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Ex-Communication Policy

March 19, 2014 6 comments

Well, I guess it would be hard to have a clearer sign that investors are over their skis than to have the Fed drop the portion of their communique that was most-binding – in a move that was fully anticipated by almost everyone and telegraphed ahead of time by NY Fed President Dudley – and watch markets decline anyway.

To be sure, the stock market didn’t exactly plunge, but bonds took a serious hit and TIPS were smacked even worse. TIPS were mainly under pressure because there is an auction scheduled for tomorrow and it was dangerous to set up prior to the Fed meeting, not because there was something secretly hawkish about the Fed’s statement. Indeed, they took pains to say that “a highly accommodative stance of monetary policy remains appropriate,” and apparently they desire for policy to remain highly accommodative for longer relative to the unemployment threshold than they had previously expressed.

The next Fed tightening (let us pretend for a moment that the taper is not a tightening – it obviously is, but let’s pretend that we’re only talking about overnight interest rates) was never tied to a calendar, and it would be ridiculous to do so. But it seems that maybe some investors had fallen in love with the idea that the Fed would keep rates at zero throughout 2015 regardless of how strong or how weak the economy was at that time, so that when the Fed’s members projected that rates might reach 1% by the end of 2015 – be still, my heart! – these investors had a conniption.

Now, I fully expect the Fed to tighten too little, and too late. I also expect that economic growth will be sufficiently weak that we won’t see interest rates rise in 2015 despite inflation readings that will be borderline problematic at that time. But that view is predicated on my view of the economy and my assessment of the FOMC members’ spines, not on something they said. You should largely ignore any Fed communication unless it regards the very next meeting. They don’t know any better than you do what the economy is going to be doing by then. If they did, they would only need one meeting a year rather than eight. Focus on what the economy is likely to be doing, and you’ll probably be right more often than they are.

Arguably, this was not the right theory when the Fed was simply pinning rates far from the free-market level, but as the Fed’s boot comes off the market’s throat we can start acting like investors again rather than a blind, sycophantic robot army of CNBC-watching stock-buying machines.

Now, I said above that “the stock market didn’t exactly plunge,” and that is true. On the statement, it dropped a mere 0.3% or so. The market later set back as much as 1%, with bonds taking additional damage, when Chairman Yellen said that “considerable period” (as in “a considerable period between the end of QE and the first rate increase) might mean six months.

Does that tell you anything about the staying power of equity investors, that a nuance of six months rather than, say, nine or twelve months of low rates, causes the market to spill 1%? There are a lot of people in the market today who don’t look to own companies, but rather look to rent them. And a short-term rental, at that, and even then only because they are renting them with money borrowed cheaply. For the market’s exquisite rally to unravel, we don’t need the Fed to actually raise rates; we need markets to begin to discount higher rates. And this, they seem to be doing. Watch carefully if 10-year TIPS rates get back above 0.80% – the December peak – and look for higher ground if those real yields exceed 1%. We’re at 0.60% right now.

Stocks will probably bounce over the next few days as Fed speakers try and downplay the importance of the statement and of Yellen’s press conference remarks (rhetorical question: how effective is a communication strategy if you have to re-explain what you were communicating)? If they do not bounce, that ought also to be taken as a bad sign. Of course, I continue to believe that there are many more paths leading to bad outcomes for equities (and bonds!) than there are paths leading to good outcomes. Meanwhile, commodity markets were roughly unchanged in aggregate today…

Clap Along if You Feel that Happiness is the Truth

March 4, 2014 6 comments

It might seem crazy what I’m ’bout to say

Sunshine she’s here, you can take a break

I’m a hot air balloon that could go to space

With the air, like I don’t care baby by the way

- From “Happy” by Pharrell Williams

Cliff Asness and John Liew have an article that is in the latest issue of Institutional Investor, discussing the development, strengths, and shortfalls of the Efficient Market Hypothesis, which underlies the Nobel award for both Fama (as a proponent) and Shiller (as a skeptic) this year.One of the interesting points that Asness and Liew make is that examinations of market efficiency depend on the “joint hypothesis” that (a) prices move efficiently to represent correct values, and (b) the model of values that they move to is correct. They point out that if prices seem to deviate from fair value (as expressed by a model), that could mean that either markets are inefficient/irrational, or that the model is wrong (or both). And they suggest strengthening the EMH to include a limitation on such models that they make some kind of sense – since a model that incorporates irrational behavior might well-describe all sorts of crazy market action but not be “efficient” in any sense that makes sense to us.

This may not be an irrelevant reflection, given the price events of today. Stocks more than rebounded from yesterday’s Ukraine-induced selloff, implying that not only are stocks just as valuable today as they were yesterday, but that they are even more valuable than they were before we found out about escalating tensions in the Crimean. This seems to border on the “unusual model” side of things – especially since nothing particularly soothing happened today.

Earlier today, Reuters reported that one of the Russian threats made in response to the vague declarations of the U.S. that “all options are on the table, from diplomatic to economic” (pointedly leaving out “military,” as Obama did yesterday, because gosh knows we don’t want the Russians to think that’s even a possibility) was that Russians might not repay loans due to U.S. banks (or, presumably, European banks if they joined any sanctions). This is a clever threat, in the old vein of “if you owe $100, it’s your problem; if you owe $1 billion, it’s the bank’s problem.” Everyone who thinks that economic sanctions are a no-brainer are correct, in the sense that it would imply no brain.

Russia also tested an intercontinental ballistic missile. This was “viewed as non-threatening and is not connected to what is going on in Crimea,” which is of course absurd: regardless of how long the test has been scheduled, someone who was trying to “de-escalate” tensions would surely defer the test for a week. The fact that the test happened is one of many signs today that Putin’s soothing words were hollow. All of the actions today, from additional warships steaming towards the Crimean peninsula to ICBM launches and confrontations between Ukrainian and Russian troops, were consistent with an escalating crisis even as Putin said there was no “immediate” need to invade eastern Ukraine.

