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Don’t put all your money into bonds, a message for SVB
So remember a while ago I wrote a post about how you should diversify your investing, not just put all your money into bonds? I just realized that if SVB had listened to me they wouldn’t have been in this mess. I talked about how rising interest rates make old bonds worth less than you payed for them, and how you’d take a loss if you needed to sell them in a hurry. That’s exactly what caused SVB’s collapse, they were sitting on assets (bonds) that had lost tons of value due to rising interest rates. That triggered fears of insolvency which triggered a bank run.
If anyone knows a dumb bank that needs to hire a smart guy like me to do risk assessment, I’m always looking for a new job. Just email theusernamewhichismine@gmail.com.
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It’s not a bailout unless it comes from the bailout region of DC
America is bailing out the banks again, but like Josh Barro writes, we don’t want to say we are. When the government hands billions of dollars to Silicon Valley hedge funds by guaranteeing their deposits, it makes us wonder why they can’t hand billions of dollars to those of us struggling with inflation. Maybe they can guarantee our rents? But this totally isn’t a bailout, just ask Biden.
For those who don’t know what I’m talking about, Silicon Valley Bank (SVB) was a bank holding deposits from hedge-fund backed startups and using them to make very risky plays. Those risks cased them to crash and burned due to rising interest rates. So the government had to bail them out, but it doesn’t want to call it a bailout.
So why isn’t this bailout really a bailout? Well, only the depositors will be getting all their money back, the bond and equity holders of SVB will be getting little to nothing. This has led some to even applaud this bailout as being re-distributive: money is going from the wealthy to the poor.
Let’s get one thing straight, this is a bailout of the rich. Depositors are ALREADY guaranteed to get their money back p to $250,000. The FDIC already made sure anyone with less than $250,000 in the bank got their money back. But what about the poor hedge funds and VCs with millions, even billions of dollars locked in the bank? Well normally they would get back $250,000, but it’s not fair that rich people lose money so that’s what this bailout is supposed to cover.
The wealthy depositors will be made whole at the expense of bond and equity holders of course. But that’s just moving money from the rich, politically connected people to the rich, not-so-connected, it’s classic graft of making sure your boys get the best from the government.
More to the point, the money may not come from the government per se but it is coming from the people, or at least the people with bank accounts. FDIC is the insurance that is paid by every bank account, and it in turn pays to cover all bank accounts up to 250,000 dollars should their be a bank run. The fact that the FDIC will now be covering more, potentially up to billions in dollars, means that money has to come from somewhere. It will come from all the other people with FDIC ensured bank accounts, all the people with a few hundred or thousand dollars in the bank.
The FDIC isn’t a line item you’ll see in your bank statement, it’s an invisible insurance policy to most people. But make no mistake it is paid by the account holders. If FDIC insurance did not exist, the bank would give you a higher interest rate on your savings account because they wouldn’t need to pay insurance on your bank account. Instead, interest on deposits is likely to be lower than expected as the FDIC will have to drawn on the insurance premiums from every small account in order to cover the billions of dollars they’ve pledged to rich hedge fund managers. Poor people with small bank accounts will be made tangibly more poor in order to ensure hedge funds get all their money back.
Not only that, there is a definite moral hazard with bailout out the rich in this manner. When a bank goes under, there is supposed to be a protocol of who gets what. Depositors up to 250,000 dollars will be covered by FDIC no matter what, everything else including bond holders, equity holders, and large depositors is fair game depending on the results of the bankruptcy.
Instead, it is know going to be assumed that depositors will always be bailed out at the expense of bond holders. People who want to make low interest money have a few options: they can give it to the bank and get interest, or they can buy a bond and get the coupon. They know that if their money is large, both of these carry risks. The deposit and interest are only covered up the 250,000 while bonds can be defaulted on or banks can go bankrupt. However now, the calculus changes. Deposits will always be bailed out by the FDIC at the expense of bonds, meaning that they are now much safer and bonds are much riskier. This could even make it worse for some banks as they will find they cannot raise money through bonds as easy as they used to. Who will buy your bond if a high-yield savings account gives roughly the same interest rate and is guaranteed zero risk by the FDIC no matter how much money you put in?
