Friday, March 5, 2021

Value At Risk Raising Risk

 I just read a very insightful article on the effects that Value At Risk (VAR) portfolio models and regulations may have on markets.  In sum, VAR could force portfolio managers and banks to sell into a down market to reduce exposure, thus accelerating and deepening the move.  The author draws a parallel to the 1987 "portfolio insurance" debacle.

In the past, investment portfolios containing both stocks and bonds were somewhat protected from such a possibility, since equities and bonds were negatively correlated: when stocks went down bonds moved up thus keeping VAR pretty steady. For the past 30 days,however, the correlation has turned positive and stocks are coming down along with bonds - Chart 1.

Chart 1 - SP500 and 10 Year Treasury Futures Moving Down Together 

The common thread between stocks and bonds is market risk.  While stocks have always been risky, Treasury bonds were considered a safe havenBut, given the enormous bond supply hitting the market, very low interest rates and the Fed's continuing apathy towards inflation, bonds are now risky, too, so they are also coming down as risk appetite subsides.

In other words, you can certainly run (get out of stocks and bonds), but you can only hide in cash which pays you zero, or less (if you are in Euro).  Now, portfolio managers have a violent dislike of cash since they don't get paid to sit on it - and why should they?  But here's the rub: it's almost always the case that the asset class that outperforms over the next 12 months (or 24, 36. 48...) is the one that has had the worst performance in the past.  Naturally, cash has been in the doghouse for ages...

Thursday, March 4, 2021

Where Are The Bond Buyers Going To Come From?

 The Treasury is planning to sell a fresh $4 trillion of debt this year in order to finance Mr. Biden's emergency relief plan ($1.9 trillion) plus the "regular" annual budget deficit.Which begs the question.. other than the Fed and the banks who buy and immediately repo, again with the Fed, who's going to buy  the flood of new debt?

The US Treasury is not used to having its bonds snubbed at auction, but that is exactly what happened last Thursday.  The $62 billion 7 year Treasury note auction was an unmitigated disaster: bid/cover at  a measly 2.04x, the lowest since 2009, a fat "tail" (the Treasury had to pay a significantly higher interest rate than it expected), AND a massive 40% of the issue had to be bought by the primary dealers, ie the buyers of last resort.

In short, the auction "failed", for all practical purposes;  an event that the US Treasury, and the rest of the world, is most certainly not used to.  And that's for just $62 billion... How and where will the Treasury find buyers for $4 trillion?

The US Treasury bond market is the largest, most sophisticated market in the world.  NASDAQ and its gang of glam-rock stocks may attract the spotlight, but the real money is in bonds.  And always has been.  When the bond market sends a signal like the one last Thursday, you can be sure that the Treasury and Fed sit up and start biting their nails because the unquestioned demand for Treasurys is nothing less than the foundation of American global power.

Am I being a touch melodramatic? Perhaps... but I have seen other failed government bond auctions  outside the US, and they always presage serious trouble.  In the case of the US, the message is very, very clear: Ladies and Gentlemen (in that order) Yellen, Lagarde, Biden and Powell, get your act together.  Your fiscal AND monetary policies are dangerous and untenable, a rare confluence of the two being in negative sync to result in a potentially vicious downward spiral.  

Stop trying to talk the market up, it's way past listening to words and is now demanding action.

Tuesday, March 2, 2021

A Long Term Look At Inflation Fears

Those of us who experienced and were traumatized by the massive double digit inflation shocks of the 1970's and 1980's still remember them very well.  Even after inflation dipped to around 2-3% and stayed there starting around 1990, we still feared its comeback.  This fear could best be seen in the yield of the 10 year Treasury bond, which stayed well above annual inflation for another 20 years.  It took almost an entire generation for that fear to dissipate and for bond yields to come way down - Chart 1.

Chart 1 - Comparison Between 10 Year Treasury and PCE Inflation

But look at it now: The spread between bond yields and inflation has disappeared, and even turned negative. The situation is even more eye-popping in Europe where Germany sports negative rates and even perennial bankrupts can borrow for 10 years or longer at under 1%.

Ten years after the Great Credit Bubble and the massive world-wide government monetary interventions which followed, inflationary fears are completely gone;  in fact they has been replaced by a personal and, even worse, institutional indifference towards inflation.  Central banks, by definition the very keepers of monetary rectitude, are now the worst offenders as they keep printing trillions to "boost the economy".

(I'm going to mention only in passing that the limits to growth nowadays have absolutely nothing to do with credit and/or the amount of money in circulation, they are much more fundamental, eg climate change)

 Looking into the future, inflation in the US is expected to be around 2-2.5%, but 10 year Treasury yields are only at 1.40%, even if sharply up from their lows last year - Chart 2. 

