You'll be reading more in coming weeks about credit-default swaps on Greek debt. The Fed seems to be interested (finally) and the do-nothings on Capitol Hill might decide to pretend they're doing something.
I've been raging over the danger of credit default swaps for years. A credit default swap is an insurance contract, only it doesn't have the word "insurance" in it. Therefore, it's not regulated like insurance. You might enter into a credit default swap against, say, General Motors bonds. If GM defaults on those bonds, the swap pays you the notional amount of the contract. This is a sensible tool if you own $10 million of these bonds. You worry about default, but you don't want to sell the bonds. So, you buy insurance against loss. Same as you do for your house or your car.
However, a central and bedrock principle of the insurance world is that, in order to buy insurance against some calamity, you have to be at risk of that calamity. I can buy insurance against my own house burning down, but I can't buy insurance against yours. This would create a moral hazard, in that I sit around hoping your house burns down. Who knows...if I were a nefarious type, I might even devise sinister methods to increase the odds that your house burns down. I might figure out ways to impede the fire trucks from getting to your house quickly. I cannot buy insurance unless I have an insurable interest.
The requirement of an insurable interest ensures that no more insurance is outstanding than the potential losses from the event. If a storm causes $1 million in damage, no more than $1 million will need to change hands. It would be profoundly destabilizing to have more money change hands than the losses from casualty events. We'd have the equivalent of people out in the streets stopping fire trucks from getting to fires simply so those people could realize a profit. We cannot have a system wherein certain participants hope that bad things happen to other people. Whenever a lot of (wealthy, influential) people hope that something happens, it generally tends to happen.
The existence of this moral hazard, and the need to outlaw it, was figured out hundreds of years ago. Lloyd's of London has had this policy in effect during its nearly 400 year existence. It is not a new notion that requires new concepts of regulation.
Credit default swaps are a end-run around the requirement that one have an insurable interest. Big banks, hedge funds and other speculators at one point ran the outstanding volume of credit default swaps into the trillions of dollars, against mere billions in potential losses. This is because the contracts can be bought by investors who don't even own any of the subject bonds. This no more a tenable outcome in the financial markets as it is in the casualty insurance market.
There is a very simple piece of regulation that will fix this problem: Credit default contracts need to be called what they are: insurance. And insurance can only be purchased by those at risk of the involved loss. It's really a rather simple concept that has served us well for hundreds of years. But, as usual, the lobbyists will fight back and true reform will probably remain elusive.
Thursday, February 25, 2010
Thursday, February 18, 2010
A Long Hot Summer for Muni Bonds
It all seems too quiet right now...but it's going to heat up. The state and local government budgeting process is going to get rolling soon, and the picture is bleak. The sheer size of the budget gaps faced by cities, counties, school districts and the state itself is downright overwhelming. Articles are already appearing that hint at potential bankruptcy filings.
In the face of this, muni bonds are still trading at very high prices -- meaning very low yields. We were offered some 1-year bonds yesterday at a yield of 0.40%.
As regular readers know, we are tactical investors. That means that we spend a lot of time waiting for opportunities -- opportunities to move into cheap assets or to move out of expensive ones. Right now, muni bonds are expensive...and we are waiting. While we are quite reluctant to get into the predicting game, we do sometimes play the expecting game. And we expect that the mid-summer budget distaster will reach a crescendo at some point and investors will flee muni bonds the way they fled Fannie Mae and Greek bonds.
If that fleeing occurs, we will buy bonds by the fistfull. As we have written before, some muni bonds are genuinely at some risk of default. But, many types of bonds are "money-good" even under a bankruptcy proceeding. Municipal bankruptcies aren't like corporate proceedings...courts don't dissolve the entity, sell the pieces, and distribute the cash to bondholders. School districts, cities and the like can't "go out of business." They don't have "equity" to give to creditors upon a default.
I read a recent rating agency report that confirmed the AAA credit rating on the general obligation bonds of my favorite California small town. This high credit rating is much deserved, and the report touted at some length our town's prudent fiscal management. But, here's the catch: The credit quality of those bonds has almost nothing to do with the town's prudent fiscal management.
The City Council doesn't "appropriate" the bond payments -- fitting them into a budget of many choices. No -- the bond payments come directly off the property tax bills that are printed, mailed and collected by the county tax collector. Should, heaven forbid, our dear town find itself in bankruptcy, the bonds payments will continue to flow from property owners, right on past city hall, and straight to the county's money pool, from where it will be sent to the paying agent for the bonds.
These are the types of bonds that would get beaten down along with other, more risky, types of muni bonds. And we will be standing by in the heat of July ready to fill our portfolios with misunderstood and high-yielding bonds. We saw the same opportunity in late 2008 and we took advantage of it then.
In the face of this, muni bonds are still trading at very high prices -- meaning very low yields. We were offered some 1-year bonds yesterday at a yield of 0.40%.
As regular readers know, we are tactical investors. That means that we spend a lot of time waiting for opportunities -- opportunities to move into cheap assets or to move out of expensive ones. Right now, muni bonds are expensive...and we are waiting. While we are quite reluctant to get into the predicting game, we do sometimes play the expecting game. And we expect that the mid-summer budget distaster will reach a crescendo at some point and investors will flee muni bonds the way they fled Fannie Mae and Greek bonds.
If that fleeing occurs, we will buy bonds by the fistfull. As we have written before, some muni bonds are genuinely at some risk of default. But, many types of bonds are "money-good" even under a bankruptcy proceeding. Municipal bankruptcies aren't like corporate proceedings...courts don't dissolve the entity, sell the pieces, and distribute the cash to bondholders. School districts, cities and the like can't "go out of business." They don't have "equity" to give to creditors upon a default.
