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Avoiding Fraud by Investment Managers

I came across an interesting article today on the financial blog Acrimoney.com. The piece is from March 2009, but the author's advice is still as true as it was then. The topic is how to avoid being the victim of Ponzi schemes and other investment scams.

Excerpt:

After fifteen years in wealth management—with both investment boutiques and brokerage houses—I know only one foolproof way to beat fraud: separate money management from reporting. You can hire that lights-out investment manager. But keep all your assets with a custodial bank like State Street or Pershing. They report your account value, not the money manager. It’s like separating church and state.

Custodians don’t make investment decisions. They hold securities, process trades, and provide independent statements showing your portfolio’s value. They collect dividends and bond payments. They receive wire transfers into your account or send them with your instructions. Their job is to watch your money. In the timeless words of Ronald Reagan, custodians enable you to “trust but verify” what your money managers claim.

Full article

New Financial Regulations

After months of intense debate and extensive media coverage, Capitol Hill and the White House have finally agreed upon a plan to overhaul financial regulations in the US. The bill still must pass through both chambers of Congress before it becomes law, but this is all but assured as President Obama and Democrats from the House and Senate are on board. Major last-minute concessions, such as allowing banks to trade swaps and derivatives to hedge against their own risk, had to be made to gain support of the bill from moderate and conservative Democrats so that the proposed bill could be finalized in time for Obama to present it to the G-20 meeting in Toronto. The provisions of the 2,000-page bill can be broken down into four categories: expanding the power of the government, tightening regulations for financial companies, protecting consumers from institutional banks and protecting investors from bad deals.

Regulations on financial companies are greatly increased in the financial reform bill. The provision that will likely have the most significant impact on how banks do business is the Volcker Rule, which prevents financial institutions from making risky trades with their own funds. This rule, similar to the Glass–Steagall Act of 1932, protects taxpayers from having to bail out institutions that risk (and lose) funds that are protected by the FDIC. It should be noted, however, that the ban on proprietary trading is not total: banks can still invest up to 3% of their funds in hedge funds and similar vehicles. Swaps will now have to be done through affiliates of banks, with the exception of trades that are tied into the banks’ business and necessary for hedging risk (interest-rate swaps, foreign-exchange swaps, gold and silver). Swaps relating to agriculture, uncleared commodities, most metals and energy will have to be traded by affiliates, since these trades do not directly pertain to banks’ business. Banks will also be required to meet more stringent capital standards, and will no longer be allowed to include trust-preferred securities in their calculations of capital. Also, financial institutions and hedge funds with more than $50 billion and $10 billion in assets, respectively, will be assessed fees over the next five years that will total $19 billion (to offset the cost of the bill). These fees will be collected by the FDIC, with any leftover funds going towards paying down the national debt.

The other goal of the bill is to protect investors and consumers from being taken advantage of by financial institutions and related businesses. Under the Federal Reserve, the new Consumer Financial Protection Bureau will oversee banks and other non-bank financial firms (including mortgage-related businesses and credit unions) and enforce regulations as needed. Mortgage lenders will now have to verify a borrower’s income, credit history and job status before giving them a loan. Banks will have to keep 5% of the credit risk from packaged loans on their own balance sheets, which should incentivize them to issue loans only to worthy borrowers. Also, the bill established a Financial Stability Council, which will monitor large financial firms and advise the Fed of any potential threats to these companies and their business. If necessary, the council, along with the FDIC, would have the authority to wind down failing firms, and the bill addresses this liquidation procedure. The bill also gives states the power to impose additional consumer protection laws against banks if they feel it necessary. For investors, the bill gives the SEC the authority to hold broker-dealers to a fiduciary standard similar to the one that investment advisers, including KCS, are currently held to. Hedge funds and private-equity firms will now have to register with the SEC as investment advisers and provide more information on their trades than currently required.

If signed into law, the financial reform bill would be the most dramatic financial regulatory overhaul in the US since the 1930s. But at this point, given that it is still just a bill and there are a number of details to be dealt with yet, it is hard to say at this point how it would affect our financial system and the way we do business in the long term. And while it seems like a lock that the bill (now being referred to as Dodd-Frank) will pass through the House and Senate, even after the death of Senator Robert Byrd (D-WV) over the weekend, we know how quickly things can change.

