The Great Unknown

"We are now ready to start on our way down the great unknown. Our boats...are chaffing each other, as they are tossed by the fretful river.  We have but a month's rations remaining.  We are three quarters of a mile in the depths of the earth, and the great river shrinks into insignificance, as it dashes its angry waves against the walls and cliffs that rise to the world above; they are but puny ripples, and we but pygmies, running up and down the sands, or lost among the boulders. We have an unknown distance yet to run; an unknown river yet to explore.  What falls there are, we know not; what rocks beset the channel, we know not; what walls rise over the river,we know not." -   John Wesley Powell explorer 1834 - 1902

As humans we are constantly striving to uncover the hidden secrets of the universe.  Centuries have been dedicated just to answer questions such as what is the purpose of life, are there other civilizations out there and who am I?  There may never be an answer to any of these but it does not stop the human mind from questioning and probing.  So too in the world of finance people have for centuries tried to develop systems that take advantage of perceived market anomalies or try to remove the risk from investments through diversification.  Medicine too is constantly trying to extend our lifespan with new wonder drugs and treatments but in all of these one thing is very seldom considered - the great unknown.

Let's start with medicine.  Clinical studies are a very poor way to determine whether a drug is right for the final patient.  No two people are the same and no two people have the same diet or drug intake, all of which will have unintended effects for the taker of the drug.  Furthermore the methodology used drives the cost of the drugs to such heights that often the people most needing the drug are not able to afford them.  Finally, the testing process is short (and often riddled with one sided data) while sometimes the prescription period can be decades leading the patients into the great unknown as far as side effects and impacts on their health is concerned.

In finance it is the same.  Legions of "trained" financial experts continue to develop the next new product that will satisfy the masses required rates of return while limiting risk, providing a one stop shop where the lemmings can deposit their money and walk into the sunset and off the side of a cliff.  "Fortunately" the investment bankers are protected by the laws set up to protect the innocent and as long as they disclose properly (normally in such small font that the majority of people cannot read it and certainly way to complex to understand) and charge low fees they can advertise that they have the solution to everyone's investment problems!  Once again the problem is that these tools are not tested on real data but on past data (data mining or back testing it is called) that is easily manipulated and does not reflect reality or the great unknown.

In either of these examples the first thing to understand is that the great unknown will always be unknown.  There is no way to uncover its secrets.  Furthermore secrets that are uncovered reveal that there are more unknowns.  So worrying about the unknown is a waste of time, what your focus needs to be on is how to benefit from the unknown.  This is not an easy question to answer as how can you benefit from something that is unknown?

As this is a financial blog I will respond to this question by remaining in the world of finance but the answers can be transposed into any area that you like.  In finance the thing to realize is that there is no such thing as normal.  A "normal" return is absurd as the market is constantly changing.  Take for example interest rates.  Right now the "normal" risk free rate might be considered 2% but in the context of 100 years 4% might be a better proxy for normal but then again what do the first 50 years of the century have to do with me and was that period, which included world war one and two "normal"?  Looking back just 20 years and the Internet was in its infancy so why was that "normal"?  So if a normal rate of return is ludicrous then what you have to determine is your required rate of return and forget about everything else as it is just noise.

The next thing to understand is that the unknown will, at some stage, create havoc in the markets.  This is not an "if" but a "when".  Consider all the financial tinkering done by the world's central bankers and it quickly is clear that there will be a problem sooner or later it is just a matter of time.  Also believing that the central bankers of the world have the ability to avert the problem is naive at best.  In reality they are the biggest part of the problem as the more that they try to "protect" the more harm is done in the unintended side effect of the unknown.  In other words, the more they try to smooth out volatility the greater the volatility will be once it reappears.

So the key is to invest in a way that not only produces your required rate of return but benefits from the fragility of the financial situation.  As Taleb coined "Antifragile".  There are simple ways to start the process for example try to be debt free or even better keep some cash aside to buy when the markets crater again.  More creative is to purchase put options on positions with perceived large downside in weak markets or distressed debt on properties in solid economic hubs at pennies on the dollar to mention a few.  There are many more ways to benefit from the unknown but the investment style, risk and expected return need to be a good fit for the investor.  One thing is for sure; to ignore the great unknown is akin to financial suicide so make sure you review your investments in light of this outlier and rework it so that you benefit as that will be an abnormal return!

An Island

"No man is an island, entire of itself; every man is a piece of the continent, a part of the main. If a clod be washed away by the sea, Europe is the less, as well as if a promontory were, as well as if a manor of thy friend's or of thine own were: any man's death diminishes me, because I am involved in mankind, and therefore never send to know for whom the bells tolls; it tolls for thee." - John Donne poem For Whom the Bells Toll

As the poem above illustrates, no man is an island.  I would also go on to say that no portfolio is an island and no country is an island.  For as much as we believe that we are insulated from global affairs and that we can hid from economic disasters unfortunately the reality is that we are very closely linked to events and affairs in remote parts of the world.  So when planning an investment strategy you need to take into account not only the investment's return and risk but also how it fits into the overall portfolio and then how that portfolio will withstand shocks from the outside world.  Talk about difficult!

