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Thought Bubbles from the Deep


"'When it becomes serious, you have to lie" - Jean-Claude Juncker

 
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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
 
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.

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)
 
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.
 

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.
 

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.


---

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:
 

@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).
 
DS...I honestly get the feeling when I read your posts that I should be paying for them.

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.
 

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.
 

Hadn't really considered any of that.
Thanks again
 
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
 
KMD-AU position was sold a few weeks back. Thanks for the heads up though.
 
Organising your notes...

Any thoughts on OneNote, Evernote or some other method of storing and organising your notes and observations?
 
Organising your notes...

Any thoughts on OneNote, Evernote or some other method of storing and organising your notes and observations?

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?
 
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:




 
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