How Lucky Do You Feel?

How Lucky Do You Feel?

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Nine years ago, I wrote about the so-called “Fed Model.” The insights there are still true, though the model has yielded no useful signals over that time. It would have told you to remain in stocks, which given the way many panic,, would not have been a bad decision.

I’m here to write about a related issue this evening.  To a first approximation, most investment judgments are a comparison between two figures, whether most people want to admit it or not.  Take the “Fed Model” as an example.  You decide to invest in stocks or not based on the difference between Treasury yields and the earnings yield of stocks as a whole.

Now with interest rates so low, belief in the Fed Model is tantamount to saying “there is no alternative to stocks.” [TINA]  That should make everyone take a step back and say, “Wait.  You mean that stocks can’t do badly when Treasury yields are low, even if it is due to deflationary conditions?”  Well, if there were only two assets to choose from, a S&P 500 index fund and 10-year Treasuries, and that might be the case, especially if the government were borrowing on behalf of the corporations.

Here’s why: in my prior piece on the Fed Model, I showed how the Fed Model was basically an implication of the Dividend Discount Model.  With a few simplifying assumptions, the model collapses to the differences between the earnings yield of the corporation/index and its cost of capital.

Now that’s a basic idea that makes sense, particularly when consider how corporations work.  If a corporation can issue cheap debt capital to retire stock with a higher yield on earnings, in the short-run it is a plus for the stock.  After all, if the markets have priced the debt so richly, the trade of expensive debt for cheap equity makes sense in foresight, even if a bad scenario comes along afterwards.  If true for corporations, it should be true for the market as a whole.

The means the “Fed Model” is a good concept, but not as commonly practiced, using Treasuries — rather, the firm’s cost of capital is the tradeoff.  My proxy for the cost of capital for the market as a whole is the long-term Moody’s Baa bond index, for which we have about 100 years of yield data.  It’s not perfect, but here are some reasons why it is a reasonable proxy:

  • Like equity, which is a long duration asset, these bonds in the index are noncallable with 25-30 years of maturity.
  • The Baa bonds are on the cusp of investment grade.  The equity of the S&P 500 is not investment grade in the same sense as a bond, but its cash flows are very reliable on average.  You could tranche off a pseudo-debt interest in a way akin to the old Americus Trusts, and the cash flows would price out much like corporate debt or a preferred stock interest.
  • The debt ratings of most of the S&P 500 would be strong investment grade.  Mixing in equity and extending to a bond of 25-30 years throws on enough yield that it is going to be comparable to the cost of capital, with perhaps a spread to compensate for the difference.

As such, I think a better comparison is the earnings yield on the S&P 500 vs the yield on the Moody’s BAA index if you’re going to do something like the Fed Model.  That’s a better pair to compare against one another.

A new take on the Equity Premium

A new take on the Equity Premium!

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That brings up another bad binary comparison that is common — the equity premium.  What do stock returns have to with the returns on T-bills?  Directly, they have nothing to do with one another.  Indirectly, as in the above slide from a recent presentation that I gave, the spread between the two of them can be broken into the sum of three spreads that are more commonly analyzed — those of maturity risk, credit risk and business risk.  (And the last of those should be split into a economic earnings  factor and a valuation change factor.)

This is why I’m not a fan of the concept of the equity premium.  The concept relies on the idea that equities and T-bills are a binary choice within the beta calculation, as if only the risky returns trade against one another.  The returns of equities can be explained in a simpler non-binary way, one that a businessman or bond manager could appreciate.  At certain points lending long is attractive, or taking credit risk, or raising capital to start a business.  Together these form an explanation for equity returns more robust than the non-informative academic view of the equity premium, which mysteriously appears out of nowhere.

Summary

When looking at investment analyses, ask “What’s the comparison here?”  By doing that, you will make more intelligent investment decisions.  Even a simple purchase or sale of stock makes a statement about the relative desirability of cash versus the stock.  (That’s why I prefer swap transactions.)  People aren’t always good at knowing what they are comparing, so pay attention, and you may find that the comparison doesn’t make much sense, leading you to ask different questions as a result.

 

Photo Credit: duncan c || It wasn't my intent initially to compare the words of the FOMC with the scrawlings of a vandal, but ya know some things are surprise fits

Photo Credit: duncan c || It wasn’t my intent initially to compare the words of the FOMC with the scrawlings of a vandal, but ya know, some things are surprise fits

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I wasn’t surprised to hear in the FOMC minutes that members of the committee thought:

For these reasons, participants generally saw maintaining the target range for the federal funds rate at 1/4 to 1/2 percent at this meeting and continuing to assess developments carefully as consistent with setting policy in a data-dependent manner and as leaving open the possibility of an increase in the federal funds rate at the June FOMC meeting.

and

Participants agreed that their ongoing assessments of the data and other incoming information, as well as the implications for the outlook, would determine the timing and pace of future adjustments to the stance of monetary policy. Most participants judged that if incoming data were consistent with economic growth picking up in the second quarter, labor market conditions continuing to strengthen, and inflation making progress toward the Committee’s 2 percent objective, then it likely would be appropriate for the Committee to increase the target range for the federal funds rate in June. Participants expressed a range of views about the likelihood that incoming information would make it appropriate to adjust the stance of policy at the time of the next meeting. Several participants were concerned that the incoming information might not provide sufficiently clear signals to determine by mid-June whether an increase in the target range for the federal funds rate would be warranted. Some participants expressed more confidence that incoming data would prove broadly consistent with economic conditions that would make an increase in the target range in June appropriate. Some participants were concerned that market participants may not have properly assessed the likelihood of an increase in the target range at the June meeting, and they emphasized the importance of communicating clearly over the intermeeting period how the Committee intends to respond to economic and financial developments.

