Monday, December 29, 2014

Various anecdotes

  • Barring a disastrous year-end, the S&P will log its 3rd year of double-digit gains. Haven't done that since '95-'99.
  • Last 2 Years - S&P vs. FTSE All-World Ex-US ---- S&P up 50%, Intl' Stocks up 20%. (see chart)

  • There have been 4 times since 1970 when the S&P outperformed international equities at the rate witnessed in 2014. Each time, in following year, world ex-US beat US by average of 14%.
  • Jim Grant's Holiday Card (see picture):

  • Greece 10 Year Bonds:
    • December: 9.7%
    • November: 8.2%
    • October: 7.1%
    • September: 5.5%
  • US Stocks vs. Bank Loans (SPY vs. BKLN): +12.8% vs. -3.8% (someone's wrong...)
  • 100% of 94 economists expect higher US bond yields in 2015, 96% see US growth above 2.5% (Bloomberg survey)
  • The massive investment into stocks for the week ended December 24th was largest since Lipper started tracking the weekly statistic in 1992.
  • NASDAQ is within 5% of reaching its 2000 peak (15 yrs...)

We had everything before us, we had nothing before us…

While the S&P 500 is on track to conclude another stellar year of gains, those who sought to beat the index are poised to finish with a more dubious distinction. According to Lipper, 85% of all active stock mutual fund managers had been trailing their benchmarks through the end of November. In a typical year, there are nearly twice as many managers outperforming, with only around two thirds of funds struggling to catch up. Lipper says this is the worst year for active managers relative to the market in three decades.
Stock pickers encountered difficulty this year in part because of concentration at the top of the market. Just five stocks—Apple, Berkshire Hathaway, Johnson & Johnson, Microsoft, and Intel— accounted for 20% of the market’s gains. If you weren’t at least equally weighted toward them, you had virtually no shot at making up for missing their enormous, index-driving gains. A majority of the market’s stocks did not perform nearly as well. According to the Leuthold Group, only 30% of S&P 1500 stocks posted gains exceeding the index itself. You’d have to go back to 1999 to see anything like this.
Fund shareholders weren’t wasting any time reacting to this year of disappointment. Collectively, they’ve added just $35 billion to active stock-picking funds in the last 11 months, less than a quarter of the $162 billion they added in 2013, which was the first year of positive flows for the industry since 2007. This is not to say that they were sitting still. ETFs and passive index funds took in over $206 billion in net deposits through Thanksgiving, and Vanguard surpassed the $3 trillion mark sometime in late summer. Investors seem to have decided that they’d rather bet on the horses than the jockeys, after all.
The malaise was not confined to those picking individual stock winners. Through December 1, aggregate hedge fund returns trailed the market to the point of farce. According to data compiled by Bloomberg, hedge funds were up an average of 2% on the year, just barely offering the coupon rate of a risk-free 10-year Treasury note. Over 1,000 funds are on track to close down in 2014, the worst year for liquidations since 2009.
Among the gargantuan hedge funds that make up a majority of the industry’s assets under management, dispersion of returns shot up to notable levels. And for every big winner, like William Ackman’s Pershing Square, there was a big loser to counterbalance it, like John Paulson’s Advantage Fund. Investors choose hedge funds for their “non-correlated returns,” meaning a tendency to move opposite from the general market’s direction. They certainly got such returns this year, unfortunately.
Financial advisors and asset allocators who had been hoping to see some benefit this year from tactical strategies were also not spared the punishment of a capricious market. Of the top three tactical strategies in the country (Mainstay Marketfield, Good Harbor U.S. Tactical Core, F-Squared Premium AlphaSector Index), two had nearly imploded with double-digit losses while the third found itself under SEC investigation for misleading the public about its historical returns. The other giant tactical manager, Schwab’s $9 billion Windhaven Diversified Growth product, looks to end 2014 with a return close to zero. So much for tactics.

Junk Bond Risk Appetites Imply Stocks Should Fall At Least 13%

Since the bull market was born in March of 2009 until this summer high-yield risk appetites (as measure by the ratio of the high-yield ETF to the 5-year treasury bond) and stock prices have had a 98% correlation coefficient.

