May 2017

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In June 1928, the Harvard law professor and future Supreme Court justice Felix Frankfurter received a letter from his patron and ally, Supreme Court Justice Louis Brandeis. In it, Brandeis gave the perfect quick description of the constitutional philosophy he had been honing during the previous five decades, first as one of America’s leading lawyers and then on the nation’s highest court, where he sat from 1916 until 1939.

“In favor of property,” Brandeis wrote, “the Constitution is liberally constructed—in favor of liberty, strictly.” In other words, when it came to laws restricting property rights and economic freedom, the courts should defer to the judgment of lawmakers and vote to uphold the vast majority of regulations, a practice known then and now as judicial restraint. But when it came to laws restricting “liberty,” by which Brandeis meant free speech, the right to privacy, and other civil liberties, the courts should carefully scrutinize each law and, if they detected the slightest whiff of unconstitutionality, strike it down without hesitation.

That double standard, which asks the courts to favor some rights over others, has dominated the American legal system since the late 1930s, essentially leaving economic liberty at the mercy of state and federal lawmakers while “fundamental” rights receive aggressive judicial protection. As Melvin Urofsky, a historian at Virginia Commonwealth University, helps explain in his exhaustive and sympathetic new biography, Louis D. Brandeis: A Life, no one did more to bring about this uneven state of affairs than Brandeis himself.

Born in 1856 to a family of wealthy Bohemian immigrants in Louisville, Kentucky, Louis Brandeis “had the good fortune,” Urofsky writes, “to live in an age when the causes that mattered to him could be shaped by a man with a powerful vision and the intellect and personality to transform ideas into action.” We call that age the Progressive Era, named after the idealistic reformers who drastically expanded the size and scope of the regulatory state between roughly 1890 and 1920. After graduating from Harvard Law School and establishing himself as one of the country’s wealthiest and most successful lawyers, Brandeis was soon “counted among the preeminent progressives of the era.”

A brilliant attorney and skilled political operative, Brandeis left an impressive record. As a judicial champion of free speech and the “right to be let alone,” he has had few equals on the bench. He was the author of several landmark free speech opinions, but his greatest achievement arguably came with the 1928 case Olmstead v. United States, where the Supreme Court considered government use of a warrantless wiretap in the prosecution of Seattle bootlegger (and police officer) Roy Olmstead. Writing for the Court’s 5-to-4 majority, Chief Justice William Howard Taft upheld the conviction, arguing that wiretapping did not amount to an invasion of Olmstead’s home by the authorities and that Olmstead’s private conversations were not protected by the Fourth Amendment’s guarantee of “the right of the people to be secure in their persons, houses, papers, and effects, against unreasonable searches and seizures.”

Brandeis saw things differently, and his dissent revolutionized Fourth Amendment law. “The makers of our Constitution,” he wrote, “conferred, as against the government, the right to be let alone—the most comprehensive of rights and the right most valued by civilized men. To protect that right, every unjustifiable intrusion by the Government upon the privacy of the individual, whatever the means employed, must be deemed a violation of the Fourth Amendment.” It hardly mattered “that the intrusion was in aid of law enforcement.” As Brandeis explained, “The greatest dangers to liberty lurk in insidious encroachments by men of zeal, well-meaning but without understanding.” By the late 1960s, the Court finally came around to this position. In the 2001 case Kyllo v. United States, Justice Antonin Scalia relied on Brandeis’ reasoning to strike down the government’s warrantless use of thermal imaging to search for signs of marijuana cultivation in the defendant’s home.

Urofsky suggests that Brandeis’ sweepingly libertarian dissent “should be read every day by government officials, including presidents,” and it’s hard to disagree. Yet for all the eloquence of his Olmstead opinion, when it came to the “insidious encroachments” of the regulatory state Brandeis was all too happy to defer to “men of zeal.”

The most vivid example of this double standard came five years later in the case of New State Ice Co. v. Liebmann(1932). While the facts behind that case have mostly been forgotten, Brandeis’ colorful dissent produced one of the most quoted passages in American jurisprudence. “It is one of the happy incidents of the federal system,” Brandeis wrote, “that a single courageous State may, if its citizens choose, serve as a laboratory, and try novel social and economic experiments without risk to the rest of the country.”

At issue was a 1925 Oklahoma statute granting a handful of companies the exclusive authority to manufacture, sell, and distribute ice. Under the law, anyone who wanted to enter the ice business had to first justify his plans by providing “competent testimony and proof showing the necessity for the manufacture, sale or distribution of ice” at all proposed locations. In other words, upstart ice vendors faced the virtually impossible task of securing the government’s permission to compete against a state-sanctioned ice monopoly.

That’s the “courageous” experiment Brandeis waxed so poetic about. But what’s so “novel” about a business currying favor with the government in order to suppress competition? That’s one of the oldest tricks in the book. Contrast Brandeis’ quick deference to the state with conservative Justice George Sutherland’s majority opinion striking the monopoly down. “In our constitutional system,” Sutherland wrote, “there are certain essentials of liberty with which the state is not entitled to dispense in the interests of experiments.”

Exactly. As his Olmstead dissent showed, Brandeis sometimes shared this skepticism of state power—at least when it came to state “experiments” on the rights he held dear. Just one year before New State Ice Co., in the case of Near v. Minnesota, Brandeis joined the Court in striking down a Minnesota defamation law as a violation of the freedom of the press. So much for allowing a courageous state to serve as a laboratory for bold experiments.

It was Sutherland’s majority opinion in New State Ice Co., not Brandeis’ famous dissent, that got it right. “In [Near v. Minnesota] the theory of experimentation in censorship was not permitted to interfere with the fundamental doctrine of the freedom of the press,” Sutherland wrote. “The opportunity to apply one’s labor and skill in an ordinary occupation with proper regard for all reasonable regulations is no less entitled to protection.”

Unfortunately, it was Brandeis, not Sutherland, who won out in the end. While Sutherland was fighting a rearguard action in defense of economic liberty, Brandeis stood at the vanguard of a sweeping new legal movement that advocated a “sociological jurisprudence,” which meant the law should adapt to new social and economic “facts.”

