Bonds – Page 2 – The Aleph Blog

Avoid Complexity in Limiting Risk

Posted on 19 October 201920 October 2019 by David Merkel

Picture Credit: Olivier ROUX || Simplicity almost always beats complexity.

I’m not a fan of EIAs. I’m not a fan of variable annuities, unless they’re really simple with rock-bottom expenses and no surrender charges. I’m not a fan of ETNs. I hate structured notes. I’m also not a fan of ETFs that are filled with derivatives.

Ten years ago, I wrote a piece called The Good ETF. It is still as valid now as before, along with its companion piece The Good ETF, Part 2 (sort of). And for Commodity ETFs, there was: Fusion Solution: The Stable Value Fund Guide to Commodity ETF Management. If you are rolling futures in an ETF, it had better be done like a short bond ladder.

You can add in the pieces that I wrote before and when the short volatility ETFs imploded. What did it say in The Good ETF?

Good ETFs are:
* Small compared to the pool that they fish in
* Follow broad themes
* Do not rely on irreplicable assets
* Storable, they do not require a ?roll? or some replication strategy.
* not affected by unexpected credit events.
* Liquid in terms of what they represent, and liquid it what they hold.
The last one is a good summary.? There are many ETFs that are Closed-end funds in disguise.? An ETF with liquid assets, following a theme that many will want to follow will never disappear, and will have a price that tracks its NAV.
The Good ETF

But tonight I have another complex investment to avoid, and a simple one to embrace. First the avoid…

There was a piece at Bloomberg Businessweek called ETFs With Downside Protection? It?s Complicated. These are called defined outcome ETFs. Basically they are a bundle of equity options that cut your losses, while limiting your gains on a given equity index. (Also, you don’t get dividend income, and have to pay manager fees.) In-between the cap on gains, and where losses kick in, your returns should move 1:1 with the index. The same will be true with losses after the first N% get eaten — below N% losses, you begin taking losses.

Illustration of Defined Outcome ETF returns as compared to an index fund using the same index as the Defined Outcome ETF

I wanted to keep the illustration simple. This hypothetical defined outcome ETF caps gains at 10%, and absorbs the first 15% of losses. This example assumes no fees, which would likely be lower on the index fund. This example assumes no dividends, which would get paid to you in the index fund, but not on the defined outcome ETF.

Defined outcome ETFs purchase and sell tailored options that are backed by the central counterparty the Options Clearing Corporation — a very strong, stable institution. Credit risk still exists, but if the OCC goes down, many things will be in trouble. The options exist for one year, after which gains are paid to and losses absorbed by ETF shareholders. The ETF then resets to start another year following the same strategy with slightly different levels because the relative amounts of the cap and the loss buffering rely on where equity volatility is for a given index at the start of the year.

Unlike an index fund, your gains cannot grow tax-deferred, though if you have gains, you can roll them over into the next year.

I’ve read the offering documents, including the sections on risk. My main argument with the product is that you give up too much upside for the downside protection. The really big up years are the places where you make your money. There aren’t so many “average” years. The protection on the downside is something, but in big down years it could be cold comfort.

The second part is the loss of dividends and paying higher fees. Using the S&P 500 as a proxy, a 2% dividend lost and a 0.5% added fee adds up to quite a cost.

There are implementation risks and credit risks but these risks are small. I ran a medium-sized EIA options book for a little more than a year. This is not rocket science. The investor who is comfortable with options could create this on his own. They list more risks in the offering documents, but they are small as well. What gets me are the costs, and the upside/downside tradeoff.

A Better, if Maligned Investment

Recently Bank of America declared ?the end of the 60-40? standard portfolio. I think this was foolish, and maligns one of the best strategies around — the balanced fund.

Yes, interest rates are low. Yields on some stocks are higher than the yields on the Barclays’ Aggregate [bond] Index. But if you only bought those bonds, you would have a rather unbalanced portfolio from a sector standpoint — heavy on utilities and financials. The Barclays’ Aggregate still outyields the S&P 500, if not by much, like 0.8%/yr.

