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Understanding Risk

September 23, 2006

"How to win friends and influence people". This was the catch phrase of Dale Carnegie - a guy who offered a self improvement course a couple of generations ago.

The key to success in life and business, according to Carnegie, is to tell people what they want to hear.

Rupert Murdoch seems to have made a lot of friends. His business has been booming and it now spans the globe. His media organization is able to reach something like 4.8 billion people. A couple of nights ago I watched a documentary on how he built his business. Basically, his organization has only a passing acquaintanceship with journalism nowadays. His formula for success: 'Perception is reality. Tell people what they want to hear, and then tell them that it's fair and balanced reporting. Keep 'em happy and keep 'em dumb'.

From time to time, they hit a speed wobble, like when Mr O'Reilly interviewed Mr Glick and Mr Glick - whose father had been killed on 9/11 - did not read from the expected script. It took Mr O'Reilly nearly a year to get over that one. Mr. Murdoch's people take their jobs seriously.

What is it that investors do not want to hear nowadays? What is it that is likely to alienate this category of person? My guess is that it is information that doesn't fall inside their own Thought Paradigms. People who think that the Sun revolves around the Earth do not want to hear that the opposite is true.

Which brings us to the markets: What are the leading Thought Paradigms of the day?

There seem to be two camps. Both are basically optimistic. Both believe that their particular view - which excludes the other - is likely to lead to personal profits.

Camp #1: The Bulls:

The economy is awash with cash
Corporations are unusually liquid. They are either going to have to invest this money or pay it out in dividends. Either way the economy is going to get a stimulative injection.
There is no real linkage between Real Estate prices and consumers. Baby Boomers are not stupid. Home owners have been borrowing against their homes for investment, not consumption
The Federal Reserve stands ready to inject cash into the economy
The Oil Price is falling. This must be good for the economy.

Conclusion: Buy Industrials

Camp #2: The Bears

The Debt situation has grown to become too large and is approaching unmanageable. For example; US Public Debt is tracking towards $9 Trillion. The Long Bond Rate is around 5% and thus Public Debt costs $450 billion p.a. just to service. US Public Debt was $8.2 Trillion only two years ago. Debt is therefore rising at $450 billion p.a. a = b. Like the Latin American Banana Republics of the 1970s and 1980s, The US is borrowing just to pay its debts
Who in his right mind would keep lending to a debtor who needs to borrow money to pay you interest on his previous loans? The day will come when foreigners stop lending and, maybe, start repatriating their capital. US Dollar must therefore collapse.
Gold will soar to the sky

Conclusion: Buy Gold

Okay, now here's some information which would not have met with Mr Carnegie's approval because it is NOT what people want to hear.

If interest rates RISE then both camps will turn out to be wrong.

Yeah, Right! But everyone knows that interest rates are going to keep falling. If the world is awash with cash, and the Fed stands ready to man the printing presses, there's only one direction interest rates are going to travel: Down.

Well, that argument may sound intuitively correct, but the markets are hinting otherwise.

Exhibit 1:

Have a look at the PMO oscillator of the chart below. Note the rising bottoms and the fact that the latest high has been higher than the previous high.

This is called a "non confirmation". Whilst it does not follow that yields will rise from this point, the message this chart is sending is: "At very least, yields have bottomed. They may very well start to rise."

(Remember, this is a monthly chart. It cuts through the noise of daily trading.)

There is a subtle difference between now and 1983 - 1987. In 1987, the high of the oscillator was higher than in 1985, but the low of 1986 was lower than the low of 1983. Now, both the low and the highs are higher.

The purpose of technical analysis, in this analyst's view, is to alert the analyst to possible change. It then behoves the analyst to come up with a fundamental argument that might validate the message that the charts are signalling. Mindlessly following the charts assumes that investors fly on emotion alone and that logic plays no part in investment. Such a view is patently wrong and, therefore, dangerous: Logic and emotion both play a part. It's just that intuition seems to precede the synaptic connections, so technicals tend to point the way. The problem is: If one cannot reconcile technicals and fundamentals then the technical "signal" may turn out to be wrong.

