Friday, April 30, 2010
If you’re wondering when the Fed will move, it is useful to look at the yield curve. This chart from CitiFX, dubbed “the best interest rate chart in the world”, shows the yield curve for the past 25 years by looking at the yield differential between the 5 and 2 year US Treasury yield:
The six major inflection points correspond to major turning points for the economy and the equity markets. The inverted yield curves occurred in:
- 1989: Almost immediately the Fed started an easing cycle (from 9.75% to 3%)
- 2000: Within about 2 months the Fed started on a sharp easing cycle (from 7% to 1%)
- 2006: The Fed dragged its feet, easing in August 2007 (from 6.25% to basically zero)
- 1992: The Fed started tightening in early 1994 (from 3% to 5.75%)
- 2003: The Fed waited until June 2004 to start tightening (from 2% to 6.25%)
- 2010: With the steepest yield curve on the records, the Fed continues to stand aside.
Another way to look at this is to consider the 5 year US Treasury bond yield relative to the 2 year bond yield (that is the ratio of the two). This also shows a similar picture with the yield curve once again turning down from an extremely accommodative position.
Click graph to see a larger version in a new window:
You can see the complete report here. But remember that even when the Fed inevitably does start to raise interest rates, that is not necessarily a death-knell for stocks.
AllAboutAlpha.com touched on this in our “Dazed and Confused ” piece last week, highlighting a recently updated survey from Ernst & Young showing that more than half of hedge fund professionals have either already made changes or plan to make changes to their redemption terms and / or fees. And we’ve certainly covered it in the past (click here  for a recent newsreel of “fee”-related articles on AllAboutAlpha.com)
In a case of great timing, the Alternative Investment Management Association’s Canada chapter  last week hosted its annual parliamentary-style debate, with this year’s focus being whether hedge funds are worth the price. Arguing in favor (the government) was Jim McGovern, founder and CEO of fund of hedge fund firm Arrow Hedge Partners. And arguing against (the opposition) was Som Seif, founder and CEO of ETF firm Claymore Investments. (Click here  for Jim’s slide presentation, and here  for Som’s).
The expected fireworks did not disappoint. In a room heavily populated with those either directly or indirectly dependent on hedge fund fees to earn a living, the debate focused on whether the actual 2 and 20 structure of hedge fund fees – long accepted as the norm – are truly reflective of performance, or whether they are a cash grab that awards managers based on the level of assets they oversee.
McGovern came out swinging, noting that the “correct” incentive structure – i.e. the one all hedge funds currently utilize – leads to better results.
“Incentive fees are a critical part of compensation, and obviously, very motivating,” he said. In other words, hedge fund fees are justified by the fact that they produce higher returns and lower volatility than equities. He pointed to the chart below showing the drawdown for hedge funds between 2007 and 2009 was far less than for equities.
Indeed, in years when hedge funds failed to produce positive returns, such as 1998 and 2008, McGovern pointed out that the losses incurred by hedge funds were less severe than those incurred by equity markets – in particular noting that hedge funds did not get paid on the performance side of the equation during those down years.
A gentleman all the way, Seif chose not to argue what many present for the debate had expected: that hedge fund returns, and hence alpha, can be replicated at a fraction of the cost, say, in an ETF. Rather, Seif argued the industry as a whole should adopt a fee structure that more effectively ties managers’ compensation to the performance of their funds.
“There has been an enormous influx of capital into the hedge fund industry,” he said. “It all but guarantees that hedge fund pay in the coming years will not be as closely tied to performance as it has been in the past.”
To illustrate his points, Seif utilized this chart showing returns versus performance for single-manager funds over 12-24 months. What the chart demonstrates is a fairly solid correlation between fees and returns.
Both agreed that hedge fund managers who produce alpha deserve to be compensated for their skill. Said Seif: “The better you are, the more assets you should have and the higher your fees should be.”
Alas, Seif did not win the debate. As duly noted by the “stacked” audience, it is difficult to defeat an issue close at heart to the government, particularly so when the government has a significant majority.
Monday, April 19, 2010
What we see is that as of the data we have through 16 April 2010, stock prices have nearly closed the loop they've made with respect to the market's trailing year dividends per share.
What's more, since we are now observing the bottoming of the stock market's trailing year dividends per share, the conditions under which orderly growth can occur in the stock market will soon emerge. Those conditions require that the market's trailing year dividends per share grow in value over time as a basic requirement to allow orderly growth to occur.
