Archive for Most Recent Stories – Page 2

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.


The Nobel Prize in Economics is Among the Most Influential Prizes in the World

I’ve been mum on the Nobel prize in economics because I honestly don’t know much about Jean Tirole and his microeconomic work.  But I think we should silence one discussion that inevitably arises every time the award is handed out.  That’s the idea that the award is somehow fake or something.  It’s true that the award in economics wasn’t conceived by Alfred Nobel and was added over 70 years after he died.  And it’s true that the award was created by the Swedish Central Bank in large part to celebrate its 300th anniversary.  So what?

No matter how many times people say that the award isn’t “official” it just doesn’t matter.  The reason why is because the award actually acts as an incredibly powerful status symbol.  If you’re an economist with a Nobel prize you are automatically lifted onto a pedestal above everyone else.  Your words carry greater influence and your impact on the world undoubtedly increases.  This is particularly true in the field of economics because economists have such a tremendous impact on public policy which impacts all of us.

In my opinion, it doesn’t matter one bit if Alfred Nobel didn’t conceive the award.  It doesn’t matter if certain people think it’s fake.  The bottom line is that winning the Nobel prize in economics is a huge huge deal that lifts the winner from being important to being beyond important.  Alfred Nobel might not have approved of the award, but the fact that his name is attached to the economics prize is a big deal.  And its winners will continue to have a tremendous impact on all of our lives in the future.  That reason alone makes the Nobel in Economics important and arguably more important and impactful than any other Nobel that is awarded.

Oh, and congratulations Mr. Tirole!  Don’t let your new found influence go to waste….

The State of Macro is Awful

In his latest piece Paul Krugman defends the state of modern macro citing how much of the modern modelling was used quite effectively by certain economists (basically, himself and a few others).  He says this was a big deal because it led to many accurate predictions.  Which is fine except I made all the same predictions without using those models so that opens the door to the idea that these models are perhaps unnecessary and maybe even flawed (ie, right for the wrong reasons).  More importantly, I think pretty differently about the state of modern macroeconomics – I think it’s terrible.

First, let’s look at some of the more prominent schools and how they’ve done in recent decades:

1)  Monetarism – Monetarism’s heyday was in the 1970’s when the Keynesian models appeared to all fall apart under the stagflation of the decade.  But the party didn’t last long.  It soon became obvious that the focus on targeting “money”, rational expectations and laissez-faire policy was largely misleading.  The Fed abandoned monetary targeting in the 80’s and Milton Friedman even admitted in 2003 that he didn’t believe in the idea as fervently as he once did.

In fact, the traditional Monetarist school has basically ceased to exist and was nearly erased from any credible record following the financial crisis when many of the ideas that form the foundation of Monetarism appeared to completely implode.  The school has received a face lift in recent years under the guise of “Market Monetarism”, but this school looks like a one way bet on a different target – NGDP Targeting grounded in the same basic thinking that was the basis for traditional Monetarism.

2)  New Classical Economics – This was another of the Chicago influenced schools that arose in the 1970’s when Keynesianism faltered.  The school was also based on ideas like rational expectations, laissez-faire government approaches, continuous market clearing and the natural rate of interest.  As Mark Thoma has explained, this view also faded over time as obvious flaws became apparent and the theory failed to accurately explain the business cycle.

3)  Behavioral Economics – This school arose out of many of the failures of the aforementioned two schools of thought.  These economists generally reject ideas like rational expectations and instead focus on understanding how economic participants are flawed and biased.  Although the school has increased greatly in popularity in recent decades the lack of rigorous economic modeling has stalled its progress.  While it’s useful in some aspects the school is better utilized as a complement to a more well-rounded approach to economics since it does not provide a comprehensive view of the macroeconomy.  It likely will not and cannot become a dominate macro school because human behavior can only explain certain parts of the economy.

4)  Post-Keynesian Economics – The PKE school claims to be the true descendants of Keynes and his work.  Unfortunately, the school has become extremely polarized within itself and has become dominated by some extremist left-wing thinking.  In fact, it’s become so polarized that most mainstream economists don’t even take it seriously and the persistent attacks by its adherents come off more as bitterness as opposed to anything useful.

Its focus on operational realities, institutions and accounting is, in my opinion, the most useful approach to economics that presently exists, but the extreme polarization within the school and with mainstream economics has rendered it void of impact.

5)  Austrian Economics – Austrian economics is most popular with conservative Americans who reject just about anything the government does.  They’ve been wrong about almost everything since the crisis occurred including the rate of inflation, direction of interest rates, the value of the USD, the stock market, the economy, the impact of stimulus, etc.  The school has, in my opinion, been almost entirely debunked and rendered largely void of value yet it continues to dominate financial TV and garners huge amounts of attention for reasons that can only be attributed to the popularity of its political positions.

