Jul 28 14

The New Normal and the New Neutral

by Jeff Speakes
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The “New Normal” is a phrase coined a few years ago by the Pacific Investment Management Company (PIMCO), or at least that’s what they claim. It referred to a lengthy period of slow economic growth that they expected to persist as people recovered from the financial crisis. In view of the very modest economic growth that has occurred over the past five years (since the recession formally ended in 2009), the PIMCO forecast has worked out pretty well. Of course, my colleagues at the CLU Center for Economic Research and Forecasting (CERF) also have consistently projected modest economic growth over this period, and have been at least as accurate as PIMCO. But, we didn’t attach a clever moniker to our scenario.

Now PIMCO is extending the new normal idea into a view on Federal Reserve policy and asset prices that they call the “New Neutral.” The argument basically is that in a world of modest economic growth, we should expect low real interest rates and elevated asset prices. In particular, PIMCO argues that the real short-term interest rate ought to be around zero, so that the neutral Federal Funds rate should be around 2%, quite a bit lower than the 4% level commonly associated with the Taylor Rule (the Taylor Rule says that the target federal funds rate should be equal to target inflation (2%) plus the short-term real rate (2%) plus premiums if either inflation is running above target or the economy is running above potential). They acknowledge that longer term yields should include a term premium, so their “new neutral” long-term real rates are 1-2%. The implication is that, for example, the 10-year Treasury yield should be in the range 2.5-4.0% over the next several years. This is below the consensus forecast for bond yields.

PIMCO uses the dividend discount model (DDM) to translate assumptions about real rates into projections for asset prices. The DDM says that fair value for equities is equal to the stream of projected future dividends discounted by the required return on equity, which is the sum of expected inflation, the long-term real interest rate and the equity risk premium. Since the real rate of interest is one component of the required return on equity, the effect of a lower real rate is a higher fair value for equities.

On the assumption that the future growth rate of dividends is constant, the DDM reduces to the Gordon Model which says that fair value equals next year’s dividend divided by the difference between the required return on equity and the dividend growth rate. In symbols

Fair Value = Dividend/(R-G)

Where R is the required return on equity and G is the growth rate of dividends (in the aggregate, this is similar to the rate of overall economic growth). Historically, R has been about 10% and G about 5%, so Fair Value for equities has been roughly 20 times next year’s dividend (1 divided by (.10-.05) is 20). PIMCO’s estimates for both R and G are much lower, about 5.5% for R and 3% for G. This implies a Fair Value of 40 times next year’s dividend (1/(.055-.03) is 40).

Let’s apply this model to the S&P500 index, which at current equity prices has a total market value of approximately $20 trillion (i.e., the sum of the market values of the 500 stocks in the index). Consensus estimates for next year’s total dividends on S&P500 stocks is about $50 billion. Based on historical equity returns and growth rates, the S&P index should be trading around 20*$50B=$10 trillion. Based on PIMCO’s assumptions, fair value is more like 40*$50B=$20 trillion. This is very close to the observed market value. Thus, on the PIMCO assumptions the current level of stock prices is fully justified; there is no equity bubble.

The Gordon Model can also be used to estimate future equity returns. Just replace Fair Value by the observed market value and rearrange the equation

Expected Return = Dividend/Market Value + G
= $50B/$20T + 3% = 5.5%

This is significantly below the historical equity return of close to 10% per year. Thus, while equity prices are not massively over-valued, the prospective return from equity investment is modest.

Components of R and G

The new normal and new neutral stories imply declines in both the equity return (R) and economic growth (G). In order for asset valuations to increase, it must be the case that the decline in R is greater than the decline in G. The components of equity return are expected inflation, the long-term real rate of interest and the equity risk premium. The historical equity return of 10% was comprised, roughly, of 3% inflation plus 2% real rate of interest plus 5% equity risk premium. The projected equity return of 5.5% is comprised, roughly, of 2% inflation plus 1% real rate of interest plus 2.5% equity risk premium.

The components of economic growth are inflation and real growth. When you take the difference between R and G, the inflation term drops out and we get R-G=Real rate of interest plus equity risk premium minus real rate of economic growth. The new normal says that economic growth is 1-2% below the historical norm, and the new neutral says that the real rate of interest is 1-2% below the historical norm. These effects net to zero. The real driving force in the PIMCO story is the assumption that the equity risk premium has declined substantially (from 5% to 2.5%).

Why would this be? Perhaps peoples’ degree of risk aversion has declined due in part to the current and prospective extremely low rates of interest. That is, people are willing to invest in stocks at lower returns simply because the alternatives are so bad. Or, maybe the new normal model, while accurate for the past several years, will soon cease to exist. If the rate of real economic growth should soon revert back to historical levels, then current stock prices are consistent with a much more modest decline in the equity risk premium. Finally, a third possibility is simply that stock prices are way too high today. These three explanations have very different implications for the future direction of equity prices.

Jun 9 14


by Jeff Speakes
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In 1873, Karl Marx published the first volume of his magnum opus Das Kapital (“Capital”, in English) which purported to describe the dynamics of a capitalist economy.  Although I have never studied Capital sufficiently closely to do justice to the work, the basic idea was that ownership of the means of production (capital) becomes increasingly concentrated in the hands of a small number of people and the vast majority of workers become increasingly impoverished and alienated.  Marx predicted that eventually, and inevitably, the workers would rise up and “cast off their chains.”

