Photo Credit: Brett Davies || Waiting, but to what end?
When I worked in the investment department of a number of life insurers, every now and then I would hear one of the portfolio managers say, “We know that the rating agencies are going to downgrade the bonds of XYZ Corp, but?we like the story. ?We’re just waiting until after the downgrade, and then we will buy, because they will be cheaper then.”
And, sometimes it would work. ?Other times, nothing would happen at the downgrade, and they would buy at the same price. ?But more interesting and frequent were the times when the bonds would rally after the downgrade, which would make the portfolio managers wince and say, “Guess everyone else was waiting to buy also.”
Now, there was a point in time where the corporate bond market was more strictly segmented, and getting downgraded, if was severe enough, would mean there was a class of holders that would become forced sellers, and thus it paid to wait for downgrades. ?But as with many market inefficiencies, a combination of specialists focusing on the inefficiency and greater flexibility on the part of former forced sellers made it disappear, or at least, make it unpredictable.
But so what? ?Bonds are dull, right? ?Well, no, but most think so. ?What about stocks? ?What if you want to buy a stock that you think is going to rise, but you are waiting for a pullback in order to buy?
In order to to get this one right, you have to get multiple things right:
The stock is a good buy long term, and not enough parties know it
The stock is short-term overbought by flexible money
Other longer-term buyers aren’t willing to buy it at the current level and down to the level where you would like to buy.
The correction doesn’t make quantitative managers panic, sell, and the price overshoots your level.
Maybe the last one isn’t so bad — no such thing as a bad trade, only an early trade, if the stock is good long term?
That’s one reason why I do two things:
I tend to buy the things I like now. ?I don’t wait. ?Timing is not a core skill of mine, or of most investors — if you are mostly right, go with it.
I pursue multiple ideas at the same time. ?If I have multiple ideas to put new money into, the probability is greater that I get a good deal on the one that I choose.
The same idea would?apply to waiting to sell. ?Maybe you think it is fully valued, but will have one more good quarterly earnings number, and somehow the rest of the world doesn’t know also.
Hint: do it now. ?If you are truly uncertain, do half. ?It’s tough enough to get one thing right. ?Getting short-term timing right verges on the impossible. ?Better to act on your strongest long-term sense of value than trying to get the short-run perfect. ?You will do best in the long run that way.
Photo Credit: whologwhy || Danger: Butterfly at work!
There’s a phenomenon called the Butterfly Effect. ?One common quotation is “It has been said that something as small as the flutter of a butterfly’s wing can ultimately cause a typhoon halfway around the world.”
Today I am here to tell you that for that to be true, the entire world would have to be engineered to allow the butterfly to do that. ?The original insight regarding how small changes to complex systems occurred as a result of changing a parameter by a little less than one ten-thousandth. ?Well, the force of a butterfly and that of a large storm are different by a much larger margin, and the distances around the world contain many effects that dampen any action — even if the wind travels predominantly one direction for a time, there are often moments where it reverses. ?For the butterfly flapping its wings to accomplish so much, the system/machine would have to be perfectly designed to amplify the force and transmit it across very long distances without interruption.
I have three analogies for this: the first one is arrays of dominoes. ?Many of us have seen large arrays of dominoes set up for a show, and it only takes a tiny effort of knocking down the first one to knock down the rest. ?There is a big effect from a small initial?action. ?The only way that can happen, though, is if people spend a lot of time setting up an unstable system to amplify the initial action. ?For anyone that has ever set up arrays of dominoes, you know that you have to leave out dominoes regularly while you are building, because accidents will happen, and you don’t want the whole system to fall as a result. ?At the end, you come back and fill in the missing pieces before showtime.
The second example is a forest fire. ?Dry conditions and the buildup of lower level brush allow for a large fire to take place after some small action like a badly tended campfire, a cigarette, or a lightning strike starts the blaze. ?In this case, it can be human inaction (not creating firebreaks), or action (fighting fires allows the dry brush to build up) that helps encourage the accidentally started fire to be a huge one, not merely a big one.
My last example is markets. ?We have infrequently?seen volatile markets where the destruction?is huge. ?A person?with a modest knowledge of statistics will say something like, “We have just witnessed a 15-standard deviation event!” ?Trouble is, the economic world is more volatile than a normal distribution because of one complicating factor: people. ?Every now and then, we engineer crises that are astounding, where the beginning of the?disaster seems disproportionate to the end.
