Photo Credit: Steve Rotman || Markets are not magic; government economic stimulus is useless with debt so high

Weird begets weird

I said in an earlier piece on this topic:

I use [the phrase] during periods in the markets where normal relationships seem to hold no longer. It is usually a sign that something greater is happening that is ill-understood.  In the financial crisis, what was not understood was that multiple areas of the financial economy were simultaneously overleveraged.

So what’s weird now?

  • Most major government running deficits, and racking up huge debts, adding to overall liability promises from entitlements.
  • Most central banks creating credit in a closed loop that benefits the governments, but few others directly.
  • Banks mostly in decent shape, but nonfinancial corporations borrowing too much.
  • Students and middle-to-lower classes borrowing too much (autos, credit cards)
  • Interest rates and goods and services price inflation stay low in the face of this.
  • Low volatility (until now)
  • Much speculative activity in cryptocurrencies (large percentage on a low base) and risk assets like stocks (smaller percentage on a big base)
  • Low credit spreads

No one should be surprised by the current market action.  It wasn’t an “if,” but a “when.”  I’m not saying that this is going to spiral out of control, but everyone should understand that The Little Market that Could was a weird situation.  Markets are not supposed to go up so steadily, which means something weird was fueling the move.

Lack of volatility gives way to a surfeit of volatility eventually.  It’s like macroeconomic volatility “calmed” by loose monetary and fiscal policy.  It allows people to take too many bad chances, bid up assets, build up leverage, and then “BAM!” — possibility of debt deflation because there is not enough cash flow to service the incurred debts.

Now, we’re not back in 2007-9.  This is different, and likely to be more mild.  The banks are in decent shape.  The dominoes are NOT set up for a major disaster.  Risky asset prices are too high, yes.  There is significant speculation in areas Where Money Goes to Die.  So long as the banking/debt complex is not threatened, the worst you get is something like the deflation of the dot-com bubble, and at present, I don’t see what it threatened by that aside from cryptocurrencies and the short volatility trade.  Growth stocks may get whacked — they certainly deserve it from a valuation standpoint, but that would merely be a normal bear market, not a cousin of the Great Depression, like 2007-9.

Could this be “the pause that refreshes?”  Yes, after enough pain is delivered to the weak hands that have been chasing the market in search of easy profits quickly.  The lure of free money brings out the worst in many.

You have to wonder when margin debt is high — short-term investors chasing the market, and Warren Buffett, Seth Klarman, and other valuation-sensitive investors with long horizons sitting on piles of cash.  That’s the grand asset-liability mismatch.  Long-term investors sitting on cash, and short-term investors fully invested if not leveraged… a recipe for trouble.  Have you considered these concepts:

  • Preservation of capital
  • Dry powder
  • Not finding opportunities
  • Momentum gives way to negative arbitrages.
  • Greater fool theory — “hey, who has slack capital to buy what I own if I need liquidity?”

Going back to where money goes to die, from the less mentioned portion on the short volatility trade:

Again, this is one where people are very used to selling every spike in volatility.  It has been a winning strategy so far.  Remember that when enough people do that, the system changes, and it means in a real crisis, volatility will go higher than ever before, and stay higher longer.  The markets abhor free riders, and disasters tend to occur in such a way that the most dumb money gets gored.

Again, when the big volatility spike hits, remember, I warned you.  Also, for those playing long on volatility and buying protection on credit default — this has been a long credit cycle, and may go longer.  Do you have enough wherewithal to survive a longer bull phase?

To all, I wish you well in investing.  Just remember that new asset classes that have never been through a “failure cycle” tend to produce the greatest amounts of panic when they finally fail.  And, all asset classes eventually go through failure.

So as volatility has spiked, perhaps the free money has proven to be the bait of a mousetrap.  Do you have the flexibility to buy in at better levels?  Should you even touch it if it is like a knockout option?

There are no free lunches.  Get used to that idea.  If a trade looks riskless, beware, the risk may only be building up, and not be nonexistent.

Thus when markets are “weird” and too bullish or bearish, look for the reasons that may be unduly sustaining the situation.  Where is debt building up?  Are there unusual derivative positions building up?  What sort of parties are chasing prices?  Who is resisting the trend?

And, when markets are falling hard, remember that they go down double-speed.  If it’s a lot faster than that, the market is more likely to bounce.  (That might be the case now.)  Slower, and it might keep going.  Fast moves tend to mean-revert, slow moves tend to persist.  Real bear markets have duration and humiliate, making weak holders conclude that will never touch stocks again.

And once they have sold, the panic will end, and growth will begin again when everyone is scared.

