potential investments. This is certainly preferable to having no information, and in my personal experience, quantitative objective data is far superior to hunches and qualitative, subjective judgment. Still, as described above, there are limits to how much quantitative methods will advance your cause, and it can be costly. 

Perhaps the worst quantitative problem was a quip I heard many years ago that I'll loosely paraphrase: "The trouble with quantitative investing is that it finds the biggest flaw in your data and puts all of your money there." This was in the context of automated quantitative investing, which "quants" do.

When I say "quantitative" (vs. "quant") I mean any sort of numeric analysis and comparison method, starting with analyzing the balance sheet, income statement, and cash flow statements, and including fundamental ratios (PE, P/S, margins, ROE), revenue and earnings histories, and more tactical data like same store sales, customer account retention, employee turnover, and market share. It also means comparison of a large number of stocks side-by-side in some fashion, valuation, and comparison to historical values. Though quantitative methods have a tendency to consume lots of resources before they produce results, the large majority of such data is nearly impossible for the human brain to grasp at once. Such data figuratively makes the difference between being blind and seeing trends.

Notice that although I am not including any form of technical analysis in my definition of "quantitative", some aspects nevertheless qualify as objective, numeric, and potentially automated, so as to eliminate bias. In this sense, although I will claim that I make little to no use of technical price and volume analysis, it at least has some advantage over purely subjective methods because of its numeric nature.

Focusing Methods: Theory

Where do you put your attention? Do you even have control of it? This is a deep question of psychology and philosophy, and will lead you to considerations of free will if you carry it too far. If you've read to this point it is probably fair to say at least that you are attracted to the idea of improving investment results by paying attention to something, including the subject of focus.

The focus problem is another quandary, an aspect of the "optimal information gathering" problem described above. For the sake of discussion, I will confine this analysis to what to focus on once you have already allocated attention to the problem of inspecting your investments. There isn't much to be gained in looking at why you don't have time for investments, or can't even start thinking about them. You likely aren't reading this post if you fall into those categories.

To begin, although some prominent people have declared that focus was helpful to their success, it's not clear that a concentrated focus is a critical activity. Too much concentration might lead one to overlook obvious dangers or obvious gains. Too little might lead to inaction. What is the optimal level? What gets the job done? Aside from homespun bromides, I'm not aware of any scientific research, success stories, or compelling common sense that declares that "this level of focus is the right one," whatever that might be. Some clearly non-optimal levels of focus are none and too much. 

Nevertheless, focus strongly affects your investments. You can't buy something you aren't aware of, and if you are too aware of your own holdings, you won't have the adverse information and perspective you need to sell them when it is objectively required. There are many, many opportunities for regret, some leading to "analysis paralysis" in which you become so aware of the many things you don't know, and compelled to find out before acting, that the information search prohibits you from taking any action until it is too late.

Though I've come nowhere close to "proving" that there is no optimal focusing method, it seems that this line of investigation is showing that there might not be anything close to an "optimal" focusing method, so instead we turn to smaller measures. We shall be inspired by folklore and common sense here.

Practical Focusing Methods

This section will use a brainstormed list of ideas for maintaining focus, obtaining or re-obtaining focus, or changing focus. Since these are practical and not theoretical methods, the proof of their performance will be in whether they work for the reader.

• making a checklist once, for today, at the beginning of the day, and going through it
• using a canned checklist that contains items that historically have been useful to review, or which at least we think might be useful to review
• looking around to see what catches your attention right now (requires that looking around be slightly more than just doing nothing)
• asking people near you what's new
• looking at an internet-based website that has a feed based on (something)
• meditating
• reflecting on what is more important, perhaps as amplified by a Franklin-Covey planner or similar time-tracking system, and using critical long term goals that can be fed through near term actions
• reading psychology papers, such as Kahneman and Tversky's psychology papers on non-rational thinking, or the behavioral economics literature, and reflecting on how those principles impact whatever it is that you are supposed to be doing today
• just doing it

Is this list satisfying? I would not be surprised if it leaves you cold. Perhaps you are thinking that I didn't really do my homework today, that this list really ought to be different, better, more complete, or more informed by research. If so, please comment. 

Using The Force to Jump Outside the Box

This article originally started as the introduction to the BDC survey I published earlier this week. It grew beyond that mission and so became its own article. The focus section was started on twice, resisted being written at least once, and perhaps changed shape overnight after the first attempt. At this moment, as I write this, my own impression is that the topic of focus is probably very misunderstood among practitioners. Nearly every industry business standard or development standard (CMM, CMMI, ISO, Kanban, DevOps, Six Sigma, etc.) involves some of the steps in the list above, with very strong emphasis on doing something, a business practice, over and over again in repeatable ways. What's missing is any sort of approach when you have a problem that is not repeatable.

