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.

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

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.

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:

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.

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:

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.

Upshots

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.

I intend to get back to answering more reader questions, and doing it through posts.  I’ve been somewhat derelict in responding to comments, and I want to do it, but time has been short.  Here is a start, because I think the answer would be relevant to a lot of readers.

From a reader in Canada:

I enjoy your writing as many of your comments generate a wider perspective than my own.  There is always something to learn.

I was too young to appreciate the last stagflationary period.  Yet, I need to manage my portfolio.  My approach is more ETF based, whereas, I see that you prefer specific stocks.

I struggle in anticipating the currency impact on my foreign holdings.  I’m a Canadian based investor.  The simple solution is to pull in my exposure and be more Canada centric.  This idea conflicts with my goal to have my portfolio weighted in similar fashion to the global markets (i.e., Canada is a very small percentage relative to the total).  I also do not subscribe to the excessive weighting in gold as a major investment theme.  To me, it’s insurance to help offset risk elsewhere.

I’m not asking for specifics as you are not familiar with my situation.  Do you have any recommended reading or suggestions to help me test my thoughts and to identify options, so that I can arrive at a better decision?

Well, I’m not that old either.  During the last stagflation, I was aged 13 to 22, from junior high through my Master’s Degree in Economics at Johns Hopkins.  That said, I have read a lot on economic history, so I understand the era reasonably.  I also spent many of my Friday evenings as a teenager watching Wall Street Week with my first teacher on investments.  (Hi, Mom! )  Another thing I remember is being the student representative to the school board for two years 1977-1979, when our district in Brookfield, Wisconsin decided to do a wide number of capital improvements in order to save energy, at the peak of the “energy crisis.”  I remember that the payback periods were 15 years or so, not counting interest that they would have to pay on the munis that they issued.  No way that project saved money on a net present value basis.  (And it was depressing to see 2/3rds of the windows covered up.)

During the last Stagflation, bonds were called “certificates of confiscation” by many professionals in fixed income.   It paid to have your fixed income assets as short as possible.  Money market funds, a new invention at the time, were the optimal place to be until about 1982, when the cycle shifted, and the longest zero coupon bonds were the new best place to be.  Timing the shift between cycles is difficult, so don’t try to time it exactly, but add more longer bonds as long rates rise.  Right now, I would stay in money market funds, inflation protected bonds, and foreign currency denominated bonds.  You have enough Canadian exposure, so aside from you money market funds, consider bond investments in the yen, Swiss franc and Euro.

As for equities, pricing power is critical.  Who can raise prices more than the cost of their inputs?  Producers of global commodities like oil, metals, etc., typically do well here.  Financial companies with short duration assets or exposure to hard assets should do better here.  Staples should do better versus durables.  Growth investing should beat value investing (uh, oh, what do I do?  All of my processes are geared toward value investing).   Cyclical names may beat them both.

If inflation really takes off, hard assets will offer some shelter though housing will lag until the inflation of real estate exceeds the deterioration of the debt.  I occasionally like gold, but it’s not a panacea.  I’d rather own the economically necessary commodities.

But what if stagflation does not become a reality?  That’s why we diversify.  I don’t tie my whole portfolio to one macroeconomic view.  Instead, I merely tilt it that way, leaving enough exposure elsewhere to compensateif my economic forecast is wrong.  I am a value investor, and almost always have a a few companies that will do well even if my economic forecast fails.

In summary: keep your domestic bonds short.  Diversify into foreign currency bonds.  Keep a diversified equity portfolio, but focus on companies that are immune to, or can benefit from inflation.

In my continuing series where I try to look beyond the current furor of the markets, here are a number of interesting items I have run into on the web:

