Posts by the Contributor
President & CEO
Masood Vojdani began his career in the financial services industry in 1981. From the outset, he was driven by the vision of a firm that was different from the industry status quo. At the heart... Full Bio
Note: Our Midweek Market Comment is actually an end of week comment this week, in order to focus on the Fed’s latest quantitative easing announcement made Thursday September 13.
The odds seemed to be on something happening, and the chorus of conventional wisdom grew louder as the week went on that it might be something big. But when it arrived, the news presented itself with a Zen-like simplicity: $40 billion every month. No cumbersome time estimates or sunset clauses. $40 billion for as long as it takes to produce results. Zero percent short term interest rates as far as the eye can see.
There are two key questions we have been focusing on in the run-up to and immediate aftermath of what the financial chattering class inevitably refers to as QE3. Those two key questions are: (1) was the Fed right to make the decision it made, and (2) having made the decision, is it likely to actually work?
Unsurprisingly that first question has been sucked into the venal vortex of partisan politics. It’s less than two months before a presidential election and the Fed – an organization independent of the three branches of Federal government – has opened the floodgates to rescue the economy (though technically the $40 billion mortgage backed buying program won’t start until after the election). Partisan reaction from both GOP and Democratic party flaks was in full view yesterday and will no doubt be woven into campaign narratives as the days go on. But that is absolutely the wrong way to look at the question of whether Bernanke’s call was the right call, which was very clearly not a political call.
The Fed has a dual organizational mandate: to undertake policies in support of full employment and price stability. That’s it. When the Fed makes its Open Market Committee decisions about whether to raise or lower or hold steady the Fed funds rate, or whether to inflate its balance sheet with more QE, it is with those two objectives in mind. Bernanke was very clear about this in his statements. The recovery continues to be anemic, unemployment is persistently high and shows no signs of budging, and is far above what any reasonable person would consider to be “full employment”. Meanwhile demand remains modest. Modest demand – reduced spending in other words – means that the threat of damaging inflation levels remains subdued. The Fed believes that a low inflation outlook gives it maneuvering room to try and stimulate the employment side of its mandate with QE. That’s what yesterday’s decision was about.
Which brings us to the second question: will it work? The task is daunting. Interest rates are already at historical lows. Credit has never been cheaper – but borrowing remains significantly below trend by both households and businesses. Is the purchase of $40 billion worth of bonds every month by the Fed going to be the act that moves the needle? It’s hard to make a compelling case – but it’s also hard to make a case for an alternative path to growth when there doesn’t seem to be one. Central banks are, sadly, the sole policymakers anywhere in the world with the ability to take remedial action to stimulate the global economy. Governments are gridlocked and political leadership is weak. It’s central bank action or nothing – and in a world where weak growth can fall back into recession in the blink of an eye, something is probably better than nothing. The markets seem to think so in the short term – but it’s the growth, consumer confidence and – yes – unemployment numbers that will provide the ultimate judgment.
Modern Portfolio Theory – the intellectual framework that underlies the methods by which the vast majority of investment managers and advisors execute decisions on behalf of their investing clients – is approaching its 40th anniversary. In a world where anybody with $1000 and an online trading account can buy once-exotic commodities futures, and where US government securities stand not so far from the precipice of a potential downgrade, how well-suited are the assumptions and tools of MPT – fashioned over the last forty years of thought and practice – to the investment challenges of today and tomorrow? MVCM President Masood Vojdani shares his insights gained from thirty years (and counting!) in the investment industry.
I started working in the investment industry in 1981, a year when both inflation and interest rates were stuck in double digits and the conventional wisdom about the equities market was that it was dead. In an age of unappetizing choices for where to put one’s money I learned an early and valuable lesson: portfolio diversification is the smartest way to ensure that when bad things happen in the market you at least have some cushion to limit the downside. Now, diversification may sound like something sensible people have always done since time immemorial, but in fact the building blocks that underlie what today’s professional portfolio managers do for a living were set in place just a handful of decades ago. The cornerstone was a Journal of Finance article called “Portfolio Selection” written by Harry Markowitz in 1952. Markowitz established the basic principles of mean-variance analysis and with that set in motion a fruitful couple decades of advancement in financial theory and practice. This rich period included contributions from William Sharpe (Capital Asset Pricing Model, early 1960s), Eugene Fama and Kenneth French (Fama-French Three Factor Model in the 1970s) and a number of other leading-edge thinkers. The burgeoning discipline that they crafted came to be known as Modern Portfolio Theory.
