Tag: portfolio

The yield curve inverted… How should we allocate our fixed income portfolios to profit

As I write this, the yield curve is about to be inverted.

I was taken aback today when I saw that 3-month LIBOR is now sitting at 2.6%. As a reminder, LIBOR is the rate that other banks will lend funds to each other on a short-term basis. It is often used a benchmark interest rate for other loans, for example corporate loans will typically be set at LIBOR + some spread.

For a long time coming out of the crisis, LIBOR didn’t matter that much for these loans since there was a floor set at 1%. As such, and L+200 loan would be 1% (the floor) plus 2.0%, to equal 3% yield. Now however, that loan would yield 4.6% due to move up in LIBOR. It has moved up as the Fed has raised short-term rates which in turn impacts other rates of similar maturities.

If we look at the 10 yr rate today however, obviously a much longer-term bond/rate than 3-month LIBOR, we can see the yield is still just ~3.2%. What this tells us right off the back is that the spread between long-term bonds and short-term bonds is very narrow. Said another way, the term structure of interest rates, or the “yield curve” must be very flat.

In a healthy market, the yield curve will typically slope upwards and to the right as investors demand higher rates of interest for longer-term investments. You want to be paid for the unknown for a longer period of time.

Yield 1

However, when the yield curve flattens people often wonder whether the yield curve will become inverted — when short-term rates actually will exceed long-term rates.

This is often viewed as a harbinger of a recession. The reason it’s a recession predictor is that every recession since 1970 has been preceded by an inverted curve.

In addition, a rise in short-term rates pulls back on the capital available on the “fringes” of the economy (e.g. entrepreneurs). At the same time, expected deflationary pressures in the long-term may push long-term rates down. The combination of these factors results in an inverted yield curve and is easy to see why this would indicate a looming recession. (Note, though, this is a small sample size of predictors and there is no perfect predictor out there!)

Ray Dalio wrote in “Principles for Navigating Big Debt Crises” that,

“Typically, in the early stages of the top, the rise in short rates narrows or eliminates the spread with long rates, lessening the incentive to lend relative to the incentive to hold cash. As a result of the yield curve being flat or inverted… people are incentivized to move to cash just before the bubble pops, slowing credit growth…”

Yield 2
Inverted yield curve
10-2 spread and recessions
10-2 spread vs. recessions

A look at prior 10-2 year spreads:

I decided to look at other instances when the spread between the 10 and 2 year were this tight and what the right investment decision at the time would be.

Below are four different instances when the spread between the 10 year and 2 year yield were as tight as it is now and what unfolded few years or months. Note, I start each the 10 and the 2 year yield at 100 and mark the change in yield over time (since price data isn’t available) which is charted on the left-hand side. The right-hand side and in gray is the spread between these two rates (the “10-2 spread”), essentially showing the data another way.

10-2 410-2 310-2 210-2 1

What may or may not be surprising is that in most cases, the yield on the 2 year tightens more than the 10 year by a dramatic amount in percentage terms. Why that may not be surprising is that the Fed uses short-term interest rates to dictate monetary policy and historically, that has had a less pronounced impact on long-term rates.

Since yields move in an inverse relationship to prices, this points to price appreciation for bonds in each of the cases.

This may not be a great predictor since you can imagine the spread widening as long-term rates gap wide and short-term rates move less, such as a long-term change in the inflation assumptions. However, given demographics and a technology changes resulting in long-term deflationary pressures, this currently seems unlikely to be the case to me.


Should we be adding long-term bonds or short-term bonds to our exposures:

Does it make sense to buy short term bonds today, which are yielding ~2.98% or the 10 year, which is yield 3.24%?

At first, I would clearly say buying a 2 year bond makes a lot of sense. You’re getting paid the same as the 10 year essentially and we know rates will go lower, driving bond prices up. However, we must remember that interest rate risk cuts both ways.

Let’s run through some scenarios by comparing the purchase of a 2 year bond and re-investing the proceeds after 2 years into another 2 year bond. We will compare this to holding a 10 year bond for a total of 4 years.

