Employment Triggers a Green Light for a Fed Rate Hike, but…

It’s still a slow growth environment. Inflation is low. Investors can expect continued performance dispersion.

Employment is off the table for the Fed

As mentioned in our earlier video blog the November employment gain of 211,000 combined with the upward revisions totaling 35,000 for September and October certainly took the employment issue off the table as a showstopper for a Fed Funds target rate hike this month. There are very few categories where the actual unemployment rate is above the 5.0% rate for the overall workforce: teenagers at 15.7%, blacks at 9.4%, Hispanics at 6.4%, those with less than a high school diploma at 6.9%, those with only a high school diploma at 5.4%, and I would highlight mining at 8.5% (versus 2.8% a year ago). I would posit that these levels are not the responsibility of the Federal Reserve to deal with. And, what is going on in the mining sector, which includes oil and gas extraction, may have added to the employment roles in other categories as lower energy prices increased both consumption and most companies’ (ex-energy’s) profit margins. The November beige book and the latest JOLTS report point to a tighter labor market with increased difficulty filling jobs and quit rates high, which point toward an increase in wage rates. The Fed does have to look at a tight labor market and make some judgments regarding this ultimate impact on inflation and the pace at which its 2% target is achieved.

So what about inflation?

The Fed’s preferred measure of inflation is the core personal consumption expenditure (PCE) index. That index is up only 1.3% year-over-year and was actually flat month-over-month in October. The general belief is that the US inflation rate may stay lower longer given the expected slow pace of global economic growth, the strong dollar and continued technological innovation. One cannot ignore the tragic events in Paris and San Bernardino as having an impact—on the margin, of patterns of consumer spending and, possibly, levels. This is likely to keep the Fed on a very slow path of target rate increases extending the runway for slow but steady real and nominal growth. I think this path will be followed until inflation actually picks up. I have some views on the timing of this, which I have been saving for this year’s Perspectives piece “What to Expect in 2016 (and Beyond),” but will provide a preview in a separate blog as a wild card to watch for.

And what about the markets?

In turn, these economic and financial results will likely produce slow growth–matching nominal GDP–in the US stock market if valuations stay close to current levels.

The fixed income markets, on the surface, could also appear somewhat benign with a moderate increase in overall rates. No doubt, the slower pace of growth will produce specific credit issues—certainly in energy, but likely some other entities—but credit overall, may hold up reasonably well. The credit markets, at the moment, would appear to be pricing a broader disaster, particularly in the high yield markets. I think we will see some specific disasters—credit issues, but decent credit analysis can eliminate or reduce the impact. An actively managed portfolio in high yield could be a logical allocation to a portfolio.

Odds are some of the longer term trends in currency, commodities, and relative market performance will continue for awhile with some bumps along the way when markets misread central bank actions or statements (à la Draghi) or geopolitical events cause temporary disruptions.

So, how should one invest?

In the table below, which looks at performance of the S&P500 over the last several years, an interesting pattern emerges:

WEB_S&P-Dispersion_Chart_640px-wide_120715When the market has been up or down double digits all one really had to do was either own or sell the whole market. However, when we have experienced single digit performance for the overall market, much as we are seeing this year, there has been significantly greater dispersion among stocks. This is an environment we expect to continue for some time—slow nominal growth in the economy and the equity markets, leading to dispersion of performance tied to active company management and active investment management. Why do we expect slow nominal growth to persist for several years making active management more important? There are at least four reasons (and I am sure some others):

