What we are reading on 3/31/2017

Here’s what we are reading today. We do not necessarily agree with the opinions expressed therein and we disavow any actual or implied investment advice therein. In no particular order:
Satire: risk disclosure plain language
Figuring out how much you need to retire
Public employee privilege
The upside of deferred gratification
Blackrock throws in the towel on stock picking … a contrarian signal?
How to mismanage a $500,000 salary
Out of sample study of the profitability premium
The share of public stock listings continues to shift away from the U.S.
We are not supposed to worry about rising margin debt and consumer confidence?
How big is managed futures?
A forecast of the Fed’s path from here
Let’s hear it for humility
Memory enhancement strategies

The basics of call options

Options are available on a wide range of financial instruments.  An option is not like a stock; an option should be viewed as an agreement between two people.  An option can be created out of thin air, if the two parties can agree on the terms.

We will focus on stock options.  A call option on a stock provides the option holder the right (but not the obligation) to purchase a stock at a fixed price up until a certain date.  The key terms are:

  • the strike price:  the price at which the option holder can buy the stock
  • expiration:  the date on which the option expires
  • premium:  the price of the option

Call options come in a wide range of strike prices and expirations.

When an option’s strike price is the same as the price of the stock, the option is “at the money.”  When the strike price of a call option is lower than the stock price, the option is “in the money.”  Finally, when the strike price of a call option is higher than the stock price, the option is “out of the money.”

Expiration is self-explanatory.  Expiration dates can range from a few days to years.

Options can be purchased or sold for a premium.  The premium is set by supply and demand, through the actions of traders, investors and other market participants.

A person who purchases a call option can participate in the rise of the stock, but does not have to expose himself to the downside.  If, before the option expires, the stock rises in value so that its price is higher than the strike price, the option holder can “exercise” the option and buy the stock at the strike price; then immediately turn around and sell the same stock at the higher market price.  But, the investor has no obligation to buy the stock.  Therefore, if the stock declines such that it is worth less than the exercise price, the call option investor can walk away and not take a loss.

If a call option offers the investor upside potential with limited downside, someone has to take the opposite side of the trade:  downside potential with limited upside.  No one in their right mind would take such a payoff pattern unless they were adequately compensated for the risk.  In practice the option premium is sufficiently generous that the option writer (i.e., the option seller) feels he is more than compensated for the risk.


Inflation monitor as of 3/29/2017

Inflation has been trending downwards for decades.  We think the following factors have created this long-term trend:

  • an aging population that buys less
  • wage competition from third-world countries, due to globalization.

With talk of border taxes and rolling back globalization (at least partially), can we assume that the downward inflation trend will continue from here?  We don’t know, but we intend to track the numbers.  This post reviews a wide range of market-based and statistically derived measures of inflation.

Our takeaway:  after this month’s review of the data, we are revising upward our inflation estimate, from 1.5%-2.5% to 2.0%-3.0%.

Backward-Looking Measures

Consumer Price Index (CPI) – changes

The CPI is calculated by the government.  More than a few investors view the index with a degree of skepticism.

CPI:  +2.84%

Median CPI:  +2.49%

Core CPI:  +2.19%

Sticky CPI:  +2.63%

Trimmed Mean PCE:  +2.42%

Producer Price Index (PPI) – changes

The PPI is calculated by the government.  Some investors regard it with suspicion:

Finished Goods:  +4.12%


Wages are very important because they account for such a large portion of the cost of goods and services.

Average hourly earnings:  +2.76%

An increase in average hourly earnings does not translate into an equal amount of inflation.  Increases in productivity can offset (entirely or partially) the inflationary effect of higher wages.

Billion Prices Project

The billion prices project estimates the annual rate of inflation by using prices posted by online merchants.

As of the last publicly available data point, BPP estimates the U.S. inflation rate at annualized rate of about +0.7%.

Purchasing Manager’s Index

The Institute for Supply Management publishes the results of a monthly survey of their members, including a price diffusion index.  A diffusion index doesn’t tell us the rate of inflation, but rather what percentage of the survey respondents are seeing prices go up or down.

The survey results suggest no significant inflationary pressures.

Manufacturing Prices:  68.0

Services Prices:  57.7

Forward-Looking Measures

Treasury Inflation Protected Securities

In addition to ordinary bonds, the U.S. Treasury issues inflation-protected securities (TIPS).  By comparing the yields, one can infer the inflation forecast of the capital markets.

Ordinarily one should assign high credibility to this type of information. However, caution may be appropriate given extensive central bank manipulation of the credit markets.

