Brexit and You

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The story of Great Britain’s exit from the European Union (EU) periodically dominates headlines and rocks financial markets.  For the individual investor, even those in Britain and Europe, the major problem is uncertainty.  No one knows how this will turn out, and what arrangements Britain will have with Europe and the rest of the world when Brexit is done.  It is pointless to guess about the possibilities.  What affects markets is not a specific possibility but rather this lack of clarity around Brexit.  This is keeping stock prices lower than they otherwise would be.  Chances are that prices would rise even if Britain got a bad deal from Europe, simply because people then would at least know what they were dealing with.  Even at that, it will take years to know the implications of any settlement.

This uncertainty has reigned since 2016, when the people of the United Kingdom (UK) voted to end their 50-year relationship with the rest of the EU. When a country, especially one like Great Britain, which ranks in the top ten economic powers in the world, changes its fundamental arrangements, many questions and concerns arise about the economic, financial, and investment implications.  Nor is it just Britain.  The UK’s economy is second only to Germany in size and power in the EU (which, American investors please take note, actually has a larger economy than the United States).  Unless Britain gets a favorable Brexit deal, it will no doubt pursue trade agreements with the rest of the world, including the United States.  Consequently, the Brexit situation has the potential to affect every economy –– and thus every market –– throughout the world.  But as I’ve said, no one can know exactly how.

Making matters murkier is that the Brexit shakeout has only just begun.  In the more than two years since the British voted to leave, it has become evident in all the failed negotiations thus far that matters were much more convoluted than anyone imagined.  Britain’s Parliament has refused to endorse any of the agreements the then Prime Minister, Theresa May, negotiated, and she resigned her office in response.  Though the new Prime Minister, Boris Johnson, has a more forceful manner, there is no indication that he will move things forward any faster than May did, or that he will have more success with Parliament.  And the recent EU elections have made it difficult to tell what its negotiators will focus on when –– and if –– they rejoin talks with the British.

Even at some distant future date, when –– and again, if –– the parties involved reach some kind of agreement, the uncertainty will linger, keeping global markets lower than they otherwise would be.  For instance, the relative success or failure of Britain may then inspire other members of the EU to consider leaving.  Already there is speculation in Italy about following in the UK’s footsteps.  Or, in another for instance, Britain may negotiate trade arrangements with Washington that give the United States leverage over the EU that it has not had to date.  There are an infinite number of possibilities, and they will push uncertainty into an indefinite future.

Because investors cannot wait for clarity on these many fronts, they should proceed with two considerations in mind:

  1. Markets have already incorporated a general level of uncertainty and have priced down assets accordingly. Almost all the news in coming months, and possibly years, will surely affect markets sharply over short periods of time, but in general the markets will always be affected by this level of uncertainty.  The advice flowing from this observation is: Do not base your investment decisions on the Brexit issue until such time when there is greater clarity.
  2. Because this eventual clarity is as likely to look good as it is to look bad for Britain, the EU, or the United States or any other economy, there is no reason to avoid these economies while framing your investment portfolio around other, more definite considerations. A good and thorough diversification along the lines described in earlier posts, most especially this one is your best answer.

This may well be a frustrating post for many readers.  It would feel more satisfying if I were to guess at a likely outcome and offer advice around it –– after all, that is what so many investment newsletters do.  But I would neither be honest nor responsible if I did that.  The best guess that even the most educated observers can offer is to exclude a few of the many possibilities that can emerge from the Brexit matter, for instance that the British economy will implode, or the EU will fly apart, or that Britain will form a new trading bloc with the United States, or many other fanciful scenarios that occasionally float up in the media.  Excluding such possibilities, however, is still not enough to guide investment decisions, except in the ways described above.

 

 

 

What Does the Market Listen to?

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I was perplexed when I got this question not too long ago.  My first impulse was to respond with a single word: “Everything.” Market participants are always gathering all the information and insight they can about investments in which they have a position or an interest. At any moment, some investors have an interest in just about every possible investment; thus the market as a whole is looking at everything.  Think of the mythical Argus, the monster with at least 100 eyes that never sleeps.

But after further consideration, I decided that my questioner was getting at something more subtle.  Though it is true that the market looks at everything, it also seems that at any point in time it focuses on particular issues – some that are specific to a company, others that are more widespread in their impact. I decided it was to these matters that my questioner referred.

Though some things attract attention more than others, they are never the same things.  What seemed of crucial importance last quarter may hardly be mentioned today.  For instance, as I write this afternoon, the buzz is about the Federal Reserve’s (Fed) interest rate policy.  The Fed’s policy-making body –– the Federal Reserve Open Market Committee (FOMC) –– is meeting to decide whether to cut interest rates, and so all of Argus’ 100 eyes appear to be on Washington.  By the time you read this, the Fed will already have made its decision, and market participants will know where things stand for the next few weeks, and so they will already have moved on to other issues — perhaps foreign trade or the credit card hacking at Capital One, with its implications for that bank and other financial firms.

To some extent, the media plays a role in these sequential shifts in what market observers focus on:  Reporters have to have a topic; they ask prominent investors their thoughts of the moment and then cover that topic with the expectation that more readers will have an interest in that article than one about another topic.  This shifting happens so quickly that no individual investor can keep up with the flow, much less get ahead of it.  Sometimes the investor who pointed the journalist to a specific issue will have moved on even before the story is published.  Over the course of a few weeks, this quick scanning of influences enables market participants –– as a group, but not individually–– to assess everything that affects all securities.

