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Tuesday, September 20, 2011

Curve Balls

Predicting interest rate movements correctly is hard. Predicting them for a living is harder still. But getting it wrong is nowhere near as painful as the experience of those who lose their own money based on someone's forecast.

A year ago, the Reuters news agency polled a group of people closer than just about any other community to those who actually decide rate movements. These were 16 money market dealers who do business directly with the US Federal Reserve.1

The so-called primary dealers — banks or broker-dealers — are market makers for government securities. They consult directly with the US central bank and Treasury about funding the budget deficit and implementing monetary policy.

So if you wanted an informed view about the interest rate outlook, these might be the people you would call on first, which is what Reuters did when it asked the dealers for their forecasts for Treasury bond yields three, six and 12 months ahead.

Back in late September 2010, the dealers came up with a consensus forecast for US 10-year Treasury note yields rising from 2.50 per cent to 2.70 per cent in three months, 2.80 per cent in six months and to 3.20 per cent by September 2011.

So how did those forecasts turn out? Well, after three months, the yields had already surpassed the 12-month forecast at around 3.3 per cent. Another three months on, yields had topped 3.4 per cent, again well above forecasts. But then they started coming down again and by September 2011, were close to 2 per cent.

So the expert panel misjudged the trajectory for bond yields in terms of the magnitude of the increase in the first six months and then completely got the direction itself wrong in the subsequent six months.

But it wasn’t just the sell side that misjudged the market. In February, the world's biggest bond fund PIMCO announced it had reduced its US government-related debt holdings from 22 per cent in December 2010 to just 12 per cent in January 2011, the lowest in two years.

In March, PIMCO announced it had eliminated government related debt entirely from its flagship fund, saying that bond yields had reached unsustainably low levels given the scale of government debt obligations and the chance of a correction when the Federal Reserve ended its quantitative easing program.

But by August, PIMCO manager Bill Gross admitted he had made a mistake, telling the UK Financial Times that he felt like "crying in his beer", so badly had he misjudged the movement in bonds in 2011.
"Do I wish I had more Treasuries? Yeah, that’s pretty obvious," Mr Gross told the FT. "I get that it was my/our mistake in thinking that the US economy can chug along at 2 per cent real growth rates. It doesn’t look like it can."

None of this is to impugn Mr Gross' logic earlier this year in saying that the term risk of investing in government bonds was not worth the meager return.

But as tends to happen with forecasts, events intervene and those who maintained an exposure to Treasuries in 2011 have enjoyed solid returns in the intervening months.

The chart above compares the relative yields of US Treasuries at various maturities in January this year versus more recently in September. You can see that the curve was relatively steeper earlier this year than it is now.

The yield spread between the 10-year bond and the 1-year bonds was just over three percentage points in January. By September, this term premium had contracted to two percentage points. The change reflects news in the intervening period. Sentiment about the US economy has deteriorated in that time and investors have become more averse to taking term risk.

Put another way, when yields fall, prices rise. So those whose net exposure was relatively longer earlier in the year have enjoyed a capital gain that was not available to those who took a bet against Treasuries early this year.

Now, Dimensional's own research has shown there is a reliable relationship between current term spreads and future term premiums. So wider yield spreads predict larger term premiums, while narrower yield spreads predict smaller term premiums.

This is why we employ a variable maturity approach, varying the allocation towards short-term and intermediate bonds depending on the shape of the yield curve.

The advantage of this approach is we are only using information available in the market at the present time. There is no need for forecasts, which no matter how rigorous the underlying analysis can come undone as events and circumstances change.

The bad news is that financial markets have a tendency of sending even the most well informed and respected forecasters a curve ball. The good news is that you don’t have to take those sorts of risks if you don’t want to.

1. POLL: Rising Bond Yields Constrained by QE, Reuters survey, Sept 28, 2011

Friday, September 16, 2011

Reality Show for Investors: “Survivor”

Anyone studying the long-run history of American business cannot help but observe how many of the prominent firms of one era fail to make it to the next. Free-market economies are characterized not only by intense competition but also by disruptive change. Sometimes a company’s toughest competitor turns out to be a firm it has never heard of selling a product or service that didn’t exist until recently. The list of companies that once dominated their industry but have fallen on hard times is lengthy enough to give every thoughtful investor reason for sober reflection.

