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Peter Thiel’s Thoughts on Capitalism, Macro and Entrepreneurship

Peter Thiel has been in the media quite a bit in recent days following the release of his new book Zero to One.  I haven’t read the book yet, but I do have some brief thoughts so far based on some media interviews I’ve heard:

  • Thiel takes a rather alternative approach to capitalism.  He says capitalism isn’t about competition, but rather monopoly.  This is similar to what I say in my book.  Capitalism, if left to its own devices, veers towards monopoly.  What Thiel doesn’t spend time discussing is how this can be negative in addition to being a positive.

 

  • The core message of the book is that if you want to be a successful entrepreneur you need to focus on creating entirely new businesses rather than competing with existing businesses.  Thiel focuses on the ability to create a monopoly rather than take existing market share.  In other words, Thiel says real entrepreneurs should seek to create entirely new markets.

 

  • The fact that Peter Thiel has released a must-read business book is great news for competing authors like myself who just so happen to also be book-ended earlier in the year by Thomas Piketty’s book, which basically blew the doors off the field of economics….

 

  • I was intrigued by Thiel’s comments in this excellent James Altucher interview in which he says that we’re in the midst of another bubble, but that it’s not quite ready to burst.  Specifically, he says government bonds are in a bubble.  He takes the highly contrarian view that bonds won’t protect investors in the next downturn as the bubble bursts.   I do wonder though, if this isn’t based on some political biases as well as some macro misconceptions (see below, for instance).

 

  • Thiel, who also runs a macro hedge fund, doesn’t seem to have a very good grasp on some macro concepts.  For instance, at one point in the interview he says that the Fed has “printed money” and that banks just aren’t “lending it out”.  Of course, as I’ve hammered on for years, this is not quite right and is based on the money multiplier view of banking.  Banks don’t lend money they obtain.  They create loans endogenously which means that they expand their balance sheets from thin air.  This misunderstanding is so common that even the most high profile macro investors seem to believe it….

Anyhow, I’ll be looking forward to reading Thiel’s new book.  He’s obviously one of the most successful living American entrepreneurs and from what I’ve heard so far it sounds like there’s a lot to learn from the book.

Be Careful Relying on Historical Market Returns

If you read just about any document published by a Wall Street firm you’ll inevitably run across some form of this statement:

“Past performance is not indicative of future returns”

We all seem to implicitly know that the future will not necessarily look like the past.  But there is, arguably, no approach more often utilized than the analysis of past returns leading to an “empirical” conclusion about the future performance of asset classes.  For instance, Eugene Fama’s famous 3/5 Factor Model approach is based almost entirely on historical market data citing the tendencies of certain asset classes to perform in certain ways.  Jeremy Siegel’s work on “Stocks for the Long Run” is based almost entirely on historical market data citing the tendencies of certain asset classes to perform in certain ways.  Robert Shiller’s CAPE is a perspective of future potential returns placing valuations in a historical context.  “Value” approaches of all types rely on using some historical context to gauge how inexpensive or expensive the market is.

The problem with all of these views is that the future never perfectly reflects the past.  And I think there’s a strong argument to be made that today’s environment is more unique than any we’ve seen in the historical data.  Yet we continue to see many investors relying on expected future returns based largely on historical data.

One thing we know, for a fact, is that investors who think the bond market will generate the types of returns that it did in the last 30 years, will be sorely surprised.  With 0% interest rates there is about a 0% chance that the next 30 years in bond returns will mirror anything like the last 30 years when the aggregate bond index returned an astounding 7.5% per year with virtually no negative volatility.  This means that an investor who uses the historical returns of a balanced portfolio is using a framework that looks nothing like what one should really expect.

Some investors like to think that they don’t make projections about the future.  Or worse, they imply that the future will look like the past just because the data says stocks and bonds perform in a certain way over the “long-term”.  But there’s one certainty we know based on the structure of interest rates today – we’ve never been in an environment like this.  And future returns are likely to be lower than most people expect given the same amount of risk taken.  And that means that your use of historical data has to be placed in the proper context or it will likely lead you astray.  Worse, if you’re not trying to look forward in today’s environment you might as well not be looking at all….

