Author Archives: gkugler

(Revised) A Constantly Changing Landscape

The landscape in which financial institutions operate is very different now than it was before the financial crisis of 2008. Mergers and acquisitions between healthy firms and failing firms allowed the strong to get stronger and subsequently gain market share. As the market has grown more concentrated, it has also grown less competitive. Although competition is a corner stone of capitalism, maybe large banks help promote financial stability. Whether or not this is true, new government regulations have been enacted with the sole purpose of reducing risk taking by financial institutions.

Unable to put as much capital at risk as before, banks are shedding operations that were once major profit centers. For example, the Volker Rule bans propriety trading and limits commercial banks to hedging and market making. Return on equity (ROE), a closely watched measure of profitability, has dropped from double digits to single digits for most banks and I believe this is representative of increased regulation. Higher capital requirements mandates that a significant portion of cash is set aside. Essentially, cash must be tied up as an unproductive asset (rather than being put at risk in order to earn a return).

While some aspects of bank operations have been forced to shrink (or be eliminated), an area of growth for banks has been in commercial lending (i.e. lending to businesses). According to the Wall Street Journal, “Lenders, too, are making bigger bets on an economic expansion at a time when tighter restrictions on many banking functions have placed more importance on core lending activities to boost earnings”. Although banks might have preferred riskier operations in order to earn a higher return, more lending to businesses is certainly better for economic growth. In addition to being less risky than certain activities such as proprietary trading, lending is a vital source of credit that promotes booming business cycles.

The increase in lending to business has been a two way street. According to the Wall Street Journal, “The rise is being driven both by banks, which are loosening their lending standards, and companies, which are seeking more money, bank executives said”. On the one hand, companies are seeking cash. If businesses use this cash to cover day-to-day expenses (i.e. meeting current obligations), then this might not mean so much for economic growth. If businesses use this cash for capital expenditures (i.e. long-term investments in equipment), then this businesses might be indicating a positive outlook for economic growth. On the other hand, banks very much want to lend the cash as evidenced by lower lending standards. Although increased availability of credit is important for economic growth, an over-leveraged can easily fall into a financial crisis. According to the Wall Street Journal, “And while relaxed standards aren’t likely to cause banks much trouble in the near future, it was reckless lending that helped fuel the financial crisis”. As long as commercial lending is monitored correctly, then the risk should be manageable.

Although banks have increased lending to businesses, the same cannot be said for lending to consumers. In order to reverse this trend, banks have loosened standards for homebuyers. According to the Wall Street Journal, “Mortgage lenders are beginning to ease the restrictive lending standards enacted after the housing boom turned to bust, a sign of their rising confidence in the housing market”. A meaningful re-acceleration of the housing market is crucial for justifying expectations for economic growth. Although the housing market seemed to heat up last year, it slowed down in the fourth quarter and the first quarter of this year. Although one factor contributing to the slowdown might have been the winter weather, rising interest rates also certainly played a role. Higher interest rates decrease affordability for homebuyers.

Changes in interest rates have significant implications for both borrowers and lenders. According to the Wall Street Journal, “Some banks said the prospect of rising interest rates in the next few years could spur additional growth in commercial lending”.  Rising interest rates make lending more appealing for a few reasons. First, creditors get to collect higher interest payments. At the expense of debtors, banks earn increased revenue from lending activities. Second, many financial institutions have a mismatch between asset and liability maturity structures. Banks’ assets are mainly long-term loans and their liabilities are mainly short-term deposits. When interest rates rise, the value of the assets decrease more than the value of the liabilities. Banks can hedge interest rate risk and realign asset and liability maturity structures through commercial lending.

I cannot help but be concerned when I hear banks are lowering their lending standards because I am reminded of bank conduct during the housing bubble. I can only hope that regulators are watching more closely this time.

Commercial Lending on the Rise

Since the financial crisis, the climate has been constantly changing for financial institutions. Bankruptcies allowed banks to grow in size as healthy banks absorbed failing banks. Since then new regulations have been imposed on the largest financial institutions changing (and in some cases eliminating) many of their most profitable operations. For example, the Volker Rule bans   propriety trading by commercial banks. Return on equity (ROE), a closely watched measure of profitability, has dropped from double digits to single digits for most banks and this is representative of increased regulation. For example, higher capital requirements mandates that a significant portion of a bank’s capital is tied up being unproductive rather than being put to use (i.e. put at risk in order to earn a return).

