Asset Allocation – The Aleph Blog

Estimating Future Stock Returns, June 2020 Update

Posted on 22 September 202022 September 2020 by David Merkel

Image Credit: Aleph Blog || Really, do you want to earn 3 1/2% for the next 10 years?

At present, the S&P 500 is priced to return 3.51%/year over the next ten years. Now if you were buying some ten-year investment grade corporate bonds, you might expect something around 2%. Is that 1.5% over corporates worth it?

Truly, I don’t know. That said, you have choices. The most overpriced segment of the market now is the large cap growth FANGMAN stocks, which accounts for around 25% of the S&P 500. You can choose safer areas:

Small cap stocks
Value stocks
Cyclical stocks
Foreign stocks, including emerging markets
Financial stocks, and maybe if you dare, energy stocks

Now I know that what I said here embeds an idea that GDP will start to grow again. Even with the lousy economic policy at present, over the next twelve months, under most conditions, the economy will grow as government reactions to the C19 virus decrease.

That said, the actions of the Fed in providing credit zoomed through the markets, and pushed stock prices up. Good for the wealthy, less good for ordinary people. Remember, I don’t think it is proper for the Fed to target the stock market. But that is what they are doing through QE.

The graph above shows what returns typically come when expected return level are as low as they are today. You shouldn’t be expecting much here. What?! You think the market will rise to the heights of the dot-com bubble and beyond?

Look, even if the big tech companies are profitable, having the S&P 500 in the mid-4000s is not sustainable. The companies will never grow into those valuations even if the economy recovers.

This is a time to lighten risk positions, or at least to move to stocks that have not been the leaders. Take this opportunity, and lessen your risks. Don’t drive through the rear-view mirror. Look to the mean-reversion that will come, as it did in 2000-2001.

Don’t Presume on History

Posted on 3 September 2020 by David Merkel

Photo Credit: Sean MacEntee || Yes, victors write history, and so we are unprepared for the war that does not resemble the past.

Dear Friends, this post is in some ways a hybrid between the posts This Has Never Happened Before and The Rules, Part LXIV “Weird begets weird.”

What I am writing stems from what I have been hearing on Bloomberg Radio and other media outlets where they have bought into the idea that buying growth stocks at any price is the prudent thing to do.

Why do they promote this idea? It stems from the idea that you can’t earn much in bonds, so you must buy stocks. It also stems from the idea that stocks outperform all asset classes over time. “Buy and hold” is a great idea most of the time, but there are occasionally times when it is not the best idea.

I am a student of market history. I know what has happened. But we are in unusual times, and we must try to analyze why the market is behaving strongly. My view is that most of it stems from monetary policy, which is goosing valuations.

This is the awkward thing: the free cash flows of the stock market are reduced, but overall stock prices are higher. Valuations are strained. Is future growth going to be so astounding as to be greater than all of the past?

Stocks are more volatile than bonds, and in a situation where volatility is high, such as is true when interest rates are low, perhaps we should be more favorable to bonds than when equity volatility is low. There are times to preserve capital. The current environment offers a 2.9%/year return on the S&P 500 over the next ten years, versus a 2.5% current yield from $AGG. This is a simple choice — the investment grade bonds are more reliable.

The main thing I want to say is this: toss your long-term assumptions out the window for short-term purposes. With the bizarre policies of the US government, many truths that were self-evident are now on hold. Don’t assume that equities will be dominant in a low interest rate environment. We have no data on this– only a theory.

So with that be careful. Consider what could go wrong and don’t risk too much.

This Has Never Happened Before

Posted on 22 July 2020 by David Merkel

Photo Credit: Boston Public Library || Should end the saying “Slower than molasses in January“

Life is somewhat predictable in the short run. That said, there are always surprises that make us say, “This has never happened before.” Here are a few examples:

The policy response to the current C19 crisis. (Note: the C19 crisis itself is not new — we have had the Spanish Flu and the Black Death, which were far worse.)
For those in the US, 9-11-2001 was a huge surprise.
Few expected that the financial crisis in 2008 would be so large.
No one expected the interest rates would rise so high 1979-82.
The high inflation era of the ’70s was a total surprise. In one sense, what is more amazing is how much it has made Americans fear inflation. That said, look at the fear the Germans have of inflation.

