Asset Allocation – Page 24

The Equity Premium is No Longer a Puzzle

Posted on 15 July 2009 by David Merkel

For a number of years, I have mused over the equity premium puzzle, and have generally written that the premium return that equities earn over stocks is less than most asset allocators assume. In January 2006, wrote an article on this topic at RealMoney: Kiss the Equity Premium Goodbye.? A few quotes:

This article won’t win me a lot of friends in the money management industry. Here’s the skinny: Stocks are unlikely to return much more than bonds over the next 10 to 20 years.Most investment consultants tell people to invest in equities because, in the long run, stocks beat bonds and cash. I agree, but how big is this advantage? Many studies suggest that the equity premium is somewhere in the vicinity of 6%; i.e., stocks beat cash by 6 percentage points a year. Against bonds, the advantage is said to be 4% or so.

However, there are persuasive arguments that the value of the equity premium will be much lower going forward. In the book Triumph of the Optimists, Elroy Dimson, Paul Marsh and Mike Staunton argue that the future equity premium in the U.S. is likely to be closer to 4% over cash for two main reasons:

Corporate cash flows have grown faster in the last 50 years than in the prior 50, and investors have bid up stocks as a result. However, the authors believe that such high rates of growth will not continue. If corporate cash flow growth reverts to the rate of the first half of the 20th century, future returns based on current equity values will be poor indeed.

Perceived risk in stock investing has diminished. Investors have bid prices up in anticipation that the equity premium is higher than it should be, and on the belief that it is not risky to try to capture it.

The researchers Peter Bernstein and Robert Arnott draw similar conclusions, but they get there in different ways. They point out that over the years, the size of the future equity premium has varied with the level of belief in its existence. When market players deny its existence, equity valuations are low, past equity performance has probably been poor, and the future equity premium is large — think of 1931, 1937, 1974, 1982, November 1987 and 2002. When everyone believes in the inevitability of stocks, ? la “Dow 36,000” (we’ll get there by 2025 or so), equity valuations are high, past equity performance has probably been great, and the future equity premium is small — think 1929, 1972, August 1987 and February 2000.

I believe stocks have been bid up because of the benefit needs for the retirement of the baby boomers. Though the savings rate is low, investment vehicles such as pension plans have made large commitments to equities, partially because plan sponsors can justify lower contributions to benefit plans by assuming a high rate of return, which stems from assuming that the equity premium will persist.

and this:

This doesn’t directly generalize to the market as a whole, because all stocks are owned by someone at the end of each day. Isn’t there always a buyer for every seller, and vice versa? Yes, but they aren’t always public-market buyers and sellers. Cash comes into the market via IPOs (both primary and secondary), rights offerings and any other way that new shares get created for the payment of cash. Cash comes out of the market through dividends, buybacks and any other way that companies disburse cash to shareholders, whether directly or in exchange for shares.

Companies tend to sell stock when it is advantageous; IPOs happen more frequently when valuations are high, and buybacks happen more frequently when valuations are low. This suggests a project for future study: Calculate the dollar-weighted return for the public equity market as a whole, and compare it with the time-weighted return figures.

It’s a difficult but not impossible project, but I don’t have the time or resources to do it. If it hasn’t been done already, it might make a rare practical Ph.D. thesis for someone. Returns for the market as a whole would equal the change in market value, plus the cash cost of shares taken out of the market (buybacks, LBOs, etc.) and dividends, less the cash added to the market through IPOs and other forms of share issuance for cash (i.e., employee stock option exercise, rights offerings, etc.). I don’t have firm numbers, but my guess is that dollar-weighted returns are less than the time-weighted returns by 1 percentage point, give or take 50 basis points.

Though the composition of an index fund changes by period to reflect additional equity issuance/buyback by companies in the index, it misses the effect on returns from having to allocate more capital when valuations are high, and having to receive capital back when valuations are low. In a whipsaw period like that which we have had from 1998 to the present, it makes a lot of difference, because many investments during the bubble era put fresh capital into the market at a time of high valuations, with buybacks predominating as valuations troughed.

In short, though the academic studies rely on time-weighted rates of return for their conclusions regarding the equity premium, which represents buy-and-hold investors, dollar-weighted returns, which is what most investors actually receive on their investments, are lower. The difference occurs because corporations issue stock when valuations are high, and retire it when valuations are low.

Okay, here’s the punchline — with not just a hat tip, but a full bow to Eric Falkenstein at Falkenblog, Ilia D. Dichev has done the research that I wanted to see done.? The difference between time-weighted and dollar-weighted returns is around 1.3% for NYSE stocks (1926-2002), around 5.3% for NASDAQ stocks (1973-2002), and 1.5% for developed market stocks generally? (1973-2004).

Doing a very rough average, and considering that the NASDAQ was in a boom period for most of the study period, I am comfortable with a reduction in the US equity risk premium over bonds down to 1-2% on average, and over cash to 3-4% on average.