At present, the data indicates the earliest that might occur approximately around June 2010.
Unfortunately, we don't yet know how long such a period might exist, since the dividend futures data that we use to create our forecasts only extends through the fourth quarter of 2010, at least as of this writing.
What we find more remarkable in the chart however is that whatever new period of order might soon emerge will do so from a level that would fall along the average projection curve defining the previous period of order in the market.
We saw this phenomenon before with the Dot-Com Bubble, where orderly growth resumed in the market after the disruptive event of the bubble concluded almost precisely at the average price level where it would have been placed by the market's trailing year dividends per share as defined by the market's previous period of order. Here, during the period from April 1997 through June 2003, the market first soared above that projected trajectory, then plummeted below it, before finally climbing back to it and embarking on a new stable trajectory. That period of order then held until December 2007.
Now, with positive trailing year dividend growth set to resume in the very near future, we see that phenomenon again with the stock market at this point in April 2010, with both stock prices and trailing year dividends per share approximately where they were in October 2005. And as it happens, right about at the level given by the projected trajectory for stock prices with respect to trailing year dividends per share that existed in the middle of the previous period of orderly growth.
The two observations, along with many others shown in the chart to the left, strongly suggest that the level of stock prices in the long run is nowhere near as random as might commonly be believed.
We find instead that stock prices in the long run are primarily a direct function of the value of their underlying dividends per share. In the short run, stock prices are primarily driven by changes in the expected rate of growth of the market's dividends per share. We find that noise, driven by common, randomly-timed events in the market, accounts for much of the deviation we see in both the short and long runs for the market.
If order does emerge in June 2010, the next six months will largely set the trajectory that we can reasonably expect stock prices to follow into the future. Knowing that trajectory will then allow us to project the future level of stock prices with a reasonable level of accuracy months, if not years, into the future - basically, as far as the available dividend futures data will allow us to see.
Provided, of course, that no new disruptive events occur that throw the market for another loop!
If you find yourself in need of some good landfill, go to a university library and ask for a dump truck full of research on determinants of the yield curve. You might be able to get enough to recreate the land bridge across the Bering Strait so that Alaskans can walk over to Asia and present gifts of bendable straws. What a loss it will be when publish-or-perish studies are Web-only.
The yield curve remains extraordinarily steep by any measure. As we'll see below, this is the result of artificially low short-term interest rates.
Three Strikes Are Out
Let’s use the spread between 10-Year US Treasuries and three-month LIBOR, commonly known as the liquidity premium. There was a time before the advent of TIPS when economists were content to recite Fisher’s Law that long-term rates are the sum of short-term rates plus expected inflation. This will be addressed at another time and place, but suffice it to say Fisher’s Law can't be demonstrated either backward or forward using actual data. As markets anticipate events, it's more demonstrable to say a steeper yield curve leads inflation expectations than to say inflation expectations determine the yield curve.
A second determinant of the liquidity premium, and one that operated robustly for much of the past decade, was currency volatility. As our foreign creditors were at risk to a declining dollar, they had to demand a higher long-term yield in recompense. While the economics remain sound, the data have been distorted completely and utterly by China’s re-pegging of the yuan and by the buffeting of the yen by spasmodic unwinding of the yen carry trade during each and every financial crisis.
A third determinant, mortgage prepayment risk, was shot down in flames during the I-can’t-believe-the-unemployed-guy-couldn’t-pay-his-mortgage era. Here again, the economics are sound and this may re-emerge as a factor some day.
Long-Term Treasury Volatility
The volatility of 10-year zero-coupon Treasuries remained a determinant of the liquidity premium until last July, marked on the chart below with a green line; it led the liquidity premium by 10 trading days on average. Then as volatility plunged once the market recognized the Federal Reserve wasn't going to raise rates until the Mayan Apocalypse of 2012, by which point it would not matter, the liquidity premium actually expanded.
Ten-year Treasury yields have increased by approximately 50 basis points since that time; however, three-month LIBOR has decreased by almost 20 basis points during an economic recovery. If we model the liquidity premium as a function of 10-year volatility through July 2009 and project the fitted value forward, we can see the current actual liquidity premium is almost 180 basis points greater than what we should expect.
As the shape of the yield curve is a determinant for all capital markets -- and I do mean all -- this artificially steep yield curve is causing distortions throughout the economy, including the ongoing frat party on Wall Street. Each day the distortion persists more energy is stored in the spring for the eventual unwinding.
