1/1/14 –

On 12/31/13 the S&P 500 closed at a record high of 1848, resulting in a total return of 32.4% for the year. The market is very overvalued. * Since operating earnings have increased by only 4.8% since the beginning of last year, stock market increases have been mainly due to a Fed policy of monetary ease that has suppressed the entire yield curve, interest rates at the zero bound at the short-end and around $3 trillion in purchases of long-term treasuries and mortgages at the long end. Starting in January, the Fed will begin tapering, reducing purchases by $10 billion to $75 billion per month, then likely further. The stock market has rallied at the news that the Fed will tighten monetary policy only slowly, as is appropriate for the real economy. There will, however, be a point when the Fed’s purchase decreases and then short-term policy rate increases will likely cause long-term rates to rise.

Drawing, of course, an imperfect historical analogy, we ask what a normalized 10 year treasury rate might be:

If history is any guide, at a 2% inflation rate, we expect an eventual 3.8% ten year treasury rate. Compare this with a 3.03% present rate, which would be an increase of 25%. Since S&P 500 operating earnings last year grew by only 4.8%, and there are doubts that earnings will grow a lot next year, we think there is the potential for future interest rate increases that will outpace future S&P 500 earnings increases. That will eventually cause a stock market decline. Since short-term, and therefore less risky, interest rates will be pinned at the zero bound for a long time, our main portfolio strategy has been to invest for a sustainable income stream. It is a mistake to equate stock market appreciation with steady income; for as the Wall Street saying goes, “Trees don’t grow to the sky.”

* This is the gist of our valuation methodology: For a low-risk stock with a strong consumer franchise, we establish a zero growth value by taking an average distributable cash flow, dividing it by 8% (the annual investment return of the stock) and then factoring in a price premium due to growth and a return on capital. We then include a margin of safety discount which will determine the stock’s purchase price. We justify that 8% as follows: 

A lower required return would, of course, justify higher equity prices; but we really don’t think the risks justify a 10 year treasury lower than 4% and therefore an equity return lower than 8%. At present prices, only a momentum investor could invest in the companies we like; and we are not a momentum investor.

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Some context:

Other investors are less than enthused about the U.S. stock market at present prices; how about their estimated 4% return (we think it’s somewhat low, but in the right direction). This return essentially ignores all pricing for risk.

The 12/27/13 Financial Times notes, “One problem is that the risks of the Fed’s easy money policy are largely invisible. Today, those Fed policies appear costless – just as they did after the last round of easing. The shortfalls in pension funds assuming 8 per cent (sic) returns in a zero rate world are barely being acknowledged, let alone dealt with. Millions of Americans who are postponing their retirements because they aren’t earning enough to finance them don’t seem to have (been) factored into the Fed’s calculations. Sadly, retail investors will be the last to get out of the risk assets they are being driven into now.”

To earn some income, investors have to take some risks; but these risks should be controlled.

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The bullish case for stocks rests upon the assumption that the market will, as in the past, simply rotate to the cyclical stocks. The problem with that idea is the elephant in the room, significant losses in the likewise overvalued bond market as the Fed gradually tightens. This CNN Money article summarizes the reasons why we are, with one exception, not invested in stocks. The long-term risk of the overvalued stock market is very high, and its expected returns are very low.

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A Wall Street research director once said, “The stock market is like life; it can’t be predicted.” add: (Some of our readers obviously don’t like this kind of honest statement.) The major investment philosophies to handle this fact relates to time horizon; long-term or short-term. Our readers should be clear which one is appropriate to their temperaments and circumstances; this will allow consistent action. Value investing is long-term investing that appraises the present value of a stock investment, its level rather than its recent trend, treating it the same as an investment in any other capital asset. 

We can discuss the merits of each philosophy (for purely academic reasons), but would like to address a present exception to both. If you have worked your whole life for the money you have or are risk adverse, we think an extraordinary degree of care is now necessary given the above discussions. At present, all major investment categories except cash are risky, distorted by the Fed’s very high creation of liquidity:

1) The Fed policy rate, and therefore cash yields, are negligible; they are likely to remain so for a few more years.

2) Bonds are overpriced.

3) Stocks are as well, although the market could go higher for cyclical reasons, IF the bond and foreign markets do not react adversely to the gradual withdrawal of Fed liquidity. We think this is overly optimistic.

As a long-term investor, we now see a large short-term principal risk for a minimal expected return; so we aren’t taking that risk. An optimistic short-term investor might jump in; but because broad markets are also affected by many sorts of events, how do they know when to jump out? Value investors try to take the middle range of stock profits, leaving the extremes to others.

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1/13/14 - This article addresses the earnings (dividend) growth fundamental upon which stock prices are based; the other fundamental is interest rates. Both can go in the wrong direction. Now add the social behavior of positive feedback; the analysis gets complicated. You get Benjamin Graham’s Mr. Market, sometimes motivated by “enthusiasm” or “fears”.

2/1/14 –

When we analyzed S&P 500 stock data between 1968-1999, we found variations from the regression model that were “persistent in sign, (ref: top of the page)”. Since the data we analyzed was yearly data, this means that market reactions to major events, such as the OPEC crisis, persisted from year to year. As of this 1/27/14 writing, the U.S. stock market has dropped by 3.4% from its peak of 1844 a few days ago. This drop was caused by two major negative (and maybe continuing) catalysts, the beginning withdrawal of Fed liquidity and a slowdown of growth in the developing world. There is a lesson to be drawn from this; markets are affected by “many sorts of events,” including foreign ones - which can either be positive or negative, trending or not. But overvalued markets are dangerous to your financial health because something negative always happens eventually, as investors take on more and more risk.

The Importance of Valuation

A value investor, that is an investor who takes stock valuations seriously, doesn’t have to be interested in the Fed’s monetary policy, the Mideast, government reforms in Asia and the foreign exchange balances held by Turkey. What you have to know is the value of a stock, determined from reliable data (Greenwald, 2001, p.p. 138-145). Then you can focus your attention on finding companies with sustainable competitive advantages at bargain prices. The lower the price of a stock, the more it can withstand the slings and arrows of macro events.

However, our futures and those of the next generation, increasingly depend upon how governments handle these macro events. On 1/23/14 Ángel Gurría, Secretary-General of the OECD, said that the easy monetary and fiscal world-wide policy responses to the Financial Crisis of 2008 have run out of room. Now, what matters is structural changes to restart growth. Mr. Gurría said, “A journey of a thousand miles begins with a single step.” Our next article will deal with the structural changes likely necessary in the U.S., starting with the way markets operate.

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We have trimmed back (but not totally sold) our holding in Citigroup. The main reason is that we are beginning to prepare our portfolio for a split. The second is the possibility for a foreign financial crisis. The problem with predicting financial crises is that some very intelligent investors are often years early when doing so. However, looking at the proximate international fundamentals of declining liquidity and large resource misallocations due to speculation, we are concerned. A recent Goldman Sachs analysis is titled, “Emerging Markets: As the Tide Goes Out.”

