Wednesday, November 27, 2013

Reflections of a Relic Investor

I used to think I was a fairly knowledgeable individual investor, watching measures such as the money supply (no one even refers to that anymore), interest rates, and comparing those to the earnings yield on stocks (the reciprocal of the Price/Earnings ratio) to partially determine asset allocation.  Alternatively there was also the tried-and-true asset allocation approach, maintaining a fixed relationship between a percentage of bonds vs. stocks in a portfolio.  March 2009 presented an incredible buying opportunity with the S&P reaching its nadir of some 676 (vs. 1,800 plus today).  If you rebalanced every year thereafter, you would have missed out on some equity appreciation, but, nonetheless, participated in the rise of the S&P with less risk. Buying long term bonds today for balancing now implies taking on more risk because of the artificially low interest rates.  The asset classes would be highly correlated in a period of rising interest rates and declining equity values.  

During that same period, the earnings yield on stocks vs. bonds became more and more divergent as the Fed moved from one stage of "quantitative easing" to the next.  The impact on both markets can be seen with clarity if five years ago you decided to commit half of your investments to the iShares 7-10 Year Treasury Bond (IEF) and the other half to the SPDR S&P 500 (SPY) and, then, took a five year trip to Mars, leaving the market behind.  Returning today, you'd find your 50/50 bond/equity allocation now at 35/65, simply because of equity appreciation.  So, what to do if you don't want so much at risk?

Jason Zweig addresses that question in this past weekend's Wall Street Journal. Bottom line, "know thyself."  He quotes investment adviser David Salem who said that investors holding large stock portfolios or are considering buying more equities, should be "both willing and able to bear the loss," clarifying that "willingness is behavioral and ability is financial, and you can't know for sure in advance which one is going to trump the other."  As the last bear market quickly eroded 50% plus of equity values, a 65% equity weighting puts one's portfolio at higher risk.  What one did as that last bear market gathered momentum is a good indication of what one might end up doing if this market, too, ends badly.  Of course, it can go higher -- in that regard I'm always reminded of John Maynard Keynes' famous comment “the market can stay irrational longer than you can stay solvent."

Today's investment environment is now as foreign to me as the Mars landscape would be.  Hostile too.  While GDP is hardly growing, and unemployment stubbornly stays above 7%, peak profits are being racked up by major corporations.  How can this be?  Zero interest rates translate into profits, borrowing at nearly nothing to reduce corporate higher-rate debt or financing stock buy-backs.  Corporations have squeezed their workers too, many laid off, a reward to shareholders in the form of increasing dividends.  Labor unions are no longer empowered, a major consequence of labor competition from overseas.  We no longer "make things" here and even intellectual labor can be harvested overseas, at lower cost, thanks to the impact of the Internet. So, by some measures, the "market" is "cheap." It certainly is cheap if you look at earnings yields vs. bond yields, a spread that has widened with every nail in the QE coffin. 

At one time I thought the Fed's actions saved the world from a financial meltdown.  Perhaps it did. But sustaining its monthly $85 billion bond buying program ad infinitum, not to mention maintaining zero interest rates, is creating an asymmetrical investment environment with every passing day (I'm avoiding the word "bubble" as the latter I sort of understand).  It gets worse: recent Fed minutes implied lowering the interest it pays on bank reserves, which has led banks to warn that such an action might force them to charge depositors for holding money in savings and checking accounts (a negative interest rate!). 

Perhaps all of this is being engineered to create a feeling of prosperity from the inflated asset prices of 401Ks, real estate, and equities, hoping that some will trickle down to the middle class via increased spending by the main beneficiaries, the wealthy. (Not surprising, Tiffany & Co. "reported a 50% increase in net earnings in its third quarter..., largely resulting from 7% growth in worldwide net sales and a higher operating margin.")   Or, perhaps, there is something more ominous behind the Fed's actions, a fear of deflation outweighing its concern for (or even desire for) inflation.  Deflation would be an investor's clarion call to buy longer term "secure" bonds, even at these low rates, but, then, we will soon see the next round of the shoot out at the O.K. Corral (a.k.a. Congress), when the debt limit debate comes up again in March.  So, even US Government Bonds may not be rated AAA given the crazy political environment.

No, all the old rules of investment are out the window in this investment environment, as understandable to me as Bitcoins, the price of which surpassed $1,000 today vs. $30 earlier this year, resembling the parabolic price rise of Dutch tulip bulbs in the 17th century.

Ending on a more understandable note, a Happy Thanksgiving to all.