Author Archive for Cullen Roche

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(This post is left blank because the Federal Reserve will not change anything substantial in the upcoming statement, you should ignore all media broadcast concerning this event and you most certainly shouldn’t consider altering your portfolio because of this event.)

Anatomy of Bubbles and Crashes

I liked the way John Mauldin described the anatomy of a bubble in his latest letter:

Anatomy of Bubbles and Crashes

There is no standard definition of a bubble, but all bubbles look alike because they all go through similar phases. The bible on bubbles is Manias, Panics and Crashes, by Charles Kindleberger. In the book, Kindleberger outlined the five phases of a bubble. He borrowed heavily from the work of the great economist Hyman Minsky. If you look at Figures 9.7 and 9.8 (below), you can see the classic bubble pattern.

(As an aside, all you need to know about the Nobel Prize in Economics is that Minsky, Kindleberger, and Schumpeter did not get one and that Paul Krugman did.)

Stage 1: Displacement

All bubbles start with some basis in reality. Often, it is a new disruptive technology that gets everyone excited, although Kindleberger says it doesn’t need to involve technological progress. It could come through a fundamental change in an economy; for example, the opening up of Russia in the 1990s led to the 1998 bubble or in the 2000s interest rates were low and mortgage lenders were able to fund themselves cheaply. In this displacement phase, smart investors notice the changes that are happening and start investing in the industry or country.

Stage 2: Boom

Once a bubble starts, a convincing narrative gains traction and the narrative becomes self-reinforcing. As George Soros observed, fundamental analysis seeks to establish how underlying values are reflected in stock prices, whereas the theory of reflexivity shows how stock prices can influence underlying values. For example, in the 1920s people believed that technology like refrigerators, cars, planes, and the radio would change the world (and they did!). In the 1990s, it was the Internet. One of the keys to any bubble is usually loose credit and lending. To finance all the new consumer goods, in the 1920s installment lending was widely adopted, allowing people to buy more than they would have previously. In the 1990s, Internet companies resorted to vendor financing with cheap money that financial markets were throwing at Internet companies. In the housing boom in the 2000s, rising house prices and looser credit allowed more and more people access to credit. And a new financial innovation called securitization developed in the 1990s as a good way to allocate risk and share good returns was perversely twisted into making subprime mortgages acceptable as safe AAA investments.

Stage 3: Euphoria

In the euphoria phase, everyone becomes aware that they can make money by buying stocks in a certain industry or buying houses in certain places. The early investors have made a lot of money, and, in the words of Kindleberger, “there is nothing so disturbing to one’s well-being and judgment as to see a friend get rich.” Even people who had been on the sidelines start speculating. Shoeshine boys in the 1920s were buying stocks. In the 1990s, doctors and lawyers were day-trading Internet stocks between appointments. In the subprime boom, dozens of channels had programs about people who became house flippers. At the height of the tech bubble, Internet stocks changed hands three times as frequently as other shares.

The euphoria phase of a bubble tends to be steep but so brief that it gives investors almost no chance get out of their positions. As prices rise exponentially, the lopsided speculation leads to a frantic effort of speculators to all sell at the same time.

We know of one hedge fund in 1999 that had made fortunes for its clients investing in legitimate tech stocks. They decided it was a bubble and elected to close down the fund and return the money in the latter part of 1999. It took a year of concerted effort to close all their positions out. While their investors had fabulous returns, this just illustrates that exiting a bubble can be hard even for professionals. And in illiquid markets? Forget about it.

Stage 4: Crisis

In the crisis phase, the insiders originally involved start to sell. For example, loads of dot-com insiders dumped their stocks while retail investors piled into companies that went bust. In the subprime bubble, CEOs of homebuilding companies, executives of mortgage lenders like Angelo Mozillo, and CEOs of Lehman Brothers like Dick Fuld dumped hundreds of millions of dollars of stock. The selling starts to gain momentum, as speculators realize that they need to sell, too. However, once prices start to fall, the stocks or house prices start to crash. The only way to sell is to offer prices at a much lower level. The bubble bursts, and euphoric buying is replaced by panic selling. The panic selling in a bubble is like the Roadrunner cartoons. The coyote runs over a cliff, keeps running, and suddenly finds that there is nothing under his feet. Crashes are always a reflection of illiquidity in two-sided trading—the inability of sellers to find eager buyers at nearby prices.

