Stocks – Page 6 – The Aleph Blog

The Little Market that Could

Posted on 20 October 2017 by David Merkel

Picture Credit: Roadsidepictures from The Little Engine That Could By Watty Piper, Illustrated By George & Doris Hauman | That said, for every one that COULD, at least two COULDN’T

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So what do you think of the market?? Why are both actual and implied volatility so low?? Why are the moves so small, but predominantly up?? Is this the closest impression of the Chinese Water Torture that a stock market can pull off?

Why doesn’t the market care about external and internal risks?? Doesn’t it know that we have divisive, seemingly incompetent President who looks like he doesn’t know how to do much more than poke people in the eyes, figuratively?? Doesn’t it know that we have a divided, incompetent Congress that can’t get anything of significance done?

Leaving aside the possibility of a war that we blunder into (look at history), what if the inability of Washington DC to do anything is a plus?? Government on autopilot for four years, maybe eight if we decide we are better of without change — is that a plus or minus?? Just ignore the noise, Trump, other politicians, media… ahh, the quiet could be nice.

Then think about Baby Boomers showing up late for retirement, and wondering what they are going to do.? Then think about their surrogates, the few who still have defined benefit pension plans.? What are they going to do?? Say that the rate that they are targeting for investment earnings is 7%/year forever.? Even if my model for investment returns is wrong in a pessimistic way — i.e., my 4% nominal should be 6%/year nominal, you still can’t hit your funding target.? As for those with defined contribution plans, when you are way behind, even contributing more won’t do much unless investment earnings provide some oomph.

I am personally not a fan of TINA — “there is no alternative” to stocks in the market, but I recognize the power of the idea with some.? It is my opinion that more people and their agents will run above average risks in order to try to hit an unlikely target rather than lock in a loss versus what is planned.? Most will “muddle in the middle” taking some risk even with a high market, and realizing that they aren’t going to get there, but maybe a late retirement is better than none.

That’s the power of bonds returning 3% at best over the forecast horizon, unless interest rates jump, and then we have other problems, like risk assets repricing.? If you are older, almost no plan is achievable at reasonable cost if you are coming to the game now, rather than starting 15+ years ago.

And so I come to “the little market that could…” for now.? My view is that those with retirement obligations to fund are bidding up the market now.? That does two things.? Shares of risk assets (stocks) move from the hands of stronger investors to weaker investors, while cash flows the opposite direction.? In the process, prices for risk assets get bid up relative to their future free cash flows.

Unlike “the little engine that could,” the little market that could has climbed some small hills relative to the funding targets that investors need. Ready for the Himalayas?? The trouble with those targets is that regardless of what the trading price of the risk assets is, the cash flows that they produce will not support those targets.

Thought experiment: imagine that the stock market was gone and all the shares we held were of private companies that were difficult and expensive to trade.? ?Pension plans would estimate ability to meet targets by looking at forecasts of the underlying returns of their private investments, rather than a total return measure.

Well, guess what?? In the long run, the returns from public stock investments reflect just that — the distributable amount of earnings that they generate, regardless of what a marginal bidder is willing to pay for them at any point in time.? Stocks aren’t magic, any more than the firms that they represent ownership in.

So… we can puzzle over the current moment and wonder why the market is behaving in a placid, slow-climbing manner.? Or, we can look at the likely inadequacy of asset cash flows versus future demands for those cash flows for retirement, etc.? Personally, I think they are related as I have stated above, but the second view, that asset returns will not be able to fund all planned retirement needs is far more certain, and is one mountain that “the little market that could” cannot climb.

Thus, consider the security of your own plans, and adjust accordingly.? As I commented recently, for older folks with enough assets, maybe it is time to lock in gains.? For others, figure out what adjustments and compromises will need to be made if your assets can’t deliver enough.

Tough stuff, I know.? But better to be realistic about this than to be surprised when funding targets are not reached.

“Bank” Some of Your Gains

Posted on 17 October 201717 October 2017 by David Merkel

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Recently I read Jonathan Clements’ piece Enough Already.? The basic idea was to encourage older investors who have made gains in the risk assets, typically stocks, though it would apply to high yield bonds and other non-guaranteed investments that are highly correlated with stocks.? His pithy way of phrasing it is:

If I have already won the game, why would I keep playing?

His inspiration for the piece stems from a another piece by William Bernstein [at the WSJ] How to Tell if Your Retirement Nest Egg Is Big Enough.? He asked a question like this (these are my words) back in early 2015, “Why keep taking risk if your performance has been good enough to let you reduce risk and live on the assets, rather than run the possibility of a fall in the market spoiling your ability to retire comfortably?”

