A Reminder About Real Return

November 20, 2013

The main thing that should matter to a long-term investor is real return.  Real return is return after inflation is factored in.  When your real return is positive, you are actually increasing your purchasing power— and purchasing goods and services is the point of having a medium of exchange (money) in the first place.

A recent article in The New York Times serves as a useful reminder about real return.

The Dow Jones industrial average broke through 16,000 on Monday for the first time on record — well, at least in nominal terms. If you adjust for inflation, technically the highest level was on Jan. 14, 2000.

Adjusting for price changes, the Dow’s high today was still about 1.3 percent below its close on Jan. 14, 2000 (and about 1.6 percent below its intraday high from that date).

There’s a handy graphic as well, of the Dow Jones Industrial Average adjusted for inflation.

Source: New York Times/Bloomberg

(click on image to enlarge)

This chart, I think, is a good reminder that buy-and-hold (known in our office as “sit-and-take-it”) is not always a good idea.  In most market environments there are asset classes that are providing real return, but that asset class is not always the broad stock market.  There is value in tactical asset allocation, market segmentation, strategy diversification, and other ways to expose yourself to assets that are appreciating fast enough to augment your purchasing power.

I’ve read a number of pieces recently that contend that “risk-adjusted” returns are the most important investment outcome.  Really?  This would be awesome if I could buy a risk-adjusted basket of groceries at my local supermarket, but strangely, they seem to prefer the actual dollars.  Your client could have wonderful risk-adjusted returns rolling Treasury bills, but would then also get to have a lovely risk-adjusted retirement in a mud hut.  If those dollars are growing more slowly than inflation, you’re just moving in reverse.

Real returns are where it’s at.

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February 15, 2013

Apparently hyperinflation can occur anywhere!

Source: Greg Mankiw 

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When Will the Fed Raise Interest Rates?

October 12, 2012

The topic of interest rates is of concern to investors for a couple of reasons.  Savers are interested in finding out when interest rates might rise and they might earn more than 0% on their accumulated capital, and bond investors would like some kind of early warning if there is trouble ahead.  I’ve seen lots of opinions on this, and they’ve mostly all been wrong.  My personal answer to the question about when interest rates would rise would have been something like “2009,” which explains why 1) I am not a prominent interest rate forecaster and why 2) everyone should use a systematic investment process (as we do)!

To attempt to answer the interest rate question, Eddy Elfenbein of Crossing Wall Street stepped in in a way I particularly admire—with actual data, not just opinions.  He showed two competing interest rate models developed by Greg Mankiw at Harvard and Paul Krugman at Princeton.  Although the coefficients are slightly different, it turns out that their models are pretty similar.  I’ve shown the two graphs below.

Mankiw Interest Rate Model


Krugman Interest Rate Model

Source: Crossing Wall Street  (click on images to enlarge)

Up until the recent financial crisis, the forecast fit the data rather well for both models.  That is to be expected, since the model is derived from the data and each modeler is searching for the best fit equation.  Both models show that, given the past behavior of interest rates in relation to the variables they use (core inflation and unemployment), current interest rates should be negative!  The Fed seems to be coping with this situation by holding rates at zero and using quantitative easing to simulate negative rates.

What will make these models suggest that interest rates should start to move higher?  If core inflation increases and the unemployment rate begins to decline, both of these models would call for higher rates.  For Krugman’s model, for example, core inflation would have to rise to 2.5% (from the current 1.8% level; I used PCE excluding food and energy), while unemployment would need to decline to 7.5% from 7.8%.  (Or it could be a different combination that was mathematically equivalent.)  For Mankiw’s model to call for higher rates, only a slight increase in inflation or a drop in unemployment would be needed.

If the economy continues to plug along with slow growth, low inflation, and relatively high unemployment, both of these models would continue to suggest that negative rates are needed to revive the economy.

So much for theory.  In reality, many considerations go into setting the Fed Funds rate.  Watching the behavior of inflation and unemployment probably enters into it, but I’m guessing the Fed is examining other data as well.  From the outside, perhaps the best thing we can do is monitor the relative strength of bonds versus other asset classes to get a handle on the expectation for interest rates.

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Inflation Also Rises

October 8, 2012

Inflation has been a big fear in the investment community for a few years now, but so far nothing has happened.  An article at AdvisorOne suggests that the onset of inflation can sometimes be rapid and unexpected.

