Thursday, December 25, 2014

A Christmas Wish

Nearly 2,000 years ago a young religious scholar, the son of a carpenter, chose to stand apart from the established religious leaders of the day. Building upon a heritage of moral virtues, he emphasized love for all, including thy enemies, as well as hope and compassion.

On this day, December 25, 2014, we are honored to celebrate his birth. In so doing, let us share with each other his message - that good will prevail over evil, that peace can and will be accomplished, and that love will conquer all.

Let us also remember his teaching - that understanding and goodwill to all leads to treasures more lasting than any accumulation of gold or silver.

May peace, love and kindness find you on this special day. Merry Christmas.

Friday, December 12, 2014

The CIA's Acts - Torture? Justified?

Torture is alleged to be undertaken by the CIA (under authorization, at least to an extent, from someone in the Bush Administration). While many issues exist, which deserve close examination in the days, weeks, months and years ahead, two issues have found their way into the discussion of the CIA’s acts:

First, was it torture?

Second, if it was torture, was it not justified? In other words, do the ends justify the means?

In this blog post I provide an examination of some of the legal authority, as well as a very brief review of ethical theories, with the hope of informing your understanding of these complex issues.

What Were the Acts Which the CIA Undertook?

While we only have the U.S. Senate Intelligence Report to rely upon, there appears to be little dispute that the acts that are described as torture actually took place, at least for some prisoners. The Report states in part:

#3: The interrogations of CIA detainees were brutal and far worse than the CIA represented to policymakers and others. Beginning with the CIA's first detainee, Abu Zubaydah, and continuing with numerous others, the CIA applied its enhanced interrogation techniques with significant repetition for days or weeks at a time. Interrogation techniques such as slaps and "wallings" (slamming detainees against a wall) were used in combination, frequently concurrent with sleep deprivation and nudity … The waterboarding technique was physically harmful, inducing convulsions and vomiting … Sleep deprivation involved keeping detainees awake for up to 180 hours, usually standing or in stress positions, at times with their hands shackled above their heads. At least five detainees experienced disturbing hallucinations during prolonged sleep deprivation and, in at least two of those cases, the CIA nonetheless continued the sleep deprivation.”

Were These Acts “Torture”?

There are several international treaties that prohibit the use of torture. An early treaty of applicability is Common Article 3 of the Geneva Conventions, to which the United States is a signatory, which states in pertinent part:

      ARTICLE 3
      In the case of armed conflict not of an international character occurring in the territory of one of the High Contracting Parties, each Party to the conflict shall be bound to apply, as a minimum, the following provisions:
      (1) Persons taking no active part in the hostilities, including members of armed forces who have laid down their arms and those placed ' hors de combat ' by sickness, wounds, detention, or any other cause, shall in all circumstances be treated humanely, without any adverse distinction founded on race, colour, religion or faith, sex, birth or wealth, or any other similar criteria.
      To this end, the following acts are and shall remain prohibited at any time and in any place whatsoever with respect to the above-mentioned persons:
(a) violence to life and person, in particular murder of all kinds, mutilation, cruel treatment and torture;
                  (b) taking of hostages;
(c) outrages upon personal dignity, in particular humiliating and degrading treatment;

(d) the passing of sentences and the carrying out of executions without previous judgment pronounced by a regularly constituted court, affording all the judicial guarantees which are recognized as indispensable by civilized peoples.

A more recent treaty is the U.N.'s Convention on Torture. In the United States’ report (Oct. 15, 1999) regarding the United Nations’ Convention against Torture and Other Cruel, Inhuman or Degrading Treatment or Punishment, which was ratified by the United States in 1994 (subject to certain reservations and interpretations), the U.S. Department of State wrote:

Torture is prohibited by law throughout the United States. It is categorically denounced as a matter of policy and as a tool of state authority. Every act constituting torture under the Convention constitutes a criminal offence under the law of the United States. No official of the Government, federal, state or local, civilian or military, is authorized to commit or to instruct anyone else to commit torture. Nor may any official condone or tolerate torture in any form … The United States is committed to the full and effective implementation of its obligations under the Convention throughout its territory.

The United States conditioned its ratification upon the following reservation:

[T]he United States considers itself bound by the obligation under Article 16 to prevent “cruel, inhuman or degrading treatment or punishment”, only insofar as the term “cruel, inhuman or degrading treatment or punishment” means the cruel, unusual and inhumane treatment or punishment prohibited by the Fifth, Eighth and/or Fourteenth Amendments to the Constitution of the United States.