There are many actors that take there places on stage for the biggest economic disasters. ?Here is a partial list:
People need to pursue speculation-based and/or debt-based prosperity, and do it as a group. ?Collectively, they need to take action such that the prices of the assets that they pursue rise significantly above the equilibrium levels that ordinary cash flow could prudently finance.
Lenders have to be willing to make loans on inflated values, and ignore older limits on borrowing versus likely income.
Regulators have to turn a blind eye to the weakened lending processes, which isn’t hard to do, because who dares oppose a boom?? Politicians will?play a role, and label prudent regulations as “business killers.”
Central bankers have to act like hyperactive forest rangers, providing liquidity for the most trivial of financial crises, thus allowing the dry tinder of bad debts to build up as bankers use cheap funding to make loans they never dreamed that they could.
It helps if you have parties interested in perpetuating the situation, suggesting that the momentum is unstoppable, and that many people are fools to be passing up the “free money.” ?Don’t you know that “Everybody ought to be rich?” [DM: then who will deliver the pizza? ?Are you really rich if you can’t get a pizza delivered?] ?These parties can be salesmen, journalists, authors, etc. whipping up a frenzy of speculation. ?They also help marginalize as?”cranks” the wise critics who point out that the folly eventually will have to end.
Promises, promises. ?And all too good to be true, but it all looks reasonable in the short run, so the game continues. ?The speculation can take many forms: houses, speculative companies like dot-coms or railroads, even stocks themselves on sufficient margin debt. ?And, dare I say it, it can even apply to old age security schemes, but we haven’t seen the endgame for that one yet.
At the end, the disaster appears out of nowhere. ?The weak link in the chain breaks — vendor financing, repo financing, a run on bank deposits, margin loans, subprime loans — that which was relied on for financing becomes recognized as a short-term?obligation that must be met, and financing terms change dramatically, leading the entire system to recognize that many assets are overpriced, and many borrowers are inverted.
Congratulations, folks, we created a black swan. ?A very different event appears than what many were counting on, and a bad?self-reinforcing cycle ensues. ?And, the proximate cause is unclear, though the causes were many in society pursuing an asset boom, and borrowing and speculating as if there is no tomorrow. ?Every individual action might be justifiable, but the actions as a group lead to a crisis.
In closing, though I see some bad lending reappearing, and a variety of assets at modestly speculative prices, there is no obvious crisis facing us in the short-run, unless it stems from a foreign problem like Chinese banks. ?That said, the pension promises made to those older in most developed countries are not sustainable. ?That one will approach slowly, but it will eventually bite, and when it does, many will say, “No one could have predicted this disaster!”
It was winter in early 1995, and I was wondering if I still had a business selling Guaranteed Investment Contracts [GICs]. ?Confederation Life had gone insolvent the August prior, and I noticed that fewer and fewer stable value funds wanted to purchase my GICs, because our?firm was small, and as such, did not get a good credit rating, despite excellent credit metrics. ?The lack of a good rating kept buyers away.
Still, I felt I needed to try my best for one more year or so, despite my feelings that the business was?dying soon. ?With that attitude, I headed off in January to sunny Southern California, to attend GICs ’95, something my opposite number at AIG referred to as a Schmoozathon.
Schmoozathon? ?Well, you took your opportunities to ingratiate yourself with current and potential clients, across four days and three nights of meetings, with a variety of parties going on. ?I was not the best salesman, so I just tried to play it as straight as I could.
In the middle of the whole affair was a special lunch where Bill Gross was to be the Keynote Speaker. ?Because I was talking with a client, I got to the lunch a little late, and ended up at a table near the back of the room.
Things were running a little behind, but Bill Gross got up and gave a talk that borrowed heavily from a recent Pimco Investment Outlook that he had written, comparing the current market opportunities to Butler Creek?(see paragraph 6), a creek that he grew up near as a kid, which gently meandered, went kinda straight, kinda not, but didn’t vary all that much when you looked at it as a whole, rather than from a nearby point on the ground.
The point? Sell volatility. ?Buy mortgage bonds. ?Take convexity risk. ?Clip yield. ?Take a few chances, the environment should be gentle, and you can’t go too wrong.
After the horrible investment environment for bonds of 1994, this was a notable shift. ?So he came to the end of his talk, and it was time for Q&A. ?Suddenly, the moderator stormed up to the front of the room and said, “I’m really sorry, but we’re out of time. ?We’ve got a panel waiting in the main meeting?room to talk about the Confederation insolvency. ?Please head over there now.”