First, I’ll go through what I personally think is most likely to happen.

We undoubtedly are later in the business cycle and when we inevitably enter a recession, I think the fed will once again lower short-term rates to help the economy with a softer landing and to spur investment. I have written a bunch of posts on why I think lower for longer is here to stay, even though that is not a popular opinion (mentioned here and here and here).

As such, I show the 2 year rate moving to ~1.80% and the 10 year moving to 2.92%. I base these numbers off of the typical tightening we saw in prior cycle in the charts above. E.g. the 2 year yield comes in by about 40% and the 10 year much less (I assume about 10%, which is not as much as it has, but am being conservative). The result may surprise you.

The 2 year actually under-performs the initial coupon rate on an IRR basis given you must re-invest in a lower yielding security at maturity. On the flip side, the 10 year appreciates in value as rates move lower and you can sell it for a nice profit, for an IRR above the initial coupon rate.

Rates go down.PNG

I know what some of you are already thinking… OK that is great, but I think rates are going up, not down! Well for that scenario, we could look back to 1994 when the Fed abruptly raised rates.

10-2 5

I didn’t show this one before given the spread between the 10-2 was high and tightened over time (opposite than today). Recall in 1994, there was a great “Bond Massacre”, as Alan Greenspan who was the Fed Chair at the time, decided to let air out of the system to prevent an overheating of the economy (that really only had been out of a recession for a couple years).

Let’s look at the numbers if that were to occur. I assume the 2-yr rate moves higher to 4.47%, nearly 150bps higher than today and also 1.5x the current level and assume that the 10 year has a 80bps spread to the 2 year, which implies a 5.27% yield.

In this case, it is obviously advantageous to invest in the two year bond and roll over into a higher yielding bond for the next two years. However, it is also interesting to see that you don’t witness a negative IRR on the 10 year bond (and obviously if held to maturity, you still capture the 3.2% that you locked in a purchase).

Rates go up

To back this up, I used portfolio visualizer to show the results of either buying $10k of  10 year treasuries (Portfolio 1) or $10k of short-term securities in 1993 (Portfolio 2) and holding through 1995.  The 10 year dips below on performance for a bit, and then returns to outperforming.

10yr vs ST

Rates moving like this is an unlikely scenario for me to bank on for a few reasons.

One, it is hard for me to see an abrupt change in the long-term inflation assumption, which will cap long term rates. For example, if the “real yield” i.e. the yield in excess of long-term inflation is 1.7% today (3.2% less 1.5% inflation assumption) then the inflation figure would have to move up to ~3.6% for the 10 year to be priced at 5.3%, keeping the real yield figure flat.

Second, it would then be tough to see how a sharp rise in short-term rates doesn’t cause a significant tightening on the economy.


Bottom line: I hope this is helpful analysis for those making long-term asset allocation decision  for an inverted yield curve.

For me, interest rates could likely move up further, but it doesn’t mean that we should be significantly underweight long-term, high quality securities at this point in the cycle. Especially when it appears to be contrarian to do so…

Growth vs. Value stocks… Why not both?

I’ll admit it. When someone asks me what type of investor I am, I always say value investor. But is that accurate? What really is the difference between growth vs. value stocks?

On one hand, traditional value investors would describe themselves as ones who buy statistically cheap stocks. The companies they buy may be down and out, but there is still a solid business supported by earnings / cash flows that you can nab for cheap. If sentiment improves or results come in better than feared, that’s all gravy.

On the flip side, I think growth investors are often relegated to universe of momentum investors. They are viewed as ones searching quickly growing companies and often ignore what the earnings of the business are.

But is this description correct or warranted? When considering growth vs. value stocks, I think people forget that growth is coming at some value.  That is why I view growth and value investors as one in the same.

Value investors are searching for companies that they think can be a low hurdle that investors are ascribing to the business. Growth investors are searching for assets that they think will beat a high hurdle.

