Get Paid to Take Risk

Is the risk-reward trade-off broken? Historically smaller companies have higher stock price returns, but this relationship has faded since 2008. What happened and why aren’t investors being compensated for taking more risk?

Table 1.1 shows how small cap stocks have performed relative to large cap stocks since the Great Financial Crisis in 2007-08. There is more volatility associated with small caps, but only a small amount of return compensation. What’s going on? For contrast, I provide the same metrics before the GFC in Table 1.2 and Chart 1.2 below.

Table 1.1: Small vs Large Cap Since the Great Financial Crisis (GFC)

SmallvslargeppostGFC.PNG

Small cap barely outperforms, and has more volatility (measured by standard deviation of stock returns). This reinforces the risk-reward dynamic. Chart 1.1 below shows this graphically. Note: SPY is the S&P 500 Index ETF (Large Cap proxy); IWM is the iShares Russell 2000 Index ETF (Small Cap proxy).

Chart 1.1: Small vs Large Cap Since the GFC

ChartSinceGFC.PNG

Table 1.2: Small vs Large Cap Pre-GFC

SmallvslargepreGFC.PNG

Over this time period, small cap outperforms significantly with the same difference in volatility. You were rewarded more for taking risk in the pre-crisis era. Chart 1.2 below shows this graphically.

Chart 1.2: Small vs Large Cap Pre-GFC

ChartPreGFC.PNG

So what gives?

Why aren’t investors being rewarded as they were before the GFC in 2008?

The answer boils down to how companies raise money. When a firm is going to undertake a new project (called capital budgeting in the biz), top brass has to decide whether to sell bonds to raise cash or to give up portions of their company (called equity) to raise cash. In order to do this, they need to weigh their options, so to speak.

Companies can minimize their cost of raising cash (called the cost of capital) by optimizing the following equation with respect to the weights of equity and debt.

Table 2.1:

WACCEqn

Cost of equity = f(company size, business risk, reputation)

It should be noted that if a company goes bankrupt, they have no obligation to pay their shareholders anything. Period. The investor accepts the risk that his investment may go to zero in exchange for a bit more return. Investors in stock take risk and are paid in stock returns or dividends. Because of this, cost of equity is always greater than the cost of debt.

Cost of Debt = f(credit conditions, company size, debt outstanding, business risk)

Debt holders are the first to be paid back should a company default. In exchange for this assurance, the company gets to borrow at a lower rate. Lenders, or buyers of the debt, receive less in return. Less risk, less reward.

In the case of both debt and equity, long established companies, like IBM or Exxon Mobil, will have a lower cost of raising capital than a recently established tech start-up. This can also be called the Size Premium. This is why you should be compensated more for owning a small company’s debt or equity.

Large Scale Asset Purchases aka Quantitative Easing:

Chart 2.1: Treasurys and Mortgage Backed Securities owned by the Fed

USTreasurysHeldFed.PNG

When financial markets began to fail in 2008, the Federal Reserve of the United States stepped in and started buying up mortgage backed securities (MBS) and US Treasury Bonds in order to stimulate the economy by artificially lowering interest rates to allow easier borrowing for companies. Cheaper debt means more companies can borrow to finance new projects, growing consumption of capital goods; at least that was the plan.

They did this in several stages known as QE1, QE2, & QE3. Some were even forced to borrow cash from the Fed in order to send a signal of stability.

Borrowing from the [Fed], even on a confidential basis, has long been viewed as a sign of weakness, to be avoided if at all possible. … [The Fed] arranged for four of the nation’s largest banks — Bank of America, Citigroup, JPMorgan Chase and Wachovia — to take what were described as symbolic loans of $500 million each. (Sauce)

Lion’s Share

Where did this liquidity go? Big banks lent it out to the nation’s largest institutions, doing what they do best, making money. They borrowed from the Fed at wicked cheap levels and lent to corporations at a higher rate which were still well below historic borrowing rates. Everyone wins, right? But who were the biggest winners?

The amount of debt a bank is willing to lend a company is directly related to the size of their operations. The bigger the firm, the more they can borrow. So who got the lion’s share of the injected cash? Big business. Think Apple, Microsoft, Amazon, Berkshire Hathaway, Facebook, JP Morgan, Johnson & Johnson, Google, Exxon Mobil, Bank of America, Visa, etc.

