COVID-19 Diary Number 2 (April 6, 2020)

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Though no one can yet say how the virus will continue to develop in the U.S., and therefore how the markets will go, a review of the past few weeks can allow this conclusion (with apologies to Winston Churchill at the end of the Battle of Britain): This is not the end or even the beginning of the end, but it is the end of the beginning.

Whenever markets suffer a shock – a collapse somewhere in the economy, natural disaster, war – participants panic.  This happened in March as the extent and severity of the Covid-19 pandemic became apparent.  Such panic could of course return if markets were to suffer another terrible surprise, but their recent behavior suggests this beginning phase of the market correction seems to have ended:

  • Equity prices have clawed back some of the ground lost to March’s panic. Stock prices fell precipitously between February 21, and March 23, with the benchmark S&P 500 stock index sliding almost 35 percent in just some four weeks, wiping out all the impressive gains of the prior three years.  Since then, investors seem to have recovered the sense that perhaps pricing had anticipated the worst, especially since the Federal Reserve (Fed) and the government have initiated policies to mitigate if not erase the recessionary effects of the measures needed to fight the spread of the virus. Pricing has begun to improve.  Stocks have risen some 19 percent from those lows, still some 21 percent below the highs of February, but a sign that panic has passed for the moment. 
  • Bond markets, while still fearful, remain relatively stable. On the first news of pandemic, Treasury yields fell precipitously, with the yield on the 10-year note dropping from just under 2.0 percent at the end of January to just over 0.6 percent by mid-March. To a large extent, the move reflected the Fed’s efforts to drive down all interest rates and bond yields. A flight to quality also was an element here.  As investors sold off bonds issued by entities with lesser credit ratings and put the proceeds into presumably safer Treasury issues, the yields on all other bonds actually rose, widening the yield spread lesser credits offered over Treasuries from a little over 3.5 percentage points late in February to just over 10.5 percentage points late in March.  This was not as high as the 20 percentage point spread that prevailed for a while in the Great Recession of 2009, but it’s hardly a sign of confidence. (This post will brief you on how bond prices and yields interact.)  The past few weeks have seen only modest improvement.  these yield spreads have declined to some 9 percentage points –– hardly much improvement but nonetheless a tentative sign of relative calm.
  • Commodity markets tell a similar story to bonds.As the lockdowns and quarantines effectively shut down the economy, industrial materials prices dropped quickly. Copper prices illustrate the common story, falling by almost 20 percent from early to late March. Oil prices did worse, falling some 40 percent during this time, though extra pumping by Saudi Arabia (because of a dispute with Russia) exaggerated the general price retreat. Prices of oil, copper and most industrial materials have since risen slightly –– again, not a sign of confidence but at least a halt to the earlier panic.
  • Currency markets, in contrast, have all but corrected their earlier panic.  When the seriousness of the pandemic first became evident, money moved toward dollars, as it does in almost every emergency.  A global index of the dollar’s value rose some 5 percent, but has nearly returned to its level of early March.  Some might interpret this as a sign that Covid-19 infections in the U.S. have risen, but on a per-capita basis the American infection rate is no worse than in most developed countries and a good deal better than some.  The movement away from the dollar speaks to a lessening of panic.

All this could change if COVID-19 changes its course.  If it worsens, panic could reappear, and the markets would return to their levels of late March or even lose more value.  But if the effects of the disease ease and promise a return to more normal levels of economic activity, the relative calm of recent weeks suggests that markets could regain ground quickly.

COVID-19 Diary – Number 1 (April 1, 2020)

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A reader suggested that while this pandemic continues, I keep an open diary on this site with frequent short entries focusing (though not exclusively) on investment and the markets. This is the first of these posts.

Markets are less concerned about the virus itself than with the recessionary impact of the lockdowns and quarantines.  That perspective points to two considerations:

  1. Actions by the federal government, and to a lesser extent states and cities, to lessen the recessionary pressure.
  2. Because the longer the lockdowns and other restraints remain in place, the deeper into recession the U.S. economy will sink and the longer and harder it will be recovering, markets necessarily also consider how long this period of restraint will last.

Washington—that is, the government and the Federal Reserve––has now delivered large (more than two trillion dollars) and well-crafted policies to deal with the recessionary dynamic. While these moves cannot ensure the economy will escape the pain of a recession, they do offer good reason to hope that the future will be less severe than it otherwise might have been.  The markets rallied in response, actually in anticipation of this welcome news.

The news on the duration of lockdowns and quarantines is less encouraging.  President Trump has given up on his “hope” that the nation could get back to work by Easter, and he extended the advice to keep things shut down until April 30.  He may have to extend it further because new Covid-19 cases are multiplying in the U.S.

