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Post Why Did Your Portfolio Do So Well under Trump? From Michael Frank
Created by John Eipper on 03/06/21 7:35 AM

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Why Did Your Portfolio Do So Well under Trump? From Michael Frank (John Eipper, USA, 03/06/21 7:35 am)

Michael Frank (formerly of the Bank of New York) writes:

In response to Enrique Torner (March 5th), ten-year interest rates bottomed at .6% last summer, marking the end of a forty-year bull market in US debt. If interest rates are essentially zero, then the net present value of a penny of future cash flow is infinite. That's why you thought your retirement account was doing well.

Interest rates had been held artificially low during the second half of Trump's term. During this period, the Fed became an enormous purchaser of US debt, which should give you a headache if you think about it for a minute or two. It was never fated to end well. At some point, rates will rise and the party will come to an abrupt end.

Jerome Powell has been a poor communicator throughout his tenure, and that hasn't helped manage investor expectations. Nothing has changed there, not one thing. With the exception of Brainard, all the Federal Reserve board officials are Trump appointees.

JE comments:  Michael, can you clarify what you mean by the following?  Remember, I'm a literature guy--

"If interest rates are essentially zero, then the net present value of a penny of future cash flow is infinite."

My stab at an interpretation:  If money is free, then it makes sense to borrow infinite amounts of it, and where else besides the stock market can you park it?  Thus the booming financial markets.  Remember, money is free, so putting it in Treasuries would be pointless.

None of this is a problem until you get inflation.  Then the punch bowl is taken away, the music goes silent, and you have nothing to look forward to except a nasty hangover.


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  • Where is Inflation? Look at the Stock Market (from Michael Frank) (John Eipper, USA 03/07/21 7:42 AM)

    Michael Frank explains:



    What I intended to say in yesterday's post was that if interest rates are zero, the net present value of a penny of future return is a penny. So any investment that produces steady returns has infinite value. I'm at that awkward age, where the mind is willing, but the keystrokes don't cooperate.


    To understand this, imagine that I promise to pay you $10 one year from today. If interest rates are 10% annually, then the value of that promise is a hair under $9.10 (Because $9.10+ $.91 interest = $10.01). If interest rates drop to zero, then this promise is worth the full $10, because a dollar in the future is worth a dollar today.


    To understand how this works for financial assets, imagine that a company will pay you an endless stream of $10 annual dividends and that the prevailing interest rate is 10%. Next year's payment is worth $9.10, and the payment for the second year is worth less, about $8.30, because it's further out in time. The third year's payment is worth $7.55. The further out in time, the less the payments are worth. Eventually, the value of the additional payments becomes inconsequential, because they are discounted at a 10% compound rate. As long as I can make an educated guess as to the cash flow over the next few years, the time value of money gives me a rational way to price the investment.


    Now the same exercise with zero rates. The present value of next year's payment is worth $10. And the second year's payment? Also $10. And so on ad infinitum. So as zero interest, a dollar at any future point is worth a dollar today. If I can reasonably expect that the operation will continue indefinitely, the price of the investment will approach infinity. Or at least, it's going to be absurdly expensive. So pricing may come down to hand waving and storytelling.


    Everyone frets about inflation and wonders how in the world we can keep increasing debt without affecting prices. Because so much of this new cash transforms into concentrated wealth, financial asset prices have spiraled upwards. My unconventional definition of inflation: too much money chasing too few securities. If you want to find inflation, throw a dart at the Wall Street Journal. Easy money has made a mockery of asset pricing.


    JE comments:  I follow this, Michael.  And you've put inflation into harsh perspective:  it's already here, in the securities markets.  And how about real estate?  Given their impact on monthly payments, low interest rates equate with inflated prices.


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  • Market Reassurances from Ric Mauricio (John Eipper, USA 03/07/21 11:07 AM)
    Ric Mauricio writes:

    First of all, everyone has a bias, be it political or cultural. This reminds me of the time my son made the statement that everyone has a prejudice, then proceeded to ask me that if I entered a room and there was a black guy, an Asian guy, a Caucasian guy, and a Hispanic guy, which one would I approach first. Oh, I replied, that's easy, the friendliest-looking guy. And he knew that was the truth; that would be exactly my approach.


    So if John has a bias, it is very well stated and not at all attacking those with opposing views. This is what makes WAIS unique, as opposed to Facebook (I don't do Twitter), where people attack each other without any evidence to support their opinions. I am happy that John is such a great moderator.