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2/11/14 - The stock market rallied further after Janet Yellen, the new head of the Federal Reserve, noted at a 2/11/14 House hearing that the economy is strengthening and the Fed tapering is likely to continue. Assume that somewhat increased revenue growth and increased interest rates will be offsets, what then remains is EPS increases due to corporate “restructuring” that might driven the stock market somewhat higher in the short-term. That is, driving the highly likely 4-5% long-term return on equities even lower. As long-term investors, we think the likely return on equity simply does not justify the risks (unless you can trade this one).  

At that hearing, two perspicacious representatives asked whether the evolution of the global economy has caused economic growth and employment growth to diverge and whether there is a remedy for the replacement of manual labor jobs by technology. Our next article addresses these absolutely crucial questions from which all other economic questions derive.

3/1/14 –

The S&P 500 is affected by two opposing currents, the prospect of somewhat increased economic growth and the prospect of somewhat increased interest rates as the Fed continues to taper its purchases of treasury and mortgage securities. At the January 28-29 FOMC meeting, “The Committee expected that, with appropriate policy accommodations, the economy would expand at a moderate pace and the unemployment rate would gradually decline toward levels consistent with the dual mandate (unemployment around 5%). However, members continued to judge that the risks to the outlook for the Committee’s longer-run objective had become more nearly balanced.” At that same meeting, “Participants agreed that, with the unemployment rate approaching 6 ½ percent, it would soon be appropriate for the Committee to change its forward guidance in order to provide information about its decisions regarding the federal funds rate after that threshold has been crossed (to broach that subject)”.

Economic conditions are likely to slowly improve, but the present likely returns of the S&P 500 do not justify long-term investment.

Value investing is a viewpoint, or investment philosophy, that handles complex markets. Pages 17-21 from Warren Buffet’s 2013 shareholder letter is well worth reading. He discusses two of his real estate investments. He got both of them at bargain prices; stock investing is not different. What matters most is the price of a particular stock at a particular time. That is the bottom line.

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Valuation Changes and Annual Rates of Return

How to derive the effect of valuation changes on the market’s annual rates of return? To quote this GuruFocus article, “As pointed by Warrren Buffet, the percentage of total market cap…relative to the US GNP is ‘…probably the best single measure of where valuations stand at any given moment.’”  The annual effect of changes in market valuation over time (N) is given by:

Change in Annual Rates of Return due to a Change in Valuation  =   (R _ending  / R _beginning ) ^(1/N)  - 1 

* 1/N means the (N) th root of that ratio. This formula is derived from the simple compounding expression: Future Value = Present Value (1+i)ⁿ

If there is no change in valuation, the ratio: R _ending  / R _beginning =1 and there is no change in the annual rate of investment return due to valuation. If the valuation doubles in 10 years, the addition to the annual rate of investment return is 7.2%/ year and so on. The ratio is around .8 in a normal market. On 3/5/14 it was 1.18, "significantly overvalued". Assume that it takes a number of years for valuation to return to normal (we’ll discuss what that means). What will the effect of this be upon each yearly rate of investment return?        

Low equity returns over many years are preferable to a quick, sharp drop, giving time for the economy to restructure and readjust. The stock market is presently overvalued because the Fed has suppressed interest rates below their normal level. A normal level of interest rates would likely imply a fair value range of the stock market. Our 1/1/14 posting suggested that the ten year treasury rate should be around 4%, rather than the current 2.71%. The Fed will probably increase the policy rate slowly if possible.*

We are seeking slightly risky but higher income returns, rather than capital appreciation. We think it is totally valid to call an exception to a general rule, rather than to invalidly claim consistency. Because markets are also globalized, we're preserving optionality by holding a large percentage in cash.

* We add a further consideration.The Fed might raise interest rates slowly, but this does not say it should clearly telegraph when it will do so. If the Fed is going to raise rates, then a clear forward guidance of their path will cause market participants to do a quick present value calculation. The financial markets will adjust and assets held in the hands of speculative institutional investors will continue to increase greatly, continuing the game, and adding even more risk to the financial system.

A FT March 10, 2014 article discusses this risk. The Geneva based Bank for International Settlements warns, "Efforts by the major central banks to spur an economic recovery by providing guidance on what will happen to interest rates could endanger the global financial system...Investors are being encouraged to load up on risks because they believe forward guidance will warn them well in advance about any rise in interest rates...The strategy could also result in rates remaining too low for too long because central banks fear the reaction of markets to any rate rise, fuelling even riskier behaviour."

When raising rates, the Fed must likely strike a balance among real economic conditions, how rates are increased and the appropriate disclosure. Better the financial markets be always vigilant rather than suddenly disappointed.

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It is possible to use many quantitative measures to value the stock market. This very useful article calculates the statistical (r2) variance of the deviation of each ratio from its statistical mean. Our own experience with the cyclical adjusted Fed ratio model is that to predict short-term market behavior with high accuracy, you need a statistical (r2) of around .95, if the intrinsic rate of growth of the economy remains unchanged.

If that intrinsic rate of growth does change, as at present, the following accuracy measures: with Robert Schiller ten year CAFE measure at .52 or the Tobin's Q measure at .79 are the best cited. By both measures, the market is wildly overvalued relative to the normal average. Unfortunately, the author does not calculate the (r2) of Warren Buffet's Market Cap/GNP ratio. The following maxim applies well to both markets and the quantitative analysis of markets, "Markets are directional and not biblical."

The Buffet ratio says the market is around 48% overvalued (close to our opinion). The Schiller and Tobin measures are respectively 57% and 58% above their arithmetic means. All three market measures indicate comparable overvaluation.

 4/1/14 -

Markets are short-term. They react much more to short-term events, favorable or not, than to their broader implications, which may not be clear. Take, for example, Putin’s invasion of the Crimea, endangering the global order. On March 3, the S&P 500 dropped by .74%. Were Putin to unwisely proceed further in the eastern Ukraine, the markets would drop again.

Considering the possibility that the Fed will raise interest rates. At her first press conference on March 19, Janet Yellen noted that the Fed will raise the policy rate, “a considerable period” after the end of taper - conditions depending. Then she clarified (somewhat) saying, “a considerable period” meant, “something in the order of around six months.” The S&P 500 dropped by .61% that day, and then rebounded, now focusing on the word, “conditions” a year from now.

The most common kind of short-term market behavior is, of course, price change when a quarterly earnings announcement diverges from a quarterly earnings consensus.

Value Investing

Short-term markets respond to short-term events. It is therefore useful to consider likely long-term events, when possible, because the market might not. Here is a quote from Warren Buffet’s 2013 shareholder letter:

Regarding the future, a present value analysis of dividends is a long-term analysis. A value investment in a company's sustainable franchise is a long-term consideration. Regarding the U.S. economy over the long-term, but of course less specifically, a restructuring will be necessary. Until this restructuring, we think the economy will likely grow slowly, its overvalued financial markets also subject to market volatility from abroad. This is the reason why we are pursuing a steady strategy of dividend accumulation combined with a high percentage of cash.