  • The global picture does offer some hope. The tracking system administered by Johns Hopkins University reports that new Covid-19 infections peaked on March 27 at 67,400 and in the following two days fell about 10 percent.  But we must keep in mind that this picture of abatement is really tentative.  At other times we have seen such improvements only to face a new surge.
  • For the U.S., the picture is less encouraging. On March 31, the World Health Organization reported that the nation suffered some 19,332 new infections, nearly five times the number reported on March 27.  Yet these figures may not be as bad as they appear.  In just the last few days, the country has made considerable headway in testing – not as much as the experts say is needed, but an improvement nonetheless.

Investors should keep in mind that the nation will survive this pandemic, as will most of its businesses.  Those who bought equities for the long term (which, as so many of these posts have emphasized, is the only way to buy stocks), should keep that “long term” in mind and hold on for the inevitable recovery.  Panic selling now will only deprive you of the opportunity to take part in that recovery.  For those who have cash, the present market setbacks presents buying opportunities. But because no one can know when the pandemic and its economic fallout will end, it is not possible to pinpoint the best buy.  The smart approach would be to invest in stocks piecemeal, and over time –– perhaps on each major market reverse.  Investment professionals call this “dollar cost averaging”.

 

 

 

The Computer’s Role in the Recent Wild Market Swings

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Computerized stock trading has played a not-insignificant role in recent violent stock market swings.  Of course, behind these swings are the perennial drivers of market lurches: fear and greed.  Fear rules whenever investors feel insecure or uncertain, but it’s greed’s turn when investors judge that the fear has created a buying opportunity that despite uncertainty and insecurity, they feel they cannot afford to miss.  But computerized trading exaggerates what otherwise might be significant swings into wild volatility.  We have been seeing a lot of this.

The computer’s role exaggerates market swings because most if not all of the algorithms running these programs react to the momentum of the market.  If investors begin selling out of fear and stock prices fall at a particular rate or beneath a certain point, the computers “see” further losses and “order” even more sales, thus ensuring that further losses take place.  Investors  rushing to buy a stock will trigger the computer programs to join in.  These investor moves, once they prompt the algorithms to act, become self-fulfilling and greatly exaggerated.

For those who find this unnerving, here are four things to keep in mind:

  1. For the computer, eternity begins and ends each day. They go with the momentum until the market closes (or, less likely, something like human action alters the momentum despite the influence of computer trading).  The computer action does not follow from one day to the next.  
  2. Though computerized trading exaggerates up and down moves, it has no effect on prices over time. Such trading can be an irritation for the fundamental investor seeking to meet the basic objectives often referred to in these posts, but don’t consider it anything more than that.  The market in the closing weeks of 2018 certainly demonstrated this:  Computerized trading pushed the downdraft in stock prices much further than it otherwise might have gone, and then exaggerated the upswing the following dayThe same thing is happening now.
  3. Individual investors who try to gain from computer-induced swings by buying and/or selling stocks ahead of the swings are as likely to lose as to win. Traders buying and selling algorithmically make money because computerized trading enables them to move blindingly fast –– faster than most professional investors and certainly faster than any retail investor –– that would be you.  (In fact, most of these operations have their computers physically near the exchange, because a profit opportunity can be missed in the less-than-instantaneous time it takes an electronic order to reach the exchange from, say, an office in Connecticut.)  Even at such speed, algorithmic traders can only make money by squeezing pennies or less out of a single transaction; it is worthwhile for them because they deal in huge stock volumes.  No individual investor can do this.
  4. Computerized trading violates a fundamental rule for the retail stock investor: Even without the added volatility of computerized trading, stocks exhibit considerable volatility. This is a fundamental aspect that should warn investors off stock investing if there is any chance they will need their invested money in a hurry.  If you cannot wait for the  market’s ups and downs to cancel each other out and give you the long-term positive gain of stocks, then you should not be in them in the first place.  Better to be in bonds or savings accounts. 

 

Market Panic Over the Coronavirus

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As of this writing, markets have fallen more than 10 percent from their highs, almost entirely in a panic over the coronavirus.  It seems the American public has also shown signs of panic. Emergency food packs have disappeared from store shelves and some towns have objected to sick people getting treatment locally.  While some investors are concerned that the virus will spread across the U.S., most of the market panic thus far centers on the economic ramifications of the virus. There are three concerns:

  1. First is that economies, China’s in particular, will suffer because of widespread sickness in the country and drag down the global economy, even if countries like the United States can contain the spread of the disease.
  2. Second is that interruptions in supply chains, again notably from China, will hamstring business around the world and set economies back, even those that can contain the coronavirus.
  3. Third is that business managers will hoard inventories, either of supplies or finished goods, which would create shortages in supply chains, even when there is no real shortage of the goods in question. (For this insight, I would like to thank a wise reader who asked about that possibility.)

