It is so many years ago now that I cannot exactly recall when it was that I started receiving Peter Bernstein’s Economics and Portfolio Strategy newsletter. At some point I guess his wife Barbara must have switched from using a typewriter to a word processor, but the format – four to eight pages or so of elegant prose, a couple of graphs, the distinctive coloured paper – has barely changed.
Now with Peter’s death, at the grand old age of 90, another distinctive voice in the investment world has been silenced. As some of his obituaries have noted, one of the remarkable things about Bernstein was that most of his intellectual output – the newsletter, the Journal of Portfolio Management, his many books on investment themes - only began at an age when most people were already contemplating retirement.
There is an irony in the fact that he should die at a point when financial markets are once again under attack for having failed the societies they are meant to serve, for few people have done more to promote an understanding of the way that financial markets work. His whole career was dedicated to advancing the idea that investment is a professional business to which rigorous thinking and standards could (and should) be applied.
He was a willing and enthusiastic exponent of the many ideas that, for good and ill, have come out of academia to reshape our attitudes to finance. The Journal of Portfolio Management, which he founded in 1974, was created precisely so as to provide a forum in which the new ideas could be presented and challenged.
In his wonderfully readable history of modern financial theory, Capital Ideas, he recalled how in his days working for a family-oriented bank in the 1950s, “clients would come to us and say ‘Here is my capital. Take care of me’. As long as their losses were limited when the market fell, and as long as their portfolios rose as the market was rising, they had few complaints. They came to use and stayed with us because we understood their problems and the myriad kinds of contingent liabilities that all individuals must face”.
“We joked that we were nothing more than social workers to the rich – but skilled social workers to the rich, confident that our performance was being measured in human satisfaction rather than in comparative rates of return. We knew no more about the clients of other investment managers than they knew about ours”. That world, still dominated by the private investor, is far removed from the faster, harsher, more institutionalised world we inhabit today.
And yet of course the changes that the intellectual advances and innovation of the last 35 years have unleashed – in performance measurement, in traded options, in asset allocation, in our understanding of risk and so on – have been far from an unalloyed success. Those who believed in efficient markets and rational expectations have been forced to accept the inexorable evidence that such ideas are badly flawed – and indeed, wrongly applied, have the power to do harm as well as good.
Bernstein never believed however that the course of financial innovation would run smoothly. In Capital Ideas, which appeared son after the 1987 stock market crash and the jailing of Michael Milliken, he was already defending the role of the stock market in capitalism. By making diversification easy and inexpensive, he argued, the stock market increases liquidity and enhances the overall level of risk-taking in society.
And risk-taking, with all its ups and downs, is essential to economic progress.”Institutions that encourage risk-taking are essential if a society is to grow and raise its living standards. Granted, risk-taking involves social costs. But the capitalist nations have no monopoly on pollution, maldistribution of income, inadequate education, poverty, speculation, crime or corruption”.
Nonetheless he ended his book by quoting Harry Markowitz, the father of modern portfolio theory: “Granted that the invisible hand is clumsy, heartless and unfair, it is ever so much more deft and impartial than a central planning committee”. Amidst the wreckage of the shadow banking system, such faith in the power of financial innovation to do good over time is inevitably once again under challenge.
The irony is that, in Bernstein’s view, the greatest contribution that financial theory has made over the last three decades is in providing the tools that allow us to understand and measure risk more accurately. Yet those tools, some of which are embedded in the Basel 2 regulatory regime, for example, have proved wholly inadequate to prevent a banking crisis of unprecedented proportions.
There is plenty of work therefore still to be done in understanding the way that unfettered markets work and the limits that should rightly be placed on them. It is a shame that Bernstein himself will no longer be around to chronicle the next stages of the ongoing financial revolution of which he was both champion and critic. His own view, elegantly expressed in his newsletter on many occasions, was that investment risk is far more complex and multi-faceted than most investors assume.
Read more...
Newsletter Update July 2010
Friday, June 19, 2009
Sunday, June 7, 2009
Normality Returns - Up To A Point
Pinch yourself for a moment and it is possible to convince oneself that the financial markets have returned to normality after the drama of the global financial crisis. Libor, for example, has returned to more traditional levels after last year’s market seizure. Many stock markets are back to somewhere around fair value. The dollar has fallen back to a point where it is trading at around purchasing power parity against sterling and the euro.
Bond yields are rising towards a level that once more incorporates at least some expectation of future inflation. The yield curve is upward sloping. Investment bankers are doing well again, even if it is largely by dint of the fees from organising rescue rights issues for each other. After a year in which it has yo-yoed crazily, from a peak of $145 per barrel down to little over $40 a barrel, the oil price has returned to a level that once more appears to bear some relationship with the fundamental balance of supply and demand. Other commodities are following suit.
