The Flattening Yield Curve

What started making me look into bonds (which spurred me to write the last article) today was this article on Bill Cara’s site, “It’s all in the slope, folks,” which suggests that the yield curve in the US is starting to look like it did in 1999, and that it is getting close to being inverted, which has often signaled the start of a US recession in the past. He used this really neat applet to look at the yield curve at any point in the last 7 years. Here are his predictions:

Note the similarity between the yield curve of today and as at year-end 1999.

If yields of today jumped to those of 1999-2000, by roughly +150 basis points across the board, then I believe that the present housing market bubble would pop, rather than have the air let out slowly as is now happening.

Should the Treasury continue to print money the way it has, and the way it must in order to meet the fiscal deficit of government, then there will be inflationary pressures.

And should the Fed continue to raise rates the way it has, and the way it must in order to stabilize prices (i.e., combat inflation), then the more downward pressure there will be on economic growth. These are also deflationary pressures.

As long as the U.S. Treasury continues to reflate, and the Fed continues to tighten, the yield curve will continue to flatten, and will soon invert, similar to what happened in 2000.

According to the Wikipedia article on Yield Curve:

An inverted curve occurs when long-term yields fall below short-term yields. Under this abnormal and contradictory situation, long-term investors will settle for lower yields now if they think the economy will slow or even decline in the future. An inverted curve may indicate a worsening economic situation in the future.

Bond Values and Interest Rates

I have to admit that until a little while ago, I did not completely understand the reason for why bond prices rise or fall depending on the prevailing interest rates. Although it made sense to me that a bond earning a lower coupon rate than currently available bonds should fall in market price because it will be less desirable than the currently available bonds, I knew there were some concepts I was missing. Once I started reading more about the basics of bonds, I realized that bonds are a lot simpler than most people think. Here are some interesting articles that I have looked at recently:

  • This article, Bond Values and Interest Rates, does a pretty good job at explaining the effect interest rates have on bond values. That web page also features an animated cat!? (if anyone can explain the cat’s relation to bonds I would be grateful). That site also has a few articles about bonds vs. stocks which I would like to comment on one day, but I need to think about it some more.
  • Investopedia‘s bond basics tutorial is a great introduction to the basics of bonds.
  • Investopedia’s advanced bond analysis tutorial is excellent from what I have seen so far. I have just looked at the section about “duration” because that’s what I was interested in and I really liked the diagrams and explanations.

ETFs vs. Index Mutual Funds

I found an informative Comparison of ETFs and Index Mutual Funds. It has some great information about the internals of ETFs and how they compare to index mutual funds. Notably, that “overall, there are few pros and many cons to using ETFs.” This came as a bit of a surprise to me. Much of what the article says is true, although told in a way that is biased towards index mutual funds. Some of the information is out of date such as: “ETFs have poor coverage of foreign style/size indexes. If you wanted to buy a foreign value ETF, for example, you would not be able to do so at present” and “there are few bond ETF options available at present.” I think these two points are no longer true.

One big difference between ETFs and mutual funds is that “they [ETFs] pay out distributions as cash. If you want to then reinvest that cash, you need to take some action to do so (and incur whatever transaction costs apply).” Although I initially found this annoying, it is really no big deal because the distributions can easily be re-invested into no-load mutual funds on a monthly basis along with other cash. Since you SHOULD be dollar-cost averaging on at least a monthly basis this should not be a problem for most people.

With many low-MER index mutual funds out there (and I expect to see even more, with possibly even lower MERs), the low-MER advantage of ETF is not a huge deal. I still think that the best option is to buy index mutual funds (with as low an MER as possible) on a monthly basis and switch them into index ETFs when the cost of making the ETF purchase (from commissions) becomes a small percentage of the total amount to be invested.

The Three Worst Reasons to Buy a House

I just came across an excellent article, “The Three Worst Reasons to Buy a Home.” It is actually a summary of “this MSN Money article.”

(1) Real estate is better than the stock market. While the real estate market has been red hot in the past few years, with a national average increase of 50% over the past five years, and prices in some markets doubling during that same timeframe, it’s important to keep in mind that past performance is no guarantee of future results. Major real estate recessions are a very real possibility, and it can often take a long time to recover. Moreover, real estate appreciation over the past 40 years has only topped inflation by 1%, as compared to 7% for the stock market. Over the long run, the law of averages has a funny habit of evening things out, so look before you leap.

