Photo Credit: Vitor D’Agnoluzzo || Politicians should think more carefully before using violence to achieve foreign policy goals — it is rare that it is ethically justified
Ten years ago, I wrote a short piece called In Defense of Home Bias. International investing is generally a good idea for diversification purposes, though it will work varyingly well over time. The last decade has not been kind to the concept for US investors, but perhaps it has been extra good for foreign investors in US companies.
The first bullet point I wrote with respect to difficulties with international investing was:
There will be no war that changes the amount or terms of commerce.
This is one case where being an economic historian will help more than studying market statistics. Most market statistics studied today come from the post-WWII era where no conflict has materially affected the markets for a long time, or done lasting damage.
Contrast that with Italy, Japan and Germany in WWII (this applies to West Germany, not East Germany) — their markets were pounded to the degree where people lost a lot in real terms if they were invested in bonds or paper money, and lost significant value in stocks for a decade, but made it all back. Thos invested in short-term government debt coasted along as did those that held gold.
Though some productive capacity was destroyed, stocks recovered rapidly because they could improve profitability to keep up with post-war inflation. Gold and short debt could tread water, but bonds and non-interest bearing deposits lost value.
But looking back in history, not many wars end with a merciful victor like the US was at that time. After WWI, the demand for reparations and bad monetary policy killed German bonds and paper money. After the Civil War, the South was economically ruined — it too a long time to recover.
So, what to think about war risk?
If its not on your home soil, it is not likely to be too damaging, though government policy could lead to inflation, as happened in the Vietnam War era.
As Sun Tzu said, “Where the army is, prices are high; when prices rise the wealth of the people is exhausted.” (Quoting from this article here.) Yes, measured inflation is scarce today, but if we had to redirect the economy for a major war, it would be different, particularly when currencies are mere fiat currencies. Think of what happened to the currency of the South during/after the Civil War, or the value of the Continental Dollar during/after the Revolutionary War.
Stocks a given society tend to do okay unless a society is wiped out, or taken over by Communism.
A balanced portfolio that contains short-term debt and gold, as well as stock and bonds should do okay so long as the society itself is not destroyed… where existing property rights get extinguished.
Don’t invest in places where a hot war is going on. Even if speculating on when the war will end, that is a gamblers’ game.
For the most part I would say don’t worry too much about war. As the 34th Ferengi Rule of Acquisition says, “War is good for business.” To which Quark added, “…only from a distance, the closer to the front lines, the less profitable it gets.” Though fictional and humorous, it is for the most part true. If your assets and your society are not destroyed, you have your capital intact to speculate on the rebuilding of places that are destroyed.
Now all that said, there is the risk that a small conflict becomes a big one. Though WWI was inevitable in many ways, no one predicted the chain of events that led to the conflict.
My advice is threefold then. 1) Don’t worry — diversify across asset classes, including hard assets. 2) If you want to remove most of the remaining risk stick to places that have the “rule of law” and are unlikely to be dragged into armed conflict on their home soil. 3) Even if not on home soil, be wary of inflation if a conflict drags on.
Photo Credit: David Lofink || Most things in life have limits, the challenge is knowing where they are
I was at a conference a month ago, and I found myself disagreeing with a presenter who worked for a second tier ETF provider. The topic was something like “Ten trends in asset management for the next ten years.” The thought that ran through my mind was “Every existing trendy idea will continue. These ideas never run into resistance or capacity limits. If some is good, more is better. Typical linear thinking.”
Most permanent trends follow a logistic curve. Some people call it an S-curve. As a trend progresses, there are more people who see the trend, but fewer new people to hop onto the trend. It looks like exponential growth initially, but stops because as Alexander the Great said, “There are no more worlds left to conquer.”
Even then, not every trend goes as far as promoters would think, and sometimes trends reverse. Not everyone cares for a given investment idea, product or service. Some give it up after they have tried it.
These are reasons why I wrote the Problems with Constant Compound Interest series. No tree grows to the sky. Time and chance happen to all men. Thousand year floods happen every 50 years or so, and in clumps. We know a lot less than we think we do when it comes to quantitative finance. Without a doubt, the math is correct — trouble is, it applies to a world a lot more boring than this one.
I have said that the ES portion of ESG is a fad. Yet, it has seemingly been well-accepted, and has supposedly provided excess returns. Some of the historical returns may just be backtest bias. But the realized returns could stem from the voting machine aspect of the market. Those getting there first following ESG analyses pushed up prices. The weighing machine comes later, and if the cash flow yields are insufficient, the excess returns will vaporize.
In this environment, I see three very potent limits that affect the markets. The first one is negative interest rates. There is no good evidence that negative interest rates stimulate economic growth. Ask those in nations with negative interest rates how much it has helped their stock markets. Negative interest rates help the most creditworthy (who don’t borrow much), and governments (which are known for reducing the marginal productivity of capital).
It is more likely that negative rates lead people to save more because they won’t earn anything on their money — ergo, saving acts in an ancient mold — it’s just storage, as I said on my piece On Negative Interest Rates.
