Tag Archives: risk

Risk, Reward, and Valuations

Risks, Rewards, and Valuation

Is the stock market risky?

Photo Rhett Sutphin. Source: Wikipedia

Of course it is. Anyone who went through the Financial Crisis or dot-com crash or Long Term Capital crisis or ’87 crash has experienced the gut-wrenching feeling of having significanlty less in savings than they had just a few months before. Nobody likes that feeling.

And the longer you hold onto stocks, the more likely you are to experience a bear market. These can be caused by wars, recessions, panics, and bad policies coming out of Washington. The world seems like an especially risky place right now, with untested political leadership confronting missile tests in North Korea, terrorist threats around the world, intelligence failures, and a stalled domestic agenda.

So why are market valuations so high?

Source: Bloomberg

The expected price-earnings ratio for the S&P 500 – computed by comparing the market’s current market-cap divided by aggregate expected earnings – is 18.5x, above its long-term average. Why – with all the risks that we’re currently facing – is the stock market making new highs?

One reason is earnings. Company earnings are hitting records. Corporate titans like JP Morgan and Johnson & Johnson and Google have never had so much money hit their bottom lines. So S&P 500 earnings are making records, and are expected to grow even more. And all the cash sitting on corporate balance sheets means that these firms have a lot of financial flexibility.

But an even bigger reason is the bond market. With inflation low and stable, bond yields are low and stable, too. Financial assets are ruled by interest rates. It’s one of the first lessons in finance: a financial asset is worth the sum of its future cash flows, discounted to present value by the appropriate interest rate. If interest rates are low, financial assets are worth more.

Does this make stocks especially risky right now?

The short answer is no. Stocks can crash when valuations are rising or when they are falling. They can crash when valuations are high or when they are low. The PE ratio is a poor predictor of market direction, but it’s a decent indicator of long-term returns. High valuations in the early ‘60s were followed by modest returns over the next 20 years; low valuations in the late ‘70s facilitated strong double-digit returns through the ‘90s.

Nothing in life is certain. If we look hard enough or deep enough, though, we can discern some of the broader trends. Equities may be risky, but no riskier than average, it seems. The race isn’t always to the swift, nor the battle to the strong. But that’s probably the way to bet.

Douglas R. Tengdin, CFA

Make Banks Safe Again

Are the big banks finally safe?

Picture: New York Fed

The Financial Crisis put bank safety and soundness fully in view. The serial bailouts or failures of Bear Stearns, AIG, Fannie and Freddie, Lehman, Merrill, and Washington Mutual put the global economy at risk. The problem was systemic: all the big banks were affected, because investors weren’t certain where their money would be safe. Bank stocks fell about 70%, and yields on their bonds rose about 4%.

When this happens, banks cut back on their lending, which slows the economy because businesses can’t borrow the money they need to grow. What the banking system should do at this point is raise more capital so they can keep lending. But there’s little incentive for any company to do this: the economy is weak, levered institutions are more risky, and stock prices are low. Why sell more stock when the price is low? That’s a good way to get your owners angry.

According to Fed data, the banking system is better capitalized than it has been in years. Of course, the data showed that just prior to the financial crisis as well.

Source: St. Louis Fed

If individual banks chose to keep their equity levels high all the time, that would prevent us from having a banking crisis, but there is little incentive to do this. A higher equity level means a lower return on equity, and lower returns for shareholders.

Because of this, Fed officials have considered whether subsidizing equity issuance could help. That is, for every dollar in capital the banks raise, the government would kick in 50 cents of its own money – into bank capital. Such an approach would reduce the chances of another financial crisis and improve future economic growth by as much as 1% per year. That’s a lot of growth: imagine how much better the world would be if we never went through the Great Recession.

But subsidizing bank capital is a non-starter, politically. Bankers aren’t very sympathetic characters. If you cruise the comments section of any prominent newspaper, people still wonder why the executives in charge of the big banks during the Financial Crisis were never put behind bars. The last time a banker was portrayed positively in the movies was George Bailey in “It’s a Wonderful Life” (1946), and he was considering suicide when his capital fell short.

Banks are essential – they provide the capital that the modern world needs to grow. But they are subject to booms, busts, and periodic panics. The only way to have a risk-free banking system would be to regulate their returns. And then you wouldn’t have enough banks – or enough capital to grow.

