Sunday Morning Coffee

As my thoughts about things like toll roads and other lowly correlated assets evolve I thought it might make sense to shed a little more light on why I am thinking about this stuff more, what realistically can be expected from these types of assets and more importantly what not to expect.

It’s no secret that I think a bear market has already started as a function of excess gone bad in the financial sector.

Regardless of whether a bear market has started or not, the fact is we have had bear markets in the past. The come, the market drops, they go and the market goes back up. This will be the fate of the next one whenever that might be.

It’s like going to the dentist. You don’t want to have to endure sitting in the chair but you pretty much know what you are going to get.

From this standpoint bear markets do not really threaten you financially (of course bad asset allocation is a different story). You pretty much know what you’re gonna get and if you can add any value during a bear market, all the better.

A bigger issue than a bear market that looms is the threat of returns below average after the bear market. Regardless of anyone’s emotional state a repeat of the past is not to be feared, it is to be endured. Once endured I think we may be in for a period of returns that are noticeably below normal for an extended period which could be a new thing. This would disrupt a lot of financial plans.

I am thinking something like US markets averaging 5% per year instead of 10%. It might sound benign but it isn’t.

Things like toll roads and plane leasing companies, as I mentioned the other day, have complex financial structures. There is a management of leverage and interest rates that is potentially more important that operating the tolls or contracting out the planes. Its kind of like car dealers. I’ve heard that selling the cars isn’t as important as how they manage their interest rate risk. Whether that is true or not crisis, like we have had this summer in the financial sector, creates either real or perceived problems for financially intricate companies like some toll roads and some plane leasing companies.

Since I think the bear market started with financial companies it seems logical to me that the toll roads and plane leasing companies may not offer as much bear market protection as we would like.

But I am not worried about the bear market I am focused on what might come afterwards; returns that are below the historical norm. That is where I think moderate exposure spread over disparate market segments that might yield 6-7% and go up in price 3-4% becomes very important.

To this point all four plane leasing stocks that I am aware of are down 20-26% in the last three months. This does not make them bad stocks, it makes this the wrong time. I don’t own any now but will be a buyer at some point (might not be for a couple of years) at a 2% weight. Anyone who bought three months ago at a 2 or 3% weight may not be happy with the purchase but they have not permanently damaged their portfolio either.

I believe the plane leasing space is a valid concept but it can, obviously be cyclical. The last few months have simply been the wrong time in the cycle. Getting the cycle wrong with too much of your portfolio becomes a real danger and all of these themes strike me as having the potential to end up being over owned.

For anyone who cares the context here is my trying to think about what comes after the bear market. If you have been reading this site for the last couple of years, or longer, you know that I was planning a strategy for what I believe is the current bear way back then and I have been making small changes in that direction (buying the double short, making the occasional sale and reducing the size of some bigger winners) for a while now.

The idea of waking up one day and saying a bear market is here I better do something seems crazy to me for anyone employing any sort of active strategy. Similarly waking up one day in 2010 and saying things are different I better do something is just as crazy.

Planning for a bear market that never comes does not seem crazy to me. Planning for a changing investment landscape that never changes doesn’t seem crazy either.

The picture is from Kapoho, which is kind of close to us. A few miles further down the road was covered by lava flow. And yes I think I did post this picture before.

28 Comments

  1. I would like to know your reasoning for thinking returns may be below average after the bear market.

    I agree with you about the bear and I think the 10% returns quoted are to high due to Mr. Bubble at the Fed distorting the last couple of decades. But I see no reason why we can not get back to “normal” returns after a bear market. I am not sure what normal is exactly but if you look at 80 to 100 years before Greenspan I think they were around 8%

    I do think this bear will be larger than usual, but I see no reason why the future will not be bright. Unless the bear is not that bad and we end up getting two in a series.

    I still think there is excessive house hold debt out there that needs to be worked off, defaulted on, etc.

    Reply
  2. This is something I have been blogging about every so often since I started the site.

    Basically I think the dollar likely sharing the role of world reserve currency (a slow unwinding type of process) will be one of a couple of things to cause US rates to generally be higher than they have been (not 1981 high, not even close).

    Rates slowly on the way up, growth a little slower, the dollar a little less important and looming imbalances will not be a Peter Schiff outcome just not so great necessitating that we seek returns elsewhere.

    Reply
  3. Peter Schiff is a little to dismal for me, but he was right about housing when everyone was saying he was to negative. I think there is excessive optimism out there as well.