6)  New Keynesian Economics – The New Keynesians are the modern adaptation of the Old Keynesians who rose up in response to the New Classicals.  Although they are called “New Keynesians” they utilize many of the ideas that are essential to Monetarism such as rational expectations, the natural rate of interest, etc.  Instead of viewing the money supply as the key variable in the economy they view the price of money as the key variable.  This has led these economists to focus on the “zero lower bound” and interest rates in particular.

They’ve focused largely on the IS/LM model in recent years and have attributed it for their good predictions.  I’ve been very critical of this school citing the flaws in the idea of a Wicksellian “natural rate of interest” adding that the focus on interest rates has distracted us from implementing more effective policy.  In fact, this school has been one of the main reasons why there is so much faith in the Federal Reserve and QE since it claims that the Fed can still be highly stimulative with zero interest rates so long as it focuses on unconventional monetary policy by altering inflation expectations.

I would blame these ideas for the fact that there has been almost no other attempt at fiscal policy and tax cuts.  It is, in my opinion, just an altered obsession with Central Banking – the same obsession with “money” and the “price of money” that ultimately proved Monetarism wrong.  Except in the case of New Keynesian economics we’ve transitioned from obsessing over monetary targets to obsessing over inflation targets and interest rates.  Same basic unrealistic model of the economy, different target.

So, those are the major schools.  How are they doing?  Well, if you ask me they’re all doing pretty pitifully.  The state of macroeconomics is as messy as its ever been.  If you can connect all the dots there we’ve basically been evolving from flawed theory to lesser flawed theory to flawed theory.  Which I guess isn’t terribly shocking since it’s not a very old field of study when considered within the grand scheme of things.  But we shouldn’t be fooled into thinking that everything is fine in the world of macroeconomics.  It’s not.  It’s a big heaping mess.  And there’s a lot of work to be done in making progress here and people who imply that their unrealistic models have it all figured out, are probably among the most dangerous people out there as that’s really just an argument for the status quo – the same status quo that has left over 100 million people out of the workforce.

Understanding the Deposit:Loan Discrepancy & Why It’s Not Scary

I’ve received a number of emails about this post at Zero Hedge which shows the deposit:loan ratio at JP Morgan.  The authors cite this as a sign of “all that’s broken with the US financial system”.  That description isn’t far off, but I do think it deserves some clarification.

First, forget JP Morgan.  Here’s the whole banking system’s deposit to loan ratio:


You’ll notice that that chart looks a lot like this chart of the reserve balances at Fed banks:


So, what’s going on at the bank level?  Let’s break this down in simple steps:

1) We know that loans create deposits.  Deposits are just the asset side of the borrower’s loan.  Deposits are the “money” you actually borrow (although we shouldn’t think that the bank actually has the money or lends someone else’s money since the bank actually just creates the loan from thin air).

2)  When the economy went into a state of deleveraging the normal process of deposit expansion via loans dried up.  In other words, the money supply stopped expanding because the demand for loans dried up.  So the Fed implemented QE to try to get more “money” into the system.  This is typical Bernanke Monetarism – increase the money supply and inflation will follow.  Of course, that’s not at all what happened as inflation has remained benign to say the least.

3) When the Fed expanded its balance sheet (also creating money from thin air just like banks do) they engaged in an asset swap with the private sector.  They “printed” money into the private sector and “unprinted” T-Bonds and MBS from the private sector.  All else being equal, this is a pure asset swap that changes the composition of the private sector’s balance sheet, but has no real reason to be inflationary since the program is much like swapping a savings account for a checking account.

4)  The loan:deposit ratio is just a sign of the deleveraging we’ve been through and the weak demand for loans.  So yes, it is a sign of “all that’s wrong with the US financial system” since it’s a sign of the deleveraging which has been the root cause of our weak economy.

5)  BUT, we should also note that this ratio is improving dramatically as the economy has healed.  In fact, lending is at its highest levels since the crisis.  Deleveraging is a process and not an event as I’ve often noted.  There are still big problems with the US economy, but we appear to be moving in the right direction.  So don’t panic over this chart.  Focusing on the aggregate size of the expansion of the deposit:loan ratio will lead you to miss the fact that things are getting better.

Some related work:

Five Ways to Keep Out of the Bond Liquidity Trap

By Douglas Peebles, AllianceBernstein

Bond investors are used to managing interest-rate risk and credit risk. But the financial crisis should have taught us that there are times when liquidity risk can be just as important to manage. Now is one of those times.

Why has liquidity become such a prevalent risk in today’s fixed-income markets?

Simply put: there’s a lot less of it. Stricter regulations that require banks to hold more capital against losses have prodded them into slashing inventories of assets such as corporate bonds. This leaves the banks unable to play the part of willing buyer when investors want to sell.