While some aspects of bank operations have been forced to shrink (or be eliminated), an area of growth for banks has been in their lending to businesses. According to the Wall Street Journal, “Lenders, too, are making bigger bets on an economic expansion at a time when tighter restrictions on many banking functions have placed more importance on core lending activities to boost earnings”. Although banks might have preferred to continue running certain risky operations such as proprietary trading, I think the increase in lending is is more beneficial for economic growth. In addition to being less risky than certain activities such as proprietary trading, lending is an vital source of credit that can promote booms in business cycles.

The increase in lending to business has been a two way street. According to the Wall Street Journal, “The rise is being driven both by banks, which are loosening their lending standards, and companies, which are seeking more money, bank executives said”. On the one hand, companies are seeking cash. If businesses use this cash to cover day-to-day expenses (i.e. meeting current obligations), then this might not mean so much for economic growth. If businesses use this cash for capital expenditures (i.e. long-term investments in equipment), then this might indicate a positive outlook for economic growth. On the other hand, part of the jump in lending is due to banks lowering their standards. Although increased availability of credit is important for economic growth, an over-leveraged can easily fall into a financial crisis. According to the Wall Street Journal, “And while relaxed standards aren’t likely to cause banks much trouble in the near future, it was reckless lending that helped fuel the financial crisis”. I agree that we are far from the dangerous lending that occurred prior to the financial crisis, however, I hope a minimum level of lending standards can be maintained so that we avoid another financial disaster.

Although banks have increased lending to businesses, the same cannot be said for lending to consumers. In order to reverse this trend, banks have loosened standards for home buyers. According to the Wall Street Journal, “Mortgage lenders are beginning to ease the restrictive lending standards enacted after the housing boom turned to bust, a sign of their rising confidence in the housing market”. A meaningful re-acceleration of the housing market is crucial for justifying expectations for economic growth. Although we had a nice pop last year, the housing market slowed down in the fourth quarter and the first quarter of this year. Part of the slowdown might have been due to weather as well as the rising interest rates.

Rising interest rates making lending more appealing for a few reasons. According to the Wall Street Journal, “Some banks said the prospect of rising interest rates in the next few years could spur additional growth in commercial lending”. First, higher interest rates help creditors and hurt debtors. Although debtors must make higher interest payments, creditors get to collect higher interest payments. Second, many financial institutions have a mismatch between asset and liability maturity structures. Banks’ assets are mainly long-term loans and their liabilities are mainly short-term deposits. When interest rates rise, the value of the assets decrease more than the value of the liabilities because longer duration securities are more sensitive to changes in interest rates. Making more commercial loans enables banks to realign asset and liability maturity structures.

The Dangers of Low Volatility

On Monday, I discussed March retail sales and that its strength might be a positive sign economic growth. Today, there is more good news for the U.S. economy. According to the Wall Street Journal, “U.S. industrial production rose in March, moving beyond a lackluster winter and showing potential to gain strength in coming months”. Industrial production gauges the output of U.S. mines, manufacturers, electric and gas utilities. The manufacturing sector is only a fraction of domestic economic activity since the U.S. has transitioned to a service oriented economy. Nonetheless, many economists consider it to be an indicator of future demand.

In fact, economic activity across the United States is picking up steam. According to the Wall Street Journal, “Overall, the latest beige book, which describes economic conditions across the central bank’s 12 districts, pointed to an economy that was getting back on track after growth slowed earlier in the year”. This report, which is two weeks before the Fed’s April policy meeting, will likely have an impact on monetary policy. As the Fed continues to reduce asset purchases, the prospect of rising interest rates becomes more of a reality.

However, the Fed must watch the level of inflation when making its decision about interest rates. Even though economic activity is picking up, inflation is remaining stubbornly low and is a source of concern for the Fed. According to the Wall Street Journal,

Price gains could provide some comfort to Fed policy makers as they debate whether to keep pulling back on their easy-money policies meant to spur growth. Consumer inflation has run below the Fed’s 2% annual target for nearly two years, but price gains have accelerated a bit recently. Some central-bank officials have been concerned that low inflation—which discourages businesses and consumers from spending—could persist and weigh on growth.

