Category: Asset Allocation

The Longer View, Part 4

The Longer View, Part 4

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

 

 

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.

Fifteen Notes on the State of the Markets

Fifteen Notes on the State of the Markets

1)? Start with the pessimists:


2)? Move to the optimists:

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.

8) 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.

Looking Beyond the US

Looking Beyond the US

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:

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.

The FOMC as a Social Institution, Part 2

The FOMC as a Social Institution, Part 2

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.

The Five Pillars of Liquidity

The Five Pillars of Liquidity

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.

Dissent on Dividends

Dissent on Dividends

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.

Twenty-Five Ways to Reduce Investment Risk

Twenty-Five Ways to Reduce Investment Risk

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.

Ten Important, but not Urgent Articles to Ponder

Ten Important, but not Urgent Articles to Ponder

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.

At The Periphery of Investing

At The Periphery of Investing

I have a friend who works for the Williams Inference Service.? Those who work for WIS spend their time looking for deep trends in our world that are underappreciated.? I dedicate a little of my time to that as well, and try to draw investable conclusions from odd bits of data that come across my radar.? But even without explicit conclusions, it richens my knowledge of our world, and perhaps with other data, will yield some return for me.? If nothing else, I love reading and writing, so join with me on this tour of articles around the web.

  1. I’m not sure if pollution problems in China are any worse than the problems faced by the US or the UK at similar points in their development.? That said, one major constraint on their ability to grow is pollution.? These articles from the Wall Street Journal are an excellent example of that: heavy metals in the food supply, and lead in jewelry that they sell domestically and export, with the lead coming from US scrap metal.? These practices may allow businesses to survive in the short run, but soon enough, jewelry will get tested in the US, and importers sued for liability.? In China, there will be increasing pressure for change, perhaps even violent change.? In Chinese history, there is a tendency for change not happen, or to happen rapidly when troubles for average people become too great.
  2. Demographics is a favorite topic of mine, particularly as the world slowly heads into a shrinking population.? For the most part, national economies don’t work so well when population levels shrink, which leads to pressure to import low skilled laborers from nations with surplus workers.? One nation that is at the front of the problem is Japan, where the population is shrinking pretty rapidly today.? Japan is now seeing that its pension system will be hard to sustain because of the lack of children being born.? Europe will face this problem as well.? The US less so, because of the higher birth and immigration rates; for us, the foreign debt will be our problem.
  3. Is war with Iran a done deal in a few years?? I hope not.? Given the mismanagement of the Iranian economy in the hands of the cronyist mullahs that run the joint, and the genuine difficulty of producing effective nuclear weapons without a strong academic/technical/manufacturing base, my guess is that there will be another revolution there before a significant bomb gets made.? (We’re still waiting on North Korea; what a joke.)? Economically, Iran is a basket case.? As I have mentioned before, they have mismanaged their oil resources.? What is less noticed is their coming demographic troubles.? Not all Muslims are fanatics, and many are having small families, which will generate it’s own old age crisis thirty years out.? That said, if Iran is provoked, it’s leaders will not give in; they iwill fight, as the second article i cited points out.? Better to quietly hem the current Iranian leadership in by supporting their enemies, than to risk another war that the US does not have the resources to fight.? Iran is weaker and more divided than it looks; its government will fall soon enough.
  4. Memo to all quantitative investors: are you ready for IFRS?? IFRS, the European accounting standard, particularly for financials will change enough things that older formulas of calculating value and safety may need to be severely modified.? The larger the importance of accrual items to an industry, the worse the adjustment will be.? All I say is, watch this.? If it changes, it will affect the way that we numerically analyze investments.? We are definitely losing foreign economies on our exchanges, mainly due to Sarbox, not accounting rules, but I think we are rushing through a compromise with IFRS to protect the interests of our exchanges, and I think that is a mistake.
  5. Then again, maybe we don’t need the Europeans to mess up our accounting rules; we can do just fine ourselves.? Our accounting standards are a hodgepodge between amortized cost and fair value standards… we keep moving more and more toward fair value, but will the auditors be able to keep up?? Auditing amortized cost is one thing; there are different skills required when fungible but not liquid assets can be written up on a balance sheet. (Think about real estate or mortgage derivatives.)? Accounting will become less reliable in my opinion.
  6. I wish we had a harder currency; why else do I buy foreign bonds?? Anyway, I appreciated this short partial monetary history of the US, from the Civil War onward, from Elaine Meinel Supkis.
  7. When you can’t deliver the underlying, typically futures markets don’t work well.? It is no surprise then that a derivatives market on economic indicators closed.? Futures markets exist to allow commercial interests to hedge.? Where there is nothing to hedge, it is akin to mere betting, and without the extra thrill of a sports contest, that rarely attracts enough interest to be economic.? That said, aren’t the VIX futures and options contracts catching on?
  8. Not sure what the second order effects will be here, but a rule is finally coming that will require the trade execution occur at the best price.? It will be extra work for the exchanges, but it will probably centralize exchanges in the intermediate term.? If you have to share data, why not merge?
  9. One reason that Buffett was/is that best was his ability to learn from mistakes.? He kept his mistakes small and eventually found ways out of many of them.? US Air?? Salomon Brothers?? He eventually gets cashed out.? General Re?? The earnings from investing float bails him out. The “Shoe Group” and World Book?? Small, and you can’t win them all.
  10. What do you do when the market has passed you by?? You got burned 2000-2002, and moved to a more conservative posture, only to find that the market ran like wild while you weren’t there.? What do you do now?? My advice: do half of what you would do if the market hadn’t run.? If you are at 20% equities, and you know that in normal times you should be at 60% equities, raise your investment level to 40% equities.? If the market rallies, you have more on, if it falls, you will have the chance to reinvest another 20% into equities at more attractive prices.
  11. I usually agree with Eddy Elfenbein; he’s very common sense.? But here I do not.? Get me right here, Eddy is correct in all that he says.? I frame the problem differently.? You have someone sitting on cash, and the market has appreciated to where valuations are high-ish.? You can? 1) invest it all now, 2) dollar cost average, or 3) do nothing.? Eddy doesn’t consider that many will choose 3.? On average, 1 beats 2 by a small margin, but 2 beats 3 by a wide margin.? Dollar cost averaging is a way to get psychologically unprepared people into the market who would never risk putting it all in at once.? We use DCA to get inexperienced investors from a bad place to a “pretty good” place, because the best place is unimaginable to them.
  12. Desalination is the wave of the future, even in the US.? Potable water is scarce globally (think of India and China), and the cost of potable water justifies the energy and other costs associated with desalination.? The article that I cited does not capture the environmental costs of desalination, in my opinion, but it gives a good taste of what the future will hold.

