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

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

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

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

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

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

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

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

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

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

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

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

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

 

 

 

The Computer’s Role in the Recent Wild Market Swings

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

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

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

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

 

An Update: The Covid-19 Recession

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The U.S. economy – and the rest of the world – is at the gates of a severe recession.  The economic downturn is emerging neither from the COVID-19 virus nor from its threats of debility and death.  It is the quarantines, the lockdowns, and the supply constraints that have created a powerful recessionary thrust, because the longer those pressures last, the greater the possibility of more fundamental layoffs, shutdowns, and bankruptcies.  Efforts by the Federal Reserve (Fed) to ease monetary policy may blunt the recessionary dynamic, as will the fiscal stimulus measures, such as tax cuts, contemplated by the White House.  But what would really help is if Washington and the states focused on the specific drivers of today’s emergency and thus break the chain  dragging us into recession.

The situation today is very different from a typical recession.  Downturns usually grow out of shortages in demand.  Governments combat demand shortages by spending themselves and by offering people inducements to spend, for example through low interest rates or tax cuts.  The coronavirus emergency has instead imposed a shortage of supply.  Quarantines are keeping people from productive jobs, first in China and now globally.  Working from home cannot fill that gap, especially with factory work as well as many service industries.  The consequent shortfalls in production have denied other production operations the parts and materials they need to meet their output schedules.  Consumers who are otherwise eager to spend face a paucity of options as public health measures have closed restaurants, events, and retail facilities.  Though the demand for goods and services remains, it is supply constraints that are limiting economic activity.

A recession will arise because these stymied demands cannot last if the shutdowns and quarantines persist.  Businesses may keep idle workers on the payroll for a while, either in response to government mandates or from loyalty, but the businesses (which must also pay taxes, rent, and interest on their debts) cannot long meet these expenses in the face of shortfalls in revenues imposed by the closing of businesses and public spaces.  Companies are reaching that limit quickly and when they do they will have to turn to more permanent layoffs and staff reductions.  Many businesses––small firms especially––will face bankruptcy, leaving employees without income and many suppliers and landlords facing additional revenue squeezes. Other businesses in less difficult straits will nonetheless shelve expansion plans, leaving producers down the line facing a shortfall in demand for their products. The number of companies in this situation will grow the longer the present economic pause persists, and the greater that number gets, the deeper into recession the U.S. and the world will fall.

Monetary easing, such as the Federal Reserve (Fed) has recently implemented, and the kinds of fiscal measures being contemplated by the administration, could blunt such recessionary effects. But it is highly doubtful that such measures can fully counteract these recessionary forces once they gain momentum.  It would be better to take additional, if less common, measures to help stop the transition from today’s “pause” to the layoffs and other cutbacks that will bring on recession. Though not a complete list, here are five suggestions for what needs to be done:

  1. During this time of emergency, Washington should enable the Small Business Administration (SBA) to make low-interest or zero-interest loans to help small businesses sustain payrolls and stave off bankruptcy. Under the standard rules of disaster relief, the SBA has made provisions for loans of up to two million dollars, but this emergency requires larger amounts extended over a longer repayment period.
  2. States and cities could bolster such an effort with similar programs of their own, and the federal government could support them by changing the rules to allow states and cities to raise money by offering tax-free bonds for such targeted lending.
  3. Though large firms have the financial resources to hold out longer than small ones, these larger ones, too, cannot survive the current pressures indefinitely. They could get essential help if Washington were to offer them “special lending,” perhaps contingent on maintaining payrolls.  Such loans could come from the federal government directly or they could be organized between the Fed and the banking community.  While the Fed has never made such arrangements for commercial and industrial endeavors, it certainly has done so for banks and other financial firms.
  4. Washington and the states might prepay (in effect, pay ahead) existing contracts for one or two years enabling those firms to use the immediate cash flow to cover expenses during this emergency.
  5. The nation’s retailers might obtain similar help from arrangements that allow consumers to prepay future purchases at a local shop or favorite restaurant, with the inducement, perhaps, of a discount. Many firms already offer such “gift cards,” but today’s greater need might involve help from local chambers of commerce or even city governments.

More imaginative people could add to this list.  Normally such admittedly unusual arrangements would not be necessary, but these are hardly normal times.

 

 

 

 

 

 

 

 

 

More on the Economics of the Coronavirus

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Let me begin by framing this essay with what is obvious: we, and the world, are in a highly fluid situation. With COVID-19 intensifying in the U.S., there has been clamoring for Washington to take action to protect the economy.  The Federal Reserve (Fed) has just cut interest rates again (March 15).  President Trump’s economics team has floated the idea of payroll tax cuts.  To many, these responses seem wholly inadequate and in many respects they are.  Tax cuts and lowering interest rates will not stop the spread of this still-mysterious disease.  Nor will they do much, if anything, to ease the supply interruptions created by COVID-19’s economic havoc thus far.  Such actions would help, however, if the virus endures and precipitates a classic economic retrenchment.  In that case, the present and contemplated policy moves will look wise.

The immediate futility of such policy measures is evident in the nature of today’s economic fallout.  The disease’s spread has kept workers from their work, not only those who are sick but also the far greater number who worry and have been warned about contagion. In reaction, much of daily activity in the country has been curtailed, including public school systems, universities, sports events, restaurants, museums, theaters, concert halls and more.  Output has slowed in China and increasingly across the world.

China’s problems are among the most pronounced.  It is where COVID-19 got its start and remains most severe.  Statistics are scarce.  Most telling is the release by China’s purchasing managers of February statistics.  Their index of production, in which the value of 50 delineates the line between expansion and contraction, showed a drop of more than 20 percent, falling from 51.1 in January to 40.3 in February.  The manufacturing subsector fell to a low of 35.7.

