Friday, January 22, 2016

Watchwords for 2016: Time in the Market Versus Timing the Market

Know your objective

Why should an investor be concerned about the chance of a recession?
What are the implications of the potential recession in 2016?
What shape would a recession take?
What risks are implicit in a recession?


It seems with the turn of the year there is a ritual where market observers and investors (they are not the same thing) feel obligated to prognosticate on the coming year.  For market observers the folly of such forecasting actually makes sense.  Their job, after all, is to entertain by doing such things.  One thing for sure is that their forecasts may entertain but certainly don't inform.   

A good illustration of that occurred on January 7, 2016 on  There were two articles with contrasting forecasts.  One was entitled “2016 Recession Imminent” and the other was entitled “A Happy New Year After All.”  They were both interesting articles with each presenting an argument to support their contrasting forecasts for 2016.  Their forecasts, in and of themselves, regardless of whether right or wrong, didn't contain a lot of information useful to investors. Similar contrasting forecast appear in just about any financial news medium.

By contrast, an investor may try to forecast the coming year, but the forecast itself is little more than background.  Articles like those cited above may be useful to those who prefer an analysis rather than wading through the raw data to arrive at their own background forecast.  After all, the investor has to make decisions about the allocation of resources including the division of cash between immediate consumption and investment with a view toward future income.  Such decisions are inherently future oriented and thus, whether explicit or not, they imply a forecast. 

However, the implications of the forecast depend upon the investor’s objectives. Consequently, the same forecast for 2016 can have markedly different implications for two different investors.  The implications can be so markedly different because of differences in objectives.  Of those differences in objectives, none is more important than differences in the time horizons of different investors.
With that introduction, it is reasonable to look at what to expect in 2016, but always from the perspective of what it implies for people with different sets of objectives.  For those with a very short-term horizon of a year or less, 2016 will be a year when it is probably better for them to be out of the market.  By contrast, those with a 5 to 10 year horizon can view 2016 as a wonderful opportunity to invest. 

An astute reader has probably already realized that those comments imply a “forecast” of a volatile, down year for the markets in general.  The 22 days since I wrote that sentence have pretty much eliminated the possibility that it will be wrong.  The year has already demonstrated volatility and dropped enough to make an up year unlikely.  It also should be apparent that those comments imply a definition of investor that excludes individuals who think they can rapidly buy and sell in order to profit from short-term (less than a year) fluctuations.

Besides short-term market timing, there are two other strategies that will be ignored in the subsequent discussion.  They are short selling (including short selling designed to produce a market neutral portfolio) and various option strategies.  Thus, the discussion that follows focuses on long-only strategies, and it ignores the potential use of cash-covered puts and covered calls as a part of the strategies.

Types of recessions

It is important to keep in mind that stock market cycles and economic cycles are different-but-related phenomena.  The timing on stock market cycles and economic cycles is different.  In fact, stock market cycles are frequently considered as fairly reliable leading indicators of economic cycles.  A closer examination and consideration of the causality shows that stock market cycles lead certain economic phenomena and lag other economic phenomena.

Stock performance is ultimately related to the profitability of the companies one owns by owning equities.  Often stocks are portrayed as being priced based upon future profitability.  However, projections of profitability are based upon both current and historical information.  As a consequence, stock prices often lag profitability.

The WALL STREET JOURNAL on 8/24/2016 published an article entitled “Will Spending, Profits Resume Climb?”  It started with the following comment “Profit growth for the constituents of the S& P 500 index stalled in 2015…”  In fact, profits have been declining for two quarters.  Other articles have referred to it as a profits recession based on the two quarter figure.  We are about to go into another earnings season, and it is unlikely that the trend will be reversed.

Lest one conclude that the phenomena is peculiar to the larger companies represented in the S&P 500, one should keep in mind that more small businesses are closing shop than are being started up.  Measures of publicly traded small-cap and mid-cap companies’ profitability also reflect a profits recession.  There are also various international surveys of business climates and the ease of starting a business that show a decline for the US.  So, when populist politicians seeking the fan envy talk about corporations earning record profits, like the president did in his State of the Union address, don't take it as investment advice.

In their book THIS TIME IS DIFFERENT, Carmen Reinhart and Kenneth Rogoff reminded readers of the fact that is all too obvious to economic historians.  No two recessions are exactly the same.  As in the quote often attributed to Mark Twain, “History never repeats itself, it only rhymes.”  It is particularly important to understand the difference in the path and financial implications of the recession brought on by a failure of profit growth versus recessions that result from a financial crisis.  The implications of liquidity crises are quite different from the implications of an environment in which the private sector cannot identify ways to produce general profitability.

