Your (un-PC) Friday giggle

In the highly polarized, politicized and politically correct climate that is America, it is difficult to have a rational conversation about some topics, such as how to heal the rift with the Muslim world and community.

Perhaps the first step is to try to relax and laugh about it. Consider these two offerings from America's closest allies, which could never be produced in the United States under the current environment. The first comes from the UK and it's a film called The Infidel, which is about a middle-aged Muslim who discovers that he was adopted and that he is actually Jewish (see the trailer here).

The second, from Canada, is a long running TV series called Little Mosque on the Prairie, about a small group of Muslims who get together and run a mosque in a small prairie town (by renting the hall from the local Anglican parish no less). See the first episode part 1 here, part 2 here and part 3 here.

Go take a look. They are both hilarious.

What QE2 cannot do

The stock and commodity markets have been rallying based on expectations that the Federal Reserve would implement QE2, aka printing money. I have written about the risks to QE2 here and here and I don't want to beat a dead horse.

Despite the general market strength, stocks fell off yesterday based on fears that the mortgage foreclosure mess would seriously impact the financials.


Is this 2008 all over again?
Others have covered the mortgage foreclosure mess much better than I have so I won't repeat the analysis (see Felix Salmon's comments here and Barry Ritholz at The Big Picture here and here). The risk here is that, if all this mortgage paper is shown to be defective, then someone, somewhere, is going to take a big haircut. Most likely, the haircut is going to show up somewhere in the financial system.

I don't want to be overly alarmist because we really don't have a good handle on the magnitude of the problem. I do have a foggy memory that back in 2008, it was the combination of bad paper and excessive leverage caused a financial panic.


The Fed can supply liquidity but not solvency
Panics are the financial equivalent of fires and central bankers act as fire fighters. During these episodes, the central banker can inject liquidity into the financial system. However, if a bank is sunk by bad loans (or bad mortgage paper that it's holding), then its assets are less than its liabilities, or deposits, and it is deemed to be insolvent. Insolvent banks can't be saved by additional liquidity, they need equity injections.

Just remember this: QE2 can only supply more liquidity to the system, not solvency. Should we experience another solvency crisis in the financial system, then no amount of Fed Treasury purchase can save the system. Something else would have to be done, e.g. another TARP.

The market is already starting to price in the solvency risk in the system. A look at the relative performance chart of the Financials against the market shows that, despite the stock market rally, Financials remain in a relative downtrend and continue to underperform the market. In fact, the sector is now testing a relative support zone, with little downside protection should relative support fail.

The behavior of the Financials highlight the risk to the system. This sector bears watching as a barometer of the robustness of continued strength of the market rally.

Will QE lead to class warfare?

Further to my last post about the risks of quantitative easing, I saw a couple of warnings from the IMF that are worrisome. First, they warned that the risks to financial stability remain high. Moreover, they indicated that Basel III won’t ward off another financial crisis.


Policy makers appear to be in my-only-tool-is-a-hammer-so-every-problem-is-a-nail mode. The consensus solution of choice are further quantitative easing, competitive devaluation and trade protectionism (mostly directed at China).

Blowing more asset bubbles
Jeff Rubin, former chief economist at CIBC World Markets, recently wrote that further quantitative easing only benefit the providers of capital, i.e. the wealthy. In other words, QE means more asset bubbles. Rick Bookstaber also commented on the income gap and looked towards a hypothetical 2025:

For those who have the money to burn, demand is moving increasingly toward things that cannot be produced. Land, art, rare wines and Super Bowl tickets are being bid up to unthinkable levels. The major economic pastime that remains to differentiate the rich from the rest of us is picking new stuff to throw into the fray. The latest one is scholar stones from the Sung Dynasty. All that money has to go somewhere. But that only leads to a transfer of income from one well-to-do pocket to another without generating any production. Sadly for those grounded in the middle class, this means more of these things are moving out of reach. But no matter. It all seems silly and abstract to most of us, like the amusing eccentricities of the English upper class a century or two before.

Notwithstanding the fact that IMF chief Strauss-Kahn is warning against using currency as a weapon, noted China watcher Michael Pettis wrote that forcing China to revalue the RMB too quickly will also result in further asset bubbles [emphasis added]:

Most probably Beijing will do the same thing Tokyo did after the Plaza Accords and Beijing did after the renminbi began appreciating in 2005. It will lower real interest rates and force credit expansion.

This of course will have the effect of unwinding the impact of the renminbi appreciation. As some Chinese manufacturers (in the tradable goods sector) lose competitiveness because of the rising renminbi, others (in the capital intensive sector) will regain it because of even lower financing costs. Jobs lost in one sector will be balanced with jobs gained in the other.

But there will be a hidden cost to this strategy – perhaps a huge one. The revaluing renminbi will shift income from exporters to households, as it should, but cheaper financing costs will shift income from households (who provide most of the country’s net savings) to the large companies that have access to bank credit. So China won’t really rebalance, because this requires a real and permanent increase in the household share of GDP. Instead what will happen is that it will reduce Chinese overdependence on exports and increase China’s even greater overdependence on investment.

This will not benefit China. It will fuel even more real estate, manufacturing and infrastructure overcapacity without having rebalanced consumption. Expect, for example, even more ships, steel, and chemicals in a world that really does not want any more.

The Federal Reserve is no doubt aware of these risks. Fed Vice Chair Janet Yellen, who is usually perceived as an inflation dove, also weighed in on the bubble risks of excessive easy monetary policy in a speech on October 11, 2010 [emphasis added]:

I noted previously--and it is now commonly accepted--that monetary policy can affect systemic risk through a number of channels.First, monetary policy has a direct effect on asset prices for the obvious reason that interest rates represent the opportunity costs of holding assets. Indeed, an important element of the monetary transmission mechanism works through the asset price channel. In theory, an increase in asset prices induced by a decline in interest rates should not cause asset prices to keep escalating in bubble-like fashion. But if bubbles do develop, perhaps because of an onset of excessive optimism, and especially if the bubble is financed by debt, the result may be a buildup of systemic risk. Second, recent research has identified possible linkages between monetary policy and leverage among financial intermediaries. It is conceivable that accommodative monetary policy could provide tinder for a buildup of leverage and excessive risk-taking in the financial system.

