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January 30, 2015

How much should the Chief Executive Officer of a company be paid?

Before we attempt to answer that question, let's see how much CEOs are paid. Back on 15 April 2014, Forbes reported on a "study" released by the AFL-CIO, once a significant labor organization in the United States, but now mostly a political fundraising operation for leftist causes:

With CEO compensation analysis season in full swing, the AFL-CIO released data this morning stating that American CEOs in 2013 earned an average of $11.7 million–an eye-popping 331 times the average worker’s $35,293.

Though down from 2012's 354-to-1 CEO-to-worker pay ratio, the multiple more than doubles when compared to minimum wage workers; the average CEO in 2013 out-earned this group 774 times over.

We put "study" in quotes because the sample for the AFL-CIO's "research" consisted of 350 of the largest companies in the U.S., out of a total of 27,092,908 firms, which means they cherry-picked the available data for the CEOs of the largest and most successful firms with the most revenue. Meanwhile, the U.S. Bureau of Labor Statistics collected the data for some 248,760 CEOS at companies of all sizes and levels of success, finding that the average pay of a CEO was $178,400.

But that's quite a range for average values, isn't it? Whether its the average of $178,400 for 248,760 companies or $11,700,000 for 350 of the biggest companies doing business in the U.S., there has to be some objective way to determine just how much a given company's CEO job is worth.

The question of how much a CEO is really worth to a company is one that you might think would be difficult to answer, but which under special conditions turns out to be a lot easier than you might think. And by "special conditions", we're referring to the unique situation that happens at some companies when they announce a surprise change in their top leadership, where they replace their CEO.

There was one such example earlier this week, when McDonalds CEO Don Thompson announced he was stepping down after two years of running the fast food giant. The company had struggled under his leadership, with the company's revenues stuck in neutral and its stock barely treading water, even as the rest of the S&P 500 had risen by 47% in the same economic environment.

So when the news was announced before the stock market opened on 29 January 2015, it was very interesting to see that the company's shareholders reacted to the news that Johnson had resigned as CEO and would be replaced by Steve Easterbook by boosting the company's stock price from a closing value of $88.78 per share on the day before to $91.50 per share at the opening bell.

McDonalds Stock Price: 27 January 2015 through 29 January 2015

That represents a gain of $2.72 per share, which when multiplied by the company's outstanding 973,200,000 shares, suggests that they collectively believe that getting the right man to turn the company's fortunes around to do the CEO job at McDonalds is worth about $2.647 billion dollars.

McDonalds Workers Demand Higher Pay - Source: Senator Bernie Sanders - http://www.sanders.senate.gov/newsroom/recent-business/starvation-wages-for-fast-food-workers

By contrast, Thompson's total compensation in 2013 was $9.5 million. If McDonald's new CEO is paid twice that figure and succeeds in growing McDonald's business, it can be reasonably argued that he's being underpaid for the value he brings to the company.

And that's the thing - it's up to the CEO to deliver that kind of value to the owners of business. A CEO who doesn't deliver is almost always overpaid.

By the way, the exact same logic applies for the lowest paid employee on the company's payroll too. If they cannot deliver value to the company in excess of what they cost the company in pay, benefits and administrative expenses, they're overpaid.

The difference is that the responsibility of delivering the kind of value demanded of a CEO by the company's owners is something that is far beyond the job responsibilities of much lower ranking employees. Which is why they're paid so much in the first place.

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January 28, 2015

Going into Wednesday, 28 January 2015, investors had believed that the Fed was likely to indicate that the U.S. economy was performing solidly enough that it would begin to implement its plan to hike short term interest rates before the end of 2015-Q2 in June 2015.

In fact, when the Federal Reserve's Open Market Committee released its statement following the end of their two day meeting, that was the first impression that investors had, as stock prices spiked upward just after the statement was released at 2:00 PM.

But then, they kept reading past the first several sentences and reset their expectations accordingly given what the Fed was really saying....

S&P 500 on 28 January 2015

What the Fed was really saying is that they still expect to start hiking short term interest rates in 2015, but they won't start by the end of 2015-Q2 as they had previously indicated. Given their concern for the substantial decrease in the growing rate of inflation, the Fed effectively directed investors to refocus their rate hike expectations toward a more distant point of time in the future.

Fed Shifts Investors Attention to More Distant Future on 28 January 2015

And that's why stock prices fell, because the expectations that coincide with the Fed's decision to continue to be patient mean that the future they expect for the U.S. economy is not as bright as it would be if they were to begin hiking interest rates sooner.

In effect, the Fed has moved the goalposts for investor expectations. And in doing so, has sent stock prices to follow a lower trajectory than they otherwise would have followed.

