Unpleasant Facts and Other Musings

It is good to have an understanding of underlying relationships between assets. Knowing that gold goes up when the dollar goes down or that airlines and consumer discretionary stocks do not benefit from higher oil prices is important for someone trying to understand the market.  However, sometimes these relationships are given an importance that masks what is really going on.  Howard Simons has an article up at Minyanville that makes this mistake.

“The current partial contribution of crude oil prices to the S&P 1500 Supercomposite remains positive, 0.59% on a net weighted beta at last calculation. The reason for this is simple: The positive impact across the Energy and Basic Materials sectors outweighs the negative impact across the Consumer Discretionary, Consumer Staples, and Health Care sectors. 

He is right that higher oil prices are generally better for Energy and Basic Materials sectors than for the others. Energy companies selling oil and oil services make more money when oil is higher, and oil is highly correlated to the price of many other commodities that materials companies make money selling.  However, implying that the S&P 1500 was driven up despite the negative effect of oil on consumer discretionary stocks is proved false by simple data analysis.

The chart below shows the weekly percent change of oil versus the weekly percent change of the AMEX Consumer Discretionary Select Index from March 2009.

The relationship between oil and consumer discretionary stocks is positive, as both have been rallying due to more positive economic and financial expectations.  The more intuitive relationship of higher oil prices mean consumers have less money to spend on everything else is masked by the more extreme financial market effects. Simons does recognize this factor when he discusses that global economic growth is partially behind the high correlation between crude and the S&P 500, but it doesn’t make his earlier statement about sectors any more correct. 

The below chart looks at crude oil weekly returns vs. the relative beta adjusted weekly return of the consumer discretionary stocks (Consumer Discretionary weekly return times beta to S&P500 minus S&P 500 weekly return). Since October 1^st, even this relationship has been slightly positive.

The chart below shows how the relationship between crude oil and the S&P 500 is variable over time (The rolling 26 week T-stat of crude oil explaining the S&P 500). Theoretically, the relationship is positive when crude oil and the stock market are being driven by economic growth and it is negative when oil is acting more of a constraint on growth due to supply restrictions. When the oil squeeze comes, this chart will fall below zero.

The charts were made with tools from Palantir Finance, which released some good news today.

When thinking about the inevitable capital gains tax increase, it is interesting to look at which sectors will be most affected. The marginal non-institutional investors with large capital gains in a stock might be motivated to sell their shares into year end in order to avoid the 5% tax increase. However, the sectors impacted by a changing capital gains tax depend on the distribution of holding times by investors.  If investors hold stocks for a year and a half on average it has a very different implication than if the average investors hold stocks for 2 or more years. 

On a 6 month time horizon, by the end of the year people who bought 6 months ago will be able to see their holdings at the long term capital gains tax rate:

1 year time horizon with returns over 50%: Everything rebounded this year, but particularly consumer discretionary and financial stocks.

2 Year Time Horizon with returns over 20%: Technology and consumer discretionary stocks are the ones with capital gains.

3 Year Horizon: Investors with a three year time horizon are sitting on gains everywhere but in financials and utilities.

5 Year Time Horizon with returns over 40%:

Source: Palantir Finance

Greece has been in the news again recently. The 5 year credit default swaps have jumped from 344 basis points last Friday to 444 basis points today, surpassing Iceland as the most worrisome sovereign debt in Western Europe. One hundred basis points in one week is a relatively large move, so it is expected that the impact of a worsening situation in Greece should impact both currency and equity markets. 

The more trouble Greece is in, the more people worry about the future of the Euro. However, it doesn’t take a probability of a currency crisis to drive the currency lower; it only takes an expectation of a relatively weak monetary policy in Europe to support Greece.

The worry that the Greek crisis will spill over into the financial system, along with its effect on the currency, has made the S&P outperform the Euro Stoxx 50 in dollar terms whenever Greece’s CDS spikes.

The rolling two month differences correlations have been relatively steady at 0.2 and 0.3 for the past 4 months (0.4 and 0.5 when looking at financial stocks). There are obviously other factors affecting currency and relative equity market performance, but the change in Greek CDS has been having a definitive impact. Those who don’t like trading the Greek CDS directly might consider a currency hedged long short equity approach.

I came across two interesting papers on capital gains taxes and their effect on the stock market.

The first paper, “Capitalization of capital gains taxes: evidence from stock price reactions to the 1997 rate reduction” was published in 1999 and was written by Mark H. Lang and Douglas A. Shackelford. 

This paper uses data from 1997 to try to get to the bottom of a few different views on capital gains taxes. The three theories are as follows:

1. When capital gains taxes are reduced, shares are more valuable to individuals and so share prices rise.  Theoretically, this effect should be larger when share repurchases or liquidation of assets are expected. It should also be larger if stock holders are likely to be individuals who are subject to capital gains taxes.
2. Capital gains taxes only tax assets that are sold, so they create a lock in effect on current owners. A reduction of the capital gains tax diminishes this lock in effect by reducing the tax on sellers, so a reduction of the tax should drive the value of stocks down.
3. If stocks are valued as the sum of their future dividends, or if the marginal investors are unaffected by capital gains tax rates, then changes in the capital gains tax rate shouldn’t have any effect at all.

The study found that during the week of the announced 1997 capital gains but not dividends tax cut, non-dividend paying stocks outperformed dividend paying stocks. This result is consistent with the first theory, where lower capital gains taxes increase the value of assets and vice versa.  The paper also failed to find evidence of a lock-in effect, as stocks with prior gains didn’t decline after the new capital gains tax rate went into effect.

