Bonds – Page 11 – The Aleph Blog

The Importance of Your Time Horizon

Posted on 29 August 2015 by David Merkel

Photo Credit: Dr. Wendy Longo || This horizon is distant... — Photo Credit: Dr. Wendy Longo || This horizon is distant…

I ran across two interesting articles today:

Volatility Doesn’t Equal Loss?Unless You Sell?from Oppenheimer Funds, and
Buying the Dips Doesn?t Work for Everyone?by the estimable Jason Zweig.

Both articles are exercises in understanding the time horizon over which you invest. ?If you are older, you may not have the time to recover from market shortfalls, so advice to buy dips may sound hollow when you are nearer to drawing on your assets.

Thus the idea that volatility, presumably negative, doesn’t hurt unless you sell. ?Some people don’t have much choice in the matter. ?They have retired, and they have a lump sum of money that they are managing for long-term income. ?No more money is going in, money is only going out. ?What can you do?

You have to plan before volatility strikes. ?My equity only clients had 14% cash before the recent volatility hit. ?Over the past week I opportunistically brought that down to 10% in names that I would like to own even if the “crisis” deepened. ?That flexibility was built into my management. ?(If the market recovers enough, I will rebuild the buffer. ?Around 1300 on the S&P, I would put all cash to work, and move to the alternative portfolio management strategy where I sell the most marginal ideas one at a time to raise cash and reinvest into the best ideas.)

If an older investor would be?hurt by a drawdown in the stock market, he needs to invest less in stocks now, even if that means having a lower income on average over the longer-term. ?With a higher level of bonds in the portfolio, he could more than?proportionately draw down on bonds during a crisis, which would rebalance his portfolio. ?If and when the stock market recovered, for a time, he could draw on has stock positions more than proportionately then. ?That also would rebalance the portfolio.

Again, plans like that need to be made in advance. ?If you have no plans for defense, you will lose most wars.

One more note: often when we talk about time horizon, it sounds like we are talking about a single future point in time. ?When the time for converting assets to cash is far distant, using a single point may be a decent approximation. ?When the time for converting assets to cash is near, it must be viewed as a stream of payments, and whatever scenario testing, (quasi)?Monte Carlo simulations, and sensitivity analyses are done must reflect that.

Many different scenarios may have the same average rate of return, but the ones with early losses and late gains are pure poison to the person trying to manage a lump sum in retirement. ?The same would apply to an early spike in inflation rates followed by deflation.

The time to plan is now for all contingencies, and please realize that this is an art and not a science, so if someone comes to you with glitzy simulation?analyses, ask them to run the following scenarios: run every 30-year period back as far as the data goes. ?If it doesn’t include the Great Depression, it is not realistic enough. ?Run them forwards, backwards, upside-down forwards, and upside-down backwards. ?(For the upside-down scenarios normalize the return levels to the right side up levels.) ?The idea here is to use real volatility levels in the analyses, because reality is almost always more volatile than models using normal distributions. ?History is meaner, much meaner than models, and will likely be meaner in the future… we just don’t know how it will be meaner.

You will then be surprised at how much caution the models will indicate, and hopefully those who can will save more, run safer asset allocations, and plan to withdraw less over time. ?Reality is a lot more stingy than the models of most financial Dr. Feelgoods out there.

One more note: and I know how to model this, but most won’t — in the Great Depression, the returns after 1931 weren’t bad. ?Trouble is, few were able to take advantage of them because they had already drawn down on their investments. ?The many bankruptcies meant there was a smaller market available to invest in, so the dollar-weighted returns in the Great Depression were lower than the buy-and-hold returns. ?They had to be lower, because many people could not hold their investments for the eventual recovery. ?Part of that was margin loans, part of it was liquidating assets to help tide over unemployment.

It would be wonky, but simulation models would have to have an uptick in need for withdrawals at the very time that markets are low. ?That’s not all that much different than some had to do in the recent financial crisis. ?Now, who is willing to throw *that* into financial planning models?

The simple answer is to be more conservative. ?Expect less from your investments, and maybe you will get positive surprises. ?Better that than being negatively surprised when older, when flexibility is limited.

Prices Have Changed; Not Much Else Has Changed

Posted on 25 August 201525 August 2015 by David Merkel

Photo Credit: Moyan Brenn || My, now doesn't that look peaceful... — Photo Credit: Moyan Brenn || My, now doesn’t that look peaceful…

There is the temptation when market prices move fast after they have been at recent highs to assume that things are going to fall apart. ?Well, guess what? ?That could happen.

I don’t think it is likely though, if falling apart means a scenario like 2008-9,?2000-2 or 1973-4. ?In order to have a significant drawdown in the market, you have to have a lot of leverage collapse, whether that is financial or operating leverage.

Financial leverage is bad debt. ?We have areas of that — student loans, agricultural loans, a modest amount of subprime lending for autos, and a decent amount of lending to junk-rated corporations, but not enough to create a self-reinforcing situation where bad debts can’t be borne by lenders, and lenders then collapse.

Operating leverage is bad assets — building up too much productive capacity such that there will not be enough demand to absorb it for the foreseeable future. ?Or, building capacity that isn’t productive… either way, assets will have to be written down.

There have been a number of parties kvetching about a lack of investment from US corporations, but let’s take this a different direction. ?There hasn’t been a lot of bad investment from US corporations… and part of that may be due to dividend and buyback policies. ?Yes, there are some IPOs that have come out that look marginal. ?I’ve looked at a variety of spin-offs where the underlying business is attractive, but they loaded the spin-off with a sizable slug of debt in order to pay a final dividend to the parent company saying farewell. ?But on the whole, I don’t see a lot of money being wasted by corporations on investments. ?That is another reason why profit margins are high.

