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I am retired and live off my portfolio income and real estate rental income. I follow a simple investment strategy: (1) spend less than I earn; (2) use the savings to add more dividend paying stocks and rental properties to my portfolio. By doing this for many years, I've been able to grow my... More
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  • This proves CAPM is wrong.
    The so-called "risk free rate of return" governs the pricing of every asset on Earth. And throughout recent history, capital markets assume that this "risk free rate of return" is that of US Treasuries. And so, with Friday's downgrade of US Treasuries, standard financial asset pricing models imply that all assets - stocks, bonds, you name it - are now riskier, and prices should adjust lower to compensate investors for that extra risk.

    The problem is that this model is fundamentally flawed. US Treasuries may now be riskier, but this says nothing about whether GE is now more likely to default on its bonds, or that McDonalds is likelier to slash its dividend. If anything, with Treasuries having now been declared riskier, and thus, less appealing as investments, stocks and corporate bonds ought to rally if anything else, because the prospects for corporate issuers of stocks and bonds have are still stable, while the prospects for "risk free" assets have deterioriated.

    Whether the market will see it this way is doubtful. 
    Aug 06 8:21 AM | Link | 1 Comment
  • Here we go again.
    The bad news is that the market tanked today. But the good news is that the S&P 500 is back to where it was in 1999. Why is this good news? The reason why is because it means we've all seen these sharp sell offs plenty of times now over the past 12 years of stagnant returns, volatility, and a steady drum beat of terrorist attacks, wars, recessions, spiraling unemployment and back to back financial crises. Today is not all that unusual in the context of this secular bear market we've been caught in. 

    But what if it is different this time, and unlike the situation in 1999, we're really and truly heading over a cliff? That could be the case - nobody knows for sure, but there are a couple of other things are different about now, verses 1999. For one thing, the P/E ratio for the S&P 500 is about 12, the earnings yield is well over 8%, reflecting an astonishing 350% risk premium over US Treasuries,  the index trades at just two times book value, and earnings growth is clocking away at a healthy 10%. In other words, for every dollar you invest in the S&P 500 today, you could (in theory) expect to make your investment back within about four years, as opposed to the thirty one years it would take you to earn back your initial investment on a ten year US Treasury. Viewed that way, stocks are now about 8 times cheaper than their so-called "risk free" counterparts.  

    To that extent, I agree that it is different this time around. But some things never change. That is, fear and greed move the market on a day to day basis - even a year to year basis, whereas valuation is pretty much worthless unless you're looking at things in ten to twenty-year slices of time (or, if you ask one friend of mine, maybe hundred year slices of time or even more). 

    Stepping back, what's going on now is that the financial market is terribly, terribly ill, and if there is any cure, it will take years if not decades to work.  But that is not the issue. The issue is that the market has not yet learned to cope with its illness, but given time, we will all learn to live with the high unemployment, overextended and rotten leverage, fiscal austerity, deficits, slow growth and the uncertain promises of a bleak future. But somehow, the sun keeps rising in the morning each day, companies keep building and selling and earning money for their shareholders. But this is not a time when investors are thinking long term - not with the scars of 2008 and 2009 so fresh. 


    Aug 04 8:35 PM | Link | Comment!
  • Stock in...... Me
    If the economic crisis of 2007-2011 (and beyond) highlights anything, it is the distinct inability of people to accurately price debt. Ratings agencies cannot seem to get it right when it comes to figuring out how likely a pool of mortgagees will be to repay their debts in a timely manner. The credit default swap market also seems somewhat suspect when it comes to pricing out a debtor's likelihood of default, for like all markets in traded securities, the credit default swap market is prone to distortions.  And both borrowers and lenders alike seem to share this remarkable inability to accurately price debt. Lenders are prone to lend at "incorrect" rates of interest, and borrowers, from corporations to governments to individuals, seem consistently prone to borrowing far beyond their means.

    Let's drill down on that concept a moment - to "borrow beyond one's means". What does that actually mean? Well, it simply means you have mismatched your cost of paying down debt to your income.  A simple example is the prospective law student, who borrows a quarter of a million dollars for law school, expecting that he will be earning $160,000 a year upon graduation, and that his income will dramatically outstrip his costs of living, leaving plenty left over to service his school debts. The problem is simply this: while income may fluctuate, debt obligations are fixed. And when income fluctuates downward, or fails to come in when or at the level expected, and you combine that with fixed debt obligations, the result is always the same: absolute misery on the part of borrower and lender alike.

    We live in a world where almost everything can and does fluctuate, so you have to wonder, should debt even have much of a place in our system? The question seems naive, to be sure, and the facile answer is "well, yes, people need capital to accomplish projects." True enough, but must the capital come in the form of debt? Why shouldn't individuals and governments, for example, take a page from the private corporate sector, and issue stock, instead, to raise capital? I'd argue that approach would solve most of the problems the world is seeing with the credit crisis because equity, unlike debt, has the virtue of tying distributions to the equity owner to the profitability (or lack thereof) of the issuer.

    How would that work, if governments and individuals simply issued stock instead debt? Well, if I wanted to fund my law school education and didn't have the cash on hand to do so, I could simply issue stock in myself. An investor would pay me cash in exchange for my stock and I, as the issuer, would agree to pay a fixed percentage of my future income for life. My obligations would obviously fluctuate according to my income, but one thing is certain: my obligations would be tied, directly, to my ability to repay whoever believed in me enough to invest in my future. 

    Governments could adopt a similar approach, issuing stock that would entitle the holder to, for example, a share of all future tax revenue. If government finances deteriorated, so too would their obligations to make equity payments, and on the other side, in flush economic times, the cash flow on government issued equity would adjust higher. 

    The main issue with equity, verses debt, is that some investors require a steady, predictable income stream, something debt promises and that equity cannot. Perhaps that is why so much more debt is floating around our capital markets than equity. But as we have seen, this promise of certain repayment that even highly rated debt is completely illusory.  The reality is that when the ability of the obligor to repay is compromised, lenders get pennies on the dollar at best - effectively, all the downside associated with equity, and none of the upside. Sadly, this lesson is likely to play out over and over for the next many years, and one lasting impact may very well be that investors will come to accept that debt is just as risky as equity when times are tough. Indeed, debt is likely even riskier than equity, thanks to the asymmetry between what these securities offer an investor when times are flush verses when times are tough. If that realization starts to sink in, we will be looking for alternative ways to finance law school educations for individuals, or to bankroll government spending.  It could well be that offering a share of future profits, as opposed to a nominally guaranteed interest and principal payment regimen, could be a solution that is less crazy than appears today.  

     
    Jan 13 9:28 PM | Link | Comment!
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