In what many people are calling the economics book of the year, or the decade, or maybe even the century, French economist Thomas Piketty’s “Capital for the 21st Century,” poses a similar question to Marx; namely, “Do capital dynamics lead to increasing inequality?”  The 700 page book, along with a 100 page technical appendix, is a towering achievement of empirical research.  Professor Piketty (TP) and colleagues have pulled together new databases on the distributions of income and wealth in various countries for multiple time periods, and have subjected them to careful analysis.  His conclusion is yes, the dynamics of capitalism tend to drive wealth inequality.

The fundamental reason, TP explains, is that the rate of return on capital (“r”) is over the long-term significantly greater than the rate of economic growth (“g”).  Wage income tends to grow at rate g and capital income tends to grow at rate r.   TP estimates that the historical rate of return on capital is 4-5% and should be expected to persist.  Meanwhile, he believes that the long-term outlook for the rate of economic growth is just 1-2%.  This is greater than the long-long-run average (pre-1800) of roughly zero growth, but is less than what has been observed in developing and developed countries over the past two hundred years.  The reasons for the projected growth slowdown are a combination of slower population growth and a slowdown in the rate of productivity growth.  TP argues that a consequence of the assumed differential between r and g is that both the ratio of wealth to GDP and the share of income from capital in total income will be high and rising.  Combining this with the assertion that wealth and capital income tend to be highly concentrated, TP concludes that the rich will continue to get richer.  Not only that, but it will become increasingly difficult for the non-rich to become rich.

During the first half of the 20th century, the concentration of wealth fell.  This was widely interpreted by economists, notably Simon Kuznets, to suggest that mature capitalist economies become more egalitarian over time as the benefits from innovations spread throughout the economy.  TP argues that inequality fell in that period due the negative impact on wealth of two major wars, hyperinflation in Germany, and the great depression.  In “normal” times, he believes, the natural tendency is for both wealth and the concentration of wealth to increase.  In support of this notion, since 1950 rising inequality trends have been re-established, and his prognosis is for more of the same.

I have not studied the data nearly as extensively as TP and his associates.  Still, I am interested in the process of wealth creation, am intrigued by the TP argument, and have a few thoughts.  First, rising wealth is not a bad thing.  It is the source of financing for new ventures and should result in greater productivity and higher wages.  If indeed wealth grows at a rapid rate, I think TP’s prediction of 1-2% economic growth will be too pessimistic.  Second, there is no guarantee that wealth-holders will earn 4-5% real returns after-tax, as TP assumes.  To achieve this requires taking on a lot of risk, and making intelligent decisions.  I think that returns like this are quite unlikely for most people, even for those people sufficiently affluent to higher expensive investment advisors.  There is a great deal of evidence to suggest that, after paying fees, expensive investment advisors do not outperform market averages.   So, TP’s assumption of 4-5% returns on capital for the typical rich guy is probably too high.

Third, even more than investment return, the key driver of wealth is your savings rate.  If rich people spend more than 3-4% of their wealth each year they are likely to dissipate that wealth, not increase it.  Of course, some people are so affluent that spending even 1% of wealth is close to impossible (think of multi-billionaires).  TP believes such levels of wealth will lead to dynastic wealth (“non-meritorious” is the translated phrase).  In fact, he conducts some analysis to conclude that a very high proportion of wealth will be owned by heirs, not by the original wealth creators.  But this flies in the face of the “shirtsleeves to shirtsleeves in three generations” process whereby even great wealth is dissipated by multiple heirs and profligate spending.  Anecdotally, the richest person in France is apparently an heir to the L’Oreal perfume fortune.  Perhaps this affects the TP perspective.  Meanwhile, in the U.S. the richest people are self-made – think of Bill Gates, Warren Buffett, the founders of Google, Facebook, etc. (granted, the children of Sam Walton, founder of Walmart, also show up in the ranks of the richest Americans).

Finally, there is nothing stopping the non-rich from becoming rich.  To me, this is the most important issue.  The key is to save a substantial portion of your income.  Although this is arguably difficult to do for those on a modest income, left-leaning Senator Elizabeth Warren, in her jointly authored book on financial planning, recommends a savings rate of 20% for nearly all families.  If you can save 20% of your income and invest so as to achieve market returns (and by doing so outperform the average highly paid investment advisor), you will build wealth and an earnings stream from that wealth.  Then you will be part of the increasing share of capital income in total income that has TP so worked up.

TP has received adulation from the left for his analysis and his policy recommendations to mitigate wealth inequality through dramatically higher tax rates on capital income and inheritance, and by introducing a global tax on wealth.  I applaud his scholarship and efforts to compile relevant and valuable data sets.  But I don’t think that higher tax rates on capital will increase the opportunity for the non-rich to become rich.  Instead, the effects of higher tax rates on capital would likely be to deter upward mobility.

May 15 14

You are not Yale!

by Jeff Speakes
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Yale University boasts one of the most successful endowment funds in the country, and maybe the world.  The Yale fund (“the fund”) has outperformed 99% of like funds for the past two decades.  The manager of the fund, David Swensen, is a superstar in the investment management industry.  I recently perused the 2013 Yale Endowment Fund Report and noticed several interesting points.

