Category: stocks

Our Perception of Risk

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May 12, 2024

by Stephen Stofka

This week’s letter is about our perception of investment risk, and the subjective and objective aspects of risk evaluation. Our journey will take us several hundred years in the past and several decades into the future. The triennial survey of consumer finances indicated that less than half of people nearing retirement have $100,000 in liquid financial assets like savings accounts, stocks and bonds. Half of all working households have no savings, leaving them vulnerable to specific circumstances or a general economic shock. In our 20s, retirement looks remote with many years of work ahead of us. As we near retirement, we look in the other direction, to the past, and wish we had saved more. We confront the reality that we feel today’s needs more urgently than tomorrow’s possibilities. A $100 saving has a $100 impact on our current consumption but is only a faint light compared to the many thousands of dollars we will need in the future. We may not understand the underlying mechanism of saving.

We rely on what is visible to our senses to develop a flow of causality. We press on our car’s gas pedal and go faster, convinced that our action is adding more fuel to the engine. What the pedal controls is not fuel, but the air flow leading into the combustion chambers of the engine. The increased flow of fuel occurs in response to the change in air pressure. Prior to the 1980s cars used carburetors and mechanically employed this process called the Bernoulli principle, the idea that faster moving air induces a lower air pressure, a vacuum effect that sucks fuel toward the engine. Today’s fuel injection systems use air flow sensors that direct a computer to adjust the fuel flow. So, what does this have to do with risk?

Bernoulli’s principle is named after Daniel Bernoulli, the son of a noted Swiss mathematician and the nephew of Jacob Bernoulli, a 17th century mathematician who developed foundational concepts in probability like the Law of Large Numbers. Jacob maintained that people perceived risk in two ways. The first was an objective measure, an estimate of the probability of some event. The second was a subjective measure that depended on each person’s wealth, an inverse relationship. The first is visible, like the pressing of a gas pedal. The second is less visible, like the change in air pressure. Imagine that two people agree to flip a fair coin for a $100 bet. Person A has $1000 in her pocket; person B has $200. The loss or gain of $100 represents only 10% of A’s wealth, but 50% of B’s wealth. Even though the chance of winning or losing is the same for each person, they perceive the outcome differently. Peter Bernstein (1998) presents an engaging narrative of Jacob’s ideas in his book Against the Gods. His trilogy of books on the history of investing, risk and gold will inform and entertain interested lay readers.

Jacob may have identified one subjective element in each person’s evaluation of risk, but a person’s stock of wealth is not the only basis for a subjective estimate of risk. There are retired folks with accumulated savings of a million dollars who keep their money in savings accounts or CDs because they perceive the stock and bond markets as risky. A $10,000 loss in the stock market is only 1% of a million-dollar wealth yet some people perceive that loss in absolute dollars, magnifying the effect of a $10,000 loss. They regard the stock and bond markets as different versions of a casino. That same person might give $10,000 to a grandchild for college or to help buy a car, reasoning that there is an exchange of something that a person values for the $10,000. A person has no sense of receiving anything when their stock portfolio shows a $10,000 decrease. The stock market should have to pay an investor for using her investment, not the other way around. Such perceptions are confirmed during crises when the stock market loses 50% of its value.

Is an investment in the stock market like putting a quarter in a slot machine? Another perspective: an investor is like an investment company selling insurance to the stock market. A century of data shows that the probability of a loss in the stock market in any specific year is about 25%, according to an article in Forbes. In 70 years, the SP500 has doubled every seven years on average. An insurance company relies on Jacob Bernoulli’s Law of Large Numbers and diversification to manage risk. An investor, like any insurance company, will experience losses in some years. In last week’s letter (see note below) I wrote about surplus as a key dynamic factor in market transactions. In most years, an investor with a surplus of funds can “sell” those funds to the market and reap a gain.

Like risk, values in the stock market are based on both objective and subjective components. Sales, profits, dividends and efficiency help anchor a stock’s price movements as objective measures of value. Price responds to changes in these variables. Objective measures also include the variation in a company’s stock as a precise measure of uncertainty. There are various less precise but objective measures of economic and financial risk. Subjective measures include an investor’s need for liquidity, the ability to turn an investment into cash without impacting the price. An investor’s wealth can act as a cushion against fear of loss, a subjective measure discussed earlier.

Index funds have grown in popularity because they take advantage of Jacob Bernoulli’s Law of Large Numbers. By owning partial shares in many companies, an investor reduces the risk exposure to the variation in the fortunes of one company. The SEC might open an investigation into the ABC company, or the company loses an important overseas market, or the company reveals that the profit margins on some of its popular products are decreasing. To an index fund investor, a 10% decrease in that company’s stock price may be barely noticeable. The investor still has a risk of a change in general conditions, like a pandemic, but has dramatically reduced the risk of local conditions specific to one company.

