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Not So Fast on the Trump Bull Market

December 1, 2016 2 comments

**NOTE – please see the announcement at the end of this article, regarding a series of free webinars that begins next Monday.**


Whatever else the election of Donald Trump to be President of the United States has meant, it has meant a lot of excitement in precincts that worry about inflation. This is usually attributed, among the chattering classes, to the faster growth expected if Mr. Trump’s expressed preference for tax cuts and spending increases obtains. However, since growth doesn’t cause inflation that isn’t the part of a Trump Presidency that concerns me with respect to a continuing rise in inflation.

In our latest Quarterly Inflation Outlook, I wrote a short piece on the significance of the de-globalization movement for inflation. That is an area where, if the President-Elect delivers on his promises, a lot of damage could be done in the growth/inflation tradeoff. I have written before about how a big part of the reason for the generous growth/inflation tradeoff of the 1990s was the rapid globalization of many industries following the end of the Cold War. Deutsche Bank recently produced a research piece (I don’t recall whether it had anything to do with inflation, weirdly) that contained the following chart (Source: as cited).

freetradeagreementsperyearThis chart is the “smoking gun” that supports this version of events, in terms of why the inflation dynamic shifted in the early 1990s. Free trade helped to restrain prices in certain goods (apparel is a great example – prices are essentially unchanged over the last 25 years), by allowing the possibility of significant cost savings on production.

The flip side of a cost savings on production, though, is a loss of domestic manufacturing jobs; it is this loss that Mr. Trump took productive advantage of. If Mr. Trump moves to increase tariffs and other barriers to trade, and to reverse some of the globalization trend that has driven lower prices for the last quarter-century, it is potentially very negative news for inflation. While there was some evidence that the globalization dividend was beginning to get ‘tapped out’ as all of the low-hanging fruit had been harvested – and such a development would cause inflation to be higher than otherwise it would have been – I had not expected the possibility of a reversal of the globalization dividend except as a possible and minor side-effect of tensions with Russia over the Ukraine, or the effect the Syrian refugee problem could have on open borders. The election of Mr. Trump, however, creates the very real possibility that the reversal of this dividend might be a direct consequence of conscious policy choices.

I don’t think that’s the main reason that people are worried about inflation, though. Today, one contributor is the news that OPEC actually agreed to cut production, in January, and that some non-OPEC producers agreed to an additional cut. U.S. shale oil producers are clicking their heels in delight, because oil prices were already high enough that production was increasing again and they are more than happy to take more market share back. Oil prices are up about 15% since the announcement.

But that’s near-term, and I don’t expect the oil rally has legs much beyond current levels. Breakevens have been rallying, though, for weeks. Some of it isn’t related to Trump at all but to other initiatives. One correspondent of mine, who owns an office-cleaning business, sent me this note today:

“Think of you often lately as I’m on the front line out here of the “instant” 25% increase in min wage.  Voters decided to move min wage out here from 8.05 to $10 jan 1.  Anyone close to 10/hr is looking for a big raise.  You want to talk about fast dollars, hand a janitor a 25% pay bump and watch the money move.  Big inflation numbers pending from the southwest.  I’m passing some through but market is understandably reacting slower than the legislation.”

Those increases will definitely increase measured inflation further, though by a lot less than it increases my friend’s costs. Again, it’s an arrow pointing the wrong way for inflation. And, really, there aren’t many pointing the right way. M2 growth continues to accelerate; it is now at 7.8% y/y. That is too fast for price stability, especially as rates rise.

All of these arrows add up to substantial moves in inflation breakevens. 10-year breaks are up 55bps since September and 30bps since the election. Ten-year inflation expectations as measured more accurately by inflation swaps are now at 2.33%. Almost all of that rise has been in expectations for core inflation. The oft-watched 5y5y forward inflation (which takes us away from that part of the curve which is most impacted by energy movements) is above 2.5% again and, while still below the “normal” 2.75%-3.25% range, is at 2-year highs (see Chart, source Bloomberg).

