Photo Credit: Wayne Stadler || Most of us have limited vision, myself included

Photo Credit: Wayne Stadler || Most of us have limited vision, myself included

=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=

In the time I have been managing money for myself and others in my stock strategy, I set a limit on the amount of cash in the strategy.  I don’t let it go below 0%, and I don’t let it go over 20%.

I have bumped against the lower limit six or so times in the last sixteen years.  I bumped against it around five times in 2002, and once in 2008-9.  All occurred near the bottom of the stock market.  In 2002, I raised cash by selling off the stocks that had gotten hurt the least, and concentrating in sound stocks that had taken more punishment.  In September 2002, when things were at their worst, I scraped together what spare cash I had, and invested it.  I don’t often do that.

In 2008-9 I behaved similarly, though my household cash situation was tighter.  Along with other stocks I thought were bulletproof, but had gotten killed, I bought a double position of RGA near the bottom, and then held it until last week, when it finally broke $100.

But, I had never run into a situation yet where I bumped into the 20% cash limit until yesterday.  Enough of my stocks ran up such that I have been selling small bits of a number of companies for risk control purposes.  The cash started to build up, and I didn’t have anything that I deeply wanted to own, so it kept building.  As the limit got closer, I had one stock that I liked that would serve as at least a temporary place to invest — Tesoro [TSO].  Seems cheap, reasonably financed, and refining spreads are relatively low right now.  I bought a position in Tesoro yesterday.

I could have done other things.  I could have moved the position sizes of my portfolio up, but I would have had to increase the position sizes a lot to have some stocks hit the lower edge of the trading band, but that would have been more bullish than I feel now.  As it is, refiners have been lagging — I can live with more exposure there to augment Valero, Marathon Petroleum and PBF.

I also could have doubled a position size of an existing holding, but I didn’t have anything that I was that impressed with.  It takes a lot to make me double a position size.

As it is, my actions are that of following the rules that discipline my investing, but acting in such a way that reflects my moderate bearishness over the intermediate term.  In the short run, things can go higher; the current odds even favor that, though at the end the market plays for small possible gains versus a larger possible loss.

The credit cycle is getting long in the tooth; though many criticize the rating agencies, their research (not their ratings) can serve as a relatively neutral guidepost to investors.  Corporate debt is high and increasing, and profits are flat to shrinking… not the best setup for longs.  (Read John Lonski at Moody’s.)

I will close this piece by saying that I am looking over my existing holdings and analyzing them for need for financing over the next three years, and selling those that seem weak… though what I will replace them with is a mystery to me.

Bumping up against my upper cash limit is bearish… and that is what I am working through now.

Full disclosure: long VLO MPC PBF and TSO

Wiped Out

Before I start this evening, thanks to Dividend Growth Investor for telling me about this book.

This is an obscure little book published in 1966.  The title is direct, simple, and descriptive.  A more flowery title could have been, “Losing Money in the Stock Market as an Art Form.”  Why?  Because he made every mistake possible in an era that favored stock investment, and managed to lose a nice-sized lump sum that could have been a real support to his family.  Instead, he tried to recoup it by anonymously publishing  this short book which goes from tragedy to tragedy with just enough successes to keep him hooked.

Whom God Would Destroy

There is a saying, “”Whom the gods would destroy, they first make mad.”  My modification of it is, “Whom God would destroy, he first makes proud.”  In this book, the author knows little about investing, but wishing to make more money in the midst of a boom, he entrusts a sizable nest egg for a young middle-class family to a broker, and lo and behold, the broker makes money in a rising market with a series of short-term investments, with very few losses.

Rather than be grateful, the author got greedy.  Spurred by success, he became somewhat compulsive, and began reading everything he could on investing.  To brokers, he became “the impossible client,” (my words, not those of the book) because now he could never be satisfied.  Instead of being happy with a long-run impossible goal of 15%/year (double your money every five years), he wanted to double his money every 2-3 years. (26-41%/year)

As such, he moved his money from the broker that later he admitted he should have been satisfied with, and sought out brokers that would try to hit home runs.  The baseball analogy is useful here, because home run hitters tend to strike out a lot.  The analogy breaks down here: a home run hitter can be useful to a team even if he has a .250 average and strikes out three times for every home run.  Baseball is mostly a game of team compounding, where usually a number of batters have to do well in order to score.  Investment is a game of individual compounding, where strikeouts matter a great deal, because losses of capital are very difficult to make up.  Three 25% losses followed by a 100% gain is a 15% loss.

