An Idea Whose Time Has Come

Laurence Siegel et al of his ilk have really thrown a gauntlet to the financial services industry.

But first: I don't like Laurence's close ties and basic advocacy of insurance products and insurance companies - because I don't trust them (they are run by actuaries with ROI hurdle rates on products). Because insurance companies can't control market returns they control their shareholder returns by embedding high costs into their products to cover their business and market risk.

Having said that, Laurence has outlined a simple, robust way for the industry to meet and support the post retirement needs of retirees. To this end he advocates the creation of new low cost annuity companies insulated from corporate default risk structured as follows:

• Separate corporate structure insulated from financial exposure to affiliated companies.
• All reserves held in default-free Treasury bonds and TIPS and properly hedged to the liability as closely as possible at all times.
• “Participating” policies, so that any longevity surprises are used to reduce annuity benefits proportionally instead of forcing the insurer to default entirely on some of the benefits (after going bankrupt)
  Advocate for setting up a 20 year TIPS ladder based on expected withdrawal rate complemented by a deferred income life annuity to protect against longevity risk.
  
• Very broad participation so there is little adverse selection.
  Withdrawal rate or spending rate based upon an annually recalculated variable annuity (ARVA).
   

The retirement investment structure that we’ve been describing doesn’t need teams of “quants” or financial engineers to create it. Mostly it involves a lot of effort in changing the culture of the investment business, refocusing it on doing what’s best for the consumer. The needed changes are not only cultural but also institutional, legal and regulatory. And, once the products are built, an incentive structure needs to be developed that motivates advisors and salespeople to place investors in these products. (and therein lies the problem)

These ideas are something the industry should, and can easily do, but won't because it can't make money from it. Someone will no doubt have a go at it but are likely to struggle. It will be a number of years before the industry mutates toward this model.

Too Binary, Too Static...Not Out Ahead Of It

It is not that I don't know the main factors related to financial markets and investment decision making or the nuances with respect to said factors, but I find myself too binary in my thinking. All too often I read an article which highlights an important principle or issue which I was aware of and/or agree with, and wonder to myself why didn't I write that.

I find myself too binary. Too static. Even though I know all the issues and am aware of the balls in play, I struggle to get ahead of the herd.

M&A Activity - Blistering (In More Ways Than One)

3G Capital (Warren Buffett) in talks to buy Kraft foods. Seems to me we are seeing no let up in acquisitions or mergers. This leads me to believe we are still some way from the bull market capitulation. Usually 6-9 months after the last major deals.

We have seen 297 deals in the $1b+ range over the last year, 211 in the $500m-$1b range, and 326 in the $250m-$500m range. Collectively, more than $1.86 trillion in deals over the last year.

Lots of deals. Lots in the healthcare space. A lot of misallocated capital coming down the pike.

6 Year Bull Market Covers Over Essence

A rising market blinds. Everyone who has held a long position in the market is a genius.

It blinds you to who is skillful and who is just riding the trend. Hint: 95% are riding the trend (but attributing their good fortune to their own skill).

The next major market correction will provide another flush. That is how markets work. Not because they have some innate mental calculation embedded in them, but because markets and their extremes are a reflection of human nature and human psychology.

Many amateur wannabes will be caught in the downdraft because they misunderstood that their returns were due to serendipitous good fortune and not of their own making.

Buffett was right"only when the tide goes out do you discover who has been swimming naked."

The Blinders of Thinking You Did It Yourself

We attribute good results to our own intelligence and good decisions, and we attribute bad results to poor luck or circumstance. This is the nature of man.

Cassandra Does Tokyo captures some of the fallacy of this narcissism in a recent post:

Giving is easy - taking is hard
http://nihoncassandra.blogspot.com/2015/03/giving-is-easy-taking-is-hard.html
...How quickly investors forget. If you'd asked large asset owners in late 2008, or early 2009: "Would you give up a tranche of the future capital gains in asset prices in exchange for a floor under prevailing prices, and the near-assuredness of significantly higher asset prices in the future?", I am quite sure of the answer, given the widespread systemic fears and paucity of alternatives at the time. Investors, after all, pay 2&20 to HFs and PE for essentially the same (pre-tax) premise. Was not QE effectively the same proposition multiplied across the entire economy? The liquidationist alternative was clearly unpalatable to asset owners, and sub-optimal for nearly everyone else. IF, as the result of a policy directive, you bestow large windfall gains, it would be only fair to harvest a an additional share of those for the Public's Interest, since the goal of QE policy was NOT to further stoke inequality, nor accelerate the growth of fortunes for existing asset owners, but rather to prevent unnecessary liquidation, and deflation so private-sector balance sheet deleveraging could work its course, and to foster stability, so reviving private investment decisions in the real economy. But, as it happens, giving is far easier than taking away - irrespective if you're a welfare deadbeat (not my language) or a leveraged rentier...
...Asset owners peculiarly act as if such windfalls somehow resulted from their own brilliance. Many, through every over-leveraged fault of their own, were a pubic-hair's breadth away from financial obliteration, saved by US - and I don't mean the United States, but rather you, and I, as representations of the taxpayer, or bag-holder as the ultimate underwriter of newly issued debt. Others - particularly in the tech world and on the left coast - are blind to the benefits wrought by munificence of The People, and the abundant liquidity finding its way into every inane crevice, and spilling over to provide VC's and PE investors exits at multiples unimagined even three years ago. And the "thanks" that all those west-coast libertarians afflicted with self-attribution bias, is to piss on the under-class who serve them, and wish for a Randian offshore tax-haven to insure they share as little as possible with the undeserving multitudes. These gripes are academic, but asset-owners would do well to reflect upon their self-attribution bias...