Related:

A Bubble is Forming in US Middle Market Leveraged Finance

by Sober Look

US middle market leveraged buyout (LBO) transactions are becoming increasingly frothy. According to the latest data from Lincoln International, risk-return fundamentals in the space are worse than they were in 2007. Here are some disturbing facts about leveraged transactions in US middle markets:

1. Leverage multiples (debt to EBITDA) are higher than at the peak of the bubble in 2007. In particular, leverage through the senior debt (dark blue) is now materially higher.

Leverage

2. Yields on senior leveraged loans for middle market deals are now significantly lower than in 2007. Investors are not getting paid for taking on riskier loans.

Yield

3. Furthermore, private middle market company valuations (as a multiple of EBITDA) are at record levels.

Valuations

4. Banks have all but exited leveraged loan origination, as institutions (shadow banking) have taken over. These institutions include loan funds (mutual funds and closed-end funds), BDCs, CLOs, hedge funds, insurance firms, pensions, etc. However, since the Fed is mostly looking at banks’ balance sheets, the central bank seems to be unconcerned about the froth in this market.

Source of capital

5. According to Lincoln International, there are signs that leveraged middle market firms are experiencing margin compression. That is worrisome given the amount of leverage these firms have.

Lincoln International: – While over 50% of companies are seeing revenue growth, the fact that over 50% are experiencing EBITDA declines suggests margin compression. For the sixth consecutive quarter, more middle market companies experienced EBITDA declines than gains.

The Fed has allowed for bubble to build in the US corporate sector – particularly in leveraged middle market companies. A broad hit to revenues could create a massive wave of failures, as firms become too leveraged to withstand such a shock. At the same time investors could face significant losses without being compensated for the risk they are taking. Let’s hope someone on the FOMC is paying attention.

 

 

The Worst Call of the Last 5 Years

We heard it a million times following the start of QE and the government’s stimulus package – high inflation was coming.  It was inevitable given all the “money printing” that was going on, right?  And when it didn’t come the narrative changed from “it’s coming” to “just you wait”.

Well, we’re now 5 years removed from the depths of the crisis and the Fed and the government’s extraordinary measures and the high inflation never came.  The bond vigilantes never came.  The dollar never crashed.  US Dollar denominated financial assets have beat the pants off of just about everything.  Interest rates never spiked.  The US government never turned into Greece or Zimbabwe.

5 years is a long enough time period to judge the predictions of those who called for a disastrous inflation.  And the predictions have been so far from right that you have to seriously wonder if many of these people are working from a proper operational understanding of the monetary system.  Of course, I would argue they haven’t been working with a full deck of cards.

I got to thinking about all of this as I read these two pieces in recent weeks about how bad these predictions have turned out.  It wasn’t me repeating myself again.  It was from Bloomberg and the Wall Street Journal.  They not only cite how much money was lost by traders who utilized this deficient framework, but they also cite how public policy has been directly hurt by these persistent calls for inflation.

This is huge stuff.  I think it calls entire forms of thought into question.  And it validates others.  Being right matters.  Unfortunately, in the world of economics and finance politics often trumps pragmatism.

 

Wednesday’s News Today: FOMC Statement Overanalysis

On Wednesday the Fed will release a very boring statement.  It will basically say:

“The economy kind of stinks still, but it’s gotten a little tiny bit better.  But we changed our statement a little tiny bit in order to communicate the fact that our views have also changed a little tiny bit.  But in reality nothing has changed all that much….”

The media and the markets will likely overreact to the FOMC statement, but just remember this picture when you consider whether the Fed will actually make any drastic moves in the near-term (via Josh Brown):

rates_fail

 

That chart shows the expectations of Fed rate hikes at various times over the course of the last 5 years.  In essence, the bond market has had this wrong all along.  Predictions about rate hikes will be headline news tomorrow and Wednesday and dozens of talking heads will fill up space debating this.  Ignore them.  Wednesday’s statement will say nothing new and any overanalysis will be largely meaningless.  We’re just not at a point in the cycle where the Fed can realistically raise rates….

How Will you Prepare for the Next Bear Market?

I wanted to revisit the question Ben Carlson answered in a recent post of his.  But I wanted to open the floor to readers.  The question:

How are you preparing for the next bear market?

