The View From Bannerstone Capital
Intuition, Francois Servois, and Elisha Graves Otis
“When the facts change, I change my mind. What do you do, Madame?” —John Maynard Keynes
Investing is difficult; have you noticed? Almost nothing about it is intuitive except the idea itself: You invest because you want more, later. Let’s just say you, like most, have never had great success investing, but you’d like to. You want to win, and you’re paying attention. You discover an investment manager with a public six-year track record. That’s credible, right, six years? Not a lifetime, but six years anyway. The six-year record, in total, is outstanding: + 231 percent. That’s four up years, two down years (years number two and six, each less than a 5 percent decline) and a compounded annual return of, hmmm, let’s see, present value . . . sign change . . . n equals six . . . uh . . . that’s 23 percent per year.
In the very next year, while you’re still on the sidelines, you watch the manager turn in another barn-burner: up 80.5 percent; his best single year yet! Now it’s getting interesting. The logic looks straightforward: 498 percent in seven years? Compounding at almost 35 percent per year? You have finally found the investment you have been looking for. You meet a guy who knows a guy whose mother knows this guy. He’s nice. He checks out. You invest $100,000 on January 2nd of the following year. You sit back and enjoy. Finally, investment success is nigh.
Except it isn’t.
Over the ensuing four years, your newly hired Mr. Superstar summarily falls apart. The next year your portfolio wheezes over the finish line at +8.1 percent, but this is more than 10.5 percentage points behind the S & P 500’s +18.9 percent that year. Profitable, true, but the world’s least imaginative index beat your guy by a factor of two. That’s over 100 percent better, not an insignificant margin. The next three years are a veritable train wreck. At the end of four consecutive miserable years, you are left staring at $55,625 of your original $100,000. You have lost 44.7 percent, a mind-bending disaster. Not only have you underperformed the market for a four-year span, but you have underperformed the S & P 500 in each of three out of the four years. The S & P 500 Index is up 2.3 percent, with dividends included, over these four years, yet you are down by almost 45 percent. Well, you’d fire that Bozo, right?
You just fired Warren Buffet, 39 years ago.
This discouraging math is derived from page two of the otherwise uplifting Berkshire Hathaway 2014 Annual Report. I simply reviewed the 11 years from 1965 through 1975. If you go look, look at the very bottom of the page. A stick-with-it investor’s overall gain from 1965 to 2014 is only 1,826,163 percent. Yes, that’s 1.8 million percent. It’s an astonishing track record, but if you started in 1972, you deftly lost over 44 percent over the next four years right alongside the eventual winners. Still think you can tell when you are winning? Who among us would have weathered the temporarily terrible return and stuck with Buffett?
Let’s just say “not John Bogle” and move on.
Mr. Bogle, you’re fired.
Almost nothing about investing is intuitive, including some investing mathematics. So now let’s hear it for François Servois, who named the commutative property in 1814. He combined commuter (French for “to substitute or switch”) with the suffix –ative, meaning “tending to,” and VIOLA! A new math word is born. You may have thought you were done with the commutative property when you finished the SAT. Not so.
The commutative property and all it implies is profoundly important to you as an investor, so listen up: It doesn’t matter if you switch the order in an addition problem or a multiplication problem. It’s commutative. Ergo, the sequence of your particular annual returns, as long as you don’t make any withdrawals, does not affect the ultimate product of your investment experience. You don’t earn more or less in the end. You can take your individual annual returns (or monthly or daily) and mix them up and multiply them in any order you like and they will produce the exact same mathematical outcome. The four bad years following seven good years didn’t ultimately matter. This is not intuitive to investors in general. What mattered is merely the multiplication product of those eleven years multiplied in any order. You can be paid to stay in even if the recent math is cruel, because the mathematical importance of these early returns may be a mirage. They are no more important than returns that come later.
