Thought Bubbles from the Deep

[DeepState]

Starting a thread on some of my thoughts, observations and views. Maybe some forum readers might find them of interest or use. I expect that these may be a little ‘specialised’ and therefore uninteresting for most. Hopefully, not all.

I am seeking useful questions, feedback or postulates which sharpen my understanding and abilities. Working collaboratively on areas of common interest would be the ideal outcome for me and the primary purpose of this. This is my signal to space. There is life here (no claims that is it intelligent). Come visit.

Some alerts: This is not an effort at a line by line account of my portfolio. I will not disclose my portfolio, or the transactions therein, in a comprehensive manner. I do not undertake to alert the forum to changes in views previously discussed. I will be wrong a lot of the time.

 

[DeepState]

The most important decision we make in investment, particularly in somewhat diversified portfolios, is the overall allocations to major risk categories. Traditionally, these are considered as equities, bonds, cash, property etc. More recently, the concept has moved to risk dimensions somewhat like those in the 3rd chart.

At a overarching level, it is absolutely clear that returns from bonds on an ongoing basis are not going to be good. Whilst it is arguable that real returns might still be positive, when the return to bonds is lower than the cost of locking cash up in a box and issuing certificates on it (sort of like callable deposits, a form of cash), you have hit the bond floor, particularly if the CBs are inflation targeting and credible enough not to hyper-inflate storage and admin costs. We are not seeing returns to duration risk being rewarded at all in large swathes.

There is a corollary to equities. Earnings still haven't done much and yet prices are moving ahead. Whatever you thought equities would do 'in the longer term' ten to twenty years ago, it is now a fair chunk lower. The debate really centers around how much lower. Answer: in all likelihood, a fair bit in the US. Nothing big looks particularly cheap, although many will argue that EM equities is cheap relative to DM equities at present.


Source: Credit Suisse (market implied real discount rate)
Note: Aust looks fair (relative to history), but our market is dominated by resources and financials.

Let's do some maths. Intergenerational report says Aust GDP will be 2.8%pa in the next 40yrs. Inflation is 2.5% per RBA target band. So-called equilibrium bond yield then works out to be about 5% per annum (sounds about right if the FOMC reckons the long term figure for the short end is 4%pa). The market implied return for Aust services and industrials is about 7.5%pa. That's a 2.5% risk premium over long term equilibrium bonds. Seems a little light. Do this for the US and you fall over.

To support high returns to equities, you need to rely on arguments like a productivity surprise when labour is returning from the doldrums (usually productivity shocks occur when everyone is losing their jobs) or that equities are going to become more expensive simply because it is the least stupid place to put your money at the moment pending a better idea. Or maybe the profit share of GDP swings even further to corporate, or the listed profit component grows at the expense of the unlisted. Stuff like that.

Assessable long term returns to long-only bulk beta just aren't what they used to be. It was made to be so by CB policy and a savings glut due to lack of confidence to convert fresh money into productive capacity and the effects are genuinely visible.

What now? $X bucks today doesn't buy the kind of retirement $X bucks bought two years ago, assuming no social security support.

There are other kinds of risk premia in the market besides equity, duration and credit. I think the way to adapt is by adding meaningful exposures to other kinds of risk premia which you can't buy-hold in a traditional sense and balancing things out. But you maintain exposure to by trading your portfolio in certain ways. Carry and momentum, which I wrote of in the forex threads, are examples.

This is where I am currently (sort of):


This is where I think I need to be going to (sort of):


Charts are from Harry Liem, Mercer. The segments represent proportion of portfolio risk, not physical allocations.

Risk is not having enough money to do what you needed to do with it. With lower expected returns from traditional buy-hold, other kinds of 'trade-to-hold-exposure' to extract other forms of premia become more viable as offsets to the tiring workhorses that have been equity risk premium and term premium.

I think someone moved my cheese.

When I started out over twenty years ago, it was deemed terribly risky to own anything other than direct property. Amazing when I look back at it. Some clients referred to equities as 'those gambling things'.

The key thing here is that investment is about buying cheap stuff. The innovation here is that this stuff is not just an asset, but an exposure to a kind of risk that looks like it has a reward in it. When the rewards to buy and hold appear much diminished, I feel compelled to look at alternatives.

I think, for example, the return to carry might re-assert in currency if cross border finance re-emerges as a phenomenon. Duration looks a really really bad bet with virtually no downside in many markets. Amazing. Equities won't give you the real returns that were once expected. May be this is as good as is possible to obtain and we need to adjust our expectations down. Maybe not.