The first bit of folklore to use to illustrate the problem is "the Force" in Star Wars. Is this a focus trick? It certainly seems to be. The Jedi advice is, roughly, do not plan or worry too much about the future, that rather than have your mind elsewhere, one should focus on being where they are.

"Always remember, your focus determines your reality." 

“Your eyes can deceive you. Don’t trust them.”

“Mind tricks don’t work on me.”

“Don't center on your anxieties, Obi-Wan. Keep your concentration here and now, where it belongs.”

Many years ago I spent a day playing a business game called Gold of the Desert Kings. Each team's task was to travel (virtually, via a game board with markers and other game accessories) across the desert, mine gold, and bring it back. Although at first you were given part of the goal of the game, you were not told much about anything else. Rules, options, potential events, and other details were omitted at the beginning. Turns were timed, with hard deadlines. Lots of information was unknown, but you were allowed to ask some types of questions. 

After it was over, during the debriefing, we were told a story. Who was the highest scoring team ever and how did they achieve it? The answer, was that the team asked early in the game what was possible, what was the previous highest score? Having obtained that answer, they could then work backwards and deduce other unknown aspects of the game. The lesson seems to have been: Find out what is possible before deciding what to do. 

The meta lesson: Jump outside the box before establishing a focus. 

This lesson too will be unsatisfying and inapplicable to some circumstances. If we have no free will the question of where to put focus and this answer are meaningless. But perhaps we do have free will, and making an effort to consider the problem is part of the art of obtaining "optimal focus", if there is such a thing. In the process of journeying briefly through the problem of where to put your attention, perhaps we have improved our chances at putting it in places of most utility.

Pizzarias: A Forgotten Favorite with Unusual Comeback Potential?

Some snack foods develop very loyal followings. One I learned about today, but I never tasted myself, is Keebler's Pizzarias. They were introduced in 1991 and were supposedly an instant hit:

Pizzarias were made in a novel process from fresh pizza dough and were available in three flavors: Cheese Pizza, Pizza Supreme, and Zesty Pepperoni. Launched in 1991, Pizzarias were reported to be the most successful snack food launch in Keebler's history, earning wholesale revenue of $75 million in their first year. Due to the success of the Pizzarias launch, Keebler was named "New Product Marketer of the Year" in 1992 by the American Marketing Association. Pizzarias also earned a Gold Edison award from the AMA for marketing excellence.

How loyal? Although discontinued in the 1990s (?), the brand has two Facebook groups and its own Wikipedia page. A Reddit posting to r/nostalgia mentioned Pizzarias 4 days ago.

Why would a successful brand be discontinued? Perhaps because management overlooked it. Actually, many managements (plural).

At the time of Pizzarias' introduction, it looks like Keebler was owned by United Biscuits. United Biscuits sold Keebler to Flowers Industries and Artal Luxembourg, a private equity firm in 1997. In 2001 Keebler was bought by Kellogg Company. In 2019 Kellogg sold Keebler to Ferrero SpA. 

At some point, the right to the Pizzarias brand changed hands separately from Keebler. According to this Wikipedia article on Pizzarias, Utz Brands now owns the Pizzarias brand.

Assuming a unit wholesale price of 80 cents, Keebler might have sold 94 million units in 1991. If Utz were to reintroduce the product today, assuming a 50% reduction in unit sales (because of health consciousness) but an increase of, say, 25% due to higher population and faster social contagion, and 50% higher unit price, then a re-introduction could be worth $88 million in revenue in the first year. Or, social media could cause it to go viral, at double the 1991 unit sales, and then the first year would produce $352 million in revenue. Perhaps a vegetable topping-based flavor variant with onion, bell pepper, and celery? Or maybe a healthy homemade dip could go viral for being famous as the perfect complement to pizza flavor (but especially cheese pizza) chips, where the home-made diced vegetable dip is based on the Cajun "holy trinity" vegetables plus tomato?

A Quick Survey of Business Development Companies (BDCs)

A so far unremarked misadventure of my own the last few years has been making several investment mistakes in mortgage real estate investment trusts (MREITs). Perhaps 10 years ago a friend of mine mentioned that he had invested in Annaly Capital Management Inc (NLY). At that time, I was leery of investing in high-yield financial securities, having observed several equity REITs with high yields crash about a dozen years before. The basic idea of an MREIT is simple enough. The problem I worried about was the conflict of interest management has with shareholders, and the intense competition among companies in the same industry trying to outdo each other in leveraging up their assets. The other problem is that I've never found interest rates to be predictable over the short term, and over the long term the error is more likely to be in holding long-dated bonds as interest rates rise.

Sure enough, my experiments in that sector resulted in mostly setbacks. At the moment I'm not convinced that I have the expertise to pick winners in the MREIT industry, and so I am currently avoiding it.

Still, MREITs are not the only high-yield sector. Another category in the Business Development Company sector. Last week I spent some time exploring it, and I liked what I found much, much more than MREITs. This article will report on my findings.