At that level, being in stocks works for long term investing, but it would almost never pay to be 100% in stocks.? The old 60/40 stocks/bonds allocation begins to look really intelligent over the long haul, but maybe not today because high quality bond yields are so low.

So, where does this leave me on the equity premium puzzle?? It is no longer a puzzle.? One can gain moderately over the very long haul in stocks versus bonds, but with significant volatility.? Don’t risk what you can’t afford to lose in the stock market, and other risky investment vehicles.

PS — this makes the old dictum on the cost of equity valid again — the cost of equity capital for a firm should be 2-3% above their longest bond yield.? Bye, bye, CAPM.

Some Practical Thoughts on Asset Allocation

Posted on 12 July 2009 by David Merkel

When I think about asset allocation, I typically begin with my model that chooses between BBB corporate bonds and common stocks.? The model still favors corporate bonds.? After that, I look at the bond market, and ask myself where I think risks have more than adequate compensation.? I look at the following factors:

Duration (Average Maturity is similar, sort of) — do we get fair compensation for lending long?
Convexity — does the bond benefit or get hurt by interest rate volatility?
Credit — are we getting decent compensation for credit risk?
Structure — Structured notes always trade cheap to rating, but how cheap?
Collateral/Sectors — Are there any collateral classes or sectors that are trading cheap to their fundamentals?
Illiquidity — are illiquid issues trading stupidly cheap?
Taxes — How are munis trading relative to tax rates and creditworthiness?
Inflation — is the CPI expected to accelerate?
Foreign currency — if nothing looks good on the above (or few things look good), perhaps it is time to buy non-dollar denominated notes.? My view is buy foreign currencies when nothing else looks good, because foreigners will do the same.

At present, I am not crazy about corporate credit relative to other bonds.? I would move up in quality.

We are getting decent compensation for duration risks, so I would buy some amount of long Treasuries.? I would also hold some cash, running a barbell.

On convexity, I would be market weight in conforming mortgages.? If I had an edge in analyzing non-conforming mortgages, I would buy highly rated tranches of seasoned deals (2005 and before).

I would do a lot of analysis, and buy seasoned CMBS (2005 and before) — there are real risks, but the seniors should not get killed.

Munis offer promise for taxable accounts — the difficulty is doing the credit analysis on long bonds.

On inflation — I am not a fan of TIPS right now.? I would rather buy foreign bonds.? The actions of foreign nations lend themselves to dollar depreciation.

So, where would I go with a portfolio that has an intermediate horizon, say, 5-10 years out?

30% global equities — half US, half foreign (emphasize value, but not financials)
15% long Treasuries
15% residential mortgages — seniors, conforming
10% CMBS seniors
15% cash
15% foreign bonds

Yeah, I know this seems conservative, but I am not a believer in the current rally in stocks or corporate debt.? This is a time to preserve capital, not hunt for yield.

Toward a New Concept of Asset Allocation

Posted on 10 July 2009 by David Merkel

To my readers: thanks for your responses to yesterday’s article.? I will do a follow up piece soon.? If you have more comments please make them — they will help me with the piece.? Main new concepts coming — need for a deliverable, speculators can’t trade with speculators, only hedgers.

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Longtime readers know that I am not a fan of modern portfolio theory.? It is a failure for many reasons:

It assumes there is one type of risk, the occurence of which is random.
It assumes that this risk can be approximated by volatility (variance of returns), rather than probability of loss, and the likely severity thereof.
Mean return estimates, volatility estimates, and correlation coefficient estimates aren’t stable.
In crises, correlations head to 1 or -1.? Assets divide into safe and “not safe.”
Problem: some assets always fall into the “not safe” bucket, but what falls into the safe bucket can vary.? Long Treasuries and commodities could be examples of assets that vary during a crisis, depending on the type of crisis.
It does not recognize multiple time horizons easily.? Bonds held to maturity have a different risk profile than a constantly rebalanced portfolio.
Risk is the same for all people, and their decision-making time horizons are the same as well.
And more…

I’m still playing around with the elements of what would make up a new asset allocation model, but a new model has to disaggregate risk into risks, and ask some basic questions:

Where am I getting paid to take risk?
Where am I getting paid to avoid risk?
What aspects of the financial landscape offer the potential for a change in behavior, even if it might take a while to get there?? What major imbalances exist?? Where are dumb people making money?
Where options are available, how is implied volatility relative to long-term averages?
What asset classes have momentum to their total returns?

One good example of an approach like this is Jeremy Grantham at GMO.? Asset allocation begins by measuring likely cash flow yields on asset classes, together with the likelihood of obtaining those estimates.? With domestic bonds, the estimates are relatively easy.? Look at the current yield, with a haircut for defaults and optionality.? Still there is room to add value in bonds, looking at what sectors are cheap.