You really don’t care when the great years happen, as long as they eventually do happen. It’s more fun when some happen right away. They might not. They might not happen at all. It doesn’t matter when the bad years happen — beginning, middle, or end. It’s more fun if they hold off or get spread out. They might not. It doesn’t matter if they occur in consecutive years. It doesn’t matter if the bad years even outnumber the good years. What matters is that the product of the multiplication of the period returns in any order. The answer will be exactly the same. Had Warren Buffet’s Bad Spell occurred in his very first four years, his very last four years, or sprinkled invisibly among his 50 years, the mathematical impact would be zero. He would still have earned 1-million-eight-hundred-and-some-odd percent, but you had to stick it out to get there. Being ahead doesn’t mean you can’t be behind and being behind doesn’t mean you can’t be ahead. If you rely only on intuition, you will lose, as sure as you would have sold Berkshire Hathaway by Christmas 1974. Heck, your broker would have insisted you take the tax loss anyway. I mean, come on . . . a bird in the hand. . . .
The dollar didn’t let me down. It has been on a tear. I’m no Bob Prechter, but I think I see a classic Elliott Wave correction on the daily Dollar Index, a.k.a. Dixie, chart. The five wave has pooped out. A zig-zag correction of some kind is underway and the Dixie is now back in the vicinity of the four wave — text book stuff. No need to jump the gun, dollar bulls. Elliott Wave Theory may help us identify the next move. I’ll try to keep you posted. The bond market may be the key next. I am reminded, Dear Reader, that the bond market has a made a fool out of just about everybody at some point. Maybe I’m next. Again.
U.S. Dollar Pause
Negative interest rates are a strange idea. I can’t get used to them. Instead of collecting a payment for lending your money, you make a payment to the borrower for the privilege of extending the loan. At the loan’s maturity, you have less money as the lender than if you had not made the loan. This is madness, isn’t it?
Well, it isn’t until it is. Then stand way back.
Central banks impose negative rates in an attempt to mobilize reluctant reserves squatting at the central bank. It’s monetary stimulus. A bank — not a central bank, but a real world bank — has to have its cash somewhere. Vaults of paper bills are passé. They usually deposit funds electronically at their respective central bank, as so-called reserves. Some level of reserves is required by regulation, but almost every bank everywhere these days has reserves on deposit exceeding mere mandatory levels, and negative interest rates on these surplus reserves is a means for pushing the excess into the economy. The reasoning is sound enough: Banks with deposits at the central bank can choose to make money by withdrawing reserves and making real-world loans or choose to lose money by paying to leave excess reserves at the central bank. It is unclear whether this penalty for reserves is working, but there have been some recent signs of loan growth in some major economies.
It’s harder to understand why a plain vanilla investor would voluntarily accept negative interest rates, which they do these days. But there are a few possible explanations. The yield to maturity for a buyer of a two-year German Bund, according to Bloomberg, is -.25 percent per year, for example. Bloomberg reports that rates on the five-year Bund are slightly negative, too, although less so. I suppose less negative rates with longer maturities is a positive yield curve, but I’m an equity guy at heart.
A beneficial change in price can occur, although the negative rate of interest itself is fixed for the buy and hold to maturity investor. Should ambient interest rates become even more negative during the holding period of either Bund, the owner could stand to make a capital gain by promptly selling prior to maturity, while rates are more negative than when this Bund was initially acquired by the now seller. Falling interest rates always mean higher prices, even if you find yourself in terra incognita on the negative side of zero on the number line. Down is still up. Confused? It gets worse.
A beneficial currency translation could also occur, concurrently or independently, for example. Say the buyer of a two-year Bund is an American sitting in Minneapolis. Said buyer must first buy euros, probably with dollars, and pay for the Bunds in euros. When the Bunds are sold or mature, the resulting euros must be converted back to dollars, the customary currency in Minneapolis. If during the holding period of the Bund, euros appreciate sufficiently against the dollar, the small negative interest rate realized on the Bund itself might be compensated for by the appreciated euro. After all, up is up when it comes to prices. Such a strategy avoids credit risk; the Bundesbank isn’t going to default on the Bunds as a corporation might, and becomes a currency bet on a stronger euro, or a weaker dollar, with the slight headwind of the negligible negative intrinsic Bund return.
