Category: Asset Allocation

“Should I be worried about the economy?”

“Should I be worried about the economy?”

Most of my friends don’t follow the economy or the markets that closely, so it has been interesting for a number of them to ask me recently, “Should I be worried about the economy?”? The answer isn’t a simple one.

Part of the answer depends on your line of work.? Stuff that’s economically necessary (utilities, staples, government, common services) will probably do okay, though there will be some slackening of demand at the edges.? For example, I visited? a hair salon recently, and asked how business was.? The answer was that customer numbers were unchanged, but that the average purchase level had dropped.? Even government positions, stable as they are will experience some pressure, because budgets have to balance, and tax revenues are starting to sag a bit.

Now if you work in an export-oriented sector, with the dollar down, you will probably do okay.? Demand for food, energy, raw materials, industrial goods, and some technologies will continue relatively strong.

But institutions that rely on credit risk, whether borrowing or lending, will have it tough.? During the boom phase, more and more bodies get added to service the cash flow.? At his point, bodies are coming out of banking, investment banking, real estate, homebuilding, etc.

You can also ask how well capitalized and profitable your current firm is.? This is not a time that rewards high degrees of leverage and short-term financing (unless you are very well capitalized). Volatility rewards firms that have excess capital; it is worth more when times are panicky.

Another part of the answer is how dependent you are on the need for continued external financing.? Can you meet all of your obligations, with some room for error over the next two years?? Do you have excess assets to aid you if you have a sudden crisis?

Finally, if you have investments, look them over.? Examine what investments are sensitive to worsening credit problems, and remove weakly financed companies from your portfolio.? You should have some investments that are inflation-sensitive, like stock in industries that have pricing power (precious few 🙁 ), cash, TIPS, and foreign-currency demoninated bonds.? Now, carefully selected muni, mortgage and corporate bonds have value here, though don’t put on a full position at present.

In summary, it depends on your personal financial position, the firm and industry that you serve, and how much you have prepared to weather bad times in investing.? It’s not a pretty time as the leverage unwinds, but if you planned in advance for the possibility of trouble, then you should do adequately.

Personal Finance, Part 11 ? Your Personal Required Investment Earnings Rate

Personal Finance, Part 11 ? Your Personal Required Investment Earnings Rate

Everybody has a series of longer-term goals that they want to achieve financially, whether it is putting the kids through college, buying a home, retirement, etc.? Those priorities compete with short run needs, which helps to determine how much gets spent versus saved.

To the extent that one can estimate what one can reasonably save (hard, but worth doing), and what the needs of the future will cost, and when they will come due (harder, but worth doing), one can estimate personal contribution and required investment earnings rates.? Set up a spreadsheet with current assets and the likely savings as positive figures, and the future needs as negative figures, with the likely dates next to them.? Then use the XIRR function in Excel to estimate the personal required investment earnings rate [PRIER].

I’m treating financial planning in the same way that a Defined Benefit pension plan analyzes its risks.? There’s a reason for this, and I’ll get to that later.? Just as we know that a high assumed investment earnings rate at a defined benefit pension plan is a red flag, it is the same to an individual with a high PRIER.

Now, suppose at the end of the exercise one finds that the PRIER is greater than the yield on 10-year BBB bonds by more than 3%.? (Today that would be higher than 9%.)? That means you are not likely to make your goals.?? You can either:

  • Save more, or,
  • Reduce future expectations,whether that comes from doing the same things cheaper, or deferring when you do them.

Those are hard choices, but most people don’t make those choices because they never sit down and run the numbers.? Now, I left out a common choice that is more commonly chosen: invest more aggressively.? This is more commonly done because it is “free.”? In order to get more return, one must take more risk, so take more risk and you will get more return, right?? Right?!

Sadly, no.? Go back to Defined Benefit programs for a moment.? Think of the last eight years, where the average DB plan has been chasing a 8-9%/yr required yield.? What have they earned?? On a 60/40 equity/debt mandate, using the S&P 500 and the Lehman Aggregate as proxies, the return would be 3.5%/year, with the lion’s share coming from the less risky investment grade bonds.? The overshoot of the ’90s has been replaced by the undershoot of the 2000s.? Now, missing your funding target for eight years at 5%/yr or so is serious stuff, and this is a problem being faced by DB pension plans and individuals today.