    Now there is a myth out there that Republicans are better for the market than the Democrats. But the numbers do not support this myth. Indeed, research has shown that when the Democrats are in office, the market outperforms the years that the Republicans are in office. Alas, one can slice and dice the statistics in many different ways and come out with many different conclusions. I would put forth the premise that the President doesn't have any effect on the markets in their first year (especially the first 3 weeks of the inauguration year, when they are not in office). In retrospect, considering how slow the wheels of government can move, I would venture a guess that during the first year of presidency, the markets are a result of the final year of presidency of the preceding president. Thus, with a 24% increase in monthly money supply in 2020 (this is double the previous record of +11% in 1982), the threat of inflation and rising interest rates are now affecting the markets. Can this be blamed on Biden? Will it will be a long and painful challenge for him to fix it?


    So when I dive into statistical analysis of Republicans vs. Democrats and market correlations, I adjust the markets to include the first year of a presidency to the preceding president.


    The best performance of the S&P 500 was around 15% on average per year for Trump (3 years plus 2 months), Obama, Clinton, Reagan and Eisenhower. The worst performance of the S&P 500 at around 4% per year on average was for Nixon, Kennedy-Johnson, Truman, and George W. Bush. So each party has their equal representation.


    Last year was an anomaly, with the pandemic. The Nasdaq 100 was up 49% thanks to the pandemic and other market goings-on. For example, Tesla stock was up 695%. So why did Tesla stock go up so much? Well, it was added to the S&P 500. And all the index funds had to add the stock to their portfolios. They had to buy Tesla stock. What happens when all these millions of dollars go chasing after the same stock? It gets pushed artificially higher. The Nasdaq 100 already had this stock, so it benefited from the S&P 500 investment managers having to now buy it. Now, what happens when all the index funds are fully invested in Tesla? Burp! Down it goes.


    Now comes the pandemic. And Netflix and Disney streaming becomes the normal entertainment channel. Zoom becomes the way of the office. Amazon is the way of shopping even more so. Microsoft and Salesforce become the cloud kings. Then the news that Covid cases are coming down and we all look forward to a normal life. Oh, take profits in TSLA, Zoom, NFLX, AMZN, MSFT, and CRM,, who all benefited from the pandemic. Never mind that only 11% of us have been vaccinated.


    In response to Enrique Torner, 10% market corrections are normal (in fact, the big buyers and sellers of stock, the institutions buy and sell to scare you out of the markets; oftentimes, I've seen where they are issuing a Buy recommendation and selling or issuing a Sell recommendation and buying; Goldman Sachs is especially notorious for doing this). The fact that you had a 5% correction is nothing, a mere blip in the long-term view of the markets. You cannot extrapolate that because you had a 5% correction, that in 20 trading days, it will be down to zero. Take a look at a long-term chart of the markets. In fact, I found that just by leaving your investment to compound over the long term, instead of fretting and worrying about what may or may not happen, often is the best way to invest. Fidelity once did a deep analysis of its retail accounts and found that the best performing clients are those who either were dead or forgot all about their accounts.


    I once told a client to turn off the TV, go sit in the sun, sip a piña colada and relax. I suggest investors on WAIS to do the same. Don't worry, be happy.


    Everything will work out in the end; if it isn't working out, it's not near the end.


    JE comments:  Ric, have you ever thought of putting out your shingle as a Life Coach?  Either way, your free advice is priceless!


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    • In Praise of Ric Mauricio and Financial Serenity (Enrique Torner, USA 03/08/21 4:20 AM)
      I want to express my appreciation for Ric Mauricio, whose wise words were very reassuring.

      Ric knows how to speak plainly to people who, like me, are no financial whizzes, so they understand what he is saying. Now, if you can explain a complicated subject in a language that even a kid can understand, that's evidence that you are an accomplished, talented teacher (or coach, as John well put it!).


      Thank you, Ric!


      JE comments: WAIS doesn't usually post attaboys (or on International Women's Day, attagirls), but I make exceptions when the situation calls for it. Enrique Torner has identified in Ric Mauricio the rarest of treasures--a Certified Financial Planner who is also "Zen"! I heartily agree.


      My two takeaways from Ric's post of March 7th:  1) When the Big Guys say sell you should buy (and vice versa), as that is what they are doing; and 2)  A hands-off approach to your portfolio is often the best strategy.  Ric pointed out that dead people with abandoned accounts often outperform the obsessive financial micromanagers. 


      Zag when others zig.  Zen, indeed.

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    • Buy and Hold? Not So Fast... (Jordi Molins, -Spain 03/08/21 11:06 AM)
      Ric Mauricio wrote, "Fidelity once did a deep analysis of its retail accounts and found that the best performing clients are those who either were dead or forgot all about their accounts."

