Risk premium

Even though our government is a week closer to default, the market risk premium appears to be edging lower.  This is one of those times that maybe the stock market doesn't behave terribly rationally.  Then again, maybe it is perfectly rational.  After all, can't we be relatively certain that Congress won't allow a default?  I'm not so sure.

Anyway, the market risk premium is sitting right about the same as last week, about 7.5%, perhaps a bit low considering the risks.  That said, I wouldn't exactly be loading up the truck right now, unless you've got the inside scoop on a great investment that no one else knows about, which is unlikely.  Also, about the same as last week, it looks like low beta stocks are still undervalued relative to high beta stocks.

As of right now, it looks like we'll be off to a rocky start on the week, with S&P futures in Sydney currently down 0.9%.  As we approach actual default, I would expect increasing volatility.  If we actually do default... well, maybe the Fed will just buy ALL the outstanding Treasuries and be done with it.  After all, it wouldn't much matter if the government defaulted then since the interest payments made to the Fed are basically just refunded back to the government anyway.  Clearly, there's nothing to worry about here.

Market imbalances

Last weekend, I built a model using the Dow Industrial stocks (^DJI) to determine what the market risk premium is for stocks.  The results weren't exactly what I expected.  I have, from time to time, estimated the market risk premium using some "back-of-the-envelope" calculations to get a feel for whether market valuations in general were high or low.  The last time I did that, I estimated a market risk premium that was, on an historical basis, relatively low, perhaps 4 or 5%.  So, I was somewhat surprised to find that using this model revealed that the risk premium is currently (as of last weekend) about 7 or 8%, or about average for the last few decades.  And this result implies that current stock valuations are, in general, about average.

Knowing this, an investor might think that the stock market isn't accurately reflecting the risk of default on U.S. debt, and I have to agree with that, especially given the other global risks that we are facing.  These are not average times, and being that the risk premium should be a reflection of investor fear, the risk premium should be high.  It isn't.

In fact, one other surprising result from this model was that low beta stocks tended to be undervalued relative to high beta stocks.  It's as if investors are not looking at beta as a measure of risk, but rather a measure of reward.  Both of these are somewhat true, since a stock with a beta of 2 would be expected to rise twice as much as the market, but it would also be expected to decline twice as much, and it appears investors are ignoring that second part, perhaps because no one really believes the market is going to correct, or crash, any time soon.

And the result of this thinking, for whatever reason it is happening, is that there are some imbalances in the stock market, resulting in a better risk/reward ratio for lower beta stocks in general.  It's important to keep in mind that this is just a general statement and should not be taken as a recommendation to start loading up on low beta stocks.  But, perhaps, it does provide a good starting point for where to look for value priced stocks.

Inside information

Some traders got 'no taper' decision news earlier

Well, not necessarily.  It does seem that way though.  But just suppose that someone decided right before the announcement to make a big bet on the announcement.  It's not that unreasonable to think that someone looked around and realized that the market had already priced in the taper.  It isn't unreasonable to make a bet against something if you think that something has already been priced by the market.  So... right before the announcement is made public, you place a bet that the announcement is going to be not what everyone expects.  If you're wrong, there's not much to lose.  If you're right, though, the gains can be big.  There is asymmetry between potential gains and losses.

So, some big player places their bet a fraction of a second before the announcement is made.  And the high frequency traders are all over it, since their program may assume that somebody knows something and an increase in buying means there was a leak.  They jump on the bandwagon, and they're all winners in this case, because one person (or more) decided to the potential reward outweighed the risk.

But then again, maybe it was a high frequency trader that decided to place a bet a little bit early, thinking that other high frequency traders would jump in on their buying.  Then, if the announcement was against them, their program could close their position and still make a gain.  For the first trader, the only risk is that others won't follow suit.  They know that they traded without inside knowledge, but they're the only ones that know that.

The point here is really that investors shouldn't pay an awful lot of attention to headlines.  This particular headline says that some traders got the news early.  But in order to make this trade work, all that a trader needed to do was to make it look like they had inside information.  And in a way they did.  The inside information was that they didn't really have inside information.  Or, maybe they did.

A rocky fall? Perhaps.

