Posted by Don Martin on Mon, Oct 31, 2011 @ 09:00 PM
Eurozone crisis is getting worse and will harm U.S. market
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Today the SP went down 2.47% and long term Treasuries went up in price 3.97%. The Treasury bond rout of last week has been dramatically reversed only two trading days after the Euro summit of Thursday morning last week. Already the market has become aware that the new Euro plan creates more questions than it answers.
The effect of the coming Eurozone crisis is that European banks will need to reduce their size so as to increase their net worth as a percentage of assets. This means they will reduce lending by ruthlessly cutting off loans to deserving customers who have corporate revolving lines of credit, thus damaging those businesses, which will result in job losses.
A recession in Europe will make it harder for Americans to sell things to Europe and thus the effect will be felt in America, leading to a world recession. During debt deflation cycle balance sheet recessions like the one in 2008-09 the crashes and market volatility occur more frequently, so the next crash will occur three years after the 2008 crash which means a recession and stock crash in 2012. The stimulus programs and payroll tax cuts expire on 12-31-2011 so that will withdraw funds from the economy. Congress wants to keep spending under control so that means a policy of austerity (meaning no stimulus) at a time when stimulus is needed. This will exacerbate the coming recession within a recession. During the Great Depression there was a recession within the Depression that occurred in 1937 when the Fed tightened too early. A similar event may occur.
Bond investing continues to be a good idea
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An article in Bloomberg today showed that bonds beat stocks over the past 30 years. The article did not mention that bonds produce a higher Sharpe ratio when they beat stocks because they have less volatility. Over the past ten years the Sharpe was 0.16 for the SP500 and 0.64 for long term government bonds. (Although there is the risk they could go down suddenly if inflation returned. But that is like saying there is a risk that if NASA sends a team of astronauts to Mars there is the risk one of them could slip on a banana peel, but it will be a long time before that. It will take a very long time for the government to inflate its way out of this recession.) Japan has been in recession with low interest rates for 21 years with no end in sight. The U.S. had a soft depression for 25 years in the 19th Century.
In writing about investing in bonds, I mean investment grade bonds issued by U.S. or Emerging Markets companies. Avoid Eurozone bonds and U.K. bonds. Avoid junk bonds, although in some cases a small investment in "BB" rated (one notch below investment grade) may be OK if the mutual fund has a cautious approach.
I have written an article “Bond bull market to continue” and “Eurozone bailout: two things you must know”.
Investors should seek independent financial advice. 
Posted by Don Martin on Fri, Oct 28, 2011 @ 02:55 PM
Using Sharpe Ratio to Shop for Junk Bonds
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One of my favorite investment techniques is to use the Sharpe Ratio and Information Ratio to screen investments. These ratios measure the reward compared to the risk and so if a very risky investment did not reward the investor enough in proportion to the risk then the score will be low to moderate, thus giving a warning that the investment is not so great. The problem is that these tools use historical data which can we warped if there was a recent cyclical rise in the asset’s value or if the price increased unjustly due to an irrational bubble. So if an investment has been going up a lot one must look at its intrinsic value and not simply look at the historical Sharpe ratio. If the Sharpe ratio is very high the investment could be at a cyclical top and it may be time to do a sector rotation out of that investment; thus a Sharpe ratio tool could backfire and damage an investor’s portfolio if it was used in a naïve manner. Intrinsic value is the best forecast of the future. For example if stocks fluctuate between a PE of 8 during a bad crash and a PE of over 25 during a boom then one could sell or at least stop buying stocks when the PE is over 25 and when the PE gets close to 8 then it would be time to buy stocks.
The Sharpe ratio doesn’t tell you this. It may be telling you that because the proposed investment went up in price and had low standard deviation that you are getting a good reward in proportion to the risk of historical share price fluctuations, but that could be due to a gentle, slowly building bubble and is not necessarily an indicator of sound value.
Examining a blizzard of paper to find the gems
A Note of Caution About Junk Bond Investing
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Regarding buying individual bonds this should not be done by retail investors but should be done by a mutual fund manager. It is too hard for a retail investor to study the subtle risks of credit default between various junk bonds. Also the bid-ask Broker-Dealer markup or markdown spread for junk bonds or any non-Treasury bond is a significant cost and this problem is best handled by using a mutual fund.
So if you are considering buying junk bonds using a Sharpe ratio what is more important than a Sharpe ratio is that dirty word “market timing”. If the market cycle is at the level where equities are high priced then sell or avoid buying; if the cycle is depressed and shares are selling at low prices relative to intrinsic value then it is time to buy. This is because equities correlate with junk bonds, because when bad times occur then junk bonds default rate increases, making junk go down in value.
Right now investors are angry that interest rates are low so they may succumb to temptation to get a higher yield by buying junk bonds, but that is wrong. Instead investors should weigh the probabilities that during a recession junk bond issuers won’t be able to make the payments and will default. Remember at one time Greece was not considered to be a junk bond type of borrower so they issued bonds at par and now they are considered like a junk bond, trading at deeply discounted prices.
Basically bonds should be a place of refuge rather than a place to seek windfall yields, so don’t fall the temptation of junk bonds.
I have written an article “Stocks vs. bonds you must know this about Sharpe ratio” and an article about PE ratio “Shiller PE10 still correct”.
Investors should seek independent financial advice.
Posted by Don Martin on Thu, Oct 27, 2011 @ 03:05 PM
Last night’s bailout won’t work
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At 4 am Central Europe time this morning the Eurozone leaders agreed to another bailout. The agreement is tentative, it is subject to approval by 17 legislatures some of which require a bicameral parliamentary approval and many have coalition parliamentary governments that could breakup and need a new election to form a clear majority. It will be difficult to get all 17 countries to finalize all the details. There is no plan on executing the agreement, no plan to enforce a “voluntary” haircut on Greek debt. The plan is to borrow even more money by leveraging up four or five times with a Special Purpose Vehicle (just like American subprime mortgages) and then use the funds to bailout Europe.
There is no rational reason for the stock market to celebrate today. The medicine prescribed does not work, can’t be formulated and costs too much, so no cure will result.
Europe has issued debt that it can’t afford to repay and the funds were spent on wasteful government projects. The money has been spent and can’t recovered. The proper solution is to face up to reality and take a write off of bad debt and for the banks to fail and bondholders to take a haircut. This will mean recession as a shortage of healthy banks means healthy businesses won’t get the loans they need and will thus collapse.
The alternative will be a bailout by the ECB where the ECB uses newly printed money to fund the bailout, resulting in ruinous inflation and devaluation of the Euro.
If one can’t trust the wisdom of the Eurozone leaders to prevent the huge debt crisis then why should one now trust them to solve the problem that they created?
Bailout worth less than this coin
The bailout, even if it works does not solve problems in U.S., China, Japan
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Even if Europe solves its problem that does not overcome the problems of high, intractable unemployment in the U.S., high debt levels in the U.S. and Japan, low growth rates in the developed world and inadequate financial structures in the Chinese economy.
The U.S. stock market was overvalued before this morning and now is even more overvalued as people foolishly celebrate a false hope of a solution for Europe’s problems.
More news is coming out of China suggesting that the government has lost control of a lending bubble, resulting in a false real estate boom that is now being brought under control. This will lead to a hard landing in China and massive selloff of hoarded commodities so as to raise cash.
The U.S. jobless figures are perhaps the world’s most important economic figure. At the current rate of slow job growth it will take five to ten years to get back to normal, which would be about as long as the Great Depression, since the crash started in mid-2007.
Today’s huge rally reminds me of rallies that occurred when the Fed cut rates at the start of the 2007 crisis a whole year before Lehman failed.
It is true that GDP was up 2.5%, which is an improvement but that is not enough to get out of the recession. A lot of stimulus programs expire in 64 days on 12-31-11. Check back at the end of 1Q2012 and see how the economy is doing.
I have written an article “Eurozone crisis to lead to recession” and an article “Shocking mistakes by EU and US experts to create new crisis”.
Investors should seek independent financial advice.
Posted by Don Martin on Thu, Oct 27, 2011 @ 01:37 PM
People ask how to protect your 401k, what is the safest investment for a 401k, what is the safest place for 401k money for deflation, is a bond fund safe in a 401k? People wonder what is the housing bubble effect on 401k’s, and what is the effect of the debt ceiling on 401(k)’s?
To protect your 401K please invest it in the most conservative investments. This means avoiding risky stock mutual funds and instead investing in investment grade bond mutual funds. It means reading the entire prospectus and annual report of the mutual fund and looking to see if they are trying to sneak some risky junk bonds into what they claim is an investment grade bond fund. This would allow the fund to boost returns while claiming to be an investment grade fund.
To make your 401K a safe place during deflation then you should avoid junk bonds, mutual funds that invest in commodities, funds that invest in risky equities. That pretty much limits your choices to investment grade bond funds (but avoid mortgage backed bonds) and so called “Guaranteed investment contracts” (GICs) that are offered in some 401k’s. (Those GICs are not really guaranteed because if the insurance company goes bankrupt then what do you have?). Don’t be discouraged by the limited choices because a 401K is best used to hold bonds because you want to make long term capital gains in stocks in a taxable account so that you can get the best tax treatment. If you get a long term gain inside of a 401K or IRA the gain is treated as ordinary income when you make withdrawals, which is a tax planning reason to use retirement accounts for bond investing.