Let's start with what I will term the "direct" influences on the portfolio; for example a company in which you have an investment has good earnings and the stock rises.  The impact on the investment is directly related to that investment.  These impacts give the investor the sense that their portfolio is an island that is only affected by direct influences.  Under these pretenses an investor would be forgiven for thinking that a portfolio where the investments show a certain lack of correlation is well diversified and therefore protected.  However looking at "indirect" influences might shed an entirely new light on the picture.

"Indirect" influences are varied and can be as remote as an earthquake in China to close to home such as losing your job.  When putting an investment portfolio together these "indirect" influences can actually be far more important than the "direct" influences in that they make up a larger portion of the portfolio and can have a magnified impact on the overall return.

Taking the close to home influences first a lot of investors make allocations based on what is perceived as a "normal" investment strategy and use a mix of stocks and bonds with little consideration even for these "indirect" influences.  The allocations are normally based on age and do not incorporate other "indirect" influences which is a mistake as leaving these off the table can destroy a portfolio quickly.  Some of the main "indirect" influences not considered are human capital, riskier employment and riskier home ownership.  Unfortunately this blog does not have the time to delve into each of these now (but I may in subsequent blog posts) but these "indirect" inputs often make up the bulk of the investment portfolio and are not considered.  Allocations into areas related to these inputs magnifies the impact of these thereby undermining the overall portfolio's resilience.  Furthermore allocations into higher risk areas when the "indirect" influences are already high in risk adds significantly to the overall risk of the portfolio and should be shunned for a more conservative approach.

Looking further afield complicates the investment process further.  In reality the idea that these influences can be predicted is asinine but with the global economy so highly integrated a general understanding and consideration of these "indirect" influences needs to be assessed during regular financial check ups.  While no-one has knowledge of what the next Black Swan will entail performing some kind of stress test on the portfolio would be helpful but unfortunately most stress tests do a poor job and often are not even considered let alone performed.  To me this is a big mistake and can expose a portfolio to unnecessary risks as, when the expected protection from diversification is most needed, it tends to evaporate.

In conclusion then your investment portfolio is anything but an island so ensure that you review carefully the impact of the "indirect" influences on your portfolio as these will have the largest influence on the overall returns of the portfolio.  Shunning an analysis of there will expose you to risks that will undo even the most carefully diversified portfolio.

Risk Free?

"The biggest risk is not taking any risk.  In a world that is changing really quickly, the only strategy that is guaranteed to fail is not taking any risks." - Mark Zuckerberg

If you had taken a wander into the deepest darkest jungles of Brazil for the past seven months and had suddenly emerged it would appear on the surface that nothing had changed in the world of finance.  The rate on the 10-year Treasury was roughly the same as it was at the beginning of the year, the stock market has essentially not budged and looking abroad it is much the same picture on the international scene (other than the Chinese stock market).  You would be forgiven for thinking that everything was moving along in a slow and steady march to prosperity but what the surface reflects is not the case behind the scenes.

Take the German and the US 10 year bonds.  These assets are considered by the financial world to be the two investments considered to be as safe and as risk free as is possible.  The perception is that there is limited to no chance that an investment into either of these assets will ever result in a loss of principle.  The investment therefore is considered risk free.  Tied to this investment is a rate of return or yield and this yield is considered to be the risk free rate.  Any investment made outside of these investments other that shorter or longer termed investments into these government bonds is expected to return something in addition to the risk free rate.  The term for the return in excess of the risk free rate is the risk premium and the risk premium should coincide with the risk of the investment.

As an example if you invest in a high quality corporate bond the risk of default may be low but it will still be more than the government debt so it should yield slightly more.  As you move out on the risk scale to say private equity, the risk of loss increases considerably but so too should the expected payout therefore, the expected return on the investment should be substantially above that of the government bond.  All other investments fall somewhere along the spectrum of risk and return and all are measured against the baseline of the risk free investment.

So one would then consider that the risk free investment, being risk free, should remain relatively stable.  Considering that the central bankers of the world do not adjust the interest rate on the underlying bonds often, the only thing that adjusts the yield on these bonds is the secondary market which trades these bonds after they have been issued.  It is the forces of supply and demand in the secondary market that determine the current yield on the investment and these forces are influenced by the expectations of the market itself.  Even so the market should be relatively comfortable with the security of the investments so they should remain relatively stable with some minor movement here and there.

Looking at the yields on these two assets year to date shows huge fluctuations in the yield of these assets.  The German Bund has gone from a yield of 0.80% at the beginning of the year to a yield of zero before rocketing back to 1.00% and then falling back to its current position of 0.80%.  The 10-year Treasury cratered from 2.20% at the beginning of the year to 1.63% before bouncing around and then jumping up to 2.45% and then gradually coming back to around the 2.20% mark again.  While to the outsider these moves may seem small but percent wise these are enormous moves and throw into question just how safe are these investments?