      I agree with Ric that the "buy and hold" strategy has been optimal, at least since Paul Volcker's helm at the Federal Reserve. However, a historical analysis of financial markets suggests that the "buy and hold" strategy is not always optimal. For example, during the Great Depression a "buy and hold" portfolio would have been far from optimal.


      "Buy and hold" has been a good strategy due to the Fed Put. Since Volcker hiked interest rates to very high levels, Central Banks could just cut interest rates a bit, when there was a crisis. However, now interest rates are around the zero bound, so it is harder to think how monetary policy could continue being as efficient as it has been during the last four decades.


      There is the possibility that a "buy and hold" portfolio will not fare as well during the next decade. I expect fiscal policies will take over monetary policy as the stabilization tool for policymakers. And fiscal policies are less efficient (but not less powerful!) than monetary ones. As a consequence, it seems to make sense to expect higher market volatility going forward.


      My bet is for the future we will need different tools to manage portfolios, quite different from static, "buy and hold" portfolios. A scientific, rational approach will be needed for that.


      JE comments:  Jordi, you're "harshing our mellow"!  Buy and hold is the best strategy, until the moment when it isn't.  One red flag is the present near-zero interest rate.  This takes away possibly the biggest weapon in a Central Bank's arsenal.


      Zen Master Ric Mauricio, what is your response?


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      • "Buy and Hold" is the Worst Investment Strategy...Except for All the Others (from Ric Mauricio) (John Eipper, USA 03/10/21 2:58 AM)
        Ric Mauricio writes:

        Democracy is the worst form of government, except for all the others. Attributed to Winston Churchill.


        I agree with Jordi Molins (March 8th), that "buy and hold" is not the most optimal strategy. But unless you were "lucky," like Joseph Kennedy, it is the best strategy. In my fifty plus years of investing, I have never found anyone who could consistently "time" the market and outperform the indices over a long term period. Where's Elaine Garzarelli? Where's Robert Prechter? Why has Jim Cramer, TV's stock guru, averaged only 4% per year vs. the S&P 500's 7% (based on 2001-2016 track records)? Why did George Soros only make 8.9% in 2017 (vs. 19.42% in the S&P 500 or 31.52% in the Nasdaq 100) and 0.9% in 2018 (vs. -6.42% in the S&P 500 and -1.04% in the Nasdaq 100)? But yes, I do follow the charts, albeit a very long-term chart. Between FOGK (Fear of Getting Killed) and FOMO (Fear of Missing Out), there has to be a happy medium.


        As we have seen in the markets recently, there is a ton of volatility. A member in my gym once told me that he doesn't want to invest in the stock market because of the volatility. I told him that if we didn't have volatility, your average return would be around the same as a CD. Ah, another mantra: Embrace the Volatility. OK, so back to the Great Depression, where stocks took a major hit of 85%. If you went back in time, you would see that everybody and their brother was investing the stock market. It was easy money, so easy a monkey can do it. 90% margin, no problem. Do you see the problem here? OK, fast-forward to the real estate bubble. No money down, negative amortization, stated income qualifying. You can't lose with real estate, right? Fast-forward to the dot com bubble. It's a new paradigm. Invest in companies whose business models make no economic sense. Wow. Today we have crypto currencies backed with uh, what are they backed with? We have SPACs with companies whose business models beg the question: what are you smoking?


        Jordi says that "in the future, we will different tools to manage portfolios; a scientific, rational approach will be needed." Jordi, I don't want to wait for the future, it's my money and I want it now. Oh, sorry, JG Wentworth, stole your line.


        Having said that, I subscribe to Sir John Templeton's maxim of buying when there's maximum pessimism and selling when there's maximum optimism. Sir John utilized P/E ratios as his scientific, rational tool in applying that maxim. But having been a Controller and an Accounting Consultant, I know all too well how today the earnings part of that equation can be manipulated, which of course prompted the SOX (Sarbanes Oxley) mandate. Alas, there will always be creative accountants egged on by their creative CEOs and CFOs. In one company, I was asked to mark up the value of a product to a supposed value and depreciate it to create losses. I refused since it didn't follow GAAP (Generally Accepted Accounting Principles). Most accountants would have done it in fear of being fired. I didn't care if they fired me; I was going to do the right thing. OK, so using today's P/E ratios may not work. In fact, Tesla's P/E ratio is north of 800.