In fact, I’ve come to learn over the years that growth can pay for a lot of sins. As Charlie Munger once said,

“Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6% return – even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive-looking price, you’ll end up with a fine result.”

 

Example of Growth & Value

Facebook’s recent decline in which it lost more than any other company in a single day is an example of this. At the end of the day, yes. Facebook has had some privacy issues among other things, but it is still a solid platform. They also own Instagram (which I spend way too much time on) and Whatsapp. Indeed, even after the disappointing earnings call that led to the drop, analysts still expect sales to grow 25% over 2018’s level and 21% in 2020. EBITDA is expected to grow at a 20% CAGR as well (slower than sales due to the company’s margin comments).

Growth vs. Value stocks? This seems like both.


Let’s examine what can happen when you buy an asset that is growing at this level. Note, this is not Facebook’s results, but an example of how growth can pay for “high-multiple” transgressions. Facebook currently has ~60% EBITDA margins, so allow me to use something more along the lines of Google and Apple at high 30s range (which is still incredible, though capex will also be high).

Let’s say you buy a business similar to this for 20x EBITDA (for context, FB trades for 14.3x est. EBITDA for this year).

Hypothetic buy

Again, these are all made-up numbers, but lets assume strong growth rates for the next few years that starts to level off over time. The business maintains high incremental margins (but offset by capex reinvested in the business). I assume little debt needed as these businesses such as Google, Apple, and Facebook don’t actually consume much cash (which is why their cash balances balloon).

Hypothetic buy 2

As you can see, the end result is still extremely attractive. I cut the multiple to 8x EBITDA which is well below where it started at 20x. The important factor still, as I have written before, is that the business has a competitive moat so that it can reach these targets. If they can, tech companies in particular are attractive since a company like Facebook or Google have tremendous platforms and additional customers or users cost next to nothing for them to serve.

On the flip side, if you’re buying a fashion retailer (something that is subject to fads), or a technology that is good today but could be disrupted tomorrow, then this is less attractive because it could be here and grow well in year 1, but destroyed in year 2 (perhaps a Snapchat IPOing vs. Instagram stories…).


Frankly, I’m tired of people saying they are a value investor when in fact they are just buying low P/E stocks and hoping it re-rates higher. I think it takes more than that, such as analyzing how the company will compound (re: grow) earnings.  

Why do sin stocks outperform?

Do you know what the best stock of all time is? You may be surprised to hear its a business in a secularly declining industry.

It’s Altria – the tobacco company that owns Philip Morris. Take a look at the returns on that one! Sin stocks outperform!

Altria

Altria isn’t the only sin stock that’s performed well. Sin stocks are stocks of companies that benefit from human vices, such as alcohol, fire arms, gambling, and tobacco. As shown below, I picked a few of these sin stocks and plotted them against the S&P500 over the past 10 years. Those stocks are:

  • Altria – Tobacco
  • RCI – Strip Clubs
  • Anheauser-Busch – Alcohol
  • Diageo – Alcohol
  • Wynn Resorts – Casinos
  • Las Vegas Sands – Casino

SIN Stocks Returns

Note, the chart above is total return so it includes dividends, which I think is important given sin stocks typically have high payouts.

So what gives? I know plenty of people who have invested in the next social benefit (such as solar or water infrastructure) and lost money. One theory of why socially-beneficially stocks under perform is that they try to do good, but do not do it well.

But in my opinion, and what has been discussed elsewhere, the reason why sins stocks outperform comes down to 4 factors:

