Category: Macroeconomics

Looking at Eleven of my Indicators

Looking at Eleven of my Indicators

I may or may not get to my part 2 on speculation because of the market action today.? I will get to that tomorrow.? Today I think it would be best for my readers if I just run through my market indicators.? Here goes:

  1. My knockoff of a famous oscillator indicates that we are ready for a short-term bounce.? That bounce may have started at 3PM yesterday, when volume climaxed near the low of the day.? That biases me long in the short run.
  2. On the other hand, the VIX under-reacted to the fall yesterday, indicating that not enough player reached for puts to hedge their positions.
  3. The Merger Fund has had a bigger correction than in February-March.? It is likely due to difficulties with deal financing.? Nonetheless, it is an indicator of how the gears of the market are jamming up.
  4. Bond volatility, whether measured by the MOVE or LBOX indexes, indicate a more volatile environment.? No surprise that prime mortgage securities have been hit.
  5. Credit spreads have widened dramatically.? Yields are another matter.? With the fall in Treasury yields, yields on bonds single-A and above have fallen in yield, whereas bonds BBB and below have risen in yield.? High credit quality corporations have a real advantage in this market.
  6. The emerging markets have gotten whacked, wholesale.
  7. The Euro and Yen are strong, and looking at falling forward interest rate differentials, threaten to get stronger.
  8. There is some liquidation happening in some carry trades.? The New Zealand Dollar has gotten whacked versus the yen over the past two days.? In general, the last three days have differentiated between countries with weak trade positions, and those with strong positions.
  9. Closed-end floating rate bank loan funds have gotten hammered recently.? Another casualty of the LBO financing problem, but worse than the raw economics of the funds would indicate.? Prices are falling much harder than NAVs.
  10. The FOMC seems tight at present, with Total Fed Credit growing slowly.? Fed funds has missed the target on the upside on average since the last meeting, and no permanent open market operations have happened.
  11. Equity and mortgage REITs have both been hit, with equity REITs hit harder (but still expensive), and mortgage REITs nearer to fair value on average.

That’s all for now.? In general, we are oversold, and should get a bounce Friday or Monday.? I favor Friday. This bounce will be short-term in nature, so don’t put a lot of long exposure on for now.

Speculation Away From Subprime, Part 1

Speculation Away From Subprime, Part 1

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.

  1. 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.)
  2. 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.
  3. 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.
  4. 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.
  5. 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.
  6. 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?
  7. 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.
  8. Becoming more proactive on ratings?? I’m not holding my breath but Fitch may be heading that way on CMBS.? Don’t hold your breath, though.

Part 2 tomorrow.

The Five Pillars of Liquidity

The Five Pillars of Liquidity

Liquidity, that ephemeral beast.? Much talked about, but little understood.? There are five pillars of liquidity in the present environment.? I used to talk about three of them, but I excluded two ordinary ones.? Here they are:

  1. The bid for debt from CDO equity.
  2. The Private Equity bid for cheap-ish assets with steady earnings streams.
  3. The recycling of the US current account deficit.
  4. The arbitrage of investment grade corporations buying back their own stock, or the stock of other corporations, because with investment grade yields so low, it makes sense to do it, at least in the short run.
  5. The need of Baby Boomers globally to juice returns in the short run so that their retirements will be adequate.? With equities, higher returns; with bonds, more yield.? Make that money sweat, even if we have to outsource the labor that our children provide, because they are too expensive.

Numbers one and two are broken at present.? The only place in CDO-land that has some life is in investment grade assets.? We must lever up everything until it breaks.? But anything touched by subprime is damaged, and high yield, even high yield loans are damaged for now.

With private equity, it may just? be a matter of waiting a while for the banks to realize that they need yield, but i don’t think so.? Existing troubled deals will have to give up some of the profits to the lenders, or perhaps not get done.

Number three is the heavy hitter.? The current account deficit has to balance.? We have to send more goods, assets, or promises to pay more later.? The latter is what is favored at present, keeping our interest rates low, and making equity attractive relative to investment grade debt.? Until the majority of nations buying US debt revalue their currencies upward, this will continue; it doesn’t matter how much they raise their central bank’s target rate, if they don’t cool off their export sectors, they will continue to stimulate the US, and build up a bigger adjustment for later.

With private equity impaired, investment grade corporations can be rational buyers of assets, whether their own stock, or that of other corporations that fit their operating profiles. Until investment grade yields rise 1-2%, this will still be a factor in the markets, and more so for foreign corporations that have access to cheap US dollar financing (because of current account deficit claims that have to be recycled).