In the process of trying to win big, he ended up losing more and more.  He concentrated his holdings.  He bought speculative stocks, and not “blue chips.”  He borrowed money to buy more stock (used margin).  He bought “story stocks” that did not possess a margin of safety, which would maybe deliver high gains  if the story unfolded as illustrated.  He did not do homework, but listened to “hot tips” and invested off them.  He let his judgment be clouded by his slight relationships with corporate insiders at the end.  HE TRIED TO MAKE BIG MONEY QUICKLY, AND CUT EVERY CORNER TO DO SO.  His expectations were desperately unrealistic, and as a result, he lost it all.

As he lost more and more, he fell into the psychological trap of wanting to get back what he lost, and being willing to lose it all in order to do so.  I.e., if he lost so much already, it was worth losing what was left if there was a chance to prove he wasn’t a fool from his “investing.”  As such, he lost it all… but there are three good things to say about the author:

  1. He had the humility to write the book, baring it all, and he writes well.
  2. He didn’t leave himself in debt at the end, but that was good providence for him, because if he had waited one more day, the margin clerk would have sold him out at a decided loss, and he would have owed the brokerage money.
  3. In the end, he knew why he had gone wrong, and he tells his readers that they need to: a) invest in quality companies, b) diversify, and c) limit speculation to no more than 20% of the portfolio.

His advice could have been better, but at least he got the aforementioned ideas right.  Margin of safety is the key.  Doing significant due diligence if you are going to buy individual stocks is required.

Quibbles

This book will not teach you what to do; it teaches what not to do.  It is best as a type of macabre financial entertainment.

Also, though you can still buy used copies of the book, if enough of you try to buy the used books out there, the price will rise pretty quickly.  If you can, borrow it from interlibrary loan.  It is an interesting historical curiosity of a book, and a cautionary tale for those who are tempted to greed.  As the author closes the book:

“Cupidity is seldom circumspect.”

And thus, much as the greedy need to hear this advice, it is unlikely they will listen.  Greed is compulsive.

Summary / Who Would Benefit from this Book

A good book, subject to the above limitations.  It is best for entertainment, because it will teach you what not to do, rather than what to do.

Borrow it through interlibrary loan.  If you feel you have to buy it, you can buy it here: WIPED OUT. How I Lost a Fortune in the Stock Market While the Averages Were Making New Highs.

Full disclosure: I bought it with my own money for three bucks.

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

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

-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-=-

Would you like a 100 million-plus percent return on your money in a little more than four years? You would? Well, it can be done, but there are a couple of catches at the end that may prevent the enjoyment of the unearned riches.

Have a look at this article from Bloomberg.com: A $35 Billion Stock, an SEC Halt and Suspicions of Manipulation.  Then meander, if you want, to the SEC EDGAR page for Neuromama.

If you read through the documents on Neuromama, it’s not different from what gets done with a penny stock to boost its value, and that is largely because it was a new penny stock when it was formed and started trading over-the-counter four years ago.

So how do you turn a sow’s ear into several billion silk purses?  Simple:

  • In March 2011, start the company for $3500.  35MM shares at $0.001 each.
  • In 2012, sell 720,000 shares @ $0.03 each ($21,600) and go public.  30x as expensive as the first valuation.  Initial name is Trance Global.
  • In 2013, change the name to Neuromama, split the stock 750:1, and announce really big plans.  Total shares: 3.1B+
  • Borrow $370,000 to develop a website, and do a few other things.
  • In late 2013, acquire a Library of Entertainment Assets including variety shows, feature films, television pilots, etc. Acquire the Assets in exchange for 4,866,180 of new common shares at a price of $20.55 (the closing price on September 3, 2013) for a total value of $100,000,000.  The main owner cancels 80% of the common shares (which belonged to him) as an aspect of the deal.  (Note: no cash changes hands.)  Total shares:  630MM+
  • Never file another financial statement with the SEC.  Issue occasional 8Ks, and engage in a running dialogue with the SEC over how the development stage company doesn’t earn any money and has negative tangible net worth.
  • Watch occasional minimal trading raise the price of the shares to $56+/sh.  Market cap exceeds $35 Billion.
  • Watch the SEC halt trading.

