Posts by TimPrice:
Take a look at this chart, what do you see?
July 8th, 2014By Tim Price.
You may not be familiar with the Greek word pareidolia, but you’ve probably experienced it. Derived from the Greek for ‘faulty image’, pareidolia refers to the psychological phenomenon of seeing meaningful shapes where none actually exist. That’s why a chicken nugget shaped like US president George Washington sold for more than $8,100 on eBay in 2012, or why a grilled cheese sandwich that apparently resembled the Virgin Mary drew 1.7 million hits (eventually selling for about $28,000).
The Rorschach inkblot tests are another good example: the inkblot shapes themselves have been specifically designed to resemble nothing in particular; we make of them what we will, projecting subjective feelings about what is essentially random data.
I wrote recently about Seth Klarman’s warning to his clients. Klarman is a billionaire investor who has returned $4bn of capital to those same clients. He reportedly now has 40% of his portfolio in cash. Why?
Because the stock market in 2014, in his view, resembles a Rorschach test: “what investors see in the inkblots says considerably more about them than it does about the market”.
Easy money doesn’t last
Personally, I’m worried by what I see. Stocks in the US and the UK just look way too overvalued. Take a look at the chart below. It shows the cyclically adjusted price/earnings (Cape) ratio of the US S&P 500 index, calculated by Yale economist Robert Shiller.
Source: http://www.irrationalexuberance.com/index.htm
Shiller uses a smoothed average of the prior ten years’ market prices in order to screen out short-term ‘noise’. As you can see, with a Cape ratio of over 25 times, the US market is trading well above its long-term average. It’s currently trading at the same level as in 1901 or 1966 – periods when the US stock market subsequently endured significant corrections.
Only two periods saw higher CAPE ratios than today, and they are 1929 and 2000.
Suffice to say I don’t find too many investment opportunities in the US at present. The recent IPOs of some very speculative social media companies point, in my mind, to a culture of easy money and effortless profits. Just as in the first wave of dotcom mania, because these businesses can’t be assessed on conventional metrics (because they’re growing so fast, though not necessarily with any attendant profits), the sky’s the limit when it comes to their potential valuation. Investors are willing to pay up for ‘growth at any price’.
But in a world in which central banks are casually printing trillions of dollars and pounds, how can we trust these prices anyway?
More to the point, the US Federal Reserve, which last year created $1trn out of thin air and used it to buy bonds, has said that it intends to “taper” bond purchases this year, at a rate which implies it will be completely out of the market by the end of 2014.
But last year, the Fed bought over $500bn of US Treasury bonds – and the bond marketstill went down. So what impact do we think the Fed will have if the largest buyer in the market steps aside?
Do we expect securities prices (both bonds and stocks) simply to brush off the presumed disappearance of the largest player in the market? I don’t. That’s why I question whether the Fed can ever truly abandon its market intervention.
But I am also acutely aware of how artificial this market is, and assuming that the Fed isable to step away, I don’t expect either the stock or bond markets to take the development in stride.
How to find value in a rigged market
There are essentially only two ways of engaging with this market. One is as a trader; the other is as an investor. In their 1934 classic Security Analysis, Ben Graham and David Dodd gave us a handy definition of the investor mindset:
“An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”
Sadly for all of us, six years of extraordinary monetary stimulus have blurred the lines between these two disparate approaches. Interest rates at 300-year lows have caused countless thousands of ‘investors to flood into the equity markets and become transformed into reluctant ‘speculators’.
The trader is driven by price momentum: if prices are rising, he’ll buy. If prices are falling, he’ll sell, and quite possibly sell short. I’m not making any value judgments here. In fact, I find trend-following (ie momentum) strategies have a role to play in a diversified portfolio.
Another way of looking at it is to call momentum strategies ‘growth’ strategies. Seen from this perspective, the market comprises essentially just two types of stocks: ‘growth’ and ‘value’.
Growth stocks typically display strong upwards price momentum, but when the momentum ebbs (say, when earnings disappoint), they fall, and they tend to fall hard.
Value stocks, on the other hand, often look terrible from a technical analyst’s or chartist’s perspective, but offer a margin of safety plus the potential for dramatic positive returns.
That’s why I think deep value stocks are the only stocks worth buying right now.
I find myself increasingly returning to Ben Graham’s classic, The Intelligent Investor, because it contains so much timeless wisdom about the markets.
This quote sums up his most fundamental advice:
“Investors do not make mistakes, or bad mistakes, in buying good stocks at fair prices. They make their serious mistakes by buying poor stocks, particularly the ones that are pushed for various reasons. And sometimes – in fact very frequently – they make mistakes by buying good stocks in the upper reaches of bull markets.”