Investors in Bitcoin do not act as an insurance fund for Bitcoin companies who mine Bitcoin. The miners have the surplus and are the sellers of Bitcoin. In the secondary market, the sellers of access to the digital currency market are the two dozen or so ETFs that allow investors to buy interest in a fund that owns bitcoin. Price movement is like a tailless kite flying in a breeze, responding mostly to price forecasts, a characteristic of some derivatives markets. The only objective measure of value and risk is the number of Bitcoin in circulation and the reward for mining new Bitcoin. Bitcoin’s price movement has a high volatility greater than 50% because there is little economic activity that anchors the variation in Bitcoin’s price. Despite the high volatility, an asset manager at an ETF fund makes the case for investing a few percent of a portfolio in a bitcoin ETF. As in our earlier example, the loss or gain depends on the current state of one’s savings.

Understanding the two aspects of risk perception, the objective and subjective, can help us manage our personal risk profile. Through research or the advice of a financial consultant we can understand the objective measures of portfolio risk but there are subjective elements unique to our personal history and disposition. The fear of having to be in a long-term care facility may influence our yearning for safety, regardless of our current health. A parent or relative may have had a similar experience and our primary concern is the protection of our portfolio value. We may feel fragile after the loss of our entire savings in a business venture. We can only become comfortable with our apprehensions by becoming familiar with them.

Next week I will look at our perceptions of other significant factors in our lives, particularly inflation.

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Photo by π“΄π“˜π“‘π“š 𝕝𝔸𝕀 on Unsplash

Keywords: stocks, bonds, risk, investment

Bernstein, P. L. (1998). Against the Gods: the Remarkable Story of Risk. John Wiley & Sons.

In last week’s letter I wrote about surplus as a key dynamic factor in market transactions. A seller of a good or service has a surplus which it values less than the buyer. However, the seller’s cost, including opportunity cost, is more than the cost to the buyer. These two ratios of benefit and cost find an equilibrium in the market that depends on the type of good or service and general conditions.

https://etfdb.com/themes/bitcoin-etfs/

https://www.vaneck.com/us/en/blogs/digital-assets/the-investment-case-for-bitcoin/

The Role of Surplus

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May 5, 2024

by Stephen Stofka

This week’s letter begins a series of subjects related to income and consumption. I will start with income, how we get the money to buy the goods and services we consume. A first-year course in microeconomics conveniently and simplistically divides the world into consumers and producers. In their textbook titled Microeconomics, Krugman and Wells (2018) explore the subject of labor as a factor of production in Chapter 19 at the end of the book. Since most of us work for forty to fifty years, the subject could be introduced to students in one of the early chapters. John Maynard Keynes, schooled in neoclassical analysis as a student of Alfred Marshall, criticized this framework because it ignored many of the flows in an economy. In a modern economy, we implement our choices with an exchange of money. Where did the money come from?

An entrepreneurial attitude to work is this: we either work for money or money works for us. If we work for money, money is our boss. If money works for us, we have a responsibility to direct it and manage it well. In that framework, money is a factor of production, the capital we use to realize goals for ourselves and our family. I was first introduced to this notion of money working for me when I was a child, and my folks opened up a savings account for me. I was amazed that my birthday money did chores just like a real person and got an allowance called interest. As the money got bigger, it worked harder and got a bigger allowance. What an amazing system!

Adam Smith, the first economist, analyzed the exchange of goods and money as a system. In the Wealth of Nations, Smith (1776; 2009) emphasized that the key to a developing economy was the subdivision of tasks to become more productive. Higher productivity created a surplus of a good or service so that the producer was willing to trade with someone else who wanted that good or service. In Chapters 2, 3, and 4 of Part 1 he repeats the point that this imbalance of supply and demand provides the energy to an economic system. In an often-cited example, Smith recounted the efficient production of a pin factory where each worker is assigned just one step in the production of a pin. An economy grows as the division of labor becomes more complex.

In Part 5 of the book, Smith predicted that the increasing division of labor would lead to greater prosperity but unevenly distributed. “For one very rich man there must be at least five hundred poor,” he wrote. Such inequality could lead to violent anarchy because the “avarice and ambitions in the rich” clashed with the “hatred of labour and the love of present ease and enjoyment” by the poor. A sovereign government had a responsibility to keep order and protect people from each other. Secondly, it should provide public works and institutions that distributed the benefits of a growing economy to more people. A road or port does not provide enough benefit to any one person or group to justify its expense, but such public projects raise the productivity and standard of living for many. Smith saw this improved public welfare and private security as key features that distinguished England from less-developed economies. To Smith, government was an intermediary between parties just as money was an intermediary of exchange.

A cost-benefit analysis of an exchange of surplus reveals some interesting ratios. A seller with a surplus of a good values the benefit from the good less than the buyer does. On the other hand, the cost to the seller includes the opportunity cost of not producing something which would earn a higher price from a buyer. The commitment of capital or time to producing a good or service requires a choice between alternative uses of that capital or time (see notes for measurement of opportunity costs). Presumably, the ratio of benefits equals the ratio of costs. If not, there is less motivation for exchange between seller and buyer. A less developed economy like Brazil generates less surplus so there is less inducement to make economic trades and money circulates at less than a third of the speed that it does in the U.S. (Notes).