But these are still far from normal times, as even the most cursory glance at the news testifies. Although the banking system appears now to have been saved by the concerted efforts of governments and central bankers, the global economy is still going backwards, only at a slower rate than before.
Unemployment continues to rise, and the fallout from the ongoing economic slowdown is causing political turmoil in some of the worst affected countries. The risk of future banking setbacks remains acute as lending losses across a range of sectors, including corporate banking, private equity and commercial property, have still to be realised.
In commercial property, for example, the bill for excessive lending threatens to be impressively large, though it has yet to show up meaningfully in reported accounts. Chris Turner, the long-serving manager of the TR Property Trust, estimated last week that the value of UK commercial property assets has fallen by around 40% from its peak of £800 billion in 2007, and there is probably a further decline in values of 10%-15% to go before the cycle is through.
The debt that supports these £400 billion of UK assets amounts to £300 billion. It is going to take several years for the property business as a whole to work its way back to a healthy capital structure - “a long drawn out and hard refinancing road lasting perhaps five to seven years”, in Mr Turner’s words.
While the recovery in equity markets has been impressive, its resilience also remains suspect. The lopsided nature of the market’s recovery, led as it has been by the most cyclical stocks, many with poor financial characteristics, appears to owe more to kneejerk reactions than to considerations of fundamental value.
Many investors have been caught out by the speed and extent of the recovery from the lows of early March and to avoid being left behind have been buying the highest beta instruments they can find. News that the Coppock Indicator has flashed a buy signal may further excite this trend.
The comments made last week on this subject by Neil Woodford, Invesco Perpetual’s income fund manager, seemed to me to be apt. He sees parallels between today’s market conditions and the two-tier market that prevailed in the immediate aftermath of the 2000 technology bubble, when many high quality companies with solid earnings and healthy balance sheets were priced on yields and p/e ratios which, both then and in retrospect, appear ridiculous, especially when compared to those accorded to much flakier businesses.
“We’re in a similar sort of polarised market” today, Woodford thinks, the irony being that the companies that are best equipped to survive the choppy economic times that lie ahead are the very ones that the market currently refuses to favour.
The cyclical stocks that have done so well in the last three months have risen to astonishing levels, in his view, given that “there’s been no recovery in the economy, there’s been no increase in earnings, [and] there’s been no tangible sign of any improvement in profitability for many months now”. As it will be a long time before the economy begins to experience a sustained renewal of economic growth, he is surely right that it leaves a lot of risk in cyclical sectors, impressive though the current momentum behind that move has been.
Of course some will say that Mr Woodford is only talking his book, as his preference for defensive, higher quality stocks has for now left his funds’ performance trailing that of many of his peers. But that would be a dangerously short-sighted conclusion. The arguments for thinking that equities are now the asset class of choice for the medium term are strong.
One historic trend that has not yet returned to normal is the yield gap between equities and government bonds, which still clearly favours the former. As was noted here last week, making money out of Government bonds over the medium term at today’s yields looks extraordinarily difficult, although there will be opportunities to trade the market’s volatile perceptions of the inflation/deflation outlook. But the value is not necessarily where the market currently chooses to think it is.
Read more...
Bond yields are rising towards a level that once more incorporates at least some expectation of future inflation. The yield curve is upward sloping. Investment bankers are doing well again, even if it is largely by dint of the fees from organising rescue rights issues for each other. After a year in which it has yo-yoed crazily, from a peak of $145 per barrel down to little over $40 a barrel, the oil price has returned to a level that once more appears to bear some relationship with the fundamental balance of supply and demand. Other commodities are following suit.
But these are still far from normal times, as even the most cursory glance at the news testifies. Although the banking system appears now to have been saved by the concerted efforts of governments and central bankers, the global economy is still going backwards, only at a slower rate than before.
Unemployment continues to rise, and the fallout from the ongoing economic slowdown is causing political turmoil in some of the worst affected countries. The risk of future banking setbacks remains acute as lending losses across a range of sectors, including corporate banking, private equity and commercial property, have still to be realised.
In commercial property, for example, the bill for excessive lending threatens to be impressively large, though it has yet to show up meaningfully in reported accounts. Chris Turner, the long-serving manager of the TR Property Trust, estimated last week that the value of UK commercial property assets has fallen by around 40% from its peak of £800 billion in 2007, and there is probably a further decline in values of 10%-15% to go before the cycle is through.