Will your 401k provide a pile of money when you are retired?
How does the housing bubble and government debt ceiling crisis affect your 401K?
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The housing bubble effect on 401k’s means that bank stocks and mortgage backed bonds have the risk that some of their assets will default and be sold at very low prices, which means banks and mortgage bonds would go down in value. So avoid bank stocks and bonds issued by banks unless you are an expert who can know what banks have honest accounting systems and very strict risk management. Avoid mortgage backed bonds because even if the housing market is close to the bottom there are a lot of “shadow inventory” houses (soon to be foreclosed and listed for sale properties). Also mortgages have a problem: even if there is no risk of default then there is risk the well qualified homeowner will refinance into a lower rate loan which will make the value of your mortgage backed investments go down. And then if rates go up your mortgage backed investments will go down in value, so it is an asymmetric relationship with the market offering to you a “heads I win, tails you lose” scenario, so don’t bother playing that game.
You may wonder what is the effect of the debt ceiling on 401K’s? The answer is that the debt government debt crisis implies an outcome of either a draconian increase in taxes or a draconian cut in spending, either one would result in consumers having less purchasing power leading to a drop in retail sales and investments, leading to recession and a drop in stock prices. This is why a conservative bond portfolio of investment grade bonds may be your best choice.
People ask is a bond fund safe in a 401K? Of course there is the risk that inflation could come back and damage bonds. There is the risk that an alleged investment grade bond fund could sneak part of the portfolio into the world of junk bonds and then suffer losses due to poor credit quality.
I have written an article “Two things you must know how Debt Ceiling crisis hurts 401K’s” and an article “How to protect your 401K from a Treasury Default”.
Investors should seek independent financial advice.
Posted by Don Martin on Wed, Oct 26, 2011 @ 02:39 PM
Depreciation charges warp corporate profit
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In yesterday’s Blog Post “Two tax items that warp stock values” I mentioned accounting gimmicks with depreciation that inflate a company’s earnings.
A thoughtful reader told me that this could not work because the depreciation charges over the life of the asset would eventually be the same regardless of how many years the annual charges were amortized.
However when an asset is purchased and a depreciation schedule is established a company can decide several years later that the equipment is obsolete and junk the equipment with the unused depreciation taken as a one-time loss. The marketplace does not recognize “one-time” losses but instead assumes that it was part of the past and since a company is valued on future cash flow the market ignores this one-time catch-up depreciation charge. Further, the company is allowed, in some cases, to post the loss directly to the net worth section instead of running it through the Profit and Loss section, as long is that is disclosed in fine print footnotes. Jeremy Grantham and Andrew Smithers have written separately about this, saying that these gimmicks have inflated earnings by roughly 10-15% annually for the post 20 years. CPA firms have been willing to negotiate and compromise with the company about what depreciation schedule to use and about suddenly recognizing the junking of depreciable items before the scheduled life of the asset had been completed.
See my review of Smithers book “Wall Street Revalued Imperfect Markets and Inept Central Bankers”.
Don't lose money becuase of accounting gimmicks
Bank loan buybacks and "mark to model" hypocrisy: a hidden land mine
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Another accounting gimmick allows banks to recognize income from their hypothetical ability to buy back their debt at a discount even if they don't buy it. Suppose a bank issues $100,000,000 in bonds and then a year later those bonds are now trading at $70,000,000 then the bank can buy them in the market, saving $30,000,000, which would be a profit if they actually bought the bonds. Now this is possible because the bank degenerated in credit quality so that its bonds became cheaper. So the bank gets rewarded for being a loser. And it doesn't have to buy the bonds, this can be hypothetical. In addition special laws allow a bank to claim that it can't mark down assets to market but instead carry them at book value. So the banks can have it both ways as needed. So a bank ought to issue lots of debt and also buy lots of bonds and then they can play a game of "heads I win, tails you lose". Of course eventually the truth would come out and the less than fully solvent bank would be punished by the marketplace and regulators, but if you the investor, buy bank stocks without being aware of this you could end up getting hurt.
Investors should seek independent financial advice.
Posted by Don Martin on Wed, Oct 26, 2011 @ 02:17 PM
Bank failures or attempts to tighten to avoid failure will create a European credit crunch
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The Eurozone crisis is primarily due to reckless lending by banks to southern European governments who are now unable to repay the loans. The banks assumed that governments never default and the bank regulators assumed there was no need for reserves against potential losses when lending to governments, so the banks were eager to do loans that did not require reserves. Banks don’t like reserves because that is “dead money” to be used in case of a write-down of a bad loan and it earns no income. Making a loan without reserves is like “saving” money by not outfitting the Titanic with lifeboats.
The result is that banks in Europe, many of which have only a 1% net worth (as opposed to the 8% required in the U.S.) will fail. The result of a wave of European bank failures will be that the surviving banks will need to reduce lending so as to avoid risk and so as to shrink their assets in order to increase their net worth as a percent of assets. This means in Europe there will be a lot less credit available. This means that when a business loan is due for a rollover or extension that it will instead be called in and the company won’t be able to get a new loan, thus the company will go bankrupt, resulting in massive unemployment.
The result of a banking crash will be recession
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French banks do a lot of trade financing in Asia and a lot of commodity financing. They will reduce this lending and thus those businesses will be hurt, leading to recession in those industries.
A needed solution to the crisis is for the weaker countries to leave the Euro, reissue their old currencies and then devalue. However, this will not solve the need for €900,000,000 debt haircuts for the PIIGs countries.
The haircuts will result in bank failures that will result in the ECB breaking its hard money pledge and printing money to solve the problem. The resulting inflation will make the Euro go down in value.
U.S. investors don’t grasp how bad the situation is. When a solution is announced they buy stocks on the news even though the proposed "solution" is inadequate. Eventually the market will realize how bad it is and stocks and the Euro will go down.
I have written “Shocking mistakes by EU and U.S. experts to create a new crisis” and “Euro bailout won’t work”.
Investors should seek independent financial advice. 
Posted by Don Martin on Tue, Oct 25, 2011 @ 12:45 PM
Tax breaks warp market values
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U.S. based multinational corporations reduced foreign tax rate warps stock market data. Foreign source income has been growing share of corporate earnings in the past 20 to 30 years. Assuming a corporation attributes half of their income to a foreign country with low tax rates, this has reduced taxes by about 17 percentage points, so if a corporation gets 65% of its earnings as after-tax income (assuming a 35% tax rate) and then gets a 17 percentage point tax savings (using foreign income kept offshore) that is really 1/0.65 times 17% or 26.15% more after-tax income. If these savings were amortized over the past 25 years that added 1% annually to the growth of corporate after-tax income.
If we add to that the income from understating depreciation expense (incorrectly reducing costs by 15% of profit or about 1.35% of revenue) then these two cost savings boosted corporate income by artificial means by roughly 2% a year in a world where over the long run stocks return roughly 9% annually. If these were taken away stocks would return about 2/9 less (22%) less, which means that share prices need to be reduced that much. This is in addition to the need for stock prices to go down to reach a more reasonable PE ratio.
If nothing else, the continued growth of after-tax income from using the technique will flatten out to zero resulting in a slowing of growth of profits. This is because the amount of income that can be attributed to offshore activities has already been overstretched and can’t be increased. For example one giant company claims that because they have 100 employees in Switzerland that therefore half of their profits should be attributed to Switzerland where the tax rate is 8.8%. That is ridiculous and thus the company is at risk that its tax benefits could be reduced by the IRS, resulting in a sudden drop in after-tax income and thus a sudden drop in its stock price. Further, relying on this income is risky as it can be taken away by a revenue hungry Congress.
I am in favor of people getting the best tax benefits for themselves, however, in the case of sound investment principles, if a corporation is boosting its earnings with tax or accounting gimmicks that is not intrinsic value but rather it may be a false or temporary type of income. There is the risk that with the stroke of a pen by a tax official or Congress that the income (from tax savings) can be reduced.
Money is going out door when investors overpay for stocks
Why did stocks go up so much in the past 20 years?
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I am interested in understanding why stocks went up so much in the past 20 years. I think some of the key factors were tax and accounting gimmicks, along with the Greenspan-Bernanke stimulus of artificially low interest rates that allowed corporations to borrow cheaply at the expense of middle class retirees and pension funds. Since these key factors did not add intrinsic value, can be taken away suddenly, and have been maxed out so that no more additional benefits can come from them, then stocks have a risk of a sudden drop in share price down to their intrinsic value.
Of course there were also legitimate reasons why stocks went up in the past 20 years: The end of the Cold War, the rise of the Baby Boomers into their peak earnings years, the opening of low cost trade with China, and East Europe, new technology, and the decline in rate of inflation that helped lower interest rates. Also, not all stocks use offshore income or depreciation accounting gimmicks.