Low levels of inflation are being experienced around the world. For example, the Bank of Japan is conducting asset purchases with the sole purpose of creating inflation. For this reason, the Fed can continue tapering at a slow pace as this should help push up inflation.

The problem with low inflation is it might be a symptom of something larger. We are starting to see the United States as well as other countries enter a stable path of growth. In addition, volatility is at very low levels. The last time we had a similar situation was during the Great Moderation. Starting in the mid-1980s, major economic variables such as gross domestic product (GDP) growth began to decline in volatility. In economics, the  “Great Moderation” refers to how stable the business cycle was at that time. We are again seeing that stable path of growth and global inflation, which is coinciding with an approaching of all-time lows again on volatility. However, this situation is easily disturbed. The first time around it masked a bubble in the housing market and that ended in a financial crisis. I am not sure what it is masking this time.

Retail Sales and Producer Prices Go Up

Following three slow months, retail sales jumped 1.1% in March. According to the Wall Street Journal, “Retail sales increased 1.1% last month… the reading was the best monthly gain since September 2012”. Strong retail sales, which are an important piece of U.S. consumer spending, could be an indication of accelerating economic growth. The healthy pickup in consumer spending suggests that weaker spending in recent months was an outlier likely due to severe winter weather.

The automotive component of retail sales led the rise with an increase of 3.1%, which reflects a significant jump in new vehicle sales. According to the Wall Street Journal, “March auto sales, as measured in dollars, rose 3.1% from the prior month. That was the best gain in a year and a half”. Purchasing a new vehicle can be a big investment. Thus, many households make use of auto loans. As a result, the increase in auto sales might also reflect improvements in private credit markets. The availability of credit plays a central role in the booms and busts of business cycles.

In addition to auto sales, other components of retail sales were also solid. According to the Wall Street Journal, “Spending also improved at general merchandise stores, restaurants and nonstore retailers, which includes online shopping… Excluding automotive purchases, sales advanced 0.7% in March, above the forecast 0.4% gain”. Retail sales beat expectations even without including the large contribution by auto sales. I think it is good that the surge in retail sales were well distributed among several different areas rather than being highly concentrated in one (i.e. auto sales). The strong retail sales in March helped restore my confidence in the economic recovery following the weaker data in December and January. The severe winter weather seems to have caused December and January to be outliers among the stronger overall trend in consumer spending.

Retail sales are meaningful component of consumer spending, which is a significant piece of gross domestic product (GDP). According to the Wall Street Journal, “Consumer spending accounts for more than two-thirds of U.S. economic output. As such, expectations for stronger economic growth this year are largely pinned to shoppers’ wallets”. Due to strong retail sales in March, some economists have raised their projections for GDP growth in the second quarter. Consumer spending is a pro-cyclical component of GDP, which means it is positively correlated with GDP. If consumer spending picks up, then we should expect GDP to follow.

Another good sign for the U.S. economy is that producer prices increased 0.5% in March, which might predict a rise in U.S. inflation. According to the Wall Street Journal, “The producer-price index for final demand, which measures changes in the prices businesses receive for their goods and services, rose a seasonally adjusted 0.5% from February”. Although the producer-price index (PPI) is not the Federal Reserve’s preferred measure of inflation, the PPI is still a useful gauge of U.S. inflation. Considering the prolonged period of low inflation, I welcome the increase in the PPI and believe it might be a good sign for the U.S. economy. Furthermore, the 0.5% increase is a noticeable change as it is the largest gain in a single month since January 2010.

Not only does rising prices indicate inflation, it also reflects increasing demand. The increase in demand can also be seen in the strong March retail sales. I think the March employment report, which showed a hiring rebound after the winter slowdown, contributed to the rise in the PPI and the jump in retail sales. When you have a job you are able to spend more and increase your demand, which pushes up prices. The labor market is incredibly important and I completely agree with Janet Yellen’s emphasis on promoting job growth. A healthy labor market is an indispensable component of economic growth.

