The Rules, Part LXX

Picture Credit: Infoletta Hambach || I suppose Euros are manna from somewhere, though not Heaven. After all, they appear out of nowhere [ECB], and there is no guarantee that any government will receive them in the long run.

“The lure of free money brings out the worst economic behavior in people.”

David Merkel, often said at Aleph Blog

Where is there “free” or at least “inexpensive” money?

  • Jobs that are overly compensated compared to the skills needed.
  • Demanding that the government give free money to people.
  • Constraining interest rates to be low.
  • Various “one decision” investment ideas.
  • The prices of houses only go up.
  • The government bails out bad investments.
  • Various investments involving derivatives where one is implicitly short volatility

I started writing this two weeks ago, and then the idea for “Welcome to our Country Club!” came into my head, partially stimulated by a young friend of mine becoming a lifeguard at a swanky country club. It made me think back on my time as a youth being a caddy at a similar club. (And being one of the smallest guys there, I had to learn to defend myself, but that is another story.)

A number of parties have directly and indirectly mused about what I what analogizing in “Welcome to our Country Club!” Real Clear Markets put up a Bitcoin logo. I commented there:

Well, you made explicit what I left implicit. Good job, but you can also throw in penny stocks, meme stocks, some SPACs, etc. Thanks for mentioning me.

Me

In the bullet point above, I listed seven classes of cases where there is free money, or at least subsidized money. I’ll take them in order.

Jobs that are overly compensated compared to the skills needed

There’s always some of that naturally, but it tends to adjust over time unless the government does something to achieve a social goal. That can be unions with a closed shop as an example, or restricting the ability to enter into a simple business, if licensing is too tight. There are corrective mechanisms for both, but they take a long time. Technology can reduce the need for labor in certain types of simple jobs. Or, it can create a competitor to those in a regulated industry (think of Uber, Lyft, Airbnb). In some cases businesses move to non-union venues whether a different part of the US, or another country.

Demanding that the government give free money to people

I’m not in favor of Universal Basic Income. I’m fine with non-subsidized unemployment insurance (though I never tapped it the three times I was out of work — desperation is a good thing).

Many quotes are attributed to Ben Franklin than he actually said. Here’s an alleged one that is interesting:

However, when McHenry made the story public in the 15 July 1803 Republican, or Anti-Democrat newspaper, it had evolved. Now the exchange was:

Powel: Well, Doctor, what have we got?

Franklin: A republic, Madam, if you can keep it.

Powel: And why not keep it?

Franklin: Because the people, on tasting the dish, are always disposed to eat more of it than does them good.

How Dr. McHenry Operated on His Anecdote

If the quote is accurate, it fleshes out the ideas that Republics have to be limited in scope to survive, and that once people that they can use the republic for their self-interests. Even in the recent mini-crisis, knew of a lot of organizations that got PPP loans that didn’t really need them — they profited from the free money. They were organized, with clever accountants, and milked Uncle Sugar while he was throwing money around. (Here’s a particularly notable case.) But there are other places where this happens as well — corporations have gotten very good at slipping ta preferences into the tax code. Even if the US Government wants to encourage a certain behavior, if they are generous, they get overused. This applies to many mass programs as well such as Crop Insurance and Flood Insurance, both of which are subsidized.

The list goes on and on, whether for the upper classes, who benefit the most from this, and the lower classes, who get enough to blunt desperation.

Constraining interest rates to be low

With the Fed following a theory close to Modern Monetary Theory Banana Republic Monetary Theory, it has inflamed three areas of the bond market — Treasuries, Conforming Mortgage Backed Securities, and Junk Corporates. This has pushed housing prices higher, and facilitated high government budget deficits (and the unrealistic spending goals of many), and aided malinvestment by firms that have access to cheap capital, when they should have gone broke.

As Cramer would say, it’s time for me to ‘fess up. I was wrong on my piece Hertz Donut. Cheap capital and the end of the C19 crisis gave equity holders a big win. I know I will sound like the Grandpa from Peter and the Wolf, “What if Peter had not caught the wolf? What then?” To those who didn’t listen to me and won, congratulations. To those who listened to me and lost, I’m sorry. I gave orthodox advice that worked 99% of the time over the prior 60 years. I will give the same advice next time, because you can’t rely on the capital markets to do a favor for you.

When the history books are written 30 years from now, the historians will point at the easy monetary policy of the Fed from Greenspan to date as the major reason US markets overshot and crashed in real terms, along with underfunded promises made by the US and State governments.

Various “one decision” investment ideas

This was the main point of “Welcome to our Country Club!” This can apply to the FANGMAN stocks, promoted stocks whether penny or meme stocks, private equity, cryptocurrencies, etc. There are no permanently good ideas in the markets. Every sustainable competitive advantage is eventually temporary. You don’t own a right to superior returns, at most you can temporarily rent it. Even the idea of buying and holding an S&P 500 index fund means that you will have to endure 50-70% drawdowns once or twice every twenty years or so.

