Recently Bill Rempel posed the following question to me:

Could you compare the total return of a 10-yr Treasury bought fresh and new anywhere from 1976-1980, and held to maturity (sending the coupons to cash) — to the total return from an equal-sized basket of stocks or residential real estate over the same time period? Please use “risk-adjusted returns” in the previous comment, re: returns on bonds. As a non-institutional investor who doesn’t care as much about the “mark to model” on any bonds I would hold, I would view double-digit Treasuries as free money, especially in light of long-term returns on stocks barely cracking the DD with divvies included …

He also made this recent post to further elucidate his views. So, let’s do a thought experiment. Suppose you knew where real interest rates and inflation would be ten years from now. How would that affect your investment policy?

The easy answer would be that you would know what to do with bonds. After all if rates are higher in the future, you would shorten your bond holdings to preserve your capital, and vice-versa if rates were lower.

But what do you do with your stocks? How is their performance impacted by future real interest rates and inflation rates? Before I answer that, let’s consider the difference between the yield of a bond, and its realized return from reinvesting the coupons. The following graph shows the coupon rate on a ten year Treasury note, and the realized return from investing the coupons at money market rates until the bond matured. The realized return is higher than the coupon when the average money market rate was higher than the coupon, and vice versa. But the difference is rarely very large. Most bond income comes from coupons.
Slide 1

Now, let’s consider how the ten year Treasury yield, inflation and real rates have varied over my study period, 1954-1997.

Slide 2

And look at how the ten year Treasury yield, the real rate of interest, and the inflation rate would change over the next ten years.
slide 3

Looking at these graphs, you can guess that future equity returns are affected by changes in inflation and real interest rates, but here’s proof:

Slide 4

Or, another way of looking at it, future equity returns depend on future real interest rates and inflation rates. Note that bonds only beat stocks for ten-year investments beginning during the period 1964-1973, and not all of the time even then.
Slide 5

I ran a regression on the difference between ten-year stock returns and ten-year realized Treasury note returns, with the regressors being the current inflation and real interest rate, and the inflation and real interest rates 10 years from then. The R-squared was 57% (good in my opinion), and the coefficients were:

  • Current inflation: +22%
  • Current real interest rate: -12%
  • Inflation 10 years from then: -121%
  • Real interest rates 10 years from then: -46%

There was some autocorrelation of the residuals, indicating that periods of under- and out-performance of equities over bonds tends to persist:

Slide 6

All were statistically significant at a 95% two-sided level. What the regression tells us is that of the four variables considered, the most important one is future inflation rates. If future inflation rises, the value of future cash flow declines. It gets even worse if the Federal Reserve tries to squeeze out inflation by raising real interest rates high enough to overcome the inflation. Oddly, higher current inflation is a modest plus — maybe that indicates pricing power? Perhaps it is useful to think of equities as ultra-long bonds, with rising coupons. Rising rates would hurt those considerably.



  1. Note that it was a bullish period, and that stocks did not lose nominal money over a ten-year period to any appreciable extent.
  2. Stocks almost always beat bonds over a ten-year period, except when inflation and real interest rates 10 years from now are high.
  3. Investing in stocks during low interest rate environments can be hazardous to your wealth.
  4. Watch for inflation pressures to protect your portfolio. Stocks get hurt worse than bonds from rising inflation.
  5. Inflation and real rate cycles tend to persist, so when you see a change, be willing to act. Buy stocks when inflation is cresting, and buy short-term bonds when inflation is rising.

With the US Dollar Index taking out an all time low previously set in 1992, I thought I would take this moment to discuss my thoughts about where the dollar is going, and what we might see along the way. If the dollar gets much lower against the major currencies of our world, I would expect to see some currency intervention to try to raise the value of the US dollar.

There are rules to effective currency interventions. There may be more than four, but here are the four that I know.

  1. Do the intervention on a day when the economic releases favor a stronger US Dollar.
  2. Do the intervention when traders are overconfident, and pressing their bearish dollar bets too aggressively. Catch them leaning the wrong way.
  3. Don’t do it alone. You will fail. You must get the central banks of most of your major trading partners to go along to create an impression of unanimity.
  4. Do it BIG. This is not a time to hold back; either do it BIG, or don’t do it at all. You want the currency traders to wish they had never taken up the profession.