Now, a lot of the furor in the markets stems from China, and the effects that slowing growth and/or bad debts in China will have on the US economy. ?Personally, I don’t think this is an issue to worry about, unless you have a lot of investments in China and other emerging markets. ?In general, US markets don’t get deeply hurt by slowdowns or even crises in other countries. ?Even if it means a slowdown in revenue growth for large US corporations, it would also likely mean that US interest rates might fall, which would often make equities fall less as bonds rally.

Also, for foreign affairs to affect the US in a big way, the US would have to have a lot of lending exposure to those nations that are struggling. ?(Think of the LDC nations in the early ’80s.) ?Maybe this is one of the benefits of running current account?deficits — we don’t have money to lend to foreign countries from our net export earnings.

Think of all the significant foreign crises of the last 30 years. ?LDC crisis, Plaza Accords leading to Japan’s lost decades, Mexico, Asian Crisis, European Union difficulties with their fringe nations, Iceland, Greece, Greece, Greece, China, etc. ?There was always temporary indigestion in US markets, but when did it ever weigh on the US markets for a long period? ?Really, it never did. ?So why are we concerned over China?

Regarding the Fed, I abstract from this old post, which quoted a 2005?piece on Fed policy at RealMoney.com, and what blew up at the end of each tightening cycle. ?I list blow-ups up to that point, and mention that I think US Housing is next:

2000 ? Nasdaq
1997-98 ? Asia/Russia/LTCM, though that was a small move for the Fed
1994 ? Mortgages/Mexico
1989 ? Banks/Commercial Real Estate
1987 ? Stock Market
1984 ? Continental Illinois
Early ?80s ? LDC debt crisis

So it moves in baby steps, wondering if the next straw will break some camel?s back where lending has been going on terms that were too favorable. The odds of this 1/4% move creating such a nonlinear change is small, but not zero.

But on the bright side, the odds of a 50 basis point tightening at any point in the next year are even smaller. The markets can?t afford it.

Position: None

Or, these two posts, which you can look at if you want? one suggested that housing was the next bubble (in 2004), and the other critiqued Bernanke?s reasoning on monetary policy.? (Aaron Task has an interesting rejoinder to the latter of these.) — [DM: these links are dead now.]

Some worry now about future Fed policy — what will blow up when the Fed tightens too much? ?I would encourage everyone to relax. ?First, we don’t know that the Fed will do anything soon. ?Second, we don’t know if they will do anything much. ?Third, we don’t even know if the Fed has a coherent theory of monetary policy anymore. ?Face it: Yellen has never tightened rates once. ?Bernanke never tightened rates aside from finishing out Greenspan’s plan to invert the yield curve at the beginning of his Chairmanship. ?Almost no one on the FOMC has any significant practical experience with tightening rates. ?What will guide them out of their zero interest rate policy? ?What will be enough?

Even so, tightening cycles usually end with something blowing up. ?Maybe this time it is the emerging markets. ?I don’t see a large concentration of US-based bad debt that the Fed might inadvertently blow up, at least not yet. ?(Maybe the day will come when the US Treasury might complain about rising financing rates. ?After all, debt is high, but affordable while rates are low.)

Valuation is the main issue as I see it at present, as I commented in my recent piece “Stocks or Bonds?” ?When stocks are priced at a level that discounts 4.5%/year returns over the next 10 years, you don’t have a lot of margin for error, especially when you can create a safer bond portfolio that yields the same.

Now, since I wrote that piece, the S&P 500 is down around 10.5%. ?The bond portfolio is down around 4.5% (it was a risky portfolio, and some of the emerging markets bonds hurt), while the Barclays’ Aggregate is up 1%. ?High-yield bond spreads have widened over that time by ~1.2%.

The anticipated return on the S&P 500 has maybe risen by 1%/year over the next 10 years, to 5.5%. ?That said, so has the yield on the risky bond portfolio. ?I see the selloff as being in-line with the yields of risky debt, which at some higher level of spread, will attract buyers, given that there have been no significant defaults recently.

The US stock market could go down another 20% from here, but I think it will be less. ?My main point is that we shouldn’t get a big washout, but just a correction of valuation levels that got too high relative to other risky assets, like junk bonds.

So don’t panic. ?You could still move some assets from stocks to bonds if you want to sleep better, but don’t do anything severe.

Buying The Next Hot Idea

Posted on 7 August 2015 by David Merkel

If you want to know what is the core problem of the average person approaching the market (though this applies more to males than females, women have more native caution on average), it is chasing a hot idea. ?This can take a number of forms:

Getting tips from friends who have bought some?stock?that is currently popular in the market.
Doing the same thing with investors who talk or write about investing. ?The best investment advice is not flashy, and does not make for good video.
Looking at charts and buying something that is rising rapidly, because popular media say?this is “The Next Big Thing.”
Buying the mutual fund or other pooled vehicle of some manager who has done very well in the past, and seems to never fail. ?(If you buy a mutual fund, don’t buy one that has had a lot of money pile into it recently… usually a bad sign. ?Spend more time to see if the manager thinks in a businesslike way about assets that he buys.)
Going to a broker who is very well-dressed and confident, and talks really well, but who has no obligation to act in your best interests. ?If you don’t know how he is earning his money from you, avoid him, because it usually means investments with high fees or hidden ways that you can lose, e.g. structured notes that offer a nice yield, but where possibilities to lose are more significant than you think. ?At best, he will give you consensus ideas and managers that deliver him above average remuneration.
Buying the newsletter of some overly confident person who claims to know the secrets of the market, which he will share with you and 100,000 other close friends for a mere $299/year! ?(Please read Mark Hulbert before buying a newsletter.)
Worse yet, giving into the fakery of those who try to bring you into a hidden opportunity. ?It can be a Ponzi scheme, a promoted stock, but they suggest returns that are huge… or, like Madoff, decent but not exorbitant returns that are altogether too regular.

