While checking how high bond yields are going this morning and cheering on the recent rises, I came across this article. The opening paragraph makes things interesting (with my bolding added):
In trading on Friday, shares of iShares DEX Universe Bond Index Fund were yielding above the 3% mark based on its monthly dividend (annualized to $0.9306), with the stock changing hands as low as $30.91 on the day. Dividends are particularly important for investors to consider, because historically speaking dividends have provided a considerable share of the stock market’s total return.
Now I knew something was wrong because the yield to maturity was only 2.42%. The headline also said 3% so at first I thought it was just referring to a different yield calculation (one that would be irrelevant to most investors). But it actually looks like this was either written by someone who was drunk and/or playing video games, or it was automatically generated based on a stock screener. The article goes on to talk about how dividends aren’t predictable because they follow the profitability of the company.
This content is apparently coming in from another site. I know Forbes isn’t exactly the top business/finance publication, but they seem to be bringing in some truly weak sources. Most amateur bloggers can do better than this.
The Globe and Mail recently ran this article which has some strange quotes. In it, a money manager makes the claim that the Canadian stock market has just entered a 12-year “secular cycle of under-performance”, and investors should focus on other markets.
His arguments for this are that the TSX index has had lower returns than the S&P 500 for the last 26 months with a cumulative difference in returns of 41% in US dollars, and has lost money so far this year (again in US dollar terms). Comparing stock markets on a currency adjusted basis makes sense (even though less-than-efficient markets can get in the way of this), but I don’t understand why he’s telling Canadian investors about returns in US dollars.
Because this under-performance has lasted for 2 years and historical studies show cycles that average 12 years in the last 60 years (that’s only 4 cycles so far), he believes the TSX will continue to do badly over the next 10 years.
Time For Some Actual Facts
That is a very weak argument. While a market that has run up a lot is less likely to continue doing well in the near future, a rapid correction over a year or two could easily reset it to a lower price where it can do well. That’s exactly what happened in 2008. We can look to valuations to get a measure of this. The TSX index currently has a lower P/E ratio than both the US market and the EAFE index (15.2 compared to 18.1 and 18.5 based on recent information from the funds we own). It has a dividend yield well above the US market, and close to that of the EAFE (2.53% compared to 1.97% and 3.15%).
Based on those numbers I have been considering moving more assets to the TSX. The gaps aren’t large and the numbers themselves aren’t that exciting on their own. But a combination of reasonable, competitive prices and the tax advantages that Canadian investors get makes it look like a good choice. If the gap widens for any reason I will be moving more into the Canadian markets.
Follow The Numbers
This has been the basis for many of my investment decisions and it’s worked well for me. I was just reflecting on this this morning when I noticed that I have had near-perfect timing with bonds over the last few years. I had a significant allocation a few years ago back when P/E ratios and bond yields were higher, which produced returns on par with stock markets as yields fell.
Then I cut back as dividend yields on stocks rose above the yield on bonds. It turned out this was just before bond yields started to bottom out and the total returns fell. I finally sold out the remaining bond funds 2 months ago because they weren’t improving and I was tired of them (a fortunate accident sealed the deal). This happened to be just before the bond market dropped, pushing them close to a negative 1-year return.
This is too good to be skill. I got lucky on a few things. But luck favors those who are prepared, and I prepare by buying things that have an attractive price and yield rather than following forecasts that are wrong more often than they are right.
The Dangers of Secular Forecasts
Secular cycles obviously exist. You can’t deny that there have been stretches of a decade or longer where certain markets have been either completely flat or going up steadily. The problem is that you’re only in a secular cycle until you aren’t. The most precise forecast, if someone happens to get it right by accident, is likely to be off by a few years. That could be enough to completely change the numbers if you buy into it.
Most people who talk about secular cycles are either doing this type of foolish extrapolation or doing multi-decade technical analysis, usually by showing how the last few years are similar to a chart from 60 years ago, and predicting that we will follow the rest of the chart. If technical analysis has any value at all it’s at a level of hours or days. Trying to do the same thing with a few decades of data is misleading because that will always include a few one-time world-changing events that won’t happen again, especially not on the fixed schedule of a technical analyst.
Another problem with this idea is that it’s based heavily on data-mining. The return over the last 26 months only depends on the prices on 2 specific days. Same with the returns for the next 10 years, and any other “proof” you want to throw in. A random change on those days, or shifting it by 1 year, can completely throw off the results which makes them meaningless. As Nassim Taleb wisely points out, if a small change in the inputs completely changes the results then your formula or forecast is worthless.
