Strategies
Answers To Questions From Advisors About The Economy And Investment Outlook
Monday, September 16, 2013 10:21

 

At last week's economic and investment update, advisors asked me a number of questions that we did not have time to answer. Here below are answers to those questions. 

 

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Please touch on the labor participation rate.
Here it is, and you can see how it’s been in steady decline since the onset of recession. Its decline in part reflects peoples’ discouragement in being able to find a job. Its decline, in part, accounts for the decline in the unemployment rate even while the rate of new job formation has been sluggish.
 

 

And here is a picture that includes the Congressional Budget Office’s most recent 10-year forecast (through 2023) for the ratio of federal debt outstanding to GDP. The point is that the $7 trillion doesn’t get repaid. But it doesn’t have to. It can (and will) simply remain outstanding and, in fact, be added to with each passing year. The U.S. government can support steadily increasing levels of outstanding debt so long as the total stock of debt’s trend rate of growth does not exceed the trend rate of GDP growth – the engine with which we service the outstanding debt. Not repaying the $7 trillion you refer to has resulted in the new, higher level of debt to GDP in the 70% range which, as I say, is sustainable indefinitely. But, this leaves the U.S. with less flexibility should another crisis come along for which we need to borrow extraordinary amounts.
 
Can you address TIPS before leaving please?
Here is the yield on the 10-year TIPS. Note how the yield has recovered from almost -1% to the current almost 1%. -1% on the TIPS coincided with the record low 1.5% 10-year Treasury yield last year during investors’ frantic scramble for yield combined with the Fed’s QE program. At today’s  1%, you’re still not being adequately compensated, in my opinion, for making a 10-year loan to the government. Historically, as you can see, something in the range of a 2% real return on a 10-year loan to the government has made more sense. My hunch is TIPS yields will, in fact, work their way back to the historic 2% range.
 

 

 

What about the approximate $7 trillion that have been added into the economy from deficit spending?  How and when does that get repaid?

Here’s the $7 trillion added to the total stock of outstanding federal debt (since 2008) that you refer to.

 

 

 

And here is a picture that includes the Congressional Budget Office’s most recent 10-year forecast (through 2023) for the ratio of federal debt outstanding to GDP. The point is that the $7 trillion doesn’t get repaid. But it doesn’t have to. It can (and will) simply remain outstanding and, in fact, be added to with each passing year. The U.S. government can support steadily increasing levels of outstanding debt so long as the total stock of debt’s trend rate of growth does not exceed the trend rate of GDP growth – the engine with which we service the outstanding debt. Not repaying the $7 trillion you refer to has resulted in the new, higher level of debt to GDP in the 70% range which, as I say, is sustainable indefinitely. But, this leaves the U.S. with less flexibility should another crisis come along for which we need to borrow extraordinary amounts.
 
 
 
 
The Budget Office just announced that the expected debt level to reach $23 trillion within 10 years - how can we continue to fund the government and handle the increasing cost of the debt without any negative consequences to the private sector economy? 
As you will can see in the preceding chart (which extends out the 10 years that you refer to), even as the debt level hits $23 trillion, the economy is forecast to expand at a similar growth rate, leaving the key debt-to-GDP level approximately constant at ~70%. This means that the economy’s annual debt-service burden as a percent of the GDP would remain unchanged, which implies no greater negative consequences to the private sector economy 10 years from now than are imposed on it today. Obviously, all of this supposes that these relatively benign CBO forecasts will in fact come to pass. That may be a stretch without some substantive modifications to the big entitlement programs, Social Security, Medicare/Medicaid and now the ACA.
 
 
You also commented on auto sales yet Ford announced yesterday that they have over capacity in Europe and are shutting down 2 plants.  Please comment on these issues.  You paint such a rosy picture and there doesn't appear to be any problems on the horizon. Household debt has been reduced because of loan forgiveness.  We are at all-time highs of consumer debt.  Is what we're hearing inaccurate?
Regarding Ford’s shutting down two plants in Europe it is yet another symptom of Europe’s basic problem: outside of Germany, they’ve long had overcapacity in virtually every industry because their labor laws have precluded companies from doing the necessary restructuring as we have been able to do here in the U.S. – to our great benefit. Downsizing, layoffs, restructuring are all extremely painful but necessary for the long-term health of any competitive, constantly changing economy. Fortunately, as I pointed out, Europe’s macroeconomic picture is improving after two dismal years.
 