This is not the first time markets have suffered in the face of — and fear of — pandemics.  The spread of SARS between 2002 and 2004 created notable market retreats within what was otherwise a bull market.  In 2009 an influenza pandemic took the lives of over 200,000 worldwide and caused momentary panic in a market that was already struggling to recover from the 2008-09 financial crisis.  In 2012 the MERS pandemic produced market setbacks for brief periods.  These experiences, and the current market reaction to the coronavirus, offer investors a lesson in how to respond.

The first thing to understand is that it is impossible to predict the extent or duration of events like these.  Many commentators will try, and experts will offer estimates. While the experts’ guesses are better than those offered by the man on the barstool next to you, they are guesses nonetheless.  Keeping this in mind, there are three scenarios about how things will work out, each with its own investment implications:

  1. The disease sweeps across the world, causing widespread death and disruption. This is the basis of the public fears that are presently gaining momentum.  In this case, the investment implications are straightforward:  You — everyone — have more to worry about in such a situation than wondering about your portfolio.  Sell out, if you think that cash or treasury securities are safer in such a world than stocks or bonds.  (Though they probably are safer, they are far from safe in that environment.) Whatever you do with your money, see to your health and that of your loved ones. The money is secondary.
  2. The disease runs its course, as did SARS, which was a far more ruthless killer than today’s coronavirus. In this scenario, the abatement of the health emergency will prompt a market rebound and an economic recovery as global supply chains quickly reboot. The present coronavirus, beginning as it did in China, may hasten the shifting of supply chains away from that economy, something that was already under way in response to the U.S-China trade war.  (That is an interesting question and perhaps food for another blog post, but it is a separate matter from today’s panic.) Whether from China or Vietnam or elsewhere, the supply pipelines, literal and metaphorical, will quickly resume once this disease ebbs.  If this is the case, the current market retreat presents a buying opportunity. Of course, purchases made in anticipation of such a rebound run the risk of suffering further declines should the virus’s worst effects linger.  Therefore it might be prudent to make purchases gradually, in increments over time.  This way you will be in position to enjoy the rebound should things change quickly, but will also have funds to buy at still lower prices should the disease take longer to run its course.
  3. The disease neither runs its course nor sweeps across the world. The virus becomes a fact of life, much like HIV did over a long period from the 1970s, when it first made its appearance.  Should things unfold this way, the market would not offer the sudden rebound described above.  It would instead recover more gradually as investors come to terms with this disease as an ongoing risk in life, like cancer or HIV or heart disease, or a long list of horrors that people are aware of and simply accept.  To an extent, this scenario, too, would offer a buying opportunity, though it would not present a sudden market rebound described above.

The odds presently suggest that the market, as well as the economic responses, will mostly resemble the second scenario. This was the case with SARS, MERS, and the influenza pandemic of 2009.  But because the behavior of viruses is so difficult to predict — impossible, in fact — any such response would come with considerable risk and should not involve a large part of any investor’s assets.

As this event continues to develop, I will update as necessary.

A Question of Objectives and Asset Allocation

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I recently received a question accompanied by an interesting description of an asset allocation debate.  It gets to the nub of several investment principles underlying Bite-Sized Investing.  To put my response in perspective, I quote  from the communication.

“A few years ago, I bought stock for my retirement account in one of the great computer-related companies – let’s call it HAL – at somewhere around $55 [a share] and watched it grow to about $140.  I was pleased with myself.  But in my year-end meeting with my broker [. . .] we discussed my retirement accounts (an IRA and one other) [. . .]  The broker wanted me to buy some bonds, which I reluctantly acceded to, but they also pressed me to sell all of my HAL stock and take my profits.  I resisted: I didn’t need cash, and because I still work [. . .] I only withdraw the minimum from my retirement accounts as dictated by law.  But they pushed me to sell, and we finally compromised that I would sell half the stock.  I did, and the stock has now gone past $180 [a share]. (I realize that the stock – any stock – could have gone south.)  I feel that I let myself be talked into a decision that I now regret.  The broker I deem to be a good guy, though not perhaps a brilliant stock-picker.  I don’t think he acted for the purposes of churning my account, but . . . I also have a friend who says that when he buys a stock, he does so without any intention to sell, because the market, in the end, prevails.

“Thoughts?  Advice?”