Decent question.? If you are young enough, your time horizon is long enough that you can ignore it.? But if you are older, you might want to consider it.

Here’s the problem, though.? What do you reinvest in?? My article?How to Invest Carefully for Mom?took up some of the problem — if I were reducing exposure to stocks, I would invest in high quality short and long bonds, probably weighted 50/50 to 70/30 in that range.? Examples of tickers that I might consider be MINT and TLT.? Trouble is, you only get a yield of 2% on the mix.? The short bonds help if there is inflation, the long bonds help if there is deflation.? Both remove the risk of the stock market.

I’m also happier in running with my mix of international stocks and quality US value investments versus holding the S&P 500, because foreign and value have underperformed for so long, almost feels like 1999, minus the crazed atmosphere.

Now, Clements at the end of the exercise doesn’t want to make any big changes.? He still wants to play on at the ripe old age of 54.? He is concerned that his nest egg isn’t big enough.? Also, he thinks stocks will return 5-6%/year over the long haul (undefined), versus my model that says 2-6%/year over the next ten years.

What would I say?? I would say “do half.”? Whatever the amount you would cut from stocks to move to bonds if you were certain of it, do half of it.? If disaster strikes, you will pat yourself on the back for doing something.? If the market rallies further, you will be glad you didn’t do the whole thing.

What’s that, you say?? What am I doing?? At age 56, I am playing on, but 10-12% higher in the S&P 500, and I will hedge.? At levels like that future market outcomes are poor under almost every historical scenario, and even if the market doesn’t seem nuts in terms of qualitative signals, the amount you leave on the table is piddly over a 10-year horizon.? If I see more genuine nuttiness beyond certain logic-free zones in the market, I could act sooner, but for now, like Jonathan, I play on.

Full disclosure: long MINT and TLT for me and my fixed income clients

The Many Virtues of Simplicity

Posted on 7 October 20178 October 2017 by David Merkel

Photo Credit: Christopher || Maintaining a marriage is simple… if you do it right…

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There are at least eight reasons why taking a simple approach to investing is a wise thing to do.

Understandable
Explainable
Reduced “Too smart for you own good risk”
Clearer risk management
Less trading
Taxes are likely easier
Not Trendy
Cheap

Understandable

You have to understand your investments, even if it’s just at the highest overview level. ?If you don’t have that level of understanding, then at some point you will be tempted to change your investments during a period of market duress, and it will likely be a mistake. ?Panic never pays. ?How to avoid panic? ?Knowledge reduces panic. ?Whatever the strategy is, follow it in good times and bad. ?Understand how bad things can get before you start an investment program. ?Make changes if needed when things are calm, not in the midst of terror.

Explainable

You should be able to explain your investment strategy at a basic level, enough that you can convey it to a friend of equal intelligence. ?Only then will you know that you truly understand it. ?Also, in trying to explain it you will discover whether your investments are truly simple or not. ?Does your friend get it, even if he may not want to imitate what you are doing?

Take an index card and write out the strategy in outline form. ?Would you feel confident talking for one minute about it from the outline?

Reduced “Too smart for your own good risk”

If you have simple investments, you will tend not to get unexpected surprises. ?One reason the rating agencies did so badly in the last crisis was that they were forced to rate stuff for which they did not have good models. ?The complexity level was too high, but the regulators required ratings for assets held by banks and insurers, and so the rating agencies did it, earning money for it, but also at significant reputational risk.

Why did the investment banks get into trouble during the financial crisis? ?They didn’t keep things simple. ?They held a wide variety of complex, illiquid investments on their balance sheets, financed with short-term lending. ?When there was doubt about the value of those assets, their lenders refused to roll over their debts, and so they foundered, and most died, or were forced into mergers.

I try to keep things simple. ?Stocks that possess a margin of safety and high quality bonds are good investments. ?Stocks have enough risk, and high quality bonds are one of the few assets that truly diversify, along with cash. ?That makes sense from a structural standpoint, because fixed claims on future cash are different than participating in current profits, and the change in expectations for future profits.

Clearer risk management

When assets are relatively simple, risk management gets simple as well. ?Assets should succeed for the reasons that you thought they would in advance of purchase.? Risk assets should primarily generate capital gains over a full market cycle.? fixed Income assets help provide a floor, and limit downside, so long as inflation remains in check.

With simple asset allocations, you don’t tend to get negative surprises.? Does an income portfolio fall apart when the stock market does?? It probably was not high quality enough.? Does you asset allocation give large negative surprises close to retirement?? Maybe there were too many risk assets in the portfolio after a long bull run.