In my opinion, buying the intangible assets and attributing a price of $20.55/share for the stock given in exchange was the critical element of getting the market valuation so high.  If you look at the graph at Bloomberg.com, and click the 5Y button, you will see that in late 2013 after the exchange was made, the stock price hovered in the $20s.  (or, click on the image below for a static image of poorer quality abstracted from the Bloomberg website)

NERO_OTC US Stock Quote

Picture Credit: Bloomberg.com

Here is a market cap of $35 billion for this stock with no business, no appreciable assets, no proprietary technology, no tangible net worth and no income — and can’t even do a few filings with the SEC.  (It looks like they gave up talking in September 2014.)

So what is it worth?  My best estimate is zero, to the nearest billion. 😉  This is still a cash-starved developmental stage business with no revenues after five or so years.  It has had the chance to bootstrap a business together, and there is nothing except the website.  The price should drop to something near zero when trading resumes.

Even if trading had not been halted, the ability of the owners to realize the value would have been quite limited.  All they would have had to do is sell a 100,000 shares, and the stock price would collapse, because there is no one out there with $5 million of real cash that wants to buy 0.015% of an empty company like Neuromama.  The interesting question is “who has been trading the stock,” because it is strictly speculative.  It is possible that related parties have slowly pushed the price up.

Anyway, this is a good reason to stay away from developmental stage companies — really, anything that doesn’t generate significant revenue.  It is also a reason to watch the fundamentals of a company rather than the stock chart only, which in this case has run up hard since 2014, but on almost no volume.  The market capitalization is an illusion if there is nothing that can produce the cash flow to justify it.

Picture Credit Bloomberg

Picture Credit: Bloomberg

=-=-=-=-=-=-=-=-=-

Rates can go lower from here.  For as long as I can remember, I have been told by many experts that rates can’t go lower, or, that they must go up — there is no way they can go lower.  I have argued with that idea, as has Hoisington (Lacy Hunt), Gary Shilling and a few others.

Note also that the Fed and most central banks have been on the wrong side of this as well.  They keep saying that inflation will come, economic activity will pick up, and that interest rates will rise.

The Fed keeps saying that they will tighten policy.  I’ll tell you this — with only 0.82% between the yields on 10- and 2-year Treasuries, the Fed is not tightening.

WIth debt levels as high as they are (both government and private), trying to influence economic activity though interest rates is a dumb idea.  Incenting borrowers to borrow more is difficult, aside from the government — and they rarely do anything with the money that helps produce opportunities for greater economic activity.

We would be better off without “policymakers” trying to “stimulate” the economy, “manage” it, “stabilize” it, etc.  (But where is the political will to change things — the populace wants easy prosperity, and who is there to tell them to accept a rough world where work and competition is tough, and there is no “Big Daddy” to make life easy?  The people are the problem.  The politicians are only a symptom.)

There is one thing that could change this, but it would lay bare the intellectual and moral bankruptcy of what policymakers have been trying to do, which is try to maintain the real value of debt claims while still trying to “stimulate” the economy.  They could burn away the value of debt claims through an inflation greater than that of the 1970s.

So far, they aren’t willing to do that.  But their existing policies will prolong the stagnation.

And as such, rates can fall further — with a lot of noise/variation around it.

Picture Credit: Peanuts Reloaded || Perhaps today Brexit; Monday an exit from Italy or Spain; [then] Europe dismantles

Picture Credit: Peanuts Reloaded || Roughly: “Perhaps today Brexit; Monday an exit from Italy or Spain; [then] Europe dismantles”

=-==-=-=-=-=-=-=-=-=-=-=-=-=-==-=-

At a time like this, when the Brexit Boogeyman goes “Boo!” it’s time to take stock of the situation amid panic.