BDC Structure and Legal Background

The BDC structure originates in a 1980 amendment to the Investment Company Act of 1940. Taxation is pass-through, like a REIT or MREIT. The BDC Wikipedia article and Investopedia have good explanations, so I will say nothing more here. I found the external links section of the Wikipedia article to be a great resource.

Use as a VC-Style Investment

Suppose you've had some success at investing in publicly-traded equities, have watched Shark Tank, and want to go further and get closer to the founding and running of new enterprises? You could start your own business, be an angel investor in friends and acquaintances' businesses, or take other risks like bungee jumping with frayed cords. BDCs offer a way to get the flavor of this style of investing, with smaller initial outlays, liquidity, and diversification. You can choose to pay little attention and just collect dividends, or inspect the portfolios to see the small businesses who are clients. In my short investigation of one BDC's portfolio I found arborists, a cosmetics company, an HVAC services company, several small manufacturers, and a construction company.

Function 

The purpose of BDCs is to provide increased borrowing options for small and medium-sized businesses. The public supplies the capital, a management team (typically fairly small with respect to the investments, of course) supplies concentrated business expertise at judging the riskiness of the client firms, and small business gets credit and expansion opportunities they might not have had otherwise. In my quick view of the business I saw multiple important functions addressed for all parties. The usual business risks are present, as they always are, but there is a fundamental purpose that is quite valuable.

The BDC purpose is not flawed like MREITs. MREITs exist to provide capital to the housing market. Unfortunately, this purpose accidentally provides all of the benefits to the public and real estate brokers. Since mortgage funds then become a commodity, mortgage rates are driven to levels that are unprofitable for the lender, and which also then drive risky behavior by management, who scramble for survival. (Or at least are scrambling for the survival of the enterprise's book value.) Though I have not yet written enough for a full article on the topic of U.S. housing finance, I think there is some reason to believe that the tax-advantaged nature of mortgage debt makes the U.S. housing market inherently unstable, and that instability is reflected in the volatile and generally poor results of the MREITs. 

Selections and Rationale

Closed End Fund Advisors maintains an outstanding database of BDC data. They maintain an extensive database and provide reports on most (all?) closed-end funds. It is well worth your time to go to their excellent, well-presented site and review what they have to offer. (No, I am not affiliated with them and this is not a paid advertisement. I doubt they even know that Vorpal Trade exists.)

I reviewed all 49 BDCs in the database, noting NAV growth especially. My method of sorting for quality using the data was to weight annualized NAV rate of return most highly, and to discount NAV ROR for length of tenure. I was also less interested in BDCs trading at a large premium to their NAV. With those criteria in mind, I found these nine BDCs worth investment: ARCC, CSWC, FDUS, GAIN, NEWT, PNNT, PSEC, SAR, TSLX.

This year's turbulence has driven down prices of most BDCs, so although some have recovered in price over the month of July, you are getting better prices than were available in 2021. Also keep the premium or discount to NAV in mind. The market clearly favors BDCs that generate above average NAV gains, so you might have to pay a premium to get quality.

The vast majority of BDCs are debt-focused, making secured loans. Many will still have some equity or warrants in their portfolio. I saw only two equity-focused BDCs, though I may have missed some others. The past performance of the equity-focused BDCs was not impressive, so none are in my list of nine.

How to Beat the Pros at Common Stock Investing

It is not hard to outperform the average professional investor, if you define "average" as the combined group of mutual fund managers, hedge fund managers, and sell-side brokers operating discretionary accounts. Because this recipe is short and easy to do, this will be a short article.

What is the Average Return?

There are so many professional investors that the average gross performance of managed investments is the market average return. As a large group the professionals cannot help but be average overall. 

Unfortunately for customers, the net return on their investments is reduced from the average, on average over all managers, by the average fees charged by the professional investment managers. These can range from 0.05% for index funds to 1.0% for smaller and specialized mutual funds, to 2% or more for specialized hedge funds. Even for famous mutual fund companies that are well-known to 401(k) participants the fees charged by their actively managed funds may be 0.3% to 0.9%, annually.

What is the average market return? Using the figures produced by SBBI, large cap stocks return about 10% annually, small caps 12% annually. Most professionals that are known are running larger amounts of money, and generally must trade in at least some large cap stocks, so returns (still on average, remember) will be a blend of 10% and 12%, and with some cash always held aside for redemptions or moving between investments, the average return will tend toward 10% or even slightly below. 

Your Strategy

As an independent investor, your strategy to beat those returns involves these steps:

1. Invest in a small cap index fund with a low fee (perhaps 0.05% to 0.15%)
2. Stay fully invested

Your long range rate of return will then be just under 12%, which will beat the average pro's return of just under 10%. You may have intermediate results that are more volatile, but over longer periods the volatility will work in your favor if you add money periodically, as you will be dollar cost averaging.