(Revised) Negative Externality from Production of Sriracha Hot Sauce

Huy Fong Foods Inc., which is the manufacturer of the Sriracha chili sauce that we all love, is being forced to consider their full costs of production. According to the Wall Street Journal, “City officials sued the company in state court last fall, claiming fumes generated by the plant’s processing of chili peppers had caused eye and throat irritation and headaches among residents”. Huy Fong relocated to Irwindale as part of an expansion effort, but fumes from the factory seem to be disturbing nearby residents. I believe the residents of Irwindale are experiencing a classic negative externality problem.

A negative externality occurs when a firm makes a decision that adversely impacts a third party. In this case, the firm making the decision is Huy Fong and the third party bearing (some of) the costs of Huy Fong’s decision are residents living near Huy Fong’s factory. The negative externality is a byproduct from Huy Fong’s production process, which is causing discomfort to nearby residents.

Although there is no market for this negative externality (classic problem of an externality), there is a market for real estate in Irwindale. Residents of Irwindale (prior to the arrival of Huy Fong’s factory) chose to live there based on certain information that did not include the negative externality from Huy Fong’s factory. After making their decision, Huy Fong changed the game. The residents were not aware of this cost when making their decision. As a result, I believe that we have a market failure because marginal social cost is higher than marginal private.

The hot chili sauce has grown in popularity over the years. The first time I tried it was two years ago at Lucky Kitchen, which is a Chinese food restaurant on East University. Since then it has rapidly expanded – I was at Subway recently and I noticed special advertising for Sriracha chili sauce! I enjoy Sriracha and hope it continues being produced at a reasonable price. According to the Wall Street Journal, “A popular Southern California hot-sauce company has been ordered to cease operations that have allegedly emitted harmful odors into the surrounding community, after residents’’ complaints of health problems prompted a lawsuit”. If Huy Fong is found to be in violation of something, then they must bear the cost of eliminating the odor. Certainly Sriracha will continue to be produced, but we might see changes in equilibrium price and quantity.

I am reminded of a similar example of a negative externality in which a smoker is sharing a room with a nonsmoker. Without putting the smoker and nonsmoker in separate rooms, the nonsmoker is forced to inhale the smoker’s second hand smoke. Either the smoker could pay the nonsmoker for the right to smoke or the nonsmoker could pay the smoker to not smoke – both solutions aim to eliminate deadweight loss. Similarly, either Huy Fong pays for the right to produce the odor or the residents pay Huy Fong not to produce the order. If Huy Fong paid for the right to produce the odor, then the price of Sriracha chili sauce would likely be higher to include the negative externality. Although the higher price might mean less Sriracha is sold, equating marginal social cost and marginal private cost is imperative to eliminating the market inefficiencies (i.e. deadweight loss). If the residents paid Huy Fong to eliminate the odor, then Huy Fong could use that to purchase odor eliminating technology.

A lot depends on the findings of the air regulator and if Huy Fong is at fault. According to the Wall Street Journal, “Huy Fong says it is working with local air quality regulators to determine the cause of the allegedly harmful fumes and the company has promised to ‘immediately fix any problems once we know what steps need to be taken’ based on the regulators’ assessment”. If Huy Fong is not found to be guilty and the negative externality continues to be produced, then the price of real estate in Irwindale should fall to include this cost. In the smoker example, the nonsmoker might have not entered the room knowing it contained a smoker. Similarly, some might have not chosen to live in Irwindale knowing the negative externalities imposed by Huy Fong. Although this solution might compensate future Irwindale residents, I do not think this would be a fair outcome for those that moved to Irwindale prior to Huy Fong’s arrival. 

I am uncertain about the outcome of this lawsuit, but certainly think there is an important negative externality to be considered. In these situations, government regulation is usually able to provide an efficient solution. For example, cap and trade is used to allocate the right to pollute. However, unlike are pollution, chemicals in Sriracha odors are not documented and impact a smaller population.

Inflection Point for U.S. Economy: And Perhaps the World

The United States economy seems to be at an inflection point in which growth will either accelerate above the trend or remain below. The March Employment report had some very positive signs, which showed that more people are finding jobs. According to the Wall Street Journal, “All of the gains came from private companies, which added 192,000 jobs. The March gain means the private sector has regained all the positions lost in the recession”. Although the 192,000 jobs added was just below forecasts, I think it is a strong number that proves the December and January employment reports were outliers that were negatively impacted by severe winter weather. The recovery has been painfully slow in the labor market, but the March employment report was a significant step in the right direction. The better level of hiring, as evidenced by the March employment report, will hopefully give a boost to consumer confidence and in turn support consumption expenditures.