Stage 5: Revulsion

Just as prices became wildly out of line during the early stages of a bubble, in the final stage of revulsion, prices overshoot their fundamental values. Where the press used to write only positive stories about the bubble, suddenly journalists uncover fraud, embezzlement, and abuse. Investors who have lost money look for scapegoats and blame others rather than themselves for participating in bubbles. (Who didn’t speculate with Internet stocks or houses?) As investors stay away from the bubble, prices can fall to irrationally low levels.

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Is a House Really a Good “Investment”?

I’ve had this post queued up for three months debating whether to post it or not because I know it will ruffle a lot of feathers.  Then I read this great article confirming many of my thoughts and I figured I should just throw this one out there for everyone to kick around….  

Recent discussion here regarding real, real returns (returns net of inflation, taxes and fees) and the flawed BLS calculation on Owner’s Equivalent Rent sparked a good discussion about the benefits of buying a home.  And it got me thinking about how most people seem to think owning a house is a great “investment”.  Now, I have an obvious issue with this misuse of the term “investment” (especially as it pertains to the way portfolio managers and retail “investors” use it), but it also got me thinking about housing price returns on a larger scale.  That is, on a real, real return basic.  Thornburg Investments says houses return a barely positive return on a real, real return basis, but as they note, all of the fees are not actually included in this calculation.  So let’s take a closer look here at this asset class that so many seem to believe is a good “investment”.

Before we start, it might help to think of a house as two distinctly different pieces.  First, there is the land that you own.  Second, there is the actual house itself.  The land is what I would call an “investment” since it’s highly probable that the land itself will appreciate in value over time.  The house itself, however, is a depreciating asset that is guaranteed to fall apart just like your car will.  If it has any intangible “investment” components those are subjective and not necessarily financial (though I guess they could be, for instance, if you work from home).

Anyhow, if you’re familiar with Robert Shiller’s work you have likely seen figure 1 below showing real house prices since 1890.  Since 1890, housing in the USA has averaged a 3.2% annualized return.  It’s been slightly better since 1960 at 4.2%, a bit better than that since 1970 (4.8%) and more in-line with the historical average since 1980 (3.8%).  That might not sound so bad were it not for inflation.  Inflation has historically averaged about 3.2% as well.  Hence the chart below which shows housing prices close to the 100 level throughout their history.  Said differently, real estate doesn’t generate a return at all when you back out inflation.

But anyone who works in the financial services business knows that there are always costs attached to purchasing various financial assets.  Most of these fees are recurring of some sort and can range from the reasonable (like ETF’s or discount brokerage fees) to the absurd (most hedge fund fees or annuities).   Real estate is not immune to the fees and the costs arise in ways that are even better disguised than a bulge bracket brokerage statement.

Like all financial asset purchases you are guaranteed to start your purchase in the red by the amount of the fees involved in purchasing the asset.  Homes are an unusual financial asset in that they’re extraordinarily expensive from an up-front cost perspective. You have realtor commissions, closing costs, inspection, appraisal, insurance and a whole slew of other potential costs such as moving or maintenance.  This is before you’ve even stepped foot into your “investment” and before you’ve started paying the real fees (like your mortgage, which will cost you almost 75% of the cost of the home over the life of a 30 year mortgage AND the maintenance)!

For simplicity, let’s take an example of a home worth $200,000 and assume some relatively modest up-front costs.   Let’s also assume, like most Americans, that we have a fixed rate 30 year mortgage at 5.5%.  Let’s also assume some fairly conservative estimates for commissions (which I split because one could argue that both the buyer and seller pay the fee), closing costs and inspection.  Nothing too complex (I know, I am oversimplifying!).  But the total comes out to about 5.25% of the cost of the house.  That’s similar to buying an A-share mutual fund, which is something that you only do if you’re suffering from sort of degenerative brain defect.

