I intend to significantly grow this section over the coming months. For now, here are my contributions:
The Inflation/Deflation Debate
Real Returns
Risk Factors, Fama-French 4 Factor Model
The Inflation/Deflation Debate
The inflation/deflation debate explores arguments promoting both US deflation and US inflation. It concludes with the resolution that rates may fall in the near term, to the benefit of US Treasuries, and rise in the long term, to the benefit of gold.
The Deflation Argument: The deflation argument originates with the idea that the US experienced an abnormal credit boom from 1980-2008. This was an abnormal event in the course of US history whereby US consumers were able to lever their personal balance sheets, primarily though popularization of home equity loans.
Furthermore, this boom took place within a fractional reserve system and fiat currency that originated in 1971. Within the fractional reserve system, the Federal Reserve prints money and pushes it to the banks, who in turn lend it to consumers. Yet, with consumers having loaded and overloaded on debt, creditworthiness is dismal. Hence, banks are unwilling to lend to consumers. Moreover, consumers are unwilling to accept additional debt, at market rates and terms, and are repaying previous loans.
Here, assumptions include that an economy with high interest rates encourages savings. The higher the interest rate, the more incentivized participants are to save rather than spend their money. Savings, in turn, is redeployed as investment. Higher interest rates, however, would decimate short-term consumption, and possibly send an economy into a recession of unknown duration. Meanwhile, banks still carry a sizeable amount of bad assets, and a rate increase would further reveal their insolvency. This could necessitate another round of bailouts. This seems unlikely because bailouts, in the US, force taxpayers to support bondholders, who are continually seem to be a protected class (note that all 24 Bear Stearns bonds still trade above par). Clearly, the Fed’s actions are directly tied to politics.
The result from this situation is a multiyear malaise consisting of widespread pessimism and deflation that resemblances Japan’s economy of the past twenty years. This situation will persist as long as the bad debts persist. Investment action is to sell stocks and buy the US 30 yr Treasury. Rates can go lower; therefore the investor wants to be in Treasuries.
The Inflation Argument: The inflation argument originates with the simple fact that the US is over-indebted, and no one should lend to it. Funding to the US persists because China is buying US Treasuries for political reasons. China may wish to avoid selling at a loss, or it is using its US Treasury holdings to manage its own currency. Meanwhile, as the Fed becomes the dominant and only buyer, the US dollar loses value as fewer countries demand it. As these dollars become less valued, the marketplace perceives inflation, and the Fed, to salvage any remaining credibility, would have to raise interest rates. From a political perspective, inflating out of a problem (which is a stealth tax to all and further impoverishes the poor) is the best alternative to unpopular austerity measures.
The main domino in this argument is the perception of the US dollar. To many, it is a risk-free asset and a safe haven during tumultuous times. However, in 2011, Treasury Secretary Geithner proclaimed that if the US did not raise the debt ceiling, the country would have defaulted. His argument implies that the US would only repay interest and principal if other countries continued to lend it funds; this is a Ponzi scheme.
The result from this situation is that interest rates will be forced to rise, and consequently, the US dollar loses its status as the world’s reserve currency. Investment action would be to short treasuries, long real assets such as commodities, and long foreign stocks on foreign exchanges (see Real Returns).
Possible actions: If deflation of economic stagnation plays out, then owning US Treasuries will be profitable. Likewise if a chaotic default in Europe occurs, US Treasuries will do; gold could also be okay here. Finally, if US inflates away its debt, real assets (gold, timber, and other commodities) will be a good investment; cash could also be okay here as it would reinvest at a higher rate every 30 days.
Conclusion: Both the deflation and inflation arguments have elements of credence to them. The inflation argument seems to lack a catalyst. The Fed has boldly proclaimed low rates through mid 2013, and this assertion seems credible. Meanwhile, China seems content to sit on its US Treasury holdings. Thus, the deflation argument will likely be correct until the foreign exchange markets drive down the value of the US dollar.