So this is a bailout that isn’t a bailout, it gives money to the rich at the expense of the poor.
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Quick Post: WTF happened with Silicon Valley Bank
So I’m really only making this post so I can link to it in another post, but while there have been plenty of explainers going around about what happened with Silicon Valley Bank (SVB) I wanted to get all the facts as I know them in one place.
Basically, Silicon Valley Bank had a bank run and needed a bailout. Why?
When you deposit your money into a bank, the bank pays you interest on the money. You are giving what is essentially a loan to the bank, and they in turn use that money to give loans to other people. The assumption is that the interest they get on their loans is more than the interest they pay you for your money, so the bank can always stay profitable.
Banks have their best relationships with the people who deposit money into them, so those tend to be the ones they reach out to and offer loans. Whatever bank you deposit your paycheck into is likely going to be the one that offers you a car or a house loan. But SVB was taking deposits from Tech startups and Silicon Valley hedge funds. Those guys don’t need or want loans. They raise money through equity, not loans. So while lots of deposits flowed into SVB, far fewer loans flowed out.
So how could SVB make money without loans? They bought bonds instead. Government bonds are just a loan you give to the government after all, and SVB thought that using their deposits to buy bonds was a surefire strategy because the government will never default. Remember that banks don’t ever just sit on loads of cash, they have to sell assets if they want “liquidity” (finance speak for cash). But if depositors want their money back, SVB can just sell bonds and give them cash, while if depositors hand them more money, SVB will use that money to buy government bonds.
But then inflation came, and brought with it interest rates. We’ve discussed before about how when interest rates rise, the price of an old bond falls. If you bought a bond paying 0.25% and interest rates have gone up to 5%, no one will buy your bond without a heavy discount. So 3 years ago a tech startup deposited $100 dollars into SVB, and SVB bought 100$ worth of bonds. Now the startup wants its money back but the 100$ bond SVB has bought has given them almost no interest (0.25%!) and has collapsed in price. When SVB sells its bond, it gets back WAY less than 100$.
So when interest rates rose, SVB’s bonds were all worth a lot less, but they were obligated to sell them to pay back their depositors. That would be fine if only a few depositors wanted their money, SVB can take a loss and make back the difference with profit elsewhere. But if ALL their depositors want their money back, SVB cannot cover.
And the depositors did want their money back. Startups backed by hedge funds get piles of money by selling stock, IPO’ing, and selling equity. Then they handed that money to SVB. Stock prices collapsed in part due to rising interest rates, the flow of cheap money stopped. Because of that, startups needed to take their money back out of SVB to keep the lights on. Money was flowing out but nothing was flowing in.
So SVB had a massive interest rates risk on both sides of its balance sheet. Interest rates decreased the amount of money going in (by tanking the stock market and making IPOs and share selling less common) while also decreasing the value of the assets SVB held (by making their government bonds worth less). Add onto that that inflation increased the amount of money flowing out (since startups needed to pay more for everything) and SVB was primed for a bank run. Depositors realized SVB didn’t have enough cash to cover everyone’s deposits, and so they all rushed to take all their money out before it collapsed.
And so collapse it did, and the government handed it a bailout. I’ll write more about that tomorrow.
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The danger of small patterns
As I’ve probably said before, I work as a researcher. When you’re doing difficult or expensive research, you don’t usually have the time or money to do a whole lot of replications. That goes doubly if you’re working with patients or patient samples. But since science is all about finding patterns, how can you find patterns in a small dataset?
