Friday, May 29, 2015

Jim Grant Takes On Risk Parity, Ray Dalio, And Cliff Asness

The hedge fund industry has become increasingly concentrated in just a handful of funds, with Bridgewater Associates and AQR Capital Management leading the pack. But the latest issue of Grant’s Interest Rate Observer argues that while the risk parity portfolio championed by Ray Dalio and Cliff Asness has done well in recent years it is now past its prime and can’t continue to perform indefinitely.

“Dalio and Asness are, of course, formidable Wall Street thinkers and doers. Formidable, too, are the critics, who include Paul Singer maĆ®tre d’hotel of Elliott Management and Ben Inker, co-head of GMO’s asset allocation department. We stand with the critics,” Grant writes.

Using leverage to achieve risk parity, then get aggressive

The basic idea is that equities provide the majority of returns for a typical 60/40 portfolio, but they also make up as much as 90% of the portfolio’s risk (in the sense of volatility). Risk parity, as the name implies, allocates risk equally between stocks and bonds (possibly adding other asset classes to the mix), using leverage to even things out. Once the base portfolio is put together, you can lever the entire thing to the level of risk you’re comfortable with and get a better Sharpe ratio than the 60/40 portfolio would have given you. As a practical matter, that means you’re going to end up buying a lot of bonds on leverage.
But leverage makes portfolios riskier in a way that isn’t well captured by volatility. When the market sours on some stock, or industry, or asset class (like nearly every credit instrument in 2008), an unlevered investor can choose to ride out the low and wait for his position to recover. It might not, and getting out is often the right decision, but a leveraged investor can be forced to sell and realize losses even when he expects the assets to rebound in a few years. Asness has said that investors should have a plan to shed leverage as losses pile up and then take leverage back on at the market bottom, but market timing is by no means easy to do and investors’ plans to protect themselves don’t always work out.
Screenshot_109 (1)
Negative skew to asset returns exacerbates the path dependence problem. If you lever up to buy corporate credit, for example, then your gains will come gradually in the form of interest payments, but your losses can come swiftly in the form of defaults. Even if the long-term average would put you ahead, the loss of principle caused by a levered position collapsing can prevent you from taking part in the long-term.

Treasury yields have more room above than below

Grant objects that risk parity ignores the ‘loss of principal’ sense of risk that clients often care about, and that it doesn’t pay enough attention to underlying value. But he also just doesn’t see any asset classes that are so attractive you would want to lever up to buy them. Backtesting shows risk parity outperforming 60/40 portfolios, but the last 30+ years in particular have been great for anyone loading up on bonds. Even if you don’t want to try to time the market it’s clear that yields have a lot more room to move up than down, so even Treasuries (with no chance of default) look negatively skewed in the current environment. A sudden spike in rates may not seem likely, but it’s more likely than a sudden plummet from current levels.

