Strange days

William Bernstein at Efficient Frontier noted back in March that dysfunctional credit markets are exhibiting historically anomalous yield spreads. Aversion to credit risk is at almost irrational levels. Spreads are only rational if you think everything else can / will crash leaving only the US government solvent to repay its debts.

First and foremost, the real yields for Treasuries, at least at the short end, have become negative; it seems highly unlikely that inflation over the next two years, any way you calculate it, is going to be less than the 1.99% yield of the two-year note. (Historical comment: During the Great Depression, because of a quirk in the math, T-bills briefly produced a tiny negative return. However, this occurred during a time of general deflation and thus still resulted in positive real returns.)

This is confirmed by the latest TIPS curve. Notice the negative real yield below five years:



Meanwhile, the junk-Treasury spread, depending on how you measure it, is now north of 700 basis points. If we assume that mid-rated junk has a loss rate of 4% per year and a maturity of 10 years, then its expected real return is the +1% TIPS yield at that point on the curve plus the 7% spread minus the 4% loss rate, or 4%. Compounding things even further, because of forced sales by hedge funds, the yields on municipal bonds are now several dozen basis points above that of Treasuries, something that occurs perhaps once in a generation, and usually at times of local government distress, which does not seem in the cards at the moment.

To complete the picture, stocks, if we are lucky, are still priced for a long-term real return of about 3.5 percent. (The dividend yield of the S&P 500 is currently 2.37%, to which another optimistic percent of real per-share growth can be added.)

Conclusion: The debt markets are so out of whack that we are now at a point where credit risk is being rewarded more than equity risk, something that should never happen in a world where equity investors own only the residual rights to earnings. This cannot last for very long: either spreads will tighten rapidly, equity prices will fall rapidly, or both. (Or, chortle, earnings will grow more rapidly.) Stay tuned.

Equities vs real estate

Which is the better long term investment, equities or real estate? The conventional (but not necessarily correct!) wisdom for a long time has been real estate, although this may be changing with the current housing bust. Note here I mean property as an investment, not as a primary residence, which has different considerations such as saved rent, etc.

Something that complicates the discussion is that typical investors are much more familiar with the use of leverage (e.g., 10% down) in buying a house than in buying stocks. The discussion below does a good job of clarifying. I'm not sure you can buy a long-dated 5 year index call at 80% strike for 28%, but that's probably the right ball park. Note the writer is in the UK.

Related posts here (see first figure below), here (second figure below) and here.

Re: the property v equities argument

Property has naturally outperformed in the last 7 years as its a much easier asset class for an individual to leverage. So its no surprise that through the final phases of the credit bubble its done much better as much broader class of people can borrow against it.

However, over a much longer time period the relative returns havet been much different. Each has had their relative booms and busts (.com bubble, property bubble etc)

The question now is which will do better as we go from a decade of excessive leveraging to a long period of de-leveraging.

Its hard to argue for property in that context, especially as its "earnings yield" is maybe 4.5% at best after all costs, while that of the average equity is more like 8% now

You can leverage an equity investment just as much as property without the hassle of finding a tenant, the stamp costs, the illiquidity etc etc

Assume a 5 year investment horizon. Imagine you had 100k of equity that you wanted to leverage 5 times into a LT investment

A) Buy a property. Borrowing 80% of purchase price, Investing 20% of your own equity and 8% for stamp. Equating to 28% cash investment upfront all-in

OR

B) Buy a 5year call option to buy the Eurostoxx @ 80% of where it is now. This will cost 28% as well

Economically you have the exact same exposure to leverage...if the value of either asset is 50% higher in 5 years you come out with 5.35x your original outlay (ie 150% / 28%)

Cool...


Advantage of the property investment;

1- You dont see the value of the investment every day, you just optimistically assume its going higher!

Advantage of the equity Option;

1- Your maximum loss is the 28%. [If the property falls > 28% and u sell u lose > 28%]
2- Its more liquid, you can sell anytime of the day Mon-Fri
3- You dont have to find a tenant or risk cashflow issues if it becomes hard to rent or int rates suddenly spike.

The first figure below, which covers 1980-2005 (i.e.,extending almost to the peak of the real estate bubble; see second figure below), shows that equity returns have exceeded real estate returns even in the hottest markets.

What equity risk premium?

Some economists view the equity risk premium as a major theoretical puzzle. US equities have significantly and consistently outperformed bonds in the last 100 years. Why have investors not bid up stock prices to erase this premium? (Perhaps they already have ;-)

It's important to note that US performance is exceptional relative to that of other countries. Part of the risk in the equity risk premium is that we might eventually regress to the mean.

Another underappreciated point is that it was during the most recent period of data that we abandoned hard currency (left the gold standard). It wasn't widely understood that inflation is a threat to bonds but less so to equities (corporations can pass inflation through to consumers -- costs, revenue and earnings are all in real dollars).

Economist: Contrary to popular belief, stocks do not always go up

IF AMERICAN investors have learned any lesson in the last 25 years, it is to buy shares on the dips. The slide in 2000-02 may have been longer and deeper than they were used to but normal service was eventually resumed, driving the Dow Jones Industrial Average to a record high on October 1st.

Among American financial commentators, it is almost universally accepted that shares always rise over the long run. And this perception does seem to be backed up by evidence; if you take any 20-year period, Wall Street has always delivered positive real returns. In addition, one ought to expect shares (which are risky) to deliver a higher return than risk-free assets such as government bonds.

...Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School examined* the record of 16 stockmarkets which were in continuous operation over the course of the 20th century. In itself, this selection showed survivorship bias by excluding the likes of Russia and China. The academics found that only three other countries could match the American record of having no 20-year periods with negative real returns.

Other investors were far less lucky. Japanese, French, German and Spanish investors all suffered instances where they had to wait 50-60 years to earn a positive real return; in Italy and Belgium, the waiting period stretched to 70 years. It was no good following the famous advice to “put the shares in a drawer and forget about them”; the furniture would not have lasted that long.

Besides survivorship bias, there is another problem with the belief that stockmarkets must always go up; the very existence of the belief is likely to lead to its falsification. Investors will keep buying until prices reach stratospheric levels. That clearly happened in Japan in the late 1980s and with the technology-heavy NASDAQ index in the late 1990s; the latter is still, after seven years, not much more than half its peak level.

A significant proportion of the return from equities in the second half of the 20th century came from a re-rating of shares; investors were willing to pay a higher multiple for profits. But re-rating cannot continue forever. Although ratings have fallen significantly since the heady days of 2000, that is in large part due to the remarkable strength of corporate profits, now close to a 40-year high relative to national output. If profits revert to the mean, that could act as a drag on stockmarket performance. And, as with Japan, investors do not have much in the way of income to fall back on; the dividend yield on the American market is just 1.7%.

If investors want a simple parallel with share prices, they need only turn to the American housing market. Back in 2005, Ben Bernanke, then an economic adviser to the president, was asked about the possibility of a decline in house prices on CNBC, a financial-television channel. He said, “We've never had a decline in housing prices on a nationwide basis. What I think is more likely is that house prices will slow, maybe stabilise.”

Lots of people took the same view and were willing to borrow (and lend) on a vast scale on the grounds that higher house prices would always bail them out. They are now counting their losses. Investors in equities should beware of overcommitting themselves on the basis of a similar belief. Just ask the Japanese.