Photo Credit: D.C.Atty || Scrawled in 2008, AFTER the crash started

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Comments are always appreciated from readers, if they are polite.  Here’s a recent one from the piece Distrust Forecasts.

You made one statement that I don’t really understand. “Most forecasters only think about income statements. Most of the limits stem from balance sheets proving insufficient, or cash flows inverting, and staying that way for a while.”

What is the danger of balance sheets proving insufficient? Does that mean that the company doesn’t have enough cash to cover their ‘burn rate’?

Not having enough cash to cover the burn rate can be an example of this.  Let me back up a bit, and speak generally before focusing.

Whether economists, quantitative analysts, chartists or guys who pull numbers out of the air, most people do not consider balance sheets when making predictions.  (Counterexample: analysts at the ratings agencies.)  It is much easier to assume a world where there are no limits to borrowing.  Practical example #1 would be home owners and buyers during the last financial crisis, together with the banks, shadow banks, and government sponsored enterprises that financed them.

In economies that have significant private debts, growth is limited, because of higher default probabilities/severity, and less capability of borrowing more should defaults tarry.  Most firms don’t like issuing equity, except as a last resort, so restricted ability to borrow limits growth. High debt among consumers limits growth in another way — they have less borrowing capacity and many feel less comfortable borrowing anyway.

Figuring out when there is “too much debt” is a squishy concept at any level — household, company, government, economy, etc.  It’s not as if you get to a magic number and things go haywire.  People have a hard time dealing with the idea that as leverage rises, so does the probability of default and the severity of default should it happen.  You can get to really high amounts of leverage and things still hold together for a while — there may be extenuating circumstances allowing it to work longer — just as in other cases, a failure in one area triggers a lot more failures as lenders stop lending, and those with inadequate liquidity can refinance and then fail.

Three More Reasons to Distrust Predictions

1) Media Effects — the media does not get the best people on the tube — they get those that are the most entertaining.  This encourages extreme predictions.  The same applies to people who make predictions in books — those that make extreme predictions sell more books.  As an example, consider this post from Ben Carlson on Harry Dent.  Harry Dent hasn’t been right in a long time, but it doesn’t stop him from making more extreme predictions.

For more on why you should ignore the media, you can read this ancient article that I wrote for RealMoney in 2005, and updated in 2013.

2) Momentum Effects — this one is two-sided.  There are momentum effects in the market, so it’s not bogus to shade near term estimates based off of what has happened recently.  There are two problems though — the longer and more severe the rise or fall, the more you should start downplaying momentum, and increasingly think mean-reversion.  Don’t argue for a high returning year when valuations are stretched, and vice-versa for large market falls when valuations are compressed.

The second thing is kind of a media effect when you begin seeing articles like “Everyone Ought to be Rich,” etc.  “Dow 36,000”-type predictions come near the end of bull markets, just as “The Death of Equities’ comes at the end of Bear Markets.  The media always shows up late; retail shows up late; the nuttiest books show up late.  Occasionally it will fell like books and pundits are playing “Can you top this?” near the end of a cycle.

3) Spurious Math — Whether it is the geometry of charts or the statistical optimization of regression, it is easy to argue for trends persisting longer than they should.  We should always try to think beyond the math to the human processes that the math is describing.  What levels of valuation or indebtedness are implied?  Setting new records in either is always possible, but it is not the most likely occurrence.

With that, be skeptical of forecasts.

 

Photo Credit: New America || Could only drive through the rear-view mirror

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This is the time of year where lots of stray forecasts get given.  I got tired enough of it, that I had to turn off my favorite radio station, Bloomberg Radio, after hearing too many of them.  I recommend that you ignore forecasts, and even the average of them.  I’ll give you some reasons why:

  • Most forecasters don’t have a good method for generating their forecasts.  Most of them represent the present plus their long-term bullishness or bearishness.  They might be right in the long-run.  The long-run is easier to forecast, in my opinion, because a lot of noise cancels out.
  • Most forecasters have no serious money on the line regarding what they are forecasting.  Aside from loss of reputation, there is no real loss to being wrong.  Even the reputational loss issue is a weak one, because Wall Street generally has no memory.  Why?  Enough things get predicted that pundits can point to something that they got right, at least in some years.  Memories are short on Wall Street, anyway.
  • The few big players that make public forecasts have already bought in to their theses, and only have limited power to continue buying their ideas, particularly if they are wrong.  This is particularly true in hedge funds, and leveraged financial firms.
  • Forecasts are bad at turning points, and average forecasts by nature abhor turning points.  That’s when you would need a forecast the most, when conditions are going to change.  If a forecast presumes “sunny weather” on an ordinary basis it’s not much of a forecast.
  • Most forecasters only think about income statements.  Most of the limits stem from balance sheets proving insufficient, or cash flows inverting, and staying that way for a while.
  • Most forecasts also presume good responses from policymakers, and even when they are right, they tend to be slow.
  • Forecasts almost always presume stability of external systems that the system that holds the forecasted variable is only a part of.  Not that anyone is going to forecast a war between major powers (at present), or a cataclysm greater than the influenza epidemic of 1918 (1-2% of people die), but are users of a forecast going to wholeheartedly believe it, such that if a significant disaster does strike, they are totally bereft?  When is the last time we had a trade war or a payments crisis?  Globalization and the greater division of labor is wonderful, but what happens if it goes backward, or a major nation like France faces a scenario like the PIIGS did?