sc-6Clearly, the chart above demonstrates that the strength in junk risk appetites led stocks off the lows back in 2009. Over the past summer, however, junk bonds started to lag stocks for the first time since the bull began (or lead lower, depending on your perspective). Since then the divergence has only gotten wider with each subsequent new high in the stock market:
sc-7So what’s going on? Why the sudden shift in equity risk appetites relative to high-yield?
Well, the popular explanation has been that the junk market has a much higher exposure to energy so the oil crash will have a much larger impact. For that reason, stocks are rightly “decoupling” from the junk market, or so it goes.
To me this argument sounds more than a little specious. The energy component in junk is about 14%. This compares to an 11% weighting in the S&P 500 so there’s a difference there, to be sure, but not a very significant one.
And as Howard Marks recently wrote, “It’s historically unprecedented for the energy sector to witness this type of market downturn while the rest of the economy is operating normally. Like in 2002, we could see a scenario where the effects of this sector dislocation spread wider in a general ‘contagion.'”
The energy boom over the past few years, driven by fracking technology, has been a major boon to the overall economy. The fact that fracking is now unprofitable means that boom is likely to bust. Believing that the boom was a positive but the bust won’t be is wishful thinking at best.
Interestingly, this morning T. Boone Pickens said he believed that weak demand was more to blame for the crash in the price of oil than excess supply. If this is the case it has much greater implications for the economy than if supply were the main culprit.
But setting the energy debate aside, investors should also consider the action in investment grade yield spreads which have widened, as well. They only have 6% exposure to energy so are much less exposed to the potential bust.
Leveraged loans are only made up of 4% energy. Still, risk appetites there have been just as weak as those in high-yield:
To me, this all points to broader risk appetites responding to growing risks within AND beyond the energy sector or what Marks refers to as, “contagion.”
But why should these risks matter to equities? The answer is because high-yield bond investors and equity investors face the very same risks. What is the ultimate risk in owning a high-yield bond? It is the risk of the company falling into a situation where their income can no longer support their debt and they are forced to default.
The ultimate risk for equity investors is just the same. However, bond holders have seniority over equity investors. Equity investors, in fact, face even greater risk of loss of principal than high-yield or leveraged loan investors do because bond holders usually have some sort of covenants that hopefully ensure recuperation of their principal to some degree. This is not the case for equity investors.
You would think, then, that when bond holders begin pricing in greater risk of default equity investors should sit up and pay attention (at least some do). So I find it very fascinating that while investors in the debt markets are pricing in greater risks, equity investors feel comfortable in paying ever higher prices (accepting less and less “margin of safety”).
Historically, it’s equity investors that prove to be oblivious to the growing risks that high-yield investors begin to pay attention to rather than high-yield investors overreacting. As I’ve written before, high-yield spreads widened dramatically prior to equities topping in out in both 2000 and 2007 . In those cases, bond investors obviously proved to be fairly prescient. Today’s divergence between the two is even greater than those past episodes.
Given that the correlation between the two is so high and for good reason, it’s interesting to note that junk bond risk appetites now imply a level of 1800 on the S&P 500 (based on their daily correlation over the past five years of 98%), fully 13.5% below its current price. Now I don’t know how this gap will be closed, whether stocks will decline or high-yield risk appetites will recover or some combination of both. I do believe, however, that the bond markets are pricing in increasing risks that some have been warning about for quite some time and that the equity market, for the moment, is ignoring.
So who are these indiscriminate buyers in equities? It’s not retail investors. As Jason Goepfert pointed out in his letter last night, outflows from mutual funds and ETFs have been above average even for December, a month where we typically see outflows.
My guess is that it could be a various group of the dumbest of the dumb money. In that group I would include indexers who are value agnostic. (Don’t get me wrong; I’m a fan of roboadvisors but I recognize the risk their growing popularity poses.) I would also include algorithmic trading, which buys and sells stocks based on who knows what (a couple of words in the Fed statement?), certainly not any kind of traditional investment philosophy. Finally, I would point to foreign buyers who are desperate to escape the confines of their weakening economies, plunging currencies and falling equity markets at home.
Again, I’ll refer to the brilliant Howard Marks:
For the last few years, interest rates on the safest securities – brought low by central banks – have been coercing investors to move out the risk curve. Sometimes they’ve made that journey without cognizance of the risks they were taking, and without thoroughly understanding the investments they undertook. Now they find themselves questioning many of their actions, and it feels like risk tolerance is being replaced by risk aversion.
This is definitely now occurring the fixed income markets. In the equity markets I believe they are still, ‘moving out the risk curve without cognizance of the risks they are taking.’ But if Marks is right and we are now switching from a period of “risk on” to “risk off,” the widening in high-yield spreads (inverted) may have much farther to go:
And if that’s the case, 1800 on the S&P 500 may be only the beginning.

Monday, December 22, 2014

Howard Marks - Oaktree Memo: Lessons of Oil

Value Investing: Digging Manager Graveyards Since 1900.

Following value strategies can be hazardous to one's wealth in the short run.

Oil stocks are a great example of the challenge value investors face:
The stocks are down big--and getting cheaper--but could go down even further!

Successful value investors are able to buy and hold cheap stocks for a number of years and avoid short-run noise.