Personally, I have always taken moderate risk in my financial dealings. My asset allocation has always been between 80/20 and 60/40 (risky/safe). I don’t go “all out,” nor do I cower in fear. I look for opportunity, but I always leave something on the side in case something goes wrong.

Unexpected things go wrong with considerable frequency, particularly when private & public debt levels get high. With little slack in the system, panics have a greater impact. This is a cost of the Fed encouraging higher levels of debt. They create the higher severity of the crises, because high debt levels leave the economy inflexible. People and institutions are relying on debts being paid.

As a result, with the highest debt levels we have ever seen in the US, I am going to improve the already high credit quality of the equities and bonds that I purchase for myself and clients. This is not sustainable, and if the Fed continues its path to becoming the universal bank of the US, we will face other problems, notably no economic growth.

My main point here is own some assets that are safe. I own short-term bonds that pay little, and I don’t care that there is almost no yield. I know that the principal is secure, and that if things get worse, I have buying power. I used the buying power back in March. I will do it again.

Make sure you own a decent amount of safe assets.

Don’t Lose Your Head

Posted on 12 June 2020 by David Merkel

Photo credit: David Seibolid || Oh dear, you lost your head!

So we had a hard market day yesterday. Maybe COVID-19 will resurge in the USA. The great thing about the USA is that no one is ever truly in charge. Power is shared. Most of the time, that’s a good thing.

I am not saying that it is time to buy, unless it is small trades. I bought 0.7% of stocks yesterday as the market fell 5%+. My aggregate cash position is around 20% of assets. After buying as the market fell in March, I was selling off stocks in May.

Did I not believe the rally? Sure I did, but there are degrees of belief, and I kept selling bits as the market rose.

Now let me tell you about two former clients. One was retiring, and wanted to move his assets to a firm I had never heard of. He notified me the second day after the bull market peak in February. I did not argue; I just liquidated the account for him. As the market fell after that, he told me to delay selling — the market would come back. I told him he had already sold.

Now, the new manager was incompetent in rolling over the assets. I was astounded how long it took, even with me helping them. As such, the client got a bad idea, and took 2/3rds of the assets and bought an equity indexed annuity decently past the recent market bottom. The insurance company knew how to roll assets. I wish my client had asked me regarding this — EIAs are “roach motels” for cash. They don’t return well, and you can’t get out of them. Your money dies there.

The incompetent asset manager ended up managing 1/3rd of the cash they thought they would. My former client is ill-served both ways.

Then there was the second client. He seemed to be happy and was interested in good long-run returns. In my risk survey, he scored normally. But when the market fell hard in March, he panicked and wanted to liquidate. But he asked my opinion on the matter. I told him that quick moves of the market tend to reverse, and that the securities that he held were well-capitalized, and even if the market fell further, they would not fall as much.

Then he told me that he never wanted the portfolio to fall below a certain level which we were at that point close to breaching. This was new information to me, and I said to him, if that’s the case, you should not be investing in stocks. Either change your goal, or change your asset allocation.

For a day, he realized he should be willing to take more risk. Than the market fell hard again, and he told me to liquidate.

I did so.

And it was the bottom.

So what is the lesson here?

It’s simple. Choose an asset allocation that you can live with under all conditions, and stick with it. This is the same thing that I tell the risk-averse pastors that I serve on the denominational pension board. And if you are not sure that you can live with it, move the risk level down another notch.

A second lesson is be honest with yourself, and also with your advisor, about your risk preferences. Most advisors that I know are happy to adjust the riskiness of client portfolios. There is no heroism in taking too much risk.