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In terms of affordability, 2014 became the worst year on record for the median price of new homes sold in the United States.

The chart below, showing the relationship between the trailing twelve month average of median new home sale prices and the trailing twelve month average of median household incomes reveals how new homes in the U.S. reached a record level of unaffordability for the typical American household.

U.S. Median New Home Sale Prices vs Median Household Income, 1999-Present (Monthly Data from December 2000 - December 2014)

In this chart, we're measuring the affordability of U.S. median new home sale prices against the trend that existed between these prices and median household income in the pre-housing bubble years from 1987 through 1999.

With that base for reference, we see that the previous record was reached in May 2006, when the trailing year average of median new home sale prices peaked at $242,658 in July 2006, which is 34% higher than the projected value of $181,000 that corresponds the same median household income of $46,700 if the stable trend that existed from 1987 through 1999 had held.

By contrast, the preliminary figures for December 2014 indicate that the median price of new homes in the U.S. exceeded that ratio, setting a new record. In December 2014, the trailing year average of median new home prices was $282,300, which is 37% above the figure of $206,000 that corresponds to the projection of the 1987-1999 trend at the same median household income level of $53,600.

To help put those figures in context, the chart below shows the major trends in the relationship between median new home sale prices and the median household income from 1967 through the present.

U.S. Median New Home Sale Prices vs Median Household Income, 1967-Present (Monthly Data from December 2000 - December 2014)

To put it bluntly, new homes have never been more out of reach for the typical American household for the 47 years for which we have both median new home sale price data and median household income data, given the typical level of affordability that existed in the nation's real estate markets before the U.S.' first housing bubble began to inflate in 2001.

References

Sentier Research. Household Income Trends: July 2014. [PDF Document]. Accessed 27 January 2015. [Note: We have converted all the older inflation-adjusted values presented in this source to be in terms of their original, nominal values (a.k.a. "current U.S. dollars") for use in our charts, which means that we have a true apples-to-apples basis for pairing this data with the median new home sale price data reported by the U.S. Census Bureau.]

U.S. Census Bureau. Median and Average Sales Prices of New Homes Sold in the United States. [Excel Spreadsheet]. Accessed 27 January 2015.


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January 27, 2015

From our perspective, the most important and useful part of the Efficient Markets Hypothesis (EMH) is its assumption that asset prices change quickly to reflect the impact of new information upon the future expectations of investors.

So what does the ability of investors to collectively and efficiently absorb and assess new information and to communicate the changes in their outlook through asset prices tell us about what the U.S. Federal Reserve is likely to do with respect to its plans to hike short term interest rates?

Well, if we go by how U.S. stock prices responded after the European Central Bank (ECB) announced its Quantitative Easing (QE) program on 22 January 2015, the immediate assessment of U.S. investors was that the Fed will most likely implement its rate hike plans sooner rather than later. We can see that shift in the sudden change in the trajectory of the S&P 500, where it has gone from following the trajectory associated with an investor focus on 2015-Q4, which is consistent with what had been the growing consensus that the Fed would delay its rate hikes until then, to the nearer-term future associated with a forward-looking focus on 2015-Q2, which investors would now appear to consider to be more likely.

Shift in S&P 500 Stock Prices from 2015-Q4 Trajectory to 2015-Q2 Trajectory on 22 January 2015 following ECB Announcement of QE

That assessment will most likely be confirmed after the Federal Reserve's Open Market Committee concludes a two-day meeting on Wednesday, 28 January 2015 and issues a new policy statement. The Wall Street Journal explains why investor expectations would change in response to the ECB's decision in its schedule of economic news events for the week.

U.S.: 2:00 p.m. EST. Federal Open Market Committee’s monetary policy announcement:

After the ECB’s bombshell news of last week, all eyes now turn to the Fed. If it signals its continued intent to raise rates in the months ahead, this will likely drive even more fund flows into the dollar. How the Fed views that ECB move will be key. If it interprets it as an effective move to restore growth in the eurozone, it will see it as constructive to U.S. growth and likely want to stay the course and move toward higher rates sometime in the last spring or summer. If it instead focuses on the surge in the dollar that has come from the ECB move, it could be inclined toward holding back because of the disinflationary effect of that.

We already know that the Fed pays very close attention to the stock market in weighing their future actions, which we observed previously during their own QE programs. The reaction of the U.S. stock market to the ECB's action to initiate a QE program for the EU is such that the Fed is likely to hike short term interest rates in the US above their current 0-0.25% range by the end of 2015-Q2.

And that will hold until newer information might force the Fed to adapt its plans.

