December 2016 – The Aleph Blog

Who Needs Liquidity Most?

Posted on 27 December 201627 December 2016 by David Merkel

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Here’s the quick summary of what I will say: People and companies need liquidity. ?Anything where payments need to be made needs liquidity. ?Secondary markets will develop their own liquidity if it is needed.

Recently, I was at an annual meeting of a private company that I own shares in. ?Toward the end of the meeting, one fellow who was kind of new to the firm asked?what liquidity the shares had and how people valued them. ?The board and management of the company wisely said little. ?I gave a brief extemporaneous talk that said that most people who owned these shares know they are illiquid, and as such, they hold onto them, and enjoy the distributions. ?I digressed a little and explained how one *might* put a value on the shares, but trading values really depended on who was more motivated — the buyer or the seller.

Now, there’s no need for that company to have a liquid market in its stock. ?In general, if someone wants to sell, someone will buy — trades are very infrequent, say a handful per year. ?But the holders know that, and most plan not to sell the shares, looking to other sources if they need money to spend — liquidity.

And in one sense, the shares generate their own flow of liquidity. ?The distributions come quite regularly. ?Which would you rather have? ?A bucket of golden eggs, or the goose that lays them one at a time?

Now the company itself doesn’t need liquidity. ?It generates its liquidity internally through profitable operations that don’t require much in the way of reinvestment in order to maintain its productive capacity.

Now, Buffett used to?purchase only companies that were like this, because he wanted to reallocate the excess liquidity that the companies threw off to new investments. ?But as time has gone along, he has purchased capital-intensive businesses like BNSF that require continued capital investment. ?Quoting from a good post at Alpha Architect?referencing Buffett’s recent annual meeting:

Question: ?In your 1987 Letter to Shareholders, you commented on the kind of companies Berkshire would like to buy: those that required only small amounts of capital. You said, quote, ?Because so little capital is required to run these businesses, they can grow while concurrently making all their earnings available for deployment in new opportunities.? Today the company has changed its strategy. It now invests in companies that need tons of capital expenditures, are over-regulated, and earn lower returns on equity capital. Why did this happen?

Warren Buffett?It?s one of the problems of prosperity. The ideal business is one that takes no capital, but yet grows, and there are a few businesses like that. And we own some?We?d love to find one that we can buy for $10 or $20 or $30 billion that was not capital intensive, and we may, but it?s harder. And that does hurt us, in terms of compounding earnings growth. Because obviously if you have a business that grows, and gives you a lot of money every year?[that] isn?t required in its growth, you get a double-barreled effect from the earnings growth that occurs internally without the use of capital and then you get the capital it produces to go and buy other businesses?[our] increasing capital [base] acts as an anchor on returns in many ways. And one of the ways is that it drives us into, just in terms of availability?into businesses that are much more capital intensive.

Emphasis that of Alpha Architect

Liquidity is meant to support the spending of corporations and people who need services and products to further their existence. ?As such, intelligent entities plan for liquidity needs in advance. ?A pension plan in decline allocates more to bonds so that the cash flow from the bonds will fund expected net payouts. ?Well-run insurance companies and banks match expected cash flows at least for a few years.

Buffer funds are typically low-yielding assets of high quality and short duration — short maturity bonds, CDs, savings and bank deposits, etc. ?Ordinary people and corporations need them to manage the economic bumps of life. ?Expenses are up, and current income doesn’t exceed them. ?Got cash? ?It certainly helps to be able to draw on excess assets in a pinch. ?Those who run a balance on their credit cards pay handsomely for the convenience.

In a crisis, who needs liquidity most? ?Usually, it’s whoever is at the center of the crisis, but usually, those entities are too far gone to be helped. ?More often, the helpable needy are the lenders to those at the center of the crisis, and woe betide us if no one will privately lend to them. ?In that case, the financial system itself is in crisis, and then people end up lending to whoever is the lender of last resort. ?In the last crisis, Treasury bonds rallied as a safe haven.

In that sense, liquidity is a ‘fraidy cat. ?Marginal borrowers can’t get it when they need it most. ?Liquidity typically flows to quality in a crisis. ?Buffett bailed out only the highest quality companies in the last crisis. Not knowing how bad it would be, he was happy to hit singles, rather than risk it on home runs.

Who needs liquidity most now? ?Hard to say. ?At present in the US, liquidity is plentiful, and almost any?person or firm can get a loan or equity finance if they want it. ?Companies happily extend their balance sheets, buying back stock, paying dividends, and occasionally investing. ?Often when liquidity is flush, the marginal bidder is a speculative entity. ?As an example, perhaps some emerging market countries, companies and people would like additional offers of liquidity.

That’s a major difference between bull and bear markets — the quality of those that can easily get unsecured loans. ?To me that is the leading reason why we are in the seventh or eighth inning of a bull market now, because almost any entity can get the loans they want at attractive levels. ?Why isn’t it the ninth inning? ?We’re not at “nuts” levels yet. ?We may never get there though, which is why baseball analogies are sometimes lame. ?Some event can disrupt the market when it is so high, and suddenly people and firms are no longer so willing to extend credit.

Ending the article here — be aware. ?The time to take inventory of your assets and their financing needs is before the markets have an event. ?I’ve just completed my review of my portfolio. ?I sold two of the 35 companies that I hold and replaced them with more solid entities that still have good prospects. ?I will sell two more in the new year for tax reasons. ?My bond portfolio is high quality. ?My clients and I are ready if liquidity gets worse.