5/1/14 –

To be able to act clearly in complex markets, you have to know your values and also to be aware of the exceptions.

For instance, in volatile stock markets, values will eventually appear. But, considering only domestic factors, what if the overvalued U.S. stock market won’t be volatile for a while due to long-term economic factors, a depressed labor market and a compensatory Fed policy of monetary ease? An investment policy generating at least some income would then be appropriate.

Although we are value investors also holding cash, we hope for relatively stable financial markets, giving the economy time to restructure. Another large crash would be in no one’s interest, making economic growth and Fed policy impossible. The Fed is a bank. It can therefore be administratively vigilant about developing market excesses in the interest sensitive sectors, like real estate, and risks to the payment system.

An investment policy holding cash is appropriate when markets are very overvalued. Andrew Smithers (2000) is a UK stockmarket researcher:

We think this is extremely good advice for conservative investors and for those nearing retirement, who ought to be conservative. The best way to make money is to be careful not to lose it. More formally, the expected returns have to be greater than the expected risks. In a non-Gaussian world, these ideas cannot be measured with precision; but they should be of second nature because a more rational investment policy will win over a less rational one over the long-term.

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Value investors generally look to some "catalyst," that is some positive event to increase the price of a value stock. That catalyst may be a positive earnings announcement, management change, sector rotation or international growth.The opposite, of course, is the negative catalyst; some negative event that decreases the price of an overvalued stock.

The fall of Yanukovych in the Ukraine provided President Putin with a challenge. He then ordered the Russian army to take the Crimea, where Russia has a naval base, and to threaten the Eastern Ukraine. This strategy is not unprecedented, for the Russian army continues to occupy Georgian Ossetia (2008). But further invasion would be a major mistake, sanctions badly affecting the Russian economy.

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Although President Putin may speak nostalgically about recreating the novorossiya empire of Tsarist days, Russia is, in fact, limited in its ability to be responsible for millions of new subjects.  add: The Ukraine was formerly a vassal state; Plan B is now unfolding. Putin is using “frozen conflicts” in the Ukraine, Transnistria, Nagorno-Karabakh, and South Ossetia (places we are sure all have heard of) to create disorder. The 2/28/14 CNN writes, “Russia has long propped up separatists, provided political backing, military support, funding and passports. This undermines the stability of its smaller neighbors, challenges those nations’ sovereignty, blocks domestic reforms, and impedes European integration (which would threaten Putin’s hold on Russia, itself).”

Since Russia is also nuclear-armed, the West cannot react militarily to this troublemaking in non-Nato countries; but it can and will ratchet up the economic pressure to deter Putin from further bullying his neighbors.

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Does anyone wonder why the religious Sunni-Shiite conflict across the Mideast is so virulent? Just look at the Ukraine. Consider the commonality, great social disorder. People then revert to their communal identities, in this case Russian or Ukranian. A 5/5/14 New York Times article on the Ukraine writes, “The conflict is hardening hearts on both sides.” It is taking on a dynamic of its own.

All societies require some political order, and it is difficult to re-establish. After the French Revolution of 1789, it took almost 170 years for the French to restore order. An evolutionary path of continual reform is vastly preferable to revolution; or if the latter, there must first be a reconciliation among social groups to make democracy possible. Whether in Egypt or Iraq, the human costs of revolution (or in the U.S., revolution in the name of radical political conservatism) is very high indeed.

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Either expansive fiscal or monetary policies should cause the economy to grow. If economic policy favors the former, the role of government will increase. If policy favors the latter, the private sector will increase. With interest rates at the zero bound for the last five years, one normal business cycle, why isn’t the private sector of the real economy investing in everything but the kitchen sink? The depth of the Great Recession of 2008 dampened economic activity; but we think much more is happening. Our next article will be titled “Automation and Capitalism in the 21^st Century.”

6/1/14 –

Increasing automation will likely cause the U.S. economy to be less cyclical, but could also reduce its growth. Investing for portfolio income is likely to remain the best policy. But obviously, interest rates are very low. The S&P 500 currently yields only 1.91% (getting down to basis points) and investment grade bonds yield only 3.86%. Our investments in pipeline limited partnerships yield more than 6%. According to the Oil and Gas Journal, in 2013 the industry planned to make around $38 billion dollars of pipeline investments, mainly to transport and process shale gas and oil. The following discusses the economics of the shale energy boom. Since there is some risk in these pipeline investments, we are maintaining portfolio diversification.

According to Edward Morse, Global Head of Commodities Research at Citigroup, natural gas production in the U.S. has increased by 25% since 2010 and crude oil production has increased by 60% (sic) since 2008.

The advancing technologies of horizontal drilling and hydraulic fracturing have made possible the exploitation of gas and oil deposits locked in dense shale and siltstone. Compared to regular wells, they have extraordinarily rapid production declines. For example, a Harvard study estimates the wells drilled in the Permian Basin will exhibit the following production decline rates, each year from the last month of the previous year:

As a result, the natural question to ask is whether the gas pipeline companies are spending billions of dollars to transport a bubble. This Bloomberg article suggests, “yes.” (In bidding situations, there are always companies that overpay.)

Fortunately, the Harvard and a U.S. Energy Information Administration map and study suggest, “no.” Unlike regular deposits, shale energy deposits are spread over many thousands of square miles, mainly in the Permian Basin (W. Texas), the Eagle Ford (South Texas) and the Bakken Formation (N. Dakota). At the present oil price of $103/barrel delivered at Cushing, OK, the success rate of hitting commercially feasible deposits is very high. A MIT Technology Review issue of 11/12 suggests that shale energy becomes feasible within an oil price range of $50-$70/barrel. OPEC, a swing producer, was “happy” at a then current U.S. price of $85/barrel.

The drilling intensity, and thus the continued production of shale gas and oil, depends very much upon the then current price of oil managed by OPEC and upon environmental regulation, particularly in the densely populated East. In 2009, the price of US oil fell to nearly $35/barrel, but then rebounded quickly. Due to the growing demand for energy abroad, the gas pipelines are very likely making sound investments. The petrochemical industry, their customer, is making the same bet. The 5/29/14 WSJ reports that around 66 industrial projects with $90 billion are planned in Louisiana during the next five years, producing a “Qatar on the Bayou”. Construction will include plants that crack gas into diesel fuels and other chemicals: fertilizers, polymers, and also methanol terminals.

The Harvard study suggests, “Figures about the Permian basin are still in the making, yet it is possible to figure out that the Big Three U.S. shale plays have a combined potential of many more than 100,000 shale producing wells, or about ten times the number of those already on line. Taking into account this potential, the limits to drilling intensity probably would start affecting Bakken…and Eagle Ford only in the second half of the 2020s. By that time, their survival will rely upon technological advancements that allow for less and less drilling to recover the same or greater amount of resource.”

