Blog

What we are reading on 2/24/2017

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:
Another dual momentum study
Time to cut back on social media.
About Charlie Munger …
Strategies for a low volatility market.
Mortgage debt has risen a lot.
A lot of people have difficulty saving.
Is there an investment opportunity in the age of shortened attention spans?
A close look at the decline in home ownership.
Small investors may have an advantage, if they can use it.
Hussman’s latest
Factor Zoo Or Unicorn Ranch
Should you ignore your portfolio?
Negotiation strategies.
This could be an interesting year for France.

Divergent Risk Control

Divergent investments offer a distinctive pattern of returns:  relatively numerous small losses punctuated by occasional large or very large gains. The accumulation of losses can test an investor’s patience and commitment to a divergent investment strategy.

Certain types of investments can offer divergent returns:  most trend following strategies, insurance contracts as well as certain strategies that involve buying options.

The following strategies may help one control the risk inherent in divergent investments:

  • Diversification:  divergent strategies can produce a reasonable return only if they get lucky with a big gain.  Otherwise, the investor is stuck with accumulating small losses.  By diversifying across a wide range of divergent strategies, an investor may increase his chances of obtaining at least one (and perhaps more than one) big payoff.  That big return could more than offset the small losses of the other divergent strategies.
  • Let profits run:  in a divergent strategy, the investor should consider “letting profits run.”  If the investor is too hasty in taking a profit, he may cut short his opportunity to make up for his losses.
  • Rebalancing:  in a diversified portfolio of divergent strategies, the few that generate profits will become a much larger part of the portfolio. Rebalancing so that equal amounts of capital are at risk gives the other strategies a fair chance of contributing to the future success of the portfolio.
  • Convergence:  convergent strategies tend to offer lots of small gains with the periodic large loss.  A convergent pattern of returns may diversify nicely a divergent strategy.

Inflation monitor as of 2/21/2017

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:  inflation is probably in the 1.5%-2.5% range with an upward bias.  If we see a continuation of recent data points, we will raise our estimate of inflation.

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:  +2.54%

Median CPI:  +2.52%

Core CPI:  +2.26%

Sticky CPI:  +2.62%

Trimmed Mean PCE:  +1.85%

Producer Price Index (PPI) – changes

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

Finished Goods:  +3.14%

Wages

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

Average hourly earnings:  +2.44%

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 -0.2%.

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:  69.0

Services Prices:  59.0

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:  +1.90% per annum (5Y Treasury Yield5Y TIPS Yield)

Ten Year Forecast:  +2.02% 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:  +2.14%

Michigan Consumer Sentiment

1-Year Expected Rate of Inflation:  +2.8

5-Year Expected Rate of Inflation:  +2.5

ECRI U.S. Future Inflation Gauge

ECRI +0.5

Trend-based indicators

Crude Oil:  Uptrend = inflationary pressure

Copper:  Uptrend = inflationary pressure

U.S. Dollar:  Uptrend = deflationary pressure

What we are reading on 2/21/2017

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:
Investment advisers sometimes offer more than investment advice.
Quantitative research on Nordic equities
ETFs and the future of factor investing.
A new ETF structure?
An update to Maslow’s hierarchy of needs.
On listening
What is going on with foreign treasury selling?
Is trouble brewing in residential lending?
Facts may not cause people to change their minds.
How should we interpret the decline in U.S. investment?
Creative potential of working on parallel projects.
Can Vitamin D prevent respiratory infections?
Is lower back pain going the way of the ulcer?
What is the brain’s default mode?
Does diet affect depression?
More on the gut-brain connection …
Will customer service problems slow Vanguard’s growth?
Hussman’s latest
Are value stocks still undervalued?
GMO’s latest seven-year forecast
Is there a way to avoid the early withdrawal penalty on an IRA?
Competition is the best 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:
Investment advisers sometimes offer more than investment advice.
Quantitative research on Nordic equities
ETFs and the future of factor investing.
A new ETF structure?
An update to Maslow’s hierarchy of needs.
On listening
What is going on with foreign treasury selling?
Is trouble brewing in residential lending?
Facts may not cause people to change their minds.
How should we interpret the decline in U.S. investment?
Creative potential of working on parallel projects.
Can Vitamin D prevent respiratory infections?
Is lower back pain going the way of the ulcer?
What is the brain’s default mode?
Does diet affect depression?
More on the gut-brain connection …
Will customer service problems slow Vanguard’s growth?
Hussman’s latest
Are value stocks still undervalued?
GMO’s latest seven-year forecast
Is there a way to avoid the early withdrawal penalty on an IRA?
Competition is the best motivator
Can carrots make you more attractive?

Slow and fast thinking

The brain appears to have two modes of thinking:  slow and fast.

Slow thinking happens when we try to use reason to think through a problem.  According to recent research, such deliberations occur in the frontal cortex which itself carries on a wide range of functions including problem solving, memory, judgment and social behaviors.  This part of the brain has the ability to guess the future consequences of current choices and to discriminate between better or worse courses of actions.  It can identify socially unacceptable responses and suppress them.