  1. As Eric Peters of One River Asset Management recently reminded us, when the Fed takes action, which is typically designed to reduce the magnitude of an economic decline or surge, it has an effect on future patterns of growth. Easing pulls growth forward, while tightening pushes growth out, reducing the depth of the valleys and the height of the peaks and the distortions in employment and inflation those produce. We have been through an extraordinary pulling forward of future growth and it will take time for us to return to normal.
  2. The debt burden incurred by sovereign nations has been and continues to be enormous. If nothing else this will affect fiscal policy as the tool it could be to add to growth opportunities.
  3. China’s transition from a global engine for industrial production and consumption to a more internally focused services economy, combined with the reversal of its own extraordinary steps to offset the impact of the western world recession—just look at the production and pricing of hard commodities beginning in 2009—will be a damper on global growth for the foreseeable future. This bears watching to see how closely the yuan continues to track the dollar, or if its inclusion by the IMF as a reserve currency leads to a tracking of a basket of currencies and a different interest rate regime.
  4. Without putting too much weight on it, the “Buffett Rule”—future equity growth is problematic for a number of years when the total market value of equities exceeds the value of GDP—is operative. I discussed this anecdotally in a recent post.

In a slower growth environment the likely dispersion of equity returns would push one away from index-hugging strategies toward active managers both long only and long/short managers. We have been suggesting this for a while. We would include private equity allocations in the active long only category if immediate liquidity is less of a need and the attractiveness of a potential illiquidity premium in a lower growth environment is magnified. We have these more active managers in our stable of funds, but others do as well. The key message is to adjust allocations to include more of these active strategies in the portfolio as one looks at the environment ahead.

In the fixed income space, while there is risk of rate volatility affecting all debt classes, as big a risk would appear to be more specific credit issues. Does that mean one should be moving up the credit curve? I think the answer is in part, “yes.” But, the preferred way to do that would be similar to the approach on equities: Look for active managers—not benchmark huggers—who are analyzing specific credits and taking advantage of the homogenization of yields that comes from index buying and selling. The high yield index is offering a fairly significant yield spread over treasuries—very tempting as a category. But, just remember that around 18% of that index is in energy and hard commodity bonds. As shown below, the rest of the index, while at lower yields, is at spreads we haven’t seen for almost three and a half years. Historically, in a different energy regime, the rest of the index used to trade at higher spreads than oil and metals.WEB_Metals+Energy_HYIndex_Chart_640px-wide_thru093015_120715

At this stage, I would rather have someone looking at individual securities making up a diversified portfolio where the detailed analyses show relatively lower credit risks in the environment we foresee. Who knows? There may even be some energy credits that are worth holding but have been tarred by association. We see that in our own portfolios. There are certainly some credits in both high yield and investment grade where the credit default swaps don’t fully reflect the degree of risk at this stage. I want managers who are running portfolios where they can tell me the precise nature of the balance sheets of their individual holdings and the risks associated with the businesses. This is different from what has been required previously.

One should not ignore the uncorrelated strategies, particularly systematic trend following. There are some long-term trends in place. While there are likely to be occasional reversals—some of which could turn into more permanent moves, I would rather use these managers to recognize the patterns and determine which foreign exchange, commodity, equity and fixed income indices should be included, negatively or positively, in the portfolio at any given moment in time given the environment we are facing.

Allocations need to change

It is hard to determine in isolation what the allocations in a specific portfolio should be. That requires a discussion. I know the allocations to active strategies should be higher. As I have been saying, past performance may not be the best guide for the future as opposed to a realization of a different pattern of future returns and an understanding of the volatilities and risks that exist in the environment we foresee. It is a less easy environment, with lower overall returns, but possibly a broader set of opportunities to meet one’s specific goals.


STA Money Hour—The Economy, The Markets, Oil, and Investing

A week ago I was in Houston for a presentation and was able to spend an hour with Mike Smith and Luke Patterson on their radio program, which provides some very good financial insights to the local listening audience. I had just come out of a presentation so was loaded with information, which they proceeded to extract from me in a useful fashion for their audience.  We discussed some history of the markets, Harry Markowitz, the current outlook, and of course, being in Texas, the energy situation.  It was an interesting session with some great questions. You will have to listen to check out the quality of the answers. It is worth visiting their archives. They have had some interesting guests who have covered a wide variety of topics. I would recommend visiting their website and view some of the archives.

