Archive for Most Recent Stories – Page 2

No, Higher Velocity Will Not Necessarily Mean Higher Inflation

In my book I go into some detail about the equation of exchange (MV = PQ) and why it can be terribly misleading. In essence, the equation is based on totally unrealistic assumptions such as the idea that “money” is some easily discernible item in an economy where financial assets have varying degrees of moneyness.  The most basic premise of the equation, the idea that more money necessarily = more inflation, has been thoroughly debunked over the last few decades, but unfortunately, I continue to field a constant barrage of questions about it and how high inflation or hyperinflation are lurking around the corner just waiting for the velocity of money to increase.  The problem is, velocity really has no statistically relevant relationship with the rate of inflation.

This whole conversation is a bit strange to begin with because Milton Friedman often assumed that V was relatively constant.  Which is bizarre because we know that V wasn’t constant even in the era before Friedman wrote his famous 1969 paper on the “Optimum Quantity of Money”.  He also made all sorts of other unrealistic assumptions in the paper such as a fixed money supply, no lending or borrowing and even assumed that people were immortal.  He called this a “hypothetical simple society”, but we really should have called it a “totally useless and fake society”.  How the paper even left a lasting impression on economists is worthy of debate….

Anyhow, I don’t want to get too deep in the weeds on this, but the idea that higher velocity necessarily leads to higher inflation can be easily debunked by looking at our “realistic complex society”.  Over the last 50 years there has been no, I repeat, no statistically significant relationship between the Consumer Price Index and the velocity of M2.  In fact, the relationship is virtually negative.  If you just eye ball the historical relationship you can see that there is none:

v2

If you actually run the regression analysis you can confirm that there is zero relationship between the rate of inflation and the velocity of money:

v1

 

So no, there is no reason to believe that higher or lower velocity of money will lead to deflation or inflation.  That’s not to say that the equation of exchange is not true.  Of course it’s true.  But you have to deep dive into the assumptions that its conclusions are based on to actually understand how useful it really is.  And when we deep dive into Uncle Milton’s “hypothetical simple society” you find that many of the conclusions are based on a world that resembles nothing like our actual monetary system.  And that is why so much of his economics has been proven void of value over the course of the last 30 years – it was based on a textbook world that made the math appear more relevant as opposed to the actual world we live in.

Yes, Boosting Gross Exports (and Imports) Would be Wonderful…

In a post today Scott Sumner says that the world would be better off if we could increase gross exports.   He refers to this Tyler Cowen post before going into more detail calling it “wonderful”.  I’ll probably never understand the Market Monetarism way of thought.  It just strikes me as reformed old school Monetarism (which has gone the way of the dodo) with a NGDP Targeting twist, but the same old laissez-faire foundation and most of the destructive nonsense that Milton Friedman injected into the field of economics.  Anyhow….

Now, Sumner doesn’t actually refer to gross exports, but I am going to assume that’s what he means.  And he’s right – boosting gross exports would be “wonderful”.  Or, said differently, if we all just produced more goods and services that other countries wanted then we could collectively increase our gross exports (as well as our gross imports).   But why is this news or some “wonderful” insight?  I mean, if I could produce a better car than Tesla then I could increase gross production for the global economy and that would be “wonderful”.  But isn’t this just an obvious fact?  But this is how neoliberal economists think. If we can just unleash unfettered capitalism then all of the untapped potential within us would just pour out into the economy, right?  As if there’s an Elon Musk inside of all of us just being held back by high taxes, regulation and the government….

Saying that we should all just boost gross exports is the mercantilists version of telling the poor guy with no job and no skills that he just needs to pick himself up by his bootstraps.  It’s obviously true, but it often makes no sense in reality because picking yourself up by the boot straps is not only extremely difficult, but takes a good deal of time.  From the perspective of economics it’s just obvious (yes, if we could all produce more then we’d likely all be better off).   But from a policy perspective it’s often just political rhetoric that sounds nice in theory and doesn’t translate into the real world in any realistic sense.  And then Sumner (predictably) goes into a bunch of laissez-faire policies that will supposedly unleash all this pent up production thereby allowing us to pick ourselves up by our boot straps.  Of course, none of the ideas are particularly new and many of them are things that many countries have been implementing for years already.  Nothing new here, certainly nothing “wonderful”….

This is the same thinking that has been poisoning economics, policy making and the global economy since the 1970s.  When will it end?