I was surprised to see some of the markets take it seriously.  Here’s why:

1) The FOMC loves to talk hawk and them be doves.  They don’t think the costs to waiting are significant, particularly given how low measured inflation and and implied future inflation are.  Five-year inflation, five years forward implied from TIPS spreads is not high at present as you can see here:

2) The FOMC is well known for giving with the right hand and taking with the left.  They would like if possible to have the best of both worlds — gentle movement of what they view as key variables, while usually not dramatically changing the forward estimates of those

3) The FOMC’s natural habitat is wishful thinking.  Their GDP forecasts are usually high, and they suspect their policy tools will move the economy the way they want and quickly, and it’s just not true.

4) LIBOR rates have done a better job of the FOMC at estimating future policy, and they have barely budged since the FOMC minutes came out.

5) The FOMC always has more doves than hawks, and that is the way the politicians who appoint and approve the board members like it.  They will live with inflation.  That was yesterday’s problem.  Today’s problem is stagnant median incomes — and looser monetary policy will help there, right?

Well, no, but I’m sure they clapped when Peter Pan asked them to save Tinkerbell.  There is no link between inflation and faster real growth over the long haul.  There may be measurement errors in the short run.

6) They don’t like moving against foreign rates, but that’s not a big factor.

7) GDP isn’t showing much lift at all.

Summary

Unless we have a change in management at the Fed, where they are not trying to manipulate markets through their words, but maybe one that said little and acted quietly, like the pre-1986 FOMC, they really aren’t worth listening to.  They act like politicians.  Let them study Martin and Volcker, and learn from when the FOMC was more effective.

PS — I’m not saying they can’t tighten in June.  I’m just saying it’s unlikely, and to ignore the comments in the FOMC minutes.  What the FOMC says is of little consequence.  It’s what they do that counts.  They are like a little dog that barks a lot, but rarely bites.

Photo Credit: GotCredit

Photo Credit: GotCredit

This is another piece in the irregular Simple Stuff series, which is an attempt to make complex topics simple.  Today’s topic is:

What is risk?

Here is my simple definition of risk:

Risk is the probability that an entity will not meet its goals, and the degree of pain it will go through depending on how much it missed the goals.

There are several good things about this definition:

  • Note that the word “money” is not mentioned.  As such, it can cover a wide number of situations.
  • It is individual.  The same size of a miss of a goal for one person may cause him to go broke, while another just has to miss a vacation.  The same event may happen for two people — it may be a miss for one, and not for the other one.
  • It catches both aspects of risk — likelihood of a bad event, and degree of harm from how badly the goal was missed.
  • It takes into account the possibility that there are many goals that must be met.
  • It covers both composite entities like corporations, families, nations and cultures, as well as individuals.
  • It doesn’t make life easy for academic economists who want to have a uniform definition of risk so that they can publish economics and finance papers that are bogus.  Erudite, but bogus.
  • It doesn’t specify that there has to be a single time horizon, or any time horizon.
  • It doesn’t specify a method for analysis.  That should vary by the situation being analyzed.

But this is a blog on finance and investing risk, so now I will focus on that large class of situations.

What is Financial Risk?

Here are some things that financial risk can be:

  • You don’t get to retire when you want to, or, your retirement is not as nice as you might like
  • One or more of your children can’t go to college, or, can’t go to the college that the would like to attend
  • You can’t buy the home/auto/etc. of your choice.
  • A financial security plan, like a defined benefit plan, or Social Security has to cut back benefit payments.
  • The firm you work for goes broke, or gets competed into an also-ran.
  • You lose your job, can’t find another job as good, and you default on important regular bills as a result.  The same applies to people who run their own business.
  • Levered financial businesses, like banks and shadow banks, make too many loans to marginal borrowers, and find at some point that their borrowers can’t pay them back, and at the same time, no one wants to lend to them.  This can be harmful not just to the banks and shadow banks, but to the economy as a whole.

Let’s use retirement as an example of how to analyze financial risk.  I have a series of articles that I have written on the topic based on the idea of the personal required investment earnings rate [PRIER].  PRIER is not a unique concept of mine, but is attempt to apply the ideas of professionals trying to manage the assets and liabilities of an endowment, defined benefit plan, or life insurance company to the needs of an individual or a family.