Cash and commodities (in small amounts) can help as well.? Those don’t have yield, and don’t typically provide capital gains, but they would help if inflation returned.

Less trading

Simplicity in asset allocation means you can sleep at night.? You’ve already determined how much you are willing to lose over the bear portion of a market cycle, so you aren’t looking to complicate your life through trying to time the market.? Few people have the disposition to sell near near top, and few?have the disposition to buy near near the bottom.? Almost no one can do both.? (I’m better at bottoms…)

Pick a day of the year — maybe use your half-birthday (as some of my kids would say — it is six months after your birthday).? Look at your portfolio, and adjust back to target percentages, if you need to do that.? Then put the portfolio away.? If you have set your asset allocation conservatively, you won’t feel the need to make radical changes, and over time, your assets should grow at a reasonable rate.? Remember, the more conservative asset allocation that you can live with permanently is far better than the less conservative one that you will panic over at the wrong time.

Taxes are likely easier

Not that many people have taxable accounts, though half the assets that I manage are taxable, but if you don’t trade a lot, taxes from your accounts are relatively easy.? Unrealized capital gains compound untaxed over time, and there is the option to donate appreciated stock if you want to get a write-off and eliminate taxes at the same time.

Not Trendy

You won’t get caught in fads that eventually blow up if you keep things simple.? You may be pleasantly surprised that you buy low more frequently than your trendy neighbors.? Remember, people always brag about their wins, but they never tell you about the losses, particularly the worst ones.? Those who don’t lose much, and take moderate risks typically win in the end.

Cheap

Simple investment strategies tend to have lower management fees, and fewer “soft” costs because they don’t trade as much.? That can be a help over the long run.

That’s all for this piece.? For most investors, simplicity pays off — it is that simple.

Book Review: The Best Investment Writing, Volume 1

Posted on 5 October 2017 by David Merkel

I was pleasantly surprised to be invited to contribute a chapter to this book.? I am going to encourage you to buy this book, but let me give some of the reasons not to buy this book:

Don’t buy it to give me something.? I don’t get anything from sales of this book.? Neither does Mebane Faber, who is giving all of the profits to charity.
Don’t buy it to read my article.? You can read it for free here.? Better, you can read the updated version of the article, which I publish quarterly, here.? (Those reading this at Amazon, there are links at my blog.? Google “Alephblog The Best Investment Writing” to find them.)
Don’t buy it to get current ideas.? There are none here.? The weakness of the book is that the articles are dated by 9-21 months or so, BUT… that doesn’t keep the book from being relevant.
Don’t buy it if you want one consistent theme.? It’s like reading RealMoney.com, except with a broader array of authors.? There is no “house view.”
Don’t buy it for the graphics in the book.? The grayscale images in the book are good for black & white, but some are hard to read.? The graphs for my article are far better at my blog.

The book is a good one because there is something for everyone here.? Do you want quantitative finance?? There is a good selection here. Do you want good basic articles about how to think about investing?? There are a good number of those as well, particularly from well-known financial journalists, and some of the most well-regarded bloggers.? Do you want a few unusual articles that might cause you consider some asset sub-classes or techniques that you haven’t considered before?? They are here too.

The writers fall into four buckets — journalists, asset managers, pundits/authors, and those who sell information at their websites.? I will tell you that my personal favorites from this volume are Tom Tresidder, Mebane Faber, Chris Meredith, Ben Carlson (how was he the only one with two articles in the book?), Jason Hsu & John West, and Cullen Roche.

Don’t get me wrong, I like almost all of the authors in this volume, and am proud to be featured among them.? For a number of them, though, I would have picked other things they have written in 2016 that had more punch, and offered more of a difference in perspective.

Why buy this?? After you read this, you will be a smarter, more well-rounded investor.? In my calculations, that’s? pretty good — 32 articles that will take you 4 hours to read.? Got seven minutes?? Read an article; it just might help you a great deal.

Quibbles

Already stated, though if you don’t like statistics, one-third of the articles may not appeal to you.? Also, a few articles veer into political commentary (not that I would ever do that 😉 ).

Summary / Who Would Benefit from this Book

Though almost anyone could benefit from this book, it is geared toward investors with intermediate-to-higher levels of knowledge and experience.? If you want to buy it, you can buy it here:?The Best Investment Writing: Selected writing from leading investors and authors.

Full disclosure:?I received two free copies of the book for contributing the article.? That’s all, unless someone buys the book through the link above.

If you enter Amazon through my site, and you buy anything, including books, 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.

