NOVEMBER 28, 2008

Online advertising

Not ye olde banners

Internet advertising will be relatively unscathed in the downturn

AT THE beginning of the year Jeff Zucker, the boss of NBC Universal, a big television and film company, told an audience of TV executives that their biggest challenge was to ensure “that we do not end up trading analogue dollars for digital pennies”. He meant that audiences were moving online faster than advertisers, thus leaving media companies short-changed. Now, near the end of the year, the situation looks even worse, as the recession threatens to turn even the analogue dollars into pennies. Will this hasten the shift towards internet advertising, or will it decline too?

Advertising rises and falls with the economy, though how much is a matter of debate. Randall Rothenberg, the boss of the Interactive Advertising Bureau, a trade association for digital advertisers, points to the remarkable stability of advertising at about 2% of GDP since 1919, when the data began to be collected. This would suggest that ad budgets will move roughly in line with economic output.

But Mary Meeker, an internet analyst at Morgan Stanley, believes that modern ad budgets rise and fall much more than GDP does. According to her estimates, if the economy stops growing, ad spending is likely to fall by 4%. If the economy shrinks by 2%, overall ad spending may fall by 10%. As for the online segment, recent history is cause for pessimism. Between 2000 and 2002, during the dotcom recession, online ad spending in America fell by 27%.

Yet the web has changed a lot since 2002. Back then, gaudy display “banners” on web portals such as Yahoo! and MSN were the preferred technology. These still exist, but they now account for less than 20% of online ad spending. More than half goes to search advertising on Google and rival search-engines, which place small text ads next to results based on the keyword of the query, and charge only when a user clicks on them. In brand advertising, “rich media” ads are taking over from banners. These allow users to interact by clicking, so their engagement can be tracked.

All this makes spending on advertising much less speculative, so that it starts to be treated instead as a cost of sales. This is one reason why online advertising should suffer less than other sorts. This week eMarketer, a market-research firm, predicted that online-advertising spending in America, which makes up about half the global total, will increase by 8.9% in 2009, rather than the 14.5% it had forecast in August. The firm thinks search advertising will grow by 14.9% and rich-media ads by 7.5%, whereas display ads will grow by 6.6%. In short, online advertising will continue to expand in the recession—just not as quickly as previously expected.

Another reason for optimism, says Mr Rothenberg, is that online advertising is making obsolete the old distinction between marketing spending “above the line” and “below” it. In the jargon, above-the-line spending drives brand “awareness” (probably on television) or “consideration” by a consumer planning a purchase (probably in a newspaper). Such spending is often slashed in recessions. Below-the-line spending includes promotions or coupons to whet the consumer’s “preference” for the brand as he nears a purchase, or schemes such as frequent- flyer miles to increase his “loyalty” afterwards. These budgets are more robust.

Online marketing increasingly aims for awareness, consideration, preference and loyalty all at once. Mr Rothenberg gives the example of a rich-media ad for Kraft, a food company, in which a yummy image raises brand awareness, a click reveals a recipe that increases consideration, another click provides coupons and yet another click initiates a game that can be shared with friends. Marketing managers can therefore defend their online budgets as being both above and below the line.

The industry is also cautiously excited about two new forms of online advertising. The first is video. So far nobody has found a way to advertise inside online clips on a large scale. YouTube, which Google bought for no less than $1.65 billion two years ago, is “a huge end-user success,” says Eric Schmidt, Google’s boss, “and we’re awaiting the monetisation.” This is his way of saying that YouTube, despite showing 5 billion video clips a month, has trivial ad revenues. The site is experimenting with text “overlays” inside clips and sponsored videos for specific search terms, but it is early days. “If only we could schedule the revolution,” jokes Larry Page, one of Google’s founders.

If something close to one is in fact near, it may not come from YouTube. Ads on Hulu, a video site that is a joint venture between Mr Zucker’s NBC Universal and News Corp, another media giant, appear to be selling well. Hulu is different from other video sites in that it only shows professionally produced videos, such as programmes and films from NBC, Fox, MGM and Warner Brothers. It runs a relatively small number of short, fun “pre-roll” ads. These incorporate some of the advantages of the web. Viewers can, for instance, vote on how good a particular ad was.

The lesson appears to be that the problem was not the format but the fact that so much of the footage online, especially on YouTube, is “user-generated”. Brands are wary of putting their ads next to amateur clips because they may be boring or offensive. This is less likely to be a problem with professional content. From a small base, says Mr Rothenberg, online-video ads grew from 1% to 3% of all interactive ads in America in the first half of the year.