If my theory that stocks are overvalued 22% because of tax and accounting gimmicks is true then that is a reason to be bearish. In addition there are powerful bearish forces such as the risk of a Eurozone default, risk of a China bubble crash, risk that commodity stocks will be hurt from a crash in China, risk that Japan will continue to get more in debt, risk that U.S. consumers will consume less because of too much debt.
I have written “Three things you must know about the crash” and “fundamental investment rules”.
Investors should seek independent financial advice.
Posted by Don Martin on Mon, Oct 24, 2011 @ 05:02 PM
How to safeguard your 401k from stock market crashes
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To protect your 401k from stock market crashes the solution would be to have the funds invested in investment grade bonds. Of course you will need to be aware of the risk of inflation, which if it suddenly increased, would make interest rates go up, which will damage bond values. A partial solution would be to diversify across the yield curve with varying maturities so a sudden increase in the discount rate would have a more moderate effect on the short and medium term maturity bonds. Some 401k’s only offer one investment grade bond fund. Don’t buy junk bonds (below investment grade bonds) because those can go down in value during a recession.
Best place to invest 401k
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The best asset class to invest in with your 401k funds is the asset class of investment grade bonds. The risk of equities is that they are too high priced and will go down. Further, equities for tax reasons should be held in a taxable account so as to get long term gains treatment. Bonds should be in a retirement account so as to get optimal tax deferred compounding.
Recession’s impact: the crisis affecting 401k’s
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The recession’s impact on 401k investing is that the Federal Reserve Bank has propped up the stock market with zero percent interest rates, creating a bubble, which means stocks are overpriced and are due for a crash. When the crash comes the Fed will have no credibility and it will be unable to re-inflate the bubble leaving stocks stranded at a lower price level.
Don't lose your 401k
European debt crisis effect on 401k’s
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This is very dangerous. The European Eurozone governments need to spend far more than they are willing to spend in order to fix the Euro crisis. They refuse to face up to the facts like a cancer patient who refuses treatment, only to have the disease get worse and harder to cure. The problem is worse than that of the 2008 U.S. Lehman crash. Melvin King was quoted on NPR KQED radio as saying the financial aspects of current crisis is worse than the 1930’s Great Depression.
The Eurozone governments create false hopes with petty attempts at reform and each time they do the stock market rallies in the hope the problem has been solved, but those are false hopes. The problem continues to get worse. The result will be a massive wave of European bank failures which means a loss of borrowing power which will spread to world trade and world commodities that are purchased with European bank loans. The resulting reduction in world trade and commodity purchase will be very deflationary; as commodities go down in price that will trigger margin calls and panic sales by speculators.
Thus a 401k holding transportation stocks and stocks of commodity producers could go down in value due to the Eurozone crisis even if the 401k had no European investments.
If U.S. economy collapses what to do with 401k?
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If the economy collapses the solution (to be done before the crisis) is to be invested in investment grade bonds. Then when the crisis is at its peak the stock market will be at the bottom at which time one should switch into stocks.
How to invest 401k if bonds collapse
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This problem can only be addressed by investing in something other than bonds before bonds collapse. When I say “bonds collapse” that is merely hypothetical; I am not forecasting that will happen in the next several years, however one should be alert for inflation which could destroy bond values, but that may be the last chapter in a very long book. Look how long the U.S. Great Depression and two depressions in the 19th century and the Japan Soft Depression lasted.
The way to reduce the risk of a bond crash is to avoid junk bonds, avoid long term maturities, consider foreign currency denominated bonds and TIP’s (but only at the right price). Be careful not to overpay for or chase after alleged inflation hedges like commodities. At times they are overpriced and as a result they will not help during inflation.
I have written “Two things you must know about debt crisis damaging 401K’s” and “Two things you must know about debt crisis hurts 401K’s”.
Investors should seek independent financial advice.
Posted by Don Martin on Mon, Oct 24, 2011 @ 01:03 PM
What does PMI’s failure mean?
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PMI, the pioneer of the mortgage insurance industry was put into Receivership on October 20, 2011. The company insured mortgages with less than 20% down payment. There are now fewer competitors and they will use the lack of competition to tighten their rules thus reducing the amount of financing available to homebuyers with less than a 20% down payment. This is a crucial blow to the “food chain” in housing. Because first time buyers with a small down payment are vital to the housing market as they form the bottom of a pyramid where people gradually move up to the top of the pyramid to more expensive homes as they get older. They are often young people with no debt who can make a fresh start into the housing market. Now that it will be harder for them to buy a house this decreases the pool of qualified buyers, further weakening the housing market and thus weakening the mortgage backed bond market.
What does the new no appraisal, no equity refinance program mean?
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Last night I wrote a post on the new Federal Housing Finance Agency rules that will have Fannie Mae and Freddie Mac offer refinance loans to borrowers with no appraisals and no limit on the loan to value ratio. This will allow people with negative equity to get a refinance loan. This may save consumers $24 Billion a year, which will also save the government from tax refunds for mortgage interest expense.
This will hurt mortgage backed securities by lowering their yield after high interest rate borrowers have refinanced into lower rates.
What does the potential purchase of Mortgage Backed Securities by the Fed mean?
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The news media publishes rumors that the Fed will buy Mortgage Backed Securities in order to raise bond prices which in turn would lower interest rates. In theory this could offset my concerns about investing in Mortgage Backed Securities but there is no guarantee the plan would work or would even be tried. When QE2 (Quantitative easing) was tried by the Fed it backfired causing overseas inflation which filtered into domestic inflation and this led to the market to increase interest rates to offset inflation. Investing in Mortgage Backed Securities is risky because borrowers can refinance into lower yielding loans during a recession and then during prosperity when rates go up the duration lengthens and the discount rate goes up so two factors combine exponentially to make Mortgage Backed Securities go down in value. Thus Mortgage Backed Securities are a risky asymmetric bet where the borrower has the upper hand and the lender takes on too much risk in terms of discount rate chnages and duration changes.
I have written “Real estate crash will continue”.
Investors should seek independent financial advice.
Posted by Don Martin on Mon, Oct 24, 2011 @ 12:21 AM
New "no equity" refinance plan will hurt mortgage backed bonds and will not solve housing crisis
The Wall Street Journal published a story Sunday night 10-23-2011 that the Federal Housing Finance Agency will have Fannie Mae and Freddie Mac offer refinance loans to borrowers with no appraisals and no limit on the loan to value ratio. This will allow people with negative equity to get a refinance loan. This may save consumers $24 Billion a year, which will also save the government from tax refunds for mortgage interest expense.
This will help reduce some of the future declines in house prices, but won’t be enough because new buyers are needed to offset the huge amount of foreclosed property and shadow foreclosures. Also there will be a lack of qualified buyers due to continued high unemployment and strict underwriting rules and a need by retirees to sell their home so as to pay for retirement. The new program only applies to refinances.
Open the secrets to the housing crisis solution
My experience as a real estate loan officer for 19 years taught me that income is the most important part of a loan application. Income continues to shrink or stagnate in terms of average earnings and in terms of the number of unemployed people. So the new refinance rules will be only a drop in the bucket in terms of solving the housing crash. To create demand (which includes the ability to pay) for real estate more jobs and better paying jobs need to be created. This will take five or seven years after the bottom of the recession has been reached, which means that the jobless problem won’t be fixed until 8-9 years from now at which time housing can begin to rebound.
The new refinances will weaken the value of mortgage backed bonds because the interest rates in those investments will be refinanced into lower yielding loans. Thus investors should sell mortgage backed securities. The cash that investors will receive when they get a loan payoff will present investors with a challenge as to where to invest those new funds in a world of low interest rates. This could lead to rallies in the corporate bonds and Treasury bond markets as investors reallocate out of mortgages.
I have written "Home price to income metrics wrong" and "How to solve the housing crisis".
Investors should seek independent financial advice
Posted by Don Martin on Fri, Oct 21, 2011 @ 09:09 AM
How to profit from the coming stock boom
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Bearish advisors (or at least me) are bullish on American stocks – it is simply that I want to wait to buy at the correct entry point. I believe a bearish advisor can give the best long term equity investing results by keeping the maximum amount of one’s powder dry (during a Soft Depression) instead of buying stocks prematurely. Bear and bull market cycles are roughly 17 to 20 years. Since the stock market peak was in 2000 then that implies the bear market will last until 2017 to 2020.
Reasons for being bullish:
- Platform economy theory (developed countries get the most profitable slice of the world’s GNP)
- U.S. business freedom, corporate governance, government fiscal condition better than other developed countries
- Corruption, cronyism, and instability in Developing countries will make capital come to the U.S.
- U.S. has the best natural resources, including oil and gas, compared to other large Developing countries.
