22 August 2017

Ethics, Audits, and Business Behaviour

So here we are again, with another corporate scandal. Who is it this week, Wells Fargo, Odebrecht, Uber, United, or someone else? The list of corporate scandals for even the past couple of years is daunting (and here, and here). Looking at the political landscape, we see the same thing, not just in the United States, but across the world. Another "breach of trust". Who would like to be dragged off the airplane today, or who would like to discover that your bank has been opening accounts in your name, that you get to pay for, without your permission?  How about that nice new bridge contract; the one that the contractor won off the back of brown envelopes, lots of envelopes?

Yet this is the reality of business today. In too many cases, the subsequent fine is significantly less than the profits from the (not proven to be criminal) activities that resulted in the scandal. Only in a few cases does the scandal result in an existential crisis for the company. Usually it only reduces management bonuses, and effectively robs the shareholders (and too frequently the customers) through destruction of share price.

Unfortunately too common following these crisis is the call for greater ethical standards. Sometimes, as happened this week with the Wells Fargo scandal, there will be calls for the audit to be improved, or the auditor sanctioned. Why unfortunately? Because such calls are meaningless.

Francine Mckenna and Andrea Riquier have written (another) strong article effectively asking "Where was KPMG, Wells Fargo’s auditor, while the funny business was going on?".  Not surprisingly, the Audit and Governance community react by pointing out that the auditor is not actually required to find or disclose non-material fraud. Nor are the auditors required to report where ethics are absent.

Pages are written about the PCAOB Auditing Standards, and the role of the Auditor. Almost all of it in defense of the audit profession. But Francine and Andrea quote Andy Green

“There’s been far too little attention since the crisis on how the external auditors should be looking out for the public,” Andy Green, managing director of economic policy for the Center for American Progress, told MarketWatch. They are not just bookkeepers, but the investors’, and the capital markets’ last defense against accounting manipulation and fraud.”

While extensively quoting the article, Norman Marks asks "Wells Fargo and KPMG – did KPMG fail the investors?" Actually, yes, they did. In fact, while Norman's list of things that Francine and Andrea "omitted from the article" are all correct, none of those change the fact that KPMG did fail the investors. They complied with the standards; they failed the ethical question.

Francine has a long history of taking the Audit profession to task, and while not agreeing with everything she has written, she is quite right far more times than not. The problem of course is that we do not want Auditors to tell the truth, or to opine on the ethical foundation of businesses or the individuals running those businesses.

On the one hand, they (the auditor) probably would not be able to, as they have spent so many decades as apologists for their clients. On the other hand, they would probably find that there were too few businesses or leaders that would pass a reasonable-man ethics course (based on their choices, not based on their ability to pass a test or give the "correct" answers).

Many years ago someone said to me that we didn't need more rules, we just needed better enunciated Ethical standards. I will repeat my answer:

"Ethics only apply to Ethical People".

All the ethical standards in the world will not make ethical people, especially when reward systems do not support ethical behavior. You can have all the ethical standards that you want, but fundamentally, unethical people will ignore then, and worse, will ensure that they pay for the appropriate PR to demonstrate just how ethical they and their businesses are.

I'm talking of course about people skilled in the art of managing the message. Not the bungling mouth pieces of today, who refuse to answer any question but use the time to rehearse some well scripted talking point.  I'm talking about Clive, from Telecom New Zealand (in the 1990s, so no relation to anyone there today, I'm sure).

Clive once said the secret to corporate communications was simple; "Bad news is good news, good news is no news".

While that works for managing the message, it does not demonstrate ethical behavior or even an ethical outlook, although there were a few cases where Clive most definitely was putting the positive face on what were apparently unpleasant situations.

Yet there is no way you can spin fraudulent accounts and accounting as good news. And there is no way that you can spin auditor ignorance or ignoring of fraudulent accounts as good news. There is no way that sexual harassment at the top of organizations can be spun to be good news. It is not even good news when these people are exposed, as it argues for a deeper pool of unexposed persons, all carrying on the behaviors that they have learned from their seniors (and betters?).

No, "Ethics only apply to Ethical People". For the rest there is something called "Jail time". We should stop trying to spin good news, or even trying to simply extract fines from companies. People did these things, and people should be held accountable.

If we want real Ethical behavior, then the cost of unethical behavior needs to be much higher.

That goes for Auditors as well.

18 August 2017

Contra-Contrarian; is the US Doomed, or about to Boom

1 Are the Contrarians Right and Wrong?

Is the United States demographically positioned for years of economic growth? I am, perhaps naturally, a contrarian, in many things, and certainly at the moment, with markets seeming to defy gravity. Yet what if I, and most contrarians, are wrong, and the (US) markets actually have years of continued growth ahead of them? Is this possible? Is if different this time, and if so, why is it different. Or are historic indicators that signal doom strong enough to overcome the current "sweet spot" that enables sustained growth?