Stocks are about to plunge, Wells Fargo warns

The Wells Fargo strategist has been bearish on stocks all year, even as she watched the S&P 500 (^GSPC) add 21 percent.

And so long as she doesn't change her mind, eventually she'll be right.  It's an old story, I know.  But wait.  It gets better.

First of all, Adams is highly skeptical about the rally that the market has enjoyed thus far. 

I've always wondered about people who are skeptical about something that is actually happening, or has actually happened.  What does that mean, exactly?  I can see being skeptical about the reasoning behind the rally, but to actually be skeptical of the rally that has already happened doesn't make much sense.  Of course, it could be that we are all experiencing some kind of collective hallucination, in which case, we would be right to be skeptical of what we see.  But then again, if that were the case, we would probably be better off accepting what we perceive to be truth as truth and act accordingly.  Kind of like if you're crossing a street and hallucinate a car about to run you over, you're probably better off trying to get out of the way of that car, even if it isn't there.  Unless, of course, in doing so you run right in front of the freight train you didn't see.

"It's all about emotion at this point. The entirety of the S&P 500's increase this year has come via the multiple," Adams said. "It's been simply through the amount that investors are willing to bid up the value of the future earnings stream."

Yeah, I don't think it's much about emotion, unless that emotion is that you'd rather make a higher return than the negative real returns otherwise available.  Still, as I've said a few times this year, or at least I think I did, stocks appear to be a bit overvalued, and after this rally, are even more so.  And, as interest rates rise, it's almost a sure thing that stocks will fall.  Of course, it could be that the market will fall before interest rates rise because of anticipation of the rise, but that doesn't appear to have happened given the current S&P 500 PE of nearly 20.

As it happens, I think the call the the S&P will revert back to about the same level as it was at the beginning of the year might be a bit conservative.  Much of what I've seen implies that stock investors are relatively highly leveraged, which will likely contribute to a much larger decline in stocks.  The good news is, from what I've seen, is that there is also a lot of cash on the sidelines which may somewhat limit the downside.  But, I think that the S&P 500 with a PE of 17 won't be enough to draw this cash in, and expect that when the "crash" does happen, it will be further than 1,440.  After all, that 17 PE wasn't enough to draw in the cash at the beginning of the year, and 17 is still relatively high, especially given the global risks we're seeing these days.

Couple the rise in rates with slow earnings growth, and Adams believes the market is in for a very tricky fall.

I agree, but I think this is an oversimplification.  Investors already expect higher interest rates, so I don't think the Fed tapering will have a significant impact in the short-run, other than, of course, the relief rally that happened immediately after the Fed announcement.  Slow earnings growth is, I think, expected despite the high PE multiple for stocks.  The high PE is the result of low returns available elsewhere.

Well, whatever happens with the Fed and earnings, I expect this autumn to be volatile at the least.  Will the S&P hit 1,440 by year end?  It's a possibility, but it does depend on interest rates rising higher than they are currently, and I'm not convinced that will happen right away even if the Fed does begin to taper its purchases.  I think interest rates already reflect the expectation of tapering, and actual tapering shouldn't lead to much change.

Is Paul Krugman right?

Okay, so I'm taking a clue from Yahoo Finance and putting a Nobel prize winner name in the headline to attract attention.  I truly am sorry.

Paul Krugman is Right, It Turns Out, About ‘Uncertainty’

I suppose that depends on your perspective.  The so-called "experts" of the world thrive on twisting ideas to make them fit reality, gaining fame and wealth for themselves in the process.  So, with that in mind, let's take a look at this article, piece by piece.

New York Times columnist and Nobel-prize winning economist Paul Krugman is taking on the role of mythbuster: in his latest column "Phony Fear Factor" -- he claims to have already blown up the following economic myths:

• Monetary expansion needn't cause hyperinflation.
• Budget deficits in a depressed economy don’t cause soaring interest rates.
• Slashing spending doesn't create jobs.
• Economic growth doesn't collapse when debt exceeds 90% of G.D.P.

