Subprime lending is grabbing a lot of attention, but it is only a tiny portion of what goes on in our capital markets.? Tonight I want to talk about speculation in our markets, while largely ignoring subprime.
I have grown to like the blog Accrued Interest.? There aren’t many blogs dealing with fixed income issues; it fills a real void.? This article deals with bridge loans; increasingly, as investors have grown more skittish over LBO debt, investment banks have had to retain the bridge loans, rather than selling off the loans to other investors.? Google “Ohio Mattress,” and you can see the danger here.? Deals where the debt interests don’t get sold off can become toxic to the investment banks extending the bridge loans.? (And being a Milwaukee native, I can appreciate the concept of a “bridge to nowhere.”? Maybe the investment bankers should visit Milwaukee, because the “bridge to nowhere” eventually completed, and made it to South Milwaukee.? Quite an improvement over nowhere, right? Right?!? Sigh.)
Also from Accrued Interest, the credit markets have some sand in the gears.? I remember fondly the pit in my stomach when my brokers called me on July 27th and October 9th, 2002, and said, “The markets are offered without bid.? We’ve never seen it this bad.? What do you want to do?”? I had cash on hand for bargains both times, but when the credit markets are dislocated, nothing much happens for a little while.? This was true after LTCM and 9/11 as well.
I’ve seen a number of reviews of Dr. Bookstaber’s new book.? It looks like a good one. As in the last point, when the markets get spooked, spreads widen dramatically,and trading slows until confidence returns.? More bad things are feared to happen than actually do happen.
I’m not a fan of shorting, particularly in this environment.? Too many players are short without a real edge.? High valuations are not enough, you need to have an uncommon edge.? When I short, that typically means an accounting anomaly.? That said, there is more demand for short ideas with the advent of 130/30 and 120/20 funds.? Personally, I think they are asking for more than the system can deliver.? Obvious shorts are full up, and inobvious shorts are inobvious for a reason; they aren’t easy money.
From the “Too Many Vultures” file, Goldman announces a $12.5 billion mezzanine fund.? With so much money chasing failures, the prices paid to failures will rise in the short run, until the vultures get scared.
Finally, and investment bank that understands the risk behind CPDOs.? I have been a bear on these for some time; perhaps the rapidly rising spread environment might cause a CPDO to unwind?
Passive futures as a diversifier made a lot of sense before so many pension plans and endowments invested in it.? Recent returns have been disappointing, leading some passive investors to leave their investments in crude oil (and other commodities).? With less pressure on the roll in crude oil, the contango has lessened, which makes a passive investment in commodities, particularly crude oil, more attractive.
Before I get started on tonight’s piece, I thought I might apologize for a wrong prediction, lest I be confused with a famous guy that I sometimes get associated with.? I was wrong that ABX.HE 07-2 would not get created.? A number of the tranches priced significantly above a 500 bp yield, and so those lower rated tranches got sold at a dsicount to the par value of the securities.? In the unlikely event that those securities get paid off at par, the buyers will be most happy indeed.
But onto tonight’s topic.? Regarding credit default swaps, and their new cousins, ABX, CDX, LCDX, CMBX, etc… there are often more swaps trading than there are underlying cash obligations.? What this implies is that most of the activity going on is not hedging and speculation facilitating hedging, but merely speculation/betting.
What this means is that in the short run, until the cash obligations underlying the default swap mature, there is little to keep the cash and derivative markets together.? The swap spread could be a lot higher than the cash market spread, indicating fear, and a lot of players being willing to bet on partial or total default occurring.? That’s where we are now.? So, when I hear new lows on ABX.HE indexes, and some authoritative voice says that means many defaults are occurring in subprime mortgages, I take a breath and remind myself that it means that more players are betting on increased defaults and loss severity on subprime mortgages.
The opposite can happen too.? Back in 2002, when I was a corporate bond manager, and default swaps were pretty new, I would not buy bonds where the cash spread was smaller then the swap spread, because that indicated a lot of players betting against the bonds in question. If someone holding a bond would sell and replace it with offering protection on a default swap, they would improve their yield, so when the swap spread was wider, it would often lead the bond spread wider as well.? I would wait until the swap spread fell beneath the cash bond spread, and then I would pile in.? Worked really well, and my brokers at the time thought I had this great sense of timing.? Well, maybe I did, but it was analytical, not intuitive.
My main point for my readers: take the prices and yields from swap markets with a grain of salt, particularly on anything they imply to the real economy.? For that, look at the spreads in the cash bond markets.? Limited arbitrage aside, those spreads are more free from raw speculative frenzy.
One last note: almost all users of the bundled credit default swaps are speculators.? They never hold the exact exposure as the swaps, and so the best of them cross-hedges his positions.? So why did these get created?? Wall Street saw a need to allow speculators to express bets that correspond to larger liquid composites in the cash bond markets.? Individual tranches in structured bond deals below AAA are all very thin, and the ability to put a lot of money to work rapidly is limited as a result.? But what if you could pair up additional shorts and longs to take on opposing risks, without them directly investing in the cash bonds?? You would then have a swap market, and the spreads there would differ from the cash market depending on which side of the trade was more motivated: the side needing yield, or the side betting on default.? It’s a big side bet, and hopefully both sides are well-capitalized, but who can really tell?