Though the UK will face some political unrest as the Prime Minister resigns, and article 50 is likely but not certainly invoked, the nature of political discourse hasn’t shifted in full.  Though an important question, it is only one question, and more things will remain stable than change.

At least that is most likely.  If you think of “real options” theory, you could say, “Okay, a door opened today that was previously locked.  What new doors beyond that one could be opened?”  Other countries could leave the EU and/or Eurozone [EZ].  The EU/EZ could dissolve.  The odds of other countries leaving isn’t that high.  For the EU or EZ to dissolve would take a lot of doing, and the odds of that happening is very low, though higher than the odds yesterday.

As I said a week ago:

Governments are smaller than markets; markets are smaller than cultures.

What I am saying is that almost everything affecting the needs of people will get done when there is sufficient freedom.  If Brexit occurs, the UK will negotiate some agreement that is mutually beneficial to the UK and the EU, and most things will go on as they do today.  Even with a subpar agreement, perfidious Albion is very effective at getting what they need completed.  This is especially true of their very effective and creative financial sector in the City of London without which most effective international secrecy, taxation avoidance and regulatory avoidance business could not be done.

Whatever happens, it will happen slowly.  Leaving a complex multinational group like the EU takes two years at least.  How it all works out in detail is not predictable.

I can say that human systems tend toward stability.  People act to preserve the things that they like.  Only under severe conditions does that cease to be true, and even then typically only for short periods of time.

I can also say something a little more controversial.  Wealth, assets, and money [WAM] act like they are alive and have more votes than people do under most conditions.  Why am I saying this?

Governments come in, and go out, but for the most part, the same things get done.  Those thinking that radical change will come are usually deeply disappointed.  WAM tend to maintain the status quo, not because their owners bribe politicians and suborn regulators pay political action contributions,  but because people want the streams of goods and services that help make WAM valuable.  Only a genuine crisis at least as large as the Great Depression or the Civil War can create truly radical change that reshapes the basic desires of most of the people in a nation.

Capitalist democracies that respect the rule of law (e.g., the government is also governed by a higher law) are usually pretty stable; systems that don’t have significant capitalism or democracy may last a couple generations, but tend to fall apart.

All that said, there is significant economic pressure to do two things after the Brexit:

  • Rethink the single currency and common laws
  • Maintain a free-ish trade zone in goods and services

The Eurozone does not allow for the necessary economic adjustments across nations in a fiat monetary system.  Nations need their own currencies, central banks, etc.  They also need to govern themselves via their local culture, not someplace far away with misguided idealists who think they know what’s best for all.

Free-ish trade maintains most of what is needed for human needs.  The European Union is a political construct meant to prevent war from ever recurring in Europe.  The best way to do that is through trade.  Severe wars rare start between nations that rely on each other and interact through commerce.

My view is that ten years from now, the goods and services that people want will get delivered, regardless of the governmental structures in Europe.  I will invest accordingly.

Practical Implications

Things will be rocky in the short run, and there will be more bumps along the road as the Brexit negotiations go on.  I will be resisting panic and euphoria in modest ways.  This isn’t the sum total of my strategies, but I expect that profitable business will continue, and that people and nations will pursue generally intelligent long-term self-interest as events unfold.

When I say modest, I tweak my portfolios at the edges.  Brexit does not comprise more than 5% of what I would do with assets.  As with any investment idea, spread your bets, diversify, don’t bet the farm.

And, I would say the same even to governments — if you don’t have contingency plans for the possibility of the EU shrinking or even disappearing, you are not truly prepared for all contingencies.  As Warren Buffett once said (something like) “We’re paid to think about the things that ‘can’t happen.'”

In closing, many thought that Brexit could not happen.  Now, what else “can’t happen?” 😉

Photo Credit: Gwydion M Williams

Photo Credit: Gwydion M Williams || They do the Hokey Pokey 😉

=-=-=-=-=-=-=-=-=-=–=

Investors need things to scare them, or they don’t have a normal life.  This is kind of like the bachelor uncle who tells little nieces and nephews about scary things that lurk under their beds, and only come out at night for mischief and mayhem.  (Then the parents pick up the pieces later, when they wonder why William or Elizabeth no longer sleep well at night.)

