Debt and wealth in a monetary system, part 2: discounted valuation issues in a declining frame with inequalities.

We are presently building up conflicts within the asset price frame:

  • Conflicts between asset values and GDP flows and their growth rates;
  • Between asset prices and return expectations;
  • Between human capital values and the distribution of those values and their impact on the overall wealth equation with respect to future consumption risks as well as asset pricing via increased asset focus of flows due to distribution dynamics;
  • Within portfolio structure and relative to the liquidity and capital security dynamics of liability streams. 

All of this tied to the relationship between frame transitions, emergent properties and structural imbalances and unconventional monetary policy focused overly on asset price support.

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Correlations, volatilities and expected returns as the monetary tide reverses flow..

I note comments by El-Erian over Central Bank’s inability to suppress volatility as a bigger risk than China and I would agree although I would qualify this in terms of the immediate asset price risk.   Asset focussed money supply growth and asset price relatives (relative to GDP growth and income growth as well as its distribution) are all deeply negative for asset markets when liquidity dynamics, amongst others, change.

Recent commentary by Zero Hedge on the winding up of Nevsky Capital is also worth reading: the Nevsky Capital report suggested that a disciplined structure can no longer be counted on to realistically manage risk and return given the uncertainty of an increasingly skewed distribution of possible outcomes in an environment worryingly distanced from fundamentals/exposed to unconventional monetary policy; liquidity dynamics in the market place also impacted.  

Another interesting piece of data shows the 10 year rolling returns on commodities that I found in a tweet from @zatapatique.

I have written on the issues of excess asset focused money supply and liquidity for some time (relevant posts of mine).

Many portfolio management structures depend on expected return/correlation/standard deviation assumptions that would be very much exposed to a break in the direction of money flows towards assets.  All statistical measures of risk and co variance are drawn from the impact of monetary demand flows for assets.  In an environment where monetary policy is accentuating flows to asset classes as well as expanding the quantity of money and reducing the supply of certain asset classes the natural flow response to risk and return in the environment are muted.  As unconventional monetary policy recedes, additions to the quantity of asset focussed money and interest rate support reverses, the natural flows not only start to reassert but the prior excess flows adjust to the new environment.  We get a break out of trading ranges and covariances.

This is all incredibly risk and uncertain for those dependent on traditional statistical measures of asset price sensitivities and covariances.

“Solving the UK Housing Crisis , the Bow Group”, so what about Canada?

“Denmark prohibits non-EU nationals from buying a home unless they have lived in the country for five years”

This is a worthwhile read.  A report on the UK housing market’s affordability crisis by a UK Right Wing think tank that recommends limiting foreign ownership of the property market.  I can definitely see some relevance to Canadian property markets here and the issues raised are very much in line with those expected by the considerable excess asset focussed money supply growth we see globally.   Unconventional monetary policy and increasing income inequality running alongside slowing economic growth have increased the asset focus of global money supply, especially towards hard real assets such as property that will not disappear in an economic/financial crisis.  

You can see this in the Canadian asset market:

The real return on the S&P/TSX composite since the market peak in September 2007 has been –23% to mid December 2015:


Yet the value of the Canadian residential property and land has moved the other way:


Interestingly the MLS Canadian Composite Home Price Index shows an increase of 33% since since September 2007 and the Greater Toronto component an increase of 59.2%.  

And there has been an increasing dialogue on the issue in the Canadian press:

Affordable housing crisis affects one in five renters in Canada: study” “One in five Canadian renters face an affordable housing crisis, spending more than half their income on shelter costs, a problem that appears to be even more acute in suburbs and small cities than in major urban centres.”

Moody’s, The Economist warn of high Canadian debt, housing prices” “”The risks are less around the rapid house price appreciation per se, than the fact that, relative to incomes, homes in Toronto and Vancouver are increasingly becoming unaffordable either to own or to rent,”

The Golden Age of Canadian stock market and other returns may have passed for now…..

The golden age of stock market returns for Canadian investors looks to have ended sometime in 2007:


Adjusted for inflation, the S&P/TSX has literally only provided returns for those able to take advantage of the significant dips in valuations post 2000:


If we look at annual returns for holding periods of 10 and 15 years we can see capital gains in decline:


For those investors unfortunate enough to be paying through the nose for closet indexing mutual fund investments, the real capital returns are likely to be lower still, and more so after tax.  The golden age looks to have peaked in and around 2007.   This is around about the same time that debt and GDP growth took their separate routes.