1) Asset Allocation

• Many people who want to stress the importance of their asset allocation services will tell you that asset allocation is responsible for 90% of all returns, so ignore other issues.  An article on the web reminded me of this debate.  The correct answer to the question, as pointed out by this paper, is that asset allocation explains 90% of the variability of the returns of a given fund across time, but only explains only 40% of the variability of a fund versus other funds.  Security selection matters.
• Two interesting papers on asset class correlation.  Main upshots: historical correlations are not fully reliable, because risky assets tend to trade similarly in a crisis.  Value tends to march to its own drummer more than other equity styles in a crisis.  The effects on correlation in crises vary by crisis; no two are alike.  Natural resources and globa bonds tend to be good diversifiers.
• In bull markets, risky asset classes all tend to do well.  Vice-versa in the bear markets.  My reason for this correlation is that you have institutional asset buyers all focusing on asset classes that were previously under-recognized, and are now investing in them, which raises the correlation level, not because the economics have changed, but becuase the buyers have very similar objectives.
• There are a few good states, but by and large, public pensions are a morass.  Most are underfunded, and rely on future taxation increases to support them.  When a public system realizes that it is behind, the temptation is to take more investment risk by purchasing alternative asset classes that might give higher returns.  This will end badly, as I have commented before… I suspect that some state pension plans are the dumping grounds for a lot of overpriced risk that Wall Street could not offload elsewhere.

2) Insurance

• When the premiums get too high, people tend to stop buying insurance, or reduce coverage severely. That’s happening for Southeast windstorm coverage now, particularly in Florida.  That might be a good bet this year, but I wouldn’t press my bet in 2008 even if 2007 ends loss free.
• Similarly, when reinsurance premiums are high, insurers buy less reinsurance, and more when prices fall.  Though Swiss Re is saying that 2007 will be worse from a loss standpoint than 2006, that’s not saying much.  Swiss Re can try to avoid premium decreases, but they will lose business in the process.

3) Investment Abuse of the Elderly

It’s all too common, I’m afraid.  Senior citizens get convinced to buy inappropriate investments.  Even the SEC is looking into it.  This applies to annuities as well, mainly deferred annuities, which I generally do not recommend, particularly for seniors.  The comment that a CEO doesn’t fully understand his own annuity products is telling.

Now fixed immediate annuities are another thing, and I recommend them highly as a bond substitute for those in retirement, particularly for seniors who are healthy.

The only real cure for these deceptive practices is to watch out for the seniors that you care for, and tell them to be skeptics, and to run all major investment decisions by you, or another trusted soul for a second opinion.

4) Accounting

• I am against the elimination of the IFRS to GAAP reconciliation for foreign firms.  What is FASB’s main goal in life — to destroy comparability of financial statements?  We may lose more foreign firms listed in the US, which I won’t like, but a consistent accounting basis is critical for smaller investors.
• Congress moves from one ditch to the other.  This time it’s sale of subprime loans.  Too many modifications, and sale treatment is at risk, so Congress tries to soften the blow for the housing market.  Let auditors be auditors, and if you want the accounting rules changed, then let Congress do the job of the FASB, so that they can be blamed for their incompetence at a complex task.
• As I’ve said before, I don’t like SFAS 159.  It will lead to more distortions in financial statements, because managements will tend to err in favor of higher asset and lower liability values, where they have the freedom to set assumptions.

5) Volatility

• Earn 40%/year from naked put selling?  Possible, but with a lot of tail risk.  I remember how a lot of naked put sellers got smashed back in October 1987.  That said, it looks like you can make up the loss with persistence, that is, until too many people do it.
• Here’s an interesting graph of the various VIX phases over the past 20 years.  Interesting how the phases are multiyear in nature.  Makes me think higher implied volatility is coming.
• I don’t think a VIX replicating ETF would be a good idea; I’m not sure it would work.  If we want to have a volatility ETF, maybe it would be better to use variance swaps or a fund that buys long delta-neutral straddles, and rebalances when the absolute value of delta gets too high.

That’s all for now.  More coming in the next part of this series.

1)  Start with the pessimists:

• It’s often thought that foreigners are the ultimate dumb money, entering near the end of a bull wave, because they are the last to notice, and chase performance.  Well, they are big investors now.
• Normal forward-looking assumptions about asset class returns don’t look that bullish either.  This is similar to my argument in this RealMoney article.

2)  Move to the optimists:

• When stocks trade like a herd, the past short-term price movements have been up on average.
• With the Dow Industrials, the dividend yield may be cheap relative to high quality bonds.  Hidden assumption: average future dividend growth or better.
• Insiders are buying.  Really, insiders are buying.
• P/Es are low in the eyes of some.  (Of course, profit margins are high…)
• The guy who said “Sell Sell Sell,” now says “Buy Buy Buy.”  (Of course, this is Europe, but equity markets are pretty correlated.)

