Thursday, December 30, 2010

Has the Stock Market Gotten Riskier? - Investing - Stocks -

Why are retail investors leaving equities amid strong returns and strong corporate profitability? 

This is a terrific article about the reasons that the stock market should be stalling.  In short, the market has become more volatile, which, in portfolio theory, means that it involves more risk and therefore require a higher risk premium.

The article suggests that valuation shouldn’t be the source of the problem, given that investors were willing to pay more in 2007 for assets that had a lower earnings yield.

Instead, it suggests that the sharp increase in the number of large movement days, up or down, that have occurred in the last 25, 15 and 10 years (2/3rds of extreme price movements since 1950 have been crammed into the last 15 years), has changed investors perspective on the “riskiness” of the market.

Portfolio theory says that assets are priced relative to each other, and that an investor begins with a “Risk-free” rate, one where the exact prices and returns are calculable with 100% knowledge, e.g. a Treasury bill.  Riskier assets should require a higher risk premium to compensate the investor for taking on the additional risk.

Risk is considered to be the volatility around an expected return.  If a Risk Free investment guarantees me 2% (no volatility – I will get my expected return, because the US government WILL make the payments it has promised, when it has promised them), then to hold a riskier asset, one where I could lose money (one possible return outcome is negative) I must be able to have a reasonable expectation of finishing well above 2%.  How much exactly is known as the “risk premium”.

Stock prices have risen as the risk free rate has collapsed to near zero – increasing the premium offered by risk assets.  (The risk premium is calculated by taking the expected return of the risk assets minus the risk free rate,  E(r)[Risk Asset] – R(f) rate.  If E(r) remains constant and R(f) gets smaller the spread will increase).

If the original premium is correct, then prices of the risky asset should rise reducing expected returns on the risky asset to the point where expected returns maintain the same risk premium. 

However, if volatility in stock prices rises, the greater risk suggests that the equity risk premium should rise, and therefore, lowering the risk free rate will not raise equity prices as much as would be expected.  In fact, if the risk free rate is perceived to be heavily manipulated, such as by extensive central bank intervention (QE2, anyone), then it may not be perceived as the true “risk free” rate.

The article suggests that retail stock investors may be catching on to this, since, in spite of the strong equity returns since March 2009, investors have yanked over $100 bn out of equity mutual funds (that has to putting hurt into someone’s management fees … wealth managers be warned).  The article notes, rightly that dividend yields (which reduce the volatility of returns by adding a regular payment that is not subject to market pricing) have collapsed from 5% to 2% over the same time period (that is, since 1950).

I think the writer underestimates the significance of the lowered expectations of returns.  For years, investors were fed a steady diet of the idea that 1) equity premia were too high, 2) that the stock market experienced a geometric growth average of around 10% – at least since 1926, and 3) that over the “long term”, the market goes up.  Thus, what financial “professionals” were selling to retail investors was something like a turbo-charged savings account.  In exchange for “temporary” losses, an investor – really a saver – could earn a high return on their savings.  Wealth building 11% returns were to be expected.

Of course, it hasn’t turned out that way.  Geometric returns since 1926 have fallen, as stocks have moved sideways for 10 years, earning only the dividend yield.  Americans shouldn’t feel too bad – if you invested in Japanese equities anytime since the early 1980s and have held, you have experienced negative returns, money invested in 1989 is still underwater by 70%.

But here is the thing – portfolio theory says that given a specific level of volatility an appropriate risk premium can be determined.  I think that the risk premium is also a factor of expected returns.  11% returns, when compounded over decades, produce very positive financial outcomes.  Lower that amount, to 8% or in my opinion a more realistic 6%, and all of a sudden, dreams of big houses, vacation homes and a boat begin to look less like sure things, and purchasing equities with savings begins to look like a risky way to pay for healthcare and food in retirement – you know, the stuff our parents and grandparents purchase.

Suddenly, the stock market doesn’t look like the best place to put one’s savings.  And so, the retail investor wants to put more money into lower volatility assets, to be sure to have something left with which to purchase necessities.  It may require increasing the amount one saves from earnings dramatically.

The article’s author does suggest a good additional approach – create an asset of your own by starting a business.  As he notes, most of the inputs are inexpensive right now, and with few attractive options to invest your money in portfolio assets, a business may be the best wealth builder yet.

Here is the link.

Has the Stock Market Gotten Riskier? - Investing - Stocks -

Friday, December 10, 2010

The US Midterm's Unwritten Story

2010 was a generational election.

Immense amounts of ink have been spilled talking about the Tea Party and the causes of the Republican victory - economic distress, Democratic legislative priorities, poor "communication" of initiatives, lack of youth voters, and the like. What you haven't heard about is a changing of the guard, generationally. This will have profound implications for politics and the economy (and macro investment factors) for the next several electoral cycles.