The other hope is for ads on social networks such as MySpace and Facebook. They are experimenting with a variety of advertising formats, though none has yet proved very successful. Their big weakness is that users go to social-networking sites to socialise, not to shop (as they might on search engines). Their biggest strength is that users spend so much time there. Two years ago 11% of time spent online was at Yahoo! and MSN, two web portals; now their share is down to 5%, and 5% of online time is spent at YouTube and Facebook.

Online traffic, in other words, is moving towards sites where advertising has so far proved ineffective and is therefore cheap. This, says Ms Meeker, presents an opportunity for innovation and arbitrage by clever marketing managers as they cut their conventional ad budgets. It may also provide a glimmer of hope for the advertising industry as it enters recession.

Battles rage for Mumbai hostages


A day of explosions and gunfire at the Taj Mahal Palace hotel

Fresh explosions and gunfire have been heard at Mumbai’s Taj Mahal Palace hotel, one of several sites targeted in attacks that have killed at least 130.

Loud blasts have also rocked a Jewish outreach centre where commandos were attempting to free several hostages.

A 29-year-old rabbi and his wife were confirmed as being among five hostages killed inside Nariman House.

India’s foreign minister said “elements with links to Pakistan” were involved in the attacks on Mumbai.

However, his Pakistani counterpart has urged India not to bring politics into the issue, saying “we should join hands to defeat the enemy”.

The BBC’s Pakistan correspondent, Barbara Plett says there is a feeling among senior officials in Islamabad that India has acted too hastily in linking the Mumbai attackers to Pakistan.

In the UK, security officials said they were investigating reports that British citizens of Pakistani origin were involved.

Fearful residents say Mumbai will cope

The stand-offs began late on Wednesday when gunmen armed with automatic weapons and grenades opened fire indiscriminately on crowds at a major railway station, the two hotels, the Jewish centre, a hospital and a cafe frequented by foreigners.Earlier, nearly 100 guests and staff – many of them westerners – were rescued from the Oberoi-Trident hotel, and the battle with gunmen there appeared to be at an end.

Around 370 people have been injured since Wednesday, while the death toll is expected to rise as more bodies are discovered.

Confirmation also came on Friday that two French and two US citizens had died in the violence. The US state department said Americans were still at risk in Mumbai.

One Indian security official said eight foreigners were known to have died, among them three Germans, a Japanese, Canadian and Australian. One Briton has also been killed.

‘Ultimate sacrifice’

As night fell at the end of a day of fighting around Nariman House, the New York-based Chabad-Lubavitch organisation confirmed that Rabbi Gavriel Holtzberg, 29, had been killed alongside his wife, Rivka.

The Holtzbergs had moved to India in 2003 from New York to run the Mumbai branch of the outreach organisation, which offers services and hospitality to passing Jewish travellers.

Rabbi Gavriel and Rivka Holtzberg (file pic, Chabad-Lubavitch)

The couple’s young son was evacuated from the building earlier in the day. There was no word on the identities of the others found dead on the premises.The couple “made the ultimate sacrifice,” said Rabbi Moshe Kotlarsky, of Chabad-Lubavitch.

Orthodox Jewish rescuers sent to Mumbai to assist also confirmed that five bodies had been found. Two kidnappers were also reported killed.

Having swooped at first light, commandos blew up a part of the wall of the fourth floor of the building, lowered down onto the roof by ropes from helicopters and dropping smoke bombs to create confusion.

The only people confirmed as leaving the building were a woman and the two-year-old child, although it was unclear whether they had managed to escape or were released.


Indian security forces have said they believe at least one gunman with “two or more hostages” remains in the Taj Mahal Palace hotel.

Large explosions and gunfire have been ringing out from the building for most of the day after truckloads of commandos entered the hotel. A journalist and bystander outside the hotel were taken to hospital after being hit by shrapnel.

Indian commandos who managed to enter other parts of the Taj Mahal say they found at least 30 bodies in one hall.

The commandos also said the militants were well aware of the layout of the hotel, and that they had recovered a Mauritius identity card as well as guns and money.


Earlier, the head of India’s National Security Guard, JK Dutt, said the Oberoi-Trident was “under our control”.