Will New Greek Drama Threaten European Periphery?

By Darren Williams and Dennis Shen, AllianceBernstein

Markets are reacting badly to Greek plans to exit its bailout program early. Uncertainties are being heightened by the prospect of early general elections. The end-result has been a sharp sell-off in Greek sovereign bonds, which has raised fresh concerns about the potential for spillover from Greek risks to other peripheral markets. 

Greece’s government is negotiating the country’s exit from its financial assistance program when it concludes at year-end. Under current agreements, Greece’s European Union (EU) loans stop at the end of 2014, but its IMF program continues through early 2016.

Prime Minister Antonis Samaras has proposed an early termination of Greece’s IMF program, in the hope that a clean exit from both lending facilities at the end of the year would boost support for his administration. Greece claims to be “fully comfortable” that it can meet its financing needs without assistance, but the EU and IMF are much less confident. And, based on the recent sell-off in Greek bonds, there are big doubts in financial markets about supporting Greece without external involvement and against a backdrop of heightened political risks. In our view, with market access now in question, Greece will most likely be forced to stay under at least a precautionary program from the EU.

A Presidential Obstacle

The negotiations on Greece’s bailout exit come at a difficult time for Samaras’ government, with a growing chance that the inability to elect a new Greek president could trigger an early parliamentary election next year.

Every five years, the Greek president is elected by members of parliament (MPs), rather than through a direct popular vote. If parliament can’t muster a three-fifths majority to support a presidential candidate, it must be dissolved and new elections called. Opposition parties can use this as an opportunity to block the presidential candidate, and force early parliamentary elections. That’s precisely what’s happening now.

Several opposition groups, led by the Coalition of the Radical Left (Syriza), are committed to blocking the government’s nominee in presidential elections due next spring—on the expectation that an early parliamentary election would strengthen their own positions. Opinion polls currently suggest that Syriza might win nearly half the seats in the event of an early election, potentially ushering in a government under its leadership.

Financial markets and European political leaders are very uneasy about this prospect. Syriza, with its traditional anti-establishment approach, is likely to escalate confrontation with Greece’s official lenders to new levels.

Greek Bond Yields Spike

Rising uncertainty around Greece’s financing and political outlook, alongside the recent spike in concerns about global growth, has led to a major sell-off in Greek government bonds. The yield on the 10-year bond has risen to 8.0%, from lows of 5.6% in early September.

Williams_Greece

In our base case, we now anticipate that an early parliamentary election will be held next year. If so, this will maintain selling pressure on Greek bonds in the near term. Against this backdrop, we are monitoring closely the potential for spillover to other peripheral markets. While in recent years there has been greater differentiation by investors between Greece and the rest of the periphery, the threat of an early election could reintroduce a degree of contagion.

Darren Williams is Senior European Economist and Dennis Shen is Economic Associate, both at AllianceBernstein.

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. AllianceBernstein Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom.

“the most crucial factor for investing success is cost” – FALSE

I was intrigued by this Vanguard response to PIMCO’s defense of active bond management in which a Vanguard spokesman said:

“We believe the most crucial factor for investing success is cost”

This is an empirically incorrect statement.  Yes, costs matter a great deal.  But the way you choose to allocate your assets is far more important to your returns than the costs you incur.

Now, the Vanguard statement was probably more true when the firm was founded and John Bogle was on the rampage against stock pickers charging 2% or 3% for their services.  But the cost of asset allocation has come down significantly over the last decade.  In fact, I’d argue that Vanguard is the leader in funds that are essentially inexpensive, but actively allocated.

Of course, regulars know that I think this “active” vs “passive” debate is misleading to begin with.  Anyone with a sound understanding of macro finance knows that there is only ONE true passive portfolio and that’s the Global Financial Asset Portfolio (see here for details).  That is, there is really only one outstanding portfolio of all the world’s financial assets.  Therefore, the true passive indexer would simply buy and hold the GFAP and take the aggregate market return as opposed to trying to beat what that portfolio can potentially return.  If you choose an asset allocation that deviates from this weighting then you are, by definition, doing what “active” investors engage in by trying to pick assets in an allocation that is superior than the global index.

Ironically, almost all “passive” index funds run by Vanguard and other firms that advocate “passive” indexing are actually deviations from the market cap weighting of the GFAP.  That is, they are inexpensive, but actively allocated deviations from the GFAP.  There’s nothing “passive” about this except that they’re not as active or expensive as the dart throwing monkeys that their research often strawmans (see this prominent indexing “research” for instance).  This is why we often see “passive” index funds underperform the GFAP - they’re nothing more than inexpensive actively chosen deviations from the GFAP.

