The Aleph Blog – Page 46 – Helping Institutions and Ordinary People Invest Better by Focusing on Risk Control

Stock Valuations: Micro and Macro

Posted on 24 July 2015 by David Merkel

From a friend who is a client:

Here are a couple of things I have been pondering.

Market capitalization is pretty fictitious. It assumes that all the shares of a company are worth the price at which the last block sold. However, if you tried to sell all of the shares of a large company (hypothetically), the price would drop to almost zero.

It seems to me the primary reason the stock market goes up over time is because the money supply increases. To put it another way, if the money supply did not increase the stock market could only increase in value by increasing the % percentage of the money supply spent on stocks, which is obviously limited.

My views here might be somewhat naive. Comments/criticism/feedback welcome.

Dear Friend,

Ben Graham used to talk about the stock market being a cross between a voting machine and a weighing machine. ?On any given day, economic actors vote by buying and selling shares, and in the short run, the?trades happen at the levels dictated by whether the buyers or sellers are?more aggressive. ?That is the voting machine of the market. ?In the short run, values can be pretty senseless if one side or the other decides to be aggressive in their buying or selling.

What arrests the behavior of the voting machine is the weighing machine. ?The price of a stock can’t get too low, or it will get taken over by a competitor, a private equity firm, a conglomerate, etc. ?The price of a stock can’t get too high, or valuation-sensitive investors will sell to buy cheaper shares of firms with better prospects. ?Also, corporate management will begin thinking of how they could buy up other firms, using their stock as a currency.

I’ve written more on this topic at the article?The Stock Price Matters, Regardless. ?Within a certain range, the market capitalization of a company is arbitrary. ?Outside the range?of reasonableness, financial?forces take over to push the valuation to be more in line with the fundamentals of the company.

Macro Stock Market Measures

Every now and then, someone comes along and suggests a new way to value the stock market as a whole. ?I’ve run across the idea that the stock market is driven by the money supply before. ?The last time I saw someone propose that was in the late 1980s. ?I think people were dissuaded from the idea because money supply changes in the short run did not correlate that well with the movements in stock indexes over the next 25 years.

Now, in the long run, most sufficiently broad macroeconomic variables will correlate with levels of?the stock market. ?Buffett likes to cite GDP as his favorite measure. ?It’s hard to imagine how over the long haul the stock market wouldn’t be correlated with GDP growth. ?(Why do I hear someone invoking Kalecki in the background? ?Begone! 😉 )

There are other popular measures that get trotted out as well, like the Q-ratio, which compares the stock market to its replacement cost, or the Shiller Cyclically Adjusted P/E ratio [CAPE]. All of these have their merits, but none of them really capture what drives the markets perfectly. ?After all:, various market players note that the market varies considerably with respect to each measure, and they try to use them to time the market.

The best measure I have run into is a little more complicated, but boils down to estimating the amount that Americans have invested in the stock market as a fraction of their total net worth. ?You can find more on it here. (Credit @Jesse_Livermore) ?Even that can be used to try to time the market, and it is very good, but not perfect.

But in short, the reason why any of the macro measures of the market don’t move in lockstep with the market is that market economies are dynamic. ?For short periods of time, our attention can fixate on one item or group of items. ?In my lifetime, I can think of periods where we focused on:

Monetary aggregates
Inflation
Unemployment
Housing prices
Commercial Mortgage defaults
Japan
China
High interest rates
Low interest rates
Bank solvency

Profit margins rise and fall. ?Credit spreads rise and fall. ?Interest rates rise and fall. ?Sectors of the economy go in and out of favor. ?The boom/bust cycle never gets repealed, and economists that think they can do so eventually get embarrassed.

That’s what keeps this game interesting on a macro level. ?You can’t tell what the true limits are for market valuation. ?We can have guesses, but they are subject to considerable error. ?It is best to be conservative in our judgments here, in order to maintain a margin of safety, realizing that we will look a little foolish when the market runs too hot, and when we seem to be catching a falling knife in the bear phase of the market. ?Take that as my best advice on what is otherwise a cloudy topic, and thanks for asking — you made me think.