The real reason that you hold bonds and cash equivalents is not the income; it is risk reduction. I’m assuming no one is thinking of buying the TLT ( 20+ Year Treas Bond Ishares ETF), which is more of a speculator’s vehicle, but something more like AGG ( US Aggregate Bond Ishares Core ETF), which yields 0.3% more, but the overall volatility is a lot less.

With AGG, fixed income claims of high investment grade entities will make it through a deflationary crisis. In an inflationary situation like the 70s, the bonds are short enough that over a five year period, you should make money, just not in real terms.

It’s good to think long term, and have a mix of fixed and variable claims. The bonds (fixed claims) lower your volatility so that you don’t get scared out of your stocks (variable claims) in a serious downdraft.

The models I have run have returns max out in an 80/20 balanced fund, and the trade-off of risk for return is pretty good down to a 60/40 balanced fund. In my personal investing, I have always been between 80/20 and 60/40.

As it is, if you are looking the likely returns on the S&P 500 over the next ten years, it’s about the same return available on a A3/A- corporate bond, but with a lot more volatility.

Thus the need for bonds. In a bad scenario, stocks will fall more than bonds, and the balanced fund will buy stocks using proceeds of the bonds that have fallen less to buy stocks more cheaply. And if the stock market rises further, the balanced fund will sell stocks and use the proceeds to bank the gains by buying bonds that will offer future risk reduction, and some income.

As such, consider the humble balanced fund as a long-term investment vehicle that is simple and enduring, even when rates are low. And avoid complexity in your investment dealings. It is almost never rewarded.

Post 3000 — I’m glad to be back!

Posted on 15 October 2019 by David Merkel

Photo Credit: Stephan Caspar || In Roman numerals 3000 is MMM… and thus the yummy picture that will make some people go “mmm….” As for me Mmm… I’m glad to be back.

Every 100 posts (except that I did not do it at the 2900 milestone), I take a moment to reflect. I started blogging back in February of 2007. I was 46 years old then; I am 58 now.

I resisted starting a blog for some time. When my editor at RealMoney asked me (she was asking all the contributors) “Are you going to start a blog?” I answered, “RealMoney, particularly the Columnist Conversation is my blog.”

I loved writing for RealMoney, but in some ways I was not the best fit for RM. I wrote more about theory, and less about actionable ideas. My main reason for that was that beyond holding a CFA charter, and at the time, a dues-paying life actuary, I have a code of ethics in addition to those from CFAI and the SOA. Aside from that, feedback is lopsided, like on Yelp. You get disproportionate feedback when you make a mistake, but little praise when you get something right.

But the reason I decamped from RealMoney was that I wanted more editorial freedom. It is the same reason that I tried writing for The Balance, and gave it up because I needed more freedom to write what I was thinking. (Also, writing for The Balance involved rewriting old articles, many of which were average for the web, but way below my standards. Rewriting those took a lot of time, and did not satisfy the other requirement of writing new articles on topics the the editors wanted, most of which were decidedly niche.)

How Aleph Blog Changed Over Time

When I began, I was writing two small articles per night. I morphed into writing articles that were relatively long, and one per night. I had a goal: to express all of the main ideas that I had come to regarding finance, economics and investment. A major part of that was The Rules posts, which mostly stemmed from insights I had between 1999 and 2003. There were a few that came after that, but not many. When I finished the last of the original Rules posts, I breathed a sigh of relief, because one of the major goals of the blog was complete. I had written an article on all of the “Rules.”

Now, one other thing that changed was the financial crisis. During the crisis, I resolved to write about all of the issues that I thought my distinct view could help explain. But I did not want to be a “crisis blogger.” There are some bloggers that are locked into writing about disaster, which is problematic when we have been in a very long though shallow recovery. Some commenters criticized me for not being like Zero Hedge back in 2009 or so. I ignored it because I want to be an “All Weather” blogger. I will write when the sun shines. I will write when it rains.