Are you ready?

Be wary of surrendering liquidity

Posted on 24 December 201625 December 2016 by David Merkel

Photo Credit: darwin Bell || You ain't getting out easily... — Photo Credit: darwin Bell || You ain’t getting out easily…

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How would you like a really good model to make money as a money manager? You would? Great!

What I am going to describe is a competitive business, so you probably won’t grow like mad, but what money you do bring in the door, you will likely keep for some time, and earn significant fees.

This post is inspired by a piece written by Jason Zweig at the Wall Street Journal:?The Trendiest Investment on Wall Street?That Nobody Knows About. ?The article talks about interval funds. ?Interval funds hold illiquid investments that would be difficult to sell at a fair price ?quickly. ?As such, liquidity is limited to quarterly or annual limits, and investors line up for distributions. ?If you are the only one to ask for a distribution, you might get a lot paid out, perhaps even paid out in full. ?If everyone asked for a part of the distribution, everyone would get paid their pro-rata share.

But there are other ways to capture assets, and as a result, fees.

Various types of business partnerships, including Private REITs, Real Estate Partnerships, etc.
Illiquid?debts, such as structured notes
Variable, Indexed and Fixed Annuities with looong surrender charge periods.
Life insurance as an investment
Weird kinds of IRAs that you can only set up with a venturesome custodian
Odd mutual funds that limit withdrawals because they offer “guarantees” of a sort.
And more, but I am talking about those that get sold to or done by retail investors… institutional investors have even more chances to tie up their money for moderate, modest or negative incremental returns.
(One more aside, Closed end funds are a great way for managers to get a captive pool of assets, but individual investors at least get the ability to gain liquidity subject to the changing premium/discount versus NAV.)

My main point is short and simple. ?Be wary of surrendering liquidity. ?If you can’t clearly identify what you are gaining from giving up liquidity, don’t make the investment. ?You are likely being hoodwinked.

It’s that simple.

[bctt tweet=”If you can’t clearly identify what you are gaining from giving up liquidity, don’t make the investment.” username=”alephblog”]

The Rules, Part LXII

Posted on 17 December 201621 December 2016 by David Merkel

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Well, I didn’t think I would do any more “Rules” posts, but here one is:

In markets, “what is true” works in the long run. “What people are growing to believe is true” works in the short run.

This is a more general variant of Ben Graham’s dictum:

?In the short run, the market is a voting machine but in the long run, it is a weighing machine.?

Not that I will ever surpass the elegance of Ben Graham, but I think there are aspects of my saying that work better. ?Ben Graham lived in a time where capital was mostly physical, and he invested that way. ?He found undervalued net assets and bought them, sometimes fighting to realize value, and sometimes waiting to realize value, while all of the while enjoying the arts as a bon vivant. ?In one sense, Graham kept the peas and carrots of life on separate sides of the plate. ?There is the tangible (a cheap set of assets, easily measured), and the intangible — artistic expression, whether in painting, music, acting, etc. (where values are not only relative, but contradictory — except perhaps for Keynes’ beauty contest).

Voting and weighing are discrete actions. ?Neither has a lot of complexity on one level, though deciding who to vote for can have its challenges. (That said, that may be true in the US for 10% of the electorate. ?Most of us act like we are party hacks. 😉 )

What drives asset?prices? ?New information? ?Often, but new information is only part of it. It stems from changes in expectations. ?Expectations change when:

Earnings get announced (or pre-announced)
Economic data gets released.
Important people like the President, Cabinet members, Fed governors, etc., give speeches.
Acts of God occur — earthquakes, hurricanes, wars, terrorist attacks, etc.
A pundit releases a report, whether that person is a short, a long-only manager, hedge fund manager, financial journalist, sell-side analyst, etc. ?(I’ve even budged the market occasionally on some illiquid stocks…)
Asset prices move and some people mimic to intensify the move because they feel they are missing out.
Holdings reports get released.
New scientific discoveries are announced
Mergers or acquisitions or new issues are announced.
The solvency of a firm is questioned, or a firm of questionable solvency has an event.
And more… nowadays even a “tweet” can move the market

In the short run, it doesn’t matter whether the news is true. ?What matters is that people believe it enough to act on it. ?Their expectation change. ?Now, that may not be enough to create a permanent move in the price — kind of like people buying stocks that Cramer says he likes on TV, and the Street shorts those stocks from the inflated levels. ?(Street 1, Retail 0)

But if the news seems to have permanent validity, the price will adjust to a higher or lower level. ?It will then take new data to move the price of the asset, and the dance of information and prices goes on and on. ?Asset prices are always in an unstable equilibrium that takes account of the many views of what the world will be like over various time horizons. ?They are more volatile than most theories would predict because people are not rational in the sense that economists posit — they do not think as much as imitate and extrapolate.

Read the news, whether on paper or the web — “XXX is dead,” “YYY is the future.” ?Horrible overstatements most of the time — sure, certain products or industries may shrink or grow due to changes in technology or preferences, but with a few exceptions, a new temporary unstable equilibrium is reached which is larger or smaller than before. ?(How many times has radio died?)

“Stocks rallied because the Fed cut interest rates.”

“Stocks rallied because the Fed tightened interest rates, showing a strong economy.”

“Stocks rallied just because this market wants to go up.”