As I have said a number of times before, I have run my portfolio at 70/30 risky/safe all of my life plus or minus 10%. I personally could run at a higher level of risk, but I would rather not take the mental toll of doing so.

And when the market moves, I trade against it — but not aggressively. I am always moving in the right direction, but slowly, because I am never 100% certain where mean-reversion will kick in.

Yesterday was tough. Big deal. Days like that will happen. It’s part of the game. As for my second client, he took more risk than he was comfortable with, and ended up leaving the game, which is the worst outcome under normal conditions.

Sun Tzu said the most important task of a general was to understand himself and his enemy. My second client did not understand his own desires, and he did not understand how volatile the market can be.

As such he lost out — as did the first client in other ways. And thus to all I say, “Choose an asset allocation you can live with under all conditions, and stick with it.” You will be happier, and you will do better if you do so.

Saving, Investing, and Storage

Posted on 6 June 20207 June 2020 by David Merkel

Photo Credit: Jason Woodhead || Forget the United States Oil Fund — if you want to own oil, buy a tank and store the oil on your own property. 😉

This should be a short post. Buffett likes to own T-bills when he doesn’t have anything that he wants to buy. Why? He is storing value until the time comes when he can buy something that he thinks offers a superb return over the long haul.

And now for something that seems completely different: commodity investing, when it was introduced in the nineties, offered “yield” from rolling the futures contracts from month-to-month. That ended when the trade got too crowded, and the “yield” went negative. The ETFs that pursued these strategies were inventory financing charities in disguise. They still are, even though their strategies are more complex than they were.

Think for a moment. Why should you earn a yield-type return off of owning a commodity? Really, that should not exist unless there is a scarcity of speculators willing to let producers hedge their risk with them. There is a speculative return, positive or negative, from holding a commodity, but in the present environment, where there is no lack of people willing to hold commodities, there is no yield-like return, unless it is negative.

As a result, commodities should be viewed as storage, not an investment. Do you think in the long run that gold will be more valuable than it is today? It might be wise to store some away. That said, you have to be careful here. In inflation-adjusted terms, most commodities have gotten cheaper over time, with occasional violent rallies that convince people to speculate (all too late).

Storage is not investing. Storage tucks something away, and it will not change, even if its price changes because of changes in the economy.

Investing is far less certain — you can lend to or buy equity in a venture which could produce astounding returns, or you could lose it all, or something in-between. With investing, it is rare that you will end up with what you started with.

This is not to say that storage is a bad thing — we exchange our savings in bank balances to store value in a different form. A bank could go bust. If enough go bust at the same time, value could be lost if the government does not back up the FDIC. Holding T-bills preserves value to the degree that the government is willing to pay on its own debts in fiat currency, which is pretty likely.

Holding a commodity with a price you think will correlate strongly with the prices you will experience in retirement is not a bad idea. That said, it is storage. It will not grow your purchasing power the way that investment will.

As such, I encourage you to mostly invest, and store a little. Storage is more certain, but has no return. Investing has returns, both positive and negative, but generally over time provides more value than storage.

PS — owning a home, except in a crowded area that is growing, is not an investment but is storage. You should not expect capital gains in real terms from owning a house. That said, it will provide you with rent-free living for a long time once the mortgage is paid off. (Please ignore the property taxes, insurance and maintenance costs.)

Notes and Comments

Posted on 25 April 20206 June 2020 by David Merkel

1) I still can�t post images at my blog. If you can believe it, WordPress is trying to fix it. The one cost involved is that the last three posts will be wiped out, and all comments since 4/8.

2) I�ve spent the time since my last post improving my models. I played around with a seven-parameter model, but found that it took ~10,000x as much time to converge to a solution, and there were multiple solutions with very different results that fit close to equally well. My conclusion was that they were different ways to amplify noise.

Instead, I created a second model based on the idea that the rate of growth of total cases was exponentially decaying at a rate slower than that of the first model. The new case figures have been coming at rates far closer to the second model.

