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What Backs the Value of Money?

I was reading this very good piece by Matthew Klein at FT Alphaville when I came across this line:

“The only kinds of money that reliably hold their value are the ones explicitly backed by a strong government*.”

This is an interesting point and one I don’t completely agree with.  I go into this in excruciating detail in my book, but I’ll spare you the copy and paste job from that since it’s too long.  Instead, here are some basic points on this topic which I think are important and put the above comment in the right perspective:

  • Money is primarily a medium of exchange utilized to obtain goods and services.
  • If the output of a society declines or is viewed as less valuable to its users then the money which is used as a medium of exchange will also be viewed as less valuable.
  • Spending in excess of productive capacity will cause high inflation which can threaten the viability of money.

Okay, so, no government here at all.  In theory, a totally private economy could utilize a form of “money” purely for the purpose of exchanging goods and services.  There are plenty of historical examples of this throughout time, but the problem is that, as inherently social animals, the mythical “Robinson Crusoe” concept of money just doesn’t work out very cleanly.  In other words, the existence of money impacts all of us who need it or want it.

If you live in the town next door and your town uses a different form of “money” than my town, but I want to buy the new long rifle that is only manufactured by a company in your town (who doesn’t accept my town’s money) then I have to obtain your town’s money.  You can imagine how this relationship plays out over history as money becomes an increasingly social construct in a world that is increasingly interconnected.  And since money is a social construct then money plays into other broader social needs.  While it is certainly an instrument of private exchange, it has become an instrument of public exchange due to the sheer complexity of the societies in which we live and their interconnectedness.

So, over time money becomes more than a private medium of exchange and becomes an instrument which can be used for public purpose like fighting wars and building roads.  And so governments begin to define what the unit of account is (things like the Dollar, Euro, Yen, etc), but continue to allow private entities like banks to issue money.  Unfortunately, we can’t trust everyone who uses money and because it is an instrument highly dependent on trust it can be helpful to have the government utilize its legal powers to enforce the use of money.

None of this government involvement in money comes first though.  You’ll notice that a viable form of money is ALWAYS preceded by a valuable private sector which produces valuable goods and services.  Almost everything the government does is after the fact in a supporting role.  As I like to say, capitalism makes socialism possible.  So yes, a government can certainly increase the viability of a form of money through things like the legal system, but we should never lose sight of the fact that money is only as good as the output it gives us access to.  And while much of that output is created by governments these days the majority of domestic innovation and production is a private undertaking.  Therefore, I would change Matthew’s comment to something more like this:

“The only kinds of money that reliably hold their value are the ones explicitly backed by strong private sector output*.”

Citi: Beware Rising HY Spreads

Worried about a potential recession and another big market decline?  Analysts at Citi say a good way to track this risk is to look at the HY bond spreads.  Specifically, spreads at 600-700 bps indicate a recession is highly probable:

Another factor that seems to flag the transition into Phase 4 is the level of HY spreads. It seems that global equities can handle an increase in spreads to around 600-700bp, but anything higher indicates that a recession is imminent. Even given the recent sell-off, spreads are now 400bp. Sure, they may go higher as the withdrawal of US QE allows spreads to recouple with fundamentals, but they are still a long way off the levels that have previously flashed warnings for equity investors. In 2007-08, they very quickly hit this danger level.


We’re far from the caution levels at present, but HY spreads can change quickly. This one’s worth keeping an eye on.

Source: Citi

Further Signs of China’s Slowing Property Markets

By Sober Look

China’s official housing index now shows home price appreciation slowing faster than some had anticipated.

China housing price appreciation

Other indicators are also pointing to weakness in China’s housing markets. For example the number of cities with falling prices has spiked sharply.

China housing

Furthermore, the steel rebar futures in Shanghai – an imporant real-time indicator of construction demand – remain under pressure.

Jan Steel Rebar

Jan steel rebar futures in Shanghai (

Related to this trend, China’s commercial floor space and the number of commercial buildings sold has declined materially (based on official reports).

Floor space and commercial buildings

There is no question that Beijing has the wherewithal and the will to support the housing market should things unravel faster than the government likes. Nevertheless, given how pervasive property markets are in the nation’s overall economy, concerns among global investors are rising with respect to China’s housing slowdown.

Scotiabank: – On the theory that where there’s smoke there’s fire (and it’s not just because I’m BBQing), weak company financing and concerns surrounding potential defaults in the shadow banking sector coupled with — and likely driven by — further evidence of falling property prices will only amplify the concerns.