What happens after the next Crash?
We learned the hard way in 2008 and 2000 that asset bubbles end quite badly. If Basel III doesn’t ward off the next Crash, what happens then?

Michael Norton and Dan Ariely wrote a short paper entitled Building a better America, one wealth quintile at a time that surveyed Americans about their perception of wealth distribution and contrasted it with the actual figures.

Not many Americans realize that the 80-20 rule applies here. Roughly 20% of the population have 80% of the wealth, which is not only very different from the estimates, but different from the popular ideal.

No doubt in the next Crash, the bulk of the adjustments will be borne again by the middle class. I hate to keep quoting Simon Johnson but as he says, we seem to keep playing the same song over and over again:

To IMF officials, all of these crises looked depressingly similar. Each country, of course, needed a loan, but more than that, each needed to make big changes so that the loan could really work. Almost always, countries in crisis need to learn to live within their means after a period of excess—exports must be increased, and imports cut—and the goal is to do this without the most horrible of recessions. Naturally, the fund’s economists spend time figuring out the policies—budget, money supply, and the like—that make sense in this context. Yet the economic solution is seldom very hard to work out...

Squeezing the oligarchs, though, is seldom the strategy of choice among emerging-market governments. Quite the contrary: at the outset of the crisis, the oligarchs are usually among the first to get extra help from the government, such as preferential access to foreign currency, or maybe a nice tax break, or—here’s a classic Kremlin bailout technique—the assumption of private debt obligations by the government. Under duress, generosity toward old friends takes many innovative forms. Meanwhile, needing to squeeze someone, most emerging-market governments look first to ordinary working folk—at least until the riots grow too large.

Depressingly, the developed and emerging markets have switched places today. The most recent IMF economic outlook confirms that:

“The world economic recovery is proceeding,” IMF Chief Economist Olivier Blanchard told a press conference. “But it is an unbalanced recovery, sluggish in advanced countries, much stronger in emerging and developing countries.”

Add to the mix with American net worth is already down 26% and the fact that the rich don’t feel rich anymore.

At what point does that lead to class warfare?

Apocalypse on November 3?

Increasingly, I am reading more and more feelings of unease about the American and global economy. Barry Ritholz's America needs an intervention is a typical sample about how America is living beyond its means:

The United States has been living a lie.

As a nation, we have been kidding ourselves, repeating myths, hoping that if we say something enough times, it will become reality — no matter how untrue. The credit crisis and now foreclosure debacle has revealed to anyone who cares to look what we have sought to ignore: That the past decade has been based on a set of fundamental beliefs that are intrinsically false.

Its time for an intervention. We need someone to force us to stop hitting the bottle, lose the bimbo, skip the dessert cart, visit the gym. Its time to stop bullshitting ourselves about Financial Engineering, and face both the Truth & Consequences of our legacy financial system.

Tim Knight at the Slope of Hope expressed his unease about the current market backdrop in his post The Looming Something:

There will come an event that will - probably very quickly - bring forth the unintended consequences of all this unprecedented action, and the Something will be reviled instead of embraced.

I feel like I am watching a horror movie and the creepy music is starting to build...and it's building to a crescendo. But what will be the trigger for the collapse?


Watch the November 3rd FOMC meeting
One trigger might be the FOMC meeting on November 3, 2010. Already there is global anxiety about currency wars - so much anxiety that the IMF has been asked to intervene and mediate. Tim Duy has indicated that should the Federal Reserve choose to implement another round of quantitative easing on November 3, it would mean the end of Bretton Woods 2:

[T]he Federal Reserve is positioned to declare war on Bretton Woods 2.  November 3, 2010.  Mark it on your calendars...

Consider the enormity of the situation at hand.  The Federal Reserve is poised to crank up the printing press for the sake of satisfying their domestic mandate.  One mechanism, perhaps the only mechanism, by which we can expect meaningful, sustained reversal from the current set of imbalances is via a significant depreciation of the dollar.  The rest of the world appears prepared to fight the Fed because they know no other path. 

Should QE2 mark the end of Bretton Woods 2, it would mark a global regime shift. Global regime shifts are not orderly events. There will be turmoil and volatility. Tim Duy writes:

The time may finally be at hand when the imbalances created by Bretton Woods 2 now tear the system asunder. The collapse is coming via an unexpected channel; rather than originating from abroad, the shock that sets it in motion comes from the inside, a blast of stimulus from the US Federal Reserve. And at the moment, the collapse looks likely to turn disorderly quickly. If the Federal Reserve is committed to quantitative easing, there is no way for the rest of the world to stop to flow of dollars that is already emanating from the US. Yet much of the world does not want to accept the inevitable, and there appears to be no agreement on what comes next. Call me pessimistic, but right now I don't see how this situation gets anything but more ugly.

The Buttonwood blog of The Economist also weighed in with similar comments:

Although asset prices may be buoyant at the moment, there are other risks ahead. Competitive devaluation is an inherently unstable system. Someone must lose their share of world trade. And a policy of boosting exports can all too easily turn into a policy of blocking imports.

Investors should be prepared for this possibility. Don't say that this is another black swan event and no one foresaw this. You have been warned.

A political Rorschach test

I read an interesting article last week in the New York Times entitled Scientists and Soldiers Solve a Bee Mystery. The article detailed how some scientific researchers collaborated with Army researchers to solve the mystery of what was killing off honey bees. It turns out that the combination of a fungus and virus is proving fatal to the honey bee population.


Why is the government doing bee research?
While the article was interesting, it occurred to me that the story could be viewed through some very different political lenses, depending on where you sit in the increasingly polarized political spectrum. Deficit hawk could ask the question: "In an era of fiscal austerity, why is the government spending money on something as esoteric as bee research? If we wanted the government to stop wasting money, this is a perfect example of activity that government shouldn't be in."


