Benjamin Swan

July 1, 2017

Rubber Duckies

Benjamin Swan

July 1, 2017

Imagine a bathtub full of rubber duckies. Most of them are bright yellow and cheerful eyed with permanent Mona Lisa beaks. But perhaps there are a few other colors, shapes, and sizes mixed in. Maybe, if this particular bathtub is anything like the one I remember my kids playing in, there are a few plastic sharks, whales, and maybe a penguin or a platypus thrown in for good measure. My favorite was always the wind-up scuba diver flippering along endlessly intrigued by who-knows-what under the bubbles. Regardless of the particulars of the floating toys, when you turn on the bath water they all float. Water in, duckies up. Water out, duckies down.

Asset prices and money (credit) behave in much the same way. When there is more money around, assets appreciate (expansion) and when there is less money around, assets depreciate (contraction). Money in, prices up, Money out, prices down.

This is obviously a simplification excluding the longer term human factors in the economic process (namely innovation and population growth). However, it serves our purpose as a way to visualize boom and bust market dynamics. An booming market can defined as the value of the stuff (stocks, bonds, real estate, money markets) people own going up relative to the size of the economy (GDP) and a bust defined as the inverse. This ratio (Household Net Worth to GDP) is shown in the following chart well over half a century.

During the period of 1945 to the early 1990's the price of assets (measured in units of economic production) remained range bound. Measured this way, asset valuations gradually rose into the early 1960's, fell as inflation became pronounced and eventually peaked in 1980, and then rose again ending entire fifty-year period close to where they began.

However, since the early 1990's the credit and market cycles have been particularly pronounced with asset valuations rising substantially overall with sharp corrections during the recessions following the tech stock boom of the late 1990's and the housing bubble culminating in the Great Recession of 2008- 2009. Over the past 25 years, aggregate asset valuations rose over 40% according to this measure.

Going back to our rubber ducky analogy, the household net worth line in the chart above is similar to the rise and fall of the floating toys (e.g. prices of stocks, bonds, real estate) in the bath. Why do they go up and down? Because of the amount of water (money/credit) in the tub.

A boom is created by a combination of available money (money, debt, credit are fairly interchangeable) and a reason (a narrative or story) to buy. There are almost as many ways to measure amounts of money and credit in our modern economic system as there are economists. Certain types of credit and debt instruments have become much more liquid and increasingly used to buy assets at the macro (Inter-bank) level. We'll use treasury securities, government agency securities (Fannie Mae mortgage securities for example), and Federal Reserve credit. The prevailing narrative depends on the period.

In 1990, there were about $2.5T of Treasury Securities, $1.5T of Agency Securities and $340B of Federal Reserve Credit. These three sources added up to $4.25T, or 71% of GDP. A decade later, at the end of 2000, the total stood at $8.34T or 81% of GDP (Treasury $3.36T, Agency $4.35T, Fed $635B). The narrative of that era was American Technological Dominance. This was the era when the Cold War was one, when America displayed overwhelming military force in Iraq (Operation Desert Storm), when the personal computer became ubiquitous, and the Internet was born. Confidence and optimism abounded. Booming markets fueled by credit growth certainly didn't hurt.

And then the technology bubble burst, resulting in widespread bankruptcies among Internet, telecom, and technology companies. The result ultimately was large stock market losses (particularly the richly-valued technology stocks), and a US Fed determined to rapidly drop interest rates (at the time the prominent Central Bank tool) and "reflate" the markets.

The chart below shows the course of Federal Reserve interest rates over the same time horizon as the net worth chart from before. This shows the Fed's efforts to react to recessions (the grey bars on the chart) by lowing borrowing rates aggressively. A critical aspect of our analysis is that there is no free lunch in economics and no way to "print to prosperity". Deliberate intervention in markets carries a cost even if that cost is not immediately recognized.