5y5y

So what is an investor to do – other than to study, which there is an excellent opportunity to do for the next three Mondays with a series of educational webinars I am conducting (see details below)? There are a few good answers. At 0.46%, 10-year TIPS still represent a poor real return but a guaranteed positive 1/2% real return beats what is available from many risky assets right now. Commodities remain cheap, although less so. You can invest in a company that specializes in inflation, if you are an accredited investor: Enduring Investments is raising a small amount of money for the management company in a 506(c) offering and is still taking subscriptions. Unfortunately, it is difficult to own inflation expectations directly – and in any event, the easy money there has been made.

What you don’t want to do if you are worried about inflation is own stocks as a “hedge.” Multiples move inversely with inflation.

Unlike prior equity market rallies, I understand this one. It is plausible to me that a very business-friendly President, who cuts corporate and personal taxes and reduces regulatory burdens, might be good for corporate earnings and even for the economic growth rate (although the bad things coming on trade will blunt some of that). But before getting too ebullient about the potential for higher corporate earnings, consider this: if Trump is business-friendly, then surely the opposite must be said about President Obama who did essentially the reverse. But what happened to equities? They tripled over his eight years (perhaps they “only” doubled, depending on when you measure from). That’s because lower interest rates and the Fed’s removal of safe securities in search of a stimulus from the “portfolio balance channel” caused equity multiples to expand drastically. So, valuations went from low, to extremely high. Multiples matter a lot, and right now even if you think corporate earnings over the next four years might be stronger than over the last four you still have to confront the fact that multiples are more likely to move in reverse. In short: if stocks could triple under Obama, there is no reason on earth they can’t halve under a “business-friendly” President. That’s not a prediction. (But here is one: equities four years from now will be no more than 20% higher than they are now, and might well be lower.)

Also, remember Ronald Reagan? He who created the great bull market of the 1980s? Well, stocks rallied in the November he was elected, too. The S&P closed November 1980 at 140.52. Over the next 20 months, the index lost 24%. It wasn’t until almost 1983 before Reagan had a bull market on his hands.


An administrative announcement about upcoming (free!) webinars:

On consecutive Mondays spanning December 5, December 12, and December 19 at 11:00ET, I will be doing a series of one-hour educational seminars on inflation. The first is “How Inflation Works;” the second is “Inflation and Asset Classes;” and the third is “Inflation-aware Investing.” These webinars will also have live Q&A. After each session, a recording will be available on Investing.com.

Each of these webinars is financially sponsored by Enduring Investments.

Can’t Blame Trump for Everything

November 15, 2016 Leave a comment

So much has happened since the Presidential election – and almost none of it very obvious.

The plunge in equities on Donald Trump’s victory was foreseeable. The bounce was also foreseeable. The fact that the bounce completely reversed the selloff and took the market to within a whisker of new all-time highs was not, in my mind, an easy prediction. I understand that Mr. Trump intends to lower corporate tax rates (and he should, since it is human beings – owners, customers, and employees – that end up paying those taxes; taxing a company is just a way to hide the fact that more taxes are being layered on those human beings). And I understand that lowering the corporate tax rate, if it happens, is generally positive for corporate entities and the people who own them. I’m even willing to concede that, since Mr. Trump is – no matter what his faults – certainly more capitalism-friendly than his opponent, his election might be generally positive for equity values.

But the problem is that equities are already, to put it generously, “fully valued” for very good outcomes with Shiller multiples that are near the highest ever recorded.

I think that investors tend to misunderstand the role that valuation plays when investing in public equities. Consider what has happened to the economy over the last eight years under President Obama: if you had known in 2008 that growth would be anemic, debt would balloon, government regulation would increase dramatically, taxes would increase, and a new universal medical entitlement would be lashed to the backs of the American taxpayer/consumer/investor, would you have invested heavily in equities? Yet all stocks did was triple. The reason they did so was that they started from fairly low multiples and went to extremely high multiples. This was not unrelated to the fact that the Fed took trillions of dollars of safe securities out of the market, forcing investors (through the “Portfolio Balance Channel”) into risky securities. By analogy, might stocks decline over the next four years even if the business climate is more agreeable? You betcha – and, starting from these levels, that’s not terribly unlikely.