I leave aside the “surprises”-type documents, which are an interesting parlor game, but have their own excuses built-in.

My advice for you is simple.  Be ready for both bad and good times.  You can’t tell what is going to happen.  Valuations are stretched but not nuts, which justifies a neutral risk posture.  Keep dry powder for adverse situations.

And, from David at the Aleph Blog, have a happy 2017.

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Here’s the quick summary of what I will say: People and companies need liquidity.  Anything where payments need to be made needs liquidity.  Secondary markets will develop their own liquidity if it is needed.

Recently, I was at an annual meeting of a private company that I own shares in.  Toward the end of the meeting, one fellow who was kind of new to the firm asked what liquidity the shares had and how people valued them.  The board and management of the company wisely said little.  I gave a brief extemporaneous talk that said that most people who owned these shares know they are illiquid, and as such, they hold onto them, and enjoy the distributions.  I digressed a little and explained how one *might* put a value on the shares, but trading values really depended on who was more motivated — the buyer or the seller.

Now, there’s no need for that company to have a liquid market in its stock.  In general, if someone wants to sell, someone will buy — trades are very infrequent, say a handful per year.  But the holders know that, and most plan not to sell the shares, looking to other sources if they need money to spend — liquidity.

And in one sense, the shares generate their own flow of liquidity.  The distributions come quite regularly.  Which would you rather have?  A bucket of golden eggs, or the goose that lays them one at a time?

Now the company itself doesn’t need liquidity.  It generates its liquidity internally through profitable operations that don’t require much in the way of reinvestment in order to maintain its productive capacity.

Now, Buffett used to purchase only companies that were like this, because he wanted to reallocate the excess liquidity that the companies threw off to new investments.  But as time has gone along, he has purchased capital-intensive businesses like BNSF that require continued capital investment.  Quoting from a good post at Alpha Architect referencing Buffett’s recent annual meeting:

Question: …In your 1987 Letter to Shareholders, you commented on the kind of companies Berkshire would like to buy: those that required only small amounts of capital. You said, quote, “Because so little capital is required to run these businesses, they can grow while concurrently making all their earnings available for deployment in new opportunities.” Today the company has changed its strategy. It now invests in companies that need tons of capital expenditures, are over-regulated, and earn lower returns on equity capital. Why did this happen?

Warren Buffett…It’s one of the problems of prosperity. The ideal business is one that takes no capital, but yet grows, and there are a few businesses like that. And we own some…We’d love to find one that we can buy for $10 or $20 or $30 billion that was not capital intensive, and we may, but it’s harder. And that does hurt us, in terms of compounding earnings growth. Because obviously if you have a business that grows, and gives you a lot of money every year…[that] isn’t required in its growth, you get a double-barreled effect from the earnings growth that occurs internally without the use of capital and then you get the capital it produces to go and buy other businesses…[our] increasing capital [base] acts as an anchor on returns in many ways. And one of the ways is that it drives us into, just in terms of availability…into businesses that are much more capital intensive.

Emphasis that of Alpha Architect

Liquidity is meant to support the spending of corporations and people who need services and products to further their existence.  As such, intelligent entities plan for liquidity needs in advance.  A pension plan in decline allocates more to bonds so that the cash flow from the bonds will fund expected net payouts.  Well-run insurance companies and banks match expected cash flows at least for a few years.

Buffer funds are typically low-yielding assets of high quality and short duration — short maturity bonds, CDs, savings and bank deposits, etc.  Ordinary people and corporations need them to manage the economic bumps of life.  Expenses are up, and current income doesn’t exceed them.  Got cash?  It certainly helps to be able to draw on excess assets in a pinch.  Those who run a balance on their credit cards pay handsomely for the convenience.

In a crisis, who needs liquidity most?  Usually, it’s whoever is at the center of the crisis, but usually, those entities are too far gone to be helped.  More often, the helpable needy are the lenders to those at the center of the crisis, and woe betide us if no one will privately lend to them.  In that case, the financial system itself is in crisis, and then people end up lending to whoever is the lender of last resort.  In the last crisis, Treasury bonds rallied as a safe haven.

In that sense, liquidity is a ‘fraidy cat.  Marginal borrowers can’t get it when they need it most.  Liquidity typically flows to quality in a crisis.  Buffett bailed out only the highest quality companies in the last crisis. Not knowing how bad it would be, he was happy to hit singles, rather than risk it on home runs.

Who needs liquidity most now?  Hard to say.  At present in the US, liquidity is plentiful, and almost any person or firm can get a loan or equity finance if they want it.  Companies happily extend their balance sheets, buying back stock, paying dividends, and occasionally investing.  Often when liquidity is flush, the marginal bidder is a speculative entity.  As an example, perhaps some emerging market countries, companies and people would like additional offers of liquidity.

That’s a major difference between bull and bear markets — the quality of those that can easily get unsecured loans.  To me that is the leading reason why we are in the seventh or eighth inning of a bull market now, because almost any entity can get the loans they want at attractive levels.  Why isn’t it the ninth inning?  We’re not at “nuts” levels yet.  We may never get there though, which is why baseball analogies are sometimes lame.  Some event can disrupt the market when it is so high, and suddenly people and firms are no longer so willing to extend credit.