Today’s Market Reflects Tomorrow’s News

So far in June, the stock market has continued to be volatile, but has gone nowhere since the end of May. Usually a stagnant period in the middle of a recovery would be disappointing, but in this case is more of a relief after a crummy May that saw a –8.3% drop in the S&P 500. In any case, mediocre market performance over the last month should not come as a surprise, given the amount of apparently bad news we have been receiving over the last few months about the progress of the recovery.

Investors often make the mistake of attributing current market performance to recent news. In reality, the stock market acts as a leading indicator for the economy. (For an explanation of economic indicators, see my last entry about the Volatility Index). News we hear on any given day is nearly always already reflected in current stock prices. (This concept is often called the “efficient market hypothesis.”) Exceptions include unforeseeable occurrences, such as the BP oil rig explosion, and events about which advance information is privy to only a select few individuals, such as the announcement of civil charges against Goldman Sachs. In nearly all other cases, so-called “current” information has already been considered by millions of investors, particularly professionals with huge amounts of capital, whose decisions move stock prices. On average, the stock market reflects information about five months in advance, so that today’s news is already 5 months old as far as the stock market is concerned.

Investment banks pay huge salaries and bonuses to analysts because they depend on them for recommendations that they use when making enormous bets on the market. Analysts are human like the rest of us, which means they can make mistakes and lack clairvoyance. But the combination of intelligence, experience, training and the resources at their disposal allows them, as a whole, to develop hypotheses about the future with a significant collectivedegree of success. This success comes from the sum of the incredible amount of manpower and money that professional investment firms devote to research.

Analysts are usually assigned to a specific sector or industry; some operate in the even narrower scope of analyzing a single security, or a select few. Many firms have multiple analysts working in each sector, which illustrates the amazing amount of resources dedicated to analyzing each area of the market (especially when you consider the inhuman hours that many analysts work). So it should come as no surprise that the European debt situation was being considered and accounted for months ago by large institutions—weeks or months before it was mentioned by the media. The same goes for financial reform, the anticipated slowdown in corporate earnings growth, and other economic issues that have recently induced fear (and selling) by day traders and non-professional investors.

Given their level of compensation and resources at their disposal, you can understand why analysts and their firms are expected to remain ahead of the curve and be right more often than not. However, this informational “edge” is not, by itself, enough to ensure outsized success for Wall Street, and it also does not mean that non-institutional investors can’t compete. Rather, it tends to create a marketplace that rewards contrarian investors who don’t blindly follow the crowd. The best investors do not act on information as it becomes public, because they know this information is already priced into the market. They take the information a step further and figure out what sort of opportunities it might create in the future.

The Volatility/Fear Index

Over the past few weeks equity markets have been shaky—to say the least—owing to rising uncertainty over the global economy. Lately it seems as if every development in the European debt situation (some call it a crisis) leads to a massive market selloff, both here and abroad, as investors weigh the effects of global problems on the US economy and fear the worst for the future. The Chicago Board Options Exchange Volatility Index (Chicago Options: ^VIX) is often called the “fear index” because it measures the implied volatility of S&P 500 index options over the next 30-days. Its price corresponds to the expected change, so the recent VIX price of 32 indicates an anticipated annualized change of 32% in the S&P 500 price over the subsequent 30 days. In stable markets, the VIX typically stays in the 10–20 range; in very unstable markets, such as September 2008 – May 2009, when the price broke 80 on two occasions, we saw short-term averages in the 50s and 60s.

The VIX price is generally (and, as we will see, erroneously) accepted as a leading market indicator, meaning its movement precedes changes in stock prices. More specifically, a sharp rise in the VIX is thought to indicate an imminent drop in the market. This idea makes logical sense—heightened fear among investors triggers a rise in option premiums (implied volatility), which in turn triggers a stock market selloff. But after comparing VIX and S&P 500 prices over time, it is apparent that the VIX price has acted as a concurrent, or even lagging, indicator during higher levels of volatility, and no indicator at all during other times. If the VIX price were a leading indicator, the highest levels of volatility would indicate that the worst is soon to come; in reality, it indicates that the worst is already here, or in some cases, has already passed.