 There is a lot going on here.  Before suggesting a course of action, here are four relevant points:

  1. I agree with you that your broker was not trying to churn your account. If he were doing so, he would have suggested many more trades, something like diversifying your HAL holdings into several other stocks or making many more changes than he did. On the contrary, as I will make clear in the following points, I believe he was acting from the best of motives, perhaps misplaced, but otherwise honest and in some ways quite reasonable.
  2. I have always stressed diversification, which makes me sympathetic to your broker’s suggestion to sell all or part of the “HAL” holding. Rather than an outright sale, I would have sought diversification by bringing down your “HAL” exposure to no more than 5 percent of your assets.  If you have an abundance of assets relative to your needs (and so could afford to risk a greater part of them) I would have upped that percentage to 10 percent, but not more.
  3. Your broker could have been reacting to the designation of your account as a retirement vehicle, especially because of the legal requirement that you must draw on your IRA after your 70th+ birthday (now 73). Typically, as a person nears retirement, investment advisors of all kinds will recommend selling stock, especially the more volatile ones, in favor of bonds and more stable, higher dividend-paying stocks.  This way, the portfolio will throw off the income a person presumably will need in retirement, and because it is more stable, the portfolio will also avoid the risk that the owner will have to sell when prices are deeply depressed. There can be little doubt that your broker had these needs in mind when he gave the advice to move from “HAL” into bonds, even though you are still working, have no need to draw on these assets for living expenses, and do not expect to have that need anytime soon.
  4. Your broker may have been under some pressure from his headquarters as well. Not too long ago, the Department of Labor threatened to designate brokers as fiduciaries, something that would have made them liable for legal action should their advice have resulted in a loss.  At the same time, the Labor Department offered guidance about what policies might be acceptable and so presumably might have protected the brokers from legal problems.  Those policies included the kind of retirement account strategy described in the point above. Though the Labor Department ultimately decided against this approach, brokers no doubt worry that the regulators will return to such thinking and so in the meantime strive to keep their advice in line with what the Department once considered acceptable.  And they might do so regardless of a client’s specific needs or desires.

I recommend two ways to cope with this situation:

  1. Make your particular circumstances clear to your broker. He should have no confusion that you have no intention of retiring anytime soon and that as a consequence he should, despite your age, treat your retirement account as he would that of a younger individual with plenty of time remaining before needing to draw income from the assets.  You might explain that you have no intention of ever retiring and that, whatever the label on the account, you mean it as a legacy for your children or other heirs.  It might help to clarify this arrangement in writing so that he can attach it to your account.  That way he can save himself from pressure from his firm, either on policy or legal grounds, and also bind his successors and assistants to your intention.
  2. You might also set up a separate account for the after-tax proceeds of what you are legally required to sell from these retirement accounts. Because such an account would not carry the retirement designation, it would avoid all the seeming requirements pressing on your broker with your other two accounts, thus relieving him of any need to follow company policy on retirement accounts or Department of Labor direction.  In this separate account you could:
    • Repurchase some or all of the “HAL” or Hal-like stocks sold from your retirement account.
    • Because the sale from your retirement account would be free of capital gains taxes, this transaction would not incur tax liability.And while you would benefit from taking all the earlier gains from your retirement account(s) tax free, the new, higher price in this new account would set a higher price base so that the taxable capital gain from any future sale would be lower than if you had to calculate it from the original price you paid when you bought it for your retirement account.
    • As a further safeguard, make this account strictly non-discretionary so that your broker can only act on your instructions.

The Good Professor’s Measure

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A reader and good friend recently sent me an article by Robert Shiller, Nobel Laureate and Sterling Professor of Economics at Yale University.  In it, Prof. Shiller uses his own tool for evaluating markets, the so-called C.A.P.E. price-earnings ratio, to make the case that markets are overpriced and that the current market rally is running on emotion. Prof. Shiller is an impressive man, with credentials to boot.  His warning that a market correction is in the cards may well be correct, but his prediction gives me the opportunity to warn readers, once again, about the hazards of forecasting and trying to time the market.

The Shiller C.A.P.E. ratio has been around for a long time.  It differs in two ways from the conventional price-earnings ratio discussed here.  First, where the conventional ratio divides stock prices by recent or future earnings, the Shiller ratio divides the price of stocks by their average earnings over the last ten years.  Second, unlike the conventional ratio, the C.A.P.E. adjusts the earnings to take inflation into account.  Shiller argues that his two adjustments uncouple his ratio from problems associated with the conventional ratio, especially with respect to recessions.  When the economy pulls back, corporate earnings typically drop faster and further than stock prices, so that at market lows, when people should be buying, the conventional price-earnings measure looks high, suggesting that stocks are overpriced.  Shiller’s measure, because it uses long and deflated averages, gets away from this misleading effect.

