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Signs of a Top, OR that I am a Grumpy Old Man

June 20, 2018 4 comments

I was at an alternative investments conference last week. I always go to this conference to hear what strategies are in vogue – mostly for amusement, since the strategies that are in vogue this year are ones they will spit on next year. Two years ago, everyone loved CTAs; last year the general feeling was “why in the world would anyone invest in CTAs?” Last year, the buzzword was AI strategies. One comment by a fund-of-funds manager really stuck in my head, and that was that this fund-of-funds was looking for managers with quantitative PhDs but specifically ones with no market experience so that “they don’t have preconceived notions.” So, you can tell how that worked out, and this year there was no discussion of “AI” or “machine learning” strategies.

This year, credit strategies were in vogue and the key panel discussion involved three managers of levered credit portfolios. Not surprisingly, all three thought that credit is a great investment right now. One audience question triggered answers that were striking. The question was (paraphrasing) ‘this expansion is getting into the late innings. How much longer do you think we have until the next recession or crisis?” The most bearish of the managers thought we could enter into recession two years from now; the other two were in the 3-4 year camp.

That’s borderline crazy.

It’s possible that the developing trade war, the wobbling of Deutsche Bank, the increase in interest rates from the Fed, higher energy prices, Italy’s problems, Brexit, the European migrant crisis, the state pension crisis in the US, Elon Musk’s increasingly erratic behavior, the fact that the FANG+ index is trading with a 59 P/E, and other imbalances might not unravel in the next 3 years. Or 5 years. Or 100 years. It’s just increasingly unlikely. Trees don’t grow to the sky, and so betting on that is usually a bad idea. But, while the tree still grows, it looks like a good bet. Until it doesn’t.

There are, though, starting to be a few peripheral signs that the expansion and markets are experiencing some fatigue. I was aghast that venerable GE was dropped from the Dow Jones to be replaced by Walgreens. Longtime observers of the market are aware that these index changes are less a measure of the composition of the economy (which is what they tell you) and more a measure of investors’ animal spirits – because the index committee is, after all, made up of humans:

  • In February 2008 Honeywell and Altria were replaced in the Dow by Bank of America (right before the largest banking crisis in a century) and Chevron (oil prices peaked over $140/bbl in July 2008).
  • In November 1999, Chevron (with oil at $22) had been replaced in the Dow (along with Sears, Union Carbide, and Goodyear) by Home Depot, Intel, Microsoft, and SBC Communications at the height of the tech bubble, just 5 months before the final melt-up ended.

It isn’t that GE is in serious financial distress (as AIG was when it was dropped in September 2008, or as Citigroup and GM were when they were dropped in June 2009). This is simply a bet by the index committee that Walgreens is more representative of the US economy than GE and coincidentally a bet that the index will perform better with Walgreens than with GE. And perhaps it will. But I suspect it is more about replacing a stodgy old company with something sexier, which is something that happens when “sexy” is well-bid. And that doesn’t always end well.

After the credit-is-awesome discussion, I also noted that credit itself is starting to send out signals that perhaps not all is well underneath the surface. The chart below (Source: Bloomberg) shows the S&P 500 in orange, inverted, against one measure of corporate credit spreads in white.

Remember, equity is a call on the value of the firm. This chart shows that the call is getting more valuable even as the first-loss piece (the debt) is getting riskier – or, in other words, the cost to bet on bankruptcy, which is what a credit spread really is, is rising. Well, that can happen if overall volatility increases (if implied volatility rises, both a call and a put can rise in value which is what is happening here), so these markets are at best saying that underlying volatility/risk is rising. But it’s also possible that the credit market is merely leading the stock market. It is more normal for these markets to correlate (inverted) over time – see the chart below, which shows the same two series for 2007-2009.

I’m not good at picking the precise turning points of markets, especially when values start to get really bubbly and irrational – as they have been for some time. It’s impossible to tell when something that is irrational will suddenly become rational. You can’t tell when the sleepwalker will wake up. But they always do. As interest rates, real interest rates, and credit spreads have risen and equity yields have fallen, it is getting increasingly difficult for me to see why buying equities makes sense. But it will, until it doesn’t.