Few truly have “diamond hands.” Perhaps Buffett could have them, but even he makes changes to his portfolio. Let me give a practical example: few people wanted to default on their mortgages during the 2007-2012 crisis, but many were forced to sell at an inopportune time because of unemployment, death, disease, disability, divorce, etc. And far more panicked. There are very few people (and institutions) that are willing to buy the whole way down, and concentrate their holdings into their best ones during a crisis. It hurts too much emotionally to do so, and looks stupid in the short run.

Don’t deceive yourself. Keeping some measure of slack capital (“dry powder”) helps keep you sane. You will look stupid at times like now, but over the long haul you will persevere.

The prices of houses only go up

At least we know from recent memory that residential housing prices can decline across the nation as a whole. On the bright side, current financing terms are not as liberal as they were in 2004-2008. Loan quality is reasonable. But the recent run-up in prices is considerable, in real terms higher than the financial crisis. If we have a significant recession, will there be another crisis?

The government bails out bad investments

One of the failures of the financial crisis was to protect industries that were larger than what was needed. Too many banks, too many houses, too many auto companies, etc. The government, including the Fed, could have protected depositors, but let those who speculated on the continual rise in housing prices fail. They bailed them out with two negative impacts: 1) unproductive investments continue, rather than bein liquidated, which slows growth, and 2) moral hazard — firms take more risk because they know there is a decent chance they will be bailed out in a crisis.

I feel the same way about the recent mini-crisis. We should not have bailed out anyone. The Fed should not have provided excess liquidity. If you don’t let recessions clean out those who have been taking too many chances, you end up with a lot of underperforming junk-rated companies that are non-dead zombies. Over the last 30 years, this is why GDP growth has slowed, we don’t let recessions eliminate subpar uses of capital.

Various investments involving derivatives where one is implicitly short volatility

This was the portion of Where Money Goes to Die that was right in the short-run. During bull markets, many short volatility strategies will make seemingly risk-free steady profits. There are other strategies like it that do well in bull and placid markets, but get killed in a bear market, even a mini-version like early 2018.

Avoid complexity in investing, and stick to simple investments like stocks, bonds, and cash. Stick to things where custody of the assets is almost certain. Cryptocurrencies and derivative strategies typically have weaknesses in custodial matters, such that there are sometimes losses from misappropriation.

Summary

Good investing and good work result from taking moderate risks on a consistent basis. Avoid situations where other are running after what is seemingly free or subsidized money — those situations often come to a bitter end.

And against the advocates for Modern Monetary Theory Banana Republic Monetary Theory, I will tell you that eventually all of the borrowing and spending will come to an end. As in the Great Depression, the rich will ask to have their claims honored at par, while the rest of the nation suffers. Whether the government goes with the rich or not is an open question. But one should not assume that inflation will be the way out… after all, that route could have been taken in greater degree in the Great Depression, but it wasn’t.

“Welcome to our Country Club!”

Image Credit: born1945 || When I was a boy, I spent many days caddying at the local country club.

(This is one of my occasional experiments. Bear with me if you will…)

==========================

Wagner: I don’t get the thrill.

Hawker: What’s not to like?

W: This is nothing like the investment memorandum said it would be.

H: It’s a work in progress. Don’t look at what it is now, think of what it will be like when everyone clamors to join us.

W: This is just a field.

H: So?

W: When I bought a small share in the ownership of this club, the memorandum had pictures of the golf course, lodge, tennis courts, bar, swimming pool, pro shop, and more. All that is here is this field.

H: You needed to read the memorandum more closely. One day we will have all that and more. As for now, we promote the potential of this place to the masses who will want to join us at a much higher price than we got in at.

W: So when will it be built?

H: That is a matter of secondary importance.

W: Huh? What’s of primary importance?

H: Encouraging others to buy shares in this, and never selling our interests.

W: Wait. You did not buy this so you could golf?

H: No merely to own, and never to sell.

W: So this is a speculation on this land?

H: Don’t say speculation! Bad word! This is an investment in the concept of getting something valuable in the future. Besides, the country club doesn’t technically own this field yet… there is a memorandum of understanding to acquire it once the price of ownership interests get high enough… at that point we will swap newly issued shares for the land. We transact everything in shares; it is our currency.

W: It doesn’t own this field? What does it own?

H: The future. Everyone is going to want to buy a share in this wondrous venture, and at progressively higher prices. Congratulate yourself, you got in on the ground floor.

W: There is no floor here! Where has the money gone that I have paid?

H: An earlier investor sold you some of his interests. Don’t worry, he still owns over 25% of the shares. Purely a portfolio management decision for him. The Founder strongly believes in the vision for this concept.

W: The concept of building a country club?

H: The concept of selling interests in the club at ever higher prices to the masses who will want an appreciating asset. And we have the track record. Prices of ownership interests have continually gone up. On a mark-to-market basis, the returns exceed 20%/year. How is that for a successful investment?!