However, if you are an emotional and impatient investor, you should think twice before you invest in a value strategy.

Here is an article we wrote on this subject:
We dig a bit deeper into this concept in this post.

Preliminary Details

Here we construct a value portfolio of mid/large cap stocks (formally above the 40th percentile for NYSE market capitalization). We select the top 10% of stocks in the universe based on EBIT/TEV, and rebalance the portfolio annually. The portfolio parameters specifics are similar to those outlined in our valuation horse race paper. We want to examine, at a monthly level, how much a value strategy can outperform as well as underperform.

So What Do the Monthly Spreads Look Like?

This graph shows the spread in returns between our value portfolio and the SP500. Monthly spreads can be huge!!!

2014-11-25 09_29_32-Microsoft Excel (Product Activation Failed) - tracking error.xlsxThe results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.
Below is a table showing the top 20 best and worst spreads:

2014-11-25 09_33_13-Microsoft Excel (Product Activation Failed) - tracking error.xlsx

2014-11-25 09_34_34-Microsoft Excel (Product Activation Failed) - tracking error.xlsx

Tracking error:

The annualized "Tracking Error" for the value portfolio (Top 10% EBIT/TEV) with the S&P 500 is about 9.38%. "Tracking Error" here is calculated as the Standard Deviation of the difference of the returns between value stocks and the S&P500 benchmark. Compared with many passive ETFs, which have ~zero tracking error, 9.38% is large. Roughly translated, this implies that in any given year, the value portfolio will be all over the map relative to the S&P 500.

Can you imagine a month where your portfolio gets beat by over 5% relative to the benchmark?

As a value investor, this isn't abnormal, you can expect it!

Taking on tracking error is a great way to get fired as an asset manager. As an individual, it is a great way to break your confidence and sell your hated value stocks.


But what is the Upside of Tracking Error Pain?

In a nutshell, the benefit of taking on the pain of tracking error is higher expected performance.

But expect a crazy ride! The markets are generally efficient and there is always a catch: Value investing can work, but it requires a serious commitment!

2014-11-24 14_48_09-Microsoft Excel (Product Activation Failed) - Book1

What Is Intrinsic Value, And Who Decides It?