We must also consider the effects of real interest rates movements. If rates go lower, then US Treasuries are clearly the way to go. If real interest rates are negative, as they were in the mid 1970s, then gold wins. Additionally, both US Treasuries and gold can perform simultaneously. For rates to rise, the US dollar would likely need to lose a significant dissatisfactory value relative to other currencies. At the very least, shorting Treasuries seems imprudent in the short run.
I believe that the only way that gold loses in the long run is a substantial change in US fiscal policy OR investors find an alternate safe haven, both of which seem unlikely. Some wildcards, such as a crack in China or a shatter in Europe, could still alter the structural landscape of both of these arguments. Overall, the best outlook seems to be long US Treasuries for short term deflation and long gold for long inflation.
Real Returns
The basic premise of investing is to generate returns on investments via cash distributions or capital appreciation. The investor requires a return for his capital risked, and this investment capital (from savings) can fund initiatives that better society. Profits captured by an investor can either be spent or reinvested (saved). Irrespective of where these funds are deployed, the investor’s home market and currency dictate the real purchasing power of that investor.
Purchasing power, and its parity across financial borders, matters a great deal to me. I believe that the impact and exposure of an investor’s home market and currency should be considered when purchasing/selling various securities such as stocks & paired trades and currencies & commodities. More broadly, this concept should permeate the portfolio modus operandi. This may be easiest to explain through some examples:
- A domestic (US) investor invests alongside his domestic stock market (S&P 500). Very simply, his nominal return is equal to the stock market’s performance. In financial jargon, the investor’s portfolio lies on the capital market line and has a beta equal to one.
- Perhaps the investor, like many investors, ventures into individual stocks. Now, his nominal return is measured as the performance of these individual stocks relative to the market’s performance. So if the investor’s stocks rise 8% while the market appreciates 11%, the investor has lost power—that is, his returns no longer enable him to consume or save as much as other investors can consume or save.
- Now let’s take a step back and throw a slight variation into this. Let’s say that instead of a domestic investor investing, a foreign investor (European) owns the S&P 500. The foreigner’s nominal return is the same as the domestic investor; his return is equivalent to the market’s performance (and the portfolio has a beta equal to one). However, since a foreigner uses his returns to consume in his own country, he must convert his gains into his home currency (euro). The foreigner’s real return is equal to the S&P 500 plus the currency differential between the US Dollar and euro. Thus, if the euro depreciates relative to the US Dollar, our two investors will have different real returns. (This example also works in reverse when a domestic investor, such as an American, invests in a foreign market index, such as the Nikkei, DAX, or FTSE).
- Combining these two previous examples is a scenario when a foreign investor (European) owns individual stocks in a domestic market (US). Here, a foreigner’s real return is measured as the performance of his individual stocks relative to the market plus the currency differential. How an investor performs relative to his peers determines incremental power gained or lost, and how an investor’s currency performs further dictates what his investment returns can buy.
Since market performance and currency performance are both global phenomena, I argue that this last example is where most investors lie, even though they may not recognize it. Since individual stocks generally have positive correlation to the stock market, an investor who invests in individual securities is accepting market exposure. Just think—if you purchase stock ABC and the stock market falls, ABC is not going to rise just because you want it to; ABC will tend to fall when the market falls and rise when the market rises. Furthermore, every stock is priced in a currency. Therefore every stock purchase irrespective of its domestic market is an exposure to currency risk. By this nature, anyone who owns or transacts in any currency is exposed to that currency’s value.
Clearly I’m not rewriting the rules of financial theory here. What I do resolve is that the application of this concept implies that every stock purchase should be done in consideration of expected market performance and expected currency performance. Paired trades and currency hedges are not uncommon occurrences, yet I believe combining the two is a necessary concern that has failed to germinate among the investment community. More broadly, construction of a portfolio requires a stock market thesis and requires a currency thesis in order to evaluate the performance power of real returns. Only when an investor measures real stock performance relative to real market performance can the purchasing power of real returns be determined.