In order to lower their cost of capital (WACC), companies took out debt, which was now the cheapest it’s ever been since at least 1962 (see Chart 2.1). But instead of financing investments in brick and mortar or research and development, they used it to purchase their own stocks.

This shifted the weights of debt and equity.

Returning to the Cost of Capital Equation:

WACCEqnChg

  1. Cost of debt falls.
  2. Companies raise more debt.
  3. They use the debt to purchase equity
  4. Lower Cost of Capital

Chart 2.1: US Treasury 10-Year Yield since 1962

USTGeneric10yr.PNG

Through stock buybacks, companies were literally purchasing their own stocks to lower their weight of equity. The more stock they purchase, the more their stock prices rise. This brings me to the punchline: large caps are performing the same as small caps because of Quantitative Easing. This isn’t guess work, it’s exactly what’s happening in  financial markets worldwide. Until interest rates behave as they did in pre-crisis, pre-QE times, I don’t expect small caps on average to perform much better than large caps given the elevated level of risks.

Further, “the top 1 percent of Americans control 50 percent of the financial wealth, [thus] they gain the most when these asset prices boom” (Sharma, p. 108). In 2014, The Fed issued a statement, “our goal is to help Main Street, not Wall Street” (WashingtonPost), yet the Fed has been feeding inequality since. I don’t mean to be critical, but the Fed has to have realized that it had this effect.

Don't pretend to be something you're not.

I think the Fed did the best with what it had. When all you have is a hammer, everything looks like a nail. They saved many in the aftermath of the crisis, which I believe would have been much deeper without Federal Reserve intervention.

Bottom Line (TL;DR):

I’m long large cap, high dividend stocks, for reasons stated in this article, as well as the tendency for high dividend stocks to outperform in rising interest rate environments. Here’s the source for that last statement: GlobalXFunds.

Thanks for reading, this was a fun one to write.

/tommander-in-chief

Sauces:

  1. NYT: The Fed’s Crisis Lending, Mar. 31, 2011. https://www.nytimes.com/2011/04/01/business/economy/01fed.html
  2. Sharma, Ruchir. The Rise and Fall of Nations. 2016.
  3. FRED
  4. Bloomberg
  5. https://getyarn.io/yarn-clip/3342b6ad-a437-40fc-8672-b064a4b7a629
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Quick Thoughts on Markets: May 24

Quick thoughts on where markets will be/are:

  1. Multiple expansion thru 2019; bull market to continue or trade sideways with lower earnings estimates, lower guidance. P/E forward and trailing, P/S, P/CapEx, all rising thru 2019
  2. Small cap debt expansion as small business owners feel more wealthy when tax season comes around in 2019, combined with rising defaults on personal debts
  3. Slower housing as a result of more expensive mortgages, less refinancing; further consolidation of wealth to middle class that bought single family homes in the early 2010’s
  4. Flat real rates as inflation rises mildly along with gasoline prices this summer into higher nat gas prices into winter. More expensive imports (fiscal policy)
  5. Flatting yield curve on long end, steeper on short end with the infection point decreasing signalling decreased optimism on future growth, end of existing govt bond purchases by central banks.
  6. Emerging market yields will continue to rise to combat the rise of the dollar; currency flows important to watch to determine winners/losers in coming debt restructuring (2019-20?) Might see some runs of EM ETF’s, which cause some liquidity issues in smaller markets.
  7. No ETF liquidity worries, unless markets stop functioning properly for several days. No way to call another vol spike like Feb. ’18. VIX continues to stay bounded around the 12-16 range on average, gone are the single digit vol days, with less Central Bank purchasing (of course, barring a significant change in geopolitcs).
  8. Swedish market may see some M&A activity with weak krona, especially from the eurozone.
  9. Watching cryptos for more use case adoption. Right now only diehards believe it is a store of wealth, only use case that’s fully developed is black markets.
  10. Big tech led markets up so it will lead markets down.

/tommander-in-chief

 

Opinions are my own.