In 2002 economist Paul Krugman, Nobel prize winning professor of economics at MIT and Princeton wrote about the difference between typical economic fluctuations and credit boom-bust dynamics. He even specifically called for the Fed to create a housing bubble to replace the Nasdaq bubble! The following is a direct quote from his "Dubya's Double Dip" article written in August 2002 in the New York Times, "The basic point is that the recession of 2001 wasn't a typical postwar slump, brought on when an inflation-fighting Fed raises interest rates and easily ended by a snapback in housing and consumer spending when the Fed brings rates back down again. This was a prewar-style recession, a morning after brought on by irrational exuberance. To fight this recession the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. And to do that, as Paul McCulley of Pimco put it, Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble. Judging by Mr. Greenspan's remarkably cheerful recent testimony, he still thinks he can pull that off."

The housing bubble was indeed created. As all good replacement bubbles must, it exceeded the previous bubble in scope. Toward the end of the mortgage finance and housing price bubble in 2007, Treasury securities exceeded $6.0T, Agency securities had surged to $7.4T and the Fed's balance sheet chipped nearly another trillion dollars at $950B. The total then stood at $14.4T or 99% of GDP.

The narrative shifted to the American Dream of Home Ownership (also plausibly named "Real Estate Always Goes Up"). With mortgages easy to obtain and rates declining, the lure of gains and fear of missing out combined with widely availability of real estate financing to drive prices upwards. Eventually rising interest rates and declining affordability slowed the boom. A recognizable characteristic of credit booms is that when the growth ends, a bust follows.

We know what happened next. In 2007, the housing bubble popped and credit growth turned sharply negative as one lender after another approached bankruptcy. The Federal Reserve repeated its burst bubble prescription, recently learned in the early 2000's, and turned again to forcing interest rates lower and encouraging credit growth. This time though, lower interest rates and optimistic talk weren't encouraging enough. The FASB accounting standards board changed rules to no longer require banks to value their credit portfolios at market prices and the Fed created a new tool. Called Quantitative Easing (QE), Central Banks led by the US Fed began creating money to purchase bonds and other credit instruments. These efforts stopped the bust in its tracks,and got credit growing again by early 2009. As shown below, heavy Central Bank money creation and asset purchases have been a persistent feature of global financial markets ever since.

What has unfolded in monetary and credit terms since early 2009 is astonishing. As of the end of 2016, Treasury securities had reached $16.0T. Surviving the mortgage bubble bust (Fannie Mae and Freddy Mac insolvency and receivership), and returning to growth, Agency securities stood at 8.52T. The Fed’s balance sheet ended 2016 at $4.43T. Again, the replacement credit boom has exceeded the preceding credit bust. The total of these sources of credit now stands at nearly $29T or 156% of GDP.

Today's narrative is Interest Rates Will Stay Low (as will inflation and economic growth). This story points to continued scarcity of yield (earnings, cash-flow, profits, and dividends) and the unfortunately common refrain in today's financial media that There Is No Alternative to investing in common stocks even as richly valued as they admittedly are.

It is futile to try to predict exactly when and how the market's prevailing winds will shift, but history shows us that nothing lasts forever. With recent coordinated efforts by Central Bankers to inch rates up and rein in asset purchases (QE), the initial steps may now be taking place.

(Additional investment specific commentary follows for client subscribers)

References:

http://www.nytimes.com/2002/08/02/opinion/dubya-s-double-dip.html?scp=4&sq=krugman%20mcculley%20bubble&st=cse

http://creditbubblebulletin.blogspot.com/2017/06/weekly-commentary-washington-finance.html?m=1