I do want to make one comment from the crisis era, when I was one of the bloggers invited to the first US Treasury / Blogger summit. In my 7-part coverage of the event, I never mentioned what I said during the main portion of the event. I was not the most outspoken at that event. Those that were “crisis bloggers” dominated the conversation.

There were only two things I got to say during the meeting. The first was my telling them that they could learn something from the way Canada regulates their banks, and also that the US state-regulated insurance companies were regulated better than the depository institutions in the US, especially for solvency.

The second thing that I said was that the US should lengthen maturities for Treasury issuance, and issue fifties, centuries, and consols. Also, they should issue floating rate debt. I told them that the US government would face a crisis when there is too much debt to roll over, so stagger the maturities, and pay up to borrow longer.

Back to the Present

I wrote a lot of book reviews in the past. I am unlikely to write a lot more of them, though there will be some. Part of that is Amazon favoring reviewers that bought their books at Amazon. I got most of mine from the publishers.

I have maybe 40 article ideas to work on now. Many of them will require significant work. Many of my best articles required that level of work, but it will mean that my output will slow down. If you have something you would like me to write about, send me an email. My address is on the Contact Me page. I don’t guarantee that I will write about it, but reader letters have led to more articles at my blog than most others.

Thanks to my Readers

There is one post that is especially dear to me, the one entitled Learning Leadership. It describes a time when I effected a huge change in the business that I worked for, and got little to no reward for doing so.

I thank all of my readers for reading me, wherever you are. One-third of my readers are outside of the US. I try to write for a global audience, but living in the US, I know that it will be somewhat US-centric. All the same, I invite those outside the US to write me and ask me questions.

And with that, I close this piece. Not that I will answer every question, but I will read everything that is written to me. My readers help make my blog better. Keep writing to me and helping me; I appreciate it.

Issue Longer Treasury Debt

Posted on 11 October 2019 by David Merkel

Picture credit: DonkeyHotey || Should bonds get longer?

When I visited the US Treasury during the first Treasury/Blogger summit I encouraged the US Treasury to issue debts longer than 30 years, and also floating rate debt. I said the insurance companies, pension funds and endowments would be willing buyers, and that it would be cheaper than issuing 30-year bonds. I thought that the yields on (say) 50-year bonds would be lower than 30-year bonds, because the yield curve for most of my life (at that point) had the yield curve peaking out at around 22 years or so. 30-year bonds usually yielded less than 20-year bonds.

The case for issuing longer debt was easy when 30-year bonds yielded less than 20-year bonds. That is no longer true, and has not been true since the financial crisis. In a low interest rate environment, 30-year bonds yield more than 20–year bonds. In a higher interest rate environment, the relationship flips.

So, should the US treasury issue 50-year, 100-year, or perpetual bonds? I still think the answer is yes, and for three reasons.

1) It’s an experiment. The market doesn’t always know what it wants until you offer an option to it. No degree of discussion with the advisory committee can beat an actual offering to the market. There used to be callable T-notes, and even a Treasury note denominated in Swiss Francs. Experiments are worth trying on a small level just to see what happens. Knowledge is a valuable thing — theory is worth less than tangible data.

2) Rates are low. Why not lock in the low rates? Even if 50-year bonds have a premium yield to 30-year bonds, those yields are likely lower than what you might get when interest rates are high.

3) It would be genuinely useful for life insurance companies and pension funds to have a benchmark for 50-year bonds, which would encourage the corporate market to issue debt as well. Those who make long promises need others who will make similarly long fixed commitments.

Then there are the speculators, who I don’t care much about. They would appreciate longer debt as well, as it would give them a greater place to speculate.

My advice to the US Treasury is this: issue longer debt as an experiment. If there is additional cost in the short-run, see if it is cheaper in the long run. There is a market for longer debt, even if your advisory committee thinks differently.