You want to have at least three of these in play for an effective intervention. You want to create a genuine panic that feeds on itself, leading everyone to readjust their positions on the US Dollar, pushing it up, and winning the psychological battle against a lower US Dollar.

Easy, right? Well, no. In the short run, interventions work if done properly. They don’t solve the macroeconomic problems underlying the weak Dollar, though, and so toward the end of the shock move upward in the Dollar, I would be inclined to buy more foreign bond exposure. Why?

During the intervention, the participating central banks suck in US Dollars, and pump out their local currencies. In the case of the Fed, they sell foreign currencies and buy US Dollars. Most of these central banks have all of the US Dollar assets that they want already, and they understand the fundamental situation regarding the US Dollar. So, like OPEC in their ineffective days, where they would announce production cuts, and then everyone cheats, in this case, the Central Banks do the intervention, but then quietly recycle the US Dollar assets that they never really wanted to hold.

That leads to a slow retest of the levels that the intervention happened at, and eventually, breaking through the level, at which point, the Central Banks can try again, or give up.  Eventually the response is a “give up,” after which, the US Dollar slowly overshoots and then finds a new temporary equilibrium level, and the rest of the world adjusts to it.

I’m leaving out a lot here.  The internal political pressures to keep the Dollar from falling.  The effects on export industries.  The slowly growing willingness to buy US Goods and services.  Rising interest rates in the US.  Rising inflation abroad.  And more.

The investment implication is this, though.  Until an intervention happens, the path of the US Dollar is down.  After it happens, the path of the US Dollar is down, until a new equilibrium is found.  Economies are bigger than governments, and in the long run, governments can’t affect exchange rates.

Just stay on your toes, and be ready to buy non-Dollar assets after the coming currency intervention.

Maybe things have normalized.  After all:

  • Implied volatilities have fallen below long-run averages for equity indexes.
  • The equity market is within spitting distance of a new high.
  • The Fed is loosening (will they do more?)
  • The discount window is largely vacant.
  • Away from real estate, and real estate finance, things seem pretty chipper.
  • The yield curve is normalizing.
  • Inflation as measured by the government is low.
  • Long term interest rates are low, for investment grade borrowers.
  • Commercial paper problems are gone.
  • LBO debt difficulties will be solved soon, through a combination of losses to the banks, and canceled deals.

Or maybe not:

  • Inflation is rising globally.
  • The dollar is weak.
  • US inflation should start to rise as a result.
  • Housing prices are weak and getting weaker.  Default and delinquency statistics are rising.
  • The CDO [Collateralized Debt Obligation] problems are still not solved.
  • Defaults should begin to increase significantly on single-B and CCC-rated corporate debts in 2008.
  • The TED [Treasury-Eurodollar] spread is still in a panic-type range.

I’m seeing more of my stocks get closer to the upper end of my rebalancing range.  I will begin reducing exposure if the market run persists.  I’m not crazy about the market here, but I am not making any aggressive moves.

Not such a bad quarter for the S&P 500, up around 2%. Unfortunately, I was down 4%. Value was out of favor, as were many of my favored industries. I got whacked along with many of the quant funds it seems. This leaves me flat versus the S&P 500 for the year. We’ll see what the fourth quarter brings.

I still like my stocks. For those that follow me, remember that my favored holding period is around three years, which is how I would recommend that people measure my ideas, over a three-year rolling horizon.

This is a rental, not a purchase per se, but toward the close, I bought some Flagstone Reinsurance.  It’s a new-ish company with one of the top 2 property reinsurance models in Bermuda.  Trading near tangible book, 6x earnings, with high quality assets and reasonable operating leverage, it is a reasonable play for the fourth quarter.

Why the fourth quarter?  No guarantee here, but property losses are headed for another light year.  No major storms in the Southeastern US so far, and by this time of year, prior patterns tend to maintain.  You can see the stock price of Ren Re take off, but Flagstone, Montpelier, and IPC Re have not moved so much.

One complicating factor: the second good year in a row will make surplus bulge at insurers, leading to lower rates next year.  I’m waiting to see articles on how the Southeast windstorm models are unduly pessimistic, or watch the state of Florida take the modelers to court.  (The State would lose, but the government there would be game to try it.)

