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How About a BEER?

How About a BEER?

Let’s Tap A BEER To See If Stocks Are Over, Under, Or Fairly Valued

“Interest rates and volatility are on the rise, as are investor jitters, so now is the perfect time to pop open the BEER analysis.”

Lager, ale, IPA, steam, stout, or pilsner?  Nope, that’s not what we’re here to discuss.  This BEER is both non-alcoholic and gluten-free.  I know what you’re thinking:  “That beer sounds terrible!  Why would I want that?”  Because our BEER is going to help us more effectively navigate the stock market.

Our BEER, the Bond Equity E​arnings-yield Ratio, is a simple, interest rate-based, stock market valuation tool, used by the Federal Reserve Bank to determine if stocks are cheap (stein is half full), or expensive (stein is half empty), relative to bonds.

Interest rates and volatility are on the rise, as are investor jitters, so now is the perfect time to pop open the BEER analysis. Interestingly, this edition of “Cutting Through the Noise” provides a glass “half full” example of the stock market’s valuation.  Well, what else would you expect when discussing BEER?  Read on!

The Bond Market as a Predictor of Stock Performance

“Are we in a period where money is likely to continue to flow into the stock market and drive stock prices higher? Or, are we in a period where bonds are attractive enough to prevent that flow of capital from occurring?”

Before we jump into the BEER analysis, recall that last May we evaluated the market through the lens of the CAPE (Cyclically Adjusted Price to Earnings) ratio, which showed the market to be approximately 30-50% expensive vs. historical prices – or glass “half empty”.  

The CAPE analysis would seem to point to an overvalued stock market which we might conclude we should avoid.  However, CAPE is only only one vantage point, and it is important to remain open to a variety of viewpoints when constructing an investment strategy.  We’ll discuss this in greater depth later in this article, after we crack open our BEER.

So, why would you look to interest rates and the bond market in an attempt to predict returns in the stock market?  Good question.

During periods of economic expansion, which has been the case for the last nine years since the Financial Crisis, bonds yields and stock market prices have generally traded inversely as they compete for investor capital. This is because when economic optimism grows, money moves into the stock market as investors seek to profit from economic growth and associated rising stock values.  

Conversely, selling in the stock market generally leads to lower bond yields as money moves out of the stock market and into the bond market, as investors flee to safety.  We presently find ourselves experiencing expanded economic growth, the stock market has done remarkably well for almost a decade, and interest rates are beginning to rise, even though they remain near historical lows.

The key question to ask and answer is thus: Are we in a period where money is likely to continue to flow into the stock market and drive stock prices higher? Or, are we in a period where bonds are attractive enough to prevent that flow of capital from occurring? This is precisely the question which the BEER analysis is designed to answer.  

OK, Let’s Brew

The Bond Equity Earnings-yield Ratio (BEER) is a metric used to evaluate the relationship between bond yields and stock earnings yields.  At its core, the BEER or Fed model evaluates whether investors are appropriately compensated for the price they are paying for riskier cash flows earned from stocks, by comparing them to the expected returns for bonds.  

BEER has two parts – a benchmark bond yield (10-year Treasury), divided by the current earnings yield of a stock benchmark (such as the S&P 500).

BEER =  Bond Yield / Stocks Earnings Yield (E/P)

The key insight from this equation is that the lower the interest rate – the higher the expected stock price.  Taking that further, standard P/E ratios as a predictor of stock market performance do not account for the present interest rate regime.  Adding the interest rate component to the BEER framework provides for a more robust stock market valuation analysis.

Is The Tap Foamy Or Flat?

“At present, the stock market appears undervalued by ~50% relative to interest rates, which leaves plenty of room for more froth (as long as interest rates remain low).”

So, what does BEER tell us about the current and potential future value of the the stock market?

Figure 1 below shows the relationship between the 10 year US Treasury bond and the earnings yield of the S&P 500 based on the next year’s forward earnings.

The Bond Yield in the numerator is the straight-forward yield of the 10yr US Treasury. The (E/P) in the denominator is simply the inversion of the P/E ratio for the S&P 500.  Inverting the P/E ratio into an E/P yield is done to compare “apples to apples” or Bond Yield to Stock Earnings Yield.

Historically, we have seen the yield on stocks and bonds to be about the same, up until 1999-2000.  Around that time, prices of stocks went up disproportionately to their underlying earnings and relative to bond yields.  Stocks were expensive (red line below blue line) relative to bonds in early 2000, and under performed coming out of that period.

Since that time, stocks have been cheap relative to bonds (red line above blue line), largely due to the impact of Central Bank policies that have suppressed interest rates.  It is important to note that stocks outperformed (as predicted by the BEER model) over this past 15 year period – including the market crash of of late 2007 to early 2009.

Figure 2 below illustrates the over/under valuation of the stock market relative to the bond market according to the BEER analysis within a single line by dividing the blue line by the red line in Figure 1 above.  What we see is that, according to BEER, the stock market has not been overvalued since that big spike up around 2000.

At present, the stock market appears undervalued by ~50% relative to interest rates, which leaves plenty of room for more froth (as long as interest rates remain low). Ten-year bond yields have historically equaled Nominal GDP, which would be ~5% today… and yet current yields are only 2.9%, which makes bonds quite expensive.  Historical P/E’s have averaged 15% and are currently at 16.3%.  Considering the present level of interest rates, one could make the case that stocks are actually cheap…as long as we don’t have a recession.

However, note that the Fed model above shows the stock market was actually viewed as inexpensive going into 2008, prior to selling off ~50%.  It is important to understand that, while the market was cheap visavis bonds during that 2008 time period, it may have also been absolutely expensive.  That 2008 period could be somewhat analogous to today’s market prices, but to a much smaller degree. Specifically, stocks are likely somewhat expensive in an absolute sense, but they remain cheap relative to the more expensive bond market.

So What Can We Expect From the Stock Market Going Forward… Light or Dark BEER?  

Occasionally financial market pundits carelessly opine that, “Stocks are undervalued according to BEER or the Fed Model (or interest rates).” Although this might be a true statement, it is careless because it implies that stock prices will necessarily go higher.

The correct interpretation of the above comparison between stock and bond yields, is not that stocks are cheap or expensive, but that stocks are cheap or expensive relative to bonds.  It may be that stocks are both cheap vs bonds and expensive in an absolute sense, which could make stocks priced to deliver returns below their long-term average.  

However, it may also be true that bonds are even more expensive than stocks and priced to deliver returns far below their long-term average and could actually lose principal after factoring in inflation.  Be aware that both stocks and bonds could lose money under the scenario highlighted above.

This should not come as a surprise, since both stocks and bonds have collectively offered record positive returns for the past 35 years, which could set up for a big bout of mean reversion at some point.  Hmmmm…perhaps we need to further diversify beyond just stocks and bonds?

Importantly, the BEER model can help explain why stocks have done so well in the face of many pundit proclamations that the market is expensive.  Additionally, this analysis demonstrates how equities could continue to climb higher, even while they remain expensive by other measures.

Mugs or Steins?

“…BEER (or some similar signal) is likely the measure used by Warren Buffet when he claims the stock market is cheap.”

It’s clear that the strength of the BEER framework is the incorporation of the additional bond yield component, which helps provide richer context to the stock market valuation analysis.  Conversely, the weakness of BEER is that the inclusion of the bond yield creates a relative comparison, which can send a misleading signal if both stocks and bonds are cheap/expensive.  Ultimately this relative analysis could lead to false signals at the wrong time.  

This is in stark contrast to our CAPE analysis, whereby the strength of the CAPE ratio is its objectivity, by averaging valuation levels over an entire market cycle.  The weakness of CAPE is that it does not consider other inputs, such as interest rates or growth rates, which can lead an investor to miss major upswings in the market.

Just as CAPE and standard P/E ratios have imperfections, so does the BEER analysis.  These two vastly different approaches often arrive at two wildly different conclusions, while each methodology independently attempts to answer the same question.  

I liken these different approaches to viewing the same picture through different lenses.  Sometimes the Rx is just right and the viewer is able to sharply see the proper valuation, while other times the picture is fuzzy, making it  difficult to discern over/under valuation.

As a point of reference, BEER (or some similar signal) is likely the measure used by Warren Buffet when he claims the stock market is cheap.  Psssst… just don’t ask Warren why he holds $120B (or 20% of his market value) in cash within Berkshire Hathaway, if the market is so cheap…

Avoiding Confirmation Bias

So why do we spend so much time looking at competing analytical frameworks when determining our investment decisions, when they often arrive at radically different conclusions?

Incorporation and analysis of multiple conflicting viewpoints is critical to avoiding what behavioral finance refers to as “confirmation bias.”  Confirmation bias occurs when an investor exclusively follows analysts or strategies with which they already agree. This can lead investors to take on too much risk at certain points of the cycle, or to miss major upswings, because they fail to adequately take into account alternative opinions and analysis.  

How many of us watch both FOX News and MSNBC – I mean both of them equally?!  Not many.  When investing, it is equally important to be aware of what the “Pollyannas” are professing, as well as the rhetoric of the “Sky is Falling” types – and everything in between.  Think of it as looking both ways when crossing the street.

It is always possible to find some really smart people on both sides of the market providing equally strong arguments toward being a buyer or a seller.  It is up to the prudent investor to determine which argument is correct at any particular time.  

Hence the need to seek multiple quantitative viewpoints like both CAPE and BEER and beyond.   

How’s The Wine?

As we just noted, it is important to consider as many flavors or methodologies as possible.  More information is always better when building your investment mosaic.

This should include making logical adjustments along the way to draw common sense conclusions regarding risk/return assessments for the markets.  It is helpful to know that some relatively straight-forward metrics view the stock market as cheap, while other, equally-sensible measures, view the market as expensive.

BEER and CAPE are simple and straightforward measures, but there are still other more complex and refined models (we’ll call them wine – When Investors Need more Explanation), which can also be very helpful in determining the markets valuation.

In fact, these more detailed models imply that the stock market is neither cheap nor rich at present, but fairly valued.  Let’s leave those more complex examples for another day.

Regardless of the valuation tool, it will be important for earnings to continue to grow faster than the increase in real interest rates for stocks to continue to deliver that refreshing taste of higher returns.

Cheers!

Three Bell Client Spotlight Socks With Benefits: Andrew Ferenci, Comrad Socks Founder & CEO

FIRST WORLD SOCK PROBLEMS

How many times have you opened your sock drawer in the morning and rummaged around for a favorite pair of socks, passing over the less desirable pairs?  Conversely, how many of you think your socks just plain suck and don’t even own a single pair you really like?

Personally, mine always slumped down after five minutes, and then flew at half-mast the remainder of the day.  I would like to think this is due to my well-developed, muscular calves, but in reality, it’s because my socks were poorly designed and made from shoddy materials.

Enter Comrad.

Founder and CEO, Andrew Ferenci, is aiming to change that experience entirely and is making socks that not only make your feet feel a whole lot better, but also have the potential to prevent blood clots that can form from sitting or standing in one place for long periods of time.  Hmmmm, how many of us can relate to that?

ANDREW’S ENTREPRENEURIAL BACKGROUND

Andrew wasn’t always a burgeoning textile baron.  Quite the opposite, he previously founded Spinback, a social commerce and analytics company that was later sold to Buddy Media, which was in turn acquired by Salesforce.  Andrew was the definition of a high-tech entrepreneur focused on engineering B2B software solutions for the enterprise market.

Coming out of the Spinback/Buddy Media exit, Andrew wasn’t long for Salesforce, and like most successful entrepreneurs, he was soon ready to start and build another company.  But this time, he was looking to make a physical product that customers would actually use everyday.  In a way, a return to the pre-internet days when entrepreneurs operated in the physical universe and manufactured widgets directly for consumers.

After exploring a few different ideas, Andrew started zeroing in on compression socks as a market opportunity.  Like many of us, Andrew had spent countless hours in cramped cubicles and long airplane flights.  His legs were often sore and upon further research, he learned that he was at risk of developing blood clots in his legs from lack of adequate movement and blood circulation.

Andrew began wearing compression socks that are ergonomically designed to promote blood flow, prevent blood from pooling in your legs, and stimulate lymphatic fluid circulation throughout the body.  He immediately felt an enormous difference.

A CHANGE IN STYLE AND YOUR HEALTH

Comrad socks are made with compression technology, which improve blood flow to and from the feet increasing circulation and reducing fatigue. They weave different thread patterns and materials up and down the length of the sock, which create compression zones at medically proven places and aid the flow of blood to the feet and back up the leg.

Originally designed for patients with diagnosed inhibited circulatory systems, compression socks can also be worn by anyone. They make a HUGE difference in how your feet feel at the end of the day, especially if you spend significant time seated sedentary in front of a computer at work.

However, the problem Andrew identified and Comrad has now corrected, is that compression socks are ugly.  Really ugly.  They traditionally come in white, nude and black, none of which really have any visual appeal, flare or style.  They look like they were made for medical purposes, so they don’t appeal to a broader audience, despite the fact that their therapeutic characteristics are universally beneficial.

Comrad combines all of the medical benefits of compression technology (increased blood flow, reduced muscle fatigue, and socks that don’t fall down during the day), and marries that with fashion forward designs people actually want to wear.

Andrew sent me a pair to check out and, after wearing them for just one day, I threw out my entire sock drawer, including my “designer socks”, and bought 10 more pairs of Comrads.  Now they are all I wear, and the entire Three Bell team is equally hooked.

