Tuesday, January 25, 2011

Mythbusting Cash

   Years ago, the Internet ushered in a new medium for the flow of information, far surpassing any previous modes in size and speed. Today's world can be characterized by overwhelming masses of information that would likely overwhelm even the highest powered computers. Individuals hardly stand a chance at sorting through all the potential news and research on a given topic, leaving individual minds and the general public vulnerable to accepting largely false information. Theories about the effects of cash on companies and markets over the past several months highlights a topic ripe for misdirection. The goal here is to provide a quick overview of a couple common mis-perceptions before offering articles with further depth and insight on the topic.

   For many months now, experts, analysts and investors in the media have pushed the idea that investors holding excess cash would eventually succumb to a strong stock market. Finally choosing to invest their saved cash would push markets even higher. At first glance, this seems like a perfectly reasonable expectation and it's likely the simplicity has accounted for the mass purveyance of this notion. However, viewing this principle within the confines of basic market exchanges reveals some gaping holes in the theory. To explain this misconception, imagine that you are an investor considering purchasing one share of IBM (closed at $161.44 today). You place an order to buy one share of IBM at the prevailing market price tomorrow morning. Let's assume that the stock opens at the same price tomorrow morning and a current shareholder elects to sell you a share at $161.44. Having matched a buyer and a seller, the transaction is executed. You receive one share of IBM and pay $161.44, while the seller gives up one share of IBM and receives $161.44. Evident from this basic scenario, total cash in the system does not change, but rather shifts between individuals. Now imagine that the price at which you purchase a share of IBM moves up to $170 or down to $150. Either way, the amount of cash switching hands changes, but the total amount of cash in the system remains the same.

   The obvious question in response to this realization is, how does the market move higher? There are many possible answers to this question, but I'll outline a few primary ones. Money flowing out of one asset class and into another (i.e. bonds vs. stocks), can push up one type of asset with an overload of buyers and the other type down with excessive sellers. Another possibility is that total units of an asset decrease, potentially through mergers, buybacks or maturation among other things. As total units decrease, total cash actually increases through the reduction in securities, providing excess cash to push up prices if/when it gets reinvested. Increasing debt or leverage used to purchase securities can also move prices higher as the newly created funds are invested. Over the past two years, mergers and buybacks have increased but so have the number of IPO's, likely maintaining the number of securities available. Most asset classes have been rising together during this period as well. Therefore, a case could be made that growing debt levels and leverage have contributed significantly in pushing stock markets higher. Recent reports suggesting leverage at hedge funds is back near pre-recession peaks supports this conclusion.

   The other large misconception related to cash involves the strength and stability of various companies based on their cash levels. For months, pundits have in unison spoke of the record level of cash on corporate balance sheets as a sign of reduced risk and potential future earnings growth. On the count of large sums of cash aiding earnings growth, the potential is certainly present. Firms feeling confident in their business or pressure to raise earnings can use their cash hoards to buy back stock, purchase other companies, increase production or dividends. As described previously, these actions generally lead to higher stock prices. On the other hand, implying that vast amounts of cash on the balance sheet reduces risk, completely ignores one of the biggest factors of risk...debt.

   Imagine that two separate friends of yours ask for a $20,000 loan in order to start a new business. The business plans and your trust in each individual are identical. The only differentiating factor between the two proposals is the effective "balance sheet" of the different friends. Friend 1 has $10,000 in cash to his name and $5,000 in debt (mortgage, credit cards, etc.). Friend 2 also has $10,000 in cash, but has racked up $50,000 in total debt. Based solely on the cash held by each friend, it appears the risks to loan re-payment are equivalent. However, considering the stark difference in accumulated debt, it becomes clear that offering the loan to Friend 1 is a significantly better proposition.

   Taking this fictitious scenario a step further, let's assume that Friend 2 takes out a $10,000 loan from a bank while awaiting your decision. Friend 2 now has $20,000 in cash and $60,000 in outstanding debt. Based on recent media commentary, Friend 2 is in a better financial position than Friend 1 due to his larger cash holdings. This assumption encourages accumulating greater and greater amounts of debt and masks the risks associated with holding such large sums of debt.

