I am generally not a fan of formulaic books on investing, and this is particularly true of books that take unusual approaches to investing. This book is an exception because it does nothing unusual, and follows what all good quantitative investors know have worked in the past.  The past is not a guarantee of the future, but if the theories derived from past data make sense from what we know about human nature, that’s about as good as we can get.

The book begins with a critique of the abilities of financial advisors — their fees, asset allocation, and security selection.  It then shows how models of financial markets outperform most financial advisors.

Then, to live up to its title , the book gives simple versions of models that can be applied by individuals that would have outperformed the markets in the past.  You can beat the markets, lower risk, and “Do It Yourself [DIY].”  It provides models for asset allocation, stock selection, and risk control, simple enough that a motivated person with math skills equal to the first half of Algebra 1 could apply them in a moderate amount of time per month.  It also provides a simpler version of the full model that omits the security selection for stocks.

The book closes by offering three reasons why people won’t follow the book and do it themselves: fear of failure, inertia, and not wanting to give up an advisor who is a friend.  It also offers three risks for the DIY investor — overconfidence, the desire to be a hero (seems to overlap with overconfidence), and that the theories may be insufficient for future market behavior.

This is where I have the greatest disagreement with the book.  I interact with a lot of people.  Most of them have no interest in learning the slightest bit about investing.  Some have some inclination to learn about investing, but even the simple models of the book would make their heads spin, or they just wouldn’t want to take the time to do it.  Some of it is similar to seeing a Youtube video on draining and refilling your automatic transmission fluid.  You might watch it, and say “I think I get it,” but the costs of making a mistake are sufficiently severe that you might not want to do it without an expert by your side.  Most will take it to the repair garage and pay up.

I put a knife to my own throat as I write this, as I am an investment advisor, but there is more specialized knowledge in the hands of an auto mechanic than in an investment advisor, and the risk of loss is lower to manage your own money than to fix your own brakes.  That said, enough people after reading the book will say to themselves, “This is just one author, and I barely understand the performance tables in the book — if right, am I capable of doing this?  Or, could it be wrong?  I can’t verify it myself.”

The book isn’t wrong.  If you are willing to put in the time to follow the instructions of the authors, I think you will do better than most.  My sense is that the grand majority people are not willing to do that.  They don’t have the time or inclination.



The book could have been clearer on the ROBUST method for risk control.  It took me a bit of effort to figure out that the two submodels share half of the weight, so that when submodels A & B flash green — 100% weight, one green and one red — 50% weight, both red — 0% weight.

Also, the book is enhanced by the security selection model for stocks, but how many people would have the assets to assemble and maintain a portfolio with sufficient diversification?  The book might have been cleaner and simpler to leave that out.  The last models of the book don’t use it anyway.

Summary / Who Would Benefit from this Book

I liked this book, and I recommend it for those who are willing to put in the time to implement its ideas.  This is not a book for beginners, and you have to be comfortable with the small amount of math and the tables of financial statistics, unless you are willing to trust them blindly.  (Or trust me when I say that they are likely accurate.)

But with the caveats listed above, it is a good book for people who are motivated to do better with their investments.  If you want to buy it, you can buy it here: DIY Financial Advisor.

Full disclosure: I received a copy from one of the authors, a guy for whom I have respect.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

Photo Credit: Mike Beauregard || Frozen solid, right?

Photo Credit: Mike Beauregard || Frozen solid, right?

The talk regarding an illiquid public corporate bond market goes on, and if you’ve read me over the past year on this topic, you know that I don’t think it is a serious issue.  One of the reasons why it is not a big issue is that the public bond market is designed to be low liquidity.

It starts with how bonds are originally issued.  New bonds and new stocks are issued in similar ways, but with a few differences:

  • IPOs of stocks have a higher retail component.  Bonds, aside from muni bonds, are typically almost entirely institutional
  • IPOs are typically priced cheap, but with bonds the cheapness is smaller and more frequent.
  • Bond IPOs usually happen with companies that have issued other bonds before
  • Bond IPOs happen more frequently, except in a bear market
  • Bond IPOs typically happen more rapidly, minutes to a few days, except in a bear market

IPOs on Wall Street get allocated if they are oversubscribed.  When they are oversubscribed, the deal is typically good, and everyone wants more, so they put in huge orders.  The dealer desks on Wall Street solves this problem by allocating proportionate to the size that they have come to understand the managers in question typically buy and sell at, with some adjustment for account profitability.

