Key determinant

In most markets, a key determinant of the price elasticity of supply is the time
period being considered. Supply is usually more elastic in the long run than in the
short run. Over short periods of time, firms cannot easily change the size of their
factories to make more or less of a good. Thus, in the short run, the quantity supplied
is not very responsive to the price. By contrast, over longer periods, firms can
build new factories or close old ones. In addition, new firms can enter a market,
and old firms can shut down. Thus, in the long run, the quantity supplied can respond
substantially to the price.

Drug use has several adverse effects.

A persistent problem facing our society is the use of illegal drugs, such as heroin,
cocaine, and crack. Drug use has several adverse effects. One is that drug dependency
can ruin the lives of drug users and their families. Another is that drug
addicts often turn to robbery and other violent crimes to obtain the money needed
to support their habit. To discourage the use of illegal drugs, the U.S. government
devotes billions of dollars each year to reduce the flow of drugs into the
country. Let’s use the tools of supply and demand to examine this policy of drug
interdiction.

Russell INDEX 2000

The result of diversification is not always a smaller loss. It can
be a smaller gain. In 2003, the year the stock market began its recovery
from the 2000 crash, the S&P 500 had a total return of
28.7 percent while the return for the Russell 2000 was a stunning
47.3 percent. The combined return was 38 percent.

The simple 50–50 INVESTMENT

You might
retort that if all the portfolio were in the Russell 2000, it would
have fallen just 3 percent. But that is known only with hindsight.
With diversification, you have to commit yourself in advance to
the fact that a variety of securities in your portfolio will move in
different directions or at different paces. The simple 50–50 split of
this example is diversification, but you can do a lot more

Russell 2000

P 500 down 9.1 percent while the Russell 2000 was off just 3
percent. They did not move in opposite directions, but that is often
what a low correlation actually is: not a rise versus a fall, but a
much smaller rise or a much smaller decline. These different paces
in the same direction change the risk of your portfolio. That is, it
is better to have half your portfolio falling 3 percent while the rest
is dropping 9.1 percent, which translates into a decline in return
of 6.1 percent, instead of all of it plunging 9.1 percent.

Diversification

Diversification is, on the surface, a simple concept and we are not
going to spend a lot of time explaining it or why it is a good idea,
because we think that is a given.
The idea is that your portfolio needs to have something that is
going up when other parts of the portfolio are going down.
Knowing that something in your portfolio is likely to go up no
matter what will make it easier for you to sleep. And diversification
can protect your portfolio from absolute routs.

Increase potential

But we also have to say that in many cases you will just
have to grin and bear it. The need to add risk to increase potential
returns and the opportunities offered by investing
abroad overwhelm concerns about the diminished benefits from
diversification.

What is happening with diversification

In addition, one of the most promising new diversifying alternatives—
diversification by sectors—is not proving to be as effective
as once hoped.
What we want to do in this chapter is explain what is happening
with diversification and show that there are ways around
the snares being created by the follow-the-leader nature of the
world’s stock markets. And while we say the benefits of diversification
abroad and by sector have been diminished, we are not
saying they have disappeared. So these strategies will still help—
just not as much.

Diversification in stocks

This diminished benefit of diversification in stocks abroad is
another consequence of the globalization of the world’s
economies and the around-the-world fight against inflation. The
growth of companies with a global reach has also contributed to
this synchronization of markets, as has the speed of communication,
which allows more and more people to know what is going
on every second in markets around the world.

Problems with diversification into foreign stocks

Problems with diversification into foreign stocks, of course,
spell trouble for all investors, big or small, if it does not reduce
the risk of loss in your portfolio. For the authors of this book,
troubles with diversification are even a bigger issue: We are urging
investors to buy more stocks abroad at a time when these purchases
may not make their overall portfolios more diversified. So
we cannot argue that it is easy to contain the added risk you are
taking on by buying more foreign stocks to increase your potential
returns.

More Than Stocks,More Than Bonds

There was a time when once you had learned about diversifying
your portfolio, the rest was pretty easy. Never hold too much of
any one stock or any one sector of stocks, and buy abroad, as
well as at home.
The rest of the world’s stock markets, and other asset classes
like bonds and commodities, provided what investors needed to
diversify—foreign markets and other investments than stocks
that would move in the opposite direction of equities in the
United States.

the market for teenage labor.