“Stocks rallied and I can’t tell you why even though you are interviewing me live.”

Okay, the last one is fake — we have to give reasons after the fact of a market move, even anthropomorphizing the market, or we would feel uncomfortable.

We like our answers big and definite. ?Often, those big, definite answers that seem right at 5PM will look ridiculous in hindsight — especially when considering what was said near turning points. ?The tremendous growth that everyone expected to last forever is a farce. ?The world did not end; every firm did not go bankrupt.

So, expectations matter a lot, and changes in expectations matter even more in the short-run, but who can lift up their head and look into the distance and say, “This is crazy.” ?Even more, who can do that precisely at the turning points?

No one.

There are few if any people who can both look at the short-term information and the long-term information and use them both well. ?Value investors are almost always early. ?If they do it neglecting the margin of safety, they may not survive to make it to the long-run, where they would have been right. ?Shorts predicting the end often develop a mindset that keeps them from seeing that things have stopped getting worse, and they stubbornly die in their bearishness. ?Vice-versa, for bullish Pollyannas.

Financially, only two things matter — cash flows, the cost of financing cash flows, and how they change with time. ?Amid the noise and news, we often forget that there are businesses going on, quietly meeting human needs in exchange for a profit. ?The businessmen are frequently more rational than the markets, and attentive to the underlying business processes producing products and services that people value.

As with most things I write about, the basic ideas are easy, but they work out in hard ways. ?We may not live long enough to see what was true or false in our market judgments. ?There comes a time for everyone to hang up their spurs if they don’t die in the saddle. ?Some of the most notable businessmen and market savants, who in their time were indispensable people, will eventually leave the playing field, leaving others to play the game, while they go to the grave. ?Keynes, the great value investor that he was, said, “In the long run we are all dead.” ?The truth remains — omnipresent and elusive, inscrutable and unchangeable like a giant cube of gold in a baseball infield.

As it was, Ben Graham left the game, but never left the theory of value investing. ?Changes in expectations drive prices, and unless you are clever enough to divine the future, perhaps the best you can do is search for places where those expectations are too low, and tuck some of those assets away for a better day. ?That better day may be slow in coming, but diversification and the margin of safety embedded in those assets there will help compensate for the lack of clairvoyance.

After all, in the end, the truth measures us.

A Failure of Insurance Regulation

Posted on 17 December 2016 by David Merkel

Credit: Bloomberg || Graph of Penn Treaty’s stock price 2002-2009

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I wrote about this last in October 2009 in a piece lovingly entitled:?At Last, Death!?(speaking of the holding company, not the insurance subsidiaries). ?I’m going to quote the whole piece here, because it says most of the things that I wanted to say when I heard the most recent news about Penn Treaty, where the underlying insurance subsidiaries are finally getting liquidated. ?It will be the largest health insurer insolvency ever, and second largest overall behind Executive Life.

Alas, but all good things in the human sphere come to an end.? Penn Treaty is the biggest insurer failure since 2004.? Now, don?t cry too much.? The state guaranty funds will pick up the slack.? The banks are jealous of an industry that has so few insolvencies.? Conservative state regulation works better than federal regulation.

Or does it?? In this case, no.? The state insurance regulator allowed a reinsurance treaty to give reserve credit where no risk was passed.? The GAAP auditor flagged the treaty and did not allow credit on a GAAP basis, because no risk was passed.? No risk passed? No additional surplus; instead it is a loan.? I do not get how the state regulators in Pennsylvania could have done this.? Yes, they want companies to survive, but it is better to take losses early, than let them develop and fester.

A prior employer asked me about this company as a long idea, because it was trading at a significant discount to book.? I told him, ?Gun to the head: I would short this.? Long-term care is not an underwritable contingency.? Those insured have more knowledge over their situation than the insurance company does.?? He did nothing.? He could not see shorting a company that was less than 50% of book value.

It was not as if I did not have some trust in the management team.? I knew the CEO and the Chief Actuary from my days at Provident Mutual.? Working against that was when I called each of them, they did not return my calls.? That made me more skeptical.? It is one thing not to return the call of a buyside analyst, but another thing not to return the call of one who was once a friend.

Aside from Penn Treaty, the only other company that I can think of as being at risk in the long term care arena is Genworth.? Be wary there.? What is worse is that they also underwrite mortgage insurance.? I can?t think of a worse combo: long term care and mortgage insurance.

The troubles at Penn Treaty are indicative of the future for those who fund long term care.? Be wary, because the troubles of the graying of the Baby Boomers will overwhelm those that try to provide long term care.? That includes government institutions.

Note that Genworth is down 60% since I wrote that, against a market that has less than tripled. ?If their acquirer doesn’t follow through, it too may go the way of Penn Treaty. ?(Give GE credit for kicking that “bad boy” out. ?They bring good things to “life.” 😉 )

Okay, enough snark. ?My main point this evening is that Pennsylvania should have had Penn Treaty stop writing new business by 2004 or so. ?As I wrote to a reporter at Crain’s back in 2008:

On your recent article on Penn Treaty, one little known aspect of their treaty with Imagine Re is that it doesn’t pass risk.? Their GAAP auditors objected, but the State of Pennsylvania went along, which is the opposite of how it ordinarily works.
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Now Imagine Re takes advantage of the situation and doesn’t pay, knowing that Penn Treaty is in a weak position and can’t fight back, partially because of the accounting shenanigans.
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It is my opinion that Penn Treaty has been effectively insolvent for the past four years.? I don’t have any economic interest here, but I had to investigate it as an equity analyst one year ago.? Things are playing out as I predicted then.? What I don’t get is why Pennsylvania hasn’t taken them into conservation.

