Monday, May 24, 2010

How to invest in gold? - Alpha

This is a question I get often these days, and my suggestion for a vehicle depends on how extreme your views on the current situation are. See my previous thoughts on gold below:
Merits of gold investing (Dec. 9, 2009)
Gold as an asset class (May 5, 2010)

Liquid paper holdings of gold: If you just want liquid, tradable exposure to gold, go for the largest ETFs: GLD and IAU.

Audited liquid paper holdings of gold, with realistic redemption rights: If you're worried about their audited holdings and sub-custodian risk and want a slightly less liquid ETF with better audited reports and the right to redeem paper units for gold bars, go with SGOL in Switzerland or PHYS in Canada.

Hard, physical gold:
If you're worried about government expropriation or gold controls (which the US and most countries did in 1933), then you want to physically own gold coins, and I would suggest American Eagles for small amounts and
gold bars for larger amounts: (points to

I personally like the 10-ounce silver bars from here: (I receive no commission or kickback in recommending this - do your own diligence!).

I'm not a fan of gold mining stocks or ETFs. Too much operations and fraud risk.

At this stage I'm comfortable with GLD and IAU. If a collapse happens and banks start failing left and right, I'll want to redeem from a gold ETF or in general have coins. One scary thing is that the US Mint has stopped producing gold and silver coins, despite a statute that requires them to do so...

From the US Mint:
"American Eagle Gold Uncirculated Coins

Production of United States Mint American Eagle Gold Proof and
Uncirculated Coins has been temporarily suspended because of
unprecedented demand for American Eagle Gold Bullion Coins. Currently,
all available 22-karat gold blanks are being allocated to the American
Eagle Gold Bullion Coin Program, as the United States Mint is required by Public Law 99-185 to produce these coins "in quantities sufficient to meet public demand . . . ."

The United States Mint will resume the American Eagle Gold Proof and
Uncirculated Coin Programs once sufficient inventories of gold bullion
blanks can be acquired to meet market demand for all three American
Eagle Gold Coin products. Additionally, as a result of the recent
numismatic product portfolio analysis, fractional sizes of American
Eagle Gold Uncirculated Coins will no longer be produced.

Update: Due to the continued, sustained demand for American Eagle Gold
Bullion Coins, 2009-dated American Eagle Gold Uncirculated Coins will
not be produced."

Wednesday, May 19, 2010

Competitive Devaluation Draws Closer - Ari Paul

The brief summary:

-We need to start worrying about currency depreciation and inflation, although deflation is more likely over the next 6 months.

-Interest rates will likely be much, much higher in 5 years. A deflationary shock is likely to send them lower first, but we can start to slowly

scale into a short treasury position as a long-term strategy.

-Fundamentals of the EU are worse than ever, but there is now coordinated support by central banks for the Euro, so it may ignore fundamentals for the next couple of years. I

have fully closed my short Euro position.

The whole story and specific recommendations:

18 months ago the US unleashed unprecedented fiscal and monetary stimulus. A lot of pundits predicted severe inflation in short order, and the destruction of the dollar. Students of past credit crises knew better and understood that the decrease in bank lending and the drop in the velocity of money would offset the money printing, at least for a little while. Since then, inflation has been tame. Most commodities are roughly unchanged, the official measure of inflation (CPI) is up about 2%, 10-year treasury rates are near their lows at 3.4%, and the dollar basket is unchanged.

So far so good. However, the money printing will eventually have an impact, possibly even causing hyperinflation. The inflationary phase of the cycle has drawn much nearer with Europe’s announcement of $1 trillion of monetary and fiscal stimulus.

In the early 1930s, countries around the world engaged in competitive devaluation. The idea is that by devaluing our currency, our exports become more competitive which reduces unemployment. The problem is that currencies are a zero sum game. Our devaluation is another country’s appreciation. This means we’re effectively just shipping our unemployment overseas. Other countries don’t like that, so they devalue their currency in turn. This leads to cycles of competitive devaluation. Competitive devaluation may lead to very severe inflation, or, if the economy is sufficiently weak, it may simply lead to extreme depreciation.

What would extreme depreciation without inflation look like? The prices of everything would go up, but wages would lag. Inflation is a cycle that is led by wage growth. If there is sufficient unemployment, labor has little negotiating power so they can’t get significant wage increases. So for example, prices might rise by 50% while wages only rise 15%. We are all effectively much poorer.

I believe that extreme depreciation (with or without inflation) is a near certainty. The tricky question is when. If we have another deflationary shock to the system, there would likely be another flight to the dollar and another wave of deleveraging which would actually cause prices to drop. In the absence of such a shock, I believe we would get significant depreciation (and price increases) within one year. My best guess is that we will see a shock and therefore the depreciation is a couple of years away, but I have no confidence in the timing.

It is very hard to profit from depreciation. Safe haven assets like gold tend to preserve wealth, but won’t necessarily increase it. Moreoever, if we have a deflationary shock first, gold and other hard assets could plummet like they did at the end of 2008.