We Eat Dollar Weighted Returns ? VI

Posted on 22 July 201522 July 2015 by David Merkel

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

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

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

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

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

Another Exercise in Dollar-Weighted Returns

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

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

HSGFX Dollar Weighted Returns — HSGFX Dollar and Time Weighted Returns

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

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

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

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

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

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

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

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

It?s Difficult to Make Predictions, Especially About the Future

Posted on 18 July 201519 July 2015 by David Merkel

It is difficult to make predictions, especially about the future.

— Attributed to many people

Susan Weiner has an interesting piece as her blog on Investment Writing called?Are financial predictions too risky for investment commentary writers?? I would say the answer is:

Yes, and
No, because you can’t avoid them if you are writing about investing

Why You Should Avoid Making Predictions

My leading reason for avoiding making predictions is that when you are wrong, and someone loses a lot of money, he gets really annoyed. ?I can’t say that I blame them much.

Now, I might do it more if I got praise equal to the amount of annoyance. ?But my experience from my RealMoney days was for every bit of praise that I would get from a correct prediction, I would get 10 bits of criticism for one that I got wrong. ?That’s not much different in a way from reviews you read on the web for restaurants, hotels, service companies, etc., because people get greater motivation to write when bad service is delivered rather than good.

Why You Can’t?Avoid Making Predictions

We can talk about the past, present, and the future. ?We know the past reasonably well. ?The present is fuzzy.?We know the future not at all — we can only make guesses. ?Those guesses might be educated guesses, but they are still guesses.

You could spend all your time writing about the past, but readers would ask how that can benefit them now. ?Logically, they could ask “If this past situation had the result you mentioned, can I expect the same thing in this current situation that seems a lot like it?” ?It’s a fair question, and if you don’t answer it, you might find that your readers go elsewhere. ?They’d rather risk being burned than not get an opinion on some issue that they care about.

You could just report on the present. ?Some of that is useful, like hearing color commentary at a sports game. ?The same set of questions could come to you, like: “The market has been hitting new highs. ?Does that mean it will hit higher highs, or is it time to take some risk assets off of the table?” ?Another fair question, and readers would like an opinion.

As an aside, when I began studying nonlinear modeling, it was noted by many that nonlinear models don’t predict well. ?One academic decided to take the bull by the horns, and wrote a paper that was entitled something like, “If Nonlinear Models Can’t Predict Well, Why Should We Bother With Them?” ?One possible answer would be that most models don’t predict well, but that’s too discouraging for most readers.

The thing is, readers have their concerns about the future, and they want advice. ?Many would rather have a false certainty than a nuanced set of possibilities. ?We can’t do anything for them — they are fodder for the charlatans.

My answer for my writing is to try to be humble about the possibilities, and write things that explain thought processes rather than conclusions.

“Give a man a fish and he eats for a day. ?Teach a man to fish and he eats for a lifetime.”

— Old Proverb

The trouble is, we can’t even give people easy?investment ideas that will always work. ?We can try to explain how to think about the question, and the possible scenarios that could result, and how likely they are. ?Giving people the building blocks of investment knowledge is more valuable than handing out tips. ?The building blocks have been tested, and work most of the time, but they take work to deploy. ?Tips are uncertain, but neophytes love them, partly because they take almost no effort to implement.

Finally, be happy about whatever audience you get. ?Largely, you will get the audience you deserve, and the criticism that goes along with it. ?Just be careful, and take a page from Hippocrates that resembles the concept of margin of safety:

First do no harm.

What is Liquidity? (Part VIII)

Posted on 17 July 201517 July 2015 by David Merkel

Here are some simple propositions on liquidity:

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

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

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

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

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

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

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

My Conclusion

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

Don’t leave the computer untended.

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

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

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

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

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

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

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

Gundlach vs Morningstar

Posted on 15 July 2015 by David Merkel

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

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

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

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

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

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

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

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

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

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

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

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

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

How To End Index Gaming

Posted on 11 July 201512 July 2015 by David Merkel

There was an article at Bloomberg on gaming additions to and deletions from indexes, and at least two comments on it (one, two). ?You can read them at your convenience; in this short post I would like to point out two ways to stop the gaming.

Define your index to include all securities in the class (say, all US-based stocks with over $10 million in market cap), or
Control your index so that additions and deletions are done at your leisure, and not in any predictable way.