“We have killed two terrorists today,” he said. “There was lots of firing, they also lobbed hand grenades. Some of them are unexploded, we are going to defuse them – you may hear some sound of explosions.”

The relief of the guests was evident as 93 of them were escorted from the hotel on Friday morning following the lengthy siege. They included 20 Air France crew members.

One of those freed, Briton Mark Abell, spoke of his delight at seeing several heavily armed soldiers at his hotel door after spending more than 36 hours in his room.

But he was shocked by the state of the hotel. “The lobby was carnage, blood and guts everywhere. It was very upsetting,” he told the BBC.

Pakistani ‘link’

State home minister RR Patil, speaking out the Oberoi-Trident hotel, said a total of nine militants had been killed, along with 15 police officers and two commandos.

He said one of those arrested was a Pakistani citizen.

30 October: Explosions kill at least 64 in north-eastern Assam
30 September: Blasts in western India kill at least seven
27 September: Bomb blasts kills one in Delhi
13 September: Five bomb blasts kill 18 in Delhi
26 July: At least 22 small bombs kill 49 in Ahmedabad
25 July: Seven bombs go off in Bangalore killing two people
13 May: Seven bombs hit markets and crowded streets in Jaipur killing 63

Earlier, the Indian navy took control of two Pakistani merchant navy ships and began questioning their crews after witnesses said some of the militants came ashore on small speedboats.India’s Foreign Minister Pranab Mukherjee said preliminary evidence “leads us to believe that some elements in Pakistan may be connected to these events”.

But he added that it was too soon to give details.

Pakistani Foreign Minister Shah Mehmood Qureshi responded by saying: “This is a collective issue. We are facing a common enemy and we should join hands to defeat the enemy.”

The head of Pakistan’s powerful military intelligence agency, Ahmed Shuja Pasha, is due to travel to India to discuss the situation with his Indian counterparts.

India has complained in the past that attacks on its soil have been carried out by groups based in Pakistan, although relations between the two countries have improved in recent years and Pakistani leaders were swift to condemn the latest attacks.

A claim of responsibility for this week’s attacks – the worst in India’s commercial capital since nearly 200 people were killed in a series of bombings in 2006 – has been made by a previously unknown group calling itself the Deccan Mujahideen.

However, most intelligence officials are keeping an open mind as the attacks have thrown up conflicting clues, BBC security correspondent Frank Gardner says.

 Map of Mumbai showing location of attacks

Turbulence Ahead

Some things to be thankful for in depressing times.

The hundred days are happening now. That’s the real headline on President-elect Obama’s series of news conferences and his announcements of intended administration policy, such as an economic stimulus package. We don’t really have to wait till after the inauguration on Jan. 20 for the new administration to begin. What the Obama transition has become is historically unprecedented. He is filling the vacuum created by a collapsed incumbency and an acute economic crisis. He is moving forward with what looks like a high, if ad hoc, awareness of the delicacy of the situation. He can’t seem presumptuous or aggressive: “We only have one president at a time.” At the same time he can’t hide. The White House exhibits chastened generosity, refusing to snipe, mock or attempt to undermine.

[Declarations] AP

Mr. Obama’s cabinet picks and other nominations suggest moderation, also maturity, and his treatment of Joe Lieberman shows forbearance and shrewdness. Politics is a game of addition, take the long view, don’t throw anyone out as you try to hit 60. Most of all, leave Mr. Lieberman having to prove every day to the Democratic caucus that he really is a Democrat. There’s nothing in being a maverick now. Mr. Obama’s preternatural steadiness continues. It’s been a while since anyone called him Bambi or compared him to the ambivalent, self-torturing Adlai Stevenson. For all of which—and for the cooperation of the Bush administration, whose desire to be of assistance in what used to be called the transition is classy and a good example—one can be thankful.

We can be thankful we had an election whose outcome was clear, not murky and a continuing trauma. It is good that 2008 was a seven-point win by someone, and not a 50-50 contest forced into resolution in the courts. Imagine what it would be like now, the general tone and feeling of the country, if at this moment we were arguing over hanging chads and bent ballots. I am thankful that more than half the country is, in at least one area, politics, happy, and that the 46% who voted the other way accepted the outcome as America always has, peacefully and with good-natured resentment. So many are hoping for the best, as if hoping for the best is a function or an expression of patriotism, which to a degree it is.