Stocks loved the idea that the conflict may be over, with the west simply conceding the Crimea and Russia deciding that she is sated for the time being, as ridiculously unlikely as that outcome actually is. And, as I fully expected, we heard over and over today the Rothschildian admonition to “buy on the sound of cannons.” And indeed, they bought. Oh, how they bought. The S&P rose 1.53% and most European bourses were up 2%-3%. The expected comparisons were made, to the performance of equities during and following the Cuban Missile Crisis, the first Gulf War, and the invasion of the Sudetenland.

These comparisons are all nonsense. Here’s why.

Event Date CAPE prior to
Sudetenland June 1938 11.99
Cuba Oct 1962 17.32
Kuwait Aug 1990 16.17
Ukraine now 24.87

This is what happens when people learn the “whats” of history, but don’t learn the “whys.” The Rothschildian point isn’t simply to buy on the sound of cannons. It’s to buy when markets are cheap because of the sound of cannons. And that is most assuredly not the case presently. If stocks had dropped 50% because of the Russian invasion, I would have been at the front of the line telling people to buy. It is reckless and feckless to buy when the market is expensive, and there are cannons that suggest a higher risk premium is warranted at least for a time.

Really, what is the risk here, today? Is the risk really that an investor might miss the next 25%, because the world becomes not only safe, but safer than it was a week ago, and a super-cheap market simply takes off? Or is there some risk that an investor might participate in the next -25%? Good heavens, surely the latter is a far greater risk right now. And, after all, Rothschild also said “sell on the sound of trumpets” (it’s always interesting how the bearish parts get forgotten), so that if the crisis is over and the west is victorious then you’re supposed to be selling! Here I guess is my point: this is not Rothschild’s market.

And, as Asness and Liew might put it, the model that implies stocks are more valuable after such an episode…might not be a rational model. But today, Pharrell wins: clap along if you feel like that’s what you want to do!

What Do You Care What Other People Think?

February 18, 2014 3 comments

In reflecting, over this weekend, about the markets of the last week, I wonder if we haven’t seen a subtle – and subtly disturbing – shift in the markets’ behavior.

Before the Fed began the taper, and even after the Fed began the taper but before we were really sure they intended to maintain it through at least mild economic wiggles, bad news was treated as good news in the markets (both stocks and bonds) because it implied more QE, or a longer QE, or a slower taper. This was lamentable because it suggested that the Fed was more important than global market fundamentals, but understandable at some level. All other forces summed to just about zero, so one big institution with a very big hammer was able to make the market vibrate the way policymakers wanted it to. So, while lamentable, this behavior was at least understandable.

But recently, as the Fed has started ever-so-slowly receding to the back pages, we have started to see behavior that is less unusual, but still not “normal.” Over the last couple of weeks, despite manifestly weak data – from the Employment report to Thursday’s surprisingly weak Retail Sales data and Friday’s weak Industrial Production data (which would have been even weaker if it hadn’t been for the utilities sector humming away) – the stock market has continued a marked rally. However, this is something we’ve seen before: a rally not because weak data would precipitate bullish policy, but because the weak data had a ready excuse in poor winter weather. In this sort of environment, good news is really good news, and bad news can be discounted (even if the cause to do so is sketchy).

There also is some “kitchen sinking” going on even among economists. “Kitchen sinking” refers to when a company takes advantage of a bad quarter to write off all sorts of expenses, all attributed to the “one time event” whether due to it in fact or not. This makes it far easier to score great earnings in the future. It’s understandable (if of questionable legality) in corporate accounting, but when economists do it then we should look askance. Without my naming names: on Friday one well-known macroeconomic advisor told clients that cold weather in November, December, and January will lower Q1 GDP by 0.4%. I am not sure how November’s weather would lower GDP in Q1…in fact, it seems to me that by lowering Q4 GDP, bad weather in December would tend to increase GDP in Q1 because it would be building from a lower base. Whatever the reason for the forecast, though, it certainly lowers the bar for the actual Q1 GDP report and increases the odds of a stock market-bullish surprise (although that’s way out in April).

Much more than the former mode of taking weak data as good because it implied more liquidity from the Fed, this sort of thing – kitchen sinking by economists, and markets taking all news as either neutral or good – is a signature of unhealthy bullishness. The concern is that when the reasons to ignore bad news have passed, the market will not be priced at a level that can sustain actual bad news. And, unlike the QE-baiting, it is something we have seen before. It is a weaker signature, and it’s entirely emotional rather than the twisted but at least debatable reasoning that investors employed when bad news was Fed-good.

It seems almost unfair to continue to list anecdotal signs of frothy behavior, because it’s so easy to do so these days. One that sprang into view last week was the incredibly vitriolic response to the chart that has been making the rounds showing the parallel in equity market action between 1928-29 and 2012-14. For example, here was one objection, which was perhaps a reasonable objection … but note the tone. And this was just one example among many.

Come on, is it really so horrible, such a threat to civilization, to have someone trot out this chart? I will take either side of the argument with no acrimony. Personally, I don’t think it’s almost ever useful to think of the past as an exact roadmap (although if I ignored this chart, and the market did crash, I hate to think of how I would explain that insouciance to my clients after-the-fact), but I also don’t care if someone else does do so. Especially if it leads them to the right conclusion, and I happen to think that if investors start being cautious right now it is the right result, whether it happens because they were scared of a spooky chart or because they understand market valuation metrics.

But again: who cares? This is not a fact which is right or wrong – unlike, say, the claim that the government made a change to the CPI in the early 1980s which subtracts 5% from CPI every year. That is a verifiable statement, and it is demonstrably false. But saying “chart A looks like chart B” can’t possibly be wrong…it’s opinion! My concern isn’t about the chart; it is about the vehemence with which some people are attacking that opinion.