More Thoughts on the CAPE and Valulations

I’ve made my opinion on valuations and the use of CAPE pretty clear - these sorts of metrics don’t tell us much about the macro environment because the whole idea of ” value” is dynamic and evolving.  If I am right then trying to calculate a market “value” through these types of metrics is likely to mislead you into thinking that the market is static and more predictable than it really is.

The point is, if valuations and market perceptions are as dynamic as I believe then the history of something like CAPE really doesn’t tell us much at all.  After all, “value” is really all in the eye of the beholder.  If investors are willing to pay more for stocks today than they were in 1950 then maybe a CAPE of 15 has no bearing on what a CAPE of 25 means.  That is, stocks could simply be perceived differently than they were in the 1950s.  Perceptions change.  And there’s no reason why stocks can’t be perceived to be inexpensive at a CAPE of 25 just because they once sold at a CAPE of 15.  In other words, what if a CAPE of 35 is the new “expensive”?   Now, I don’t know if that’s true, but in the process of managing one’s risk I think you have to consider that possibility.

I bring all of this back up because Brad Delong wrote a nice piece citing a similar view in response to Robert Shiller’s NY Times piece this weekend.  Delong basically notes that stocks were undervalued for no good reason in the past:

“Given the large number of investors and institutions in our economy with very long time horizons that thought to be in the stock market for the long-term–insurance companies, pension funds, rich individuals with grandchildren–for me the anomaly does not seem to be a CAPE of 25 (or, given historical real returns on other asset classes and very low current yields on investments naked to inflation risk, 33) but rather the CAPEs of 14-20 that we saw in the 1980s, 1960s, 1950s, 1900s, 1890s, and 1880s that Robert Shiller appears to think of as “normal” and to which today’s CAPE should someday return. “

I am going to be blunt – I have no idea if any of this is true.  I don’t know what the “value” of stocks are today.  And I don’t think anyone else really does.  And I think trying to put a value on them through these sorts of metrics is just a big waste of time that leads some people to believe they’ve been able to pinpoint the “value” of stocks at present when the reality is that they’ve simply tried to calculate, with  precision, something that is very imprecise (human perception).  Therefore, if “value” is just another dynamic and evolving concept based largely on human perception then calculating it at any given time is likely to mislead you more than it’s likely to help you.

Don’t Be Passive About Rising Rates

By Chris Marx, AllianceBernstein

Though they’ve defied expectations this year, higher interest rates appear to be all but inevitable. Investors need to take measure of the rate sensitivity in their portfolios—and stay agile—to negotiate the rough market crosscurrents a rate reversal may bring.

We expect the shift to be gradual, judging from US Federal Reserve’s commitment to tying future rate increases to a sustained economic recovery. Widespread predictions that bond yields would continue to climb following last year’s uptick have proven premature, as renewed geopolitical anxieties and the still-anemic global recovery have rekindled investor affection for the safe havens of US, German, UK and even Japanese sovereign bonds.

As our research has shown, equities typically do very well when rising rates coincide with a strengthening economy. Nonetheless, a rate reversal, when it comes, will mark a significant departure from a status quo sustained by years of super-easy monetary policies and a 30-year downtrend in US Treasury bond yields. The shift will influence market yields globally—and, we think, could spark a major shift in market leadership. Investors will not want to be caught wrong-footed.

Safety Not So Safe

Stocks in some “safer” (income-oriented) industries, such as utilities, tobacco, telecom and real estate investment trusts, are the most obviously vulnerable. Their dividends will look less appealing as the yields on less volatile fixed-income alternatives climb. These bond proxies have become popular with yield-hungry investors, driving up their valuations, and according them an outsized presence in many portfolios. As a result, investors may be far less diversified versus their bond holdings than they realize.

Other victims of rising rates include housing-related stocks, such as homebuilders, building-materials suppliers and even home-improvement retailers, as rising rates make owning and maintaining homes more expensive.  Mortgage insurers and originators could also prove at risk, though the story here is more nuanced. Rising rates clearly make buying or refinancing a home less attractive. However, if higher rates are a by-product of a strengthening economy, their impact may be offset by greater housing demand and, as important, improvements in credit quality. Finally, higher borrowing costs will put pressure on a broader set of capital purchases, such as for automobiles and equipment, which are typically financed.

