Saturday, April 20, 2013

Moving My Blog to Seeking Alpha

I am going to be moving my blog to Seeking Alpha, a place where there are many more articles you can find, more comments, etc.

You can find my articles at this URL:


Wednesday, April 17, 2013

"The Signal and the Noise" book & Jan Hatzius article

The book "The Signal and the Noise" by Nate Silver is a great read, especially for anybody interested in investing.  One of the people highlighted there, Goldman Sach's Jan Hatzius, talks about his predictions for 2013 in this article:

Monday, April 15, 2013

The Commodity Cycle Continues to Unwind

As I wrote in an earlier post, the S&P500 hit a record high... but it was brief!  After today's drop, the value is back under the level that would break the monthly close record high.  Of course if you want to be an investor, the key is to ignore short-term moves and focus on long term themes.

One thing I've been writing about for a while is that the emerging market and commodity cycle themes of the last decade are likely to unwind.  Today's moves continued a trend that has been happening for several years now where these areas of the market are hit more heavily than the S&P 500.

  Now 1 Year Ago 2 Years Ago 5 Years Ago
SPY 1.000 0.882 0.843 0.800
XLE 0.482 0.451 0.501 0.488
EWC 0.171 0.179 0.208 0.192
EEM 0.263 0.267 0.310 0.290

The table here shows the dividend-adjusted levels of various ETFs, all relative to the value of the S&P500 today.  You can see that the S&P has given a 25% return in the last 5 years (remember, including dividends).  In contrast, XLE (energy sector of the S&P 500) has been slightly down, EWC (Canadian index in US$) and EEM (Emerging Markets in US$) have both dropped significantly... again after dividends!  While single day numbers are pretty useless, today's drop was also consistent with this:  -4% for XLE and EWC versus -2.3% for the S&P500.

To me this is showing that these areas are significantly under-performing.  Is it a buying opportunity?  If you look at other posts I've made about longer term values for these ratios (link for Canadian equitieslink for energy sector), you'll see that there's still plenty of room for these ratios to "revert to the mean".

Wednesday, April 10, 2013

Real Record High for S&P 500, 12.7 years later!

I've been writing for some time on how to correctly compute the last record high in stock prices (see link).

Based on this analysis (which uses monthly closing stock prices), the last record high was in September 2000.  Today's closing S&P 500 price is the first time that high was crossed in the last 12.7 years.

That means that after almost 13 years, an investor buying the S&P 500 on September 1, 2000 in a tax-free account, then re-investing all dividends along the way, has finally broken even after inflation.

That is one awful 13 year period, only matched by a 12 year period from February 1973 to February 1985. The only thing left for me to actually record this new high is for the S&P to hold or exceed this level when the month ends.  Of course nobody knows whether that will happen, but for the moment, the general message of breaking even after 13 years is still the take-away.

This makes me intuitively bullish - it seems the next 13 years have got to be better than the past 13 just based on how unlikely it is for there to be generation-long (25-30 year) periods of zero real returns!

Thursday, April 04, 2013

Longer history of Canadian equities (TSX) vs US equities (S&P500)

In an older post I showed data for US vs Canadian equities back to 1999 (link).  I said it would be nice to have older data, which I realized I could get by not using the ETFs and instead directly dividing the TSX value by the S&P500 value on a monthly basis.  For that the data is available back to 1984 (from Yahoo at least).

The graph is below.  One downside to this comparison is it doesn't factor in currency - if it was stated in US$, the peak would be a lot higher as it was in the ETF comparison (EWC is in US$).

Regardless, the cyclicality of the Canadian economy becomes very evident in this graph!

Monday, April 01, 2013

The Relationship Between Wages and GDP

This graph shows the ratio of Wages & Salaries from the Federal Reserve data (link) to GDP (link) since 1947.

To me, this graph shows the power of labor in the economy.  For example, you can see the rise in the late 60s when low unemployment was held in place despite rising inflation, leading to a natural power shift towards labor.  There has been a steady drop since then, with an interesting exception in the dot-com bubble times, when labor (presumably programmers!) were in short supply and companies were paying increasing sums for warm bodies.

