December 6, 2010
A Most Important Rule
A few weeks ago, I noted that the return/risk profiles that we identify for stocks, bonds and precious metals had shifted abruptly. Since then, a decline in bond prices has modestly improved expected returns in bonds, but not yet sufficiently to warrant an extension of our durations. Precious metals have become more overbought, and while we are sympathetic to the long-term thesis for gold, intermediate term risks are now elevated. Finally, we have observed a further deterioration in market conditions for stocks.
Since the early 1980's, I've examined and tested an enormous range of analytical techniques and investment rules, including various versions of "Don't fight the Fed," and "Don't fight the tape." If I had to choose between only these two, "Don't fight the tape" would win, hands down, as Fed-based investment approaches typically endure excruciating drawdowns - even those that succeed in slightly improving long-term returns. That said, there are numerous refinements that perform far better than these simple rules-of-thumb; especially those that reflect broader considerations such as valuation, sentiment, economic pressures, yield trends, market internals, and so forth. If I had to pull a single rule from these combinations, one particular admonition - "Don't take risk in overvalued, overbought, overbullish, rising-yield environments" - is one of the single most important in terms of avoiding major, sometimes catastrophic losses.
Our investment stance is not defensive here based on our concerns with the appropriateness or legality of various Fed actions, nor based on our concerns about the underlying state of balance sheets in the financial sector, nor based on the elevated vulnerability of economic outcomes to small shocks. We are defensive because stocks are presently overvalued, overbought, and overbullish, and this combination is joined by rising yield pressures despite Fed actions.
The lessons that we've learned over the past two years do not include disregarding overvalued, overbought, overbullish, rising-yield conditions. Nor are we convinced that it would have been appropriate, except in pure hindsight, to ignore the evidence of past credit crises in the U.S. and internationally. It is undoubtedly true that it would have been more rewarding, in hindsight, to treat the most recent economic cycle as a standard, run-of-the-mill recession. I remain convinced that this is not a reasonable assumption, and that it would have been improper to ignore other post-credit crisis data given that the past two years were "out of sample" from relative to post-war experience.
At the same time, I believe that we've learned a great deal that will be of long-term value. Most importantly, the experience of recent years has fueled research that recently convinced us to expand the range of Market Climates we identify, defining their robustness and measuring their "model risk" by testing them in multiple subsets of historical data. As I noted last week, the first outcome that shareholders are likely to observe will be an increased tendency to accept moderate, transitory exposures to market fluctuations. Large shifts in market exposure will most likely still require a large shift in valuations or a broad combination of improved economic fundamentals, sentiment conditions, yield pressures, and other factors.
While we do keep certain aspects of our approach proprietary, somewhat more detail may be helpful. Generally speaking, our investment exposures are proportional to the expected return that we can expect per unit of risk in any given Climate. Each Climate is built from a set of criteria, and is therefore sensitive to the particular set of criteria being used. The challenge in broadening the range of Market Climates is that we require those Climates to be "robust" across time, and not highly sensitive to the way they are defined. Accordingly, it's useful to measure not only the average expected return and variability of returns (risk) in a given Climate, but also the variability of those outcomes across multiple criteria and multiple subsets of data.
Consider the whole set of observable conditions on any given date in market history, which might include valuations, market action, interest rate behavior, economic evidence and so forth. There are billions of ways that you could potentially combine this data. If you would assign very different expected returns depending on the specific set of criteria you examine, you've got a great deal of model risk. In contrast, if a given set of market conditions results in uniformly positive or uniformly negative expected returns, without much sensitivity to the specific way you define the "Market Climate" or the subset of data you are examining, your return expectations are more robust, and it's reasonable to have a greater sensitivity to the expected returns on that basis.
Of course, at the heart of everything, we still depend on strong valuation models, reliable indicators, and the like, but we've extended our approach by broadening the range of Climates we identify, while explicitly estimating the associated "model risk" that we face at each point in time. Again, the main practical effect will be an increased tendency to accept moderate, transitory exposure to market fluctuations on a more frequent basis than we have in recent years.