It seems strange to adjust the earnings for inflation.  After all, stock prices – the point of comparison – are not adjusted for inflation.  The use of a long average introduces other problems.  Because earnings rise over time, his use of a ten-year average tends to make the C.A.P.E. ratio look high and the market therefore look overpriced much of the time.  Together, these effects make the C.A.P.E. measure give a sell signal even when much else suggests that stocks are a good buy.  Here are three illustrative examples:

  1. C.A.P.E’s implicit pessimism was certainly evident during the earnings and market surge between 2017 and 2019. Leading up to 2017, earnings had disappointed, biasing downward the ten-year deflated earnings average.  As a consequence, as 2017 drew to a close the C.A.P.E. measure indicated less attractive market valuations than at any time since 2001.  C.A.P.E. followers would have sold and missed the better than 20 percent appreciation in stock prices over the last two years.
  2. The recovery from the great recession tells a similar story. The C.A.P.E. ratio showed a buying opportunity in 2009, and it was a good opportunity.  The market rallied in the years following the recession’s end even though the economic recovery was disappointingly slow.  But because the ratio’s use of a deflated ten-year earnings average could not fully capture the post-recession surge in earnings, the Shiller ratio by the end of 2013 showed even less attractive stock valuations than at the start of the great recession.  Investors following the ratio would surely have sold and missed the huge gains of the next six years right up to the present.
  3. In 1990, the C.A.P.E. ratio showed the least attractive valuation in sixteen years. Yet the 1990s saw great market gains of some 274 percent!

The media’s treatment of Prof. Shiller’s efforts adds to the damage of these misleading signals.  He is a famous man and receives attention from financial journalists, who broadcast his warnings; several publications have given him his own platform.  When his early sell signals prove mistaken, people naturally forget them amid the endless flow of market commentary.  And when after several false warnings the market does correct – and there is always a market correction on the horizon – the media says, in effect, that he “got it right again,” or words to that effect.

My point is not to criticize Prof. Shiller and his efforts to chart market valuations.  He is a thoughtful and insightful man.  However, his is just one of many measures, all of which have their drawbacks.  We should not ignore Shiller’s work, despite the C.A.P.E. ratio’s sometimes misleading nature. But we should keep in mind that his measure’s failings show, compellingly, how difficult it is even for even the best-educated minds to forecast market moves and why timing the market is so dangerous, especially using a single measure.

Why We Should Be Careful With Statistics

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After I voiced skepticism in my recent post about the Business Roundtable’s newfound interest in stakeholders (in addition to shareholders), readers have asked how we could judge –– with hard, meaning statistical evidence –– whether the decision-makers in these firms really do consider all stakeholders.  The short answer is that it would be all but impossible to get statistics that would definitively judge this matter.  But this answer brings up a broader issue: the difficulty in using statistics to analyze many of the issues of concern to investors, business decision- makers, and public policy-makers.

I admit this question can quickly move the discussion away from the focus of this website –– investing –– but it seems worthwhile nonetheless.  Statistics are employed endlessly to praise or condemn business and public policy issues. An intelligent investor need not be a statistician, but facing this barrage of numbers he or she should at least have a sense of how to think about them.

Let’s look at some issues, such as stakeholders versus shareholders, diversity, and a few more relevant questions to show how statistics inflict bias and how, on any particular matter, they will always fall short of providing a reliable judgment of success or failure.

Because the Business Roundtable started all this, it might help to revisit its recent “change of heart.”  The Roundtable had long insisted that business managers consider the shareholder –– and only the shareholder –– in their decision-making. Recently, it said that a better way to proceed would be to include the interests of what they call stakeholders: workers, customers, and the communities in which businesses operate.  What hard evidence –– that is, statistics –– could help us judge whether these men and women were living up to their newfound commitment?

Would, for instance, a comparison of returns to shareholders and to workers answer this need?   If so, what statistic could provide the insight?  A historic comparison of relative shares of gains might provide a guide here, but what historic period should we choose as appropriate?  Even an answer to these questions would still leave out customers and communities.  Would a markup from cost prices adequately assess whether the customer was being treated fairly?  If so, what would the appropriate markup be, and for which sorts of products?  Would dollars spent on community projects be an adequate basis to judge?  Even if the members of the Roundtable could settle on such a figure, how would they trade it off against the “needs” of other stakeholders?  For instance, might shareholders and workers feel cheated by what they felt was an excess of business involvement in community affairs, and what measure could properly respond to their complaints?

These questions should shed light on my earlier post in which I speculated that the Roundtable sought this muddled attempt at assessment in order to avoid responsibility to any particular stakeholder.  Noteworthy in this regard is that for all the Roundtable’s high-minded language, not one of its members has even begun to offer a way to judge this matter, or how to trade off the interests of one stakeholder against another.  Perhaps more noteworthy is that presidential candidate Sen. Elizabeth Warren, the candidate who has most vocally touted this approach, also has failed to suggest ways to carry it out.

