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Before I write this evening, I would like to point out what is going on with Horsehead Holdings [ZINCQ].  There was an article in the New York Times on it recently.  It’s an interesting situation where an equity committee exists in a bankruptcy, largely because the management team looks like it is not trying to maximize the value of the bankruptcy estate, but is perhaps instead trying to sell the company off to creditors cheaply in an effort to receive a benefit later from the new owners.  Worth a look, because if the equity committee wins, it will be unusual, and if the debtors win, it very well may take value that legitimately belonged to the equity.

That said, I don’t have a strong opinion because I don’t have enough data.  But I will be watching.

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I received a letter from a reader yesterday on a related topic from my most recent article.  Here it is:

Hi David,

First of all, it’s nice to find you (and Ed Yardeni and Mohamed El-Erian) working when most analysts seem to be at the beach. That said, a question:

In early ’09, as you will recall, the big banks were begging for relief from mark-to-market accounting for their holdings of mortgage-backed securities, on the grounds that these securities weren’t trading at all.

“Ridiculous!” said Jeremy Grantham. “Put 2 percent of your holding out to auction and you will learn its market value quick enough.”

At the time, I thought Grantham had a fair point. Now I’m not so sure.

What was your view on that issue? John Hussman has said repeatedly that it was the FASB’s relaxation of the mark-to-market rules that set off the dramatic resurgence in stock prices that we have seen (and which he deplores).

Was the FASB’s change of policy warranted, under the circumstances?

And should the mark-to-market rule now be restored?

Here was my reply:

Hi,

I wrote a lot about this at the time.  I remain in favor of mark-to-market accounting.  The companies that got into trouble from the effects of mark-to-market accounting had engaged in sloppy risk management practices, and got caught with their pants down.

The difficulty that most of the complaining companies had was a mix of liquid liabilities requiring prompt payment, and relatively illiquid assets that would be difficult to sell.  It was the classic asset-liability mismatch — long illiquid assets financed by short liquid liabilities.  Looks like genius during the bull phase.  Toxic during the bear phase.

On Grantham’s comments: my comments Saturday night are pertinent here for two reasons — anyone selling illiquid CDO tranches, subordinated mortgage bonds, etc., immediately prior to the crisis would find two things: 1) the bids were non-existent or really poor, and 2) if the trade did take place, it would be at levels that reset the pricing grid for that area of the market a LOT lower, leaving the remaining securities looking worse, and a diminution of GAAP equity.

(As an aside, the diminution of GAAP equity might affect the ability to do secondary IPOs of stock at attractive prices, but in itself it did not affect solvency of most financial firms, because statutory accounting allowed for investments to held at amortized cost.  As such the firms could be economically insolvent, but not regulatorily insolvent unless they ran out of cash, or their short-term lending lines of credit got pulled.)

Anyway, this piece is a summary of my thoughts, and provides links to other things I wrote during that era: Fair Value Accounting — It Is What It Is

The regulators were pretty lenient with most of the companies involved — the creditors weren’t.  They enforced margin agreements, and pulled discretionary credit lines.

I’m not of Hussman’s opinion that relaxation of the mark-to-market rules had ANY effect on stock prices.  In general, GAAP accounting rules don’t affect stock prices, because they don’t affect free cash flow, unless the GAAP rules are embedded in credit covenants.  Statutory accounting does affect free cash flow, and can affect the prices of stocks.

Those are my opinions, for what they are worth.

Sincerely,

David

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This post may be a little more complex than most. It will also be more theoretical. For those disinclined to wade through the whole thing, skip to the bottom where the conclusions are (assuming that I have any). 😉

Asset Prices are (Mostly) Validated by a Thin Stream of Transactions

One thing that I have been musing about recently is how few transactions exist to validate the pricing of various markets.  I’ll start with two obvious ones, and then I will broaden out to some more markets that are less obvious.  (Hint: markets that have a high level of transactions relative to the underlying asset value have a lot of speculative “noise traders.”)