Slow thinking can be very helpful in dealing with investment problems.  The ability to weigh evidence, to speculate about the future effects of actions taken today and to make well-informed decisions is critical to one’s success as an investor.

When compared to slow thinking, fast thinking appears almost as a reflex. Fast thinking in part can be linked to activity in different parts of the brain, depending on context.  The amygdalae are involved in the emotion of fear and in linking certain memories and actions to fear.  The amygdalae are essential to our survival:  they allow us to react very quickly to perceived threats and thus to avoid injury or even death.

According to one study, conditioned responses to positive stimuli may involve the hippocampus.  The hippocampus is buried deep in the brain. It appears to be heavily involved in the conversion of short-term memories into long-term memories.  A damaged hippocampus can result in amnesia with respect to short-term memories but not long-term ones.

Scientists have inferred that the amygdalae and hippocampus are involved in fast thinking by monitoring brain activity in certain experiments.  When subjects engage in fast thinking, either or both areas of the brain show increased activity.

Fast thinking has a role in investing, although perhaps not always a positive one.  The emotions of fear (negative; in the amygdalae) and greed (positive; in the hippocampus) can influence investor thinking and decision making.

What we are reading on 2/17/2017

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:
We may have to assume we live a bit longer in retirement.
TAA insights
An inflation-stock market model
The valuation of smart beta strategies
Americans hit new peaks in stress!
Individual ownership of stocks has shifted to retirement accounts.
Possible drivers of currency returns.
Keeping costs low is an important part of retirement.
ETFs are surprisingly tax efficient.
A Bitcoin ETF primer
Are we late in the credit cycle?
Inflation has ticked up.
Where are the software developers?

Don’t make this mistake when analyzing an oil company

Some investors attempt to value the common stock of an oil and gas company using familiar metrics such as price-to-earnings, price-cash-flow or similar ratios.  The problem is that these metrics do not account for reserves.  One such consider the PV10 instead.

Reserves are the oil and gas that the company has in the ground.  They are a source of future cash flow that the company realizes when it produces the reserves and then sells them into the market.

Each unit of production reduces the value of reserves in the ground.  If the company does not spend money to replace production, reserves will decline.  Eventually, a company that fails to replace its produced reserves will eventually have nothing left to produce and go out of business. Companies fail to replace produced reserves because they choose not to (i.e., they don’t spend the money), they make bad decisions (i.e., they spend the money unwisely) or they have bad luck (i.e., they spend wisely but still don’t find anything). Reserve life is how many years of reserves the company has at current rates of production.

Companies with many years of reserves should be valued more highly than companies with fewer years of reserves.  Long-lived reserves imply staying power:  such companies can make mistakes and still recover. Companies with short-lived reserves cannot afford to make mistakes.

From a safety perspective, a long reserve life is preferable to a short reserve life.  But leaving the reserves in the ground produces no return for the shareholder.  Therefore, when reserves are too long-lived the company’s profitability may be too weak to keep the company out of bankruptcy.

Reserve life carries other analytical baggage.  One can reasonably assume that finding new reserves costs more when oil and gas prices are high. When prices are high, lots of companies will have money to spend on new exploration and development projects.  Competition will tend to push costs upwards.  When prices are low, costs should fall due to less money being available.

To maximize long-term profitability, an oil and gas company should produce rapidly when prices are high and cut production when prices are low.  They should do the opposite for investments in new reserves – when prices are high they should cut back, but invest more heavily when prices are low.  But such a strategy would wreak havoc on reserve life:  it would plummet when prices are high and extend dramatically when prices are low.

The “PV10” conveniently summarizes all of this information into a simple table.  “PV10” is a present value calculation using a 10% discount rate. The SEC requires oil and gas companies to estimate the present value of future production of oil and gas, using a 10% discounting rate to account for the timing of such cash flows.  One can find it by doing a word search on the term “10%” in a company’s form 10-K.

PV10 can be criticized.  The 10% discount rate should bear some relation to the uncertainties surrounding a company’s reserves. The discount should be higher in when there is more uncertainty.  A higher discount rate means a lower present value of reserves.  may not be the best discount rate for a particular company.

Similarly, the PV10 is calculated using oil and gas prices as of a point in time.  Most of the time, today’s oil and gas prices are not the same as the prices used to calculate the PV10.  The present value is not a linear function of the prices of the commodities.

After making adjustments, one should compare the PV10 to the value of the reserves on the company’s balance sheet.  If there is a significant difference, one can revise one’s estimate of the fair value of the stock.

Clearly PV10 is not a perfect measure, but to our thinking its a lot better than price-to-earnings or price-to-cash-flow ratios and reserve life.

