It feels like we are in the slough of despond.
Fighting a market is not a wise thing (least of all on the positive side of the economic/market cycle). Taking your medicine and getting with the game is always easier said than done.
The markets incessant march onward and upward since its August lows is wearing us down. Just "buy the dip" is the mantra of the moment.
I'm thinking we're not far from a nice pullback, and "sell the rip" is probably a better banner.
Doubling down is a very dangerous sport, but can sometimes cover over a multitude of sins.
The courage to be, and the courage of ones convictions are in short supply. But at some point you've got to take a stand.
Friday, February 11, 2011
Thursday, January 13, 2011
The Problem With Relative Value*
Virtually every asset class looks attractive relative to bonds right now (except for cash**).
And that is the problem when you have an externality like a central bank setting interest rates. That distortion of the supply/demand nexus, sets up an imbalance. In the current case, it is the misallocation of resources within an economy toward risky assets*** (although it is highly ironic that petrified retail investors actually sought out bonds like a giffen good).
Relative value investors (and that is what most are) look at those signals and from them determine that equities, commodities, precious metals, real estate, you name it, are attractive relative to bonds. And they are. The problem is bond yields are at artificially low levels, and when they normalize (a.k.a., go up) those assets that looked attractive relative to bonds previously no longer look as attractive.
Proper analysis of risk assets should incorporate normalized growth, margins, and discount rates into their framework, otherwise they risk falling for the "relative value illusion" and a host of other fallacies (ie. cyclical illusion, history will repeat illusion, et al).
*Actually there are numerous problems associated with relative value analysis, but that is for another day.
**But even cash looks attractive if you believe bond rates are going to go up.
***Actually, the misallocation may be less to risky assets, than to risky behavior.
And that is the problem when you have an externality like a central bank setting interest rates. That distortion of the supply/demand nexus, sets up an imbalance. In the current case, it is the misallocation of resources within an economy toward risky assets*** (although it is highly ironic that petrified retail investors actually sought out bonds like a giffen good).
Relative value investors (and that is what most are) look at those signals and from them determine that equities, commodities, precious metals, real estate, you name it, are attractive relative to bonds. And they are. The problem is bond yields are at artificially low levels, and when they normalize (a.k.a., go up) those assets that looked attractive relative to bonds previously no longer look as attractive.
Proper analysis of risk assets should incorporate normalized growth, margins, and discount rates into their framework, otherwise they risk falling for the "relative value illusion" and a host of other fallacies (ie. cyclical illusion, history will repeat illusion, et al).
*Actually there are numerous problems associated with relative value analysis, but that is for another day.
**But even cash looks attractive if you believe bond rates are going to go up.
***Actually, the misallocation may be less to risky assets, than to risky behavior.
Friday, December 31, 2010
Good bye 2010
Good bye 2010. Can't say I am sad to see you go. The beauty of a new year is that it promises something better.
2010 was a classic recovery in the economy and the market. Doom and gloom still resonate, and it probably won't be until blue skies and sunshine return that the piper will next come calling.
Lesson learned. Don't fight the Fed. Easier said than done, when every fiber of your being thinks it an emperor with no clothes.
Here's to 2011, and the hope for conviction.
2010 was a classic recovery in the economy and the market. Doom and gloom still resonate, and it probably won't be until blue skies and sunshine return that the piper will next come calling.
Lesson learned. Don't fight the Fed. Easier said than done, when every fiber of your being thinks it an emperor with no clothes.
Here's to 2011, and the hope for conviction.
Monday, November 8, 2010
All Roads Lead to Inflation
At this point, all roads lead to inflation. This may be strange given that there are strong deflationary forces brought about by the deleveraging from a balance sheet recession still in the system.
But if you take a step back. The Fed is implicitly (if not explicitly) trying to create it. The third world is experiencing it. Risky asset prices are reflecting it. The markets are beginning to come around to it.
We're playing with fire here.
Most historical studies indicate that inflation is generally positive for risky assets, but too much inflation is bad. Hyperinflation is another thing all together, leading to the wipe out of an existing order/system. But even if we don't see hyperinflation, only inflation, there are assets that provide a better store of value than others. What inflation does is force you to do something. You can't just sit there (and especially not at the moment with cash and bond yields so low).
If it true that all roads lead to inflation, then how can investors best preserve their purchasing power? What stores of value will help protect investors against inflation? How should investors best approach this problem? Investors need to take greater risk with their asset allocation. Being fearful and leaving money in cash or bonds is perhaps the worst thing they can do.
But if you take a step back. The Fed is implicitly (if not explicitly) trying to create it. The third world is experiencing it. Risky asset prices are reflecting it. The markets are beginning to come around to it.
We're playing with fire here.
Most historical studies indicate that inflation is generally positive for risky assets, but too much inflation is bad. Hyperinflation is another thing all together, leading to the wipe out of an existing order/system. But even if we don't see hyperinflation, only inflation, there are assets that provide a better store of value than others. What inflation does is force you to do something. You can't just sit there (and especially not at the moment with cash and bond yields so low).
