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

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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

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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.

 

 

The Meaning of Negative Interest Rates

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So called “negative interest rates” have appeared with greater frequency in Europe and Japan.  It is not that individuals in these countries can borrow from a bank and get paid to borrow.  The negative rates concern governments and large, financially sound corporations.  Here is how they work:  A government issues a bond at a very low coupon –– that is, stated –– interest or attaches no interest to it at all.  Effectively, the government issuer promises the bond buyer to return at a future date only the money borrowed.  For reasons discussed below, these bonds become so popular that the price gets bid above the amount that the borrower (governments and solid corporations) promises to repay. These bond buyers then, if they hold the bond to maturity, will get less back than the premium price they paid for the bond.  That constitutes a negative interest rate.

The increased number of such foreign bonds has led to speculation whether, and when, negative-yield bonds might come to this country.  The answer is straightforward: not for a while and perhaps never.  The economic fundamentals that have brought negative interest rates and bond yields to Europe and Japan do not exist in the United States.  And until they do, if ever they do, U.S. interest rates will stay positive, if low.

The way to understand this is to look at the fundamental economic background in Europe and Japan and then to compare it with the United States.  There are two differences: cyclical conditions and more fundamental long-term factors.  I count four of the first and two of the second:

The Four Cyclical Conditions

  1. Recession:  Recession, or the fear of, it always drives investors into quality sovereign debt (bonds and the like issued by governments) as a haven from stocks that will likely suffer in a recession.  Japan, which harbors almost half the world’s negative yielding debt, is in recession.  Europe has for some time shown signs of economic weakness and stagnation and seems to have entered a modest decline.  The United States economy continues to grow, though there are increasing fears here of recession.
  2. Trade war:  While the trade war between the United States and China contributes to concerns about recession across the globe, it also has generated some fear that the value of the dollar will eventually decline, even though thus far it has held steady.  That prospect has convinced many to prefer Euro- and Japanese yen-based bonds, and to accept their negative yields in the expectation that their value will increase relative to the dollar.  This is called a currency arbitrage.
  3. Monetary Policy: Both the European Central Bank (ECB) and the Bank of Japan have signaled their intentions to pursue extreme monetary ease. These policies could drive interest rates and yields downward and accordingly drive up the price of bonds, as I have described in this post.  In anticipation, investors have bought bonds in these areas, bidding up their prices so aggressively that they have created negative yields.
  4. Momentum:  There is always a lot of momentum at work, especially in shorter-term market moves, not the least because much algorithm trading implicitly assumes that recent trends will continue, especially in the short run.  Prices of bonds have risen.  Many will buy bonds simply on the assumption that their nominal value will continue to rise, giving them an opportunity to sell at a profit even though they have purchased bonds that will lose these investors money if they hold the bonds to maturity.

Two Longer-Term Considerations:

  1. The possibility of deflation: Japan has already experienced deflation –– defined as falling prices on goods and services.  In Europe, though there is still positive inflation, it is low.  In the U.S., Federal Reserve Chairman Jerome Powell has pointed out the unusually low rates of inflation, given that the economy is at full employment.  There is much talk both here and abroad that we have moved into a new normal where, for a number of reasons, inflation will remain quiescent regardless of economic fundamentals.  To many observers, this perspective, even in the absence of an explicit forecast for deflation, makes deflation seem much more likely.  Faced with potential deflation, nominally negative bond yields look less expensive in real terms, because the purchasing power of money will rise, providing a positive real return on the bonds even without any interest payments.  If such ideas strengthen in the U.S., the appearance of negative yields here will become more likely.
  2. Long-term economic decline:  Bond yields, especially on low-risk instruments, should reflect the nominal return on all kinds of assets in the overall economy.  If the real economy is producing little nominal return on assets, why should financial instruments do any better?  In Japan, where there is very little growth in the economy, the general run of business is seeing no growth either, and the return on their assets is next to nothing.  It is little wonder, then, that Japan’s financial assets, bonds in particular, pay no return –– that is, they have negative interest rates.  Europe is beginning to look that way, too, at least large parts of the Eurozone. Indeed, limited returns in a general economy would also limit the tax revenues of any government, making it difficult if not impossible for that government to honor obligations that offered much positive return. Recent statistics indicate that the U.S. economy is far from such a position, but should its economy weaken, ideas about long-term decline will gain more traction and the prospect of negative interest rates will become more likely.

For the time being, Americans investing in dollar-based financial instruments have little to worry about on this score.  Nonetheless, we should be aware of the warning signs outlined here.

 

 

CDs

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Of late my inbox has filled with suggestions from my bank that I transfer some of my savings account into certificates of deposit (CDs).  The e-mails from my bank correctly point out that, because the rates on conventional savings accounts are lower than the rate of inflation, I am actually losing purchasing power on the money I leave there.  They suggest that the purchase of CDs paying a higher rate can remedy my situation. Some readers and friends have received similar messages and have asked me how to respond.  The short answer is that the banks could have a very good idea. But as I have pointed out often in these posts, it all depends on your personal needs and plans.

