Saturday, October 26, 2013

The Dollar Survives Ted Cruz

Some twenty years ago, Moody's published an investor comment entitled "Southeast Banks Survive Hugo". A number of us (who hadn’t written the comment) found it pretty funny since banks typically survive hurricanes and other natural phenomena (e.g., “Russian Banks Survive Cold Winter”).

I am honoring that ground-breaking piece of research with today's post: "The Dollar Survives Ted Cruz".

The financial media (especially in Europe, and especially at the FT*) have been rife with commentary about America's sad decline as an economic superpower as a result of the latest government shutdown and the latest debt ceiling kerfuffle.  “Can These People Govern Themselves?”,  “Are Tea Party Crazies Running America?”, etc.

It is solemnly agreed by saddened commentators that global investors have lost confidence in the US as a result of the recent dustup. This most recent discrediting of the US follows many previous discreditings when foreign investors lost confidence in the United States, its currency and its debt: the “Constitutional crisis” of Watergate, the double-digit inflation of the Carter era, the "massive deficits" of the Reagan years, the fiscal profligacy of the Bush tax cuts and, most recently, Obama's "massive" stimulus and trillion-dollar deficits.

Global investors must be exhausted by the experience of repeatedly losing confidence in the United States. You'd think by now that Treasury bonds would be be used as toilet paper like the Zimbabwe trillion dollar note.

Isn't it odd then, that Treasury yields have steadily fallen throughout the "crisis", and that this banana republic can borrow money for 30 years at 3.6%? And isn't it odder still  that the worthless dollar and the dodgy Treasury Bond continue to constitute the majority of foreign central banks' international reserves? Perhaps these central banks didn't get the memo that they were supposed to flee the dollar and buy Yuan or bullion or pork bellies. The Dallas Fed got the memo.

What the FT and other serious commentators forget is that the US Treasury bond is a monopoly product because it is the only security denominated in US dollars issued by an entity that can print US dollars. Like Porsche, there is no substitute.

Let's look at the T-bond’s competitors: eurozone government bonds, Japanese JGBs, British gilts, and not much else. What about the yuan, every journalist’s favorite currency these days? Like the North Korean won, the Cuban peso and the Venezuelan Bolivar, the yuan is nonconvertible, and thus useless as a reserve asset.

Eurozone government bonds? Too small a float to be liquid in an emergency, not denominated in any country’s domestic currency, and most eurozone governments are far from AAA. Japanese JGBs? A huge market, but not as liquid as one would think, in the wrong time-zone, and nowhere near AAA. Not a good substitute for the greenback.

Central banks must be able to provide dollar liquidity to their members at all times because the business of international finance is conducted in dollars. Thus, whenever there is a market convulsion, banks require dollars from their central banks to meet dollar claims, which is why the Fed is asked to establish dollar swap lines during financial crises. The alternative would be for central banks to fire-sale their own currencies in the middle of a crisis.

There are no credible threats to the global dominance of the dollar and the T-bond. Treasury yields have never been lower, despite trillion-dollar deficits and deteriorating debt ratios. A dollar-zone crisis is much less likely than a eurozone crisis; Japan’s debt-trajectory is asymptotic; and the UK's credit was wounded by the financial crisis.

The US is not a pretty credit, like Estonia or Botswana (no debt), but it will remain the #1 credit for the rest of this century, no matter what Fitch and S&P have to say about it.
*“Washington’s flirtation with a voluntary default has shaken confidence in American political institutions…the world is now monitoring the US to see when it will recover its senses."--FT: A Superpower At Risk Of Slippage”, Oct. 25th, 2013

Tuesday, October 22, 2013

How To Invest In The Stock Market

Presentation to the Episcopal High School Investment Club, Alexandria, VA. 17 Oct. 2013

What Is A Stock?
1. One element of a corporation’s capital structure.

2. Corporate capital structure ranked by declining priority of claim:
Secured debt
Senior unsecured debt
Subordinated debt
Preferred stock
Common stock

3. Common stock is the only security that participates in the financial performance of the firm: no fixed interest or dividend, no claim in bankruptcy.

4. Stocks are the only asset class that offers the opportunity to “strike it rich”, or to lose it all.

What Makes Stocks Special?
1. Stocks permit an small investor to participate in the ownership of a large company.
2. The smallest investors can own shares in the biggest companies.
3. Stocks are a much better hedge against inflation than bonds.
4. In the postwar era, stocks have outperformed bonds by a wide margin: Dow was at 160 on V-J Day; at 1000 30 years ago; is now at 15000. I expect it to go to 20000 over the next two years.