First, thanks to large contributions and exceptional investment performance, the scale of the fund is huge.  Total assets at year-end were a bit greater than $20 billion, and the contribution in 2013 to Yale’s operating budget was $1.1 billion (or about four times combined tuition and room and board).  The long-term objective of the fund is to earn a real (after inflation) return exceeding five percent per year.  This would enable the fund to contribute five percent of assets per year (the actual spending formula is a bit more complex than this) and still grow in real terms (even before receiving additional gifts).

Second, the investment strategy is unconventional, or at least it was until other endowment funds began attempting to emulate Yale.    Based on the twin premises a) you must take on equity-like risk to earn positive risk premiums and b) it is very difficult to outperform the market in highly liquid markets, Swensen has led the fund to emphasize non-traditional asset classes including private equity, absolute return, and natural resources over the more traditional equity, fixed income and real estate allocations.  For example, the target allocation to US equities is 6% and the target allocation to private equity is 31%.

Yale’s objective is to perform in the top quartile of each asset class.  To accomplish this, the fund employs a staff of very sophisticated, and highly paid, investment analysts to review and select investment managers to run portfolios.  The assumption is that it is possible to identify top management talent in most every asset class, particularly the less liquid asset classes.  Only the fixed income portion of the fund (target allocation 5%) is managed in-house.

At first blush, the Yale strategy seems to contradict some of the assertions I have made in the past.   For example, for most individuals I favor the passive investment strategy promulgated by Vanguard founder John Bogle:  buy low cost broad based index funds.  Second, I have argued that annual spending 3% of your wealth is reasonable but not really conservative.  Spending 1% each year is conservative.  How is it that the Yale fund can target spending more than 5%?

What is going on?  Well, you are not Yale.  For one thing, endowment funds pay very little or no taxes.  It is much easier to earn a 5% return pre-tax than after-tax.  Second, the scale of the Yale fund is such that they can retain very highly paid investment professionals.  This gives them a much better chance of identifying and negotiating with managers that are able to outperform the overall market.  Finally, it is highly likely that Yale will receive large future gifts from successful alumni.  The analogous thing for an individual would be receiving a large inheritance or winning the lottery.  Do you want to count on that?

Evidence in favor of the benefits of large scale comes from the wide ranging magnum opus “Capital for the 21st Century” written by French economist Thomas Piketty.  Piketty’s general argument, which I will address in future blogs, is that the natural dynamics of capitalism result in growing wealth inequality over time.  One part of the argument is that larger portfolios earn higher rates of return due to economies of scale in investment management.

Piketty’s primary evidence in support of scale economies in asset management is, you guessed it, University endowment fund returns. He reports that the top funds, including Yale, Harvard and Princeton, each have more than $20 billion in assets and have achieved 10% average annual returns over the period 1990-2010.  Meanwhile, medium-sized funds (assets between $500 million and $1 billion) have earned 8% over the same period, and small funds (less than $100 million) have earned just 6% on average.  Piketty points out that Harvard’s internal cost to manage their fund is negligible in terms of return, just 0.3% of assets.  But on Harvard’s $30 billion fund, this is $100 million.  Obviously, smaller funds cannot match this level of expenditure.

The argument that scale contributes to return in a positive way is interesting, but to me not convincing.  A counter-argument is that superior managers have greater opportunity to outperform when assets under management are smaller, simply because there is a greater array of potential investments that could have a meaningful impact on overall returns.  Many of the great investors have performed much better when they had small portfolios to run instead of large ones.  For example, the returns on Warren Buffett’s partnerships in the 1950s and 1960s are much greater than the returns on Berkshire Hathaway in the 1990s or 2000s.  This is because Warren was able early in his career to discover small illiquid securities that were highly under-valued.  Such opportunities, even if he could find them today, would not be material to the giant Berkshire Hathaway portfolio.  Evidently, Harvard and Yale have figured a way to offset this problem, but it would be a mistake to assume that bigger size generally means higher return.

The Yale Endowment Fund is a terrific case study; one that I am embedding into my classes on investment management and financial economics.   But it is not feasible for the vast majority of individuals to attempt to replicate the strategy.  In particular, don’t count on achieving a 5% return on investment, after adjusting for inflation and taxes.

Mar 13 14

82% Savings Rate!

by Jeff Speakes
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The bankruptcy rate for professional athletes just a few years from retirement is extremely high.  To take one example, 60% of NBA players are reported to become bankrupt within five years of retirement from the league.  This is a league with average compensation $5 million per year. 

I am interested in applying my Sustainable Wealth (SW) idea to the case of the professional athlete.  The key idea of the SW plan is the spending rule that says you can spend each year 3% of total wealth which includes the discounted value of future earnings (“human capital”).  For professional athletes, this human capital is quite large.  Consider the NBA player with a six year contract paying $9 million per year.  After tax, this is about $5 million per year and the present value is just a bit less than $30 million.  The base SW consumption rule is to spend 3% of $30 million or $900,000 per year.  This is based on the assumption that a reasonably conservative investment strategy can earn a 3% real after-tax return, on average.  The idea of the SW plan is that, regardless of age, the athlete can comfortably spend this amount (adjusted upward for inflation) for the rest of his life. 

$900,000 is certainly a lot of money to spend each year, but from one point of view it is extremely conservative.  If you make $5 million after-tax and spend just $900K, you have a savings rate of 82% (savings is after-tax income less consumption, and the savings rate is savings divided by income, or $4.1M/$5.0M).  Few self-respecting financial planners would tell a client to save 82%, and if they did what client would accept that advice?  Suppose a very conservative advisor recommended spending just 50% of after-tax income, or $2.5M.  That seems doable, right?