I am less surprised with the selloff in global bond markets, and not really surprised much at all with the rally in inflation breakevens. As I’ve said for a long time, fixed-income is so horribly mispriced that you should only hold bonds if you must hold bonds, and then you should only hold TIPS given how cheap they were. Because of their sharp outperformance, 10-year TIPS are now only about 40-50bps cheap compared to nominal bonds (as opposed to 110 or so earlier this year), and so it’s a much closer call. They are not relatively as cheap as they were, but they are absolutely less expensive as real rates have risen. 10-year real rates at 0.37% aren’t anything to write home about, but that is the highest yield since March.

Some analysis I have seen attributes the large increase in market-based measures of inflation expectations on Mr. Trump’s victory. For example, 10-year breakevens have risen 20bps, from about 1.70% to about 1.90%, since Mr. Trump sealed the win (see chart, source Bloomberg).

usggbe

I think we have to be careful about blaming/crediting Mr. Trump for everything. While breakevens rose in the aftermath of the election, you can see that they were rising steadily before the election as well, when everyone thought Hillary Clinton was a sure thing. Moreover, breakevens didn’t just rise in the US, but globally. That’s a very strange reaction if it is simply due to the victory of one political party in the US over another. It is not unreasonable to think that some rise in global inflation might happen, if Trump is bad for global trade…but that’s a pretty big reach, and something that wouldn’t happen for some time in any event.

In my view, the rise in global inflation markets is easy to explain without resorting to Trump. As the previous chart illustrates, it has been happening for a while already. And it has been happening because global inflation itself is rising (although a lot of that at the moment is optics, since the prior collapse of energy prices is starting to fall out of the year-over-year figures).

The bond market and the inflation market are acting, actually, like the Great Unwind was kicked off by the election of Donald Trump. We all know what the Great Unwind is, right? It’s when the imbalances created and nurtured by global central banks and fiscal authorities over the last couple of decades – but especially in the last eight years – are unwound and conditions return to normal. But if pushing those imbalances had a soothing, narcotic effect on markets, we all suspect that removing them will be the opposite. Higher rates and inflation and more volatility are the obvious outcomes.

Equity investors don’t seem to fear the Great Unwind, even though stock multiples are one of the clearest beneficiaries of government largesse over the last eight years. As mentioned above, I can see the argument for better business conditions, even though margins are still very wide. But I’m skeptical that better business conditions can overcome the headwinds posed by higher rates and inflation. Still, that’s what equity investors are believing at the moment.

*

A couple of administrative announcements about upcoming (free!) webinars:

On Thursday, November 17th (aka CPI Day), I will be doing a live webinar at 9:00ET talking about the CPI report and putting it in context. You can register for that webinar, and the ensuing Q&A session, here. After the presentation, a recording will be available on TalkMarkets.

On consecutive Mondays spanning November 28, December 5, and December 12, at 11:00ET, I will be doing a series of one-hour educational seminars on inflation. The first is “How Inflation Works;” the second is “Inflation and Asset Classes;” and the third is “Inflation-aware Investing.” These webinars will also have live Q&A. After each session, a recording will be available on Investing.com.

Each of these webinars is financially sponsored by Enduring Investments.

Brexit and Trump and Free Options

November 9, 2016 1 comment

As the evening developed, and it began to dawn on Americans – and the world – that Donald Trump might actually win, markets plunged. The S&P was down 100 points before midnight; the dollar index was off 2%. Gold rose about $70; 10-year yields rose 15bps. Nothing about that was surprising. Lots of people predicted that if Trump somehow won, markets would gyrate and move in something close to this way. If Clinton won, the ‘status quo’ election would mean much calmer markets.

So, we got the upset. Despite the hyperbole, it was hardly a “stunning” upset.[1] Going into yesterday, the “No Toss Ups” maps had Trump down about 8 electoral votes. Polls in all of the “battleground” states were within 1-2 points, many with Trump in the lead. Yes, the “road to victory” was narrow, requiring Trump to win Florida, Ohio, North Carolina, and a few other hotly-contested battlegrounds, but no step along that road was a long shot (and it wasn’t like winning 6 coin flips, because these are correlated events). Trump’s victory odds were probably 20%-25% at worst: long odds, but not ridiculous odds. (And I believe the following wind to Trump from the timing of Obamacare letters was underappreciated; I wrote about this effect on October 27th).