I don’t know whether the expansion will end within the next 2, 3, or 4 years. I am thinking it’s more likely to be 6 months once the tax-cut sugar high has truly worn off. And I think the market peak, if it isn’t already in, will be in within the next 6 months for those same reasons as companies face more difficult comps for earnings growth. But it could really happen much more quickly than that.

However, I recognize that this might really just mean that I am a grumpy old man and you’re all whippersnappers who should get off my lawn.

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You Haven’t Missed It

April 26, 2018 2 comments

A question I always enjoy hearing in the context of markets is, “Have I missed it?” That simple question betrays everything about the questioner’s assumptions and about the balance of fear and greed. It is a question which, normally, can be answered “no” almost without any thought to the situation, if the questioner is a ‘normal’ investor (that is, not a natural contrarian, of which there are few).

That is because if you are asking the question, it means you are far more concerned with missing the bus than you are concerned about the bus missing you.

It usually means you are chasing returns and are not terribly concerned about the risks; that, in turn – keeping in mind our assumption that you are not naturally contrary to the market’s animal spirits, so we can reasonably aggregate your impulses – means that the market move or correction is probably underappreciated and you are likely to have more “chances” before the greed/fear balance is restored.

Lately I have heard this question arise in two contexts. The first was related to the stock market “correction,” and on at least two separate occasions (you can probably find them on the chart) I have heard folks alarmed that they missed getting in on the correction. It’s possible, but if you’re worried about it…probably not. The volume on the bounces has diminished as the market moves away from the low points, which suggests that people concerned about missing the “bottom” are getting in but rather quickly are assuming they’ve “missed it.” I’d expect to see more volume, and another wave of concern, if stocks exceed the recent consolidation highs; otherwise, I expect we will chop around until earnings season is over and then, without a further bullish catalyst, the market will proceed to give people another opportunity to “buy the dip.”

The other time I have heard the angst over missing the market is in the context of inflation. In this, normal investors fall into two categories. They’re either watching 10-year inflation breakevens now 100bps off the 2016 lows and 50bps off the 2017 lows and at 4-year highs (see chart, source Bloomberg) and thinking ‘the market is no longer cheap’, or they just noticed the well-telegraphed rise in core inflation from 1.7% to 2.1% over the last several months and figuring that the rise in inflation is mostly over, now that the figure is around the Fed’s target and back at the top of the 9-year range.

Here again, the rule is “you didn’t miss it.” Yes, you may have missed buying TIPS 100bps cheap to fair (which they were, and we pointed it out in our 2015Q3 Quarterly Inflation Outlook to clients), but breakevens at 2.17% with median inflation at 2.48% and rising (see chart, source Bloomberg), and still 25bps below where breakevens averaged in the 5 years leading up to the Global Financial Crisis, says you aren’t buying expensive levels. Vis a vis commodities: I’ve written about this recently but the expectations for future real returns are still quite good. More to the point, inflation is one of those circumstances where the bus really can hit you, and concern should be less about whether you’ve missed the gain and more about whether you need the protection (people don’t usually lament that they missed buying fire insurance cheaper, if they need fire insurance!).

(In one way, these two ‘did I miss it’ moments are also opposites. People are afraid of missing the pullback in stocks because ‘the economy still looks pretty strong,’ but they’re afraid they missed the inflation rally because ‘the economy is going to slow soon and the Fed is tightening and will keep inflation under control.’ Ironically, those are both wrong.)

My market view is this:

  • For some time, TIPS have been very cheap to nominal bonds, but rich on an absolute Negative real yields do not a bargain make, even if they look better than other alternatives when lots of asset classes are even more expensive. But as real yields now approach 1% (70bps in 5y TIPS, 80bps in 10y TIPS), and with TIPS still about 35bps cheap to nominal bonds, they are beginning to be palatable to hold on their own right. And that’s without my macro view, which is that over the next decade, one way or the other, inflation protection will become an investment theme that people tout as a ‘new focus’ even though it’s really just an old focus that everyone has forgotten. But the days of <1% inflation are over, and we aren’t going to see very much <2% either. We may not see 4% often, or for long, but at 3% inflation is something that people need to take into account in optimizing a portfolio. I think we’re at that inflection point, but if not then we will be in a year or two. And TIPS are a key, and liquid, component of smart real assets portfolios.
  • Stocks have been outrageously expensive with very poor forward return expectations for a long time. However, these value issues have been overwhelmed by strong momentum (that, honestly, I never gave enough credit to) and the currently in-vogue view that momentum is somehow better than value. But perennially strong momentum is no longer a foregone conclusion. Momentum has stalled in the stock market – the S&P has broken the 50-day, 100-day, and (a couple of times, though only briefly so far) 200-day moving averages. The 50-day has now crossed below the 100-day. And the longer that the market chops sideways the weaker the momentum talisman becomes. Eventually, the value anchor will take over. There may be more chop to come but as I said above, I think another leg down is likely to come after earnings season.