This may seem like a most difficult situation, especially for the individual investor, but it does offer bits of investment advice:

  • If the media is talking about it, the market already has long since considered what is knowable, so trading on “public news” only insures that the investor will be behind the information curve. The most useful part of a news item comes not from the facts of what has happened, or from the quotes of so-called experts, but rather from any insight the investor can glean about next stepsFor example, the Fed has cut rates.  That news is already discounted.  But is there something in what the policy-makers said that speaks to the Fed’s next move?  That is the more valuable piece of information, even though it is less definite.
  • The investor can get the most value out of what is less thoroughly discussed. While everyone is talking about the strain on Capital One, look for information about other financial firms.  Are some equally vulnerable but have not yet suffered a price decline or, alternatively, have some financial firms taken more steps than others to protect against hacking and thus stand to benefit as market participants begin to think more deeply about such risks (as they will in response to the news about Capital One).
  • Despite the insight of the last two points, most investors –– professionals as well as individual investors –– should understand that they cannot get ahead of this process: it happens too quickly, and except for scheduled meetings of the Fed and the like, too randomly. Rather than try to divine what the market has missed in the deluge of daily news, it would be better to consider the long term.  Pick investments with characteristics that meet your long-term goals. Build a diversified portfolio, as described in my earlier posts, so that it can enjoy the effects of the occasional pieces of unexpected good news while standing up to the strain of those inevitable pieces of bad news.

Of course, there are disasters that require quick sales to avoid horrendous losses.  But these are few and far between.  If your long-term analysis is good, or if you have bought an index fund or a large-enough slice of the market so that your portfolio is broadly instead of narrowly exposed, then this kind of urgency might occur only a few times in an investment lifetime.  Always keep in mind that your chief aim is to have exposure not to any specific securities, but to securities that behave in ways that are suited to your long-term goals.

Cyber Currencies and Gold

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Not a day goes by, it seems, that an item does not pop up in my inbox imploring me –– for my own sake! –– to buy gold.  So far Bitcoin and other cyber currencies have yet to find this route into my thinking.  It’s somewhat curious that stodgy old gold has made better marketing use of cyberspace than the cyber currencies, but then, they don’t need the help.  Countless media outlets frequently hyperventilate about Bitcoin and other cyber currencies, and my younger associates gush about the prospects of such dollar alternatives.  So the time seems right to take a look at what this is all about.

Much of the excitement about cyber currencies simply reflects the continual enchantment of the new and the different.  But look further, and one sees that the pleas for Bitcoin, its cyber kin, and, indeed, stodgy old gold, have the same roots: concern about the dollar’s future.  People doubt that the greenback can keep its value after the flood of liquidity the Federal Reserve (Fed) has poured into financial markets over the years.  Huge federal budget deficits redouble such doubts, as does the legacy of past budget profligacy that has created an overhang of outstanding government debt in excess of the U.S. economy’s entire annual output of goods and services — the gross domestic product (GDP).  The marketers of gold and cyber currencies suggest that, rather than putting one’s savings at risk with what this dire debt situation might mean for the dollar, it would seem better to entrust one’s assets to something “untethered” from the government that might weather the economic and financial problems better than the greenback.  Gold has been the traditional haven for those who share such fears.  Bitcoin and other cyber currencies present themselves as modern (and no doubt “cooler”) alternatives.

Though I don’t dismiss concerns about the dollar, one thing is clear: Bitcoin has failed utterly as an alternative.  An effective currency, whether government-issued or not, must possess three qualities: (1) widespread acceptance in transactions; (2) ease of convertibility to goods, services, and other assets, including other currencies; and (3) a stable store of value.  On all of these, the dollar has outshone Bitcoin and other cyber currencies.  So, too, by the way, has gold, the original global currency independent of national issuers. Both the dollar and gold are more widely used than any cyber currency.  Of course, advocates of the cybers might with some justice say it is just a matter of time. But for now, these alternatives have to play catch-up.  On convertibility, the dollar also wins, as does gold.  Indeed, options for convertibility on both exist worldwide 24/7.  Here, too, the cyber currency advocates may well say, also with some justice, that it is just a matter of time.  But convertibility for cybers is far out on the horizon, if it ever develops.

It is especially on the last of these qualities –– as a stable store of value –– that Bitcoin has failed most dramatically. Over the past three years, Bitcoin has offered anything but stability.  Between January 2016 and January 2018, its value multiplied by some 20 times, encouraging holders of Bitcoin to hang in there.  Then, between January 2018 and January 2019, it gave back the bulk of those gains. Recently, it has risen off its lows. For traders, this kind of volatility has been a Godsend, especially for those who went long in the first phase and short in the second.  But for people who viewed Bitcoin as a currency substitute, it was a disaster. Gold has been more stable than Bitcoin, but it has hardly shown itself to be of urgent need in a portfolio.  Continuing low rates of inflation in the U.S. make plain that the dollar has hardly lost value in terms of what it can buy in goods and services.

If, on closer examination, the cyber currencies possesses little luster as a dollar alternative, it is then fair to ask why so many financial entities have decided to introduce cyber currencies of their own. Most prominently, J. P. Morgan has announced its own cyber currency, called the JP Morgan, for trading between customers.  More flamboyantly, Facebook has announced the issuing of its cyber coin, the Libra.  Both stand to gain wider acceptance more quickly than Bitcoin.  J. P. Morgan, after all, has a powerful presence in financial markets and on Main Street, while Facebook has a remarkable reach (at least for the time being) that is enhanced by others involved in its announced but for the moment seemingly postponed launch –– among them Visa, MasterCard, PayPal, and Uber Technologies.  Both the Morgan and the Libra, however, fail to offer the untethered promise of gold or Bitcoin and other cyber currencies.  The J. P. Morgan coin will tie itself to the dollar.  The Libra is to tie itself to a basket of government-issued currencies in which the U.S. dollar is prominent.  Thus, rather than disconnect their value from the dollar, these “currencies” will act as extensions of it; in fact, they will be less a separate currency than a technologically advanced version of the kinds of payments systems that have been around for decades.