A cycle caused by lack of profitable investment opportunities takes a particular path.  First, profits become harder and harder to produce.  Then in response, corporations cut capital expenditures and entrepreneurs reduce the number of companies starting up.  The article cited above reports on both of these phenomena as follows:

“Expenditures by members of the S& P 500 index fell in the second and third quarters of 2015 from a year earlier, the first time since 2010 that the measure has fallen for two consecutive quarters, according to data from S& P Dow Jones Indices. Another measure of businesses spending on new equipment—orders for nondefense capital goods, excluding aircraft—was down 3.6% from a year earlier in the first 11 months of 2015, according to data from the U.S. Department of Commerce.”

“More broadly, only 25% of small companies plan capital outlays in the next three to six months, according to a November survey of about 600 firms by the National Federation of Independent Business. That compares with an average of 29% and a high of 41% since the surveys began in 1974.”

For a while, corporations can maintain reported profitability by cutting capital expenditures and introducing efficiency initiatives.  In the US, both those options seem to have run their course.  Once those two opportunities have played out, financial markets have to respond to the increased risk and reduced profitability.  That can take the form of investors selling assets or just not investing.  We have reached that status of not buying and, in some cases, of actually selling assets. 

Public pensions and mutual funds are holding increasing amounts of highly liquid short-term assets (i.e., cash).  In our words, they are not investing in long-term assets.  Households have increased their savings rate, and although many commentators can't see past the reduction in consumption implied by an increased savings rate, viewing it relative to mutual fund flows shows that households are not using net savings to invest.  They are also keeping it in near cash form and reducing their debt.  Both the cash and the reduced debt indicate they are increasing their liquidity.  Increased capital requirements and the risk weightings used to determine capital requirements for different types of loans are inhibiting the free flow of that near cash into productive investment.  In an environment where no other sector is investing in long-term assets, it should not be surprising if corporations are also retaining more cash and cutting capital expenditures.

The next phase in this type of recession is for consumers to shift their focus from just not investing to reducing their consumption.  To date, that has taken the form of a fall in the rate of growth of consumption.  The most recent retail sales numbers show an estimate of virtually no growth and an actual contraction if one removes auto sales.  There is an outside chance that government retail sales data underestimate sales because they don't adequately capture the shift from brick-and-mortar retailers to e-commerce.  That may introduce more uncertainty, but it hardly supports an argument that retail sales are still growing.  If anything, it would indicate that the government may be underestimating the falloff in retail sales.

Reports from Nielsen regarding cash register scans and credit card companies’ reports of transactions (which would include most e-commerce), all support the notion that retail sales have plateaued or begun to decline.  The notion of a disappointing holiday season is also consistent with reports from the shipping companies that handle most e-commerce.  They may have successfully avoided finding themselves with excess capacity when shipments didn't rise as much is expected.  However, the fact that they not only maintained but actually were ahead of schedule on deliveries would indicate that the volumes were not as high as they had expected.

Further, there have been numerous reports of retailers’ over inventoried for the holiday season.  In fact, when considering investments in the retail sector, how the retailer accounts for markdowns in that over inventory can be an important influence on when they report a contraction in their margins.  Inventory build can temporarily sustain an economy, but since World War II many mild recessions resulted from inventory cycles.  When inventories are built in anticipation of growth that actually materializes, they contribute to growth.  But, when inventories build because of an unanticipated fall off in sales, they contribute to a downturn.  Going forward, orders fall off while the companies involved clear the excess inventory. 

To this point, the discussion has been about how things are developing.  But developments to date can only reflect what could happen.  How they will play out in the future is not predetermined.  For example, it is quite possible that consumers will not respond by cutting consumption.  In fact, that would be the forecast of those who think we will avoid recession.  They would argue based upon current employment developments that consumption will turn up.

There are number reasons to doubt that employment will be a good predictor of future consumption.  The first concerns the implications of employment.  Consumption is not based upon employment: it is based upon the wages earned.  Wage data is far less easily interpreted than employment data.  The survey and the definitions used to generate wage data introduce some uncertainty into how to interpret the data.  But, one thing is for sure: wages are not rising.  They may actually even be falling on average.  It isn't until personal income data is made available that one can verify conclusions based on wage data. 

By looking at the wage component of the personal income data, one can separate out the wage effect from the other components of personal income.  That exercise is rather discouraging.  The role of wages as a component of personal income is being decreased by the increasing importance of property income (rents, interest, dividends, and royalties) and transfer payments (Social Security and Disability benefits, as well as other components of the “safety net" such as food stamps, subsidized healthcare, tax credits, etc.).