   The above example has been used to highlight the misleading portrayal of strength in corporate America, especially of the largest financial institutions. Readily apparent is that without considering the level of debt held by any individual, corporation, state or country, it is practically impossible to accurately determine the credit risk associated in providing loans. A likely reason that pundits have been remiss to comment on the debt or leverage of corporate America, is that size of debt has been rapidly approaching pre-recession levels.
contractionary economic environment. Can we afford to turn a blind eye to accumulation of debt once again? Although cash is unlikely to be the cause of future recessions, it's benefits are currently being wildly mis-portrayed by the general media. For this with a tendency toward risk management, history shows that being wary of debt offers far more insight than levels of cash. Ultimately, news must be viewed with a more skeptical approach, as the sheer volume leaves all of us prone to accepting half or false truths.

Suggested Reading:

Monday, January 24, 2011

Bernanke Changes His Tune

   Imagine yourself as an investor trying to determine which hedge fund manager is most capable of managing your money. After debating several options you decide upon Mr. Positive who promises stable returns. Mr. Positive outlines the tenets of his fund as seeking to provide returns exceeding those of the S&P 500 with less volatility than the actual index. Halfway through the year, Mr. Positive sends out his mid-year results showing gains of 5% with a volatility slightly above 1 percent per day. These results sound good, but upon reviewing how the benchmark index (S&P 500) has fared over the same period, you learn that the index is up 8% despite volatility below 1% per day. Questioning your decision, you place a call to Mr. Positive and ask why the under performance occurred. Mr. Positive replies that the measures you are reviewing fail to accurately depict the strength of his investment strategy. Mr. Positive explains that during the previous 6 months, assets under management have grown by nearly 20%, showing the true strength of his investment strategy.
   If this were a real scenario (which is certainly possible), it would be understandable for an investor to remain upset with their investment decision. Despite Mr. Positive's arguments for remaining positive, the size of assets under management helps the manager but provides little, if anything, for investors. The above situation was outlined not to bash potential hedge fund managers, but rather mimic the curious adjustment in measuring success outlined in recent comments by the Federal Reserve Chairman.
   The Federal Reserve currently enjoys the dual mandate of maintaining full employment and stable prices (consistent, reasonably low inflation). As unemployment remained near 10% and inflation (core-CPI, the Fed's preferred measure) stagnated slightly above 0, the Fed decided to embark on a new round of quantitative easing in November. Three months later, the unemployment picture has barely budged and the Fed's measure of inflation and outlook remains below their ideal range of 1.7%-2%. In lieu of this data, the Fed Chairman appears to have changed his tune on how the Fed's efforts should be measured.
   In a recent op-ed and interview, Fed Chairman Bernanke argues that the Federal Reserve's policies have been successful, as demonstrated by the greater than 25% rise in U.S. stock markets since announcement of QEII. These statements are especially surprising given their stark contrast with previously established views of the Fed Chairman. For years, Chairman Bernanke has expressed views that the Fed's actions could not be blamed for previous stock market bubbles. Now that Fed policy seems to be driving stock market gains, the Fed Chairman appears very willing to accept the rise as a direct result of the Fed's zero interest rate policy and further quantitative easing.
   Using stock markets as a basis for judging Fed policy not only opposes previous Fed views, but extends the misguided view that stock markets and the economy are one-in-the-same. Stock markets have always been and remain a means for companies to acquire cheap funding and investors to gamble on expectations of future corporate profits. A quick glance at history shows these expectations have frequently proved incorrect, creating little correlation between stock markets and GDP growth. Corporate profits, as determined in a free market economy, show no discretion for equitable outcomes and investors have proved able to value the same profits more or less highly at any given time. As witnessed in the most recent recovery, shedding jobs and lowering wages can vastly increase profitability (at least in the short-run). Energy and food prices have also risen dramatically of late, and while these costs have major effects on the majority of consumer spending, they are not counted as official inflation. Under perfectly normal circumstances, it is therefore possible (potentially likely), that the stock market could rise significantly during periods of high unemployment and high inflation (based on total CPI).
    If unemployment were to run up above 15% with inflation above 4% a year, would the economy still be considered strong? What if the stock market were still rising? Would the Fed's policies then be viewed as effective? These are the fundamental questions worth considering when assuming stock markets are the best reflection of the true economy and measure of Fed policy success. Is it possible that stock market gains will lead to increased investment and reduced unemployment, as Chairman Bernanke hopes...absolutely. However, history suggests the wealth effect is minimal at best, maybe 4 or 5 cents on the dollar. So we return to the fundamental  goals of the Federal Reserve, whose current mandate is to maintain full employment and stable prices. Measuring the results of their policy by any other means is simply misleading.

