Value Investing – Page 2

The Sirens’ Call

Posted on 16 November 2019 by David Merkel

Photo Credit: Miles Nicholls || Actually, the bells get rung at the top, and quite frequently for the duration of the process. People hear it and they decide not to listen. Too many false alarms.

The stock market model is projecting a 3.06%/year return over the next ten years as of the close on 11/15/2019. That’s near where a 10-year mid-single-A rated bond would trade. That’s not offering a lot of compensation for putting your money at risk.

I’m planning on reducing my total risk level by 15% or so, moving my equity allocation from around 70% to 55%. That will be the lowest it has been in two decades. I’m not running to do this. I am still working out the details.

The Fundamentals of Equity Market Tops

You might recall an old piece of mine that I wrote for RealMoney back in January 2004 — The Fundamentals of Market Tops. In it, I gave a non-technical analysis approach to analyzing whether we might be near a market top. In 2004, I concluded that we were NOT near a market top. (This article also served as a partial template for the article at RealMoney in May 2005, which said that YES we were near a market top for Residential Real Estate. Two good calls.)

The article is longer than most, should not fit in the TL;DR bucket for most investors. I’m not going to reconstruct the article here, but just give some brief points that fit the frame of the article. Here I go:

Value investors have been sidelined. Growth is winning handily.
Valuation-sensitive investors are raising cash. Buffett sitting on $130 billion is quite statement. He’s not alone. More on that below.
Momentum is working.
There has been a decline in IPO quality.
Lots of money is getting attracted to private equity.
Corporate leverage is high, and covenants are weak.
Non-GAAP accounting gets more attention than it deserves.
Defined benefit plans are net sellers of stock, but not for the reasons I posit in my article — they are doing it to move to private equity and alternatives, and bonds as a part of liability-driven investing.

Cutting against my thesis:

More companies are committing to paying dividends, and growing them. I’m impressed with the degree that corporations are thinking through their use of free cash flow, even as they lever up.
Actual volatility isn’t that high.
The Fed is supportive.

On net, these conditions give some confirmation to what my quantitative model is saying… the market is near a top. Could it go higher still? You bet, with an emphasis on the word “bet.” The S&P 500 at 4500 would be where valuations were during the dot-com bubble.

Asset-Liability Management and Market Tops

I want to emphasize one point, and then I am done. I wrote another article called Look to the Liabilities to Understand the Assets. There are a few more like it at this blog.

The main idea as applied to the present is this: when you have “strong hands” (those with long time horizons and strong balance sheets) raising cash levels and those with “weak hands” (those with shorter time horizons and weaker balance sheets) staying highly invested in risk assets, it is a situation that is unstable. Those that have capability to “buy and hold” are sitting on their hands, whereas those who have to get returns or they will suffer (typically municipal defined benefit plans and older retail investor who didn’t save enough) are risking a great deal, and have little additional buying power.

This is unstable. This situation typically exists at market tops. Remember, it is what investors DO that is the consensus, not what they SAY.

With that, consider your risk positions, and if you think you should act, do so. If you are uncertain, you could ask an intelligent friend or do half.

Dissent on Triple-S Management II

Posted on 15 November 201915 November 2019 by David Merkel

Photo Credit: Morris Zawada || Looked at many dissent pictures, and they did not represent my views. A Pro-life march, in its principled and relatively quiet nature, with people who are mostly otherwise apolitical, fits.

I’ll give the big news up front, then I will explain. I decided to put Triple-S Management in the “too hard” pile, to use a phrase of Buffett’s. I am flat the stock for my clients and me. I don’t short, but if the price drops severely if/when Propiedad (the P&C subsidiary) goes into insolvency, I will buy in again.

Here’s my overall thesis: 1) I find it difficult to believe that Propiedad is solvent on a current basis. I do think there are reasons for the PR insurance department to play along as if they are solvent, giving them time to become solvent… but that’s a gambit that might not work if enough policyholder lawsuits succeed and get payments significantly higher than the amounts at which they are reserved. If that happens, and claims incurred from prior years goes significantly positive, there will be a lot of disbelief about the solvency of Propiedad.