The decision must involve more than just comparative interest rates.  Because CDs involve the commitment of a sum of money for a set period of time, the first question to ask yourself before buying one is: “How much money do I need in ready cash that I can get at a moment’s notice?”  That amount should remain in your savings account. The number, of course, will depend on your personal circumstances.  Aim to hold between three and six months worth of expenses in ready savings to deal with emergencies –– most especially if you lose your job. Where you fall in that three- to six-month range depends largely on your answers to two questions:

  1. If you have a spouse or partner, do they have a paying job? If they do, you probably need less. The three months of expenses should cover emergencies, such as having to replace a roof, or at least give you a good start on covering such expenses.  If you lose your job, this other income can cushion your household from that loss, reducing your need for ready cash.
  2. Is your job secure? If you are a civil servant or belong to a strong union, you are less likely to suffer a job loss than, say, if you work on Wall Street or in industrial employment, where slowdowns can lead quickly to layoffs.

The other consideration on a buying a CD depends on your personal plans.  You may have built up your savings account to make an investment move or to make a large purchase of a car, for instance, or a new kitchen or even a house. If you want to do that in the very near future, then the CD will not suit you, because most CDs require that you tie up the money for several months.  But if you expect you won’t need the money for at least a year, then a CD can earn you more and you can accumulate savings at a faster rate.

There are all sorts of CDs, and they have all sorts of provisions.  Once you have decided you want to buy, you will need to consider these and understand how banks quote the rates of return on various CDs.   This earlier post outlines those options.

 

A Sane Response to Market Panics

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Stocks have panicked twice during the last few weeks. The first downdraft came on Monday, August 12 on the news that China had allowed its currency, the Yuan, to fall sharply against the dollar.  The Dow Jones Industrial average fell some 400 points that day.  All day, people asked each other, “Is this the big turn?” In the days following, the market recovered the lost ground.  On the following Wednesday, August 14, the Dow Index crashed again  –– an even more dramatic 800 points –– on news that, first, already weak European economies might actually have shrunk slightly and, second, on renewed awareness that long-term bond yields had fallen below short-term note yields in what is termed a yield curve inversion and which is a classic sign of an impending recession.  But before the week was out, markets had all but recovered that lost ground.

There is a lesson here about the largely emotional behavior of investors and pricing stocks on a day-to-day rather than a fundamental basis.  Actually, there are at least four lessons:

  1. Headlines intend to inflame readers, and fear is the ultimate clickbait. China, in allowing the Yuan to lose value against the dollar, was not, as was so frequently described during that panicked day, a sign of resolve or a trump card (no pun intended) played in its trade war with the United States.  A little reflection, which was something investors did in subsequent days, revealed that Beijing’s gesture was more a sign of weakness than anything else.  It showed that China could not successfully match the United States tariff-for-tariff, as it had earlier in this conflict.  In the teeth of that Monday panic, if investors had just waited for the market close to think about reality instead of giving in to fear, they might have used the retreat as an immediate buying opportunity, or simply saved themselves needless anxiety.
  2. There are no foolproof indicators. During the second panic, many guests on CNBC and other financial news outlets spoke of the wonderful forecasting record of yield curve inversions.  No one used the word “foolproof,” but it was all but implied. If, however, the yield curve indicator is really as good as people said that day, we would all be billionaires, because market forecasting would be as easy as, let’s say, falling off a log. Since everyone is not yet a billionaire, we all have reason to doubt the claims that commentators made for the yield curve that afternoon.  Further, if yield inversions were really that reliable, the market would have long since fallen, because the curve had moved in and out of inversion since May of this year, when I first wrote on the subject and itemized how many times the yield curve has given false signals.  I’m not saying that people should ignore yield curve indicators.  On the contrary, investors should pay close attention and look for corroborating evidence, but panic should have no role in that effort.
  3. Markets, especially in the short run, feed on themselves. Not all sale decisions reflect a careful consideration of the fundamentals.  Program trading often relies on algorithms that use recent trends to forecast the next few hours.  When markets fall dramatically, for whatever reason, these asset managers sell, adding momentum to the down move.  (They can do the same on the way up.)  Adding more impetus to any downward momentum are sellers who had bought on margin (credit), and who must often sell into a sudden price drop to avoid a margin call that would force them to put up more money to support their position.
  4. It was not new news that European economies were weak, as was Japan’s. This information is valuable and it suggests that the U.S. recovery will increasingly face headwinds, unless these foreign economies pick up.  But that warning is an alert, and not a sign to panic, especially because the news is rather old. 

So, shut off the TV if necessary.  The way to deal with such events is to wait for the close of trading. Weigh what news there is –– if it really is news –– against the flow of information from the last few weeks and months. Only after you have done this review should you decide if your long-term plan (stressed so frequently in these posts that a hyperlink would go on for several lines) warrants action.  Perhaps, if that basic plan calls for you to commit idle cash, you might use the downslide as a buying opportunity, not to time market ups and downs, but to do what you needed and planned to do anyway, when the time was opportune.

 

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

women wearing white long sleeved collared shirt holding bitcoin

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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.