You may be wondering whether it is possible to improve on the average by market timing. The answer is a strong "not really." Academic papers showed over 30 years ago that at most 2% of investment performance depends on timing, so on average the pros could at most move their 10% large cap returns to 10.2%. The advantage remains with the small caps, and with the low fees of index funds. 

QED

An Outlook for Inflation

The professional economists, including experts, the Fed, university professors, and Paul Krugman, appear to have gotten the call on inflation wrong. Krugman at least admits culpability:

First, yes, the Fed — and a number of economists, me included — called inflation wrong over the past year and a half, which has a reputational cost. Fair enough. But when people talk about policy getting behind the curve, they mean more than being embarrassed 2/

— Paul Krugman (@paulkrugman) July 15, 2022

In this thread he reviews the results of inflation expectation surveys and finds that expectations are moderate or moderating, a sign that current rampant inflation will quickly subside over the next few years. Though human sentiment is of value, this data is not sufficient for predicting the future course of inflation, which will depend on other macro factors.

Three Causes Not Addressed

It takes more than "entrenchment" of expectations to generate inflation. The causes of current inflation include:

1. increases in energy costs, especially prices of crude oil and gasoline;
2. increases in the money supply. M1 and M2;
3. surges in demand for goods and services combined with constraints on production or supply of raw materials.

As I pointed out last week, refiners foresee weak to moderate medium-to-long term demand for gasoline, and therefore do not plan to build new refineries or increase production. U.S. oil production is potentially constrained by the availability of leases on federal lands. International oil production is constrained by warfare in Ukraine and sanctions on Russia. Russia also discovered a war bonus: Sanctions have increased its income from selling oil. Even if the West were to seek to end the war soon or lift sanctions, it's not clear that Russia would increase its output. OPEC and Russia have an incentive to hold down production to raise market prices, and with the U.S. and Europe willing to throttle their own production in the name of climate change, the policy tools may not be in the toolbox to force oil supply to meet demand. 

Since energy is an input to many other costs of production, high prices of oil and gasoline will then have a cascading and continuing influence on pricing of other goods and services.

The second cause, money supply, might not be a cause of future inflation, but the existing increased level will act against possible deflationary influences, as too many dollars will continue to chase goods.

The third case has been drive in part by the so-called Great Resignation, in which people incentivized by government payments or other aspects of COVID-19 decided to retire or stay home rather than work. That doesn't seem to have changed; turnover is still high, and early retirements in many sectors are still unusually high. 

Longer term, constraints on labor supply then depend on net immigration and birth rates. Total fertility rate (TFR) in the U.S. is now below 2.0, where 2.1 is considered the minimum for replacement of a constant population level. Worldwide, TFR is well below 2.0 in nearly every developed country. Europe, China, North America, and Australia have shrinking populations when immigration is excluded. 

The ratio of retirees to workers has been decreasing for decades, and is a big problem for the solvency of Social Security. Even if SS were not a problem, one has to think about what happens to the economy when a third of the population is retired (or trying to be) and the other two-third holds jobs. Clearly the market-clearing prices for labor will rise and be under increasing pressure as time passes. Already we see many, many markets in the U.S. where the "natural" lowest wages payable for entry level work are well above the national minimum wage.

The escape valve for labor costs since 1995 or before has been offshoring, especially to China for manufactured goods and India for IT services. As China's economy booms, wages have been increasing there too. They will not be "cheap" relative to American wages forever. When they catch up, wage inflation in China will then affect goods inflation in the U.S.

Forecast

Officially, there is no Vorpal Trade forecast on inflation. Best I can do is ramble on about what I might believe and why, and then you can take it from there to decide what will happen.

Structurally, the world is presently set up to avoid inflation as long as work can move across national borders. There are limits to the rate of this process, so there will always be pockets of inflation, such as in China, when countries run out of under-employed populations. The amount of liquidity in the US is ridiculous; with so much cash and high absolute levels of wealth even among the poor and middle class long-term low interest rates will still dominate in the long term future.

Against that backdrop is the usual rent-seeking behavior of elites, much of it both unconscious and arising from entitlement feelings. Colleges, medical care, and glamour city real estate will continue to be highly controlled for the benefit of the elite, and will experience severe long term inflation in the future. This is a trend that could go too far. If there were a perception that lack of college was cool, or dying nobly without medical care was cool, or some other crazy systemic shock, then denying medical cost inflation could turn into a macro phenomenon. But the odds are low because these scenarios are just plain weird.

As for the headline numbers, CPI and PPI, they will likely subside once the initial post-COVID YOLO and FOMO impetuses have run their course. In Spring 2022 people finally felt released from the confines of their houses and had enormous spring fever and urges to travel and be outside, which required large amounts of gasoline. People are fond of blaming Biden for high oil prices. He mostly didn't cause it directly, except that restrictive health policies exacerbated the pent up demand for outdoor travel experiences, so in that sense both the CDC and Putin caused our 2022 gas prices. 