3) Hedge funds are getting outflows at present (and here), and August performance was pretty bad (and here — look at  “Splutter”).  I began toting up a list of notable losers, but it got too big.  One positive note, many of the large quant funds bounced back from their mid-August stress.

4)  When muni bonds get interesting, you know it’s a weird environment.  It starts with the fundamental mismatch of muni bonds.  Muni issuers want to lock in long term financing, but most investors want to invest shorter.  Along come some trusts that buy long bonds and sell short-dated participations against them, and hedge the curve risk with Treasuries.  When credit stress got high, long munis were sold because they could be, and long Treasuries rallied, which was the opposite of what was needed for a hedge.  (Note: hedging with Treasuries can work in normal markets, but fails utterly in panics, as happened in 1998.)  When the selling was done, in many cases high quality muni yields were high than Treasuries even before adjusting for taxes.  That didn’t last long, but munis are still a good deal here.

5) Large caps are outperforming small caps.  Foreign exposure that large caps have here is a plus.

6) Not all emerging markets are created equal.  Some are more likely to have trouble because they are reliant on foreign financing. (Latvia, Iceland, Bulgaria, Turkey, Romania)  Others are more likely to have trouble if the US economy slows down, because they export to us. (Mexico, Israel, Jordan, Thailand, Taiwan, Peru)  I would be more concerned about the first group.

7) Are global banks cheap?  Yes on an earnings basis, probably not on a book basis.  We need to see some writedowns here before the group gets interesting.

I’ve talked about SFAS 159 before, and you know I think it is a bad accounting rule.  This article from my friend Peter Eavis helps to point out some of the ways that it allows too much freedom to managements to revalue assets up.  What I would watch in financial companies is any significant increase in their need for financing, which could point out real illiquidity, even though the balance sheet might look strong; this one is tough because financials are opaque, and the cash flow statement is not so useful.  Poring over the SFAS 159 disclosures will be required as well.

9) As I have suggested, pension plans will probably end up with a decent amount of the hit from subprime lending, through their hedge fund-of-funds.

10) Hedge funds do better if the managers went to schools that had high average SAT scores?  I would not have guessed that.  Many of the best investors I have known were clever people who went to average schools.

11) My but bond trading has changed.  When I was a corporates manager, hedge funds weren’t a factor in trading.  Now they are 30% of the market.  Wow.  Surprises me that volatility isn’t higher.

12) Rich Bernstein of Merrill (bright guy) is getting his day in the sun.  His call for outperformance of quality assets seems to be happening.  Now the question is whether the cost of capital is going up globally or not.  If so, he says to avoid: “1) China, 2) emerging market infrastructure, 3) small stocks, 4) indebted U.S. consumers, 5) financial companies, 6) commodities and energy companies.“  Personally, I think the cost of capital is rising for companies rated BBB and below, which brings it back to the quality trade.

13) Econocator asks if markets have priced in a recession, and he says no. My problem with the analysis is that we would need 10-year Treasury yields in the 2.5% area to fully price it in by his measure, and that makes no sense, outside of a depression, and then, nothing is priced in.

14) Morningstar moves into options research.  Could be interesting, though Value line has had a similar publication, and I’m not sure that the market for publications like this is big enough.  They make a good point that most people use options wrong, and get the short end of the stick.

15) Oil is amazing, but wheat is through the roof.  I’ve seen articles about bread prices rising.  Fortunately, the cost of grain is a small part of the cost of foods that rely on grain.

With that, I bid you good night.

So, what’s happening in the global economy?  Let’s start with the weak dollar.  As Fed policy tilts toward loosening, the already weak dollar hits a 15-year low, and is less than 2% from an all time low.  The carry trade currencies, the yen and the Swiss franc, rallied the most during the dollar sell-off.  (Here’s a good summary article on the carry trade.)

It’s not that foreigners are fleeing the dollar (unlike this article), though Treasuries are getting less attractive, because the dollar-based investments must be bought by someone.  That doesn’t mean the exchange rates don’t shift down in the process, though, and exports seem to be improving because of the weaker dollar.  Also, the idea that China would try to ruin the US through selling all of their dollar-based reserves is unlikely, though not impossible.  China is too big of a holder to sell without driving the dollar down massively, which would force down the value of their remaining holdings, and harm their ability to export to the US.