Those that flip cheap bonds for a quick profit typically get penalized, and their allocations get reduced.  Those that buy bonds in the open market when the deal breaks and becomes “free to trade” can become eligible for larger allocations.  The dealer desks work in this way because they want the buyers to be long-term holders, and not seekers of easy profits from flipping.  That doesn’t mean you can never trade a bond you have bought — just not in the first month, subject to a few exceptions like a small allocation, your credit analyst rejected it, etc.  (Oh, and if one of those exceptions exists, the primary dealers want to do the secondary trade.  If the exceptions don’t exist, they don’t want to know about it.)

If flippers ever get big, despite the efforts of the dealer desks, they will price a deal very tight, and let the flippers take a big loss, with no one wanting to buy the excess bonds unless they are much, much cheaper.

The main effect of this is that once a deal is allocated, it is typically “well-placed,” with few secondary trades after the IPO.  This is even more pronounced with mortgage bonds, which aside from the AAA tranches, have very small tranche sizes, making them very illiquid.

In this environment, where yields have fallen over the past few years, it is difficult for financial companies that have bought bonds to replace the income if they sell the bond.  Thus, few bonds will be sold unless they are in the hands of buyers that don’t have a formal balance sheet, or, when credit quality is deteriorating badly.

Add in one more factor, and you can see why the market is so illiquid — the buy side of the market is more concentrated than in prior years, with big buyers like PIMCO, Blackrock, Metlife, Prudential, etc. being a larger portion of the market.  Concentrated markets with few holders tend to be less liquid.

All Good/Bad Things Must Come to an End

Some of these factors can be reversed, and others can be mitigated.

  • There’s no reason why the buy side has to stay concentrated.  Big institutions eventually break up because diseconomies of scale kick in.  Management teams typically do worse as companies get more complex.
  • Eventually interest rates will rise.  Once bonds are in a nearly neutral to negative capital gains positions, parties with balance sheets will trade bonds again.
  • Even mutual funds that own a lot of yieldy bonds can have a strategy for dealing with the illiquidity.  Yieldy bonds have excess yield relative to bonds of similar duration and credit quality, and are often less liquid because there is something odd about them that makes some portion of the market skeptical, which reduces liquidity.  A mutual fund holding a lot of less liquid bonds, can deal with illiquidity by selling opportunistically, selling more liquid bonds in the short-run, while discreetly inquiring on a few less liquid issues to see where real bids might be.  Remember, the amount of underperformance is likely to be limited, if any, so a run on a mutual fund is not likely, but in the unlikely case of a run, this can mitigate the effects.  Personally, I would not be concerned, so long as you keep your pricing marks conservative if cash outflows become a rule in the short-run.

In closing, don’t worry about illiquidity in the bond markets.  If there is a need for liquidity, the problem will solve itself as sellers lose a little bit in order to gain cash to make payments.  It’s that simple.

Photo Credit: DonkeyHotey

Photo Credit: DonkeyHotey

Here are two ideas for the Fed, not that they care much about what I think:

1) Stop holding regular press conferences and holding regular meetings.  Only meet when a supermajority of your members are calling for a change in policy.  Don’t announce that you are holding a meeting — perhaps do it via private video conference.

Part of the reason for this is that it is useless to listen to commentary about why you did nothing.  You may as well have not held a meeting.  Another reason is that governors could act more independently if a meeting can’t be called unless a supermajority of voting members calls for it.

Yet another reason is that the frequent and long communication has not eliminated the Kremlinology that exists to interpret the Fed.  When changes to the FOMC statement are small, they get over-interpreted — remember the “taper” comment?  Far better to say nothing than to repeat yourself with small meaningless variations.

Along with that, you could eliminate issuing statements altogether, and go back to the way things were done pre-Greenspan.  Need it be mentioned that monetary was executed better under Volcker and Martin?  We don’t need words, we need to feel the actions of the Fed.  That brings me to:

2) Stop trying to support risky asset markets.  It is not your job to give equity or corporate bond investors what they want.  If you do that, too much liquidity gets injected into the system, creating the financial bubbles of 2000 and 2007-9.

Instead, give the risk markets some negative surprises.  Don’t follow Fed funds futures; make them follow you.  Show them that you are the boss, not the slave.  Let recessions do their good work of clearing out bad debts, and then the economy can grow on a better basis.  Be like Martin, and take away the punchbowl when the party gets exciting.

Do these things and guess what?  Monetary policy will have more punch.  When you make a decision, it will actually do something.

Realize that policy uncertainty is not poison for risk markets. It forces businessmen to avoid marginal ideas — things that only survive when the weather is fair.  The accumulated underbrush of bad debts doesn’t keep building up until the eventual fire is impossible to control.

If were going to have fiat money, do it in such a way that bubbles do not develop, which means not caring about the effects of policy on risky asset markets.  This might not be popular, but it would be good for the economy in the long run.