But we’re really just getting started with the fees involved in this financial asset.  Over the life of a home you’ll have to pay taxes, mortgage payments, property insurance, utilities, water, disposal and routine maintenance.  These are all fixed costs and whether you rent or buy you’ll have to pay some of these fees no matter what.  So let’s throw out utilities, water and disposal with the assumption that your rental option has those costs embedded.  But when you own a home you’re still paying the mortgage, taxes, property insurance and you’ll have to maintain the property yourself.

According to the 2009 American Housing Survey these costs come out to about 7-8% of the value of the home per year.  Here’s the breakdown:

Now, that mortgage “cost” includes principal payments so let’s just take the average national mortgage rate according to the AHS and assume that the 30 year mortgage will cost you roughly $165,000 over the life of the mortgage (this is JUST the interest paid).  Using a basic amortization schedule it’s pretty safe to assume a monthly interest payment of $800 or $9,600 per year.   That brings our annual costs down to about 6.5%.  You could also back out part of the taxes due to the mortgage deduction so let’s be generous and assume that our home costs us about $10,000 per year or roughly 5% of the mortgage.  Even in the best periods where real estate returns 4.8%, the total return is still negative!  That’s one expensive financial asset and it brings our real, real return down to -5% per year assuming we break-even after inflation.

The Bottom Line

Don’t worry.  This post isn’t intended to wreck the “american dream”.  None of this analysis means that buying a house is a bad idea.  You have to live somewhere and this analysis does not compare the specifics of renting versus the specifics of buying a house outright, buying a house with a mortgage or using the property as an income source.  The analysis is simply intended to put the total costs and real, real returns in the right perspective for those of us who buy a house with a mortgage and live in that home (as most people do).  In my personal opinion, I view buying a home as a less expensive way to live than the option of renting (but I guess you could make both arguments depending on where you live).  Plus, there are numerous intangibles involved in owning your own home that make it a wise purchase.  But we should stop thinking about housing or talking about it like it’s an amazing “investment”.  Whether you rent or buy you are experiencing an expense.  The real costs of that expense will depend on your specific situation.  But in both real returns and real, real returns (including taxes and fees) the returns are unlikely to be anything to write home about.  And certainly not what I would refer to as a good financial “investment”.


(Figure 1 – Real house prices)

The End of America

I had to laugh at this ad (at the bottom) that’s been playing on the site here in the last few weeks.  It says:

“THE END OF AMERICA – Blah, blah, some guys will sell you doom and glooom, sign up here so he can separate a fool from his money.”

Regulars know that I am a pretty optimistic person over the long-term.  That is, I am a big believer that there are more people waking up in the morning saying “I want to be smarter and better than I was yesterday” than there are waking up saying “the world is doomed, I should build a bunker and hide out”.  That’s just my general view of things.  Maybe I am wrong, but I don’t think so.

More importantly, this is an incredibly powerful macro trend at work.  It’s a trend that drives progress and output going forward.  Obviously, there are more pieces to the puzzle than that, but you get the general trend.  The Neanderthal who shorted Cro-magnon Man stock 30,000 years ago is sitting on hefty losses.  Not just because he was dumber than Cro-Magnon man, but because Cro-Magnon man continued to progress at a faster rate due to this inherent desire to wake up in the morning and learn and grow within his/her surroundings (I just made a mockery of human evolution so feel free to lay into me if you have any historical expertise here – and yes, I know there is some historical record of Neanderthal and Cro-Magnon man intermingling, but my example doesn’t sound as emphatic if I say that).

Of course, betting all-in very aggressively on on progress over the long-term can be irrational.  Yes, the Cro-Magnon man long bet turned out well, but no Cro-Magnon man lived the 30,000 years to cash in his/her bet.  And there have been some pretty dicey times for our species over the course of this bet.  Some lasting entire lifetimes or longer.  So it makes it very difficult to plan for life around this uncertainty since we can’t know precisely how this powerful long-term trend will impact us in the short-term.  There have been clear cases where persistent hard times last throughout our lifetimes.  Unfortunately, the macro trend at work in these timeframes doesn’t always play out perfectly over the course of time when you actually need it to.