James Osborne of Bason Asset Management recently published an excellent critique of the investment concept of “Intrinsic Value.”  I urge readers to take a minute and go check it out.  In this piece, I’m going to try to tackle a question that James poses.
That question: what is intrinsic value, and who decides it?
No Selling Allowed 
Here’s my answer.  The “intrinsic value” of a security is the maximum price that an investor would be willing to pay to own the security if she could not ever sell it.
Three points:
(1) All I am doing here is defining the term.  You can define the term in another way if you wish, but then you will be talking about something else.  When I use the term “Intrinsic Value”, I am talking about the maximum price that an investor would be willing to pay to own a security if she had to hold it until “maturity”, i.e., for the entirety of its natural life as a security, which, for an equity security, means forever.
(2) According to the definition, the “intrinsic value” of a security is different for different individuals.  That’s to be expected.  Value, like beauty, is a judgement made by the individual–it exists only in the mind of the individual, the eye of the beholder.
(3) The definition fits with the literal meaning of the word intrinsic–”inherent, innate, inborn, inside the thing itself.”  The value that an asset has, inside itself, cannot be a function of the quantity of other useful things that other people happen to be willing to exchange it for in a market.  Rather, the value must remain present even when no trading is allowed.
Intrinsic Value: A Thought Experiment
So let me now ask you a question.  Suppose that I have a security to sell you.  The security works as follows.  It pays out $10 in dividends per year.  The dividends grow at a real (inflation-adjusted) rate that ranges anywhere from 3% to 5% per year.  Of course, over the short-term, the dividends can grow at different rates–sometimes they can even grow at negative rates, i.e, fall.  But, crucially, over the very long-term, they always recover. They always regain their 3% to 5% long-term growth trendline.
Now, to avoid uncertainty, let’s assume that the aforementioned features of the security are guaranteed by the full faith and credit of the U.S. government.  So there is essentially zero risk that the security will not behave  in the way that I just described.  The question: what is the maximum price that you would be willing to pay, in cash, to own the security, if you could not ever sell it?  Alternatively, what, for you, is the “intrinsic value” of the security?
Take a moment and consider the question as if the proposition were really there for you to take. What is the maximum price that you would be willing to pay? I’m not going to mention any number as a starting offer, because I don’t want to influence your answer.
I’ve posed this question to a number of individuals, both inside and outside the financial industry.  Almost everyone answers with a price that is less than $250.  Note that at a price of $250, the security would offer a 4% yield, fully protected from inflation, with 3% to 5% real per annum growth added on top.  Not bad.  That valuation is seen as minimally necessary to compensate the investor for the cost of forever parting with his principal.
The S&P 500A Growing Stream of Dividends
If you’re particularly clever, you’ve probably noticed that the security that I’ve described here is basically the S&P 500 stock index divided by four.  The S&P 500 presently pays an annual dividend of around $40 per year.  Not all of the earnings of the companies in the S&P 500 are paid out to shareholders as dividends–some are spent (read: “used up”) on capital expenditures and asset acquisitions.  That is precisely why the dividends are able to grow over time at a rate that exceeds the rate of inflation, i.e., the rate at which the prices of all things in the economy, including the prices of the goods and services that corporations sell, changes.
The reason that I divided the S&P 500′s dividend by four is to prevent the current price, 2070, from creating a false anchor in the mind that influences the “intrinsic value” intuitively ascribed to it.  So take your earlier price, the maximum price that you would pay for the $10 per year security, and multiply that price by four.  That’s your final price, the intrinsic value that you ascribe to the S&P 500.  I ascribe around 800.  You might ascribe 1000.  Or maybe 600.  Certainly not the present price of 2070–unless you’re crazy.
If you doubt the logic here, ask yourself: what is the S&P 500, intrinsically, apart from all of this baseball-card-trading that we engage in when we play in markets? That’s the question that you will have to confront if you decide to make a genuine, non-redeemable investment in the security, that is, buy the security without having the ability to sell it.  The answer: to you, it is just a growing stream of dividends, nothing more.
Now, how reliable is the assumption that the dividends will grow over the long-term at a rate that exceeds the rate of inflation?  Pretty reliable.  The historical reliability of the assumption is demonstrated in many centuries of actual data, not only in the US, but in other capitalist economies. That reliability is supported by the inherent diversification of the index–we’re talking about many different companies from many different industries, rather than a single company that might one day go bust.  But even if we view the dividend stream as not growing reliably over the long-term, or posit a larger uncertainty around the growth than the previous 3% to 5% range allowed, that will only pull the “intrinsic value” lower–and the lowness relative to the current market price is precisely what I’m trying to emphasize.
As you can see in the chart, the historical real rate of growth of per-share dividends for the S&P 500 has been significantly less than the stipulated 3% to 5%.  It’s actually been closer to 1.4%. But there’s an important factor at work.  Most of the S&P’s history was dominated by periods in which only a small portion of earnings were consumed on the purchase of future growth.  Most of the earnings were delivered directly to shareholders in the form of dividends.  Corporate managers have since evolved a preference for earnings reinvestment, and so the current dividend stream tends to grow faster, though it is smaller than it could be, or would have been in the past.
Now, to create a full analogy with the “intrinsic” (i.e., can’t-sell) S&P 500, let’s add a final caveat to the security.  You, as the owner, get to determine the payout ratio.  We can think of the payout ratio as a dial that you can adjust, any time, at will.  You can opt for less dividends now, and more dividend growth, or for less dividend growth, and more dividends now.  If you want, you can even choose to have all of the annual earnings that back the security–in the case of the S&P 500, around $110–paid out to you in dividends. The cost of doing this, of course, is that the earnings and dividends will stop growing.  They will grow at a real rate of 0%.
You might think that the S&P’s current price of 2070 is a reasonable price for a growthless security that pays out $110 a year.  But check that thought.  Suppose you had $100,000 in cash sitting around, earning nothing.  Suppose further that there is nothing else on earth that you can invest it in but the “intrinsic” (i.e., can’t-sell) S&P 500, priced at 2070.  Would you really be willing to part with all of that money, permanently, in exchange for a perpetual payment of only 5.3%$5,300 per year?  Not very many people would be.  Some people wouldn’t even be willing to accept 10%$10,000 per  year, or even 20%, $20,000 per year.