Knee Jerk Vol & the Fed

 

The Fed is now shrinking its balance sheet; they are no longer buying new securities as they mature. Below is a bit of analysis on if the Fed’s recent activities in shrinking its balance sheet is the cause of the recent rise in volatility.

Quick note: Data is at a weekly tenor, from Jan. 8, 2014 to April 4, 2018.

vixtreasurysspApr6.JPG

The thinner vertical line denotes when the Fed began to shrink their balance sheet last October; the thicker vertical line denotes when we had that massive vol spike in February of this year.

On the surface, the Fed’s action doesn’t appear to be the cause of all the hullabaloo, i.e. the shift from risky assets to safer assets.

If we turn to bonds, we see the following.

vixtreasurys10yrApr6.JPG

Rates on 10-Year Treasurys have moved higher since the Fed began shrinking it’s holdings of US Treasurys. Recall, bond prices fall as rates rise. Less buyers = lower prices = higher rates.

It appears these movements aren’t directly related to the recent rise in volatility.

However, there appears to be an inverse relationship between bond rates and the VIX Index.

A simple linear regression would see if the markets follow each other and if there was any preditcability between the markets. The equation is as follows:

eqnvixbondsApr6.JPG

Regression Summary:

reg summary apr6.JPG

We see a significant coefficient, with a value of -8.545, and an insignificant alpha. Therefore your new equations is:

eqnvixbondsnewApr6

If you predict a 25 bps rise in bond rates, we would expect to see a 2.3136% fall in the VIX Index, with 95% confidence:

eqnvixbondsnew2Apr6.JPG

The VIX is crazy volitile and the regression has a small R squared, so take the results with a grain of salt.

 

Thanks for reading,

/tommander-in-chief

Sauces:

  1. http://www.statisticshowto.com/probability-and-statistics/f-statistic-value-test/
  2. https://www.cnbc.com/2015/09/25/what-happened-during-the-aug-24-flash-crash.html
  3. https://fred.stlouisfed.org/series/TREAST
  4. Yahoo Finance
  5. Bloomberg

 

Note: The VIX and the 10-Yr are already percentages, so they’re calculated in absolute terms.

Delta VIX = VIX Value Today – VIX Value Yesterday

Delta 10-Yr = 10-Yr Today – 10-Yr Yesterday

Trouble in Yellen-Land

Bond markets and the Fed aren’t making sense.

The Fed (“Yellen”) rose the Federal Funds Rate (FFR) last Wednesday, June 12th to a range of 1.00% to 1.25%.

The Fed has two mandates: (1) to keep prices stable (i.e. keep inflation around 2%) and (2) to minimize unemployment. In other words, stabilize the economy by cooling it off when growth gets too fast and heating the economy up when growth slows.

The mechanisms to do this are two fold. The Fed can raise the “Federal Funds Rate” (FFR), making short term credit less available. The FFR is the lowest rate at which a financial institution can borrow. If you raise the lowest rate available in US markets, everything else should follow. Right?

Wrong. The FFR is a very short term instrument. Changes in the FFR only change short term interest rates. (See: Term Structure of Interest Rates). This brings us to our second weapon in the Fed’s arsenal: the Balance Sheet. The Fed can buy and sell securitized mortgages and government debt. They can hold assets on their balance sheet to synthetically alter the supply of debt at longer tenors.

Quantitative Easing (QE) by the Fed flooded markets with cash by purchasing bonds in the open market in order to promote lending (i.e. liquidity). The Fed’s balance sheet exploded… I mean EXPLODED. Check this post for relativity. In the most recent Fed statement, the Committee agreed it would soon be time to bring the balance sheet back to “normal”. This means they will no longer buy new treasuries or redeem matured securities.

Once balance sheet normalization begins, there will be less demand for Treasuries and yields should rise, ceteris paribus. Right?

However, longer term treasury yields have fallen while short term rates rose. This results in a flatter yield curve. Growth in the US and the world remains tepid; and inflation in the US remains under the 2% target rate, but the Fed sees fit to continue tightening monetary policy.

So what gives Janet? 

This morning, Lisa Shalett, Head of Wealth Management Investment Resources at Morgan Stanley, wrote: “… we believe the Fed has embraced a new narrative that extends beyond its mandate of full employment and 2% target inflation.”

