Portfolio Management – Page 130

Another Win for the Broad Market Portfolio

Posted on 28 June 2007 by David Merkel

Well, score one more for my portfolios, Komag is being bought by Western Digital for $32.25/share. This was a remarkably quick win, given the initial purchase back in late March, and a rebalancing buy in late May.

Investments rarely work this quickly, but I am grateful when they do. In the last portfolio reshaping back in March, I put more weight on EV/EBITDA, and Komag scored well there. I’ll be selling Komag at the portfolio reshaping, which should take place in the next two weeks.

I sometimes mention that my investment methods allow me to be away without worrying too much; this closing week of the quarter is one more example of that, at least, so far.

PS — On another note, wasn’t it interesting today to see the market get excited about the supposedly dovish FOMC language, and then sell into the reality that nothing had changed?? I chuckled; people expect too much of the FOMC…

Full disclosure: long KOMG

Trailing E/P as a Function of Treasury Yields and Corporate Spreads

Posted on 27 June 200720 June 2017 by David Merkel

As part of my 2-part project on the Fed Model, I want to give you the results of my recent investigation. This is the simpler of the two projects. A little while ago, Bespoke Investment Group published two little pieces on the relationship between the yield curve and the absolute level of the S&P 500 over short time periods. (You can see my comments below what they wrote.)

My data went from April 1954 to the present on a monthly basis. I regressed the yields on the three and ten-year treasuries, and a triple-B corporate bond spread series on twelve month trailing earnings yields for the S&P 500. The regression as a whole is highly statistically significant. Except for the t-statistic on the 10-year Treasury yield, the other regressors have t-statistics that are significant at a 95% level. I only did two passes on the data, because I didn’t realize until later that I had the spread series… in the first pass that did not have the spread series, the ten-year yield was significant.

Anyway, here are the statistics. What this says is that in the past trailing earnings yields tended to:

decline when BBB spreads rose
rise when three-year treasury yields rose
rise when parallel shifts of the yield curve up
rise when the yield curve flattens, with no adjustment in the overall height of the curve

The last three observations make sense, while the first one does not, at least not on first blush. Typically, I associate higher credit spreads with higher E/Ps, and thus lower P/Es, because tighter financing is associated with a lower willingness for equity investments to receive high valuations. I’m not sure what to do with that last observation; perhaps it is that my practical experience exists over the last 20 years which have been different than the whole data sample. Or, perhaps my readers will have a few ideas? 🙂

As for the main current upshot from this admittedly limited model is that current trailing E/Ps, and thus P/Es, are fairly valued against current treasury yields and bond spreads. Here are two graphs that illustrate this:

The nice thing about these graphs is that they easily point out the stock market undervaluation relative to bonds in 1954, 1958, 1962, 1974, 1980, 1982, and September 2002, and overvaluation relative to bonds in 1969, early 1973, 1987, and March 2000 and March 2002. Now this model might have suggested staying in bonds for most of the 90s, but the 90s were a relatively good decade to be in bonds, though not as good as equities.

This is the first time I have done a post like this, and so I put it out for your consideration. Comments?

Post 150

Posted on 23 June 2007 by David Merkel

Every now and then I do a post to talk about the blog itself, and my future plans for it.? While talking with an old friend of mine, who founded and majority owns a company that makes the best commercial lawn mowers in the world (full disclosure: I own a little less than 1%), I told him about my blog, and he thought it made perfect sense for me to do it.? Regardless of the eventual result, he said that I was building my brand.

I never thought of it that way before, and much as I like contributing to RealMoney.com, I am putting more of my thinking, and the better part of my thinking here.? So where am I going with the blog in the near term?

Finishing off the portfolio reshaping.? RealMoney will see the results of this second, and the blog first.
I have five news compendia posts coming on Economic Theory, Macroeconomics, Speculation, Derivatives (yes, Bear, subprime, and more), and Miscellaneous (the grab bag).
I also plan on improving some of the permanent pages, particularly my bio, fleshing out the investment books that I have learned from, and fleshing out my investment performance, so that I can publicly display it to readers (I’ve had a great last seven years).