Another matter was that Imagine Re was an Irish reinsurer, and they have weak reserving rules. ?That also should have been a “red flag” to Pennsylvania. ?The deal with Imagine Re was struck in late 2005, leading to upgrades from AM Best that were reversed by mid-2006.

It was as if the state of Pennsylvania did not want to take the company over for some political reason. ?Lesser companies have been taken over over far less. ?Pennsylvania itself had worked out Fidelity Mutual a number of years earlier, so it’s not as if they had never done it before.

Had they acted sooner, the losses would never have been as large. ?I remember looking through the claim tables in the statutory books for Penn Treaty because the GAAP statements weren’t filed, and concluding that the firm was insolvent back in 2005 or so. ?Insurance regulators are supposed to be more conservative than equity analysts, because they don’t want companies to go broke, harming customers, and bringing stress to the industry through the guaranty funds.

The legal troubles post-2009 probably?had a small effect on the eventual outcome — raising premiums might have lowered the eventual shortfall of $2.6 billion a little. ?But raising premiums would make some healthy folks surrender, and those on benefit are not affected. ?It would likely not have much impact. ?Maybe some expenses could have been saved if the companies had been liquidated in 2009, 2012, or 2015 — still, that would not have been much either.

Some policyholders get soaked as well, as most state guaranty funds limit covered payments to $300,000. ?About 10% of all current Penn Treaty policyholders will lose some?benefits as a result.

Regulatory Policy Recommendations

Often regulators only care that premiums not be too high for the insurance, but this is a case where the company clearly undercharged, particularly on the pre-2003 policies. ?For contingencies that are long-lived, where payments could be made for a long time, regulators need to spend time looking at premium adequacy. ?This is especially important where the company is a monoline and in a line of business that is difficult to underwrite, like long-term care.

The regulators also need to review early claim experience in those situations (unusual business in a monoline), and even look at claim files to get some idea as to whether a company is likely to go insolvent if practices continue. ?A review like that might have shut off Penn Treaty’s ability to write business early, maybe prior to 2002. ?Qualitative indicators of underpricing show up in the types of claims that arrive early, and the regulators might have been able to reduce the size of this failure.

But wave goodbye to Penn Treaty, not that it will be missed except by policyholders that don’t get full payment.

Patience and a Little Courage

Posted on 16 December 2016 by David Merkel

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If I had to suggest two attitudinal adjustments for the average retail investor, I would encourage patience and a little courage. ?Why these two?

Patience is needed for a wide variety of reasons. ?There is almost never a need to act quickly. ?If a few days matters to a decision, such that you feel that you have to act NOW, you’re probably playing the wrong game. ?Of course don’t dawdle when you know what you need to do, but don’t let markets, relatives or salesmen push you around.

One example of that hit me recently when I realized that I had acquired 0.1% of the market cap of a microcap stock. ?It rarely if ever trades, so it took three weeks to patiently source that many shares by waiting patiently on the bid price of the market. ?The amount I have gotten already has exceeded my expectations, but I’m still bidding for more, quietly.

I’m usually pretty patient in trading, which means occasionally some trades won’t get done. ?That’s okay, there are usually multiple opportunities, and alternative stocks to buy if you can’t get one of the stocks that you want at the price that you want.

Patience is also useful when the market is rising or falling quickly. ?Many people will get tempted to greed or fear, but someone who is patient and has his emotions under control can wait and then make a more rational decision without concern.

Patience is also needed for just maintaining an asset allocation over a long time. ?Remember, you don’t make money while you buy and sell, you make money while you wait. ?For average investors, those that are patient do best.

That is why some courage is also needed. ?Many investments will lose money for a time. ?I would estimate that 2/3rds of the stocks that I currently hold have been at a unrealized capital loss for over a month of time at some point at minimum. ?At present, almost all are at?unrealized capital gains. ?So much for the bull market.

There will be a lot of people who try to scare investors. ?Some mean well; some don’t — they are just trying to sell you on their services. ?A little courage pays here. ?Remember that the investors that buy and hold almost always do better than traders — and this is true of all mutual funds including ETFs.

And now for something completely different

I wrote these three pieces at unpopular times:

Buy and Hold Will Return?– 2/15/2009
Buy-and-Hold Can?t Die?– 3/6/2012
Buy-and-Hold Can?t Die, Redux?– 3/7/2012

If indeed you bought and held from February of 2009, you did quite well. ?Even from March of 2012 you did well.

But what of now? ?How will you do in the future if you buy-and-hold now? ?I can tell you two things:

Better than most of those that trade, and
Likely not as well as in 2009 or 2012. ?In 2009, we were staring at 16%+/yr returns over the next ten years, and people were scared to death. ?In 2012, it was 8.5%/year for the next ten years. ?Now it’s around 6%.

If you were to say to me, I don’t think 6%/yr?is worth playing for, you would get an ambivalent answer from me. ?I would tell you that I am staying in, but that you should do what you are comfortable doing, if you can avoid future panic and greed.