First, let me say this: The article has actually reversed the supposed myths.  For example, "Monetary expansion needn't cause hyperinflation" is not the myth.  It is the reality, while the myth, if there is one in there, is that monetary expansion always causes (hyper)inflation.  The others are similarly backwards, so I'll be referring to the myths as they should apparently have been worded.

The first myth is that monetary expansion causes hyperinflation.  Of course it doesn't always, and anyone who believes that monetary expansion always has some predictable result probably needs to go back to school, or, perhaps should just leave the thinking to someone else.  To use economic terminology, monetary expansion leads to inflation, ceteris paribus, or all other things equal.  But if the velocity of money slows down while the currency base expands... well, it depends on exactly how much of each change there is.  It isn't inconceivable that there would be deflation even with monetary expansion.  I'm not sure that this was ever a myth at all.  Did some people believe that the current Fed expansion of the monetary base might lead to hyperinflation?  Of course they did.  Look what happened to gold prices over the last few years.  This time, those people appear to have been wrong.  but to assume that they will always be wrong would be a huge mistake.

The second myth is that budget deficits in a depressed economy cause soaring interest rates.  In a true market economy, interest rates would have risen, maybe enough to be referred to as "soaring."  But this isn't a true market economy and interest rates are being held artificially low by the Fed.  The Federal Government is free to borrow as much as it wants because the Fed is willing to loan as much as the Federal Government wants to borrow.  But in a free market economy, the scarcity of loanable funds would force the government to pay ever higher interest rates.  With the Fed, there is no scarcity of loanable funds.  The Fed will just print more, and interest rates stay low.

The third myth is that slashing spending creates jobs.  No.  I don't know anyone that thinks this.  Slashing spending and cutting taxes proportionately could have the effect of spurring job creation.  But the idea that simply cutting spending will somehow create jobs is ludicrous.  So, if all consumers just decided to not spend any money, we're well on our way to 4% unemployment, I guess.  Of course not.  It isn't spending cuts that creates jobs; it's the tax cuts that should go along with those spending cuts that will give consumers more money to spend.  But if consumers don't spend that money, then even tax cuts won't do any good.  Another way to look at this is to realize that the best thing government can do to spur job growth is to butt out.

The final myth is that economic growth collapses when debt exceeds 90% of G.D.P.  Now, think about this for just a second.  Let's say I'm going to make $100,000 this year, so I go out and borrow $90,000 payable in 1 year at 0% interest that I can just roll over into new loans every year.  Is my economic standing doomed?  Not so long as my interest rate is 0%, and actually, I might be able to manage at as much as 10% or more.  I realize that this isn't exactly the case for the government.  Their interest rate isn't 0%.  I used that example to show that the collapse is not so much dependent on the dollar amount of debt as it is dependent on the interest rate.  As far as the dollar amount of debt compared to G.D.P. goes, it is dependent on whether anyone wants to loan the government money with a debt level that high.  Of course, in our artificial world, the Fed stands willing to loan however much the government wants to borrow, so even that isn't an issue, at least not at the moment.

But the article I'm addressing isn't really about Mr. Krugman.  I think maybe they put his name in the headline just to get attention.  Reference a Nobel prize winner and suddenly people are interested.  On the other hand, mention me and at best people will say, "Who?"  before moving on to the funny papers.

No, this article is about uncertainty.  More specifically, it is about something called the Economic Policy Index "which has plunged to levels not seen since 2008. 'Uncertainty has improved,' says Newman."  Um, no.  Regardless of how people feel about the uncertainty of the future, it is always uncertain.  The future is never more certain, or less certain.  It is always uncertain.  However, people may feel more, or less, certain, but in reality they are still just as uncertain as ever.  Nobody can know what the future holds, no matter how certain they are of the future.

Now, it might be useful to know how uncertain people feel about the future.  In fact, if people in general are more certain about what the future has in store for them, then they will act with increasing confidence, and that is a good thing, at least when the economy is recovering from a big, bad recession like the one we've just experienced.  Confident people spend more, and this in turn leads to increasing demand and job creation, which in turn make people even more confident.  Eventually, though, that confidence turns to overconfidence, and that's where it appears we are right now, at least that's the impression I get when I read this article even though that wasn't the impression I think I was supposed to get.