Wednesday, April 14, 2010
Maulding: The Man Who Cries Bear
John Mauldin, former print shop professional and current perma-bear investment strategist, unfortunately seems to have taken a page from Aesop’s book by consistently crying for a market collapse. After spending many years wrongly forecasting a bear market, his dependable pessimism eventually paid dividends in 2008. Unfortunately for him, rather than reverse his downbeat outlook, he stepped on the pessimism pedal just as the equity markets have exploded upwards more than +80% from the March lows of last year. Mauldin is widely followed in part to his thoughtful pieces and intriguing contributing writers, but as some behavioral finance students have recognized, being bearish or cautious on the markets always sounds smarter than being bullish. I’m not so sure how smart Mauldin will sound if he’s wrong on the direction of the next 80% move?
The Challenged Predictor
I find it interesting that a man who freely admits to his challenged prediction capabilities continues to make bold assertive forecasts. Mauldin freely confesses in his writings about his inability to manage money and make correct market forecasts, but that hasn’t slowed down the pessimism express. Just two years ago as the financial crisis was unfolding, Mauldin admits to his poor fortune telling skills with regards to his annual forecast report each January:
“ I was wrong (as usual) about the stock markets.”
Here’s Mauldin explaining why he decided to switch from investing real money to the simulated version of investment strategy and economic analysis:
“I wanted to begin to manage money on my own… I found out as much about myself as I did about market timing. What I found out was that I did not have the emotional personality (the stomach?) to directly time the markets with someone else’s money… I simply worried too much over each move of the tape.”
Apparently timing the market is not so simple? Readers of Investing Caffeine understand my feelings about market timing (read Market Timing Treadmill piece) – it’s a waste of time. Market followers are much better off listening to investors who have successfully navigated a wide variety of market cycles (see Investing Caffeine Profiles), rather than strategists who are constantly changing positions like a flag in the wind. I wonder why you never hear Warren Buffett ever make a market prediction or throw out a price target on the Dow Jones or S&P 500 indexes? Maybe buying good businesses or investments at good prices, and owning them for longer than a nanosecond is a strategy that can actually work? Sure seems to work for him over the last few years.
When You’re Wrong
Typically a strategist utilizes two approaches when they are wrong:
1) Convert to Current Consensus: Most strategists change their opinion to match the current consensus thinking. Or as Mauldin described last year, “I expect that this year will bring a few surprises that will cause me to change my opinions yet again. When the facts change, I will try and change with them.” The only problem is…the facts change every day (see also Nouriel Roubini).
2) Push Prediction Out: The other technique is to ignore the forecasting mistake and merely push out the timing (see also Peter Schiff). A simple example would be of Mr. Mauldin extending his recession prediction made last April, “We are going to pay for that with a likely dip back into a recession in 2010,” to his current view made a few weeks ago, “I put the odds of a double-dip recession in 2011 at better than 50-50.”
More Mauldin Mistake Magic
Well maybe I’m just being overly critical, or distorting the facts? Let’s take a look at some excerpts from Mauldin’s writings:
A. January 10, 2009 (S&P @ 890):
Prediction: “I now think we will be in recession through at least 2009 before we begin a recovery….We could see a tradable rally in the next few months, but at the very least test the lows this summer, if not set new lows….It takes a lot of buying to make a bull market. It only takes an absence of buying to make a bear market.”
Outcome: S&P 500 today at 1,179, up +32%. Oops, maybe the timing of his recovery forecast was a little off?
B. February 14, 2009 (S&P @ 827):
Prediction/Advice: “Let me reiterate my continued warning: this is not a market you want to buy and hold from today’s level. This is just far too precarious an economic and earnings environment.”
Outcome: S&P 500 up +45%. You pay a cherry price for certainty and consensus.
C. April 10, 2009 (S&P @ 856):
Prediction: “All in all, the next few years are going to be a very difficult environment for corporate earnings. To think we are headed back to the halcyon years of 2004-06 is not very realistic. And if you expect a major bull market to develop in this climate, you are not paying attention.” On the economy he adds, “We are going to pay for that with a likely dip back into a recession in 2010.” (S&P +40% since then with the economy currently in recovery).
Outcome: S&P 500 up +38%. Interestingly, his comments on corporate earnings in February 2009 referenced an estimate of $55 in S&P 2010. Now that we are 14 months closer to the end of 2010, not only is the consensus estimate much firmer, but the 2010 S&P estimate presently stands at approximately $75 today, about +36% higher than Mauldin was anticipating last year.