We should be clear about costs – costs matter.  There’s no doubt that John Bogle was right about his cost matters hypothesis.  But the way you go about choosing your allocation will be a far more important driver in your future returns than costs – especially in a world where asset allocation has become so inexpensive.  I’ve called this the “Allocation Matters Most Hypothesis”.  Interestingly, we can actually prove that the GFAP return is often an inferior asset allocation by studying Vanguard’s own actively allocated funds.

Over the course of the last 40 years bonds have generated tremendous returns.  But the GFAP, which is just an ex-post response to the market’s allocations, had just a 37% bond market weight relative to the 63% equity market weighting in 1970.  If you’d followed this truly “passive” allocation until today you would have generated a 9.65% annualized return with a standard deviation of 12.11, Sharpe Ratio of 0.43 and a Sortino of 0.81.*  Not bad.  But Vanguards own actively chosen allocations beat this allocation on a risk adjusted and nominal basis!

Over the same period the Vanguard Wellesley fund, one of their oldest funds (which overweights bonds on average), generated a 9.96% CAGR, a 9.05 standard deviation, a Sharpe Ratio of 0.57 and a Sortino Ratio of 1.35.  The Wellesley fund’s active deviation from the global market cap weighting “beat the market”.   Of course, the Wellesley Fund costs 0.26% per year but even with that small fee the nominal AND risk adjusted returns were superior than the truly passive index before any fees.  In other words, by constructing a fund that actively deviates from the global market cap weighting of outstanding financial assets Vanguard was able to construct a fund that defies the firm’s own logic.

The cost matters hypothesis is important.  But the allocation matters most hypothesis is even more important.

* Interestingly, if you’d chosen not to rebalance and let the portfolio evolve with the naturally occurring cap weightings you would have generated a lower risk adjusted return of just 0.39 Sharpe and 0.69 Sortino Ratio.  

 

The Unintended Consequences of Fed Policy

For the most part, I think it’s safe to say that Central Banks are designed to help the economy.  As I’ve described before in detail, at their most basic level Central Banks are just big clearinghouses.  For instance, in the case of the Fed it’s really just an entity that oversees the clearing of payments in the interbank market.  This is an economic positive in that it creates a place where banks can settle payments across the payment network without having to worry about the quality of another bank’s financial assets given that they all deal in a form of pseudo government backed interbank reserves.  Overseeing the smooth operations of this system is the primary purpose of a Central Bank and it is, in my opinion, an unquestionable positive in a system where most of the money is created by risk taking private profit seeking banks.

Of course, Central Banks have become much more than just big clearinghouses.  They’ve become central policy makers via things like interest rate changes and other forms of policy (like QE).  Central Banks implement policy by trying to help the economy (obviously), but their toolkit is an extremely imprecise and blunt set of instruments.  Because of this imprecision there are often unintended consequences that arise  from such a broad instrument.

Today’s earnings report on IBM shed light on a recent trend that I have often criticized – corporate America’s fictitious obsession with boosting EPS by buying back shares.  Since the Fed implemented ZIRP and QE we’ve seen a huge boom in firms borrowing to boost EPS via buybacks.  It’s so inexpensive for a high quality firm to borrow and buyback shares that they can easily boost EPS this quarter without actually having to do anything substantive to the business.  In the case of IBM their revenues have been marginally higher over the last 5 years, but their EPS has shot up 50%.  That is, to a large degree, the result of a 22% decline in the share count thanks to buybacks.  It’s not necessarily “fake”, but it’s nothing like investing in the firm in a way that will create future organic EPS growth.  So these buybacks help in the present, but potentially hurt in the long-term.

There are plenty of other examples of the unintended consequences and the moral hazard of Fed policies.   But the question we have to ask ourselves is whether all of this Central Bank tinkering with interest rates and QE does more good than bad.  I don’t know the answer to that, but I do know that Central Banks operate with a very imprecise toolkit and so relying on them to steer policy over the course of the business cycle seems like a rather naive way to approach the goals of full employment, price stability and growth.