Many of these appeal to our desire to get something for nothing, which is endemic — we all have it to some degree, and marketers play off this regularly by offering us “free” this, and “free” that. ?Earning returns from your investable?assets is a business in its own right, and there are costs to doing it well. ?You should not be surprised that doing well with it will take some time and effort.

You also have to avoid the impulse that there is some hidden knowledge, or group of insiders that have found an easy road to riches. ?The markets aren’t rigged in any material way. ?The principles of investing are well-known, but applying them takes creativity, time and effort. ?There are no significant players with a new theory?who make amazing money investing in secondary markets for stocks and bonds.

Most of the things that I listed above involve low-thought imitation of others. ?There is little advantage in investing to mimicry. ?Even if it worked for someone else, the prices are different now, and easy gains have been made. ?You will do worse than the one you are trying to imitate with virtual certainty, and likely worse than average. ?You need to plan to take an independent course, and learn enough such that if you do choose to use advice of any sort, that you can evaluate it rationally. ?If you choose to do it yourself, you will need to learn more than that. ?It takes effort, but that effort will pay off, if not in investing itself, but there are spillover effects in intelligent management of your finances, and in improving your abilities in the businesses that you serve.

In most areas of life, most things that pay off well take effort. ?If people?present you with easy or hidden ways to make above average money, be skeptical. ?Doing it right takes discipline and effort. ?(If you want the easy route while avoiding all the pitfalls see the postscript. ?It is boring, but it works.)

Postscript

As an aside — you can always index, and beat most average investors over the long haul. ?Buy broad funds that invest in a large fraction of all of the stocks that there are, and those that replicate the bond market as a whole. ?Make sure they have low fees. ?Buy them, hold them, and be done. ?You will still face one hurdle: will you be able to maintain your strategy when everything is in a crisis, or when your friends tell you they are earning a lot more than you, and it is easy to do it? ?Size the bond portion of your assets to the level where you can sleep soundly in all circumstances, and you will be fine.

Volume Is Usually Low At Turning Points

Posted on 1 August 2015 by David Merkel

A few days ago, I was trying to buy a little bit of a defense company that I own for myself and clients. ?It was relatively inexpensive, and had fallen out of favor. ?Now, it’s not the most liquid beastie on the US market, so I put in an order to buy 2000 shares, while showing 100 shares, offering to buy at the current bid of $25.50 while allowing purchases at up to $25.57, while the ask was at $25.65. ?I then shifted away from my trading application, and went to do other work.

After an hour, I went back to my trading screen, and saw that 1200 shares had executed between $25.50 and 25.57, but now the price was much higher, and by the end of the day, higher still. ?It is even higher now.

At the time, I took a look, and lo and behold: I got the bottom tick — the lowest price on that stock ever (for now). ?I also noted that I had almost all of the volume when it went down to the low price. ?But 1200 shares is small compared to the total trading in the name, and $30,000 is also a small amount of money. ?I concluded that it was a happy accident that I got the bottom tick.

I’ve had the same experience working at a hedge fund. ?I would occasionally get the bottom tick when buying, or the top tick when selling, and most of the time I ended up saying that it had to happen to someone — it was us that day. ?That said, the total amount of volume was almost always low near the top or bottom, so getting that versus a trade nearby was not worth that much.

To have a lot of volume near a top or bottom, you need two or more determined and anxious traders with large capacity to trade, a need for speed, and opposite opinions. ?That happens sometimes, but in experience, not that often. ?Near a peak, you would need a buyer anxious to buy a lot more NOW. ?Near a trough, a seller wanting to sell it all NOW.

Most of the time, large institutional investors are cautious, and try to minimize their impact on market prices — being too aggressive will likely give them a worse result than being patient. ?The exception would be someone who thinks he knows a lot more than the market, but feels that edge will erode soon, and therefore has to do the trade in full NOW.

That doesn’t happen often. ?Practically, that means to not be so picky about levels in buying and selling. ?If you are getting the trade off and there is decent volume at a price near where you want to do the trade, do the trade, and don’t worry much about the small amount of profit that you might be giving up. ?Better to focus on ideas that you think have long term potential for profit, than to waste time trying to squeeze the last bit of profit out of a trade where incremental returns will be minuscule.

Redacted Version of the July 2015 FOMC Statement

Posted on 29 July 2015 by David Merkel

Photo credit: jonesylife || Oh look, a dozen doves flying at the FOMC!

