wawallace

I am still finding investable companies at the micro cap scale, including banks, so I agree with you... I guess that's the problem with speaking in generalizations. My fear is that the weight of 85% of the investable universe correcting to higher ""risk-free rates"" will crush us all; so margin of safety, management experience and conservatism, and adequate cash balances are huge. I read in Grant's that there are 263 Trillion in global assets. Google says only 20T of that is the US stock market, and 63T in stocks worldwide... that's a big tide to swim against. Enjoy your newsletter, btw!

It's easy to see pockets of overvaluation when there is wide dispersion among asset classes and within asset classes. When you get to this point, and nothing is "absolutely" cheap and you have to get out your "relative" valuation ruler, it gets much harder to judge. Banks look cheap, but they are by-and-large being converted into public utilities. Jamie Dimon said this himself. In addition, cost of regulation is increasing and they may be bumping into the ceiling on buybacks, especially if the regulatory restrictions keeps getting cranked tighter. Didn't JPM's annual report say something about 800 attorneys on staff, just to implement Dodd-Frank? Insurers look cheap as well; however, (especially in Europe) a lot of them are upside down on assets in relation to guaranteed minimums on contracts, see Germany; we haven't had a hurricane in like 10 years; and as long as inflation is subdued underwriting losses will remain relatively predictable. Food companies look cheap because commodity prices have adjusted downward 20%, but if this deflationary cycle continues, they will have to reduce prices as well based on demand. Profit margins are at 11%. Isn't mean something like 8%? Sure there is the argument that technology has propelled us to a new higher plateau of margins...but Irving Fischer would remind you to be cautious about this prognostication. In addition, buy backs will stop at exactly the wrong moment, which is coming down the pike because the fixed income guys are starting to cry about the increase in risk caused by declining equity cushions... it will eventually be worked into covenants. Meanwhile, the lens through which all assets are priced, interest rates, are rising. 30 year is over 3% from 2.5%. And revenues are down over a strengthening dollar. Higher interest rate = higher dollar = lower revenues for our companies that now get 30% of sales from overseas. Declining revenues, declining margins, compressing multiples (due to increasing long rates)...

In my very humble opinion it depends on whether you have permanent or temporary capital, and whether you have annual cash flow outflows to support. Buffet, owning Berkshire, raking in cash every year to invest no matter what the market climate has no need to think about macro or its implications. An open-ended fund manager who will experience significant outflows due to market underperformance, may benefit from managing risk based on macro factors...not that she will succeed, that is a different conversation. A pension fund manager who has annual, un-even cash inflows, outflows and fluctuating funded liabilities should also be keenly aware of the interest rate environment and market structure, and may need to closely manage volatility at the cost of future cash flows.

IMO, capital has been like water. Low rates have caused it to seep into every nook and cranny in the investment universe. This whole theory of allocating capital by measuring past correlations is going to fall apart when it becomes obvious that correlation is caused by capital allocation (it is reflexive). In 2000 all of the excess capital was in large cap tech stocks, which found its way into real estate and now it is everywhere. The overvaluation was narrow and tall and now it is wide and (relatively)short; but which is more dangerous- obvious pockets of extreme overvaluation, or an insidious overvaluation of every capital outlet? Instead of one obvious bubble, there is a reverse bubble in cash...if such a thing exists. If you think of capital as stored labor/consumption converted into an income stream, you will find that we have too much stored labor and not enough demand for current consumption to effectively put all of the capital to use. So either it resets to a lower value that equalizes the utility of consumption or future returns continue to be very low. I read somewhere (I think Frank Martin) that capital is the most overvalued in relation to labor than it has ever been. It takes something like $2,000,000 in capital to replace one median household income in a conservative portfolio. In other words, you have to contribute a very large amount of capital to replace your labor.

On the retail side I'm noticing a fair amount of "brother-in-law" envy, which was indicative in both 1999 and 2007. The fact that it appears mathematically impossible for professional investors to beat amateur investors shows where we are in the cycle, as professionals are being cautious and indexes continue to increase risk as the market gets more expensive. One side is pushing the brake and the other pushes the gas until it goes full Thelma and Louise.

What makes matters worse is that the asset floor no longer exists for most companies because they trade at multiples of manipulated book value, or don't really use capital in any meaningful way at all. At least if we could see that there were $1,000,000,000 in assets backing a $500,000,000 market cap, a margin of safety would exist... and the second level is that the assets themselves are extremely distorted due to interest rates.

"It is not a case of choosing those [faces] that, to the best of one's judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees." (Keynes, General Theory of Employment, Interest and Money, 1936). In this example "pretty faces" = "rate increases".

I think what she said next was more important: “They are not so high when you compare the returns on equities to the returns on safe assets like bonds, which are also very low. But there are potential dangers there.” Ms Yellen also pointed to very low long-term interest rates and the risk that depressed term premiums could suddenly shoot up — something that was seen in the so-called taper tantrum of 2013. “We need to be attentive — and are — to the possibility that when the Fed decides it is time to begin raising rates these term premiums could move up, and we could see a sharp jump in long-term rates.” How you can categorize bonds as "safe" in that context is beyond me. Also, their fear is that any spark is going to set the entire theatre, the entire block and the entire county on fire.