There are statistical tools that can help with this, but even before you get to the hypothesis testing phase, you need to know which direction your hypothesis will go in. For that, we tend to look at the small patterns which aren’t yet statistically significant and try to see what they mean. The danger here is when you don’t get data in a reasonable amount of time, you want to work on your project but you don’t have data to work on. So you go back to whatever you have, the “small patterns” and start extrapolating from there. “If this pattern holds, what could it mean for this disease?”
Then you can start getting attached to a hypothesis that has no data to back it. When you do get data, you may start to interpret it in light of the small pattern you already detected, a pattern which may not even hold. That’s the problem with small patterns, you get to thinking they mean more than they do.
The human brain is a pattern matching machine. Our first calendars came about from noticing that the seasons of a year came in patterns, and that certain stars in the sky could be seen during the hot season while others could be seen during the colder one. But people also thought they detected patterns about how certain things happened on earth when certain stars were seen in the sky. One pattern between stars and the sky held true, there is a correlation between which stars you can see and the season in your local area. But another pattern was false. Yet both patterns were studied and believed for thousands of years.
I hope I don’t get attached to bad patterns for quite so long as that, but it’s hard to avoid. When you’ve got all the time in the world and not enough data, you get attached to these small patterns that you think you detect. And that can hold true even when the pattern is no longer real.
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Joel Kurtzman is the opposite of Richard Heinberg
I just wanted to start by saying I’ve become much more lackadaisical about these posts recently. My work is getting interesting, so I’m not putting as much time and effort into my research prior to posting. I’m mostly shooting from the hip based on whatever comes to mind. I still enjoy this though so I’ll keep doing it, and I hope my couple of readers don’t mind the decline in quality.
With that said, it’s so interesting that Joel Kurtzman detects the exact opposite problem as Richard Heinberg. For those who remember, Richard Heinberg wrote “The End of Growth” in which he posited that there would be no more economic growth after 2010 (lol, lmao even). He claimed that this was because the world had entered an inextricable supply crunch, there just wasn’t enough stuff to go around (especially oil!) and our economy was already well past the carrying capacity of the planet. This meant that we couldn’t keep growing, because without more stuff to put in our factories we couldn’t make products to sell to people. We would all have to get by with less.
Hilariously, Joel Kurtzman detects the opposite problem from his vantage point in 1987. He detects a severe overproduction of commodities and finished goods caused by the industrialization of the global south and its competition with America, Europe and Japan. In Kurtzman’s thesis, we are entering an inescapable race to the bottom where wages will continue to fall further and further as companies try to make money while the prices of goods fall. Not only that but the nations of the world have financed their overproduction through the accumulation of debt, which they won’t be able to pay off as prices fall meaning there will be a debt collapse and further unemployment.
I’m sure both authors would think me uncharitable towards their theses, but that was my reading from their books.
The point is, I think both of them are suffering from extreme recency bias. Heinberg was writing after a decade of constricted oil supply had caused a rise in prices and had been followed by an economy crash. He thought the constricted supply would continue forever and the low-growth era following the crash was permanent.
Kurtzman was writing after a supply crunch had turned into a supply glut. OPEC’s oil embargo of the 70s had forced the world’s economies to become more efficient and induced many companies to step up their own oil production. In the late 80s, rising oil investment turned into an oil boom, and to maintain market share OPEC countries increased production without the consent of the entire group. This, alongside new technologies to make oil use more efficient, led to an oil glut and depressed prices. Add to this that prices were falling in other sectors, and Kurtzman thought this trend would continue forever.
Both Kurtzman and Heinberg astutely identified trends in their immediate present, and then extrapolated those trends infinitely into the future to arrive at their desired policy goals. For Heinberg: it was degrowth. For Kurtzman: it was protectionism. Both of them failed to understand that actions change with changing conditions. Heinberg didn’t realize that a rise in oil prices would spur investment into new extraction methods (fracking) and more efficient usage of oil (hybrid/electric cars). Kurtzman didn’t understand that falling commodity prices allows companies to produce more for less, nor did he understand that the American economy didn’t need manufacturing jobs to stay highly paid. If more stuff is being produced while still profitable, then consumers win because prices go down. And American consumers won most of all because tech jobs were replacing laborious manufacturing jobs.