As a final note let me end with one chart from the recent data from FOMC participants:

central tendency_1915_image001

I suspect the FOMC will tighten in December, but remember that the FOMC doesn’t have a roadmap for the environment they are in, and they are acting like slaves to the risky asset markets.  Another burp in the markets, and lessening policy accommodation will be further delayed.


Photo Credit: Nate Steiner || There is always enough time to panic. ;)

Photo Credit: Nate Steiner || There is always enough time to panic. ;)

Today, I happened to stumble across an old article of mine: Easy In, Hard Out (Updated).  It’s kind of long, but goes into the changes that have happened at the Fed since the crisis, and points out why tightening policy might be tough.  Nothing has changed in the 2.4 years since I wrote it, so I am going to reprint the end of the article.  Let me know what you think.


In normal times, central banks buy only government debt, and keeps the assets relatively short, at longest attempting to mimic the existing supply of government debt.  Think of it this way, purchases/sales of longer debt injects/removes liquidity for longer periods of time.  Staying short maintains flexibility.

Yes, the Fed does not mark its securities or gold to market.  Under most scenarios, it is impossible for a central bank which can issue its own currency to go broke.  Rare exceptions — home soil wars that fail, or political repudiation of the bank, where the government might create a new monetary standard, or closes the bank because of inflation.  (Hey, the central bank has been eliminated twice before.  It could happen again.)

The only real effect is on how much seigniorage the Fed remits to the Treasury, or, if things go bad, how much the Treasury would have to lend/send to the central bank in order to avoid the bad optics of negative capital, perhaps via the Supplemental Financing Account.  This isn’t trivial; when people hear the central bank is “broke,” they will do weird things.  To avoid that, the Fed’s gold will be revalued to market at minimum; hey maybe the Fed at that time will be the vanguard of market value accounting, and revalue everything.  Can you imagine what the replacement cost of the NY Fed building is?  The temple in DC?

Or, maybe the bank would be recapitalized by its member banks, if they are capable of doing so, with the reward being the preferred dividend they receive.

Back to the main point.  What effect will this abnormal monetary policy have in the future?



1) Growth strengthens and inflation remains low.  In this unusual combo, it will be easy for the Fed to collapse its balance sheet, and raise rates.  This is the dream scenario; and I don’t think it is likely.  Look at the global economy; there is a lot of slack capacity.

2) Growth strengthens and inflation rises.  The Fed will likely raise the interest on reserves rate, but not sell bonds.  If they do sell bonds, the market will back up, and their losses will be horrible.  If don’t take the losses, seigniorage could be considerably reduced, or even vanish, as the Fed funds rate rises, but because of the long duration asset portfolio, asset income rises slowly.  This is where the asset-liability mismatch bites.

If the Fed doesn’t raise the interest on reserves rate, I suspect banks would be willing to lend more, leaving fewer excess reserves at the Fed, which could stimulate more inflation. Now, there are some aspects of inflation that remain a mystery — because sometimes inflationary conditions affect assets, rather than goods, I think depending on demographics.

3) Growth weakens and inflation remains low.  This would be the main scenario for QE4, QE5, etc.  We don’t care much about the Fed’s balance sheet until the Fed wants to raise rates, which is mainly a problem in Scenario 2.

4) Growth weakens and inflation rises, i.e. stagflation.  There’s no good set of policy options here. The Fed could engage in further financial repression, keeping short rates low, and let inflation reduce the nominal value of debts.  If it doesn’t run wild, it could play a role in reducing the indebtedness of the whole economy, though again, it will favor debtors over savers.  (As I’ve said before, in a situation like this, or like the Eurozone, all creditors want to be paid back at par on the bad loans that they have made, and it can’t be done.  The pains of bad debt have to go somewhere, where it goes is the argument.)

I’ve kept this deliberately simple, partially because with all of the flows going back and forth, and trying to think of the whole system, rather than effects on just one part, I know that I have glossed over a lot.  I accept that, and I could be dead wrong, as I sometimes am.  Comment as you like, with grace and dignity, and let us grow together in our knowledge.  I’ve been spending some time reading documents at the Fed, trying to understand their mechanisms, but I could always learn more.



During older times, the end of a Fed loosening cycle would end with the Fed funds rate rising.  In this cycle, it will end with interest of reserves rising, and/or, the sale of bonds, which I find less likely (they will probably be held to maturity, absent some crisis that we can’t imagine, or non-inflationary growth).  But when the tightening cycle comes, the Fed will find that its actions will be far harder to take than when they made the “policy accommodation.”  That has always been true, which is why the Fed during its better times limited the amount of stimulus that it would deliver, and would tighten sooner than it needed to.