We all know it’s coming eventually.  And no one really knows when.  And while we know that bear markets only occur about 20% of the time we also know that they can be extremely devastating events as they can set us back by years in trying to achieve our financial goals.  It’s times like these when you really should be preparing a plan because stability inevitably leads to instability.  At a time when everyone is getting more bullish you should be thinking about how to benefit when the bear market really comes.

So, how are you prepared for this inevitable event?  Are you just mentally preparing?  Diversify, hold and hope?  Are you more active?  Are you more likely to move into “actively” managed funds given the uniqueness of this environment? Are you just putting together a “passive” portfolio assuming that the future will look something like the past?  Let me know what you think….

Calpers Takes a Major Swipe at the Hedge Fund Industry

The California Public Employees’ Retirement System just took a major swipe at hedge funds as they decided to eliminate all hedge funds and fund of fund strategies from their allocations.  They don’t cite performance as the concern despite a poor run in recent years by the vast majority of hedge funds.  Instead, they cite costs and complexity (via Businessweek):

“We concluded that we would eliminate the hedge fund program in order to reduce the complexity, reduce the costs in the program, particularly in relation to our view that given the scale of Calpers, we would not be able to scale a hedge fund program to a size that would really move the needle,”

It’s probably a good move.  The opaqueness of many funds and the high fees make them poor additions to public employment programs where fund administrators need to be much more cognizant of any potential conflicts.

More interestingly, this is another big blow to high fee fund managers.  The days of being able to charge 2 & 20 are dying out.  My general guidance on any form of active management is to avoid any fund with a fee structure over 0.5%.  I make an exception on rare occasion for higher fee funds, but that’s a pretty good rule of thumb in most cases.  And that’s on the high side….

The Economics of Digital Currencies

Just passing along this nice piece from the Bank of England on Bitcoin and its role in the monetary system.  A lot of this stuff jibes nicely with Monetary Realism.  Here’s a short summary:

  • The article discusses the reality that the monetary system is essentially already an endogenous system in which we all can issue money, but banks dominate the system with their issuance of the primary form of money, bank deposits.
  • The banking system is constructed around the Central Bank as the bank where interbank payment clearing occurs.
  • The Bank of England is skeptical about the ability of Bitcoin to serve as a competing form of money without the same components that have been addressed by modern banks.

If you’ve read most of my thoughts on Bitcoin I don’t think that much of this will be new to you, but it’s an interesting read for the uninitiated. Read it here.

How to Preserve Capital During a Bear Market

By Ben Carlson, A Wealth of Common Sense

A few weeks ago I took part in a webcast with MarketWatch on long-term investing that was partly spurred on by a post I wrote about my idea for a TV show about investing. MarketsWatch’s Victor Reklaitis ran the show while I was joined by Tim Strauts from Morningstar and Chuck Jaffe of MarketWatch to answer viewer questions.

Here’s one of the questions that I thought deserved a deeper dive:

What’s your advice for handling an awful year for stocks like 2008?

This may seem like a silly thing to think about now, but you don’t start planning for a bear market after it occurs. If you prepare yourself psychologically for any investment environment ahead of time it decreases the chances of blowing up your portfolio by making unforced errors at the wrong time.

Courtesy of Eric Nelson from Servo Wealth Management, here are the five most severe bear markets since the 1920s broken out by losses, recovery and total return from peak to peak:

Bear-Mkts

A few observations on Nelson’s data:

  • You don’t need to get fancy with black swan disaster hedges. High quality intermediate-term bonds have been your best option for preserving capital during an economic disaster. They do their job as the portfolio anchor during periods of stress to give investors dry powder for rebalancing purposes to buy stocks on sale or for spending purposes so stocks don’t get sold after a crash has occurred.
  • Stocks can fall far and fast but also tend to recover very quickly. That’s why bailing out of stocks after they crash just compounds your problems if you held them through the crash in the first place.
  • Balance is the key to surviving these periodic crashes. The Balanced Asset Class Index which included large caps, small caps, value stocks and bonds fared much better than the all-stock options and outperformed the other options over the full cycle 4 out of 5 times.
  • Value and small cap stocks are great diversifiers and return enhancers as you can see from the All Stock Asset Class, but be prepared for large losses as well.

The biggest thing is to have a plan and stick with it (everyone says this but it’s true). You won’t know the exact reasons ahead of time as to why the market will fall, but understand that you will see a handful of market crashes over your lifetime.