That’s the way I feel about US & international market reactions to the possibility of UK/Britain exiting the EU, otherwise called “Brexit.”  It’s overblown.  Quoting from an older article of mine:

Governments are smaller than markets; markets are smaller than cultures.

What I am saying is that almost everything affecting the needs of people will get done when there is sufficient freedom.  If Brexit occurs, the UK will negotiate some agreement that is mutually beneficial to the UK and the EU, and most things will go on as they do today.  Even with a subpar agreement, perfidious Albion is very effective at getting what they need completed.  This is especially true of their very effective and creative financial sector in the City of London without which most effective international secrecy, taxation avoidance and regulatory avoidance business could not be done.

There are other reasons not to worry as well if you live outside the UK.  The biggest reason is that the UK is only a small part of the global economy, and the economic effects on non-EU trade and finance are smaller still.  And unlike the idea was small but “contained,” in this case, large second order effects aren’t there.  Yes, someday other nations may wise up and decide to leave the EU, but no major countries are likely to do that over the next decade, absent some crisis.  (Crises in the EU? Those aren’t allowed to happen; ask any Eurocrat, they’ll tell ya.)

A second reason not to worry is that leaving the EU ends a second level of regulation of UK economic activity.  This will enable better growth in the longer term.  Are there things that the UK will lose?  Sure, they won’t have as good of a trade deal with the EU, but they will have the ability to try to craft better deals elsewhere, like a Transatlantic Free Trade Area.

The Economist had a decent summary of the good and bad for the UK over leaving the EU.  Here’s their summary table:

Looking over this, the UK already depends less on the EU than most member states, making the exit less of a big deal for the UK and the EU.

My view is this: leaving the EU won’t be a big thing in the long run for the UK.  In the short-run, there will be some uncertainty and volatility as things get worked out.  For the rest of the world, it will be a big fat zero, so ignore this, and focus on something with more meaning, like bizarre monetary policy, and the twisting effects it is having on our world, or the global entitlements crisis — too many people retiring, too few to support them, especially medically.

So, be willing to take some additional risk if people mindlessly panic if the UK/Britain exits the EU.

ecphilosopher data 2015 revision_21058_image001

You might remember my post Estimating Future Stock Returns, and its follow-up piece.  If not they are good reads, and you can get the data on one file here.

The Z.1 report came out yesterday, giving an important new data point to the analysis.  After all, the most recent point gives the best read into current conditions.  As of March 31st, 2016 the best estimate of 10-year returns on the S&P 500 is 6.74%/year.

The sharp-eyed reader will say, “Wait a minute!  That’s higher than last time, and the market is higher also!  What happened?!”  Good question.

First, the market isn’t higher from 12/31/2015 to 3/31/2016 — it’s down about a percent, with dividends.  But that would be enough to move the estimate on the return up maybe 0.10%.  It moved up 0.64%, so where did the 0.54% come from?

The market climbs a wall of worry, and the private sector has been holding less stock as a percentage of assets than before — the percentage went from 37.6% to 37.1%, and the absolute amount fell by about $250 billion.  Some stock gets eliminated by M&A for cash, some by buybacks, etc.  The amount has been falling over the last twelve months, while the amount in bonds, cash, and other assets keeps rising.

If you think that return on assets doesn’t vary that much over time, you would conclude that having a smaller amount of stock owning the assets would lead to a higher rate of return on the stock.  One year ago, the percentage the private sector held in stocks was 39.6%.  A move down of 2.5% is pretty large, and moved the estimate for 10-year future returns from 4.98% to 6.74%.

Summary

As a result, I am a little less bearish.  The valuations are above average, but they aren’t at levels that would lead to a severe crash.  Take note, Palindrome.

Bear markets are always possible, but a big one is not likely here.  Yes, this is the ordinarily bearish David Merkel writing.  I’m not really a bull here, but I’m not changing my asset allocation which is 75% in risk assets.