Cyclicals to Rise to the Occasion

On the other side of the ledger, a rotation out of defensives would likely favor cheaper, more cyclically sensitive stocks in materials, energy and consumer discretionary industries. But positive rate sensitivity lurks in many other corners as well.  Financial stocks are an obvious example. Banks typically see a nice boost in their net interest margins if long-term rates rise faster than short-term rates (as is typical in an economic recovery).

The situation for insurers is more mixed. Life insurers tend to benefit from rising rates, as they should bolster returns of their predominantly fixed-income general account investments and reduce balance-sheet-impairment risks. More subtle is the impact on their annuity portfolios. Earnings from these businesses have been under pressure over the past several years, as declining reinvestment rates made it tougher to meet the high minimum-return guarantees on these vehicles. As rates pick up, policyholders are more likely to let these contracts lapse, as they pursue higher-return alternatives.

Rising rates are trickier for property and casualty insurers and reinsurers. Though they too benefit from improved returns on their investment portfolios, history shows that this is often offset by more aggressive (re)insurance pricing as less underwriting income is required to achieve total-return hurdles. Moreover, claims losses tend to climb as the economy improves and inflation rises. However, the recent influx of third-party capital seeking the uncorrelated returns of catastrophic insurance has been depressing rates for a couple of years now. Higher returns elsewhere might stem this tide.

The economic ripple effects of rising rates will be varied and subtle, differing from industry to industry and from company to company. In our view, these times call for active investing approaches, which have the flexibility to anticipate and react to whipsawing market conditions and adjust exposures accordingly.

Chris Marx is a Senior Portfolio Manager on the Global Value Equities team at AllianceBernstein (NYSE: AB).

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.


Looking Beyond Interest Rate Risk in Bonds

By Ben Carlson, A Wealth of Common Sense

Interest rate risk has been THE big worry for bond investors for a number of years now. It seems that everyone has been predicting a rise in interest rates, but it just hasn’t happened quite yet.

This has caused many investors to shift their bond allocation in anticipation of a rate increase and price losses in bonds. The problem when making wholesale portfolio changes based on these fears is the timing, as always.

When rates do finally rise bond prices will fall as they’re inversely related to interest rates, but the losses need to be put into perspective. Last year Vanguard performed a study on the effects of an unexpected 3% rise in rates on the Barclays Aggregate Bond Index over five years:

rising-rts (1)


In this example the initial rise would lead to a steep loss in the near-term (almost 13% on the first year). But as newer bond holdings would get added to the index at the now higher interest rates as older bonds matured the performance would play catch-up. In this scenario the bond market ends up being positive within 4 years.

Also, it’s worth noting that even under this more than doubling of rates from their current levels, these losses are a fraction of the 50% declines that investors have experienced in stocks over the past two decades. A terrible year in high-quality bonds is a bad week in the stock market.

In fact, if you go back to the last period of a sustained rising rate environment from the early 1950s to the early 1980s the annual losses in 10 year treasuries were never really that significant:

Annual losses in the 1950s: -0.30%, -1.34%, -2.26%, -2.10%, -2.65%

Annual losses in the 1960s: -1.58%, -5.01%

Annual losses in the 1970s: -0.78%

The reason there were never any huge losses is because rates slowly crept up over time. In 1950 the 10 year yield was 2.3% while it finished the decade at 4.7%. In the 1960s rates went from 4.7% to 7.8% and by 1980 rates were at 10.8% before finally topping out at 15.3% in 1981.

This slow churn higher until the very end meant that there were never any shocks that led to large drawdowns in bonds.

Yet even with a quick spike higher in yields, as the Vanguard study showed, bond investors can recover from interest rate risk over time. There are a number of other risks to consider when investing in bonds that are potentially more harmful than rising rates.

Inflation Risk: Bond returns weren’t terrible on a nominal basis in the previous rising rate environment referenced above. It was the after-inflation real returns that hurt investors:


In fact, from 1950-1981 inflation led to nearly 40% losses in real terms for 10 year treasuries. But it was more of a death by a thousand cuts than a crash like we see in the stock market.

Generally, the longer the holding period for bonds the higher the inflation risk.

Credit Risk: Investors that are chasing yield in lower qualiity bonds are doing so by increasing their credit or default risk. Higher yielding fixed income offers those higher yields because the issuers of the bonds have a better chance of defaulting on their debt.

Credit risk doesn’t only concern defaults either. A downgrade in the credit rating of a bond by the credit agencies can affect bond performance as well if institutional investors are forced to sell because of restrictions on the credit quality of the bonds they’re able to hold.