Chart 2 - Comparison Between 10 Year Treasury and  5-Year Forward Inflation Expectation

Despite their recent rise, yields are still significantly below inflation expectations, a situation that can best be described as abnormal.  Now, if the market was left to itself you can be certain that rates would be well over 2% and probably closer to 3%.  But, the Fed (and the ECB) is in the market daily, buying everything that moves in a an attempt to keep rates low.  IMHO, that's ultimately a fool's errand, the bond market is simply too huge to manipulate once it gets convinced that inflation is on the rise.

To make matters worse, the money the Fed prints daily (and more is coming!) is creating the largest stock market bubble in history.  Share valuations are - to put it mildly - insane, with price to sales ratios at heroic levels - Chart 3.

  Chart 3 - S&P 500 Price to Sales Ratio At Nosebleed Level

We are living through very interesting times, an unprecedented nexus where Treasury, Fed, market operators/manipulators and small-time, clueless plungers are all fearlessly aligned against rationality. By comparison, Flat Earthers are logical..

It won't end well.

Monday, March 1, 2021

A New Type Of Stock Index

Right now, all sorts of index tracking investments like Exchange Traded Funds (ETFs), contracts for delivery (CFDs), index futures, options and plain vanilla open-ended index mutual funds are very popular.  ETFs alone now account for up to 40% of all trading volume on exchanges.

This makes the subject of how indexes are constructed very important.  

Almost all broad indexes like S&P 500 and Nasdaq 100 are capitalization weighted, i.e. a stock's weight in the index increases as its stock price rises.  Right now, the top 5 companies in NASDAQ 100 account for a massive 40% of the index value (Apple, Microsoft, Amazon, Google, Tesla - in that order). The next five add just another 13% (FB, NVIDIA, PayPal, Intel, Comcast).

The index is obviously extremely top heavy and narrow.  Combine this fact with the prevalence of index tracking and you have a vicious cycle of bubble making: a stock rises, its index weight increases and funds must buy more to increase their exposure to the stock... Also, as new funds are created they too add to the buying pressure.  You can see the problem...

What if we constructed a different type of index based on, say, rolling 12 month net income or, better yet, rolling 24 months to average out any unusual one time events, such as write-offs or gains from subsidiary spin-offs/sales. 

Here's a side by side comparison of the 10 top NASDAQ companies using the current market capitalization method versus the rolling 12 month net income method.  The percentages have been normalized as if the index had only 10 members.

AAPL 22.8% AAPL 21.1%
MSFT 17.6% MSFT 17.9%
GOOG 16.0% AMZN 15.9%
FB 11.6% GOOG 13.1%
AMZN 8.5% TSLA 8.1%
INTC 8.3% FB 6.3%
CMCSA 4.8% NVDA 5.3%
CSCO 4.5% PYPL 4.7%
PEP 2.9% INTC 3.9%
AMGN 2.9% CMCSA 3.7%
TOTAL 100.0%

Three stocks (Tesla, NVIDIA and PayPal) have been removed from the top 10 since their net income doesn't make the cut and have been replaced by Cisco, Pepsi and Amgen. The relative positions have also changed, with Google, FB, Intel and Comcast moving up and Amazon dropping.

Why use net income? It is a pretty good measure of a company's real impact on the economy, as opposed to its share price which gyrates daily.  Just look at Tesla...

I could even go one step further and construct an index weighted by dividends paid - now that would be revolutionary! Imagine, real money, real income to shareholders as a measure of the company's importance to the economy... somehow, I don't think this won't go down well with most CEOs (big smile).

Anyway, the real danger of indexing by market cap right now is that it blows the speculative bubbles ever bigger.  Somehow, it must be addressed.

Sunday, February 28, 2021

Chasing Peaks Is Dangerous

I'm looking at NASDAQ today... 

  • Since 1982 the index has had a compound annual growth rate (CAGR) of 11.8%
  • After reaching a peak in early 2000 during the dotcom bubble, it crashed 80%
  • It wasn't until 2016 that NASDAQ made it back to its 2000 high - a full 16 years !!
  • Since then its CAGR has been a torrid 29% 
  • Just a few days ago NASDAQ peaked at near 14.150
  • Reversal to the long term CAGR would bring back to around the 8000 level

But, hey!!, the Fed will keep printing money forever, right? What, no???

Saturday, February 27, 2021

Raise The Minimum Wage

The chart below shows the inflation-adjusted  federal minimum wage and makes obvious why it should be raised to at least $15/hr. Real minimum wages have been stuck at the same level for over 30 years, dealing a very raw deal to low income  Americans. The same chart also points out one of the driving forces of Trumpism: working class people have seen their living standards constantly deteriorate.