The U.S. Senate, in approving the Convention Against Torture, in its advice and consent also indicated that its approval was subject to particular understandings concerning “mental torture,” a term that is not specifically defined by the Convention. The U.S. Senate stated: "The United States understands mental torture to refer to prolonged mental harm caused or resulting from: (1) the intentional infliction or threatened infliction of severe physical pain and suffering; (2) the administration of mind-altering substances or procedures to disrupt the victim’s senses; (3) the threat of imminent death; or (4) the threat of imminent death, severe physical suffering, or application of mind-altering substances to another."

In 1994, Congress enacted a federal law to implement the requirements of the Convention against Torture relating to acts of torture committed outside United States territory. The statute adopts the Convention’s definition of torture, consistent with the terms of United States ratification.  Torture is therefore defined in U.S. statutory law (18 U.S. Code §2340): “[A]n act committed by a person acting under the color of law specifically intended to inflict severe physical or mental pain or suffering (other than pain or suffering incidental to lawful sanctions) upon another person within his custody or physical control.”

Of note, a 2009 study of the Guantanamo detainees stated: “[t]wo-thirds of the former detainees [interviewed] report residual psychological and emotional trauma.” Laurel E. Fletcher & Eric Stover, The Guantanamo Effect: Exposing The Consequences Of U.S. Detention And Interrogation Practices (2009). 

Can we conclude that the actions described in the U.S. Senate Intelligence Committee’s report, such as waterboarding, sleep deprivation, and “walling,” constitute “torture”? To this I would also ask, “How could rationale men and women conclude otherwise?”

But, Even if the Acts Were Torture, Was the Torture Justified?

According to the U.S. Senate Intelligence Committee Report, “These techniques were approved because Bush Administration lawyers and officials were told, and believed, that these coercive interrogations were absolutely necessary to elicit intelligence that was unavailable by any other collection method and would save American lives.” [Emphasis added.] To put it more simply, it is argued that torture was justified if it was necessary to save lives. In essence, the ends justified the means.

The key is the word “necessary.” As a society we accept that one might harm another in very limited circumstances. The "doctrine of necessity" applies when an illegal or harmful behavior may be used to prevent or correct a greater harm. It provides a legal justification for the necessary action, allowing people to avoid or reduce liability.

For example, one might act in self-defense, where no reasonable avenue exists to evade and flee, to save one’s own life from an assailant. But, can we extend this “doctrine of necessity” or “doctrine of self-preservation” to justify torture?

There exist ethical theories under which the "doctrine of necessity" can be examined.

Contrasting Utilitarianism with Natural Rights Theory

Under the ethical theory of utilitarism, the consequentialist theory of torture states that torture may be acceptable or even mandated if society receives a net benefit that outweighs the harm of torture. Under this theory we must consider not just the harm experienced by the individual victim but also by society in general. The “greatest good” then prevails. Hence, for those who follow this ethical view, the “doctrine of necessity” could exist.

But, under natural rights theory – an ethical theory that all men and women possess certain natural rights that cannot be violated without their consent – a near-absolute ban on torture exists. Under this theory, no conduct, no matter how deplorable, will permit torture. This view generally follows Kantian philosophy. Accordingly, under natural rights theory the “doctrine of necessity” cannot be used to justify torture, as each individual’s rights inviolable even in extreme circumstances.

View of the U.S. State Department: Torture Cannot Be Justified, Even Under "Exceptional Circumstances"

In the U.S. State Department 1999 Report on the Convention on Torture, the State Department wrote:

No exceptional circumstances may be invoked as a justification of torture. United States law contains no provision permitting otherwise prohibited acts of torture or other cruel, inhuman or degrading treatment or punishment to be employed on grounds of exigent circumstances (for example, during a “state of public emergency”) or on orders from a superior officer or public authority, and the protective mechanisms of an independent judiciary are not subject to suspension.

By implication, therefore, the U.S. State Department appeared to have previously negated the applicability of the doctrine of necessity as justification for torture.

Examining the “Doctrine of Necessity” via a Shipwreck, Lifeboat, Murder and Cannibalism

An early legal precedent from England examines the "doctrine of necessity."