The main idea is to try to calculate the rate of return you will need over time to meet your eventual goals.  From my prior “PRIER” article, which was written back in January 2008, prior to the financial crisis:

To the extent that one can estimate what one can reasonably save (hard, but worth doing), and what the needs of the future will cost, and when they will come due (harder, but worth doing), one can estimate personal contribution and required investment earnings rates.  Set up a spreadsheet with current assets and the likely savings as positive figures, and the future needs as negative figures, with the likely dates next to them.  Then use the XIRR function in Excel to estimate the personal required investment earnings rate [PRIER].

I’m treating financial planning in the same way that a Defined Benefit pension plan analyzes its risks.  There’s a reason for this, and I’ll get to that later.  Just as we know that a high assumed investment earnings rate at a defined benefit pension plan is a red flag, it is the same to an individual with a high PRIER.

Now, suppose at the end of the exercise one finds that the PRIER is greater than the yield on 10-year BBB bonds by more than 3%.  (Today that would be higher than 9%.)  That means you are not likely to make your goals.   You can either:

  • Save more, or,
  • Reduce future expectations,whether that comes from doing the same things cheaper, or deferring when you do them.

Those are hard choices, but most people don’t make those choices because they never sit down and run the numbers.  Now, I left out a common choice that is more commonly chosen: invest more aggressively.  This is more commonly done because it is “free.”  In order to get more return, one must take more risk, so take more risk and you will get more return, right?  Right?!

Sadly, no.  Go back to Defined Benefit programs for a moment.  Think of the last eight years, where the average DB plan has been chasing a 8-9%/yr required yield.  What have they earned?  On a 60/40 equity/debt mandate, using the S&P 500 and the Lehman Aggregate as proxies, the return would be 3.5%/year, with the lion’s share coming from the less risky investment grade bonds.  The overshoot of the ’90s has been replaced by the undershoot of the 2000s.  Now, missing your funding target for eight years at 5%/yr or so is serious stuff, and this is a problem being faced by DB pension plans and individuals today.

The article goes on, and there are several others that flesh out the ideas further:

Simple Summary

Though there are complexities in trying to manage financial risk, the main ideas for dealing with financial risk are these:

  1. Spend time estimating your future needs and what resources you can put toward them.
  2. Be conservative in what you think you assets can earn.
  3. Be flexible in your goals if you find that you cannot reasonably achieve your dreams.
  4. Consider what can go wrong, get proper insurance where needed, and be judicious on taking on large fixed commitments to spend money in the future.

PS — Two final notes:

On the topic of “what can go wrong in personal finance, I did a series on that here.

Investment risk is sometimes confused with volatility.  Here’s a discussion of when that makes sense, and when it doesn”t.

I’m thinking of starting a limited series called “dirty secrets” of finance and investing.  If anyone wants to toss me some ideas you can contact me here.  I know that since starting this blog, I have used the phrase “dirty secret” at least ten times.

Tonight’s dirty secret is a simple one, and it derives mostly from investor behavior.  You don’t always get more return on average if you take more risk.  The amount of added return declines with each unit of additional risk, and eventually turns negative at high levels of risk.  The graph above is a vague approximate representation of how this process works.

Why is this so?  Two related reasons:

  1. People are not very good at estimating the probability of success for ventures, and it gets worse as the probability of success gets lower.  People overpay for chancy lottery ticket-like investments, because they would like to strike it rich.  This malady affect men more than women, on average.
  2. People get to investment ideas late.  They buy closer to tops than bottoms, and they sell closer to bottoms than tops.  As a result, the more volatile the investment, the more money they lose in their buying and selling.  This malady also affects men more than women, on average.

Put another way, this is choosing your investments based on your circle of competence, such that your probability of choosing a good investment goes up, and second, having the fortitude to hold a good investment through good and bad times.  From my series on dollar-weighted returns you know that the more volatile the investment is, the more average people lose in their buying and selling of the investment, versus being a buy-and-hold investor.

Since stocks are a long duration investment, don’t buy them unless you are going to hold them long enough for your thesis to work out.  Things don’t always go right in the short run, even with good ideas.  (And occasionally, things go right in the short run with bad ideas.)

For more on this topic, you can look at my creative piece, Volatility Analogy.  It explains the intuition behind how volatility affects the results that investors receive as they get greedy, panic, and hold on for dear life.

In closing, the dirty secret is this: size your risk level to what you can live with without getting greedy or panicking.  You will do better than other investors who get tempted to make rash moves, and act on that temptation.  On average, the world belongs to moderate risk-takers.

Photo Credit: Kathryn

Photo Credit: Kathryn || Truly, I sympathize.  I try to be strong for others when internally I am broken.

Entire societies and nations have been wiped out in the past.  Sometimes this has been in spite of the best efforts of leading citizens to avoid it, and sometimes it has been because of their efforts.  In human terms, this is as bad as it gets on Earth.  In virtually all of these cases, the optimal strategy was to run, and hope that wherever you ended up would be kind to foreigners.  Also, most common methods of preserving value don’t work in the worst situations… flight capital stashed early in the place of refuge and gold might work, if you can get there.