The part of the video that struck me the most was when the participants started talking about how "all the tail risks are behind us."  Um, no.  Only the ones we expected, which are really the risks to be least worried about.  It is the unexpected risks that can really wreak havoc.  Those risks are still there.  They didn't go away because we somehow muddled through our problems.

Krugman brings it full-circle: "The truth is that we understand perfectly well why the recovery has been slow, and confidence has nothing to do with it. What we’re looking at, instead, is the normal aftermath of a debt-fueled asset bubble..."

He's right, you know.  Unfortunately, he probably doesn't care much (and neither do many people) whether I agree or not.  The main thing, though, is I don't think we're out of the woods yet.  I don't think anything has been "proven" here.  We still don't know if the economy is going to finish the collapse that was started in the financial crisis.  There is still significant uncertainty in the world despite people thinking it's all behind us, and that thinking is what will make those unseen tail risks all the more destructive should they arise.

If we assume, then, that people in general really believe that those bad "tail risks" are all behind us, then it is likely time to head for the fallout shelter, in a metaphoric sense at least.  The time to be defensive is when everyone else believes "the worst is over."  Of course, it may be some time before the really bad, surprising tail risk hits us, so it probably isn't really time to move completely into that fallout shelter.  But I do think it's time to start building a defensive position, and at least open the door to that shelter.

7/29/2013 Comments

Pending home sales pull back in June as rates rise

Contracts to purchase previously owned U.S. homes fell in June, retreating from a more than six-year high touched the prior month, suggesting rising mortgage rates were starting to dampen home sales.

While this sounds negative, as someone mentioned in the comments, the headline could read "Compared to last year contracts were up 10.9 percent, despite higher rates."  Then again, I might read that as being just a bit overly positive.  Yes, it's more than last year; but perhaps the more important fact is that it is down from the previous month.

Are Stocks Heading for a 1987-Style Crash?

Enjoy your summer.

Thanks, I will, although I think that ending line was meant to be somewhat ominous.  It might have been if the article had actually pointed out some reasons why we might be heading toward a 1987-style crash other than "the market went up a lot."  But, you know, these days it's all about quantity, which is why I'm not very successful.  I try to produce a quality product knowing that in the short run I could do better focusing on quantity.

I've fallen behind on my coverage, so here are some recent stories for stocks I'm covering.  I'll be working on getting more articles written on these and other stocks in the coming weeks.

Harley-Davidson Posts Second-Quarter 2013 Earnings, Revenue And Retail Motorcycle Sales Growth 


Arrow Reports $5.2 Million Profit, Solid Second Quarter Results


Finish Line Declares Quarterly Cash Dividend

Stanley Furniture Company Announces Second Quarter 2013 Operating Results 

That's the news July 13, 2013

I decided to try posting this just once a week, but I'm not thrilled, so perhaps I'll go back to the occasional posting.

Monday, July 8, 2013

Bitcoin ATM Gets Ready for Roll Out

The device boasts the ability to change fiat currencies into the crypto-currency in just 15 seconds and accepts notes from over 200 countries around the world.

So now we have the ability to transform actual currency into play money at ATMs worldwide.  Of course, some people would call "actual currency" play money as well.  I'm just not sure why they accept actual currency in exchange for play money, if the play money is supposed to somehow be better.  Clearly, I'm missing something here, so anyone that wants to explain it, feel free to comment.

Stocks rise, dollar pulls back from 3-year high

A Reuters poll conducted after the release of Friday's government payrolls data -- which showed U.S. employers added 195,000 jobs in June -- found more than half of the major Wall Street bond firms surveyed expected the Fed would reduce its $85 billion monthly purchases of Treasuries and mortgage-backed securities in September.

At least the market is responding as if this is good news for once.  I'm not sure why bond yields would fall though.  Seems to me that would be the one place investors wouldn't want to have their money.  Well, one of the places.  Others are dollar denominated commodities like oil, probably gold, and bitcoins.

It’s Not Just Thomson Reuters – Elite Investors Get Tons of Unfair Advantages: Blodget

Blodget doesn’t expect the decision will do small investors any good. “The market will never, ever be safe for the little guy,” says Blodget. “So anything we do that makes it appear a little bit safer…is actually worse because then people think they are on the same playing field as the little guy.”