Liquidity, that ephemeral beast.? Much talked about, but little understood.? There are five pillars of liquidity in the present environment.? I used to talk about three of them, but I excluded two ordinary ones.? Here they are:
The bid for debt from CDO equity.
The Private Equity bid for cheap-ish assets with steady earnings streams.
The recycling of the US current account deficit.
The arbitrage of investment grade corporations buying back their own stock, or the stock of other corporations, because with investment grade yields so low, it makes sense to do it, at least in the short run.
The need of Baby Boomers globally to juice returns in the short run so that their retirements will be adequate.? With equities, higher returns; with bonds, more yield.? Make that money sweat, even if we have to outsource the labor that our children provide, because they are too expensive.
Numbers one and two are broken at present.? The only place in CDO-land that has some life is in investment grade assets.? We must lever up everything until it breaks.? But anything touched by subprime is damaged, and high yield, even high yield loans are damaged for now.
With private equity, it may just? be a matter of waiting a while for the banks to realize that they need yield, but i don’t think so.? Existing troubled deals will have to give up some of the profits to the lenders, or perhaps not get done.
Number three is the heavy hitter.? The current account deficit has to balance.? We have to send more goods, assets, or promises to pay more later.? The latter is what is favored at present, keeping our interest rates low, and making equity attractive relative to investment grade debt.? Until the majority of nations buying US debt revalue their currencies upward, this will continue; it doesn’t matter how much they raise their central bank’s target rate, if they don’t cool off their export sectors, they will continue to stimulate the US, and build up a bigger adjustment for later.
With private equity impaired, investment grade corporations can be rational buyers of assets, whether their own stock, or that of other corporations that fit their operating profiles. Until investment grade yields rise 1-2%, this will still be a factor in the markets, and more so for foreign corporations that have access to cheap US dollar financing (because of current account deficit claims that have to be recycled).
The last one is the one that can’t go away, at least not for another seven years as far as equities go, and maybe twenty years as far as debt goes.? There is incredible pressure to make the money do more than it should be able to under ordinary conditions, because the Baby Boomers and their intermediaries, pension plans and mutual funds, keep banging on the doors of companies asking for yet higher returns.? With debt, there is a voracious appetite for seemingly safe yet higher yielding debt.? The Boomers need it to live off of.
So where does that leave us, in terms of the equity and debt markets?? Investment grade corporates and munis should be fine on average; prime MBS at the Agency or AAA level should be fine.? Everything else is suspect.? As for equities, investment grade assets that are not likely acquirers look good.? The acquirers are less certain.? Even if acquisitions make sense in the short run, it is my guess that they won’t make sense in the long run. On net, the part of the equity markets with higher quality balance sheets should do well from here.? The rest of the equity markets… the less creditworthy their debt, the less well they should do.
Everything old is new again.? If we jumped into the “wayback machine” (?Where are we going Mr. Peabody??) and turned the dial to 1957 (?1957. We are going to meet Elvis, Sherman.?) we would find that the few equity investors that are there are highly concerned about yield, and that the yield on stocks was threatening to dip below the yield on bonds.
This was the twilight for yield-based investing.? Through the next fifty years, there would be among value investors a few absolute yield investors that prospered for a time, then died when interest rates rose, and a few relative yield investors who would die when credit spreads blew out. (Note: an absolute yield manager will only buy stocks with more than a given yield, like 4%; a relative yield manager will only buy stocks that yield more than a benchmark, like the yield on the S&P 500.)
As an example, when I was with Provident Mutual in the mid-1990s, I created a series of multiple manager funds.? One was a value fund that we were creating to replace an absolute yield manager who had done exceptionally well over the past 19 years, but cruddy over the last four.? Assets had really built up in that fund, and our clients were getting jumpy.
A large part of the problem was that interest rates had fallen from 1980 through 1993, but had risen since.? Buying steady cash generating low-growth companies while interest rates were falling was a thing of genius.? As interest rates fell, the dividend stream was worth more and more.? When interest rates rose, that pattern reversed, and 1994 was particularly ugly.? We sacked the absolute yield manager as a one trick pony.? A wise move in hindsight.
Now we have enhanced indexers basing whole strategies off of yield, because their backtests show that yield is an effective variable for allocating portfolio weights.? Given that the last 25 years or so have had falling interest rates, this should be no surprise.? Yield will always be an effective variable when rates fall; but what if rates rise?
Also, what happens when Congress does not renew the reduction of the tax on dividends?? Don?t get me wrong, I like dividends; my portfolios yield much more than the markets.? But I don?t go looking for dividends.? I look for companies that generate cash earnings.? What they do with the cash earnings is important; I don?t want management reinvesting the cash foolishly, but if they have good investment prospects, then please don?t send me dividends.