We think the natural gas pipeline companies will do well. This discussion illustrates another fact. In the United States, for the right ideas, a lot of capital is quickly available and at low interest rates. The growth of shale energy, add: a development of smaller companies, took a lot of people by surprise. Once such projects became feasible, the pipeline companies ramped up planned 2013 capital expenditures to around $38 billion from $8 billion the previous year.

7/1/14 –

The 6/3/14 Bloomberg noted, “Bond Yields Lowest Since Napoleon.” This indicates that something is not right with the world financial markets. The last graph in this article charts the long-term government bond yields of the major economic powers of the time, starting with the Venetians in 1285 to, presently, the United States.

As a fundamental investor, we ask, what do British bond yields in Napoleon’s time have to do with U.S. bond yields now? In fact, both were caused by destruction of different sorts. Between 1803 and 1815, Napoleon engaged in a series of European wars. Since 2000, the capitalist system has been automating and globalizing, continuing its campaign of “creative destruction,” boosting productivity and thus profits. This has unbalanced the U.S. labor market and reduced its income. The median real income of all Americans between 1992-2002 grew by 18.1%; between 2002-2012 it dropped by 4.4%.*

What is the effect of low interest rates upon portfolio policy? In our essay, “Automation and Capitalism in the 21^st Century,” we discussed the effects of automation and, to a lesser extent, job export upon the U.S. economy. In their May, 2014 “Secular Outlook," Pimco announced “The New Neutral,” to describe the 0% real central bank policy rate that the major world economies are converging to (with the prospects of future U.S. economic growth being marked down) due to:

1)    The absence of aggregate deleveraging in the global economy and demographic changes.

2)    A global economy unable to generate aggregate demand in line with potential output. “Unless and until it does, we will be operating in a multi-speed world with countries converging to historically modest trend rates of potential growth with low inflation. 0% neutral real policy (Fed funds) rates for many developed and some developing countries will likely be the investment outcome…the investment implications are striking: low returns yet less downside risk than investors currently expect, an end to bull markets as we’ve known them, but no perceptible growling from the bears…Zero percent neutral policy rates imply similarly low returns on risk assets perhaps 3% for bonds and 5% for stocks over our secular time frame, and 3-5% expected asset returns cannot satisfy many liability structures dependent on more (like a pension fund assuming a 8% return).”

Maybe we should have been more careful what we wished for in our 3/1/14 posting. If low financial risks and returns are in the future, then the appropriate portfolio policy is obvious. Load the entire portfolio up with long-term income producing assets; set and forget. Are we going to bet our entire portfolio on depressed aggregate demand due to automation and the “New Neutral”? We think we have made a case for doing just that. But what if something else happens?

This is what disturbs us, “Bond Yields Lowest Since Napoleon.” The ten year U.S. treasury rate is currently 2.61%, and it could increase for other reasons.

It would be better to borrow an idea from bond portfolio management: a barbell bond strategy combines two extremes, a short-term portfolio of bonds and a long-term portfolio of bonds. We like investing in high income paying (long-term) equities; because if rates increase, the price of our pipeline limited partnerships will drop – but will have generated income and might have sufficiently appreciated beyond cost, (to be temporally precise) so we really don’t care.** Second, and most important, bond managers use a barbell structure when they don’t know what interest rates will do.

We are leaving the short end of our barbell in cash. The proportion of the portfolio in long-term income assets (note, we didn’t say bonds) could equal the portfolio owner’s age.

*    The median is a very useful statistic in the social sciences, because it is the numerical value that equally separates the upper half of the data from the lower half, not giving an arbitrarily large result as long as at least half the data is representative. Here it measures what is really happening to the U.S. economy and renders irrelevant other variables, such as executive compensation, that have more complicated explanations. By comparing two medians, we are measuring the effect of changing economic forces upon the real income of individuals.

Very clearly, the U.S. economy has not served the needs of most Americans, and some rethinking is necessary to adapt to a world of rapidly advancing technology and the growing economic power of other nations.

**  We’re discussing income. To consider a cash inflow, income, you have to preserve principle. The way to preserve principle is to look for a margin of safety. In lending or in bond analysis, equity –the residual on the balance sheet- provides a margin of safety enabling a company to better meet its obligations. In equity investing, the difference between a company’s intrinsic (present) value and its market value provides a margin of safety to the investment. In this case, we expect the present values of our partnerships will grow in time, thus increasing the margin of safety add: above the positive fundamentals of the investments.

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On our Apple computer, there is an icon representing the programming gears that run the iMac. We’ll click on that icon and discuss the strategy we chose to deal with market complexity:

Markets are an instance of social complexity, and there are several ways to handle it:

1)    Modern portfolio theory. Assume all the complexity of large individual actors away and simply assume that the market knows everything, discounting all perfectly forseen knowledge into a placid, mathematically tractable Gaussian manifestation of securities prices. We need cite just one significant counterexample, the Financial Crisis of 2008, the dimensions of which were not foreseen by the markets for most of 2007.

2)    Derivatives and contract options. Options theory also assumes the world is Gaussian; but leaving its questionable mechanics aside, options are used in a complex world, requiring that people know nothing. The trouble with keeping all your options open is that there is a cost, in real life as in finance. The cost in finance is the trillions of dollars of derivatives contracts that allow investors to hedge against their mistakes. In 2008, the consequence of this was sloppy lending and a derivatives industry that, in the words of one investor, turned “sows’ ears into silk purses.”  The consequence of options for portfolio management is, at least, high costs.

3)    Looking for a nugget of add: essential truth in a complex world, that leads to other truths (given institutions). This is the approach we favor, for it assumes people can know something and allows for exceptions - for instance seeking dividend yield in what is usually a bond portfolio. Driven by the growth of Florentine commerce, the Renaissance of the 15^th century developed a new mental attitude. This is a drawing of a horse by Leonardo da Vinci. Note, da Vinci did not aim to depict someone’s dream of a horse or the idea of a horse, but the real horse he observed. Therefore we ask, “What is reality?” when observing the world or analyzing an investment.

The keys to handling complexity are the goals and the practical solutions that have real effects on people.

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During the two years between 6/30/12 and 6/30/14, the S&P 500 increased by 43.9% to 1960. During that same period, S&P 500 operating earnings increased by only 18.6%. The 10 year U.S. treasury rate remained very low at 2.6%. 

Over the last two years, the S&P 500 has increased mainly due to extraordinary central bank measures that have depressed interest rates across the entire yield curve, including a nearly 0% Fed funds rate and Quantitative Easing securities purchases at the long end. The result of this easing has not been rapid economic growth, as cyclical macroeconomic theory suggests, but an increase in almost all financial asset prices as investors reach for yield, regardless of the long-term risk. When will the central banks take away the punch bowl of monetary ease?