Re U.S. consumer debt, the stock of consumer debt has come down from its all-time high as you can see in this chart. That has occurred, yes, partially as a result of foreclosures, but principally from Americans using their rising aggregate income to spend less and pay down some of that debt.

 

 

 

In fact, the result of rising income combined with declining debt is today’s record-low Financial Obligation Ratio, next chart. This measure is the acid test of consumers’ ability to make discretionary expenditures – and it suggests that American consumers’ ability to cover the monthly “nut” and then some has rarely been better. It’s a Federal Reserve statistic and the numbers don’t lie.

 


 

 
With continued upward GDP growth in the US + the Eurozone + China  and with interest rates rising materially over the last couple of months - why have commodities in general been so weak?
I think what you refer to is linked to what I was saying about the Gold story. That is, the “Fed is printing money” that is ultimately going to cause rampant global inflation and currency debasement – that whole hypothesis – has been debunked. (Refer to what I was saying about the key difference between the Monetary Base and M2 Money Supply) Global inflation trends just keep heading flat to lower. There is zero wage push inflation – the key to inflation – anywhere in the world. The other part of the story is China’s attempt to move away from export-led, commodities-usage-heavy expansion, toward internal consumer demand-growth driven expansion. So, China’s voracious appetite for many commodities has slackened. It’s put Brazil and Australia, in particular, into very low growth mode as ore orders have fallen way off.

 

 

 

 

 
 
 
 

 

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Forget Peer Groups And Indexes; Hypothesis Testing Will Revolutionize Due Diligence For Hedge Funds
Monday, August 26, 2013 13:20

Tags: alternative investments | Due Diligence | hedge funds | investment strategies

With a perfect financial storm brewing, it’s likely that more investors will turn to hedge funds as an alpha alternative to conventional investing strategies built on stocks and bonds. It’s time for advisors to stop relying on biased data based on peer groups and indexes and switch to a science-based system of performance evaluation.

 

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Peer into the Future of Hedge Fund Evaluation: Send in the Clones from Ron Surz on Vimeo.

United States equities have reached new highs, skyrocketing more than 100% since May 2009, as bond yields remain near historic lows. Stir in the federal government’s humongous budget deficit and the imminent tapering of the Federal Reserve’s quantitative easing program and we’re looking at one rocky future. No wonder it’s a bull market for investment alternatives, especially hedge funds.
 
The demand for these products is sure to increase substantially in the years ahead as the crowd grapples with the harsh reality of the future. But separating the alpha wheat from beta’s chaff is crucial in the business of intelligently selecting hedge funds.
 
In the future, we won’t pay much for exotic hedge fund betas (risk profiles), but the market will continue to put a premium on superior human intellect. We’ll know the difference because we’ll abandon simple-minded performance benchmarks like peer groups and indexes, and replace them with smart science.
 
Prudently choosing hedge funds demands a higher standard than the traditional methods. Hedge funds, after all, are unique. Products in the same strategy are usually galaxies apart when it comes to management details.
 
That unique quality is also the primary reason why a robust due diligence process is essential. The definition of unique is “without peers,” which means that a distinctive hedge fund can’t be squeezed into an artificially defined group. “Unique” and “peer” simply do not play well together. Hedge fund managers win or lose against peer groups because they are different, not because their strategies are better or worse than quasi-comparable strategies.
 
No one wants or needs to pay for exotic betas that can be reverse-engineered (replicated). In sharp contrast, everyone is willing to pay for that critical factor that can’t be synthesized: superior human intelligence and wisdom that engender profitable decisions by way of savvy investment choices.
 