Ending the article here — be aware.  The time to take inventory of your assets and their financing needs is before the markets have an event.  I’ve just completed my review of my portfolio.  I sold two of the 35 companies that I hold and replaced them with more solid entities that still have good prospects.  I will sell two more in the new year for tax reasons.  My bond portfolio is high quality.  My clients and I are ready if liquidity gets worse.

Are you ready?

Photo Credit: darwin Bell || You ain't getting out easily...

Photo Credit: darwin Bell || You ain’t getting out easily…

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How would you like a really good model to make money as a money manager? You would? Great!

What I am going to describe is a competitive business, so you probably won’t grow like mad, but what money you do bring in the door, you will likely keep for some time, and earn significant fees.

This post is inspired by a piece written by Jason Zweig at the Wall Street Journal: The Trendiest Investment on Wall Street…That Nobody Knows About.  The article talks about interval funds.  Interval funds hold illiquid investments that would be difficult to sell at a fair price  quickly.  As such, liquidity is limited to quarterly or annual limits, and investors line up for distributions.  If you are the only one to ask for a distribution, you might get a lot paid out, perhaps even paid out in full.  If everyone asked for a part of the distribution, everyone would get paid their pro-rata share.

But there are other ways to capture assets, and as a result, fees.

  • Various types of business partnerships, including Private REITs, Real Estate Partnerships, etc.
  • Illiquid debts, such as structured notes
  • Variable, Indexed and Fixed Annuities with looong surrender charge periods.
  • Life insurance as an investment
  • Weird kinds of IRAs that you can only set up with a venturesome custodian
  • Odd mutual funds that limit withdrawals because they offer “guarantees” of a sort.
  • And more, but I am talking about those that get sold to or done by retail investors… institutional investors have even more chances to tie up their money for moderate, modest or negative incremental returns.
  • (One more aside, Closed end funds are a great way for managers to get a captive pool of assets, but individual investors at least get the ability to gain liquidity subject to the changing premium/discount versus NAV.)

My main point is short and simple.  Be wary of surrendering liquidity.  If you can’t clearly identify what you are gaining from giving up liquidity, don’t make the investment.  You are likely being hoodwinked.

It’s that simple.

If you can't clearly identify what you are gaining from giving up liquidity, don't make the… Click To Tweet

Ben Graham, who else?

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Well, I didn’t think I would do any more “Rules” posts, but here one is:

In markets, “what is true” works in the long run. “What people are growing to believe is true” works in the short run.

This is a more general variant of Ben Graham’s dictum:

“In the short run, the market is a voting machine but in the long run, it is a weighing machine.”

Not that I will ever surpass the elegance of Ben Graham, but I think there are aspects of my saying that work better.  Ben Graham lived in a time where capital was mostly physical, and he invested that way.  He found undervalued net assets and bought them, sometimes fighting to realize value, and sometimes waiting to realize value, while all of the while enjoying the arts as a bon vivant.  In one sense, Graham kept the peas and carrots of life on separate sides of the plate.  There is the tangible (a cheap set of assets, easily measured), and the intangible — artistic expression, whether in painting, music, acting, etc. (where values are not only relative, but contradictory — except perhaps for Keynes’ beauty contest).

Voting and weighing are discrete actions.  Neither has a lot of complexity on one level, though deciding who to vote for can have its challenges. (That said, that may be true in the US for 10% of the electorate.  Most of us act like we are party hacks. 😉 )

What drives asset prices?  New information?  Often, but new information is only part of it. It stems from changes in expectations.  Expectations change when:

  • Earnings get announced (or pre-announced)
  • Economic data gets released.
  • Important people like the President, Cabinet members, Fed governors, etc., give speeches.
  • Acts of God occur — earthquakes, hurricanes, wars, terrorist attacks, etc.
  • A pundit releases a report, whether that person is a short, a long-only manager, hedge fund manager, financial journalist, sell-side analyst, etc.  (I’ve even budged the market occasionally on some illiquid stocks…)
  • Asset prices move and some people mimic to intensify the move because they feel they are missing out.
  • Holdings reports get released.
  • New scientific discoveries are announced
  • Mergers or acquisitions or new issues are announced.
  • The solvency of a firm is questioned, or a firm of questionable solvency has an event.
  • And more… nowadays even a “tweet” can move the market

In the short run, it doesn’t matter whether the news is true.  What matters is that people believe it enough to act on it.  Their expectation change.  Now, that may not be enough to create a permanent move in the price — kind of like people buying stocks that Cramer says he likes on TV, and the Street shorts those stocks from the inflated levels.  (Street 1, Retail 0)

But if the news seems to have permanent validity, the price will adjust to a higher or lower level.  It will then take new data to move the price of the asset, and the dance of information and prices goes on and on.  Asset prices are always in an unstable equilibrium that takes account of the many views of what the world will be like over various time horizons.  They are more volatile than most theories would predict because people are not rational in the sense that economists posit — they do not think as much as imitate and extrapolate.

Read the news, whether on paper or the web — “XXX is dead,” “YYY is the future.”  Horrible overstatements most of the time — sure, certain products or industries may shrink or grow due to changes in technology or preferences, but with a few exceptions, a new temporary unstable equilibrium is reached which is larger or smaller than before.  (How many times has radio died?)

“Stocks rallied because the Fed cut interest rates.”

“Stocks rallied because the Fed tightened interest rates, showing a strong economy.”