Are corporate spreads narrow or wide?
How are residential mortgage bonds priced relative to agency bonds, after adjusting for negative optionality?
How steep is the yield curve, and where is Fed policy?
What is the speculative feel of the market now?? Bold? Scared? Normal?
Related, how are illiquid issues doing?? Are they permafrost, or are molasses not in January?
If every risk factor in domestic bonds looks lousy, it is time to make a larger allocation to foreign bonds.
Cash is underrated, and it is safe.

Understanding bonds is an aid to understanding the rest of the market.? The risk factors in play in the bond market are more transparent than elsewhere, but the rest of the markets eventually adjust to them.

With stocks and commodities, the answer is tougher — we have to estimate future demand and supply for commodities.? Tough.? With stocks, we need to estimate future earnings, and apply a P/E multiple that is consistent with the future yield on BBB corporate bonds.? There is some degree of mean-reversion that can help our estimates, but I would not rely on that too heavily.

There is one more aspect to layer in here: illiquidity of equity investments.? With limited partnerships of any sort, whether they are hedge funds, venture capital, private equity, etc., one has to analyze a few factors:

Where is the sector in its speculative cycle?? Where are secondary interests being sold?
How much capacity do you have for such investments?? How much of your liability structure is near-permanent?? Is the same true of peer institutions?
Is the public equity market overvalued or undervalued?? Public and private tend to track each other.

Beyond that we get to the structure and goals of the entity neding the assets allocated.? Time horizon, skittishness, and understanding levels are key for making a reasonable allocation.

This is just my initial brain dump.? It was spurred by this article in the WSJ, on how asset allocation had failed.? Add in the article on immediate annuities, which are a great aid in personal retirement planning.? For those that think that immediate annuities reduce the inheritance to the children, I would simply say that it is longevity insurance.? If the annuitant lives a long time, he might run out of assets, and might rely on his children for help.? The immediate annuity would be there to kick in something.

Why did asset allocation fail in 2008?? All risk assets failed.? Stocks, corporate bonds, venture capital, private equity, CMBS, RMBS, ABS… nothing held up.? There were just varying degress of loss.? Oh, add in Real Estate, and REITs.? Destroyed.? Destroyed…

When the system as a whole has too much leverage, all risky asset classes get affected.? That’s what happened in 2008, as speculators got their heads handed to them, including many who did not realize that they were speculators.

Post 1000

Posted on 8 July 20098 July 2009 by David Merkel

Every 100 posts or so, I stop to talk to my readers more personally, thank them for reading me, reflect on where we have been, and where we might be headed.

From my heart, I thank you for reading me.? You have many things to do with your time, and you deign to read me.? Thanks.? In some ways, my blog is an acquired taste.? I cover many areas thinly, because I have a broad range of interests in finance, business and economics.? I’m sure that the average reader has to endure (or ignore) 50% of what I write, and that’s fine.

Where have we been

I am reminded of Psalm 66, verse 12 in the era we have been through: Thou hast caused men to ride over our heads; we went through fire and through water: but thou broughtest us out into a wealthy place. [KJV]? The wealthy place is not yet here.? This has been a chaotic time.? We have seen markets destroyed, and come back to life in more limited ways.? There has been a bounce-back from panic, but options are reduced compared to where we were when I started writing this blog.? Areas of over-leverage have been revealed, even in seemingly safe areas.? There is nothing certain in such an environment.? All of the old certainties get questioned, even if they survive.

Where we are now

Though I am a value investor, and a quantitative investor, I don’t write much about my stock picks, mainly because you don’t get much praise for it, and you get a lot of complaints when you are wrong.? I wrote a piece at RealMoney that reflected my frustration in writing there about my investments.? It was called: Investing Is About the Whole Portfolio.? Too many people are looking for stock picks, when they should be looking to learn thought processes.? With a stock pick, you don’t know what to do as markets change.? Learning the thought processes is more complex, but it prepares you in how to understand the market as it changes, albeit imperfectly.

I spend a lot of time on macroeconomic and fixed income issues.? Why?? The bond market is bigger than the stock market, and has a big effect on the stock market.? I keep toying with an idea that would replace Modern Portfolio Theory, with something that would use contingent claims theory to develop a consistent cost of capital model for enterprises.? Essentially, it says that in ordinary circumstances, the more risk one takes in the capital structure of a company, the higher the return required to invest.? Estimate the implied volatility of the assets, and then apply that to the liabilities and equity.

Another way of saying it is that we can learn more from the shape of the yield curve and credit spreads than by looking at backward-looking estimates of asset class returns.? I continue to be amazed at those that use historical averages for asset allocation.? Start with the yield curve.? That will give you a good estimate on bond returns.? When credit spreads are high, typically it is better to be in corporate bonds rather than stocks, but it does imply that stocks might be cheap relative to Treasury bonds.