Postscript for Nerds

One other thing affecting this calculation is the Federal Reserve revising estimates of assets other than stocks up prior to 1961.  There are little adjustments in the last few years, but in percentage terms the adjustments prior to 1961 are huge, and drop the R-squared of the regression from 90% to 86%, which also is huge.  I don’t know what the Fed’s statisticians are doing here, but I am going to look into it, because it is troubling to wonder if your data series is sound or not.

That said, the R-squared on this model is better than any alternative.  Next time, if I get a chance, I will try to put a confidence interval on the estimate.  Till then.

=-=-=-=-=-=-=-

Let me mention four posts that I did recently on energy issues:

There were four main ideas that came out of those articles:

  • Saudi Arabia would allow the price of crude oil to fall to hurt competitors/rivals, particularly Iran.
  • The price of crude oil would stay near $50/barrel.
  • Lots of overlevered companies dependent on a high price for crude oil would go bankrupt.
  • But bankruptcy would happen to fewer, and more slowly, because of all the private equity wanting to buy distressed assets.

All that said, my view has changed a little recently.  I could be wrong, but I think that the ceiling price for crude oil may be $70/barrel for a few years, with the average remaining at $50.  I believe this because I think the Saudis are more desperate for cash than most believe.

Here’s my reasoning:

  • First, you have them selling off a 5% interest in Saudi Aramco.  When you need money, there is a tendency to sell high quality easily saleable assets, because they will sell for a high price, and with little fuss.  Admittedly, they aren’t rushing to do it, which weakens my point.  My view is that you would sell off lesser things that aren’t core, rather than complicate life by selling off a portion of a top quality asset.
  • Second, they are seeking loans, and considering selling bonds.
  • Third, they are considering decreasing the subsidies that they give to their people.  I think this will be very difficult to achieve politically.
  • Fourth, when the amount of Saudi holdings of US Treasury bonds was announced, it was lower than many expected, at $120+ billion, which only covers a little more than a year of their budget deficits, which was $98 billion last year.
  • Fifth, and most speculatively, I wonder if many of the US Treasury holdings have been pledged to cover other debts.  No proof here, but it’s not uncommon to use highly liquid assets as collateral for privately contracted debts.  That may explain the musing by some that there had to be more US Treasuries  there… but where are they?

What this implies to me is that Saudi Arabia is now little different than most of their associates in OPEC.  Their financial situation is tight enough that they must pump crude oil without respect to the strategy of holding crude oil off the markets to get better prices.  It’s not just punishing US shale oil production and Iranian crude production — the Saudis need the money.

If the Saudis need the money, and must pump, then OPEC lacks any significant coalition to raise prices.  Prices will rise with growth in demand, and cheap resource depletion… but as for right now, there are enough barrels to come out of the ground below $70.

The Saudi need for money is a much simpler explanation than trying to knock out US shale oil, or gouge the Iranians, because it has the Saudis acting directly in their own interests, and it fits the price series for crude oil better.

PS — One more note: this is mildly bearish for the US Dollar as the US does not have the same dedicated buyer of US Dollar assets as it once did.  I say mildly bearish, because most of the damage is already past.

How Lucky Do You Feel?

How Lucky Do You Feel?

-=-=-=-=-=-=-

Nine years ago, I wrote about the so-called “Fed Model.” The insights there are still true, though the model has yielded no useful signals over that time. It would have told you to remain in stocks, which given the way many panic,, would not have been a bad decision.

I’m here to write about a related issue this evening.  To a first approximation, most investment judgments are a comparison between two figures, whether most people want to admit it or not.  Take the “Fed Model” as an example.  You decide to invest in stocks or not based on the difference between Treasury yields and the earnings yield of stocks as a whole.

Now with interest rates so low, belief in the Fed Model is tantamount to saying “there is no alternative to stocks.” [TINA]  That should make everyone take a step back and say, “Wait.  You mean that stocks can’t do badly when Treasury yields are low, even if it is due to deflationary conditions?”  Well, if there were only two assets to choose from, a S&P 500 index fund and 10-year Treasuries, and that might be the case, especially if the government were borrowing on behalf of the corporations.