2) If Propiedad goes insolvent there may be an effort to allege or force the parent company to stand behind all claims. That may take a number of forms, some of which are informal and messy, and are not likely to work. The formal methods of trying to do it are also not likely to work. That said, who can tell how a judge might rule on some marginal things that Triple-S did.

3) The stock is not going to zero. My base case is around $30/share if Propiedad is allowed to fail without additional cost to Triple-S.

Why Propiedad might Fail

I spent a decent amount of time thinking about the reserving issues, and it is possible for a P&C insurer to estimate values considerably lower in the short-run than what the company might ultimately pay. This is particularly true with long-tail coverages like asbestos and environmental, but less true with home and property claims.

In the 1980s, it was alleged by some industry observers that the entirety of long-tail P&C reinsurers that were active at that time were effectively broke. They were under severe stress. They delayed paying claims. They played for time hoping that they would earn enough on new business that they could stay afloat. Like the old joke, they hoped to eat the whole elephant “one bite at a time.” And for many of them with forbearing regulators and insureds, it worked. In similar situations, if regulators or insureds don’t play along, they can be forced into insolvency.

That may end up being the case with Propiedad. Insureds may win in court cases, and the initial winners will deplete the claims paying ability of Propiedad, leading the PR insurance department to take over to preserve value for the remaining claimants.

We are now more than two years past the Maria hurricane, and much of Puerto Rico is still a mess. Part of that stems from slowness in the US Government in giving aid. Some of its stems from insurers being slow to pay, and the courts of PR possibly being clogged as a result of all of the lawsuits being filed.

It seems that Propiedad has saved the worst for last in its effort at paying its claims. Thus comparisons to what has been paid already may be less than valid. It’s unusual to have so many claims hanging out past two years. Part of this is due to the size of the disaster relative to the size of Puerto Rico. Part of it also is that claims contested in court will take longer, and the courts may have their hands full.

But another aspect could be the insurance department trying to maximize claim payments to commercial insureds. If Propiedad survives, claimants have the opportunity to get a full payment. If Propiedad fails, and goes into liquidation, claimants will be limited a share of the assets in Propiedad, and whatever can be assessed by the PR Insurance Department on the premiums of surviving P&C insurers serving the state, up to a limit of $300,000/claim and $1,000,000 to any given entity.

In other words, you can sue Propiedad for what you would like, but the maximum you can recover if it is insolvent rests on:

the maximums as specified by the guaranty fund, or if there is more money from the insolvent estate of Propiedad
pro-rata reimbursement of claims over the maximums of the guarantee fund.

If Propiedad is afloat and earning money, and not paying dividends to Triple-S, the recovery levels of all claimants above the guaranty fund limits get higher. Also note that the PR Insurance department may not want to assess the remaining insurers. With the limited supply of insurers active in PR, it would likely mean higher premiums for all who are insured, in order for the companies to pay the assessments.

(As an aside, the P&C guaranty funds have a nice website with lots of data. I’ve cited some here already. It would have been more interesting if a means of contacting the PR guaranty fund were there, or how many claims their guaranty fund has had, and the assessments needed to fund them. But alas, PR has not reported financial data to them since 2010.)

But that brings us to the next point which will be:

Will Triple-S Pay the Claims of Propiedad?

I don’t think so. First, such an obligation is not listed in the 10-K or the statutory statements. A. M. Best rates them that way also. Propiedad has made statements like Triple-S stands behind Propiedad, but those are far short of a “full faith and credit guarantee” from the parent company. I should know: for four years I wrote GICs [guaranteed investment contracts] from a bankruptcy-remote subsidiary of the parent company. When my credit rating was no longer good enough to sell GICs because of buyers insisting on higher ratings, I could not get the parent company to agree to guarantee the GICs, and so I closed down the line of business.

It’s not impossible, though, that a judge would look at the vague statements and conclude otherwise. I think Triple-S would have meritorious arguments that other companies have said things like that, and they were not used to create a “full faith and credit guarantee.”

It is more likely that implicit pressure against the health subsidiary could be used to have Triple-S pay a limited amount to help with claims as they send Propiedad into insolvency.