America has at times had major elections which have seen a change in the age of its officials. We tend to notice this more directly when presidential generations change, such as in 1960 or 1992. But Congressional elections have also been subject to generational change, and with it a change in the political tenor of the country.

The Generational Divide

Many people would argue that the boom runs until 1964, when the US Census declared an end to the (demographic) Baby Boom. But researchers Strauss and Howe have made a compelling case that the Boomer psychographic ended at 1961, and that those born after are actually part of a different generation, too young to remember the Kennedy administration or his assassination, and too young to have participated in the counterculture movements of the late 1960s (either affirmatively or in awestruck horror).

Thus, those born after 1960 are part of the famous, and maligned "Generation X". Barack Obama is part of this generation, which has different attitudes towards political warfare: less ruthless and much less committed to destruction of one's enemies. Instinctively, younger voters understood when Obama talked about "change" in politics and about a "post-partisan" climate, that he meant that he was not going to continue fighting Boomer culture wars, he was not going to try and remake the country in his own image, and he wasn't committed to the utter destruction of his opponents.

In short, he wasn't going to engage in the shrill histrionics of Rush Limbaugh or Keith Olbermann: classic Boomers. Instead, he was going to be analytical, thoughtful, reasoned and practical, all classic Xer traits. A welcome change, quite frankly. The one commentator to pick up on this was E.J. Dionne, who noted that Obama's campaign was "waging a subtle fight against a generation - my generation, the Baby Boomers".

The brilliance of the subtle campaign was that most Boomers didn't recognize it. Boomer journalists, too self-focused, and still seeing themselves as the drivers of American culture, and perhaps terrified of the implications for their own longevity, failed to cover it. Thus, many Boomers on the left voted for him, thinking that he endorsed their ends and means, and rejected the symbol of their own generation, Hillary Clinton, who both loved engaging in the politics of personal destruction and who was a classic culture warrior. In fact, much of the anti-Hillary vitriol was aimed at preventing her from becoming a symbol of the cultural change her own generation wrought.

Thus, it is no suprise that much of the frustration with Barack Obama on the Left (or as his own Press Secretary said "the Professional Left") is that he doesn't share Boomer attitudes towards political methods and means, even as he espouses fairly leftist policy. Obama's actual policies and policy priorities were a liberal wish list, and yet the Left is totally frustrated, even as Obama has delivered for them. What he seems to lack is the passionate hatred for people who disagree with him, and the Boomer Left, which controls much of the official political media, see the lack of hatred as weakness, even a betrayal of the cause.

The 2010 Election

If the 2008 election saw the Boomers lose the executive branch, 2010 saw a sharp rise in the number of nationally elected officials born after 1960, particularly in the House.

Entering the election, Boomers controlled most Governors mansions, had a narrow majority of Senate seats (though the Silent Generation held most of the committee chairs), and a solid lead in the House, with the other two generations, Silent and Xer approximately equal in size.

As the nearby chart shows, the Silent generation, which has held political power out of all proportion to its size, suffered major setbacks in Congress, losing 1/6th of its House seats and 8 Senate seats, out of 15 it was defending. Just wait as the next 2 electoral cycles see 20 more members up for reelection: I predict that they will lose more than 60% of those seats.

The Boomers fared better, losing a few governorships and actually gaining Senate seats from the Silent, but Xers made gains across the board, governorships, Senate seats, and big gains in the House, putting them well ahead of the Silent there.

Three additional facts are worth noting:

First, is that the Boomers lost share of offices. The generational research done by Strauss and Howe generational power waxes, then wanes, but once it begins waning, it does not wax again. This suggests that Boomer shares of all three institutions will likely decline in each election going forward. The 2010 election signifies that the high-water mark for Boomer power has passed.

Second, the House usually has the lowest average age of all three institutions, and is therefore the first place that a new generation gains power. While the Xers do not yet have a majority, it is reasonable to believe that they will continue to gain seats in all three areas in each of the next several electoral cycles. Much of this will come at the expense of Silent generationl lawmakers getting very long in the tooth, but as the House races show, it will also come at the expense of Boomers.

Third, while Xers will increase their share of government offices, Boomers may get one more crack at the Oval Office. Governorships are still largely in Boomer hands, which means that despite calls for Xers like Chris Christie and Bobby Jindal to run in 2012, Obama will likely face a Boomer challenger in the general election, and possibly in his primary.

Nevertheless, Generation X is now entering midlife and as the Boomer slide into dotage we will increasingly be confronted with Xer America. It has different outlooks, and different politics, and different economics. It will fall to this generation to decide how to confront America's most pressing problems, and their solutions will have big implications for all of us, not least in our investment strategies.

In future posts, we will examine the quintessential Xer political movement, the Tea Party and will also look at how probable Xer policy will affect the macro environment.