June 2015	July 2015	Comments
Information received since the Federal Open Market Committee met in April suggests that economic activity has been expanding moderately after having changed little during the first quarter.	Information received since the Federal Open Market Committee met in June indicates that economic activity has been expanding moderately in recent months.	No real change.
Growth in household spending has been moderate and the housing sector has shown some improvement; however, business fixed investment and net exports stayed soft.	Growth in household spending has been moderate and the housing sector has shown additional improvement; however, business fixed investment and net exports stayed soft.	No real change. Swapped places with the following sentence.
The pace of job gains picked up while the unemployment rate remained steady. On balance, a range of labor market indicators suggests that underutilization of labor resources diminished somewhat.	The labor market continued to improve, with solid job gains and declining unemployment. On balance, a range of labor market indicators suggests that underutilization of labor resources has diminished since early this year.	No real change. Swapped places with the previous sentence.
Inflation continued to run below the Committee’s longer-run objective, partly reflecting earlier declines in energy prices and decreasing prices of non-energy imports; energy prices appear to have stabilized.	Inflation continued to run below the Committee’s longer-run objective, partly reflecting earlier declines in energy prices and decreasing prices of non-energy imports.	No real change.
Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations have remained stable.	Market-based measures of inflation compensation remain low; survey?based measures of longer-term inflation expectations have remained stable.	No change.? TIPS are showing higher inflation expectations since the last meeting. 5y forward 5y inflation implied from TIPS is near 2.10%, up 0.07% from April.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.	Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.	No change. Any time they mention the ?statutory mandate,? it is to excuse bad policy.
The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators continuing to move toward levels the Committee judges consistent with its dual mandate.	The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators continuing to move toward levels the Committee judges consistent with its dual mandate	No real change.
The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced. Inflation is anticipated to remain near its recent low level in the near term, but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of earlier declines in energy and import prices dissipate. The Committee continues to monitor inflation developments closely.	The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced. Inflation is anticipated to remain near its recent low level in the near term, but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of earlier declines in energy and import prices dissipate. The Committee continues to monitor inflation developments closely.	CPI is at +0.2% now, yoy.? No change in language.
To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.	To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.	No change.
The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.	The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen some further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.	No real change. No rules, just guesswork from academics and bureaucrats with bad theories on economics.
The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.	The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.	No change.? Changing that would be a cheap way to effect a tightening.
When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.	When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.	No Change. ?Balanced? means they don?t know what they will do, and want flexibility.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Jeffrey M. Lacker; Dennis P. Lockhart; Jerome H. Powell; Daniel K. Tarullo; and John C. Williams.	Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Jeffrey M. Lacker; Dennis P. Lockhart; Jerome H. Powell; Daniel K. Tarullo; and John C. Williams.	No change, sadly. We need some people in the Fed and in the government who realize that balance sheets matter ? for households, corporations, governments, and central banks.? Remove anyone who is a neoclassical economist ? they missed the last crisis; they will miss the next one.

Comments

This FOMC statement was another great big nothing. No significant changes.
Don?t expect tightening in September. People should conclude that the FOMC has no idea of when the FOMC will tighten policy, if ever.? This is the sort of statement they issue when things are ?steady as you go.?? There is no hint of imminent policy change.
Despite lower unemployment levels, labor market conditions are still pretty punk. Much of the unemployment rate improvement comes more from discouraged workers, and part-time workers.? Wage growth is weak also.
Equities and long bonds rise. Commodity prices and the dollar are flat.
The FOMC says that any future change to policy is contingent on almost everything.
Don?t know they keep an optimistic view of GDP growth, especially amid falling monetary velocity.
The key variables on Fed Policy are capacity utilization, labor market indicators, inflation trends, and inflation expectations. As a result, the FOMC ain?t moving rates up, absent improvement in labor market indicators, much higher inflation, or a US Dollar crisis.
We have a congress of doves for 2015 on the FOMC. Things will continue to be boring as far as dissents go.? We need some people in the Fed and in the government who realize that balance sheets matter ? for households, corporations, governments, and central banks.? Remove anyone who is a neoclassical economist ? they missed the last crisis; they will miss the next one.

Pick a Valid Strategy, Stick With It

Posted on 29 July 2015 by David Merkel

I’m not going to argue for any particular strategy here. My main point is this: every valid strategy is going to have some periods of underperformance. ?Don’t give up on your strategy because of that; you are likely to give up near?the point of maximum pain, and miss the great returns in the?bull phase of the strategy.

Here?are three?simple bits of advice that I hand out to average people regarding asset allocation:

Figure out what the maximum loss is that you are willing to take in a year, and then size your allocation to risky assets such that the likelihood of exceeding that loss level is remote.
If you have any doubts on bit of advice #1, reduce the amount of risky assets a bit more. ?You’d be surprised how little you give up in performance from doing so. ?The loss from not allocating to risky assets that return better on average is partly mitigated by a bigger payoff from rebalancing from risky assets to safe, and back again.
Use additional money slated for investing?to rebalance the portfolio. ?Feed your losers.

The first rule is most important, because the most important thing here is avoiding panic, leading to selling risky assets when prices are depressed. ?That is the number one cause of underperformance for average investors. ?The second rule is important, because it is better to earn less and be able to avoid panic than to risk losing your nerve. ?Rule three just makes it easier to maintain your portfolio; it may not be applicable if you follow a momentum strategy.

Now, about momentum strategies — if you’re going to pursue strategies where you are always buying the assets that are presently behaving strong, well, keep doing it. ?Don’t give up during the periods where it doesn’t seem to work, or when it occasionally blows up. ?The best time for any strategy typically come after a lot of marginal players give up because losses exceed their pain point.

That brings me back to rule #1 above — even for a momentum strategy, maybe it would be nice to have some safe assets?on the side to turn down the total level of risk. ?It would also give you some money to toss into the strategy after the bad times.

If you want to try a new strategy, consider doing it when your present strategy has been doing well for a while, and you see new players entering the strategy who think it is magic. ?No strategy is magic; none work all the time. ?But if you “harvest” your strategy when it is mature, that would be the time to do it. ?It would be similar to a bond manager reducing exposure to risky bonds when the additional yield over safe bonds is thin, and waiting for a better opportunity to take risk.