The Fed isn’t raising rates because our economy is heating up; they’re trying to combat the next recession proactively. They’re ‘normalizing’ the FFR and the balance sheet back to levels where they can reasonably combat the next recession.

OK, but why the flatter yield curve?

A colleague of mine introduced the idea of relative interest rates as an additive theory. The risk/reward profile of US debt is one of the best in the world. For example, the 10-year government debt yield in Singapore is comparable to the same rate in the US. Would you rather have Singaporean dollars or US dollars given current market conditions? That being said, we have seen a sell off in the US dollar since the beginning of the year. Take a look at what has happened to the US dollar since President Trump took office:

USDsinceTRUMP

The dollar has rallied and subsequently sold off since the election. In my colleague’s argument, the dollar should rise. If there is a high demand for Treasury bonds, we will see a rise in demand for dollars. You can’t buy US government debt with foreign currency; you have to convert it to US dollars first. More buying of USD pushes up the price.

The recent bond market rally on the long end of the yield curve has pushed rates lower. This could be from more demand as per my colleague’s point; or the bond market is calling bullsh*t on the Fed’s optimistic outlook for the economy because a movement from stocks into bonds signifies a move to safety. When the 10- to 2-year spread tightens, it signifies lower growth expectations in the future.

tenminustwosinceTRUMP

When Trump was elected, stock markets rallied. The so called “reflation trade” became all the buzz and a “risk-on” mentality became popular. Check out the pop in the 10 to 2 on November 8-10th. This was a spark of optimism that the US economy might see some fiscal stimulus. Since, the bond market has postulated that the current administration might not be able to meet goals in respect to healthcare and infrastructure stimulus, thus spreads have narrowed and expectations tempered.

To review:

The Fed says we’re growing at a healthy clip, with inflation rising. Their reflation narrative is weak, and the bond market isn’t buying it.The Fed is trying to stockpile ammo before the next recession.

What I’m watching:

An inverted (i.e. negative) 10- to 2-year spread has preceded EVERY recession in recent history. Check it out:

10two

Keep an eye on the 10 to 2.

What I’m Reading:

Thanks for reading,

– Tommander-in-Chief

 

Disclaimer: there are SO MANY moving parts in finance. It’s impossible to point to any one factor because it’s always a combination of several or many factors that affects markets.

Who’s got the power?

 

When interest rates go up, and they will, the 50% increase across the board will topple markets, namely bond markets.

Today’s interest rates are unprecedented. The lowest possible bound for an interest rate USED to be 0%. In finance terms, we call it the ZLB or the zero lower bound. Today bond yields in Germany and Denmark (among others) are NEGATIVE! What does this mean for me, the common investor?

Examples of Interest Rates  in History, for relativity:

I’ll admit, I’m not finished with the 700+ page novel written by Sidney Homer first published in 1963. The preface is packed with insightful information such as:

1.) In ancient India, the going rate of interest on livestock was 100%. Then: You can borrow my cow for one year, if after the year is over you’ll pay be back with two cows. Today: I’ll let you use my house for a year, but after that, I’m gunna need that house back, plus a whole extra house.

2.) In early 20th century Indo-China, loans on rice were given at a rate of 50% annually commonly.

3.) In British Columbia, a phenomenon called “potlatch” was first documented. The Kwakiutl, an Candaian Indian tribe, used thin white blankets currency, roughly valued at $0.50 per item. The citizens of this tribe would give the blankets as ‘forced loans’ to one another, with the expectation of receiving what they gave plus interest. “Wealthy Indians vied with each other to see who could give away the most blankets, all with the understanding that even more would be given back—usually double.” – (p. 23, Homer) Kind of wonky huh? They gave because they were greedy.

4.) In Northern Siberia, domesticated reindeer, horses, and sheep were used to collateralize loans. They exchanged the animals like currency, usually charged at an annual rate of 100%.