Even if this forecast is true it might be meaningless for the average investor who could pick up a lot of shares at good prices by buying a little every month for the next decade, and get dividends along the way too. If this forecast is true and dividend payouts hold up or rise, it could actually mean that the Canadian market is a great deal for long-term investors. Over a long enough period where nothing else changes, falling stock prices are always good. Many investors forget this.
What Can We Expect?
There are a few things I look at when deciding what investments are most attractive to me, including valuation and relative performance over the past decade. I believe this helps me buy more of the things that are unpopular and cheap today, and have the best opportunities for growth. But even that is a very weak prediction. A Vanguard study last year showed that valuations are only 40% correlated with the next decade’s returns. And that’s one of the best signals we have.
The opposite of these signals, which are sometimes useful but not perfect, is predicting that the trend from the last 2 years will continue for the next 10 years. The only redeeming point in this article is when it says that “nimble investors” could take advantage of “brief periods of leadership reversals within these long-term secular trends”. In other words they are admitting that this is a worthless prediction and we have absolutely idea what will happen over the next 10 years. And here I thought reporters were supposed to put the most important point in the headline.
Who knew – the SEC isn’t all grey suits and ties, and sometimes its employees have a little fun according to this quote from an interesting and important BusinessWeek article on high frequency trading:
Around the office, Gregg’s group is known as the League of Extraordinary Gentlemen, […] And it is one group that is not made up of lawyers, but instead actual market and research experts.
Although some people have criticized the SEC for many shortcomings and oversights over the last year, it’s good to see that regulators are also making an effort to keep up with the latest developments in the market.
An article on the WSJ site recently makes the case that investors are facing probable losses in both stocks and bonds as the two major asset classes are positioned to deliver returns below inflation in the US. While this is an alarming idea, especially considering how low inflation is, there are several questionable parts in the article.
The real issue this points out is that the stock market is rising as though the economy is doing well, but bond yields are staying low as though the economy is doing poorly. Which one is it? And as things change, will both markets lose money?
Why It’s Dangerous
First, on the risks of stocks it quotes a money manager who says that stock prices are high because people believe the downside risks to be limited (meaning we are overconfident). I’m not sure if that’s the case among large traders but what I’m hearing from individual investors and the media does not reflect that view. This article is just one example of the general fear of stocks that is spreading now. And yet the prices remain high in spite of that fear.
The author also mentions the Shiller P/E ratio, which is now at a level that has historically indicated poor returns. That is something to watch, but over-reliance on a single indicator is often dangerous.
For bonds the main threat is the current low interest rates. Both government and corporate bonds have very low yields. If yields stay stable or drop they won’t provide much return, and if yields rise there is a threat of capital losses.
As the article correctly points out, stocks and bonds can move in the same direction. The boom in the 80s and 90s was good for both markets until it slowed down in the last decade. But in the 1940s and 1970s, a balanced portfolio would have had a negative real return. I believe one big reason for this is that in all 3 time periods there were major events in the economy and the world that were unexpected, causing a revaluation of investments. Unfortunately it is particularly difficult to predict unexpected events in the future.
What Will Happen Next?
We know that the actions of the Fed are influencing the market. If the economy does well, the Fed will withdraw support as the author notes and possibly cause asset prices to fall (we don’t know by how much). If it doesn’t, corporate profits will fall and the Fed will take action again, lowering bond returns.
The conclusions are where things start to get shaky. I agree that it’s hard to see things ending well for bondholders which is why I don’t have any money in bonds. However I don’t know if the low yields are really a signal of economic trouble. After all the Fed is currently openly manipulating the bond market, so we can’t say that it reflects true market views. Maybe the current economic strength would lead to bond yields 2-3% higher without that manipulation, giving us a better view of what’s happening now.
When it comes to the stock market there are as many good signs as danger signals. The current P/E ratio is reasonable, so it’s not pointing to extreme overvaluation. Profits are rising quickly as corporations stockpile cash and cut costs (including refinancing debt to lock in low interest rates for a long time).
The biggest argument you can make against stocks is that profits might fall. If they do, then current stock owners are overpaying. That is a real risk. But something like that is also hard to predict, and once again the market prices remain high in spite of that danger.
If profits don’t fall then it’s hard for things to go wrong in the stock market. Investors may gain confidence and drive the prices up. Or prices may drop because of a withdrawal of Fed support or many other reasons, which would make it even easier to pick up shares in profitable companies. If we get to a P/E ratio of 10 and a dividend yield of 5-6% in the broad market indexes, I’ll be leveraging our investments to take advantage of that special opportunity.
