On Friday 4/30 the Commerce Dept. (more specifically, the Bureau of Economic Analysis, or BEA) released its first estimates of economic activity for the first quarter. The headline number was that GDP grew in the first quarter at an annual rate of 3.2%. OK...that's a number, but what does it mean?
First, you need to ask whether that is a figure that adjusts for inflation or not. News accounts didn't make the distinction, and the first few paragraphs of the official release don't say either. I had to dig pretty far into the news release to be sure that, yes, that figure is a post-inflation number.
The BEA estimates total economic output for the quarter and then "annualizes" it...which is a fancy way of saying, "multiply by four" (or, "add one; raise to the fourth power; subtract one"). But, it does little good to know that output went up by 2% if inflation was running at 2% -- the net growth is really zero in that case. So, the BEA wisely factors in the amount of inflation that it measured. Along with the economic output data, the staff comes up with a "price deflator." In Q1 2010, the BEA figured that total output grew by 1.02%. Annualizing that figure, we get 4.1%.
Now the question is...how much of that was eaten up by inflation? The BEA figured that prices rose at an annual rate of 0.9% in the quarter, which results in the net reported figure of 3.2%. With me so far...?
But, if I wander over to the website of the Bureau of Labor Statistics (part of the Department of Labor), I find that those folks figured that prices rose by an annual rate of 3.1%. Subtracting that from the 4.1% total growth rate reported back over at the BEA, and we get a net figure of only 1.0%, not the 3.2% reported by BEA!
So what's going on here? Is this some secret government conspiracy where the Commerce Department wants to say the economy is great and the Labor Department wants to say, no, it's not...? I don't subscribe to such theories. I think simpler and more mundane explanations are at work. The fact of the matter is that nobody knows for sure just what happened in a particular quarter until a year or so later. The Commerce Department has three scheduled revisions of the GDP figures yet to come. Frankly, I trust the Labor Department's inflation figures since they have far more resources dedicated to gathering the data and emply state of the art statistical methods and concepts in deriving a useful price index.
Whichever figure you want to use -- 3.2% or 1.0% -- the fact of the matter is that this growth rate is not sufficient to soak up unemployment. Productivity grows at 1.6% to 1.8% per year; the workforce grows by 1.0% or so. These combine to "use up" all of the growth we are experiencing at the moment, and don't provide much room to put everybody back to work.
The economy is still digging out of a hole and we've got a ways to go.
Tuesday, May 4, 2010
Wednesday, April 14, 2010
Stocks Could Keep On Rollin'
Regular readers (and clients) know that we are underweight to equities at the moment. Meaning that, if a family has a long-term objective of 60% stocks, we only have about half that exposure to stocks and stock-like assets. We made this tactical change in late 2009 when stocks moved into mildly over-valued territory.
Our view is that a collection of stocks (say, the S&P500) is inherently worth some multiple of the ability of those companies to produce earnings. In the short run, earnings are affected by all sorts of things and will spike up and down. In the longer run, the earnings of a large group of companies grows on a relatively stable path, as all the short-term fluctuations (charge-offs, one-time gains, etc.) are smoothed out. If we further adjust for inflation, we find that real earnings growth moves like a battleship -- nice and steady and relatively predictable.
Using data available on Standard & Poor's website, we find that the trailing one-year earnings of the S&P500 companies peaked in June 2007 at $85 per share. As I write, the current trailing one-year earnings are reported at about $60 per share. This is up from the bottoming-out figure of only $7 per share a year ago, and reflects the ongoing and robust recovery. A key question for us now is whether earnings are headed back to their earlier level of $85, or if they will instead now oscillate around a different level. If earnings are headed back to a steady $85, then the S&P500 is worth about 20% more than today's price. If earnings are instead going to settle in the $60 range, then the index is overvalued by about 20%. This is a critical question that can't be answered with certainty, but can be analyzed a bit to understand the probabilities.
In the chart below, the red line shows the short-term variability of earnings (click on it for a bigger view). The blue line is the 10-year trailing average; the dotted line is the trendline of the blue line. As you can see, short-term earnings have recovered right back above the 10-year average.
So, again, our question is whether "it's different this time" and earnings will escalate back to their earlier highs -- and stay there. Or, will they settle nearer to their long-term potential, as shown by the blue and dotted lines? We cannot know for sure, but we need to make a decision about portfolios. To make that decision, we look to the individual investment policies and mandates of our actual clients. Unlike institutional managers and hedge funds, who typically deal with a small slice of a client's overall wealth, we manage most of the life savings of our clients. Our mandate is not, "just go make money," it is a mandate to balance opportunities with the very real fact that this is all the money our clients have, and we cannot risk losing it.
With that mandate in mind, we choose not to make a big bet that "it's different this time" -- even though it might be. After all, earnings moved above trend for most of the 1990's, and stocks went to the moon. As we know, they then fell back to earth. Rather than make that painful and disruptive round trip, we are placing our bets conservatively. We will have to be patient if and when earnings accelerate past a sustainable level, which will surely pull stocks up with them.
Read our quarterly newsletter here for some further commentary on our current positioning.
Our view is that a collection of stocks (say, the S&P500) is inherently worth some multiple of the ability of those companies to produce earnings. In the short run, earnings are affected by all sorts of things and will spike up and down. In the longer run, the earnings of a large group of companies grows on a relatively stable path, as all the short-term fluctuations (charge-offs, one-time gains, etc.) are smoothed out. If we further adjust for inflation, we find that real earnings growth moves like a battleship -- nice and steady and relatively predictable.
Using data available on Standard & Poor's website, we find that the trailing one-year earnings of the S&P500 companies peaked in June 2007 at $85 per share. As I write, the current trailing one-year earnings are reported at about $60 per share. This is up from the bottoming-out figure of only $7 per share a year ago, and reflects the ongoing and robust recovery. A key question for us now is whether earnings are headed back to their earlier level of $85, or if they will instead now oscillate around a different level. If earnings are headed back to a steady $85, then the S&P500 is worth about 20% more than today's price. If earnings are instead going to settle in the $60 range, then the index is overvalued by about 20%. This is a critical question that can't be answered with certainty, but can be analyzed a bit to understand the probabilities.
In the chart below, the red line shows the short-term variability of earnings (click on it for a bigger view). The blue line is the 10-year trailing average; the dotted line is the trendline of the blue line. As you can see, short-term earnings have recovered right back above the 10-year average.
So, again, our question is whether "it's different this time" and earnings will escalate back to their earlier highs -- and stay there. Or, will they settle nearer to their long-term potential, as shown by the blue and dotted lines? We cannot know for sure, but we need to make a decision about portfolios. To make that decision, we look to the individual investment policies and mandates of our actual clients. Unlike institutional managers and hedge funds, who typically deal with a small slice of a client's overall wealth, we manage most of the life savings of our clients. Our mandate is not, "just go make money," it is a mandate to balance opportunities with the very real fact that this is all the money our clients have, and we cannot risk losing it.
With that mandate in mind, we choose not to make a big bet that "it's different this time" -- even though it might be. After all, earnings moved above trend for most of the 1990's, and stocks went to the moon. As we know, they then fell back to earth. Rather than make that painful and disruptive round trip, we are placing our bets conservatively. We will have to be patient if and when earnings accelerate past a sustainable level, which will surely pull stocks up with them.
Read our quarterly newsletter here for some further commentary on our current positioning.
Thursday, February 25, 2010
Greece, Default and Insurable Interests
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.
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 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.
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