 

[qldfrog]

Duration looks a really really bad bet with virtually no downside in many markets. Amazing.

do you mean no "upside"?
And just for a complete novice trying to understand very unfamiliar concept
"Duration"-> aka the fact of holding onto an asset be it equity, bond, TD, gold?
In essence, a buy and hold for any asset becomes too risky vs the reward potential it might bring?

Sorry for the focus on duration,I understand this is just one risk factor among others but I got troubled by your sentence
Many thanks anyway to take the time to teach that view

 

[DeepState]

do you mean no "upside"?
And just for a complete novice trying to understand very unfamiliar concept
"Duration"-> aka the fact of holding onto an asset be it equity, bond, TD, gold?
In essence, a buy and hold for any asset becomes too risky vs the reward potential it might bring?

Sorry for the focus on duration,I understand this is just one risk factor among others but I got troubled by your sentence
Many thanks anyway to take the time to teach that view

My first visitor! Welcome welcome welcome....

Bonds are all backwards. Yields up, price down. No downside (to yields).

Duration is a concept which expresses the (sort of) average number of years that payments from the bond are made. If the bond has long maturity, is usually has a duration which is longer than a bond with shorter maturity. At its most technical, duration is a measure of interest rate sensitivity of the price of a bond. The longer the duration, the more sensitive the bond price is to yield movements.

Duration is thus to do with the time frame over which coupons and capital will be returned and nothing to do with holding period (which can be fractions of a second).

Ordinarily, you get paid to hold long duration relative to short duration. There is no really super-solid explanation for it other than this stuff moves a lot more in value than short duration and you need to be compensated for that risk over time. Also, long bonds are usually a bit more specialized and and less people are habituated to these and hence prices trade higher than arbitrage arguments might warrant. Also, when you make a loan for a long period of time, it's not like you can change your mind part way through (for the most part). Hence, you need to be compensated for this lack of lending flexibility. For all these reasons, you get paid for holding long bonds over time and expect to make more money than holding near term debt securities over time.

Right now, any concept of a premium for these things has basically vanished by dint of CB policy moves. They have priced the risk out in the hope that it encourages borrowing and forces money out of bonds into other risky stuff like direct capex and equities.

You now pay for the right to lend in a heap of places. This vaguely makes sense if you think prices will fall by more over the period that you hold the bond for (you might, for example, hope to sell it at an even more negative yield and make a capital profit despite negative interest rates - a greater fool strategy rationale). Alternatively, you think that prices are going to fall at a rate faster than you are losing nominal value. Except, there is nothing around suggesting the inflation expectations are that weak.

You might lend at negative rates because holding heaps of cash is actually not costless. You need to allow for rotting of your notes, guarding it, moving it around etc. Hence, you can put up with negative interest on deposits to some degree. That forms the floor on which cash rates can flow unless we become cashless and cannot actually take notes and coin out of a bank. Once the yields on bonds falls below the point at which cash at bank with fees is higher than the bond yield, it is utterly stupid to hold bonds on any argument whatsoever beyond the belief that short term debt will take more of a haircut than long term debt in the event of restructure despite rates being priced as totally riskless. That, or you expect bank fees to go through the roof over time. A CB might, possibly, do something incredible to the capital requirements to back short term deposits that achieves this. You have to reach that deep to justify this stuff.

We're pretty much at the point where burying your cash is a better option than buying bonds. This was supposed to be impossible. Yet, here we are.

 

[Faramir]

The key thing here is that investment is about buying cheap stuff. The innovation here is that this stuff is not just an asset, but an exposure to a kind of risk that looks like it has a reward in it. When the rewards to buy and hold appear much diminished, I feel compelled to look at alternatives.

Thank you Deepstate. I understand this but I am struggling to apply it to the real world. I caught two falling knifes in the past 12 months. Thankfully I also got some good shares as well. Of the total amount (which is not much) that I started with 12 months, about 40% is still in cash. Why do I feel some hesitation to spend more? I haven't even looked into EFTs yet. Gut feeling tells me to wait (beginner's gut feeling.) I see in one of the pie charts, "Term" is nearly one third of the pie.

I think, for example, the return to carry might re-assert in currency if cross border finance re-emerges as a phenomenon. Duration looks a really really bad bet with virtually no downside in many markets. Amazing. Equities won't give you the real returns that were once expected. May be this is as good as is possible to obtain and we need to adjust our expectations down. Maybe not.