I am thankful for something we’re not seeing. One of the weirdest, most perceptually jarring things about the economic crisis is that everything looks the same. We are told every day and in every news venue that we are in Great Depression II, that we are in a crisis, a cataclysm, a meltdown, the credit crunch from hell, that we will lose millions of jobs, and that the great abundance is over and may never return. Three great investment banks have fallen while a fourth totters, and the Dow Jones Industrial Average has fallen 31% in six months. And yet when you free yourself from media and go outside for a walk, everything looks . . . the same.

Everyone is dressed the same. Everyone looks as comfortable as they did three years ago, at the height of prosperity. The mall is still there, and people are still walking into the stores and daydreaming with half-full carts in aisle 3. Everyone’s still overweight. (An evolutionary biologist will someday write a paper positing that the reason for the obesity epidemic of the past decade is that we were storing up food like squirrels and bears, driven by an unconscious anthropomorphic knowledge that a time of great want was coming. Yes, I know it will be idiotic.) But the point is: Nothing looks different.

In the Depression people sold apples on the street. They sold pencils. Angels with dirty faces wore coats too thin and short and shivered in line at the government surplus warehouse. There was the Dust Bowl, and the want of the cities. Captains of industry are said to have jumped from the skyscrapers of Wall Street. (Yes, those were the good old days. Just kidding!) People didn’t have enough food.

They looked like a catastrophe was happening.

We do not. It’s as if the news is full of floods but we haven’t seen it rain.

I asked an economic expert a few weeks ago if a second Great Depression would come to look at all like that, like a catastrophe, and he said no, not at all. In 1930 we had no safety net. Unemployment benefits, food stamps, welfare, an interlocking system of city, state and federal services—these things will keep it from being so bad.

But in tough times we will surely expand unemployment benefits, and welfare, and food stamps and housing assistance, which will mean more and greatly accelerated spending, which will mean bigger and steeper deficits, and higher taxes, with the one feeding on the other, which may mean an economic death spiral comparable to, say, Britain in the decades after World War II, its economy mired and held down by government control and demands. It continued more than a quarter century, until the change of economic thinking encapsulated in the phrase “the Thatcher years.” Is that what this will be?

Anyway it is odd, surreal, to have the steady downbeat of Great Depression II all over the news, and few signs of GDII on the street, odd that the news we’re hearing is at odds with what our eyes are seeing, at least at the moment.

So where is GDII happening? Right now mostly in conversations between wives and husbands, in families and among friends, about selling, about digging in, about layoffs, and not taking chances, and reduced income, and fear.

As for what we see, in economic stories there’s always a lag. New York in 1990 did not know it was in the midst of coming levels of affluence unseen in all of human history. The storefronts in my neighborhood at that time were tatty, tired. At some point in the next 10 years everything in the neighborhood was updated and started to gleam. There were bright new awnings on the shops, and the windows shining. Everything was washed clean by affluence. The food stores on Lexington Avenue offered more and more varied fruit for sale in thicker stacks outside. Even the dogs were suddenly more beautiful, handsome brushed brown Labs and stately golden retrievers.

I suppose as months and years pass it will all gleam less, with a steady falling off from perfection. It will roughen.

We’ve gotten through roughness before. Of things to be thankful for, I personally include this. I traveled this year, and when I fly I say a prayer that has become a ritual: “Dear God, put your big hands under this plane and lift it up, and carry it forward through the air untouched and unharmed by other objects. And may its inner workings work. And put us down softly in our place of destination, and return us safely to our homes, and to those in whose lives we are enmeshed.”

It occurs to me that is perhaps how many of us are feeling about our country this Thanksgiving: Lord, thank you for our previous safety, and get us through this turbulence.

I close with a nod of small thanks for the title of a book I saw the other day called, “Are You There, Vodka? This is Chelsea.” The stewardess was reading it on a flight from Phoenix to Newark. She was laughing. It was nice.

Hillary of State

How much will this cost the Obama administration?

One rule of employee relations? Never hire someone you can’t afford to fire. Barack Obama’s offer to let Hillary Clinton be secretary of state has already been marked down as a brilliant co-option of his former rival. But nothing comes for free, and the question is just how big a price Mr. Obama will pay in the end.

[Potomac Watch] AP

For now, he is getting only praise for his surprise pick. The move fits neatly into the media narrative that Mr. Obama is drafting a team that will challenge his thinking. It’s also being described as a gesture that could heal party wounds and mollify Clinton supporters Mr. Obama never won to his side.

