Month: June 2014

Stock market vs. Junk spreads

This chart comes via David Stockman’s blog:

Bond-YieldSpread-S&P500-061214-2

The chart plots the evolution of the S&P (blue) vs. Junk Bond Yields (red).  The S&P hasn’t seen a major correction for almost three years. I do not remember such a dull market environment – even in the 2004-07 period there were occasional shakeouts. Both markets are in “uncharted territory,” as they say.

I have written about how the stock market is linked with frothy credit markets via buybacks. I admit that buybacks really occupy my from a theoretical perspective (charts are nice, but I prefer to have a sound theory behind it). However, conventional theory is of no help  – the market is efficient and the buybacks vs. dividends decision is a function of tax rates. This is consistent with Eugene Fama’s view that the Fed’s policy has a negligible impact on the markets. In short, if you are an efficient market guy the above chart is merely noise.

As a value investor, however, I think that “Mr. Market” – one of Ben Graham’s favorite metaphors – is prone to over-and under valuations. Under such circumstances issuing debt to buy back stock at overvalued levels is a phenomenon that CAN occur and that CAN destroy value.

The view of the Austrian school is consistent with Graham’s view: it shows that in a world with non-constant money supply (M), money prices of capital goods (stocks and bonds) are distorted in such a way as to induce entrepreneurs to make errors in a systematic way (i.e. they do not cancel out). “Wrong” prices send wrong signals to market participants as to the future profitability of certain projects (think skyscrapers in Dubai, or bulk carriers). Sooner or later, the true economics of these investments will come to the fore and are classified as malinvestments. These malinvestments are value destructive for the economy.

In the same vein, falling bond yields and rising markets can signal management that it is more profitable to buy back stock on margin. After all, stocks are a very long-term asset (being a residual claim on the companies operating assets). It’s therefore no wonder that their attractiveness increases with falling long-term rates. Buying back stock is a long-term investment decision, akin to building a skyscraper or increasing spending on iron-ore capacities . In a world with steadily increasing M we should not be surprised to see all these phenomena happen at the same time…

On Eugene Fama and Fed QE

About one year ago, Professor Fama from Chicago caused quite a stir by stating that the impact of the Fed’s QE (or tapering) on the markets (and the economy) would be low and an exit from QE  possible in an orderly way. In other words, things (interest rates) would look pretty much the same with and without QE.  How did he arrive at this conclusion? Fama got his hands dirty by looking at the accounting impact QE has on the Fed’s balance sheet. The paper he wrote can be found here.

As Prof. Eugene Fama sums it up in this interview: the fed is merely exchanging assets with a low maturity (central bank reserves) with assets of a higher maturity (bonds) thereby affecting the relative interest rates between the curves – not the aggregate level! Fama comes to the stunning conclusion that short rates would even be lower without fed intervention, whereas long rates would be higher. Given the “high demand” for short them liquidity rates would go down, if the fed would not supply market participants with what they desire, whereas due to their selling of long-term bonds (the demand for money must come from somewhere), long-term bond yields would be higher if the Fed would not purchase them by issuing short-term assets (reserves). There is no free lunch: yes, the curve would be steeper, but the net effect on rates would be minuscule.

Three things spring out that I want to discuss in this post:

  • For Fama there seems not exist a fundamental difference between money and other (liquid) assets
  • Fama implicitly assumes a constant money supply
  • Only the steepness of the yield curve changes, but this does not matter

 From this interview an Austrian could conclude that Fama has no clue of monetary theory: money (monetary base) and money substitutes (deposits) have a feature that distinguishes them from other “highly liquid” assets (bonds): they can be used to make final payments, i.e. to extinguish debt, as Mises explained. If I buy bread at the bakery I can fulfill my obligation by paying him with base money (cash) or with deposits (card). If all I have are treasury bonds, I first have to SELL to somebody with money, to get money. Only then, the baker gets paid. Given this fundamental difference, you should be highly sceptical if somebody tells you that QE has no effect since it is merely shifting assets of different durations around.

Now, it is easy to see how Fama could come to this conclusion: it in good times when liquidity is ample this difference might not be perceived to matter. After all, bonds can easily be sold and turned into cash, so whats the difference?…”Let’s assume they are one and the same thing and make a regression analysis!”… just kidding. Market participants (not tenured professors apparently)  know that liquidity of an asset is relative:  good times usually do not last forever. In a crisis, for example, there IS a big difference between an asset and money. Heck, in a real crisis there is even a difference between money substitutes (deposits) and cold, hard cash, as many Cypriots have found not a long time ago. Summary: there is a fundamental difference and logic tells us it should matter.