D. May 2, 2009 (S&P @ 878):
Prediction: “This rally has all the earmarks of a major short squeeze. ..When the short squeeze is over, the buying will stop and the market will drop. Remember, it takes buying and lot of it to move a market up but only a lack of buying to create a bear market.”
Outcome: S&P 500 up +36%.
Now that we have entered a new year and experienced an +80% move in the market, certainly Mauldin must feel a little more comfortable about the current environment? Apparently not.
E. April 2, 2010 (S&P @ 1178):
Prediction: “ I think it is very possible we’ll see another lost decade for stocks in the US. If we do have a recession next year, the world markets are likely to fall in sympathy with ours.”
Previous Mauldin Gems
Here are few more gloomy gems from Mauldin’s bearish toolbox of yester-year:
2005: “The market is a sideways to down market, with the risk to the downside as we get toward the end of the year and a possible recession on the horizon in 2006. And not to put too fine a point on it, I still think we are in a long term secular bear market.” Reality: S&P 500 up +5% for the year and up a few more years after that.
2006: “This year I think the market actually ends the year down, and by at least 10% or more during the year. Reality: S&P 500 up +14% (excluding dividends).
2007: Mauldin’s rhetoric was tamed in light of poor predictions, so rhetoric switches to a “Goldilocks recession” and a mere -10-20% range correction. He goes on to dismiss a deep bear market, “In future letters we will look at why a deep (the 40% plus that is typical in recession) stock market bear is not as likely.” Reality: S&P 500 up +5%. Looks like the writing on the wall for 2008 turned out a bit worse than he expected.
2008: Sticking to soft landing outlook Mauldin states, “I think this will be a mild recession … I don’t think we are looking at anything close to the bear market of 2000-2001.” Uggh. Ultimately, the bear market turned out to be the worst market since 1973-1974 – his prediction was just off by a few decades. Reality: S&P 500 down -37%.
Lessons Learned from Market Strategists
I certainly don’t mean to demonize John Mauldin because his writings are indeed very thoughtful, interesting and include provocative financial topics. But put in the wrong hands, his opinions (and dozens of other strategists’ views) can be extremely dangerous for the average investor trying to follow the ever-changing judgments of so-called expert strategists. To Mauldin’s credit, his writings are archived publicly for everyone to sift through – unfortunately the media and many average investors have short memories and do not take the time to hold strategists accountable for their false predictions. Although, Iike Warren Buffett, I do not make market timing predictions or forecast short-term market trends, I see no problem in strategists making bold or inaccurate forecasts, as long as they are held responsible. Every investor makes mistakes, unfortunately, strategist predictions are usually not readily available for analysis, unlike tangible investment manager performance numbers. When forecasting lightning strikes and extreme bets win, every newspaper, radio show, and media outlet has no problem of placing these soothsayers on a pedestal. Thanks to the law of large numbers and the constantly shifting markets, there will always be a few outliers making correct calls on bold predictions. Who knows, maybe Mauldin will be the next CNBC guru du jour in the future for predicting another lost decade of equity market performance (see Lost Decade article)?
Regardless of your views on the market, the next time you hear a financial strategist make a bold forecast, like John Mauldin crying wolf, I urge you to not go running with the motivation to alter your investment portfolio. I suppose the time to become frightened and drive the REAL wolf (bear market) away will occur when consistently pessimistic strategists like Mauldin turn more optimistic. Until then, tread lightly when it comes to acting on financial market forecasts and stick to listening to long-term, successful investors that have invested their own money through all types of market cycles.
Along with his sons, Jerry Murrell of Five Guys Burgers and Fries built a 570-store chain that enjoys a cult following.
The Real Deal His restaurants are Spartan. And Jerry Murrell never advertises. Instead, he prefers to spend on worker bonuses and fresh ingredients.
Sell a really good, juicy burger on a fresh bun. Make perfect French fries. Don't cut corners. That's been the business plan since Jerry Murrell and his sons opened their first burger joint in 1986. When they began selling franchises in 2002, the family had just five stores in northern Virginia. Today, there are 570 stores across the U.S. and Canada, with 2009 sales of $483 million. Overseeing the opening of about four new restaurants a week, the Murrells are proof that flipping burgers doesn't have to be a dead-end job.