If equity markets and commodity prices remain depressed they are clearly going to detract from economic momentum going forward and may well exacerbate the latent fissures in the residential property market that we already know off (i.e. high consumer debt loads and historically high valuations). 


Wage and salary growth has also been on a slide:


So yes the drop in market valuations is a concern given the accompanying commodity price weaknesses and other structural risks that have built up in the Canadian economy over the decade.  This will likely raise the odds of much more aggressive monetary and fiscal policy.

This is more or less a follow up from a December 2014 post:

Is Canada’s Mini Golden Age behind it?

And in the context of the above, this is worth a read –

No need to worry!

I recently came upon an article entitled “What You Can Do About The Upcoming Stock Market Crash”.  The title was tongue in cheek and perhaps unfortunately so given recent events.  Nevertheless, it made a number of important points about the difficulty of knowing when a market is at its peak and when a market is at its lows, and of knowing in which direction and by how much a market is going to move at any given point in time.  Much of this I agreed with, but not all:

When you think about it that risk and fear will always be there no matter how far the market goes up, down, or sideways. So what can you do?

Be prepared for a crash at any time. If you need to withdraw money in the next few years or you want to cushion the blows, then you need to diversify your portfolio with enough bonds, cash, or other assets that won’t fall along with the stock market.

Once you figure out what is right for your current situation you don’t have to worry about what happens because you are controlling the risks instead of letting them control you. That means you are safe to invest your money today and start earning your way to the freedom you want for yourself and your family.

Points 1 and 2 noted above are more or less correct, but the last point I have emboldened is where I diverge.  You are never ”controlling” risk, just diversifying it relative to return, and if possible, its covariance, itself a function of risk.  You cannot control risk, only minimise its impact through structure.  You are certainly not safe to invest your money today and there is no guarantee that you will earn your way to freedom. 

Return is an important consideration when accepting risk and many today who use simple mean variance models assume that expected returns are invariant and that risk is only volatility around this return.  In a general equilibrium, random, independent price movement model it does not pay on average to delay or defer investment (any benefit is purely attained by chance), but even here you are hostage to the probability distribution since the expected return in Monte Carlo land is only the average of many outcomes, some of which turn out to be quite disastrous from any level.

But expected returns do matter and while timing your investment to maximise your returns and minimise your losses is impractical and impossible for the market as a whole to do, making value judgements about market valuations and economic cycles to inform you of the boundaries of return and its significance is I believe worthwhile if you possess the expertise..  Where people run into trouble is where they either lack the knowledge and expertise to make the type of judgements needed to define the boundaries of expected return, and its impact on structure, as markets and economic cycles mature or react to market falls and meteoric rises as if one is the end of the world and the other its never ending bliss.

Deferring new risky investment at high market valuations is a value call and a discipline, but it is an act which relies on knowledge of the significance of valuation differentials.  It is one of my concerns that “we” have been taught that we should invest in markets at all times irrespective of the valuation, the cycle and the specific characteristics of either.  One of the reasons the world has been through innumerable crises since the late 1990s is because we have ignored significant accumulating structural economic and financial imbalances and the differential between asset valuations and economic fundamentals.  In a well balanced world we could probably ignore valuations and invest at will, ignoring volatility. 

But then again context is everything.  While one may not invest/sell at cyclical highs/lows there is little reason to sell all (high) and then attempt to reinvest all (lows) at perceived key turning points.  Portfolios should adjust to the relationship between valuation risks and the time frame of their liability profiles and it is here where we need to pay attention to valuation risks since these do have material impact.   As markets rise returns fall and the risks to the ability of assets to meet future needs increases, and vice versa.  When returns and risks pass barriers of significance that is where changes at the margin need to be made.  It is therefore not a question of timing but of tangible discipline and its benchmarks.

And, of course, I believe we are in the middle of a very long period of global economic and financial fragility, so safe is a word I would eschew for some time.

How far can we defer the next asset price crisis? Depends on how fat the tail of the distribution is!

I have blogged on fundamental liquidity issues recently and one point that I want to bring out is that the greater the divergence between asset values and GDP and the greater the divergence between broad MS growth and GDP growth, especially in slower growth frames, the “fatter the tail of the distribution”.  