But here’s another way of stating that the interest rate can become more negative: The price may rise even more from here. Rather than lower rates driving the price up, let’s talk about a rising price depressing rates. Same thing, right? Under most circumstances, yes, but I will argue here it is price driving yield, not yield driving price. Investors are probably chasing the seemingly inexorable rise of Bund (and other bond) prices. There may be far too much talk about investors chasing yields. Interest payments are de minimus for Bunds. Does anyone chase zero? Virtually all other sovereign debt of less than five years maturity has essentially no current yield. Investors are buying these instruments because they don’t go down in price and they only go up. And besides, they can’t default.
This is likely Greater Fool theory investing incognito: You buy because somebody later pays you even more for it, or at least no less. That’s a harder deal to get in the stock market. Real estate was in a similar mood from 2003 through 2007. For over 30 years, investors have gone unpunished for believing that eventually, interest rates will support and, in fact, bolster the price of any sovereign bill, note, or bond they buy. Even among non-sovereigns, only the alchemical structured finance oddities described and explained in Michael Lewis’ extraordinary The Big Short became truly extinct. If you bought OECD sovereign obligations, ate your broccoli, and exercised now and then, you have done very well as a buy-and-hold bond investor, for 34 years and counting. This might build confidence to unrealistic levels, huh?
Forget central bank policy, unemployment rates, money velocity; forget currency exchange rates and macro-economic mumbo jumbo. Forget taper. What could very well turn the bond market on its proverbial ear is the very same unmistakable clarion call that heralded the onset of the Internet bust in 2000 and the real estate top in 2007. It is the same clarion call that foretold the bone-jarring crack in crude oil prices just last summer.
Nothing . . . chirp, chirp . . . crickets.
There wasn’t an event. Prices broke badly because buyers just quit buying. You can’t put six pounds of ‘taters in a five-pound sack: full up. No mas. Investors had simply, and mysteriously, stopped. Buying apathy was soon followed by a buyers strike followed by selling, soon followed by panic selling. Then, even more selling. This is sometimes referred to as the “prices take the stairs up but the elevator down.” Sometimes the elevator down is so overloaded that the cable breaks.
There won’t be an Elisha Graves Otis for bonds. You may recall Otis. He was the guy in New York City who, in 1853, cut the cable on an elevator while he was in the elevator to prove his point: His elevators were immune from a catastrophic plunge. The bond market is not in an Otis elevator, Yellen put or not.
Bonds will fall when sellers finally overwhelm buyers. I think sellers will, again, react to saturation and supply. Not the Beige Book. It will feel sort of metaphysical. It always does. When this bond bull market ends for good and sovereign debt stops rising in price (and it will), the Greater Fool element will evaporate. Vapor. Don’t count on it being attributable to a BLS number on a Friday morning or a Fed transcript. Dennis Gartner won’t call it early. Mr. Market, like the infamous John Maynard Keynes quip about changing facts, will simply change his mind. What will you do? You’ll be lucky if you can even cram into the doomed elevator if it arrives. The first reluctant catastrophic loss will be the smallest loss. Negative interest rates may mean the down arrow may finally pong at any moment. Keep in mind that intuition is an unreliable companion. Maybe you think you know, before the doors open, if there will be room for you. If it’s an Otis elevator, and your intuition is right, maybe you can climb aboard at the last minute for the safe ride down. I’m taking the stairs.
This publication does not constitute, in any way, investment advice. The views described may have changed by the time you read this, anyway. Use your head, for crying out loud. Craig Cox is our editor. Thank you, Craig. Bannerstone Capital Management, LLC is a registered investment advisor. We are on the web at bannerstonecapital.com