Roger Nusbaum ably pointed out how demographics favors an increasing amount of dividends being paid to retiring Baby Boomers.? That is true.? We have ETNs being set up to do that (beware of Bear Stearns default risk), and hedge fund-of-funds crowding into strategies that synthetically create yield.? Beyond that, we have Wall Street creating funky yield vehicles that gyp facilitate the yield needs of buyers (while handing them capital losses).
My main point is this.? Approach yield the way a businessman would.? If you see an above average yield, say 4% or higher, ask what conditions could lead them to lower the yield. History is replete with situations where companies paid handsome dividends for longer than was advisable.
Back in 2002, I heard Peter Bernstein give an excellent talk on the value of dividends to the Baltimore Security Analysts Society.? At the end, privately, many scoffed, but I thought he was on the right track.? I still like dividends, but I like businesses that grow in value yet more.? Aim for good returns in cash generating businesses, and the dividends will follow.? Stretching for dividends is as bad as stretching for yield on bonds.? That extra bit of yield can be poisonous, leading to capital losses far greater than the incremental yield obtained.
With all of the concern in the present environment, it is good to be reminded of the actions one should take in order to reduce risk in the present, should the investment environment turn hostile in the future.
Diversify by industry, country, currency, inflation-sensitivity, yield, growth-sensitivity and market capitalization
Diversify by asset class. Make sure you have liquid safe assets to complement risky assets. This is true whether you are young (tactical reasons) or old (strategic reasons).
Diversify by advisors; don’t get all of your ideas from one source (and that includes me). In a multitude of counselors, there is wisdom, which is something to commend RealMoney for — there is no “house view.”
Diversify into enough companies: better to have smaller positions in 15-20 companies, than 5 larger ones. When I began investing in single stocks 15 years ago, I started with 15 positions of $2,000 each. That made each $15 commission bite, but the added safety was worth it.
Avoid explicit leverage; don’t use margin.
Avoid shorting as well, unless you’ve got a profound edge; few are constitutionally capable of doing it well. Are you the exception?
Avoid implicit leverage. How much does the company in question rely on the kindness of the financing markets in order to continue its operations? Highly indebted companies tend to underperform.
Avoid balance sheet complexity; it can be a cover for accounting chicanery.
Analyze cash flow relative to earnings; be wary of companies that produce earnings, but not cash flow from operations, or free cash flow.
Avoid owning popular companies; they tend to underperform.
Avoid serial acquirers; they tend to underperform. Instead, look at companies that do little in-fill acquisitions that they grow organically.
Analyze revenue recognition policies; they are the most common way that companies fuddle accounting.
Focus on industries that are out of favor, and look for strong players that can withstand market stress.
Focus on companies with valuations that are cheap relative to present fundamentals, particularly if there are low barriers against competition.
Take something off the table when the markets run, and edge back in when they fall.
Analyze how any new investment affects your total portfolio.
Don’t use any investment strategy that you don’t fully understand.
Understand where you have made errors in the past, so that you can understand your weaknesses, and avoid acting out of weakness.
Buy only the investments that you want to buy, and not what others want to sell you. Use only investment strategies with which you are fully comfortable.
Find ways to take the emotion out of buy and sell decisions; treat investing as a business.
Match your assets to the horizon over which you will need the proceeds. Risky assets should not get a heavy weight when the proceeds will be needed within five years.
When you get a new idea, and it seems like a “slam dunk,” sit on it for a month before acting on it. More often than not, if it is a good idea, you will still have time to act on it, but if it is a bad idea, you have a better chance of discovering that through waiting.
Prune your portfolio a few times a year. Are there new companies to swap into that are better than a few of your current holdings?
Size positions inversely to risk levels.
Finally, think about risk before you need to; make it a positive component of your strategies.
Remember, risk preparation begins today. That way, you will be capable to invest in the bargains that a real bear market will produce, and not leave the investment game disgusted at yourself for losing so much money.
If I had a dollar for every person that I knew who ignored risk in the late 90s, and dropped out of investing in 2002, just in time for the market to turn, I could buy a nice dinner for you and me in DC, near where I work. So, analyze the riskiness of your portfolio today, and prepare now for the bad times that will eventually come, whether this year, or four years from now.
I have three portfolios that I help manage. They are listed over at Stockpickr.com. The big one is insurance stocks, where I serve as the analyst, and have a lot of influence over what is selected, but don’t make the buy and sell decisions. The second is my broad market fund, over which I have full discretion. The last is my bond fund, which doesn’t have an independent existence, but fills the fixed income role for the two balanced mandates that I run, in which the broad market fund serves as the equity component. I’m going to run through each portfolio, and hit the high points of what I think about my holdings. Here we go: Bond PortfolioI sold our last corporate loan fund in early June. We made a lot of money off these over the past two years as LIBOR rose, and the discounts to NAV turned into premiums. New issuance of corporate loans has been more poorly underwritten. I’m not coming back to the corporate loan funds until I see high single digit discounts to NAV, and signs that credit quality is flattening from its recent decline.