Tuesday, May 26, 2015

A Dozen Things I’ve Learned about Value Investing from Jean Marie Eveillard

Jean-Marie Eveillard “started his career in 1962 with Societe Generale until relocating to the United States in 1968. Two years later, Mr. Eveillard began as an analyst with the SoGen International Fund. In 1979, he was appointed as the portfolio manager of the Fund, later named the First Eagle Global Fund. He then went on to manage the First Eagle Overseas and First Eagle Gold Funds at their inception in 1993 as well as the First Eagle U.S. Value Fund in September 2001. After managing the Funds for over 30 years, Mr. Eveillard now serves as Senior Adviser and Board Trustee to First Eagle Funds and as a Senior Vice President of Arnhold and S. Bleichroeder Advisers, LLC.”
1. “Benjamin Graham’s book The Intelligent Investor has three lessons. The first is humility, that the future is uncertain. There are people on Wall Street who will predict the Dow will be at a certain level, but that is nonsense. The second thing is that because the future is uncertain, there’s a need for caution. The third thing was especially important. Graham values the idea that securities can be more than just paper. You should try to figure out the intrinsic value of a business. In the short term, the market is a voting machine where people vote with their dollars, but in the long term, it’s a weighing machine that measures the realities of business.” 
“You need humility because you know you can be wrong, and when you admit that you stress caution by assigning a margin of safety to your investments so that you don’t overpay for them.”  
“I focused mainly on stocks that were trading at 30 to 40 percent below my intrinsic value calculations.”
This passage is a distillation of many key points about value investing. The Great Depression made Ben Graham humble as an investor. As a result of that experience he developed his value investing system. This system is only appropriate for people who can take a long term viewpoint and sometimes underperform a benchmark in the short term. Many people can’t do these things for psychological or emotional reasons, or won’t do the work required to actually understand the business underlying each security.
Value investing is not the right investing system for everyone, but it is unique in that can potentially be successfully implemented by an ordinary investor with slightly above average intelligence and a sound work ethic. The limitation of the system is that very few people actually have the full set of skills and personal attributes required to be successful in implementing the system. Value investing is simple but not easy.
As for the 30-40% discount to intrinsic value which creates the margin of safety, Matthew McLennan (one of Jean-Marie Eveillard’s colleagues at First Eagle) notes:
“We’ve typically looked to buy 70 cent dollars. I think the mental model of paying 70 cents for a business makes great sense; if the normal equity is priced for 7% returns, and you’re going for 70 cents on the dollar, you’re starting with a 10% ROI. Closing that valuation gap over five to ten years may generate a low-teens return. If it’s a great business, there’s an argument to be made, not necessarily for paying 100 cents on the dollar, but for paying 80 to 85 cents on that dollar. As Charlie Munger would say, it’s a fair price for a great business. Your time horizon’s long enough that you’re capturing less spread day one, but if the business has a drift to intrinsic value of 4-5% a year, held for a decade, you may potentially reclaim that and then some. The more patient you are, the more you’re potentially rewarded for holding good businesses.”
2. “By being a value investor you are a long-term investor. When you are a long-term investor, you accept the fact that your investment performance will lag behind that of your peers or the benchmark in the short term. And to lag is to accept in advance that you will suffer psychologically and financially. I am not saying that value investors are masochists, but you do accept in advance that your reward, if any, will come in time and that there is no immediate gratification.”
“I think one of the reasons I didn’t enjoy growth investing was because it assumes the world to be perfect and certain, which it is not! Becoming a value investor allowed me to acknowledge the fact that I am uncertain about the future.”
What Jean Marie Eveillard is talking about here is something that you either understand and embrace or you don’t.  It is also something that you are comfortable with or not. People who are not humble about their ability to predict the future or who need immediate gratification are not good candidates to be successful value investors. These people should put value investing in the “too hard” pile and move on.
3. “We don’t buy markets. We buy specific securities.” 
“An investor who buys a building or an entire corporation gives a great deal of attention to the price to be paid for the asset. So does the buyer of a car or even a bathing suit. They all seek value. What’s so different with equities? Are they just pieces of paper to be traded in and out of on the basis of psychology, sentiment, herd instinct?” 
“The search for undervalued stocks beings with the idea that stocks are not just pieces of paper that are traded in the market. Every stock represents a business, which has its own intrinsic value. To determine that value, you have to estimate what a knowledgeable buyer would be willing to pay for the business in cash. It is important to understand that intrinsic value is not an exact figure, but a range that is based on your assumptions. Because you have to revise your assumptions from time to time to reflect business and market conditions, intrinsic value fluctuates over time, and it can go up or down.”
The best value investors are people who have significant experience in business. This allows the investor to successfully answer a key question: What would a private market buyer pay in cash for the business in question? The point made by Jean Marie Eveillard about intrinsic value not being precise is important. The future is always uncertain and a future business result is not an annuity.
One other important thing about determining intrinsic value is knowing that it is not always possible to determine intrinsic value in a given case. If you can’t reliably determine intrinsic value for a specific business, just move on (put it in the “too hard” pile). In other words, the value investor will try to find another security to buy which allows them to easily determine intrinsic value. Jean Marie Eveillard is also pointing out that a fuzzy intrinsic valuation result can be OK for a value investor since the investor is protected to a significant degree by a margin of safety. First Eagle’s approach as described by Matthew McLennan is as follows:
“There’s a willingness to pay higher multiples for franchise businesses. By going in at 10x – 12x EBIT, you could get a 6%normalized free cash flow yield that can potentially grow 4-5%sustainably over time, and thus you may achieve the prospect of a double digit return. If it’s a businesses that is more Graham in nature, with no intrinsic value growth, we may be inclined to go in at 6x – 7x EBIT, where we get our potential return through a low double digit normalized earnings yield.”
4. “We invest, if in the end we think we understand the business, we think we like the business and we think the investors are mispricing the business.”  
“We try to determine what a knowledgeable buyer expecting a reasonable return would be willing to pay today, in cash, for the entire business. Our approach requires us to understand the business – its strengths and weaknesses – rather than just the numbers. As investors have learned, the numbers can’t always be trusted.” 
“Buffett says that value investors are not hostile to growth. Buffett says that value and growth are joined at the hip – value investors just want profitable growth and they don’t want to pay outrageous prices for future growth because, as Graham said, the future is uncertain.” 
As Howard Marks points out, investing is “the search for mistakes by other investors.” Sometimes a security is offered for sale at a bargain price that represents a 30% discount to the intrinsic value of the business. This will happen rarely, but when it does there will often be several opportunities available at the same time. In other words, the arrival of opportunities for value investors will tend to be lumpy.