Yes, we should be prepared to pay a fair price for brainwork, commensurate with the level of brainwork rather than the typical “2 and 20” fee. But first we’ll need a robust model for deciding who is truly delivering performance in the hedge fund universe.
 
There is an alternative to peer groups that is totally unbiased so you and your clients make better decisions, and it’s far less expensive than the universes you’re currently paying for. Performance evaluation is a hypothesis test, and hypotheses are tested by comparing the actual outcome to all of the possible outcomes. That’s exactly what we’ve done to replace peer groups. Portfolio Opportunity Distributions (PODs) create all of the portfolios the manager could have held, selecting stocks at random from the manager’s benchmark. You then compare what actually happened to all of the returns that could have happened, and you can be confident that your inferences are not contaminated by the host of biases in traditional peer groups.
 
Check out our Oscar-worthy hedge fund movie for a brief, fun and enlightening look at why hypothesis testing and cyberclones will revolutionize due diligence.
 
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Holding Bonds In IRAs - A Big Mistake?
Monday, August 19, 2013 18:10

Tags: account aggregation | investment management | investment strategies | portfolio management | tax efficient investing | Tax-efficient investing

Advisors who manage their clients' investments at the household level (across accounts) have an opportunity to create tax savings.  Location optimization - holding specific types of investments within specific types of accounts - can minimize tax costs. Unfortunately, in today's market, advisors are getting it wrong. 

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Before I get into why, let's review the basics.

Location optimization organizes accounts into 3 types:

-          Taxable: accounts such as joint accounts, trust accounts and personal accounts that are subject to state and federal tax as income and gains are recognized

-          Tax Deferred: accounts that will be subject to ordinary tax rates at the time that amounts are withdrawn, such as IRAs, 401(k)s and annuities

-          Tax Free: Roth IRAs (assuming held for 5 years and age 59-1/2, otherwise, only the basis is tax-free)

Applying location optimization strategy, investments should be divvied up as follows:

-          Put investments with the highest expected returns in the Roth IRA. Since the Roth will never be taxed (see above), higher returning investments will get the greatest benefit.

-          Put investments that produce regular ordinary income in tax deferred accounts. When distributions begin, they will be taxed at ordinary rates - the same as if held in a taxable account.

-          Put appreciating investments, such as equities, in the taxable accounts. Since appreciation isn't taxed until sold, these assets effectively achieve tax deferral without being held in a tax deferred account. When eventually sold, the appreciation is taxed at capital gain rates.

Currently, most advisors applying location optimization hold U.S. corporate bonds in tax deferred accounts.  This is not ideal in today's market environment. With the new surtax on investment income and municipal bonds often paying more than corporate bonds, advisors should be structuring portfolios differently.  How? Take U.S. bond investments out of IRAs and, instead, hold municipal bonds in taxable accounts. Put other high yielding investments (such as real estate or international bonds) in tax deferred accounts.

When "repositioning" bonds in a client's portfolio, the advisor must consider tax costs.  For example, a tax savvy advisor decides to reposition holdings by placing REITs in the IRA and municipal bonds in the taxable account (rather than holding taxable bonds in the IRA).  Thus, the REITs must be sold in the taxable account. If the REIT holdings have appreciated, the client will recognize capital gains. Clearly, the tax cost on material short-term gains would outweigh the benefit of changing asset location. But, if it's a long-term gain, would the location savings be worth the tax bill? To answer this question, the advisor must consider:

-          How material is the gain?

-          Does the client have capital losses to offset and/or are they in a low tax bracket?

-          How old is the client? (With a young investor, appreciation will likely be taxed at some point anyway.  However, an older client might never pay tax on the appreciation. Thus, recognizing gain for an older client could make the tax cost too steep.)

-          Will the reduction in the investment income surtax be greater than the tax on recognized gain?

 

Bottom line: To maximize tax benefits for clients, advisors should revisit their bond decisions, considering municipal bond yields vs. taxable yields as well as individual client circumstances.