There is also the question of diversity in employment.  Percentages of various groups in a company’s workforce would seem to be an obvious way to proceed, but the look of that analysis would depend heavily on who was included in which group.  Will the diversity-seekers parse all gender, ethnic, national, religious, and racial groups?  Do the statistics count Muslim and Hindu Indians as one group of Indians or as two separate religious groups?  Is someone who was labeled male at birth but identifying now as a woman count as a woman for statistical purposes?  If the statistics depend on self-identification, what guidance, if any, should the firm offer people on answering that question?  Does someone of mixed race count as both races or only one, and if one, which one?  Should the effort also look at the jobs involved?  If all women (however defined) cluster in HR and all people of color (however defined) cluster in Compliance, is that really a diverse workforce? Questions might arise over which groups have which opportunities.  For instance, do women have the same opportunity to travel for work (typically a steppingstone to management) as do men?  Does a strenuous effort for such diversity “cheat” stakeholders?

This line of questioning could extend without end, because the answer to each question creates yet another question.  Measuring customer complaints, for instance, opens questions on whether the firm should count the numbers of complaints, or their severity, or both.  What about accidents on the shop floor? Environmental damage is a critical issue these days.  Should statistics measure the number of environmental incidents, or their severity?  Should they measure particles in the air or carbon dioxide?  Should the measures be across the entire firm or for each division?  Does environmental repair by one division of the firm balance environmental damage by another?  Whatever method is chosen, the figures bias the results, sometimes intentionally, sometimes inadvertently.

I offer no answers because there are none.  My point here is not to confuse, but to make readers aware that statistics are inherently biased, and so are always dangerous, especially when used to “prove” virtue or vice in a firm, an individual, or a public policy. A good investor –– a good citizen –– needs to understand this and treat all statistical interpretations with appropriate skepticism.

 

 

Bill Gates Embarrasses Himself, But Offers an Investment Lesson Nonetheless

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Bill Gates of Microsoft fame and fortune gave an interview recently, and though he embarrassed himself, the exchange offers investors an important lesson:

No one has secret knowledge. Someone may perhaps have special knowledge, but nothing that amounts to magic. The Gates interview teaches this important point in two different ways:

He spoke on the inadequacies of economists and the economics profession in general.  “Too bad,” he told the interviewer, that “economists don’t actually understand macroeconomics.” By macroeconomics he meant those aspects of economics concerned with large-scale or general economic factors, such as interest rates and national productivity.

On this point he is correct.  They do not.   Economists and economic thought cannot grasp all the intricacies of the macro economy, much as historians cannot grasp all the intricacies and motivations involved in past events, and much as medical doctors admit to the ongoing mysteries of human health.

Everyone knows – or should know – that, unlike mechanical engineering for instance, economics deals with people, their perceptions and their irrationalities. What seemed to work one way yesterday can lurch in a different direction tomorrow. Why?  Because, for example, the public mood is now different from what it was yesterday, or because popular ideas have changed, or because businesses, having observed yesterday’s results, have now repositioned themselves.  No one pretends, or should pretend, that economics can predict accurately in the way that physics can be sure of the speed of Newton’s famous apple falling from that tree.

Most economists know this and readily admit it. Economists make the effort to predict, not because they are arrogant (though some are), or because they have deluded themselves (though some have), but rather because their subject matter is so immediately important to so many people. If economics were astronomy, this state of affairs would hardly merit comment or criticism. No one faults astronomers because they cannot fully explain the existence of black holes, or even characterize them adequately. People do not readily accept the limitations of economic thought because its subject matter is jobs and income, prosperity and wealth, things that matter deeply to individuals and businesses, as well as to governments. When Washington and businesses try to improve the fortunes of citizens or workers or shareholders, they want a roadmap to tell them where the turns are and where the pitfalls lie. When told that economic thought and its practitioners cannot provide such guidance, these decision-makers ask for a best guess, rough guidance on at least what is not likely to happen. Because a guess that is made within disciplined thought — no matter how inadequate to the task — is better than simply a guess, these decision-makers accept what they can get from the economists.

My posts have repeatedly focused on this lesson – that no one can know, because no one can see the future.  Every forecast, whether about the market or an individual security, is a guess, an educated guess perhaps, but a guess nonetheless.  There is no magic, which is why my posts advise against trying to time markets but emphasize instead diversification so as to avoid having too much riding on one or two insights.