Please also note, that Fama implicitly assumes a constant money supply, although we know – even by official sources – that this is not the case, not even desired. When he says that, without QE, interest rates would be lower at the short end and higher at the long end, therefore netting out somehow, he assumes that only what is sold (for money) can be used to buy things – which is true in a constant money supply world: if I want to buy more bread (thereby increasing its price at the margin), I have to spend less on other goods (driving down their price) – the aggregate effect (a dubious concept, anyway) should be negligible. However, in a world (such as ours), where the money supply grows, you can buy things without foregoing others. In other words, it is possible to sell your bonds to the fed thereby increasing the demand for money and lowering the short rates, without necessarily lowering the prices of the bond, as the supply of bonds is absorbed by an increased (base) money supply. Summary: with an expanding money supply there IS a free lunch for somebody. In times when economists really where theoreticians – and not merely statisticians – this was known as the “Cantillon-effect“. In our case the free lunch is enjoyed by banks and other bondholders: they can become more liquid (i.e. holding more reserves) without paying the price through lower prices on the bonds they are selling.

On the last point I partially agree with Fama: QE really does impact the slope of the yield curves. Contrary to Fama, however, I think this does have an impact. After all, if long-term and short-term assets can be interchanged without further consideration, we have to face the question of why yield curves, where different rates are quoted for different maturities, exist at all. For those familiar with “Austrian Business Cycle Theory” (ABCT) it will be no surprise when I state that the slope of the yield curve matters a lot to economic actors. Not just to carry traders, but to corporations in the “real economy” as well since they base their capital spending decisions on the price signals received from the yield curve. Summary: as expected, Fama is not familiar with ABCT. In best Chicago School tradition he assumes money neutrality, ignoring the lessons from the recent financial crisis.

I applaud Fama for his effort to tackle a real world problem. I do think that he tried to approach the problem in an objective, non-partisan way. Sadly, this is more than can be expected from most professors nowadays, who are either politically corrupt or who only write for other academics about irrelevant topics. Fama, however reveals a serious lack of knowledge of history of economic thought. In intellectually arrogant fashion,  typical for mainstream economists, he has tried to tackle the problem without even considering historical debates of similar problems.

China’s debt expansion put into context

China Credit Expansion

Chart: China’s debt growth compared to famous historic episodes preceding market crashes.

In a fractional reserve banking system, debt expansion usually means money supply growth, i.e. the classical definition of inflation. Note, that under the old definition of inflation it doesn’t matter whether you include or exclude asset prices from the basket of goods. Baskets are always arbitrary and subject to manipulation – see Argentina for a recent example. According to Austrian Business Cycle Theory, a rising money supply leads to malinvestment as manifested by a distorted capital structure in the economy. Malinvestment means there is to much of what is not needed by consumers and too little of what is needed.

China bulls probably would remark that china is different because it controls interest rates, capital flows, has many reserves etc. I do not know whether proponents of this theory realize that their view implies that there is no universal economic theory. Just as marxists differentiated between bourgeois and proletarian logic, thereby denying that political classes could understand each others viewpoint (“das Sein bestimmt das Bewusstsein”), a host of people seem to think different laws apply to china because it is run by chinese (in all likelyhood they are not familiar with the theory either).

Given the size of its economy, the unravelling of this house of cards will have tremendous global implications – not only economical. Our views of how states should be run, will similarly be impacted.

Mark Spitznagel and Nassim Taleb Talk Inequality

Mark Spitznagel has recently issued a book where he tries to use Böhm-Bawerk’s capital theory in order to explain his tail-hedging strategy. The book is somewhat lengthy and has some redundancies, but is a good introduction to Austrian Capital Theory and how it is different from mainstream economics concept of capital (as used by Piketty for example).

In this interview they talk about inequality (Spitznagel’s statements on Piketty are a good summary of an Austrian’s view of this book) and how it is caused by the Fed. By trying to avoid short-term pain (recession) the Fed eliminates failures which has two main negative side effects:

  • preventing recessions and failures and leads to less downward mobility of the rich and potential social tensions (“lack of fairness”)
  • comes at increasing unstability down the road (“myopic shortsightedness” of decision makers (Wall street, politicians) due to skewed incentives)