What this means is that the rally in these shares will be cut short by the fears of falling premium rates, sometime after the third quarter earnings are reported.  So, be nimble here, and there should be a short-term rally in the property-centric reinsurers.

Full disclosure: long FSR

Apologies for not posting last night.  A power outage hit our neighborhood, and ate my post.  It also ate a decent amount of the work I was doing to respond to some questions of Bill Rempel, aka NO DooDahs!  It seems that I am used to having the “autosave” on at work and not home.  Well, that will change.

I should have something more up this evening, with a big post off of Bill’s questions Saturday evening.

Three reasons:

  • There are still significant areas of concern that have not unwound yet — residential housing exposure will increase as housing prices fall further, including lawsuits which will eventually prove not meritorious, and CDO exposure.
  • It is my firm belief that their hedges hold in minor moves, but not major moves.  VAR modeling is fine for when the winds are calm, but not when they are gale force.  At gale force the Extreme Value Theory models kick in, and they are untested at present.  Berkshire Hathaway’s experience in unwinding GenRe’s swap book was telling; few things were marked conservatively.  That is probably true industrywide, partly because auditors are incapable of audit the swap books in all of their complexity, or they’d be working for the investment banks themselves.
  • New accounting regulations make earnings quality more opaque, and less comparable across time periods and companies.  This should result in lower multiples, akin to big commercial insurers.

That’s all.  Personally I think the investment banks will be a buy sometime in 2008, but I am waiting to see how the current leverage unwind affects them.

I’m about to add advertising to my blog, and I’d like to ask a small favor from my readers.  If you happen to see an advertisement that is morally objectionable, please send me an e-mail.  Include the URL of the ad.  Examples would include:


  • Payday lenders
  • Gambling
  • Tarot Reading
  • Known Investment Scams


There are likely more, but that’s a start.  Google on ads is not “don’t be evil,” but rather, is amoral in their ad filtering, not allowing even for rudimentary category blocking.  One has to block ads URL by URL.  Klunky, if you ask me.


Again, thanks to all my readers for their help in making this a better site.

Yesterday over at RealMoney, I made the following post on monetary policy:

David Merkel
Monetary Policy at Present
9/25/2007 11:29 AM EDT

Though I don’t agree with all of his theories, John Hussman did an excellent job describing how little the recent Fed loosening has done for monetary policy. There still has not been a permanent injection of liquidity since May 3rd. The monetary base is flat. The real changes in monetary policy have come through additional leverage at the banks. That comes through explicit policy waivers, policy changes (e.g., permitted collateral at the discount window, removal of stigma), and the “wink, wink, naughty boy” returning to bank exams.

That reflects in the monetary aggregates. M2 and MZM both have moved up smartly since the beginning of the temporary loosening, as have total bank liabilities, which is a good proxy for M3. That said, because LIBOR is high relative to Fed funds, it is less good of a proxy, because banks are less willing to lend unsecured to each other in the Eurodollar markets.

Think of it this way, US Dollar LIBOR has only incorporated 16 basis points of the 50 basis point rate cut, measured from the equilibrium level that existed previous to the latest crisis in 2007. During the rate rise, they moved pretty much in lock-step.

So, things are a little better on the liquidity front in the short-run, but not much better. If the banks begin to become more conservative, just for survival reasons (i.e., more leverage is permitted, but they don’t want to use it), the small effects of regulatory easing will be erased.

Position: none, but while I wrote this, my youngest boy (10) came up to me, and asked me to explain what the stock market was like during 9/11, and during the Great Depression. It is very rewarding to be with my family during the day.

After this, Dr. Jeff Miller of A Dash of Insight pinged me asking me to clarify a little.  My response went like this:

You’re right, I need to be plainer about where I agree with him, and disagree with him, and I’ll probably put that into a post tonight at my blog.  Oddly, his models, from what I can gather, work off of some sort of cash flow yield for valuation, and even have a “don’t fight the Fed” component to them, in addition to momentum.  The reason this is weird, is that from those simple measures, he should be far more bullish, but he is not.  My suspicion is that he assumes that profit margins will mean revert, which they will, but maybe that will happen a lot more slowly than many anticipate.