If someone was to start now (like me), have we missed the boat? Has the opportunity vanished?

 

[qldfrog]

Duration is thus to do with the time frame over which coupons and capital will be returned and nothing to do with holding period (which can be fractions of a second).

ok
5y/10/20y bond and the expected premium due to risk taken irrelevant to the fact you can sell/buy them in a few days if you wish to.
Got that one. thanks so this is specific to bond (corporate/state)

 

[qldfrog]

and one more point of vclarity:
EM equities is cheap relative to DM equities at present.
EM vs DM
I initially thought European Market vs ..hum D for Deutsch?? but that was too euro centric based on my background and made no sense related to your graph
EM as emerging market is more like it but vs DM??not an acronym I know to mean first world/aka developed market
and bingo Developed market with a bit of google help
so
unless wrong and to help other beginners
EM emerging market vs DM developed market

The discount existing between is one of the reason i actually have a reasonably big exposure to the EM in my current portfolio

 

[DeepState]

about 40% is still in cash. Why do I feel some hesitation to spend more? I haven't even looked into EFTs yet. Gut feeling tells me to wait (beginner's gut feeling.) I see in one of the pie charts, "Term" is nearly one third of the pie.


If someone was to start now (like me), have we missed the boat? Has the opportunity vanished?

You might be reluctant to spend for a number of reasons.
- Fear. By not fully investing, you will lose less than you might have if investments go bad. That way, you are going to feel somewhat better than you would have if the worst happens. We think in relative terms (and it makes us miserable, see Relational Frame Theory if interested). You will feel less bad....a good thing. When less experienced, in these types of situations where it is not some form of entertainment for you or a desparate effort to escape poverty via a long shot, downside is the thing we think of most. You won't be thinking much about how you would make less if the investments actually go well. You have two anchor points in your head. Zero and what would happen if things were fully invested. You are trying to minimize regret against both anchors. That leads to partial investing. Most often, you will just do half of what you targeted...in your case, you've invested 60%.
- Lack of opportunity. Not many ideas coming your way.
- Mentally averaging in over time to reduce the potential regret of getting set on one day and that one day turning out to be a bad day to start.

Given you are not experienced yet and have not been purposefully training yourself on this for a long time, the gut feel is likely not informative to you about genuine money making.

You have not missed the boat. It's just that the distance traveled in the boat for the same ticket price is now maybe half to two-thirds of what it might have been pre GFC for a typical retirement 'balanced/growth' mix. If you invest primarily via bonds, it is a total disaster.

 

[DeepState]

ok
5y/10/20y bond and the expected premium due to risk taken irrelevant to the fact you can sell/buy them in a few days if you wish to.
Got that one. thanks so this is specific to bond (corporate/state)

There are different concepts to duration and we have only been discussing the most common usage. The concept is applied to nominal bonds issued by gov't at any level, corporates and, maybe, asset backed securities of some stripe.

The second most common is 'credit duration'. The change in the value of a security for a small change in the credit spread.

You can estimate the duration for equities too, but equities are rarely assessed with this concept in mind.

 

[qldfrog]

And to follow on Faramir, trying to apply this in concrete terms is not that easy.
The good thing Deepstate is that once again, your email cleared my complacency and let me had a look at my portfolio as a whole; inc super/real estate
and I am not confortable with what I see

I also am selling my residential IP this month and will get some fair amount of cash coming in at settlement.Where to from there?
while I see short term the ASX jumping above the 6000, I do not expect to be there in early 2016, and the risk is so big of a black swan trigger that i am not confortable to put that cash back in the market even if I have a short term positive outlook;

Risk approach is personal and based on situation, but as i try VERY hard to avoid having to go back to corporate slave, it is critical for me to manage risk.
Your thread is a gem both for learning and to trigger thought processes;
Why did not I go into finance 20 y ago.....
Many thanks please carry on;
PS: being in Australia, apart from these worl wide trends which obviously impact us, do you sometimes try to use some of the local trends for investing decision?
By that I mean, I have a groundhog day feeling here of a society going thru all what I experienced in the 90's in western europe, in term of immigration, economy,sense of entitlement, politics etc and the sad future here is pretty easy to draw based on this experience.Any meaningful way to leverage that "knowledge" on an investment scale?