W: I can understand the concept of buying rare and beautiful art to hang on the wall of my house as an investment. It might appreciate over time or not. I enjoy looking at it, and my friends as well, while I pay insurance premiums to protect it for my heirs. Is the only value of this investment possible monetary gain? At least will there be dividends paid?

H: You are missing the point. With this, your heirs will have something far more valuable than a stream of dividends. They will own a share in something that everyone wants to buy. Everyone wants to own an investment that only goes up.

W: So the only driver of value here is others envying what we have, and wanting to buy it from us at prices higher than what we paid?

H: Envy is an ugly word, but yes, and that is why we continually promote how wonderful this investment will be.

W: I am disappointed. I really wanted to golf. Hmm… what if I sold my interests and used the money to go golfing, whether I buy another country club membership, or just hit the links at the local public course?

H: And I am astounded. Why would you give up the glorious future of this enterprise?

W: I want to golf. Say, if you are so convinced, would you buy my interests from me at 5% more than I paid for them?

H: Well, I would be a “better buyer” at that price, but I don’t have enough cash to do that.

W: Would the Founder be interested?

H: The Founder continues to acquire ownership interests as a result of his labors as management. That is how he gets paid. As far as I have heard, he graciously sells them to those who want a piece of the action.

W: Uh-huh. At this point I would rather golf. I will sell my interests to the best bidder.

H: I thought better of you than that. Giving up on an astounding future just to play a game?

W: No, giving up on a game to enjoy life.

Q&A on Estimating Future Stock Returns, March 2021 Update

Image Credit: Aleph Blog || The model fits the data well

I don’t plan on doing this often, but I got a number of good responses on the last article, and I want to answer them in a more complete way, rather than doing it in the comments, where they for practical purposes never get read.

Thanks for sharing your estimates and work on the average investor equity allocation. I recently wrote an email to you asking if you have done similar studies for other countries. I read that while the US has 45% the UK is at 10% average equity allocation. Have you seen if the average equity allocation can be applicable model for other countries or you reckon everything moves together with the S&P? The Hang Seng for example gained after the dot com bubble and was not flat to down in 10 years. Peak was 7 years later… this could be an opportunity to outperform if you are selective because while you are saying avoid large cap growth names it is worth noting that the US has outperformed the world last 10 years since Osama died and the USD has been the strongest currency. It may be the case of avoid US stocks here and be aggressive in Australia which has value oriented index and has been flat since GFC.

https://alephblog.com/2021/06/18/estimating-future-stock-returns-march-2021-update/#comment-39991

I haven’t run into any other nation where there is sufficient data to do what I am doing here. Remember, the data from the Fed’s Z.1 report include estimates of the value of private assets. I can’t believe the 10% number for the UK. That has to be wrong… it is probably not counting private assets, and may only be counting direct holdings by individuals and not those of institutions.

Is this CAPE forward returns, or the money-flow based model?

Also, how do you think about the fact that CAPE Excess spread is still positive?

Thanks.

https://alephblog.com/2021/06/18/estimating-future-stock-returns-march-2021-update/#comment-39992

Neither. This is the asset share model, not the CAPE, which less accurate than this model. I have no idea regarding the CAPE Excess spread. I don’t pay attention to that.

The asset share model measures the percentage of assets held by Americans in stocks. The highest figure ever is 52.3%, the lowest is 21.8%. When the value is high, future returns are low, and vice-versa. We are over 51% at present.

The bailouts always favor the rich. As I am sure you know, people like Charlie Munger have basically said that the peasants should shut up and be grateful because if the rich hadn’t been bailed out (bailouts are ongoing), the peasants would have had an even worse outcome.

Sheila Bair had a plan to go into these financial firms and do a few things: 1. protect depositors 2. fire management 3. re-open by selling to a healthy firm. She was laughed out of the room, and resigned (around 2008).

Never forget that all the rich folks you see on CNBC, even Warren Buffet, were bailed out. I wasn’t. Luckily I had taken action to retain most of my gains, so I did pretty well. These people that are supposed to be so much smarter than the rest of us? Probably not so much. They are just in the right club.

https://alephblog.com/2021/06/18/estimating-future-stock-returns-march-2021-update/#comment-39993

Charlie Munger is a bright guy, but he’s wrong here. Anyone reading Aleph Blog during the Financial Crisis knows that I did not favor the bailouts, and that I would not have minded another depression. That’s an unpopular view, but it would have punished the rich for borrowing too much. It would have leveled the playing field, and things would have normalized within ten years.

People forget the the promiscuous monetary policy of the Fed set us up for both crises 1929 and 2008. It’s setting us up for another one now. BTW, Buffett did not get bailed out. He didn’t need it with his fortress balance sheet.