Spitznagel also mentions that Piketty failed to notice that, according to his own data, measured inequality was/is highest in 1929 – right before the great crash – and now, the two most notorious periods of the biggest monetary-induced asset bubbles in recorded history. Chance? While the verdict is still out on the current period and many observers think markets are generally not frothy, I definitely agree with Mark. After all, it has been declared policy of the Fed to raise asset prices in order to “kick-start” the economy (for mainstream economists the economy is best understood as a machine rather than as an organism). So if you really believe markets are not unnaturally high, it implies you think that the Fed has not accomplished its mission. In this case, you probably should also not bet on the Fed’s ability to exit its unusual monetary arrangements in an orderly fashion…

What Record chinese indebtness tells us

Stumbled upon this FT-article yesterday, according to which China’s corporations have more debt outstanding than America’s corporates (whose debt levels also happen to be at record levels, see chart below). It says, that from now until 2018 china’s corporates are expected to borrow USD 20 tn, i.e. more than the size of US gdp (around USD 16 tn.). It is not clear how much of it is due to increased lending and how much is due to refinancing, anyway the number seems high.

This figure just confirms that China has been the largest money printer around and in largely responsible for inflated prices (assets, commodities) globally. Of course this whole monetary expansion is only made possible by record low rates on the USD, the world’s  reserve currency. China’s corporates are mainly bank financed (even most of its corporate bond issuance is held by banks). In a fractional reserve system increasing bank lending usually means creating deposits (i.e. money).

Contrary to what many  think, debt issuance per se is not inflationary. If you buy a bond out of your savings (forgone purchasing power) it is a perfectly fine transaction and NOT inflationary as the money supply stays constant. The story is different, however, if a bank grants loans by lowering its reserve ratio thereby increasing (sight) deposits (by getting a loan your deposit account is credited with the sum). Deposits are money substitutes, i.e. increasing them, increases the money supply. The increased supply of money can then be used to buy assets, commodities or consumer goods, thereby affecting different price aggregates depending on who gets the money first and depending on what he/she intends to do with it. Watching the CPI when most money nowadays is created by the commercial banking system or central bank repo (lending against collateral, i.e. assets) will only get you so far. This is different to some famous past episodes: historically most hyperinflation were characterized by money printing in order to finance government employees directly (Weimar republic, Yugoslavia, Zimbabwe a.s.o.) whose preference was to spend it on (imported) consumer goods, first. In the Weimar republic the striking coal workers got paid straight out of the printing press. Of course, once the inflation culture had taken hold, people started investing in assets in order to conserve their purchasing power (Mises’s “crack-up boom” comes to mind). In former Yugoslavia people started building houses like crazy, right u untill the beginning of the civil war…

Al the major monetary blocks have been expanding their money supply for decades, lately they have been joined and surpassed by the lunatics from Beijing. We live in exiting times…

Chart: the indebtedness of US corporations is not exactly small either – at least if we use history to guide us…

CorporateDebtLevels

Disclosure: short AUD, short CNY

A Chart Says More Than a Thousand Words…

Post_Chart_tellsmorethanathousandwords

…we are clearly in uncharted territory when it comes to credit standards. I posted about the worrying credit market developments here.

Credit markets are a bit frothy,ok. But stocks? Some investors undoubtedly think, that the stock market is only moderately affected by these developments. However, stock prices are linked with the credit markets via buyback activity. Unless you are very confident of your market timing abilities….

 

 

Warrent Buffet on Independent Thinking

I have already written how I like the old Warren Buffet, with his independent and clear thoughts, more than the everybody’s-darling-guy he is now…

The following quote from one of his early partnership letters…

“(…)We derive no comfort because important people, vocal people, or great numbers of people agree with us. Nor do we derive comfort if they don’t. A public opinion poll is no substitute for thought. When we really sit with a smile on our face is when we run into a situation we can understand, where the facts are ascertainable and clear, and the course of action obvious. In that case – whether conventional or unconventional – whether others agree or disagree – we feel we are progressing in a conservative manner (…)”

…could easily serve as the introduction to some “independent thinkers’ manifesto”!

Follow-Up on my Negative Rates Post

The excellent Spontaneous Finance blog explains in technical terms why banks will not start lending due to negative rates from a micro-economic, i.e. bank perspective. For Austrians, general statements about the economy need to be funded on microeconomic insights (methodological individualism). Macroeconomic aggregates have no meaning, since individual actors cannot observe them and hence do not act on them. (Exceptions may be some financial market participants, other than value investors. But then again they usually do not produce things in the real economy, although they can certainly influence outcomes in the short run). In that respect this post sums it up nicely.