Answer:  wrong.  $2.5 million represents 8% of total wealth and will dissipate wealth in just a few years.  This suggests the essence of the dilemma for the professional athlete, or any other of the top 1% income earners who only earn that high income for few years.  If you are going to provide for 60 or 70 years of consumption with only a few years of earnings, you have to save a very high percentage of that income. 

Another interesting feature of very long horizons is that the probability of plan failure increases with the length of the horizon.  This is because the volatility in ending wealth rises over time.  So, even though you are spending a fraction of initial wealth that equals your expected annual rate of return, over a 70 year period there is a non-negligible chance of plan failure.  Even the 82% savings rate is not high enough to ensure success!

If the athlete were my client, I think I would recommend a variant on the SW plan, namely the 1% Ratchet Rule.  This rule says that you can spend each year 1% of the maximum value of your portfolio.  That is, each time your portfolio value increases you ratchet up your spending, but you do not lower spending when the portfolio value falls.  Coupled with a conservative investment strategy, the 1% Ratchet Rule practically ensures that the athlete never runs out of money.  Additionally, there will be a pretty good chance that the athlete’s wealth will rise over time to the point that he can buy the team and become the owner.  But, the guy would have to constrain first year spending to $300,000 and endure the ignominy of having a 94% savings rate ($4.7M/$5.0M).

While this plan is simple in concept, it is not easy to implement.  The famous athlete is almost surely under great pressures by friends, family and associates to spend lavishly and engage in dubious investment schemes.  The huge bankruptcy rate for former athletes is likely to persist due to the difficulty of combating these pressures.

Feb 11 14

Mr. Money Mustache

by Jeff Speakes
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I have suggested that people would be better off if they massively increased their savings rates.  The aggregate Personal Savings Rate (PSR) is defined as the difference between disposable (after-tax) income and consumption spending.  It is reported each month by the Department of Commerce and has recently been running around 4%, compared to a 50-year range of 2% to 15%.  My proposed savings rate is derived from my recommended spending rule, which is to spend each year 3% of your total wealth, including both financial wealth (the value of all assets less the amount of debt) plus the present value of future net earnings.  For example, consider the median income family with head of household aged 40 and income of $50,000 per year.  This family has a present value of future income of around $1,000,000 and therefore can spend about $30,000 per year according to my spending rule.  The implication of this consumption rule for the measured savings rate is quite variable across families, but in the aggregate amounts to about 30%, or more than seven times the current observed savings rate. 

The rationale for my proposal is that spending 3% of your wealth each year is consistent with maintaining the value of wealth over time (that why it is called the Sustainable Wealth plan).  The advantages of this are both macro and micro.  From a macro perspective, the proposal would mean greater growth in the overall capital stock, productivity and real wages.  From an individual perspective, people would build and retain valuable options as they get older; options to retire early, to support family education, business or charitable activities, or to spend more.  My proposal flies in the face of much conventional thinking in economics and financial planning.

One criticism is simply one of feasibility.  How can people increase their savings seven-fold?  Of course, some people cannot.  If you are living at or near subsistence then you can’t lower consumption very much.  In order to build up your savings, you need to focus on building income. 

However, most of us are way past subsistence levels of spending.   There is a very interesting blog called “Mr. Money Mustache” (MMM) that is written by a fellow who decided that his primary goal was to build up a sufficient investment portfolio that would enable him and his wife to drop out of the work force and focus on enjoying themselves and raising their young son.  After appropriate study, they determined that investment income of $25,000 a year would provide for their needs.  Then, estimating the future rate of return on a broad equity index fund to be about 4%, they calculated that they needed a portfolio of $25,000/.04=$625,000 in order to retire.  Both husband and wife were software engineers enjoying pretty high incomes, approximately $100,000 after tax.  If you combine a 75% savings rate (savings of $100K-$25K, divided by $100K) and a 4% real investment return you will achieve your required retirement portfolio in just seven years.  They ended up accelerating this process by earning better than 4%.  In just a few years they had achieved their portfolio objective and retired.  MMM and his wife were quite young when they put their plan into action, and they were able to retire in their early 30s.  This opportunity is available to anyone, so long as you can save 75% of income and earn a decent return on investments.  If your savings rate is lower it will take longer.

I see two messages in this story.

First, the level of spending that MMM determined to be fully satisfactory for he and his family is surprisingly low.  Most families spend a lot more than this.  Based on this one example, many if not most families have the ability to dramatically increase their savings rates.

Second, even though we come up with similar recommendations (save a lot more than you are currently doing, and don’t dissipate your wealth in retirement) MMM approaches the problem of optimal financial planning quite differently from me.   Instead of starting with his projected lifetime earnings stream and attempting to preserve that value, MMM starts with a desired consumption level and uses that to determine the earliest possible retirement date.  Both of us target sustaining your wealth in retirement, instead of allowing it to dissipate.  MMM’s approach is to cut short the value of future earnings as soon as a satisfactory level of financial capital is achieved. 


Many financial planning proposals are fragile in the sense that they depend on a long list of assumptions including investment returns, rates of inflation and non-occurrence of various debacles like major illness or job loss or collapse of financial counterparties (like, for example, companies that sell annuities).  In general, any plan that seeks to maximize lifetime consumption is likely to be fragile, unless it is built on extremely conservative assumptions.