There was this little hamburger place where I grew up in northern Michigan. Almost everyone in our town, except the uppity uppities, ate the burgers. Even though the owner had a cat, which he'd pet while cooking. People called them fur burgers, but they still ate them because they were good.
I studied economics at Michigan State. I had no money and needed a place to stay, so I ran a fraternity house's kitchen. I got the cook a raise and let her do the ordering. We started making money, because she knew what she was doing.
My parents died my last year in college. I married, had three kids, divorced, then remarried. I moved to northern Virginia and was selling stocks and bonds. My two eldest sons, Matt and Jim, said they did not want to go to college. I supported them 100 percent.
Instead, we used their college tuition to open a burger joint. Ocean City had 50 places selling boardwalk fries, but only one place always has a 150-foot line -- Thrashers. They serve nothing but fries, but they cook them right -- high-quality potato, peanut oil. That impressed me. I thought a good hamburger-and-fry place could make it, so we started with a takeout shop in Arlington, Virginia.
Our lawyer said, "You need a name." I had four sons -- Matt, Jim, Chad are from my first marriage, and Ben from my second to Janie, who has run our books from Day One. So I said, "How about Five Guys?" Then we had Tyler, our youngest son, so I'm out! Matt and Jim travel the country visiting stores, Chad oversees training, Ben selects the franchisees, and Tyler runs the bakery.
Three days before we opened, I was still working as a trader in stocks and bonds and was in a hotel for a meeting in Pittsburgh. I found a book in the nightstand, next to the Bible, about JW Marriott -- he had an A&W stand that he converted and built into the Hot Shoppes chain. He said, Anyone can make money in the food business as long as you have a good product, reasonable price, and a clean place. That made sense to me.
We figure our best salesman is our customer. Treat that person right, he'll walk out the door and sell for you. From the beginning, I wanted people to know that we put all our money into the food. That's why the décor is so simple -- red and white tiles. We don't spend our money on décor. Or on guys in chicken suits. But we'll go overboard on food.
Most of our potatoes come from Idaho -- about 8 percent of the Idaho baking potato crop. We try to get our potatoes grown north of the 42nd parallel, which is a pain in the neck. Potatoes are like oak trees -- the slower they grow, the more solid they are. We like northern potatoes, because they grow in the daytime when it is warm, but then they stop at night when it cools down. It would be a lot easier and cheaper if we got a California or Florida potato.
Most fast-food restaurants serve dehydrated frozen fries -- that's because if there's water in the potato, it splashes when it hits the oil. We actually soak our fries in water. When we prefry them, the water boils, forcing steam out of the fry, and a seal is formed so that when they get fried a second time, they don't absorb any oil -- and they're not greasy.
The magic to our hamburgers is quality control. We toast our buns on a grill -- a bun toaster is faster, cheaper, and toasts more evenly, but it doesn't give you that caramelized taste. Our beef is 80 percent lean, never frozen, and our plants are so clean, you could eat off the floor. The burgers are made to order -- you can choose from 17 toppings. That's why we can't do drive-throughs -- it takes too long. We had a sign: "If you're in a hurry, there are a lot of really good hamburger places within a short distance from here." People thought I was nuts. But the customers appreciated it.
We have never solicited reviews. That's a policy. Yet we have hundreds of them. If we put one frozen thing in our restaurant, we'd be done. That's why we won't do milk shakes. For years, people have been asking for them! But we'd have to do real ice cream and real milk.
When we first opened, the Pentagon called and said, "We want 15 hamburgers; what time can you deliver?" I said, "What time can you pick them up? We don't deliver." There was an admiral running the place. So he called me up personally and said, "Mr. Murrell, everyone delivers food to the Pentagon." Matt and I got a 22-foot-long banner that said ABSOLUTELY NO DELIVERY and hung it in front of our store. And then our business from the Pentagon picked up.
When we first started, people asked for coffee. We thought, Why not? This was our first lesson in humility. We served coffee, but the problem was that the young kids working for us don't know anything about coffee. It was terrible! So we stopped serving coffee. We tried a chicken sandwich once, but that did not work, either. We do have hot dogs on our menu, and that works. But other than that, all you are going to get from Five Guys is hamburgers and fries.
Our food prices fluctuate. We do not base our price on anything but margins. We raise our prices to reflect whatever our food costs are. So if the mayonnaise guy triples his price, we pay triple for the mayonnaise! And then we'll increase the price of our product. About five years ago, hurricanes killed the tomato crop in Florida, and prices went from $17 to $50 a case. So a few of my franchisees called and said, "We're not using tomatoes. The prices are too high." I suggested using one slice instead of two. My kids were furious: "It should be two! Always!" They were right -- it's too easy to start slipping down that slope. We stuck with two slices, and so did our franchisees.