But if you do things like that, be disciplined in how you do it. ?I’ve seen people violate their strategies, and reinvest in the hot asset when the bull phase lasts too long, just in time for the cycle to turn. ?Greed got the better of them.

Markets are perverse. ?They deliver surprises to all, and you can be prepared to react to volatility by having some safe assets to tone things down, or, you can roll with the volatility fully invested and hopefully not panic. ?When too many unprepared people are fully invested in risky assets, there’s a nasty tendency for the market to have a significant decline. ?Similarly, when people swear off investing in risky assets, markets tend to perform really well.

It all looks like a conspiracy, and so you get a variety of wags in comment streams alleging that the markets are rigged. ?The markets aren’t rigged. ?If you are a soldier heading off for war, you have to mentally prepare for it. ?The same applies to investors, because investing isn’t perfectly easy, but a lot of players say that it is easy.

We can make investing easier by restricting the choices that you have to make to a few key ones. ?Index funds. ?Allocation funds that use index funds that give people a single fund to buy that are?continually rebalanced. ?But you would still have to exercise discipline to avoid fear and greed — and thus my three example rules above.

If you need more confirmation on this, re-read my articles on dollar-weighted returns versus time-weighted returns. ?Most trading that average people do loses money versus buying and holding. ?As a result, the best thing to do with any strategy is to structure it so that you never take actions out of a sense of regret for past performance.

That’s easy to say, but hard to do. ?I’m subject to the same difficulties that everyone else is, but I worked to create rules to limit my behavior during times of investment pain.

Your personality, your strategy may differ from mine, but the successful meta-strategy is that you should be disciplined in your investing, and not give into greed or panic. ?Pursue that, whether you invest like me or not.

We Eat Dollar Weighted Returns ? VI

Posted on 22 July 201522 July 2015 by David Merkel

One of the constants in investing is that average investors show up late to the party or to the crisis. ?Unlike many gatherings where it may be cool to be fashionably late, in investing it tends to mean you earn less and lose more, which is definitely not cool.

One reason why this happens is that information gets distributed in lumps. ?We don’t notice things in real time, partly because we’re not paying attention to the small changes that are happening. ?But after enough time passes, a few people notice a trend. ?After a while longer, still more people notice the trend, and it might get mentioned in some special purpose publications, blogs, etc. ?More time elapses and it becomes a topic of conversation, and articles make it into the broad financial press. ?The final phase is when?general interest magazines put it onto the cover, and get rich quick articles and books point at how great fortunes have been made, and you can do it too!

That slow dissemination and?gathering of information is paralleled by a similar flow of money, and just as the audience gets wider, the flow of money gets bigger. ?As the flow of money in or out gets bigger, prices tend to overshoot fair value, leaving those who arrived last with subpar returns.

There is another aspect to this, and that stems from the way that people commonly evaluate managers. ?We use past returns as a prologue to what is assumed to be still?greater returns in the future. ?This not only applies to retail investors but also many institutional investors. ?Somme institutional investors will balk at this conclusion, but my experience in talking with institutional investors has been that though they look at many of the right forward looking indicators of manager quality, almost none of them will hire a manager that has the right people, process, etc., and has below average returns relative to peers or indexes. ?(This also happens with hedge funds… there is nothing special in fund analysis there.)

For the retail crowd it is worse, because?most investors look at past returns when evaluating managers. ?Much as Morningstar is trying to do the right thing, and have forward looking analyst ratings (gold, silver, bronze, neutral and negative), yet much of the investing public will not touch a fund unless it has four or five stars from Morningstar, which is a backward looking rating. ?This not only applies to individuals, but also committees that choose funds for defined contribution plans. ?If they don’t choose the funds with four or five stars, they get complaints, or participants don’t use the funds.

Another Exercise in Dollar-Weighted Returns

One of the ways this investing shortfall gets expressed is looking at the difference between time-weighted (buy-and-hold) and dollar-weighted (weighted geometric average/IRR) returns. ?The first reveals what an investor who bought and held from the beginning earned, versus what the average dollar invested earned. ?Since money tends to come after good returns have been achieved, and money tends to leave after bad returns have been realized, the time-weighted returns are typically higher then the dollar-weighted returns. ?Generally, the more volatile the performance of the investment vehicle the larger the difference between time- and dollar-weighted returns gets. ?The greed and fear cycle is bigger when there is more volatility, and people buy and sell at the wrong times to a greater degree.

(An aside: much as some pooh-pooh buy-and-hold investing, it generally beats those who trade. ?There may be intelligent ways to trade, but they are always a minority among market actors.)

HSGFX Dollar Weighted Returns — HSGFX Dollar and Time Weighted Returns

That brings me to tonight’s fund for analysis: Hussman Strategic Growth [HSGFX]. John Hussman, a very bright guy, has been trying to do something very difficult — time the markets. ?The results started out promising, attracting assets in the process, and then didn’t do so well, and assets have slowly left. ?For my calculation this evening, I run the calculation on his fund with the longest track record from inception to 30 June 2014. ?The fund’s fiscal years end on June 30th, and so I assume cash flows occur at mid-year as a simplifying assumption. ?At the end of the scenario, 30 June 2014, I assume that all of the funds remaining get paid out.

To run this calculation, I do what I have always done, gone to the SEC EDGAR website and look at the annual reports, particularly the section called “Statements of Changes in Net Assets.” ?The cash flow for each fiscal year is equal to the?net increase in net assets from capital share transactions plus the net decrease in net assets from distributions to shareholders. ?Once I have?the amount of money moving in or out of the fund in each fiscal year, I can then run an internal rate of return calculation to get the dollar-weighted rate of return.