I recognize that investors are eager to move on to the thesis of sustained economic recovery, with no need for any risk management at all. However, it appears unwise for investors to rest their financial security on faith in a recovery that relies on the government running a deficit of 8.5% of GDP, simply to keep the existing 6.3% gap between actual and potential GDP from widening further. It appears equally unwise to rely on Fed purchases of Treasury bonds to sustain ever greater exposure of investors to risk, when the creation of financial bubbles does nothing to increase the underlying cash flows deliverable by the securities that are increasing in price.
While we have succeeded over time in outperforming our respective benchmarks with smaller periodic losses than a passive investment approach, we have certainly been penalized for not taking "enough" risk in a world where formal U.S. policy has been singularly focused on bailing out private lenders at public expense while the Fed's "more, bigger" policies aim at encouraging stock market speculation in hopes of creating a wealth effect. The frantic "risk on" attitude of investors over the past several weeks has been difficult for us. Given that a large proportion of our stocks lean toward what we consider "high quality" - consistent revenue growth, stable profit margins, and an emphasis on sound balance sheets - the embrace of leveraged, cyclical companies by investors in recent weeks has made our holdings appear to have far smaller "betas" than is typically the case over longer horizons. This has made market advances somewhat uncomfortable, while market declines have been more profitable than they "should" be. I am convinced that this is short-run behavior, but we continue to carefully modify our hedges in response.
A Trifecta of Reckless Central Bankers
I continue to view Bernanke's apparent objective for QE2 - to create a "wealth effect" by encouraging speculation in risk assets - to be dangerously misguided. Historically, the elasticity of GDP to changes in the stock market is on the order of 0.03 to 0.05, and is transitory at that. In plain English, this means that even large changes in the value of the stock market do not translate well into changes in GDP. This is because consumers correctly consume on the basis of what they see as their "permanent income," and are well aware that changes in volatile assets tend to be transitory when they are not accompanied by growth in real output and incomes. Bernanke is not thinking as an economist in this regard. He is thinking like a witch doctor calling on animal spirits (ooh, eee, ooh-aah-aah, ting, tang, walla-walla bing-bang).
With regard to Sunday's "60 Minutes" piece, I sometimes enjoy seeing Barbara Walters do a celebrity puff piece, but I expected more from a show on investigative journalism. Proper questions might have included, "Chairman Bernanke, how do you justify the fact that all of Bear Stearns' bondholders stand to get 100% of their money, plus interest, while at the same time, the Fed still holds $30 billion dollars worth of Bear Stearns' questionable MBS junk in an off-balance sheet shell company called Maiden Lane, which you justify by appealing Section 13-3 of the Federal Reserve Act, despite that this section deals explicitly with "discounting" - which everywhere else within the meaning of the Act allows nothing but a short-term check-cashing function, in nearly every case for paper of less than 90 days in maturity?" Nothing about Fannie or Freddie, or the fact that Treasury yields have increased since QE2 was announced.
Meanwhile, Alan Greenspan appeared on CNBC on Friday, and said with a straight face (I believe he has no other kind) that the "equity risk premium" on stocks was higher than it has been in 50 years. Evidently, this remark reflects the standard "Fed model" idea that the forward operating earnings yield on stocks can be usefully compared with the yield on 10-year Treasuries in order to estimate the attractiveness of stocks.
With all due respect, Mr. Greenspan - no less reckless than he was during the dot-com and housing bubbles - is out of his gourd.
