Monday, May 27, 2013

From Essays to Equations (1)

WALL STREET SMARTS, THE BLOG, IS NOW WALL STREET SMARTS, THE BOOK.  FULLY EDITED AND REVISED WITH NEW MATERIAL ON AMAZON

I did not study economics in school.  The books I have read on the subject since then have all been geared to people with no background in what is sometimes referred to as the "dismal science."  One of the earliest and most enduring books on economics, An Inquiry Into the Nature and Causes of the Wealth of Nations, was written by Adam Smith and first published in 1776. A Scot educated as a moral philosopher, Smith took ten years to research and write his classic.  Referred to popularly as The Wealth of Nations, the treatise is considered the foundation of many modern economic theories.  The 1,200 page book contains several tables of goods and their prices in Smith's day, but unlike many books on economics today, Wealth of Nations does not contain one mathematical equation to demonstrate the movement of money through a country's economy.

Possibly  the most studied and documented event in the history of Wall Street is the October, 1929 market crash.  It is the standard by which all other U.S. market melt downs continue to be measured.  In my opinion, the best and, certainly, the most entertaining analysis of this event is Professor John Kenneth Galbraith's work The Great Crash 1929.  It was first published in 1955 and has remained in print ever since.  Galbraith, a professor for many years at Harvard, wrote over 40 books on the subject of economics.  In his wry, self deprecating way, he attributed the long running success of The Great Crash to the fact that, every time sales of the book would slip to the point of going out of print, there would be another market bubble and subsequent drop which would rekindle public interest in the financial devastation of 1929.  I would like to share with you his analysis of why brokerage firms offered their customers margin loans, which were also referred to as "call loans" since they could be terminated or "called" at any time by the lending broker.  In describing the purpose for these loans, Professor Galbraith wrote as follows: 

The purpose is to accommodate the speculator and facilitate speculation.  But the purposes cannot be admitted.  Margin trading must be defended not on the grounds that it efficiently and ingeniously assists the speculator, but that it encourages the extra trading which changes a thin and anemic market into a thick and healthy one.  At best this is a dull by-product and a dubious one.  Wall Street, in these matters, is like a lovely and accomplished woman who must wear black cotton stockings, heavy woolen underwear, and parade her knowledge as a cook because, unhappily, her supreme accomplishment is as a harlot.*

Who would think that you could find yourself chuckling while reading a book on economic history?   With humor and insight, Galbraith lays out the events in America during the "Roaring Twenties" and their tumultuous conclusion.  Galbraith, like Adam Smith, used prose, not mathematics, to explain economic events.

Another example of a book which is an easy and enlightening read for non-economists is Yale Professor Robert J. Shiller's best seller, Irrational Exuberance.  The title is a reference to the comment of Alan Greenspan, then Chairman of the US Federal Reserve, describing the state of the stock market in 1996.  Shiller described the history of bull markets in America as follows: 

As we have noted, there have been only three great bull markets, periods of sustained and dramatic stock price increases, in the U.S. history: the bull market of the 1920s, culminating in 1929; the bull market of the 1950s and 1960s, followed by the 1973-1974 market debacle; and the bull market running from 1982 to the present.** 

His work hit the book stores in March, 2000, the month during which the last mentioned bull market hit its peak.  In a 2001 Afterword to the paperback edition of Irrational Exuberance, Professor Shiller described how, despite the severe drop in stock prices in the months following publication of his book, people still believed the market would ultimately resume its 18 year rise.  As we know, market results over the next few years proved them wrong, very wrong.

We will continue looking at economics in the next blog.

* Quote from the edition of The Great Crash 1929 by John Kenneth Galbraith published in 1997 by Houghton Mifflin Company, page 20.

** Excerpt from Shiller, Robert J.; Irrational Exuberance, copyright 2000 Robert J. Shiller, published by Princeton University Press, reprinted by permission of Princeton University Press.

Comments are always welcome.

Monday, May 20, 2013

The Risks of Debt Investing (2)

WALL STREET SMARTS, THE BLOG, IS NOW WALL STREET SMARTS, THE BOOK.  FULLY EDITED AND REVISED WITH NEW MATERIAL ON AMAZON

Some Wall Street professionals devote their time to buying debt at one market interest rate and selling it at another.  They trade based on their expectation of the direction of interest rates in the short term.  Bond prices and interest rates move in opposite directions.  As we learned in the last blog, if market interest rates rise above a bond's rate, the market price of the bond will drop.  Conversely, if market interest rates drop below a bond's rate, the market price of the bond will rise.  Bond traders look for a profit in the interest rate fluctuations rates and the resulting movement of bond prices.  Although the security being traded is a bond, the profit is based on interest rates.  Another way to trade on interest rates is the purchase and sale of bond futures contracts.  This is too complicated for me to explain so I provided a link, but, obviously, it is a market strategy for professional traders, not individual investors.