That’s the perversity of markets.  They are far more volatile than the economy as a whole, and in the end don’t deliver any more than the economy as a whole, but sucker people into thinking the markets are magical money machines, until what is weird (too good) becomes weird (too bad).

Don’t let this situation be “too bad” for you.  If you are looking at the current situation, and think that you have too much in risk assets for the long-term, sell some down.  Preserving capital is not imprudent, even if the market bounces.

In that vein, my final point is this: size your position in risk assets to the level where you can live with it under bad conditions, and be happy with it under good conditions.  Then when markets get weird, you can smile and bear it.  The most important thing is to stay in the game, not giving in to panic or greed when things get “weird.”

Hey, it only took 18 years to eclipse the prior high in purchasing power terms! Better than the Great Depression!

 

This is an update of a post I did less than three years ago.  In that relatively short time, the NASDAQ Composite hit an all-time record in purchasing power adjusted terms.  Quite an ascent in the last two years.  I never would have predicted it.  If you took the other side of my advice you did better.

That said, the S&P 500 is forecast to return 3.4%/year prior to inflation for the next ten years.  Aside from one quarter during the go-go years (1968), the only period with lower anticipated returns was during the dot-com bubble.  The levels you see today will be revisited going the other way.

Are you too “chicken” to buy the NASDAQ Composite? Then you are like me.

The last time I wrote on this, I asked whether it would be better the NASDAQ Composite [IXIC] or Industrias Bachoco [IBA].  IBA is the second largest producer of chicken in North America, and is now expanding in the US.  From the time I wrote the last article it has returned 20%.  NASDAQ Composite? 47%.

That said, I still prefer IBA for the future.  Strong competitive position, little debt.  Intelligent tuck-in style of M&A, showing intelligent capital allocation.  1.7x book.  12-13x earnings.  If it weren’t a Mexican firm, it would be valued a lot higher.  IXIC’s valuation metrics are roughly double those.

All that said, IBA beat IXIC over the 12.5 years I have owned it.  487% vs 401%.  And if you were measuring from the top of the dot-com bubble the return difference is 1460% vs 71%.

IBA still has a lot of room to expand, and is subject to less competition and antitrust threats than many large technology companies.

Not that you should run out and buy IBA (caution: thin market), but what do you do if you are looking for ideas that could be good, but not as much in the spotlight as the companies that make up the bulk of the NASDAQ Composite?  I’ll quote the end of my last article, because the ideas are good, and will likely do better than buying hot ideas now.

…where are the good assets that few are looking at?

Tough question.  I’ll give you a few ideas, but then you have to work on it yourself.

1) Look at higher quality names in out-of-favor industries.  The advantage of this approach is that your downside is likely to be limited, while the upside could be significant.  I’ve seen it work many times.  Note: avoid “buggy whip” industries where the decline is final; the internet is eating a lot of industries.

2) Look at companies outside the US that act in the best interests of outside, passive, minority investors like you and me.  There is less competition there from analysts and clever US-focused investors.  Note: spend extra time analyzing how they have used free cash flow in the past.  Is management rational at allocating capital, or even clever?

3) Look at firms that can’t be taken over, where a control investor seems savvy, and acts in the best interests of outside, passive, minority investors.  Many won’t invest in those firms because they are less liquid, and a takeover is very unlikely.

4) Look at smaller firms pursuing a growing niche in an otherwise dull industry.  Or smaller firms that have good finances, but have some taint that keeps investors from re-examining it.

5) Look through 13F filings for new names that look promising, before too many people learn about the company.  Or, IPOs and spin-offs in industries that are dull.

6) Analyze stocks that are in the lowest quartile of performance over the last 3-5 years.

7) Or, go to Value Line, and look at the stocks with the highest appreciation potential, with an adequate safety rank.

I use a variety of these ideas.  If I see somethings interesting, I will dig deep and sometimes I get a real gem.  Sometimes not.  But with an adequate margin of safety, I don’t get killed.

Full Disclosure: long IBA

This should be a brief article.  I remember back in 1999 to early 2000 how P&C insurance stocks, and other boring slower-growth industries were falling in price despite growing net worth, and reasonable earnings.  I was working for The St. Paul at the time (a Property & Casualty Insurer), and for an investment actuary like me, who grew up in the life insurance business it was interesting to see the different philosophy of the industry.  Shorter-duration products make competition more obvious, making downturns uglier.

The market in 1999-2000 got narrow.  Few groups and few stocks were leading the rise.  Performance-conscious investors, amateur and professional, servants of the “Church of What’s Working Now,” sold their holdings in the slower growing companies to buy the shares of faster growing companies, with little attention to valuation differences.