If Triple-S Avoids Claims Due to Propiedad

The tangible book value of Triple-S excluding their equity in Propiedad is a little more than $34/share. Imagine Triple-S closing down operations because PR takes away their ability to write more health business. There would be a minor panic as many people and companies would have to go to the remaining health insurers in PR for coverage, and insurance rates would certainly rise. Triple-S would keep a skeleton staff for one year, and a smaller one for the next year as they pay out terminal dividends to the shareholders of at least $30/share.

But I could be wrong. Clever lawyers could find a way to charge Triple-S with the full value of claims owed by Propiedad, and those claims would have to be over $1.2 billion to drive the stock to zero. Those are the two victory criteria for the shorts. If Maria claims against Propiedad end up less than $300 million or Triple-S can send Propiedad into insolvency, then it is worth more than the current price.

But for now I will sit back and watch. There are too many jolts and bumps here, and I have safer ideas to invest in.

PS — I think the shorts would do better if they laid off the sensationalism of certain events associated with the management of Triple-S, and focus on the main question: can Triple-S be charged with the claims that Propiedad can’t pay? That is the key question.

Full disclosure: no positions in any companies mentioned in this article, for clients or me. This updates my views since the last article.

No es ESG

Posted on 14 November 201914 November 2019 by David Merkel

Picture Credit: David Merkel || E & S are hollow, G is solid

There are fads in investing. They eventually go away. Remember ARM funds? The Americus Trusts? (Neat idea, killed by a legal change). The nifty fifty? Hot industries that produce a lot of IPOs?

I also think cryptocurrencies are a fad, and also factor and volatility investing, at least in terms of the ETFs that are offered to retail investors.

And, I think ESG is a fad, at least in terms of the way it is being deployed today. My main point is that E (environmental) & S (social) are mostly subjective, and not related to investment returns or risk control. G (governance) is mostly objective and related to investment returns and risk control.

Now some will say “But wait, there are all these journal articles showing that ESG produces better volatility-adjusted returns.” Quantitative finance has a laundry list of problems:

We have only one world, one history, one data set. We’ve gone over the data set numerous times, knowing its proclivities. It’s not hard to tease “alpha” out in a study, but it is difficult to realize alpha in real life.
Researchers often take multiple passes over the data set as they do their analyses. Only the ones with results supporting the expected conclusions get a paper published.
Neutral observers don’t exist — their pay and social standing get determined by producing a series of statistically significant results, regardless of whether they tortured the data to get there or not. (Aside: when I read some of the macroeconomic crud out of the Federal Reserve, and I see the abstruse technique employed to get a result, I know the data has been tortured, and of course the model does not predict well.)
And more — you can read this for the rest of the problems. I don’t think I even get all of the issues with academic-style research in that article.

As such, I don’t trust the research on ESG. The limited history that we have for general inquiries is even shorter for ESG analyses. The likelihood of picking up spurious correlation is high. As such, unless I have a good mental model for how environmental or social issues affect long-term growth in value, I can’t use them as a fiduciary. I have those mental models for governance, so I use them — just not the same way as some of the quantitative governance models do.

Governance issues are perennial; they are not a fad. The agency problem, where corporate managements pursue goals that are in their interests, but not in the interests of shareholders never goes away. It can be reduced by a variety of measures, like splitting the CEO and Chairman positions. removing management influence over the audit and compensation committees, end things like that.

That said, there are exceptions to the rules, and certain strong managers running companies with highly focused and ethical cultures might be allowed more running room. Berkshire Hathaway doesn’t fit most of the rules, and in general it has done well. One size fits most, but not all.

It’s similar to the way I view management use of free cash flow. With a talented and honest management team, I want the management to have the freedom to retain all of the cash flow for growth if they see the opportunities. But most managements aren’t that good, and they should pay a dividend. Buybacks should only be done when the stock is notably cheap compared to the private market value of the firm, and the balance sheet remains solid.

That’s why I think many simple governance scores are mistaken. You have to take a look at the management team and culture in order to do a broader evaluation of the governance. I for one a comfortable buying stakes in a company where there is a control investor if the control investor is known for treating the outside passive minority investors fairly, and does not scrape too much off the top.