COMRAD IS KILLING IT

The company has been hugely successful since it’s launch in November 2017.  Comrad is now shipping an average of 6,000 pairs of socks per month and is on track to book $1.5M in revenue its first year, 1,400% top line revenue growth from months 2-7, and 6% eCommerce conversion rate.  To quote Sundown from Top Gun, “It doesn’t get to look any better than that!”

Thus far, Andrew has bootstrapped the company with his own money, and only taken in a very small amount of capital from a few very lucky friends and family.  As the company continues to ramp sales and scale production, they will begin looking for an institutional round of capital from top tier investors in Q1 of 2019.

TRY COMRAD FOR YOURSELF

How can you lay your hands (or feet, to be more precise) on these badass foot-massaging super socks?  Glad you asked, cause we’ve got ya covered.  Andrew has created a special promo code “3BELL”, just for us.  Since he knows as well as we do that good things come in threes, for the next month the “3BELL” promo code will get you a free pair of socks with every two pairs purchased at regular price.

Just go to www.comradsocks.com, enter your 3BELL promo code, pick out your favorite designs, and get ready to feel the love.  Just don’t be surprised when, like me, you find yourself throwing out the rest of your sock collection and buying more Comrads.

LEARN MORE ABOUT ANDREW

Add Compression Socks to Your Long-Haul Travel Routine

The 10 Best Socks to Wear While You Travel, Run, and Rest

These stylish compressions socks are perfect for sitting at a desk all day, traveling, or working out

Andre Huaman of Three Bell Capital Named NAPA Congressional Delegate

Andre Huaman of Three Bell Capital Named NAPA Congressional Delegate

LOS ALTOS, Calif.–(BUSINESS WIRE)– Andre Huaman, Partner at Three Bell Capital (Three Bell) and head of Three Bell’s Corporate Retirement Plan Division which manages approximately $1B in plan assets, has been selected as a delegate to the National Association of Plan Advisors’ (NAPA) DC Forum.

The NAPA DC Forum is an invitation-only, exclusive gathering of the Nation’s leading corporate retirement plan advisors formed to communicate with and brief top congressional leaders about the importance and future of the Nation’s workplace retirement plans.

As advocates for the employers and participants with whom they work, NAPA DC delegates will share with members of Congress and the Department of Labor, how proposed laws and regulations might impact American workers’ retirement security.

Three Bell Capital - National Association of Plan Advisors

“NAPA is widely regarded as the premier dedicated retirement plan advisory advocate in the U.S., and they are consistently at the forefront of legislative and regulatory thought leadership,” said Three Bell CEO, Jon Porter. “We are thrilled that Andre has been tapped to share his perspective and leverage his extensive subject matter expertise to help optimize America’s corporate retirement plan laws.”

“With 10,000 U.S. Baby Boomers turning 65 each day and many Millennials assuming they may never be able to fully retire, we are in a time of unprecedented retirement uncertainty,” said Mr. Huaman. “I’m humbled and honored to be selected to join the other esteemed NAPA delegates to engage with key policymakers and help ensure our legislators are armed with the data and perspective they need to make informed decisions.”

About Three Bell Capital

Headquartered in Silicon Valley, Three Bell Capital works with entrepreneurs, venture capital firms, and high-growth technology companies to establish and manage their 401(k), cash balance and deferred comp plans, while developing comprehensive financial plans for company founders and executives. Three Bell Capital ranked #1 on the 2017 Top 100 Emerging Wealth Management Firms in the U.S. by Forbes. For more information, please visit http://www.three-bell.com/.

About NAPA

NAPA, a sister organization of the American Retirement Association, was created by and for retirement plan advisors. NAPA is the only advocacy group exclusively focused on the issues that matter to retirement plan advisors. Membership offers three valuable benefits: advocacy, business intelligence, and networking – all designed to keep plan advisors in the forefront of the industry and help them succeed.

Want to Invest in Cryptocurrencies?

Want to Invest in Cryptocurrencies?

Here’s What You Need to Know

Cryptocurrency is the buzzword du jour for investors and technology enthusiasts alike.  Last month we gave an overview of cryptocurrencies and their foundational platform structure, the blockchain.  This month, Andre Huaman, Partner at Three Bell Capital, follows up our cryptocurrency primer with a detailed Q&A with cryptocurrency expert, Brayton Williams.

Brayton Williams is a Co-Founder and Managing Partner at Boost.VC.  Boost VC is a venture capital firm headquartered in San Mateo, CA, investing in cryptocurrency, virtual reality, and other emerging technologies.

Brayton and his team have been in the cryptocurrency space for over 5 years and were one of the first venture capital firms to place concentrated bets on the cryptocurrency industry. He is considered an industry expert in the cryptocurrency space.

Boost.VC is currently investing out of their 3rd fund, with $38m of committed capital. Limited Partners in Boost.VC funds include the likes of Tim Draper, Marc Andreessen, and Fidelity Investments.

Brayton Williams, Boost.VC

Andre: Thanks for being with us, Brayton.  Cryptocurrency and blockchain are fascinating to us and to many of our clients.  We are closely monitoring the activity in the space and more importantly, the potential for investment. Your expertise as an investor in the industry will help us to frame the cryptocurrency space and raise client awareness of potential benefits and drawbacks.

Brayton: Happy to be here.  This industry (blockchain/cryptocurrency) is fascinating and being in it for over five years, I have definitely witnessed both the high-net-worth crowd and larger financial institutions start monitoring cryptocurrency and begin to invest in it, as well. It is an exciting time.

Andre: What about this space is most exciting you right now?

Brayton: For the very first time, people are not only asking the question “What is money?”, but they are also exploring solutions to make money and currency better.  Of course, that was primarily driven by Bitcoin.  As people are now questioning this, they are beginning to also ask:  “Can society decentralize money? Can we remove government from money?”

And over the last 2 years, because of Bitcoin, people are questioning what else can be decentralized beyond currencies, and in particular, areas in which the government is involved. People are questioning institutions, their role in processes and business, and exploring if they can be removed from those industries.

Andre:  With this momentum, there must be some areas of concern in the blockchain space.  What about this industry is making you the most nervous and worried?

Brayton: Overall, my biggest worry is the irrational exuberance.  Market caps of many of these cryptocurrency projects are grossly over what the project has actually delivered. Many market caps are in the hundreds of millions and there is no working product.

Left and right, people are becoming self-proclaimed crypto investors and are only making money, not losing money. Most of the new market participants have never seen a downturn. This makes investors, as a whole, think investing in this industry is “easy money”.

However, they are failing to look at what is on the near to mid-term horizon. At some point in the next couple of years, we will see regulation shut down a large amount of these coin projects. We also are likely to see that many of these coins don’t serve an important purpose and like many startup companies, will fail.

Practically, I am worried about regulation.  People are not taking the regulatory bodies seriously. They think the decentralized nature of the crypto projects circumvent government authority.  This is plain wrong.

I strongly believe that in the next couple of years, laws will be put in place and government regulations and parameters will be implemented in the cryptocurrency space. Because of that, some projects will be negatively affected and may outright fail.  

Andre:  What areas, in particular, do you think the government will regulate?

Brayton: The U.S. government cares about three main things and this is where we will see them step in:

  1. Taxes (IRS). Given the decentralized nature of these coins and some of their privacy features, figuring out how to compel coin owners to self-report has been very difficult. The IRS is laser-focused on how to make sure coin owners pay their fair share of taxes.
  2. Securities Law (SEC). Many of these ICOs have issued coins that should be classified as securities and therefore subject to securities laws. Yet, most of these projects have not followed SEC guidelines on the issuances of these securities. The SEC is beginning to investigate and explore crypto projects that may have committed securities fraud or broken forms of security law. It is yet to be determined as to how they will punish these actors. We do know for a fact that cryptocurrency is a focus of the SEC.
  3. Anti-Money Laundering/Terrorism (DHS). Given some of the privacy features associated with cryptocurrencies, there is every opportunity for bad actors to utilize the coins as a way to fund terrorism, drug cartels, etc. One of Bitcoin’s first use cases was on Silk Road, the web-based black market that sold items and services ranging from heroin to hitmen, which was later shut down by a combination of the DHS and FBI. The DHS and other U.S. agencies will be focused on how to stop this technology from being used to enhance the funding of illegal activities.  

These bodies will be focused on this industry, how to best regulate it, and remove some of the bad actors in the space. And trust me when I tell you, there will be many shady characters who will be called out and punished for their fraudulent and manipulative actions in this industry.

Andre: We often hear about the “Bitcoin” or “Crypto” community. What is this community thinking about as it relates to blockchain technology and its use cases?

Brayton:  Blockchain by design eliminates the need to trust a third party. Historically, trust needed by a 3rd party cost money. Blockchain enables the removal of third parties since the blockchain itself is truth. And, because it is software, you do not pay for that third party.

Proof of ownership is the key behind the ledger and blockchain. And it is not limited to money. It relates to real estate deeds, proof of ownership of digital goods, contracts, etc…  While the rise in cryptocurrency prices has been fascinating and hard to ignore, entrepreneurs who are involved directly in this space are most excited to see blockchain positively impact the entire world and many of the daily activities and critical functions that help society function.

I should mention, in my opinion, I believe that a considerable amount of the cryptocurrencies now in circulation will eventually fail. There are too many cryptocurrencies chasing the same carrot. Some of them likely will end up getting in trouble due to fraud, misleading statements, etc. This will be a much-needed awakening for the crypto market.

Andre: Earlier, you mentioned involvement by U.S. based government agencies.   How do other nations’ governments view these currencies? Are there some that are more open to cryptocurrencies and others that are more cautious, versus the U.S.?

Brayton:  Some countries, such as Denmark, Sweden, Canada, and others, are positioning themselves as friends of the cryptocurrency space.  

I think the countries focused on creating “crypto-friendly” environments are very smart. There is a massive opportunity for any individual or group of countries to be considered the “capital of crypto”.  It would be similar to the U.S. being considered the hub of the internet and therefore reaping the benefits of being the home to the top technology companies in the world.

Should a country become the capital of cryptocurrency, it will see tens of thousands of talented engineers and professionals moving in to work on cryptocurrency and the various blockchain applications. The (tax) revenues associated with that, along with increased demand for housing, goods, etc., in those countries, will be massive and can change an entire country’s economy.

Andre: What if, in the worst case scenario, these projects are completely rejected by all governments.  If that occurs, can these currencies thrive, or even survive, outside of government acceptance, or could they be absolutely shut down?

Brayton: Yes it could survive and no it can not absolutely be shut down. Shutting down this system, from a government’s perspective, is nearly impossible. If mining became illegal, it would literally take only a handful of computers worldwide to maintain the system.

View this similarly to the gold rush. Did the government grab all the country’s gold? No. Like gold, Bitcoin is too distributed for the government to seize total control.

The only technological way that government could kill Bitcoin is if it placed more resources behind mining than currently exists within the decentralized mining system.  If the government finds a way to own 51% or more of hashing power, they could potentially freeze or alter the Bitcoin network. I think this is highly unlikely.

The U.S. government, in particular, has shown interest in wanting to learn more about cryptocurrency, blockchain, and the implications and benefits of these systems. The U.S. government and other governments recognize that these cryptocurrency projects are global and many of the blockchains are primarily maintained and supported (via miners) outside of the United States.

If one country bans a cryptocurrency from being used or mined within its jurisdiction, it does not kill the currency or its potential use cases. If anything, the outright banning of a certain cryptocurrency may, in fact, increase that cryptocurrencies value and utility.

Andre:  Moving away from regulatory risk, can you explain how one can buy a Bitcoin? And related, how can an investor be comfortable they will not be defrauded?

Brayton: With cryptocurrency, security as it relates to coin theft or a hacked wallet is generally all about keeping private keys safe. The problem is that for an average investor, being able to securely purchase and store cryptocurrency is both difficult and requires some level of technical prowess.  

Crypto security is a growing industry right now. However, the solutions are still extremely difficult for the average investor to manage.  Currently, I recommend smaller investors use Coinbase to purchase Bitcoin, as it is the easiest solution in the marketplace today.

With Coinbase and other like crypto exchanges, technically, those exchanges own the currency and the associated private keys on behalf of the purchaser. This is a major risk to all investors who purchase on these sites and something they must realize. The worst case scenario leads to Bitcoins being lost in a hack along with any other Bitcoins stored on any given exchange.

As an investor’s sophistication grows or their portfolio grows, I would begin looking into cold storage solutions. Cold storage solutions mean that you, the purchaser, truly own your cryptocurrency and the private keys. There are a variety of cold storage methods. In almost all cases, cold storage is a smarter way to store one’s cryptocurrency vs. on a public exchange.  

The trade-off between security and convenience is a big one here.

Andre: How secure is the blockchain itself? Can the software that runs these coins and projects, blockchain, be hacked? Is this an investor concern?

Brayton: The Bitcoin and Ethereum blockchains today, as we know them, are secure.  I reference these two since they are the largest and longest standing without hacks.

With that said, these are emerging technologies. They are susceptible to attacks, hacking, etc… Yet, they have proven to be virtually bulletproof so far.

Keep in mind that Bitcoin currently holds $100b+ of market value.  This provides an awful lot of incentive and temptation to crack. If someone in the world figures out a way to break Bitcoin and its code, even a fraction of it, they may have access to some of that $100b in value. You couldn’t ask for a bigger potential bounty.

Therefore, investors should realize that the blockchain is constantly being explored and prodded for weaknesses and potential errors by hackers. Every day it is not hacked adds to its credibility and security.

Andre: How easy is it to lose Bitcoin, whether it be because of technical incompetence or some other factor? What happens if I sent a Bitcoin to a wrong address or forget my wallet address and private keys?