An 1884 English case examined the “doctrine of necessity” in the context of a shipwreck in which several survivors found themselves in a lifeboat, in desperate straights. Two sailors, adrift in a lifeboat at sea for several weeks, and without food or water for eight straight days, “were subject to terrible temptation, to sufferings which might break down the bodily power of the strongest man, and try the conscience of the best … [the two sailors] put to death a weak and unoffending boy upon the chance of preserving their own lives by feeding upon his flesh and blood after he was killed, and with the certainty of depriving him, of any possible chance of survival.”

Chief Justice Lord Coleridge, delivering the opinion of the Court, stated: “Now it is admitted that the deliberate killing of this unoffending and unresisting boy was clearly murder, unless the killing can be justified by some well-recognised excuse admitted by the law … the temptation to the act which existed here was not what the law has ever called necessity. Nor is this to be regretted. Though law and morality are not the same, and many things may be immoral which are not necessarily illegal, yet the absolute divorce of law from morality would be of fatal consequence; and such divorce would follow if the temptation to murder in this case were to be held by law an absolute defence of it. It is not so. To preserve one's life is generally speaking a duty, but it may be the plainest and the highest duty to sacrifice it. War is full of instances in which it is a man's duty not to live, but to die. The duty, in case of shipwreck, of a captain to his crew, of the crew to the passengers, of soldiers to women and children, as in the noble case of the Birkenhead; these duties impose on men the moral necessity, not of the preservation, but of the sacrifice of their lives for others from which in no country, least of all, it is to be hoped, in England, will men ever shrink, as indeed, they have not shrunk. It is not correct, therefore, to say that there is any absolute or unqualified necessity to preserve one's life … It is not needful to point out the awful danger of admitting the principle which has been contended for. Who is to be the judge of this sort of necessity? By what measure is the comparative value of lives to be measured? Is it to be strength, or intellect, or 'what? It is plain that the principle leaves to him who is to profit by it to determine the necessity which will justify him in deliberately taking another's life to save his own. In this case the weakest, the youngest, the most unresisting, was chosen. Was it more necessary to kill him than one of the grown men? The answer must be ‘No’ … it is quite plain that such a principle once admitted might be made the legal cloak for unbridled passion and atrocious crime.” [Emphasis added.] The Queen v. Dudley and Stephens (December 9, 1884).

In Conclusion

This brief post is not intended as a full examination of the ethical theories and legal precedents as to whether torture, in the face of terrorism, can be justified. Rather, the theories and legal authority set forth above are offered merely to assist others in framing a few aspects of the debate.

You might like to believe that the natural rights theory, seemingly applied in the Dudley & Stevens case, would be adopted by you. You might believe that you would respect the inalienable human rights men and women possess and that you would not engage in torture.

But are you so certain?

Suppose a terrorist was caught. The terrorist has planted a bomb in your city, which will destroy your city and everyone in it. There is not enough time to evacuate the entire town – perhaps only a third could escape the blast in the few hours remaining.

Thousands and thousands (if not hundreds of thousands) of your fellow citizens will likely lose their lives to the massive bomb that is ticking, should it explode. Your spouse, and your children (or grandchildren) are among those likely to lose their lives. As well as your brother, sister, nieces and nephews.

You are in charge of the interrogation of the terrorist, who has refused to answer your questions thus far. Three hours remain. What would you do?

Monday, December 8, 2014

U.S. Equities: Valuations Per P/B Ratios

I've grown increasingly concerned about stock market valuation levels.

There are many ways to determine valuations of individual stocks, and then by extrapolation the valuation levels of asset classes or the overall U.S. stock market. Some measures, however, such as P/E ratios, are highly volatile and can at times yield valuation measures which are even, at times, nonsensical. CAPE is, in my view, a better way of determining price on the basis of earnings, given that earnings are smoothed over a decade, although as many have written various adjustments may (or may not) need to be undertaken for CAPE.

Other measures of valuation tend to incorporate yields on U.S. Treasury bills, notes or bonds. While there is much intellectual underpinning to this approach, if you are a short-term investor, I am suspect of the introduction of bond yields into equity valuation models for purposes of a very long-term (15 year or more) investor. Over any 15-year period yields can tremendously vary.

For over a decade I've primarily relied upon price-book ratios to provide me a sense of how overvalued, or undervalued, the U.S. stock market may be. Why? First, for the Russell 1000 and 2000 indexes (growth, balanced and value) I've been able to reconstruct an estimate of the average p/b ratio, going back to 1977. This gives us 34 years of data to come up with an average. Second, p/b ratios for Russell indexes are provided monthly, giving us fairly up-to-date measures. Third, book values don't fluctuate wildly over the short term.