The labor shortage is real, as people decided to take the CDC seriously that they might die any minute, so why bother working? It just takes a few percentage points and some poor policy that exacerbates the trend to cause a serious imbalance. Old people are retiring, and since women no longer have children, the old workers are not being replaced by younger ones. Expect labor shortages and wage inflation to continue at rates that are beyond the cost inflation of inputs like fuel and mining outputs.

The other factor that seems remote to U.S. persons but is very unfortunately real to citizens of countries like Sri Lanka is that food prices have exploded and will not retreat because ESG policies will heavily constrain food production. This is a partly world-wide WEF agenda movement that will constrain food production in a way that we haven't seen before. I see very little chance of the ESG and pro-WEF folks backing down. The starvation caused by food restrictions is, unfortunately, part of the plan, and since the first world elite will deny that this pain exists, it will continue.

We cannot foresee the political fallout. As for inflation economics, the net result will be strange: computers, games, television, communications, gadgets, and clothes will show little to no inflation, while medical care, transportation, and food will continue to see moderate inflation, possibly lasting a decade or more.

House price inflation is likely already dead, at least for a while. To me housing looks like it has finished a "bang-bang slam" against the constraints and topped out. It is strange to see this happen to housing again, as before say 1996 we didn't used to see so much boom and bust in real estate. Boom or mini-boom, yes, but bust? Not very often. When I say "bang-bang" I'm thinking of the tendency of some commodity markets to slam back and forth between over bought (high price) and over sold (low price) conditions, not spending much time in middle prices and back and forth steady state markets. Hence, I would not be surprised to see housing park itself at current prices for two to five years before the next major move.

Update: Additional News and Sources

AMZN: Janet H. Cho and Liz Moyer at Barron's say in CEO Pay and Corporate Profits Rose in 2021. Workers Wages Didn't Keep Up.: 

The average starting pay for Amazon workers is more than $18 an hour, the spokesperson told MarketWatch.

$18 per hour is about $36,000 annually, assuming full time work at 40 hours per week and two weeks unpaid time off, or $37,440 paid time off. The spokesperson did not elaborate on how many salaried and information technology workers are included in the average. 

According to Indeed, Amazon packers, warehouse workers, drivers, and store shoppers make between $15 and $16 per hour ($30,000 to $32,000 annually).

Small business: According to guest writer Nancy Rommelman reporting at Common Sense, small business owners are being hit in multiple ways by inflation: by increased costs for the goods they buy, by customers who blame them for the high prices, and by reduced store traffic as customers shy away from travel (contradicting VT's "ferment" thesis) and buying things because the high prices no longer fit their budget. Says the owner of Taiwan Pork Chop House in NYC:

“We’ll never return to the way we were living before,” Wang says. “There’s so much instability, with the government but also with individuals and lifestyles and concepts and even our ideas of what life and work and eating out should be. You never know.”  

CAG: ConAgra's FY22Q4 shows that even though customers didn't cut back as much as expected in response to increased prices, overall results were not adequate, and the market sold off CAG. Says Morgan Stanley:

CAG’s Q4 organic sales were relatively in-line with expectations (+6.8% vs. consensus +7.1%) reflecting stronger than expected price/mix +13.2% and softer volumes -6.4% as demand elasticity has remained below historical levels. 

Progressive Write Down Dings PGR Shares

In the recently completed June quarter PGR wrote down a substantial portion of the goodwill from its acquisition of ARX Holding Corp., the parent holding company of American Strategic Insurance (ASI) in St. Petersburg. The amount, $224.8 in the month of June, is marked with an annotation in the June report as "Reflects partial write down of goodwill associated with the ARX Holding Corp. acquisition."

Likely the problem is that ASI "gunned" its property insurance business, writing business with one expectation of coverage that does not reflect what customers were led to believe. Hence although paid claims matched expectations of the ASI group, PGR is losing business as customers drop off the platform. In some cases, PGR may be losing multiple lines of business associated with ASI, including auto insurance, to other carriers.

Some of these issues were likely known in May 2021 or earlier. PGR was weak prior to the June 2022 earnings release, indicating that news of the writedown may have become known outside PGR.

Long term, PGR will eventually recover, as the ethics that came with the ASI acquisition do not appear to have infected the rest of PGR. Look for some more turbulence over the rest of 2022 and perhaps 2023 as PGR figures out what to do with its property insurance business.

Updates posted 2:35 p.m. EDT:

Review of a sell side report indicates that ASI impairment is not fully showing up in analysis.

Morgan Stanley analyst Michael Phillips maintains Progressive (NYSE:PGR) with a Equal-Weight and raises the price target from $115 to $121. (Benzinga)

MKM Partners Maintains Buy Rating, raises its price target from $125.00 to $135.00.