Interest Rates are less Important Than Economists Think

I complain about the state of modern economics a good deal because, as a market practioner and an entrepreneur, I notice that much of the textbook theoretical modeling doesn’t actually reflect anything realistic about the way the world works.  While there are many flawed econ and finance concepts such as the Efficient Market Hypothesis, the quantity theory of money, rational expectations, etc, few are more dangerous than the modern economist’s obsession over interest rates.

There was a time before the 1970’s when fiscal policy dominated policy discussions and Central Banks were viewed as relatively secondary players in policy.  That all changed in the 1970’s when Milton Friedman and the Monetarists defeated the Keynesians during the stagflation of the decade.  The USA shifted dramatically from a focus on fiscal policy to a shift in Central Bank monetary policy.  Of course, Friedman and the Monetarists turned out to be fabulously wrong for focusing on the quantity of money utilizing the Central Bank and the policy focus shifted once again as the US Fed moved from targeting the quantity of money to targeting interest rates.  Although Friedman and the Monetarists were wrong the policy focus never really shifted from the Central Bank.  It just shifted its style.

Today, the obsession over Central Banking is as strong as it’s ever been.  And a new research report which was cited in The Economist this weekend shows us that interest rates are a lot less important than economists think.  The paper titled “The behaviour of aggregate corporate investment” by S.P. Kothari, Jonathan Lewellen and Jerold Warner confirms what I’ve long believed – that interest rates are a blunt instrument.  And no, they’re not a blunt instrument because we’re in a liquidity trap as Paul Krugman and others have (incorrectly) argued.  They’re a blunt instrument at all times.  That is, interest rates just aren’t that important in the way corporations actually decide to invest.  That’s not surprising since the Central Bank sets one interest rate which only loosely impacts the rest of the economy.  Therefore, the idea that the Central Bank can steer the economy via this imprecise tool, was always misguided.

Interestingly, as the Fed remains at 0% interest rates and this interest rate targeting proves inept, the policy discussion has shifted yet again.  But it hasn’t shifted from Central Banks.  It’s just shifted to the way Central Banks can implement policies in alternative manners.  Hence the obsession with ideas like QE.  Of course, QE doesn’t do nearly half the things most people seem to think so here we have another shift to a policy that just doesn’t do as much as most economists seem to think.

So, where to next before the profession realizes that its focus on interest rates is largely wrong?  I don’t know.  My guess is we’ll move to targeting other things like an explicit inflation target or a NGDP target.  And when those policy ideas fail, and they will, who knows where we’ll go next?  But it seems to me that the impact of Milton Friedman and the Monetarists is alive and well.  And no matter how badly certain policies fail we seem to keep turning to monetary policy and Central Banks to provide the answer to full employment and high growth.  When will we learn that Central Banks don’t have all the answers?

Why I Love the Stock Market

By Ben Carlson, A Wealth of Common Sense

“The thing that most affects the market is everything.” – James Playsted Wood

While it’s never fun to lose money, the past couple of weeks reminded me once again why I love the stock market. Mr. Market is basicallly a crazy person that takes pride in frustrating people on a consistent basis. Every investor feels the market’s wrath at some point.

There’s always a chance that investors will get caught flat-footed. In 2013, anyone that was too negative got left behind in the relentless rise. This year the market slowly built up double digit gains over nearly nine months, only to turn on a dime and give most of the gains back in a month.

The stock market is always somewhere on the continuum of panic, fear, complacency, greed or euphoria, but it’s tough to guess where and when the mood will shift from one to the other. This week it happended on a day-to-day basis.

Over the very long-term the stock market tracks the fundamentals — company earnings, dividends and the growth in the economy to some extent, but over the short-term it’s really just a huge experiment in human behavior and emotions.

If you take away the money-making or losing function of the market, it’s really a fascinating system. Sometimes I still wonder how it all works. It’s built on trust, because no one really knows what this stuff is worth with any degree of accuracy. If they did, we wouldn’t have 5 billion shares trading hands back and forth every day on the NYSE.

Last week billionaire Carl Icahn said that Apple, one of the largest, most closely followed companies in the world, was undervalued by half. Sure, why not? A case could be made for or against Icahn’s claims and you could probably talk me into both with enough data and narrative.

The reason the market functions is because it’s a collection of different opinions that are always at odds with one another. And investors can never agree on anything. There’s a buyer for every seller, as they say. The market provides capital for corporations, but also brings together a hugely diverse group of traders, individuals, institutions, speculators and even Mila Kunis to voice their opinions depending on their current investment stance.