As you can see in Figure 1.1 below, the highest levels of the VIX usually coincide with cyclical lows in the S&P 500. The relationship is much more evident in declining markets, which makes sense, since the VIX price stays relatively consistent when the market is doing well. In Figure 1.2 I have included markers to show cyclical lows of the S&P 500 and the corresponding peaks in the VIX price. Perhaps even more helpful is Figure 1.3, which shows the S&P 500 vs. 1/VIX (the reciprocal of the VIX). You can see how the two measures move in tandem, since stock prices and volatility generally move inversely. This relationship is shown in greater detail in Figure 1.4, which tracks S&P 500 prices and 1/VIX from 2007 – 2009. Again, the relationship is stronger during this bear market, where volatility plays a greater role in investor decision-making.

One specific situation that helps illustrate this point, and has a number of parallels to the current situation in Greece, is Russia’s debt crisis of 1998 (Figure 1.5). The country was dealing with excessive inflation, and appeared susceptible to defaulting on its debt, much like Greece today. The ensuing panic (in the US) led to a -11.7% drop in the S&P 500 over a period of just 3 trading days, beginning on August 27, 1998. But as you can see from the graph, the VIX did not top out until approximately two weeks later, illustrating once again that the VIX typically coincides with or lags market movements. The fallout from the Russian debt crisis also led to a “double-bottom” the next month (shown by the green circles), where the market fell again soon after rebounding from a collapse. Once again, the VIX’s high came shortly after the market bottomed out for the second time.

It is no surprise that the volatility caused by the Flash Crash (May 6), combined with the situation in Europe, gave way to the S&P’s lowest close since February. But given what we have learned from the VIX (which hit 42.15, a 52-week high, on May 7), we know this increase in volatility was indicative of a current low, not an impending one. While this doesn’t mean that stocks can’t go somewhat lower before rebounding, perhaps accompanied by an even higher VIX, the May 7 peak in the VIX is useless in predicting whether or not this will happen.

The BP Oil Spill

Last week the Deepwater Horizon, a Transocean Ltd. (NYSE: RIG) oil rig leased to British Petroleum (NYSE: BP), exploded and sank in the Gulf of Mexico, costing at least eleven lives, hundreds of millions of dollars in damages and great harm to the environment as its well leaks oil at a rapid rate. As I write this entry, the well is leaking 5,000 barrels (155,000 pounds) of oil per day into the Gulf. Even more frightening is the fact that if the well cannot be closed, the total leakage could amount to over 100,000 barrels (4.2 million pounds) of oil.

Many Americans are wondering why more safety precautions were not taken in anticipation of such an event, given the potentially catastrophic damage we are seeing now. Every oil well has a shut off valve, known as a blowout preventer, which cuts the flow of oil from a well when closed. Crew members of the rig were either unable to close the valve, or they tried and the shut-off process simply did not work. Still, the shut-off process should have happened automatically through the “dead man” switch, whose purpose is to sense catastrophe and close the valve. The Deepwater Horizon did have a dead man switch, but for unknown reasons it failed to close the valve. The last line of defense in this situation would be an acoustic trigger, a device that sends acoustic impulses through the water that can trigger a valve to shut down the well; however the Deepwater Horizon did not have one. Interestingly enough, BP was the main opponent of regulations proposed by the US that would have required acoustic triggers on deep sea rigs, citing unproven effectiveness and cost issues as their reasons for opposition. If it fails it fails, but it looks like it would have been worth the $500,000 (the cost of an acoustic trigger) to try – this incident alone is costing BP $6 million a day, not to mention the $560 million cost of replacing the rig.

The issue now is trying to stop the leak at its source, and then deciding how to move forward if that effort fails, which is very possible. Remote-controlled robots were dispatched to activate the blowout preventer, but so far those efforts have not proven effective. On Wednesday, BP conducted a “test burn” to measure the effectiveness of setting fire to the oil-filled water. While the test was successful, weather conditions deteriorated soon after, preventing any further burning from taking place. Other ideas for containing the leak include building a massive dome to be placed over the well, as well as drilling a second well at an angle to relieve the pressure of the leaking well, and intercept its contents. BP’s stock price has already fallen 13.8% since April 20th, the day of the explosion. But even more damaging to BP is that it is on the hook for the total cost of containment and cleanup, which is an unknown at this point but exceed $1 billion. Luckily for Transocean, it is insured for the total cost of the rig, $560 million, as well as $950 million in third-party liability coverage, but is responsible for any losses exceeding that figure.