These liquidity dynamics likely magnified recent sell-offs in high-yield bonds and bank loans. It’s unclear how quickly interest rates will rise in anticipation of tighter Federal Reserve policy next year. But rise they probably will, and any drift upward could intensify selling pressure. In a worst case scenario, today’s trot to the exit could turn into a mad dash—and we doubt that everyone would fit through the door.

The good news is that liquidity risk is manageable—and can even offer attractive opportunities, given the right time horizon. When liquidity dries up in one sector, it can be plentiful in another. If managed properly, it can be an additional source of returns.

Here are five things investors can do to stay afloat:

1) Broaden your horizons with a multi-sector mind-set. Liquidity is episodic and can affect different sectors in different ways. Consequently, segregating one’s allocations into single-sector funds—high yield, emerging markets and so on—can be dangerous; if liquidity dries up in one sector, investors can quickly find themselves trapped. In our view, a holistic and dynamic multi-sector approach that lets investors tap into a broad universe of fixed-income assets offers better protection should liquidity in a specific sector dry up(Display).


2) Don’t skimp on cash and don’t overlook derivatives. Holding too much cash has been a losing proposition for investment returns these past six years, thanks to the Federal Reserve’s successful campaign to drive down the risk-free interest rate. But cash can come in awfully handy when it comes to meeting redemptions in low-liquidity environments. That’s why US mutual funds were allocating 9% of their portfolios to cash on average through August, according to Morningstar. Investors were much less prepared when the global financial crisis hit: the average cash allocation in December of 2008 was just 1.6%. To offset the potential performance drag of cash, investors can potentially improve returns by tapping the derivatives market to get exposure to “synthetic” securities. The liquid derivatives market also gives investors access to additional pools of liquidity.

3) In today’s market, look for “hands-on” trading expertise. Historically, traders at asset management firms mostly executed orders. But as banks have retreated from the bond-trading business, the responsibilities of buy-side traders have grown. The best traders are adept at finding sources of liquidity and making the most of opportunities caused by its ebb and flow. Investment managers who have embraced a more active role for traders stand a better chance, in our view, of managing liquidity risk effectively.

4) Be flexible with your investment horizons. This is especially important when low liquidity makes the trading environment so inflexible. When liquidity is plentiful, it’s easy to exit trades that have achieved their objectives. But in today’s fixed-income markets, investors shouldn’t assume liquidity will be there when needed. That’s why we think it pays to dig deeply into every possible investment. Multiple time horizons, including “holding to maturity,” should be considered when analyzing bonds. And if holding a particular bond to maturity doesn’t look attractive in today’s environment, investors might want to reconsider the security altogether.

5) Consider selective investments in private credit. File this one under the “silver lining” tab: the forces that have been reducing liquidity—increased regulation and stricter capital requirements—are also unlocking attractive opportunities in private credit. As banks originate fewer residential and commercial mortgages and lend less to mid-size companies, asset managers are filling the void. Yields on many private credit assets are on average considerably higher than those on more traditional bonds. The reason, of course, is simple: these investments are not as liquid. But as we’ve seen, liquidity isn’t what it used to be throughout the fixed-income market. In our view, investors with long time horizons may want to consider taking advantage of these “illiquidity premiums.”

We believe that these prudent steps can help investors navigate a less liquid market.

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.

Douglas J. Peebles is Chief Investment Officer and Head of Fixed Income at AllianceBernstein (NYSE:AB).


Economics is a Social Science, not a Natural Science

Economics is categorized as a “social science” alongside anthropology, psychology and sociology.  Which makes complete sense considering that economics studies the relationships that dictate how we produce and consume goods and services within the society.   But you wouldn’t know that from the way many economists discuss economics.  Too often economists try to establish economics as an empirical science grounded in some sort of natural phenomena.

I was thinking about all of this as I was reading this piece by John Hilsenrath who was discussing Hayek’s views on this matter:

“His central grievance was the field’s long-running infatuation with scientific method and certitude. It was an impossible and misleading task for economists, he said. In their “vain search for quantitative and numerical constants,” Mr. Hayek argued, economists were constantly overlooking essential facts and misunderstanding the complexity of the social mechanisms under their microscopes.”

Hayek has this dead right even if we might have disagreed on how to apply it.  In the search for quantitative and numerical constants we often overlook just how much our economic system resembles the soft science and not the natural sciences.  And it can lead to extremely misguided thinking on certain matters.

Of course, the economy is not grounded in anything resembling the natural sciences.  There’s very little that’s “natural” about our economic system.  The economy is made up of the sum of the decisions of the people who operate within that system.  And the system exists, to a large degree, in our heads as records of accounting.   These records can be erased, created from thin air, manipulated, etc.  And the people creating those records are driven in large part by their own biases.  They react inefficiently and irrationally.  Mister Market, as Warren Buffett likes to say, is often manic.