Red herring - Yield that counts

Red herring - distracting attention from an issue by introducing an irrelevant issue or one that is only superficially related to the one being discussed.

I am not sure that is the right fallacy to be using here, but I am sure a fallacy is carried out when investors focus on dividend yields or buyback yield and neglect the true yield (Earnings or FCF Yield).

The equivalent canard in done in the return area when investors focus on dividend yield or buyback yield when they should be looking at total return (capital appreciation + income).

The yield (equity) investors should be concerned with is the earnings yield (not the dividend yield and/or the buyback yield).

With investors searching for, and in many cases chasing yield, they are often focused on the wrong thing.

Earnings yield translates into ROE.

Keep that in mind the next time someone wants to talk about dividends and yields. Yield chasers are making an error of false alternatives by neglecting to focus on total yield (aka Earnings Yield).

Reaching For Yield

For the past forty years, investors were accustomed to bond yields sufficient to generate enough income to cover the traditional 4% withdrawal rate. With the 30 yr bond trading below 3% and the 10 yr bond trading below 2.5%, this approach has become much harder to achieve in current markets. 

Bonds are still a portfolio diversifier, but with in the current low yield environment they offer lower returns and less portfolio protection than they have in the past. As a result, many investors are seeking higher yields elsewhere and in the process are incurring higher risks than what they may have bargained for. Here are the main trade-offs:

Action                                                           Effect
Overweight high-yield bonds                                                           Increases credit risk/increased volatility

Overweight longer term bonds (extend duration)                            Increases interest rate risk

Overweight dividend paying stocks                                                 Skews exposure to certain sectors

Shift from bonds to dividend paying stocks                                     Increases portfolio's overall volatility and risk


Investors need to keep in mind that concentrating assets in higher yielding investments can lead to increased risk and volatility. These strategies can be damaging to your portfolio's overall health.

An alternative to reaching for yield by moving out on the risk-return spectrum is to take a total return approach (viewing your portfolio from both a capital appreciation and a yield perspective), harvesting capital gains (which incidentally is often more tax efficient than receiving interest income) to make up withdrawal needs.

Solving the failure to deliver problem!

The financial advisory industry has a problem. For years it promoted active management and beating benchmarks. To wit, it is slowly but surely realizing it cannot deliver on those implicit contracts. And to make matters worse, the industry is promoting performance based outcomes when it has no control over the performance or the outcomes. The marketing gurus are going to have to put their thinking caps on and come up with a solution. And this is what they are doing! The solution from what I hear is to redefine success from beating a benchmark to being on track to meet a long term goal and to focus on process. I think the focus on process is a positive (along with tax & estate planning). But the redefinition of success seems to be a fudge or smokescreen for underperformance. Something along the lines of "the greatest trick the Devil ever pulled was convincing the world he didn't exist" translated to "the greatest trick the financial advisory industry ever pulled was convincing investors that underperformance was overperformance" or when in doubt redefine the benchmark.

Ultimately I think the industry will paint itself in a corner again. The irony is that Charlie Ellis has been pointing in the right direction for years (putting asset management outcomes in the context of educated investment counsel). The problem is the industry cannot adopt his suggestions because it means losing a lot of money. This is how deeply entrenched systems work. Vested interests cling  to the old ways even as the foundations are eroding all around. Eventually a catastrophic collapse takes place and the foundations are rebuilt anew from the rubble.

Zero Hedge - The Flipside of the Sellside

I read Zero Hedge everyday. I find the writing witty, pithy and insightful. They are my news source of choice when I want comment and insight to either breaking news or other issues that warrant understanding.

It boggles my mind that they have been so unrelentingly wrong (at least from a helping people make money perspective). It just proves the adage that perma-bear arguments always sound more insightful and compelling than the conflict ridden cheerleading of Wall St.