Reinsurancene says PGR "has seen a significant dent in its H1 2022 results due to investments losses and the writedown of ARX Holdings impacting the property segment." PGR holds common stocks in its investment portfolio.  Progressive said: 

“Based on our analysis, we concluded that the fair value of our Property segment is less than the current carrying value, primarily driven by reduced forecasted profitability given the magnitude of recent weather events, as well as other factors impacting our plans to restore our Property business to target profitability in a timely fashion.

“There is no indication of impairment on the remaining $227.9 million of goodwill, which is primarily attributable to our Personal Lines Agency business and related to the ARX acquisition.” 

(As noted above, ARX held the ASI business.)

References, added 7/19/22:

https://stpetecatalyst.com/progressive-is-about-to-complete-its-1-4-billion-deal-for-homegrown-insurer-asi/

https://www.americanstrategic.com/about-asi/our-companies-and-affiliations

"Progressive Insurance Acquiring Homeowners Group ASI for $875M; December 16, 2014" https://www.insurancejournal.com/news/national/2014/12/16/350221.htm

• $875M to bring ownership from 5% to 67% (+62%, implied valuation of $1,411M as of 2014)
• This article has 21 comments primarily from agents and similar close parties.

A Critical Cathie Wood Macro Error

In April 2021, Cathie Wood laid out a macroeconomic case that stocks were too low relative to GDP, based on the observation that in the late 1800s there was a much higher ratio.

In the late 1800’s and early 1900’s - as telephone, electricity, and the automobile were emerging - the US equity market cap relative to GDP appears to have been 2-3 times higher than it is today. We need to verify this difficult-to-get data but, if true, I have a hypothesis. https://t.co/7V4dNo3vBL

— Cathie Wood (@CathieDWood) April 11, 2021

In her third reply on this thread, she says

The technologically-enabled innovation evolving today dwarfs that of the late 1800s/early 1900s: genomic sequencing, robotics, energy storage, artificial intelligence, and blockchain technology. Moreover, Bitcoin could be today’s “gold standard”, increasing purchasing power!

The problem with this analysis, as I see it, is that the late 1800s saw the introduction and refinement of technologies that generated enormous amounts of leverage over physical economic results. Prior to this phase of the Industrial Revolution, human manual labor was limiting economic growth. The ratio of stock market value to GDP then reflected this new and incredibly optimistic (but rational!) result.

In contrast, the post-silicon stock market results in enormous gains in mental economic growth. This is a completely different animal, in which physical comforts (food, shelter, clothing, transportation) continue at a more or less constant or only gradually improving level, while ideas, manipulation of ideas, and computer-enhanced communication experience much greater gains. Part of the current problem with the economy is that the post-silicon world is validly better only for or primarily for information workers, not physical object workers. 

As an example, consider the costs of getting a barrel of oil out of the ground, in terms of barrels of oil. There is no gain unless the ratio is more than one-to-one. In the early 1900s this ratio might have been 50-to-one from the numbers I have seen. More recently, U.S. oil fields might be more like a five-to-one ratio, with Alberta tar sands being quoted by some sources at three-to-one. Clearly, as this ratio declines less physical gain is available for increasing the basic human standard of living.

Other physical industries have improvement rates that are far less than the miraculous growth rates of information technology. Although we see technological progress in autos, chemicals, space transportation, ocean shipping, construction and other physical industries, they constantly work against the continually increasing cost of petroleum fuels and certainly experience much lower technical growth rates than IT.

It is entirely possible for the mental revolution of computation improvements to feel good, but be illusory. In fact, we have had more or less flat economic gains for most of the U.S. population since 1973 (when did the Intel 8080 debut? when did the 1970s oil crisis hit? when did worker wage gains cease climbing?) while the elite, 1%, college-educated, and knowledge workers have done quite well, but perhaps at the expense of physical workers. Leverage over physical workers could be, and was, enhanced through free-trade agreements that off-shored factory and much manual labor to countries with lower labor costs.

In short, Cathie Wood's ratios are meaningful, but she has not interpreted them correctly. Instead, they highlight the problem with reaching the limits of the physical Industrial Revolution, especially when the elite "conspire" to capture an outsized portion of the economic profits. 

Hence You Must Invest in Equities

An understated theme here in Vorpal Trade is that everyone, not just the elite but especially the physical workers of the U.S., need to continually underspend their earnings, save, build capital, and invest that capital into equity of U.S. and international corporations. The economic model of the 1970s and after is that all persons, even those earning minimum wage, need to build up a capital base that pays dividends forever after the initial savings. A "factory worker" in their 40s and 50s then winds up with two revenue streams, one from manual work, but a large and increasingly important stream from dividends and capital gains. This second stream does not depend on the actions of management, and can in fact be used in conjunction with other equity owners to influence company operations, if necessary. I will have more to say about this process in future posts.