I expect companies that I own to follow the laws of the countries that they work in, and engage in ethical behavior. My rule is simple: if a company tries to cheat one set of stakeholders, the odds are higher that they will cheat shareholders at some point. Most of my significant losses have stemmed from some sort of fraud issue… this is etched in my mind.

But many of the details of environmental and social factors seem utterly tangential to me — I don’t see how they drive value. Let the government press its claims on corporations to avoid discrimination and limit pollution. That is the proper locus for these issues, particularly if you are a fiduciary. What is in the best financial interests of your clients should be your guiding principle.

Note as well that the implementation of E, S, and G are nowhere near standardized. G is probably the closest. (This also applies to factor investing as well, which is constantly ~~engaging in new specification searches~~ sharpening their statistical analyses.) Even if I wanted to do E & S, how would I know that I have the right figures? How would I know that they weren’t a product of backtest biases?

Also, as Matt Levine points out, many applications of ESG don’t make a lot of sense, even if these were desirable goals. As such, I look at many of the ESG products being put out there are marketing fads to take the attention of retail away from earning returns… after all, it is tough to beat the market, and ESG will give you many ways to have have a built-in excuse.

Do I know that I am in a minority for my views here? Yes. But I am often in a minority, and I would argue that the degree of agreement with ESG is paper-thin. It’s good while it brings in assets to manage, but the moment it doesn’t bring home the bacon, it will be jettisoned.

I’m in the minority for now. I expect the majority to come my way, not vice-versa. No illusions — it will take time for that to happen.

Industry Ranks November 2019

Posted on 8 November 20198 November 2019 by David Merkel

Photo Credit: Kailash Giri || I used to live near a crude oil refinery. Got soot on my car, but it provided a lot of jobs for people in the area.

Data from Value Line, Calculations by me

Remember when I used to do posts like these? The last full time was May 2014. I lost access to the data, and eventually I gave up.

Recently, I got access to the data back, and I rebuilt the model. I’ll do a post like this every now and then.

My main industry model is illustrated in the graphic. Green industries are cold. Red industries are hot. If you like to play momentum, look at the red zone, and ask the question, ?Where are trends under-discounted?? Price momentum tends to persist, but look for areas where it might be even better in the near term.

If you are a value player, look at the green zone, and ask where trends are over-discounted. Yes, things are bad, but are they all that bad? Perhaps the is room for mean reversion.

My candidates from both categories are in the column labeled ?Dig through.?

You might notice that I have no industries from the red zone. That is because the market is so high. I only want to play in cold industries. They won?t get so badly hit in a decline, and they might have some positive surprises.

If you use any of this, choose what you use off of your own trading style. If you trade frequently, stay in the red zone. Trading infrequently, play in the green zone ? don?t look for momentum, look for mean reversion. I generally play in the green zone because I hold stocks for 3 years on average.

Whatever you do, be consistent in your methods regarding momentum/mean-reversion, and only change methods if your current method is working well.

Huh? Why change if things are working well? I?m not saying to change if things are working well. I?m saying don?t change if things are working badly. Price momentum and mean-reversion are cyclical, and we tend to make changes at the worst possible moments, just before the pattern changes. Maximum pain drives changes for most people, which is why average investors don?t make much money.

Maximum pleasure when things are going right leaves investors fat, dumb, and happy ? no one thinks of changing then. This is why a disciplined approach that forces changes on a portfolio is useful, as I do 3-4 times a year. It forces me to be bloodless and sell stocks with less potential for those with more potential over the next 1-5 years.

I like some technology stocks here, some industrials, some retail stocks, particularly those that are strongly capitalized.

I?m looking for undervalued industries. I?m not saying that there is always a bull market out there, and I will find it for you. But there are places that are relatively better, and I have done relatively well in finding them.

At present, I am trying to be defensive. I don?t have a lot of faith in the market as a whole, so I am biased toward the green zone, looking for mean-reversion, rather than momentum persisting.

The Red Zone has tech, financials, communications, and areas geared to home building and improvement. I don’t own much in the way of financials, aside from a few beaten-up life insurers. Really, I don’t own much in the red zone at all.