This makes the study of economics extremely tricky because we’re dealing in uncertainties at most times.  Thankfully, we seem to be making good progress in fields like behavioral finance, but I do worry that the “science envy” of many economists continues to plague views and progress.


The Changing Face of the Global Bond Market

This meshes nicely with my recent discussions about the importance of understanding the global financial asset portfolio for the purposes of portfolio construction (see here and here).  I’ve emphasized that the only truly “passive” portfolio is the portfolio of total outstanding financial assets.  Of course, that portfolio is constantly changing and replicating it is nearly impossible.  Therefore, we all have to actively choose to deviate from the global cap weighted portfolio and make active decisions about how to allocate our portfolios.  Owning the “market portfolio” just isn’t a realistic option.

To emphasize this point just look at how much the bond market has changed in recent years.  bond_marketIf you wanted to replicate the global bond market in 1989 you wouldn’t have been terribly far off if you just owned the US bond market (though that would have only gotten you 60% of the total market).  But that has completely shifted in the last 30 years as the US has fallen to just 38% of outstanding global bonds and the developed markets ex USA and emerging markets have jumped to 62%.  In other words, if you wanted to just invest “passively” you’d now own a much larger slice of bonds outside of the USA than you probably do.

This is even more interesting when we look at the stock market relative to the bond market because the structure of interest rates has caused an equally substantial flip.  In the early 80’s the global market cap weighting of outstanding stocks was about 60%, but today that has fallen to just 45%.   As I’ve noted, the outstanding global cap weighted portfolio had you positioned to be underweight bonds before the greatest bull market in bonds ever – talk about a failure of Modern Portfolio Theory!  And it now has you overweight bonds relative to stocks at the time when bonds are almost certain to deliver weak future returns.

It all goes to show what should be obvious – at the macro level the market actually isn’t all the “efficient”.  It’s just an ex-post snapshot of recent trends.  And more importantly, it’s incredibly dynamic and constantly shifting.  A “static” portfolio approach might serve you fine, but it’s doubtful that it will be optimal over the course of the business cycle as risks and markets evolve.

Source: JP Morgan Q4 Guide


Confessions of a Financial Services Worker

I’ll never forget the day I got officially fed up with Wall Street.  I was in my early 20’s and I had been working as a broker on a big team in what was basically a dream position at the time.  I was handed a huge amount of assets, being trained at one of the best firms in the world and working with some of the best people I’ve ever known.   What wasn’t to love?  But something kept nagging at me.  The business model just didn’t feel right.  I don’t mean that it didn’t feel like an optimal business model.  I mean it didn’t feel morally right.  I didn’t feel like I was doing the right thing for my clients.  Maybe I was being overly sensitive, but a constant thought kept coming over me: “this can all be done in a more client friendly manner.”

It was a little before 4PM at the end of the week and I had a good family friend who was a client of mine.  He trusted me with millions of dollars.  He’d do whatever I said.  I knew a decent amount back then, but looking back I have to admit that I probably had no business managing millions of dollars for people.

Anyhow, we would get analyst reports every day about “actionable ideas” so we could drum up commissions and try to act on what our analysts reported.  On this particular day I had a report on Merck and this family friend of mine just happened to own it.  The stock had fallen 20-30% that morning on some report by the FDA or something (I really had no idea what the hell was going on with the company and frankly, it wasn’t my job to know – we took our cues from the firm’s research analysts) and we were unloading everything because that’s what our analysts recommended.

I remember it vividly because I had been engrossed in Warren Buffett’s annual letters at the time and I’d come to believe in the contrarian perspective.  You were supposed to buy when others were fearful and sell when others were greedy or something like that.  So I called up my family friend and we dumped his shares even though Warren Buffett was kicking the back of my chair the whole time.   Selling was the exact opposite of what I thought I was smart, but the business model of the firm was designed to treat Merck as a “sell” and so sell we did.

When I hung up the phone I looked at the profit and loss report.  Not for the client’s profit or loss, but for my commission.  It said $2,000.  I felt sick to my stomach.  Literally.  I went to the bathroom and I sat on the toilet with my head in my hands thinking about how I had charged this great man $2,000 when I knew I could do it for $9.99 at a low discount brokerage firm.  I couldn’t handle it.  And I quit the firm within 6 months.

The sad thing is, that’s been my story the whole way through this industry.  The first job I ever had was selling Long Term Care Insurance right out of college.  We were boxed in rooms like sardines, 50 guys deep just banging the phones and telling fart jokes for 18 hours a day.  And every once in a while you’d leave the office to go sell someone some insurance that they may or may not need.  I moved on to life insurance which felt marginally less dirty.  And then stocks which felt a little less dirty.  When I got sick of that I managed a small investment partnership for 5 years where I worked for a few rich guys who still made me feel dirty even though I generated some pretty lucky returns through a difficult environment (2006-2011).  And then I started Orcam where I am finally feeling like I am doing something for my clients that makes a difference and isn’t a rip-off.  It’s been a long strange trip….