I�m sensitive to when models keep having errors in the same direction� 2-3 weeks ago, errors were close to even � as many up as down. But since then more new cases have persistently come in than the first model would have predicted.

Austria, Switzerland and Germany are fine, but most of nations I have modeled have a long way to go, if model 2 is closer to the truth. Add five weeks onto getting to the 99% point.

As such, don�t put me in the camp of optimists any more. I recognize my initial predictions were wrong. Some of it stems from increasing testing as time has gone on. Indeed, what will happen if that study in New York is correct (seems to be too small of a sample, and perhaps biased), and maybe 10-15% of the NY population caught COVID-19 with almost no symptoms? That is mostly a good thing, and might even be a testimony to how little reported cases moved up in the face of that � social distancing restrains the spread of COVID-19, particularly with those who would be most harmed distancing via self-quarantine.

3) I think the history books will end up calling this the voluntary recession, where governments chose ham-fisted solutions out of fear, and did not consider the long-run implications of draconian solutions like general quarantine. What are the effects on:

Unemployment
Division of labor
Pensions, both public and private
health care for those that don�t have COVID-19
Small businesses that run out of resources

Death rates rise from sudden recessions. Might it be more than the lives saved via general quarantine. What Sweden is doing makes more sense. Yes, their death rates are a little higher, but they didn�t close many things at all � their populace has covered up, and kept working. They integrated social distancing into their total lives, including work.

4) But, after the crisis is over, there will be some things that we realize we did not need. Will a video teleconference do as well as a trip to a remote office? How much additional productivity do we get or lose from having staff in a single location? Hay, I can cook for myself! I don�t have to go to restaurants! We don�t need low-end malls! And more� we just don�t know what all will change. That said, never underestimate the ability of Americans to forget.

5) There are charities that help some businesses finance their inventories. They are called commodity ETFs. Long ago, I wrote about the folly of buying ETFs that follow complex strategies. USO always underperformed. This past week was the worst of it.

Negative prices for oil futures are like negative interest rates. If you can safely store paper currency, you will never have a negative interest rate. If you can safely store oil, then a day will come when you can use or sell it.

6) One of my clients asked me what I thought about what the Fed is doing now. My answer is this: they aren�t doing much. The market took their bluff and ran with it. How is this?

All of the risk flows back to the US Treasury explicitly or implicitly, via loss of seigniorage.
They are mostly financing assets, not buying them.
When they are buying assets, they aren�t taking much risk, either in duration or credit.
The QE that they are doing is just a closed loop with the banks � it doesn�t get into the general economy.

The Fed makes me think of a nerdy kid who thinks he is being cool, but all the cool kids know he is a nerd. That said, in this case a good bluff can be quite effective if the cash keeps flowing.

Personally, I like the fact that the Fed is taking little risk. That�s the way a central bank should be. But that�s not the way the markets are interpreting the matter � they think the Fed will always rescue them.

7) But at least at present, I don�t think we are using MMT yet, unless you mean that the Fed buys government debt.

To me, the big question is when do foreign entities get sick of owning US Dollar claims? When do foreign governments finally say that they won�t subsidize exporters anymore, and will stop investing in US Dollar claims?

Of the major governments, the US is the �cleanest dirty shirt,� but when will the free ride of cheap capital end? Nature abhors free lunches, and this one has gone on for a long time� pity that the competition is so poor.

8 ) When will we learn that savings doesn�t inhibit growth? Stable households and businesses survive better, and ultimately spend more.

9) 60/40 stocks/bonds as an asset allocation has been maligned, but not for any good reason. Yes, high-quality interest rates are low. The real value of bonds is that they don�t fall as much as stocks. In a stock market where valuations are still high, though not relative to bond yields, stocks should play a larger role, but not so much as to eliminate the value of having assets that protect the portfolio against hard falls.

That�s all for now.

It Doesn’t Get Much Better Than This?