And yet, stock markets in the two days prior to the election rose aggressively, pricing in a near-certainty of a Clinton victory. Again, recall that pundits thought that a Clinton victory would see little market reaction, but a violent reaction could obtain if Trump won. Markets, in other words, were offering tremendous odds on an event that was unlikely, but within the realm of possibility. The market was offering nearly-free options. The same thing happened with Brexit: although the vote was close to a coin-flip, the market was offering massive odds on the less-likely event. Here is an important point as well – in both cases, the error bars had to be much wider than normal, because there were dynamics that were not fully understood. Therefore, the “out of the money” outcome was not nearly as far out of the money as it seemed. And yet, the market paid you handsomely to be short markets (or less long) before the Brexit vote. The market paid you handsomely to be short markets (or less long) before yesterday’s election results were reported. And, patting myself on the back, I said so.

capture

This is not a political blog, but an investing blog. And my point here about investing is simple: any competent investor cannot afford to ignore free, or nearly-free, options. Whatever you thought the outcome of the Presidential election was likely to be, it was an investing imperative to lighten up longs (at least) going into the results. If the status-quo happened, you would not have lost much, but if the status quo was upset, you would have gained much. As I’ve been writing recently about inflation breakevens (which was also a hard-to-lose trade, though less dramatic), the tail risks were really underpriced. Investing, like poker, is not about winning every hand. It is about betting correctly when the hand is played.

At this hour, stock markets are bouncing and bond markets are selling off. These next moves are the difficult ones, of course, because now we all have the same information. I suspect stocks will recover some, at least temporarily, because investors will price a Federal Reserve that is less likely to tighten and the knee-jerk response is to buy stocks in that circumstance. But it is interesting that at the moment, while stocks remain lower the bond market gains have completely reversed and are turning into a rout. 10-year inflation breakevens are wider by about 9-10bps, which is a huge move. But there will be lots of gyrations from here. The easy trade was the first one.

[1] And certainly not “the greatest upset in American political history.” Dewey Defeats Truman, anyone?

Math is Bad for Equities

June 7, 2016 4 comments

In recent years, equities have been carried higher by several compounding effects: the growth of the economy, expanding profit margins, and expanding multiples.

These three things, by definition, determine equity prices (if we assume that gross sales are tied to economic growth):

Price = Price/Earnings x Earnings/Sales x Sales

When all three are rising, as they have been, it is a strong elixir for stock prices. Now, this explains why stock prices are so high, but the devil lies in predicting these components of course – no mean feat.

Yet, we can make some observations. It has been the case for a while that P/E ratios have been extremely high by historical measures, with the Shiller Cyclically-Adjusted P/E ratio (CAPE) roughly doubling since the bottom in 2009. With the exception of the equity bubble in 1999-2000, the CAPE has never been very much higher than it is now, at 26.4 (see chart, source Gurufocus). This should come as no surprise to anyone who follows markets regularly.

chart

Somewhat less obviously, recently sales have been declining. However, on a rolling-10-year basis, the rise has been reasonably steady as the chart below (Source: Bloomberg) illustrates. Over the last 10 years, sales per share have risen about 2.85% per year.

sales

Finally, profit margins have recently been elevated. In fact, they have been elevated for a long time; the 10-year average profit margin for the S&P 500 (see chart, source Bloomberg) has risen to 8% from 6% only a few years ago. Recently, however, profit margins have been receding.

profmgn

Both the rise in profit margins and the current drop in them make some sense. Value creation at the company level must be divided between the factors of production: land, labor, and capital. When there is substantial unemployment, labor has little bargaining power and capital tends to claim a higher share. Moreover, labor’s share is relatively sticky, so that speculative capital absorbs much of the business-cycle volatility in the short run. This is ever the tradeoff between the sellers of labor and the buyers of labor.

I used 10-year averages for all of these so that we can use CAPE; other measures of P/E are fraught. So, if we take 26.4 (CAPE) times 7.84% (10-year average profit margin) times 1005.55 (10-year average sales), we get an S&P index value of 2081, which is reasonably close to the end-of-May value of 2097. That’s not surprising – as I said, these three things make up the price, mathematically.

