Hitting ‘Em Where They Ain’t

 “Keep your eye on the ball and hit ‘em where they ain’t” 

                                                                                         — Wee Willie Keeler

It was at an “ideas” dinner that I was introduced to Mike. Someone from the host firm grabbed me and said: “You should meet Mike, he’s doing the same thing you are”. That thing was building a track record in global bond investing as a precursor to creating a business in the asset class. What I remember from our conversation was how Mike framed the problem. Our common yardstick, the FTSE World Government Bond Index, was dominated by three markets: the US, Japan and Germany. Mike thought that getting those three markets right was the key to his performance. I listened, nodded politely, but walked away feeling that I just did not agree with his view of the problem. I preferred to seek opportunities in niche markets, misperceived situations and mispriced securities.

Consistently timing large bond markets is nearly impossible. Most market commentators have been calling for higher rates every year for the last decade. Their batting average has been a lot lower than Wee Willie’s. Willie’s lifetime average of .341 places him 14th on the all time list. Pretty good for a guy who made a living shooting the gaps, bunting and dinking balls over the infielders.

Indexing large efficient markets like the S&P 500 or the US government bond market has been an efficient way to access their returns. Paying premium prices in attempts to beat them has proven to be a waste. Investments that can add to your returns versus your strategic allocation are likely to be found in niches that do not scale, in securities that should be unaffected but fall in sympathy with those that should, or in situations where prices overcompensate for risk.

There are such niches. They are hard to find and evaluate. Worse, they are often buried in portfolios of filler. In Portfolio Management: Cooking With Hamburger Helper, I talked about the fact that equity portfolio managers typically have a handful of high conviction ideas and that those ideas have been proven to do well. The rest of their portfolios were Hamburger Helper. This holds in asset classes like global bonds too.

In the global bond world, the major markets are beta, standard exposures that can be accessed simply and cheaply. I spent my time on other things like buying unrated Iraq bonds post US invasion, because US involvement meant I was overcompensated at the price I paid. I bought Mexican T-bills during the Asia crisis; their yields had risen to 35% and I was pretty sure that Mexico wasn’t in Asia. I bought Israeli bonds and hedged them into US dollars with mispriced shekel currency forwards for a significant, yet low risk, yield boost. All of these things involved mispricing, misperception or niche markets. All were buried in my larger portfolio; they helped performance at the margin, but didn’t dominate. I had to consider overall portfolio risk. My investors did fine, but they paid my employer for a large ribeye while receiving a just a taste.

In my opinion, the way to square this circle is to maintain a strategic allocation in low cost strategies while reserving a portion of your portfolio, if you’re inclined, for strategies or individual investments that have the potential to add excess value.  Some managers can provide such strategies, but don’t be fooled; they cannot offer them across a well diversified portfolio. Do not pay luxury tax for a buffet size helping of filler leavened with an amuse bouche portion of investments with the potential to add value.

 

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Portfolio Management: Cooking With Hamburger Helper

“Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”
― John Maynard Keynes, The General Theory of Employment, Interest, and Money

Betty Crocker introduced Hamburger Helper in 1971. You took chopped meat and added it to the eponymous mixture of macaroni* and spices. In essence, you took the good stuff, the ground round, and added filler to stretch out the meal. Much of active management works the same way.

170px-ProdPack-Hamburger-Helper-CheeseMac-Small Continue reading

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Missing the Forest for the Trees

There is a tendency among market commentators to seize upon a data point and declare that hellfire and brimstone are about to come raining down. They blow things out of proportion. They see fire when they should be on the lookout for ice. A recent example is auto loan delinquencies. This looks bad:

Auto90+

Here’s a typical reaction, by which I mean, one completely lacking in perspective:

  • The number of auto loans at least 90 days late exceeded 7 million at the end of 2019 hitting the highest level in decades.

An old boss of mine would have told them to stop hyperventilating.

Of course auto loan delinquencies are growing and hitting the highest number in decades. Population grows. Loans grow. Delinquencies grow. We need some context here. Continue reading

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Heads Up, I’m Now “The Market Cyclist”

I am now The Market Cyclist.  This blog will continue to feature posts on markets and investing. Afterall, Market is in the title (and markets do have cycles). I anticipate adding personal finance related content and other, non-finance related, content. The change comes because my role has expanded beyond investing. As an advisor, I help people in many aspects of their financial lives.

