Paper: "Fiscal Dominance and the Return of Zero-Interest Bank Reserve Requirements"

We have been arguing for the past two years (see also) that the path of least resistance for the central bank would be to do what is known as yield curve control. That concept dates back to WW II, when the Federal Reserve bought the debt issued by the U.S. Treasury, which had the effect of capping rates on longer-term Treasuries. This lasted almost a decade, from 1942 until the Treasury–Federal Reserve Accord in 1951.

Our "path of least resistance" thesis supposes two things: number one, that the government (meaning the Fed and the Treasury) will likely take the easy path in response to a challenge rather than something hard that might have greater long-term benefit. In other words, that the government has a very high discount rate or low pain tolerance. And number two, that printing money - in whatever euphemism you want to use to describe it - would be that easiest path.

In our review of Nick Timiraos' hagiography of Federal Reserve chair Jerome Powell, we observed that Powell has been closely involved in the response to six financial embarrassments or crises, and he has recommended, advised, or chosen the bailout every time. Had he chosen different courses, for example to discourage moral hazard, it would have been at the cost of greater short term pain. But we are aware that Powell's commitment to bailouts has never been tested against conditions of rising inflation. He sure has been talking tough about inflation for the past year. How can we predict what he is actually going to do?

Along comes a paper by an academic economist named Charles Calomiris titled Fiscal Dominance and the Return of Zero-Interest Bank Reserve Requirements, just published by the Federal Reserve Bank of St Louis. Calomiris is a "system man," a baby boomer economist who went to Yale and got a PhD in economics from Stanford, before being part of a number of think tanks. He has had four commentaries published by the Wall Street Journal in the past year. For all we know, he was in Skull and Bones. The abstract of his article:

As a matter of arithmetic, the trends of US government debt and deficits will eventually result in an outrageously high government debt-to-GDP ratio. But when exactly will the United States hit the constraint of infeasibility and how exactly will policy adjust to it? This article considers fiscal dominance, which is the possibility that accumulating government debt and deficits can produce increases in inflation that “dominate” central bank intentions to keep inflation low. Is it a serious possibility for the United States in the near future? And how might various policies change (especially those related to the banking system) if fiscal dominance became a reality?

What is utterly fascinating about this paper is that he is looking at an impending crisis - the over-indebtedness of the federal government - and reasoning through the possible responses, looking for the easiest one: the path of least resistance. Broadly speaking, he sees three possible choices:

First, reduce fiscal deficits. He confesses that it "may be a hard policy to enact," since the main contributors to the deficit are Medicare, Social Security, and the defense budget. Look at a long term chart of Unitedhealth Group or Lockheed Martin. Does the market seem worried that those budgets are going to get axed? Social Security and Medicare are the only benefits that normal, hard working people get from a lifetime of federal income taxation. It says a lot about Paul Ryan that his main political priority was to try to cut these benefits. Anyway, Calomiris does not think that this would be a path of least resistance.

Second, increased income taxation. Calomiris says that it is an unlikely path, "not only because of the lack of political consensus about taxation but also because it would reduce growth in income, which would partly offset" any benefit that it might confer. 

The third choice is what the paper is really about. Calomiris thinks that the path of least resistance would be "inflation taxation," which is implemented by large and inflationary purchases of government debt.

"To be specific, here is how I imagine this occurring: When the bond market begins to believe that government interest-bearing debt is beyond the ceiling of feasibility, the government's next bond auction 'fails' in the sense that the interest rate required by the market on the new bond offering is so high that the government withdraws the offering and turns to money printing as its alternative."

The Federal Reserve would buy the bonds that the Treasury issues, thereby funding government budget deficits. It is the same as printing money to fund the deficit, but with a fig leaf of euphemism and confusion. The "inflation tax" refers to the amount of real value that government bondholders lose to inflation. If there is $25 trillion of federal debt held by the public and there is a ten percent inflation (devaluation), then the inflation tax raises $2.5 trillion, a healthy amount in relation to the current annual expenditure level of $6.5 trillion.