There.  That’s the worst survivable scenario I can think of.  What does it take to get there?

  • Total government and market breakdown, or
  • A lost war on your home soil, with the victors considerably less kind than the USA and its allies

The odds of these are very low in most of the developed world.  In the developing world, most of the wealthy have “flight capital” stashed away in the USA or someplace equally reliable.

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Most nations, societies and economies are more durable than most people would expect.  There is a cynical reason for this: the wealthy and the powerful have a distinct interest in not letting things break.  As Solomon observed a little less than 3000 years ago:

If you see the oppression of the poor, and the violent perversion of justice and righteousness in a province, do not marvel at the matter; for high official watches over high official, and higher officials are over them. Moreover the profit of the land is for all; even the king is served from the field. — Ecclesiastes 5:8-9 [NKJV]

In general, I think there is no value in preparing for the “total disaster” scenario if you live in the developed world.  No one wants to poison their own prosperity, and so the rich and powerful hold back from being too rapacious.

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If you don’t have a copy, it would be a good idea to get a copy of Triumph of the Optimists.  [TOTO]  As I commented in my review of TOTO:

TOTO points out a number of things that should bias investors toward risk-bearing in the equity markets:

  1. Over the period 1900-2000, equities beat bonds, which beat cash in returns. (Note: time weighted returns. If the study had been done with dollar-weighted returns, the order would be the same, but the differences would not be so big.)

  2. This was true regardless of what presently developed nation you looked at. (Note: survivor bias… what of all the developing markets that looked bigger in 1900, like Russia and India, that amounted to little?)

  3. Relative importance of industries shifts, but the aggregate market tended to do well regardless. (Note: some industries are manias when they are new)

  4. Returns were higher globally in the last quarter of the 20th century.

  5. Downdrafts can be severe. Consider the US 1929-1932, UK 1973-74, Germany 1945-48, or Japan 1944-47. Amazing what losing a war on your home soil can do, or, even a severe recession.

  6. Real cash returns tend to be positive but small.

  7. Long bonds returned more than short bonds, but with a lot more risk. High grade corporate bonds returned more on average, but again, with some severe downdrafts.

  8. Purchasing power parity seems to work for currencies in the long run. (Note: estimates of forward interest rates work in the short run, but they are noisy.)

  9. International diversification may give risk reduction. During times of global stress, such as wartime, it may not diversify much. Global markets are more correlated now than before, reducing diversification benefits.

  10. Small caps may or may not outperform large caps on average.

  11. Value tends to beat growth over the long run.

  12. Higher dividends tend to beat lower dividends.

  13. Forward-looking equity risk premia are lower than most estimates stemming from historical results. (Note: I agree, and the low returns of the 2000s so far in the US are a partial demonstration of that. My estimates are a little lower, even…)

  14. Stocks will beat bonds over the long run, but in the short run, having some bonds makes sense.

  15. Returns in the latter part of the 20th century were artificially high.

Capitalist republics/democracies tend to be very resilient.  This should make us willing to be long term bullish.

Now, many people look at their societies and shake their heads, wondering if things won’t keep getting worse.  This typically falls into three non-exclusive buckets:

  • The rich are getting richer, and the middle class is getting destroyed  (toss in comments about robotics, immigrants, unfair trade, education problems with children, etc.  Most such comments are bogus.)
  • The dependency class is getting larger and larger versus the productive elements of society.  (Add in comments related to demographics… those comments are not bogus, but there is a deal that could be driven here.  A painful deal…)
  • Looking at moral decay, and wondering at it.

You can add to the list.  I don’t discount that there are challenges/troubles.  Even modestly healthy society can deal with these without falling apart.

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If you give into fears like these, you can become prey to a variety of investment “experts” who counsel radical strategies that will only succeed with very low probability.  Examples:

  • Strategies that neglect investing in risk assets at all, or pursue shorting them.  (Even with hedge funds you have to be careful, we passed the limits to arbitrage back in the late ’90s, and since then aggregate returns have been poor.  A few niche hedge funds make sense, but they limit their size.)
  • Gold, odd commodities — trend following CTAs can sometimes make sense as a diversifier, but finding one with skill is tough.
  • Anything that smacks of being part of a “secret club.”  There are no secrets in investing.  THERE ARE NO SECRETS IN INVESTING!!!  If you think that con men in investing is not a problem, read On Avoiding Con Men.  I spend lots of time trying to take apart investment pitches that are bogus, and yet I feel that I am barely scraping the surface.

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Things are rarely as bad as they seem.  Be willing to be a modest bull most of the time.  I’m not saying don’t be cautious — of course be cautious!  Just don’t let that keep you from taking some risk.  Size your risks to your time horizon for needing cash back, and your ability to sleep at night.  The biggest risk may not be taking no risk, but that might be the most common risk economically for those who have some assets.

To close, here is a personal comment that might help: I am natively a pessimist, and would easily give into disaster scenarios.  I had to train myself to realize that even in the worst situations there was some reason for optimism.  That served me well as I invested spare assets at the bottoms in 2002-3 and 2008-9.  The sun will rise tomorrow, Lord helping us… so diversify and take moderate risks most of time.