Gates’s interview teaches this lesson again, from a different vantage point, though no doubt he did so inadvertently.  In his criticism, he implied that his insight about the inadequacies of economics was somehow new or shared by only a select group.  As I have said, most economists admit their knowledge is limited, that the subject matter is too complex and too variable for any straightforward treatment.

If Gates had wanted to convey what most everyone knows, he might have explained why economics cannot do what politicians and others sometimes expect of it. As if to buttress my point about his claim to special knowledge, he called in this interview on the wisdom of another billionaire, Warren Buffett.  Mr. Buffett, it seems, has pointed out the existence of negative interest rates and faulted the discipline of economics because no textbook mentions the phenomenon. Somehow, this is supposed to explain how the field does not understand its own subject matter. It would be strange to fill textbooks with anomalies, but that aside, negative interest rates are neither hard to understand nor are they a particularly economic development. They occur less because of economic forces (though those forces have some role), than because institutional arrangements in day-to-day financial business –– the need for collateral, for instance –– force people and institutions to buy and hold instruments that pay a negative rate of interest. They do not buy to invest in a financial instrument that lose them money. It was hardly magical knowledge that informed the more thorough discussion of negative rates I offered in a previous post.  But such explanations matter little when billionaires opine smugly on the inadequacies of others.

Whether the speaker or writer is a billionaire, a spokesperson for a respected investment house, or someone you just met at the bar, they may have experience and insight worth listening to and considering, but nobody knows.  The advice offered in my posts will never lose sight of that fact.

The Stock Market and Trading with China

people visiting forbidden city

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Financial pages note diligently, seemingly daily, how stock prices rise and fall with the prospects of a U.S.-China trade deal.  When hopes dim, prices fall, and when they improve, prices surge.  Partly this reflects investors’ constant desire for peace and business-as-usual. They want the uncertainty to lift and to be able to plan around doing business with China and seeing the potential profits therein.  But that is far from the whole story.  Markets – along with the Trump administration and many in Congress (including Democrats) – would also like to see China end its unfair business practices, its outright theft of technologies, and its regulatory biases against American firms.  And as much as they all want such reform, they also fear the tariff weapon that Trump has deployed to achieve those ends.  All these considerations lie behind the market’s response to these tense negotiations.

Let’s look at each of these drivers:

The ever-present discomfort with uncertainty among investors dominates most of the media coverage. This is as it should be, because uncertainty is the most obvious trigger that moves the market.  Before President Trump decided to take on Beijing, everyone knew where they stood. Matters may not have been as people would have liked, but they understood, at least roughly, what to expect and they could make their investment plans on that basis.  But now matters are up in the air; no one can accurately predict how things will come out.  When negotiations between the U.S. and China appear to be going well, the prospect of certainty buoys investors’ hopes and they buy.  When negotiations appear to falter, they pull back, and market prices reflect that lack of support.

Aside from planning, investors want trade to resume and the profits that flow from it. Though China acted in ways that the U.S. didn’t like, the trade provided a reliable flow of inexpensive consumer goods and materials for American consumers and American industry — for instance, the rare earth elements that are essential for battery technology. This trade flow enhanced America’s general growth prospects as well as corporate profitability.  China trade also enhanced growth in Europe and elsewhere in Asia, which in turn further enhanced the business prospects of American companies. Investors love nothing that interrupts this pattern.

Market participants also fear tariffs.  They have learned from textbooks and from bitter, real world experience that tariffs and subsidies distort markets and make business less efficient and thus, on balance, less profitable.  We all know that firms favored by tariffs and subsidies can benefit from them greatly, but only at the expense of other businesses.  On net, the business community generally and the American and other economies lose out.  There is also the historical warning from the last time the U.S. turned to tariffs with the Smoot-Hawley Act, passed in 1930 during the Great Depression.  Those tariffs hurt American consumers and businesses by raising the cost of much of what they bought, and they hurt American exports when other countries retaliated with tariffs of their own.  There is ample evidence that those tariffs turned what might have been a severe recession in the early 1930s into the Great Depression.   The Trump tariffs are nowhere near as extensive or severe as Smoot-Hawley, but the warning is there.

Yet anger at Chinese business practices keeps investors rooting for some success in the Trump administration’s efforts.  The business community, both here and in the rest of the world, have long complained about how China subsidizes its industry and about its local content rules that go beyond those of any other major nation in insisting that contractors, foreign and domestic, use domestically produced materials in China, regardless of cost or quality.  Also, in the past, China has manipulated its currency to give its industry price advantages over American, European, and Japanese businesses.  Beijing turns a blind eye when its firms, including government-owned enterprises, steal technologies and business secrets from foreign firms, including American companies.  Perhaps most irritating of all is Beijing’s insistence that any foreign firm doing business in China must have a Chinese partner and must reveal to that partner its technological and commercial secrets.  U.S. presidents going back at least to Bill Clinton have complained about these practices and have received assurances from China’s leadership that they will stop (most prominently, assurances given to President Obama during his second term).  But Beijing has always reneged.  There is hope that the current trade negotiations will exact something more substantive.

