Search Results for: COVID

Lack of Slack

Posted on by David Merkel

Picture Credit: AJC1 ||We are dealing with many different types of bottlenecks, with many second-order effects happening due limits in the system. Neoclassical economics in its simple form doesn’t deal with issues like these, and even what I got in Grad School was pretty limited.

According to some of my friends who work at T. Rowe Price, the founder, Thomas Rowe Price, Jr. said something like, “The hardest time to invest is today.” There are also those who say, “It’s different this time,” to which the pithy response is, “It’s always different this time.”

Uncertainty is normal in life as well as investing. It is not a bug. It is a feature of the system. It keeps away people who otherwise might profit if they were willing to take moderate risks. That makes the returns higher for those that do participate.

Leaving aside Covid-19, and all of its side effects we have many fascinating things going on partially as a result of trying to overstimulate the economy. The economy is meant to have small amounts of stimulative government influence, not large amounts. When the stimulative government influence gets too large, elements of the system begin to get hyperactive. Because interest rates are so low, mortgage rates are low. Because mortgage rates are low, many people are buying new houses who otherwise would not. Because many people are buying new houses, lumber is in short supply. And not only lumber, but many industrial metals, parts, and skilled labor are also in short supply.

Typically it takes time to develop skilled labor, and to ramp up supply of parts, commodities, transport, etc. If you try to get these done things done too quickly, you get supply shortfalls which are bottlenecks on the economy.

It doesn’t help that we had “just in time” manufacturing, lean manufacturing, and businesses hoarding commodities and goods that are used in early stage production. When firms realize that there are supply shortages, they take action, accentuating the shortages.

Of course, there is the well known shortage of semiconductors that are slowing down the production of various technological hardware, and particularly automobiles. But what company had the sense to always maintain a stockpile that would be adequate to survive a 6-month crisis? Of course no one does that. They would be told by their management that that much investment in inventory would kill the return on equity.

We can add in the supply problem stemming from the Ever Given and it’s blockage of the Suez canal, and the delays induced in much global shipping while the ships waited for the canal to clear. We can also bring up how Los Angeles ports are hopelessly clogged. And how intermodal lacks enough trucks and drivers to cart the stuff away.

For another example consider the trouble stemming from Colonial Pipelines getting hacked. The gasoline shortage resulting from that came mostly from hoarding, but showed us how much we rely on a single enterprise to provide energy to the South and Northeast.

There’s not enough slack in the system. We need more redundancy. And that won’t happen because firms are looking to maximize the return on equity, and as such they tend not to keep too much excess supply of ability to produce or transport. Most government regulation does not help here, but it would be interesting to see what would happen if the government mandated that firms maintain sufficient slack capacity for production or transport. That would be an ugly regulation, but if it affected everyone maybe it wouldn’t be so bad. How to enforce that would be an absolute headache and so it will never happen.

And at Aleph Blog, in the past I would talk about plague, pestilence, war and other things that people typically don’t anticipate. Not that I thought that any particular one was going to happen at any particular time, but just to make you think about what could happen. Well, now we have experienced plague. Let me try out another idea on you: how many people are expecting a war right now? Yeah, not many people. Can you imagine how badly a war might snarl global trade, particularly since the division of labor is global? Who is prepared for this? Probably no one.

This is one reason among many that I try to emphasize caution in investing. We are running an economic system that has no slack. We are overstimulating by a monetary policy and creating asset bubbles. The government is borrowing far beyond its means which means that someday it will not be able to pay it all back, and at that point in time what will the dollar be worth? When the government has to borrow the money in order to pay the interest, something is so wrong that eventually foreign creditors will not lend any longer.

No, if I can get off that bleak topic of macroeconomics for a moment, let me talk about what probably would not work in investing now. In general, these shortages will be transitory. The capitalist system will overcome these things, despite the best efforts of the government to thwart that. So, I don’t think it’s time to invest in semiconductor equipment or semiconductor stocks. I don’t think it’s a time to invest in trucking. We invest on the basis of the long haul, not on the basis of temporary disruptions.

I would rather invest in the companies that will do well once the supply shortages or bottlenecks are eliminated. In other words who uses the products or services that are currently less available? That is where to invest.  Look for the areas that have continuing usefulness and are still down considerably since 2019. That’s where I’ll be digging; I’m not sure I have the answers yet, but I think that’s where to look. In the meantime, hold enough slack assets in short-dated bonds to give additional buying power, and average in as prices of stocks fall.