5. “If one is wrong in judging a company to have a sustainable competitive advantage, the investment results can be disastrous.” 
A “sustainable competitive advantage” is another name for a “moat.”  Sometimes even the best value investors fail to see that the business has no moat or that the moat is about to disappear. For example, Warren Buffett found in buying Dexter Shoes that “What I had assessed as durable competitive advantage vanished within a few years.”  Warren Buffett also thought the UK retailer Tesco had a moat at one point. Other investors thought at an inopportune time that Kodak had a moat, or Blackberry or Nortel. Without a moat a business has no pricing power. 0Matthew McLennan of First Eagle puts it this way:
“Unfortunately, asset-intensive businesses often lack pricing power. What sometimes occurs is a need to reinvest during a time of weak pricing power, and this results in balance sheet deterioration and reduced earnings power. Also, asset-intensive businesses tend to have longer tail assets. With those come management teams that promote their desire to reinvest and grow the business. As a result, there’s less return of capital.”
6. “Value investing is a big tent that accommodates many different people. At one end of the tent there is Ben Graham, and at the other end of the tent there is Warren Buffett, who worked with Graham and then went out on his own and made adjustments to the teachings of Ben Graham.”  
“Over the past almost 30 years, we have sort of floated between Ben Graham and Buffett. We began with the Graham approach which is somewhat static and less potentially rewarding than the Buffett approach, but less time consuming. So as we staffed up, we moved more to the Buffett approach, although not without trepidation because the Buffett approach – yes, you can get the numbers right, but there is also a major qualitative side to the Buffett approach.”
“Having more people allowed us to spend a lot of time trying to find out the major characteristics of businesses and their sustainable competitive advantage – what Buffett calls a ‘business moat.’”
There are many ways to be a value investor as long as the four bedrock principles of value investing are adhered to – 1. a security is partial stake in a business, 2. margin of safety, 3. Mr. Market is your master and not your servant, 4. be rational. Value investing styles can vary when it comes to issues like the level of diversification, whether quality of the business is taken into consideration, and the amount of the margin of safety. Some value investors diversify their investments more than Warren Buffett. Other value investors are numbers-driven cigar-butt investors who do not consider the quality of the business. Other value investors are “focus investors” (they concentrate holdings rather than diversify) and do consider quality of the company in question.
7. “I have a great belief that everything is cyclical in life, particularly in the investment world. Value investors are bottom-up investors. But when we establish intrinsic values and update them, we do not assume eternal prosperity but accept that there is a business cycle.”
Other people I have written about in this series like Howard Marks , Fred Wilson, and Bill Gurley also believe that cycles are inevitable in all types of businesses.  That cycles are inevitable does not mean that their timing is predictable with certainty.
8. “I think the secret of success of most value investors is that when times became difficult they stuck to their guns and did not capitulate.”
It is easy to talk about being “greedy when others are fearful and fearful when others are greedy,” but actually doing so is harder than people imagine. It is warm and comforting for many people to sit inside a herd. Being genuinely contrarian is a lonely thing to do at times. Especially when fear of missing out is strong, people can do nutty things.
9. “Both closet indexing and shooting for the stars are exposing financial planners’ clients to undue risk. Both are a result of benchmark tyranny.” 
“The knock on diversified funds is that they’re index-huggers, which given the geographic breadth of where we invest, is not at all the case for us. I know the argument that you should only own your best 30 or 40 ideas, but I’ve never proven over time that I actually know in advance what those are.”
“I think a concentrated portfolio is more of a bull market phenomenon. In a bear market, if you are too concentrated, you never know what can happen to your stocks. Some people have asked me whether I just invest in my best ideas, but the truth is that I don’t know in advance what my best ideas will be, so I’d rather diversify. Besides, the beauty of our global fund was that we could invest internationally, which helped to minimize country-specific risks. With that in mind, I am not saying that you should diversify the portfolio to the extent of creating a quasi-market index.” 
“How come we don’t have more concentrated portfolio? Number one, because I’m not as smart as Warren Buffett. And number two, because truly, people say, “Well, why don’t you just invest in your best ideas?” But I don’t know in advance what will turn out to be my best ideas. So, that’s why we’re diversified.” 
Some value investors own only six stocks, some 30 and some hundreds. The degree of diversification an investor uses is a choice that fits within value investing as long as it does not rise to the level of closet indexing (“index huggers”). Charlie Munger points out that “[With] closet indexing, you’re paying a manager a fortune and he has 85% of his assets invested parallel to the indexes.  If you have such a system, you’re being played for a sucker.”
10. “By definition there are two characteristics to borrowing. Number one: borrowing works both ways. So you are compromising the idea of margin of safety if you borrow. Number two: borrowing reduces your staying power. As I said, if you are a value investor, you are a long term investor, so you want to have staying power.”
You can’t stay invested and participate in rising markets caused by a growing economy if you are out of the process since leverage has wiped out your equity stake. Howard Marks says: “Leverage magnifies outcomes, but doesn’t add value.”  Charlie Munger has said: “I’ve seen more people fail because of liquor and leverage – leverage being borrowed money.” Montier adds: “Leverage can’t ever turn a bad investment good, but it can turn a good investment bad.  When you are leveraged you can run into volatility that impairs your ability to stay in an investment or investing in general which can result in “a permanent loss of capital.”
11. “Sometimes in life, it’s not just about what we buy, but what we don’t buy.” 
“A value investor doesn’t need to be constantly in touch with every security in every market in the world.”
This is consistent with Charlie Munger’s idea that instead of focusing all your energy on trying to be smart, a person should also focus on not being dumb.  It is important to have a “too hard pile” and to limit decisions to areas in which we are competent. By focusing your research on a smaller number of businesses that fall within your circle of competence you can do a better job on your research. Risk goes down when you know what you are doing.
12. “Contrary to many mutual fund managers, we do not believe we have to be fully invested 100% of the time.”
“Our cash balance is purely a residual of whether or not we’re finding enough to invest in.”
Some people think that because value investors tend to have cash to invest when markets are near bottom, value investor are “timing” markets. Value investors tend to have cash near market bottoms since they stop buying securities when markets are near the top of the cycle due to individual company valuations that do not provide a margin of safety.  If a value investor focuses on the micro aspect of individual businesses on a bottoms up basis, the macro tends to take care of itself. Matthew McLennan of First Eagle said recently: “We had our greatest cash levels in early 2009, not because we correctly timed the market bottom.”  Value, not price determines how much cash a genuine value investor has in the portfolio at any given time since that cash is a residual of a disciplined buying process.
Notes:
Staying Power: Jean-Marie Eveillard – Graham And Doddsville  http://www.grahamanddoddsville.net/…/an_interview_with_jeanmarie_eveillar …