With this as background, we can identify four possibilities and the market’s likely reaction in each, though I am not foolish enough to attach a precise number to any one of them:

  1. Best Case: The United States prevails in the negotiations.  Beijing offers acceptable assurances that China will alter its business practices.  The tariffs are removed, and with it the fear of where the continuation of tariffs might have led.  Trade resumes, and so do the prospects of global growth.  American businesses can plan again in a more favorable environment. Stock prices would not only surge on the news but the advance would likely continue with the prospect of improved commercial profitability.
  2. Second Best Case: Washington accepts something akin to China’s old assurances, lifts the tariffs, and trade resumes.  This possibility would have all the positives of the best case above and the market would indeed lift, but not nearly as much as in the best case, because investors and business people would have no real confidence that China would change its business practices.
  3. Pretty Bad Case: Trump backs down, lifts the tariffs, but gets no deal from China to speak of.  This possibility would have a lot of the positives of the two better cases above, but there would be no hope that China would change its business practices and everyone would know that in the future Washington would be negotiating from a position of weakness.  The markets might briefly surge on the positives, but such a rally would have no staying power and might even reverse as the longer-term negatives became apparent.
  4. Worst Case: The battle goes on with no sign of resolution.  This prospect would maintain all the tariffs and the fears associated with them.  It would offer not even a hope that that the Chinese would change their business practices, and it would signal that the interruptions and uncertainties in trade would last indefinitely.  The market would sink on this news and it would continue to lose ground.

 

 

 

When to Get Out – Or Not

person on a bridge near a lake

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No doubt because markets rose and fell so violently in August, many are asking whether now is the time to get out of stocks.  My answer has two parts:

  1. If you are within five years of needing any or all of the money you presently have in stocks, now would be a good time to withdraw those funds. As so many of my posts have explained, no one should have their money in stocks if they are within five years of needing it. By getting out now, you may miss some of the upside, but it is still better than doing so after the market has suffered a setback.  Put the proceeds of your sale in intermediate bonds set to mature about the time you will need it.  For guidance on which bonds, see this post.
  2. If you do not need the money for five or more years, stay in the market. Trying to accurately time market swings is delusionary.  Practically speaking, no one has ever demonstrated a consistent ability to time market swings.  Many claim to have this ability, and/or a system to sell to you, and, yes, some do get lucky.  But think: “Why would anyone with such an ability or system include me, even for a hefty price?”  That person would not need to sell anything, or even talk to anyone.  All he or she would need do is apply the system for his or her own portfolio and get filthy rich.  But no one seems to be doing that.

Because no one can reliably time stock market swings, getting in an out can be dangerous.  Emotions and media chatter urge people to throw money into stocks when the market is on a roll­­ — in other words, when prices are high — while fear, and chatter about fear, urge selling when the market has taken a major hit and prices are low.  You would be buying high and selling low, precisely the reverse of the age-old advice on how to make money in the market: buy low, sell high. This happened to many people in 2008, when the stock market crashed. Fearing that it would just keep going down, they sold when (as many said) they “could no longer stand the losses.”  Few got back in quickly enough to capture the upturn when it came in 2009, not the least because the crash had generated so much fear that most people, and the media too, wrote off any gains as a “false” signal.

It would be better to work with your anxiety and ride the stocks down and have your money in them for the inevitable upturn when it arrives.  And because you have no business being in stocks if you will need the money soon, the wait should impose no hardship (beyond depressing reading when you open your statements).  Understandably, any market setback, especially one like the crash of 2008, creates a lingering fear that prices cannot recover, but this flies in the face of long market experience.  Stock prices have always recovered and gone to new highs, and have done so within the five-year horizon used here as a test of whether stocks are right for you. After the great crash of 2008, stock prices surpassed their old highs within three years.  Usually the recovery happens even faster.

If you have trouble sitting on your nerves, there is an alternative; it’s called dollar cost averaging.  In this approach, you do not buy in all at once but rather feed that portion of your assets, those funds that you won’t need for five years, into the stock market gradually, over time, say monthly or quarterly or even annually, and you do so regardless of what else is happening.  If it turns out that you have made any of these incremental purchases near a market peak, you can comfort yourself for having bought in at high prices that you did so with only a small portion of your assets, and that many of your incremental purchases were made at more attractive price points.