Let me start with the market that I know best as far as this topic goes: bonds.  Aside from some government and quasi-governmental bonds, very few bonds trade each day — less than a few percent.  It’s very difficult to use the small volume of trades to price the whole market, but it can be done.

When I was a bond manager for a semi-major insurance company, I was the only one of the top managers that was a mathematician, and familiar with all of the structures underlying the bonds.  I could create my own models of bonds if needed, and I often did for interest rate risk analyses (which was still a responsibility amid bond management).  Combined with my knowledge of insurance accounting, it made me ideal to do a certain monthly task: making sure all of the bonds got priced.

The first part of that isn’t hard.  The pricing service typically covers 90-98% the bonds  in the portfolio.  What I would receive on the first day of the month was a list of all the bonds the pricing service could not calculate a price for.  I would take that list and compare it to last month’s list of the same bonds and add to it any new bonds we had bought that month, and who the lead dealer was.  I would then ask the dealers for their prices on the bonds (which were typically illiquid).  I would compare those prices to the prices of the prior month, and maybe ask a question or two about the prices that were out of line.  That would usually elicit a comment from my coverage akin to, “The analyst thinks spreads have widened out for that credit because spreads in that industry have widened out, and a less liquid bond would widen out more.  The why the price fell more (or rose less).

After that was done, that left me with a small number of utterly illiquid bonds that we had sourced totally privately, or where the dealers who had originated the bonds had ceased to exist.  All of those deals lacked options to accelerate or decelerate payment, so it was a question of modeling the cash flows and applying an appropriate yield spread over the Treasury or Swap yield curve.  [Note: the swap curve gives the yield rates at which AA-rated banks are willing to trade fixed rate exposures in their own credit for floating rate exposures in their own credit, and vice-versa.]

But what is appropriate and how did the three methods of getting prices differ?  The second question is easier.  They didn’t differ much at all.  The dealers and I were likely doing the same things — just with different sets of bonds.  The pricing service, on the other hand, was much more complex, and the other two methods relied on its results.

It was was called “grid” or “matrix” pricing, though it was much more complex than a grid or a matrix.  The pricing service models would look at all of the most recent trades that had happened in the bond market, and use all of the prices to estimate yields that were adjusted for the options inherent in the bonds that could accelerate or decelerate payments.  From that, they would piece together yield curves that varied by industry and collateral type, credit rating (agency or implied by a model that involved stock prices and equity option prices), individual creditors, etc.  Trades on different days were adjusted for market conditions to make the pricing as similar as possible to the end of the month.  After that the yield and yield spread curves generated would be applied to the structures of individual bonds with a adjustments for whether the bonds were:

  • premium or discount
  • large deals that were widely traded or small illiquid deals
  • callable or putable
  • senior or subordinate or structurally subordinate (a bond of a subsidiary not guaranteed by the parent company)
  • secured or unsecured
  • bullet or laddered maturities (sinking funds, etc.)
  • different currencies
  • and more

And there you would have a set of self-consistent prices that would price most of the bond universe.  That’s not where transactions would necessarily take place… particularly with illiquid securities, what would matter most is who was more incented to make the trade happen — the buyer or the seller.

Implicitly, I learned a lot of this not just from modeling for risk purposes, but from trading a lot of bonds day by day.  How do you make the right adjustments when you compare two bonds to make a swap, and, how much of a margin do you put in as a provision to make sure you are getting a good deal without the other side of the trade walking away?  It’s tough, but if you know how all of the tradeoffs work, you can come to a reasonable answer.