While the ’80s and ’90s were roaring, DB plan sponsors made minimal contributions, and did not build up a buffer for the soggy 2000s.? Part of that was due to stupid tax law that the government put in because they didn’t want pension plans to shelter income from taxes for plan sponsors.? (As an aside, public plans did less than corporations, even though they did not face any tax consequences.)

But the same thing was true of individuals.? When the markets were good, they did not save.? Now when the markets are not good, the habit of not saving is entrenched, and now being older, saving might be more difficult because of kids in college, interest on a mortgage for a house larger than was needed, etc.

Now, absent additional saving, when investment earnings lag behind the PRIER, that makes the future PRIER rise, to try to make up for lost time.? Perhaps I need to apply the five stages of grieving here as well… trying to earn more to make up for lost time is a form of bargaining.? It rarely works, and sometimes blows up, leaving a person worse off than before.? Most aggressive asset allocation strategies only work over a long period of time, and only if a player is willing to buy-rebalance-hold, which only a few people are constitutionally capable of doing.? Most people get scared at the bottoms, and get euphoric near tops.? Few follow Buffett’s dictum, “Be greedy when others are fearful, and fearful when others are greedy.”? Personally, I expect the willingness to take investment risk over the next five years to rise, but over the next ten years, I don’t think it will be rewarded.

Now, as time progresses, and the Baby Boomers gray, unless the equity markets are returning the low teens in terms of returns, there will be a tendency for the average PRIER to rise, absent people realizing that they have to save more than planned, or reduce their goals.? This problem will be faced in the ’10s, bigtime.? The pensions crisis will be front page news, and I’m not talking about Social Security and Medicare, though those will be there also.? The demographics will be playing out.? After all, what drives the funding of retirement at a DB plan, but aging, where the promised expected payments get closer each day.

Well, same thing for individuals.? Every day that passes brings a slow weakening of our bodies and minds.? Dollars not saved today, or bad investment returns mean the PRIER rises, making the probability of attaining goals less achievable.

Now, is there nothing that can be done aside from increasing savings and reducing future plans?? In aggregate, no.? You will have to be someone special to beat the pack, because few do that.? Better you should take the simple solution, which is a humble one: save more, expect less.? For those that do have the talent, you will have to take the risks that few do, and be unconventional.? Note: for every four persons that think they can do this, at best one will succeed.? My own methods are always leaning against what is popular in the markets, and I think that I am one of those few, but it takes work and emotional discipline to do it.

Then again, I have done it, as far as my PRIER is concerned — it is below the rate on 10-year Treasuries.? Most of that is that my goals are modest, aside from putting my eight kids through college, and I am not planning on retiring.

With that, I leave to consider a post I wrote at RealMoney two years ago.? It’s kind of a classic, and Barry Ritholtz e-mailed me to say that he loved it.? Given what we are experiencing lately, it seems prescient.? Here it is:


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

What a Day!

What a Day!

I didn’t feel well today, but my broad market portfolio did better than me. I probably could not have picked a worse day to do my reshaping, but here are the results:

Sales:

  • Aspen Holdings
  • Flagstone Reinsurance
  • Redwood Trust
  • Mylan Labs
  • Lafarge SA

Purchases:

  • Reinsurance Group of America (old friend, cheap price)
  • Honda Motors

Rebalancing Buys:

  • Valero
  • ConocoPhillips
  • Vishay Intertechnology

Rebalancing Sale:

  • Deerfield Capital

I’m not done. My moves today raised cash from 5% to 10%, and trimmed positions from 36 to 33. I have room for two more ideas, and am working on where to place cash. My timing of buys and sells today was good — not that that is a key competency of mine by any means.

Aside from the sale of the reinsurers, which were just cheap placeholders, the other positions were not as relatively cheap as they once were. RGA and Honda are quality companies selling at bargain prices. If I had more names like those, I would buy them all day long.

Away from my broad market portfolio, I raised my equity exposure in my mutual funds fractionally today. Time to rebalance.

PS — I can’t remember another day quite like this, where the late negative to positive move was so pronounced.