https://fred.stlouisfed.org/graph/?g=cvIg

http://www.bloomberg.com

SVANE CAPITAL, LLC IS A REGISTERED INVESTMENT ADVISOR. INFORMATION PRESENTED IS FOR INFORMATIONAL AND EDUCATIONAL PURPOSES ONLY AND DOES NOT INTEND TO MAKE AN OFFER OR SOLICITATION FOR THE SALE OR PURCHASE OF ANY SPECIFIC SECURITIES, INVESTMENTS, OR INVESTMENT STRATEGIES. INVESTMENTS INVOLVE RISK AND UNLESS OTHERWISE STATED, ARE NOT GUARANTEED. INTERNATIONAL INVESTING INVOLVES SPECIAL RISKS INCLUDING THE POSSIBILITY OF SUBSTANTIAL VOLATILITY DUE TO CURRENCY FLUCTUATIONS AND POLITICAL UNCERTAINTIES. AN INVESTMENT CONCENTRATED IN SECTORS AND INDUSTRIES MAY INVOLVE GREATER RISK THAN A MORE DIVERSIFIED INVESTMENT. THERE IS NO ASSURANCE THAT A DIVERSIFIED PORTFOLIO WILL PRODUCE BETTER RETURNS THAN AN UNDIVERSIFIED PORTFOLIO, NOR DOES DIVERSIFICATION ASSURE AGAINST MARKET LOSS. ANY GRAPH PRESENTED CANNOT IN AND OF ITSELF BE USED AS THE SOLE DETERMINANT IN MAKING AN INVESTMENT DECISION. GRAPHS ARE HISTORICAL DEPICTIONS AND HAVE INHERENT LIMITATIONS IN MAKING INVESTMENT DECISIONS AND CANNOT PREDICT THE FUTURE RESULTS OF ANY INVESTMENT. PAST PERFORMANCE IS NOT AN INDICATION OF FUTURE PERFORMANCE. BE SURE TO FIRST CONSULT WITH A QUALIFIED FINANCIAL ADVISER AND/OR TAX PROFESSIONAL BEFORE IMPLEMENTING ANY STRATEGY DISCUSSED HEREIN.

Benjamin Swan

March 1, 2017

The most important price in the world

Benjamin Swan

March 1, 2017

The most important price in the world is the price of money because it affects the price of everything else. How much does it cost in the future to get enough money to buy that tractor now? A farmer knows how much more corn he’ll get by having a newer, larger tractor. He knows the value of the tractor, but the price he’s able to pay depends on the interest rate. The price of money.

If the farmer decides to buy the tractor now, he’ll improve the productivity of the farm. The tractor maker will show a profit and hire more workers. Those tractor workers will buy cars to get to work. The car maker will show a profit and hire more car workers. Those workers will buy houses. You get the point. Lots of good things will happen in the economy if our favorite farmer decides to buy a tractor.

But there is a small catch. He will pay for that tractor in the future. The tractor he buys today means he can’t buy one next year. There is no free lunch. Sandwiches do cost money and the sandwich we eat today can’t be eaten tomorrow. Tractors are similar. But, the interest rate, will determine when the farmer buys the tractor and at what price. By way of example, if he qualifies for a 72 month 0.9% interest only loan, he will likely decide differently about that $100,000 tractor, then if he must come up with $10,000 in interest each year.

We write all that about farming and tractors to say this. The United States is the center of capitalism for the whole world. However, the very most important price, the price of money, is set by a committee sitting in a dark, smoke filled room. Seriously. Okay, it’s 2017 so the room is probably neither dark, nor smoke filled, but the effect is the same. The unelected Federal Reserve sets the most important price in the world by mandate.

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Benjamin Swan

February 1, 2017

Good news doesn't sell ads

Benjamin Swan

February 1, 2017

Emotions are running high due to political “what-if’s”
But very little has changed in terms of market fundamentals
Thinking as a long-term owner and buying pessimism when possible

Look at any newspaper, television channel, or social media app and the intensity of politically supercharged emotions becomes apparent. The old saying that good news doesn’t sell is probably worth repeating here. Regardless, the rhetoric and actions of the Trump administration is front and center everywhere one looks, with talking heads often ascribing current market action and future forecasts to the recent political winds of change. We think this is a mistake.

The general economic mood has certainly been strongly positive. On Friday, the closely followed University of Michigan consumer sentiment indicator reached the highest levels in 13 years. Not since 2004, have consumers been so optimistic about their financial situation. Richard Curtin, the director of the consumer survey said that consumers “reported much more positive assessments of their current financial situation due to gains in both incomes and household wealth, and anticipated the most positive outlook for their personal finances in more than a decade”.