Since then, the overall trend of lower labor costs has continued downward.  Since this is a US data series, it may hide labor costs outside the US (outsourcing for example).  At the same time, I believe GDP ignores the growth in foreign sales for US companies, so I would assume the two cancel out at least somewhat.

If I'm right, this trend explains some of why corporate profits are so strong right now compared to any time in the past.  Separately, I've scatter-graphed this ratio against profit margins and there isn't a trend - perhaps this implies that the extreme dip in the past decade is behind it and this will unwind as and when unemployment improves?

Saturday, March 23, 2013

The Bull Case for US Equities in 2013

There are so many unique things going on in today's market that it is easy to come up with arguments for and against almost every investment (maybe that's not so unique after all!).  I am putting together the various pieces of my analysis & thinking in this post.

My analysis leads me to be bullish for equities going forward - that doesn't mean stocks will continue rising in the short term (nobody can predict that!), but US stocks seem to be the best source of real returns over the long run.

(1) Surverying the alternatives

First, let's look at the alternatives.  The only alternatives I consider are cash, bonds, and equities - other things like gold, fine art, etc are beyond my knowledge or interest as they aren't productive assets.

  • Inflation is running about 2% in the US.
  • Cash is yielding 0.2%, for a large negative real yield.
  • Long treasury bonds are yielding 1.9% for 10yr, 3.1% for 30yr, so basically you are making very little on inflation that is likely to be at least the same if not higher over those long periods.
  • The S&P500 yields profit of 6.3% (ttm profits), 5.5% (3yr average profits), or 4.5% (10yr average profits, used in Shiller's CAPE).

S&P profit premiums to inflation are close to average (using the CAPE data), whereas cash and bond premiums are 2-3% lower than average (1.5 standard deviations lower for cash, 0.5 standard deviations for 10yr treasuries).

Just looking at this instantaneous data, equities are clearly the best choice.  However, there are many who correctly argue that the low rates which make equities look attractive are artificial and so shouldn't be used for valuing equities (due to the US government's intervention through Operation Twist, Quantitative Easing, etc).

I completely agree that a significant rise in rates would change the equation, but I can't predict whether this will happen, or more importantly when it will happen.  I'm also not convinced anybody else can predict this, since there have been plenty of incorrect macro calls made by the best of the best, even legends like Ben Graham and Warren Buffett!  In the end, Buffett's advice of ignoring macro issues and focusing on buying good business cheaply seems like the only reasonable approach to me unless an alternative investment is a better risk-reward based on data today (no predictions!).

Given all this, the first piece of my analysis says to invest in the best choice I have today, which is in US equities.

(2) Macro Economic Thoughts

While I just said that ignoring macro factors is best, it is interesting to think about the environment to see if that thought process yields at least some reason to support the investments I am making today.

(2a) Government intervention & rising rates - The Impossible Trinity

One way I think about the environment today is by considering the Impossible Trinity (  It says a government can only have 2 of these things:  control of monetary policy (interest rates), free capital mobility, and fixed exchange rates.  The US is holding rates low (control of monetary policy), and has free capital mobility, which implies a floating exchange rate.  If the action of keeping rates low were beyond what the market would support, the US dollar should be dropping and inflation should be rising, neither of which have been happening.

Now consider China, which I believe is an important part of this equation.  China has control of monetary policy and a fixed (pegged) exchange rate to the dollar.  Therefore China cannot have free capital mobility.

I am no expert in how macroeconomics work, but the pegged exchange rate seems to be allowing the US to borrow at low rates from a China forced to buy US dollars (in order to keep their peg working).  The exchange rate peg allows the US to print money without paying the cost (inflation, loss of currency's purchasing power), in fact exporting the inflation to China and other countries that manage their exchange rates.

What if China decided to stop their peg?  To me that seems unlikely for an economy that is reliant on exports to the US - allowing the Yuan to appreciate would devastate their export-driven economy dramatically more than it is already being hurt today.  The level of social unrest such a policy change would cause in China is against the incentives of all the leadership, who like any politicians would single-mindedly avoid losing power.