My kids wanted to franchise from the start, because we couldn't get the money to expand on our own. Opening a store costs $300,000 to $400,000. Banks won't help. They thought we were crazy going up against Burger King, McDonald's.
I was dead set against franchising. I didn't think we'd be able to control the quality. That worried the heck out of me. They pulled me into it kicking and screaming. At that point, we had five stores in the northern Virginia region.
When we started to sell franchises in 2002, Virginia went in three days. We accept only financially sound franchisees who can weather the storms without the help of banks.
We make 6 percent of sales on the franchises. All franchises work the same way: People say they want to sell your product. So you give them a Franchise Development Agreement that explains all the ways we can beat them down. I don't know if I would ever sign it. We can get out of the deal a million ways, but they are stuck.
Still, we have never had a franchisee go legal on us. I think that's because we have an independent franchise committee that meets once a quarter. People said, "Don't do it! They'll form a union!" But we thought, If someone comes in with a wacky idea, instead of the Murrells putting it down, the other franchisees would say, "That's a dumb idea."
Franchisees are opening four new stores a week. But we always wanted to run more than our franchisees, so we can say, "Look, we are doing it." We own 90 stores -- Chicago, San Diego, Phoenix, a bunch in North Carolina and Virginia. We don't do any less than five stores per franchisee. We have one in California that just signed up for 400 stores.
Before we agree to work with a franchisee, Ben and I sit down and talk about our marketing plan. A lot of companies put 3 percent of their revenue toward marketing or advertising -- we collect 1.5 percent from all our franchisees and give bonuses to the crews that score the highest on our weekly audits.
We have two third-party audits in each store every week. One is called a secret shopper -- folks pretend they're customers and rate the crews on bathroom cleanliness, courtesy, and food preparation. Then we have safety audits -- they identify themselves and check all the kitchen equipment. The crews make about $8 or $9 an hour. If they get a good score, they will split another $1,000 among them, usually five or six people per crew. A press release goes out to every store announcing the winners. Right now, it's the top 200 stores. Last year, we paid out between $7 million and $8 million; this year, it will be $11 million or $12 million.
We try to make the kids feel ownership in the company. Boys hate to smile. It's not macho. And it's definitely not macho to clean a bathroom. But if the auditor walks in and the bathroom isn't clean, that crew just lost money. Next thing he knows, the guy who was supposed to clean the bathroom has toilet paper all over his car and a potato in his tailpipe.
To grow this fast, we had to come up with some big bucks -- we got a $30 million loan from GE and used that to move into a 20,000-square-foot office space in Lorton, Virginia. That's where 80 of our 200 corporate employees work.
We've had many of the same vendors since 1986. And they're not the cheapest by a long shot. We stick with what we like. One day, our purchasing guy said he wanted us to switch to a frozen burger product. But we all picked the fresh one in a blind test and stuck with that. We taste-tested 16 different types of mayonnaise to find the right one.
We make the same bun we started with. We hired the old guy who used to bake our bread for the first store, and one of his partners. They work in the Virginia bakery. We have 10 bakeries scattered around the nation. Our bread is baked daily, picked up by 3 p.m., and put on truck or plane so every store gets fresh bread every morning, even if they are 400 miles away from the nearest bakery.
When we got pulled to Florida, I didn't want to go! Too far. I didn't want to go to Canada -- we're there now. Two princes came from the Middle East. They want us to go over there. We have another group that says, "Anywhere you want to go, we'll fund it." We've also had a few companies that want to come in and buy us. They say they would let us run it, but I don't think they would. Why would they put up with fresh bread and taste-testing 16 different mayonnaises?
But, since these articles have focused on bonds, lets focus on bonds.
Looking at the Barclays Capital Aggregate Bond Index "BarCap Agg", one of the most widely used benchmarks to represent high-quality investment grade bonds, the chart below shows the yield to worst "YTW" and the duration of the index going back 20 years. As can be seen, these two levels have crossed as the yield of the benchmark continues to ratchet down to historic lows.
Why does this matter? Well if the YTW is less than the duration, that means if interest rates rise across the yield curve by 100 bps (i.e. 1%) or more in the next 12 months, then the yield of the portfolio (i.e. carry) will not make up for the loss an investor realizes from the price impact of rising rates (this ignores convexity, but a duration of 1 roughly means that if rates rise 1%, the portfolio sells off by 1% all else equal).