So, is there an argument that could be put forward as to how interest rates might rise in an environment where the corporations are awash with cash, the Fed stands ready to print as much money as it needs, and the velocity of money might be slowing.

Sure there is! It involves a concept called "risk".

There is a well known but little understood concept in investment called "risk weighted return on investment" (RWROI). What does this mean?

If you use the 30 year "risk free" yield on Government Bonds as the benchmark, then all other investments are compared against this benchmark and should be weighted for risk.

Let's say that the risk of investing in listed equities is 2.5 times as great as investing in 30 year bonds, and let's say that 30 year government bonds yield 5% p.a. This means that investors will "demand" 2.5 X 5% = 12.5% Return On Investment in listed equities to compensate for risk.

What will happen if the yield on 30 year bonds rises to (say) 5.5%. Well then, under those circumstances, RWROI in listed equities will need to rise to 2.5 X 5.5% = 13.75%.

There can be long periods of time that elapse when emotion rules over logic and the markets do not behave in this way. Then, finally, the realization dawns that this logic is perfectly correct, and the markets make a savage adjustment.

So let's look at the Industrial Market's returns over the past 12 months, and let's take the S&P 500 as the benchmark.

Last June, the SPX was standing at around 1200. It now stands at around 1325 (I'm being generous by choosing the lowest and the highest)

This shows a capital gain of 10.4% over the "year". Add this to the current trailing Dividend Yield of 1.8% and you get - wait for it - 12.2%.

Self fulfilling prophecy? Well, that's the historical view. What about the view looking forward?

If yields on the long bond fall to (say) 4.5% then RWROI on the equities only needs to be 11.25%. In this case, the market has room to rise immediately to form a new base, so that the base from which they continue to rise will give rise to a new capital growth rate of 11.25% - 1.8% = 9.45%.

Unfortunately, the key to capital growth lies in the earnings "power" of the underlying company's revenues and assets. Every company has a business model that can be typically expressed in terms of "maintainable earnings as a percentage of revenues" and, perhaps surprisingly, every business has its own profile that tends to be unique - like a fingerprint. For example, a retail supermarket chain will likely earn 3% - 5% EBIT: Revenue, on average. It maximises its return on invested assets by turning these assets over quickly (typically a standard ratio that doesn't change much), and it minimises its amount of capital required by buying on 60 day terms and selling for cash. The music goes round and round, and the Return on Revenues is 3% - 4%, on average.

When the economy is booming, revenues are growing but return on assets remains fairly stable and the company needs more infrastructure and assets to support the sales growth. It therefore pays to plough back capital and minimise dividends because the capital value of the business will grow quickly. When the economy slows and revenue growth slows, the need for cash to plough back into assets slows, dividend payouts rise and capital reinvestment falls. On balance RWROI remains constant from the shareholders' perspective because they get less capital growth and more dividends.

So, if dividends rise because companies are cash rich and can't really see high revenue growth going forward, and dividend yields rise to (say) 5% then only those small cap and mid cap companies which can sustain high growth can get away with low dividends. Those that can't grow fast enough and also can't pay 5% dividend will experience a downward pressure on their share prices.

But what will happen if companies are paying 5% dividend yield and the Government is paying 5% on its 30 year bonds? Will perception of risk change given that the US Government is "tapped out"?

Would you as a Baby Boomer investor rather put your money into (say) General Electric at 5% DY or US Government Bonds at 5%?

Okay. Now, before we answer that question, let's have a look at GE's latest cash position, by way of an example.

At the end of 2005 GE had roughly $1 per share in cash in the bank. At last Friday's price of $34.40 this represented 2.9%. Last year's dividend yield was 2.9% so, assuming GE paid out all its cash in one hit, its annual dividend would rise to 5.8%.

To get to 12.5% total return to compensate for investor risk, GE shares will need to rise by only 6.7% in the coming year.

So now lets look at their EBIT:Total Assets for 2005.

Total assets were $673 billion. Maintainable EBIT (after adding back interest and non recurring items in 2005 was around $23.7 billion and, remember, this isbefore tax.

23.7/673 = 3.5%.