One more note before the summary.  The less common it is for a bond or group of related bonds to trade, the more effect a trade has on the overall process.  It becomes a critical datapoint that can redefine where bonds like it trade.  Illiquidity begets volatile prices changes in the grid/matrix as a result.  On the bright side, illiquidity is usually associated with small sizes, so it doesn’t affect most of the market.  There is an exception to this rule: trades done during a panic or the recovery from a panic tend to be sparse as well.  The trades that happen then can temporarily change a wider area of pricing.  I remember that vividly from the whipsaw markets 2001-3, especially when the bond market was restarting after 9/11.  If that crisis had happened later in the month, the quarterly closing prices might not have been as accurate.

Summary for Part 1 (Bonds)

The bond market is complex, far more complex than the stock market.  Pricing the market as a whole is a complex affair, but one for which prices are reasonably calculable.  For the average retail investor investing in ETFs, the bonds are liquidi enough that pricing of NAVs is fairly clean.  But even for a large ugly insurance company bond portfolio, pricing can be significantly accurate.  Next time, I’ll talk about a related market that has its own pricing grid(s) — mortgages and real estate.  Till then.

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

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

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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

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.

How Lucky Do You Feel?

How Lucky Do You Feel?

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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!

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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.

 

This is the fourth article in this series, and is here because the S&P 500 is now in its second-longest bull market since 1928, having just passed the bull market that ended in 1956.    Yeah, who’da thunk it?

This post is a little different from the first three articles, because I got the data to extend the beginning of my study from 1950 to 1928, and I standardized my turning points using the standard bull and bear market definitions of a 20% rise or fall from the last turning point.  You can see my basic data to the left of this paragraph.

Before I go on, I want to show you two graphs dealing with bear markets:

As you can see from the first graph, small bear markets are much more common than large ones.  Really brutal bear markets like the biggest one in the Great Depression were so brutal that there is nothing to compare it to — financial leverage collapsed that had been encouraged by government policy, the Fed, and a speculative mania among greedy people.

The second graph tells the same story in a different way.  Bear markets are often short and sharp.  They don’t last long, but the intensity in term of the speed of declines is a little more than twice as fast as the rises of bull markets.  If it weren’t for the fact that bull markets last more than three times as long on average, the sharp drops in bear markets would be enough to keep everyone out of the stock market.

Instead, it just keeps many people out of the market, some entirely, but most to some degree that would benefit them.

Oh well, on to the gains:

Like bear markets, most bull markets are small.  The likelihood of a big bull market declines with size.  The current bull market is the fourth largest, and the one that it passed in duration was the second largest.  As an aside, each of the four largest bull markets came after a surprise:

  1. (1987-2000) 1987: We knew the prior bull market was bogus.  When will inflation return?  It has to, right?
  2. (1949-56) 1949: Hey, we’re not getting the inflation we expected, and virtually everyone is finding work post-WWII
  3. (1982-7) 1982: The economy is in horrible shape, and interest rates are way too high.  We will never recover.
  4. (2009-Present) 2009: The financial sector is in a shambles, government debt is out of control, and the central bank is panicking!  Everything is falling apart.
Sometimes you win, sometimes you lose...

Sometimes you win, sometimes you lose…

Note the two dots stuck on each other around 2800 days.  The arrow points to the lower current bull market, versus the higher-returning bull market 1949-1956.

Like bear markets, bull markets also can be short and sharp, but they can also be long and after the early sharp phase, meander upwards.  If you look through the earlier articles in this series, you would see that this bull market started as an incredibly sharp phenomenon, and has become rather average in its intensity of monthly returns.

Conclusion

It may be difficult to swallow, but this bull market that is one of the longest since 1928 is pretty average in terms of its monthly average returns for a long bull market.  It would be difficult for the cost of capital to go much lower from here.  It would be a little easier for corporate profits to rise from here, but that also doesn’t seem too likely.

Does that mean the bull is doomed?  Well, yes, eventually… but stranger things have happened, it could persist for some time longer if the right conditions come along.

But that’s not the way I would bet.  Be careful, and take opportunities to lower your risk level in stocks somewhat.

