- "We do not expect any material selling of Treasuries as a result of this action. Indeed, the economic consequences of S&P’s puritanical austerity demands are likely to be bullish for Treasuries because the pressure for greater fiscal austerity is likely to be bearish for nominal growth"
- "This suggests that growth will be 1.75%-2.0% over the next few years. Failure to extend these temporary tax proposals could push growth towards 1%."
- "The Federal Reserve and Ben Bernanke in particular have absorbed the lessons of the past and will pursue further quantitative easing to prevent recession and deflation."
- "(T)he resulting growth will resemble Japan’s lost decade rather than the Great Depression."
Friday, August 12, 2011
One Economic Analysis Following the Downgrade
Stuart Thomson,chief economist at Ignis Asset Management, posted an analysis of the economic environment following S&P's downgrade. The highlights:
Wednesday, August 10, 2011
Let QE3 Begin!
In April, I wrote about the pending close of Quantitative Easing 2, and a couple of announced transactions that indicated that the Fed may be starting the process of mopping up the liquidity. In June, I followed up with comments from economists on the accomplishments of QE2 and the wisdom of initiating QE3.
Since then we have had an estimated 1.4% growth in the second quarter of 2011, and restated growth of 0.4% in the first quarter. Greece restructured its debt, again, and the U.S. nearly maxed out its borrowing authority and ultimately had its credit rating cut. Markets are fearing a double dip recession. So now, the Fed has committed to maintaining low interest rates through the middle of 2013. And the Fed Chairman is willing to pursue the policy despite dissension on the board of Governors.
This has all the earmarks of panic. The articles I have seen all describe the two-year commitment as unique. the level of disagreement over the policy is unusual. And no mechanism for implementation has been announced. All of these suggest that the Fed desires to be seen as doing something as opposed to having a sharply defined strategy.
It is also an indication that the Fed's concern over deflation is much higher than for inflation. Continued loose money will exert more inflationary pressure on markets. The only question is whether or not that pressure will be overwhelmed by the disinflationary pressure of a weak economy. So far, we have not seen the expected inflation, because pricing weakness, especially in the housing and real estate markets, have offset increasing pricing in the food and energy sectors especially.
Be vigilant. Inflation is always and everywhere a monetary phenomenon. Central banks have a horrible track record in managing the excessive liquidity created in these easing periods. There has been a lot of currency pumped into the economy. Inflation could arrive and wreak havoc on portfolios in the blink of an eye.
Since then we have had an estimated 1.4% growth in the second quarter of 2011, and restated growth of 0.4% in the first quarter. Greece restructured its debt, again, and the U.S. nearly maxed out its borrowing authority and ultimately had its credit rating cut. Markets are fearing a double dip recession. So now, the Fed has committed to maintaining low interest rates through the middle of 2013. And the Fed Chairman is willing to pursue the policy despite dissension on the board of Governors.
This has all the earmarks of panic. The articles I have seen all describe the two-year commitment as unique. the level of disagreement over the policy is unusual. And no mechanism for implementation has been announced. All of these suggest that the Fed desires to be seen as doing something as opposed to having a sharply defined strategy.
It is also an indication that the Fed's concern over deflation is much higher than for inflation. Continued loose money will exert more inflationary pressure on markets. The only question is whether or not that pressure will be overwhelmed by the disinflationary pressure of a weak economy. So far, we have not seen the expected inflation, because pricing weakness, especially in the housing and real estate markets, have offset increasing pricing in the food and energy sectors especially.
Be vigilant. Inflation is always and everywhere a monetary phenomenon. Central banks have a horrible track record in managing the excessive liquidity created in these easing periods. There has been a lot of currency pumped into the economy. Inflation could arrive and wreak havoc on portfolios in the blink of an eye.
Friday, August 5, 2011
The Enemy of Prudent
Tom Kostigen at Financial Advisor magazine is at it again. His premise: clients want to invest in "private equity investments in the emerging markets that have potential to do good and provide good returns." The problem is, "advisors don’t know how to sell these investments." The author claims that the problem is that advisors don't know how to get paid. I beg to differ. Fee only and fee and commission advisors can easily get paid under a fee structure based on hourly or AUM structures. The overwhelming majority of advisors to clients with an interest in this arena operate under one of these compensation structures.
