Of Arnott, Shiller P/E, and Y-Curves

IWM and moving averages

The past few days have certainly provided some new data points. The IWM is below it’s 50 DMA, and I’m sure if it finally breaks, technicians will point to this fact. Except that it broke through the average in early March also, only to give a false signal.

The flip side, is that I’m pretty bearish on equities, so I tend to view these signals with a confirmatory bias. Regardless of one’s reasoning, being long here doesn’t seem prudent.

And just another note on moving averages…In a new study of utilizing momentum strategies, Isakov and Marti showed that signals have more predictive value the longer out one looks, meaning, utilizing moving averages for short-term market timing doesn’t work as well as using the to identify larger trends. At that point, technical and fundamental analysis seems to overlap. Here’s the abstract:

This article extends the literature on the profitability of technical analysis in three directions. First, we investigate the performance of complex trading rules based on moving averages over longer horizons than those usually considered. The different trading rules are simulated on daily prices of the S&P 500 index over the period 1990 to 2008 and we find that trading rules are more profitable when signals are generated over longer horizons. Second, we analyse if financial leverage can improve the profitability of the different strategies. It appears to be the case when leverage is achieved with debt. Third, we propose a new test of market timing that assesses whether a trading strategy is able to generate signals corresponding to longer market phases. According to this test, the signals generated by the complex rules investigated in this article coincide strongly with bull and bear markets.

But back to expectations…The markets are finally showing signs of recognition that the Fed-induced rally might be in jeopardy. China’s growth is finally being questioned, as we have done many-a-time here. And the euro is no longer being heralded as the new USD alternative. So maybe the technicals and fundamentals aren’t that far off now.

Relevant ETFs: IWM, RWM

Demographics

A few days ago, Mark Hulbert wrote a piece on MarketWatch.com that caught my attention: USA Will be Especially Youthful in 2020. I often write about demographics as one of the more predictable and powerful, yet least utilized, factors, and I was sure that by now, this research would have been picked up by more analysts. It hasn’t.

A quick summary: Hulbert points to research by Ned Davis Research that the proportion of children under the age of 15 will rise by 2020 to levels unmatched by any other developed nation except Ireland. Aside from being a long, long-term positive for Ireland, this will give the US distinct advantages in the future. But, and it’s a big BUT, this is a very long term demographic shift. What are the implications?

For starters, the immediate implications are to know that investors tend to not account for changes that are more than 5 years out, so this won’t be factored in by most investors for at least 3-5 years. Addressing just this issue, Hulbert writes:

Entitled “Attention, Demographics, and the Stock Market,” the study found that the market systematically does not take into account the consequences of demographic trends that are more than five years into the future — even when those consequences are quite predictable. (The study’s authors are Stefano DellaVigna, an associate professor of economics at University of California at Berkeley, and Joshua M. Pollet, an associate professor of finance at Michigan State University. Click here for a copy of the study .)

Another of the professors’ findings shows just how much is at stake: On average historically, they found, whenever demographic trends predicted a one-percentage-point increase in demand for an industry’s goods or services, its profits that year were 5% to 10% higher.

So even though 2020 seems like an awfully long way off, the rewards will be great for those who begin now to anticipate what the world will look like then.

The rewards for thinking and planning ahead will be great. The TradersNarrative blog picked up on Hulbert’s analysis and provided the following analysis:

A chart of the ratio of those middle-aged and those young has an unbelievably good track record for predicting the price earnings ratio of the stock market. And since the vast majority of the total return from the stock market comes from price earnings expansion, this provides us with a very good guide for future stock market returns. Of course, this is a long term and macro guide. It is not suitable for navigating the short-term gyrations of the market.

Here is a chart from a research paper written by Favero, Gozluklu and Tamoni illustrating the relationship between stock market returns and the MY ratio:

Source: Demographic Trends, the Dividend/Price Ratio and the Predictability of Long-Run Stock Market Returns

This would lead one to assume that the bear market has a few more years to go, with wild swings the norm. Additionally, it means that the areas most vulnerable might be luxury retail, high end restaurants, and large mcmansions. It’s also a long term benefit to companies geared towards the under 15 year crowd – from educational games, video games, and your local jungle gym manufacturer. For now, it confirms for me place I want to stay away from (luxury and “wants”) and places where I want to look for solid foundations in demand (“needs”).