What, then, are the issuers looking for when they offer a cyber currency to the public?  The answer is age-old and straightforward: They aim not to bring a revolution to finance but to secure or enhance their own prospects for profits.  No doubt the credit card issuers in the consortium issuing the Libra see it as a way to enlarge the scope for the fees they receive from retailers each time someone uses their card for a purchase.  However, primary among the advantages is seigniorage.  This old-fashioned term refers to the real advantages available to any issuer of currency, whether it is a government or a private venture.  The more widely used a currency, the greater the number of people who will hold it.  The issuers of the currency meet the demands of those who hold the currency by buying from them goods and services with their issued currency.  As long as the public is willing to hold the currency, the issuers get the use of these goods and services, while those who provide them get to hold the currency.  The more the currency expands, the more seigniorage the issuers secure.  When some politicians suggest that the United States should cover its deficit by printing more money, they refer to this process.

This picture should clarify where gold and cyber currencies belong in an investment strategy: less as a new way to conduct the business of life or a means to protect oneself from economic vicissitudes and more as simply another investment option.  Gold is a commodity.  Cyber currencies that are not tied to the dollar are a form of synthetic gold. Some may offer a haven should the marketplace lose faith in the dollar.  Gold, as well as other commodities and also real estate certainly protected asset values during the period of great inflation in the late 1970s and early 1980s. But for the most part, it is simply a question of how much enthusiasm –– genuine or manufactured –– will push up the currency’s price in the immediate future.  The question is purely a matter of anticipated price appreciation. Neither gold nor the cyber currencies pay interest or a dividend, at least not yet, and some, like gold, can cost the holder for insurance, should he or she opt to hold the bullion itself.  If cyber currencies, and gold, are not the most secure investment bet, neither are they illegitimate.  A note of common sense: given the history of Bitcoin, an investor should put no more into such assets than he or she can afford to lose.

 

 

 

A Word on Price-Earnings Multiples

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An avid reader recently asked a two-part question: Why do investors put so much store in a stock’s P-E (price-earnings) multiple and is the ratio as reliable an indicator as many professionals suggest? The short answers are: 1) P-E ratios are extremely helpful in comparing investment choices.  2) They are reliable but only in context.  I will explain.

Why This Particular Ratio 

This indicator is a simple calculation that divides the stock’s current price per share by its annual earnings per share.  Because it tells the investor how much earnings he gets for a given investment, it’s extremely handy when comparing one stock to another, even if they are in very different businesses.

The ratio has its roots in an old investment rule-of-thumb that dates back into the mists of time.  Long before there were organized stock markets, merchants would assess the merits of a business opportunity by estimating how long it would take to earn back their original investment.  If someone offered them, say, one twentieth of their business for an investment of a certain amount, they would immediately ask how much the business earned during the last year.  With that information, they could calculate how many years it would take for them to earn back their initial investment, after which time the deal would be pure profit for them.  The shorter the earn back period, the more attractive the deal, all else being equal. The calculation also offered an easy metric for comparisons to other deals.  If another business owner offered them a share that would pay back in less time, it would (all else being equal) be more attractive.  The P-E ratio gives the same information.

Another way to look at the P-E multiple is to turn it on its head.  The upside down ratio, instead of telling you how many years’ earnings you must pay for a share, tells you the earnings as a rate of return on the initial investment. A P-E ratio of 20, for instance, pays you one twentieth of your investment every year or 5 percent. Expressing things as a percentage not only allows comparisons to other stocks, but it also enables the investor to compare a prospective stock investment to the yields on bonds and interest rates paid on deposits.

Kinds of Multiples

 Whether presented right side up or upside down, there are more than one kind of P-E multiple.  Some investors prefer to measure the price relative to the previous year’s earnings. They argue that those earnings are definite and involve no dubious estimations.  Others construct the ratio using the current year’s earnings, claiming that these are more up to date and only involve estimates for that part of the year not yet done.  Still other investors prefer to make the comparison with estimates for next year’s earning.  This approach has the drawback of being a pure estimate, but future earnings, after all, are what you are buying.

There is an additional consideration.  The number of shares in the market today may differ from the number going forward.  The company might buy back shares, holding them as what are called “treasury shares” and thereby reducing the number of shares available for purchase in the open market.  The company could also sell additional shares, and so increase the number available for purchase.  Buyers are seldom in the know of such plans. They can, however, know about options outstanding.  These enable others (often executives of the company) to buy newly created shares directly from the firm.  Such potential purchases can often significantly change P-E calculations, and it is something that any P-E calculation should take into consideration.  In cases where multiples appropriately account for the potential of conversions from options into shares, the calculation is said to be fully diluted.

Is the P-E Multiple Reliable? 

Yes, but only up to a point.  A company with rapid earnings growth will in time give shareholders claims on much more earnings than in the year they bought the stock.  Such stocks can remain attractive even though they have a much higher P-E multiple than companies with slower-growing earnings.  For example, an exciting technology company may look more attractive than a utility even if the stock on that technology company carries (to use financial jargon) a higher P-E multiple.  Similarly, a company dominating a secure industry offers greater security about future earnings than a small player in an uncertain industry, making it more attractive even if it carries a higher price-earnings ratio.  These assessments put price-earnings ratios into necessary context before the investor makes a decision.  To do justice to the information provided by these ratios, the investor must also add considerations of competition, the quality of management––indeed, the whole array of issues involved in securities analysis.