Problems, of course, have extended beyond China.  That country’s quarantines have cut off the huge and lucrative flow of moneyed Chinese tourists to Japan, South Korea, North America, and Europe.  And producers in these and other countries have found it increasingly difficult to get needed supplies and parts from China.  Apple, for instance, sources many of its products there.  The United Auto Workers recently hinted that General Motors may have to close some of its plants because of a lack of parts, and it appears that some 125 prescription medicines in the United States will be unavailable because of a lack of China-based ingredients.  As the virus has spread to Europe and North America, cutbacks in travel and work have repeated the Chinese problem and added to supply and parts pressures elsewhere in the world.  Neither interest rate cuts nor tax cuts can do anything to address these matters.

  • Lower rates might otherwise encourage borrowing for capital investment and expansion, but it is highly unlikely that businesses will invest or expand when concerns about contagion are otherwise idling existing facilities.
  • Tax cuts might otherwise increase take-home pay and thus induce people to work and spend more, but it is questionable how effective such policies would be if people are afraid of catching the virus and managers are telling existing workers to stay home.
  • And neither action will restart the flow of tourists from China or its shipments of parts and supplies.

Tax and interest rate cuts only can help in the case of classic recessions, which involve a drop in demand for goods and services.  The problem today is a shortage of supplies, parts, and workers.  Should, optimistically speaking, COVID-19 run its course relatively quickly, as SARS and MERS and other similar pandemics did earlier, people would soon return to work, supply chains would resume functioning, and economies would soon rebound, which is what happened in the case of past viral outbreaks.  In such an environment, lower interest rates and lower taxes would do little to accelerate the process and would be useless, except perhaps to calm nerves.

But this does not mean that the policies already implemented or contemplated have no purpose.  There is no guarantee that COVID-19 will follow past patterns.  If it persists, continuing supply shortfalls and bottlenecks will generate layoffs (of which there already is evidence) instead of pauses and work-at-home arrangements, leading to a drop in consumer spending.  Supply problems of long duration would lead to other and more permanent cutbacks, including bankruptcies, which would compound the shortfalls in demand and would bring on a classic recession (of which there already is some evidence). In these circumstances, the demand stimulus of interest rate cuts and tax cuts could perform important counteracting roles,  and such stimulus actions would look prescient in retrospect.

It hardly matters whether policy-makers in Washington are thinking about this longer-term possibility or are simply trying to calm nerves by “doing something.” The interest rate cuts announced by the Federal Reserve on March 15 and earlier in the month, as well as ongoing tax cut considerations, though they may look inept in light of immediate problems, would nonetheless position the U.S. to deal forcefully if the world, in its efforts to combat COVID-19, doesn’t have the relative luck it had with SARS, MERS, Ebola, and other outbreaks.

 

 

Market Panic Over the Coronavirus

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

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

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

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

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

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

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

A Question of Objectives and Asset Allocation

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

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

“Thoughts?  Advice?”

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

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

I recommend two ways to cope with this situation:

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

What Are These Central Banks After?

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Recent news from Europe prompts a quick offer of perspective.  The president of the European Central Bank (ECB), Christine Lagarde, recently announced plans to launch a digital version of the euro. The Banks of England, Japan, and Canada quickly made similar announcements, as did the Swedish Riksbank and the Swiss National Bank.  All this follows an announcement late last year that the People’s Bank of China (PBOC) would launch a digital yuan.

The word “digital” tends to dazzle many people and make them feel as though any such effort is welcome –– that it would be more modern and better than what had existed.  But that is not what is going on here.  The banking systems in these countries, including China, already do a fine job of digitizing business and individual transactions with all the modern speed and convenience people associate with the word “digital.” The central bankers’ real reason for a digital currency is not modernity or safety or convenience, or any other of their stated explanations: their real reason is control.

These central banks want to drive out paper currency because it is the last method by which people and businesses can perform their transactions anonymously.  If digital alternatives to paper money can do that –– and they can –– then the authorities will have the ability to track everybit of business, no matter how innocent or small.  Existing arrangements already facilitate much government surveillance.  Banking, even before it was digitized, left a record that could be made available to the authorities.  Credit and debit card transactions certainly do the same.  Even the so-called “shadow banking system” –– on-line lenders that are separate from the established banking institutions –– leaves an electronic record of who is doing what.  Only paper currency leaves no trail to follow.

Aside from any government’s seemingly constant desire to know all and control all, there are legitimate reasons to get rid of anonymous transactions.  For one thing, they often support criminal activities, including the worst sin of all as far as governments are concerned: tax evasion.  Anonymous transactions allow people to hide their spending, making it hard for the authorities to compare it with their declared income.  Anonymous transactions might also allow people to send assets out of the country when the government would rather they did not.  Still, this recent quest to surveil leaves an uneasy feeling –– if not a down right creepy one –– that the digital payment system(s) will reach the point where one cannot stop for a cup of coffee or tea or buy a snow cone for a child without an official electronic record of the transaction.

Perhaps the need to snag tax-evaders and those committing other crimes is worth the loss of privacy.  This would not be the first time that people voluntarily gave up something for the sake of some collective interest expressed by the authorities.  But the press by these central banks, especially the ECB, carries no little irony and hypocrisy when set against Brussels’s histrionic outrage about the dangers to privacy from technology platforms like Google and Facebook. At least with the private platforms, people have the option of walking away.  They won’t be able to do that from a completely digitized currency.

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

person holding paper in left hand and pen on right hand sitting beside desk

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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.