Postscript

  • Using Sentieo I did massive searches through their databases to see when the shortage talk began — it started four months ago, peaked in March/April, and is still quite high now.
  • There’s a neat transcript of Tracy Alloway and Joe Weisenthal talking to an executive of a logistics company about current transportation issues. It’s long but good.
  • Another article from Bloomberg on the same topic.
  • We know about US housing issues, but they are even more severe in Canada.
  • A CEO friend of mine who runs a small manufacturing firm says he has more orders than he can fill. He just can’t get the parts, and the same is true for his industry globally.

Dear Young Old Friend

Posted on by David Merkel

Photo Credit: Davide Mauro || It is good to have relationships that transcend generational divides

Here is a comment from an old friend of mine who I knew when he was young.

I’m curious how your model works to claim that SPY is priced to grow 0.54% per year for the next 10 years. You may be going off the historical ~7% average annualized returns, but everyone knows past performance is no indicator of future performance. A few things…

1) yes, valuations in SPY are high. But you have to remember that SPY is market cap weighted, so somewhere around a quarter of the total balance is concentrated in high growth tech stocks (FAANG, etc).

2) getting into high growth tech stocks, yes valuations are through the roof. But so are the year over year revenue and EPS growth of these companies. This is a distinct difference from the dot com bubble. And this gets me into

3) the information revolution is the single greatest industrial/technological revolution since possibly the railroad, or steel, or the assembly line. In the history of SPY (at least since the 1900s when we had exchanges and a central bank) we have not had a truly transformative industrial revolution. We are still in the early phases of history here. And finally

4) 2020 was the swiftest recovery from a bear market in history. Year over year GDP growth went from negative 2% to a projected +6% in 2021. Stocks went from lows of -30% to record highs. This is clearly due to swift and competent action from the fed (injecting liquidity into the markets, keeping interest rates low, quantitative easing) and the government (leveraging historically cheap debt to deliver fiscal stimulus rapidly).

I truly believe it was lessons learned from the past – in the Great Depression, in the subprime crisis, and others – that kept this from being a major covid-induced market meltdown and recession. We now have over a century of fiscal, monetary and regulatory experience to keep markets operating smoothly. In summary, past returns do not take away from the fact that there is plenty, plenty, plenty of reason to be optimistic about the next 10 years.

Estimating Future Stock Returns, December 2020 Update

Thanks for writing. I always thought you were quite bright. But investing is something where raw intelligence does not always lead to a good result. Bright people can be overconfident, and can overprice assets that are very good… it has happened many times in history.

I explained this model in the greatest degree of detail in the first two articles in this series (one, two). I have made no significant changes since then, aside from coming up with a way to estimate the model more accurately between the quarterly releases of data that the Fed provides.

The model that I use estimates the percentage of assets that the average American holds in stock (public and private) versus total assets. When that percentage is high, future returns have been low. When that percentage is low, future returns have been high. Since 1945, the lowest percentage has been 21.9%, and the highest 51.8%. The current value is 47.6%, which implies returns over the next 10 years of 0.66%/year, less than what can be earned on a ten-year T-note.

It’s an ordinary least squares regression model, and is the best-fitting model of all the competing theories for valuing the market as a whole. It reflects human nature — manias and panics. If people are farsighted and rational, why should the value of equities as a percentage of all assets change so much?

Now, you might ask: doesn’t taking more risk always lead to more returns? My answer to you is no. There are prudent risks, and imprudent risks. An asset will be riskless at a low price, but very risky at a high price. Remember the dot-com bubble, the go-go years, and the Great Depression. These were separated from each other by 35 years on average — basically a generation. Each generation gets at least one mistake. Popular companies became overvalued because of overly easy monetary policy, and crowd mania (r/wallstreetbets is a current example).

Now, the amount held in stock on average by Americans is high now than at any point since the dot-com bubble. Now, in the dot-com bubble, companies that had no profits were notable. It was a nutty era. But they weren’t the biggest companies in the S&P 500 index, and most of the largest companies were overvalued, but to the same degree as the growth companies today are overvalued, and with similar growth prospects then as now.

There is a conceit around the “information revolution.” It’s difficult to measure whether there is truly productivity growth from it. Take a look at the charts of productivity growth since 1990, productivity growth has not accelerated over the years prior.. Personally, I think materials science has had a greater impact. All the substances that we can use now that have greater tensile strength, conductivity, durability, flexibility, ability to deal with heat, cold, moisture, etc. That has affected what information technology can do as well… without improvements in materials science, information technology improvements would be much slower, and programmers could not be as sloppy.