It is like I tell my daughter when someone calls her a dunderhead, or whatever the 7-year-old equivalent is these days. I ask “well, are you a dunderhead?” If the answer is yes, then you have bigger problems than what they’re calling you. If the answer is no, then as Feynman said what do you care what other people think? Similarly, if you’re bullish, what do you care if someone runs that chart? If it’s right, then you have bigger problems than the fact they’re running the chart. And if it’s wrong, then what do you care what they think?

Don’t Bank on it

February 17, 2014 7 comments

Here is a post from Sober Look that has some really good charts on the changing asset mix at US banks. I was a little surprised that they didn’t point out the obvious connection in the charts, although they do make some key points in a previous post.

To summarize: the charts show that the loan-to-deposit ratio in the banking system recently hit a 35-year low, and that the proportion of cash on the balance sheet of banks has gone from maybe 5% to around 20% (eyeballing it) in the last ten years.

Obviously, these two facts are not unconnected, since loans and cash are both assets to banks. The reason for the shift from loans to cash is very simple: QE. Banks don’t want to hold as much cash (reserves) as they are carrying, but the alternative is to lend it to people in sub-optimal loans – that is, where the interest rate charged does not compensate for the risk that the loan will not be paid back, so that the lending has a negative NPV. Moreover, the cash itself has a positive return because the Fed is paying interest on excess reserves, so that the lending has a higher hurdle to achieve than it would if this was just “normal” cash or reserves.

Understanding this dynamic is really important. So here’s how this works: if interest rates rise, but reserves have the same yield, then lending becomes more profitable and loans will increase – that is, the money multiplier will rise, with less money in the vault and more money in transactional accounts. If, on the other hand, the Fed raises the interest on excess reserves while lending rates stay unchanged, then even fewer loans will be made and banks will hold more cash relative to loans. This is one mechanism by which higher interest rates initially encourage higher inflation.

(And yes, while the total amount of reserves in the system is fixed, the total amount of loans is not, so while the Fed controls the former they do not control the latter except indirectly).

So, consider the “exit” strategy. As interest rates rise, the multiplier will increase unless the Fed hikes interest on excess reserves. But since interest rates move more flexibly, more rapidly, and often further than do policy rates, this probably means the multiplier will be determined mostly by the market (I wonder if the Fed declared the IOER to be “10-year yields minus 250bps” if that would change things?). The gap is the thing. And, if Yellen actually cuts the IOER to zero, as she has intimated is possible, then the multiplier would rise…and we don’t know by how much.

On the flip side, if the Fed tapers QE to zero, and lending rates fall, then the multiplier would tend to fall further because that gap narrows. In that case, you really could get a disinflationary scenario…though I am skeptical that long rates can fall very much when public debt is so high and the Fed is withdrawing its support for the bond market. Still, a crisis could do it. To be clear: you’d need the Fed to stop adding reserves, to neglect the IOER – or increase it – and long rates to decline substantially (at least 100bps, say). So if you are a deflationist, there are your signposts. I don’t anticipate that any of that happening, except that I imagine they will screw up the IOER strategy and they could screw that up in either direction.

And by the way, I don’t think any of that would affect inflation much in 2014, since higher housing prices are already going to be pressing core inflation higher. But it could affect 2015.

However, I digress from the other point I wanted to make that was suggested by the Sober Look article, and that is this: it continues to amaze me how well bank stocks are trading. I’ve been saying this for years – which helps to illustrate that I am a strategic investor, not a twitchy tactical guy. Return on equity equals gross margin (profit/revenue), times asset turnover (revenue/assets), times leverage (assets/equity), and for banks all three of these components are under pressure. Gross margin is under pressure from the movement of more products to electronic trading and from increasing legal bills at banks (the FX trading scandal is the latest threat of multibillion-dollar fines, adding to the LIBOR scandal and probes of the gold and silver price fixing system as sources of legal headaches for banks). Banks have been forced via the crisis to shed leverage, as a chart I recently ran illustrated. And low interest rates combined with large amounts of cash compared to loans on the balance sheet pressures the asset turnover statistic. So it isn’t surprising that bank ROEs are low (see chart of the NASDAQ bank index ROEs, source Bloomberg). roebanksWhat is surprising is that they even got this high, and market pricing seems to anticipate that they’ll keep rising. Bank stocks are actually outperforming the S&P since late 2011, and their P/E ratios are essentially where they have always been, excluding the spike when earnings collapsed in the crisis, causing P/Es to skyrocket (see chart, source Bloomberg).

bankpeMaybe all the bad news is already in the price of bank stocks, but it doesn’t look like it to me.

Two Types of People?

February 10, 2014 2 comments

Investors have learned the same wrong lessons over the last couple of years that they learned in the run-up to 2000, evidently. I remember that in the latter part of 1999, every mild equity market setback was met immediately with buying – the thought was that you had to jump quickly on the train before it left the station again. There was no thought about whether the bounce was real, or whether it “made sense”; for quite a number of them in a row, the bounce was absolutely real and the train really did leave the station.

Then, the train reached the end of the line and rolled backwards down the mountain, gathering speed and making it very difficult to jump off. I remember getting a call from my broker at the time, recommending Lucent at around $45 – quite the discount from the $64 high. I noted that I was a value investor and I didn’t see value in that stock, and to not call me again until he had a decent value idea. He next called with a recommendation later that year, with a stock that had just hit $30…a real bargain! And, as it turned out, that stock was also Lucent. The lesson he had learned was that any stock at a discount from the highs was a “value” stock. (Lucent ended up bottoming at about $0.55 in late 2002 and was eventually acquired by Alcatel in 2006).