Here’s why: in my prior piece on the Fed Model, I showed how the Fed Model was basically an implication of the Dividend Discount Model.  With a few simplifying assumptions, the model collapses to the differences between the earnings yield of the corporation/index and its cost of capital.

Now that’s a basic idea that makes sense, particularly when consider how corporations work.  If a corporation can issue cheap debt capital to retire stock with a higher yield on earnings, in the short-run it is a plus for the stock.  After all, if the markets have priced the debt so richly, the trade of expensive debt for cheap equity makes sense in foresight, even if a bad scenario comes along afterwards.  If true for corporations, it should be true for the market as a whole.

The means the “Fed Model” is a good concept, but not as commonly practiced, using Treasuries — rather, the firm’s cost of capital is the tradeoff.  My proxy for the cost of capital for the market as a whole is the long-term Moody’s Baa bond index, for which we have about 100 years of yield data.  It’s not perfect, but here are some reasons why it is a reasonable proxy:

  • Like equity, which is a long duration asset, these bonds in the index are noncallable with 25-30 years of maturity.
  • The Baa bonds are on the cusp of investment grade.  The equity of the S&P 500 is not investment grade in the same sense as a bond, but its cash flows are very reliable on average.  You could tranche off a pseudo-debt interest in a way akin to the old Americus Trusts, and the cash flows would price out much like corporate debt or a preferred stock interest.
  • The debt ratings of most of the S&P 500 would be strong investment grade.  Mixing in equity and extending to a bond of 25-30 years throws on enough yield that it is going to be comparable to the cost of capital, with perhaps a spread to compensate for the difference.

As such, I think a better comparison is the earnings yield on the S&P 500 vs the yield on the Moody’s BAA index if you’re going to do something like the Fed Model.  That’s a better pair to compare against one another.

A new take on the Equity Premium

A new take on the Equity Premium!

=-=-=-=-=-=-

That brings up another bad binary comparison that is common — the equity premium.  What do stock returns have to with the returns on T-bills?  Directly, they have nothing to do with one another.  Indirectly, as in the above slide from a recent presentation that I gave, the spread between the two of them can be broken into the sum of three spreads that are more commonly analyzed — those of maturity risk, credit risk and business risk.  (And the last of those should be split into a economic earnings  factor and a valuation change factor.)

This is why I’m not a fan of the concept of the equity premium.  The concept relies on the idea that equities and T-bills are a binary choice within the beta calculation, as if only the risky returns trade against one another.  The returns of equities can be explained in a simpler non-binary way, one that a businessman or bond manager could appreciate.  At certain points lending long is attractive, or taking credit risk, or raising capital to start a business.  Together these form an explanation for equity returns more robust than the non-informative academic view of the equity premium, which mysteriously appears out of nowhere.

Summary

When looking at investment analyses, ask “What’s the comparison here?”  By doing that, you will make more intelligent investment decisions.  Even a simple purchase or sale of stock makes a statement about the relative desirability of cash versus the stock.  (That’s why I prefer swap transactions.)  People aren’t always good at knowing what they are comparing, so pay attention, and you may find that the comparison doesn’t make much sense, leading you to ask different questions as a result.

 

Photo Credit: GotCredit

Photo Credit: GotCredit

This is another piece in the irregular Simple Stuff series, which is an attempt to make complex topics simple.  Today’s topic is:

What is risk?

Here is my simple definition of risk:

Risk is the probability that an entity will not meet its goals, and the degree of pain it will go through depending on how much it missed the goals.

There are several good things about this definition:

  • Note that the word “money” is not mentioned.  As such, it can cover a wide number of situations.
  • It is individual.  The same size of a miss of a goal for one person may cause him to go broke, while another just has to miss a vacation.  The same event may happen for two people — it may be a miss for one, and not for the other one.
  • It catches both aspects of risk — likelihood of a bad event, and degree of harm from how badly the goal was missed.
  • It takes into account the possibility that there are many goals that must be met.
  • It covers both composite entities like corporations, families, nations and cultures, as well as individuals.
  • It doesn’t make life easy for academic economists who want to have a uniform definition of risk so that they can publish economics and finance papers that are bogus.  Erudite, but bogus.
  • It doesn’t specify that there has to be a single time horizon, or any time horizon.
  • It doesn’t specify a method for analysis.  That should vary by the situation being analyzed.