        I did have an indicator that did work perfectly until a few years ago. When my "best man" (in my wedding) said he was buying, that proved to be the best time to sell and when he said he was selling, that proved to be the best time to buy. Alas, I think he figured out that I was following his signals, so he is no longer sharing stock market tips. Another indicator, which for now has been put on hold, is to sell when I go on vacation. I recall when I was in Beijing in late September 2008, that the market fell 700+ points, leading to an overall drop of 20%. When I got back to work at Franklin Templeton, everyone was asking if I had lost money. I told them I lost a million (pause) in yuan. I could see the wheels turning as they tried to translate that into dollars. So the next time I plan on going on vacation in a place where there is not good internet connection (the PRC has a firewall that makes it very challenging), I will let everyone know. In 1987, I sold a good portion of my portfolio. Was I a timing genius? No, needed the funds to remodel my kitchen. I'll also let everyone know when I do a big project.


        Michael Frank stated that "If you want to find inflation, throw a dart at the Wall Street Journal." I'll go you one better. Throw a dart at the prices at Home Depot or Costco. CDX graded 4 x 8 plywood has increased from $26 to $39 or a 50% increase. A bag of broccoli at Costco has gone from $4.99 to $6.99, or a 40% increase. Brent crude oil has gone up 100% in the last year. Not even interest rate calculations can predict these type of inflationary numbers. In fact, I need to ask Mr. Frank how his calculations translate into valuing equity prices. Please use real-world examples to help us simple-minded folks understand. Thanks.


        JE comments:  Here's a title suggestion for your book, Ric:  Serene Investing with Ric Mauricio. (!)  You especially "got" me with the Best Man Strategy:  Zag when the masses zig.  (You really should write a book, by the way.)


        I've frequently used P/E to gauge whether a stock is overpriced or a bargain.  As a corollary, I buy only companies that generate a profit.  This seems to be Capitalism 101, but look at Amazon:  it didn't make a penny for seven years (literally:  its first profit was in the final quarter of 2001, at 1 cent per share).  That was a huge MO.  I should have had more FO.

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        • Can You "Time" the Market? (Jordi Molins, -Spain 03/11/21 3:56 AM)
          I agree with my friend Ric Mauricio that the motto "buy low, sell high" is difficult to accomplish in practice.

          However, I disagree that there is value in Ric's statement, "In my fifty plus years of investing, I have never found anyone who could consistently 'time' the market and outperform the indices over a long term period."


          The reason is that money and financial markets have existed for five millennia. And the right strategy to invest has changed dramatically over the years. So, an investor may think that he or she is an investment guru, but then the market regime changes, and a strategy proves to be disastrous.


          What is different in the last four decades (overlapping Ric's experience) is that the Federal Reserve has told us not to try to buy low or sell high, but we just need to keep one thing in our minds: "do not sell low." Unlike the "buy low, sell high" mantra, the "do not sell low" can be easily applied in practice: basically, never sell.


          The reason for the "do not sell low" is the Fed Put: in times of crisis, the Fed will be there to help, and soon after the market bottom, there will be a fast recovery, that will lead to new market highs.


          What I want to emphasize is that, despite the fifty years of Ric's experience, the current market behaviour is not the "normal one." In fact, I think that the Fed has introduced clearly un-American values into American society, since now everybody understands that an investor does not need to devote much effort or work in understanding markets. An investor only needs to have faith in the government (the Fed, in this case) and blindly follow the government's instructions ("never sell").


          In fact, even the jokes about Jim Cramer (which I share) are distressing: evolutionary, it has been advantageous for humans to have deeply ingrained in our minds the idea of "selling low and buying high." The reason is "if you find yourself in a hole, stop digging." It may be hurtful to "sell low," but in normal circumstances in nature, it is usually a good evolutionary reaction.


          As a consequence, that the government has convinced us that we do not need to follow our natural instincts, but instead we need to follow the artificial wishes of the government, is deeply distressing for a libertarian. But American society has deeply embraced these anti-meritocratic values (in financial markets, not in other parts of the economy).


          In fact, in normal circumstances, without a Central Bank's massive interventions, trying to understand better markets, in order to time them (the rational approach I defend, and which Ric does not like) would yield good results. In normal life, the more we invest, the more effort we put in something, the better it is for us (plus / minus luck, of course). But as said, we have internalized that financial markets are an exception: we do not need to invest in good tools, we do not need to put any effort, we just need to trust the government, and everything will be alright.


          Financial markets have been dominated, in recent decades, by monetary policy, globalization and demography. Demography changes very slowly (but it is becoming a bigger drag over time in the developed world). Globalization is showing tentative signs of a slowdown. Policymakers are openly saying, for the first time in decades, that fiscal policy must substitute monetary policy as the main macroeconomic stabilization tool.


          Market regimes change from time time. The current one has lasted already longer than usual. My bet is that a new regime (not benign to a buy-and-hold strategy) is near the horizon (on historical time frames, which range from years to decades).