Volatility at one level is a measure of the sensitivity of an asset’s price to new information, shocks to the system/de facto changes in the energy of the system.   It reflects changes in demand flows for assets which can reflect changes in risk preferences and risk/return expectations.   In a general equilibrium volatility is meant to be a static physical characteristic reflecting the fundamental nature of the asset and its relationships, but we do not currently have general equilibrium relationships and volatility is not a stable measure of anything.

Essentially when we have excess asset focussed money supply growth (EAFMS) amidst a slowing growth frame the “accumulated liquidity in” decisions exceed the “present value of future liquidity out” (PVLO) decisions.  In a sense liquidity (at its heart a function of the relationship between asset allocation decisions and C/S/I/P decisions) becomes more sensitive to short term  changes in demand flows and risk/return expectations, risk preferences and other factors.   As the ratio of EAFMS to PVLO rises so does the natural volatility of the system.

Why the tail?   Why not volatility at 1 standard deviation?  During periods of excess monetary flows demand changes are not in totality covariance issues (ie. relative attractiveness of one asset to another) but absolute flows that suppress relative price reaction.   In other words we see a fall in volatility throughout most of the distribution.   All the while the system due to EAFMS/PVLO imbalances becomes more sensitive to changes in flows, preferences, expectations and shocks.  

Given that the system because of its imbalances becomes more sensitive to small changes in any one factor, the bigger the divergence noted in paragraph A the greater the probability of an extreme risk event.   The greater the accumulated liquidity in to PVLO the larger the tail: the risk event and its probability increase. 

In reality, from a given point on, we can effectively discount the rest of the distribution in any analysis as a dynamically widening tail is merely a statistical constraint on the way we should be viewing risk.  We are only exposed to the wider risk distribution if forces suppressing risk remain influential.  

On the question of market liquidity and the liquidity time bomb.

In a recent tweet I made the comment “Not a paradox: ratio of MS to assets & of asset prices to GDP, and hence to GDP functions C/I/S/P out of synch”.

Given the sensitivity of markets to even small changes in demand should anyone stand ready to provide liquidity at the onset of the tail of a distribution?

If a liquidity decision eventually exits, then there is a maximum amount of divergence which any given financial system can accommodate before the dynamics of the reverse flow overwhelm any attempt to keep it afloat. We must bear this in mind.

A recent article by Nouriel Roubini “The Liquidity Time Bomb”, to which the tweet responded, commented on the apparent paradox between vast amounts of financial stimulus and monetary expansion alongside a decline in market liquidity for assets.  

Why do we need liquidity in the market place?  There are a variety of fundamental economic reasons.  Entities wishing to purchase assets (from savings out of income or from loans) in either new/existing issues, entities who may be dissaving and wish to sell assets in exchange for cash for either consumption (debt repayment) or to purchase higher yielding assets, businesses that wish to raise capital and other entities like governments that wish to borrow.  That is markets function as an important medium for saving, consumption, investment and production decisions…they facilitate the allocation, pricing, accumulation (and the reverse) and transfer of capital ownership rights.

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Comments on “Developments in credit risk management across sectors”

A recent BIS report on “Developments in credit risk management across sectors:” raised some interesting points regarding the stability of the financial system.  What I found interesting was the increasing use of collateral agreements and in particular higher quality/more liquid assets.   If the financial system is exposed to a risk event there is a risk that this collateralisation of higher quality assets could increase the correlation of these assets to the risk event and may well end up drawing liquidity from other areas.  Likewise as risk in the system increases the need to hedge and hence post collateral may further infect expected price reactions.

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Critical perspectives on US Market Valuations 2…includes 17 charts

Many say that lower interest rates should raise asset valuations by lowering the rate at which future income streams are discounted.  This may be fine for high quality government bonds where coupons are fixed, but is not necessarily the case for equities where we are dependent on future flows (earnings, dividends, economic growth, CAPEX). 

What is the major determinant of long term real equity returns?  Earnings growth, and long term earnings growth is dependent on real economic growth.  If we look at real growth rates they are falling, and have been falling for some time.  This is part of the reason why interest rates have been falling; that is to accommodate falls in nominal and ultimately real flows.

The following shows annualised annual growth rates over rolling 15 year time frames (in other words geometric returns) compared to the Shiller Cyclically Adjusted PE ratio:


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A wider narrative is needed to fully frame risk for longer term investors

I read Dan Bortolotti’s “3 Reasons to ignore market downturns” last week and the more recent Jonathan Chevreau’s “If you can’t take the pain of plunging markets, don’t watch”.