In short: Don’t buy rubbish. Don’t overpay for quality.
Tobias Carlisle, who also happens to be a Ben Graham-style deep value contrarian investor, points to the current lack of dispersion in stock valuations in North America.Price/earnings (P/E) multiples for stocks in the S&P 500 index are now clustered together very tightly, irrespective of whether they are strictly ‘growth’ or ‘value’ businesses. I suspect this has happened as desperate investors, unwilling to sit in cash given zero interest rates, have chased the valuations of even relatively conservative businesses significantly higher. In other words, ‘value’ has become increasingly expensive of late, and ‘deep value’ is now either very difficult or impossible to find, from within the major US stock indices, at least. As Carlisle has it: “There are now fewer stocks with low P/Es than at any time in the last 25 years”.
I’m more convinced than ever that ‘deep value’ equity is now by far the best way to participate in equity markets, because of the ‘margin of safety’ that Ben Graham has always advised investors to seek. Stocks offering a ‘margin of safety’ are surely the antidote to markets that are murkier and more uncertain than anyone has ever seen before.
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Madness!
May 20th, 2014
By Tim Price.
“Central bankers control the price of money and therefore indirectly influence every market in the world. Given this immense power, the ideal central banker would be humble, cautious and deferential to market signals. Instead, modern central bankers are both bold and arrogant in their efforts to bend markets to their will. Top-down central planning, dictating resource allocation and industrial output based on supposedly superior knowledge of needs and wants, is an impulse that has infected political players throughout history. It is both ironic and tragic that Western central banks have embraced central planning with gusto in the early twenty-first century, not long after the Soviet Union and Communist China abandoned it in the late twentieth. The Soviet Union and Communist China engaged in extreme central planning over the world’s two largest countries and one-third of the world’s population for more than one hundred years combined. The result was a conspicuous and dismal failure. Today’s central planners, especially the Federal Reserve, will encounter the same failure in time. The open issues are, when and at what cost to society ?”
– James Rickards, ‘The death of money: the coming collapse of the international monetary system’, 2014. [Book review here]
“Sir, On the face of it stating that increasing the inheritance tax allowance to £1m would abolish the tax for “all except a very small number of very rich families” (April 5) sounds a very reasonable statement for the Institute for Fiscal Studies to make, but is £1m nowadays really what it used to be, bearing in mind that £10,000 was its equivalent 100 years ago ?
“A hypothetical “very rich” person today could have, for example, a house worth £600,000 and investments of £400,000. If living in London or the South East, the house would be relatively modest and the income from the investments, assuming a generous 4 per cent return, would give a gross income of £16,000 a year, significantly less than the average national wage.
“So whence comes the idea that nowadays such relatively modest wealth should be classified as making you “very rich” ? The middle-aged should perhaps wake up to the fact that our currency has been systematically debased, though it may be considered impolite to say so as it challenges the conventional political and economic wisdom. To be very rich today surely should mean you have assets that give you an income significantly higher than the national average wage ?”
– Letter to the editor of the Financial Times from Mr John Read, London NW11, 12 April 2014
“The former coach house in Camberwell, which has housed the local mayor’s car, was put on the market by Southwark council as a “redevelopment opportunity”. At nearly £1,000 per square foot, its sale value is comparable to that of some expensive London homes.”
– ‘London garage sells for £550,000’ by Kate Allen, The Financial Times, 12 April 2014.
“Just Eat, online takeaway service, slumped below its float price for the first time on Tuesday as investors dumped shares in a raft of recently floated web-based companies amid mounting concern about their high valuations..
“Just Eat stunned commentators last week when it achieved an eye-watering valuation of £1.47 billion, more than 100 times its underlying earnings of £14.1 million..
““They have fallen because the company was overvalued. Just Eat was priced at a premium to Dominos, an established franchise that delivers and makes the pizzas and has revenues of £269 million. Just Eat by comparison is a yellow pages for local takeaways where there is no quality control and no intellectual property and made significantly less revenues of £96.8 million. A quality restaurant does not need to pay 10 per cent commission to Just Eat to drive customers through the door,” Michael Hewson, chief market analyst at CMC Markets said.”
– ‘Investors lose taste for Just Eat as tech stocks slide’ by Ashley Armstrong and Ben Martin,
The Daily Telegraph, 8 April 2014.