And, with that, that completes my tour of the periphery.? Next week, I hope to provide more color for you on our changing risk environment.

The “Fed Model”

The “Fed Model”

Recently there has been a discussion of the so-called ?Fed Model,? with some questioning the validity of model, and others affirming it. Even the venerable John Hussman has commented on models akin to the Fed Model that he dislikes. This piece aims at taking a middle view of the debate, and explain where the Fed Model has validity, and where it does not.

What is the Fed Model?

The Fed Model is a reasonable but imperfect means of comparing the desirability of investing in stocks versus bonds. It can be considered a huge simplification of the dividend discount model, applied to the market as a whole, rather than an individual stock. The dividend discount model states that the value of the stock is equal to the future stream of dividends discounted at the corporation?s cost of equity capital.

What simplifying assumptions get applied to the dividend discount model to create the Fed Model?

  1. The market as a whole is considered rather than individual stocks.
  2. A constant ratio of earnings is paid out as dividends.
  3. The growth rate of earnings is made constant.
  4. A Treasury yield (or high/moderate quality corporate bond yield) is substituted for the cost of equity capital.
  5. Instead of following a strict discounting method, the equation is rearranged to make an explicit comparison between bond yields and equity yields.

Assuming that the dividend discount model is valid, or at least approximately so, what do these simplifying assumptions do to the accuracy of valuing the market as a whole? The first assumption is more procedural in nature, and does no major harm. The fifth assumption simply reorganizes the equation, and doesn?t affect the outcome, but only the presentation. The real changes come from assumptions 2-4.

Dividends are more stable than earnings, so the payout ratio certainly varies over time. Additionally, corporations have shown less willingness to pay dividends, and investors have shown less inclination to demand dividends, to the payout ratio today is roughly half of what it was in the early 60s.

Fed Model Chart 3

Earnings don?t grow at a constant rate, either. Over the last 53 years, earnings have grown at a 6.7% rate, but that has included times of shrinkage, and boom times as well.

Fed Model Chart 4

As for the cost of capital to a corporation, I believe that the Capital Asset Pricing Model is genuinely wrong, and I refer you to Roll?s famous critique for what should have been its burial. Academics need risk to be something simple though, with risk being the same for all investors (not true), so that they can easily calculate their models, and publish. The CAPM provides useful, if mistaken, simplification to financial economists. It is not going away anytime soon.

One day I will write an article to explain my cost of equity capital methods in more depth, which derive corporate bonds and option pricing theory. In basic, for any corporation, the basic idea is to compare the riskiness of the equity to that of a bond. Look at the yield on juniormost debt security of the firm, the cost of equity is higher than that. Examine the implied volatility [IV] on the longest dated at the money options for the firm. How do those implied volatilities compare with other firms? In general the higher the IV, the higher the cost of equity capital.