According to Ray Dalio, credit expansion and credit contraction essentially determine booms and busts in economic business cycles. Following many years of expansion, the credit market collapsed in the recent financial crisis. Thus, the health of private credit markets is central to the current inflection point of the U.S. economy.

fredgraph_credit

As seen above, the year over year percent change in private credit has recently turned in the right direction. If credit markets continue to strengthen, households will be able to take on more leverage. An improvement in private credit conditions is indispensable to supporting the positive signs in the March employment report.

If the March employment report was so lovely and credit conditions are improving, then why the recent dip in financial markets? I believe changing expectations about future interest rates played a significant role. Expectations about interest rate increases are mid-2015 (i.e. 6 months following the end of quantitative easing) and there are concerns surrounding what the impact will be on each sector of the U.S. economy. On the one hand, financial stocks moved up on the news as they stand to earn more interest revenue from loans. On the other hand, sectors sensitive to interest rates (ex. Housing) will likely suffer when rates move up at first. For example, higher interest rates decrease affordability in the housing market and could potentially lead to decreased residential investment. A key rate to watch is the ten-year Treasury yield, which is usually considered the risk-free rate for long-term debt and is thus intertwined with many other rates.

fredgraph_10yr

The yield on the ten-year Treasury has tested 3%, but has remained below it. I believe it is only a matter of time before the 3% level is breached. As mid-2015 approaches, expectations about future rates will need to be fully priced in. As a result, a first test for the inflection point will be whether sectors that are sensitive to interest rates can handle higher rates. If all of this goes smoothly, then the United States economy could reach escape velocity and grow above the cyclical trend of 2.5%. Wonderful! Not so fast… According to the Wall Street Journal,

If the U.S. grows a half-percentage point faster than expected, it would force the Federal Reserve to raise interest rates at a quicker clip. That would boost borrowing costs for emerging markets more than many governments and investors planned, raising serious questions about the ability of countries, households and corporations to pay off their debts.

Although I am hoping for stronger economic growth in the United States, I was unaware that it might cause problems for the rest of the world. To be clear, the IMF is expecting the U.S. economy to expand at 2.8% this year and 3% in 2015. I am not sure how likely the U.S. is to grow above these levels, but I am very pleased by the signs in the labor and credit markets. Hypothetically, if U.S. economic growth takes off, then the Fed must respond quickly and effectively with higher rates despite a negative impact on the rest of the world. As the Fed demonstrated during the major sell off in emerging markets this year, the Fed’s mandate is the U.S. economy and so it must keep its focus here.

Buying High and Selling Low

Stock buybacks have occurred at a faster pace this year than last year. According to the Wall Street Journal, “Companies in the S&P 500 increased share repurchases by 29% during the three months through January 2014 compared with a year earlier”. During a stock buyback, a company purchases outstanding shares at current market prices and pays stockholders cash for their shares. The repurchased shares are placed in the company’s treasury stock, which means they are no longer considered outstanding shares. According to the Wall Street Journal, “In theory, buybacks are nearly equivalent to dividends as a way to return cash to shareholders”. Both cash dividends and stock buybacks provide investors with a cash payment based upon the number of shares they own. Cash dividends, which are decided upon by the company, are usually a small fraction of share price. On the contrary, stock buybacks occur at market prices that are determined my market forces. Although investors prefer stock buybacks when stock prices are high, corporations should prefer repurchasing their own stock when it is cheap. However, companies are performing stock buybacks while stock prices are very high – this rewards investors while the company takes unnecessary risk.

Besides returning cash to shareholders, companies have other incentives to conduct stock buybacks. With less shares outstanding, stock buybacks artificially increase earnings per share (EPS). According to the Wall Street Journal, “By reducing shares outstanding, repurchases flatter earnings per share, making stocks look more attractive. During the reporting season that just ended, earnings growth slowed to a crawl and likely would have been negative without buybacks”. A company’s business model should prioritize producing goods and services. A successful business model will exhibit continuous growth in earnings. When organic growth slows, however, companies can propel stock valuations through stock buybacks. Although buybacks can inflate EPS and push up a company’s stock price, it can be a risky strategy that can cause problems in the future.