The debt that supports these £400 billion of UK assets amounts to £300 billion. It is going to take several years for the property business as a whole to work its way back to a healthy capital structure - “a long drawn out and hard refinancing road lasting perhaps five to seven years”, in Mr Turner’s words.
While the recovery in equity markets has been impressive, its resilience also remains suspect. The lopsided nature of the market’s recovery, led as it has been by the most cyclical stocks, many with poor financial characteristics, appears to owe more to kneejerk reactions than to considerations of fundamental value.
Many investors have been caught out by the speed and extent of the recovery from the lows of early March and to avoid being left behind have been buying the highest beta instruments they can find. News that the Coppock Indicator has flashed a buy signal may further excite this trend.
The comments made last week on this subject by Neil Woodford, Invesco Perpetual’s income fund manager, seemed to me to be apt. He sees parallels between today’s market conditions and the two-tier market that prevailed in the immediate aftermath of the 2000 technology bubble, when many high quality companies with solid earnings and healthy balance sheets were priced on yields and p/e ratios which, both then and in retrospect, appear ridiculous, especially when compared to those accorded to much flakier businesses.
“We’re in a similar sort of polarised market” today, Woodford thinks, the irony being that the companies that are best equipped to survive the choppy economic times that lie ahead are the very ones that the market currently refuses to favour.
The cyclical stocks that have done so well in the last three months have risen to astonishing levels, in his view, given that “there’s been no recovery in the economy, there’s been no increase in earnings, [and] there’s been no tangible sign of any improvement in profitability for many months now”. As it will be a long time before the economy begins to experience a sustained renewal of economic growth, he is surely right that it leaves a lot of risk in cyclical sectors, impressive though the current momentum behind that move has been.
Of course some will say that Mr Woodford is only talking his book, as his preference for defensive, higher quality stocks has for now left his funds’ performance trailing that of many of his peers. But that would be a dangerously short-sighted conclusion. The arguments for thinking that equities are now the asset class of choice for the medium term are strong.
One historic trend that has not yet returned to normal is the yield gap between equities and government bonds, which still clearly favours the former. As was noted here last week, making money out of Government bonds over the medium term at today’s yields looks extraordinarily difficult, although there will be opportunities to trade the market’s volatile perceptions of the inflation/deflation outlook. But the value is not necessarily where the market currently chooses to think it is.
Read more...
Monday, June 1, 2009
The Argument For Long Bonds
One phrase of Professor Paul Samuleson’s that has stuck in my mind for 20 years was his exhortation that investors should always “work the other side of the street”, the idea being that you are more likely to find value in testing non-consensual views as in accepting conventional thinking at its face value. Given that the remarkable feature of financial markets at present is how quickly consensus thinking seems to switch from one extreme view to another, the mental gymnastics required to do as he suggests have become increasingly demanding.
But the need for such challenge remains, with the inflation-deflation debate the most important current issue. In little more than a year, market prices suggest that we have moved from fear of inflation to fear of savage deflation – and now back again. True, it is not easy to gauge where consensus thinking genuinely now lies on this subject, as short covering by frustrated bears surely accounts for a good deal of the force behind the equity market’s recent strength.
My impression is that the majority of market participants remain unconvinced by the argument that inflation is once again the main enemy. There is no denying however that sentiment to that effect is gaining momentum. Most of the professional investors whose judgement I rate highly are now acting in the belief that the inflation, not deflation, camp is the right place to belong. The belief that deflation has been licked is one of the factors that has been driving equity markets higher.
In such circumstances, the need to stand back and look at the other side of the argument is greater than ever. The bond market is one obvious place to look. Peter Geikie Cobb, who co-manages Thames River Capital’s Global Bond fund (up a handsome 36% last year), gave me a powerful corrective opinion last week. His view is that there is simply no convincing evidence that inflation is rearing its head, or will do so any time soon. So firm is this conviction that his fund’s largest position by far is now in the longest duration UK gilt you can find, namely the 4.25% 2055 issue, currently yielding 4.5%. He and Paul Thursby, his co-manager, have never, it seems, owned such a long duration government bond portfolio as they do today.
The argument for such an apparently high risk stance, in essence, is that even if renewed inflation is eventually on its way, to bet on such an outcome today is distinctly premature. The only way that the US and UK economies can redeem their spiralling debt burden in the short term is through a rapid increase in the savings rate. That is already happening, but many investors may be underestimating how far and fast that process needs to unfold. Past experience suggests it will be dramatic.