Brayton: One of the biggest issues with the cryptocurrency space is that, because it is such a young market, most of the tools, services, and products are not user friendly. Therefore, errors on a user’s end are very possible. There are a handful of ways to lose Bitcoin:

  1. If you store on an exchange or brokerage, and that exchange is hacked, there is no government agency to bail you out for the funds that have gone missing (and most of the exchanges would cease to be in business if that happened to them).
  2. Your email, phone, and computer can be compromised which allows hackers to sign on to your exchange and brokerage accounts and steal from it.
  3. The technology interfaces are very young and technical. There is no “undo” button.  Sending money to the wrong address means it’s gone forever.
  4. One of the best methods for storing Bitcoin is a method called: cold storage.  In this method, you own and hold the individual keys associated with your Bitcoin, similar to owning the actual certificate of a stock associated with an equity.  The Bitcoin is not held on an exchange. However, because you own and control those keys (which are long lines of numbers and letters), the risk remains of losing Bitcoin. If your computer gets hacked and somebody gets access to your keys, you lose the keys, etc., you run the risk of having your Bitcoin stolen.

Bottom line: proceed with caution!

Andre:  If one of our clients decides they want to invest in the cryptocurrency space, what would you advise them to consider buying or avoiding?

Brayton: The first thing I tell individuals who want to be involved in cryptocurrency, whether it be via becoming an investor in coins, investing in the companies that are making new tokens and running projects, or investing in a crypto fund, is to actually use the currency.  

Take a very small amount of the capital you want to invest and buy Bitcoin (BTC) and Ethereum (ETH). Send fractions of amounts to other wallets, to merchants that accept the currency, and to friends and family.  The client must familiarize themselves with the technology, how it works, and how the transference of these coins works, and the power of the blockchain, before becoming an investor in it.

For a novice looking to purchase a small amount of cryptocurrency, I would buy BTC and ETH, as they are the two top market cap coins.  They are clearly the leading coins in terms of community, developer network, etc… They have different use cases and different features. From my perspective, both can be wildly successful for entirely different reasons.

For larger investors, there are a handful of investment funds available. Many of them, given the market over the last 12-24 months, are all showing impressive return metrics. My recommendation is to explore investing in funds that have the flexibility to invest both in coins/tokens and in the equity associated with some cryptocurrency companies.

Andre: Will Bitcoin always be the king of crypto? Do other currencies have a shot at occupying the top spot?

Brayton: Right now, BTC has the network effects in its favor, it was first to market, and it is truly decentralized.  It would be very hard for another coin to overcome Bitcoin, but, there could be a scenario where something takes over.

The decentralization of the coin is a critical point. All new cryptocurrencies clearly have founding teams and a founder that controls a large portion of the coin’s development and growth.  This creates centralization, which is one of the characteristics of traditional currency that cryptocurrency was supposed to eliminate.

Bitcoin is the reserve currency of crypto.  All cryptocurrencies peg their value to Bitcoin. It would take a catastrophic event for Bitcoin to be removed as the reserve cryptocurrency.

Andre:  In the 1849 gold rush, companies that provided services to the miners made large amounts of money selling pans, picks, jeans, etc..  Most of the miners themselves went bankrupt. Investing in Levis would have been a better investment than gold at the time.

How would you contrast investments in the tokens and coins of cryptocurrencies vs. companies that are utilizing blockchain technology to create services and products?  Are there parallels we should be drawing here?

Brayton: Like with any investment strategy, especially in a new and emerging market, it is totally undefined who the winner is (the coins or the projects using blockchain).

My fund, Boost.VC, has direct exposure to cryptocurrencies themselves (Bitcoin, Ethereum, Aragon, etc.) and also exposure to and investments in the equity of companies building in the crypto space (exchanges and hardware companies like Coinbase, Ledger, etc…).  

I obviously think this is a superior way to invest in the space. It is a dual approach in ownership via owning part of the actual tokens and companies. It is unclear which side will be the ultimate winner in the space – so, for the time being, we prefer to own both.

Not all tokens and coins are created equal. Some token projects accrue value on the token layer while others accrue value on the project layer. Therefore, realize that some of the tokens may never appreciate or may not need to have a value, yet, their projects may be highly successful.  

In other words, there are other tokens that do not require value or appreciation in their coins for the projects to work. Some of the coins may not rise in value at all, while the actual companies could be hugely successful.  In that scenario, it is better to own the equity in the company/project instead of the coin or token of that company.

Andre: Sometimes when looking at these projects, we hear founders of crypto projects discuss how their coins or projects are built on top of Bitcoin, Ethereum, etc. Can you please explain what that means?  Do those projects cease to exist without their underlying coin? Are they dependent on whichever major coin they choose?

Brayton: One of the hardest things about starting a new crypto project is the integrity and security of the blockchain. A coin I am very excited about, Aragon, is building out a project using blockchain that will eventually allow for decentralized government and organization models. Some call it digital jurisdiction. In order to jumpstart their project and have security and integrity associated with their coin and project, Aragon decided to build their coin on top of Ethereum and leverage the security of that ETH blockchain.

Building “on top of” reputable projects like BTC and ETH only enhance the security of those projects. Because of this phenomenon of building on top of BTC and ETH, BTC and ETH inherently become more critical in the cryptocurrency ecosystem given their association with so many other coins.

These coins can build and exist within their own blockchains, however, if their community is not large enough and the support isn’t at the level required, their blockchains will fail. Therefore, building on top of BTC and ETH is, as of now, a common decision made by new crypto projects.

Andre: Whether it be a coin or equity ownership in a cryptocurrency project, it seems like the market is inflated. Are we in a bubble? Does Bitcoin going from under $100 in 2013 to over $15,000 in December of 2017 worry you?

Brayton: Ok, Andre – short answer for you is: short-term we are in a bubble, yes. But long term, no. Cryptocurrencies will have a market cap, eventually, much larger than today.

Prices of projects today are greatly inflated compared to the status of what the projects have delivered.  Some of these projects have yet to deliver a product, yet, they are receiving $100m+ valuations. That said, there are some projects today, that if they work as the developers believe, can absolutely rise much higher than they are today as they will have major positive effects on the world’s population.

While the analogy is used often, I view an investment in Bitcoin and other cryptocurrencies as similar to investing in Amazon, Ebay, Google, at the inception of these companies and when the internet was still young and the power of it unknown. I view Bitcoin as undervalued and I would absolutely be an investor today at the current prices.

Andre: As we wrap up, any final thoughts or words you would like to share with our clients?

Brayton: Crypto is one big R&D project. Nobody knows what is going to work but we all have a shared vision for the future. We are all running experiments and hoping we find the “next big thing”.   So, view this as an absolutely risky allocation/investment, especially in many of the newer projects. 2017 brought a new asset class – cryptocurrencies. They were used for little more than speculation – eventually, these currencies must have utility or something from which to derive value or else they will rapidly drop to zero.

I think that in 2018 we will start to see the use cases emerge outside of speculation. It will be a year where crypto teams need to deliver on some of their promises related to their companies and projects.  Keep an eye on those projects that start getting real traction because they will certainly stand out.

Andre: Thanks for the time and thoughts, Brayton. We look forward to the next conversation and wish you the best of luck on your new fund!

CHAIN REACTION: UNDERSTANDING CRYPTOCURRENCIES AND BLOCKCHAIN

CHAIN REACTION: UNDERSTANDING CRYPTOCURRENCIES AND BLOCKCHAIN

By Jon Porter and Andre Huaman

“The root problem with conventional currency is all the trust that’s required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust. Banks must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles with barely a fraction in reserve. We have to trust them with our privacy, trust them not to let identity thieves drain our accounts.” -Satoshi Nakomoto

What is Bitcoin, the Blockchain, and Why Care?

In 2008, a psuedo-anonymous individual, ‘Satoshi Nakamoto’, released a paper that described a digital currency he was developing called Bitcoin and the underlying technology that enabled Bitcoin, referenced as the blockchain.  In 2009, Satoshi released the first Bitcoin software and began further developing it with a close handful of other scientists, engineers, and cryptologists he trusted.

In 2010, Satoshi handed over the control of Bitcoin source code (some of the keys of Bitcoin) to a set of early Bitcoin adopters/engineers, and left his role as the head developer of Bitcoin.  Since then, he has yet to be identified, has not worked on or influenced the Bitcoin project, and has not transferred or spent any of his 1 million Bitcoins.

This article is the first part of a two part series in which we attempt to answer the questions:  “What is blockchain (and by proxy, cryptocurrencies), should we be investing in it, and if so, how?”  However, it is impossible to address whether we “should be investing in this, and if so how?”, without first understanding  blockchain and cryptocurrencies.

As such, this first article is dedicated to a plain English (hopefully) explanation of those technologies.  A crypto-primer, if you will.  We will explain the underlying platform for all cryptocurrencies that is blockchain technology, cryptocurrencies, and why they are important.

In part two, we will engage in a detailed Q&A with a recognized blockchain expert, in an attempt to better understand the relative risks and rewards associated with Bitcoin, blockchain and cryptocurrencies, and in so doing, provide a framework for answering the questions: “Should we invest in this, what are the risks, and what should we know about this space?”

Satoshi and the small group that began working on Bitcoin were tired of governments manipulating money supply, interest rates, and currency pricing, for their own purposes.

Booting up to Speed…

Never in our collective investment management careers have we had so many people ask about the same topic, at the same time.  Blockchain has clearly moved out of the realm of theoretical, and firmly into the reality of the here and now. It has serious potential implications to the way certain transactions are processed, and the systems that support them.

Why did blockchain technology suddenly become mainstream?  In one sense, and on the surface, it is because of the rapid rise in value of certain cryptocurrencies, mainly Bitcoin.  When something goes up 1000% in one year, it acts as its own marketing machine, which turns into a self-fulfilling prophecy.  People take notice.

However, one must dig deeper into the origins of blockchain to really understand why it was invented in the first place.  The advent and proliferation of blockchain technologies was in response to the types of governmental currency manipulations detailed in our November Blog.

Satoshi and the small group that began working on Bitcoin were tired of governments manipulating money supply, interest rates, and currency pricing, for their own purposes.  Their response was to write code that would create an entirely new digital-only currency, Bitcoin,  that was immune to manipulation, and whose pricing was set not by a centralized government. Rather, the price was set by the parties engaged in the creation and then later distribution and ultimately the marketplace trading of Bitcoin itself.

In order to understand how this came about, and how Bitcoin and other cryptocurrencies are structured, one must first understand blockchain technology.

What is a Blockchain?

The terms “blockchain” and “cryptocurrency” are neither interchangeable nor synonymous, yet both rely heavily on one another. Blockchain is a public database and transaction processing technology.

Imagine a spreadsheet, containing information about transactions and data, that is duplicated thousands of times across a network of multiple different computers. And then imagine that this network, which tracks transactions and other forms of data,  is regularly updating and validating those changes to this spreadsheet. This is blockchain.

Breaking it down into its fundamental components, a blockchain is:

  • A peer-to-peer database (with copies of the database replicated across multiple computers),
  • of transactions (between two or more parties)
  • split into blocks (with each block containing details of the transaction such as the seller, the buyer, the price, the contract terms, and other relevant details),
  • which are validated by the entire network via encryption by combining the common transaction details with the unique digital signatures of two or more parties.

Full stop.  Now go back, and re-read each of those bullet points slowly and methodically, until you are comfortable with each part.  This is the foundation upon which everything that follows, including cryptocurrencies, is built.

The heart of blockchain’s potential lies in the unique properties of a distributed database and how it can improve transparency, security, and efficiency.

How Does Blockchain Work?

When an individual chooses to join a blockchain network, they can download a copy of the blockchain software onto their computer.  Each computer, or peer, in the network has a full copy of the blockchain, which is nearly impossible to manipulate or change.  When a computer has the full copy of blockchain downloaded and installed, it becomes what is referred to as a “node.”

The heart of blockchain’s potential lies in the unique properties of a distributed database and how it can improve transparency, security, and efficiency. Historically, organizations used databases as central data repositories to support transaction processing and computation. Control of the database rested with its owner (a company’s servers, hardware, etc) who managed access and updates, limiting transparency, scalability, and the ability for outsiders to ensure records were not manipulated. A distributed database, which blockchain is, was practically impossible because of a myriad of technological limitations. But advances in software, communications, and encryption now allow for a distributed database spanning multiple organizations and individuals.

In its purest form – as used by Bitcoin to create and track units of the cryptocurrency – blockchain is a shared digital ledger of transactions recorded and verified across a network of participants in a tamper-proof chain that is visible to all.  Permissioned or private variations add a layer of privileging to determine who can participate in or view a particular chain.

Blockchain how it works

Blockchain’s Primary Benefits

So why is everyone so excited about this new type of decentralized database technology?  Why is everyone saying this is the “next biggest thing since the Internet?”  Because blockchain technology, for many types of transactions, blows traditional databases out of the water in terms of security, transparency, and efficiency.

Security

Blockchain relies on encryption to validate transactions and activity by verifying the identities of parties involved in a transaction. Further, each person on the system has a unique, encrypted, “digital signature” identifying the person; like a digital fingerprint of sorts.  This ensures that a “false” transaction cannot be added to the blockchain without the consent of the parties involved.

While discussed in greater detail in the “mining” section below, in order for a transaction to be completed, a complex mathematical calculation known as a “hash” is performed each time a transaction is initiated. The transaction data, including the digital identities of the parties involved in the transaction, what is being transferred, and all previous transaction history, is verified by the complex network of computers. This process ensures that no fraud, double spending, or other erroneous actions or transactions are taking place.