This makes it highly imprudent to wander through life just assuming that everything is going to turn out for the best.  There’s a chance of pro-longed hardship and trouble over the course of much of your lifetime.  And designing a portfolio and planning for the future has to take this into account.  That doesn’t mean you turn into a permabear or build your portfolio around the end of the world and positions in gold, guns and bunkers, but it does mean you have to approach the world in a prudent manner that takes these risks into consideration.  I say, be a pragmatic optimist.  You don’t want to be the irrational bull or the irrational bear.  But if you’re constructing a portfolio with an overweight against human ingenuity and progress then you’re likely to lose out over the long-term.

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Hatzius: The Deficit Will Decline Substantially in the Coming Years

Jan Hatzius of Goldman Sachs had some interesting commentary on the deficit the other day.  You’ll recognize the sectoral balances chart in his work as he’s one of the few analysts on Wall Street who seems to really appreciate the importance of Wynne Godley’s work.

Here, he describes the 3 reasons why the deficit is about to slide in the coming years:

“There are three main reasons for the sharp reduction in the deficit:

1. Lower spending. On a 12-month average basis, federal outlays have fallen by a total of 4% in the past two years, the first decline in nominal dollar terms over a comparable period since the demobilization from the Korean War in the mid-1950s.

2. Higher tax rates. The increase in payroll tax rates in January 2013 has boosted federal receipts by around $120 billion (annualized), or about 0.8% of GDP.

3. Economic improvement. Although real GDP has only grown at a sluggish 2%-2.5% pace since the end of the 2007-2009 recession, this has been enough to generate a sizable improvement in tax receipts, over and above the more recent impact of higher tax rates. Even prior to the tax hike that took effect in early 2013, total federal receipts had grown by 7% (annualized) from the 2009 bottom, nearly twice the growth rate of nominal GDP.

We expect the deficit to continue to decline and are forecasting a deficit of 3% of GDP or less in fiscal 2015. Some of this is policy-related. Sequestration has barely started to show up in the outlay data, and the expiration of the Bush tax cuts for high income earners in 2013 is likely to reduce tax refunds and boost final settlements in early 2014. In addition, the two parties are calling for further spending cuts and/or tax increases (although it is unclear whether these will be enacted).

But the more important reason, in our view, is that there is still a great deal of room for the economic recovery to reduce the deficit for cyclical reasons. The key to this forecast is our expectation that the private sector financial surplus–the difference between the total income and total spending of all households and businesses–will decline substantially further from the 5.5% of GDP reading of the fourth quarter of 2012 toward the historical average of 2% of GDP.

As a matter of accounting, this reduction must be mirrored in a drop in the federal deficit, a drop in the state and local deficit, an increase in the current account deficit, or a combination of all three. In practice, however, we expect it to translate primarily into a decline in the federal deficit, as tax receipts rise and outlays decline (e.g. via reductions in the unemployment rolls.) This expectation is consistent with the historical record. As shown in Exhibit 2, there has been a close inverse relationship between the private sector balance and the federal government balance in recent decades, with a correlation in annual data of -0.72.

gs1

And the conclusion from Hatzius:

“In our view, the most important implication from the reduction in the budget deficit for the near-term economic outlook is reduced pressure for further fiscal retrenchment. Partly for this reason, we expect the drag from fiscal policy on real GDP growth to decline sharply from around 2% of GDP in 2013 to around 0.5% in coming years. This is a key reason for our expectation that real GDP growth will accelerate from around 2% (annualized) in Q2/Q3 2013 to 3%-3.5% in 2014-2016.”

I’d only add that it’s important that the private sector’s de-leveraging is slowing and even turning into a re-leveraging to some degree.  This means the private sector is healthier than most presume and that the government deficit isn’t needed to power private growth as much as it has been in the last few years.  This passing of the baton is important in understanding the future trajectory of the economy.  The decline in the deficit is as much as a result of mild government austerity as it is a sign of increased private sector health.

Thoughts on the “Value” of Fiat Money

I generally liked this post by Joe Weisenthal on Bitcoin and the value of fiat money.  In particular, I like these points:

“But fiat currencies have tremendous intrinsic value because governments say they do. That’s why they’re called fiat currencies. They have value by government fiat.