(2b) The Commodity Cycle

Countries like Canada have been isolated from the US economic weakness of late because of a strong commodity cycle.  I have written about this in the past in terms of the Canadian stock market relative to the US market (link).  With recent US energy production surging and the inherent cyclicality of commodities, the commodity cycle should continue to unwind in my view, giving further tailwinds to the US consumer especially.

(3) Profit Margins

Many people point to the historically high profit margins and say that this indicates over-inflated profits that must be discounted when valuing stocks.  Certainly, the level of corporate profits as a % of GDP (based on Federal Reserve data at FRED) is at record highs of 11% vs an average of 6% over the past 50 years or so.

Looking at the S&P500, the total after-tax profit margin is 8.6% on a trailing 12 months basis.  I don't have historical data for this, but Warren Buffett's 1977 article (link) mentions that margins were 8% to 8.6% pre-tax in the 1955-1975 time period.  So margins are higher because the latter numbers are pre-tax, but not as dramatically as the 11%-vs-6% the FRED data implies.

If you are reading this far, you will no doubt have heard the famous saying that 'This time is different' is the most dangerous phrase in investing (I believe originally said by John Templeton).  So are margins certain to revert back to the 8% pre-tax level?  Perhaps.  But on the other hand, there's also some reason to think higher margins are supported by fundamentals.

On one hand, an article I linked to earlier (link) shows a graph that I've pasted below showing how productivity has increased far faster than wages since the mid-70s.

The graph below shows this another way by graphing the 5-year growth in real salaries & wages from Federal Reserve data at FRED.  Only in the early 80s was the wage growth so poor (if you track markets, you will know that the early 80s were one of the best times to invest!).  All of this lines up with what I see as much lower power for labor than has been the case in past decades, which when combined with increases in outsourcing & a relatively high unemployment rate, supports higher profit margins from cheaper labor costs.

In addition to the above, there are so many companies out there that are issuing long bonds for close-to-inflation interest rates, using proceeds to buy back stock aggressively.  Many big companies have been doing this, and you can see an older article about this here.  All of this borrowing & stock buyback results in higher ROE for the same ROA.  While this doesn't affect margins directly, it explains why ROE of the S&P500 is 14% today vs more normal levels of 12% (see again the Buffett article mentioned above).  So from a return on capital perspective, the higher level of 14% makes intuitive sense and doesn't seem ripe for falling apart in the short term.

(4) Sentiment & Historical Factors

There are several historical ways to look at things that further encourage my bullishness.  The graph below shows the real value of the S&P500 if dividends were re-invested.  Note that the Y-axis is logarithmic, which is required for any long time period like the one here going back to 1928.  You can see that real returns were:

  • near-zero from 1928 to 1942 (14 years)
  • strong from 1942 to 1962 (20 years)
  • near-zero from 1962 to 1982 (20 years)
  • strong from 1982 to 2000 (18 years)
  • near-zero from 2000 to 2012 (12 years)

Can you take a couple samples like this to the bank?  Of course not, but it is interesting that there have been pretty consistent cycles that last ~35 years.  I also find it interesting that 35 years is not too different than what the investing lifetime of an average investor must be.
The graph below shows a picture of the previous 5-year growth in real earnings (measured as the average of the last 3 years) and of dividends.  A cycle is again visible, with good times to buy generally being when the lines are low, and with no cases where the line doesn't rise up a peak much higher than where we are today.

Next, this graph is from the Horan Capital Advisors blog, which shows that fund flows have only recently started to turn around for equities, but far from adequate considering how bad a bond investment is today (Warren Buffett has said bonds should come with a warning label!).

Chart Comparing Other Plunges to Today's Environment

The Usefulness of Investor Sentiment

The AAII (American Association of Individual Investors) maintains a sentiment survey with its members, and provides historical data all the way back to 1987.  The graph below shows the delta between the % of people saying they are bullish and the % saying they are bearish.

There are some interesting points, such as a peak in bullishness in Jan-2000, or a record low in bullishness in Mar-2009, both of which were great points to exit/enter the market respectively.  Oct-1990 was also quite low and another good time to enter the market.