Liquidity Risk: Bonds aren’t as liquid as stocks for trading purposes. This can lead to short-term selling pressure in bond ETFs and mutual funds. There can be a mismatch between the liquidity of the individual holdings and the overall funds.

When everyone heads for the exits all at once it could accelerate the losses in these funds beyond their net asset value. The prescription for this risk is to never be in the position to have to liquidate an entire position just because it’s getting killed in the short-term.

Duration Risk: If interest rates do ever decide to rise, duration will be the most important statistic for bond investors to pay attention to. In the Vanguard study the 5.5 year duration of the fund meant that for a 1% increase in yields you would expect the price to fall by roughly 5.5%. Longer maturity bonds have higher durations along with higher yields.

The higher the duration of a bond or fund the higher the potential for volatility in both directions when rates move.

It’s worth noting that many of these risks are related. You can’t simply hedge one of these risks without affecting the others. There’s no such thing as ‘all else equal’ in the financial markets as nothing occurs in a vacuum.

We have to consider why interest rates could rise and how each risk factor would be affected. When it happens it will likely be for a number of different reasons including a combination of higher economic growth, higher inflation, lower risk aversion or a pullback in bond purchases by the Fed.

The only thing we can say with any certainty is that bond returns will be much lower going forward than they’ve been since the early 1980s. They have to be because interest rates can only fall so much further and lower yields means less interest income.

Therefore the biggest risk bond investors face is misaligning expectations with this reality.

Risk of loss: Should the prospect of rising rates push investors from high-quality bonds? (Vanguard)

Chart of the day – Silly Charts Edition

Here’s a lesson in the dangers of charting.  The following quote is from John Mauldin’s latest weekly letter.  He’s making the case for a bond bubble.  This chart specifically refers to US government 10 years:

One day, all the debt will come due, and it will end with a bang. “We are building a bigger time bomb” with $500 billion a year in debt coming due between 2018 and 2020, at a point in time when the bonds might not be able to be refinanced as easily as they are today, Mr. Ross said. Government bonds are not even safe because if they revert to the average yield seen between 2000 and 2010, ten year treasuries would be down 23 percent. “If there is so much downside risk in normal treasuries,” riskier high yield is even more mispriced, Mr. Ross said. “We may look back and say the real bubble is debt.”


I have a couple of thoughts here:

1)  The debt actually doesn’t all “come due”.  In a credit based monetary system it’s actually impossible for ALL of the debt to come due because that would actually eliminate most of the money we use.  Repaying loans destroys deposits just like new loans create deposits.  But think of this specifically from the government’s perspective.  The only way the debt goes away is if the government goes away or is reduced SUBSTANTIALLY.  But the reason the government’s debt continually expands is because the services never go away.  The government tends to grow in-line with the economy and the population as the needs of the public grow.  That doesn’t mean the government can’t shrink or that debt can’t be reduced, but it’s virtually impossible for it to all “come due”.  I’m not against shrinking the size of government at all, but I think the terminology here is a little misleading.

2)  More importantly, the chart is a case of manipulating the axis on one side to make the other lines appear similar.  If you look closely you’ll see that the Nasdaq expanded over 400% over this period while the bonds are up just 33%. Using this sort of analysis could lead one to justify the idea of a “bubble” using almost any level of price rise at all.  That’s obviously not very useful and in this case a 33% rise and a 400% rise are obviously apples and oranges.

I’ve been debunking the US government “bond bubble” story for over 4 years now so you’ve probably read some version of this over the years.  But this doesn’t mean bonds aren’t potentially overpriced. Especially junk bonds and some other corporate bonds that have benefited from the chase for yield induced by the Fed. But I think we have to be careful about the term “bubble”, especially when discussing government bonds. “Bubble” implies an extraordinarily overpriced market susceptible to tremendous downside. Frankly, I don’t think Treasury Bonds look remotely similar to something like the Nasdaq….

The Contradiction of “Passive” Index Fund Investing

I am a huge fan of index fund investing.  I use index funds in my approaches and I can’t emphasize how important it is to maintain a low fee, diversified and tax efficient investment structure.  When it comes to creating an efficient portfolio approach there is, in my opinion, no better way to do this than using low fee and tax efficient index funds.

I have a minor beef with some other indexers though.  I am probably being overly precise and anal in my views here, but I don’t like the way some index fund advocates promote their approach because once one looks at this from the macro perspective it becomes clear that many indexers are hypocritical and employ a much more “active” and forecast based approach than they imply.  Let me explain.