Lets dive deeper and take a look at the ratio of YTW to duration. At the end of March, the YTW of the BarCap Agg was 3.46%, while the duration was 4.68 years (3.46 / 4.68 = ratio of 0.74). At this point, if rates rise by 74 bps across the entire yield curve, the price impact of the portfolio = -3.46% (-0.74 * 4.68), exactly offsets the yield of the portfolio 3.46%, thus TOTAL returns over a 12 month period would equal zero (again, ignoring convexity).
Below is a historical look at that ratio (we'll call it the Duration Coverage ratio) vs. 12 month forward returns of the BarCap Agg. Interestingly enough, the ratio has closely tracked performance. One thought is that the Duration Coverage ratio shows how much an investor is being compensated for taking risk; when the ratio is low, they are not being compensated much (thus the lower returns on a going forward basis).
So bonds are rich and duration should be avoided at all costs? Hardly.
This type of thinking made sense when one could focus solely on absolute terms. There is no question that an investor is not being compensated much in absolute terms to take on duration risk. But, this should not be a surprise when one considers return expectations for less risky investments. Shown below is the difference between the yield on the ten year and two year Treasury... it is now at historic wide levels (the green line).
As a result, while an investor is not being compensated much to take on duration risk in absolute terms (the ten year yield is low), they are in relative terms as the two year bond was yielding a measly 0.96% at the end of March. The chart below shows the same rolling Duration Coverage as the chart above with one exception... that being the YTW is adjusted by subtracting out the two year Treasury yield to put it in "relative" terms. This changes the story completely. Rather than appearing rich, the relative duration coverage now seems cheap compared to historical levels.
And THAT'S the problem with investing these days (and not just with bonds). With risk-free rates hovering near zero, an investor must take a much larger amount of risk to achieve any level of absolute return. This concept is even more meaningful for an investment in risk assets, such as equities and commodities, as the downside risks of those asset classes are MUCH higher than even the worst case rising rate scenario on an investment in the BarCap Agg.
As a result, the question for all investors should be how comfortable you are taking risk to get a return ON your capital and not just a return OF your capital?
The issue is that a lot of investors don't realize this question needs to be answered.
This suggests the long post-Volcker period of declining yields has finally ended. Volcker established that a central bank, when acting decisively enough, can break inflation. But fighting inflation has eventually taken second place in central banks' priorities to rescuing the economy and the financial sector. Of course, inflation is still currently low but investors are starting to demand a premium for the risk that fiscal and monetary policy will eventually generate higher prices. And, as the Greeks are discovering, rising bond yields add to the problems of a government with a weak economy and huge deficit.
• Whether a premise is fundamentally true or false is irrelevant as to whether it is actionable. If enough fools believe something is so, it will impact the markets.
• Always be conscious of the cognizant biases and selective perceptions you bring to investing. Learn to recognize the same bias in the crowd, the media, and Wall Street. Avoid the herding effect.
• After a collapse (i.e., a 55% market sell off), most of the terrible structural news that existed before the collapse is reflected in prices. Let it go.
• You must acknowledge when the data gets stronger or weaker, regardless of your current market posture. Be skeptical, but not rigid.
• Market Pros simply cannot afford to sit out a major (i.e., 75%+) rally; Individuals that miss that sort of move should reconsider what their investment strategies are. If your approach has you long during selloffs and in cash during rallies, something is wrong.
• Everything cycles: Recessions turn into recoveries; bull markets give rise to bear markets. Every rally that there ever was or there ever will be eventually ends. Adapt to this truism or lose your money.
• One of the hardest things to do in investing is to reverse your thinking. It is even more difficult to do after a specific approach has been profitable for a long time. The longer the period of successful thinking, the more important the reversal will be.
• Cheap markets can get cheaper; Expensive markets can get dearer.
• The markets frequently diverge from the macro economic environment. This can be both long lasting and maddening; Your job is to be aware of how wide the gap between the two is.
• Variant perception is a rarity; Identifying the moment when the crowd figures out they are wrong is rarer still.
For those of you fighting the tape, ignoring the data and arguing against even the mere idea of a recovery, ignore the above at your own risk . . .