          JE comments:  Jordi, this makes one think.  You've brought up two investment phenomena I've never considered:  1)  We have been "trained" not to sell low, because of our assumption, conscious or not, that the government will intervene to prop up a declining market.  WAISer Tor Guimaraes has described this as the privatization of profits and the socialization of losses.  2)  We may be on the cusp of a new financial era:  monetary policy is out, fiscal policy is in.  Meaning, less emphasis on interest rates and money supply, and more emphasis on taxing and spending.  Less Jerome Powell and more Janet Yellen?



          Might the two be related?  When interest rates are at near-zero, what can a Central Bank realistically do?

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          • "Sort of Timing the Market, but Really Not": Ric Mauricio Explains (John Eipper, USA 03/31/21 2:53 AM)

            Ric Mauricio writes:



            I thank my friend Jordi Molins (March 11th) for his input on my statement of "not finding anyone who consistently 'times' the market."


            Perhaps my statement was too vague and needed clarification. First I need to clarify the definition of "market." The "market" is defined as the Dow Jones Industrial, the S&P 500, or the Nasdaq (usually the Nasdaq 100 rather than the entire 3,300-company Nasdaq index). "Timing" is defined as selling at or near the peak or buying at or near the bottom. And thus my definition of "market timing." Usually, those who say they can "time" the market are technical chartists, watching those squiggly lines on charts (think of Robert Prechter of Elliott Wave Theory, Elaine Garzarelli, or Joe Granville of On Balance Volume; none of whom have even come close to the performance of the passive S&P 500). Fundamentalists (those who buy and sell securities based on economic fundamentals; think of the Wall St. analysts who have their own agendas) will accuse the technicians of voodoo investing. And as is usually the case, the truth lies in between. I do look at the fundamentals of a company as well as their chart to determine the trend and where the buyers and sellers are placed in the daily tug of war between prices.


            Now there is a myth that Warren Buffett never sells. He does sell. He reallocates. It is true that many of his positions are long term (just think of the tax consequences of selling a stock position when the gain is in the millions). I use Buffett as an example, but there are many other successful investors that "time" their investments. Sir John Templeton is another example. He buys when there is maximum pessimism and sells when there is maximum optimism. Ah, did I just contradict my statement of not finding anyone who consistently "times" the market? Well, yes and no. You see, Templeton bought companies (some of whom belonged to a certain index, like the S&P 500 or the Nikkei) but he is buying companies that he believes will do well going forward and are valued below their intrinsic value (ah, yes, Benjamin Graham). So, no, he is not buying or selling the "market," he is buying or selling companies.


            This leads me to what I will dub (key in John Coltrane here), JEZZ. JEZZ is, in honor of our esteemed moderator, the "John E Zig Zag" method of investing. Let's take the Crash of 1929. Although I was not around for that event, I am a student of economic market history, so I would argue that my knowledge base goes beyond my 50 years of investing. What I found was that investors in the Roaring Twenties could buy stocks at 90% margin. So if their holding dropped 10%, they've essentially lost 100% of their equity. And of course, the brokerage house will unwind their position, thus sending the share price lower and it will just cascade lower, resulting in a crash. Fast-forward to today (in fact, the last week) and you can no longer buy stocks on 90% margin (after the Crash of 1929, the SEC tightened the margin requirements), but on 50% margin. Ah, as we have seen in the Archegos saga this last week, if you are at 50% equity (the inverse of 50% margin), and the share price falls below 30% equity (the broker minimum--you can still trade futures with huge margins), you are required to either sell the position or deposit more funds to bring the equity to 30% or more. So if your $100 stock falls $21, a margin call happens. Then if the investor doesn't deposit enough funds to restore their equity position above 30%, the stock is sold to cover. Of course, a large position placed in a block trade can result in an even lower price execution, so the situation compounds. ViacomCBS fell over 50% as a result. What is that? A 100% loss. Ouch. The investor felt a great amount of pain and the banks, who lent him the money to buy the stocks on margin, were hurting in the millions. This is why I don't invest in banks. Oh, yes, Goldman is an astute manipulator in the markets, but the Wells Fargos and Bank of Americas have proven themselves to be just plain incompetent.


            So do we JEZZ and buy Viacom? Yes, you can, but I'm not convinced that ViacomCBS is a good company to buy. But I did buy my Apple stock when the news was that the Chinese were not going to be buying Apple phones. Proved to be a fantastic investment at the right time. I am not a believer in not selling low. If the company is well managed and management has shown that they can pivot with the times, then I will not sell. If the company is not well managed (think of GE), then yeah, time to sell. Government intervention results in artificial valuations.