Is the Fed Going to Cut Interest Rates?

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Federal Reserve Board (Fed) Chairman Jerome H. Powell announced on June 4 that the central bank is prepared to sustain an economic expansion should the trade dispute with China weaken the economy.  Market participants read into his remarks an intention to cut interest rates, and enthusiasm over the prospect generated enough buying action to move the markets up smartly.  Of course the Fed never made such a promise, nor is it ever likely to do so.  Thus the market’s response, set against the Fed’s cautious words, raises two questions for any investor:

  1. What is the Fed actually planning?
  2. Over what time period will the policy change develop?

Question 1: If and when the Fed acts, it will do so with a rate cut, but otherwise, matters are far from definite.  Powell has not promised a rate cut, but neither has he taken one off the table.

Powell has been equivocal for good reason.  The Fed cannot forecast its policy moves: doing so would create major risk by inviting market participants to base their trading decisions entirely on that forecast.  As well, the Fed cannot forecast any better than anyone else, and Powell and his policy team know that.  If the Fed were to forecast one way and then see unanticipated conditions develop, it would have to change its plans, and even if it did so in a minor way, everyone in the market would have to adjust almost simultaneously.  The consequent disruption would be huge. It’s better that the Fed keeps its (always tentative) plans secret, so that market participants settle on a variety of positions.  Then, should the Fed have to shift policy, not everyone would have to change.

With this constraint in mind, a natural question would be: “Why say anything?”  And usually, the Fed refuses to speak.  But in the present environment, Chairman Powell probably had two reasons to make a statement.

First he could see that market participants were worried about the negative effects of the U.S.-China trade dispute.  Even if that dispute ends with a favorable trade deal, worries during the run-up to such a deal could itself do economic harm.  Not only has it depressed the stock market until recently, but if concerns become more widespread, they could dissuade consumers from spending and, more significantly, convince businesses to hold back on hiring and expansion plans.  The economy itself could falter from this negative psychology, creating a self-fulfilling prophecy of economic trouble.

The second reason is that Powell and his Fed team have no idea how long the trade dispute will drag on.  They, too, must share concern about the extent of the trade dispute’s economic ramifications.  They want the country to know they are not asleep at the switch, but at the same time they cannot know if, or when, they will have to respond.  This brings us to the second question –– over what period of time will a change in Fed policy occur?

Question 2:  Here, too, the answer is frustratingly vague.  The Fed cannot know if it will have to shift policy, or when it will have to do so: All will depend on the flow of economic data. Signs of economic weakness — whether caused by trade disputes or by worries over the trade disputes — will prompt a Fed reaction, one that would almost certainly involve an interest rate cut, probably of modest size, at least initially.  For now, the balance of economic data looks pretty good.  The first quarter’s real growth was strong, so even in the face of a sudden weakening, the Fed would likely hold off acting until it was convinced that the new, weaker picture was real and not just some quirk in the data. Indeed, if history is any guide, the Fed would likely wait for 2-3 months data before acting, because a premature policy move can cause far more harm than a delayed one.  This would mean that if suddenly in June the data turned weak, a rate cut would likely wait until the fourth quarter, and each month that shows signs of strength would delay such a cut accordingly.

A Last Word

 Fed policy on raising or lowering interest rates is a frustratingly uncertain process, and many have expressed their disapproval of how those in charge proceed in such matters.  But the Fed’s process leads less to a decision based on its preferences than on a recognition of this reality: the Fed cannot forecast, and in this moment’s case either the direction of trade negotiations or their likely economic effects, and that a false move by the Fed would do more harm than a month or two of delay.  The Fed’s process is one of necessary prudence.

Facebook: “Breaking Up is Hard to Do” In Some Industries, But Not This One

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The fuss over Facebook offers lessons about the abuses of monopoly power and how best to avoid them.  The authorities have two options: (1) force breakups, thereby inviting competition to discipline bad behavior, or (2) regulate the monopolies and thus guard directly against abuses.  A third approach might use a combination of both, which is probably what is necessary for the monster that is Facebook.

Facebook clearly holds a monopoly position, or as close to one as a company can get.  It earns fully 80 percent of the world’s social network revenues.  Though it may have thus far avoided the historical associations of monopoly — price gouging and the abuse of employees – Facebook has certainly abused its customers’ trust and privacy, and that in itself should be enough for a call to action.  Recently the matter has come up dramatically when Chris Hughes, one of Facebook’s founders, characterized the firm’s power as “unprecedented and un-American,” and described Facebook CEO Mark Zuckerberg as all-powerful within the company.  According to Hughes, Zuckerberg and Facebook, are “unaccountable,” particularly on questions of “privacy and election interference.”  He wants Washington to impose regulations on the social network industry and break up Facebook.

Hughes has a point.  Unlike some businesses, competition would offer a lasting discipline with social media.  The crucial issue is the cost of entry into the business.  When it is reasonable, as with social media, competition can persist after a breakup.  Problems arise only when costs of entry are high.  In such cases, the industry itself has a persistent natural tendency toward monopoly.  Take electric utilities.  In that industry, firms must construct generating equipment, string wires, and connect to homes and businesses before they can ever earn a dime. Airlines are another example.  These firms have to buy planes, build maintenance facilities, and contract for terminal space in many cities before making money.  To spread these fixed, up-front costs over as many paying customers as possible the firms present in the industry will undercut each other ruthlessly and keep doing so until most of the competition is driven out of business.  The remaining firm (or firms) then has no difficulty raising prices and improving profitability.   If government were to impose a breakup on such “natural monopolies,” it would only invite another round of vicious price-cutting that would continue until a new monopoly forms.  In such cases, breaking up is indeed hard to do.