From Theory to Practice
MPT, as it is known in the trade, had thus already been around in some form for nearly 30 years when I first hung out my shingle as an investment professional. But it seemed to really come into its own as the Great Bull Market of 1982-2000 gathered steam, so to a certain extent I feel like I came of age alongside the movement of MPT from academia’s ivory towers into the cut and thrust of real investment markets. The practical mechanism that effected this movement was asset allocation, which in turn is a somewhat fancy way of saying diversification. Asset allocation is rooted in the two critical measures of Markowitz’s mean-variance analysis: (a) the risk-return characteristics of different types of assets relative to each other, and (b) the level of correlation between different assets in the same portfolio. A whole industry sprang up around the business of making efficient allocation decisions, perhaps best illustrated by the so-called Morningstar “style boxes”. These nine boxes divided the world of stocks into nine flavors from large-cap growth to small-cap value. Pick judiciously among the style boxes for your risk assets, leaven these allocations with whatever percentage of bonds was appropriate for the risk tolerance of a given portfolio style, and you were good to go.
Challenges of the Post-Modern Era
Modern Portfolio Theory has for the most part served the investment industry well; but for two reasons I feel that we may be entering a new – call it “post-modern” – era. The two reasons are: the rapid growth of liquidity-providing financial instruments in an ever-wider spectrum of asset classes; and the increasingly dubious notion that there is a good proxy for a risk-free rate of interest in the market. Let’s look at each of these in turn.
On its face the rise of liquidity-providing instruments would seem like a good thing. Take commodities futures. Back in the 1970s, when MPT was still mostly confined to the halls of academia, it would take a considerable amount of money, sophistication and hard-to-obtain access to a trading platform for an individual to take positions in exotica such as crude oil, soybeans or pork belly futures (remember the movie “Trading Places”, anyone? Randolph and Mortimer Duke were not your typical middle class family with a savings account and retirement plan). Now, for those larger investors (like the Dukes) able to trade in these rarefied markets there were distinct benefits: commodities futures would tend to trade with very low correlation to movements in the stock market. In the late 1970s, for example, equities investors fared quite poorly, while investors in commodities like gold and oil did really well. That changed in the mid-1980s when the stock market rallied strongly while metals and oil prices plummeted. The point is, having the ability to diversify a portfolio across both equities and commodities was a source of value to portfolios of risk assets.
So isn’t it good news that this source of value is now accessible by typical retail investors who live far from the opulent world of Wall Street barons? Yes, to a point. Mutual funds and more recently Exchange Traded Funds (ETFs) have democratized finance. But they have also been at least partly responsible for a noticeable trend in recent years: those low correlation benefits that historical trading patterns produced are disappearing. Commodities futures are now just another so-called risk asset. What markets exhibit now is a tendency to move in and out of risk broadly – not in and out of equities, or in and out of commodities – but in and out of risk. So commodities and equities tend to move in a more correlated pattern than they used to – and the same goes for other risk assets like real estate trusts. This challenges that one important plank of MPT that selecting among different risk asset classes can add value through low correlation.
The Disappearing Risk-Free Rate
While that is concerning enough, I find the second “post-modern” trend even more unsettling. At the heart of practically every valuation technique that has flowed from Modern Portfolio Theory is the notion of the “risk-free” rate of interest. Think of the risk-free rate as a starting point: as you identify and categorize risks that apply to specific assets the investor’s required rate of return moves upwards in increments from the risk-free rate. Investment valuation models usually include some mathematical formula that reflects the idea of “risk-free plus risk market premium”.
For the entire time that MPT has been around the proxy for the risk-free rate has been the US Treasury bond (or note, or bill). The US had established itself as the world’s reigning economy and financial center long before Markowitz’s 1952 paper – that transition really happened when the world went off the Bank of England-centric gold standard in the years following the First World War and never went back. Now US government debt is teetering on the edge of losing its longstanding preeminence, and in the current climate there is even a plausible case to make that the government will at some point in the not too distant future default on certain existing obligations. Whether or not this happens – and I for one believe that ultimately cooler heads will prevail – the fact is fairly indisputable that Treasury debt today substantially lacks the robust “risk-free” nomenclature. It may still be less risky than just about anything else in the market, but that just means that the whole risk curve has shifted upwards and everything in effect is a risk asset. And those time-honored valuation models are rendered much less useful.
