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Thought Bubbles from the Deep
- Thread starter DeepState
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Good example sinner. I'll be the first to admit im in way over my head talking about this stuff. Conceptually though If I'm running money (be it a big hedge fund or mum and daddy smsf) 1-2% in the bank vs 7,8,9% in shares its a no brainer.
As you right say whether this has any historical backing I don't know and it appears not - atleast in Japan
As you right say whether this has any historical backing I don't know and it appears not - atleast in Japan
Dividends are not a right. They are a privilege. How many companies didn't pay out a single dollar of dividends in 2008? How much can you really payout in dividends with negative earnings anyway?
Returns to shareholders (be it via dividend, share repurchase or long term debt repayments) are a function of the returns generated from assets/equity/invested capital/etc. There is no guarantee there either. Individual company returns are completely dependent on a functioning economy.
Meanwhile, returns on "bond yields" as you called them, are nominally a function of the Governments ability to issue currency (real returns are again completely dependent on a functioning economy). That is a much lower bar
Big hedge funds and SMSF are not the only form of "running money" as you put it, in those cases the goal of investment is specifically maximising total return.
What about insurance funds? They sell premiums and need to invest (at least a large part of) those premiums into something that can guarantee a nominal return in the event of a payout. In which case the thought of having to pay out huge premiums in the middle of a financial crisis (think AIG?) makes not holding stocks a no brainer. Liquidity is more important than returns. Even to seasoned investors like Warren Buffett!
Note the bolds, Berkshire could get "no brainer" get a better rate by increasing duration from 90 days to 2y (or 10y or 30y), or by investing in AAA corporate bonds vs Treasury cash (or junk bonds
), or even investing 100% of their funds into stocks.But they don't
(for those playing at home, Berkshire market cap is ~330 billion USD)
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Perhaps dividend yield was the wrong concept.
As you point out I should have used 'earnings' and then we are talking about comparing earnings to the 'risk free' rate.
I guess the point I was enquiring about is whether an ever decreasing yield will encourage investors to look elsewhere and ultimately pay greater premiums in other assets.
I've seen the discussions between yourself/DS/craft about these topics in the past and I find them interesting.
With regards to the insurance example, different horses for different courses, obviously there's many players in the market each with differing goals and needs, after all that's what makes a market. I guess I was specifically talking about those investing to achieve a return - I perceive these players to make up the bulk of the market, once again however I could be wrong.
As you point out I should have used 'earnings' and then we are talking about comparing earnings to the 'risk free' rate.
I guess the point I was enquiring about is whether an ever decreasing yield will encourage investors to look elsewhere and ultimately pay greater premiums in other assets.
I've seen the discussions between yourself/DS/craft about these topics in the past and I find them interesting.
With regards to the insurance example, different horses for different courses, obviously there's many players in the market each with differing goals and needs, after all that's what makes a market. I guess I was specifically talking about those investing to achieve a return - I perceive these players to make up the bulk of the market, once again however I could be wrong.
Imagine that the yield is the bond markets "implied annualised growth forecast" for the duration of the bond. It isn't, but imagine it is. So if the 10y risk free rate is 2% then imagine the bond market is forecasting annualised growth of 2% per annum for 10 years.
Now consider Intrinsic Valuation of a listed company. On the one hand, because the interest rate is low, your bar for earnings yield is lower. But the other edge of that sword is that you can no longer realistically forecast high levels of growth far out into the future.
Assuming S&P500 EPS growth of 6.3% and current Cyclically Adjusted P/E (10) of 26.48 and the long term historical average of CAPE as 16, dividend of 2% we approximate the annualised return for the next 10 years as:
100 * (1.063 * (16/26.48)^(1/10) - 1 + 0.02) = 3.07%
Currently the US 10Y yield is 2.05% ...
So the (much more realistic) equity risk premium is only 1%. Basically, you have to be willing to take on double the volatility for an extra 1% per annum return, and that is assuming you believe EPS can grow at 6.3% per annum with profit margins at record highs, with no cuts to dividends.
DeepState
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The main trigger is the China Flash PMI, which came after the Yuan devaluation. In the background is the expectation of the first step to monetary tightening by the Fed.
Other matters:
+ US market is unambiguously expensive on metrics.
+ EM commodity exporters are being crunched. To the extent they are financed by USD loans, credit will be increasingly impaired.
+ There is a flight to safety going on
I believe that this is the trigger that sees US valuations brought more into alignment. The market sometimes accepts a fantasy for a while and then wakes up. Some trigger is always identifiable in hindsight, but is not thought to be a trigger at the time until a roll gets going. In this case, the US market influences everything else, but how it recovers from here relative to other markets will be interesting.
Although economic releases in the developed markets are generally alright, there is a risk of disruption emanating from China. It is widely believed that the Chinese GDP is very weak because various partial indicators like imports, electricity consumption, demand for commodities related to capital investment... suggest a weakening picture. The PMI was very weak (77 month low) but, worse, the new orders component is deteriorating...meaning that this will be sustained.