The euphemism and confusion part of the inflation tax is actually very important because it allows the government to collect more than it would be able to if it were honest about what was happening. Here is how Calomiris explains it:

"When fiscal dominance hits and leads to monetization [printing money], if this is not anticipated sufficiently far in advance, it also causes some or all existing bonds (long-term bonds with existing low coupons that aren't indexed to inflation) to fall in nominal value. This is a one-time gain to the government because, going forward, the government will pay a market interest rate on all new debt issues that incorporates the future rate of inflation. If the average duration of government debt is sufficiently long, and fiscal dominance is not anticipated years in advance, the government could benefit from a substantial capital gain from the unexpected inflation tax, which increases its real capacity to issue new interest-bearing debt by a similar amount."

Calomiris thinks that the inflation tax is the path of least resistance because people "are not aware that they are actually paying it, which makes it very popular among politicians." 

If you were running things, how would you maximize the amount you could raise via the inflation tax? You need to trick bondholders, otherwise the market interest rate on new debt issues will reprice higher for inflation. This seems to imply that the best strategy is periodic, large devaluations with the rest of the time spent talking very tough about inflation.

Paper: "The Games They Will Play: Tax Games, Roadblocks, and Glitches Under the New Legislation"

SSRN:

Both the House and Senate bills would tax corporate income at a flat rate of 20%. Without effective anti-abuse provisions, this change would encourage taxpayers to use the corporate form as a tax-sheltered savings vehicle.

The basic advantage to investing through a corporation is that income is not currently taxed to the investor. The cost of investing through a corporation, however, is the “double tax” on income, both to the corporation (when income is earned) and to the investors (upon a distribution or sale of their corporate interest). If, however, the corporate tax is reduced, taxpayers can use the corporate form to shelter their income from tax.

In combination, the 20% corporate rate and the later second layer of capital gains or dividend tax can produce a rate roughly equivalent to the top ordinary rate. But, deferring or potentially even eliminating the second layer of tax then makes the C-corporation preferable to simply earning the income as an individual subject to the top rate. Corporations can also deduct the state and local income taxes that individuals cannot, which will provide another incentive for individuals to form corporations.

The benefit of a low corporate tax rate is compounded by other structural features of the income tax. Both the House and Senate bills would preserve the “basis step-up” upon a taxpayer’s death. As a result, investment income held through a corporation can first accrue at a low rate during the investor’s life. The investor’s heirs can then inherit the corporate interest with a basis equal to its fair market value, and thereby eliminate the second individual layer of tax. There are also other methods described below for avoiding the second layer of tax.

A great read. Some of the ideas for avoiding the second layer of corporate tax are: the step-up in basis for heirs, holding the C-corp investment in a Roth IRA, waiting until retirement, or the qualified small business stock exclusion.

Paper: "Analyst Promotions within Credit Rating Agencies: Accuracy or Bias?"

Ha!:

We examine whether credit rating agencies reward accurate or biased analysts. Using data collected from Moody’s corporate debt credit reports, we find that Moody’s is more likely to promote analysts who are accurate, but less likely to promote analysts who downgrade frequently. Combined, analysts who are accurate but not overly negative are approximately twice as likely to get promoted. Further, analysts whose rating changes are more informative to the market are more likely to get promoted, unless their ratings changes cause large negative market reactions.

Paper: "Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers"

Highlights:

• Payouts to shareholders reduce the resources under managers’ control, thereby reducing managers’ power, and making it more likely they will incur the monitoring of the capital markets which occurs when the firm must obtain new capital. Financing projects internally avoids this monitoring and the possibility the funds will be unavailable or available only at high explicit prices.
• Managers have incentives to cause their firms to grow beyond the optimal size. Growth increases managers’ power by increasing the resources under their control. It is also associated with increases in managers’ compensation, because changes in compensation are positively related to the growth in sales. The tendency of firms to reward middle managers through promotion rather than year-to-year bonuses also creates a strong organizational bias toward growth to supply the new positions that such promotion-based reward systems require.
• Debt creation, without retention of the proceeds of the issue, enables managers to effectively bond their promise to pay out future cash flows. Thus, debt can be an effective substitute for dividends, something not generally recognized in the corporate finance literature. By issuing debt in exchange for stock, managers are bonding their promise to pay out future cash flows in a way that cannot be accomplished by simple dividend increases. In doing so, they give shareholder recipients of the debt the right to take the firm into bankruptcy court if they do not maintain their promise to make the interest and principal payments.

