Author Archive for Cullen Roche

We Are All Charlatans!

I love Larry Swedroe’s work.  If you haven’t read some of his books on investing then you’re probably less informed than you otherwise could be.  But Larry also believes in the “forecast free” view on indexing.  And while it’s a nice message and one that we can all relate to (forecasting is hard), I think it misrepresents what we all do when we allocate assets.

In a recent blog post Larry says that prognosticating the future is “the occupation of charlatans”.  That’s pretty harsh if you ask me.  But we see this all the time with indexers.  They say that they don’t predict the future, don’t engage in trying to outguess the market and that they leave that up to the “active” gamblers.  And then they whip out their handy dandy set of backtested results and datamined “evidence” and say “buy low fee index funds and don’t listen to anyone who makes a forecast”.  Or they look at past results and conclude that certain “factors” should be weighted in a certain way because they have shown evidence of good performance.  Or they choose to actively deviate from global cap weighting (as all indexers do) and then claim they’re still not predicting the future.

This is all fine except for one small problem – by using a rear view mirror approach the indexers are all making forecasts.  They’re just extrapolating the past into the future in what amounts to little more than “well, asset classes have averaged X% per year for XXX years so that’s a reliable assumption going forward”.  This could be true.  And it could also be completely wrong.  They’re making a fairly smart forecast based on a fairly long dataset, but it’s not like they’re not making a forecast about the future.

Worse, as I’ve noted recently, indexers all deviate from the global market cap weighting because no indexer can buy the total world’s financial assets nor would they want to.  And when you deviate from global cap weighting you are, by definition, an active investor.  And you are, by definition, making a forecast about how your allocation will perform in the future.  I don’t care if you look at some historical dataset and extrapolate it forward or if you focus on trying to understand the world for what it is and make probabilistic forecasts (as I do).  We all make forecasts about the future.  Some do it in rather silly ways while I’d argue that some are more realistic and calculated.  But all of our portfolios are constructed by making forecasts and implicit assumptions about how certain asset class weightings will help us achieve our financial goals.

Of course, the future is extremely difficult to forecast.  We don’t deal in certainties in life.  We deal in probabilities.  Which is fine.  I don’t know what the weather will be like in one month (except, actually I do know what it will be like here in San Diego), but that doesn’t mean I start throwing my beer at the TV every time a weather man comes on.  Constructing a portfolio is a lot like forecasting the weather where you want to get married.  You pick a place where it likely won’t rain, a time of year where it doesn’t rain much and then you cross your fingers and hope that your probabilistic forecast was smart.  But you don’t just go and get married anywhere in the world just because the weather is difficult to predict.

We deal in a very complex system in the financial markets.  But don’t be the person who goes into all of this using some backtested set of results that you extrapolated into the future thereby leading to the silly conclusion that you aren’t making forecasts.  Doing that would just make you a charlatan and someone who, if I ever met you, I might just have to waste a perfectly good beer on (literally, on you).  Just kidding, I would never waste a perfectly good beer on someone who believes in “forecast free passive indexing”.  Unless it was in the process of erasing such a terrible misconception from your mind.  Which might require more than one beer….

 

Be Careful Where you get your Financial Advice from….

You have to be so careful getting your financial advice from entertainers and people who put themselves out there as “financial experts” (I do that also and you should be damn skeptical of everything I write).  I got to thinking about this as I read this post on Dave Ramsey’s website about asset allocation.  Here is the question from a listener of Dave’s show and his subsequent answer:

Dear Dave,

Can you explain the “asset allocation” theory when it comes to investing?

Matthew

Dear Matthew,

The asset allocation theory is one touted by lots of people in the financial community. It’s also a theory with which I disagree.

In short, the asset allocation theory means that you invest aggressively while you’re young. Then as you get older, you move toward less aggressive funds. If you follow this theory to the letter, you’re left pretty much with money markets and bonds by the time you’re 65.

The reason I don’t believe in this theory is simple. It doesn’t work. If you live to age 65 and are in good health there’s a high statistical likelihood that you’ll make it to 95. The average age of death for males in this country is now 76, but that includes infant mortality and teenage deaths. So, a healthy 65-year-old man in America can look at having another quarter century on earth. If you move your money to bonds and money markets at age 65, inflation is going to kick your tail. Your money will grow slower than it will devalue, and you’ll have little purchasing power. That’s the problem with the asset allocation methodology.

I advise investing in good, growth stock mutual funds  that have strong track records of at least five to ten years. Spread your money across four types of funds: growth, growth and income, aggressive growth and international. These groups provide diversification across risk, as well as a little splash overseas.