This fact of economic life is why government is best advised to count on regulation instead of the discipline of competition to keep such industries from engaging in abuse.  Rather than fight this natural tendency, government tolerates the presence of a single firm in the market, but insists on pricing guidelines and standards of service.  Just about all power and electric utilities work this way.

The problem has become clear since the breakup of AT&T in the 1980s.  Right after the breakup was ordered, the rump of the original monopoly and all the so-called “baby bells” would seem to have offered adequate competition.  But the undercutting stated almost immediately and over time the number of firms in the industry has shrunk from what it looked like right after the breakup.  The pattern will doubtless continue until there is only one or a handful of companies, what we call an oligopoly.  Then, in reaction, it is likely that more regulation will return.  Similarly, the competition unleashed among airlines when the industry was deregulated in the 1970s has in time reduced the number of firms in the industry to an oligopoly in which most cities in the country have only one carrier servicing them.  Because breakups in such industries naturally devolve into monopoly or oligopoly, regulation is required to maintain competitive discipline.

This is not the situation with social media and other Internet applications. Forcing break-ups to increase competition might offer a lasting way to alleviate today’s abuses.  The industry has none of the natural barriers to entry that exist in, say, the prodigious cost of constructing a utility network.  If people had more choices, customers who resent the abuse of privacy so apparent with Facebook could simply switch to a competitor’s platform.  Indeed, competitors could market themselves on their reputation for privacy protections. Given the ease with which customers could switch, the slightest hint of impropriety could destroy a firm.  This fear inspires firms like Facebook to gobble up clever new players before they turn into formidable competitors.

No doubt, Facebook CEO Zuckerberg realizes such dangers to his firm’s position, which is why he has made pleas for regulation instead of a break-up.  With regulation, he knows he will retain a measure of control –– which he would lose in a truly competitive environment.  Zuckerberg of course would prefer to go on as he has, peddling his Facebook’s clients’ information and gobbling up smaller firms.  But because that is no longer in the cards, he sees regulation less as a potential check on his behavior than as a way to maintain control of the process. He and his colleagues in the world of social networks know that the new regulators would have to work with those established in the industry to set the standards, because only the established players have the necessary expertise to write the new rules.  This kind of “consultation” has always been the case in the past when industries have come under regulation. Though not all those new rules would necessarily please Facebook, they would suit it better than if another firm pointed up Zuckerberg’s abuses and making the case that it would run a more respectful platform than Facebook.

Even more appealing to Zuckerberg is that new regulations imposed by Washington would make it more difficult for new social media companies to establish themselves; the new rules would in fact raise the cost of entry and help make the social network industry a natural monopoly, in which case Facebook would need trouble itself less about competitors than it would have in the past.  The regulators would effectively protect Facebook, if inadvertently.

But if more competition would do much to correct the abuses of Facebook and other Internet giants, regulation still may have a role to play.  So much in these companies happens behind what is for most of us an impenetrable curtain of technology.  A regulatory review, such as when the Securities Exchange Commission (SEC) or the Federal Reserve examines a financial firm, could presumably lift the technology curtain in ways even an investigative journalist could not.

So it seems that a combination of breakup and regulation would best serve to overcome these abuses.  Consumers could go where reputations are best. Regulators, by peering behind the technological curtain, would uncover abuses that might have remained disguised or hidden, or the regulators could scotch false rumors of abuse. The social media industry would still have its problems, but the dominance and the abuses that it invites and that Facebook seems to have engaged in, would, if not disappear, at least impose on us less.

 

 

 

 

On Calling the Next Recession

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Earlier this year, fears of an economic recession became widespread, largely driven by investor wariness of what is termed an “inversion”in the yield curve.  A long-standing Wall Street rule of thumb holds that when the yields offered by long-term bonds give up the typical premium they hold over interest rates on shorter-term instruments, a recession is on the way.  And that narrowing of the premium happened.  The spread between the yields on 10-year treasury notes and 1-year treasury paper shrank during that time from 75 basis points (that is, seventy-five hundredths of one percentage point) to only 15 basis points (fifteen hundredths of one percentage point).  But before simply accepting this common perception, it pays to have a look at how reliable this yield curve signal has been in the past.  The results are mixed.

Inversions have given false signals on a number of occasions.  In 1995 the yields on 10-year treasuries suddenly lost the premium they had over 1-year treasuries.  That was six years before the 2001-02 recession, so we cannot count it as an early warning, especially because spreads widened again during the intervening period.  In 1998, the yield curve inverted for a few months, and for some weeks the 10-year treasury yield fell below the 1-year yield.  But then the “normal” upward sloping curve returned in 1999.  A clear recession signal had to wait until 2000, when for a number of months the 10-year yield fell more than 50 basis points below the 1-year yield before the mild 2001-02 recession took hold.

The first hint of an inversion in this century came in early 2006, and some might consider it a very early warning of the Great Recession (as it is now remembered) of 2008-09.  But that would be a stretch.  For one thing, the yield curve by the middle of 2006 had returned to its normal upward slope.  It then reverted to an inversion later in 2006 and early 2007, only to resume its upward slope later in 2007, and it continued to get steeper into 2008, when the 10-year yield stood fully 100 basis points above the 1-year yield.  That can hardly be called consistent signaling.  Indeed, using those statistics, observers relying on the yield curve signal would have been calling an “all clear” just before the 2008-09 great recession began.  And, indeed, some did.