I wrote about the the bear and bull markets of 2020. It’s been an odd time, but no odder than any other time. There is the conceit that the present moment is the hardest to understand in the markets, but we forget how confused we were in the past because of the “benefit” of hindsight bias.

Where I disagree with you the most is with you is on monetary and fiscal policy. The proper lesson of the Great Depression is not “when things go bad run deficits and print lots of money (or credit).” The proper lesson is: under ordinary circumstances run balanced budgets, don’t let monetary policy get too loose, and regulate banks tightly so that you don’t have rashes of bank failures.” Our leaders have consistently failed at this, and what we are facing as a result is either a bout of significant inflation (which will hurt stocks less than bonds), increased taxation (gotta pay off those bonds), or deflation, as economies that ae highly indebted, as ours is, do not grow rapidly.

I am not faulting our leaders for their current actions to avoid a crisis, but the past actions that have created the crisis, and for which they will not admit blame. I understand deficits in wartime, but not peacetime.

I appreciate your questions, and hope for more of them. But if you want to get a economic education, here are a bunch of books to consider. Oh, here are some investment books as well.

Don’t Lose Your Head

Posted on by David Merkel

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

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

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

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

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

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

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

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

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

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

I did so.

And it was the bottom.

So what is the lesson here?

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

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

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

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

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

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

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

Notes and Comments

Notes and Comments

Posted on by David Merkel

1) I still can’t post images at my blog. If you can believe it, WordPress is trying to fix it. The one cost involved is that the last three posts will be wiped out, and all comments since 4/8.

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

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

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

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

As such, don’t put me in the camp of optimists any more. I recognize my initial predictions were wrong. Some of it stems from increasing testing as time has gone on. Indeed, what will happen if that study in New York is correct (seems to be too small of a sample, and perhaps biased), and maybe 10-15% of the NY population caught COVID-19 with almost no symptoms? That is mostly a good thing, and might even be a testimony to how little reported cases moved up in the face of that — social distancing restrains the spread of COVID-19, particularly with those who would be most harmed distancing via self-quarantine.

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

  • Unemployment
  • Division of labor
  • Pensions, both public and private
  • health care for those that don’t have COVID-19
  • Small businesses that run out of resources

Death rates rise from sudden recessions. Might it be more than the lives saved via general quarantine. What Sweden is doing makes more sense. Yes, their death rates are a little higher, but they didn’t close many things at all — their populace has covered up, and kept working. They integrated social distancing into their total lives, including work.

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

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

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

6) One of my clients asked me what I thought about what the Fed is doing now. My answer is this: they aren’t doing much. The market took their bluff and ran with it. How is this?

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

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

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

7) But at least at present, I don’t think we are using MMT yet, unless you mean that the Fed buys government debt.

To me, the big question is when do foreign entities get sick of owning US Dollar claims? When do foreign governments finally say that they won’t subsidize exporters anymore, and will stop investing in US Dollar claims?

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

8 ) When will we learn that savings doesn’t inhibit growth? Stable households and businesses survive better, and ultimately spend more.

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

That’s all for now.

Fastest Bull Chases Fastest Bear

Fastest Bull Chases Fastest Bear

Posted on by David Merkel

23 trading days from bull market peak to bear market bottom. 12 trading days from bear market bottom to the start of the new bull market. Both are records.

As I have often said. “Weird begets weird.” When things are weird, it may not be prudent to rely on prior statistical measures. It might be better to think about the structural economy and try to reason about what is going on.

As for me, I am tracking the leading cause of the weirdness — COVID-19, and trying to get a grasp on when the new cases will be minimal.

Things are going better than the politicians are saying. That is why the market has been rallying.

It may take 6-12 months for the economy to return to normal, assuming that the government does its job well with respect to its restrictions.

All that said, it will be volatile. After all,one thing that is utterly new is that the economy would be voluntarily shut down. There were better ways to do this, and there will be many arguments as the actions of governments are debated after this crisis.

It Doesn’t Get Much Better Than This?

Posted on by David Merkel

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

Image Credit: Aleph Blog

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

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

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

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

It Doesn’t Get Much Worse Than This?