Negative interest rates are a good example of what happens you ignore limits — it doesn’t lead to prosperity. It inhibits capital formation.
Another limit is that stock prices have a harder time climbing as they draw closer to the boundary where they discount zero returns for the next ten years. That level for the S&P 500 is around 3840 at present. To match the all time low for future returns, that level would be 4250 at present.
Here’s another few limits to consider. We have a record amount of debt rated BBB. We also have a record amount of debt rated below BBB. Nonfinancial corporations have been the biggest borrowers as far as private entities go since the financial crisis. In 2008, nonfinancial corporations were one of the few areas of strength that the bond markets had.
One rule of thumb that bond managers use if they are unconstrained is that the area of the bond market that will have the worst returns is the one that has grown the most during the most recent bull part of the cycle. To the extent that it is possible, I think it is wise to upgrade corporate creditworthiness now… and that applies to bonds AND stocks.
Of course, the other place where the debt has grown is governments. The financial crisis led them to substitute public for private debt in an effort to stimulate their economies. The question that I wonder about, and still do not have a good answer for is what will happen in a fiat money world to overleveraged governments.
Everything depends on the policies that they pursue. Will the deflate — favoring the rich, or inflate, favoring the poor? No one knows for sure, though the odds should favor the rich over the poor. There is the unfounded bias that the Fed botched it in the Great Depression, but that is the bias of the poor versus the rich. The rich want to see the debt claims honored, and don’t care what happens to anyone else. The Fed did what the rich wanted in the Great Depression. Should you expect anything different now? I don’t.
As such, the limits of government stimulus are becoming evident. The economic recovery since the financial crisis is long and shallow. The rich benefit a lot, and wages hardly rise. Additional debt does not benefit the economy much at all. We should be skeptical of politicians who want to borrow more, which means all of them.
One of the greatest limits that exists is that of defined benefit pension plans vainly trying to outperform the rate that their risky assets are expected to earn. They are way above the level expected for the next ten years, which is less than 3%. Watch the crisis unfold over the next 15 years.
Finally, consider the continued speculation that shorts equity volatility. You would think that after the disaster that happened in 2018 that shorting volatility would have been abandoned, but no. The short volatility trade is back, bigger and badder than ever. Watch out for when it blows up.
Summary
Be ready for the market decline when it comes. It may begin with a blowout with equity volatility, but continue with a retreat from risky stocks that offer low prospective returns.
Photo Credit: Miles Nicholls || Actually, the bells get rung at the top, and quite frequently for the duration of the process. People hear it and they decide not to listen. Too many false alarms.
The stock market model is projecting a 3.06%/year return over the next ten years as of the close on 11/15/2019. That’s near where a 10-year mid-single-A rated bond would trade. That’s not offering a lot of compensation for putting your money at risk.
I’m planning on reducing my total risk level by 15% or so, moving my equity allocation from around 70% to 55%. That will be the lowest it has been in two decades. I’m not running to do this. I am still working out the details.
The Fundamentals of Equity Market Tops
You might recall an old piece of mine that I wrote for RealMoney back in January 2004 — The Fundamentals of Market Tops. In it, I gave a non-technical analysis approach to analyzing whether we might be near a market top. In 2004, I concluded that we were NOT near a market top. (This article also served as a partial template for the article at RealMoney in May 2005, which said that YES we were near a market top for Residential Real Estate. Two good calls.)
The article is longer than most, should not fit in the TL;DR bucket for most investors. I’m not going to reconstruct the article here, but just give some brief points that fit the frame of the article. Here I go:
Value investors have been sidelined. Growth is winning handily.
Valuation-sensitive investors are raising cash. Buffett sitting on $130 billion is quite statement. He’s not alone. More on that below.
Momentum is working.
There has been a decline in IPO quality.
Lots of money is getting attracted to private equity.
Corporate leverage is high, and covenants are weak.
Non-GAAP accounting gets more attention than it deserves.
Defined benefit plans are net sellers of stock, but not for the reasons I posit in my article — they are doing it to move to private equity and alternatives, and bonds as a part of liability-driven investing.
Cutting against my thesis:
More companies are committing to paying dividends, and growing them. I’m impressed with the degree that corporations are thinking through their use of free cash flow, even as they lever up.
Actual volatility isn’t that high.
The Fed is supportive.
On net, these conditions give some confirmation to what my quantitative model is saying… the market is near a top. Could it go higher still? You bet, with an emphasis on the word “bet.” The S&P 500 at 4500 would be where valuations were during the dot-com bubble.
The main idea as applied to the present is this: when you have “strong hands” (those with long time horizons and strong balance sheets) raising cash levels and those with “weak hands” (those with shorter time horizons and weaker balance sheets) staying highly invested in risk assets, it is a situation that is unstable. Those that have capability to “buy and hold” are sitting on their hands, whereas those who have to get returns or they will suffer (typically municipal defined benefit plans and older retail investor who didn’t save enough) are risking a great deal, and have little additional buying power.