Estimating Future Stock Returns, June 2017 Update

Posted on 22 September 2017 by David Merkel

I’d say this is getting boring, but it’s pretty fascinating watching the rally run. ?Now, this is the seventh time I have done this quarterly analysis. ?The first one was for December 2015. ?Over that time period, the expected annualized 10-year return went like this, quarter by quarter: 6.10%, 6.74%, 6.30%, 6.01%, 5.02%, 4.79%, and 4.30%. ?At the end of June 2017, the figure would have been 4.58%, but the rally since the end of the quarter shaves future returns down to 4.30%.

We are now in the 93rd percentile of valuations.

Wow.

This era will ultimately be remembered as a hot time in the markets, much like 1965-9, 1972, and 1997-2001.

The Internal Logic of this Model

I promised on of my readers that I would provide the equation for this model. ?Here it is:

10-year annualized total return = 32.77% – (70.11% * Percentage of total assets held in stocks for the US as a whole)

Now, the logic of this formula stems from the idea that the return on total assets varies linearly with the height of the stock market, and the return on debt (everything else aside from stocks) does not. ?After that, the formula is derived from the same formula that we use for the weighted average cost of capital [WACC]. ?Under those conditions, the total returns of the stock market can be approximated by a linear function of the weight the stocks have in the WACC formula.

Anyway, that’s one way to think of the logic behind this.

The Future?

Now, what are some of the possibilities for the future?

Above you see the nineteen scenarios for where the S&P 500 will be in 10 years, assuming a 2% dividend yield, and looking at the total returns that happen when the model forecasts returns between 3.30% and 5.30%. ?The total returns vary from 2.31%/year to 6.50%, and average out to 3.97% total returns. ?The bold line above is the 4.30% estimate.

As I have said before, this bodes ill for all collective security schemes that rely on the returns of risky assets to power the payments. ?There is no conventional way to achieve returns higher than 5%/year for the next ten years, unless you go for value and foreign markets (maybe both!).

Then again, the simple solution is just to lighten up and let cash build. ?Now if we all did that, we couldn’t. ?Who would be buying? ?But if enough of us did it such that equity valuations declined, there could be a more orderly market retreat.

The attitude of the market on a qualitative basis doesn’t seem nuts to me yet, so I am at maximum cash for ordinary conditions, but I haven’t hedged. ?When expected 10-year market returns get to 3%/year, I will likely do that, but for now I hold my stocks.

PS — the first article of this series has been translated into Chinese. ?The same website has 48 of my best articles in Chinese, which I find pretty amazing. ?Hope you smile at the cartoon version of me. 😉

How to Invest Carefully for Mom

Posted on 21 September 2017 by David Merkel

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Just a note before I begin. My piece called “Where Money Goes to Die” was an abnormal piece for me, and it received abnormal attention. ?The responses came in many languages aside from English, including Spanish, Turkish and Russian. ?It was interesting to note the level of distortion of my positions among those writing articles. ?That was less true of writing responses here.

My main point is this: if something either has no value or can’t be valued, it can’t be an investment. ?Speculations that have strong upward price momentum, like penny stocks during a promotion, are dangerous to speculate in. ?Howard Marks, Jamie Dimon and Ray Dalio seem to agree with that. ?That’s all.

Now for Q&A:

Greetings and salutations. ?:)

Hope all is well with you and the family!

Just have what I believe is a quick question. I already know [my husband’s] answer to this (Vanguard index funds – it his default answer to all things investment), but this is for my Mom, so it is important that she get it right (no wiggle room for losing money in an unstable market), hence my asking you. My Mom inherited money and doesn’t know what to do with it. a quarter of it was already in index funds/mutual funds and she kept it there. The rest came from the sale of real estate in the form of a check. That is the part that she doesn’t know what she should do with. She wanted to stick it in a CD until she saw how low the interest rates are. She works intermittently (handyman kind of work – it is demand-dependent), but doesn’t have any money saved in a retirement account or anything like that, so she needs this money get her though the rest of her life (she is almost 60). What would you recommend? What would you tell [name of my wife] to do if she were in this position? BTW, it is approx $ZZZ, if that makes a difference. Any advice you can give would be very much appreciated!

Vanguard funds are almost always a good choice. ?The question here is which Vanguard funds? ?To answer that, we have to think about asset allocation. ?My thoughts on asset allocation is that it is a marriage of two concepts:

When will you need to spend the money? and
Where is there the opportunity for good returns?

Your mom is the same age as my wife. ?A major difference between the two of them is that your mom doesn’t have a lot of investable assets, and my wife does. ?We have to be more careful with your mom. ?If your mom is only going to draw on these assets in retirement, say at age 67, and will draw them down over the rest of her life, say until age 87, then the horizon she is investing over is long, and should have stocks and longer-term bonds for investments.