And because the network is decentralized and maintained by thousands and thousands of computers, no one party has a monopoly or the ability to alter or manipulate transaction data or future transactions.

The fact that the current state of the blockchain depends on previous transactions ensures that a malicious actor cannot alter past transaction data. In effect, every time a new transaction occurs and is completed, the network of computers that maintain the blockchain are all updated to reflect the new transaction and its place in the database.

Transparency

By its very nature, blockchain is a distributed database that is maintained and synchronized among multiple nodes – for example, by multiple parties who transact with each other frequently.

In addition, transaction data must be consistent between parties in order to be added to the blockchain in the first place. This means that by design, multiple parties can access the same data (in some cases locally within their organizations).

This significantly increases the level of transparency versus conventional systems that might depend on multiple “siloed” databases behind firewalls that are not visible outside a single organization.

In practice, at any time, one can to go online and search the transaction history of any Bitcoin wallet that exists. While the person’s name may not be known, the unique ID that holds their cryptocurrency can be found publicly along with seeing on what dates that person either sent or received cryptocurrency. So, while transparent, there is also a layer of privacy.

Efficiency

Conceptually, it seems counterintuitive that maintaining multiple copies of a database with blockchain would be more efficient than a single, centralized database.

However, in most real-world practical applications, multiple parties already maintain duplicate databases containing information about the same transactions. In many cases, the data pertaining to the same transaction is in conflict – resulting in the need for costly, time-consuming reconciliation procedures.

Employing a distributed database system like blockchain across multiple organizations can substantially reduce the need for manual reconciliation, thus driving considerable savings across organizations.

In addition, in some cases, blockchain offers the potential for organizations to develop common or “mutual” capabilities that eliminate the need for duplication of the same effort among multiple organizations.

Although the world of digital currencies may seem completely novel, almost every single one of us has used a form of digital currency:  credit cards.  No physical money is actually ever exchanged, but ledgers of who owns and owes what are transferred digitally.  The primary difference is that cryptocurrencies, in particular, Bitcoin, are not secured by people, trust, or a centralized database, but rather by the mathematical underpinnings of the blockchain which we discussed above.

…cash is exchanged for the cryptocurrency at an online exchange, and the rights to the cryptocurrency are transferred across the network to the new owner.  Technically, the parties are merely exchanging the rights to a digital block on the blockchain.

Cryptocurrency?  Does Webster know about this?

“Cryptocurrencies” are simply a type of digital asset that leverages blockchain technology in order to create, store, and trade the currency (each unit of a cryptocurrency is called a “coin” or “token”). The name “cryptocurrency” is derived from the fact that these types of currencies use cryptography to secure the transactions and control the creation of new coins within the same blockchain.  Bitcoin is an example of a cryptocurrency.

Cryptocurrencies don’t move around as do conventional currencies or money.  Rather they stay fixed on the public ledger called a “blockchain.”  When it comes to blockchain, remember to think of a “ledger” as a giant Excel spreadsheet that tracks who owns what cryptocurrency and who is trading what amounts of a particular cryptocurrency at any given time.  Except this particular ‘Excel spreadsheet’ is instantaneously updated, everyone who is participating in the cryptocurrency has a full and accurate copy on their computer at all times, and it is nearly impossible to hack.

As a result, people don’t “exchange” coins, they simply change ownership of a particular part of the blockchain ledger.  Anyone with access to the blockchain can check ownership by checking the public ledger.

In such a transfer, cash is exchanged for the cryptocurrency at an online exchange, and the rights to the cryptocurrency are transferred across the network to the new owner.  Technically, the parties are merely exchanging the rights to a digital block on the blockchain.  Nothing physical is moving or is held  (contrast this to gold).

The new owner can choose to hold the cryptocurrency, or theoretically convert it to cash or exchange it for other cryptocurrencies.  We say theoretically because there has to be someone on the other side of that transaction willing to buy your ‘coin’ with cash or exchange it for other types of coins.  More on that potential pitfall in part 2 next month.

As we’ve discussed, because of the way cryptocurrencies work, the blockchain ledger makes it difficult to commit fraud.  One can’t spend someone else’s coin, because everyone knows who owns them (based on the public ledger).  One can’t spend the same coin twice, because the network keeps the ledger up to date and there’s only one ledger.  If the same person tried to spend the same coin twice, everyone would know because the ledger is visible across every blockchain participant and the transaction would be stopped by the system.

When launching a new cryptocurrency, one of the critical decisions is to choose the “mining” method.

How do Cryptocurrencies Store Value?

There are now over 2000 cryptocurrencies on the market, such as Ethereum, Monero, and ZCash, with more coming every day.  So it is imperative to pay attention to how these cryptocurrencies intend to retain their value, if they are to act as surrogates for money.

Recall from your high school economics classes that “money” must possess six key traits:

  1. A medium of exchange
  2. Portable
  3. Durable
  4. Divisible
  5. Fungible, and drumroll….
  6. A store of value

From what we have reviewed above, it is readily apparent that blockchain technology enables cryptocurrencies to satisfy the first 5 requirements of money.  It is the last requirement, that it be a “store of value” to which we now turn our attention.

Remember that just like any currency, cryptocurrencies are only as valuable as those that are trading them believe them to be.  Merchants accept dollars in exchange for goods because they have faith that the paper money, or the credit card ledger that corresponds to that paper money, is a store of value, and can be exchanged for other things of value.

It is therefore critical to understand exactly how a blockchain system creates additional coins, incentivizes participants to maintain the system, and is a mechanism with the potential to maintain and increase value.

Mining Cryptocurrencies

When launching a new cryptocurrency, one of the critical decisions is to choose the “mining” method.  Every cryptocurrency is forced to choose between two methods; ‘Proof of Work’ or ‘Proof of Stake’.  Coins can only use one and the method they choose depends on a variety of factors including on which blockchain they are building, the goals and objectives of the project, and the goals for their community.

Proof of Work (“PoW”)

One of the core events that must continuously take place in order to maintain the cryptocurrency ecosystem and blockchain is “mining.”

Approximately every 10 minutes, a number of Bitcoin transactions are grouped together into what is called a “block.”  These transactions might be a son sending Bitcoin to his grandmother or a financial institution buying cryptocurrency for the first time. Regardless, these crypto transactions are grouped together into a consolidated block.

These blocks, each containing multiple pending transactions, are turned into a mathematical problem/puzzle. In order for these transactions to be approved, verified, and completed within the blockchain, those math problems must be correctly solved.

Insert miners.  Miners, which are effectively very powerful computers, compete to be the first to solve the math problem. Once the first miner solves the problem, it announces to the network that it has been solved. Other miners then verify the equation is correctly answered.

Once verified for accuracy, the transactions represented in the block are allowed to be completed and added to the public ledger on the blockchain.  The grandmother receives her Bitcoin and the client receives his or her cryptocurrency.  The miner who found the solution and answered the equation for the block is rewarded by being given the cryptocurrency they are mining for.

So, miners are rewarded in cryptocurrency. This mining process, which is happening at all times, is the function that not only upholds the integrity of the blockchain, but also distributes newly minted cryptocurrency into the ecosystem at a predetermined rate.

The cryptocurrency mining reward, and therefore the value of the associated coins, is required as it acts as an incentive for the miners to utilize their computing power, electricity, and time to mine.  If Bitcoin was worth $0, why would people volunteer and/or be in the business of mining? Why would they have their supercomputers run 24/7, solving math problems, when being rewarded nothing? Without value in the underlying coin, miners would have no reason to utilize their resources to support the system (hence, why Bitcoin and other true cryptocurrencies need value).

The above is how mining works for Bitcoin, the most reputable and oldest standing cryptocurrency.  As of late, a new style of mining, called “proof of stake” has entered the field as a positive alternative to proof of work.

Even as traditional IPOs have slowed to a historical trickle, there were almost 300 Initial Coin Offerings (ICOs) in 2017, with a total of over $3.7B raised.

Proof of Stake (“PoS”)

Proof of stake is another way a blockchain can validate and approve blockchain transactions. Unlike PoW, where the winner of the block reward is determined based on computing power and the ability to solve mathematical problems, PoS currencies approve transactions by utilizing resources from current owners of the coin, who publicly “stake” their coins in order to help validate the system.

In PoS, owners of the coins are semi-randomly selected to create or “forge” blocks, validate them, and approve their inclusion in the blockchain. The more coins you have, the higher chance you have of being chosen by the system to forge the block.  This process is less energy intensive than PoW and rewards current users for owning a portion of the coins.

PoS helps avoid several downsides of PoW, including:

  • Reduces need for expensive hardware
  • Reduces energy spent on powering the hardware
  • Faster and more efficient validations
  • More loyalty amongst coins

Some potential PoS downsides include:

  • Reduced security
  • Small group of owners taking over system

The industry is still debating which type of mining system is best.  However, we have examples of both in the cryptocurrency marketplace today and expect the discussion to continue.  When a new cryptocurrency is developed, it is required to choose either PoS or PoW. That decision determines a major part of how the new cryptocurrency will operate.

How long before traditional credit cards and checks, built on outdated 1970’s era technology and security, are obliterated by blockchain the same way email replaced snail mail?  The answer:  not as long as you might think…

Is ICO the new IPO?

Initial Coin Offerings (ICO) have become a popular way to fund both cryptocurrency projects and the companies that promulgate them.  An ICO is an event whereby a new blockchain/cryptocurrency project sells part of its cryptocurrency tokens to early adopters and investors in exchange for money.

Even as traditional IPOs have slowed to a historical trickle, there were almost 300 ICOs in 2017, with a total of over $3.7B raised.  There are more planned for 2018 with the estimated total amount to be raised topping $5B.

Funds raised for Blockchain

Essentially, ICOs are a fundraising mechanism.  The ICO usually takes place before the project is completed, and helps fund the expenses undertaken by the founding team until launch.  Similar to IPOs (hence the name), ICOs are used to sell a “stake” and raise money. Both have investors who see the potential of a particular project or coin and risk their capital for a potential reward.

While we will discuss the potential hazards of ICOs, and there are many, in part two  next month, we would be remiss not to mention that many recent ICOs have resulted in scams, fraud, and misleading projects.

When will Blockchain Technology Really be Adopted?

Consider this:  credit cards typically take between 2-3% in transaction fees for every purchase made.  Blockchain and cryptocurrencies can take far less due to the efficiency of digital ledger technology.

Similarly, when someone writes a physical check, you take it to the bank, physically deposit it, and wait for the check to clear based on your bank’s verification.  That process is slow, usually taking a few days for a check to “clear” and funds to hit your account, or the check might bounce.

How long before traditional credit cards and checks, built on outdated 1970’s era technology and security, are obliterated by blockchain the same way email replaced snail mail?  The answer:  not as long as you might think…

Although blockchain is still nascent from an adoption standpoint, the horse appears to have left the stable.  Most of the experts expect to see early-stage technical prototypes within the next two years, with limited market adoption in 2-5 years, and broader acceptance in 5-10 years.

However, a variety of industries could begin to implement blockchain-based identity and reputation management systems in relatively short order.  They extend from identity theft, real estate contracts, insurance, and more.  In capital markets, expect to see a series of early prototypes over the next two years on a limited scale and with limited numbers of participants.

Broader market acceptance is likely to take as much as 10 years given the regulatory oversight required and a large number of market participants in large-scale markets such as cash equities in the US.

Summing Up

Blockchain, as a technology, is eventually going to fundamentally change the way many types of complex transactions are processed.  And, in the more immediate sense, blockchain technology has enabled the creation of a myriad of cryptocurrencies which are challenging the way we think about money and currencies across the board.

This primer to next month’s deeper dive is designed to help understand the key terms and concepts that form the framework for blockchain and cryptocurrencies.  Next month we will take this newfound knowledge and, through Q&A with a cryptocurrency expert, attempt to answer the questions “should we invest in this, and if so, how?”

Until then!

Three Bell Capital – Forbes #1 Emerging Wealth Advisor

Three Bell Capital – Forbes #1 Emerging Wealth Advisor

A letter from the CEO:

Happy New Year! As we officially kick off 2018, I wanted to share some very exciting news about Three Bell Capital. Thanks to our dedicated team, loyal clients, and innovative partners, Three Bell Capital was recently named the #1 Emerging Wealth Management Firm in the U.S. by RIA Channel on the Forbes list of Top 100 Emerging Wealth Management Firms.

Over the past six years, we have carefully assembled a team of talented, experienced, intelligent professionals, to provide the best possible service and advice to our private wealth management and corporate retirement plan clients.

As a result, our team has the distinct honor of working with some of the most prolific entrepreneurs and innovative companies in the world. By taking on all aspects of our clients’ financial lives, we enable them to focus their time and energy on their entrepreneurial endeavors and bringing game-changing services and technologies to market, while generating lasting wealth for their families.

We could not effectively assume the comprehensive role that we do, without the help and expertise of our carefully-vetted network of professional advisors, which include CPA’s, tax advisors, estate planning attorneys, insurance specialists, mortgage agents, and investment bankers.

As we head into 2018 as the #1 Emerging Wealth Management Firm in the U.S., we are incredibly grateful for our clients’ trust, our partners’ support, and our team’s hard work, and we look forward to continued shared successes in 2018.

From the article:

“Based in Silicon Valley, Three Bell Capital works with many entrepreneurs and start up businesses. Their focus on alternative wealth building strategies coupled with delivery of comprehensive planning services has served their clients well. Three Bell Capital is also almost 100% referral-based.”  READ MORE

Happy new year!