Douglas R. Tengdin, CFA

French Lessons

And people thought our Presidential election was wild.

Source: Marine 2017

Election season in France has generated one surprise after another. The first round in their Presidential race occurs April 23rd. Currently, there are 10 contenders. Marine Le Pen – the French Nationalist candidate – is leading in the polls with 27% of the vote. If no candidate wins a majority in the first round, as seems likely, there will be a run-off vote between the two leading vote-getters on May 7th. Parliamentary elections will follow on June 11th, with their run-off races on June 18th.

Le Pen leads the National Front party, a nationalist and populist group whose main policy positions include opposition to French membership in the European Union, economic protectionism, and opposition to immigration. The party was founded by Le Pen’s father in 1972 as the EEC—later EU—came to dominate European politics. Le Pen, Senior was kicked out of his own party in 2015 for his anti-Semitic and holocaust-denying comments. His daughter – the current Presidential front-runner — led the effort to oust him

Marine Le Pen. Photo: AG Gymnasium Melle. Source: Wikipedia

Le Pen’s leading opponents are Emanuel Macron on the left and François Fillon on the right. But Macron has proven an uninspiring candidate, and Fillon’s race has been plagued by scandal. A few weeks ago, investigators revived a probe into his personal finances – alleging he created fictitious, publically-funded positions for his wife and children. Last night his wife was reportedly questioned by authorities for her $1 million salary as his “assistant.” At the same time, Le Pen’s chief of staff Catherine Griset has become the subject of an enquiry as to whether she held a fake European Parliament job. But this has been dismissed by Le Pen as a political prosecution led by the media and political elites. Up until this point, both Macron and Fillon had been leading Le Pen in the polls. But who knows?

Source: UBS

At stake is France’s place in Europe. If elected, Le Pen has promised to hold a referendum on France leaving the EU. In an environment where dynasties are toppled by their own children and spouses are employed in fictitious jobs, it seems that anything could happen. This has been a bizarre political season, and European markets are struggling to price in the uncertainty. French Treasury bond yields have risen from 0.15% to 0.89%.

French 10-year Treasury. Source: Bloomberg

The once-unthinkable now seems possible: if Le Pen wins and France invokes Article 50, the EU would be significantly diminished, or could even break up.

Douglas R. Tengdin, CFA

Investments, Risk, and Return

What is risk?

Base jumpers. Photo: Christophe Michot. Souce: Wikipedia

In 1952 Harry Markowitz changed the world. By combining different assets he proved that a diversified portfolio would have a lower variance. His mathematical formula used the variance of asset prices around an average as a proxy for risk. It made sense at the time: the more asset prices jump around, the more nervous people get.

Markowitz’s work was ground-breaking. Never before had risk been so clearly linked to return, nor had its reduction via diversification been so elegantly quantified. Modern Portfolio Theory was born. The biggest problem Markowitz faced with his idea was classifying it: it wasn’t math; it wasn’t corporate finance; it wasn’t classical economics. Of course he got a Ph.D. in economics, and later won the Nobel Prize for his work.

Risk and Return of possible portfolios. Source: Wikipedia

But Markowitz had another problem. He didn’t have anything but a slide rule to calculate his numbers. He had to do all his math by hand. Variance is fairly simple to calculate, but most investors don’t think of risk as variance. For them, risk is the chance of losing money. It comes in two flavors: short-term and long-term.

Short-term risk is the risk of 9/11 or the Financial Crisis or the Asian Contagion: major events that impact the market but that we also get over and move on from in a couple years or so. Unless you have to sell when the market is down, your portfolio will recover. Diversification reduces short-term risk, precisely because that’s the kind of risk Markowitz was calculating with his slide-rule.

But long-term risk is the risk of hyperinflation or asset seizure or devastation–by war or natural disaster. It’s the kind of loss that Shakespeare or Solomon worried about. And the solution is similar: spread your assets out, because you don’t know what disaster may be waiting around the corner. But it’s not enough just to buy stock in different companies if a revolution is headed your way. To hedge that sort of risk, you need to think differently.

Apple “Think Different” Ad. Public Domain. Source: Wikipedia

It’s a mistake just to look at short-term fluctuations. Long-term issues are real. Investors need to be ready, just in case.

Douglas R. Tengdin, CFA

Chief Investment Officer

Risk, Return, and Investment Fads

Do low-risk stocks have higher returns?