Great question, Matthew!

—Dave

Poor Matthew.  I sure hope you didn’t take this advice to heart because it’s pure nonsense.  There’s so much wrong I don’t even know where to start…

First, “asset allocation” isn’t a theory that any reputable financial expert rejects.  It’s about as close to a law of finance as it gets.  The idea is extremely simple.  By owning the market portfolio of financial assets you reduce unsystematic risk.  That is, owning a slice of the market portfolio exposes you to company or entity specific risk.  By owning a broader swath of the outstanding financial asset portfolio you reduce the risk of being exposed to an Enron,Lehman Brothers or Greek style collapse.  Again, this isn’t a theory.  It is a basic understanding of modern finance.

Second, you don’t own bonds to beat inflation.  I think this is a case of Dave’s politics getting in the way of sound thinking.  Bonds provide investors with a fixed income stream and embedded guarantees.  This reduces the volatility in the returns of the instrument and provides the investor with greater security. Over the history of the bond market, bonds don’t tend to outperform inflation by much.  The inflation adjusted return of a 10 year T-note is about 2%.  Not exactly a great inflation fighter.  But that’s not why you should own bonds.  You own bonds because they provide stability in your portfolio.  They counteract the volatility of instruments like stocks and help you smooth the total portfolio return.  Most of us don’t want to expose our financial assets to the stock market rollercoaster ride because that creates uncertainty and instability in our personal lives.  Bonds are one form of instrument that helps us generate an income for our savings without jumping on that rollercoaster.

Lastly, the idea that you should just own stock mutual funds is horrible advice.  Various studies show that past performance of mutual funds is a poor predictor of future returns.  In addition, most mutual funds charge very high fees despite regularly underperforming index funds.  And owning nothing but stocks doesn’t diversify the risk of stocks away.  In fact, it just exposes you to the aforementioned rollercoaster ride.

No wonder Americans lack basic financial literacy.  Even some of the experts lack basic financial literacy….

Putting the Performance of Gold in Perspective

My comments about gold during the RT interview with Peter Schiff made a lot of people upset.  I’ve received a number of emails, angry comments and forum posts.  One of the common responses is to highlight the past performance of gold as a justification for various arguments about the positive aspects of gold.

To begin with, we have to be very careful with past performance.  It’s nice to have a historical record of how certain asset classes have performed in the past, but it’s always dangerous to assume that the future will necessarily look like the past.  I often gripe about how stock permabulls use a historical record to justify their views.  I think this is naive to some degree so we should apply the same thinking here.  That said, we do have some evidence to work with and it would be equally naive to totally ignore past performance so let’s actually put these historical figures in some perspective.

The price of gold was fixed before 1971 so we don’t have as much history as we might like, however, we can still make some sound conclusions based on this time period.  So, let’s compare gold with a standard 60/40 stock/bond portfolio and a bond aggregate.  The results are pretty clear:

perf

 

The 60/40 portfolio has outperformed the other two portfolios in nominal returns, but the bond portfolio has the most consistent risk adjusted returns.  Therefore, being overweight bonds relative to stocks and gold over this period produced outstanding results (that’s not likely to continue for several reasons so again, take this data with a grain of salt).  But the most interesting conclusion is that gold has actually been an atrocious risk adjusted performer.  It generates a compound annual growth rate that is the equivalent of the bond portfolio, but does so with over 4X the volatility!  Even a pure stock portfolio had a standard deviation that was 40% lower over the same period.  Gold’s quantifiable risk is through the roof relative to other assets.

The one nice thing about the performance of gold over this period is that it has provided some non-correlation to other asset classes.   This creates increased diversification and could boost the risk adjusted returns of a broader portfolio by having this slice of non-correlation included.  But we should not overlook the fact that gold is an extremely volatile asset class that does not tend to perform well on a risk adjusted basis on its own.

So yes, gold has performed fine in nominal terms since the price fix was removed.  But it has not been remotely stable.  In fact, it has been so volatile that its risk adjusted returns are among the worst of all available asset classes over this period.  Most importantly, I would add that the past is not prologue.  And my rationale for disliking gold as a substantial holding in any portfolio has nothing to do with past performance, but rests in what I believe is the risk of a collapsing “faith put”.  That is, there is a price premium in gold due to its perception as a currency.  I personally believe this perception is flawed and I think technology will render it entirely false as time goes on.  The future of money is not in rocks, but in spreadsheets on computers.  Therefore, it’s my opinion that this faith put will slowly be removed over time as this added demand for gold disappears.