Keep interest rates at zero, whilst printing trillions of dollars, pounds and yen out of thin air, and you can make investors do some pretty extraordinary things. Like buying shares in Just Eat, for example. But arguably more egregious was last week’s launch of a €3 billion five-year Eurobond for Greece, at a yield of just 4.95%. UK “investors” accounted for 47% of the deal, Greek domestic “investors” just 7%. Just in case anybody hasn’t been keeping up with current events, Greece, which is rated Caa3 by Moody’s, defaulted two years ago. In the words of the credit managers at Stratton Street Capital,
“The only way for private investors to justify continuing to throw money at Greece is if you believe that the €222 billion the EU has lent to Greece is entirely fictional, and will effectively be converted to 0% perpetual debt, or will be written off, or Greece will default on official debt while leaving private creditors untouched.”
In a characteristically hubris-rich article last week (‘Only the ignorant live in fear of hyperinflation’), Martin Wolf issued one of his tiresomely regular defences of quantitative easing and arguing for the direct state control of money. One respondent on the FT website made the following comments:
“The headline should read, ‘Only the EXPERIENCED fear hyperinflation’. Unlike Martin Wolf’s theorising, the Germans – and others – know only too well from first-hand experience exactly what hyperinflation is and how it can be triggered by a combination of unforeseen circumstances. The reality, not a hypothesis, almost destroyed Germany. The Bank of England and clever economists can say what they like from their ivory towers, but meanwhile down here in the real world, as anyone who has to live on a budget can tell you, every visit to the supermarket is more expensive than it was even a few weeks ago, gas and electricity prices have risen, transport costs have risen, rents have risen while at the same time incomes remain static and the little amounts put aside for a rainy day in the bank are losing value daily. Purchasing power is demonstrably being eroded and yet clever – well paid – people would have us believe that there is no inflation to speak of. It was following theories and forgetting reality that got us into this appalling financial mess in the first place. Somewhere, no doubt, there’s even an excel spreadsheet and a powerpoint presentation with umpteen graphs by economists proving how markets regulate themselves which was very convincing up to the point where the markets departed from the theory and reality took over. I’d rather trust the Germans with their firm grip on reality any day.”
As for what “inflation” means, the question hinges on semantics. As James Turk and John Rubino point out in the context of official US data, the inflation rate is massaged through hedonic quality modelling, substitution, geometric weighting and something called the Homeowners’ equivalent rent. “If new cars have airbags and new computers are faster, statisticians shave a bit from their actual prices to reflect the perception that they offer more for the money than previous versions.. If [the price of ] steak is rising, government statisticians replace it with chicken, on the assumption that this is how consumers operate in the real world.. rising price components are given less relative weight.. homeowners’ equivalent rent replaces what it actually costs to buy a house with an estimate of what homeowners would have to pay to rent their homes – adjusted hedonically for quality improvements.” In short, the official inflation rate – in the US, and elsewhere – can be manipulated to look like whatever the authorities want it to seem.
But people are not so easily fooled. Another angry respondent to Martin Wolf’s article cited the “young buck” earning £30K who wanted to buy a house in Barnet last year. Having saved for 12 months to amass a deposit for a studio flat priced at £140K, he goes into the estate agency and finds that the type of flat he wanted now costs £182K – a 30% price increase in a year. Now he needs to save for another 9 years, just to make up for last year’s gain in property prices.
So inflation is quiescent, other than in the prices of houses, shares, bonds, food, energy and a variety of other financial assets.
The business of rational investment and capital preservation becomes unimaginably difficult when central banks overextend their reach in financial markets and become captive to those same animal spirits. Just as economies and markets are playing a gigantic tug of war between the forces of debt deflation and monetary inflation, they are being pulled in opposite directions as they try desperately to anticipate whether and when central bank monetary stimulus will subside, stop or increase. Central bank ‘forward guidance’ has made the outlook less clear, not more. Doug Nolandcites a recent paper by former IMF economist and Reserve Bank of India Governor Raghuram Rajan titled ‘Competitive Monetary Easing: Is It Yesterday Once More ?’ The paper addresses the threat of what looks disturbingly like a modern retread of the trade tariffs and import wars that worsened the 1930s Great Depression – only this time round, as exercised by competitive currency devaluations by the larger trading economies.
Conclusion: The current non-system [a polite term for non-consensual, non-cooperative chaos] in international monetary policy [competitive currency devaluation] is, in my view, a source of substantial risk, both to sustainable growth as well as to the financial sector. It is not an industrial country problem, nor an emerging market problem, it is a problem of collective action. We are being pushed towards competitive monetary easing. If I use terminology reminiscent of the Depression era non-system, it is because I fear that in a world with weak aggregate demand, we may be engaged in a futile competition for a greater share of it. In the process, unlike Depression- era policies, we are also creating financial sector and cross-border risks that exhibit themselves when unconventional policies come to an end. There is no use saying that everyone should have anticipated the consequences. As the former BIS General Manager Andrew Crockett put it, ‘financial intermediaries are better at assessing relative risks at a point in time, than projecting the evolution of risk over the financial cycle.’ A first step to prescribing the right medicine is to recognize the cause of the sickness. Extreme monetary easing, in my view, is more cause than medicine. The sooner we recognize that, the more sustainable world growth we will have.