Five Year Forecast:  +1.73% per annum (5Y Treasury Yield5Y TIPS Yield)

Ten Year Forecast:  +1.98% per annum (10Y Treasury Yield10Y TIPS Yield)

5-Year, 5-Year Forward Inflation Expectation Rate

Inflation expected from 5 years from now to 10 years from now:  +2.23%

Michigan Consumer Sentiment

1-Year Expected Rate of Inflation:  +2.4

5-Year Expected Rate of Inflation:  +2.2

ECRI U.S. Future Inflation Gauge

ECRI +0.4

Trend-based indicators

Crude Oil:  Uptrend = inflationary pressure

Copper:  Uptrend = inflationary pressure

U.S. Dollar:  Uptrend = deflationary pressure

What we are reading on 3/28/2017

Here’s what we are reading today. We do not necessarily agree with the opinions expressed therein and we disavow any actual or implied investment advice therein. In no particular order:
An evaluation of gamma hedging
Is there a downside to passive funds?
A lot happens in the last five minutes of trading
Why investors are migrating to bond ETFs
A contrarian stock ETF
Being wrong helps us learn
Are tontines the future of retirement?
How MSCI builds its indices
A periodic table of returns including alternative assets.
Questions a value investor should ask
What comes after coding?
Declining physical strength among men
Globalization threatens the welfare state
The narrowing circle of global winners
With health care reform dead, what are the prospects for tax reform?

Distressed Debt: What is it and why should a value investor care?

We define “distressed debt” as fixed obligations for which timely payment of interest and principal have stopped, are unlikely or are in serious doubt. Such obligations typically trade for dimes, nickels or pennies on the dollar. While legally these obligations remain debt, their precarious circumstances often cause them to exhibit the price volatility one would associate with stocks rather than bonds. Accordingly, we view them as “fair game” for any serious investor in undervalued stocks.

Companies do not typically issue distressed debt. Most companies that issue securities to the public have an appropriate balance of equity and debt, the market value of which are equal to the value of the company’s business. For example. let’s consider a retailer that generates $50 million of operating income. At a multiple of 8x, the retailer is worth $400 million. The market value of the company’s capital sources are also equal to $400 million. In this case, the company has been financed with $150 million of debt and $250 million of equity:


Now let’s imagine that the company is doing really well and profits grow to $75 million. At a multiple of 8x, the company is now worth $600 million:

We see that the value of the retail business is now greater than the original value of the debt and the equity combined. The value of the debt remains the same at $150 million. The value of the equity is the remainder ($450 million).

Now let’s imagine what happens if the company’s profits fall all the way to $30 million. At 8x, the company is worth $240 million:

The debt remains fixed with a value of $150 million. The value of the equity accounts for the remainder of the business value ($90 million, which is $240 million less the $150 million of debt).

Now let’s imagine that the business takes a further turn for the worse and operating profit drops to just $10 million. At this point, the company’s interest expense could be approximately equal to or maybe greater than the operating profit. Investors would have significant doubts as to the ability of the company to pay its debts.

At a multiple of 8x, the company’s business is worth just $80 million. Here’s where things get interesting:

The company’s business value is always equal to the fair value of its capital sources. To make the numbers balance, we first must assume that the equity is worth nothing. But zero equity value is insufficient to make the market value of the company’s capital sources equal to the market value of the business.

To make the numbers work, we must also mark down the value of the debt. In this case, the total value of the debt must equal the value of the business ($80 million). If the debt were to trade at 53.3 cents on the dollar, the $150 million would be worth only $80 million.

This is the kind of situation that qualifies as distressed debt. If one were to invest in such an opportunity, one would hope that the situation evolves in one of several positive directions. Perhaps new management successfully improves the profitability of the business, or maybe the company can sell some assets and pay down debt, or maybe a strategic acquirer purchases the company for a high price.

What we are reading on 3/24/2017

Here’s what we are reading today. We do not necessarily agree with the opinions expressed therein and we disavow any actual or implied investment advice therein. In no particular order:
Worried about stock prices are increasing
Skew risk pricing is now an outlier
AQR has packed hedge fund strategies for the masses
A new low in ETF expense ratios
Are stocks overvalued?
Free investment tools
Can one time factors?
A critique of levered ETFs
Institutions are scrounging for returns
Public pensions are becoming interested in securities litigation
Another quant pushes the research frontier
Does buying bad performing funds work?
Does the skew index have predictive value?
A contrarian case on 401k contributions
Nearly 1 in 200 Americans is an attorney
Lots of errors in psych research
Focusing on the present increases well-being
An investing blogroll

Retirement planning and life expectancy

In some ways, retirement planning is all about achieving the second of the following two outcomes:

  1. Running out of money before one runs out of time, or
  2. Running out of time before one runs out of money.

The time aspect of the equation deals with life expectancy.  An adequate retirement plan may become wholly inadequate if one lives an extra ten years. On the other hand, a much more luxurious retirement could be experienced if one correctly anticipates a relatively short life span.

Thus, having a good grasp of life expectancy is a critical component of retirement planning.  In answering this question, one can consider using some or all of the following tools:

SOcial Security Administration

The simplest of tools can be found on the website of the Social Security Administration.  The Life Expectancy Calculator provides an estimate of the number of remaining years one can expect to live based on one’s gender and birth date.  The estimate considers only the average results of a particular gender/age cohort.  It does not contemplate one’s healthy or unhealthy lifestyle.  It also ignores one’s genetics (e.g., did your mother and father die early?).