The MSN article provides further information about past market declines:

Ask homeowners in Boston, Dallas, Houston, Anchorage and Southern California — all of which suffered major real estate recessions in the past 20 years. After dropping more than 20% in the 1990s, Los Angeles home prices took almost 10 years to regain their peak, says real estate expert John Karevoll, an analyst with DataQuick Information Systems.

Two articles at the van-housing blog: here and here show that Vancouver has had drops as well. This should all be no surprise to most people. Yet 3 weeks ago one of my in-laws claimed that “real estate is the best investment ever.” Just last week someone (a recent condo buyer) said to me “you think it’s going to go down?” with complete disbelief. And this week someone else told me they didn’t think prices were going to fall but that they might “level-off.”

The final nail-in-the-coffin for the “real estate is better than the stock market” argument comes from the MSN article: “In the past 40 years, the average appreciation for homes has exceeded the inflation rate by only a percentage point or so. Compare that to stocks, which have bested inflation by 7 percentage points in the same period.”

(2) Rent is the equivalent of throwing your money away. Renting is often cheaper than owning, especially in overpriced markets. Also, you’re not really throwing your money away when you write a check to your landlord — you’re exchanging cash for a place to live, and you’re buying flexibility, freedom, and a lack of homeowner headaches.

The Wealthy Barber provides some excellent commentary against the “rent is throwing your money away” argument:

Paying rent is no more throwing your money away than is buying food or clothing. You need shelter. It’s one of the three basic necessities of life. Renting is one way to acquire that shelter, and in some cases, it’s a very intelligent way.

The last reason to not buy a house, is one that applies to those in the US:

(3) The tax deduction makes it all worthwhile. While it’s true that your mortgage will get you a tax break, it’s not like you’re going to end up profiting. Deductions such as this are like giving someone a dollar for the privilege of receiving 35 cents (or less) in return. While this helps to offset the cost of ownership, it’s by no means a justification for buying a house. Moreover, the other costs associated with home ownership (e.g., insurance, repairs, maintenance, etc.) aren’t typically tax deductible. On top of all this, recent legislation seeks to place a cap on the mortgage tax deduction, meaning that the tax benefits of buying a home may shrink substantially.

Canadians have no mortgage-interest deduction. So this is irrelevant. Not without doing something crazy like The Smith Manoeuvre. One less reason to buy a house for the wrong reasons!

Google shares reach $400, still a good value?

Today, Google’s shares reached $400. It seems unlikely that any true value investor would consider Google (GOOG) to be a good “value.” Renowned fund manager Bill Miller seem to think it is. His Value Trust fund (a fund that I am considered for my US portfolio) has a good portion (4.3%) of it’s assets invested in Google. Bill Miller “follows a value discipline in selecting securities” according to Value Trust fund’s Investment Strategies statement.

Just for fun, I wanted to see if Google meets any of Graham’s basic criteria for defensive investors (or rather, how badly it fails):

  • Google’s price/book ratio from the most-recent quarter is 12.64. Graham probably wouldn’t touch Google unless it’s P/B Ratio was less than 1.5, meaning Google would have to trade in the $50 range.
  • Google does have a positive book value, which Graham considered a must.
  • Google’s current ratio from the most recent quarter is 15. Graham looked for a current ratio of at least 2.
  • Google’s growth rate has been phenomenal. About 400% from 2003 to 2004, and on pace to grow earnings about 350-400% in 2005. Graham looked for earnings growth of 33% over 10 years. Google hasn’t even been around for 10 years yet and Graham would probably classify it as a “new issue” and would stay clear of it.
  • Google has never paid a dividend. Graham looked for stocks with uninterrupted dividends over 20 years.
  • Google has not made money in each of the last 10 years. Graham liked businesses which had some earnings in each of the past 10 years. Since Google was a start-up not too long ago, there was a time within the last 10 years when it did not make money. Basically Google fails this test because it is just too new.
  • Google’s revenue was $3 billion in 2004, on pace for more than that in 2005. Graham recommends investments with annual revenue of more than $500 million (in today’s dollars).
  • GOOG’s valuation is now $119 billion. This meets Graham’s criteria of being a large-cap stock. Although if Google were valued at its book value of $9 billion it doesn’t look so big.
  • P/E ratio on trailing 12-month earnings is about 89. This is well above Graham’s recommended 15.