And so, in neither case have you “missed it.”

Being Closer to the ‘Oh Darn’ Inflation Strike

April 19, 2018 5 comments

The time period between spikes of inflation angst seems to be shortening. I am not sure yet about the amplitude of those spikes of angst, but the concern seems to be quickening.

This is not without reason as it seems that concerning headlines are occurring with more frequency. This week the Bloomberg Commodity Index again challenged the 2016 and 2017 highs before backing off today (see chart, source Bloomberg).

Somewhat more alarming than that, to people who watch commodities, is how the commodity indices are rallying. The culprits are energy as well as industrial metals, and each has an interesting story to tell. Energy has been rallying partly because of global tensions, but also partly because US shale oil production appears to be running into some bottlenecks on production (wages, shortages of frack sand) as well as delivery (capacity constraints on pipelines), and part of what has kept a lid on energy prices over the last couple of years was the understanding that shale oil production was improving rapidly and becoming lots more efficient due to improved technology. If shale is limited, the ‘lid’ on prices is not as binding as we had thought. On industrial metals, some of the upward pressure has been due to fallout from US sanctions on Rusal, a major supplier of aluminum and alumina. Since those sanctions were announced, aluminum prices have risen around 25%, and alumina (a raw input to aluminum production) about 50%, with knock-on effects in other industrial metals.

Both of these items bear on the market’s recent fears about new pressures on inflation – capacity constraints (especially rising wages for long-haul truckers) and potential fracturing of the global trade détente.

And 10-year breakevens are at new 4-year highs, although it is worth remembering that this is nowhere near the 10-year highs (see chart, source Bloomberg).

Shorter inflation swaps look less alarming, and not at new four-year highs. However, even here the news is not really soothing. The reason that shorter inflation swaps are lower than they have been in the past is because the energy curves are in backwardation – meaning that the market is pricing in lower energy process in the future. In turn, this means that implied core inflation – once we strip out these energy effects – are, in fact, at 4-year highs (see chart, source Enduring Investments).

So there is legitimate cause to be concerned about upside risks to inflation, and that’s one reason the market is a bit jumpier in this regard. But there is also additional premium, volatility, and angst associated with the level of inflation itself. While as I have pointed out before much of the rise in core inflation to date due to optics arising from base effects, that doesn’t change the fact that the ‘oh, rats’ strike is closer now. That is to say that when core inflation is running at 1.5%, stuff can go wrong without hurting you if your pain threshold is at 3%. But when core inflation is at 2.5% (as it will be this summer), not as much “bad stuff” needs to happen to cause financial pain. In other words, both the ‘delta’ and the ‘gamma’ of the exposure is higher now – just as if one were short a call option struck at (say) 3% inflation. Because, implicitly, many investors are.

If inflation is low, then even if it is volatile in a range it can be consistent with high market valuations for stocks and bonds. But when inflation starts to creep above 3%, those markets tend to suffer in non-linear fashion.

And this, I believe, is why the market’s nervousness about inflation (and market volatility resulting from that nervousness) is unlikely to soon abate.

Nudge at Neptune

Okay, I get it. Your stockbroker is telling you not to worry about inflation: it’s really low, core inflation hasn’t been above 3% for two decades…and, anyway, the Fed is really trying to push it higher, he says, so if it goes up then that’s good too. Besides, some inflation isn’t necessarily bad for equities since many companies can raise end product prices faster than they have to adjust wages they pay their workers.[1] So why worry about something we haven’t seen in a while and isn’t necessarily that bad? Buy more FANG, baby!