This is unstable. This situation typically exists at market tops. Remember, it is what investors DO that is the consensus, not what they SAY.
With that, consider your risk positions, and if you think you should act, do so. If you are uncertain, you could ask an intelligent friend or do half.
Picture Credit: David Merkel || E & S are hollow, G is solid
There are fads in investing. They eventually go away. Remember ARM funds? The Americus Trusts? (Neat idea, killed by a legal change). The nifty fifty? Hot industries that produce a lot of IPOs?
I also think cryptocurrencies are a fad, and also factor and volatility investing, at least in terms of the ETFs that are offered to retail investors.
And, I think ESG is a fad, at least in terms of the way it is being deployed today. My main point is that E (environmental) & S (social) are mostly subjective, and not related to investment returns or risk control. G (governance) is mostly objective and related to investment returns and risk control.
Now some will say “But wait, there are all these journal articles showing that ESG produces better volatility-adjusted returns.” Quantitative finance has a laundry list of problems:
We have only one world, one history, one data set. We’ve gone over the data set numerous times, knowing its proclivities. It’s not hard to tease “alpha” out in a study, but it is difficult to realize alpha in real life.
Researchers often take multiple passes over the data set as they do their analyses. Only the ones with results supporting the expected conclusions get a paper published.
Neutral observers don’t exist — their pay and social standing get determined by producing a series of statistically significant results, regardless of whether they tortured the data to get there or not. (Aside: when I read some of the macroeconomic crud out of the Federal Reserve, and I see the abstruse technique employed to get a result, I know the data has been tortured, and of course the model does not predict well.)
As such, I don’t trust the research on ESG. The limited history that we have for general inquiries is even shorter for ESG analyses. The likelihood of picking up spurious correlation is high. As such, unless I have a good mental model for how environmental or social issues affect long-term growth in value, I can’t use them as a fiduciary. I have those mental models for governance, so I use them — just not the same way as some of the quantitative governance models do.
Governance issues are perennial; they are not a fad. The agency problem, where corporate managements pursue goals that are in their interests, but not in the interests of shareholders never goes away. It can be reduced by a variety of measures, like splitting the CEO and Chairman positions. removing management influence over the audit and compensation committees, end things like that.
That said, there are exceptions to the rules, and certain strong managers running companies with highly focused and ethical cultures might be allowed more running room. Berkshire Hathaway doesn’t fit most of the rules, and in general it has done well. One size fits most, but not all.
It’s similar to the way I view management use of free cash flow. With a talented and honest management team, I want the management to have the freedom to retain all of the cash flow for growth if they see the opportunities. But most managements aren’t that good, and they should pay a dividend. Buybacks should only be done when the stock is notably cheap compared to the private market value of the firm, and the balance sheet remains solid.
That’s why I think many simple governance scores are mistaken. You have to take a look at the management team and culture in order to do a broader evaluation of the governance. I for one a comfortable buying stakes in a company where there is a control investor if the control investor is known for treating the outside passive minority investors fairly, and does not scrape too much off the top.
I expect companies that I own to follow the laws of the countries that they work in, and engage in ethical behavior. My rule is simple: if a company tries to cheat one set of stakeholders, the odds are higher that they will cheat shareholders at some point. Most of my significant losses have stemmed from some sort of fraud issue… this is etched in my mind.
But many of the details of environmental and social factors seem utterly tangential to me — I don’t see how they drive value. Let the government press its claims on corporations to avoid discrimination and limit pollution. That is the proper locus for these issues, particularly if you are a fiduciary. What is in the best financial interests of your clients should be your guiding principle.
Note as well that the implementation of E, S, and G are nowhere near standardized. G is probably the closest. (This also applies to factor investing as well, which is constantly engaging in new specification searches sharpening their statistical analyses.) Even if I wanted to do E & S, how would I know that I have the right figures? How would I know that they weren’t a product of backtest biases?
Also, as Matt Levine points out, many applications of ESG don’t make a lot of sense, even if these were desirable goals. As such, I look at many of the ESG products being put out there are marketing fads to take the attention of retail away from earning returns… after all, it is tough to beat the market, and ESG will give you many ways to have have a built-in excuse.
Do I know that I am in a minority for my views here? Yes. But I am often in a minority, and I would argue that the degree of agreement with ESG is paper-thin. It’s good while it brings in assets to manage, but the moment it doesn’t bring home the bacon, it will be jettisoned.
I’m in the minority for now. I expect the majority to come my way, not vice-versa. No illusions — it will take time for that to happen.
Photo Credit: Ben Schumin || Looks like a place where you may get a fast deal, but not the best deal.
Remember 125% LTV loans on houses prior to the financial crisis? Well, auto loans now are their twin separated at birth. The Wall Street Journal wrote an article recently about those who lend more than 100% on automobiles.
Now, in the old days, auto loans were short. They were shorter than five years, and never more than 80% of the value of the car. This meant that the balance of auto loan would always be less than the depreciated value of the car under ordinary circumstances.