Everyone got up, and dutifully headed over to the Confederation panel. ?I was disappointed that I wouldn’t get a chance to ask Bill Gross a question, so as I started to leave, I looked to the front of the room, and I saw Bill Gross standing there alone. ?It struck me. “Wait. ?What don’t I know about Confederation? The best bond manager in the US is standing up front.”
So I walked up to the front, introduced myself, told him that I was an investment actuary, and asked if I could talk with him about mortgage bonds. ?He told me that he could until his driver showed up. ?As?a result, for the next 15 minutes, I had Bill Gross to myself, asking him how they analyzed the risks and returns of complex mortgage securities. ?His driver then showed up; I thanked him, and he left.
Feeling pretty good, I wandered over to the Confederation panel. ?As I listened, I realized that I hadn’t missed anything significant. ?Then I realized that the rest of the audience had missed a significant opportunity. ?Oh, well.
As it turned out, I made many efforts in 1995 to resuscitate my GIC business. ?It survived for one more year, and collapsed in 1996, with little help from senior management. ?It was for the best, anyway. ?It was a low margin, capital intensive business, and closing it enabled me to focus on bigger things that improved corporate profitability. ?I never went to another?Schmoozathon as a result, but the last one had a highlight that I would not forget: meeting Bill Gross.
Photo Credit: Beto Vilaboim || No, you are not crazy — it *is* hopeless
I thought of structuring this post like a fictional story, but I couldn’t figure out how to make it good enough for publication. ?Well, truth is often stranger than fiction, so have a look at this Bloomberg article pointing at a 37% loss in the?ProShares UltraShort 20+ Year Treasury (TBT).
A few points to start with: shorting is hard. ?Leveraged shorting is harder. ?I think I have reasonable expertise in much though not all of investing, and I put most shorts in the “too hard pile.”
That said, I have taken issue with the “interest rates can only go up” trade for 8-9 years now. ?It is not a major theme of mine, but I remember a disagreement that I had with Cramer over it back when I was writing for RealMoney. ?(I would point to it now, but almost all content at RealMoney prior to 2008 is lost.)
Many bright investors (usually not professional bond investors) have taken up the?”interest rates can only go up” view because of the loose monetary policy that we have experienced, and thanks to Milton Friedman, we know that “Inflation is always and everywhere a monetary phenomenon,” or something like that.
Friedman may or may not be right, but when banks do not turn the proceeds of?deposits into loans, inflation doesn’t do much. ?As it is, monetary velocity is low, with no signs of imminent pickup.
At least take time to read the views of those who are long a lot of long Treasuries, and have been that way for a long time — Gary Shilling and Hoisington Management. ?Current economic policies are not encouraging growth, and that is true over most of the world. ?We have too much debt, and the necessary deleveraging inhibits growth.
Think of this a different way: we have a lot of people thinking that they will retire over the next 10-30 years. ?To the extent that you can live with the long-run volatility, I accept the idea that you can earn 6-8%/year in stocks over that period, so long as there isn’t war on your home soil, or a massive increase in socialism.
But what if you are running a defined-benefit plan, investing to back long-dated insurance products, or just saying that you need some degree of nominal certainty for?some of your assets. ?The answer would be debt claims against institutions that you know will be around to pay 10-30 years from now.
In an era of change, how many institutions are you almost certain will be here 10-30 years from now? ?Personally, I would be comfortable with most government, industrial and utility bonds rated single-A or better. ?I would also be comfortable with some municipal and financial company bonds with similar ratings.
If followed, and this has been followed by many institutional bond investors, this would result in falling long-term yields, particularly now when economic growth is weak globally.
Now, rates have fallen a great deal over 2014. ?Can they fall further from here? ?Yes, they can. ?Is it likely? ?I don’t know; they have fallen a lot faster than I would have expected.
I would encourage that you watch bank lending, and to a lesser extent, inflation reports. ?The time will come to end the high quality long bond trade, but at present, who knows? ?Honor the momentum for now.
Full Disclosure: Long TLT for my fixed income clients and me (it’s a moderate?part of a diversified portfolio with a market-like duration)
Every now and then, a piece of good news gets announced, and then something puzzling happens. ?Example: the GDP report comes out stronger than expected, and the stock market falls. ?People scratch their heads and say, “Huh?”
A friend of mine who I haven’t heard from in a while, Howard Simons, astutely would comment something to the effect of: “The stock market is not a futures contract on GDP.” ?This much is true, but why is it true? ?How can the market go down on good economic news?