I believe the best way to position ourselves is to gradually scale into a long position in hard assets, hedged with short equities. Today, owning some gold is smart diversification. If we get a deflationary shock that sends gold down 25%, hard assets like gold, commodities, and real estate, will be very attractive purchases. So, begin to very slowly scale into owning hard assets, but make sure to leave plenty of cash to buy more on a deflationary shock. To be perfectly clear, my best guess is that hard assets fall over the next year, but I expect them to be a good purchase over the next decade. Given my uncertainty on the timing, it is prudent to begin scaling into a long position very slowly over the next few months.

There is no great way to wager on rising interest rates. It is very likely that interest rates will be much, much higher within 5 years. ETFs like TBT are terrible investment vehicles because they have massive hidden transaction costs. The best method I can think of is to short sell the long bond ETF TLT. The risk is that short selling may be banned on a severe market sell off, or the ETF could go “hard to borrow” which means your broker would start charging you outlandish interest to be short the ETF. A riskier and more sophisticated approach is to sell calls on TLT every few months.

There is coordinated worldwide support for the Euro by central banks. Coordinated currency interventions are rare, but usually very successful. The world supported the Euro in 2000 successfully and pushed up the Yen and the Mark versus the dollar in 1985. You can’t fight central banks in the short-term. In the long-term the fundamentals will reassert themselves but it could be a long wait.

Tuesday, May 18, 2010

Baupost's Seth Klarman is Bearish - Alpha

Reuters reports that star hedge fund manager Seth Klarman of Baupost Group is bearish and:

-is back to holding 30% cash and is considering returning money to investors because he thinks stocks may earn 0% for the next decade.

-sees no great value at current valuations.

-believes the market is being extensively manipulated by the government.

-see inflation as the biggest risk and thinks there is a substantial risk that interest rates will rise above 10%.

-has positioned his portfolio by buying far out of the money options on interest rates (predicting a rise) and by looking for cheap real estate assets (presumably as an inflation hedge).

How should John Doe (an ordinary, unsophisticated saver) invest his/her money?

From: VEGA
Subject: Long-term portfolio for unsophisticated investors

What do you think? The average investor should hold the following depending on their liquidity needs. The premise is that trying to get more specific is more likely to cause harm then help. Following the plan below also minimizes advisor fees, churn (both tax consequences and transaction costs), and mental energy

The basket:
VEU = whole world ex-US. Very low expense ratio of .25%. A little too much emphasis on Japan and old Europe for my taste.
EEM = emerging markets
LQD = investment grade corporate bond fund
HYG = high yield corporate debt

20+ years:
10% LQD, 10% HYG, 30% EEM, 25% SPY, and 20% VEU, 5% physical gold

10-20 years:
20% LQD, 15% HYG, 25% EEM, 20% SPY, 15% VEU, 5% physical gold

5-10 years:
25% LQD, 30% HYG, 15% EEM, 15% SPY, 10% VEU, 5% physical gold

2-5 years:
40% LQD, 25% HYG, 10% EEM, 10% SPY, 5% VEU, 10% physical gold

<2 years:
65% LQD, 25% cash, 10% physical gold

Subject: RE 1: Long-term portfolio for unsophisticated investors

I think of it differently, but I agree that one must try to keep it simpler for the "average investor" or saver. Some general themes are to be global and watch for inflation (one must have a personal view on the likelihood and/or timing of inflation).

1) Safe Assets: The bond allocation should equal the investor's age. So a 60-year old should have 60% bonds and cash.
ETFs choices for that would be: SHY (short-duration US Treasuries, 1-3 yr), TIP (US inflation protected bonds), EMB (Emerging market bonds), HYG/JNK (High yield corp. bonds)
Cash should be enough to meet the next 1-3 year's spending needs, and should be split between 2-3 currencies (dollar, euro, gold, with my personal preference being some local currency mixed with a large gold holding over the next 5 years). If one has extreme views about inflation (above 5%), up to half the safe assets allocation could be in gold. If one has extreme views about deflation, long-term USTs or IGs such as LQD should work.

2) Risk Assets: Stocks and a real estate allocation should be the rest. One needs to have a sense of over and under valuation to invest in risk assets. I would never give a generic recommendation (passive holders make stocks go to dumb prices). Generally, fair valuation for US stocks occurs when the P/E is 15 (a 6.7% yield), and for real estate when REITs yield 5-6%. But this all depends on what the benchmark 10-year UST and German Bund rates are. For risk assets, one should try to buy low, sell high. Right now, some sectors of the stock market seem expensive (financials) whereas others seem cheap (energy and mining). So while I may suggest some SPY and EEM for diversification, I would feel better about suggesting IXC, XLE, XES, XOP. For REITs, I would consider RWO, VNQ, and so on.