On top of this, the Chinese government and monetary authorities also have a reserve drain issue and a lowflation problem as well. They also want to become a reserve currency. The true market value of the CNY is below the previous peg and remains below the current price which is being supported by the PBOC with very significant intervention. This cannot be sustained and more devaluation is inevitable.
When this occurs, and if the economy remains weak and is getting weaker, it will drain growth from all over the place. This is part of the reason why bonds have rallied. It is interesting that investment grade BBB credit, even in financials, is not trading all that much wider. So nothing in the credit world is getting too stressed...outside of China.
There is something very screwed up that is occurring in China as the reactivity of the officials to the equity market was extraordinary. Perhaps it was to do with protecting the reputation of the government. Perhaps it was because there may be contagion effects to sentiment.
The key swing factor now is whether China can bail itself out again from seeming disaster. If it can't, the rest of the world will share its pain. I need to look into this aspect some more.
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When central banks push down rates using QE or other measures, they are trying to stimulate growth. One channel is to push up the prices of securities in the share market. By doing so, companies can raise funds more cheaply and invest it. That's the theory. So far, for the most part, all that has happened is that prices have gone up. However, I cannot know how much more capital expenditure would have been cut if it weren't for this.
DS...I honestly get the feeling when I read your posts that I should be paying for them.
One small point, re the BBB spreads, just because I have been looking at these recently. What I have noticed is that it's less about the absolute measure of spread. The "uniformity" (stealing the phrase from John Hussman here) with other assets is more important. i.e. if spreads are widening when the market is rallying, that's a divergence worth paying attention to, re stress.
This is something that only recently clicked for me, but when it finally did I remembered how the TED spread was slowly widening in early 2011, but nobody payed attention because the absolute level was low.
Anyway, here is my payment:
Long term options adjusted daily US BBB from FRED:
Same, zoomed into the last year, up 53%, this warning signal has obviously been flashing for a while:
Bonus round: 1y of monthly AU nonfinancial BBB spread from the RBA, up ~30%, wonder what it'd be with fins included:
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Brilliant guys thank you
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@DS - Thanks, very informative post. I am curious about the above quote though...
Why would the PBOC want to maintain a higher level for the CNY, if inflation is low and the economy is struggling? I would have thought the opposite would cause inflation and improve competitiveness of exports (hence increased growth).
DeepState
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High praise indeed especially considering the source. Thanks.
Take your points on BBB. I guess I was looking for a discontinuity following the equity shake.
DeepState
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The currency is a political issue and not just market oriented. There are also concerns for international credit market stability. A depreciation which is sudden may worsen demand for Chinese exports if it causes stress in the European, Asian and Japanese banking systems, for example.
There is a form of Tragedy of the Commons which can break out if China did this is a disorderly fashion.
Under current circumstances, China needs to devalue. However, it will likely seek to do so in a 'crossing the river by feeling the stones' method...incrementally.
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And I would add that the Chinese president is seeing Obama next month if I am right and may want to be a "nice guy" till the visit, and a better chance to join the club of respected currencies
pure politics but there the country, the party and the institution are one
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There she blows...AUDUSD now sub 70
http://www.smh.com.au/business/retail/kathmandu-loses-place-in-asx-top-200-20150904-gjf42c.html
kicked out of the index, normally a price positive signal, stocks tend to outperform the benchmark once they get kicked out, maybe worth complementing this position with a short SPI hedge.
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This is a result of the takeover, and implied lower liq and free float even if it fails.
I say good riddance
DeepState
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KMD-AU position was sold a few weeks back. Thanks for the heads up though.
DeepState
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Organising your notes...
Any thoughts on OneNote, Evernote or some other method of storing and organising your notes and observations?
Any thoughts on OneNote, Evernote or some other method of storing and organising your notes and observations?
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A colleague used one note quite extensively, and my son is using it as the only support for school.
wonder about sharing these notes via iphone/android..
supposed to be possible but never used..
anyone?
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Didn't know where else to put this, so thought id post it in this great thread.
Thoughts from the legendary fund manager Ray Dalio, published Aug 25 2015:
Thoughts from the legendary fund manager Ray Dalio, published Aug 25 2015:
The Dangerous Long Bias and the End of the Supercycle
Why We Believe That the Next Big Fed Move Will Be to Ease (via QE) Rather Than to Tighten
As you know, the Fed’s template and our template for how the economic machine works are quite different so our views about what is happening and what should be done are quite different.
To us the economy works like a perpetual motion machine in which short-term interest rates are kept below the returns of other asset classes and the returns of other asset classes are more volatile (because they have longer duration) than cash. That relationship exists because a) central banks want interest rates to be lower than the returns that those who are borrowing to invest can generate from that borrowing in order to make their activities profitable and b) longer-term assets have more duration that makes them more volatile than cash, which is perceived as risk, and investors will demand higher returns for riskier assets.