The Life Expectancy Calculator is a start but not a great answer.  It gives a single point estimate when a range of values is probably more useful.  For example, there is about a 50% chance one will live longer than the average life expectancy.  If that happens, then one wants to know by how many years one will outlive the average.  One extra year?  Five?  Twenty?  The Life Expectancy Calculator does not answer these questions.

The Social Security Administration’s Actuarial Life Table may help.  For example, according to the table a male of exactly 70 years has a 2.3528% chance of dying in the next year.  This also means a 97.6472% chance of living for more than one year.  A person with good math skills should be able to work out the probabilities of living to each age, up to the maximum of 119 on the table.  Like the Life Expectancy Calculator, the Actuarial Life Table does not consider the unique circumstances of an individual (e.g., the life expectancy implications of genetics and lifestyle choices).

John Hancock

John Hancock offers its own Life Expectancy Calculator.  This calculator may offer a more customized estimate of life expectancy because it accounts for a person’s unique circumstances, such as:

  • height
  • weight
  • blood pressure
  • cholesterol
  • exercise habits
  • alcohol consumption
  • driving habits


Do REIT valuations offset the tax advantages of REITs?

We believe that the stock market generally does not make widely available any “free lunches.”  From time to time low-risk, high-return opportunities may appear but they are rare.  In that light, we wonder whether the tax advantages of REITs are impounded in, and offset by, higher valuations on REIT shares. This is an impossible-to-answer question, but one that is worth considering.

We start with the idea that – all things otherwise being equal –  a higher stock price today means a lower expected long-term return in the future.  Over a sufficiently long time horizon, a stock is worth the present value of all the dividends it is expected to pay in the future.  If the present value of the expected dividends have not changed, then paying a higher price today simply reduces the expected rate of return.

In a highly competitive market for investment ideas, one should not expect that stocks with similar levels of expected risk should offer approximately the same levels of expected return.  Assuming the same level of expected risk, if stock A is expected to offer a higher return than stock B, investors would be expected to buy stock A and to sell stock B.

Buying and selling causes stock prices to move.  As we asserted earlier, over the long term, the higher a stock price today, the lower the expected future return. Contrariwise, the lower a stock price today, the higher the expected future return.

Thus, if the income tax code grants REITs a special tax advantage, we would expect the stock market to account for that advantage in the form of a higher stock price, which would have the effect of reducing the expected return of the REIT.  Stock market participants should bid up the price (and reduce the expected future return) until the REIT has the same expected future return as a taxable company with the same risk.

What we are reading on 3/21/2017

Here’s what we are reading today. We do not necessarily agree with the opinions expressed therein and we disavow any actual or implied investment advice therein. In no particular order:
An update on the permanent portfolio
The Dirtiest Word In Finance: Market Timing
Are universities becoming daycare centers?
Does skew mean anything?
How much upside does tax-loss harvesting offer?
A look at interval funds
The U.S. is ‘over-stored’
Being busy versus being productive
Time to thing globally?
Loud noises are worse for your hearing than earlier thought.
Fatty food makes a comeback
Simple stress reduction techniques.
People seem to think of themselves as nicer than they really are.
Maybe you don’t need to improve yourself.
Be careful if you depend on a public pension scheme.
Use car prices appear to be rolling over
Kansas’ experiment with tax cutting isn’t going so well
Hussman’s latest


Overconfidence is a well-established cognitive bias.  Investors need to understand how overconfidence affects investment decision making. For the investor, overconfidence manifests itself in several different ways.

Overconfidence may lead investors to believe that their past investment returns exceed what they actually achieved.  The obvious solution is to perform accurate return calculations.  In practice, coming up with meaningful return calculations is much harder than one might think. When return calculations are either inaccurate or non-existent, the overconfident investor fills up the information vacuum with a rosy, distorted view of the past.  Overconfidence may lead one to focus on the investments that did well while ignoring the poor performers.

Outside of investments, one can see such overconfidence in the public as a whole:  the average American considers himself an above average automobile driver.

Overconfidence may also manifest itself in an unwarranted belief that one has a correct, accurate and truthful understanding of an investment opportunity.  Sometimes, the more an investor “knows” about an investment, the more confident the investor becomes in his assessment of the investment’s prospects even if the “information” has little relevance. The investor’s confidence about his ownership of a company soars as he progresses from understanding value and momentum to memorizing its product line, visiting each of its field offices and interviewing sales trainees.

This form of overconfidence can also be seen in the paper industry analyst who gets promoted to portfolio management.  Paper stocks are cyclical and not a significant share of the stock market.  Therefore, a portfolio manager could ignore them most of the time:  if he is wrong and they go up, they are unlikely to move the market so much that the portfolio’s returns will suffer (the same cannot be said for other sectors such as technology or health care).  But the former-paper-analyst-turned-portfolio-manager will face constant temptation to own them because he “knows” the paper stocks so well.

One can protect against the dangers of knowing too much about an investment by deciding, in advance, what information best predicts future returns and ignoring all other information.