So let’s look forward. Recently, as the Unemployment Rate has fallen – and yes, I’m well aware that there is more slack in the jobs picture than is captured in the Unemployment Rate, but the recent direction is clear – wages have accelerated as I have documented in previous columns. It is unreasonable to expect that profit margins could stay permanently elevated at levels above all but a few historical episodes. Let’s say that over the next two years, the average drops from 7.84% to 7.25%. And let’s suppose that sales continue to grow at roughly 2.85% per year (which means no recession), so that sales for the S&P are at 1292 and the 10-year average at 1064.15. Then, if the long-term P/E remains at its current level, the S&P would need to decline to 2037. If the CAPE were to decline from 26.4 to, say, 22.5 (the average since 1990, excluding 1997-2002), the S&P would be at 1736.

None of this should be regarded as a prediction, except in one sense. If stock prices are going to continue to rise, then at least one of these things must be true: either multiples must expand further, or sales growth must not only become positive again but actually accelerate, or profit margins must stop regressing to the mean. None of these things seems like a sure thing to me. In fact, several of them seem downright unlikely.

The most malleable of these is the multiple…but it is also the most ephemeral, and most vulnerable to an acceleration in inflation. We remain negative on equities over the medium term, even though I recently advanced a hypothesis about why these overvalued conditions have been so durable.

Categories: Investing, Stock Market, Theory

Roller Skating in a Buffalo Herd

The ECB fired its “bazooka” today, cutting official rates more into negative territory, increasing QE by another €20bln per month, expanding the range of assets the central bank can buy to now include corporate bonds, and creating a new 4-year program whereby the ECB will loan long-term money to banks at rates that could be negative (based on bank credit extended to corporate and personal borrowers).

My point today is not to opine on the power or wisdom of these policy moves. The main thing I want to observe is this: the inflation market is pricing in what amounts to success for global central banks, with consumer inflation averaging something between 1 and 2 percent per year for the next decade (a bit lower in Japan; a bit higher in the UK). Not only are inflation swaps prices much lower than would be expected from a pure monetarists’ standpoint – but options prices are also very low. The chart below (source: Enduring Investments) shows normalized volatilities[1] over the last five years for a 10-year, 2% year-over-year inflation cap. That is, every year you take a look and see if inflation was over 2%. If it was, then the owner of this option is paid the difference between actual inflation and 2%; if it was not, the owner gets zero. So you get to look ten times at whether inflation has gotten above 2%, and get paid each time it has.

uscpi10y2pct

The chart shows that whatever inflation is expected to be, the price to cover the risk that inflation is actually somewhat higher is very low. So, not only is inflation expected to be low, but it is expected to be not volatile either.

Look, we’re talking about bazookas, helicopters…does something not seem right about pricing in very little risk of screwing up?

Whether you believe my thesis in my freshly-released book What’s Wrong With Money?[2]  that the likely course of inflation over the next few years is higher and potentially much higher, or you agree with those who think deflation is imminent, shouldn’t we agree that bazookas introduce volatility?

Central banks are attempting to do something that has never been done. Shouldn’t we at least be a teensy bit nervous, as they line up to perform the first-ever quintuple-lutz, that no one has ever landed one before? That no one has ever landed a commercial passenger jet on an aircraft carrier?

Uncertainty is supposed to lower asset values, all else being equal. So even if you think stocks at these levels are “fair,” in an environment with earnings and interest rates where they are now and projected earnings following a certain path, an increase in the volatility of those outcomes should lower the clearing price of those assets since the buyer of the asset (which has positive value) is also assuming the volatility (which has a negative value).

But the market also says that uncertainty right now is low. Yes, the VIX is well off its lows and seems to suggest greater short-term uncertainty (see chart below, source Bloomberg) – but I would argue that the long-term volatility of the economic fundamentals has rarely been this high.

vix

Supposedly you can’t roller skate in a buffalo herd,[3] but we also have never tried to do it. There’s a reason we haven’t tried to do it!

But the Fed, and the rest of the world’s central banks, are not only roller skating in a buffalo herd – the world’s markets seem to be suggesting that investors are sure they’re going to succeed. Regardless of whether you’re optimistic about the outcome, I would argue it’s nearly impossible to be both optimistic and highly confident!