Among many possible examples, a number of firms come to mind that were once highly regarded but later encountered serious or even fatal problems.
  • Bethlehem Steel pioneered the steel I-beam, which launched a skyscraper boom in cities across the country. Its engineering expertise supplied the steel sections for the Golden Gate Bridge. But growing competition and a changing marketplace eventually took their toll, and the firm filed for bankruptcy in 2001.
  • In 1973, Eastman Kodak held a seemingly impregnable position in the lucrative market for photo film and chemicals, enjoyed a reputation for innovation and astute marketing, and boasted a market value even greater than oil giant Exxon. Kodak shareholders had been favored with an uninterrupted stream of dividends dating back to 1902. Today the company is struggling to reinvent itself as the film business shrivels, the dividend has been suspended, and the share price is limping along under $3.
  • A Fortune article profiling Pfizer in mid-1998 praised it for having “one of the richest product pipelines in the Fortune 500.” A Wall Street analyst enthused that “some of my clients refer to Pfizer as the best company in the S&P 500.” In early 1999, a Forbes cover story sounded a similar note, crowning Pfizer “Company of the Year” and observing that “the people who brought us Viagra have more blockbusters on the way.” Thirteen years later, the Viagra boom has subsided, patents are expiring on highly profitable products, and the gusher investors expected from the research pipeline has slowed to a trickle. The share price has slumped over 50% since year-end 1998 compared to a 3% loss for the S&P 500 Index.
Some companies almost single-handedly create new industries but still find it difficult to turn innovation into a permanent advantage. Pan Am (air travel), Kmart (discount retailing), Polaroid (instant photography), and Wang Laboratories (word processing) all had impressive initial success and provided handsome rewards for their investors. Alas, neither Pan Am nor Polaroid survives today, and Kmart shareholders were wiped out when the firm emerged from bankruptcy in 2003. (Kmart, Polaroid, and Wang Laboratories were all cited as examples of “excellent” companies in the 1982 bestseller In Search of Excellence.)

Evidence of this “creative destruction” appears all around us. For example, the Wall Street Journal reported that shares of Minnesota-based Best Buy Co. slumped Wednesday to their lowest level since 2008 after reporting a 30% drop in quarterly profits. For most of its life, Best Buy has been the toughest kid on the block, vanquishing rivals such as Highland Superstores and Circuit City on its way to becoming the nation's leading electronics retailer.

Will Best Buy fall victim to even tougher competitors such as Amazon.com or Walmart? Or is this current downturn just a speed bump on the road to even greater success? No one can say. For every riches-to-rags story, we can find another tale of decline followed by dramatic recovery. According to some accounts, for example, Apple was only a few months from bankruptcy when Steve Jobs returned to the company in 1997. Now it vies with ExxonMobil for the number one spot in a ranking by market cap. And who would have imagined that a floundering New England textile firm with a low-margin business that sells suit-lining fabric would one day become a financial colossus known as Berkshire Hathaway?

The thrill of owning a great growth company during its most lucrative phase is a powerful incentive to search for the Next Big Thing. But almost every company with a highly profitable position is under constant attack from competitors seeking to garner a portion of those hefty profits for themselves.
As a result, the search for firms destined to generate greater-than-expected profits for many years into the future is fraught with peril and likely to end in frustration. Most investors will be far better off harnessing the forces of competitive markets and putting them to work on their behalf by holding a diversified portfolio. As Nobel laureate Merton Miller once observed, “Above-normal profits always carry with them the seeds of their own decay.”

Miguel Bustillo and Matt Jarzemsky, “Best Buy Gets Squeezed” Wall Street Journal, September 14, 2011.

David Stipp, “Why Pfizer Is So Hot,” Fortune, May 11, 1998.

“Pfizer: Company of the Year,” Forbes, January 11, 1999.

Standard & Poor’s Stock Guide, 1974.

Thomas Peters and Robert Waterman, In Search of Excellence (HarperCollins, 1982).

Merton Miller, “Is American Corporate Governance Fatally Flawed?” Journal of Applied Corporate Finance, Vol. 6, No. 4, Winter 1994.