They both pass some genuinely rationale advice…if you have a long term portfolio structured cognizant of risk then there is no point in reacting to a boundary you have already accepted you will cross numerous times.   But just what are the boundaries that you have accepted and just what are the risks since it is the context in which the statement is made that matters?

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Is the greatest risk to investors’ portfolios really longevity…?

A recent article in the Journal of Portfolio Management argued that longevity is the greatest risk to returns.   It also argued that investors should be moving along the risk horizon towards unconstrained portfolios.  

There were some aspects that I agreed with – I agree that portfolios should at the core be focussed on lowest cost allocation vehicles- but I disagreed with much of the following:

the rock-bottom interest rates of the past few years have forced risk-averse fixed-income investors to find ways of generating income without taking on too much volatility: as a result, many have turned to unconstrained, multi-asset strategies….The single biggest challenge facing investors remains how to pay for longer lives. Achieving that goal will require some adjustments—moving into nontraditional strategies, letting go of benchmarks, and, for many investors, taking on a higher level of risk throughout their investment horizon—both by holding higher levels of equity and, in many cases, through investments in alternative asset classes.

The biggest challenge is the low prospective returns from all asset classes and the much higher than historical risks to those returns.   Moving out along the risk spectrum throughout their investment horizon effectively entails reducing liquidity and certainty of return over the key short to medium time horizon of the portfolio.  It would also likely increase costs, especially at the short end of the horizon where once upon a time direct allocations to lower risk government bonds would have provided yield and capital security.  This needs to be planned for….

So the portfolio is increasing long term allocations to enhance long return at the cost of greater short term risk.  This essentially means that individuals are going to be more highly exposed to short term expenditure deficits…taking more risk to enhance returns means taking greater short term risk to returns…short term financial security has to take the hit.  I am not so sure that I am confortable with this.

Longevity needs to be planned for and for many it may require a downward adjustment of expenditure over lifetimes.  But if overly optimistic return assumptions are used to model expected withdrawal rates it will not matter what your investment strategy or your adjusted expenditure profiles are.   I am concerned that people are seeing low IRs on the one hand and normal expected cash flows on risky assets on the other.  I also express concern that longevity risk may be the lure towards higher cost more remunerative more complex structures for the sake of chasing return while the tide is in the asset manager’s favour.

Share buybacks..quantitative easing, secular stagnation and the risks of Myopic Share Virus..

The point about share buybacks is that they sit uncomfortably in a widening narrative of increasing inequality, weak income growth (worse at lower income levels), falling economic growth rates and disturbing trends in both human and capital investment. The backdrop to the narrative and one that threatens to envelop it as one are the burgeoning asset and debt markets, whose rise is at odds with the weakening fundamental growth prospects of many developed economies. Asset markets and hence debt are being supported, yet the fundamental underpinning to their longer term valuation, investment and growth in real incomes is being weakened. At some point the two, economic reality and asset market capitalisation will need to meet.

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In pursuit of “high yield candy”: Floating Rate Income Funds and mutual fund disclosure in Canada…

Floating rate income funds are not automatic high yielding replacements for a portfolio’s low yielding core bond or cash holding and have a myriad of risks that may impact a portfolio’s ability to meet an investor’s income and or capital needs over the duration of their lifetimes, especially during risk events.

Yet, these investments are apparently “sold” with next to no disclosure over the risks, or the complete nature, of the investments and no apparent guidance over allocation and risk management imperatives. Too much emphasis is placed on a couple of simple and easy reasons for buying them – yield and reduced interest rate risk.

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Floating Rate Income Funds–Excerpt from a 2013 Vanguard report

Floating-rate bonds differ from traditional bonds in several respects that we discuss next—notably, interest rate terms, capital-structure seniority, and borrower credit quality—with each contributing to the asset class’s unique risk–return profile – From Vanguard’s A primer on floating-rate bond funds.

There has been a lot of comment recently about Floating Rate Income funds. More recently we have Tom Bradley’ Fixed Income’s New Reality (Live) discussion over the credit and liquidity risks of Floating Rate investments as well as their role in the portfolio. There has of course been a lot of press about these vehicles, and most of this coverage with few exceptions barely scratches below the surface of the issue.  