The Balance: On Private Activity Bonds

Posted on 10 August 2018 by David Merkel

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For about two months, I wondered when I would write this.? Now I know… I’m writing it now.? To all my readers, I am letting you know that Aleph Blog is not ending, but it is changing.? I accepted a writing assignment with The Balance.? I am going to write 4-5 articles for them per month, and correct some old articles as well.? I will publish links to them here.? Like Aleph Blog, The Balance is free, so you don’t have to do anything more than click on the article link here to read it.

Why did I do this?? I felt I was getting stale in my writing.? I was a little bored; that’s why I wasn’t writing so much.? I had completed all of my main goals for the blog in 2014, and slowly lost the will to keep cranking it out.

The deal with The Balance is like theStreet.com in that I get compensated.? It is not like theStreet.com in three ways.

I write primarily in the third person, like a journalist.
They don’t want any stock picks.
They assign me topics to write on, and I pitch ideas to them, which they must approve before I write.

I like it.? It forces me to learn new things and write in a new way outside of my comfort zone.? It is a challenge.

I will still write some pieces natively for Aleph Blog, but most of what you will see here will be lead-ins to my articles at The Balance.? I will personalize them here, and say things that I can’t say there, because here I don’t have to be neutral.

Here’s my first piece:?Private Activity Bonds As An Investment

Let me simply say here that I am not crazy about Private Activity Bonds [PABs], and municipal bonds generally.? If you have a long enough time horizon to buy and hold a muni bond 20-30 years, then you may as well own stocks.? Aside from that, these aren’t municipalities paying on the PABs — these are private corporations.? It is a “heads they win, tails you lose” situation in many cases.? The credit risk level is higher than an equivalently rated muni.? So, buyer beware, and stick to investments that are simple, because complexity favors the financial structurer, not the buyer of the note that is a part of the financial structure.

But maybe I am wrong.? If you think I missed something, let me know in the comments.

The Pips are Squeaking

Posted on 15 May 2018 by David Merkel

Photo Credit: sid=================

This should be a short post.? I just want to note the degree of stress that many emerging market countries are under.? The Fed raises rates, and something blows up.? That is often the class of debt that has grown the most in the bull phase of the cycle, or, the one that has financed with short-term debt.? This is the “volatility machine” that Michael Pettis wrote so well about.

The Brazilian stocks I own have been falling.? A little lower, and I will make them double-weight positions.? Five times earnings for utilities that cannot be done without?? Wave the shares in.

Look at Argentina, Indonesia, and Turkey.? Fundamentally misfinanced.? Maybe own assets there that have enduring demand.? I own IRSA [IRS].

Russia is fundamentally sound.? I own shares in RSXJ, which is not so connected to the energy sector.

Buy the emerging markets generally, avoiding those markets are fundamentally misfinanced.? Or wait, and buy later.? Emerging market selloffs are often sharp and significant.? I’m not sure what is the right way to do it, so you could buy half now, and wait.? If it rallies, be glad you got some cheap.? If it sells off more, buy the full position.

There are some good values now; they could get better later.? Buy a little and wait like my “do half” strategy says.? Don’t get greedy, look for decent gains over 3-5 years.

And now for something completely different:

https://www.youtube.com/watch?v=gLyoBCIBCW8?t=1343

I appeared on RT Boom/Bust two weeks ago, and offered my thoughts on Wells Fargo at the end of the show.? I think they still have more problems to be revealed.? That said, things aren’t getting worse, so this might be a good time to buy the shares of Wells Fargo.

Full disclosure: My clients and I own shares of IRS, SBS, ELP, BRF, and RSXJ

Thoughts on Bank Debt

Posted on 11 May 2018 by David Merkel

I have long said that until an asset class goes through a “failure cycle,” risk-based pricing will be weak toward the assets in question.? One asset class that has become popular of late is bank debt.? Bank debt is a loan to a corporation that typically has first priority to make claims on the company in bankruptcy, ahead of the bondholders, much less the preferred stockholders and the common equity.

