Just because it’s a New Year…

Money is made in the buying

Prieur du Plessis from “Investment Postcards” quote Richard Russell as saying:

Long-term profits depend largely on your original buy price. Today, as I write, stock valuations are extremely high. For instance, the price-earnings (PE) ratio for the Dow is now 18.02. The dividend yield for the Dow is a thin 2.67%. For the S&P 500 the PE is 86.20; the dividend yield is a mini 1.96%. In the face of these valuations, the odds of building impressive profits over the next decade are very poor (unless, of course, there’s a crash and a new bull market).

The great fortunes in stocks are made by buying stocks at true bear market lows. At today’s bloated values, profits in stock over the coming decade will probably not be any better than the percentage increase (if any) in the GDP over the same time period.

I would expand on that and paraphrase from Reminiscence of a Stock Operator: “Money is made in the waiting.” Plessis then goes on to show that even using 10-year cyclically adjusted P/E’s (CAPE), today, at 20+ we are in the upper quintile of historical CAPE’s, and should expect low single digit returns, at best.

We have written here often that returns come from dividends and P/E expansion. With dividends anemic, we have to depend on P/E expansion. Yet starting from such a high multiple, coupled with the fact that profit margins are probably at a cyclical high, we should expect even less than historical averages going forward. Namely, we will be lucky if in 10 years time we will be about where we are today.

This is not a time to put new money into the market. Are there deals out there that will outperform? Definitely! But be wary. While holding cash is not a pleasant option, sometimes not losing is not that bad.

http://www.investmentpostcards.com/2009/12/08/quote-du-jour-money-is-made-in-the-buying/

How Much Is That Basis Point Worth?

In the recent Journal of Financial Planning, Edward F. McQuarrie highlights how your broker or financial advisor is probably steering you wrong in terms of fees. The traditional thought process is that you should pay less for bonds and more for equity investments (because of the higher expected return, higher risk, or whatever).

Executive Summary

• Mutual fund expense ratios and loads, along with adviser fees and wrap account charges, are among the many ways in which investors pay for investment management.
• Unfortunately, to assess trade-offs between alternative fee arrangements expressed in fractions of a percentage point requires a facility with exponential series (that is, time value of money calculations) that too many investors lack.
• To bring to the surface the kind of misunderstandings to which investors all too often succumb, this article reviews such questions as:
      – Are low expense ratios generally more important in the case of stock funds or bond funds?
      – If paying a load earns a reduction in expense ratio, should the load be paid on one’s stock funds or bond funds?
      – If one financial planner charges an annual wrap fee, and another a one-time setup charge, what’s the best way to compare total costs?
• The proper procedure is not to focus on the magnitude of the expense ratio in relation to the forecast returns, but to calculate dollar results for the two exponential series.
• All basis points are not created equal when they figure in exponential series. This is the dark side of what is sometimes referred to as the magic of compound interest. The higher the rate of return, the more costly a single basis point of additional expense becomes.
• Wrap fees can be far more expensive than they first appear.

http://www.fpajournal.org/CurrentIssue/TableofContents/HowMuchIsThatBasisPointWorth/

Asset Allocation, or Why Your Advisor is Failing You

Earlier this week, we posted a piece by James Montier on the Efficient Market Theory (EMT) and where it has led us astray. Let us now go deeper into the implications of EMT for financial advisors and clients.

            With EMT as our backbone, the advisory industry has been able to sell seemingly scientific – and certainly mathematical – approaches to asset allocation. Clients often fill out questionnaires or sit with advisors, discussing investment horizon, risk tolerance, liquidity needs, etc. Then the advisor goes into the laboratory and plugs in some characteristics into an off-the-shelf software or a home grown asset allocation model and comes out with an efficient frontier. Most programs also come out with charts, statistics, and qualifiers, such as “an 80% probability of achieving between $XX assets and $YY assets in 20 years”. In fact, here is one software packages description with the name omitted:

SampleAllocationModel is a state-of-the-art asset allocation and portfolio optimization software. It provides an investor with advanced tools to successfully tackle major problems of quantitative portfolio management: parameter uncertainty, nonnormality of returns and uncertainty in investor’s preferences. The analytical methods adopted include the Black-Litterman model, several Shrinkage Estimates, Robust Optimization, Walk-Forward Optimization, Target Shortfall Probability Minimization, and many others. At the same time, SampleAllocationModel is the only professional product in the market, affordable to individuals. It combines highly advanced and innovative analytics with a user-friendly, intuitive interface, perfectly suited to any level of expertise and experience.

It sounds incredibly impressive, and based on the EMT, this kind of product would certainly lead investors down the path of diversification between different asset classes along the efficient frontier. The implications of the EMT are not limited to individual investors and advisors. Large pension firms use the same methodology to achieve their efficient frontier and allocation. They use state of the art consulting firm to help them categorize, diversify, and hedge different risks. Just as importantly, the advisors love to use these models because it transfers accountability to “the market”, to “the long term”, to “anyone but me”. No advisor wants to leave out an asset class (citing diversification, but feeling like the asset might go up). In the end, however, Keynes was right when he stated, “It is better to fail conventionally than to succeed unconventionally,” and the EMT gave advisors the intellectual framework to fail conventionally.