You’ve persuaded me. How do I persuade my young?

https://alephblog.com/2021/06/18/estimating-future-stock-returns-march-2021-update/#comment-39994

That’s a tough question. I raised eight children, who all got to listen to me for a long time. Only three out of eight ended up doing well in their finances. (Two are stay-at-home moms who married the right guys. Note: the good ones marry early. Those who purposely delay marriage typically have troubles.) Four are marginal, and one is a total failure. Did I expect better? Yes. but once the arrow leaves the string, you can’t influence it any more.

One of the smartest guys I know said to me, “Once they become adults, don’t say anything, but pray for them a lot.” I think he is correct, though if a teachable moment comes, seize it.

I think most people have to pay “market tuition.” Losses teach investors a lot, and do much good, so long as the investor does not give up. Those that give up will likely never learn.

The children of mine that are succeeding ask my advice. Now, you could tell your kids about Aleph Blog, but they might find me boring.

Given the extreme valuations of the market and exuberant behavior by average investors, I wonder if even deep value stocks and funds will provide a reasonable return going forward. What worked back in 2000 – 2010 may not work this time around. I currently like Aegis Value (AVALX) which is heavily invested in resource stocks including precious metal miners. Manager is a deep value investor with portfolio currently having a P/B of 0.8 and average stock market cap < $800M. This fund outperformed during the 2000 to 2010 bear market but does lag during times when growth stocks are in vogue. Currently looking for other deep value funds to protect capital over the next 10 years. Just wish T. Rowe Price Capital Appreciation was still open. I’m thinking maybe a good balanced fund from Dodge & Cox or Oakmark might be a worthy holding at this point.

https://alephblog.com/2021/06/18/estimating-future-stock-returns-march-2021-update/#comment-39995

Those are credible investments, and seem reasonable to me. There is still a huge valuation gap between growth and value stocks. I am not worried about value here.

There are ways to get shares of funds that are closed, but you might have to pay a premium to get them.

Any thoughts about the attractiveness of local-currency (or hard) emerging sovereign bonds at this point in time?

https://alephblog.com/2021/06/18/estimating-future-stock-returns-march-2021-update/#comment-39996

If the Fed is moving to tighten, or even taper, these are not good ideas. I lost money in those asset classes after Bernanke uttered “taper.” Emerging market debt typically does not do well when the Fed is tightening policy.

IMO valuations will go higher than the last tech bubble. Trend over time has been bubbles getting bigger and valuations getting higher. Accommodative FED, low interest rates will support the market and technology which is truly changing the world will cause euphoria in investors and the market. We have a ways to go before the top is in, IMO.

I work in the tech industry (software for years, now in IT), and I see the world moving to the cloud in droves. I see the SAAS companies growing 30-100%+ per year in revenue. Yes they are 20-50x sales valuations, but when you are growing that fast and your growth is accelerating every quarter, and it’s obvious the entire world is going to be using your product in the near future, what is the proper value? All I can do is buy on pullbacks, and wait for euphoria signals like the 90s (CNBC on the tv at the country club instead of ESPN, stuff like that). When I start seeing that stuff, I’ll sell some on pops, and then trail the rest with a moving average to get me out after the bubble pops.

David I believe you are a very smart guy, and a very good investor. As with most good value investors, they are early. Just my opinion.

https://alephblog.com/2021/06/18/estimating-future-stock-returns-march-2021-update/#comment-39997

I think you are a good investor as well, but you fish in a different pool than I do. Yes, I know value investors are early. When I worked for a value-oriented hedge fund, I was the the “black sheep” that looked at momentum and tried to coax my associates out of short positions that looked doomed.

I am not as sanguine as you, but you know that. The model that I use implies that there are limits to how high or low equity valuations can get. We are near that top now. The dot-com bubble was worse then the bubble before the financial crisis as far as the equity markets go, though the financial crisis was more severe for the economy as a whole, as it affected the banks.

On a macroeconomic basis, my concern is that the Fed will run into a zugzwang situation where they have to choose from two bad options. Personally, I think they will choose to deflate, but really, who knows? They tend to favor the unlevered rich, and not the working poor.

Dumb question but when you say the expected returns are under 1% are you simply just doing an inverse of the current S&P PE ratio, which is around 44?

https://alephblog.com/2021/06/18/estimating-future-stock-returns-march-2021-update/#comment-39998

That’s not a dumb question. No, that’s not what I am doing. I am using the asset share model. The asset share model measures the percentage of assets held by Americans in stocks. The highest figure ever is 52.3%, the lowest is 21.8%. When the value is high, future returns are low, and vice-versa. We are over 51% at present.

Using what the asset share for stocks was in the past, I run a regression to calculate how sensitive 10-year returns on the S&P 500 are to the asset share of stocks. Then I use that equation to forecast future performance. At present the model is forecasting returns of -0.91%/year over the next ten years, not adjusted for inflation.

To those asking how David calculates this, the model is here:

https://alephblog.com/2016/04/16/estimating-future-stock-returns-follow-up/

https://alephblog.com/2021/06/18/estimating-future-stock-returns-march-2021-update/#comment-40000

Thank you for saying that. And hey, you got comment 40,000. Well done.