Monday, January 10, 2011

Rising Yields Prove Less Treacherous for Stocks

   In an article today titled The Best Rising Interest Rate Trade, Cullen Roche outlines a recent strategy note published by Credit Suisse. The article is one of many published on the website, Pragmatic Capitalism, which offers interesting new insights on a near daily basis along with links to some of the best pieces from other sources. Anyhow, the strategy outlined describes investing in the Japanese stock market as the best idea in a rising yield environment. Taken from the strategy note, "the rise in real bond yield reflects a rise in growth expectations – and Japan, as the country with highest operational leverage, should benefit from such a rise." Below is a graph and chart from the report depicting the very relationship described and returns during rising yield environments over the past 30 years.

   While the average return is certainly impressive, investors would be wise to notice the variation in returns during previous periods. Investors adhering to this strategy between 1993 and 1997 would have found themselves vastly under performing other equity markets around the world. Beyond the above average returns in Japan, the relative under performance of U.S. equity markets noted above is quite striking. During the 11 periods of rising yields over the past 30 years, the U.S. equity market has only increased twice and by a mere 2%. Recently, yields have been rising again and may still be in an upward trend, although they've retreated slightly from the most recent peaks. Therefore, it seems worthwhile to consider how different equity markets have responded during the most recent period of rising yields.

   The yield on 10 year treasuries last bottomed on October 8th, 2010 and has since peaked on December 15th, 2010. During that time the benchmark index for the UK, the FTSE 100, rose nearly 4%. The Nikkei 225, Japan's benchmark equity index, gained more than 6.5%, fulfilling the strategy's expectations. However, most surprising is the S&P 500's nearly 6.5% gain in the face of rising yields. Rising yields accompanied by strength in U.S. equity markets clearly breaks away from history. Is this a trend that's likely to continue or a warning sign of a coming correction?

   As Credit Suisse describes in their note, the basic investment thesis revolves around rising real yields reflecting improving growth expectations. Previously I've noted that the natural extension of this theory would imply that falling real yields reflect deteriorating growth expectations. Despite this natural extension, falling real yields have been widely heralded over the past year as positive for equity markets and unrelated to growth expectations. If rising yields have now become a positive catalyst for stocks, then it's possible that yields no longer have any reliable effect on equity markets. Another possible explanation is that the Federal Reserve's quantitative easing skews normal market correlations. The Federal Reserve has openly stated it's goal of raising equity markets through its program and therefore the recent trend would be deemed a success, at least in the short-run. A third potential explanation is offered by extreme levels optimism in equity markets leading to gains despite typically negative signals. Under this view, the market likely faces some downside in the near future. Whether or not yields continue to rise may affect the size of any coming correction and ultimately determine if the most recent period is truly an outlier. 