The MMM plan is pretty good on this score, largely because expense levels are low relative to earnings ability.  Should MMM suffer a calamitous stock market decline or medical emergency that causes a major disruption in the amount of financial capital, he and his wife could presumably return to the workplace and build back up their portfolio in just a few years to a level satisfactory to handle their consumption needs.

The plan would be even more robust if the spending rate were lower.  Instead of spending 4% of wealth each year, if MMM were to spend just 3% (or better yet 2% or 1%) of their wealth each year, then the exposure to a market collapse is much lower.   But then again, this would require a larger portfolio and would take more time to accumulate.

My Sustainable Wealth plan is robust as well.  The basic idea of the plan is to maintain your wealth indefinitely by keeping spending at or below investment income.  Once you are on the plan, subsequent negative shocks to wealth (for example, market downturns) do not necessarily trigger decreases in consumption.  The idea is to maintain a stable consumption path.  According to the plan, you only “retrench” your spending when the value of a fixed annuity based on current wealth and a conservative estimate of mortality drops below last year’s spending level.  In general, it will require a sizable drop in wealth to trigger a spending retrenchment.   And even should that occur, you can look for guidance and wisdom in spending retrenchment from Mr. Money Mustache.  Like him, you might find that this is a blessing in disguise.

Jan 31 14

New GDP Data & Are We at a Turning Point?

by Dan Hamilton
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The U.S. Bureau of Economic Analysis (BEA) released their first estimate of the fourth quarter 2013 Gross Domestic Product today. The estimate indicates that the economy grew 3.2 percent in 4th quarter. This followed a 4.1 percent growth rate in quarter 3 which followed a 2.5 percent growth rate in quarter 2. The growth in the latter three-quarters of 2013 was the best three-quarter performance on record, since a period ending March 2006.

The fourth quarter was driven most significantly by personal consumption and export growth, at 3.3 and 11.4 percent respectively. Nonresidential fixed investment and inventory investment provided more modest sources of growth.

With strong consumption growth we might suspect that the personal savings rate fell, and it did, from 4.9 percent in the third quarter to 4.3 percent in the fourth quarter. Given that household debt levels are still relatively high, rapid consumption expenditures, while a boost to current economic growth, might not be the best recipe for the future health of the economy.

Residential investment expenditures fell 9.8 percent, the first contraction in three years. A relevant question in this case is if this contraction is a one-time thing or if it is a turning point in housing construction? Recent existing house demand has been driven in part by investors. At some point, probably within the year, this demand source will subside. The investment companies are renting the homes that they bought. At some point, that stock of homes might be converted back to ownership, which would supply the housing market. It could be that not much new housing construction is needed.

It does not appear like housing markets are back to normal still, even though it has been almost eight years since the national U.S. home price began its decline in the third quarter of 2006. Housing is important to economic activity. Why? A house has a large “multiplier”, and real estate is where the bulk of many families’ stock of wealth is stored. This one large asset is an important consideration to many household decisions to consume, save, and invest.

Coming back to the overall economy, the fairly strong growth report for quarter 4 is encouraging, particularly given the weak December jobs report. However, I am not convinced it is sustainable in future quarters, and I am still not quite ready to believe the economy has reached a point of historically normal post-recession growth.

Jan 8 14

Qualifying Mortgage Loan

by Jeff Speakes
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Declining underwriting standards for mortgage loans played a major role in the housing boom and bust that culminated in the financial crisis of 2007-2009.  During the housing boom in the years preceding the crisis, housing prices were rising rapidly and nearly all loans, irrespective of underwriting standards, performed well.  In part due to this strong performance, underwriting standards became progressively more lax.  Other reasons for lax underwriting standards included a major policy public objective to expand the rate of homeownership, hefty demand for mortgage securities by professional investors, and the securitization process itself in which the mortgage lender was generally not the final investor in the loan, or the security formed by a number of loans. In addition, there was a widespread belief that “traditional standards” (at least 20% down payment, the ratio of the monthly payment to income (known as “debt to income” or DTI) less than 28%, and FICO credit score greater than 700) were too strict.

The financial crisis provided a severe test of weaker underwriting standards and revealed weakness of mortgage loans created during this period.  Falling home prices led an initial wave of defaults, particularly among owners of second homes.  This triggered losses on complex mortgage securities that were held by financial intermediaries, including banks and hedge funds, often in highly leveraged accounts funded with short-term wholesale funds.  Falling security values severely weakened these levered balance sheets eventually causing widespread financial failures and ultimately a very serious recession.  This put massive further downward pressure on housing prices and led to a much more serious wave of defaults.  

In retrospect, maybe the push toward lower underwriting standards was ill-advised.  One effect is to increase demand for homes and therefore home prices.  Other things equal, this means housing is less affordable. Further, if this effect is offset by liberal credit, the risk is that people take on financial burdens which are not feasible in the absence of continued housing price appreciation.  If this argument holds water, maybe a useful move is to move in the other direction.  By assuring high quality loans, the ability of private markets to fund these loans, either through portfolio lending by banks or private label securitization, is heightened.

One of the lessons many people took from the crisis is the need for mortgage lenders to retain a portion of credit risk on loans that they originate and sell.  The Dodd-Frank Act (DFA) includes a requirement that lenders retain 5% of any securitization, unless the underlying loans meet the “Qualifying Residential Mortgage” (QRM) test.  The QRM provides a safe harbor against risk retention by the lender.  It would seem natural to establish conservative underwriting standards for the QRM.