The last one is the one that can’t go away, at least not for another seven years as far as equities go, and maybe twenty years as far as debt goes.? There is incredible pressure to make the money do more than it should be able to under ordinary conditions, because the Baby Boomers and their intermediaries, pension plans and mutual funds, keep banging on the doors of companies asking for yet higher returns.? With debt, there is a voracious appetite for seemingly safe yet higher yielding debt.? The Boomers need it to live off of.

So where does that leave us, in terms of the equity and debt markets?? Investment grade corporates and munis should be fine on average; prime MBS at the Agency or AAA level should be fine.? Everything else is suspect.? As for equities, investment grade assets that are not likely acquirers look good.? The acquirers are less certain.? Even if acquisitions make sense in the short run, it is my guess that they won’t make sense in the long run. On net, the part of the equity markets with higher quality balance sheets should do well from here.? The rest of the equity markets… the less creditworthy their debt, the less well they should do.

Ten Important, but not Urgent Articles to Ponder

Ten Important, but not Urgent Articles to Ponder

I am an investor who does not consider background academic and semi-academic research to be worthless, even though I am skeptical of much of quantitative finance. Here are a few articles to consider that I think have some importance.

  1. Implied volatility is up. Credit spreads are up, and the equity market has not corrected. Time to worry, right? Wrong. When implied volatilities (and credit spreads) are higher, fear is a bigger factor; valuations have already been suppressed. Markets that rally against rising implied volatility typically have further rises in store.
  2. Many thanks to those that liked my piece on the adaptive markets hypothesis. Here is a piece about Andrew Lo, one of the biggest proponents of the AMH, which fleshes out the AMH more fully. I would only note that the concept of evolution is not necessary to the AMH, only the concepts inherent in ecological studies. Also, all of the fuss over neuropsychology is cute, but not necessary to the AMH. It is all a question of search costs versus rewards.
  3. John Henry alert! Will human equity analysts be replaced by quantitative models? Does their work have no value? My answer to both of those questions is a qualified “no.” Good quant models will eat into the turf of qualitative analysts, and kick out some of the marginal analysts. As pointed out by the second article analysts would do well to avoid focusing on earnings estimates, and look at other information that would provide greater value to investors from the balance sheet and cash flow statement. (I am looking at Piotroski’s paper, and I think it is promising. He has made explicit many things that I do intuitively.
  4. I work for a hedge fund, but I am dubious of the concept of double alpha. It sounds nice in theory: make money off of your shorts and longs without taking overall market risk. As I am fond of saying, shorting is not the opposite of being long, it is the opposite of being leveraged long, because in both cases, you no longer have discretionary control over your trade. Typically, hedge fund investors are only good at generating alpha on the long side. The short side, particularly with the crowding that is going on there is much tougher to make money at. If I had my own hedge fund, I would short baskets against my long position, and occasionally companies that I knew had accounting problems that weren’t crowded shorts already (increasingly rare).
  5. Maybe this one should have run in my Saturday piece, but some suggest that we are running out of certain rare metals. I remember similar worries in the early 70s, and we found a lot more of those metals than we thought possible then. There is probably a Hubbert’s peak for metals as well, but conservation will increase the supply, and prices will rise, quenching demand.
  6. For those that remember my piece, “Kiss the Equity Premium Goodbye,” you will be heartened to know that my intellectual companion in this argument, Morningstar, has not given up. Retail investors buy and sell at the wrong times because of fear an greed, so total returns are generally higher than the realized returns that the investors recieve.
  7. When there are too many choices, investors tend to get it wrong. When there is too much information, investors tend to get it wrong. Let’s face it, we can make choices between two items pretty well, but with many items we are sunk; same for choosing between two interpretations of a situation versus many interpretations. My own investing methods force me to follow rules, which limits my discretion. It also forces me to narrow the field rapidly to a smaller number of choices, and make decisions from that smaller pool. When I make decisions for the hedge funds that I work for, I might take the dozen names that I am long or short, and compare each pair of names to decide which I like most and least. Once I have done that, numeric rankings are easy; but this can only work with small numbers, because the number of comparisons goes up with the square of the number of names.
  8. Jeff Miller aptly reminds us to focus on marginal effects. When news hits, the simple linear response is usually wrong because economic actors adapt to minimize the troubles from bad news, and maximize the benefits from good news. People don’t act as if they are locked in, but adjust to changing conditions in an effort to better their positions. The same is true in investing. Good news is rarely as good as it seems, and bad news rarely as bad.
  9. This article describes sector rotation in an idealized way versus the business cycle, and finds that one can make money using it. Cramer calls methods like this “The Playbook.” (Haven’t heard that in a while from Cramer. I wonder why? Maybe because the cycle has been extended.) I tend not to use analyses like this for two reasons. First, I think it pays more to look at what sectors are in or out of favor at a given moment, and ask why, because no two cycles are truly alike. They are commonalities, but it pays to ask why a given sector is out of line with history. Second, most of these analyses were generated at a time when the US domestic demand was the almost total driver of economic activity. We are now in a global economic demand context today, and those that ignore that fact are underperforming at present.
  10. Finally, it is rare when The Economist gets one wrong. But their recent blurb on bond indexing misses a key truth. So bigger issuers get a greater weight in bond indexes. Index weightings are still proportional to the range of choices that a bond manager faces. Care to underweight a big issuer because they have too much debt outstanding? Go ahead; there are times when that trade is a winner, and times when it is a loser. Care to buy securities away from the index? Go ahead, but that also can win or lose. If bond indexes fairly represent the average dollar in the market, they have done a good job as a benchmark; that doesn’t mean they are the wisest investment, but indexes by their very nature are never the wisest investment, except for the uninformed.