Someday, in the possibly near future, you will suddenly be paying $10 for a gallon of milk and wondering how the heck it happened so fast.

That is the strange and terrible way of inflation, said State Street Global senior portfolio manager Chris Goolgasian in a panel talk on Thursday at Morningstar ETF Invest 2012. Inflation has a way of appearing to be a distant threat before it sneaks up suddenly and starts driving prices through the roof.

Quoting from Ernest Hemingway’s novel “The Sun Also Rises,” Goolgasian took note of a passage where a man is asked how he went bankrupt. “Two ways,” the man answered. “Gradually, then suddenly.”

“The danger is in the future, and it’s important to manage portfolios for the future,” Goolgasian concluded. “Real assets can give you some assurance against that chance.”

That’s good to know—but which real assets, and when?  After all, Japanese investors have probably been waiting for the inflation bogeyman for the last two decades.  This is one situation in which tactical asset allocation driven by relative strength can be a big help.  If you monitor a large number of asset classes continuously, you can identify when any particular real asset starts to surge in relative performance.

For example, on the Dorsey Wright database, the last extended run that gold had as a high relative strength asset class (ETF score > 3) was from 3/9/2011 to 12/21/2011.  Below, I’ve got a picture of the ETF score chart, along with a performance snip during that same period.  Perhaps because of investor concern about inflation—misplaced, as it turned out—gold outperformed fixed income over that stretch of time.

ETF Score for GLD

2011 Performance Snip

Source: Dorsey Wright  (click on images to enlarge)

There’s no guarantee that gold will be an inflation hedge, of course.  We never know what asset class will become strong when investors fear future inflation.  Next time around it could be real estate, Swiss francs, TIPs, or energy stocks—or nothing.  There are so many variables impacting performance that it is impractical (and impossible) to account for them all.  However, relative strength has the simple virtue of pointing out—based on actual market performance—where the strength is appearing.

Investment history sometimes seems to be a never-ending cycle of discredited themes, but those themes can drive the market quite powerfully until they are discredited.  (Remember the “new era” of the internet?  Or how “peak oil” was so compelling with crude at $140/barrel?)  It’s helpful to know what those themes are, whether you are trying to take advantage of them or just trying to get out of the way.

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Quote of the Week

September 18, 2012

The cult of equity may be dying, but the cult of inflation may only have just begun—-Bill Gross

I don’t know if Mr. Gross will be correct with this forecast—he certainly isn’t always—but it’s worth paying attention to his thinking.

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The Inflation Mystery

September 17, 2012

Michael Sivy has a think piece on inflation in Time Magazine.  His premise is that, based on what economists think they know about deficit spending, economic stimulus, and money creation, we should be having serious inflation.  But so far that hasn’t happened.

The economy of the past three years has puzzled experts and policy makers in all  sorts of ways, but the greatest mystery has been the recent decline in the rate  of inflation. That may not seem remarkable in a stagnant economy, except that  all the major economic theories suggest that prices should now be rising at a  fast clip.

What’s most striking today is that all three of these factors are now at  extremes that should be fanning the flames of inflation. Deficits of more than a trillion dollars a year are the  highest in history. At close to zero, short-term interest rates are at their lowest level in more  than 30 years. And the Fed’s monetary base has been expanding at an  unprecedented rate. The remarkable thing is that none of this is translating  into serious inflation. Over the past three years, some volatile prices, such as  those for food and gasoline, have indeed gone up. But there still  haven’t been sustained widespread price increases throughout the economy.

Mr. Sivy has a preferred explanation for this inflation mystery, and also suggests what may happen when things change.

The explanation is that all the money in the world won’t push up prices unless  people are willing and able to spend it. So the dog that didn’t bark in this  story is the money that didn’t get spent.

The current stagnation may simply have to run its course. But once it does and  the economy really begins to rebound, it could well be accompanied by a  surprisingly fast resurgence of inflation.

I think his viewpoint is worth considering.  Inflation hasn’t been a problem so far, but that doesn’t mean it will never become a problem.  Investors, many with bond-heavy portfolios, may be ill-equipped to deal with a bout of inflation.  If inflation does occur, it may catch a lot of investors off guard, if only because they have seen declining inflation over their entire investing careers.