PS — one difference with the Bloomberg article linked to in the first paragraph, the longest bull market did not begin in 1990 but in 1987.  There was a correction in 1990 that fell just short of the -20% hurdle at -19.92%, as mentioned in this Barron’s article.  The money shot:

The historical analogue that matches well with these conditions is 1990. There was a 19.9% drop in the S&P 500, lasting a bit under three months. But the damage to foreign stocks, small-caps, cyclicals, and value stocks in that cycle was considerably more. Both the Russell and the Nasdaq were down 32% to 33%. You might remember United Airlines’ failed buyout bid; the transports were down 46%. Foreign stocks were down about 30%.

And then Saddam Hussein invaded Kuwait.

That might have been the final trigger. The broad market top was in the fall of 1989, and most stocks didn’t bottom until Oct. 11, 1990. In the record books, it was a shallow bear market that didn’t even officially meet the 20% definition. But it was a damaging one that created a lot of opportunity for the rest of the 1990s.

FWIW, I remember the fear that existed among many banks and insurance companies that had overlent on commercial properties in that era.  The fears led Alan Greenspan to encourage the FOMC to lower rates to… (drumroll) 3%!!!  And, that experiment together with the one in 2003, which went down to 1.25%, practically led to the idea that the FOMC could lower rates to get out of any ditch… which is now being proven wrong.

Every now and then, you will run across a mathematical analysis where if you use a certain screening, trading, or other investment method, it produces a high return in hindsight.

And now, you know about it, because it was just published.

But wait.  Just published?

Think about what doesn’t get published: financial research that fails, whether for reasons of error or luck.

Now, luck can simply be a question of timing… think of my recent post: Think Half of a Cycle Ahead.  What would happen to value investing if you tested it only over the last ten years?

It would be in the dustbin of failed research.

Just published… well… odds are, particularly if the data only goes back a short distance in time, it means that there was likely a favorable macro backdrop giving the idea a tailwind.

There is a different aspect to luck though.  Perhaps a few souls were experimenting with something like the theory before it was discovered.  They had excellent returns, and there was a little spread of the theory via word of mouth and unsavory means like social media and blogs.

Regardless, one of the main reasons the theory worked was that the asset being bought by those using the theory were underpriced.  Lack of knowledge by institutions and most of the general public was a barrier to entry allowing for superior returns.

When the idea became known by institutions after the initial paper was published, a small flood of money came through the narrow doors, bidding up the asset prices to the point where the theory would not only no longer work, but the opposite of the theory would work for a time, as the overpriced assets had subpar prospective returns.

Remember how dot-com stocks were inevitable in March of 2000?  Now those doors weren’t narrow, but they were more narrow than the money that pursued them.  Such is the end of any cycle, and the reason why average investors get skinned chasing performance.

Now occasionally the doors of a new theory are so narrow that institutions don’t pursue the strategy.  Or, the strategy is so involved, that even average quants can tell that the data has been tortured to confess that it was born in a place where the universe randomly served up a royal straight flush, but that five-leaf clover got picked and served up as if it were growing everywhere.

Sigh.

My advice to you tonight is simple.  Be skeptical of complex approaches that worked well in the past and are portrayed as new ideas for making money in the markets.  These ideas quickly outgrow the carrying capacity of the markets, and choke on their own success.

The easiest way to kill a good strategy is to oversaturate it too much money.

As such, I have respect for those with proprietary knowledge that limit their fund size, and don’t try to make lots of money in the short run by hauling in assets just to drive fees.  They create their own barriers to entry with their knowledge and self-restraint, and size their ambitions to the size of the narrow doors that they walk through.

To those that use institutional investors, do ask where they will cut off the fund size, and not create any other funds like it that buy the same assets.  If they won’t give a firm answer, avoid them, or at minimum, keep your eye on the assets under management, and be willing to sell out when they get reeeally popular.

If it were easy, the returns wouldn’t be that great.  Be willing to take the hard actions such that your managers do something different, and finds above average returns, but limits the size of what they do to serve current clients well.