Other factors to consider:

Risk preferences (willingness to take risk) - people willing to take risk could have a larger risk assets allocation

Large wealth (ability to take risk) - ditto for people with large amounts of wealth and small commitments/liabilities - if one is frugal, has a large income and large wealth base, that person can own more risk assets

Correlation to day job - people with safer/stable day jobs (dentists, doctors, accountants, etc.) can afford to take more risk compared to others (bankers, traders, real estate developers, etc.). For example, the billionaire Donald Bren, one of the world's best developers, doesn't own stocks or other risk assets. 90% of his wealth is in real estate which fluctuates a lot and which he personally oversees (control matters!), and the remaining 10% is in ultra-safe USTs (I wouldn't be surprised if he has millions in gold stocked away too).

From: VEGA
Subject: RE 2: Long-term portfolio for unsophisticated investors

The whole idea is to take “personal view” out of the average investor’s decisions, since their personal view is by definition very likely to be wrong. When the average investor is most bearish on anything, that’s the best time to buy. By creating a mechanical system, we protect the investor from themselves. Also, the purpose is to create a template that will be generally sustainable for 20+ years, similar to what Graham did in Intelligent Investor. Recommendations of specific sectors will be outdated within 4 years, and more importantly, its fundamentally subjective. With a good template, advisors might argue over appropriateness, but not the investment recommendations themselves.

For most investors, I don’t think SHY provides any benefit over a savings account or money market account. The transaction costs are likely to outweigh the slight interest.

The target audience that I mean when I write “unsophisticated investor” is someone who would likely believe that PEs were over 200 back in March of 2009. PEs were indeed over 200 by some calculations but that was because of one-time writedowns. Sifting through the various PE calculations requires some sophistication.

During bottoms there are a ton of smart analysts who write convincing articles about how PEs are rich, and the opposite is true at peaks.

Graham came up with mechanical ways to buy low and sell high, like automatically rebalancing when stocks become too big a portion of the portfolio. I think that’s reasonable, but I wanted to keep my template as simple as possible, and I don’t think all that much is lost (after tax considerations and transaction costs) by not rebalancing.

An even simpler form (comparable to old adage of 50% bonds 50% stocks) might look like this:

Putting starting prices and short-term economic views aside, gold is the least attractive asset (compared to stocks and bonds). This has been true over the last thousand years, 150 years, and 50 years, and I would wager it would be true over the next 50 as well. It should be viewed as an alternative currency and used for diversification and protection again hyperinflation risk. It is not a good hedge against moderate inflation, since stocks and high yield bonds tend to outperform gold under those conditions (both empirically and conceptually).

What template would you create if you had to present it to the world and then go into a 100 year coma, and 75% of all investors would follow it exactly for 100 years?

Subject: RE 3: Long-term portfolio for unsophisticated investors

I guess I don't think complete dunces should be "investing", just as they shouldn't be practicing medicine on themselves (it's as dangerous to one's financial health as it is to operate on one's own kidneys or heart). I don't think one needs to follow markets and economies daily, but without basic views/knowledge about the world, it's perilous to invest without an advisor (a good advisor is worth it). The world and markets are too dynamic for a 100-year mechanical allocation (even Graham's rules are obsolete and have been for 30 years).

Also, your 100 year hypo is an unrealistically long time horizon. Over the last two hundred year periods (1800-1900, 1900-2000), a diversified basket of equities in the safe, English-speaking countries (US, Canada, UK, Australia) did the best by far. If I were forced to, I would do an 90/10 stocks/bond basket in "safe" countries for a 100 year horizon (the 10% bonds are "what-if" safe money). But if a longer sample of history is any guide (500BC to 2000AD, the recorded history of the West), then the lesson is that everything is in flux, and no rule can work. You have to adapt and move to the countries where economic growth and opportunities are, following booms and busts with care. So there is no 100-year buy and hold - as your time horizon gets longer, everyone becomes a trader.

Markets are humbling. There is no such thing as a "smart" analyst. If you're right 60% of the time, that's good enough to make money. 70% (the Soros/Buffett/Klarman league) is superhuman.

From: VEGA
Subject: RE 4: Long-term portfolio for unsophisticated investors

I think it may actually be impossible, since we simply don’t have access to advisor track records. Even of institutions, its hard to overcome reporting bias (e.g. a mutual fund family is constantly closing unsuccessful funds), lottery sale bias (i.e. a manager can generate an impressive track record selling downside puts). If someone generates accurate macroeconomic predictions over 5 years, odds are they just flipped heads a few times. If they do it over 20 years, we couldn’t afford their services.

If it is at all possible to identify a good advisor, I think it would require such skills and knowledge that the advisor would be superfluous. Investing with the smartest guy you know doesn’t work, nor does investing with the most respected.

Subject: RE 5: Long-term portfolio for unsophisticated investors

I agree. Tough to do. Talent evaluation is very hard. Yet many people with common sense (Ann Landers) bought BRK shares in the 1970s and 1980s and did quite well. Bill Ruane and other Buffett/Graham associates have beaten the benchmarks. I would bet on El-Erian and Berkowitz outperforming their benchmarks over the next 20 years, assuming their fund sizes don't balloon too much (like Gross's Total Return Fund). Yet talent can get de-motivated by wealth, cars, toys, mistresses, divorces, a fawning press, etc. You're right that it takes a great manager to recognize other great ones (e.g. Steindhart, Greenblatt, and Julian Robertson are good pickers of talent).