Relevant ETFs: XRT, RTH, XLY, VCR, IYC, SZK

Vive la vérité . . . Vive la volatilité

For months I have been frustrated and surprised by the action of the markets in the face of continued turmoil. In different contexts, I’ve used terms such as disconnected or bifurcated where there seems to be a total discontinuity between the facts and the market actions. I now have a new term: The Negative Volatility Regime.

In a new report from Artemis Capital, Christopher Cole outlines the current environment by focusing on volatility. After my own heart, he starts with behavioral finance and defines the normalcy bias:

Normalcy Bias and Crisis: A quirk of the human condition is for the mind to desire normalcy so intensely as to consciously or subconsciously disregard knowledge that is disruptive to a pre-conditioned reality. This phenomenon is an important part of crisis management and market psychology. The consequence of a normalcy bias is that warning signs of a potential crisis go unnoticed or are interpreted optimistically. When a crisis occurs people are so overwhelmed by events inconsistent with a desired reality they lose their ability to make decisions. Researchers believe when the mind encounters an entirely new experience or event it attempts to match that reality to relevant experiences from the past. If there are no matching experiences the mind enters into a kind of feedback loop resulting in passivity. This lack of action as a response to risk is called negative panic1 and it culminates in a dangerous inability to act assertively in crisis. In essence, the psyche struggles to come to terms with what is really happening. Paralysis follows.

He then goes on to discuss how the normalcy bias can lead investors to ignore looming threats, which in turn can lead to “a cancellation of short-term volatility risk premium that should otherwise exist.” This new Negative Volatility Regime is defined by:

1. Large declines in spot volatility: The past nine months have shown an unusually high number of large declines in spot volatility (realized and implied) that are of a much higher magnitude and length than what has been observed historically. As a result of these large declines the VIX index and short-term realized volatility are below historic averages;
2. Abnormally steep volatility curve: The manifestation of an abnormally steep volatility curve (as a % of spot volatility) with a linear shape that more closely resembles a glacial cliff as opposed to the more traditional desert plateau (see chart);
3. Underperformance of Variance Hedges: Low volatility-of-volatility on the back of the variance term-structure results in the underperformance of out-of-the-money options and variance as a hedge against market declines;
4. High Volatility Skew: High levels of volatility skew for far out-of-the-money options showing increased likelihood of large declines in equity prices.

The article has a detailed discussion and great graphs representing the shape of the volatility structure. The full report can be accessed at: Artemis Q1 2011_Is Volatility Broken. (It is posted with permission.)

Global Tactical Asset Allocation (GTAA)

Long time readers know that The Hard Trade started as a way to publish some of the thoughts, research, and trade ideas that came from my money management firm. We have openly shared our decision-making processes, which are based on both fundamental and technical factors.

More recently, I have started formalizing the allocation and portfolio management processes. The main questions I’m dealing with are (in no particular order):

• Is there a simple, robust quantitative method that can improve the risk-adjusted returns across asset classes? (Simple answer is YES!)
• How do we build a complete allocation system?
• How do we define our “universe” of available asset classes for a global macro strategy?
• Are there appropriate benchmarks to utilize?
• How do we think through the various factors as applied to different asset classes? For example, it’s easy to apply price and time data across asset classes, but less straightforward to apply a P/E factor to commodities.
• How should we address different implementation vehicles (e.g. futures, options, etfs, etc.)?
• Should currencies be an overlay or an asset class?
• Should we include spreads and shorting as a viable strategy for average investors?
• What resources are available and will be available for investors?

These are just some of the initial questions we started with.

We already have some of the answers, although we find that as we research more, we have more questions. The academic literature is less robust than I would have hoped, but it is there nonetheless and provides an excellent starting point. We’ll share some of these resources in the upcoming weeks.