So, what constitutes a reasonable standard for a QRM?  This is a matter for regulators to address, but some very useful data have recently been released by Freddie Mac (the Federal Home Loan Mortgage Company).  This data shows default rates for loans purchased or guaranteed by Freddie Mac from 1999 through 2011.  Even through this very stressful and turbulent time period, loans that featured at least 10% down payment, a payment to income ratio of less than 36% and a borrower credit score north of 660, performed quite well with default rates less than 1%.  Meanwhile, loans with lower down payment combined with a higher ratio of payment to income and lower credit scores performed much worse, as much as 20 times worse.  One reason this data is interesting and revealing is that it shows that origination standards looser than the traditional 20% down, 28% payment-to-income ratio and 700+ FICO are consistent with excellent credit performance through a very difficult period. 

Has this information provided a standard for a QRM?  No, perhaps in deference to pressures from housing, lending and community organizing groups, regulators seem to be set on a path to equate the QRM standard with the looser “Qualifying Mortgage” (QM) standard that has been established to provide a presumption of meeting the ability to repay test, also specified by the DFA.  QM standards include a maximum DTI of 43%, maximum origination fees of three points, and full documentation.  The QM standard does not specify a minimum down payment or minimum credit score.

This is unfortunate.  Easy lending standards, in particular low or zero down payments, helped create a positive feedback loop, or reinforcing cycle, that contributed to the boom/bust housing cycle.  While apparently beneficial during the boom to those home borrowers who otherwise would not have been able to afford a home, the consequence of the bust was pretty negative for all homeowners.  The effort to deflect conservative underwriting standards (which, by the way, largely prevail in many other countries that have home ownership rates equal or greater than in the US) is detrimental to development of an improved housing finance system.

If the QRM standard were more restrictive, that would mean that many loans currently being made would require credit risk retention by the lender, if put into a security and sold to investors (for loans that are made to be held in portfolio, lenders would only have to meet the weaker QM standard).  The effect of this would be to reduce lender willingness to make such loans and would increase the note rate (mortgage rate) on such loans.  This is the price to pay to dampen the boom/bust cycle.

Dec 6 13

Nobel Thoughts

by Jeff Speakes
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Winners of the 2013 Nobel Prize in Economics are three professors – Eugene Fama, Robert Shiller and Lars Peter Hansen – who collectively pushed forward economists’ understanding of asset prices. 

Fama invented the efficient market hypothesis (EMH) which says that liquid asset markets like stock markets are efficient in the sense that relevant information is fully and immediately incorporated into stock prices, with the implications that stock prices move randomly as random pieces of information are received, and that effort spent trying to predict future stock price movements is almost surely useless.  Naturally, this conclusion did not sit well with professional investment managers who were basically told that their economic contribution was negative (they charged fees for activities that were useless).  But this conclusion created a paradox – if it weren’t for the activities of professional investors, how would new information get incorporated into stock prices?  And if there were no positive return to this activity, why would people engage in it?  Eventually economists came around to the understanding that markets are pretty efficient, but not completely so.

Even though economists grudgingly allowed that professional investors may have a useful role to play, the data suggest that on average the performance of active mutual fund managers lags behind the performance of passive market indexes, after deduction of management fees.  Again, when you think about it, this conclusion is not all that surprising.  Since the bulk of investments are run by professional managers, in the aggregate they are the market.  So, it must be the case that in the aggregate they will underperform net of fees.  This realization gave birth to the creation of passively managed index funds that provide market returns at very low cost.  These funds are available to retail investors and enable Mom and Pop to achieve investment returns that surpass that of the average actively managed mutual fund.  Index funds are an important financial innovation that came about in large part due to Fama’s research.

However, although such passively managed index funds have been around for 30 years or more, they still do not constitute a large fraction of retail investors’ portfolios.  Taking a longer view, maybe that is just as well; if a majority of assets were moved to passive accounts then these markets might become less efficient, with negative consequences for resource allocation.

A possible reason for slow adoption of a superior investment product has been suggested by Shiller, namely, people are not rational.  Shiller looked at the volatility of stock prices and proved that stock price swings are suggestive of irrational boom and bust cycles rather than rational analysis of incoming information.  While Shiller agrees with Fama that stock prices are not predictable over the short-run, his research suggests that stock prices are at least somewhat predictable in the long-run.  This is because they tend to “mean revert” from irrational highs and lows and move back toward fundamental value.  This provides an economic basis for active market timing by investment professionals and for the concept of “rebalancing” for small investors.  Rebalancing involves selling stocks to maintain your target asset allocation after major stock price increases and, conversely, buying stocks after major market setbacks.

Although the re-balancing idea has the support of economists and many investment advisors, it is not easy to carry out.  In particular, after a major market downturn, as occurred in 2009, it is very difficult to jump into the market to buy stocks.  Instead the natural tendency is to sell everything so as to prevent further losses.  The legendary investor Warren Buffett is immune to this “natural tendency” and tends to buy most aggressively after market declines (like 2009).  Aside from those periods, he spends a lot of time thinking, looking for attractive purchase opportunities.  He famously characterized the normal pace of activity at Berkshire Hathaway’s corporate offices as “lethargy, bordering on sloth.”