This truth might be annoying, but the fact of the matter is that we live in a world of laws, where governments have armies, and can imprison you if you don’t pay taxes. And every transaction that you do is taxed in some way, meaning that to operate in any practical matter in this world means transacting in US dollars.

So the US dollar isn’t just important because other people think it is. The US dollar is important, because the world’s strongest entity, with the full force of the US army, the FBI, the CIA, the NSA, and various local authorities with guns demands that you pay them in US dollars. That’s not faith. That’s the law. Sorry.

Even outside of the requirement to pay taxes in US dollars, the Federal Reserve system has established the dollar as the unit of currency for banking in the United States. So if you want to be plugged into the banking system at all — which is a requirement for virtually all individuals — you have to use US dollars.

So instantly, anyone who says the US dollar is backed by “faith” or an “illusion” has no concept of the sheer force behind the currency.

This isn’t true of Bitcoins at all.”

I think that’s pretty good.  But I think Joe’s description misses an important point.  Money doesn’t just have value because a government says it has value.  After all, that money just serves as a means to an end.  Saying that a US Dollar has intrinsic value just because the government says it has value is like saying that a theater ticket has value because a theater company declares it as the thing that gains you entry into a show.  But this misses the point.  The ticket to enter the show is just a means to an end.  The real value is not in the ticket, but in the show itself.  If the show is terrible no one will want your tickets even if you have an army that can attempt to force people to use your tickets.

The same can be said of the US economy.  If the output of the US economy is not worthy of demand then the Dollar will have no value.  Bitcoin has value in that it achieves the same thing the US dollar does – it gives someone access to goods and services.  And its users attribute some value to it because it skirts the costs of transacting with bank deposits (like taxes and other associated costs).  But the problem with Bitcoin (as I described here) is that it has an intrinsically low level of trust (because it is unregulated – yes, that court system and regulated monetary system most certainly does embed a certain level of trust in the money system) and does not give you access to the majority of the show that is the US economy.  In other words, unlike bank deposits, Bitcoin isn’t a very good medium of exchange in that it doesn’t serve money’s primary purpose all that well.  Not having access to all that output is a big problem for any kind of money.  But there must be valuable and high quality output in the first place.

I think it’s important not to put the cart before the horse when discussing these matters.  Output necessarily precedes taxation and government power.  That’s why I put output at the top of my hiearchy of fiat money viability (see here).  Miss the emphasis there and you’ll completely misunderstand the purpose of money in the first place.

Redesigning the “Ask Cullen” Section

The “Ask Cullen” section has turned into a total mess with over 1,800 comments and absolutely no organization. So I added a forum style page that will organize the questions and comments better. It will be in the same place where the old comment section was on the front page menu bar.

I hope this makes the site easier to use and that you find it helpful.

Kahneman Fathoms the Human Mind

I always enjoy the thoughts of Daniel Kahneman even if I don’t entirely agree with everything he says. Then again, I might just be one of those quacks he refers to who has convinced himself that he’s an expert in something that no one is really an expert in….

Via Forbes:

Forbes: You won a Nobel Prize for fathoming the human mind. You’ve made the point that perhaps because there are so many smart people in finance, that individual stock pickers, managers, cannot consistently beat the market.

Kahneman: Well, it’s not a point I made. The point, I’m not a finance expert, so you know.

Forbes: Well, clearly, they’re not either.

Kahneman: Well, when it comes to stock picking perhaps nobody is. That certainly was [Burton] Malkiel’s (PH) point. So, I am the consumer of this stuff. But what I find very interesting is that although everybody, I think, recognizes that in principle, you can’t do this. Because if you could pick stocks very well, then other people would also be picking those stocks, so the advantage would be gone. So everybody realizes that in principle, it’s impossible. But everybody personally thinks they can do it.

Kahneman: Yeah. And that’s exactly like the officer story. That, I find fascinating. I call it an illusion of skill. You know that it’s wrong, but you feel something else.

Forbes: And why does that persist?

Kahneman: It persists because you get the immediate feeling that you understand something. That is much more compelling than the knowledge of statistics that tell you that you don’t know anything. And, that again, is the officer story. But it’s writ large, that you really see it at work in many domains. In the financial domain, where people feel that they can do things that, in fact, we know and they should know they can’t do.