Image Credit: Aleph Blog

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

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

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

Four Interesting Periods in the Stock Market

So think about:

  1. The Great Depression
  2. Black Monday and related problems in 1987
  3. The Great Financial Crisis in 2008, and
  4. Now

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

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

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

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

Two Final Notes

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

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

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

Too Much Debt

Posted on by David Merkel

Photo Credit: Steve Rotman || As Simon and Garfunkel sang, “The words of the prophets are written on the subway walls…”

Debt-based economies are unstable. Economies with a lot of short-term debt are more unstable. The Fed is like Johnny One-Note, or Fat Freddie with a hammer. They only know one tool, and it will solve all problems.

Are there problems from too much debt? More debt will solve the problem. Shift debts from the private to the public sector. Don’t let the private market solve this on its own.

Though the bed debt is not in the same place as the last crisis, we are once again trying to play favorites through the Federal Reserve and rescue entities that took too much risk.

My view is let them fail. The whole system is not at risk, and the COVID-19 crisis will pass in two weeks. The great risk is not from the disease, but from the ham-handed response from policymakers who are short-sighted, and highly risk averse to the point of not wanting to cross the street for fear of dying.

Have we become like the Chinese, who bail out their banks and non-banks regularly? Who can’t bear to see any significant institution fail?

(Yes, I know they are getting more willing to see entities fail in China, but why are we getting less that way in the US? Let market discipline teach companies to not have so much debt.)

Here are three things to consider:

  1. Bond ETFs Flash Warning Signs of Growing Mismatch — The Fed now think its purview extends to managing the discounts of bond ETFs? Let the system work, and let profit seeking institutions and individuals benefit from artificially high yields. Let insurance companies do what I did: purchase a cheap package of bonds in an ETF, and convert it into the constituent bonds, and sell those that you don’t want for a profit. (Losses from ETFs premiums and discounts are normal, and it is why the dollar weighted returns are lower than the time-weighted returns.)
  2. The same applies to repo markets. As I have said before, the accounting rules need to be changed. Repo transactions should not be treated as a short-term asset, but as a long asset with a short-term liability, because that is what it is. With Residential Mortgage-Backed SecurIties in trouble, the market should be allowed to fail, to teach those who take too much risk to not do that. This failure will not cascade.
  3. The same applies to the crony of Donald Trump — Tom Barrack. He pleads his own interest, seeking for the Fed or the Treasury to bail him out, and those who are like him. Let him fail, and those who are like him.

Market participants need to know that they are responsible for their own actions, particularly in a small and short-lived crisis as this one. COVID-19 as a systemic crisis will be gone within weeks.

My statement to all of those listening is “When will we set up a more rational system that discourages debt?” We could made dividends tax-exempt, and deny interest deductions for non-financial corporations, including financial subsidiaries of non-financial corporations. Of course we would grandfather prior obligations.

Are we going to wait for the grand crisis, where the Fed will continue to extend credit amid roaring inflation, or where extend no credit amid a tanking economy? This is what eventually faces us — there is no free lunch. The Fed can’t create prosperity via loose monetary policy, and Congress cannot create prosperity via loose fiscal policy.

The bills eventually come due. The USA might get the bill last after the failure of China, Japan, and the EU, but it will eventually get the bill.

As such, consider what you will do as governments can’t deal with the economic and political costs of financing the losses of the financial system.

The Worst Policies are Made During Crises

Posted on by David Merkel

Photo Credit: Mike Licht || As a culture, we are very much “live for the moment.” But what happens when buyers of Treasuries decide that it’s not worth it anymore?

I am not a fan of the Democrats or of Big Government Republicans like Bush Jr. and Trump. In general, I think we need to shrink our government, decentralize, and de-lever our economy such that we make debt a smaller component of how we finance our lives. The Democrats talk about inequality, but they don’t really mean it. Increasing marginal tax rates is good show, but the real game is how income is calculated, and they won’t touch that, because their richest donors find ways to hide their income — the same as donors to the Republicans.

That’s why I call the governing elite in DC “The Purple Party.” A blend of red and blue, with just enough difference to get politically motivated donors to give, but practically doing the same thing, serving wealthy elites.

I’m going to make a post on COVID-19 next week, but my last post on the topic was too optimistic. That said, the politicians, particularly governors, are being scaremongers. They are vastly overestimating the size of the crisis.

What really bugs me are the foolish ideas being propounded by the Fed and politicians. Let me talk about a few of them.