I remember flipping the chart of the S&P 1500 Supercomposite for P&C Insurers, and laying it on top of an index of the dot-com stocks.  They looked like twins separated at birth, except one was upside down.

When shares are sold, they don’t just disappear.  Someone buys them.  In this case, P&C firms bought back their own stock, as did industry insiders, and value investors — what few remained.  When managed well, P&C insurance is a nice, predictable business that throws of reliable profits, and is just complex enough to scare away a decent number of potential investors.  The scare is partially due to the effect that it is not always well-managed, and not everyone can figure out who the good managers are.

So shares migrate.  Those that fall in the midst of a rally, despite decent economics, get bought by long-term investors.  The hot stocks get bought by shorter-term investors, who follow the momentum.  This continues until the gravitational effects of relative valuations gets too great — the cash flows of the hot stocks do not justify the valuations.

Then performance reverts, and what was bad becomes good, and good bad, but as with almost every investment strategy you have to survive until the turn, and if the assets run from the prior migration, it is cold comfort to be right eventually.

As an aside, this is part of what fuels dollar-weighted returns being lower than time-weighted returns.  The hot money migration buys high, and sells low.

Thus I say to value investors, “Persevere.  I can’t tell you when the turn will be, but it is getting closer.”

Photo Credit: jessica wilson {jek in the box}

David:

It’s been a while since we last corresponded.  I hope you and your family are well.

Quick investment question. Given the sharp run-up in equities and stretched valuations, how are you positioning your portfolio?

This in a market that seemingly doesn’t go down, where the risk of being cautious is missing out on big gains.

In my portfolio, I’m carrying extra cash and moving fairly aggressively into gold. Also, on the fixed income side, I’ve been selling HY [DM: High Yield, aka “Junk”] bonds, shortening duration, and buying floating rate bank loans.

Please let me know your thoughts.

Regards

JJJ

Dear JJJ,

Good to hear from you.  It has been a long time.

Asset allocation is always a marriage between time horizon (when is the money needed for spending?) and expected returns, with some adjustment for risk.  I suspect that you are like me, and play for a longer horizon.

I’m at my lowest equity allocation in 17 years.  I am at 65% in equities.  If the market goes up another 4-5%, I am planning on peeling of 25% of that to go into high quality bonds.  Another 20% will go if the market rises 10% from here.  At present, the S&P 500 offers returns of just 3.4%/year for the next ten years unadjusted for inflation.  That’s at the 95th percentile, and reflects valuations of the dot-com bubble, should we rise that far.

The stocks that I do have are heading in three directions: safer, cyclical and foreign.  I’m at my highest level for foreign stocks, and the companies all have strong balance sheets.  A few are cyclicals, and may benefit if commodities rise.

The only thing that gives me pause regarding dropping my stock percentage is that a lot of “friends” are doing it.  That said, a lot of broad market and growth investors are making “new era” arguments.  That gives me more comfort about this.  Even if the FAANG stocks continue to do well, it does not mean that stocks as a whole will do well.  The overall productivity of risk assets is not rising.  People are looking through the rearview mirror, not the windshield, at asset returns.

I can endorse some gold, even though it does nothing.  Nothing would have been a good posture back in the dot-com bubble, or the financial crisis.  Commodities are undervalued at present.  I can also endorse long Treasuries, because I am not certain that inflation will run in this environment.  When economies are heavily indebted they tend not to inflate, except as a last resort.  (The wealthy want to protect their claims against the economy.  The Fed generally helps the wealthy.  Those on the FOMC are all wealthy.)

I also hold more cash than normal.  The three of them, gold, cash and long Treasury bonds form a good hedge together against most bad situations.

The banks are in good shape, so the coming troubles should not be as great as during the financial crisis, as long as nothing bizarre is going on in the repo markets.

That said, I would be careful about bank debt.  Be careful about the covenants on the bank debt; it is not as safe as it once was.  I don’t own any now.

Aside from that, I think you are on the right track.  The most important question is how much you have invested in risk assets.  Prudent investors should be heading lower as the market rises.  It is either not a new era, or, it is always a new era.  Build up your supply of safe assets.  That is the main idea.  Preserve capital for another day when risk assets offer better opportunities.

Thanks for writing.  If you ever make it to Charm City or Babylon, let me know, and we can have lunch together.

Sincerely,

David

Credit: Roadsidepictures from The Little Engine That Could By Watty Piper Illustrated By George & Doris Hauman c. 1954

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I wish I could have found a picture of Woodstock with a sign that said “We’re #1!”  Snoopy trails behind carrying a football, grinning and thinking “In this corner of the backyard.”