The intellectual framework of the EMT rested three main elements: defining return as some “average return” over a long period, defining risk as volatility, and using historical correlations between asset classes. Let us start by critically examining these foundations:

            Every advisor warns clients that “historical returns are not indicative of future returns”. Yet, the models advisors utilize predict future returns based on historical returns. For most advisors, that actually seems appropriate, alongside their recommendations to invest in last years star mutual fund. Models rarely take into account forward looking return projections based on fundamentals. In statistics there is a saying to draw attention to the dangers of averages: if your head is in the oven and your feet are in a bucket of ice, on average, you’ll be fine. The reality is far from it. Using historical returns fails to consider limitations in the data, the disparity of returns, and factors influencing returns.

That’s where risk is supposed to come in. Risk under the EMT focuses on distribution. Assuming that returns are normally distributed (a false assumption), risk measures the standard deviations based on historical volatility (again, a false methodology). Risk should help clients and advisors minimize the chances of permanent loss of capital. It should help clients recognize that risk is often NOT rewarded. In fact, under the EMT, the more risk the better, just increase your investment horizon. The number of errors in these assumptions has been widely discussed, yet the asset allocation models used by advisors and consultants continue to look at volatility and risk in the same light.

            Lastly, we have correlation. Again, using historical correlations as stable (a false assumption), the EMT leads us to seek historically uncorrelated assets. In and of itself that’s fine, except that historical correlations fail to take into account the changing nature of correlation itself. This often happens just when you need diversification the most, such as in a down market when correlations often increase.

So where does that leave us? For starters, let’s recognize that the path we grew up on led us in the wrong direction. With this recognition comes the need for new tools. Asset allocation must move away from the “frontier” with an upward sloping trajectory (the more risk, the more return). Instead, valuation and price, confidence in NOT having exposure to overpriced assets, risk assessment based on permanent loss of capital and not on volatility, and a willingness to be critical and take a stand apart should drive our models and client interactions.

Asset/Portfolio Position Size Decisions

Position sizing, whether you’re managing a single asset class portfolio or a diversified portfolio of managers, is a key parameter that managers often point to as adding alpha. Goldman Sachs and the other large wirehouses have started Investment Strategy Groups in different configurations to make tactical asset allocation recommendations, RIA’s often recommend that clients make 1% allocations to various mutual funds or even asset classes, and mutual fund managers, in the name of diversification, take small positions on a regular basis.

The question this raises for me is whether this advice is valuable. Putting aside the intellectual shenanigans of how firms measure their “alpha generating” tactical allocation services, the questions that this topic brings up are manyfold:

1. Is there value in ever smaller positions?
2. Is there an optimal position size?
3. Given an uncertain return regime, is equal sizing a valid alpha generator?
4. Assuming that positions can be classified into risk/return parameters (and that is a huge assumption), at what point does a small position imply there are better opportunities that are more “worth it”?
5. If there is a minimum or optimal size for positions, should rebalancing occur below that threshold? For example, let’s assume the minimum appropriate size for a position is 3%, if a target allocation is set with a 10% allocation to an asset class of position, should it be rebalanced if it’s not outside of the +/- 3% of the target (i.e. 7%-13%)?
6. Is trading “around” positions alpha-generating?

The questions continue for me, but you get the idea. I don’t know the answer. I’ve been looking at some of the academic literature and, quite honestly, it is sparse. The implications could be far ranging and might help avoid some classic traps such as overdiversification, closet indexing, high transaction costs, etc. and might help clients and advisors pick their spots only in opportunities that make sense (since they’ll stay away from just putting small positions for no real reason). If anyone has any research available, I’d love to see it.

Connect The Dots: Week Ending 06.12.2009

Last week was full of charts. This week, let’s discuss some of the main themes we’re witnessing.

The equity markets were relatively tame this week. Gold, oil, and agribusiness industries showed big moves, but not in the same direction. All eyes were on interest rates and more specifically the steepening yield curve. As I mentioned throughout the week, the US’s ability to garner the worlds savings a plow them into our ever increasing supply of Treasuries will end at some point. For a long time, my focus was on maintaining a short Treasuries position through TBT and futures positions. I am no longer comfortable with that trade. The long term position still makes sense, but the implementation has become more difficult. There are now endless pundits talking of inflation risks, hedge funds piling into TBT, and short US dollar positioning. I just don’t like it when so many people agree in such a short period of time. Just a few months ago, we were in the minority as survey after survey showed most money managers believing deflation was the main problem. I can’t help but believe that most of them will end up being squeezed. Look at the 2-10 spread below. The steepener trade has been all the rage of late hitting ALL TIME highs early last week. Things settled down a bit toward the end of last week and the steepener has continued its correction this week closing at 2.50. Thatsabet and I disagree on how long the correction could last. He is looking at around 2.30-ish as the limit; however, I believe that it depends on who is going to get caught on the wrong side of this move. We might see some big names being squeezed and have to push yields on the 10 year back down significantly.