1) Don’t close the stock or bond markets. Closing the markets does not eliminate volatility. It only hides it. Practically, it makes the price of securities to be zero for those who want to sell them. And, for those who left some cash on the side, it denies them the opportunity to profit from their wisdom.

2) The Fed should only hold short government debt. That is a neutral asset. Anything else makes the Fed play favorites in what they buy, whether it is mortgage-backed securities, municipal bonds, or corporates. Don’t let the Fed become a political institution, creating ad hoc policy by whose debt they do and don’t buy.

3) Don’t close businesses. Let all businesses set their own policies. They don’t want their workers to infect others. Let them operate.

The idea that there are “necessary businesses” is foolish. The “necessary businesses” rely on other businesses to be their suppliers.

What would be better would be to have extensive testing for COVID-19, and to quarantine those who are infected, and those who are not tested who had contact with those who are infected. Leave the rest of society free. Don’t close firms down, and then give some lame amount of government assistance to them. We do best when we are working. People staying at home lack the healthy stress that working provides.

4) Now, if you have to give assistance, giving it to people directly is the best way. I advocated for that in the last financial crisis. But you should give it to all Americans equally, to avoid favoritism. Now, there is the issue of those who buy US Treasury debt objecting to the concept, and I can respect that. Why else do you think that the yield on 30-year Treasury Bonds has risen 0.8% over the last ten days?

There is no such thing as a free lunch, and with all those advocating excessive deficit spending, I would say “Yes, the past efforts have not disrupted the markets, but if you read economic history closely, no one can tell what will make the paradigm shift. Are you feeling lucky?”

Summary

From my reading of the data, I don’t see how this crisis lasts past the end of April. Yet there are governors of states foolishly shutting down businesses, and thinking that they are doing something good. “Shelter in place” is a recipe for turning all Americans into lawbreakers in the same manner as is with highway speed limits. Do you really want to ruin our culture via overly strict laws?

What of the poor people running out of money? What of the small businesses that go broke? Governments should focus on testing for the virus, and quarantining those who have it and those who have had contact and are untested.

In closing, I would encourage all readers to vote all incumbents out of office. They are not serving the interests of average Americans well. They are cowards who listen to scaremongers, and that includes Trump.

PS — some people might suggest that I am not kind to those that are hurting. It’s not true. I give over 10% of my income to charity each year. Beyond that, I would challenge people to consider Venezuela. Many small to medium-sized actions by Chavez and Maduro slowly robbed the country of economic vitality. The wealthiest nation in South America became the poorest.

The same could happen here. Economic disasters often spring from something small — remember Ben Bernanke saying that the risk from subprime mortgages was “well contained?” Yes, subprime mortgages were small, but they represented the marginal buyers of residential real estate, so when they failed, so did property prices. Like dominoes, they fell.

Thus I am saying to urge the government to not engage in policies that increase its deficits. You can’t tell when the last bit of debt will be the straw that breaks the back of the camel.

Estimating Future Stock Returns, December 2019 Update

Posted on by David Merkel

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

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

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

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

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

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

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

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

Implications for Asset Allocation

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

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

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

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

Full disclosure: long RGA for clients and me

The S-Curve, Once More, with Feeling

Posted on by David Merkel

Photo Credit: Lars Plougmann || Indeed, this seems like a race, and the S-Curve is a major challenge to drive through

This will be brief, because I am still working on it, but it is my weak conviction that as far as the markets are concerned, the COVID crisis will largely be over by next Friday. How certain am I? Not very — I give it a probability value of around 30%.

If my thesis is correct, reported new cases of COVID-19 in the US will peak by Friday of this week, and will be 90% complete by next Friday. I will be watching how many new cases are reported. New cases tend to peak when total cases increase at a mid-teens percentage rate over the prior day. Because reporting is noisy, you don’t see that so easily, but the inverse logistic curves I am estimating are consistent on that figure for all the countries I have modeled so far.

I’ve run models for South Korea and Italy as well, and I’ll run them for a few more countries tomorrow. They are all pretty consistent with each other. Italy’s new cases should peak tomorrow, if they haven’t already.

I know everything is dark and gloomy now. Even if my modeling is wrong, which is a significant likelihood (I am extrapolating), I find it difficult to believe that we will still be in crisis mode by tax day.

So, cheer up. The number of COVID-19 cases is unlikely to be overwhelming, and we are all likely to survive this. The markets will revive, though maybe not energy stocks for six months. Those are a separate issue.

And if new cases track my estimates, I will put more money into the market. That’s all for now.

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