The concept of surplus helps us distinguish different types of exchange. When two people trade services, they trade their labor, which has no surplus as such. To barter their labor, buyer and seller must match the type of good or service to be exchanged. To each party, the benefit must equal the cost, a hindrance to exchange. In an economy promoting the production of surplus, the benefit and cost are unequal to each party, but the ratios of benefits and costs are equal. Matching is easier and there are more trades.

Can we apply this analysis to the exchange of securities? The seller of a security like Apple’s stock does not have a surplus because she produces Apple stock for sale. She is motivated to sell because she thinks it might go down in price, and the benefit she receives from the sale is greater than the cost if she held onto the stock. The buyer thinks the security might go up in price, so his benefit is also greater than the cost. The key to this transaction is the broker who produces trades for sale, the matching of security transactions. The benefits to the buyer and seller of the stock are greater than the benefit to the broker. The broker’s cost, including the opportunity cost, is greater than either the buyer or seller of the security because the broker could always make more in commission by facilitating a different type of trade.

A year ago, I spent a few months studying the dynamics of a developing country in Africa. Because there was a lack of surplus in some parts of the economy, I came to appreciate the key role that surplus plays in our lives. In the coming weeks, I will try to understand various aspects of our working lives through these ratios of seller and buyer costs and benefits and how those ratios are influenced by surplus.

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Photo by Adam Jang on Unsplash

Keywords: securities, stock, cost, benefit

Krugman, P. R., & Wells, R. (2018). Microeconomics (Fifth). Macmillan education.

Smith, A. (2009). Wealth of Nations. Classic House Books.

Brazil Money Velocity: In the third quarter of 2023, M1 velocity for Brazil was .35, meaning that money circulates a rate that is a third of GDP output. The same velocity in the U.S. was 1.5, more than four times the rate. Brazil M1 measure is MANMM101BRM189S. Final demand, a measure similar to GDP, is  BRAPFCEQDSMEI. There was not a current measure of M2, a broader measure of money often used in the U.S. The series for M1 velocity is M1V.

Physics Imbalance: Coincidentally, an imbalance in electron fields causes atoms to bind together in an exchange of electrical charge. Khan Academy has a short explanation with graphics.

Opportunity cost: this is a fundamental concept in economics, yet economists disagree on how it should be measured. In 2012, Potter & Sanders justified four different answers economics graduate students gave to the calculation of opportunity cost found in an introductory economics textbook.

Potter, J., & Sanders, S. (2012). Do economists recognize an opportunity cost when they see one? A dismal performance or an arbitrary concept? Southern Economic Journal, 79(2), 248–256. https://doi.org/10.4284/0038-4038-2011.218

Investing, Not Gambling

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January 22, 2023

by Stephen Stofka

This week’s post is about expectations, investing and gambling. After last year’s slump in asset prices, investors may be disappointed in the recent performance of their portfolio. A 60/30/10 (U.S. stocks/bonds/cash) had a 3-year return* of 3.65%. A 5-year return was 5.53%, according to Portfolio Visualizer (2023).  Investors tend to weight losses more than they do gains. Following portfolio losses during the financial crisis, many investors turned to more conservative assets, selling their beaten down stocks at a low. Following this past year’s selloff in both bonds and stocks, investors might be tempted to shed both. Let’s take a look at the averages.

Only three years out of the past fifteen has a balanced portfolio had a negative return. When a stock fund loses 35% in a year, investors can feel the loss so deeply that they liken stock investing to gambling. A gamble is a win or lose event with a high return and a low probability of winning, a probability so low that it outpaces any winnings I might get. For example, if I could bet a $1 and win a million, that is a 1,000,000 to 1 leverage. But my chances of winning might be 1 out of 300,000,000. Take that probability and turn it upside to get its inverse of 300,000,000 to 1. Compare that to the leverage and the ratio is 300 to 1. The gambler is at a distinct disadvantage. That’s how lotteries raise money for parks and common areas and how casinos stay profitable.

A prudent portfolio is not a win or lose bet but a series of erratic steps, the familiar model of the random walk. In any year, our expectations should be guided by historical averages, not the last erratic step. In the fifteen years since the year of the financial crisis, the average of the annual returns of a 60/30/10 portfolio, rebalanced annually, was almost 7.2%. (Note: this is slightly higher than the annualized growth rate). A more conservative 50/40/10 asset mix averaged 5.6%. Last year’s portfolio loss of 15.55% was unusual and not likely to be repeated. Investors who were spooked by market losses last year risk losing positive gains in the following years if they let one year’s return dictate their allocation targets.