But there is a problem here. ?Drawing on an earlier article of mine, investors today face a big problem:

The biggest problem for investors is low future returns. ?Bonds have low rates of returns, and equities have high valuations. ?You?ll see more about equity valuations in my next post.

This is a real problem for those wanting to fund retirements. ?Stocks are priced to return around 4%/year over the next ten years, and investment-grade longer bonds are around 3%. ?There are some pockets of better opportunity and so I suggest the following:

Invest more in foreign and emerging market stocks. ?The rest of the world is cheaper than the US. ?Particularly in an era where the US is trying to decouple from the rest of the world, foreign stocks may provide better returns than US stocks for a while.
Invest your US stocks in a traditional “value” style. ?Admittedly, this is not popular now, as value has underperformed for a record eight years versus growth investing. ?The value/growth cycle will turn, as it did back in 2000, and it will give your mom better returns over the next ten years.
Split your bond allocation into two components: long US high-quality bonds (Treasuries and Investment Grade corporates), and very short bonds or a money market fund. ?The long bonds are there as a deflation hedge, and the short bonds are there for liquidity. ?If the market falls precipitously, the liquidity is there for future investments.

I would split the investments 25%, 35%, 20%, 20% in the order that I listed them, or something near that. ?Try to sell your mom on the idea of setting the asset allocation, and not sweating the short-term results. ?Revisit the strategy every three years or so, and rebalance annually. ?If assets are needed prematurely, liquidate the assets that have done relatively well, and are above their target weights.

I know you love your mom, but the amount of assets isn’t that big. ?It will be a help to her, but it ultimately will be a supplement to Social Security for her. ?Her children, including you and your dear husband may ultimately prove to be a greater help for her than the assets, especially if the markets don’t do well. ?The asset allocation I gave you is a balance of offense and defense in an otherwise poor environment. ?The above advice also mirrors what I am doing for my own assets, and the assets of my clients, though I am not using Vanguard.

Book Review: Big Money Thinks Small

Posted on 6 September 2017 by David Merkel

Joel Tillinghast, one of the best mutual fund managers, runs the money in Fidelity’s Low-Priced Stock Fund. ?It has one of the best long-term records among stock funds over the 28 years that he has managed it.

The author gives you a recipe for how to pick good stocks, but he doesn’t give you a machine that produces them. ?In a style that is clever and discursive, he summarizes his main ideas at the beginning and end of the book, and explains the ideas in the middle of the book. ?The ideas are simple, but learning to apply them will take a lifetime.

Here are the five ideas as written in the beginning (page 3):

Make decisions rationally
Invest in what we know (did I mention Peter Lynch wrote the foreword to the book?)
Worth with honest and trustworthy managers
Avoid businesses prone to obsolescence and financial ruin, and?
Value stocks properly

At this point, some will say “You haven’t really given us anything! ?These ideas are too big to be useful!” ?I was surprised, though, to see that the same five points at the end of the book said more (page 276). ?Ready?

Be clear about your motives, and don’t allow emotions to guide your financial decisions
Recognize that some things can’t be understood and that you don’t understand others. ?Focus on those that you understand best.
Invest with people who are honest and trustworthy, and are doing something unique and valuable.
Favor businesses that will not be destroyed by changing times, commoditization, or excessive debt.
Above all, always look for investments that are worth a great deal more than you are paying for them.

That says more, and I think the reason they are different is that when you read through the five sections of the book, he unpacks his initial statements and becomes more definite.

Much of the book can be summarized under the idea of “margin of safety.” ?This is a type of value investing. ?When he analyzes value, it is like a simplified version of reverse discounted cash flows. ?He tries to figure out in a broad way what an investment might return in terms price paid for the investment and what “owner earnings,” that is, free cash flow, it will generate on a conservative basis.

One aspect of the conservatism that I found insightful is that he assumes that the terminal value of an investment is zero. (page 150) ?In my opinion, that is very smart, because that is the area where most discounted cash flow analyses go wrong. ?When the difference between the weighted average growth rate of free cash flow and the discount rate is small, the terminal value gets really big relative to the value of the cash lows prior to the terminal value. ?In short, assumptions like that say that the distant future is all that matters. ?That’s a tough assumption in a world where companies and industries can become obsolete.

Even though I described aspects of a mathematical calculation here, what I did was very much like the book. ?There are no equations; everything is described verbally, even the math. ?Note: that is a good exercise to see whether you understand what the math really means. ?(If more people on Wall Street did that, we might not have had the financial crisis. ?Just sayin’.)

One more fun thing about the book is that he goes trough his own experiences with a wide variety of controversial stocks from the past and his experiences with them. ?His conservatism kept him a great number of errors that tripped up other celebrated managers.