1.1 Is a crash due?

There are too many indicators that suggest a crash is due, ranging from record or near record EPS (earnings per share) levels, increasing consumer financial leverage, expanding sub-prime auto loans coupled with ever longer loan periods on vehicles, to inconsistent messages from the FED, the US debt and deficits, concern at the ability of the Trump administration to achieve any meaningful tax or economic program, to global debt levels and the real threat of a trade war with China, Russia and possibly Europe. There are simply so many potential triggers that could push investor confidence over the edge, and "buy the dip" has not, this recent post-election cycle, been adequately tested against a real dip of 5% or more.

1.2 Is Unemployment as low as official figures?

Counter balance the signs of potential doom with another terrible number, so terrible that it actually might be the number that enables multi-year sustained economic growth in the United States: Real Unemployment. Not the number produced by the BLS (Bureau of Labor Statistics), which is based not on the number of people not working, but on the number of people collecting an unemployment benefit. That number is now in the high 4% range, a historically low number, and a number that fills economists with fear of wage and then wider inflation.

But if the Shadow Stats (http://www.shadowstats.com/) number is correct, then over 22% unemployment is the correct number of the United States today. This is based on the Shadow Stats use of historic methodologies for the determination of unemployment (and inflation, etc). Over the decades, the US Government's methodology for calculation these key metrics has changed. Shadow Stats continues to use the earlier methodology, on the assumption that while much has changed, the primary methodologies for calculating unemployment, for example, remain the same.

This is in part bolstered by the labor participation rate, which remains at historically low level, even with a recent up-tick in participation. Current labor force participation rate is around 62%, the same level as 1978. The gap between the highest participation rate of 67% in 2007 and the current participation rate amount to approximately 6.4 million potential workers.

The BLS tells us that the current Civilian Labor Workforce is 160 million. This means that the 4% drop equates to roughly 6.4 million potential workers who are not in the workforce. If 4% unemployment is this historical “full employment” number, then we are at or close to full employment, meaning there is an additional 4% of the workforce that is untapped. Shadow Stats estimates the number of additional discouraged worker who want a job to be around 4.75 million (as at June 2016).

2 Demographic "sweet spot"

So the US has seen a dramatic fall in the labor participation, and an explosion of unemployment to the 20% level, resulting in a huge pool of unemployed working age individuals. While the "dependency ratio" has not improved, at least one element of the demographic sweet spot is definitely in place.

So what is the demographic sweet spot, and how can a nation experience this twice?

As counties have matured over the past century, a trend has been seen that is now known as the demographic sweet spot. Effectively this is the period of time between the fall in birth-rates and the exhaustion of the available surplus working age population. That surplus available working age population is created through a higher dependency ratio (the number of working age individual for every dependent - child or elderly). As infant mortality rates fall, younger, and then working age, populations surge. At the same time, longevity improvements take some time to filter through, so the number of elderly dependents remains low.

The dependency ratio is important because the greater the number of working age individuals to retired or young, the greater the available pool of labor. The US currently has a low dependency ratio, which argues against there being a pool of available labor, yet we know from participation rates, unemployment rates, and the growth in the over-65 workforce, that the dependency ratio in the US is not acting as a drag on potential productivity increase.

This sweet spot increases the available human capital, and fuels economic growth through the increased productive capacity of the country.

Might the United States be in (again) that sweet spot, with a very large pool of available labor, ready to join (or re-join) the workforce once jobs are available?

3 If Shadow Stats is mostly right

Basically it comes down to the question; is Shadow Stats right on the unemployment rate, coupled with the labor market participation rate. If they are, then there is a massive pool of untapped labor available to industry. Bringing that labor into the workforce will require new jobs, and wage inflation.

Yet wage inflation is completely normal in developing countries that are going through their sustained growth periods when they reach the demographic sweet spot. The available workforce increases, jobs come in to absorb the available labor, skill improve, wages increase as the available labor at previous rates is soaked up, new jobs are created, etc.

4 If Shadow Stats is very wrong.

Yet is Shadow Stats is wrong, and the unemployment rates are actually lower, and that low labor market participation rates are low because of a systemic shift in workforce expectations and available jobs at any economic rate, then we are Doomed, Doomed. Well, maybe not doomed, but we cannot expect to see a demographically based sustained growth period.

If we are not in for such growth, then we should expect one of the factors mentioned in the opening paragraphs to be the trigger for a market collapse. If that does happen, all bets are off, and it will not be different this time.