Thanks for coming back! If you missed the first or second entry in the series you will want to read those first since I will be referencing them throughout this post.

Labor Markets

The Labor market is… messy. One share of stock is as good as another however no employee is exactly the same as another. Outcomes are unknown, can be effected by things unrelated to your company, and an interview/resume combo is far less informative then a stock’s disclosure report. Among salesmen, the top tier commonly sell twice the average. The bottom tier commonly sell only half the average. That is a 4 fold difference in outcome based on something that can’t be measured before they are hired.

While stocks and products don’t care what portfolio they are in or what shelf they sit on, people do care and care deeply what company they work for and what work they are doing. A loaf of bread does not care if it is sold for 75¢ or $3 dollars. To an employee there is a massive difference between making $25,000 a year to $100,000 a year. If my grocery store puts bread on sale, it is still the same bread and my sandwich tastes the same. If I cut an employee’s salary from $50,000 to $35,000 odds are their productivity will plummet.

These non-market factors also carryover to the distribution of labor. Financial assets are non-physical so can be transferred near instantly; Products can be shipped from one side of the country to the other although it may take a few days and cost a bit. Employees are very different. People can relocate, but slowly and with great difficulty. The effect of this is that many labor markets are localized, although this can vary by skill set. Higher skills sets tend to be more likely to move and companies are generally willing to pay more to get people to move. For lower tiers of skill the markets are more local.

In short, labor is a product that cares where it is thus limiting distribution, cares what it costs thus you have non-market forces effecting price, and the buyer has incomplete information about the quality of labor they are buying. Labor markets are messy.

Much like production technology and product development, companies invest in their human capital. There is a natural attrition rate for employees that the company will have to work against. Human capital can’t be mothballed and it takes a long time to develop good employees. Thus, companies don’t, nor should they, instantly optimize their long-term workforce to match only short-term needs.

If revenue has dipped then it may make sense to hold on to excess employees for the dip since you will need them when sales return to normal. Of course the problem with that statement is knowing if this is a short-term dip or a long-term shift. It’s also important to never forget that employees are people. Nobody wants to fire someone they like and who they know is working hard. While it is easy to see how larger companies can commoditize their labor, for smaller companies letting people go can be personally painful for the owner/operator. This can be a major market friction.

This pressure to hold a non-optimum amount of employees is one of two big sticking points in the division between GnS and the Labor Market. The second is the Keynesian notion of sticky wages, which we have already touched on in passing.

The connection between GnS and Labor

So what is the net effect of all of this? Expect the Labor market to lag behind the GnS market in terms of lowering total jobs vs. output. Expect employees to be unwilling to lower the price of their labor… at least in the short run. Note that both of these trends are the effect of a negative GnS on the labor market. Companies aren’t too hesitant to hire during a boom and employees will gladly accept a raise and accept it right now. Thus a positive GnS can interact very smoothly with the labor market while the effects of a negative GnS are commonly delayed and dissipated.

Labor economists must look at the long term when discussing these numbers. Seasonal variations are strong, effects are delayed, and different labor types can be treated as either a short term cost or a long term asset depending on their skill sets and the company. While the links between the financial markets and GnS only apply to some firms, the links between Labor and GnS are all about a mix of short vs. long delays in effects and the natural frictions in hiring/firing. It is also critical to remember that while any company wanting finance has access to the same financial market, firms hiring employees may face dramatically different labor markets given there location. Skill sets and education are not highly fluid and thus these markets can be highly isolated.

I started with the statement that the labor market is messy. That is the best ways I know to end.

Final Notes on the 3 Economies

Now here is where we start to get blunt and maybe a little mean. I am not here to be a jerk but there is a point in time where things are simplified to the point of inaccuracy.

The debate between “Wall Street and Main Street” is nonsense. Not because of political ideology but because when people talk about “Main Street” they are general talking about the labor market which is highly disconnected to the financial markets. As you have seen both are connected via the GnS market but both have very imperfect connections to the GnS market itself much less each other. If it feels like the financial market and the labor market are completely unrelated it is because they largely are. A good policy for the financial market might have no bearing at all on the labor market. That is not the fault of the policy, those markets are naturally that far apart. The same goes for the effect of labor market policies on the financial market.

If a labor policy is good it is because of what it does to the labor markets, not the stock market. If a financial policy is good it is because of what it does to the investment world as a whole, not just the NYSE and definitely not a shift in the unemployment rate a week or two later.

Both labor costs and credit issues do effect the cost side of the GnS market; however, these effects can differ wildly per company and sector of the economy. Different companies within a sector have different exposures to the credit market, however all companies share that one credit market. Companies within a sector do share a labor market for much of their workers, but it is commonly limited to those within that sector. A glut of teacher does not counter act a shortage of nurses in the short run. Neither will a credit crunch.

That “nice one size fits all” analysis about how the jobs report boosted the moving average of the NYSE… bullshit. Just bullshit. Just retail stocks within the NYSE, ok that makes sense. I can get behind that story.