The qualities I look for:
-an even and contrarian temperament and open mind willing to change quickly
-smarts but more specifically a shrewd common sense that understands human nature and institutional logic/constraints
-mathematical fluency and the ability to deal with opposing probabilistic views, tail probabilities, and so on
-frugality in life and a sense of purpose/values (heavy drinkers/drug users/stressed people don't last) AND
-finally a deep understanding of economies, markets, businesses, and financial statements (usu. people only consider the last element).


Thursday, May 13, 2010

Kabaam: How to Short the Next Market Collapse (and then Go Long) - Alpha

Fundamentals are weak
Corporate earnings are at record highs, but still below 2007 peaks. S&P's forecast for net earnings in 2011 (not the bogus operating measure), are at a fair $65 to $72 (the operating earnings est. is in the $90 range), which makes the current PE ratio around 17x (but dividend yields are still very low). Clearly the equity bulls have paid more attention to the price rally, where low interest rates have made the maddening herd push toward any risk asset, and diverted investors from economic fundamentals and weaknesses in revenues, free cash flows, and dividends (numbers harder to fudge).

The "smart money" managers that I talk to (whom I can't name but are large HF managers), are bearish on any security that isn't super-senior (mortgages with large cushions, DIP loans, etc.) and on cyclical industries. Ordinary people can't buy these easily. Also, economic fundamentals are very weak in Europe, as the PIIGs' GDP will contract this year and next, unemployment will go to protest levels, and greater socialist policies (wealth transfers, taxes, regulations) will pick up.

The next 5 years - from the second collapse to "reflation part deux"
The best smart money macro view (from paranoid HF managers who made money in 2008 and 2009):

1) Second Collapse: In the short run, the enormous piles of global debt (government, household, and corporate) will naturally push towards a second collapse, which will rhyme with the Sept.-Dec. 2008 collapse (remember, history doesn't repeat itself, it just rhymes). You can trade into shorts, discussed below, for this. But governments will stop the collapse, as they've shown in 2008 and last weekend, by throwing everything and the kitchen sink at it (fiscal and monetary stimulus, i.e., printing cash when selling bonds doesn't work), damn the consequences. Politicians will not (and perhaps cannot) be responsible enough to encourage policies of saving, long run budget surpluses (not just reduced deficits), or boring (and safe) utility banking. And the key, remaining structural problem is all the debt. There is only one way to reduce debt if paying it back through austerity or defaulting aren't allowed. Inflation. Or politely put, "reflation" of asset values (and prices).

2) Reflation Part Deux:
So in the long run, governments and central banks (esp. the Fed and ECB) will be forced to print money to bail out banks again and to keep confidence levels up (as both the ECB and Fed showed last weekend). That will "reflate" assets and lead to high inflation (above 4% certainly, but a high chance of above 5%). Hence the optimal trading strategy: Short risk assets for the short run (next 12 months), through aggressive trading, and then go buy-and-hold long on inflation-assets (gold, metals ETFs, well-capitalized REITs, energy stocks, other stocks of companies with pricing power, etc.) after the governments lift up the floodgates again. Shorting long-duration bonds like zeros would work too, but that's hard for small speculators.

A 400-point trading day is bad news

Monday showed that the collapse is closer than we think. The ECB said that default would never happen, as it was commited to buying unlimited amount of government bonds to stave off a collapse. Hence any sort of inflation is better than market austerity for profligate borrowers and dumb lenders (Greek consumers and German/French banks, respectively). Or as the investment strategist David Rosenberg, who called the 2008 crash in 2006, put it this week:

"We said last week, and again earlier this week, that the behaviour of the VIX index has recently been consistent with either the tail end of a bull market in equities or the onset of a new bear phase. Indeed, a cursory glance of the market internals — divergences, put-to-call ratio, investor sentiment, the new high-low list — strongly suggest that the first move above 1,200 on the S&P 500 in January resembled the break above 1,500 in July 2007, and the next blowoff move through 1,200, again in late April, looked like the double peak in October 2007.

The obvious question is: how can the bull market possibly be over considering that we enjoyed that amazing 405-point rally on the Dow just three days ago (Monday, May 10)? Wasn’t that an exclamation mark that the bull is alive and well? Far from it. There have been no fewer than 16 such rallies of 400 points or more in the past, and 12 of them occurred during the brutal burst of the credit bubble and the other four took place around the tech wreck a decade ago. In other words, the most valuable information contained in last week’s intense volatility, underscored by the 400-plus point bounce in the Dow, is that it’s time to take chips off the table and brace for the breakdown."

Step 1: Securities to Trade the Second Collapse

Generally, I think the best short vehicles are European bank stocks and in Ultra-short ETFs (which are very bad investments, but are good, albeit very risky, short-term trading vehicles). Again, one should be very trading oriented when shorting (since psychology matters as much as fundamental valuation or the prediction of the reflation trigger).