Now that said, I should add one thing. Roughly one year ago, I figured out how to more accurately estimate the values between the quarterly data that the Fed puts out. I ran some regressions to estimate how much money goes into stocks and everything else, independent of returns on the asset classes. It has made the model work better over the last two years.

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At Aleph Blog, I try to say what I think is true, whether it is popular or not. I think we are in a precarious place at present and am reducing risk. I don’t think there is much upside in this environment, aside from some safe and boring value stocks, and those only maybe — but that is where my money is, along with 30% in very short fixed income.

Estimating Future Stock Returns, March 2021 Update

Image Credit: Aleph Blog || Recently I was talking with a younger pastor friend of mind who is pretty bright. I have known him since he was a teenager. He said to me, “I have concluded the the stimulus actions of the Fed and the Government benefit the rich predominantly.” I told him that he was certainly correct.

Sorry for being late with this update. Have you ever considered the idea that trying to avoid depressions encourages cronyism — the government favors the rich through QE and deficit spending? QE inflates assets and commodity prices. The rich benefit from the first, and the poor are hurt by the second. The same applies to most government spending programs. The rich employ accountants and lawyers, and find ways to benefit from changes in the law, and lobby for exceptions to policies that seem to favor “soak the rich.”

The main thing supporting the market as a whole is low interest rates. And as the Fed suggested they are thinking of tightening policy two years from now, short rates rose and long rates fell. Markets anticipate. I can tell you that if the yield curve gets very flat, the Fed won’t do much tightening, unless they are nuts, which is occasionally true.

On March 31st, the S&P 500 was priced to return 0.07%/year over the next 10 years. Today, that figure is -0.67%. At the close on Monday, that figure was -1.03%. These figures do not take account of inflation, so it indicates real annual returns between negative 2 and negative 3 percent.

The only period that compares with this is the dot-com bubble. If we want to hit new valuation records, 4450 on the S&P would exceed the valuations of the dot-com bubble. Thus when I hear investment banks call for 4800 on the S&P 500 in 2022, I think they are just doing what profits them. They push people to take on more risk, particularly near market tops. If ordinary people get more aggressive here, some of the investment banks will take the opposite side of the trade, so they can profit as the market falls. Those at r/wallstreetbets are being the dumb money that the investment banks will eventually profit from.

Investment banks make a lot of money from offering the shares of speculative firms during a bull market. Then they run for cover faster than retail clients can during the transition to a bear market.

Image credit: Aleph Blog

In he past, valuation levels like the present have always led to losses 10 years out. Unless your portfolio is vastly different from the market as a whole, you will suffer these losses. Only if you buy the stocks that have not done well over the past 5 years do you have a chance of producing positive returns. It is exactly parallel to the dot-com bubble. You must avoid large cap growth.

At some point in time the S&P 500 will have a value under 3000. The more interesting question is whether it will have a value under 2000. I don’t think it will ever reach three digits again, unless we get significant deflation.

This is an ugly situation. Pare back risk positions. Focus on undervalued companies in industries that will not go out of fashion. Add investment grade bonds to your portfolio to lose less in real terms than you will get from investing in the S&P 500 index.

Just as no one thought they would lose in late 1999, so it is now. Be aware, and reduce exposure to large cap growth stocks. Replace them with value stocks or investment grade bonds.

Lack of Slack, Redux

Photo Credit: Bartleby || Remember the 2020 toilet paper, paper towel, and cleaning supplies shortage. That got worked out after a reasonable period. Now if we could only find corrugated cardboard.

After I wrote last night’s piece, I thought of another area that is investable. It is unfashionable today to be vertically integrated. There’s a good reason for that. When you are vertically integrated your immune from the pricing signals between divisions that could instruct you to do things differently. (i.e., sell your intermediate goods to other companies, or buy intermediate goods from other companies.  Low price wins.)  As such, because of activist investors, companies have been broken up into simpler component units because management teams are sharper when they are managing just one thing.

But the benefits of vertical integration mean that when there is a supply crisis, they can keep running their business on affected. I’ll give you an example: a favorite company of mine called Industrias Bachoco [IBA]. They’re one of the biggest meat producers in North America; mostly they grow chickens, and they produce most of the feed that they use. Did you know that there is a feed shortage? I don’t think it’s affecting Industrias Bachoco. Anyway, it has cheap valuation, no debt, and in this case, an advantage from being vertically integrated.

I want to talk about another aspect of what I discussed last night. I read an article today which said that the most scarce resource in the United States for building homes is not lumber, but land that is already approved to be built on. Zoning is perhaps well-meaning, but that doesn’t help younger people who are looking to buy homes.

So this is in this environment there are bidding wars, and 20% of the buyer base is investors looking to buy at least the house out. In the old days, and this may not be true anymore, but I doubt it, we used to say a market was overheating when it had more than 10% investors.

And this article indicates that housing prices in the United States are as high as they were at the peak of the housing bubble back 2007-2008. Does that mean we’re in a bubble now?