Another take on the rebalancing idea is found in a story related by Robert Kirby, the former head of the large equity management company Capital Guardian.  Kirby was managing the portfolio of a wealthy woman whose husband also had substantial assets, but did not enlist Kirby’s advisory service.  Eventually the husband died and Kirby was asked to be trustee for the estate.  He was shocked when he reviewed the husband’s portfolio.  It turned out that every time Kirby recommended buying a stock for the wife, the husband would buy the same stock for his own portfolio.  However, every time Kirby recommended a stock sell for the wife, the husband ignored that advice and simply held on.  What was shocking was not so much that the husband had “free-ridden” on Kirby’s buys, but rather that the performance of the husband’s portfolio dramatically outstripped the wife’s!  The key difference was that the husband’s portfolio was dominated by a few big winners, like Kodak, that had gone up 10-fold or more.  Kirby concluded that expert stock managers, like himself and his company, were much better at making buy decisions than sell decisions, and concluded that the best way to manage a portfolio is what he called the “coffee can” approach.  Simply buy a portfolio of stocks, put the shares into a coffee can (this was back in the days when physical stock certificates were held by investors) and forget about them.

The coffee can story supports the idea of buying when prices are low, hence rebalancing after a market downturn, but not the idea of selling when prices are high.  Perhaps the difficulty of making smart sell decisions is that there is a strong long-term upward trend in stock prices, so trying to call a top is hazardous.

Nov 19 13

Jerry Brown and California’s “Attractive” Poverty

by Dan Hamilton
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This article was written by Bill Watkins and previously published on New Geography on November 12, 2013.

Jerry Brown is supposed to be a different kind of politician: well informed, smart, slick, and skilled. While he has had some missteps, he’s always bounced back. His savvy smarts have allowed him to have a fantastically successful career while generally avoiding the egregious dishonesty that characterizes so many political practitioners.

So, I was shocked to read that he said that California’s poverty is a result of the State’s booming economy. Here’s part of the Sacramento Bee report:

Gov. Jerry Brown, whose pronouncements of California’s economic recovery have been criticized by Republicans who point out the state’s high poverty rate, said in a radio interview Wednesday that poverty and the large number of people looking for work are “really the flip side of California’s incredible attractiveness and prosperity.”

The Democratic governor’s remarks aired the same day the U.S. Census Bureau reported that 23.8 percent of Californians live in poverty under an alternative calculation that includes the cost of living.

Asked on National Public Radio’s “All Things Considered” about two negative indicators — the state’s nation-high poverty rate and the large number of Californians who are unemployed or marginally employed and looking for work — Brown said, “Well, that’s true, because California is a magnet.

“People come here from all over in the world, close by from Mexico and Central America and farther out from Asia and the Middle East. So, California beckons, and people come. And then, of course, a lot of people who arrive are not that skilled, and they take lower paying jobs. And that reflects itself in the economic distribution.”

This is so incredibly wrong that I’m worried that Brown has lost his head and ability to reason. If he really believes what he said, he’s living in the past and he’s so ill informed as to be delusional. If he doesn’t believe what he said, I’m worried that his political skills have slipped. To my knowledge, he’s never said anything so clearly at odds with the truth in his career.

Here are the facts:

• California’s poverty is not where the jobs are, which is what we’d expect if what Brown said was true. Most of California’s jobs are being created in the Bay Area, a region of fabulous wealth. By contrast, California’s poverty is mostly inland. San Bernardino, for example, has the second highest poverty rate for American cities over 200,000 population, and no, it’s not because it’s a magnet. Most of California’s Great Central Valley is a jobs desert, but the region is characterized by persistent grinding poverty and unemployment. No one in recent years is moving to Kings County to look for a job.

• States with opportunity have low poverty rates. North Dakota may have America’s most booming economy. According to the Census Bureau, North Dakota’s Supplemental Poverty Measure is 9.2 percent. That is, after adjustments for cost of living, 9.2 percent of North Dakotans live in poverty. The rate in Texas – a state with a very diverse population, and higher percentages of Latinos and African-Americans – is 16.4 percent. California leads the nation with 23.8 percent of Californians living in poverty.

• According to the U.S. Census, domestic migration (migration between California and other states) has been negative for 20 consecutive years. That is, for 20 years more people have left California for other states than have come to California from other states. Wake up, Jerry, this is no longer your Dad’s state – or that of his successor, Ronald Reagan. This is a big change from when Brown was elected governor the first time. At that time, California was a magnet. It had a vibrant economy, one with opportunity. California was a place where you could have a career, afford a home, raise a family. It was where the American Dream was realized.

• How about the magnetic attraction for immigrants from all over the world? According to the Census Bureau, international migration to California is way down. The number of California international immigrants has been declining for a decade at least. Indeed, in recent years there have been about half as many international immigrants to California than we saw in the 1990s. Over the past decade, the number of foreign born increased more in Houston than the Bay Area and Los Angeles put together. Opportunity, not “attractiveness”, drives people to move.

• California’s migration trends combined with falling birth rates has resulted in the lowest sustained population growth rates that California has seen.

The data are clear: Brown’s assertions have no basis in fact. California – with the exception only recently of the Bay Area – is not a magnet. California is not “incredibly attractive and prosperous.” People are not coming from all over the world. California may beckon, but more are leaving, and those here are having fewer children. California’s seductive charms go only so far.