GMO's James Montier: Bernanke and Yellen don't understand how the economy works

In this era of unprecedented, global monetary stimulus, markets hang on every word central bankers utter.
Central bankers, however, are less interested in financial markets. If you ask Janet Yellen, for instance, she’d say that the stock market is one “transmission mechanism” through which monetary policy affects the real economy. Yes, low interest rates will indirectly lead to higher stock valuations, but the central bank’s real aim is to simulate the real economy by encouraging businesses to invest and consumers to spend.
James Montier of the investment management firm GMO, however, argues that central bank policy never makes it to the real economy. In a paper published this week, Montier argues that the economics and investment communities “idolatry” of interest rates is the “greatest con ever perpetrated.” Writes Montier:
There seems to be a perception that central bankers are gods (or at the very least minor deities in some twisted economic pantheon). Coupled with this deification of central bankers is a faith that interest rates are a panacea. Whatever the problem, interest rates can solve it. Inflation too high, simply raise interest rates. Economy too weak, then lower interest rates . . . This obsession with interest rates as a cure-all rests on some dubious views about the way the world works. First, is an interest rate cut expansionary or contractionary with respect to spending? Those who believe interest rates are an effective tool clearly believe a rate cut is expansionary because it reduces the cost of financing and then stimulates demand (via investment, consumption, and/or net exports). This emphasises the obvious but oft unspoken truth that monetary policy works via the debt channel (or reducing savings, which is the same thing as increasing leverage).
Montier argues that, actually, interest rates have very little bearing on corporate and individual investment and consumption decisions. Take a look at the following charts. The first shows that corporate investment is generally financed with internal funds, rather than debt:
Screen Shot 2015-05-21 at 1.16.12 PM
Here’s another showing interest rates over time, combined with surveys showing “internal hurdle rates” for investment projects. Regardless of where interest rates are, companies generally require a 15% rate of return when embarking on a new investment:
Screen Shot 2015-05-21 at 1.20.16 PM
Finally, Montier argues that there isn’t a strong correlation between household savings rates and interest rates:
Screen Shot 2015-05-21 at 1.43.55 PM
“It would appear that monetary policy isn’t the most effective tool for managing the economy,” Montier writes. “I am well aware that almost everyone reading this is likely to disagree: that is the nature of the greatest con ever perpetuated.”
Montier argues that fiscal policy is the only way for the government to meaningfully manage the economy, but it is ignored for “political rather than economic” reasons. He postulates that business groups are wary of the idea that direct government spending could support employment or play too large a role in the economy, because that require the business community to relinquish power.
Economist and New York Times columnist Paul Krugman took umbrage with Montier’s analysis, despite the fact that these two seem to agree on Montier’s larger point that government spending should play a bigger role in propping up the economy. But Montier lumped Krugman in along with economists like Ben Bernanke and Janet Yellen who place too much faith in the power of monetary policy to manage the economy. Krugman struck back in a blog post, arguing that while interest rates may not affect business investment, they do have a major effect on housing:
Screen Shot 2015-05-21 at 4.41.22 PM