No, the biggest obstacle to overcome is the risk and due diligence necessary to vet this (or any) investment. The regulatory environment is such that disappointing performance is grounds for seeking legal recourse. Recommending an investment with an objective expressed in terms other than risk and return is exposing one's self to unnecessary risk of litigation. And the illiquidity and lack of transparency that are characteristics of private equity and their funds exacerbates that risk.
Now the industry is moving toward a fiduciary standard for all advisors, raising the expectations of clients, and the risks to advisors. How can an investment objective of "doing good" be measured, in the face of requiring that all actions be taken in the best interest of the client? Isn't forgoing some portion of a market return in order to achieve some societal goal, a failure against such a fiduciary standard?
By and large, the impact investments I have reviewed do not qualify as prudent investments. Either they rely on subsidized operations, or require a reduced cost of capital. Usually, they are inefficient solutions to problems that are being resolved on a more rational basis, but at a slower pace that desired. That is a recipe for disappointed capital.
No, the biggest obstacle to overcome is the risk and due diligence necessary to vet this (or any) investment. The regulatory environment is such that disappointing performance is grounds for seeking legal recourse. Recommending an investment with an objective expressed in terms other than risk and return is exposing one's self to unnecessary risk of litigation. And the illiquidity and lack of transparency that are characteristics of private equity and their funds exacerbates that risk.
Now the industry is moving toward a fiduciary standard for all advisors, raising the expectations of clients, and the risks to advisors. How can an investment objective of "doing good" be measured, in the face of requiring that all actions be taken in the best interest of the client? Isn't forgoing some portion of a market return in order to achieve some societal goal, a failure against such a fiduciary standard?
By and large, the impact investments I have reviewed do not qualify as prudent investments. Either they rely on subsidized operations, or require a reduced cost of capital. Usually, they are inefficient solutions to problems that are being resolved on a more rational basis, but at a slower pace that desired. That is a recipe for disappointed capital.
Wednesday, August 3, 2011
Advisors' Favorite Bond Funds
Mark Hulbert reports on a survey that he conducted among 200 advisors of the funds they recommend to clients. The five most popular funds are bond funds, which, on its face, is surprising, given that most advisors expect interest rates to increase. However, looking over the lost, it makes sense, especially since bonds are an essential portfolio allocation. The funds, in order of their popularity:
Of the five, the Short Term Investment Grade is the most straightforward; I have known institutions that use the fund as an alternative to money markets once a prudent reserve is established. The other four have some hidden weaknesses that an advisor must recognize to use the funds effectively. The GNMA fund is invested in mortgages, subjecting the fund to the risk of maturity extension. The Fidelity fund invests in floating rate bank loans, which have a higher credit risk than might be immediately apparent. The Inflation Protected fund is invested primarily in TIPs which currently have extremely low current yields, which could lead to increased volatility. And the high yield Corporate is a junk bonk fund.
Nothing particularly wrong with any of these funds, but it is important to understand the nature of each to accurately anticipate the performance when risks are realized.
- Vanguard GNMA (VFIIX)
- Fidelity Floating Rate High Income (FFRHX)
- Vanguard Inflation Protected (VIPSX)
- Vanguard Short Term Investment Grade (VFSTX)
- Vanguard High Yield Corporate (VWEHX).
Of the five, the Short Term Investment Grade is the most straightforward; I have known institutions that use the fund as an alternative to money markets once a prudent reserve is established. The other four have some hidden weaknesses that an advisor must recognize to use the funds effectively. The GNMA fund is invested in mortgages, subjecting the fund to the risk of maturity extension. The Fidelity fund invests in floating rate bank loans, which have a higher credit risk than might be immediately apparent. The Inflation Protected fund is invested primarily in TIPs which currently have extremely low current yields, which could lead to increased volatility. And the high yield Corporate is a junk bonk fund.
Nothing particularly wrong with any of these funds, but it is important to understand the nature of each to accurately anticipate the performance when risks are realized.