The Fed repeats its 2% inflation target mantra as if it were some kind of holy writ. 2% is an entirely arbitrary figure, subject to state distortion in any event, that merely allows the US government to live beyond its means for a little longer and meanwhile to depreciate the currency and the debt load in real terms. The same problem in essence holds for the UK, the euro zone and Japan. Savers are being boiled alive in the liquid hubris of neo-Keynesian economists explicitly in the service of the State.
Doug Noland again:
“While I don’t expect market volatility is going away anytime soon, I do see an unfolding backdrop conducive to one tough bear market. Everyone got silly bullish in the face of very serious domestic and global issues. Global securities markets are a problematic “crowded trade.” Marc Faber commented that a 2014 crash could be even worse than 1987. To be sure, today’s incredible backdrop with Trillions upon Trillions of hedge funds, ETFs, derivatives and the like make 1987 portfolio insurance look like itsy bitsy little peanuts. So there are at this point rather conspicuous reasons why Financial Stability has always been and must remain a central bank’s number one priority. Just how in the devil was this ever lost on contemporary central bankers?”
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More Bread and Circuses
March 31st, 2014By Tim Price.
Editor’s note: We’re grateful to Tim Price of PFP Group for this article. PFP has made this document available for your general information.
“Lower borrowing and a smaller deficit mean less debt.”
– George Osborne, British Chancellor, in his 2014 Budget Speech.“Bingo ! Cutting the bingo tax and beer duty – To help hardworking people do more of the things they enjoy.”
– Asinine Conservative post-budget advertisement.“Bingo ! I say, you there ! How is your whippet ? Jolly good, jolly good. Carry on.”
– Inevitable twitter response via #torybingo.“..beer, and above all gambling, filled up the horizon of their minds. To keep them in control was not difficult.”
– George Orwell, ‘1984’.“Mad piece of theatre over the petty cash”
– Headline to Matthew Engel’s budget review in the Financial Times.
First, pedantry corner: lower government borrowing and a smaller deficit do not mean less debt, they merely imply that the rate at which the government’s vast debt pile grows is slowing. It is still growing. But in a triumph of Orwellian doublespeak, the UK coalition government has managed to handily conflate ‘debt’ (the overall mountain of government borrowing) and ‘deficit’ (the shortfall between government revenues and expenditure in a given year), in much the same way that it has contrived to conflate tax ‘avoidance’ (which is entirely legal) with tax ‘evasion’ (which isn’t). The financial media tend toward tacit support of this deliberate confusion. At first glance, George Osborne’s budget did contain some eye-catching announcements on savings and pensions – until the BBC’s Paul Lewis pointed out that only 1 in 8 UK adults has more than £50,000 in savings and 1 in 5 have no savings at all, with those in between having, on average, around £10,000 in their savings or pensions ‘pot’. A nation of savers we are not.
But then with deposit rates hovering at around zero, is it any surprise ? The Chancellor did manage to drive a further wedge between the pensioner and younger generations by introducing ‘Pensioner bonds’ paying 4% for three year paper (versus the 1% available on three year Gilts). If this is a lousy time to be a saver, it’s an even lousier one to be a young saver. Speaking of inter- generational tensions: as we’ve said before, a heavily indebted government’s fiscal policy can be reduced to just four words: the unborn cannot vote. “Welcome to the world kids,” tweeted Oliver Ralph (Deputy Head of the FT’s Lex column), “after paying off your student loan and saving for a house deposit you can now subsidize your parents’ retirement.”
On a more positive note, the broadening of the ISA subscription limit to £15,000 makes these relatively simple, flexible and transparent vehicles quite an attractive alternative to pensions for many private investors (given Paul Lewis’ observation above), provided that cash-strapped future governments aren’t tempted to raid them. But given trends in longevity, healthcare and government indebtedness, one is obliged to ask quite how the State will manage to support a growing population of elderly poor.. We’ll pass over that for the time being.
So you have your expanded ISA – what are you going to put in it ?