On the other hand, many of the questions are still unanswered or are in the development stages. We’ll share our research struggles along the way. I am open to any feedback. In the past, most readers have preferred to contact me directly, and I have been consistently impressed by the level of dialogues we have started as a result, so thank you, in advance. I hope we continue and expand on those conversations, some of which provided the basis for this new research angle.

I’ll be posting these articles under the Strategy/Allocation category or just search for GTAA.

Q-Ratio

This is an updated chart of Tobin’s Q and is a must-see (my thanks to Greg Mankiw for posting it):

Free money?

I often try to highlight trends and macro themes, but periodically, I feel compelled to share trading strategies, especially when one involves a structural arbitrage trade. In this case, the structures in question are ETFs. Specifically, levered ETFs. I have already highlighted that the daily compounding feature of these levered ETFs is detrimental to the health of longer-term investors. The basic strategy employed to take advantage of these ETFs is to short levered ETF’s and to short a comparable unlevered ETF in the opposite direction. For example, short the ultra short S&P 500 ETF (SDS or comparable), which then gives you a levered long exposure. At the same time, hedge that position with an equal short  exposure to SPY. Turns out that the challenge is actually finding the levered ETFs to short. For more specifics, read here: http://tiny.cc/9rt3b.

Then, yesterday I read this article (http://etfdb.com/2011/inverse-vix-etns-free-money-2/) and thought that much in the same light as the strategy above, there are structural trades based on ETFs. ETFs are derivative products, and by understanding the structure of the underlying, we can explore valid trading strategies. The recent one on the VIX is one I still have to research to fully understand the trading implications, but at first glance, I think there is potential here.

Relevant ETFs: VXX, VXZ, XIV

Stylized traders – winning traders, utilitarian traders, and futile traders

As I was cleaning some files, I came across an old study I had kept and haven’t revisited. Here’s the abstract:

Trading is a zero-sum game when measured relative to underlying fundamental values. No trader can profit without another trader losing. People trade because they obtain external benefits from trading. These benefits include expected returns from holding securities, risk reduction from holding correlated assets and gambling entertainment.

Three groups of stylized characterisic traders are examined. Winning traders trade for profit. Utilitarian traders trade because their external benefits of trading are greater than their losses. Futile traders expect to profit but for a variety of reasons their expectations are not realized.

Winning traders make prices efficient and provide most liquidity. Utilitarian and futile traders effectively  underwrite the winning traders’ efforts.

If that subject wasn’t interesting enough, Lawrence Harris, the author, goes on to provide an interesting breakdown of winning, utilitarian and futile traders at the end of the report. Read the full report at: http://www.turtletrader.com/zerosum.pdf. The table in the back was of particular interest and trying to figure out where you fit in. Or, in the words of Paul Newman: “If you’re playing a poker game and you look around the table and and can’t tell who the sucker is, it’s you.”

Heuristics in option trading

For those interested, here’s an interesting article on how option traders use, or don’t use, the Black-Scholes-Merton option pricing formula.

http://tiny.cc/bkea1

The Largest Arbitrage Ever Documented

This article showed up in the FT.com in mid-Sept. 2010, and referenced a working paper that took me a while to get to. That was a mistake. This is a very interesting study and might point to additional structural inefficiencies. From the paper:

In this paper, we study the relative pricing of TIPS and Treasury bonds. A simple no-arbitrage argument places a strong restriction on the relation between the prices of these securities. We show that this no-arbitrage relation is frequently violated in the markets. To our knowledge, this arbitrage, which can exceed $20 per $100 notional amount, represents the largest arbitrage ever documented in the literature. Furthermore, the sheer magnitude of this mispricing in markets as deep and actively traded as the Treasury bond and TIPS markets presents a serious challenge to conventional asset pricing theory.

titutional investors can take advantage of, but are not accessible to retail investors. The main idea here is that

Here’s the original FT.com article and here’s a link to the NBER working paper.