Keep in mind that there is a very good chance that your stockbroker, if he or she is under 55 years old, has never seen an investing environment with inflation. Also keep in mind that the stories and scenes of wild excess on Wall Street don’t come from periods when equities are in a bear market. I’m just saying that there’s a reason to be at least mildly skeptical of your broker’s advice to own “100 minus your age” in stocks when you’re young, which morphs into advice to “owning more stocks since you’re likely to have a long retirement” when you get a bit older.

Many financial professionals are better-compensated, explicitly or implicitly, when stocks are going up. This means that even many of the honest ones, who have their clients’ best interests at heart, can’t help but enjoy it when the stock market rallies. Conversations with clients are easier when their accounts are going up in size every day and they feel flush. There’s a reason these folks didn’t go into selling life insurance. Selling life insurance is really hard – you have to talk every day to people and remind them that they’re going to die. I’d hate to be an insurance salesman.

And yet, I guess that’s sort of what I am.

Insurance is about managing risks. Frankly, investing should also be about managing risks – about keeping as much upside as you can, while maintaining an adequate margin of safety. Said another way, it’s about buying that insurance as cheaply as you can so that you don’t spend all of your money on insurance. That’s why diversification is such a powerful idea: owning 20 stocks, rather than 1 stock, gets you downside protection against idiosyncratic risks – essentially for free. Owning multiple asset classes is even more powerful, because the correlations between asset classes are generally lower than the correlations between stocks. Diversification works, and it’s free, so we do it.

So let’s talk about inflation protection. And to talk about inflation protection, I bring you…NASA.

How can we prevent an asteroid impact with Earth?

The key to preventing an impact is to find any potential threat as early as possible. With a couple of decades of warning, which would be possible for 100-meter-sized asteroids with a more capable detection network, several options are technically feasible for preventing an asteroid impact.

Deflecting an asteroid that is on an impact course with Earth requires changing the velocity of the object by less than an inch per second years in advance of the predicted impact.

Would it be possible to shoot down an asteroid that is about to impact Earth?

An asteroid on a trajectory to impact Earth could not be shot down in the last few minutes or even hours before impact.  No known weapon system could stop the mass because of the velocity at which it travels – an average of 12 miles per second.

NASA is also in the business of risk mitigation, and actually their problem is similar to the investor’s problem: find protection, as cheaply as possible, that allows us to retain most of the upside. We can absolutely protect astronauts in space from degradation of their DNA from cosmic rays, with enough shielding. The problem is that the more shielding you add, the harder it is to go very far, very fast, in space. So NASA wants to find the cheapest way to have an effective cosmic ray shield. And, in the ‘planetary defense’ role for NASA, they understand that deflecting an asteroid from hitting the Earth is much, much easier if we do it very early. A nudge when a space rock is out at the orbit of Neptune is all it takes. But wait too long, and there is no way to prevent the devastating impact.

Yes, inflation works the same way.

The impact of inflation on a normal portfolio consisting of stocks and bonds is devastating. Rising inflation hurts bonds because interest rates rise, and it hurts stocks because multiples fall. There is no hiding behind diversification in a ’60-40’ portfolio when inflation rises. Other investments/assets/hedges need to be put into the mix. And when inflation is low, and “high” inflation is far away, it is inexpensive to protect against that portfolio impactor. I have written before about how low commodities prices are compared with equity prices, and in January I also wrote a piece about why the expected return to commodities is actually rising even as commodities go sideways.

TIPS breakevens are also reasonable. While 10-year breakevens have risen from 1.70% to 2.10% over the last 9 months or so, that’s still below current median inflation, and below where core inflation will be in a few months as the one-offs subside. And it’s still comfortably below where 10-year breaks have traded in normal times for the last 15 years (see chart, source Bloomberg).

It is true that there are not a lot of good ways for smaller investors to simply go long inflation. But you can trade out your nominal Treasuries for inflation bonds, own commodities, and if you have access to UCITS that trade in London there is INFU, which tracks 10-year breakevens. NASA doesn’t have a lot of good options, either, for protecting against an asteroid impact. But there are many more plausible options, if you start early, than if you wait until inflation’s trajectory is inside the orbit of the moon.