That’s how I feel regarding all of the attention that has been paid to the S&P being up every month in 2017, and every month for the last 14 months.  These have never happened before.

There’s a first time for everything, but I feel that these records are more akin to the people who do work for the sports channels scaring up odd statistical facts about players, teams, games, etc.  “Hey Bob, did you know that the Smoggers haven’t converted a 4th and 2 situation against the Robbers since 1998?”

Let me explain.  A month is around 21 trading days.  There is some variation around that, but on average, years tend to have 252 trading days.  252 divided by 12 is 21.  You would think in a year like 2017 that it must  have spent the most time where 21-day periods had positive returns, as it did over each month.

Since 1950, 2017 would have come in fourth on that measure, behind 1954, 1958 and 1995.  Thus in one sense it was an accident that 2017 had positive returns each month versus years that had more positive returns over every 21 day period.

How about streaks of days where the 21-day trialing total return never dropped below zero (since 1950)?  By that measure, 2017 would have tied for tenth place with 2003, and beaten by the years 1958-9, 1995, 1961, 1971, 1964, 1980, 1972, 1965, and 1963.  (Note: quite a reminder of how bullish the late 1950s, 1960s and early 1970s were.  Go-go indeed.)

Let’s look at one more — total return over the whole year.  Now 2017 ranks 23rd out of 68 years with a total return of 21.8%.  That’s really good, don’t get me wrong, but it won’t deserve a mention in a book like “It Was a Very Good Year.”  That’s more than double the normal return, which means you’ll have give returns back in the future. 😉

So, how do I characterize 2017?  I call it The Little Market that Could.  Why?  Few drawdowns, low implied volatility, and skepticism that gave way to uncritical belief.  Just as we have lost touch with the idea that government deficits and debts matter, so we have lost touch with the idea that valuation matters.

When I talk to professionals (and some amateurs) about the valuation model that I use for the market, increasingly I get pushback, suggesting that we are in a new era, and that my model might have been good for an era prior to our present technological innovations.  I simply respond by saying “The buying power has to come from somewhere.  Our stock market does not do well when risk assets are valued at 40%+ of the share of assets, and there have been significant technological shifts over my analysis period beginning in 1945, many rivaling the internet.”  (Every era idolizes its changes.  It is always a “new era.”  It is never a “new era.”)

If you are asking me about the short-term, I think the direction is up, but I am edgy about that.  Forecast ten year returns are below 3.75%/year not adjusted for inflation.  Just a guess on my part, but I think all of the people who are making money off of low volatility are feeding the calm in the short-run, while building up a whiplash in the intermediate term.

Time will tell.  It usually does, given enough time.  In the intermediate-term, it is tough to tell signal from noise.  I am at my maximum cash for my equity strategy accounts — I think that is a prudent place to be amid the high valuations that we face today.  Remember, once the surprise comes, and companies scramble to find financing, it is too late to make adjustments for market risk.

I was approached by a younger friend for advice.  This is my response to his questions below:

Thank you for agreeing to do this for me. I would love to have an actual conversation with you but unfortunately, I think that between all of the classes, exams, and group project meetings I have this week it would prove to be too much of a hassle for both of us to try to set up a time.

1. What professional and soft skills do you need to be successful in this career and why?
2. What advice would you give to someone considering working in this field?
3. What are some values/ethics that have been important to you throughout your career?
4. I understand that you currently run a solo operation, but are there any leadership skills you have needed previously in your career? Any examples?
5. What made you decide to make the switch to running your own business?

Thanks again,

ZZZ

What professional and soft skills do you need to be successful in this career and why?

I’ve written at least two articles on this:

How Do I Find a Job in Finance?

How Do I Find a Job in Finance? (Part 2)

Let me answer the question more directly.  You need to understand the basics of how businesses operate.  How do they make money?  How do they control risk?

Now, the academics will show you their models, and you should know those models.  What is more important is understanding the weaknesses of those models because they may weakly explain how stocks in aggregate are priced, but they are little good at understanding how corporations operate.  The real world is not as ideal as the academic economists posit.

It is useful to read broadly.  It is useful to dig into a variety of financial reports from smaller firms.  Why smaller firms?  They are simpler to understand, and there is more variation in how they do.   Learn to read through the main financial statements well.  Understand how the income statement, balance sheet, and cash flow statement interact.  Look at the footnotes and try to understand what they mean.  Pick an industry and compare all of the companies.  I did that with trucking in 1994 and learned a boatload.  This aids in picking up practical accounting knowledge, which is more powerful when you can compare across industries.