The actual motivation? Short term, Mr. Obama understands his real struggles are going to be in the Senate, where he will need 60 votes. Left there with nothing but a potential future run against Mr. Obama, Mrs. Clinton would be tempted to use her position to highlight her differences with the sitting president. Even as a junior senator, she could gum up his works. Mr. Obama does not need that.

The job at State all but eliminates this threat. As the nation’s top diplomat, Mrs. Clinton will be barred, both by law and by custom, from partisan politics. She’ll have to dismantle her extensive political operation, and end the patronage that has earned her continued loyalty.

There’s arguably also not enough time for Mrs. Clinton to make her mark as secretary of state, and find a reason to break with her boss, and piece back together her empire, and get into a presidential race. They both know that in taking this cabinet post, Mrs. Clinton is clearing herself from Mr. Obama’s political path.

Having lived with, up close, the Clinton political threat, Mr. Obama might be forgiven for agreeing to just about anything to forestall a repeat. But no one should forget that this is Mrs. Clinton we are talking about — with all her ambitions, all her frustrations, all her family relations and all her past. The price of neutralizing Mrs. Clinton as an outside rival, by bringing her inside, could make today’s bailouts look cheap.

The early media pronouncement is that Mr. Obama is getting, for this post of top diplomat, a woman with great “experience.” Oh, how short memories are. Mrs. Clinton staked her early primary claim on foreign policy. So determined was she to out-tough Mr. Obama that she walked into wild exaggerations — Bosnian sniper fire and Northern Ireland peace, to name a few.

Egged on by former Clintonite Gregory Craig (Mr. Obama’s newly picked White House general counsel), the media reported on just how little “experience” she’d had as the former first lady. Mrs. Clinton worked hard on foreign policy in the Senate, but it still remains far from clear how talented she’ll prove at this job. Mr. Obama is taking a flyer on one of his bigger promises — that of changing American foreign policy.

His onetime rival will also have plenty of leeway to go rogue. The State Department is traditionally hard to rein in, and Mrs. Clinton has insisted she also be free of traditional constraints. She’s demanded the right to staff her department with her own people. And while national security advisers are often more powerful than secretaries of state, she wants the ability to circumvent that position and go directly to Mr. Obama.

This is the stuff ugly internal disputes are made of.

As for the issues, there are plenty on which the rivals disagreed in the primaries, from how tough to be on Iran to how strongly to stand with Israel. And let’s not forget any differences between Mr. Obama and Bill Clinton — since no matter how many promises to the contrary, he will be co-secretary of state.

Speaking of Bill, Mr. Obama famously noted during the primary that it was time to move beyond the Clinton era. Instead, he’s dragging that baggage back into the White House living room. The Obama team is combing through the hundreds of thousands of donors to Mr. Clinton’s foundation. Those papers surely contain compromising conflicts. There was good reason the Clintons have always refused to make that information public.

Mr. Obama can now sit on those documents, renege on his pledges to be one of the most “transparent” presidencies in history, and endure the rightful outrage that will follow. Or he can release them, and guarantee a feeding frenzy. Either option will prove an unpleasant side story to his more pressing policy concerns. And that’s just the immediate issue. There are also the 1990s Clinton documents, which remain under wraps at the Clinton library, but not forever.

Having made the grand gesture, Mr. Obama can now only get rid of Mrs. Clinton at risk of another party rift. The president-elect now owns Mrs. Clinton’s past, and future, behavior. That could turn out to be some deal.

Detroit Needs a Selloff, Not a Bailout

Government can help get the Big Three’s assets into more productive hands.

Congress was decidedly unimpressed by the three domestic auto makers’ plea for a bailout last week and responded by asking them to do the impossible: conjure up plans by Dec. 2 detailing how a bailout would revive them.

[Commentary] Martin Kozlowski

After more than three decades of denial about their long-term decline, Detroit’s car companies must now face the facts. A bailout will not revive them. Moreover, the leading alternative that has been proposed by others — bankruptcy — will not re-energize these companies sufficiently to reverse their decline.

In our judgment, based on experience elsewhere in American industry, the most constructive role the government can play at this point is to provide a short-term infusion of capital with strict repayment rules that will essentially require the auto makers to sell off their assets to other, successful companies.