Losses in both the stock and bond markets last year made rebalancing counterintuitive. In a simplified model, bonds go up when stocks go down. To rebalance, an investor sells some bonds and buys stocks, selling high and buying low. Likewise, when stocks climb, bonds show a negative return. For twenty years, Callan (2023) has charted seven asset classes and their returns, demonstrating the wisdom of asset diversification. In 2021, a mix of large and small cap stocks returned about 21% while a mix of domestic and foreign bonds fell 3-4%, depending on the mix. Rebalancing toward a target allocation, an investor would have sold some stocks and bought bonds. In 2022, both stocks and bonds had approximately similar negative returns. An investor may have found that their allocation changed little except that the cash portion of their portfolio might have grown a bit.

An unusual year like 2022 can distract or confuse an investor’s strategy. A casino or lottery wants to draw our attention to the unusual event – the win – and away from the average – the loss. If gamblers were to focus on the averages, few would play. Investing is the opposite of gambling and our focus should be trained on the averages.

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Photo by Kaysha on Unsplash

*CAGR – compound annual growth rate

Callan. (2023, January 16). Periodic table. Callan. Retrieved January 21, 2023, from https://www.callan.com/periodic-table/ Note: this chart ranks the annual returns of seven asset classes for the past twenty years. Go to the web site, then click the PDF link for the free chart.

Portfolio Visualizer. (2023). Backtest portfolio asset class allocation. Portfolio Visualizer. Retrieved January 20, 2023, from https://www.portfoliovisualizer.com/backtest-asset-class-allocation

Bray and Begone

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January 1, 2023

by Stephen Stofka

This week’s letter is about an unusual year and the lessons we can and can’t learn from it. As I wrote last week, we must carefully sift through the unique circumstances in a time series to learn any lessons that we can carry into the future. Sometimes we bray at the passing of an unusual year and continue on our course. Other times, like 9-11 and the 2008 financial crisis, we sort through the debris of an unusual year to understand how we can avoid a repeat occurrence.

What made this year so unusual was the bond market’s loss of almost 13% in addition to the stock market’s loss of 18%. Normally, bonds zig when stocks zag but not this year. This year’s loss in the bond market was the steepest drop ever. This year has been a good test of an investor’s allocation but a long term perspective is encouraging.

During our working years we accumulate assets. In retirement we distribute the price appreciation and income from those assets. In a down market like this past year, a younger investor must balance the opportunity to buy assets at lower prices with the probability they will need liquidity, i.e. cash for living expenses. A basic recommendation is to have six month’s income in cash for emergencies and loss of job. Someone in an executive position might store up to two years of cash or highly liquid investments in anticipation of a much longer job search to find a comparable position.

This past year has tested retired investors who have relied on the historical stability of bond prices. An aggregate bond mix lost 12.8%, surprising investors who may have used bond funds as a substitute for cash funds that paid little interest in the previous years. A bit of historical perspective – in 1994, after five years of relatively low rates, the Fed began raising rates. An intermediate term bond fund lost 4.2%, while an average treasury bond lost 8% that year. The Fed has kept rates far lower and far longer than that five year period and the market reaction has been greater as well. A 60-40 portfolio (60% stocks, 40% bonds) has moderate risk and good long term returns, making it a choice of many money managers. That typical portfolio weighting lost 16.5% this year.

An asset’s ultimate value is measured in the goods and services that they can buy. Today’ retiree might live 20 – 25 years or more, tapping their assets for their income needs. A few months ago, Gupta et al (2022), researchers at McKinsey & Company, found that the SP500 index has returned about 9% since 1994, including the dot-com frenzy of the late 1990s. To measure the purchasing power of the SP500 index over a 23 year period, I adjusted the index by the CPI index in January 2000, near the height of the dot-com bubble. In that span of time, we have endured a dot-com meltdown, the Great Financial Crisis and its slow recovery, followed by a once-in-a-century pandemic and a disruption of the global supply chain. The wide adoption of the internet in commerce has prompted a fundamental shift in jobs and revenue. Despite those disruptions, the purchasing power of stocks has increased 1.8% above annual inflation since 2000. Including an average dividend return of 2.02%, the broad stock market has grown in purchasing power almost 4% every year.

The SP500 index is a compilation of companies that have survived tough economic conditions. Companies that fail the adversity test are discarded from the index and replaced by another company. It is like a game of β€œKing of the Hill” that we played as kids but the stakes and price volatility are farΒ  higher. A broad index of bonds usually offsets that volatility, sacrificing a little return for a big reduction in the value of a portfolio. In the past 23 years, a 500 index fund had a standard deviation – or wag of the tail – of more than 15%. According to Portfolio Visualizer (2022), a simple 60-40 portfolio had less than 10% deviation. That lack of volatility cost .25% per year in return, about the same as the annual cost to insure a house. Investors with a 6-30-10 portfolio, setting aside 10% in cash, paid an additional .25% less return in exchange for a slight reduction in price volatility.