Ways To Invest In Stocks
1. Stock-picking based on fundamentals
2. Market-timing based on valuation
3. Market-timing based on patterns
4. Mutual funds and ETFs

>Stock-Picking Based On Fundamental Analysis
1. Revenue and earnings growth (growth): GOOG, AMZN, AAPL
2. Low PE ratio, undervaluation (value): out-of favor sectors
3. High dividend yield (income): utilities, cyclicals
4. Long-term stability (blue chip): JNJ, KO, PEP, GE
5. Strong free cash flow (value): tend to be unsexy
6. Return of capital (stewardship): management that works for the shareholder
7. Strength of franchise (moat): brand names
8. Financial fundamentals: capitalization, profitability, cash generation, cash disposal policies, accounting conservatism, management risk tolerance.

>Market-Timing Based On Valuation
1. Analyzes the market like an individual stock
2. Values the market based on expectations of earnings and PE ratio.
3. Some look at overall dividend yield, some look at PE and some look at the equity risk premium over bonds [market earnings yield vs bond yields].
4. Buy cheap (March 2009), sell dear (now?)

>Market Timing Based On Patterns
This is called “Technical Analysis” and looks for patterns in the prices of individual stocks or of the overall market that are believed to provide information about future price movements. While many respected market gurus use technical analysis, economists consider it to be pure voodoo.

>Mutual Funds And ETFs
1. Mutual funds and ETFs are an efficient way for the small investor to diversify his equity portfolio.
2. Managed funds offer the style, sector, objective and expertise of the portfolio manager.
3. Style: e.g., large cap growth; sector: e.g., financials; objective: e.g., long-term capital gains; expertise: e.g., technology.
3. Passive funds seek to efficiently replicate the performance of an index with minimal overhead.
3. ETFs offer a somewhat static portfolio, with a stated style, sector, and objective, with periodic rebalancing.
4. Indexed ETFs, like passive mutual funds, seek to replicate the performance of an index. The most popular market index is SPY, which replicates the S&P 500.
5. Some good performers: PKW, RPV, RPG, CSD, USMV, PFM, FPX, CSM, VIG, SPHQ, HDV, SDY, DVY.

Beta and Alpha
1. Beta measures the degree to which a stock or portfolio matches the performance of the overall market (SPY). A low beta means low correlation, while a high beta means high correlation or a super-charged correlation (more volatile than the market but in the direction of the market).

2. Alpha measures the ability of a portfolio to produce returns in excess of the market average. Indexed funds have low alpha (= to market), while managed funds may have high or low alpha. The goal in active investing is to outperform the market, i.e., to generate alpha. Most managed funds lack alpha. Some indexed ETFs have alpha (e.g., PKW).

Understanding Corporate Cashflow
-Operating Expense
=Operating profit
=Net income
-Capital expenditures
+ Noncash expenses (e.g., depreciation)
=Free cashflow
-retained cash
= cash returned to shareholders (dividends, buybacks)

Should You Invest In Individual Stocks?
1. Are you a full-time professional equity analyst?
2. Do you have access to proprietary valuation models for each industry in which you invest?
3. Are you an expert in the relevant industries?
4. Do you listen to quarterly earnings calls and attend the annual Investor Day? Can you call the CFO with questions?
4. How well do you understand the financial dynamics of technology stocks, or pharmaceuticals?
5. Do you possess information not shared by the wider market?
If you answered no to these questions, then don’t buy individual stocks.  Invest in mutual funds or ETFs.

How Can I Know When It’s A Good Time To Buy Stocks?
1.You will need to work on yardsticks for estimating the intrinsic value of the stock market in order to compare your estimates with the current market price.

2. Typical yardsticks are: PE ratio (looking both backward and forward, which requires forward earnings estimates), dividend yield, market-to-book, market to FCF.

3. The problem with such yardsticks is that they only compare the market to itself, not to interest rates. High interest rates lower the value of the corporate earnings yield (E/P), while low interest rates raise the value of corporate earnings (lower discount rate).

4. The best measure for market valuation is the Equity Risk Premium which can be crudely be described as the market earnings yield minus the risk-free rate.  

5. Today's ERP is almost 6%, which is high by historical standards.

6.If we calculate the ratio of ERP to the risk-free rate, we get a multiple of 3.3x, which is extremely high by historical standards. If you accept the premises of this analysis, then you must conclude that stock prices today are very cheap, and that you should buy stocks right now.