I read a recent rating agency report that confirmed the AAA credit rating on the general obligation bonds of my favorite California small town. This high credit rating is much deserved, and the report touted at some length our town's prudent fiscal management. But, here's the catch: The credit quality of those bonds has almost nothing to do with the town's prudent fiscal management.
The City Council doesn't "appropriate" the bond payments -- fitting them into a budget of many choices. No -- the bond payments come directly off the property tax bills that are printed, mailed and collected by the county tax collector. Should, heaven forbid, our dear town find itself in bankruptcy, the bonds payments will continue to flow from property owners, right on past city hall, and straight to the county's money pool, from where it will be sent to the paying agent for the bonds.
These are the types of bonds that would get beaten down along with other, more risky, types of muni bonds. And we will be standing by in the heat of July ready to fill our portfolios with misunderstood and high-yielding bonds. We saw the same opportunity in late 2008 and we took advantage of it then.
Wednesday, December 30, 2009
My Two Cents
I've been writing newspaper columns, blogs and essays fairly regularly for about the past 8 years. In all that time, I have stayed away from the other half of the "friendly gathering taboo" duo: politics, or at least, political policy. It's said to never discuss money or politics in polite company. I violate the former all the time, but I generally shut my trap on the latter. Why? Because people pretty much hold their opinions strongly, and are only interested in mine to the extent that they can then berate me for my foolishness. Given that I am an avowed political eccentric -- simultaneously holding both left- and right-handed views -- everybody I meet is always ready to disagree with me about something. And, since I am as stubborn as they are...I don't really want to hear it. So, we talk about sports or the appetizers instead.
But, just this once -- I've got an opinion to share and it's about taxes. First, I will establish that I'm not a harsh anti-tax table-pounder. We want stuff; we have to pay for it. Taxes pay for the stuff we like getting -- roads, schools, courts, jails, firemen, police, parks, beaches, cash-f0r-clunkers rebates, etc. Don't get me wrong -- I don't favor tax increases. We pay plenty here in Cali, and the state is going to have to figure out how to cut expenses. Ditto the feds.
My problem with the tax code is its bass-ackwards investment incentive structure. As currently written, the capital gains tax rate only makes one distinction: how long did you hold the investment asset? If you held it a year or longer before sale, you profits are taxed at a 15% rate. The intent here is to move away from short-sighted trading strategies into more stable long-term outlooks.
Let's take a sidetrack for moment so that I can make a distinction between investments that add to economic productivity and those that are merely transfers of money from one pocket to another. If a plumber spends $25k to expand his business (buying tools or training apprentices), that investment of $25k was productive. If instead he buys $25k worth of Google stock, that investment was not productive and will have zero effect on job creation or GDP growth. Remember, when we buy stock, we buy it from someone else. Google doesn't actually get any of that money.
In the tallying up of the National Income and Product Accounts, stock purchases are not "investments." Purchases of commercial equipment are "investments." Productive investments are those that put money directly to work in profit-making enterprises. If you buy a condo that already exists simply to flip it to the next sucker, you are making a non-productive investment. If you build or significantly remodel a condo, and then manage it over time for income, you are making a productive investment. You have to understand that the VAST majority of money that flows into and around Wall Street has nothing to do with actual productive investment. Most money spent on productive investments in the U.S. comes from retained earnings. The plumber, and Google for that matter, expand their businesses by deploying money they earned in the past. Wall Street provides only a tiny fraction of actual productive investment capital. Our national obsession with "saving Wall Street" is based on the myth that, without Wall Street, businesses will have no access to investment capital. The reality is far different.
Yet, the tax code provides an equal treatment of productive and non-productive investment profits. The long-term capital gains tax rate of 15% applies equally to hedge funds trading currency swaps and to the plumber who one day sells his business to retire. This is, in my view, absurd and destructive. Your Congress has swallowed this story whole-hog from hedge fund managers:
I am paraphrasing here an actual bit of testimony before Congress the last time it considered requiring that hedge fund managers pay income taxes instead of capital gains taxes.
Our business tax policy should create incentives to make actual, productive investments instead of encouraging the non-productive and speculative practices of simply moving money and assets from one account to another, while skimming off the crumbs as they go by. These trading practices should be taxed at ordinary income rates, since they are returns not based on real additions to GDP, but are instead returns to the labor and skill of the traders. In all other professions, income earned for labor and skill is taxed at ordinary rates. Only on Wall Street are such skills taxed at artificially low rates under the lie that the income is based on "investment returns."
So, here's my rough proposal as we move into what should prove to be an interesting year as Congress is forced to re-consider the Bush tax structure:
But, just this once -- I've got an opinion to share and it's about taxes. First, I will establish that I'm not a harsh anti-tax table-pounder. We want stuff; we have to pay for it. Taxes pay for the stuff we like getting -- roads, schools, courts, jails, firemen, police, parks, beaches, cash-f0r-clunkers rebates, etc. Don't get me wrong -- I don't favor tax increases. We pay plenty here in Cali, and the state is going to have to figure out how to cut expenses. Ditto the feds.
My problem with the tax code is its bass-ackwards investment incentive structure. As currently written, the capital gains tax rate only makes one distinction: how long did you hold the investment asset? If you held it a year or longer before sale, you profits are taxed at a 15% rate. The intent here is to move away from short-sighted trading strategies into more stable long-term outlooks.
