Another sign that I have no idea what's going on with Mr. Market these days (or ever):
Bond prices continue to go higher, driving yields lower. Some are already trading with negative yields. This might be due to central bank influence, general risk-aversion, or lower inflation (or growth) expectations or a combination of such.
Corporate profits continue to drop. The latest figures show that trailing-twelve month profits peaked at 106 in Q3 2014. Most recent figures were ~86.5 for Q1 2016. That's close to a 20% drop.
On the other hand, US equity markets are making new highs. Looking at the S&P 500, you wouldn't have noticed the decline in profits. In fact, since Q3 2014, the S&P has actually gone up another 100 points or so, gaining well over 5%. Equity markets seem to believe that either discount rates will go lower, or earnings have stabilized and will rebound from this point. (Both of which are possible.)
One explanation might be the central bank's actions pushing investors toward riskier assets. Holding all else equal, this make sense. By effectively reducing the risk-free rate, and hence, discount rate, asset prices should go higher.
In this case, however, all else may not be equal. That's because the reason for all this monetary stimulus is that economic conditions are weak. So while discount rates are lower, the expected earnings growth may also be lower. Given the two adjustments, it's unclear to me whether equity prices should be higher, lower, or flat.
Sunday, June 12, 2016
Wednesday, April 27, 2016
The Condensed Wealth of Nations
I recently read a condensed version of the Wealth of Nations. The book was written by Eamonn Butler and published by the Adam Smith Institute. I wanted to read the original but it would have been a challenge given its epic length and older language.
This condensed version was excellent. It captured the key points of the original such as the specialization of labour, benefits of trade, role of the invisible hand and others while using modern day vocabulary. For example, capital is used instead of "stocks" as in the original. To enhance your understanding and provide a flavour of authenticity, the author also included some of the Adam Smith's well-written prose.
One point I found especially interesting was Adam Smith's writing on wealth and money. In his days, most people believed in mercantilism and that wealth is derived from the amount of "money" (aka gold or silver). This of course led to hoarding and trade restrictions. Countries didn't want their gold leaving their borders. Adam Smith accurately noted that wealth comes from the value of the products and services that someone produces. Money was just a way to measure that wealth and to make transactions more efficient. (Rather than having to barter all the time.)
The irony is that, some 200+ years after this book, in an age of fiat currencies, many people and countries continue to believe in mercantilism.
This condensed version was excellent. It captured the key points of the original such as the specialization of labour, benefits of trade, role of the invisible hand and others while using modern day vocabulary. For example, capital is used instead of "stocks" as in the original. To enhance your understanding and provide a flavour of authenticity, the author also included some of the Adam Smith's well-written prose.
One point I found especially interesting was Adam Smith's writing on wealth and money. In his days, most people believed in mercantilism and that wealth is derived from the amount of "money" (aka gold or silver). This of course led to hoarding and trade restrictions. Countries didn't want their gold leaving their borders. Adam Smith accurately noted that wealth comes from the value of the products and services that someone produces. Money was just a way to measure that wealth and to make transactions more efficient. (Rather than having to barter all the time.)
The irony is that, some 200+ years after this book, in an age of fiat currencies, many people and countries continue to believe in mercantilism.
Sunday, April 24, 2016
Another Global Housing Bubble?
In 2007, excessive debt led to a housing boom and bust of extraordinary proportions. Household debt in a handful of countries peaked in 2007, at the height of the boom. The countries (ex. US, UK, Spain) that went through the crisis have somewhat de-levered their household balance sheets. Household in many other countries, unscathed by the crisis, have continued their relentless borrowing.
For example, Australia, Canada, Norway and Netherlands have household debts far higher than the U.S. at its peak. There are likely structural differences for the different levels of debt such as regulations, lending practices, interest rates, etc. But how much is too much? At some point too much debt will increase the risk to the entire financial system. One argument for higher debt is that interest rates remain low. The servicing costs of debt is relatively stable despite much higher borrowings. On the other hand, household debt is typically used for consumption or to buy a house, not the most productive use of capital given the low returns on rent. As more and more money gets tied into illiquid, unproductive assets, who ends up paying off the debt? Will the principal ever be repaid?