The operational way to think about the equity risk premium to define it as the difference between the expected total return of the S&P 500 and the expected yield on Treasury securities. In order to estimate the equity risk premium, you had better have an empirically testable measure of long-term expected returns that actually works historically. On this basis, the forward operating earnings yield fails miserably (see Long-Term Evidence on the Fed Model and Forward Operating P/E Ratios). In contrast, the chart below presents the average of three models that I've detailed in previous comments - one based on forward operating earnings (adjusted for cyclical margins), one based on normalized earnings, and one driven by yields. At present, the average 10-year total return projection for the S&P 500 is just 3.76% annually. While it is true that this is higher than the 3.02% yield available on 10-year Treasury debt, it is also true that the average historical premium has been 4% (and even higher prior to 1995). When one subtracts the 10-year Treasury yield, the present equity risk premium is far from the highest in post-war data (an honor that goes to the premium of well over 15% in the late 1940's), but is in fact the lowest in history outside of the late-1990's stock market bubble over which Mr. Greenspan presided.
Technically, the equity risk premium should be measured over a horizon equal to the effective duration of stocks, which is currently over 50 years. Unfortunately, the longest horizon, liquid Treasury series is the 30-year bond, which has an effective duration of about 17 years. Since we have to work with the data we've got, the chart below presents our projection of the 17-year annual total return for the S&P 500, which presently stands at 5.61%. This compares with a yield of 4.32% available on similar duration Treasury bonds. Regardless of which long-term maturity one chooses, the implied equity risk premium is only slightly over 1% annually. Prior to the late 1990's market bubble, the average post-war equity risk premium was closer to 5%, and stocks had much shorter durations and therefore less risk in response to yield changes.
In the chart below, note that the bubble peak of 2000 is associated with a positive outlier for the actual return versus what would have been projected in 1983, but aside from this effect, valuations clearly explain a great deal of the variation in historical market returns.
Again, the likely premium for equity risk is presently among the lowest in history. In fact, the situation is even worse, because in return for just over 1% of additional expected return versus Treasury bonds, equity investors are accepting a duration (and accompanying volatility risk) that is three times as great as that of a 30-year Treasury.
Finally, last week, Jean Claude Trichet, the head of the European Central Bank, provided early indications that the ECB would be stepping up its buying peripheral government debt issued by Ireland, Greece, Portugal and Spain. Of course, the ECB prefers to "sterilize" these interventions, so it can be expected to sell the debt of stronger members such as Germany. Accordingly, yields dropped on the debt of credit-strained European countries, while German yields pushed to fresh yearly highs.
It doesn't take much thought to recognize that, like Bernanke's actions, the actions of the ECB are ultimately likely to represent not monetary policy but fiscal policy. When you buy the debt of countries that have a high likelihood of defaulting on this debt, or will avoid default only by the creation of currency that could have been issued to finance fiscal expenditures, it follows that you are engaging in fiscal policy without the authorization of elected governments.
This is a dangerous and cowardly road. We are allowing 99% of the world to accept budget cuts and austerity in order to defend bondholders from taking losses or having to accept debt restructuring. When bondholders lend money to a financial company or to a country, at a spread over the yield available safe debt, they are explicitly accepting the risk that the bet will not work out, and that they may lose money in the event of a restructuring. When government policy at every level focuses on making bondholders whole, then government policy at every level focuses equivalently on protecting the inefficient and dangerous misallocation of capital. The situation is even worse when unelected officials such as Ben Bernanke and Tim Geithner bend the clear meaning and intent of the law (such as section 13-3 of the Federal Reserve Act) in order to arbitrarily reward private interests. This will end badly. That doesn't mean that we need to persistently avoid market risk until it does, but investors who put these risks too far from their minds are likely to be blindsided as repeatedly as they have over the past decade.
Government Deficits and Potential GDP
As a final note on the U.S. budget deficit, the working group on deficit reduction failed to reach a consensus on Friday. My own impression is that the most efficient tax systems have a very broad base, coupled with flat rates and a large exclusion at low income levels, and tax income as close to their source as possible. Moreover, if we want an efficient tax system that encourages job creation, we have to deal with payroll taxes at the same time, which are presently extremely regressive (more than three of four families pay more in Social Security than in income taxes).