7. Why are stocks so cheap? Because it is only five years since the Crash, and investors remain highly risk-averse. They think they are “safe” and “conservative” holding 3% bonds.

8. What could derail this view? Either (i) higher interest rates, which I do not expect; or (ii) lower corporate earnings due to another recession, which I also do not expect. What I expect is that stock prices will continue to rise until the ERP and the EY/RFR normalize. That would imply that stocks could double over the next few years, as greed replaces fear.

Sunday, October 20, 2013

Bearish Scenarios Lack Credibility

On October 8th, I wrote that equity investors should ignore the “budget crisis” because stock prices were low (“Forget The Debt Ceiling: Stock Prices Are Very Low”). That was the point at which the pundits were telling us to stock up on canned goods (“worse than 2008”). The day I wrote that post, the Dow closed at 14,773. 

On Friday (10/18), the Dow closed at 15,400--a gain of over 600 points in 10 days. Once again, we have relearned the lesson that there is very little actionable information in the A section of the paper, and not much more in the business section. Actionable investing information is found in the calculation of market valuation, not in the blathersphere.

On October 1st, Damodaran* calculated the Equity Risk Premium at almost 6%. It has been hovering in this vicinity since the Crash. The ERP had not been this high in absolute terms since the inflationary Carter years; it has historically trended around 3%. As a multiple of the risk-free rate, the ERP has never been this high (3.3x). Over the past 50 years the multiple has remained below 1x, generally in the .5 to .7 range. Today, the multiple is about five times its historical average. Hence, the compelling imperative to remain heavily exposed to the stock market.

Should the ERP and the ERP multiple revert to their historical levels (of 3% and .6x), the stock market would be perhaps 2-3x its current level, without factoring in future earnings growth. I would also point out that corporate earnings do not need to grow for market eps to grow. Many companies today have excess free cashflow, and are using it to reduce their float (the denominator for the calculation of eps) and thus increase earnings per share.

It is true that higher bond yields would also reduce the ERP. That is a risk to the rosy scenario. But given the fact that inflation remains at extremely low levels, and that the Fed is unlikely to adopt a radical reflationary policy, the prospects for higher inflation are bleak.

Many market analysts are focused on the fact that today’s market PE ratio (18.2x) appears quite high in an historical context. This might be a useful factoid if today’s interest rates were anywhere near their historical norms. But interest rates are at levels never seen before, not even under the gold standard. Therefore historical PE comparisons are meaningless. The market is very cheap.       

Wednesday, October 9, 2013

Yellen Can't Change Fed Policy

First the good news: Yellen is a monetarist, a dove and an activist. She believes that monetary policy plays an important role in achieving good economic growth, and that the Fed should respect its employment mandate . She is more dovish than Bernanke, and more forceful. She is, in my view, an improvement over Bernanke who placed too much emphasis on consensus.

Now for the bad news: Like Bernanke, Yellen will be faced with the hawkish faction which is likely to tie her hands and prevent her from doing what she believes is right. Were Yellen to advocate more radical policies, such as price-level targeting or nominal growth targeting, she would invite discord and vocal dissent. She would injure the Fed’s “institutional credibility”, and invite Congressional interference, which is anathema.

So here is the bottom line: Yellen will fail as Bernanke has failed. Only radical policies can move the dial on money growth, and radical policies are precluded by the hawks. Indeed, the hawks want to return to orthodoxy as soon as possible. She will have her hands full fighting against this tendency.

Thus, the outlook for the US economy is grim: low money growth, low inflation, low growth, high unemployment, weak fiscal revenue and an ever-growing output gap. That suggests that the bond market should not react to her appointment: she can’t raise the inflation rate any more than Bernanke could.

Tuesday, October 8, 2013

Forget The Debt Ceiling: Stock Prices Are Very Low

Thesis: Don’t sell, but be prepared to buy aggressively if prices go any lower.

Q: Given the risk of a Treasury default, should the prudent investor sell now and repurchase when it’s all over?

A: I say don’t sell, but be ready to buy if there is a big selloff.

The Dow is down 800 points since mid-September, and is now selling for the same price as in May. The forward earnings yield on the S&P 500 is 6.4% and the current dividend yield is 2.1%.