Let's take a sidetrack for moment so that I can make a distinction between investments that add to economic productivity and those that are merely transfers of money from one pocket to another. If a plumber spends $25k to expand his business (buying tools or training apprentices), that investment of $25k was productive. If instead he buys $25k worth of Google stock, that investment was not productive and will have zero effect on job creation or GDP growth. Remember, when we buy stock, we buy it from someone else. Google doesn't actually get any of that money.
In the tallying up of the National Income and Product Accounts, stock purchases are not "investments." Purchases of commercial equipment are "investments." Productive investments are those that put money directly to work in profit-making enterprises. If you buy a condo that already exists simply to flip it to the next sucker, you are making a non-productive investment. If you build or significantly remodel a condo, and then manage it over time for income, you are making a productive investment. You have to understand that the VAST majority of money that flows into and around Wall Street has nothing to do with actual productive investment. Most money spent on productive investments in the U.S. comes from retained earnings. The plumber, and Google for that matter, expand their businesses by deploying money they earned in the past. Wall Street provides only a tiny fraction of actual productive investment capital. Our national obsession with "saving Wall Street" is based on the myth that, without Wall Street, businesses will have no access to investment capital. The reality is far different.
Yet, the tax code provides an equal treatment of productive and non-productive investment profits. The long-term capital gains tax rate of 15% applies equally to hedge funds trading currency swaps and to the plumber who one day sells his business to retire. This is, in my view, absurd and destructive. Your Congress has swallowed this story whole-hog from hedge fund managers:
"If you are going to ask me to be in the same tax bracket as a plumber, I cannot be bothered to get out of bed in the morning. I will be forced to close my business. I can get by on $10 million a year. If you tax me to the point where I can only make $9 million a year, then I will have no choice but to stop working and go on welfare. Tax the plumber and leave me alone."
I am paraphrasing here an actual bit of testimony before Congress the last time it considered requiring that hedge fund managers pay income taxes instead of capital gains taxes.
Our business tax policy should create incentives to make actual, productive investments instead of encouraging the non-productive and speculative practices of simply moving money and assets from one account to another, while skimming off the crumbs as they go by. These trading practices should be taxed at ordinary income rates, since they are returns not based on real additions to GDP, but are instead returns to the labor and skill of the traders. In all other professions, income earned for labor and skill is taxed at ordinary rates. Only on Wall Street are such skills taxed at artificially low rates under the lie that the income is based on "investment returns."
So, here's my rough proposal as we move into what should prove to be an interesting year as Congress is forced to re-consider the Bush tax structure:
- Capital gains realized from the sale of productive investments will be taxed at 15%. This will include pretty much all small businesses since their cost basis is entirely productive investments. Buying a condo and flipping it a year later is not productive -- it's trading income and should be taxed at ordinary rates. If you construct a building, rent it out and sell it later, you can have the 15% rate.
- Corporations should get a full expense deduction for dividends paid out to shareholders, to the extent they are less than or equal to taxable earnings. Corporations should not pay a punitive double-tax for returning cash to shareholders.
- Capital gains taxes on ordinary stocks, bonds and mutual funds should depend on who you are. If you're a household taxpayer (or a trust benefitting a household), you qualify for the current long-term capital gains rate of 15%. If you're a hedge fund, investment bank or other entity that is in the business of making such profits, your profits are taxed at ordinary income tax rates.
My frustration with the tax code is that it rewards non-productive "investment" behavior the same way as it rewards productive investments. Our long-term economic growth depends entirely on productivity growth. Productivity growth arises from productive investments in equipment, research and education. It does not arise from condo-flipping, day trading and CDO-packaging.
Thursday, November 19, 2009
Tactical Changes - Tale of Two Outcomes
In our quarterly commentary, we carried the theme that we are at a crossroads. While we still feel that's true, we feel that both roads lead to disappointment for holders of long-dated risk assets.
I don't mean to make this overly simplistic, but I'm going to try anyway. Here is the investment decision of our time, and investors (and their, ahem, advisors) need to take sides:
Either inflation will rise in the near term or it will not.
As we have written, the Fed is desperately trying to get prices moving up again. Part of its mandate is price stability. What that really means in a paper-money world is a controlled and predictable slow rise of prices. Say, 2.5% to 3.5% per year. The Fed is deathly afraid of deflation. Money supply has grown barely 5.5% in the past year and the Fed would probably prefer to see it grow twice that fast. What little money growth we're getting seems to be pouring into financial assets (and gold) rather than into business expansions and paychecks.
The argument for high inflation takes the position that the Fed will get what it wants, and probably overshoot the mark. Couple that overshooting with rising borrowing demands and you've got yourself an inflation/interest rate/falling dollar scenario that scares the bejeezus out of the doom-and-gloom crowd. Global collapse and all that.
On the other hand...
The Fed could fail. Compelling arguments can be made that without a surge in consumer demand, you just can't get a wage-price spiral rolling. The Fed reports that we're running our economy on 70% of its productive capacity. The official unemployment number is above 10% and the real, actual unemployment number is probably north of 15%. At no time in our history have low capacity utilization and high unemployment numbers paired up and produced spikes of inflation. For reference, capacity utilization was above 83% when inflation spiked in 1978-1980. It takes more than money expansion to produce inflation in the near-term -- it also requires that more money is chasing less output capacity.
There are smart, experienced and successful investment celebrities both sides of this bet-of-a-lifetime. We're not here to make big bets. The difference between most of those pundits, bloggers and analysts is that they either (1) don't invest other people's money for a living; or (2) only invest a small subset of other people's money. If the latter, their job is to be aggressive and be right. If they are neither, they get fired and the client has only lost a few dollars.