The portfolio is clearly geared toward preservation of purchasing power. We have TIPS and funds that invest in inflation-sensitive bonds [TIP, IMF]. We have foreign bonds [FXC, FXF, FXY, FAX, FCO]. The Yen and Swiss Franc investments are there as systemic risk hedges. The Canadian bonds and the two Aberdeen funds are there for income generation. If energy stays up, Canada might never need to borrow in the future. I also have a short-term bond fund [GFY] trading at a hefty discount, and cash. Finally, I have a speculative deflation in long Treasuries. [TLT]
This is a very eclectic portfolio that has done very well over the last 24 months. This portfolio will underperform if any of the following happen:
Inflation falls
The dollar strengthens
The yield curve steepens amid the Fed loosening
Credit spreads tighten
The Broad Market Portfolio
There are four things that give me pause about RealMoney. First, there is a real bias toward sexy stocks, and commonly known stocks. That bias isn’t unusual; it plagues all amateur investors. Two, few players talk about bonds, and how to make money from them, as well as reducing risk. Three, almost everyone trades more than me. Finally, there is a “home turf” bias, where everyone sticks to their niche, whether it is in favor or not.
I try to be adaptive in my methods through careful attention to valuation and industry rotation. Underlying all of it, though, is a focus on cheap valuations. There are seven summary categories here at present, and then everything else. Here are the categories:
Energy — Integrated, Refining, E&P, Services, Synfuels. I am still a bull here.
Light Cyclicals — Cement, Trucking, Chemicals, Shipping, Auto Parts
Odd financials — European banks, an odd mortgage REIT [DFR], and Allstate [ALL].
Latin America — SBS, IBA, GMK. All are plays on the growing buying power in Latin America.
Turnarounds — SPW, SLE, JNY. Give them time; Rome wasn’t burnt in a day.
Technology — NTE, VSH. Stuff that is not easily obsoleted.
Auto Retail — LAD, GPI.
So far this overall strategy has been a winner for the past seven years. No guarantees on the future, though. In the near term, rebalancing trades could include purchases of JNY and sales of DIIB and SPW. Beyond that, I am waiting for a week or so to sell my Lyondell. It is possible that another bid might materialize. Allstate is also on the sell block, though, I might just trim a little. What makesme more willing to sell the whole position is the disclosure of an above average position in subprime loans.
Insurance
There is one easy play going into earnings season, and one moderate play. Beyond that, there is dabbling in the misunderstood.
Easy: buy asset sensitive life insurers, ones with large variable annuity, life and pension businesses. Who? LNC, NFS, SLF, MFC, PNX, PRU, MET, HIG, and PFG. Why? Average fees from domestic equities are up 5% over the first quarter, and the third quarter looks even better for now. Guidance could be raised. Away from that, the dollar fell by 2% on average over the quarter, so those with foreign operations (excluding Japan) should do well also, all other relevant things equal.
Moderate: no significant hurricanes so far. Given that there is some positive correlation between June-July, and the rest of the season, are you willing to hazard some money on a calm storm season? With global warming DESTROYING OUR PLANET!!!! (not, this is cyclical, not secular.) If you are willing to speculate, might I recommend FSL? They manage their business well, though they are new.
Beyond that, I would commend to you both Assurant (a truly great company that will survive the SEC), and Safety Insurance (investors don’t get the risks here, they are small, and management is smart).
Summary
Managing portfolios has its challenges. One has to balance risk and reward on varying investments. Sometimes the market goes against you, and you question your intelligence. But good fundamental managers persevere over time, and produce good returns for their investors. That’s what I aim to do.
I am an investor who does not consider background academic and semi-academic research to be worthless, even though I am skeptical of much of quantitative finance. Here are a few articles to consider that I think have some importance.
Implied volatility is up. Credit spreads are up, and the equity market has not corrected. Time to worry, right? Wrong. When implied volatilities (and credit spreads) are higher, fear is a bigger factor; valuations have already been suppressed. Markets that rally against rising implied volatility typically have further rises in store.
Many thanks to those that liked my piece on the adaptive markets hypothesis. Here is a piece about Andrew Lo, one of the biggest proponents of the AMH, which fleshes out the AMH more fully. I would only note that the concept of evolution is not necessary to the AMH, only the concepts inherent in ecological studies. Also, all of the fuss over neuropsychology is cute, but not necessary to the AMH. It is all a question of search costs versus rewards.
John Henry alert! Will human equity analysts be replaced by quantitative models? Does their work have no value? My answer to both of those questions is a qualified “no.” Good quant models will eat into the turf of qualitative analysts, and kick out some of the marginal analysts. As pointed out by the second article analysts would do well to avoid focusing on earnings estimates, and look at other information that would provide greater value to investors from the balance sheet and cash flow statement. (I am looking at Piotroski’s paper, and I think it is promising. He has made explicit many things that I do intuitively.