Then pray that they never decide to hand your money back to you, and manage only for themselves.  At that point, the narrow door excludes all but geniuses inside.

Photo Credit: Baynham Goredema || When things are crowded, how much freedom to move do you have?

Photo Credit: Baynham Goredema || When things are crowded, how much freedom to move do you have?

Stock diversification is overrated.

Alternatives are more overrated.

High quality bonds are underrated.

This post was triggered by a guy from the UK who sent me an infographic on reducing risk that I thought was mediocre at best.  First, I don’t like infographics or video.  I want to learn things quickly.  Give me well-written text to read.  A picture is worth maybe fifty words, not a thousand, when it comes to business writing, perhaps excluding some well-designed graphs.

Here’s the problem.  Do you want to reduce the volatility of your asset portfolio?  I have the solution for you.  Buy bonds and hold some cash.

And some say to me, “Wait, I want my money to work hard.  Can’t you find investments that offer a higher return that diversify my portfolio of stocks and other risky assets?”  In a word the answer is “no,” though some will tell you otherwise.

Now once upon a time, in ancient times, prior to the Nixon Era, no one hedged, and no one looked for alternative investments.  Those buying stocks stuck to well-financed “blue chip” companies.

Some clever people realized that they could take risk in other areas, and so they broadened their stock exposure to include:

  • Growth stocks
  • Midcap stocks (value & growth)
  • Small cap stocks (value & growth)
  • REITs and other income passthrough vehicles (BDCs, Royalty Trusts, MLPs, etc.)
  • Developed International stocks (of all kinds)
  • Emerging Market stocks
  • Frontier Market stocks
  • And more…

And initially, it worked.  There was significant diversification until… the new asset subclasses were crowded with institutional money seeking the same things as the original diversifiers.

Now, was there no diversification left?  Not much.  The diversification from investor behavior is largely gone (the liability side of correlation).  Different sectors of the global economy don’t move in perfect lockstep, so natively the return drivers of the assets are 60-90% correlated (the asset side of correlation, think of how the cost of capital moves in a correlated way across companies).  Yes, there are a few nooks and crannies that are neglected, like Russia and Brazil, industries that are deeply out of favor like gold, oil E&P, coal, mining, etc., but you have to hold your nose and take reputational risk to buy them.  How many institutional investors want to take a 25% chance of losing a lot of clients by failing unconventionally?

Why do I hear crickets?  Hmm…

Well, the game wasn’t up yet, and those that pursued diversification pursued alternatives, and they bought:

  • Timberland
  • Real Estate
  • Private Equity
  • Collateralized debt obligations of many flavors
  • Junk bonds
  • Distressed Debt
  • Merger Arbitrage
  • Convertible Arbitrage
  • Other types of arbitrage
  • Commodities
  • Off-the-beaten track bonds and derivatives, both long and short
  • And more… one that stunned me during the last bubble was leverage nonprime commercial paper.

Well guess what?  Much the same thing happened here as happened with non-“blue chip” stocks.  Initially, it worked.  There was significant diversification until… the new asset subclasses were crowded with institutional money seeking the same things as the original diversifiers.

Now, was there no diversification left?  Some, but less.  Not everyone was willing to do all of these.  The diversification from investor behavior was reduced (the liability side of correlation).  These don’t move in perfect lockstep, so natively the return drivers of the risky components of the assets are 60-90% correlated over the long run (the asset side of correlation, think of how the cost of capital moves in a correlated way across companies).  Yes, there are some that are neglected, but you have to hold your nose and take reputational risk to buy them, or sell them short.  Many of those blew up last time.  How many institutional investors want to take a 25% chance of losing a lot of clients by failing unconventionally?

Why do I hear crickets again?  Hmm…

That’s why I don’t think there is a lot to do anymore in diversifying risky assets beyond a certain point.  Spread your exposures, and do it intelligently, such that the eggs are in baskets are different as they can be, without neglecting the effort to buy attractive assets.