    I do not think the dollar will be replaced until the Chinese currency can take over as the reserve currency and that could take a while. I just do not see enough euros being printed to replace the dollar and nothing else comes close.

    I do agree people will diversify out of dollars more in the future though. Its just that the dollar will be the defacto currency for a while during a decline.

    Reply
  4. Roger,

    Thank you for a great blog. Could you repeat the four plane leasing stocks you referenced?

    Thank you,

    CA

    Reply
  5. FLY, AER, AYR, GLS.

    At this point all I know is I won’t be buying GLS.

    To reiterate it could two years before I do anything here and even then I may do nothing.

    Reply
  6. anon@7:26.
    The question is why would returns be in the 8-10% level?
    To start with, if you look at the table for the SPY at the end of each decade that Roger posted few weeks back and plug it into an Excel sheet You will notice that the compounded returns are about 6%. Add to that the historical dividends and you will get closer to 10%.
    The dividends are no where close to their historical levels and it seems that they are not going back any time soon. So in order to get the historical “norms” you will need above “normal” earning expansion and possibly earning multiple expansion.
    The earning multiple is already at the top of its historical long term range.
    So the question is, are earnings going to expand enough to pick up all the slack.

    In my view the answer is no. There was a reason for the normal returns over the last century. It was not because it was the law or god’s word. It happened due to huge economical expansion that was the direct results of:
    1) World war II and the reconstruction that followed.
    2) Talent/Brain inflow from Europe and other countries.
    3) Huge leverage of the industrial revolution and using it to produce a ton of everything (cars, planes, machines, etc…).
    4) Huge advances in agriculture both as a science and the amount of land utilized, resulting in enormous production gains.
    5) Unprecedented scientific advances.
    6) The switch to the fiat currency system and establishing the dollar as the world currency reserve.

    So, what did we do with all of those gains? we pissed them away.

    1) We “proudly” became a service economy. Meaning, we produce less and less and just “service” each other. Think of an Island with a lawyer, a waitress, a banker and no farmers/builders/manufacture. Long term this is a recipe for economic collapse.

    2) We drowned ourselves in debt. If you do not want to look at why/how historical empires collapsed just look at the sub-prime borrower. We, as a country, are one big sub-prime borrower.

    3) We ceded our technological leadership. Just spend few weeks overseas and you will realize that. Instead we elect idiots who are proudly anti-science and we are still debating with our presidential candidates whether the earth is 6000 years old or not.

    In short, we took the gift of the greatest economic expansion (20th century) of all time and squandered it.

    If the market does return in excess of 10% compounded annually going forward it will be due to inflation and loss of purchasing power. we will have more money but we will be poorer.

    Reply
  7. Roger,
    Wow, what a pivotal time in your thinking wrt process. Thanks for letting us into the wheel house, to borrow your own phrase.

    I posted this Q on the prior thread. It basically is…any suggestions on how to find a mutual fund that encapsulates what you are talking about and can help to distribute risk wrt strategies? Would it be tagged “Total Return” Might be an intersting way to see how such a fund fared in prior mkt environments.

    And to add to the list, what about a fund that trades volatility? Is there one. Volatility is an asset class that can be leveraged independent of the market. Yes?

    As a newcomer to managing risk I am all ears for your process. As a prior avid camper, my motto was never underestimate mother nature, so I over engineered my campsites and planned for contingencies that sometimes never happened. But, it was me that had the dry tent, the right equipment, and could put together a nutritious meal. A spurious listener to Cramer but last night I heard him describe the common mistakes of amateur investors…one was think first about how much risk, not how much profit. What ashame that in the 90’s I never borrowed my mindset about mothernature and applied it to the market.

    A young analyst was on Bloomberg. Her primary dynamic was how the domestic consumer will spend less and that will slow the economies that import to us, and that a decoupling expectation will be a hard sell. On the other hand, as they like to say, the SWF/sovereign wealth funds are going to be a huge buffer to worse case scenarios.

    Roger…how can we identify the countries with growth rates higher than inflation?
    /jasper

    Reply
  8. Bear Markets come . . . and Bear Markets go – but how long will it take to get back on track?
    If I recall correctly, it took 21 years for the Dow Jones Industrial Index to gain back the losses of the 1929 Bear Market

    …………..

    Reply
  9. Damn, Sami had an extra espresso and brought his A game. Oh snap.

    I agree directionally with what you are saying about that which was squandered but I don’t know what I think about magnitude.

