Photo Credit: jessica wilson {jek in the box}


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

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

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

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

Please let me know your thoughts.



Dear JJJ,

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

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

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

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

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

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

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

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

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

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

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



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


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

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

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

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

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

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

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

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

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

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

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

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

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

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

Thanks again,


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

I’ve written at least two articles on this:

How Do I Find a Job in Finance?

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

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

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

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

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

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

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

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

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

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

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

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

Here are some:

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

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

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

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

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

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

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

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

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

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


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

With that, here is the article:


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


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


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


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

How a Securitization Works (Basically)


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


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


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


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


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


From Hedging to Speculation


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


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


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


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


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


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

How It Impacts Housing


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


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


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


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


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


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

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

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

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

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

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

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

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

Going Forward

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

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

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

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

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

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


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


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

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

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

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

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

The eventual compromise was not a pretty one:

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

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

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

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

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

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


Last week, there was an article in Barron’s describing how many mutual fund families take advantage of a provision in the law allowing them to have funds lend to one another.  Quoting from the article:

Under normal circumstances the Securities and Exchange Commission bars funds from making “affiliated transactions,” but there’s a loophole in the Investment Company Act of 1940 for funds to apply for an exemption to make such “interfund loans.” Until recently, few fund families applied for this exemption. None had before 1990. From 2006 to 2016, the SEC approved just 18 interfund lending applications. But since January 2016, the agency has approved 26. Most major fund families—BlackRock, Vanguard, Fidelity, Allianz—now can make such loans. Stiffer regulations of banks, which are now less willing to offer funds credit lines, partly explain the application surge.

I’m here tonight to suggest making a virtue out of necessity, because one day this practice will be banned after another crisis if something goes afoul.  Let the mutual fund companies that do this set up a special “crisis lending fund,” and put in place the following provisions:

  • The various funds that can borrow from the crisis lending fund must pay a commitment fee for the capital that could be lent.  Make it similar to what a bank provides on a revolving credit line.
  • When funds are not lent, it is invested in Treasury securities, or something of very high quality, in a five-year ladder.
  • When funds are lent, they receive a rate similar to rates current on single-B junk bonds.
  • The lending to other funds is secured, such that if the loans are collateralized by less than 200%, the loans must be paid down.  I.e., if the fund has $200 million of net asset value, there can be at most $100 million of loans, from all parties lending to the fund.

This would be an attractive, somewhat countercyclical asset for people to invest in.  Who wouldn’t want a fund that made additional money during a crisis, and was safe the rest of the time as well?

Just a stray thought.  As with many of my ideas, this would help create a stable private-sector solution where the government might otherwise intrude.

Don’t look at the left side of the chart on an empty stomach


This will be a short post.  At present the expected 10-year rate of total return on the S&P 500 is around 4.05%/year.  We’re at the 94th percentile now.  The ovals on the graph above are 68% and 95% confidence intervals on what the actual return might be.  Truly, they should be two vertical lines, but this makes it easier to see.  One standard deviation is roughly equal to two percent.

But, at the left hand side of the graph, things get decidedly non-normal.  After the model gets to 2.5% projected returns, presently around 3100 on the S&P 500, returns in the past have been messy.  Of course, those were the periods from 1998-2000 to 2008-2010.  But aside from one stray period starting in 1968, that is the only time we have gotten to valuations like this.

My last piece hinted at this, but I want to make this a little plainer.  For sound effects while reading this, you could get your children or grandchildren to murmur behind you “We know it can’t. We know it can’t.” while you consider whether the market can deliver total returns of 7%/year over the next 10 years.

There are few if any things that remain permanently valid insights of finance.  Anything, even good strategies, can be overdone.  Even stable companies can be overlevered, until they are no longer stable.

In this case, it is buying the dips, buying a value-weighted cross section of the market, and putting your asset allocation on autopilot.  Set it and forget it.  Add in companies always using spare capital to buy back shares, and maxing out debts to fit the liberal edge of your preferred rating profile.

These have been good ideas for the past, but are likely to bite in the future.  Value is undervalued, safety is undervalued, and the US is overvalued.  A happy quiet momentum has brought us here, and for the most part it has been calm, not wild.  Individually prudent actions that have paid off in the past are likely to prove imprudent within three years, particularly if the S&P 500 rises 10-15% more in the next year.

People have bought into the idea that market timing never matters.  I agree with the idea that it usually doesn’t matter, and that it is usually is a fool’s game to time the market.  That changes when the 10-year forward forecast of market returns gets low, say, around 3%/year.