Besides, what would they trade into?  The US has the largest, most diverse debt markets in the world.  One reas
on why the US is the world’s reserve currency, despite all of its flaws, is that there is no other economy with a currency capable of filling the role.  Perhaps this article should have been titled, “Why isn’t the dollar falling more?” because the dollar has been falling, yet there are some things good about the dollar, and the US economy.

China is bumping up against the boundaries of its economy’s current capacity.  With few additional young laborers, wage rates are rising.  Inflation is now at a 10-year high.  That’s leading the government to tighten monetary policy.  Beyond that, it is raising the prices of their exports, which slowly forces inflation into the US and other trading partners.

India is facing similar difficulties.  Wages are rising rapidly, amid rapid real growth, putting pressure on interest rates to rise.  In one sense, this is what you get for taking back US assets in exchange for selling goods and services to the US.  So long as your labor pool appears inexhaustible, you can avoid inflation at home, because you aren’t paying new workers much.  But when workers become more scarce, the absence of imported goods for those workers to buy means that there will be inflation.  Also, excess dollar reserves often produce excess credit, if the central bank allows the money supply to grow from the dollar reserves, which can lead to credit-induced inflation.

Final quick notes:

• Doesn’t look like the ECB, or any other major developed country central bank will tighten anytime soon.  India and China are different here.
• As for Japan, if the credit crunch isn’t enough, GDP shrank recently.  No tightening likely there.
• For average people planning on retirement, a declining dollar will hurt a little, but not a lot.  It will add to inflation, and perhaps raise US interest rates, harming bond returns in the short run.  Also, for those with no foreign investments, a declining dollar means foregone returns.

In summary, we are in a situation where the dollar is likely to remain weak.  If currency calm returns, the carry-trade currencies will do badly, but if volatility picks up, the opposite will happen.  (I can make a case either way.)  China and India are on fire, and the developed nations are largely on ice.  We are living in interesting times; in the long run, the development of the poorer areas of the world will be a big plus, particularly for US agriculture and resource extraction industries, but there will be bumps along the way.  Keep your positions flexible enough to be able to benefit from volatility; I sense we are entering a more volatile period.

Part 1 of this unintended series came two weeks ago, when the FOMC was resolute that there were no problems in the markets that could potentially har,m the economy.  Then, one week later, after the FOMC showed that it was willing to toy around with temporary liquidity, I knew that I had to change my FOMC opinion, and rapidly.  It’s akin to a situation where someone protests their virtue, but cheats a little; at that point the question become how far he will go.  With the FOMC, a small change in temporary liquidity would not convince the banks of the seriousness of the FOMC, and would engender no additional confidence.  Given that the FOMC showed that it wanted to fix the problem, it had to ask the question, “What’s the minimum we can do to make the problem go away?”  Or at least, get the problem away from the Fed’s door?

Here’s the problem, though.  In a credit crisis, there is variation in how much trouble each firm is in.  When the FOMC provides liquidity, it stimulates healthy firms and provides no stimulus at all to firms that will die, because the credit spreads to those firms are too wide, assuming that anyone will lend at all to them.  It’s the marginal firms that benefit the most from a change in Fed policy to loosening.  The earlier the FOMC acts in a credit crisis, the fewer marginal firms go under.  The lowering of short term rates convinces lenders that the marginal firms can be refinanced at lower rates, and after some fitful action, the weak but not dead survive (and their stocks fly).  Also, the earlier the FOMC acts, the more moral hazard it creates, because the markets know that the FOMC will rescue them, and so they take risk to excess.

Now, a lowering of the discount rate, and encouragement to use it,  does several things.  Unlike Fed funds, lower quality collateral can be lent against.  The encouragement to borrow reduces the stigma; it tells the bankers that the regulators won’t cast a jaundiced eye on borrowing.  (Previously bankers would worry about that.)  That will to some degree reliquefy the market for riskier assets, but given that credit spreads have blown out for a wide variety of Asset-, Residential Mortgage-, and Commercial Mortgage-Backed securities, how much will 1/2% on the discount rate do?  My guess: not much.