Our job, on the other hand, is to preserve the entirety of our clients' life savings. In over 90% of our client relationships, we oversee the entire investment portfolio. We therefore make more measured bets and always err on the conservative side of split decisions. We are tactical allocation investors. The classic model of tactical investing means that, absent a compelling reason to move into or out of an asset class, we stay neutrally invested in a vanilla mix of stocks and bonds. Say, 60% stocks and 40% bonds, with a little foreign thrown in there for flavor.
We are instead going to move away from the classic model. Rather than stay in a vanilla portfolio while waiting for clear signals and opportunities, we are going to move more strongly into a defensive stance. We are in the process of reducing holdings of equities and high-yield bonds and will move those funds into short-term bonds and TIPs, both domestic and foreign. These assets have moved up significantly over the past 9 months. We have profited nicely and it's time to take some of those profits.
Then, we will wait. When there are cracks in the prices of assets that we like for the long-term, we will buy a little and then wait some more. When we look at the choice between "inflation soon" and "inflation later" we see little upside for stocks over the next few years. This is particularly true since we believe that stocks are already trading above their long-term fair value.
So, while the debate rages between a "V" (straight up), a "W" (double-dip) or an "L" (extended doldrums), we will sit quietly by and wait for opportunities.
I don't mean to make this overly simplistic, but I'm going to try anyway. Here is the investment decision of our time, and investors (and their, ahem, advisors) need to take sides:
Either inflation will rise in the near term or it will not.
As we have written, the Fed is desperately trying to get prices moving up again. Part of its mandate is price stability. What that really means in a paper-money world is a controlled and predictable slow rise of prices. Say, 2.5% to 3.5% per year. The Fed is deathly afraid of deflation. Money supply has grown barely 5.5% in the past year and the Fed would probably prefer to see it grow twice that fast. What little money growth we're getting seems to be pouring into financial assets (and gold) rather than into business expansions and paychecks.
The argument for high inflation takes the position that the Fed will get what it wants, and probably overshoot the mark. Couple that overshooting with rising borrowing demands and you've got yourself an inflation/interest rate/falling dollar scenario that scares the bejeezus out of the doom-and-gloom crowd. Global collapse and all that.
On the other hand...
The Fed could fail. Compelling arguments can be made that without a surge in consumer demand, you just can't get a wage-price spiral rolling. The Fed reports that we're running our economy on 70% of its productive capacity. The official unemployment number is above 10% and the real, actual unemployment number is probably north of 15%. At no time in our history have low capacity utilization and high unemployment numbers paired up and produced spikes of inflation. For reference, capacity utilization was above 83% when inflation spiked in 1978-1980. It takes more than money expansion to produce inflation in the near-term -- it also requires that more money is chasing less output capacity.
There are smart, experienced and successful investment celebrities both sides of this bet-of-a-lifetime. We're not here to make big bets. The difference between most of those pundits, bloggers and analysts is that they either (1) don't invest other people's money for a living; or (2) only invest a small subset of other people's money. If the latter, their job is to be aggressive and be right. If they are neither, they get fired and the client has only lost a few dollars.
Our job, on the other hand, is to preserve the entirety of our clients' life savings. In over 90% of our client relationships, we oversee the entire investment portfolio. We therefore make more measured bets and always err on the conservative side of split decisions. We are tactical allocation investors. The classic model of tactical investing means that, absent a compelling reason to move into or out of an asset class, we stay neutrally invested in a vanilla mix of stocks and bonds. Say, 60% stocks and 40% bonds, with a little foreign thrown in there for flavor.
We are instead going to move away from the classic model. Rather than stay in a vanilla portfolio while waiting for clear signals and opportunities, we are going to move more strongly into a defensive stance. We are in the process of reducing holdings of equities and high-yield bonds and will move those funds into short-term bonds and TIPs, both domestic and foreign. These assets have moved up significantly over the past 9 months. We have profited nicely and it's time to take some of those profits.
Then, we will wait. When there are cracks in the prices of assets that we like for the long-term, we will buy a little and then wait some more. When we look at the choice between "inflation soon" and "inflation later" we see little upside for stocks over the next few years. This is particularly true since we believe that stocks are already trading above their long-term fair value.
So, while the debate rages between a "V" (straight up), a "W" (double-dip) or an "L" (extended doldrums), we will sit quietly by and wait for opportunities.
Wednesday, October 28, 2009
Thinking About Gold
We've been thinking a lot about inflation risk lately. As was discussed in our recent quarterly commentary, we grind our teeth at night worrying about the potential for an uncontrollable rise in the money supply, interest rates or both. In the past year or so, the Fed has added more money to the reserve accounts of its member banks than was the entire global supply of currency before August 2008. We took 100+ years to put $900 billion into circulation. We took merely a few months to add an equal amount to banks' reserve accounts. The banks are now free to withdraw that money and start lending it out; the usual multipliers will kick in and and what starts out as, "Good news! Banks are lending again!" turns into, "Yikes! A gallon of gas costs six bucks!" That worries us, and we think it should worry you. (As soon as you start reading stories about how banks are lending madly again, go fill up your tank.)
Our job at Creekside isn't to fix such problems. Those who recently rifled through Timothy Geithner's phone records learned that he hasn't been calling me for advice. Our job is to accept the world as it is and make investment decisions for our clients that, we hope, keeps them moving forward toward their financial goals.