All in all, lending is not new, but this new environment of negative interest rates is new. You have never  had to PAY someone so they can use your money, that just seems backwards. Remember quantitative easing (QE*)? The Europeans are doing the exact same thing. However, the European Central Bank (ECB) are buying up these negative interest charging bonds because the ECB is attempting to inject liquidity into markets. The ECB is allowing banks to use their cash and they’re paying the banks interest… hmm…

The goal of QE* is to inject liquidity into markets to avoid disastrous outcomes. The program is designed to allow debt to be more readily available for the average consumer. Lowering interest rates and loading up commercial banks with cash will help settle investors’ concerns surrounding a global financial meltdown without a doubt. This being said, if times are bad (economically), the average consumer will become risk averse, and will stay as far from debt as possible until things get better. When consumers get a pay raise or a new job, they might think about taking out a loan to build a new deck or get a new car. Demand drives supply and the policy makers who control interest rates and QE can only control supply. No matter how hard they try to get us to take out debt, we just won’t do it unless market conditions are appropriate. The final result of QE in the United States was a massive increase in the amount of cash that banks hold in reserves.

The graph below shows the level of reserves banks have on their balance sheet from 1984 to 2008. In 1999, banks jacked up their reserves because of Y2K scares; if the whole system imploded at the turn of the century, they wanted to have enough cash on hand to prevent a catastrophic collapse of our financial system. Notice how the level was just shy of $70 billion.

Screen Shot 2016-08-02 at 5.44.39 PM

This graph below shows what has happened to reserves since the beginning of quantitative easing. In 1999, (from above) the level of reserves his $70 billion, here $70 billion isn’t even on the scale. This is where all the bailout money went, onto the balance sheets of big banks.

Screen Shot 2016-08-02 at 5.45.07 PM

Holding reserves used to be an implicit tax for banks, because the more cash they held, the more return they were missing out on (opportunity cost, for you econ buffs). The banks could have put the currency to work in stocks or bonds to achieve a higher return. However, the less cash a bank has on hand, the more risky the institution is. The Fed instituted a return on cash of 50 basis points (0.5%) in order to incentivize holding cash reserves (both required* and excess). The banks can hold all of it in cash and make a half a percent annually or they can buy negative yielding bonds. It’s a positive, riskless yield. Why wouldn’t banks take advantage?

*Note: by law, the required reserve ratio in the US is 10% for big banks.

QE works as a mechanism to prevent economic collapse, but demand drives supply; thus, you cannot force people to buy things they don’t want (except maybe in Communist Russia where they don’t actually tell you what you’re taking until you’re disqualified for the Olympics) QE cannot create prosperity because no matter how available you make debt, it is the preferences of the consumers that ultimately drives demand for loanable funds.

The Federal Reserve of the United States holds way, way more power than Donald Trump and Hilary Clinton, yet when they make a statement in the press, it usually doesn’t even make the front page. The Fed has the power to control interest rates. They also have the power to create money, as in printing currency (yup, money growing on trees). They control what you pay on your mortgage and they control how much interest your money makes (in markets and in savings accounts). This affects how soon you will be able to retire, how much your house is worth, how much your pension has in cash (i.e. how much risk your pension can take), how much your kid’s college fund will make… you name it, the Fed controls it. The best part is, you didn’t get to elect these officials. The US government deemed it too risky to put big financial decisions in the hands of under-informed citizens (*cough* Brexit *cough*).

Thanks for reading.

– tommander-in-chief.

Note: For more on pensions taking on too much risk check out this economist article, http://tinyurl.com/hg4rbjl

Sources:

  1. http://www.forbes.com/sites/marcprosser/2013/04/07/beyond-the-10-year-treasury-yield-how-to-follow-the-bond-market-with-etfs/#7c753437523d
  2. http://www.wiley.com/WileyCDA/WileyTitle/productCd-0471732834.html
  3. https://fred.stlouisfed.org/series/WRESBAL/

 

Side note on bond prices –

Bond prices are inversely related to bond yields. That is, when the rate on a bond rises, it’s price will drop. Because today’s rates are so low, the effect that a rise in interest rates will have will be massive. For a little relativity, interest rates (the fed funds rate) in 1999 was around 5%. A 50% increase in this rate would raise the rate to 7.5%, which is a massive jump. Now, we are debating a 25 basis point* increase in rates, which brings them from 25-50 bps to 50-75 bps. This may seem trivial, but that represents the same 50% increase in the fed funds rate!

*Note: a basis point is a ten thousandth of a percent; 1 basis point = 0.01%