There’s no way you can avoid risk in the financial markets if you hope to beat inflation over the long-term and earn a respectable return on your portfolio. Stocks outperform bonds over longer cycles, but bonds provide stability when you need it the most. Stocks wouldn’t offer a risk premium over bonds if they didn’t have these periodic large selloffs.

It’s also important to understand your ability and willingness to take risk. Allocate more money to less volatile investments if you can’t handle losses, but understand that you will likely have to save more to reach your financial goals if you carry a more risk averse portfolio.

And for those investors that are in or approaching retirement, don’t have money tied up in stocks that you’ll need to use for spending purposes within 5 years or so. It’s too much of a risk that stocks could take a hit right when you need to sell if you have an all-stock portfolio.

For most average investors, a good rule of thumb would be to never own more stocks in a bull market than you’re comfortable holding during a bear market.

There really are no easy answers to this question as every investor’s tolerance for risk and investment strategy is different. Investing really is a balancing act that’s full of trade-offs. There is a constant tug of war going on inside our brains between fear and greed depending on the market environment. We want to be able to sidestep losses in the markets and only participate in the gains but it’s impossible to to invest in stocks and not experience periodic losses.

Pick your poison and understand your emotional swings.

Watch the entire MarketWatch webcast here: How to make money in the long run

“The Stupidest Article Ever Published”

I got a good chuckle from this comment over at Mark Thoma’s website:

Via email, I was asked if this is the “stupidest article ever published?”:

The Inflation-Debt Scam

If not, it’s certainly in the running.

The articles promotes the Shadow Stats views and the idea that the USA is on the verge of catastrophe.  In essence, they argue that inflation has been massively understated, the US government is on the verge of financial insolvency and that GDP is actually lower than it was in 2002.

I’ve touched on the Shadow Stats and hyperinflation views enough in the last 5 years that I don’t think I need to repeat myself.  Besides, Mark Thoma’s comment pretty much covered all the necessary bases there.  People who still buy into the views of the hyperinflationists and Shadow Stats are working from what has been a seriously discredited framework….

Related:

 

Commodity ETFs are Dying and that’s a Good Thing

One of the points I stress in my book is how commodities are not really a wise asset class to allocate assets to for long periods of time.  History has shown us that commodities generate poor real, real returns over the long-term.  But we don’t have only history on our side.  It makes perfect sense that commodities aren’t good long-term performers because they’re huge cost inputs in the capital structure.  So they tend to have a very high correlation with inflation.

It’s interesting to look at commodity trading exchanges where these financial products were created primarily as hedging products and slowly became trading vehicles.  As a hedging vehicle commodities often make a lot of sense.  But as a long-term allocation they make no sense.

It’s my opinion that commodity investing has become somewhat of a fad.  As some people have tried to add forms of diversification to portfolios to add some non-correlation they’ve tilted towards commodities.  This became a hot selling idea for Wall Street firms who could create products that invested in commodities.  And in my opinion, the foundation of this thinking was never very sound as it made no sense to allocate assets towards commodities in the first place.

Anyhow, we’re now seeing a massive supply glut in commodity ETFs and so the death of the commodity ETF has begun.  That’s a good thing.  Commodities in a portfolio are often diworsification.  That is, there’s a level where adding too many assets and trying to get too fancy can be detrimental.  I hope retail investors begin to shun commodity ETFs en masse.  That way hey’ll be transferring a lot less of their money into the pockets of financial engineers.

The Savings Portfolio Perspective

I really liked this piece by Ben Carlson.  Particularly the conclusion:

“There will always be a handful of standout market performers that earn seemingly easy profits, but that’s really a pipe dream for 99% of investors. For the rest of us, getting rich at a painstakingly slow pace is still the best option.”

It’s funny how “investors” abuse the term “investing”.  What we’re really doing when we buy shares on a secondary exchange is not really “investing” at all.  It’s just an allocation of savings.  Investing, in a very technical sense, is spending for future production.  So, if you build a factory and spend money to do so then you’re investing.  But when companies issue shares to raise money they’re simply issuing those shares so they can invest.  And once those shares trade on the secondary exchange the company really doesn’t care who buys/sells them because their funds have been raised and they’ve likely already invested in future production.  You just allocate your savings by exchanging shares with other people when you buy and sell financial assets.