I learned a lot from this book, and I enjoyed the writing style as well. ?He clearly put a lot of effort into it; many people will benefit from his insights.

Quibbles

His methods are a lot like mine, and he clearly put a lot of thought into this book. ?That said, he doesn’t understand insurance companies as well as he thinks (I’m an actuary by training). ?There are a number of small errors there, but not enough to ruin a really good book.

Summary / Who Would Benefit from this Book

I highly recommend this book. ?This is a book that will benefit investors with moderate to high experience most. For those with less experience, it may help you, but some of the concepts require background knowledge. ?If you want to buy it, you can buy it here: Big Money Thinks Small: Biases, Blind Spots, and Smarter Investing.

Full disclosure:?The publisher asked me if I wanted a free copy and I assented.

Where Money Goes to Die

Posted on 5 September 2017 by David Merkel

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It is often a wise thing to look around and see where people are doing that is nuts. ?Often it is obvious in advance. ?In the past, the two most obvious were the dot-com bubble and the housing bubble. ?Today, we have two unrelated pockets of nuttiness, neither of which is as big: cryptocurrencies and shorting volatility.

I have often said that that lure of free money brings out the worst economic behavior in people. ?That goes double when people see others who they deem less competent than themselves seemingly making lots of money when they are not.

I’ve written about Bitcoin before. ?It has three main weaknesses:

No intrinsic value –?can?t be used of themselves to produce something else.
Cannot be used to settle all debts, public and private
Less secure than insured bank deposits

In an economic world where everything is relative in a sense — things only have value because people want them, some might argue that cryptocurrencies have value because some people want them. ?That’s fine, sort of. ?But how many people, and are there alternative uses that transcend exchange? ?Even in exchange, how legally broad is the economic net for required exchangability? ?Only legal tender satisfies that.

That there may be some scarcity value for some cryptocurrencies puts them in the same class as some Beanie Babies. ?At least the Beanie Babies have the alternative use for kids to play with, even though it ruins the collectibility. ?(We actually had a moderately rare one, but didn’t know it and our kids happily played with it. ?Isn’t that wonderful? ?How much is the happiness of a kid worth?)

I commented in my Bitcoin article that it was like Penny Stocks, and that’s even more true with all of the promoters touting their own little cryptocurrencies. ?The promoters get the benefit, and those who speculate early in the boom, and the losers are those fools who get there late.

There’s a decent public policy argument for delisting penny stocks with no real business behind them; things that are worth nothing are the easiest things to spin tales about. ?Remember that absurd is like infinity. ?If any positive value is absurd, so is the value at two, five, ten, and one hundred times that level.

The same idea applies to cryptocurrencies; a good argument could be made that they all should be made illegal. ?(Give China a little credit for starting to limit them.) ?It’s almost like we let any promoter set up his own Madoff-like scheme, and sell them to speculators. ?Remember, Madoff never raked off that much… but it was a negative-sum game. ?Those that exited early did well at the expense of those that bought in later.

Ultimately, most of the cryptocurrencies will go out at zero. ?Don’t say I didn’t warn you.

Shorting Volatility

This one is not as bad, at least if you don’t apply leverage. ?Many people don’t get volatility, both applied and actual. ?It spikes during panics, and reverts to a low level when things are calm. ?It seems to mean-revert, but the mean is unknown, and varies considerably across different time periods.

It is like the credit cycle in many ways. ?There are two ways to get killed playing credit. ?One is to speculate that defaults are going to happen and overdo going short credit during the bull phase. ?The other is to be a foolish yield-seeker going into the bear phase.

So it is for people waiting for volatility to spike — they die the death of one thousand cuts. ?Then there are those that are short volatility because it pays off when volatility is low. ?When the spike happens, many will skinned; most won’t recover what they put in.

It is tough to time the market, whether it is equity, equity volatility, or credit. ?Doesn’t matter much if you are a professional or amateur. ?That said, it is far better to play with simpler and cleaner investments, and adjust your risk posture between 0-100% equities, rather than cross-hedge with equity volatility products.

Again, this is one where people are very used to selling every spike in volatility. ?It has been a winning strategy so far. ?Remember that when enough people do that, the system changes, and it means in a real crisis, volatility will go higher than ever before, and stay higher longer. ?The markets abhor free riders, and disasters tend to occur in such a way that the most dumb money gets gored.

Again, when the big volatility spike hits, remember, I warned you. ?Also, for those playing long on volatility and buying protection on credit default — this has been a long credit cycle, and may go longer. ?Do you have enough wherewithal to survive a longer bull phase?

