Monthly Archives: August 2013

Some Thoughts on Bad News

No normal person likes bad news.

A quick scan of any media source will result in any number of bits of bad news.  A wildfire here, an earthquake there – wars, rumors of wars, plagues and pestilences of all shapes and sizes fill our daily sphere of consciousness.

Some of this bad news appears to affect the capital markets.  An earnings report below expectations can weigh heavily on an individual stock. A disappointing employment number or GDP figure can put pressure on the overall market.  Fears of Western military intervention in Syria took down the S&P 500 by 1.5% in one day earlier this week.

In spite of the bad news we see often, the stock market stands just below its all-time high.  Ultimately, stock prices are not determined by the balance of good news versus bad.  Fundamental factors such as corporate earnings (both level and growth rate), interest rates (level and trajectory), funds flows, cash levels and sentiment are, in my view, much more important to the markets than the daily news flow.  I would submit that stock prices are where they are because fundamentals are quite positive.  I would also suggest that they are supported to an important extent by the ton of bad news out there.

Let me explain.  There has been only one period in my career where bad news was hard to find – the late 1990s.  Business was booming, the dot.com era represented a “paradigm shift” and the stock market was a one-way bet.  I knew people who would use cash advances from credit cards to day trade.  I once saw a colleague, who had never invested in the stock market before, plunk down $100,000 on one stock (he made tons money on this stock, but that is beside the point…). Those were heady times.  The dearth of bad news created a euphoric aura around the stock market – everyone “knew” that stocks were a “sure bet,” a “riskless investment” and “the only game in town.”  This kind of universally positive sentiment always accompanies the peak of the market.  The bear market following the tech bubble was not pretty, and was caused in part by the lack of bad news.

I sometimes hear from a client or a colleague something like, “If we could only get some better news on ____ (fill in the blank), I think stock prices could move higher.”  This statement supposes that the lack of good news is the only thing keeping stocks from moving higher. I might argue that when all bad news is gone, that is the time to get cautious.  As long as we have much to fear, things are probably going to be alright.

In closing, let me share some data I got from Liz Ann Saunders, the equity strategist at Charles Schwab.  From March 31, 1960 to December 31, 2012, when the year-over-year change for GDP was less than 0.5%, the annual returns on stocks was 10.5%.  When year-over-year GDP was between 0.5% and 6.0%, the annual return was 7.2%.  When GDP grew more than 6% (this has to be good news right?), the annual return on stocks averaged -4.6%.

So, whenever you catch yourself bemoaning all the bad news out there, stop and think about how it might actually be helping your portfolio in the long run.

Making Sense of the Notion of Yield

Every now and then I meet someone who says something like “If I could just get a steady return of 6% on my investments, I’d be happy.”  I suspect that this idea comes from something read about, seen or experienced in the past.  There was a time when the yield on a super-safe U.S. bond was over 6%.  That would look like a “steady return” vehicle.  Nowadays, with the yield on cash close to zero and the 10-year U.S. Treasury bond offering 2.7%, getting a “steady return of 6%” looks highly problematic.

Yet, there are a larger number of “investment products” out there which purport to offer something like a “steady return of 6%” or even more.  The first question one should ask when presented with a product like this is “Why does it yield so much?”  The answer one is likely to hear will contain fancy words like “option pricing models” or will involve a bevy of math PhDs cranking out proprietary algorithms or some such like.  Rare would be the answer that simply states “I get a huge commission for selling this thing” or, in my view the best answer, “It’s really, really risky!”

The (mostly) linear relationship between risk and return represents the best weapon against being sold something that looks attractive, but may be unquantifiably risky.  If the yield on the U.S. 10-year bond is 2.7% (arguably the most “steady” bond yield one could hope for), then anything with a higher yield is, by definition more risky.  Something yielding 5.4% would likely be twice as risky as the 10-year; a yield of 8.1% would be three times as risky and so forth.

But “risk” is also something people tend to struggle to define, especially in useful, practical terms.  If someone gambles on something that has a low probability of payoff (a lottery ticket for example) and they WIN – would they consider that investment “risky?”  Perhaps not.  Quite often, when a risky investment works out (that is, makes you money), the investor mentally adjusts the “risk” to zero, exactly because the investment did not lose money.  This mentality (which is probably very normal and common) can lead rational and intelligent people to engage in very risky investment behavior.

Analyzing and quantifying the risk of every asset claiming a “steady return of 6% or higher” is well beyond the scope of this note.  Let me simply offer a few “rules of thumb” that might help when approached by something that looks very attractive.

1)     If it looks too good to be true, it probably is.  The economics 101 axiom “there is no such thing as a free lunch” applies here.

2)     Compare the asset to other similar ones.  All else held equal, higher yield always implies higher risk.  If one 10-year bond yields 6% when the U.S. T-bond is yielding 2.7%, it contains more risk.  High-dividend yield stocks also may have more risk than is obvious to the casual observer.

3)     Get the details on the fees, commissions, sales incentives and so forth.  The financial services industry is highly regulated and many of the rules are designed to protect the individual investor from getting burned.  Sometimes the fees are paid to the sales person directly by the company offering the product, so it looks like a “no-fee” investment to the investor, yet the sales person may have a considerable incentive to offer this product, regardless of its investment merits.

4)     Complexity is sometimes a clever marketing tool.  I have seen many products that offer what looks like a reasonable return, but only in a very narrow range of possible outcomes.  Never invest in something you don’t really understand.

5)     Read the fine print.  It may explain the true riskiness of the product.

Let me close by quoting Donald Cassidy, who used to work as an analyst at Lipper.  “The market, while not reliably efficient, is not dependably stupid.  Income vehicles trading at higher yields within their asset class do so because of great risk – of reduced income payments and the underlying asset price… Always avoid yield chasing.”