  • operate in monopolistic or oligopilistic markets
    • Consider cigarette companies which were told they could no longer advertise via new regulation. That essentially eliminated their marketing teams, increasing earnings and cash flow, but also eliminated any new entrants into their space (i.e. if you can’t advertise, you can’t enter)
  • managers may overlook them or underweight them
    • One theory that is that fund managers underweight sin stocks or simply avoid them in order to please their shareholders or their own ethics. In essence, by all the socially responsible funds avoiding these stocks, they make them cheaper at the same time.
  • they also happen to be “bond proxy” stocks
    • As interest rates fell from all time highs in the 70s & 80s to essentially zero following the Great Recession, stocks that are “bond proxies” performed demonstrably well. These sectors include utilities and consumer staples.  Sin stocks (outside of casinos) are also very stable businesses and have nearly inelastic demand. As such, as investors were pushed out of bonds and into stocks, these stable businesses with high dividends were solid opportunities.
  • there may be an embedded risk premium
    • Similar to the “avoiding” bullet above, financial theory would tell us that the because there are lots of funds out there that actively avoid these stocks, that should drive the cost of capital up for sin stocks (and drive it down for non-sin stocks). As a result, investors expect a higher return given the elevated risk premium.

To be clear, I am not advocating that you need to invest in these companies, but I find it fascinating and not something that one would necessarily expect. I also am always trying to understand any biases I may have that prevents me from generating the best returns I can.

3 (often forgotten) things to remember when investing in Emerging Markets

I wanted to take some time to discuss 3 things when investing in Emerging Markets that are not widely discussed. The impetus for this article was driven by my blog post titled, “How to invest when inflation picks up“, in which I said that because I was bullish on commodity prices, I was going long Brazil.

Brazil has a very commodity driven economy (oil, metals & mining, agriculture) and my view was that a rebound in commodity prices would result in Brazil’s economy improving and its stock market should improve as well.

That call has not come to fruition yet, as shown by the Brazil ETF EWZ being down 21% since that call. And here are 3 lessons I think are important when investing in emerging markets, of which the first will relate to why my call on Brazil has been wrong so far.

1. Changes in currency can have a big impact on results

I would say a central reason why my call on Brazil has been wrong is because of currency.

The Real (Brazil’s currency) has been very volatile and has depreciated against the dollar since the slowdown in China started to occur in 2015 along with the commodity bust, which put Brazil in a deep recession. Recently, a trucker strike derailed plans to get the economy back on the path to recovery and sent the currency tumbling again.

BRL depreciation

What this has meant for my dollar investment is also depreciation…

Let’s use an example to see why: say a stock in Brazil was trading for 100 BRL when the USD/BRL rate was at 3.00. I place an $10,000 order, exchaning my dollars for 30,000 BRL and buy 300 shares. In local currency terms, lets say the stock goes up 10%, such that the quoted price is 110 BRL. I should have made $1,000 bucks on my investment, right?

Nope. If the BRL depreciated like it did in the chart above from 3.00 to 3.85, I’d be sitting on a pretty poor return actually, as shown below.

BRL Investment Example

Alas, this would mean even though I was right on stock selection, the currency movements negatively impacted my returns. This is partially why with all the global currency volatility, currency hedged ETFs are launching all over.

When in investing in emerging markets, currency will be key.

Do I advocate for currency hedges? Sometimes. It depends on the time-horizon. A long term investor may look at the levels of the BRL to the USD and see this as a buying opportunity and therefore, you can be right on stock selection AND the currency may be in your favor which would boost returns.

However, I don’t think anyway can really tell me where a currency will be in 10 years, so I won’t opine on that. What I will say is that our return thresholds should be much higher when investing in Brazil than lets say the US or another developed economy like Germany.

I don’t know what the currency will do over the next 2-3 years, but what I do know is that the real will depreciate over time relative to the dollar. No one questions that the inflation rate in Brazil will be higher than the US over the long run and that should mean that over time, the real should depreciate relative to the USD.

In sum, you have to be aware of currency, especially volatile ones. You’re taking a risk, so we should get paid for that.

2. Just because you’re buying a company’s stock, it does not mean you are afforded the same protections as the US.

Alibaba’s stock is up 25% in the past year and has roughly doubled since IPO’ing in 2014.

But did you know that if you hold BABA which trades on the NYSE, you actually don’t own Alibaba at all?

China forbids foreign investors from owning certain types of companies. As such, you aren’t really buying Alibaba. You are buying a holding company that has a claim on Chinese subsidiaries profits, but no economic interest. The risk here is that China comes in and says that is not allowed and guess what? You own nothing.