But as has been common in American history, we always test the limits in lending. Maturities have been lengthened and loan-to-value ratios expanded. If you need a car, and your current loan is more than the value of the car you want to trade in, some lender will be willing to roll the loss into the value of the loan to purchase the next car, with a higher interest rate to compensate for the added risk.
Why is the risk higher? Auto loans are collateralized by the car. If you don’t pay, the repo man comes and takes the car. If the car is worth less than the loan, the borrower is liable for the difference. When the difference is big, the lender will pursue the borrower for payment, and either get the payment, or send the borrower into bankruptcy. The costs of bankruptcy to the borrower means losing the car and not being able to borrow for seven years or so.
But there will be costs to the lender as well. In a financial crisis, most of them will go bankrupt themselves. They aren’t thickly capitalized, and can’t afford a lot of losses. That’s part of the price of making low quality loans.
What to do
The first step in doing well here is to buy a cheap car that is of reasonable quality, even if it isn’t fashionable. I have only once paid more than $11,000 for a car, and that was for a 15-seat Ford XLT Van that last 14 years for me. Typically these days, I buy refurbished cars that have been through a wreck, and carry a salvage title. I would say, “You don’t need to look good,” but I look just fine. I pay very little for cars, and they last well.
Part of the challenge is finding honest auto dealers who charge a reasonable markup over their costs. Ask your smart friends for advice. (If you don’t have smart friends, get some.) Part of the price of the method that I use is that few lenders will lend on “salvage title” vehicles, so I have to pay cash. It is better to borrow unsecured at a high rate and buy a cheap but quality salvage title car than to buy an expensive vehicle from a regular dealer.
There is a hidden cost to buying salvage title cars though. If there is an accident and it is totaled, the insurer will pay you far less than for a similar non-salvage title vehicle.
Don’t Borrow to Buy a Car
This is the simplest advice. When I was 27, my parents came to visit me in California. My Father looked at the two used cars that my wife and I owned, and praised me — “You haven’t bought a lot of fancy rolling stock.”
I have never taken out an auto loan. I never will. Borrowing should only be for things that don’t depreciate, like a house.
People need to get over the idea that their car has to be powerful or pretty, and focus on buying cars that are reliable. Paying less for a car is one of the easiest ways to save money, so long as you get a quality car.
Avoid Owning Shares in Auto Lenders
I don’t know who you have to avoid here. I can’t think of a pure play. If you know of one, please mention it in the comments. I simply know that those who lend without adequate security eventually get hosed.
You would think we would have learned from the Financial Crisis, but the more I look at current conditions, the more I think we are short-sighted.
We are not facing a banking crisis now, but maybe we might around 2030. The banks are mostly in good shape now, but perhaps we might see the failure of some non-bank lenders in the next recession who have lent too much on autos.
In summary, try to avoid borrowing on a car, and don’t own companies who lend more than 100% on a car.
PS — three articles that I have written on buying cars:
Photo Credit: Sitoo || No, you can’t eat money. But without money farmers would have a hard time buying what they need to grow crops, and we would have a hard time bartering to buy the crops
Data obtained from filings at SEC EDGAR
Tonight I am going to talk about one of the most underrated concepts in finance — the difference between dollar-weighted and time-weighted returns, and why it matters.
So far on this topic, I have done at least seven articles in this series, and you can find them here. The particular article that I am updating is number 3, which deals with the granddaddy of all ETFs, the SPDR S&P 500 ETF (SPY), which has been around now for almost 27 years. It is the largest ETF in the world, as far as I know.
From the end of January 1993 to the end of March 2019, SPY returned 9.42%/year on a time-weighted or total return basis. What that means is that if you had bought at the beginning and held until the end, you would have received an annualized return of 9.42%. Pretty good I say, and that is an advertisement for buy and hold investing. It is usually one of the top investing strategies, and anyone can do it if they can control their emotions.
Over the same period, SPY returned 7.29%/year on a dollar-weighted basis. What this means is if you took every dollar invested in the fund and calculated what it earned over the timespan being analyzed, they would have received an annualized return of 7.29%.
That’s an annualized difference of 2.13%/year over a 26+ year period. That is a serious difference. Why? Where does the difference come from? It comes partially from greed, but mostly from panic. More shares of SPY get created near market peaks when everyone is bullish, and fewer get created, or more get liquidated near market bottoms. Many investors buy high and sell low — that is where the difference comes from. This also is an advertisement for buy and hold investing, albeit a negative one — “Don’t Let This Happen To You.”
Comparison with the 2012 Article
Now, I know few people actually look at the old articles when I link to them. But for the sharp readers who do, they might ask, “Hey, wait a minute. In the old article, the difference was much larger. Time-weighted was 7.09%/year and dollar-weighted was 0.01%/year. Why did the difference shrink?” Good question.
The differences between time- and dollar-weighted returns stems mostly from behavior at turning points. As I have pointed out in prior articles, typically the size of the difference varies with the overall volatility of the fund. People get greedy and panic more with high-volatility investments, and not with low-volatility investments.
