WHAT WOULD HAPPEN IF THE "INDIANA POLICY REVIEW" REALLY HAD POLICY TO REVIEW AND WRITE ABOUT??

Somewhere on the Isle of Irony a publication entitled “Indiana Policy Review” clings to the fabulists notion that Indiana government actually generates policy or resembles an organization that could actually develop policy, rather than put ad hoc glosses on whatever squirms through the Indiana House and Senate in the late winter and spring.

The “Indiana Policy Review” publishes four editions per year. It would seem there would not be enough substance for an annual tri-fold, but it is their press, their ink, and their electrons.

An editorial in the “Indiana Policy Review” combines racist southern revisionism with a sucker’s punch aimed at Fort Wayne Mayor Tom Henry.  It begins by deriding the long overdue riddance of memorials to confederate treason.

Armed rebellion against the government of the United States is the basest form of treason. It was tried in 1861 by indolent operators of forced labor camps. The military leader of the traitors was Robert E. Lee.  Fortunately for Lee, he was not hung after the rebellion along with the rest of the treasonous leadership.

Louisiana is currently removing statutes that honor Lee and the southern war of treason. Indeed, as regaled by the editorial, removing the idols will not change the sordid history. But it lessens the reverbative message of hate and the daily reminder of the abomination of carnage unleashed by the treasoners.  It removes the imprimatur of government assent.  It continues the shaming that is welcome to most, but still little effect on the south’s endemic racism and bigotry.

But the “Indiana Policy Review,” not content to fete Lee and his legions of the treacherous, slams Fort Wayne’s Tom Henry to out bigot Brietbart and out apologize the League of the South.  The editorial further degrades the 21^st century inclusive leadership to which all should aspire.

The statue of General “Mad” Anthony Wayne, a founder and name sake of Fort Wayne,  was reconditioned in 2013 as part of a proposed move to the Court House lawn across the street. The purpose of the move was to provide better visibility to the statue.  The public objected and the statute was not moved. Seemingly end of story.  But still big news for bigots.

MAD ANTHONY WAYNE WOULD HAVE LIKED THE DESERT OF THE REAL!

A LOOK BACK AT NORTH KOREA. AND MAYBE A PATH FORWARD...

In September of 2005, the Author Rob wrote a long post in his predecessor Blog. The title of the post was "Happy Pirate's Day from North Korea." It was written on September 19, Talk Like a Pirate Day.

North Korea is a recurring and long metastasizing world threat. It was thought in 1990 that it would go away with the rest of the Communist world. It didn't. There were several junctures where an "acceptable" accommodation could have been made with the hermit regime. They were might have held, they might not. But in any event, they were missed.

TIME AND OPPORTUNITY ARE RUNNING OUT. WITH NO COOLER HEADS...

The common American dismissal of adversaries or cultures they do not see a vassal states, is "those people over there are crazy." During Desert Storm One, the Author Rob often heard the statement "those people over there (Arabs) are crazy. Let's let them kill each other off."  These statements were from college educated individuals. So much for college.

FAST A LITTLE FORWARD

On 9-11, the TVs were playing at work. Early into the attack, the Author Rob was reminded by a co-worker that "those people over there are all a little crazy."  No, they are not. The terrorists conduct, however homicidal and small-scale suicidal, was "rationale" based upon their situation and their world view.  They must be dealt with on that basis. We must know what they will respond to, and what they will not respond to. I give the UK, France, and Israel great credit for engaging them without naive posturing. Postponing the pain with the "they're crazy" refrain will make the fix harder and deadlier.

The only refrain that sounds worse is "they hate us for our freedom." The 9-11 terrorists could give a rat's gonad less about "our freedom." That is just more pablum to avoid addressing the matters head one rather that showing hours of grainy gun and bomb camera footage.

FAST MORE FORWARD

So guess what the Author Rob is hearing? "That guy over there is crazy." Some people, but not many,  can even correctly recount their leader's name, Kim Jong-Un.

The North Korean leadership is not crazy. They have held their hell-hole together for more than seventy years. It was widely believed that North Korea would fail when Communism fell in the early 1990s. It didn't. And each president has made some effort to deal with the regime. Bill Clinton had the most success. His deal(1) keep North Korea non-nuclear weaponized. Each subsequent president has done less. Bush made a good start but dropped the ball when he stumbled into the Iraq misadventure.  Obama's focus was domestic and more opportunities were lost.  Failure to address the issues with North Korea is a bipartisan issue.

NOW AN EMPTY HEAD IS RATTLING (LIKE A BABY'S RATTLE) THE SABRES

 Here is the Author Rob's post from 2005. It is long but is a tale of the lost:

On September 15th, the Author saw an amazing documentary about North Korea at his favorite theatre, the Guild Cinema in Albuquerque. And yesterday it was announced that the six-nation talks had produced a tentative agreement for North Korea to drop its nuclear weapons program in exchange for nuclear assistance, other aid, and what sounds like a non-aggression pact to be executed between the US and North Korea.