The key is that the reasons for being bullish will not outweigh and overcome the reasons for being bearish until the cycle changes in the 2017 to 2020 period. So until then the best plan is to be bearish in the intermediate term. In the past stocks have gone up or down roughly six months before the economy changes, but I doubt they will go up in a “V” shaped recovery several years before the real world economy gets better. When the economy recuperates from a long, hard crash it is like an accident victim recovering slowly and gradually from a near fatal crash. The victim does not spend the weekend in the hospital recovering from broken bones and then immediately go out and run a marathon the next day. Today’s economy is like when Bob Dole was injured in WWII and he spent three years in the hospital and three additional years of outpatient treatment to get back to normal. The Reinhart-Rogoff book “This time it is different” and the McKinsey study about the financial crisis show that a debt crisis takes about seven years to fix, which would imply a recovery in 2015. But retired advisor Harry Schultz said this is the worst bubble in 300 years, which in my opinion implies it might take a trifle longer than 2015 to fix. Further a date of 2015 is merely a turning point in terms of fixing excess debt, but it does mean that simply because debt problems were fixed that the economy is ready to grow. In addition to fixing debt it will take a long time to regain the jobs lost in the 2008 crash.
“V” shaped recoveries worked in the past because investors had a Pavlovian response to inappropriate Central bank easing during a crash. But now we are in a Japan style Soft Depression with zero percent rates so the Fed’s medicine does not work and the Fed has lost credibility.
Open the door to profitable investing by looking from a new viewpoint
What will trigger the coming stock boom
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As you read this you may be hoping that a Fed rate cut, a tax cut or the invention of new technology will fix everything resulting in a rapid “V” shaped recovery. Sorry, it will be a long time before the patient can return to normal.
To get well the following must occur:
- Stocks need to fall to “capitulation phase” levels with a PE ratio below 10
- Wages must fall in developed countries (They can fall indirectly by increasing productivity per hour of work and people can work more overtime to pay their bills)
- Debt balances must be cut with tax free debt forgiveness so that people can get a fresh start
- Taxes must be trimmed
- The Fed and the ECB and Japanese Central bank must stop manipulating the markets with risky non-productive Quantitative Easing schemes
- Instead of the U.S. trying to pressure China to stop exporting goods and to upvalue their currency, a better solution would be for China to allow their people and companies to freely invest in Developed country assets resulting in a massive inflow of capital to the U.S. This would deflate the commodities and real estate hoarding bubble in China allowing resources to be deployed more productively. The world’s investors would dump commodities and buy stocks, triggering a selloff of bonds which would cause more cash to flow to stocks.
- Keynesian stimulus can’t work with excess sovereign debt
- These things will eventually happen because it is the only cure. As Churchill said (to paraphrase) “The Americans will first try every wrong solution until they finally try the right one”.
Assuming the SP500 falls from 1210 to roughly 600 and then slowly forms a base, then it will begin to repeat the long term average of 9.5% total annual return. So 20 years after a bootom in 2017, at 9.5% annual return, the SP with dividend reinvestment may be at 3685 in 2037, assuming the bottom is at 600 points and assuming the reinvestment occurs in a tax deferred account.
But stocks and the real economy have to earn their way to success; it can’t come effortlessly with a Fed rate cut, a Long Term Capital Management bailout or Bears Stearns bailout. The tools used to bailout the economy in the past 20 years created an irresponsible bubble that inflated stocks and real estate. To start a new stock bull market the market must start all over from a low base.
I have written “When to buy equities” and “U.S. equities are 70% overpriced”.
Investors should seek independent financial advice.
Posted by Don Martin on Thu, Oct 20, 2011 @ 09:25 AM
What strategies do Bear Market advisors contemplate using?
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The problem a bearish advisor faces during the first half of a Depression, while waiting for the stock market to reach the bottom, is that all bearish strategies except cash have some risk and of course cash has the risk of being hurt by a surprise development of inflation.
Strategies that Bearish advisors contemplate: hedge funds with long-short market neutral activities, ultra-short term investment grade bonds; any investment grade bonds, corporate junk bonds, Muni bonds, buy-write sale of covered calls, precious metals, high quality dividend paying stocks, oil (peak oil investment theory), foreign currency; shorting “risk assets” like stocks, buying CDS on bonds, buying Puts on risk assets. All of these strategies have the risk that if the worst depression scenario occurs then strategies like quality equities with big dividends or a buy-write strategy can backfire and cause big losses. And there is risk that derivatives like CDS or Puts can backfire by failing to correlate with a decline in the economy or they can simply expire worthless. A depression implies that junk bonds, quality equities, oil stocks, and commodities would go down. Buying Puts runs the risk that the Put will expire worthless and that one might need to keep buying them for several years to finally profit, which is too risky. During the Great Depression stocks paid big dividends and near the mid-point of the Depression stock prices had bottomed out, so one strategy is to buy high quality stocks mainly for the dividend (with hopes of appreciation to be slow, gradual and far away), but only if the price is at depression levels like a 666 value for the SP500 which occurred in March, 2009 and only if the individual stocks pass a quality screen. Also the client would need to have a recommendation that fits his personalized risk tolerance and suitability needs.
Don't let your assets become worth a single brass coin
Mistaken Strategies Three Bear Market Advisors are Making
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One bearish advisor recommends mostly Treasuries, which is reasonable advice. In addition he advocates a small allocation to REIT’s that invest in medical offices. That is risky because if there is a glut of commercial real estate then those offices can be converted to medical offices. He also likes North American oil stocks, which is risky because if investors have overpaid for this before the stock market crashes then it may go down even if “peak oil” is correct. Also the risk of foreign oil being confiscated by foreign governments is overestimated. During a recession they will be forced to sell it to the highest bidder to pay for their mistakes like the Dubai real estate bubble. He also recommends investing in publicly traded investment advisory firms, which I strongly disagree with. If there is a depression many people will close their stock brokerage account and put their funds into a CD, or they will move it to an obscure deep discount broker and leave it in a money market fund with no profit for the stockbroker. In addition investment firms could step up advertising during a depression causing their profit margins to shrink.
Another bearish advisor advocates a one third allocation in commodities and precious metals, and a one third allocation in Long-Short hedge funds, the remainder in bonds including junk bonds. The reason I disagree with that is that during a depression, commodities and precious metals will do poorly. They did OK in the Great Depression but that may have just been a coincidence rather than something that happened for a fundamental reason. Junk bonds are bad because during a depression they can act like equities and go down with equities. Long-Short hedge funds are interesting but it is difficult to determine how reliable and consistent the talent of the manager will be; also their strategies are increasingly being copied so that the profit potential is being competed away. These funds depend on the willingness of other investors to sell Put options to them or to offer to loan stocks for short-selling, but during a crisis those other (counterparty) investors will be less willing to do those things at a reasonable price.
Another bearish advisor holds only U.S. Treasuries and switches between short term and long term maturities. During a depression one should own long term Treasuries and then when the stock market bottom is reached it may be time to switch to short term Treasuries to avoid the risk that the return of inflation and the rise of the bond discount rate would destroy long term bonds. In theory this is a good strategy but the risk is it may be difficult to time the market so as to correctly change maturities. The problem with the "Treasuries only" strategy is that the dollar could go down in value, so it may be better to invest in bonds denominated in foreign currency of solvent nations (that excludes Euro, Yen) in proportion to their weight in the world's economy. Of course this to is risky since other currencies can go down against the dollar during a depression, however, that paradigm (that the dollar is a haven) may have changed.
In recent years all types of risk assets have become correlated during crashes, so it is dubious that assets like junk bonds, commodities, precious metals will be able to withstand the Jupiter sized gravitational tug of a great depression. The best strategy is to avoid risky assets until the Soft Depression’s cycle has reached the bottom. Methods to judge when the bottom has been reached may include examining Tobin’s Q and PE10 to see when they reach a once in a generation low with PE ratios below 10. Read Andrew Smither’s book Wall Street Revalued to learn about Tobin’s Q and PE10.
I have written “Does buy and hold investing work?” and “Shiller PE 10 still correct”.
Investors should seek independent financial advice.
Posted by Don Martin on Wed, Oct 19, 2011 @ 02:02 PM
How does dividend investing help investors?
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Dividend investing is important because during the Great Depression once stocks finished their decline they provided an annual dividend return of about 6%. Since stocks over the long run provided a total return of 9.5% then during the Great Depression they provided two-thirds of this figure with dividends for those investors who bought after the market bottomed out. If we go into a Soft Depression then at a certain entry point when stocks become attractively priced it may be appropriate to repeat that strategy. I feel the SP low of March, 2009 of 666 points is a fair value for an entry point or possibly at 800 points. Today the SP is now trading at about 1210 points.
Dividend investing is an important screen for stock picking because stocks with big dividends may meet the screening test of what is a “quality company”. The test examines the corporate moat, low debts, strong balance sheet, stable and growing earnings and a reasonable dividend. (However some big dividend stocks are bad because they are a “value trap” stock that is going to keep going down while its dividend becomes larger as a percentage of the share’s price. Thus one must screen carefully when investing in stocks that pay big dividends.)
Are dividends the key?
One other point to be aware of the risks of dividend investing: People who are frustrated with ultra-low bond yields may be tempted to buy equities in the hopes of getting a higher yield. The rhetorical argument is “well if I can’t get a 3% bond yield I might as well buy a stock”, but that is like saying I can earn more money being a military independent contract guard in Iraq than working a security guard in the U.S., however the risk levels between those two choices are extremely different. The concept of equities should never be confused with bonds. A stock can go down a lot and stay down, while an “A” rated bond has a very high probability of being repaid on time. A bond is a sanctuary asset that one can hide in to avoid stock crashes. Bonds should be bought to preserve capital rather than to milk them for yield.
