The Good Professor’s Measure

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

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

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

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

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

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

Why We Should Be Careful With Statistics

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

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

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

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

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

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

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

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

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

 

 

What Motivated the Business Roundtable to Move to the Left?

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Not too long ago, the Business Roundtable shocked both the business and the political communities when it revised its statement on corporate responsibility.  The Roundtable, composed of the chief executive officers (CEOs) of 181 of the nation’s major corporations, stated that companies are responsible not only to their shareholders, but also to a broad array of what the group called “stakeholders,” including, in addition to shareholders: employees, customers, suppliers, and the communities in which they operate.

This is a major change.  For decades, in fact ever since the Roundtable was founded, it has stressed only business’s responsibilities to shareholders, though it has also acknowledged obligations to law and decency.  The Roundtable’s restatement was greeted with delight by the political left, who saw in it the conversion of powerful people to its way of thinking, while those on the right and free-market supporters warned about decision-making chaos and a loss of corporate efficiency.

Without taking sides –– left or right –– it might be useful for investors to use this incident to understand corporate decision-making generally.  The relevant question is: “What might have motivated these CEOs to change their thinking?” There is, of course, the matter of principle.  Perhaps this group of powerful men and women really did have a change of heart about the correct way to run a company –– there may actually have been such a “road-to-Damascus” moment.  But because no one can look into the heart or soul of another, we must leave that possibility as just that –– a possibility.  An investment analyst (and let’s include ourselves here) might also consider two other perspectives regarding the Roundtable’s change of heart:

  1. What corporate interests might this statement serve?
  2. What personal CEO interests might this statement serve?

 

Corporate Interests

On the first question, the statement may constitute a form of defense against the possibility of a Democratic victory in 2020, in particular Sen. Elizabeth Warren’s proposal to enact what she calls the Accountable Capitalism Act (ACA).  Her proposal, should it become law, would have six basic provisions:

  1. Corporations with more than $1 billion in annual revenue would have to secure a federal charter. (Presently, most corporations are chartered by states.)
  2. The federal charter would obligate company directors and managers to consider the interests of employees, customers, and the communities where they operate, in addition to those of shareholders.
  3. Under the proposal, employees would choose 40% of corporate boards.
  4. Directors or corporate officers would be prohibited for five years from selling shares received in compensation.
  5. Corporations could not make political contributions until they secured the approval of 75% of their directors and shareholders.
  6. The federal government would have the power to revoke the charter of any corporation engaged in illegal activity.

Facing the prospect of such a fundamental change in corporate structures, these 181 CEOs may well have decided that publicly embracing some of these provisions might disarm more revolutionary action from Washington, should Warren win the White House. Holding up their newfound principles, they could claim there is no need for such a law and that they themselves could accomplish its main objectives with less compulsion or institutional change –– all of which, of course, would limit the power and influence of CEOs.

Given Sen. Warren’s statements to date, such a defense would be unlikely to succeed should she be elected and have a sympathetic Congress at her back.  Still, for the CEOs, the Roundtable’ statement would be a low-risk response to the threat of a Warren White House.  After all, they would hardly be bound by their own statement.

 

Personal Interests

 These 181 CEOs are not without personal interests in this matter.  Corporate history shows that CEOs regularly put personal interests ahead of their obligations to their companies, its shareholders, and other stakeholders.  There are at least two such interests:

  1. As I have noted, Senator Warren’s bill would not only disrupt corporate structures, it would also weaken the power and prerogatives of CEOs. They hardly want that, especially because the changes the senator envisions would make it more difficult for them to arrange friendly boards that would then endorse the lucrative pay packages to which most CEOs have grown accustomed.  Thus they would be protecting themselves from job disruption and perhaps also a pay cut.
  2. And quite aside from Senator Warren’s ambitions, the Roundtable’s statement, if taken seriously, would significantly muddle the obligations of management accountability.  These new additional stakeholders would each have their own agendas that could conflict with the aims of other stakeholders.  This ambiguity has led several business leaders to question the wisdom of the new Roundtable commitment.  Nonetheless, such ambiguity might have a distinct appeal to certain corporate leaders. Where a company has only a single objective, for instance shareholders, management can be held incompetent for any decision that hurts those shareholder interests. But where there are a multiplicity of interests, a decision that hurts shareholders could be justified in terms of the interests of another stakeholder.  In other words, decision-makers would have a ready excuse for every move and thus could more easily avoid blame than they could in the past.  That is an appealing prospect for any manager.

This view might seem too cynical for some readers.  Perhaps it is.  But such thinking is essential for any investor who wants a full perspective on corporate decision-making and public policy.

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.