Full disclosure: long DFR RGA HMC VLO COP VSH

A Bonus from <I data-src=

A Bonus from MoneySense Magazine

For my readers, particularly my Canadian readers, you can read an article that I wrote on risk control in portfolio management for MoneySense magazine.? In the process of writing the piece for MoneySense, I got to read a number of back issues, and found it to be a good quality publication, of most use to Canadians.? Having passed the Life Actuarial exams, I know enough about Canadian tax law and financial services to be a danger to myself, and those who listen to me.? Fortunately, the piece I wrote was generic, and can benefit investors anywhere.

Notes on Stocks and the Fed

On a side note, why didn’t the stock market fall more today? For me, it boils down to two things: the FOMC surprise move, which ratcheted up total rate cut expectations for January, and seller exhaustion.? It’s hard for the market to fall hard when you have already had a high level of down volume net of up volume, and huge amounts of 52-week lows net of 52-week highs.? This wasn’t just true of the US, but of most global equity markets.

So, if we are going down further, the market will have to rest a while.? That said, valuations are more compelling than they were, especially compared to Treasuries.? Compared to BBB corporate yields, they are still attractive.? I think I would need to see 10-year BBB corporates at yields of 7% or so before I would begin edging in there.

One other note, the forward TIPS curve is showing some life again; perhaps that will be another fake-out, as in August, but there is certainly more oomph in the inflationary effort now than when the stimulus effort was grudging and fitful as it was back then.

On Benchmarking

On Benchmarking

Sorry for not posting yesterday, there were a number of personal and business issues that I had to deal with.

Sometimes I write a post like my recent one on Warren Buffett, and when I click the “publish” button, I wonder whether it will come back to bite me. Other times, I click the publish button, and I think, “No one will think that much about that one.” That’s kind of what I felt about, “If This Is Failure, I Like It.” So it attracts a lot of comments, and what I thought was a more controversial post on Buffett attracts zero.

As a retailer might say, “The customer is always right.”? Ergo, the commenters are always right, at least in terms of what they want to read about.? So, tonight I write about benchmarking.? (Note this timely article on the topic from Abnormal Returns.)

I’m not a big fan of benchmarking.? The idea behind a benchmark is one of three things:

  1. A description of the non-controllable aspects of what a manager does.? It reflects the universe of securities that a manager might choose from, and the manager’s job is to choose the best securities in that universe.
  2. A description of the non-controllable aspects of what an investor wants for a single asset class or style.? It reflects the universe of securities that describe expected performance if bought as an index, and the manager’s job is to choose the best securities that can beat that index.
  3. A description of what an investor wants, in a total asset allocation framework.? It reflects the risk-return tradeoff of the investor.? The manager must find the best way to meet that need, using asset allocation and security selection.

When I was at Provident Mutual, we chose managers for our multiple manager products, and we would evaluate them against the benchmarks that we mutually felt comfortable with.? The trouble was when a manager would see a security that he found attractive that did not correlate well with the benchmark index.? Should he buy it?? Often they would not, for fear of “mistracking” versus the index.

Though many managers will say that the benchmark reflects their circle of competence, and they do well within those bounds, my view is that it is better to loosen the constraints on managers with good investment processes, and simply tell them that you are looking for good returns over a full cycle.? Good returns would be what the market as a whole delivers, plus a margin, over a longer period of time; that might be as much as 5-7 years.? (Pity Bill Miller, whose 5-year track record is now behind the S&P 500.? Watch the assets leave Legg Mason.)

My approach to choosing a manager relies more on analyzing qualitative processes, and then looking at returns to see that the reasons that they cited would lead to good performance actually did so in practice.

Benchmarking is kind of like Heisenberg’s Uncertainty Principle, in that the act of measurement changes the behavior of what is measured.? The greater the frequency of measurement, the more index-like performance becomes.? The less tolerance for underperformance, the more index-like performance becomes.