One might try to argue that income is income and this doesn't matter whether increases in personal income are due to the wage component or some other component.  But, there is a problem with that argument as noted in the December 30, 2015 posting entitled “’It’s a Wonderful Life’ Rebroadcast.”  It commented: “How many pundits point out that about two thirds of Gross Domestic Product is represented by consumption?  They don't bother to note that it is previous investment and labor that produces 100% of Gross Domestic Product.  One can’t consume what isn't produced.”

In an environment where the incentives to invest in productivity-improving capital are weak, there may actually be a substitution effect between wage growth and growth in other components of personal income.  That may be particularly true of transfer payments since they involve shifting income away from those who generate output to those who receive the transfer payments.  If it discourages work incentives or investment incentives, such a transfer will manifest itself through lower productivity and lower wages.

That type of response to incentives would be very hard to detect.  However, there is other data that would suggest it is occurring.  That other data concerns productivity.  The productivity data is consistent with the notion that wages will not rise without an increase in capital expenditures.  One should note however the productivity data is derived indirectly from data in the National Income and Product Accounts (the data used to estimate Gross Domestic Product).  Thus, even though the data is consistent with this hypothesis, it's worth noting it may be underestimating.

Previous to the development of National Income and Product Accounts, economist relied on trade figures and hardgoods output figures to try to estimate whether the economy was expanding or contracting.  As services have become increasingly important in the economy, the output of goods (manufacturing and mining output) has become a less reliable measure of overall prosperity.  If that were not case, there would be little doubt that we would currently be assuming we are already in a recession. 

Direct output data highlights a contraction, but that's generally attributed to the shift away from manufacturing.  Nevertheless, there is no doubt that there has been a falloff in trade. Shipping activity in general is falling off.  International trade data has been contracting for a while and the railroads are currently reporting that shipments are down.  That is to be expected.  If there is less economic activity, there is less to ship.  Consequently, any hypothesis that sees employment as a stimulus for growth has to address the question of whether expanded employment in low productivity, low wage service sectors can accomplish the task.  It can only accomplish that if it is additional employment as opposed to a substitute for higher productivity, higher wage manufacturing and mining employment.

The decrease in productivity has occurred simultaneously with public-sector efforts to try to boost productivity by placing a floor under the wage component.  That's being done by essentially raising the opportunity costs of employment by placing a floor under income regardless of whether one is working or not.  That increase in the floor below which one can expect people not to work takes many forms.  They range from minimum wages (below which employment is illegal), subsidized consumption that would be lost if one increases income (food stamps is a prime example, but welfare payments also have to be considered since the Obama administration eliminated the work provisions implemented by the Clinton Administration), and Social Security and Disability benefits that are structured in a way that discourages work.

While all of these conditions would point to a downturn, they also would result in it being mild and short-term.  The lack of investment discussed above is being accompanied by a strengthening of the balance sheets of the financial and corporate sectors.  It also means that households are increasingly liquid.  That liquidity of businesses, financial institutions, and households will eventually be invested once profitable opportunities arise.  It also provides a cushion to absorb decreases in the value of assets as the recession proceeds.  In short, the threshold at which a write-down of asset values will produce a financial crisis has been raised.

All of these factors discussed above have a negative economic impact.  They will probably produce a slowdown at a minimum.  During this expansion the economy has experienced a number of slowdowns.  They are sometimes attributed to shortcomings in the way seasonality is handled in the economic data.  In other cases, they are attributed to external shocks (the winter was too cold, winter was too warm, there was uncertainty about political developments). 

In the current environment, shocks such as cold-weather, warm weather, a political impasse, or an adverse international development will produce much more than a mild slowdown.  Economists often attribute reversals in an expansion to what is referred to as an external shock.  But, external shocks occur all the time: it is the internal dynamics described above that ensure that this year any external shock has a high probability of putting the US economy into recession.  The nature of the shock could make the recession far more severe than the economy’s internal dynamics would by itself.

Investment implications

It is easy to overestimate the change in behavior that an investor should make in response to an environment like we are likely to experience over the next year or two.  As successful investors know, the environment is probably less important than the investor’s objectives in determining what the appropriate strategy is.  At the same time, recessions are usually accompanied by down stock markets and shouldn't be ignored.