Does the Pentagon get a free pass?
On the other hand, this isn't just the federal government doing esoteric research, it's a special branch of the government, i.e. the Pentagon. For some conservatives, the military gets a special pass for their activities. Is bee research one of them?


Or has the military gone too far?

Or has the military gone too far to intrude into ordinary life? Consider the development of the publication of a controversial article by Andrew Milburn (Lieutenant Colonel, USMC) in the Joint Forces Quarterly entitled Breaking Ranks: Dissent and the military professional. Key quote here [emphasis added]:

There are circumstances under which a military officer is not only justified but also obligated to disobey a legal order. In supporting this assertion, I discuss where the tipping point lies between the military officer’s customary obligation to obey and his moral obligation to dissent. This topic defies black-and-white specificity but is nevertheless fundamental to an understanding of the military professional’s role in the execution of policy. It involves complex issues—among them, the question of balance between strategy and policy, and between military leaders and their civilian masters.

One more step towards Argentina?
Lt. Col. Milburn's comments are reminiscent of comments from the colonels of the Latin American juntas of a bygone era. At what point does the military stop getting a free pass on policy?

Allowing the Army to reach into parts of civilian life where it doesn't have a traditional role, e.g. bee research, echoes the reach of the Army in other emerging market countries of today, e.g. Asia where the Army can be found in industries such as banking and real estate.

Is this another step in America going south towards Argentina?

This is a political Rorschach test: Your answer depends on where you are in the (increasingly polarized) political spectrum.


Disclaimer: The purpose of this post is to raise questions so that you can examine your own biases. I actually don't have a strong opinion on this issue. Good investors are politically neutral and agnostic. They watch, react and capitalize on the political, economic and financial climate.

Equity analysis: Beyond corporate stenography

I normally don't write very much about company analysis, because I have spent most of my professional life as a quant. Nevertheless, I was fortunate to have been a small cap/special situations analyst early in my career. That experience from the school of hard knocks taught me that, indeed, different industries have very different value-drivers and therefore different valuation metrics, which was a invaluable lesson for me later in my life as an equity quantitative analyst.

Two recent events prompt me to write this post. Firstly, I volunteered to be a team mentor in the CFA Institutes' Global IRC Challenge, where teams from universities around the world compete by performing investment analysis. As well, I was asked to give advice to a junior company seeking a stock exchange listing on the issues of raising capital and investor relations.

I therefore write this post with those two groups in mind.


The basics of company analysis
The basics of company analysis depend on how an investor answers the following two questions:

1. What is the company's competitive "moat"? Why does it exist in the first place? For example, a corner grocery store's competitive position is likely it's location - convenience is probably the main factor here. On the other hand, a company like Apple depends mainly on its technology, design and "coolness" factor - which is why customers line up overnight for new releases of iPhones.
2. How do you value the company? Answering this question depends on how you answered the first question. What kinds of margins are sustainable in that business? If the "competitive moat" is large enough, then the company can extract above average margins and returns on capital for a long time. On the other hand, a corner grocery store in a commoditized business can only earn market rates of return, barring other competitive advantages.

Don't just focus on valuation
IMHO, way too much of the focus in business schools is on valuation. No doubt, corporate valuation modeling is a skill that need to be learned. Once learned, however, it's a highly commoditized skill and offers the analyst little or no competitive advantage over his peers. Analysts who mainly focus on building company financial models often wind up just becoming a stenographer for the company and add little new investment insight.


Adding independent investment insight
I have found that the analysts that really stand out from the crowd are the ones who have effectively mastered the principles in Michael Porter's books Competitive Advantage and Competitive Strategy.

It doesn't mean, however, that the analyst needs to do a 50 page Porter analysis of a company's competitive position, i.e. threats from suppliers, customers, existing competitors and new entrants, etc. It does mean that the analyst should be aware of these issues and flag the positives (competitive advantage) and negatives (risks) faced by the company.

To give an anecdotal example, I recall researching Nokia, a darling stock during the days of the Tech Bubble. It was the American based analysts who were very good at understanding the Nokia competitive position at a top down level. The story at the time, was that Nokia had a leading market share in handsets and a valuable brand. It could therefore use its volume muscle to drive down margins for its competitors and remain dominant.

On the other hand, the European based analysts who knew where all the figurative bodies were buried. They were much better at the bottom-up analysis and the channel checks. I depended on the European analysts for alerts about problems in the telecom business, e.g. relationships with major customers, production lines going down and their possible implications, etc.

Both are forms of competitive analysis. One is strategic in nature and the other tactical. Both are valuable. Without both, financial modeling becomes a GIGO (garbage-in-garbage-out) exercise in fundamental analysis.

Danger! Will Robinson!

I have learned over the years that my underlying investment outlook has a Value bias and that I suffer from the curse of Value investors everywhere by being too early. Often, I have found myself fighting the trend and underperforming as a result. One of the tools that I have used to mitigate that effect is to look for inflection points in sentiment and momentum.

First of all, I agree with John Hussman that the US economy appears to be deteriorating (and his writes much more eloquently than I do). So far, the stock market hasn't paid much attention to those risks and is in fact probing new highs as I write this.

However, the inflection point may be arriving. Bloomberg reports that the Street is now cutting S&P 500 earnings estimates:

For the first time in more than a year analysts are cutting their forecasts for Standard & Poor’s 500 Index earnings, jeopardizing gains from the biggest September rally since World War II.

Estimates for S&P 500 companies’ combined 2011 profit fell as low as $95.17 last month from an August high of $96.16 and posted the first quarterly reduction since the three months ended June 2009, according to more than 8,500 analyst forecasts tracked by Bloomberg. The revision came as the benchmark gauge for U.S. equities rose 8.8 percent last month, the largest September advance since 1939.

Moreover, the number of new highs aren't expanding despite the strength in the averages:

Just as the bulls appear to be taking control, I am put in the position of the robot in the old TV series Lost in Space as I warn: "Danger! Will Robinson! Danger!"