But beyond that, hold dry powder.  Think of cash, which doesn’t earn much or lose much.  Think of some longer high quality bonds that do well when things are bad, like long treasuries.

Remember, the reward for taking business risk in general varies over time.  Rewards are relatively thin now, valuations are somewhere in the 9th decile (80-90%).  This isn’t a call to go nuts and sell all of your risky asset positions.  That requires more knowledge than I will ever have.  But it does mean having some dry powder.  The amount is up to you as you evaluate your time horizon and your opportunities.  Choose wisely.  As for me, about 20-30% of my total assets are safe, but I have been a risk-taker most of my life.  Again, choose wisely.

PS — if the low volatility anomaly weren’t overfished, along with other aspects of factor investing (Smart Beta!) those might also offer some diversification.  You will have to wait for those ideas to be forgotten.  Wait to see a few fund closures, and a severe reduction in AUM for the leaders…

Photo Credit: Tony & Wayne || Do we PEG the growth of pretty flowers?

Photo Credit: Tony & Wayne || Do we PEG the growth of pretty flowers?

I was looking through an article to see if it had any decent stock ideas, and noted that most of the companies featured were growth stocks.  As such, my first pass for analysis is the PEG ratio, which is the ratio of the Price-Earnings ratio divided by the growth rate expressed as a percentage (e.g. 8% => 8 for this calculation.).

I’ve written about the PEG ratio a long time ago, and it is a classic article of mine.  The PEG ratio is a valid concept for “growth at a reasonable” price investors.  It does not work well for value investors or aggressive growth investors.  My rule for implementation comes to this: if the current P/E ratio is 12 or higher and the PEG ratio is lower than 1.5, that stock might be worth a look.  Better to find the PEG ratio below one, though.

I went through the article and concluded that maybe Becton Dickinson and Hanesbrands might be worth a look.  But then I thought, “What if I applied the formula to propose overvalued stocks?”

I set my screener for a 2016 PE higher than 12 and a PEG higher than 2.0x, with failing momentum, where the stock was down more than 20% in the nine months prior to the current month.  Here were the 50 stocks that resulted:

What I find fascinating here is the mix of hot companies, basic materials and energy names, and limited partnerships.

This is only a start for analysis, so don’t run out and short these.  Not that I am big on shorting, but high earnings valuations, and failing price momentum could be a good place to start.  I have no positions in any of these companies, and I rarely if ever short.  I just thought this would be an interesting exercise.

 

I’m still working through the SEC’s proposal on Mutual Fund Liquidity, which I mentioned at the end of this article:

Q: <snip> Are you going to write anything regarding the SEC’s proposal on open end mutual funds and ETFs regarding liquidity?

A: <snip> …my main question to myself is whether I have enough time to do it justice.  There’s their white paper on liquidity and mutual funds.  The proposed rule is a monster at 415 pages, and I may have better things to do.   If I do anything with it, you’ll see it here first.

These are just notes on the proposal so far.  Here goes:

1) It’s a solution in search of a problem.

After the financial crisis, regulators got one message strongly — focus on liquidity.  Good point with respect to banks and other depositary financials, useless with respect to everything else.  Insurers and asset managers pose no systemic risk, unless like AIG they have a derivatives counterparty.  Even money market funds weren’t that big of a problem — halt withdrawals for a short amount of time, and hand out losses to withdrawing unitholders.

The problem the SEC is trying to deal with seems to be that in a crisis, mutual fund holders who do not sell lose value from those who are selling because the Net Asset Value at the end of the day does not go low enough.  In the short run, mutual fund managers tend to sell liquid assets when redemptions are spiking; the prices of illiquid assets don’t move as much as they should, and so the NAV is artificially high post-redemptions, until the prices of illiquid assets adjust.