In the green zone, I picked almost all of the industries. I don’t like retail much, and I am not a fan of E&P here. That still leaves me with a bunch of cyclicals in industries that have lagged the market, and a melange of other things.

The questions is: how well will the economy continue to do? This recovery is pretty long in the tooth. If it doesn’t do well, how much protection does a low valuation carry?

What would the model suggest? Ah, there I have something for you, and so long as Value Line does not object, I will provide that for you. I looked for companies in the industries listed, but in the top 4 of 9 balance sheet safety categories, and with returns estimated over 12%/year over the next 3-5 years. The latter category does the value/growth tradeoff automatically. I don?t care if returns come from mean reversion or growth.

Also, I wanted firms selling at a low-ish forward EV/EBITDA multiple (in relative terms to each industry), and having grown book value after dividends are reinvested over the past seven years.

But anyway, as a bonus here are the names that are candidates for purchase given this screen. Remember, this is a launching pad for due diligence, not hot names to buy.

Data is a mix from AAII Stock Investor, Value Line and Sentieo || Calculations are mine

Full Disclosure: Clients and I own shares in DLX, SLB, GPC & MGA

Why I Like Foreign Small Cap ETFs

Posted on 15 March 2018 by David Merkel

Photo Credit: amanda tipton || It may not be foreign, and not an ETF, but it IS a small cap

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This should be a short post.? When I like a foreign market because it seems cheap (blood running in the streets), I sometimes buy a small cap ETF or closed-end fund rather than the cheaper large cap version.? Why?

They diversify a US-centric portfolio better.? There are several reasons for that:
a) the large companies of many countries are often concentrated in the industries that the nation specializes in, and are not diversified of themselves
b) the large companies are typically exporters, and the smaller companies are typically not exporters.?Another way to look at it is that you are getting exposure to the local economy with the small caps, versus the global economy for the large caps.
They are often cheaper than the large caps.
Institutional interest in the small caps is smaller.
They have more room to grow.
Less government meddling risk.? Typically not regarded as national treasures.

Now, the disadvantages are they are typically less liquid, and carry higher fees than the large cap funds.? There is an additional countervailing advantage that I think is overlooked in the quest for lower fees: portfolio composition is important.? If an ETF does the job better than another ETF, you should be willing to pay more for it.

At present I have two of these in my portfolios for clients: one for Russia and one for Brazil.? Overall portfolio composition is around 40% foreign stocks 40% US stocks, 15% ultrashort bonds, and 5% cash.? The US market is high, and I am leaning against that in countries where valuations are lower, and growth prospects are on average better.

Full disclosure: long BRF and RSXJ, together comprising about 4-5% of the weight of the portfolios for me and my broad equity clients.? (Our portfolios all have the same composition.)

Estimating Future Stock Returns, December 2017 Update

Posted on 14 March 2018 by David Merkel

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Rules, Part LXIV

Posted on 6 February 2018 by David Merkel

Photo Credit: Steve Rotman || Markets are not magic; government economic stimulus is useless with debt so high

Weird begets weird

I said in an earlier piece on this topic:

I use [the phrase] during periods in the markets where normal relationships seem to hold no longer. It is usually a sign that something greater is happening that is ill-understood. ?In the financial crisis, what was not understood was that multiple areas of the financial economy were simultaneously overleveraged.

So what’s weird now?

Most major government running deficits, and racking up huge debts, adding to overall liability promises from entitlements.
Most central banks creating credit in a closed loop that benefits the governments, but few others directly.
Banks mostly in decent shape, but nonfinancial corporations borrowing too much.
Students and middle-to-lower classes borrowing too much (autos, credit cards)
Interest rates and goods and services price inflation stay low in the face of this.
Low volatility (until now)
Much speculative activity in cryptocurrencies (large percentage on a low base) and risk assets like stocks?(smaller percentage on a big base)
Low credit spreads

No one should be surprised by the current market action.? It wasn’t an “if,” but a “when.”? I’m not saying that this is going to spiral out of control, but everyone should understand that?The Little Market that Could?was a weird situation.? Markets are not supposed to go up so steadily, which means something weird was fueling the move.