Part 1:


Part 2:

Modern Portfolio Theory Today

University of California, San Diego (UCSD) held a wonderful event October 16, celebrating the 25th anniversary of Dr. Harry Markowitz Nobel Prize in Economics for his seminal and lasting work on Modern Portfolio Theory. Among other activities, Dr. Markowitz still teaches at the University. And now, there will be an endowed Chair in his honor. If one looks at the body of work produced by Markowitz one could see other areas of research that would qualify for a Nobel. There have been many other awards in adjacent fields for his work. Needless to say, in spite of a changed world since his 1952 paper in the Journal of Finance, Modern Portfolio Theory remains at the core of investment activity today. And if one reads carefully through Dr. Markowitz’ papers, the kernels relating to almost all perceived advances and variations on MPT were anticipated and articulated in his work.  I was fortunate enough to be an attendee and a speaker at the event. I emphasize the attendee part as there were many major contributors to our industry in attendance. The opportunity to speak with many of them at what was a truly celebratory event, was worth the effort in preparing a ten-minute talk for such an intimidating audience. And, in this case I am not referring to the overflow crowd, but simply having Dr. Markowitz sitting there. It felt a bit like one’s orals as a final step toward getting that advanced degree. As one also knows, to paraphrase Winston Churchill, it takes hours to prepare a ten minute talk and ten minutes to prepare an hour talk.

Below are the prepared remarks for the event. A little history does provide a perspective.


Modern Portfolio Theory Today

It is an honor to be here this evening. I am not sure why I am up here. I am just a practitioner, not a researcher or an academic. I apply what has been developed. It just so happens, Modern Portfolio Theory (MPT) is and has been a key application. To talk about MPT today one does have to go back to the beginning to put into context what the state of the art was at that time and then discuss the context in which MPT is applied today. In 1952, when then, just plain 25-year-old Harry Markowitz published his paper in the Journal of Finance, the average daily volume on the exchanges was 1.9 million shares. Trading took place 6 days a week. The total market value, including what traded in the Over the Counter markets was about $181 Billion or about half of the reported GDP for that year at $368 Billion. A positive ratio, Warren Buffett would say. Over the next 10 years the equity markets more than doubled.  The average mutual fund holding period was about 9 years and stayed that way until the end of the 60’s.

When I first came to Wall Street as an analyst in 1968, the average daily volume was a little under 13 million shares with a couple of peak days around 21 million. The total market value of traded stocks including the OTC markets was a little over $1 trillion or slightly more than the GDP of $942 Billion. BTW, with some volatility the market ended a decade later at about the same level—actually 2% lower.  The trading took place for fewer than 5 days a week as the exchanges had to shut down for full days and occasional half days to process the trades. Help was on the way though, courtesy of Fairchild, Texas Instruments and Intel with the development of the integrated circuit and the microchip. Intel was actually founded in 1968, the same year I came into the business. Moore’s Law was in full swing by that time—processing speeds doubling every two years. So, doubling every two years, processing speeds today are about 8.4 million times faster than they were then. Yes, 8.4 million. And one does not have to put each line of code on an IBM punch card. This does lead to the ability to create some extraordinary very short-term algorithms around which to trade, based on an assumption that speed leads to greater certainty. I call it Rivkin’s Law. “The perceived utility (value) of information is inversely proportional to the time it takes to get it.” Notice, I say “perceived utility,”—not necessarily actual value. Not as punchy as Moore’s Law—just an observation on the big data phenomenon.