“Stocks rallied just because this market wants to go up.”

“Stocks rallied and I can’t tell you why even though you are interviewing me live.”

Okay, the last one is fake — we have to give reasons after the fact of a market move, even anthropomorphizing the market, or we would feel uncomfortable.

We like our answers big and definite.  Often, those big, definite answers that seem right at 5PM will look ridiculous in hindsight — especially when considering what was said near turning points.  The tremendous growth that everyone expected to last forever is a farce.  The world did not end; every firm did not go bankrupt.

So, expectations matter a lot, and changes in expectations matter even more in the short-run, but who can lift up their head and look into the distance and say, “This is crazy.”  Even more, who can do that precisely at the turning points?

No one.

There are few if any people who can both look at the short-term information and the long-term information and use them both well.  Value investors are almost always early.  If they do it neglecting the margin of safety, they may not survive to make it to the long-run, where they would have been right.  Shorts predicting the end often develop a mindset that keeps them from seeing that things have stopped getting worse, and they stubbornly die in their bearishness.  Vice-versa, for bullish Pollyannas.

Financially, only two things matter — cash flows, the cost of financing cash flows, and how they change with time.  Amid the noise and news, we often forget that there are businesses going on, quietly meeting human needs in exchange for a profit.  The businessmen are frequently more rational than the markets, and attentive to the underlying business processes producing products and services that people value.

As with most things I write about, the basic ideas are easy, but they work out in hard ways.  We may not live long enough to see what was true or false in our market judgments.  There comes a time for everyone to hang up their spurs if they don’t die in the saddle.  Some of the most notable businessmen and market savants, who in their time were indispensable people, will eventually leave the playing field, leaving others to play the game, while they go to the grave.  Keynes, the great value investor that he was, said, “In the long run we are all dead.”  The truth remains — omnipresent and elusive, inscrutable and unchangeable like a giant cube of gold in a baseball infield.

As it was, Ben Graham left the game, but never left the theory of value investing.  Changes in expectations drive prices, and unless you are clever enough to divine the future, perhaps the best you can do is search for places where those expectations are too low, and tuck some of those assets away for a better day.  That better day may be slow in coming, but diversification and the margin of safety embedded in those assets there will help compensate for the lack of clairvoyance.

After all, in the end, the truth measures us.

Idea Credit: Philosophical Economics Blog || I get implementation credit, which is less…

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My last post on this generated some good questions.  I’m going to answer them here, because this model deserves a better explanation.  Before I start, I should say that in order to understand the model, you need to read the first two articles in the series, which are here:

If you are curious about the model, the information is there.  It includes links to the main article at Economic Philosopher’s blog ( @jesselivermore on Twitter).

On to the questions:

Is this nominal or real return? Where can I find your original blog post explaining how you calculate future returns? Similar charts using Shiller PE, total market cap to gdp, q-ratio etc. all seem to imply much lower future returns.

This is a nominal return.  In my opinion, returns and inflation should be forecast separately, because they have little to do with each other.  Real interest rates have a large impact on equity prices, inflation has a small impact that varies by sector.

This model also forecasts returns for the next ten years.  If I had it do forecasts over shorter horizons, the forecasts would be lower, and less precise.  The lower precision comes from the greater ease of forecasting an average than a single year.  It would be lower because the model has successively less power in forecasting each successive year — and that should make sense, as the further you get away from the current data, the less impact the data have.  Once you get past year ten, other factors dominate that this model does not account for — factors reflecting the long-term productivity of capital.

I can’t fully explain why this model is giving higher return levels, but I can tell you how the models are different:

  • This model focuses in investor behavior — how much are investors investing in stocks versus everything else.  It doesn’t explicitly consider valuation.
  • The Shiller PE isn’t a well-thought-out model for many reasons.  16 years ago I wrote an email to Ken Fisher where I listed a dozen flaws, some small and some large.  That e-mail is lost, sadly.  That said, let me be as fair as I can be — it attempts to compare the S&P 500 to trailing 10-year average earnings.  SInce using a single year would be unsteady, the averaging is a way to compare a outdated smoothed income statement figure to the value of the index.  Think of it as price-to-smoothed-earnings.
  • Market Cap to GDP does a sort of mismatch, and makes the assumption that public firms are representative of all firms.  It also assumes that total payments to all factors are what matter for equities, rather than profits only.  Think of it as a mismatched price-to-sales ratio.
  • Q-ratio compares the market value of equities and debt to the book value of the same.  The original idea was to compare to replacement value, but book value is what is available.  The question is whether it would be cheaper to buy or build the corporations.  If it is cheaper to build, stocks are overvalued.  Vice-versa if they are cheaper to buy.  The grand challenge here is that book value may not represent replacement cost, and increasingly so because intellectual capital is an increasing part of the value of firms, and that is mostly not on the balance sheet.  Think of a glorified Economic Value to Book Capital ratio.

What are the return drivers for your model? Do you assume mean reversion in (a) multiples and (b) margins?

Again, this model does not explicitly consider valuations or profitability.  It is based off of the subjective judgments of people allocating their portfolios to equities or anything else.  Of course, when the underlying ratio is high, it implies that people are attributing high valuations to equities relative to other assets, and vice-versa.  But the estimate is implicit.