To the extent that a manager has genuine skill, you don’t want to constrain them.? Who would want to constrain Warren Buffett, Kenneth Heebner, Marty Whitman, Michael Price, John Templeton, John Neff, or Ron Muhlenkamp? I wouldn’t.? Give them the money, and check back in five years.? (The list is illustrative, I can think of more…)

What does that mean for me, though?? The first thing is that I am not for everybody.? I will underperform the broad market, whether measured by the S&P 500 or the Wilshire 5000, in many periods.? Over a long period of time, I believe that I will beat those benchmarks.? Since they are common benchmarks, and a lot of money is run against them, that is a good place to be if one is a manager.? I think I will beat those broad benchmarks for several reasons:

  • Value tends to win in the long haul.
  • By not limiting picks to a given size range, there is a better likelihood of finding cheap stocks.
  • By not limiting picks to the US, I can find chedaper stocks that might outperform.
  • By rebalancing, I pick up incremental returns.
  • Industry analysis aids in finding companies that can outperform.
  • Avoiding companies with accounting issues allows for fewer big losses.
  • Disciplined buying and selling enhances the economic value of the portfolio, which will be realized over time.
  • I think I can pick good companies as well.

I view the structural parts of my deviation versus the broad market as being factors that will help me over the long haul.? In the short-term, I live with underperformance.? Tactically, stock picking should help me do better in all environments.

That’s why I measure myself versus broad market benchmarks, even though I invest more like a midcap value manager.? Midcap value should beat the market over time, and clients that use me should be prepared for periods of adverse deviation, en route to better returns over the long haul.

Tickers mentioned: LM

The Nature of a Nervous Bull

The Nature of a Nervous Bull

Cast your bread upon the waters,
For you will find it after many days.
2 Give a serving to seven, and also to eight,
For you do not know what evil will be on the earth.
3 If the clouds are full of rain,
They empty themselves upon the earth;
And if a tree falls to the south or the north,
In the place where the tree falls, there it shall lie.
4 He who observes the wind will not sow,
And he who regards the clouds will not reap.
5 As you do not know what is the way of the wind,[a]
Or how the bones grow in the womb of her who is with child,
So you do not know the works of God who makes everything.
6 In the morning sow your seed,
And in the evening do not withhold your hand;
For you do not know which will prosper,
Either this or that,
Or whether both alike will be good. [Eccelesiates 11:1-6, NKJV, copyright Thomas Nelson]

The point of Ecclesiastes 11:1-6 is that the farmer in Spring, much as he might be hungry, and want to eat his seed corn, instead has to cast his seed into the muddy soil, perhaps planting 7 or 8 crops, because he doesn?t know what the future may bring. If he looks at the sky, wondering if it will rain enough, or whether the winds might ruin the crops, he will never get a crop in Summer or Fall.

That?s the way that I view investing. You always have to have something going on. You can?t leave the market entirely, because it?s really tough to tell what the market might give you. Typically, across my entire set of investments I run with about 70% equity investments, and the rest cash, bonds, and the little hovel that I live in. Private equity is a modest chunk of my equity holdings, so public equities are about 60% of what I own. Domestic public equities are about 45%.

I don?t think of that as particularly bullish or bearish. Even with public equities trading at high price-to-sales ratios, my portfolio doesn?t trade at high ratios of sales, cash flow, earnings, or book value. Together with industry selection, modest valuations provide some support against bear markets.

My tendency will be if the market moves lower from here to layer in slowly using my rebalancing discipline. That?s what I did in my worst period 6/2002-9/2002, and the stocks that I held at the end were ideally positioned for the turn in the market.

So, I never get very bullish, or bearish. I see the troubles in the markets, and I avoid most problem areas, such as in housing-related areas, but I continue to plug along, doing what I do best — trying to pick good stocks and industries (and occasionally, countries.)

Personal Finance, Part 5.1 ? Inflation and Deflation 2

Personal Finance, Part 5.1 ? Inflation and Deflation 2

I wish that I had more time to respond to readers both in the comments and e-mail.? Unfortunately, I am having to spend more time working as I am in transition as far as my work goes.? I’ll try to catch up over the next week or so, but I am behind by about 50 messages, and I hate to compromise message quality just to clear things out.