I work for a hedge fund, but I am dubious of the concept of double alpha. It sounds nice in theory: make money off of your shorts and longs without taking overall market risk. As I am fond of saying, shorting is not the opposite of being long, it is the opposite of being leveraged long, because in both cases, you no longer have discretionary control over your trade. Typically, hedge fund investors are only good at generating alpha on the long side. The short side, particularly with the crowding that is going on there is much tougher to make money at. If I had my own hedge fund, I would short baskets against my long position, and occasionally companies that I knew had accounting problems that weren’t crowded shorts already (increasingly rare).
Maybe this one should have run in my Saturday piece, but some suggest that we are running out of certain rare metals. I remember similar worries in the early 70s, and we found a lot more of those metals than we thought possible then. There is probably a Hubbert’s peak for metals as well, but conservation will increase the supply, and prices will rise, quenching demand.
For those that remember my piece, “Kiss the Equity Premium Goodbye,” you will be heartened to know that my intellectual companion in this argument, Morningstar, has not given up. Retail investors buy and sell at the wrong times because of fear an greed, so total returns are generally higher than the realized returns that the investors recieve.
When there are too many choices, investors tend to get it wrong. When there is too much information, investors tend to get it wrong. Let’s face it, we can make choices between two items pretty well, but with many items we are sunk; same for choosing between two interpretations of a situation versus many interpretations. My own investing methods force me to follow rules, which limits my discretion. It also forces me to narrow the field rapidly to a smaller number of choices, and make decisions from that smaller pool. When I make decisions for the hedge funds that I work for, I might take the dozen names that I am long or short, and compare each pair of names to decide which I like most and least. Once I have done that, numeric rankings are easy; but this can only work with small numbers, because the number of comparisons goes up with the square of the number of names.
Jeff Miller aptly reminds us to focus on marginal effects. When news hits, the simple linear response is usually wrong because economic actors adapt to minimize the troubles from bad news, and maximize the benefits from good news. People don’t act as if they are locked in, but adjust to changing conditions in an effort to better their positions. The same is true in investing. Good news is rarely as good as it seems, and bad news rarely as bad.
This article describes sector rotation in an idealized way versus the business cycle, and finds that one can make money using it. Cramer calls methods like this “The Playbook.” (Haven’t heard that in a while from Cramer. I wonder why? Maybe because the cycle has been extended.) I tend not to use analyses like this for two reasons. First, I think it pays more to look at what sectors are in or out of favor at a given moment, and ask why, because no two cycles are truly alike. They are commonalities, but it pays to ask why a given sector is out of line with history. Second, most of these analyses were generated at a time when the US domestic demand was the almost total driver of economic activity. We are now in a global economic demand context today, and those that ignore that fact are underperforming at present.
Finally, it is rare when The Economist gets one wrong. But their recent blurb on bond indexing misses a key truth. So bigger issuers get a greater weight in bond indexes. Index weightings are still proportional to the range of choices that a bond manager faces. Care to underweight a big issuer because they have too much debt outstanding? Go ahead; there are times when that trade is a winner, and times when it is a loser. Care to buy securities away from the index? Go ahead, but that also can win or lose. If bond indexes fairly represent the average dollar in the market, they have done a good job as a benchmark; that doesn’t mean they are the wisest investment, but indexes by their very nature are never the wisest investment, except for the uninformed.
Well, that’s it for this evening. Let’s see how the market continues to move against the shorts; there are way too many shorts, and too many people wondering why the market is so high. Modifying the concept of the pain trade, maybe the confusion trade is an analogue, the market moves in a way that will confuse the most people.
This was an article that I submitted to RealMoney, but was rejected because it was not relevant enough to “retail investors.” I offer it to you for your consideration. It was the follow-up piece to this article: The Long and Short of Trend Investing.
Throw in the Short Run
But now let?s move to the technicals of the situation. Given that I am a longer-term investor, this doesn?t play as great a role for me as other investors at RealMoney, but I don?t ignore it entirely. I simply view technicals through a fundamental framework. I have described this in the following articles, which still have value today, in my opinion:
(As an aside, I would simply say that technical analysis, as construed by most technicians, does not work on average. Most technicians die the ?death of a thousand cuts,? as they take multiple small losses. Successful technicians have something fundamental going on, whether they realize it or not.)
Institutional investors run most of the money in the market. Most of them have been trained to think in valuation terms exclusively, and so they set buy and sell prices for their positions. This influences even small investors, because of the impact of sell-side research. Almost every buy or sell recommendation comes with a price target. The sell side analysts often issue new buy or sell when a price target they have been looking for occurs.
But not every fundamental investor agrees on what the proper prices are for buying and selling. As the old saying goes, ?It takes two to make a market.? Sometimes, I will make it into the office and my trader will tell me that someone is aggressively selling a company that we own. I might ask him if our brokers have any feel for the size of the seller, and how desperate he is. The answer is usually ?no,? but if we do get an answer, that can help dictate our trading strategy. We would want to buy more as the big seller is closer to being done. In fact, we want to buy his last block of shares from him, if possible. Sometimes that can be arranged by talking to our broker; other times not.