The Fed changing interest rates causes tech stocks to drop a half a percent. Bullshit. The Fed rate affecting banks… ok that makes sense. The connection is obvious. A report on the lack of graduates with computer science degrees causes tech stocks to drop half a percent. That might or might not be true but at least that makes senses, the details belong together. It is a story the reporters can tell and the pieces make sense.

There are these grand stories of interconnect pieces where the burden of proof is just not met. It is on the story teller to prove the connection. When facing these kinds of stories I make it a point of looking for the mechanism. What is the piece that causes X to change Y. How significant of an effect does X have on Y? What are the limits to that effect? What counters and substitutes for that effect?

The take away is this: there are simple stories and fundamental truths that do hold for parts of the US Economy, but when we start to simplify across complex systems and ignore major frictions and mechanisms between sectors we are simply lying to ourselves. If we are going to talk about complex systems, then let’s recognize that they are complex, treat them as such, and require a bit more proof.

…

Thank you for joining me over the last 3 week. As always, I will have a new topic starting on the first Friday of each month. Next time I will be talking about the force structure questions the US Military faces, how foreign policy fits into these questions, and the pros and cons of different solutions.

Thanks for joining me again. If you missed last week’s blog you will want to read it before you read this one.

The Goods and Services Market

When Economists talk about “the Economy” this is the part they are generally talking about. This is (most of) GDP, products going to customers, and services being used. However this process is not instant, perfect, all knowing, or omnipresent. Even in the world of modern e-commerce where hundreds of intermediate sellers are presenting the same item, the results at check outs can vary and the item still has to be shipped. In cases where products are similar but not identical more research is need and sources may be good for popular items but will most likely be limited for more specialized items.

Different products and services can take on different market structures. As we move from identical or nearly identical products into items which are more complex, specialized or unique, the rules shift. The issues of understanding quality, getting clear pricing, and delivery/transaction costs can increase in complexity and increase dramatically. In these cases it is also common for market structures to shift from near prefect competition into more oligopoly like conditions.

The key thing to remember here is the effect of these frictions. There is no factory, retail outlet, or service provider that is going to be as fluid as the financial markets. Prices will not change by the second, items are not delivered instantly, and disclosure rules are minimal (if at all) thus information is normally wrapped in marketing or opinions on review sites.

The market for goods and services (GnS) will adapt but it takes time and energy to produce products, liquidate excess inventory, restock, and for management to manually adjust prices. Most companies are doing all four of these tasks at all times to some extent or another. While different financial markets tend to be highly interconnect, goods and service can be surprisingly independent from each other at times. There have been many, many times where people say “the economy” is doing badly but a large number of sectors are very stable and growing year to year as if nothing has changed.

It is a well understood economic phenomena for some companies to be cyclical while a few are counter-cyclical, i.e. for some companies to perform well in tandem with “the economy” while others actually improve when the economy is down and struggle when the economy is doing well.

Yes, we live in an age where things have become more and more connected than ever before; however, we must be careful not to jump to grand conclusions and image connectivity where it simply is not, or where they may be an effect but it is minor at most. My challenge for anyone on this issues is simple. Before you think something is connected try to quantify how interconnected it is. Try to calculate that number. If the best you can muster is notions about how it is connected to “the economy” as a whole then they probably are not as connected as you think.

A shift in other sectors might change a company’s revenue from 52 million to 51 million. A million dollars is a lot of money, but note that 98% of the firm’s revenue has not changed. When was the last time 98% of your life was exactly the same from year to year?

The news media, politicians, and even we lowly economists like to talk about “the economy” as if it is a race horse bounding down the track. It makes for great TV and catchy news titles online but is commonly over stated. In reality it a jumbled mess lurching in all direction with the aggregate effect being a slight movement in one direction or the other. For most companies the actions of your competitors and middle managers are more important to your bottom line than the larger economic picture. I am not saying the effect isn’t there. I just want to place that effect in a more reasonable, empirically accurate context.

Not all Markets are Highly Competitive Open Markets

When people talk about economics they tend to assume an underlining structure of an open competitive market place with near perfect information, lots of sellers, and lots of buyers. However if you take a hard look at most market places the reality can be much less Marshallian than we imagine. Marketers work very hard to create price discrimination via ad campaigns and product differentiation. Branding has become a proxy for quality. Stores are stocked to provide options… but those are often limited to good-better-best sales pitches. Sales, coupons, and various point schemes cloud the true costs/savings of different bundles of goods.

For many industries, selection can be a real issue. It common to see a pair of heavy weight businesses going head to head with a more niche 3^rd tier competitor far behind. This has improved dramatically in recent times with e-commerce outlets bringing a range of smaller sellers to market places well beyond their normal geographical reach.

The connection between Financial Market and the Goods and Services Market

Before I dive too far into this connection I want everyone to take a second and just think through a question: If the NYSE drops 2% on Thursday does a car manufacturer in Alabama drop its production goal for Friday?