My favorite bank shorts are Euro bank ADRs: STD (Santander), BBVA, DB (Deutsche Bank), BCS (Barclays), RBS, etc. All their balance sheets are horrible (to the extent the assets are measurable), and realistically, creditors will have to face losses after the equity is eaten through (more likely, governments will bail out creditors but let equity-holders take a beating).

My favorite ultra-risky Ultra short ETFs: EEV (Ultrashort Emerging Markets), EPV (Ultrashort MSCI Europe), and FXP (Ultrashort China).

Again, shorting is speculative. You need to dart around, trading, and market timing is essential, along with risk limits. This isn't for the faint of heart. The ETFs tend to be choppy and illiquid, among other risks. Vega thinks the double-short ETFs are highly inefficient vehicles to express a thesis due to their poor trade execution on the swap, and I agree (so I never hold them for more than two weeks, usu. two days to a week is my holding period). Using futures and options is better, but few people have those accounts set up (I can't set them up for certain reasons). If you just want to avoid playing with fire (double short etfs) and avoid getting hammered, hold cash and gold, then follow step 2.

Step 2: Securities for the "Buy-and-Hold" Reflation/Inflation Period

This is a tougher call. I would suggest three layers to think about.

First, you want to short Euros, and to a lesser extent dollars. All countries are debasing their currencies, and the US isn't as bad as Europe. The best currency short (of USD, EUR, JPY, etc.) is to go long by holding gold, the only "fixed currency": GLD (SPDR Gold Trust), GDX (MarketVectors Gold), UGL (Ultra Gold). I truly believe the second phase of the gold boom has started, and this too will eventually end in a bust years down the road (the first phase started in 2001). See a previous piece on gold here: MERITS OF GOLD

Also, you should cut your bank cash account in half and put that half into gold (with some physical gold nearby, just in case).

Second, you want exposure to hard assets like metals, energy, and REITs, such as: DBP (Powershares Precious Metals), VGPMX (Vanguard Precious Metals and Mining), VDE and VGENX (Vanguard Energy ETF and index), VNQ and VGSIX (Vanguard REIT ETF and Index), and so on. Most paper assets, esp. bonds, will tend to show their worthlessness in an inflationary world.

Third, take on as much (fixed-rate) debt as you can afford, if you can comfortably meet the interest payments load. Go buy a second house, if you can get a 5-6% fixed-rate 30-year mortgage, or put the money in natural resource stocks or gold. Consolidate your student loans and make only the minimum payment. As government policies will favor debtors (the more irresponsible the better), you have been incented to lever up, so you might as well get some benefit from the Great Reflation/Inflation that will come to stave off the Second Collapse.

The Coming Protests in Europe (and the US?) - Alpha

Protests in San Francisco
As I walked to get a late take-out Korean lunch in downtown SF today, I saw another protest on the halcyon streets. About 40 people were marching with bullhorns around the Grand Hyatt Hotel in downtown SF, in protest about wages and benefits in union bargaining. They were angry and aggressive (I almost felt sorry for the Hyatt's guests). But such protests are becoming more common. Over the last year, I have seen about 8-10 protests (slightly less than one a month) in downtown SF, in the financial district, within a block of my office. Most are around hotels, but a few concern insurance companies and banks (I'm not close to the municipal/state govt. buildings, which I know have their own protests). For example, walking out of my gym at the Embarcadero Center a month ago, I was stunned to see a protest had actually come into the building into the mezzanine floor (private property) and that 6 security guards were scuffling with about 20 protestors trying to get into the elevator bank and go upstairs. The SF police finally came and broke it up, arresting and ejecting the protestors out of the building. Will matters get worse?

Protests in the Western World

Yes. My thesis is that protests in Greece, with violent street fighting, fires, and flares, are just the beginning. As unsustainable debt loads and the eventual financial crises force governments and economies to deal with the real problems, much of Europe will have to deal with protests. Taxes will have to go up as government services, esp. welfare services, are cut. I see Spain, Portugal, and the UK as the highest risk, but Portugal and France aren't far off (it doesn't take much to get the workers of France to strike). Odds are still high that one or more PIIGS will leave the euro (the currency, but probably not the Euro-zone). The US and Japan have 1-3 years more breathing room (maybe less if financial contagion spreads), but politicians in both countries still want to maximize very short term political gains over dealing with the long-term problem (including President Obama - if a ship is moving toward an iceberg of debt defaults, you don't speed up the ship's engine with more health care obligations). Much of the fiscal data is here in the McKinsey and IMF reports: &

THE FINANCIAL BEZZLE OF THE WEST: The data jumps from the table (click on it to enlarge it):