Of course, there are downsides to the utilization of price-book ratios. Since 1977 the U.S. economy has moved substantially away from capitalization-intensive industries and toward service industries. As part of this evolution, new industries have substantially grown, such as computer software, which are not very capital intensive. And many companies have outsourced their manufacturing to companies in China, the Phillippines, Indonesia, or other countries, thereby lowering the book equity. Hence, one can argue that the "mean" for price-book ratios should be higher than the "1977-2013 Estimated Average P/B Ratio" shown below.

Current (12/7/2014) valuations of U.S. stock asset classes are as follows, based
upon price-book measures of these asset class relative to 1977-2013 norms,
with further adjustments reflecting 11/1/2014-12/5/14 returns:
10.31.14 P/B Ratio
P/B Ratio after 11/1-12/5/14 returns adjustment
Est. Avg. P/B Ratio
Percent Overvaluation / (Undervaluation)
Relative to Estimated Average P/B Ratios
Resulting Adjustment to Asset Class Historical Rate of Return
U.S. Large Cap Growth
U.S. Large Cap Balanced
U.S. Large Cap Value
U.S. Small Cap Growth
U.S. Small Cap Balanced
U.S. Small Cap Value

Source: Data based upon Russell Indexes for U.S. stock asset classes, and Vanguard funds monthly/MTD data, as accumulated and analyzed by ScholarFi Inc. All measures of overvaluation/undervaluation are estimates, only. An adjustment is then made to available month-end data, derived from Russell Index data site, for changes in prices over subsequent period to date shown. PAST PERFORMANCE IS NOT A GUARANTEE OF FUTURE RETURNS. For educational purposes only. No warranties are provided as to the accuracy of the data provided.

The last column in the chart above reflects an adjustment to estimated average rates of return for the asset class, should reversion to the mean occur over a 15-year period.
Just because the stock market is "overvalued" does not mean that valuations cannot go much higher. In fact, following are the "low" and "high" markets of the valuations for the foregoing asset classes during the 1977-2013 era (with 12/6/2014 "current" estimated valuations shown again, for comparison purposes):
Lowest P/B Ratio (Month/Year)
Current Estimated
P/B Ratio (12/5/2014)
Highest P/B. Ratio (Month/Year
U.S. Large Cap Growth
2.06 (12/1978)
11.00 (12/1999)
U.S. Large Cap Balanced
1.23 (12/1978)
5.21 (12/1999)
U.S. Large Cap Value
0.87 (12/1978)
3.31 (12/2000)
U.S. Small Cap Growth
1.73 (12/1978)
5.77 (12/1999)
U.S. Small Cap Balanced
0.99 (12/1978)
2.72 (12/1999)
U.S. Small Cap Value
0.69 (12/1979)
2.11 (12/1997)
Source: Data based upon Russell Indexes for U.S. stock asset classes, as accumulated and analyzed by ScholarFi Inc. All measures of overvaluation/undervaluation are estimates, only. An adjustment is then made to available month-end data, derived from Russell Index data site, for changes in prices over subsequent period to date shown, using Vanguard funds data. PAST PERFORMANCE IS NOT A GUARANTEE OF FUTURE RETURNS. For educational purposes only. No warranties are provided as to the accuracy of the data provided.

Where does all of the foregoing leave us? Permit me to share a few of my own conclusions:
First, I believe that the U.S. stock market has likely reached a point of overvaluation, relative to historic norms. Perhaps in the range of 0% to 40% overvalued. (The data, for the reasons stated above, does not permit in my view a closer approximation of values.)
Second, if you tilt your U.S. equity allocation in your portfolios toward value and small-cap stocks (on a diversified basis), it does not appear that value and small-cap stocks are as significantly overvalued as large-cap growth stocks might be. Hence, some comfort should be taken that the value and small cap risk premia are likely to deliver, with a high degree of probability (but not certainty), higher returns in the U.S. equity portion of a portfolio over the long term (15 years or longer).
Third, I don't believe that valuation levels have reached such stellar heights that investors should flee the U.S. stock market, nor any particular asset class. (I'm not convinced that "market timing" in the form of "tactical asset allocation" can consistently add value, over and above a consistent exposure to the value and small cap risk premia.)
What do you think?