Despite the bull market and lofty stock prices, companies have been conducting a record amount of stock buybacks. According to the Wall Street Journal, “Buybacks and bull markets are self-reinforcing”. During a bull market, companies feel pressure to keep increasing EPS (and subsequently increasing stock price) and to put all of their cash to use. Unfortunately, spending too much on stock buybacks benefit the short run while causing damage in the long run. According to the Wall Street Journal, “If share repurchases consume too much of companies’ excess profits, the underlying businesses might end up starved, which could lower future returns”. Although companies might wish to perform buybacks and boost EPS in the short run, it can be a waste of cash that would otherwise be spent to increase EPS in the long run. Companies should be careful in how much money they spend on share repurchases, which are not essential to day-to-day business operations. Corporate spending should prioritize other expenditures before stock buybacks.

Ironically, companies would get more bang for their buck if they conducted buybacks when they feel least comfortable (i.e. during bear markets when stock prices are low). According to the Wall Street Journal,

During the previous bull market, buybacks peaked in the same quarter the stock market did. Less than two years later, during the quarter in which tock prices bottomed, companies spent 83% less on buybacks. That is despite the fact they would have gotten far more earnings-boosting effect at those low prices for each dollar spent.

When done at the right time (i.e. when stock prices are low), stock buybacks can be more effective and less risky. In order to time buybacks right, management must be patient and not give into short term temptations. Although it can be tough (or even impossible) to determine the exact value of a stock, companies should be able to tell if their stock price is roughly overvalued or undervalued. Even when stock prices are low and stock buybacks would make  sense, the economic climate and outlook might be more negative causing companies to make conservative decisions. Stock buybacks might be hard to time, but I think it is pretty clear that companies should avoid buying high and selling low.

(Revised) Owning Bonds Despite a Bearish Perspective

During the financial crisis, the Federal Reserve (Fed) cut the federal funds rate from above 5% to below 1% and has not raised rates since.

fredgraph_effectivefedfunds

As seen above, the grey shaded area represents the recent financial crisis. After reaching the zero lower bound (ZLB) in late 2008, the federal funds rate target has remained at 0.00-0.25%. With interest rates unable to go any lower due to the ZLB, the only way interest rates can move is upwards. The only question is – when will the Fed decide to raise rates?

Although I have been bearish on bond prices for some time, I have not traded on this perspective because I did not know when rates would rise. I am bearish on bond prices because bond yields and bond prices have an inverse relationship (ex. when interest rates rise, bond prices fall). As the economy improves, the moment that interest rates rise (and bond prices subsequently fall) approaches. Following the march FOMC meeting, I have come to believe that rates will rise in 2015. According to the Wall Street Journal, “If you expect lower returns from an asset class than it has provided historically, such as lower returns from bonds, then the math, and probably logic, would tell you to lighten up on bonds”. In order to lighten up on bonds, I would need to sell any bonds that I own. However, I do not own any bonds so I have considered shorting bonds instead through an exchange-traded fund (ETF) such as ProShares UltraShort Lehman 20+ Year Treasury.

Although this investment logic might be right, I have made a mistake by not having any exposure to bonds in the first place. According to the Wall Street Journal, “To be clear, the solution is not to eliminate bonds from your portfolio because they will still provide the very important diversifying benefit of cushioning your portfolio if the market should pull back”. Diversification is an important part of asset allocation that helps reduce the variance of expected returns through decreasing (and potentially eliminating) unsystematic risk from one’s portfolio. In a well-diversified portfolio, only systematic risk remains. On the one hand, systematic risk is correlated among all securities (i.e. macroeconomic news). On the other hand, unsystematic risk is uncorrelated among all securities (i.e. industry or company specific news). Traditionally, stock prices and bond prices have demonstrated a negative correlation. Adding bonds to my portfolio, which consists entirely of large cap U.S. equities, would offer me meaningful benefits through diversification. Recently, irregularities in the relationship between stock prices and bond prices (i.e. a positive correlation) due to quantitative easing might lead one to think that the benefits of diversification are lessened or eliminated. According to Burton Malkiel, “But note that even though correlations between markets have risen, they are still far from perfectly correlated, and broad diversification will still tend to reduce the volatility of a portfolio” (212). Although Malkiel was not referring to quantitative easing, he makes a useful point. As long as two securities are less than perfectly correlated (i.e. less than 1), then there will be benefits from diversification. With my portfolio consisting entirely of large cap U.S. equities, I could reduce the variance of my portfolio’s expected returns through diversification.