ECB Imposes Negative Interest Rate – And Why They Will Not Create Jobs

As you surely must have heard, last week the European Central Bank (ECB) lowered its benchmark interest rate from 25 basis points (bp) to 15 bp. and imposed negative rates for banks that hold cash with the ECB (mostly German banks). This measure is intended to kick-start lending in the periphery countries, where credit to SME and corporates is decreasing. With better credit availability, the ECB seems to think, growth will follow. It is often argued that credit is what is needed for young entrepreneurs and small businesses to get their ideas started. This is how these measures are sold to the gullible public. Needless to say,  none of this will have the desired effect, on the contrary it only unnecessarily delays necessary reforms by providing ever cheaper finance for the incompetent political class in europe.

Two years ago I had the opportunity to visit an italian subsidiary of a european bank. The subsidiary was in deep trouble, its previous management had expanded to quickly without proper risk management in place. As a result, it had mounting non-performing loans and losses. The decision was taken to work out the portfolio as quickly as possible and without making any new loans. The company had previously only employed sales-staff, whereas what was now needed were workout-specialists. As the headquarter found out, however, firing the old staff would have cost three annual salaries for every employee, thereby basically significantly lowering the “recovery value” of these operations. For instance, even in Austria, over-regulated, overtaxed and facing a serious pension problem itself, it would “only” have cost the equivalent of three monthly salaries, i.e. less than one tenth the cost in Italy. The bank reasoned, the only viable option was to retrain former sales staff into workout specialists. I wished them good luck…

It is easy to see why no one in his right mind would open a business under these conditions in Italy (or Spain or France for the matter where labour markets are similarly rigid). The rigid labour laws in italy kick-in once you employ more than seven employees. This is the main reason why company structures remain small and uncompetitive. The italian entrepreneurs try to overcome these obstacles by employing family members, as they are more unlikely to go to court over these matters. Contrary to what many think,  it is not their sense of family or whatever, no, it is often the only way to stay in business. Now, I do not know whether the law is still in place or not, but is easy to see how the lower ECB interest rate and the planned asset backed repo program will not induce entrepreneurs to expand under such conditions. The labour law has been the binding constraint forever, NOT credit availability.

But what about start-ups, don’t they need credit to start the business? Let them worry about the “seven employee problem” later, once they are established… This argument is often made by politicians in public discussions, and then always some (ex-post) successful entrepreneurs are quoted who mortgaged their parents’ house in order to start their businesses. While I generally admire such people, the unfortunate fact is that most of the time this gamble goes wrong. The reason? Young businesses need EQUITY NOT DEBT! Financing a start-up with debt is really bad corporate finance advice. After all, most businesses do not produce cash flow from the start, you must have the staying power to whither the first hard years. This is why silicon valley is heaven for equity investors but not for bank lending (unless they need an IB for the IPO).

The next thing the ECB doesn’t seem to understand is that european banks are themselves constrained by their risk weighted assets (RWA) and increasing regulatory requirements. As SME lending is mostly unsecured, they simply do not have enough equity to expand their loan book by lending to companies, for which they have to hold more costly equity, than if they buy their government’s bonds. No bank manager will go to prison because five years down the road his government maybe defaulted on its government bonds and a bank run ensues. But probably this is the ultimate goal of the ECB, to make sure cheap funding for incapable governments is still available for the (near future)…

Corporations Driving the Stock market: Stock Buy-Backs Reach USD 160 Billion in the First Quarter

In the first quarter of 2014 stock-buy backs have reached USD 160 bn. This marks the highest quarterly reading in this up-cycle (see chart below).  If buy-backs continue at this pace a new yearly record will be set some when around summer. Now, what do we make of these numbers? Bullish or bearish?

StockBuybacks

With net equity fund flows persistently negative, corporates have been the net buyer for many quarters in a row. Some observers, as  Martin Armstrong for instance, see this as a bullish sign from a technical perspective interpreting the weak mutual fund flows as a sign that the bulk of the investors has yet to jump on the stock bandwagon, ultimately driving stock prices up further. According to this logic, no rally is complete without the “retail-suckers” getting screwed. To Martin’s credit, his argument has solid empirical evidence backing it up and it is not easy to argue with.