The Financial Bezzle of the Western World is Lifting

What Europe hasn't realized is that large parts of it are closer to being Argentina of 1999 versus a solvent "developed world" country (Singapore of 2010). Argentina is sobering because bad choices by the elites made the country, once the 5th richest in the world (1914), into a third-world country (1980). An unsustainable debt boom from 1994-2000 ended in the largest sovereign default so far, 5 presidential administrations in a year, tears, and a national poverty rate above 45%. What the Western financial system has done the last 10-30 years is create a "bezzle," where financial innovations made it look like people were getting richer, but they weren't - the "inventory of hidden embezzlement" was growing as unrealistic and unsustainable debt loads grew. Real (after-inflation) incomes in the US have stayed constant from 1975 to 2010, but employment is much higher (wages for men have fell while those for women have increased, so the gender pay gap has narrowed in an uncomfortable way). See Galbraith describing the aftermaths of the 1920s debt bubble and bezzle, ending in the 1929-31 crash:

“In many ways the effect of the [1929] crash on embezzlement was more significant than on suicide. To the economist embezzlement is the most interesting of crimes. Alone among the various forms of larceny it has a time parameter. Weeks, months, or years may elapse between the commission of the crime and its discovery. (This is a period, incidentally, when the embezzler has his gain and the man who has been embezzled, oddly enough, feels no loss. there is a net increase in psychic wealth.) At any given time there exists an inventory of undiscovered embezzlement in – or more precisely not in – the country’s business and banks. This inventory – it should be called the bezzle. It also varies in size with the business cycle.”

The Great Crash: 1929″, John Kenneth Galbraith, First Published 1955, Page 152 to 153.

What should we make of the bezzle that is slowly lifting? The asset reflation/boom of the past 12 months has very much been part of it, temporarily covering the core economic problems. Most politicians still have not communicated the bankruptcy or near-bankruptcy of Western countries. The UK will be the first realistic test (the Irish are struggling under their painful reforms).

Capital and Labor

What this means is that capital and labor both need to get realistic.

The shrewdest businessmen/investors I observe (smart capital), with $100mn plus portfolios, are realistically expecting NO GAIN on their capital over 10 years. Basically, they expect a 3-4% real return for consumption/donations, and 2-3% for inflation. So their capital base won't grow at all, and they are realistically worried they will have to spend down capital. So businessmen expect 5-7% nominal returns (real returns plus inflation), but like monkeys covering their eyes, they are afraid to think about inflation above 3%, let alone 5% to 10%. Contrast this with most large pension funds, endowments, and foundations (dumb capital), which still think they can get 8.5% returns (the 1950-2000 average for a 60/40 portfolio). How much does the 8.5 - 5 = 3.5% differential matter? A lot, as in 20 years it means these funds, providing for workers and charities, will have half as much capital as they project (so pension/ foundation underfunding will be massive). Also, inflation will return in a big way. Countries with long maturity, fixed rate nominal debt (in their own currency), with many external debt holders (but that is a detail), will inflate away the real value of these debts. Count on it. The UK is the highest rich country on my list for this, but the EU and US aren't far behind.

As for labor, I roughly see two groups: educated workers with a 4-7% unemployment rate, and the un-educated underclass with 10% to 30% unemployment rate. Group 1 tends to ignore Group 2. It should be a national priority to transform the second group into the first. Politicians have spouted lots of cute rhetoric in the US, but little to no real action has occurred. What protestors don't understand is that the pie is small, and that they can win higher wages and benefits in a further bezzle (look at UAW union workers at auto plants and their generous concessions), but they will still be bust unless they improve their skills. And they need help to do that (national student loan programs aimed toward jobs in demand, education programs tracked toward hard job skills and not 19th century liberal arts categories). As for national saving, clueless economists have applauded GDP growth fueled by debt and more consum er spending, when what the US needs is more saving (by capital and labor) and real investment (in job training) for its people.

Maybe Shakespeare was wrong, and "The first thing we do, let's kill all the economists." Would that pacify the protestors?

NOTE: One reader told me I'm an idiot (usually true), because he doesn't see protests yet in Philly or NYC, and that SF is just a protester city of whiners. Maybe. We shall see. Tourism is the biggest industry here, so hotel employees are the largest labor group. Detroit saw protests as the auto industry collapsed. North Carolina saw protests as the textile industry died. I have yet to see construction workers get out the pickets, but...

Wednesday, May 12, 2010

Thursday, May 6, 2010

Credit Crisis Round 2 - Ari Paul

The news this week is that Greece will be getting a $145 billion bailout, up from $60 billion just a week ago. With each bailout announcement, the euro sinks lower, stocks sink lower, and Eurozone bond yields rise. Sound familiar? This was the same pattern in late 2008 as every bank bailout just brought attention to the next domino to fall.

I’ve been a broken record for the last year, repeating the story that the recovering economy was a temporary byproduct of shifting debt from companies to countries. The Eurozone is now experiencing the start of a sovereign debt crisis with yields climbing for all the PIIGS (Portugal, Italy, Ireland, Greece, and Spain). Will the Greek bailout push the problems another 3 years down the road? I don’t know, but I wouldn’t count on it. Optimists hope that Greece will undergo a deliberate depression to reduce their deficit. This has virtually no chance of success, rather, the real hope is that Germany and the IMF (of which the US is the biggest sponsor), will simply accept losses on the loan, effectively providing a direct gift to the people of Greece. Even this will be insufficient to cure Greece’s problems since the fundamental problem of Greece’s uncompetitive labor remains.