So what does this suggest could be done to improve capital allocation? The debt solution is probably a pretty good one since it is also tax efficient. On the other hand, we are so anti-debt that it's worth looking at a couple other possibilities.

Require shareholder approval to spend funds on new capital projects. For example, an S-corp might already have a stipulation that some or all taxable earnings be dividend-ed to shareholders (so that they can meet their tax obligations). That would require management to try to raise new capital through some other means, for example a rights offering (which seems like a fair tool to use). The rights offering might be improved upon by requiring shareholder approval before implementation.

Perhaps the organizational bias towards growth could be defeated by increased profit sharing or employee ownership instead of rewarding strictly via promotion.

"Multiple discovery and invention: Zeitgeist, genius, or chance?"

"The occurrence of independent contributions by 2 or more scientists can be interpreted in terms of zeitgeist, genius, or chance. The relative adequacy of these 3 theories was examined by examining the general and intradisciplinary probability distribution of multiples and the relationship of individual eminence with multiple production and priority. An analysis of 579 multiples and of 789 scientists and inventors gave the most support to the chance theory, followed by the zeitgeist theory. Results are integrated into a single probabilistic perspective that incorporates some of the major features of all 3 theories. A small group of highly productive individuals is most likely to participate in multiples, including independent rediscoveries. These same persons are also unusually intimate with the 'technoscientific' zeitgeist and perhaps equally gifted with an inordinate amount of good luck."

Review of Fischer Black and the Revolutionary Idea of Finance by Perry Mehrling

Remember quant Emanuel Derman who worked for Fischer Black? This is Fischer Black's story, who is best known for being a coauthor of the Black-Scholes model for pricing options.

This is an interesting example of simultaneous invention because his coauthor Myron Scholes presumably might have come up with the model on his own, eventually. Even if he hadn't, Robert Merton also discovered the model, and in fact the two teams split the 1997 Nobel economics prize. Ed Thorp claims that he discovered it too but kept quiet about it and used it to make money trading options.

The story of increased efficiency in options pricing is another example of how profitable trading opportunities go through a lifecycle where the innovation diffuses and they become commodities. No evergreen investment strategies!

Simultaneous invention makes biographies of inventors philosophically uninteresting. Who cares about the idiosyncrasies of somebody who discovered something at the same time as two other people?

Note that the oldest of the three official Black-Scholes discoverers was Fischer who was born in 1938 and the youngest was Robert Merton who was born in 1944. Right place, right time; like Aubrey McClendon and Tom Ward who were born three days apart in Oklahoma. Similarly, J.S. Bach and G.F. Handel were both born in 1685.

Fischer Black was part of the move to get endowments invested in equities. See this paper from 1952 [pdf] when, within recent memory, there were only certain securities that were legal for fiduciaries to purchase. One of causes of the great 20th bull market - which cannot be repeated - was loosening these standards and creating more valuation-insensitive purchasers of stocks.

Similarly, the baby boomers' 401(k) accounts were valuation-insensitive purchasers, and they have absorbed a (false) lesson that one owns securities to make money through rising valuations and capital gains. A stock index with a high enough dividend yield to justify owning absent price momentum is a foreign concept to baby boomers.

Tyler Cowen quotes Fischer Black: "The easiest theory to falsify is a theory which is false."

Black had a pretty good theory of the business cycle. A boom is a period when the pattern of production is a good match for the pattern of demand. A bust is a period when the match is bad. It means that people are working in the wrong sectors, producing the wrong mix of goods and services. Fortunately, price signals will encourage a shift to the right pattern of production (at least if the economy is left alone.)

This fits well with Falky's Batesian mimicry theory: the mimicry of successful entrepreneurs by copycats is what causes the glut and bust.

3/5

Overestimating Conjunctive Probabilities and Underestimating Disjunctive Probabilities

Here's an interesting finding from cognitive bias researchers (like Tversky and Kahneman): people tend to overestimate conjunctive probabilities and underestimate disjunctive probabilities.