Krugman points to the strong correlation between housing construction and interest rates. Housing is a long-term investment in which the cost of money adds up to quite a lot over time. That’s a lot different than, say, a company’s decision to invest in smartphones for its employees.
So, perhaps Montier overstates his case. But it is striking to see the many ways in which monetary policy doesn’t touch the real economy. It’s been common among the economic commentariat to lament that the Fed is the only institution in Washington that has the freedom to experiment with stimulus, because of gridlock in Congress. But the Fed’s own impotence may allow it such freedom. Sure, Fed policy creates a lot of controversy. Members of Congress are known to wax apocalyptic about the effects of quantitative easing. But even the Fed itself admits that its trillions of dollars worth of bond buying has had, at best, a slightly positive effect on economic growth.
Fiscal policy on the other hand, is potent. And the American government–with its numerous checks and balances and veto points–is pretty good at preventing the wielding of power. Whether you believe more in the power of tax cuts or in infrastructure spending, changes in fiscal policy will have a powerful effect on the economy and create winners and losers. Monetary policy, on the other hand, is perhaps more like a placebo, that may help boost confidence but doesn’t come with too many unsavory side effects.

Research Affiliates: Expect Less Than 1% Per Year Over 10 Years


Is the U.S. experiencing “secular stagnation” as former Treasury Secretary Larry Summers argues, or is the cause of our economic woes a “global savings glut,” as former Fed chair Ben Bernanke has argued?
That is the key debate among economists and investment strategists today, and each view carries with it distinctly different investment implications.
Not everyone falls within one of these camps, though even GMO’s James Montier, who casts doubt on the legitimacy of both, acknowledges that most everyone else aligns with one of those two positions.
As for Research Affiliates, its May newsletter leaves no doubt where it stands on the issue: firmly in Summers’ secular stagnation camp, which is why the Newport Beach, Calif. firm’s 10-year capital market return expectations are so low.
“We currently expect about 0.7% average annual real returns over the next decade for both core U.S. bonds and core U.S. equities,” writes Shane Shepherd, the firm’s head of macro research.
The reason for the firm’s low return expectationsessentially comes down to its belief in the persistence of the negative trends slowing down the U.S. economy as opposed to Bernanke’s view that what ails the global economy is of a more temporary nature.
To Summers, inadequate aggregate demand—i.e., slower consumer spending and tepid investment—is the source of the slow economic growth and low real interest rates we have experienced since 2008, launching a period that Pimco (presciently, in Shepherd’s view) dubbed the “new normal.”
Rates must remain low under these conditions.
Indeed, according to Summers the Fed is actually constrained in its ability to lower them to the rate (called the equilibrium real interest rate) that is consistent with full employment and stable inflation—(because the Fed can only go as low as 0 in nominal terms while the current equilibrium rate is negative).
Crucially, chief among the reasons Summers provides for weak demand are trends—for example, continuing deleveraging from the housing bubble and aging demographics— that could take decades to play out. That is why Research Affiliates return expectations are low within its 10-year investment horizon.
In contrast, Ben Bernanke is more upbeat because the savings glut he views as the source of our current low growth could be ameliorated by overseas investment. Viewing the current weak growth as cyclical rather than structural, Bernanke thinks it is just a matter of time before the savings glut dissipates.
Indeed, the former Fed chair even specifies in his new Brookings blog what will trigger the new uptick in capital flows: “when the European periphery returns to growth,” he writes.
But Shepherd, who argues that conditions of secular stagnation are if anything more deeply entrenched in Europe and Japan than in the U.S., views the Bernanke position as overly optimistic.
“The secular stagnation-based outlook may seem glum, but is it any better to pin hopes for stronger U.S. growth on the economic recovery in Greece and Italy and the savings of the emerging markets?” he asks.
And no is his answer. Structural problems like slower population growth, productivity growth and deleveraging from high debt ratios “will continue to exert downward pressure on demand.”
Shepherd agrees that the global savings glut will take less time to correct, but when it does, the longer-term problems will remain, as will correspondingly low interest rates.
“We see evidence of secular stagnation continuing in the long term, and the consequent dampening of growth, as our nation’s and the developed world’s inescapable destiny,” he concludes.