Though it is called bank debt, often the loans are arranged by banks and allow others to lend alongside them.? This has become popular among closed-end funds and ETFs like BKLN.? What are the advantages?

In the past credit losses have been low, partially because of strong covenants and low availability.
The loans have floating rates, so if interest rates rise, you get paid more, assuming the company does not choke on higher interest rates.

Recently a friend wrote me, asking:

Hi David:

Hope everything is well.

Quick investment question, if you don’t mind.

Wanted to get your thoughts on the leveraged loan asset class. From my perspective, there are both positive and negative factors at play currently, e.g., higher interest rates (positive), weaker covenant packages (negative), among other things.

Would love to get your opinion.

He has a decent summary of the situation.? My view is similar to this analysis at Bloomberg.? Underwriters of the loans have become less choosy, and as such have allowed loans to be made with weak covenants.? As a result, more loans have been made,? increasing their size versus bonds at junk-rated corporations.

I can tell you one thing with certainty.? When the losses of this cycle come, it will be decidedly worse than the prior cycles that had light losses.? That is due to the weaker covenants and the increase in the proportion of financing coming from bank debt.? When the debt had more parties taking losses in front of them, their losses were lower.? Even without the change in the covenants, the larger relative size would lead to greater losses.

I summarize it this way: those throwing money into bank debt do so to earn money but not take interest rate risk.? In the process they absorb more credit risk than prior generations of bank debt investors took on.

I have often invested in bank debt in the past, but I am not doing so now.? I think the credit risk is a lot higher than before, and not worth taking the risk in order to get a floating rate for returns.? Instead, I have invested in short-term bond funds with high credit quality.? Less yield, but more security.

Why I Watch the Thirty

Posted on 19 April 2018 by David Merkel

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I like long bonds.? I am not saying that I like them as an investment.? I like them because they tell me about the economy.

Though I argued to the Obama Administration that they should issue Fifties, Centuries and Perpetuals, the Thirty-year bond remains the longest bond issued.? I think its yield tells us a lot about the economy.

How fast is nominal growth?? Look at the Thirty; it is highly correlated with that.

What should the Fed use for its monetary policy?? Look at the Thirty, and don’t let the Five-year note get a higher yield than it.? Also, don’t let the spread of the Two-year versus the Thirty get higher than 1.5%.? When things are bad, stimulus is fine, but it is better to wait at a high spread than goose the spread higher. Excesses in loose policy tend to beget excesses in tight policy.? Better to avoid the extremes, and genuinely mute the boom-bust cycle, rather than trying to prove that you are a genius/maestro when you are not.? Extreme monetary policy does not get rewarded.? Don’t let the yield curve get too steep; don’t invert.

Finally, the Thirty is a proxy for the cost of capital.? It’s long enough that it is a leap of faith that you will be paid back.? Better still for the cost of capital is the Moody’s Baa average, which tracks the bold bet of lending to low investment grade corporations for 20-30 years.

That said, the Thirty with its cousin, the long Treasury Inflation Protected Security [TIPS] gives you an idea of how long term inflation expectations and real rates are doing.? The thing that kills stocks is higher long term real interest rates, not inflation expectations.? The main reason for this is that when inflation rises, usually earnings do also, at least at cyclical companies.? But there is no reason why earnings should rise when real rates rise.

This is why I pay more attention to the Thirty rather than the more commonly followed Ten.? I know that more debt gets issued at a maturity of ten years.? Granted.? But the Thirty tells me more about the economy as a whole, and about its corporations.? That’s why I carefully watch the Thirty.