(source: Bloomberg)

It will be interesting to see this unfold in the next few weeks. What we are witnessing is a two-faced market. On the one hand, there are clear signs of inflation. Oil has doubled off its $35 lows and is now above $70. The steepening yield curve can signal inflation expectations rising (as investors don’t want to hold long term fixed income instruments). And, since inflation is always and everywhere a monetary phenomenon, dollars continue to be pumped into the system through the ballooning of the Fed balance sheet (quantitative easing) and the USD is facing significant strain.

On the flip side, we have deflationary pressures continuing. Job losses and recessionary pressures are continuing. Real estate deflation continues in virtually every segment as rental yields continue to decline. Companies face continuing pricing pressures with no ability to raise prices. The best business to start these days appears to be a bank, with government subsidies and a steep yield curve, a regional player with no legacy portfolios is a no brainer.

Can the Fed increase interest rates here? I don’t think so. Can they stop buying 20-30% of every auction? I doubt it. So the inflationary pressures will continue. Yet simultaneously, I don’t see margin expansion and earnings power returning to companies. So I’m wary of the pure inflation story.

Some other notes we made from conversations this week. Some advisors out there are encouraging clients to move into credit and high yield, even as they are warning against investing in equities. This seems somewhat incongruous. For high yield bonds (junk bonds) to provide adequate return, these advisors must believe that the yield and capital appreciation available will make up for the higher default rates we have been witnessing. If they believe that these companies will be able to pay back the 15-20% interest rates on some of these bonds, they must believe that the companies are going into an earnings environment that will support those payments. Additionally, these same advisors are now mentioning gold and inflation protection in the same presentations. Hmmmmm. If inflation is indeed coming, I wouldn’t want to be in a fixed income instrument. If earnings and margins will improve, I’d also rather be in stocks than bonds. Separately, if earnings won’t be improving, then the junk bonds won’t provide me with the returns I seek. High yield spreads need to get wider in this kind of environment for me to find them attractive enough.

Paulson is buying CBRE. I don’t like being on the other side of the trade from Paulson. The Ultrashort Real Estate ETF, SRS, a favorite of day traders and amateur traders, has gone from $60 to $18. For those still holding on, just know that the numbers from daily compounding are working against you. Say thank you for the $18 and walk away. There are other ways to short real estate if you want to take the other side of Paulson.

Lastly, I just want to note a couple of important points we can’t take our eyes off of.

In the currency markets the USD has continued its correction but the possible basing pattern continues. Should DXY hold 79 and proceed to take out 81.5 we could have a target toward 84. Thatsabet believes this would be a negative for equities, but I think it would be a positive as money flows back into the equity market from abroad. Overall, higher yields will be USD positive.

 (source: Bloomberg)

On another note, any recovery will probably need financials to stabilize and lead the way. Below is the XLF relative to the SPX. This continues to be an important and leading indicator for the direction of the markets. For the past several weeks the banks have been going nowhere RELATIVE to the markets. They have issued 85B in securities and that is currently being digested by the markets. Underperformance by the banks is usually a precursor to overall market weakness. We’ll keep following it with you to look for signs of a real recovery.

(source: Bloomberg)

And for those of you keeping track of our weekly standards:

Our market monitor…looking at various indices for the week, month, quarter, and YTD…

(source: Bloomberg)

And our relative monitor – Looking at the changes of various sectors relative to the S&P 500…

(source: Bloomberg)

Goldman Reverses U.S. Stock Advice, Says Shun Overseas Sales

Nov. 6 (Bloomberg) — Goldman Sachs Group Inc. strategists
advised U.S. stock investors to buy companies that generate most
of their sales in America and avoid those with high overseas
revenue, reversing a strategy they had advocated through July.

David Kostin, who leads Goldman’s New York-based portfolio
strategy team, recommended shares of 50 companies that get a
large percentage of sales in the U.S., including Union Pacific
Corp. and Kohl’s Corp., on expectations that foreign economies
will deteriorate at a faster pace. Money managers should reduce
holdings of companies with the most non-U.S. sales and sell short
those with high revenue from western Europe, according to a
research note dated yesterday.

http://www.bloomberg.com/apps/news?pid=20601213&sid=al..sz9RIqTA&refer=home

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Prepare for Inflation…NOT deflation

Nov. 7 (Bloomberg) — Japan will benefit from a strong yen
because it will hold down prices for raw materials, said Eisuke
Sakakibara, formerly Japan’s top currency official.

“I still believe a strong yen is in the national interest
of Japan, particularly in this situation when raw material prices
will increase,” Sakakibara said in an interview with Bloomberg
Television in Singapore yesterday. The yen may rise to as high as
80 per dollar as so-called carry trades unwind, said Sakakibara,
who was dubbed “Mr. Yen” during his 1997-1999 tenure at the
Finance Ministry because of his influence over currency markets.

The yen’s 15 percent gain against the dollar this year and
33 percent advance versus the euro prompted Japan’s government to
announce last month it may buy or sell currencies to influence
exchange rates, as the world’s second-largest economy stumbled.
Gross domestic product shrank by an annualized 3 percent in the
second quarter as exports dropped 2.5 percent, according to
government data.

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