I have written “Does buy and hold investing still work?” and “Shiller PE 10 still correct”.
Investors should seek independent financial advice.
Posted by Don Martin on Tue, Oct 18, 2011 @ 08:59 AM
Bond bull market from 1981-2011 is measured incorrectly
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There have been several deflationary eras where bond bull markets have lasted about 20 years. During the Great Depression one lasted from 1930 to 1951 with rates at the lowest point about seven years after the bull market started. (Bond bull markets usually occur when there is a bear market for stocks). There were two long depressions in the 19th century. Japan has beenin a 21 year depression.
Commentators love to criticize the current bond bull market by saying that because it has lasted for 30 years that therefore it is time for the cycle to reverse. However, the 1981-1996 era was one of interest rates dropping from absurdly high levels, which is why the bond bull market occurred. That should be viewed as one type of bond bull market that was back-to-back with the current deflationary market.
Starting with the Asian crisis of 1997 Greenspan and his successor Bernanke kept lowering rates to keep the economy from crashing. The past 14 years since then has been a new type of bond bull market where investors reacted to the threat of deflationary crashes. From 1998 to present there has been no increase in ‘real” private sector GDP; since 1999 no “real” increase in personal income. Thus the idea that a bull market can’t last over 20 years is not applicable, since this a new one (that began in 1997) that simply happened to be adjacent to another one. The Volcker era Fed of 1979-1986 had very high “real” rates and when “real” rates came down to normal levels in the 1990’s the economy became normal, only to fall into a disinflationary era of bubbles and crashes and lack of developed country growth.
Open the secrets to understanding the economy
The world has encountered and will encounter huge, unresolved debt-deflation crisis. The sovereign and consumer debt loads are so high that new Keynesian stimulus may not work. Inflating our way out of debt would only help pay off the 30% of debt or obligations that are not indexed to inflation or short term rates, so it is doubtful that inflation will return in the next few years.
I expect the Soft Depression to continue from roughly 2000 to 2017 at which time the bond bull market (and the stock bear market) would have run its course. This would be a 36 year bond bull market, except that I'm dividing into two smaller bull market eras.
I have written “When will interest rates return to normal?” and “Treasury Bonds to be OK”.
Investors should seek independent financial advice.
Posted by Don Martin on Mon, Oct 17, 2011 @ 02:09 PM
Housing statistics are misinterpreted
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The statistic “new housing starts” is currently at a very low level and is even lower when adjusted for population and low interest rates. So some commentators have suggested this means that the data will revert to the mean (revert to the average) and thus the number will go up. Investors want to use this data to determine when to invest; they are being fooled because the data is greatly misunderstood.
This is wrong because during the era of “Easy Qualifier” mortgages from 1984 to 2009 borrowers who did not qualify for a loan were able to get one and thus the past 25 years was a misleading statistic. Further, some of those buyers need time to get rid of the house they can’t afford, and then the market needs time to digest the huge shadow inventory of unsold homes.
It may tempting to say “well if you don’t like the data from 1984-2009 then why not use the data from 1945 to 1984?” But that data is also full of non-recurring good news. During the 1945-1974 era the economy was very prosperous and people were recovering from the suppression of demand caused by the Great Depression and WWII which were during 1929-1945. In 1950 the typical home was only 1,000 square feet, today it is 2,500. So during the boom from 1945-1974 people were improving the standard of living from a low base and they were backed by the very good job market that occurred from 1945-1974 (which was greatly aided by the one-time luck of being the only major country not to have its economy destroyed by World War II). After 1974 there was stagflation, OPEC price increases, etc. So the current era can’t be compared to the 1945-1974 era of great growth and prosperity and it can’t be compared to the era of excessively easy credit of 1984-2008. The inflationary 1970’s often had interest rates that were negative “real” rates and with the mortgage interest tax deduction the real cost to borrow was even lower. Borrowers were being paid to borrow with a fixed rate loan in the 1970’s. It was only in the 1980’s that adjustable rates became widely used. So none of the eras from 1945 to 2009 are comparable to the current housing market. It is in uncharted territory with a need for prices to go down roughly 15% to revert to the mean of established trend lines. However those trend lines were based on a debt bubble economy, so that implies there could be even less support for a bottom in housing than simple mean reversion would imply.
The value of bad advice
The future of housing will be that the 2,500 square foot homes get converted into duplexes and triplexes. People will simply learn to live with a lower living standard. Gary Shilling mentioned this in his book Age of Deleveraging. My opinion is that the one budget item consumers can cut is housing. They can do it by giving up a nice home and move into a generic small, less attractive home. The amount of money to be saved is so much bigger than simply switching to a cheaper grocery store of cheaper cell phone, etc. Besides, most cost cutting requires constant discipline to shop for the cheapest substitutes, which is hard if you buy groceries at 11 pm after a hard day at work you may be too tired to clip coupons and watch your pennies. By contrast, switching properties from a $3,000 total monthly payment to a $1,000 payment allows the savings to be a permanent and easily controlled and quantified part of one’s budget. People are going to flee from owner occupied homes as the only way to save money.
If a great many large homes were converted to duplexes that would be a huge increase in housing which would not require a new housing start to install a second kitchen and partition the house, and this would greatly repress new housing starts.
So the old statistics on housing from 1945-2008 are of little use due to a massive paradigm change.
I have written “Housing not comparable to the past” and “80% of loans were not safe”.
Investors should seek independent financial advice.
Posted by Don Martin on Fri, Oct 14, 2011 @ 01:05 PM
Would a debt jubilee help the economy?
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Yesterday Martin Feldstein wrote in the WSJ and today Gavyn Davies wrote in the Financial Times that the housing crisis must be fixed by some type of debt relief where over-indebted homeowners would get part of their debt forgiven by lenders.
I am reluctant to recommend that because it is rewarding people who should have avoided buying a home at the top of the bubble. However my solution maybe a program that each individual family that has too much debt could simply file for bankruptcy. To facilitate this Congress could pass a special temporary law setting up special bankruptcy courts for consumers who have relatively simple over-consumption and overuse of debt. The law would fund government paid lawyers to represent the bankrupt party. The problem now is that middle class salaried and wage earners are not used to the type of tough and sophisticated things that some upper class people and business owners may be more comfortable with, so the middle class needs some legal representation. Of course they can always pay for an attorney but if they are under financial stress they may be reluctant to get counseling. My thinking is that if the Supreme Court ruled that poor criminal defendants are entitled to a government paid attorney then why not extend that to bankruptcy petitioners.
Part of the program would include a legilative directive to the bankruptcy courts to allow more generous protection of assets and earned income from creditors and may be more right to keep some credit cards after filing for bankruptcy.
The goal would be to make it easy and painless to get rid of debt so that those individuals with a negative or zero net worth or unaffordable monthly payments could get a fresh start and still keep their home, car, furniture and a few credit cards.
Currently the Federal Reserve has manipulated financial markets making stocks artificially high priced in an attempt to raise the self-confidence and animal spirits of those who own stocks so as to get the economy out of recession. But that has given an unearned windfall profit to stock investors. So why should anyone object if over-indebted people get a windfall in the form of a one-time legislative relief of debt.
The worst victims of the bubble are people of modest means who lack the street smarts to hire a bankruptcy attorney. Further, filing bankruptcy is very risky because the courts have enormous power to away everything, leaving the petitioner to be homeless and without credit cards, a bank account, phone service, etc. So if the middle class salaried people could get some mentoring from a government paid attorney and then file for bankruptcy under a new law that gave them a better outcome and under special courts that were designed to make it fast and painless and they had relief from taxation on “forgiveness of debt” income then this package of benefits might be a way to get rid of the excess debt.
In the real estate crash of 1990 there was a famous real estate developer who filed bankruptcy and he was able to intimidate his creditors by saying that if they did not help him then he would let the insurance policies lapse on his buildings, etc. These types of threats are best done by members of the upper-class; by contrast salaried middle-class people are too scared and unimaginative to be tough a fight the system so they end up putting up with excessive debt.
To give them equal footing Congress should set up a temporary once in a lifetime special bankruptcy court with free attorneys, free counselors and social workers would could encourage people not to be afraid of the process. The idea is that it would be like the criminal courts’ policy that the defendant is entitled to a free attorney or else the trial would be unjust.
I am in favor of property rights and I enjoy being a bond investor, however property rights have been trampled by the Federal Reserve making interest artificially low thus transferring wealth from middle class savers to upper class stock investors, further wealth has been transferred by income taxes to those who got government stimulus benefits. So by contrast my program would be far less of a transfer. If this is not done it will slowly happen as people gradually give up and go into foreclosure over many years. So why not get it over with in a fast and easy way instead letting this problem drag on for a decade.
The damage to the economy from extra bankruptcies could be perhaps, as a rough guess, a 5% loss to a diversified domestic bond portfolio, or if the bond portfolio was half in domestic debt then the loss would half of that. Assuming someone believed in always having a 50% bond allocation of which half of that was foreign then his portfolio would go down 1.25% but the economy would get better, thus benefiting stock and benefiting some junk bonds that were not in the mortgage industry.