Brandeis made a big deal out of that little word, facts, and Urofsky gets a lot of mileage out of it as well, writing that the facts put forward by Brandeis and his allies “embarrassed the assumptions of conservative advocates of substantive due process and liberty of contract, and so were ignored”; that laissez-faire lawyers and judges maintained a “deliberate ignorance of the facts of industrial society”; and that one of Sutherland’s opinions exhibited “a complete disregard for the real world.”

But consider the two decisions that most offended Brandeis and his progressive friends: Lochner v. New York (1905) andAdkins v. Children’s Hospital (1923). In Lochner, the Supreme Court ruled that the maximum working hours provision in New York’s 1895 Bakeshop Act, which forbade bakery employees to work more than 10 hours per day or 60 hours per week, violated the liberty of contract secured by the Due Process Clause of the 14th Amendment, which reads, “nor shall any State deprive any person of life, liberty, or property, without due process of law.”

As Justice Rufus Peckham wrote for the majority, while New York certainly possessed the power to enact health and safety regulations (as all good progressives wanted), the maximum hours provision of the Bakeshop Act “is not, within any fair meaning of the term, a health law.” Not only was the baking trade “not dangerous in any degree to morals, or in any real and substantial degree to the health of the employee,” but the limit on working hours involved “neither the safety, the morals, nor the welfare, of the public.”

So what was the purpose of the law? As George Mason University legal historian David Bernstein has shown, the origins of the Bakeshop Act lie in an economic conflict between unionized New York bakers, who labored in large shops and lobbied for the law, and their nonunionized, mostly immigrant competitors, who tended to work longer hours in small, old-fashioned bakeries. As Bernstein observed, “a ten-hour day law would not only aid those unionized workers who had not successfully demanded that their hours be reduced, but would also help reduce competition from nonunionized workers.” So Lochner not only protected a fundamental economic right, it thwarted an act of economic protectionism as well.

Something similar happened in Adkins v. Children’s Hospital, where the Court struck down the District of Columbia’s minimum wage law for women as a violation of liberty of contract. This was the case where Urofsky claimed Sutherland exhibited “a complete disregard for the real world.” Well, here are some facts about that world. One of the figures in the case was an elevator operator named Willie Lyons, who had earned $35 per month from the Congress Hotel. Under the new minimum wage law, the hotel would have had to pay her $71.50 per month. So they fired Lyons and replaced her with a man willing to work at her old wage. That’s why she sued. As the legal scholar Hadley Arkes memorably put it, “the law, in its liberal tenderness, in its concern to protect women, had brought about a situation in which women were being replaced, in their jobs, by men.”

Had the Progressives cared to look, they would have discovered all sorts of equally inconvenient facts about their various regulatory schemes. More to the point, had Justice Louis Brandeis given economic rights the same constitutional respect he gave to free speech and privacy, the Willie Lyonses of the world might still have a fighting chance in the legal system that Brandeis did so much to reshape.

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May 29, 2017

When Valuations Don’t Seem to “Work”

John P. Hussman, Ph.D.
All rights reserved and actively enforced.

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“Historically, when trend uniformity has been positive, stocks have generally ignored overvaluation, no matter how extreme. When the market loses that uniformity, valuations often matter suddenly and with a vengeance. This is a lesson best learned before a crash rather than after one.”

– John P. Hussman, Ph.D., October 3, 2000

“One of the best indications of the speculative willingness of investors is the ‘uniformity’ of positive market action across a broad range of internals. Probably the most important aspect of last week’s decline was the decisive negative shift in these measures. Since early October of last year, I have at least generally been able to say in these weekly comments that “market action is favorable on the basis of price trends and other market internals.” Now, it also happens that once the market reaches overvalued, overbought and overbullish conditions, stocks have historically lagged Treasury bills, on average, even when those internals have been positive (a fact which kept us hedged). Still, the favorable market internals did tell us that investors were still willing to speculate, however abruptly that willingness might end. Evidently, it just ended, and the reversal is broad-based.”

– John P. Hussman, Ph.D., July 30, 2007

When one examines market cycles across history, including the most extreme speculative bubbles, one typically finds segments where valuations were clearly elevated relative to historical norms, and yet the stock market continued to advance. Still, one also finds that the market dropped like a rock over the completion of the market cycle. Likewise, one finds that virtually every point of significant overvaluation was systematically followed by below-average total market returns over a 10-12 year horizon.

It’s precisely the failure of valuations to matter over shorter segments of the market cycle that regularly convinces investors that valuations don’t matter at all. This delusion is strikingly ingrained into investor behavior, and is almost inescapably revived during every speculative episode. As Graham and Dodd wrote in Security Analysis (1934), referring to the final advance that led to the 1929 market peak, the reason investors shifted their attention away from historically-reliable measures of valuation was “first, that the records of the past were proving an undependable guide to investment; and, second, that the rewards offered by the future had become irresistibly alluring.” The consequence of the delusion that “old valuation measures no longer apply” was predictably wicked, as it was after the 1969, 1972, 2000 and 2007 extremes. What’s distressing is that this delusion is actively encouraged by investment professionals who ought to know better.

Valuations seem unreliable during speculative episodes because investors neglect a critical distinction. While long-term and full-cycle market outcomes are tightly determined by market valuations, the effect of valuations on outcomes over shorter segments of the market cycle depends on the psychological preference of investors toward speculation or risk aversion. When investors are inclined to speculate, they tend to be indiscriminate about it, and for that reason, we’ve found that the most reliable measure of investor psychology is the uniformity or divergence of market action across a wide range of individual stocks, industries, sectors, and security types, including debt securities of varying creditworthiness.

Our own measures of market action extract a signal from the behavior of thousands of securities, and are not captured by simple indicators like 200-day moving averages or advance-decline lines. Still, as a rule-of-thumb, divergence in the behavior of a broad range of individual stocks from the behavior of the major indices tends to be a warning sign, as do widening credit spreads, or lack of uniformity in the behavior of various market sectors.

Put simply, when valuation measures are steeply elevated but investors remain inclined to speculate, as evidenced by very broad uniformity of market action and the absence of internal divergences, rich valuations often have little effect on market outcomes. However, in an environment of extreme valuations, even fairly subtle deterioration in the uniformity of market internals should be taken as a signal of increasing risk-aversion among investors, and the market becomes vulnerable to steep and abrupt losses.