The minimum wage has its greatest impact on the market for teenage labor.
The equilibrium wages of teenagers are low because teenagers are among the
least skilled and least experienced members of the labor force. In addition,
teenagers are often willing to accept a lower wage in exchange for on-the-job
training. (Some teenagers are willing to work as “interns” for no pay at all. Because
internships pay nothing, however, the minimum wage does not apply to
them. If it did, these jobs might not exist.) As a result, the minimum wage is
more often binding for teenagers than for other members of the labor force.
Many economists have studied how minimum-wage laws affect the teenage
labor market. These researchers compare the changes in the minimum wage over
time with the changes in teenage employment. Although there is some debate
about how much the minimum wage affects employment, the typical study finds
that a 10 percent increase in the minimum wage depresses teenage employment
between 1 and 3 percent. In interpreting this estimate, note that a 10 percent increase
in the minimum wage does not raise the average wage of teenagers by 10
percent. A change in the law does not directly affect those teenagers who are already
paid well above the minimum, and enforcement of minimum-wage laws is
not perfect. Thus, the estimated drop in employment of 1 to 3 percent is significant.

Risk in American portfolios

Risk has been increased in American portfolios not only by
adding more American stocks but also by beginning to add stocks
from abroad, especially as the fall in the dollar in the past several
years has made buying abroad much more profitable.
Treasury data on the purchase of foreign stocks by Americans
shows that the dollar total has risen dramatically. Annual net
purchases of foreign stocks did not get over $10 billion until
1989 and by 2005 they had zoomed to over $127 billion. For the
12 months through November of 2006, Americans were buying
foreign stocks at a pace that would bring them close to the 2005
total. Purchases of foreign bonds, which used to be more popular
than foreign stocks, totaled $47.1 billion in 2005, the third highest
yearly total ever in the history of the Treasury data. At the furious
pace of buying through November of 2006, Americans
were en route to more than double that 2005 total and set a new
annual record.

Threatto End Rent Control Stirs

T h r e a t t o E n d R e n t C o n t r o l
S t i r s Up NYC
BY FRED KAPLAN
NEW YORK—One recent lunch hour at
Shopsin’s, a neighborhood diner in
Manhattan’s West Village, conversation
turned to the topic of the state Senate
majority leader, Joseph L. Bruno. “If he
ever shows his face around here, we’ll
string him up,” a customer exclaimed.
“The guy deserves death,” another said
matter-of-factly.
Rarely has so much venom been
aimed at a figure so obscure as an
Albany legislator, but all over New York
City, thousands of otherwise fairly civilized
citizens are throwing similar fits. For
Bruno is threatening to take away their
one holy fringe benefit—the eternal right
to a rent-controlled apartment.
Massachusetts and California have
abolished or scaled back their rentcontrol
laws in recent years, but New
York remains the last holdout, and on a
scale that dwarfs that of the other cities

New Stock Index portfolio

Your new portfolio would look like the composition of the
Lehman Brothers U.S. Aggregate Index,4 with 40 percent in mortgage-
backed and other so-called securitized securities, 25 percent
in Treasury securities, almost 20 percent in investment-grade corporate
bonds, and 15 percent in other government-related securities,
including the so-called agency bonds issued by the likes of
Fannie Mae. If you decreased the Treasury portion and just
moved the money into corporate bonds, for example, your risk
and potential return would rise a little.

Investment safest corner

A move from the safest corner of the
Treasury market to a mix of Treasury securities, from bills to
bonds, and the addition of investment-grade corporate bonds and
securities backed by mortgages raises the compound annual return
over the past 31 years to 8.6 percent. The risk factor is 7.4,
more than twice the risk of the safest of the safe, Treasury bills. In
those 31 years, there was a loss in only two years.

Treasury bills

In the 81 years through 2006, 30-day Treasury bills have been
the safest place to be, as can be seen in Table 1.2. Their risk measure—
their standard deviation—is way down at 3.1. These Treasury
bills have produced a loss in only one year, in 1938. But their
compound annual rate of return over those 81 years is just 3.7 percent,
according to Ibbotson Associates, a Morningstar company.

Returns from stock market and the bond market

Also remember that we believe that the returns from both
the stock market and the bond market will be lower in the
years ahead. So these historical returns are even less likely to be
repeated.
Risk here is measured by what economists call the standard
deviation of annual returns. The higher this number, the riskier
the investment because the assets chosen have a wider range of
returns, both positive and negative, over time.

How much do these shifts in risk help you?

How much do these shifts in risk help you? Let’s take a look.
Remember that the historical data used here is to give you a way
to compare the risk and return trade-offs of the various investment
categories we are describing. These compound annual rates
of return do not tell you what you will earn in the future. They
are only an indication of the difference in returns possible for different
levels of risk.