Photo: Chamomile. Source: Morguefile

That’s what a lot of people are thinking. It’s kind of counter-intuitive. After all, it’s always been taught that in order to get returns, you have to take some risk. Bonds are more risky than bank deposits, but they pay more. Long-term bonds are more risky than short-term bonds. Stocks are more risky than bonds—their prices are more volatile, and if a company goes bust, stock investors usually don’t get anything back. For example, when after the financial crisis, investors who owned Lehman’s shares were wiped out, while those who owned senior Lehman’s senior debt received around 30 cents on the dollar. That’s not a lot, but it’s a whole lot better than nothing.

The assumption that risk and return are linked is central to much of modern finance. It is assumed that your total investment returns are generally limited by your risk tolerance. In fact, this has become a central tenet in most asset-mangers’ education. You won’t pass the CFA curriculum if you put a risk-averse 100% into stocks. The theoretical foundation of this practical norm is the Capital Asset Pricing Model, first formulated by Bill Sharpe in 1964. He won the Nobel Prize in Economics for his insight.

But academics began documenting anomalies to the CAPM almost as soon as it was proposed. They discovered a “size effect,” a “quality effect,” and a “value effect.” These factors capture the fact that small companies, well-run companies, and cheap stocks tend to do better than the general market. Lately researchers have been looking at a “low-volatility” effect—the notion that stocks where the price doesn’t jump around as much seem to do better than shares of jumpy firms. This turns risk/return thinking on its head. If the “low-vol” effect is right, then the least risky stocks are better investments—more return for less risk.

Source: Eric Falkenstein, “Finding Alpha

The financial industry has capitalized on this notion, creating a host of low-vol funds and ETFs. These appear to be pretty successful. The five largest funds have almost $40 billion in assets under management, gathering $25 billion in the last two years. Year-to-date, they have returned over 11%, while the S&P 500 is up only 8%.

But on further examination, much of the low-vol effect turns out to come from other factors. High-volatility stocks historically have been penny stocks and the most speculative shares. Penny stock marketing was reformed in the early ‘90s, and when the tech bubble burst, a lot of non-income “concept companies” went away.

Lately, low-volatility stocks have done well, but much of that can be attributed to the recent outperformance of dividend-growth companies like utilities, consumer products firms, and pharmaceutical corporations. Since bonds don’t pay much—if anything—any more, income-oriented investors have shifted their funds from bonds to stocks, pushing the prices of dividend-growth stocks to record levels. The PE ratio of the Dow Jones Select Dividend Index is now 37% above its average level.

Source: Bloomberg

Financial fads come and go. In the late ‘90s it was tech stocks. Before the financial crisis it was China. Now it’s dividend growth. Investors rush into a concept and rush right back out again, leaving disappointment and disillusionment in their wake. Technology and China and dividends remain important investment themes, but not at any price. If you pay too much for anything, your performance will suffer.

In a portfolio, as with clothes, fashion is what you’re offered. But style is what you choose.

Douglas R. Tengdin, CFA

Chief Investment Officer

Certain About Uncertainty

How is investing like backgammon?

Photo: Katana. Source: Morguefile

Both involve uncertainty. Both are highly quantitative. And both combine skill, strategy, and a bit of luck.

I loved backgammon growing up. I could play for hours with family and friends. I read books and studied different board combinations. I even organized a couple of tournaments in college. I loved the fast pace and exciting finishes, and learned a lot. I think the most important skills I gained were knowing how to work with uncertainty and using probabilities to gain an advantage.

The main factor in backgammon, of course, is the element of chance. You can’t know what the dice will do each time you roll. No matter how careful or calculating you are, if you roll a 2-1 and your opponent rolls double-sixes three times in a row after you’ve broken contact—unlikely as that might be—you’re going to lose some ground. In the same way, there’s a lot of chance and random events in the stock market. Companies get taken over; firms miss their earnings expectations; regulators change the rules; courts award billion-dollar verdicts. No one knows what the market will do from one day do the next.

But there are ways to improve your chances. In backgammon, if you need to leave a piece exposes, leave it far enough away so your opponent can only hit it with a combination of both dice, rather than with just one die. As the board develops, certain strategies will do better—a back-game, a blocking game, reading your opponent’s tendencies. Being flexible is important.