The gaming problem occurs because index funds find that they have to buy or sell stocks when indexes change, and more flexible investors act more quickly, causing the index funds to transact at less favorable prices. ?You never want to be in the position of being forced to make a trade.

The first solution means using an index like the Wilshire 5000, which in principle covers almost all stocks that you would care about. ?Index additions would happen at things like IPOs and spinoffs, and deletions at things like takeovers — both of which are natural liquidity events.

Solution one would be relatively easy to manage, but not everyone wants to own a broad market fund. ?The second solution remedies the situation more generally, at a cost that index fund buyers would not exactly know what the index was in the short-run.

Solution two destroys comparability, but the funds would change the target percentages when they felt it was advantageous to do so whether it was:

Make the change immediately, like the flexible investors do, or
Phase it in over time.

And to do this, you might ask for reporting waivers from the SEC for up to x% of the total fund, whatever is currently in transition. ?The main idea is this: you aren’t forced to trade on anyone else’s schedule. ?The only thing leading you would be what is best for your investors, because if you don’t do well for them, they will leave you.

Now, that implies that if you were to say that your intent is to mimic the S&P 500 index, but with some flexibility, that would invite easy comparisons, such that you would?be less free to deviate too far. ? But if you said your intent was more akin to the Russell 1000 or 3000, there would be more room to maneuver. ?That said, choosing an index is a marketing decision, and more people want the S&P 500 than the Wilshire 5000, much less the US Largecap Index.

So, maybe with solution two the gaming problem isn’t so easy to escape, or better, you can choose which?problem you want. ?Perhaps the one bit of practical advice here then is to investors — choose a broad market index like the Wilshire 5000. ?At least your index fund won’t get so easily gamed, and given the small cap effect over time, you’ll probably do better than the S&P 500, even excluding the effects of gaming.

There, a simple bit of advice. ?Till next time.

Asset-Liability Mismatches and Bubbles

Posted on 9 July 2015 by David Merkel

There’s a lot of talk about the Chinese stock market falling. I look at it as an opportunity to talk about why bubbles develop in markets, and why governments don’t take steps to avoid them until it is too late — also, why they try to prop the bubbles up, even though it is hopeless. ?But first an aside:

Three weeks ago, I was interviewed on RT/America Boom/Bust. ?Half of the interview aired — the part on domestic matters. ?The part on Greece and China didn’t air, and what a pity. ?I argued that China today was very much like Japan in the late ’80s, where the Japanese had a hard time investing abroad, and had an expansive monetary policy. ?People had a hard time figuring out where to put their money. ?Savings and fixed income didn’t offer much. ?Real Estate was great if you could afford it. ?The stock market was a place for putting money to work — and it had a lot of momentum behind it.

China has the added complexity of wealth management products which are opaque and many are Ponzi schemes. ?Also, the fixed income markets in China are not as mature as Japan’s markets 30 years ago. ?Both have the difficulties that they are too big for some of the indexes that international investors use.

Another reason for the bubbly behavior was use of margin, both formal and informal, and, the tendency for stock investors to have very short holding periods. ?Short-termism and following momentum is most of what creates bubbles. ?Ben Graham’s voting machine dominates, until the weighing machine takes over, and the voting machine votes the opposite way.

Long term assets like stocks should be financed with equity, or at worst, long-term debt. ?Using a lot of margin debt to finance equity leads to a rocket up, and a rocket down. ?When the amount of equity in the ?account gets too low, more assets have to be added, or stocks will have to be liquidated to protect the margin loan that the broker made. ?When enough stocks in margin accounts are forced to be sold, that can drive stock prices down, leading to a self-reinforcing cycle, until the debt levels normalize at much lower levels. ?This is a part of what happened in the Great Depression in the US.

Now governments never argue with bubbles when they expand, because no one dares to oppose a boom. ?(Note: that article won a small award. Powerpoint presentation here.) ?The powers that be love effortless prosperity, and no one wants to listen to a prophet of doom when the Cabaret is open.

Now, the prosperity is mostly?fake, because all of the borrowing is temporarily pulling future prosperity into the present. ?When the bubble pops, that will revert with a vengeance, leaving behind bad debts.