Adventurous to invest abroad

If you are already much more adventurous and have a lot of
your portfolio in stocks, you can add risk by changing your
mix of stocks. For example, you can move into smaller company
stocks—what are called small-capitalization or small-cap
stocks.
A bolder step is to invest abroad. To this end you can add a
lot of risk by moving to emerging markets, the growing stock
markets in developing nations.

Scheme for managing

All in all, economists agree that while no scheme for managing
an economy is perfect, one battle—the battle against inflation—
has to be won if there is going to be hope for long-term
growth.
But even such a cure-all has its downside. In this case, it is
that the roller-coaster ride to lower inflation can be much more
profitable for investors than the stable price environment the containment
of inflation brings. That is because there is a one-time
upward revaluation of the value of assets, like stocks, bonds, and
real estate, as inflation in wrung out of the system. And investors
have already profited from that.

Blame stability

The reason investors have to get to know risk better, despite the
potential discomfort, is that we got what we wished for—an
economy with inflation in check.
The long secular battle against inflation began with the appointment
of Paul A. Volcker as chairman of the Federal Reserve
in 1979 by President Jimmy Carter, and was won, for now, during
Alan Greenspan’s more than 18 years at the helm of the nation’s
central bank. He retired at the end of January 2006.

Midst of a Investors risk squeeze

In other words, we are in the midst of a risk squeeze, where
investors will get less for more risk. So it is likely that many investors,
in order to meet their investment and savings goals, will
have to take on what is now considered above-average risk just to
get an average return, or substantial risk to get an above-average
return.
The most cautious investors, whether they like it or not, will
not have the luxury of putting much of their money into the traditional
safe harbor of the Treasury market and earning enough
to live on.

Politically difficult

What are the pros and cons of the multilateral approach to free trade? One
advantage is that the multilateral approach has the potential to result in freertrade than a unilateral approach because it can reduce trade restrictions abroad as well as at home. If international negotiations fail, however, the result could
be more restricted trade than under a unilateral approach.
In addition, the multilateral approach may have a political advantage. In
most markets, producers are fewer and better organized than consumers—and
thus wield greater political influence. Reducing the Isolandian tariff on steel, for
example, may be politically difficult if considered by itself. The steel companies
would oppose free trade, and the users of steel who would benefit are so numerous
that organizing their support would be difficult. Yet suppose that
Neighborland promises to reduce its tariff on wheat at the same time that
Isoland reduces its tariff on steel. In this case, the Isolandian wheat farmers,
who are also politically powerful, would back the agreement. Thus, the multilateral
approach to free trade can sometimes win political support when a unilateral
reduction cannot.

Treasury’s 10-year

This willingness to take on added risk is one of the reasons
that longer-term interest rates remained unexpectedly low in
2004, 2005, and 2006, even as the Federal Reserve raised its
short-term interest rate target, the federal funds rate on
overnight loans. After the central bank had increased its target
by 4.25 percentage points, from 1 percent to 5.25 percent, the
yield on the Treasury’s 10-year note at the end of 2006 was virtually
at the 4.70 percent level of June 2004, when the Federal
Reserve began that round of interest rate increases. The yield
on the 10-year note did not get above 5 percent until April of
2006, the first time in four years, but stayed there for only four
months.

How to buy riskier investments

If more and more investors are willing to buy riskier invest-
ments, for example moving even cautiously from a portfolio
stashed in the Treasury market to one filled with investmentgrade
corporate bonds, that new demand bids up the price for
those corporate bonds. Prices and yields move in opposite directions,
so when investors pay a higher price for these corporate
bonds they get a lower yield. As prices of riskier assets rise, the
return for that added risk decreases.

Federal Reserve policy makers

At that point, the Federal Reserve will be faced with two
problems. One will be to prevent the economic slowdown from
deepening. The other—and more serious—problem will be to
prevent a slowing in the rate of inflation, which is called disinflation,
from turning into deflation, an actual decline in
prices.
In the most recent recession, which ended in November of
2001, Federal Reserve policy makers were open about the threat
of deflation as they pushed Treasury interest rates lower and
lower. Their short-term interest rate target, which is the central
bank’s main tool for steering the course of the economy, got
down to 1 percent in June of 2003 and stayed there for a year. It
is likely that in the next recession, this rate will have to go below
1 percent.

Revival of inflation

But unless there is a revival of inflation, it is unlikely that
rates will get near that average again for any length of time. In
fact, it is more likely that these interest rates will go even lower,
making the safe harbor of the Treasury market an unsafe place
for investors to be in if they are in any way worried about the size
of their returns.