The author is not naive about the possibility of North Korea sabotaging this agreement, or the lesser possibility of the hard-line Neo-Conservatives in the US sinking the nascent entente. The North Koreans are consummate deceivers, vacillators and manipulators. But this might be the breakthrough that has eluded the parties since 1994. And if the agreement comes to fruition, it will be the most important diplomatic event to date in this early century. It would signal the end of The Cold War and would resolve the final issue that remains from World War II. Big Stuff. Important Stuff.

So what does this have to do with Economics? Much. North Korea is the last Communist State on earth. It is a living fossil, like the coelacanth or the gingko tree. It has outlived Stalin, Mao, the Berlin Wall, Marshal Tito, Leonid Brezhnev’s eyebrows and Fearless Leader, the scar-faced potentate of Pottsylvania.[1] Despite all that was and is wrong with communism, North Korea still trundles along in the Land of the Morning Calm.

Deprivation amid Technicolor Displays

The film the author saw was entitled “State of Mind”. The BBC produced it in 2003 and the documentarians had extraordinary access to this xenophobic country to produce a story about the Mass Games. The Mass Games are a periodic gymnastic showcase to celebrate North Korean events, such as the birthday of President Forever Kim Il Sung or the peasants exceeding their cabbage-growing quotas.[2]

The storyline follows the preparation of two 12-year old girls who will participate as gymnasts in the Mass Games. The Mass Games are indeed impressive. They make the Superbowl Halftime extravaganza look like a first-grade pageant. North Korean “guides” constantly escorted the filmmakers, but none of the documentary was censored. There were several reasons nothing was censored, but two stand out. The filmmakers did not need to ask probing political questions. The poverty, the totalitarian nature of the state, the comical propaganda recited all showcased the degraded conditions of the marginally operating state. Food is rationed. Power outages occurred daily. The buildings are old and decaying. The massive boulevards are crumbling and bereft of traffic. It looks worse than Albania circa 1965.

Secondly, the North Koreans are genuinely proud of these Mass Games. They wanted this story told. The games showcase, in the minds of North Koreans, the resilience and strengths of the country. The skills and discipline of the participants are amply evident. But the show backstage is far different. The director of the games has only rotary dial phones. And the images of the prior Mass Games were filmed in Technicolor, a film process that has been obsolete since the time of the Korean War. The Author, an assiduous student of film minutiae and obscurities found the use of Technicolor quaint and fun.[3]

Yet within all of this state domination, children worked several hours per day, in addition to their schoolwork and homework, to compete in the games. People go to work and about their lives. They walk in the park on Sunday. And underneath all of the pretense, poverty and some unintentional parody, there is a pride and work ethic that may explain how this pariah nation keeps going amid sacrifice, suffering, and occasional famine.

North Koreans Would Not Greet “Liberators” with Street Dancing and Flowers
Korea, like Vietnam, has a history of foreign invasion met with fierce resistance. North Koreans believe that they stood up to, and repelled, U.S. forces in the Korean War. They did, but with the help of a few million Chinese soldiers. The “victory” they won in 1953 when the Korean conflict ended still defines the country. And in fact, the Mass Games that were the subject of the movie were held to celebrate the 50th anniversary(in 2003) of the North Korean “victory”. This “victory” is manifested in “juche”, which roughly translates to “self-reliance”.

War on the Korean peninsula would be a very barbarous affair. It is estimated that there would be one million casualties within the first 24 hours of peninsular war. Seoul, the capital of South Korea, is within artillery range of the border with North Korea. Except in tactical Pentagon plans and in the vituperative and vacuous minds of a few American chickenhawks, a second peninsular Korean war is unthinkable. Millions of Koreans and tens of thousands of American GIs would die. Korean terrain makes most of the country a huge killing zone. Mortars are already dialed in and fields of fire plotted.

Back to economics. Just as market forces have unleashed reform and emergent prosperity in Russia, Eastern Europe and China, North Korea could one day become a prosperous and democratic nation. The work ethic of its people is strong and the success in South Korea would appear to be reproducible.

Can Bush go to “China”? With the Domestic Side not Looking So Good Right Now, Bush Could use the Frequent-Flier Miles.
When the Clinton Administration was negotiating with North Korea in 1994, it had two problems. One domestic, one intelligence-related. Pressure from the Republican Right prevented him from offering the Koreans what they really want. A non-aggression pact with the US that recognizes its independence and puts some ink on the end of the Korean conflict. Both political parties and most of the western intelligence world shared the other problem. It was generally believed that North Korea would go the way of every other communist nation and collapse. In that sense, whatever deal was made with North Korea was deemed at the time to be irrelevant. In a year or two there would be no communist Korean government to deal with.

The US and its Asian Allies must resign themselves to the fact that North Korea will not fall of its own weight and will become a nuclear power if nothing changes. If an enforceable and verifiable deal can be put in place, it would be a monumental move. Continued stalemate will allow the North Koreans to develop, or increase, their nuclear arsenal[4]. And miscalculation leading to a shooting war is always a possibility in the tense standoff that currently exists between North and South.

Change is on the wind. These winds can either steer our ships of state on a safer course or blow us further into uncharted and dangerous waters.