Though the rewards are likely lower now than previously, you still have a decent number of players that don’t believe the rally, and probably have not had a lot of exposure to the market for a while. ?The psychology of?most people lends itself toward self-justification. ?If they have missed much of the rally, they are likely to pooh-pooh it now. ?Only a rare person would switch now, though if you saw a lot of people switching to bull mode, then it would be time to worry, and maybe, lighten up.

Personally, I don’t see it, and together with my other studies, it leads me to hold on. ?And guess what, that could be wrong, at least in the short-run. ?But when you take into account the odds of making two correct timing trades — out now, in later, and the cost of the taxes on my taxable account, the incentives for reducing equity exposure now look poor.

Back to the Beginning

That’s why you need patience and some courage. ?Those will steady you through the hard times. ?Hard times will come, and I can’t tell you when. ?If you want to sell a little now, go ahead, and leave it in a fund that is safe. ?Then set up a googlebot to track both “buy-and-hold” and “dead.” ?When you begin to get a lot of pings, invest the money again.

But for most of us, we will be best off maintaining a constant risk posture, because it is?too hard to time the market, especially after taxes. ?So, be patient and little courageous.

PS — I don’t say be a LOT courageous, because I’ve seen guys make significant errors taking large chances. ?Remember, moderate risk wins in the end.

Estimating Future Stock Returns, September 2016 Update Redux

Posted on 15 December 2016 by David Merkel

Idea Credit: Philosophical Economics Blog || I get implementation credit, which is less…

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My last post on this generated some good questions. ?I’m going to answer them here, because this model deserves a better explanation. ?Before I start, I should say that in order to understand the model, you need to read the first two articles in the series, which are?here:

If you are curious about the model, the information is there. ?It includes links to the main article at Economic Philosopher’s blog ( @jesselivermore on Twitter).

On to the questions:

Is this nominal or real return? Where can I find your original blog post explaining how you calculate future returns? Similar charts using Shiller PE, total market cap to gdp, q-ratio etc. all seem to imply much lower future returns.

This is a nominal return. ?In my opinion, returns and inflation should be forecast separately, because they have little to do with each other. ?Real interest rates?have a large impact on equity prices, inflation has a small impact that varies by sector.

This model also forecasts returns for the next ten years. ?If I had it do forecasts over shorter horizons, the forecasts would be lower, and less precise. ?The lower precision comes from the greater ease of forecasting an average than a single year. ?It would be lower because?the model has successively less power in forecasting each successive year — and that should make sense, as the further you get away from the current data, the less impact the data have. ?Once you get past year ten, other factors dominate?that this model does not account for — factors reflecting the long-term productivity of capital.

I can’t fully explain why this model is giving higher return levels, but I can tell you how the models are different:

This model focuses in investor behavior — how much are investors investing in stocks versus everything else. ?It doesn’t explicitly consider valuation.
The Shiller PE isn’t a well-thought-out model for many reasons. ?16 years ago I wrote an email to Ken Fisher where I listed a dozen flaws, some small and some large. ?That e-mail is lost, sadly. ?That said, let me be as fair as I can be — it attempts to compare the S&P 500 to trailing 10-year average earnings. ?SInce using a single year would be unsteady, the averaging is a way to compare a ~~outdated~~ smoothed income statement figure to the value of the index. ?Think of it as price-to-smoothed-earnings.
Market Cap to GDP does a sort of mismatch, and makes the assumption that public firms are representative of all firms. ?It also assumes that total payments to all factors are what matter for equities, rather than profits only. ?Think of it as a mismatched price-to-sales ratio.
Q-ratio compares the market value of equities and debt to the book value of the same. ?The original idea was to compare to replacement value, but book value is what is available. ?The question is whether it would be cheaper to buy or build the corporations. ?If it is cheaper to build, stocks are overvalued. ?Vice-versa if they are cheaper to buy. ?The grand challenge here is that book value may not represent replacement cost, and increasingly so because intellectual capital is an increasing part of the value of firms, and that is mostly not on the balance sheet. ?Think of a glorified Economic Value to Book Capital ratio.

What are the return drivers for your model? Do you assume mean reversion in (a) multiples and (b) margins?

Again, this model does not explicitly consider valuations or profitability. ?It is based off of the subjective judgments of people allocating their portfolios to equities or anything else. ?Of course, when the underlying ratio is high, it implies that people are attributing high valuations to equities relative to other assets, and vice-versa. ?But the estimate is implicit.

So?I?m wondering what the difference is between your algorithm for future returns and John Hussman?s algorithm for future returns. For history, up to the 10 year ago point, the two graphs look quite similar. However, for recent years within the 10-year span, the diverge quite substantially in absolute terms (although the shape of the ?curves? look quite similar). It appears that John?s algorithm takes into account the rise in the market during the 2005-2008 timeframe, and yours does not (as you stated, all else remaining the same, the higher the market is at any given point, the lower the expected future returns that can be for an economy). That results in shifting your expected future returns up by around 5% per year compared to his! That leads to remarkably different conclusions for the future.

Perhaps you have another blog post explaining your prediction algorithm that I have not seen. John has explained (and defended) his algorithm extensively. In absence of some explanation of the differences, I think that John?s is more credible at this point. See virtually any of his weekly posts for his chart, but the most recent should be at http://www.hussmanfunds.com/wmc/wmc161212e.png?(DJM: the article in question is here.)