It’s safe to say that we will see major changes in safety regulations for deep sea oil rigs, and eventually BP will be faced with fines and lawsuits related to the incident, but at this point the main concern is containing this massive leak and minimizing further damage. It also remains to be seen whether or not the government will scale back offshore drilling in general, mainly in the Gulf and off of the Atlantic.

Financial Reform Bill

All the focus this week is on two issues surrounding the financial industry – Obama’s efforts to push his financial regulatory reform bill through Congress, and the fraud lawsuit brought against Goldman Sachs by the SEC. While these two issues should be unrelated, it’s hard to overlook the convenient timing of the SEC’s accusation against Goldman. But since our President has assured us that he found out about the accusations from the news media, and that the SEC is an independent agency that does not report to the White House (and we know politicians always tell the whole truth), we can chalk it up to “coincidence.” And since I already discussed at length the charges being brought against Goldman and the likely effect on the company and stock market, I will spend more time focusing on the impending financial reform bill.

The financial regulatory debate has parallels with the recent healthcare issue. While most people understand why Washington is trying to implement these reforms, much like the healthcare reform bill, few people understand what reforms they are advocating, and how these reforms will affect Wall Street or anyone else. Additionally, both parties are taking such a strong stance on this issue that the facts have become secondary to partisan jabbing, leaving the American people clueless.

The goal of all the proposed reforms fall under four major categories: protecting individuals from banks and other large financial institutions, protecting these institutions from themselves, increasing the power of shareholders, and requiring more disclosure by financial institutions. The strongest opposition from Wall Street has been in response to the idea of a tax that would affect bank, thrift and insurance companies with more than $50 billion in assets, in order for the government to recoup its losses from the bailout. While this would generate more cash flow for the government, it would almost certainly lead to increased fees for these institutions’ clients. The law also seeks to heavily regulate the trading of derivatives, financial instruments whose value is dependent upon the price of an underlying asset. But too much regulation of derivatives could impede the ability of financial institutions and others to hedge against major losses (the intended purpose of derivatives trading). Other proposals include increased shareholder powers, a consumer protection agency, and the Volcker Rule which would require banks to be separate entities from hedge funds or private equity funds, and would also ban proprietary trading by banks except in certain cases.

Any future changes to our country’s financial industry will undoubtedly come with one major caveat – people will find a way around them. Congress needs to limit changes to things that have a high likelihood of achieving the above four goals without unpleasant side effects. Delaying full commissions for mortgage brokers until the loans have been refinanced or shown to be performing, and requiring banks to retain a stake in loans they securitize so that they remain on the hook for some of the losses, are both ideas that would provide positive incentives to do good while increasing accountability by financial institutions. These are the types of changes that might actually prevent another financial crisis. We could do without regulations that just create loopholes, encourage gaming the system and cause more distress to the American taxpayer.

Government Bond Yields Reflect More Than Just Default Risk

I’ve said it before and I’ll say it again – we (investors and non-investors alike) need something to worry about. So it shouldn’t come as too much of a surprise that members of the media are questioning the safety of US debt after three Treasury auctions were met with poor demand a couple of weeks ago, mainly from foreign investors. There are a lot of things we should worry about as investors, but the safety of US Treasury debt is not one of them. In the Wall Street Journal article entitled “Debt Fears Send Rates Up,” the reporter points out that during the prior week, U.S. Treasuries were yielding slightly more than U.S. corporate bonds, which is surprising but not unheard of. But her source, an economist at BNP Paribas, brazenly goes on to say that maybe investors are more comfortable with the risks of owning bonds backed by U.S. corporations than the government. This seems far-fetched considering our government just bailed out a number of our country’s most prominent banks and automakers to the tune of nearly a trillion dollars, and given the fact that the US has never even come close to defaulting on our debt. While it is a worst-case scenario, we could simply print more money, unlike many European governments—such as Greece—which depend on the European Central Bank to control the money supply in the Eurozone.

A rising yield for Treasuries, or any developed country’s debt issues, is only occasionally reflective of increased default risk, which is not the main determinant of bond yields and prices. Expected growth, inflation and changes in currency exchange rates are the major determinants of government bond prices; in many cases, they are more important than default risk in pricing a bond. Let’s look at current bond yields to illustrate this point. 10-year U.S. Treasuries and U.K. Gilts currently yield 3.63% and 3.75% respectively, while Japanese government bonds yield only 1.40%. However, according to the S&P, Japan’s credit rating is “AA” while the U.S. and U.K. both have the most secure rating of “AAA.” Whether this is caused by expected appreciation of the Yen against other currencies or assumptions about growth rates or inflation in Japan, it is clear that investors are willing to take a much lower interest rate on Japanese bonds despite their supposed higher default risk.