As for soft skills, the ability to deal with people on a firm and fair basis is huge.  Keeping your word is big as well.  When I was a bond trader, I ate losses when I made promises on trades that went wrong.  In the present era, I have compensated clients for losses from mistaken trades.

Here’s another “soft” skill worth considering.  Many employers are aghast at the lousy writing skills of young people coming out of college, and rightly so.  Make sure that your ability to communicate in a written form is at a strong level.

Oral communication is also important.  If you have difficulty speaking to groups, you might try something like Toastmasters.

Many of these things come only with practice on the job, so don’t think that you have to have everything together in order to do well — the important thing is to improve over time.  Young people are not expected to be as polished as their older colleagues.

What advice would you give to someone considering working in this field?

It’s a little crowded in finance.  That is partially because it attracts a lot of people who think it will be easy money.  If you are really good, the crowding shouldn’t be much of a hurdle.  But if you don’t think that you are in the top quartile, there are some alternatives to help you grow and develop.

  • Consider developing your skills at a small bank or insurer.  You will be forced to be a generalist, which sets you up well for future jobs.  It also forces you to confront how difficult the economics of smaller firms are, and how costly/difficult it is to change strategy.  For a clever person, it offers a lot of running room if you work for a firm that is more entrepreneurial
  • Or, consider working in the finance area of an industrial firm.  Finance is not only about selling financial products — it is about the buyers as well.
  • Work for a government or quasi-governmental entity in their finance area.  If you can show some competence there, it would be notable.  The inefficiencies might give you good ideas for what could be a good business.

What are some values/ethics that have been important to you throughout your career?

Here are some:

  • Be honest
  • Follow laws and regulations
  • Work hard for your employer
  • Keep building your skills; at 57, I am still building my skills.
  • Don’t let work rob you of other facets of life — family, friends, etc.  Many become well-paid slaves of their organization, but never get to benefit personally outside of work.
  • Avoid being envious; just focus on promoting the good of the entity that you work for.
  • Try to analyze the culture of a firm before you join it.  Culture is the most important aspect that will affect how happy you are working there.

I understand that you currently run a solo operation, but are there any leadership skills you have needed previously in your career? Any examples?

This is a cute story: Learning Leadership.  I have also written three series of articles on how I grew in the firms that I worked for:

There’s a lot in these articles.  They are some of my best stories, and they help to illustrate corporate life.  Here’s one more: My 9/11 Experience.  What do you do under pressure?  What I did on 9/11 was a good example of that.

I know I have a lot more articles on the topic on this, but those are the easiest to find.

What made you decide to make the switch to running your own business?

I did very well in my own investing from 2000-2010, and wanted to try out my investing theories as a business.  That said, from 2011-2017, it worked out less well than I would have liked as value investing underperformed the market as a whole.

That said, I proceed from principle, and continue to follow my investment discipline.  It follows from good business management principles, and so I continue, waiting for the turn in the market cycle, and improving my ability to analyze corporations.

Nonetheless, my business does well, just not as well as I would like.

I hope you do well in your career.  Let me know how you do as you progress, and feel free to ask more questions.

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I thought this old post from RealMoney.com was lost, never to be found again.  This was the important post made on November 22, 2006 that forecast some of the troubles in the subprime residential mortgage backed securities market.  I favored the idea that there there would be a crash in residential housing prices, and the best way to play it would be to pick up the pieces after the crash, because of the difficulties of being able to be right on the timing of shorting could be problematic.  In that trade, too early would mean wrong if you had to lose out the trade because of margin issues.

With that, here is the article:

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I have tried to make the following topic simple, but what I am about to say is complex, because it deals with the derivative markets. It is doubly or triply complex, because this situation has many layers to unravel. I write about this for two reasons. First, since residential housing is a large part of the US economy, understanding what is going on beneath the surface of housing finance can be valuable. Second, anytime financial markets are highly levered, there is a higher probability that there could be a dislocation. When dislocations happen, it is unwise for investors to try to average down or up. Rather, the best strategy is to wait for the trend to overshoot, and take a contrary position.

 

There are a lot of players trotting out the bear case for residential housing and mortgages. I’m one of them, but I don’t want overstate my case, having commented a few weeks ago on derivatives in the home equity loan asset-backed securities market. This arcane-sounding market is no small potatoes; it actually comprises several billions of dollars’ worth of bets by aggressive hedge funds — the same type of big bettors who blew up so memorably earlier this year, Amaranth and Motherrock.

 

A shift of just 10% up or down in residential housing prices might touch off just such another cataclysm, so it’s worth understanding just how this “arcane-sounding” market works.