Posted on 27 March 2020 by David Merkel

Photo Credit: Valerie || Photo taken from the coast of Key West at sunset. Relaxing and peaceful, so they say…

What an amazing three days. I’ve said to some of my clients that moves of this magnitude are highly unusual. How unusual?

The returns of the last three days would rank sixth in the top ten three-day moves upward for the S&P 500 since 1928. When did the rest of the top ten take place? During the Great Depression — four in 1932, three in 1933, and one each in 1931 and 1935.

Given the overall difficulties of the stock market in the Great Depression, one could say that the 2020 stock market should find being peers with which to keep company.

One more note about March 26th, 2020, that sets it apart: It’s the only one of the dates that may be a bounce up from a bear market low. The fastest bear market may become the fastest bull market if the S&P 500 closes above 2685 soon.

It Doesn’t Get Much Worse Than This?

Consider monthly price volatility. Using 21 days to represent a month, the standard deviations of price movements for March 26th would be the eleventh highest. When did the other ten take place. One day after another for ten trading days starting on November 14th, and ending on the 27th of the same month.

Do you feel like the current market action has slugged you hard? I do. That would be a normal feeling, as we haven’t been through anything quite like this in our lifetimes.

Even if you look at implied volatility, for which we only have data since 1986 (if you are looking at the old VIX, 21-day average volatility would have ranked 54th. 39 trading days starting on October 27th, 2008, and 14 trading days starting on November 3rd, 1987 ranked higher. Still it been fascinating to not see the VIX move down much over the last three days. Perhaps there are a lot of investors still aggressively buying puts and calls.

Four Interesting Periods in the Stock Market

So think about:

The Great Depression
Black Monday and related problems in 1987
The Great Financial Crisis in 2008, and
Now

The two “Greats” had collapses in asset prices and corresponding impairments of banks, and some other financial institutions. They were for practical purposes universal panics.

1987 was shocking, but it came back fast, and it didn’t have much collateral damage. The current time period? Well, banks are lending to creditworthy borrowers, and March is a record for US dollar denominated investment grade corporate bonds, Jon Lonski reported at Moody’s in his report released tonight. There’s no lack of liquidity to the big guys with normal balance sheets.

For CLOs, MLPs, repos and Mortgage REITs, that’s different. They are highly dependent on capital market conditions to do well. They are “fair weather” vehicles. In this situation, the Fed is extending itself in ways that it doesn’t need to, and for areas that should be left alone. Nonbanks should not be an interest of the Fed. If you’re going to take all systematic risk away from business, they’re going to behave in even more aggressive ways, and create an even bigger crisis. This one would have been small enough for the private sector to handle, once the initial wave furor over COVID-19 dies away in a couple of weeks.

Same for the Treasury. We don’t need the stimulus, and recessions help to clear out bad allocations of capital. This is a waste of the declining creditworthiness of the US Treasury, which will find itself challenged by a bigger crisis in 10-15 years, with no flexibility to deal with it.

Two Final Notes

I have a series of four articles called, “Goes down double-speed.” The market going down rapidly is less unusual than it going up rapidly. Typically the speed of down moves is twice as fast as up moves. For the current up moves to be so fast is astounding. I would say that it shouldn’t persist, but I think the market will be higher because the first wave of COVID-19 will fade.

And so I go back to one of my sayings: “Weird begets weird.” Weird things happen in clumps, in bunches. Much of it is driven by bad monetary and fiscal policies, including policies the encourage people and institutions to take on too much debt. Unusual factors include COVID-19 and the policy response to it. Part of it is cultural — we take too much risk as a culture, which works fabulously in the bull phase of the cycle, and horribly in the bear phase.

And thus I would say… prepare for more weird. Like COVID-19, it’s contagious.