Sunday, January 9, 2011

Hedgehogs Respond to Jobs Report

   Recently I read the book Expert Political Judgment: How Good Is It? How Can We Know? by Philip E.Tetlock which discusses the ability of experts to accurately predict future outcomes. Tetlock breaks down experts into two distinct groups as characterized by "Isaiah Berlin's prototypical fox--those who 'know many little things,' draw from an eclectic array of traditions, and accept ambiguity and contradiction as inevitable features of life" and "hedgehogs--those who 'know one big thing,' toil devotedly within one tradition, and reach for formulaic solutions to ill-defined problems." Tetlock's work shows that while hedgehogs are less accurate forecasters, bolder predictions make their views more appealing to general media sources. The research goes on to show that hedgehogs tend to "dig themselves into intellectual holes. The deeper they dig,...the more tempting it becomes to keep on doing what they know how to do: continue their metaphorical digging by uncovering new reasons why their initial inclination, usually too optimistic or pessimistic, was right." From my perspective, and likely Tetlock's, the typical cast of experts portrayed on CNBC offers a prime example of hedgehogs willing to make overly bold predictions and scampering to explain how their views were correct, regardless of the true outcome. On Friday, the Bureau of Labor Statistics reported non-farm payrolls data for December and hedgehogs were out in mass with an abundance of explanations for how their incorrect predictions were not technically "wrong."
   Earlier this week, the ADP payroll report showed an unexpected jump in private job growth to 297,000 jobs in the month of December. Following the strong report, most analysts and economists raised expectations for December payroll growth announced by the Labor Department Friday morning. As of Thursday night, depending on the source, expectations were for an increase of approximately 175,000 jobs with predictions ranging from from 100,000 to 300,000. Friday morning, the official number released showed payrolls only increasing 103,000 in December but with revisions to October and November totaling another 70,000 jobs added.
   Given the data above, what would you expect to be the general consensus on the actual results compared to expectations? If you said somewhat disappointed, you would unfortunately be dead wrong. The consensus portrayed on CNBC was nearly unanimous saying that the number was basically in-line with expectations and right on track for increasing growth in the months ahead. Now I'm certainly not an expert on jobs or unemployment, but in my reality, if consensus expectations miss the mark by nearly 40% and almost all the "experts" miss to the wrong side, that shows a real disparity in the numbers between projections and reality. However, as Tetlock describes, hedgehogs employ several different belief system defenses to explain away any inconsistencies between predictions and reality.
   Many experts argued that revisions to previous months data offset the "slight" miss on December's data. Before discrediting this notion, let's take a look at the revisions compared to prior expectations. A month ago, expectations for November payrolls held hopes of continuing growth with average projections for an increase of 150,000 jobs. The preliminary number from the Labor Department came in at only 39,000 jobs and was raised Friday morning to 71,000. Even with the recent revision, the total increase in payrolls remains less than half of initial expectations. Also including revisions, October non-farm payrolls are now believed to have increased by 210,000, beating expectations of 60,000 by a reasonable margin. Although the average increase in payrolls may be closer to average expectations over the previous three months, the ability to accurately predict on a month to month basis appears widely off base.

   One analyst on CNBC Friday morning noted that adding the 70,000 jobs revision to December's total and the previous months would bring total payroll growth more in line with expectations. Another analyst suggested that the trend is still upward based on a rolling 3 month average of payroll growth. No disrespect to either analyst, but double counting numbers or suggesting that jobs are moving in the right direction based on rolling averages (3 month average for March through May was nearly 318,000 compared to 128,000 in October through December) simply misconstrues the data. Throughout the day other analysts offered explanations such as private payrolls being closer to expectations or the data simply being calculated incorrectly. Ignoring parts of the prediction or simply ruling government data as false, adds to the number of defense mechanisms used by experts to ignore the reality of their incorrect predictions.
   Moving beyond basic payroll numbers to the actual U.S. unemployment level provides a different unique perspective. More shocking than the low total in payroll growth was the significant drop in the unemployment rate from 9.8% to 9.4%. Supposedly, "the number of unemployed persons decreased by 556,000 to 14.5 million in December (BLS)." My math may be a bit fuzzy, but if payrolls grew by only 103,000 in December and were revised higher by a total 70,000 in the months prior, it's hard to find total growth of 556,000. Digging deeper into the actual report, the population not included in the labor force actually grew last month by another 434,000, despite more than 130,000 new entrants. As the portion of the population not included in the labor force grows, the employment participation rate (proportion of the population in the labor force) continues to fall. The participation rate in December fell to 64.3%, the lowest reading since April 1984. During the early 1980's double dip recessions, the participation rate reached a low of 63.5% from a peak of 64% in January 1980. Since the second recession ended in November 1981, the participation rate has averaged over 66.1%, topping out at 67.3% in January 2000.

   As for the Federal Reserve, Ben Bernanke spoke this morning before Congress and said that the jobs picture will take several more years to revive. For the participation rate to reach it's average of the past 30 years, the labor force needs to grow by nearly 6 million, excluding any population growth. Considering an unemployment rate near 10% and 8 million jobs during the last recession, the economy needs to create a conservative 13 million jobs to attain anything resembling full employment. Were payroll growth to vastly improve to an average of 250,000 jobs per month, it would still take more than 4 years to achieve that goal. With the Fed's inflation expectations remaining below their stated goal looking several years out, it's hard to envision any rate increases in the near future. As recently as yesterday the market was pricing in about a 50% chance of the first rate hike in November of this year. We should not be surprised if these projections again prove too early or if any rate hikes are delayed potentially beyond 2012.