If it true that all roads lead to inflation, then how can investors best preserve their purchasing power? What stores of value will help protect investors against inflation? How should investors best approach this problem? Investors need to take greater risk with their asset allocation. Being fearful and leaving money in cash or bonds is perhaps the worst thing they can do.
Tuesday, November 2, 2010
Why are bond yields so low?
There are myriad reasons why bond yields are so low. I have found it useful to list them so that I have a framework for seeing the various parts and gauging how they change over time. Here is why bond yields are so low:
(1) Relatively low inflation.
(2) Exceptionally low short term rates (controlled by the Fed).
(3) The investor fearful of deflation.
(4) The investor fearful of equities.
(5) The investor who is simply fearful.
(6) Foreign central bank buyer.
(7) Federal Reserve POMO monetization.
(8) The ride-the-yield curve financial institution buyer.
(9) The front-run the Fed speculative buyer.
(10) The momentum buyer.
(1) Relatively low inflation.
(2) Exceptionally low short term rates (controlled by the Fed).
(3) The investor fearful of deflation.
(4) The investor fearful of equities.
(5) The investor who is simply fearful.
(6) Foreign central bank buyer.
(7) Federal Reserve POMO monetization.
(8) The ride-the-yield curve financial institution buyer.
(9) The front-run the Fed speculative buyer.
(10) The momentum buyer.
The Failure of the System
The primary failure of the system has been the unwillingness to allow markets to clear.
Whether it has been the unwillingness to allow housing to clear, or the unwillingness to let insolvent institutions go bust, or the unwillingness to address structural deficits or unfunded entitlement liabilities, markets must be allowed to clear when they become unbalanced.
Markets get out of whack for a variety of reasons. Whether it is due to externalities (poor regulation and regulators, perverse incentives, the guiding hand of the Fed, moral hazard, etc.), or because they reflect the mass delusion of crowds, markets need to be allowed to clear before they can operate effectively again. By shooting the messenger (thereby trying to prop up prices), authorities are addressing the symptoms rather than the cause.
In many ways, the crisis of the last few years has been a failure of the visible hand, as much as a failure of the invisible hand.
The reasons given for bailing out entities or propping up prices are noble (in a way). To defer, delay, take away the negative social effects/impact of market collapse (usually for political reasons). But there is a cost to artificial intervention, and sometimes the cost is greater than the initial price tag.
It remains to be seen how all of the bail-outs of the recent past will pan out.
Whether it has been the unwillingness to allow housing to clear, or the unwillingness to let insolvent institutions go bust, or the unwillingness to address structural deficits or unfunded entitlement liabilities, markets must be allowed to clear when they become unbalanced.
Markets get out of whack for a variety of reasons. Whether it is due to externalities (poor regulation and regulators, perverse incentives, the guiding hand of the Fed, moral hazard, etc.), or because they reflect the mass delusion of crowds, markets need to be allowed to clear before they can operate effectively again. By shooting the messenger (thereby trying to prop up prices), authorities are addressing the symptoms rather than the cause.
In many ways, the crisis of the last few years has been a failure of the visible hand, as much as a failure of the invisible hand.
The reasons given for bailing out entities or propping up prices are noble (in a way). To defer, delay, take away the negative social effects/impact of market collapse (usually for political reasons). But there is a cost to artificial intervention, and sometimes the cost is greater than the initial price tag.
It remains to be seen how all of the bail-outs of the recent past will pan out.
Money Sloshing Around The System
Excess liquidity must go somewhere! It is like water following the path of least resistance.
Much of it has sat on bank balance sheets as excess reserves. Some of it has wound its way into commodities and precious metals. A little has tentatively ventured back into the stock market.
Sadly, investors have parked a large portion of their hard earned savings in cash and bonds. That is going to end badly.
For two reasons. First, bonds offer very little in the way of a wealth effect. And as a corollary, there are no obvious asset classes where investors can participate in asset appreciation the way they did with their homes. Second, the asset classes showing the most signs of appreciating (energy, commodities, currencies), are also likely to translate that appreciation into inflation, thereby eroding real incomes and real returns.
Not only that, but in the absence of real structural reforms, we are entering another game of chicken in the markets (or, musical chairs - take your pick). That postponed day of reckoning may be 2, 3, 5 years off. But its out there, and once again, market participants are betting they are able to hit the exit button when the time comes. History would indicate otherwise.
Much of it has sat on bank balance sheets as excess reserves. Some of it has wound its way into commodities and precious metals. A little has tentatively ventured back into the stock market.
Sadly, investors have parked a large portion of their hard earned savings in cash and bonds. That is going to end badly.
For two reasons. First, bonds offer very little in the way of a wealth effect. And as a corollary, there are no obvious asset classes where investors can participate in asset appreciation the way they did with their homes. Second, the asset classes showing the most signs of appreciating (energy, commodities, currencies), are also likely to translate that appreciation into inflation, thereby eroding real incomes and real returns.
Not only that, but in the absence of real structural reforms, we are entering another game of chicken in the markets (or, musical chairs - take your pick). That postponed day of reckoning may be 2, 3, 5 years off. But its out there, and once again, market participants are betting they are able to hit the exit button when the time comes. History would indicate otherwise.
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