Uniformity of market internals matters

My hope is that, before the current speculative episode predictably unwinds in another catastrophe, investors will learn something from my own successes and challenges over more than 30 years as a professional investor. With regard to successes, my anticipation of the 2000-2002 and 2007-2009 market collapses was based on the combination of rich valuations and deteriorating market internals, which I discussed at the time. Conversely, my adoption of a constructive or leveraged investment stance after every bear market decline in the past three decades typically reflected the combination of a material retreat in valuations coupled with an early improvement in our measures of market action (though my early measures were rather crude).

Since valuation is something I’ve never overlooked, the periodic challenges I’ve encountered in the past three decades have invariably centered on measures of market action. During the advance to the 2000 bubble peak, I became defensive too early. Still, I adapted not by abandoning valuations, but by increasing my research efforts. That research led to the recognition that uniformity across market internals could make even the most obscene levels of overvaluation temporarily irrelevant. Respecting that distinction, without disregarding overvaluation, allowed us to come out ahead over the complete market cycle, as the 2000-2002 decline wiped out the entire total return of the S&P 500, in excess of Treasury bills, all the way back to May 1996.

Likewise, nearly all of our challenges during the advancing half-cycle since 2009 can be traced to my 2009 decision to stress-test our market return/risk classification methods against Depression-era data, which inadvertently led us to overemphasize “overvalued, overbought, overbullish” syndromes that had reliably warned of market losses in prior market cycles across history. The very reliability of these syndromes in prior market cycles made them a complication in the period since 2009. If quantitative easing and zero-interest rate policy made anything legitimately “different” about this half-cycle, it was to disrupt that historical reliability, and to encourage investors to continue speculating even after those extreme syndromes emerged.

Most of our difficulty in the advancing half-cycle since 2009 would have been avoided by the key adaptation that we made in 2014: in the presence of zero-interest rate conditions, even the most extreme “overvalued, overbought, overbullish” syndromes were not enough. One had to wait for market internals to deteriorate explicitly before adopting a hard-negative market outlook (see Being Wrong in an Interesting Way for the full narrative).

The supports have already eroded

If one is talking about a complete market cycle, or 10-12 year investment prospects, valuations matter unconditionally. But if one is talking about a segment of the market cycle, valuations matter to the extent that they are aligned with the prevailing psychology of investors toward speculation or risk-aversion. Those preferences are best inferred from the uniformity or divergence of market internals. The result is that an undervalued market can continue to collapse until market internals demonstrate early improvement and positive divergences. Likewise, an overvalued market can continue to advance until market internals demonstrate early deterioration and negative divergences.

Those shifts of internal market action don’t always have immediate consequences, and they have to be constantly monitored as the evidence changes. Still, a shift in market internals does immediately change the return/risk profile of the market; that is, the probability distribution that describes likely subsequent returns. An overvalued market with uniformly favorable market action has a dramatically different return/risk profile than an overvalued market with deteriorating market action.

At present, we continue to identify one of the most hostile market environments we’ve observed in a century of historical data, not only because obscene valuations and extreme “overvalued, overbought, overbullish” syndromes are in place, but also because our measures of market internals remain in a deteriorating condition. That may change, in which case we will shift to a more neutral outlook. Indeed, if improvement in market internals is joined by a material retreat in valuations, we would expect to shift to a constructive or aggressive outlook (even if valuation measures were still well-above historical norms).

Presently, speculators seem not to recognize how strongly the odds are stacked against them, and how steep and abrupt market losses could become. We are not inclined to “fight” further speculation by raising our safety nets on every advance, and again, our outlook would become far more neutral if market internals were to improve. Still, given the deterioration we observe in market internals here, Wall Street’s habit of dismissing and second-guessing every historically reliable valuation measure is likely to be rewarded by steep losses, as it has following every speculative extreme in history.

Remember the key lesson

Over the weekend, my friend Jonathan Tepper sent me a note suggesting that it might be interesting to discuss the extreme position of the S&P 500 relative to its upper Bollinger bands (two standard deviations above a 20-period moving average) at monthly, weekly, and daily resolutions. Several variants I’ve constructed to identify “overvalued, overbought, overbullish” syndromes include the use of Bollinger bands. Those who fully understand the key lesson of our 2014 adaptations will also know why Jonathan’s question made me cringe.

See, prior to the advancing half-cycle that began in 2009, those “overvalued, overbought, overbullish” syndromes were regularly followed by air pockets, panics and crashes in stock prices. But in this cycle, there’s a whole block of those signals, literally for years, that were followed by further market advances, as the Federal Reserve’s deranged zero-interest rate policy encouraged continued yield-seeking speculation. One had to wait for internals to deteriorate explicitly before taking hard-defensive action in response to those signals. That single restriction (among the adaptations we introduced in 2014) is sufficient to wipe out the entire block of incorrect warnings. But the real-time challenges we experienced as a result of responding to those warnings prior to mid-2014 were ruthless to my previously lauded reputation (hence the cringe).

It may take the completion of the current market cycle for investors to recognize that we’ve already adapted. Though the gain in the S&P 500 since 2014 is likely to be wiped out rather easily, the challenge for hedged equity strategies in the interim has been the extended duration of this top formation, coupled with a feverish shift of investors toward indexing, which has benefited the capitalization-weighted indices relative to a wide range of historically effective stock-selection approaches. As I noted approaching the 2007 peak, value-tilted portfolios often lag just before extended periods of weak or negative performance for the major indices. Conversely, the best time to establish a constructive or leveraged market outlook is when a material retreat in valuations is joined by an early improvement in market action. That’s the point that observers who consider me a “permabear” may become deeply confused, but again, I’ve done the same after every bear market decline in over 30 years of investing. My inadvertent branding is an artifact of my 2009 stress-testing decision (which truncated our late-2008 constructive shift), and it will understandably take a greater portion of the market cycle to shed that.