But this is a blog on finance and investing risk, so now I will focus on that large class of situations.

What is Financial Risk?

Here are some things that financial risk can be:

  • You don’t get to retire when you want to, or, your retirement is not as nice as you might like
  • One or more of your children can’t go to college, or, can’t go to the college that the would like to attend
  • You can’t buy the home/auto/etc. of your choice.
  • A financial security plan, like a defined benefit plan, or Social Security has to cut back benefit payments.
  • The firm you work for goes broke, or gets competed into an also-ran.
  • You lose your job, can’t find another job as good, and you default on important regular bills as a result.  The same applies to people who run their own business.
  • Levered financial businesses, like banks and shadow banks, make too many loans to marginal borrowers, and find at some point that their borrowers can’t pay them back, and at the same time, no one wants to lend to them.  This can be harmful not just to the banks and shadow banks, but to the economy as a whole.

Let’s use retirement as an example of how to analyze financial risk.  I have a series of articles that I have written on the topic based on the idea of the personal required investment earnings rate [PRIER].  PRIER is not a unique concept of mine, but is attempt to apply the ideas of professionals trying to manage the assets and liabilities of an endowment, defined benefit plan, or life insurance company to the needs of an individual or a family.

The main idea is to try to calculate the rate of return you will need over time to meet your eventual goals.  From my prior “PRIER” article, which was written back in January 2008, prior to the financial crisis:

To the extent that one can estimate what one can reasonably save (hard, but worth doing), and what the needs of the future will cost, and when they will come due (harder, but worth doing), one can estimate personal contribution and required investment earnings rates.  Set up a spreadsheet with current assets and the likely savings as positive figures, and the future needs as negative figures, with the likely dates next to them.  Then use the XIRR function in Excel to estimate the personal required investment earnings rate [PRIER].

I’m treating financial planning in the same way that a Defined Benefit pension plan analyzes its risks.  There’s a reason for this, and I’ll get to that later.  Just as we know that a high assumed investment earnings rate at a defined benefit pension plan is a red flag, it is the same to an individual with a high PRIER.

Now, suppose at the end of the exercise one finds that the PRIER is greater than the yield on 10-year BBB bonds by more than 3%.  (Today that would be higher than 9%.)  That means you are not likely to make your goals.   You can either:

  • Save more, or,
  • Reduce future expectations,whether that comes from doing the same things cheaper, or deferring when you do them.

Those are hard choices, but most people don’t make those choices because they never sit down and run the numbers.  Now, I left out a common choice that is more commonly chosen: invest more aggressively.  This is more commonly done because it is “free.”  In order to get more return, one must take more risk, so take more risk and you will get more return, right?  Right?!

Sadly, no.  Go back to Defined Benefit programs for a moment.  Think of the last eight years, where the average DB plan has been chasing a 8-9%/yr required yield.  What have they earned?  On a 60/40 equity/debt mandate, using the S&P 500 and the Lehman Aggregate as proxies, the return would be 3.5%/year, with the lion’s share coming from the less risky investment grade bonds.  The overshoot of the ’90s has been replaced by the undershoot of the 2000s.  Now, missing your funding target for eight years at 5%/yr or so is serious stuff, and this is a problem being faced by DB pension plans and individuals today.

The article goes on, and there are several others that flesh out the ideas further:

Simple Summary

Though there are complexities in trying to manage financial risk, the main ideas for dealing with financial risk are these:

  1. Spend time estimating your future needs and what resources you can put toward them.
  2. Be conservative in what you think you assets can earn.
  3. Be flexible in your goals if you find that you cannot reasonably achieve your dreams.
  4. Consider what can go wrong, get proper insurance where needed, and be judicious on taking on large fixed commitments to spend money in the future.

PS — Two final notes:

On the topic of “what can go wrong in personal finance, I did a series on that here.

Investment risk is sometimes confused with volatility.  Here’s a discussion of when that makes sense, and when it doesn”t.