Zero Hedge is going to be right one of these days. That is just how it works. As they say, even a broken clock is right twice a day. They will likely do numerous victory laps and tout their superiority from the rooftops. When they do, they will exhibit the same lack of integrity as the Wall St shrills they take shots at everyday.

Caveat emptor!

What Is Market Efficiency?

No one knows what intrinsic value really is. That is what makes a market. Myriad investors with different amounts of money, different levels of sophistication and different motives place their bets and the current market price is where that supply and demand meet.

I believe there is such a thing as intrinsic value. However, intrinsic value is in the eye of the beholder (different investors use different discount rates, different growth and profitability assumptions, different multiples) and is better looked at as something within a band or range of values (as compared to a singular point estimate). At a micro level that band is narrower for individual companies than it is for the market as a whole. As you add companies to the investment universe, the number of factors, level of uncertainty and multitude of different individual value ranges expands the general market's intrinsic value range.

So, for example, a company's intrinsic value may range between $18-$22 given all currently available information. This might translate to a multiple of 14x-16x based on an historic average multiple of 15x. This does not mean a company's stock will be priced within its intrinsic value range. Conversely, the general market's intrinsic value may range between $16-$24 based on cumulative individual valuations with a multiple ranging from 12x-18x based on a historic average multiple of 15x.

When the market price (and a company's price) is within its intrinsic value range you should go with the trend (momentum). When the market price goes outside its intrinsic value range that is when you should adopt a contrarian or mean reversion position.

80% of the time, the market trades within its intrinsic value range. But there are times when "animal spirits" (whether fear or greed) commandeer the zeitgeist and lead to exploitable inefficiencies (playing defense when things are overcooked and offense when things are falling apart).

Helter Skelter

It amazes me the extent to which I am harassed and harried when going into queues or getting into lines with lots of people around.

Basically I'm neurotic and have little appreciation for how good I actually have it in the modern world.

Just saying.

The Loneliness of a Long Distance Runner

What is my aptitude?

Do I have the courage to act upon it?

Smart Investing Is Smart Business

It amazes me that people who have been phenomenally successful in creating and building valuable businesses - people we call "good businessman" - are often bad investors. And not just bad investors in the sense that they make lousy investment decisions (they do that also, but that is a post for another day). But bad investors in the sense of not knowing the price they pay for financial services and not knowing the pros & cons of the strategy(ies) they have hooked their 'barrow to. Quite simply, when it comes to managing their financial wealth, they leave their business brains at the door. When in their business would they not carry out the requisite due diligence to not pay more for something than they need and when in their business would they not want to understand the rules of the game. For whatever reason (usually social norm because they are friends and run in the same circles) they trust their advisor is doing the best thing for them. That is a false assumption that has cost a lot of people a lot of money over the years.

A little bit of education and a little bit of knowledge can go a long way to minimizing those kinds of mistakes.

Secular Cycle vs Cyclical Forces

The secular cycle portends the positivism of growth, expansion and rising productivity. It also increasingly includes certain headwinds from changing demographics over the next 50 years.

Cyclical stimulus (monetary and fiscal) has managed to delay, defer and extend the full impact of the prior cycle's contraction. The question is whether such actions have got us over the hump or whether there will be a price to be paid? and if so, what the price will be?

The price is likely to be a rebalancing of labor/capital wealth distribution (probably through taxes) and lower growth. To some extent we have already seen some of those factors playing out: higher taxes and lower relative growth.

Why Are Interest Rates So Low?

Quite frankly, I don't really know and I can't make heads or tails of it. The current environment is a classic case of my habit of missing regime/paradigm shifts. The scales usually drop way after the trend or the event has manifested itself.

There are numerous reasons posited:

• Savings glut (this one is a mystery to me when you look at savings rates relative to history and trends...the argument is the savings glut comes from China/Russia/Brazil).
• Supply deficit (can't quite work this argument out; I think it relates to QE and lack of collateral).
• QE (combination of reduced supply and scramble for collateral).
• Financial repression (combination of debt overhang and distorted price signals from QE).
• Low inflation (yes inflation is low and has been trending down...let's call it declining inflation, but it is still positive and real rates are low). 
• Fears of deflation (I don't see deflation...commodities have taken it on the chin in the last year, but asset prices have gone through the roof and commodity prices are cyclical).
• Fears of market collapse/capital protection (maybe...but those Wally's have all missed the boat).
• Currency wars (fight to the bottom). 

I just can't understand why any investor would settle for a negative interest rate. This makes no sense to me at all. US rates look as attractive as ever relative to European rates. European rates are crazy. What are they telling us? Imminent collapse in the Euro? Maybe!

It should be noted, that you can't talk about why interest rates are so low in the US without taking account as to why they are so low (or even much lower) elsewhere.