And EVERYONE has an opinion (myself included). Now more than ever you can see those opinions in real-time on 24 hour financial news networks, finance websites, blogs, Twitter and other social media outlets like Stock Twits. During this minor four week pullback I’ve heard hundreds of different takes on where we go from here. They all sound good, for the most part, but who knows what will happen over the next few months or even years?

Also, we never really know the real reason for the movements in the market. There are 2-3 legitimate-sounding reasons every day that are thrown out there for the market’s move one way or the other, but they seem to change constantly. One day those 2-3 things “matter” to investors but the next day it’s a completely different set of reasons and no one has any recollection of what happened the day before.

The psychology of the market’s participants is by far the most important aspect for investors to understand. Yet the economy, the markets and businesses involved are constantly evolving. Plus, there’s the fact that investors themselves are always changing with divergent objectives, motives, incentives and strategies.

That means that the market will always and forever be interesting, which is why I love it.

The Good, the Bad and the Ugly of Falling Energy Prices

By Sober Look

The recent correction in the price of crude oil should have an immediate positive impact on the US consumer as well as on a number of business sectors. However there also may be a significant economic downside to this adjustment. Here are some facts to consider.

1. The good:

The US consumer is not only about to benefit from materially lower gasoline prices (see chart), but also from cheaper heating oil.

Heating oil

With wages suppressed, the savings could be quite impactful, particularly for families with incomes below $50K per year.

Merrill Lynch: – … consumers will likely respond quickly to the saving in energy costs. Many families live “hand to mouth”, spending whatever income is available. The Survey of Consumer Finances found that 47% of families had no savings in 2013, up from 44% in the more healthy 2004 economy. Over time, energy costs have become a much bigger part of budgets for low income families. In 2012, families with income below $50,000 spent an average of 21.4% of their income on energy. This is almost double the share in 2001, and it is almost triple the share for families with income above $50,000.

Energy

Furthermore, with gasoline prices lower, it is unlikely that consumers will be buying significantly more of it than they have been. Historically when oil prices fell, gasoline consumption in dollar terms also fell. Dollars saved on fuel will be redirected elsewhere in the economy.

Gasoline

Moreover, suppressed oil prices will, at least in the near-term, keep inflation expectations lower. That means lower short-term rates for longer (see chart) and therefore lower home equity and adjustable rate mortgage monthly payments. It also means lower longer-term rates and cheaper fixed rate mortgages (see chart). We may even see some new refi activity.

Other benefits include cheaper transport (potentially lower travel costs) and shipping costs (lower UPS/Fedex surcharges), as well as cheaper PVC, nylon, polyester, foam, etc. – all of which should benefit the consumer.

2. The bad:

The US has become a major energy producer, with the sector partially responsible for improving economic growth and lower unemployment in recent years. As an example here is the GDP of Texas as a percentage of the US GDP. This trend is driven in part by the recent energy boom in the state.


1pic1

If oil prices remain under pressure, this boom could soon be in jeopardy. While large US energy companies are sitting on a great deal of cash, at some point they will begin to cut portions of the higher cost development and production. And private investment into energy and oil services firms, which has been brisk lately, is likely to moderate. For example, here is the private debt and equity capital flowing into various states last month.

Texas

While, only a portion of the funds going to Texas is directly energy related, various other Texas firms funded by PE (including some real estate, manufacturing and financial companies) have been benefiting from the energy boom. Soon that flow of private capital may slow dramatically.

To put this into perspective, here are the jobs directly generated from Texas oil and gas extraction in recent years. And this does not include the thousands of jobs that support this industry. Such trend is unlikely to continue if oil prices remain at current levels or fall further.

O&G employees Texas

In fact, while the overall industrial production growth in the US has been strong recently (see chart), a big portion of the gains are energy driven (see chart from Lee Adler). A slowdown in that sector will be quite visible across the US.

3. The ugly:

A significant number of middle market energy firms in the US – many funded via private capital (above) – are highly leveraged. The leveraged finance markets are becoming quite concerned about the situation – even for larger firms with traded debt. Here is the yield spread between the energy sector loans in the Credit Suisse Leveraged Loan Index and the index as a whole.