This is the fourth article in this series, and is here because the S&P 500 is now in its second-longest bull market since 1928, having just passed the bull market that ended in 1956.    Yeah, who’da thunk it?

This post is a little different from the first three articles, because I got the data to extend the beginning of my study from 1950 to 1928, and I standardized my turning points using the standard bull and bear market definitions of a 20% rise or fall from the last turning point.  You can see my basic data to the left of this paragraph.

Before I go on, I want to show you two graphs dealing with bear markets:

As you can see from the first graph, small bear markets are much more common than large ones.  Really brutal bear markets like the biggest one in the Great Depression were so brutal that there is nothing to compare it to — financial leverage collapsed that had been encouraged by government policy, the Fed, and a speculative mania among greedy people.

The second graph tells the same story in a different way.  Bear markets are often short and sharp.  They don’t last long, but the intensity in term of the speed of declines is a little more than twice as fast as the rises of bull markets.  If it weren’t for the fact that bull markets last more than three times as long on average, the sharp drops in bear markets would be enough to keep everyone out of the stock market.

Instead, it just keeps many people out of the market, some entirely, but most to some degree that would benefit them.

Oh well, on to the gains:

Like bear markets, most bull markets are small.  The likelihood of a big bull market declines with size.  The current bull market is the fourth largest, and the one that it passed in duration was the second largest.  As an aside, each of the four largest bull markets came after a surprise:

  1. (1987-2000) 1987: We knew the prior bull market was bogus.  When will inflation return?  It has to, right?
  2. (1949-56) 1949: Hey, we’re not getting the inflation we expected, and virtually everyone is finding work post-WWII
  3. (1982-7) 1982: The economy is in horrible shape, and interest rates are way too high.  We will never recover.
  4. (2009-Present) 2009: The financial sector is in a shambles, government debt is out of control, and the central bank is panicking!  Everything is falling apart.
Sometimes you win, sometimes you lose...

Sometimes you win, sometimes you lose…

Note the two dots stuck on each other around 2800 days.  The arrow points to the lower current bull market, versus the higher-returning bull market 1949-1956.

Like bear markets, bull markets also can be short and sharp, but they can also be long and after the early sharp phase, meander upwards.  If you look through the earlier articles in this series, you would see that this bull market started as an incredibly sharp phenomenon, and has become rather average in its intensity of monthly returns.

Conclusion

It may be difficult to swallow, but this bull market that is one of the longest since 1928 is pretty average in terms of its monthly average returns for a long bull market.  It would be difficult for the cost of capital to go much lower from here.  It would be a little easier for corporate profits to rise from here, but that also doesn’t seem too likely.

Does that mean the bull is doomed?  Well, yes, eventually… but stranger things have happened, it could persist for some time longer if the right conditions come along.

But that’s not the way I would bet.  Be careful, and take opportunities to lower your risk level in stocks somewhat.

PS — one difference with the Bloomberg article linked to in the first paragraph, the longest bull market did not begin in 1990 but in 1987.  There was a correction in 1990 that fell just short of the -20% hurdle at -19.92%, as mentioned in this Barron’s article.  The money shot:

The historical analogue that matches well with these conditions is 1990. There was a 19.9% drop in the S&P 500, lasting a bit under three months. But the damage to foreign stocks, small-caps, cyclicals, and value stocks in that cycle was considerably more. Both the Russell and the Nasdaq were down 32% to 33%. You might remember United Airlines’ failed buyout bid; the transports were down 46%. Foreign stocks were down about 30%.

And then Saddam Hussein invaded Kuwait.

That might have been the final trigger. The broad market top was in the fall of 1989, and most stocks didn’t bottom until Oct. 11, 1990. In the record books, it was a shallow bear market that didn’t even officially meet the 20% definition. But it was a damaging one that created a lot of opportunity for the rest of the 1990s.

FWIW, I remember the fear that existed among many banks and insurance companies that had overlent on commercial properties in that era.  The fears led Alan Greenspan to encourage the FOMC to lower rates to… (drumroll) 3%!!!  And, that experiment together with the one in 2003, which went down to 1.25%, practically led to the idea that the FOMC could lower rates to get out of any ditch… which is now being proven wrong.