Meanwhile, Jonathan is right – the S&P 500 is currently at extremely overvalued, overbought, overbullish levels. In the chart below, I’ve coupled one of our “Bollinger band” variants, limited to periods featuring explicit deterioration in our measures of market internals. Without that limitation, there would be a thick red block of false signals covering much of the recent half-cycle. That additional limitation also filters out a few useful warnings that preceded corrections in excess of -10% in 1998 and 1999, but it retains most of the signals in prior market cycles because “overvalued, overbought, overbullish” syndromes typically overlapped a shift toward risk-aversion by investors and a deterioration in our measures of market internals. To the extent that the Federal Reserve’s policies of quantitative easing and zero interest rates disrupted that overlap in the recent half-cycle, “this time” was legitimately “different.” But don’t fall prey to the delusion that this difference can’t be accounted for in a systematic way.

Remember the key lesson. At the personal risk of sounding like a broken record, I also recognize the far greater risk that investors face by ignoring valuations, or assuming something has “gone wrong” with historically reliable measures. The upshot is that the psychological preference of investors toward speculation (which we infer from the behavior of market internals) can temporarily defer the consequences of extreme valuations. Respect that distinction without abandoning valuations altogether, and recognize that at least for now, the combination of obscene overvaluation, extreme overvalued, overbought, overbullish conditions, and divergent market internals creates a terribly hostile return/risk profile for investors. That profile will change as market conditions do. The extent that investors are sensitive to those changes will likely determine the extent that they weather the completion of the current cycle, and benefit from future ones.

You are here

Finally, we should distinguish ignoring valuation measures from systematic research to improve them. Much of my work over the past three decades has been along those lines. For example, our effort to carefully account for the impact of foreign revenues, and to create an apples-to-apples measure of general equity valuation led us to introduce MarketCap/GVA, which is better correlated with actual subsequent 10-12 year market returns than any of scores of measures we’ve studied.

The problem is that we often see investors dismissing various measures of valuation, or proposing alternative measures, without any examination of the logic or historical validity of those measures whatsoever. Every valuation measure should be judged by a) whether it can be reasonably interpreted as a relationship between the current price and the very long-term stream of cash flows that stocks can be expected to deliver over the long-term, and b) the link between that valuation measure and actual subsequent total market returns, ideally over a period of 10-12 years (which is the horizon at which the autocorrelation profile of most valuation measures hits zero).

I’ve previously demonstrated that the correlation of the Shiller cyclically-adjusted P/E (CAPE) with subsequent market returns is substantially strengthened by considering its embedded profit margin (the denominator of the CAPE divided by S&P 500 revenues). Indeed, adjusting for that embedded profit margin boosts the correlation with subsequent 10-12 year returns to nearly 90%. I mention this because investors seem to be playing a game of “you are here”: comparing the current unadjusted CAPE of 28 with the 2000 record high of over 43, inferring that the S&P 500 could rise by over 50% before matching that 2000 extreme. The problem is that in 2000, the CAPE was elevated because the embedded profit margin was just 5.1%, compared with a historical norm of 5.4%. In contrast, current CAPE embeds a profit margin of 7.4%, which results in a lower multiple that is only valid if we require recent record profit margins to be sustained permanently. On the basis of normalized profit margins (which improves the relationship of the CAPE with actual subsequent market returns), the margin-adjusted CAPE was 41 at the 2000 bubble peak, and is above 38 today.

We observe the same thing for other historically-reliable measures such as MarketCap/GVA and the S&P 500 price/revenue ratio. Among the valuation measures having the strongest correlation with actual subsequent market returns, current levels are actually within 10% of the March 2000 extreme. There’s no question that investors have become nearly frantic in their verbal arguments about the permanence of elevated profit margins (which is something that Benjamin Graham observed at other market peaks, and warned against decades ago). We’re certainly open to systematic evidence supporting those arguments in a significant span of post-war data, ideally partitioning margins into the components that drive them. For my own analysis on this subject, see This Time is not Different, Because This Time is Always Different. Meanwhile, our best response to Wall Street’s evidence-free assertions about profit margins is to quote W. Edwards Deming: “Without data, you’re just another person with an opinion.”

Again, if our measures of market internals were to improve, we would allow for the possibility that reliable measures of market valuations could surpass their 2000 extreme, and we would not place a “cap” on how high stock prices could move. As I observed approaching the 2007 peak, “As long as investors perceive valuations to be acceptable, there is no compelling reason why the actual facts should get in their way over the short-term. That allows for the possibility that the current speculative blowoff will continue further. The implications for long-term returns remain daunting, but over the short-term, perception is reality.”

The effect a shift back to uniformly favorable market internals would be to move us to a more neutral outlook, though we would maintain our expectation of dismal full-cycle and long-term outcomes. An early improvement in market action following a material retreat in valuations would provide latitude for a constructive or aggressive outlook. Presently however, the market environment features a combination of obscene overvaluation, extreme “overvalued, overbought, overbullish” syndromes, and deteriorating market internals. The first two features of that combination create poor long-term and full-cycle prospects for the market. The last feature of that combination is what currently opens a potential abyss. Our outlook will shift as conditions change.

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My most memorable high school experience occurred on the first day of my senior year. I was sitting in an Advanced Placement US Government class when the teacher posed a simple question to the students. It was a question intended to set the course in motion, and get us fledgling statecraft scholars thinking.

The question was, “what is government?”

My hand was in the air before he completed the sentence. (I had prepared an answer in anticipation of the course.) Holding on to my holster full of knowledge garnered from my proudly self-described “intellectually avant-garde” internet musings, I said, “Governments (i.e., states in this case) are those organizations that have monopolized the use of force over any given geographical region.”

I then felt embarrassment as my passionate answer was struck down by laughter from the class. My teacher looked down at the floor, unsure how to respond. He had obviously never heard such an answer before, and recovered by reverting back to his conventional train of thought and answering the question as he had been conditioned to: “Governments” he said, “are simply those institutions that make policy.”

I do not remember what he said next. Though I do remember what I was thinking, or rather, what I was feeling.

And I was feeling frustrated and unsatisfied.

My teacher was wrong; the class was wrong. Indeed, I felt my answer was more than appropriate; or, at least more appropriate than the “correct” response — according to the teacher — which was simply: “Government makes policy.” This didn’t answer the underlying question about the nature of government, but specified a function of government. In fact, my teacher was failing to follow the traditional guidelines of credible civics educators around the world. My definition was not extrapolated from some strange corner of the internet, but from famous sociologist Max Weber’s book, Politics as a Vocation. In the book, Weber discussed the concept that states are no different than regular organizations — people coming together with a common goal. But what sets states apart is their assertion of a “monopoly on violence.”