 

I said I might expand on that post, but the need for comment and explanation of this market just got more pressing: To my surprise, one of my Googlebots dragged in a Reuters article and a blog post on the topic. I’ve seen other writeups on this as well, notably in Grant’s Interest Rate Observer (a fine publication) and The Wall Street Journal.

How a Securitization Works (Basically)

 

It’s difficult to short residential housing directly, so a market has grown up around the asset-backed securities market, in which bulls and bears can make bets on the performance of home equity loans. How do they do this?

 

First, mortgage originators originate home equity loans, Alt-A loans and subprime loans. They bring these loans to Wall Street, where the originator sells the loans to an investment bank, which dumps the loans into a trust. The investment bank then sells participation interests (“certificates”) in the trust.

 

There are different classes of certificates that have varying degrees of credit risk. The riskier classes receive higher interest rates. Typically the originator holds the juniormost class, the equity, and funds an overcollateralization account to give some security to the next most junior class.

 

Principal payments get allocated to the seniormost class. Once a class gets its full share of principal paid (or cancelled), it receives no more payments. Interest gets allocated in order of seniority. If, after paying interest to all classes, there is excess interest, that excess gets allocated to the overcollateralization account, until the account is full — that is, has reached a value equal to the value of the second most junior class of trust certificates — and then the excess goes to the equity class. If there’s not enough interest to pay all classes, they get paid in order of seniority.

 

If there are loan losses from nonpayment of the mortgages or home equity loans, the losses get funded by the overcollateralization account. If the overcollateralization account gets exhausted, losses reduce the principal balances of the juniormost certificates — those usually held by the originator — until they get exhausted, and then the next most junior gets the losses. There’s a little more to it than this (the prospectuses are often a half-inch thick on thin paper), but this is basically how a securitization works.

 

From Hedging to Speculation

 

The top class of certificates gets rated AAA, and typically the lowest class before the equity gets rated BBB-, though sometimes junk-rated certificates get issued. Most of the speculation occurs in securities rated BBB+ to BBB-.

 

The second phase of this trade involves credit default swaps (CDS). A credit default swap is an agreement where one party agrees to make a payment to another party when a default takes place, in exchange for regular compensation until the agreement terminates or a default happens. This began with corporate bonds and loans, but now has expanded to mortgage- and asset-backed securities.

 

Unlike shorting stocks, where the amount of shorting is generally limited by the float of the common stock, there can be more credit default swaps than bonds and loans. What began as a market to allow for hedging has become a market to encourage speculation.

 

With CDS on corporate debt, it took eight years for the notional size (amount to pay if everyone defaulted) of the CDS market to become 4 times the size of the corporate bond market. With CDS on home equity asset-backed securities, it took less than 18 months to get to the same point.

 

The payment received for insuring the risk is loosely related to the credit spread on the debt that is protected. Given that the CDS can serve as a hedge for the debt, one might think that the two should be equal. There are a couple reasons that isn’t so.

 

First, when a default happens, the bond that is the cheapest to deliver gets delivered. That option helps to make CDS trade cheap relative to credit spreads. But a bigger factor is who wants to do the CDS trading more. Is it those who want to receive payment in a default, or those who want to pay when a default occurs?

How It Impacts Housing

 

With CDS on asset-backed securities, the party writing protection makes a payment when losses get allocated to the tranche in question. Most protection gets written on tranches rated BBB+ to BBB-.

 

This is where shorting residential housing comes into the picture. There is more interest in shorting the residential housing market through buying protection on BBB-rated home equity asset-backed securities than there are players wanting to take on that risk at the spreads offered in the asset-backed market at present. So, those who want to short the market through CDS asset-backed securities have to pay more to do the trade than those in the cash asset-backed securities market receive as a lending spread.

 

One final layer of complexity is that there are standardized indices (ABX) for home equity loan asset-backed securities. CDS exists not only for the individual asset-backed securities deals, but also on the ABX indices as well. Those not wanting to do the credit work on a specific deal can act on a general opinion by buying or selling protection on an ABX index as a whole. The indices go down in quality from AAA to BBB-, and aggregate similar tranches of the individual deals. Those buying protection receive pro-rata payments when losses get allocated to the tranches in their index.

 

So, who’s playing this game? On the side of falling housing prices and rising default rates are predominantly multi-strategy and mortgage debt hedge funds. They are paying the other side of the trade around 2.5% per year for each dollar of home equity asset-backed securities protection bought. (Deals typically last four years or so.) The market players receiving the 2.5% per year payment are typically hedge and other investment funds running collateralized debt obligations. They keep the equity piece, which further levers up their returns. They are fairly yield-hungry, so from what I’ve heard, they’re none too picky about the risks that they take down.