That leads us to consider all the available asset classes and ask what might be the effect on that asset class if high inflation does, in fact, come to pass. While some assets, such as stocks and real estate, keep up with inflation in the fullness of time, that time horizon can be unacceptably long. We think about asset classes that can offer the possibility of keeping up with inflation in real-time. As you might imagine, we field a lot of questions about gold as.
It is true that gold will generally rise in periods of accelerating inflation. The problem is that its rise and fall is far out of scale to the nature of the problem -- and the reversal of the problem. The price index grew by 36% between fall 1976 and spring 1980. Gold rose by 740%. While you might think that proves that gold covers inflation, it should in fact give you pause. Gold prices wildly overshot inflation. When a price overshoots its proper place, it inevitably falls back to earth. Sure enough, gold had lost more than 60% of its value by summer 1982. Between spring 1980 and summer 1982, the price index rose by 22% and gold fell by 63%. Some inflation hedge!
If you were fortunate enough to have gotten in early -- say by early 1978, then you ended up with decent inflation protection by the summer of '82. Gold did cover inflation over that period, from where it started to where it bottomed out.
In our view, the extreme volatility of gold is in large part due to the fact that so little of the world's gold is available for investment applications. Jewelry, dental and industrial uses consume some 90 percent of the world's annual gold production of about 2,200 tons. The total annual production of gold would make a pile that would fit in your living room -- and only a small fraction of it ends up in coins or bullion. The world's entire historical accumulation of gold in all forms would make a cube that would fit on the infield of a Little League baseball diamond.
Given the somewhat small market for actual gold, it is surprising (to me, anyway) that the annual futures market trading activity in just the Chicago exchange exceeds $3.4 trillion dollars! That trading volume is about 40 times the world's actual yearly production of gold -- and Chicago is just one of many worldwide exchanges. (Coincidentally, that figure equals the approximate market value of all gold that exists in the entire world.)
The result of this very large amount of money chasing around this very tiny amount of gold is that a surge in demand for gold can easily send its price soaring past all measures of reasonableness. We expect that will happen if inflation accelerates. We also expect that the price will collapse once the inflationary fears abate -- as happened in the early 1980's. We are quite reluctant to buy into an asset class whose profit potential is utterly dependent on getting the starting and ending dates right.
We can grant for the moment the goldbug's assertion that, volatility aside, gold will keep up with inflation. True enough, perhaps. But -- how much of your portfolio are you going to invest in gold? Some gold proponents say 2-3%; others 5%. The more aggressive folks say 10%. Now, let's imagine that the consumer price index rises twofold over the next five years -- bordering on hyperinflation. If gold matches inflation (and it has never done more than that over a full economic cycle), a 5% position in gold will have added 5% to your portfolio value (since the gold doubled in price). That's about 1% a year contributed toward your inflation protection, during a time when inflation was raging at nearly 20% per year.
Not such a great hedge, eh? The only way gold is going to cover your loss of purchasing power over an entire bust-boom cycle is if you put everything into gold. And then you hope and pray you bought early enough, and will sell out at the right moment.
We agree with the premise that, in the face of runaway inflation, we are well-advised to own "real" assets instead of paper ones. However, we think that gold is not that asset. While gold is a physical commodity, its market price is as often as not fueled by the same irrational human emotions and "animal spirits" as are the prices of paper assets (eg, stocks or currency). We prefer physical assets that have a role in the production chain instead -- industrial metals, oil, gas and other natural resources. With a far larger base of annual production and consumption, we are more confident that the prices of these assets will stay more closely linked to the real world than will the highly emotional price of gold.
While we worry about a spike of inflation over the next couple of years, we think there are better ways to position our portfolios than making a meaningful commitment to gold. We have our bonds concentrated in short maturities (less than three years); we have our stock positions tilted toward energy and natural resources companies; we have overweight positions in foreign-denominated stocks and bonds. We are in the midst of a closer look at inflation-indexed bonds, or "TIPS," and will publish our conclusions soon.
We have taken a serious and sober look at gold, and we can only conclude that the risks far outweigh the potential benefits. We believe there are less volatile and equally effective ways of mitigating the effects of inflation on our clients' portfolios.
Our job at Creekside isn't to fix such problems. Those who recently rifled through Timothy Geithner's phone records learned that he hasn't been calling me for advice. Our job is to accept the world as it is and make investment decisions for our clients that, we hope, keeps them moving forward toward their financial goals.
That leads us to consider all the available asset classes and ask what might be the effect on that asset class if high inflation does, in fact, come to pass. While some assets, such as stocks and real estate, keep up with inflation in the fullness of time, that time horizon can be unacceptably long. We think about asset classes that can offer the possibility of keeping up with inflation in real-time. As you might imagine, we field a lot of questions about gold as.
It is true that gold will generally rise in periods of accelerating inflation. The problem is that its rise and fall is far out of scale to the nature of the problem -- and the reversal of the problem. The price index grew by 36% between fall 1976 and spring 1980. Gold rose by 740%. While you might think that proves that gold covers inflation, it should in fact give you pause. Gold prices wildly overshot inflation. When a price overshoots its proper place, it inevitably falls back to earth. Sure enough, gold had lost more than 60% of its value by summer 1982. Between spring 1980 and summer 1982, the price index rose by 22% and gold fell by 63%. Some inflation hedge!
If you were fortunate enough to have gotten in early -- say by early 1978, then you ended up with decent inflation protection by the summer of '82. Gold did cover inflation over that period, from where it started to where it bottomed out.