In contrast to this level of optimism and the cacophony from the news media, markets have been quiet. Similarity, fundamental valuations and long-term outlooks for most asset classes have remained much more stable than many investors might guess. What should we make of this? Probably not too much.

Being a relaxed long term owner

Long-time Wall Street analyst Lucian Hooper wrote “What always impresses me is how much better the relaxed long-term owners of stock do with their portfolios than the traders do with their switching of inventory. The relaxed investor is usually better informed and more understanding of essential values; he is more patient and less emotional; he pays smaller capital gains taxes; he does not incur unnecessary brokerage commissions; and he avoids behaving like Cassius by ‘thinking too much’”.

Contrast this sound advice with the wonderful double self-contradictory “advice” delivered by Will Rogers in one-liner fashion. “Don’t gamble. Buy some good stock. Hold it till it goes up, then sell it. If it doesn’t go up, don’t buy it!”. (For extra credit, can you spot both contradictions?) We are convinced that many “investors” foolishly try to follow Rogers’ “advice”!

Buying pessimism when possible

While we certainly want to think as long term owners and avoid hasty decisions, the other component of our investing strategy is to take advantage of market opportunities that come from other market participants’ emotional decisions. We seek to identify periods of both overwhelming fear and panic and also of wild optimism and euphoria. In the first case, we can benefit from the resulting bargains and in the second, we can lower our risk by steering clear.

Famous value investor Sir John Templeton remarked “People are always asking me where is the outlook good, but that’s the wrong question. The right question is ‘Where is the outlook most miserable?’” He expands on the thought noting that “There is only one reason a share goes to a bargain price: Because other people as selling. There is no other reason. To get a bargain price, you’ve got to look for where the public is most frightened and pessimistic. Bull markets are born in pessimism, grow on skepticism, mature on optimism, and die on euphoria.”

So buying pessimism and selling euphoria is a great plan! Just figure out where the market is trading on the handy chart above and buy or sell accordingly. Of course, as Mike Tyson famously quipped, “Everyone has a plan until they get hit in the mouth!”. We try to moderate our expectations regarding our ability to measure and determine where in the cycle a given asset class is at any point in time. In fact, as long term investors we are doing well if we can merely tell whether we’re closer to pessimism or to euphoria and then over or underweighting a given position accordingly.

Benjamin Swan

December 1, 2016

Investing

Leave it alone!

Benjamin Swan

December 1, 2016

Investing

Some things just ought to be left alone. My son and I have often disagreed on this point. "Leave it alone!" "Why are you touching that?" "Stop rolling the window up and down." "Would you please stop pushing that button?" "Don't bother your sister." "Turn the windshield wipers off." "DO NOT PLUG THAT SCREWDRIVER INTO THE POWER OUTLET!"

Many investors to share his tendencies.

Meb Faber wrote a great study on various asset models called Global Asset Allocation. The book is a detailed performance analysis of eight "reasonable" but very different allocation strategies over the most recent forty year period.

These portfolios had stock allocations as low as 25% and as high as 90% (Warren Buffet's famous 90/10 allocation). They included a bond allocation from 10% on the low end to 55% on the high end. Real assets (commodities, real estate, natural resource equities) ranged from 0% in, two of the eight portfolios, all the way up to 50%.

While the reading is admittedly a bit dry, the conclusion is remarkable. Over the forty year period, these eight very different strategies all produced annual returns within 2% of each other (8.5% to 10.4%)!

On the surface this might not seem all that amazing, after all it matches what we've all been told about investing for the long run, right? However, consider that for "shorter" periods of seven to ten years (that surely must have felt like an eternity to under-performing investors) it wasn't uncommon for a given allocation strategy to have been outperformed by up to 100% by other strategies. That brings a whole new meaning to patience, doesn't it?

But the penalty for lacking patience can be harsh. The often quoted and annually updated DALBAR study shows that actual composite mutual fund investors returns have averaged only 2-3% over a thirty year period in which stocks returned better than 11% per year and bonds returned more than 7%. The only possible explanation for this huge performance discrepancy is investors buying after period of price appreciation and selling after periods of losses.