Now, this might all sound like a bunch of semantics, but it’s really important in my opinion.  After all, when you understand the precise definitions of saving and investing you realize that our portfolios actually look more like saving accounts than investment accounts.  That is, they’re not really these sexy get rich quick vehicles.  Yes, the allure of becoming the next Warren Buffett by trading stocks is powerful.  But the reality is that you’re much more likely to get rich by making real investments, ie, spending to improve your future production.  Flipping stocks isn’t going to do that for you.

This leads you to realize your portfolio is a place where you are simply trying to grow your savings at a reasonable rate without exposing it to excessive permanent loss risk or excessive purchasing power loss.  It’s not a place for gambling or getting rich quick.  In fact, it’s much the opposite.   It’s a nuanced view, but one I feel is tremendously important to financial success.

The First Mover Advantage

By Ben Carlson, A Wealth of Common Sense

“Diversifying is easy; doing so early is difficult.” – William Bernstein

John Burr Williams wrote The Theory of Investment Value in 1938. It was based on his Ph.D. thesis that stated prices in the financial markets were a reflection of an asset’s intrinsic value.

He was among the first people to ever use Discounted Cash Flow analysis (DCF) to value stocks, which states that any investment is simply the present value of its net future cash flows. Before this theory was more broadly accepted, most investors were purely speculating on past prices.

One of the early benficiaries of the fact that valuation was such a new phenomenon was Benjamin Graham. He bought value stocks throughout the 1930s, 40s and 50s while the playing field was wide open. It was easy pickings because there wasn’t much competition.

Shortly before his death, Graham discussed how the changing investment landscape altered his views on discovering value:

I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity say, forty years ago when our textbook Graham and Dodd (Security Analysis, 1935) was first published. But the situation has changed a good deal since then. In the old days any well-trained analyst could do a good professional job of selecting undervalued issues through detailed studies. But in light of the enormous amount of research now being carried on, I doubt that in most cases such extensive efforts will generate sufficiently superior returns to justify their costs.

Fast forward to the early-1970s for another early adopter of market analysis, Michael Steinhardt.  Steinhardt’s hedge fund was one of the most successful funds of all-time, racking up annual returns of nearly 25% over a dozen years. The majority of this success can be traced to a three year period from 1973 to 1975.

Here’s one of the main reasons Steinhardt’s fund was so successful from the book More Money Than God about one of the researchers on his team:

Cilluffo had begun tracking monetary data, hoping it might anticipate shifts in the stock market. A decade or so later, this sort of exercise was common on Wall Street. […] But during the 1960s, Wall Street’s equity investors could not be bothered with this sort of analysis. Monetary conditions and the Federal Reserve’s response were marginal to their thinking.

This different line of thinking helped the firm anticipate and profit from both the 1973-74 stock market collapse as well as the eventual recovery that followed. The fund was up 43% in the 73-74 bear market when the S&P 500 was down almost 37% and up 54% in 1975 when the market recovered 37%.

Both of these instances show the first mover advantage that can be gleaned from non-traditional analysis. Stating the obvious, this is not an easy task, especially in today’s day and age where knowledgable investors are constantly seeking out mis-priced securities.

Something I’ve noticed since the financial crisis is a steady stream of investors touting back-tested models they’ve created in the past few years that make some variation on this claim:

The model we created would have gotten out right before the market peaks of 1929, 1973, 2000 and 2007 and got back in at the bottom so you’d miss the downside but participate in the upside.

Unfortunately, it would have been extremely difficult to pull this off in those earlier periods. You have to ask yourself: Could I have made these same decisions with the information that was available to me at that time?

While I don’t question the fact that you can create systems based on historical information to show just about anything you want, I am skeptical of any model or investor that thinks they can guess the future of investor emotions. Because that’s really what you’re saying when you make the claim that a model can call tops and bottoms.

Although market analysis will continue to evolve, the aspect of investing that will never change is our human nature. Emotions will always play a role in causing some investors to make the wrong move at the wrong time.

Regardless of the fire hose of information we try to digest it will still take second level thinking to truly separate yourself from the crowd. Emotional intelligence, discipline and patience will never go out of style. They will be tested, but that’s nothing new.