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Looking Ahead To The Fall, September Is Historically The Worst Month For Market Performance
Monday, August 19, 2013 13:34

Tags: investment strategies | markets | stocks | volatility

Most investors and advisors are familiar with the “January effect,” the tendency for the stock market to perform well in January. There’s a less well-known “September effect” that is just the opposite. Will September of 2013 conform to a history of disappointment?

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As shown in the table and graph below, the month of September stands out as being the most likely to disappoint. Here are some observations:
 
·       September’s -0.8% average return is not only the lowest of all 12 months, it’s the only month with a negative average return.
·       Unlike the other 11 months, September is more likely to produce a negative return (44 months is 51% of the time) than a positive return (43 months is 49%). All of the other months have a history of positive returns 60% of the time.
·       September’s worst return – losing 29.7% in 1931 - is the worst of the worst.
·       September’s best return – 16.7% in 1939 – is far below the average of the best returns, at 21.27%, although it is median.
 
So why is September such a nasty month? I’d like to hear your opinions, especially regarding your outlook for the upcoming September. I think it’s due to the fact that investors are done with their vacations, so they’re back at their computers trading, and mucking things up.
 
In his 1999 book, Beast on Wall Street, Dr. Robert Haugen shows that market volatility is mostly driven by investor behavior. He documents the fact that there is only a weak connection between major events and market swings: Little has happened historically on the days of big market swings, and the market response has been ho-hum on big event days.
 
A related explanation is that investors start their tax loss harvesting in September, to get ahead of the end-of-year crowd. This would represent the flip side of the “January effect,” which is caused by investors buying back the stocks they sold for tax purposes.
 
If my explanation is correct, this September is likely to disappoint because investors will be back at their trading desks, but history tells us that it is a coin-flip probability – worse than the other 11 months but not all that predictable. For more market insight, see the table and the graph below, and visit PPCA Inc.
 
 

S&P500 Returns for the 1,044 months from January, 1926 – December, 2012

 

Best

Worst

Average

   

Month

Return

Date

Return

Date

Return

# Plus

# Minus

1

13.4

1987

-8.4

2009

1.3

54

33

2

11.9

1931

-17.7

1933

0.4

50

37

3

11

1928

-24.9

1938

0.7

54

33

4

42.6

1933

-20

1932

1.5

54

33

5

16.8

1933

-22.9

1940

0.5

55

32

6

25

1938

-16.3

1930

1

51

36

7

38.2

1932

-11.3

1934

1.7

51

36

8

38.7

1932

-14.5

1998

1.3

56

31

9

16.7

1939

-29.7

1931

-0.8

43

44

10

16.6

1974

-21.5

1987

0.4

52

35

11

12.9

1928

-12.5

1929

1.4

56

31

12

11.4

1991

-14

1931

1.7

69

18

               

Average

21.27

 

-17.81

 

0.925

   

Source: PPCA Inc

 

 
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You May Be Surprised To Learn The Best Regions Worldwide For Investors To Seek Safety
Tuesday, August 13, 2013 13:56

Tags: dividends | global investing | income planning | investment strategies | value investing

Many investors are focused on safety right now for understandable reasons: The world economic situation is unclear at best. What regions of the globe currently offer the most safety for investment dollars?

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I started by comparing the investment markets of countries and regions in terms of “Value,” defined as low price/earnings ratios and high dividend yields. The following graph shows the current situation:
 
 
As you can see, the United States is currently not offering the best value, since it has the highest P/E ratio and the second lowest dividend yields. But it’s not clear from this graphic which area does offer the best value. On a P/E basis, “Emerging Markets” and “Asia Without Japan” are the better buys, but “Australia and New Zealand” and “United Kingdom” boast the highest yields.
 
To resolve the confusion, I created a composite measure that adds earnings yield (the reciprocal of P/E) to dividend yield, and came up with the following scores:
 
 
And the winners are “Australia and New Zealand” and “Emerging Markets.” If you’d like to stay closer to home, Canada looks good.
 
Now you know. I hope you find this useful. For more investing ideas, visit PPCA Inc.
 
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