This theory could explain why investors are (over)confident that a company they've bet on will succeed. As Kahneman explains in Thinking, Fast and Slow:

"Biases in the evaluation of compound events are particularly significant in the context of planning. The successful completion of an undertaking, such as the development of a new product, typically has a conjunctive character: for the undertaking to succeed, each of a series of events must occur. Even when each of these events is very likely, the overall probability of success can be quite low if the number of events is large. The general tendency to overestimate the probability of conjunctive events leads to unwarranted optimism..."

I'll bet that when people think of a plan that only needs seven things to succeed, each with a 90 percent chance of success, they essentially mentally average the probabilities to come up with a roughly 90 percent conjunctive probability. When at that point, it's actually more likely than not (0.9^7=0.48) that the plan will not succeed!

So, looking at an investment like Molycorp, the backers need to be able to make a conjunctive probability assessment. The company needs to make many systems work along a chain from ore to refined product. Some of those systems, like the hydrochloric acid plant and the leach tanks, have had what are now longstanding, intractable problems. My skepticism last November about Molycorp's ability to produce (see 1,2,3), not to mention the price that rare earth metals would bring, seems in retrospect like a good conjunctive probability assessment.

In contrast, people underestimate disjunctive probabilities, as Kahneman explains:

"A complex system, such as a nuclear reactor or a human body, will malfunction if any of its essential components fails. Even when the likelihood of failure in each component is slight, the probability of an overall failure can be high if many components are involved."

It seems like judging failure is almost always going to be disjunctive (many possible causes) and success almost always conjunctive. Add in people's existing biases for optimism, and you can see why investors are mostly bulls and bears are so rare.

Paper: "Re-Thinking Risk: What the Beta Puzzle Tells Us about Investing"

I can't find a PDF link, but this was from a GMO whitepaper by David Cowan and Sam Wilderman:

"These results suggest that hedge funds as a group earn steady returns by underwriting extreme downside market moves. Remarkably, an asset class that purports to be an 'alternative' source of returns, with low correlation to equity markets, turns out to be simply another way to take downside equity market risk. Individual funds and strategies certainly vary greatly, but in aggregate, once fees are taken into account, hedge funds appear to offer nothing beyond a way to sell insurance against sharp market declines. This is a perfectly reasonable way to earn a return, but from a risk perspective offers less diversification than many investors expect.

In addition, the returns required to justify the real risks being taken by hedge funds are higher than people usually realize. When investors give hedge funds credit for having low beta, they will tend to think the funds are adding a lot of value, generating high returns relative to their risk. When they see them as earning a return for taking downside equity exposure, investors will tend to think the funds are generating a reasonable return, but nothing beyond what they should be getting given the risk they are taking."

In other words, hedge funds as a class are selling put options. This reminds me of John Porter quoted in Inside the House of Money:

"[H]edge funds in general are all about leveraged selling of volatility"

If a hedge fund manager makes money while consistently being long volatility, there's a much better chance that he's not just a monkey than if he's consistently short volatility.

Paper: "Why do humans reason? Arguments for an argumentative theory"

Reasoning is generally seen as a means to improve knowledge and make better decisions. However, much evidence shows that reasoning often leads to epistemic distortions and poor decisions. This suggests that the function of reasoning should be rethought. Our hypothesis is that the function of reasoning is argumentative. It is to devise and evaluate arguments intended to persuade. Reasoning so conceived is adaptive given the exceptional dependence of humans on communication and their vulnerability to misinformation. A wide range of evidence in the psychology of reasoning and decision making can be reinterpreted and better explained in the light of this hypothesis. Poor performance in standard reasoning tasks is explained by the lack of argumentative context. When the same problems are placed in a proper argumentative setting, people turn out to be skilled arguers. Skilled arguers, however, are not after the truth but after arguments supporting their views. This explains the notorious confirmation bias. This bias is apparent not only when people are actually arguing, but also when they are reasoning proactively from the perspective of having to defend their opinions. Reasoning so motivated can distort evaluations and attitudes and allow erroneous beliefs to persist. Proactively used reasoning also favors decisions that are easy to justify but not necessarily better. In all these instances traditionally described as failures or flaws, reasoning does exactly what can be expected of an argumentative device: Look for arguments that support a given conclusion, and, ceteris paribus, favor conclusions for which arguments can be found.