[1] Pottsylvania is the fictional US adversary in the Bullwinkle and Rocky cartoon show of the 1960s. The cartoon was a cold war satire and a darn good one. Fearless Leader commanded Boris and Natasha in their ever-failing efforts to bring down our heroes, Bullwinkle J. Moose and Rocket J. Squirrel. Pottsylvania appeared to be a place not unlike a seedy beer hall undergoing a perpetual –putsch.
[2] The Author is of course being smarmy. Westerners should be suspicious of the degree of Korean loyalty to their leaders. But we must not completely discount it. Kim Il Sung has been proclaimed “President Forever,” and his son, the puffy Kim Jong Il the “Great General”. The author has heard the level of cult worship of Kim I and II as something akin to the Christian Trinity. Kim Il Sung is “the father”, Kim Jong Il is “the son”, and juche, the doctrine of self-reliance, is “the holy spirit”.
[3] Some of the scenes from the prior Mass Games were of fireworks. Technicolor produces “hot” tones of red, and vibrant golds and silvers. They looked good on screen.
[4] There is some question whether North Korea has weaponized its nuclear capacities, or if it is still in the process of weaponizing their nuclear materials. Regardless, without massive incentives, it will be a nuclear state.


1. Clinton may have missed a clear opportunity to change the relationship in his presidency. Clinton later went to North Korea in 2009. http://www.eastwestcenter.org/news-center/east-west-wire/bill-clinton-in-north-korea-winners-and-losers And like nearly all former American political leaders, they sound rationale, sensical and reasonable after they leave office. He said in the early 2000s that the US should just bite the bullet and sign a non-aggression agreement with North Korea in return for aid and the dismantling of the-then nascent nuclear weapons program. Sure the North Koreans would try to cheat on their promises. But such agreements, even with nations like Iran, Russia, and North Korea, have, like options, "time value." You buy time, allowing for things to change that may better your position. But American have a one news cycle memory and a view of the future that changes faster than the TV remote control.

KOREA IS FAR AFIELD FROM THE DESERT OF THE REAL.

The Great Depression in Eight Minutes. And the Evolution of a Sperm Whale in One Minute

None of us can forget the real estate and derivative market crash of 2008 and the ensuing Great Recession. The Author Rob remembers it vividly. Just as many remember where they were when President Kennedy was shot or the Twin Towers fell, the Author Rob remembers vividly the day that the commercial paper market locked up, rising by 200 basis points in minutes. The scene is seared into his brain. He was living in Albuquerque (the greatest town in America) and was day trading. CNBC was on in the living room and he was in the office. He came out of the office and the chart was on the TV screen. He sat down on the floor and sort of stopped breathing for a minute or so. And he knew things would not be the same again for a long time.

Many comparisons were made between the Great Recession and the Depression. When the Depression hit, there were few fiscal and monetary tools. And the ones that were used were disastrous. The National Recovery Act and its price controls. The Smoot-Hawley Tariff Act. 

And the Dust Bowl, which likely could have been prevented or greatly ameliorated by better plowing techniques, grass plantings on bare land, and fence rows to stop erosion. (But hey, it would not be America without an agriculture disaster every twenty years requiring a taxpayer bailout.)

Back in the late 2000s the Author Rob read  the definitive books on the Depression, “The Great Depression” by Robert S. McElvaine. A real good look into the guts of an event that is fading from human memory. But the Author Rob remembers the stories his grandparents and other ancestors or old timers recounted.

Here is a link to a eight-minute video that provides a brief description of the event with a special focus on the collapse of aggregate demand.

The video is one of many on the Marginal Revenue Online Educational Platform.

FROM PAKIECETUS TO SPERM WHALE IN ONE MINUTE

Cetaceans (whales, dolphins) descended from a large dog-like quadraped beginning 500 million years ago. The Pakiecetus began swimming in the ocean, and over millions of years of random genetic changes, a more successful animal emerged. Below is a link to a video compressing that evolution into one minute. Very fun.

http://www.slate.com/articles/video/video/2017/05/watch_the_50_million_year_evolution_of_the_whale_in_1_minute.html

STOCK REPORT:

One Stock on our watch list, AERI Pharmaceuticals, hit its break out price of $52. It gapped up from 42 to 53 based upon news of late trials success on a glaucoma drug.

LIVE FROM A RAINY DAY IN THE DESERT OF THE REAL!

Do People That Have Health, Care?

The ACA is always at risk. At its baseline, it is at risk because of its gerry-rigged nature. (Try getting anything that requires just a tiny bit of sacrifice from Americans.) It would make  Rube Goldberg envious.

To keep most then-existing health insurers around it had to be cost inefficient and leave some of the skim for the health insurance industry. And the providers could not come out net negative.

And it is always at risk from "repeal and replace," one of the main planks of the republican party. But this recent foray in the House has showed that only repeal is possible. It cannot be "replaced"  because the nation cannot even decide if healthcare is a basic right or a commodity that some on the far right gleefully wish to deny others because the market cannot and never will provide supply at the demand (price level) that most Americans can afford.