Know where your edge is before you bet

A friend recently asked me my opinion about what she should do with a certain stock. This is the sort of question that I hate to answer. First of all, I knew nothing about the stock, which happened to be the shares of a junior mining company. Notwithstanding the fact that I knew nothing about it, it was also difficult to answer the question because I knew little about the rest of the portfolio. How big a position is it? Why did she buy it in the first place? Was it for diversification? Was it because she got a "hot tip"?

In other words, what was the bet that she was making in the portfolio? Until an investor can answer that question, then it's impossible to know what to do with the stock.


What is your edge?
First of all, what constitutes properly diversification and what constitutes a "big bet"? For example, Avner Mandelman, writing in the Globe and Mail, believes that 15 to 20 stocks is enough for portfolio diversification. That may or may not be correct number. I refer you to my past post about Richard Grinold's Fundamental Law of Active Management:

The idea behind the Fundamental Law of Active Management is to size the bets according to the edge you have.

In Mandelman's case, he has an investment process that is based on intensely focused fundamental research. Under those circumstances, you want to bet where his edge is, i.e. fundamental research, and a 15 to 20 stock portfolio may not be a bad idea. On the other hand, a top-down based investment process that picks sectors or countries needs a much larger number of positions in the portfolio because you want to diversify away the individual stock bets in the portfolio but concentrate the sector or country bets.

Returning to the question about what to do with the junior mining stock, my questions would be:

1. Why did you buy it in the first place?
2. What was the bet you wanted to make? How big a bet did you want it to be?

If you don't know the answer to the first question, then recall the adage about looking around a poker table to spot the chump. If you can't find him, then it's time to look in the mirror.

Can bonds run much further?

The bond market rally has prompted some market observers to declare that bonds are in a bubble. FT Alphaville pointed out that research from Morgan Stanley indicates that money flows into US bond mutual funds now exceed purchases of US stock funds that occurred at the height of the TMT (Tech-Media-Telecom) bubble:

What is forgotten in this analysis is that the bond market is substantially larger than the stock market. The size of the US bond market is estimated to be between $31T and $34T. By contrast, the total market capitalization of the Wilshire 5000, which encompasses virtually all of the investable stocks in the US, variees in the $13T to $15T range.

If this is indeed a bond bubble, then based on the disparity between the size of the stock and bond markets and the funds flow data, bond prices have the potential to run much, much further than anyone expects.

The seven lean years scenario is still intact

The was some recent buzz in the blogosphere when Jeffrey Hirsch of the Stock Traders' Alamanac forecast that the Dow would go on an eight-year tear with a target of 38,820 (see the full comment here). Most commentators focused on the maginitude of the gain. Lost in the noise of the forecast was that the start of the bull market would begin in 2017.

I have written about this in the past. A lot of long-term analysis is pointing toward the 2017-8 as the start of a new bull, meaning that we would have to endure seven lean years. On September 7, 2010, I wrote that:

Jeremy Grantham revisited his “seven lean years” scenario in his July quarterly letter. About a year ago, Art Cashin highlighted the 17.6 year stock market cycle, which pointed to a bottom around 2017. I also wrote about an academic study that correlated demographic trends to P/E ratios, which pointed to a long-term bottom around 2018. I also suggested that while markets are likely to be flat longer term, they are going to be volatile and experience huge intermediate term swings.

Now Hirsch has bought a ticket on the 2017 train and that ticket is looking more and more interesting.

In that kind of low-return environment, I would reiterate my thesis that buy-and-hold strategies are likely to disappoint, especially in an era of uncertain equity risk premiums. Investors need to look to new strategies to raise their returns.

How big is the Pension Time Bomb?

Most of my more astute readers already understand that defined benefit pension funds is a time bomb waiting to explode. Now a new study that suggests that we don't even known how big the problem is.

To set the stage, the Wall Street Journal recently reported that public plans haven't changed their return expectations since 2001 and still have return expectations of 8%:

The median expected investment return for more than 100 U.S. public pension plans surveyed by the National Association of State Retirement Administrators remains 8%, the same level as in 2001, the association says.

The country's 15 biggest public pension systems have an average expected return of 7.8%, and only a handful recently have changed or are reconsidering those return assumptions, according to a survey of those funds by The Wall Street Journal.

 Corporate plans are not much better:

Corporate pension plans in many cases have been cutting expectations more quickly than public plans, but often they were starting from more-optimistic assumptions. Pension plans at companies in the Standard & Poor's 500 stock index have trimmed expected returns by one-half of a percentage point over the past five years, but their average return assumption is also 8%, according to the Analyst's Accounting Observer, a research firm.

To understand how realistic an 8% assumption is. Let's assume a 60% stock/40% bond asset mix. Let's be generous and say that the bond market can return 3%. That comes to a long-term equity return assumption of 11.3%, or an equity risk premium of 8.3%!

The actuaries add to the problem

David Merkel at Aleph Blog pointed out a bigger problem, i.e. the practice of the actuarial profession [emphasis added]:

When I was a young actuary, I was preparing to take the old Society of Actuaries test eight, which was the Investments exam. An older British actuary made a comment in one of the study notes that I had to think about several times before I understood it: “Risk premiums must be taken as earned, and never capitalized.”

Sadly, the pension profession never got the memo on that idea. The setting of investment assumptions accepts as a rule that risk margins will be earned without fail. Therefore, when looking at a portfolio of common stocks in a pension trust, the actuary will assume that the equity premium will be earned over the long haul and build that into his discount rate assumptions and earned rate assumptions.

In other words, if an actuary is told that the equity risk premium is 8.3%. He will build it into his models and assume, come hell or high water, that stocks will earn 8.3% over bonds over the long run.


Unstable risk premiums
So far, this is all old hat for those who have been following the pension fund time bomb story. As interest rates have fallen, the net present value of pension liabilities rise, but return assumptions have fallen enough and a big yawning pension gap is the result. Moreover, the historical experience shows that an equity risk premium of 8.3% is, shall we say, a tad high.