The nice thing about taking a macro approach like mine is that we can get a very clear 30,000 foot view of the world.  If we look at the world’s financial assets in aggregate then there’s obviously just one portfolio of all the world’s assets.  This can be thought of as the ultimate benchmark for global assets.  As I’ve previously noted, this study comes pretty global_portfolioclose to establishing what that portfolio looks like.   It’s roughly a 55/40/5 bonds/stocks/alternatives allocation.  When you establish a portfolio that is different from this then you’re basically saying that the global asset portfolio is wrong and that you can outperform it.  You’re declaring that you’re smarter than the global asset portfolio.

I’m probably being too hard on indexers in general here, but the reason I find this interesting is because it means that most indexers are actually active index pickers. A 70/30 stock/bond advocate is saying that he/she is smarter than the global financial asset portfolio and can pick funds better than the aggregate because they think they can forecast the returns of equities relative to bonds better than the aggregate.  Just like the stock pickers that indexers often demonize for picking assets inside a broader aggregate, they too end up picking indexes inside of this global index.  Index fund investors often berate people for trying to “beat the market”, but that’s precisely what they’re trying to do when they construct anything other than the global index.  The fact that picking indexes is more efficient and generally less risky than picking stocks doesn’t mean they aren’t actively picking assets or trying to “beat the market”, but that’s generally how the approach is portrayed.

Of course, no one can buy the global index perfectly and it wouldn’t even be appropriate for everyone to do so because we all have differing risk tolerances and financial goals.  But it just goes to show that we really are all active investors and that the key to portfolio construction is not about getting caught up in whether you’re “active” or “passive”, but really it’s about creating the portfolio that’s most efficient for your personal needs.



The Upside and Downside of Holding Cash

Earlier this week I discussed the unfortunate reality of holding cash – if you’re an investor or asset manager who holds cash you’re automatically less correlated to your benchmark.  This creates huge amounts of career risk for asset managers who are constantly compared to that benchmark.  And unfortunately, the people doing the comparing often aren’t benchmarking correctly or make these comparisons without properly accounting for the fact that “active” managers often hold cash.  This accounts for a big chunk of the managers who underperform their benchmarks – they have cash mandates or cash flow needs that require that they not be 100% fully invested all the time so they’re increasing the likelihood that their correlated benchmark is beating them.

Now, none of this is to excuse active managers for charging the high fees or creating the tax inefficiencies that often add to this underperformance.  But when we read about studies where active managers underperform it’s not necessarily because they’re bad at what they do (though, admittedly, many are) – they just aren’t doing things precisely like the index they’re often compared to.  In other words no one can realistically invest precisely like an index fund so it’s kind of silly to constantly compare yourself to an index that exists on paper and can’t be replicated perfectly in reality.

Of course, this can all be a good thing and a bad thing.  As I previously explained, most “active” managers (and really all investors) hold some cash at times because we all have cash flow needs.  Even the most “passive” investor has cash flow issues that require reinvestment or other issues that make them an imperfect “index”.   But cash can be a powerful tool in this regard.  For instance, while that cash might be creating some non-correlation to a correlated index (and increasing your underperformance risk) it’s also got the aspect of optionality that Warren Buffett talks about.  To an indexer this optionality can mean the ability to dollar cost average, rebalance, etc.  To a more active investor it can mean buying when others are fearful (as Buffett would do), making cyclical changes or being highly active (if that’s your thing).

So there’s an obvious upside and downside to cash just like any other asset.  But the important point is that cash is a necessary asset in our portfolio construction process and we all have to learn how to manage it.  Understanding its strengths and weaknesses is an important part of knowing how to do that.


Three Reasons Europe is Struggling

I was watching this CNBC video with Chase’s Chief Economist Anthony Chan who cites three reasons why he thinks Europe is struggling:

1. Q1 weather in Europe hurting Q2 numbers.
2. Negative sentiment.
3. A lack of ECB action.

I don’t know about all of that. Those sort of sound like lame reasons for the lagging growth (no offense to Mr. Chan). I have three reasons of my own:

1. A flawed currency union.
2. A flawed currency union.
3. A flawed currency union.

This environment is and has been the result of the flawed currency union that is acting a lot like a gold standard handcuffing Europe’s economies. We experienced a small bounce back in the last few years from a minor trade rebalancing, but it’s been far from enough to generate substantial growth. And all the while the recovery has been very uneven with many of the periphery countries continuing to suffer.  The Japanification of Europe is continuing.