Even if never used, the simple ability to get your money out of the security and back into your pocket is worth a ton.  That ability represents the difference between your being willing to pay 2070 for the security, on the trust and confidence that you will only be one mouse click–one sell order–away from getting your money back, and being willing to pay only 600, on the stipulation that you will be stuck holding the security until maturity, i.e., for the rest of its life, which means the rest of your life.
Now, to be clear, I’m not saying that it’s irrational for you to be willing to pay 2070 for the security.  I’m saying that, built into your willingness to own it at that price, is a (largely justified, at least for now) expectation that you will be able to sell it, on demand, to someone else at a price near that price–hopefully, at a price higher.  That expectation makes the security dramatically more attractive to own than it would be if it were just what it is intrinsically–a simple stream of growing dividends that had to be held as such.
The Dividend Discount Model
In 1956, Myron Gordon and Eli Shapiro developed the dividend discount model of equity valuation.  On this model, the intrinsic value of an equity security is the sum total of all of the security’s future payouts, from time now until time infinity, discounted back to the present.  Gordon and Shapiro showed mathematically that when discounted at a required rate of return r, an infinite stream of dividends with a starting annual dividend level of and an annual growth rate is worth a present price p, roughly equal to,
(1) p = d / (r – g)
Rearranging to solve for r, we get,
(2) r = d / p + g
which neatly says that the rate of return that an equity security produces for its owner equals the dividend yield (d / p) plus the dividend growth (g).  Note that if we want, we can make the dividend yield equal the earnings (e) yield, but then g will go to zero, so we will end up with,
(3)  r = e / p
which simply states that the rate of return that an equity security produces for an investor equals the earnings yield, provided that all of the earnings are paid out in present dividends.
Now, the dividend discount model is just a way of formalizing the intrinsic valuation process. The ambiguity and subjectivity in that process remains–the model simply places the ambiguity and subjectivity inside the convenient term r, the discount rate, which is the rate of return that investors demand in order to exchange cash now for cash later.  You can make the intrinsic value of a security be anything you want, any number from 0 to infinity, depending on the discount rate that you choose to impose.  And why must you choose to impose any one discount rate over any other?  As an investor, it’s your call.
To illustrate the power of the discount rate, let’s do the actual exercise for the S&P 500. The index pays a dividend of $40 per year, and the dividend grows at a real rate of 3% per year.  Pick your discount rate, and make sure that it’s a real discount rate, adjusted for inflation).  If you pick a 7% discount rate, then the S&P 500 is intrinsically worth  $40 / (.07 – .03) = 1000.  If you pick a 5% discount rate, then the S&P is intrinsically worth $40 / (.05 – .03) = 2000.  The difference in rate is only 2%–but the difference in price is 100%.
Ask yourself: what makes a 7% discount rate any more “privileged” than a 5% discount rate?  To cover the “losses” associated with converting a present cash sum into an infinite stream of future cash payments, why must an investor demand 7% rather than %5?  Or 5% rather than 3%?  Note that all of these rates are above the loss-adjusted rates that can presently be earned in other asset classes.  Indeed, the risk-free dollar benchmark is priced (in dollars) to deliver an inflation-adjusted rate close to zero, even on very long time horizons.
Robert Shiller and Equity Volatility
In the 1981 masterpiece that earned him a Nobel Prize, Robert Shiller posed the question: “Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?” He empirically demonstrated that the answer was yes, and concluded that markets cannot be described as “efficient.”  Notably, he used a definition of the term “efficient” that his efficient market hypothesis (EMH) opponents, chiefly Eugene Fama, would never accept. But that is a topic for a different piece.
Shiller blamed the large discrepancy between realized price fluctuations and realized dividend fluctuations on the irrational psychological and emotional forces that drive investor behaviors.  His underlying point–that behavior drive the market–is obviously true, but I think there is a more elegant, less demeaning way to frame it.
The intrinsic value of a security–the price that investors would be willing to pay to own it on the stipulation that they would have to hold it indefinitely–is dramatically different from the price that investors are willing to pay knowing that they can easily sell it to others (without incurring a large loss.)  That difference is the value of liquidity.
When liquidity is present, backed by trust and confidence in the stability of the market, investors tend to view their equity holdings as if those holdings were identical to cash in the bank.  They don’t price in the lost liquidity associated with making a genuine, non-redeemable investment in something, an irreversible conversion of present cash into long streams of small future cash payments.  Nor should they price in that lost liquidity–it’s not lost.
If lost liquidity were a reality that had to priced into stock market investments, equities would trade at valuations that are significantly lower than the valuations at which they currently trade. Instead of being willing to pay 2070, and probably higher in the coming months, for the $40 per year, 3% to 5% real growth security that the the S&P 500 represents, investors would demand a far more attractive price–probably a price below 1000.  For some investors, a price as  low as 200 might not even be enough.
Suppose you have $1,000,0000.  I ask you how much money you have, in your name. You will answer $1,000,000–whether that money is invested in an S&P 500 index fund, or whether it’s sitting in the bank.  If it’s in the index fund, it’s not money–but, for you, it might as well be, because you have access to a simple, on-demand means of exchanging it for money, a stable, reliable market in which you can exchange it.  Because of that access, you are able to derive all of the psychological and consumptive benefits of having the money, even though it is not actually in your possession.
But now let me put you in a situation where you might not be able to get that $1,000,000 out of the S&P 500 for a very long time, maybe for the rest of your life, because the markets are crashing and are going to stay crashed.  If I tell you “Don’t worry, the dividends that underlie the true value of your investment will be unaffected by the crash”, will that be much consolation to you?  Will it relieve you of the sense of loss?  Obviously not.
As an investor, you lose your money not when the prices of your investments fall, but when you exchange money for them in the first place.  When you initially buy in–that is when the money is no longer yours.  Crashes force you to view the condition of no longer having access to the money as a genuine loss, a genuine sacrifice, because it removes the people who are otherwise there to give the money back to you.