The Bank for International Settlements has 60 national central bank members. A central bank for central bankers, its 6/29/14 annual report contends that the world’s economies have been too reliant upon a monetary policy that assumes the short-term business cycle, rather than taking into account the long-term financial cycle that accumulates excess debt. “Financial fluctuations…that can end in banking crises such as the recent one last much longer than business cycles. Irregular as they may be, they tend to play out over perhaps 15 to 20 years on average. After all, it takes a lot of tinder to light a big fire….The fallout from the financial cycle can be devastating. When financial booms turn to busts, output and employment losses may be huge and extraordinarily long-lasting….Thus, when policy responses fail to take a long-term perspective, they run the risk of addressing the immediate problem at the cost of creating a bigger one down the road (our note).”

On 7/4/14 Bloomberg reported, “Central Bankers Fire Back at Their Own Club Over Bubbles.” Janet Yellen, Mario Draghi and the Bank of England contended: 1) It’s a bad idea to raise interest rates now. 2) Monetary policy faces significant limitations as a tool to promote financial stability; macroprudential regulation should have the primary role. This is a very interesting controversy, of import to investors. Our 8/14 comment will discuss the potential output of the economy and the practical implications of this central bank discussion.

8/1/14 –

On 7/24/14 the S&P 500 closed at 1987.

In testimony before the Senate Banking Committee on July 15, Fed Chair Janet Yellen noted that most Federal Reserve board members expect a Fed Funds rate of 1% by the end of next year. What effect would that have on the 10 year benchmark treasury rate, the rate from which long-term financial assets are priced? We expect an upward adjustment in bond yields, the maximum something like the following: 10 year treasury rate = 2% Fed targeted inflation + 1.8% historical spread over inflation = 3.8% (see 1/1/14 analysis above).

Ten year treasuries currently yield 2.51%. A 3.8% yield nearly guarantees a massive stock market drop, in reaction to a very negative bond market. But if rates were to rise to, only say, 3.2% we would expect, at best, a very minimal stock market appreciation. We don't think an investment with a minimal upside, but a varying downside, is very attractive. (We are talking only about capital appreciation, not income.)

In the above we considered the short-term course of interest rates which will likely increase over the next year. A long-term view of the world financial system also suggests that the normalization (increase) of interest rates is desirable because continued low interest rates do financial systems damage. ¹ The Bank for International Settlements is the central bank for national central banks, such as the Fed. In their 2013/2014 annual report they succinctly note:

1)    The global economy has shown encouraging signs over the past year but it has not shaken off its post-crisis malaise. Despite an aggressive and broad-based search for yield, with volatility and credit spreads sinking towards historical lows and unusually accommodative monetary conditions, investment remains weak (according to economic theory, this should not happen).

2)    Debt, both private and public, continues to rise while productivity growth has extended further its long-term downward trend. ²

3)    Macroprudential measures, while useful to strengthen banks, have on their own proved unable to effectively constrain the build-up of financial imbalances, especially where monetary conditions have remained accommodative. Time and again, in both advanced and emerging economies, seemingly strong bank balance sheets have turned out to mask unsuspected vulnerabilities that surface only after the financial boom has given way to bust. ^2a

4)    To return to sustainable and balanced growth, policies need to go beyond their traditional focus on the business cycle and take a longer-term perspective-one in which the financial cycle takes centre stage. The output gap between potential and actual GDP is measured to also include financial factors, the deviations of the (private sector) credit-to-GDP ratio and real property prices from their long-term trends.

5)    They need to address head-on the structural deficiencies and resource misallocations masked by strong financial booms and revealed only in the subsequent busts. The only source of lasting prosperity is a stronger supply side. It is essential to move away from debt as the main engine of growth.

Due to financial excesses, in 2008 the world economy nearly collapsed. It is very notable that the cause was not a central bank tightening to contain inflation, as in the past. The cause was excesses in the financial sector. The BIS writes:

The BIS then discusses the long-term challenge of, “…adjust(ing) policy frameworks so as to promote healthy, sustainable growth. This means two interrelated things. The first is to recognize the only way to sustainably strengthen growth is to work on structural reforms that raise productivity and build the economy’s resilience....The second, more novel, challenge is to adjust policy frameworks so as to address the financial cycle more systematically. Frameworks that fail to get the financial cycle ⁵ on the radar screen may inadvertently overreact to short-term developments in output and inflation, generating bigger problems down the road….Policy does not lean against the booms but eases aggressively and persistently during busts. This induces a downward bias in interest rates and an upward bias in debt levels, which in turn makes it hard to raise rates without damaging the economy – a debt trap….Over time, policies lose their effectiveness and may end up fostering the very conditions they seek to prevent. In this context, economists speak of ‘time inconsistency’: taken in isolation, policy steps may look compelling but, as a sequence, they lead policymakers astray….there are signs that this may well be happening.” ⁶

An interest rate policy at the zero bound cannot restore high sustainable economic growth to an economy requiring structural reforms. But interest rates, set at a level appropriate to the likely economy, will also reign in financial speculation that allows the financial markets to borrow short and to invest long  - in overvalued assets. ⁷

1  Prolonged monetary easing damages savers and (n.b.) pension plans, encourages speculation and displaces markets.

2 Private and public debt remain excessive in the advanced economies at the end of 2013. See table on p. 10, Bank of International Settlements Annual report 2013/2014.

2a Ibid, p. 13. The 7/7/14 Barron’s quotes Goldman Sachs, ‘“ The most important implications of these (macroprudential) reforms is their intent to more or less eliminate the credit cycle.’ In other words, to end the all-to-human pendulum swings from greed to fear and back again.”

3  Ibid, p. 11.

4 Ibid, p. 16.

5  BIS Working Paper No 395, December 2012, estimates a macroeconomic financial cycle of about 16 years across seven economies, in addition to a business cycle of around 1 to 8 years. (p.3)

This paper, “The financial cycle and macroeconomics: What have we learnt?” is written in the narrative economic style of Minsky (1982) and Kindleberger (2000). It therefore avoids theoretical mathematical pyrotechnics in favor of simple (and associated) causal explanations. The author Claudio Borio, chief economist of the BIS writes, “The length and amplitude of the financial cycle are not constants of nature (as exist in physics)…they depend on the policy regimes in place.” This is one of the best economic papers we have read; definitely recommended. To further quote: *  

a)     The nexus between financial and business fluctuations have been a lodestar of the analytical and policy work of the BIA. It is simply not possible to understand business fluctuations and their policy challenges without understanding the financial cycle. The most parsimonious description of the financial cycle is in terms of credit and also property prices.

b)    Peaks in the financial cycle are closely associated with systematic banking crises.

c)     The banking system does not simply transfer real resources…from one sector to another. It generates (nominal) purchasing power…while the generation of purchasing power acts as oil for the economic machine, it can, in the process, open the door to instability…

d)    There is a risk that failing to recognize that the financial cycle has a longer duration than the business cycle could lead policymakers astray…policymakers may focus too much on equity prices and standard business cycle measures and lose sight of the continued buildup (of risk in) the financial cycle. There are deleterious side-effects of extraordinarily accommodative and prolonged monetary easing.

e)     Worryingly, several emerging market economies have been seeing symptoms of the build-up of financial imbalances that are eerily reminiscent of those seen in mature economies ahead of their financial crisis. (This is a major problem of financial globalization; contagion can be more readily transmitted from abroad. The remedy is to have an investing margin of safety.) 

f)     The end-result can be a downward trend in policy rates across cycles and increasing resort to balance sheet policies without lasting gains in terms of financial and macroeconomic stability. Globally, the monetary stance in the core economies is then transmitted to the rest of the world, reinforcing that downward trend. Such as trend is all too obvious across financial cycles in the data…

* These six quotes are respectively found on p.p. 2, 4, 11, 15, 23, 23.