Now, my ultimate goals are to either start an investment newsletter or start my own investment shop.? I have described what I would do on the following permanent pages (newsletter — investment management).? So far, I have gotten about 20 bites on the newsletter, but I would need a minimum of 100 to make me quit my job to do that.? As for investment management, I am actively interested in any seed investor that would be willing to fund me.? Aside from that, I am still working with a fellow who is looking to revolutionize the health insurance industry, who if he gets funded, would like me to be his CIO.? We’ll see.

Because my main calling is to be a good husband and father, I can live with delays in my longer-term planning; things are going well.? I also have a calling to my church, which is having its annual meeting this coming week.? I can’t tell whether I will be posting more or less while I am at the conference; I’ll see what I can do.

Regardless, have a great week as the second quarter finishes up.

Portfolio Reshaping Mid-Year 2007, Part 2

Posted on 23 June 2007 by David Merkel

Here are my current industry ratings.? Using my Bloomberg Terminal, I? ran a screen looking for cheap companies in those industries.? The result yielded eight tickers:

ACO CONN GMRK HES NSIT PDE SMRT SSI

I also added in the top 12 tickers from the last time that didn’t make it into my portfolio, and aren’t on the current list.? Here are the tickers:

ABFS [DBK GR] FINL FL GGC HERO [NGX CN] PTSI RADN SNSA URI WIRE

If you have other stock ideas for me, let me know (post a comment!).? Remember that I am a value investor.? I like them cheap.

Aside from any names that readers might give me, my list of possible replacements is done.? All that is left is to run my valuations/technicals model, and think about what to but and sell.? Early next week, I will run those models, and make the decisions by Independence Day.

Portfolio Reshaping Mid-Year 2007, Part 1

Posted on 23 June 200723 June 2007 by David Merkel

Well, the second portfolio reshaping of the year has begun. To refresh your memory on what I do here, you can review this short post. Here are the tickers from my initial stack, candidates to replace my current portfolio:

ABY ACI ACTU AFN APA ARLP ASEI BBG BHP BLX BMI BOW BTU BVN C CBE [CMB PE] CMC CNX CQB [CRY CN] CRZ CTHR CTL CVX CWEI CY DELL DNR DVN DVR EMR EOG EPEX EPL ERF ESV FCGI FCX FRD FRO FRX FSS FST FTO GIFI GMK GMR GSF GVHR GW GYI HHGP HNR IDCC IMMR IMOS INTX IO IR ITW IVAC KAR KEP LRCX LRW [LUN CN] MEOH MGS MKSI MLR MRO MTL MVC NAT NBL NBR NFX NR NRP OMM OPMR PCZ PH PRKR PTEN PVX PWE R RDC RDS RGS RIG RIO ROK RRC RSH S SHOO SPH SPI STZ SU SWKS TAP TLM TPL TSO TX TXI TYC UNT UNTD UPL WCC WDC WFC WIN XTO

If you have ideas, post them in the comment section of this post.? I’ll be running my industry model and an additional screen to generate a few more tickers, and then the comparison to my current portfolio. I should have more later today. Till then.

Nine Notes on Speculation

Posted on 21 June 200722 June 2017 by David Merkel

Recently I have been clipping articles, and arranging them by category, so that I can comment on them as a group more easily.? Tonight’s topic is speculation again, but these articles are all of the odd bits that don’t follow any particular theme.