–– Jon

Three Bell Capital - Jon Porter Signature

Forbes’ Julie Cooling recently spoke with our CEO Jon Porter. Watch the interview!

There are certain disclosures that apply to awards and recognitions. Read about those here.

A View of the Economy: Coming and Going

A View of the Economy: Coming and Going

“You Can’t Know Where You Are Going Until You Know Where You’ve Been” ~ Maya Angelou

As an institutional asset manager, I often compared quantitative investment management to driving through the rear-view mirror.  The view looking backward offers clear 20/20 vision that allows investors to update their inputs and dial settings while relying on objective analysis and eliminating emotion.  The problems arise around corners or “inflection points” in the economy… where we tend to “oversteer”.  The quantitative approach has both positive and negative aspects.

On the other hand, fundamental management is akin to driving while looking through the front windshield during a rainstorm with broken wipers and bugs plastered to the glass.  This provides a somewhat blurry vision of what is coming, but at least the view is forward, providing the ability to course correct – typically more subjectively.  Once again, there are positive and negative characteristics associated with this style of investment management.

The “Holy Grail” is to be able to merge these two completely different, time-tested approaches.  Today, we will look backward with perfect hindsight and use what we learn to clean our screen for a clearer view of what lies ahead.

2017 In Rear View – Where We Have Been

Season’s Greetings – The US stock market has already put together 13 consecutive months of positive returns… an all-time record!  

Key Market Indicators and Market Review:

YTD % Return as of 12/21/2017

S&P 500 (Large Cap Core) +22.2

Russell 2000 (Small Cap Core+14.8

Russell 1000 Growth (Large Cap Growth) +30.5

Russell 1000 Value (Large Cap Value) +13.0

MSCI All Country World Index ex-US +25.2

EEM (Emerging Market Equity) +33.5

AGG (Bloomberg IG bond)  +2.9

JNK (High Yield Bond)  +5.5

In 2017, the markets enjoyed strong returns around the globe.  The strongest returns were found in emerging markets equities (EEM), followed by the MSCI All Country World Index ex-US, and then a still strong US Large Cap stock market (S&P 500).  This return pattern was very much a reflection of economic strength relative to expectations… the international economy showed a larger pick-up in growth rates relative to the US.

The bond market earned its coupon as interest rates more or less “marked time”, with 10 year US Treasury bonds yielding 2.1-2.5% throughout the year.  We did see the high yield (JNK) market do better than investment grade bonds (AGG) as credit spreads tightened.  However, we are now very near record tight credit spreads, so the risk/return outlook is unfavorable for High Yield debt from these levels.

Within the US, we saw a return to a strong ‘Growth’ market (Russell LC Growth) over the ‘Value’ sector (Russell LC Value).  This was predominantly a reflection of a weaker US dollar and stronger growth overseas. The large multinational ‘Growth’ companies were best positioned to benefit from strength in overseas economies.  We once again saw Small Cap stocks lag Large Cap stocks. Looking forward, Value and Small Cap (RUY) stocks appear inexpensive relative to Large Cap Growth and could benefit most from potential changes to the tax policy.

Three Market Drivers in 2017-

  • Markets climbing a wall of worry
  • Anticipating tax reform
  • Relatively easy comparables for earnings and GDP vs 2016

Global Thermonuclear War starts on the Korean Peninsula, ISIS/terrorist strikes damage infrastructure in the Middle East and beyond, cyber-warfare, bio-hazardous germ warfare, drought, pestilence, locusts, frogs, and alien invasions are the usual suspects…

Climbing the Wall of Worry

An old adage says “The stock market climbs a wall of worry”. This simply means that as the stock market rises as a whole there are more and more investors that believe the existing rally will come to an end. But, the higher it goes, the more greed takes over and more and more investors jump on board and continue to invest.  The more this behavior continues, the more prices continue to rise, thus fueling the rally and creating a self-fulfilling prophecy.  

At some point, the rally becomes based more on price movement than fundamental value of the underlying stock.  And as the other saying goes, “the bigger they are, the harder they fall.”  The higher up the worry wall the market climbs, the more precipitous the drop when the market loses its footing.

Right now, there are three primary “worries” that comprise the current wall.  We are paying particularly close attention to Geopolitics, Rising Interest Rates, and Valuation.

Geopolitics/Black Swan Events-

Global Thermonuclear War starts on the Korean Peninsula, ISIS/terrorist strikes damage infrastructure in the Middle East and beyond, cyber-warfare, bio-hazardous germ warfare, drought, pestilence, locusts, frogs, and alien invasions are the usual suspects that are often included in this category.  

These outcomes are impossible to score. However, it appears clear that our allies are increasingly disillusioned with our role and our enemies are more emboldened and on alert.  The ‘end of the world clock’ has never been closer to midnight (other than 1953, when the US and the Soviet Union were both testing their first Thermonuclear devices…aka H-Bomb).

Optimists will say the US has done quite well since the time that Elvis first hit the stage, thank you.  The pessimist will say that we are on borrowed time.  The realist will say that the risks are real and we never know when the market will decide to price those risks.  All that said, the risks do seem to be rising.

However, somewhat inexplicably, the market continues its climb over each headline risk, as we have enjoyed the longest period of prolonged lack of volatility in the history of the stock market.  

Eventually, volatility will return to the market as the mean reverts, and we believe that could translate into substantial downside risk.  However, in the meantime, the market continues to climb ever higher.  

Rising Interest Rates-

Now that the Fed has begun to raise interest rates and allow the reserves accumulated through their Quantitative Easing program (last month’s blog) to unwind, investors are concerned that rates will normalize back toward 4-5%.  As 10 year US Treasury rates hold steady in the 2.1-2.5% range, investors are living with the risk and climbing over this worry, for now.

economic uncertainty chart

Notice the chart above from the National Bureau of Economic Research that shows the overall risk for a potential Global Economic Policy misstep.  The policy uncertainty index charts uncertainty through news articles, changes in political control, changes in tax policy, monetary policy, and dispersion in economic estimates.  

The chart graphically depicts what is meant by “climbing a wall of worry”.  The actual policy uncertainty is now even higher than that realized during the GFC (Great Financial Crisis).   Indeed, the market has risen in near lock-step fashion with the uncertainty index, which is counterintuitive to what investors would normally expect.  

Valuations-

No matter how we analyze market valuations, the market is at or near record high values, which has been the case for the past year.  That said, valuations alone aren’t a catalyst for a market decline.  However, valuations will determine future rates of returns which makes when you invest almost as important as in what you invest.   

From current price levels, history suggests that investors can expect approximately 2-4% annual real (after inflation) returns over the next 10 years.  

Also, the scale of the ultimate market correction (although there is nothing that states market prices MUST correct) will be impacted by the severity of the over-valuation.  So far, the market is happily rationalizing the record price levels and continues to grind higher.

The truth is that the current actual effective corporate tax rate averages 24% (not 35%)

Anticipation

Waiting for tax reforms reminds me of the iconic Heinz Ketchup commercial in the 1970’s that shows the young boy patiently waiting for his prized ketchup bottle to delicately and deliciously drip mouthwatering, flavor-filled, tomato sauce all over his burger, as Carly Simon melodiously sings “Anticipation” (Ann-ti-ci-Pay-Aay-Shun) in the background…mmmmm?  Well, this is the same scene as investors await their precious, promised tax cuts.

The market has been running on the promise of lower taxes since the election.  The administration has done a great job of selling the merits of a lower corporate tax rate from 35% to 20%.  The truth is that the current actual effective corporate tax rate averages 24% (not 35%).   When considering the level of anticipation in this tax policy, my mind races to the old adage, “buy the rumor, sell the news.”

We will dig further into the specifics of tax policy in a future blog since the final bill has passed and we know what we’re dealing with.  For now, suffice it to say… it will be a net positive for the corporate world (more so than for individuals), but likely much less so than conventional wisdom suggests.

 Inventories are a typical swing component in growth that act like an accordion.  Sometimes inventories stretch and get ahead of an economy and sometimes they lag and compress the GDP growth rate.  

Global Pick-up and Easy Comps    

The US Real (inflation-adjusted) GDP growth rate looks likely to rebound to 2.5+% in 2017 after falling below 2% in 2016. In fact, after growing at an average 2.3% rate from 2013-2015, the US economy actually slowed to 1.8% in 2016.   

The deceleration in 2016 was largely due to a stronger US dollar and lower government spending.  The stronger currency in 2016 hurt competitiveness and compressed revenues and earnings when translated back into US dollars.  The government spending cutbacks in 2016 came from a Republican Congress that was intent on maintaining a deficit hawk image.  That image has since been tossed aside, now that we have a Republican administration.  

The third temporary cause for a 2017 bounce in GDP growth is an accumulation of business inventories, which basically borrows from future growth.  Inventories are a typical swing component in growth that act like an accordion.  Sometimes inventories stretch and get ahead of an economy and sometimes they lag and compress the GDP growth rate.  

Lastly, a more positive and sustainable component of GDP growth was the pick-up in global economies and markets.  This was a far larger contributor of higher US GDP growth than anything the new administration created domestically.  The global economy showed signs of life in 2017, growing at a 3.5%+ rate after habitually slogging along below 3% since the Great Recession.  The stronger global economic growth, coupled with a weaker US dollar, finally helped US trade, on the margin.

Overall, business and personal GDP growth have been steady at about 2.25% over the past 5-7 years, with government spending, net trade deficit, and inventory accumulation providing volatility around that number.  The true test will be if the rate of GDP growth continues up over 3%, or levels-out in the 2-2.5% range that has become the norm since the Great Recession.

This “easy comparable” syndrome, which occurred due to a decent bounce in 2017 GDP growth coming off a subdued 2016, reminds me of what happens during college football bowl games each year.  During college bowl season, we find out which conferences benefitted from easy competition during the regular season.  Those conferences eventually get exposed.  As an alum of the University of Illinois, I was particularly scarred by the 1984 Rose Bowl game.  I witnessed my beloved Illini (then favored by 18 points) get trounced 46-9 by UCLA after leaving the “easy comps or competition” of the Big 10 conference.  

This year’s economy not only feasted on easy 2016 comps, but with the global economy kicking in more aggressively combined with a weak currency and inventory builds, it is as though we got an extra scholarship for a top recruit to aid in our battle this year.  The “comps” are about to get more challenging.

Is it obvious that the snow has not been spectacular here in Tahoe and I have spent too much time watching college football?

2018 Through The Windscreen – Where Are We Going?

Looking ahead to 2018, we see three themes that will shape the contour of the economy and the markets:  

  • Fiscal Policy (taxes and deregulation),
  • Monetary Policy (interest rates and currency)  
  • Productivity (particularly as it relates to wages).

Let’s examine each in turn with an eye towards how they might influence global economies and markets.

 All other things being equal, the time for cutting taxes or expanding deficit spending would have been following the Great Recession, not following the 9th year of an economic expansion.

Fiscal Policy – Stepping On The Gas

The role of government within the economic realm in a capitalist society is to 1) Create and maintain a legal framework for fairness, confidence, and incentives to prosper,  2)  Provide infrastructure to help facilitate trade, improvements to health, safety, training, and education, and 3)  Enforce regulations to deter abuses.  

After that, get out of the way.

Keynsian economists actually argue that the government should also strive to stimulate the economy through deficit spending/tax cuts during times of economic weakness, while similarly harnessing growth during times of economic overheating.  This toggling of stimulative and restrictive fiscal policies act as a governor to prevent the economy from careening too far in any one direction.  

The raising and lowering of taxes is one such toggle.  Ideally, taxes are to be raised in times of prosperity to save for a rainy day.  All other things being equal, the time for cutting taxes or expanding deficit spending would have been following the Great Recession, not following the 9th year of an economic expansion.

New Tax Policy

Let’s not sugarcoat this.  That tax reform process was sub-optimal and seemed rushed.  Most Senators, including Republicans, weren’t even given enough time to review the new tax law prior to voting on the initial bill.   Senator John McCain made it clear that he did not think it went well.

When President Ronald Reagan’s Republican party reformed tax policy in 1986 there were 33 public hearings with dozens of scorings by the Congressional Budget Office (CBO).  The bill passed 90-10 in the Senate.  

Even still, that program led to an explosion in public debt following a massive shot in the arm to the markets.  Yet the broader economy never benefited in terms of “above trend” economic growth throughout the Reagan/H.W. Bush years.  

Throughout this year’s tax reform process, there were no public hearings and the Senate used “reconciliation” to avoid needing 60 votes.  As such, the bill passed with a straight-up partisan 51-48 vote.  This tax reform bill received scary scorings from the (CBO) for its impact on the deficit.  

The CBO claims the recently approved tax bill will lead to increasing the Federal debt by $1.5T over the next 10 years. This is the case even under rosy, non-recessionary economic growth assumptions.  Think about that.  Even after 9 years of non-recessionary growth (second longest in history), the CBO scored this bill assuming no recession for the next 10 years and it is STILL expected to add to the deficit.  That means that the deficit will surely soar in the likely event that we do have a recession within the next 10 years.

The fiscally conservative Republican Party that once protected against swelling deficits appears to be conspicuously absent from the Congressional floor.

Impact of the New Tax Policy-

The reality is that the effective US corporate tax rate is already 24% (not the 35% quoted by the administration).  This means there will be winners and losers among sectors, as we move to a flat 21% for corporations.  For example, Amazon’s effective rate is currently 38% (winner), while Nvidia only pays an effective 13% rate (loser).

The biggest benefit realized from the proposed tax policy will be the eventual repatriation of US earnings/cash by US-based corporations from overseas accounts.  This should help spur mergers/acquisitions, stock buybacks and increase dividends.  The jury is still out on whether we will see higher wages and increased capital expenditures.