Slow news day, except this release (Q-ratio update)

Every quarter, I eagerly await the flow of funds report, so I can play around with the numbers on the back of an envelope – yup, I still use a pencil and scrap paper for quick calculations; call me old fashioned. Of course, long time readers will know that the Flow of Funds report contains 2 pieces of information that we use to calculate the q-ratio. A quick word on q-ratio for the un-initiated:

Q is a method of estimating the fair value of the stock market. It’s defined as the total price of the market divided by the replacement cost of all its companies.

The concept was originally developed by economist James Tobin. More recently, it’s been advocated by Andrew Smithers and Stephen Wright in their prescient book Valuing Wall Street.

…The data from which q is calculated are published in the “Flow of Funds Accounts of the United States Z1″, which is published quarterly by the Federal Reserve. This data source is available from 1952 onwards.

Smithers & Co.
http://www.smithers.co.uk/faqs.php

The Fed can’t manage the economy, but they can still do interesting research

The Breadth of Disinflation

By Bart Hobijn and Colin Gardiner

In recent months, inflation as measured by the personal consumption expenditures price index has been trending lower. This slowdown, known as disinflation, has raised concerns that inflation might actually drop below zero and enter a period of deflation. An examination of the distribution of inflation rates across the range of goods and services that compose the index suggests that downward pressures on inflation are relatively high by historical standards.

For the full paper, click here. I continue to believe that debt deflation will put downward pressure on the traditional stores of value (real estate, equity, bonds), while monetary and fiscal policies will haphazardly put pressures on “needs” or inputs – biflation. This will have the effect of squeezing margins, and increasing pricing uncertainty, which in turn will make it difficult for businesses to invest and plan. Coupled with high unemployment, increasing unfunded pension liabilities, and geopolitical instability, the “fingers of instability” which we have discussed in the past are now long and networked – meaning a small disturbance can have large consequences.

Early, but I’ll say it anyway

China. China. China. And the US dollar.

I wish the US government, along with all its subsidiaries and pro-government idealists would calm down about China. As long as China continues down the path of government-mandated loans, non-market based supply manipulation, and all the other games and number fudging it plays, we need to worry more about the political and military threat it poses rather than the financial. Instead, we should worry about our own internal policies that are moving in the wrong direction – namely, away from market-based practices and an increase in government debt that is unsustainable. That’s our own fault, not the Chinese government’s fault. Now, many readers have gone ga-ga for China, so I wanted to share some history. I took an article (see link at the end) from a few years ago, and replaced China wherever it mentioned the other country’s name. My reaction is at the end. Here are a few highlights:

Containing [China]

[China]‘s one-sided trading will make the U.S.-[Chinese] partnership impossible to sustain—unless we impose limits on its economy.

…[China] is more important to the United States, in more ways, than Saudi Arabia or most other countries will ever be. Yet [Chinese]-American relationships have a fragile, walking-on-eggs quality, which makes people think that it’s dangerous to talk frankly in public. Many other international relationships are robust enough to survive open discussions of disagreements; during the nasty little “beef hormone” war early this year, for example, no one imagined that the United States and the European Community were about to turn their backs on each other. But the American fraternity of [China]-handlers, which includes most diplomats and a number of businessmen, scholars, and journalists, instinctively stifles outright complaints about [China].

…Now, however, [China] has become too important to be treated with such delicacy. Excessive politeness prevents [China] and the United States from facing the conflict that in the long run endangers their relations much more than the comments of any bigoted [China]-bashers could.

For the foreseeable future [China] will be America’s single most valuable partner, because of what it can do in three areas. First is the U.S.-[China] military understanding…Second is finance: [China] has become America’s financier, providing investment capital and covering much of the U.S. government’s debt. Third is business: [Chinese]-American business relations provide technology, markets, talent, supplies, and other essential elements to both nations’ companies.

These three realities tempt many people, especially American diplomats, to assume a fourth: that [Chinese] and American interests do not clash in any fundamental way. This assumption is wrong. There is a basic conflict between [Chinese] and American interests—notwithstanding that the two countries need each other as friends—and it would be better to face it directly than to pretend that it doesn’t exist.