    One thing I would add about our debt is some portion has to be attributed to our status in the world. We have the money (or we had it if you prefer) and so other countries have to sell to us essentially. I read this somewhere a while ago (don’t remember where, sorry) and it makes sense to explaining a portion of our debt mess, but clearly we have made it worse.

    Jasper, a lot there. As far as finding different mutual funds for any theme I don’t really know. Over the summer there was a WSJ article about long/short funds not doing the job that listed a bunch of them, I found Nakoma because a reader left a comment about it–point being I tend to just stumble across them so if any other readers know of a site that lets you sort by theme I’d like to know too.

    As far as know the economic situation in a country I know The Economist has data in every issue. Every central bank site from around the world I have ever looked has an English version and they have data.

    Bloomberg.com seems to cover a lot of countries too.

    If you were a decision maker for some portion of an SWF would you buy US assets if you thought things were clearly going to worsen? We are not at that point now, I don’t know if we ever will be but if it ever does look that, we become Japan, SWF’s may shop elsewhere.

    As far as 21 years to make it back; in 1934 the Dow was up 38%, in 1935 the Dow was up 28%, in 1937 the Dow was up 28%, in 1944 the Dow was up 26%.

    There were plenty of crappy years mixed too, point being that “it took 21 years to gain back the losses” is not the best way to look at it.

    Reply
  10. Retirement Portfolio Managers must act within a conventionally accepted framework.
    Investment being mostly about Risk and Reward, it would seem hopeful if one could identify a Portfolio with Zero downside risk and 50% upside potential.
    A Portfolio constructed from 50% GLD [gold] and 50% GDX [gold miners] would probably achieve this risk/reward profile.

    …….

    Reply
  11. There has been discussion about the normal yield curve. I just stumbled across the treasury yield curve at etfconnect/tools. Here is the link:
    http://www.etfconnect.com/tools/tools.asp
    (The date on the chart is 12/28/07; so, presumably they update it daily.) The curve looks normal to me, except for the the 6 month-to-2 year durations; yields from 2.5% to 4.5%. Roger, other than the rates being low, why is this yield curve not normal? Thanks, JCarr

    Reply
  12. because libor is much higher and libor is the starting point for a lot of capital flows. Also the Fed Funds and Fed discount rate are both much higher.

    Reply
  13. I had thought of the Fed Funds and Fed discount rates being higher, but not the libor. Where does one find info on libor? I am considering buying an aggregate bond fund or ETF when 10-year hits about 6%. Thoughts? And, thanks for the quick response and the tremendous service you give to us non-professional investors. JCarr

    Reply
  14. Jasper,
    I mentioned this once before and was immediately ridiculed. The book, “The Hedge Fund Edge” goes into detail discussion of the Austrian Liquidity Cycle and the causes/results of the economic expansion/contraction. It also goes into lengthy details on how to find economies that are growing and hitting their strides.
    It is an expensive book but IMO definitely worth the money.

    According to Bespoke, the US market ranked 59th out of 87 countries they track in terms of returns.
    http://tinyurl.com/2nthk2

    that validates what Roger has been saying all along. Country diversification can do wonders to your portfolio. Couple that with some research into which economies are expanding and you will be way ahead of the game.

    Reply
  15. LMAO, I don’t know where it is. I have the teevee on all day so they refer to it all the time (that is until it stops mattering which one day it will go back to obscurity).

    6% seems like it would be somewhat compelling, ofcourse with a fund you are not locking in 6%. If rates go to 6%, you buy a fund, then rates go back to 4% your fund will yield 4%-ish. of course the price should go up but with funds you cannot lock in a yield…if that even matters to you.

    Reply
  16. Anyone buy the argument that the declining dollar means the US might suddenly start making stuff for export again? I think it means boomtimes for US agriculture, although there’s more to that than just the dollar.

    Reply
  17. Roger,
    For your clients do you have a basket of cef’s and/or single stocks dedicated to getting income? If so, as a group, what percentage of the port do they represent and how did they do. In my own watchlist of cef’s, yield for the ones I follow are in the range of 6-8%; nav though did rather poorly ytd, except for IAF,CGO,and DTH
    jasper

    Reply
  18. I think 10% return for the US market is very possible… but not because companies are actually growing by 10%… I think inflation will pick up a bit and most companies will raise thier prices and the share prices will pick it up to keep up with inflation. So even if a 10% return is acheived… if inflation is higher than normal, it doesn’t mean the companies REALLY grew by 10%.

    I mean, it makes sense to me…. falling USD… rising commodities… eventually it has to hit the pocket book and cause some inflationary problems.