Despite the increase in debts, and speculative changes in economic behavior, most policymakers will claim that they can’t tell whether a bubble is growing or not. ?Their bread is buttered on the side of political contributions from financial firms.

But when the bubble pops, and things are ugly, governments will try to resist the deflating bubble — favoring relatively well-off asset owners over not-so-well-off taxpayers. ?In China at present, they are closing down markets for stocks (if it doesn’t trade, the price must not be falling). ?They are trying to be more liberal about liquidating margin debt. ?They are limiting share sales by major holders. ?They are postponing IPOs. ?They are inducing institutions to buy stock.

China thinks that it can control and even reverse the deflating bubble. ?I think they are deluded. ?Yes, they are relatively more powerful in their own country than US regulators and policymakers. ?But even if their institutions were big enough to suck up all of the stock at existing prices, it would merely substitute on problem for another: the institutions would be stuck with assets that have?low forward-looking returns. ?If you use those to fund a defined benefit pension plan, you will likely find that you have embedded a loss in the plan that will take years to reveal itself.

As a result, since China is much larger than Greece, its problems get more attention, because they could affect the rest of the world more. ?For Western investors without direct China exposure, I’m not sure how big that will be, but with highly valued markets any increase in volatility could cause temporary indigestion.

The one bit of friendly advice I might offer is don’t be quick to try to catch a falling knife here. ?It might be better to wait. and maybe buy stocks in countries that get unfairly tarred by any panic coming out of China, rather than investing in China itself. ?Remember, margin of safety matters. ?More on that coming in a future post.

Avoid Indexed Life Insurance Products

Posted on 8 July 2015 by David Merkel

Everyone reading should know that I am an actuary, as well as a quant and a financial analyst. ?Math is my friend.

Math is not the friend of many of my readers, so I usually don’t bother them with the math. ?Tonight’s post will be no different. ?It stems from my time of creating investment strategies for what was at that time a leading indexed annuity seller.

What is the return that you get from an indexed annuity? ?It is the return from index options, subject to a certain minimum return over a 7-15 year period. Now, on average, what is the return you get from buying any fairly priced option? ?You get the return on T-bills plus zero to a slight negative percentage. ?So, if the option premiums paid are cumulatively greater than the guaranteed minimum return, the product should return more than the minimum on average — but likely not much more on average.

Why is that? ?Options are a zero sum game, and usually there is no inherent advantage to the buyer or seller. ?There are some exceptions to this rule, but it favors at-the money option sellers, never buyers.?Buying options is what happens with?indexed annuity products.

Now, over any short amount of time, like 5-10 years, you can get very different results than the likely average. ?That doesn’t affect my point. ?With games of chance, some get get good outcomes, and other get bad outcomes.

Now, the indexed product sellers will tell potential buyers that they will never lose money if the market goes down. ?True enough. ? What they don’t tell you is that over the long haul, you will most likely earn more investing in one of Vanguard’s S&P 500 funds or even their Balanced Index Fund. ?You may even earn more investing in their high yield fund, or even their bond market index fund.

In exchange for eliminating all negative volatility, you end up getting very modest interest credits, while still being exposed to the credit risk of the insurance company. ?In an insolvency, your policy will be affected. ?The state guaranty funds will likely protect you if your policy is underneath the coverage limits, but still it is a bother.

Add to that the illiquidity of the product. ?Yes, you can cash it in at any time, do 1035 exchanges, etc., but before the end of the surrender charge period you will pay a fee that compensates the insurance company for the amortized value of the large commission that they paid the agent that sold you the policy. ?For most people, the surrender charge psychologically locks them in.

Thus I say it is better to be disciplined, and buy and hold a volatile investment with low fees over time, rather than own an indexed annuity that will tend to lock you in, and deliver lower returns on average. ?That’s all, aside from the postscript.

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Postscript

How does an insurance company make a profit on an indexed annuity? ?They take the proceeds of the sale, pay the agent, and use the rest to invest. ?About 90% of the money will be invested in a bond that will cover the minimum guarantee. ?The remainder will buy option premiums — the amount of money that gets applied to that is close to the credit spread on the bonds less the insurance company’s fees to pay the costs of the company and?a charge for profit. Not a lot is typically left in a low yield environment like this. ?The company tries to buy the most attractive options that they can on a limited budget. ?Inexpensive options typically imply that most will finish out of the money, and/or when they do finish in-the-money, the rewards won’t be that large.