Paper: "Identifying Overvalued Equity" and the "O-Score"

Reading a paper called Identifying Overvalued Equity by Beneish and Nichols:

"Our model is a scoring system that combines firm characteristics into an overvaluation score (O-Score) ranging from zero to five. Firms receive one point for having a high likelihood of earnings overstatement (based on the Beneish (1999)’s PROBM measure), high sales growth, low operating cash flows to total assets, an acquisition in the last five years, and unusual amounts of equity issuance in the past two years. Thus, firms with glamour characteristics, poor current operating cash flow performance, a high likelihood of earnings overstatement, a history of merger activity, and recent but excessive issuances of stock fit our profile of overvalued equity. And, we show the overvaluation is substantial; firms with O-Scores equal to five lose about a quarter of their value."

Indexing idea: use Falkenstein's low volatility approach, and also prune any firms with high O-scores or high yield debt.

Armen Alchian, Golf, High Status Jobs, and Longevity [Also, Paper: "Vertical Integration, Appropriable Rents, and the Competitive Contracting Process"]

The paper is "Vertical Integration, Appropriable Rents, and the Competitive Contracting Process" [pdf] and it has some good thoughts about contracting between (or vertical integration of) oil producers, pipelines, and refineries; or of coal mines and power plants.

Appropriable quasi rents exist in specialized assets of oil refineries, pipelines, and oil fields. This leads to common ownership to remove the incentive for individuals to attempt to capture the rents of assets owned by someone else.

Suppose several oil wells are located along a separately owned pipeline that leads to a cluster of independently owned refineries with no alternative crude supply at comparable cost. Once all the assets are in place (the wells drilled and the pipeline and refineries constructed) the oil-producing properties and the refineries are specialized to the pipeline. The portion of their value above the value to the best alternative user is an appropriable specialized quasi rent. The extent of the appropriable quasi rent is limited, in part, by the costs of entry to a potential parallel pipeline developer. Since pipelines between particular oil-producing properties and particular refineries are essentially natural monopolies, the existing pipeline owner may have a significant degree of market power.

These specialized producing and refining assets are therefore "hostage" to the pipeline owner. At the "gathering end" of the pipeline, the monopsonist pipeline could and would purchase all its oil at the same well-head price regardless of the distance of the well from the refinery. This price could be as low as the marginal cost of getting oil out of the ground (or its reservation value for future use, if higher) and might not generate a return to the oil-well owner sufficient to recoup the initial investment of exploration and drilling.

Some other good examples, including mine-mouth coal plants, or specialized dies for auto manufacturers.

One of the authors was Armen Alchian who just died in 2013 at age 98. From wikipedia:

"[T]he Alchian–Allen theorem[,] colloquially known as 'ship the good apples out,' states that when output varies in quality, the lower quality output is consumed nearby while the higher quality output is shipped long distances. The reason is simple: transportation costs vary with the weight and bulk, but not the quality, of that which is transported. The added per-unit amount decreases the relative price of the higher-grade product."

Alchian's textbook Exchange and Production sounds worthwhile:

"Because of its literary quality and complexity, the textbook generally did not work with undergraduate or even M.B.A. classes."

I've been fascinated recently by the longevity of men with high-status, intellectually stimulating jobs. Charles Munger (still doing Q&A in public at 91), Judge Robert Patterson (who died last week, at 91). I'm sure it didn't hurt Armen Alchian that he lived in LA and had a flexible schedule for golfing:

"Alchian was an avid golfer throughout his lifetime. He rose very early and teed off at day break at nearby Rancho Park Golf course for an early morning round of golf. He still arrived at the office before many of his colleagues for a full day of work. When he traveled to conferences around the world, his golf clubs accompanied him. In his eighties he could look at his collection of golf score cards and describe the holes he had played on many of the courses he enjoyed."

It's sort of like how Tyler Cowen gets to eat all over the world because of economics conferences. Except a round of golf is better for you than eating deep fried chimichangas from three different street food vendors in one day.