Risk Factors, Fama-French 4 Factor Model
The Fama-French factor model is rooted in the idea that risk factors, such as fundamental macroeconomic factors, can outperform the market. When such factors or anomalies persist, markets lack perfect efficiency, and investment opportunities exist outside of the market portfolio.
CAPM
The Capital Asset Pricing Model is a financial model, which calculates expected returns as a function of the risk-free rate, market risk, and market returns. Central to this model is the idea that returns are solely dictated by systematic risk. That is, if all market participants hold similar beliefs about expected returns and the dispersion of returns, then only increases or decreases in market risk will change portfolio returns.
While the idea behind the CAPM seems generally okay, I have some issues with it. Deep down, the CAPM relies on a static beta, which is a correlation measure between stocks and the market. Unfortunately, historical measures of individual stocks’ market correlation are fluid, so the robustness of the model is suspect. Furthermore, market participants hold a variety of risk tolerances, time horizons, and investment constraints. This assortment of characteristics differs from the CAPM’s primary tenet.
Fama-French 3 Factor Model
In 1993, Fama and French challenged the CAPM idea that market risk was the only determinant of returns. Instead, Fama and French argued that risk factors, such as style and size of companies, could be used to enhance portfolio returns for a given level of risk. Style, which can be measured as a company’s book-to-market ratio, historically favors value stocks (low book-to-market) over growth stocks (high book-to-market). For example, over many years, a group of cash cow, well known companies will have better stock returns than trendy start-up companies with high expectations. Size, which is measured by market capitalization, historically favors smaller companies over large companies. For example, over many years, smaller, niche player companies will have better stock returns than larger, established companies.
Fama and French took the CAPM market factor and added style and size to create the Fama-French 3 Factor Model. Here, the style factor is calculated as high value stocks minus low value stocks, and the size factor is calculated as small stocks minus big stocks. In other words, the style factor buys value stocks while shorting growth stocks, and the size factor buys small cap stocks while shorting large cap stocks.
Using data from Ken French’s website, one can replicate empirical data behind the conclusion. Since 1927, the Fama-French 3 Factor Model (blue line) has outperformed the market portfolio (red bars). Look at the gap between the blue line and red bars.
In the graph, three particular time periods show noteworthy outperformance. In 1943-45, both style and size contributed significant outsized gains. From 1963-68, style (value) outperformed for a few years, then size (small stocks) outperformed in the later years. Lastly, small cap stocks dominated large cap stocks from 1975-83 while value stocks beat growth stocks from 1981-84. Among these three time periods, no attribute singlehandedly dominated. The risk factors are successful in combination and over a series of years.
Value seems to persist because of investor behaviors. Investors tend to over-extrapolate past growth rates into the future and bid up prices to the point of excessive optimism; this optimism does not always materialize, and prices retreat. Thus, returns of growth stocks tend to be less than returns of value stocks. This anomaly persists because a multi-year time horizon is generally necessary to capture the value opportunity. Since fund managers are evaluated on monthly, quarterly, and annual bases, the euphoric competition for short term excessive returns creates a structural opportunity for value investing.
Style persists because of the amount of information needed to be processed. Thousands of small, publicly traded stocks exist, and finding winners among the group requires a herculean effort. Here too, fund managers play a role by tending to guard their reputation. If a fund manager does poorly by investing in well known companies like Apple, Exxon Mobil, and Wal-Mart, his misfortune may be excused as just a market downturn. Yet, if the manager unsuccessfully invests in smaller companies that few people have heard of, he will be considered aloof for investing in such losers. Thus, feasibility and reputation risk are likely to favor the style attribute going forward.
Fama-French 4 Factor Model
Also in 1993, Jegadeesh and Titman found that adding a fourth factor, momentum, to the market-style-size model also enhanced portfolio returns for a given level of risk. Momentum is calculated by investing in firms that have increased in price while selling firms that previously decreased in price (winners minus losers). Today, the four factors of market, style, size, and momentum, constitute the Fama-French 4 Factor Model.