Some of us as investors use a concept called a discounted cash flow model. ?The price of a given asset is equal to the expected cash flows it will generate in the future, with each future cash flow?discounted to reflect to reflect the time value of money and the riskiness of that cash flow.
Think of it this way: if the GDP report comes out strong, we can likely expect corporate profits to be better, so the expected cash flows from equities in the future should be better. ?But if the stock market prices fall, it means the discount rates have risen more than the expected cash flows have risen.
Here’s a conceptual problem, then: We have estimates of the expected cash flows, at least going a few years out but no one anywhere publishes the discount rates for the cash flows — how can this be a useful concept?
Refer back to a piece I wrote earlier this week. ?Discount rates reflecting the cost of capital reflect the alternative sources and uses for free cash. ?When the GDP report came out, not only did come get optimistic about corporate profits, but perhaps realized:
More firms are going to want to raise capital to invest for growth, or
The Fed is going to have to tighten policy sooner than we?thought. ?Look at bond prices falling and yields rising.
Even if things are looking better for?profits for existing firms, opportunities away from existing firms may improve even more, and attract capital away from existing firms. ?Remember how stock prices slumped for bricks-and-mortar companies during the tech bubble? ?Don’t worry, most people don’t. ?But as those prices slumped, value was building in those companies. ?No one saw it then, because they were dazzled by the short-term performance of the tech and dot-com stocks.
The cost of capital was exceptionally low for the dot-com stocks 1998-early?2000, and relatively high for the fuddy-duddy companies. ?The economy was doing well. ?Why no lift for all stocks? ?Because incremental dollars available for finance were flowing?to the dot-com companies until?it became obvious that little to no cash would ever flow back from them to investors.
Afterward, even as the market fell hard, many fuddy-duddy stocks didn’t do so badly. ?2000-2002 was a good period for value investing as people recognized how well the companies generated profits and cash flow. ?The cost of capital normalized, and many dot-coms could no longer get financing at any price.
Another Example
Sometimes people get puzzled or annoyed when in the midst of a recession, the stock market rises. ?They might think: “Why should the stock market rise? ?Doesn’t everyone?know that business conditions are lousy?”
Well, yes, conditions may be lousy, but what’s the alternative for investors for stocks? ?Bond yields may be falling, and inflation nonexistent, making money market fund yields microscopic… the relative advantage from a financing standpoint has?swung to stocks, and the prices rise.
I can give more examples, and maybe this should be a series:
The Fed tightens policy and bonds rally. (Rare, but sometimes…)
The Fed loosens policy, and bonds fall. (also…)
The rating agencies downgrade the bonds, and they rally.
The earnings report comes out lower than last year, and the stock rallies.
Etc.
But perhaps the first important practical takeaway is this: there will always be seemingly anomalous behavior in the markets. ?Why? ?Markets are composed of people, that’s why. ?We’re not always predictable, and we don’t predict?better when you examine us as groups.
That doesn’t mean there is no reason for anomalies, but sometimes we have to take a step back and say something as simple as “good economic news means lower stock prices at present.” ?Behind that is the implied increase in the cost of capital, but since there is nothing to signal that, you’re not going to hear it on the news that evening:
“In today’s financial news, stock prices fell when the GDP report came out stronger than expected, leading investors to pursue investments in newly-issued bonds, stocks, and private equity.”
So be aware of the tone of the market. ?Today, bad news still seems to be good, because it means the Fed leaves interest rates low for high-quality short-term debt for a longer period than previously expected. ?Good news may imply that there are other places to attract money away from stocks.
Ideas for this topic are welcome. ?Please leave them in the comments.
Photo Credit: Moon Lee || When is this train going to arrive?
There are several ways to gauge the Federal Open Market Committee wrong. I am often guilty of a few of those, though I hope I am getting better. ?Don’t assume?the FOMC:
Shares your view of how economies work.
Cares about the politics of the situation.
Knows what it really wants, aside from magic.
Won’t change its view by the time an event arrives that was previously deemed important for monetary policy.
Cares about the reasoning of dissenters on the committee.
Understands what is actually happening in the economy, much less what its policy tools will really do.
But you can assume the FOMC:
Cares about the health of the banks, at least under extreme conditions
Wants to do something good, even if their minds are poisoned by neoclassical economics
Will err on the side of saying too much, rather than too little, when it feels that its policies are not having the impact?desired on the markets and economy.