The more, the more. If you're smart and manage to be high-status, you'll live a happier and longer life and accomplish more.

Paper: "Books Average Previous Decade of Economic Misery"

Abstract:

"For the 20th century since the Depression, we find a strong correlation between a 'literary misery index' derived from English language books and a moving average of the previous decade of the annual U.S. economic misery index, which is the sum of inflation and unemployment rates. We find a peak in the goodness of fit at 11 years for the moving average. The fit between the two misery indices holds when using different techniques to measure the literary misery index, and this fit is significantly better than other possible correlations with different emotion indices. To check the robustness of the results, we also analyzed books written in German language and obtained very similar correlations with the German economic misery index. The results suggest that millions of books published every year average the authors' shared economic experiences over the past decade."

That's interesting - think of the period from 2005 until present. That is probably what people have integrated into their minds as "normal" economic conditions. That period includes only two crash years, 2008-2009 (20%), and quite a few mania years.

Paper: "Noise Trader Risk in Financial Markets"

"Noise Trader Risk in Financial Markets" [pdf].

"In a world with mean-reverting noise traders' misperceptions, the optimal investment strategy is very different from the buy and hold strategy of the standard investment model. The optimal strategy for sophisticated investors is a market-timing strategy that calls for increased exposure to stocks after they have fallen and decreased exposure to stocks after they have risen in price. The strategy of betting against noise traders is a contrarian investment strategy: it requires investment in the market at times when noise traders are bearish, in anticipation that their sentiment will recover. The fundamentalist investment strategies of Graham and Dodd (1934) seem to be based on largely the same idea, although they are typically described in terms of individual stocks. The evidence on mean reversion in stock returns suggests that, over the long run, such contrarian strategies pay off."

Couple Other Good Thoughts From Falkenstein

Followup on the book review,

• Why equities could have a return premium, but a very modest one: "cross-sectional equity returns over a hundred years are not positively related to economic growth, so it is not as if the economy is a representative firm and a risk averse individual is choosing how much wealth to allocate to a stochastic investment; rather, the stock market is a subtle game between insiders and outsiders where the insiders merely provide enough top-line returns to keep the rabble unaware they are being had."
• "Stocks with higher volatility generate more news than less volatile firms. Such stocks are then in play and so become relevant to the investor interested in deviating from the index. Stocks that are in the news generate lots of information that fiduciaries can use to sell their ideas to clients. Such cocktail party stories are very helpful, and it is much easier to talk about something in the news..."

A stock like Conrad reports once a quarter and is otherwise never in the news. Think about how often Chesapeake Energy has been in the news.

Paper: "Corporate Pensions and Financial Distress"

NY times article:

"A paper by the academics Ying Duan, Edith S. Hotchkiss and Yawen Jiao, studied 729 troubled publicly traded companies over 20 years and found that the amounts of money that employees had in company stock remained relatively stable during periods of trouble, as did their new contributions. This is true even as the stock prices decline and the number of investors betting against the stock in the public markets through short sales increases."

From the paper abstract:

"We examine the role of corporate pension plans in determining how firms restructure in financial distress. Both defined benefit (DB) and defined contribution (DC) plans can have significant exposures to the company’s own stock, imposing significant losses on employees if the firm defaults and/or files for bankruptcy. We find that firms with DB plans typically have little exposure to the stock prior to default; the degree of underfunding increases significantly as firms near default, but is not related to restructuring types (bankruptcies versus out of court restructurings). In contrast, large exposures to company stock in DC plans often are not reduced prior to default. High levels of own-company stock ownership are positively related to default and bankruptcy probabilities. Our evidence suggests a link between employee-ownership related managerial entrenchment and default risk."

Very interesting. Their finding is (as we would expect) that the company employees are dumb money even when investing in the companies where they work. This is like all the people at Bear Stearns and Lehman that couldn't figure out their firms were going to fail.

Paper: "What Are the Most Profitable Business Models?"

This "Do Some Business Models Perform Better than Others? A Study of the 1000 Largest US Firms" is a cool paper [pdf]. Although it doesn't really answer the question, they came up with a two dimensional classification of different business model types which I think is useful.