Now, to the main point of this piece.  Equity prices are volatile–much more volatile than the earnings-backed dividend payments that render them intrinsically valuable, i.e., valuable in themselves–because the trust and confidence that forms the basis for liquidity in the market can be fickle and unreliable.  The market can pull its liquidity in a heartbeat, and sometimes does pull it. When the liquidity is pulled–when investors conclude that they aren’t going to be able to sell at the prices they paid, at least not for a long time–their desire to be invested falls dramatically, as it should, given that they did not enter into their investments on the stipulation that they they would be permanently stuck inside them.
We can think of market prices as hovering between two poles: (1) the “intrinsic value” price, the maximum price that investors would be willing to pay to own a cash flow stream if there were no liquidity, no ability to sell the investment, ever, and (2) the “bubble” price, the maximum price that investors would be willing to pay own a cash flow stream, however paltry, if they were certain they would be able to get out of the investment without losing money, and hopefully be able to get out of it making money, realizing a return simply from the trading process.  These poles are separated by many thousands of points, many hundreds of percent.  The market swings between them based on factors that seem to have little to do with the long-term earnings and dividend prospects of companies because the factors influence the tender trust and confidence that investors have in the market’s future stability and trajectory, a trust and confidence that ultimately separates the two poles from each other.
Interestingly, on this way of thinking, the main reason why bond prices are less volatile than equity prices is not that the coupon payments of bonds are more reliable than the dividend payouts of well-diversified equity indices.  Rather, the reason is that bonds have a maturity date, a date where you can get your money out of the investment even if no one is willing to buy it from you.  That difference makes all the difference in the world.
If you buy a brand new 10 year treasury bond, and its price plunges in a panic, the worst that will happen to you is that you will be stuck holding the security for 10 years.  At 10 years, you will be made whole on your investment, regardless of what the market decides to do with the price.  Having to wait 10 years is certainly not as costly as having to wait forever, as one would have to do with an equity security that no one wants to buy.
Importantly, as the maturity date–the “finish line”–of a bond gets closer, it becomes easier to find others willing to risk a loss of liquidity in the security, given that that the “finish line” represents their “finish line” as well.  The security becomes easier to buy and just hold to maturity, which essentially ensures that there will be liquidity–a price reasonably to close to fair value–driven by confident investors that are willing to buy regardless of whether they think there will be yet others willing to buy from them.
For equities, however, there is no maturity, no “finish line.”  There is no amount of time that you can wait inside the investment in order to be guaranteed of being made whole on it.  Being made whole on it requires other people to want to buy it from you–without their interest, which depends crucially on their trust and confidence in the reciprocal process, their sense that others will be willing to buy from them at some point, you cannot be made whole on the investment, at least not in any finite amount of time.
Now, to be clear, if you hold an equity security for a long enough period of time, you can get your initial investment back in dividends.  But that’s not the issue.  You are not in the investment to get your initial money back, a return of your initial capital.  You are in the investment to get an appropriate return on your capital–you cannot get such a return in any finite amount of time without other people to sell to.
To use an example, if  you hold an equity security with a growing 2% yield, you will get your money back after 30 years or so.  But you will not get the return on your money that holding a security for 30 years demands.  In contrast, if you hold a 30 year government bond for the same amount of time, the entirety of its term, you will get such a return, which is why the two types of securities–bonds and equities–are fundamentally incomparable as instruments.
Valuation: Why It Matters
As investors in the real world, we do not invest in securities on the assumption that we are going to hold them forever, and therefore realize their “intrinsic value.”  Rather, we invest in them with the specific expectation of being able to sell them to other people at higher prices than we paid, thereby realizing a return.  We expect this return to be realized in a reasonable amount of time–months, years, maybe decades–certainly not any longer. A dividend stream can help pad our returns over those horizons, but the prices at which we sell the securities ultimately determine them.
We should worry about valuation, then, not because it determines the dividend return that we will receive on our investments, but rather because valuation is a factor that influences the perceived attractiveness of the security to other potential buyers of the security, those to whom we will sell, who we should view as our customers.  It is their perception of an equity security’s valuation–not our opinion of the reality–that will determine the price that they will be willing to pay for it.
That’s why it can be misguided for investors to focus on valuation metrics that no one uses. The value of an attractive valuation is that the valuation will be attractive to other potential buyers of the security–not that it is attractive to us, using our own pet methods.
Now, to be fair, let me add some nuance to the point.  Attractive valuations can either be obvious–readily seen by all–or they can be hidden.  When they are obvious to all, manifest in the classic “P/E” heuristic that investors use to quickly assess valuation, there will usually be some other factor–some set of fears–that is causing investors to not want to buy, despite the low P/E.  If we know that those fears are misguided and will eventually subside, then we can buy now, at the low P/E, and sell later, at what will by then be a more normal P/E.
Alternatively, the value may be hidden by the present P/E ratio.  It is then that unconventional metrics–metrics such as price-to-book, price-to-sales, enterprise value to EBITDA, Shiller CAPE, and so on–can be useful.  Such metrics can point to situations where the P/E is high, but high because of an abnormally low present E, rather than an abnormally high P.  Knowing that the E will eventually rise in a way that the market is not presently expecting, we can buy a cheap security that the market does not yet know is cheap, and then sell it when the value becomes evident to all, at which point the price will already have been pushed up.  Note that we can do the same in reverse, using unconventional metrics to stay away from expensive securities that appear cheap, appearing cheap because their Es have been artificially inflated by unsustainable trends–fads, bubbles, and so on.