Now, the change in the bias does more.  It shows that the FOMC will start permanently loosening Fed funds, probably at the September meeting, unless conditions worsen soon.  They still haven’t injected any permanent liquidity yet, aside from what little the discount window will bring, so some marginal firms will continue to deteriorate until then.

That they did a rare intermeeting announcement highlights the FOMC’s commitment to reliquefying the economy.  They are into the game with both feet, betting their socks and underwear.

Here’s my projection, then.  There are still a lot of hedge funds that are presently alive that will die in the next six months. Housing prices will continue to go down, dragging down hedge funds and financial institutions with overcommitments to alt-A loans and home equity loans.  There will be howls of pain from them and their lenders, which will goad the FOMC into loosening more than is currently believed.  I see a 3% Fed funds target rate at some point in 2008, barring a US Dollar crisis (possible), or inflation (however well-massaged) convincingly exceeding 3%.

A few final points before I end. The communication of Governor Poole certainly could have been handled better.  We got a real whipsaw in the markets as a result.  I have mentioned in the past that he is often out of step on the hawkish side; this was another example.  But for the repudiation to come so quickly was astounding.  As it was, the New York (read, Wall Street) and San Francisco (read, Countrywide) Regional Federal Reserve Banks sponsored the actions, and all but Poole’s district, St. Louis, went along, and asked for cuts in the discount rate.  St. Louis, caught off guard, belatedly asks for the same thing but starting Monday, not today.

Now, do I favor this from a public policy standpoint?  No.  Let the system purge, that risk once again gets respected.  You can hear the indignation on some market participants, like my friend Cody Willard, and Allan Sloan at Fortune, who wonder why we bail out extreme risk takers.  (My take, the extreme risk takers will still get purged, but the marginal ones won’t.)  Others, like Larry Kudlow, and perhaps Rich Karlgaard at Forbes, wring their hands over moral hazard, but say it has to be done this time to preserve the economy.  Then you have clever realpolitik coming from Caroline Baum of Bloomberg (written before today’s moves), who says that Bernanke will do all he can to prevent another Depression.  Beyond that, we get booyahs from Cramer, PIMCO, and a few others.

So here we are, two weeks later.  The stock market is lower. Yields on the highest quality debt is lower, and low quality yields are higher.  Option volatilities for almost all asset classes are much higher.  The separation of firms viewed as marginal now will continue to get separated into two piles, dead and survived.  In the last FOMC loosening cycle it took three years to get there, from March of 2000 to the spring of 2003, when the high yield market realized the crisis was past.  And housing was flying.  Amazing what reliquefication can do for a healthy sector, and creating the next bubble too.

This won’t be over in a short amount of time.  Look for quality firms that can benefit from lower funding costs, and toss out firms where additional financing is needed, but won’t be available because of high credit spreads, devalued collateral, etc.  Buy some TIPS too, and maybe some yen [FXY] and swiss francs [FXF].  Dollar purchasing power will continue its decline.

Liquidity, that ephemeral beast.  Much talked about, but little understood.  There are five pillars of liquidity in the present environment.  I used to talk about three of them, but I excluded two ordinary ones.  Here they are:

1. The bid for debt from CDO equity.
2. The Private Equity bid for cheap-ish assets with steady earnings streams.
3. The recycling of the US current account deficit.
4. The arbitrage of investment grade corporations buying back their own stock, or the stock of other corporations, because with investment grade yields so low, it makes sense to do it, at least in the short run.
5. The need of Baby Boomers globally to juice returns in the short run so that their retirements will be adequate.  With equities, higher returns; with bonds, more yield.  Make that money sweat, even if we have to outsource the labor that our children provide, because they are too expensive.

Numbers one and two are broken at present.  The only place in CDO-land that has some life is in investment grade assets.  We must lever up everything until it breaks.  But anything touched by subprime is damaged, and high yield, even high yield loans are damaged for now.

With private equity, it may just  be a matter of waiting a while for the banks to realize that they need yield, but i don’t think so.  Existing troubled deals will have to give up some of the profits to the lenders, or perhaps not get done.