Just for interest: There are roughly 10.6 billion shares in issue, and at a share price of $34.40 this means that GE is capitalised at $364.4 billion, so Maintainable EBIT Return on shares is 673/364.4*3.5% = 6.27%

6.27% (earnings pre tax) + 5.8% (dividends) = 12.07%

Oops. There is no way that GE can return 12.5% to shareholders if it is going to pay 5.8% dividends unless its Price:Earnings ratio rises - because underlying earnings cannot grow fast enough to drive the share price up. (As an aside, it is now clear that what has driven the markets over the past 15 years or so has been falling Interest Rates which have led to upwardly adjusting P/E ratios)

So, if we take GE as a proxy for the US market (wild assumption, but it makes the point in principle) even if corporations pay out all their spare cash in dividends, the market is fully priced based on the POWER of underlying earnings. To get a higher yield on assets is very difficult. When the economy booms, the amount of money you need to invest in assets rises and you need more infrastructure and more assets.

Okay, so this brings us back to the initial question. If GE raises its dividend to 5% would you rather buy GE shares at 5% or the Government bonds at 5%?

Answer: I would rather buy Government Bonds because the risk of investing in GE is 2.5X that of investing in the government of the USA.

Unless, the US Dollar starts to fall.

Why would this be the case?

Because, from a foreign investor's perspective, the risk of lending to the US Government is not really related to whether he will be repaid what the US Government owes him in dollars, but what the US Government owes him in his currency.

If I as a foreign lender am going to have to take a risk that the US Dollar may fall, then I need to be compensated for that risk.

There are two ways I can be protected against this risk. I need to be paid a return on investment that will compensate me for my possible capital loss. This would be virtually impossible if (say) the US dollar were to fall by (say) 20%.

Let's look at this example: Assume I lent $1 billion to the US Government by subscribing to $1 billion 30 year bonds, and I want a 5% return. I need to get back $1.05 billion.

If the US Dollar falls by 20% then my capital will fall to $0.8 billion, and the dividend the US Government needs to pay me to compensate me for my currency risk will be $260 million or 26%. That is not going to happen.

So this leaves the second way: The US Government has to prevent the US Dollar from falling. How can it do this? By pre-emptively raising interest rates so that money keeps flowing in because the US Government pays a relatively higher return than other "risk free" governments.

Conclusion

If the US Government is to continue issuing Government Bonds to foreign investors, the US Dollar must be protected. Yields on Government Bonds need to RISE.

Technically, that is what the long term monthly charts are telling us.

What is the likely impact of rising Bond yields?

Well, if bond yields rise then the stock market needs to fall to a new base - from which base the annual return going forward will be 2.5X the long bond rate.

As an aside, but maybe even the main the Page One story that Mr Murdoch's organization will likely choose to put on page 3 if it reports it at all, is that if interest rates rise the benefits the consumers of a falling oil price will be eaten away at best and, at worst, will negatively impact on consumption - which is the ultimate driver of the US economy.

We could go through the arithmetic of the argument, or we could just accept the base principle that there is no way the US Industrial Equity market is going to surge upward from this point - not unless foreign investors in US Government Bonds have taken leave of their senses and are prepared to accept the risk that the Dollar will not collapse if interest rates do not rise.

Overall Conclusion

Those people who believe that interest rates will fall from this point do not fully understand the concept of "risk". If yields do not rise from this point, the probability that the dollar will collapse will rise and the probability that overseas money will continue to flow into the US to fund US deficits will fall.

In either event yields must rise. If the US Government cannot raise money from overseas investors it will be seriously short of cash and will have to pay more to borrow domestically.

Therefore, the long dated chart is not lying. Yields have stopped falling and may soon start to rise.

If they do, this will put a downward pressure on gold - until it becomes obvious to even a blind man that the US Debt position is no longer manageable.

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There is one argument that could be put forward to counter the above:

The US Government issues bonds for which the Fed subscribes 100%. This will lead to massive US internal price inflation, and will savage the capital value of the savings of Baby Boomers - who will demand higher interest rates in order to survive. Whichever way you look at it, is only a matter of time before yields start to rise, because failure to rise will be a sign that the patient is terminal. The economy will become dysfunctional and will collapse through a severe contraction in velocity of money.

That a downward move in the US stock market is not far away, is evident from the seriously overbought charts below