Well, that’s it for this evening. Let’s see how the market continues to move against the shorts; there are way too many shorts, and too many people wondering why the market is so high. Modifying the concept of the pain trade, maybe the confusion trade is an analogue, the market moves in a way that will confuse the most people.

At The Periphery of Investing

At The Periphery of Investing

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

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

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

Seven Notes on Real Estate

Seven Notes on Real Estate

All the furor over subprime. The furor is deserved, but is getting adequately covered elsewhere. The bigger stories are over residential real estate generally, and Alt-A lending, where the problems are as big, but not as well publicized.

I would write about subprime, but I feel that I would be adding to the din at this point. I’ll write about a few other real estate issues this evening.

  1. Last November on RealMoney, I wrote a timely piece that described securitization, and the subprime market, and the credit default swaps that traded around it. It was an ambitious piece, and my editor told me it must be good, because she was able to understand the complexity of the market after reading the piece. Well, a picture is worth a thousand words. The Wall Street Journal has done me one better by giving a visual description of securitization. Here it is.
  2. Housing prices are falling nationally. Barry Ritholtz has a good summary of it. I would only add that the situation is not getting better. We have had falling prices during a peak sales time, and…
  3. More homes being built even as vacancy rates increase. In the short run, it seems optimal to a homebuilder to finish the projects he has begun. Sunk costs are sunk, and he wants to maintain good relations with those whom he worked with during the good times, so many will still build if it covers their variable costs, even if they take a loss in the process. The alternative would be to sell the land at a discount, and destroy useful subcontracting relationships that will be useful once the market turns. The trouble is, if all builders act in a way that is short-term rational, it can worsen the situation in the intermediate term.
  4. Is it time to speculate on the Homebuilders yet? I don’t think so. At residential real estate market bottoms, homebuilders trade for 50-80% of their fully written down book value. There are more writedowns to come, and many still trade over 80% of book, so I don’t think we are done yet. People are still too willing to speculate here. Perhaps the time to move will be when the vacancy rate begins a decline from the record levels that it is at now.
  5. What are Alt-A loans? Loans where the borrower is alleged to be prime, but for one reason or another, declines to prove it as comprehensively as one receiving a prime loan would. Loans that are “alternative prime” should be doing okay, right?? Well, no.? The trouble with Alt-A, is that even though the credit score is higher, the level of information that the lender is getting is a lot lower.? Good lending has safeguards in place, rejecting unworthy borrowers, and then charges an adequate rate.? Yes, it’s a lot more sexy to charge a high rate to whomever walks in the door with a high FICO score, but risk control is a key to all of business and finance.? Those who neglect it are asking for trouble.? As it is now, we have rising Alt-A delinquencies, and rising losses on mortgage loans.? This trend should persist until homeowner vacancy rates begin to fall again, and prices stop falling.
  6. In commercial real estate, rents are still rising in the office space.? I’m a little skeptical about the staying power of that trend, because vacancy rates aren’t low, except in highly desirable areas like Midtown Manhattan.? Away from office, thoug,h prospects are not as good.
  7. Beyond that, the trouble with commercial real estate is that borrowing costs often exceed current yields.? The valuation levels embed a high level of growth in rent, which may or may not happen.?? Part of the valuation problem is private equity, which is willing to borrow a lot more than REITs would.? My guess is that equity REITs are a good place to avoid for now.? Gains should be limited, and they bear the risks of a slowdown in private equity, slowing/falling rents, or a rise in financing costs.