            As you can see, I am not timing the "market" per se (in fact, 80% of the S&P 500 will underperform the average at any given time), but rather investing more in good companies during market selloffs and buying less when companies become a bit rich for comfort. Sort of market timing, but really not.


            JEZZ comments:  Ric, I'm honored to get my own acronym!  In our investment summits at WAIS HQ, I characterize myself to Aldona as a "bottom feeder":  show me a company that's been beaten up for little or no apparent reason, and I'll buy as long as it looks like it won't collapse altogether.  How do you determine its survivability?  Well, then I apply my other metric:  the "seat-of-the-pants" analysis.  Sometimes it works (Starbucks, Occidental Petroleum), and sometimes it does not (Corinthian Colleges [yikes] and long, long ago, Pets.com).

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            • Indexes are NOT Portfolios (from Michael Frank) (John Eipper, USA 03/31/21 4:58 PM)
              Michael Frank responds to Ric Mauricio (March 31st):

              First of all, let's talk a bit about what we mean by "the market." The standard proxy at the moment is the S&P 500 index. Here are a few things to think about: the index is a list of the 500 "best stocks," this according to a group of nameless analysts at S&P. It's not a portfolio. It's a list. That's not a picayune point. A list has no cost. I could make up a list of stocks at any point in time; all it costs me is a piece of paper. To actually turn it into a portfolio not only requires investment capital, it requires transaction costs, custody costs, opportunity costs, and financing costs. So you're behind before you begin. The S&P index is market cap-weighted. Which means that the more a company is worth, the larger its representation. While it's not really clear why that would be a good idea, the effect is that the very biggest companies on the list have the greatest impact on its value. So you can play around with Viacom all you like. The twenty top companies in the S&P list account for 90% of the variance. And here's the tricky part: since it's just a list, the ordering changes with every tick. Today's top twenty can be costlessly replaced at any moment by tomorrow's top-twenty list. And S&P analysts can add or remove component stocks at any time. So the index investor is passively investing in an active list. This is why it's tough to "beat the market."


              The expectation of market beaters is that performance of any outlier will eventually revert to the mean. Your bet on Viacom is based on the expectation that it will do exactly that. But what if it doesn't? You don't have to go to far to find a marquee company of yesterday that went permanently off the rails. GE for example. The management situation there wasn't clear to the general world for many years. If you had taken that bet in 2016, 2017, 2018, 2019 or even 2020, you would have lost your bankroll. It's done better so far in 2021, but so what? How long can you tolerate the downside? All you need is one mistake to ruin your portfolio. So its no surprise that it's tough to consistently beat the market. It's true that from time to time, even a dealer with a stacked deck can be beaten. But success won't happen with any consistency. The occasional bad play aside, time and repetition favors the dealer.


              For me, the more interesting question is why tracking funds work. Because unlike an index, a tracking fund is a real portfolio. It has to rebalance daily, and customers continuously make deposits and withdrawals. All of which require stock transactions. So it pays commissions and spreads, custodial fees, marketing and advertising, accounting costs, makes regulatory filings, holds shareholder meetings, pays interest on uninvested balances, maintains capital reserves, and on and on. There is some advantage to scale, but most of these expenses are going to cost a small percentage of portfolio value that compounds every singe day. Given the many sources of friction, there should be either significant tracking error, sales loads, or expense ratio. The fact that these funds are close to zero in every expense category should raise an eyebrow. I think there are two components to their "secret sauce." The first is that for the last forty years, net inflows have been positive almost all the time. Which means that "new money' pays to keep the fund in balance. The other is stock lending, which is "free" income to the fund. The downside of lending is that it causes volatility in the money markets in bad times, and in good times it enables short bets against the fund's own shareholders.


              JE comments:  Michael, I follow you up to the very end of your essay.  I understand the "new money" part, as this is how America's pensions have worked since ERISA in 1974, but what are "short bets against the fund's shareholders"?  Who shorts anything in good times?


              Here's a tribute to secret sauce, and its Big Mac-inspired cousin, the special sauce. Is there a single American from my generation who doesn't know the full lyrics to the ditty?  Two all-beer patties, special sauce, lettuce, cheese...

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              • What is Stock Lending? From Michael Frank (John Eipper, USA 04/02/21 3:43 AM)

                Michael Frank writes:



                When commenting on my recent WAIS post, John E posed two questions: "What are 'short bets against the fund's shareholders'? And who shorts anything in good times?"