Our view is that any benefit of lowering the corporate tax rates will be offset by higher debt levels down the road.   The new tax bill should provide short-term gains for the stock market at the expense of long-term challenges to our deficit.  Sadly, this appears to be the modus operandi for both sides of the aisle in our modern day Congress.  

Deregulation

Deregulation will help certain industries (domestically oriented financials, retail, energy, and segments of healthcare), while likely hurting others (multi-nationals).  Unfortunately, the short-term gains will not come without potential long-term pain down the road.  

Take for example the subprime credit crisis of 2008-2009.  The subprime crisis was largely a byproduct of deregulation by both political parties that created a system that encouraged moral hazard.  

Moral hazard exists when a person or entity engages in risk-taking behavior based on a set of expected outcomes where another person or entity bears the costs in the event of an unfavorable outcome.  Think Bank Bailouts!  

All of this was allowed so politicians could curry political favors from industry lobbyists and industry titans.  It certainly feels as though some of the deregulation programs currently getting passed increase the risk of re-visiting some of those horrendous ethical dilemmas that almost took down our capital markets.

Ethics aside, deregulation in the energy sector will help our trade deficit as we move from a net importer to a net exporter of oil.  This large swing in global energy markets will correspondingly put upward pressure on the USD, thus ultimately pressuring earnings of large multinational U.S. domiciled corporations. This policy entanglement exemplifies the potential unexpected impact and unintended consequences in unrelated portions of the economy.  

Another example will be the rollback of Dodd-Frank and the Volker Rule in the Financial industry.  Deregulation in financials will likely ease lending restrictions, which should lead to higher industry profits and potentially place upward pressure on inflation.  An uptick in structural inflation would not be ideal this late in the economic cycle.  Not only that, but deregulation will likely lead to more instability in our nation’s banks.

Our view is that Deregulation may ultimately end up having a larger initial upward impact on future economic growth than the total net impact of tax reform.  We also expect that there will be long-term consequences associated with these short-term gains.

The larger factor for the markets to digest is the unwinding of the Fed’s QE (Quantitative Easing) program.

Monetary Policy – Pumping The Brakes

The Federal Reserve Bank (the “Fed”) is the banker’s bank.  It is charged with oversight of the banking industry and maintaining solvency while managing interest rate and liquidity conditions for our economy.  

Similar to fiscal policy, the Fed operates counter-cyclically to economic activity.  Since the Great Recession began in 2008, the Fed has done most of the heavy lifting to keep the economy moving.  It will now be charged with offsetting the net effects of the new tax policy, while also attempting to maximize full employment, stabilizing financial conditions, and maintaining price stability.

Interest Rate Policy

The Fed raised interest rates three times in 2017 from 0.75% to 1.5%.  Looking forward, the market is pricing-in ONE .25% interest rate increase in 2018, while the Fed is expecting THREE more .25% hikes (based on their published “dot plot”).  

The larger factor for the markets to digest is the unwinding of the Fed’s QE (Quantitative Easing) program.  The Fed has a number of balls in the air as it tries to stay ahead of potential inflation created by the tax policy from this low level of unemployment, while also making sure the markets don’t get spooked as they begin to wean themselves off their “drug of choice” (cheap money).

Complicating the Fed’s job will be the swearing in of a new Fed Chairman to replace Janet Yellen in February 2018.  My mind races back to 1987 when the markets tested the then-new Fed Chairman, Alan Greenspan, after he replaced Paul Volker.  The markets collapsed in October of that year, eventually leading Greenspan to turn on the monetary hoses, reflating the stock market.  It will be no surprise if the markets test the new Fed Chairman relatively early in their term.

The surprisingly disappointing evidence over the past 10 years (since the Great Recession) is that despite huge technological advancement, we are not capturing the gains in the form of higher productivity as measured through GDP accounting…. that means non-inflationary productivity enhancements are NOT helping us grow out of our increasing debt loads.

US Dollar

Be careful for what you wish.  More advantageous trade terms aggressively negotiated through a more transactional and less strategic approach will likely lead to less trade and higher prices, despite a stronger USD.  As Charles Plosser, former Philly Fed President and CEO, stated at an event that I attended earlier this year… “higher prices and weaker economic growth are a Central Banker’s nightmare”.  A stronger dollar further complicates the Fed’s ability to fight potential inflation through higher interest rates.

Productivity – Smoother Ride, Same mpg

Artificial Intelligence (AI), Machine Learning (ML), Blockchain, Robotics, and Innovation – those are the buzz-words and themes that will continue to grow in 2018 and beyond.  

Interestingly while all of these concepts are almost universally viewed as positive, ultimately these trends will put downward pressure on wages. The surprisingly disappointing evidence over the past 10 years (since the Great Recession) is that despite huge technological advancement, we are not capturing the gains in the form of higher productivity as measured through GDP accounting.  

That means non-inflationary productivity enhancements are NOT helping us grow out of our increasing debt loads.

I realize that many readers live in the Silicon Valley and will want to argue with this statement.  So, I promise to dedicate a future article on this topic to flesh out the evidence from an economic perspective.

The consensus opinion is that populism will not fix stagnant wages.  The simple fact is that innovation will continue to put downward pressure on wages for most of the population.  The shareholder class (equity owner) is much more inclined to benefit from today’s trends than the stakeholder class (employee)…regardless of which political party is in power.

Best reason to be bearish is there is no reason to be bearish. ~Michael Hartnett

WILD CARD ALERT:  There is little debate that the economy, and the stock and bond markets have greatly benefited from low inflation and low volatility.  In fact, in addition to the S&P 500 setting records for consecutive monthly gains, the stock market is similarly setting records for low volatility almost daily.  Most market commentators agree that the record low volatility and record high market prices are inexorably intertwined as one grinds lower and the other grinds higher.  

There are many factors that contribute to these idyllic economic underpinnings, which have correspondingly helped create an environment of low-interest rates and high earnings multiples.  Due to overcapacity in the global production markets, it is unlikely we will see a significant unexpected rise in inflation that negatively impacts interest rates, volatility, and stocks prices.  

In fact, the consensus view is for inflation and volatility to drift just a bit higher than current, but still at comfortably low levels.  As Bank of America Merrill Lynch’s strategist, Michael Hartnett, recently put it, the “best reason to be bearish is there is no reason to be bearish.” Contrarian much?  That said, consensus is so strong against a surprise increase in inflation that it could be quite detrimental to all financial assets… if we were to see the “whites of its eyes”.

This is important because passing tax policy this late in the economic cycle coupled with individually negotiated trade “deals,” increases the odds of higher than expected inflation.  As such, we feel it is prudent to consider some form of inflation protection (which is cheap) in addition to allocating to truly diversified alternative asset classes.

Unwrapping our Review and Outlook

The economy and markets have been on cruise control due to artificially suppressed interest rates through Quantitative Easing (QE) policies by the world’s Central Bankers.  The US economy also benefited from easy comparisons coming off a weak 2016 and a bounce back in the global economy.

Looking ahead, we have fiscal policy being applied at a strange time, given the maturity of this economic recovery.  Normally, we would expect a pro-growth tax policy coming out of a recession, not 9 years into a recovery.  This will likely accelerate the world’s Central Banks to move to a more restrictive stance.  All of this will finally introduce a bit more uncertainty into the markets.   

In fact, it is time to let the markets determine winners and losers, rather than use artificially suppressed interest rates to prevent business failures. Not everyone gets a ribbon anymore.  The bottom line suggests that given all of the uncertainties and moving pieces in the global economy, stocks look better positioned than bonds at this juncture, but many alternative investments offer the most favorable risk-return payoff.

My forecasting goggles indicate that an increase in uncertainty in Monetary Policy coupled with growing tensions in the geopolitical landscape will create a negative market-month at some point in 2018; i.e. the record consecutive winning streak for the market will come to an end in 2018.  How’s that for a prediction…too bold?

Happy Holidays,

Financial Alchemy – The Great Experiment

Financial Alchemy – The Great Experiment

Unwinding the Fed’s Quantitative Easing Program

The Great Experiment is unwinding. The U.S. Federal Reserve Central Bank (Fed) is beginning to reverse its Quantitative Easing (QE) program, a 2009 policy created in response to the worsening financial crisis known as the Great Recession.  Since its very conception, QE was considered a controversial, unconventional, and some would say experimental, monetary policy.

QE occurs when a Central Bank purchases a predetermined amount of government bonds or other securities from the market in an attempt to lower interest rates, increase asset prices, and stabilize the economy.

In total, Central Banks across the globe followed the US Fed’s lead and combined to purchase more than $20T in assets under the QE umbrella.  This coordinated effort had a massive effect on asset prices and interest rates across the globe.  

This monetary policy experiment (QE) had no historical precedent and was the financial equivalent of other controversial lab experiments like GMOs (genetically modified organisms), stem cell research, or genome sequencing/editing: praised by some and scorned by others.  Hence, Quantitative Easing became know as “The Great Experiment”.

Proponents of QE credit it with stabilizing the economy and pulling the United States out of the Great Recession.  Critics claim the effects have increased income inequality, inhibited our return to historical economic growth rates and dramatically increased the chances of future policy missteps.

We’ are about to find out if the old adage “don’t fight the Fed”, which was true on the way up, will hold true in reverse. After more than eight years of QE variations, the Fed finally began to move from QE to QT (Quantitative Tightening) just a few weeks ago.

While the Fed actually ended its bond-buying program in early 2015, they never removed the increased reserves created through this activity.  The Fed is now allowing its bonds to mature without reinvesting the proceeds, and thus those reserves will gradually be removed from the monetary system.

In this edition of “Cutting through the Noise” we review some of the more dramatic effects created by QE that are captured in our “Three Favorite Charts” below and discuss how QE, and its present unwinding, is likely to impact both the economy and capital markets.

Tools And Materials For The QE Experiment

How quantitative easing works

The process described in Steps 1, 2 and 3 above is quite straight-forward. In a nutshell, the Fed buys government bonds and mortgages, which pushes up prices of those securities while pushing down interest rates.  

These lower rates inspire economic activity, while simultaneously encouraging investors to take more risk in securities that offer higher returns than the bonds bought by the Fed.  The net effect is that the money created by the Fed to buy bonds is ultimately re-deployed into riskier assets by the investment community.  

If all of this feels more like market manipulation rather than the ‘free market pricing’ of the cost of money or interest rates; Guess what?  It is!  Prior to its own QE implementation, the U.S. openly criticized other governments for similar behaviors through the IMF, World Bank, and World Trade Organization.  

Immunization or Mutation

U.S. hypocrisy aside, The Goal stated in the above chart is unambiguous and the results are irrefutable.  Since this process began on March 9, 2009, the stock market is up almost 400%, mortgage rates declined more than 3%, and spreads on high yield junk bonds compressed by 15-20% to historic lows, making corporate borrowing much more affordable. These very impressive results helped inflate consumer confidence and jumpstart the economy.

Thus far, the QE experiment is a success on many levels and was necessary at the depths of the recession to avoid total economic collapse.  However, we will never know if (once the economy survived the initial free fall with the help of extensive government programs such as QE) it would be in better shape today had the government backed off such aggressive intervention and allowed more businesses to fail, thereby removing more debt through bankruptcies, and bringing about more business investment in the subsequent recovery.

That question will be the topic of white papers for generations.  Managing this unwind will determine whether the Fed can claim ultimate victory with their Great Experiment or if they created a Frankenstein economy.

The Risks highlighted in the chart above are a bit more debatable.  To be sure, the risks were somewhat avoided because other global Central Banks implemented the same policies as the Fed.  This coordinated global liquidity program prevented the U.S. dollar from falling on a relative basis.  A weaker dollar is often considered a precursor to inflation because a weaker currency leads to paying more for imported products or “importing inflation”.

At the end of the day, it is easy to conclude that the “Goal” of QE was accomplished, and to this date, the risks mostly avoided.  That said, it’s likely the task of unwinding this experiment will get a bit more complicated… all the more so with a new Fed Governor set to take the helm from Janet Yellen next February.

Let’s See What Those Central Bankers Created In The Lab!

Now that we have discussed how QE actually works, let’s take a look at the impact of this program on various segments of the capital markets.  

Favorite Chart #1 – The chart below illustrates the direct impact QE had on stock prices.  The blue line represents the assets purchased through global Central Bank QE operations (RHS).  The red line shows how the S&P 500 responded to these excess reserves being pumped into the capital markets.  WOW.  We have seen ETFs (designed to tightly track a specified index) in certain illiquid markets that exhibit a lower correlation.  This is strong evidence that equity investors benefited from QE.

European central bank bank of japan federal reserve vs s&p 500

This does not necessarily mean that the stock market is about to fall or even that it has to fall at all.  It does suggest this may be a great time to take some profits or consider other avenues for excess returns going forward.

Favorite Chart #2 – European High Yield bonds trade at lower interest rates than U.S. Treasuries or the first time EVER!   Shown below is the Euro High Yield non-financial bond index (blue line) vs the U.S. Treasury bond (white line). Not surprisingly, Euro High Yield bonds traded with much higher interest rates through most of the last cycle, because as expected, High Yield bonds carry more risk.  

BOA US treasury vs BOA Euro High Yield

In late 2008 / early 2009 we see that interest rates on riskier bonds increased to historically wide spreads vs U.S. Treasuries during the depths of the Great Recession. Once the QE policies kicked in 2009, credit spreads began to tighten again.   