 As economists, commentators, or cranks, we can fantasize about market solutions that will magically turn a very distorted and dysfunctional system into an Elysian Field complete with widgets that grow on trees and efficient market theorizers that pick up every loose penny as soon as it falls to the street. Maybe when more of Congress agree that healthcare is a right US healthcare will move much closer to universiality.

QALY’S (Quality-adjusted life year(s)) PROVIDE “OBJECTIVE” GUIDANCE.

This post takes the Author into dark and deep water. This post takes on healthcare economics straight on. Right between the eyes. The Author, as many readers know, was formerly a healthcare law and economics geek. He would have remained one, but grew ill watching the nation in the 1990s eschew healthcare cost containment.

QALY (quality-adjusted life years) is a formula for measuring the long-term effectiveness of a healthcare treatment or intervention. QALYs are often combined with a cost factor to assess and compare the relative value of a treatment or intervention. QALYs give healthcare economists and policy makers an important, if somewhat limited, method of valuing the cost and effectiveness of treatments across populations.

HERE’S HOW TO CALCULATE A QALY:

If a treatment or intervention provides one year of “good health”, it yields one QALY. Such a treatment could also yield more than one (or sometimes less than one), QALY(s).

As most of you know, the Author just underwent open-heart surgery. This intervention saved his life and he is now in “good health” again. Given an estimated life expectancy of 80, the Author has 30 more years of good health to expect (at least from the heart surgery), so the heart surgery can be assigned a QALY of 30.

QALYs can also be less than one, and many interventions yield less than perfect health. Death is assigned a factor of 0. Some health states are considered worse than death (consider Terry Schaivo). Below is a graph of QALY health state valuations using the EQ-5D weighting system:

Health state Description Valuation

11111 No problems 1.000

11221 No problems walking about; no problems with self-care; some problems with performing usual activities; some pain or discomfort; not anxious or depressed 0.760

22222 Some problems walking about; some problems washing or dressing self;
some problems with performing usual activities; moderate pain or discomfort;
moderately anxious or depressed 0.516

12321 No problems walking about; some problems washing or dressing self; unable to perform usual activities; some pain or discomfort; not anxious or depressed 0.329

21123 Some problems walking about; no problems with self-care; no problems
with performing usual activities; moderate pain or discomfort; extremely
anxious or depressed 0.222

23322 Some problems walking about, unable to wash or dress self, unable to perform usual activities, moderate pain or discomfort, moderately anxious or depressed 0.079

33332 Confined to bed; unable to wash or dress self; unable to perform usual
activities; extreme pain or discomfort; moderately anxious or depressed
-0.429

Note that the last condition yields a QALY of less than 0. Also remember that this scale is much generalized. This health state scale was taken from “What is a QALY”, published by Hayward Medical Communications.

LESS THAN ONE, LESS THAN A QALY?

Many interventions, as you can see from the health state scale above, yield QALY factors of less than one. For simplicity, let’s say that an intervention will provide someone with four years of health state .75. We then multiply 4 (life years) * .75 (health state) and get a QALY of 3. So this intervention (or treatment) provides 3 QALYs.

DARE TO COMPARE?

The intervention above yields 3 QALYs. If we know how many QALYs this intervention yields, we can compare it to other interventions for the same condition. A competing treatment for the same condition as above yields five years of health state .50. So we multiply 5 (life years) * .5 (health state) and get a QALY of 2.5. Ceteris paribus, the first treatment is a “better treatment” Or is it?

MORE YEARS OR BETTER YEARS?

The question above involves a topic close to the hearts’ of healthcare economists. (Or close to the spot where their hearts would otherwise be.) It is the Time-trade off. Below is a definition of the Time-trade off lifted from Wikipedia.

Time-Trade-Off (TTO) is a tool used in Health Economics to help determine the quality of life of a patient or group. The individual will be presented with a set of directions such as:

Imagine that you are told that you have 10 years left to live. In connection with this you are also told that you can choose to live these 10 years in your current health state or that you can choose to give up some life years to live for a shorter period in full health. Indicate with a cross on the line the number of years in full health that you think is of equal value to 10 years in your current health state.

The Time-Trade Off illustrates a problem with QALYs. They are only generalizations that do not account well for individual preferences. But as tools for economists and policy makers, they provide useful formulas to compare treatment efficacies. And when combined with cost-utility ratios, they allow cost-based efficacy comparisons to be made; turning health care decision making from the game of “whatever the doctor orders” to the science of what is most cost-effective.

MORE NEXT TIME…

In the next couple of posts we will discuss how to use QALYs to make cost-effectiveness determinations and how to address some well recognized problems with QALYs.

STAY HEALTHY OR HEAL FAST IN THE DESERT OF THE REAL!

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QALYs AND COST-UTILITY RATIOS-COMPARING ORANGES TO ORANGES, ORANGES TO APPLES

Remember that a  QALY is a formula for measuring the long-term effectiveness of a healthcare treatment or intervention. QALYs are often combined with a cost factor to assess and compare the relative value of a treatment or intervention. QALYs give healthcare economists and policy makers an important, if somewhat limited, method of valuing the cost and effectiveness of treatments across populations.

KEEP YOUR EYES ON THE COIN

More examples. The cost of Treatment B for a disease is $50,000 and it yields 5 QALYs. The cost of Treatment A is $70,000 and it yields 6 QALYs. The calculation to compare the cost-utility ratios is:

Cost of Treatment A – Cost of Treatment B
__________________________________
No. of QALYs produced by Intervention A -
No. of QALYs produced by Intervention B

But before we run the calculation, let’s look at the cost of CALYs for each treatment. Treatment B yields 5 QALYs and costs $50,000. Five CALYs/ $50,000 = $10,000 per CALY.

Treatment A yields 6 QALYs but costs $70,000. Six CALYs/ $70,000 = $11,666 per CALY. So on its face, Treatment B is the more cost effective deal. But it should also be remembered that Treatment B yields 6 CALYs, one more year than Treatment A. Maybe that extra CALY is “worth it”. Let’s see what the cost-utility ratio is and then decide.

$70,000 (cost of treatment A) - $50,000 (cost of treatment B)
___________________________________________
6 QALYs (treatment A) – 5 QALY’s

$20,000
______
1

This means it costs $20,000 to yield 1 additional QALY. Cost effective? Who knows. But under current “QALY” cost-utility quidelines”, $20,000 per QALY is often seen as cost-effective. And for reasons we will look at in the next post, anything up to $50,000 per QALY is usually seen a “cost-effective”.

COST-UTILITY RATIOS DRIVE THE SUN AND WIND IN THE DESERT OF THE REAL!

ARE QALYs INHERENTLY BIASED IN FAVOR OF PREVENTION OVER CURE?

YES, WHEN YOU ARE TALKING ABOUT ZAMBIA AND BURKINA FASO*

An article in Slate Magazine, “Wrong Number: Is it Cost Effective to Treat the World’s Poor”, written by pediatric cardiologist Darshak Sanghavi, triggered the Author’s interest in revisiting QALYs. Sanghavi begins the Slate article with the story of one of his former students working in a remote Zambian clinic. A three-year old boy, weighing only 15 pounds, was admitted to the malnutrition clinic. When the student listened to the boy’s heart, the student determined that the boy had a serious heart malformation.

The student then emailed her former professor Sanghavi and asked it there were any inexpensive drugs that she could give the child. Sanghavi replied to the email stating that unfortunately, there were no drugs that could help the child. And without surgery, the child would almost certainly die.

THE ZAMBIAN MEDICAL SYSTEM DOES NOT HAVE THE RESOURCES TO HELP THE BOY

Sanghavi notes the seemingly obvious:

Pediatric heart surgery is fabulously expensive, often costing hundreds of thousands of dollars per case in the United States. Thus it would be foolhardy, goes the thinking, to offer surgery to poor African children who live on less than a few dollars per week. Isn't it better to invest in more cost-effective public-health measures, like mosquito netting to prevent malaria and vaccines against diarrhea? For decades, this kind of reasoning has been used to deny expensive but lifesaving treatments to the world's poor, most notably for HIV infection, in favor of more cost-effective measures focused on prevention. Dollar-for-dollar prevention is supposed to yield greater aggregate quality-of-life benefits than actual treatment.

Sanghavi then states that this argument, prevention buying lots cheap QALYs over expensive intervention, rigs the game so that the world’s poor will rarely receive expensive but effective medical care.

Know what? He is right. QALYs are economic calculations, not moral pronouncements. But unfortunately, money is a devilish limit upon otherwise salutary aims. And even the angels cannot manufacture more of it.

SO WHAT THEN IS TO BE DONE?

Most of the readers know that the author is an economic conservative and a social liberal. Nay, social radical. He believes that everyone on earth deserves a base level of support, food and health care. (Even uninsured Americans.)

To that end, he further believes that developed countries, and emerging developed nations such as Brazil and India, should be required to pay some percentage of their GNP, perhaps around 5%, to developing nations to eliminate hunger, provide medical care, alleviate poverty, and stimulate economic development. Of course the Author recognizes that the governments of some developing nations (and at least one large developed nation) are riddled with corruption. In all cases the funds drawn from developed nations should be provided both to the government and NGOs. This would require that they "compete" for efficiency and effectivenss. In cases where the governments are so corrupt that they cannot be trusted with the resources, the proceeds should go to NGOs.

If there are better solutions, the Author would like to hear them.

ESCHEWING THE CULT OF NATIONALISM SINCE 2001 IN THE DESERT OF THE REAL!


*Zambia and Burkina Faso are relatively poor, developing countries in Africa. The Author is confident that his loyal readers already know this, but offers this explanation for newcomers.

May 2017 Desert of the Real Economics Investment Newsletter

Desert of the Real Economic Analysis*

May 2017

JUST ONE MORE GREEK…FOR NOW…

Alpha.  All Good Things Start with Alpha

A POSTIVE ALPHA IS A FREE LUNCH**, WHILE THE NEGATIVE ALPHA INVESTOR GOES HUNGRY

Alpha can be a difficult concept to understand. The last newsletter took on the topic of Beta. Beta, as readers should recall, is the volatility of an investment when compared to the volatility of the S&P 500 Index.

Let’s start with the definition of Alpha:

Alpha is a risk-adjusted return on an investment. Alpha demonstrates whether your investment outperformed or underperformed a risk-related benchmark. If you outperformed the benchmark, then you got more reward for a given amount of risk. If the investment underperformed the benchmark, then you took on extra risk to get less reward. Alpha is measured in percent of overperformance or underperformance. (i.e., Alpha of 1, 2, or -.5 or –1)

The basic question that Alpha asks and answers is: did you get more reward or less reward for a given amount of risk? Let’s look at the concept of a “given amount of risk”. To do so, we will spin the Roulette Wheel.

Roulette is a mainstay at most casinos.[i] The Roulette Wheel is a spinning wheel with 64 numbers[ii]. The wheel is spun and then a ball is released. There are holes in the wheel that correspond to the numbers. There are two sets of numbers 1 through 32, with a set in red and a set in green. Your odds of hitting Red 1 or Green 32 are one in 64. 1:64. If you bet on Red 1 and win, you get $35 (Check). So 1 unit of risk gets you $35. But there are other ways to play. Lots of bets, but let’s focus on just as couple.

You can bet on the wheel hitting a Red number or a Green Number. One-half the numbers are Red and one-half are Green. You have a much better chance of winning betting on Red or Green, but your winnings are correspondingly smaller. You have a 1 in 2 chance of guessing Red or Green on each spin of the wheel and the payout is $1, 1:2. For a lower risk bet, you get a lower reward.

When people invest in riskier stocks or bonds, they demand a higher return. They demand a higher return because their chance of earning the expected return is less than it is with a safer investment. This is a logical approach, but it often breaks down. It breaks down for two reasons. First, it is often difficult to determine if you are exposing your investment to more risk than necessary for the expected return. Accurate information and projections are not always available to perform the risk/reward assessment. Second, most investors do not even engage in a thorough risk/reward assessment.

ALPHA GIVES MUTUAL FUND INVESTORS THE TOOLS TO ASSESS RISK AND REWARD

Let’s go back to the Roulette wheel. Remember the bet on a single colored number. One dollar, or one unit of risk, will get us a $64 (Check) reward. And one unit of risk will get us one additional dollar if we make a 1:2 bet on Red or Green. The same kind of risk/reward analysis, using historical data, is what Alpha can tell us. Alpha cannot guarantee future risk/reward, but it does give us historical data that we can use in making projections.

Let’s revisit the Alpha calculation we did in the earlier post. For this calculation we will use the Slow and Steady Value Mutual Fund. Last year, the Slow and Steady fund returned 10%. And in doing this calculation we will bring in a couple of other financial concepts. You won’t need a calculator Just follow the Bouncing Ball . . .:

1. Risk-free rate of return. One of the first things you need to know to calculate alpha is the risk free rate of return. This is not hard to calculate, however. The risk-free rate of return is the interest rate paid on a US treasury note. Why the Treasury Note? They are considered risk-free because they are guaranteed by the “Full Faith and Credit” of the US government. So let’s say that a 6-month Treasury note is paying 4%. So the risk-free rate of return is 4.

If we invested in any investment considered to be more risky than the US Treasury Note, like stocks, bonds, nearly anything else and earned less than 4%, we got less reward for taking more risk. But if we invested in nearly anything else and got more than 4%, we might have gotten more reward for less risk. But we won’t know until we do the Alpha calculation.

Let’s follow the analysis and work up the Alpha equation at each step. Slow and Steady returned 10% last year. The risk-free rate of return was 4%.

10 (Slow and Steady Return-4 (Risk free rate of return)) = 6. Slow and Steady exceeded the risk-free rate of return by 6%. Pretty good. But we still won’t know if Slow and Steady gave us a higher return or a lower return for the amount of risk we incurred until we complete the Alpha calculation.

2. Excess Return. In a good year for the stock market, many stocks and most indices will have a higher return than the risk-free rate of return, or the interest paid on a Treasury Note. Slow and Steady had an excess return of 6%. However, the excess return has to be considered in light of a benchmark for similar investments.

Slow and Steady is a value stock mutual fund. For a comparison with an index of comparable stocks, we will compare it with the Russell 1000 Value Index[iii]. This is an index of large capitalization value stocks. Last year this index returned 7%. So the benchmark excess return for large cap value stocks is:

7 (Large value stock benchmark)-4 (Risk free rate of return) = 3

3. Beta and Expected Excess Return. Remember Beta is a volatility measurement. We need this figure to compare our risks with our returns. The excess risk we would expect for a our large value fund is calculated as follows:

Beta * Excess Return for Benchmark = Expected risk-adjusted return

.8 (Beta for Slow and Steady) * 3 (Excess Return for large value index) = 2.4

So the expected excess return for Slow and Steady is 2.4%. This number is critical. This tells us the return we should have earned on a value stock mutual fund. If Slow and Steady mutual fund exceeded this 2.4% return, then the investor for more reward for less risk. But if our mutual fund lagged this 2.4%, then we got less reward for the risk we took by investing in a Slow and Steady.