I’d love to meet and talk with John Hussman. ?I have met some members of his small staff, and he lives about six miles from my house. ?(PS — Even more, I would like to meet @jesselivermore). ?The Baltimore CFA Society asked him to come speak to us a number of times, but we have been turned down.

Now, I’m not fully cognizant of everything he has written on the topic, but the particular method he is using now was first published on 5/18/2015. ?There is an article critiquing aspects of Dr. Hussman’s methods from Economic Philosopher. ?You can read EP for yourself, but I gain one significant thing from reading this — this isn’t Hussman’s first model on the topic. ?This means the current model has benefit of hindsight bias as he acted to modify the model to correct inadequacies. ?We sometimes call it a specification search. ?Try out a number of models and adjust until you get one that fits well. ?This doesn’t mean his model is wrong, but that the odds of it forecasting well in the future are lower because each model adjustment effectively relies on less data as the model gets “tuned” to eliminate past inaccuracies. ?Dr. Hussman has good reasons to adjust his models, because they have generally been too bearish, at least recently.

I don’t have much problem with his underlying theory, which looks like a modified version of Price-to-sales. ?It should be more comparable to the market cap to GDP model.

This model, to the best of my knowledge, has not been tweaked. ?It is still running on its first pass through the data. ?As such, I would give it more credibility.

There is another reason I would give it more credibility. ?You don’t have the same sort of tomfoolery going on now as was present during the dot-com bubble. ?There are some speculative enterprises today, yes, but they don’t make up as much of the total market capitalization.

All that said, this model does not tell you that the market can’t fall in 2017. ?It certainly could. ?But what it does tell you versus valuations in 1999-2000 is that if we do get a bear market, it likely wouldn’t be as severe, and would likely come back faster. ?This is not unique to this model, though. ?This is true for all of the models mentioned in this article.

Stock returns are probabilistic and mean-reverting (in a healthy economy with no war on your home soil, etc.). ?The returns for any given year are difficult to predict, and not tightly related to valuation, but the returns over a long period of time are easier to predict, and are affected by valuation more strongly. ?Why? ?The correction has to happen sometime, and the most likely year is next year when valuations are high, but the probability?of it happening in the 2017?are maybe 30-40%, not 80-100%.

If you’ve read me for a long time, you will know I almost always lean bearish. ?The objective is to become intelligent in the estimation of likely returns and odds. ?This model is just one of ones that I use, but I think it is the best one that I have. ?As such, if you look the model now, we should be Teddy Bears, not full-fledged Grizzlies.

That is my defense of the model for now. ?I am open to new data and interpretations, so once again feel free to leave comments.

[bctt tweet=”As such, if you look the model now, we should be Teddy Bears, not full-fledged Grizzly Bears.” username=”alephblog”]

Redacted Version of the December 2016 FOMC Statement

Posted on 14 December 201614 December 2016 by David Merkel

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Comments

The FOMC tightens 1/4%, but deludes itself that it is still accommodative.
The economy is growing well now, and in general, those who want to work can find work.
Maybe policy should be tighter. The key question to me is whether lower leverage at the banks was a reason for ultra-loose policy.
The change of the FOMC?s view is that inflation is higher. Equities and bonds fall. Commodity prices fall and the dollar strengthens.
The FOMC says that any future change to policy is contingent on almost everything.

Estimating Future Stock Returns, September 2016 Update

Posted on 10 December 201610 December 2016 by David Merkel

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Are you ready to earn 6%/year until 9/30/2026? ?The data from the Federal Reserve comes out with some delay. ?If I had it instantly at the close of the third quarter, I would have said 6.37% — but with the run-up in prices since then, the returns decline to 6.01%/year.

That puts us in the 82nd percentile of valuations, which isn’t low, but isn’t the nosebleed levels last seen in the dot-com era. ?There are many talking about how high valuations are, but investors have not responded in frenzy mode yet, where they overallocate stocks relative to bonds and other investments.

Think of it this way: as more people invest in equities, returns go up to those who owned previously, but go down for the new buyers. ?The businesses themselves throw off a certain rate of return evaluated at replacement cost, but when the price paid is far above replacement cost the return drops considerably even as the cash flows from the businesses do not change at all.

For me to get to a level where I would hedge my returns, we would be talking about?considerably higher levels where the market is discounting future returns of 3%/year — we don’t have that type of investor behavior yet.

One final note: sometimes I like to pick on the concept of Dow 36,000 because the authors didn’t get the concept of risk premia, or, margin of safety. ?They assumed the market could be priced to no margin of safety, and with high growth. ?That said, the model does offer a speculative prediction of Dow 36,000. ?It just happens to come around the year 2030.

Until next time, when we will actually have some estimates of post-election behavior… happy investing and remember margin of safety.

[bctt tweet=”Are you ready to earn 6%/year until 9/30/2026?” username=”alephblog”]

A Cautionary Tale on Municipal Pensions

Posted on 10 December 201610 December 2016 by David Merkel

Photo Credit: ajehals || Pensions are promises. Sadly, promises are often broken. Choose your promiser with care…

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If you want a full view of what I am writing about today, look at this article from The Post and Courier, “South Carolina’s looming pension crisis.” ?I want to give you some perspective on this, so that you can understand better what went wrong, and what is likely to go wrong in the future.