The yield curve offered far clearer signals during the last two decades of the twentieth century.  Strong and persistent inversions predated the 1990-91 recession as well as recessions in 1980 and 1981-82.  But if we look further back, the record again becomes spotty.  Inversions in 1969 and 1973 did signal the recessions of respectively 1970-71 and 1974-75, but an inversion in 1966 saw no following recession.  Even if one were to make the dubious claim that it was a very early indicator of the recession that did develop four years later, it still would not explain why the yield curve assumed its normal upward slope in those intervening four years.

While this uneven history may offer evidence that yield curve inversions provide a worthy signal, the record also suggests that the investor use such signals with care.  Helpful here may be research by the Federal Reserve Bank (Fed) of St. Louis, which has looked back at some 60 years of economic cycles.  The Bank found guidance in its research for interpreting the yield curve.  It also uncovered other indicators to improve forecasting by offering a verification of the yield curve signal. Regarding the yield curve itself, the Bank found that inversions must persist if they are to give a clear signal, and that even when they do, a recession takes, on average, 10-18 months to develop.  For verification, the Fed researchers recommend three checks:

First is the number of building permits for new houses.  It can confirm a recessionary signal from yield curve inversions with the same average 10-18 month lead-time.  In the current environment, these data (despite the first quarter’s overall economic strength) seem to suggest at least a tentative conformation of a recessionary signal. Permits for new construction rose a slight 0.6% from March to April, the most recent month for which data are available, but the April figure is 5.0% lower than April a year ago.  However, permit requests are also up almost 3.8% from the lows of last August, which might indicate that the dip was less a cyclical sign than simply the inevitable fluctuation of building permits from month to month and quarter to quarter.

Second, the Fed’s economists identified employment in construction as another verifier of the yield curve’s recessionary signal.  But at the moment, the reading is hardly recessionary.  For April, the Labor Department reported that the U.S. employed 7,486,000 people in construction, up 3.5% from April 2018, and a steady, if slow, rise for 2019 so far.  This picture, however, does not entirely contradict recessionary readings, because, on average, this indicator lags some months after the yield curve inverts before offering a confirmation of coming economic trouble.  This same lag also is true with the third confirming indicator uncovered by the Fed analysts: manufacturing employment.  The Labor Department indicates 12,838,000 people working in manufacturing in April, up about 1.6% from April 2018, and this too at a steady if slow pace so far in 2019.  Here as well it is hard to make a call for a recession but from a strict reading of the averages, it is also impossible to dismiss a recession out of hand.

On these bases, one cannot dismiss the recent spate of recession forecasts. They do, however, seem premature. And even if –– despite the tentative evidence available so far –– the flattened yield curve really is giving a signal for recession, the averages indicate that the slide in real economic activity would only begin to emerge by the turn of the year at the earliest and would likely not gain force until summer 2020.  Though only a fool would bet on such a forecast at this stage, there are enough straws in the wind to make it worthwhile to watch the indicators offered by the St. Louis Fed carefully for a confirming sign.

 

Ethical Investing

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This is, of course, an ambiguous phrase.  It could refer to how diligently professional investors do their duty to clients, in which case it would mean staying within the guidelines imposed by the client while using every legal means to obtain the highest return for the least risk.  But these days, as in other times in the past, “ethical investing” means choosing investments that further some social or moral purpose, possibly forgoing returns to promote certain corporate or national policies or to punish undesirable behavior.  For instance, investors who disapprove of Israeli policies might exclude investments in that country from their portfolio.  Others, concerned about the fate of human civilization, might emphasize investments deemed to benefit the environment while excluding those they feel would harm it.  Millennials, especially, seem to favor such approaches, though they are not the only ones pursuing social and ethical investing.

Approaches to ethical investing have grown in recent years.  I won’t go through them here, nor will I judge them from either a moral or an investment perspective.  However, there are two investment implications that deserve attention here: one concerns portfolio distortions; the other, fiduciary considerations.

Distortions

These require a recognition of the biases such investing will build into a portfolio and consequently into its performance.  Most investing, especially when done by professionals, measures success relative to an investment index that includes the relevant universe of assets available to an investor for purchase –– what professionals refer to as a “benchmark,” or “bogy.”  With American stocks, that benchmark is often the S&P 500 Stock Index, which includes the 500 largest corporations in the country, with representatives in just about every industry.  There are broader indexes for American stocks that include smaller companies, global indexes, indexes for other countries, and indexes for regions, say Europe or Asia or emerging markets. Investors can say they have added value to their portfolio if they can produce for their clients a higher return than the relevant index, “outperform” it, to use financial jargon.  When, for ethical reasons, an investor excludes certain stocks that are otherwise in the index, or chooses to emphasize others, the portfolio’s performance will deviate from the benchmark for reasons that have nothing to do with the stock’s possible gain or risk.

Some years ago ethical investing excluded stocks of companies that did business in South Africa (as some investors do today with Israel), and the consequent distortions were huge.  These ethical portfolios could not buy any major oil company or any major auto manufacturer.  They could not own shares in most machinery or appliance producers, defense contractors, and many retailers –– the list was long.  Some portfolio managers bought smaller companies to maintain involvement with industries otherwise excluded, but investing in small companies to replace large ones introduced other distortions.  When some or all of these excluded stocks did well, the ethical portfolios trailed their respective benchmarks.  When these excluded stocks did poorly, the ethical portfolios outperformed their benchmarks.  But neither difference had anything to do with investment management abilities.  It was entirely an accident imposed by excluding South Africa.