Those estimates of equity risk premiums based on historical experience may not be valid. I was further shaken by the publication of an important academic paper entitled  New 'Risky' World Order: Unstable Risk Premiums: Implications for Practice by Aswath Damodaran of NYU. Here is the abstract:

Investors have to be offered risk premiums to invest in risky assets. These risk premiums take different forms in different asset markets: equity risk premiums (ERP) in stock markets, default spreads in bond markets and real asset premiums in other asset markets. These premiums have their roots in fundamentals and will vary as a function of uncertainty about the economy, the risk aversion of investors, information uncertainty and fear of catastrophe, among other factors. In practice, analysts in developed markets have generally looked backwards to estimate risk premiums, using historical data to arrive at their estimates. Implicitly, they assume that historical averages are not only precise but also that risk premiums are stable and revert back quickly to historical norms. In this paper, we present evidence that risk premiums in equity, bond and real asset markets are not only imprecise, but are also unstable and linked across markets. We present estimation approaches that are more in line with dynamic, shifting risk premiums. We argue that the resulting estimates can help use make more informed asset allocation and asset valuation judgments in portfolio management and better investment, financing and dividend decisions in corporate finance.

For newbies, let me explain the importance of this paper. Millions of business school and actuarial students have been taught Modern Portfolio Theory, or MPT. It is an investment theory that tries to maximize expected return for a given level of risk by carefully choosing the proportions of various assets in a portfolio. Harry Markowitz, who earned a Nobel Prize in Economics for the theory, modern portfolio theory introduced the idea of diversification as a tool to lower the risk of the entire portfolio without giving up high returns.

Modern Portfolio Theory: A choice between risk and return

Using MPT depends on knowing, or estimating, two numbers for each asset class – risk and return. In practice, most investors estimate returns for stocks using an equity risk premium using the following procedure: Historically, stocks have returned X% over bonds. Bond yields are currently Y%, therefore we can expect a return of X + Y for stocks.

The Damodaran paper calls that estimation procedure into serious question. He concluded that historical data studies indicate that estimates of asset class risk premiums don't really mean revert to long-term averages and they are unstable in the short and long run.

If an investor doesn’t have a good estimate for equity returns, then how can he build a portfolio? Damodaran suggests that investors should look to market based indicators. Consider the bond default spread as a signal of equity risk appetite and realized vs. estimated risk as another indicator, e.g. realized vs. implied volatility embedded in equity option markets around the world.

How high the pension deficits?
In the past year alone, we have seen studies indicating $1T deficits in public pension plans and other similar stories of pending disaster. Are US public plans "only" facing a $1T deficit?

Given the results indicated by the Damodaran paper, the scary part is we don't even know.

A warning for the bulls

As NBER has declared the recession over and with the SPX decisively rallied through technical resistance at 1130, traders should be tilting towards the bullish side, right?

Not necessarily. Barry Ritholz posted on the 10 things that make him nervous about the market. I generally agree with Barry's assesssments and I would like to add a few more of my own. While I don't have ten items, here is what is bothering me about stocks at the current levels.


Technicals pointing to economic deterioration
Analyzing relative charts, sectors/industries relative to the market, can tell you a lot about what the consensus is thinking. Here is the relative chart of the Morgan Stanley Cyclicals Index:

The chart looks like an inverted saucer to me - which is bearish. The cyclicals deteriorated through a relative uptrend in May and are now in a relative downtrend. This is not the picture of a robust economic recovery.

What's more, when I look at housing, as proxied by XHB against the market, it isn't signalling a rip roaring recovery either.

As well, the Banking Index looks terrible against the market. This picture looks a lot like the relative chart of the cyclicals - a relative downtrend within an inverted saucer top formation. Without leadership from the Financials, can a new upleg be launched?

For the followers of my Inflation-Deflation Timer model, I refer to my latest comment indicating that I am getting very mixed signals. The model has moved to a technical "inflation" signal. I would tend to discount that signal and remain in "neutral" because of the anomolous condition of strong commodity prices and falling bond yields.


Watch out for the double-tip talk
John Hussman has been writing in the last several weeks about impending deterioration in economic indicators [emphasis added]:

As I've emphasized in recent weeks, the U.S. economy is still in a normal "lag window" between deterioration in leading measures of economic activity and (probable) deterioration in coincident measures. Though the lags are sometimes variable, as we saw in 1974 and 2008, normal lags would suggest an abrupt softening in the September ISM report (due in the beginning of October), with new claims for unemployment softening beginning somewhere around mid-October. It's possible that the historically tight relationships that we've reviewed iin recent weeks will not hold in this particular instance, but we have no reasonable basis to expect that. Indeed, if we look at the drivers of economic growth outside of the now fading impact of government stimulus spending, we continue to observe little intrinsic activity.

Already, the employment picture is ominous:

• IMF Managing Director Dominique Strauss-Kahn has warned about a jobless recovery.
• The New York Times reports that older Americans are worrying that they will be permanently locked out of employment. Even if that isn't true, these concerns will serve to put a lid on their spending.
• Polls show that unemployment is rising again.
• At a local level, Gregor Macdonald reports that California employment is falling again.

Should we depend on a Bernanke Put?
To be sure, the latest FOMC statement seem to indicate that the Fed stands ready to act with another round of quantitative easing should the economy show signs of further weakness - and that should put a floor on any stock market decline. In the interim, however, the bulls may have to suffer through a growth scare before the Fed rides to the rescue.

Could China be ahead of the curve on Basel III?

In the wake of the announcement of the Basel III standards, there have been numerous calls that the standards are too relaxed (see comments here, here, here and here).


Last Friday, the following statement appeared on the PBoC website on the topic of banking in China:

Bank lending is concentrated on local government financing vehicles, the infrastructure sector and big corporations. With the speeding up of structural economic adjustments, there is clearly a rising possibility of loan losses. The quality of loans to the property industry is currently still sound. But we need to be on high alert as to the impact of property price fluctuations on such loans. The NPL ratio of credit card loans is rising rapidly and the potential risks demand attention. By the end of 2009, bad credit card loans reached 7.8 billion yuan, up from 3.5 billion yuan a year earlier. The NPL ratio of such loans stood at 2.8 percent.