That conflict arises from [China]‘s inability or unwillingness to restrain the one-sided and destructive expansion of its economic power. The expansion is one-sided because [Chinese] business does to other countries what [China] will not permit to be done to itself. It is destructive because it will lead to exactly the international ostracism that [China] most fears, because it will wreck the postwar system of free trade that has made [China] and many other nations prosperous, and because it will ultimately make the U.S.-[Chinese] partnership impossible to sustain.

The [Chinese] do not desire any of these results, or the erosion of American power that would go along with them. Despite their pride, veering toward arrogance, about what [Chinese] business has achieved, most [Chinese] would feel more comfortable with a United States that is strong, stable, and rich enough to remain the No. 1 of the non-communist world. (Much more frequently than Americans, [Chinese] talk about nations holding No. 1 and No. 2 positions.) [China]‘s twentieth-century history in Asia implies that it will be much better accepted as an economic power and cultural force than as a major military power. As a diplomatic leader, [China] is still reluctant and inexperienced. It has given the world an example of what hard work can do, but in general [China] prefers to focus on its own affairs and let other countries proselytize for democracy, capitalism, communism, or whatever else they believe in. Most [Chinese] politicians say that they would like to leave non economic initiatives to the United States—if the United States can afford them. Unfortunately, the major external threat to America’s ability to pay the costs of leadership is [China]‘s uncontrolled, unbalanced economic growth. To keep a world trade system going, the strongest powers must be willing to make certain sacrifices—for example, keeping their own markets open, despite domestic political objections, as the British did during their free-trade heyday and as the United States has on the whole done since the end of the Second World War. ([Chinese] and Korean politicians now complain about American “protectionism,” but how protectionist can a country with a $10 billion monthly trade deficit really be? [ It’s much higher now!!]) [China] shows very little inclination to make these sacrifices itself, and its continued expansion will in time weaken the ability of the United States to do so.

Friends must sometimes help friends break destructive habits. [China] is in a good position to lecture the United States about its destructive business and financial habits, and more and more [Chinese] officials have been doing just that. But [China]‘s destructive habits are potentially more harmful to the rest of the world than America’s are. If [China] cannot restrain the excesses of its own economy, then the United States, to save its partnership with [China], should impose limits from outside.

…There is one further indication of economic imbalance: the continuing pattern of one-sidedness in many [Chinese] transactions. A few years ago the management expert Peter Drucker introduced the term “adversarial trade” to describe [China]‘s approach to commerce, which is characterized by resistance to high-value imports and by targeted attacks on established foreign industries. The contrast with Germany is instructive. Like [China], Germany chronically runs a large trade surplus; exports actually represent a higher proportion of its GNP. The reason there are fewer complaints about Germany, however, is not simply that it imports much more than [China] (20 percent of its GNP, versus [China]‘s six percent) but also that it imports more valuable things. Three fourths of the goods that Germans (and Americans and most Western Europeans) import are manufactured products; less than half of [China]‘s imports are. Germany’s trading patterns are similar to those of most other developed countries—Germany is simply more successful at carrying them out. [China]‘s are the exception. [China] is now starting to import more manufactured goods, but from a very low base.

Money Politics

IF NORMAL MARKET FORCES WON’T MODERATE [CHINA]‘S expansion, what about outright political control? For more than five years [Chinese] leaders have said, with seeming sincerity, that they want to reduce their nation’s trade surplus sharply, since it is the source of 90 percent of the ill will that [China] encounters in the world. So far their efforts have made little or no difference, because the basic elements of [Chinese] politics—the flow of money, the balance of power, and the underlying structure of ideas—all push the economy ahead on its unbalanced course.