The second paper was published in 2001 by James M. Poterba and Scott J. Weisbenner wrote “Capital Gains Tax Rules, Tax-loss Trading, and Turn-of-the-year Returns” 

This paper combines an analysis of end of the year trading anomalies with tax-loss trading. One theory is that losing trades will be sold at the end of the year in order to counter the tax implications of realized gains in other parts of the portfolio. Unfortunately, this same behavior can also be explained by “window dressing”, in which firms sell losers so their investors don’t see bad stock picks in their year end statements.  The paper attempts to distinguish the two by looking at how end of the year effects react to changes in tax laws.  A capital gains tax change would only affect individual investors while it wouldn’t affect window dressing at all, as window dressing may be done by managers for untaxed institutions as well managers for individual investors.  

The study looked at three different regimes.

Regime 1: Six month short term holding period, long term losses 100 deducible against adjusted gross income

Regime 2: Six month short term holding period, long term losses 50 deductible against adjusted gross income

Regime 3: 12 month holding period.

Stocks with losses at the start of the year exhibited less year end anomalies when 6 months was the demarcation before short term and long term holding. The paper doesn't disprove window dressing, but it does show that tax laws impact year end trading.

"The greatest shortcoming of the human race is our inability to understand the exponential function." 

-Albert A. Bartlett

Exponential growth is often widely underestimated. Here are a few issues where many people make mistakes because they don’t understand the simple math of exponential growth.

1. Economic Growth: When there are trade offs between efficiency and equality, many people today think that the taxes, regulation and redistribution are worth a slightly lower growth rate.  However, when this trade off is applied over a long time period, the results can be staggering. If the choice was made in 1870 to have more equality at a cost of 1 percentage point of growth a year, America in 1990 would be no richer than Mexico.
2. Entitlement Spending and National Debt: As I have pointed out previously, the United States is headed for very high debt levels if entitlement spending is not reformed.  One very simple way to fix this is to index entitlement benefits to inflation and not income. The growth of the economy would make it easy to pay for a safety net at today’s living standards. Unfortunately, this would only work for Social Security and not Medicare as the medical system is structured in a way that leads to health care inflation greater than that of the real economy.  Additionally, there is another problem when the net national debt reaches 100% of GDP. If the market perception of the debt turns negative and nominal interest rates remain higher than nominal GDP growth, then there is no way for the economy to grow itself out of debt.  This is the current situation with Greece, and Japan isn’t doing too much better.
3. Personal Finance and Pension Plans: If a prudent investor can make 10% real returns in a year, then they can turn 50 thousand dollars into over 1.6 million dollars after 35 years. This simple math explains how many of the rich people today consist of those who have saved and invested prudently. On the other hand, a supposedly fully funded pension fund planning on a world of 8% real returns that finds itself in a world of 4% real returns will find itself underfunded by over 75% 35 years later (In this case, the people making pension return assumptions are underestimating how much they matter, they just know that their books look better if they assume a higher return). Robin Hanson has been proposing that people don't give to the future because they don't care about it, but it may also be that they do not fully understand the impact of exponential growth*.
4. Overpopulation and increasing Resource Consumption: Overpopulation does not seem to be the exponential problem that we once thought it was. Once become rich enough, their population growth rate slows down. The UK’s Ministry of Defense 2008 Strategic Trends report expects the population to level out at around 9 billion people between 2050 and 2100 (page 25).  While overpopulation is itself not a problem, the exponential economic growth of these emerging economies are coincident with an exponential increase in demand for resources and these limited resources present constraints on growth.

Having established that exponential growth rates are important, here is a handy rule of thumb that will give an intuitive understanding of exponential growth. To calculate the doubling time of an exponentially growing series, take 70 (or 69.3 to be exact) and divide it by the growth rate. This means that a 10% growth rate leads to a doubling every 7 years, a 7% growth rate is a doubling every 10 years and a 3.5% growth rate is a doubling every 20 years.

*It is also possible that someone who both cares about the future and understands exponential growth might think that there were existential problems for the current society that are significant enough to reduce the probability of a far future donation from ever paying off.

One of the basic ideas in finance is that if something is widely known, then it is already priced in by the market. This leads to the contrarian style of investing, as pictured below:

If an idea isn’t believed by the market, then taking a position against the market view generally leads to a better risk/reward pay off because the idea can’t be priced out of the market when it is already priced in.  Of course, it is often very difficult to determine what market positions are contrarian because figuring out why the market is moving outside of earnings announcements, economic data and changes in government policy is a full time job in itself.

One way to clarify this is to focus on what people don’t like thinking about.

Trading based on what people don’t like thinking about can consist of taking the long term point of view, or just the politically incorrect point of view. An example of a politically incorrect view is that of vice stocks, stocks in industries that could be considered questionable. These types of stocks outperformed the S&P up until the start of 2008, by which time the idea that investing in vice outperforms could be said to no longer be contrarian.

Another area that investors avoid is the long term.  Investors may acknowledge long term trends are important but their incentives are short term. They are paid and allocated capital based on yearly performance. This leads to a focus on the short term, where earnings reports and economic data more than a year away are seen as insignificant. This is partially why the value based investor strategy works (in the sense that value stocks have consistently outperformed growth stocks in many basic quant models) – if a company is cheap relative to its price then the investor will make money in the long term despite the lack of a positive story in the short term. Of course, sometimes the stock is cheap because it has a negative story in the short term, so the value stock is also a contrarian idea.