...but banks continue to have a dual mandate

Banks should continue to support exporters to help a recovery in exports and support domestic firms venturing abroad. Banks need to increase recapitalisation efforts and replenish their core capital base via retained earnings and fresh injections of capital from shareholders.

...and they expect to implement Basel III:

China will restrain the blind expansion of banks by implementing stricter capital requirements in line with the Basel Accord. China will open up the banking sector in a timely manner and actively attract foreign financial firms that will help the country to better serve small businesses and agriculture and to boost domestic consumption.

If official government policy is that the banking system is to support "a recovery in exports and support domestic firms venturing abroad" and the banking system is fragile, then something must be done to ensure that banks don't drag the system down. There was also a Bloomberg story that China may impose a 15% capital ratio for the biggest banks.

Is China ahead of the curve on this?

Another strike against a gold standard

As the gold price moves to all-time highs, it's useful to revisit the debate over the usefulness of a gold standard.

I have written before about the problems surrounding the inflexibility of a gold standard (see previous posts here and here). Now comes an NBER working paper by Douglas Irwin entitled Did France cause the Great Depression?  Here is the abstract:

The gold standard was a key factor behind the Great Depression, but why did it produce such an intense worldwide deflation and associated economic contraction? While the tightening of U.S. monetary policy in 1928 is often blamed for having initiated the downturn, France increased its share of world gold reserves from 7 percent to 27 percent between 1927 and 1932 and effectively sterilized most of this accumulation. This “gold hoarding” created an artificial shortage of reserves and put other countries under enormous deflationary pressure. Counterfactual simulations indicate that world prices would have increased slightly between 1929 and 1933, instead of declining calamitously, if the historical relationship between world gold reserves and world prices had continued. The results indicate that France was somewhat more to blame than the United States for the worldwide deflation of 1929-33. The deflation could have been avoided if central banks had simply maintained their 1928 cover ratios.

Brad DeLong also put up a chart showing that the French were the last to emerge out of the Great Depression. Was it because of their stubborn embrace of the gold standard?

In Peter Bernstein's important work entitled The Power of Gold, which discusses the history of gold and the story of other commodity backed currencies, the author appears to be relatively agnostic over the issue of the value of a gold standard. 

I believe that the role of gold and other commodities in a global economic system is to act as a sentinel for central bankers. Bullion seems to be acting as an alternative currency - a barometer of confidence in fiat currencies. Former Fed Chairman Alan Greenspan recently spoke at the Council of Foreign Relations on this very issue. The NY Sun reported that:

“Fiat money has no place to go but gold,” the former Fed chairman said at the Council, according to economist David Malpass, who quotes Mr. Greenspan in one of Mr. Malpass’ emails on the political economy. Mr. Malpass writes that the former chairman of the Federal Reserve’s board of governors was responding to a question in respect of why gold was hitting new highs.

Mr. Greenspan replied that he’d thought a lot about gold prices over the years and decided the supply and demand explanations treating gold like other commodities “simply don’t pan out,” as Mr. Malpass characterized Mr. Greenspan. “He’d concluded that gold is simply different,” Mr. Malpass wrote. At one point Mr. Greenspan spoke of how, during World War II, the Allies going into North Africa found gold was insisted on in the payment of bribes. Said the former Fed chairman: “If all currencies are moving up or down together, the question is: relative to what? Gold is the canary in the coal mine. It signals problems with respect to currency markets. Central banks should pay attention to it.”

Market sentinel and canary in the coal mine? Yes.

A gold standard for currencies? No. It's too inflexibile and creates too much economic volatility.

Technical resistance: Here we go again

This has been a frustrating few months for both bulls and bears. The market has been mired in a trading range since June with an upside of 1100-1130 and downside of 1020-1040 with little directional bias. As the stock market rallies into technial resistance in the 1100-1130 zone yet again, the question has to be asked, "Will it get rejected once more in this resistance area?"

The odds seem to favor another downleg for a couple of reasons. First of all, investor sentiment has gotten incredibly bullish in the space of a couple of weeks, which is contrarian bearish.

More important for the intermediate term, the market is facing a number of macro headwinds of economic weakness starting in 4Q. John Hussman noted in his latest weekly comment [emphasis added]:

As I've noted frequently in recent commentaries, the typical lag between deterioration in say, the ECRI Weekly Leading Index and the ISM Purchasing Managers Index is about 13 weeks, and sometimes longer. The typical lag with respect to new claims for unemployment is about 23-26 weeks (which puts the likely window of deterioration at about the October - November time frame), and the typical lag with respect to the payroll unemployment report is, not surprisingly, about 4 weeks beyond that. 

Uber-bear Albert Edwards put it more bluntly:

The current situation reminds me of mid 2007. Investors then were content to stick their heads into very deep sand and ignore the fact that The Great Unwind had clearly begun. But in August and September 2007, even though the wheels were clearly falling off the global economy, the S&P still managed to rally 15%! The recent reaction to data suggests the market is in a similar deluded state of mind. Yet again, equity investors refuse to accept they are now locked in a Vulcan death grip and are about to fall unconscious.

Given the sentiment backdrop, where readings improved from investors being ultra-bearish two weeks ago to very bullish today, the market is not likely to advance significantly from current levels. I believe that the more important test will come when it descends once again to the 1020-1040 level. Will sentiment swing once again to widespread fears of a double-dip slowdown or will there be sufficient complacency for it to fall through that important support level? Will economic data weaken to suggest a higher probability of a slowdown to warrant further de-risking?

Only time can tell.

Diagnosing America's ills

Last week the World Economic Forum reported that the US has fallen from second to fourth in its competitiveness rankings. It lost its top spot last year to Switzerland. This year, it had been overtaken by Singapore and (socialist!) Sweden.