In my table, the cash flows into/(out of) the fund are in millions of dollars, and the column titled Accumulated PV is the?accumulated present value calculated at an annualized rate of -2.56% per year, which is the dollar-weighted rate of return. ?The zero figure at the top shows that a discount rate -2.56% makes the cash inflows and outflows net to zero.

From the beginning of the Annual Report for the fiscal year ended in June 2014, they helpfully provide the buy-and-hold return since inception, which was +3.68%. ?That gives a difference of 6.24% of how much average investors earned less than the buy-and-hold investors. ?This is not meant to be a criticism of Hussman’s performance or methods, but simply a demonstration that a lot of people invested money after the fund’s good years, and then removed money after years of underperformance. ?They timed their investment in a market-timing fund poorly.

Now, Hussman’s fund may do better when the boom/bust cycle turns if his system makes the right move?somewhere near the bottom of the cycle. ?That didn’t happen in 2009, and thus the present state of affairs. ?I am reluctant to criticize, though, because I tried running a strategy like this for some of my own clients and did not do well at it. ?But when I realized that I did not have the personal ability/willingness to?buy when valuations were high even though the model said to do so because of momentum, rather than compound an error, I shut down the product, and refunded some fees.

One thing I can say with reasonable confidence, though: the low returns of the past by themselves are not a reason to not invest in Mr. Hussman’s funds. ?Past returns by themselves tell you almost nothing about future returns. ?The hard questions with a fund like this are: when will the cycle turn from bullish to bearish? ?(So that you can decide how long you are willing to sit on the sidelines), and when the cycle turns from bearish to bullish, will Mr. Hussman make the right decision then?

Those questions are impossible to answer with any precision, but at least those are the right questions to ask. ?What, you’d rather have the answer to a simple question like how did it return?in the past, that has no bearing on how the fund will do in the future? ?Sadly, that is the answer that propels more investment decisions than any other, and it is what leads to bad overall investment returns on average.

PS — In future articles in this irregular series, I will apply this to the Financial Sector Spider [XLF], and perhaps some fund of Kenneth Heebner’s. ?Till then.

What is Liquidity? (Part VIII)

Posted on 17 July 201517 July 2015 by David Merkel

Here are some simple propositions on liquidity:

Liquidity is positively influenced by the quality of an?asset
Liquidity is positively influenced by the simplicity of an?asset
Liquidity is negatively influenced by the price momentum?of an?asset
Liquidity is negatively influenced by the level of fear (or overall market price volatility)
Liquidity is negatively influenced by the length of an asset’s cash flow stream
Liquidity is negatively influenced by concentration of the holders of an asset
Liquidity is negatively influenced by the length of the?time horizon?of the holders of an asset
Liquidity is positively influenced by the amount of information available about an asset, but negatively affected by changes in the information about an asset
Liquidity is negatively influenced by the level of indebtedness of owners and potential buyers of an asset
Liquidity is negatively influenced by similarity of trading strategies?of owners and potential buyers of an asset

Presently, we have a lot of commentary about how the bond market is supposedly illiquid. ?One particular example is the so-called flash crash in the Treasury market that took place on October 15th, 2014. ?Question: does a moment of illiquidity imply that the US Treasury market is somehow illiquid? ?My answer is no. ?Treasuries are high quality assets that are simple. ?So why did the market become illiquid for a few minutes?

One reason is that the base of holders and buyers is more concentrated. ?Part of this is the Fed holding large amounts of virtually every issue of US Treasury debt from their QE strategy. ?Another part is increasing concentration on the buyside. ?Concentration among banks, asset managers, and insurance companies has risen over the last decade. ?Exchange-traded products have further added to concentration.

Other factors include that ten-year Treasuries are long assets. ?The option of holding to maturity means you will have to wait longer than most can wait, and most institutional investors don’t even have an average 10-year holding period. ?Also, presumably, at least for a short period of time, investors had similar strategies for trading ten-year Treasuries.

So, when the market had a large influx of buyers, aided by computer algorithms,?the prices of the bonds rose rapidly. ?When prices do move rapidly, those that make their money off of brokering trades take some quick losses, and back away. ?They may still technically be willing to buy or sell, but the transaction sizes drop and the bid/ask spread widens. ?This is true regardless of the market that is panicking. ?It takes a while for market players to catch up with a fast market. ?Who wants to catch a falling (or rising) knife? ?Given the interconnectedness of many fixed income markets who could be certain who was driving the move, and when the buyers would be sated?

For the crisis to end, real money sellers had to show up and sell ten-year Treasuries, and sit on cash. ?Stuff the buyers full until they can’t bear to buy any more. ?The real money sellers had to have a longer time horizon, and say “We know that over the next ten years, we will be easily able to beat a sub-2% return, and we can live with the mark-to-market risk.” ?So, though they sold, they were likely expressing a long term view that interest rates have some logical minimum level.

Once the market started moving the other way, it moved back quickly. ?If anything, traders learning there was no significant new information were willing to sell all the way to levels near the market opening levels. ?Post-crisis, things returned to “normal.”

My Conclusion

I wouldn’t make all that much out of this incident. ?Complex markets can occasionally burp. ?That is another aspect of a normal market, because it teaches investors not to be complacent.

Don’t leave the computer untended.

Don’t use market orders, particularly on large trades.

Be sure you will be happy getting executed on your limit order, even if the market blows far past that.

Graspy regulators and politicians see incidents like this as an opportunity for more regulations. ? That’s not needed. ?It wasn’t needed in October 1987, nor in May 2009. ?It is not needed now.