RELATED: “Theories of the State” by Franz Oppenheimer

It is unclear whether that classroom incident was a failure on the part of the teacher or the course itself. However, upon examining the course syllabus (as well as the syllabus for the sister class, “AP Comparative Politics”) on the college board website, it becomes evident that there is no mention of the “definition of government” (only definitions of more basic topics such as the “study of government” and “democracy” and “federalism”), and the only mention of Max Weber is his views on bureaucracy.

In reality, the AP program was designed to give high school students a chance to earn college credits, and therefore, this was designed as a college course by college educators! Therefore, it is likely that this problem extends to entry level college civics courses. Additionally, most high school students will never take an AP government course, or any political science course for that matter. These factors contribute to a population that is ignorant about the nature of states, and their relationship to each person who is subject to the state’s monopoly power.

Thus, discussions concerning the fundamentals of governments are largely nonexistent. When the topic indeed arises among students who take a critical view, such views are stigmatized — labeled as “deviant thinking.” If we really want to allow our students to think critically about those who have authority over them, the intellectually lazy approach that is currently taken in government classes (namely, AP government courses) must end now.

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Our current state of affairs – this is an overgeneralization – two versions of the American existence are emerging as separate entities.

There’s the Knowledge Economy and there’s Trumpism, with a lot less overlap between the two with each passing day. We’re not exactly forced to pick the one around which we’ll coalesce, it’s more that we increasingly feel compelled to. Your choice depends on where you live, what your community looks like, which media outlet you get your news from, how religious you are, what level of education you’ve attained, the industry you work in and the amount of exposure you’ve had – in real life – to people from different walks of life and ethnic backgrounds.

Social media has aggravated these differences and recent political contests have hardened them.

Former Vice President Joe Biden spoke at the Cornell commencement last week, akin to making a direct address to the Knowledge Economy. The crux of his remarks:

I thought we had passed the days when it was acceptable for political leaders at local and national levels to bestow legitimacy on hate speech and fringe ideologies. But the world is changing so rapidly…

There are a lot of folks out there who are both afraid and susceptible to this kind of negative appeal. We saw the forces of populism not only here but around the world call to close our nation’s gates against the challenges of a rapidly changing world…

The immigrant, the minority, the transgender, anyone not like me became a scapegoat. Just build a wall, keep Muslims from coming into the United States.

‘They’re the reason I can’t compete, that’s why I don’t have a job. That’s why I worry about my safety.’ And I imagine, like me, many of you have seen this unfold. It was incredibly disorienting and disheartening.

Biden’s audience – remember, we’re talking about Cornell graduates and their families – is extraordinarily divorced from Trump’s audience. They won’t compete for jobs or real estate or potential mates with the Trumpists. They’ll consume information from different sources and have an almost entirely different life experience as they build their careers and raise their families in the coming years.

It’s sad that this is where we are. I don’t think most people want to be compelled to choose a team within one country, but the environment we’re in now practically demands it. This is deeper than political affiliation or just the usual city versus rural heuristic. It’s cultural. We’re supposed to be one culture, generally speaking. Maybe once we were. Or maybe we never were and it’s only becoming more obvious now. Differences in income and opportunities, magnified by Instagram glamor shots and Facebook status updates, are driving people crazy and forcing them onto teams. And teams discourage independent thought.

There is an implicit conceit within the Knowledge Economy that if everyone would just get with the program, the future would be brighter. From the outside, this can be taken as a chide or a scolding. We know what’s best for you. You shouldn’t be surprised that the kneejerk reaction to this sort of thing is a big f*** you and even votes cast out of spite. No one wants to be lectured by people who presume to be better than them. No one wants to be constantly presented with evidence that their life choices have been self-destructive – especially on social media, which is like one giant, raw nerve ending, continually being rubbed the wrong way.

But what if it flipped?

What if, all of a sudden, the Knowledge Economy didn’t look so hot. By publicly denigrating climate science and prioritizing the re-opening of coal mines, it sometimes seems as though this is an explicit aim of the Trumpists – a reactionary counter-revolution rolling back decades of social progress and industry-specific obsolescence. Re-shuffling the deck of cards. Flipping over the roulette table. Letting the chips fall to the ground and the players starting from scratch.

One current White House advisor said last year that “2016 is the Flight 93 election: charge the cockpit or you die. You may die anyway. You—or the leader of your party—may make it into the cockpit and not know how to fly or land the plane. There are no guarantees.” The implication being that complete destruction is preferable to allowing things to keep going in the current direction. This is a desperation that is utterly inexplicable to those who are currently toward the top of the income and education scale.

In the event of a “complete destruction” of society, how would the denizens of the Knowledge Economy fare?

I came across an extreme example in the novel World War Z. Author Max Brooks explored this idea back in 2006, a full decade before the election that would crystallize these two renditions of American life. His narrator interviews the fictional Director of the Department of Strategic Resources in the aftermath of a global zombie epidemic, which humanity has just barely managed to survive. Having non-Knowledge Economy people as instructors may have saved the world…

America was a segregated workforce, and in many cases, that segregation contained a cultural element. A great many of our instructors…these were the people who knew how to take care of themselves, how to survive on very little and work with what they had. These were the people who tended small gardens in their backyards, who repaired their own homes, who kept their appliances running for as long as mechanically possible. It was crucial that these people teach the rest of us how to break from our comfortable, disposable consumer lifestyle even though their labor had allowed us to maintain that lifestyle in the first place…

Imagine the typical Cornell grad in this sort of scenario. What is she bringing to the table? I imagine my own paltry set of skills and realize how unhelpful they would be as the Department of Strategic Resources classifies us all and puts us to work in staving off the undead hordes at the gate…

You’re a high-powered corporate attorney. You’ve spent most of your life reviewing contracts, brokering deals, talking on the phone. That’s what you’re good at, that’s what made you rich and what allowed you to hire a plumber to fix, which allowed you to keep talking on the phone. The more work you do, the more money you make, the more peons you hire to free you up to make more money. That’s the way the world works. But one day it doesn’t. No one needs a contract or a deal brokered. What it does need it toilets fixed. And suddenly a peon is your teacher, maybe even your boss. For some, this was scarier than the living dead.