                Picture an index fund as a vault filled with stock. The stock is titled to the fund. While the investors have an undivided interest in the portfolio, they do not have direct ownership of the underlying stock. Consequently, the fund has some important rights that the participants don't. For example, the fund votes the proxies. The fund also has the right to lend securities from the pool, provided that any gains accrue to the benefit of the fund. The net lending fees can be used to defray cost, or perhaps paid to the investors as a little extra bonus. So let's take a closer look at stock lending.


                Stock lending and shorting go hand in hand...somewhere in the world, a speculator wants to bet against a stock. So they borrow the stock and immediately sell it. When the loaned stock is eventually called back, the speculator will then need to buy the stock in order to return it. The hope is that the stock will have dropped in price by that time, and the speculator can pocket the difference. Prospective borrowers are always lined up, because the fund is sitting on a vast pool of securities. There's always something in the vault that will be in demand by short sellers.


                Engaging in stock lending is facilitating short bets against the assets of the fund. It's tough to spin this as being in the best interests of the fund's customers. The argument for shorting is that it merely accelerates the inevitable. Since the fund is compelled by its charter to hold through thick and thin, no foul. Win or lose, the fund keeps the lending fees, and that reduces expense ratio. But even if shorting doesn't result in excess losses, the optics are terrible. Or would be if anyone took notice. The index fund lends because it's trying to track a frictionless list with an expensive portfolio. It needs to make the costs go away, because customers want to believe they're trading for "free." They'll keep the investors focused on low expense ratios and avoid the discussion of the impacts of stock loan.


                As to why anyone would short in good markets, it's because the price of any given stock is a random walk about the mean. So we can speculate that the price of Viacom is depressed because of some unusual selling activity, and will soon bounce back. We can just as rationally speculate that Tesla is grossly overpriced, because it's market cap exceeds that of all the other auto companies combined. Neither speculation necessarily involves a judgment about the quality of the companies, only a judgement that the market price is mismatched to the underlying trend. Shorting Tesla at the peak of its game may be completely rational, an example of value investing in reverse. (Don't mistake these hypotheticals for recommendations. And by way of full disclosure, I'm neither long nor short either company.)


                Let's finish this by examining how stock lending adds risk to the index investor, since it's not at all obvious. When the fund loans stock to a speculator, the borrower places collateral in trust with the lender, usually 105% of the amount borrowed. The fund takes this collateral, usually in the form of cash or treasuries, and invests it in the money market. So it not only collects fees on the loan, it makes interest on the collateral. Pretty cool, you're thinking. However, when the market crashes, this collateral becomes a frightful liability, because it has to be marked to market every single day. Whenever the price of the borrowed stock is falling, the fund's cash flow is working backwards: the lender actually has to repay the borrower's excess collateral. You may recall hearing that money funds "busted the buck" in 2008, this is a big reason why. The vicious demand for cash in a bear market disrupts the money markets in ways that aren't always orderly and predictable.


                When the market is deeply panicked, investors head for the doors. Index investors aren't immune to the siren call of cash. In order to fund redemptions, the fund has to sell stock, which means that it first needs to recall its loaned securities. Meanwhile, the shorts are living the dream--plunging stock prices and collateral being returned--and will delay returning shares if they can. Liquidity locks up, and the panic deepens, prompting more weak hands to sell. And that's why funds reserve the right to delay withdrawals.


                Against this sort of situation, index funds have effectively zero cash reserve. The thinking is that the investor's interest is always secured by the underlying stock. And that if the stock has been loaned away, it's still secured by IOU's from the borrowers and by collateral. So it's fine until it's not fine. One of the serious oversights following the meltdown is that not one asset manager has been identified as systemically important.


                I don't tell you these things to cause you to stuff your money under the mattress. I tell you these things because it's important to understand the things you can't control so that you can make good decisions about the things you do control.


                JE comments:  A most instructive explanation, Michael.  Thank you!  How many in WAISworld have contemplated what an index fund "does" with its existing portfolio?  Or for that matter, for short-sellers, do you wonder where the shares actually come from?  (I'm an amateur investor but a seasoned editor:  doesn't "short-seller" have to be hyphenated?  Otherwise we're implying that the investors are vertically challenged.  There's an analogy here with small-business owners.)

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                • More on Stock Lending, SPACs, NFTs (from Ric Mauricio) (John Eipper, USA 04/20/21 3:36 PM)
                  Ric Mauricio writes:

                  An excellent post on stock lending by Michael Frank (April 2nd). Allow me, if you may, to expand upon the subject.


                  Index funds that primarily invest in large cap stocks benefit the least in lending out their securities due to the smaller spread between the bid and ask (a result of their increased liquidity in the markets), while the index funds that invest in mid cap or small cap stocks will benefit the most due to the larger spread, thus they are able to offset more of their expense ratios that would benefit their shareholders.