Tuesday, May 19, 2015

Market Valuation

Buffett's response (at the 2015 annual meeting) to questions regarding the valuation of the stock market was interesting.  He used to just say it's in a "zone of reasonableness", but this time said that if interest rates stay at current low levels, the stock market is cheap, and if interest rates normalize, it is expensive. Well, he has been saying for a while that stocks are better than bonds.


We know there is a relationship between interest rates and stock market valuation.  Some criticized the old Fed model (10-year bond yields compared to the earnings yield of the S&P 500 index) saying that there was a correlation between the two for only a short period in history but there hasn't been a correlation between them for most of history.  This is true, but it is also true that there is a logical connection between them so we can't deny a relationship just because we can't get some charts to look convincing.

Anyway, just for fun, I decided to play around with some figures.  My goal was actually just to see what the stock market should be valued at if interest rates normalize.  I did that before, but this time I wanted to do it empirically.

One thing I don't advocate or call for is for the stock market to catch up to the bond market.  If it did, then the P/E ratio of the market would get to 50x, and that's too expensive.  At that level, even I would pound the table to get out of the market.

So first of all, we've already seen the many charts comparing bond yields to earnings yields and how they have tracked each other closely (and diverged)  in recent years.  So I decided to look at it a different way; by X-Y plotting it.  This is nothing new; strategists do this sort of thing all the time (as I used to too back in the old days).

This is the data from 1871 through the end of 2014.  The earnings yield is on the Y-axis and the 10-year bond rate is on the X-axis. (all data is based on the S&P 500 index (and predecessors for older data), ttm earnings from Shiller's website).


Earnings Yield Vs Bond Yield 1871 - 2014
        (x=bond yield, y = earnings yield)


Wow.  Looks like a raptor claw.  So the Fed model critics are right.  The R² is basically zero. But we knew that.

The two vertical clusters are from the era when interest rates were low.  The cluster to the left is when rates were around 2% and the stock market got cheap in the late 1940's and early 50's.  The second vertical cluster (or claw) was when the market swung around in 1915-1920.    Excluding those two periods, there seems to be sort of a linear relationship.

So let's see what happened since 1955:

Earnings Yield Vs Bond Yield 1955 - 2014
        (x=bond yield, y = earnings yield)

Now we see a little bit more of a clear slope, verified by the higher R² of around 0.4.

Not that different, but here it is from 1970:

Earnings Yield Vs Bond Yield 1970 - 2014
        (x=bond yield, y = earnings yield)


We can see that the stock market didn't continue down the slope as rates declined.  The dots all the way at the bottom when interest rates were between 2% to 4% and earnings yield dipped below 2% was just from the financial crisis; the E declined dramatically.

Eye-balling this chart, even if rates got back up to 6%, the stock market valuation would still be reasonable; no need for a valuation adjustment.

Just for fun, I took out the data after 2007.  Let's look at this from 1980-2007:

Earnings Yield Vs Bond Yield 1980 - 2007
        (x=bond yield, y = earnings yield)

Obviously, the  R² increases and the slope gets closer to 1 (0.8367).

So we see that stock prices are cheap at current interest rates, but the thought is that they may become expensive if interest rates "normalize".

But what does it mean for interest rates to normalize?  From the above charts, it looks like the stock market can be in the fair value range even with rates going back up to 6% or more.

What is "Normal"?
People have been calling for higher rates for years now, so I won't quote anyone's guess on where they think rates will go.  Here's a chart I used in a post a while back about valuing the stock market using interest rates.  Since noone can predict interest rates, as a proxy, I used the nominal GDP growth rate as a level where long term interest rates should eventually settle.

Here's the chart that only goes to 2012, but since it's a long data series, it doesn't matter too much:



Of course, the problem with this is that yes, nobody can predict interest rates but to use this model we need to predict GDP growth and inflation.  Economist track records there aren't much better.