Losses from errors are a great teacher. ?I’ve suffered my own losses on misplaced market orders and learned from them. ?Instability in markets is a good thing, even if a lot of price movement is just due to “noise traders.”

As for the Treasury market — the yield on the securities will always serve as an aid to mean-reversion, and if there is no fundamental change, it will happen quickly. ?There was no liquidity problem on October 15th. ?There was a problem of a few players mistrading a fast market with no significant news. ?By its nature, for a brief amount of time, that will look illiquid. ?But it is proper?for those conditions, and gave way to a normal market, with normal liquidity rapidly.

That’s market resilience in the face of some foolish market players. ?That the foolish players took losses was a good thing. ?Fundamentals always take over, and businesslike investors profit then. ?What could be better?

One final aside: other articles in this irregular series can be found here.

Gundlach vs Morningstar

Posted on 15 July 2015 by David Merkel

I’ve been on both sides of the fence. ?I’ve been a bond manager, with a large, complex (and illiquid) portfolio, and I have been a selector of managers. ?Thus the current squabble between Jeffrey Gundlach and Morningstar isn’t too surprising to me, and genuinely, I could side with either one.

Let me take Gundlach’s side first. ?If you are a bond manager, you have to be fairly bright. ?You need to understand the understand the compound interest math, and also how to interpret complex securities that come in far more flavors than common stocks. ?This is particularly true today when many top managers are throwing a lot of derivative instruments into their portfolios, whether to earn returns, or shed risks. ?Aspects of the lending markets that used to be the sole province of the banks and other lenders are now available for bond managers to buy in a securitized form. ?Go ahead, take a look at any of the annual reports from Pimco or DoubleLine and get a sense of the complexity involved in running these funds. ?It’s pretty astounding.

So when the fund analyst comes along, whether for a buy-side firm, an institutional fund analyst, or retail fund analyst who does more than just a little number crunching, you realize that the fund analyst?likely knows less about what you do than one of your junior analysts.

One of the issues that Morningstar had ?was with DoubleLine’s holdings of?nonagency residential mortgage-backed securities [NRMBS]. ?These securities lost a lot of value 2007-2009 during the financial crisis. ?Let me describe what it was like in a chronological list:

2003 and prior: NRMBS is a small part of the overall mortgage bond market, with relatively few players willing to take credit risk instead of buying mortgage bonds guaranteed by Fannie, Freddie and Ginnie. ?Much of the paper is in the hands of specialists and some life insurance companies.
2004-2006 as more subprime lending goes on amid a boom in housing prices, credit quality standards fall and life insurance buyers slowly?stop purchasing the securities. ?A new yield-hungry group of buyers take their place, with not much focus on what could go wrong.
Parallel to this, a market in credit derivatives grows up around the NRMBS market?with more notional exposure than the underlying market. ?Two sets of players: yield hogs that need to squeeze more income out of their portfolios, and hedge funds seeing the opportunity for a big score when the housing bubble pops. ?At last, a way to short housing!
2007: Pre-crisis, the market for NRMBS starts to sag, but nothing much happens. ?A few originators get into trouble, and a bit of risk differentiation comes into a previously complacent market.
2008-2009: the crisis hits, and it is a melee. ?Defaults spike, credit metrics deteriorate, and housing prices fall. ?Many parties sell their bonds merely to get rid of the taint in their portfolios. ?The credit derivatives exacerbate a bad situation. ?Prices on many NRMBS fall way below rational levels, because there are few traditional buyers willing to hold them. ?The regulators of financial companies and rating agencies are watching mortgage default risk carefully, so most regulated financial companies can’t hold the securities without a lot of fuss.
2010+ Nontraditional buyers like flexible hedge funds develop expertise and buy the NRMBS, as do some flexible bond managers who have the expertise in?staff skilled in analyzing the creditworthiness of bunches of securitized mortgages.

Now, after a disaster in a section of the bond market, the recovery follows a pattern like triage. ?Bonds get sorted into three buckets: those likely to yield a positive return on current prices, those likely to yield a negative return on current prices, and those?where you can’t tell. ?As time goes along, the last two buckets shrink. ?Market players revise prices down for the second bucket, and securities in the third bucket typically join one of the other two buckets.

Typically, though, lightning doesn’t strike twice. ?You don’t get another crisis event that causes that class of?securities to become disordered again, at least, not for a while. ?We’re always fighting the last war, so if credit deterioration is happening, it is in a new place.

And thus the problem in talking to the fund analyst. ?The securities were highly risky at one point, so aren’t they risky now? ?You would like to say, “No such thing as a bad asset, only a bad price,” but the answer might sound too facile.

Only a few managers devoted the time and effort to analyzing these securities after the crisis. ?As such, the story doesn’t travel so well. ?Gundlach already has a lot of money to manage, and more money is flowing in, so he doesn’t have to care whether Morningstar truly understands what DoubleLine does or not. ?He can be happy with a slower pace of asset growth, and the lack of accolades which might otherwise go to him…

But, one of the signs of being truly an expert is being able to explain it to lesser mortals. ?It’s like this story of the famous physicist Richard Feynman:

Feynman was a truly great teacher. He prided himself on being able to devise ways to explain even the most profound ideas to beginning students. Once, I said to him, “Dick, explain to me, so that I can understand it, why spin one-half particles obey Fermi-Dirac statistics.” Sizing up his audience perfectly, Feynman said, “I’ll prepare a freshman lecture on it.” But he came back a few days later to say, “I couldn’t do it. I couldn’t reduce it to the freshman level. That means we don’t really understand it.”