In our view, the extreme volatility of gold is in large part due to the fact that so little of the world's gold is available for investment applications. Jewelry, dental and industrial uses consume some 90 percent of the world's annual gold production of about 2,200 tons. The total annual production of gold would make a pile that would fit in your living room -- and only a small fraction of it ends up in coins or bullion. The world's entire historical accumulation of gold in all forms would make a cube that would fit on the infield of a Little League baseball diamond.
Given the somewhat small market for actual gold, it is surprising (to me, anyway) that the annual futures market trading activity in just the Chicago exchange exceeds $3.4 trillion dollars! That trading volume is about 40 times the world's actual yearly production of gold -- and Chicago is just one of many worldwide exchanges. (Coincidentally, that figure equals the approximate market value of all gold that exists in the entire world.)
The result of this very large amount of money chasing around this very tiny amount of gold is that a surge in demand for gold can easily send its price soaring past all measures of reasonableness. We expect that will happen if inflation accelerates. We also expect that the price will collapse once the inflationary fears abate -- as happened in the early 1980's. We are quite reluctant to buy into an asset class whose profit potential is utterly dependent on getting the starting and ending dates right.
We can grant for the moment the goldbug's assertion that, volatility aside, gold will keep up with inflation. True enough, perhaps. But -- how much of your portfolio are you going to invest in gold? Some gold proponents say 2-3%; others 5%. The more aggressive folks say 10%. Now, let's imagine that the consumer price index rises twofold over the next five years -- bordering on hyperinflation. If gold matches inflation (and it has never done more than that over a full economic cycle), a 5% position in gold will have added 5% to your portfolio value (since the gold doubled in price). That's about 1% a year contributed toward your inflation protection, during a time when inflation was raging at nearly 20% per year.
Not such a great hedge, eh? The only way gold is going to cover your loss of purchasing power over an entire bust-boom cycle is if you put everything into gold. And then you hope and pray you bought early enough, and will sell out at the right moment.
We agree with the premise that, in the face of runaway inflation, we are well-advised to own "real" assets instead of paper ones. However, we think that gold is not that asset. While gold is a physical commodity, its market price is as often as not fueled by the same irrational human emotions and "animal spirits" as are the prices of paper assets (eg, stocks or currency). We prefer physical assets that have a role in the production chain instead -- industrial metals, oil, gas and other natural resources. With a far larger base of annual production and consumption, we are more confident that the prices of these assets will stay more closely linked to the real world than will the highly emotional price of gold.
While we worry about a spike of inflation over the next couple of years, we think there are better ways to position our portfolios than making a meaningful commitment to gold. We have our bonds concentrated in short maturities (less than three years); we have our stock positions tilted toward energy and natural resources companies; we have overweight positions in foreign-denominated stocks and bonds. We are in the midst of a closer look at inflation-indexed bonds, or "TIPS," and will publish our conclusions soon.
We have taken a serious and sober look at gold, and we can only conclude that the risks far outweigh the potential benefits. We believe there are less volatile and equally effective ways of mitigating the effects of inflation on our clients' portfolios.
Friday, August 7, 2009
Whoa...Slow Down There, Cowboy!
I'm about to head off on a nice week to the beaches of San Diego with my family. But before I go, I thought it important to remind our clients and readers of our outlook and tactics for portfolios.
At the top of most folks' minds at the moment is the historic rally in the stock market since its bottom in early March. A 50%+ rise in so short a period has only been matched one previous time in the last century. I'm getting calls even from conservative investors imploring me to get heavily back into stocks. Momentum is a very real effect on near-term stock prices and it's not to be ignored. Stocks surely could continue to rally strongly as the year rolls on.
But we don't think it is worth the risk. First, and most importantly, we now believe that stocks have pushed past fair value. As Jeremy Grantham recently lamented, stocks spent about 15 years being overvalued. They went below fair value for all of a couple of months and are now look modestly expensive again. Life's not fair.
In our opinion, fair value for the S&P500 is around 925 (it's at 1000 today). Important to note is that our view of fair value already assumes a full earnings recovery. It's not like we think the market is worth 925 based on today's temporary depressed earnings -- we think that is the right price after earnings recover from the recession. The recent good earnings reports are merely the path back to normal earnings. These earnings reports do not warrant pushing the S&P500 back over 1000.
The second point I'd like to make is that, while stocks have had a huge rally from the March bottom, they are only up about 11% year to date*. We ask the question: Since we have been underweighted in stocks, how have the assets performed that we bought instead of stocks. Quite nicely, thank you.
What we bought with money that would otherwise be in stocks:
Foreign Bonds = up 15% year to date
High-Yield Bonds = 32%
Energy Stock Fund = 26%
Natural Resource Fund = 37%
Muni Bonds = 10.2%
(*Vanguard S&P500 Index Fund returned 11.03% through 7/31/09)
So, while the stock market has had a sharp V-shaped year, our average client has had a far smoother ride and has ended up at a slightly higher point.
The standard disclaimer applies: Past results are not necessarily indicative of future performance. All investments bear risks. For a complete description of Creekside's performance composites, you can email me at rick@creeksidepartners.com.
Again -- and this is very important -- we believe that the S&P500 at a price of about 925 is the fair value of the market after a full recovery from the recession. That's why we're willing to pay that price today. But we are not terribly willing to make full allocations back to stocks at a price closer to 1000.
Cheers,
Rick
At the top of most folks' minds at the moment is the historic rally in the stock market since its bottom in early March. A 50%+ rise in so short a period has only been matched one previous time in the last century. I'm getting calls even from conservative investors imploring me to get heavily back into stocks. Momentum is a very real effect on near-term stock prices and it's not to be ignored. Stocks surely could continue to rally strongly as the year rolls on.