[1] Your stockbroker conveniently forgets that P/E multiples contract as inflation rises past about 3%. Also, your stockbroker conveniently abandons the argument about how businesses can raise prices before raising wages, meaning that consumer inflation leads wage inflation, when he points to weak wage growth and says “there’s no wage-push inflation.” Actually, your stockbroker sounds like a bit of an ass.

Kicking Tails

February 12, 2018 5 comments

Note: my articles are now released about 8 hours earlier on the blog site and on my private Twitter feed @inflation_guyPV, which you can sign up for here, than they are released on my ‘regular’ Twitter feed. Moreover, until this Friday you can use the code “onefree” at checkout to get $10 off, which means you get a free month when you sign up!


Like many people, I find that poker strategy is a good analogy for risk-taking in investing. Poker strategy isn’t as much about what cards you are dealt as it is about how you play the cards you are dealt. As it is with markets, you can’t control the flop – but you can still correctly play the cards that are out there.[1] Now, in poker we sometimes discover that someone at the table has amassed a large pile of chips by just being lucky and not because they actually understand poker strategy. Those are good people to play against, because luck is fickle. The people who started trading stocks in the last nine years, and have amassed a pile of chips by simply buying every dip, are these people.

All of this is prologue to the observation I have made from time to time about the optimal sizing of investment ‘bets’ under conditions of uncertainty. I wrote a column about this back in 2010 (here I link to the abbreviated re-blog of that column) called “Tales of Tails,” which talks about the Kelly Criterion and the sizing of optimal bets given the current “edge” and “odds” faced by the bettor. I like the column and look back at it myself with some regularity, but here is the two-sentence summary: lower prices imply putting more chips on the table, while higher volatility implies taking chips off of the table. In most cases, the lower edge implied by higher volatility outweighs the better odds from lower prices, which means that it isn’t cowardly to scale back bets on a pullback but correct to do so.

When you hear about trading desks having to cut back bets because the risk control officers are taking into account the higher VAR, they are doing half of this. They’re not really taking into account the better odds associated with lower prices, but they do understand that higher volatility implies that bets should be smaller.

In the current circumstance, the question merely boils down to this. How much have your odds improved with the recent 10% decline in equity prices? Probably, only a little bit. In the chart below, which is a copy of the chart in the article linked to above, you are moving in the direction from brown-to-purple-to-blue, but not very far. But the probability of winning is moving left.

Note that in this picture, a Kelly bet that is less than zero implies taking the other side of the bet, or eschewing a bet if that isn’t possible. If you think the chance that the market will go up (edge) is less than 50-50 you need better payoffs on a rally than on a selloff (odds). If not, then you’ll want to be short. (In the context of recent sports bets: prior to the game, the Patriots were given a better chance of winning so to take the Eagles at a negative edge, you needed solid odds in your favor).

Now if, on the other hand, you think the market selloff has taken us to “good support levels” so that there is little downside risk – and you think you can get out if the market breaks those support levels – and much more upside risk, then you are getting good odds and a positive edge and probably want to bet aggressively. But that is to some extent ignoring the message of higher implied volatility, which says that a much wider range of outcomes is possible (and higher implied volatility moves the delta of an in-the-money option closer to 0.5).

This is why sizing bets well in the first place, and adjusting position sizes quickly with changes in market conditions, is very important. Prior to the selloff, the market’s level suggested quite poor odds such that even the low volatility permitted limited bets – probably a lot more limited than many investors had in place, after many years of seeing bad bets pay off.


[1] I suspect that Bridge might be as good an analogy, or even better, but I don’t know how to play Bridge. Someday I should learn.

Categories: Analogy, Investing, Theory, Trading

Are Rising Yields Actually a Good Thing?

February 6, 2018 2 comments

I’ve recently been seeing a certain defense of equities that I think is interesting. It runs something like this:

The recent rise in interest rates, which helped cause the stock market swoon, is actually a good thing because interest rates are rising due to a strong economy and increasing demand for capital, which pushes up interest rates. Therefore, stocks should actually not mind the increase in interest rates because it’s an indication of a strong economy.

This is a seductive argument. It’s wrong, but it’s seductive. Not only wrong, in fact, but wrong in ways that really shouldn’t confuse any economist or strategist writing in the last twenty years.