4. Alpha. Whew. Finally. And as you have figured out by now, Slow and Steady placekicked the competition and earned us a lot of excess return for the risk we took.

6 (Slow and Steady’s Excess Return) – 2.4 (Expected Excess Return) = 3.6 Slow and Steady has an Alpha of 3.6%. This means you got a return of 3.6% above and beyond the return you should have expected given the risk that you took (as measured by Beta) for investing in Slow and Steady. You should send the Fund Manager a Christmas Card and a Chia pet.

HOW DO YOU FIND THE HIGH ALPHA FUNDS?

Morningstar is a common source of investment information. Many public libraries have Morningstar services. Your broker or investment planner may also have access to Morningstar services. Also, many mutual funds will post their Alphas and Betas on their websites. But remember, Alpha is only one measurement in the selection of a mutual fund. But it is an important one.

Stock Update 

Last month the Desert of the Real stock portfolio was much like Humphrey Bogart and Gloria Grahame in the 1950 Film Noir classic, “In a Lonely Place.  This month it feels like “The Asphalt Jungle,” the 1950 John Huston directed classic. Set in an urban wasteland that was Cincinatti,  Ohio, the film is littered with back schemes, double crosses and weird, almost trivial character glitches that collapse their worlds. 

There are several stocks we are still looking at for breakout moves. But the markets are in trading zone and we are not looking for movement, at least upward movement, in the near term.  The market can’t move forward and won’t move back. After we are done looking at option positions this month, we will take a crack at more stock screens and try to come up with some more ideas. And Author Julie will have more time over the summer to look at some biotechs ready for big breakouts or breakdowns. 

STOCK             SYMBOL                                  Price 5.12.17                  SIGNAL

Aeri Pharmaceuticals        AERI                           39.05                             Breakout at 52

Neuoraderm                     NDRM                         23.65                            Breakout at 29

Vanda Pharm                  VNDA                          14.50                            Breakout at 16

Kindred Bioscience             KIN                               7.00                           Breakout at 7.50

Essent Group                  ESNT                            36.72                           Breakout at 39

KNOW GREEK, KNOW GEEK, IN THE DESERT OF THE REAL!

*We wish to announce the launch of Feightner Consulting LLC. Feightner Consulting will research and develop white papers and other knowledge documents for industry and business. Julie Feightner is the President of Feightner Consulting LLC. You can visit us at feightner.consulting@gmail.com. Our website will be up soon. 

Desert of the Real Economics is now a member of the Feightner Consulting LLC family of companies and is an assumed business name of Feightner Consulting LLC. (This should keep our lawyers pacified.)

**Actually, the No Free Lunch debate has tied down mathematicians, economists and philosophers. It has several websites and is often considered in terms of lost opportunity costs. Every choice you make has a next, best alternative that you could have chosen but didn't. That is, the price you paid for doing whatever it is you did was the opportunity you can no longer enjoy. But if considered in the context that comes to mind when regular people hear the phrase is that someone cannot get something for nothing unless someone, somewhere, gets nothing for something.

The Author Rob’s take on the No Free Lunch debate is that we have one massive free lunch, brunch, dinner, supper and endless snack bar overhead every day. The sun makes the world run and only in a cosmic sense is it not a Free Lunch. Just like the beer at the Delta House Rush Party, it "don't cost nuthin'."So let’s leave it there.

[i] We will use a gambling analogy because it is a good demonstration of “risk and reward”. Gambling is not the same thing as investing, however.
[ii] Except at the casinos, where they add one or two zeroes. These zeroes lower your odds of winning and make sure that the house always wins. This is the best argument one can make against gambling at a casino. It is statistically a game you cannot win.
[iii] The symbol of the ETF for this index is IWD. http://finance.yahoo.com/q?s=IWD If we were looking at another type of mutual fund, such as the Afterburner Tech Stock fund, we would compare it with an index of tech stocks.

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A Classic Post that Never Loses Relevance. From 2006.

THE INEVITABILITY (AND NECCESSITY) OF BEING WRONG LOTS OF TIMES 

CREATIVE DESTRUCTION IS THE FORCE OF RADIAL AIRCRAFT ENGINE IMPROVEMENT, ECONOMICS AND THE DRIVER OF EVOLUTION

One of the Author’s favorite writers is Kevin Cameron, the Technical Editor at Cycle World magazine[i]. Mr. Cameron writes a column called “TDC” (Top Dead Center). Mr. Cameron is likely an engineer and he knows a lot about engines and the mechanics and technical intricacies of motorcycles. And he is able to explain these concepts clearly and concisely in his column. He is the kind of guy you would like to have as a neighbor or a friend to talk with about motors, mechanics and motorcycles.