This lesson appears to have been learned as well. On Thursday and Friday a furious rally took stocks up, erasing a week and a half of decline. This happened despite the fact that Friday’s Employment number was just about the worst possible number for equities: weak enough to indicate that the December figure was not just about seasonal adjustment, but represented real weakness, but nowhere near weak enough to influence the Federal Reserve to consider pausing the recent taper. We will confirm this fact tomorrow, before the market open, when new Fed Chairman Janet Yellen delivers the Monetary Policy Report (neé Humphrey-Hawkins) testimony to the House Financial Services Committee (her comments to be released at 8:30ET). While I believe that Yellen will be very reluctant to raise rates any time soon, and likely will seize on signs of recession to stop the taper in its tracks, she will be reluctant to be a dove right out of the gate.

And that might upset the apple cart tomorrow, if I’m right.

I have been fairly clear recently that I see a fairly significant risk of market volatility to come, both on the fixed-income side but especially on the equity side. I think stocks are substantially overvalued and could fall markedly even without any important change in the underlying economic dynamics. But there is actually good news which should be considered along with that fact: when markets were last egregiously overpriced, financial institutions were also substantially more-levered than they are today. The chart below (source: Federal Reserve) shows that as a percentage of GDP, domestic financial institutions are about one third less levered than they were at the 2008 peak.

debtdelevNow, this exaggerates the deleveraging to some extent – households, for example, appear to have deleveraged by about 20% on this chart, but the actual nominal amount of debt outstanding has only declined from about $14 trillion to about $13.1 trillion. Corporate entities have actually put on more debt (which made sense for a while but probably doesn’t now that equity is so highly valued relative to earnings), but in terms of a percentage of GDP they are at least not any more levered than they were in 2008.

The implication of this fact is some rare good news: since the banking system has led the deleveraging, the systemic risk that could follow on the heels of a significant market decline is likely to be much less, at least among U.S. domestic financial institutions. So, in principal, while it was clear that a decline in equity and real estate prices in 2007-2008 would eventually cause damage to the real economy as the financial damage was amplified through the financial system, this is less true today. We can, in other words, have some reasonable market movements without having that automatically lead to recession. The direct wealth effect of equity price movements is very small, on the order of a couple of percent. It’s the indirect effects that we have to worry about, and the good news is that those indirect effects are smaller now – although I wouldn’t say those risks are absent.

Now for the bad news. The bad news is that significant market volatility – say, a 50% decline in stock prices – would likely be met with “help” from the federal government and monetary authorities. It is that help which likely would hurt the economy by increasing business uncertainty further. It is probably not a coincidence that the last couple of months, which correspond to the implementation of the Affordable Care Act, have led to some weaker growth figures. Whether change is perceived as positive or negative, it’s the constant changing of the rules – and especially now that these rules are increasingly changed by executive fiat without the moderating influence of Congress (I never thought I would write that) – that damages business confidence.

In other words, I wouldn’t be concerned about the direct economic effect of a 50% decline in equity prices; but I would be concerned if such a decline led to meddling from the Fed, the Congress, or the White House.

While investors learned the hard lessons after 2000 and 2008 about the wisdom of automatically buying dips, they eventually forgot those lessons. But that makes them almost infinitely smarter than policymakers, who have refused to learn the obvious lesson of the last few years: your ministrations do little to help, and most likely hurt. So, maybe it really is true that there are two types of people: those who listen to everybody, and those who listen to nobody. The former become investors, and the latter enter government service!

Do Data Matter Again?

February 3, 2014 Leave a comment

In normal times, by which I mean before actions of the Federal Reserve became the only data point that mattered, the monthly ISM report was important because it was the first broad-based look at the most-recent month’s data.

Now that the Fed’s taper has begun – right about the time that the uncertainty of the impact of Obamacare implementation was at its peak, curiously enough – the ISM data seems to have taken on importance once again. I must say that I did not see that coming, but since guessing at the Fed’s actions every six weeks and ignoring all intervening data was so all-fired boring, I suppose I am glad for it. Looking at economic data and trying to figure out what is happening in the economy is more like analysis and less like being on The People’s Court trying to rule on a he-said, she-said case where the hes and shes are Federal Reserve officials. And that is welcome.

That being said, the January ISM report isn’t one I would necessarily place at the head of the class of importance, mainly because it is January. Still, it was an interesting one with the Manufacturing PMI dropping 5.2 points, matching the steepest decline since October 2008. The New Orders subindex plunged to 51.2 versus 64.4 last month, and Employment and Production indices also declined significantly. It’s clearly bad news, but I would be careful ascribing too much value to any January number – especially one based on a survey.

Also standing out in the report was the increase in the (non-seasonally adjusted) “Prices Paid” subcomponent, to 60.5. the jump was initially somewhat surprising to me because as the chart below – which I tweeted shortly after the number – seems to show, we have had a jump in Prices Paid that is not being driven by a concomitant jump in gasoline prices – and Prices Paid is predominantly driven by gasoline prices.

ismpric and gasoline

However, as I noted in that tweet, the Prices Paid index is measuring the rate of change of prices (the question posed to purchasing managers is whether prices are increasing faster, slower, or about the same as the month before), so just eyeballing it may not be enough. The chart below plots the 3-month change in gasoline prices versus the ISM Prices Paid subindex. What you can see is that the first chart is slightly deceiving. The change in gasoline prices has accelerated – back to zero after having been declining since February of 2013. And “unchanged” gasoline prices is roughly consistent with about 60 on the Prices Paid indicator. So, this isn’t as much of a surprise as it looked like, initially.

ismvsgas

Still, whether it was the data or because of continued concern about emerging markets (though the S&P fell nearly as far in percentage terms as did the EEM today, leaving open the question of which is following which), stocks didn’t enter February with much cheer. But never fear, I am sure there is “cash on the sidelines” that will come charging to the rescue soon.