The good news is, I feel like my story from a bad place to a better place is the general trend we’re seeing in financial services.  I don’t know where exactly this industry is going.  But I feel like its best days are ahead.  The people in this industry aren’t bad people.  I just think there’s been a client second culture that has persisted even as the business has become infinitely more client friendly.  Sadly, there will always be bad segments of the business.  There will always be bad firms.  There will always be people who think that “greed is good” and all that bull shit.  But I honestly believe it’s getting better.  It’s never been less expensive, it’s never been more transparent and the vast amount of information has made it easier for investors to make smart decisions.  And I think it’s only going to keep getting better.  Unfortunately, there’s still a lot of work to be done before we’re at a spot where I can say that financial services contributes to the economy in a deeply positive way.

What Are the Odds We’re Heading For Another Crash?

By Ben Carlson, A Wealth of Common Sense

“The fundamental law of investing is the uncertainty of the future.” – Peter Bernstein

Many investors have been hoping for a “healthy” correction to put money to work at lower prices, but corrections never feel healthy when they finally hit.

It always feels like this is the big one when losses start to pile up. We start hearing comparisons to the prior peaks in 2000 and 2007 along with some scary stories about the 1987 crash.

Investors are now conditioned to expect binary outcomes in the markets. It’s either a top and we’re heading for a crash or it’s a bottom and markets are going straight up. Either of these scenarios is always a possibility, but rarely are the markets at an inflection point. There’s usually more of an ebb and flow than most investors realize.

In his terrific video called How the Economic Machine Works, Ray Dalio explains how the credit cycle works in general terms. Dalio offers an example using a simplified version of the relationship between credit growth and growth in the economy and how it fluctuates around productivity growth:



When the good times start to roll we see too much debt in the system and things can get out of control, which is exactly what happened leading up to the great financial crisis. Following the euphoric build-up, there’s a readjustment period where we undershoot potential productivity in the economy (sound familiar?).

Within this long-term secular cycle are much shorter cyclical periods:



With two huge market declines in a the same decade, investors are constantly on edge waiting for the next crash. The scars are still fresh. But we’re more likely to see cyclical, not secular, market drops for the simple fact that they happen more often.

Let’s assume the S&P 500 ends up falling 10% or more, something that hasn’t happened since 2011. I don’t know if this will happen, but it’s not out of the realm of possibilities. Does this mean we’re heading for another 50% crash? Maybe, but probably not. That magnitude of loss is fairly rare historically.

I looked at the S&P 500 data going back to 1950 and found that there have been nearly 30 instances when stocks fell by 10% or more, roughly once every two years (go back to 1928 and it happens around once a year).

In that time stocks have only fallen 30% or more five times. It happens, but it’s rare. That’s one out of every thirteen years. Here are the rest of the stats on the double digit losses:


You can see the average double digit loss lasted almost 8 months and led to a bear market. The huge losses are the exception, not the rule. Two-thirds of the time, when the market falls by double digits, it’s down by less than 20%. About half the time it’s down less than 15%.

These numbers don’t make you feel any better when you see the value of your portfolio drop, but it’s puts things into perspective. There are no rules set in stone in the financial markets and there’s no playbook that tells you ahead of time that this type of market will only lead to a 10-12% decline but that one will lead to a 30%+ crash.

Of course, these aren’t actual odds. It’s just what’s happened historically. Anything can happen. There are always outlier events that could strike and upset market dynamics to cause a crash. No one really knows.

But you can’t plan on a stock market crash every single time stocks fall. Sometimes stocks go down without an enormous crash. Were it not for the occasional correction or bear market stocks wouldn’t offer a risk premium over bonds and cash.

Plan on seeing stocks fall plenty of times over your lifetime, including the occasional crash.

How the Economic Machine Works

Further Reading:
The difference between a correction and a crash
How I think about stock losses

The Great Mortgaging

By Òscar Jordà, Alan Taylor, and Moritz Schularick (via VOX)

Òscar Jordà is a Research Advisor, Federal Reserve Bank of San Francisco; Professor of Economics, UC Davis

Moritz Schularick is a Professor of Economics at the University of Bonn

Alan Taylor is a Professor of Economics and Finance, University of California, Davis

Investing for Tax-Efficient Portfolio Income

By Tara Thompson Popernik and Robert Dietz, AllianceBernstein

With tax-exempt income from US municipal bond portfolios still near historic lows, investors spending from their portfolios can no longer get the income they need by simply increasing their allocation to high-quality, intermediate-duration bonds. As a result, many investors today are chasing yield into dangerous territory.