So…I’m wondering what the difference is between your algorithm for future returns and John Hussman’s algorithm for future returns. For history, up to the 10 year ago point, the two graphs look quite similar. However, for recent years within the 10-year span, the diverge quite substantially in absolute terms (although the shape of the “curves” look quite similar). It appears that John’s algorithm takes into account the rise in the market during the 2005-2008 timeframe, and yours does not (as you stated, all else remaining the same, the higher the market is at any given point, the lower the expected future returns that can be for an economy). That results in shifting your expected future returns up by around 5% per year compared to his! That leads to remarkably different conclusions for the future.

Perhaps you have another blog post explaining your prediction algorithm that I have not seen. John has explained (and defended) his algorithm extensively. In absence of some explanation of the differences, I think that John’s is more credible at this point. See virtually any of his weekly posts for his chart, but the most recent should be at http://www.hussmanfunds.com/wmc/wmc161212e.png (DJM: the article in question is here.)

I’d love to meet and talk with John Hussman.  I have met some members of his small staff, and he lives about six miles from my house.  (PS — Even more, I would like to meet @jesselivermore).  The Baltimore CFA Society asked him to come speak to us a number of times, but we have been turned down.

Now, I’m not fully cognizant of everything he has written on the topic, but the particular method he is using now was first published on 5/18/2015.  There is an article critiquing aspects of Dr. Hussman’s methods from Economic Philosopher.  You can read EP for yourself, but I gain one significant thing from reading this — this isn’t Hussman’s first model on the topic.  This means the current model has benefit of hindsight bias as he acted to modify the model to correct inadequacies.  We sometimes call it a specification search.  Try out a number of models and adjust until you get one that fits well.  This doesn’t mean his model is wrong, but that the odds of it forecasting well in the future are lower because each model adjustment effectively relies on less data as the model gets “tuned” to eliminate past inaccuracies.  Dr. Hussman has good reasons to adjust his models, because they have generally been too bearish, at least recently.

I don’t have much problem with his underlying theory, which looks like a modified version of Price-to-sales.  It should be more comparable to the market cap to GDP model.

This model, to the best of my knowledge, has not been tweaked.  It is still running on its first pass through the data.  As such, I would give it more credibility.

There is another reason I would give it more credibility.  You don’t have the same sort of tomfoolery going on now as was present during the dot-com bubble.  There are some speculative enterprises today, yes, but they don’t make up as much of the total market capitalization.

All that said, this model does not tell you that the market can’t fall in 2017.  It certainly could.  But what it does tell you versus valuations in 1999-2000 is that if we do get a bear market, it likely wouldn’t be as severe, and would likely come back faster.  This is not unique to this model, though.  This is true for all of the models mentioned in this article.

Stock returns are probabilistic and mean-reverting (in a healthy economy with no war on your home soil, etc.).  The returns for any given year are difficult to predict, and not tightly related to valuation, but the returns over a long period of time are easier to predict, and are affected by valuation more strongly.  Why?  The correction has to happen sometime, and the most likely year is next year when valuations are high, but the probability of it happening in the 2017 are maybe 30-40%, not 80-100%.

If you’ve read me for a long time, you will know I almost always lean bearish.  The objective is to become intelligent in the estimation of likely returns and odds.  This model is just one of ones that I use, but I think it is the best one that I have.  As such, if you look the model now, we should be Teddy Bears, not full-fledged Grizzlies.

That is my defense of the model for now.  I am open to new data and interpretations, so once again feel free to leave comments.

As such, if you look the model now, we should be Teddy Bears, not full-fledged Grizzly Bears. Click To Tweet

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November 2016December 2016Comments
Information received since the Federal Open Market Committee met in September indicates that the labor market has continued to strengthen and growth of economic activity has picked up from the modest pace seen in the first half of this year.Information received since the Federal Open Market Committee met in November indicates that the labor market has continued to strengthen and that economic activity has been expanding at a moderate pace since mid-year.FOMC shades GDP up.
Although the unemployment rate is little changed in recent months, job gains have been solid.Job gains have been solid in recent months and the unemployment rate has declined.Shades up their view on labor.
Household spending has been rising moderately but business fixed investment has remained soft.Household spending has been rising moderately but business fixed investment has remained soft.No change.
Inflation has increased somewhat since earlier this year but is still below the Committee’s 2 percent longer-run objective, partly reflecting earlier declines in energy prices and in prices of non-energy imports.Inflation has increased since earlier this year but is still below the Committee’s 2 percent longer-run objective, partly reflecting earlier declines in energy prices and in prices of non-energy imports.Shades their view of inflation up.
Market-based measures of inflation compensation have moved up but remain low; most survey-based measures of longer-term inflation expectations are little changed, on balance, in recent months.Market-based measures of inflation compensation have moved up considerably but still are low; most survey-based measures of longer-term inflation expectations are little changed, on balance, in recent months.No change.  TIPS are showing higher inflation expectations since the last meeting. 5y forward 5y inflation implied from TIPS is near 2.08%, up 0.24%  from November.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.No change. Any time they mention the “statutory mandate,” it is to excuse bad policy.
The Committee expects that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace and labor market conditions will strengthen somewhat further.The Committee expects that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace and labor market conditions will strengthen somewhat further.No change.
Inflation is expected to rise to 2 percent over the medium term as the transitory effects of past declines in energy and import prices dissipate and the labor market strengthens further.Inflation is expected to rise to 2 percent over the medium term as the transitory effects of past declines in energy and import prices dissipate and the labor market strengthens further.No change. CPI is at +1.6% now, yoy.
Near-term risks to the economic outlook appear roughly balanced. The Committee continues to closely monitor inflation indicators and global economic and financial developments.Near-term risks to the economic outlook appear roughly balanced. The Committee continues to closely monitor inflation indicators and global economic and financial developments.No change.
Against this backdrop, the Committee decided to maintain the target range for the federal funds rate at 1/4 to 1/2 percent.In view of realized and expected labor market conditions and inflation, the Committee decided to raise the target range for the federal funds rate to 1/2 to 3/4 percent.Builds in the idea that they are reacting at least partially to expected future conditions in inflation and labor.
The Committee judges that the case for an increase in the federal funds rate has continued to strengthen but decided, for the time being, to wait for some further evidence of continued progress toward its objectives. Sentence dropped.
The stance of monetary policy remains accommodative, thereby supporting further improvement in labor market conditions and a return to 2 percent inflation.The stance of monetary policy remains accommodative, thereby supporting some further strengthening in labor market conditions and a return to 2 percent inflation.Shades down their view of how accommodative monetary policy is.