    Oh, and a reply to ANON who said: “I do not think the dollar will be replaced until the Chinese currency can take over as the reserve currency and that could take a while”

    That will never happen… The Euro or an Amero will be the new reserve currency… or a basket will be… but I can’t imagine anyone wanting to hold Chinese currency when they are a communist country that maniupulates it to keep it low so they can retain the status of world manufacturing super power. If they raise thier currency too high or decide to pay thier workers too good, companies will move to South America and Africa to get the new cheap labour. China is already the worlds manufacturing powerhouse and they still do less trade with America than Canada… food for thought. Oh, and don’t forget the 4-2-1 rule … 4 grandparents, 2 parents and 1 child. Try supporting that society in 4 or 5 decades.

    Reply
  19. Oh and here is some more food for thought> http://www.census.gov/foreign-trade/top/dst/2007/10/balance.html

    That is year to date up to October 2007. Note: a country of 32.5 million people (also very much a service oriented, but also resource oriented economy)is doing $467.34 B in trade with US. China (1.3 billion people) is doing $318.57 B in trade and they already manufacture pretty much EVERYTHING in that is sold in the US.

    Reply
  20. Inflation higher than it is now? Sure. I am skeptical about dynamic-altering inflation rates.

    Jasper on a wide spread basis I have two CEFs in my ownership universe for convertible bonds, one has done worse than the other.

    I used to have a CEF for foreign that is down that i swapped for actual bonds (in the last year i learned how easy they are to buy when you can buy in volume for a bunch of clients).

    I have several preferreds that are all down varying degrees in the crisis.

    The one call writing fund i use widespread is luckily only down 2% YTD but it paid about 8% out. My luck with this fund is not lost on me.

    Anytime I have written about using CEFs (I think I say this everytime) I stress moderation. They have been pasted this year. A big weight has been a real problem, a small weight is only a drag.

    Reply
  21. You would think that, “prior to ringing bells” one would look deeper in to the market tell alls,
    I know the disconnects are the current excusables, but i will still expect gold to take a tumble of sorts prior to anything big happening..My thought is, where is the new low for gold, fully understanding current world pressure on the metal?

    Mac

    Reply
  22. “That will never happen… The Euro or an Amero will be the new reserve currency… or a basket will be…”

    I did not say I like china I said they would be the world reserve currency because they will be the world power house. I am thinking 10 to 30 years – kind of hard to predict. You and I do not have to like it, but we should not lie to our selves.

    As far as children, you would be surprised how easy it is to stop using birth control once you choose to stop.

    Reply
  23. China isn’t all that. China is a paper dragon.

    Reply
  24. Robert Shiller, Professor of Economics at Yale University, predicted that there was a very real possibility that the US would be plunged into a Japan-style slump, with house prices declining for years.

    Professor Shiller, co-founder of the respected S&P Case/Shiller house-price index, said: “American real estate values have already lost around $1 trillion [£503 billion]. That could easily increase threefold over the next few years. This is a much bigger issue than sub-prime. We are talking trillions of dollars’ worth of losses.”

    Reply
  25. Hi Roger.

    I’m very new to your Blog having stumbled across it just the other day.

    Well done on maintaining excellent content.

    An observation with respect to your ‘I think a bear market has started’ comments.

    http://www.crestmontresearch.com/content/market.htm

    In particular ‘Secular Cycles’

    http://www.crestmontresearch.com/pdfs/Stock%20Secular%20Chart.pdf

    infers that based on PE the US has been in a Bear since 2000.

    If you modify their chart to combine the shorter Bear/Bull/Bear cycle 1925 to 1941 as per :-

    http://www.jfholdings.pwp.blueyonder.co.uk/beari5.gif

    then historic Bears have typically run for around 15 years e.g. up to 2015 odd for the current Bear cycle, with an indication that the end of that Bear will be with the Dow at 11497 or lower and a PE of perhaps high single digits (8 or 9).

    Judging by the previous Bears the PE typically falls in the latter half of the cycle. So on that proxy we might encounter a further 7 or 8 years of sideways ranging prices but inter-spaced with run-up’s and down’s.

    My domestic market – the UK – typically mirrors the US. My preference is similar to that of what another poster has already mentioned – international diversification – as being the likely best avoidance mechanism for relatively poor performance.

    http://www.jfholdings.pwp.blueyonder.co.uk/countryreturns.png

    All the best for the New Year.

    Reply
  26. Roger,
    You have mentioned several times that you think the bear market has begun. Most definitions of a bear market is one that HAS fallen, say 20%. One can not, at least I have heard no one, say that we have had, or are starting a bear market, because by definition, we would not know we are in it until the market has fallen 20%.