Notes on the Fed Announcements

Posted on 22 March 2018 by David Merkel

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Listening to the Fed Chair’s press conference, there was one thing where I disagreed with what Powell was saying.? He said a few times that they only made one decision at the FOMC meeting, that of raising the Fed Funds rate and the reverse repo rate by 0.25%.? They made another decision as well.?The decided to raise the rate of quantitative tightening [QT] by increasing the rate of Treasury, MBS and agency bonds rolloff by $10B/month starting in April. They did that by increasing the rate of reduction of MBS and agency bonds from $8B to $12B/month, and Treasuries from $12B to $18B/month. The total rate of QT goes from $20B to $30B/month.? This may raise rates on the longer end, because the Fed will no longer buy so much debt.

There was also a little concern over people overinterpreting the opinions of the Fed Governors, especially over the “dot plot,” which shows their opinions over real GDP growth, the unemployment rate, PCE inflation, and the Fed funds rate.? My point of view is simple.? If you don’t want people to misinterpret something, you need to defend it or remove it.

Personally, I think the FOMC invites trouble by doing the forecasts.? First, the Fed isn’t that good at forecasting — both the staff economists and the Fed Governors themselves.? Truly, few are good at it — people tend to either follow trends, or call for turns too soon.? Rare is the person that can pick the turning point.

Let me give you the charts for their predictions, starting with GDP:

The Fed Governors have raised their GDP estimates; they raised the estimates the most for 2018, then 2019, then 2020, but they did not raise them for the longer run.? I seems that they think that the existing stimulus, fiscal and monetary, will wear off, and then growth will return to 1.8%/year.? Note that even they don’t think that GDP will exceed 3%/year, and generally the Fed Governors are paid to be optimists.? Wonder if Trump notices this?

Then there is the unemployment rate.? This graph is the least controversial.? The short take is that?unemployment rate estimates by the Fed governors keep coming down, bottoming in 2019, and rising after that.

Then there is PCE Inflation.? Estimates by the Fed Governors are rising, and in 2019 and 2020 they exceed 2%.? In the long run the view of the Fed Governors is that they can achieve 2% PCE inflation.? Flying in the face of that is that they haven’t been able to do that for the duration of this experiment, so should we believe in their power to do so?

Finally, there is the Fed Funds forecast of the Fed Governors — the only variable they can actually control. Estimates rose a touch for 2018, more for 2019, more for 2020, and FELL for the long run. Are they thinking of overshooting on Fed Funds to reduce future inflation?

Monetary policy works with long and variable lags, as it is commonly said.? That is why I said, “Just Don?t Invert the Yield Curve.”? Powell was asked about inverting the yield curve at his press conference, and he hemmed and hawed over it, saying the evidence isn’t clear.? I will tell you now that if the Fed Funds rate follows that path, the Fed will blow something up, and then start to loosen again.? If they stop and wait when 10-year Treasury Note yields exceed 2-year yields by 0.25%, they might be able to do something amazing, where monetary policy hits the balancing point.? Then, just move Fed funds to keep the yield curve slope near that 0.25% slope.

There would be enough slope to allow prudent lending to go on, but not enough to go nuts.? Much better than the present policy that amplifies the booms and busts.? The banks would hate it initially, and regulators would have to watch for imprudent lending, because there would be no more easy money to be made.? Eventually the economy and banks would adjust to it, and monetary policy would become boring, but predictably good.

Just Don’t Invert the Yield Curve

Posted on 21 March 2018 by David Merkel

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Jerome Powell is not an economist, and as such, has the potential to try to remake the way the Fed does monetary policy.? Rather than hold onto outmoded ideas ideas like the Phillips Curve, which may have made sense when the US was a more insular economy, there are better ways to think of monetary policy from a structural standpoint of how financial firms work.

(Note: the Phillips Curve relies on a very simple assumption that goods and services price inflation stems from wage inflation, and that wage inflation occurs when domestic unemployment is low.? In a global economy, those relationships are broken when labor can be easily added from sources outside of the US.)