But we can at least see where rates would be without the "distortion" of central banks given reasonable assumptions.

For example, I have no problem with "normal" long term real GDP growth of 2.0%, and inflation in the 2.0%-3.0% range.  That gives us a range for nominal GDP growth of 4-5%.  So interest rates too, should be around there.  I have no problem thinking of 4-5% as the level of long term interest rates in a normalized environment with no central bank manipulation of long term rates (well, there will always be some sort of activity going on, but I just mean the massive QE-type thing).

Let's go back to the above X-Y plot charts.   I am going to go back to the chart from 1955 to include more data.  Data before 1955 may not be too meaningful, plus 59 years is enough data for this.

I drew vertical lines between 4% and 6%.  My question is, what is the average earnings yield (and standard deviation) of the stock market when interest rates were in this range?  Keep in mind that this interest range is far higher than where interest rates are now.

Earnings Yield Vs Bond Yield 1955 - 2014
        (x=bond yield, y = earnings yield)


When interest rates were between 4% and 6% since 1955, the stock market traded at an average P/E of 20.4x.  If you put standard deviation bands around the cluster, the range would be 16.6x - 26.6x for one standard deviation and 14x - 37.9x for two standard deviations.

If you expand the range to 4-7% or 4-8%, then the average P/E comes down to 14x, so in that case the market would look overvalued.  But I think a lot of the vertical dot cluster in the 7-8% range is from the 1970's.  Of course, we can't assume that won't happen again.

Just for fun, let's see these figures from 1980-2014.  Some will argue that this is no good since the market has been overvalued for most of the past three decades.  But again, let's just see for fun:

             Interest rate range            average P/E
                   4 - 6%                            23.3x
                   4 - 7%                            22.7x
                   4 - 8%                            21.6x

If you do it by constant range (instead of expanding it) you get:

               Interest rate range           average P/E
                   4 - 6%                             23.3x
                   6 - 8%                             19.6x

Using data since 1980, even if rates went up to the range of 6-8%, the market would be fairly valued at 19.6x P/E.

I actually don't agree with this; I would still value the market at closer to the inverse of the bond yield; a 6-8% interest rate range would suggest P/E ratios of 13-17x.

Shorting an Overvalued Market?
So people keep saying the market is overvalued.  If you are short the market because you think it's overvalued, then you would have to think hard about it.  The above suggests that the market is not overvalued even with interest rates going up to 6%  (well, I would view it as a little overvalued with rates at 6%).  If you think the market is overvalued, then you have to think that bond yields have to go higher than 6%.  But then if that is the case, it's probably a better trade to just short the bond market.

When you say the market is overvalued, you are basically saying that interest rates are too low.  In that case, the bond market is even more overvalued than the stock market; the stock market has a big valuation cushion before rising rates start to hurt it whereas bond prices will get hit immediately.   In fact, if you believe in mean regression, then you would have to actually buy stocks and short bonds against it.

Of course, there are other reasons to be short the market, but I am just isolating this one component, valuation.

If you look at long term charts of market valuation, it looks really high and scary, but the above shows that in this environment, things are pretty normal.

If you do assume that a 1970's event is coming soon (and this view is not so uncommon), then shorting stocks and bonds might be a great idea.  But even then, you have to keep in mind that if you do short expecting a 1970's-type event, you are betting on an event that occurs very infrequently. How many interest rates spikes and inflationary events have we had in the past 100 years?

As Buffett likes to say, it's not smart to bet on low probability events.   (It's just as dumb to assume that low probability events are zero probability events!)


Conclusion
I don't know why, but I suddenly just wanted to do this.   I guess Buffett's comment made me think about market valuation again and made me wonder what "normal" interest rates are and where the market should trade in that case. Sometimes it's fun to plot some data to see what things look like.

I am more comfortable comparing bond yields and earnings yields directly as Buffett does in his discussion about market valuation (which I excerpted in length here:  Buffett on Market Valuation) without going through all of this.

From this, though, we can conclude that even if long term interest rates pop up into the 4-6% range, the stock market is still in the fair value range; the market is trading now at just about exactly the average level the market has traded at when interest rates were between 4% and 6% since 1955.

Yes, moving that range up to 7% or 8% moves the average down to a 14x P/E, but most of that vertical cluster is from the 1970's (note the lack of that cluster since 1980).  The same figures for data since 1980 shows much higher valuation levels (but maybe biased on the high side).