That’s all for now.? The media can howl about subprime, but it’s really just a sideshow in the total set of problems facing residential real estate.

The “Fed Model”

The “Fed Model”

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

What is the Fed Model?

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

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

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

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

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

Fed Model Chart 3

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

Fed Model Chart 4

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

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

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

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

The Results

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

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

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

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

Or,

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

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

Fed Model Chart 5

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

Fed Model Chart 1

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

Fed Model Chart 2

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

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

Limitations

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

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

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

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

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

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

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

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

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

Conclusion

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

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

Thirteen Macroeconomic Musings

Thirteen Macroeconomic Musings

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:

  1. 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.
  2. 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.
  3. Here you can get a look at the dollar reserve levels of many nations. China has been absorbing a lot of dollar claims.
  4. 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.
  5. 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.
  6. On a more positive note, Jim Griffin suggests that the economies of Europe and Japan may be heading into classical recoveries. If true, good for all of us, particularly if they buy US goods.
  7. 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.
  8. 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.
  9. 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.
  10. 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.
  11. 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.
  12. 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.
  13. 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.

Reasons For Short-Term Optimism

Reasons For Short-Term Optimism

Bond investors and value investors tend to be cautious in investing. It is possible to be too cautious, though, and so sometimes it pays to lay out the bull case. Indirectly, I learned this after several years of sitting next to the high yield manager at Dwight Asset Management (a very good firm that few know about). He wasn?t unconcerned about negative developments, but knew that fewer bad things happen than get talked about, and that they tend to take longer to happen than most imagine. He knew that he had to take some risks, because if you wait for the market to correct before you enter, you will miss profits while waiting, and the correction could be a long time in coming.

Also, I fondly remember our weekly economic conference calls in 2002, where the high yield manager and I would take the bull side in the discussions. For me it was fun, because it was so unlike me (I tend to be a bear), and it helped me to learn to balance the risks, and not be a perma-bull or a perma-bear.

So with that, here?s my quick list on what is going right in this environment:

  1. Earnings yields are higher than bond yields, particularly among many investment grade companies, fostering buybacks and occasional LBOs. Profit margins may mean-revert eventually, but it might be a while for that to happen, given the global pressures that are keeping wage rates low.
  2. The financing of the US current account deficit is still primarily being done through the purchase of US dollar denominated debt securities, keeping interest rates low in the US. This may shift if enough countries experience inflation from the buildup of US dollar reserves that they do not need, and allow their currencies to appreciate versus the US dollar. That hasn?t happened in size yet.
  3. ECRI?s weekly leading index continues to make new highs.
  4. Money supplies are growing rapidly around the world. Most of the paper is creating asset inflation, rather than goods inflation so far.
  5. Bond yields have moderated since the yield peak in mid-June. Spreads on corporate investment grade debt have not widened much. Financing is cheap for the creditworthy.
  6. Short sales are at a record at the NYSE. Part of that is just the influence of hedge funds.
  7. Vulture investors have a lot of capital to deploy. Marginal assets are finding homes at prices that don?t involve too much of a haircut. (I?m not talking about subprime here.)
  8. On a P/E basis, stocks are 45% cheaper than when the market peaked in March 2000.
  9. Sell-side analysts are more bearish than they ever have been.
  10. Investment grade companies still have a lot of cash sitting around. The washout from 2000-2002 made a lot of companies skittish, and led them to hold extra cash. Much of the cash has been deployed, but there is still more to go.
  11. The FOMC is unlikely to tighten before it loosens.
  12. Yield-seeking on the part of older investors is helping to keep interest rates low, and the prices of yield-sensitive stocks high.
  13. DB Pension plans and endowments are still willing to make allocations to private equity.
  14. The emerging markets countries are in aggregate in better fiscal shape than they ever have been.
  15. Trade is now a global phenomenon, and not simply US/Europe/Japan-centric.
  16. The current difficulties in subprime are likely to be localized in their effects, and a variety of hedge funds and fund-of-funds should get hit, but not do major damage to the financial system.

Now, behind each of these positives is a negative. (Every silver cloud has a dark lining?) What happens when these conditions shift? Profit margins fall, interest rates rise, inflation roars, risk appetites decrease, etc?

These are real risks, and I do not mean to minimize them. There are more risks as well that I haven?t mentioned. I continue to act as a nervous bull in this environment, making money where I can, and realizing that over a full cycle, my risk control disciplines will protect me in relative, but not absolute terms. So I play on, not knowing when a real disaster will strike.