Before I start, remember that the rich get richer, and the poor poorer even among states. ?Unlike what many will tell you though, it is not any conspiracy. ?It happens for very natural reasons that are endemic in human behavior. ?The so-called experts in this story are not truly experts, but sourcerer’s apprentices who know a few tricks, but don’t truly understand pensions and investing. ?And from what little I can tell from here, they still haven’t learned. ?~~I would fire them all, and replace all of the boards in question, and turn the politicians who are responsible out of office~~. ?Let the people of South Carolina figure out what they must do here — I’m a foreigner to them, but they might want to hear my opinion.

Let’s start here with:

Central Error 1: Chasing the Markets

Much as inexperienced individuals did, the South Carolina?Retirement System Investment Commission [SCRSIC] chased the markets in an effort to earn returns when they seemed easy to get in hindsight. ?As the article said:

It used to be different, before the high-octane investment strategies began. South Carolina?s pension plans were considered 99 percent funded in 1999, and on track to pay all promised benefits for decades to come.

That was the year the pension funds started investing in stocks, in hopes of pulling in even more income. A change to the state constitution and action by the General Assembly allowed those investments. In the previous five years, U.S. stock prices had nearly tripled.

Prior to that time, the pension funds were largely invested in bonds and cash, which actually yielded something back then. ?If the pension funds were invested in bonds that were long, the returns might not have been so bad versus stocks. ?But in the late ’90s the market went up aggressively, and the money looked easy, and it was easy, partly due to loose monetary policy, and a mania in technology and internet stocks.

Here’s the real problem. ?It’s okay to invest in only bonds. It’s okay to invest in bonds and stocks in a fixed proportion. ?It’s okay even to invest only in stocks. ?Whatever you do, keep the same policy over the long haul, and don’t adjust it. ?Also, the more nonguaranteed your investments become (anything but high quality bonds), the larger your provision against bear markets must become.

And, when you start a new policy, do what is not greedy. ?1999-2000 was the right time to buy long bonds and sell stocks, and I did that for a small trust that I managed at the time. ?It looked dumb on current performance, but if you look at investing as a business asking what level of surplus?cash flows the underlying investments will throw off, it was an easy choice, because bonds were offering a much higher future yield than stocks. ?But the natural tendency is to chase returns, because most people don’t think, they imitate. ?And that was true for the SCRSIC,?bigtime.

Central Error 2:?Bad Data

The above quote said that “South Carolina?s pension plans were considered 99 percent funded in 1999.” ?That was during an era when government accounting standards were weak. ?The?standards are still weak, but they are stronger than they were. ?South Carolina was NOT 99% funded in 1999 — I don’t know what the right answer would have been, but it would have been considerably lower, like 80% or so.

Central Error 3: Unintelligent Diversification into “Alternatives”

In 2009, I had the fun of writing a small report for CALPERS. ?One of my main points was that they allocated money to alternative investments too late. ?With all new classes of investments the best deals get done early, and as more money flows into the new class returns surge because the flood of buyers drives prices up. ?Pricing is relatively undifferentiated, because experience is early, and there have been few failures. ?After significant failures happen, differentiation occurs, and players realize that there are sponsors with genuine skill, and “also rans.” ?Those with genuine skill also limit the amount of money they manage, because they know that good-returning ideas are hard to come by.

The second aspect of this foolishness comes from the consultants who use historical statistics and put them into ~~brain-dead~~ mean-variance models which spit out an asset allocation. ?Good asset allocation work comes from analyzing what economic return the underlying business activities will throw off, and adjusting for risk qualitatively. ?Then allocate funds assuming they will never be able to trade something once bought. ?Maybe you will be able to?trade, but never assume there will be future liquidity.

The article kvetches about the expenses, which are bad, but the strategy is worse. ?The returns from all of the non-standard investments were poor, and so was their timing — why invest in something not geared much to stock returns when the market is at low valuations? ?This is the same as the timing problem in point one.

Alternatives might make sense at market peaks, or providing liquidity in distressed situations, but for the most part they are as saturated now as public market investments, but with more expenses and less liquidity.

Central Error 4: Caring about 7.5% rather than doing your best

Part of the justification for buying the alternatives rather than stocks and bonds is that you have more of a chance of beating the target return of the plan, which in this case was 7.5%/yr. ?Far better to go for the best risk-adjusted return, and tell the State of South Carolina to pony up to meet the promises that their forbears made. ?That brings us to:

Central Error 5: Foolish politicians who would not allocate more money to pensions, and who gave?pension increases rather than wage hikes

The biggest error belongs to the politicians and bureaucrats who voted for and negotiated higher pension promises instead of higher wages. ?The cowards wanted to hand over an economic benefit without raising taxes, because the rise in pension benefits does not have any immediate cash outlay if one can bend the will of the actuary to assume that there will be even higher investment earnings in the future to make up the additional benefits.

[Which brings me to a related pet peeve. ?The original framers of the pension accounting rules assumed that everyone would be angels, and so they left a lot of flexibility in the accounting rules to encourage the creation of defined benefit plans, expecting that men of good will would go out of their way to fund them fully and soon.

The last 30 years have taught us that plan sponsors are nothing like angels, playing for their own advantage, with the IRS doing its bit to keep corporate plans from being fully funded so that taxes will be higher. ?It would have been far better to not let defined benefit plans assume any rate of return greater than the rate on Treasuries that would mimic their liability profile, and require ~~immediate~~ relatively quick funding of deficits. ?Then if plans outperform Treasuries, they can reduce their contributions by that much.]