Caption from the WSJ: Regulators don’t think it is the place of Congress to second guess how they size up securities. Fed Chairwoman Janet Yellen said recently that legislation would “interfere with our supervisory judgments.” PHOTO: BAO DANDAN/ZUMA PRESS

PHOTO CREDIT: BAO DANDAN/ZUMA PRESS

March 2016April 2016Comments
Information received since the Federal Open Market Committee met in January suggests that economic activity has been expanding at a moderate pace despite the global economic and financial developments of recent months. Information received since the Federal Open Market Committee met in March indicates that labor market conditions have improved further even as growth in economic activity appears to have slowed. FOMC shades GDP down and employment up.
Household spending has been increasing at a moderate rate, and the housing sector has improved further; however, business fixed investment and net exports have been soft.Growth in household spending has moderated, although households’ real income has risen at a solid rate and consumer sentiment remains high. Since the beginning of the year, the housing sector has improved further but business fixed investment and net exports have been soft.Shades down household spending.
A range of recent indicators, including strong job gains, points to additional strengthening of the labor market.A range of recent indicators, including strong job gains, points to additional strengthening of the labor market.No change.
Inflation picked up in recent months; however, it continued to run below the Committee’s 2 percent longer-run objective, partly reflecting declines in energy prices and in prices of non-energy imports.Inflation has continued to run below the Committee’s 2 percent longer-run objective, partly reflecting earlier declines in energy prices and falling prices of non-energy imports.Shades energy prices up, and prices of non-energy imports down.
Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed, on balance, in recent months.Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed, on balance, in recent months.No change.  TIPS are showing higher inflation expectations since the last meeting. 5y forward 5y inflation implied from TIPS is near 1.73%, up 0.08% from March.  Significant move since February 2016.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.No change. Any time they mention the “statutory mandate,” it is to excuse bad policy.
The Committee currently expects that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace and labor market indicators will continue to strengthen.The Committee currently expects that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace and labor market indicators will continue to strengthen.No change.
However, global economic and financial developments continue to pose risks.They moved this down two sentences, sort of, as global markets are calmer.
Inflation is expected to remain low in the near term, in part because of earlier declines in energy prices, but to rise to 2 percent over the medium term as the transitory effects of declines in energy and import prices dissipate and the labor market strengthens further.Inflation is expected to remain low in the near term, in part because of earlier declines in energy prices, but to rise to 2 percent over the medium term as the transitory effects of declines in energy and import prices dissipate and the labor market strengthens further.No change. CPI is at +0.9% now, yoy.

Shades inflation down in the short run due to energy prices.

The Committee continues to monitor inflation developments closely.The Committee continues to closely monitor inflation indicators and global economic and financial developments.Adds in monitoring of global economics and finance.
Against this backdrop, the Committee decided to maintain the target range for the federal funds rate at 1/4 to 1/2 percent.Against this backdrop, the Committee decided to maintain the target range for the federal funds rate at 1/4 to 1/2 percent.No change.
The stance of monetary policy remains accommodative, thereby supporting further improvement in labor market conditions and a return to 2 percent inflation.The stance of monetary policy remains accommodative, thereby supporting further improvement in labor market conditions and a return to 2 percent inflation.No change.  They don’t get that policy direction, not position, is what makes policy accommodative or restrictive.
In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation.In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation.No change.
This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.No change.  Gives the FOMC flexibility in decision-making, because they really don’t know what matters, and whether they can truly do anything with monetary policy.
In light of the current shortfall of inflation from 2 percent, the Committee will carefully monitor actual and expected progress toward its inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.In light of the current shortfall of inflation from 2 percent, the Committee will carefully monitor actual and expected progress toward its inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.No change.  Says that they will go slowly, and react to new data.  Big surprises, those.
The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction, and it anticipates doing so until normalization of the level of the federal funds rate is well under way. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction, and it anticipates doing so until normalization of the level of the federal funds rate is well under way. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.No change.  Says it will keep reinvesting maturing proceeds of agency debt and MBS, which blunts any tightening.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; James Bullard; Stanley Fischer; Loretta J. Mester; Jerome H. Powell; Eric Rosengren; and Daniel K. Tarullo.Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; James Bullard; Stanley Fischer; Loretta J. Mester; Jerome H. Powell; Eric Rosengren; and Daniel K. Tarullo.No change. Not quite unanimous.
Voting against the action was Esther L. George, who preferred at this meeting to raise the target range for the federal funds rate to 1/2 to 3/4 percent.Voting against the action was Esther L. George, who preferred at this meeting to raise the target range for the federal funds rate to 1/2 to 3/4 percent.One lonely voice that can think past the current consensus of neoclassical economists.

Comments

  • Policy continues to stall, as the economy muddles along.
  • But policy should be tighter. Savers deserve returns, and that would be good for the economy.
  • The changes for the FOMC’s view are that labor indicators are stronger, and GDP and household spending are weaker.
  • Equities rise and bonds rise. Commodity prices flat and the dollar falls.
  • The FOMC says that any future change to policy is contingent on almost everything.
  • The key variables on Fed Policy are capacity utilization, labor market indicators, inflation trends, and inflation expectations. As a result, the FOMC ain’t moving rates up much, absent much higher inflation, or a US Dollar crisis.

Every now and then, you will run across a mathematical analysis where if you use a certain screening, trading, or other investment method, it produces a high return in hindsight.

And now, you know about it, because it was just published.

But wait.  Just published?

Think about what doesn’t get published: financial research that fails, whether for reasons of error or luck.

Now, luck can simply be a question of timing… think of my recent post: Think Half of a Cycle Ahead.  What would happen to value investing if you tested it only over the last ten years?

It would be in the dustbin of failed research.