Bringing us into the present, the daily trading volume for all of the exchanges last Friday, October 9, was 6.8 Billion shares–520 times the volume in 1968.   The total market value of all equity securities is north of $21 Trillion vs. a GDP of $17.9 trillion—and we are only talking about the US. That ratio reminds a bit of 1968.  And, by the way, the average mutual fund holding period is down to less than 9 months. That says nothing about the average holding period away from the mutual funds. With the daily notional value of securities traded on the exchanges of around $250 Billion, the average holding period for all securities including the mutual funds is around 4 months. That means the average holding period away from the funds is about a day.  The ability to process the data, combined with the perceived reduction in transaction costs—notice I used the term “perceived,” once again–has led to different time frames to determine co-variance, the value of diversification, expected returns, and the likely variability of those returns. There is more information available to those making investment decisions—certainly more information that originally required human beings to develop and deliver in idiosyncratic and asymmetric ways. And the stability of all those variables comes into question, certainly over varying time frames and the correlations change as well.

In addition, particularly if we are talking about applying Modern Portfolio Theory today, I believe we are entering into an environment where even if one is actually making investments as opposed to trades, past performance may not be indicative of future results, particularly if one is relying on historical returns and risk measurements. “Past Performance is not Indicative of Future Results.” That wonderful statement that one finds on the bottom of almost every investment report. Although, this time I think it may be true. Much as it was true, beginning in the 1980’s when we moved from a long period of rising inflation and an accelerated move toward a service economy and a different mix of winners and losers compared to what we have, for the most part, experienced for the last 35 years—a very different regime. I was around in 1981, after living through more than a decade of flat returns for the overall market, when the Fed Funds rate peaked at 21.36%. Modern Portfolio Theory was being practiced at that time by a reasonable number of serious investors. Although, it unfortunately took the awarding of the Nobel Prize in 1990 before the general institutional investing public truly began putting those three words together. And, by the way, the average daily trading volume that year was 159 million shares, the market value of all US traded stocks was $3.4 Trillion, and the GDP was $5.6 Trillion.  The equity markets were up 4 ½ times in the subsequent decade.

This 30+–year period, since the peak in rates in the early ‘80’s, has been a very fortunate time to be involved in the investment business. A tail wind of generally falling interest rates, combined with a global economy changing dramatically, Moore’s Law at work, technological innovation, and global trade arbitrage of labor and capital, have benefited both the equity and the fixed income markets. We are coming to the other side of that trade. And to a time where one needs to heed the words of Dr. Markowitz from that first publication, “…of combining statistical techniques and the judgment of practical men” (and women—my add). And,  “…statistical computations should be used to arrive at a tentative set of expected returns and risks. Judgment should then be used in increasing or decreasing some of these [expectations] on the basis of factors or nuances not taken into account by the formal computations.”

I think we are entering another one of those periods where the judgments—the formation of relevant beliefs on the basis of observation–become more important, particularly at this stage of the transition. I have spent most of my investment life attempting to find those relevant beliefs and most active managers, away from those of us involved in allocations among asset classes, still continue that search. The element of risk as it relates to return remains an important part of that search.  Ultimately though, it all goes back to Modern Portfolio Theory, the Efficient Frontier and the portfolio optimization that comes from the direct application of the principles laid down by Dr. Markowitz and the Markowitz Model. Others have added bells and whistles–including the two Nobel winners who shared the economic prize in 1990. Others have pointed out additional considerations such as transaction costs and liquidity—important considerations—but all were already highlighted if one reads carefully through the papers of Dr. Markowitz. Those papers show a much broader set of contributions that include the application of MPT well beyond the traded securities investment industry, and other rational and Hume-like major intuitive observations and innovations in systems applications.

The investment industry specifically, but any other entity or activity that has to make some judgments about portfolio returns relative to the risks that may be incurred, must draw off of the principles developed by Dr. Markowitz. It is such an honor to be present on this occasion, much less a participant. Thank you, Harry Markowitz.  Thank you for this opportunity to share a few thoughts, and thank you all for joining in this celebration. As I said to my investment associates—a number of whom I see here this evening, if you haven’t had the opportunity before, being in the room with Harry Markowitz is one of those bucket list items for any investment professional. Pay attention and do take advantage of this opportunity. Thank you.