[1] This means something to options traders but can be glossed over by non-options traders. Essentially the point is that you can’t use a regular Black-Scholes model to price options if the strike and/or the forward can have a negative value!

[2] #1 on Amazon in “Economic Inflation,” thanks largely to all of you!

[3] Roger Miller

First Ballots are in on Results of Fed Tightening

February 11, 2016 3 comments

It fascinates me how bear markets all feel alike in some ways. What I remember very clearly from the equity bear markets of 2000-2002 and 2007-2009 is that bulls wanted to bottom-tick the market at every imagined opportunity. Every “support level,” for the first half of each decline at least, saw bulls pile in as if the train were about to leave the station without them on it. Of course, the train was about to leave the station, but it was backing up.

Today, the S&P didn’t quite touch 1810 on the downside, basically matching the 1812 low from January. Bulls love double-bottoms. Of course, many of those turn out not to be double-bottoms after all, but the ones that are look very nice on the charts. So stocks rocketed off the lows, rising 25 S&P points in a matter of minutes after briefly being down 51. The rally was helped ostensibly by comments from the UAE oil minister, who claimed OPEC is ready to cooperate on a production cut. But that isn’t really why stocks rallied so dramatically; after all the news only pushed crude oil itself up about a buck. The real reason is that bulls are crazy maniacs.

They’re that way for a reason. If you are benchmarked against an equity index, it is very hard for an unlevered fund manager to beat that index in an up market. Once you subtract fees, and a drag from whatever cash holding you must have, you’re doing well to match the index since your limitation is (by definition of ‘unlevered’) 100% long.[1] Where a fund manager must beat his index is in a down market, by participating less than 100% in a selloff. But being an outperformer in a down market is less valuable since customer outflows are likely to outweigh the inflows if there is a serious bear market. Therefore, fund managers naturally fall into a pattern of scalping small selloffs for outperformance. But since they can’t really afford to miss being long in a bull market, there is a serious tendency to dive back in at any hint that the decline may be over.

So we get these entertaining, furious bear market rallies, which tend not to last very long. Of course, my entire premise is that this is an equity bear market, and I could be completely wrong on that. If I am, then ignore the prior paragraphs.

Where I am more confident that I am right is on the monetary policy side. Get this: since the Fed hiked rates, year-over-year M2 money growth has gone from 5.7% to…5.7%. Lest you think this anomaly (because tightening is supposed to involve a deceleration in money growth, right?!?), the 26-week growth rate in M2 has gone from 5.3% to 6.8%, and the 13-week growth rate from 2.9% to 7.3%. The annualized growth rate of M2 from mid-December to February 1st (the figure that was released today) is 11.2%. In other words, money supply growth is clearly not decelerating.

Now, in a traditional tightening, the Fed would restrict reserves and this would have the effect of reducing, or at least causing a deceleration in the growth rate of, M2 through the money multiplier. As a side effect, interest rates would rise but the point of tightening is to reduce the growth rate of money. Or, at least, it used to be.

With the Fed’s current operating framework, in which interest rates are moved around like magnets on a refrigerator to the desired level, there should be no meaningful effect on money supply growth. That’s not to say that money growth rates should accelerate (as they evidently have), merely that the growth rates should be stochastic with respect to authoritarian interest-rate manipulation. They may fall, or they may rise, but it should not be related to the Fed’s “tightening.” I’ve been saying this for a long, long time and the first evidence is in. The Fed’s rate hike has done nothing to reduce the growth rate of money, and therefore ought to do nothing to restrain inflation. Indeed, if higher interest rates follow from a series of Fed hikes – which they haven’t, but mainly because no one believes the Fed is going to hike again while their precious stocks are only 35% above fair value rather than 50% – then the expected effect would be for monetary velocity to rise and inflation to accelerate.

At this point, the Fed can thank the market that their moves haven’t accelerated the already-established trend towards higher inflation. But the clock is ticking. If the Fed does indeed hike rates next month, the bond market may start taking it seriously and start the rates-inflation spiral.