Well, we might be in a bubble for stocks. You can only be in the 99th percentile of valuations for a couple years at most.  But housing is different in this environment because the terms of the loans being done are better than back during the bubble. However, bit by bit we are seeing leverage rise on home purchases. A bubble might be forming, but we’re not there yet. (Hey, thanks Fed.  You never admit to being wrong.)

And Now for Something Marginally Related Completely Different

Before I close this evening, I want to talk about a somewhat different topic. I think one of the weaknesses of academic economics, and those who use it within the government and the central bank, is that they think that they can eliminate the boom bust cycle. When I read about the startup, shutdown, and switching costs that many capital intensive industries have to go through in order to increase or decrease capacity, or change capacity to a different form, I think economists don’t realize that it is impossible to eliminate the boom bust cycle.

It takes a long time and a big opportunity to make capital intensive firms expand capacity. It takes a long time and a dearth of opportunities to make a capital intensive firm go through shutdown of some capacity. And getting them to shift from one type of production to another takes a long time. They must be convinced that the shift will be profitable for many years.

Economics is a lot more complex than it seems for academics sitting in their chairs with their toy models. It would be far better to get some of them out working in some industrial, financial, and utility firms so that they can understand how difficult it is to work amid volatility.

And as I said, not quite in the same way last night, the virtue of capitalism is that it can deal with volatility more effectively than any other economic system. Supply and demand imbalances will get addressed, and the price mechanism will be the incentive to do so.

The supply imbalances will end, likely in the next two years. It will be replaced by other imbalances. That’s normal. We need to stop treating every problem as a crisis. We especially need to stop asking the government to intervene. In most cases they will do more harm than good, and sometimes they will even prolong the crisis.

And if I didn’t say it last night, be sure to own companies that have strong balance sheets. You want them to be able to survive times of imbalance. As we have seen over the last 15 months, there are often unexpected troubles in an interconnected world.

Full disclosure: Long IBA for clients and me

Lack of Slack

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.

The Rules, Part LXIX

Photo Credit: EveryCarListed P || The world is tough, and you must prepare yourself to avoid licit con men

“Don’t buy what someone else wants to sell you. Buy what you have researched that you want to buy.”

David Merkel at Aleph Blog, many times

Poverty is not just a lack of money. It is a lack of knowledge, a lack of intelligent friends who can guide a person through tough decisions. Or, it is pride, thinking you can figure it out on your own when you are truly not capable. Stop it with the positive self-esteem jive. Most people should not have positive self-esteem — they need help, or, they need to spend more time figuring out the right answers to hard questions rather than using the time for leisure pursuits. They need to work harder to be smarter, or at least cultivate smart friends to help them.

The rule above has been mentioned at this blog 16 or so times in different ways. Many of the articles were dealing with penny stocks and other sorts of investment cons. Almost no one is out to do you a favor. The rules that the government puts in place to prevent fraud on a statutory basis will only catch the dumb crooks. Smart crooks can work around them, and convince you that they are your friend. Modern crooks are dressed nicely, speak nicely, and are friendly until the deal completes.

This is why you have to be your own best defender, or have intelligent friends to help you. Can you figure out:

  1. Am I getting a good deal on this house my realtor is trying to sell me?
  2. Am I getting a good deal on this car that this salesman is trying to sell me?
  3. Is the financing that they are offering me to buy the house or car a good deal?
  4. Can I reasonably negotiate with an employer for better compensation?
  5. Should I buy this life insurance or annuity policy that the salesman is showing me?
  6. Am I paying too much for investment services? Does my advisor have talent?
  7. Should I buy this complex investment that my broker says can’t lose?
  8. Can I ask for a discount on this big ticket item?

The answers to 4, 6a, and 8 are usually yes, and the rest are usually no. But I will tell you that this is the era of the internet. More information is available to the common man than at any time in the past, and better yet, some of that information is even correct. Be skeptical, but not cynical. Weigh arguments. Compare what different parties say, and try to understand who has the better argument. Learn how to negotiate — life is not fair, you don’t get what you deserve, you get what you negotiate.

Beware convenience. The first three letters of convenience are “con.” Spend a little more time analyzing price/quality tradeoffs before you decide to buy something. In the era of Yelp and Google, look at the ratings of those that you might buy from. In the era of Amazon and Google Shopping, use the internet to find the low price.

If you are not willing to put in the work, then don’t complain when you get a bad deal. It is easier now than ever to get information on price and quality. A subscription to Consumer Reports is cheap and worth it. So much pricing data and customer reviews are freely available over the internet.

So do your homework and buy– you will be better off than if you listen to a salesman who is compensated to sell you something that is not what you need.