Number three is the heavy hitter.  The current account deficit has to balance.  We have to send more goods, assets, or promises to pay more later.  The latter is what is favored at present, keeping our interest rates low, and making equity attractive relative to investment grade debt.  Until the majority of nations buying US debt revalue their currencies upward, this will continue; it doesn’t matter how much they raise their central bank’s target rate, if they don’t cool off their export sectors, they will continue to stimulate the US, and build up a bigger adjustment for later.

With private equity impaired, investment grade corporations can be rational buyers of assets, whether their own stock, or that of other corporations that fit their operating profiles. Until investment grade yields rise 1-2%, this will still be a factor in the markets, and more so for foreign corporations that have access to cheap US dollar financing (because of current account deficit claims that have to be recycled).

The last one is the one that can’t go away, at least not for another seven years as far as equities go, and maybe twenty years as far as debt goes.  There is incredible pressure to make the money do more than it should be able to under ordinary conditions, because the Baby Boomers and their intermediaries, pension plans and mutual funds, keep banging on the doors of companies asking for yet higher returns.  With debt, there is a voracious appetite for seemingly safe yet higher yielding debt.  The Boomers need it to live off of.

So where does that leave us, in terms of the equity and debt markets?  Investment grade corporates and munis should be fine on average; prime MBS at the Agency or AAA level should be fine.  Everything else is suspect.  As for equities, investment grade assets that are not likely acquirers look good.  The acquirers are less certain.  Even if acquisitions make sense in the short run, it is my guess that they won’t make sense in the long run. On net, the part of the equity markets with higher quality balance sheets should do well from here.  The rest of the equity markets… the less creditworthy their debt, the less well they should do.

Everything old is new again.  If we jumped into the “wayback machine” (“Where are we going Mr. Peabody?”) and turned the dial to 1957 (“1957. We are going to meet Elvis, Sherman.”) we would find that the few equity investors that are there are highly concerned about yield, and that the yield on stocks was threatening to dip below the yield on bonds.

This was the twilight for yield-based investing.  Through the next fifty years, there would be among value investors a few absolute yield investors that prospered for a time, then died when interest rates rose, and a few relative yield investors who would die when credit spreads blew out. (Note: an absolute yield manager will only buy stocks with more than a given yield, like 4%; a relative yield manager will only buy stocks that yield more than a benchmark, like the yield on the S&P 500.)

As an example, when I was with Provident Mutual in the mid-1990s, I created a series of multiple manager funds.  One was a value fund that we were creating to replace an absolute yield manager who had done exceptionally well over the past 19 years, but cruddy over the last four.  Assets had really built up in that fund, and our clients were getting jumpy.

A large part of the problem was that interest rates had fallen from 1980 through 1993, but had risen since.  Buying steady cash generating low-growth companies while interest rates were falling was a thing of genius.  As interest rates fell, the dividend stream was worth more and more.  When interest rates rose, that pattern reversed, and 1994 was particularly ugly.  We sacked the absolute yield manager as a one trick pony.  A wise move in hindsight.

Now we have enhanced indexers basing whole strategies off of yield, because their backtests show that yield is an effective variable for allocating portfolio weights.  Given that the last 25 years or so have had falling interest rates, this should be no surprise.  Yield will always be an effective variable when rates fall; but what if rates rise?

Also, what happens when Congress does not renew the reduction of the tax on dividends?  Don’t get me wrong, I like dividends; my portfolios yield much more than the markets.  But I don’t go looking for dividends.  I look for companies that generate cash earnings.  What they do with the cash earnings is important; I don’t want management reinvesting the cash foolishly, but if they have good investment prospects, then please don’t send me dividends.

Roger Nusbaum ably pointed out how demographics favors an increasing amount of dividends being paid to retiring Baby Boomers.  That is true.  We have ETNs being set up to do that (beware of Bear Stearns default risk), and hedge fund-of-funds crowding into strategies that synthetically create yield.  Beyond that, we have Wall Street creating funky yield vehicles that gyp facilitate the yield needs of buyers (while handing them capital losses).

My main point is this.  Approach yield the way a businessman would.  If you see an above average yield, say 4% or higher, ask what conditions could lead them to lower the yield. History is replete with situations where companies paid handsome dividends for longer than was advisable.