The Euro remains an inherently flawed currency system that has no efficient rebalancing mechanism. The ECB has done enough to quell solvency concerns at the sovereign level in the peripheral countries, but the ECB cannot fix the inherent imbalances that have arisen.

I continue to think that the only measure that can efficiently resolve this is a form of fiscal transfers that turns Europe into a single currency system with a national treasury that acts as a redistributive entity to help the current account deficit countries in the process of rebalancing as the existence of the single currency makes trade rebalancing a highly inefficient process (unlike the USA’s system). Until this is done I have a hard time seeing how the problems on the periphery can be resolved. As I’ve said a million times over the years the debts will continue to rise relative to growth because there is insufficient demand.  The lack of a real resolution here means continuing high sovereign debt levels, continued austerity and aggregate demand that is too weak to sustain high levels of growth.


The New Headline Indicators

By Ben Carlson, A Wealth of Common Sense

“There are few corners of the investment business where reversion to the mean does not hold sway.” – Michael Mauboussin

Investors are constantly searching for reasons to explain the movements in the financial markets. When no concrete reasons exist we construct narratives to create a feeling of comfort for making certain investment decisions.

The problem is that many times these narratives are simply an excuse to chase past performance and hop on the bandwagon of a hot investment trend.

These hot trends have a tendency of eventually reversing when everyone is in agreement. Mean reversion shows that periods of above-average performance are followed by periods of below-average performance.

Howard Marks, as usual, has a great take on this subject:

Nothing goes in one direction forever. Trees don’t grow to the sky. Few things go to zero. And there’s little that’s as dangerous for investor health as insistence on extrapolating today’s events into the future.

Extrapolation is what gets most investors into trouble.

The financial media can play a role in shaping this behavior and can often act as a contrary indicator. The most infamous headline indicator of all-time was from Business Week’s The Death of Equities piece in 1979 that came out just before one of the most massive bull markets of all-time.


These indicators are by no means a signal because you can start to look for them everywhere, but they can provide anecdotal evidence when everyone is jumping on the same theme at once.

Here are some more recent examples of headline indicators.

The Headline: Gold-Dispensing ATMS: Coming to a City Near You (June 2010)

Gold was up almost 18% a year in the ten years leading up to this headline. Well-known gold bugs weren’t batting an eye as they threw out price targets of $5,000-10,000 an ounce. Everyone wanted to add gold to their portfolios because it looked great in the rearview mirror.

Enter mean reversion. Here’s the performance of gold since this headline appeared:


The Headline: ‘Fragile Five’ is the Latest Club of Emerging Nations in Turmoil (January 2014)

One of my rules of thumb in the investment world is that once something gets a nickname attached to it (think Nifty Fifty, BRICs, PIIGS, etc.) there’s a good chance it’s going to perform very well or very poorly from that point on depending on how it’s framed.

Case in point is the ‘Fragile Five’ emerging market countries of Turkey, Brazil, India, South Africa and Indonesia.  The worry was the Fed cutting back on their bond buying purchases was going to destroy these countries with inflation. Investors were dumping the stocks of these countries first and asking questions later.

Here are the stock returns since the Fragile Five nickname really took off:


The Headline: How to Invest as interest Rates Rise (January 2014)

In early 2014 a Bloomberg survey of 67 economists showed that all 67 of them thought that interest rates would rise this year. Instead rates have continued their slide leading to stellar performance in bonds this year, especially longer-dated treasuries:


The goal here is not to point out the mistakes of these headlines, but to show that things are not always as dire or rosy as they may appear. No investment opportunity is so bad that the right price can’t make it attractive and vice versa.

This doesn’t mean you can always be a contrarian because markets do tend to trend. It’s just that extrapolating recent gains into the infinite future is a bad idea. Markets tend to make investors look foolish when everyone’s on the same page.

Now for the best of what I’ve been reading lately:

  • Making your own luck in the generational roll of the financial dice (Abnormal Returns)
  • There are different degrees of passive and active investing (Basonand Does overweighting domestic equities count as active management? (Oblivious Investor)
  • Four great books for new investors (Millennial Invest)
  • Bob Seawright on negative knowledge: “Few papers get published establishing that something doesn’t work.” (Above the Market)
  • The benefits of home ownership (Dumb Money)
  • Smart investors ignore the news (MarketWatch)
  • Why you should avoid a home country bias in your portfolio (Cordant Wealth)
  • The keys to keeping your portfolio on track for the long-term (WSJand The long-term investors comes out ahead of the short-term trader no matter what (WaPo)
  • The guys who get you out will never get you back in (Reformed Broker)

Cullen Roche’s Not So “Pragmatic Capitalism”

I was forwarded a thoughtful and critical review of my book this morning.  It’s titled “Cullen Roch’s Not So Pragmatic Capitalism”.   While it would be great if everyone just agreed with everything I write it’s actually nice to get pushback so I appreciate this review.  I certainly don’t know everything and I am a perennial work in progress so I always try to view criticism as constructive rather than viewing it too negatively.  It’s easier to learn that way.