As economist Alvin Rabushka argued more than a decade ago, the amount of income taxed under Social Security is capped at less than $100,000 "to maintain the fiction that Social Security is a retirement insurance program in which contributions are linked to benefits, rather than what it is—a transfer of income from workers and the self-employed to retired people." This tax structure is wildly inefficient. My personal view is that the Social Security tax rate should be significantly lowered, but should apply to all income, wage and non-wage, while at the same time the income tax should be flattened. People at higher incomes would have a slightly higher total tax burden in the end, but lower marginal rates that would encourage work and discourage inefficient sheltering of income. Meanwhile, people at lower incomes would be spared a tax wedge that continues to discourage employment.
That said, we should always look at the government budget deficit in relation to where the economy is in the economic cycle. Part of the deficit simply reflects the current position of the economy in the business cycle, while part of it does not. One way to think about this is to look at the deficit in terms of what it would be at "potential GDP" - a figure that is regularly estimated by the Congressional Budget Office and represents what GDP would be at reasonably full levels of employment and capacity use.
The"output gap" (the difference between actual and potential GDP) has always had a significant, but temporary effect on the government deficit. In general, every 1% shortfall in GDP from potential GDP is associated with a reduction of about 0.33% in government revenues as a share of potential GDP, and an increase of about 0.33% in government expenditures as a share of potential GDP. In other words, there is a natural and useful "counter-cyclical" element to the deficit that serves as what economists call an "automatic stabilizer. "
Rather than targeting a balanced budget in the midst of a deep economic downturn (still more than 6% below potential GDP), we should be focused on policies that could reasonably be expected to achieve a deficit of between 0-1.5% of GDP at the point where GDP is again operating at potential. While I certainly think there is room to integrate unemployment compensation, earned income tax credits and Social Security in a way that strengthens the incentive for part-time work (I have friends with special needs who would lose all benefits if they worked even a few hours a week), I also believe that extending unemployment compensation is the smallest of our budget problems, and is a necessary response in an economy whose problems have been largely brought on by people at the highest income levels (particularly in the banking sector and Wall Street).
The larger problem is that we have still failed to restructure debt, so we will see perennial credit strains, and perennial short-term fixes that use public funds to bail out private lenders. Our current deficit is in the yellow oval, and is nearly $700 billion worse than it should be even in the presence of normal automatic stabilizers. Much of this is bailout funding to Fannie Mae and Freddie Mac, with another major contribution from defense spending. The immediate objective in deficit reduction is to take further bailout funding off the table, and to push aggressively toward debt restructuring. The public is being abused for the sake of protecting bondholders that lent at a spread. This protection should end, or the resulting "austerity" will either weaken our defense or remove our automatic stabilizers. If the world doesn't wake up to the fact that central bankers exist to serve the banks, we will suffer for it.
As of last week, the Market Climate for stocks remained characterized by overvalued, overbought, overbullish, rising-yield conditions that have historically been hostile for stocks. Both Strategic Growth and Strategic International Equity remain tightly defensive. A variety of outcomes could, in combination, clear this condition sufficiently to warrant some exposure to risk - most likely moderate and transitory in the near term - but at present, the expected return/risk tradeoff in the equity markets is poor.
In bonds, the Market Climate last week was characterized by slightly unfavorable yield levels and unfavorable yield pressures. In general, yield levels are a more important driver of total returns in bonds than yield pressures because unlike equities, there is no uncertainty about future cash flows (which is the main element that contributes to bubbles in stocks). Accordingly, expect that we'll modestly increase duration on further increases in yields, but the key word will remain "modestly" unless we observe fresh indications of economic pressures. The November jobs figure last week may have been a disappointment to the markets, but on the basis of the new unemployment claims we've seen over the past weeks, we're actually still at a level that has historically been associated with job losses averaging nearly 100,000 per month. Suffice it to say that the economic data is much more spotty than one would infer from many analysts, but at least over the short-term, the ebullience of the markets over QE2 has translated into more favorable economic sentiment. Strategic Total Return continues to carry a duration of only about 1 year, with about 1% of assets in precious metals shares, about 2% in utilities, and about 1% in foreign currencies.
The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.
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