Back in 2002, I heard Peter Bernstein give an excellent talk on the value of dividends to the Baltimore Security Analysts Society.  At the end, privately, many scoffed, but I thought he was on the right track.  I still like dividends, but I like businesses that grow in value yet more.  Aim for good returns in cash generating businesses, and the dividends will follow.  Stretching for dividends is as bad as stretching for yield on bonds.  That extra bit of yield can be poisonous, leading to capital losses far greater than the incremental yield obtained.

With all of the concern in the present environment, it is good to be reminded of the actions one should take in order to reduce risk in the present, should the investment environment turn hostile in the future.

1. Diversify by industry, country, currency, inflation-sensitivity, yield, growth-sensitivity and market capitalization
2. Diversify by asset class. Make sure you have liquid safe assets to complement risky assets. This is true whether you are young (tactical reasons) or old (strategic reasons).
3. Diversify by advisors; don’t get all of your ideas from one source (and that includes me). In a multitude of counselors, there is wisdom, which is something to commend RealMoney for — there is no “house view.”
4. Diversify into enough companies: better to have smaller positions in 15-20 companies, than 5 larger ones. When I began investing in single stocks 15 years ago, I started with 15 positions of $2,000 each. That made each $15 commission bite, but the added safety was worth it.
5. Avoid explicit leverage; don’t use margin.
6. Avoid shorting as well, unless you’ve got a profound edge; few are constitutionally capable of doing it well. Are you the exception?
7. Avoid implicit leverage. How much does the company in question rely on the kindness of the financing markets in order to continue its operations? Highly indebted companies tend to underperform.
8. Avoid balance sheet complexity; it can be a cover for accounting chicanery.
9. Analyze cash flow relative to earnings; be wary of companies that produce earnings, but not cash flow from operations, or free cash flow.
10. Avoid owning popular companies; they tend to underperform.
11. Avoid serial acquirers; they tend to underperform. Instead, look at companies that do little in-fill acquisitions that they grow organically.
12. Analyze revenue recognition policies; they are the most common way that companies fuddle accounting.
13. Focus on industries that are out of favor, and look for strong players that can withstand market stress.
14. Focus on companies with valuations that are cheap relative to present fundamentals, particularly if there are low barriers against competition.
15. Take something off the table when the markets run, and edge back in when they fall.
16. Analyze how any new investment affects your total portfolio.
17. Don’t use any investment strategy that you don’t fully understand.
18. Understand where you have made errors in the past, so that you can understand your weaknesses, and avoid acting out of weakness.
19. Buy only the investments that you want to buy, and not what others want to sell you. Use only investment strategies with which you are fully comfortable.
20. Find ways to take the emotion out of buy and sell decisions; treat investing as a business.
21. Match your assets to the horizon over which you will need the proceeds. Risky assets should not get a heavy weight when the proceeds will be needed within five years.
22. When you get a new idea, and it seems like a “slam dunk,” sit on it for a month before acting on it. More often than not, if it is a good idea, you will still have time to act on it, but if it is a bad idea, you have a better chance of discovering that through waiting.
23. Prune your portfolio a few times a year. Are there new companies to swap into that are better than a few of your current holdings?
24. Size positions inversely to risk levels.
25. Finally, think about risk before you need to; make it a positive component of your strategies.

Remember, risk preparation begins today. That way, you will be capable to invest in the bargains that a real bear market will produce, and not leave the investment game disgusted at yourself for losing so much money.

If I had a dollar for every person that I knew who ignored risk in the late 90s, and dropped out of investing in 2002, just in time for the market to turn, I could buy a nice dinner for you and me in DC, near where I work. So, analyze the riskiness of your portfolio today, and prepare now for the bad times that will eventually come, whether this year, or four years from now.

I am an investor who does not consider background academic and semi-academic research to be worthless, even though I am skeptical of much of quantitative finance. Here are a few articles to consider that I think have some importance.