Sometimes I think that the major financial press that covers Wall Street should send chocolates to Jim Cramer for creating TheStreet.com.? Where else would they get high quality journalists the understand the markets?? Writing for RealMoney, Matthew Goldstein would occasionally e-mail me with a question.? He was the one who covered financials in the news group for TSCM.? Financials are harder to learn than industrials, and I thought he would go far.
Well, he has gone far, to Business Week.? The advent of hedge funds has created a great demand for shorting stock, and there are concerns on the part of some with naked shorting, where one does not borrow the shares before they are sold.? This article describes the probe into stock lending, and what may come of it.? Personally, I wonder why investment banks don’t create single-name total return swaps.? E.g., receive three month LIBOR plus or minus a spread, pay IBM total return.? That would allow the same economics of shorting, without the stock borrow, and no charges of naked shorting.? Why not?
Brave new world; the uptick rule is history.? Well, that should provide more liquidity to buyers.? I’m indifferent on this one, though I would warn anyone doing a death-spiral convert that the elimination of the uptick rule means there is no way that the short sellers won’t win.
Once you have derivatives, almost anything is possible.? Insider trading can be hidden through derivative instruments, because they are not publicly reported.? Now, in practice, it may not be that simple, because derivatives are a zero sum game, and the counterparty loses what the one with information wins, unless they are hedged.? Whoever bears the loss after the takeover is announced has a concentrated interest to find the one who ended up winning, because they might get back what they lost.
I think it is inevitable that there will be different ways of trading large and small blocks of stock.? Most industries have different distribution methods for wholesale and retail.? Dark pools of liquidity don’t surprise me; when I was a bond trader, if I wanted to trade a large fraction of some bond deal, quietness and anonymity were crucial.? My view: have the SEC serve as trading apprentices a large equity or bond shops, and see why large trading is different from small trading.
Fitch gets it, maybe.? They see why hedge funds might be weak holders during a crisis.? I’m not sure what Fitch will do with it, but that skepticism will make for a better rating agency.
130/30 seems to be coming along at the wrong time.? There is too much pressure on the borrow from hedge funds already.? My opinion is that short-selling is getting close to useless on average, given the high level of shorting.? When the bad event happens, the covering keeps the stock afloat.
No more earnings guidance? Yay!!? Let analysts be real analysts, and not just take what management has fed them.? I like it when companies I follow eliminate earnings guidance, because it increases the advantage of analysts who really understand what is going on.
Investing in commodities was a great idea until players started to invest in an indexed manner on the front month.? This has forced the front month to be low versus future months, and the continuing roll depresses returns.? If I were running such a fund, I would invest in a ladder of contracts similar to the pro-rata ladder of contracts currently traded; that would minimize the antiselection.
Finally, be wary of funky ETFs that don’t actually own the underlying assets in a direct way.? There are too many ways for those vehicles to go wrong.? Good ETFs have direct ways of hedging that keep the prices in line with what they are trying to replicate.

That’s all for now.? My own investing has gone well so far this week, but who can tell what the future will bring?

Supply and Demand Factors in the Equity Market

Posted on 18 June 2007 by David Merkel

My posting philosophy when doing commentary on the news is not to do “linkfests,” much as I like them, but to try to give a little more thought behind what has been written, and try to weave them into a greater coherent whole.? My career has been diverse; if I wanted to be mean I would say that I was a dabbler, a patzer, a dilettante.? A jack of all trades and a master of none.? The strength of my varied career is that I have insights into a wide number of areas in the markets, and how they interconnect.? I have always believed that understanding multiple markets helps shed light on each one individually.

So, when I comment on the news, it is my aim to give you a broader perspective on the major factors influencing our investment decisions.? That also means that I might not be commenting on what is breaking news, but on what trends are going on behind the scenes.? Today’s topic is supply and demand factors in the equity market… the true technical analysis. 😉

Let’s start with Jeff Miller at A Dash of Insight. He gives the classic case of why a management would buy back stock.? A management team is able to capture more of the excess returns that the business is earning by substituting cheaper debt for equity in their capital base.? In moderation, this is a decent strategy; it is a strategy increasingly employed because of high profit margins and low interest rates.

Now, as you go through this discussion, you will run into the term “Fed Model.”? The Fed model is a simplified version of a discounted cash flow model, where the earnings of an equity market are discounted using a common interest rate, frequently a long treasury rate, and compared to the current price, to see whether stocks are rich or cheap.? (Note: this calculation does not actually prove whether stocks are absolutely rich or cheap, but only rich or cheap relative to bonds.)? In practice, the calculation can come down to comparing the earnings yield of an index (earnings divided by market capitalization) to the yield on the long Treasury note.