Lose Less

Photo Credit: Bilal Kamoon || If you want to lose less physical property than your neighbor, do things to make your house a less desirable target — locks, better lighting at night, no obvious signs of wealth, security system, etc. But to protect your financial assets…

I believe in simplicity in investing. I think investors are ill-served by buying complex instruments in order to enhance return, or limit losses. I read about an example of this today called the [LINK] Infinity Q Diversified Alpha Fund. It invested in derivatives (specifically variance swaps) as well as vanilla investments and seemed to show some really good returns in 2020. The trouble was that either due to neglect or malign intent, some of the derivatives were overvalued. Now who could tell that they weren’t properly valued? Average investors certainly couldn’t. Well, some consultants and competitors had questions. Some of them talked to the SEC, and in February of 2021, this mutual fund had to suspend redemptions. Investors will likely take losses versus the last calculated net asset value as the fund liquidates.

But there are other ways to take too much risk. I believe that those investing in the broad stock market indexes are taking a lot of risk right now, and that it would serve them well to hold some bonds.

Yes, I heard arguments against this position in my last piece that I wrote on it back in the beginning of April. My position is that you do not hold bonds to make money – you use them to lose less money than you will by investing in broad market equities.  They are dry powder for when the bear market comes. Can you predict when things will fail? When the bull market will end?

I certainly can’t. But I do know the tops are a process. I also know that toward the end of that process all manner of speculative variables are flashing red, but most market participants are either ignoring them, explaining them away, or saying that it’s different this time.

What I can tell you is this since the beginning of April the 10-year forecast for the S&P 500 has gone negative, and this does not take into account inflation. The current reading is that the model expects -0.25%/year over the next 10 years.  At present the 10-year Treasury note is priced to return 1.57%/year. The odds are tilted in your favor at present of losing less money holding on to that ten-year Treasury than holding the S&P 500 over the next ten years.

If you are holding for 30 years, and know that you will never need the money for that length of time — yes, if your time horizon is that long you’re better off investing in stocks than investing in the 30-year long bond. Nonetheless, I think it would still be smart to hold 80% in stocks and 20% bonds because some were in that period you will get an opportunity to rebalance from stocks to bonds, and make some money in the process.

Now, what do I do for my clients and me in this situation? Well, for one, I am not invested in the S&P 500. I hold an eclectic portfolio of stocks spread across countries and industries, and generally in industries that are out of favor over the last five years. My portfolio does not march to the beat of the S&P 500. That gives me some comfort, even though for years I have underperformed the S&P 500. I think value is coming back, though I hold that idea weakly.

Then I hold some bonds — most of them are ultra-short. Some are foreign. Some are emerging markets. And I own an eclectic closed end fund trading at a discount that has a duration of about two. I think it’s very well positioned. And I’ve written about it before (point 5). Also here.

So when I say buy bonds, I’m not telling you to go and buy the Barclays’ Aggregate. I’m not telling you to go and buy $TLT. (Though maybe it might be good for speculation now.) 😉

In aggregate, the fixed income securities that I hold are single-A credit quality and blend out to an average duration of about one and a half years.  This is pseudo-cash with a decent yield.

The concept of avoiding a bigger loss is a tough one for investors to consider. Most of us as investors are at least somewhat optimistic. I learned a lot in life sitting next to a junk bond manager who was pretty good at his game. Even when things look dark in the market he always had an intrepid disposition. He did not manage to limit losses, but to earn well over the cycle.

But it’s one thing to be managing other people’s money. It’s something different to be managing your own. Thus I think it is wise to take some equity money off the table now, and reinvest into bonds, or pseudo-cash, and wait for better days to invest in stocks.

Too Smart for His Own Good

Picture Credit: Rachel Maddow / Kevin Perez || Deepwater Horizon was a preventable accident created by neglect on the part of BP and Transocean. This is an example of neglecting risk control.

If it were in the public domain, I would have put a picture of Bill Hwang at the top of this post. My blog is mostly about risk control, and secondarily about making money — even though my view is that if you don’t control risk, you will make less money in the long run.

If I know that a company neglects safety for its workers, I don’t invest in it. Companies that cut corners, and companies that are shady will eventually cheat their shareholders as well. Ethics, not the ES of ESG, are a part of good firms and will reward shareholders in the long run.

Back to Bill Hwang. I’m not convinced that he was as rich on paper as the media believes. Why? Because there are no financial statements to back the claims up. We know that the investment banks allowed him to lever up 6-7x via total return swaps, but we don’t know how much money he borrowed aside from that. That is the nature of family offices. Until the IRS starts publishing everyone’s tax returns, we will have no idea of what family offices are doing.

One of the reasons that I think this is that investment banks require margin for swap agreements. That requires them to do a review of the ability of the investor to post more capital. The investment banks were surprised when they found that Archegos did not have more capital to post, after the decline in the price of ViacomCBS after the announcement of their secondary offering of stock. $VIACA must have been one Archegos’ largest positions if that led to the collapse of the family office.