The decrease in Treasury prices and subsequent increase in yields (since prices and yields move inversely to one another) isn’t something to completely overlook. This could be problematic for the housing market, as it could lead to increased mortgage rates, or could be indicative of other impending problems for the U.S, such as higher inflation down the road. But it certainly does not mean U.S. debt is any less secure than it always has been for many decades.

Gambling, Losing, and Complaining About It

There has been a recent uproar from citizens and politicians, in Los Angeles and a number of other cities and counties in the U.S., over municipal interest rate swaps that are now costing local governments millions of dollars a year. An interest rate swap is essentially a legal bet between two entities, one of which is trying to hedge its interest rate exposure. In Los Angeles’ case, the swap was made with Bank of New York (BNY) Mellon, who in 2006 exchanged $443 million worth of fixed-rate debt for an equivalent amount of variable-rate debt issued by the city.

Los Angeles made the deal to protect itself against the possibility of rising interest rates, which would have increased the interest owed on its variable-rate municipal bonds. However, in agreeing to this exchange, the city exposed itself to the risk that interest rates would fall, which they of course did—dramatically. The payoff in a swap is determined each quarter by the spread (difference) between the variable and fixed rate. Thus, the fixed-rate buyer stands to gain if interest rates rise, or lose if they fall.

Four years and one economic crisis later, the City of Los Angeles finds itself on the hook for $19 million a year (at today’s interest rates). But rather than accept the consequences of its gamble, or opt to refinance the floating rate debt with fixed-rate bonds, the city is demanding a renegotiation of the deal and threatening to never do business with BNY again if it does not comply. The most vocal cry baby of this effort is city councilman Richard Alarcon, who according to the LA Times described the deals as “tantamount to gouging” and likened the bank to merchants who sold water for $20 per gallon after the 1994 Northridge earthquake.

Conveniently, Mr. Alarcon doesn’t bother to mention that the City of LA, arguably a sophisticated investor, agreed to the deal, in which BNY also assumed risk. This is very different from the price-gouging merchants, who were taking advantage of increased demand owing to a natural disaster. “The bank is taking an unconscionable profit,” said Alarcon according to the Wall Street Journal. “We want to bring it down to a simple customer-to-vendor relationship. When a customer is not satisfied, they go to a different vendor.”

Yes, Mr. Alarcon, LA is welcome to use a different swap vendor in the future, but the city still owes the money on the legal contract signed by consenting adults. We feel that there is even less substance to these claims than to those of a gambler who asks for his losses back from the casino.

Taxpayers in LA and other municipalities where interest-rate swaps have gone awry (such as Jefferson County, AL which owes $3.2 billion on sewer bonds) are probably all wondering the same thing: Why gamble? Swaps are typically used as a hedging instrument. For example, if you have exposed yourself to the risk of rising interest rates from issuing floating-rate bonds, you can mitigate that risk (and any reward if interest rates drop) with a swap. So the city either made a cold bet on the future of interest rates, or it has succeeded in hedging another risk and still wants to recoup its losses on these swaps. What we are seeing here is nothing more than a case of buyer’s remorse at the municipal level.

Currencies and Purchasing Power

This week we are looking at the fluctuation of currency exchange rates, as well as the effects of exchange rates on investors and consumers. The exchange rate between two currencies indicates the relative worth of one currency against the other. As I write this article, the Euro-to-US dollar (EUR/USD) exchange rate is 1.36 – one Euro has the equivalent value to $1.36 USD. The American dollar-to-British Pound (USD/GBP) exchange rate is 0.66, so an American dollar in England can purchase £0.66 worth of goods. In efficient markets, equivalent items should cost the same in all countries; this is known as “the law of one price.” But since prices cannot adjust to rapidly fluctuating exchange rates, the purchasing power of one currency against another is constantly changing.