                  Now, here's the rub. When an investor opens a brokerage account, they can open an account with margin capabilities. Now the brokerage firms that hold these accounts now have the privilege of lending out the investor's holdings and they don't even have to tell the investor. More so, unlike the index funds (or any fund, for that matter; doesn't have to be an index fund), the brokerage firm earns the lending fee, which they keep. Imagine, they are earning fees on securities they don't even own.


                  Now, here's a further rub. Let's say the funds and brokerage firms lend the short sellers the securities, which, in turn the short sellers sell to another investor, who now holds the borrowed securities. Keep in mind that the short sellers no longer have the borrowed securities (otherwise they would be long and not short) but are obligated to buy back the borrowed securities if their brokerage calls them to do so. Now let's go once step further. The investor who purchased the borrowed securities from the short seller now has those securities in their "margin" account. Ha, the brokerage firm that administers their account can now lend those same securities to another short seller. This is why some companies can have a 125% short interest on their float, as we saw on one very visible stock in the last few months. A very dangerous game, if I may say. Does anyone remember October 1987? I couldn't even get a good quote from my market makers on the NYSE or NASDAQ.


                  Now onto JEZZ. I recently received an email from a neophyte investor asking me what I thought of cryptocurrencies, the stock market in general (and the "fact" that it will now collapse along with the economy because of Biden), and gold. Oh my, my JEZZ antenna is tingling. Whenever I hear, read, or see these comments, it usually signals that you may not want to play in this game. I am sure that this neophyte investor is also wondering about SPACs and NFTs. SPACs (Special Purpose Acquisition Corporation) are created to bypass the normal IPO (Initial Public Offering) that are run through a consortium of brokerage firms. SPACs require less due diligence than IPOs, but save on costs because they don't have to share anything with the big bad greedy brokerage firms. But they do require greater due diligence on the investor's part because of this. By the way, due diligence by the brokerage firms does not guarantee that the company is a company that will do well. Remember the dot com bubble? All IPOs. Ouch!


                  NFTs are Non Fungible Tokens. Note the word Fungi in the description. Well, some fungi aka mushrooms are poisonous, but most I fear are hallucinogenic. I mean, if I hold an original Honus Wagner card in my hands, or hang a Monet in my family room, I get that touchy feely tactile sensation. But something digital? I may be wrong, but sorry, I'll stick with companies and real estate that generate real revenues. Sure, I'll collect that coin or Pez, but at least I can enjoy it by holding it. By the way, the TV shows that sell collectible coins are scams... they are overpriced.


                  As to John E's Pets.com, it was a matter of execution. Great idea, but terrible execution. Chewy had the same concept and is doing well. Takes a little research to separate the wheat from the chaff.


                  One member in the gym commented to me that the reason he doesn't invest in the stock market is because of the volatility. Well, if you removed the volatility from the markets, you will end up with a return on investment equal to a CD, which underperforms inflation, so you will not be building a nest egg. Now there is the concept of market timing, to avoid the volatility. The issue of market timing is that most timing systems are based on moving averages. And the problem with moving averages is getting whipsawed. You sell when the security falls below a certain moving average and you buy when the security rises above a certain moving average. Many times you end up buying above your selling point, only to have to sell again, and buy again. Not only are you not getting anywhere or ending up where you would have been if you did nothing, but you incurred transaction costs (and yes, even though you may have zero commission cost, there is the spread between the bid and the ask prices) and possible tax consequences.


                  Now what I found is that most investors tend to think too much and start ignoring or waiting on the signals. I like to embrace the volatility. I like to buy good companies when they are on sale. I execute the JEZZ system and buy when there's maximum pessimism and sell when there's maximum optimism. I also avoid, like my neophyte investor above, investments that are being highly touted (especially by the media and brokerage firms).


                  JE comments:  Lots of acronyms here, but I'll start with most arcane:  JEZZ is the only known acronym in my honor, coined by our dear friend Ric Mauricio:  the John Eipper Zig-Zag approach (i.e., zag when others zig, investment-wise).  Ric also brings up one of the more bizarre "investment" vehicles of our age, the Non-Fungible Token/NFT.  The NPR radio show Marketplace did a segment on them recently.  In short, via NFT exchanges you can "buy" an digital token, such as the first-ever Tweet.  Who would pay good money for such nonsense?



                  I'll change my mind when I can visit a Museum of NFTs.  Granted, the Henry Ford Museum in Dearborn, Michigan houses a test tube containing Thomas Edison's last breath.

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