That said, my inflation/deflation piece yesterday attracted two comments worthy of response.? The first was from James Dailey, who I would recommend that you read whenever he comments here.? We may not always agree, but what he writes is well thought out.? He thinks I attribute too much power to the Fed.? He has a point.? From past writings, I have suggested that the Fed is not all-powerful.? What I would point out here is that the Fed controls more than just the monetary base.? They control (in principle) the terms of lending that the banks employ.? With a little coordination with the other regulators, the Fed could restrict non-bank lenders by raising the capital requirements that banks (and other regulated institutions) must maintain in lending to non-bank lenders.? So, if credit is outpacing the growth in the monetary base, it is at least partially because the Fed chooses to allow it.? Volcker reined in the credit card companies in the early 80s, which was not a normal policy for the Fed; it had a drastic impact on the economy, but inflation slowed considerably.? (Causation?? I’m not sure.? Fed funds were really high then also.)

The other comment came from Bill Rempel.? He objected more to my terminology than my content, though he disliked my comment that “Inflation is predominantly a monetary phenomenon.”? I think we are largely on the same page, though.? I know the more common phraseology here, “Inflation is purely a monetary phenomenon,” and I agree with it, but with the following provisos:

  • If we are talking about goods, services, and assets as a group, or,
  • If the period of time is sufficiently long, like a century or so, or,
  • If we are talking about monetary inflation.? (Who disagrees with tautologies? 🙂 Not me.)

Part of my difficulty here, is that when we talk about money, we are talking about something that lies on the spectrum? between currency and credit.? By currency I am talking about whatever physical medium can be commonly deployed to effectuate transactions.? By credit, anything where the eventual exchange of currency is significantly delayed, and perhaps with some doubt of collection.? Because of the existence of credit, over shorter periods, the link between monetary inflation and good price inflation is more tenuous, which leads people to doubt the concept that “Inflation is purely a monetary phenomenon.”? My post, rather than weakening that concept, strengthens it, because it broadens the concept of inflation, so that the pernicious effects of monetary inflation can be more clearly seen.? I wrote what I wrote to distinguish between monetary, goods and asset inflation.? I think it is useful to make these distinctions, because most people when they hear the word “inflation” think only of goods price inflation, and not of monetary or asset inflation.

Now, onto today’s topic: how to protect ourselves from inflation and deflation.? With goods price deflation (should we ever see that under the Fed), the answers are simple: avoid debt, lend to stable debtors, and make sure you are economically necessary to the part of the economy that you serve.? You want to make sure that you have enough net cash flow when net cash flow is scarce.? You can use that cash flow to buy distressed assets on the cheap.? Economically necessary and low debt applies to the stocks you own as well.

On goods price inflation, take a step back and ask what is truly in short supply, and buy/supply some of that.? It could be commodities, agricultural products, or gold. ? As a last resort you could buy some TIPS, or just stay in a money market fund.? You won’t get rich that way, but you might preserve purchasing power.? In stocks, look for those that can pass through price inflation to their customers.? In bonds, stay short, unless they are inflation-protected.

This is not obscure advice, but there is an art to applying it.? There comes a point in every theme where prices of the most desirable assets discount or even over-discount the scenario.? Safe assets get overbought in a deflation toward the end of that phase of the cycle.? Same thing for inflation-sensitive assets during an inflation.? As for me at present, you can see my portfolio over at Stockpickr; at present, I split the difference, though my results over the last five months have been less than stellar.? I have companies with relatively strong balance sheets, and companies with a decent amount of economic sensitivity, whether to price inflation or price inflation-adjusted economic activity.

I don’t see the global economy heading into recession; I do see price inflation ticking up globally, and also asset inflation in some countries (China being a leading example). ? But we have a debt overhang in much of the developed world, so we have to be careful about balance sheets.

I may have it wrong at this point.? My equity performance over the last seven-plus years has been good, but the last five months have given me reason for pause.? Well, things were far worse for me 6/2002-9/2002; I saw that one through.? I should survive this one too, DV.

Personal Finance, Part 5 ? Inflation and Deflation

Personal Finance, Part 5 ? Inflation and Deflation

This is another in the irregular series on personal finance.? This article though, has implications beyond individuals.? I’m going to describe this in US-centric terms for simplicity sake.? For the 20-25% of my readers that are not US-based, these same principles will apply to your own country and currency as well.

Let’s start with inflation.? Inflation is predominantly a monetary phenomenon.? Whenever the Fed puts more currency into circulation on net, there is monetary inflation.? Some of the value of existing dollars gets eroded, even if the prices of assets or goods don’t change.? In a growing economy with a stable money supply, there would be no monetary inflation, but there would likely be goods price deflation.? Same number of dollars chasing more goods.