But we don't think it is worth the risk. First, and most importantly, we now believe that stocks have pushed past fair value. As Jeremy Grantham recently lamented, stocks spent about 15 years being overvalued. They went below fair value for all of a couple of months and are now look modestly expensive again. Life's not fair.
In our opinion, fair value for the S&P500 is around 925 (it's at 1000 today). Important to note is that our view of fair value already assumes a full earnings recovery. It's not like we think the market is worth 925 based on today's temporary depressed earnings -- we think that is the right price after earnings recover from the recession. The recent good earnings reports are merely the path back to normal earnings. These earnings reports do not warrant pushing the S&P500 back over 1000.
The second point I'd like to make is that, while stocks have had a huge rally from the March bottom, they are only up about 11% year to date*. We ask the question: Since we have been underweighted in stocks, how have the assets performed that we bought instead of stocks. Quite nicely, thank you.
What we bought with money that would otherwise be in stocks:
Foreign Bonds = up 15% year to date
High-Yield Bonds = 32%
Energy Stock Fund = 26%
Natural Resource Fund = 37%
Muni Bonds = 10.2%
(*Vanguard S&P500 Index Fund returned 11.03% through 7/31/09)
So, while the stock market has had a sharp V-shaped year, our average client has had a far smoother ride and has ended up at a slightly higher point.
The standard disclaimer applies: Past results are not necessarily indicative of future performance. All investments bear risks. For a complete description of Creekside's performance composites, you can email me at rick@creeksidepartners.com.
Again -- and this is very important -- we believe that the S&P500 at a price of about 925 is the fair value of the market after a full recovery from the recession. That's why we're willing to pay that price today. But we are not terribly willing to make full allocations back to stocks at a price closer to 1000.
Cheers,
Rick
Monday, June 22, 2009
Over-Expectations
It's been a while since my last blog. Spring, little league baseball and too many hours spent pondering the state of the world have distracted me from my scheduled semi-occasional written musings. Not that I haven't been thinkin' -- I just haven't been writin'.
I've spent many of my waking hours trying to figure out what to make of all this. The economy doesn't seem to be in free-fall any longer. It is, as best I can tell, far from a recovery. But still, we have reached somewhat of a steady-state. Consumption, income and employment are all below previous highs. I expect they might stay that way for a while. Stocks have recovered strongly from the lows reached in early March.
As money managers, we have gone from a six-month state of constantly reacting to rapid changes (I made more trades from Sept 08 to April 09 than in the previous six years combined) to now having a little breathing room to make some forward-looking decisions.
Most of my head-scratching the past six weeks havs been about stocks. What should we expect from stocks? After staring at data series to the point of blindness, I have some thoughts about expectations. Namely -- people expect too much from stocks. We are prone to anchoring our expectations in the good years (double-digit returns) and forget to factor in the so-so years (losses). I still come across articles by various financial planning pundits such as Suze Orman that counsel us to expect high returns over any given reasonably long holding period. Such advice is usually accompanied by a cherry-picked starting and ending point for the analysis. The starting point is invariably a period of low stock valuation, and the ending point is one of normal or high valuation. Of course returns were high with such assumptions. But, if you bought stocks in 1966, you have had a lousy 43 years. Bonds would have done better.
But really -- what can we expect with some degree of certainty, or at least rationality? Your stock portfolio grows faster than inflation due to three and only three sources:
- Growth in Real* Earnings per Share
- Dividends
- P/E* Expansion
(*"Real" means after-inflation; "P/E" means Price divided by Earnings, using our method of adjusting for inflation, and averaging Earnings over 10 years to smooth out accounting shenanigans.)
The earnings per share of a large basket of public companies grows at a real rate about 1-2% less than the growth rate of GDP. You would think that these companies would grow their collective earnings at about the same rate that the whole economy grows. They do actually come close, but that's on an aggregate basis. Your portfolio of stocks only goes up if the earnings rise per share -- and big companies relentlessly dilute their shareholders with new share creation. Since 1945, real EPS grew at 1.7%; real GDP grew at 3.3%. Over longer periods, the gap is worse.
So, let's assume that real EPS grows at an optimistic 1% slower than GDP. In a near-perfect world, GDP grows at about 3 to 3.5%. Alas, the world is not perfect in the U.S. Working age population growth is slowing -- and that growth rate is an arithmetic addition to GDP growth. If you drop 1% off the population growth rate, you eventually reduce GDP growth by the same 1%. GDP's other arithmetic input is productivity growth (yes, those are the only two long-run inputs to GDP growth), and productivity growth is likely to be dampened as we work off our debt. So, we've got a double-layer wet blanket thrown over the economy.
I would be surprised to see real GDP grow by more than about 2.5% per annum over the next decade. That would mean real EPS growth in the 1-1.5% range. (And I don't mean growth from the temporary lows of today -- I mean growth from the line we were on before the boom and bust. Growth back up to that line is merely a recovery -- it's not really moving us forward.)
Add the current 2% dividend rate to that EPS growth figure and you get an expected return on stocks of 3 to 3.5% after inflation. And, in fact, that's the return we've achieved since the last time the market was priced like it is today. (See the blog below for our discussion of the price of the market.) This is the "baked in" return on stocks -- it will grind away in our favor regardless of what the market does year to year.
Now -- what about P/E expansion? Yes, every rise in the P/E ratio is additional returns to stock owners. If the P/E rises from 17 to 22 over a three year period, that's a bonus of 8.8% per year added to our 3-3.5% expectation. Good times indeed!