Far better to be like McChesney Martin or Volcker, and be tough, letting recessions do their necessary work of eliminating bad debt.  Under Greenspan, and Bernanke to a lesser extent (though he persists in pushing the canard that the Fed was not too loose 2003-2004, ask John Taylor for more), there were many missed opportunities to stop the buildup of bad debts, but the promise of the “Great Moderation” beguiled so many.

Removing policy accommodation is always tougher than imagined, and carries new risks, particularly when new tools have been used.  Bernanke can go to his carefully chosen venues and speak to his carefully chosen audiences, and try to exonerate the Fed from well-deserved blame for their looseness in the late 80s, 90s, and 2000s.  Please, Mr. Bernanke, take some blame there on behalf of the Fed — the credit boom could never have happened without the Fed.  Painting the Fed as blameless is wrong; the “Greenspan put” landed us in an overleveraged bust.

I’m not primarily blaming the Fed for its current conduct; we are still in the aftermath of a lending bust — too much bad mortgage debt, with a government whose budget is out of balance.  (In the bust, there are no good solutions.)  I am blaming the Fed for loose policies 1984-2007, monetary policy should have been a lot tighter on average.  But now we live with the results of prior bad policy, and may the current Fed not compound it.


The main difference between this time and the last time I wrote on this is QE3.  What has been the practical impact since then?  The Fed owns more MBS and long maturity Treasuries, financed by more reserve balances at the Fed.

Banks use this cheap funding to finance other assets.  But if they want to make money, the banks have to take credit risk (something the Fed is trying to stimulate), and/or interest rate rate risk (borrow short, lend long, negative convexity, etc).  The longer low rates go on through interest on reserves, the greater the tendency to build up imbalances in the banking system through credit and interest rate risks. 1992-1993 where Fed funds rates were held at 3%, was followed by the residential mortgage backed security market melting down in 1994, not to mention Mexico.  Sub-2% Fed funds rates from 2002 through mid-2004 led to massive overinvestment in residential housing, leading to the present crisis.

Fed tightening cycles often start with a small explosion where short-dated financing for thinly capitalized speculators evaporates, because of the anticipation of higher financing rates.  Fed tightening cycles often end with a large explosion, where a large levered asset class that was better financed, was not financed well-enough.  Think of commercial property in 1989, the stock market in 2000 (particularly the NASDAQ), or housing/banks in 2008.  And yet, that is part of what Fed policy is supposed to do: reveal parts of the economy that are running too hot, so that capital can flow from misallocated areas to areas that are more sound.  At present, my suspicion is that we still have more trouble to come in banking sector.  Here’s why:

We’ve just been through 4.5 years of Fed funds / Interest on reserves being below 0.5% — this is a far greater period of loose policy than that of 1992-1993 and 2002 to mid-2004 together, and there is no apparent end in sight.  This is why I believe that any removal of policy accommodation will prove very difficult.  The greater the amount of policy accommodation, the greater the difficulties of removal.  Watch the fireworks, if/when they try to remove it.  And while you have the opportunity now, take some risk off the table.

This should be short. There are a lot of good reasons not to worry about the FOMC raising Fed funds or not.  If they raise Fed funds:

  • First, savers deserve a return.  Economies work better when savers get rewarded.
  • Second, investors do better on the whole when there is a risk free asset earning something to allocate money to, because otherwise investors take too much risk in an effort to generate income.
  • Third, the FOMC should never have let Fed funds rates go below 1% anyway — the marginal stimulus is limited once the yield curve gets slope enough for the banks to lend.  They don’t really need more than that.
  • Fourth, it’s not as if monetary policy has been doing that much.   Outside of the government and corporations, most entities have not shown a lot of desire to lever up after the financial crisis.
  • Fifth, long Treasury yields will do what they want to do — they won’t necessarily go up… it all depends on how strong the economy is.

But if the they don’t raise Fed funds, no big deal.  We wait a little longer.  What’s the difference between having zero interest rates for 6.5 years and 7.5 years?  Either one would build up enough leverage if the economy had the oomph to absorb it.

As it is, corporate borrowing has been the major place of debt expansion through both loans and bonds.  Watch the debt of energy firms that are allergic to low crude oil prices.  Honorable mention goes to auto, student, and agricultural lending.  May as well mention that underwriting standards are slipping in some areas for consumers, but things aren’t nuts yet.

I’ve often said that the FOMC stops tightening rates when something big blows up.  Can’t see what it will be this time — the energy sector will be hurt, but it isn’t big enough to impair financials as a group.  Subprime lending is light at present outside of autos.