Like it or not, the Morningstar folks have a job to do, and they will do it whether DoubleLine cooperates or not. ?As in other situations in the business world, you have a choice. ?You could task smart subordinates to spend adequate time teaching the Morningstar analyst your thought processes, or, live with the results of someone who fundamentally does not understand what you do. ?(This applies to bosses as well.)

In the end, this may not matter to DoubleLine. ?They have enough assets to manage, and then some. ?But in the end, this could matter to Morningstar. ?It says a lot if you can’t analyze one of the best funds out there. ?That would mean you really don’t understand well the fixed income business as it is presently configured. ?As such, I would say that it is incumbent on Morningstar to take the initiative, apologize to DoubleLine, and try to re-establish good communications. ?If they don’t, the loss is Morningstar’s, and that of their subscribers.

Sixteen Implications of “The Phases of an Investment Idea”

Posted on 2 July 2015 by David Merkel

My last post has many implications. I want to make them clear in this post.

When you analyze?a manager, look at the repeatability of his processes. ?It’s possible that you could get “the Big Short” right once, and never have another good investment idea in your life. ?Same for investors who are the clever ones who picked the most recent top or bottom… they are probably one-trick ponies.
When a manager does well and begins to pick up a lot of new client assets, watch for the period where the growth slows to almost zero. ?It is quite possible that some of the great performance during the high growth period stemmed from asset prices rising due to the purchases of the manager himself. ?It might be a good time to exit, or, for shorts to consider the assets with the highest percentage of market cap owned as targets for shorting.
Often when countries open up to foreign investment, valuations are relatively low. ?The initial flood of money in often pushes up valuations, leads to momentum buyers, and a still greater flow of money. ?Eventually an adjustment comes, and shakes out the undisciplined investors. ?But, when you look at the return series analyze potential future investment, ignore the early years — they aren’t representative of the future.
Before an academic paper showing a way to invest that would been clever to use in the past gets published, the excess returns are typically described as coming from valuation, momentum, manager skill, etc. ?After the paper is published, money starts getting applied to the idea, and the strategy will do well initially. ?Again, too much money can get applied to a limited factor (or other) anomaly, because no one knows how far it can get pushed before the market rebels. ?Be careful when you apply the research — if you are late, you could get to hold the bag of overvalued companies. ?Aside for that, don’t assume that performance from the academic paper’s era or the 2-3 years after that will persist. ?Those are almost always the best years for a factor (or other) anomaly strategy.
During a credit boom, almost every new type of fixed income security, dodgy or not, will look like genius by?the early purchasers. ?During a credit bust, it is rare for a new security type to fare well.
Anytime you take a large position in an obscure security, it must jump through extra hoops to assure a margin of safety. ?Don’t assume that merely because you are off the beaten path that you are a clever contrarian, smarter than most.
Always think about the carrying capacity of a strategy when you look at an academic paper. ?It might be clever, but it might not be able to handle a lot of money. ?Examples would include trying to do exactly what Ben Graham did in the early days today, and things like Piotroski’s methods, because typically only a few small and obscure stocks survive the screen.
Also look at how an academic paper models trading and liquidity, if they give it any real thought at all. ?Many papers embed the idea that liquidity is free, and large trades can happen where prices closed previously.
Hedge funds and other manager databases should reflect that some managers have closed their funds, and put them in a separate category, because new money can’t be applied to those funds. ?I.e., there should be “new money allowed” indexes.
Max Heine, who started the Mutual Series funds (now part of Franklin), was a genius when he thought of the strategy 20% distressed investing, 20% arbitrage/event-driven investing and 60% value investing. ?It produced great returns 9 years out of 10. ?but once distressed investing and event-driven because heavily done, the idea lost its punch. ?Michael Price was clever enough to sell the firm to Franklin before that was realized, and thus capitalizing the past track record that would not?do as well in the future.
The same applies to a lot of clever managers. ?They have a very good sense of when their edge is getting dulled by too much competition, and where the future will not be as good as the past. ?If they have the opportunity to sell, they will disproportionately do so then.
Corporate management teams are like rock bands. ?Most of them never have a hit song. ?(For managements, a period where a strategy improves profitability far more than most would have expected.) ?The next-most are one-hit wonders. ?Few have multiple hits, and rare are those that create a culture of hits. ?Applying this to management teams — the problem is if they get multiple bright ideas, or a culture of success, it is often too late to invest, because the valuation multiple adjusts to reflect it. ?Thus, advantages accrue to those who can spot clever managements before the rest of the market. ?More often this happens in dull industries, because no one would think to look there.
It probably doesn’t make sense to run from hot investment idea to hot investment idea as a result of all of this. ?You will end up getting there once the period of genius is over, and valuations have adjusted. ?It might be better to buy the burned out stuff and see if a positive surprise might come. ?(Watch margin of safety…)
Macroeconomics and the effect that it has on investment returns is overanalyzed, though many get the effects wrong anyway. ?Also, when central bankers and politicians take cues from the prices of risky assets, the feedback loop confuses matters considerably. ?if you must pay attention to macro in investing, always ask, “Is it priced in or not? ?How much of it is priced in?”
Most asset allocation work that relies on past returns is easy to do and bogus. ?Good asset allocation is forward-looking and ignores past returns.
Finally, remember that some ideas seem?right by accident — they aren’t actually right. ?Many academic papers don’t get published. ?Many different methods of investing get tried. ?Many managements try new business ideas. ?Those that succeed get air time, whether it was due to intelligence or luck. ?Use your business sense to analyze which it might be, or, if it is a combination.

There’s more that could be said here. ?Just be cautious with new investment strategies, whatever form they may take. ?Make sure that you maintain a margin of safety; you will likely need it.