Use of this model is controversial and can produce widely varying results depending on your assumptions.? Take for example, this article over at Trader’s Narrative. It draws the conclusion that the market is “extremely undervalued” at these levels.? This is true, if interest rates and credit spreads stay low, and profit margins stay high.? All three data series tend to mean revert, so how long these factors remain favorable is open to question.? Nonetheless, in the past, comparing treasury and earnings yields was a smart strategy.? Will that continue?

John Hussman ably argues that profit margins are mean-reverting, and that the relationship of earnings yield to bond yields has been spotty at best.? I agree with both of those ideas, but with some caveats:

Profit margins could remain high for a longer time than anticipated because of increased globalization, and increased willingness to lever up.
The relationship of earnings and bond yields has gone through eras where there has been extreme greed and fear.? That earnings and bond yields do not track perfectly is not a weakness, but a strength of the model.? If they tracked perfectly, there would be nothing to game here.? At extreme differences the yield differential produces signals that will make money, and reduce risk to investors.? (Personally, I like my models to explain half of the variation or so — a good balance between there being a signal, and having significant noise to exploit.)

I expect profit margins to mean-revert, but what if they don’t do so quickly?? As an example, consider the upside surprise delivered in the first quarter.? US corporations don’t just depend on the US economy anymore; they sell outside the US, and buy resources outside of the US, even labor (outsourcing).? With a weak dollar, earnings in dollar terms surprised on the upside.? Buybacks also increased earnings per share.

Ignore Shiller when he does the 10-year average earnings.? 10-year averages are less representative of future earnings than the current year’s earnings.? There has been a lot of earnings growth for sustainable reasons.? Could earnings pull back significantly?? Yes, but not to the 10-year average, unless we get a depression.

What of rising interest rates?? Will they derail the equity market?? Some think so.? Some think not.? My view is that at around 6.50% on the 10-year Treasury, bonds would present serious competition to stocks.? Down here around 5.15%, we will continue to have the substitution of debt for equity through LBOs and buybacks.? Despite the volatility, investment grade credit spreads are still tight, and the collateralized loan obligation market is still active, allowing LBOs to be more easily financed.? Further, there is a yield hunger on the part of buyers that allows corporations to sell debt, even subordinated debt cheaply.? This will eventually change, but we need some genuine failures of investment grade companies to demonstrate the real risks of borrowing too much.

In the short run, that IPOs are being well-received is a plus to the market.? There is demand for stock.? In the long run, buying at low P/Es is also a plus (ask David Dreman).? That’s not true now, except relative to bonds, which are providing little competition to stocks.

So where does that leave me?? My view is more complex than many of the caricatures being trotted out.? Let me give you the main ideas:

Comparing earnings yields to bond yields is useful, but must be done with discretion.
Profit margins will mean-revert, but given globalization, and its effect in restraining wages, that may be a while in coming.? How much do you want to leave on the table?
Demographic trends should keep real interest rates low.? The graying of the global Baby Boomers is one of the factors keeping interest rates low.? Retirees and near-retirees want income, and that is surpressing interest rates.
Also suppressing interest rates are those that have to recycle the US current account deficit.? Until we see large currency revaluations in countries that have large surpluses with the US, rates should stay low.
Until we get a significant set of defaults in the credit markets, credit spreads should stay low.? At present, there is too much vulture capital lurking, waiting to buy distressed assets.? The distressed investing community needs to be seriously scared; then maybe valuations will head south.

So, reluctantly, in the short run I carry on as a moderate bull.? That said, the valuations in my portfolio are cheap relative to the market, and the balance sheets are stronger than average.? The names are inclined more toward global growth than US growth.? Many companies in my portfolio have buybacks on, but none are doing it to the level where it compromises their credit quality.

Trends have a nasty tendency to persist longer than fundamental investors would anticipate.? So it is with the markets at present.? Honor the momentum, but keep one eye on shifts in interest rates and profit margins.