 

[DeepState]

and one more point of vclarity:
EM equities is cheap relative to DM equities at present.
EM vs DM
I initially thought European Market vs ..hum D for Deutsch?? but that was too euro centric based on my background and made no sense related to your graph
EM as emerging market is more like it but vs DM??not an acronym I know to mean first world/aka developed market
and bingo Developed market with a bit of google help
so
unless wrong and to help other beginners
EM emerging market vs DM developed market

The discount existing between is one of the reason i actually have a reasonably big exposure to the EM in my current portfolio

EM: Emerging Markets.
DM: Developed Markets.

The argument is made that the relative P/E between the two favours EM based on historical relationships. This result is genuinely there, but the implications are just not that straight forward if you look into reasons why that might be the case. Lots of arguments are made based on things like demography etc. What is often missing in these arguments is what you get for a dollar spent. The growth rate for EM nations like China is now much slower than it had been as it matures. Russia is cheap for a reason. etc. I have some EM, but it is less than 10% of my current total equity exposure.

 

[craft]

You can estimate the duration for equities too, but equities are rarely assessed with this concept in mind.

Duration (as in interest rate sensitivity) is very important for long term equity selection, especially at the moment with interest rates so low. High duration stocks (little pricing power, big current asset bases) – banks spring to mind - seem overpriced too me unless interest rates don’t move up for a long time. Duration margin seems negative in the equities market to me at the moment. However some of the lower duration stocks are much more attractive from a long term perspective. One of the few opportunities left in this time of financial suppression.

Basically the negative duration premium in equities makes the yield chase occurring now dangerous but still leaves opportunities for buying long term growth at a reasonable price.

 

[Ves]

Duration (as in interest rate sensitivity) is very important for long term equity selection, especially at the moment with interest rates so low. High duration stocks (little pricing power, big current asset bases) – banks spring to mind - seem overpriced too me unless interest rates don’t move up for a long time. Duration margin seems negative in the equities market to me at the moment. However some of the lower duration stocks are much more attractive from a long term perspective. One of the few opportunities left in this time of financial suppression.

Basically the negative duration premium in equities makes the yield chase occurring now dangerous but still leaves opportunities for buying long term growth at a reasonable price.

(My bold above)

craft - when you say "current" do you mean current as the accounting definition (less than 12 months, ie. high working capital requirements) or do you just mean companies that currently have big asset bases / capital requirements in general? I'm thinking that you mean the latter, and at the end of the day the first thing your post reminds me of is Buffett's comments re See's Candy and the hyper-inflation period in the 70s/80s.

I've been thinking about the yield chase, and my own personal bias towards stocks that pay healthy dividends right now (ie. I'm usually after 4-5%+), and decided that its for two main reasons: its easily understood because cash coming to you right now as an investor is tangible and it scratches the short-term success itch (I paid this much and now I'm getting X% return right now). It's a bias that I'm trying to move away from: much of it is comfortably accepting the long-term feedback cycle of the market, and not comprising it with short-term thinking.

PS: Thanks for the thread DeepState, I've often meant to pick your brain about certain concepts I've come across, but didn't want to derail any existing threads too much.

 

[DeepState]

This is the kind of development which tells me carry is probably making a come-back in FFX. Will probably add carry currency exposure in limited quantity later today or early next week. Rationale and calculations will be outlined at some stage.

 

[DeepState]

This is the kind of development which tells me carry is probably making a come-back in FFX. ....

FOMC Flow of Funds report for Q4 2014 confirms:

At a time when credit creation is returning towards 'normal' levels, the pattern of foreign borrowers raising funds from the US has declined. In other words, cross border finance is increasing (increasing gross flows) but they are borrowing less from the US in net terms. That's carry in action.

---

Prior RBA data indicates that funds are leaking from Japan at a rate of knots.
Prior ECB data shows EU bank lending to offshore is also recovering.

All movements in the expected direction and accelerating.

Carry in FFX is good to go. This appears real.

Major visible risks:
ECB upgrade to GDP expectations may mean that the program is cut short relative to expectations. Event risk.
EZ monetary set-up is still non-viable but being held together by political will. Depending on what is called 'Euro' in a dissolution event, major moves in any direction could occur.
BoJ throws in the towel. They remain convinced that things are working out for the better. BoJ Board is being stacked with pro-liquidity doves.
UK property market led financial distress (need to investigate....no immediate impediment for proceeding).
Oil based financial risk (Check CDS spread for majors vs oil)
Recent US Comprehensive assessments give reasonable all-clear on domestic banking system.