Google fails several of these basic criteria by such a huge margin that it makes me feel good about not owning Google, and somewhat worried about buying Bill Miller’s Fund. Apparently, in retrospect, Google’s IPO price of around $100 was a good value, and so was $200 3 months later. And it was still a good value earlier this year when it traded at $300. Google has certainly paid off for Bill Miller who apparently bought it at $85. I’m just not sure if he’s skilled or lucky. Some of his other tech stocks have not fared as well, such as Amazon and eBay, both among his top 10 holdings, and he is at risk of ending his 15 year beat-the-S&P500 streak. Miller’s Value Trust fund has only gained 1.82% this year so far, compared to 3.06% for the S&P 500.

Out of curiosity, I checked ABC Funds American Value Fund, a true value fund (no tech stocks here), and is up 6.34% year-to-date as of October 31, 2005. I am a bit more comfortable with ABC Funds’ true value investing approach, but the minimum required investment is just too high for me right now.

Growth vs. Cash

Investors (actually “288 investment professionals” according to MSNBC and “290 mutual fund managers” according to the Globe & Mail) are apparently preferring growth to cash (dividends):

About 49 per cent of the 288 investment professionals quizzed by Merrill in November said they wanted to see companies increase capital expenditure, the highest response since this question was first asked in September 2002, 11 points higher than the corresponding figure three months earlier.

I am not sure what fundamentally changed in the average business to cause this increase in three months. Here’s what Benjamin Graham had to say about this in 1949:

A company’s management may run the business well and yet not give the outside stockholders the right results for them, because its efficiency is confined to operations and does not extend to the best use of the capital. The objective of efficient operation is to produce at low cost and to find the most profitable articles to sell. Efficient finance requires that the stockholders’ money be working in forms most suitable to their interest. This is a question in which management, as such, has little interest. Actually, it almost always wants as much capital from the owners as it can possibly get, in order to minimize its own financial problems. Thus the typical management will operate with more capital than necessary, if the stockholders permit it-which they often do. [italics theirs]

Jason Zweig, in his commentary in Chapter 19 of the Intelligent Investor Revised Edition, notes two interesting pieces of research: “Surprise! Higher Dividends=Higher Earnings Growth” (Arnott and Asness) and “Dividend Changes and Future Profitability” (Nissim and Ziv). However there has been some contradictory research as well: “Dividend Changes do not signal future Profitability.” Without pouring over these papers in detail it’s impossible for me to judge who is right. Zweig does say that “even researchers who disagree with Arnnott-Asness and Nissim-Ziv agree that dividend increases lead to higher future stock returns.” Either way, I think this comment by Zweig sums it up nicely:

Paying out a dividend does not guarantee great results, but it does improve the return of the typical stock by yanking at least some cash out of the managers’ hands before they can either squander it or squirrel it away. [italics his]

ETFs to Stay Away From

With the increasing popularity of ETFs, many companies are trying to capitalize on this popularity and are coming up new sector-specific ETFs left and right. I’ve seen some recently in the home building sector and defense sector. These are both available from PowerShares. Apparently a defense sector ETF “could be used as a short-term vehicle to play geopolitical developments such as terrorist attacks.” This is not something the long-term investor saving for their retirement should be going after. If you are tired of playing the slot machine, however, this may be for you.

Then there’s the new Lux nanotech index, also from PowerShares. It is one of 8 new PowerShares (including the housing and defense ETFs) which came on the market on October 26, 2005.

Do not get caught up in the hype of ETFs and buy these sector-ETFs unless you know what you are doing. I got caught up in the technology-sector hype in 1999 and bought the TD Science & Technology mutual fund. I also bought some of the TD Health & Sciences fund. I bought them, thinking they could repeat their amazing performance in years past. How wrong I was. Here are the yearly returns for the TD Science & Technology Fund:

2004 2003 2002 2001 2000 1999
-8.2 21.4 -41.9 -38.8 -33.4 89.1

iUnits conversions approved

The iUnits unitholders of the ETFs (Exchange-traded funds) XIC, XGV, XSP, and XIN have approved changes to the underlying investment objectives (ie. they have changed the underlying index being tracked by these ETFs).