They don’t get that policy direction, not position, is what makes policy accommodative or restrictive.  Think of monetary policy as a drug for which a tolerance gets built up.

In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation.In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation.No change.
This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.No change.  Gives the FOMC flexibility in decision-making, because they really don’t know what matters, and whether they can truly do anything with monetary policy.
In light of the current shortfall of inflation from 2 percent, the Committee will carefully monitor actual and expected progress toward its inflation goal.In light of the current shortfall of inflation from 2 percent, the Committee will carefully monitor actual and expected progress toward its inflation goal.No change.
The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.No change.  Says that they will go slowly, and react to new data.  Big surprises, those.
The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction, and it anticipates doing so until normalization of the level of the federal funds rate is well under way. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction, and it anticipates doing so until normalization of the level of the federal funds rate is well under way. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.No change.  Says it will keep reinvesting maturing proceeds of agency debt and MBS, which blunts any tightening.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; James Bullard; Stanley Fischer; Jerome H. Powell; Eric Rosengren; and Daniel K. Tarullo.Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; James Bullard; Stanley Fischer; Esther L. George; Loretta J. Mester; Jerome H. Powell; Eric Rosengren; and Daniel K. Tarullo.Full agreement
Voting against the action were: Esther L. George and Loretta J. Mester, each of whom preferred at this meeting to raise the target range for the federal funds rate to 1/2 to 3/4 percent.Prior dissenters are now happy, but was a 0.25% increase enough?  Or, as Steve Hanke has said, has monetary policy had to be loose to fight lower bank leverage?

Comments

  • The FOMC tightens 1/4%, but deludes itself that it is still accommodative.
  • The economy is growing well now, and in general, those who want to work can find work.
  • Maybe policy should be tighter. The key question to me is whether lower leverage at the banks was a reason for ultra-loose policy.
  • The change of the FOMC’s view is that inflation is higher. Equities and bonds fall. Commodity prices fall and the dollar strengthens.
  • The FOMC says that any future change to policy is contingent on almost everything.

Idea Credit: Philosophical Economics Blog || I get implementation credit, which is less… 😉

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Are you ready to earn 6%/year until 9/30/2026?  The data from the Federal Reserve comes out with some delay.  If I had it instantly at the close of the third quarter, I would have said 6.37% — but with the run-up in prices since then, the returns decline to 6.01%/year.

That puts us in the 82nd percentile of valuations, which isn’t low, but isn’t the nosebleed levels last seen in the dot-com era.  There are many talking about how high valuations are, but investors have not responded in frenzy mode yet, where they overallocate stocks relative to bonds and other investments.

Think of it this way: as more people invest in equities, returns go up to those who owned previously, but go down for the new buyers.  The businesses themselves throw off a certain rate of return evaluated at replacement cost, but when the price paid is far above replacement cost the return drops considerably even as the cash flows from the businesses do not change at all.

For me to get to a level where I would hedge my returns, we would be talking about considerably higher levels where the market is discounting future returns of 3%/year — we don’t have that type of investor behavior yet.

One final note: sometimes I like to pick on the concept of Dow 36,000 because the authors didn’t get the concept of risk premia, or, margin of safety.  They assumed the market could be priced to no margin of safety, and with high growth.  That said, the model does offer a speculative prediction of Dow 36,000.  It just happens to come around the year 2030.

Until next time, when we will actually have some estimates of post-election behavior… happy investing and remember margin of safety.

Are you ready to earn 6%/year until 9/30/2026? Click To Tweet

Photo Credit: ajehals || Pensions are promises. Sadly, promises are often broken. Choose your promiser with care…

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If you want a full view of what I am writing about today, look at this article from The Post and Courier, “South Carolina’s looming pension crisis.”  I want to give you some perspective on this, so that you can understand better what went wrong, and what is likely to go wrong in the future.

Before I start, remember that the rich get richer, and the poor poorer even among states.  Unlike what many will tell you though, it is not any conspiracy.  It happens for very natural reasons that are endemic in human behavior.  The so-called experts in this story are not truly experts, but sourcerer’s apprentices who know a few tricks, but don’t truly understand pensions and investing.  And from what little I can tell from here, they still haven’t learned.  I would fire them all, and replace all of the boards in question, and turn the politicians who are responsible out of office.  Let the people of South Carolina figure out what they must do here — I’m a foreigner to them, but they might want to hear my opinion.