Typically, today’s yield-hungry investors are shifting to longer-duration or lower-credit-quality (high-yield) bonds, or both. Such investments may merit an allocation, but many investors do not adequately weigh the likely consequences.

We think that investors seeking tax-efficient income should weigh three considerations: after-tax income, tax-efficient growth and risk. Below, we evaluate the trade-offs for several potential solutions.

Popular Solutions

The income that can be gained from shifting the fixed-income portion of a portfolio to high-yield or long-duration bonds is indeed substantial. The left side of the Display below shows that investors can increase the after-tax annual income on a $1 million portfolio with a 60/40 stock/bond mix by about $9,000 if they shift the bond allocation to long-term, high-quality bonds. They can gain more than $21,000 of additional income if they shift it all to high-yield bonds, and about $15,000 more if they shift it to an equal mix of the two.


But the magnitude of the risk that these three popular income strategies add is not well understood. We estimate that an investor in a 60/40 portfolio now faces a 29% chance of incurring a large loss (defined as a 20% loss from peak to trough) in some period within the next 20 years. Shifting the bond allocation to long bonds would increase the risk of a large loss to 39%, because long bonds lose more value than intermediate-term bonds when interest rates rise. The risk of a large loss rises to 55% for the 60/40 portfolio with high-yield bonds and to 47% for the 60/40 portfolio with an equal mix of high-yield and long-term bonds.

These three popular income strategies are also likely to lead to less wealth over time than a core bond strategy would. For example, we project that the 60/40 portfolio with high-yield bonds, which generates the most income, would lead to a give-up in future wealth similar to a 20/80 portfolio, in the median case, as the display also shows.

In our experience, the risks that each of these three popular strategies pose are too high for most income-oriented investors.

Lower-Risk Solutions

Fortunately, it’s possible to garner more income without adding as much risk. The key is to source the higher-income (but higher-risk) investments from the stock allocation of the portfolio, rather than from the bondallocation. You can see this in the three potential lower-risk variations on a 60/40 portfolio in the display.

The first lower-risk variation replaces the broad US large-cap stock portion of the 60/40 portfolio with similar stocks with higher dividend yields. This increases the after-tax income of the portfolio by less than $1,300. That’s even less than shifting to a 20/80 stock/bond mix, but the decrease in the projected future value of the portfolio isn’t as bad as it  is for a 20/80 portfolio.

The tilt to higher dividends reduces the risk of a large loss from 29% to 25%, because higher-dividend-yielding stocks are typically less volatile. However, they offer moderately lower growth potential than the broad market.

The second lower-risk variation adds a 10% allocation to high-yield municipal bonds; importantly, it reallocates the capital for this high-yield investment from stocks, rather than bonds. This variation increases the portfolio’s after-tax income to $24,100, nearly $6,000 more than the original 60/40 allocation, and also reduces the probability of a large loss substantially—from 29% to 19%. While high-yield bonds are more volatile than investment-grade bonds, they are less volatile than stocks.

The downside is that this lower-risk portfolio is likely to be worth less after 20 years, in the median case, because high-yield bonds tend to generate much less growth than stocks do.

The third lower-risk variation combines the first two. This variation increases the portfolio’s after-tax income the most, to $25,200, nearly $7,000 above the original 60/40 allocation. The investor gets the additional income with a lot less risk: the probability of a 20% peak-to-trough loss falls to just 16%, close to the 15% probability of a large loss that a 60/40 portfolio offers under normal market conditions. The downside is that it also reduces the projected value of the portfolio after 20 years the most, to $849,000.

In our experience, the three lower-risk solutions are likely to fit the risk tolerance of most income-oriented investors better than the three popular solutions.

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.

The Bernstein Wealth Forecasting System uses a Monte Carlo model that simulates 10,000 plausible paths of return for each asset class and inflation and produces a probability distribution of outcomes. The model does not draw randomly from a set of historical returns to produce estimates for the future. Instead, the forecasts (1) are based on the building blocks of asset returns, such as inflation, yields, yield spreads, stock earnings and price multiples; (2) incorporate the linkages that exist among the returns of various asset classes; (3) take into account current market conditions at the beginning of the analysis; and (4) factor in a reasonable degree of randomness and unpredictability.

This article was adapted from a longer piece by the same authors published in the September 2014 issue ofThe CPA Journal.

Tara Thompson Popernik, CFA, CFP®, is Director of Research of the Wealth Planning and Analysis Group at Bernstein Global Wealth Management, a unit of AllianceBernstein (NYSE: AB). Robert Dietz, CFA, is a Senior Investment Planning Analyst in the group.

Are There Flaws in Ray Dalio’s “Machine”?