But the most important skill in backgammon is being able to read the board and calculate your odds of success at any particular time. If you can calculate your chance of winning, you will be able to use the doubling cube effectively. The rules and strategies for doubling and redoubling have a lot of nuance, but using the doubling cube allows you to play the probabilities and manage the stakes of the game.

Photo: Takasaki. Source: Wikipedia

Reading the board and managing your stake are a lot like reading the market and managing a portfolio. There are times when valuations, momentum, and fundamentals are in your favor, and when they’re running against you. There are times when one approach performs better than another, based on how the market is playing out. But risk and uncertainty are always part of the equation.

Many people are obsessed with finding the optimal portfolio—looking for certainty in their investments. But nothing is certain. Instead, we need to embrace the uncertainty of the markets. Only then can we make the odds work for us.

Douglas R. Tengdin, CFA

Chief Investment Officer

Values and Valuation

Does valuation matter?

Photo: Carspotter. Source: Car Pictures

Many analysts consider the stock market expensive right now. They look at high-flyers, like Facebook, Netflix, and Tesla—with their eye-popping PE ratios, and conclude that the market has gone crazy. Other folks note that these companies are new, and that they’re priced for significant future growth. If you look at the rest of the market—with pedestrian names like Exxon, Apple, and Caterpillar—valuations are far more reasonable. Which is it?

The market has always been an amalgamation—some companies are expensive, some companies are cheap. When a company has a high valuation, investors are looking for them to grow their revenue, cash flow, and earnings significantly faster than the economy. That’s the case with many concept companies right now. They have the potential to disrupt the economy in significant ways—like Amazon, or Uber. In the process, they carve out a new niche for themselves.

Cheap stocks, on the other hand, are cheap for a reason. There are problems on the horizon—like falling oil and iron ore prices, or there are regulatory concerns, or environmental issues threaten the company. Low valuations don’t just happen. They have to be earned—the same as high valuations. Prices are just projected cash flows discounted back to their present value. For the price to be low, either the expected cash flows are low, or the discount rate is high, or both. And when things get more risky, discount rates rise.

But the world has a funny way of not ending. That’s why the cheapest assets tend to perform better over time. When the market’s fears don’t play out, valuations move back up to normal. Conversely, when the latest hot trend turns into a normal—as opposed to disruptive—growth opportunity, valuations fall from stratospheric levels to just high. Mean-reversion works both ways. There are times when value stocks are in demand, and other times when growth stocks outperform.

Source: Bloomberg

It all depends on what you’re looking for from your investments. Do you want a safe, steady stream of growing dividends? Then your portfolio may not grow as fast as the market. Do you want disruptive, transformative growth? Then get ready for some gut-wrenching volatility. And be careful that you don’t panic when things look really bad. That’s often when they’re about ready to turn around—like March 2009, or October 1998. The best way to turn volatility into permanent losses is to panic.

Valuation matters. It shows how much growth the market expects, and also how risky a business might be. Buying stocks isn’t that different from buying anything else: you get what you pay for. You just have to know what you’re looking for.

Douglas R. Tengdin, CFA

Chief Investment Officer

Nature’s Diversity and Portfolio Diversification

Nature is diverse.

Source: NOAA

Whether down in the depths of the sea or soaring in the Himalaya Mountains or out on the African veldt, we find a broad array of plants, animals, fungi, and microorganisms. Wherever there’s a source of energy, there’s something out there that uses that energy to grow, reproduce, and spread.

That’s why the discovery of deep sea geothermal vents by the crew of the Alvin in 1977 was so revolutionary. They found a whole community of tube worms, clams, limpets, and shrimp that feed off the bacteria that in turn get food from the chemicals in the vent fluids. There’s a whole ecosystem down there supported by geothermal energy.

Nature’s diversity allows it to recover quickly from disasters. In 1980 Mount St. Helens in Washington State erupted with enormous force, creating a zone of devastation over 200 square miles. But traces of life survived beneath the debris: seeds, spores, and fungi. Within a couple years, a few hardy plants had colonized the area. Several decades later, satellite images show the mountain covered by a rich carpet of forest and grasslands.

Source: US Geological Service

Our investments should follow nature’s example. Invention and ingenuity allow for commerce and production in almost every sphere imaginable: from nomadic desert tribesmen conducting tourists across the Sahara to people arranging helicopter commutes via their smartphones. By diversifying globally across various sectors and industries, into small, mid, and large-cap companies we participate in the broad spectrum of human resourcefulness. And when there’s a disaster, a diversified portfolio comes back much more quickly.