Most of the time the markets as a group tell the same story.? It gets interesting where one is out of line from the others.? My current example is banks exposed to commercial real estate versus REIT stocks and bonds, and CMBS.? The banks are not reflecting the future losses, but the REITs and CMBS are reflecting the losses.? Chalk it up to accounting rules for the banks.

Where are we going?

Demographics is destiny, to some degree.? Countries that shrink, or have large pension/healthcare promises will have a hard time of it.

Defaults are rising in both the corporate and consumer sectors.? Anyone who thinks the financials are out of the woods is wrong.? Even as new housing sales rise, there are many defaulting on their mortgages because they can’t afford their mortgages, or think that they are stuck with too much payment for too little house.? Add onto that continuing problems with commercial mortgage defaults and corporate defaults.

The Dollar is a problem in search of a solution.? None of the solutions are any good, so changes get delayed until the pain can’t be stood anymore.? This could be decades or years — but the Dollar is in decline.

The world has more laborers, the same amount of capital, and declining resources.? Relatively, the price of labor should go down, and the price of resources up.? The value of capital will fluctuate in-between.

Where is this blog headed?

We are going in my own idiosyncratic direction.? That means when crises hit, I will be there.? Aside from that, I will talk about the issues that affect the markets more generally.? There will be book reviews.? The next two are from Justin Fox, and James Grant.

I have more models that I will trot out.? For example, I have a short-term investment model that I am developing, and I hope it will come out in the next six months.? I might also roll out my alternative to Modern Portfolio Theory, if I work it out (I am dubious that I will get there).? I also have a review of the people on the FOMC coming out.? There’s more… I always have a list of articles that I want to get to, but time is short.

Time is short.? My apologies to all who have written to me, but I have not responded to.? I can’t answer all of my e-mails.? I do read all of them, and I appreciate that you write to me.? I don’t read comments on other sites that repulish my works, so I urge you to write to me here if you want to bring something to my attention.

One last bit of thanks

I could have stayed behind the pay wall at RealMoney, but I wanted to interact with a broader audience.? Amid some criticism, the investment blogosphere is a very intelligent place, and more attuned to the real situation than most of the mainstream news media.? Give the New York Times, the Wall Street Journal, Bloomberg, and Reuters their due, but the world needs investment bloggers — we point out truths that are missed by many.? I am not speaking for me, but for the many that I respect in blogging.

And as for readers, I thank the following selection of institutions where I have readers:

Alexander & Alexander
AllianceBernstein L.P. (US)
AMAZON.COM (US)
American International Group
Bank of America (GB)
Banque Paribas (US)
Barclays Capital (GB)
Bharti Broadband (IN)
BLOOMBERG, LLP (US)
Bridgewater Associates
Cambridge MAN Customers (GB)
Charles Schwab & Co. (US)
CIBC World Markets (CA)
Citadel Investment Group
Citicorp Global Information
Credit Suisse Group
DBS VICKERS SECURITIES
Dean Witter Financial Services
DEUTSCHE BANK (US)
Dow Jones-Telerate (US)
Dresdner Kleinwort Wasserstein
Federal Home Loan Mortgage
Federal Reserve Board (US)
Fidelity Investments (US)
GOLDMAN SACHS COMPANY (US)
Google (US)
H&R Block (US)
Harvard University (US)
Hewlett-Packard Company (US)
HSBC Bank plc, UK (GB)
Intel Corporation (US)
INTERNAL REVENUE SERVICE (US)
Jefferies & Company (US)
Johns Hopkins University
JPMorgan Chase & Co. (US)
Knight Capital Group (US)
KOCH INDUSTRIES (US)
KPMG LLP (US)
LEHMAN BROTHERS (US)
MAN Financial (US)
Merrill Lynch and Company (US)
Michigan State Government (US)
Microsoft Corp (US)
MILLENIUM PARTNERS, L.P. (US)
Moody’s Investors Service (US)
Morgan Stanley Group (US)
Morningstar (US)
Mutual of Omaha Insurance
Nat West Bank Group (GB)
Nesbitt Burns (CA)
Nomura International plc
Northern Trust Company (US)
RBC CAPITAL MARKETS
Repubblica e Cantone Ticino
Royal Bank of Canada (CA)
Salomon (US)
Societe Generale (FR)
Speakeasy (US)
Stanford University (US)
STARBUCKS COFFEE COMPANY (US)
The St. Paul Travelers Companies
The Vanguard Group (US)
Thomson Financial Services (US)
UBS AG (US)
Union Bank of California (US)
United States Senate (US)
University of Chicago (US)
University of Virginia (US)
US Department of the Treasury
Watson Wyatt
WELLS FARGO BANK (US)
Yale University (US)

What a group.? I am honored.? Again, thanks for reading me, whoever you are, and whoever you work for.