This is why the past data is even more dangerous than many people think.  If I am right about my views going forward then gold isn’t just risky based on past performance, but it could be even riskier in the future as the faith put subsides and the myth that “gold is money” disappears.

Are We In a Permanent Liquidity Trap?

Grrrrrr.  Paul Krugman is stealing my thunder on the interest rate call that wrecked PIMCO and Bill Gross.  Like myself, Krugman was loudly declaring that interest rates had no reason to rise when QE2 ended in 2011.  Rates fell after QE2 ended, fell a lot and Gross never quite regained his footing.  The rest is history.  So Paul Krugman was dead right.  He said we were in a liquidity trap and that people preferred to hold money and that that meant traditional monetary policy wasn’t working.  And since the economy was weaker than expected then it meant that the risk was not rising inflation, but low or falling inflation and that meant rates would remain low despite the end of QE2.

What I was saying at the time was different.  I said QE didn’t have much of an impact on interest rates to begin with because it was a simple asset swap of safe assets for safe assets.  That is, QE is like swapping a savings account (t-bonds) for a checking account (cash) and since this didn’t change the flow of funds in the economy then there was little reason to expect a change in the composition of the stock of assets to make a huge difference because QE wouldn’t be inflationary.  I’ve also said, flatly, that were are not in a Keynesian “liquidity trap” in the sense that Keynes actually thought.  Most importantly, the Central Bank never really controls the broad money supply in any meaningful way so this whole concept of the Fed being able to control the economy through interest rate changes didn’t apply in the sense that many economists seem to think.

All of this meant, all else being equal, that the end of QE2 wouldn’t cause rates to rise because the demand for safe interest bearing assets would remain the same in a low inflation environment which meant that people would simply gobble up more T-bonds as they were issued or they’d remain indifferent as QE2 ended.  In other words, so long as there’s low inflation the preference for safe interest bearing instruments is always there whether we’re in a “liquidity trap” or not.  So, we agree on the basic story and conclusion, but we disagree on the framework being used to come to this conclusion.

Now, Dr. Krugman has defined the liquidity trap as follows:

“Well, my definition of a liquidity trap is, purely and simply, a situation in which conventional monetary policy — open-market purchases of short-term government debt — has lost effectiveness. Period. End of story.”

That’s pretty friggin’ vague.  And it confuses a lot of people because this is not how Keynes thought of a liquidity trap.  Keynes said the liquidity trap was a period in which cash and bonds became perfect substitutes:

“There is the possibility … that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest. But whilst this limiting case might become practically important in future, I know of no example of it hitherto.”

In other words, the Central Bank cannot stimulate the economy by printing money because banks and consumers will hoard the cash, interest rates will be uncontrollable and monetary policy won’t work.  But this isn’t at all what happened during the crisis and it’s certainly not what’s happening now.   The Fed only lost control of interest rates for the briefest of moments during the crisis and the huge demand for certain types of bonds in today’s environment shows very clearly that there’s a strong portfolio preference for interest bearing assets.  Ie, there’s actually very strong demand for bonds and, in the aggregate, people don’t want to hold cash.  Therefore, cash and bonds are not perfect substitutes.  People literally can’t get enough bonds in today’s environments because they want the interest flows from these instruments.  They aren’t just holding cash as if their liquidity preferences are low.

Worse, the view that the “money printing” would not work was perpetuated by people who said the Fed would print all this money and the banks would simply “hold it” as though their preference was to not make loans.  Ie, they wouldn’t lend it out.   In 2008 Dr. Krugman stated this position clearly:

“Here’s one way to think about the liquidity trap — a situation in which conventional monetary policy loses all traction. When short-term interest rates are close to zero, open-market operations in which the central bank prints money and buys government debt don’t do anything, because you’re just swapping one more or less zero-interest rate asset for another. Alternatively, you can say that there’s no incentive to lend out any increase in the monetary base, because the interest rate you get isn’t enough to make it worth bothering.”

Of course, readers here know that this is nonsense.  Banks don’t “lend out” the monetary base.  The multiplier is a myth. Krugman claims he understood this all along, but his comments clearly convey an erroneous understanding of how banking works.  So the liquidity trap view is clearly wrong for the following reasons:

  1. Banks were never “hoarding” the monetary base or refusing to lend reserves out.
  2. The Central Bank never lost control of interest rates.
  3. Bonds are not viewed as perfect substitutes for cash in the current environment.

 Therefore, the Krugman rationale for a “liquidity trap” was never quite right even if some of the predictions were right.  Yeah, the interest rate channel has proven dysfunctional in the current environment, but not because of liquidity preference, liquidity traps or something like that.  More likely, the interest rate channel has always been a pretty weak way to steer the economy and we didn’t realize it until the current crisis.