Given that, let's now imagine how the machine works to affect debt, asset prices, and economic activity.
Because short-term interest rates are normally below the rates of return of longer-term assets, you'd expect people to borrow at the short-term interest rate and buy long-term assets to profit from the spread. That is what they do. These long-term assets might be businesses, the assets that make these businesses work well, equities, etc. People also borrow for consumption. Borrowing to buy is tempting because, over the short term, one can have more without a penalty and, because of the borrowing and buying, the assets bought tend to go up, which rewards the leveraged borrower. That fuels asset price appreciation and most economic activity. It also leads to the building of leveraged long positions.
Of course, if short-term interest rates were always lower than the returns of other asset classes (i.e., the spreads were always positive), everyone would run out and borrow cash and own higher returning assets to the maximum degree possible. So there are occasional "bad" periods when that is not the case, at which time both people with leveraged long positions and the economy do badly. Central banks typically determine when these bad periods occur, just as they determine when the good periods occur, by affecting the spreads. Typically they narrow the spreads (by raising interest rates) when the growth in demand is growing faster than the growth in capacity to satisfy it and the amount of unused capacity (e.g., the GDP gap) is tight (which they do to curtail inflation), and they widen the spreads when the opposite configuration exists, which causes cycles. That's what the Fed is now thinking of doing—i.e., raising interest rates based on how central banks classically manage the classic cycle. In our opinion, that is because they are paying too much attention to that cycle and not enough attention to secular forces.
As a result of these short-term (typically 5 to 8 year) expansions punctuated by years of less contraction, this leveraged long bias, along with asset prices and economic activity, increases in several steps forward for each step backwards. We call each step forward the expansion phase of each short-term debt cycle (or the expansion phase of each business cycle) and we call each step back the contraction phase of each short-term debt cycle (or the recession phase of the business cycle). In other words, because there are a few steps forward for every one step back, a long-term debt cycle results. Debts rise relative to incomes until they can't rise any more.
Interest rate declines help to extend the process because lower interest rates a) cause asset prices to rise because they lower the discount rate that future cash flows are discounted at, thus raising the present value of these assets, b) make it more affordable to borrow, and c) reduce the interest costs of servicing debt. For example, since 1981, every cyclical peak and every cyclical low in interest rates was lower than the one before it until short-term interest rates hit 0%, at which time credit growth couldn't be increased by lowering interest rates so central banks printed money and bought bonds, leading the sellers of those bonds to use the cash they received to buy assets that had higher expected returns, which drove those asset prices up and drove their expected returns down to levels that left the spreads relatively low.
That's where we find ourselves now—i.e., interest rates around the world are at or near 0%, spreads are relatively narrow (because asset prices have been pushed up) and debt levels are high. As a result, the ability of central banks to ease is limited, at a time when the risks are more on the downside than the upside and most people have a dangerous long bias. Said differently, the risks of the world being at or near the end of its long-term debt cycle are significant.
That is what we are most focused on. We believe that is more important than the cyclical influences that the Fed is apparently paying more attention to.
While we don't know if we have just passed the key turning point, we think that it should now be apparent that the risks of deflationary contractions are increasing relative to the risks of inflationary expansion because of these secular forces. These long-term debt cycle forces are clearly having big effects on China, oil producers, and emerging countries which are overly indebted in dollars and holding a huge amount of dollar assets—at the same time as the world is holding large leveraged long positions.
While, in our opinion, the Fed has over-emphasized the importance of the "cyclical" (i.e., the short-term debt/business cycle) and underweighted the importance of the "secular" (i.e., the long-term debt/supercycle), they will react to what happens. Our risk is that they could be so committed to their highly advertised tightening path that it will be difficult for them to change to a significantly easier path if that should be required.
To be clear, we are not saying that we don't believe that there will be a tightening before there is an easing. We are saying that we believe that there will be a big easing before a big tightening. We don't consider a 25-50 basis point tightening to be a big tightening. Rather, it would be tied with the smallest tightening ever. As shown in the table below, the average tightening over the last century has been 4.4%, and the smallest was in 1936, 0.5%— when the US was last going through a deleveraging phase of the long term debt cycle. The smallest tightening since WWII was 2.8% (from 1954 to 1957). To be clear, while we might see a tiny tightening akin to what was experienced in 1936, we doubt that we will see anything much larger before we see a major easing via QE. By the way, note that since 1980 every cyclical low in interest rates and every cyclical peak was lower than the one before it until interest rates hit 0%, when QE needed to be used instead. That is because lower interest rates were required to bring about each new re-leveraging and pick-up in growth and because secular disinflationary forces have been so strong (until printing money needed to be used instead). We believe those secular forces remain in place and that that pattern will persist.