Watch and see, but in my opinion, it is a sideshow.  Watch how the long end behaves, and see if the market reflates.  We need more confusion and less concern over what the next crisis is, before any significant crisis comes.

Photo Credit: Kevin Dooley || At the Ice Museum, ALL of the assets are frozen!

Photo Credit: Kevin Dooley || At the Ice Museum, ALL of the assets are frozen!

This article is another experiment. Please bear with me.

Q: What is an asset worth?

A: An asset is worth whatever the highest bidder will pay for it at the time you offer it for sale.

Q: Come on, the value of an asset must be more enduring than that.  You look at the balance sheets of corporations, and they don’t list their assets at sales prices.

A: That’s for a different purpose.  We can’t get the prices of all assets to trade frequently.  The economic world isn’t only about trading, it is about building objects, offering services… and really, it is about making people happier through service.  Because the assets don’t trade regularly, they are entered onto the balance sheet at:

  • Cost, which is sometimes adjusted for cost and other things that are time-related, and subject to writedowns.
  • The value of the asset at its most recent sale date before the date of the statement
  • An estimated value calculated from sales of assets like it, meant to reflect the likely markets at the time of the statement — what might the price be in a deal between and un-coerced buyer and seller?

Anyway, values in financial statements are only indicative of aspects of value.  Few investors use them in detail.  Even value investors who use the detailed balance sheet values in their investment decisions make extensive adjustments to them to try to make them more realistic.  Other value investors look at where the prices of similar companies that went private to try to estimate the value of public equities.

Certainly the same thing goes on with real estate.  Realtors and appraisers come up with values of comparable properties, and make adjustments to try to estimate the value of the property in question.  Much as realtors don’t like Zillow, it does the same thing just with a huge econometric model that factors in as much information as they have regarding the likely prices of residential real estate given the prices of the sparse number of sales that they have to work from.

Financial institutions regularly have to estimate values for variety of illiquid assets in a similar way.  I’ve even been known to help with those efforts on occasion, though management teams have not always been grateful for that.

Q: What if it’s a bad day when I offer my asset for sale?  Is my asset worth less simply because of transitory conditions?

A: Do you have to sell your asset that day or not?

Q: Why does that matter?

A: If you don’t need the money immediately, you could wait.  You also don’t have to auction the asset if you think that hiring an expert come in and talk with a variety of motivated buyers could result in a better price after commissions.  There are no guarantees of a better result there though.

The same problem exists on the stock market.  If you want the the money now, issue a market order to sell the security, and you will get something close to the best price at that moment.  That said, I never use market orders.

Q: Why don’t you use market orders?

A: I don’t want to be left at the mercy of those trading rapidly in the markets.  I would rather set out a price that I think someone will transact at, and adjust it if need be.  Nothing is guaranteed — a trade might not get done.  But I won’t get caught in a “flash crash” type of scenario, or most other types of minor market manipulation.

Patience is a virtue in buying and selling, as is the option of walking away.  If you seem to be a forced seller, buyers will lower their bids if you seem to be desperate.  You may not notice this in liquid stocks, but in illiquid stocks and other illiquid assets, this is definitely a factor.


That’s all for now.  If anyone has any ideas on if, where, or how I should continue this piece, let me know in the comments, or send me an e-mail.  Thanks for reading.


An investor can and should learn from the past.  He should never react to the recent past.  Why?  The past can’t be changed, but it can be known.  Reacting to the recent past leads investors into the valleys of greed and regret — good investments missed, bad investments incurred.

We’ve been in a relatively volatile environment for the last two weeks or so.  Markets are down, with a lot of noise over China, and slowing global growth.  Boo!

The markets were too complacent for too long, and valuations were/are higher than they should be, given current earnings, growth prospects and corporate bond yields.  It’s not the best environment for stocks given those longer-term valuation factors, but guess what?  The market often ignores those until a crisis hits.

The FOMC is going to tighten monetary policy soon.  Boo!

The things that people are taking on as worries rarely produce large crises.  They could mark stocks down 20-30% from the peak, producing a bear market, but they are unlikely of themselves to produce something similar to 2000-2 or 2008-9.

Let’s think about a few things supporting valuations and suppressing yields at present.  The overarching demographic trend in the market leads to a fairly consistent bid for risky assets.  It would take a lot to derail that bid, though that has happened twice in the last 15 years.  Ask yourself, do we face some significant imbalance where the banks could be impaired? I don’t see it at present.  Is a major sector like information technology or healthcare dramatically overvalued?  Maybe a little overvalued, but not a lot in relative terms.

There are major elections coming up next year, and a group of politicians harmful to the market will be elected.  This is a bad part of the Presidential Cycle.  Boo!