 The real question now is, how long is this myth of a “liquidity trap” going to continue?  How long can we continue to say we’re in a liquidity trap when this model is obviously based on flawed thinking?  Or better yet, isn’t it now becoming clear that the Fed NEVER really had an omnipotent type control over the “money supply” and the economy to begin with?  In other words, has the interest rate always been a poor way to enact monetary policy?  I’d say that’s pretty accurate.  And either way, it renders the idea of the liquidity trap misguided at best and useless at worst.

NB – I should also add that it’s wrong to say that monetary policy has become ineffective.  Yes, changing interest rates has become ineffective, but that doesn’t mean that monetary policy as a whole has become ineffective.  I’ve pointed out, on several occasions, that the Fed could enact extraordinary measures which would likely have highly beneficial effects.  Policies such as pegging the long bond rate explicitly, buying municipal bonds (thereby financing state government spending) or buying nonfinancial assets in exchange for cash would all have positive economic outcomes in my view.  The fact that the interest rate channel has become ineffective is not a sign that all potential actions by the central bank are ineffective.

Some Thoughts on Static vs Dynamic Projections

We all have to make projections about the future in just about everything that we do.  It’s just a fact of life.  When one invests their money in certain instruments the ability of those instruments to meet your financial goals will depend on a certain degree of projection about the future and the way those instruments will perform.  Some of us look at historical data and project it forward while others take a more forward looking perspective and engage in what could be thought of as guesswork (or, at times, rejecting the idea that past is prologue).  Forecasting the future is part of any honest approach to asset allocation.

What’s interesting about projecting the future is not necessarily whether you’re trying to project the future or not, but how dynamic your model is in achieving this.  This gets very tricky for several reasons.  Someone like Jeremy Siegel, who’s become famous for his “Stocks for the Long Run” perspective, has a very static view of the world.  That is, he basically assumes that economic growth will continue into the future and that means stocks will expand over time and if you have a long enough time horizon then you are best off owning a portfolio of equities (he’s even recommended leveraging that portfolio up if you can stomach it).  This is a perspective that is generally based on fine assumptions (eg, betting on long-term economic growth is a pretty smart bet in general).  But it also doesn’t reflect our financial lives all that realistically because our financial lives are quite dynamic.  Our financial lives are not these static sort of linear experiences.

This reality is why people love Robert Shiller so much.  Shiller’s view is more dynamic.  Shiller basically says that the world is super duper complex, extremely dynamic and that the market’s participants are extremely irrational.  Shiller uses quite a bit of historical data in his work, but he’ll be the first person to tell you that the past is not necessarily prologue.  People relate to this view because they can see how dynamic their lives are.  Shiller’s model based on irrational behavior and dynamism is something that resonates with people because we experience it every day whereas Siegel’s long-term view is something that doesn’t resonate on a daily, monthly or even an annual basis.

So, which type of view is actually more helpful?  It depends quite a bit.  In a general sense, Siegel’s view is right because the world does tend to adhere to the big trends that drive Seigel’s thinking.  But in a more micro sense Shiller is right and the world does go through these periods of turbulence in the near-term that are consistent with a dynamic world view.

Now, is one model necessarily better than the other?  No!  There are parts of the Seigel and Shiller model that are both right.  And there are parts of both models that are wrong.  Finding which one applies to you more appropriately is a process of learning how certain ideas apply to your personal needs.  There’s a lot of dogma in the world about certain views being “right” or “wrong” when the truth usually lies in the middle.

 

 

Not All Bonds Are Created Equal

Here’s some really long-term perspective for you – this chart via Deutsche Bank shows the nominal yields for several government bond markets at present.  The trend is generally the same in all of these charts so they don’t actually look all that different, but I’d argue that there’s a big difference in these bonds:

bonds

 

The thing is, the Italian and Spanish bond yields are being suppressed by the ECB’s interventions.  But under the surface lies a gigantic risk in owning these bonds.  While investors are being paid close to nothing for owning these bonds now there is still a substantial amount of solvency risk involved in owning these bonds.  The thing is, because the European Monetary Union is incomplete, each of the nations using the Euro are the equivalents of states in the USA.  So the risk of insolvency is very real.  In other words, they are essentially users of a foreign currency and can be determined insolvent by virtue of not being able to obtain the necessary funding to remain solvent in that currency.