For the first time since records began, bonds did not offset the volatility of stock prices this past year. Depending on their age, health, location and available resources, some investors have a greater tolerance for risk than others. Investors with exactly the same circumstances may perceive their risk differently and comparisons between individuals are difficult and ill-advised. Some investors feel more fragile, giving greater weight to unique outcomes like this past year. Others give more weight to average trends, taking comfort in the probability that this year was an anomaly.

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Photo by Mary Farrell on Unsplash

Backtest portfolio asset allocation. Portfolio Visualizer. (2022). Retrieved December 31, 2022, from https://www.portfoliovisualizer.com/backtest-portfolio#analysisResults. Stocks: an SP500 index fund. Bond: an intermediate term broad bond fund. Cash: money market.

Gupta , V., Kohn, D., Koller, T., & Rehm, W. (2022, August 4). Markets will be markets: An analysis of long-term returns from the S&P 500. McKinsey & Company. Retrieved December 31, 2022, from https://www.mckinsey.com/capabilities/strategy-and-corporate-finance/our-insights/prime-numbers/markets-will-be-markets-an-analysis-of-long-term-returns-from-the-s-and-p-500

Find the Hidden Value

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September 25, 2022

by Stephen Stofka

This week the SP500 index closed down more than 20% from its closing price at the beginning of the year. Where did the value go? When stocks were rising where did the value come from? Trained in neoclassical economics, the economist John Maynard Keynes asked the same question. He criticized the conventional economic analysis because it focused only on the present, disregarding the flow of money and goods into and out of the marketplace. Let’s explore that flow this week.

Let’s imagine that there is a car company called Drive whose stock symbol is DRV. When its stock price goes down on Monday, there were more sellers than buyers. The quantity of shares has not changed but the market value has declined. Where did that value go?

Let’s say that Sally bought 100 shares of DRV for $40,000 cash, or simply $40. I’ll leave off the 1000s in this story. She could have spent the money on a new SUV – satisfying her current needs – but buys a stock which she hopes will someday be used to satisfy her future needs. A car dealer did not make a sale. Let’s assume that the dealer has $36,000 cost invested in the vehicle.

What did the stock seller do with the proceeds? We might trace the money through many transactions in the stock market but eventually we come to Sam who took the proceeds from the sale of his 100 shares of DRV and bought a Drive SUV for $40. Sam’s net cash position is $0. A measure of economic activity, Final Sales of Domestic Product (BEA, 2022), has increased by $40,000 .

To recap the beginning positions: Sally = $40 cash, Sam = $40 stock, Drive dealer = $36 invested in car. Total = $116K. Let’s leave out income taxes, sales taxes and brokerage fees to keep the story simple.

A month later, the price of DRV goes down so that the market value of a 100 shares of stock is $36. The value of Sam’s SUV is not affected – or is it? If Sally were to sell her newly acquired shares at the lower price, she could buy a less expensive car but not that brand of SUV. Thus, there is less demand and the market for SUVs is softer because of the decline in DRV’s stock price.

Let’s imagine that Sally and Sam meet at the grocery store. Sally likes the SUV and offers to sell her DRV stock to Sam for $36, the market value. Sam thinks that is a good deal. He now has the same quantity of shares that he had before. If he had held onto the stock, the market price of the stock would have gone down anyway. He has driven the SUV for 1000 miles for free except for the gasoline. The dealer has $36 cash, covering the cost of the SUV, and $4 in cash profit.

Let’s recap: Sally = $36 car, Sam = $36 stock, Drive dealer = $40 cash. Total = $112K.

Sam and Sally each have $4,000 less than they started with for a total of $8,000 less. The dealer has $4,000 more than they started with. Where is the other $4000? Is it in the SUV’s depreciation or the stock’s lower market value?

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Photo by HAMZA YOUNAS on Unsplash

BEA: U.S. Bureau of Economic Analysis, Final Sales of Domestic Product [FINSAL], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/FINSAL, September 22, 2022.

A Good Decade

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January 23, 2022

by Stephen Stofka

As a year-end review I’ll compare risk and returns of the past ten years with the decade before. I submitted several standard portfolios to Portfolio Visualizer. These portfolio metrics are based on broad indexes with a yearly rebalancing. These are broad benchmarks and the performance metrics don’t include fees, taxes and transactions costs that would reduce an investor’s actual returns.

The CAGR is the compounded annual return. Worst Year measures the worry level that an investor might face. The first portfolio might be termed aggressive but would be typical for a person who is more than ten years from retirement. The 60/30/10 is a moderate portfolio allocation and the 50/40/10 is a balanced weighting, more appropriate for those who might need to draw funds from the portfolio.