I have written “real estate crash to continue”.
Investors should seek independent financial advice.
Posted by Don Martin on Thu, Oct 13, 2011 @ 01:31 PM
Is the cash flow from a pension the same as owning a bond?
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In recent years financial planners and investment advisors have written that the cash flow from a Defined Benefit pension such as Social Security is mathematically the same thing as a bond so therefore the client’s investment allocation must be adjusted for this hypothetical bond ownership. This is wrong because when you own a bond you can make a profit when rates go down because bond prices go up then. When a recession occurs interest rates drop, making bond prices go up, and stock prices go down. During that time the strategy is that you sell your bonds at a high price and use the cash to buy stocks at a low price. This is called rebalancing. You can’t do that with a pension income stream. Thus a bond-like cash flow from a pension is not a substitute for or a proxy for owning a bond. (Try and ask Social Security if they will give you a lump sum payout instead of a monthly income stream!).
So if an investor decided that his pension income was the mathematical equivalent of a portfolio with a 40% bond allocation then he might be tempted to have a portfolio with 100% stock allocation. Then during a stock crash he would suffer from deeper losses and would not have spare cash to buy more stock at low prices.
If a personal crisis developed where he needed to sell assets to pay for a major expense he would have to sell stocks during a time when the price was depressed, thus incurring more problems. If an investor owned a significant allocation of bonds they may act to provide stability in the portfolio that would allow the investor to have a more reliable asset that can be sold to pay for major personal expenses.
Don't be penny wise and pound foolish
The risk of a pension is that inflation can destroy its value; by contrast owning a bond means that the investor could sell the bond and invest in a blend of inflation hedges, short term bonds, TIP’s, foreign currency denominated bonds, etc.
However, the emotional aspect of a retired person feeling financially secure because he is getting a significant pension income may cause the client to be more confident and flexible about risk tolerance and this will make the client better able to withstand the emotional rigors of stock investing and thus lead to a greater portfolio return (by taking on more risk), but that is something which can only be measured by personalized assessment of the client’s psychology.
I have written “Fundamental investing rules” and “Four investment tools you must know”.
Investors should seek independent financial advice.
Posted by Don Martin on Wed, Oct 12, 2011 @ 04:54 PM
European Union Eurozone crisis not helped by recent additional subsidy to Greece
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The European Union Eurozone crisis is getting worse. The decision by the EU to give Greece an extra €8 Billion is a foolish mistake. Greece will default and settle for a 60% to 90% haircut, so the extra 8% is a waste of money. The fact that the EU has done this means that they have not faced up to the need for aggressive action to solve the problem. Thus are in a state of denial so they are making things worse.
Several years ago the myth was that European countries’ citizens loved to vote in favor of high taxes so that they would have a balanced budget and thus with no deficit they would not have the Central bank print money and thus not have inflation and thus have sound money. By contrast the myth was that American voters wanted excessive deficit causing tax cuts that would saddle the country with excessive debt. But several years ago I began to notice that Europe was not living up the t myth. Yes, they paid more in taxes, but they could not resist excessive spending increases that outstripped tax increases. Some of the excessive spending was financed with new issuance of bonds that the EU member countries in the south can’t afford to pay. The spending that was a waste of money has resulted in €900 Billion of potential losses in government bonds (once the true value is reached). This is the amount of future or current loss and not the total amount of debt issued. The EU does not have enough money to bail itself out. The only two solutions are either: 1. a massive default and write down of sovereign debt by southern EU countries or 2. a massive subsidy from the European Central Bank using newly printed money, which is in violation of the Central Bank’s charter. So when the truth comes out and is fully recognized by the marketplace then Europe will be plunged into a Depression or else will have a lot of inflation.
Since it will take time to amend the Treaties between the EU members then maybe as a temporary measure the ECB could set up a shell company to buy bonds at face value and then loan newly printed fiat money (created electronically by book entry) to the shell entity and then by the time a court order stops the ECB the governments will have changed the laws and treaties so as allow this. But by then the fiscally conservative anti-inflation northern countries like Germany will become very unhappy with the EU monetary union and will withdraw from the Euro leading to its breakup.
Gain access to new insights with a contrarian attitude
What is truly amazing is that giant European banks bought poor quality southern European debt without studying the details. They simply assumed that because the currency was in Euros and was a sovereign debt that it was risk free. That was a very bad assumption. So the major banks of Europe are insolvent and will need a huge bailout once the sovereign bonds they own are marked down to their true value.
It is amazing how the best and brightest economists working for large banks in the U.S. missed the mortgage and real estate bubble and in Europe they missed the sovereign debt bubble. Their mistake was to blindly trust computer printouts of data instead of digging deep beneath the surface to see if a new paradigm has been created that rendered old patterns irrelevant. In the case of U.S. real estate the old paradigm was that real estate never went down since the Great Depression and since there is no way to increase the supply of land then the assumption was that real estate was risk free. In the case of European sovereign debt the paradigm was that voters meekly agreed to ever-increasing taxes so the sovereign debt was risk free and so the sovereign could perpetually increase its debt with no risk the bond investor. These paradigms were wrong, even though the raw data (when interpreted in a naïve way) supported those beliefs.
This is why I like creative, contrarian thinking.
I have written “Eurozone debt crisis ready to blowup” and “Euro bailout won’t work”.
Investors should seek independent financial advice.
Posted by Don Martin on Tue, Oct 11, 2011 @ 01:22 PM
Is your portfolio getting good risk control?
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How do investment advisors handle risk control? An investment advisor is a fiduciary who adheres to the higher fiduciary standard instead of the lower, simpler “suitability” standard of a Broker-Dealer.
To meet a fiduciary standard of risk control an investment advisor might have clients fill out an extensive questionnaire to understand the client’s verbal descriptive responses to investment risk and investment experience. The adviser might ask the client what percentage of assets should be in low risk, medium risk, high risk, etc.
The adviser might then look for contradictions in the client’s statements. For example a client could say he wants “high returns but no risk”, which is a contradiction. The advisor would ask the client to clarify this and try to educate the client about the tradeoff between risk and reward.
One way to gauge the appropriate amount of risk for a client to take would be to take a weighted average of the client’s desired level of risk and produce a score. Then the adviser would examine blend of the standard deviation of domestic bonds (now 5%) and the standard deviation of domestic stocks (now 21%) and then estimate what combination would be the appropriate risk level. So if a client indicated a moderate risk tolerance perhaps that would be like a blend of 40% bonds and 60% stocks which is a score of standard deviation of 14. Then when constructing portfolios the adviser could aim for a target of a blend of assets that have a standard deviation of 14.5. Of course it gets more complicated when the advisor is considering Emerging Markets, or junk bonds, etc.
That is merely one way to gauge risk. In addition an adviser might manually reject some industries that have a reputation for high risk even if the standard deviation of that industry was acceptable. For example junk bonds may have a higher risk than would be shown by their three year historical standard deviation because once a decade they could suffer from a severe recession and stock market crash (junk bonds often decline in price in tandem with stock crashes). Financial service companies like banks tend to be leveraged by a factor of 16 which makes them riskier than a hedge fund, so that industry should be viewed as riskier than a simple statistic like standard deviation would tell us. In addition banks have obtained legislative relief from being required to “mark to market” so that their assets are overvalued and thus bank stocks are overpriced. Another industry to manually reject is the asset class of high p.e. or rapid growth Tech stocks. I have seen this pattern in 24 years of working in Silicon Valley where a company becomes popular for a few years and appears ready to rule the universe and then after three years the popularity fad bubble is broken and the company becomes just another generic company, resulting in its share price going down.
Be open to new investment ideas
How to do risk control for bond investing
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In selecting bond mutual fund portfolios one way to practice risk control is to shop based on quality of assets, which means accepting a lower yield in return for less risk. It means reading the prospectus and fund card and Morningstar write up to see if the mutual fund is doing a blend of junk and investment grade bonds while trying to claim it is an investment grade bond fund and then avoid that fund, in most cases. It means shopping for high Sharpe ratios instead of high returns. A Sharpe ratio weighs the reward with the risk so if the reward was not big enough to compensate for risk then it produces a low score. Another way to work on risk control for bonds is to limit maturities to medium term in case inflation suddenly breaks out. That way the damage will be less than if the portfolio was all in 30 year maturities.
In investing in Emerging Market (EM) bonds a risk control technique might be to choose a mutual fund with a reputation for conservative approach to credit quality, meaning a fund that has a higher than average credit quality. Most EM bond funds hold B or BB credit quality bonds because that is typical of EM borrowers, so a risk controlled approach would be to rank EM mutual funds in order of credit quality and pick the ones with the highest rated assets.
These techniques vary a lot and can’t be used in a mechanistic, simplistic way. Some asset classes have minimal choices so it may not always be possible to get the optimal amount of risk control.
When I hear the financial news media say they like an investment because it was the best performing I am unhappy with their naive approach; instead I prefer to shop for the best Sharpe ratio or Information ratio so as to have risk control at the top of my criteria.