In Thames River Capital’s view, with prices still falling, it is likely to be several years before we see reported inflation rising above 0%, which is why they see real yields of 4% or more at the long end of the curve as attractive. While it is evident that quantitative easing will hold down shorter dated yields in the government bond market, there is no doubt that the prices of longer dated issues do look, in general, more appealing. Although TIPs appear better value, real yields on index-linked gilts are too low to generate much current interest.
Given the unprecedented reflationary efforts now under way, some will argue that the 20-year bull market in government bonds must already be approaching its end. The charts still tell a somewhat different story. Measured against their 20-year history, yields for 10-year benchmark gilts, at 3.5%, are still firmly in the middle of the down-trending channel they have followed over the whole of those two decades. If the tipping point is coming, in other words, it has certainly not yet arrived, let alone confirmed.
So while government bonds as a class seem distinctly unattractive to those of us who expect higher inflation, the more you look at it, the case for the long bond play, whether you regard it as a hedge or as a trade, looks not unreasonable. To put it another way, even if you are concerned about inflation, it may be the least worst option available in Government bonds.
Notable too is another of the Thames River Capital team’s current convictions, which is that sterling’s renewed has further to run. Their argument is that the eurozone has still to take the punishment that sterling has had over the past few months and that the pound could well go to $1.65/$1.70 to the dollar and 1.25/$1.30 to the euro before its current bout of strength is done. Even if sterling loses its AAA status, as is certainly possible, most other currencies will be suffering just as much, if not more.
Read more...
But the need for such challenge remains, with the inflation-deflation debate the most important current issue. In little more than a year, market prices suggest that we have moved from fear of inflation to fear of savage deflation – and now back again. True, it is not easy to gauge where consensus thinking genuinely now lies on this subject, as short covering by frustrated bears surely accounts for a good deal of the force behind the equity market’s recent strength.
My impression is that the majority of market participants remain unconvinced by the argument that inflation is once again the main enemy. There is no denying however that sentiment to that effect is gaining momentum. Most of the professional investors whose judgement I rate highly are now acting in the belief that the inflation, not deflation, camp is the right place to belong. The belief that deflation has been licked is one of the factors that has been driving equity markets higher.
In such circumstances, the need to stand back and look at the other side of the argument is greater than ever. The bond market is one obvious place to look. Peter Geikie Cobb, who co-manages Thames River Capital’s Global Bond fund (up a handsome 36% last year), gave me a powerful corrective opinion last week. His view is that there is simply no convincing evidence that inflation is rearing its head, or will do so any time soon. So firm is this conviction that his fund’s largest position by far is now in the longest duration UK gilt you can find, namely the 4.25% 2055 issue, currently yielding 4.5%. He and Paul Thursby, his co-manager, have never, it seems, owned such a long duration government bond portfolio as they do today.
The argument for such an apparently high risk stance, in essence, is that even if renewed inflation is eventually on its way, to bet on such an outcome today is distinctly premature. The only way that the US and UK economies can redeem their spiralling debt burden in the short term is through a rapid increase in the savings rate. That is already happening, but many investors may be underestimating how far and fast that process needs to unfold. Past experience suggests it will be dramatic.
In Thames River Capital’s view, with prices still falling, it is likely to be several years before we see reported inflation rising above 0%, which is why they see real yields of 4% or more at the long end of the curve as attractive. While it is evident that quantitative easing will hold down shorter dated yields in the government bond market, there is no doubt that the prices of longer dated issues do look, in general, more appealing. Although TIPs appear better value, real yields on index-linked gilts are too low to generate much current interest.
Given the unprecedented reflationary efforts now under way, some will argue that the 20-year bull market in government bonds must already be approaching its end. The charts still tell a somewhat different story. Measured against their 20-year history, yields for 10-year benchmark gilts, at 3.5%, are still firmly in the middle of the down-trending channel they have followed over the whole of those two decades. If the tipping point is coming, in other words, it has certainly not yet arrived, let alone confirmed.
So while government bonds as a class seem distinctly unattractive to those of us who expect higher inflation, the more you look at it, the case for the long bond play, whether you regard it as a hedge or as a trade, looks not unreasonable. To put it another way, even if you are concerned about inflation, it may be the least worst option available in Government bonds.
Notable too is another of the Thames River Capital team’s current convictions, which is that sterling’s renewed has further to run. Their argument is that the eurozone has still to take the punishment that sterling has had over the past few months and that the pound could well go to $1.65/$1.70 to the dollar and 1.25/$1.30 to the euro before its current bout of strength is done. Even if sterling loses its AAA status, as is certainly possible, most other currencies will be suffering just as much, if not more.
Read more...
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