Editing note — my apologies.? The second paragraph omitted the word “not” in the original publication.? What a word to omit, not. ??

Efficient Markets Versus Adaptive Markets

Efficient Markets Versus Adaptive Markets

The Efficient Markets Hypothesis in its semi-strong form says that the current market price of an asset incorporates all available information about the security in question. Coming from a family where my Mom was a successful investor, I had an impossible time swallowing the EMH, except perhaps as a limiting concept — i.e., the markets tend to be that way, but never get there fully.

I’m a value investor, and generally, over the past fourteen years, my value investing has enabled me to earn superior returns than the indexes. A large part of that is being willing to run a portfolio that differs significantly from the indexes. Now, not everyone can do that; in aggregate, we all earn the market return, less fees. The market is definitely efficient for all of us as a group. But how can you explain persistently clever subgroups?

Behavioral finance has been the leading challenger to the efficient markets hypothesis, but the academics reply that behavioral anomalies are not an integrated theory that can explain everything, like the EMH, and its offspring like mean variance analysis, the capital asset pricing model, and their cousins.

Though it is kind of a hodgepodge, the adaptive markets hypothesis offers an opportunity for behavioral finance to become an integrated theory. First, behavioral finance is a series of observations about how most investors systemically misinterpret investment data, allowing for value investors and momentum investors to make money, among others. The adaptive markets hypothesis says that all of the market inefficiencies exist in a tension with the efficient markets, and that market players make the market more efficient by looking for the inefficiencies, and profiting from them until they disappear, or atleast, until they get so small that it’s not worth the search costs any more.

Consider risk arbitrage strategies for a moment. Arbitrage strategies earned superior returns through 2001 or so, until a combination of deals falling through, and too much money chasing the space (powered by hedge fund of funds wanting smooth returns) made it less worthwhile to be a risk arb. It is like there were too many fishermen in that part of the investment ocean, and the fish were depleted. After years of poor returns money exited the space. Today with more deals to go around, and fewer players, risk arbitrage is attractive again. No good strategy is ever permanently out of favor; after a strategy is overplayed to where the prospects of the assets are overdiscounted, a period of underperformance ensues, and it gets exacerbated by money leaving the strategy. Eventually, enough money leaves the the strategy is attractive again, but market players are slow to react to that, becaue they have been burned recently.

Strategies go in and out of favor, competing for scarce above-market returns in much the same way that ordinary businesses try to achieve above market ROEs. Nothing works permanently in the short run, though as a friend of mine is prone to say, “There’s always a bull market somewhere.” Trouble is, it is often hard to find, so I stick with the one anomaly that usually works, the value anomaly, and augment it with sector rotation and the remainder of my eight rules.

Now, I’m not a funny guy, so my kids tell me, but I’ll try to end this piece with an illustration. Here goes:

Scene One — Efficient Markets Hypothesis

An economics professor and a grad student are walking along the sidewalk, and the grad student spots a twenty dollar bill on the sidewalk. He says, “Hey professor, look, a twenty dollar bill.” The professor says, “Nonsense. If there were a twenty dollar bill on the street, someone would have picked it up already.” They walk past, and a little kid walking behind them pockets the bill.
Scene Two — Adaptive Markets Hypothesis, Part 1
An economics professor and a grad student are walking along the sidewalk, and the grad student spots a twenty dollar bill on the sidewalk. He says, “Hey professor, look, a twenty dollar bill.” The professor says, “Really?” and stoops to look. A little kid walking behind them runs in front of them, grabs the bill and pockets it.

Scene Three — Adaptive Markets Hypothesis, Part 2
An economics professor and a grad student are walking along the sidewalk, and the grad student spots a twenty dollar bill on the sidewalk. He says quietly, “Tsst. Hey professor, look, a twenty dollar bill.” The professor says, “Really?” and stoops to look. He grabs the bill and pockets it. The little kid doesn’t notice.
Scene Four — Adaptive Markets Hypothesis, Part 3
An economics professor and a grad student are walking along the sidewalk, and the grad student spots a twenty dollar bill on the sidewalk. He grabs the bill and pockets it. No one is the wiser.
Scene Five — Adaptive Markets Hypothesis, Part 4
An economics professor and a grad student are walking along the sidewalk, and the grad student is looking for a twenty dollar bill lying around. There aren’t any, but in the process of looking, he misses the point that the professor was trying to teach him. The professor makes a mental note to not take him on as a TA for the next semester. The little kid looks for the twenty dollar bill as well, but as he listens to the professor drone on decides not to take economics when he gets older.

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