However, fast forward to 2016 and look what happened in the Euro Junk bond market.  Once the Fed stopped buying bonds in 2015 and the ECB ramped up their QE or bond-buying activities, we saw High Yield bond interest rates in Euro decline to the same level or lower than U.S. Treasury bonds.  This is crazy!  

How can Junk bonds in Euro trade with the same implied risk as U.S. Treasuries??  This single, irrational data point highlights how the effects of QE have simply gone too far and must recede at some point.

That said, the Fed has begun to let some of their bonds roll off (QT), which is their plan to reverse the effects of QE. However, the BOJ and ECB (and possibly China) will continue their QE operations, so some of these relationships could get even crazier.  

Investors need to be aware of how we got here, because some of those principal drivers are about to reverse.  This policy reversal is likely to reverse the price patterns of many securities that benefited from QE on the way up.

What Effect Did QE Have On Passive vs. Active Managers?  

Favorite Chart #3 – Let’s look at a less direct impact of QE as seen in the chart below.  This chart displays the impact of investors indiscriminately buying passive equity investments rather than actively managed investments after the onset of QE.

Active manager vs all assets

Active managers were clearly outperforming across the board until shortly after QE “goosed” the markets in 2009, which led to initial outperformance from passive products coming off the market bottom.  The longer that paradigm persisted, the more and more investment dollars shifted from active to passive.  At this point, active funds have given up all of their previously accrued outperformance and an additional 3+% to passive funds.

This process has a self-fulling effect, whereby active managers that suffer redemptions must sell their “active” positions, thus putting downward pressure on those active exposures.  This money then goes to passive indexes/ETFs, which continue to funnel into the same basket of market cap leaders.  

The effect of driving more and more money into the largest stocks based on market capitalization had a derivative effect of also driving down volatility.  Guess what, lower volatility leads algorithmic asset allocators to also push more money to stocks.  Lather, Rinse, Repeat…and so on.

Just like the crazy relationship described earlier with the Euro Junk bond yields trading below Treasury yields, this passive craze will likely reverse at some point as the buoyancy offered through QE recedes.

We have seen this before, markets are cyclical and the drivers of market performance ebb and flow.  One cycle that we expect to reverse at some point is the consistent outperformance of passive over active investments.  Not only is the main driver of this phenomenon about to reverse, but active management tends to outperform late in the cycle.

As The Globe Continues To Spin, The Fed Begins To Unwind…

Going forward, it will be interesting to dissect the result of the Fed tapering QE while Congress gets busy implementing fiscal stimulus through tax cuts.  This could break in a number of directions…

The Fed suggests that it will be like watching ‘paint dry’; while others speculate this will lead to a de-synchronized global economy resulting in wild currency swings, higher interest rates and a return to a more normal business cycle that ultimately careens off the tracks.  

The truth will no doubt be found somewhere in between.  Let’s remember this is probably the first step in the eventual return to increased uncertainty in our markets and ultimately more volatility.  That is a good thing. Volatility creates opportunity.

Let’s hope global Central Bankers slowly turn down their Bunsen burners and allow the effects of this simmering experiment to slowly subside.  The free markets have a fine record without the need to put the economy on chronic steroids, and it’s now time to wean it off the performance enhancing monetary policies.

Extra Credit:  

While QE was successful in stabilizing the economy during the Great Recession, it was not the single greatest government policy that helped prevent the economy from the slipping into depression in March of 2009.  

The monetary effects of QE were amplified atop the fiscal effects of TARP (Troubled Asset Relief Program).  TARP was QE’s equivalent on the fiscal side, which was implemented by the Bush and Obama Administrations in conjunction with Congress.  These programs included purchases of mortgage-backed securities along with bailouts for the banking and auto industries.

All that said, the single greatest policy change that occurred on that fateful March 9th morning in 2009 was the removal of ‘Mark-to-market’ accounting for the banks.  This policy not only removed the need for banks to value their loans (and underlying collateral) at market value, but actually allowed them to value their loan portfolio at the purchase price.  The ultimate result was that banks no longer needed to sell assets to reduce risk and thus, removed downward pressure across all assets at our darkest hour.

The combination of all three of these policies (QE, TARP, and removal of ‘Mark to market’) undoubtedly kept our economy out of the dustbin of history and allowed us to eventually regain momentum.  Going forward, it is likely that the government will revert to using its full bag of tricks, or create new tricks in the lab, to avoid a similar collapse in the future.  It will be interesting to see to what degree the government allows the economy to return to a ‘free market’ and how much they continue to use policy tools as political weapons.

 

Disclosures

Three Bell Capital (“Three Bell”) is a registered investment adviser with the Securities Exchange Commission. The information provided by Three Bell (or any portion thereof) may not be copied or distributed without Three Bell’s prior written approval. All statements are current as of the date written and do not constitute an offer or solicitation to any person in any jurisdiction in which such offer or solicitation is not authorized or to any person to whom it would be unlawful to make such offer or solicitation.

This information was produced by and the opinions expressed are those of Three Bell as of the date of writing and are subject to change. Any research is based on Three Bell proprietary research and analysis of global markets and investing. The information and/or analysis presented have been compiled or arrived at from sources believed to be reliable, however, Three Bell does not make any representation as their accuracy or completeness and does not accept liability for any loss arising from the use hereof. Some internally generated information may be considered theoretical in nature and is subject to inherent limitations associated therein. There are no material changes to the conditions, objectives or investment strategies of the model portfolios for the period portrayed. Any sectors or allocations referenced may or may not be represented in portfolios of clients of Three Bell, and do not represent all of the securities purchased, sold or recommended for client accounts.

Seeking Magnified Returns via Alternative Investments

Seeking Magnified Returns via Alternative Investments

Where to Find Reliable, Risk-Adjusted Returns on investments…

  • Peer-To-Peer Lending
  • Short-Term Construction Lending
  • Life Settlements
  • Merger Arbitrage

Most of us are familiar with the famous fictional private detective, Sherlock Holmes, created by British author, Sir Arthur Conan Doyle. In the stories, Holmes was known as a “consulting detective”, tactically tapped by his clients (often Scotland Yard) for his proficiency with observation, forensic analysis, and logical reasoning, to help solve tough cases.

One of Sherlock’s famous phrases was “whenever you have eliminated the impossible, whatever remains, however improbable, must be the truth”.  We at Three Bell suggest that while making solid risk-adjusted returns in the public markets is not necessarily impossible, it is becoming more and more improbable. As such we are looking elsewhere for opportunity. Much like Holmes, we apply many of the same principals and skillsets to assist our clients in navigating the changing (and at present, challenging) financial markets.

Last month, we discussed how the public stock and bond markets are fully priced and adding alternative investments to your portfolio can reduce volatility, increase returns, and mitigate downside risk.

In this edition of “Cutting through the Noise”, we examine alternative investments to overvalued public market investments.  Although its anything but, ‘Elementary, my Dear readers’, we believe these alternatives provide clues to where to find higher returns with lower risk. Let’s dive in!

THE BIG PICTURE

Holmes was famous for his use of deductive reasoning to take seemingly disparate facts, and use them to formulate a complete picture of what had actually occurred. Following Holmes’ example, in order to understand where certain alternative investments fit into a well-diversified portfolio, we must first understand where the sum total of all of the world’s investable assets are deployed.

By limiting investment choices to stocks and bonds, we eliminate options in two-thirds (~66%) of the investment world.

Take a look at the chart below. What we can deduce is that public markets (stocks and bonds) actually represent a comparatively small portion of the overall investable universe…and, as we discussed in our last article are the most overvalued cross-section at that.

Domestic equities and bonds - fraction of investables
Source: Oliver Wyman

The vast majority of the public market investment universe (stocks and bonds) is confined to the first four ‘colored blocks’ above, and represents just $159T out of a total $437T of investable assets. By limiting investment choices to stocks and bonds, we eliminate options in two-thirds (~66%) of the investment world.

However, almost all of that remaining $300T can be accessed through some form of private offering, typically through a hedge fund framework, that can blend nicely with a public market portfolio. On that note, let’s take a look at some of the specific alternative investment strategies Three Bell is currently leveraging on behalf of our clients to help mitigate the volatility of the broader stock and bond markets, as part of a well-diversified portfolio.

…many new private credit markets [sic] can offer disproportionate returns to those available in the public fixed income market.

TYPES OF ALTERNATIVE INVESTMENTS

Our last edition of “Cutting through the Noise – Think Alternative(ly)” broadly discussed alternatives as an asset class. However, there are a wide variety of investments that fall within that category and generate returns in vastly different ways.

Credit Market Niches’

The financial crisis of 2008-09, which was first and foremost a credit crisis fueled by defaulting subprime mortgages, resulted in many changes to the banking sector. The sum total of these changes was a substantial pullback from banks offering certain types of financial products, and a “back to basics” mandate. The net response to these changes is many new private credit markets that can offer disproportionate returns to those available in the public fixed income market.

Peer-To-Peer Lending Funds

A specific niche type of lending platform that has gained significant traction since the Financial Crisis is peer-to-peer (P2P) lending. This category looks to serve the individual loan market that does not want to borrow through unsecured, revolving credit (eg credit cards).

Lenders (in our case, a hedge fund) extend credit, often at rates similar to credit cards, but allow borrowers to amortize that debt from the outset, enabling borrowers to see the light at the end of the tunnel and thereby dramatically reduce instances of default. These lenders can then pass along high returns to their investors because they operate much more efficiently than the big banks.

One such hedge fund utilizes a complex algorithm that evaluates and weighs over 1200 different unique data points for each loan, then uses a high-speed trading conduit into the lending platforms to purchase the best loans within 40 milliseconds. This pretty much leaves the little guy out of the equation, but does offer an excellent risk-return profile to investors in such funds.

What do we like about this alternative investment?

  • Consistent, high single digit, low double digit returns since inception (currently annualizing at approximately 12% net of fees)
  • Little to no correlation with the stock or bond markets
  • Maximum loan size is $30K and most are 3-year loans, which means a fund investing tens of millions of dollars is going to own a LOT of loans that are paying off in a relatively short period of time
  • Personal loan deficiencies consistently remain lower than other loan types, including auto loans, mortgages, and credit cards. Supporting data illustrates this further.
  • 9% of investors in this market segment have made money in personal lending over the past 10 years.
  • Default rates through the Financial Crisis needed to be 70% more severe before investors would have lost ANY money in this asset class (see chart below)
Source: Federal Reserve via Theorem Marketplace Lending Fund

Short-Term Construction Lending Funds

Traditional banks lost their shorts in the Financial Crisis, partly because they had loaned money to real estate developers who walked away from unfinished projects, forcing the banks to repossess the properties. Worse, global Basel III commercial banking regulations written after the Financial Crisis prohibited the banks from holding the assets until they recovered their value, and banks were thus forced to liquidate in a fire sale, locking in substantial losses.

Due to those regulations, many traditional banks exited the short-term construction lending sphere, which left a void of capital for real estate developers that needed to borrow money to build their properties. Enter private real estate debt funds…

There are many high return business models that lend themselves well to the private, hedge fund format.

Because of the scarcity of capital for real estate projects, hedge funds that effectively analyze and pick high quality, low risk projects, can charge double-digit interest rates on what are typically relatively short term loans (1-3 years), and are then cashed out of the project entirely when the development is complete and the debt is refinanced with a traditional bank and long-term debt.

What do we like about this alternative investment?

  • High annual interest rates of approximately 12% net of fees
  • No property depreciation risk since not buying the asset, just loaning funds
  • Short term loan duration of 1-3 years
  • Senior secured debt gets paid off first in the event of default
  • Maximum 70% LTV established at time of investment
  • Ability to repossess property at a very low cost and hold that property or develop it to maximize investor returns (thus eliminating need for fire sales)
  • Little to no correlation with the larger stock or bond markets

Special Situations

There are many high return business models that lend themselves well to the private, hedge fund format.  These opportunities vary in their reliance on the underlying stock and bond markets, but one variable remains the same… the overall correlation to the public markets is historically very low.

Life Settlement Funds

A life settlement is the transfer of ownership and beneficiary rights of an unwanted or unneeded life insurance policy in exchange for a cash settlement. The seller of the policy no longer has the responsibility of paying future premiums.  In exchange, buyers (investors) profit based on the difference between the face value of the policy (death benefit) and the aggregate of the acquisition price, plus accumulated premium costs.

The typical returns for investors in these policies have been 10-18% per year with very little volatility, as seen in the graph below.

Carlisle Life Settlements IRR
Source: Carlisle Management Company

The life settlements industry, and returns thereon, are expected to continue to grow due to 1) projected increases in the US senior population and a resulting larger pool of policyholders potentially looking to sell, and 2) the large gap between the current size of the life settlement market (under $20B) and the value of the individual policies that lapse or are surrendered each year (over $640B).

Voluntary Life Insurance Terminations and US Population age
Source: Carlisle Management Company

What do we like about this alternative investment?

  • There is little to no correlation to the larger stock and bond markets
  • Returns are well into the high teens every year since inception
  • Returns are very stable and experience very little volatility
  • The underlying policies are with investment grade carriers
  • Returns are almost all long-term capital gains making it very tax efficient

Merger Arbitrage Funds

Merger arbitrage entails investment in event-driven situations such as leveraged buyouts, mergers, and hostile takeovers. Because of the risk that a merger will not close, the target company’s stock will typically sell at a discount to the deal price. This pricing discrepancy or “spread” is a merger arbitrage fund’s potential profit.