I’m not saying that diversification is simple or that it provides a free lunch. But the best way to benefit from the amazing creativity of the human spirit is to have part of our portfolios exposed to as much as possible. There’s a line about this in the new musical Hamilton: “When you’ve got skin in the game, you stay in the game. But you don’t get a win unless you stay in the game.”

Douglas R. Tengdin, CFA

Chief Investment Officer

The Danger of Safety

Do safety measures encourage us to take more risks?

Photo: Magnus Manske. Source: Wiki

The US Forest Service was created in 1905. Teddy Roosevelt signed the bill in response to a series of disastrous forest fires, like the Great Hinckley Fire of 1894. These fires threatened future commercial timber supplies, and the Federal Government had begun to establish national forest reserves. Why create them, people wondered, if they were just going to burn down?

So the Forest Service established a systematic approach to fire control, building a network of roads, lookout towers, ranger stations, and communications. They also offered financial incentives for states to fight fires. With new technology, like airplanes, smokejumpers, and chemicals, they established their 10 am policy: every fire should be suppressed by 10 am the day following its initial report.

But a funny thing happened: by eliminating fire from the forest ecosystem, a lot of dead wood and other fuel accumulated over time. This insured that when fires did break out, they would become far more destructive. Moreover, scientists noted that fire was an essential part of many plant and tree life cycles. The Forest Service changed its approach from fire control to fire management—letting naturally occurring fires burn, unless they threatened developed areas.

Is this part of what led to the Financial Crisis of 2007-2009? During the 25 years prior, economists had noted that more effective bank regulation and monetary policy had led to a “Great Moderation”—a significant dampening of the business cycle in the US and other developed nations.

Source: Lawrence Khoo, FRED, Wiki

It’s possible that reduced economic volatility led investors, homeowners, and banks to take on greater risks. In essence, the Fed’s policy of fire suppression allowed toxic assets to be created and distributed throughout the financial ecosystem. Highly regulated (and insured) banks were replaced by (uninsured) shadow banks. These assumed particular risks and contributed to a culture of increased systemic risk. When some of their assets began to unravel, it was impossible to contain the damage.

We find a sort of risk-homeostasis in other areas. Anti-lock brakes encourage more aggressive driving; better skydiving gear allows hazardous high-speed maneuvers close to the ground. This is sometimes called the Peltzman effect: people behave as if they want a certain level of risk in their lives. This appears to be the case with ecosystems and economies, too.

Are safety measures useless, then? Absolutely not! The rate of accidental fatalities has fallen dramatically over time, and there are also fewer bank failures. But like the US Forest Service, we need to focus on risk management rather than risk reduction. Don’t assume government regulators will control your financial risks. Diversification, analysis, and—above all—not paying too much are still crucial, and always will be.

The biggest risk, after all, is believing that we aren’t taking any risk. In a dynamic world, that’s guaranteed to fail.

Douglas R. Tengdin, CFA

Chief Investment Officer

Above Average Investing

Above Average Investing

Photo: Jim Machley. Source: Mountain Graphics. Used by permission

“Raise your hand if you’re an above-average driver.”

Ask that question in any group and see how many hands go up. Usually it’s way more than half. That’s because we’re pretty overconfident. We think we know more than we do, and we think that we’re better than we are.

This isn’t because we’re naturally arrogant. It’s because the folks who lack a true expert’s abilities simply can’t discern what makes someone really good at something. For example, if you’re not very good at learning languages, you might not be able to tell that you’re not very good, because the skills you’d need to tell a good language-learner from a bad one—an ear for sounds, a broad vocabulary—are the ones you lack.

This has broad implications for investing. It’s fairly easy to measure investment return, but it’s difficult to evaluate risk. Most occasional investors never consider the risks that they’re taking when they measure their investment returns. So they may have a great run, but usually it’s because they’re taking significant risks that they’re not even aware of.

All the more reason to be humble about our investment prowess. There are some real tools investors can use to improve their performance, but they’re mostly humdrum matters of policy, discipline, and humility. Investing is a game of inches, and little things add up to improve performance.

Investment skill is real, and above-average performance is possible. But this isn’t Lake Wobegon: not everyone can be above average.

Douglas R. Tengdin, CFA

Chief Investment Officer