I know pontificating is a hard job, I think all the pontifications I’ve made on this blog have been off the mark (though I don’t ask for money). But I find it fascinating that these two authors erred in exactly the same way to arrive at completely divergent answers. I’d love to have Kurtzman from 1987 debate Heinberg from 2010. Don’t let them use historical data, just explain to each other why will commodity prices have to remain high/low for the foreseeable future? I wonder whose head would explode first.
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Follow up: what did Joel Kurtzman think of the 90s and 2000s?
I wrote a post last week about Joel Kurtzman’s “The Decline and Crash of the American Economy,” a book from the 80s that posited that America’s best days were behind it. Kurtzman’s central thesis appears to be:
- Manufacturing is moving overseas, causing America to run a trade deficit
- To buy foreign goods, America and Americans are becoming indebted to the rest of the world
- Foreign investment is flooding into American stocks and American debt, causing us to lose control of our own economy
- The much touted “service jobs” and “information age economy” are a mirage
- As a result of the above four facts, the American economy is entering a period of decline and crash which can only be solved by strong protectionism and government control of the economy
This was all written in the 80s, and to an old-school leftists I guess it all seemed very sensible. I could imagine Jeremy Corbyn or Bernie Sanders making these exact arguments in 1980, while adding a few more worker-centric chapters of their own. The problem is that this thinking has largely been supplanted by modern economics.
Manufacturing is not the only thing an economy does. The knowledge economy, which Kurtzman scoffed at as the “information age economy,” has rapidly eclipsed all the manufacturing that came before it and continues to propel American forward. Likewise foreign investment flooding into America is by no means bad, as it allowed American companies and the Government to finance themselves with debt or equity. If foreign investment was fleeing America, that would be cause for concern. Being in debt is not a biblical sin for an economy. We all take on debt all the time because the value of having a car or a house now is greater than the value of the money we will use to pay off that debt over 5 to 20 years. The same is true for companies expanding, and foreign investment flooding into America means companies can issue debt much more cheaply than they could otherwise.
Furthermore Kurtzman’s prescription was largely abandoned in the 90s. Both Republicans and Democrats largely made peace with free trade (although the 2 most recent presidents have bucked this trend). There is a strong argument to be made that tariffs on foreign goods hurt the American economy as much as they do the foreign economy for a number of reasons. Tariffs create a walled garden for certain goods, allowing noncompetitive industries to remain in business for longer than they should. In turn these noncompetitive industries suck up investment and compete for resources, making it harder for actually competitive companies to expand as they should be able to. There is only so much supply of money, parts, and workers, if Ford was heavily subsidized by tariffs, would Tesla have been able to take off? Finally tariffs alter the incentive calculus for a company because once tariffs are part of the political equation, companies can increase their profits more by demanding higher and higher tariffs from the government than they can by actually improving production. This caused some Latin American countries to enter a tariff spiral where goods became more and more expensive because rather than compete with the rest of the world, companies put their effort into demanding higher and higher tariffs.
In the 90s and the 2000s America largely abandoned Kurtzman’s thesis and his prescriptions. Angst and newsrooms aside, the trade deficit kept expanding, NAFTA remained in place, the service and information sector were seen as avenues of growth, and debt kept piling up. If Kurtzman then thought the Financial Crisis was proof of his theory, he would have been rather sad that America came out of the crisis much better than most of the nations he said it was indebted to, such as Japan, Latin America, and Europe.