What rights are being sold? The four Basic Business Model Archetypes
The heart of any business is what it sells. And perhaps the most fundamental aspect of what a business sells is what kind of legal rights they are selling. The first, and most obvious, kind of right a business can sell is the right of ownership of an asset. Customers who buy the right of ownership of an asset have the continuing right to use the asset in (almost) any way they want including selling, destroying, or disposing of it.

The second obvious kind of right a business can sell is the right to use an asset, such as a car or a hotel room. Customers buy the right to use the asset in certain ways for a certain period of time, but the owner of the asset retains ownership and can restrict the ways a customers use the asset. And, at the end of the time period, all rights revert to the owner.

In addition to these two obvious kinds of rights, there is one other less obvious—but important—kind of right a business can sell. This is the right to be matched with potential buyers or sellers of something. A real estate broker, for instance, sells the right to be matched with potential buyers or sellers of real estate.

[E]ach of these different kinds of rights corresponds to a different basic business model. The figure also reflects one further distinction we found useful. For companies that sell ownership of an asset, we distinguish between those that significantly transform the asset they are selling and those that don’t. This allows us to distinguish between companies that make what they sell (like manufacturers) and those that sell things other companies have made (like retailers).

A Creator buys raw materials or components from suppliers and then transforms or assembles them to create a product sold to buyers. This is the predominant business model in all manufacturing industries. A key distinction between Creators and Distributors (the next model) is that Creators design the products they sell. We classify a company as a Creator, even if it outsources all the physical manufacturing of its product, as long as it does substantial design of the product.

A Distributor buys a product and resells essentially the same product to someone else. The Distributor may provide additional value by, for example, transporting or repackaging the product, or by providing customer service. This business model is ubiquitous in wholesale and retail trade.

A Landlord sells the right to use, but not own, an asset for a specified period of time. Using the word “landlord” in a more general sense than its ordinary English meaning, we define this basic business model to include not only physical landlords who provide temporary use of physical assets (like houses, airline seats and hotel rooms), but also lenders who provide temporary use of financial assets (like money), and contractors and consultants who provide services produced by temporary use of human assets. This business model highlights a deep similarity among superficially different kinds of business: All these businesses—in very different industries—sell the right to make temporary use of their assets.

A Broker facilitates sales by matching potential buyers and sellers. Unlike a Distributor, a Broker does not take ownership of the product being sold. Instead, the Broker receives a fee (or commission) from the buyer, the seller, or both. This business model is common in real estate brokerage, stock brokerage, and insurance brokerage.

What assets are involved? The 16 detailed Business Model Archetypes
The other key distinction we use to classify business models is the type of asset involved in the rights that are being sold. We consider four types of assets: physical, financial, intangible, and human.

Physical assets include durable items (such as houses, computers, and machine tools) as well as nondurable items (such as food, clothing, and paper).

Financial assets include cash and other assets like stocks, bonds, and insurance policies that give their owners rights to potential future cash flows.

Intangible assets include legally protected intellectual property (such as patents, copyrights, trademarks, and trade secrets), as well as other intangible assets like knowledge, goodwill, and brand image.

Human assets include people’s time and effort. Of course, people are not “assets” in an accounting sense and cannot be bought and sold but their time (and knowledge) can be “rented out” for a fee.

[E]ach of the Basic Business Model Archetypes can be used (at least in principle) with each of these different types of assets.

Paper: "Talking Your Book: Social Networks and Price Discovery"

"Alpha Architect" talks about a paper called "Talking Your Book: Social Networks and Price Discovery".

"If I already have all my money in a stock or I’ve hit a risk limit in my portfolio (e.g, 10% of NAV), there is no cost to sharing my private information. Perhaps I’ll get lucky and convince another value investor that the stock is cheap and the price will rise.

1. Find honest to goodness undervaluation or overvaluation. (Obviously, if you aren’t discovering genuinely “good” ideas, talking your book is not going to work.)
2. Take a full position in the stock.
3. Crank on your PR engines and spread the word about your idea (VIC, Sumzero.com, SeekingAlpha, etc.). Here is a paper looking at the performance of Seeking Alpha posts.
4. Drive prices closer to fundamentals in a shorter amount of time.