Just published… well… odds are, particularly if the data only goes back a short distance in time, it means that there was likely a favorable macro backdrop giving the idea a tailwind.

There is a different aspect to luck though.  Perhaps a few souls were experimenting with something like the theory before it was discovered.  They had excellent returns, and there was a little spread of the theory via word of mouth and unsavory means like social media and blogs.

Regardless, one of the main reasons the theory worked was that the asset being bought by those using the theory were underpriced.  Lack of knowledge by institutions and most of the general public was a barrier to entry allowing for superior returns.

When the idea became known by institutions after the initial paper was published, a small flood of money came through the narrow doors, bidding up the asset prices to the point where the theory would not only no longer work, but the opposite of the theory would work for a time, as the overpriced assets had subpar prospective returns.

Remember how dot-com stocks were inevitable in March of 2000?  Now those doors weren’t narrow, but they were more narrow than the money that pursued them.  Such is the end of any cycle, and the reason why average investors get skinned chasing performance.

Now occasionally the doors of a new theory are so narrow that institutions don’t pursue the strategy.  Or, the strategy is so involved, that even average quants can tell that the data has been tortured to confess that it was born in a place where the universe randomly served up a royal straight flush, but that five-leaf clover got picked and served up as if it were growing everywhere.

Sigh.

My advice to you tonight is simple.  Be skeptical of complex approaches that worked well in the past and are portrayed as new ideas for making money in the markets.  These ideas quickly outgrow the carrying capacity of the markets, and choke on their own success.

The easiest way to kill a good strategy is to oversaturate it too much money.

As such, I have respect for those with proprietary knowledge that limit their fund size, and don’t try to make lots of money in the short run by hauling in assets just to drive fees.  They create their own barriers to entry with their knowledge and self-restraint, and size their ambitions to the size of the narrow doors that they walk through.

To those that use institutional investors, do ask where they will cut off the fund size, and not create any other funds like it that buy the same assets.  If they won’t give a firm answer, avoid them, or at minimum, keep your eye on the assets under management, and be willing to sell out when they get reeeally popular.

If it were easy, the returns wouldn’t be that great.  Be willing to take the hard actions such that your managers do something different, and finds above average returns, but limits the size of what they do to serve current clients well.

Then pray that they never decide to hand your money back to you, and manage only for themselves.  At that point, the narrow door excludes all but geniuses inside.

Photo Credit: Istvan || Note OPEC HQ in Vienna

Photo Credit: Istvan || Note OPEC HQ in Vienna

Most games in life are cooperative.  Many are competitive.  A few are perverse.

That’s what the crude oil market is like today.  It reminds me of the prisoner’s dilemma.  In the prisoner’s dilemma, two parties that would benefit from cooperating together tend not to do so because of other incentives that if both follow, they will both end up in a worse place.

This stems from three problems facing OPEC [Organization of the Petroleum Exporting Countries].

  1. The Saudis and the Iranians don’t want to take any action that would benefit the other, even if it would help themselves.
  2. It’s virtually impossible to keep member nations in OPEC from cheating, and producing more than their quota.
  3. Thanks to hydraulic fracturing (at least for now) there is enough supply outside of OPEC at inexpensive prices, that if OPEC cut production as a group, it might not gain as much of the benefit as they did in the ’70s and early ’80s.

Factors 1 and 2 interact, because even if there was a credible deal to cut production on the table, the Saudis likely think that the Iranians might cheat and produce more… leaving the Iranians much better off and the Saudis not that much better off.

We have to remember that the neoclassical model of man as a maximizer of utility or profits is often wrong.  People and nations are envious, and will make do with less if it means those that they dislike are even worse off.  The Saudis may be burning through their financial reserves quickly, but virtually everyone else in OPEC is worse off.  The Saudis might think that they can drive a better deal inside OPEC when almost everyone else is desperate.

What this argues for is crude oil prices staying lower for a longer period of time — my guess is between $30 and $50 per barrel of Brent-type crude.  What could change this?

  • Faster economic growth
  • Turmoil in oil producing regions that reduces supply
  • Depletion of short-life low-cost sources of crude (as is common with hydraulic fracturing)
  • Some clever third parties in OPEC find a way to get the Saudis and Iranians to cooperate while saving face, and no one cheats.

On the other side there is:

  • More cheating within OPEC
  • Weaker growth
  • Higher energy taxes
  • Further technological refinements that lower crude oil production costs further
  • Continued improvements in solar, wind, and energy storage (primarily battery) technology.

At present, my guess is that the marginal barrels of crude oil are being extracted in North America, and probably will be out to 2020 or so.  As such, I would encourage energy investors to stick with strong companies with a mix of low debt and cheap production costs.  Also, look for companies that are misunderstood, that have other businesses away from energy but have been tarred with the low energy price story.

In summary, play it safe while the members of OPEC flounder in a game that they designed for themselves.