Even as the world recovery remains tepid, the housing markets in many of these countries caught on fire, fueled by debt-driven demand. Take Canada, a country whose economy is closely associated with the U.S.. With commodity prices facing severe overcapacity and weak export demand, the country's GDP growth has been weak. Yet, housing prices in the country's two main cities, Toronto and Vancouver, have been extremely strong with prices growing by double-digits year-over-year.
Foreign demand has certainly played a role in driving up prices. Yet, it's probably disingenuous to attribute all of the price action to foreign capital. Just looking at the base rate, with millions of households in these two cities, the prime buyers of Vancouver and Toronto real estate remain the residents of these cities. But how can locals afford ever increasing prices with relatively stagnant wages? Hint: credit growth. Consumer in Canada has continued to grow at around 6% annually, or double the rate of GDP growth mainly due to lower interest rates. As such, the carrying costs of owning a house in these two regions have been relatively flat despite the higher debt levels. The question remains, unless wages pick up significantly, how will people afford to repay the debt?
I suspect that, most probably won't. The repayment of debt will likely be shared by society. At some point, too much debt changes from a household problem to a systemic problem. (They will in the traditional sense, but because their wages got a boost from higher inflation.)
In Canada, around 50% of mortgages (mostly high LTV) are insured by the CMHC, a government entity. Mechanism like these help de-risk the system in the event of a financial crisis. However, it means that the costs of a potential debt crisis will be borne by all members of society.
The fall-out will likely be even lower rates and a depreciation of the currency, which decreases real purchasing power so that nominal wages can stay flat or rise moderately. Or higher inflation to boost nominal wages, even as real purchasing power stays flat, which will erode the value of liabilities over time.
This leads to a dilemma for the investor. Do you remain financially prudent even though you will borne the costs of society's excessive leverage, or do you become financially imprudent to try and benefit from the eventual fallout?
For example, Australia, Canada, Norway and Netherlands have household debts far higher than the U.S. at its peak. There are likely structural differences for the different levels of debt such as regulations, lending practices, interest rates, etc. But how much is too much? At some point too much debt will increase the risk to the entire financial system. One argument for higher debt is that interest rates remain low. The servicing costs of debt is relatively stable despite much higher borrowings. On the other hand, household debt is typically used for consumption or to buy a house, not the most productive use of capital given the low returns on rent. As more and more money gets tied into illiquid, unproductive assets, who ends up paying off the debt? Will the principal ever be repaid?
Even as the world recovery remains tepid, the housing markets in many of these countries caught on fire, fueled by debt-driven demand. Take Canada, a country whose economy is closely associated with the U.S.. With commodity prices facing severe overcapacity and weak export demand, the country's GDP growth has been weak. Yet, housing prices in the country's two main cities, Toronto and Vancouver, have been extremely strong with prices growing by double-digits year-over-year.
Foreign demand has certainly played a role in driving up prices. Yet, it's probably disingenuous to attribute all of the price action to foreign capital. Just looking at the base rate, with millions of households in these two cities, the prime buyers of Vancouver and Toronto real estate remain the residents of these cities. But how can locals afford ever increasing prices with relatively stagnant wages? Hint: credit growth. Consumer in Canada has continued to grow at around 6% annually, or double the rate of GDP growth mainly due to lower interest rates. As such, the carrying costs of owning a house in these two regions have been relatively flat despite the higher debt levels. The question remains, unless wages pick up significantly, how will people afford to repay the debt?
I suspect that, most probably won't. The repayment of debt will likely be shared by society. At some point, too much debt changes from a household problem to a systemic problem. (They will in the traditional sense, but because their wages got a boost from higher inflation.)
In Canada, around 50% of mortgages (mostly high LTV) are insured by the CMHC, a government entity. Mechanism like these help de-risk the system in the event of a financial crisis. However, it means that the costs of a potential debt crisis will be borne by all members of society.
The fall-out will likely be even lower rates and a depreciation of the currency, which decreases real purchasing power so that nominal wages can stay flat or rise moderately. Or higher inflation to boost nominal wages, even as real purchasing power stays flat, which will erode the value of liabilities over time.