Will act in the manner that most protects its continued existence and privileges.
So if we want to guess when the FOMC will tighten, we can do three things:
Look at market opinion
Look at the FOMC’s own opinions, or
Something else 😉
Let’s start with market opinion. ?At present, Fed funds futures have the Fed funds rate rising to 0.25% in the third quarter of 2015, and 0.50% in the fourth quarter. ?Now, market opinion has tended to be ahead of the actual actions of the FOMC on tightening policy, so maybe that will be true in the future as well. ?So far, those betting for tightening in the Fed funds futures market have been losing over the last few years along with those shorting the long Treasury bond, because rates have to go up.
Okay, so what does the FOMC think? ?Starting back in January of 2012, they started providing forecasts to us, and here is a quick summary of their efforts:
In general, they have been overly optimistic about growth in the US economy. ?They probably still are too optimistic.
They have been better at forecasting the unemployment rate, even as it has become less useful as an indicator of how strong labor conditions are because of discouraged workers and more lower wage jobs.
In general, they have expected inflation to perk up in response to their policies a lot faster than it has happened.
And as a result, like the market, they have expected to tighten in the past a lot sooner than they are presently projecting, which is not all that much different than the view of the market. ?Also like the market, you can’t simply take an average of their views as representative of where Fed Fund will be. ?Since the FOMC relies on voting, the median view would be more representative than the average Fed funds rate forecast, and that has remained at a relatively consistent “tightening will happen sometime in 2015” since September 2012. ?The median estimate of where Fed funds would be at the end of 2015 has also been 0.75-1.00% over that same period, which is higher than the current market estimate of 0.60%, but lower than the FOMC’s own estimate of 1.1%.
So, where does this leave us, but with a view that the FOMC will tighten policy next year. ?But what if the monetary doves on the FOMC remain dominant? ?After all, those that are permanent voting members are more dovish than the average participant tossing out an estimate. ?That leaves me with this, which reflects the influence of the doves better:
This graph is based on the average forecast, which includes a decent number of outlier views from some of the doves, which at present suggests tightening in January of 2016, but if you take into account the time drift of views since September 2012, it augurs for tightening in August of 2016.
The drift has happened because the economy has not strengthened the way the FOMC expected it would. ?If we muddle along at the average rate of growth over the last two years, the FOMC may very well sit on its hands and not tighten as quickly as presently expected. ?After all, labor conditions are soft, and inflation as they measure it is not roaring ahead. ?(Please ignore the asset price inflation that aids the non-existent wealth effect.)
As it is, statements from the FOMC have been noncommittal, only saying that they are ending QE. ?They are still waiting for their grand sign to act on Fed funds, and it has not come yet.
Summary
Current expectations from the market and the FOMC suggest that the Fed funds rate will rise in 2015. ?Prior expectations of FOMC action have signaled much earlier action than what has actually happened. ?From my vantage point, it is more likely that the FOMC moves later than the third quarter of 2015 versus?earlier than then. ?The FOMC has been slow to remove policy accommodation; it is more likely that they will remain slow given present economic conditions.
Photo Credit: eric731 — People can budget, but can they manage risk?
Investing is difficult. ?That said, we can make it harder still. ?We can encourage people with little to no training to try to do it for themselves. ?Sadly, many people get caught in the fear/greed cycle, and show up at the wrong time to buy and/or sell. ?We get there late, and then our emotions trick us into action, when the rational investor says, “Okay, I missed that move. ?Where are there opportunities now, if there are any at all?”
But investing can be made even more difficult. ?Investing reaches its most challenging level when you are relying on your investing to meet an anticipated and repeated need for cash outflows.
Institutional investors will tell you, portfolio decisions are almost always easier when there is more cash flowing in than flowing out. ?It means that there is one dominant mode of thought: where to invest?new money? ?Some attention will be given to managing existing assets — pruning away assets with less potential, but the need won’t be as pressing. ?(Note: at really high rates of cash?inflow, investing gets really tough as well, but that’s another story, and one that I successfully lived though 1998-2003…)
1) You don’t know how long you, your spouse, and anyone else relying on you will live. ?Averages can be calculated, but particularly with two people, the odds are that one will outlive an average life expectancy. ?Can you be conservative enough in your withdrawals that you won’t outlive your money?
2) My estimate of what the safe withdrawal rate is on a perpetuity is the yield on the 10-year Treasury Note plus around 1%. ?That additional 1% can be higher after the market has gone through a bear market, and valuations are cheap, and as low as zero when you are near the end of a bull market.