Finally, somebody says what has always been true.  But of course, it won't do any good.  People will still rush to put their money in whatever Warren Buffet already has his money in.  They won't get the same deal as Mr. Buffet.  It likely won't be a good investment for "the little guy."  The most important thing to remember is, the stock market isn't safe.  Higher returns result from higher risk

Wednesday, July 10, 2013

 'About half' of Fed officials expect QE3 to end this year

About half of Federal Reserve officials expect that economic conditions will be appropriate to not only taper, but end QE3 entirely this year, according to minutes from the central bank's June meeting, released Wednesday.

I'm not exactly sure when these guys decided that 6.5% unemployment was probably an unrealistic target, but it appears they have.  Unfortunately, I didn't see anything in this article that said why they thought it would be "appropriate" to end QE3 this year.  The only thing that comes to mind is that real estate has been looking, well, "bubbly" lately, although there are plenty of reasons to think there is no real estate bubble as well.  When I look at a chart of home prices, though, it certainly looks as if there is significant downside to real estate, as if the government and the Fed basically put a floor under the housing market.  I'm just not sure how secure that floor is.


MBA: Mortgage Refinance Applications Decline as Mortgage Rates Increase in Latest Weekly Survey

Note: This was for a holiday week with a large seasonal adjustment. I expect a large decline in refinance activity in the survey next week.

So, here's a little speculation about the Fed's coming actions.  With the market's reaction to the rumors about Fed tapering resulting in higher mortgage rates and falling mortgage applications, it will suddenly be "appropriate" to continue with QE.

The Housing Unrecovery: Mortgage Application Drought Continues

and as a reminder... this DOES impact affordability - no matter how much your friendly local realtor or mortgage broker tries to explain still-generational-low mortgage rates - it's simply all about the marginal move...

Which is right in line with what I've been thinking.  Unless, of course, people still remember that home prices are still quite high compared to where they "should" be.  We just need Mr. Bernanke to stay the course, so that people will forget about how high home prices are, and this will become the new normal.  But by then, ultra-low interest rates will also be the new normal and people will accept nothing higher.  Maybe.

Saturday, July 13, 2013

Are Banks and Housing About to Get Crushed by Rising Rates?

"In May, the banks had no idea where rates were going, and so they're going to tell us now where they think they're going to go in August," he says, before labeling the highly complex and qualified earnings reports from banks a ''best guess."

I don't actually care where banks think interest rates will be in August.  At least not 2013 anyway.  I want to know where they'll be in a year or two.

What really happens when QE ends?

Markets have apparently been speculating that the Fed will begin to taper quantitative easing (QE) sometime sooner than was previously anticipated. (See: Stocks plunge as Fed minutes hint at cutback for more detail.) What bothers me is that a lot of people don't really seem to understand what the result of Fed tapering will be. So, let's see if we can work this out.

When the Fed sets the Fed Funds Rate, it typically uses open market operations to manipulate short-term interest rates. Basically, when the Fed wants to lower interest rates, it buys treasury bills to lower the yield on short-term government borrowings. Because banks are limited in what they can do with excess cash, a lower yield on T-bills makes overnight loaning to other banks more attractive, and banks will be more willing to loan to other banks when the alternative (T-bills) offer a lower yield. In this case, the T-bill rate is the driver behind the Fed Funds Rate.

In theory, all other things equal, if the Fed lowers the yield on T-bills, the yield on longer-term government borrowings will follow, so the Fed doesn't normally get involved with those. But in the wake of the last recession, the Fed, for multiple reasons, decided that long-term rates (especially mortgage rates) weren't falling enough to spur growth. So, they decided to take a more direct approach, purchasing long-term treasury bonds, which have a more direct effect on mortgage rates. As near as I can tell, this isn't the official explanation for QE, but it's the one that I think explains the reason for QE best, and certainly does actually address the effect of QE. Forget about money supply; it's about interest rates.