This leads to a dilemma for the investor. Do you remain financially prudent even though you will borne the costs of society's excessive leverage, or do you become financially imprudent to try and benefit from the eventual fallout?
Monday, April 18, 2016
Spy the Lie: Three Former CIA Officers Reveal Their Secrets to Uncloaking Deception
As the title suggests, this book was written by three former CIA officers trained in polygraph testing and interrogations. They've developed a technique to help you detect deception and potentially uncovering the truth by asking the right questions and listening for certain responses.
The conventional wisdom is that you should be looking at the subject's global responses, such as how their eyes move, how they sit, the manner of their speech, to determine whether they are telling the truth. The author's suggest otherwise. That's because most people have idiosyncratic behaviour so responses to questioning vary widely. A lot of these behaviours tend to be "noise" instead of "signal".
Instead, the authors focus on the contents of the answer along with a narrow set of behavioural cues that are correlated with deception. The key is to look for a "cluster" of these deceptive responses and behaviours following a question and to continue with the line of questioning until you reach the truth.
Interestingly, I found that their method has similarities to investing. Sometimes, it may be better to focus on the key drivers of an investment thesis than to look at every aspect. By tuning out the "noise", it might make it easier to identify good investments. This could also be part of the reason so many research analysts can know so much about a company but not know whether it's a good investment or not.
Finally, while reading this book made me aware of the techniques, I am far from becoming a lie-detector. Achieving that type of competence will require years of training and practice. Again, more similarities to investing.
The conventional wisdom is that you should be looking at the subject's global responses, such as how their eyes move, how they sit, the manner of their speech, to determine whether they are telling the truth. The author's suggest otherwise. That's because most people have idiosyncratic behaviour so responses to questioning vary widely. A lot of these behaviours tend to be "noise" instead of "signal".
Instead, the authors focus on the contents of the answer along with a narrow set of behavioural cues that are correlated with deception. The key is to look for a "cluster" of these deceptive responses and behaviours following a question and to continue with the line of questioning until you reach the truth.
Interestingly, I found that their method has similarities to investing. Sometimes, it may be better to focus on the key drivers of an investment thesis than to look at every aspect. By tuning out the "noise", it might make it easier to identify good investments. This could also be part of the reason so many research analysts can know so much about a company but not know whether it's a good investment or not.
Finally, while reading this book made me aware of the techniques, I am far from becoming a lie-detector. Achieving that type of competence will require years of training and practice. Again, more similarities to investing.
Friday, April 1, 2016
How to Fail at Almost Everything and Still Win Big
This is a fun book by Scott Adams, the creator of the Dilbert comic strips. The book is meant to provide some meaningful and practical advice for success and share some of the author's experiences.
The big emphasis was on using a system rather than setting goals to achieve success. A system is similar to a set of routines or "best-practices". By having a good system, success will come to you. For example, rather than setting a goal of "good health", you should create a system where you have to exercise actively. This way, you ensure that the goal is achieved without even intending to do so.
The book also has many practical life advice, such as improving your personal energy through diet and exercise or learning a list of necessary skills (ex. learning basic psychology, writing, communication, etc.) to improve your odds.
Surprisingly, I found a lot of the advice is relevant for the investor. As an investor, your personal abilities are critical to investment success. The book has helpful tips on increasing personal energy. The most important of which is to have systems that enhance your diet, sleep and exercise. Having more energy can potentially help enhance investment results through clearer thinking and better research stamina.
In addition, investing is a highly process/system driven activity. Having goals, ex. "achieving xx% returns" can be detrimental since you can't control how markets behave over the short-term. By sticking to a good system, ex. buying stocks at a discount to NAV, you are more likely to achieve investment success over the long-run.
I did find that some advice, for example, "affirmations", strayed a bit into the superstition. His constant emphasis on the "diversity ceiling" and ability to self-diagnose and cure some of his diseases are also somewhat hard to believe.