Idea Credit: Philosophical Economics Blog

Idea Credit: Philosophical Economics Blog

My most recent post, Estimating Future Stock Returns was well-received.  I expected as much.  I presented it as part of a larger presentation to a session at the Society of Actuaries 2015 Investment Symposium, and a recent meeting of the Baltimore Chapter of the AAII.  Both groups found it to be one of the interesting aspects of my presentation.

This post is meant to answer three reasonable questions that got posed:

  1. How do you estimate the model?
  2. How do we understand what it is forecasting given multiple forecast horizons seemingly implied by the model?
  3. Why didn’t the model how badly the market would do in 2001 and 2008?  And I will add 1973-4 for good measure.

Ready?  Let’s go!

How to Estimate

In his original piece, @Jesse_Livermore freely gave the data and equation out that he used.  I will do that as well.  About a year before I wrote this, I corresponded with him by email, asking if he had noticed that the Fed changed some of the data in the series that his variable used retroactively.  That was interesting, and a harbinger for what would follow.  (Strange things happen when you rely on government data.  They don’t care what others use it for.)

In 2015, the Fed discontinued one of the series that was used in the original calculation.  I noticed that when the latest Z.1 report came out, and I tried to estimate it the old way.  That threw me for a loop, and so I tried to re-estimate the relationship using what data was there.  That led me to do the following:

I tried to get all of them from one source, and could not figure out how to do it.  The Z.1 report has all four variables in it, but somehow, the Fed’s Data Download Program, which one of my friends at a small hedge fund charitably referred to as “finicky” did not have that series, and somehow FRED did.  (I don’t get that, but then there are a lot of things that I don’t get.  This is not one of those times when I say, “Actually, I do get it; I just don’t like it.”  That said, like that great moral philosopher Lucy van Pelt, I haven’t ruled out stupidity yet.  To which I add, including my stupidity.)

The variable is calculated like this:

(A + D)/(A + B + C + D)

Not too hard, huh?  The R-squared is just a touch lower from estimating it the old way… but the difference is not statistically significant.  The estimation is just a simple ordinary least squares regression using that single variable as the independent variable, and the dependent variable being the total return on the S&P 500.

As an aside, I tested the variable over other forecast horizons, and it worked best over 10-11 years.  On individual years, the model is most powerful at predicting the next year (surprise!), and gets progressively weaker with each successive individual year.

To make it concrete: you can use this model to forecast the expected returns for 2016, 2017, 2018, etc.  It won’t be very accurate, but you can do it.  The model gets more accurate forecasting over a longer period of time, because the vagaries of individual years average out.  After 10-11 years, the variable is useless, so if I were put in charge of setting stock market earnings assumptions for a pension plan, I would do it as a step function, 6% for the next 10 years, and 9.5% per year thereafter… or in place of 9.5% whatever your estimate is for what the market should return normally.

On Multiple Forecast Horizons

One reader commented:

I would like to make a small observation if I may. If the 16% per annum from Mar 2009 is correct we still have a 40%+ move to make over the next three years. 670 (SPX March 09) growing at 16% per year yields 2900 +/- in 2019. With the SPX at 2050 we have a way to go. If the 2019 prediction is correct, then the returns after 2019 are going to be abysmal.

The first answer would be that you have to net dividends out.  In March of 2009, the S&P 500 had a dividend yield of around 4%, which quickly fell as the market rose and dividends fell for about one year.  Taking the dividends into account, we only need to get to 2270 or so by the March of 2019, works out to 3.1% per year.  Then add back a dividend yield of about 2.2%, and you are at a more reasonable 5.3%/year.

That said, I would encourage you to keep your eye on the bouncing ball (and sing along with Mitch… does that date me…?).  Always look at the new forecast.  Old forecasts aren’t magic — they’re just the best estimate a single point in time.  That estimate becomes obsolete as conditions change, and people adjust their portfolio holdings to hold proportionately more or less stocks.  The seven year old forecast may get to its spot in three years, or it may not — no model is perfect, but this one does pretty well.

What of 2001 and 2008?  (And 1973-4?)

Another reader wrote:

Interesting post and impressive fit for the 10 year expected returns.  What I noticed in the last graph (total return) is, that the drawdowns from 2001 and 2008 were not forecasted at all. They look quite small on the log-scale and in the long run but cause lot of pain in the short run.

Markets have noise, particularly during bear markets.  The market goes up like an escalator, and goes down like an elevator.  What happens in the last year of a ten-year forecast is a more severe version of what the prior questioner asked about the 2009 forecast of 2019.

As such, you can’t expect miracles.  The thing that is notable is how well this model did versus alternatives, and you need to look at the graph in this article to see it (which was at the top of the last piece).  (The logarithmic graph is meant for a different purpose.)

Looking at 1973-4, 2001-2 and 2008-9, the model missed by 3-5%/year each time at the lows for the bear market.  That is a big miss, but it’s a lot smaller than other models missed by, if starting 10 years earlier.  That said, this model would have told you prior to each bear market that future rewards seemed low — at 5%, -2%, and 5% respectively for the  next ten years.

Conclusion

No model is perfect.  All models have limitations.  That said, this one is pretty useful if you know what it is good for, and its limitations.