Now, most?people people with discipline want a simple spending rule, and so those that are moderately conservative choose that they can spend 4%/year of their assets. ?At present, if interest rates don’t go lower still, that will likely (60-80% likelihood) work. ?But if your income needs are greater than that, your odds of yields over the long haul go down dramatically.
3) Will you be able to maintain an iron discipline, and not overspend your assets? ?It’s tempting to do so, and the temptation will get greater when bad events happen that break the budget, whether those are healthcare or other needs. ?It is incredibly difficult to?avoid paying for an immediate pressing need, when the soft cost?is harming your future. ?There is every incentive to say, “We’ll figure it out later.” ?The odds on that being true will be low.
4) How will you deal with bear markets, particularly ones that occur early in retirement? ?Can?you and?will you reduce your expenses to reflect the losses? ?On the other side, during bull markets, will you build up a buffer, and not get incautious during seemingly good times?
This is an easy prediction to make, but after the next bear market, look for a scad of “Our retirement is ruined articles.” ?Look for there to be hearings in Congress that don’t amount to much — and if they do amount to much, watch them make things worse by creating R Bonds, or some garbage like that.
5)?Avoid investing in too many income vehicles; the easiest temptation to give into is to stretch for yield — it is the oldest scam in the books. ?This applies to dividend paying common stocks, and stock-like investments like REITs, MLPs, BDCs, etc. ?They have no guaranteed return of principal. ?On the plus side, they may give you capital gains if you use them right, buying them when they are out of favor, and reducing exposure when everyone is buying them.
Another easy prediction to make is that junk bonds and non-bond income vehicles will be a large contributor to the shortfall in asset return in the next bear market, because a decent number of people are buying them as if they are magic. ?The naive buyers think: all they do is provide a higher income, and there is no increased risk of capital loss.
6) Avoid taking too much?or too little risk. It’s psychologically difficult to buy risk assets when things seem horrible, or sell when everyone else is carefree. ?If you can do that successfully, you are rare. ?What is achievable by many is to maintain a constant risk posture. ?Don’t panic; don’t get greedy — just stick to your investment plan through the cycles of the markets.
7) As assets shrink, what will?you liquidate? ?The best thing would be?being forward-looking, and liquidating what has the lowest risk-adjusted future return. ?What is achievable is selling assets off from everything proportionally, taking account of tax issues where needed.
8 ) Are you ready for Social Security to take a hit out around 2026? ?Once the trust fund gets down to one year’s worth of?payments, future payments get reduced to the level?sustainable by expected future contributions. ?Expect a political firestorm when this becomes a live issue, say for the 2024 Presidential election. ?There will be a bloc of voters to oppose leaving benefits unchanged by increasing Social Security taxes.
9) Be wary of inflation, but don’t overdo it. ?The retirement of so many people may be deflationary — after all, look at Japan and Europe so far. ?Economies also work better when there is net growth in the number of workers. ?It will be tempting for policymakers to shrink what liabilities they can shrink through inflation, but there will also be a bloc of voters to oppose that.
10) You need a defender of two against slick guys who will try to cheat you when you are older. ?If you have assets, you are a prime target for scams. ?Most of these come dressed in suits: brokers and other investment salesmen with plausible ways to make your money stretch further. ?But there are other scams as well — run everything significant past a smart younger person who is skeptical, and knows how to say no when needed.
Conclusion
If this all seems unduly dour (and I haven’t even talked about defined benefit plan issues), let me tell you that this?is realistic. ?There are not enough resources to give all of the Baby Boomers a lush retirement, without unduly harming younger age cohorts, and this is true over most of the developed world, not just the US.
Even with skilled advisers helping you, you need to be ready for the hard choices that will come up. ?Better you should think through them earlier rather than later. ?Who knows? ?You might take some actions that will lower your future risks. ?More on that in a future post, as well as the other retirement risk issues.
There have been a few parties worrying about crises stemming from ETFs, because they make it too easy for people to sell a lot of assets?in a crisis.
I think that fear is overblown, but I don’t think it is non-existent, and I would like to use a bond ETF as an example of what could be possible.
Most bonds don’t trade every day. ?Only the most liquid bond issues trade every day, and they form the backbone for pricing the bonds that don’t trade.