Reading Kurtzman’s book is like reading politics from a bygone age. I once read a book about “the Crime of ’73,” a much maligned bill which removed the right of silver-bullion-holders to have their silver minted into dollars. Pro-silver advocates despised this bill so utterly that it eventually launched William Jennings Bryan as a presidential candidate, a candidacy he might not have gained had the silver movement not been so motivated and powerful. Yet reading it today, it’s hard to understand why this economic debate was filled with such hatred and vitriol. It’s hard to understand the motivations behind the players, and how for them this was the defining issue of their age. Because honestly, America has moved past that debate long ago: silver isn’t money and neither is gold, dollars are. I almost feel the same way with Kurtzman’s book. The last 2 presidents notwithstanding, most of my adult life has been shaped by a bipartisan agreement on free trade and the importance of the information economy over traditional manufacturing. I just wonder what Kurtzman would think now.
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Was the Crash of 1987 all that important?
America has had a lot of recessions, depressions, and financial crises. Every country has of course, but since America has been the world’s largest economy for well over 100 years, ours get more press and reverberate more strongly throughout the world. But the crash of 1987 is one that I rarely see talked about, and I thought that was with good reason. On October 19th 1987, stock prices worldwide crashed by double digits in a single day. But the effects on the wider economy were not so severe, and the US economy still grew by 3.5% that year.
The Crash of 1987 is a good reminder that the stock market is not identical to the “real” economy. Now, they are not wholly diverged either, and if stock prices crash companies will find it harder to use their stock to finance expansion. But they aren’t tightly coupled and the Crash of 1987 is one of the many events that proves it. However I’m reading a book now called “The Decline and Crash of the American Economy” that appears to posit more from 1987 than was warranted.
The author, Joel Kurtzman, tells you his thesis on the cover of the book, and the inside jacket makes special note of how 1987 heralded deep problems that would not be fixed without his preferred policies being implemented. But Kurtzman is basically a left-protectionist who blames Nixon and Reagan for ending the gold standard/Bretton Woods and liberalizing American trade. Kurtzman’s policies were by no means implemented, but the 90s were hardly a decline and crash by anyone’s definition. It feels to me like Kurtzman had a thesis already in place, and simply used the crash of 1987 as ex post facto proof of what he already believed.
I’ll try to write more about this book in the coming days, but I don’t think 1987 was an important as Kurtzman thinks.
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Do momentum strategies beat buy-and-hold?
This post has been a LONG time coming, but a while ago I wrote about the rate of return for investing in the S&P 500. In that article, I compared the returns of someone executing a buy-and-hold strategy starting in a certain year and ending 10 years later. Unsurprisingly, the best time to start a 10-year investment was in 1990 or early 1991, as the peak of the DotCom bubble happened 10 years later and you could sell out at the top.
Figure 1: Return over 10 years of a $10,000 investment, assuming buy-and-hold strategy
But what about someone who wants a more sophisticated strategy than simple buy-and-hold? The reason people day-trade is that they hope to beat the market, not just match it. One strategy that I have seen genuine, peer-reviewed literature discussing is the so-called “momentum” strategy of buying while the market is going up and selling while it’s going down. In this way you should avoid big loses (like the DotCom bust) but still have big gains (like the DotCom bubble).
Now, a momentum strategy can be done in different ways. It can look at specific time periods, it can include shorting, it can include sector rotation, etc. But the simplest momentum strategy I found was to simply sell out whenever the market dropped by 20%, and then buy back in when it recovered 20% from the bottom. This is intended to stop loses on the way down and avoid FOMO-ing back in during a bull trap, only buying stocks during a true bull market.
I wrote a program to calculate the return on a $10,000, 10-year investment using that strategy.
Figure 2: Return over 10 years of a $10,000 investment, assuming 20% momentum strategy
The results are fairly discontinuous because of the rigidity of the 20% cutoff, but some patterns do emerge. The return is almost identical for people who invested in 1990, because for that 10-year period the market never dropped 20%. Once you get into 1991 however, this strategy would have allowed some people to avoid the worst of the DotCom crash, as they would have sold out when the market dropped hard. In that case they would have done better than a buy-and-hold strategy.