Purchasing power parity (PPP), based on the law of one price, attempts to find the appropriate exchange rate so that an identical good in two different countries has the same price in terms of purchasing power. In theory, PPP should determine exchange rates; in the real world, currencies fluctuate for all sorts of other reasons, while the prices of goods and services remain constant over short periods of time. (A notable exception is The Trader Bar in Melbourne, Australia, where the price of each drink fluctuates based on the current demand. A lighthearted, though effective, illustration of PPP is The Economist’s Big Mac Index, which compares the price of a McDonald’s Big Mac in different countries against the country’s exchange rate to show how relatively expensive or cheap each currency is.

The market exchange rate determines the purchasing power of one currency relative to another, but what determines market exchange rates? Let’s look at the recent situation in Europe and how it has affected the purchasing power of the Euro. Currencies fluctuate similarly to bonds in that a rise in interest rates results in a decrease in the currency value, which happened recently as a Greece, Spain and other European nations issued a large amount of debt. Uncertainty over these governments’ ability to repay loans to their investors forced them to issue debt at a higher interest rate than previously; as expected, the Euro declined sharply. For example, relative to the US dollar, Australian dollar and Yen, the Euro has fallen -4.90%, -5.63% and -7.66% respectively since January 1, 2010. These are drastic declines over such a short period.

Investing in the foreign exchange market is unique in that it operates 24/7 and produces small profit margins in comparison to other markets. As a rule, I do not attempt to use currencies as long-term investments. I do, however, occasionally hedge against large fluctuations in exchange rates that may affect my foreign investments by using various techniques. Currency fluctuations don’t usually affect investment returns that much over the long term, but exchange rates can be highly volatile over short periods of time.

In the long run, purchasing power parity should determine the relative value of currencies. But in the short term, currencies can be substantially over or undervalued, such as the Yuan which the Big Mac Index estimated to be almost 50% cheaper than the US dollar. So if you are looking for the best price on Big Mac’s, look no further than Beijing!

GDP: Fourth Quarter 2009

This morning the Bureau of Economic Analysis (BEA) released its second estimate for 2009 4th quarter gross domestic product (GDP), which they estimated at just under $14.5 trillion. GDP measures the output of domestically-produced goods and services. The real (inflation-adjusted) GDP increased at an annualized +5.9% from the third quarter, a jump from the previous quarter’s +2.2% increase. And while annual GDP decreased -2.4% from 2008 to 2009, last quarter’s GDP was +0.1% higher than the 4th quarter of 2008. The current report indicates positive shifts in a number of important areas, and is consistent with a country beginning to claw its way out of recession.

GDP is divided into four broad categories: personal consumption, private investment, government spending and net exports (the difference between exports and imports). The largest increase from the prior quarter came from private investment, which increased an astounding +48.9%, thanks in part to improvement in private inventories (after a -23.1% decrease over all of 2009). The change in private inventories accounted for 64% of the total change in real GDP. Both this change and the +2.8% increase in consumption of goods reflect the improved consumer spending as well as anticipated spending. They also demonstrate what I discussed yesterday in my email article – that both recessions and recoveries are driven by business spending, not consumers. Consumers buy after Corporate America: if Wal-Mart is re-stocking their inventory, they do so because they are expecting us to buy more of their products.

As for government expenditures, which include federal and state/local spending, you may be surprised to learn that they decreased by -1.2% from the prior quarter. State and local governments decreased spending by -2.0% while the federal government increased spending by +0.1%. Federal government spending is broken down into defense and non-defense spending, which dropped -3.5% and increased +8.3%, respectively. The fact that a small decrease in defense spending and a large increase in non-defense spending effectively negate one another shows how much of our discretionary spending (64%) is devoted to national security.

Another favorable economic indicator from the recent GDP estimates is the increase in both exports and imports. While we are still running a trade deficit of -$347 billion, we can take some solace in the fact that exports increased +22.4% from the previous quarter while imports rose +15.3% over the same time period. This capped off a 2009 that saw a +$138.9 billion increase in net exports (a decrease in the trade deficit) from the previous year and a fourth quarter increase of +$10.3 billion. Historically, a substantial increase in both imports and exports is a strong indicator of economic recovery.

While it is promising to finally see significant growth in consumer spending, private investment, exports and other important areas, it only means things are headed in the right direction. Last year’s real GDP is still a -2.4% decrease from 2008. We are definitely on the road to recovery, but we still have a ways to travel to get there.

Treasuries

Last week we looked at historical returns on gold and showed that, despite widely-held beliefs about the commodity, it’s a risky investment that barely keeps up with inflation. We showed that over time, gold has proven itself to be significantly riskier and far less profitable than stocks.