Let’s move on to price inflation.? There are two types of price inflation, one for assets, and the other for goods (and services, but both are current consumption, so I lump them together).? When monetary inflation takes place, each dollar can buy less goods or assets than in the absence of the inflation.? Prices would not rise, if productivity has risen as much or more than the amount of monetary inflation.

Now, the incremental dollars from monetary inflation can go to one of two places: goods or assets.? Assets can be thought of? as something that produces a bundle of goods in the future.? Asset inflation is an increase in the prices of assets (or a subgroup of assets) without equivalent improvement in the ability to create more goods in the future.? How newly printed incremental dollars get directed can make a huge difference in where inflation shows up. Let me run through a few examples:

  1. ?In the 1970s in the US, the rate of household formation was relatively rapid, and there was a lot of demand for consumer products, but not savings.? Money supply growth was rapid.? The stock and bond markets languished, and goods prices roared ahead.? Commodities and housing also rose rapidly.
  2. In? the mid-1980s the G7 induced Japan to inflate its money supply.? With an older demographic, most of the excess money went into savings that were invested in stocks that roared higher, creating a bubble, but not creating any great amount of incremental new goods (productivity) for the future.
  3. In 1998-1999, the Fed goosed the money supply to compensate for LTCM and the related crises, and Y2K.? The excess money made its way to tech and internet stocks, creating a bubble.? On net, more money was invested than was created in terms of future goods and services.? Thus, after the inflation, there came a deflation, as the assets could not produce anything near what the speculators bid them up to.
  4. In 2001-2003 the Fed cut rates aggressively in a weakening economy.? The incremental dollars predominantly went to housing, producing a bubble.? More houses were built than were needed in an attempt to respond to the demand from speculators.? Now we are on the deflation side of the cycle, where prices adjust down, until enough people can afford the homes using normal financing.

I can give you more examples.? The main point is that inflation does not have to occur in goods in order to be damaging to the economy.? It can occur in assets when people and institutions become maniacal, and push the price of an asset class well beyond where its future stream of cash flow would warrant.

Now, it’s possible to have goods deflation and asset inflation at the same time; it is possible to save too much as a culture.? The boom/bust cycles in the late 1800s had some instances of that.? It’s also possible to have goods inflation and asset deflation at the same time; its definitely possible to not save enough as a culture, or to have resources diverted by the government to fight a war.

The problem is this, then.? It’s difficult to make hard-and-fast statements about the effect of an increasing money supply.? It will likely create inflation, but the question is where?? Many emerging economies have rapidly growing money supplies, and they are building up their productive capacity.? The question is, will there be a market for that capacity?? At what price level?? Many of them have booming stockmarkets.? Do the prices fairly reflect the future flow of goods and services?? Emerging markets presently trade at a P/E premium to the developed markets.? If capitalism sticks, the premium deriving from faster growth may be warranted.? But maybe not everywhere, China for example.

The challenge for the individual investor, and any institutional asset allocator is to look at the world and estimate where the assets generating future inflation-adjusted cash flows (or goods and services) are trading relatively cheaply.? That’s a tall order.? Jeremy Grantham of GMO has done well with that analysis in the past, and I’m not aware that he finds anything that cheap today.

We live in a world of relatively low interest rates; part of that comes from the Baby Boomers aging and pension plans investing for their retirement.? P/E multiples aren’t that high, but profit margins are also quite high.? We also face central banks that are loosening monetary policy to reduce bad debt problems.? That incremental money will aid institutions not badly impaired, and might eventually inflate the value of houses, if they get aggressive enough.? (Haven’t seen that yet.)? In any case, the question is how will the incremental dollars (and other currencies) get spent?? In the US, we have another demographic wave of household formations coming, so maybe goods inflation will tick up.

We’ll see.? More on this tomorrow; I’ll get more practical and less theoretical.

Ten Years From Now

Ten Years From Now

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.
Slide 1

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

Slide 2

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.
slide 3

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:

Slide 4

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.
Slide 5

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:

Slide 6

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.
Investing in a Stagflationary Environment

Investing in a Stagflationary Environment

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.

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