Final note

I am still looking for a lead institutional investor for my equity fund, which is available in both a long only, and market-neutral form.? (I’ve beaten the S&P 500 8 out of the last 9 years.)? If any of my readers have a lead on any institutional investor who might want to invest $1 million or more in my fund, please e-mail me, and I will send you my pitchbook.? Whoever gets me my first institutional investor gets my undying gratitude.? Help me if you can.

Efficient Markets as a Limiting Concept; There are Conceptual Limits to Efficient Markets

Posted on 4 July 200916 October 2010 by David Merkel

I do and don’t believe in the efficient markets hypothesis [EMH].? I do believe in the adaptive markets hypothesis [AMH].?? The efficient markets hypothesis posits that:

Past price-related information can’t be used to obtain better-than-average returns. (weak form of the EMH — cuts against technicians)
Past and present public information can’t be used to obtain better-than-average returns. (semi-strong form of the EMH — cuts against fundamental analysis)
Public and private information can’t be used to obtain better-than-average returns. (strong form of the EMH — believed by few)

In practice, the academic community holds to the semi-strong? form, while the investment community holds to the weak form.? One thing is certain: the market is dominated by large institutions, and the market on the whole, less fees, cannot beat the returns of the market on the whole.

Part of the problem with the EMH is that with respect to the market as a whole, of course it is true.? The real question is whether any particular strategy covering a small portion of the assets of the market can consistently beat the returns of the market on the whole.? I believe the answer to that question is yes.

An implicit assumption of the EMH is that research costs are free.? They are not free.? Also, it implicitly assumes that a dominant number of investors understand what information drives the markets.? Both assumptions are not true — even in the most clever firms, there is information that is missed, and research costs are expensive, and not always rewarded.

But the effort to earn above-average returns forces the market closer to the EMH.? When the competition is tough, finding excess returns is hard.? This makes it a limiting concept.? We never get there, but effort to find above-average returns gets us closer to that ideal.? Conversely, when many decide to index, those who do not index have a better chance at earning above normal returns, because there is a large chunk of naive capital in the market seeking average returns with certainty.

I want average people to use index funds for many reasons:

It lowers their costs.
It is tax-efficient.
Most people aren’t very good at picking equity managers.? They go for the manager who is hot, in the style that is hot, rather than one that did better in the past, and is in a cold spell now.? They go for large fund groups that spread their research over large asset bases, diluting whatever skill they might have.?? The best managers are the smaller specialists running their own funds, and who eat their own cooking.? They are also inconvenient to use.
It improves conditions for the remaining active managers.

I also want them to buy-and-hold (dirty words) because they aren’t very good at market timing, and also have enough in safe assets to lower the downside of returns to a level that does not panic them.? Most people are bad at most investment decision-making.? Better to hand it off to those who don’t panic or get greedy, than to be a part of those who buy into tops or sell into bottoms.

On the AMH, quoting from another piece of mine of the topic:

The adaptive markets hypothesis says that all of the market inefficiencies exist in a tension with the efficient markets, and that market players make the market more efficient by looking for the inefficiencies, and profiting from them until they disappear, or atleast, until they get so small that it?s not worth the search costs any more.

And so it is for those of us who are active managers.? We have a twofold task:

Base our strategies in areas that are unlikely to be overfished for long — e.g., low valuation, positive momentum, and earnings quality.
Dip into areas that are temporarily out of favor, whether those are industries, countries, or odd risk factors.? (Odd risk factors: occasionally certain factors in the markets are poison, and even the slightest taint marks a security off-limits, even though those that are barely affected are fine.? My example would be Enron-like structures 2001-2002.? Few would buy the stocks or bonds of companies that had them, even though those structures were not large enough to impair the company, as they did with Enron.? We bought the bonds of a Dominion subsidiary with abandon, because we knew the covenants the bonds had would not kill Dominion, and we had extra value as a result.? What killed Enron benefited us, indirectly.)

To active managers then, I warn: watch how your main strategy goes in and out of favor.? It happens to all of us.? Add to your main strategy most when it is out of favor, and add to whatever alternative you have when your main strategy is running hot.

To average investors, then, I advise: if you adjust frequently, add to your winners and prune your losers.? If you adjust infrequntly (once a year or less), prune your winners and add to your losers.? In the short run, momentum persists, in the longer-term, it mean reverts.

Know yourself.? If you are prone to panic and fear with investments, better to hand the job off to someone competent who will be dispassionate.? If you have conquered those emotions, you can potentially do better yourself in investing.? But ask yourself what your sustainable competitive advantage is in investing.? If you don’t have one, better to index.