2012-2021Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β  2002-2011Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β Β 

Stocks/Bonds/CashCAGRWorst YearCAGRWorst Year
70/25/512.2%-3.6%4.6%-24.6%
60/30/1010.7%-3.0%4.7%-20.6%
50/40/109.4%-2.5%4.9%-16.3%

The last decade stands in stark contrast to its predecessor, which included the great financial crisis of 2008-2009. The 7.5% difference in annual returns between the two decades was worth $106K extra return on a $100K portfolio. The more aggressive 70/25/5 portfolio gained an additional 1.5% during the past β€œgood” decade but had only a .1% lower return during the previous β€œbad” decade. During that bad decade, however, the aggressive portfolio lost 25% of its value in one year. A 20% drop in value is considered a bear market. For investors with no need to sell any of their portfolio, those were β€œpaper” losses. Some investors needed to tap their portfolio for living expenses in retirement or to recover from job loss. During the recovery from the financial crisis, some older investors continued to work past retirement age to replenish their portfolio. Many of them left the labor force when the pandemic struck. The number of workers over 55 is still 1.2 million less than it was at the onset of the pandemic (FRED Series LNS12024230).

The government learned valuable lessons from its response to the financial crisis in 2008-9. Both the fiscal and monetary response had been too moderate and that prolonged the recovery over many years. When the pandemic struck in March 2020, Congress and the Federal Reserve enacted strong relief measures that protected many families and some businesses from the economic fallout of pandemic restrictions. Occasionally, Congress can come together on a bipartisan basis and accomplish something.

It is unlikely that the 2020s will have the same high returns as the last decade. A younger investor can take a more aggressive stance and rely on the law of averages. Time is on their side. An investor who may need funds from their portfolio in the coming years might check their allocation and rebalance to a more appropriate level of risk.

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The Old Normal

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January 2, 2022

by Stephen Stofka

β€œWe wish you a Merry Christmas and a Normal New Year” could be this year’s chorus. We left normal about 13 years ago when the global financial crisis erupted. Twenty schoolchildren were massacred at Sandy Hook Elementary in 2012. When Congress could not agree on any weapon restrictions, we knew we had veered onto the land of abnormal. In 2016, 60 million people voted for a candidate with no political experience. They had stopped believing in the normal and now embraced the abnormal. When the pandemic emerged in 2020, we stepped off the gangplank into the dark waters of the unnormal. That year a record number of people voted for a candidate who had spent most of his adult life in politics. They voted for normal.

On January 6th, 2021, the abnormals stormed the halls of Congress. They wore American flags and big bull horns and painted their bodies red and blue. They believed in a vast conspiracy. They had convinced themselves they were heroes. American cable and social media had created a funhouse of distorted reality and values. In that palace of crazy where everyone looked warped and bent, the warped and twisted looked like everyone else. Acting irrational became a strategy.

What is normal? In the past ten years, the SP500 has nearly quadrupled. Investors know the momentum can’t last but when will it end? Abnormal returns don’t return to normal. They pause then lurch in a different direction. The latest craze has been ESG funds, which grew by another $120B this year, according to Bloomberg. As the dot-com craze and the housing boom showed, investment flows can be fickle.

The flow of goods and services in the economy is more stable but the pandemic upset that dynamic balance. As we avoided close contact with others we diverted our purchasing power from services to goods. In April 2020, orders for durable goods fell 36% from the previous year’s level, comparable to the decline during the 2008-2009 recession (FRED, 2022). Production of gasoline fell 25%. National refineries did not return to their former level of production until April 2021(EIA, 2022). Durable goods boomed back in the spring of 2021. Federal relief supported many families but helped fuel inflation in a distorted economy. When and if the pandemic eases and people resume their habits, the economy may discover a more familiar equilibrium. That will help relieve price pressures.

What will relieve the erratic sentiments that drive investment flows? Casual investors who are young can afford to follow an investment theme. Older investors must protect their savings and avoid chasing the latest passion. A portfolio can protect us only if we protect it.

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Photo by Christophe Hautier on Unsplash

EIA. (2022). Weekly petroleum status report – U.S. energy information administration (EIA). Retrieved January 1, 2022, from https://www.eia.gov/petroleum/supply/weekly/. Table 3.

FRED (Federal Reserve). (2020, November 4). Manufacturers’ New Orders: Durable Goods (DGORDER). Retrieved January 1, 2022, from https://fred.stlouisfed.org/series/DGORDER#0

A Tale of Caution

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January 31, 2021

by Steve Stofka

The trading in GameStop (GME) has spurred romantic visions; a mob of peasants has stormed the castle and the nobles have fled! Huzzah! This love of the romantic convinced a bunch of peasants to storm the Capitol on January 6th. We are human beings; we love stories. The truth is less appealing or ordinary.

At a press conferences this week, the well-prepared and even-tempered White House Press Secretary, Jen Psaki, was asked if President Biden planned to speak to the issue of the volatile trading in GameStop (GME). She said that it was a new age; the President was not going to speak to issues he had no expertise in. Imagine that. We will miss the enjoyment of watching former President Trump standing in the White House driveway and opining to reporters on every topic under the sun.

Reporter: β€œMr. President, what’s your source on that?”

Mr. Trump: β€œMy mind. I have a very smart mind.”

Without the daily source of ridicule that Mr. Trump provided, comedians are having to write new material.

