6 September 2014 – The Aleph Blog

Goes Down Double-Speed (Update 2)

Posted on 6 September 20147 September 2014 by David Merkel

2791702123_3a088ec05d_z — Photo Credit: hounddiggity

This is the third time I have written this article during this bull market. ?Here are the other two times, with dates:

Goes Down Double-Speed?2/17/2011
Goes Down Double-Speed (Updated)?5/22/2013

The first time, we had doubled since the bottom. ?Second time, up 2.5x. ?Now it is a triple since the bottom. ?That doesn’t happen often, and this rally is getting increasingly unusual by historic standards. ?That said, remember that every time a record gets broken, it shows that the prior maximum was not a limit. ?If you think about that, after a bit you know that idea is obvious, but that isn’t the way that many people practically think about extreme statistics.

Let’s look at my table, which is the same as the last two times I published, except for the last line:

Since the second?piece, the gains have come slowly and steadily, though faster than between the first and second pieces. ?As I said last time,

“In long recoveries, gains first come quickly, then slowly, then near the end they often come quickly again.? Things are coming quickly again now, but who can tell how long it might persist.”

Indeed, and after the first piece, the market did nothing for about 16 months, after which the market started climbing again at a rate of about 1.5% per month for the last 27 months. ?Though not as intense as the rally in the mid-’80s, this is now the third longest rally since 1950, and the third largest. ?It is also the third most intense for rallies lasting 1000 calendar days or more. ?This is a special rally.

And now look at the cumulative gain:

Does this special rally give us any clues to the future? ?Sadly, no. ?Or maybe, too much. ?Let me spill my thoughts, and you can take them for what they are worth, because I encouraged caution the last two times, and that hasn’t been the winning idea so far.

To top the rally of the ’90s for total size, we would have to see 2700 on the S&P 500.
It is highly unlikely that this rally will top the intensity of that of the ’50s or ’80s. ?Gains from here, if any, are likely to be below the 1.7%/month average so far.
For this rally to set a length record, it would have to last until 12/14/16 (what a date).
Record high profit margins should constrain further growth in the?S&P 500, but that hasn’t worked so far. ?As it is, there are very good reasons for profit margins to be high, because unskilled and semi-skilled labor in the capitalist world is not scarce.
Rallies tend to persist longer when they go at gradual clips of between 1-2%/month. ?Still, all of them eventually die.
At present the market is priced to give 5.5%/year returns over the next 10 years. ?That figure is roughly the 85th percentile of valuations. ?Things are high now, but they have been higher, as in the dot-com bubble. ?We are presently higher than the peak in 2007.
On the negative side, it doesn’t look like the market is pricing in any war risk.
On the positive side, I’m having a hard time finding too many industries that have over-borrowed. ?Governments and US students show moderate?credit risk, as do some industries in the finance and energy sectors.
Finally, the most unusual aspect of this era is how little competition bonds are giving to stocks. ?In my opinion, that idea is getting relied on too heavily for a relative value trade. ?Instead, what we may find is that if bond yields rise, stocks, particularly dividend paying stocks, will get hit. ?By relying on a relative yield judgment for stocks, it places them both subject to the same risks.

I still think that we are on borrowed time, but maybe you need to regard me as a stopped digital clock with a date field, which isn’t even right twice per day. ?Historically, if the rally persists, stock prices should only appreciate at a 8-9% annual rate with the bull this old.

That’s all for now. ?I’m not hedging my equity portfolio yet, but maybe my mind changes near 2300 on the S&P 500, should we get there.

PS — the title comes from the fact that markets move down twice as fast as they go up, so be ready for when the cycle turns. ?The first article in the series focused on that.

The FSOC is Full of Hot Air

Posted on 6 September 2014 by David Merkel

I’ve written about this before, but if the FSOC wants to prove that they don’t know what they are doing, they should define a large life insurer to be a systemic threat.