Much work to be done to create monitoring tools to make monitoring this position tractable. However, no immediate impediment noted.

 

[qldfrog]

FOMC Flow of Funds report for Q4 2014 confirms:

And how do you play that game, instead of euro/japanese borrowing in USD, the opposite happens with raising rate in the US expected earlier than the rise elsewhere
so
USD climb vs euro/yen?
And so expect AUD to carry on its descent? (no not that carry game)
I noticed this morning the AUD was up 1.5 % (6AM or so on yahoo finance probably last trading values) then when I last checked a few min ago was going down again.
After this morning checked i bought a few USD but had to race to get it as it was climbing again.
So yes how do you get in? do you purchase debt in japan/euro , invest in the US?
not that easy to do as a retail investor
or justplay forex with that in mind, knowing any little phrase of teh feb will have teh exchange rate jump right and left
Anyway, enough question from the ignorant pupil

 

[CanOz]

Deepstate, for your equity portion of your portfolio, why would you not just buy EU equities given that the last two examples of QE bond buying resulting in equity bull markets?

 

[DeepState]

PS: being in Australia, apart from these worl wide trends which obviously impact us, do you sometimes try to use some of the local trends for investing decision?
By that I mean, I have a groundhog day feeling here of a society going thru all what I experienced in the 90's in western europe, in term of immigration, economy,sense of entitlement, politics etc and the sad future here is pretty easy to draw based on this experience.Any meaningful way to leverage that "knowledge" on an investment scale?

Yes, I look at Australia specific data.

As for your experiences and potential usage for investments, my view is you use whatever you've got to greatest advantage if you can. Your direct experiences in Europe may help inform you of potential developments elsewhere - like Australia. It might lead you to identify where the beliefs of most might be at odds with what you've seen roll out. Sometimes, there is profit in that.

 

[DeepState]

And how do you play that game, instead of euro/japanese borrowing in USD, the opposite happens with raising rate in the US expected earlier than the rise elsewhere
so
USD climb vs euro/yen?
And so expect AUD to carry on its descent? (no not that carry game)
I noticed this morning the AUD was up 1.5 % (6AM or so on yahoo finance probably last trading values) then when I last checked a few min ago was going down again.
After this morning checked i bought a few USD but had to race to get it as it was climbing again.
So yes how do you get in? do you purchase debt in japan/euro , invest in the US?
not that easy to do as a retail investor
or justplay forex with that in mind, knowing any little phrase of teh feb will have teh exchange rate jump right and left
Anyway, enough question from the ignorant pupil

You purchase FFX spot or forward contracts in the relative currency pairs to give effect to the carry trade exposure. These are as you have been postulating above.

Any FFX trading platform will allow you to do this. By buying USD and selling JPY (for example), one exposure you are getting is to carry.

This is not a short term timing thing. It is an exposure which has been shown to be rewarded and has some decent reason to be rewarded going forward. Doing this is like buy-hold, except that you need to trade a bit to buy-hold carry. As stocks move up and down, you just buy-hold them if you believe in the LT equity risk premium. Over the long run, the starting point means less and less. Same deal with carry. It's a long-term play. The difference is that you have to keep re-shaping your portfolio to keep your exposure.

Once you make the mental leap on this stuff, you'll find it is very real world. It's just different to bulk practice. The ideas have been around for a very long time. The ability to capture them is also readily available to retail. Just that most don't think this way (incl insto). Right now, the key practitioners are in hedge funds or in hedge fund replication.

The ability to implement this stuff has been heavily democratized with technology. What is not democratized is the willingness to learn about this and, possibly, the ability to do so. That smells like opportunity to me.

 

[DeepState]

Deepstate, for your equity portion of your portfolio, why would you not just buy EU equities given that the last two examples of QE bond buying resulting in equity bull markets?

I guess there is more to life than QE... The positioning is based around questions like 'Would I hold this position for 20 years?' and 'Would that be a stupid thing to do?' The proposal of just EU, given it is embarking on QE, is quite tactical in nature. Markets are weird. Sometimes bad news is treated as good news...and then it changes for reasons that only become clearer afterwards. I am just trying to look through all of that for the most part without being totally ignorant of current circumstances. The record of successful market timing is utterly shocking, especially given how much robust commentary is released on it all day long. I'm not playing that game if it is not necessary to do so. I have no edge there.