I was recently asked in the Forum to critique Ray Dalio’s popular video describing how the “economic machine” works.  If you haven’t seen the video you should take a look.  It’s very good.  But I do have some issues with his description of the economic machine.  Here are some of the ones that really jump out at me:

  • Early in the video Dalio says “the central bank “controls the amount of money and credit in the economy”.  This is a common view, but an incorrect one.  The Central Bank indirectly influences the amount of credit in the economy by changing its target on the overnight interest rate.  This helps influence the spread at which banks lend, but it does not “control” several other variables such as the demand for credit, the creditworthiness of borrowers or the interest rate at which loans are made.  These factors are all out of the Central Bank’s control and are far more important in the credit creation process than the overnight lending rate.


  • At about the 7 minute mark Dalio puts a timeframe on the credit and production cycle, but I have to say that I really don’t like doing that.  It implies that the past is prologue, but as we know from the current credit cycle, the past doesn’t always repeat.  Not a major complaint in the description, but worth keeping in mind.


  • At the 9 minute mark Dalio says money and credit are different things.  Specifically, he says that cash is “money”.  I don’t think this is correct.  Money is a medium of exchange.  And credit is the ultimate medium of exchange.  Therefore, credit is money.  Cash is simply a derivative of credit.  That is, in order to use cash in a modern monetary system you must first have a deposit account with a bank.  That is, someone must have borrowed the funds into existence which created the bank deposits which allowed someone to draw down that bank account.  Cash comes AFTER credit.  Not before it.  That doesn’t mean cash isn’t money.  It is.  As I’ve described before, cash is “outside money” and credit is “inside money”.   Understanding the distinction is crucial to understanding the monetary system and I don’t think Dalio’s distinction puts the “money supply” in the proper perspective as it implies that the Central Bank and government create the “real money” and the banks are just creating something fake or totally different.


  • At the 24 minute mark Dalio goes on to state that the Central Bank can “print money”.  He says this is “inflationary”.  He’s basically describing QE and we know that QE hasn’t been inflationary.  He fails to explain that QE is really not “money printing”, but “asset swapping”.  That is, the private sector is experiencing a simple change in their portfolio composition (from bonds to deposits/reserves).  So the bonds are the equivalent of being “unprinted” from the private sector while the deposits/reserves are “printed”.  As we know, the confusion over this sort of terminology has created all sorts of flawed thinking in recent years.   See my primer on QE for more.

That’s about it.  Overall I think it’s a tremendously good video.  You’ll learn a lot from it.  So give it a watch.

What Will be the Most Likely Cause of the Next Big Downturn?

Predicting a tail risk event is just about always a silly thing to do.  The markets are too complex to predict such things.  Of course, this doesn’t mean we can’t be prepared, but you get the point.  So, knowing that we shouldn’t try to predict what the next big black swan will be – let’s try to predict the next big black swan type event…

I don’t fully believe that the markets are so complex and dynamic that they’re entirely unpredictable.  I think that a sound understanding of the macro system, the monetary system and the financial system can help one substantially increase their odds of making high probability decisions about how to approach the financial markets.  A big part of that is identifying where excessive risks are at times.

Over the course of the last 5 years I have repeatedly written about one flawed system in particular – Europe.  We can look at Europe’s monetary system and identify, for a fact, that it has a structural flaw.  That is, with a single currency the countries are all locked into a fixed exchange rate.  This leads to natural trade imbalances within Europe.  So the trade imbalances can’t rebalance via FX markets.  But there’s a bigger problem.  The countries also can’t print their own currency to devalue the currency.  And perhaps most importantly, there is no central Treasury system to redistribute funds to alleviate the debt burdens that inevitably arise from the current account deficit nations.  So you end up with a bunch of bankrupt nations who can’t print money, can’t rebalance via FX and won’t get any outside assistance.  This is PRECISELY what happens in the USA except states like Florida, Louisiana, South Carolina, Hawaii and Virginia receive huge amounts of federal aid which helps alleviate what would otherwise become an unbearable debt burden.

The point is, we can look at Europe and know, for a fact, that the monetary system is deficient.  And the only way to fix it is to implement a rather substantial change.  I’ve proposed moving towards a United States of Europe.  But we could also see a complete break-up of the Euro or even a partial break-up.  But the point is, no matter what happens, it’s likely to be hugely controversial and hugely disruptive to the markets and the economy.  And if and when this does happen it will likely ripple through the entire global economy as uncertainty overtakes markets.

Anyhow, if I had to guess what would cause the next big market downturn that would be my guess.  But it’s only an educated guess….Not terribly useful I know, but a fun thought experiment if nothing else.

It’s Always the Same Novel

By Ben Carlson, A Wealth of Common Sense

The Nobel Prize for Literature was awarded this morning to a French author by the name of Patrick Modiano. Modiano has written more than 20 novels, with the first one published in 1968.