Estimating Future Stock Returns, December 2019 Update

Posted on 19 March 202019 March 2020 by David Merkel

Graphic Credit: Aleph Blog, natch… same for the rest of the graphs here. Data is from the Federal Reserve and Jeremy Siegel

Here’s my once a quarter update. If you owned the S&P 500 at the end of 2019, it was priced to give you a return of 2.26%/year over the next 10 years. That said, the market has changed a lot in the last 2.6 months –as of the close of business on March 18th the market was priced to give you a return of 7.28%/year over the next 10 years. Finally, you have a chance to double your money over the next ten years, while a 10-year Treasury would give you 1.5%/year over the same horizon. To match the expected returns on stocks at this point in bonds, you would have to invest in junk debt, but junk typically doesn’t go longer than 10 years, and who knows what the defaults will be over the next two years?

Now, actual returns from similar levels have varied quite a bit in the past, so don’t take the 7.28%/year as a guarantee. WIth a 2%/year dividend yield, price returns have ranged from -0.95%/year to 6.89%/year, with most scenarios being near the high end.

At the end of 2019, valuations were higher than any other time in the past 75 years, excluding late 1964, and the dot-com bubble. It is not surprising there was a bear market coming. Because “there was no alternative” to stocks, though, it took an odd external event or two (COVID-19, oil price war) to kick bullish investors into bear mode. This was not a supply and demand issue in the primary markets. This was a shift in estimates of investors regarding the short-term effects of the two problems extended to a much longer time horizon.

Two more graphs, and then some commentary on portfolio management. First, the graph on the channel the market travels in, subject to normal conditions:

This graph shows how the model estimates the price level of the S&P 500. It is most accurate at the present, because the model works off of total returns, not just the price level. The gap between the red and blue lines is mostly the effect of the present value of future dividends, which are reflected in the red line and not the blue.

The maximum and minimum lines have hindsight bias baked into them, but it gives you a visual idea of how high the market was at any given point in time — note the logarithmic scale though. If you are in the middle using linear distance, you are a little closer to the bottom than the top.

And finally, that’s how well the model fits on a total return basis. Aside from the early years, it’s pretty tight. The regression explains more than 88% of the total variation in returns.

Implications for Asset Allocation

If you haven’t read it, take a look at my article from yesterday. I am usually pretty disciplined about rebalancing, but this bear market I waited a while, and created two schedules for my stock and balanced fund products to adjust my cash and bond versus stock levels. I decided that I would bring my cash levels to normal if the market is priced to give its historical return, i.e. 9.5%/year over the next ten years. That would be around 2100 on the S&P 500. Then I would go to maximum stock when the market is offering a 16%/year return, which is around 1300 on the S&P 500.

The trouble is this is psychologically tough to do when the market is falling rapidly. I am doing it, but when I rebalance at the end of the day I sometimes wonder if I am throwing my money into the void. Remember, I am the largest investor in my strategies, and if my ideas don’t work, I will lose clients, so this is not an idle matter for me. I’m doing my best, though my call on the market was better during the first decade of the 2000s, not the second decade.

In the process, I bought back RGA at prices at which I love to have it, and have been reinvesting in many of the companies I own at some really nice levels… but for now, things keep going down. That’s the challenge.

In summary, we have better levels to invest at today. Stocks offer better returns, but aren’t screaming cheap. Some stocks look dirt cheap. Most people are scared at the speed of the recent fall. I view my job as always doing my best for clients, and that means buying as the market falls. I will keep doing that, but I have already lost a few clients as a result of doing that, even though I tell them in advance that I will do that. So, I will soldier on and do my best.

Full disclosure: long RGA for clients and me

The Rules, Part LXV

Posted on 18 March 202018 March 2020 by David Merkel

Photo Credit: vldd || Relative to a complete bridge, what’s the value of a bridge that will never be completed?

Here’s number 65 in this irregular series:

The second-best plan that you can execute is better than the best plan that you can’t execute.
Rule LXV

It takes more than the right ideas to be an investor. It also takes the courage to make the hard decisions at the time when it hurts to do so.