That said, most of the advice was useful. A lot of was just common sense, but some would call it wisdom. After all, common sense is almost an oxymoron in real life. After reading the book, I've created a long list of things to do/learn. Time to get started.
Analyst
The big emphasis was on using a system rather than setting goals to achieve success. A system is similar to a set of routines or "best-practices". By having a good system, success will come to you. For example, rather than setting a goal of "good health", you should create a system where you have to exercise actively. This way, you ensure that the goal is achieved without even intending to do so.
The book also has many practical life advice, such as improving your personal energy through diet and exercise or learning a list of necessary skills (ex. learning basic psychology, writing, communication, etc.) to improve your odds.
Surprisingly, I found a lot of the advice is relevant for the investor. As an investor, your personal abilities are critical to investment success. The book has helpful tips on increasing personal energy. The most important of which is to have systems that enhance your diet, sleep and exercise. Having more energy can potentially help enhance investment results through clearer thinking and better research stamina.
In addition, investing is a highly process/system driven activity. Having goals, ex. "achieving xx% returns" can be detrimental since you can't control how markets behave over the short-term. By sticking to a good system, ex. buying stocks at a discount to NAV, you are more likely to achieve investment success over the long-run.
I did find that some advice, for example, "affirmations", strayed a bit into the superstition. His constant emphasis on the "diversity ceiling" and ability to self-diagnose and cure some of his diseases are also somewhat hard to believe.
That said, most of the advice was useful. A lot of was just common sense, but some would call it wisdom. After all, common sense is almost an oxymoron in real life. After reading the book, I've created a long list of things to do/learn. Time to get started.
Analyst
Friday, March 25, 2016
Quantitative Easing and High Asset Prices
As you are aware, since the global financial crisis, central banks around the work have embarked on an unprecedented amount of monetary easing. During the crisis, a shortage of liquidity in the financial system caused central banks to step in with monetary stimulus to provide liquidity and restart the financial system.
The global economic shortly fell into a severe recession, which was followed by increased monetary stimulus to try to increase nominal growth. Political gridlock surrounding fiscal stimulus and structural reform has made it extremely difficult to ease economic conditions on that front. This became part of the reason for continued and increased monetary stimulus.
Monetary policy was aimed at lowering interest rates, ideally below the rate of inflation/nominal growth, (ex. 10Y German/Japanese Gov. Debt) which increases asset prices (ex. S&P 500) and pushes investors into riskier assets. By elevating asset prices, the idea was that, it will repair overly-indebted balance sheets and force investors to consume or invest in the real economy.
Interestingly, while asset prices have continued to rise, economic activity has failed to match its pace. There's probably a lag between monetary stimulus and real "main street" economic activity. After 7 or so years, you have to wonder whether things are working and when activity will truly pick up.
I also wonder, whether there are negative aspects to the distorting effect of elevated asset prices. One potential pitfall may be the creation of asset bubbles. There's already plenty of talk of extreme housing prices in many parts of the world including Hong Kong, Sweden, Canada, Australia, etc. Would a negative feedback loop also exist? For example, as expected returns from assets become lower (due to the elevated prices), people may try to save even more in order to have enough for their retirements. Secondly, stimulus works to generate demand, but it may also have a supply-side effect. Lower rates may stimulate more output and capacity than demand.
Another question is whether central banks can continue easing. In a recent G20 speech, Mark Carney, Governor of the Bank of England made a few points that I'm would like to emphasize here:
"However, the effect of QE on the wealth channel cannot last forever. Monetary neutrality means real asset prices are not boosted indefinitely by such policies; their economic effects must ultimately unwind."
"Said differently, unless an improvement in fundamentals boosts the underlying cash flows of these assets, real valuations will fall back. That structural policies have not boosted real growth sufficiently is a better justification for the re-pricing in risk markets than any loss of confidence in the power of central banks."
This puts the investor in a tough spot. Some central banks have hinted that they will support asset prices until economic fundamentals pick up and start to reflect the elevated asset prices. Yet, if fundamentals remain weak over extended periods, the market may adjust downward regardless of central bank support.
You have to make the choice of either:
1) Purchasing expensive financial assets due to explicit central bank support, but face the risk of central banks withdrawing support, or real growth failing to pick up.