Generally speaking, then, the effect of QE is to flatten the yield curve. Has it worked? You tell me. Here is a chart of showing the Treasury Yield Curve currently, as well as in November of 2008, before QE1. (Source)

Yes it has, because the green line isn't as steep as the blue line. And one effect is that we've seen historically low mortgage rates, rates that we'll likely not see again in any of our lifetimes. Low mortgage rates help to pave the way to stabilizing the real estate market, and, in my opinion, the latest QE has done that a little too well.

But the point of this post is not so much what's happening in the markets now, but what to expect when the inevitable end of QE comes. The recent market reaction to rumors about the Fed maybe tapering earlier than expected shows a high level of uncertainty. Pretty much, every asset class dropped, indicating there must have been a substantial move into cash. Why cash? Because the value of cash is not dependent on interest rates at all, but nearly every other investment in the world is. Even gold.

Now, I know there are some people thinking that what I just said about the value of cash not being dependent on interest rates is just plain wrong, and that the end of QE will make cash more valuable. All other things equal, it will, but not because of the interest rates; it will be because of the difference in the supply of money. Other countries have turned on their printing presses as well, and if one stops, it will likely see an increase in the value of its currency as the supply of other currencies relative to that one currency grows. At least in the short-run. Longer term, there are other factors that will affect the value of the currency, but interest rates just isn't one of them. As usual, that's my opinion, based on the current workings of the global monetary system. Things change, though, and I could change that opinion at any time.

Okay, back to the topic at hand: the effect of ending QE. The first thing we should see is a steepening of the yield curve, and we can check that out using the same graphing utility on the Treasury's web site.

This time, I figured the beginning of the year as being as good a starting point as any, and as we can see, this time the blue line (January) is less steep than the green line (Current). Why? Because of speculation that the end is nearer than investors thought it was in January. (Almost) Nobody wants to be holding those long bonds when the Fed stops buying. This chart also shows something which is vital to a discussion of the effect of ending QE: rates under 2 years hardly budged. So, here we've found evidence that when people say interest rates are going to sky rocket with the end of QE are misstating what will actually happen. Some interest rates will likely increase, but not all interest rates. In other words, the yield curve will get steeper.

So what. Right? It is a kind of big deal depending on what investments you have in your portfolio. If you are invested in companies with little or no debt, then the impact should be minimal. However, there will be some slight decline as the risk premium rises (and perhaps whatever proxy for the risk-free rate investors are using). But for most companies with little debt, there should be no major impact on that company's results. For companies with a lot of debt on their balance sheet, it could be another story though. It really depends on how each company's debt is structured. If a company has a lot of long-term fixed rate debt, then it shouldn't be impacted as much because it has a low rate locked in. Maybe. Sometimes companies issue "putable" bonds to get a lower rate. These, of course, are not safe against interest rate increases.

One of the things that makes me believe that people in general don't understand QE is the volume of articles, blog posts, and comments that QE is somehow a way of bailing banks out, or making life easier for banks. There may be ways for banks to "game" QE that I'm unaware of, but generally speaking, QE is actually makes life harder for banks. The reason is clear when you consider that banks generally borrow short-term funds and loan long term, pocketing the difference in rates. A steep yield curve benefits banks because the spread is bigger, similar to a store that can raise prices while their cost remains the same can increase gross margin.

But, and there's always a but isn't there, the end of QE might not be that great for all banks (or other financial institutions that make money in similar ways). It's possible that the loans (or investments) made by the bank will lose value, making their collateral worth less and forcing the bank to pay higher interest, or perhaps issue more stock, or... well, lots of bad stuff can happen. If the loans a bank makes are fixed rate, then the value of those loans will fall; but if the loans are variable, then the value should stay the same because the borrower will have to pay a higher interest rate. However, this may not be true; if the variable rate loan has a floor (minimum) rate, and the borrower is currently paying the "floor" rate, then even if rates go up, the borrower may not be required to make higher payments, and so, the value of that loan will still decline.

Hopefully, this gives you some kind of idea of the complexity surrounding QE and its end. Because of this complexity, I've decided to start writing a series of articles that I'll publish on Seeking Alpha covering a variety of types of financial institutions. In case anyone was wondering, this is what I've been working on lately and the reason I'm posting less frequently.