January’s TDC was about spark duration in engines and how changes in spark duration aided (or degraded) the performance of air-cooled radial aircraft engines, nitrous-burning dragsters and two-cycle engines[ii]. Particularly interesting to the Author was the discussion of radial aircraft engines. The performance curve of the radial aircraft engine peaked shortly after World War II[iii]. The jet engine replaced these workhorses in fighter aircraft by the time the Korean War began.

Engineers struggled to squeeze every ounce of horsepower from these huge radial engines before and during World War II. Lives and victory over the Axis powers depended, in part, upon the performance of these machines. So lots of solutions were tried. A few worked.

ORDER FROM APPARENT CHAOS

Mr. Cameron’s February article is entitled “Untying Knots”. Cameron reviewed documents circa 1920-1926 from the military’s aircraft development center. The documents were related to the testing of early rotary aircraft engines. The point of the article was how small changes to the interrelated elements of engine operation had large, and often fatal, effects upon other elements of engine operation. Change one thing and another thing fails. Tweak this and then that breaks. Yet it is only through these putative “mistakes” that success emerges. And over time with much experimentation, and almost countless failures, solutions emerge. Creative Destruction. Order from apparent chaos.

CREATIVE DESTRUCTION AND NATURAL SELECTION

“Creative Destruction” is a concept and a process originally developed by Joseph Schumpter in his 1942 book “Capitalism, Socialism and Democracy”[iv]. Creative Destruction is the process by which product and technological innovation challenge, overtake and eventually supplant existing firms, services and products. Examples are PCs that eliminated many mainframe and minicomputers, diesel locomotives that replaced steam engines, and the cassette that supplanted the eight-track. This Creative Destruction is the engine of innovation that creates new value even as it destroys the value of existing firms.

Evolution is a similar process. It of course operates without direction or design, but it has the same effect as creative destruction. Small mutations (putative “mistakes”) in organisms compete for resources with non-mutated organisms. Most fail, like nearly all of the radial aircraft engine experiments. But a few succeed and pass their genetic information on to the next generation. Over vast periods of time and nearly countless small experiments, different, and better, organisms move forward.

THE SAME THING HAPPENS WITH ENGINES AND EAGLES.
HATE WALMART OR MICROSOFT? WAIT A FEW DECADES.

Better performing radial engines resulted from multiple experiments. And they worked well. However, the radial engine was creatively destroyed when the jet engine came along. And the same fate will probably befall the jet engine.

Similar fates await living organisms. It is commonly stated that 99.99 percent of species that ever lived are now extinct. The Creative Destruction that is the process of evolution ensures that this will be the result. Just as Creative Destruction will probably knock out Microsoft, WalMart and yes, possibly even Ducati, at some point in the future. And probably the human species, felines, canines and cetaceans. [v]

But there is another way to conceive of Creative Destruction. Each improved iteration of an organism, idea, a product, or a service has a better chance of survival by avoiding subsequent failure. One can also think of these as the beneficial mutations that drive the evolutionary process.

Similarly, failed engine designs or noncompetitive companies are cast aside, like deleterious mutations. There elimination removes the probability of similar failures in the future.

FUEL INJECTION REFUTES IRRREDUCIBLE COMPLEXITY?

But just one final twist. What has failed in one iteration may yet comeback as a positive addition in the future. Sometimes changed conditions can later resurrect and idea or product feature that previously failed. Consider fuel injection.

Fuel injected engines were built at least as far back as the 1950s. These systems were mechanical and did not function well enough to receive broad acceptance. In the 1980s, however, computer technology took over the fuel metering functions of fuel injection and nearly all current vehicles have fuel-injected engines. So much for irreducible complexity!

MISTAKES MADE IN PURSUIT OF INNOVATION NARROW THE FIELD FOR SUCCESS IN THE DESERT OF THE REAL!


[i] www.cycleworld.com
[ii] Old school dirtbikers, streetbikers and snowmobilers will remember the frustration of two-stroke engine spark plug fouling. And the spare plugs that one bought by the dozen. I cannot count the number of spark plugs that I replaced in two-stroke engines. But the solution to this fouling is elegant.  In a two-cycle engine, the air-fuel mix contains a small amount of atomized oil. The oil has to be in the mix to lubricate the mechanical parts of the engine.  So occasionally when the spark plug fires there is a lot of engine oil surrounding it. When this happens, the oil will not burn like the fuel mixture and the plug fouls out. The solution was to increase the duration of the spark. So when the spark plug fires anda there is only oil around it it will spark long enough for the oil to pass and the fuel mixture to blow through the spark.
[iii] Radial engines are still used in some aircraft and power many of the antique aircraft so popular at air shows. And just as the descendants of the dinosaur soar overhead as our feathered friends (modern birds), the radial aircraft engine lives on as the air-cooled, pushrod activated, single-pin crank V-Twin that powers Harley-Davidson motorcycles.
[iv] http://en.wikipedia.org/wiki/Creative_destruction
[v] Forgive the Author if he is mixing Orders, Families and Species. He doesn’t know much about taxonomy.  That is what the Author Julie is for.

posted by FOXP2 @ 6:09 AM   0 Comments