Lack of volatility gives way to a surfeit of volatility eventually.? It’s like macroeconomic volatility “calmed” by loose monetary and fiscal policy.? It allows people to take too many bad chances, bid up assets, build up leverage, and then “BAM!” — possibility of debt deflation because there is not enough cash flow to service the incurred debts.

Now, we’re not back in 2007-9.? This is different, and likely to be more mild.? The banks are in decent shape.? The dominoes are NOT set up for a major disaster.? Risky asset prices are too high, yes.? There is significant speculation in areas?Where Money Goes to Die.? So long as the banking/debt complex is not threatened, the worst you get is something like the deflation of the dot-com bubble, and at present, I don’t see what it threatened by that aside from cryptocurrencies and the short volatility trade.? Growth stocks may get whacked — they certainly deserve it from a valuation standpoint, but that would merely be a normal bear market, not a cousin of the Great Depression, like 2007-9.

Could this be “the pause that refreshes?”? Yes, after enough pain is delivered to the weak hands that have been chasing the market in search of easy profits quickly.? The lure of free money brings out the worst in many.

You have to wonder when margin debt is high — short-term investors chasing the market, and Warren Buffett, Seth Klarman, and other valuation-sensitive investors with long horizons sitting on piles of cash.? That’s the grand asset-liability mismatch.? Long-term investors sitting on cash, and short-term investors fully invested if not leveraged… a recipe for trouble.? Have you considered these concepts:

Preservation of capital
Dry powder
Not finding opportunities
Momentum gives way to negative arbitrages.
Greater fool theory — “hey, who has slack capital to buy what I own if I need liquidity?”

Going back to where money goes to die, from the less mentioned portion on the short volatility trade:

Again, this is one where people are very used to selling every spike in volatility. ?It has been a winning strategy so far. ?Remember that when enough people do that, the system changes, and it means in a real crisis, volatility will go higher than ever before, and stay higher longer. ?The markets abhor free riders, and disasters tend to occur in such a way that the most dumb money gets gored.

Again, when the big volatility spike hits, remember, I warned you. ?Also, for those playing long on volatility and buying protection on credit default ? this has been a long credit cycle, and may go longer. ?Do you have enough wherewithal to survive a longer bull phase?

To all, I wish you well in investing. ?Just remember that new asset classes that have never been through a ?failure cycle? tend to produce the greatest amounts of panic when they finally fail. ?And, all asset classes eventually go through failure.

So as volatility has spiked, perhaps the free money has proven to be the bait of a mousetrap.? Do you have the flexibility to buy in at better levels?? Should you even touch it if it is like a knockout option?

There are no free lunches.? Get used to that idea.? If a trade looks riskless, beware, the risk may only be building up, and not be nonexistent.

Thus when markets are “weird” and too bullish or bearish, look for the reasons that may be unduly sustaining the situation.? Where is debt building up?? Are there unusual derivative positions building up?? What sort of parties are chasing prices?? Who is resisting the trend?

And, when markets are falling hard, remember that they go down double-speed.? If it’s a lot faster than that, the market is more likely to bounce.? (That might be the case now.)? Slower, and it might keep going.? Fast moves tend to mean-revert, slow moves tend to persist.? Real bear markets have duration and humiliate, making weak holders conclude that will never touch stocks again.

And once they have sold, the panic will end, and growth will begin again when everyone is scared.

That’s the perversity of markets.? They are far more volatile than the economy as a whole, and in the end don’t deliver any more than the economy as a whole, but sucker people into thinking the markets are magical money machines, until what is weird (too good) becomes weird (too bad).

Don’t let this situation be “too bad” for you.? If you are looking at the current situation, and think that you have too much in risk assets for the long-term, sell some down.? Preserving capital is not imprudent, even if the market bounces.

In that vein, my final point is this: size your position in risk assets to the level where you can live with it under bad conditions, and be happy with it under good conditions.? Then when markets get weird, you can smile and bear it.? The most important thing is to stay in the game, not giving in to panic or greed when things get “weird.”