Expect the Unexpected
If I had a large allocation to bonds I would be pretty worried right now. Outside of that there are risks but we seem to be in a balanced investing environment. As always, those who are prepared for the possibility that they may be wrong will do the best.
Although I have a very passive and low-maintenance portfolio I like to read about financial markets regularly to learn more, especially at times like this when something new or unusual is happening. Unfortunately there aren’t that many wise and practical things you can say about the market so this quickly devolves into reading a bunch of senseless garbage (often promoting some newsletter or book). It all sounds like a reasonable, logical, and detailed analysis and yet it has no basis in reality.
On another side, I’ve noticed that certain family members don’t understand the markets that well. The strange thing about it is that even after losing tens or hundreds of thousands of dollars they still think they can predict what will happen next. And these are people who work in a somewhat obscure statistical field (when I tell people what they do I have to spell the job title) so they should have the capacity to figure it out.
I think both examples come back to the same thing which sounds kind of crazy: being smart is a disadvantage when it comes to investment markets. The reason is simple as this comic shows. Smart people think they can take the information that’s available and figure out what’s happening. So they automatically start trying to do that with any numbers and charts they can find.
But this approach is far too simple since you can only analyze a few numbers at a time. Investment markets are driven by millions of factors. Most of those are only known to a few people and some aren’t known until much later. Many of them are completely illogical. It’s the perfect trap. It looks like a puzzle that a smart person can solve. But if they actually try they will just get lost in it and never reach the end.
Nassim Taleb talks about this a bit in his latest book Antifragile with a story that is probably dramatized a little: when he started trading he expected to find other traders walking around with calculators and using pricing formulas all day. To his great surprise he found that the best traders were almost anti-intellectual and uneducated. The top trader in Swiss francs couldn’t even locate the country on a map.
This is important to remember when you’re reading anything about the markets. Any analysis and prediction, as clever as it sounds, is missing important information and is probably wrong. Trying to guess what will happen next is a bad idea.
I chose a different approach by following a passive, diversified model. As long as our portfolio is prepared for many different outcomes I don’t need to know what will happen next. I do tilt and tweak this a bit but you’ll never see me making one big concentrated bet. I do my best to not get too smart. Only time will tell if it’s working.
John Kay writes about an old Rothschild legend that illustrates an important insight: we put people in jail if they get an advantage in the market by talking to insiders, but we let them spend hundreds of millions of dollars tunneling cables through mountains so they can trade a few milliseconds faster. In both cases someone profits from knowing the news before anyone else. So what’s the difference?
He ends the article by asking “Why should it be unacceptable to gain advantage from knowledge of the outcome of the battle but acceptable to gain advantage by getting faster to London with that news?” I think he knows as well as us that there is a difference. We punish insiders because the incentives of fully legalized insider trading would harm the markets a lot more than anything that’s legal now. Even if the enforcement goes too far that can still be a good thing since it deters market manipulation.
On the other side, insider trading that doesn’t involve market manipulation could be a good thing. If someone knows of bad news that is about to come out and starts selling large quantities of a company’s stock, that will drive the price down earlier. This saves uninformed buyers from over-paying for a stock that is about to crash. In this case the insider makes a profit but also performs a public service. That’s just the invisible hand of the market – the same standard we expect from any corporation.
This probably can’t be separated from the less beneficial form of insider trading. Similarly, high-frequency trading might get the news out sooner but it can also be used to simply run slower traders in circles, and it should probably be taxed to lessen the advantage. There is a public benefit from committed long-term investors working with transparent prices in a market where they bear full responsibility for their mistakes. Anything else should be watched very closely.
A few months ago I wrote about why I thought Apple’s stock was over-hyped – it has good profit margins now, but it will be nearly impossible to hold them up as competition increases from other manufacturers such as Samsung.
Now Google is openly going after the iPhone’s profit margins. They aren’t doing this to take the profit themselves, but rather to lower the cost of smartphones. A Google executive at Motorola states “Those products earn 50 per cent margins. We don’t necessarily have those constraints. Those [margins] will not persist” as they prepare to launch a new phone that will be “priced well below the iPhone 5”.
As the article mentions, smartphone prices haven’t really declined over the last few years in the same way that other electronics tend to do. As new technologies spread amongst manufacturers, it seems like it will only become more difficult to create a product unique enough to command sustainable high profit margins. And if someone does, there’s no telling which manufacturer will get there first and push everyone else out of the market for a few years.
But there’s always the watch market right? Haha, just joking. When I think of watches I remember brightly-colored plastic and $15 price tags. If Apple is shameless enough to jump into that market, look out below!