However that’s just an example of the strategy working at it’s best. I decided to compare the two strategies. I simply subtracted the two graphs from each other, creating the below figure as a result. Any dot that is on the zero line is a point in which buy-and-hold performed identically to momentum. Any dot below is where momentum performed worse, and the few dots above are where it performed better.
Here, we see some interesting patterns, the momentum strategy actually performed pretty poorly for anyone who started a 10-year investment in the 2000s. The peaks in the early 90s are people who sold out during the DotCom bust and missed the worst of the loses. The peak around 1999 is people who sold out during the Financial Crisis and missed the worst of the loses. But the declining valley during the 2000s is the result of people who would have sold out during the Financial Crisis, but then waited for the market to get above where they had sold before buying back in.
Remember that the momentum strategy involves selling when the market has lost 20% and only re-buying when it’s regained 20% off the bottom. Less than 20% off the bottom and you can argue (as some have this year) that it’s just a “bull trap” and the market still has “another leg down” ie much further to fall. This can result in standing on the sidelines with your cash while the market makes money without you. And using this momentum strategy, that’s exactly what can happen.
I use this to illustrate a point I’ve talked about before, it’s not usually smart to just sit on cash waiting for the market to fall further. Sure the market can fall further, but it can also rise and leave you behind. Time in the market beats timing the market. Furthermore, this experiment is as generous as possible to the momentum strategy: there are no transaction costs (the bid-ask spread is an unavoidable real-world cost) and we ignore dividends (which further rewards time in the market at the expense of timing the marker). If total returns were taken into account along with transaction costs, it’s debatable as to whether any 10-year momentum investment would have beaten buy-and-hold. Even as it stands now, only a very few lucky investment windows would have benefited from momentum strategies, most would do best with buy-and-hold.
Just for kicks, I reran this data with a 10% momentum strategy instead of 20%, and the results were even worse for momentum. Selling out at the first sign of trouble, FOMO’ing back in to the first recovery, and then losing all over again makes for a terrible strategy and that can basically be what momentum trading is.
I can go forward and look at more exotic momentum strategies some other time (for example short stocks that are falling and long stocks that are rising), but for now I think I’ve proven my point.
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Technical analysis and fundamental analysis cannot both be true
I’ve said before about how I’m not sold on technical analysis being viable, but I’ve seen counter-arguments floating around that say “it doesn’t matter if TA doesn’t make sense, if people believe it and act on it then it will still move the markets.” In this case, knowing TA yourself lets you read the minds of all the other TA-knowers and join in their pumps and their dumps, making money by being part of the crowd. Yet fundamental analysis says that there is an underlying “fair value” for an asset, and good investing is about going long on undervalued assets and short on overvalued ones. Fundamental analysis accepts the possibility of hype and speculation, “the market can stay irrational longer than you can stay solvent” etc, but it requires that at SOME point things fall back to earth and assets reach their fair value.
Technical analysis on the other hand implies that the future price of a stock is most strongly connected to its previous prices, not to the value of the underlying asset. This means that previous highs, lows, and averages give a kind of momentum that can be predicted and traded on.
My question is, how can these both be true? Technical analysis assumes that the price reflects all available information, otherwise past trends cannot predict future prices. Fundamental analysis assumes that the price does not reflect all available information, otherwise there are no over-valued or under-valued stocks and all stocks are at their fair value.
How can the price of a stock be dependent both on the analysis of the underlying asset AND on the previous prices of the stock, since those can easily move in opposite directions? If there is a conflict between the TA and the FA, who wins? Well if you believe the Efficient Market Hypothesis, neither win because the winning move is to buy once and hold forever. But if you believe FA then FA wins and the price must go up, if you believe TA then TA wins, but I don’t think both can be true in all or most cases.
I’d like to know if anyone believes both TA and FA can be true and if so why.
As an aside, Wikipedia explicitly labels Technical Analysis as a pseudoscience.
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Streams of Consciousness 