Despite my bearish view on bond prices, there are still ways for me to purchase bonds and gain the benefits of diversification. My bearish view on bonds is due to interest-rate risk. In this case, increasing interest rates will push down bond prices. If I wanted to still purchase bonds in order to diversify, then I could purchase bonds with short maturities. The shorter the maturity of a bond, the less it is subject to interest rate risk. This can be seen in the yield curve, which has a positive slope as maturities increase (and the credit rating remains fixed). Although the prices of short term bonds will still fall as rates rise, there will still be benefits from diversification.

As I attempt to adjust my portfolio’s asset allocation, I will consider both diversification and my bearish perspective on bonds. On the one hand, I will purchase bonds with short maturities. On the other hand, I will sell (i.e. sell short) bonds with long maturities. As a small investor, I will use ETFs in order to implement my strategy because it is more cost effective.

Yellen Attempts to Control Expectations

Interest rates rose following the March Federal Open Market Committee (FOMC) meeting in which the Fed eliminated the quantitate thresholds for unemployment and inflation from forward guidance. Without these thresholds, financial markets were left in perplexing uncertainty regarding the timing of interest rate hikes. Particularly, markets speculated as to when rates would rise once the Fed completed tapering its asset purchases. Although the FOMC statement provided an extremely vague time period, Yellen seemed to define the time period to be precisely six months in the post-FOMC press conference.

Unfortunately, financial markets misinterpreted Yellen’s words to be more exact than she intended. Prior to the March FOMC meeting, expectations for a first rate hike were in late 2015 or early 2016. According to the Wall Street Journal, “Some investors had taken Ms. Yellen’s remarks at a news conference after that [FOMC] meeting to mean rate increases might come sooner than they expected”. After the March FOMC meeting, yields on the two-year and five-year treasury adjusted to price in a rate hike around mid-2015 (i.e. about 6 months following the projected conclusion of the Fed’s tapering).

fredgraph2yrTreasuries fredgraph5yrtreasuries

As seen above, the two-year treasury yields had their largest single-day move since 2011 and the five-year treasury yields had their largest single-day move since September 2013 and rose the most since June 2013. The two-year and five-year treasury yields rose to reflect changes in expectations about the future.

In a speech on Monday, Yellen attempted to diminish these expectations to stop yields from moving higher. Yellen offered five reasons why she still sees slack in the economy. First, the number of involuntary part-time workers remains elevated. Second, statistics on job turnover is very low. According to the Wall Street Journal, “[Low job turnover] is an indicator that people are reluctant to risk leaving their jobs because they worry that it will be hard to find another”. Third, wage growth since the financial crisis has been low by historical standards. Fourth, a significant portion of the unemployed has been out of work for six months ore more. According to the Wall Street Journal, “The concern is that the long-term unemployed may remain on the sidelines, ultimately dropping out of the workforce”. Fifth, the proportion of working-age adults that hold or are seeking jobs (participation rate) has continued declining since the recession and throughout the recovery. Yellen believes these signs of slack in the economy give the Fed room to keep interest rates low.

Yellen also attempted to reshape the perspective on tapering. According to the Wall Street Journal, “She emphasized that the Fed’s recent decisions to reduce the size of its bond-buying program, meant to keep long-term interest rates low to spur growth, shouldn’t be viewed as a withdrawal of support of the economy. Rather, she said the Fed is adding support at a lower pace”. Although some might view the tapering of asset purchases as a withdrawal of stimulus, Yellen prefers the perspective that it is only a decrease in the rate by which stimulus is growing. Furthermore, monthly asset purchases themselves do not stimulate the economy. Instead, the size and duration of the Fed’s balance sheet (i.e. balance sheet monetary policy), which the Fed will maintain even after it stops expanding, will continue to stimulate the economy. As a result, financial markets should not be concerned that the Fed’s tapering is representative of tightening monetary policy.