But, should you expect the P/E to expand from its historic levels in the mid-to-high teens? If it is low to start with, sure. But, if it is at or above reasonable long-term levels, no. Realize what you are expecting to happen if you expect to sell your stocks to somebody else at a higher P/E in the future. You bought stocks expecting a return of 3-3.5%, and you are hoping someone else will come along expecting something lower and buy your stocks from you. Remember, the 3-3.5% expected return is baked in and doesn't change with the market. The more someone pays for stocks, the more they are eroding their ability to actually capture that 3-3.5%.
P/E expansions above trend are only sustained by the speculative hope that someone will come along and pay more. They are not sustained by fundamentals.
We expect stocks to pay 3-3.5% real return over the coming 7-10 years -- we are not going to hang our retirement hopes on P/E expansion. That is not a terrible return, but it does give us pause in going back to full stock allocations. It's because stocks are not a take-it-or-leave-it choice. They are an either-or choice, and we have other assets to choose from that offer similar or higher expected returns.
More on those choices in the next installment...
I've spent many of my waking hours trying to figure out what to make of all this. The economy doesn't seem to be in free-fall any longer. It is, as best I can tell, far from a recovery. But still, we have reached somewhat of a steady-state. Consumption, income and employment are all below previous highs. I expect they might stay that way for a while. Stocks have recovered strongly from the lows reached in early March.
As money managers, we have gone from a six-month state of constantly reacting to rapid changes (I made more trades from Sept 08 to April 09 than in the previous six years combined) to now having a little breathing room to make some forward-looking decisions.
Most of my head-scratching the past six weeks havs been about stocks. What should we expect from stocks? After staring at data series to the point of blindness, I have some thoughts about expectations. Namely -- people expect too much from stocks. We are prone to anchoring our expectations in the good years (double-digit returns) and forget to factor in the so-so years (losses). I still come across articles by various financial planning pundits such as Suze Orman that counsel us to expect high returns over any given reasonably long holding period. Such advice is usually accompanied by a cherry-picked starting and ending point for the analysis. The starting point is invariably a period of low stock valuation, and the ending point is one of normal or high valuation. Of course returns were high with such assumptions. But, if you bought stocks in 1966, you have had a lousy 43 years. Bonds would have done better.
But really -- what can we expect with some degree of certainty, or at least rationality? Your stock portfolio grows faster than inflation due to three and only three sources:
- Growth in Real* Earnings per Share
- Dividends
- P/E* Expansion
(*"Real" means after-inflation; "P/E" means Price divided by Earnings, using our method of adjusting for inflation, and averaging Earnings over 10 years to smooth out accounting shenanigans.)
The earnings per share of a large basket of public companies grows at a real rate about 1-2% less than the growth rate of GDP. You would think that these companies would grow their collective earnings at about the same rate that the whole economy grows. They do actually come close, but that's on an aggregate basis. Your portfolio of stocks only goes up if the earnings rise per share -- and big companies relentlessly dilute their shareholders with new share creation. Since 1945, real EPS grew at 1.7%; real GDP grew at 3.3%. Over longer periods, the gap is worse.
So, let's assume that real EPS grows at an optimistic 1% slower than GDP. In a near-perfect world, GDP grows at about 3 to 3.5%. Alas, the world is not perfect in the U.S. Working age population growth is slowing -- and that growth rate is an arithmetic addition to GDP growth. If you drop 1% off the population growth rate, you eventually reduce GDP growth by the same 1%. GDP's other arithmetic input is productivity growth (yes, those are the only two long-run inputs to GDP growth), and productivity growth is likely to be dampened as we work off our debt. So, we've got a double-layer wet blanket thrown over the economy.
I would be surprised to see real GDP grow by more than about 2.5% per annum over the next decade. That would mean real EPS growth in the 1-1.5% range. (And I don't mean growth from the temporary lows of today -- I mean growth from the line we were on before the boom and bust. Growth back up to that line is merely a recovery -- it's not really moving us forward.)
Add the current 2% dividend rate to that EPS growth figure and you get an expected return on stocks of 3 to 3.5% after inflation. And, in fact, that's the return we've achieved since the last time the market was priced like it is today. (See the blog below for our discussion of the price of the market.) This is the "baked in" return on stocks -- it will grind away in our favor regardless of what the market does year to year.
Now -- what about P/E expansion? Yes, every rise in the P/E ratio is additional returns to stock owners. If the P/E rises from 17 to 22 over a three year period, that's a bonus of 8.8% per year added to our 3-3.5% expectation. Good times indeed!
But, should you expect the P/E to expand from its historic levels in the mid-to-high teens? If it is low to start with, sure. But, if it is at or above reasonable long-term levels, no. Realize what you are expecting to happen if you expect to sell your stocks to somebody else at a higher P/E in the future. You bought stocks expecting a return of 3-3.5%, and you are hoping someone else will come along expecting something lower and buy your stocks from you. Remember, the 3-3.5% expected return is baked in and doesn't change with the market. The more someone pays for stocks, the more they are eroding their ability to actually capture that 3-3.5%.
P/E expansions above trend are only sustained by the speculative hope that someone will come along and pay more. They are not sustained by fundamentals.
We expect stocks to pay 3-3.5% real return over the coming 7-10 years -- we are not going to hang our retirement hopes on P/E expansion. That is not a terrible return, but it does give us pause in going back to full stock allocations. It's because stocks are not a take-it-or-leave-it choice. They are an either-or choice, and we have other assets to choose from that offer similar or higher expected returns.
More on those choices in the next installment...
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