If we are constrained in growth as economies around the world mature, then normal interest rates may not go too far above the 4-6% range. If that's the case, the stock market looks fine.

Cliff Asness - Interview: what to do when stocks & bonds are expensive....




Goldman Sachs: Market's going nowhere for a year

CNBC Article here...

Monday, May 11, 2015

Graham & Doddsville Newsletter is out [LINK]

http://heilbrunncenter.org/sites/default/files/civicrm/persist/contribute/file/Graham%20%26%20Doddsville_Issue%2024.pdf

A History of Bond Market Corrections


It’s been almost four years since the S&P 500 has had a 10% correction. That makes it the second longest such streak since World War II, trailing only the period from 1990 to 1997 that went longer without experiencing a double digit loss.
Bonds, however, the investor’s go-to asset class for safety, have experienced two separate corrections of 10% or more in that time when looking at long-term U.S. treasury bonds. In fact, long bonds are in the midst of a correction as we speak because interest rates have finally risen over the past couple of months.
Using Ibbotson data on long-term U.S. treasuries going back 1926*, I looked back at the historical corrections to see how often they experienced double digit losses. From 1926-1957 there were actually none, but they did come close a few times:
  • -9% in 1931
  • -8% in 1939
  • -8% in 1951-1953
  • -9% in 1954-1957
It wasn’t until 1958 that a double digit correction finally took place in long-term treasuries. Here are each of the drawdowns since then:
LT Treas Losses
Roughly one out of every five years there has been a double digit correction in the long bond with an average loss of almost 14%. Another was to look at it this is that over 40% of all double digit bond market losses have come since 2003 alone. Why is this the case? It could be that investors are losing patience and trading more often, increasing short-term volatility in a long-term asset. Or it could be that bond market volatility picks when interest rates are lower, especially in long maturity bonds. It’s probably a little of both.
But why were there no large corrections in the 1926-1957 time frame?
I reached out a reader who’s my resident market historian to ask for his take on the pre-World War II lack of large losses in treasuries. Here’s what he had to say:
My understanding is that until the mid-1950s, Treasuries were much less volatile than they have been since then. From 1942-1951 long bonds were pegged by the Fed at around 2.25% yield. But before then, during 1926-1941, Treasuries just didn’t react very much to bubbles and crashes in stocks. Apparently under the gold standard, bond investors regarded long-term prices as stable, and took little heed of short-term economic and price trends.
Even though these are long-term assets, it seems that there are now more momentum investors and macro traders than ever trying to play this space. The chase for yield has also caused many investors to increase the duration in their bond holdings to earn more income. The current state of interest rates doesn’t necessarily means bonds are in a bubble as many presume, but it does mean losses are more likely to occur than they have in the past.
If you’re invested in longer maturity bonds you have to understand the risks involved. All else equal, volatility in bond prices from interest rate moves is higher the longer you go out on the maturity and duration spectrum and the lower the level of interest rates.
For example, the duration of the iShares 20+ Year Treasury Bond ETF (TLT) is currently 17.1 while the duration for 7-10 Year ETF (IEF) is only 7.6. This means you could expect a 1% rise in interest rates to lead to something approaching a 17.1% decline in TLT prices, but just a 7.6% fall in the IEF price (this doesn’t include the income earned on these funds).
None of these historical drawdowns come close to matching the worst historical bear markets in stocks, but they’re probably larger than most bond investors would care to sit through.
It’s worth remembering that a higher yield can lead to higher risk.

The trend is no longer your friend

There Have Been Some Big, Mysterious Moves in Markets Lately

It has been a busy period in markets across the globe, with trends (and trades) breaking down everywhere.

The U.S. dollar has been weakening.
Euro-area sovereign debt has been selling off, causing yields to rise.
Asian stocks, which have been in a bull market for years, have been feeling the pressure, with the Shanghai Composite Index closing lower in the last couple of sessions.
Meanwhile, oil has been rallying, with WTI crude moving above $62 on Wednesday morning.
Copper, long considered a bellwether for the global economy, has been surging higherrecently.
There doesn't seem to be any single driver that would explain all of these moves, though plenty of analysts are pointing to the unwinding of consensus positions such as trades built around the expectation of continued deflation and quantitative easing in Europe. Others have highlighted more technical factors and illiquid markets that have amplified  the moves.
Whatever the reason, the recent seismic activity in these markets has, no doubt, been painful for some big investors. 

Lunch is for wimps

Lunch is for wimps
It's not a question of enough, pal. It's a zero sum game, somebody wins, somebody loses. Money itself isn't lost or made, it's simply transferred from one perception to another.