The New York Times reported on how China has not actually weighed in on this. You may also want to check out the risk factors of Alibaba’s 10-k entitled, “If the PRC government deems that the contractual arrangements in relation to our variable interest entities do not comply with PRC governmental restrictions on foreign investment, or if these regulations or the interpretation of existing regulations changes in the future, we could be subject to penalties or be forced to relinquish our interests in those operations”. 

I don’t mean to pick on BABA here (Tencent, Baidu, JD.com each have this problem as well), but the risk here might be higher than you think. Lots of people would say, “look China is relaxing its command economy and moving more to a free market. They wouldn’t do something like that.”

Rule of law is paramount in the US, but often forgotten when investing in Emerging Markets because people just look at the low P/E ratios.

And to that I say, look at Russia. In the 1990’s, following the “end” of the Cold War, Russia issued privatization vouchers that allowed investors to actually own former State Owned Enterprises. This was a huge step for Russia and it seemed like the old communist power would be relaxing its grip on businesses. But I encourage you to study what happened when Russia deemed it needed to re-control “strategic sectors”. Yuko Oil Company is a fascinating case study.

In a very brief summary, Yuko went to the private markets and quickly adopted transparent rules and practices, became one of the world’s largest non-state owned oil companies, and even had 5 Americans on its board. The company was paying dividends and growing internationally as well.

When Putin came to power, things quickly changed. The CEO of Yukos was arrested for tax evasion and fraud and Yukos was slapped with a $27 billion fine which was higher than its total revenues for the past 2 years. Yukos was forced to break up and its shares were frozen (to prevent a foreign company like Exxon from buying them). Eventually, Yukos declared bankruptcy. Many viewed this as a direct attack on the CEO of Yukos who was gaining political power.

In sum, I think its important to remember these risk factors and not get too comfortable in international / emerging markets that are known to have limited privileges to foreign investors.

3. Active management makes sense in Emerging Markets

So much has been written on active vs. passive investing in the US, it is actually making me nauseous. But I think this is a good topic to end on for this post, because it sums up the previous points here.

An active manager can weigh the impact of currency on a potential investment. They can weigh the political changes that are happening in the base of a country. And lastly, they are paid to do work on changes in the tastes of the economy.

One area of research I always try to look for is primary work. That is, if I buy the stock of a company, particularly one oriented to consumers, I want to conduct surveys on what its consumer say about the actual product and understand if that helps or hurts the investment decision in any way.

It’s also important to remember that sometimes we take for granted the tidal shift occurring in the U.S. such as Amazon, Netflix, or Apple because we interact with those products and see them on TV everyday. But how can you tell what type of products they are using in India or China without being there? Did you know Netflix and Apple are not the primary sources of products in those countries? They have their own.

Tastes change and they change quickly, so in my view, unless you’re traveling to the country often, you are paying an active manager to do that work. Indexes are backward looking (i.e. they weight the companies that have performed the best in the past at the top in a market cap weighted index), so they do not always calculate the risks mentioned herein. Sometimes they don’t include the entire universe, which can limit returns or at least potential for higher returns.

And as a result, we can see in the chart below that it pays to pay the higher management fee for active. This chart (taken from AllianceBernstein) shows that “70% of active managers in emerging equities have beaten the benchmark over the five-year period ended March 31, 2017, while 66% have outperformed over 10 years, net of fees. On a rolling five-year basis, the percent of active managers outperforming the EM index has never fallen below 50%”.

Active managers in EM

Hope this was helpful for investing in Emerging Markets.

Ray Dalio’s All Weather Portfolio and the place for fixed income in the portfolio

After reading Principles, by Ray Dalio, this past winter (which I highly recommend as it gave me many, many things to think about) I have been reconsidering my position on being highly underweight fixed income. Perhaps you are similar to me and kept waiting for rates to move up for an attractive entry point. Ray Dalio’s All Weather portfolio is something to consider.