Why is such a dramatic step necessary? For the unavoidable reality that the fundamental problem the auto makers face is not their pension, health-care or other legacy costs. It is that they are not making cars and trucks that enough Americans want to buy. And this has been true to some degree since the first energy shock hit the U.S. in the early 1970s.

In 1970, General Motors, Ford and Chrysler made about 90% of the new cars sold in the U.S. Today their share is closer to 40%. Their market share of light trucks has also declined, but less precipitously thanks to a 25% tariff on many imported light trucks.

How could a federal bailout or a bankruptcy reorganization change that? Pension and health-care liabilities have been a hindrance, but they haven’t blocked product innovation.

Bankruptcy has allowed some industries to turn themselves around. A decade ago more than 40% of the steel industry’s capacity was reorganized in bankruptcy. The result was the rationalization of capacity and new labor agreements that allowed three large players — U.S. Steel, Severstal and Mittal — to create a more efficient steel industry.

But this change occurred only after a dramatic restructuring of the industry in the face of fierce competition from new “minimills.” By the time the larger companies — Bethlehem, LTV, Weirton and others — collapsed into bankruptcy, they had already shed a vast amount of uneconomic capacity and ceded the production of certain types of products to the minimills.

Thus, the operations that Mittal, U.S. Steel and Severstal bought out of bankruptcy were the most efficient remnants and were devoted principally to making products used in motor vehicles, appliances and (to a lesser extent) construction. They did not have to build new blast or steel furnaces or revamp product lines. They simply had to rewrite labor agreements.

Similarly, the airline industry weathered a round of bankruptcies following 9/11. The problem then was overcapacity relative to what the changing market would bear. But economic recovery and lower labor costs negotiated in bankruptcy allowed most airlines to rebound because they did not have to face multiple carriers that offered better service and cheaper fares.

Detroit faces very different problems. It has had a persistent product-line problem that may be even more severe than its labor problems, and in any event will not be solved by getting UAW wage rates in line with those at the U.S. plants of Toyota, Honda, BMW and Nissan by 2010. The gaps between U.S. and foreign competitors simply have become too large to make up by reducing labor costs or rationalizing capacity. Even if the overall economy rebounds and gives Detroit auto makers some breathing room to emerge from bankruptcy, they will likely face similar — if not more severe — problems in the next recession.

In the end, the capital and labor of these companies need to be reallocated into better hands. To this end, we suggest that assistance of some form — short-term financing or government purchase of equity — be granted under the condition that the Detroit Three restructure their labor relations so as to be able to sell some or all of their major assets.

There are a number of potential buyers for these assets. Toyota’s market cap is $100 billion and Volkswagen’s market cap is $110 billion. Either could bid for these assets. Honda, Nissan and even U.S. companies in related sectors, such as Caterpillar or John Deere, are possible buyers.

Members of Congress need to accept that the best possible outcome is a fundamental change in direction for the American automotive industry — a change that includes making Detroit’s facilities more attractive to successful companies. A joint venture between GM and Renault-Nissan was briefly discussed last year, and Daimler-Benz’s majority ownership of Chrysler was abandoned this year. Both failed because the Detroit-based operations could not improve their labor relations measurably and otherwise restructure sufficiently to be competitive.

By establishing firm mileposts for asset divestitures from which the companies could repay government funds, taxpayers could be reasonably assured that their money is well spent. But if Congress enacts a bailout without our conditions, the U.S. taxpayer will likely be on the line not only for additional support in the next recession, but likely on a regular basis for the foreseeable future.

We do not generally support government assistance to failing companies. But we think that our proposal will cost taxpayers less and, in the long run, be more beneficial to labor and the overall economy than either a straight bailout or bankruptcy.

Messrs. Crandall and Winston are senior fellows at the Brookings Institution.

Obama’s War Cabinet

Gates and Jones are welcome signs of continuity.

The names floated for Barack Obama’s national security team “are drawn exclusively from conservative, centrist and pro-military circles without even a single — yes, not one! — chosen to represent the antiwar wing of the Democratic party.” In his plaintive post this week on the Nation magazine’s Web site, Robert Dreyfuss indulges in the political left’s wonderful talent for overstatement. But who are we to interfere with his despair?

If reports are correct, on Monday the President-elect will ask Robert Gates to stay on as Secretary of Defense and name retired Marine General James Jones as National Security Adviser. These are the Administration posts most critical to the successful conduct of wars in Iraq and Afghanistan, and to possible entanglements with Iran, North Korea and who knows who else. With these personnel picks, Mr. Obama reveals a bias for competence, experience and continuity. Hence the caterwauls from his left flank.