Correlation Does Not Imply Causation; A Study of Sector Correlations

Posted on 2 July 20092 July 2009 by David Merkel

There was an interesting post on Bloomberg regarding asset class correlations, and a lot of blogs wrote about it, including Abnormal Returns, which did a nice summary, and expanded the argument to university endowments.? Part of the issue here is that under conditions of stress, assets separate into two simple categories — safe and risky.? To what degree can an asset be turned into cash at anything near its fair value under stressed conditions?

I ran into something similar back in 2006, so I wrote this CC post:

		David Merkel
		Make the Money Sweat, Man! We Got Retirements to Fund, and Little Time to do it!
		3/28/2006 10:23 AM EST

What prompts this post was a bit of research from the estimable Richard Bernstein of Merrill Lynch, where he showed how correlations of returns in risky asset classes have risen over the past six years. (Get your hands on this one if you can.) Commodities, International Stocks, Hedge Funds, and Small Cap Stocks have become more correlated with US Large Cap Stocks over the past five years. With the exception of commodities, the 5-year correlations are over 90%. I would add in other asset classes as well: credit default, emerging markets, junk bonds, low-quality stocks, the toxic waste of Asset- and Mortgage-backed securities, and private equity. Also, all sectors inside the S&P 500 have become more correlated to the S&P 500, with the exception of consumer staples.

In my opinion, this is due to the flood of liquidity seeking high stable returns, which is in turn driven partially by the need to fund the retirements of the baby boomers, and by modern portfolio theory with its mistaken view of risk as variability, rather than probability of loss, and the likely severity thereof. Also, the asset allocators use “brain dead” models that for the most part view the past as prologue, and for the most part project future returns as “the present, but not so much.” Works fine in the middle of a liquidity wave, but lousy at the turning points.

Taking risk to get stable returns is a crowded trade. Asset-specific risk may be lower today in a Modern Portfolio Theory sense. Return variability is low; implied volatilities are for the most part low. But in my opinion, the lack of volatility is hiding an increase in systemic risk. When risky assets have a bad time, they may behave badly as a group.

The only uncorrelated classes at present are cash and bonds (the higher quality the better). If you want diversification in this market, remember fixed income and cash. Oh, and as an aside, think of Municipal bonds, because they are the only fixed income asset class that the flood of foreign liquidity hasn’t touched.

Don’t make aggressive moves rapidly, but my advice is to position your portfolios more conservatively within your risk tolerance.

Position: none

Hmm… in early 2006, we were considerably in advance of the peak that would come in late 2007, but considerably above where we are now.? In my opinion, given my longer timeframe, a good call.

But maybe correlations might rise during times when everyone is anxious to buy risky assets, not just when the want to throw them away.? Do asset correlations rise near peaks for risky assets?

My model on correlations relies on the major industry sectors of the S&P 500:

Consumer Discretionary
Consumer Staples
Energy
Financials
Health Care
Industrials
Information Tech
Materials
Telecom Services
Utilities

If lots of money is getting thrown at stocks, won’t the correlations between sectors rise?? And if so, won’t future returns be low or negative?

Here is a graph showing the price return on the S&P 500 over the next 60 days as a function of the average sector correlation over the last 60 days:

Not much of a relationship, huh?? 1% R-squared.? And it goes the wrong way — high correlations very weakly favor higher returns.

But what if we do a regression where future S&P 500 returns are regressed on past S&P 500 returns and average sector correlations?

Wow, we get a 2% R-squared! 😉 It also shows that momentum persists, and higher average sector correlation has a similar effect to the above model, still positive on future returns.

Here is a heat map where the average 60-day past return is on the horizontal axis, and average sector correlation is on the vertical axis, and the variable displayed is frequency of occurrence.

Looks pretty average, with the two effects being fairly separate, with an odd southwestern quadrant.

Here is a heat map where the average 60-day past return is on the horizontal axis, and average sector correlation is on the vertical axis, and the variable displayed is average future 60-day returns.

Here are my tentative findings:

Price momentum persists.? 60 days of weakness/strength tends to beget 60 more days of weakness/strength.
Extremely high or low average sector correlations seem to go along with low returns.? Middling average sector correlations seem to go along with higher returns.
Low average sector correlations and lousy past price performance seems to beget excellent future performance.
High average sector correlations and lousy past price performance seems to beget lousy future performance.
When past price momentum is high, average sector correlation doesn’t seem to matter as much.
If past trends continue, average returns over the the next 60 days are around 2.5% with a very wide error band.? Current average sector correlation is 50%, and past 60 days returns are 9%.

One final graph:

Do you see a pattern here where high average sector correlations come before market peaks?? I don’t.

All that said…

I know the earlier articles dealt with asset class correlations, rather than correlations with stock market sectors.? I would have expected the same result.? Maybe there is aonther way to do this analysis separating out safe sectors from risky sectors.

But what are safe sectors?? Utilities? Consider 2001-2003.? Telephone services? Also 2000-2003.? Financials? 2007-?? Perhaps Consumer Staples is the only truly safe sector… or maybe it should be energy? Consider the early ’90s.