Cash has to be low down the list of priorities. In a fiat currency world in which politicians can print unlimited amounts of ex nihilo money as they see fit, one has to ask whether there is any point to cash savings at all, except to provide the optionality of investible dry powder as and when markets “correct” – assuming that they ever will, given those unlimited amounts of ex nihilo money cascading into the markets.
With interest rates still stuck at 300-year lows, most bonds look distinctly unpromising as anything except material for gallows humour. Our own bond exposure is limited to sovereign and quasi- sovereign paper offering a positive real yield – and to floating rate exposure in the same names targeting USD Libor + 7%.
By a process of elimination, equity markets seem set to be the primary beneficiaries of all those yawning ISA pots. But which ones ? The most important characteristic of any investment one makes is its starting valuation. That would tend to argue against most North American stocks, given a) the close-to-all-time-highness of the major indices and b) the absolute all-time-highness of US corporate profits as a share of GDP. Assuming the latter mean reverts, US equities are destined to disappoint almost everybody over the medium term. European markets are more fairly priced, but then they should be since the euro zone remains stuck in an existential crisis of bad banks, low growth and insoluble indebtedness. Since we’re not constrained by index or benchmark, we can pursue value for value’s sake, and the answer remains: Asia, albeit selectively (and ex-China). Our favourite (by definition bottom-up, deep value) Asian equity fund has the following characteristics:
Average price / earnings ratio: 9x.
Price / book: 0.9.
Historic return on equity: 14%.
Average yield: 3.8%.
Relative to any other market or sector, there is simply no comparison.
Other than geopolitics, the major fly in the ointment for equities as an asset class remains confusion over the extent and duration of Fed (and other central bank) interference across financial markets. We think the Fed, after five years of increasingly ludicrous monetary stimulus, has painted itself into a corner from which it cannot escape, and it has created a false and grossly inflated market from which both equity and bond investors are now reluctant to withdraw. And so the investment world effectively now falls into just two camps: momentum investors (hot money), and investors only interested in valuation. We are happy to occupy the latter camp. There are presumably also some somewhat lonely investors occupying the sidelines and waiting to take advantage of lower prices, but their wait may be long, and you won’t likely hear much about them because the fund management industry and its attendant financial media abhor the vacuum of market non-participation (aka “cash”). As in 2007, there are too many investment managers apparently hearing the music and feeling compelled to dance.
In summary, we are trying to have our cake and eat it. In a financial environment where no prices can really be trusted because relentless QE and monetary stimulus distort everything, we strive to be fully invested – but across multiple asset classes, selectively incorporating high quality debt, deep value equity, uncorrelated funds and precious metals. By not capitulating entirely to the equity market gods we plan to avoid the risk of appreciable loss from overmuch equity market commitment. As the noted value manager Seth Klarman points out,
“The flexibility of institutional investors is frequently limited by a self-imposed requirement to be fully invested at all times. Many institutions interpret their task as stock-picking, not market timing; they believe that their clients have made the market timing decision and pay them to fully invest all funds under their management.”
Given the thick fog that surrounds any consideration of the future, being fully invested (in stocks, specifically) seems as dangerous as the concept of indexing itself. Seth Klarman again:
“To value investors the concept of indexing is at best silly and at worst quite hazardous. Warren Buffett has observed that “in any sort of a contest—financial, mental or physical—it’s an enormous advantage to have opponents who have been taught that it’s useless to even try.” I believe that over time value investors will outperform the market and that choosing to match it is both lazy and short-sighted.”
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The turtle and the hare
December 4th, 2013
By Tim Price.
“You can’t win without an edge, even with the world’s greatest discipline and money management skills. If you don’t have an edge, all that money management and discipline will do for you is guarantee that you will gradually bleed to death. Incidentally, if you don’t know what your edge is, you don’t have one.”
– Jack Schwager, ‘Market Wizards’, quoted in a Cambridge Trading Research presentation.
Of all the stories in the history of markets, that of ‘the turtles’ may well be the most intriguing. In 1983, commodities trader Richard Dennis set out to show that anybody could trade profitably provided they were taught some simple rules. His partner, William Eckhardt, disagreed – and a wager was born. (If this sounds familiar, it should be. It forms the basis of the plot to John Landis’ 1983 comedy, ‘Trading Places’.) Dennis placed classified ads in the financial press soliciting trainee traders – no experience required. Successful applicants were subsequently taught some basic rules about risk management and trend-following. These aspirant traders were called ‘turtles’ after Dennis’ experience of seeing a Singaporean turtle farm, and his belief that successful traders could be “grown” just like those turtles. 21 men and two women were hired over the next two years in two separate programmes. Long story short, many of ‘the turtles’ went on to become multi-millionaires.
Continue to read full report: The turtle and the hare