  • The new investment objectives of XIC and XGV are to replicate the S&P/TSX Capped Composite Index and the Scotia Capital Short Term Bond Index, respectively. The Funds’ new names are the “iUnits Composite Cdn Eq Capped Index Fund” and the “iUnits Short Bond Index Fund,” respectively. As of November 16, 2005, the ticker symbol for the iUnits Short Bond Index Fund will change to “XSB” on the Toronto Stock Exchange.
  • The new investment objectives of XSP and XIN are to replicate the S&P 500 Hedged to Canadian Dollars Index and the MSCI EAFE 100% Hedged to CAD Dollars Index, respectively. These are the same indexes these funds previously replicated, except the currency exposure is now hedged to reduce the risk of exchange rate fluctuations affecting the returns of XSP and XIN.

Information regarding the increase in the MER (Management Expense Ratio) for XIC is curiously absent from this press release. Not only that, but links to the original press release announcing the unitholders meeting (which mentioned the commission increase) and the information circular outlining the changes to the iUnits ETFs are now absent from the iUnits home page.

ABC Funds

I think I’ve found my dream mutual fund company: ABC Funds. From the introduction:

The most distinguishing characteristic of the ABC Funds is our firm adherence to true value investing. The funds use a “bottom up,” Graham and Dodd style in selecting securities. This style commands thorough, proprietary research on fundamentally undervalued Canadian and American securities and strong investor discipline. All three ABC Funds use this investment approach.

Before you go on and read about it, you should know that they require a minimum initial investment of $150,000 per fund (I assume that’s CAD). The MER is 2% on all their funds and they seem to have an excellent track record at beating the indexes. Some years they do worse than the indexes, but that shouldn’t worry the long-term investor.

Do not shy away from clicking on the “client area” link on the main page. It looks like everything there is publicly accessible.

It seems easy to find good active value management in Canada if you have lots of money. Another company that comes to mind is Strategic Advisors Corp (affiliated with Ross Healy).

Value Investing and the Death of Efficient Market Theory

This article by Joseph Nocera about the recent annual Graham and Dodd breakfast at Columbia University brought up a few interesting things that I hadn’t read too much about before, mostly concerning the theory behind how 95% of the world invests today. Apparently most business schools across the United States teach Modern Portfolio Theory as a way to minimize risk in a portfolio. It (MPT) holds that because the market is efficient (an assumption), it cannot be beaten, and therefore the only way to minimize risks and maximize returns is through diversification. This is essentially the theory from which banks and other financial managers from all over will tell you things like “Experts agree that the asset mix of your investments – safety, income and growth, account for more than 80% of your portfolio’s return.” This statement doesn’t even make sense to me, although I have sort of accepted it gospel for a long time, since it was posted on TD Canada Trust’s website, and of course the big banks know everything.

Bruce Greenwald, who runs a value investing course at Columbia, like Benjamin Graham and Robert Heilbrunn before him, says that “efficient market theory is basically dead.” Warren Buffet says modern portfolio theory is akin to the theory that the “world is flat.” Well that was enough for me… I guess modern portfolio theory is just a theory and the efficient market hypothesis is just a hypothesis.

There is also talk in the article about why value investing is so unpopular, even with the success of Buffett and Graham and many others and the fact that studies that have been published which show that “a portfolio of value stocks generally outperformed the market.” There are many reasons given. Jason Zweig (who wrote the updated in comments in Graham’s latest Intelligent Investor), says that value investing is “just plain hard,” (ie. takes a long time pouring over statements) and others say that there simply aren’t as many value stocks out there these days (could be true, if you look at the long term trend in P/E ratios). But Jean-Marie Eveillard, a successful value mutual fund manager said what Joseph Nocera thought was the best answer, that “It goes against human nature . . . You have to be very patient. You’re not running with the herd — and it’s much warmer inside the herd.”