As another aside, this is simpler to do in the bond market than the stock market. The large brokers generally know who is doing what. Be nice to your sales coverages, and you?d be amazed what they will tell you?. Here?s a stylized example.
Broker: ?You sure you want to buy that Washington Mutual bond??
Me: ?Yes, why??
Broker: ?Uh, there?s someone with size selling the name.?
Me: ?How much size??
Broker: ?Best indications are eight times your order size.?
Me: ?I can?t take that much down. Keep me in mind, and when he gets down to about double the size of my order, call me, and I?ll take the tail [everything that?s left].?
Broker: ?You got it.?
But suppose we don?t have any idea what the intentions of the seller are. We would have to be more humble, and try to infer from the chart what his methods are. Does he put a ceiling over the stock price, and only sell when it gets to a certain level? Or is he a ?mad bomber? that keeps selling regardless of the price level? Looking down the holders list, can I figure out anyone who might be incented to sell so much, and so aggressively? Who is disappointed at present that has a trading style like the group that is selling the stock?
Does he sell in dribs and drabs, scaling over time? Does he do a series of block trades? Is he using some sort of quantitative selling strategy that incorporates both time and price? These are the questions that I try to answer as I strategize my trading. It doesn?t give me perfect information, but it aids me at the margins.
So, say after your analysis of the technicals, you think the stock will continue to go down for a while, or won?t rise because the seller is big, seemingly larger than you can take down. Still, you like the company at the present valuation levels. What do you do?
You could sit on your hands, and wait out the seller. But what if you?re wrong about the size of the seller? The stock could move higher before you get a position on if the seller is smaller than you anticipated. Remember, other traders are watching the big seller also, and they will be waiting for him to be done as well.
You also could buy your full position immediately. After all, you have firm convictions about the secular trends and the stock?s valuation. Timing is for losers, and we are fundamental investors. Well, okay, but what if you are wrong, and the seller is right? Or, what if you like the idea here for the long run, but you would buy even more at lower prices? As Bill Miller has put it, ?Lowest average cost wins.?
Again, we could put on half the position and wait for the seller to be done. I like that, but are there alternatives? We could estimate the size of the seller (imperfectly), try to figure out how long he will be around and do a time-based scale where we put on 80-90% of a full position over that estimated time period. We also could do a price-based scale, and try to estimate (even more imperfectly) how much the seller will drive down the price before he is done. Buy 25% of a full position now, and then scale the remainder of what would be 80-90% of a full position down at the price you the seller gets exhausted at.
These strategies are illustrative, and meant to show the range of ways that one can balance off fundamental conviction versus the technicals of the market. In general, price scales work better when you think the seller is valuation sensitive, or other buyers are showing up in size to gobble up the seller?s supply at a given level. In the absence of that, time-based scales are the proper strategy if you have some confidence in the timing of the seller. Failing all of that, my humble strategy is to buy half and wait. It will never be perfect, but if I am right on the fundamentals, the results will be good enough.
The Fed Model is a reasonable but imperfect means of comparing the desirability of investing in stocks versus bonds. It can be considered a huge simplification of the dividend discount model, applied to the market as a whole, rather than an individual stock. The dividend discount model states that the value of the stock is equal to the future stream of dividends discounted at the corporation?s cost of equity capital.
What simplifying assumptions get applied to the dividend discount model to create the Fed Model?
The market as a whole is considered rather than individual stocks.
A constant ratio of earnings is paid out as dividends.
The growth rate of earnings is made constant.
A Treasury yield (or high/moderate quality corporate bond yield) is substituted for the cost of equity capital.
Instead of following a strict discounting method, the equation is rearranged to make an explicit comparison between bond yields and equity yields.
Assuming that the dividend discount model is valid, or at least approximately so, what do these simplifying assumptions do to the accuracy of valuing the market as a whole? The first assumption is more procedural in nature, and does no major harm. The fifth assumption simply reorganizes the equation, and doesn?t affect the outcome, but only the presentation. The real changes come from assumptions 2-4.
Dividends are more stable than earnings, so the payout ratio certainly varies over time. Additionally, corporations have shown less willingness to pay dividends, and investors have shown less inclination to demand dividends, to the payout ratio today is roughly half of what it was in the early 60s.
Earnings don?t grow at a constant rate, either. Over the last 53 years, earnings have grown at a 6.7% rate, but that has included times of shrinkage, and boom times as well.
As for the cost of capital to a corporation, I believe that the Capital Asset Pricing Model is genuinely wrong, and I refer you to Roll?s famous critique for what should have been its burial. Academics need risk to be something simple though, with risk being the same for all investors (not true), so that they can easily calculate their models, and publish. The CAPM provides useful, if mistaken, simplification to financial economists. It is not going away anytime soon.