We are in the 5th inning of a 9 inning global deleveraging cycle. I mentioned 6 months ago that I didn't believe the wave of populist anger against banks was anywhere near peaking. Every banking crisis in modern history has led to a huge increase in regulation and a correspondingly huge decrease in banking profits. The civil and criminal suits against Goldman Sachs are just the beginning. Before this is over, I'll be very surprised if big banks are earning significant profits doing anything other than basic banking. What will take their place? One of the biggest hedge funds, Citadel, is trying to get into the investment banking business. There are many funds with $15 billion+ in assets that could take over the "big balance sheet" services. They'll likely grow quickly by issuing debt once its obvious they can take over a great deal of what was formerly banking business.

How should we position ourselves? I don’t want to guess on inflation versus deflation. I think the most prudent strategy is patience to wait for value opportunities to come to us. If/when we get a severe stock market sell off, we should not expect a quick bounce like last year. Rather, we should expect asset prices to drop and stay down for a number of years until the deleveraging is complete. Therefore, we should be ready to lock in high yields, whether through safe corporate bonds trading far below par value, high dividend paying blue chips trading near book value, or REIT type equities. If the market undershoots to the downside, I expect we’ll be able to lock in relatively safe yields of 20-40% for 2 years. I don’t expect a true bull market to start for 4-6 years. I’ll provide specific investment ideas if/when asset prices fall considerably.

Wednesday, May 5, 2010

Asset Class Return, Risk, and Correlation Data, 1900-2009 - Alpha

See the data table of asset class return, risk, and correlation data here, for 4 time periods:

For a previous post on some asset allocation thoughts, see what the Talmud recommends here.

Some thoughts and commentary:

-Gold is the best performing asset class in the last 5 and 10 years. Yet over long periods, gold offered sub-standard, fixed-income like returns with the volatility of equities, with a real return of about 2%.

-German government bonds (bunds) offered a slightly lower yield but a more attractive risk/reward than US Treasuries, with a real return of about 1.5% to 4%. The recent low semi-deviation (downside risk) on bunds is stunning, as it is close to zero (much lower than Treasuries).

-Investment grade fixed income (FI), whether US or global, offered an attractive risk/reward ratio and low downside risk, over all periods, with a real return of 2% to 4.5%. Surprisingly, the semi-deviation of these diversified bond indices is lower than that of Treasuries, for all periods of time! So diversified bond indices have done much better than developed world stock indices for 5 and 10 years. For the last 20 years, they came close to matching the S&P 500 but with much lower risk (semi-standard deviation).

-For the last two decades, high-yield fixed income (junk bonds) has been a much better proposition than any equities (investors take equity risk but with more downside protection), with a real return of 4% to 6%.

-Fine art is a poor investment, in that its real return is low at 1% to 3%, but the volatility and semi-standard deviation are high. However, fine art offered some of the best option-like returns if you possess good artist selection ($1,000-$10,000 pieces can return 30%+ a year for decades, if the right piece is chosen, like a Van Gogh held from 1930 to 1980, a Picasso held from 1950 to 2010, or a Francis Bacon piece held from 1960 to 2005).

-US equities at -2% to 6.5% real returns almost always have beaten EU equities (at -5% to 2%), but EM equities do stunningly well with a real return of 5% to 10% (if your stomach can handle the down markets - also note that the track record for EM equities is short, only from 1988).

-Commodities have done well in the last decade with real returns of 8%, but have a poor track record from 1970 with real returns of ~1.5%.

-Regarding correlations, fine art as an asset class is least correlated with the other asset classes. Commodities are correlated with gold and EM equity to some degree. The bonds are correlated mostly to bonds, with the exception being HY FI, which has a high equity correlation and weaker correlation to normal bonds. Cash (US T-bills) and gold are negatively correlated, so when the USD weakens, gold prospers, and vice-versa. Real estate has a moderate correlation to HY FI and equities.

-Caveat lector: Statistics, which represent populations of data, can vary considerably based on starting points and ending points of the data sample, but some trends are perceptible. Also, it's important to note that statistics (averages, standard deviations, etc.) in financial datasets may be non-stationary, which means that they aren't stable and change over time. What that means: future performance and correlations may be quite different than past ones.

The only other publication that I know of that tracks this data is the Morningstar Ibbotson SBBI book. Also the Dimson/CSFB Global Investment Returns Yearbook is worth checking out.

Sunday, May 2, 2010

True GDP - Ari Paul

In this issue:
1) The Credit Card Analogy
2) What is GDP?
3) Why isn't Fiscal Stimulus Real Growth?
4) What is the US' True GDP?
5) Where is the Stimulus Going?