Relative strength might be a useful guide to solving the inflation mystery.  If traditional inflation-sensitive assets like commodities or energy and basic materials stocks start to pick up significant relative strength versus other asset classes, it might be time to focus on portfolio protection.

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From the Archives: Inflation Rears Its Ugly Head

May 25, 2012

Howard Marks is chairman of Oaktree Capital, a large and well-known institutional alternative fixed income manager.  Mr. Marks’s memos are always thoughtful and worth reading.  This go round he has a discussion of all of the things that could go wrong with the world economy—essentially a list of all of the things that could go wrong.  One of the things that could go wrong is inflation.

He believes rates are more likely to go higher than lower, and that inflation, long forgotten as a risk factor, might return.  In addition, he has a list of suggestions on how to deal with inflation including TIPs, floating rate debt, gold, real assets like commodities, oil, and real estate, and foreign currencies.  His catalog of alternatives is even longer, but you get the idea.  (If you want to read the whole memo, you can find it here.)

That’s quite a list, but the first thing that I noticed about it is that not one of these items is generally considered as an investment option by retail investors.  Most investors are mentally stuck in the domestic stocks/domestic bonds arena.  Diversification consists of hitting more than one Morningstar style box.  If inflation does come back, that’s not going to cut it.  In fact, Mr. Marks asks investors, “How much of your portfolio are you willing to devote to protect against these macro forces?”  He says if the answer is 5%, or 10%, or 15% that those levels are pretty close to doing nothing.  He thinks a portfolio will need to devote at least 30-40% of assets toward inflation protection if it recurs.

Investment flexibility and risk diversification were the primary reasons that we launched the Systematic RS Global Macro account as a retail product last year.  Many of the inflation hedges in Mr. Marks’ list are asset classes that are available in the Global Macro portfolio, including TIPs, gold, commodities, oil, real estate, and foreign currencies.  Given our basket rotation strategy and our adherence to relative strength, the Global Macro portfolio could easily have 40% of its assets, or more, in inflation hedges if inflation were to recur.  I think the jury is still out about how the world economy will respond to decreased levels of fiscal stimulus, but it’s good to know that you have options.

—-this article originally appeared 1/25/2010.  We have not seen runaway inflation so far, but the point Howard Marks makes is valid.  If/when inflation does occur, you might need to devote a lot of your portfolio to inflation protection.  Is your investment process up for the challenge?

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Beautiful Deleveraging

May 21, 2012

Ray Dalio of Bridgewater Associates is an interesting and pragmatic economic thinker.  He had a recent interview with Barron’s, in which he described the deleveraging process in the US as “beautiful.”  Here’s a snippet:

A beautiful deleveraging balances the three options. In other words, there is a certain amount of austerity, there is a certain amount of debt restructuring, and there is a certain amount of printing of money. When done in the right mix, it isn’t dramatic. It doesn’t produce too much deflation or too much depression. There is slow growth, but it is positive slow growth. At the same time, ratios of debt-to-incomes go down. That’s a beautiful deleveraging.

We’re in a phase now in the U.S. which is very much like the 1933-37 period, in which there is positive growth around a slow-growth trend. The Federal Reserve will do another quantitative easing if the economy turns down again, for the purpose of alleviating debt and putting money into the hands of people.

We will also need fiscal stimulation by the government, which of course, is very classic. Governments have to spend more when sales and tax revenue go down and as unemployment and other social benefits kick in and there is a redistribution of wealth. That’s why there is going to be more taxation on the wealthy and more social tension. A deleveraging is not an easy time. But when you are approaching balance again, that’s a good thing.

What makes all the difference between the ugly and the beautiful?

The key is to keep nominal interest rates below the nominal growth rate in the economy, without printing so much money that they cause an inflationary spiral. The way to do that is to be printing money at the same time there is austerity and debt restructurings going on.

It’s interesting that he seems pretty satisfied with the process the US has taken so far, in the sense that we may avoid significant inflation or deflation.  The deleveraging process won’t be easy socially or economically, but it’s certainly preferable to a Japan-type scenario.  His opinion is interesting to me because so many other commentators are falling into the doomsday camp, although half are expecting Japan-style deflation and the other half are counting on Weimar-style inflation.

I suppose it is human nature to worry about the worst thing that can happen, but Mr. Dalio suggests a middle path might be the most realistic.

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