Practically, when looking at the capital structure of the firms in the S&P 500, I think that the yield on a BBB bond plus a spread could be a good proxy for the weighted average cost of capital for the firms as a group. I?ll get to what that spread might be in a bit. We have BBB yield series going back a long way. Equity risk for the S&P 500 (a high credit quality group) is probably akin to the risk of owning weak BB or strong single-B bonds on average. (My rule of thumb for cost of equity capital in an individual corporation is take the juniormost debt yield and add 3%. For those with access to RealMoney, I have written more on this here.)

To summarize then: there?s not much I can do about assumptions 2 and 3. The only thing I might say is that earnings are a better proxy for value creation than dividends, and that expectations for longer-term earnings growth do not change nearly as much as actual earnings growth does. On assumption 4, a BBB bond yield plus a spread will be a reasonable, though not perfectly accurate proxy for the cost of equity. My view is that spread should be between 2.5%-3.0%.

The Results

With that, the ?Fed Model? boils down to a comparison of BBB bond yields less a spread versus earnings yields. Wait, ?less? a spread? Didn?t I say ?plus? above?

Let?s consider how a stock differs from a bond. With a bond, all that you can hope to get is your principal and interest paid on a timely basis. With equity, particularly in a diversified portfolio, one can expect over the long term growth in the value of the business from a growing dividend stream, and reinvestment of retained earnings. As I mentioned above, that has averaged 6.7%/year earnings growth over the past 53 years.

If I were trying to balance the yield needed from bonds to compete with equities, it would look like this, then:

Earnings Yield + 6.7% = BBB bond yield plus 2.5-3.0%

Or,

Earnings Yield = BBB bond yield – 4% (or so)

Here is how earnings yields and BBB bond yields have compared over the years.

Fed Model Chart 5

Thus my criteria for investing would be under the ?Fed Model,? when the earnings yield is more than 4% less than the BBB bond yield, invest in bonds. Otherwise, invest in stocks. Following this method, how would a portfolio have done since 1954?

Fed Model Chart 1

Wow. Pretty good rule, in hindsight. Is the spread of 4% the best spread for simulation purposes?

Fed Model Chart 2

Pretty close. The optimum value is 3.9%. This chart uses an actuarial smoothing method to give a fairer view of noisy historical results. (Life actuaries use this smoothing method in cash flow testing to calculate required capital, because sometimes small changes in spread produce large differences in the results for a particular scenario.)

The strategy produces a return roughly 2.0%/year higher than investing in stocks only, with a standard deviation roughly 1.5%/year lower. At least in a backtest, my version of the ?Fed Model? works.

Limitations

Okay, given the above, I endorse my version of the ?Fed Model? as being useful, but with five caveats:

The first thing to remember is that the ?Fed Model? doesn?t tell you whether stocks are absolutely cheap, but whether they are cheap versus bonds. There may be other more desirable asset classes to choose from: cash, commodities, international bonds or equities, etc.

The second thing to remember is that when interest rates get low, yields do not reflect the true riskiness of bonds ? a slightly superior model would be 107% of BBB yields less 4.7%. But that could just be an artifact of backtesting. To its credit though, the slightly superior model behaves the way that it should in theory, in term of how credit spreads move.

Number three, ideally, all models would not use trailing earnings yields, but expected earnings yields. That said, trailing yields are objective, and expected yields have often proiven wrong at turning points.

The fourth limitation: a high earnings yield might reflect low earnings quality or profit margins higher than sustainable. No doubt that is possible, and particularly in the current era. On the flip side, there may be times when a low earnings yield might reflect high earnings quality or profit margins lower than sustainable. A rule is a rule, and a model is only a model; they don?t reflect all aspects of reality, they are just tools to guide us.

What P/E ratio would the current BBB bond yield (6.74%) support? I am surprised to say that it would support a P/E in the high 30s; 39.8 for the simple model, and 35.2 for the ?slightly superior? one. With the current trailing P/E at 18.1, that would indicate that on an unadjusted basis, the market could be twice as high as it is presently.

That thought makes me queasy, but here three other ways to look at it:

  • How inflated are profit margins? If they are going to regress by less than half, then stocks are still a bargain.
  • Are bond yields/spreads too low? The recycling of the current account deficit into US debt instruments keeps yields low, and the speculation in the credit markets keeps spreads low. What should be the normalized BBB yield?
  • Will earnings growth slow beneath the 6.7% average? If so, the spread needs to come down.

Fifth, this is simply a backtest, albeit one that conforms to my theories. The future may not resemble the past.

Conclusion

My version of the Fed Model provides us with a way of comparing corporate bond yields with earnings yields, giving credit for growth that happens in capitalist economies that are free from war on their home soil. There are reasons to think that current profit margins are overstated, and perhaps that corporate bond yields will rise. All of that said, there is a large provision for adverse deviation in the present environment.

I would rather be a moderate bull on stocks versus bonds in this environment as a result. Don?t go hog wild, but current bond yields are no competition for stocks at present. If you think bond yields will normalize higher, perhaps cash is the place you would rather be for now.

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