This is one article where I end scratching my head, but publish anyway, because:

1) My readers may help me.

2) It is valuable to know where research dead ends exist.

After all this, I don’t see average sector correlations as a valuable variable in investing.? Maybe that is not true of asset classes.? If anyone has the proper data to send to me on that, I will reproduce an analysis like this, and tell you what I find.

Unchangeable

Posted on 19 June 2009 by David Merkel

When people look at this crisis, they look for simple answers — they want to find one or two parties to blame, not many, a la my Blame Game series.? The economic system is an interconnected web, and it is not easy to change one part without affecting many others.? Intelligent ideas for change consider second order effects at minimum.? This piece, and any that follow under the same title, will attempt to point at things that are not easily done away with.? Some of these will be controversial, others not.

1) Derivatives.? What is a derivative?? A derivative is a contract where two parties agree to exchange cash flows according to some indexes or formulas.? There are some suggesting today that all derivatives must be standardized, and/or traded on exchanges.? That might make sense for common derivatives where there are large volumes, but many derivatives are “out in the tail.”? Not common, and standardization of what is not common is a fool’s errand.

To regulate derivatives fully is to say that certain types of contracts between private parties may not exist without the consent of the government.? Thinking about it that way, what becomes of free enterprise?? Granted, there are some contracts that cannot be considered enforcable, like that of a hit man, arson for hire, etc.? Those are matters that any healthy government would oppose.

What makes more sense is to bring the derivatives “on balance sheet.”? Let the effects of the notional value play out, showing owners what is happening, rather than hiding it.

2) Rating agencies — Moody’s, S&P, and Fitch deserve some blame for what happened, but the regulators needed the rating agencies.? They still do.? The rating agencies make imperfect estimates of relative credit quality for a wide munber of instruments, which then feed into the risk-based capital formulas of the regulators.? To rate such a wide number of instruments means that the issuers must pay for the rating, because there is no general interest for most ratings.

Yes, let more rating agencies compete, but they will find that the “issuer pays” model is more compelling than the “”buyer pays” model.? The concentrated interests of issuers in a rating trumps the diffuse interests of buyers.? Bond buyers need to learn to live with this, and employ buy-side analysts that don’t take the opinion of the rating agencies blindly.? What the analysts at the rating agencies write is often more valuable than the rating itself, though it doesn’t change capital charges.

Rating agencies make the most errors with new asset classes.? Better that the regulators do their jobs and prohibit immature? asset classes where the loss experience is ill-understood.

I don’t think that rating agencies are going away any time soon.? I do think that the government and regulators contemplated this, but concluded that the changes to the system would be too drastic. (Contrary opinions: one, two)

3) Yield-seeking — the desire to seek yield is near-universal.? As a bond manager, I found it rare that a manager would do a “reduce yield, improve quality or certainty” trade.? The pattern is even more pronounced with retail accounts.? They underestimate the value of the options that they are selling, and take a modicum of yield in exchage for lower certainty of return.

Can this be banned, as some are proposing with reverse convertibles?? I don’t think so, there are too many variables to nail down, and too many people in search for a yield higher than is reasonable.? Yield-hogging is an institutional sport, not only one for retail fans to grab.? As one of my old bosses used to say, “Yield can be added to any portfolio.”? How?

Offer protection on CDS
Lower the quality of your portfolio.
Buy all of the dirty credits that trade cheap to rating.
Buy securities from securitizations — they almost always trade cheap to rating.? (Ooh! CDOs!)
Sell a call option on the securities you hold.
Buy mortgage securities with a lot of prepayment or extension risk.
Accept the return in a higher inflation currency, assuming that their central bank will tighten.
Do a currency carry trade.
Lever up.
Extend the length of your portfolio.
Underwrite catastrophe risk through cat bonds.

Adding yield is easy.? The transparency of that addition of yield is another matter.? Reverse convertibles have been the hot issue recently since this article.? Here is a small sample of the articles that followed: (one, two, three).? Reverse convertibles, and other instruments like them give bond-like performance if things go average-to-well, and stock-like performance if things go badly.? The inducement for this is a high yield on the bond in the average-to-good scenario.

What to do?

I have three bits of advice for readers.? First, don’t buy any financial instruments tht you don’t understand well. This especially applies when the party selling them to you has options that they can exercise against you.? Wall Street excels at products that give with the right hand and take with the left, so beware structured products sold to retail investors.

Second, don’t buy any financial product that someone appears out of the blue and says, “Have I got a deal for you!”? Stop.? Take your time, ask for literature, maybe, but say that you need a month or more to think about it.? Haste is the enemy of good financial decision-making.? Instead, do your own research, and buy what you conclude that you need.? Consult trusted advisors in either case.