The proposal allows for “swing pricing.”  From the SEC release:

The Commission will consider proposed amendments to Investment Company Act rule 22c-1 that would permit, but not require, open-end funds (except money market funds or ETFs) to use “swing pricing.” 

Swing pricing is the process of reflecting in a fund’s NAV the costs associated with shareholders’ trading activity in order to pass those costs on to the purchasing and redeeming shareholders.  It is designed to protect existing shareholders from dilution associated with shareholder purchases and redemptions and would be another tool to help funds manage liquidity risks.  Pooled investment vehicles in certain foreign jurisdictions currently use forms of swing pricing.

A fund that chooses to use swing pricing would reflect in its NAV a specified amount, the swing factor, once the level of net purchases into or net redemptions from the fund exceeds a specified percentage of the fund’s NAV known as the swing threshold.  The proposed amendments include factors that funds would be required to consider to determine the swing threshold and swing factor, and to annually review the swing threshold.  The fund’s board, including the independent directors, would be required to approve the fund’s swing pricing policies and procedures.

But there are simpler ways to do this.  In the wake of the mutual fund timing scandal, mutual funds were allowed to estimate the NAV to reflect the underlying value of assets that don’t adjust rapidly.  This just needs to be followed more aggressively in a crisis, and peg the NAV lower than they otherwise would, for the sake of those that hold on.

Perhaps better still would be provisions where exit loads are paid back to the funds, not the fund companies.  Those are frequently used for funds where the underlying assets are less liquid.  Those would more than compensate for any losses.

2) This disproportionately affects fixed income funds.  One size does not fit all here.  Fixed income funds already use matrix pricing extensively — the NAV is always an estimate because not only do the grand majority of fixed income instruments not trade each day, most of them do not have anyone publicly posting a bid or ask.

In order to get a decent yield, you have to accept some amount of lesser liquidity.  Do you want to force bond managers to start buying instruments that are nominally more liquid, but carry more risk of loss?  Dividend-paying common stocks are more liquid than bonds, but it is far easier to lose money in stocks than in bonds.

Liquidity risk in bonds is important, but it is not the only risk that managers face.  it should not be made a high priority relative to credit or interest rate risks.

3) One could argue that every order affects market pricing — nothing is truly liquid.  The calculations behind the analyses will be fraught with unprovable assumptions, and merely replace a known risk with an unknown risk.

4) Liquidity is not as constant as you might imagine.  Raising your bid to buy, or lowering your ask to sell are normal activities.  Particularly with illiquid stocks and bonds, volume only picks up when someone arrives wanting to buy or sell, and then the rest of the holders and potential holders react to what he wants to do.  It is very easy to underestimate the amount of potential liquidity in a given asset.  As with any asset, it comes at a cost.

I spent a lot of time trading illiquid bonds.  If I liked the creditworthiness, during times of market stress, I would buy bonds that others wanted to get rid of.  What surprised me was how easy it was to source the bonds and sell the bonds if you weren’t in a hurry.  Just be diffident, say you want to pick up or pose one or two million of par value in the right context, say it to the right broker who knows the bond, and you can begin the negotiation.  I actually found it to be a lot of fun, and it made good money for my insurance client.

5) It affects good things about mutual funds.  Really, this regulation should have to go through a benefit-cost analysis to show that it does more good than harm.  Illiquid assets, properly chosen, can add significant value.  As Jason Zweig of the Wall Street Journal said:

The bad news is that the new regulations might well make most fund managers even more chicken-hearted than they already are — and a rare few into bigger risk-takers than ever.

You want to kill off active managers, or make them even more index-like?  This proposal will help do that.

6) Do you want funds to limit their size to comply with the rules, while the fund firm rolls out “clone” fund 2, 3, 4, 5, etc?

Summary

You will never fully get rid of pricing issues with mutual funds, but the problems are largely self-correcting, and they are not systemic.  It would be better if the SEC just withdrew these proposed rules.  My guess is that the costs outweigh the benefits, and by a wide margin.