I guess the point here is that it’s never going to be easy. The low hanging fruit is gone. Unless you can be truly innovative in your approach, you’re never going to completely outsmart the market at all times. And the innovation life cycles are getting shorter and shorter, so one of the only ways to really differentiate yourself these days as an investor is to extend your time horizon.

There will always be a handful of standout market performers that earn seemingly easy profits, but that’s really a pipe dream for 99% of investors. For the rest of us, getting rich at a painstakingly slow pace is still the best option.

Source:
More Money Than God

And here’s the best stuff I’ve been reading this week:

  • 28 secrets of exceptionally productive people (Inc.)
  • Failure is not predictive of your future success in life (Reformed Broker)
  • A dozen lessons learned from Josh Brown (25iq)
  • Never delegate your understanding (Research Puzzle)
  • When’s the best time to invest? (Boomer & Echo)
  • The secret to investing success: Amnesia (Daily Finance)
  • Avoid extreme stances and give up on the either/or line of thinking when building a portfolio (Derek Hernquist)
  • Rick Ferri’s solution for the mutual fund industry (WSJ)
  • Things you should know the difference between (Morgan Housel)
  • Why we watch certain movies over and over again (Atlantic)
  • Watching the market all day is a bad idea (Abnormal Returns)
  • How to invest in active funds (Monevator)

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Goldman Sachs: The Economy Grew at 4.7% in Q2

Although it doesn’t feel like a recovery for everyone (see here) the economy does appear to be moving in the right direction.  Goldman Sachs is now reporting that Q2 GDP was much stronger than expected at 4.7% (via Business Insider):

Goldman Sachs revised its estimate of second-quarter GDP growth to 4.7% on Thursday, based on new data from the Census Bureau’s Quarterly Services Survey (QSS). 

Stronger-than-expected healthcare spending growth led to the revised Goldman estimate of 4.7%, which was up 0.5% from the Bureau of Economic Analysis’ second advance estimate of 4.2%.

That’s well above the consensus of 4.2%.  Q3 is still estimated to come in at 3.1% as growth moderates after the big seasonal snapback.  Steady as she goes….

Thinking about the Cost of College

By Marc Chandler, Global Head of Currency Strategy, Brown Brothers Harriman

The beginning of the new school year heightens the anxiety over the rising cost of higher education. The cost of a college education is increasingly beyond the means of average American family. Tuition has risen faster than inflation, student debt has soared and jobs are difficult to secure.

At the same time, it seems that more people are questioning the value of a college degree. The New York Federal Reserve’s Current Issues newsletter recently took a look these issues. The authors, Jaison R. Abel and Richard Peitz, also posted an article “The Value of a College Degree” on the NY Fed’s blog Liberty Street that looks at the cost of an associate and bachelor’s degree. They conclude that the benefits still outweigh the costs. While the cost have risen, the wages to workers without a two or four-year degree have fallen.

NPV College

These two Great Graphics come from their work and illustrates their conclusion. This first chart shows their calculation of the net present value of a bachelor’s degree between 1970 and 2013. It is expressed in constant 2103 dollars.

They estimate that the value of a four-year college degree fell from about $120,000 in the early 1970s to about $80,000 in the early 1980s. It then proceeded to more than triple in the next decade and a half to nearly $300,000 by the late 1990s. It has been surprising stable since. It has eased a bit in in the post-crisis period, but it remains near the all-time high.

Recoup College

The second chart shows how long one needs to work to recoup the cost of college. The authors use the discounted cash flows that were used to calculate the net present value to determine how many years it take to turn the cash flow positive. To say the same thing, after earning a four-year degree how many years does it take to recover the cost of the degree.

It shows that the time required to recoup the costs of a bachelor’s degree has fell significantly in the 1980s and then leveled off. In the late 1970s, it took nearly two decades to coup the cost of college. Now it takes about half as long.

The authors conclude that the value of a college degree remains near its historic highs, while the time to recoup the cost is near historic lows. This study is part of a larger work. In an essay earlier this year, the authors calculated the return on investment for the average colleges student was about 15%. In a subsequent report, the authors look at the distribution of the wages earned by college graduates and find that for a sizable fraction, a college degree has not paid off. College may be a negative investment for one in four who attend.