Northwest Airlines

Many Americans also have lost or are threatened with losing
the pensions they have counted on from their companies. Others
are facing freezes that will reduce the expected value of their retirement
benefits. Among the big-name companies that announced
the freezing of their benefits in 2006 alone were IBM,
Alcoa, Northwest Airlines, and Sprint Nextel. And it is possible
that state, county, and municipal employees could face threats to
their pensions similar to those now faced by government workers
in San Diego.

Total USA revenue

Because of this adverse effect of drug interdiction, some analysts argue for alternative
approaches to the drug problem. Rather than trying to reduce the supply
of drugs, policymakers might try to reduce the demand by pursuing a policy of
drug education. Successful drug education has the effects shown in panel (b) of
Figure 5-10. The demand curve shifts to the left from D1 to D2. As a result, the equilibrium
quantity falls from Q1 to Q2, and the equilibrium price falls from P1 to P2.
Total revenue, which is price times quantity, also falls. Thus, in contrast to drug interdiction,
drug education can reduce both drug use and drug-related crime.

Standard & Poor’s after World War II

So what should that be? The compound annual rate of return
for stocks from 1946 through 2006 is 11.5 percent, with the after-
inflation or real return at 7.2 percent. So investors may be
faced not with just half the returns from the 1990s stock bubble,
but less than half.
Another reason for thinking stock market returns will be
lower is the valuation of the equity market. Stocks in the closely
watched S&P 500 stock index are still a little expensive historically,
even after the collapse that began in 2000. As of the end of
Returning to the historic pace of stock returns means a big decline from the
pace of the 1990s. Total returns and real total returns, adjusted for inflation,
at compound annual rates.
Source: Ibbotson Associates. Data from Standard & Poor’s.
2006, the price-to-earnings ratio for the S&P 500 stock index
was 17.4, according to Standard & Poor’s. That is above the P/E
average of 16.1 since World War II, although it is well below its
peak of 46.5 for 2001.

HORIZONTAL EQUITY AND THE MARRIAGE TAX

The treatment of marriage provides an important example of how difficult it is
to achieve horizontal equity in practice. Consider two couples who are exactly
the same except that one couple is married and the other couple is not. A peculiar
feature of the U.S. income tax code is that these two couples pay different
taxes. The reason that marriage affects the tax liability of a couple is that the tax
law treats a married couple as a single taxpayer. When a man and woman get
married, they stop paying taxes as individuals and start paying taxes as a family.
If the man and woman have similar incomes, their total tax liability rises
when they get married.
To see how this “marriage tax” works, consider the following example of a
progressive income tax. Suppose that the government taxes 25 percent of all income
above $10,000. Income below $10,000 is excluded from taxation. Let’s see
how this system treats two different couples.
Consider first Sam and Sally. Sam is a struggling poet and earns no income,
whereas Sally is a lawyer and earns $100,000 a year. Before getting married, Sam
pays no tax. Sally pays 25 percent of $90,000 ($100,000 minus the $10,000 exclusion),
which is $22,500. After getting married, their tax bill is the same. In this
case, the income tax neither encourages nor discourages marriage.
Now consider John and Joan, two college professors each earning $50,000 a
year. Before getting married, they each pay a tax of $10,000 (25 percent of
$40,000), or a total of $20,000. After getting married, they have a total income of
$100,000, and so they owe a tax of 25 percent of $90,000, or $22,500. Thus, when
John and Joan get married, their tax bill rises by $2,500. This increase is called
the marriage tax.

Return for the Stock Market

First, let’s take a look at expectations and reality.
The 28.6 percent compound annual rate of return for the
stock market at the end of the 1990s is a dream now.1 Those returns
were the product, in part, of a revolution in the investing
environment as the Federal Reserve, the nation’s central bank,
conquered inflation and the federal government seemed to get
sensible about its own fiscal policies, which led to an all-too-brief
period of federal budget surpluses. While the term new economy
may have fallen into disrepute, the sometimes baffling surge in
worker productivity that characterized this period was also behind
the rise in equities, as was more than 18 years of economic
growth, interrupted by just one recession.

Older Americans

Older Americans also have to face the fact that they are expected
to live a lot longer than their parents. Because of that,
those near retirement and even those already retired will have to
keep a much bigger portion of stocks in their portfolios than their
parents would have. As we will see, this adds risk.

Meet risk.