 

Who wins and who loses? This is tricky, but if residential real estate prices fall by more than 10%, the buyers of asset-backed securities protection will probably win. If less, the sellers of protection probably win. This may be a bit of a sideshow in our overly leveraged financial markets, but the bets being placed here exceed ten billion dollars of total exposure. Aggressive investors are on both sides of this trade. Only one set of them will end up happy.

 

But how can you win here? I believe the safest way for retail investors to make money here is to play the reaction, should a panic occur. If housing prices drop severely, and home equity loan defaults occur, and you hear of hedge fund failures resulting, don’t act immediately. Wait. Watch for momentum to bottom out, or at least slow, and then buy the equities of financially strong homebuilders and mortgage lenders, those that will certainly survive the downturn.

If housing prices rise in the short run (unlikely in my opinion), and you hear about the liquidations of bearish hedge funds, then the best way to make money is to wait. Wait and let the homebuilders and mortgage finance companies run up, and then when momentum fails, short a basket of the stocks with weak balance sheets.

Why play the bounce, rather than try to bet on the success of either side? The wait could be quite long before either side loses? Do you have enough wherewithal to stay in the trade? Most players don’t; that’s why I think that waiting for one side or the other to prevail is the right course. Because both sides are levered up, there will be an overshoot. Just be there when the momentum fails, and play the opposite side. Personally, I’ll be ready with a list of homebuilders and mortgage lenders with strong balance sheets. Though prospects are not bright today, the best will prosper once the crisis is past.

Another quarter goes by, the market rises further, and the the 10-year forward return falls again.  Here are the last eight values: 6.10%, 6.74%, 6.30%, 6.01%, 5.02%, 4.79%, and 4.30%, 3.99%.  At the end of September 2017, the figure would have been 4.49%, but the rally since the end of the quarter shaves future returns down to 3.99%.

At the end of June the figure was 4.58%.  Subtract 29 basis points for the total return, and add back 12 basis points for mean reversion, and that would leave us at 4.41%.  The result for September month-end was 4.49%, so the re-estimation of the model added 8 basis points to 10-year forward returns.

Let me explain the adjustment calculations.  In-between quarterly readings, price movements shave future returns the same as a ten-year zero coupon bond.  Thus, a +2.9% move in the total return shaves roughly 29 basis points off future returns. (Dividing by 10 is close enough for government work, but I use a geometric calculation.)

The mean-reversion calculation is a little more complex.  I use a 10-year horizon because that is the horizon the fits the data best.  It is also the one I used before I tested it.  Accidents happen.  Though I haven’t talked about it before, this model could be used to provide shorter-run estimates of the market as well — but the error bounds around the shorter estimates would be big enough to make the model useless. It is enough to remember that when a market is at high valuations that corrections can’t be predicted as to time of occurrence, but when the retreat happens, it will be calamitous, and not orderly.

Beyond 10-years, though, the model has no opinion.  It is as if it says, past mean returns will occur.  So, if we have an expectation of a 4.58% returns, we have one 4.58%/yr quarter drop of at the end of the quarter, and a 9.5% quarter added on at the end of the 10-year period. That changes the quarterly average return up by 4.92%/40, or 12.3 basis points.  That is the mean reversion effect.

Going Forward

Thus, expected inflation-unadjusted returns on the S&P 500 are roughly 3.99% over the next ten years.  That’s not a lot of compensation for risk versus investment-grade bonds.  We are at the 94th percentile of valuations.

Now could we go higher?  Sure, the momentum is with us, and the volatility trade reinforces the rise for now.  Bitcoin is an example that shows that there is too much excess cash sloshing around to push up the prices of assets generally, and especially those with no intrinsic value, like Bitcoin and other cryptocurrencies.

Beyond that, there are not a lot of glaring factors pushing speculation, leaving aside futile government efforts to stimulate an already over-leveraged economy.  It’s not as if consumer or producer behavior is perfectly clean, but the US Government is the most profligate actor of all.

And so I say, keep the rally hats on.  I will be looking to hedge around an S&P 500 level of 2900 at present.  I will be watching the FOMC, as they may try to invert the yield curve again, and crash things.  They never learn… far better to stop and wait than make things happen too fast.  But they are omnipotent fools.  Maybe Powell will show some non-economist intelligence and wait once the yield curve gets to a small positive slope.

Who can tell?   Well, let’s see how this grand experiment goes as Baby Boomers arrive at the stock market too late to save for retirement, but just in time to put in the top of the equity market.  Though I am waiting until S&P 2900 to hedge, I am still carrying 19% cash in my equity portfolios, so I am bearish here except in the short-run.