The past week has given a great illustration of one important difference between the price behavior of equities and commodities. That is that stocks are negatively skewed and positively kurtotic, while commodities are positively skewed and negatively kurtotic. That is to say, in layman’s terms, that stocks tend to crash downward, while commodities more frequently crash upwards. This happens because what tends to drive severe movements in commodities is shortages, where the short-term supply curve becomes basically vertical so that any increase in demand pushes up prices sharply. Exhibit one is Natural Gas (see chart, source Bloomberg), where inventories were above normal as recently as October and now are the lowest in a decade.

natty

Exhibit two is Coffee (see chart, source Bloomberg), where drought in Brazil has lifted coffee prices 8-9% today and 35% from the five-year lows set in November. There’s an awful lot of coffee in Brazil, I understand, but there may be less this year.

coffee

In my view, stocks remain very expensive even after this quick 5.75% loss (-2.3% today). Obviously, less so! Commodities have outperformed stocks by basically remaining unchanged, but remain very cheap. Bonds have rallied, as money has shifted from stocks to bonds. This is fine, except that 10-year notes at 2.57% with median inflation at 2.1% and rising is not a position to own, only to rent. The question is, when investors decide that it’s time to take their profits in bonds, do they go to cash, back to equities, or to commodities? If you are one of the people mulling this very question, I have another chart to show you. It is the simple ratio of the S&P to the DJ-UBS (source: Bloomberg).

stockscomm

I think that makes where I stand fairly clear. If both stocks and commodities represent ownership in real property, and both have roughly the same long-term historical returns (according to Gorton & Rouwenhorst), then the ratio of current prices should be a coarse (and I stress coarse) relative-value indicator, right?

But let’s shift from the long-view lens back to the short view, now that a retreating Fed makes this more worthwhile. I am not sanguine about the outlook for stocks, obviously (and here’s one for the technicians: for the first time in years, exchange volume in January was higher than last year’s January volume). However, bulls may get a brief reprieve later this week when the Employment Report is released. Yes, it’s another January data point that ought to be ignored or at least averaged with December’s figure. And that’s the point here. Last month’s Employment Report showed only a 74k rise in Nonfarm Payrolls. That weakness was likely due to the fact that the seasonal adjustments (which dwarf the net number of jobs, in December and January) assumed more year-end and holiday hiring than actually occurred. But the flip side of that is that if fewer were hired in December, it probably means fewer were fired in January. Thus, I expect that the 185k consensus guess for new jobs is likely to be too low and we will have a bullish surprise on Friday. That might help the bulls get a foothold…but it is a long three trading days away.

Do Floating-Rate Notes (FRNs) Protect Against Inflation?

February 1, 2014 Leave a comment

Since the Treasury this week auctioned floating-rate notes (FRNs) for the first time, it seems that it is probably the right time for a brief discussion of whether FRNs protect against inflation.

The short answer is that FRNs protect against inflation slightly more than fixed-rate bonds, but not nearly as well as true TIPS-style bonds. This also goes, incidentally, for CPI-linked floaters that pay back par at maturity.

However, there are a number of advisors who advocate FRNs as an inflation hedge; my purpose here is to illustrate why this is not correct.

There are reasonable-sounding arguments to be made about the utility of FRNs as an inflation hedge. Where central bankers employ a Taylor-Rule-based approach, it is plausible to argue that short rates ought to be made to track inflation fairly explicitly, and even to outperform when inflation is rising as policymakers seek to establish positive real rates. And indeed, history shows this to be the case as LIBOR tracks CPI with some reasonable fidelity (the correlation between month-end 3m Libor and contemporaneous Y/Y CPI is 0.59 since 1985, see chart below, data sourced from Bloomberg).

liborcpi

It bears noting that the correlation of Libor with forward-looking inflation is not as strong, but these are still reasonable correlations for financial markets.

The correlation between inflation and T-Bills has a much longer history, and a higher correlation (0.69) as a result of tracking well through the ‘80s inflation (see chart below, source Bloomberg and Economagic.com).

tbillscpi

And, of course, the contemporaneous correlation of CPI to itself, if we are thinking about CPI-linked bonds, is 1.0 although the more-relevant correlation, given the lags involved with the way CPI floaters are structured, of last year’s CPI to next year’s CPI is only 0.63.

Still, these are good correlations, and might lead you to argue that FRNs are likely good hedges for inflation. Simulations of LIBOR-based bonds compared to inflation outcomes also appear to support the conclusion that these bonds are suitable alternatives to inflation-linked bonds (ILBs) like TIPS. I simulated the performance of two 10-year bonds:

Bond 1: Pays 1y Libor+100, 10y swaps at 2.5%.

Bond 2: Pays an annual TIPS-style coupon of 1.5%, with expected inflation at 2.0%.

Note that both bonds have an a priori expected nominal return of 3.5%, and an a priori expected real return of 1.5%.

I generated 250 random paths for inflation and correlated LIBOR outcomes. I took normalized inflation volatility to be 1.0%, in line with current markets for 10-year caps, and normalized LIBOR volatility to be 1.0% (about 6.25bp/day but it doesn’t make sense to be less than inflation, if LIBOR isn’t pegged anyway) with a correlation of 0.7, with means of 2% for expected inflation and 2.5% for expected LIBOR and no memory. For each path, I calculated the IRR of both bonds, and the results of this simulation are shown in the chart below.

nominalcorrs

You can see that the simulation produced a chart that seems to suggest that the nominal internal rates of return of nominal bonds and of inflation-linked bonds (like TIPS) are highly correlated, with a mean of about 3.5% in each case and a correlation of about 0.7 (which is the same as an r-squared, indicated on the chart, of 0.49).

Plugged into a mean-variance optimization routine, the allocation to one or the other will be largely influenced by the correlation of the particular bond returns with other parts of the investor’s portfolio. It should also be noted that the LIBOR-based bond may be more liquid in some cases than the TIPS-style bond, and that there may be opportunities for credit alpha if the analyst can select issuers that are trading at spreads which more than compensate for expected default losses.