As for his theory on the Fed, he is off.  The Fed has real impact on the economy through its effect on short term rates, admittedly with a lag, and they can’t fix inverted situations, no matter how low rates go (like Japan).  They affect bank leverage quite a bit, and though not cost-less, it has a real impact on the economy, with less of a lag, unless they go too far.

In essence, Hussman got the data right, and part of the interpretation, but missed increased leverage at the banks, which so long as it is sustainable, will stimulate economic activity.  He also missed that “Don’t fight the Fed” generally works.  I understand his valuation arguments, but he needs to get more sophisticated, and look at relative valuations of stocks to bonds.  Stocks are quite attractive on a relative basis, at least for now.

Monetary policy and its effects are complex, and non-nuanced explanations do a disservice to readers, particularly when the investment prescription is too simplistic.  At present, the Fed has done little to increase the money supply directly, but has encouraged the banks to lend more.  If the banks can tolerate that, then good.  If not, then watch out, because the banks are integral to our credit-based economy.

No tickers mentioned

There is a misunderstanding about contrarianism, that somehow if a lot of people think something, it must be wrong, so take the other side of the trade.  We can make an exception here for some financial journalists, because they are often late to catch onto a story, and thus, the magazine cover indicator often works.

My point here is that intelligent contrarianism does not work off of what market players think, but how much they have invested relative to their investment policy limits, and the capital that they have available to carry the trade.  When there are many investors that have gone maximum long on a given company, that is a situation to either avoid or short, because unless new longs show up, the current longs have no more buying power — it is a crowded trade.

I saw this with housing in 2005, as I wrote a piece on residential real estate that proved prescient.  It drew a lot of controversy, but my point was plain.  Where would additional buying power come from?  In September of 2005, I concluded that we were at the inflection point.  One of my theories about inflection points is that there is no good numerical signal of an inflection point, but qualitative chatter undergoes a shift at the inflection points.  In that case, I had a series of googlebots trawling the web for real estate related chatter.  The tone shifted in September/October of 2005, but it was largely missed by the media and the markets.

Though I have nothing written on the web on the Internet Bubble, the qualitative chatter change that happened in March of 2000 was commentary from a variety of companies that had relied on vendor financing were turned down by their vendors.  That was new, and it indicated a scarcity of cash.  My rule of thumb on bubbles is that they are primarily financing phenomena; bubbles pop when cash flow proves insufficient to finance them.

Now, with both the residential real estate and internet bubbles, there were a bunch of naysayers prior to the bubbles.  Most were way too early.  Keynes observed something to the effect that markets can remain irrational longer than an investor can remain solvent.  Risk control is a key here, as well as cash flow analysis. When does the financing fall apart?  What will the inflection point, with all of its fog, look like?  Where is the weak spot in the financing chain?

Those naysayers were an inadequate reason to take a contrarian position; many of them didn’t have a dog in the fight, aside from intellectual bragging rights.  Rather, the contrarian position was to ask what side had overcommitted relative to their ability to carry the positions, and the ability of others to get financing to buy them out.

Where I differ with many permabears is that I am usually unwilling to extend my logic to second order effects.  Just because one area of the economy is falling apart, doesn’t mean that a related area will of necessity get blasted.  There are dampening effects to almost any economic phenomena, such that you don’t get cascading effects where failure in one area leads to failure in others, leading to a failure of the system as a whole.  The exception is of course the great depression, and that was a situation where the whole economy was overlevered.  We’re not there today, yet…

Okay, one semi-practical application, and then this article ends.  I get a certain amount of pushback for being bearish on the US Dollar.  I’ve been bearish on the US Dollar since mid-2002, when I saw that our monetary and fiscal policy were shifting to aggressive levels of debasement stimulus.  Today I heard someone dismiss further US dollar weakness because “everyone knows that.”  Well, if everyone knows that, tell it to the foreign investors who are stuffed to the gills with US dollar claims (bonds), such that their economies are beginning to suffer higher inflation.  I see a continued crowded trade here, and I am waiting to see where the pain points are, such that foreign central banks begin to intervene to prop up the dollar.  It hasn’t happened yet, and we are within 20 basis points of taking out the all time low in the dollar index, set back in 1992.