Like anyone who moves I’ll want you to have my new address. It is:  themarketcyclist.com The old URL,  globalinvestmentstrategy.wordpress.com,  will redirect to the new one, so no worries there.

I would like to thank everyone who has followed me or visited this blog over the last several years. I hope you come along for the ride.

FarmersDaughterStart

Waiting for the start of The Farmer’s Daughter Gravel Grinder  in 2017.

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Diversify When the Upside Is Limited

While having lunch with a client recently, I asked about his attitude towards risk.  His half-joking response was that he would like high returns with no risk. I’ve heard similar sentiments echoed many times down the years. We all want the magic pill, weight loss without dieting or exercise, gain without pain.

Because we all want that, we fall prey to the idea that there are ways to engineer returns without having to endure volatility. It’s why investing with Bernie Madoff was so attractive. He proffered a long term record of over 10% per annum with few down months and no down years. It didn’t end well. Continue reading

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Baseball and Stocks: Games of Failure

Remember that the best hitter in baseball this year will fail 65 percent of the time.

— George Will

Mookie Betts hit .346 in 2018, failing 65.4% of the time.  Mr. Betts reached base more often than his batting average indicates due to walks. His on base percentage (OBP), was .438, decreasing his failure rate to about 56%. Stocks, in the long run, have a similar failure rate.

Recent research from Hendrik Bessembinder of Arizona State¹ shows that from 1926 to 2016 just 42.6% of stocks provided lifetime returns that beat one month treasury bills. Fifty seven percent of stocks destroyed value over that ninety year span. If such a low percentage of stocks outstripped the return of a t-bill, how is it that stocks provided an 8.5% return over t-bills from 1926 to 2015? Back to baseball.

Batting average is indicative of skill, but it’s incomplete. It omits extra base hits. Slugging, the ability to hit doubles, triples and home runs, increases the value of a player immensely. In 2018, a high slugging percentage made the guy with the 56th highest batting average, a .270, the fifth most valuable batter. Conversely, just 5 of baseball’s sixteen .300 hitters made it into the twenty most valuable hitters when extra base hits are considered.  In statistics, this outsize contribution per hit is called skewness. Continue reading

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Fear Itself?

As 2018 fades to black, we find ourselves in more volatile markets than we have seen in a while. Multiple large daily drops, at times followed by enormous upswings like the 5% surge on December 26th, are par for the course. Almost all asset markets are negative in the year to date, even former stalwarts of positive return like US stocks and high yield bonds. No developed country stock market is up for the year. Emerging markets, whose outcomes are more varied, are also in the red thus far, though change may be in the air; seven have been rallying for the last three months. Treasury bonds are now positive in reaction to the equity selloff. Short and intermediate corporate bonds have also eked out small gains.

Markets are nervous. Are problems coming down the pike or, as FDR would have put it, do we have nothing to fear but fear itself? No one can say in the moment what is driving the volatility and the selloffs. History will judge. What we can say is that the stock and bond markets are sending us signals, signals about participants’ beliefs regarding economic and political developments. These signals are hard to read, cloaked in noise as they are. We don’t yet know the answer, but we do know that concerns can be overblown and that overreacting to volatility can be counterproductive.

Below are some issues we have seen raised in the press or by market participants. It is not a comprehensive list, nor does it imply a clear direction. Don’t read too much into it; it is far easier to enumerate a list of fears than to see the opportunities. Those will come in time. In the meanwhile, don’t let volatility drive you off course.