You may view this week's newsletter in PDF format here:

Over the last two quarters, US real GDP grew at an annualized rate of 5.6% and 3.2% respectively. Wow! Over the last 3 and half years, US real GDP grew a total of about 1.5%. Not bad for the worst economy since the Great Depression. Unfortunately, the US government had to spend an incredible $4.1 trillion to produce this $200 billion in growth. Without this new government spending, real GDP would have shrunk 30% (if nothing else had changed). How should we think about this fiscal stimulus? Is it more accurate to say that GDP has grown 1.5% or shrunk 30%? I believe the latter is more accurate and will demonstrate why.

The Credit Card Analogy
If I lose my job, I can sustain my lifestyle for a while, first with my savings and then with credit cards. Despite having no income, I can continue going to the movies and eating at fine restaurants. I can use one credit card to pay off another, but over time the interest I’m paying on the credit cards will rise until eventually I can’t make the payments. The US is currently in the situation of using our credit to maintain the lifestyle to which we’ve become accustomed. Optimists hope the economy will recover before we’re overwhelmed with our interest payments, and that over time we can pay back the newly accumulated debt. Regardless of whether we’re eventually able to pay the debt back, we should recognize that the “GDP growth” spurred by debt is a mirage; it’s the equivalent of getting a $1000 cash advance from a credit card and thinking you’re a $1000 wealthier. I started with this analogy to explain how “true GDP” could have shrunk by 30% without us feeling that much poorer; our new borrowings are being spent to maintain unsustainable consumption levels.

What is GDP
“Real GDP growth” is defined as GDP growth minus inflation. GDP = consumption + investment + governments spending + exports - imports. The important thing to notice is that if the government increases spending by $1, GDP automatically goes up by $1. So why doesn't the government just increase spending by 10% every year and give us permanent 10%+ GDP growth? I'll explore that question in the next section.
First I want to distinguish between “real gdp growth” and “true gdp growth.” I’ll define the latter as real GDP growth minus fiscal stimulus. I’ll show why GDP growth generated by stimulus isn’t real growth so much as a temporary loan that the economy will eventually pay back with interest. Then I’ll look at growth in the US and roughly estimate the “true GDP growth” number.

Why isn't Fiscal Stimulus Real Growth?
Unfortunately there’s no free lunch and stimulus produces all sorts of nasty effects. The most obvious problem is that it increases government debt and eventually investors will stop lending to an over indebted government. Every major long-term economic study I could find suggests that $1 of government spending in mature economies produces less than $1 of growth, probably much less. Businesses thrive by borrowing $1, growing it to $1.20, paying the bank a nickel in interest, and pocketing the extra 15 cents. If the government is borrowing $1, turning it into 70 cents, and then owes investors $1 in principal with 5 cents in interest, it will eventually go broke. This problem can take decades to manifest, so let’s look at some of the more immediate ramifications.

The economist Hayek noted that most economic collapses are the result of a misallocation of resources. The problem is that when a ton of people are employed making buggy whips that no one wants, sooner or later they’ll be unemployed and the economy will have little to show for the labor but warehouses of dusty whips. Japan’s excess infrastructure spending in the 90s is a real-world example. Capitalism works when bad businesses go broke and incompetent employees change jobs or even careers. When we provide massive stimulus to pay for projects that the market doesn’t value, not only are we misallocating resources, we are also creating perverse incentives. For example, the government guaranteed the debt of the country’s largest banks. That gave investors an incentive to give those banks as much money as the banks wanted. The banks knew they couldn’t fail with government backing, so they have tremendous incentive to take excessive risk with the unlimited money investors are giving them. In other words, $1 of government stimulus can actually reduce future GDP by producing perverse incentives.

What is the US' True GDP Growth?
From January 2007 until today, US government debt increased by $4.1 trillion dollars.
During that time, real GDP increased by about $200 billion. This means that “true GDP growth” over the period was about -30%. This sounds very extreme which is why I started with the analogy. It doesn’t feel like GDP shrunk by 30%, because we’re maintaining our consumption levels with new debt.

How is the Money Being Spent?
My argument is entirely dependent on the assumption that $1 of government spending produces less than $1 of real productivity. It’s worth looking at the actual spending to see if this is true. In developing countries, there is frequently an opportunity to invest productively in the infrastructure of the country. For example, China has spent a lot of money on roads, railways, and energy infrastructure that will support future growth. Of the roughly $600 billion in stimulus, about 65% was spent on infrastructure, and 20% was spent specifically on long-term development projects like new education and energy technology; a meager 10% was spent on transfer payments (e.g. unemployment benefits). Alternatively, very little spending in the US has gone to productive projects. The bulk of stimulus went to tax cuts, Medicaid, state fiscal relief, and unemployment benefits. We can view the tax cuts as just more spending on our core budget. Currently about 56% of the US budget goes to entitlements like social security and Medicare and 23% to defense. Obviously, none of this produces great future growth. A quick look at the remaining budget suggests that only about 6% of the total is in any way devoted to growing productivity.

A final note – I’m not arguing against Keynes’ style fiscal stimulus; it may prevent far worse economic outcomes. Heck, if I was out of a job and starving, I’d probably use my credit card to buy food. We just need to recognize as investors that growth in government spending is fundamentally different from growth that comes from consumption and investment.