That said, most of the effects of the difference are created at the turning points. During the midst of a big move up or down, the amount of difference between dollar- and time-weight returns is relatively small. The big differences get created near the top (buying) and the bottom (selling).
So, since the article in 2012, the fund has grown from $80 billion to over $260 billion at the end of March 2019. There have been no major pullbacks in that time — it has been a continuous bull market. We will get to see greater divergence after the next bear market starts.
Be Careful what you Read about Dollar-Weighted Returns
I’m not naming names, but there are many out there, even among academics that are doing dollar-weighted returns wrong. They think that differences as cited in my articles are too large and wrong.
The idea behind dollar-weighted return is to run an Internal Rate of Return calculation. To do that you have to have a list of the inflows and outflows by date, together with the market value of the fund at the end as an outflow, and calculate the single rate that discounts the net present value of all the flows to zero. That rate is the dollar-weighted return, and you can use the XIRR function is Excel to help you calculate it. (Note that my calculations use a mid-period assumption for when the cash flows.)
The error I have seen is that they try to make the dollar-weighted calculation like that of the time-weighted, creating period by period values. Now, there is a way to do that, and you can see that in the appendix below. As far as I can tell, they are not doing what I will write in the Appendix. Instead, they treat each year like its own separate investing period and calculate the IRR of that year only, and then daisy-chain them like annual returns for a time-weighted calculation.
Now, the time-weighted calculation does not care at all about investor-driven cash flows, like purchases and sales of fund shares, aside from dividend payments and things like that. It does not care about the size of the fund. It just wants to calculate what return a buy and hold investor gets. [Just remember the rule that an NAV must be calculated any time there is a cash flow of any sort, otherwise some inequity takes place.]
The dollar-weighted calculation cares about all investor cash flows, and ultimately about the size of the fund at the end of the calculation. It doesn’t care about when the returns are earned, but only when the cash flows in and out of the investment.
The odd hybrid method is neither fish nor fowl. Time-weighted corresponds to buy and hold, and dollar-weighted to the returns generated by each dollar in the fund. The hybrid says something like this: “We will calculate the IRR each year, but then normalize the fund size each year to the same starting level so that the fund flows at tops and bottoms do not compound. Then we show them year-by-year so that the returns are comparable to the total returns for each year.
As H. L. Mencken said:
Explanations exist; they have existed for all time;?there is always a well-known solution to every human problem?neat, plausible, and wrong.
Source: Quote Investigator citing Mencken’s book “Prejudices: Second Series”
In an effort to make a simple annual comparison between the two, they eradicate most of the effects of selling low and buying high. More in the Appendix.
Summary
Be aware of the difference between dollar-weighted and time-weighted returns. If you have a strong control on your emotions, this is not as important. If you tend to panic, this is very important. It is more important if you buy highly volatile investments, and less so if you size your volatility to your ability to bear it.
To fund managers I would say this: if you are tired of all of the inflows and outflows, and are tired of getting whipsawed by your clients, maybe you should take a step back and lower the overall risks you are taking. This will benefit both you and your clients.
Appendix
Here’s how to run an annual calculation of dollar weighted returns that be correct. For purposes of simplicity, I will assume a simple annual calculation that has multiple cash flows inside it. (If we are working with a US-based mutual fund, there would be reporting of change in net assets every six months.)
Calculate the first year (dw1) the way the hybrid method does. No difference yet. Then for the second year, run the IRR calculation for the full two-year period (IRR2). Then the second year only dollar-weighted return (dw2) would be:
((1+ IRR2) ^2) / (1+dw1) -1 = dw2
and for each successive period it would be:
(1+IRR[n])^n(1+IRR[n-1])^(n-1) – 1 = dw[n]
That is more complex than what they do, but it would preserve the truths that each entail. It would make the values for the yearly dollar-weighted returns look odd, but hey, you can’t have everything, and the truth sometimes hurts.
Full disclosure: a few of my clients are short SPY as part of a hedged strategy.
Photo Credit: The Aspen Institute || His shadow still affects central banking today…
At Aleph Blog, I will argue for things that are against my short term interests. After all, the higher stock and bond prices go, the higher my income goes in the short-run. In the long-run, that’s not sustainable.
I am here this evening to criticize the philosophy of Alan Greenspan that had the FOMC doing the bidding of the stock, bond, and futures markets.
Don’t disappoint the markets.
Give the markets what they want, and everything will work out well.
Flag the markets to tell what your intentions are.
None of those are the province of the Fed. The Fed is supposed to care for:
Low inflation
Low labor unemployment
Moderate long-term interest rates
(and indirectly) A healthy banking system, because the levers of Fed policy depend on it.
All of these things are going well at present, AND the yield curve has normalized. So why loosen again? Well, Fed funds futures indicate a igh probability of a cut… so give the market what it wants, right?
Ah, bring back Volcker and Martin, who would follow their statutory mandate, and not just mention it to excuse policy errors.