To all, I wish you well in investing. ?Just remember that new asset classes that have never been through a “failure cycle” tend to produce the greatest amounts of panic when they finally fail. ?And, all asset classes eventually go through failure.

Why is the Stock Market So High?

Posted on 5 August 20176 August 2017 by David Merkel

Photo Credit: Carl Wycoff || It is a long way to the end of retirement. ?People are getting ready for it. ?Are you?

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Assuming that you could throw stones on the financial internet, it would be hard to toss a stone and miss articles talking about how high the stock market is. ?One good article from last week was?Why Do U.S. Stocks Keep Hitting Records? Here Are Five Theories from the Wall Street Journal. ?Here were the five theories:

Stocks Reflect the Resurgent Health of American Corporations
The Global Outlook Is Looking Brighter
The U.S. Economy Is in a ?Goldilocks? Situation
Passive Funds Are Propping Up Prices
There Is No Alternative

Of this list, I think answers 1, 3 and 5 are correct, and 2 and 4 are wrong. ?I have a few other answers that I think are right:

Demographics are leading people to buy assets that will provide long-term cash flows.?Monetary policy has led to asset price inflation, not goods price inflation.
People are overestimating the resiliency of the political and social constructs that make all of this possible.
The “Dumb Money” hasn’t arrived yet, but the sale of volatility by retail contradict that.

I disagree with point 2 from the WSJ article because a stronger global economy not only means that profits will rise, but also the cost of capital. ?Depending on which factor is stronger, a stronger global economy can make stocks go up, down, or be neutral.

On point 4, I’ve written about that in?Overvaluation is NOT Due to Passive Investing. ?What matters more than the active/passive mix is the total shift in portfolio holdings into stocks versus everything else. ?When people hold a lot of their portfolio in stocks, stock prices tend to be high.

The active/passive mix does have effect on the relative prices of securities in the indexes versus outside the indexes.?The clearest place to see the impacts of ETFs and indexing is in bonds, where bonds that are in the indexes trade at lower yields and higher prices than similar non-index bonds.

With stocks, it is probably the same, but harder to prove;?I wrote about this here.??In the short run, the companies in the popular indexes are getting a tailwind. That will turn into a headwind at some point, because the voting machine always eventually becomes a weighing machine.

Why are stocks high?

Profit margins are high because of productivity increases from the application of information technology. ?Also, there is a lot of lower paid labor to employ globally which further depresses wage rates in developed countries.

Points 3 and 5 of the WSJ article are almost saying the same thing. ?Interest rates are low. ?They are low because inflation is low,, and general economic activity is not that robust. ?As such, the cost of capital is low, people are willing to pay high prices for stocks and bonds relative to their cash flows.

Part of this stems from demographics, which was my first additional point. ?For those that are retired or want to retire, there aren’t a lot of ways to transfer money earned in the present so that you can get the equivalent purchasing power or better far into the future. ?There are a few commodities that you can store, like gold, but most can’t be stored. ?Thus you can buy bonds if you don’t think inflation will be bad, or inflation-protected bonds if you can live with low real returns. ?Money market funds will keep your principal stable, but also provide little return. ?You can buy stocks if you are willing to get some inflation protection, and run the risk of a rising cost of capital at some point in the future. ?Same for real estate, but substitute in rising mortgage rates.

A shift can happen when the marginal dollar produced by monetary policy shifts from being saved to being spent. ?For now, monetary policy inflates asset prices, not goods prices (much).

My second point says that people are willing to spend more on stocks when they think that the system will remain stable for a long time. ?That seems to be true today, but as I have pointed out before, it discounts the probability of trade wars, real wars, resurgent socialism, and bad future demographics. ?Nations with shrinking populations tend to have poor asset returns. ?Also, nations with unproductive cultures don’t tend to make economic progress.

My third point is equivocal. ?I don’t see a lot of people yelling “buy stock!” ?There’s a lot of disbelief in the market; this is what Jason Zweig was talking about in his most recent WSJ column. ?That said, when I see lots of activity from people shorting volatility through exchange traded products in order to earn returns, it makes me wonder. ?As I have said before, “Nothing brings out the financial worst in people like the lure of seemingly free money.” ?Eventually those trades sting those that stay at the party too long.

So, where does that leave me? ?The market is high, as my models indicate. ?It may remain high for a while, and may get higher still. ?That said, it would be historically unprecedented to remain in the top decile of valuations for more than three years. ?It would be healthy to have the following:

A garden-variety recession
A garden-variety bear market
More varied sector/industry performance

Will we get any of those? ?I don’t know. ?I can tell you this, though. ?For now, my asset allocation risk is on the low side for me, with stocks at around 70% (that is high for most people, but that is how I have lived my life). ?If we get over the 95th percentile of valuations, I will hedge what I can. ?For now, I reluctantly soldier on.