[Review & Outlook] AP

Robert Gates.

The Gates selection is an implicit endorsement of President Bush’s “surge” in Iraq and its military architect, General David Petraeus. More broadly, it recognizes that America will continue to deal with a daunting post-9/11 security environment. As a member of the Iraq Study Group, Mr. Gates was against the surge before Mr. Bush made support for it a condition of his taking the Pentagon job. But at Defense since late 2006, Mr. Gates has supervised the successful new counterinsurgency strategy in Iraq. He also championed a new generation of military leaders, chiefly General Petraeus, who now commands U.S. forces in the Mideast, and he has poured additional resources into Afghanistan.

On all of the above, continuity would be welcome. Recall that Candidate Obama opposed the surge, called for a speedy withdrawal from Iraq and brushed back General Petraeus’s pleas to rethink both during his summer visit to Baghdad. Presumably President-elect Obama gave Mr. Gates some reassurances about future policy and his ability to shape it without repudiating the Secretary’s record to date. Mr. Gates will also give Mr. Obama some political insulation if events go wrong; Republicans may be less willing to criticize a Defense Secretary who served GOP Presidents than they would some standard-issue liberal like Michigan Senator Carl Levin.

[Review & Outlook] AP

Gen. James Jones.

General Jones is also a reassuring get. In the campaign, the former Marine Commandant and NATO Commander never endorsed anyone, though possible Obama Secretary of State Hillary Clinton and John McCain both avidly courted him. The General comes from a fine tradition that puts national security above partisanship.

Here’s how he explained his then-controversial support for the surge to a Journal reporter in April: “Understand the fact that regardless how you got there, there is a strategic price of enormous consequence for failure in Iraq.” In his postmilitary life, he worked on energy at the U.S. Chamber of Commerce. On paper, General Jones sure beats Bill Clinton’s NSC advisers (Anthony Lake and Sandy Berger) and perhaps President Bush’s.

Both these men can help Mr. Obama check the worst reflexes of his anti-antiterror base. Starting in Iraq. Having pacified al Qaeda and the Sunni insurgency, America now has a chance to midwife Iraq into a stable and free ally in the middle of a bad neighborhood. Local and national elections due next year will require U.S. support and counsel, and any rash drawdown in troops would be dangerous.

Mr. Obama will have political running room. Americans are now preoccupied with the economy. His own pledge to remove most combat troops by 2010 leaves open exactly what he means by “combat” and “most.” The new status-of-forces agreement with Iraqi also commits the U.S. to leave by 2011. These decisions can now be made with a view to the realities in Iraq rather than to the American campaign trail.

There’s talk that Mr. Gates will serve a year, then hand over the reins to an Obama loyalist, but the U.S. needs more than a caretaker in that job. Mr. Gates is a savvy enough bureaucratic operator to fight his corner. Aside from Iraq, Mr. Gates has staked out positions — on missile defense in Eastern Europe, enlarging the military, and modernizing the U.S. nuclear arsenal — that are at odds with the Democratic establishment. He and his future boss agree that additional forces are needed for Afghanistan. Let’s hope that’s not a one-time policy accord.

Mr. Obama deserves credit for making flexibility a principle in assembling his Administration. As he said last year, “people should feel confident that we’ll be able to hit the ground running.” So far on security, not bad.

Thursday, November 27, 2008

Why fairly valued stock markets are an opportunity

By Martin Wolf

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Pinn illustration

We have bad news and good news. The bad news is that the world economy is teetering on the brink of what may well be the most damaging slowdown since the second world war. Policymakers around the world – particularly in the inordinately complacent surplus countries – do not begin to understand what this may mean. The good news is that, after an extended period of overvaluation, stock markets are, at last, attractively priced. This should have enticing implications for investors and even for audacious governments.

How does one measure fundamental value? The chart shows two such measures – “Q” and the “cyclically adjusted price earnings ratio” (Cape).

The first of these measures derives from the work of the late James Tobin, a Nobel laureate economist. Q is the ratio of the value of an individual stock (or of the stock market as a whole) to net assets, at replacement cost. Tobin initially proposed this ratio as a way of explaining investment. Andrew Smithers of London-based Smithers & Co, from whom I have obtained the data, realised that Q could be turned round, to value the stock market, instead: high Q then forecasts not so much an investment surge as a stock market fall, and vice versa. If the stock market values the net worth of a company at far more than it costs to re-create its assets, either assets should expand or the market valuation should fall. In practice, argues Mr Smithers, it is more likely that the market is wrong than the investment decisions of companies.