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January 26, 2015
The Science of NFL Football - Source: National Science Foundation http://www.nsf.gov/news/special_reports/football/

Can physics explain what's wrong with Tom Brady's balls?

We're going to find out. Picking up on the speculation offered by a Boston sportswriter, who argued that weather alone was responsible for half of the underpressurization found in 11 of the 12 balls that the New England Patriots' offense brought with them to the 2015 AFC Championship game, we thought we'd check their math.

It's a good thing that we did, because they botched it. Badly.

We know that because of the physics that applies here, the combined gas law, which defines the relationship that exists between the internal pressure, volume and temperature of an enclosed vessel like a football will be a constant. That means that we can nearly perfectly predict how much the internal pressure, or inflation, of a football might change when the temperature of the ball changes from one point in time to another, using the following formula:

Combined Gas Law - Source: Wikipedia http://en.wikipedia.org/wiki/Combined_gas_law

We're going to do that math using the information we know about the situation. We'll assume that the footballs were inflated at a temperature of 68 degrees Fahrenheit, which is consistent with the interior thermostat setting recommended by the U.S. Department of Energy for optimal personal comfort and low energy consumption in the winter, the gametime temperature of 51 degrees Fahrenheit, the minimum acceptable inflated pressure specified by the NFL's rules of 12.5 pounds per square inch, and the approximate internal volume of the football of 258.5 cubic inches, which we'll assume is unchanged from the time when the footballs were filled and checked to when they were discovered to have deflated by roughly 2.0 pounds per square inch.

Enough talk - let's do some math using the tool we built just for that purpose!

Update 30 January 2015: We've added the standard sea level atmospheric pressure to the NFL's pressure gauge readings in the tool below, as per the New York Times' article proclaiming that the weather was responsible for the deflation of Tom Brady's balls. Judge for yourself just how well that explains the situation.

Football Inflation Data Before the Game
Input Data Values
Initial Measured Internal Pressure [psi]
Initial Volume [cubic inches]
Initial Temperature [degrees Fahrenheit]
Football Inflation Data at Halftime
Internal Pressure at Halftime [psi]
Volume at Halftime [cubic inches]
Temperature at Halftime [degrees Fahrenheit]

How Much of Football Deflation Is Explained by Weather?
Calculated Results Values
Expected Internal Pressure of Footballs at Halftime
Actual Internal Pressure of Footballs at Halftime
Percentage of Change in Pressure Explained by Change in Temperature
If you're reading this article on a site that republishes our RSS news feed, click here to access a working version of this tool!

So we find that, at best, the change in temperature in going from a room inside the stadium where the internal pressures of the footballs the New England Patriots brought to the game were inspected to on the field during the game can only, at best, explain 20% of the change in pressure that was measured.

We were curious to find out what of temperature would have to be held in order to produce the observed amount of deflation, and used trial and error in our tool above to find that Tom Brady's balls would have had to have been inflated and inspected at a temperature of 148.4 degrees Fahrenheit to account for a decrease in internal pressure from 12.5 psi to 10.5 psi.

That, of course, assumes that the volume of the bladder inside the football didn't change size. Going back to our initial temperature range, using trial and error in our tool once again, we found that it would have to expand to 297.85 cubic inches, or 115% of its initial volume, to account for the observed change in pressure.

That is something that might perhaps seem plausible, but a reality check indicates that would involve the footballs growing to be larger than the maximum dimensional specifications mandated by the NFL. It would have been incredibly easy for even the NFL's officials to determine that something was greatly amiss with the Patriots' footballs if that were the case.

Instead, the physics involved are such that it is clear that Tom Brady's balls achieved their deflated state through other means.

And if nothing else, we have perhaps demonstrated that one cannot trust either the scientific or mathematical claims made by a hack sportswriter from Boston.


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January 23, 2015

There are more Boeing 737s flying in the skies of Earth today than any other model of commercial air transport. Back in 2000, to keep up with demand, the company began producing 737s at the then record rate of 1 per day, or rather, 30 per month. Ten years later, the company was producing 737's at a rate of 31.5 per month.

At that point in 2010, the company's orders were finally strong enough to justify speeding things up. By 2014, the company was producing 737s at a rate of 42 per month and now has plans to increase its production rate further with the goal of delivering 47 per month in 2017 and possibly as many as 52 per month in 2018.

The YouTube video below reveals some insights into how Boeing's mechanics do it.

To get an idea of how much the video has been speeded up, the assembly line shown after the wings are attached to the fuselage, where 737s are "flying" down the factory floor in single file, moves forward at a continuous rate of two inches per minute.

Altogether, the production of a Boeing 737 represents anywhere from 367,000 to 600,000 individual parts (depending on the exact model) that are assembled to fly together in close formation.

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