Nine Business Days Ago

Posted on 15 June 2007 by David Merkel

The most recent closing high in the S&P 500 was on June 4th.? Since then, we have been through a spin cycle where all that mattered were yields on the long end of the Treasury curve.? That’s why I wrote late on Thursday at the RM Columnist Conversation:

	David Merkel
	Bonds and Stocks Decoupling? They were only Together by Accident.
	6/14/2007 4:50 PM EDT

I was somewhat skeptical when I saw bonds and stocks trading in tandem. The relationship between bond and stock earnings yields is a tenuous one operating over the long haul and on average. Using the five-year Treasury as and the S&P 500 my proxies, bond yields have exceeded earnings yields by as much as 8% in the mid-’50s, while earnings yields have exceeded bond yields by more than 4% in 1981, 1984 and 1987. On average earnings yields are 32 basis points over bond yields. If there is mean reversion in the difference between the two yields, the effect is not a strong one. At present, the relationship between earnings and bond yields seems tighter because of the large substitution of debt for equity going on, but that’s not a normal thing in the long run.

Even with all the buybacks and LBOs, it isn’t normal for stocks and bonds to trade in a tight correlated way in the short run, so, take one of your eyes off of bonds, and look at the fundamentals of the companies that you own. You’ll make more money that way, and take less risk.

PS: if the ten-year crosses 5.50%, go ahead and look at bonds again, and maybe allocate some more money to fixed income. Repeat the process each 0.5% up, should we get there. Equilibrium for stocks and bonds on a valuation basis is a 6.50 10-year. We’re not there yet, so I expect the substitution of debt for equity to continue, albeit at a slower pace.

Sometimes I think investors and the media search for an easy target on which to pin their fears or hopes.? In this case, it was the bond market.? Don’t get me wrong, the bond market is important, and usually ignored by investors to their peril.? But using the bond market to make short term equity trading decisions is just plain silly.

Now, when actual volatility rises, my methods usually do well against the broad averages.? One of the things that I have tried to achieve in my adaptive approach to the markets is to create a system does does well in calm markets, but does relatively better in volatile markets.? Volatile markets scare inexperienced investors into making the wrong moves.? My methods are geared toward allowing ordinary investors to benefit from volatility in a rational way.? As I stated in the CC on Friday:

	David Merkel
	Rebalancing Trades
	6/15/2007 11:55 AM EDT

Wow. Nice rally over the last chunk of time, and it’s time to “ring the register” and lighten on a few names that have run nicely. I do this primarily for risk control purposes. Here are the names that I trimmed: Noble Corp (NE), Cemex (CE), Lyondell Chemicals (LYO), and Tsakos Energy Navigation (TNP). They are now back at their target weights in my portfolio. My rebalancing discipline is a way of:

Lowering risk on companies that are more expensive, and thus more risky than when I last bought them.
Raising exposure on names that are cheaper, and thus less risky than when I last bought or sold them.
Capturing swings in sentiment in industries, companies and the market as a whole, without becoming a momentum trader.
Lowering my market impact costs by leaning against the wind (selling into a rise, buying into a fall), and
Forcing a review process at certain price levels
Taking the emotion out of selling and buying
Making an additional 2% to 3% a year on my portfolio.

You can only do this with a high quality portfolio; don’t try this with companies that have a non-zero chance of a severe drop. For more information, review my “Smarter Seller” article series.

Position: long NE LYO TNP CX

Since 6/4, my broad market portfolio has outperformed the S&P 500 by roughly 1%.? My methods are designed to be able to cope with volatility and some back smiling.? Why can I go on business trips or vacation and not worry about the markets?? Why don’t I get scared by many of the negative macroeconomic situations out there?? First, I trust in Jesus; my life is not just the markets.? But beyond that, my eight rules are design to deal with the volatility that the market serves up, and adapt to what is undervalued in the present environment.

My plan for the next three weeks on the blog is to go through another portfolio reshaping.? You’ll get to see how I make choices in my portfolio.? Beyond that, I have one big article on the Fed Model coming, and continuing coverage of the major factors driving the markets.? Have a great weekend.