Up until the late 1990s, we couldn’t really tell the main reason that nominal interest rates were rising or falling. For an increase in market rates there are two main potential causes: an increase in real interest rates, which can be good if that increase is being caused by an increasing demand for credit rather than by a decreasing supply, and an increase in inflation expectations, which is an unalloyed negative. But in 1995, we would have had to just guess which was causing the increase in interest rates.

But since 1997, we’ve had inflation-linked bonds, which trade on the basis of real yield. So we no longer have to guess why nominal rates are rising. We can simply look.

The chart below shows the decomposition of 10-year nominal yields since early December. The red line, which corresponds to the left scale, shows “breakevens,” or the simple difference between real yields and nominal yields; the blue line, on the right-hand scale, shows real yields. So if you combine the two lines at any point, you get nominal yields.

Real yields represent the actual supply and demand for the use of capital. That is, if I lend the government money for ten years, then in order to entice me to forego current consumption the government must promise that every year I will accumulate about 0.68% more ‘stuff.’ I can consume more in the future by not consuming as much now. To turn that into a nominal yield, I then have to add some premium to represent how much the dollars I will get back in the future, and which I will use to buy that ‘stuff’, will have declined in value. That of course is inflation expectations, and right now investors who lend to the government are using about 2.1% as their measure of the rate of deterioration of the value of the dollar.[1]

So, can we say from this chart that interest rates are mainly rising for “good” reasons? On the contrary! The increase in inflation expectations has been much steadier; only in the last month have real interest rates risen (and we don’t know, by the way, whether they’re even rising because of credit demand, rather than credit supply). Moreover – although you cannot see this from the chart, I can tell you based on proprietary Enduring Intellectual Properties research that at this level of yields, real yields are usually responsible for almost all of the increase or decrease in nominal yields.[2] So the fact that real yields are providing a little less than half of the selloff? That doesn’t support the pleasant notion of a ‘good’ bond selloff at all.

As I write this, we are approaching the equity market close. For most of the day, equities have been trading a bit above or a bit below around Monday’s closing level. While this beats the heck out of where they were trading overnight, it is a pretty feeble technical response. If you are bullish, you would like to see price reject that level as buyers flood in. But instead, there was pretty solid volume at this lower level. That is more a bearish sign than a bullish sign. However, given the large move on Friday and Monday it was unlikely that we would close near unchanged – so the last-hour move was either going to be significantly up or significantly down. Investors chose up, which is good news. But the bad news is that the end-of-day rally never took us above the bounce-high from yesterday’s last hour, and was on relatively weak volume…and I also notice that energy prices have not similarly rallied.


[1] In an article last week I explained why we tend to want to use inflation swaps rather than breakevens to measure inflation expectations, but in this case I want to have the two pieces add up to nominal Treasury yields so I am stuck with breakevens. As I noted in that article, the 2.1% understates what actual inflation expectations are for 10 years.

[2] TIPS traders would say “the yield beta between TIPS and nominals is about 1.0.”

Historical Context Regarding Market Cycles

February 5, 2018 4 comments

I really enjoy listening to financial media outlets on days like this. Six days removed from all-time highs, the equity guys – especially the strategists, who make their money on the way up – talk about “capitulation,” and how “nothing has changed,” and how people need to “invest for the long-term.” If equities have entered a bear market, they will say this all the way down.

It helps to have seen a few cycles. Consider the early-2000s bear market. In 2000, the Nasdaq crested in March. After a stomach-churning setback, it rallied back into August (the S&P actually had its highest monthly close for that cycle in August). The market then dropped again, bounced, dropped again, bounced, and so on. Every bounce on the way down, the stock market shills shrieked ‘capitulation’ and called it a buying opportunity. Eventually it was, of course. But if there is a bear market, there will be plenty of time to buy later. This was also true in ’09, which was much more of a ‘spike’ bottom but let’s face it, you had months and months to get in…except that no one wanted to get in at the time.