Related to this, a paper called "Facebook for Finance: Why do Investors Share Ideas via Their Social Networks?":

"My 'diversification' sharing model suggests that capital constrained arbitrageurs will share ideas to gain access to new ideas and lower their portfolio volatility. My 'awareness' sharing model suggests that arbitrageurs share their private information to attract additional capital into their asset market."

Paper: "The Limits of Arbitrage"

This is an important paper [pdf] by Andrei Shleifer and Robert Vishny that's been cited over 3000 times. (Same authors, previously, on value vs glamour, principal-agent problems, and comparative investor rights/debt enforcement globally.)

Here are the highlights:

• "Markets in which fundamental uncertainty is high and slowly resolved are likely to have a high long-run, but a low short-run, ratio of expected alpha to volatility. For arbitrageurs who care about interim consumption and whose reputations are permanently affected by their performance over the next year or two, the ratio of reward to risk over shorter horizons may be more relevant."
• "As we argue in this article, the theoretical underpinnings of the efficient markets approach to arbitrage are based on a highly implausible assumption of many diversified arbitrageurs. In reality, arbitrage resources are heavily concentrated in the hands of a few investors that are highly specialized in trading a few assets, and are far from diversified. As a result, these investors care about total risk, and not just systematic risk."
• "[I]n extreme situations, arbitrageurs trying to eliminate the glamour/value mispricing might lose enough money that they have to liquidate their positions. In this case, arbitrageurs may become the least effective in reducing the mispricing precisely when it is the greatest."
• "The glamour/value anomaly is one of several that our approach might explain. The analysis actually predicts what types of market anomalies can persist over the long term. These anomalies must have a high degree of unpredictability, which makes betting against them risky for specialized arbitrageurs. However, unlike in the efficient markets model, this risk need not be correlated with any macroeconomic factors, and can be purely idiosyncratic fundamental or noise trader risk."
• "[A]nomalies become understood very slowly and that investors do not take definitive action on their information until long after a phenomenon has been exposed to public scrutiny. The anomaly is more easily accepted when the pattern of returns is not very noisy and the payoff horizon is short (such as the small firm effect in January). A 'noisy' anomaly like the value-glamour anomaly is accepted only slowly, even by relatively sophisticated investors."

A Couple Papers About the Inefficient Market in Stock Lending

Previously,

1. "Market prices would be more accurate if it was easier (and cheaper) to borrow shares to sell short."
2. "The stock lending market is too opaque, borrowing costs are too high, leading to not enough stock being shorted and prices being less accurate than they should be. However, short selling is 'bad,' so there is no political pressure to clean up the stock lending market."

Two papers worth mentioning,

• "Securities Lending, Shorting, and Pricing": "The prospect of lending fees may push the initial price of a security above even the most optimistic buyer’s valuation of the security’s future dividends. A higher price can thus be obtained with some shorting than if shorting is disallowed."
• "A Dynamic Model for Hard-to-Borrow Stocks": "Consequences of our model for dynamics are elevated volatilities, sharp price spikes and occasional crashes followed by often dramatically lower hard-to- borrowness."

"Predicting economic market crises using measures of collective panic"

Wow, I wonder if Falky (mimicry theory of recessions) knows about this paper: "Predicting economic market crises using measures of collective panic" [pdf]? Abstract:

"Panic may be due to a specific external threat, or self-generated nervousness. Here we show that the recent economic crisis and earlier large single-day panics were preceded by extended periods of high levels of market mimicry — direct evidence of uncertainty and nervousness, and of the comparatively weak influence of external news. High levels of mimicry can be a quite general indicator of the potential for self- organized crises."

This reminds me of Prechter's theory of endogenous causation. The paper goes on,

"[E]ven when price changes are small, we expect that co-movement itself is the collective behavior that is characteristic of panic, or panicky behavior that precedes a panic. Thus, rather than measuring volatility or correlation, we measure the fraction of stocks that move in the same direction. We find that this increases well before the market crash, and there is significant advance warning to provide a clear indicator of an impending crash."

And, speaking of the Chicago Spire condo tower mentioned in our mimicry post, that ludicrous project has been cancelled.