The analysis so far certainly appears to validate the hypothesis that LIBOR bonds are nearly-equivalent inflation hedges, and perhaps even superior in certain ways, to explicitly indexed bonds. The simulation seems to suggest that LIBOR bonds should behave quite similarly to inflation-linked bonds. Since we know that inflation-linked bonds are good inflation hedges, it follows (or does it?) that FRNs are good inflation hedges, and so they are a reasonable substitute for TIPS. Right?

However, we are missing a crucial part of the story. Investors do not, in fact, seek to maximize nominal returns subject to limiting nominal risks, but rather seek to maximize real return subject to limiting real risks.[1]

If we run the same simulation, but this time calculate the Real IRRs, rather than the nominal IRRs, a very different picture emerges. It is summarized in the chart below.

realirrs

The simulation produced the assumed equivalent average real returns of 1.5% for both the LIBOR bond and the TIPS-style bond. But the real story here is the relative variance. The TIPS-style bond had zero variance around the expected return, while the LIBOR bond had a non-zero variance. When these characteristics are fed into a mean-variance optimizer, the TIPS-style bond is likely to completely dominate the LIBOR bond as long as the investor isn’t risk-seeking. This significantly raises the hurdle for the expected return required if an investor is going to include LIBOR-based bonds in an inflation-aware portfolio.

So what is happening here? The problem is that while the coupons in this case are both roughly inflation-protected, since LIBOR (it is assumed) is highly correlated to inflation, there is a serious difference in the value of the capital returned at the maturity of the bond. In one case, the principal is fully inflation-protected: if there has been 25% inflation, then the inflation-linked bond will return $125 on an initial $100 investment. But the LIBOR-based bond in this case, and in all other cases, returns only $100. That $100 is worth, in real terms, a widely varying amount (I should note that the only reason the real IRR of the LIBOR-based bond is as constrained as it appears to be in this simulation is because I gave the process no memory – that is, I can’t get a 5% compounded inflation rate, but will usually get something close to the 2% assumed figure. So, in reality, the performance in real terms of a LIBOR bond is going to be even more variable than this simulation suggests.

The resolution of the conundrum is, therefore, this: if you have a floating rate annuity, with no terminal value, then that is passably decent protection for an inflation-linked annuity. But as soon as you add the principal paid at maturity, the TIPS-style bond dominates a similar LIBOR bond. “Hooray! I got a 15% coupon! Boo! That means my principal is worth 15% less!”

The moral of the story is that if your advisor doesn’t understand this nuance, they don’t understand how inflation operates on nominal values in an investor’s portfolio. I am sorry if that sounds harsh, but what is even worse than the fact that so many advisors don’t know this is that many of those advisors don’t know that they don’t know it!


[1] N.b. Of course, they seek to maximize after-tax real returns and risks, but since the tax treatments of ILBs and Libor floaters are essentially identical we can abstract from this detail.

Shots Fired

January 29, 2014 8 comments

This isn’t the first time that stocks have corrected, even if it is the first time that they have corrected by as much as 4% in a long while. I point out that rather obvious fact because I want to be cautious not to suggest that equities are guaranteed to continue lower for a while. Yes, I have noted often that the market is overvalued and in December put the 10-year expected real return for stocks at only 1.54%. Earlier in that month, I pointed out and remarked on Hussman’s observation that the methods of Didier Sornette suggested a market “singularity” between mid-December and January. And, earlier this month, I followed up earlier statements in which I said I would be negative on stocks when momentum turned and added that I would sell new lows below the lows of the week of January 17th.

But none of that is a forecast of an imminent decline of appreciable magnitude, and I want to be clear of that. The high levels of valuation make any decline potentially dangerous since the levels that will attract serious value investors are so far away. But that is not tantamount to forecasting a waterfall decline, which I have not done and will not do. How does one forecast animal spirits? And that is exactly what a waterfall decline is all about. Yes, there may be precipitating events, but these are rarely known in prospect. Sure, stocks fell sharply after Bear Stearns in the summer of 2007 liquidated two mortgage-backed funds, but stocks reached new highs in October 2007. What happened in mid-October 2007 to trigger the top? Here is a crisis timeline assembled by the St. Louis Fed. There is basically nothing in October 2007. Similarly, as Bob Shiller has documented, at the time of the 1987 crash there was no talk whatsoever about portfolio insurance. The explanation came later. How about March 2000, the high on the Nasdaq (although the S&P 500 didn’t top until September)?

What two of these episodes – 2000 and 2007 – have in common is that valuations were stretched, but I think it’s important to note that there was no obvious precipitating factor at the time. It wasn’t until well into the stock market debacle in 2007-08 that it became obvious (even to Bernanke!) that the subprime crisis wasn’t just a subprime crisis.[1]

Here is my message, then: when you hear shots fired, it isn’t the best idea to wait around to figure out why people are shooting before you put your head down. Because as the saying goes: if the enemy is in range, so are you.

And, although it may not end up being a full-fledged firefight, shots are being fired, mere days before Janet Yellen takes the helm of the Fed officially (which may be ominous since Fed Chairmen are traditionally tested by markets early in their tenure). Last night, Turkey was forced to crank up money rates by about 450bps, depending which rate you look at. When Argentina was having currency issues, it wasn’t surprising – when you have runaway inflation, even if you declare inflation to be something else, the currency generally gets hit eventually. And Russia’s central bank was established only in 1990. But Turkey, about 65% larger in GDP terms than Argentina, is relatively modern economically and has a central bank that was established in the 1930s and has been learning lessons basically in parallel with our Fed since the early 1980s. Heck, it’s almost a member of the EU. So when that central bank starts cranking up rates to defend the currency, I take note. It may well mean nothing, but since global economics has been somewhat dull for the last year or so (and that’s a good thing), it stands out as something different.