Energy loans

Rumors have been circulating of a number of energy (and related services) firms getting ready to “restructure”. There are also stories that some large funds are gearing up to scoop up distressed debt of levered energy firms. However, in spite of the ample liquidity out there, bets on companies with significant commodity exposure will be limited going forward – at least until stability returns to the oil markets. Defaults, layoffs, and cancelled projects in the energy space may be in store in the near-term. And that is sure to have a negative impact on the US labor markets and the economy as a whole.

Finally, this is terrible news for the development of alternative energy sources. At these prices, fossil fuels are becoming increasingly difficult to compete with.

Sunday Q&A

I wanted to open the comments up here for a Q&A since I haven’t done one in a while.  With the markets so volatile and the global economy looking shaky again I figured people might have some questions.  So fire away if you want.  Anything goes….

Three Bullish Macro Charts

You didn’t think I was going to let you go into the weekend all depressed now did you?  I mentioned last week that the recent downturn in stocks appears to be a purely non-USA event.  That is, the US economic data that’s been coming out in recent weeks really looks no different than anything we’ve been seeing for the last few years.  Specifically, we saw three of my favorite macro indicators this week all come in at record high levels or strong levels.

Retail sales missed expectations on a monthly basis, but are still growing at a 4.5% annual clip.  Healthy by any standard:

retail_sales

Initial jobless claims fell to a 14 year low:

claims

And industrial production hit an all-time high:

indpro

Now, the stock market isn’t the economy so it’s not surprising to see temper tantrums every now and then, but I don’t see much of an excuse for a prolonged downturn in equities at this point based on the macro view of the US economy….Sure, some foreign weakness might creep into the balance sheets of US corporations, but a modest expansion in future earnings hasn’t been altered by recent events.  Of course, if some draw dropping change came out of the EMU (like a Greek restructuring of the monetary union) then my views would be void of value, but I don’t see that happening any time soon.  If anything, we’re more likely to move in the direction of more Central Bank intervention as opposed to a restructuring of the system.

 

Implied Vol Dislocation

By Sober Look

The recent spike in volatility has created a “dislocation” in US equity options markets. VIX, which is a measure of implied volatility for large cap shares is now higher than RVX – the small-cap equivalent. This is highly unusual, since small caps tend to be more volatile. Part of the issue is the outsized spike in the volatility of large energy shares due to the recent sell-off in crude oil.

VIX vs RVX

“Why Did the Stock Market Decline?”

Whenever the market moves violently in one direction or the other we tend to ask questions after the fact.  In recent days the stock market has been falling rather rapidly.  And people want answers.  But I find this questioning misguided.  Who cares why the stock market went down.  Answering that question serves no purpose.  You don’t get your money back if you find the answer.  You don’t get a prize.  All you get is some comfort knowing that you know why something happened after the fact.  And that’s not worth a whole lot.

The more important question is “why should the stock market rise?”  Or better yet, “what if the stock market declines?” These questions get us to think in a proactive manner. These questions force us to think in a critical manner.  The world of asset allocation isn’t about being reactive.  It’s all about being proactive.

It’s fashionable to bad mouth people who make forecasts and people who “manage risk”, but the reality is that all smart asset allocation involves risk management and forecasting. We are all putting together a portfolio of assets and trying to interpret how we can best reduce risk while achieving our financial goals.  The only way to achieve this is to think in a proactive fashion because once you’re the person asking “why did the stock market decline” you’re the person who is being reactive.  And once you’re reacting to the market’s moves you’re likely already behind the curve.

Smart asset allocators prepare rather than react.  They ask themselves the scary questions before those scary questions need to be answered in real life.  Market declines shouldn’t surprise you.  And they shouldn’t worry you.  That is, of course, unless you’re not prepared.  And to be prepared you have to be asking the right questions.

REDEMPTION!

9% decline in the S&P and suddenly everyone who predicted constant recession, bear market, hyperinflation and the end of the world have their sweet redemption!  Recency bias at its best….

redemption

 

H/T reader rconners

 

 

Three Things I Think I Think

A few thoughts on a crazy day in the markets…

1)  There’s hyperinflation in bond prices!  Well, not really.  But the 10 year T-note dipped below 2% for a brief while this morning and the 30 year just continues to rip higher.  The 30 year zero coupon is up over 40% this year.

bond_prices

 

Of course, one place where yields aren’t falling is in Greece where the government is discussing an early exit from the backstop.  There’s been a chronic illiquidity in Greek bonds and I still think the unraveling of Greece and Europe remains the biggest risk in this market.  If there’s one thing that would lead to a huge amount of uncertainty it would be a restructuring of the EMU of some sort to make the monetary system more workable….