In many of these surveys, the scores of the top countries are all clustered together so small movements in rankings aren’t terribly meaningful. However, for the US to slip from first in one year and then to fourth the following year is a disturbing trend.

Here are the cited reasons for the decline in American competitiveness:

The report said a lack of macroeconomic stability continues to be America's greatest area of weakness, with repeated fiscal deficits leading to burgeoning public indebtedness.

It also said that U.S. business leaders show less trust in politicians and the government's ability to maintain an arm's-length relationship with the private sector.

Populism rears its ugly head
In other words, things are getting tough and people are getting cranky. I have written before about the risks of populism and a cranky population before (see examples here and here). The level of discontent rising and the risk of class warfare is going up with it. Consider these items that have appeared recently, some of which has come from middle-of-the-road figures):

• Profiting from layoffs (CNN)
• HP: The face of America’s decline (Commentary on the culture of rewarding slash and burn CEOs while offshoring jobs from Fabius Maximus)
• What makes America great: Layoffs (CNBC via Barry Ritholz)
• Land of Opportunity running out of opportunities (MarketWatch)
• A pity party for America’s rich and powerful (Commentary on Daniel Loeb’s comment about unfair taxation from Fabius Maximus)
• Despite US corporations sitting on $2T (in cash), the work force has become the New Expendables (Barry Ritholz)
• End wage inequality to end the recession (Robert Reich)
• A belief in free markets has turned us into Matrix drones (The Independent)

What’s wrong with America?
I believe that America’s ills stems from neglect, largely from the short-term nature of American thinking. There has been a neglect of infrastructure, a lack of focus on basics of innovation and wealth creation, as well as an erosion of the advantages bestowed by education.

The most recent infrastructure report card gives American physical infrastructure badly failing grades: Aviation (D), Bridges (C), Dams (D), Drinking Water (D-), Energy (D+), Hazardous Waste (D), Inland Waterways (D-), Levees (D-), Public Parks and Recreation (C-), Rail (C-), Roads (D-), Schools (D), Solid Waste (C+), Transit (D), and Wastewater (D-). Fixing this shortfall requires spending of over $2T. Nevertheless, there are calls for greater infrastructure spending as a way to build an economic recovery.


The erosion of education as a competitive advantage
Mike Mandel, who has blogged extensively on innovation, has complained that there has been too much spending on housing, too little on IT. While education has been the key to higher value-added jobs, the competitiveness advantages conferred by education have been eroding. IT skills, as an example, are becoming commoditized and offshored, according to this New York Times article:

These higher skills have become commodities, said Catherine L. Mann, a global finance professor at the Brandeis University International Business School who studies the outsourcing of jobs. The programming language “C++ is now an international language,” she said. “If that’s all you know, then you’re competing with people in India or China who will do the work for less.” In addition to lower wages, developing countries offer significant consumer growth, giving businesses a reason to make more products closer to the buyer, and hire locally.


And increasingly, these new, lower-cost research centers, while perhaps initially intended to adapt products for local use, are becoming sources of innovation themselves.

James Kwak, who blogs at Baseline Scenario with Simon Johnson, explains:

But since 1980, and especially since 1990, the world has become more open. If the American capitalists want to make more money, they still have to invest in new technology, and they still need an increasingly educated workforce. But now, because of globalization, they can get that workforce anywhere in the world. You can think of this as arbitrage: China doesn’t have that many college graduates as a proportion of its population, but they come cheaper than American college grads. Or you can think of it as free riding: if China (or Korea, or India, or Brazil, or anywhere else) is willing for whatever reason to invest in increasing the number of domestic college graduates, the American capitalists can simply expand their operations over there and save themselves the trouble and expense of investing in the American educational system. (And for China, the returns on investment in education might be higher than the returns for America, because the marginal productivity of new investments in education is probably higher.) And as a result, average educational attainment only went up by 0.8 years from 1980 to 2005.

Perhaps the next big engine of growth will not come from Silicon Valley, but from another sector. Mike Mandel believes that the US has made a big bet on life sciences, in the form of the human genome project, but it hasn’t paid off. In addition, other countries have exploited the competitive disadvantage of American restrictions on stem cell research to catch up and overtake US research in this field.


Two paths
I don’t have the answers to America’s ills. I can see two paths, both equally likely.The first path leads us to Greece (see this excellent Vanity Fair article on Greek culture and the crisis), where people have turned inward and milk institutions (governments, foreign entities such as the IMF, EU and ECB) for everything they can get away with, while public institutions wither.

As it turned out, what the Greeks wanted to do, once the lights went out and they were alone in the dark with a pile of borrowed money, was turn their government into a piñata stuffed with fantastic sums and give as many citizens as possible a whack at it. In just the past decade the wage bill of the Greek public sector has doubled, in real terms—and that number doesn’t take into account the bribes collected by public officials.

And that's just the Greek solution for "when the lights go out" and no one is watching. Other countries behaved differently and abused the system differently:

What they wanted to do with money in the dark varied. Americans wanted to own homes far larger than they could afford, and to allow the strong to exploit the weak. Icelanders wanted to stop fishing and become investment bankers, and to allow their alpha males to reveal a theretofore suppressed megalomania. The Germans wanted to be even more German; the Irish wanted to stop being Irish. All these different societies were touched by the same event, but each responded to it in its own peculiar way.

Will Time heal our wounds?
There is a more optimistic solution to global healing. The second and more benign solution is simply time. Ken Rogoff explains in his excellent commentary entitled Why America isn't Working:

The honest answer – but one that few voters want to hear – is that there is no magic bullet. It took more than a decade to dig today’s hole, and climbing out of it will take a while, too. As Carmen Reinhart and I warned in our 2009 book on the 800-year history of financial crises (with the ironic title “This Time is Different”), slow, protracted recovery with sustained high unemployment is the norm in the aftermath of a deep financial crisis.