    1) What is your definition of a “bear market” that allows us to declare that we have started one?

    2) Since bear markets are technical and not fundamental, ie down 20% …has nothing to do with the economy…how can we be in it when the markets had an up year?

    I really want to know, I’m not just busting your chops.

    g

    Reply
  27. Hi George

    May I propose an alternative interpretation of a Bear, and one that I personally prefer, as being :

    A Bull is a prolonged period where prices rise faster than their historical average.

    A Bear is a prolonged period where prices rise slower than their historical average.

    Regards. Clive.

    Reply
  28. George, great question.

    The better, but much longer, way to phrase it is that I believe a top is in. I think we will look back to October 9 as being the high for the cycle and that this will become a normal bear market.

    I hope I am wrong but there was an element in 2002 of well of course we were destined to fall. I feel like all of the things confronting markets today, 6 months or a year from now there will be a lot of “of course we have a bear market now.”

    You are right that we are only down a little from the high but this one feels like a bear starting with the broad rolling over in the market.

    As I have said repeatedly I have only made small changes so far and we’ll just have to say if my thoughts hold any water.

    Clive that is an interesting thought, i like it.

    Reply

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Sunday Morning Coffee

As my thoughts about things like toll roads and other lowly correlated assets evolve I thought it might make sense to shed a little more light on why I am thinking about this stuff more, what realistically can be expected from these types of assets and more importantly what not to expect.

It’s no secret that I think a bear market has already started as a function of excess gone bad in the financial sector.

Regardless of whether a bear market has started or not, the fact is we have had bear markets in the past. The come, the market drops, they go and the market goes back up. This will be the fate of the next one whenever that might be.

It’s like going to the dentist. You don’t want to have to endure sitting in the chair but you pretty much know what you are going to get.

From this standpoint bear markets do not really threaten you financially (of course bad asset allocation is a different story). You pretty much know what you’re gonna get and if you can add any value during a bear market, all the better.

A bigger issue than a bear market that looms is the threat of returns below average after the bear market. Regardless of anyone’s emotional state a repeat of the past is not to be feared, it is to be endured. Once endured I think we may be in for a period of returns that are noticeably below normal for an extended period which could be a new thing. This would disrupt a lot of financial plans.

I am thinking something like US markets averaging 5% per year instead of 10%. It might sound benign but it isn’t.

Things like toll roads and plane leasing companies, as I mentioned the other day, have complex financial structures. There is a management of leverage and interest rates that is potentially more important that operating the tolls or contracting out the planes. Its kind of like car dealers. I’ve heard that selling the cars isn’t as important as how they manage their interest rate risk. Whether that is true or not crisis, like we have had this summer in the financial sector, creates either real or perceived problems for financially intricate companies like some toll roads and some plane leasing companies.

Since I think the bear market started with financial companies it seems logical to me that the toll roads and plane leasing companies may not offer as much bear market protection as we would like.

But I am not worried about the bear market I am focused on what might come afterwards; returns that are below the historical norm. That is where I think moderate exposure spread over disparate market segments that might yield 6-7% and go up in price 3-4% becomes very important.

To this point all four plane leasing stocks that I am aware of are down 20-26% in the last three months. This does not make them bad stocks, it makes this the wrong time. I don’t own any now but will be a buyer at some point (might not be for a couple of years) at a 2% weight. Anyone who bought three months ago at a 2 or 3% weight may not be happy with the purchase but they have not permanently damaged their portfolio either.

I believe the plane leasing space is a valid concept but it can, obviously be cyclical. The last few months have simply been the wrong time in the cycle. Getting the cycle wrong with too much of your portfolio becomes a real danger and all of these themes strike me as having the potential to end up being over owned.

For anyone who cares the context here is my trying to think about what comes after the bear market. If you have been reading this site for the last couple of years, or longer, you know that I was planning a strategy for what I believe is the current bear way back then and I have been making small changes in that direction (buying the double short, making the occasional sale and reducing the size of some bigger winners) for a while now.

The idea of waking up one day and saying a bear market is here I better do something seems crazy to me for anyone employing any sort of active strategy. Similarly waking up one day in 2010 and saying things are different I better do something is just as crazy.

Planning for a bear market that never comes does not seem crazy to me. Planning for a changing investment landscape that never changes doesn’t seem crazy either.

The picture is from Kapoho, which is kind of close to us. A few miles further down the road was covered by lava flow. And yes I think I did post this picture before.

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