Financial firms tend to grow rapidly when the yield curve is steeply sloped.? Borrowing short and lending long is profitable, at least in the short-run.? This provides a lot of credit to the economy, which in the short-run, encourages growth, as businesses borrow to build supply, and consumers borrow, which temporarily boosts demand.

Financial firms tend to shrink?when the yield curve is flattish and certainly when negatively sloped.? Borrowing short and lending long is unprofitable, at least in the short-run.? This reduces credit to the economy, which in the short-run discourages growth, as businesses don’t borrow to build supply, and consumers borrow less, which temporarily reduces demand.

If there are misfinanced (too much short-term borrowing) or over-indebted areas of the economy, there can be considerable economic failure with a flat or inverted yield curve.? As I have said before, when the FOMC tightens without thinking about the financial economy, they keep tightening until something blows up, and then they loosen too much, starting the next cycle of over-borrowing.? I said this at RealMoney in 2006:

One more note: I believe gradualism is almost required in?Fed?tightening cycles in the present environment ? a lot more lending, financing, and derivatives trading gears off of short rates like three-month LIBOR, which correlates tightly with fed funds. To move the rate rapidly invites dislocating the markets, which the FOMC has shown itself capable of in the past. For example:

2000 ??Nasdaq

1997-98 ? Asia/Russia/LTCM, though that was a small move for the Fed

1994 ? Mortgages/Mexico

1989 ? Banks/Commercial Real Estate

1987 ? Stock Market

1984 ? Continental Illinois

Early ?80s ? LDC debt crisis

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

But on the bright side, the odds of a 50 basis point tightening at any point in the next year are even smaller. The markets can?t afford it.

Position:?None

I also commented that housing was likely to be the next blowup in a number of posts from that era.? Sadly, they are mostly lost because of a change in the way theStreet.com managed its file system.

As such, it behooves the Fed to avoid overly flattening the yield curve.? In late 2005, I wrote at RealMoney.com that the Fed should stop at 4%, and let the excess of the economy work themselves out.? By mid -2006, they raised the Fed Funds rate to 5.25%, flattening to invert the yield curve, which collapsed the leverage in the economy in a disorderly way.

It would have been better to stop at 4%, and watch for a while.? Housing prices had peaked, and I wrote about that at RealMoney.com as well.? The Fed could have been more gradual at that point.? There really wasn’t that much inflation, and the economy was not that strong.? Bernanke may have felt that he needed to prove that he wasn’t a dove on inflation.? Who knows?? The error was unforced, and stemmed from prior bad practices.

In this case, the Fed does have an alternative to crashing the economy again.? I would encourage the FOMC to not raise rates over 2.5%.? When they get to 2.5%, they should start selling the longest bonds in their portfolio (note: I would encourage them to end balance sheet disclosure before they do this, after all, the Fed suffers from too much communication not too little.? The Fed was better managed under Volcker and Martin.)

This would test the resilience of the economic expansion, and if the economy keeps growing as long bonds rise in yield, then match the rises in long yields with rises in the Fed Funds rate.? This is a neo-Wicksellian method of managing monetary policy that could match the ideas of Jerome Powell, who was more skeptical than most Fed Governors about about Quantitative Easing [QE].

The eventual goal is to manage monetary policy aiming for a yield curve that has a low positive slope, allowing the banks to make a little money, but not a lot.? The economy would expand moderately, and not be as prone to booms and busts.

My summary advice for the FOMC would be this: before you flatten/invert the yield curve, start selling all of the long MBS and Treasury bonds with average maturities longer than 10 years.? That will slow down the economy more effectively than flattening the yield curve, and it is not as likely to lead to a crisis.

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I have no illusions — the odds of the FOMC doing this is remote.? But given past failures, isn’t a new idea worthy of consideration?

PS — there is another factor here.? What happens to the financing costs of the profligate US government?