  • Fed tightening: The US central bank has raised the funds rate upper bound to 2.5% from just 0.25% in December 2015. It has also been shrinking its balance sheet by letting treasury notes and mortgages it holds mature rather than reinvesting all the proceeds.
  • Yield curve inversion: Some short term bond yields rose above longer term yields earlier in December causing a yield curve inversion.  Yield curve inversions have often preceded recessions, though it has taken as long as two years from the initial inversion for the recession to arrive.
  • US tax cuts boosted earnings for many firms in 2018. In 2019, there will be no such boost. Tax rates will still be low, but the comparison will be apples to apples. Earnings growth will have to come from business growth, not outside forces.
  • Leverage in the US corporate sector is very high, as it is in the rest of the world. There may not be a systemic risk from this debt pile, as there was ten years ago, but higher rates and slower growth could strain many companies.
  • China’s growth is decelerating. The easy gains from urbanization and industrialization are petering out and the trade war may be taking its toll. Debt issuance has been high for the last decade, much of it for uneconomic projects. If the government takes on the distressed debt, it will diminish its capacity to stimulate the economy. Chinese equity markets have been among the worst performers this year. Will China follow Japan into stagnation or is there a productive way to reignite growth?

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Floating Interest, Not What You Think

A theme of the past several years has been the need to protect yourself from the bond market selloff, a selloff that seems to have arrived. The idea that you should protect against this has led to the suggestion that you should buy floating rate funds. This sounds like a great idea. Maybe yes, maybe no.

There are two very different kinds of floating rate funds. The first kind, exemplified by ETFs like FLOT and FLRN, hold investment grade floating rate bonds issued mostly by banks. Modest issuance by other sectors makes up the balance. Loan funds are also floating rate, but that’s where the similarity ends.

The investment grade funds will provide you with yields tied to short term rates like LIBOR. FLRN’s yield fully reflects the Fed’s tightening cycle. Each point on the chart shows the yield you would have earned over the prior 12 months. Looking forward, the fund is paying 2.6%, versus the current funds rate of 2.2% or 1.94% more than it was paying before the Fed started raising rates.

FLRNyld

Loan funds pay a juicier yield that is tied to LIBOR, just as in investment grade floating rate funds. That’s where the similarity ends. The yield of the SRLN ETF, where SRLN stands for senior loans, did not follow the Fed as rates rose. It’s up just 0.15%, from 4.29% to 4.44%.

SLRNyld

Loan yields have barely budged as the Fed has tightened

Continue reading

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Markets Fluctuate

“Markets fluctuate.” That was the entire comment by Ace Greenberg, the CEO of Bear Stearns, in a special issue of Institutional Investor magazine dedicated to opinions from the great and the good regarding the causes and consequences of October 1987’s 508 point/-23% market crash. Others said more. Much more. None of it is memorable. I suspect that (almost) all of it was wrong. We don’t know in the moment what is causing markets to move, despite what they say on CNBC.  Nor can we foresee the ramifications of large and volatile market movements. Sometimes, as in 2008, they are profound. Other times, like in 1987, they are speed bumps, nothing more. Ace understood that.

We don’t yet know if we are experiencing fundamental changes in the markets or the economy. We do know that markets are likely to stay volatile for a time. Volatility has a tendency to stay high once it spikes.

vix10172018

Volatility remains elevated for a while before it mean reverts

Given that our understanding of volatile market events is limited in real-time, I have found that making sudden changes in investments or asset allocations is not helpful. What has worked best for me through episodes like this, over many cycles, has been to assess the landscape and, if I can discern a change in the market environment, to look for opportunities.

The other thing that I have seen work well is rebalancing back to a target portfolio. If a downturn becomes deep, you want to be exposed to equities for the rebound. It’s an easy thing to say and a difficult thing to do. Historically, it has been the correct move.

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Incentives Matter

We’ve had a Toyota RAV4 for over eight years now. It’s been great because it’s reliable and can hold a ton of stuff with the seats down. However, every once in a while we receive a recall notice from Toyota, because while it’s great, it’s not perfect.

The last time we received such a notice it was related to the rear seatbelts being improperly anchored. I went to the dealer service facility and almost as soon as I arrived, a couple of mechanics started slapping devices resembling Denver boots on each of the four wheels. An Indy 500 pit crew couldn’t have done it much faster.

I asked: “What are those for?” They said: “Oh, we’re checking to see whether your wheels are properly aligned.” I suppressed my inclination to point out that I was a) there for a recall relating to my rear seatbelts, b) was not interested in having them do an alignment, since it was sure to be overpriced. Luckily, the wheels were aligned properly so I didn’t have to deal with it. Continue reading

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