Meet risk. You know what it looks like—a little scary. You know
how it makes you feel—queasy. You know what it can do to
your portfolio—make it shrink.
Right, right, and wrong. Scary, queasy, yes. But risk does not
produce just losses. In fact, based on historical data, it is well
proven that adding risk can improve investor returns over time.
So return, which you know and love, has a regular dance
partner. And the better they dance together, the better you and
your portfolio perform.
You may have been doing only a safe waltz with risk for
years, or maybe a little bit jazzier foxtrot. Now it is time to learn
some more difficult—and, probably, intimidating—steps: the
quickstep or a tango.

We cannot make investing less difficult than it is

We cannot make investing less difficult than it is. Even if you
are investing for the long term and using well-known mutual
fund companies or a smart money manager that you like, you still
have to question the advice you get, make your choices, and live
with the consequences.
And we are not, like some prognosticators, preparing you for
the good time or the bad time we see ahead. We are predicting
neither an investing nirvana nor an investing debacle ahead—just
curves and straightaways.

McCulley’s management at PIMCO

McCulley’s insights are based on years of economic forecasting
and money management at PIMCO. Since September of
1999, he has expressed his views on monetary policy, markets,
and economic thought in his “Fed Focus” column, which was recently
renamed “Global Central Bank Focus.”
At The New York Times, Jonathan Fuerbringer was a financial
columnist and wrote extensively about economic policy, the
Federal Reserve, and stocks, bonds, commodities, and currencies

PIMCO

We also take a side trip into the world of mutual funds to
look at the consequences of being right and of being wrong as a
money manager—and we illustrate how being right or wrong can
make a difference of billions of dollars very quickly. And we
show what groupthink did to the best call on interest rates that
McCulley has ever made at PIMCO. We will also take a peek at
McCulley’s portfolio—a look that will show that he is much
more of a Main Street investor than you might think. For years,
in fact, his most exotic investment was his home! McCulley will
also lay out what he is doing with his own money in two investing
situations, one a plan for his son and the other the investments
for his foundation. And we offer a primer on some of the
big—and small—thoughts that drive markets.

THE DEADWEIGHT LOSS DEBATE

Supply, demand, elasticity, deadweight loss—all this economic theory is enough
to make your head spin. But believe it or not, these ideas go to the heart of a profound
political question: How big should the government be? The reason the debate
hinges on these concepts is that the larger the deadweight loss of taxation,
the larger the cost of any government program. If taxation entails very large deadweight
losses, then these losses are a strong argument for a leaner government
that does less and taxes less. By contrast, if taxes impose only small deadweight
losses, then government programs are less costly than they otherwise might be.
So how big are the deadweight losses of taxation? This is a question about
which economists disagree. To see the nature of this disagreement, consider
the most important tax in the U.S. economy—the tax on labor. The Social Security
tax, the Medicare tax, and, to a large extent, the federal income tax are
labor taxes. Many state governments also tax labor earnings. Alabor tax places a
wedge between the wage that firms pay and the wage that workers receive. If we
add all forms of labor taxes together, the marginal tax rate on labor income—the
tax on the last dollar of earnings—is almost 50 percent for many workers.

Resurgence in inflation

While it is easier to read the intentions of Federal Reserve policy
makers than it was several decades ago, their statements and
speeches can still be confusing, leading investors to make mistakes.
We will tell investors how to figure out what Federal Reserve
policy makers are doing as they are doing it, and we roll out
our favorite leading indicator of Fed policy. But one old adage is
still true—do not bet against the Fed. And do not doubt the policy
makers’ anti-inflation commitment. They would still rather
risk a recession than see a resurgence in inflation

The governors of the Federal Reserve Board

The governors of the Federal Reserve Board and the presidents
of the 12 regional Federal Reserve banks now have to
shoulder the task of getting us through the next recession without
a deflationary spiral, and through the next bubble without too
much damage to the financial system and the economy. Later in
this book, we look at their ability to do this and propose a tool
for managing monetary policy that would be helpful to both investors
and the policy makers at the nation’s central bank.

Peace dividend

The Federal Reserve’s success on inflation is also a reason that
returns have shrunk in both the stock and bond markets. As the
Fed was winning the fight against inflation, it provided a one-time
opportunity for big returns in the bond market as interest rates
adjusted to new lower levels. There were even bigger returns in
the stock market as the prospect of declining inflation raised the
value of future equity earnings in line with falling interest rates,
and then some. But now both these markets are assuming that inflation will be stable, with real rates and price-earnings (P/E) multiples
reflecting that stability. And you do not get to go to heaven
twice for winning the war against inflation—the “peace dividend”
is paid just once, as the victory occurs, not year after year
in its aftermath.