"Kee" Points with Jim Kee, Ph.D.

  • Expect This Kind of Volatility  
  • Bonds as a Separate Asset Class  


Expect This Kind of Volatility

Financial economists tend to look at stocks through the lens of discounted cash flows, which means they start by estimating the future cash flows (profits) that a company is likely to generate. But a dollar received today is worth more than a dollar to be received ten years from now. That is because a lot can happen in ten years, from tax rate changes, to changes in inflation, to the company going out of business (to name a few). So future cash flows are “discounted,” meaning analysts estimate a discount rate in order to value future cash flows less than current cash flows. Hence the term “discounted cash flow models.” While people tend to look at big short-term swings in market prices or valuations as irrational, economists like Nobel Laureate Merton Miller would often point out that it only takes a small change in the future cash flow estimates and/or the discount rate to lead to huge swings in prices. And since events happen all of the time that could influence both cash flows and discount rates, market swings or stock price volatility should be expected. With that as background, I had worked with what is perhaps the best data set for estimating cash flows and discount rates while I was at the Credit Suisse Holt group. My take away was that nobody has a model good enough to peg what the theoretical value of the market should be within, say, plus or minus ten percent. So I would expect movements within that range to be pretty common. With a DOW level of 26,000-27,000, a ten percent movement is 2,500 points or more. Looked at this way, movements within 1,000 should be viewed by investors as normal, unpredictable, and meaningless in the long-run. Looking at this past week, the ups and downs in the trade talks have clearly lead to ups and downs in the markets. The media, which is often a distraction to investors, has been focusing on everything from Middle East strife, to Presidential Impeachment talks, to Hong Kong protests. But keep in mind that the media watches market movements and looks for stories to explain them, so they follow the market, they don’t lead it. As I mentioned in a prior Kee Points, that means you cannot extrapolate media stories to anticipate the markets. As for turmoil in Hong Kong, I have also mentioned in a prior Kee Points that it has been a long-time coming. My guess is that China will back off a bit, as they seem to have too many fires going at the moment.


Bonds as a Separate Asset Class

One sign that I and most of the economists I know aren’t comfortable with is low long-term interest rates. As I write, 10-Year US Treasury yields are just below 2 percent, which I believe reflects their global safe-haven status, i.e. when turmoil occurs anywhere in the world money flows into US Treasuries, bidding up prices and lowering yields. It remains to be seen whether yields will fall to the 1.4 percent levels we saw during the summer of 2016. But of most concern to investors should be whether or not they or their advisors are buying the right kind of bonds. You want to make sure that you are actually investing in an asset class that is driven by factors distinct or different than those that drive stocks. Stocks should be the risky portion of your portfolio, while bonds should be the safe portion. Often there are factors that affect stocks more than bonds, like changes in corporate tax rates. Likewise there are also factors that affect (in general) bonds more than stocks, like inflation. Certain types of bonds, however, are driven mostly by the factors that drive stocks, so they do not provide downside protection to your portfolio. High-yield corporate (i.e. junk) bonds are a good example. Environments that tend to be hard on corporate profits, like economic downturns, also make it harder for companies to make their bond coupon commitments, particularly companies in the high-yield space that were already on the edge (that’s why they have to borrow at higher interest rates). Instead, you want bonds like US Treasuries, which have the taxing power of the federal government to help keep their promise to pay; or general obligation municipal bonds which have similar authorities backing them. Those bonds are least likely to behave like stocks during a period when stocks are selling off. As for corporate bonds, only those issued by companies with healthy balance sheets and cash flows should be considered, and they tend to be able to borrow at lower rates (so they have lower yields), not junk rates. And sure, junk bonds tend to do well when stocks do well, but in those cases you’re much better off just owning stocks.