The review doesn’t seem to have any problems with my overall views on investing.  But it takes a broad swipe at my economic views.  That’s not surprising I guess.  My heterodox views are controversial and while I wish they were totally grounded in reality I know there’s a degree of theory and political philosophy involved here.  It’s clear that the reviewer is an Austrian advocate so I wanted to respond to a few points.

First, the reviewer states that inflation is an increase in the money supply. That’s fine, but even if it’s true then so what?  In a system with endogenous money the money supply is just about always increasing because the population needs more loans to fund future spending and investing.  Saying that inflation is an increase in the money supply actually tells us nothing about anything.  It just points out an obvious fact of life.  It’s like saying that the human population increases with time.  Okay.  So what.  Is that good, bad, what does it mean?  We know, for a fact, that more money doesn’t necessarily mean higher prices so what’s the point?  What’s the value in saying this?

He goes on to cite the money supply as the monetary base, but this is an obviously flawed measure.  If inflation were merely an increase in the monetary base then QE would have created catastrophic inflation.  It didn’t and the many Austrian predictions about hyperinflation, predicated on this underlying view, have been explained away with no empirical argument at all.

He goes on to claim:

“an autonomous currency issuer can never effectively reach absolute insolvency, without any specific regard for the nature of money and that which truly ascribes value to it: purchasing power”

This is not at all what I say in the book.  In fact, I say that an autonomous currency issuers primary concern should be purchasing power!

He then says:

“Roche fails to recognize that without savings, there can be no consumption or deferment of consumption, the latter of which is entirely forgotten in his work Pragmatic Capitalism. “

This appears to be a misunderstanding of one of the most essential concepts of the book.  Savings does not fund aggregate spending.  Saving money means someone else is not earning an income.  And spending means someone else has an income of which some portion can be saved.  The way we fund future spending is not through saving more (in fact, if you save more then aggregate spending will fall, all else being equal).  Crucially, it is investment (spending, not consumed for future production) which creates saving.  This is a complex point which Austrians continually fail to understand.  He goes on to say this is false, but confuses financial assets with non-financial assets which is like talking apples and oranges.

Anyhow, I enjoyed the critique even if I disagreed with it.  It’s always nice feedback.







Household Debt Accumulation Remains Tepid

The situation in household debt remains tepid according to the latest household debt report from the NY Fed.  According to the report Q2 household debt fell slightly:

“Aggregate consumer debt was roughly flat in the 2nd quarter of 2014, showing a minor decrease of $18 billion. As of June 30, 2014, total consumer indebtedness was $11.63 trillion, down by 0.2% from its level in the first quarter of 2014. Overall consumer debt still remains 8.2% below its 2008Q3 peak of $12.68 trillion.”

Mortgages, the largest component of household debt, accounted for the decline:

“Mortgages, the largest component of household debt, decreased by 0.8%. Mortgage balances shown on consumer credit reports stand at $8.10 trillion, down by $69 billion from their level in the first quarter. Balances on home equity lines of credit (HELOC) also dropped by $5 billion (1.0%) in the second quarter and now stand at $521 billion.”

Outside of housing there was a broad gain in household debt:

“Non-housing debt balances increased by 1.9 %, boosted by gains in all categories. Auto loan balances increased by $30 billion; student loan balances increased by $7 billion; credit card balances increased by $10 billion; and other non-housing balances increased by $9 billion.”


The continued weakness in housing is a direct extension of the weak consumer balance sheet.  It’s a worrisome sign to say the least.  While the de-leveraging appears to be ending (or at least slowing) there are still substantial signs of fragility at work.