This compares with a Treasury yield curve of:
1-year: 0.10%
5-year: 1.4%
10-year: 2.6%
20-year: 3.4%
30-year: 3.7%

Aswath Damodaran* at NYU estimates the Equity Risk Premium as of Oct. 1st at 5.73%, which is as high as it’s been since the Carter years. However, if you look at his calculation of the ratio of the ERP to the risk-free rate, now ~3.2x, it is the highest it has ever been, and six times its historical average of 0.5x.

Clearly stocks are deep in value territory by these yardsticks. It is true that Treasury yields could rise, but it almost certain that the earnings yield will rise by more, since corporate earnings continue to grow, and companies continue to reduce their float. 

We are looking today at an historic buying opportunity, similar to the inflationary period of 1977 to 1983, when the Dow was bouncing around 900. If nothing else were to happen except that the ERP/risk-free rate were to normalize at .5x, the Dow today would be ten times its current level. That is the scale of today’s opportunity, at least according to me.

Given that both sides on the Hill appear to be digging in, there is a chance that the risk of a Treasury default could produce a major selloff, which would make equity valuation all the more compelling. Similarly, there is also the risk of a last-minute deal that could produce a rally. My thinking is that one should hold back just a little longer before taking a plunge, but not too long. I assign a very low probability to a default, so my inclination is to start bargain-hunting soon, before it’s too late.

Thursday, October 3, 2013

The Debt Ceiling Is Not Lehman

“A default would be unprecedented and has the potential to be catastrophic: credit markets could freeze, the value of the dollar could plummet, U.S. interest rates could skyrocket, the negative spillovers could reverberate around the world, and there might be a financial crisis and recession that could echo the events of 2008 or worse.”

--US Treasury, Oct. 2nd, 2013

Yesterday, the Treasury published a paper, “Macroeconomic Effects Of Debt Ceiling Brinkmanship” which lays out the consequences of a government default.  Here are the paper’s assertions:
1. Credit markets could freeze;
2. The dollar could plummet;
3. Interest rates could skyrocket;
4. There could be a financial crisis similar to 2008.

I understand the Treasury’s motivation in publishing this paper. It is the Treasury’s job to protect the credit of the US, and to maintain the Treasury as the gold standard of global credit risk. If I were Secretary of the Treasury, I would publish a paper exactly like this. There is absolutely no reason to run such a dangerous experiment to see if it is survivable. The Republican party is not, or should not be, a bunch of drunken rednecks lighting a match and saying “Watch this!”. Only a reckless fool would allow the US to default, and I trust that Speaker Boehner is not a reckless fool like Ted Cruz and his ilk.

However, as investors we must prepare for any eventuality, including a government default. In yesterday’s post I addressed the first three risk factors above, and concluded that the credit markets would stay open, the dollar would not plummet, and interest rates would not skyrocket.

Today I will address Point Four: the risk of another financial crisis like 2008. That assertion is just preposterous. It could only be suggested by someone who has already forgotten what happened in 2008. Permit me to refresh Jacob Lew’s memory about 2008.

This is what happened then:
1. Overnight, $2 trillion of subprime mortgage-related securities went from being zero risk to being toxic, opaque and of unknowable value.
2. No one knew who was exposed to what securities in what amount.
3. The FASB, at that very moment, chose to change the accounting treatment for such securities from mark-to-model to mark-to-market, just as the market disappeared.
4. In the midst of a crisis in which no counterparty could be sure of another, the Treasury allowed a $700 billion financial institution to go bankrupt, which completely blindsided the markets.
5. The credit markets froze solid because (a) no one knew who was solvent; (b) no one knew who was or wasn’t TBTF; and ( c ) credit committees decided that, given the level of uncertainty, they would only take good names irrespective of the quality of collateral offered by the “question mark” names such as Goldman and Morgan Stanley.
Hence the crisis and hence the bailout.

This scenario is not remotely analogous to a debt ceiling problem:

1. No large asset class will go from being riskless to being risky. This is not a credit event.
2. No one will care who is exposed to defaulted Treasuries because they will be worth 100 cents on the dollar. No one will be rendered insolvent (except maybe some naked ultra-shorts).
3. Treasuries are already carried at market, so the accounting won’t change.
4. No systemically-significant financial institution will fail because of a government default.
5. Counterparty credit lines will remain open because nothing material will have happened.

That’s my view. I don’t buy the Armageddon talk. I don’t see a breach of the debt ceiling as a meaningful economic event, any more than Y2K might have been. Markets can handle events when there is adequate certainty about the implications for all participants. A government debt default would be survivable, like a dirty bomb or another 9/11.