Into the Future
At MVCM these problems have been occupying our attention on a constant basis since the market meltdown in 2008. We will by no means claim to have all the answers at our fingertips. But we strongly believe that the investment assets we will be evaluating for portfolio decisions in the months and years to come require different tools than the ones we have become comfortable using over the last thirty years. Post-modern does not have to mean, as it often does in various arts and humanities usages, jarringly chaotic, confusing or depressing. The challenge is to incubate, develop and deploy tools that work within the practical contours of post-modern markets.
The market has been going sideways for much of the past two months – sideways with extreme lurches up and down reflecting the persistent uncertainty among investors about where the global economy is headed. Are Greece and Spain going to render the Eurozone a failed experiment in unifying distinct national economies? Is China going to slam on the brakes and bring global growth to a screeching halt? Are US consumers going to finally hang up their hats, retire their credit cards and call it a day?
I hear these questions in the predawn hours of every morning as the financial news accompanies my exercise routine. A few weeks ago I was pondering it all as I was driving into work. Now, my route to the Bethesda office happens to take me past the local Apple Store. As I turned onto Bethesda Avenue I could see that this day was not like other days. A huge crowd thronged outside the store and the line extended clear down to the end of the street. Mind you, this was at 8am, two hours before the store was due to open. Truth be told I was not surprised. A fair number of Apple products can be counted among members of my household, and I knew what the big event was today – the launch of the iPhone 4. The expectant masses on Bethesda Avenue that morning were there to part with upwards of $300 each for the latest “this will change the world” offering of Steve Jobs & Co.
The iPhone 4 had received decidedly mixed reviews by the techno-pundits in the run-up to the product’s launch. Technical glitches, security issues – and I am assuming that a good number of the early adopters clamoring at the store entrance had read the reviews. No matter – they all wanted another piece of the magic. No doubt many of them had also shelled out for the iPad when that snazzy tablet appeared earlier in the year.
I usually am not one to conflate one data point into some larger explanation for What It All Means. And Bethesda, one of the richest zip codes in the country, is hardly a proxy for the US at large. But what happened that morning in suburban Maryland was happening all over the country as it turns out – iPhone 4s have been selling like hotcakes. Not surprisingly, Apple’s formidable earnings announcements last week were a meaningful reference point for the strongest week in stock market performance for some time now. Here’s how I see it: American consumers seem perfectly willing – giddily so – to part with hundreds of dollars for technology that – let’s face it – is as much about hype and glitz as it is about real functionality. This does not say “economy in freefall” to me.
Our consumer economy has been vibrant for decades, surviving the nastiest of downturns along the way, because our wants keep evolving into needs over and over again. Does anyone really need an iPhone 4 or an iPad? Not in the strict sense of the word – but if the perception of need exists then the need is real. We see this play out every time we switch on the AMC drama Mad Men, now in its 4th season. One of the really enjoyable things about that show is seeing the postwar consumer culture take root and permeate throughout all economic and cultural strata of the society, with “Relaxicisers” and Kodak Carousels filling the emergent needs of that time the way that iPhones and Viking grills do today.
There is a great deal of doomsday commentary out there. While I certainly do not intend to underestimate the scope or depth of our current economic woes, and particularly for the many who are out of work or underemployed, I also am fairly confident that our consumer culture is not grinding to a halt. For better or worse it is a deeply ingrained aspect of our economy and our society, and I expect to see those same breathless crowds amassing outside the Bethesda Avenue store next time Steve Jobs proclaims that the future has arrived in the form of some stylish construction of bits and bytes.
The news of this Monday morning could be seen as a brief vignette for the tenor of the year as a whole. In the US another set of data points supports a positive market case that seems to be getting better by the week - the “fits and starts” theme is starting to run the risk of lacking any “fits” at all. Consumer spending enjoyed another strong uptick, and given that income growth was more subdued it seems that our never-say-die consumers are dipping into their savings (which at 2.7% represents a low for the year). Another notch in the ISM manufacturing sector index takes this above 60 and marks the 9th straight month above the critical 50 level.On the other side of the Atlantic a different mood prevails. Although the €110 billion bailout agreement for Greece cobbled together over the weekend puts any day of reckoning off beyond the 19th of May, when Greece’s next debt payment is due, the package leaves little about which to be optimistic down the road. My advice: watch the spreads between bond indices of the European majors, in particular Germany and Italy. Any hint of a bloodbath among other second-tier Eurozone countries (like Portugal or Spain), or collateral damage in the non-Euro accession countries like Hungary that are teetering on the edge of the precipice, will likely create a widening rift between Germany, the Continent’s most solid credit by far, and Italy, which is at risk of being dragged into the vortex if containment gives way to contagion. So for now it’s all about apple pie and US equities, and this may be the tone of things for some time to come.