Take a step back, and ask how you would want your portfolio positioned for a moderate pullback, where you can’t predict how long it will take or last.  Also ask how you would like to be positioned for the market to return to its recent highs over the next year.  Come up with your own estimates of likelihood for these scenarios, and others that you might imagine.

We work in a fog.  We don’t know the future at all, but we can take actions to affect it, and our investing results.  The trouble is, we can adjust our risk profile, but our ability to know when it is wise to take more or less risk is poor, except perhaps at market extremes.  Even then, we don’t act, because we drink the Kool-aid in those ebullient or depressed environments.  We often know what we should do at the extremes, but we don’t listen.  There is a failure of the will.

This is a bad season of the year.  September and October are particularly bad months.  Boo!

I often say that there is always enough time to panic.  Well, let me modify that: there’s also always enough time to plan.  But what will you take as inputs to your plan?  Look at your time horizon, and ask what investment factors will persistently change over that horizon.  There are factors that will change, but can you see any that are significant enough for you to notice, and obscure enough that much of the rest of the market has missed it?

Yeah, that’s tough to do.  So perhaps be modest in your risk positioning, and invest with a margin of safety for the intermediate-to-long-term, recognizing that in most cases, the worst case scenario does not persist.  The Great Depression ended.  So did the ’70s.  Valuations are higher now than in 2007.  (Tsst… Boo!)  The crisis in 2008-9 did not persist.

That doesn’t mean a crisis could not persist, just that it is unlikely.  Capitalist systems are very good at dealing with economic volatility, even amid moderate socialism.  Go ahead and ask, “Will we become like Greece?  Argentina?  Venezuela?  Russia?  Spain?  Etc?”  Boo!

It would take a lot to get us to the economic conditions of any of those places.  Thus I would say it is reasonable to take moderate risk in this environment if your time horizon and stomach/sleep allow for it.  That doesn’t mean you won’t go through a bear market in the future, but it will be unlikely for that bear market to last beyond two years, and even less likely a decade.

This is just a “what if” piece. If one of my readers knows better than me, leave a comment, or email me. Thanks.

The Surprise Dividend

Imagine one day in 2019 that your favorite dividend-paying stock made the following announcement:

Dear Shareholder,

As you may know, we currently pay a dividend of $2/year to holders of our common stock for each share they hold.  In this current climate where there is uncertainty over whether dividends will be cut at some companies, we would like to guarantee the current payout, and give you more.

We are replacing the current dividend and declaring a special payout today — an unsecured perpetual junior subordinated bond that will pay 80 cents quarterly per current share, payable to all current shareholders as of June 1st, 2019.  It will be eligible to trade separately under the ticker [TICKER].  You are free to sell this income stream for a current gain, or you can continue to receive this income in perpetuity, as will any future holder of this bond.

Why are we doing this?  The Total Revenue And Safe Harbor Act of 2018 repealed special treatment of dividends, but interest is still tax-deductible to us as a corporation.  Much as we like the flexibility of dividends, our cash flow is more than sufficient, and can handle a higher payout.  This higher payout is possible partially because this is an interest payment, and we get to deduct the payment from taxable income.  With our current corporate tax rate of 35%, the effective cost of the new dividend to the corporation is $2.08 per current share.

Many of our shareholders are not taxable, or have taxes deferred.  Still others are retirees who are in lower personal tax brackets.  We expect that some current shareholders in higher tax brackets will choose to sell their bonds.  We would not be surprised to find life insurance companies as willing buyers, given our high credit rating, and their need for long bonds as investments.

Though in the near-term, we will not pay a dividend, that does not mean we will never pay a dividend again.  We will review our payout policy regularly, and make changes as we see best.  It is also possible that future shareholders could see further issuance of these securities if our reliable excess cash flow grows.

As always, we welcome your inquiries to our Investor Relations Department.  Please be aware that this does not constitute tax advice, nor will we provide that to you.  Please give your tax questions to your own personal tax adviser.

Many thanks for being one of our shareholders.  We hope you prosper in 2019 and beyond.

I left aside the argument that now shareholders could choose their own income preference, and also that the income from a junior subordinated bond could survive bankruptcy (though unlikely), and could control the company post-bankruptcy (also unlikely).  Mentions of bankruptcy don’t travel well, even in vague terms.

I also did not mention that the package of the junior bond and the post-dividend stock would likely trade at a higher price post-event.  Might some activist investors try some more severe proposals of this sort?

Your thoughts on this proposal are welcome.  I can’t think of any firm that has done something like this in the past.  Might they do it in the future?

Photo Credit: Dr. Wendy Longo || This horizon is distant...