Friday, July 29, 2011
Cole Credit Property Trust II Valuation
On July 27, Cole Credit Property Trust II (CCPT2) filed an 8-K with an updated value of $9.35 per share. This is an increase of more than 16% over the valuation estimate of June 22, 2010. The filing gives a detailed explanation of the methodology, but leaves out the specific metrics and multiples used in arriving at the valuation.
I did a couple of quick desktop valuation estimate based on CCPT2's most recent 10-K and 10-Q. I applied multiples based on data available at REIT Watch, Realty Rates, and NNNEX. Book value of the shares is about $7.45 per share. Capitalized NOI suggests a Net Asset Value of approximately $7.72 per share. However, the public value estimate is between $9.02 and $9.58 based on $118 million of Funds From Operations and multiples of 16 to 17. The FFO multiples are consistent with the trading ranges of National Retail Properties (NNN) and Realty Income Corp. (O), the two publicly traded REITs with objectives and properties similar to CCPT2.
It would make some sense that the share valuation would come in close to the valuation metrics of publicly traded comparable. The REIT announced on June 28 that it was exploring exit strategies to execute within the next twelve months, and it is specifically considering the listing of the shares. As part of the due diligence process, management would be expected compare the values to be received under different strategies and pursue the one that provides the greatest net benefit to shareholders. My quick and dirty analysis suggest that the public listing, or something close, is likely to provide the highest valuation.
Special Thanks: The Rational Realist
I did a couple of quick desktop valuation estimate based on CCPT2's most recent 10-K and 10-Q. I applied multiples based on data available at REIT Watch, Realty Rates, and NNNEX. Book value of the shares is about $7.45 per share. Capitalized NOI suggests a Net Asset Value of approximately $7.72 per share. However, the public value estimate is between $9.02 and $9.58 based on $118 million of Funds From Operations and multiples of 16 to 17. The FFO multiples are consistent with the trading ranges of National Retail Properties (NNN) and Realty Income Corp. (O), the two publicly traded REITs with objectives and properties similar to CCPT2.
It would make some sense that the share valuation would come in close to the valuation metrics of publicly traded comparable. The REIT announced on June 28 that it was exploring exit strategies to execute within the next twelve months, and it is specifically considering the listing of the shares. As part of the due diligence process, management would be expected compare the values to be received under different strategies and pursue the one that provides the greatest net benefit to shareholders. My quick and dirty analysis suggest that the public listing, or something close, is likely to provide the highest valuation.
Special Thanks: The Rational Realist
Thursday, July 28, 2011
A Discount Rate Primer
Bloomberg has an essay about an alternative means for discounting future events. The author provides a link to his blog, which includes a link to the paper on which the Bloomberg essay is based. The gist of the paper, and thus the essay, is that discount rate may not be consistent throughout the discounting period, and the discount rate may change over time. The paper then develops a more complex discounting mechanism which specifically accounts for the uncertainty of the discount rate.
The discounting function is the fundamental equation of finance. It provides the comparison yardstick by which we can evaluate the wisdom of current expenditures for future benefits. The concept of a discount rate underlies such ideas as a required rate of return, cost of capital, and bond duration. The one number represents all of the factors which make a future event less valuable than an immediate one.
We can agree that the market prices different discount rates for different discreet periods in the future. The sloping yield curve of the bond market is evidence of that. The market also gives us very precise measures of the discount rate related specifically to the time value of money for up to thirty years: the US Treasury STRIPS market. The market can also give us some indications and estimates of a discount rate for longer periods (corporate bonds have been issued with up to 100-year maturities) but these throw in some default risk and reinvestment risk premiums which are difficult at best to identify individually.
In the context of evaluating appropriate discount rates for very long term analyses, which seems the purpose of the exercise of considering alternative means for arriving at a discount rate, we don't need an estimate for the entire period. The STRIPS market already tells us that the value of a good thirty year on the future is 25.255% of a good today Now the estimate need only be made to that point thirty years from now. And no matter what discount rate is applied from that thirty-first year forward, the current price, the present value, of the good will be less than 25.255% of the ultimate value of the good. For example, if the second thirty years was to be discounted at 1%, one would be willing to forgo only 18.74% of the value of good today in return for the promise of the full value of the good in 2071.