So, what is an individual investor to do?  

One of the basic rules of investing is asset allocation.  This means dividing your investment portfolio into three categories, equities, debt and cash.  Conventional wisdom holds that a person should have the equivalent of three to six months of monthly wages put aside in savings for the inevitable "rainy day."  This war chest should be accumulated before a person considers any equity or debt investing.  As to the division between equities and debt, the old rule of thumb is that you deduct your age from 100.  Your age is the percentage of your portfolio to be invested in debt and the difference is put into equities.  If you are young, the majority of your investments will be in stocks.  As you age, your portfolio allocation shifts to keep the percentages of debt and equity in line with the rule.  Generally, stocks, like bond prices, and interest rates move in opposite directions in the market.  Although stocks are viewed as riskier than debt instruments, they have generated annual returns of somewhere between nine and ten percent over several decades.  If interest rates are high, in double digits, investors move into the debt market to garner these returns without the perceived risk of equities.  When interest rates are at levels below the expected returns on stocks, investors gravitate back to the stock market.

This general rule provides an answer to the question of what to do; however, it provides no answer to the question of why to do it.  Why an individual is making an investment is the most important issue to resolve before actually investing.  Since trading debt is really an interest rate game, it is probably best left to the professionals, as I said earlier.  The individual investor should view debt more as the place to put a portion of his or her money to keep it "safe" rather than as an investment with an interest return.  The fact that the money is "safe" from equity market risk is more important than the yield made on the debt.  Many people liken the stock market to a casino.  There are very few big long term winners in either.  As Kenny Rogers sang in his hit song, The Gambler, "You never count your money when you're sitting at the table."  When the stock market is on a roll and your equities are soaring, it is counter intuitive to sell some of that stock.  However, if you want to keep those gains, take some of the chips off the table.  You should put some of those profits in a place where, as my Father used to say, "Wall Street can't get it."

Savings accounts and certificates of deposit in federally insured institutions and short term US Treasuries (maturities of less than a year) are dull, pedestrian investments, but they provide the individual investor with places to put their money with little risk of principal loss.  If an individual investor wants to buy US Treasuries without incurring a brokerage fee or commission, he or she can buy from the US Treasury at Treasury Direct

Comments are always welcome.

Monday, May 13, 2013

The Risks of Debt Investing (1)

WALL STREET SMARTS, THE BLOG, IS NOW WALL STREET SMARTS, THE BOOK.  FULLY EDITED AND REVISED WITH NEW MATERIAL ON AMAZON

Ben Franklin may have said it best in 1758 when he wrote in Poor Richard's Almanack, "Creditors have better memories than debtors."  Sometimes, debtors just can't pay their creditors back.  Individual debt investors face the same issue as global banks.  How likely is repayment?  This may be their primary concern, but there are other issues, not as obvious, but just as important for individuals.

US Treasuries are considered the gold standard of debt.  America has always repaid its loans.  It is assumed by most that it always will.  When financial markets in the world get rough, US Treasuries are seen as a "safe haven" by both individual and professional debt investors.  Since repayment is not an issue, what other perils exist?  Let's assume that you buy a $10,000 US Treasury bond paying a rate of 8% per annum with a 20 year maturity.  If you hold that bond for 20 years you will make 8% on your investment every year and get your principal back at maturity.  Sounds pretty safe, doesn't it?  However, under certain circumstances, you could face a loss of principal.

If you unexpectedly need cash and interest rates on similar Treasuries have climbed to 10% in the market, you will not get the face value of your bond when you go to sell it.  If the market rate is now 10%, why would anyone pay face value for your bond with an 8% yield?  There are hundreds of billions of dollars of Treasuries traded every day, so it would not be hard for an investor to find that 10% yield.  To get a 10% return on your 8% bond, the buyer will pay less than its face value such that your bond will yield 10% to him or her.  In this case, the value of your 8% bond drops to $8,300.  You will have lost 17% of your investment in the safest form of debt in the world because you needed immediate cash.

Let's look at the opposite and, certainly, more pleasant scenario.  Assume that interest rates have dropped since you bought your bond.  Now the going interest rate on similar bonds is 6% in the debt market.  Since the money being generated on your bond exceeds the amount of money to be received at a market rate of 6%, you are not going to sell your Treasury at face value.  The value of your bond will have increased from $10,000 to $12,300, a 23% premium.