On the Migration of Stock

Posted on 17 January 2018 by David Merkel

This should be a brief article.? I remember back in 1999 to early 2000 how P&C insurance stocks, and other boring slower-growth industries were falling in price despite growing net worth, and reasonable earnings.? I was working for The St. Paul at the time (a Property & Casualty Insurer), and for an investment actuary like me, who grew up in the life insurance business it was interesting to see the different philosophy of the industry.? Shorter-duration products make competition more obvious, making downturns uglier.

The market in 1999-2000 got narrow.? Few groups and few stocks were leading the rise.? Performance-conscious investors, amateur and professional, servants of the “Church of What’s Working Now,” sold their holdings in the slower growing companies to buy the shares of faster growing companies, with little attention to valuation differences.

I remember flipping the chart of the S&P 1500 Supercomposite for P&C Insurers, and laying it on top of an index of the dot-com stocks.? They looked like twins separated at birth, except one was upside down.

When shares are sold, they don’t just disappear.? Someone buys them.? In this case, P&C firms bought back their own stock, as did industry insiders, and value investors — what few remained.? When managed well, P&C insurance is a nice, predictable business that throws of reliable profits, and is just complex enough to scare away a decent number of potential investors.? The scare is partially due to the effect that it is not always well-managed, and not everyone can figure out who the good managers are.

So shares migrate.? Those that fall in the midst of a rally, despite decent economics, get bought by long-term investors.? The hot stocks get bought by shorter-term investors, who follow the momentum.? This continues until the gravitational effects of relative valuations gets too great — the cash flows of the hot stocks do not justify the valuations.

Then performance reverts, and what was bad becomes good, and good bad, but as with almost every investment strategy you have to survive until the turn, and if the assets run from the prior migration, it is cold comfort to be right eventually.

As an aside, this is part of what fuels dollar-weighted returns being lower than time-weighted returns.? The hot money migration buys high, and sells low.

Thus I say to value investors, “Persevere.? I can’t tell you when the turn will be, but it is getting closer.”

On a Letter from an Old Friend

Posted on 16 January 2018 by David Merkel

Photo Credit: jessica wilson {jek in the box}

David:

It’s been a while since we last corresponded.??I hope you and your family are well.

Quick investment question. Given the sharp run-up in equities and stretched valuations, how are you positioning your portfolio?

This in a market that seemingly doesn’t?go down, where the risk of being cautious is missing out on big gains.

In my portfolio, I’m carrying extra cash and moving fairly aggressively into gold.?Also, on the fixed income side, I’ve been selling HY [DM: High Yield, aka “Junk”] bonds, shortening duration, and buying floating rate bank loans.

Please let me know your thoughts.

Regards

JJJ

Dear JJJ,

Good to hear from you.? It has been a long time.

Asset allocation is always a marriage between time horizon (when is the money needed for spending?) and expected returns, with some adjustment for risk.? I suspect that you are like me, and play for a longer horizon.

I’m at my lowest equity allocation in 17 years.? I am at 65% in equities.? If the market goes up another 4-5%, I am planning on peeling of 25% of that to go into high quality bonds.? Another 20% will go if the market rises 10% from here.? At present, the S&P 500 offers returns of just 3.4%/year for the next ten years unadjusted for inflation.? That’s at the 95th percentile, and reflects valuations of the dot-com bubble, should we rise that far.

The stocks that I do have are heading in three directions: safer, cyclical and foreign.? I’m at my highest level for foreign stocks, and the companies all have strong balance sheets.? A few are cyclicals, and may benefit if commodities rise.

The only thing that gives me pause regarding dropping my stock percentage is that a lot of “friends” are doing it.? That said, a lot of broad market and growth investors are making “new era” arguments.? That gives me more comfort about this.? Even if the FAANG stocks continue to do well, it does not mean that stocks as a whole will do well.? The overall productivity of risk assets is not rising.? People are looking through the rearview mirror, not the windshield, at asset returns.

I can endorse some gold, even though it does nothing.? Nothing would have been a good posture back in the dot-com bubble, or the financial crisis.? Commodities are undervalued at present.? I can also endorse long Treasuries, because I am not certain that inflation will run in this environment.? When economies are heavily indebted they tend not to inflate, except as a last resort.? (The wealthy want to protect their claims against the economy.? The Fed generally helps the wealthy.? Those on the FOMC are all wealthy.)