Will you make more money if you allocate at least 80% of your assets to stocks and other risk assets? Yes. How will you hold on during a gut-wrenching bear market that gives you the feeling that you are losing everything?

You could just refuse to look at your statements, or listen to financial media. But most people will bump into that randomly during a bear market, because the level of chatter goes up so much. It may be better to take a second-best solution and reduce the portion of risky assets to 50-60%, and simply sleep better at night. Reduce until you won’t be nervous, and preferably, make this adjustment during the bull market.

Do you have a nifty trading strategy that you are tempted to overrule because it generates trades that you think don’t make sense, or come at times that seem too painful? Perhaps you need to abandon the strategy, or lower the size of the trades done. Maybe do half of what the strategy would tell you to do.

If you use the Kelly Criterion to size your trades, and the volatility drives you nuts, maybe size your trades to “half Kelly.”

Am I offering an opiate for underachievement? Well, no… maybe… yes… Look, personalities are not fixed, much as some say that they cannot change. If you have sufficient motivation, you can come up with ways to change your personality to be able to deal with more risk, or, conclude that you will do better if you take less risk.

Writing out a set of rules can useful, as is testing them to make sure they actually work. In general fewer rules are better.

An example of this in my life was when I was a corporate bond manager, I made an effort to forget prior prices of a bond, thus forcing me to be forward-looking in my management. When I was younger, I told myself that there would be losses, and they were a price of getting the gains on average.

But if you can’t make your personality change, then you have to adapt your investment strategy to let you be happy while still achieving most of your goals. As an example, if you like to sell stocks short, it would be wise to have some sort of limit as to how much you are willing to lose before closing out a trade — this applies more to shorting, as losses are unlimited as prices rise, but gains are capped.

Ordinarily, if a person or institution is close to even-keeled with respect to risk, the time horizon and uncertainty of the cash flows from the assets should be the main criteria for asset allocation. But when a person is overly timid or bold, that will become the dominant criterion for their asset allocation.

It is important not to be of two minds here. Admit your weaknesses, and either fix them, or live with them. The trouble comes when you think you are strong, but then give in when a bad event happens that was beyond your capacity to handle.

It’s also important to understand that the market can be more vicious than at any prior point in history. Yes, there are historical highs and lows for every variable — but both can be exceeded… the speed of the current bear market is an excellent reminder of that. Try to understand that there will be as Donald Rumsfeld once said “unknown unknowns.” Have you left enough slack in your strategy for some really bad scenarios? Have you considered that it’s not impossible to have a second Great Depression event, despite the best efforts of politicians, regulators and economists? Have you considered that it is possible to eclipse the valuation highs achieved in 2000?

And consider the phrase from my disclaimer “The market always has a new way to make a fool out of you.” Have you considered what scenario would be poison for what you currently do? Unlikely as it may be, can you live with that scenario? If not, scale down your strategy until you can live with it. Or, figure out what your coping strategy would be.

The first life insurer that I worked for had the strategy that if things went wrong with their investing, they would sell policies more aggressively and invest the proceeds to grow their way out of the problem. They ended up being the largest life insurance insolvency of the 1980s, as their worst case scenario arrived, and their capital was depleted. They would have done better to grow more slowly, and more soundly. The same would apply to Enron and other companies that try to grow too fast. This is another case where the second best is achievable, but the “best” is not.

So, know yourself, and know the markets well. Leave some slack in your strategy… don’t play it to or past the absolute maximum that you can handle. Have some humility, and live in reality. For most investors, that will pay off in a big way.

What Makes An Asset Safe?

Posted on 14 February 2020 by David Merkel

Photo Credit: acciarini ||Sometimes a good conversation elucidates a matter…

Q: What defines a safe asset?

A: My, but that is a broad question. Do you have something more specific that you are trying to answer?

Q: Well, I’ve heard that the wealthy often invest their excess assets in real estate. It seems perfect. As Twain said, “Buy land, they aren’t making any more of it.” It provides income, and protects against inflation.