I write this partly after reading this article at Marketwatch. The article is a mix of different opinions, but the ones that get me are the ones that say that the Fed has to listen to the markets.
Well, that’s what Greenspan, Bernanke, and Yellen did, and it led us into a low interest rate morass because they never let recessions do their work and eliminate entities with low marginal efficiencies of capital.
Recessions are not always bad, and lower interest rates are not always good. Just as fires are good for forests in the long run, so are recessions that clear away marginal economic ideas.
It may not come this week. It may not come in the next few years, but eventually the Fed will be willing to offend the markets again. When it does, the jolts will be considerable, but it may lead to a better economy in the long-term.
Picture Credit: Brian Solis || What is true for a political leader is not the same as for an investor, unless you are an activist or a short seller who publishes
Understanding the consensus in investing is important. During the middle of when an investment idea is succeeding or failing, typically the consensus is correct. At the turning points, the consensus is typically wrong. That is why it is important to try to understand what the consensus is.
Often we listen to or read the news to learn the what current opinion is. In the quotation in the picture above, King was a major molder of the consensus on race relations in America. He knew the situation, and took action to try to change people’s minds, and thus move the consensus to a better place — closer to a colorblind society. We haven’t arrived on that yet; maybe in the generation of my children we will get there. We owe a debt of gratitude to King politically. (Religion was a different matter for King. If you want to read about that, there is an appendix at the bottom.)
Picture credit: tara hunt || Active managers must avoid being consensus thinkers, lest they be expensive indexers
But for investors, reading or listening to the news will not give you the consensus. It will give you opinions, and sometimes the agreeing chatter of opinions may give you the illusion that you know the consensus.
In an election, the consensus is whoever manages to win a majority of votes, whether of people, or their electoral representatives. This is can take place in a simple district, or in the more messy situation of who prime minister will be in a parliamentary system, or even the election of a US President.
But in the markets consensus does not stem from what is said, but rather where money is invested. This is once again the concept of Ben Graham’s voting machine. Thus to understand the consensus, we don’t read the news. Rather, we look at prices, and then try to do some sort of analysis, usually fundamental, to see whether the consensus is right or wrong.
Indexing is the ultimate statement of an investor saying he will just go with the consensus. That’s not a bad idea for many people. Active investing is a statement that you think the consensus is wrong, and that over a reasonable period of time, the consensus will be proven wrong, and you will make good money in the process. But part of that question is whether your investors will hang around long enough for you to be proven right. The other part is that you could be wrong — non-consensus does not mean right. (In my time, I have known more than my share of cranks who held extreme minority positions for a long period, and would rarely admit they were wrong. When they would admit failure, typically, they would blame someone else.)
Now let me give you two large present examples of how the “consensus” in the investment news is not the market consensus:
One frequent thing that I run into both on the web and radio is the argument from many advisors as to how pessimistic investors are today. The correct way to understand this is that because the market is high, many investors are skittish about future commitments. So what is the consensus here? The big investors of the world have and are investing money in the stock market such that prices are high — they discount a low expected future return.
The second example is people who kvetch about low interest rates and say they have nowhere to go but up. I’ve been hearing this off and on since 1987, when my boss said, “Interest rates will never go below 10%.” These arguments are a little dented today, because of the shell-shock stemming from negative interest rates in much of the developed world, but I still read commentators on the web and on the radio saying that interest rates must rise.
But what does the behavior of market participants tell you? It tells you that investors at present are yield-hungry, and that there has been money looking for a home than entities willing to borrow. No promises about the future, but the consensus has been that yields have been attractive to lenders, and that may continue for a while.
Now a hybrid regarding investment consensus and activists and short sellers who publish their opinions to the market in an effort to profit. In the long run, the cash flows will dictate the market movements, but in the short run their words, purchases/sales, and expected purchases/sales implied by their writing will drive prices in the short run.
Articles
Now, I’ve written a series of articles dealing with this topic over the years:
On Contrarianism — ” With markets, it doesn?t matter what people say.? What matters is what they rely upon.” I give several examples for how to possibly generate a correct contrarian (or, non-consensus) opinion.
My 9/11 Experience — A brief telling of what happened to me on 9/11/2001, but focusing on the very non-consensus investment decisions we made immediately after that.
The Ecology of Investment Strategies — ‘ Any investment strategy can be overused.? Part of the job of a portfolio manager is to ask the question ?To what degree am I in or out of the consensus? Where am I in the cycle for my strategy?? ‘ (I wish I had applied that to my deep value investing when the FOMC dropped rates to zero.)
Book Review: The Most Important Thing — Howard Marks as an investor is probably the best explainer of non-consensus investing, which he entitles “second level thinking.” I’m currently reading the book Non-Consensus Investing by Rupal Bhansali. This also seems to be a good book on the topic, and I will likely review it.
But then if you want to hear the same thing from someone who is out of favor right now it would be: Book Review: The Only Three Questions That Count by Ken Fisher. It’s his second question: ” What can you fathom that others find unfathomable?”