The last few weeks have been an excellent example of the temptation to "touch things" as investors have bid up industrial stocks (e.g. the Dow Jones Industrial Average or DJIA) and sold off gold mining stocks (the Philadelphia Gold and Silver Index or XAU). As often happens when prices change, sentiment (mood) indicators are now depressed for the mining shares and ebullient for industrial stocks. Does this make sense? Thirty years from now, we can be fairly confident that industrial companies will still be doing industrial things, and miners will still be mining gold. Trees won't grow to the sky, and gold won't become worthless. On the contrary, over many years, economic expansions, and recessions, it is quite likely that both US industrial companies and gold will maintain substantial value. However if you had to take either a share of General Electric or a gold coin, and then play Rip Van Winkle for a century, I bet you'd take the coin!

Understanding all of that, why wouldn't a rationale long term investor be more inclined to buy a little bit more of what is on sale and a little bit less of what has been marked up? First of all, my son would tell you it's because sitting still is tough sometime. Secondly, our human brains have learned that doing more of what feels good is fun. But following those normal psychological instincts flat out doesn't work for investing. Prices go up and down as a normal part of markets and the best way to lock in poor long term investment performance is to change strategy when it doesn't "feel good". Fortunately, good habits can eventually be learned with enough reinforcement...my son no longer tries to plug things into power outlets!

Benjamin Swan

November 1, 2016

Energy

Natural Resources

Benjamin Swan

November 1, 2016

Energy

Summary:
•   Natural resources can add portfolio diversification and stability
•   Natural resource stocks are a good option and…
•   appear historically under-weighted and undervalued

The Case for Natural Resources Equity Investments
Natural resources are things like corn, cattle, wheat, coffee, iron ore, copper, natural gas, timber, oil, silver, and gold. They are sometimes consumed directly, as food and gasoline are, and they are also important inputs to the economic processes that create goods and deliver services. As input prices rise, the economic profit usually decreases in an economy. To use a very simple example, if a bakery must pay more for wheat flour and is unable to raise prices by a corresponding amount, the bakery’s profit will decline. Therefore, it follows that resource prices can often move inversely to the general economic ebb and flow.

Unlike financial assets like stocks and bonds that derive their value through a combination of expected cash-flows and the interest rate at which those cash flows are priced, natural resources are valuable in and of themselves. While often volatile, with significant gains and losses in the short term, this inherent value leads to price stability and reduced risk over longer periods of time.

By investing in companies that produce, harvest, manage, or conserve natural resources we can gain stock market returns (the equity risk premium) while also obtaining the diversification benefits of the natural resources themselves. The following charts from GMO show the long-term diversification benefits of including resource equity investments in an investment portfolio (Note: These charts specifically refer to energy and metals stocks due to the availability of long term historical data for these specific types of resource equities. Public investment options in agriculture equities have only recently become more widely available, but similar conclusions apply):

Despite these noteworthy portfolio benefits, investors generally do not have significant natural resource equity exposure. In recent years as commodity prices retreated, both the US S&P 500 and the global MSCI ACWI stock market index exposure to energy & metals dropped by more than 50%:

However, current valuations of natural resource stocks are near 90 year lows when compared to their general stock market brethren:

In summary, natural resources can provide excellent diversification for investment portfolios and currently appear under-weighted and undervalued by many investors. By including these types of investments as specific asset classes and increasing our allocation to them, we may improve our long-term portfolio stability and return.

Reference:
White, Lucas. Grantham Mayo Van Otterloo & Co. LLC. An Investment Only a Mother Could Love: The Case for Natural Resource Equities. 2016. www.gmo.com

Being a relaxed long term owner

Buying pessimism when possible

Summary:• Natural resources can add portfolio diversification and stability • Natural resource stocks are a good option and…• appear historically under-weighted and undervalued

Summary:
• Natural resources can add portfolio diversification and stability
• Natural resource stocks are a good option and…
• appear historically under-weighted and undervalued