Substitute “corporate attorney” for graphic designer or evening news anchor or financial advisor or web developer in your mind. Imagine a world in which those skills suddenly had no meaning, no utility. Now think of the millions of your fellow Americans who have been made obsolete by technology or foreign trade over the last few decades – or live in constant fear that they are about to be.

Once, on a fact-finding tour of LA, I sat in the back of a reeducation lecture. The trainees had all held lofty positions in the entertainment industry, a melange of agents, managers, “creative executives,” whatever the hell that means. I can understand their resistance, their arrogance. Before the war, entertainment had been the most valued export of the United States. Now they were being trained as custodians for a munitions plant in Bakersfield, California.

100,000 retail jobs have been lost over the last year. Hiring in e-commerce positions – from web design to fulfillment and shipping – does not offset these job losses on a one for one basis. And if these workers remain out of work for long, or end up doing something they’re unhappy with, whose message will they be more susceptible to, the Knowledge Economy’s or the Trumpists’? Which team will they join?

How about the 3 million Americans who list their occupation as “driver”? As automated vehicles take their place on the road, will Biden’s appeal resonate? I don’t think so. It’s much more likely that the rhetoric of “the experts were wrong, burn it all down” will get through and take hold.

Can anyone or anything turn this tide of our growing separation from each other? I can’t imagine what could do it in the short-term. And I still can’t change an oil filter.


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Suppose that over time traders have experimented with trading rules, drawn from a very wide universe of trading rules, perhaps tens of thousands of different iterations. As time progresses the rules that happen to perform well historically, attract more attention and are considered serious rules by the trading community, while unsuccessful rules gradually fall by the wayside.

If enough trading rules are considered over time, some rules, by pure luck, even in a large sample, will produce superior performance, even if they do not genuinely possess predictive power.

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Moral hazard, easy money, and cheap credit have never produced good results. History is littered with examples of financial disaster brought about by monetary manipulation originating in central banks and then spreading to other parts of the system. One would think that the 2007/8 credit crisis, whose effects have not quite withered away, would teach politicians, central bankers, corporations, and consumers something about the causes of credit crunches and meltdowns.

Consumer credit markets are the ones already signaling distress.

Think again. The world’s four largest central banks have pumped more than $9 trillion into the system since the last financial crisis and brought about a world of absurdly low and even negative interest rates. The incentives generated by these policies and their effects – moral hazard, easy money, cheap credit – will lead, at some point, to the bursting of new bubbles.

Which ones? It’s never easy to say, but the United States has seen an unhealthy growth of subprime credit, and credit in general, in three markets – credit cards, auto loans, and student loans. It would not be a surprise if one of these brought about the next credit crunch.

Big Debt

Total credit card debt has surpassed the $1 trillion mark for the first time since 2009, student loans now amount to a total of $1.4 trillion, and auto loans are not far off at $1.2 trillion – an amount that dwarfs the pre-financial crisis peak.

Over the past five years, U.S. corporations have issued more than $7 trillion of new debt, showing that the incentives created by these perversely low interest rates go beyond the markets mentioned before.

However, those consumer credit markets are the ones already signaling distress, so we better pay some attention. Capital One, a big lender to subprime borrowers (particularly through credit cards and auto loans), has had to write off a lot of debt lately – for a total of more than 5 percent of its outstanding loans, the level usually considered the threshold of very dangerous territory.

Predictably the auto industry is now experiencing defaults.

The auto loan sector is especially alarming. Auto sales doubled in the last seven years and are now at an unprecedented level. As happened with mortgage loans before the 2007/8 debacle, money was thrown around in the form of auto loans with no down payment and extended periods.

Predictably the industry is now experiencing defaults (delinquencies are at the highest point since 2009). The result is a heavily increased supply of used cars that have driven down their price. A large part of the auto industry, including manufacturers who lend money to purchasers and rental companies, rely on the sale of securities backed by used cars to fund their operations. Rental companies also rely on the sale of used cars in order to purchase new ones.

Déjà Vu

These symptoms point to risks not dissimilar in nature to what was happening before the housing-related financial meltdown. Banks are beginning to reduce outstanding corporate lending for the first time since that crisis – total loans at the fifteen largest U.S. regional banks in the first quarter of 2017 were $10 billion below the previous quarter, a very significant reversing of the trend.

Standard and Poor’s downgraded 1,088 companies in the United States last year, and analysts are predicting a wave of junk-debt defaults, perhaps encompassing one in every four high-yield debt issuing companies.

One can never tell exactly when a bubble will burst or which corner of the financial system will be the epicenter of the earthquake. But if and when these looming bubbles explode, the main culprit will be the irresponsible policies that were supposed to prevent future bubbles and that created the perfect storm of moral hazard, easy money, and cheap credit once again.


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It was this [partial] post that got me thinking, as there are a number [lots?] of systems traders out there:

I don’t think I curve fit and use price action patterns as a basis for all my code , the majority of my indicators are custom written by myself ( why I will not divulge or discuss ) and represent tangible price action events . Median reversion is the basis of my systems and I filter what I see as important aspects of price action . The counts used in charts here are only a part of the process but they do measure trend and reversals and are integral part of what I do on every time frame .

So my question is: is every bar created equal?

The answer [to my mind] is clearly no.

Some bars contain nothing but trading noise, whereas other bars contain important information.

Will the market [the sum of all participants of a given bar] treat the same information in the same way as they did previously?

Again, my answer would be clearly no. The participants could, and likely would be, completely different, with the commensurate difference in subjective views. That is just one example, there are hundreds of reasons why the reaction could be different.

Therefore, building a trading system/methodology, based on historical data is prone to randomness, exactly what you are trying to eliminate.

Is this a futile undertaking?

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On May 24, 1976, the Judgment of Paris pitted some of the finest wines in France against unknown California bottles in a blind taste test. Nine of the most respected names in French gastronomy sat in judgment.

It was the tasting that revolutionized the wine world.

Forty years ago today, the crème de la crème of the French wine establishment sat in judgment for a blind tasting that pitted some of the finest wines in France against unknown California bottles. Only one journalist bothered to show up — the outcome was considered a foregone conclusion.