2) Not purchasing expensive financial assets, but face the risk of continued asset price appreciation and miss out on a potential recovery. And also, potentially unfavourable movements in inflation or currency as monetary policy flows through these other channels.
Not sure, what the best choice is. This post really raises more questions than answers.
Analyst
The global economic shortly fell into a severe recession, which was followed by increased monetary stimulus to try to increase nominal growth. Political gridlock surrounding fiscal stimulus and structural reform has made it extremely difficult to ease economic conditions on that front. This became part of the reason for continued and increased monetary stimulus.
Monetary policy was aimed at lowering interest rates, ideally below the rate of inflation/nominal growth, (ex. 10Y German/Japanese Gov. Debt) which increases asset prices (ex. S&P 500) and pushes investors into riskier assets. By elevating asset prices, the idea was that, it will repair overly-indebted balance sheets and force investors to consume or invest in the real economy.
Interestingly, while asset prices have continued to rise, economic activity has failed to match its pace. There's probably a lag between monetary stimulus and real "main street" economic activity. After 7 or so years, you have to wonder whether things are working and when activity will truly pick up.
I also wonder, whether there are negative aspects to the distorting effect of elevated asset prices. One potential pitfall may be the creation of asset bubbles. There's already plenty of talk of extreme housing prices in many parts of the world including Hong Kong, Sweden, Canada, Australia, etc. Would a negative feedback loop also exist? For example, as expected returns from assets become lower (due to the elevated prices), people may try to save even more in order to have enough for their retirements. Secondly, stimulus works to generate demand, but it may also have a supply-side effect. Lower rates may stimulate more output and capacity than demand.
Another question is whether central banks can continue easing. In a recent G20 speech, Mark Carney, Governor of the Bank of England made a few points that I'm would like to emphasize here:
"However, the effect of QE on the wealth channel cannot last forever. Monetary neutrality means real asset prices are not boosted indefinitely by such policies; their economic effects must ultimately unwind."
"Said differently, unless an improvement in fundamentals boosts the underlying cash flows of these assets, real valuations will fall back. That structural policies have not boosted real growth sufficiently is a better justification for the re-pricing in risk markets than any loss of confidence in the power of central banks."
This puts the investor in a tough spot. Some central banks have hinted that they will support asset prices until economic fundamentals pick up and start to reflect the elevated asset prices. Yet, if fundamentals remain weak over extended periods, the market may adjust downward regardless of central bank support.
You have to make the choice of either:
1) Purchasing expensive financial assets due to explicit central bank support, but face the risk of central banks withdrawing support, or real growth failing to pick up.
2) Not purchasing expensive financial assets, but face the risk of continued asset price appreciation and miss out on a potential recovery. And also, potentially unfavourable movements in inflation or currency as monetary policy flows through these other channels.
Not sure, what the best choice is. This post really raises more questions than answers.
Analyst
Saturday, February 6, 2016
The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It
I recently read The Quants by Scott Patterson while on vacation. This book was decent as light-reading material. The author chose to write this book in a series of stories and anecdotes covering several leading quant/"hedge fund" managers from their inception to the end of the financial crisis.
It's unclear how the line between "quant" and "hedge fund" manager was drawn. My understanding was that "quants" are the financial engineers building complex mathematically-driven products and trading strategies. Some of the "quants" featured in the book seemed to focus on more fundamentally-focused strategies like capital-structure arbitrage or value-driven investments.
While the book was good for an airplane read, it mostly just scratched the surface on these quant operations. The writing was also disjoint and the story jumps across characters and time-frames. By the end, you sort of get an idea of what happens, but not really. I would love to hear more details on how Renaissance Technologies actually generate those eye-popping returns, it's highly secretive, and this book does unveil much.
I did learn something interesting though. I hadn't realize how big of an influence Edward Thorp has on the current generation of top "quant" investors. Judging by the stories, it seemed like every hot shot investor of today has read one of this books. Thorp seems like a household name in those circles, much like Buffett or Graham is in value circles. Maybe it's time to read one of Thorp's books.
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