Similar distortions are present in more contemporary ethical concerns.  For instance a preference for renewable energy or electric cars would render a portfolio extremely sensitive to fluctuations in oil prices –– perhaps even more so than one with an overweighting in major oil companies.  Though renewables and electric vehicles are an alternative to fossil fuels, their business prospects nonetheless rise when oil becomes more expensive and the public seeks alternatives, and fall just as dramatically when gasoline and fuel oil become more affordable.  Some investors, though eager to support renewables, feel uncomfortable with this exaggerated sensitivity to oil prices.  They might exclude oil companies from their holdings in order to blunt the volatility.  Such a decision might also fit with the ethical convictions built into the portfolio.  Whatever the individual tolerances for volatility or available investing offsets, investors wanting to pursue such ethical mandates need to know these implications.

Distortions can affect portfolios that exclude Israel or defense issues or timber production or any of a host of corporations that might bear, favorable or unfavorably, on ethical implications.  With each decision, investors must consider the potential effects on their portfolios and whether the proposed ethical stand is worth it to them.  The decision may involve soul searching about the extent of their conviction.  For those who invest on another’s behalf, especially professional investors, there is also a fiduciary consideration.

Fiduciary Concerns   

 Anyone who invests for others carries a measure of fiduciary responsibility to do the best they can at the least financial risk while also considering the preferences, tolerances, and objectives of those on whose behalf they are investing.  The law is explicit about who is a fiduciary, but the responsibility devolves to anyone thus involved.  This, too, involves ethics.  If you informally advise family and friends, your legal responsibility is limited, but your moral responsibility remains.  Your legal responsibility grows when you are paid for advice, and especially when arrangements empower you to buy and sell on another’s behalf.

If “clients” –– whether formal clients of a broker, or just friends and family to whom you’re giving advice –– have not brought up special ethical considerations, then it’s best to proceed without regard to your own personal convictions.  If they have expressed ethical considerations, have them state them as explicitly as possible:  Put them in writing.  This will protect you from blame or lawsuit if the “ethical portfolio” disappoints.  Having the client’s considerations in writing will also guide your professional investing decisions, keeping in mind that an ethical overlay on a portfolio is not in the professional investment manager’s area of expertise.  For example, if someone wants to punish Israel for its policies, find out if they want simply to avoid investing in Israel or if they want also to avoid corporations from other countries that do business in Israel.  If the client wants to buy “green” stocks, make sure the word “green” is well defined.  You don’t want to buy timber because it is a renewable energy source only to discover that your client wants nothing to do with any activity that cuts down trees. It would also be useful for you to brief the client on the possible distortions involved.  You should document that briefing as well.

A perfect example of the potential troubles surrounding ethical investing involves South Africa during its apartheid era, when the boycotts of that country in the 1980s led many U.S. foundations and municipalities to impose restrictions on their investment managers.  Because foundations usually have boards that are both in control of the foundations and responsible for their actions, the choice to boycott seldom caused trouble, except for managers who had failed to alert the foundations ahead of time of how the restrictions could affect their portfolios’ relative performance.

With the municipalities, however, matters were more complex.  The pools of money that municipal politicians and bureaucrats control are usually funds set up to support pensions obligations.  When those in control imposed the ethical restriction (whether from conviction or to get votes) they had neither an easy way (nor a desire) to consult the beneficiaries of the pension schemes.  If the ethically imposed distortions benefitted the portfolio and it performed well against its benchmark, there was seldom a complaint.  But when the portfolio underperformed its benchmark, participants in these pension schemes sued, sometimes individually but usually as a class.  In every case the courts found against the municipalities. However admirable the municipalities’ ethical commitment, it imposed a hardship on those who had no say in the decision but whom those decision-makers were legally bound to protect.  The courts ordered that the municipalities involved make up the difference.  Then, of course, the taxpayers suffered, though they could not sue for compensation.

A Last Word

 As is so often the case with investing, every move imposes a risk, a potential cost.  When such a move, in this case an ethical one, results in serendipitous advantages, no one complains.  But the story is almost always different when the decision imposes costs.  Those investing, for themselves or as agents for others, owe it to all involved, investors and their clients, to strive to become fully aware of the implications of their decisions.

So What Is This Recent Rally About?

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It is interesting, as media reports suggest, that markets have done so well this year even as concerns over a global economic slowdown have intensified. Even more interesting is that media discussion of the rally interprets it from an entirely different perspective than it employed when it interpreted the market retreat during the fourth quarter of 2018.  Then, the economy seemed to be doing reasonably well.  Media commentary took the decline in stock prices as a sign that an economic slowdown was coming.  But now, with stock prices up, the media says nothing about it as a sign of an economic pickup.  Rather, it expresses bewilderment about market strength in the face of economic weakness.  Could it be, as the media treatments seem to imply, that the market was forward-looking last year but this year has abandoned that practice?  That inconsistency seems unlikely.  The market is always forward looking.  Isn’t it more likely that, contrary to the media’s treatment, the market has maintained a consistent perspective and that this year’s rally is forecasting a pickup in economic fortunes later this year?