“Obviously, the French wines were going to win,” says George Taber, who was then a correspondent for Time magazine in Paris. He says everyone thought “it’s going to be a nonstory.”

Taber did attend, as a favor to the organizers. And he ended up getting the biggest story of his career: To everyone’s amazement, the California wines — red and white — beat out their French competitors.

“It turned out to be the most important event, because it broke the myth that only in France could you make great wine. It opened the door for this phenomenon today of the globalization of wine,” Taber says.

The Judgment of Paris, as that May 24, 1976, wine tasting has come to be known, began as a publicity stunt. Steven Spurrier, an Englishman who owned a wine shop in Paris, wanted to drum up business. So, prompted by Patricia Gallagher, his American associate, Spurrier decided to stage a competition that highlighted the new California wines they’d been hearing so much about.

Spurrier tapped nine of the most respected names in French gastronomy for the job. They included sommeliers from the best French restaurants in Paris, the head of a highly regarded French vineyard, and Odette Kahn, the editor of the influential Revue du vin de France (The French Wine Review).

As the sole journalist present, Taber had a lot of access, and he had a list of the order of the wines being served during the tasting. The judges didn’t. He watched as they swirled and spat.

At one point, Taber says, a judge — Raymond Oliver, chef and owner of Le Grand Véfour, one of Paris’ great restaurants — sampled a white. “And then he smelled it, then he tasted it and he held it up again, [and] he said, “Ah, back to France!” Taber recalls.

Patricia Gallagher (from left), who first proposed the tasting; wine merchant Steven Spurrier; and influential French wine editor Odette Kahn. After the results were announced, Kahn is said to have demanded her scorecard back. “She wanted to make sure that the world didn’t know what her scores were,” says George Taber, the only journalist present that day.

Except it was a Napa Valley chardonnay. The judge didn’t know that. “But I knew,” Taber says. And once he realized what was happening, Taber says, “I thought, hey, maybe I got a story here.” Decades later, he penned The Judgment of Paris, an account of that day and its aftermath.

When the scores were tallied, the top honors went not to France’s best vintners but to a California white and red — the 1973 chardonnay from Chateau Montelena and the 1973 cabernet sauvignon from Stag’s Leap Wine Cellars. (A bottle of each now resides at the Smithsonian’s National Museum of American History.)

Taber says the results shocked everyone. When it was over, Kahn unsuccessfully demanded her scorecard back — according to Taber, “she wanted to make sure that the world didn’t know what her scores were.”

Wine writer David White says the tasting was a major turning point for the industry. “The 1976 judgment totally changed the game,” says White, who runs the popular wine blog Terroirist and is the author of the forthcoming book But First, Champagne: A Modern Guide to the World’s Favorite Wine.

While winemaker Robert Mondavi played a major role in making California the wine powerhouse it is today, the Paris tasting was equally influential, White says. As the late Jim Barrett, part owner of Napa Valley’s Chateau Montelena, told Taber back in 1976, the results were “not bad for kids from the sticks.”

And it wasn’t just California that was transformed. The results “gave winemakers everywhere a reason to believe that they too could take on the greatest wines in the world,” White says.

In the aftermath of the tasting, new vineyards bloomed around the U.S. (think Oregon, Washington and Virginia) and the world — from Argentina to Australia.

The Judgment of Paris prompted the world’s winemakers to start sharing and comparing in a way they hadn’t done before, says Warren Winiarski, the Polish-American founder of Stag’s Leap, whose cabernet sauvignon took top honors among the reds in Paris.

As a result, he said at a recent Smithsonian event in honor of that long-ago tasting, “the wines of the world are better, the wines of France are better.”

Which means the world’s wine lovers were the real winners that day.

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SHIRLEY SCHMITT is no one’s idea of a dangerous criminal. She lived quietly on a farm in Iowa, raising horses and a daughter, until her husband died in 2006. Depressed and suffering from chronic pain, she started using methamphetamine. Unable to afford her habit, she and a group of friends started to make the drug, for their own personal use. She was arrested in 2012, underwent drug treatment, and has been sober ever since. She has never sold drugs for profit, but federal mandatory minimum rules, along with previous convictions for drug possession and livestock neglect, forced the judge to sentence her to ten years in prison. Each year she serves will cost taxpayers roughly $30,000—enough to pay the fees for three struggling students at the University of Iowa. When she gets out she could be old enough to draw a pension.

Barack Obama tried to reduce the number of absurdly long prison sentences in America. His attorney-general, Eric Holder, told federal prosecutors to avoid seeking the maximum penalties for non-violent drug offenders. This reform caused a modest reduction in the number of federal prisoners (who are about 10% of the total). Donald Trump’s attorney-general, Jeff Sessions, has just torn it up. This month he ordered prosecutors to aim for the harshest punishments the law allows, calling his new crusade against drug dealers “moral and just”. It is neither.

More is not always better

Prisons are an essential tool to keep society safe. A burglar who is locked up cannot break into your home. A mugger may leave you alone if he thinks that robbing you means jail. Without the threat of a cell to keep them in check, the strong and selfish would prey on the weak, as they do in countries where the state is too feeble to run a proper justice system.

But as with many good things, more is not always better (see article). The first people any rational society locks up are the most dangerous criminals, such as murderers and rapists. The more people a country imprisons, the less dangerous each additional prisoner is likely to be. At some point, the costs of incarceration start to outweigh the benefits. Prisons are expensive—cells must be built, guards hired, prisoners fed. The inmate, while confined, is unlikely to work, support his family or pay tax. Money spent on prisons cannot be spent on other things that might reduce crime more, such as hiring extra police or improving pre-school in rough neighbourhoods. And—crucially—locking up minor offenders can make them more dangerous, since they learn felonious habits from the hard cases they meet inside.

America passed the point of negative returns long ago. Its incarceration rate rose fivefold between 1970 and 2008. Relative to its population, it now locks up seven times as many people as France, 11 times as many as the Netherlands and 15 times as many as Japan. It imprisons people for things that should not be crimes (drug possession, prostitution, unintentionally violating incomprehensible regulations) and imposes breathtakingly harsh penalties for minor offences. Under “three strikes” rules, petty thieves have been jailed for life.

A ten-year sentence costs ten times as much as a one-year sentence, but is nowhere near ten times as effective a deterrent. Criminals do not think ten years into the future. If they did, they would take up some other line of work. One study found that each extra year in prison raises the risk of reoffending by six percentage points. Also, because mass incarceration breaks up families and renders many ex-convicts unemployable, it has raised the American poverty rate by an estimated 20%. Many states, including Mr Sessions’s home, Alabama, have decided that enough is enough. Between 2010 and 2015 America’s incarceration rate fell by 8%. Far from leading to a surge in crime, this was accompanied by a 15% drop.

America is an outlier, but plenty of countries fail to use prison intelligently. There is ample evidence of what works. Reserve prison for the worst offenders. Divert the less scary ones to drug treatment, community service and other penalties that do not mean severing ties with work, family and normality. A good place to start would be with most of the 2.6m prisoners in the world—a quarter of the total—who are still awaiting trial. For a fraction of the cost of locking them up, they could be fitted with GPS-enabled ankle bracelets that monitor where they are and whether they are taking drugs.

Tagging can also be used as an alternative to locking up convicts—a “prison without walls”, to quote Mark Kleiman of New York University, who estimates that as many as half of America’s prisoners could usefully be released and tagged. A study in Argentina finds that low-risk prisoners who are tagged instead of being incarcerated are less likely to reoffend, probably because they remain among normal folk instead of sitting idly in a cage with sociopaths.

Justice systems could do far more to rehabilitate prisoners, too. Cognitive behavioural therapy—counselling prisoners on how to avoid the places, people and situations that prompt them to commit crimes—can reduce recidivism by 10-30%, and is especially useful in dealing with young offenders. It is also cheap—a rounding error in the $80 billion a year that America spends on incarceration and probation. Yet, by one estimate, only 5% of American prisoners have access to it.

The road to rehabilitation

Ex-convicts who find a job and a place to stay are less likely to return to crime. In Norway prisoners can start their new jobs 18 months before they are released. In America there are 27,000 state licensing rules keeping felons out of jobs such as barber and roofer. Norway has a lower recidivism rate than America, despite locking up only its worst criminals, who are more likely to reoffend. Some American states, meanwhile, do much better than others. Oregon, which insists that programmes to reform felons are measured for effectiveness, has a recidivism rate less than half as high as California’s. Appeals to make prisons more humane often fall on deaf ears; voters detest criminals. But they detest crime more, so politicians should not be afraid to embrace proven ways to make prison less of a school of crime and more of a path back to productive citizenship.

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For centuries, cross-border trade has come with a currency problem. The expansion of globalisation has not made it any less pressing. The dilemma identified by the economist Robert Triffin is a powerful – and alarmingly current – reminder that a worldwide foreign exchange crisis is only one big mood change away.

The Scottish philosopher and economist David Hume identified the fundamental issue in 1752. While the sum of global exports always equals global imports, countries can run persistent trade deficits. In Hume’s time, the deficit country shipped gold to pay for overseas goods. Today, creditors have to accept large quantities of deficit countries’ currency.

Hume thought the free market would correct these imbalances, through what we now call currency devaluations. Exports would rise, imports would fall, and the gold would return. But it turns out that the economic patterns which lead to trade deficits are remarkably stubborn. They persist as long as importers can find a way to pay for their lifestyles.

When the gold runs out or the lenders finally give up, default is almost unavoidable. Usually, such national financial failures cause only small ripples in the world economy. But that is not always the case. As Triffin pointed out in 1960 the effects would be much more serious if creditors lose faith in the global reserve currency – the unit which is readily accepted for trade and commonly used for savings pretty much everywhere.

A flight from a reserve currency would throw the global trading system into disarray. As in Triffin’s day, the currency in question is the U.S. dollar. As the Belgian-American economist understood, the dollar will remain solid until the day of reckoning. Foreigners will be willing to accumulate more greenbacks because holdings of the global reserve currency help trade run smoothly. So they are more than happy to finance America’s trade deficit.

But the more the United States spreads dollars around the world, the more likely holders are to question America’s creditworthiness. Economists named the simultaneous desire for dollars and the danger involved in holding them the Triffin dilemma. Valéry Giscard d’Estaing, then the French finance minister, called it America’s “exorbitant privilege”.

The United States has exercised its privilege abundantly ever since. As the chart shows (, the net U.S. international investment position – basically the market value of dollars invested from America minus the value of dollars lent to it – first turned negative in 1988. After some gyrations, a firm trend has set in. By 2016, the deficit had reached around 11 percent of global GDP.

That is an awful lot of dollar value at risk. But the development is not surprising. Cross-border trade has increased from 17 percent of world GDP in 1960 to 45 percent today, according to the World Bank. The first horn of the Triffin dilemma explains that this growth leads to more expatriate dollars. The other horn points out that a currency crisis now would be very disruptive.

Suppose some American irresponsibility or arrogance exhausts the patience of the Chinese government, prompting it to sell some of its vast stock of dollar-denominated assets. Others would follow, rushing to currencies still perceived as relatively safe. That creates political discontent in countries such as Japan and Switzerland. Capital controls would come and cross-border trade would go.

Meanwhile, the U.S. Federal Reserve would probably raise interest rates to defend the dollar. Leveraged investors would be forced to sell, creating market mayhem. Big banks could topple over. Though they are better capitalised than a decade ago, they still rely extensively on the ready global availability of supposedly risk-free U.S. government debt.

The unity of that global quasi-government is fraying, though. Central bankers have tested politicians’ patience with years of ultra-low rates. And global politics are troubled. President Donald Trump does not generally behave like a believer in cross-border solidarity. The euro zone has become more inward looking. China has become larger but also more nationalistic. Japan has become smaller.

Ultimately, all profound financial problems must have political solutions, because only governments have enough authority to allocate damage and restore confidence. This explains why cross-border financial problems are especially hard to solve – there is no international government to intervene.

The U.S. dollar’s reserve status has withstood numerous shocks and a succession of profligate presidents. If the Triffin dilemma turns into a crisis, though, everyone will wonder why the dollar was allowed to underpin the global economy in a political near-vacuum.

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