The Sotheby’s Indicator Points to Caution

Just passing along some interesting thoughts from our friend Martin at Macronomics.  Not sure how useful this is, but interesting nonetheless:

In this previous conversation we also argued that the performance of Sotheby’s, the world’s biggest publicly traded auction house was indeed a good leading indicator and has led many global market crises by three-to-six months. Looking at the fall in Sotheby’s stock price on the 8th of August following a second-quarter profit fall of 15% with the share plunging 11% after its earnings miss, we wonder if indeed the S&P 500 is indeed not vulnerable down the line using the aforementioned relationship we discussed – graph source Bloomberg:


Mind the gap…Also note that Sotheby’s private sales fall by 50% in first half of 2014 as reported by Philip Boroff in Artnet on the 12th of August in his article entitled “What Sotheby’s Doesn’t Want You To Know About Its Private Sales”:

“Sotheby’s private sales have plunged following the auctioneer’s public feud with activist investor Daniel Loeb.

Long a focus of company executives, private sales tumbled 48 percent in the first half of the year, according to an August 8 Securities and Exchange Commission filing. The value of private transactions, in which Sotheby’s discretely brokers art and other collectibles to one prospective purchaser at a time, dived to $294 million in the first half of 2014 from $561 million a year earlier. It was the lowest private sales total since 2010. The drop contributed to a 15 percent decline in quarterly earnings and an 8 percent drop in Sotheby’s stock on Friday. The shares are off 15 percent in the past year, as the benchmark Standard & Poor’s 500 Index rallied 15 percent.” – source Artnet.

The role of Sotheby’s stock price as an indicator was as well confirmed by our good friends at Rcube Global Asset Management back in our November conversation but them using MSCI World as a reference – graph source Bloomberg:


“The Art market has always been an interesting indicator. The only major public auction house is Sotheby’s since its floatation in the mid-1980s. It has proved a timely indicator of potential global stock markets reversal.

Whenever its price reached 50 or so with sky high valuations, a reversal was not far away. We can also take notice of the extremely weak jewelry and contemporary art auctions recently.”


Open Forum: What is “Market Timing”?

I wanted to continue the discussion about “passive” vs “active” investing here with an important question for readers:

What is market timing?

A basic definition of market timing would be the attempt to predict the market’s future direction.  I’ve argued that there is no such thing as an investment approach that doesn’t construct a general foundation that has implicit market predictions.  For instance, a 60/40 stock/bond portfolio is a stock biased portfolio that makes an implicit bullish macroeconomic forecast.  That is, the performance of this portfolio is contingent on the performance of the underlying economy.  So, even if you don’t change the portfolio over time you are still making a bullish macro forecast.  That forecast just doesn’t change.

The reason I ask this is because the concept of “market timing” is an extremely vague one often used in the “passive” vs “active” debate.  If you accept my view that there is no such thing as truly passive investing then that means we’re all active to some degree and the key to portfolio construction is really all about finding the most efficient active approach that is consistent with our personal financial goals.  But even if that’s true then the concept of “market timing” still plays an important role in how we go about formulating an investment methodology because it will help us understand how to maximize the various efficiencies.

So, what is market timing in your opinion and where do we draw the ling between what is market timing and what isn’t?  Obviously, day trading and even picking stocks would be an approach I disagree with in general because they involve a degree of forecasting that seems largely unrealistic or just extremely difficult.  Is market timing really just a term to deter people from using short timeframes and specific strategies that are extremely difficult to implement?  For instance, the longer into the future we look the greater the probability of making accurate forecasts (ie, output will grow over time).  And the greater number of instruments we utilize the greater probability we have of being right (ie, diversify and you’re more likely to be right than you would be by picking a handful of stocks).  Is this all just a discussion about the optimal timing period?  Looking too far into the future is useless while looking too far into the present is unpredictable?  What is the right time period then?  And what is the right amount of diversification?  At what point do we diversify to the point that we’re actually hurting performance?

And what about asset allocation strategies that involve option writing on a monthly basis?  Or what about asset allocation strategies that hedge portfolios at times to create greater stability (for instance, a business that buys futures contracts on a related commodity)?  What about Risk Parity approaches and Smart Beta strategies?  Are they really that different from “passive investing” or is this all just different variations of active investing?  Where do we draw this line between what is “market timing” and what isn’t?  Or is the whole concept nebulous to begin with?  Are we really just worried about avoiding high fees and other actions that lead to inefficient portfolio construction while building a relatively long-term portfolio that is diversified in order to increase the probability of our implicit forecasts?

I should be clear – while I am obviously a macro investor I am not against the use of lazy portfolios or what is thought of as “passive” investing.  But I do wonder if the approach has been portrayed as something entirely different from “active” investing when in reality it’s just a generally more efficient version of it with a good deal of gray area between “active” and “passive” strategies.  I’d be interested in your thoughts.