Summary
In general, talk is cheap. Money talks louder than human chattering when it comes to the markets. The consensus derives from the investment actions that market players make, not the words they utter.
Appendix (skip if you don’t want to read a brief critique of liberation theology)
Martin Luther King, Jr. was probably the most famous American example of a liberation theologian. Unlike many liberation theologians in Latin America, he was far more moderate in his goals — he sought the end of segregation, not a violent revolution.
Even the verse the liberation theologians so often cite, Jesus saying, “Think not that I have come to bring peace. I have not come to bring peace but a sword,” wasn’t talking about war. It meant that a division would be made between Christians and non-Christians, such that non-Christians would sometimes hate Christians, even if they were family members.
But King’s preaching nonetheless focused on ending a great evil in this life, rather than pointing people to repentance from sin, and faith in Jesus Christ, which would lead to eternal happiness in the life after death.
The Bible does not promise human happiness in this life to Christians, or anyone else for that matter. Christ said believers should not be surprised if they were persecuted, poor, and/or their own families might hate them. He said “I will never leave you nor forsake you.” He would bring comfort in the midst of sorrow.
As the BIble says, “What does it profit a man to gain the whole world, and lose his soul?” (This was my Bloomberg banner message for years.) The liberation theologian offers his hearer a poor deal. “Listen to me, overthrow the wicked government — God is behind you — He will support you in your goal.” Even if they succeed, and those who rebel rarely win, they might be happy for this life, but not eternally.
There are many verses in the Bible that discourage rebellion against the powers that be, but the overarching reason is that God sets rulers in place, even bad ones (see Romans 12). God says, “Vengeance is Mine, I will repay.” As such, it is not for us to take revenge against those who rule us. As it says in the Psalms many times, God will bring judgment on all bad rulers.
That’s my brief argument. I have a lot more to say, but the main thing is this: the Bible focuses on the eternal, not the temporal. It teaches that this short life of ours that ends in death is a test. Would you rather ignore God and enjoy life now, or deny present desires, and aim for heaven? God isn’t looking for perfection, but repentance and faith in Jesus Christ as Lord.
I know that I fail to always do what’s right, but I trust in Christ. Anyway, if you got this far, pray and consider it. Thanks.
Disclosure
If you enter Amazon through my site, and you buy anything, I get a small commission. This is my main source of blog revenue. I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip. Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book. Also, I never use the data that the PR flacks send out.)
Most people buying at Amazon do not enter via a referring website. Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites. Whether you buy at Amazon directly or enter via my site, your prices don?t change.
Picture Credit: Olivier ROUX || Simplicity almost always beats complexity.
I’m not a fan of EIAs. I’m not a fan of variable annuities, unless they’re really simple with rock-bottom expenses and no surrender charges. I’m not a fan of ETNs. I hate structured notes. I’m also not a fan of ETFs that are filled with derivatives.
* Small compared to the pool that they fish in * Follow broad themes * Do not rely on irreplicable assets * Storable, they do not require a ?roll? or some replication strategy. * not affected by unexpected credit events. * Liquid in terms of what they represent, and liquid it what they hold.
The last one is a good summary.? There are many ETFs that are Closed-end funds in disguise.? An ETF with liquid assets, following a theme that many will want to follow will never disappear, and will have a price that tracks its NAV.
But tonight I have another complex investment to avoid, and a simple one to embrace. First the avoid…
There was a piece at Bloomberg Businessweek called ETFs With Downside Protection? It?s Complicated. These are called defined outcome ETFs. Basically they are a bundle of equity options that cut your losses, while limiting your gains on a given equity index. (Also, you don’t get dividend income, and have to pay manager fees.) In-between the cap on gains, and where losses kick in, your returns should move 1:1 with the index. The same will be true with losses after the first N% get eaten — below N% losses, you begin taking losses.
Illustration of Defined Outcome ETF returns as compared to an index fund using the same index as the Defined Outcome ETF
I wanted to keep the illustration simple. This hypothetical defined outcome ETF caps gains at 10%, and absorbs the first 15% of losses. This example assumes no fees, which would likely be lower on the index fund. This example assumes no dividends, which would get paid to you in the index fund, but not on the defined outcome ETF.
Defined outcome ETFs purchase and sell tailored options that are backed by the central counterparty the Options Clearing Corporation — a very strong, stable institution. Credit risk still exists, but if the OCC goes down, many things will be in trouble. The options exist for one year, after which gains are paid to and losses absorbed by ETF shareholders. The ETF then resets to start another year following the same strategy with slightly different levels because the relative amounts of the cap and the loss buffering rely on where equity volatility is for a given index at the start of the year.
Unlike an index fund, your gains cannot grow tax-deferred, though if you have gains, you can roll them over into the next year.
I’ve read the offering documents, including the sections on risk. My main argument with the product is that you give up too much upside for the downside protection. The really big up years are the places where you make your money. There aren’t so many “average” years. The protection on the downside is something, but in big down years it could be cold comfort.