Third, don’t be a yield hog.? Yield is rarely free.? There are times to take risk and accept higher yields, but those are typically scary times.? At other times, make sure you understand the portfolio of risks that you accept, and that you are being adequately paid for those risks.? Better to have a ladder of high quality noncallable debt, and take some risk with equities than to take risk in a series of yieldy and illiquid bonds that you don’t understand so well.? At least you will be able to know what risks you have, and that is an aid to asset management.

Final Question

This article began as a discussion of things that are very hard to change in the current environment.? I thought of several here:

The continuing need for derivatives, and the impossibility of full standardization
The continuing need for rating agencies
Human nature makes us yield hogs.
Wall Street builds traps for investors off of that weakness.

What other things are very hard to change in the current environment?

Praise for Peter Bernstein

Posted on 18 June 200918 June 2009 by David Merkel

I have learned a lot from the late Peter Bernstein. I remember a piece of his entitled (something like), “What is Liquidity?” where he described liquidity as the ability to change your mind or request a do-over. Bright guy, and one who focused on the big issues, not minutiae.

I met Peter Bernstein in 2002 when he delivered a timely talk to the Baltimore Security Analysts Society called (something like), “The Continuing Relevance of Dividends.” I asked a question during the Q&A, and then was able to talk with him for ten minutes afterward, because few wanted to embrace such a boring topic. He was very gracious to me, and encouraged me in my research pursuits.

There were many who offered their praises of Peter Bernstein and I offer the links here:

As for his books, I offer the links here:

There may be more than this, but it was what I was able to find.? Peter Bernstein aimed for large targets, and gave broad and convincing evidence of how markets worked.? He only erred in letting Modern Portfolio Theory and Keynesianism affect him.

With that, I hail Peter Bernstein, regretting his demise.? He will be missed, as few of us had such global vision of markets as he had.

Full disclosure: if you buy anything from Amazon after entering here, I get a small commission, but your prices don’t go up.

Fruits and Vegetables Versus Assets in Demand

Posted on 9 June 20099 June 2009 by David Merkel

There is a way in which fruits and vegetables and financial products are opposites: when quantities are high for fruits and vegetables, quality is high, and prices are low. With financial products, when issuance is high, quality is low, and pricing is expensive, leading to poor future returns from lower yields, and higher future defaults. I offer this for what it is worth, but is there something more to it, than the seeming oppositeness?? Why are they opposites?

Problems with Constant Compound Interest

Posted on 4 June 20094 June 2009 by David Merkel

This piece is an experiment.? I’m not exactly sure how this will turn out by the time I am done, so if at the end you think I blew it, please break it to me gently.

People in general don’t get compound interest, or exponential processes generally.? It is not as if they are pessimistic, they are not numerate? enough to apply the rule of 72.? (Rule of 72: For interest rates between 3 and 24%, the time it takes to double the money is approximately 72 divided by the interest rate, expressed as a whole number.)

But there is a greater problem, and it applies to the bright as well as the dull.? People don’t understand the limitations of compound interest.

Let me begin with a story: I started my career at Pacific Standard Life, a little life insurer based in Davis, California.? The universal life policieswere crediting 11-12% interest, and annuities were in the 9-10% region.? It was fueled by junk bonds.? One of my first projects was to set the factors that would give us GAAP reserves for the universal life products.? To do this, I was told to project UL account values ahead at 11-12% interest for the life of the policies.

That rate of interest doubles policy account values every six or so years.? What economic environment would it imply to sustain such a rate of interest?

High inflation, or
High opportunities, because there is little competition.

The former was a possibility, the latter not.? As it was, inflation was receding, and 1986 was the nadir for the 80s.

People buying policies would see these tremendous returns illustrated, and would buy, because they saw an easy retirement in sight.? Alas, constant compound growth rarely happens in economics.? Policyholders ended up very disappointed; Pacific Standard went insolvent in 1989, and the rump was sold off to The Hartford.

Where do we often see constant compound growth modeled in finance?

Asset allocation models, including simple illustrations done by financial planners
Life insurance sales and accounting
Defined benefit pension accounting
Long-dated debt obligations
Simple stock price models, like the Gordon Model, and all of its dividend discount model cousins.
Social finance systems, like public pensions and healthcare.

There are likely many more.? Whenever we talk about long-dated financial obligations, whether assets or liabilities, we need something simple to aid us in decision-making, because the more variables that we toss in, the harder it is for us to make reasonable comparisons.? We need to reduce calculations to single variables of yield, present values, or future retirement incomes.? Our frail minds need simple answers to aid us.

I’m not being a pure critic here, because I need simple answers also.? Knowing the yield of a long debt obligation has some value, though if that yield is high, one should ask what the is likelihood of realizing the value of? the debt.? Similarly, it would be useful to know how likely it is that one would receive a certain income in retirement.

I’m going to hit the publish button now, and pick this up in a day or so.? Until then.