Of course, it would take a political event for that to occur (the EMU has to essentially choose to let one of the countries go bankrupt), but it might not be as far fetched as you think.  Say, for instance, that Italy’s debt to GDP ratio just continues to worsen and Germany slowly realizes that this country can’t reverse course without debt forgiveness or its own currency.  In that case Germany could essentially choose to pull the plug on letting Italy use the Euro and decide that it’s best to part ways as it becomes clear that the currency union just isn’t working as planned and Germany doesn’t want to get involved in a fiscal union that would alleviate the pressures.

Now, this risk doesn’t exist in the USA at the federal level.  The USA doesn’t have foreign denominated debt and there’s no political risk of the Fed not being able to intervene to hold rates low or buy bonds.  But you actually earn less on a Spanish 10 year bond than you do on a US government bond which is priced about the same as an Italian 10 year in nominal terms.  In my opinion, you have to be insane to hold these bonds and view them as being near equivalents.  In my view, peripheral government bonds are significantly more risky than German Bunds or US government bonds.  And that’s largely because there is massive solvency risk due to a very fragile political landscape.  Investors who don’t realize this could be taking on significantly more risk they realize.

Rail Traffic and Jobless Claims Still Point to Expansion

Just a quick update here on some of the near real-time economic indicators I track.  Rail traffic and jobless claims are among the better macro indicators we see with some regularity.  They’re obviously not a perfect reflection of the economy, but when taken in accordance with the broader picture they certainly help provide some clarity

The latest update on rail trends continues to show signs of modest expansion.  The latest 12 week moving average comes in at 5% which is actually a healthier average rate than we’ve seen through most of the recovery.  Granted, this is just one sliver of the economy, but it is certainly a positive sign (via AAR):

rails

Weekly jobless claims continued their downward trend in recent weeks with the 4 week average dipping below 300K.  This is generally consistent with a healing labor market and a clear sign that the US economy continues to move in the right direction.

claims

 

All in all, this seems to confirm the “muddle through” macro view I’ve maintained for the last few years and these indicators look consistent with the other indicators I track more broadly….

What is the Purpose Of Interest?

Good question here from the forum:

“Can you explain what actually is the reason/purpose of interest in our modern day monetary system?”

Money is endogenous in the modern monetary system.  That means it can be created by any user within the system and can be created from what is really nothing more than an agreement between parties.  The primary form of money in our system is bank deposits and they are created by banks when banks make loans.  Private banks essentially control the primary payment system that we all use and so they create the primary form of money and maintain the system in which it is used.  If you want to participate in the US economy to purchase goods and services then you need a bank account.

Banks make money by charging you a fee to use their system and to use the money they create within this system.  Because the system is privately controlled there is an element of risk management in everything that a bank does.  That is, if a bank doesn’t properly manage its risks it can end up like Washington Mutual or Northern Rock.  Because banks are private profit maximizing entities they have to balance how they generate a profit and how much risk they take in the process of doing this.

The privately controlled element of this system creates competition which makes banks operate more efficiently and makes them accountable for how they operate their businesses.  But since this payment system is so central to the health of the economy the payment system has a unique relationship within the economy.  And as we’ve all discovered over the last 5 years when the payment system doesn’t work properly the whole economy stops working properly.  And so you get this inherent and tricky mix between government intervention in the banking system and the way banks try to operate within their “free market” to compete.  It’s all a bit messy because the banks are profit maximizing and risk taking entities who can, at times, threaten the health of the entire economy through their ability (or inability) to manage their risks in the pursuit of profit.

When a bank lends you money they are essentially allowing you to use their payment system for a fee.  And they will assess this fee based on the duration in which you want to use that money and the risks you pose to using that system.  So, a borrower with bad credit could be rejected from being allowed to use the payment system that banks operate.  Or the banks could just choose to charge that person a very high fee (interest rate) to use the system.  So, in its simplest form interest is just the fee that banks charge users of the payment system.

Of course, there are lots of instruments which convey a similar temporal relationship like stocks or corporate debt.  These instruments convey a similar type of relationship where one party is again creating a financial instrument to obtain money and thereby paying someone a fee to use that money.  So, for instance, a corporate bond is an agreement by a corporation to obtain bank deposits for a certain period of time at a certain interest rate.  In the process of creating this instrument with lower moneyness than the bank deposit they will pay the lender a fee for the specific period.  They are, in essence, convincing the bank deposit user to forgo using their bank deposits in exchange for a fee.  So you can see how this process of financial asset creation can be thought of within the spectrum of moneyness with different entities creating different forms of money within that system….

I hope that helps answer the question.

The Trade that Led to the Demise of PIMCO Total Return

In a great piece over the weekend Josh Brown goes into some detail on the situation with Bill Gross leaving PIMCO.  He asks the important question – what does an owner of the Total Return Fund do now that Gross is gone?   I’m not going to answer that question, but I did think there was an important lesson in Josh’s post.