But I digress. GameStop. Twenty-five years ago, internet stocks were taking off. Message boards at AOL, CompuServe and others lit up with stories of β€œTen baggers,” the holy grail of stock investing. Buy a stock for a $1 and watch it rise to $10. Those in Bitcoin have experienced the heady feeling.

That romance incentivized peasants to join the Crusades; there was gold in Solomon’s Temple at Jerusalem. Thousands poured into the California gold fields in the hopes of striking it rich. The people who get rich are the ones selling pickaxes and panning tools to the miners. The gold is not in the hills but in the people digging up the hills.

On message boards in the 1990s we learned about options. Instead of buying Microsoft stock, an investor can buy options to buy Microsoft’s stock. If Microsoft’s stock is selling for $25, it costs $2500 to buy a 100 shares, the minimum lot. At that time, buying less than a 100 shares cost a lot more in commissions. If an option were selling for $1, an investor could buy 2500 options! If the price went up $5 you could quintuple your money. Imagine making $10,000 in a few weeks.

People quit their jobs to day trade. The successful ones were cautious, taking profits quickly, not taking too many risks. Someone with a family to feed and rent to pay must be responsible. A modestly successful trader can convince themselves that they have a well-balanced strategy.

About a year before the internet stock bubble blew up, someone posted a rather long post on a message board. Since he was in the options business, a family member had asked him for his advice. Aware for the first time that inexperienced retail traders were taking positions, he offered his advice, which I will paraphrase. A few points stuck with me.

Options are tools. 94% of options trades expire worthless. Professional traders use options like car insurance. Yes, there are some companies who take risks, but most of those in the business use options to mitigate risk.

Understand that multi-national companies pour hundreds of thousands of dollars into news gathering, sophisticated computers and programming by very smart people to develop and deploy options strategies. They are on the other side of the trade.

A retail trader may get lucky. The prospects for Company A improve, the stock goes up and the trader makes money. A company using options aims to make money whether the prospects for Company A improve or deteriorate. A successful racetrack makes money no matter what horse wins.

Gamblers at a racetrack can rush the window in the closing moments before a race begins and cause the track to lose money on that race because the track doesn’t have the time to change the odds to layoff the bets. With the advent of the internet, a group of retail options traders could do the same with a hedge fund, who can’t lay off the bets fast enough. It could be done but it would be difficult.

25 years later, it has become much easier for gamblers to rush the betting window. The success of those traders will no doubt inspire others to try the same strategy. An industry which uses options to mitigate risk on trillions of dollars will not let a few retail traders upset that market for long, so don’t gamble with the rent money.

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Photo by Kay on Unsplash

Price Plateaus

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October 20, 2019

by Steve Stofka

Occasionally the stock market plateaus for six to nine months. The competing market sentiments – positive and negative – that cause a price plateau usually turn in one direction or another. Rarely does this leveling period last for twelve months or more. When those indecisive conditions don’t resolve for a year, what happens next?

Let’s begin by looking at shorter duration plateaus which occur more frequently. The market gets a bit too exuberant or conflicting economic signals make it more difficult to predict the future. Some investors read the data and reach for risk; others read the same tea leaves and opt for safety.

In 1999, near the peak of the dot-com fever, prices plateaued for seven months before going onto new highs in 2000Β . Again, the market paused for much of the year.Β  It was the end of the huge bull market of the 1990s.

In the beginning of 2004, investor indecision caused a leveling of price action after market sentiment had turned positive in 2003. The dot-com bust, the 2001 recession, the 9-11 tragedy, and the Enron and accounting scandals had combined to cut stock values in half by the spring of 2003. Investor optimism following the tax cut package of 2003 suffered when employment gains in late 2003 turned erratic. Investors were wary. Would this be a double-dip recession like the early 1980s?Β 

A relaxation of financial regulations helped spur more residential investment and the market continued upward. The erratic gains in employment were attributed to seasonal volatility in the construction industry. Many factors contributed to the complex international financial environment that spurred a boom in housing. In 2007, investors began to question market evaluations and prices plateaued for six months.

Two recent price stalls lasting more than twelve months seem to buck the trend of shorter-term plateaus. That there have been two in less than five years is concerning. In mid-2014, oil prices began a steep decline. Lower commodity input prices helped the profits of the broad market but by early 2015, investors grew worried that this decline was a reaction to a broad economic downturn. For 18 months, prices leveled. As voters went to the polls in early November 2016, prices were the same as in February 2015. Some voters chose an inexperienced Donald Trump as an alternative to Clinton 3.0 or Obama 3.0.

Shortly after the passage of tax reform in December 2017, investor optimism hit a peak and it has barely surpassed that high since then. The optimism of this year’s gains has only balanced the pessimism and losses of last year’s final quarter. What will happen after this? I don’t know. Investors need to think like fighters who stay balanced on their feet because they don’t know where the next punch is coming from.