…Capitalistic trade is not supposed to be reciprocal on the small scale. I buy from the local grocery store, and it doesn’t buy anything back from me. But capitalist theory assumes that life will be reciprocal in a larger sense. Each of us specializes in certain functions, and we use our earnings to buy from those who specialize in something else. This model, more or less unchanged since Adam Smith set it out in the Wealth of Nations, stands in contrast to several other ideas of how economic systems should work. One is the primitive-village model, in which small groups of people produce everything they want to use. Another is the mercantilist system that Adam Smith was directly attacking, in which the Spanish and Portuguese empires tried to store up as much gold as they could, rather than frittering any of it away in trade. And the latest and most relevant is what Chalmers Johnson calls the “capitalist developmental state,” whose prime example is [China]. Here the government uses a number of strategies to suppress consumption, channel personal savings to industrial investment, and convert industrial competition into a ratchet-like process. In the industries where the country has a lead-in [China]‘s case, consumer electronics and autos—it holds on to the lead, and in areas where it lags, it discourages imports until its own industries can grow. [Chinese] corporations typically compete with each other in every product line—each beer maker produces a draft beer, a “dry” beer, a lager, and so on; each electronics company tries to produce a full range of radios, TVs, and fax machines. Successful [Chinese] students are expected to get top marks in every subject; star pitchers in [Chinese] baseball often burn out early because they are expected to pitch in practically every game. Trying to be on top in every field, rather than specializing in some and leaving the rest to competitors, is a stronger impulse in [Chinese] society than in most others, and is the rule that [China]‘s trade policy appears to follow.

Americans may complain about the decline of their steel and semiconductor industries—that is, areas where the United States once enjoyed a lead and has had to watch factories shut their doors. But few Americans really think it is a problem if we have to buy our entire supply of CD players from overseas. The United States has no government project under way to create a domestic fax industry, and when government guidance is proposed—for semiconductors, high-definition TVs, and superconductors—it is always controversial. [China] acts differently.

What Will Change

WHAT PRECISELY IS THE DANGER FROM CONTINUED [Chinese] expansion? Some people say there is no danger at all. Three lines of reasoning lead to such a conclusion.

The first is that whether or not the expansion can be controlled, it is about to end. Many [Chinese] people, temperamentally pessimistic even though their country has repeatedly surmounted prophecies of doom, fall into this camp. So do some outside observers… The population will soon have the world’s highest proportion of retirees and will be using up some of the savings it is amassing now; Korea and Taiwan will exert unrelenting pressure; at some point the [yuan] may rise so far that it actually does price [Chinese] exporters out of the world market. And let’s not forget the next big [natural disaster]. In addition, certain divisions are opening within [Chinese] society, which could eventually impair the country’s ability to sacrifice, invest, and grow. Besides cynicism about [China]‘s money-politics system and the rise of an affluent and perhaps less self-sacrificing yuppie generation, a noticeable gap is opening up between [Chinese] haves and have-nots. This class divide has to do mainly with land ownership-land has become so expensive that people who do not inherit it from their parents can probably never afford their own house—but also with education, which is becoming stratified. In theory, such developments could limit [China]‘s growth quite soon. However, the limits are still purely theoretical; no symptom of slowdown can yet be observed. By every measurable indication—corporate profit, personal savings, industrial productivity—[China] is distinctly on the rise.

According to the second line of reasoning, [China]‘s expansion cannot, by definition, be threatening to anyone else, since it merely increases the wealth and welfare of customers in the rest of the world. This is the classic free-trade view, which often guides U.S. government policy toward [China] and which dominates the view of the American media. On its own narrow terms, it is obviously correct: consumers are always better off with fewer restrictions on trade. Indeed, the main reason American consumers now live so much better than those in [China] is that U.S. policy has hewed closer to free trade.

Inconveniently, offering consumers the best price is not the only thing involved in building a good society. Permitting children to work in garment factories, for instance, would lower the price of shirts and help the American consumer, but it is against the broader national interest. In the case of [China]‘s expansion, the harm comes from the erosion of numerous elements of American strength, especially those being left to erode because of a sense that the United States is so deep in debt that it can’t afford to do many of the things a leading power should do—explore space, improve its schools, maintain its military bases in [China] so that [China] doesn’t build its own army, and so on.