1. Implied volatility is up. Credit spreads are up, and the equity market has not corrected. Time to worry, right? Wrong. When implied volatilities (and credit spreads) are higher, fear is a bigger factor; valuations have already been suppressed. Markets that rally against rising implied volatility typically have further rises in store.
2. Many thanks to those that liked my piece on the adaptive markets hypothesis. Here is a piece about Andrew Lo, one of the biggest proponents of the AMH, which fleshes out the AMH more fully. I would only note that the concept of evolution is not necessary to the AMH, only the concepts inherent in ecological studies. Also, all of the fuss over neuropsychology is cute, but not necessary to the AMH. It is all a question of search costs versus rewards.
3. John Henry alert! Will human equity analysts be replaced by quantitative models? Does their work have no value? My answer to both of those questions is a qualified “no.” Good quant models will eat into the turf of qualitative analysts, and kick out some of the marginal analysts. As pointed out by the second article analysts would do well to avoid focusing on earnings estimates, and look at other information that would provide greater value to investors from the balance sheet and cash flow statement. (I am looking at Piotroski’s paper, and I think it is promising. He has made explicit many things that I do intuitively.
4. I work for a hedge fund, but I am dubious of the concept of double alpha. It sounds nice in theory: make money off of your shorts and longs without taking overall market risk. As I am fond of saying, shorting is not the opposite of being long, it is the opposite of being leveraged long, because in both cases, you no longer have discretionary control over your trade. Typically, hedge fund investors are only good at generating alpha on the long side. The short side, particularly with the crowding that is going on there is much tougher to make money at. If I had my own hedge fund, I would short baskets against my long position, and occasionally companies that I knew had accounting problems that weren’t crowded shorts already (increasingly rare).
5. Maybe this one should have run in my Saturday piece, but some suggest that we are running out of certain rare metals. I remember similar worries in the early 70s, and we found a lot more of those metals than we thought possible then. There is probably a Hubbert’s peak for metals as well, but conservation will increase the supply, and prices will rise, quenching demand.
6. For those that remember my piece, “Kiss the Equity Premium Goodbye,” you will be heartened to know that my intellectual companion in this argument, Morningstar, has not given up. Retail investors buy and sell at the wrong times because of fear an greed, so total returns are generally higher than the realized returns that the investors recieve.
7. When there are too many choices, investors tend to get it wrong. When there is too much information, investors tend to get it wrong. Let’s face it, we can make choices between two items pretty well, but with many items we are sunk; same for choosing between two interpretations of a situation versus many interpretations. My own investing methods force me to follow rules, which limits my discretion. It also forces me to narrow the field rapidly to a smaller number of choices, and make decisions from that smaller pool. When I make decisions for the hedge funds that I work for, I might take the dozen names that I am long or short, and compare each pair of names to decide which I like most and least. Once I have done that, numeric rankings are easy; but this can only work with small numbers, because the number of comparisons goes up with the square of the number of names.
8. Jeff Miller aptly reminds us to focus on marginal effects. When news hits, the simple linear response is usually wrong because economic actors adapt to minimize the troubles from bad news, and maximize the benefits from good news. People don’t act as if they are locked in, but adjust to changing conditions in an effort to better their positions. The same is true in investing. Good news is rarely as good as it seems, and bad news rarely as bad.
9. This article describes sector rotation in an idealized way versus the business cycle, and finds that one can make money using it. Cramer calls methods like this “The Playbook.” (Haven’t heard that in a while from Cramer. I wonder why? Maybe because the cycle has been extended.) I tend not to use analyses like this for two reasons. First, I think it pays more to look at what sectors are in or out of favor at a given moment, and ask why, because no two cycles are truly alike. They are commonalities, but it pays to ask why a given sector is out of line with history. Second, most of these analyses were generated at a time when the US domestic demand was the almost total driver of economic activity. We are now in a global economic demand context today, and those that ignore that fact are underperforming at present.
10. Finally, it is rare when The Economist gets one wrong. But their recent blurb on bond indexing misses a key truth. So bigger issuers get a greater weight in bond indexes. Index weightings are still proportional to the range of choices that a bond manager faces. Care to underweight a big issuer because they have too much debt outstanding? Go ahead; there are times when that trade is a winner, and times when it is a loser. Care to buy securities away from the index? Go ahead, but that also can win or lose. If bond indexes fairly represent the average dollar in the market, they have done a good job as a benchmark; that doesn’t mean they are the wisest investment, but indexes by their very nature are never the wisest investment, except for the uninformed.

Well, that’s it for this evening. Let’s see how the market continues to move against the shorts; there are way too many shorts, and too many people wondering why the market is so high. Modifying the concept of the pain trade, maybe the confusion trade is an analogue, the market moves in a way that will confuse the most people.