One day I will write an article to explain my cost of equity capital methods in more depth, which derive corporate bonds and option pricing theory. In basic, for any corporation, the basic idea is to compare the riskiness of the equity to that of a bond. Look at the yield on juniormost debt security of the firm, the cost of equity is higher than that. Examine the implied volatility [IV] on the longest dated at the money options for the firm. How do those implied volatilities compare with other firms? In general the higher the IV, the higher the cost of equity capital.
Practically, when looking at the capital structure of the firms in the S&P 500, I think that the yield on a BBB bond plus a spread could be a good proxy for the weighted average cost of capital for the firms as a group. I?ll get to what that spread might be in a bit. We have BBB yield series going back a long way. Equity risk for the S&P 500 (a high credit quality group) is probably akin to the risk of owning weak BB or strong single-B bonds on average. (My rule of thumb for cost of equity capital in an individual corporation is take the juniormost debt yield and add 3%. For those with access to RealMoney, I have written more on this here.)
To summarize then: there?s not much I can do about assumptions 2 and 3. The only thing I might say is that earnings are a better proxy for value creation than dividends, and that expectations for longer-term earnings growth do not change nearly as much as actual earnings growth does. On assumption 4, a BBB bond yield plus a spread will be a reasonable, though not perfectly accurate proxy for the cost of equity. My view is that spread should be between 2.5%-3.0%.
The Results
With that, the ?Fed Model? boils down to a comparison of BBB bond yields less a spread versus earnings yields. Wait, ?less? a spread? Didn?t I say ?plus? above?
Let?s consider how a stock differs from a bond. With a bond, all that you can hope to get is your principal and interest paid on a timely basis. With equity, particularly in a diversified portfolio, one can expect over the long term growth in the value of the business from a growing dividend stream, and reinvestment of retained earnings. As I mentioned above, that has averaged 6.7%/year earnings growth over the past 53 years.
If I were trying to balance the yield needed from bonds to compete with equities, it would look like this, then:
Earnings Yield + 6.7% = BBB bond yield plus 2.5-3.0%
Or,
Earnings Yield = BBB bond yield – 4% (or so)
Here is how earnings yields and BBB bond yields have compared over the years.
Thus my criteria for investing would be under the ?Fed Model,? when the earnings yield is more than 4% less than the BBB bond yield, invest in bonds. Otherwise, invest in stocks. Following this method, how would a portfolio have done since 1954?
Wow. Pretty good rule, in hindsight. Is the spread of 4% the best spread for simulation purposes?
Pretty close. The optimum value is 3.9%. This chart uses an actuarial smoothing method to give a fairer view of noisy historical results. (Life actuaries use this smoothing method in cash flow testing to calculate required capital, because sometimes small changes in spread produce large differences in the results for a particular scenario.)
The strategy produces a return roughly 2.0%/year higher than investing in stocks only, with a standard deviation roughly 1.5%/year lower. At least in a backtest, my version of the ?Fed Model? works.
Limitations
Okay, given the above, I endorse my version of the ?Fed Model? as being useful, but with five caveats:
The first thing to remember is that the ?Fed Model? doesn?t tell you whether stocks are absolutely cheap, but whether they are cheap versus bonds. There may be other more desirable asset classes to choose from: cash, commodities, international bonds or equities, etc.
The second thing to remember is that when interest rates get low, yields do not reflect the true riskiness of bonds ? a slightly superior model would be 107% of BBB yields less 4.7%. But that could just be an artifact of backtesting. To its credit though, the slightly superior model behaves the way that it should in theory, in term of how credit spreads move.
Number three, ideally, all models would not use trailing earnings yields, but expected earnings yields. That said, trailing yields are objective, and expected yields have often proiven wrong at turning points.
The fourth limitation: a high earnings yield might reflect low earnings quality or profit margins higher than sustainable. No doubt that is possible, and particularly in the current era. On the flip side, there may be times when a low earnings yield might reflect high earnings quality or profit margins lower than sustainable. A rule is a rule, and a model is only a model; they don?t reflect all aspects of reality, they are just tools to guide us.
What P/E ratio would the current BBB bond yield (6.74%) support? I am surprised to say that it would support a P/E in the high 30s; 39.8 for the simple model, and 35.2 for the ?slightly superior? one. With the current trailing P/E at 18.1, that would indicate that on an unadjusted basis, the market could be twice as high as it is presently.
That thought makes me queasy, but here three other ways to look at it:
How inflated are profit margins? If they are going to regress by less than half, then stocks are still a bargain.
Are bond yields/spreads too low? The recycling of the current account deficit into US debt instruments keeps yields low, and the speculation in the credit markets keeps spreads low. What should be the normalized BBB yield?
Will earnings growth slow beneath the 6.7% average? If so, the spread needs to come down.
Fifth, this is simply a backtest, albeit one that conforms to my theories. The future may not resemble the past.
Conclusion
My version of the Fed Model provides us with a way of comparing corporate bond yields with earnings yields, giving credit for growth that happens in capitalist economies that are free from war on their home soil. There are reasons to think that current profit margins are overstated, and perhaps that corporate bond yields will rise. All of that said, there is a large provision for adverse deviation in the present environment.