But how do you price a bond when it doesn’t trade? ?It’s complicated, but let me try to explain…
When a less liquid bond actually has a trade, the bond pricing services take note of it. ?They calculate the yield spread of the less liquid bond versus similar bonds (similar in industry, rating, maturity, currency, domicile, other features) that are liquid, and compare it to:
where that yield spread was in the past
where the yield spread is relative to other similar?less?liquid bonds that have recently traded
where models might imply the yield spread should be, given other securities related to it (stock, preferred stock, junior debt, other bonds in the same securitization, etc.)
where investment banks that make a market in the bonds are indicating they would buy or sell.
Now consider that the bond pricing services are doing this for all the bonds they cover every day, and in real time when?the NAVs are made available for ETFs. ?The bond pricing services attempt to create a set of prices for all securities that they cover that is consistent with the market activity in aggregate, adjusting at a reasonable speed to changing market conditions. ?It’s complex, but it allows investors to have a reasonable estimate of the value of their bonds.
(Note: the same thing is done with illiquid stocks as a result of the late trading scandal in mutual funds back in the early 2000s for setting the NAV of mutual funds — ?less liquid?stocks have the same problem in a lesser way than bonds.)
The technical name for this is matrix pricing, which is a bit of a misnomer — multifactor pricing would have been a better name. ?It works pretty well, but it’s not perfect by any means — as an example, you can’t take the calculated price and trade at that level — it is only indicative of where an uncoerced buyer and seller might trade on a normal day. ?It may be a useful guide, though your broker making a market may disagree, which is part of the art of understanding value in the bond markets.
The Possible Problem
Now imagine an ETF with a relatively large amount of less liquid bonds in it, and a market environment where yield spreads are relatively tight, as it is now. ?In such an environment, even the less liquid bonds may have their yield spreads relatively tight?versus their more liquid cousins. ?Now imagine that a relatively violent selloff starts in the bond market over credit issues.
If you were a bond manager at such a time, surprised at the move, but thought it would go further, and you wanted to lighten up on some of your positions, would you try to sell your liquid or less liquid bonds first? ?Most of the time, you would sell the liquid ones, because it is relatively easy to get the trades done. ?If the selloff is bad enough, it will be impossible to sell the less liquid bonds — practically, that market shuts down for a time.
But if there are very few trades of the less liquid bonds, what does the pricing service do? ?Initially, it might rely on the old spread relationships, leaving the less liquid bonds with higher prices than they should have. ?But with enough time, a few trades will transpire, and then the?multifactor models will catch up “all at once” with where the pricing should have been.
For a time, the NAVs would be high relative to where the bonds actually should trade. ?The unit creation/liquidiation process might not catch up with it, because the less liquid bonds are difficult to source, and there is often a cash payment in lieu of the less liquid bonds. ?That cash payment figure could be too high in my scenario, leading to a rush to liquidate by clever investors sensing an arbitrage opportunity.
Now, would this be a catastrophe for the markets as a whole? ?I don’t think so, but some investors could find the NAVs of their bond ETFs move harder than they would expect in a bear market. ?That might cause some to sell more aggressively, but remember, for every seller, there is a buyer. ?Someone outside the ETF processes with a strong balance sheet will be willing to buy when the price is right, because they typically aren’t forced sellers, even in a crisis.
Practical Advice
If you own bond ETFs, know what you own, and how much of the portfolio is less liquid. ?Have a passing familiarity with how the NAV is calculated, and how units get created and liquidated. ?Try to have a sense as to how “jumpy” investors are in the asset sub-class you are investing in, to know whether your fellow investors are likely to chase market momentum. ?They may cause prices of the ETFs to vary considerably versus NAVs if a large number of them take the same action at the same time.
Know yourself and your limits, and be willing to hold or add when others are panicking, and hold or sell when others are too optimistic. ?If you can’t do that, maybe hand it over to a financial advisor who?stays calm when markets are not calm.
Morningstar estimates that over the past five years, the average investor fell behind Pimco Total Return?s 5.6% annual gain by 1.6 points a year?largely as a result of buying high and selling low. That gap is among the widest of any large bond fund; at the Vanguard Total Bond Market Index Fund, for example, investors have earned returns only 0.4 point lower than those of the portfolio itself.
In the short run, this offers a reason to follow Bill Gross to Janus. ?He is starting with a clean slate, and will be able to implement positions that seem attractive to him that would not have been attractive at Pimco because they would have been too small. ?Managing less money lets Bill Gross be more choosy.