Perceived Versus Real Risk Tolerance

Posted on 8 July 201712 July 2017 by David Merkel

Picture Credit: Denise Krebs || What RFK said is not applicable to investing. ?Safety First! ?Don’t lose money!

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Investment entities, both people and institutions, often say one thing and mean another with respect to risk. ?They can keep a straight face with respect to minor market gyrations. ?But major market changes leading to the possible or actual questioning of whether they will have enough money to meet stated goals is what really matters to them.

There are six factors that go into any true risk analysis (I will handle them in order):

Net Wealth Relative to Liabilities
Time
Liquidity
Flexibility
Investment-specific Factors
Character of the Entity’s Decision-makers and their Incentives

Net Wealth Relative to Liabilities

The larger the surplus of assets over liabilities, the more relaxed and long-term focused an entity can be. ?For the individual, that attempts to measure the amount needed to meet future obligations where future investment earnings are calculated at a conservative level — my initial rule of thumb is no more than 1% above the 10-year Treasury yield.

That said, for entities with well defined liabilities, like a defined benefit pension plan, a bank, or an insurance company, using 1% above the yield curve should be a maximum for investment earnings, even for existing fixed income assets. ?Risk premiums will get taken into net wealth as they are earned. ?They should not be planned as if they are guaranteed to occur.

Time

The longer it is before payments need to be made, the more aggressive the investment posture can be. ?Now, that can swing two ways — with a larger surplus, or more time before payments need to be made, there is more freedom to tactically overweight or underweight?risky assets versus your normal investment posture.

That means that someone like Buffett is almost unconstrained, aside from paying off insurance claims and indebtedness. ?Not so for most investment entities, which often learn that their estimates of when they need the money are overestimates, and in a crisis, may need liquidity sooner than they ever thought.

Liquidity

High quality assets that can easily be turned into spendable cash helps make net wealth more secure. ?Unexpected cash outflows happen, and how do you meet those needs, particularly in a crisis? ?If you’ve got more than enough cash-like assets, the rest of the portfolio can be more aggressive. ?Remember, Buffett view cash as an option, because of what he can buy with it during a crisis. ?The question is whether the low returns from holding cash will get more than compensated for by capital gains and income on the rest of the portfolio across a full market cycle. ?Do the opportunistic purchases get made when the crisis comes? ?Do they pay off?

Also, if net new assets are coming in, aggressiveness can increase somewhat, but it matters whether the assets have promises attached to them, or are additional surplus. ?The former money must be invested coservatively, while surplus can be invested aggressively.

Flexibility

Some liabilities, or spending needs, can be deferred, at some level of cost or discomfort. ?As an example, if retirement assets are not sufficient, then maybe discretionary expenses can be reduced. ?Dreams often have to give way to reality.

Even in corporate situations, some payments can be stretched out with some increase in the cost of financing. ?One has to be careful here, because the time you are forced to conserve liquidity is often the same time that everyone else must do it as well, which means the cost of doing so could be high. ?That said, projects can be put on hold, realizing that growth will suffer; this can be a “choose your poison” type of situation, because it might cause the stock price to fall, with unpredictable second order effects.

Investment-specific Factors

Making good long term investments will enable a higher return over time, but concentration of ideas can in the short-run lead to underperformance. ?So long as you don’t need cash soon, or you have a large surplus of net assets, such a posture can be maintained over the long haul.

The same thing applies to the need for income from investments. ?investments can shoot less for income and more for capital gains if the need for spendable cash is low. ?Or, less liquid investments can be purchased if they offer a significant return for giving up the liquidity.

Character of the Entity’s Decision-makers and their Incentives

The last issue, which many take first, but I think is last, is how skilled the investors are in dealing with panic/greed situations. ?What is your subjective “risk tolerance?” ?The reason I put this last, is that if you have done your job right, and properly sized the first five factors above, there will be enough surplus and liquidity that does not easily run away in a crisis. ?When portfolios are constructed so that they are prepared for crises and manias, the subjective reactions are minimized because the call on cash during a crisis never gets great enough to force them to move.

A: “Are we adequate?”

B: “More than adequate. ?We might even be able to take advantage of the crisis…”

The only “trouble” comes when almost everyone is prepared. ?Then no significant crises come. ?That theoretical problem is very high quality, but I don’t think the nature of mankind ever changes that much.

Closing

Pay attention to the risk factors of investing relative to your spending needs (or, liabilities). ?Then you will be prepared for the inevitable storms that will come.