From the strict free-trade perspective, not even the accumulation of debt is necessarily a cause for worry. The borders between [China] and the United States are increasingly artificial to corporate managers and to consumers, who buy Sony Walkmen in Chicago and McDonald’s hamburgers in Tokyo. Perhaps the borders should be ignored in observing capital flows as well. No one cares about the Texas state “deficit” relative to Illinois; we concentrate on how individual firms are doing. Some [Chinese] internationalists suggest that the overall U.S.-[China] balances should also be overlooked. This is noble-sounding and forward-looking, but the fact is that [China] and the United States still are two separate nations, and America’s ability to pay its own way still is the basis of its strength. The United States can’t tax the [Chinese] to pay for its military—it can only borrow. Until national borders really don’t matter, America’s ability to meet its commitments will depend on its own solvency, not on the size of the combined U.S.-[Chinese] capital pool.

This is related to the third line of reasoning: that reasonably soon the borders between [China] and the United States will for all practical purposes disappear. [China] and the United States, which already interact closely in business and the military, will integrate themselves in other ways and, despite remaining separate countries, will function essentially as one unit.

Anyone who has spent time in [China] will recognize how attractive such a merger would be. These two countries, with their respective economic strengths, technical skills, political ideologies, and sources of social resilience, make up two complementary halves of the mightiest possible superstate. I would be delighted by the creation of a hybrid U.S.-[Chinese] state. For all its difficulties, [Beijing] is a more stimulating place to live than almost any city in America. I would rather work with my best [Chinese] friends than for most companies in the United States, and would rather bind [China]‘s strengths to America’s than view [China] as a threat. But like most other foreigners who have lived in [China], I consider such a de facto merger impossible, because of social resistance on the [Chinese] side.

…I admire the idealists and hope they turn out to be right, but nothing I have seen so far makes me believe that they will.

…Unless [China] is contained, therefore, several things that matter to America will be jeopardized: America’s own authority to carry out its foreign policy and advance its ideals, American citizens’ future prospects within the world’s most powerful business firms, and also the very system of free trade that America has helped sustain since the Second World War. The major threat to the free-trade system does not come from American protectionism. It comes from the example set by [China]. [China] and its acolytes, such as Taiwan and Korea, have demonstrated that in head-on industrial competition between free-trading societies and capitalist developmental states,” the free traders will eventually lose. The drive to break up the world into trading blocs—united Europe, North America, East Asia—is largely fueled by other countries’ desire to protect themselves against [China]. Even in their own inroads into the [Chinese] market, foreigners are tempted to settle for a small place [role]…rather than pushing for truly open competition in [China]. The ideal of free trade retreats, as the states that don’t really believe in it expand.

THE PURPOSE OF THIS ARTICLE IS TO MAKE THE CASE for containing [China]‘s expansion, rather than to discuss specific means of containment. The specifics will be the subject of a future article. But merely recognizing that American and [Chinese] interests do conflict is in itself an essential step. It frees us of the delusion that normal business competition will balance out whatever is unbalanced now.

Of course America needs to reform its own corporate practices, improve its schools, and reduce its debt. Of course our economic goal should be an open free-trading system around the world, not escalating trade barriers. Of course we have no business telling the [Chinese] how to run their own subtle, sophisticated society. But we do have the right to defend our interests and our values, and they are not identical to [China]‘s.

The article is much longer and I cut out as much as I could. I did my best to maintain the flow of the article with the changes in [] for clarity. Please click here for the full article. It was written by James Fallows in The Atlantic Monthly in 1989…about Japan! The fear of Japanese expansion was palpable. In the article, Fallows talks about the trend in trade and the continued dependence of the US government on Japanese financing. And of course, the final paragraphs encouraging active retribution, protectionist measures, and even military options is not surprising.

We all know how this ended. The Japanese miracle was ending, and Japanese economic expansion was halted. Japanese purchases of US assets with overvalued currency ended up being incredible burdens on Japanese firms, especially banks, for decades, in fact, they continue to this day.