Second, in the short run, growth in bond assets at Janus will temporarily push up the prices of bonds held by Janus. ?Those that get in early would benefit from that if bond assets grow under the management of Bill Gross. ?Just keep your eye on when assets stop growing if you are buying for that speculative reason.
A third potential reason to follow Gross depends on how much Pimco continues to use his quantitative strategies. ?If Pimco abandons them (unlikely, but not impossible), Janus would get the chance to use them on much less money, which would make the excess returns greater. ?If I were considering this as a reason, I would watch the turnover in Pimco’s main funds, and see if certain classes of assets disappear.
My last point here is that the abilities of Bill Gross will do better managing less money, but the effect won’t be so great if he is competing with Pimco to implement the same strategies. ?At minimum, he’s not likely to do worse than at Pimco, and in the short-run, there are some reasons why he will likely do better.
PS — please remember that Bill Gross has two hats: the showman and the quant. ?The quant makes money for clients while the showman entertains them. ?The showman opines about the Fed, politics, etc. ?That can get investors interested because it sounds clever, but that is not how Bill Gross makes money.
This brings up one more point. ?If you do decide to invest with him at Janus, review the prospectus to see what degree of flexibility with derivatives Gross will have. ?If it similar to what he had at Pimco, he is likely following the same strategy.
Pimco has always used a lot of derivatives, though for marketing reasons some of their funds have fewer derivatives, even as Pimco tries to follow the same strategies. ?You can view this three ways:
It hasn’t had horrible effects in the past, so why worry now?
We haven’t had the market event that would test the limits of this strategy yet, but can it really get that bad?
Now that the bond market is more crowded, Pimco’s quantitative bond strategies have less punch. ?They don’t have the same room to maneuver. ?Like the London Whale, have they become the market?
I lean toward the last of these views. ?When you manage so much money, it becomes difficult to wrench alpha out of the market because mispricings are limited, and it is difficult to keep your trades from moving the market.
You might want to split your “safe monies” in your 401(k) plan if you have other credible investments. ?That said, the likelihood of a large disaster harming Pimco is small — but you could try to cover that risk by setting a relative?stop loss where you would exit Pimco versus a similar maturity fund run by Vanguard.
Another letter:
I’m a fledgling portfolio manager and blog reader.? Would you care to comment on the bounce we’ve seen in Treasury rates this month? (28 bp on the 10-year month to date).? I just don’t get it.? I see global growth continuing to underwhelm, more monetary opiates out of Asia, persistent dovishness from the Fed and the arrival (?) of the Godot that has been ECB stimulus.? These circumstances plus ongoing geopolitical issues make me wonder why Treasury yields have not gone further down or at least held the line.? I know it might be mean reversion or a supply/demand phenomenon but do not feel qualified to say and would enjoy reading your perspective.
Separately, are you aware of any Readers’ Digest Condensed summaries of monetary policy in Europe since 2007?? My career is not so old and each time I read about their approach to sorcery I encounter yet another acronym of which I am ignorant.
Best and thank you!
Back when I was a corporate bond manager, and things were moving against me, I would do a few things:
Seek out contrary opinion, and see if there was something I was missing.
Go out to lunch for Chinese food, dragging my trading notebook, and a sheaf of research with me, and schmooze over the data while there was no Bloomberg terminal in front of me.
Now, my own current views are conflicted, because I view the global economy like you do. ?There is no great growth anywhere. ?Geopolitical events should lead to a Treasury rally, and sanctions should weaken growth prospects. ?I’m still long a moderate amount of the?iShares 20+ Year Treasury Bond (TLT), for myself and clients — it is difficult to see too much of a bear market with monetary velocity so weak.
That said, my recent 2-part series on the shape of the yield curve suggested that the curve shape was the sort where we often get negative surprises. ?Despite the Fed’s confident mutterings that amount to little more than “Trust us!” the Fed has never been in a situation like this one and does not have the vaguest idea as to what it is doing. ?They are proceeding largely off of untested theories that so far haven’t done much good or bad, aside from allowing the US Government to finance its deficits cheaply, thus cheating savers who deserve a better return on their money.
This is my thought: the slightest hint of tightening coming sooner moves the forward yield curve up, particularly in the 3-5 year region of the curve, but extending to 2- and 10-year notes as well. ?But the questions remain how well growth holds up, how sensitive will the economy be to higher interest rates, and whether banks start genuinely lending against their expanded liabilities.
Personally, I expect rates to go lower after further growth disappointments, but I could be wrong, very wrong, so don’t be too bold here — scale into positions as you see opportunity.