Sixteen Implications of “The Phases of an Investment Idea”

Posted on 2 July 2015 by David Merkel

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

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

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

The Phases of an Investment Idea

Posted on 27 June 201528 June 2015 by David Merkel

Investing ideas come in many forms:

Factors like Valuation, Sentiment, Momentum, Size, Neglect…
New technologies
New financing methods and security types
Changes in government policies will have effects, cultural change, or other top-down macro ideas
New countries to invest in
Events where value might be discovered, like recapitalizations, mergers, acquisitions, spinoffs, etc.
New asset classes or subclasses
Durable competitive advantage of marketing, technology, cultural, or other corporate practices

Now, before an idea is discovered, the economics behind the idea still exist, but the returns happen in a way that no one yet perceives. ?When an idea is discovered, the discovery might be made public early, or the discoverer might keep it to himself until it slowly leaks out.

For an example, think of Ben Graham in the early days. ?He taught openly at Columbia, but few followed his ideas within the investing public because everyone was still shell-shocked from the trauma of the Great Depression. ?As a result, there was a large amount of companies trading for less than the value of their current assets minus their total liabilities.

As Graham gained disciples, both known and unknown, they chipped away at the companies that were so priced, until by the late ’60s there were few opportunities of that sort left. ?Graham had long since retired; Buffett winds up his partnerships, and manages the textile firm he took over as a means of creating a nascent conglomerate.

The returns generated during its era were phenomenal, but for the most part, they were never to be repeated. ?Toward the end of the era, many of the practitioners made their own mistakes as they violated “margin of safety” principles. ?It was a hard way of learning that the vein of financial ore they were mining was finite, and trying to expand to mine a type of “fool’s gold” was not a winning idea.

Value investing principles, rather than dying there, broadened out to consider?other ways that securities could be undervalued, and the analysis process began again.

My main point this evening is this: when a valid new investing idea is discovered, a lot of returns are generated in the initial phase. For the most part they will never be repeated because there will likely never be another time when that investment idea is totally forgotten.

Now think of the technologies that led to the dot-com bubble. ?The idealism, and the “follow the leader” price momentum that it created lasted until enough cash was sucked into unproductive enterprises, where the value was destroyed. ?The current economic value of investment ideas can overshoot or undershoot the fundamental value of the idea, seen in hindsight.

My second point is that often the price performance of an investment idea overshoots. ?Then the cash flows of the assets can’t justify the prices, and the prices fall dramatically, sometimes undershooting. ?It might happen because of expected?demand that does not occur, or too much short-term leverage applied to long-term assets.

Later, when the returns for the investment idea are calculated, how do you characterize the value of the investment idea? ?A new investment factor is discovered:

it earns great returns on a small amount of assets applied to it.
More assets get applied, and more people use the factor.
The factor develops its own price momentum, but few?think about it that way
The factor exceeds the “carrying capacity”?that it should have in the market, overshoots, and burns out or crashes.
It may be downplayed, but it lives on to some degree as an aspect of investing.

On a time-weighted rate of return basis, the factor will show that it had great performance, but a lot of the excess returns will be in the early era where very little money was applied to the factor. ?By the time a lot of money was applied to the factor, the future excess returns were either small or even negative. ?On a dollar-weighted basis, the verdict on the factor might not be so hot.

So, how useful is the time-weighted rate of return series for the factor/idea in question for making judgments about the future? ?Not very useful. ?Dollar weighted? ?Better, but still of limited use, because the discovery era will likely never be repeated.

What should we do then to make decisions about any factor/idea for purposes of future decisions? ?We have to look at the degree to which the factor or idea is presently neglected, and estimate future potential returns if the neglect is eliminated. ?That’s not easy to do, but it will give us a better sense of future potential than looking at historical statistics that bear the marks of an unusual period that is little like the present.

It leaves us with a mess, and few?firm statistics to work from, but it is better to be approximately right and somewhat uncertain, than to be precisely wrong with tidy statistical anomalies bearing the overglorified title “facts.”

That’s all for now. ?As always, be careful with your statistics, and use sound business judgment to analyze their validity in?the present situation.