In 2011 Bill Gross, who had crushed the aggregate bond market by almost 2% per year before fees for 30 years, made one of the most vocal bets on interest rates that we’ve seen since the crisis.  He was very worried about rising rates when QE ended.  He asked “who will buy the bonds” in his March 2011 monthly letter and his bearish stance on T-bonds led him to reduce his allocation to T-bonds to zero.

I was very vocal about this view at the time because I believed Gross was misunderstanding the impact of QE.  In fact, I thought a large portion of the field of finance and economics was misunderstanding the risks of QE, the “money printing”, etc because they weren’t properly understanding its operational reality.  In essence, Gross was saying that interest rates would rise because QE was ending and the decline in rates due to QE would have to reverse.  That is, of course, unless you don’t think QE had much of an impact on rates to begin with.  If that was your belief and you thought that inflation would remain low (as I did) then there was really no rational reason to expect interest rates to surge following the end of QE2.

Of course, Gross ended up being wrong as rates actually fell after QE2 ended.  The Total Return Fund went on to underperform the long bond by a huge margin PTTRXover the next 2 years and the very public call came under harsh scrutiny.  Investors began to ask if Gross had lost his touch.  And the fund flows reversed out of the fund began as quickly as they’d flooded in after 2008.  As the years went by Gross appeared to never recover from the call and last week we learned that Gross was leaving the firm he founded.

The interesting thing is not that Gross was a victim of bond market ignorance – he’s obviously a bond market genius, far more savvy than a chump like myself.  but he was a victim of macro ignorance.  The implementation of QE by the Fed had forced all market participants to take on a whole new set of understandings.  And those who had a sound understanding of macroeconomics were better prepared to deal with the aftermath.

In my new book I outline 8 rules for picking an asset manager (see here).  Rule 8 is ensuring that a fund manager has a sound understanding of the macro world.  Misunderstanding the big picture creates tail risks in a portfolio because it means that fund manager exposes investors to the risk that he/she could dramatically misunderstand important macro events.  And in a world where everything is becoming increasingly macro oriented (whether it’s Fed policy, dependence on global events, etc) you can’t afford to invest with asset allocators who don’t have a sound understanding of the macro environment.

Of course, understanding the world isn’t a guarantee of future performance.  But I am a big believer in the idea that those with a superior understanding of macro dynamics will be better prepared to manage the risks that threaten investment performance.  In other words, by having a superior understanding we can better understand what we know in addition to what we don’t know.  And this ultimately helps you avoid the pitfalls that befell the PIMCO Total Return Fund.

Government Job Cuts are Driving Down the Labor Force Participation Rate

One point that doesn’t get a lot of airtime in current economic discussions is just how much the US government has cut back on its worforce in recent years.  Government employees are still off by 491,000 since the start of 2008.

gpayrolls

This is an unprecedented cut in total government employees.  No President in the post-war era has presided over two terms in which government employment declined through his Presidency.  Not Reagan, not Bush, no one.  In general, they were all huge expanders of government employment.

What’s interesting about all of this is the labor force participation rate which is often cited as a sign of structural weakness in the US economy. Which is true to some degree.  But how much of this decline in the participation rate is due to the government job cuts since 2008?

I went back and ran the figures and added in the trend growth in government employment since 1950.  Rather than cutting half a million jobs since 2008 the US government would have added about 2.4 million jobs.  In this scenario the labor force participation is 64% vs today’s actual rate of 62.8%.  Since the rate peaked at 67.3% it’s declined by 4.5 points.  In other words, the government’s job cuts have accounted for 27% of the decline in the labor force participation rate.   And who knows how much all of that lost input and income could have further multiplied growth and employment….

lfpr

The Great Gold Debate

I went back on Boom/Bust today to discuss the merits of gold in the economy.  Regulars know my position here:

  • Gold is an unproductive asset that shouldn’t be the center of a portfolio.
  • Gold can serve as a hedging or insurance component of a portfolio.
  • Going back to the gold standard isn’t a wise move because it would lead to imbalances similar to what we’re seeing in Europe today with the fixed exchange rate.
  • Gold is “money”, but it’s generally not a very good form of money because its utility as a medium of exchange is not very high.

This was a fun interview which included some gold heavyweights like Rick Rule, Peter Schiff and Marshall Auerback.  Everyone was very courteous and I thought the overall discussion was very fair and balanced.  Peter and Rick made some smart points (though we also disagreed at points) and I obviously agree with Marshall on a number of things.   Erin Ade and Ed Harrison did a great job moderating the discussion and keeping it on point.