If manual labor ceases to achieve gains because the underlying technology is not advancing rapidly enough to generate gains of physical goods, then the goal of a manual laborer must be to gain capital to own the means of production. If corporations then collect rent on intellectual capital, then a manual worker owning stock of the corporation is in turn collecting rent on intellectual capital. 

The alternatives to ownership are messy. Redistribution through taxation and welfare programs tends to reduce agency and cause psychological damage to those who are "helped", slows the economy, and causes increased incentives for corruption among the elite. We already see all of these effects. Some people see this result, claim that capitalism has failed, and call for socialism or other centrally-planned solutions, which are more of the same types of redistribution, but with worse results, messier side effects, and even greater corruption. Even worse, the price of redistribution schemes may turn out to be entrenching an elite class that, through personal connections and rights of family and birth, comes to feel that they are entitled to the reins of the economy.

I am not intentionally mixing normative and objective; what you personally choose to do should not be governed or directed by national policy or the tides of public opinion. Just the opposite. The point is that the solution for each individual does not depend on government action, and that individual actions are nonetheless not only the path to a personal glorious future of success, but then incidentally are the salvation of the country.

That doesn't mean that the U.S. cannot do better by reducing corruption among the elite. It should, and must. For some examples, see The Captured Economy: How the Powerful Enrich Themselves, Slow Down Growth, and Increase Inequality. The legal and medical professions are rife with rent capture, as are occupational licensing, college tuition, and real estate zoning laws. Some of this is subtle, but still evil. Little Grandma in her 5,000 sf house on 16 acres in Mountain View, CA rails against further real estate development, and donates heavily to her local town councilmen; who is willing to write a newspaper article calling her evil? And yet she is corrupt, as the legal machinations that elevate the price of her real estate and keep low-earning local workers destitute are nevertheless manipulations of the system design to enrich her at the expense of others. 

In the meantime, put away 10% or more of what you earn, take advantage of low stock prices, and build up a dividend stream that Grandma Tyrant can't have any effect on. 

The State of Refining

A few words about refining. This is not an area where I claim much expertise, beyond a materials science college course that covered hydrocarbon chemistry many years ago and pumping my own gas. World oil prices are distorted by the Ukraine war. In turn, gasoline prices are also distorted. You can see it in this chart:

Gasoline prices are behaving as though they are constrained by supply. Since gasoline is apparently an exportable product, U.S. domestic prices are affected by world market prices. So if you bid $3.00 a gallon for Exxon gas, but Brazil bids $4.00, guess who Exxon will sell the gasoline to? This appears to be well-documented (see WSJ article) but never referenced by politicians. Washington D.C. could regain control over prices by passing legislation prohibiting exports of fuel from the U.S. If they have decided not to do that, it may be because they know that it would be bad policy.

Refining is constrained because, although the U.S. is generally well-supplied with refineries, the number of existing working refineries is shrinking and has been for a long time. The industry, taking cues from actual declines in demand (driven by auto manufacturer fleet MPG requirements and increasing numbers of EVs on the road) and extremely popular left-leaning climate change rhetoric, has taken the message ("DON'T BUILD REFINERIES") seriously. 

Of course, the screaming on Twitter by know-nothings echoes the politically-motivated outrage and moral grandstanding by Biden. It's a temper tantrum, deserving of the same respect one would give a two year old's demands for candy. I find it much easier to believe the American Fuel & Petrochemical Manufacturers, especially when they cite a Motley Fool posting that cites Chevron's Mike Wirth saying that "he doesn't believe there will ever be another new oil refinery built in the U.S." 

Chevron like all of the other oil majors, is making money this year. But overall the oil business has had a tough past six years. Chevron made losses or near-zero earnings in 2015, 2016, 2017, 2019, and 2020.

It's very difficult to have sympathy for the critics of the oil industry. Sure, all customers want your best product for free, but, by definition, no industry can survive when it is directed to commit suicide. The lack of mature understanding and lack of cooperative spirit makes it clear that those criticizing the oil industry are not capable of providing supervision for a complex modern economy.

Oil supplies in the U.S. are tight, but not tight enough to be the bottleneck. Clearly it is refining, as you can see in these tweets outlining the long term business prospects and current utilization, which is so near 100% the industry is probably setting records:

CHART OF THE DAY: US refineries in the Gulf of Mexico (PADD3) are running the hottest for this time of the year in at least 30 years: 97.9% of their capacity running. Surreal. You can not run hardest than this. Whatever the White House says | #OOTT pic.twitter.com/NpcpkwDuBl

— Javier Blas (@JavierBlas) June 29, 2022

As long as the futures curve implies low prices in the future, it will be difficult to incentivize production. After having their teeth kicked in from 2014-2020, the survivors don’t want to commit to risky expensive capex unless they can hedge their risk.https://t.co/1WHZ6cOm4l

— cogito, ergo lorem ipsum (@randolph_zeke) June 14, 2022

A Barron's analysis found that profits of gas stations are actually down this year.