Hard to Fire Yourself; Easy to Fire Your Manager

Looking for Someone to Blame: Delegation, Cognitive Dissonance, and the Disposition Effect


We analyze brokerage data and an experiment to test a cognitive-dissonance based theory of trading: investors avoid realizing losses because they dislike admitting that past purchases were mistakes, but delegation reverses this effect by allowing the investor to blame the manager instead. Using individual trading data, we show that the disposition effect -- the propensity to realize past gains more than past losses -- applies only to non-delegated assets like individual stocks; delegated assets, like mutual funds, exhibit a robust reverse-disposition effect. In an experiment, we show increasing investors' cognitive dissonance results in both a larger disposition effect in stocks and also a larger reverse-disposition effect in funds. Additionally, increasing the salience of delegation increases the reverse-disposition effect in funds. Cognitive dissonance provides a unified explanation for apparently contradictory investor behavior across asset classes and has implications for personal investment decisions, mutual-fund management, and intermediation.

Disposition Effect in Stocks:

This paper reinterprets a well know behavioral bias, the "Disposition Effect", which depicts investors' greater propensity to sell assets at a gain than at a loss. We describe the disposition effect in "Sell Winners Too Early and Hold Losers Too Long."

The authors first highlight a psychological explanation that helps investors understand such reluctance to realize losses: People will experience discomfort or psychological pain when encountering new information which contradicts their existing beliefs.

To be specific, an investor who has created the self-image of being a good decision-maker does not like to admit that he is wrong. Thus, he will be reluctant to realize losses when investment performance is bad, which leads to the "disposition effect." He wants to reduce the mental costs of admitting mistakes or at least delay such pain.

Reverse-Disposition Effect in Funds:

This paper also finds that the disposition effect is reversed in the case of delegated assets, such as in mutual funds. That is, investors have a greater propensity to sell losing funds compared to winning funds. This behavior is consistent with behavioral psychology: when fund performance is bad, investors tend to blame fund managers and sell the related assets as a consequence. By blaming a scapegoat, investors feel mitigation of pain associated with losses, while still maintaining a positive self-image. 

 Key Findings:

1. Paper run regressions (see Part II) with several dummy variables to test for the disposition effect. Data include 128,829 accounts from 1991 to 1996.
  • Results (Table II and III) confirm the hypothesis: the disposition effect in stocks and the reverse-disposition effect in actively managed funds holds for the same investors at the same time.
2. It is worth mentioning that the paper designs two experiments to provide direct evidence of cognitive dissonance as a cause of the disposition effect. 520 undergraduates participated in their online trading experiments, which lasted over 12 weeks. Each student was given an initial endowment of $100,000 and randomly assigned to trade either stocks or mutual funds. There were two treatments:
  • "Story" treatment: This treatment is designed to increase cognitive dissonance. All students have to present a reason for their buy decisions and they are reminded frequently about their stated reasons during the experiments, especially when they move to sell the asset.
  • "Fire" treatment: This treatment is designed to increase the salience of the fund manager. Students are provided with choices of "Hire", "Fire", and "Fund Manger's performance/gain/loss" rather than "Buy""Sell" and "Portfolio performance/gain/loss". In addition, students in the fire treatment are provided with a fund managers' bios.
2014-11-11 11_05_02-Looking for someone to blame.pdf - Adobe Reader

2014-11-11 11_06_20-Looking for someone to blame.pdf - Adobe Reader

The experiment's results can be found from Table VI.
  • The higher the level of cognitive dissonance, the larger the disposition effect in non-delegated assets (stocks) and the larger the reverse-disposition effect in delegated assets (funds).
  • The bigger the effect of delegation, the bigger the reverse-disposition effect. In other words, if investors focus more on the role of the fund manager instead of their own role, they feel mitigation of pain associated with realizing losses.