However, there are also a lot of signals in the middle of the graph that don't seem super-correlated.  Dec-2003 is a peak, but was a good time to invest, for example.  If you look at forward-5yr-nominal-returns, the bullish % correlation value ("r-squared") is -0.32, and the bearish % is 0.13.  As you'd expect, the bullish one is negatively correlated with returns and the bearish one positively correlated, but neither is very strong.

In general, I would conclude that only when the values are very significantly different is it worth considering them, and even then probably in the context of other more fundamental indicators.

Wednesday, March 20, 2013

Analysis: Small and mid-sized banks face interest-rate struggles

By Tim McLaughlin
BOSTON (Reuters) - Some banks have been buying longer-term bonds to boost profits in a low-interest rate environment, sparking fears their profits will be squeezed when the Federal Reserve eventually starts to hike rates.
Banks are drawn to bonds maturing years in the future because the securities pay more interest than shorter-term debt. But rising rates will give banks higher funding costs, without necessarily giving the same lift to the income from all their assets, squeezing profits.
The lenders that could get hit hardest by higher rates are smaller community banks and mid-size regional lenders, analysts say. These banks generally have low income from fees and no real earnings from investment banking, relying mostly on income from lending and their growing bond portfolios.
Jeremy Stein, a member of the Federal Reserve's powerful board of governors, recently warned in a speech that low interest rates may have quietly contributed to banks taking more risk "below-the-radar."
"The added interest rate exposure may itself be a meaningful source of risk for the banking sector and should be monitored carefully, especially since existing capital regulation does not explicitly address interest rate risk," Stein said.
Bankers say they have few good choices when it comes to investing now, and are buying bonds because they need the income.
"Running a bond shop is not my favorite way to deploy assets," Commerce Bancshares Inc Chief Financial Officer Charles Kim said.
Since 2008, the Kansas City, Missouri-based bank's investment portfolio has surged by $5.9 billion, or 156 percent, to more than $9 billion, and the bank has been buying longer-dated bonds. Investment securities account for 44 percent of the bank's $22.2 billion in assets, compared with 22 percent in 2008.
"It is big. There is no denying that," Kim told analysts and investors last month during a banking conference in Boston. ...
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Monday, March 18, 2013

Interesting book - American Phoenix

This book is an interesting read - it describes how the Chinese currency peg and European monetary system explain some of the things going on in the world right now.  It describes how the US can export inflation to China instead of paying for their loose monetary policy at home because of the Yuan peg to the US Dollar.

The views in the book align well with my investment outlook, so I thought I would link to it here.

Canadian Equities Continue Relative Decline

Almost exactly a year ago, I said the ratio of EWC (ishares Canada ETF) to SPY (S&P500 ETF) had declined to 0.203 (see article).

Today, that ratio has dropped to 0.183 as the Canadian Dollar and stock market has lagged their American counterparts.  I am looking for this trend to continue, at least to the 0.1 level that existed in the late 90s.

Saturday, March 09, 2013

Dow record highs? Almost, but don't be fooled by the news

There's a lot of attention being put on "record highs" for the Dow lately, but if you're an investor you should ignore this fundamentally flawed way of looking at things.  A recent example of this is this article, which gives lots of seemingly wise, yet useless, advice like "investors should proceed, but with caution".  What does that mean exactly?

Anyway, the reason to ignore this type of analysis is that the level of the Dow is not normally adjusted for inflation, nor for dividends, which matter to you as an investor.

Instead of looking at it this way, I've been keeping track of the level of the S&P500 adjusted for inflation and assuming re-invested dividends.  The last peak for this was in September 2000 (not 2007!  See here for a set of past articles talking about this).  Based on the value of the S&P500 today, it is still 1.2% away from that record high.

What this means is that an investor who put money into stocks more than 12 years ago, and dutifully re-invested dividends the whole way, is close to breaking even in real terms.  Not great, but it's interested to note that the only time in the past ~80 years that this has happened was from January 1973 to January 1985 - 12 years, and only a little bit shorter than this time around assuming the 1.2% is crossed soon (no guarantee of that of course!).