The reason risk control is important is because if an investor suffers from too much risk he will burn out of investing and sell at the bottom and stay in cash for years and miss the next rally. Further, when you invest $100 and lose 50% and then gain 50% you now have only $75. Thus once you get into a hole it is hard to get out of the hole.
Past performance is not indicative of the future as fundamental paradigms can change in a way that makes historical data not relevant enough to use.
I have written “Blacks swans and risk aware investing” and “Increasing results using risk aware investing”.
Investors should seek independent financial advice.
Posted by Don Martin on Mon, Oct 10, 2011 @ 04:59 PM
Foreign currency investing – when will the dollar decline?
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The traditional paradigm is that when the world goes into recession or a panic that every “risk asset” including foreign currency is sold and investors rush to buy U.S. dollars and U.S. Treasuries.
But paradigms can change. At one time the British Pound was the world’s reserve currency but after 1945 the Pound was gradually, permanently significantly devalued, dropping down from $4.80 to almost $1 and is now at $1.57.
Could the same thing happen to the U.S. dollar? What will happen to retired people who only invest in U.S. dollar savings accounts and who ignore the rest of the world? Will their savings become devalued by 70% over several decades?
There are two parts to the decision about foreign currency:
Part one is to decide if there is going to be serious recession versus a mild recession that people can muddle through. If a mild recession develops next year then there is less of a need for investors to panic and sell everything and buy dollars.
Part two is to decide is if the fundamental paradigm shift will occur where the dollar is no longer a haven in times of risk.
For part two we should look at how strong is the U.S. economy versus Emerging Markets. The EM economies have:
- 52% of the global GDP
- Solvent governments with low, stable debt loads
- Citizens who don’t expect the government to give them excessive, unaffordable benefits
- Solvent corporate bond issuers and banks with low, stable debt loads
- Solvent consumers with low, stable debt loads
- A growing economy that increases the government’s tax revenue base
- A growing economy which implies that their expanding economy will attract an inflow of funds which will push up the value of their currency.
Are your savings protected from a dollar crash?
Should investors use balance sheet or cash flow to analyze foreign currency?
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The developed countries have a lot of “balance sheet” resources, but these can be depleted in less than generation. In analyzing investments cash flow analysis outweighs asset analysis. If a company (or a nation) has significant assets, that is not as important as their cash flow. Assets can be squandered away if the owner’s cash flow is negative. By contrast, someone who has good and growing cash flow and low, stable debt is going to emerge as a winner because their wealth will compound over time. The developed countries are prisoner to a huge, growing private and governmental debt load; the EM countries are not. A debtor may “solve” his problem by selling productive assets to pay off debt but after losing the earnings from a profitable asset that was sold the debtor will have less income and thus not be able to increase his net worth.
So in the long run I think the paradigm shift will occur. The problem is that it is very hard to time the market. The paradigm shift could occur several years from now. Also investors could be prejudiced against Emerging Markets and may be clinging to an old paradigm that is not fundamentally true. Once the truth comes out then investors will embrace the new paradigm.
Arguments against this paradigm shift would be that EM economies depend on selling to developed countries, so if developed countries go into recession then they can’t afford to buy from EM countries, in which case the EM countries would experience an outflow of funds leading to a drop in their currency values.
However, in a recession consumers may try harder to buy cheaper goods, so they may step up purchases from the Developing world. If a significant recession comes then Developed countries may try to use deficit spending to create make-work jobs, which risks creating inflation and excessive debt, and inflation makes currencies go down.
I have written “Foreign currency investing” and “Emerging market currency – is it OK?”
Investors should seek independent financial advice.
Posted by Don Martin on Fri, Oct 07, 2011 @ 03:22 PM
Does the report say the economy is OK?
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Today the unemployment report was released showing 103,000 net new jobs. However to keep pace with population growth we need 125,000 to 150,000. And at two years after the bottom of recession it is typical to have 200,000 net new monthly jobs each month, so we are operating below “stall speed” where the economy is like an airplane flying so slowly that it will stall out (where the wing’s airfoil loses the ability to generate “lift”) and go down.
The Verizon strike settlement resulted in 50,000 people going back to work, which was half of the 103,000 new jos, so realistically, new jobs were only about 53,000, which is one thrrd of the amount needed just to meet population growth.
What is risky about depending on today’s report is that a naïve reader of the report may assume that any positive number is OK, but we need 125,000 to 150,000 monthly net new jobs to breakeven due to population growth and 300,000 to recover the lost jobs to get back to normal. So a careless reader may fail to grasp how serious the situation is and further there is no sign of any new driving engine of growth. So if we are below stall speed then the economy will fall back into recession.
Open the lock to uncover the secret
The U-6 measure that includes all types of unemployed, including those who have given up looking for work, is at the highest of 2011 at 16.5%. The WSJ has an excellent color coded heat map of unemployment since 1948 shows the current recession is the deepest since 1948 and is still near the worst point in the recession.
If Baby Boomer generation is trying to save more and spend less, then that act of saving will be deflationary, which when added to the jobless problem, means that very low bond yields are legitimate and not simply a temporary bubble or panic.
I have written “Tomorrow’s unemployment report may be the start of something terrible” and “Recession coming".
Investors should seek independent financial advice.
Posted by Don Martin on Thu, Oct 06, 2011 @ 08:51 PM
Are we in a recession even though GDP has been rising?
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Tomorrow, on Friday, October 7 the monthly unemployment figure will be released. It is the most important monthly economic number in the world. One French investment company, GaveKal, said last week that the U.S economy has been getting weaker and if this number that is to be released October 7 fails to show a substantial increase of jobs then that means the world is heading into recession. The news media has forecasted 100,000 jobs increase, half of which is due to the end of a Verizon strike, so it would really be a 50,000 increase. However, to get out of the recession we need a long, sustained period of monthly increases of 300,000 of jobs, not the 100,000 forecast for tomorrow. The U.S. has added only about 25,000 jobs a month since the recession officially ended in June 2009, which is over two years is what should be done every two months. So the economy is only creating jobs at one-twelfth the speed that we need to get back to normal. Part of the need to create 300,000 new jobs each month for several years is due to a 0.8% annual population increase.
A recession is not simply “two quarters of negative GDP”, rather it is a complex series of symptoms: no growth in real personal income, excessive joblessness, lack of increase in industrial production, inability to reach new highs in real sales. We are in a big, bad recession and there is nothing on the horizon that is a potential engine of growth. We have only regained 20% of the lost jobs that were lost in the 2008-09 crash.
The GDP and various broad indicators sometimes incorporate some intangible measures such as stock prices or low interest rates and that can make the broad economic indicator look better than it really is. But the “real world” of jobs, sales, personal income (excluding government transfer payments) is what should count, not a statistic that can be manipulated (and is potentially a bubble) statistic like stock prices or interest rates. We have seen the irrational judgment of stock investors during the 2000 Tech stock bubble, so using stock prices to determine whether or not we are in a recession is often worthless. Congress passed a law in 2009 forcing CPA’s to switch from “mark to market” to “mark to model” for banks so this created false valuations of bank loan portfolios that were legislatively imposed, so how can stock prices be useful information?
Using interest rates to measure the economy or their maturity spreads is very worthless because of the Fed’s absurd hyper-manipulation of them. For example if it were practical to have negative nominal short term rates then the yield curve would be very steep, but it is not practical to have negative nominal rates. (That would require legislation imposing mandatory fees and price controls on interest rates for all bank depositors to transfer 2% a year from zero yield savings accounts to borrowers, since in normal situations a bank can’t offer a savings account with negative rates.)
Be open minded to new viewpoints
Personal income has been declining
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The private sector has had no real (inflation adjusted) increase of personal income since 1998. Stock prices are the same as in 1998 (lower if adjusted for inflation). A graph I saw pointed that real personal income for men has declined since the 1960’s; for women it has increased but at much lower amounts in absolute dollars. The women’s increase was probably due to the women’s lib movement as women moved from clerical work to professional occupations that pushed the gender average. Presumably the blue collar women have suffered the same fate as men’s income as jobs have been moved offshore.
With these negative items there is no chance of inflation coming and high chance of Japan-style Soft Depression with the fair value of a ten year Treasury at a 1.5% yield. Of course buying long term debt is risky since I could be wrong and somehow inflation could surprise and that could make bond prices go down. But I don’t see how inflation can happen, unless Congress legislates truly massive Keynesian deficit spending and at the same time the Fed monetizes the new debt. How can that happen given the recent budget fight led by Tea Party Congress members?
I have written “Recession coming” and “Is economic recovery possible even if housing remains depressed?”
Investors should seek independent financial advice.
Posted by Don Martin on Wed, Oct 05, 2011 @ 08:28 PM
Steve Jobs has passed on today at age 56. What made him great was that he was creative and independent minded. He refused to go to college and instead focused on learning in the real world. He was an iconoclastic business leader and perhaps the most influential leader in the computer industry of all time. He created enormous wealth for his stockholders, starting with $1,300 of capital at age 21. In his 56 years he lived life larger than what others could do in ten or twenty times as much time.
