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Archive for December 23rd, 2011

Returns on Equity Amid the Financial Crisis, Response

Friday, December 23rd, 2011

I appreciate constructive criticism.  I particularly appreciate comments at this blog, regarding my long article on how return on equity changed during the financial crisis.

The reviewer said,

In a world in which I didn’t have only 20 minutes to read, analyze and write about this paper, I’d like to think through his model choices. I would feel much more comfortable on this point if he accepted the Russ Roberts Science challenge and have a section discussing the process by which he arrived at the process by which he arrived at his conclusions.

Look, I have a policy.  I don’t do specification searches.  If I don’t get reasonable results in the first two tries, I abandon the project.  As it was in this case, I only did one pass through the data.  I was testing for the idea that state or national governmental policy might affect book or market value returns, after adjusting for market sector.

He later commented,

I’d have two comments:

1. What’s the point of decomposing them, then?

2. Can’t you just attribute ALL variance of corporates to ‘historical accident’? Can there be no policy implications?

On point #2, I’d defend Merkel by saying that policy implications need a big enough sample that you can reasonably hold other factors constant. You’d need a dataset of every industry in every state over every conceivable macro-economic environment, then control for those other factors. Same applies for analyzing different countries.

The point of decomposing them is that you don’t know in advance what the result will be.  I only did one pass at the data (please ask academic economists what they do), in this case, it showed that after adjusting for sectors and general economics (time), the states one was in did not matter much, as those that did well did not move to seek lower tax environs.

The piece I did last year did not attribute everything to historical accident.  This year, I was surprised to find that few successful companies had not moved to lower tax/regulation jurisdictions.

I did not know what the decomposition would lead to — that was a major reason for doing it.  If there had been some indication that companies in the US sought lower tax or regulation states, I would have published that, but it was not so, in aggregate.  I does not matter that the result was ordinary.  Once I start the problem, if I come to any understandable result, consensus or non-consensus, I publish it.

Now in truth, I don’t think the paper was one of my best efforts.  I would like to have set error bounds, but I didn’t have access to good software.  I also would have liked to use a better database, like the CRSP database, but that was not available.  Given my lack of resources, it was the best I could do.  Anyway, anyone with more constructive criticisms, I welcome them.



David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.

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