6  BIS Annual Report 2013/2014, p.p. 17-18.

7 Ibid, p. 25. We take as a sign of bond overvaluation the observed compression of corporate credit spreads. The stock market is overvalued for two three reasons: 1) Bond market overvaluation. 2) The decreased intrinsic growth of the U.S. economy in the absence of structural reforms 3) During the two years between 6/30/12 and 6/30/14, the S&P 500 increased by 43.9% to 1960. During that same period, S&P 500 operating earnings increased by only 18.6%. add: This excerpt suggests that a belief’s supporting evidence should be both true and complete as possible. add: The first two are components of the present value model of securities valuation; the last is the result of the momentum of events. Daily securities prices are the result of that model and large statistical error around that model, which will be corrected. In the meantime…

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add: Many Master Limited Partnerships were purchased at high distribution yields, some exceeding 6%. When the Fed begins to raise interest rates, possibly around the first half of next year, these partnerships may, or will, drop in price. Since short-term interest rates are at the zero bound, we really don’t care if they do because we have bought MLPs for a stream of income. Over the long-term, the total return of stocks will be most affected by dividends; and that is how we would consider these investments. Look at it this way. If the Fed raises the short-term policy rate “drastically” to 1%, an investor would still get 5% more (and tax benefits) per year by staying invested in these partnerships regardless of current price decreases. This 8/17/14 WSJ article discusses the rate issue and a similar MLP partnership.

A note about U.S. tax regulations. It is generally not appropriate to sell directly owned limited partnerships. Income from many limited partnerships is generally shielded from taxation by tax losses. When a partnership is sold, all or some of these losses must be given back as ordinary income. This is the reason it is generally appropriate to buy a limited partnership for keeps. You should talk with your tax advisor about this.

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The Ukraine and Iraq are trouble. What happens in the Ukraine depends upon what the improvising Mr. Putin decides to do. At this 8/10/14 writing, Iraqi Premier Maliki, increasingly encircled by ISIL, has refused to step down and surrounded himself with tanks. add: The Iraqi crisis presents the United States with many foreign policy dilemmas, but a threat to the world’s oil supply is not one of them. According to the 8/13/14 Bloomberg, U.S. shale oil production has added more than 3 million barrels of daily supply since 2008. In 2013, Iraq’s entire oil production was 3.05 million barrels a day. add: On 8/14/14, Premier Maliki finally agreed to step down, thus clearing the way for the Iraqis to form a more inclusive and collaborative government, a tough task.

How to relate politics and economics to the financial markets? The 8/8/14 FT writes, "When (relevant) war trumpets sound, geopolitics beats finance. The rest of the time worry about monetary policy."

9/1/14 –

A 9/1/14 Business Week article is titled, “Stocks Overvalued? Who Cares?” because, “…a portfolio with a large exposure to equities remains essentially the only option for people with a 10-year or longer time horizon…” The problem with this strategy is that the present short-term interest rate is zero. Can the authors guarantee this low interest rate in the future? A possible turning point for the financial markets will occur when investors begin to foresee an increase in the Fed’s policy rate, usually 6 months before the fact.  

Furthermore, both the Ukraine and the Mideast are very problematic in different ways. Mr Putin’s invasion of the Ukraine to support the Russian separatists will accelerate the West’s sanctions, thus affecting Europe’s energy supplies and exports. This conflict will affect the stock markets by affecting the growth of their economies.

Turmoil in the Mideast now has less effect on short-term oil prices; but is a long-term threat to the United States, and a short-term one to many countries in the region. This article diagrams the mutual interactions of thirteen parties in the Syrian civil war. The Washington consensus is that there will be no American troops on the ground in the Mideast. However, the degree of other U.S. involvements in the complex Mideast is under discussion. The U.S. will likely be very involved because the post W.W. II liberal world order is its creation.

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The present value model captures a large amount of real-world truth: we have discussed the discount rate (determined by Fed policy), the growth rate (determined in the long-term by the structure of the economy), and the error term (determined by the crisis in the Ukraine and the existential turmoil in the Mideast).

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This is a website of political economics and finance, also describing the role of government in maintaining the structure of society and in making the long-term investments necessary for economic prosperity. What are the consequences of government’s absence? The political philosopher Thomas Hobbes (1588-1679) wrote that in the state of nature, without government, life was, “nasty, brutish, and short.” Right after 9/11, Fareed Zakaria wrote an essay in Newsweek titled “Why Do They Hate Us?” In a recent 9/5/14 Washington Post, he discussed further. These two articles well describe the current situation in the Mideast, a zone of disorder that now stretches in an arc around the Mediterranean, from Libya to Syria (speaking broadly).

Reflecting on current events, he writes:

The Mideast is now a complex problem requiring an informed and balanced solution. On 9/10/14, President Obama presented a strategy for military operations in the Mideast, led by the U.S. The two main elements will be U.S. airstrikes and local troops on the ground. Alliances will then combine these air and ground capabilities.

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On 9/15/14 we sold our investment in Citigroup (C) at $52.22. Contrary to our expectations at the time of purchase, this investment has only been moderately profitable. After purchasing the stock, we were right about the speed with which the company would rebuild its capital reserves with essentially free money, but did not adequately factor in the very slow economy after 2008 that would drastically reduce interest rates on the lending side. The company’s low 5% return on equity will likely improve; but macroeconomic factors, such as a (hopefully) slow increase in the Fed’s policy rate, will increase its cost of funds. For banks, higher interest rates first mean a higher cost of funds only then a higher lending rate.

Our next article will investigate the relevance of economic theory to practical realities.

10/1/14 –

In 1919, Keynes nostalgically recalled an age when, “The inhabitant of London could order by telephone...the various products of the whole earth, in such quantity as he might see fit, and reasonably expect their early delivery upon the doorstep…” The first golden age of globalization was brought to an end by W.W. I, the boundaries between many states undecided and national movements growing. In the contemporary world, some analogous political problems are beyond traumatic for the people living through them; but they are unlikely to affect by much the U.S. stock market. This being the way of the world.