If it is not a bear market, then sure – it’s a buying opportunity. But what I know from watching this drama play out several times is that you cannot tell at the time whether it’s a buying opportunity, or a dead-cat bounce. It does not help at all to say “but the economy is okay.” Recalling that the Nasdaq’s peak was in March 2000: the Fed was still hiking rates in May of that year, and didn’t cut rates until 2001.  In late July 2000, GDP printed 5.2% following 4.8% in Q1. In October 2000, GDP for Q3 was reported to still be at 2.2%. Waiting for the economy to tell you that all was not well was very costly. By the time the Fed was alarmed enough to ease, in a surprise move on January 3, 2001, the S&P was down 16%. But fortunately, that ended it as stocks jumped 5% on the Fed’s move. Buy the dip!

By mid-2002, stocks were down about 50% from the high. Buying the dip was in that case precisely wrong.

Then there is the bear market of a decade ago. The October 2007 market high happened when the economy was still strong, although there were clearly underlying stresses in mortgages and mortgage banking and the Fed was already easing. Yet, on January 10, 2008, Fed Chairman Bernanke said “the Federal Reserve is not currently forecasting a recession.” On January 18, he said the economy “has a strong labor force, excellent productivity and technology, and a deep and liquid financial market that is in the process of repairing itself.” In June 2008, he said “The risk that the economy has entered a substantial downturn appears to have diminished over the past month or so.” Stocks were already down 19%. It got somewhat worse…and it didn’t take long.

So the thing to remember is this: equities do not wait for earnings to suffer, or for forecasts of earnings to suffer, or for everyone to figure out that growth is flagging, or for someone to ring a bell. By the time we know why stocks are going down, it is too late. This is why using some discipline is important – crossing the 200-day moving average, or value metrics, or whatever. Or, decide you’ll hold through the -50% moves and ignore all the volatility. Good luck…but then why are you reading market commentary?

I don’t know that stocks are going to enter a bear market. I don’t know if they’ll go down tomorrow or next week or next month. I have a pretty strong opinion about expected real returns over the next 10 years. And for that opinion to be realized, there will have to be a bear market (or two) in there somewhere. So it will not surprise me at any time if a bear market begins, especially from lofty valuation levels. But my point in this article is just to provide some historical context. And my general advice, which is not specific to any particular person reading this, is that if anyone tells you that price moves like this are ‘capitulation’ to be followed by ‘v-shaped recoveries,’ then don’t just walk away but run away. They haven’t any idea, and that advice might make you a few percent or lose you 50%.

To be sure, don’t panic and abandon whatever plan you had, simply because other people are nervous. As Frank Herbert wrote, “fear is the mind-killer. Fear is the little-death that brings total obliteration.” This is why having a plan is so important! And I also think that plans should focus on the long term, and on your personal goals, and matching your long-term investments to those goals. Rebalancing and compounding are powerful tools, as is a value ethic of buying securities that have a margin of safety.

And, of course, diversification. Bonds today did what they’re supposed to do when ‘risky assets’ take a tumble: they rallied. As I noted on Friday: “I am not saying that interest rates are going directly from 3% to 6%. Indeed, the rates/equity ecosystem is inherently self-dampening to some degree (at least, until we reach a level where we’ve exceeded the range of the spring’s elasticity!) in that if equity prices were to head very much lower, interest rates would respond under a belief that central bankers would moderate their tightening paths in the face of weak equities.” The problem with nominal bonds at this point, though, is that they’re too expensive. At these yields, there is a limit to the diversification they can provide, especially if what is going to drive the bear market in stocks is rising inflation. Bonds will diversify against the sharp selloff, but not against the inflation spiral. (I’ve said it before and I will say it again. If you haven’t read Ben Inker’s piece in the latest GMO quarterly, arguing why inflation is a bigger risk for portfolios right now than recession, do so. “What happened to inflation? And What happens if it comes back?”)

Which brings us to commodities. If the factor driving an equity bear market turns out to be inflation, then commodities should remain uncoupled from equities. For the last few days, commodity indices have declined along with equities – not nearly as much, of course, but the same sign. But if the problem is a fear of inflation then commodities should be taking the baton from stocks.

So there you go. If the problem is rising interest rates, then that is a slow-moving problem that’s self-limiting because central banks will bring rates back down if stocks decline too far. If the problem is rising inflation, then commodities + inflation bonds should beat equities+nominal bonds. Given that commodities and inflation bonds are both relatively cheaper than their counterparts, I’d rather bet that way and have some protection in both circumstances.

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