Photo Credit: Dr. Wendy Longo || This horizon is distant…

I ran across two interesting articles today:

Both articles are exercises in understanding the time horizon over which you invest.  If you are older, you may not have the time to recover from market shortfalls, so advice to buy dips may sound hollow when you are nearer to drawing on your assets.

Thus the idea that volatility, presumably negative, doesn’t hurt unless you sell.  Some people don’t have much choice in the matter.  They have retired, and they have a lump sum of money that they are managing for long-term income.  No more money is going in, money is only going out.  What can you do?

You have to plan before volatility strikes.  My equity only clients had 14% cash before the recent volatility hit.  Over the past week I opportunistically brought that down to 10% in names that I would like to own even if the “crisis” deepened.  That flexibility was built into my management.  (If the market recovers enough, I will rebuild the buffer.  Around 1300 on the S&P, I would put all cash to work, and move to the alternative portfolio management strategy where I sell the most marginal ideas one at a time to raise cash and reinvest into the best ideas.)

If an older investor would be hurt by a drawdown in the stock market, he needs to invest less in stocks now, even if that means having a lower income on average over the longer-term.  With a higher level of bonds in the portfolio, he could more than proportionately draw down on bonds during a crisis, which would rebalance his portfolio.  If and when the stock market recovered, for a time, he could draw on has stock positions more than proportionately then.  That also would rebalance the portfolio.

Again, plans like that need to be made in advance.  If you have no plans for defense, you will lose most wars.

One more note: often when we talk about time horizon, it sounds like we are talking about a single future point in time.  When the time for converting assets to cash is far distant, using a single point may be a decent approximation.  When the time for converting assets to cash is near, it must be viewed as a stream of payments, and whatever scenario testing, (quasi) Monte Carlo simulations, and sensitivity analyses are done must reflect that.

Many different scenarios may have the same average rate of return, but the ones with early losses and late gains are pure poison to the person trying to manage a lump sum in retirement.  The same would apply to an early spike in inflation rates followed by deflation.

The time to plan is now for all contingencies, and please realize that this is an art and not a science, so if someone comes to you with glitzy simulation analyses, ask them to run the following scenarios: run every 30-year period back as far as the data goes.  If it doesn’t include the Great Depression, it is not realistic enough.  Run them forwards, backwards, upside-down forwards, and upside-down backwards.  (For the upside-down scenarios normalize the return levels to the right side up levels.)  The idea here is to use real volatility levels in the analyses, because reality is almost always more volatile than models using normal distributions.  History is meaner, much meaner than models, and will likely be meaner in the future… we just don’t know how it will be meaner.

You will then be surprised at how much caution the models will indicate, and hopefully those who can will save more, run safer asset allocations, and plan to withdraw less over time.  Reality is a lot more stingy than the models of most financial Dr. Feelgoods out there.

One more note: and I know how to model this, but most won’t — in the Great Depression, the returns after 1931 weren’t bad.  Trouble is, few were able to take advantage of them because they had already drawn down on their investments.  The many bankruptcies meant there was a smaller market available to invest in, so the dollar-weighted returns in the Great Depression were lower than the buy-and-hold returns.  They had to be lower, because many people could not hold their investments for the eventual recovery.  Part of that was margin loans, part of it was liquidating assets to help tide over unemployment.

It would be wonky, but simulation models would have to have an uptick in need for withdrawals at the very time that markets are low.  That’s not all that much different than some had to do in the recent financial crisis.  Now, who is willing to throw *that* into financial planning models?

The simple answer is to be more conservative.  Expect less from your investments, and maybe you will get positive surprises.  Better that than being negatively surprised when older, when flexibility is limited.

Photo Credit: Moyan Brenn || My, now doesn't that look peaceful...

Photo Credit: Moyan Brenn || My, now doesn’t that look peaceful…

There is the temptation when market prices move fast after they have been at recent highs to assume that things are going to fall apart.  Well, guess what?  That could happen.

I don’t think it is likely though, if falling apart means a scenario like 2008-9, 2000-2 or 1973-4.  In order to have a significant drawdown in the market, you have to have a lot of leverage collapse, whether that is financial or operating leverage.

Financial leverage is bad debt.  We have areas of that — student loans, agricultural loans, a modest amount of subprime lending for autos, and a decent amount of lending to junk-rated corporations, but not enough to create a self-reinforcing situation where bad debts can’t be borne by lenders, and lenders then collapse.

Operating leverage is bad assets — building up too much productive capacity such that there will not be enough demand to absorb it for the foreseeable future.  Or, building capacity that isn’t productive… either way, assets will have to be written down.