[1] Unless, of course, you’re adding alpha. But the universe of fund managers adds approximately zero alpha – slightly positive, and negative net of fees. Except whoever your manager is, of course. I’m sure he’s the best. Good job finding him!

Zigs and Zags

January 13, 2016 Leave a comment

“The market,” said J.P. Morgan, when asked for his opinion on what the market would do, “will fluctuate.”

Truer words were never spoken, but the depth of the truism as well is interesting. One implication of this observation – that prices will vary – is that the patient investor should mostly ignore noise in the markets. Ben Graham went further; he proposed thinking about a hypothetical “Mister Market,” who every day would offer to buy your stocks or sell you some more. On some days, Mister Market is fearful and offers to sell you stocks at a terrific discount; on other days, he is ebullient and offers to buy your holdings at far more than they are worth. Graham argued that this can only be a positive for an investor who knows the value of the business he holds. He can sell it if Mister Market is paying too much, or buy it if Mister Market is selling it too cheaply.

Graham did not give enough weight to momentum, as opposed to value – the idea that Mister Market might be paying too much today, but if you sell your holdings to him today, then you might miss the opportunity to sell them to him next year for double the stupid price. And, over the last couple of decades, momentum has become far more important to most investors than has value. (I blame CNBC, but that’s a different story).

In either case, the point is important – if you know what you own, and why you own it, and even better if you have an organized framework for thinking about the investment that is time-independent (that is, it doesn’t depend on how you feel today or tomorrow), then the zigs and zags don’t matter much to you in terms of your existing investments.

(As for future investments, young people should prefer declining asset markets, since they will be investing for long periods and should prefer lower prices to buy rather than higher prices; on the other hand, retirees should prefer rising asset prices, since they will be net sellers and should prefer higher prices to lower prices. In practice, everyone seems to like higher prices even though this is not rational in terms of one’s investing life.)

We have recently been experiencing a fair number of zigs, but mostly zags over the last couple of weeks. The stock market is near the last year’s lows – but, it should be noted, it still holds 84% of its gains since March 2009, so it is hardly disintegrating. The dividend yield of the S&P is 2.32%, the highest in some time and once again above 10-year Treasury yields. On the other hand, according to my calculations the expected 10-year return to equities is only about 1.25% more per annum than TIPS yields (0.65% plus inflation, for 10 years), so they are not cheap by any stretch of the imagination. The CAPE is still around 24, which about 50% higher than the historical average. But, in keeping with my point so far: none of these numbers has changed very much in the last couple of weeks. The stock market being down 10%, plus or minus, is a fairly small move from a value perspective (from a momentum perspective, though, it can and has tipped a number of measures).

But here is the more important overarching point to me, right now. I don’t worry about zigs and zags but what I do worry about is the fact that we are approaching the next bear market – whether it is this month, or this year, or next year, we will eventually have a bear market – with less liquidity then when we had the last bear market. Dealers and market-makers have been decimated by regulations and constraints on their deployment of capital, in the name of making them more secure and preventing a “systemic event” in the next calamity. All that means, to me, is that the systemic event will be more distributed. Each investor will face his own systemic event, when he finds the market for his shares is not where he wanted it to be, for the size he needed it to be. This is obviously less of a problem for individual investors. But mutual fund managers, pension fund managers – in short, the people with the big portfolios and the big positions – will have trouble changing their investment stances in a reasonable way (yet another reason to prefer smaller funds and managers, but increasing regulation has also made it very difficult to start and sustain a smaller investment management franchise). Another way to say this is that it is very likely that while the average or median market movement is likely to be similar to what it has been in the past, the tails are likely to be longer than in the past. That is, we may not go from a two-standard-deviation event to a four-standard-deviation event. We may go straight to a six-standard-deviation event.

If market “tails” are likely to be longer than in the past because of (il)liquidity, then the incentive for avoiding those tails is higher. This is true in two ways. First, it creates an incentive for an investor to move earlier, and lighten positions earlier, in a potential downward move in the market. And second, in the context of the Kelly Criterion (see my old article on this topic, here), rising volatility combined with decreased liquidity in general means that at every level of the market, investors should hold more cash than they otherwise would.

I don’t know how far the market will go down, and I don’t really care. I am prepared for “down.” What I care about is how fast.

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