Now I am not considering for a moment that these investments will not be repaid, they will and so they are safe but what I am pointing out is that the world of investments at present is anything but safe.  There are considerable undercurrents that are bubbling below the surface, the majority of which are being created by the massive "stimulus" policies of the central bankers and this is what is causing the massive swings in a normally complacent market.  Think of it in terms of global warming, as the world heats up there are more and larger environmental consequences beyond the control of humans, the same is happening in the world of investments; as the pot of money sloshing around the financial markets increases daily by billions of dollars in the biggest monetary expansion experiment known to man, so the risks to the financial systems around the world increase exponentially.

In this ever changing world make sure that you keep a close eye on the gyrations in yields in these markets as until they settle down it is clear that there is a lot of risk that is being hidden below the surface.

A Bubble Bursts - Oh Well

"If you must play, decide on three things at the start; the rules of the game, the stakes and the quitting time." - Chinese proverb

"Please God, just one more bubble." - Bumper sticker in Silicon Valley 2003

Since the June 13, 2015 peak of 5,166 the Chinese stock market plunged to 3,507 on July 7 before staging a moderate recovery.  The loss of 1,659 points or more than 30% has all the signs of a bubble bursting.  Certainly at their peak Chinese stocks were far too richly valued with the average price to earnings ratio at 64.  To give you a metric for comparison, U.S. stocks normally trade with a P/E of 15 and are thought to be extremely overvalued when they reach 25.  So there was no doubt that the Chinese market was in bubble territory and I would expect that it has far further to fall as even today the average P/E for Chinese stocks is above 40 and their stock market is still up over 20% year to date and up almost 100% over the last twelve months.

This sudden plunge spooked international markets and combined with the Greek issues and the possibility of an interest rate rise it appears that the market in the United States is ready to follow suite, but while the two external shocks are bad for the locals I have little reason to believe that these events will undermine the US economic recovery.  First the fallout in Chinese stocks seems to be a local affair with the small investor taking the brunt of the fall.  Second the Greek issues are largely contained as most of the debt, assuming it is written off, sits in the central bankers coffers rather than individual banks.  Third the chances of contagion occurring throughout the Euro zone are limited as the poorer performing nations are expected to remain in the Euro and may even get their houses in order quicker once they witness the fall out effects of a Greek exit.

So while the markets here are gyrating wildly these events are not the black swan that people are waiting for (remember that a black swan event is something completely unknown so by its very nature these events cannot be black swans).  The short term results are more than likely a longer period of low interest rates and potentially a resumption of the secular gold bull market.  The Federal Reserve is under no pretenses that the global economy is weak and has been further weakened with these events.  Furthermore raising the interest rates now, as I have repeatedly blogged, would strengthen the dollar and weaken the tepid recovery in the United States right when it appears that there is finally some decent economic traction.

Whether the market recovers and shoots to new highs is any ones guess but to me a decent bet would be to buy into some of the gold mining stocks.  They have really been battered over the past few years and if the Chinese move their money from the stock market into the gold market, as is being promoted in China, it would not take a lot to tip the scales back into the gold bull camp and this would be magnified in the down trodden gold stocks.

Good Greekf!

"Good grief." - Charlie Brown

No the heading is not a typo but a poor play on words as it seems to me that there is a very lackadaisical attitude towards the Greek debt issue.  Not only does it seem that the world's leaders and markets have assumed that Greece will remain in the Euro they have also assumed that the debt will be repaid!  Less than a year ago Greek debt was yielding less than 6% and today with default imminent it is only at 14%, hardly a big number considering the risks of default.

If I look at the situation from a turnaround and restructuring perspective it appears to me that the Greeks have nowhere to turn other than to leave the Euro and default on all of their debt.  Sure they have the ability to recover but they need the ability to let their currency devalue steeply to achieve the necessary stimulus that lower prices will have on tourism and exports.

While some may argue with me that leaving the Euro would be suicide I would point out that adding new debt to an already over burdensome debt level definitely will not sort out the problem.  Reducing the debt to a manageable amount would raise the heckles of Portugal, Spain and Italy so this is virtually off the table; so all that remains if they stay in the Euro is to lend them more money essentially kicking the can once again down the road.  This is exactly what happened last time this crisis was here and all it did was delay the inevitable for two years.

Even a moratorium on all debt and interest payments for say 5 years would still not provide enough runway to repair all of the structural problems that Greece faces and I question whether their current leader is mature enough to handle such changes.  In fact until these structural changes are implemented even leaving the Euro would not solve their problems in the long run but it seems to me to be a far higher probability than the markets are expecting.

So if the markets are not pricing a Greek exit from the Euro and it happens then there will be bloodshed in the markets next week for the simple reason that it would be an unexpected outcome.  To me it should not come as a surprise however the depth of the market correction will be unknown.

I would like to wish all of my America colleagues, friends and readers a very happy 4th July.