Now the ten year treasury is hovering around 3% and as I noted previously, is not that far off from long-term averages. Does it make sense to allocate more of our portfolios to fixed income now?

Perhaps you have heard of Ray Dalio’s “All Weather Portfolio” in which he allocates a surprising amount to fixed income, as shown below. His rationale centers on a few factors. One is that by having weighting your portfolio at 80% stocks / 20% bonds is actually heavily weighting “risk”, given the volatility of stocks vs. bonds and for someone like Ray Dalio who is trying to build wealth over the long, long term, performing well in down markets matters.

Bonds should go up when stocks go down due to “flight to quality” impact in a down market. The allocation to gold and commodities provides extra diversification, plus these assets perform well during periods of high inflation, whereas bonds will not perform well.

  • 40% long-term bonds
  • 15% intermediate-term bonds
  • 30% stocks
  • 7.5% gold
  • 7.5% commodities

“The principles behind All Weather Portfolio relate to answering a deceptively straight-forward question explored by Ray with co-Chief Investment Officer Bob Prince and other early colleagues at Bridgewater – what kind of investment portfolio would you hold
that would perform well across all environments, be it a devaluation or something completely different?”

The results are pretty surprising. Dalio says he’s back-tested the portfolio from the great depression, to the Weimar Republic when hyperinflation set into Germany. If you choose not to read Principles, then I implore you to read the white paper on Bridgewater’s website on the background of the strategy.

Using portfoliovisualizer.com, I decided to see the results for myself and ran different 3 portfolio cases from 1978-2017.

The first is based on Dalio’s All Weather Portfolio, though admittedly, I had to do a 15% allocation to gold as a general commodities fund was not available that far back. I then ran a 60% stocks / 40% intermediate treasuries portfolio and then an 80% stocks / 20% intermediate treasuries portfolio.

Let me first say that it shouldn’t be too surprising that the higher stock portfolio wins out. Stocks have been a terrific asset class over this time period. Its higher risk, so higher return makes sense.

But look at the results of portfolio 1, the All Weather Portfolio. Results over this time period are not too shabby, logging a 9.4% CAGR and growing $10K to $380K. But the really interesting thing to me is the worst year and worst drawdown. The worst year was only down ~4%! Compare that to the stock heavy portfolio of -25% and having a near 40% loss in portfolio value during the year. Makes me think of “Slow and steady wins the race”

PV All WeatherPV ALl Weather Chart

This analysis isn’t perfect for a host of reasons. Bonds have been in a bull market for 30 years and were at much higher rates during this time period and subsequently went way down. I do like a quote from the white paper though, in which it states,

“In the US after peaking above 15% in the 1980s, cash rates are now zero. Stocks and bonds price relative to and in excess of cash rates. A 10-year bond yield of 2% is low relative to history but high relative to 0% cash rates. What is unusual about the recent environment is the price of cash, not the pricing of assets relative to cash.”

For further analysis on portfolio outcomes that aren’t tied to back testing, I decided to build a monte carlo spreadsheet analyzing a 50/50 portfolio of stocks and bonds. I then ran 10 random simulations over 40 years to see where the portfolios would shake out. This was pretty simple analysis and I probably should’ve added a component that says, “if stocks are down, then bonds are flat or up”, but decided to keep it random.

Given how high the standard deviation is for bonds, it is no surprise that the highest returning situations are driven by bonds outperforming, but we should also not ignore the simulations where in year 38 out of 40, stocks fall 45%, as shown in scenario 3. Bond provide decent offset to a devastating scenario.

Monte Carlo assumptions

Monte Carlo

I think the takeaway I have is that bonds / fixed income can make sense in the portfolio, depending on what you buy. So far, all I’ve shown is buying treasuries, but think there are solid opportunities in high yield and municipal bonds which are much more stable than stocks, but provide good returns.

I’ll follow up in another article on a bond fund that I think makes a lot of sense to buy for a pretty attractive return.

-DD