U.S. Government figures match what the industry is saying. The U.S. Energy Industry Administration data shows refineries over time if you want to check.

Once you understand the refinery situation, it's clear why tapping the Strategic Petroleum Reserve could and would result in sending oil to China. Refineries already have 100% of their supply lined up. Adding to crude supply then just sends it to the next hungry market, part of which will be overseas. Strategically, it might make a small amount of sense to capitalize on high oil prices by selling some of the SPR oil. After all, we got that SPR oil cheap when Trump decided to add to SPR reserves against a rainy day. The rainy day is here. The U.S. Government is making a profit from the oil shortage. What's wrong with that?

Links in this article:

https://www.wsj.com/articles/high-u-s-fuel-exports-are-contributing-to-5-a-gallon-gas-11655371801

https://www.fool.com/investing/2022/06/05/chevrons-ceo-says-no-more-us-oil-refineries-what-s/

https://www.afpm.org/newsroom/blog/refining-capacity-101-what-understand-demanding-restarts

https://www.eia.gov/dnav/pet/pet_pnp_cap1_dcu_nus_a.htm

Is it time to stop hyping the idea that AI has been hyped?

It has become fashionable to capitalize on the mistakes of individuals, who as humans are quick to anthropomorphize things, who encounter text-based (e.g. GPT-3) AI systems and conclude that they might be sentient. Come on people! Isn't it time to stop hyping the idea that AI has been hyped?

Here we have yet another story, yet another piece in social media, this one in LinkedIn, about the need to stop hyping AI.

Ever since the dawn of the Industrial Revolution in the 1700s, coming shortly after the full flower of The Enlightenment, we have experienced significant, continual profound changes in technology and society. This has led to both people anticipating more change, and to people failing to fully understand and keep up with changes that have already occurred. This includes the mundane, such as user interface changes to browsers and operating systems that wipe out personal productivity gained from daily practice, to profound societal challenges, such as erosion of community cohesion as religious institutions have declined in popularity and not been replaced with equivalent neighborhood-building systems.

With artificial intelligence, even the basic curve fitting model of deep learning that is in widespread practice is both taken for granted and yet not fully understood. When it comes to AGI, it is not the case that most people believe that it exists. Those who believe in dualism basically find the idea of AGI impossible. Then there are AI researchers who, having failed many ways in the past to create AI beyond curve-fitting or Eliza-era symbol manipulation, think that it is impossible for anyone else to create it either. Hubris never so clearly indicated that a contrary event was just around the corner.

The deeply learned cynics have certainly been keen to smash AI anticipation based on Terminator movie -like fears or suspicions. Social media, as always, is prone to promote outrage and the barely believable. Yet is there a sense that people are committing, en masse, to the firm belief that AGI exists right now? I don't see it. The existence of a single blog post, tweet, or Facebook message doesn't prove that there is mass hyping of AGI.

Becoming accustomed to new things involves so many different waves, all overlapping. First there is creation of the thing. It's not always a binary, "it was impossible, now it's practice" event. When the Wright brothers flew their airplane at Kitty Hawk, it was a short flight at low altitude with barely any payload. It took much more experimentation, engineering, and practice to get to the primitive airplanes that fought in World War 1. The same is true of AI. First we have curve fitting, then really good curve fitting, then profound curve fitting. Perhaps then we get some ambiguous results. If the first AGI has an IQ of 40, would you call it intelligent? No, you would call it stupid! It's sentience will be highly questionable. And yet there may never be a moment when you can say, "before this all was not sentient, and after this artificial sentience exists".

The second wave is getting the news out. The researcher does the experiment. The knowledge produced may have to be replicated, shared with other researchers, discussed, written up, then published. This takes months or even years. 

The third wave is belief among many. When the news comes out, did you read about it? Did you get the right message? After all, journalists are abysmal at getting the facts straight in fields they don't experience or understand fully. As it is discussed, some believe it, others discount the news story.

The fourth wave is belief within yourself. You've heard the news, but do you believe for yourself what was conveyed. You have to not just hear it, but have a mental model of it that works. It may take some time to get enough information that you can form an accurate belief.

The fifth wave is understanding the implications of your beliefs. It is one thing to understand a phenomenon. But what does that mean for your profession? For your home life? For your religion, your beliefs, your politics? Does it change your values, how you approach the goals of your life? Does it pose a danger to any of the aforementioned?

The current state of AI and AGI is subject to all of those waves. So articles about "hype" are troughs of such waves. They could be an indication of proper sober reflection. The "experts" still put AGI out five to 15 years or more. That some laypeople are confused to think that it is happening now is well within the adoption wave system.