A: Do you own the land free and clear, or did you have to borrow to own it?

Q: I don’t own any land, aside from my house, and yes, I have a mortgage there. Why are you asking this?

A: Do you remember the financial crisis 2008-2011?

Q: Yes, but why does that matter?

A: Many people had paid a lot for their homes, and were stretched in making mortgage payments. Then one of the Ds hit.

Q: Ds?

A: As written by one wordy blogger:

3) As housing prices fall, which they should because housing is in oversupply, more homeowners find themselves in trouble. Remember, defaults occur because a property is underwater, and one of the five Ds hits:

Divorce
Disability
Death
Disaster
Dismissed from employment

Q: My, but he is a piece of work. So, houses aren’t a safe asset?

A: Well, most of the time they are, particularly if don’t have any debt on them. But there are situations where housing prices have been bid up to where the prices don’t justify the cash flows if you are borrowing to own it and are renting it out.

Q: What do you mean?

A: No asset’s price can survive if the implicit net rent is negative. I.e., if you have to feed the property to hold it.

Q: Huh?

A: Imagine that instead of living in your home, you borrowed money to buy the house, and have rented it out. What I am saying is that when those that do this are losing money, the price of the house is too high. They are relying on price appreciation to bail them out, and no one can control that.

Q: Is there a simpler way to say this?

A: When you have to give up money to hold onto an asset, you are in a weak position, and it means you should sell, particularly if many people are having to do the same thing. Properly priced assets produce cash; they don’t consume cash. If on net it is cheaper to rent than borrow and own, then it is probably better to rent.

Q: Are you just saying that risk is a function of the price of the asset? An overpriced asset is risky, and an underpriced asset is not?

A: I am saying that, but there is more to say as well. An asset could be priced below its fair market value, and it could still be risky if it is misfinanced. Take for example the insurance company General American back in August 1999.

Q: Huh?

A: Old news, I know, and most people don’t follow insurers. But they had written a lot of floating rate GICs terminable at par in 7 days if they got a ratings downgrade. What was safe if it had only been 5% of their assets became toxic at 25% of their assets. The amount they were selling ballooned because money market funds could treat the assets as short-term paper.

Once the downgrade came, there was no way to raise that much money so fast. They ended up selling out to MetLife for 50% of their net worth. MetLife picked up control of one of their subsidiaries, RGA, in the process. They made exceptionally good money on that purchase.

It’s like crossing a stream that is 3 feet deep on average, but there is a spot in the middle that is 20 feet deep. If you can’t swim, don’t cross it.

Q: I heard you wrote to Cramer about General American at the time.

A: Yes, that was my first email to him, and I explained the situation in such detail that he republished the email for readers. That was my introduction to Cramer.

Q: So, you are saying there are two things to safety — price and financing?

A: That’s all I’ve said so far, but there are a few other things. The character of management matters. Remember my piece, Dead as a Severed Horse?s Head?

Q: Oh, the zinc miner that sided with the bondholders against the shareholders?

A: Exactly. With better management, they could have skated through the troubles, and perhaps sold the company to a larger base metals miner like BHP.

Q: Is any of this similar to the losses you took on Scottish Re or National Atlantic?

A: Yes. I thought you were my friend, though.

Q: Well, I read your confession pieces on both of them.

A: It still hurts, but faithful are the wounds of a friend.

Q: Proverbs 27:6, I like it.

A: I still remember the stress and the losses.

Q: Then is that all? Price, leverage, and management?

A: Pretty much. There are some secondary matters to those who do not want to do the hard work. Companies that pay dividends and buy back stock are shareholder friendly, and that is good so long as they don’t borrow too much to do that.

Also, there are the issues of operating leverage — companies with low fixed costs are safer. But that’s about it, unless you want to talk about investments other than stocks.

Q: Can we take this up later?

A: Sure, let’s take this up in part 2.