There have been a number of parties kvetching about a lack of investment from US corporations, but let’s take this a different direction.  There hasn’t been a lot of bad investment from US corporations… and part of that may be due to dividend and buyback policies.  Yes, there are some IPOs that have come out that look marginal.  I’ve looked at a variety of spin-offs where the underlying business is attractive, but they loaded the spin-off with a sizable slug of debt in order to pay a final dividend to the parent company saying farewell.  But on the whole, I don’t see a lot of money being wasted by corporations on investments.  That is another reason why profit margins are high.

Now, a lot of the furor in the markets stems from China, and the effects that slowing growth and/or bad debts in China will have on the US economy.  Personally, I don’t think this is an issue to worry about, unless you have a lot of investments in China and other emerging markets.  In general, US markets don’t get deeply hurt by slowdowns or even crises in other countries.  Even if it means a slowdown in revenue growth for large US corporations, it would also likely mean that US interest rates might fall, which would often make equities fall less as bonds rally.

Also, for foreign affairs to affect the US in a big way, the US would have to have a lot of lending exposure to those nations that are struggling.  (Think of the LDC nations in the early ’80s.)  Maybe this is one of the benefits of running current account deficits — we don’t have money to lend to foreign countries from our net export earnings.

Think of all the significant foreign crises of the last 30 years.  LDC crisis, Plaza Accords leading to Japan’s lost decades, Mexico, Asian Crisis, European Union difficulties with their fringe nations, Iceland, Greece, Greece, Greece, China, etc.  There was always temporary indigestion in US markets, but when did it ever weigh on the US markets for a long period?  Really, it never did.  So why are we concerned over China?

Regarding the Fed, I abstract from this old post, which quoted a 2005 piece on Fed policy at, and what blew up at the end of each tightening cycle.  I list blow-ups up to that point, and mention that I think US Housing is next:

  • 2000 — Nasdaq
  • 1997-98 — Asia/Russia/LTCM, though that was a small move for the Fed
  • 1994 — Mortgages/Mexico
  • 1989 — Banks/Commercial Real Estate
  • 1987 — Stock Market
  • 1984 — Continental Illinois
  • Early ’80s — LDC debt crisis

So it moves in baby steps, wondering if the next straw will break some camel’s back where lending has been going on terms that were too favorable. The odds of this 1/4% move creating such a nonlinear change is small, but not zero.

But on the bright side, the odds of a 50 basis point tightening at any point in the next year are even smaller. The markets can’t afford it.

Position: None

Or, these two posts, which you can look at if you want… one suggested that housing was the next bubble (in 2004), and the other critiqued Bernanke’s reasoning on monetary policy.  (Aaron Task has an interesting rejoinder to the latter of these.) — [DM: these links are dead now.]


Some worry now about future Fed policy — what will blow up when the Fed tightens too much?  I would encourage everyone to relax.  First, we don’t know that the Fed will do anything soon.  Second, we don’t know if they will do anything much.  Third, we don’t even know if the Fed has a coherent theory of monetary policy anymore.  Face it: Yellen has never tightened rates once.  Bernanke never tightened rates aside from finishing out Greenspan’s plan to invert the yield curve at the beginning of his Chairmanship.  Almost no one on the FOMC has any significant practical experience with tightening rates.  What will guide them out of their zero interest rate policy?  What will be enough?

Even so, tightening cycles usually end with something blowing up.  Maybe this time it is the emerging markets.  I don’t see a large concentration of US-based bad debt that the Fed might inadvertently blow up, at least not yet.  (Maybe the day will come when the US Treasury might complain about rising financing rates.  After all, debt is high, but affordable while rates are low.)

Valuation is the main issue as I see it at present, as I commented in my recent piece “Stocks or Bonds?”  When stocks are priced at a level that discounts 4.5%/year returns over the next 10 years, you don’t have a lot of margin for error, especially when you can create a safer bond portfolio that yields the same.

Now, since I wrote that piece, the S&P 500 is down around 10.5%.  The bond portfolio is down around 4.5% (it was a risky portfolio, and some of the emerging markets bonds hurt), while the Barclays’ Aggregate is up 1%.  High-yield bond spreads have widened over that time by ~1.2%.

The anticipated return on the S&P 500 has maybe risen by 1%/year over the next 10 years, to 5.5%.  That said, so has the yield on the risky bond portfolio.  I see the selloff as being in-line with the yields of risky debt, which at some higher level of spread, will attract buyers, given that there have been no significant defaults recently.

The US stock market could go down another 20% from here, but I think it will be less.  My main point is that we shouldn’t get a big washout, but just a correction of valuation levels that got too high relative to other risky assets, like junk bonds.

So don’t panic.  You could still move some assets from stocks to bonds if you want to sleep better, but don’t do anything severe.