The risk for you, an individual bond holder, is twofold.  First, can you hold the bond to maturity?  Second, if you must sell, what has happened to interest rates in the interim?  Market interest rates fluctuate daily, and you have no way of knowing what the rate might be if and when you need to sell.

It is said that there are two constants in this life, death and taxes.  I would suggest that there is a third constant in life these days: inflation.  The loaf of bread you bought 10 years ago for $2.00 now costs more.  The purchasing power of your money has declined.  That dollar you put away in a savings account 10 years ago is worth a lot less today.  If you buy a10% bond and inflation is running at 3% each year, the real rate of return on your investment is actually 7% (10%-3%).   Your real rate of return is then reduced even further by one of the other constants in life, taxes.  If you lived through the years of high inflation in the late 70s and early 80s in the US, you know how rampant inflation can impact investments.  A 10% bond in an era of 12% inflation results in a loss of purchasing power at the rate of 2% every year, and the taxes you must pay on the interest you received will further deepen that loss.

So, even the safest investment in the world, US debt, carries risk.  Individual investors need to keep these facts in mind when they approach investing a percentage of their portfolio in debt instruments.  We will continue to look at debt as an investment in the next blog.

Comments are always welcome.


Monday, May 6, 2013

With Apologies to Shakespeare

 WALL STREET SMARTS, THE BLOG, IS NOW WALL STREET SMARTS, THE BOOK.  FULLY EDITED AND REVISED WITH NEW MATERIAL ON AMAZON

I owe William Shakespeare an apology.  In his play, Hamlet, Polonius, a counselor to the King of Denmark, gives his son, Laertes, some fatherly wisdom as the young man leaves for school.  He advises him, "Neither a borrower nor a lender be."  I always attributed that line to Ben Franklin.  In any event, not many adhere to this proverb these days.  From individuals to governments, the use of credit is ubiquitous.  In April, 2013, the US national debt exceeded $16 trillion.  Total US debt, including household, corporate and government borrowings, exceeded $50.7 trillion in 2009.  According to the US Government Accountability Office, total daily trading volume in US bond markets in 2011 was $900 billion.  You read that right; $900 billion is the face value of the loans changing hands every day in America's debt markets.  US Treasury debt made up $500 billion of that $900 billion total. 

The forms of that debt are quite varied as well.  There are US treasury securities, bonds issued by states, counties and municipalities, US governmental agency debt and US corporate debt, secured and unsecured.  Foreign government and corporate bonds issued in US Dollars for purchase by US citizens (called Yankee Bonds) can also be found in US bond markets.  These are forms of direct debts owed by a borrower to the holder of the promissory note.

There are also debt securities "manufactured" by Wall Street and sold to investors.  Wall Street investment banks will buy government and corporate bonds and combine them into a security which is called a Collateralized Debt Obligation (CDO).  They pool the debt and then divide it into what are called tranches, each with a different maturity, interest rate and, in many instances, level of creditworthiness (the likelihood of repayment).  Tranche is a French word for "slice."  The investment bank marks up the price of the tranche to make its money and sells certificates for this new security to debt investors.  Each portion of the pool of debt instruments is sold to someone looking for a particular cash flow and rate of return.  These are "pass through" securities in which the borrowers' repayments on the loans in the pool are recycled to make the payments to the CDO owners.

Some CDOs are made up of pools of consumer debt.  There are CDOs consisting of pools of credit card debt, student loans or auto loans.  Of recent infamy are mortgage backed securities (MBS), also referred to as collateralized mortgage obligations (CMO).  During the US real estate bubble in the early years of this century, the mortgages taken out to finance those home purchases found their way into CMOs distributed by Wall Street around the world.  When the bubble burst and the recession hit, home values plummeted.  Home owners became either unable or unwilling to service the debt on their now much less valuable homes.  In many instances, the value of the home fell to less than the amount of mortgage debt on it.  Homeowners in this situation are commonly referred to as being either "upside down" or "underwater."  As the home owners' payments dried up, the CMOs containing those mortgages defaulted on a mammoth scale, and the debt market plunged into a credit crisis.  Although not the only reason, worthless CMOs played a role in the recession of 2007-2009.

Most financial advisers advise their clients to divide their portfolios between equity and debt.  This asset allocation is supposed to reduce the overall volatility of the investor's investment portfolio.  We will begin our study of investment opportunities and risks for individual investors in debt markets in the next blog.

Comments are always welcome.