Financial meltdowns are much more damaging to U.S. markets than political ones abroad. For example, at the start of the War, between a July 1914 peak and a November 1914 trough, a compendium of 20 Dow industrial stocks traded OTC (the exchanges being closed) dropped by -18%. During the most recent financial crisis, between a September 2008 peak and a March 2009 trough, the Dow 30 dropped by -41%.

We would consider Fed monetary policy to be the major determinate of near-term stock market prices. The Fed will likely raise interest rates somewhat during the first half of next year.

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10/9/14 - Although the U.S. economy is beginning to accelerate, Europe and Asia are slowing down. As a result, the S&P 500 dropped by 2.07%. The U.S. benchmark crude slipped to $85.77 / barrel, down 19.6% from $112.31 on 4/27/11. There is doubt whether Saudi Arabia can or will be the swing producer in the international oil market given (to understate) the fractious relations among the OPEC countries. Due to shale, the U.S., producing 12.1 million barrels per day of crude oil and liquids separated from natural gas, is now the largest energy producer in the world. Saudi Arabia produces slightly less. 

The prices of our two pipeline companies with shale exposure have also dropped. The two greatest risks to these companies are: 1) Physical overcapacity 2) Insufficient earnings to cover cash distributions. The plant expansions of both these companies have been prudent; their dividend distribution will be only around 2/3 of this year’s distributable cash flow. We aren’t worried.

We prefer the traditional way of structuring portfolios, first for income and then second for capital appreciation (taking into consideration value). We invest for use rather than resale. Unfortunately, the unitary capital asset pricing model - that assumes all stocks are fairly priced - is invalid, having no statistical significance because the distribution of stock market returns is not Gaussian.

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In 2008 and 2009, the price of oil dropped from $137.51/ barrel on 7/08 to $41.83 / barrel on 2/09; the economy was on the verge of collapse. All our directly held pipeline companies maintained or increased their distributions.

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10/15/14 - At this writing, 10 year treasury bond yields have dropped to 2.05% and U.S. crude oil prices have dropped to $82.23/ barrel. A possible economic downturn abroad might be balanced against the improvement in the U.S. economy and now likely Fed policy. The picture abroad is beginning to coalesce; it will be simpler to discuss both the foreign and domestic economies together. The general picture emerging is that the world might be facing economic conditions with some similiarities to the 1930s, the aftermath of another balance sheet crisis.

The United States, NYT columnist Thomas Friedman quotes on 10/14/14, now has the advantage of code, crude and capital. He suggests, with these advantages, a carbon tax to replace corporate taxes might be more feasible. Furthermore, low oil prices have a foreign policy silver lining; oil export revenues account for 50-60% of Russia and Iran's government budget.

11/1/14 -

To get an idea of what the stock market might bring, it would be very useful to gauge how the foreign slowdown will affect net exports (imports) and thus GDP. If U.S. exports decrease, and imports stay constant or increase (as is likely), the U.S. economy will slow down.  GDP = Consumption + Investment + Government Spending + Net Exports. This brings us to a somewhat esoteric discussion of statistics in business analysis.

The most natural way to summarize business data: revenues, profit margins, annual stock market returns and so on, is to take an average (mean). It is then said that the average of this economic series is such, and that the phenomenon of mean reversion will eventually give us this value, so lets plan on it. This, might be true for many phenomena measured in the physical sciences, but it is not generally true for the biological or social sciences that involve complicated change, where the statistical distributions of these changes are therefore not Gaussian. Take, for example, a simple data series that we would really like to predict from past data: Net Exports (Deficits) in Goods and Services Produced, a significant component of GDP. Here is what we did:

1)    Data Series: Bureau of Economic Analysis, Percent Rate of Change Contribution to GDP of Net Exports of Goods and Services; SECTION 1, table 1.1.2; (2002-2012); Data: -.64, -.42, -.66, -.34, -.08, .58, 1.11, 1.19, -.46, -.02, .04   mean = .03% standard deviation = .66%

2)    We think we're being pretty smart, because we're getting rid of distracting serial correlation (straight line growth behavior) in the trade data, by analyzing rates of change. Are the above rates of change Gaussian? We're staking our whole analysis on the answer to this question. We used the Lilliefors statistical test for normality to answer this question. The answer is, resoundingly, No.What if we trim the extremes of this data? Then, it might be conditionally Gaussian; again, No. The statistical average and standard deviation of this series go out the window. Something else is happening.

3)    The trade balance is the result of a very complicated series of economic adjustments, among them the effects of the Great Recession of 2008 that markedly reduced imports, and a gradual improvement in the trade balance due to decreased energy imports.

What's likely to happen? We fall back on judgment. A foreign slowdown will likely decrease exports and economic growth; we wouldn't invest in an U.S. stock market already overvalued.

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There is an apparent exception to this analysis. The Central Limit Theorem of statistics justifies the use of econometrics to measure and predict economic series. This theorem justifies the use of linear regressions to analyze almost anything because the sum of many random and independent variables will constitute a normally distributed population, provided: these variables have finite variances (spreads).

This is not generally true in market economies, where individual prices are subject to the extreme fluctuations of human fear and greed and other economic variables also fluctuate according to economic change. The mathematician, Benoit Mandelbrot, hypothesizes that price distributions actually have infinite variances and are very complicated. This is why government institutions exist, to stabilize market societies.

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On 10/31/14, seeking to end decades of economic stagnation, the Bank of Japan announced that it will embark on a massive quantitative easing by increasing its asset purchases up to 33%, buying more government bonds, stocks and real estate as well. Lowering interest rates even further doesn't help if an economy is caught in a liquidity trap and needs massive restructuring. Nonetheless, world financial markets jumped. The S&P 500 increased by 1.2% to 2018, and the Nikkei 225 increased by 4.8%.

We ask whether stocks should be held for their dividend income, as they were in the 1930s. We compare S&P 500 dividends, then and now:

1930-1940: Average* T Bill Yield = .47%, Average S&P 500 Dividend Yield = 5.78%

10/31/14: T Bill Yield = .01%, S&P 500 Dividend Yield = 2.0%.

* We're using averages here only to describe, not to predict.

We think a 2% dividend yield in a low-growth economy does not justify the risk to principal. That risk involves either the implosion of a financial bubble; or the hint that the Fed will begin to raise interest rates, at least somewhat. A much better alternative is to have some sort of political consensus, using appropriate fiscal and monetary policies to create healthy growth, rather than the growth of subprime auto loans.

12/1/14 -

Globalization opens countries up to change and therefore to potentially destabilizing market forces. Due to its ability to rapidly increase wealth with labor of average skill (from agriculture), manufacturing has been highly prized in many developing countries all the way back to the Russian revolution, where it expanded within a closed and faulty economic system, Frieden (2006) *. In search of efficiency and minimal costs, companies have now exported average skill manufacturing within an open, globalized market system from the U.S., to Japan, then to China and now to Vietnam, Cambodia.