This week we look at treasuries, which by their nature are not as risky as stocks or commodities, but are still perceived to be far safer than they truly are when you look at real (inflation-adjusted) return. Treasuries are unique in being fully guaranteed by the US government. If you buy a $1,000 10-year treasury bond with a 6.8% coupon, you will undoubtedly receive $34 semi-annually until the bond matures, at which point you get your $1,000 back. The total interest earned over this period (before reinvestment) is $680. But even with the ultra-safe, guaranteed return, you could still lose money!

You may be wondering how it’s possible for an investment with guaranteed returns to lose value. The answer is inflation. For example, $1,000 in 1970 had spending power equivalent to over $2,160 in 1980. If you collected any less than $1,160 in interest payments over the life of the bond, your real (inflation-adjusted) return was negative. In the example above, you would actually have lost $480 over the 10-year period.

Let’s compare treasury bills, which mature in one year or less, treasury bonds, which mature between 20 and 30 years, and common stocks. Since 1871, stocks have returned +6.3% annually after inflation, compared to +1.9% for treasury bills and +2.4% for treasury bonds. So stocks provided far better returns over the long term.

Now let’s look at risk. Over the past 110 years, the worst decades for stocks were the 2000s, when they returned –2.2% annually, and the 1910s (–2.1% annually). Treasury bills, on the other hand, returned –4.5% per year during the 1940s, while treasury bonds dropped –4.8% per year in the 1910s and –3.2% in the 1940s. Not so safe after all it seems.

So while treasuries fluctuate less than stocks in the short term, their worst-case performance over a decade is lower than for stocks. And stocks’ best-case performance is far better: +15.7% in the 1990s vs. +8.1 for treasury bonds and +3.7% for bills in the 1980s. So while bonds are an important part of a diversified portfolio, and usually yield a positive real return, it is important to understand that risk is inherent in any potentially profitable endeavor. US treasuries are no exception.

Gold – Not So Safe after All

Following a disastrous 2008 for equities, stocks have come to be perceived as risky, volatile investments, especially for investors funding retirement accounts and other conservative portfolios. Instead of trying to find the next Google, investors have become more interested in finding safe places for their money – low-volatility, minimal-risk investments that hopefully protect against inflation. Gold has recently developed a reputation for being one of these “safe” investments after posting a comparatively fantastic +11.28% annualized return from 2000-2009, a decade during which stocks actually declined for the first time since the 1930s. Seems like gold is the place to be!

But wait one second. An historical analysis of gold returns against the S&P 500 shows that not only has gold been less profitable than stocks over the long-run – it has also been more volatile. You may be surprised to learn that gold has only outperformed stocks in three of the eleven decades since 1900, and has barely posted a positive return since 1871, with less than +0.8% annual growth, while stocks have grown +6.3% annually over the same period (both of these figures are after inflation). To get an idea of the significance of this difference, over 30 years at the above rates of return, $1,000 worth of gold would have grown to $1,266, vs. $6,252 for stocks (again, after inflation).

Until 1968, the price of gold fluctuated little owing to fixed prices and the Bretton Woods System, which held gold to a fixed price relative to the value of the US dollar, the system’s anchor currency. The system was enacted partly because the US government had nearly $26 billion in gold reserves, and by controlling the price of the commodity it virtually ensured the value of its gold would not substantially decrease. Bretton Woods eventually became unsustainable and was ended in 1968, at which point the price of gold was free to fluctuate. But in comparing returns on stocks and gold since the 1970s, a decade where gold returned an average of +16% annually after inflation, we still see a greater annualized return for stocks (+5.2%) than for gold (+4.2%) in the 40 years since 1970. The 80s and 90s saw a massive disparity between the two investments: stocks posted annualized after-inflation returns of +9.9% and +15.7% respectively over each of the two decades, while gold lost value at annualized rates of -8.2% and -5.3%. So much for hedging against inflation!

My point is not that one should only own stocks and never own gold. Nor do I necessarily disagree with analysts who project that gold will be a profitable investment over the near term. I am just using historical analysis to show that gold has been a relatively poor investment and ineffective inflation hedge over the long term, and is even more volatile and unpredictable than stocks. Its recent reputation as the perfect inflation hedge or as a “safe” investment is not deserved.

This is an illustration of how $100 would have grown over the last thirty years (click to enlarge):