Remember, the market goes down double-speed.  Just because the 10-year returns don’t lose much, doesn’t mean that there might not be better opportunities 3-5 years out, when the market might offer returns of 6%/year or higher.

Also, remember that my data set begins in 1945.  I wish I had the values for the 1920s, because I expect they would be even further to the left, off the current graph, and well below the bottom of it.

This isn’t the most nuts that things can be.  In fact, it is very peaceful and steady — the cumulative effect of many rational decisions based off of what would have worked best in the past, in the short-run.

As a result, I am looking 10 years into the future, and slowly scaling back my risks as a result.  If the market moves higher, that will pick up speed.

Picture Credit: Roadsidepictures from The Little Engine That Could By Watty Piper, Illustrated By George & Doris Hauman | That said, for every one that COULD, at least two COULDN’T


So what do you think of the market?  Why are both actual and implied volatility so low?  Why are the moves so small, but predominantly up?  Is this the closest impression of the Chinese Water Torture that a stock market can pull off?

Why doesn’t the market care about external and internal risks?  Doesn’t it know that we have divisive, seemingly incompetent President who looks like he doesn’t know how to do much more than poke people in the eyes, figuratively?  Doesn’t it know that we have a divided, incompetent Congress that can’t get anything of significance done?

Leaving aside the possibility of a war that we blunder into (look at history), what if the inability of Washington DC to do anything is a plus?  Government on autopilot for four years, maybe eight if we decide we are better of without change — is that a plus or minus?  Just ignore the noise, Trump, other politicians, media… ahh, the quiet could be nice.

Then think about Baby Boomers showing up late for retirement, and wondering what they are going to do.  Then think about their surrogates, the few who still have defined benefit pension plans.  What are they going to do?  Say that the rate that they are targeting for investment earnings is 7%/year forever.  Even if my model for investment returns is wrong in a pessimistic way — i.e., my 4% nominal should be 6%/year nominal, you still can’t hit your funding target.  As for those with defined contribution plans, when you are way behind, even contributing more won’t do much unless investment earnings provide some oomph.

I am personally not a fan of TINA — “there is no alternative” to stocks in the market, but I recognize the power of the idea with some.  It is my opinion that more people and their agents will run above average risks in order to try to hit an unlikely target rather than lock in a loss versus what is planned.  Most will “muddle in the middle” taking some risk even with a high market, and realizing that they aren’t going to get there, but maybe a late retirement is better than none.

That’s the power of bonds returning 3% at best over the forecast horizon, unless interest rates jump, and then we have other problems, like risk assets repricing.  If you are older, almost no plan is achievable at reasonable cost if you are coming to the game now, rather than starting 15+ years ago.

And so I come to “the little market that could…” for now.  My view is that those with retirement obligations to fund are bidding up the market now.  That does two things.  Shares of risk assets (stocks) move from the hands of stronger investors to weaker investors, while cash flows the opposite direction.  In the process, prices for risk assets get bid up relative to their future free cash flows.

Unlike “the little engine that could,” the little market that could has climbed some small hills relative to the funding targets that investors need. Ready for the Himalayas?  The trouble with those targets is that regardless of what the trading price of the risk assets is, the cash flows that they produce will not support those targets.

Thought experiment: imagine that the stock market was gone and all the shares we held were of private companies that were difficult and expensive to trade.   Pension plans would estimate ability to meet targets by looking at forecasts of the underlying returns of their private investments, rather than a total return measure.

Well, guess what?  In the long run, the returns from public stock investments reflect just that — the distributable amount of earnings that they generate, regardless of what a marginal bidder is willing to pay for them at any point in time.  Stocks aren’t magic, any more than the firms that they represent ownership in.

So… we can puzzle over the current moment and wonder why the market is behaving in a placid, slow-climbing manner.  Or, we can look at the likely inadequacy of asset cash flows versus future demands for those cash flows for retirement, etc.  Personally, I think they are related as I have stated above, but the second view, that asset returns will not be able to fund all planned retirement needs is far more certain, and is one mountain that “the little market that could” cannot climb.

Thus, consider the security of your own plans, and adjust accordingly.  As I commented recently, for older folks with enough assets, maybe it is time to lock in gains.  For others, figure out what adjustments and compromises will need to be made if your assets can’t deliver enough.

Tough stuff, I know.  But better to be realistic about this than to be surprised when funding targets are not reached.