This assumes that the company in question is truly an oil and gas company.  If the company’s business includes other types of assets such as pipelines, refineries, chemical plants or retail gasoline service stations, the above analysis would apply only to the oil and gas portion of the company.

Convergent Risk Control

As we saw in an earlier article, convergent investments produce a distinctive pattern of returns:  relatively frequent but modest positive returns with an occasional large or very large loss.  Wall Street pros sometimes refer to this pattern of payoffs as “picking up nickels in front of a steamroller.”  The idea is that one gets to collect all these nickels but it might end very, very badly if one’s finger gets caught by the steamroller (and then one’s arm, and then the rest of one’s body).

A wide range of investments may offer convergent returns, including bonds (most of the time) and stocks (some of the time).  Certain option strategies also offer convergent returns (i.e., writing options).

The following strategies may help one control the risk inherent in convergent investments:

  • Diversification:  the greatest convergence risk occurs when an investment suffers a total and permanent loss of value.  Prudent diversification may reduce the risk of disaster.  Some assets are better for diversification than others.  For example, diversifying one apparel retail stock with another apparel retail stock may not achieve much in the way of diversification.
  • Undervaluation:  we think overvalued assets are at greater risk for large losses than undervalued assets.  If one can choose among a range of assets with convergent return properties, the risk of a large loss may be lower with the more undervalued assets.
  • Quality:  assuming no difference in valuations, we believe the higher quality asset is less likely to suffer a catastrophic loss.  Reducing exposure to speculative investments may be a way to reduce the risk of disaster.
  • Contractual cash flows:  consider investing in financial instruments where the cash flows are contractual rather than at the discretion of management.  This would mean eschewing stocks in favor of bonds.  Note that for speculative bonds, credit rate risk may have a lot in common with equity risk.  Therefore, if one wants to reduce interest rate risk in favor of equity-like risks, then one could consider owning speculative-grade and/or distressed bonds.
  • Recomposition:  sometimes, despite one’s best efforts, a well-diversified portfolio of convergent assets suffers a large loss; too many of the assets suffer a significant loss at the same time.  In that case, recomposition may make the best of a bad situation.  With recomposition, one attempts to capitalize on misfortune by reducing exposure to the convergent assets that did somewhat badly and increasing exposure to the convergent assets that performed the worst on the theory that they are the most undervalued (see “undervaluation” above).
  • Divergence:  divergent strategies may offset some of the disaster risks of convergent strategies.  Divergent strategies have a return pattern of many small losses with the occasional large gain.

 

What we are reading on 2/14/2017

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:
If you miss the move, what should you do?
Understanding bull and bear markets
Hedge funds and the low volatility effect
How an investor can deal with emotions
Tax-exempt bonds and tax reform
The global stock ETF
Does residential solar power make sense?
How moving changes your personality.
The case for HIIT: high intensity interval training
Humanity is weakening physically.
One explanation of why kids cost so much
Thinking about the future of the Euro
Leverage in the housing market.
Are America’s foreign creditors getting worried?
A look at Reality Shares
Hussman’s latest

Good news for insomniacs!

Who says the U.S. government cannot solve your problems?  If you are an insomniac, hope has arrived in the form of the 2016 Financial Report of the United States Government.  Reading this 274-page tome from cover to cover should put you to sleep.

On the other hand, if you are a taxpayer and can understand financial statements, this same document may cause you to lose some sleep.  Not that 2016 is any different than 2015, 2014, 2013 or many other years.

First, we draw your attention to page 11.  A single table dominates this page:  “Table 1:  The Federal Government’s Financial Position and Condition.”  The last row of the table is labeled, “Unified Budget Deficit” and shows a $587.4 billion deficit for the fiscal year ending September 30, 2016.

We contrast the $587.4 billion deficit with the actual increase in federal debt for the same period, which can be found here:

9/30/2015 = $18,151 billion

9/30/2016 = $19,573 billion

Change = $1,422 billion

Interesting that the actual federal debt is rising much faster than what the deficit suggests.  Somehow they left out of the “unified budget deficit” an incremental $835 billion of borrowing.

But there’s more to the story.  If you turn back to “Table 1:  The Federal Government’s Financial Position and Condition,” you will see a row labeled “Social Insurance Net Expenditures” for the amount of (46.7) trillion dollars.

The detail on the amount can be found on p. 61, in the row labeled “Total present value of future expenditures in excess of future
revenue” (the last row in the table).  This is the amount we taxpayers can be expected to spend on entitlements such as Social Security and Medicare over the next seventy-five years, net of expected tax revenues.

Notice how the 46.7 trillion in 2016 is higher than the 41.5 trillion net spending projection in 2015, and the 38.6 trillion in 2012. The jump in 2016 was 5.2 trillion, with an average annual increase since 2012 of about two trillion.

So what is the correct deficit calculation:

$587 billion, as the government calculates it?

$1,422 billion, as measured by the change in Federal Debt?

$6,622 billion, which is the sum of the change in Federal Debt plus the change in entitlements?