Despite Yellen’s dovish message, treasury yields have not fallen to their pre-FOMC meeting level. I am not surprised by this because treasury yields were quite low before and are now adequately pricing interest rate risk. Although interest rates might not rise in early 2015, I think rates will start rising by late 2015 and this is reflected in the current level of the two-year and five-year treasury yield.

Combining Stock Picking and Stock Indices

In A Random Walk Down Wall Street, Burton Malkiel suggests owning stock indices as the best way to trade in the market. He writes, “Indexing is the strategy I most highly recommend for individuals and institutions” (402). An exchange traded fund (ETF) trades like a stock, but consists of more than one stock (i.e. a fund). For example, the SPDR S&P 500 (ticker: SPY) is an ETF that tracks the Standard & Poor’s 500-Stock Index. Malkiel highly recommends purchasing a portfolio of all companies in an index such as the S&P 500 because you avoid the challenges of identifying between winners and losers, which might actually be impossible. According to Malkiel,

The logic behind this strategy is the logic of the efficient-market hypothesis. But even if markets were not efficient, indexing would still be a very useful investment strategy. Since all the stocks in the market must be owned by someone, it follows that all the investors in the market will earn, on average, the market return. (391-192)

As a result, owning a stock index is a smart and effective way to invest in financial markets. If the efficient market hypothesis (EMH) is correct, then purchasing an index is the only sensible decision since there is no way to correctly pick winning stocks. If the EMH is not correct, then purchasing an index will still at least produce the market return.

Despite these wise words, many investors still wish to be stock pickers. According to the Wall Street Journal, “Here’s the latest evidence that stock picking is back: Investors are buying and selling fewer exchange-traded funds… The data suggests that investors are increasingly favoring trades in individual stocks”. The article suggests that investors’ preference for ETFs is dependent upon the predominance of macroeconomic headlines. When macroeconomic issues dominate the news, then the correlation among stocks increases. Macroeconomic data contributes to systematic risk, which is something that all stocks are exposed to. According to Malkiel,

Now, the important thing to realize is that systematic risk cannot be eliminated by diversification. It is precisely because all stocks move more or less in tandem (a large share of their variability is systematic) that even diversified stock portfolios are risky. (217)

When positive macroeconomic data is released, then all stocks will likely rise. When negative macroeconomic data is released, then all stocks will likely fall. As a result, investing in an ETF is an effective way to increase your exposure to systematic risk and diversify away unsystematic risk (i.e. factors particular to an individual company). And when macroeconomic issues become less prevalent, then investors would rather conduct stock picking.

Although Malkiel much prefers investing in indices, he understands that not all investors will always prefer investing in indices and offers four rules as a guide for selecting individual stocks. According to Malkiel, “Rule 1: Confine stock purchases to companies that appear able to sustain above average earnings growth for at least five years” (403). Following this rule will help investors select stocks with potential for future earnings growth. If the investor is successful, then the stock will increase earnings and the stock’s multiple might increase as well. According to Malkiel, “Rule 2: Never pay more for a stock than can reasonably be justified by a firm foundation of value” (403). Although Malkiel believes that it is impossible to calculate the exact intrinsic value of a stock, he does believe one can assess whether a stock is reasonably priced using the price-to-earnings (P/E) multiple. If a stock is trading at a P/E multiple that is significantly above the market average and the company’s growth prospects are not significantly above average, then that stock is overpriced and an investor should not but it. According to Malkiel, “Rule 3: It helps to buy stocks with the kinds of stories of anticipated growth on which investors can build castles in the air” (404). Due to the importance of psychological elements in determining stock prices, stock prices can skyrocket as investors’ expectations about future growth increase. Although predicting the expectations of investors in the future is inherently challenging, it is still a worthwhile pursuit. According to Malkiel, “Rule 4: Trade as little as possible” (404). Transaction costs such as broker fees and taxes can erode the profit from any investment strategy. In short, investors must resist the urge to trade frequently.

Although I am a strong believer in using ETFs to invest in entire indices, I also think there is a place and a time for picking individual stocks. After an investor has a well diversified portfolio, I believe an investor can take the risk and choose individual stocks. If an investor follows Malkiel’s  four rules, then I think stock picking can supplement ETFs.