What I found interesting about his story is that he said he is “always writing the same book.” Here’s more:

Modiano says that like every other novelist he is always writing the same book, ‘on fait toujours lemême roman.’ (translation: it is always the same novel) Modiano more than most, perhaps. The mania for looking back is always there. His characters collect shreds of old evidence, handwriting, photographs, police files, newspaper cuttings. They follow the footsteps of vanished people, snooping on the world of others like unemployed private detectives who can’t find anything else to do. They have what I take to be Modiano’s own interest in Paris streets, particularly those of the outskirts, and they ceaselessly list addresses, consult old directories, make calls to telephone numbers no longer in service.

I was instantly reminded of Jason Zweig’s now-classic piece entitled Saving Investors from Themselves that was written last summer. It’s one of my all-time favorite investment articles because it cuts to the heart of good financial advice:

I was once asked, at a journalism conference, how I defined my job. I said: My job is to write the exact same thing between 50 and 100 times a year in such a way that neither my editors nor my readers will ever think I am repeating myself.

That’s because good advice rarely changes, while markets change constantly. The temptation to pander is almost irresistible. And while people need good advice, what they want is advice that sounds good.

I had dinner last week with a fellow financial writer and we talked about the fact that sometimes it feels like we’re constantly repeating ourselves in our message. The more I thought about this the more I realized that some people need to hear a similar message over and over again to cut through all of the noise that’s out there. I need to hear good advice on a consistent basis to keep my own behavior in check.

Zweig’s message is a great reminder, since it’s so easy to get bogged down in the minutiae of the markets and your own financial situation. The markets are constantly evolving and will continue to do so in the future.

But the truly useful and sound investing principles will always stay the same.

Nobel Prize for Literature Goes to French Author Patrick Modiano (Atlantic)
The Intelligent Investor: Saving Investors From Themselves (WSJ)

Risk, EMH and Grocery Store Lines

Proponents of the Efficient Market Hypothesis are masters at marketing their concepts by simplifying them into easily discernible ideas.  For instance, I ran across this post by Tim Harford who writes for the FT in which he discussed how the grocery store makes for a good EMH analogy.  The story goes like this – you finish getting your groceries only to begin eyeing the checkout lines.  Which one do you choose?   Grocery store checkout lines are a great example of an efficient market, right?  They’re simple, we all have the same information and one would assume, that, on average, it’s extremely hard to consistently choose the best line because of the “wisdom of crowds”.  That is, everyone else is working with the same set of information and digests it in a manner that doesn’t make it possible or worthwhile to try to pick the best line.  It’s so obvious and easy to understand, right?

Tim goes further though.  He says:

“All this assumes something rather important: that the risk-adjusted return (or the length of the queues) is indeed the same.”

I’m an American critiquing an English author’s article so I just have to say, “bollocks!”  The thing is, we all know what “risk” is in the grocery store.  The risk in the grocery store line is that you’ll waste time relative to another line.  That’s it.  It’s not hard to understand and everyone who confronts the grocery store checkout line knows precisely what they’re trying to avoid, how to quantify it and how to try to avoid it.  But the financial markets are totally different for several reasons:

  1. We all have different perceptions of what “risk” is.
  2. Most of us actually have no idea what market “risk” means in the first place.
  3. None of us actually knows what the risk of assets relative to others is at any given time (although I’d argue that some people come much closer than others).

This presents a very different situation than the simple and easily discernible grocery store analogy.   Now, the EMH is based on rational expectations and the idea that markets are in equilibrium.  And based on this (total misrepresentation of reality) the idea goes that the risk adjusted returns of all investments should be roughly equivalent because the market will price assets according to their proper risks.  But there’s that word “risk” again.  The word that no one in financial markets really understands, can quantify or knows the relative value of. Yes, academic economists like to use standard deviation because it’s easy to quantify, but volatility is hardly the only way one perceives financial risk.  In fact, volatility could be a very good thing.  In reality, the idea of “risk” is dynamic, evolving and uniquely personal.  But the academic models presenting this idea turn it into a static and quantifiable concept which misrepresents reality.

This presents us with a different conundrum though.  If no one really understands the risks they’re undertaking when they put money to work in the markets then how are the assets being priced efficiently so that good risk adjusted returns are hard to come by?  One would assume the assets aren’t actually being priced “right” or efficiently.  Instead, they’re being priced wrong.  But that doesn’t make the market easy to predict.  After all, this misunderstanding actually means that markets are hard to predict because everyone is working with such an imprecise and different set of understandings that one must also be able to predict when and how those participants are mispricing assets (in addition to assuming that those same irrational participants will one day price the assets the way YOU think they should).

The key point is, none of this has anything to do with rational expectations, equilibrium and the all knowing market.  In fact, it’s precisely the opposite.  It’s the stupidity of the crowd that often makes it so difficult to make money in the markets.  And so none of this should rationalize the underlying ideas in the Efficient Market Hypothesis.  And sadly, easily discernible analogies only muddy the waters rather than help to clear them up.