Error 5 is likely the biggest error, and will lead to most of the tax increases of the future in many states and municipalities.

Central Error 6: Insufficient Investment Expertise

Those in charge of making the investment decisions proved themselves to be as bad as amateurs, and worse. ?As one of my brighter friends at RealMoney, Howard Simons, used to say (something like), “On Wall Street, to those that are expert, we give them super-advanced tools that they can use to destroy themselves.” ? The trustees of?SCRSIC received those tools and allowed themselves to be swayed by those who said these magic strategies will work, possibly without doing any analysis to challenge the strategies that would enrich many third parties. ?Always distrust those receiving commissions.

Central Error 7: Intergenerational Equity of Employee Contributions

The last problem is that the wrong people will bear the brunt of the problems created. ?Those that received the benefit of services from those expecting pensions will not be the prime taxpayers to pay those pensions. ?Rather, it will be their children paying for the sins of the parents who voted foolish people into office who voted for the good of current taxpayers, and against the good of future taxpayers. ?Thank you, Silent Generation and Baby Boomers, you really sank things for Generation X, the Millennials, and those who will follow.

Conclusion

Could this have been done worse? ?Well, there is Illinois and Kentucky. ?Puerto Rico also. ?Many cities are in similar straits — Chicago, Detroit, Dallas, and more.

Take note of the situation in your state and city, and if the problem is big enough, you might consider moving sooner rather than later. ?Those that move soonest will do best selling at?higher real estate prices, and not suffer the soaring taxes and likely?diminution of city services. ?Don’t kid yourself by thinking that everyone will stay there, that there will be a bailout, etc. ?Maybe clever ways will be found to default on pensions (often constitutionally guaranteed, but politicians don’t always honor Constitutions) and municipal obligations.

Forewarned is forearmed. ?South Carolina is a harbinger of future problems, in their case made worse by opportunists who sold the idea of high-yielding investments to trustees that proved to be a bunch of rubes. ?But the high returns were only needed because of the overly high promises made to state employees, and the unwillingness to levy taxes sufficient to fund them.

[bctt tweet=”Seven central errors committed by the South Carolina Retirement System and politicians” username=”alephblog”]

The Beauty of Old Ideas

Posted on 6 December 20166 December 2016 by David Merkel

Photo Credit: Daniele Dalledonne || Ever been to a place where everything was a little past its prime, but showed that it was a beautiful place in its time?

One of the great draws in?reading investment writing is the lure of “hot tips.” ?Everyone wants an investment idea that they can put a lot of money into that will reward buyers (or shorts) with a quick and large score. ?Thus most publications try to lure you in with articles like these, whether they will work or not.

We live in an era where market players scour as much fresh data as possible to make money, because there is validity to the idea that only fresh, previously unknown information can produce excess returns. ?The grand majority of us will never receive that information for free, and can’t afford to pay up for services that promise to give such carefully researched ideas (whether true or not, and whether they work or not).

So what’s a humble value investor to do, professional or amateur? ?I can suggest five?things:

Take a look at old ideas that seemed promising but when the news hit the market, there was a price jump, then a fall, then nothing. ?Typically, I have lists of companies that I have looked at — maybe it is time for a second look?
Source your own ideas — particularly look at smaller companies that have low or no analyst coverage. ?As regulations have come over Wall Street, you might be surprised at the number of companies in seemingly boring industries that have little to no real coverage. ?Some of them are sizable. ?(By “real coverage” I mean a human being, not an algorithm. ?Don’t get me wrong, algorithms are often better than people, but the value of a human being ?here is that he/she is more representative of how human investors think — and we love exciting stories.)
Scan 13Fs for new positions and additions — my favorite ideas are when a number of clever investors are adding on net to their holdings (and the stock has done nothing), or two hedge funds buy a new name at the same time that none of the other bright investors hold at all. ?(not a spinoff)
Or, look at spinoffs. ?For a little while, there will be liquidity and small or no analyst coverage. ?Many large investors and indexers will toss out the smaller spinoff, often leaving a undervalued company behind.
Hold onto companies in your portfolio if they stumble, but you still think management is making the right decisions.

One of the main ideas behind this is that it takes a while for business ideas to work out. ?Most valid ideas will hit a couple of bumps along the way, and short-term earnings will disappoint occasionally with good companies. ?Companies that never have disappointing earnings may be manipulating their accounting.

Many if not most of the companies that I hold for years run into disappointments, become an unrealized capital loss in my portfolio for a while, and come back to greater success. ?The short-term disappointments sometimes allow me buy a little bit more, but the main thing to analyze is that the company’s management continues to behave rationally for the good of all shareholders.

Final Notes

This only applies to healthy companies. ?Do not try this with companies that have weak balance sheets that might be forced to try to raise funds (at unattractive levels) if their plans don’t go right. ?All good investing embeds a margin of safety.

Another way to phrase this is think differently. ?There is a lot of money out there chasing the most liquid companies. If you can take on a little illiquidity on a quality company that is not well-known, that could be a good idea. ?But remember, thinking differently is not enough if?your idea isn’t smart. ?It has to be smart and different.

With that, happy hunting. ?Sometime in the near term, I will do a post on underfollowed companies. ?Read it when it comes — it might have some good ideas.

[bctt tweet=”So what?s a humble value investor to do, professional or amateur? I can suggest five things” username=”alephblog”]