Given the introductory discussion of objectives, the question is: How should long only investors proceed if their objective is to build a portfolio that will provide current or future income?  In the current environment, three approaches suggest themselves:

One approach is to dollar-cost average all investments over the coming year or two.  That approach has the advantage of ensuring that the investor will not be caught out of the market if the forecast turns out to be wrong.  But, it should be undertaken with an understanding that investments made early in the year may be at higher prices than are available later in the year.  If it is a down year, investments made during the year will contribute substantially to future growth in the portfolio.  They may not result in immediate growth in income, but with a 5 to 10 year horizon that is of little consequence.  If the investor’s horizon is one year, the comparable approach is to not invest this year.
A second approach is to not let the economic environment influence the timing of the investment.  Rather, the investor can target acquisitions in stocks that perform relatively well in such an environment.  For example, the widows’ and orphans’ portfolio was discussed in a 2011 blog (“Investing PART 9: One version of the“Unfinished symphony”) and was updated periodically, most notably in the only blog that discussed actually selling one of the holdings in the portfolio (“TheWidows’ and Orphans’ Portfolio and US Banks”).

If one is building a portfolio like the widows’ and orphans’ portfolio, it is close to a permanent investment.  The current and likely outlook over the near-term could be used as an opportunity to select from the options implied by the portfolio. 

For example, a down market is a good time to be adding to the consumer staples category if one wants to reduce volatility implied by a recession.  Companies like Pepsi, General Mills, Procter & Gamble, Kimberly-Clark, Clorox, and Colgate-Palmolive mentioned in connection with the widows’ and orphans’ portfolio would be reasonable additions to the portfolio early in the year.  Johnson & Johnson is another firm that will hold up during an economic downturn.  If one has been building a position in pharmaceutical, medical devices, or healthcare products companies other than Johnson & Johnson they also may should hold up well. 

By contrast, industrial firms like General Electric, United Technology, Honeywell, Emerson, Eaton, PPG and 3M would not look like timely acquisitions until they have come down more in price.  If they are acquired early in the year, it should be done with the understanding that they could go down in value significantly during the year.

The third approach is to try to expand the portfolio by adding new names.  The diversification the portfolio provides could be expanded by entering new industries.  For example, the only extractive firms identified in a portfolio are major integrated oil companies.  Adding holdings in extractive firms represent one approach consistent with expanding the portfolio.  That approach is tricky since it involves try to pick the bottom.  However, resource cycles are long.  As a consequence, there is no reason why an investor should feel an obligation to pick the absolute bottom in the resource cycles.  If one sticks the companies with strong balance sheets, all one loses by not getting the absolute bottom of the resource cycle is time.  But, with a 5 to 10 year horizon, most resource cycles will have played out by the intended target date.  The loss from bad timing on resource companies is often the opportunity costs of having money tied up in equities that are not performing well.

Another approach to adding diversification would be to acquire a firm in the technology area.  Technology is interesting in that the investor can either try momentum investments or value investments.  If one needs names, understanding that I tend to be a value investor, I would provide Microsoft or Intel as examples.  But, as always, investors should do their own research. 

In the original widows’ and orphans’ portfolio the only defense exposure came with Boeing.  Boeing is dominated by commercial aircraft manufacturing.  So, if one is looking for defense exposure, an additional holding may be appropriate.  Both General Dynamics and Lockheed Martin are positioned to experience performance that will be uncorrelated with the economy.

Another option is to expand into an area that was briefly mentioned in passing in the original discussion of the widows’ and orphans’ portfolio.  That is fast food restaurants.  My preference there has been McDonald's, but again, investors may choose either momentum or a value investment, and investors should, of course, do their own research.  By way of disclosure, during McDonald's difficulties over the last few years I've periodically added to a position in the company.  I'm not sure I would add to it at current prices, and given the current value of the stock acquired over the last two years, I'm in the advantageous position of not having to make that decision.  In the original widows’ and orphans’ portfolio I mentioned Yum brands as an alternative to McDonald's. 

The point being, during recessions there are some of the best opportunities to invest that investors can expect to experience during an entire lifetime.  Recessions provide an opportunity to buy companies with strong balance sheets, strong franchises, and healthy cash flows at prices well below their norm.  It is very rewarding to purchase a stock when the company may actually be reporting no current earnings and yet receive an increase in the dividend based upon management's understanding that the long-run value of the company is actually increasing. 

Successfully approaching the markets during recessionary periods requires a very well-anchored understanding of one's objective.  It necessitates actions that properly reflect the investor's disposition toward volatility and willingness to stick with their chosen time horizon.

Disclosure: The Hedged Economist holds or is planning to add positions in the stocks mentioned in this posting.  They are appropriate for my particular risk tolerance and investment objectives.  Discussing them does not imply that they would be appropriate for any other investor.

