Three Things I Think I Think

Hamilton, Short selling and 60/40.

1) Ben Bernanke is not happy that Alexander Hamilton is being replaced on the $10 bill.  He says Hamilton helped establish the piping that is our current monetary system. He also adds that Andrew Jackson was an opponent of Central Banks all along and should therefore be removed from the $20 instead of Hamilton.

Okay, so a central banker likes the original central banker and hates the original opponent of central bankers. You can see how this will all get very political (and has already). But Bernanke makes an important point. From an operational perspective Central Banks are a necessary evil. That is, if you want private banking where the money supply is essentially controlled by private banks who create money via an elastic market based loan creation process then we know we can’t also have no central clearinghouse. And we can’t have a private clearinghouse because history shows that the private clearinghouses shut down when they’re most needed (during banking panics). So, the Central Bank is the happy medium between having a fully nationalized banking system and a private system with publicly supported central clearing.

In addition, as I noted back in 2011,  Hamilton was instrumental in establishing the symbiotic relationship that the Central Bank and Treasury now have. And as we all know, it’s this lack of a symbiotic relationship within the common currency system that has contributed to so many of Europe’s woes. In other words, Europe is still waiting for their Alexander Hamilton to come along and create a fully united monetary union.  And thanks to Hamilton, the USA probably avoided a lot of financial woes that Europe is now experiencing.  In fact, the piping for the union was so strong that the USA boomed to become the largest economy in a very brief history.

So yes, I think Bernanke has this one right. Jackson probably doesn’t want his face on Federal Reserve notes to begin with.

2) The NY Times has a good piece on the “loneliness” of short sellers.  Short selling is alluring, but so difficult. Here’s how I think of it. The stock market is in a bull market about 75% of the time. And those 25% declines tend to be rather sharp and short lived. So, when you decide to short stocks what you’re really saying is that you can time the 25% of the time when the market will be declining. Those are tough odds.

And that doesn’t even take into account that you’re playing an inherently short-term game (incurring short-term capital gains taxes), incurring the fees of the trades AND you’re paying someone else to hold the position (margins and dividends). Add all this together and you can see why there just aren’t many short funds out there who last very long.

The bottom line is – shorting is really hard. If you ever get the urge to hedge a portfolio with shorts then it’s usually wise to consider a more attractive option.

3) 60/40 Forever?  I mentioned on Twitter yesterday how I’ve noticed that the 60/40 stock/bond portfolio seems to be recommended by almost everyone these days. It’s like I can’t read anything without seeing some reference to this being the greatest portfolio since, well, whatever was the latest untouchable investment portfolio to come along at certain times during the market cycle.

60/40 strikes me as particularly interesting at this time because it’s benefited tremendously from the greatest bull market in the history of bonds. After all, the bond aggregate has generated 7.4% returns in the last 35 years with a standard deviation of just 5.5. That’s relative to the stock market which generated 10.4% returns with a standard deviation of 18. It’s no wonder that 60/40 looks so good in backtests.

The problem is that this isn’t 1970 or 1980 with a likelihood of falling interest rates. It’s looking a lot more like 1940 when we’re on the verge of either low rates or slow and steady rising rates.  And we know that 10 year notes only generated about 2.7% between 1940 and 1980. It’s probably safe to say that bonds won’t do much better than that given that a 30 year T-Bond is locked in at about 3.2% as of today.  John Bogle thinks we’ll see 7% stock returns going forward which is not an unreasonable estimate considering an estimated equity risk premium of 5-6%.  And if Bogle is right then your standard 60/40 will generate an average annual return of about 5.2% or about half of what we experienced during the last 30 years.

Of course, the flip side is that the estimated ERP is too low and stocks do much better. Well, in that case you likely still won’t come close to generating the same nominal return (stocks would have to do about 15% per year) and you’ll certainly be taking a lot more risk than you think because well over 90% of the portfolio’s volatility will come from the stock portion. In other words, your 60/40 is so unbalanced in that world that it might as well be unhedged since the 40% bond component will be a practically meaningless contributor in relative terms.

The 60/40 of the next 40 years isn’t going to look like the 60/40 of the last 40 years. And it makes me wonder if a lot of investors aren’t piling onto an investing fad that is really nothing more than a big bond bull market that is long gone. And in doing so they’re either setting themselves up for low returns or much higher risk portfolios than they think.