Isn't there a well known warning about things that are relatively cheap, but absolutely expensive?

The trick is to remember that all of the participants have information that you don't. If you try to solve from their perspective you'll not be able to answer, because this is a second level problem.

Possibly a good time to buy TFCVX in my opinion. Spread expansion has murdered them the last 6 months. I think average price is in the 70s and yield is double digits. Most recent quarterly is almost giddy with how great they are positioned. They do go into some detail about individual positions and how their "fulcrum security" philosophy works. My humble opinion is that some of their positions are priced more like zero coupons and hence much more volatile than in index performing bonds. My only hold back is that they're positioned for a continued economic recovery, which appears to be sputtering. The '40 act structure will be a liability given further spread expansion.

Post it Post it Post it.

http://fortune.com/2011/06/12/buffett-how-inflation-swindles-the-equity-investor-fortune-classics-1977/ Buffet said in 1977 that your return will be Return on Equity adjusted for premium to book value. And then in 1999 he changed it to a function of GDP Growth, profit margins and interest rates (which makes it look pretty poor right now). http://www.tilsonfunds.com/MrBuffettStockMarket.pdf Everyone's read these both 100 times, I'm sure, but I digress.

"To Ricardo more than to any other economist belongs the credit for having given to the world the orthodox theory of the value of money. In his controversies with Malthus and with Bosanquet he gave one of the ablest expositions of monetary theory ever written. "That commodities would rise or fall in price, in proportion to the increase or diminution of money," said he, "I assume as a fact which is incontrovertible." Reply to Bosanquet, in Works, 326 note. Footnote 1 Chapter 1 page 2 "The value of money, other things being the same, varies inversely as its quantity; every increase of quantity lowering the value, and every diminution raising it, in a ratio exactly equivalent. This...is a property peculiar to money." ...But, "In a state of commerce in which much credit is habitually given, general prices at any moment depend much more upon the state of credit than upon the quantity of money" Principles of Political Economy II. 30, 53. Footnote 2 chapter 1 page 2 "Money And Credit Instruments In Their Relation To General Prices" Edwin Walter Kemmerer, PhD. 1907

"The re-discount rate of the New York Federal Reserve Bank was cut from 4 to 3.5 per cent. Government securities were purchased in considerable volume with the mathematical consequence of leaving the banks and individuals who had sold them with money to spare. Adolph C. Miller, a dissenting member of the Federal Reserve Board, subsequently described this as 'the greatest and boldest operation ever undertaken by the Federal Reserve System, and... [it] resulted in one of the most costly errors committed by it or any other banking system in the last 75 years!' The funds that the Federal Reserve made available were either invested in common stocks or (and more important) they became available to help finance the purchase of common stocks by others. So provided with funds, people rushed into the market. Perhaps the most widely read of all the interpretations of the period, that of Professor Lionel Robbins of the London School of Economics, concludes: 'From that date, according to all the evidence, the situation got completely out of control". From "The Great Depression" by Lionel Robbins (1934) Quoted in "The Great Crash- 1929" by John Kenneth Galbraith Seems too simple, right? The period discussed is 1927. Anyway, I'm not trying to be clever, but that is a very direct, non-Keynesian discussion of the actual impact of QE (or in their case OPM), if you replace "common stocks" with "derivatives". I'd just like to have a thread where you can jot down a quick note if you run into something brilliant written in the old world (pre-1970). I don't think it goes in the Book Thread because it's not about a specific book.

Not to pick nits, but I think Howard said "All assets are in the upper band of fairly valued", and then Leon chimed in about bonds, and Howard agreed, and then explained the interest rate environment. Since Oaktree's strategy revolves around credit analysis, interest rate risk is a secondary (but not unimportant) concern to their strategy.

The bigger risk would be their mix of floating-rate versus fixed-rate debt, I would propose. But as rates rise, increasing FFO will be the main objective, either through rent increases, reducing vacancy, or increasing service revenue. If they have long leases, a high proportion of floating-rate debt, are subject to lockout provisions and are fully leased at current cap rates, I would take a pass. Longer term, I would guess that demographic factors are equally as important.

Right, so an increase in the general level of interest rates will cause an increase in the market cap rate. If you define Cap Rate = annual operating income/ value, and further breakdown annual operating income into (Rent-Operating Expenses) you get a high level view of the moving parts. Increase in interest rates forces cap rate up due to income alternatives. Increase in interest rate allows increases in rent due to the higher cost of purchasing as an alternative. Timing depends on current leases, automatic rent increases, etc. Higher costs could also increase vacancy rate due to marginal business failure, etc. Increase in interest rates due to inflationary pressure (or otherwise, really) increases operating expenses, but decreases real value of debt attached to properties. Increase in interest rates in the absence of inflation decreases property/asset values, in general. So the answer is a probabilty and magnitude equation that determines whether or not the REIT can increase rents as quickly as cap rates accelerate, property values decline and operating expenses increase. In general, (all other things being equal, which they never are) the price of Equity REITs should be negatively correlated with interest rates in the short-term, but provide moderate inflation protection over the long-term.

Equity, Mortgage or Hybrid? Sounds like hybrid based on your question.