It is rich, really rich, to look at the rantings of a bunch of bureaucrats and banking regulators who could not properly regulate banks for solvency from 2003-2008, and have them suggest solvency regulation for a class of businesses that they understand even less.

And, this is regarding an industry that posed little?systemic threat during the financial crisis. ?Yes, there were the life subsidiaries of AIG that were rescued by the Fed, and a few medium-large life insurers like Hartford and Lincoln National that took TARP money that they didn’t need. ?Even if all of these companies failed, it would have had little impact on the industry as a whole, much less the financial sector of the US.

Life insurance companies have much longer liability structures than banks. ?They don’t have to refresh their financing frequently to stay solvent. ?It is difficult to have a “run on the company” during a time of financial weakness. ?Existing solvency regulation done by actuaries and filed with the state regulators considers risks that the banks often do not do in their asset-liability analyses.

Systemic risk comes from short-dated financing of long-dated assets, which is often done by banks, but rarely by life insurers. ?I’ve written about this many times, and here are two of the better ones:

MetLife and other insurers should not have to live with the folly of “Big == Systemic Risk.” ?Rather, let the FSOC focus on all lending financials that borrow short and lend long, particularly those that use the repurchase markets, or fund their asset inventories via short-term lending agreements. ?That is the threat — let them regulate banks and pseudo-banks right before they dare to regulate something they clearly do not understand.

One Less Mentioned Reason for Stock Buybacks

Posted on 6 September 2014 by David Merkel

1357046602_c11590eace_z — Photo Credit: Bill Selak

Buybacks are not my favorite way to redeploy excess capital, in general. ?But let me describe to you when they are useful and when they are not [taken from this article]:

Buybacks are preferred on a taxation basis to dividends.
But buybacks are especially good when the stock is trading below its franchise value, and especially bad the further above franchise value the stock is trading.
Using slack capital to improve operations, or do little tuck-in acquisitions is probably best of all.? Organic growth is usually the best growth, and small acquisitions can facilitate that.? Small acquisitions are usually not expensive.? Be wary of acquisitions to increase scale, they don?t work so well.
Paying a dividend makes management teams more cognizant of the cost of equity capital, which makes them more effective.
In the reinsurance business in Bermuda, companies with slack capital tend to buy back shares below 1.3x book value, and issue special dividends if they are above that level.

The whole article is worth a read, but there is one more factor that drives buybacks, especially illogical buybacks where they pay more than the per share intrinsic value of the company: they don’t want to get taken over by another company. ?After all, the current management team may never have such nice jobs ever again.

Buying back stock at uneconomic prices temporarily keeps the stock price high, and removes cash from the balance sheet that an acquirer could use to help purchase the company. ?We haven’t seen it in a while, but some companies under threat of a takeover would do a semi-LBO and borrow a lot of money to buy back stock, making a purchase of the company?less attractive.

Thus, I’m not sure we could ever get rid of buybacks, even when they don’t make sense, except perhaps in the long run by selling the shares of companies that are too aggressive in the buybacks.

Closing Note

I rarely disagree with Josh Brown, but I did not find the?HBR article he cited?criticizing buybacks to be compelling. ?I would find it really difficult to believe that management teams avoid projects offering organic growth at rates exceeding the implied yield from buying back stock. ?Also, there are many different ways to run businesses in our country, and if public companies suffer from a buyback bias, then private companies might be able to think longer-term, and invest in profitable?organic ventures.

Thus I would not blame buybacks for other problems in society; I might blame too much investment in residential housing and financial institutions, but even then, I would not be certain. ?What we invest in as a society does affect future growth, but it is difficult to see where the end-investments take place. ?Money from a stock buyback might get redeployed into a business startup. ?It may be that public businesses are light on organic investing, and take less risk in investing via buybacks.?But that is why we have startups, private equity, etc., much of successful of which go public or get acquired by public companies.

Anyway, just a few thoughts…