Let’s start here with:

Central Error 1: Chasing the Markets

Credit: The Courier and Post

Much as inexperienced individuals did, the South Carolina Retirement System Investment Commission [SCRSIC] chased the markets in an effort to earn returns when they seemed easy to get in hindsight.  As the article said:

It used to be different, before the high-octane investment strategies began. South Carolina’s pension plans were considered 99 percent funded in 1999, and on track to pay all promised benefits for decades to come.

That was the year the pension funds started investing in stocks, in hopes of pulling in even more income. A change to the state constitution and action by the General Assembly allowed those investments. In the previous five years, U.S. stock prices had nearly tripled.

Prior to that time, the pension funds were largely invested in bonds and cash, which actually yielded something back then.  If the pension funds were invested in bonds that were long, the returns might not have been so bad versus stocks.  But in the late ’90s the market went up aggressively, and the money looked easy, and it was easy, partly due to loose monetary policy, and a mania in technology and internet stocks.

Here’s the real problem.  It’s okay to invest in only bonds. It’s okay to invest in bonds and stocks in a fixed proportion.  It’s okay even to invest only in stocks.  Whatever you do, keep the same policy over the long haul, and don’t adjust it.  Also, the more nonguaranteed your investments become (anything but high quality bonds), the larger your provision against bear markets must become.

And, when you start a new policy, do what is not greedy.  1999-2000 was the right time to buy long bonds and sell stocks, and I did that for a small trust that I managed at the time.  It looked dumb on current performance, but if you look at investing as a business asking what level of surplus cash flows the underlying investments will throw off, it was an easy choice, because bonds were offering a much higher future yield than stocks.  But the natural tendency is to chase returns, because most people don’t think, they imitate.  And that was true for the SCRSIC, bigtime.

Central Error 2: Bad Data

The above quote said that “South Carolina’s pension plans were considered 99 percent funded in 1999.”  That was during an era when government accounting standards were weak.  The standards are still weak, but they are stronger than they were.  South Carolina was NOT 99% funded in 1999 — I don’t know what the right answer would have been, but it would have been considerably lower, like 80% or so.

Central Error 3: Unintelligent Diversification into “Alternatives”

In 2009, I had the fun of writing a small report for CALPERS.  One of my main points was that they allocated money to alternative investments too late.  With all new classes of investments the best deals get done early, and as more money flows into the new class returns surge because the flood of buyers drives prices up.  Pricing is relatively undifferentiated, because experience is early, and there have been few failures.  After significant failures happen, differentiation occurs, and players realize that there are sponsors with genuine skill, and “also rans.”  Those with genuine skill also limit the amount of money they manage, because they know that good-returning ideas are hard to come by.

The second aspect of this foolishness comes from the consultants who use historical statistics and put them into brain-dead mean-variance models which spit out an asset allocation.  Good asset allocation work comes from analyzing what economic return the underlying business activities will throw off, and adjusting for risk qualitatively.  Then allocate funds assuming they will never be able to trade something once bought.  Maybe you will be able to trade, but never assume there will be future liquidity.

The article kvetches about the expenses, which are bad, but the strategy is worse.  The returns from all of the non-standard investments were poor, and so was their timing — why invest in something not geared much to stock returns when the market is at low valuations?  This is the same as the timing problem in point one.

Alternatives might make sense at market peaks, or providing liquidity in distressed situations, but for the most part they are as saturated now as public market investments, but with more expenses and less liquidity.

Central Error 4: Caring about 7.5% rather than doing your best

Part of the justification for buying the alternatives rather than stocks and bonds is that you have more of a chance of beating the target return of the plan, which in this case was 7.5%/yr.  Far better to go for the best risk-adjusted return, and tell the State of South Carolina to pony up to meet the promises that their forbears made.  That brings us to:

Central Error 5: Foolish politicians who would not allocate more money to pensions, and who gave pension increases rather than wage hikes

The biggest error belongs to the politicians and bureaucrats who voted for and negotiated higher pension promises instead of higher wages.  The cowards wanted to hand over an economic benefit without raising taxes, because the rise in pension benefits does not have any immediate cash outlay if one can bend the will of the actuary to assume that there will be even higher investment earnings in the future to make up the additional benefits.

[Which brings me to a related pet peeve.  The original framers of the pension accounting rules assumed that everyone would be angels, and so they left a lot of flexibility in the accounting rules to encourage the creation of defined benefit plans, expecting that men of good will would go out of their way to fund them fully and soon.

The last 30 years have taught us that plan sponsors are nothing like angels, playing for their own advantage, with the IRS doing its bit to keep corporate plans from being fully funded so that taxes will be higher.  It would have been far better to not let defined benefit plans assume any rate of return greater than the rate on Treasuries that would mimic their liability profile, and require immediate relatively quick funding of deficits.  Then if plans outperform Treasuries, they can reduce their contributions by that much.]

Error 5 is likely the biggest error, and will lead to most of the tax increases of the future in many states and municipalities.