I don’t know if I’d prefer that Brown was delusional or lying. On the one hand, policy made from a delusional analysis of the world is sure to be bad policy. Brown, for example, may convince himself that Twitter, Google, and Facebook are the future of the California economy, without recognizing how few people, particularly from the working class or historically disadvantaged minorities, they employ. On the other hand, Brown is very skilled in the political arts. If someone as skilled as he has to resort to such outright misdirection, we may be in worse shape than I think.

Nov 13 13

Sustainable Investment Plan

by Jeff Speakes
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The key to sustainable wealth is to tie your level of consumption spending to the product of your total wealth (including financial wealth and human capital, or the present value of future net income) and the after-tax real rate of return.  If you do this, the affluence that you enjoy in your youth, due to the prospect of future earned income, will not be dissipated over time and you will have plenty of valuable options in your declining years, like supporting family member education or business pursuits, or charitable activities.

I have recommended that moderately risk tolerant people use 3% as a reasonable estimate of the future after-tax rate of return.  Using this 3% rate to discount future income, I estimate total wealth to be approximately $300 trillion for the US, or about 25 times aggregate disposable income.  Thus, my consumption rule of 0.03 times wealth turns out to be equivalent to 0.75 times disposable income and thusly a personal savings rate of 25%.  Since we observe savings rates closer to 5% of disposable income, it is clear that my Sustainable Wealth model is not a good descriptor of actual behavior.  That’s OK by me.  The intent of the plan is not to explain what people actually do, but rather to provide one simple means by which to achieve a desirable financial objective. 

Based on observed savings behavior, it seems very likely that many if not most people will be forced to significantly retrench their spending in retirement.  Of course, it could be that realized investment returns will be much higher than the 3% I think is reasonable.  Indeed, over the last 100 years or so equity returns in the US have been roughly on the order of 10% per year.  So, what is wrong with extrapolating these results going forward?  Well, there are a number of issues including:  1) the 10% actual return is nominal, pre-tax not real after-tax; the historical after-tax real return is closer to 5-6%, 2) most people would not be comfortable with a 100% allocation of financial capital to equities; a fifty/fifty equity/bond split would have generated a net real return more like 3-4%, 3) prospective returns today are probably lower than they have been on average over the past 100 years due to lower current dividend yields and slower economic growth, and higher current valuations, as indicated by relatively high current price earnings multiples.  Each of these three factors suggests lower prospective equity returns.  4) Finally, as documented extensively by John Bogle, retail investors do not come close to achieving the returns offered by the market.  This is due to a combination of bad timing and payment of large fees and costs for little or no benefit.

Whew.  Maybe 3% is too high!  In fact, achieving a 3% return is not like falling off a log.  But I think that it can be achieved and one strategy for doing so is outlined below.  The first question to ask is:  do you have special investment skill?  Some people do have such skill, but most do not.  If you fall into the former category you should apply your skill, but if you like most people fall into the second category you should invest in low cost highly diversified index funds and you should refrain from active trading.

Asset Allocation for Mom and Pop

Here is a simple five step plan.

Step one.             

Select one or more passive investment vehicles, like Vanguard’s total US stocks (symbol VTI) or Vanguard’s total global stocks (symbol VT).  This will be the “stock” portfolio.

Step two.

Select a low-risk portfolio consisting of Treasury securities, Treasury inflation-indexed securities (TIPS) and money market funds.  Call this the “bond” portfolio.

Step three.

Through a process of self-reflection, assess your tolerance for return volatility.  The greater your tolerance, the higher is your portfolio weight to equities.  For young people, whose total wealth is primarily composed of human capital, you should follow retirement specialist Miles Milevsky and ask this question:  “is your job more like a bond or a stock?”  For most people, their jobs provide relatively steady income, like a bond.  But some people, like actors or professional athletes, have very volatile incomes that are more like stocks.  If your job is like a bond, you should consider a heavier equity allocation in your financial portfolio, and vice versa if your job is like a stock.

Step four.

Suppose you determine that you are comfortable with a fifty/fifty allocation between the bond and stock portfolios.  The next step is to set up a brokerage account and implement the strategy.

Step five.

The next step is to wait.  Once the stock market moves dramatically in one direction or the other, it may be time to take further action.  If the stock market declines 50 percent, let’s say, then on a market value basis your allocation to equities has declined from 50% to 33%.  It is appropriate to “re-balance” by selling a portion of your bond portfolio and re-investing in the stock portfolio until you have re-established the initial fifty/fifty allocation (in this example, it would require liquidating about one quarter of the bond portfolio).

Similarly, if the stock market moves up dramatically, the re-balancing logic would suggest selling a portfolio of the stock portfolio in order to move back to the fifty/fifty split.  The consequence of the rebalancing strategy is to force you to sell after prices rise and to buy after prices fall. 

Finally, as you age and the financial portfolio becomes a greater percentage of total wealth, you should gradually decrease the allocation to equities in the financial portfolio.  One rationale for this is that the older you are, the less time you have to recover from a market downturn.  Also, to the extent your job is like a bond (probably the case for most people), the decline over time in the weight of human capital in total wealth means that your bond “allocation” is falling.  So it appropriate to offset this by carrying more bonds in the financial portfolio.   

Bottom line, is this the best investment strategy ever devised?   The answer is no.  Almost surely you can do better if you have a real skill in economic forecasting or security analysis or manager selection.  However, the strategy summarized here is easy to comprehend and deploy and it will keep you away from most of the debacles that seem to visit the average retail investor.  In that sense, it is a major step forward.