Full Disclosure: long CX TNP LYO NE

Private Equity: Short Term versus Long Term Rationality

Posted on 14 June 200720 June 2017 by David Merkel

Until you learn to accept it, it is painful for many fundamentally driven investors to accept trends that are short-term rational, but long-term irrational. (And, much as it hurts my fingers to type this, technicians don’t have that problem… they have other problems though.) 😉

Tonight’s topic is private equity. There has been a cascade of bits and bytes splattered across the web on this topic, so I thought I would try to give a well-rounded picture, together with my views on the topic. Let’s start with the bull case:

Who better to start with than my colleague Jim Cramer? Two articles:

Let’s take the latter article. What were his five reasons?

Funny; it [DM: the private equity wave] will end. But not before many things happen, including these five:

Interest rates on the long end going to at least 6%-7%. At that point, I believe it will get too risky.
The equity market being closed to the IPOs of the companies that need to be flipped. It’s wide open right now.
Not one, not two, but maybe three or four, or even five deals going bust. Can’t we wait for even one to go belly-up before we get too nervous?
Valuations ramping up more. With the S&P 500 selling for about 17.5 times next year’s earnings, there is plenty of room to keep buying.
Private equity funds running out of money. Very unlikely.

He has made the case exceptionally well as to why Private Equity should continue to be a factor in the market in the short-to-intermediate run. Here are two other pieces that make a similar case, which can be summarized like this: if there is a positive spread between the forecast earnings yield of a company, and the interest rate at which we can finance the purchase of the company, then it is rational to take the company private.
It’s at times like this that my inner actuary comes out and says, “Hey, what about a provision for adverse deviation?” That is, how much can go wrong, and still make this deal work? My inner financial analyst asks a slightly different question, “Will you need additional financing later, even if it is selling off the company? What if financing or selling is not available on today’s advantageous terms?”

The private equity folks will say that the high debt levels force success; there is no room for error, so we will work like crazy to make it work. As for financing, there are always windows of opportunity within a reasonable time span. There is no reason to worry.

Now not all deals work out, despite the best efforts of the new private owners. Most are marginal with a few celebrated home runs. During mania times, buyers definitely overpay. As an example, you can see how badly Daimler Benz did in its purchase of Chrysler. Will Cerberus do as well? I am not as bullish as the BW article, but it is clear the Cerberus does not have as much at risk as Daimler. Where I differ is that it will be harder to shed liabilities and reduce costs than the article implies.

At present there aren’t a lot of hot problems in private equity deals. There are financing difficulties, like KKR finding it hard to get additional private equity investors. Institutional investors like to be diversified, which always makes it tough for the biggest players in any asset class to get financing. Aside from that, the risks from doing deals are in the future.

At present, there is a lot of cash to finance private equity for both debt and equity commitments. Today it is rare to find assets that cannot be refinanced. There are more vultures than carrion. There have also been many articles pointing out that amid the flood of financing, the leverage has been going up, and the interest coverage down.

These are not the problems of today, so bulls ignore it and bears get frustrated. These will be problems, just not yet. What if real interest rise? Well, that will affect the ability to re-IPO the company, but it won’t absolutely stop a deal today. What if interest rates rise simply due a bond bear market, whether due to inflation, or global competition for capital? That will affect new deals, making it harder for them to get done, and sale multiples will fall on companies that the private equity folks try to sell.

Perhaps the effects are reversed here. Maybe private equity troubles will be a harbinger of the next junk bond bear market. Could be; after all, one weakness of being private is that tapping the public equity markets is not an easy option, much as that can be valuable when times are about to get tight.

Here’s my verdict. In the short run, almost anything can work. When debts go bad, it typically occurs because the company chokes on paying the interest, not the principal. Private companies that can pay the interest will likely survive to make some money for their private equity sponsors. But many will over-borrow, and in a recession, or in an industry or company downturn, will find that they no longer have enough cash to make the interest payments, and possess limited options for refinancing. Multiple defaults will happen then; think 2009, give or take a year.

But maybe it takes until 2012. If so, perhaps this letter from the future will seem prescient in hindsight. Private equity is not a bubble today; history may judge it to be a mania. To my readers I say be careful, and stick with higher quality bonds and stocks.