Central Error 6: Insufficient Investment Expertise

Those in charge of making the investment decisions proved themselves to be as bad as amateurs, and worse.  As one of my brighter friends at RealMoney, Howard Simons, used to say (something like), “On Wall Street, to those that are expert, we give them super-advanced tools that they can use to destroy themselves.”   The trustees of SCRSIC received those tools and allowed themselves to be swayed by those who said these magic strategies will work, possibly without doing any analysis to challenge the strategies that would enrich many third parties.  Always distrust those receiving commissions.

Central Error 7: Intergenerational Equity of Employee Contributions

The last problem is that the wrong people will bear the brunt of the problems created.  Those that received the benefit of services from those expecting pensions will not be the prime taxpayers to pay those pensions.  Rather, it will be their children paying for the sins of the parents who voted foolish people into office who voted for the good of current taxpayers, and against the good of future taxpayers.  Thank you, Silent Generation and Baby Boomers, you really sank things for Generation X, the Millennials, and those who will follow.

Conclusion

Could this have been done worse?  Well, there is Illinois and Kentucky.  Puerto Rico also.  Many cities are in similar straits — Chicago, Detroit, Dallas, and more.

Take note of the situation in your state and city, and if the problem is big enough, you might consider moving sooner rather than later.  Those that move soonest will do best selling at higher real estate prices, and not suffer the soaring taxes and likely diminution of city services.  Don’t kid yourself by thinking that everyone will stay there, that there will be a bailout, etc.  Maybe clever ways will be found to default on pensions (often constitutionally guaranteed, but politicians don’t always honor Constitutions) and municipal obligations.

Forewarned is forearmed.  South Carolina is a harbinger of future problems, in their case made worse by opportunists who sold the idea of high-yielding investments to trustees that proved to be a bunch of rubes.  But the high returns were only needed because of the overly high promises made to state employees, and the unwillingness to levy taxes sufficient to fund them.

Seven central errors committed by the South Carolina Retirement System and politicians Click To Tweet

Photo Credit: elycefeliz

Photo Credit: elycefeliz || Duck, it’s a financial crisis! 😉

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Should a credit analyst care about financial leverage?  Of course, the amount and types of financial claims against a firm are material to the ability of a firm to avoid defaulting on its debts.  What about operating leverage?  Should the credit analyst care?  Of course, if a firm has high fixed costs and low variable costs (high operating leverage), its financial position is less stable than that of a company that has low fixed costs and high variable costs.  Changes in demand don’t affect a firm as much if they have low operating leverage.

That might be fine for industrials and utilities, but what about financials?  Aren’t financials different?  Yes, financials are different as far as operating leverage goes because for financial companies, operating leverage is the degree of credit risk that financials take on in their assets. Different types of lending have different propensities for loss, both in terms of likelihood and severity, which are usually correlated.

A simple example would be two groups of corporate bonds —  one can argue over new classes of bond ratings, but on average, lower rated corporate bonds default more frequently than higher rated bonds, and when they default, the losses are typically greater on the lower rated bonds.

As such the amount of operating risk, that is, unlevered credit risk, is material to the riskiness of financial companies.

Credit analysis gets done on financial companies by many parties: the rating agencies, private credit analysts, and implicitly by financial regulators.  They all do the same sorts of analyses using similar underlying theory, though the details vary.

Regulators typically codify their analyses through what they call risk-based capital.  Given all of the risks a financial institution takes — credit, asset-liability mismatch, and other liability risks, how much capital does a financial institution need in order to stay solvent?  Along with this usually also comes cash flow testing to make sure that the financial companies can withstand runs on their capital structure.

When done in a rigorous way, this lowers the probability and severity of financial failures, including the remote possibility that taxpayers could be tagged in a crisis to cover losses.  In the life insurance industry, actuaries have worked together with regulators to put together a fair system that is hard to game, and as such, few life and P&C insurance companies went under during the financial crisis.  (Note: AIG went under due to its derivative subsidiary and that they messed with securities lending agreements.  The only failures in life and P&C insurance were small.)

Banks have risk-based capital standards, but they are less well-designed than those of the US insurance industry, and for the big banks they are more flexible than those for insurers.  If I were regulating banks, I would get a small army of actuaries to study bank solvency, and craft regulations together with a single banking regulator that covers all depositary financials (or, state regulators like in insurance which would be better) using methods similar to those for the insurance industry.  Then every five years or so, adjust the regulations because as they get used, problems appear.  After a while, the methods would work well.  Oh, I left one thing out — all banks would have a valuation actuary reporting to the board and the regulators who would do the cash flow testing and the risk-based capital calculations.  Their positions would be funded with a very small portion of money that currently goes to the FDIC.

This would be a very good system for avoiding excessive financial risk.  Dreaming aside, I write this this evening because there are other dreamers proposing a radically simple system for regulating banks which would allow them to write business with no constraint at all with respect to credit risk.  All banks would face a simple 10% leverage ratio regardless of how risky their loan books are.  This would in the short run constrain the big banks because they would need to raise capital levels, though after that happened, they would probably write riskier loans to get their return on equity back to where it was.

My main point here is that you don’t want to incent banks to write a lot of risky loans.  It would be better for banks to put aside the right amount of capital versus varying classes of risk, and size the amount of capital such that it is not prohibitive to the banking system.

As such, a simple leverage ratio will not cut it.  Thinking people and their politicians should reject the current proposal being put out by the Republicans and instead embrace a more successful regulatory system manned by intelligent and reasonably risk-averse actuaries.