What should have been the course of action: continued open markets, low tarrifs, encouragement of free trade, and an investment in US infrastructure and education. What should be our policy now towards a seemingly unstoppable economic superpower?

So I might be early in saying that Chinese economic might will be waning, but it will come. And I anticipate that it will come soon.

S&P 500 – summary of valuation metrics

Prieur du Plessis has a great summary of some valuation metrics, from CAPE to q-ratio.

Here’s a quick summary, but the full article can be read here:

CAPE

Robert Shiller’s cyclically adjusted price earnings ratio (CAPE)
The CAPE ratio, defined as the ratio of the inflation-adjusted S&P 500 Index to the average of the past ten-year inflation-adjusted trailing S&P 500 annual earnings, is currently at 21.39. That compares to the historical average of 16.4 since 1881 and is at the top end of the range pre-2000. Barring the first quarter of last year when the ratio fell below 15, it is at the lower end of the range over the past ten years. So yes, the S&P 500 is expensive on a long-term basis but inexpensive compared to the past ten years.

Price-to-book ratio
The price-to-book ratio of the S&P 500 is 2.3 times and is inexpensive compared to the historical average of 2.9 times since 1981.

Tobin’s Q ratio
The Tobin’s Q ratio is calculated as the valuation of the whole market in relation to the aggregate corporate assets. It displays valuation patterns similar to those of the price-to-book ratio. According to dshort.com, the ratio is estimated to be approximately 1.0. It is at the upper end of the range since 1900 but at the lower end of the range since 2000.

Source: dshort.com.

In conclusion, the S&P 500 is in my view neither extremely cheap nor very expensive. The dominant factor is how dividend yields will pan out over the next seven years. If the average of the past ten years holds, the market is likely to return in excess of 6% and is therefore relatively inexpensive. However, the average dividend yield will rise if significantly higher inflation is on the cards, resulting in negligible returns over the next seven years. What is clear, though, is that investors should scale down their return expectations as the likely outcome is somewhere in between.

Good old-fashioned stock picking remains my favored approach to equity investment in developed markets. (I will devote a separate post to emerging markets over the next few days.)

Here was my response to Prieur on his site:

Thanks for this great summary and analysis. One point to add regarding the q-ratio. In their work on q-ratio (Valuing Wall Street), Smithers and Wright showed why q-ratio averages around .7 and why P/E ratios are q-equivalent.

By that measure, the equity markets are 30-35% overvalued at this point, and that’s assuming it doesn’t overshoot on the downside. It is also roughly the same valuation level as we saw around the pre-1970′s bear market.

Separately, based on work done by multiple academics and popularized by Ed Easterling, a move away from price stability (towards deflation OR inflation – doesn’t matter which) will probably lead to margin compression. Easterling called this the y-curve. That should lend itself to poor contribution to returns from margin expansion going forward.

Just some thoughts that I hope will add to the conversation as we muddle through the proverbial “interesting times”.

Benoit Mandelbrot dies at 85

When asked to look back on his career, Dr. Mandelbrot compared his own trajectory to the rough outlines of clouds and coastlines that drew him into the study of fractals in the 1950s.

“If you take the beginning and the end, I have had a conventional career,” he said, referring to his prestigious appointments in Paris and at Yale. “But it was not a straight line between the beginning and the end. It was a very crooked line.”

Read the NY Times piece here.

Benoit Mandelbrot was the father of fractal theory. His work was influential in fields from animation to finance. In animation, his fractals and fractal geometry help artists create realistic landscapes that mimic nature. In finance, his theories helped shape non-normal distribution models. In science, he influenced chaos theory. And much more.

‘Fractals are easy to explain, it’s like a romanesco cauliflower, which is to say that each small part of it is exactly the same as the entire cauliflower itself,’ Catherine Hill, a statistician at the Gustave Roussy Institute, told AFP.

‘It’s a curve that reproduces itself to infinity. Every time you zoom in further, you find the same curve,’ she said.

He was a great mind, constantly challenging the established academic community, and using his position to teach others. I would encourage everyone to check out The (Mis)Behavior of Markets.