Rogoff went on to skewer traditional macro solutions such as supply-side economics and Keynesianism. In the end, he does warn about the growing class divide, which I also worry about as it can lead to class warfare, populism and the disintegration of the social fabric:

[T]here is a fairness issue. By some measures, nearly half of all Americans do not pay any income tax already, so cutting taxes skews an already very unequal income distribution. Deferred maintenance on income equality is one of many imbalances that built up in the US economy during the pre-crisis boom. If allowed to fester, the political consequences could be severe, including trade protectionism and perhaps even social unrest.

Are "Black Swans" not so black anymore?

John Hempton at Bronte Capital recently blogged about the puzzling condition of rising gold prices and falling  bond yields. Indeed, we have seen rising commodity prices in the form of the CRB Index (pictured below) and the CRB Raw Materials Index, which is largely composed of nom-traded raw materials, is only 3% from its all-time highs.

Normally, bond yields rise as inflationary expectations rise. But instead of rising yields, we have seen falling bond yields – which is typically associated with deflationary episodes instead of rising inflationary expectations.

Rising tail risk
I interpret these conditions as Mr. Market being worried about both inflation and deflation. Moreover, when we see stories like Titan Capital Joins Black Swan's Taleb in Raising Bets on Crash, it seems to me that Mr. Market is also worried about rising tail risk, i.e. extreme events.

This may be an indication that tail risk is becoming a crowded trade.

Is this a time to sell tail risk volatility?

Waiting for 2017 (or 2018)

A lot of long-term analysis seems to be converging towards the launch of a new secular stock bull in the 2017-2018 timeframe.


Jeremy Grantham revisited his “seven lean years” scenario in his July quarterly letter July. About a year ago, Art Cashin highlighted the 17.6 year stock market cycle, which pointed to a bottom around 2017. I also wrote about an academic study that correlated demographic trends to P/E ratios, which pointed to a long-term bottom around 2018. I also suggested that while markets are likely to be flat longer term, they are going to be volatile and experience huge intermediate term swings.


Investment Policy for a Lost Decade
At best, this scenario means nearly a decade of flat returns. In this case, standard buy-and-hold asset allocations will disappoint investors with their low returns and high volatility.

Some investment strategists, like David Rosenberg at Gluskin Sheff, advocate an approach of focusing on yield and safety for return and risk mitigation. That's a good "first order" solution, but there is another way. During Japan’s Lost Decades, there were huge swings in the market that an astute investor could have profited from. Albert Edwards of SocGen agrees and wrote:

I have long maintained that even within a structural bear market, there are huge returns to be made in equities from participating in short-lived cyclical rallies like the one we have just seen. The Nikkei regularly used to enjoy 40-50% rallies as policy stimulus drove pronounced cyclical upturns in both GDP and profits.

My preferred investment approach, which I wrote about in the Qwest Investment Management’s September 2010 newsletter, is to embrace the volatility and use dynamic asset allocation techniques to trade the intermediate swings in the market.

When social mores and free markets collide

I would like to try something different for a change this Labor Day long weekend. In these pages I have been an advocate of examining assumptions so that a modeler can understand the weaknesses of his models. With that thought in mind, here are a thought experiment that I would like to conduct. Bear in mind that there are no right or wrong answers, only better answers about yourself and your world views.


The plight of the Chilean miners
Economists generally like free markets as they are efficient allocators of resources. But what happens when free market principles collide with social mores?

Consider the plight of the 33 Chilean miners who were trapped underground by a rock slide. The plan is to drill a hole roughly half a mile down through solid rock to rescue them:

Walter Herrera, quality control and risk manager for the Chilean mining company GeoTech, has said his company was bringing a specialized device typically used for boring water holes to the mine. The drill would use one of the three bore holes already made as a pilot and widen the diameter to about 28 inches, which officials have said is wide enough for the miners to be hoisted through.

Here are some questions, as a thought experiment, as a litmus test of true belief in free market principles:

1. Mining is a dangerous profession and the miners knew the risks. Certainly they would have been paid a risk premium for dangerous work and someone with rational expectations would have bought insurance to prepare for such an event. Drilling down half a mile through solid rock using specialized equipment can’t be cheap. Given the costs involved, do they deserve to be rescued?
2. If the answer to the previous question is “yes”, then who should pay for the rescue? If the company pay, has it done a cost benefit analysis of paying compensation of no rescue vs. the cost of a rescue? (Does the company bear any legal liability in this case given the miners knew that they knowingly took risky jobs?) If the government pays, doesn’t that just socialize the costs, just like the banking bailouts? Should the miners themselves pay? After all, they should have known that mining is a risky job and therefore demanded a risk premium in their wages. If that was the case, why would they not have hedged (bought insurance) against such an eventuality? In the tradition of Hayek and Friedman, they were free to choose their own risk profiles.

If you find these questions objectionable, then how do you react to a hypothetical case of an American without health insurance who is diagnosed with cancer? Should the patient be asked to pay for his or her care? What if the cancer is not immediately life threatening and care was not mandated? Is your answer any different from your previous answers about the Chilean miners?

What about these issues raised by Brad Delong on the segmentation effects of genetic testing on the life insurance business? We can identify with the Horatio Alger story of the self-made man. Free market principles are about creative destruction: aallowing people to succeed (and allowing failure). What are the effects when someone wins or loses the genetic lottery without any action on their own?

Isn't the practice of genetic screening just the free market at work?

Back in the days of the Soviet Union, there were endless essays about the "purism" of various schools of Marxist thought. This has been a self-test of the purity of adherence to free market thoughts.

Remember, there are no right or wrong answers, just insights about yourself and your assumptions about the world.

Time to sell Australia

Back in late May I suggested that a cheap way to buy Canadian-like equity exposure would be to buy the Australian market, as both markets and economies are fairly similar. The chart below shows the relative returns of the iShares Australia ETF (EWA) relative to iShares Canada (EWC) and what the pair has done since the call:

Since my post, the Australian market has beaten the Canadian market by about 8%. The maximum outperformance of this trade was about 11%. The pair trade has reached parity. It's time to take profits.