What was not different today was the Fed’s statement, compared to its prior statement. The FOMC decided to continue the taper, down to “only” $65bln in purchases monthly now. This was never really in question. It would have been incredibly shocking if the Fed had paused tapering because of a mild ripple in global equity markets. The only real surprise was actually on the hawkish side, as Minnesota Fed President Kocherlakota did not dissent in favor of maintaining unchanged (or increased) stimulus – something he has been agitating for recently. Don’t get too used to the Fed being on the hawkish side of expectations, however. As noted above, Dr. Yellen takes the helm starting next week.

The Treasury held its first auction of floating rate notes (FRNs) today, and the auction was highly successful. And why should they not be? They are T-bill credits that reset to the T-bill rate quarterly, plus 4.5bps. In the next few days I will post an article explaining, however, why floating rate notes don’t provide “inflation protection;” there has been a lot of misinformation about that point, and while I explained why this isn’t true in a post from May 2012 when the concept of the FRN program was first mooted, it is worth reiterating in more detail.

So we now have a new class of securities. Why? What constituency was not being sufficiently served by the existing roster of 1-month, 3-month, 6-month, and 1-year TBills, and 2 year notes?

I will ask another “why” question. Why is the President proposing the “myRA” program, which is essentially a way to push savings bonds (the basics of the program is that if you sign up and meet certain income requirements, the government will give you the splendid opportunity to put your money in an account that returns a low, guaranteed rate of interest). This is absolutely nothing new. You can already set up an account with http://www.TreasuryDirect.gov and have your employer make a payroll direct deposit to that account. And there’s no income maximum, and no requirement to ever roll it into an IRA. Yes, it’s true – with Treasury Direct, you will have to pay federal taxes on the interest, but the target audience for the myRA program is not likely to be paying much in the way of taxes so that’s pretty small beer.[2]

The answer to the “why” in both cases is that the Treasury, noticing that one regular trillion-dollar buyer of its debt is leaving the trough, is looking rather urgently for new buyers. FRNs, and a new way to push Treasuries on middle-class America.

Interest rates have declined since year-end, partly because equities have been weak, partly because some growth indicators have been weak recently, and partly because the carry on long Treasury securities is positively terrific. But the Treasury is advertising fairly loudly that they are concerned about whether they’ll be able to raise enough money, at “reasonable” rates, through conventional auctions. Both of these “innovations” cause interest payments to be pegged at the very short end of the curve, where the Fed has pledged to control interest rates for now, but I think interest rates will rise eventually.

Probably not, however, while the bullets fly.


[1] In a note to Natixis clients on December 4th, 2007, entitled “Tragedy of the Commons,” I commented that “M2 has grown only at a 4.4% annual rate over the last 13 weeks, and that’s egregiously too little considering the credit mess (not just subprime, as I am sure my readers are aware, but Alt-A and Prime mortgages, auto loans and credit cards too),” but the idea that the crisis was broader than subprime wasn’t the general consensus at the time by any means. Incidentally, in that same article I said “We have not entered a recession with core inflation this low in many decades, and this recession looks to be a doozy. I believe that by late 2008 we will be confronting the possibility of deflation once again. And, as in the last episode, the Fed will face a stark choice: if short rates don’t get to zero before inflation gets to zero, the Fed loses as they will never be able to get short rates negative,” which I mention since some people think I have always been bullish on inflation.

[2] I wonder how the money is treated for purposes of the debt ceiling. If the Treasury is no longer able to issue debt, then surely it won’t be able to do what amounts to issuing debt in the “myRA” program? So if they hit the debt ceiling, does interest on the account go to zero?

Get A Grip

January 26, 2014 6 comments

What I am about to write will probably not be terribly popular in this equity-centric culture of ours, but it needs to be said.

On a number of business news shows this weekend, I’ve heard about this week’s “equity market debacle.” Fox Business News on Saturday noted that “retirees depending on their savings are very nervous right now” because of “serious damage to portfolios after the big sell off this week.”

Get a grip, people!

To be sure, the 3% decline this week is the largest 5-day decline since June, but the real implication of that fact is that we have been in a frighteningly one-way market for a while now. I recently documented that we hadn’t had a drawdown of more than 5% from a previous peak since June 24th, and nothing more than 2% for a couple of months. However, 3% declines over 5 days should not be unusual. If implied volatility, e.g. the VIX, is at 13%, which is was until this selloff began, then a 5-day decline of 3% is only a 1.67-standard deviation event and it should happen about three or four times a year. The 2-day selloff of nearly 3% was a more unusual event, but hardly financial Armageddon.

Here’s the bigger point. You’ve laid out all your plans for the remainder of your life. If, one week ago, you were going to achieve your goals, but today with stocks 3% below all-time highs you are not, then you should not be in stocks. You’re 3% away from success – why would you risk that?

If, on the other hand, you’ve laid out your plans but you need stocks to rise 30% per year to make your plans work – your retirement goals, or your kids’ college education, or whatever – then you shouldn’t be in equities either. The problem here isn’t the market – it’s your plans. I blame financial television for this one, for the popularizing of the absurd term “putting your money to work.” Your money doesn’t work. Money is inert. The best you can hope for if you prod it with a stick is that it doesn’t blow away. Sometimes stocks go up, and sometimes they go down. From these valuation levels, it has long been the case that down was more likely than up over the next few years. Your money is “at work,” but it’s working in a wind tunnel and it’s not tied down.

Stocks are risky assets, folks! A gambling metaphor is probably inappropriate, and investing is different from gambling in that with gambling, the gambler generally loses over time while with investing – smart, patient investing – the investor generally wins, but here is one way in which the metaphor works: when you enter a casino, you only gamble what you can afford to lose. In the case of stocks, you should only invest as much as you can afford to lose 60-70% of. So your first question, in thinking about your asset allocation, should not be “how much do I need my portfolio to return,” and then spin the risk dial so you get the answer, but “can I lose 70% of this and still accomplish my goals?” If the answer is no, then you are risking too much because stocks sometimes do fall 70%.