The second part is the loss of dividends and paying higher fees. Using the S&P 500 as a proxy, a 2% dividend lost and a 0.5% added fee adds up to quite a cost.
There are implementation risks and credit risks but these risks are small. I ran a medium-sized EIA options book for a little more than a year. This is not rocket science. The investor who is comfortable with options could create this on his own. They list more risks in the offering documents, but they are small as well. What gets me are the costs, and the upside/downside tradeoff.
Yes, interest rates are low. Yields on some stocks are higher than the yields on the Barclays’ Aggregate [bond] Index. But if you only bought those bonds, you would have a rather unbalanced portfolio from a sector standpoint — heavy on utilities and financials. The Barclays’ Aggregate still outyields the S&P 500, if not by much, like 0.8%/yr.
The real reason that you hold bonds and cash equivalents is not the income; it is risk reduction. I’m assuming no one is thinking of buying the TLT ( 20+ Year Treas Bond Ishares ETF), which is more of a speculator’s vehicle, but something more like AGG ( US Aggregate Bond Ishares Core ETF), which yields 0.3% more, but the overall volatility is a lot less.
With AGG, fixed income claims of high investment grade entities will make it through a deflationary crisis. In an inflationary situation like the 70s, the bonds are short enough that over a five year period, you should make money, just not in real terms.
It’s good to think long term, and have a mix of fixed and variable claims. The bonds (fixed claims) lower your volatility so that you don’t get scared out of your stocks (variable claims) in a serious downdraft.
The models I have run have returns max out in an 80/20 balanced fund, and the trade-off of risk for return is pretty good down to a 60/40 balanced fund. In my personal investing, I have always been between 80/20 and 60/40.
Thus the need for bonds. In a bad scenario, stocks will fall more than bonds, and the balanced fund will buy stocks using proceeds of the bonds that have fallen less to buy stocks more cheaply. And if the stock market rises further, the balanced fund will sell stocks and use the proceeds to bank the gains by buying bonds that will offer future risk reduction, and some income.
As such, consider the humble balanced fund as a long-term investment vehicle that is simple and enduring, even when rates are low. And avoid complexity in your investment dealings. It is almost never rewarded.
Picture Credit: OTA Photos || This is easier said than done!
The SEC is seeking ideas on how to make small cap stocks more tradable. Let me quote the closing of an article from the Wall Street Journal:
In soliciting the proposals, the SEC laid out a number of possible approaches, without endorsing any of them.
One such approach would limit trading in low-volume stocks to the exchange where they are listed. Nasdaq Inc. has promoted a similar plan, arguing that it would create deeper markets for small-cap stocks by concentrating the trading of their shares on one venue. But critics, including some rival exchanges,?have attacked Nasdaq?s plan?as anticompetitive, saying it would benefit big exchanges like Nasdaq.
In another approach floated by the SEC, trading in low-volume stocks would take place in periodic auctions, separated by discrete time intervals, instead of continuously throughout the trading day.
I’m not sure that any of these proposals will work. Longtime readers know that I think that liquidity is hard to permanently increase, or decrease for that matter.
By nature, small cap stocks have smaller floats. There’s less information about them Many accounts and managers have mandates that don’t allow them to purchase small cap stocks. Bid-ask sizes and spreads tend to be smaller and larger respectively than those of large caps. That’s largely a function of floating market cap and the underlying riskiness of the company in question. Market structure plays less of a role.
The composition of investors does matter. It typically doesn’t change that much; it is cyclical. Horizons shorten as volatility rises, and vice-versa.
The more buy-and-hold investors there are, the more liquidity decreases. The more traders with short time horizons there are, the more liquidity increases. Commissions declining will possibly make time horizons a little shorter for day-traders, but I can’t imagine that the effect will be that big.
As a smaller investor, I do like the concept of a central order book that would have a monopoly on trading a stock, because it would remove an informational edge that high-frequency traders [HFT] have. I don’t think it would increase liquidity much though. It would change where the trades happen, and perhaps who makes the trades. I think that some less technologically inclined investment advisors would be willing to put up larger bids and asks in such a context, but they would mostly replace lost volume from HFT.
I also think that having more auctions during the day would be a good idea, say like one every half hour. I don’t think it would increase liquidity, though. Trading would become more sparse away from the auctions.
I own four illiquid stocks for my stock strategy clients, and one less liquid closed-end fund for my bond clients. I can trade them if I need to. I just have to be more patient with those securities, and break trades up into bite-size pieces.
For me, trading is a way of implementing changes to the portfolio. If any of the proposed changes happened, my trading would not change much at all. I suspect that would be true for all but the investors with the shortest time horizons, but I think that could go either way. We have lower commissions on one hand, and disadvantages for HFT on the other. Could be a wash.
Enough rambling. I don’t see a lot of likely change here, and liquidity should not be the highest priority at the SEC. Rather than facilitating more secondary trading, it would be nice to see more private firms going public. SEC efforts on that would get my attention.