PS — think of it this way: it should not have gone this high, therefore it could go higher still…

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Dear Readers, this is another one of my occasional experiments, so please be measured in your comments.  The following was written as a ten-year retrospective article in 2042.

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It was indeed an ugly surprise to many when the payments from Social Security in February 2032 did not come.  Indeed, the phones in Congress rang off the hook, and the scroll rate on incoming emails broke all records.  But as with most things in DC in the 21st century, there was no stomach to deal with the problem, as gridlock continued to make Congress a internally hostile but essentially passive institution.

Part of that gridlock stemmed from earlier Congressional reforms that looked good at the time, but reduced the power of parties to discipline members who would not go along with the leadership.  Part also stemmed from changes in media, which were developing in the 1980s because the media was increasingly out of sync with the views of average Americans, but came to full fruition after the internet became the dominant channel for news flow, allowing people to tune out voices unpleasant to them.  Gerrymandering certainly did not help, as virtually all House seats were noncompetitive.  Finally, the size of the debt, and large continuing deficits limited the ability of the government to do anything.  The Fed was already letting inflation run at rates higher than intermediate interest rates, so they were out of play as well.

Despite occasional warnings in the media that began five years earlier after the Chief Actuary of the Social Security Administration suggested in his 2027 year-end report that this was likely to happen in 4-6 years, most media and people tuned it out because it was impossible in their eyes, and face it, actuaries are deadly dull people.  Only a few bloggers kept up a drumbeat on the topic, but they were ignored as Johnny One-Note Disasterniks.

Shortly thereafter, the obligatory hearings began in Congress, and the new Chief Actuary of the Social Security Administration was first on the list to testify.  First he explained that when the Social Security was developed, this safeguard was added in case the income and assets of the trust were inadequate to make the next payment, that payment would be skipped.  He added that by law, skipped payments would not be made up later.  After all, Social Security is an earned right, but mainly a statutory right and not a constitutional right.  Then he commented that without changes, a payment would likely be skipped in 2033 and 2034, two skips each in 2035 and 2036, and by 2037 three skips would be the “new normal” until demographics normalized, but that would likely take a generation to achieve, as childbearing was out of favor.

There were many other people who testified that day from AARP, its relatively new but strong foe AAWP (w -> Working), and various conservative and liberal think tanks, but no one said anything valuable that the Chief Actuary didn’t already say: without changes to benefits or taxes (contributions, haha), payment skipping would become regular.  It was a darkly amusing sidelight that members of the House of Representatives managed to trot out every “urban myth” about Social Security as true during their hearings, including the bogus idea that everyone has their contributions stored in the own little accounts.

The eventual compromise was not a pretty one:

  • Cost-of-living adjustments were ended.
  • Benefits were means-tested.
  • Late retirement adjustment factors were decreased.
  • All the games where benefits could be maximized were eliminated.
  • Immigration restrictions were loosened for well-off immigrants.
  • The normal retirement age was raised to 72, and
  • “Contributions” would now be assessed on income of all types, with no upper limit.  That said, the rate did not rise.

That ended the payment skipping, though it is possible that a skip could happen in the future.  As it is, much of the current political climate is marked by intergenerational conflict, with Social Security viewed derisively as an old-age welfare plan.  A visitor to the grave of FDR did not find him doing 2000 RPM, but did note the skunk cabbage that someone helpfully planted there.  As it was, quiet euthanasia, some voluntary, some not, took place among the elderly Baby Boomers, tired of being labelled sponges on society, or picked off by annoyed caretakers.

It should be noted that as benefits were cut in real terms, friends and families of the some elderly and disabled helped out, but many elderly people led lives of poverty.  Perhaps if they had expected this, they would have prepared, but they trusted the malleable promises of the US Government.

The open question at present is whether it was wise for society to promote collective security schemes.  As it is, with seven states in pseudo-bankruptcy, many municipalities in similar straits if not real bankruptcy, and many countries suffering with worse demographic problems than the US, the problems of these arrangements are apparent:

  • Breaking the link between childbearing and support in old age discouraged childbearing.
  • Every succeeding generation of participants got a worse deal than those that came before.
  • Politicians learned to prioritize the present over the future, and use monies that should have been put to some productive future use into the benefit of those who would consume currently.
  • Complexity encouraged gaming of the system, whether it was maxing benefits, or faking disability.
  • Retirement ages that were too low made the burden too heavy to the workers supporting retirees.

Future articles in this retrospective series will touch on some of the other problems we have recently faced, as many involuntary collective security measures have hit troubled times, and the unintended effects of too much debt, both governmental and private are still with us.