Reaching Consensus

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September 22, 2019

by Steve Stofka

In the early 1980s, scientists at NASA raised the alarm that much of the protective ozone layer over Antarctica was missing. Newspapers and TV carried images of the “ozone hole” (Note #1). In 1987, countries around the world enacted the Montreal Protocol and banned the use of aerosols and chlorofluorocarbons (CFCs). There were some arguments and a few AM radio talk show hosts called the ozone hole a scientific hoax. However, most of the world reached consensus. There will always be crackpots who ride backwards on their horse and claim that everyone is lying about what lies ahead.

Compare those days of yesteryear with today. We have a wide array of media and information outlets. People who can’t make change are self-proclaimed experts on climate change. The Decider-in-Chief can’t reach consensus with himself for more than a day. A slight breeze changes his opinion. Intentionally or not, he has become the Anarchist-in-Chief.

The younger generation is quite upset because they will have to live with the consequences of climate change. The fat cats who make their money proclaiming climate change is a hoax will be dead. Next week there’s a climate summit at U.N. headquarters in NYC. A lot of young people demonstrated in cities around the world this past Friday to let the world know that they are concerned. That’s consensus.

What happened to us in the past thirty years? It’s tougher for us to reach consensus about guns, immigration, climate change, women’s rights, and health care to name a few. Let’s turn to a group of people whose job it is to craft a consensus. In a recent Town Hall Supreme Court Justice Neil Gorsuch pointed out that the nine justices reach unanimous consensus on 40% of the 70 cases that they decide each year. Only the most contentious cases make it to the Supreme Court. 40% unanimity means they agree on many principles. 25-33% of their cases result in a 5-4 decision. Those are the ones that get all the attention. The nine justices who currently sit on the Court were appointed by five different Presidents over the past 25 years. Despite the changing composition of the Court over the past seventy years, those percentages of unanimous decisions and split decisions have remained the same.

Let’s turn to another issue concerning consensus – money. Specifically, digital money like Bitcoin. Some very smart people believe in the future of Bitcoin and the distributed ledger concept that underlies digital money. In this podcast, a fellow with the moniker of Plan B discusses some of the econometrics and mathematics behind Bitcoin (Note #3). However, I think that pricing Bitcoin like a commodity is a mistake.

I take my cue from Adam Smith, the father of economics, who lived during a time and in a country with commodity-based money like gold and silver. Unlike today, paper money was redeemable in precious metal. However, Smith did not regard gold or silver as money. To Smith, the distinguishing feature of money is that it could be used for nothing else but trade between people. Money’s value depends exclusively on consensus, either by voluntary agreement or by the force of government. Using this reasoning, Bitcoin and other digital currencies are money. They have no other use. We can’t make jewelry with Bitcoin, or fill teeth, or plate dishes as we can with gold and silver. The additional uses for gold and silver give it an anchoring value. Bitcoin has an anchoring value of zero.

When people lose confidence in money, they lose consensus over its value. Previous episodes of a loss of confidence in a country’s money include Zimbabwe in the last decade, Yugoslavia in the 1990s, and the sight of people pushing wheelbarrows of money in Germany during the late 1920s.

Like gold, Bitcoin must be mined, a process that takes a lot of electricity and supercomputers but does not give it any value. Ownership in a stock gives the owner a claim on the assets of a company and some legal recourse. Ownership of a digital currency bestows no such rights.

In an age when we cannot reach consensus on ideas like protecting our children at school or the rights a woman has to her own body, we seek consensus with others on more material things like Bitcoin. We seek out information outlets which can provide us with facts shaped to our perspective. When facts don’t fit our model of the way things should be, we bend the facts the way water bends light.

John Bogle, the founder of Vanguard, died recently. He was an advocate of investing in the consensus of value about stocks and bonds. Now we call it index investing. That’s all an index is – a consensus of millions of buyers and sellers about the value of a financial instrument. There are several million owners of Bitcoin – a small consensus. There are several thousand million owners of SP500 stocks. That is a very large consensus, and like a large ship, turns slowly in its course. A small ship, on the other hand, can zip and zig and zag. That’s all well if you need to zig and zag. Many casual investors don’t like too much of that, though. They prefer a steadier ship.

I do hope we can move toward a consensus about the bigger issues, but I honestly don’t know how we get there. In 2008, former President Obama called out “Si, se puede!” but quickly lost his super-consensus in Congress. “No, you can’t!” called out the new majority of House Republicans in 2010. We’ve gotten more divisive since then. Journalist Bill Bishop’s 2008 book “The Big Sort” explained what we were doing to ourselves (Note #4). Maybe he has an answer.

In the next year we are going to spend billions of dollars gloving up, getting on our end of the electoral rope and pulling hard. Our first President, George Washington, was reluctant to serve a second term. Hadn’t he given enough already? In our times, each President looks to a second term as a validation of his leadership during his first term. There’s that word again – consensus.

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Notes:

  1. Images, video of the ozone hole in 1979 and 2018 from NASA.
  2. We the People podcast from the National Constitution Center
  3. Discussion of bitcoin on this podcast
  4. The Big Sort by Bill Bishop