The second of these measures has been used, in particular, by Robert Shiller of Yale University. The denominator is a 10-year moving average of earnings, in real terms. The purpose of this adjustment is to eliminate the cyclical effects on earnings that make price/earnings ratios look low at cyclical peaks, when earnings exceed sustainable levels. At times of rapidly increasing leverage, such as the 2000s, cyclically unadjusted earnings are likely to prove particularly meaningless because they are intensely vulnerable to changes in economic conditions. Leverage, after all, works both ways.

These two indicators should, if properly measured, give much the same result. The chart, which measures Q and Cape, relative to their long-run averages for the US, shows that they do.

What, then, does it show? I would focus on five principal conclusions.

First, valuations show pronounced long-term cycles. They are not a “random walk”. But these cycles are so long that it is nigh on impossible for investors to bet successfully against them: they will run out of money before momentum-driven markets change their mind. This is why markets may be inefficient and yet private investors cannot easily make money betting against them.

Second, the market has seen three peaks since 1920: 1929, 1965 and, biggest of all, 1999 (on the Cape). Prolonged bear markets followed in all cases. Peaks were, in other words, bad times to “buy and hold” – the recommended strategy in the 1990s.

Third, the market has also seen two bear market troughs since 1920: 1932 and 1981. These were excellent times to buy stocks. It helps if purchasers are patient: the period from trough to subsequent peak was 33 years and 18 years, respectively.

Fourth, the US stock market has been in a bear market since 2000, with two downward legs, 2000-2002 and 2007 until now. In the first leg, corporate investment remained weak, as stock prices collapsed. In the second leg, the credit and housing bubbles – partly explained by the Federal Reserve’s response to that investment weakness – imploded. This story is normal: bear markets usually coincide with periods of recession (see chart).

Finally, today’s valuations are considerably below average for the first time since 1988, on the Cape, and 1991, on Q. This does not mean they could not fall far further and, in bad conditions, they are even likely to do so. But, unless one expects another Great Depression and world war, history suggests valuations should not remain below current levels for more than, say, 15 years or so. That may not sound very enticing. But it is a different story from what people like Prof Shiller and Mr Smithers argued back in 1999, when history suggested one might never see such valuations again. Rational people would buy now, not then. Rational people, alas, are rare. As Warren Buffett has argued, buy when “Mr Market” is scared, not when he is bold.

The average valuation of the US stock market corresponds to a real return of 6½-7 per cent, which implies an “equity risk premium” – a margin of return over risk-free government bonds – of about 4 percentage points. This has long seemed high. During the great bull market of the 1990s, some even argued that no such premium was justified. But if one has to ask why equity holders should be risk-averse, one need only look at history. For mortals (rather than immortal institutions), the risk of being caught in a bear market (that is, a period of below average valuations) for 15 years, as happened from 1973 to 1988, is scary. Anybody retiring today knows this.

Directly comparable data are unavailable for other markets. But data on ratios of stock market valuation to gross domestic product for the world, the European Union and the UK, since 1980, have a similar pattern to those of the US. Correlation across markets is so close that what applies to the US should apply to the rest. Japan is different, however. The valuation peak there was in 1990.

I draw four implications. The first is that investors with long time horizons (the relatively young, or institutions) are, for the first time in almost two decades, confronting attractive, although not sensationally attractive, market valuations. The second is that there are, nevertheless, formidable pressures for further falls in valuations, as leveraged players continue to be forced to offload assets at bargain prices. The third is that bottom-fishing investors may at last start to supply some of the equity capital that companies – particularly financial companies – need, once a floor on asset prices is at last set.

Finally, governments might sensibly act as stabilising speculators, as John Muellbauer of Oxford university and Michael Spence, the Nobel laureate from Stanford University, suggested in Tuesday’s Financial Times and on the Economists’ Forum, respectively. Governments have the deep pockets and the time horizon that is needed. They can offload what they buy when markets have recovered. To the extent that the collapse of markets is self-feeding, such actions should also stabilise the economy. Given the unprecedented actions taken in recent months, this no longer seems a policy step too far.

US stock market valuation

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