And if you can’t accomplish your goals with the cash you have unless you have a strong equity market, then you have two prudent choices: 1) work harder, and longer, or 2) save more during the same period of work. The third choice is to gamble it on stocks and hope it turns out well.

If you’re over-committed to equities, this is an excellent time to reconsider that commitment. If you have ridden stocks up, then pat yourself on the back and think hard about reallocating. You haven’t lost much and it shouldn’t be keeping you up at night…because the ‘carnage’ just isn’t that bad. The chart below (source: Bloomberg with my annotations) is of the ETF EEM, which tracks the MSCI Emerging Markets Index. Repeatedly on Thursday and Friday, we heard that US stocks were suffering because of the “rout” in emerging markets. Some currencies took a hit, yes. But emerging equity markets were hardly “routed.” Again: if 12% is going to destroy you financially, then you should count on being destroyed with some regularity.

eem

I have to say the carnage isn’t that bad yet, because stocks might still drop precipitously and in any event probably won’t perform like they did for the last six months again for some while. But if you have the right, prudent plan, then not only do you not have to panic now, you won’t have to panic then.

Forecasting Cold to Continue Into Summer?

We are a people of language. The way we talk about a thing affects how we think about it. This is something that behavioral economists are very aware of; and even more so, marketers. There is a reason that portfolio “insurance” was such a popular strategy. Language matters. When we call a market decline a “correction,” we tend to want to buy it; when we call it a “crash” or a “bear market”, we tend to want to sell it.

And so as the “arctic vortex” reaches its cold fingers down from the frozen northland, it is really hard for us to think about economic “overheating.” Even though economic overheating doesn’t lead to inflation, I really believe that it is hard for investors to worry about inflation (the “fire” in the traditional “fire versus ice” economic tightrope that central bankers walk) when it is so. Darn. Cold.

But nevertheless, we can take executive notice of certain details that may suggest, overheating or not, inflation pressures really are building. I have been writing for some time about how the recent rapid rise in housing prices was eventually going to pass through to rents, and although the lag was a couple of months longer than it has historically been, it seems to be finally happening as an article in today’s Wall Street Journal suggests. This is significant for at least two reasons. The first is that housing costs are a very large part of the consumption basket for the average consumer, so any acceleration in those prices can move the otherwise-ponderous core CPI comparatively quickly. The second reason, though, is more important. Over the last couple of years, as housing prices have improbably spiked again and inventories have declined sharply, many observers have pointed out the presence of an institutional element among home purchasers. That is to say that homes have been bought in large numbers not only by individuals, but by investors who saw an inexpensive asset (they sure solved that problem!). And some analysts reasoned that the prevalence of these investors might break the historical connection between rents and home prices, at least in the short run, in the same way that a sudden influx of pension fund money could change the relationship between equity prices and earnings (that is, P/Es).

In the long run, of course, this is unlikely, but to the extent it happens in the short run it could delay the upturn in core inflation for a long time. But recent indications, such as that article referred to above, are that this effect is not as large as some had thought. The substitution effect does work. Higher home prices do cause rents to rise as more potential buyers choose to rent instead. It is a question for econometricians in the next decade whether the institutions had a large and lasting effect, or a short and ephemeral effect, or no effect at all. But what we can begin to say with a bit more confidence is that this influx of investors did not remove the tendency of home prices and rents to move together, with a lag.

On to other matters. The market curve for inflation has remained remarkably static for a long time. It is relatively steep, and perennially seems to forecast benign inflation for the next couple of years before headline inflation becomes slightly less-benign (but still not high) a few years down the road. The chart below (Source: Enduring Investments) shows the first eight years of the inflation swaps curve from today, and one year ago.

zc20132014If that was the only story, I probably wouldn’t bother mentioning it. But inflation swaps settle to headline CPI, like TIPS and other inflation-linked bonds do; however, a fair amount of the volatility in headline inflation comes from movements in energy. This is why policymakers and prognosticators look at core inflation. You cannot directly trade core inflation yet, but we can extract expected energy inflation (implied by other markets) from the implied headline inflation rates and derive “implied core inflation swaps” curves. And here, we find that the relatively static yield curves seen above hide a more interesting story. The chart below (Source: Enduring Investments) shows these two curves as of today, and one year ago.

core20132014At the beginning of 2013, investors has just experienced a 1.94% rise in core prices (November to November, which is the data they would have had at the time), yet anticipated that core inflation would plunge to only 1.22% in 2013. They actually got 1.72% (as of the latest report, so still Nov/Nov). Now, investors are anticipating about 1.8% over the next 12 months – I am abstracting from some lags – but expect that inflation will ultimately not rise as much as they had feared at this time last year.

Another way to look at this change is to map the implied forward core inflation rates onto the years they would apply to. The chart below (Source: Enduring Investments) does that.

calcore20132014The blue line shows the market’s forecast of core inflation as of January 7th, 2013, year by year. So investors were implicitly saying that core CPI would be 1.22% in 2013, 2.36% in 2014, 2.68% in 2015, 2.87% in 2016, and so on. One year later, the forecast (in red) for 2014 has come down to 1.80%, the forecast for 2015 has declined to 2.20%, the forecast for 2016 has dropped to 2.41%, etcetera.

Has this happened because inflation surprised to the downside in 2013? Hardly. As I just noted, the market “expected” core inflation of 1.22% in 2013 and actually got 1.72%. And yet, investors are pricing higher confidence that inflation will stay low – remaining basically unchanged in 2014 before rising very slowly thereafter – and in fact won’t seriously threaten the Fed’s core mission basically ever.

As I wrote yesterday, we need to tread carefully around consensus. Now, some investors might prefer to be non-consensus by anticipating and investing for deflation in the out years, but taking the whole of the information I look at and model I think the more dangerous break with consensus would be a more-rapid and more-extreme rise in core inflation. I do not think that this economically-cold pricing environment will continue into what is essentially a monetary summer.

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