Tuesday, April 06, 2010
While everyone seems to be watching for Dow 11,000, interest rates are making their own run to the 4% level. As of this morning, 10-Year US Treasuries are trading just below that level with a yield of 3.95%. While 4% is a nice round number, the more important level is probably 4.30%. A break of that level would be more indicative of a meaningful uptick in rates.
Sunday, April 04, 2010
This represents my personal opinion, not the views of the SEC or its staff.
My first blog post was in June, 2007. It was titled “What sorts of crises am I worried about now”. My answer was housing and credit. With the benefit of hindsight, this might be considered a no-brainer, although at the time it was not so clear where things would go.
Now as the dust settles from the crisis that emerged in 2008, we can start to think about what might come next. And yes, the crisis really is settling down, despite the alarmists who, thinking we were in a 1930’s style depression, pushed the panic button and stuffed their mattresses (or portfolios) with cash. For whatever reason, be it astute government intervention or the natural healing process, we are looking back at something along the lines of a bad, credit-driven recession.
I don’t think we will see a big crisis emerging for some time in banks, hedge funds or derivatives, mostly because, like with a knockout punch, the risks that matter don’t come from where you are looking. Unless the current push for legislation is a failure, which, of course, still remains to be seen, we will have steely eyes hovering over these sources of crisis. It will be awhile before the guards start dozing off at their posts.
So, where to look next. To see other potential sources of crisis, let’s first recount the lessons learned from this crisis:
- Problems occur when things get leveraged and complex (and thus opaque).
- If the problems occur in a very big market, especially in a very big market like housing that is tied to the credit markets, things can go systemic.
- The notion that you can diversify by holding a geographically broad-based portfolio, (“there has never been a nation-wide housing recession”), works fine – until it doesn’t.
- A portfolio that is apparently hedged can blow apart. So we have to look at the gross value of positions, even if they are thought to be hedged.
- Don’t bet on ratings, because rating agencies are conflicted and might not be all too dependable at their job.
- Defaults are never easy to manage, but it gets worse when there are a lot of them happening at the same time. It is harder to manage the mess, and there is less of a stigma in defaulting. And it is all the worse when, as is the case in the housing markets, those defaulting are not businessmen. As an added complication, with housing the revenue that we thought was there really wasn’t. Income that was supposed to be there to finance the mortgages – even when that income was fairly stated – became committed to other areas (like second mortgages). .
Answer: The municipal market.
Leverage and Opacity. Leverage in the municipal market comes from making future obligations to employees in order to pay them less now. This is borrowing in the form of high pension benefits and post-retirement health care, but borrowing nonetheless. Put another way, in taking lower pay today, the employees have lent money to the municipality, with that money to be repaid via their retirement benefits. The opaqueness comes from the methods of reporting. For example, municipalities are not held to the same standards as corporations in their disclosure.
Size and potential systemic effects. That this is a big market in the credit space goes without saying.
Diversification. Geographic diversification would give a lot more comfort for municipals if it hadn’t just failed for the housing market. Think of why housing breached the regional barriers. It was because similar methods of leveraging were being employed through the country. So the question to ask is: Are there common sorts of strategies being applied in municipalities across the nation?
Gross versus net exposure. The leverage for municipals is not easy to see. It might appear to be lower than it really is because many, including rating agencies, look at the unfunded portion of these liabilities. They ignore the fact that these promised payments are covered using risky portfolios. And not just risky -- the portfolio might apply hefty (a.k.a. unrealistic) actuarial assumptions of asset growth.
Rating agencies. In terms of the work of the rating agencies, here are two questions to ask. First, list the last time they did an on-site exam of the municipalities they are rating. Second, are they looking at the potential mismatch between assets and liabilities, or simply at the net – the under funded portion of the portfolio.
Defaults. Municipalities are not quite as numerous as homeowners, but there certainly are a lot of them. And they have the same issues as homeowners. Granted, they will not pour cement down the toilet before walking away. But they have a potentially equally irrational group – the local taxpayers – to deal with.
Oh, and just as homeowners took their income and locked it up via secondary loans, much of the tax base for municipalities is already mortgaged, through the sale of tax-related revenues streams like tolls and parking fees. Indeed, although general obligation bonds are considered the cream of the crop, they might just as well be regarded as the residual claim after anything with solid fee streams has been sold off.
Once a few municipalities default, there is a risk of a widespread cascade in defaults because the opprobrium will be lessened, all the more so if the defaults are spurred along by a taxpayer revolt – democracy at work.
Thursday, April 01, 2010