For the moment I am going to introduce excerpts from a Vanguard report (A primer on floating-rate bond funds) into these investment vehicles and in further posts discuss some of my concerns over the way they are likely being sold in the market place:

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Underfunded pensions..not such a slam dunk

I picked up the link to the following report on twitter: THE FUNDING OF STATE AND LOCAL PENSIONS: 2013-2017

The report stated that the funding status of state and local pension funds was at some 72% of liabilities and would likely rise further assuming a return to historical returns.   The report did look at current funding liabilities under a range of equity return scenarios none of which were as low as many pundits (Hussman, GMO and myself) would model.   The lowest return figure of 4% (all assets combined) would yield a liability with a net present value of $3.8trn or circa 22% of current GDP or 32% of personal consumption expenditure ….this translates into my vague assumption that if future GDP rates are based on current consumption, then future return assumptions would need to incorporate pension fund liability shortfalls.  

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“The future is now”

I have stolen a line from John Hussman’s most recent market commentary.  Like most who are focussed on valuation, Hussman is not concerned about how much stocks can rise or fall at any one point in time, but to what extent, or not, prices have discounted future earnings growth.  This is translated into an estimated total return that is likely available from stocks based on current valuations, expected future growth in earnings and an assumption regarding an appropriate valuation range. 

All decisions today are effectively based on an assumption about the future, so the future is always now, but when valuations are at extremes, inappropriately structured portfolios are exposed to the future.

There are three portfolio management mechanisms that need to be borne in mind as markets and risks peak and these are a) the return assumptions you use to project asset/liability modelling and management planning and decisions going forward, b) the extent to which your asset and liability management is impacted by the longer duration of short term economic and market risks to return and c) the extent to which you adjust asset allocation to take account of the longer duration of short term risk and the narrower margin of return on risky assets.

I do not believe that any of a, b or c are market timing exercises per se because our view is not now but the future – in other words the future is now.  I also believe that managing risks to return and the ability of assets to meet future and especially near term liabilities as markets peak to be a natural economic mechanism for managing consumption/production and savings/investment balances.    

The portfolio allocation should match the economic allocation!

Weak demand dynamics and final Q4 US GDP

I was just looking through the GDP revisions: real growth was higher because a decline in the GDP deflator and nominal GDP fell from the last revision.  Nominal net exports also fell while health care expenditure was a significant upward revision.  


My concern rests with the underlying growth rate of the US economy, especially domestic demand and the PCE component in particular.  I have referenced this issue before.

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My submission to the CSA re Risk Classification disclosure

Re: CSA Notice 81-324 and Request for Comment – Proposed CSA Mutual Fund Risk Classification Methodology for Use in Fund Facts

The part must relate to the whole and the whole to the part and the both must know of it:

The CSA in their consultation paper fail to explain how the risk classification methodology proposed for use in the point of sale documents is to be used by investors to make informed decisions, and how advisors are to use the same to determine suitability.

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IIROC’s guidance for leveraged investment

I can see that IIROC have put some real work into this and have largely done as much as they can given the constraints they are operating under: they cannot rule against leveraged investment or unilaterally move outside of a transaction remuneration regime; this is the main securities regulator’s job, if not a government level responsibility.    

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A brief thought on market valuations

As I work my way back into the mental state required to hold the data points I just wanted to make one key point.   Many have commented on the pointlessness of market timing and therefore the pointlessness of listening to those who believe that a large negative market movement is around the corner.  I have never been one for wholesale market timing transactions, but I do believe that high market valuations impact one critical dimension of the portfolio and need to be treated with respect.   The higher a market is valued, in an out of equilibrium world, the lower the future expected returns.  Therefore, without an adjustment for future returns the liability demands  on the portfolio (which have likely been revised higher due to higher portfolio values) will place undue and increasing stress on the portfolio’s ability to meet those returns, especially in the event of an eventual market adjustment.   As markets rise and as the time frame of significant market risk extends, for a given level of liabilities, it makes sense to adjust asset allocation towards lower risk/fixed return asset classes.   We cannot ignore valuations and we cannot ignore their impact on the management of income and capital liabilities over time.    

Is the balance sheet recession over? Financial sector debt…

Financial sector debt (and as noted consumer debt) has fallen significantly since the crisis:


Yet, if we look at the financial sector assets with respect to non financial sector credit market debt, we start to see an interesting picture:

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