Estimating Future Stock Returns, December 2017 Update

Posted on 14 March 2018 by David Merkel

The future return keeps getting lower, as the market goes higher

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Jeff Bezos has a saying, “Your margin is my opportunity.”? He has found ways to eat the businesses of others by providing the same goods and services at a lower cost.? Now, that makes Amazon more productive and others less productive.? The same is true of other internet-related businesses like Google, Netflix, etc.

And, there is a slight net benefit to the economy from the creative destruction.? Old capital gets recycled.? Malls that are no longer so useful serve lower-margin businesses for locals, become homes to mega-churches, other area-intensive human gatherings, or get destroyed, and the valuable land so near many people gets put to alternative uses that are better than the mall, but not as profitable as the mall prior to the internet.

Laborers get released to other work as well.? They may get paid less than they did previously, but the system as a whole is more productive, profits rise, even as wages don’t rise so much.? A decent part of that goes to the pensions of oldsters — after all, who owns most of the stock?? Indirectly, pension plans and accounts own most of it.? As I have sometimes joked, when there are layoffs because institutional investors representing pension plans? are forcing companies to merge, or become more efficient in other ways, it is that the parents are laying off their children, because there are cheaper helpers that do just as well, and the added profits will aid their deservedly lush retirement, with little inheritance for their children.

It is a joke, though seriously intended.? Why I am mentioning it now, is that a hidden assumption of my S&P 500 estimation model is that the return on assets in the economy as a whole is assumed to be constant.? Some will say, “That can’t be true.? Look at all of the new productive businesses that have been created! The return on assets must be increasing.”? For every bit of improvement in the new businesses, some of the old businesses are destroyed.? There is some net gain, but the amount of gain is not that large in aggregate, and these changes have been happening for a long time.? Technological progress creates and destroys.

As such, I don’t think we are in a “New Era.”? Or maybe we are always in a “New Era.”? Either way, the assumption of a constant return on assets over time doesn’t strike me as wrong, though it might seem that way for a decade or two, low or high.

As it is today, the S&P 500 is priced to deliver returns of 3.24%/year not adjusted for inflation over the next ten years.? At 12/31/2017, that figure was 3.48%, as in the graph above.

We are at the 95th percentile of valuations.? Can we go higher?? Yes.? Is it likely?? Yes, but it is not likely to stick.? Someday the S&P 500 will go below 2000.? I don’t know when, but it will.? There are enough imbalances in the world — too many liabilities relative to productivity, that crises will come.? Debt creates its own crises, because people rely on those payments in the short-run, unlike stocks.

There are many saying that “there is no alternative” to owning stocks in this environment — the TINA argument.? I think that they are wrong.? What if I told you that the best you can hope for from stocks over the next 10 years is 4.07%/year, not adjusted for inflation?? Does 1.24%/year over the 10-year Treasury note really give you compensation for the additional risk?? I think not, therefore bonds, low as they may be, are an alternative.

The top line there is a 4.07%/year return, not adjusted for inflation

If you are happy holding onto stocks, knowing that the best scenario from past history would be slightly over 3400 on the S&P 500 in 2028, then why not buy a bond index fund like AGG or LQD that could virtually guarantee something near that outcome?

Is there risk of deflation?? Yes there is.? Indebted economies are very susceptible to deflation risk, because wealthy people with political influence will always prefer an economy that muddles, to higher taxes on them, inflation, or worst of all an internal default.

That is why I am saying don’t assume that the market will go a lot higher.? Indeed, we could hit levels over 4000 on the S&P if we go as nuts as we did in 1999-2000.? But the supposedly impotent Fed of that era raised short-term rates enough to crater the market.? They are in the process of doing that now.? If they follow their “dot plot” to mid-2019 the yield curve will invert.? Something will blow up, the market will retreat, and the next loosening cycle will start, complete with more QE.

Thus I am here to tell you, there is an alternative to stocks.? At present, a broad market index portfolio of bonds will likely outperform the stock market over the next ten years, and with lower risk.? Are you ready to make the switch, or at least, raise your percentage of safe assets?