The general consequence of such a system is the eventual equalization of wages across the world for work of comparable skill, and the disappearance of that work from expensive areas. The U.S. needs investments in improved skills, to produce new products and services to justify its living standards, and must deal with increasing add: automation. There are many possibilities to increase the wealth of the nation.

The slow economic recovery results from a lack of fiscal policy from Congress, see the Janet Yellen reference below. People now have the choice of adapting their institutions to change; or closing off their minds **, stagnate and becoming irrelevant like the former East Germany. In "Global Capitalism," Frieden (2006) writes, "The history of the modern world economy illustrates two points. First, economies work best when they are open to the world. Second, open economies work best when governments address the sources of global dissatisfaction with global capitalism." In the long-run, globalization has to benefit people both as consumers and producers.

* 1930s Soviet industrialization was overcentralized and lacked incentives. This is the conservative critique of government in the United States. The economic system is now market-driven and globalized; but such a system is socially self-destructive; as World War I, the Great Depression, World War II and the Great Recession demonstrated. Frieden writes, "The challenge of global capitalism in the twenty-first century is to combine international integration with politically responsive, socially responsible government." Markets, Kindleberger (2000) wrote, require an (institutional) stabilizer.

** Professor Andrew Hoffman, of the University of Michigan School of Natural Resources, notes at least nine (non-economic) reasons why people don't believe in global warming climate change because that affects cultural values, for instance those concerning the role of government. He further says because business is now the major source of world-wide authority, markets really matter.

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Fed Chairwoman, Janet Yellen, speaking before a Paris meeting of central bankers, said rate increases when they happen, "...could lead to some heightened financial volatility." New York Fed President, William Dudley, said of future U.S. rate increases, "...this shift in policy will undoubtedly be accompanied by some degree of market turbulence."

A normalization of U.S. interest rates after six years at the zero bound is unprecedented. Normalization should occur slowly in order not to adversely affect the real economy. However, it is not known how the financial markets will react other than they are going to be "volatile," due to front-running. But it is possible to get some idea of portfolio policy.

The guiding principle of investing is to have some general idea of the expected returns and risks in a given situation. Over the next three years, we expect a normalization of interest rates. Here is an analysis of that effect on U.S. equity markets, with specific timings within that three years unknown. Our readers whose utilities don't include numbers and estimates might want to go to the last paragraph of this discussion.

Return

Since S&P 500 operating earnings grew around 10% per year in the last two, we optimistically assume they will grow at the same rate in the next three. If the yield of the ten year treasury remains only at 2.39 % (a best case assumption), then the P/E of the overvalued market is unlikely to change and the market, all things being equal, will be about 30% higher in the next three years.

Risk

At this writing, the U.S. unemployment rate is 5.9%. If that rate drops further, it is nearly certain the Fed will begin to raise the policy rate slowly, to reach full normalization (we assume) in the next three years. The duration (price sensitivity to interest changes) of the ten year treasury rate is around 8.6 years. The rule of thumb for pricing the 10 year treasury is that it should normally equal the nominal growth of GDP, which is now around 4% (2% real + 2% inflation). The decrease in the price of the 10 year due to the normalization of yields will be (4%-2.39%) x (8.6)= 13%.

Such a decrease in the treasury markets will likely catalyze around a 30% decrease in the price of the S&P 500, which would move it slightly below normalized fair value. Therefore, a rational expected return investor would expect to see no gain in the next three, (30% gain -30% loss). It is possible to make many theoretical objections to this back of the envelope calculation, but this is a way to make sense of markets by aggregating years when appropriate.

Most people, and we assume this is true for most of our readers, are risk adverse. Kahneman and Tversky (1979) suggest that the pain of loss exceeds the pleasure of gains of a like amount of money, and that this disproportion increases the greater amounts at stake. This suggests a stock market strategy that invests in equities when the expected returns are quite higher than the expected losses We will make only a minor change in the portion of the portfolio held for income, that is of continuing benefit.

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Oil prices continue to drop, and that will depress U.S. economic activity. But we can almost guarantee the Fed policy rate won't be zero in three years. The treasury futures market currently predicts a short term rate of around around 2% by the end of 2017, equal to the planned rate of inflation. Therefore, the 10 year treasury could be a normalized 4%, as we assumed above.

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The 12/2/14 WSJ website interviewed Stanley Fischer, Vice-Chairman of the Fed. He was asked how the Fed can raise interest rates when there is so much downward pressure on inflation from abroad.

He answered that slow foreign economic growth has impact on the U.S., but it is not the main driver of the U.S. economy. If unemployment drops and inflation increases, then interest rates will increase. He added that 0 is not the natural place for interest rates to be, "...far from it." The first interest rate hike will begin a process occurring over many years, "...as we continue to try to return the economy to a normal situation."

The Fed must stay ahead of the inflation curve and also enable future monetary policy.

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Today's 12/9/14 WSJ contains two headlines: "China Stocks, Currency and Corporate Bonds Fall," the Shanghai Composite dropped by 5.4% on the news that credit availability there was being tightened. The second was, "Crude Oil's Fall Pressures Energy Megaprojects." Both events will cause additional volatility in our portfolio that now consists almost entirely of cash and energy pipeline companies.In the 1990s, the U.S. economy was less globalized. The economic cycle was simpler. In a much more complex globalized economy where, "a flap of a butterfly's wing" can cause a large effect, it is much more difficult to predict system behavior because there are now so many more factors. The two ways to handle this are: 1) Remain always invested, and that includes being invested in an assuredly non-Gaussian stock market. 2) Invest for value, when it occurs. Configure a portfolio for current income because, in the short-intermediate (5 year) term, it is a strategic mistake to rely solely on unpredictable stock appreciation opportunities.

Oil prices have dropped by 41% since their highs in June, and we ask whether that drop affects the midstream gas pipeline companies. We think, much less so and will discuss the impact of this drop and do an oil industry study in January.

12/15/14 -

We have reduced (but not eliminated) our investments in the pipeline limited partnerships, because we now consider them higher equity risks. The drop in oil prices does not adversely affect, in the short-term, the main transport business of the pipeline companies nor does it affect by much their lesser hedged gas processing business. However, it is highly likely that the goals of OPEC are both political and economic, to crimp Shiite Iran's ambitions in the Mideast and to regain market share in the commodity oil business. Given these two strategic factors, we think it is probable that OPEC will wage a long price war, no longer acting as the world's swing producer.

The profits of the pipeline companies will first increase as the existing drilling contracts of their customers are fulfilled, and then the price war will decrease future growth. In any case, both the oil markets and financial markets are due for a likely period of rather high turbulence, and we think it is best to somewhat step aside. Our January industry study will detail the reasons.

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