Monday, December 15, 2014

What America Does Not Understand About Russia & Oil

As hard as it is to believe - given the strength of the "Russia-is-doomed" meme - Crude oil prices for Russia (in Rubles) are unchanged since February... This is important as all costs are Ruble denominated while revenues are USD denominated, leaving Russian oil companies’ margins insulated despite the dollar decline in price. In addition, the Russian government is easing the export taxes which further improve the profitability of Russian oil. So as US Shale Oil sector is destroyed by its USD costs, it appears Putin's core energy industry is somewhat insulated... and America's late-80s "defeat The Sovet Union" playbook is failing.

Reserves are tumbling with the Ruble...

Did Russia peg the Ruble to Crude? Not quite the crash everyone thinks of...

As Giannis Kolmer explains,
The subject under discussion is whether or not the “clearing” taking place in the oil markets “rhymes” with the events of 1986 that led to fall of the Soviet Union; and the effects of the devaluation of the Ruble, which I strongly believe will be more favorable for Russia, combined with recent trade agreements.

The last time around the US used oil as a tool to combat Russia (at the time the Soviet Union), on a nominal basis Brent underwent a correction from over $30 toward the range of $11-13.5 where it remained until the defeat of the Soviet Union and the withdrawal of the Red Army from Afghanistan in February 1989 after the signing of Geneva Accords in 1988.
While successful this time around the Russian’s via Putin are more than able to cope with an oil rout for the near future. Already the devaluation of the Russian Rubble means that oil revenues will in fact be more in Rubles than last year since the devaluation is currently wider than the correction of the oil price itself.
In many ways, the Ruble is the thing to watch in terms of timing the bottom. Since intervention is ahead of the correction.  From 33 to 63 rubles per dollar, that’s almost a 50% devaluation while the correction of oil prices is just nearing the 50% correction level at 52.5 assuming a peak of $105 per barrel. So where does intervention stop? $45 on Brent Crude means 40 to 42 for WTI while in the relationship of USD with respect to the RUB that means 70 to 75 or another few billion worth of foreign reserves while revenues from oil in rubles double at the minimum. Also it is important to remember that Russia has very low debt compared with the 80’s and 90’s.

Meanwhile such weakness in oil markets leads to strength in the Natural Gas sector as the aged, inverse correlation between the two (as oil rises NG prices fall and vice versa) combined with winter conditions boost a price, which in itself is stable-NG prices are not in the process of price discovery but rather in the stage of consolidation, after a violent upswing last winter. While since October NG prices have sold off from 4.5 to 3.7 currently, the 20% drop is nothing compared to the drop in WTI.
In the meantime, if 1986 is any indication, the process of price discovery “clears out” when the correction enters the 60% territory or in number terms from 105 to 42 dollar per barrel
So really what all this suggest is that a bounce is to be expected as we head into the winter, howeverthe long term lows suggest that the mid 40’s is where all this end, which coincides with the correction of 86 and a Ruble above 70 per USD.

Anything below 50 is scary for the energy sector, which accounts for a third of capex in a world dominated by buybacks and dividends fueled by cheap financing. But credit markets are already actively taking that option away.
“Widening”, is definitely the word of the week. However, like in Afghanistan in the late 80’s, in the words of Charlie Wilson, the US "are fucking up the endgame."
After spending a few billion along with the Saudi’s fighting a covert war, the Senate committee in charge of the budget did not see fit for the US to spend a few more million to build schools and infrastructure, indirectly enforcing the belief that God helped the Afghan people, (who for the most part were under the age of 20 at a rate of 1 out of three) fight off the Red Army, not the US taxpayer.

This time, after spending billions to make the USA energy independent, at great risk, they are falsely using a vulnerable geopolitical tool as a weapon against a highly formidable opponent. In the game of career politician versus former spy, like in the game of follow the leader, the bets are in favor of the side with less layers of political red tape and influence.

As George R.R. Martin’s King Robert Baratheon stated “which is the bigger number 5 or 1?... One, one army, united behind one leader with one purpose.
This is not a result of problematic markets. It’s a problem of political stupidity. The question is do you bet on the one leader or on the combination of the Senate, the President, NATO, the Pentagon and all related offensive defensive components in its arsenal.
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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.