Although I am not competent to give advice on technical matters (having missed a good part of the rally sitting on a large cash position for 14 months now), I still fail to understand how the retail investor is going to drive this market higher. With savings rates that low and a weak economy, where is  he/she going to take the money from? The rich already have plenty of shares and seem to get interested in more profane things…

Regardless, I want to focus on the fundamental implications instead. Contrary to what many seem to think, buy-backs are no panacea. They only make sense if the stock trades below its intrinsic value and no better investment opportunities are available. Buying back overvalued stock destroys shareholder value as you give up valuable cash (or you risk your credit rating in case the buyback is financed by debt) for something that is too expensive. Not all shareholders are getting harmed to the same degree, though: short-term shareholders, i.e. those that are willing to sell into the rise, benefit at the expense of long-term investors who ultimately are harmed by the wrong capital allocation decisions. (so you also get a nice long-term negative selection problem)

Now, none of this matters of course if you are in the mainstream financial economics camp: markets are efficient and there are no systematic over or under valuations. This view holds that either buy-backs don’t matter or that,  if they are treated differently than dividends from a tax perspective – as is the case in most jurisdictions, buy-backs might even be of some benefit (mostly tax-arbitrage).

While I am a big fan of supporting one’s opinion with theory, I do not subscribe to the above view. First, most financial models (such as the CAPM) are one-period models, completely neglecting multiperiod dynamics. They are therefore completely unsuited analyzing situations where decisions that are made now (such as issuing debt to buy back stock) are affecting my opportunity set and decisions in the future (i.e. I have to pay back the debt). These are only captured with math-heavy multiperiod models which need stronger assumptions (removing them further from reality) in order to be tractable. Second, principal agent considerations are implicitly neglected although managers, long-term stockholders as well as speculators rarely have the same utility function. Given that  corporate management decides whether to buy back or not and given that incentives MATTER, it makes sense to look closer at their motives. (CAPM assumes all agents have the same risk preferences and objectives, making it a non-subjectivist theory)

Although one would assume that managers know best whether their stock is under or overvalued, I have made the experience that the average board member knows about as much about valuing a company as your average grandmother. It has been well known that the majority of acquisitions destroy value, which in literature is usually explained by management’s desire for empire building or such phenomena as the winner’s curse (Buffett’s advice never to participate in auctions comes to mind). Managements, the research suggest, are prone to emotional overbidding rather than being cool calculators with a maximum price in mind. So far, so good. What is less well-known however is that management’s track record in buying back its own stock doesn’t look that great either, as the following chart demonstrates.

StockbuybacksvsEquity

The chart is somewhat outdated but given that buybacks, the market and debt issuance have continued to climb, the pattern has been more or less adhered to. We see that debt issuance AND buybacks have been at the highest at the prior market peak and lowest at market bottoms! With the benefit of hindsight, we know for sure that directors buyback decisions have been terrible over the most recent fully completed cycle. Further, regardless of whether you think that the market is currently overvalued or not, it cannot be denied that it would have been a much better decision to buy back stock in 2009/2010 than now. Yet at the bottom of the last crisis there were ZERO net equity buy-backs! If anything, they were net issuers in order to repair their balance sheets (including financials in the above chart would worsen the picture dramatically) Now, neither the winner’s curse nor empire building cannot account for that. If not, what can?

You will also notice from the chart that buy-backs at such a large-scale are a phenomenon of the past 15 years. Prior to that they were quite rare, directors preferring paying out dividends instead. It is no coincidence in my view, that over the same period the amount of CEO compensation tied to stock performance indicators (EPS, stock option grants…) has increased dramatically. By buying back stock CEOs can directly impact EPS and hence the stock price without changing the fundamentals of the company in a significant way – clearly the incentives are stacked in favor of buy-backs over (tedious) improvements in operating performance. Buying-back stocks makes you a Wall-Street darling, Manhattan dinners, booze and hookers. Do not think these things have disappeared, just because they brabble something about “ethical conduct” in their annual report. Building a new plant and negotiating with local majors and enviromentalists is clearly less of a thrill.

An efficient market’s believer might object, that it is the role of the debt holders (who usually provide the funding for buybacks) to instill discipline on managements, and that the monitoring at least in deep american markets should work properly. My concerns, therefore only apply to “backward” financial markets. Now, this view again overlooks two things. First there is a principal agent problem at the investor level as well, since most institutionals manage “other people’s money”. Second and related to my post two weeks ago: in a period characterized by low-interest rates and the corresponding “hunt for yield”, decision makers at all levels are prone to miscalculate the odds of investments in a systematic (albeit non scientifically quantifiable way) – even if properly incentivized!

Conclusion

Given the fact that buy-back activity as well as debt levels (see chart below) are at record highs and taking into account directors’ and lenders’ skewed incentives, coupled with their horrible track record, I think the buy-back data rather confirm  my overvaluation thesis. If I am correct, every quarte that passes destroys shareholder value on an aggregate basis increasing the probability of a nasty bear market and record debt defaults.

CorporateDebtLevels

Graph: Total as well as net corporate debt at all time highs.