I have never bought Apple stock or Apple products. My reason for this blog post, besides paying respect to Mr. Jobs, is to inspire readers to see that wealth is often created through being creative, contrarian, and independent minded rather than blindly sticking to the conventional wisdom.
The conventional wisdom in finance was that banks would not buy bad quality mortgages and that ratings agencies would not falsely rate a mortgage backed bond as AAA when it was really B or C paper. The conventional wisdom was that real estate would never go down and that an insurance company would never insure against a decline in real estate unless they had plenty of capital to handle the losses. The conventional wisdom was that if house prices were rising in 2005 then it must be due to an increase in consumers’ income (it was not). Conventional wisdom is what caused enormous losses in banking and insurance which the taxpayers are now going to pay for. It also caused losses for companies that manufactured PC 's and giant mainframe computers becuase they did not think creatively and respond to customers' needs.
So if you want to learn from Steve Jobs the key thing to learn from his life is not a technical skill but rather a talent and appetite for thinking creatively, entrepreneurially, going against the grain, seeking a new way to do things. Of course his legacy also includes good marketing intuition to serve the customers’ needs for user friendly, intuitive products, which his competitors often badly lagged behind.
Apple was founded in a garage on a house that Steve Jobs lived in on Crist street, Los Altos, about a mile away from my office.
Hopefully independent financial advice is something that is symptomatic of creative, contrarian ways of building wealth.
Posted by Don Martin on Wed, Oct 05, 2011 @ 05:24 PM
See an article today in the San Francisco Chronicle about strategic mortgage defaulters who disguise themselves. The article shocked me by saying that studies show that people with high credit scores have a higher tendency to do this.They do it by getting a new house and new credit cards and then they abandon the old house and refuse to pay the mortgage on the old house. In California lenders have no right to sue to get a deficiency judgment against mortgage defaulters who default on a home purchase loan (but not if the default was on a refinance loan).
I used to work in real estate lending and remember when "Easy Qualifier" loans were promoted by banks as something that was low risk because the credit bureau experts alleged that there is only a one in 1200 chance of a high credit score person defaulting. I felt that this was intuitively wrong. Well, a decade later I now have proof!
The problem with statistical analysis is that it can go wrong if it based on a genteel era of prosperity, full employment, stable or rising real prices, etc. During the good times people want to pay bills on time so credit scores work then, but they are not really needed during good times. However, during a bad, hard crash then some people change their character and become ruthless and let properties go into foreclosure. The problem with credit scores is that they did not dig deep enough into how people would behave when confronted with a once in a lifetime crisis.
So the news article is inspiration for avoiding naive investment techniques. Don't simply use a statistical tool to judge an investment (including creating a loan), instead look to incorporate an overall sense of wisdom into your decision process. When you hear an idea that sounds too good to be true (like the claim that credit scores are a magic way to do a nearly risk free approval of a loan with minimal verification of the borrower's qualifications) that you should be suspicious and seek alternate and more thorough ways to verify something.
I wrote "Will relatives destroy your retirement?" and "80% of laons were not safe".
Investors should seek independent financial advice.
Posted by Don Martin on Wed, Oct 05, 2011 @ 12:57 PM
An interesting article today is in Yahoo! Finance about Emerging Markets Currency investing. The article did not recommend funds that I like. The article mentioned an ETF fund "EMB" that invests in Emerging Market dollar denominated bonds, so the investor would not be getting an investment in bonds denominated in foreign currency, thus the investor would not be protected from a dollar devaluation.
A quick screening in Morningstar fails to identify mutual funds that have bonds denominated in Emerging Market currency, so an investor could buy EM bond mutual funds but end up losing money if the dollar was devalued.
Should investors buy a pile of foreign currency?
In the short run there is a high probability of another recession which could cause people to panic and flee into the safety of U.S. Treasuries and other very large (mainly the G3 countries) AAA rated sovereigns who have the ability to issue debt in their own currency. and thus foreign assets could go down in value. That was the old paradigm, but that paradigm is likely to fade away. No one knows if it will fad away soon in in a long time. The only solution is to hedge one's bets by diversifying with some bonds in EM denominated in foreign currency and some in dollar denominated bonds.
Bill Gross, Pimco's bond expert, said yesterday on Bloomberg that the pattern of capital fleeing Emerging Markets in recessions and going to developed countries is a thing of the past. However, it still happened during the previous two months when EM currencies went down; I think he was referring to a big picture long term macroeconomic viewpoint rather than a short term trading idea.
I wrote some posts "Foreign currency investing" and "Foreign currency investing" .
People should seek independent financial advice
Posted by Don Martin on Tue, Oct 04, 2011 @ 03:11 PM
Are independent financial advisors better than bank investment advisors?
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The difference between independent financial advisors and bank investment advisors is that a bank advisor is an employee of a Broker-Dealer corporation that is a subsidiary of a bank. The employee may be required to meet a sales quota and sell expensive in-house products. By contrast, independent financial advisors who are licensed as a Registered Investment Advisors are fiduciaries who chose a custom tailored investment for their client with no sales pressure and no sales quota.
A bank investment advisor may appear reliable because they appear to be the employee of a solvent, stable, big, prestigious bank. But they are employees of a subsidiary; they are not bankers. They may be susceptible to pressure by the bank to avoid recruiting depository customers and thus they may not be fully free to objectively discuss investing in a bond portfolio that yields more than a CD.
The appearance of being a bank employee may make a naïve investor think there is a higher margin of safety with a bank investment advisor.
How to screen for an investment advisor
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However, the best way to get safety is verify that the advisor is:
- Truly independent: not an employee of a subsidiary company
- Well educated with financial credentials such as CFP® and a college degree in Finance.
- A fee-only financial advisor. This means no commissions, and no referral fees and no sales quota. His or her employee must also be a fee-only financial company. One way to review this is to ask if the advisor is a member of NAPFA.
- Has plenty of work experience in finance
- Affirms that he or she is a fiduciary. This means the advisor is not using the lesser standard of mere “suitability” of the recommended investments that Broker-Dealers use but is instead using the higher standard of a custom-tailored fiduciary financial advice.
Investors should seek independent financial advice.
Posted by Don Martin on Mon, Oct 03, 2011 @ 10:24 PM
Emerging Market Foreign Currency Denominated Investment Grade Bond Mutual Funds
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Using YTD price return (not total return) figures on Yahoo! Finance through 9-30-11 one well known actively managed Emerging Market Foreign Currency Denominated Investment Grade Bond Mutual Fund that is six years old is down 6%; EMB (an ETF that holds dollar denominated EM bonds) is down 2%, another actively managed EM FX bond fund founded four years ago is down 3%, Indian Rupee and Brazilian Real both down about 10%. EMB is $ denominated ETF so its decline would be due to credit quality. The spread widening between the two actively managed FX bond funds (down 6% and 3% divided by 2 averages 4.5% loss before dividends) on one hand versus EMB (down 2%) on the other hand is a 2.5% loss, which is far tinier than the EM stock (price return) loss YTD of 27%. The Standard Deviation for three years of an EM bond fund denominated in foreign currency is about 13, versus 31 for MSCI index of EM stock funds. EM stock price loss was six times greater than the price loss of 4.5% for EM FX bonds, but the Standard Deviation of EM stock mutual funds is 2.4 times greater than EM FX bond mutual funds. Assuming that losses should have been proportionate to the difference in Standard Deviation then EM FX bonds declined by less than half of what they should have, when compared to EM stocks. The difference in loss between the Dollar denominated bonds in EMB versus the loss in FX denominated EMB bond funds was only 2.5%, yet currencies such as the Indian Rupee, Brazilian Real plunged 10%. The use of two EM FX bond mutual funds is somewhat arbitrary on my part due to lack of an index that represents an investment grade FX EM bond, and is also due to my preference to avoid less than investment grade bonds; an investor might get different results if he picked mutual funds that were different from what I picked. Past performance is not to be relied on as a prediction for future performance. The mention of ETF’s in this article is for educational purposes and is not a recommendation to buy or sell.
An Examination of Emerging Market Foreign Currency Denominated Investment Grade Bond Mutual Funds
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The way to make an investment decision is to get evidence and use logic and avoid making an emotional decision. Sure it hurts when an investment goes down, but investment grade EM FX bonds did better than currency and did not fall as much as would be expected based on the relative differences in Standard Deviation.
During September the outflows from EM were 62% greater than during the Lehman crisis but the EM FX bond market has not declined as much. During the 2008 Lehman crash one FX EM investment grade bond mutual fund (now four years old) the price dropped 24%; in the current decline it went down YTD by 3%.
In the FT on 10-2-2011 an article titled “Battle Lines are Drawn in Changing Foreign Exchange Landscape” quoted a senior spot trader at JPMorgan in London. “Everyone wants a weaker currency, but the US is the king of getting its currency down”. Martin Wolf of the FT said earlier this year that the depreciation of the dollar is a battle that the Fed must win against other countries.
I have written “Foreign Currency Bonds Two Things You Must Know” and “Understanding Foreign Currency Bonds”.
Investors should seek independent financial advice.