So let's not get confused: Receipt of a good in the future is always less valuable than receipt of the good currently. No matter what the discount rate, a good delivered in the distant future will always be significantly less valuable than an immediate good. There are empirical means for determining a precise discount rate for up to thirty years, and very good estimates for many years more. And even if we agree on the weaknesses in our estimation methodologies, more sophisticated calculations are not going to change these fundamental relationships.
The discounting function is the fundamental equation of finance. It provides the comparison yardstick by which we can evaluate the wisdom of current expenditures for future benefits. The concept of a discount rate underlies such ideas as a required rate of return, cost of capital, and bond duration. The one number represents all of the factors which make a future event less valuable than an immediate one.
We can agree that the market prices different discount rates for different discreet periods in the future. The sloping yield curve of the bond market is evidence of that. The market also gives us very precise measures of the discount rate related specifically to the time value of money for up to thirty years: the US Treasury STRIPS market. The market can also give us some indications and estimates of a discount rate for longer periods (corporate bonds have been issued with up to 100-year maturities) but these throw in some default risk and reinvestment risk premiums which are difficult at best to identify individually.
In the context of evaluating appropriate discount rates for very long term analyses, which seems the purpose of the exercise of considering alternative means for arriving at a discount rate, we don't need an estimate for the entire period. The STRIPS market already tells us that the value of a good thirty year on the future is 25.255% of a good today Now the estimate need only be made to that point thirty years from now. And no matter what discount rate is applied from that thirty-first year forward, the current price, the present value, of the good will be less than 25.255% of the ultimate value of the good. For example, if the second thirty years was to be discounted at 1%, one would be willing to forgo only 18.74% of the value of good today in return for the promise of the full value of the good in 2071.
So let's not get confused: Receipt of a good in the future is always less valuable than receipt of the good currently. No matter what the discount rate, a good delivered in the distant future will always be significantly less valuable than an immediate good. There are empirical means for determining a precise discount rate for up to thirty years, and very good estimates for many years more. And even if we agree on the weaknesses in our estimation methodologies, more sophisticated calculations are not going to change these fundamental relationships.
Wednesday, July 20, 2011
The New Market Timing
I am really disappointed in the product description outlined in an article in Investment News. It advocates an investment process focused on evaluating asset classes and sectors for valuation, allocating capital when the valuations are attractive. When valuations get "extended," capital is to be allocated to alpha-generating strategies.
This is just a market timing scheme dressed up with some new nomenclature. The object is to be in a "risky" asset (e.g. stocks) when they are going up, and a risk-free asset (e.g T-Bills) at all other times. Substitute some equity sector options and maybe some commodity exposure for a stock fund, and an absolute return fund for the T-Bills, and you have engineered the suggested strategy. Unfortunately, the empirical evidence is that the strategies do not add value, either underperforming or taking excessive risk, or both.
The use of the alpha-generating strategies introduces an element of risk that few are willing to acknowledge. These absolute return strategies are highly susceptible to fat tails. And the leverage used on the strategies makes encountering the fat tail extremely dangerous., Just ask Long Term Capital Management.
I will continue to advocate a strategic asset allocation approach for individual investors. Creating the lowest risk portfolio that will achieve the goals and educating the client on the relationship between risk and return ultimately will provide the most successful relationship.
This is just a market timing scheme dressed up with some new nomenclature. The object is to be in a "risky" asset (e.g. stocks) when they are going up, and a risk-free asset (e.g T-Bills) at all other times. Substitute some equity sector options and maybe some commodity exposure for a stock fund, and an absolute return fund for the T-Bills, and you have engineered the suggested strategy. Unfortunately, the empirical evidence is that the strategies do not add value, either underperforming or taking excessive risk, or both.
The use of the alpha-generating strategies introduces an element of risk that few are willing to acknowledge. These absolute return strategies are highly susceptible to fat tails. And the leverage used on the strategies makes encountering the fat tail extremely dangerous., Just ask Long Term Capital Management.
I will continue to advocate a strategic asset allocation approach for individual investors. Creating the lowest risk portfolio that will achieve the goals and educating the client on the relationship between risk and return ultimately will provide the most successful relationship.
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