I don’t say much in the first 9 minutes, but I was just lurking in the tall grass (or maybe I was just confused/intimidated by the whole 4 person panel thing going on).  I made a couple of key points after that:

  • The value of the dollar declining in terms of gold or CPI is a useless metric.  You have to compare it relative to real wage rates which have vastly outpaced inflation over the last 100 years (see here for more).
  • It doesn’t make a lot of sense to build a portfolio around an unproductive asset class like gold because its value is based more on the belief that it’s valuable as opposed to some inherent utility (see here for more).
  • The 1800’s were a period of great turmoil.  This commonly cited era included a number of financial panics and depressions.  My favorite line of the debate was at minute 24 when Peter says we should just ignore those depressions….
  • The hyperinflationists have been wrong for 10 years running.  How much longer can these predictions garner attention before we all begin to question the foundation upon which they rest?

Watch the full video below:

 

Some Thoughts on Risk Parity

This is a very good piece by Cliff Asness on his new blog.  If you don’t follow it then add it.  Cliff is one of the smartest dudes around.  Anyhow, his firm AQR runs a strategy called “risk parity”.  I am not positive where this idea originated, but it was made relatively famous by Asness and Ray Dalio who has been running a form of risk parity for decades.  You can read Dalio’s description of the approach here.

I’m oversimplifying here, but the basic approach is to create a risk balanced approach.  So, if you have a 60/40 stock/bond portfolio most people don’t realize that over 80% of the portfolio’s performance is being driven by the 60% portion because stocks are so much more volatile than bonds.  So you’re not really in a 60/40 when you buy a 60/40.  You’re really in something more like a 80/20.  The idea of risk parity seeks to eliminate this imbalance by making the portfolio risk balanced.  This is generally done by overweighting the low volatility assets in the portfolio to make them equal contributors to the portfolio’s overall risk.  So, if you wanted to make a 60/40 more balanced you might buy a 40/60 stock/bond portfolio and leverage it up 1.5X. This gets you to the same standard deviation, but it beats the living daylights out of a 60/40 portfolio on a nominal and risk adjusted basis (over the last 20 years it generates a CAGR of ~11% vs the 8.4% CAGR of the 60/40 with better risk adjusted figures).

So, what’s good and bad about this approach?   First the good:

  • It’s a smart form of strategic diversification.  In other words, this isn’t just some cookie cutter index fund approach that anyone and everyone can implement.  It’s a very sophisticated and value adding methodology.

 

  • The focus on fixed income is a nice deviation from so much of Modern Portfolio Theory’s obsessive focus on equity returns and the nonsensical idea that “risk = returns”.  This changes the focus of the traditional debate by ensuring that shareholders are taking a more balanced approach rather than naively jumping into what they think is a “balanced index” like the Vanguard Balanced Index (which actually isn’t very “balanced” at all because the majority of the volatility is derived from the 60% equity portion of the portfolio).

 

  • Historically, risk parity portfolios add diversification to a portfolio in a way that reduces overall volatility and increases nominal and risk adjusted returns.

It’s not all good though (sorry Cliff).  There are some cons to the risk parity story (as there are in any portfolio):

  • The focus on “risk” as volatility leaves the door open for potential misalignment between the way client’s perceive risk and the way a portfolio’s risks are managed.  Shareholders don’t view risk merely as volatility.  This could result in periods of performance which don’t properly protect shareholders from the way they perceive risk.

 

  • There is some significant forecasting error risk involved in risk parity.  As with any allocation approach there is some degree of forecasting, but in a portfolio that is fixed income heavy the portfolio relies, to a large degree, on the positive risk adjusted returns of the fixed income portion.  This means that a risk parity portfolio, is, to some degree, a bullish forecast on the future of bonds (at least more so than a traditional balanced index).  The underlying model also involves some forecasting of changing risk dynamics.  This is difficult, if not impossible….

 

  • The portfolios are sophisticated.  The modeling is a little black boxy (is that a word?) because the idea of “risk” can be perceived differently at different points in the market cycle.  How risky are bonds in a world of ZIRP?  Who the eff knows?  Different models will come up with very different answers and so the degree of sophistication in the  black boxy model is a significant driver of future returns.  The investor doesn’t know how this is being done which creates some degree of added risk.

 

  • The fees on these portfolios are usually high.  We’re not talking about cookie cutter index funds here.  You’re paying for the modelling and strategic diversification that these portfolios add.  Personally, I am not always comfortable with a 1%+ fee structure, but given the degree of strategic diversification these funds add it could be appropriate for slices of a portfolio for certain people.