Tuesday, January 5, 2016

The big lie or bad reporting?

You be the judge.

In article entitled “Wealthiest Face Bigger Tax Bite” somebody should have done some editing for content.  Since it is not clear who was responsible for the snafu, it seems appropriate to point out both the author and the source of what may be the deceptive statement.  The article appeared in the final issue of 2015 (Thursday, December 31) of the WALL STREET JOURNAL.  It represents an embarrassing way to finish the year.

First, let's start with what is either the big lie or sloppy report.  The bold has been added for emphasis.  The author has the following quote from Len Burman, director of the Tax Policy Center which he reports as follows: “Capital gains taxes bring in more than $100 billion in some years ‘and almost all of it is realized by people with very high incomes,’ he said.”  The author then goes on to report: “In 2013, the 400 households earned 5.3% of all dividend income and 11.2% of all income from sales of capital assets.” It would seem to me that “11.2%” is not “almost all.” Further, the $100 billion figure does not refer to the 400 households.

The bait and switch in the contrast between Len Burman’s quote about very high incomes and the reporter’s citation of 2013 data about the 400 households makes it clear that someone is either being intentionally deceptive or is misusing potentially interesting data.

If Len Burman was aware that the article was about the 400 highest income households then clearly he was being deceptive.  He would know full well that 400 highest income households do not pay “almost all” capital gains tax.  The reporter cites The Tax Policy Center as a nonpartisan think tank. If Len Burman knew how the quote was going to be used, one would have to seriously question whether the Tax Policy Center is really nonpartisan.  

However, even if Len Burman was intentionally being deceptive, the author of the article, Josh Zumbrun, can be faulted for a poor selection of a supposedly nonpartisan source.  It is also quite possible, and highly likely, that nonpartisan is the label the Tax Policy Center chooses to disguise its partisan efforts, in which case Josh Zumbrun can only be faulted for his political naivety or intentional bias. One should learn to question the partisan motives of anyone who cites capital gains figures without any reference to the fact that capital gains are by their very nature non-repetitive.  When one takes a capital gain, it is a onetime event.  Citing capital gains as if they were ongoing sources of income for a fixed set of households is inherently deceptive.

What is particularly distressing is that there is considerable evidence that the reporter was intentionally being deceptive and that the editor let it get published anyway.  The article starts out with the statement: “Tax rates on the 400 wealthiest Americans in 2013 rose to their highest average since the 1990s, after policy changes that boosted levies on capital gains and dividends.”  So the author has clearly set up the article to be talking about a very limited group of people, 400 households. 

The author even makes a meaningless comparison of what was paid by the 400 households in 2013 with what was paid by a different set of 400 households in the 1990s.  The author treats them as if they were the same households.  He then attributes the higher taxes to changes in tax rates on capital gains and dividends without making any reference to the fact that the incomes of the 400 households were different in different years.  He never makes any reference to how much of the increase in the taxes paid by the households in 2013 could be attributed to the interaction between a progressive tax structure and higher incomes.

One might conclude from that opening sentence that the article was going to be about the taxes of the 400 wealthiest Americans.  But, the very next paragraph makes it clear that the author does not know the difference between a stock of wealth and a flow of income.  That is not a major offense.  It is a very common misunderstanding among reporters and conforms to a common misuse of economic terminology among the general population.  However, one would think a journalist would be literate enough to properly use the English language and careful enough to select the words with the least ambiguity.  Further, one could hope that a newspaper that reports on financial markets would have the good sense to employ reporters who understand the difference between wealth and income.  Using the two words interchangeably is not only sloppy, it is deceptive.

Newspapers will often use wealthy to refer to high income as a simple expediency to cut down the number of words in the headline.  But to continue to misuse wealthy in the text of the article is a more serious issue.  It is particularly awkward since the author’s lack of clarity on the difference between wealth and income is a major deficiency in the article’s reporting on the taxes paid by the 400 highest income households.  One would hope that the WALL STREET JOURNAL would employ reporters who understood the implications, origins, and reason for differences in taxes on changes in wealth (the stock) versus income (the flow). 

That understanding is a precondition to accurately portraying the implications of the quotes that the article has gathered from Scott Greenberg, an analyst at the Tax Foundation; Gabriel Zucman, a professor at the University of California, Berkeley, and Len Burman, director of the Tax Policy Center.  Further, how can a newspaper ever hope to meaningfully report on financial markets if it employs reporters who have no understanding of the difference between a cash flow and market value?