I also hold more cash than normal.? The three of them, gold, cash and long Treasury bonds form a good hedge together against most bad situations.

The banks are in good shape, so the coming troubles should not be as great as during the financial crisis, as long as nothing bizarre is going on in the repo markets.

That said, I would be careful about bank debt.? Be careful about the covenants on the bank debt; it is not as safe as it once was.? I don’t own any now.

Aside from that, I think you are on the right track.? The most important question is how much you have invested in risk assets.? Prudent investors should be heading lower as the market rises.? It is either not a new era, or, it is always a new era.? Build up your supply of safe assets.? That is the main idea.? Preserve capital for another day when risk assets offer better opportunities.

Thanks for writing.? If you ever make it to Charm City or Babylon, let me know, and we can have lunch together.

Sincerely,

David

Since 1950, the S&P 500 in 2017 Ranks First, Fourth, Tenth or Twenty-third?

Posted on 3 January 2018 by David Merkel

Credit: Roadsidepictures from The Little Engine That Could By Watty Piper Illustrated By George & Doris Hauman c. 1954

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I wish I could have found a picture of Woodstock with a sign that said “We’re #1!”? Snoopy trails behind carrying a football, grinning and thinking “In this corner of the backyard.”

That’s how I feel regarding all of the attention that has been paid to the S&P being up every month in 2017, and every month for the last 14 months.? These have never happened before.

There’s a first time for everything, but I feel that these records are more akin to the people who do work for the sports channels scaring up odd statistical facts about players, teams, games, etc.? “Hey Bob, did you know that the Smoggers haven’t converted a 4th and 2 situation against the Robbers since 1998?”

Let me explain.? A month is around 21 trading days.? There is some variation around that, but on average, years tend to have 252 trading days.? 252 divided by 12 is 21.? You would think in a year like 2017 that it must? have spent the most time where 21-day periods had positive returns, as it did over each month.

Since 1950, 2017 would have come in fourth on that measure, behind 1954, 1958 and 1995.? Thus in one sense it was an accident that 2017 had positive returns each month versus years that had more positive returns over every 21 day period.

How about streaks of days where the 21-day trialing total return never dropped below zero (since 1950)?? By that measure, 2017 would have tied for tenth place with 2003, and beaten by the years 1958-9, 1995, 1961, 1971, 1964, 1980, 1972, 1965, and 1963.? (Note: quite a reminder of how bullish the late 1950s, 1960s and early 1970s were.? Go-go indeed.)

Let’s look at one more — total return over the whole year.? Now 2017 ranks 23rd out of 68 years with a total return of 21.8%.? That’s really good, don’t get me wrong, but it won’t deserve a mention in a book like “It Was a Very Good Year.”? That’s more than double the normal return, which means you’ll have give returns back in the future. 😉

So, how do I characterize 2017?? I call it?The Little Market that Could.? Why?? Few drawdowns, low implied volatility, and skepticism that gave way to uncritical belief.? Just as we have lost touch with the idea that government deficits and debts matter, so we have lost touch with the idea that valuation matters.

When I talk to professionals (and some amateurs) about the valuation model that I use for the market, increasingly I get pushback, suggesting that we are in a new era, and that my model might have been good for an era prior to our present technological innovations.? I simply respond by saying “The buying power has to come from somewhere.? Our stock market does not do well when risk assets are valued at 40%+ of the share of assets, and there have been significant technological shifts over my analysis period beginning in 1945, many rivaling the internet.”? (Every era idolizes its changes.? It is always a “new era.”? It is never a “new era.”)

If you are asking me about the short-term, I think the direction is up, but I am edgy about that.? Forecast ten year returns are below 3.75%/year not adjusted for inflation.? Just a guess on my part, but I think all of the people who are making money off of low volatility are feeding the calm in the short-run, while building up a whiplash in the intermediate term.

Time will tell.? It usually does, given enough time.? In the intermediate-term, it is tough to tell signal from noise.? I am at my maximum cash for my equity strategy accounts — I think that is a prudent place to be amid the high valuations that we face today.? Remember, once the surprise comes, and companies scramble to find financing, it is too late to make adjustments for market risk.