Updating My Thoughts of Two Years Ago

Posted on 11 June 200712 June 2007 by David Merkel

Two years ago in the RealMoney Columnist Conversation, I wrote the following:

Yield curve be nimble, yield curve be quick, yield curve go under limbo stick.Okay, no great allusion in the song there, but I sit watching the long end of the yield curve rally as the short end falls slightly. Is the FOMC back in play that fast after yesterday? I don’t think anything has shifted, but Mr. Market is manic.

It’s times like this that make me want to review the full set of reasons why the long end is rallying:

The supply of long bonds is shrinking, and the Treasury hasn’t decided to reissue the 30-year bond yet.
Pension Reform is happening in Europe, and some Europeans are buying long U.S. debt together with currency swaps.
Pension reform might happen in the U.S. as well.
The PBGC is buying long investment grade debt (it likes to immunize, because it’s risk-averse), particularly Treasuries and Agencies like a madman, and it just got a new slug of cash in with the takeover of the UAL (UALAQ:OTC BB) plans.
Mortgage refinancing tends to depress rates as originators hedge.
Speculators that were previously short longer bonds are now long. (uh oh)
An aging population wants income and increasingly favors bonds.
Neomercantilistic economies buy U.S. bonds because they can’t find anything better to do with their export earnings.
Market players trust the FOMC (however misguidedly) to control inflation in the long run.
There aren’t a lot of other places to get incremental yield, so extending maturities is a temptation for bond investors.
The U.S. economy is anticipated to be growing at a slower rate.
The marginal efficiency of new capital is falling because of the introduction (in principle) of 2 billion laborers to the global capitalist labor pool.

This last point I covered in parts of the articles, “Implications of a Low-Nominal World,” and “The Economy, Seen From Many Angles.” When labor is abundant, more capital isn’t needed to produce a greater output, until labor is scarce again. The returns to the employment of additional capital fall, which leads market players to bid up the prices of fixed claims on the economic system, i.e., bonds, because they can’t find better places to assure a return for the future.

This also explains the increase in buybacks and debt reduction on the part of corporations, relative to increases in plant and equipment. That said, it’s a tough environment, but on the bright side, previously poor areas of the world are developing, and that bodes well for those countries, and the global economy 20 years out, once the labor that is new to the capitalist world is productively deployed.

What a difference two years makes. The above post was meant to justify low rates, and it did a fair job of making the case. Later I added a reason 13, that suggested that there was no other currency that could serve as the world’s reserve currency. Unless we move to a gold or commodity standard, that is probably still true.

So what among the above reasons are still valid? Let’s go through them:

30-year bonds are being issued now, though not in great abundance.
Still a factor, but small because the initial surge has worn off.
Only 40% complete in the US, but FASB may fix that within a year, which would intensify demand for long bonds as defined benefit plans attempt to match liability cash flows.
The bankruptcy wave is past. Not a factor now.
With rates higher, the mortgage hedging flows favor higher rates.
Kind of a wash. Speculators are long the 10-year and short the 30-year. Not a factor on rates now.
Still a factor. Yield seeking on the part of retirees is big, and Wall Street i catering to that search. (Hold onto your wallets.)
Still true.
Still true.
False; can’t get much incremental yield at all through extension of durations now.
True, but the degree of the slowdown is open to question, and foreign financial flows are a bigger factor.
Still true, though the marginal effect at present is probably smaller.

So where does that leave us on interest rates? Muddled. Most of the big demographic and international effects on rates still favor lower rates. A new factor that was only partially understood by me two years ago has become a bigger factor: rising inflation in countries that fund the US current account deficit. That favors higher rates, both here and abroad. The question is whether foreign countries bite the bullet and allow their currencies to rise against the dollar or not. To the extent that they allow their currencies to rise, so will rates in the US. But if they keep their currencies artificially weak by buying US dollar bonds with their own currencies, it will continue to depress US long interest rates.

Human nature being what it is, I would expect that most countries continue their policies of buying US fixed income until a crisis forces them to change. Those don’t come on schedule, so I will not try to predict timing. I continue to keep a large portion of my fixed income investments in foreign currencies, which has not been a winner in the last month, but has served me well over the last two years.