My greater problem with Bill Hwang is this: God doesn’t need us. God wants us to be prudent, and if we incur debts, we are supposed to repay them. As Psalm 37:21 says “The wicked borrows and does not repay, but the righteous shows mercy and gives. [NKJV]” There is a moral imperative to avoid the possibility of default. This means that Christians should not run highly leveraged strategies. We’re only human; we don’t know the future. We will do more good in the long run if we stay afloat, rather than risking it all for the big kill, and run the risk of failure. We are supposed to take businessman’s risks, but not speculate.

At this point, Bill Hwang should dedicate the rest of his life to repaying Nomura and Credit Suisse. We don’t have debtor’s prisons anymore, nor debt slavery. But if he wants to show that he follows God, let him figure out how to repay his creditors. (But in today’s world, I have no doubt that someone will recapitalize Bill Hwang, thinking that he will make a killing for them.)

I firmly believe that moderate risk-taking is a moral imperative if you are a businessman. You take risks, but you should never risk the firm. Risking the firm is arrogant, and dishonest to your creditors. (This does not say that some who lend to risky debtors is not greedy in its own right. We are all sinners, myself included.)

In good societies, debt levels are low. People pursue limited goals, avoid debt, and grow from retained earnings. As your great-grandparents might have said, a good life relies on deferred gratification. But such humility does not characterize the present.

Our culture thinks prosperity is its birthright, and so we incur many debts. The Fed is not the impetus for debt, but is the slave of the culture that expects easy prosperity, and as a result, floods the USA with easy credit. Dare we remember that we have higher overall debt levels than the Great Depression? Or are things different now that we have MMT/BRMT? (Modern Monetary Theory / Banana Republic Monetary Theory — same thing)

What I am saying is that the nation as a whole is not much different than Bill Hwang. Borrow and impoverish our grandchildren. The present is all that matters. We are headed for a crackup. What form it will take I don’t know, but I know that you can’t get something from nothing, and that overindebted societies eventually fail.

For me and my clients, I have companies that are low in indebtedness, and bonds that will provide buying capacity when stock prices fall. But I don’t lever up. Therein lies madness, and default when things turn bad.

The Main Problem in Using Stocks for Income Investing

Picture Credit: Quinn Dombrowski || Today we’re going to play the “tiny game.” How about a T-bill? Oh, you won, you showed me the interest on your checking account…

This article arises out of two articles that I’ve read in Barron’s over the past 3 months. One was in early January, and it was the front page article on income investing. The other was the front page article for this past week, and it was on dividend paying common stocks as a means to finance your retirement.

With the first article on income investing, the main point I was going to make is that risky bonds and other investments that carry high yields usually embed some sort of equity risk. In a scenario where the credit cycle goes bearish, those risky investments will be as risky as common stocks for the duration of the bear market.

Remember that the time to buy risky assets is when most other people and you are scared to death in the midst of a bear market.  Or, wait until the price cuts above the 50-day moving average.  Don’t be a yield hog when market valuations are so extended.

But for the article in this week’s Barron’s, my point is a different one.  Many people have gotten too comfortable with the concept of using dividend paying common stocks for income in retirement portfolios. The first thing you have to remember about dividend paying common stocks is that they are stocks. Over short horizons they carry considerable risk of loss of principal.

What does that imply for the investor that wants to pursue such a strategy? It means that he must have a long enough time horizon and a diversified portfolio that has some safe assets in it. This allows the investor to be able to ride out a temporary decline in the market, together with any dividend cuts that you might face in a bearish market environment.  The safe assets can be tapped to provide emergency spending money, or used to buy cheap dividend paying stocks amid the carnage.

Now, you can mitigate some of these risks by buying high quality dividend paying common stocks. Note: you will have to give up some income to do this. Those stocks have adequate coverage for the dividend and adequate ability to reinvest in their business. They sport reasonable prices relative to their earnings potential.

You can also mitigate the risk even though it does not pay much yield at present by owning a ladder of bonds or bond funds with high credit quality.  Remember that laddering is consistently the second best strategy with respect to interest rate risk.  Being good at forecasting is the best strategy, but who can be so good?

If you do it this way, which is similar to the income strategy that I do for older folks, you will never get thrown out of the game via panic. In my investing, I never go below 60/40 stocks/bonds, and I never go above 80/20 stocks/bonds. Right now I’m at 65/35, and I’m thinking about going to 60/40.

Even though I think the market on the whole is overvalued, there are many niches in the market that are not. There are areas with stocks that have a reasonable price earnings multiple, accompanied by a reasonable dividend. That said you won’t be in the part of the market that has been popular for the last several years. Few people want to take the path that has underperformed in the recent past.

To summarize: if you have so much assets that the yields on your dividend portfolio will never provide less income than what you need, great, go ahead and invest solely in dividend paying common stocks. But if you want to avoid the panic in the bear markets and perhaps take a little bit less in return but still do well over the long haul, do what I do: run a portfolio that’s a balanced fund where the stocks pay dividends. With a portfolio like that you won’t win awards in a bull market but you will feel very comfortable in a bear market and not be scared or pressured to sell at a bad time.

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