Greek

 

On a related note, I think Paul Krugman was way too harsh on Cliff Asness in his piece yesterday.  We should be clear – Cliff has been wrong about inflation and he made that clear.  What he hasn’t been wrong about is the fact that the Fed is potentially creating a huge amount of risk in the financial markets.  One of the risks Asness has expressed over the years is the potential for market disequilibrium resulting from programs like QE which are designed to intentionally distort markets.  I mean, the Fed itself has stated that the purpose of QE is to keep asset prices “higher than they otherwise would be”.  That can be translated into “we will create false optimism about our ability to bolster asset prices”.

What we’ve seen in the last few weeks is a reversal in some of that “reach for yield” trade and we’re seeing lots of investors reverse their positions from high yield bonds and some Euro bonds because it’s become clear that the rewards are simply not worth the risks.  Of course, this is precisely what Central Banks want.  They want you to take more risk, but in a low growth world this becomes highly problematic and potentially creates more instability than stability.  Krugman says Asness should stop criticizing Central Bankers about monetary policy, but maybe economists and Central Bankers should stop promoting actions that create market risks they clearly don’t understand….

2)  Retail sales were actually up 4.5% year over year.  US economic data hasn’t been great in recent weeks, but the sell-off in stocks really has nothing to do with the US economy softening.  It’s entirely based on the assumption that now, when the world sneezes, the US catches a cold.  Historically, that’s been the other way around and given the continued moderate domestic strength of the US economy relative to the rest of the world I see no reason why this time is different.

rsales

3)  Vanguard’s Balanced Index Fund is underperforming in 2014…. Yes, I am still on that whole “passive” vs “active” kick.  Get used to it because I think this is an incredibly important thing to understand.  Anyhow, I think it’s pretty interesting to see how some “passive” funds are performing relative the Global Financial Asset Portfolio (GFAP) which is the one true global benchmark.

While stocks got kicked in the teeth today bonds actually did pretty well.  We all know how most asset allocation models via Modern Portfolio Theory work – you almost always end up with a stock heavy portfolio even though the GFAP is bond heavy.  So, ironically, what we get with most “passive” indexers is an excuse (such as “factor tilting” or “risk tolerance” or timeframe) to overweight stocks and deviate from the global cap weighted index.  There’s really nothing “passive” about this at all.  It’s someone misunderstanding the macro cap weighted GFAP and then making a flimsy excuse to deviate from the global cap weighting and buy stocks because they have tended to generate better nominal returns than other assets.

Anyhow, the GFAP is up roughly 5% year to date while a “passive” 60/40, which has become all the rage in the investment world, is up a measly 1.2%.  The ironic thing is that the people who own a 60/40 really buy into the idea that they’re being “passive” even though they’ve actively chosen to deviate from the GFAP.  And all the while they’re underperforming by a wide margin on a nominal and risk adjusted basis this year.  As I showed here, “passive index” advocates regularly perform studies on stock pickers without noting that the indices they pick also tend to underperform relative to the global aggregate.  The irony is so thick here that it makes me question the macro understanding of anyone who advocates “passive indexing”….

It just goes to show how misguided some of the Wall Street sales lingo can be.  “Passive indexing” is just another clever sales pitch for an approach that actively picks an asset allocation and differentiates itself by charging a low fee all the while strawmanning stock pickers to death.  I’m all for low fees.  But I’m vehemently against deceptive sales practices that lead people to believe they’re engaged in something that they’re not.  The reality is that most passive indexers are just as bad at picking assets as the stock pickers they regularly demonize.

You can read about the Global Financial Asset Portfolio and the general methodology here and here.

So Much for Rate Increases…

It seemed like just last week we were debating the potential for the Fed to raise rates.  And then today we have Fed officials discussing the potential for more QE.  What a manic world.  One little 7.5% decline in the stock market and people start assuming that the world is falling apart.

Anyhow, another way of visualizing the market’s perception of future easy Fed policy is to look at the Fed Funds Futures Curve.  The red line in the chart below shows the curve from 6 months ago relative to the blue line which is the updated curve.  As you can see, 6 months ago the market expected a rate hike in early 2015.  But that rate hike has now been bumped out to November 2015.

I’ve been pretty vocal about my view that the Fed isn’t raising rates any time soon.  And I think that will continue to be the right call well into 2015.

FFF