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.