In an earlier post, I explained the inherent pitfalls in how the media discusses economic and financial events.  This latest inconsistency should illustrate some of the points I made earlier.  Though I can’t know what will happen or even whether the rally will last (nor can anyone else), here are three interpretations that might explain recent events in a less mysterious manner than they have received in the media:

  1. The slowdown reported in the media is hardly the stuff to significantly sway investors’ perceptions of the future. The media referred to comments from the Federal Reserve (Fed) and the International Monetary Fund (IMF) about downgrading their forecasts for economic growth in the coming quarters.  The Fed relied mostly on language rather than on statistics and it made no mention of recession or abrupt economic developments. The IMF announced it had lowered its 2019 forecast of global economic growth to 3.3 percent from 3.5 percent that it made last January and from 3.7 percent it made last October.  These revised forecasts, while definitely on the downside, are well within the usual error attached to forecasts.
  2. The timing of these downgrades in global economic fortunes also seems significant. The Fed made its comments during the market retreat last year.  In fact, many media reports referenced the Fed’s more cautious outlook as reason for the market’s retreat.  The IMF made most of its downgraded revision during the month of December.  It is likely that the market –– always forward looking –– adjusted prices to a less robust 2019 in reaction to those forecasts made in 2018’s final quarter.  So, having already adjusted prices down to account for the economic slowdown, the market would hardly need to do so again as the outlook to which it had already adjusted itself became a reality.
  3. It is more likely the market has continued to look forward and now expects forecast upgrades. Indeed, recent weeks have brought news of upturns from areas as disparate as the American consumer and China’s industrial output, not a boom in either case, but an improvement over how the situation looked at the end of 2018. Japan remains stagnant and so does most of Europe, but this is hardly a change from the world to which market prices had already adjusted when they fell late last year.  Now that the market has priced valuations into reasonable ranges with last year’s adjustment, it has built on this limited positive news by pushing prices upward.

Though these explanations may not exhaust all interpretations of recent events, they do treat the retreat of late 2018 and the rally of early 2019 consistently, which is more than the media treatment has done. Keep in mind that because the rally has already responded to the news of some economic improvement, the ever-forward-looking market will need to see additional economic improvement to sustain its upward momentum.

 

 

Pertinent Questions

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I met recently with a group of business students.  Not surprisingly, we talked mostly about their careers and how they could best position themselves for the jobs they covet.  Four questions came up that belong in this blog.

  1. How does one secure a good track record managing equities?

There are a number of ways to manage stocks: some lean toward value, some toward growth, some are purely quantitative, some rely exclusively on human judgment, and some blend these elements.

For growth, the aim is to ferret out companies that are growing rapidly or, better yet, are about to experience a growth spurt. You buy their stock to enjoy the price increases that emerge from the growing market enthusiasm about the firm’s success.  You must always remain on top of the firm’s prospects and its stock price, because there will come a time when the market’s enthusiasm for the company outstrips reality, at which point, even if the company continues to do well, its stock price will languish or fall.  You must have the insight to recognize this moment and sell quickly –– boldly –– and put the money to work elsewhere before suffering the losses, absolute or relative to the other buys you could make.  Your insight must distinguish between a fundamental turn and the inevitable pauses that occur even as a stock climbs.  Therefore, growth management styles involve much trading –– turnover, in financial jargon.

Quantitative techniques have limited value for the growth approach.  You could devise a computer-based algorithm to identify fast-growing companies from a universe of stocks and perhaps even to assess whether the stock prices have kept up with that rapid growth.  Otherwise the effort involves a lot of research about why the company is growing fast and judgment about management, competition, and product offerings to determine whether that growth will last.  For those who have the skill and diligence, it can be very rewarding.

Quantitative techniques can have a larger role in the value approach.  The object here is to find stocks where the market has pegged the firm’s stock price beneath the company’s fundamental value.  The presumption is that at some point the market will wake up to its pricing mistake and price the stock upward accordingly.  This approach might lead to buying slow-growing, unexciting companies the market has neglected.  It might also involve a fast-growing firm for which the market has yet to wake up to its potential.  All sorts of computer-based algorithms can test for such valuation mistakes in the market. When I managed money professionally, I used one that assessed the earnings prospects of hundreds of companies, using what is called an earnings discount model to estimate the price they should sell at –– what in market jargon is called a fair value price.  That algorithm then compared the fair-value estimate to the actual market price and ranked stocks from those with the largest positive gap between fair value and the actual price –– the undervalued stocks –– to the smallest or negative gap (the over-valued stocks). In building a diversified portfolio, I would focus my research and analysis on those the algorithm identified as most attractively priced.

Whichever approach you take, you must stick with it over time.  The market can overlook value and fail to respond to growth for longer than you might feel comfortable with.  One is never always right, but if there is worth in the approach, it will only tell in the long run.  If you cannot stay the course for at least five years, you do not belong in stocks.  Choose bonds or bank deposits.

  1. If you were to become a professional portfolio manager and had a need to make your mark in less than a year, what approach would you use then?

The best approach then is to pray for luck. Luck is always a big part of investment success, but if you must make your mark in stocks in less than a year, luck is all you have.

  1. What about Bitcoin or some other cyber-currency? Do you think it would be good to have a global currency?

There was a time when the world did have one: gold. It worked for a long time, but it could not do so today for a number of reasons.  In theory, a substitute for traditional, nationally based currencies has appeal.  Bitcoin and other cyber-currencies have, however, failed in this regard.  They don’t have the stability that, among other things, is essential in a successful currency.  Cyber-currencies values have swung wildly relative to all major currencies (dollars, euros, yen, yuan etc.) and, most importantly, against goods and services in general. To take the place of dollars or any other currency, cyber-currencies must show more stability than these currencies do, not less.

  1. If you cannot buy a cyber-currency, what can you do if you expect dollar inflation?

You don’t need a global currency to protect yourself from dollar inflation, though a viable one would be convenient.  You can buy real estate, art –– things that hold real value when the dollar is losing value.  If you want an asset that gets priced every day, then buy gold or commodities.  Their prices swing up and down but they usually keep up with general prices levels, especially when inflation is a problem. Copper or zinc will work, too. They have in the past.