No… of course not.

The talking heads on the news love horse races and thus financial markets. They are always in flux thus have content to cover, regardless of if that content actually means anything. So the question quickly becomes how does the financial market effect firms? The answer to that question largely depends on the firm, but we will cover large archetypes here.

The first is a mix of long term and short term loans. Long term for when they can’t, or shouldn’t, self-fund expansions and retooling. The second is short term loans for covering various cash flow issues like seasonal variants in revenue or one time production costs both of which are common issues in business.

Note that these are fairly simple bank operations, not complex financial arrangement. Financial markets can lower the costs of these transaction or simply provide a skilled CFO a range of options beyond traditional banking, like issuing stock or corporate bonds. The results of lower costs will increase the rate at which companies retool or the easy with which they can address cash flow issues. Although these costs are lowered they still exist and of course not needing to pay any cost will always beat paying a low cost.

Improvements in the financial markets, lowing financing options, and providing flexibility to CFO’s who are facing complex financial challenge can all help to increase production in the GnS markets… but only among the firms facing those kinds of financial problems and then only for a fraction of those firms’ total production. These are marginal gains, not grand economics revolutions.

The important thing to remember about financial markets is that it is at the edges, not the core, of business finance. Although we saw major financing issues starting in 2009, specifically in housing and cars, most elements in the economy were unaffected. Groceries were still bought, doctors still cared for patients, and electronics were still developed/produced/sold. Firms that had financial issues before the financial crisis were the ones that suffered heavily during the credit crunch. The credit crunch was irrelevant to businesses that did not need credit.

…

Next week I will be concluding this series with a discussion of the labor market and how it differs from and interacts with both the GnS and Financial Markets.

The 3 Economies

When talking about the US Economy there is a set of problems that I see people running into again and again. It is almost as if people are not talking about the same economy which in turn leads to economic arguments where we can’t even agree on basic facts much less begin to work towards a solution.

Instead of viewing the US economy as a single entity, I believe there is value in viewing it and discussing it as 3 different economies that are imperfectly connected to each other. Each of these economics follow slightly different rules. The 3 economies are: the financial market, the goods and services market, and the labor market.

The Financial Markets

The financial markets are hyper reactive. Things change on a dime. A new market price can be reached in a fraction of a second. Pricing information is largely open and readily available. Due to public disclosure laws, it is as close to perfect information as you can get for a product. Don’t misunderstand me, a skilled and unethical accountant can fudge the numbers to make a company look better than it is, but only to a point. In terms of information, you know far more about the stock you are buying then your next toaster.

Note that although the NYSE is critical, it is only part of a larger international financial market place. Other stock exchanges, various public and private bonds, venture capital, and private investment are all competing for the same resource, capital. Ups and downs in a specific subset may reflect a fundamental change in the financial markets… or may just be a rebalance between subsets. The old joke in Economics is that the NYSE has correctly predicted 9 of the last 5 recessions.

It is also critical to remember that the financial market is what statisticians call “noisy”. There is a lot of ups and downs that just happen. Over the last decade, on average the Dow Jones Industrial Average changed about .75% per day on trading days. If you look for dramatic changes then a guideline of two standard deviations (to cover about 95% of the data) comes out to be about a shift of 1.8%. In other words, a shift of greater than 1.8% in a single day happens about once a month. If someone tells you that something massively important happens and that the markets reacted to it, then look at the shift. If it was less than 1.8% shift then it was not that dramatic. If it is less than .75% then there was actually a less than average about of change on the market that day. If you take a hard look at most financial reporting, expect to see a lot of false drama over sexy issues used to explain tiny shifts that frankly are just noisy markets being noisy.

The big, powerful, fancy theory in Economics to explain the financial market is something called “Modern Portfolio Theory” (MPT). It is taught in most graduate schools and is largely regarded by both practitioners of the market and scholars as dysfunctional. Specific critiques center on false assumptions built into the underlining theory and a mismatch between forecasts made using MPT and actual market prices. In fact more recent graduate level text books open with a discussion on MPT not as a tool that should be used but as a pedagogical exercise.

I genuinely believe that MPT can and will be replaced, and fairly swiftly, once a better theory with more consistent predicting power enters the field. Traders and Economists have been watching for that theory since the mid 1970’s and it has not yet emerged. This theoretical gap is critical since those who turn a profit in the market are those who can “get in front” of the market. It is this desire that has in many ways forced traders to be overly sensitive to changes and information. This adds to the lean, aggressive trader and the quick changes in prices that we see in modern financial markets.

…

Thank you for taking the time to read my blog. The entries for the next two weeks will be about twice as long. Next week I will be talking about the goods and services market as wells how it fundamentally differs from and interact with the financial market. In two weeks I will conclude this topic by using the same approach to discuss the labor market with a few final conclusions to wrap things up.