There are a variety of reasons why a merger might fail, creating this opportunity, including government antitrust rulings, financing failures, and shareholder rejections. However, with proper position selection, a merger arbitrage fund can largely immunize itself against stock market fluctuations. This is due to the fact that the fund isolates its exposure to the compression of the spread between only two stock prices, the acquiring company and the target company. Thus price movements at the market level become largely irrelevant.

What do we like about this alternative investment?

  • Returns for the fund we utilize have annualized at approximately 28% since inception, net of fees
  • Low-interest rates and a sluggish economy should lead to increased M&A activity
  • At 170 announced deals, there are a lot of potential mergers to address
  • The Dodd-Frank Bill forced many investment banks out of merger arbitrage, lessening competition
  • Arbitrage spreads tend to be positively correlated to overall interest rate levels (profit tends to increase along with interest rates in a rising rate environment)
  • Fund strategy isolates returns from larger stock market fluctuations, reducing correlation and providing true diversification

THE SCIENCE OF DEDUCTION

Based on an extensive examination of all the clues presently available, we deduce that the public markets offer more risk than return. That said, no one can predict the market, and there is always the possibility that it pushes inexorably higher.

In response to this upsidedown risk-return paradigm, we do not suggest investors retreat to the unacceptably low-interest rates available in money funds.  Rather, we can utilize certain alternative investments to continue to produce stable returns by investing in funds whose underlying assets and strategies are not tied to the stock and bond markets.

Through the use of alternative investments, in concert with stock and bonds, our intention is not to predict the market, but rather prepare for all outcomes.

 

Disclosures

Three Bell Capital (“Three Bell”) is a registered investment adviser with the Securities Exchange Commission. The information provided by Three Bell (or any portion thereof) may not be copied or distributed without Three Bell’s prior written approval. All statements are current as of the date written and does not constitute an offer or solicitation to any person in any jurisdiction in which such offer or solicitation is not authorized or to any person to whom it would be unlawful to make such offer or solicitation.

This information was produced by and the opinions expressed are those of Three Bell as of the date of writing and are subject to change. Any research is based on Three Bell proprietary research and analysis of global markets and investing. The information and/or analysis presented have been compiled or arrived at from sources believed to be reliable, however Three Bell does not make any representation as their accuracy or completeness and does not accept liability for any loss arising from the use hereof. Some internally generated information may be considered theoretical in nature and is subject to inherent limitations associated therein. There are no material changes to the conditions, objectives or investment strategies of the model portfolios for the period portrayed. Any sectors or allocations referenced may or may not be represented in portfolios of clients of Three Bell, and do not represent all of the securities purchased, sold or recommended for client accounts.

Think Alternative(ly)… Invest Different

Think Alternative(ly)… Invest Different

By: Bill Martin
Senior Managing Director and Investment Strategist


With both stock and bond markets priced for perfection, it is time to look for asset classes that can provide true diversification to lower risk and increase returns.

Introduction

Apple, Inc. taught us the power and promise available through embracing change, if we only learn to ‘Think Different’.  We believe that has never been more appropriate and applicable than right now for the financial markets.  In an homage to that timeless Apple precept, we encourage investors to look beyond the typical herd mentality for answers and find “alternative” sources of excess returns.  With the bond market offering record low yields and the stock market trading at record high earnings multiple valuations, we try to answer the question… what’s an individual investor to do?

We’ve all heard it our entire investing lives:  diversification is the key to stable, long-term investment returns.  OK, great, but diversification into what exactly?  It’s entirely possible to diversify into a terrible investment and in so doing, do yourself a disservice.  Logically, diversification into just “different” investments, in and of itself, is not going to help investment returns, particularly in the event of a substantial market correction.

Historically, for many investors, diversification has meant spreading assets across different segments of the stock market, with a portion of the allocation going to smaller more nimble growth-oriented companies, some to larger more established value-oriented companies, and then splitting that up across both domestic and international exposure.  The resulting pie chart shows a wonderfully diverse array of colored pie wedges, creating the illusion that we have accomplished our diversification objectives (at least graphically).

The only way to achieve this “true diversification” is through an asset class broadly referred to as “alternative investments.”

However, when markets experience severe declines, the returns of these various sectors tend to homogenize and drop at the same rate.  This is what we refer to as “correlation.”  During the Great Recession, even if you had all of your fixed income allocation in US Treasuries you still experienced a drawdown of -20% or more.  That number was closer to -40-50% if you were 100% in stocks and bonds that did not contain Treasuries… no matter if you were in US or International, investment grade corporates, or high yield bonds.

So, when we think about true diversification, and the benefits we are supposed to realize from that concept, we must find investments that are not correlated to the larger stock and bond markets, and are capable of generating positive returns regardless of any form of precipitous correction, market decline or increase in interest rates.

The only way to achieve this “true diversification” is through an asset class broadly referred to as “alternative investments.”  By using alternative investments, it is possible to design an “all-weather” investment portfolio where each individual component of the allocation is making money in a way which is both divorced from the broader stock and bond markets, and at the same time different from the other investments within the portfolio.

In this edition of Cutting Through the Noise, we investigate how to use alternative investments as a key component to portfolio construction to achieve stable non-correlated, long-term returns, and why it is particularly important to do so now given where we are in the current market cycle.

Low Expected Returns for Stocks and Bonds and the Need for Diversification

In order to understand the importance of incorporating alternatives into your portfolio, we must first understand the current challenges of the two traditional primary asset classes:  stocks and bonds.  As you will see below, neither are poised for outsized gains, and instead both are set to experience significant headwinds.

Bond Market Headwinds

In the fixed income world, we earn the interest income from the bonds we hold, plus or minus any increase or decrease in the underlying value of the bond holdings.  The biggest driver of increases or decreases of bond prices are interest rates, namely, what is the present interest rate vs the rates when the bonds we hold were issued.

As interest rates rise, the price of a bond portfolio tends to depreciate, and vice versa.  This is because in a rising interest rate environment, new bonds are being issued which pay higher coupon rates than those that are held in the current portfolio.  Thus, if those bonds were to be liquidated in that environment, they would need to be discounted to account for the lower coupon payments.

So, where are we in this cycle?  Gradually lower and lower interest rates due to global Central Bank bond buying programs (“Quantitative Easing”) has driven interest rates to levels previously not seen.  From this level (see chart below),

there is more risk than return available in the bond market.

Based on the chart above, we believe that its more likely interest rates will rise from where they are now… versus fall.  If this is in fact accurate, the best case is for bond investors to earn the income associated with the bond coupon and hold those bonds to maturity to eliminate interest rate risk and resulting pricing fluctuations.  This puts returns anywhere between 2-5%, depending on how much credit risk an investor is willing to accept.

Stock Market Headwinds

As a result of these artificially suppressed interest rates, investors have sought higher returns elsewhere and have correspondingly pushed stock prices to near historical high valuation multiples – particularly when considering the low level of economic growth in the underlying economy.

In order to understand where the headwinds exist in the stock market, we need to start with the general understanding that the more an investor pays for earnings, the lower their expected return.  We have a nice chart that illustrates that point below.

Both the bond and stock markets are much more likely to decline than provide historical levels of return going forward. 

Time to get outside of the box…

The market is currently trading at earnings multiples that are higher than any other time in our history, except for a few months in 2000.  As such, we believe P/E multiples are unlikely to expand much further and are instead much more likely to contract.

This, coupled with muted GDP (around 2%), means that earnings growth is also likely to be muted which creates overwhelming risks to the downside for the stock market.  Historically, the 10 years after the stock market trades at these levels, the result is a paltry 1% annual growth (see our CAPE blog for more in depth analysis).

Key Takeaway

Both the bond and stock markets are much more likely to decline than provide historical levels of return going forward.  Interest rates are more likely to rise than fall dramatically hurting bonds, and earnings multiples are more likely to revert to the mean and compress hurting stocks.

As a result, we believe traditional portfolios that have relied solely on these two asset classes for diversification and returns are, at best, going to suffer mediocre returns for the foreseeable future, and at worst (particularly in the case of the stock market) suffer severe declines in asset values.

Time to get outside of the box…

What are Alternative Investments and What Do They Do?

The intent of considering alternative investments is to maximize the odds of increasing our total investment return profile, while reducing the risks that are stacked against us if we invest only in the public stock and bond markets.

The chart below illustrates some of the high level key differences between alternative and traditional investments:

The alternative investment category opens up a broad universe of options that are often times overlooked, which if properly deployed can create correspondingly superior risk/return opportunities. 

We are all very familiar with the “Traditional” row on the top of the chart – buy stocks and bonds and hope they go UP…that is what is meant by “Market Direction Sensitive” in the last column in the top row above.

In the “Alternatives” row on the lower part of the chart we see options beyond just stocks and bonds which, very generally, include all asset classes other than long stocks, bonds, and cash. Specifically, Alternatives include funds that trade long/short equity, real estate, private equity, life settlements, venture capital, commodities, merger arbitrage, specialized debt, and much, much more.

The alternative investment category opens up a broad universe of options that are often times overlooked, which if properly deployed can create correspondingly superior risk/return opportunities.

The triangle chart below provides a conceptual framework that illustrates the potential benefits of combining various alternative investments.  Specifically, alternative investment portfolios should include an intelligent combination of fund strategies that generate outsized uncorrelated returns, deliver inflation protection, and provide hedged downside protection thru “true diversification.”

…many hear the term “hedge fund” and pre-judge in the negative, either because of historical underperformance or because they have heard hedge funds are all “risky.” 

Impact of Alternatives on Portfolio Returns

We wouldn’t be looking at this important asset class if it didn’t deliver demonstrable benefits.  However, we must start with a caveat:  most alternatives are packaged as “hedge funds” and most hedge funds have lagged the broader stock market recently.  As such, many hear the term “hedge fund” and pre-judge in the negative, either because of historical underperformance or because they have heard hedge funds are all “risky.”

“… alternatives have shown the ability to both lower risk AND increase return.”

To that we have three comments:

  1. Returns are time period dependent. As such, many hedge funds did their jobs well and looked dominant vs index funds and ETFs leading up to and through the financial crisis.  They “hedged” against negative returns.  That’s what they do.  Now that the market has run to historically high valuations (see above), would you rather stay almost entirely in long only stocks and bonds or consider diversifying to hedge some of the downside?

 

  1. There are many types of hedge funds, ranging from “conservative” to “aggressive” and everything in between, and many of them do not simply “hedge” stock or bond market risk. In fact, some of them are completely off the grid, don’t have anything to do with stocks or bonds, and can perform well regardless of what the broader stock or bond markets do.

 

  1. Keep an open mind as we avoid driving through the rearview mirror. Investing is not easy and the truest long term successful strategy is to be contrarian.  Many alternatives and hedge strategies are built to capitalize on this phenomenon.

We have two very important graphs to examine below.  The key take-away is that alternatives have shown the ability to both lower risk and increase return.  This is despite following a record bull market run facilitated by the world’s central bankers.  History suggests that the risk-return benefits of alternatives will be even higher in the intermediate future.

The first graph shows the risk and return for a typical “balanced” 60% stock and 40% bond portfolio.  The stock portion is invested 2/3 domestically and 1/3 internationally.  The return of that balanced portfolio has been 7.94% with an annualized volatility of 8.81%.  This portfolio is said to have a simplified Sharpe ratio (return/volatility) of .90.

This simplified Sharpe ratio is an efficiency evaluation metric to indicate how much return your portfolio gets per unit of risk.  The benefit of lower volatility is that it will typically help investors from selling at the wrong time.  It is always important to keep that number as low as possible.

The next graph below shows the benefit of allocating 50% of the portfolio to Alternatives, while keeping the remaining 50% in the 60/40 stock bond mix cited above.  The return increases to 9.33%, while risk declines to 7.28.  This configuration delivers a 1.28 Sharpe ratio, or a 42.4% increase in efficiency.  Greater returns, less risk.  Check!

“… investors often end up taking more risk by going into riskier market segments like high yield bonds or emerging market equities at just the wrong time.  At market peaks, these segments actually add risk rather than reduce risk.  We call this Di-worse-ification.”

These graphs clearly illustrate the benefit of adding alternatives into a portfolio otherwise comprised entirely of stocks and bonds.  The alternative investments into which we are currently deploying capital should have an even more dramatic positive effect, as they have higher expected returns with lower downside risk than the examples used in the above graphs.

Summary: Utilize Alternative Investments to Provide True Portfolio Diversification, NOT Di-worse-ification!

As we began by postulating, most investors seek to diversify their return patterns by going into more and different public market sectors.  While this can be helpful, investors often end up taking more risk by going into riskier market segments like high yield bonds or emerging market equities at just the wrong time.

At market peaks, these segments actually add risk rather than reduce risk.  We call this phenomenon, “Di-worse-ification”: the act of unknowingly constructing a highly correlated portfolio.  The dangers of diworseification are highest at low levels of interest rates, tight credit spreads and elevated earnings multiples.  Strike 1, 2 and 3.

We want to highlight the benefits of including completely different asset classes with different return drivers, such as some of the broad categories mentioned in the segments above.  The potential benefits and opportunities of including alternative assets have never been greater.

With the stock and bond markets both priced for near perfection, the greatest risk is that stock and bond markets continue to trade together. This means higher interest rates will bring lower bond prices.  Higher rates will also bring commensurately lower earnings multiples and lower stock prices.  In that event, diversification into traditional asset classes will not mitigate risk or stem investment losses.

That said, we see plenty of opportunity to reduce an investor’s risk profile, while increasing potential returns. Investors need to expand their selection universe to include new ‘alternatives’. This month we introduced the benefits of including alternatives in a well-diversified portfolio. Next month we will dig deeper into specific alternative investment opportunities.