 

  • The leverage issue doesn’t scare me as much as it scares some other people, but it can be deadly in the wrong hands.  Leverage is like steroids – in the right hands it can be used in a controlled and intelligent manner.  In the wrong hands it can be very dangerous.  The use of leverage by someone like Asness or Dalio doesn’t scare me.  But you pay for that management expertise.

Now, the average indexer might say that risk parity portfolios are just another form of “active” management or a “better mousetrap”.  Well, I hate to inform you, but all of those Vanguard funds these indexers own are also active deviations from the global cap weighting being paraded as “passive” in order to create brand differentiation.  They’re just different forms of an actively picked index with lower fees.  They’re no less a “mousetrap” than any other index of assets that deviates from global cap weighting.  It’s just that people who buy Vanguard funds don’t often realize they’re in a mousetrap that’s just a lot less expensive than other mousetraps.

On the whole, I think risk parity is a smart approach, but like a lot of Wall Street’s recent innovations it’s probably too expensive to own in any substantial quantity.  That doesn’t mean it’s inappropriate for all asset allocators, but in a world where future returns are likely to be lower than most people expect the fee story becomes a glaring part of the equation.  If I could buy a risk parity portfolio for the same cost as a balanced Vanguard Index then it would be a no-brainer.  But we’re not there yet….

Read some more on Risk Parity approaches:

Why We Need Robots to Win the Technology War

Peter Thiel had a good piece in the FT today on the debate about robots and whether the rise of technology is a good thing or a bad thing.  I tend to fall on the side that says robots are a good thing, but I do acknowledge that the pace of technological acceleration is frightening precisely because humans can’t come up with enough alternative jobs to offset the rapid growth in robot-led job losses.  Still, Thiel makes an altnernatively superb point:

“Spiralling demand for resources of which our world contains a finite supply is the great long-term threat posed by globalisation. That is why we need new technology to relieve it.”

Technology is costing us jobs, but it’s also keeping costs down by reducing our dependence on the finite supply of natural resources.  We not only need the robots to win this war, but we are dependent on them to win this war.  Technology is the path to energy independence and resource independence.

As for the jobs, well, profit maximizing capitalists aren’t likely to solve that problem because they’re the ones leading the robot charge.  Which is great.  They’re not the bad guys in this war.  But we should realize that if they’re not going to fix the job problem then smarter government policy has to play a bigger role.  And that means lower taxes and more government investment.  Unfortunately, we’re still waiting for the capitalists to reach that magical and mythical “equilibrium” point for us.  And it just ain’t happening…

The Influential Indicator Pointing to Easier Fed Policy

Very good insight here from Sober Look – inflation expectations are falling fast again:

“The 5-year real rates in the US have recently turned positive, which some would suggest represents tighter monetary conditions. With real rates on the rise, the Fed will have a great deal of room to “slowroll” the rate hikes. If inflation expectations fall further, we may see a more dovish stance from the FOMC. “

Yes, that means one thing – if you’re betting on tighter Fed policy any time soon then this doesn’t bolster your case.  We’re seeing low inflation around the globe, continued economic weakness and with inflation expectations falling even further it means that global central banks have more breathing room to continue with their accommodative policy.

I continue to see lots of commentators talking about how “tapering is tightening” or how the Fed is likely to tighten in early 2015.  This indicator makes that a very unlikely scenario unless things change quickly and dramatically….

infl_exp

Boom/Bust Appearance: Macro Thoughts

I joined Erin Ade today on Boom/Bust to talk about some macro events.  The video can be found here, but here’s a brief rundown.  Oh, also, I’ll be joining a Boom/Bust roundtable discussion tomorrow to debate the merits of gold – Peter Schiff will be on the panel so that should be fun….

  • I briefly discussed why I wrote my book, Pragmatic Capitalism and how one of my main goals was to bridge the fields of finance and economics to hopefully provide a superior understanding of how both fields are much more closely intertwined than we often think.
  • Why endogenous money is so hard – in part, it’s because money is something that is a construct of the human mind.  That is, the whole financial system is not necessarily tangible or real in the sense that goods and services are.  So the idea that we have created this whole system out of thin air is not only difficult to comprehend because it’s complex, but it is also somewhat hard to believe in because, ultimately, that’s what our system is built on – trust.
  • Why the low inflation environment is a sign that future returns are likely to be much lower than many people expect.
  • Why buybacks are good for the near-term and bad for the long-term.
  • Why investors are going to have to come to grips with the likelihood of lower future returns.