I would rather be a moderate bull on stocks versus bonds in this environment as a result. Don?t go hog wild, but current bond yields are no competition for stocks at present. If you think bond yields will normalize higher, perhaps cash is the place you would rather be for now.
There are three great economic distortions in our world today that will eventually have to be unwound. All of them are temporarily self-reinforcing, so they will persist until something breaks. Here they are:
Recycling the US current account deficit.
Too much speculation in leveraged credit markets.
Too much speculation from private equity investors.
I could add a fourth, willingness of institutions to invest in weakly funded structures, like hedge funds, and anything else with liquid liabilities and illiquid assets, but that is for another day. Tonight, I want to focus primarily on the first of those issues, the consequences of the US current account deficit. Here goes:
Almost all bond managers love positive carry. It is the lure of free money, and it works most of the time. Borrow cheaply and invest the money in something that yields more. That simple idea lies behind most of the excesses in our debt markets globally, and fuels the three excesses listed above. With currencies, market player borrow in yen and Swiss francs, and invest in higher yielding currencies like the New Zealand Dollar. Even major corporations like Citigroup borrow in yen, because the rates are low.
When a country sends more goods to the US than it receives back, there is a natural inflationary effect. The local population buys goods and services, not US bonds, yet as banks accumulate the bonds, considering them to be part of their reserves, the balance sheets of the banks expand, because increased capital allows them to make more loans, which adds to the buying power of individuals and corporation, and can lead to more inflation. To resist the inflation, a country can let its currency rise versus the dollar, making exports less competitive, and increasing the willingness to import. This has happened in Thailand, India, and South Korea. Once this happens in enough nations, interest rates will rise in the US. We will send more goods to balance the accounts, and fewer bonds.
Thinking about inflation, wages are rising in China, particularly for those that work in export-oriented sectors. That is leading to rising prices for exports to the US. That will eventually have an upward impact on US price inflation.
Now, inflation is not a serious concern yet in Japan or Switzerland. But if it did become an issue, the carry trade would end rapidly. Interest rates would be forced up rapidly, and the cost of loans denominated in those currencies would rise as well, making the borrowing uneconomic. Personally, I think the yen is 20% undervalued; in a few years, the yen will correct, if not more.
Now, imbalances are not forever. The emerging markets ten years ago were fragile because they ran current account deficits. Today many of them have the high quality problem of surpluses (and the inflation they can engender). They are in a stronger position to deal with crises. The US, though is does not know it yet, is ina weaker position to deal with crises.
On the “dark matter” debate, my position has been that the US has a big debt to the rest of the world, but that since the US invests in higher yielding investments abroad than foreigners do in the US, until recently, the US earned more from foreign investments than foreigners earned off of US investments. This WSJ blog post supports my contention. On net, the US contains risk-takers, and the returns have been good so far, but the foreign debt has become so great, that the added yield is not enough to keep up with what we have to pay out.
The main thing that could go wrong here would be a trade war.? Now, one of those is not imminent, but the Doha round at the WTO has not been a success, and there is pressure in many nations to restrict trade, or foreign ownership of assets.? If one wants to destroy the gains from trade, that would be the way to go.
The 10-year Treasury yield has gotten jumpy in this environment, closing the week out at 5.18%.? I would expect the yield to muddle between 4.75 and 5.50% through the remainder of the year.? This is a finely balanced environment, with reason for rates to rise and fall.? Thus I expect the muddle.
Finally, three bits on debt and demographics.? The first is an article from the Wall Street Journal on how insurers are going after Baby Boomers.? This is just another factor in the yield seeking that I have been talking about.? Baby boomers want yield from their assets so that they can enjoy their retirement.? That yield-seeking is and will be a major force distorting the markets for years to come.? It is much easier to demand more yield from your assets than to save more.? In the long run, it is much harder to realize more yield from your assets than it is to save more.
Don’t trust US Government estimates of the deficit; instead, look at the change in net liabilities, the way a corporation might do it.? That would balloon the paltry $250 billion deficit to $1.3 trillion.? I have been writing about this since 1992.? The US government will not make good on all the promises it has made in money with today’s purchasing power.? The tipping point is not here yet for when this becomes obvious, but I believe it will become clear within the next ten years.? Pity the next three presidents.
Partly as a result of this, and greater labor competition from abroad, we are finally seeing some evidence that the current generation of young adults is not doing as well as their parents did.? This may be a case of increasing income inequality, so that the average can increase while the median decreases.? From my angle in society, this is happening.? A few motivated people are prospering, and many are muddling along.? Where my opinion differs here is that people are generally getting what they deserve; in a more competitive world, people have to compete harder than their parents did, in order to do better.? In general, people are not working harder, and so their results are falling behind those of their parents on an inflation adjusted basis.
Not to leave it on a down note, but that’s it for the evening.? Hope to write cheerier stuff next week.