I can’t bring myself to believe that anyone could be so stupid as to run this experiment as a form of political theater. But then again, it never occurred to me that Paulson-Geithner-Bernanke would let Lehman go either. So we must force ourselves to think through such an eventuality. I am staying overweight in US equities.

Investment Implications Of A Government Default

Should you google “debt ceiling default” or its variants, you will discover a substantial literature on the subject. Four sources are particularly interesting.* These publications are quite alarming:
“Let us be perfectly clear: crossing the debt ceiling would be catastrophic.”
NY Magazine: 
“Economists and policy experts agree that reaching the X Date
could be the start of financial Armageddon...We don't really know what happens if Treasury bonds default, since it's never happened. What we do know is that it would destroy the market as we know it.”

US Treasury:

"A default would be unprecedented and has the potential to be catastrophic: credit markets could freeze,the value of the dollar could plummet, U.S. interest rates could skyrocket, the negative spillovers could reverberate around the world, and there might be a financial crisis and recession that could echo the events of 2008 or worse."

Among the risks cited are:

1. A flight from Treasuries

The thinking here is that, once Treasuries lose their “risk free status”, portfolio adjustments will inevitably ensue. Many investors are not permitted to hold defaulted securities, but cannot discriminate between the defaulted and the undefaulted securities of the same issuer.

2. Disruption of the money market

The Fedwire will not accept defaulted securities, and cannot discriminate between defaulted and nondefaulted securities of the same issuer. Thus, it is conceivable that the Fedwire will not be able to accept any Treasury securities.

3. Disruption at the discount window

Here again, the Fed cannot accept defaulted collateral, but is unable to discriminate between defaulted and undefaulted securities of the same issuer.

4. Loss of reserve currency status
The global perception of the Treasury as a risk free security would be jeopardized by a default, leading to a move out of dollar assets.

5. Ratings downgrades
Rating agencies will react adversely to a default, as they have already cited it as a risk factor.

Let me address these risks in turn:

1. Flight from Treasuries
This is far-fetched. Treasury prices are rising. There is no change in the creditworthiness of the United States. Insofar as anyone is forced to sell, there will be plenty of investors who would be happy to buy Treasuries at a discount. The Treasury market is infinitely efficient.

2. Market disruption
This strikes me as quite likely, given the reasons cited above. A Treasury default would necessitate some extraordinary actions on the part of both the Fed and portfolio managers (and perhaps their clients), which I think would be readily accepted by the market. The simplest fix would be to ignore the defaulted status of Treasuries altogether, since they remain risk-free even in default (aside from the timeliness issue).

3. Loss of reserve currency status
This is a long shot. The factors supporting the dollar as a reserve currency and the Treasuries as reserve assets are unaffected by this event, and the factors weighing against JGBs and Bunds remain.

4. Rating downgrades
Reading the tea leaves, I doubt it. S&P has already downgraded the US to AA+ in part because of this risk. Moody’s did not downgrade the US, and recently changed the rating outlook from negative to stable, citing the declining deficit. I think that S&P would feel that its downgrade was justified by the default, and that Moody’s would not reverse itself because of an event unrelated to underlying creditworthiness. There is no doubt in my mind that a post-default US would remain a AAA credit in both a cardinal and ordinal sense, and that the market’s opinion of the US as a credit would not change either. A technical default is not a credit event. (If a gold mine shuts down for a week, it is still a gold mine.)

With respect to the stock market, I would expect a selloff of a few hundred Dow points in the event of a default. I would view such a selloff as irrational and an opportunity to buy stocks at a discount. I am overweight equities, and I intend to remain so. If there is a default-induced dip, I plan to buy into it.

The best modern analogues are Y2K and 9/11. Y2K was an anticipated financial disaster that didn’t happen. Had it happened, it would have been an example of a noneconomic event with financial implications. Similarly, the U.S. capital market shut down on 9/11, due to mechanical disruption in the Financial District. Bond and stock trading ceased while Wall Street struggled to restore power and communications. The market didn’t do well after it reopened, but I think that was due to the breaking Enron story, which shook the credit markets to a much greater extent than 9/11. 9/11 was a black swan that could be absorbed, whereas Enron was a black swan that shattered market confidence.

*1. “Here are Some of the Apocalyptic Things That Could Happen If the Debt Ceiling is Breached”, NY Magazine:

3. “Debt Ceiling Analysis” by the Bipartisan Policy Center:
4. "Macroeconomic Implications Of Debt Ceiling Brinkmanship", US Treasury: