I’ll be back from vacation next week, hopefully rested and ready to return to a more regular regimen of posting. In the meantime, I thought I’d share an article that caught my attention during a week otherwise occupied by beach reading, …and playing with my kids.

For those of you who follow this blog, you know that I have an interest in the job market for MBA graduates. As I have argued in the past, as difficult as the job market has been for MBA graduates from the class of 2009, it is my expectation that that the job market will, unfortunately, turn out to be worse for graduates from the class of 2010 (see Visit to the FT and Crisis for MBA Grads). I was therefore not surprised to come across an article in yesterday’s New York Times  detailing the difficulty that Law students have been having on this year’s market (see Downturn Dims Prospects).

This fall, law students are competing for half as many openings at big firms as they were last year in what is shaping up to be the most wrenching job search season in over 50 years.

New York University, Georgetown, Northwestern and other top universities confirm that interviews are down by a third to a half compared with a year ago, while lower-ranked schools are suffering more. What is more, when interviews finish in a few weeks, even fewer offers will be extended, said Howard L. Ellin, the chairman of global hiring at Skadden, Arps, because many firms are interviewing students for slots they may not fill.

We were already in recession at this time last year. So if interviews are down 33-50% from last year’s already depressed level, how bad must the market be this year?? Wow!

Although the New York Times article is specific to the market for attorneys, the job market for Law School grads shares many similarities with the market for MBA grads. Interviews start a bit earlier for law graduates than business graduates; but as with law, the lion’s share of the MBA interview activity takes place in the Fall.

And even if the broader economy is improving (and I am not quite convinced improvement is the word to characterize it, stabilizing is probably more accurate), it will be quite some time before the market for MBA grads picks back up, as many companies do not foresee robust growth. So not only are graduates competing for fewer overall slots, but they are also competing with the unemployed and under-employed (individuals who are working part-time for economic reasons, and similarly-credentialed graduates who took whatever jobs they could find).

So unfortunately, no green shoots for grads thus far…

On my way out of town for a much needed break. Here are a few things that caught my attention:

1. American Graduates Finding Jobs in China
2. Hints of a Rebound in Global Trade
3. Interest Fizzles in Cash for Clunkers
4. Volkswagen and Porsche Close In on Deal to Combine
5. The Pay at the Top (Compensation for 200 Chief Executives)
6. Life without Landlines
7. An Early Stab at Quantitative Easing
8. US Homeowners Cut Asking Prices
9. GM and Chrysler in Different Paths to Recovery
10. Asia’s Astonishing Rebound?
11. A Debate over Cause and Effect (kind of geeky, but how can I not include an article that mentions instrumental variables)

Happy Weekend!

Stumbled across the following in New York Magazine — Hot Waitress Economic Index. According to Hugo Lindgren, there may actually be a better gauge of economic activity than GDP.

Are things getting better? The answer is rarely straightforward.

In New York, we have our own economic indicators, often based on the degree to which people are being thwarted by the lack of opportunity. An old standby is the Overeducated Cabbie Index. The Squeegee Man Apparition Index is another good one. There’s also the Speed at Which Contractors Return Calls Index: within 24 hours, you’re in a recession; if they call you without prompting, that’s a depression.

The indicator I prefer is the Hot Waitress Index: The hotter the waitresses, the weaker the economy…

Interesting hypothesis.

Check out the full satire by clicking Hot Waitress Economic Index.

Back in March I suggested that an open discussion about the future of financial economics seemed warranted (see Future of Financial Economics). I wrote:

Are the fundamental assumptions about human behavior associated with the dominant paradigm in financial economics appropriate?

The first assumption that I took issue with was that of complete markets. In fact, as I suggested:

One of the things that drew me to the field of strategy in the first place (versus finance or economics) is that we start with a baseline assumption that markets are incomplete, and markets break down.

Markets break down largely because humans do not behave as “rational” actors typically assumed in our most celebrated models.

In addition to the view of markets as complete, I took issue with some of the other assumptions underlying the efficient market hypothesis.

…associated with the [efficient market hypothesis] EMH-dominated financial economics view is an assumption that there is a true, objective, underlying fundamental price for an asset. We might deviate from that price in the short run; but in the long run, the fundamental price will prevail.

I concluded by calling for greater inclusion, and an openness to contributions from behavioral economics and other social science disciplines.

All told, I think the field of financial economics would be well served to be more inclusive when it comes to behavioral approaches to human behavior (whether from economics or psychology) and behavioral views of the firm (whether informed by psychology, sociology, or economics). Thankfully, not only are both processes well underway, but in some quarters, they have been for some time.

With that as background, I was pleased to come across a fascinating set of articles from this week’s issue of the Economist entitled “Economics: What went Wrong?” This collection of articles asked fundamentally important questions about the future of the field of economics (see Economics: What went Wrong?, Other-worldy Philosophers, and Efficiency and Beyond).

On the field of economics:

Barry Eichengreen, a prominent American economic historian, says the crisis has “cast into doubt much of what we thought we knew about economics.”

…two central parts of the discipline—macroeconomics and financial economics—are now, rightly, being severely re-examined. There are three main critiques: that macro and financial economists helped cause the crisis, that they failed to spot it, and that they have no idea how to fix it.

On financial economics:

In 1978 Michael Jensen, an American economist, boldly declared that “there is no other proposition in economics which has more solid empirical evidence supporting it than the efficient-markets hypothesis” (EMH). That was quite a claim. The theory’s origins went back to the beginning of the century, but it had come to prominence only a decade or so before. Eugene Fama, of the University of Chicago, defined its essence: that the price of a financial asset reflects all available information that is relevant to its value.

From that idea powerful conclusions were drawn, not least on Wall Street. If the EMH held, then markets would price financial assets broadly correctly. Deviations from equilibrium values could not last for long. If the price of a share, say, was too low, well-informed investors would buy it and make a killing. If it looked too dear, they could sell or short it and make money that way. It also followed that bubbles could not form—or, at any rate, could not last: some wise investor would spot them and pop them.

That is why many people view the financial crisis that began in 2007 as a devastating blow to the credibility not only of banks but also of the entire academic discipline of financial economics.

On macroeconomics:

In many macroeconomic models…insolvencies cannot occur. Financial intermediaries, like banks, often don’t exist. And whether firms finance themselves with equity or debt is a matter of indifference. The Bank of England’s DSGE model, for example, does not even try to incorporate financial middlemen, such as banks. “The model is not, therefore, directly useful for issues where financial intermediation is of first-order importance,” its designers admit. The present crisis is, unfortunately, one of those issues.

…Economists can become seduced by their models, fooling themselves that what the model leaves out does not matter. It is, for example, often convenient to assume that markets are “complete”—that a price exists today, for every good, at every date, in every contingency. In this world, you can always borrow as much as you want at the going rate, and you can always sell as much as you want at the going rate.

The benchmark macroeconomic model…suffers from some obvious flaws, such as the assumption of complete markets or frictionless finance…nuanced theories are often less versatile. They shed light on whatever they were designed to explain, but little beyond.

On behavioral economics:

…[a] branch of financial economics is far more sceptical about markets’ inherent rationality. Behavioural economics, which applies the insights of psychology to finance, has boomed in the past decade. In particular, behavioural economists have argued that human beings tend to be too confident of their own abilities and tend to extrapolate recent trends into the future, a combination that may contribute to bubbles. There is also evidence that losses can make investors extremely, irrationally risk-averse—exaggerating price falls when a bubble bursts.

“In some ways, we behavioural economists have won by default, because we have been less arrogant,” says Richard Thaler of the University of Chicago, one of the pioneers of behavioural finance. Those who denied that prices could get out of line, or ever have bubbles, “look foolish”.

The Economist concludes:

Add these criticisms together and there is a clear case for reinvention…Economists need to reach out from their specialised silos…

I could not agree more.

However you may feel about the future of financial economics, I encourage you to read the articles in full:

• Economics: What went Wrong?
• Other-worldy Philosophers
• Efficiency and Beyond

A friend and colleague of mine who accepted a job at a European university jokingly explained in an email yesterday that his move to London could easily be explained by the fact that he had always wanted to become a currency speculator. I asked whether he really want to bet against the Dollar, or for that matter, for the Pound. He preceded to ask me what I thought about the strength of the Dollar, and the strength of the Dollar vis-a-vis the Pound.

I wrote the following, off-the-cuff response (edited slightly to censor expletives and to improve readability):

In my opinion there are a couple of forces impacting the value of the dollar right now.

1. Dollar as a “flight to quality” vehicle (pushing it up)

2. Dollar as a debased currency with the Fed/Treasury programs of fiscal stimulus plus quantitative easing (pushing it down)

The question then becomes which of these effects represents the stronger influence.

Although the dollar has weakened recently, I believe the “flight to quality” effect will dominate in the near term with the dollar strengthening over the next 6 months or so. Eventually however (looking 1 to 2 years out), the debasement effect will kick in leading to a fall in the value of the dollar.

That opinion, however, only addresses the Dollar versus a basket of world currencies, not necessarily the Pound.

With respect to the USD/GBP, it becomes a relative game with respect to the two effects above. Specifically, is the dollar a stronger “flight to quality” play than the pound and/or is the Bank of England debasing the Pound faster than the Fed/Treasury is debasing the dollar?

I think the answer to both is an emphatic yes. At this point, the Dollar remains a stronger “flight to quality” vehicle than the Pound given its higher status in the pecking order of reserve currencies. In addition, although the US recession has been severe by almost any metric, the situation is actually worse in the UK, leading the UK to engage in larger relative programs of both fiscal stimulus and quantitative easing.

For these reasons, although I feel that the value of the dollar will decrease with respect to world currencies in the long term, I expect the Dollar to strengthen vis-a-vis the pound.

Interesting stuff. In an article published last week at Slate (ht Barry Ritholtz), Daniel Gross takes issue with a McKinsey & Co. report about the The New Power Brokers (see McKinsey’s Cracked Crystal Ball). Gross criticizes McKinsey for offering inaccurate predictions with respect to the rise of private equity funds and hedge funds. Gross writes:

In October 2007—the precise market top—McKinsey Global Institute, a think tank nestled in the confines of the blue-chip consulting firm McKinsey & Co., issued a report documenting the stunning rise of four comparatively new pools of capital—hedge funds, private-equity firms, Asian sovereign capital (Asian central banks and sovereign wealth funds), and petroleum exporters (companies, governments, and central banks of oil producers). These new power brokers had been major beneficiaries of recent trends in the global economy. And if existing trends were to continue—and why wouldn’t they?—they’d be even bigger in a few years.

As the executive summary noted (here’s the whole report), in mid-2007 that group collectively held $8.4 trillion in assets, more than triple the amount they held in 2000. But that was just the beginning. “Under current growth trends, MGI research finds that their assets will reach $20.7 trillion by 2012.”

Like virtually every professional economic-forecasting outfit, McKinsey’s crew failed to see how the easy money created by the rise of Asian sovereign wealth and petroleum exporters would be put to spectacularly bad use by private-equity firms and hedge funds…Of course, you don’t have to be a management consultant to know that simply projecting recent trends into the near future—forecasting by extrapolation—is dangerous, especially today, when volatility and discontinuities are rampant. A scant two years ago, MGI’s brainpower was unable to foresee the forces that would cause hedge funds to take a tumble and private-equity deals to blow up.

The interesting thing to me about Gross’ piece is not the criticism of McKinsey. It is not even that McKinsey might have been off in its prognostication. The most interesting part was that the article elicited a response from McKinsey. Why McKinsey would feel threatened by the piece is beyond me. It’s not like the piece does irreparable harm to McKinsey’s reputation.

Nevertheless, Rebeca Robboy, the media representative from the McKinsey Global Institute, responded in the comments section on the slate site. She writes:

Dan Gross is entitled to disagree with our conclusions, but not to misrepresent our research…

First, Gross wrote that our original 2007 report “utterly failed to sniff out the systemic risks” posed by the rise of these four increasingly large and influential investor groups. In fact, and to the contrary, our report explicitly noted that the “the rise of the power brokers also poses new risks to the global financial system.” We noted specifically that the surplus capital invested by oil exporters and Asian sovereign investors was lowering interest rates and “may be inflating some asset prices and enabling excessive lending” and we highlighted real estate as an area that warranted concern.

Second, Gross fundamentally misrepresents our work by stating that we assume that recent trends will continue into the future.

Third, he errs in calling our work “forecasting by extrapolation.” We are not forecasters. We have reported the facts based on proprietary databases, and our analyses of future trends under three proprietary macroeconomic scenarios.

SIDEBAR: Call me crazy, but with respect to the third point, doesn’t “analyses of future trends under three proprietary macroeconomic scenarios” qualify as a forecast? Am I missing some semantic subtlety?

Anyhow, I still find it interesting that McKinsey felt compelled to respond to Gross in a public forum. Although I am sure their response was in the interest of setting the record straight, it comes across as defensive overly sensitive, borderline desperate. C’mon, this is McKinsey we’re talking about, the Goldman of consulting. They need not have responded.

For the record, I have been writing about private equity funds for quite awhile. By the end of 2006/early 2007, it was patently obvious to most that hedge funds and private equity funds were in decline. In fact, in April of 2007, in a post entitled Private Equity – Stupid Money Chasing Stupid Deals, I wrote:

I do believe that the increasing number of private equity deals of late is an exemplar of excess…I refer to this as the phenomenon of stupid money chasing stupid deals…will all these ventures be successful? Likely not. With most private equity firms flush with cash as a result of the global liquidity glut (caused by historically low interest rates and a change in attitudes toward risk) and with only a finite number of targets to buy, increased competition among LBO funds (and industry acquirers) for the same handful of firms has led many buyers to overpay. Moreover, with creditors offering enough debt to hang oneself with, many targets will become overextended.

I followed that in March of 2008 with a post about the end of the private equity era (see Private Equity: The End of an Era). I wrote:

If anyone thought that private equity acquisitions were driven purely by skillful strategists and financiers (alpha in their parlance), here’s your evidence to the contrary. Many such deals were a simple product of the times (fueled by the availability of cheap money and credit). This is not to say that some private equity players are not skilled, just that there are likely much much fewer of the skilled type than many of us had thought just as little as one year ago.

Frankly, I have expected this endgame for quite awhile now – one in which many of the private equity portfolio companies would go bankrupt, and potentially take a few of their parents with them…

But more than that, for me, these events officially mark the end of an era. We will likely look back at this period and eventually refer to it as the second LBO wave. In my opinion, there are now two identifiable, and distinct, LBO waves:

1. The 1980’s – the wave that most of us associate with the LBO heyday; driven by the break-up of conglomerates, culminating with the RJR Nabisco deal, and etched in our memories by the movie “Wall Street”
2. The 2000’s – the cheap money wave; fueled by excess leverage, cov-lite deals, financial engineering, and a dose of Sarbanes-Oxley compliance avoidance

CAVEAT: None of my writings about private equity qualifies as a forecast, …simply reporting the facts based on proprietary databases, and my analysis of future trends.

My schedule has kept me on the road for the better part of the past few weeks. I first traveled to Los Angeles, then San Diego, and then on to Cape Cod (with a brief one-night stopover in New York). The bookends of the trip (LA and Cape Cod) were largely recreational. The San Diego leg was strictly business, where I attended the Annual Meeting of the Academy of International Business (AIB).

The AIB meetings were fun, as usual. I got to participate in Academy business, discuss research with colleagues, catch up with friends, and attend some parties (which, not unexpectedly, were subdued compared with years past). In LA and Cape Cod, I spent my time largely with family and friends.

Last summer, while in Cape Cod, I made the following observations (see Musings Après Vacation):

1. “For Sale” signs on homes were abundant
2. There was, uncharacteristically, little traffic on the drive between New York City and Cape Cod
3. Our usual haunts (e.g., Cooke’s, Four Seas) seemed unusually quiet

This year I’ve noticed that “For Sale” signs have stopped growing like weeds. Although there continue to be more homes for sale than I am accustomed to seeing in a usual summer, there are certainly fewer than last year. This stylized fact seems to reflect an improvement in home inventory conditions; however, I am hesitant to characterize it as such for certain, as it could simply be a reflection of a substantial “shadow inventory” of homes (see Calculated Risk for information on shadow inventory and huge shadow inventory).

One thing that I have noticed much more of this summer in and around Cape Cod is a huge increase in “For Sale” and “For Rent” signs for commercial real estate. Many buildings have been abandoned. Many are available for sale/lease. There is an incredible amount of vacancy at the local strip malls, and even at the Cape Cod Mall. This is consistent with commercial real estate as the next shoe to drop in this cycle (see Commercial Real Estate Time Bomb).

Note: I travel to LA quite frequently too, and the trends struck me as similar to those that I described for Cape Cod. I noticed fewer homes for sale on this trip than on previous (the same caveat regarding “shadow inventory” applies). Likewise, there has been a noticeable increase in signs advertising the sale/lease of commercial real estate.

Insofar as getting in and out of NYC on summer weekends (and in and out of Cape Cod), the highways seem slightly more trafficked than last summer. But again, the crowds are far from normal. Ditto for foot traffic at our local haunts. Although business seems a bit better than last year, it is way off from what I would characterize as normal, healthy summer activity.

In concluding last year’s post, I wrote:

Now I realize that the anecdotes that I’ve shared simply represent one person’s observations (an n of 1 as we like to say in the business), but if my experiences thus far this summer are any indication, I think we’re in for a long and difficult slog. I have never seen anything quite like it…

Not much has changed from last year. Economic activity continues at depressed levels. The best I can say is that we may have found a floor. The question remains: Where do we go from here??

As I have suggested in previous posts, the immediate growth engine for the U.S. economy is unclear. I see some potential in alternative energy, nano-technology, and biotech (specifically, genome mapping and its associated applications). However, I am skeptical that those industries will grow fast enough to quickly bring about robust growth. Although the U.S. economy will likely return to growth in 2010, there is a decent probability that the recovery will be a weak one.

Oh yeah, …and I’ll be back from vacation next week.

In a recent post (see Are Better-than-Expected Earnings Illusory?) I suggested that first quarter earnings came in better than expected largely because corporations undertook larger-than-expected cost cuts.

In response to economic malaise, it’s fairly typical for firms to try to reduce costs in an effort to stave off the deleterious consequences of decreased demand. There are several ways that a firm can do so: through layoffs, by rationalizing product lines, by trimming fat from operations, and/or by squeezing suppliers for lower input costs.

Nike provides a classic example of the illusory earnings effect that I described in that post. Take, for example, the following nonsensical headline from CNBC: Nike Posts Surprise Profit Increase, Tops Estimates. At first glance, one might think, “Wow, great news, Nike (a consumer products giant) did well. Maybe there are some green shoots in this economy after all.” But after digging a bit deeper, reality sets in:

The maker of athletic shoes and apparel said after markets closed Wednesday that it earned 99 cents a share in its fiscal fourth quarter, excluding one-time items. Nike reported revenue of $4.71 billion during the period. On a comparable basis a year ago, Nike turned a profit of 98 cents a share on a topline of $5.088 billion.

During the quarter, Nike reduced several layers of management and cut more than 1,750 jobs worldwide, or 5 percent of its global work force. About 500 of the jobs lost were at Nike’s world headquarters in Beaverton, Ore.The cuts come on top of other measures that the company has taken—including a hiring freeze and tight inventory controls—to improve its bottom line as the economic meltdown took a toll on its sales.

So, let’s take stock. Nike’s revenues were down 8% from last year. The reason it reported profits that beat estimates was because of layoffs and its success in squeezing its suppliers.

As I wrote in my previous post:

…cost cutting has systemic implications…Many analysts are overlooking the higher order effects of layoffs and capital expenditure reductions on the broader economy. This manifests as the dreaded negative feedback loop – fewer jobs leads to reduced consumer spending which then reduces demand for firms’ products resulting in decreased corporate profits leading to fewer jobs (wash, rinse, repeat).

Squeezing suppliers generates the same effect. It reverberates up the supply chain by reducing supplier revenues leading to fewer jobs leading to reduced consumer spending which then reduces demand for firms’ products resulting in decreased corporate profits leading to fewer jobs. Again, wash, rinse, repeat.

I concluded that post by suggesting:

The key then to the future of corporate profitability lies in whether you believe corporate earnings have bottomed out and will now begin to increase from a lower base, or whether you believe that there is still substantial downside risk that increasing unemployment and decreased consumer spending will continue to put a crimp in profitability. Given the nearly 40% rally in equity markets over the past several months, market participants clearly believe the former. I fear that the latter might be more representative.

I concede that the economy is more stable now versus when Lehman collapsed and AIG nearly collapsed. We successfully averted the financial armageddon scenario. However, I believe that economic growth and corporate earnings are farther off than most think. Nike is fairly representative of the broad corporate earnings effect that I described in that prior post, and writ large, anemic corporate earnings coupled with cost cutting are likely to keep economic growth muted for quite some time.

So I ask: Where are those green shoots?

I am officially confused.

Much has been written about how managers respond rationally to pay incentives, and how their supposedly “rational” behavior manifests as excessive risk taking with other people’s money. Many have even detailed how excessive risk taking brought about by distorted pay incentives was central to the financial crisis.

I agree that excessive risk taking played a role in the financial crisis. This has been well documented. Moreover, I am willing to concede that in some cases the behavior observed may have seemed rational. At the very least, the managerial behavior was a response to some form of incentive. And after all, we know incentives work, …even distorted ones.

Indeed, I have even written a bit about executive compensation and managerial excess on this blog (see Op Ed on Executive Pay, The Credit Crunch and Executive Pay, New Approach to Executive Compensation, and Revisiting Executive Pay). But for me, the issue of executive pay is a systemic, economy-wide problem, not simply limited to the financial sector.

That said, there is one thing that has always bothered me about the explanation that somehow managers acted rationally, and that this “rational” behavior to an existing incentive structure caused the financial crisis. That is, it implies that someone else, somewhere, acted irrationally.

For example, Calculated Risk, discussing Martin Wolf’s column (see Financial Reform and Incentives or Reform of Regulation), writes:

[Martin] Wolf discusses how it is rational for management…to gamble when the risks are asymmetrical (huge potential winnings, limited losses).

But this begs the question: Why was a system that provides managers the incentive to make stupid bets like that constructed in the first place? That seems pretty irrational to me.

If the person/people who built such a system were rational, they would have anticipated the deleterious consequences of the system that they were about to enact, and they would have refrained from so doing.

So then who are all these irrational people running around building silly executive compensation systems? Aren’t they, after all, current and former managers – boards of directors, compensation consultants, and the like?

So then remind me again, how can managers be the rational ones??

No real news on GM today. The market largely anticipated the event, as it had been wholly telegraphed by the Obama administration (see Finally a Sensible Approach).

Moreover, as I stated on several occasions, if handled properly, there would be no reason to fear a GM bankruptcy (see Could GM Survive Bankruptcy?). Back then I concluded:

YES, GM could survive bankruptcy, and we needn’t be frightened by the prospects, …no matter how much GM tries to convince us that it would spell the apocalypse.

So here we are post bankruptcy, and as far as I can tell, the world has neither come to an end nor has the economy ground to a halt.

In a broader sense, the market’s lack of response to GM’s bankruptcy sends a signal that the economic future of the United States is no longer dependent on, or inextricably tied to, firms like GM. This is not to say that manufacturing is not important to the prosperity of the United States; rather, simply that the manufacturing future of the U.S. is not about the manufacture/assembly of automobiles. But that’s another story for a different day.

For now then, I’ll simply share GM’s official bankruptcy press release. It was sent to me from our new employees – the kind folks from the new GM, the firm in which you, me, and the rest of the American taxpayers will become majority shareholders. Click below to view the full release.

GM Bankruptcy Press Release

Now back to the fascinating part of the bankruptcy – the impending battle between GM bondholders and the U.S. Government. I would not be surprised to see this battle play out in much the same fashion as the battle between creditors and the U.S. Government in the Chrysler case (see Chrysler Bankruptcy: Anything but Surgical, Legal Issues Affecting Chrysler, and Lessons for GM for background). Nevertheless, as I suggested in my post Lessons for GM:

Although the debt restructuring problems they both face are the same in theory, in the case of Chrysler, it was much easier for the federal government to get Chrysler’s lenders to accept a haircut because the majority of its first lien debt sat with banks that accepted TARP money (e.g., Citigroup and JP Morgan). The government could therefore exert tremendous influence over these lenders.

Not so in the case of GM. GM’s bondholders are a much more diffuse bunch with disparate interests. Moreover, the government has much less of a direct influence over GM’s bondholders.

Although GM was able to reach an agreement, in principle, with many bondholders (see US Strikes Deal with Bondholders), it will be interesting to watch how those who remain opposed to the deal ultimately play their hand.